Origen Financial manages a portfolio of manufactured housing loans and asset backed securities (ABS). The company delisted in 2008 and is in liquidation mode since. It sold the loan originating and servicing business and is now only managing seven separate trusts that were created between 2004 and 2007 and hold housing loans. The trusts have debt that is non recourse to the parent company. Because some trusts are performing well while others have suffered substantial losses the consolidated balance sheet is useless to evaluate the available asset value, creating a potential opportunity.
The idea shares many similarities with Gramercy Capital that I have written up before, but in the end that one was just too hard to value for me (I’m considering giving that a new shot though). Origen reports monthly performance numbers for the ABS trusts on their website making it easier to value the assets of the company. Since almost all the assets of the company are within those trusts they offer the key to determine the asset value of the company.
Company structure
As already explained Origin Financial holds interests in seven different trusts. The trusts are separate entities that have non-recourse debt. While some trusts are performing and producing cash flow to the parent company other trusts are underwater and are probably never going to produce any cash flow. The cash flow from these trusts is one way traffic: it can only flow from the trust to Origen Financial, not the other way around.
- 2004-A, 2004-B and 2005-A: these are performing fine and produced 11.7M in cash flow to the parent company the past twelve months.
- 2005-B: hasn’t produced any cash the past years, but probably does have some value since it is close to meeting requirements.
- 2006-A, 2007-A, 2007-B: no value?
Each trust started with several layers of debt and a pool of loans with a face value higher than the total amount of debt. To take the 2004-A trust as an example: this one started with $200M in debt that was backed by $239M in face value of contracts with an average contract rate of ~10%. The debt is sliced in several layers. The most senior layer has the lowest interest rate, but it does have the highest rating because when loans default these defaults are first absorbed by the excess amount of collateral and then by the more junior debt levels.
Origen Financial doesn’t own the debt of the trusts (with one small exception) but the remaining equity, so to get cash the interest on the notes needs to get paid first and certain targets need to be met. Most importantly there needs to be an amount of excess collateral available before distributions to Origen Financial can be made. Since all defaults are absorbed by the overcollateral the difference between the interest paid to the debt and the interest received on the total loan pool has to be big enough to absorb these defaults. The equity interest in the trust is leveraged to the default rate of the underlying contracts, and when it’s spikes any excess overcollateral can be wiped out easily. This is exactly what happened with the 2006 and 2007 trusts.
All the trusts start liquidating as soon as they are created. Loans get repaid, default or reach maturity and when this happens the note holders of the trust get repaid as well (starting with the most senior notes). To take the 2004-A trust again as example: it started with $200M in debt and $239M in contract face value, and at the moment $55.7M in debt is remaining and $81.3M of contract face value. When the amount of debt is dropping the amount of overcollateralization that is required is also dropping. The trust started with an overcollateralization target of $42.8M, and the target is now $25.6M. With the target dropping the excess money can be distributed freely to Origen.
So to summarize there are two sources of value:
- OC targets are lowered, making it possible to return capital to Origen
- The underlying loans can produce excess cash flow after servicing the debt
Asset value
To determine the value of the interests that Origen has in the trusts the amount of overcollateralization is a dirty shortcut to get some idea of the available value. The 2004-A, 2004-B and 2005-A trust have a total of $62.5M in excess collateral, but this is understating the value of these trusts. For the past three years these trusts all have produced cash flow in excess of the return of overcollateral. This basically means that the current default rate is lower than the delta between the rate paid to the ABS note holders and the rate that the underlying assets are paying. The table below summarizes the performance data from the three performing trusts.
As is visible the amount of required overcollateral dropped by a total of $9.2M the past twelve months while a total of $11.7M was distributed to Origen. So taking the total overcollateralization for these trusts as the total asset value is too pessimistic. At the same time it’s too optimistic for the 2005-B trust. This trust has significant OC ($15.4M), but here defaults have been eating away at the excess collateral for the past years. The graph below shows the OC target, the actual OC and the delta between them.
As is visible the trust is very close to meeting it’s OC target, but so far the available amount of OC is dropping at a nearly identical rate as the target. If this trend continues the trust would have at the end of it’s life no OC available, and it would not have produced any cash flows to Origen. It’s highly likely that this trust does have some value, but it’s almost certainly a lot less than the current amount of OC available. Usually the default risk decreases when the portfolio ages because at the end you keep the people that have been paying you back for years, and at the same time the loan to value ratio is on average going down because principal payments get made.
Answering the question how much value this trust has is very hard. Not only do you need to estimate how much of the overcollateralization is actually excess collateral and will be returned to Origen, the timing of these payments also matter a lot if you want to determine the current value. A scenario where the trust would start to create some cash flow this year would be way more favorable than a scenario where the cash only starts flowing after 5 years. I’m going to take the easy and conservative option and simply ignore any potential value this trust could have.
Timing
While we have determined that the value of the assets is significantly above the $62.5M that it has in excess collateral in the three oldest trusts this does not complete the valuation story. Equally important is the timing of the cash flows, and this is the second key part of the thesis. All notes have optional redemption clauses that make it possible for the servicer to buy the contracts from the trust and repay the notes at par when less than 20% of the debt remains outstanding. The graph below shows the amount of debt outstanding for the 2004-A trust, and the optional redemption threshold:
Just by looking at the graph it should be clear that the optional redemption threshold is probably going to be reached somewhere in 2014, maybe 2015. And while it’s called an optional redemption, I think you can be confident that it’s going to be used, since the prospectus states that when the servicer fails to exercise his purchase option an auction process is started to sell the trust assets at the highest possible price. But that’s probably not necessary since the trust holds loans that pay around 10%, so buying the assets and retiring the remaining debt at par should be an attractive transaction in the current low-rate interest environment. The story is roughly the same for the 2004-B en 2005-A trusts: these should reach the thresholds a bit later, probably somewhere in 2015. When this happens the remaining OC is returned to Origen Financial.
Completing the valuation picture
To complete the valuation we have to make some rough estimates about the cash flows and the timing. Since that’s not easy I’m going to take a very simplistic and very pessimistic scenario and show that even in this case the NPV of the assets is higher than the current market capitalization of the company. Assumptions in this case:
- The three performing trusts are all liquidated after 4 years (begin 2016)
- No cash is returned before this date
- The amount of cash returned is the total amount of OC (64M)
- Discount rate is 10%
If you would throw this in Excel you will get a NPV of $42M while the current market capitalization is $36M. This scenario is especially pessimistic because in reality a lot of cash would be returned earlier, although it’s hard to model this exactly. In 2011 $11.3M in cash flow was generated while $10.9M was distributed to shareholders. You should probably asume that this amount shrinks slowly every year going forward, until the redemption thresholds are reached.
At the same time this valuation ignores the overhead costs of the Origen Financial entity itself. These should be around $2M a year, but the excess interest received above the return of OC should easily be able to cover these costs ($2.5M was received the past year). Another minor source of value is the fact that the company holds $3.5M in notes: probably the B2 notes in the 2005-B trust since these have exactly $3.5M in face value outstanding. These notes have a 7.2% yield and are protected by 15.4M in OC, so these should probably be at least worth par (and should add $0.14/share in value).
Insiders
The company delisted in 2008 and is only publishing financial statements since, so I don’t know how much insiders exactly own today. In the 2008 annual report insiders and directors as a group owned 37.2% of the company. More interesting is the Succes Fee Letter Agreement with the CEO that gives him incentive to work towards liquidating the company since he will be paid a 1% bonus based on the value of a liquidity transaction.
A little bit of history
Origen Financial got in trouble in 2007 in the height of the financial crisis. It had to sell the loans it owned at large losses (before creating an ABS trust it needs to own a bunch of loans first), it required a rescue loan, and it sold the loan originating and servicing business. At the moment the company doesn’t have any debt at the parent level anymore, and it started distributing liquidation payments in 2010. Origen paid $2.6M in 2010, $10.9M in 2011 and $3.9M has been paid so far in 2012. So this shows that liquidation payments are at the moment occurring at a rapid rate.
Conclusion
The valuation work in this write-up has been crude for assets this complicated, but I think it’s sufficient to show that the asset value behind the Origen Financial is not only significantly more than the current market cap, there is also a strong catalyst in a few years time when the trusts reach the ‘optional’ redemption thresholds. At the same time management has shown that it is willing to liquidate the company and return capital.
While I do think Origen Financial is a compelling opportunity, it’s not without risks, and I wouldn’t want to buy a huge position. There is a lot of leverage at work, although that’s partly offset by the fact that money extracted from the trusts can never flow back.
Disclosure
Author is long ORGN.PK
Hi. I have followed ORGN for a long time. While much of your analysis is spot-on, your understanding of the optional redemption is a bit off and this is quite material to your valuation conclusion. A minor quibble is that the optional redemption is based on assets, not debt, reaching 20% of original value. But the bigger issue is your confidence that GreenTree (the servicer) will exercise the option. Origen’s management does NOT believe that GreenTree will do so, in which case Origen will have the option to exercise the redemption (this was written into the sale agreement that transferred servicing to GreenTree during the recession). Origen would need to arrange for new financing to exercise the option, then it would most likely hold the loans until maturity.
Why is this? First, your comment that the nearly 10% yield makes these loans attractive overlooks the fact that the expected return will be quite a bit lower, for three reasons. I’ll use the 2004A Trust as an example, which has loans currently yielding 9.9%.
A) The yields on longer-term loans are, on average, lower than shorter-term loans. Thus, the stated yield will decline over time and the average yield over the life of the portfolio will be lower than 9.9%. For 2004A, I think the average yield over the life will be about 0.5% lower.
B) Credit losses. It’s hard to come up with an estimate on this, but I think 1.5% is a reasonable assumption. That’s quite a bit lower than it has been over the past few years.
C) Servicing fees. No matter who owns these loans, they still require servicing. Assume 1.25%, which is the current rate on the trusts.
So the true expected return of the 2004A loan portfolio is likely to be somewhere around 6.65%, not 10%. If you do a similar analysis for the other trusts, you’ll find that they all have lower expected returns than 2004A.
So now the question is, who wants a portfolio of manufactured housing loans that might return 6.65%? Unfortunately, there aren’t many ready buyers for these assets. GreenTree is highly unlikely to want to exercise the option and hold these assets on its own balance sheet, as the expected return does not exceed its cost of capital. However, if GreenTree could find an investor willing to pay a meaningful premium to the outstanding principal balance, then it could be profitable to exercise the option and sell the portfolio. But who will want these assets? While the expected return looks reasonable, the portfolios will still have about 20 years to run before the last loans mature (the average life will be closer to 10 years) and you can’t count on ever selling the loans again at a fair price, so you need to have a buy and hold to maturity expectation. Regulated financial institutions won’t want them due to high required capital ratios. Mutual funds and hedge funds won’t want them due to the lack of liquidity.
So when the optional redemption days come, most likely GreenTree will pass and Origen will exercise their option, assuming they can get financing (I think they will). Then Origen will hold the loans to maturity, pay down the new financing, and distribute excess cash to investors in a 20-year slow motion liquidation. I think if you are a long-term investor willing to just sit on some ORGN shares for a decade or two, you can probably earn annual returns over 10% (Beware! Assumptions are very dependent on expected credit losses and company operating expenses over a 20-year period), but the optional redemption bonanza scenario you outlined is probably not going to happen. If it was, ORGN’s stock price would be quite a bit higher already.
Thanks for your comment, some great stuff.
I did reread the text about the optional redemption and you are indeed right that it’s based on asset value remaining instead debt remaining. This should push this event further in the future (1 or 2 years I’d guess).
About the value of the loans: I agree that the final return will be significantly lower than the average rate because of service fees and credit losses. But at the same time those loans were originated in an environment when interest rates were significantly higher. You can get a 15yr mortgage for ~3% these days and that’s also before servicing costs and credit losses. In an environment like this I would expect that it should be possible to sell housing loans with an almost 10% yield and shorter duration easily for more than par. And if that’s the case you should expect that GreenTree is going to exercise the early redemption option. But maybe I’m wrong about the attractiveness of the current yield of these loans.
I’m by the way not convinced by the argument that if I would be right the market price would already be higher, because it seems to me that very few people truly understand Origen (me included). The company for example announced in May that it had terminated the interest rate swaps related to the newer trusts and received close to 10M in cash. The share price of the company only started to rise in June after the company had announced that this money would be distributed in this month’s dividend.
I don’t dispute that the loans will have good returns for the risk. But that still doesn’t answer the question of who will buy them. GreenTree is in the business of servicing, not investing in 6% fixed income, so they aren’t going to be interested. As to when those loans were made years ago, keep in mind that in order to get investors to buy the securizations’ debt, they needed to be heavily over-collateralized and have high credit ratings attached. That will not be the case with the loan portfolios after the optional redemption.
Origen’s management knows more than we do about the marketability of these loans and they don’t believe they can sell for more than the face value. That counts for a lot, in my opinion.
Can’t disagree with that logic. Management’s opinion > my opinion. And also agree that GreenTree isn’t going to buy if they would need to keep the loans on their own balance sheet. Wonder if that has to mean that Origen is going to try to get financing and hold the portfolio till maturity. They could also decide to sell @ face value or at a small discount.
That said; a lot can change in a couple of years time, and if the loans have indeed a favorable risk/reward ratio there must emerge a buyer at some point in time. Otherwise I don’t mind owning it myself, but will need to take a hard look at the overhead costs of Origen if it’s going to be a longer term buy and hold.
About the securizations; they indeed needed a lot of over-collateral and a high-credit rating, but at the same time the senior tranches also paid a very low interest rate. The loan portfolio isn’t going to have the perception to be ultra safe, but it’s also not going to have the low interest rate.