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Ocwen Financial Corporation (NYSE:OCN)

Q2 2010 Earnings Call

August 03, 2010 09:00 pm ET

Executives

Dave Gunter - Chairman and CEO

Bill Erbey - President

Ron Faris - CFO and EVP

Analysts

Bob Napoli - Piper Jaffray

Bose George - KBW

Mike Grondahl - Northland Capital Markets

Ryan Zacharia - Jacobs Asset Management

DeForest Hinman - Walthausen & Company

Rob Schwartzberg - Compass Point

Jack Blair

Operator

Welcome to the Second Quarter 2010 Results Conference Call. All lines have been placed on listen-only until the question and answer session. (Operator Instructions). Today's conference is being recorded. If you have any objections you may disconnect at this time.

I will now turn the call over to Dave Gunter.

Dave Gunter

Thank you. Good morning everyone and thank you for joining us today. Before we begin, I want to remind you that the slide presentation is available to accompany our remarks.

To access the slides, log on to our website at www.ocwen.com, select Shareholder Relations, then Calendar of Events, then Click Here to listen to Conference Call, then under Conference Calls, Second Quarter 2010 Earnings, select Click Here to listen and view slides.

Each viewer will be able to control the progression of the slides during the presentation. To move the slides ahead, please click on the gray button pointing to the right.

As indicated on slide two, our presentation may contain certain forward-looking statements that are made pursuant to the Safe Harbor provisions of the Federal Securities Laws. These forward-looking statements may be identified by reference to a future period, or by use of forward-looking terminology. They may involve risks and uncertainties that could cause the company's actual results to differ materially from the results discussed in the forward-looking statements.

For an elaboration of the factors that may cause such a difference, please refer to the risk disclosure statement in today's earnings release, as well as the company's filings with the Securities and Exchange Commission, including Ocwen's Form S-3, first quarter 2010 Form 10-Q, and 2009 Form 10-K. If you would like to receive our news releases, SEC filings and other materials via email, please contact Linda Ludwig at linda.ludwig@ocwen.com.

As indicated on slide three, joining me for today's presentation are Bill Erby, Chairman and CEO of Ocwen; and Ron Faris, President of Ocwen.

And now, we turn the call over to Bill Erby. Bill?

Bill Erbey

Thank you, Dave. As shown on slide four with the acquisition of HomEq, we will become the third largest subprime servicer with more than $80 billion in unpaid principal balances. Since 2001, our servicing portfolio has grown at an annual rate of 17.8%. The primary value of growth is that it enables Ocwen to improve its operating margins.

We believe there will be continued consolidation in the servicing industry, and we are well positioned to benefit due to our significant and sustainable competitive advantages, including our strong financial position, highly scalable platform, lowest operating cost structure and our ability to resolve delinquent loans faster and for higher value than other servicers.

Additionally, servicing loans to credit impaired borrowers is a growth market. According to the Mortgage Bankers Association, 14.7% of all mortgage loans, both prime and subprime were 30 plus days delinquent as of March 31, 2010. Even more important than our growth has been the resiliency of our business model.

We have withstood three major economic downturns since the inception. Since our inception because we have a recurring revenue stream and self-hedging operating model, low leverage, self-liquidating assets with a duration shorter than our liabilities, and well hedged interest rate risk. Dave will be covering these items later in the call.

With the Saxon and HomEq transactions, we doubled the equity and earning assets committed to the servicing business. Slide six details the $443 million that we invested in the combined portfolios. We committed the $443 million with the expectation of a 25% pre-tax return on equity, including the $60 million of transfer expenses which under accounting rules are required to be immediately expensed as opposed to amortized over the life of the investment.

Additionally, revenue from a newly acquired portfolio was not leveled throughout the life of the investment. These dynamics will be explained by Ron later in the call. Our ability to be competitive and earn these returns is to look directly related to first, our ability to resolve non-performing loans, reducing advances which in turn reduces interest expense and lowers equity committed to the transaction, and second operating cost 60% lower than the industry.

Even after the completing the Barclays acquisition, Ocwen will have available liquidity of $200 million.

I'll now turn the call over to Ron who will review the results of our servicing business in the second quarter. Following that, Dave will review one-time and deal related expenses and the health of our balance sheet. Ron?

Ron Faris

Thank you, Bill. As reflected on slide seven, revenues of $75.8 million were up slightly over the first quarter. The addition of $6.9 billion Saxon portfolio mid-way through the quarter added revenue. However, this increase was mostly offset by lower modification and related HAMP fees. HAMP fees were down to $3.9 million in Q2 compared to 6.2 million in the first quarter.

In the second quarter for the first time loans modified under HAMP reached their one year life entitling us to a success fee. We recorded $663,000 in HAMP success fees in the second quarter and expect this revenue stream to increase over the next few quarters as more loans reach this one year anniversary.

Turning to slide eight, operating expenses for the second quarter totaled $41.2 million, an increase of $10.4 million or 34% over the first quarter of this year. We normally don't have our expenses go up like this in the quarter and there are due to one-time items. The increase was primarily due to a $5.1 million one-time accrual related to an agreement in principal to settle the MDL proceeding along with 2.7 million in professional facilities and other ramp up expenses in anticipation of the closing of the

HomEq transaction.

In addition, amortization of mortgage servicing rights increased by $1.5 million over Q1, primarily as a result of the Saxon transaction. As we have done in past quarters, slide nine reflects the common sized income statement in basis points per average quarterly UPB serviced for the past five quarters.

Adjusting for the accrual for the potential legal settlement, we had pre-tax earnings of 5.1 basis points per average UPB in Q2. The $2.7 million of home equity related expense accounted for some of the decline from Q1, while other primary drivers with the Saxon transaction and the lower revenues from loan modifications.

Overall, the Saxon portfolio had minimal impact on the quarter, despite the increase in UPB serviced. First, it was boarded mid-way through the quarter and second, the capture of deferred servicing fees and ancillary revenues generally don't ramp up until several quarters after an acquisition of this type.

We expect to see a ramp up in Saxon revenue and a reduction in outstanding advances on the Saxon portfolio over the next several quarters as our loss mitigation efforts take hold.

As shown on slide 10, our largest opportunity for both Saxon and HomEq acquisitions is to reduce the percentage of non-performing loans to Ocwen's historical level, enhance generate ancillary fees and reduce advantages. By reducing advances, we generate cash and reduce our capital consumed by the acquisitions.

In terms of credit quality, LTV and product type, both the Saxon and HomEq portfolios are similar in nature to the historical Ocwen portfolio. Therefore, we believe that with time, we can reduce delinquencies and advances on both portfolios.

As we have highlighted in the past, modifications are a significant driver of our profitability representing between $500 and $1500 for modifications.

As shown on slide 11, our total modifications for Q2 were 14,384 compared to 19,612 in Q1 of this year. This performance fell within our previous Q2 estimates of 12,500 to 15,500.

Slide 12, represents our completed HAMP modifications by quarter. We have very little history but today approximately 81% of our HAMP modifications remain current and are eligible for the annual success fee of up to $1,000. For Q3, we expect total modifications in a range of 13,000 to 16,000.

Finally, we continue to make progress in reducing advances on our historical portfolio. As shown on slide 13, net advances decreased by $33.3 million for the quarter and are down 106.7 million since December 31, 2009 excluding the effects of the Saxon acquisition.

We continue to refine our loss mitigation models and approach to keep more borrowers in their homes. Reduce losses to investors and improve the quality of our servicing portfolio. We are particularly excited about the HAMP program's new emphasis on principal reductions as we believe this will increase after acceptance rate and decrease with redefault rates.

In addition to the HAMP changes, we are testing similar new loan modifications for borrowers who do not qualify for HAMP.

Now I would like to turn the call over to Dave Gunter. Dave?

Dave Gunter

Thank you, Ron. I would like to walk through a reconciliation of the items impacting our Q2 results. We accrued $5.1 million in connection with an agreement and principal to settle the MDL proceedings without reducing litigation exposure and expense prospectively.

We took a one time non-cash write off of a $3 million interest in a real estate partnership deemed uncollectible during the quarter. This represented the company's last commercial real estate asset. We incurred professional services of $1.2 million as part of the announced acquisition of HomEq.

We incurred expenses for new facilities and other ramp up expenses in anticipation of the closing of HomEq of $1.5 million. We sold $46.8 million of auction rate securities on June 29, 2010 at a loss of $1.7 million. This transaction yielded cash of $4 million and allowed us to further reduce our exposure to non-servicing assets.

We took a credit of $8.3 million in income tax expense, as we released the valuation allowance related to our financing vehicles. The net effect of all of the above items is that Q2 results were essentially flat to Q1 with the decline in modification income offset by the initial impact of the Saxon portfolio.

Moving on to the health of the balance sheet, since December 31, 2009 we have continued to decrease our exposure to non-servicing assets. As showed on slide 14, in the first six months of 2010 in total our auction rate securities, subordinates and residuals, loans held for resale, and investments in unconsolidated entities decreased by 59%. We have a low risk balance sheet as approximately 80% of our assets are investment grade quality.

As shown on slide 15, even if our mortgage servicing rights, deferred tax assets, net receivables and other assets all fell to zero. We would still have more than sufficient equity to cover all debt and other liabilities.

Slide 16 shows that our maturing assets exceed maturing liabilities even with no new financing or renewals. Our maturing assets are generated almost $1.6 billion of cumulative cash and exceed maturing liabilities in all periods for the next three years.

Also as shown on slide 16, our interest rate exposure to floating LIBOR rates is well hedged. We entered in the swap agreements that allow us to pay cash and receive floating rates of interest over a three period. These positions in conjunction with our medium term TALF notes and float balances allow us to effectively eliminate our exposure to rising interest rate.

We entered a $350 million senior secured term loans to provide acquisition financing for the HomEq platform. We were pleased that the term loan was over subscribed and that our original covenants and pricing levels held throughout the marketing period.

Even with the $350 million of term loan financing, our recourse debt is still only $457 million and as Bill said, even after closing the HomEq transaction, we will still have $200 million of available liquidity.

Although our leverage ratios will peak with the closing of the $350 million term loan at 1.7 times the corporate debt to adjusted EBITDA and 2.7 times total debt to equity we intend to lower these levels on a go forward basis. Thank you. We would now like to open the call up to questions. Operator?

Question-and-Answer Session

Operator

And thank you. (Operator Instructions). Our first question today comes from Bob Napoli from Piper Jaffray.

Bob Napoli - Piper Jaffray

I guess I'd like to focus on the revenue yield, there are few on page nine. And I missed the little bit at the beginning of the call there, so I mean you guys were moving through there pretty quick. I know you gave a little bit of color on it but the revenue yield is far below prior year quarters and then revenue was kind of flat quarter-over-quarter.

And I can understand some delay in receiving some of the ancillary revenues from Saxon we still should had an increase in revenue unless it was something in the first quarter unusual or some revenue item in the second quarter that was unusual.

What is the right revenue yield? The basis points you had were pretty consistent around the 15.5 to 16.5 basis point range of revenue. Now what is that, should we bring our expectations down long-term for that?

Bill Erbey

Bob a couple of things were occurring in that and I'll rely on Ron and Dave to add more color. There are three components if you will to the, really we could look at, the three components to those numbers.

One is servicing contractual fees; two are subservicing contractual fees which did not change throughout the quarter at all. We added some servicing in the form of [Saxon] part way through the quarter and then third, there are ancillary fees with regard to it.

So the mix, on weighted average on the mix I think was more heavily subservicing weighted until definitely before this Saxon transaction came in. So you had more subservicing fees which are lower were a greater proportion in that quarter than they were in prior quarters.

That's going to swing the other way obviously with those Saxon and HomEq getting board and which are full servicing. Because at one point, I think we actually reached below 50% servicing, we were more than 50% subservicing during that quarter. So I think that's one of the elements, the other are the items we talk about with respect to modifications et cetera.

The first quarter was a very strong modification quarter, the second quarter was about on target on budget so with those third-party ancillary fees with regard to the existing portfolio and as while it was laid you pick up nominal amount of the ancillary fees when you first board a new portfolio, primarily because of the time it takes to either modify a loan or the foreclose on loan as well as with REO. So that's a two or three quarter ramp up once that portfolio was actually boarded and we actually price them that way in that assumption

So there were number of moving parts was that?

Bob Napoli - Piper Jaffray

Yes. I guess maybe, let me take it a step further and guess say I mean your target is a 25% pre-tax return on equity. I mean how confident are you that you'll attain that pre-tax 25% of ROE in 2011 with the acquisition of the HomEq deal?

Bill Erbey

Well, I think we are very comfortable with those numbers with regard to its servicing has always been you know services are very stable revenue and expense business for us. It will ramp up you know to that part of the year as we begin to pick up ancillary fees from those transactions we have just boarded.

Operator

And our next question comes from Bose George from KBW.

Bose George - KBW

I had a question, you decreased the HomEq acquisition expense outlook for the back half of the year to $50 million, and soon if you include the $2.7 million it took this quarter so are you guiding to kind of a lower number for that versus the 60 you had originally expected?

Dave Gunter

You'll see the rest of that number come into to say 2011, so most of it, most of the 50 that you heard about comes in quarters three and four, but you'll have some flow into next year.

Bose George - KBW

Okay. So it's still the 60, it's still what we should use?

Dave Gunter

Of course we'll try to beat that number, but you should think about that as your round number.

Bose George - KBW

Okay. And the second thing, the charge on the what's that, the MDL proceeding, I mean should we you know be concerned about other potential one-time things like that, or it's just kind of a one off that you are pretty comfortable is taken care of?

Dave Gunter

Well, I mean we lay outed our queue, all the litigation is outstanding. Obviously, we feel in all cases that you know we've done the right thing with regard to those matters, so you know the MDL is it has been out there for a long period of time.

And almost all of our motions have been upheld. This is really my cost efficiency as much as anything. We didn't feel we would lose the case. There is always a risk though whenever you go into a trial, and we have been burning quite a bit of legal expenses and we would continue that ramp rate of legal expenses would continue to accelerate.

So, our law department calculates you know basically the net present expected value. And we felt this was well within the range of providing you know the legal expenses that we would incur.

Bose George - KBW

Okay and then just finally to switching to the outlook for modifications. Once the Barclays portfolio is on I mean should we assume that we could see a pretty good ramp in the modification activity I guess that would be early next year?

Dave Gunter

Yes, I mean our primary means of resolving assets is resolving out performing loans just through the modification program. It will require little bit of ramp before you start seeing that follow through, our expectations are within our pricing if that would occur.

Operator

Our next question comes from Mike Grondahl with Northland Capital Markets.

Mike Grondahl - Northland Capital Markets

Bill if you could just talk a little bit about the pricing environment for acquisitions out there would you seem to be going in your favor? And secondly may just your capacity to take on further acquisition and maybe the execution ability that you have to do it you know with all the activity you've done recently?

Bill Erbey

Well I take the first part and have Ron take the second part of that would make sense to you.

Mike Grondahl - Northland Capital Markets

Of course.

Bill Erbey

I mean it's really the biggest challenge we have on getting product is really the decision on the part of the seller to sell. Certainly, I think we have very significant competitive advantages going up against our peer group in terms of both most importantly our ability to reduce delinquencies which is a huge driver of our economics.

It reduces the amount of capital consumed in the business both interest expense and equity, and it also basically generates modification fees et cetera and reduces our operating expense because its more intensive service of the non-performing loans that are performing loans.

So it's not so much that it's the other bidder we have to compete against. We're competing against the marks that institutions have run their assets. So it's really a question of taking a loss as much as it is determining who the highest bidder is.

There has been some interesting changes that have occurred in [Basel] and I've been surely busy on a number of same [stuff] at least of which are Q2 earnings calls, that I'd like to spend more time thinking about that because under Basel there's been a limitation that has been proposed for banks to hold MSR's deferred tax assets which get generated by the servicing business as well as any minority interest within entity.

So that 15% could be rather interesting in terms of the capacity that players might have in the market for a product. We're even seeing a little bit of weakness quite frankly in the secondary market with not on subprime but you are seeing weakness, I would say in the (inaudible) market, in terms of what servicing really work when it goes to trade, which I think long-term could be very helpful to us in that market.

So I think I think there are weakness out there and some capacity problems with regards to people being able just to buy servicing.

Mike Grondahl - Northland Capital Markets

Okay.

Bill Erbey

Ron, do you want to go for it?

Ron Faris

Yes. From an operation standpoint, we're definitely on track to close the HomEq transaction on September 1. We've had 90 plus days to prepare for that and to ramp up for that. So I think that, you know we will be well positioned in the fourth quarter for example, to extent there are larger opportunities out there to take those on, I don't think we have any concerns about you know our infrastructure or anything else that would restrict us from being able to take on additional portfolios, you know small or large, once we have this HomEq deal boarded and closed on September 1.

Mike Grondahl - Northland Capital Markets

Okay and then maybe just a follow-up for you Ron, the prepayment speed during the June quarter stayed lower than I might have thought. It was at 13% up tick from 12% in the March quarter. I mean clearly that's speaking for the stickiness of the portfolio in some of the modification work you are doing but why do you think that number is you know mid-term to longer-term.

Ron Faris

You know what, we don't really like to forecast things but I mean don't really see any reason why we should expect any you know significant ramp up in that, maybe a slight tick up if we see there have been things put in place by the state government, and you know bankruptcy and foreclosure attorneys that may have made the process of getting through foreclosure slower than it had been historically, to the extent that we are not able to modify loans.

You know those loans maybe taken a little longer to move through the process and then ultimately you know results at the back end, that might result in a small tick up as you start to flush through some of those but I don't think that's a huge impact, I don't see even with interest rates where they are, I think there is still you know the ability to the kind of borrowers that we have to go out and get a conforming type loan is very, very restricted.

You know the modifications that we are giving borrowers generally are such that they probably can't go out in the market and replace that with a better loan. So I think the voluntary aspects of prepayment speeds in our portfolio that we should remain very low and not really change significantly going forward for quite a while.

Mike Grondahl - Northland Capital Markets

Okay, thank you.

Ron Faris

Those I'm sure you are aware of it. You know our voluntary rate is probably like 3%.

Mike Grondahl - Northland Capital Markets

That's pretty low.

Ron Faris

It's specifically almost the same as zero.

Mike Grondahl - Northland Capital Markets

Ron, just you know you have a much bigger portfolio over the next couple of years than what we might have thought of three, four quarters ago when it was earning 20, 22%, so you know, you make those basis points on a bigger asset for a longer period of time. It's good.

Ron Faris

Yes.

Operator

Our next question comes from Ryan Zacharia with Jacobs Asset Management.

Ryan Zacharia - Jacobs Asset Management

So I guess you know the 25% pre-tax that we think about that you guys paid is kind of the overall return over the life of any given transaction. How can we think about how that translates in the kind of intermediate term 2011 and '12 numbers, maybe try inflating that to a pre-tax income over average UPB figure, because I find that the timing is you know, difficult to understand with the ramp and how you guys basically get the value that you expect to get out of it over the life of the portfolio so maybe you guys kind of speak to what 2011 is going to look like and why does Saxon and HomEq because you know, based on the way you talk about Saxon requiring several quarters to ramp and I would kind of think of HomEq as a mid-2011 thing now whereas I didn't think that was the case earlier.

Bill Erbey

Right. The one thing that complicates on that is the upfront expenses really we think of them from a cash flow perspective of looking as if they were PMSRs. In other words, it's an upfront cash flow outflow. And it just means that we have to expense them in the current periods as opposed to expensing them to an amortization over the life of the asset. So I'm going to try to differentiate between cash flow and actually reported earnings in at least in the short-term if that's okay with you.

Ryan Zacharia - Jacobs Asset Management

Sure.

Bill Erbey

It's a little bit easier to deal you just to have basically figure out when you think about this 60 million it has to be think about it as an investment it normally would be amortized. We can at least normalize all these transactions because it is the only one that has that effect upfront of that, okay? How you think about how it ramps is that when you take over a portfolio you have assets in various buckets. You have assets that are current, those that are non-performing flash foreclosure bucket and those that are in REO, okay.

And as that flows through, let's suppose it takes on average about 180 days to sell REO and it takes on average about 200 days around to foreclose.

Ryan Zacharia - Jacobs Asset Management

Yes.

Bill Erbey

I got those numbers yesterday I think it's 202 days or something like that. So as you see the pig going through the pipeline, if you are able to start modifying those loans that's starts in the second quarter, after you have it, you start seeing a ramp in modification fees as a result of that and then you start seeing as you go through the back end of the process and you know recaptures some of the other fees that you had with respect to it.

The second quarter will get a pretty good size bump, if you will. It even might Saxon hasn't even been on for a quarter, it's really on for half of a quarter. So and day one you take over portfolio, you don't start immediately generating the ancillary fees right? You can't modify instantaneously, there's a process.

Ryan Zacharia - Jacobs Asset Management

But the ancillary fees are not the entirety of your return. There are fees that your generating kind of on the day after you board the loans and those should be coming through we should see them this quarter and next quarter and the quarter after that.

Bill Erbey

Absolutely, well absolutely. If you look at, we had a basis point chart that looks at ancillary fees?

Ryan Zacharia - Jacobs Asset Management

Yes.

Bill Erbey

We took it out.

Ron Faris

Would you remember what it was?

Dave Gunter

I think it was 2.7 basis points were ancillary fees.

Bill Erbey

Does it sound right to you Dave and Ron?

Dave Gunter

Yes.

Ron Faris

I want to take a look at the model but that's very, very close.

Dave Gunter

So that's the number you are talking about. You got none of that, virtually none of that on Saxon in the first quarter that you, the first half quarter that was in the portfolio.

The 2.7, when it's compared to say 15, is in whole lot. So when your comparing to whether its you know around 6, it's a meaningful number of the net down below. Obviously anything becomes meaningful when you don't put expenses against it. So that was our only point with regard to that.

Ryan Zacharia - Jacobs Asset Management

But on an absolute dollar basis, I mean quarter-over-quarter you know, sequentially, servicing fees were down but UPB was up, I mean so how do we reconcile that? I mean I understand that there is a mix differential but it all kind of comes out in a wash or it should, so how do we reconcile the absolute dollars being down but UPB being up?

Bill Erbey

There is couple of things that happened here. As I have seen before, in the quarter your mix for most of the quarter had more subservicing than it had previously which has a much lower fee. Our mods were down, so modify a 1000 times every month that we did less than we did in the prior quarter and that's about $4 million. Okay.

Ryan Zacharia - Jacobs Asset Management

But it shouldn't your amortization than be lower, if this was predominantly subservicing your MSR amortization was up over 20% sequentially?

Bill Erbey

Right because we added Saxon in it. That's correct, when they first came in.

Ryan Zacharia - Jacobs Asset Management

So you are only getting the negatives from Saxon in the second quarter and none of the benefits?

Bill Erbey

No I just don't, I think Saxon helped to make up for the lower mods that we had in the quarter compared to the first quarter.

Dave Gunter

Let me try to add, I mean we definitely did receive the contractual servicing fee revenue that you would get off of the portfolio but we did not receive the kind of the ancillary fees including you know any sort of modifications related fees that we would get. We also haven't had much opportunity to reduce advances and when we reduce advances we will also recover some of the deferred servicing fees which would bring up even the contractual servicing fee line as we start to reduce advances on that portfolio, and that portfolio had I think, Dave correct me but in excess to $500 million of advances.

And I think we had a slide where you know 90 plus delinquency rate is over 40%. So there is a lot of loans with deferred servicing fees that you know won't be recovered until we actually are able to modify the loan or push them through the foreclosure process. You know our interest expense went up because we added in the $500 million of advances and had to finance those for a portion of the quarter.

And we did take amortization expense on our purchase price, which is what drove the increase in the MSR amortization. So, there was revenue, but they were probably over the long-term we'll see more revenue versus some of those expense items than we did in this initial you know couple month period.

Ryan Zacharia - Jacobs Asset Management

Okay, but I still don't understand how the MSR balance only increased to 6% sequentially, CPR stays flat and MSR and amortization is up, you know on the order of 20 plus percent.

Dave Gunter

It's not Ron. It's Dave. The biggest item really is the pull back in March from what was at 19,612 in the first quarter to 14,000 plus in the second quarter. That's significant because it's the timing of when you recognize your servicing fees and then your late fees. And so what you have are two moving pieces, the decrease in the mods is significant and then bringing on facts and you've got UPBs who aren't up to, yet the full run rate that you are accustomed to on the basis point model and therefore the discussion about the ancillary fees and the ramp up to get there.

Ron Faris

Right. If you look at the overall net if you took out the one-time charges that were like you know MDL and the commercial write off et cetera. Essentially, the fourth quarter was flat with the first quarter however.

Ryan Zacharia - Jacobs Asset Management

Except you added $7 billion of servicing generating at 25% pre-tax ROE?

Dave Gunter

Yes. For part of the quarter that's correct but you lost 4000 mods in dollars

Ryan Zacharia - Jacobs Asset Management

So in order to kind of just thread water now because of shortfall and HAMP is it a safe assumption that we need to keep adding UPB?

Dave Gunter

No. First of all, what is just HAMP it was any mod in terms of that numbers. So, our mod numbers in the first quarter were very high compared to historical and they were down more on that the normal range which we reflected to everyone in our guidance. So that number bounces around, as you can see on chart 11 and it depends on where you are in that up or down a little bit makes such a difference 4000, 5000 mods is $4 million, $5 million.

Ryan Zacharia - Jacobs Asset Management

So I guess just again trying to look at 2011 you know, getting all of this stuff put together, what's an appropriate kind of way to think about what pre-tax income as expressed in basis points of UPB looks like I mean, it just for modeling purposes, you know we can say that things extend out in that recognition is tough to quantify but?

Dave Gunter

You would expect to see that, there are two elements again; I went through with respect to the revenue for in UPB. One is the mix between subservicing and servicing and the other is basically the amount of ancillary fees that (inaudible).

You had a downward [stress] slow when we were being conservative with when there was illiquidity in the marketplace, we were doing much more subservicing than servicing. So you see that in subservicing it has lower basis points per UPB than servicing does. The new business we've added in such as the Saxon transaction and the HomEq transaction are all servicing transactions which will in fact raise your revenue per dollar of UPB.

Ryan Zacharia - Jacobs Asset Management

But I am talking about pre-tax income. So the servicing versus subservicing, the mixed debate should be a wash because whatever upside you are losing in your subservicing is basically the amortization of the servicing rights that you have with servicing?

Dave Gunter

No. Not entirely at all because you have capital against the servicing business. You make more money in absolute dollars on servicing than you do on subservicing but your capital up against it. The return on equity on subservicing is very high but it's not in terms of what dollars; it doesn't generate the same amount of pre-tax net income.

Ryan Zacharia - Jacobs Asset Management

So when we look at this pre-tax income over UPB you know is 7 bps, is that a reasonable assumption?

Dave Gunter

It's the highest number on the page, right? That was driven by one of our highest quarters in terms of modifications. You will see though as you begin to go through this process as more it comes in the servicing and natural upper trend in pre-tax income for UPB and basis points increasing with the addition of much more servicing as the proportion about the portfolio.

Operator

The next question comes from DeForest Hinman with Walthausen & Company

DeForest Hinman - Walthausen & Company

Can we get some clarity on the charges we are expecting in the third quarter in the 15 million you know, how much of that is lease charges, software write-offs, severance. I mean can you help us understand what those are?

Dave Gunter

We don't really want to comment on that because it will be indicative to what our intensions are with respect to the operation.

DeForest Hinman - Walthausen & Company

Okay. I guess in a sense some of that, since we did the acquisition, we paid cash for it but in regards to those charges what component of those will be I guess a cash component?

Dave Gunter

They are all cash numbers. We treat that 60 million as if it were an addition to MSRs in the economics. The cash outflow on the front end of the transaction that's recovered over the subsequent life of the asset.

Bill Erbey

And Deforest, we will expect that the dollars we spoke of today will spread roughly evenly over Q3, Q4 could bounce around a little bit but you will look forward into the two quarters.

DeForest Hinman - Walthausen & Company

Alright, and then so when the third quarter rolls around we'll be able to get details on what those expenses are then, is that what you are saying then?

Bill Erbey

You'll see them as they flow through; yes you'll see what buckets they are in. I think, correct me if I'm wrong I don't recall any of that are non-cash. It's the same as if we paid $60 million more for the MSRs than we did.

DeForest Hinman - Walthausen & Company

No. I understand that, but I mean software write-off. You know if you are not going to use their servicing platform I mean that seems reasonable, I just want to how much that would have been, but that's alright. Thank you.

Operator

Our next question comes from Rob Schwartzberg with Compass Point.

Rob Schwartzberg - Compass Point

Good morning, you might have already answered this, but I am trying to understand the expense side and the expenses as a percentage of UPB because as you've been increasing the portfolio there has been a pretty clear reduction in operating expenses a percentage of UPB up until this quarter.

And I understand there is some timing issues, but I still don't understand how an increase of let's call it 12% or 14% you are still are increasing the size of the portfolio, was there some other event? I mean I understand that you had some expenses prior to boarding HomEq but, was there anything else going on from an expense angle in the portfolio that would have accounted for the uptick?

Dave Gunter

Hi Rob, its Dave, let me step you through that just at the highest levels you recount.

Bill Erbey

Do you open up the earnings release as well to follow along it goes through the…

Rob Schwartzberg - Compass Point

I have everything.

Bill Erbey

Okay, if you look at the earnings release as Dave goes through this it might be helpful.

Rob Schwartzberg - Compass Point

I've been through it a few times; but I'm willing to go through it with you guys.

Dave Gunter

Okay. So all together the pieces were 5.1 million litigation accrual for MDL.

Rob Schwartzberg - Compass Point

Is that in this operating expense because underneath the footnote says it is normalized for it so that shouldn't have impacted it right?

Dave Gunter

Because that's one item, if you are looking at page nine that's right, that one item is normalized for those basis points.

Ron Faris

That's the only presentation in here we will have to normalized, all the other ones will give you the actual expenses.

Rob Schwartzberg - Compass Point

Okay.

Ron Faris

So half that change was the MDL?

Rob Schwartzberg - Compass Point

I guess I'm confused because the footnote makes it look like with $5.1 million in the 6.9 of UPB.

Bill Erbey

It is normalized out of slide nine; you don't have the MDL represented in slide nine and it would be burn out roughly a full basis point if it were there.

Ron Faris

The only presentation slide well that is I have taken it out.

Rob Schwartzberg - Compass Point

Okay.

Ron Faris

It's actually when you are looking at the $10 million increase in expenses, $5 million of that is the MDL settlement.

Rob Schwartzberg - Compass Point

Okay. Is the $3 million non-cash write-off of the real estate partnership in the 6.9?

Ron Faris

That would be at the corporate level not in the servicing business.

Rob Schwartzberg - Compass Point

Okay. And I assume then of 1.7 of auction rate securities is also not in there?

Ron Faris

Corporate, that's true.

Rob Schwartzberg - Compass Point

Right, so the only thing that's really in there is $1.5 million I would think of the ramp up expenses related to HomEq right?

Bill Erbey

And you got another $1.3 million in the HomEq professional fees, another over $1 million which was to increase in the amortization.

Rob Schwartzberg - Compass Point

Okay.

Bill Erbey

And then you got the swing effect a change and what are the strata inside our MSR that is about $1.3 million impact if you compare sequentially Q1 to Q2 and yet for the full year, you are slightly positive on that. So you got that swing of about 1.3 as well.

Ron Faris

Essentially you had no increases in operating expenses associated with the ongoing platform.

Rob Schwartzberg - Compass Point

That's what I was trying to get out for expenses and I would have thought actually since your increase in the amount of UPB, you might have even actually gone down slightly from the 6.2?

Ron Faris

Yes, but again, that has it does not apply one as but it has the other ones, you know the $2.7 million for HomEq and then Saxon increased amortization of MSR's. If you look at the gross number, we did not increase operating expenses on the portfolio during the quarter even though we added you know about 6.9 billion.

So in operating, we have, as Ron alluded to, I mean we focus very much on being as very efficient and effective. We have not suddenly had a breakdown in expense control. As a matter of fact, the expense control, even though it's a little cluttered up with these one time things, expense control is very strong in the quarter.

Rob Schwartzberg - Compass Point

No, I am just counter intuitive that your portfolio will be getting larger and your operating expenses as a percentage of the portfolio will still also be getting larger? And I understand there are some one-time charges but it still seems unusual to me and does any of this have to?

Ron Faris

We are unclear sorry. Lets go the absolute, forget the basis points for a minute, lets go to actual dollars if we can Dave, you walk through what it was in the prior quarter, what it is this quarter and then the delta, let's clear.

Dave Gunter

Well, the pieces are and Bill I have got that at a consolidated levels here. I don't have the servicing in front of me.

Bill Erbey

Okay, let's do [consolidated].

Dave Gunter

But it's the pieces that we just walked through and you and I had done it at a pre-tax level. So Rob you are aware, you have talked through all the components that we talked about. If you were to go back and model that out and start with your operating expense and you can pick either the servicing business or the consolidated business but if you start with the OpEx at Q1 and then reconcile for all the items that we wrote about in the press release and that we discussed here with you.

You would get back to stable operating expenses for Q1, that's true both for the servicing business and for the consolidated business.

Rob Schwartzberg - Compass Point

Okay. So there is nothing related to the decline in modification that has end sort of implications for expense control. There is no connection there either, right?

Dave Gunter

No.

Rob Schwartzberg - Compass Point

They are not trying to work harder to maintain a level of modifications or spending more money?

Dave Gunter

No. We always work hard, trying go get. Here are the numbers and Ron went through this, just $41.2 million of operating expenses in the quarter and that's an increase of $10.4 million.

Rob Schwartzberg - Compass Point

All right.

Dave Gunter

Okay. 5.1 of that or half was the one-time charge related to the MDL so we are down like 5.3, right?

Rob Schwartzberg - Compass Point

Right.

Dave Gunter

There is $2.7 million associated with the ramp up of HomEq which is not boarded yet, right?

Rob Schwartzberg - Compass Point

Right.

Dave Gunter

So undoubted $2.6 million at that particular point right? There is $1.5 million of the amortization associated just with the Saxon acquisition. So I am down to $900,000 and the strata on amortization, we accelerated some of the amortization we accelerated some of the amortization and that was an over 1 million. So actually the expenses look boarding, the operating expenses of servicing having boarded Saxon went down for the quarter.

So it's sometimes easier to if look at the operating expenses and take out the amortization number and just get the true operating expense. That true operating expense when you take out the one-time charges decreased in the quarter yet we added $6.9 billion of servicing.

Operator

Our next question comes from Jack Blair. Your line is open.

Jack Blair

Hi, it's Jake Blair, my question was about the Freddie Mac trial program that you guys have got going on right now. Is there any update on that and any potential new business that might be coming on as that program develops over time and matures? Thanks.

Dave Gunter

Ron would you like to handle that?

Ron Faris

Yes, first off we have a pilot program with Freddie Mac and then we have additional business that we boarded last year, and some of it continues to board even into this year from Freddie Mac. We can't really project when and how much more is going to come from Freddie Mac; we do know that you know, they have indicated to us that we are designated as one of their go-to-special servicers.

And it's a very small list, only a couple of names on the list. But to-date we have not seen them proactively you know, move troubled servicing, accept maybe what they have done with us already to any special servicer.

Although we believe that that is in the cards and coming, we just don't know how much and we don't know when.

Jack Blair

And in terms of taking on additional business that might be born from FHA loans, can you guys tells us what you are working on there and how that might play out over the course of next year or two?

Ron Faris

Yes. We are investigating that obviously being a larger scale servicer in that venue the Altisource which is another company owns a cooperative that represents about 6%, their members originated by 6% of all mortgages originate in the United Sates. There is an opportunity we think to help those members realize greater value in their loans that they have originated and at the same time for us to basically capture a stream the servicing related to FHA you know so as Jenny May servicing.

So we are investigating doing that because the economics for FHA servicing more closely approximate subprime than they do prime with regards to the business.

Jack Blair

And in terms of time, I mean you probably can't go in too much of it but when you think that might play out or when you know whether or not something you want to spend some money trying to make it happen?

Ron Faris

We will start very, very candidly towards the end of the year it would be sort of like over-and-over right taking off. There won't be a big splash or anything but I think we've been spending well over a year going through trying to and making sure we understand exactly the economics and what the different events that can occur on the business. So we would see a very nominal amount towards the end of this year and at the beginning of next year with regard to that. And I didn't know if it's obviously it will grow that as we become more comfortable but we understand everything that can go wrong.

Operator

The next question comes from Bob Napoli, your line is open.

Bob Napoli - Piper Jaffray

Hi, just quickly on mods, what percentage did you say of your mods are current and I guess and what percentage of the completed mods have made it a full year and what kind of metrics do you expect on that front?

Bill Erbey

Ron would you like to handle that please?

Ron Faris

On the HAMP side what we've said in the presentation was that it's early and we don't have a lot of data but we're seeing about 81% of them making it through that one year period.

Over, we've historically seen a modifications including non-HAMP on our portfolio were redefault rates of 25 to 30%. The industry is seen closer to 50%.

Bob Napoli - Piper Jaffray

Okay and the 81%, I mean that sounds like a really high number it is. I mean its still I think very early and getting to that point but what are you hearing from others in the industry?

Ron Faris

Well there hasn't been a lot of information that I've seen out there. We were one of the first servicers to actually get loans modified truly modified under HAMP. So we're one of if not the first servicer to actually have loans that have reached that one year anniversary and actually receive some of the success payment.

So I'm not sure a lot of the other servicers have a lot of that data yet. For many of them it took them many, many, many months just to complete the modification, so they are still a number of months away from hitting that point.

We are hopeful that our numbers will better than the industry, although it is a program that is the same for all parties involved and so you know, to some degree, we shouldn't see drastically different results from the rest of the industry but we still believe or else will likely be better but I don't have any real good information on where are the rest of industry is tracking right now.

Bob Napoli - Piper Jaffray

Ron, do you think that 80% number is somewhere in that range if from what you are seeing on payments at various stage the number that you think is reasonable and reasonably sustainable and does that surprise you that's it's been high?

Ron Faris

Keep in mind about that's our number at the 12 months mark, that's not our average.

[Multiple Speakers]

Bill Erbey

Our loans hitting the 12 month mark I think that's reasonably good. Again it's a small data set right now but I don't know why, I have no reason to believe that they were going to see anything totally different from that for hitting the one year mark. Obviously you know, as you hit the two year mark which is another success fee. At two years you know, you are going to see us at additional follow up just from the passage of time and some borrowers will run into trouble but I think for HAMP, at least for now we test the best information we have.

Bob Napoli - Piper Jaffray

All right and what date did your debt deal close?

Bill Erbey

It was July 29.

Bob Napoli - Piper Jaffray

July 29, okay.

Ron Faris

And then Bob, I think you will see one of the things that they did in HAMP that you know; we are big believers in using our psychology department to look at the offers that are made.

I think HAMP by making an offer where people get a reward for staying in front has a pretty, strong positive reinforcement to them. So you would expect the HAMP mods with the $1,000 payment to be meaningfully better in terms of the redefault rate than without.

The other thing that they've just recently come out with, which I think will have a very significant impact on the industry is the new HAMP program permits principal reductions to you know because the largest reason I believe and our numbers show, that people redefault is because they are woefully underwater.

So I think that's a change that hasn't been talked about very much, but actually will change modification rates. I think pretty significantly, it takes a little while to operationalize that change. But I think it adds legitimacy to that as a resolution strategy and the numbers we've run in terms of the tests we've done shows that it meaningfully improves net present value to the investor.

So, how you modify those cash flows and how the borrower perceives it has a significant impact on redefault rates. And again, I think the new program that the administration has rolled out will be very beneficial to redefault.

Bob Napoli - Piper Jaffray

Have you used that new program much at this point?

Ron Faris

We are only in the test phase right now. And we'll roll the HAMP program modification out in October.

Operator

And so we take our final question. [Operator Instructions]. Our follow up question at this time comes from Mr. George, your line is open.

Bose George - KBW

Can you guys give the cost of the debt that you just issued?

Bill Erbey

Yes, think about it with a 2% LIBOR floor and then 700 basis points.

Ron Faris

And two point discount.

Bill Erbey

Through OID.

Bose George - KBW

And 700 basis point spread.

Ron Faris

Yes.

Bill Erbey

Thank you very much everyone, have a great day.

Operator

That does conclude today's conference call. We thank all for participating. You may now disconnect and have a great rest of the day.

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