Financial regulators – especially the New York Department of Financial Services have put nonbanks in the spotlight with questions about the growth rates, servicing practices, and related-party transactions.
In addition to Ocwen, regulators are looking at Nationstar (NSM)and Walter Investments (WAC). The nonbank service companies have been purchasing mortgage-servicing rights by the truckload and as each company grows its portfolio, critics are highlighting supposed cracks in each company’s foundation.
The superintendent of New York’s Department of Financial Services put an indefinite freeze on the $2.7 billion MSR deal between Ocwen and Wells Fargo (WFC) which Ocwen’s CEO says has put a freeze on all MSR deals in the market.
Nonbank servicers are taking a hit on regulatory costs, Ocwen’s management says.
Ocwen chairman Bill Erbey noted in the Thursday conference call that "increased compliance and operational risk management does not come without a cost, as you can see from our first quarter normalized earnings."
Ocwen says regulatory compliance costs sparked a 44% increase in operating expenses of $349.2 million during the quarter compared to first quarter 2013.
Standard & Poor’s Rating Services primary credit analyst Stephen Lynch says that while it's difficult to predict what may result from such regulatory scrutiny and related actions, he sees three potential scenarios arising, each of which may differ in their impact on the creditworthiness of U.S. nonbank mortgage servicers.
“The rapid growth of mortgage servicers Ocwen and Nationstar has led to questions, particularly from the New York DFS, as to whether this growth is straining the companies' operational capacity and ability to help borrowers avoid foreclosure,” Lynch says. “Depending on how servicers choose to resolve the regulatory issues, we believe the range of potential outcomes could have positive, negative, or neutral effects on our ratings.”
Here are the three possible scenarios from Standard & Poor’s:
1) The Best Case Scenario
In the first, and in our view the most benign scenario, regulatory pressure could ultimately benefit the creditworthiness of these companies if it slows--but does not halt--the outsized growth they've reported in recent years. Mortgage servicers have largely funded their growth with debt, and leverage is a key rating factor for the U.S. nonbank mortgage servicing companies we rate. Slower growth may also reduce the possibility of poor servicing practices. In this scenario, we assume that the servicers will quickly address the regulators' concerns, and new acquisitions of mortgage servicing rights (MSRs) will roughly offset the typical run-off of existing ones. In such a scenario, we could maintain or even raise our ratings on certain U.S. nonbank mortgage servicers because of better foresight into how the industry will operate in a more mature life cycle.
2) The Middle Ground Scenario
In a second, more adverse scenario, we assume that pressure from regulators is protracted and servicers have trouble addressing their concerns, causing growth to slow to the point that servicers' MSRs and earnings contract. This scenario assumes that these pressures compel the servicers to change their servicing practices in ways that hurt their earnings or that put them into conflict with holders of residential mortgage-backed securities. We believe such a scenario is at least as likely as the first scenario, and could lead to downgrades if it causes performance to deteriorate
As regulatory scrutiny and related actions continue, many parties are watching from the sidelines. Large banks have looked to sell MSRs to companies like Ocwen and Nationstar to reduce their burden of servicing higher-risk mortgages and to help them comply with looming tighter regulatory capital requirements under Basel III. The CFPB is watching because it ultimately has authority to take regulatory actions from a federal level. State regulators are interested because some of the mortgages in limbo affect their constituents.
And then there are investors: Some RMBS investors have questioned whether servicers are providing loan modifications too easily and at the expense of their investments, while equity investors in the servicers seem eager for continued growth.
3) The Doomsday Scenario
In a third, worst-case scenario (which we view as the least likely), we assume that the servicers might not only struggle to address the regulators' concerns, but may also resort to legally challenging the regulators or seek to escape their jurisdiction. In either case, this scenario could lead to downgrades.
We're continuing to watch how these events unfold to gauge their impact on the nonbank servicers we rate. While the credit implications of tougher regulatory scrutiny will become clearer over time, we believe how nonbank mortgage servicers choose to respond can go a long way toward determining outcomes: Those that get mired in battles with regulators could get burned, while those that take steps to address regulators' concerns quickly could maintain or even boost their credit quality--especially if growth slows to more manageable levels.