The small-cap arena is where you are most likely to find stocks that deliver multiples of return, since it’s the small companies that grow to become the behemoths. Rarely, however, do you find a small-cap stock that offers a huge dividend. Even more rare is the small cap that offers a huge yield that is involved in the mortgage arena, but is not a mortgage real estate investment trust, or mREIT.
Home Loan Servicing Solutions (HLSS) is a Cayman Islands-based mortgage servicing operation. The company purchases mortgage servicing assets, which are non-agency mortgage servicing advances, rights to non-agency mortgage servicing rights and cash reserves.
Does that make sense to you? At first it didn’t to me, either. To put it in layman’s terms: a mortgage servicing asset is the right by a bank to service mortgage loans owned by someone else. So a bank may sell the loan to Federal National Mortgage Association (FNMA) but retain the right to service the mortgage, or to sell off those rights. The mortgage servicing firm collects a fee.
To be clear, HLSS doesn’t originate mortgages, nor does it have its own servicing platform. Instead, it buys the servicing rights and partners with Ocwen Financial (OCN) to do the actual servicing.
The business itself is a good one. HLSS has limited credit and valuation risk from its asset base, which has grown at a compound annual growth rate of 85% since the company went public in late 2012. It has rights to well over $100 billion worth of mortgages and has a solid and reliable revenue stream from the servicing fees it earns. Plus, it picks up some interest on a small portfolio of FHA-insured assets.
The servicing assets are so well collateralized that the company says it would take a 96% drop in real estate values to impair its servicing assets. Indeed, 82% of its servicing assets consist of advances or cash which have no mark-to-market. Servicing revenue makes up 90% of its revenue.
In short, the business model means that the company’s profits are purchased up front. Its target return is not dependent on what happens with the underlying asset since the company only deals with servicing the mortgages. The stock currently trades around $19, down from its 52-week high of $24.10, and it pays a 10.4% yield.
Any risks? There is one potential large risk to be aware of.
Ocwen shares have taken a big hit this year because of accounting issues that it disclosed in August, even though those issues weren’t material enough to change its financials. However, the NY attorney general also raised questions about how Ocwen was handling fees paid to HLSS, a former subsidiary, and another firm, Altisource Portfolio Solutions (ASPS). Ocwen is also being scrutinized for other allegedly questionable practices.
These concerns could potentially roll downhill to HLSS, since Ocwen’s chairman is also the largest shareholder in HLSS. That’s the risk you are looking at here. If you separate the risk out, the business is a great one with plenty of upside. If you want to wait for the risk to either come to fruition or be dismissed, you can certainly wait on the sidelines.
Lawrence Meyers does not own shares in any company mentioned.
