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 No one buys assets out of bankruptcy as well as Wilbur Ross, and he's done it again with the launch of his next rollup: mortgage servicers.
Wilbur L. Ross Jr. follows a simple formula before he rolls up an industry. He makes two lists -- the first containing everything he thinks is wrong with an industry, the second what he would change. Then he and his private equity firm, WL Ross & Co. LLC, wait for the industry to implode, giving him the opportunity to match column A with column B. "When the two charts are symmetrical, that's when we invest," Ross told an audience at a recent M&A conference.
Ross has become a master at biding his time, studying a sector's fundamental weaknesses, figuring out a strategy to reinvent it, then pouncing on a company to serve as his vehicle of change -- ultimately profiting handsomely. His best work has tended to be in heavily unionized, old- economy manufacturing sectors. He bought LTV Corp. for $325 million in 2002, using it as a vehicle for other bankrupt steel company assets, which became International Steel Group Inc. In 2003, he parlayed the purchase of Burlington Industries Inc. into a rollup of broken textile makers known as International Textile Group Inc. Out of his 2004 purchase of Horizon Natural Resources Co., he bought troubled coal mining companies to create International Coal Group Inc. His acquisition of Collins & Aikman Europe in 2005 gave him the foundation in auto parts for International Automotive Components Group North America LLC. He even dabbled in rolling up telecom assets, buying 10% of the equity and 13% of the debt of 360networks Corp. when it exited bankruptcy in late 2002. The company has gone on to buy Dynegy Inc.'s 16,000-mile fiber network and the private line and Internet businesses of Touch America Holdings Inc. While he still owns interests in the coal, textile, telecom and auto parts rollups, he scored his splashiest exit when he cashed out of International Steel Group on Dec. 17, 2004, making an 11-fold profit by selling it for $4.5 billion in cash and stock to LNM Group, controlled by London-based CEO of steelmaker ArcelorMittal, Lakshmi Mittal.
"Wilbur Ross has a reputation for investing in troubled industries, and the mortgage industry is a troubled industry," says AHM director of restructuring Kevin Nystrom. Doomed is more like it. Mortgage lenders such as New Century Financial Corp., First Magnus Financial Corp., HomeBanc Mortgage Corp., Aegis Mortgage Corp. and Spectrum Financial Group Inc. aren't just in bankruptcy, they're liquidating. Perhaps no industry since the S&L crisis has experienced such a mass extinction. Can Ross make another killing? That may depend on how quickly the market recovers. What's more certain is that few are more skilled at buying assets out of bankruptcy than Ross. A close look at how Ross won the AHM servicing unit provides a primer in how to negotiate the tangle of complications and interests in a deeply distressed situation. AH Mortgage was a departure from Ross' past rollups. There wasn't much union presence, hard assets such as factories and machinery, or legacy healthcare and retiree costs. Ross had to resort to an unusual two-pronged closing, withstand a battle over whether the mortgage-servicing unit could be separated from AHM's loan-origination business and sweat out whether he'd be stuck with defaulted mortgages. But for all the differences and difficulties, say observers, the AHM acquisition was pure Wilbur. Ross sees value in the carnage, as others once saw it in busted S&Ls. Almost 70% of American families own their own homes, a large percentage through mortgages. "There is $10 trillion in outstanding mortgage loans," he says. "It was an opportune time to come into it." Pure Wilbur. So when American Home Mortgage filed for Chapter 11 on Aug. 6, Ross saw something he had been seeking for more than a year. He now had not only symmetrical lists, but a vehicle to put his strategy into motion. He also did something no one else did: He offered a bankrupt mortgage lender a debtor-in-possession loan. Through WL Ross & Co.'s WLR Recovery Fund III LP, he offered AHM an initial DIP of $50 million. "They needed the loan to enter bankruptcy, and we felt there was enough value there that it was a safe loan," he says. "We were also interested in acquiring the mortgage-servicing business, so providing the loan was useful to stabilize the company before the sale process got under way." AHM wasn't a subprime lender but provided mortgages to borrowers with better creditworthiness, namely, the Alt-A crowd. It was the 10th-largest mortgage originator in the U.S. before it filed in the U.S. Bankruptcy Court for the District of Delaware in Wilmington, generating a mortgage volume of $58.9 billion in 2006. But Ross didn't care about origination volumes. He wanted loan servicing, not origination. Nystrom, who is also a senior director at crisis management firm Kroll Zolfo Cooper, thinks Ross picked AHM's servicing business over others because it was, he says, "well organized." Indeed, it may have been in his sights before AHM filed. "It was clear that AHM wanted to sell its loan-servicing business and the timing was right for Ross," says Ross' attorney on the deal, David Heiman of Jones Day. Origination and servicing are very different businesses. On the origination side, the two critical components are a sales force (loan officers) and liquidity, Nystrom says. And, like other mortgage lenders, AHM suffered from a liquidity crisis. Nystrom says AHM's warehouse lenders pulled their lines, forcing it to slash lending. Without liquidity, loan officers had nothing to sell and left. AHM then tried to sell its origination business, but instead ended up shutting it down, Nystrom says. "No one is having luck selling their origination business." Loan servicing, on the other hand, doesn't need the capital of origination. Another plus: Cash flow is steady. Servicing fees are generally based on a percentage of the outstanding balance of the loans per annum -- generally 0.25% to 0.5% -- and paid monthly, Nystrom says. "If a loan has an interest rate of 7%, one quarter of the 7% goes to the servicer and the rest goes to whoever owns the loan," he says. "People need loan servicing no matter what happens in the mortgage market," adds an attorney who worked on the deal. When AHM services loans, it collects mortgage payments, administers tax and insurance escrows, responds to borrower inquiries and maintains control over the collection and default mitigation processes, all of which generate steady cash flow. AHM's average outstanding loan balance was $225,000, and the average fee was "three-eighths of a percent per annum" when the servicing was sold to Ross last year, Nystrom says. That means AHM's average fee is $843.75 per mortgage annually. (To show how overheated the mortgage market had quickly become, AHM in 2006 serviced just 197,000 loans with a principal amount of $26.3 billion, meaning the average loan was just $133,502 and the average yearly servicing fee of $500.63.) What also appealed to Ross was the scalability of a loan-servicing operation, which, he says, can be doubled or even tripled without meaningful capital expenditures. The AHM unit services $50 billion now in mortgages, Ross says, but he hopes to expand to $100 billion to $150 billion. Why is that possible? Because the operation is mostly automated. Once you have the system, you can add more loans with little boost to your labor force, Nystrom says. Actually running a servicing business may be less complicated than what Ross had to go through to buy the unit out of bankruptcy. His bid last fall was for $6 million, plus the initial servicing balance price (the unpaid principal balance on the mortgage loans) and 92% of the amount outstanding on the principal balances, which have been paid out but have not yet been collected from third parties. In other words, the bid was based on 92 basis points of the aggregate balance of the outstanding mortgage loans still being serviced, which was about $40 billion, the attorney says. According to Mark Indelicato of Hahn & Hessen LLP, the counsel to the unsecured creditors' committee, that $40 billion or so was spread over 200,000 servicing contracts. Ross says he bid such a large amount for the servicing business because the price was based on the company's current value and its future cash flow. Ross, however, only bought rights to service Fannie Mae, not Freddie Mac or Ginnie Mae, loans, Nystrom says, adding that he thinks Ross will eventually get certification for all three. Still, while interest in the AHM assets was keen, only Ross submitted a stalking-horse bid for all of the business. "There was a lot of competition for the loan-servicing business," says Jones Day's Heiman. "A lot of other bidders came forward for pieces of the servicing business, but not the whole thing." Getting court approval wasn't easy. More than 80 objections were lodged against the sale, and a five-day hearing was needed to sift through them. "Any time a hearing lasts five days, a person should be nervous," Nystrom says. Complicating the sale, too, was its execution according to both Section 363 and Section 365 of the federal Bankruptcy Code. While the former is common -- Section 363 requires procedures for an open auction and involves buying assets and leaving most liabilities behind -- the latter involves the assumption of contracts. And that means all alleged defaults involving the contracts were resolved, Heiman says. Ultimately, none of these issues were dealbreakers. "The objections were largely related to the use of the [sale] proceeds rather than the idea of us owning the servicing," Ross says. The real sticking point involved whether the mortgage-servicing business could be separated from the loan origination unit, Heiman says. When AHM originated loans and then sold them to various financial institutions, it made the sale on a "servicing-retained" basis, which means the seller of the loan retains the right to designate who services the mortgage loans. The alternative is a "servicing-released" basis, which enables the buyer of the mortgages to designate the loan servicer. But the buyers of these mortgage loans pay more because they also get the right to decide who services them. If they do the servicing themselves, they can collect steady fees. If they subcontract the servicing out -- which is highly unusual -- the loan buyers might get some portion of the fees. But the usual reason for buying the loans is really to service them, not subcontract them. Over the five-day hearing, AHM convinced the court that loan origination and servicing businesses were separate. But controversy didn't end there. Like other originators, AHM early on agreed that it would buy back defaulted loans. Under many loan agreements, if the mortgage goes into default in the first year, making it "an early default claim," the seller would have to buy it back. According to Heiman, AHM was on the hook for hundreds of millions of dollars worth of early default claim loans. And many of the parties AHM sold loans to argued that Ross' new servicing company should buy them back. "We were not prepared to do that," Ross says. "We didn't sell them the loans, [AHM] did." The question became, however, whether AHM could transfer the servicing rights to Ross without the accompanying early default claims, Nystrom says. U.S. Bankruptcy Judge Christopher Sontchi settled the matter, ruling that Ross' AH Mortgage wasn't responsible for taking back the defaulted loans and that the origination and servicing businesses were separate. Heiman says language was even added to the sale order to keep Ross safe from those defaults in the future. Instead, the early default claims will remain with AHM's bankruptcy estate, and they will be considered unsecured claims when AHM files its liquidation plan. "They will have to stand in line with other unsecured creditors," Nystrom says. Sontchi approved the sale Oct. 23, but Ross still wasn't out of the woods. The AHM unit had to be relicensed for mortgage servicing in all 50 states, among other things, which took time. In a novel twist, the sale underwent two closings. At the first, known as the economic closing, Ross paid the purchase price but did not take the legal title to the company. AHM agreed to continue operating and managing the loan-servicing business until the so-called legal closing. That occurred April 11, well before a projected Sept. 30 date. In addition, there were still several lawsuits to contend with over servicing contracts. Even before AHM announced it was selling the servicing unit, the company faced a number of proceedings filed against it, all from investment banks seeking to get back loans that AHM had been servicing for them. Credit Suisse First Boston, Morgan Stanley Mortgage Capital Holdings LLC, Bear Stearns Mortgage Capital Corp., EMC Mortgage Corp. and Calyon's New York branch all filed lawsuits against AHM to regain the rights to service their loans. Nystrom argues that most of these lawsuits and relief motions did not relate directly to the sale of the loan-servicing business, because some of the banks' servicing rights were not sold to Ross in the first place. For example, Ross didn't get Calyon New York and Credit Suisse's servicing rights, he says. And yet the suits involved fundamental questions. The investment banks accused AHM of defaulting on their master repurchase agreements, or MRA, which consisted of a two-part transaction. The first was the transfer of mortgage loans from one party to another for cash. In the second, the company that sold the loans repurchased them at their original price plus an agreed-upon premium, according to court papers. While most of the lawsuits were settled, Calyon's went to trial. Calyon had sued AHM on Aug. 28 after the mortgage company defaulted on its MRA, asking that AHM transfer the servicing to J.P. Morgan Chase Bank NA. Once the lawsuit was filed, AHM argued that the agreement wasn't an MRA at all and that the contract provided only for creating a lien on the mortgage loans, making it resemble secured debt. As a result, AHM asserted, safe-harbor provisions under Sections 555 and 559 of the federal Bankruptcy Code did not apply. (Section 555 and Section 559 effectively exempt MRAs from the automatic stay conferred by a bankruptcy filing.) AHM also argued that the safe-harbor provisions under those sections didn't apply to loan servicing because Calyon had bought them on a servicing-retained basis. In other words, AHM, as the seller, had the right to designate the mortgage loan servicer, not Calyon. On Jan. 4, Sontchi rejected AHM's first argument, ruling the agreement was, in fact, an MRA and thus protected by safe-harbor provisions under Sections 555 and 559. But he sided with AHM on the second, agreeing that loan servicing contracts weren't protected because AHM had sold the mortgage loans to Calyon on a servicing-retained basis. So AHM didn't have to turn over the servicing rights. One result of the decision, says Nystrom, is that no one now wants to own loans without controlling the servicing as well as the fees they generate. "The decision is significant," agrees Hahn & Hessen's Indelicato. "It's the first place people will look in the future." Sontchi's ruling could have far-reaching effects for MRAs. "It will strengthen the 'repo' market," says an attorney not involved in the AHM case but who's familiar with the opinion, Katherine Burroughs of Dechert LLP. Repos are repurchase agreements, like the arrangement between Calyon and AHM. Sontchi's decision clears up what had been a murky area. "It will impact how people look at these 'repo' agreements and will be significant for other mortgage lender bankruptcy cases," she says. With these court cases out of the way, Ross can now focus on completing the Option One deal by April 30. Private equity firm Cerberus Capital Management LP had originally been slated to buy both H&R Block's loan-servicing business and its origination business, but the deal stalled. That put Option One, the fourth-largest servicing business in the U.S. -- now servicing $53 billion in subprime mortgages -- in play. Ross pounced and grabbed it. The result: AH Mortgage will service $95 billion and will be the No. 2 U.S. loan-servicing business after Countrywide Financial Corp., which Bank of America Corp. acquired earlier this year, when the Option One deal is completed. That will get Ross close to the $100 billion in critical mass he wants. Meanwhile, he's far from finished with the mortgage business. "In general, I think that with all of the distress that has come in the mortgage industry, there is lots of opportunity in the industry," he says. "We would be interested in buying additional things." It's fair to say he'll have ample opportunity. -- Jamie Mason See the full issue of the 4.28 Deal newsweekly See TheDeal.com story: Ross buys H&R Block subprime unit See TheDeal.com story: Ross entity wins AHM servicing unit CategoriesComments Deal Video
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I get so tired of hearing how good of a business man Wilbur Ross is. His company's make money, not because of his management skill, but because he cuts wages and benefits. Anybody can do that. We took a 20% paycut 2 years ago and he wants another 20% now.