Mortgage servicing is supposed to be one of the most boring topics in the financial universe. The servicer collects payments from the homeowners, manages escrow accounts for property taxes and insurance, maybe originates a few new mortgages on the side. All in all, it's a pretty straightforward business. This makes the recent happenings in the saga of Ocwen Financial (NYSE:OCN) even more peculiar.
This story has all the thematic elements you could want in a Wall Street novel. Drama, suspense, heroes, villains, conspiracy theories, moments of gut wrenching agony, and fleeting glimmers of hope. Ocwen, America's largest servicer of subprime mortgages, is on trial for its life after landing in the crosshairs of the CFPB and state regulators. So should OCN investors accept their losses or stick around and let the drama unfold? Let's explore.
Before we dive into the events of April 20th, let's set the stage and examine what was going on in the Ocwen world prior to that fateful day. Let's examine a particularly strange phenomenon that was unfolding in the share price of Ocwen's sister company Altisource Portfolio Solutions (NASDAQ:ASPS).
In mid February 2017, ASPS reported Q4 2016 earnings and disclosed a probe by the CFPB into its technology services supplied to Ocwen. ASPS shares were crushed falling from $30.79 at the close on February 15th and hitting a low of $22.73 the next day or a drop of around 27%. Ocwen shares were down by 10% in sympathy. The fact that ASPS share got pummeled was not peculiar in the least. It made perfect sense. What was somewhat odd is the absurd prices people were willing to pay to short ASPS shares in the weeks that followed.
ASPS was so heavily shorted that by March 22nd, the stock ended up on the SEC's Regulation SHO list meaning that shorted shares were failing to deliver and brokerage houses would force buy ins. Major ASPS shareholders including John Devaney (more on him later) pulled shares from lending pools and set up a major short squeeze. The cost to short shares of ASPS rose to 30%. Quite a ransom to pay to short a stock that already had been crushed, yet it did not stop there. The cost to short surged to 70% on 03/24, 100% by 04/07, and 118% on 04/19.
So under what scenario would it ever make economic sense to pay a 118% interest rate to short a stock? The only answer I can come up with would be that if you knew very bad news was coming and coming very soon. Think about it. At that interest rate, if it took 6 months for the disaster scenario to play out, shorting would not make economic sense because the interest rate would eat all of the potential gains to be made by shorting.
With the number of federal and state agencies involved in the Ocwen case, it is not hard to imagine there was a hedge fund or two who caught a whiff of a magnificent short opportunity and were willing to pay any price because they knew pain was coming for ASPS and OCN and coming in a hurry. Someone knew something.
The 4/20 Massacre
This may be particularly painful for Ocwen shareholders, but before we can figure out where we are going, we need to recap where we have been. We need to understand the charges before we make snap judgments on the fate of OCN.
On April 20th, the Consumer Financial Protection Bureau and a coalition of 31 state regulators filed various lawsuits and cease & desist orders against Ocwen. The allegations include wrongful foreclosures, mishandling of escrow account funds, operating in some locales without proper licensing among many other things. I won't go into depth on each issue as that has been extensively covered elsewhere (Ben Lane from HousingWire has provided some exceptional coverage). The merits of each individual charge are also not as pertinent to the investment thesis as one might expect. Nevertheless, Ocwen shareholders watched in horror as the stock was eviscerated falling from $5.51 to $2.12 (write that $2.12 number down for later) at the lows of the day, a 62% decline.
The accusals are very concerning, yet perhaps in retrospect somewhat unsurprising given Ocwen's lengthy history of regulatory issues (I personally was blindsided). When it comes to the perfect whipping boy that just about every financial regulator would love to tee off on, a subprime mortgage company has got to be at the top of nearly every regulator's wishlist. Subprime mortgages have caused a lot of grief in this country so sticking it to any business associated with them makes for great headlines.
Ocwen's rise to subprime market share dominance following The Great Recession was fueled as the Big Banks unloaded their subprime assets to clean up their balance sheets and remove themselves from the regulatory spotlight that comes with anything associated with subprime mortgages. The cost for Ocwen's explosive growth from 2010 to 2013 was its assumption of that very top spot in the cross hairs of regulatory agencies that the Big Banks were so eager to be rid of. From 2014 on, Ocwen has faced one regulatory issue after another developing quite a lengthy rapsheet and poor reputation.
So we have a defendant, Ocwen, who stands accused of heinous acts and who is already guilty in the eyes of the public. The company will get no sympathy in the court of public opinion. Who would defend such a company? Who would take on such a case? Enter John Devaney, our modern day Atticus Finch. Just as Atticus took on the case of Tom Robinson, John Devaney comes to the defense of Ocwen. John put his money where his mouth is and used the turbulence on 04/20 to boost his stake in Ocwen to 10% of the outstanding shares. That's quite a vote of confidence from one of the company's largest shareholders.
John also wrote a lengthy and blistering diatribe in an open letter to President Trump, the House Financial Services Committee, the SEC, and a few other agencies. He makes the convincing argument that this whole ordeal is part of a grand plan to put the company out of business by hedge funds who are short OCN stock and RMBS holders who are on the losing end when Ocwen modifies the mortgages for struggling homeowners. It really is a "must read" for anyone following Ocwen. In a later article on ASPS, John confirms that he has had conversations with lawmakers regarding Ocwen so it seems that his efforts have not gone unnoticed.
"I am currently talking to lawmakers in Congress who wish to hear from me how I believe that various groups that I have discussed previously, created phony research reports, might have shown this phony data to the CFPB or other state regulators such as the NY DFS or the California DBO. There are fairly powerful Republican politicians that are hell bent on discovering if the CFPB at any time might have improperly crossed the line in their interactions between those in the private sector, which I intend on helping to prove had their own profit agenda. Did regulators rely on phony data and accusations?"
This scenario seems incredibly plausible. Not outright intentional collusion by regulators with the shorts, more likely just pointed in the direction the shorts were hoping for. Regulators just doing what they do best... regulate. And when they are handed "evidence" of wrong doing by America's largest subprime mortgage company with a history of bad behavior, it must have been a dream-like fantasy scenario for the CFPB to sink its teeth into.
What is striking to me about this whole situation is that this "probe" by the CFPB seems to be remarkable shallow. It doesn't appear the CFPB did its own investigation into Ocwen at all, instead relying on Ocwen's own internal data and reporting from a multistate examination conducted in 2015 covering loans from 2013 to 2015. Ocwen stated this in a press release.
"The substantive allegations in today's suit are inaccurate and unfounded. Indeed, the Company is unaware of the CFPB conducting any detailed review of Ocwen's loan servicing files. Rather, the CFPB suit is primarily based on the CFPB's flawed review of data and its self-serving conclusion about isolated instances where Ocwen self-identified ways we can do better."
The CFPB handed out a virtual death sentence without doing its own investigation and relying on data that was a minimum of 2 years old? That seems bizarre and an overstep of power.
Another seemingly silly tactic employed by the CFPB is cherrypicking individual loans out of hundreds of thousands serviced by Ocwen and citing flaws. Mistakes happen. The Law of Large Numbers says that with that many mortgages being serviced, you eventually have a few mistakes. What strikes me as odd is that on the Q1 2017 earnings report conference call, Ocwen CEO Ron Faris addresses some of these cherrypicked loans and the scenarios he describes seem to be valid foreclosures. Here is an example:
"Example one, this loan was transferred to Ocwen for servicing in 2010 and is already in foreclosure and almost three years delinquent. In 2011 Ocwen provided the customer HAMP modification. This government-sponsored modification allows the consumer to resume payments, clear the delinquency and remain in the home. In other words it gave the borrower a second chance.
Unfortunately, in late 2012, the consumer again stopped making payments. We attempted to contact the borrower numerous times with only limited success. In mid 2013, the consumer did engage with us about trying to do a deed in lieu of foreclosure. A deed in lieu is where the homeowner returns over the property and walked away from the debt similar to what occurs in a foreclosure sale. A deed in lieu of process is complicated because other liens on the property must clear before we can proceed.
In contrast liens are generally automatically cleared in a foreclosure sale. We tried working with the borrower of the deed in lieu for over a year. However, the homeowner did not return the executed documents required to complete the process. Finally, in October 2014 the foreclosure sale was completed. At the time of the foreclosure sale the consumer was not living in the property and they had not made a house payment in over two years. Ocwen, over a period of seven years this homeowner made 26 out of 84 possible mortgage payments. Despite our efforts to meet facts the CFPB seems to believe that this foreclosure sale was not appropriate. We disagree."
Are there any witnesses to the incident in question? Is there anyone who can speak to the quality of Ocwen's internal controls, its recent process improvements, and focus on accountability? Curiously, there are two such witnesses that even the prosecution would be hard pressed to say would have any Ocwen slanted bias, the California Department of Business Oversight (CADBO) and the New York Department of Financial Services (NYDFS).
See these two state financial watchdog agencies both installed independent monitors in 2015 to oversee Ocwen's operations after determining the company was not playing by the rules. These auditors were actually inside the company on a day to day basis to assess Ocwen's processes and procedures and to verify the company was in full compliance with laws and settlements reached with the two states.
Ocwen settled with the CADBO on February 17th, 2017 and then with the NYDFS on March 27th. So I find it hard to believe that Ocwen's internal processes could be so out of whack yet these two financial regulatory agencies from two of the most liberal states in the union would release Ocwen from its monitorship. The NYDFS had the option to extend the monitor through 2018 if they felt it was necessary. They did not extend.
Are there any other character witnesses to speak for Ocwen? How about New Residential Investment (NYSE:NRZ) CEO Michael Nierenberg? In NRZ's first quarter conference call. Nierenberg disclosed that NRZ and OCN were deep in talks on a deal to purchase $425 million in mortgage servicing rights from Ocwen, retain Ocwen as the subservicer of those mortgages, and NRZ would also take a 4.9% stake in Ocwen's common stock.
There was speculation that the new CFPB issues would put a strain on NRZ's prior relationship with OCN. That was not the case at all. Nierenberg laid those concerns to rest saying:
"And again, I think going back to 2015, having Ocwen as a healthy counterparty to the mortgage servicing system is something that we think is extremely important. So over the past week or so and well into the night and into this morning, we've been talking to Ocwen about figuring out a way to do a deal that should work for both counterparties or both parties, I should say, that will ensure success for us and ensure success for Ocwen in the long run."
NRZ now has a very vested interest in seeing Ocwen succeed. They made a significant investment in Ocwen's stock. They deepened the commitment to the relationship between the two companies. It's doubtful they would have done so if they felt Ocwen was incapable of basic functionality as the CFPB alleges.
Is there anyone who can speak to the value opportunity in Ocwen's shares? Someone intimately familiar with Ocwen? Well, there's hedge fund veteran Leon Cooperman of Omega Advisors. Cooperman disclosed a 6.8% stake in OCN on 05/12. One does not simply casually buy a nearly 7% stake in a company without doing some due diligence. Cooperman is a longtime ASPS shareholder and has been critical of management in the past. He also had previously held a large stake in Ocwen but has been out of the stock since December of 2014. Cooperman would not have taken this new stake in OCN if he did not feel the share price represented a deep value opportunity.
Leon Cooperman. source: Business Insider
So we have two state regulatory agencies, the CEO of NRZ, and a well-respected hedge fund manager all giving Ocwen a seal of approval??? The prosecution's case seems to be on ever shakier ground.
The Road Forward
Ocwen shareholders are at a crossroads. Let's not sugarcoat things. This is probably the most significant event in the company's history. The CFPB can end Ocwen if it so chooses. Just as Atticus Finch attacked the credibility of the prosecution and its witnesses in To Kill a Mockingbird, so too has Devaney attacked the CFPB's overreach of power. So who is the Boo Radley in this story? Is there a potential savior in the darkest hour of the night? I'd argue there are two candidates. Jeb Hensarling, chairman of the House Financial Services Committee and Donald J Trump, president of the United States of America.
Hensarling has had an ax to grind with the CFPB for years. He has long argued that the CFPB is too powerful and its penchant for over-regulation hurts businesses and the economy. He has called the CFPB a "rogue agency" and "unconstitutional".
President Trump is also no ally of CFPB Director Richard Cordray. It's been reported that Trump's economic adviser Gary Cohn gave Cordray an ultimatum back in April 2017 to leave on his own accord or be fired by President Trump. There is speculation that Cordray wants to make a run in the election for Ohio's governor in 2018. What better way to make a political splash and show you are "sticking up for the average American" than to take a subprime mortgage company out behind the woodshed and give them a good lashing? Devaney's point that this case may be politically motivated is gaining traction. I find it a bit strange that the CFPB now chooses to pursue action against the company when OCN-related complaints to the CFPB are hovering near an all time low as illustrated in the graphic below.
The upcoming case between fellow mortgage servicer PHH (NYSE:PHH) and the CFPB is of great importance to Ocwen. That case kicks off May 24th with an earlier court decision ruling that the CFPB's structure is unconstitutional and the president would have the authority to fire the director. The Justice Department under President Trump changed positions and now backs PHH's claim that the structure of the CFPB is unconstitutional.
So are OCN shares a deep value buy or a strong sell? Despite all the regulatory issues, I remain cautiously optimistic. My investment thesis never was that Ocwen could transform itself into a quality mortgage company with an outstanding reputation and customer service record. The idea was that the shares were too cheap and the sum of the parts were worth more than shares were trading at.
At the end of Q1 2017, Ocwen had roughly $268 million in cash on the balance sheet. That was before the proposed deal with NRZ for the $425 million sale of MSRs. So the company will have roughly $700 million in cash (although the NRZ deal will likely be amortized over a few years). The current market cap of the company is around $320 million. So by my quick math, Ocwen's cash position could eventually be more than double that of its current market cap. That is not assigning any value to the rest of the company's assets such as other MSRs and subservicing contracts.
Respected bond and bank analyst Christopher Whalen commented on Twitter that he felt the liquidation value of OCN was around $6 if the company was simply to shut down and sell off the parts. That was before the NRZ deal was announced. He also recently released a research report on the Ocwen situation supporting Devaney's claim that the CFPB has abused its power and recent events may have been set in motion by a concerted effort of short sellers of ASPS and OCN stock. The report should be at the top of the reading list for any OCN or ASPS shareholder.
As I said previously, I remain cautiously bullish on Ocwen's prospects based on a sum of the parts argument. Do I think the shares should be trading north of the $5-6 range? No. Absolutely not. Ocwen's future is much too cloudy. But with shares currently trading in the $2.50 range and OCN having roughly $2 and change of cash on the balance sheet with more on the way once the NRZ deal closes, I think there is a significant opportunity for price appreciation from current levels. I plan on adding to my stake on any non-OCN related dip but the situation is very fluid so if the facts on the ground change, my opinion could change. If the stock were to rally significantly from these levels, I may lighten up my position in the $4-4.50 range. With the 200 day moving average around $4.30, that may provide a significant hurdle for the Ocwen bulls to overcome barring any significant positive news event.
As with all great stories, the Ocwen saga is dripping in irony. The CFPB is supposed to protect consumers yet is persecuting the company that modifies more mortgages for struggling homeowners than any other lender. Ocwen completed more than 18,000 modifications in the first quarter of 2017 alone.
I tend to side with Devaney in thinking this case is a witchhunt but I am not certain it matters who is right. Tom Robinson ends up dead in To Kill a Mockingbird. The Ocwenite faithful still have a very much uphill battle in overcoming these long odds. These next few months should provide plenty of gripping suspense filled moments. For now, I am along for the ride.
Disclosure: I am/we are long OCN. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Because I think this story needs time to play out, I am currently long call options for 2018 and 2019 with strike prices ranging from $3-5.50.