The precipitous decline in Walter Investment Management's (WAC) stock price in the past week since the release of the 2016 yearly results instigated speculations that the company is on the verge of an imminent bankruptcy. In this article, I lay out the key problems that are at the root of the company's current woes and investigate each in turn. The decline in the MSR valuations in low rates environment and its subsequent recovery post the November election are well known and covered extensively by industry watchers, and I focus on Walter-specific issues: 1) hangover from the acquisition of Green Tree and RMS, 2) enormous cash burden to support HECM securitization vehicles, and 3) costly transition to a new mortgage servicing IT platform, MSP.
1. WAC's original sin: overpaying for the acquisition of Green Tree and RMS
At the end of 2013, WAC carried a total of $657MM in goodwill and $144MM of intangibles. Of $657MM of goodwill, $430MM was from the acquisition of Green Tree and $101MM from the acquisition of RMS. In March 2011, WAC paid more than $1bn to acquire Green Tree Credit Solutions, which subsequently merged with Ditech, WAC's servicing subsidiary. To pay for the acquisition of Green Tree, WAC issued $765MM in debt, which is now part of the $1.4bn outstanding term loans and $200MM convertible notes.
The total of $800MM in goodwill and intangibles started its precipitous fall starting in 2014, as interest rates declined from 2.7% to hit its nadir at 1.36% in July 2016 and non-bank mortgage servicers had to cope with declining profitability and increased regulatory burden.
Cumulatively, WAC wrote off a total of $610MM of goodwill and $106MM of intangibles in the past three years, and all subdivisions of WAC now carries zero goodwill, with the exception of its origination arm ($47.75MM). Given the origination segment is one of the few profitable businesses, it appears that the relentless write-off of goodwill and intangibles appears to be finally done. The amount of writedown exceeds the cumulative loss in MSR due to change in assumptions ($525MM) during the same period. Through the painful writedowns, WAC has paid the price for its past hubris, and if it survives the current liquidity crisis (see the next section), the end of 2016 can prove to be a turning point in WAC's history.
2. Intensive cash needs from its reverse mortgage business
All reverse mortgages (net of curtailment liabilities) on WAC's balance sheet are guaranteed by Ginnie Mae, and as a servicer, WAC is not exposed to any credit or interest rate risk of its HECM holdings. Most of the HECMs (excluding those temporarily held in warehouse financing facilities waiting to be securitized/liquidated) are securitized in HMBS vehicles, and therefore, HMBS investors are responsible for all risks (mortality risk, prepayment risk etc). Note that HECM-backed liabilities have no recourse to WAC and are entirely backed by the HECMs in the securitization pool, and WAC is not responsible for any losses suffered by the investors in the HECM-backed securities. However, as the HECM securitization was not recognized as a true sale, WAC has to carry both the assets and liabilities of the HECM securitization vehicles at fair value. Given that the HECM loans are longer in duration than the corresponding securitized debt instruments, WAC is exposed to the fluctuation in interest rates, although any gains on losses on the securitization vehicles are not WAC's responsibility.
However, as a servicer, WAC is responsible to advance payments to the HECM securitization vehicles to repurchase any loans that reach 98% of the limit or any loans that are more than 90 days delinquent. As long as the loans are performing, WAC is reimbursed from Ginnie Mae for any advances made within 30 days. However, delinquent loans that WAC has to repurchase from securitization vehicles take longer time to liquidate, and this operation consumes an enormous amount of cash relative to WAC's working capital.
Cash flow from the reverse mortgage segment can be categorized into two parts: 1) cash received from securitization net of cash spent in purchase/origination (Cash from HMBS Securitization in blue in the chart above), and 2) cash received from liquidating HECM loans net of cash advanced to the securitization investors (Cash from HMBS servicing in orange). As we can see above, the cash advanced to the securitization vehicles increased dramatically in 2016, and it is reflected in the large jump in the "Loans subject to repurchase from Ginnie Mae" item within the Payables and Accrued Liabilities on the balance sheet, starting in 2016Q3 (see the chart below).
On the asset side, this increase in payables was matched by the increase in "Rollforwards of reverse loans and real estate owned" (i.e. the amount of reverse loans that WAC has to carry on its balance sheet until they are liquidated and reimbursed by Ginnie Mae). It increased $185MM in 2016 from $234MM at the beginning of 2016 to $419MM at the year-end.
To make the matters worse, WAC's 2013 Revolver facility was decreased from $125MM to $100MM in August of 2016, and it was permitted to use only $20MM of this facility as it did not meet certain leverage criteria.
Now, we see why WAC entered into a flow agreement with New Residential Investment Corp. (NYSE:NRZ) in a desperate firesale in the third quarter of 2016. It simply did not have enough cash to meet the responsibilities as a servicer. One thing we have to clarify at this point is that the problem facing WAC is not that of solvency but of pure liquidity. Cash advances made to HMBS holders will eventually be paid back when the properties are liquidated regardless of the salvage value of the REOs, assuming WAC did its job properly as a servicer.
WAC has attempted to mitigate its acute liquidity problem in the following ways: 1) transfer $100MM of repo facility from Ditech to RMS, 2) exit the reverse mortgage origination business, 3) enter into an MSR flow agreement with NRZ, and 4) sell its GTIM division for $125MM. $100MM repo facility, which previously was available to Ditech, is now available to RMS. This will make a total of $400MM of secured borrowing facility available to RMS, of which, approximately $110MM was used at the end of 2016. Exiting the origination business will give RMS a further breathing room, as the facility can now be 100% dedicated to warehousing the loans repurchased from Ginnie Mae pools.
The deal with NRZ effectively transforms the MSR holdings into a "cash equivalent" item on the balance sheet. I do not expect WAC to be utilizing this option in so far as warehouse facilities are available, as the carry from MSR far exceeds the financing costs of these warehouse facilities. Finally, the sale of the insurance arm for $125MM, which had a carrying value of $68.7MM on its book, should provide added liquidity, as well as adding $56MM to the bottom line in 2017Q1 (this was completed in February 1, 2017) and lowering its DTA by the corresponding amount.
The liquidity squeeze is a genuine and urgent problem, because a failure to meet its responsibility as a servicer can jeopardize WAC's viability to retain the servicing and subservicing rights. It remains to be seen how WAC's board deals with its liquidity issues, but on the surface, it appears that WAC has survived the most challenging period in its history (albeit barely and at the expense of selling its MSRs at the nadir of the market).
3. Ongoing expenses associated with transition to MSP
Transition to MSP is another headache that detracts WAC from returning to profitability. In 2016 alone, it spent $50.2MM in IT-related initiatives and related consulting fees. I suspect that the recent disclosure of material weakness in Ditech and the departure of its former COO, David Schneider, are related to problems that were discovered while the system was going through the transition. Although the adoption of MSP had the benefit of reducing the amount of payables that WAC carried on its balance sheet (possibly by expediting the payment and receipt of cash related to reverse mortgage securitization), the failure to complete the transition in time is a large detractor to returning the company to its profitability.
4. How likely is a Chapter 11 for WAC?
A short answer: barring a liquidity-induced disqualification as a servicer, it is highly unlikely.
The reason is that no one, neither creditors nor equity holders, stands to gain from a bankruptcy. Before I dig into the issue of a potential bankruptcy, we need to see the "clean" balance sheet, removing from the consolidated report those assets that are held in bankruptcy-remote vehicles and those liabilities that do not have recourse to the unencumbered assets of WAC. After reflecting $131.1MM cash received from GTI sale, it would look close to below:
A few notes here. Servicer advances are recorded after netting the servicer advance related liabilities, which only have recourse to receipts from advance receivables. Interest in residual trust is recorded as the value of loans in residual trusts net of liabilities of those trusts, as it represents a limited liability interest of WAC in these trusts. Payables are net of restricted cash and the loans subject to repurchase from Ginnie Mae.
So we see that WAC is indeed a highly levered company, and even more so given close to $2bn needs in secured financing (not reported in the above table) that it needs for operational cash.
Now, if WAC defaults, it qualifies as an "Event of Default" by the servicer, and those mortgage trusts that WAC services can move their servicing to another servicer without any compensation to WAC. In other words, the MSR it currently carries on its balance sheet will become worthless in the event of default. MSRs, by nature, are capitalized future revenues, and its value ultimately depends on the servicer's viability as a going concern. In addition, DTA will clearly be worthless and the remaining goodwill and intangibles will be useless as a consequence.
So if WAC files for bankruptcy, creditors are looking at salvageable assets of $1.4bn to pay for $2.5bn in liabilities, and the creditors have every reason to keep WAC above bankruptcy.
Another interesting observation is that WAC's subservicing portfolio is not capitalized on its balance sheet. Both servicing rights and subservicing rights derive their value as discounted future revenues derived from its right to service (subservice) a pool of mortgages. But the former is capitalized while the latter is not. So from the creditors' perspective, the true value of WAC's assets, as a going concern, is something like this (assuming subservicing contracts are valued at 0.2% of the UPB):
The assumption of 0.2%, which is roughly 25% of the book MSR values, are consistent with the market compensation for the subservicers.
So from the creditors' perspective, they have every reason to keep the company afloat and enter into some restructuring plan whereby WAC pays down its debt over an extended period of time (albeit at a higher interest rate).
There are questions about an outright sale of the company to another servicer. But it will trigger a write-down of DTA, and the true carrying book value of the equity will be near $6.5 per share, which is nowhere near the price at which the current owners (Baker Street etc.) purchased the stocks. So an outright firesale of the company is also quite unlikely.
I do not claim that the true value of WAC's equity is $530MM shown above, because realizing this value is conditional on WAC preserving enough liquidity to perform its duties as a servicer, which still remains questionable, and its ability to return to profitability in time to realize the value of DTA it's currently carrying. But deciding whether the bankruptcy is likely or not is a bit more complicated matter than looking at the reported Net Income numbers.
5. Concluding Remarks
Based on a detailed look at the current state of business, WAC has more than a handful of problems to solve: 1) improving its liquidity profile as a servicer, 2) completing its IT transition in time, 3) minimizing its curtailment liabilities, which depends upon improving the transparency of its operations, and 4) liquidating its reverse mortgage business promptly. All these involve significant efforts, luck and risk, but I do not believe that a bankruptcy is a guaranteed outcome, on balance. So when the stock is priced for a certain bankruptcy, the risk to the downside over long term remains limited.
I am/We are long WAC, and we do not intend to transact in the WAC-related securities in the next three business days.
Disclosure: I am/we are long WAC.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.