Eight years after the bottom fell out of the housing market, investment giants including BlackRock Inc. are facing off against small hedge funds over the detritus of the subprime era.
The issue: When does it stop making sense to keep struggling subprime borrowers in their homes? The hedge fund faction is better off when loan terms are modified. The BlackRock camp could potentially profit more when banks foreclose.
At the center of the debate is Ocwen Financial Corp., an embattled mortgage servicer that's been more aggressive than its competitors in slashing loan balances and lowering interest rates for borrowers — sometimes three or four times. BlackRock, Pacific Investment Management Co. and others say Ocwen is failing to do its job by modifying loans in ways that make no sense in order to avoid foreclosures. The hedge funds dispute that and say everyone gets more money when Ocwen keeps people in their homes. Ocwen says the ways it deals with delinquent home loans are in line with industry standards.
Dealing in mortgage-backed securities containing these loans is risky business. More than 50% of outstanding subprime mortgages within bonds have been modified, according to a November report from Credit Suisse Group AG. Two modifications often aren't enough. Borrowers who got a second adjustment were 1.5 times more likely than homeowners getting their first modifications to default again within two years, according to data from 2010 and 2011 compiled by the bank.
The dollar amount of loans Ocwen services grew by more than 300% during the housing slump and the company is now the largest servicer of subprime loans in the U.S. It's faced scrutiny from state and federal regulators. In December it reached a $150 million settlement with the state of New York, agreeing that it steered work to affiliated businesses that sometimes overcharged for their services.
Ocwen shares rose 0.8% to $10.31 at 9:54 a.m. in New York. They've tumbled more than 80% since 2013.
Investors who benefit most from Ocwen's strategy of leniency are mostly so-called junior bondholders. They're the ones who've bought riskier slices of the securities. Prolonging the length of time borrowers stay in their homes can lead to big returns from interest payments and possible windfalls from legal settlements with lenders.
"We believe Ocwen's use of affiliated companies needs scrutiny and loan reporting needs to improve, but for pure servicing, we think they're the best in the business for subprime," said Roberto Sella, managing partner of the $1.5 billion Philadelphia-based LL Funds. Along with Deer Park Road Corp., which manages $1.9 billion from Steamboat Springs, Colo., LL Funds is one of the firms clashing with BlackRock ($4.8 trillion under management), Pimco ($1.6 trillion) and others.
The senior bondholders, who own the less risky parts of the bonds, disagree. They get paid faster in foreclosures.
The big firms argue that many of Ocwen's modifications have been too generous, pointless or terrible for borrowers. They hired the Houston law firm Gibbs & Bruns LLP to protest Ocwen's modification strategy and a slew of other practices.
In an April 2 letter to bond trustees, Gibbs & Bruns partner Kathy Patrick said her group found more than 1,000 examples of questionable Ocwen modifications. Some of them were given to borrowers who hadn't made a payment for more than four years, some loans had already been modified three or more times and some borrowers immediately fell back into default after the modification, according to Patrick's letter. They even found some that increased borrowers' monthly payments, she said.
Bond trustees such as Wells Fargo & Co., which oversee the mortgage-backed securities, are investigating the charges. The probe could end with Ocwen forced to change the way it operates or being replaced by another mortgage servicer.
Ocwen has said in letters to trustees that it stands ready to explain any questions about its reporting and disagrees that its loan modifications were questionable. The company is confident the investigation will show it's "an effective servicer with practices in accord with industry standards and applicable agreements," John Lovallo, an Ocwen spokesman at Levick LLC, said in an email.
BlackRock and Pimco referred questions to Patrick, the Gibbs & Bruns lawyer representing the investor group.
Patrick said her clients are "industry leaders in advocating timely and appropriate loan modifications for borrowers" and have encouraged them in legal settlements with big banks.
From his Philadelphia office tower with views of the Philadelphia Museum of Art, Sella has spent the past few months pulling together data he hopes will prove that Ocwen's approach is best. Sella said he and members of his team are so convinced they've bought the company's stock.
When Sella started LL Funds in 2009 he bought subprime mortgage-backed securities that were trading for as little as five cents on the dollar. Sella said he targeted deals where Ocwen was the servicer because it was the company most likely to modify delinquent home loans.
Deer Park Road was founded by Michael Craig-Scheckman, who was pursing a doctorate in X-ray astrophysics at Columbia University in the 1970s when he decided a life in finance might be more interesting. He traded gold and then mortgage bonds and opened Deer Park in 2003. He's focused on mortgage bonds minted from 2004 to 2007, when lenders offered negative-amortization loans, also called Option ARMs, in which payments don't cover all the interest so the balances keep growing.
By Sella's calculations, outlined in a 15-page white paper, if every modified loan had been liquidated, the average loss for bondholders would have been between 65% and 75%, depending on when the foreclosures were made. He estimates the loss with Ocwen's modifications would be between 42% and 53%, depending on the strength of the economy.
"Everyone has a vested interest," said Sella. "I want to spark a dialogue by looking at the data in an impartial way and showing that Ocwen is servicing the mortgages for all bondholders, as required."
