Walter Investment Management

What are Mortgage Servicing Rights (MSR)

• Buying the MSR gives a company the right to service a mortgage

• In exchange for a small fee (usually 25-50 basis points of the principle) the company ensures that the mortgage payer is paying his mortgage to the bank as well as paying all applicable taxes and fees.

• Companies buy MSR because they can profit from the fee.

Example of NSM MSR transaction

Cost of Mortgage Servicing (PHH)

Cost of Mortgage Servicing

• Doing the math average profit Margins before taxes = 57%– (Loan servicing income-total expenses)/Loan

servicing income• At a tax rate of 38% (the tax rate Walter uses

for their estimates) = 35.38% net profit margin• Using the NSM example yields a “P/E” of 3.8

and a ROI of 26%

Walter Investment Management

• Walter Investment Management had a deal where they bought 93 billion dollars of Unpaid Principle Balance (UPB) for 2.05 times their 27 basis point servicing fee.

• At 35% profit margin is 9.55 basis points• Cost is 27*2.05=55 basis points• Subtracting out 55/10*(1-.38) for amortization and adding

on ancillary income: That is a ROI of 28.1% and a “P/E” of 3.55– In line with Managements EBITDA guidance of 40-45%

• Servicing Portfolio’s are mortgages and last an average of 10 years

Why is the Market so Good for MSRs?

• From Deloitte (sorry I don’t have the link they took the report down):– “Under Basel III, banks will be allowed to include only

a maximum 10% of mortgage servicing rights in their capital measures. Any amount above that is deducted; and then, in combination with financial holdings and deferred tax assets, that can only be up to 15% of aggregate capital. In contrast, under current rules mortgage servicing rights are included in capital up to 90% of fair value or book value, whichever is lower.”

Additional reasons for Buyers Market

• Mortgage servicers consolidated so now the top 5 servicers account for over 50% of the Market. – Link:

http://www.blogtalkradio.com/lykken-on-lending/2012/02/06/weekly-mortgage-housing-market-update

• Also Banks have been absolutely hammered these past five years and MSR are mark to market on the balance sheet which adds a lot of earnings volatility which banks are eager to get rid of.

As a result Banks are selling their MSR

• Bank of America, Ally Financial liquidating their entire portfolio

• Citi, JP Morgan, Morgan Stanley significantly scaling down

• Smaller originators forced to sell due to liquidity reasons

• Pre-great recession, MSRs were selling for 4-5 times the MSR fee – Now around 2 times

• Still a 300 billion dollar UPB pipeline

Walter Investment Management

• Walter has 6 Business segments– Servicing, Asset Receivables management,

Insurance, Loans and Residuals, Reverse Mortgage and Other

• All segments are tied in with Mortgage Servicing.

• Mortgage servicing is going to provide the majority of the growth.– First focus on other business segments

Walter Businesses

Other Business segments

• Asset receivables– Preform collections for post charge off accounts receivables– Steady but minimal income

• Insurance– Hazard placed insurance for lenders– Very lucrative business

• Combined ratio of 55%

– With minimum leverage make oversized margins• Consists of Assets and mortgage backed debt of residual

trusts– Non-recourse so they can only make money (if they start to lose

money they just walk away and make lenders take care of it)

Reverse Mortgage

• Market leader in the Reverse Mortgage Servicing Segment

• Purchased Reverse Mortgage Segment in Nov of 2012– So Full year earnings: 3121*6=18726K– Recently doubled UPB so income may be around 36000K

• Management expects similar opportunities (albeit on a smaller scale) in the Reverse Mortgage Segment as in normal Servicing segment– 15-20% ROI– Thesis supported by the fact that Ocwen and NSM are getting

into the business as well

Earnings growth for NSM(and margins expansion)

Walter Investment Management Growth

Mortgage Servicing Segment

• Management forecasts EBITDA of around 680– Historically EBITDA has been in guidance range

• My calculations are around 600, but don’t take into account operating leverage

• Current selloff due to higher than expected Constant Prepayment Rate– Rate at which mortgages currently serviced are

refinanced

Management Guidance for 2013• Management guides for approx. 125 million dollars in interest expense

– In line with my estimates• Management guides approx. 350 million in depreciation and amortization

– About 135 million over my and most analyst estimates– Responsible for 20+% drop on March 19th

• Implies 127 million in earnings for a 1.2 billion dollar company– Still has a lot of growth potential next couple years– Probably will grow EBITDA significantly in 2013-2014 as Servicing is ramped up– Nationstar set to grow their late 2012 early 2013 portfolio from .75 EPS in 2013 to 2.50

EPS in 2014. That is a 333% growth rate.– Walter acquired about 50% of their UPB in late 2012 early 2013 using Nationstar’s

ramp up their servicing earnings could grow by over 100% in 2013-2014– Nationstar expects ROI on servicing to be over 20% (which is in agreement with the

numbers I calculated) • Calculating 20% of the estimated value of there total mortgage servicing rights assets gives a

net income of 295 million which is 2.5 times next years projected earnings

It gets better…• Depreciation and Amortization of 350 million is significantly

elevated from normal/trend. • Management attributes this high Constant Prepayment rate (CPR)

of 25-28%– CPR implies amortization cost by that amount– Historically and industry wide CPR has been between 8-12%– I used 10% CPR for my ROI calculation

• Management went out of the way specifically to say the new portfolio they bought (which is 50% of UPB) would have extremely high CPR/delinquency rate in the first couple years due to high number of underwater mortgages but would return to trend in 2014

• HARP modified a lot of these mortgages which increases CPR

Trend Depreciation

• Trend Depreciation as I calculated is 215 million– This implies earnings of 204.2 million

• In line with 25% ROI times 55 basis points times 155 billion UPB plus current earnings

– P/E of 6– All this for a company that is set to grow significantly more

in 2014• This doesn’t include the 300 billion dollar pipeline of

MSR coming this year• Analysts have stated that the current decline in price is

an overreaction

Risks

• Risks: Net income growth will fail to pan out. – Unlikely because other companies that are buying

MSR are projecting similar outcomes.• Interest rates will go down– Already near zero, can’t go down much more

• Housing will decline– Currently housing is on an uptrend and projections

have it going up