Mortgage servicers in the United States are evolving into the next big lenders, sidestepping regulatory scrutiny to win business in a gap left by the retreat of big banks from the home-loan market.
By writing new mortgages, non-bank servicers such as Ocwen Financial Corp (OCN.N) and Walter Investment Management Corp (WAC.N) have grabbed the opportunity to supply less creditworthy borrowers with funding no longer available from banks.
The trend, investors and analysts say, could spark a revival in the shares of non-bank servicers by relieving the pressure that has accompanied regulators' questions over how well these companies are treating struggling borrowers.
But, as they compete for limited business, the temptation to offer ever-riskier loans raises the specter of another subprime crisis.
"Ocwen and the special servicers could become the next generation of non-prime originators," said Warren Kornfeld, a senior vice-president at Moody's Investor Service.
Non-bank mortgage servicers, which collect and process home loan repayments, benefited hugely from post-crisis regulatory clampdowns that pushed big banks to unload servicing rights due to stronger capital requirements.
Their explosive growth, however, brought with it tougher scrutiny. In February, New York's financial regulator identified this growth as a "troubling trend" that must be confronted "before more homeowners get hurt." [ID:nL2N0LH18O]
Exempt from the capital requirements to which big banks are subject, the non-bank mortgage servicers drew up Plan B.
Banks such as JPMorgan Chase & Co (JPM.N), the second-largest U.S. mortgage lender, were withdrawing from making home loans to less creditworthy borrowers. A gap had appeared in the market. [ID:nL2N0PQ2TS]
"They are servicing existing loans and that is a dwindling business," said Tom Sontag, a managing director at Neuberger Berman Group LLC, an asset management firm which held a 2.5 percent stake in Ocwen at the end of March.
"They have to find out some way to grow their business, and the most logical next step would be origination."
In its first financial quarter of 2014, Nationstar Mortgage Holdings Inc (NSM.N), the fifth-largest U.S. mortgage servicer, issued $4.5 billion in new mortgages, known in the business as originations.
This was a third more than it had issued in the same year-earlier period and equivalent to nearly 2 percent of the entire mortgage industry's originations in the three months to March 31, according to industry publication Inside Mortgage Finance.
Smaller rival Walter Investment Management's mortgage lending business rose nearly tenfold in the same period to account for a 1.6 percent share of the overall market.
Acquisitions have helped to fuel growth. Ocwen entered the home-loan business in 2012 when it bought Homeward Residential Holdings Inc from private equity firm WL Ross & Co LLC. Walter bought Residential Capital LLC's origination business in 2013.
Ocwen and Walter declined to comment for this article. A spokesman for Nationstar, John Hoffmann, said the company saw "significant improvement" in originations for the first quarter.
As concerns have lingered over scrutiny of their core mortgage servicing businesses, Ocwen and Walter have each lost between a fifth and a quarter of their market value in the past 12 months. Shares of Nationstar have fallen 30 percent.
Some investors and analysts say the stocks are undervalued, a theory supported by Thomson Reuters StarMine's intrinsic valuation model — a measurement of how much a stock should be worth, considering expected growth rates over the next 15 years.
Ocwen's intrinsic valuation is $45.39, versus the stock's close of $35.17 on Tuesday, according to StarMine. Based on the same model, Nationstar is worth $52.83 versus a close of $31.95 and Walter offers even better prospects: $79.96 versus $28.92.
"In general, the companies are trading at a discount to intrinsic value and they are a good buy," said Kenneth Domilise, a senior equity analyst at Century Management, an Austin, Texas-based investment firm which holds Ocwen and Walter shares.
TEMPTED BY NON-PRIME
As mortgage servicers lend more, and competition between them grows, there exists the temptation to overextend into the subprime market in pursuit of fatter profits.
As long ago as late-2012, Ocwen Chairman William Erbey had said it made sense for the company he founded to take part in the non-prime origination market. There was a caveat, though — such loans should be prudent.
David Lykken, president of consulting firm Mortgage Banking Solutions, estimated an annual market for non-prime mortgages — almost non-existent today — worth anywhere between $100 billion and $200 billion in the next few years.
Lenders, though, should adopt strict underwriting standards when dealing with non-prime borrowers, he said.
The non-bank mortgage servicers also face two major hurdles. The first is the absence of a robust secondary market, where they can bundle non-prime loans and sell them to investors.
"If you are a non-bank doing origination, you need to have securitization as your exit," said Christopher Ames, head of asset- and mortgage-backed securities at Schroder Investment Management North America Inc.
"The problem that we, as investors, have is the lack of fiduciary responsibility to us from the servicers," said Ames, whose company owned about 258,400 Ocwen shares as of March 31.
The other big problem for mortgage servicers would be the rise in scrutiny that non-prime loans would eventually bring.
"It's a slippery slope and the consequence of not underwriting these loans intelligently will be that consumers will be hurt," said Lykken. "The regulators are going to be there to double-check."
(Editing by Feroze Jamal, Robin Paxton and Joyjeet Das)