Walter Investment: Can the specialty servicer reverse stock performance?

Walter Investment has bad news, bad news, and good news

Walter Investment Management posted a second-quarter net loss of $12.9 million, or $0.34 per diluted share, which includes charges related to goodwill impairment in the reverse mortgage segment and reductions in the fair value of the company’s servicing rights related to changes in valuation inputs.

Net income adjusted to reflect these items came in at $45 million, or $1.19 per diluted share, compared to net income of $88.6 million, or $2.36 per diluted share, in the second quarter of 2013.

The main performance differences from a year ago were driven by strong operating results in the originations segment in the second quarter of 2013 due to HARP related retention volumes and margins. As of the end of September, the value of stock in Walter is down more than 40%. 

But it is not all bad news, second-quarter numbers reflect improved results from the first quarter of 2014 in the originations segment and receipt of performance related fees in the investment management business.

“Our originations segment increased AEBITDA by 138% as compared to the first quarter, originating more than 16,000 HARP loans in the second quarter.  In addition, our investment management business recorded significant performance fees in the quarter and in July we completed the initial funding of WCO representing the foundation for future growth in assets under management in this business,” said Mark O’Brien, Walter Investment’s chairman and CEO.

The servicing segment generated revenue of $127.8 million in the second quarter of 2014, which included $174.9 million of gross servicing fees, $25.6 million of incentive and performance-based fees and $19.2 million of ancillary and other fees.

Meanwhile, the originations segment generated revenue of $150.3 million in the second quarter, driven primarily by the consumer lending channel, while the reverse mortgage segment generated revenue of $38.7 million for the quarter.

The BEAR case

As said, when Walter Investment Management released its second-quarter earnings, the news wasn’t good.

Unsurprisingly, the company’s chairman and CEO, Mark O’Brien, said that the company was not concerned with the weak quarter.

“We believe the combination of strong execution against our strategic plan coupled with ensuring each of our businesses embraces and drives a culture of compliance and positive consumer experience will provide benefits to each of our core constituencies: consumers, clients, our stakeholders and regulators,” O’Brien said in August.

But Wall Street analysts don’t share O’Brien’s positive view of the future in the wake of the weak second-quarter results. Compass Point Trading & Research, which had already downgraded Walter to “sell” in May, reiterated its position and lowered its price target for Walter from $23 to $18.

“The second-quarter earnings release was in-line with our expectations as a bounce back in amortization expense pushed servicing margins lower, origination earnings benefited from a larger HARP-eligible servicing portfolio, and the company guided to lower earnings in the back half of 2014,” Compass Point’s Kevin Barker said in a note to clients.

“However, the vast majority of the 2Q14 earnings report was driven by HARP originations and there are a series of regulators investigating WAC’s servicing practices,” Barker continued. “We expect the expense associated with addressing regulators concerns (as we have seen from other servicers) and the impact of refi burnout on origination revenue to make it difficult for WAC to sustain GAAP earnings above $0.50 per share over the next several quarters.”

Compass Point decreased its 2014 year-end earnings-per-share projection from $3.50 to $2.83 and also slashed its 2015 EPS projection from $3.26 to $2.55.

Walter has been on Compass Point’s radar for quite some time and this isn’t the first time that it has warned investors about Walter’s future prospects.

In May, Compass Point downgraded Walter to sell after its subsidiary Green Tree Servicing failed eight of 29 compliance tests administered by the Office of Mortgage Settlement Oversight.

After that news came out, Compass Point lowered its target from $28 to $23. After the release of Walter’s weak second-quarter results, Compass Point has now dropped its target price $10 in just three months.

Compass Point also warned investors that Walter would be at the most risk if the Federal Housing Finance Agency sues its servicers and lender-placed insurance providers because the companies cost the government-sponsored enterprises hundreds of millions of dollars by charging excessively high rates for LPI, as the FHFA’s watchdog suggested it should do in a report filed in June.

“If the FHFA were to attempt to recover ‘damages’ related to excessive fees on lender-placed insurance, we do not expect any potential litigation to be a significant hit to the large banks involved in servicing large delinquent portfolios,” Compass Point said at the time

“But it could have a material impact on special servicers that have a less diversified revenue base and service highly delinquent GSE mortgage portfolios.”

Compass Point cautioned that nonbank servicers could be prime targets for the FHFA’s potential wrath with Walter at the forefront. Compass Point suggested that Walter would be the most “exposed” to the potential litigation.

“WAC recorded $85 million of revenue and $46 million of pretax income from their insurance segment during 2013, of which 65% of the policies written were for lender-placed insurance,” Compass Point’s analysts noted at the time.

“Lender-placed insurance is significantly more expensive than voluntary homeowners’ insurance and we estimate the total insurance commissions from lender-placed policies could be 70%+ of total insurance revenue for WAC.”

In its latest report, Compass Point said that it is concerned about the potential litigation costs and the costs associated with bringing Green Tree’s servicing practices up to the standard set by the OMSO.

Compass Point is predicting that Walter’s profitability from its servicing segment will continue to drop.

“Although we expected a decline in 2Q14, it was more than estimated and likely indicates margins will remain subdued for the foreseeable future as the company deals with regulatory expense,” Compass Point said in its note. “We estimate margins only bounce back to the 3-5 bps range from an average of 6 bps in 1Q12-1Q14.

“Where operating expenses settle in the face of increased regulatory issues is a major driver of earnings going forward.”

The BULL case

Walter’s chief financial officer, Gary Tillett, and chief information officer, Denmar Dixon, told investors at the second-quarter briefing that the company is well positioned for growth in the remaining two quarters of 2014.

Notable among the wide-ranging presentation was the discussion of Walter Capital Opportunity Corp. When Walter Investment released its third-quarter earnings for 2013, the company announced that it had “executed a letter of intent with York Capital Management for an initial capital commitment of $200 million to fund Walter Capital Opportunity Corp., an externally managed real estate investment trust.”

In Walter’s 2014 first-quarter earnings release, the company announced that it had executed the final securities purchase agreement with York for the formation of Walter Capital.

During a presentation at an event sponsored by securities broker/dealer Keefe, Bruyette & Woods, one of Walter’s panelists said that the company anticipates Walter Capital launching by the end of second quarter and that they also anticipate Walter Capital to be licensed to purchase mortgage-servicing rights by the end of the year. 

“The plan would be to be for them to look at transactions and potentially acquire MSRs,” one of the panelists said.

The panelists said that Walter Capital could purchase MSRs and use Green Tree Servicing, which Walter also owns, as the sub-servicer.

Walter Capital “will consider credit-based investments, loans, and actually carrying loans in a bigger way instead of (the company’s traditional) core of fee-based revenue,” according to a panelist.

One panelist said that Walter Capital could also purchase non-performing loans in the future. “Any asset that would benefit from Green Tree’s high touch servicing is fair game for Walter Capital.” Once Walter Capital has “a few transactions” under its belt, the company may consider taking Walter Capital public.

The panelists also commented on Green Tree’s performance ratings in the latest servicing compliance report from National Mortgage Settlement’s Office of Mortgage Settlement Oversight.

In that report, Joseph Smith, monitor of the National Mortgage Settlement, reported that Green Tree failed eight of the 29 servicing metrics that are tested as part of the settlement.

Walter’s executives told the investors that headlines surrounding the company’s servicing failures were “a little bit misunderstood.”

 The panelist said that the company is currently working with the OMSO to remedy the eight areas where its servicing practices fell short.

“There is a process in the NMS to submit corrective action plans,” one panelist said. “Once they’re approved, you implement them and then you’re tested again. And we’re in that process now. We’ve got all the corrective action plans now submitted. So the way we think about is that if we are successful in the next cycle, Green Tree will have implemented the whole NMS settlement as soon or sooner than the other servicers.”

The panelists also touched on the potential enforcement action that the company is facing from the Consumer Financial Protection Bureau. 

“We can’t add much more than we said during our last earnings call,” one panelist said. “But we are in the process of working with them to try to get a settlement.” 

Editor’s note: Bull vs. Bear is a non-positional column that presents both “bull” and “bear” cases surrounding a publicly-traded stock impacting the U.S. housing economy. Analysis focuses primarily on macro-economic factors impacting the company’s outlook and the column is designed to allow investors to choose for themselves which case they find most compelling. HousingWire does not recommend specific investments, nor should any comments in this column be construed as investment advice.

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