Sunday, January 11, 2015

HLSS and evolution of tail risks

HLSS stock got killed this week. To me, this is an example of when the market re-prices former “tail risks” as not so “tails”. The market starts out seeing certain risks as a <1% probability event, then re-evaluates that to be a 5% probability event, and then a 20% probability event. How did this happen?? I’m writing this to clarify and record my thoughts. Also, this could be of help to someone looking at HLSS.

Although it’s clear that HLSS’ problems are tied to Ocwen (OCN), how OCN’s issues transmit to HLSS can get pretty esoteric and not well understood –even now. This is not a simple matter of Ocwen no longer adding any more MSRs and thus curtailing HLSS’s growth potential. (In fact, anyone investing in HLSS should have valued it based on a runoff scenario in the first place).

I’ll go over a few risks here. A year from now we may look back and say these concerns are absurd. But what I want to emphasize here is how they changed over time.

Evolution of Risks

1. Risk of forced servicing transfers away from Ocwen. Ocwen’s weak servicer ratings triggered Event of Default (EOD) in certain nonagency MBS, which makes them eligible for servicing transfers. Ying Shen at Deutsche Bank gave an example recently:
“For investors of MSAC 2005-HE3, the Master Servicer, Wells Fargo, sent an EOD notice to all bondholders seeking to vote by the January 5, 2015, deadline as to whether Ocwen shall be terminated as a servicer.”
Just a few months ago, the default reaction is “Impossible! MBS investors won’t terminate Ocwen given lack of alternatives!” But now, firing Ocwen is no longer some unimaginable tail risk, but rather an actual item on the table, being voted on. The probabilities are still low, but not that low. If Ocwen’s troubles keep dragging on (perhaps due to even more lawsuits which Dr. Shen contemplated), then MBS investors will really have to start thinking about plan B. If and when that plan B develops, Ocwen will be in real trouble. How that plays out for HLSS will be left to the lawyers. Keep in mind HLSS never actually owned the legal title to Ocwen serviced MSRs, but is technically more like a secured lender.

2. Cash flows to equity from advance securitizations get shut off (very esoteric). Dr. Shen also commented on HLSS’s servicing advance (SA) deals:
 “We expect extension of distress timelines due to the delay in the foreclosure process…likely result in a slowdown of advance recoveries…Significant reduction of recovery speeds beyond certain thresholds will likely trigger an early amortization event, which will likely result immediately in paydown of the SA notes”.
For equity holders, the implication is cash flows getting funneled to pay down debt instead of going to equity. This would hurt dividend coverage (which are still strong but have deteriorated) and reduce present value of cash flows by pushing them back. I bet not many people thought of this one back in January 2014!

3. Ocwen and HLSS re-negotiate their contracts to the disadvantage of HLSS. This was my main concern back around August. I think the risk actually decreased with the exile of Bill Erbey, because OCN affiliates are now more likely to deal in a true arms-length manner.

My Own Experience in This Name

My investments in HLSS mirrored how these risks evolved. I first bought HLSS in late 2012. It was a major position after a lot research. But honestly, I never even thought of three risks discussed above! Even if I did, I would have considered them extremely low probability to the point of paranoia. It wasn’t until August 2014 that I started worrying about #3 (threat of recontracting) and reduced my positions. October 2014 is when the market really started talking about #1 and #2, and I further cut my position to a minimal amount. By mid-December I exited the remaining stake and actually thought about going short, but the high dividends held me back. Overall HLSS was a slight loss for me.

In each of these gap downs, I was tempted to say “these are super low probabilities, the market is over-reacting, and I should be a contrarian and double down” but decided not to. The reasons are twofold: 1) given my belated recognition of these risks, I wonder if there's even more risks that I have not thought of?  I’m just not close enough to the non-agency MBS market to sense its latest developments. 2) what’s the upside? Why wouldn’t people just move to AGNC which yields a solid 12% without these issues? I think the latter argument will be repeated throughout 2015.

1 comment:

  1. Here's to the "unknown unknowns"!