|Shares Out. (in M):||37||P/E||0.0x||0.0x|
|Market Cap (in $M):||1,090||P/FCF||0.0x||0.0x|
|Net Debt (in $M):||0||EBIT||0||0|
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Walter Investment Management is a long. We see little downside from here as we think the stock is trading at a 16% FCF yield in a steady state scenario and that the stock could more than double over the next 12-18 months as regulatory fears dissipate and portfolio growth returns. We think Walter is misunderstood due to regulatory fears that are more than priced in at current levels. The company, with its strong ties to Fannie Mae, is in a great position to take advantage of the trend of banks selling mortgage servicing rights to non-bank institutions, which may actually accelerate due to the increased regulatory headlines.
Why now? We think there are multiple catalysts over the next few months: 1) a new CFO with substantial mortgage finance experience starts this month and should help alleviate Walter’s communications issues with investors, 2) Walter Capital Corporation, a financing vehicle funded by Walter and York Capital Management, should close in the next month and will provide an alternative source of capital and an avenue for fully monetizing originated loans, and 3) multiple conversations with industry and political contacts suggest that the political and regulatory pressure should blow over in the next 3-6 months.
We tried to keep this mostly focused on our current thoughts, so please see 85Bears write up from October 2011 for more background on Walter and the industry.
Walter is a mortgage originator, servicer, and asset manager primarily for credit challenged loans. Walter converted from a mortgage REIT in 2011 in order to purchase Green Tree Servicing, which is Walter’s current primary servicing platform. Walter’s management at the time saw enormous opportunity with a supply/demand mismatch for MSR purchases, an opportunity which may be greater today as described below.
Walter gets a fee of 25-40bps for each dollar of mortgage face value (the unpaid principal balance or UPB) it services and acts as a middleman collecting the principal, interest, and taxes from the borrower and facilitating the transfer to the loan owner (trust/bondholder). Walter currently services ~$200bn face value of mortgages, should originate $20-25bn of mortgages in 2014, and also has an insurance (~$20-30mm in EBITDA), asset receivables management (debt collection, ~$20mm in EBITDA), and reverse mortgage business ($55-65mm in EBITDA). Though these businesses are smaller than servicing and originations at this point (in total they represent ~18% of EBITDA), we think insurance should be steady from here and that ARM and reverse mortgage should have growth opportunities over time. In particular, the reverse mortgage business has positive demographic factors as the population ages and retirees monetize equity in their homes.
There are more than $10 trillion of residential mortgage loans outstanding in the US. For each of these loans there is party that has to calculate the monthly bill, monitor payments, collect payments, administer foreclosure procedures, and perform similar tasks that facilitate payments from the borrower to the creditor (usually a trust for mortgage bond holders). For performing these tasks, the servicer receives a small fee based on the principal balance of the mortgage. Mortgage servicers have an immaterial amount of credit risk as they are required to advance payments to loan owners if payments are not made by borrowers. However, these advance payments amount to an extremely low loan to value and servicers are senior in securitizations and foreclosure proceedings so the risk of credit loss is tiny. Servicers also usually benefit from a better housing environment and higher interest rates as the cost of servicing comes down as delinquencies fall and pre-payments drop as rates rise.
Why the Current Opportunity Exists:
Mortgage servicing is a complex industry and a relatively new standalone business that is subject to significant regulatory oversight. The regulatory risk has put the group under a microscope as Ocwen was fined in December and had an MSR transfer halted in February by the New York State Department of Financial Services (NYDFS) due to concerns over the company’s servicing practices. In its latest 10-K, Walter also disclosed that it is subject to an enforcement action by the CFPB for past servicing practices. Due to fears of further regulatory action and that action would halt all future MSR transfers, the group is down ~25% ytd.
We think the most likely outcome for Green Tree/Walter is a fine and the appointment of a monitor to oversee servicing practices. Ocwen came to an agreement with the CFPB in December 2013 and was fined $127M, half of which was covered by the former owners. Though we don’t have specific insight, we think Walter’s fine would likely be lower as Ocwen services 45% more accounts and Walter’s alleged violation appears to stem from 2010. We do not expect the outcome to materially impair Green Tree’s business or raise servicing costs substantially as the CFPB has already raised servicing standards with its January 2014 rules and conversations with regulatory advisors suggest that there is not much the CFPB can do outside of a fine.
Although there has clearly been a slowdown in MSR transfers, our calls have indicated that the non-bank servicers are a necessary piece of the mortgage industry. Regulators have an interest in maintaining healthy servicers and banks increasingly want delinquent MSRs off of their balance sheets for capital reasons. We view the regulatory headlines largely as political noise that will dissipate after politicians score a few points.
Background on the Regulatory Risk:
Our calls with regulatory sources suggest that the current headlines from DC and the NYDFS stem from the desire of politicians (and future politicians) to appear as helping homeowners. Politically, votes are won by protecting consumers against big, bad corporations, which in this case is the servicing industry. This has created a competition between federal officials (CFPB, FHFA, Maxine Waters) and state regulators (primarily NYDFS) in order to win votes (or future votes) and regulatory power. We have heard that a number of the complaints come from consumers who had benefitted from not paying their mortgage for a long period of time and had not been called by the original loan servicer (usually money-center banks) for collection. After the loan transfer to the non-banks, the homeowner is then actually contacted by the new servicer for payment and is not happy about having to start paying the bill. This is a big reason why the non-banks exist in the first place: most banks are not set up operationally to do large amounts of default servicing, nor do they want to. We acknowledge that there have certainly been a small number mistakes by all servicers, but we take comfort in the thousands of audits routinely conducted on Walter’s operations every year by Fannie Mae, state regulators, and the banks (as former owners of the MSRs). Thus, we like that Walter is already heavily regulated, has a top rating from Fannie Mae, and that Fannie Mae recently said on its earnings call that there were no issues with its non-bank servicers. As mentioned above, our calls suggest that though some additional audits or certifications may be required, the political headlines will blow over and the industry will go back to business as usual.
Non-Bank Servicer Opportunity:
Due to the regulatory backlash on bank and non-bank mortgage servicers, operational constraints following the mortgage crisis, and the potential for higher capital costs on MSRs due to Basel 3, banks have been selling large portfolios of MSRs to high-touch, specialized servicers. With a historical focus on delinquent loans, the non-banks service non-performing loans more effectively and at a lower cost than banks.
As banks do not want to deal with servicing, especially for low-priority, delinquent customers, and federal regulators favor removing delinquent MSRs from bank balance sheets, we believe accretive transfers will continue. In fact, we think transactions may accelerate in the coming year as the recent regulatory headlines surrounding the servicing industry are pushing more banks to consider unloading MSRs at a faster pace according to our industry discussions. Jamie Dimon indicated this sentiment at the recent JPM analyst day: “If I had a choice, I would never be in default servicing again. I would tell anyone which got a mortgage with us, ‘You're 60 days late. We're selling the mortgage, and we don't want to do any business with you anymore.’ It's just far too painful.” Banks do not want to service delinquent MSRs due to the regulatory issues and negative publicity that could affect other portions of their business and in order to focus on customers that could actually be profitable from a banking perspective. However, these MSRs will still be attractive and accretive for scale non-banks that are solely focused on servicing. Not all banks will be sellers, but we think this backdrop provides an enormous servicing and sub-servicing opportunity for Walter/Green Tree especially considering its top rating from Fannie Mae and its “white-glove” high-touch servicing model that should appeal to banks. In fact, Obama’s latest budget proposal requested Congress to grant FHA authority to mandate that poor-performing servicers enter into subservicing agreements, which could force some banks to outsource servicing to entities like Walter/Green Tree.
There are only three scale players for the MSRs sold by banks (Walter, Ocwen and Nationstar), creating a significant moat in an oligopolistic market that allows for mid-to-high teens, if not 20+%, IRRs on MSR purchases. Though pricing has increased for MSR deals as capital has flowed into the market, our discussions suggest that the delinquent pools that the public non-bank servicers are buying have moved much less due to the complexity of servicing delinquent borrowers, economies of scale for large portfolios, and primarily the track record that sellers and the GSEs/FHFA require prior to considering a transfer for delinquent portfolios. In addition to bulk transfers, flow agreements (standing purchase or subservicing agreements directly from banks) and originations will help non-bank servicers maintain and grow MSR balances.
The non-bank MSR trade has received a lot of press over the past year with Ocwen on the Investor’s Business Daily list, etc. We think Walter/Green Tree is one of the best operators and is the most underappreciated of the group. Numerous channel checks indicate that Green Tree is a fantastic servicing operation, which is confirmed by a 4-Star rating by Fannie Mae. To be clear, this rating matters: Fannie and FHFA ultimately approve all transfers of Fannie Mae/GSE loans so having the highest rating from your biggest customer is a clear advantage. Banks do not want the press, embarrassment, or uncertainty of a halted transfer so a stamp of approval provides greater certainty. Walter is not the lowest cost servicer and doesn’t off-shore servicing to India (which may turn out to be a positive if there is a crackdown on Ocwen), but we believe its reputation in the industry for servicing GSE loans provides it with significant opportunity to buy MSRs and receive subservicing (i.e. service a loan that remains on a bank’s balance sheet) from banks. Note that Walter’s portfolio is much more heavily weighted to GSE loans than Ocwen, which does more legacy sub-prime loans from private label securities. As each has its own expertise, Walter and Ocwen generally do not look at the same deals and are thus rarely competitors. Although Walter is not low cost they are “white glove” high touch and have high EBTIDA margins and returns on capital for their purchases.
As mentioned, industry contacts suggest that the Green Tree servicing operations are fantastic. We also give management a lot of credit for taking advantage of the MSR opportunity by purchasing assets that we think will continue to perform well over time. Industry checks also suggest that senior management is very focused on returns on capital and is not willing to overpay for MSRs or other assets in order to unprofitably grow for the sake of growth. Ultimately we think the combination of strong operational prowess at Green Tree and capital allocation at Walter will drive strong shareholder returns over time.
Our view on management is very different from the street. Over the past year management has had numerous communication issues with investors, leading many investors to lose confidence. This perception began with a 25% drop post-earnings a year ago when Walter announced it was accounting for some MSRs and originations differently than comps on the suggestion of its auditors. Rather than a sign of incompetence, our numerous discussions with management lead us to believe that this is a communications issue that we believe is on the way to being fixed. First, over the past few quarters the company increased transparency on guidance and key drivers. More importantly, the recent hiring of a new CFO should be a huge step-up over the last CFO who was a holdover from the J. Walter Homes/Walter Energy era. We think this CFO, who has vastly more experience in mortgage finance, will be able to better tell the Walter story, explain the drivers, and provide fewer surprises than the past year.
Valuation has been one of the bigger debates for the servicers. At current prices, clearly the market does not believe that the EPS estimates for any of the public servicers are sustainable. We don’t necessarily think current EPS is sustainable, but we do think a reasonable (and relatively conservative) way to look at the business is on a steady state basis. While one could look at a run-off case, we think a run-off is unlikely, too punitive, and subject to a wide variety of long-dated assumptions (we do think though that a realistic run-off case you a higher price than where the stock is today). Instead we think it makes sense to understand what free cash flow would look in a steady state. In other words, what does cash flow look like if only enough UPB is added to replace run-off? In this scenario Walter’s financing vehicle, Walter Capital Corporation, is a game changer as it allows monetization of originations and is a separate financing source outside of a straight debt raise. This alternative financing source should allow Walter to meaningfully reduce debt over time and also become a more capital-light, fee-for-service business. Note that Walter currently has ~$2.37bn in corporate debt, but the headline balance sheet on Bloomberg/CapIQ looks materially more levered due to the accounting treatment for reverse mortgage sales to Ginnie Mae securitizations, mortgage debt in Walter’s legacy mortgage trusts, and origination warehouse facilities.
Steady State Case
As we believe Walter will continue to grow, this case is theoretically thought of a few years out. At that point in time, we expect servicing EBITDA margins to come down to 12.5bps from what should be a normalized 15bps due to a higher proportion of lower margin/less capital intensive subservicing, for runoff to drop to 12% from 15-16% due to a higher rate environment, and for originations profitability to drop dramatically from current levels as the HARP and refinancing opportunities dissipate. However, in the meantime, servicing and originations profitability should be higher providing cash flow to grow UPB and/or de-lever. This steady-state case could turn out to be very conservative as corporate interest expense could be materially lower from deleveraging, and originations, servicing, and reverse mortgage profitability could be much higher a few years out.
Note that Walter’s originations have a non-cash gain of 1-1.2% due to the embedded capitalized servicing rights that is part of a mortgage’s gain on sale. We expect Walter to monetize half of capitalized MSRs via the Walter Capital Corp vehicle and retain the sub-servicing rights. This type of transaction is what drives down Walter’s servicing margins, but is clearly less capital-intensive and is why Walter Capital Corp is such a big deal.
At a 10% FCF yield, which we think is reasonable once the business has proven sustainable, we see a mid-to-high $40s stock
Servicing EBITDA (based on 12.5bp of $250bn UPB) 313
ARM EBITDA 20
Insurance EBITDA 30
Total Servicing Operations EBITDA 363
Originations EBITDA 85
Reverse EBITDA 65
Other EBITDA 65
Total EBITDA 578
Tax @ 39% (100)
Core Net Income 157
Adj. EPS $4.14
Less: Replenishment* (143)
FCF Yield @ $29.19 16.2%
*Replenishment is cash outflow on assumed 12% runoff of $250bn UPB (ie replacing $30bn of UPB). This is made up of $22bn of WAC originations, $5bn of sub-servicing, and $3bn of purchases. Assumes 50% of future originations and purchases sold to/financed by Walter Capital Corporation.
UPB Growth Case
Though it may seem crazy considering the headlines, we see continued UPB growth as the base case. As mentioned above, industry discussions suggest that the recent regulatory headlines have intensified regulatory fears within banks and are leading to increased interest in unloading MSRs. Walter has a $345bn pipeline and should get its fair share of the $1 trillion expected to trade over the next few years. Should Walter grow UPB by $100bn we think it could conservatively add $1.25-$1.50 in steady state EPS and FCF per share leading to sustainable FCF of $5.75+ per share. At a 10% FCF yield this would be a high $50’s stock or 125% upside.
Walter reported results on February 27 and gave guidance for 2014. Core earnings for the quarter missed on what we think is a temporary lowering of servicing profitability due to the boarding of new MSR transfers and from the large HARP volume of 2013 where a number of costs are borne by the servicing business and due to lower originations profitability. Management expects servicing profitability to improve as HARP declines and transaction expenses normalize. For 2014, adjusted EBITDA expectations were raised to $650-725M from $650-700M, but core EPS was lowered to $5.25-6.25 from $6.00-6.50. The lowering of EPS, but raising of EBITDA is largely due to the increase in amortization from a higher mix of servicing revenue and from fair value gains taken in 2013. While amortization is a real cost, we think it makes sense to look at what it would ultimately cost to replace servicing which is what we attempt to do in the steady-state case. The business will continue to be lumpy from quarter to quarter due to amortization, servicing expenses, and originations volumes /margins, but we think over time the business will generate a significant amount of cash that is not appreciated at current levels.
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