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Some Thoughts On OCN's Recent Regulatory/Legal Issues

|Includes: Ocwen Financial Corporation (OCN)

*Updated 2/16/2014. Originally posted 2/11/2014.

In the span of a week OCN was hit with two legal issues - 1) NY regulator put a stop on the MSR transfer from Wells Fargo, and 2) a group of MBS investors are reportedly looking to sue regarding modification practices. Although it's too early to assess regulatory liabilities, I believe the latter has a bigger impact and could lead to higher advances/funding requirements, and further acceleration toward a capital light model.

2/6/2014 - NY regulator halts OCN/WFC deal ($39bn UPB)

Looking beyond the immediate delay of UPB transfers, I think OCN ultimately cuts a deal for enhanced compliance practices and oversights. They may also end up bringing some jobs back from India. All these could lead to temporarily lower margins but in the longer term a higher quality service. Their low tax rates can also come under scrutiny - I'm no tax expert and someone else could comment.

2/11//2014 -Potential lawsuit by group of ABS/MBS investors on modification

This one is more interesting and could have some implications for OCN's business model. The FT report was very vague, but after talking to a couple of industry contacts, a few complaints on OCN surfaces:

· Modifications in general are less preferable to bond holders. Mods delays/reduces cash flows to bonds because servicers can divert collections until advances are fully recovered. Some examples here. Mods also lead to slower cash flows relative to liquidations (where investor gets a lump of cash).

· What bothers bond holder even more is HOW Ocwen goes about its business. 1) OCN gives away principal reduction mods with no rhyme or reason. MBS holders have no control over this. From their perspective it's literally sit there, wait for the monthly remittance come in and say "oh wow these 200k loans just got reduced to 100k". 2) OCN (as well as NSM) tends to stop advancing on non-performing loans after a servicing transfer, this leads to lower cash flows for MBS holders.

How does this impact the stock? Let's quickly think through the incentives of various players here:

· MBS holders. Bond holders do not like modifications - especially if these bonds were bought at a discount, a quick liquidation would be better. They resent the unpredictable way that OCN goes about modifying loans.

· Servicers. Modifications keep those UPB in the pool so servicers can keep collecting fees. OCN tends to modify loans (even after the borrower re-defaults) as opposed to kicking people out right away.

· Borrowers/home owners. A modification (particularly principal reduction) is their best alternative. "Mods" help people stay in their homes as opposed to a short sale or foreclosure.

· Regulators/politicians. They have to stick up for the little guys. Will encourage or force lender/servicer do mods. Strongly oppose foreclosures.

· Banks. They have had enough of bad presses. Would prefer staying away from servicing non-performing loans and let servicers be the bad guys.

As seen above, in this case OCN's interest are actually aligned with those of borrowers and regulators and directly conflicts with MBS investors. Since pushing for lower level of loan modifications would be incompatible with the government/social agenda, what I can see MBS investors do is ask for more/longer advances from OCN. If they succeed this would reduce management's "adjusted cash flow from operations" and increase funding costs. Although a low probability, it might make sense for servicers to hold subordinate bonds as a way keep their incentives aligned - mirroring the CMBS model which effectively means higher capital requirements.

If the end game is more advances/capital and higher funding costs, OCN will be forced to accelerate its move toward subservicing - i.e the capital light model. In that model there's no capital expenditure for MSRs, no advance financing cost. The value drivers are simplified to subservicing fee and operation expenses. Since operating expense on a $ per loan basis is relatively fixed, the key is subservicing fee %. Going forward, investors in OCN/NSM/WAC should focus not only on the sustainable level of UPB, but also the revenue mix (nonagency, agency, 1st lien, second lien…etc). As the higher fee legacy subprime deals go away, the development of a non-QM market will be eagerly anticipated. I heard Wellsfargo is already exploring "alternative mortgages"