Altisource’s share price fell dramatically today following a letter by Benjamin Lawsky to Ocwen (PDF link) that finds problems with a practice called force-placed insurance. Normally, lenders will require the homeowner to pay for hazard/property insurance. Part of each mortgage payment goes into an escrow account that pays for insurance and property taxes. However, there are some rare cases where the borrower pays hazard/property insurance separately. Perhaps they already had insurance before getting a HELOC. Or, they wish to exercise their right to choose their own insurance provider. In those situations, a borrower who has run into financial difficulties may stop paying their hazard/property insurance because they have more important expenses to pay. This exposes both the lender and the borrower to the risk of catastrophic damage to the home. Mortgage contracts generally allow the mortgage servicer to obtain hazard/property insurance elsewhere on behalf of the borrower.

There are two issues with force-placed insurance:

It’s almost always significantly more expensive than the original hazard/property insurance policy. The mortgage servicer can take kickbacks/commissions from the insurance company.

Force-placed insurance is expensive

Force-placed insurance (also called lender-placed insurance) is inherently more expensive even without kickbacks. The insurer generally agrees to insure all of the houses from a given mortgage servicer where the insurance has lapsed, without the ability to reject loans that do not meet their normal underwriting criteria.

Unfortunately, the consequences for the home owner are tough. Somebody who is behind on their mortgage will suddenly be even more behind due to the increased cost of hazard/property insurance. While this is a concern from a consumer protection standpoint, force-placed insurance is a “necessary evil”. Without it, the borrower and lender are exposed to catastrophic risk. (Or mortgages will suddenly become more expensive and difficult to obtain if force-placed insurance clauses aren’t allowed…)

For non-delinquent homeowners, force-placed insurance is a nasty surprise. They may have accidentally forgotten to renew or pay their insurance, unaware that force-placed insurance is significantly more expensive. Insurance companies will generally contact their clients before their policy lapses so that they do not forget to renew their insurance.

The mortgage servicer can take kickbacks

Because the mortgage servicer originates the flow of force-placed insurance, the mortgage servicer could take kickbacks or commissions from the insurance company. The real losers from this practice are typically the mortgage investors. Many borrowers who aren’t paying their insurance will likely default on their mortgage anyways. Once the loan goes into foreclosure, it will be the mortgage investors who pay for the kickbacks on force-placed insurance. Mainly for this reason, the GSEs have changed their rules in the past few years to forbid servicers from taking kickbacks on force-placed insurance.

Consequences for Ocwen

Benjamin Lawsky’s letter to Ocwen basically implies the following things:

That Altisource is taking kickbacks for force-placed insurance. (The practice hurts consumers and mortgage investors because they will be paying for those kickbacks. As well, it arguably hurts Ocwen’s sub-servicing clients.)

That Altisource is trying to side step borrower protections through complex arrangements.

That Bill Erbey is hurting Ocwen shareholders to benefit Altisource shareholders. The letter does not expand on this conflict of interest but shareholders should be concerned about the implications of the alleged wealth transfer. Because it is Ocwen that determines the flow of force-placed insurance, it should be Ocwen that receives any kickbacks (not Altisource). Ocwen is further hurt by the arrangement because Ocwen has to provide advances on forced-placed insurance and pay for the financing of those advances.

Here is my version of the narrative laid out in Lawsky’s letter:

Ocwen’s existing force-placed arrangement with the insurer Assurant was set to expire in March 2014. In August 2013, Ocwen appointed an Altisource subsidiary called Beltline Road Insurance Agency, Inc. (“Beltline”) as its exclusive insurance representative. Beltline’s stated task was to find an alternative arrangement. In January 2014, Altisource provided a memo to the Credit Committee of Ocwen Mortgage Servicing. Altisource recommended itself to provide fee-based services to SWBC. Ocwen’s new force-placed arrangement with Altisource replaced Assurant with Southwest Business Corporation (“SWBC”). The agreement is apparently a pass-through agreement so that Ocwen and Altisource are not directly contracting with each other. However, Altisource can still receive insurance commissions and certain fees seemingly for doing very little work. The NY DFS letter is basically implying that Altisource, not Ocwen, is keeping kickbacks/fees from force-placed insurance. (Note: The letter uses the word “kickback”. While it suggests that Altisource is taking kickbacks on force-placed insurance, it does not use the word kickback when describing Ocwen’s and Altisource’s activities.) In emails dated January 15 and 16, 2014, the transaction was approved by the three members of the Credit Committee: William Erbey, Duo Zhang, and Richard Cooperstein. The Credit Committee did not meet to discuss this proposal, no minutes were taken of the Credit Committee’s consideration of this proposed transaction, and the proposed transaction apparently was not presented for review or approval to any member of the Ocwen Board of Directors. Just one month after this Credit Committee approval, on February 26, 2014, the company received a letter from Lawsky’s New York Department of Financial Services raising concerns about potential conflicts of interest between Ocwen and its related public companies. Disregarding the concerns raised in the Department’s letter, Ocwen proceeded to execute contracts formalizing this new force-placed arrangement. It appears that payment of the kickbacks/fees exclude premium generated by policies issued on properties in New York State. The new force-placed insurance contracts, dated as of June 1, 2014, indicate that Altisource will generate significant revenue from Ocwen while apparently doing very little work. A careful review of these and other documents suggests that Ocwen hired Altisource to design Ocwen’s new force-placed program with the expectation and intent that Altisource would use this opportunity to steer profits to itself.

Do the numbers add up?

The numbers in Lawsky’s letter are quite significant. The letter states:

Documents indicate that Ocwen expects to force-place policies on its borrowers in excess of $400 million net written premium per year; a 15% commission on $400 million would be $60 million per year.

It seems slightly implausible to me that there would be a wealth transfer of this magnitude from Ocwen shareholders to Altisource shareholders. The actual wealth transfer is slightly larger than $60M/year because Ocwen has to put up advances for the inflated cost of force-placed insurance. $60M/year is substantial compared to Altisource’s operating income of $162M in YE2013. The contract described in Lawsky’s letter seems like an egregious violation of securities law.

Secondly, I’m not sure if Ocwen generates that level of force-placed insurance premiums on the ~2.8M loans that it services and on the loans that it sub-services. Force-placed insurance only applies if the borrower was paying insurance separately and if the borrower stops paying his/her insurance policy. It would only apply to a small portion of Ocwen’s delinquent loans and a small portion of loans that Ocwen sub-services. Looking at Altisource’s 10-K, the “insurance services” segment only generated $42.483M in revenue from Ocwen (page 31). Altisource describes its segment as follows:

Insurance services include an array of title insurance services, including pre-foreclosure and REO title searches, title commitments, settlement and escrow services and other title insurance services including title insurance for loan originations. We also provide insurance program management and insurance agency and brokerage services applicable to lenders and residential loan servicers.

To me, the description suggests that non-kickback revenue accounts for most of Altisource’s insurance services revenue. The part that can be construed as kickbacks on force-placed insurance seems to be, at the most, a very minor part of the insurance services segment.

Thirdly, there has been a lot of scrutiny regarding the practice of force-placed insurance. The Ocwen 10-K notes that there was scrutiny regarding this practice since January 2012:

On January 18, 2012, OLS received a subpoena from the NY DFS requesting documents regarding OLS’ policies, procedures and practices regarding lender-placed or “force-placed” insurance which is required to be provided for borrowers who allow their hazard insurance policies to lapse.

Since then, other servicers have settled class action lawsuits relating to the practice. The CFPB has also been scrutinizing the practice. It seems like a dumb move for Bill Erbey to transfer wealth from Ocwen to Altisource (in the manner laid out in the DF NYS letter) given the increased scrutiny over the practice. Did Ocwen or Altisource take kickbacks in the past? According to the NY DFS letter, Assurant provided force-placed insurance to Ocwen in the past. Assurant and Ocwen’s competitors seem to have engaged in kickbacks in the past: Assurant and JP Morgan settled a class action lawsuit for $300M (Wall Street Journal article).

Assurant and Citigroup paid $110M to settle its lawsuit relating to force-placed insurance (Marketwatch article).

Assurant, QBE (another major insurance provider), and Wells Fargo settled a lawsuit against it (Marketwatch article). I believe Ocwen is currently facing a lawsuit over alleged kickbacks from force-placed insurance. I do not believe that the kickbacks/commissions are clearly illegal. A small commission is reasonable given that it costs the servicer money to obtain and finance force-placed insurance. I believe excessive commissions/kickbacks run afoul of consumer protection-type laws. The bottom line To recap, the issues are: Did Ocwen or Altisource take kickbacks in the past? If so, what would be the cost of settling lawsuits related to that practice? Is Ocwen or Altisource still taking kickbacks? I doubt that Bill Erbey would do that considering the previous class action settlements, Ocwen’s settlement with the CFPB, etc. etc. On the other hand, the history of certain areas of the finance industry is that some companies will repeatedly commit wrongdoing and make huge profits despite all the settlements they pay (e.g. most investment banks). Did Bill Erbey transfer wealth from Ocwen to Altisource? I don’t think he’s that stupid. I added slightly to my position in ASPS today after the stock fell by almost a fifth. I think that the fears are overblown. *Disclosure: Long OCN and ASPS. Links Ocwen Accused Of Forcing Costly Insurance On Homeowners – 2012 news article Mortgage loan companies skirting federal regulations – 2014 news article. Walter Investment most at risk of FHFA forced-placed insurance suit – This article suggests that Ocwen did not take kickbacks on force-placed insurance for FHFA loans. (Assurant) Frequently Asked Questions: Lender-Placed Insurance – For some reason this website is broken but you can view the HTML source code to read the answers to the questions.

(added 11/12/2014) Force-Placed Insurance Kickbacks Still Alive – This article quotes the executive director of the Center for Economic Justice as saying that Beltline is a means by which Ocwen and Altisource are getting around rules on force-placed insurance. Instead of receiving a continual stream of kickbacks, Ocwen received a front-loaded one-time payment when it sold Beltline to Altisource.