10-K 1 a14-25744_110k.htm 10-K

Table of Contents

 

 

 

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

Form 10-K

 

R

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

 

 

For the fiscal year ended December 31, 2014

 

 

 

OR

 

 

o

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

 

 

For the transition period from _______to_______

 

Commission File No. 1-7797


 

PHH CORPORATION

(Exact name of registrant as specified in its charter)

 

MARYLAND

 

52-0551284

(State or other jurisdiction of

 

(I.R.S. Employer

incorporation or organization)

 

Identification Number)

 

 

 

3000 LEADENHALL ROAD

 

08054

MT. LAUREL, NEW JERSEY

 

(Zip Code)

(Address of principal executive offices)

 

 

856-917-1744

(Registrant’s telephone number, including area code)


 

SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:

 

 

TITLE OF EACH CLASS

 

NAME OF EACH EXCHANGE

 ON WHICH REGISTERED

 

 

Common Stock, par value $0.01 per share

 

The New York Stock Exchange

 

 

SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT: None

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes R  No o

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Securities Act.  Yes o No R

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes R  No o

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes R   No o

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

(Check one): Large accelerated filer R   Accelerated filer o  Non-accelerated filer o (Do not check if a smaller reporting company) Smaller reporting company o

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).   Yes o   No R

 

The aggregate market value of our Common stock held by non-affiliates of the registrant as of June 30, 2014 was $1.0 billion.

 

As of February 17, 2015, 51,196,675 shares of PHH Common stock were outstanding.

 

Documents Incorporated by Reference: Portions of the registrant’s definitive Proxy Statement for the 2015 Annual Meeting of Stockholders, which will be filed by the registrant on or prior to 120 days following the end of the registrant’s fiscal year ended December 31, 2014 are incorporated by reference in Part III of this Report.

 

 

 



Table of Contents

 

TABLE OF CONTENTS

 

 

 

 

Page

 

Cautionary Note Regarding Forward-Looking Statements

 

1

PART I

 

 

Item 1.

Business

 

3

Item 1A.

Risk Factors

 

9

Item 1B.

Unresolved Staff Comments

 

22

Item 2.

Properties

 

22

Item 3.

Legal Proceedings

 

22

Item 4.

Mine Safety Disclosures

 

22

 

 

 

 

PART II

 

 

Item 5.

Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

 

23

Item 6.

Selected Financial Data

 

25

Item 7.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

26

Item 7A.

Quantitative and Qualitative Disclosures About Market Risk

 

69

Item 8.

Financial Statements and Supplementary Data

 

71

Item 9.

Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

 

133

Item 9A.

Controls and Procedures

 

133

 

Report of Independent Registered Public Accounting Firm

 

134

Item 9B.

Other Information

 

135

 

 

 

 

PART III

 

 

Item 10.

Directors, Executive Officers and Corporate Governance

 

135

Item 11.

Executive Compensation

 

135

Item 12.

Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

 

135

Item 13.

Certain Relationships and Related Transactions, and Director Independence

 

135

Item 14.

Principal Accounting Fees and Services

 

135

 

 

 

 

PART IV

 

 

Item 15.

Exhibits and Financial Statement Schedules

 

135

 

 

 

 

 

Signatures

 

136

 

Exhibit Index

 

137

 



Table of Contents

 

Except as expressly indicated or unless the context otherwise requires, the “Company,” “PHH,” “we,” “our” or “us” means PHH Corporation, a Maryland corporation, and its subsidiaries.

 

CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

 

Certain statements in this Annual Report on Form 10-K are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements may also be made in other documents filed or furnished with the SEC or may be made orally to analysts, investors, representatives of the media and others.

Generally, forward-looking statements are not based on historical facts but instead represent only our current beliefs regarding future events. All forward-looking statements are, by their nature, subject to risks, uncertainties and other factors. Investors are cautioned not to place undue reliance on these forward-looking statements.  Such statements may be identified by words such as “expects,” “anticipates,” “intends,” “projects,” “estimates,” “plans,” “may increase,” “may fluctuate” and similar expressions or future or conditional verbs such as “will,” “should,” “would,” “may” and “could”. Forward-looking statements contained in this Form 10-K include, but are not limited to, statements concerning the following:

¡          the execution of our strategic priorities, including re-engineering our mortgage business and executing our growth strategies;

¡          other potential acquisitions, dispositions, partnerships, joint ventures and changes in product offerings to achieve disciplined growth in our franchise platforms and to optimize our mortgage business;

¡          our expectations of the impacts of regulatory changes on our businesses;

¡          future origination volumes and loan margins in the mortgage industry;

¡          our expectations regarding the impacts of the shift in our volume to a greater mix of subserviced loans, including the impacts on our earnings and potential benefits to our capital structure;

¡          our expectations around future losses from representation and warranty claims, and associated reserves and provisions;

¡          the impact of the adoption of recently issued accounting pronouncements on our financial statements; and

¡          our assessment of legal proceedings and associated reserves and provisions.

Actual results, performance or achievements may differ materially from those expressed or implied in forward-looking statements due to a variety of factors, including but not limited to the factors listed and discussed in “Part I—Item 1A. Risk Factors” in this Form 10-K and those factors described below:

¡          our ability to successfully re-engineer our mortgage business, re-negotiate our private label agreements, and implement changes to meet our operational and financial objectives;

¡          the effects of market volatility or macroeconomic changes on the availability and cost of our financing arrangements and the value of our assets;

¡          the effects of changes in current interest rates on our business and our financing costs;

¡          our decisions regarding the use of derivatives related to mortgage servicing rights, if any, and the resulting potential volatility of the results of operations of our business;

¡           the impact of changes in the U.S. financial condition and fiscal and monetary policies, or any actions taken or to be taken by the U.S. Department of the Treasury and the Board of Governors of the Federal Reserve System on the credit markets and the U.S. economy;

¡          the effects of any further declines in the volume of U.S. home sales and home prices, due to adverse economic changes or otherwise, on our business;

¡          the effects of any significant adverse changes in the underwriting criteria or existence or programs of government-sponsored entities, including Fannie Mae and Freddie Mac, including any changes caused by the Dodd-Frank Wall Street Reform and Consumer Protection Act or other actions of the federal government;

 

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¡          the ability to maintain our status as a government sponsored entity-approved seller and servicer, including the ability to continue to comply with the respective selling and servicing guides;

¡          the effects of changes in, or our failure to comply with, laws and regulations, including mortgage- and real estate-related laws and regulations, changes in the status of government sponsored-entities and changes in state, federal and foreign tax laws and accounting standards;

¡          the effects of any inquiries and investigations by attorneys general of certain states and the U.S. Department of Justice, the Bureau of Consumer Financial Protection, U.S. Department of Housing and Urban Development or other state or federal regulatory agencies related to our mortgage origination or servicing activities, any litigation related to our mortgage origination or servicing activities, or any related fines, penalties and increased costs;

¡           the ability to maintain our relationships with our existing clients, including our efforts to amend the terms of certain of our private label client agreements, and to establish relationships with new clients;

¡          the effects of competition in our business, including the impact of consolidation within the industry in which we operate and competitors with greater financial resources and broader product lines;

¡          the inability or unwillingness of any of the counterparties to our significant customer contracts or financing arrangements to perform their respective obligations under, or to renew on terms favorable to us, such contracts, or our ability to continue to comply with the terms of our significant customer contracts, including service level agreements;

¡          the impact of the failure to maintain our credit ratings, including the impact on our cost of capital and ability to incur new indebtedness or refinance our existing indebtedness, as well as on our current or potential customers’ assessment of our long-term stability;

¡          the ability to obtain alternative funding sources for our mortgage servicing rights, servicing advances or to obtain financing (including refinancing and extending existing indebtedness) on acceptable terms, if at all, to finance our operations or growth strategies, to operate within the limitations imposed by our financing arrangements and to maintain the amount of cash required to service our indebtedness and operate our business;

¡           any failure to comply with covenants or asset eligibility requirements under our financing arrangements;

¡           the effects of any failure in or breach of our technology infrastructure, or those of our outsource providers, or any failure to implement changes to our information systems in a manner sufficient to comply with applicable laws, regulations and our contractual obligations;  and

¡           the ability to attract and retain key employees.

Forward-looking statements speak only as of the date on which they are made.  Factors and assumptions discussed above, and other factors not identified above, may have an impact on the continued accuracy of any forward-looking statements that we make. Except for our ongoing obligations to disclose material information under the federal securities laws, we undertake no obligation to release publicly any revisions to any forward-looking statements. For any forward-looking statements contained in any document, we claim the protection of the safe harbor for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995.

 

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PART I

 

Item 1. Business

 

General

 

We were incorporated in 1953 as a Maryland corporation.  For periods between April 30, 1997 and February 1, 2005, we were a wholly owned subsidiary of Cendant Corporation (now known as Avis Budget Group, Inc.) and its predecessors that provided mortgage banking services, facilitated employee relocations and provided vehicle fleet management and fuel card services.  On February 1, 2005, we began operating as an independent, publicly traded company pursuant to our spin-off from Cendant.

 

Material Transaction

 

Effective on July 1, 2014, we sold all of the issued and outstanding equity interests of our Fleet Management Services business and related fleet entities (collectively the “Fleet business”) to Element Financial Corporation, an Ontario corporation for a purchase price of $1.4 billion.  The Fleet business was focused on providing commercial fleet management services to corporate clients and government agencies throughout the U.S. and Canada which included fleet leasing services and additional services and products for vehicle maintenance, accident management, driver safety training and fuel cards.  For the year ended December 31, 2014, the transaction resulted in a $241 million net gain on sale.

 

Upon the completion of the sale described above, the Fleet business was no longer a reportable segment.  The results of the Fleet business are presented as discontinued operations and have been excluded from continuing operations and segment results for all periods presented. For additional information related to this transaction, see Note 2, “Discontinued Operations” in the accompanying Notes to Consolidated Financial Statements and “Part II—Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations—Results of Operations—Discontinued Operations.”

 

Segment Overview

 

We are a leading non-bank mortgage originator and servicer of U.S. residential mortgage loans.  Through our wholly-owned subsidiary, PHH Mortgage Corporation and its subsidiaries (collectively, “PHH Mortgage”), we provide outsourced mortgage banking services to a variety of clients, including financial institutions and real estate brokers throughout the U.S. and are focused on originating, selling and servicing residential mortgage loans.  According to Inside Mortgage Finance, PHH Mortgage was the 6th largest overall mortgage loan originator with a 2.9% market share for the year ended December 31, 2014 and the 5th largest retail mortgage originator with a 4.7% market share for the nine months ended September 30, 2014. Inside Mortgage Finance also reported that PHH Mortgage was the 8th largest mortgage loan servicer with a 2.3% market share as of December 31, 2014.

 

Our business activities are organized and presented in two operating segments:  Mortgage Production and Mortgage Servicing.  A description of each operating segment is presented below with further details and discussions of each segment’s results of operations presented in “Part II—Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations—Results of Operations”.  Also refer to see Note 21, “Segment Information” in the accompanying Notes to Consolidated Financial Statements for financial information about our segments.

 

Mortgage Production

 

Our Mortgage Production segment provides private-label mortgage services to financial institutions and real estate brokers.  We generate revenue through fee-based mortgage loan origination services and the origination and sale of mortgage loans into the secondary market.  PHH Mortgage generally sells all saleable mortgage loans that it originates to secondary market investors, which include a variety of institutional investors, and initially retains the servicing rights on mortgage loans sold.  The mortgage loans are typically sold within 30 days of origination and classified as held for sale until sold.  During 2014, 69% of our mortgage loans were sold to, or were sold pursuant to, programs sponsored by Fannie Mae, Freddie Mac or Ginnie Mae and the remaining 31% were sold to private investors.

 

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We source mortgage loans through our retail and wholesale/correspondent platforms.  Within our retail platform, we operate through two principal business channels: (i) private label and (ii) real estate.   A summary of these platforms and channels follows, with the percentage of our loan closings that each represents for the year ended December 31, 2014 compared to 2013:

 

·                Retail - Private Label (72% in 2014 compared to 67% in 2013):  We offer complete mortgage outsourcing solutions to wealth management firms, regional banks and community banks, including Merrill Lynch Home Loans, a division of Bank of America, National Association, Morgan Stanley Private Bank, N.A. and HSBC Bank USA which represented 24%, 21%, and 10% respectively, of our total mortgage loan originations for the year ended December 31, 2014.

 

·                Retail – Real Estate (24% in 2014 compared to 23% in 2013):  Our real estate channel is primarily supported by our relationship with Realogy, which represented 24% of our mortgage originations for the year ended December 31, 2014, and is more fully described below.

 

·                Wholesale/Correspondent (4% in 2014 compared to 10% in 2013):  We purchase closed mortgage loans from community banks, credit unions, mortgage brokers and mortgage bankers, and also acquire mortgage loans from mortgage brokers that receive applications from and qualify the borrowers.

 

Realogy Relationship

 

The Mortgage Production segment includes PHH Home Loans, LLC (together with its subsidiaries, “PHH Home Loans”), which is a joint venture that we maintain with Realogy Corporation.  We own 50.1% of PHH Home Loans through our subsidiaries and Realogy owns the remaining 49.9% through their affiliates.  We have the exclusive right to use the Century 21, Coldwell Banker and ERA brand names in marketing our mortgage loan products through PHH Home Loans and other arrangements that we have with Realogy.

 

The results of our real estate channel are significantly driven by our relationship with Realogy.  We work with brokers associated with NRT Incorporated, Realogy’s owned real estate brokerage business, brokers associated with Realogy’s franchised brokerages (“Realogy Franchisees”) and third-party brokers that are not affiliated with Realogy.  NRT Incorporated is the largest owner and operator of residential real estate brokerages in the U.S. and Realogy is a franchisor of some of the most recognizable residential real estate brands.  In this channel, we also work with Cartus Corporation, Realogy’s relocation business, to provide mortgage loans to employees of Cartus’ clients.  Cartus is an industry leader of outsourced corporate relocation services in the U.S.

 

The following presents a summary of our relationships with Realogy-owned brokers and its franchisees and third-party brokers within the real estate channel:

 

Realogy-owned Brokers. Realogy has agreed that the real estate brokerage business owned and operated by NRT Incorporated and the title and settlement services business owned and operated by Title Resource Group LLC will exclusively recommend PHH Home Loans as provider of mortgage loans to: (i) the independent sales associates affiliated with Realogy, excluding the independent sales associates of any Realogy Franchisee; and (ii) all customers of Realogy Services Group LLC and Realogy Services Venture Partner Inc., excluding Realogy Franchisees.  In general, our capture rate of mortgage loans where we are the exclusive recommended provider is much higher than in other situations.

 

Realogy Franchisees and Third Party Brokers.  Certain Realogy Franchisees have agreed to exclusively recommend PHH Mortgage as provider of mortgage loans to their respective independent sales associates. Additionally, for other Realogy Franchisees and third-party brokers, we seek to enter into separate marketing service agreements or other arrangements whereby we are the exclusive recommended provider of mortgage loans to each franchise or broker. We have entered into exclusive marketing service agreements with 2% of Realogy Franchisees as of December 31, 2014.

 

Unless terminated earlier, our relationship with Realogy continues until January 31, 2055.  Beginning on February 1, 2015, Realogy has the right, at any time, to give us two years notice of their intent to terminate their interest in PHH Home Loans, which would result in the termination of our other agreements with Realogy, including the strategic relationship agreement.

 

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Mortgage Servicing

 

Our Mortgage Servicing segment services mortgage loans originated by PHH Mortgage, purchases mortgage servicing rights from others and acts as a subservicer for certain clients that own the underlying servicing rights. We service loans on behalf of the owners of the underlying mortgage, and we have limited exposure to credit risk because we do not hold loans for investment purposes.  We principally generate revenue in our Mortgage Servicing segment through contractual fees earned from our servicing rights primarily based on a percentage of the unpaid principal balance, or from our subservicing agreements, which are typically a stated amount per loan.  In circumstances where we own the right to service a mortgage loan, either through purchase or origination, we recognize a mortgage servicing right asset; whereas there are no servicing rights associated with our subservicing agreements, and those agreements are less capital intensive.

 

Our corporate strategy has been to position our mortgage business to be less capital intensive and to have more fee-based revenue streams.  As a result, we grew the UPB of our subservicing portfolio from $40.8 billion at the end of 2012, to $96.3 billion at the end of 2013, and $113.4 billion at the end of 2014.  A majority of the growth was the result of a new subservicing arrangement entered into during 2013 that added approximately $47 billion to our subservicing portfolio.  Our subservicing portfolio growth during 2014 resulted from two MSR flow sale arrangements with counterparties who purchase a portion of our newly-created servicing rights while we continue to subservice the underlying loans, as well as a greater mix of fee-based closings.  As a result of the MSR flow sale arrangements, we receive cash payments upon the sale of MSRs and will earn a lower subservicing fee over the life of the loan compared to if we owned the MSR asset.  The focus on growth in the subservicing portfolio has led to a lower replenishment rate of MSRs.  In the short-term, we do not expect significant changes to the results of operations of our Mortgage Servicing segment as we continue to grow our subservicing portfolio.

 

Regulation

 

Our business is subject to extensive federal, state and local regulation.  Our loan origination and servicing activities are primarily regulated at the state level by state licensing authorities and administrative agencies, with additional oversight from the Bureau of Consumer Financial Protection (the “CFPB”).  The CFPB has rule-making, supervision and examination authority, and is responsible for enforcing federal consumer protection laws.  In addition, certain agreements with our private label clients require us to comply with additional requirements that our clients may be subject to through their regulators.  From time to time, we receive requests from federal, state and local agencies for records, documents and information related to our policies, procedures and practices related to our loan originations, servicing and collection activities.  We are also subject to periodic reviews and audits from the Federal Housing Finance Authority (FHFA), Fannie Mae, Freddie Mac, Ginnie Mae, the U.S. Department of Housing and Urban Development, various investors and regulators of our clients.

 

In addition to state licensing requirements, we are required to comply with various federal consumer protection and other laws, including but not limited to:

¡               the Gramm-Leach-Bliley Act, which requires us to maintain privacy regarding certain consumer data in our possession and to periodically communicate with consumers on privacy matters;

¡               the Fair Debt Collection Practices Act, which regulates the timing and content of debt collection communications;

¡               the Truth in Lending Act, or TILA, and Regulation Z, which requires certain disclosures be made to mortgagors regarding the terms of their mortgage loans;

¡               the Real Estate Settlement Procedures Act, or RESPA, and Regulation X, which require, among other things, certain disclosures to mortgagors regarding the costs of mortgage loans, the administration of escrow accounts, the transferring of mortgage loans, lender-placed insurance and other customer communications;

¡               the Fair Credit Reporting Act, which regulates the use and reporting of information related to the credit history of consumers;

¡               the Equal Credit Opportunity Act and Regulation B, which prohibit discrimination on the basis of age, race and certain other characteristics in the extension of credit;

 

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¡               the Homeowners Protection Act, which requires, among other things, the cancellation of private mortgage insurance once certain equity levels are reached;

¡               the Home Mortgage Disclosure Act and Regulation C, which require reporting of certain public loan data; and

¡               the Fair Housing Act, which prohibits discrimination in housing on the basis of race, sex, national origin, and certain other characteristics;

 

In recent years, the residential mortgage industry has been under heightened scrutiny from federal, state and local regulators.  We have also observed increased regulatory oversight of non-bank mortgage servicers.  On January 30 2015, the FHFA proposed new minimum financial eligibility requirements for Fannie Mae and Freddie Mac seller/servicers which include: (i) a minimum net worth of $2.5 million plus 25 basis points of the unpaid principal balance for loans serviced, excluding subserviced loans; (ii) a minimum tangible net worth to total assets capital ratio of 6% and (iii) a minimum liquidity requirement based upon the total Agency servicing portfolio with incremental requirements for certain nonperforming Agency loans.  The FHFA expects to finalize these eligibility requirements during the second quarter of 2015 which will become effective six months after they are finalized.   We will continue to monitor the proposal to ensure we meet the minimum financial eligibility requirements.

 

We also expect the heightened regulatory and public scrutiny with regard to origination and servicing practices to continue which could result in increased laws, regulations and investigative proceedings.  We continue to work diligently to assess and understand the implications of the recent developments in the regulatory environment.  We have devoted substantial resources towards implementing all of the new rules to ensure we continue to maintain regulatory compliance, while, at the same time, working towards meeting the needs and expectations of our clients and the borrowers whose loans we service.

 

We expect that the higher level of legislative and regulatory focus on mortgage origination and servicing practices will result in higher legal, compliance and servicing related costs as well as a heightened potential regulatory fines and penalties.  For more information, see “—Item 1A. Risk Factors—Risks Related to our Company—Our business is complex and heavily regulated, and the full impact of regulatory developments to our business remains uncertain. In addition, we are subject to litigation, regulatory investigations, inquiries and proceedings and we may incur fines, penalties, and increased costs that could negatively impact our future results of operations, liquidity and cash flows or damage our reputation.” in this Form 10-K.

 

Competition

 

The mortgage origination and servicing markets in which we operate are highly competitive.  We compete with large financial institutions as well as non-bank originators and servicers.  Some of our biggest competitors are large banks which include Wells Fargo Home Mortgage, Chase Home Finance, Bank of America and CitiMortgage.  Non-bank originators and servicers have played an increasingly important role in the mortgage industry over the past few years, and we compete with companies which include Quicken Loans, Ocwen Financial Corporation, Nationstar Mortgage Holdings, Inc, among others.  There are, however, a limited number of industry participants in the mortgage outsourcing business.

 

Production

 

In our origination business, we compete based on product offerings, rates, fees and customer service.  In recent years, more restrictive loan underwriting standards and the widespread elimination of certain non-conforming mortgage products throughout the industry have resulted in a more homogenous product offering, which has increased competition across the industry for mortgage originations.  Loan margins have also been impacted by the current interest rate environment and lower origination volumes.

 

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Many of our competitors for mortgage loan originations that are commercial banks or savings institutions typically have access to greater financial resources, have lower funding costs, are less reliant than we are on the sale of mortgage loans into the secondary markets to maintain their liquidity, and may be able to participate in government programs that we are unable to participate in because we are not a state or federally chartered depository institution, all of which places us at a competitive disadvantage.  Other advantages of our largest competitors include, but are not limited to, their ability to hold new mortgage loan originations in an investment portfolio and their access to lower rate bank deposits as a source of funding.

 

Our competitive strengths flow from our established private label outsourcing model which allows for customized end-to-end product and service offerings.  We are highly dependent on our customer relationships, including our large private label clients and our access to originations sourced from the real estate markets through Realogy.  Many smaller and mid-sized financial institutions may find it difficult to compete in the mortgage industry due to the consolidation in the industry and the need to invest in technology in order to reduce operating costs while maintaining compliance with more restrictive underwriting standards and increasing regulatory requirements.  Our ability to win new clients and maintain existing clients is largely driven by the levels of customer service we provide and our ability to comply and adapt to an increasingly complex regulatory environment.

 

Our relationship with Realogy, among other things, restricts us and our affiliates, subject to limited exceptions, from engaging in certain residential real estate services, including any business conducted by Realogy.  The strategic relationship agreement also provides that we will not directly or indirectly sell any mortgage loans or mortgage loan servicing to certain competitors in the residential real estate brokerage franchise businesses in the U.S. (or any company affiliated with them).

 

Servicing

 

According to Inside Mortgage Finance, 35% of outstanding mortgages at December 31, 2014 were serviced by the top 3 mortgage loan servicers which included Wells Fargo, JPMorgan Chase and Bank of America, compared to 37% and 44% at the end of 2013 and 2012, respectively.  The decline in outstanding mortgages serviced by the top 3 mortgage loan servicers represents a substantial shift in the industry as large banks have reduced their share of servicing in response to new regulations and to meet new capital requirements, while non-bank servicers have increased their market share of outstanding mortgages serviced.  We believe that this shift provides us with an opportunity to continue to pursue growth in fee-based revenue streams by adding new subservicing loans to our portfolio.

 

Our competitive position within the loan servicing industry is dependent on our continued ability in demonstrating compliance with local, state, federal and investor regulatory requirements, improving technology and processes and maintaining a high quality servicing portfolio.

 

Employees

 

As of December 31, 2014, we employed a total of approximately 4,100 persons.  Management considers our employee relations to be satisfactory.  None of our employees were covered under collective bargaining agreements during the year ended December 31, 2014.

 

Trademarks and Intellectual Property

 

The trade names and related logos of our private-label clients are material to our Mortgage Production and Mortgage Servicing segments, as these clients license the use of their names to us in connection with our mortgage outsourcing business.  These trademark licenses generally run for the duration of our origination services agreements with such financial institution clients and facilitate the origination services that we provide to them.

 

Realogy licenses its real estate brands and related items, such as logos and domain names, to us for use in the mortgage loan origination services that we provide to Realogy’s owned real estate brokerage, relocation and settlement services businesses.  In connection with our spin-off from Cendant Corporation (now known as Avis Budget Group, Inc.), we entered into trademark license agreements with TM Acquisition Corp., Coldwell Banker Real Estate Corporation and ERA Franchise Systems, Inc.  Pursuant to these agreements, PHH Mortgage was granted a license in connection with mortgage loan origination services on behalf of Realogy’s franchised real estate

 

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brokerage business and PHH Home Loans was granted a license in connection with its mortgage loan origination services on behalf of Realogy’s owned real estate brokerage business owned and operated by NRT, the relocation business owned and operated by Cartus Corporation and the settlement services business owned and operated by Title Resource Group LLC.

 

Seasonality

 

Purchase activity in our Mortgage Production segment is subject to seasonal trends that reflect the pattern in the national housing market.  Home sales typically rise during the spring and summer seasons and decline during the fall and winter seasons.  This seasonality typically causes fluctuations in our Mortgage Production segment results.

 

Refinance activity in our Mortgage Production segment is less impacted by seasonality since refinancing activity is primarily driven by prevailing mortgage rates relative to borrowers’ current interest rate, home prices and levels of home equity.

 

Our Mortgage Servicing segment is generally not subject to seasonal trends.

 

Inflation

 

An increase in inflation could have a significant impact on our business.  Interest rates normally increase during periods of rising inflation.  Historically, as interest rates increase, mortgage loan production decreases, particularly production from loan refinancing.  An environment of gradual interest rate increases may, however, signify an improving economy or increasing real estate values, which in turn may stimulate increased home buying activity.  Generally, in periods of reduced mortgage loan production, the associated profit margins also decline due to increased competition among mortgage loan originators, which further pressures mortgage production profitability.  Conversely, in a rising interest rate environment, our mortgage loan servicing revenues generally increase because mortgage prepayment rates tend to decrease, extending the average life of our servicing portfolio and increasing the value of our MSRs.

 

See further discussion within “—Item 1A. Risk Factors— Risks Related to our Company—Certain hedging strategies that we may use to manage risks associated with our assets, including mortgage loans held for sale, interest rate lock commitments, and mortgage servicing rights, may not be effective in mitigating those risks and could result in substantial losses that could exceed the losses that would have been incurred had we not used such hedging strategies.”, “Part II—Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations—Risk Management,” and “Part II—Item 7A. Quantitative and Qualitative Disclosures About Market Risk.” in this Form 10-K.

 

Available Information

 

Our corporate website is www.phh.com. We make our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(e) or 15(d) of the Securities Exchange Act of 1934 available free of charge on our website under the tabs “Investors—SEC Reports” as soon as reasonably practicable after they are electronically filed with or furnished to the Securities and Exchange Commission.  The SEC also maintains a website (www.sec.gov) where our filings can be accessed for free.  The public may also read and copy our filings with the SEC at the SEC’s Public Reference Room at 100 F Street, NE, Washington, DC 20549.

 

Our Corporate Governance Guidelines, Code of Business Ethics & Conduct, Code of Ethics for Chief Executive Officer and Senior Financial Officers, and the charters of the committees of our Board of Directors are also available on our corporate website and printed copies are available upon request. We intend to disclose any amendments or waivers to our Code of Business Ethics and Conduct and our Code of Ethics for Chief Executive Officer and Senior Financial Officers on our website at www.phh.com within four business days of the date of such amendment or waiver in lieu of filing a Form 8-K pursuant to Item 5.05 thereof.  The information contained on our corporate website is not part of this Form 10-K.

 

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Item 1A. Risk Factors

 

Risks Related to Our Company

 

We may not be able to fully or successfully execute or implement our business strategies or achieve our objectives, including our initiatives to re-engineer and grow our mortgage business.

 

We intend to deploy up to $200 million of excess cash to re-engineer our operations and support infrastructure for a stand-alone mortgage business, and we intend to invest up to $150 million to fund select growth opportunities to enhance the scale and profitability and diversify our revenue streams of our mortgage production and servicing operations.  We may not achieve our stated goals or our expected annualized operating benefits in connection with these efforts, which include but are not limited to, expense reductions, restructuring our private label business model, growing our origination volume and expanding our target market in our existing real-estate and private label client bases, and growing our mortgage subservicing portfolio.  The successful deployment of capital and achievement of our goals is subject to both the risks affecting our business generally (including market, credit, operational, and legal and compliance risks) and the inherent difficulty associated with implementing our strategies and is dependent on the skills, experience and efforts of our management team and our success in negotiating with third parties.

 

We may be unable to fully or successfully execute or implement our strategic investments or objectives, in whole or in part, or within the projected timeframe, and, even if we are successful, there can be no assurances that we can implement these initiatives in a cost efficient manner or that these initiatives will have the impact that we intend on our business activities and results of operations.  Changing business or market conditions could necessitate a change in our business and capital deployment strategy.  Further, pursuing and completing these goals could divert management’s attention towards and financial resources from the goals and operations of our existing business.

 

In addition, beginning in the fourth quarter of 2013, we have implemented a strategy to shift the mix of our servicing portfolio to a greater mix of subserviced loans.  To execute this strategy, we have entered into agreements to sell a portion of our newly-created Mortgage servicing rights to third parties, where we will have continuing involvement as subservicer.  We expect this strategy to have long-term benefits to our capital structure as we will require less capital to fund capitalized MSRs and related servicing advances. We also expect this strategy to, among other outcomes, result in lower Segment profit that is offset by a higher return on equity in the segment and cause a decline in our capitalized portfolio. This strategy may result in a lower replenishment of prepayments and amortization with newly originated servicing rights.  Further, there is increased risk with respect to increasing our focus on subservicing relationships, as the terms of a substantial portion of our subservicing agreements allow the owners of the servicing to terminate the subservicing agreement without cause.  If we were to have our subservicing agreements terminated on a material portion of our subservicing portfolio, this could adversely affect our business, financial condition, and results of operations.

 

Our business is complex and heavily regulated, and the full impact of regulatory developments to our business remains uncertain. In addition, we are subject to litigation, regulatory investigations, inquiries and proceedings and we may incur fines, penalties, and increased costs that could negatively impact our future results of operations, liquidity and cash flows or damage our reputation.

 

Regulatory Environment

 

Our business is subject to extensive regulation by federal, state and local government authorities and may be subject to various judicial and administrative decisions imposing various requirements and restrictions on how we conduct our business. These laws, regulations and judicial and administrative decisions include those pertaining to: real estate settlement procedures; fair lending; fair credit reporting; truth in lending; compliance with federal and state disclosure and licensing requirements; the establishment of maximum interest rates, finance charges and other charges; secured transactions; collection, foreclosure, repossession and claims-handling procedures; other trade practices and privacy regulations providing for the use and safeguarding of non-public personal financial information of borrowers and guidance on non-traditional mortgage loans issued by the federal financial regulatory agencies. In addition, by agreement with our private-label clients we are required to comply with additional requirements that our clients may be subject to through their regulators. Our failure to comply with applicable laws,

 

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rules or regulations could result in:

¡                 loss of our approvals to engage in our origination and servicing businesses;

¡                 government investigations and enforcement actions;

¡                 litigation;

¡                 required payments of fines, penalties, settlements or judgments;

¡                 the termination of our private-label agreements; and/or

¡                 inability to fund our business, or otherwise operate our business.

 

Any of these outcomes could have a material adverse effect on our business, financial position, results of operations or cash flows.

 

We are monitoring a number of recent and pending changes to laws and regulations and other financial reform legislation that are expected to impact our business.  These developments include but are not limited to: (i) regulations from the Dodd-Frank Act; (ii) proposed changes to the infrastructures of Fannie Mae and Freddie Mac; and (iii) current rules proposed and adopted by the CFPB, including the implementation of changes to mortgage origination and settlement forms currently required under the Truth in Lending Act and Real Estate Settlement Procedures Act of 1974 which require significant modifications and enhancements to our mortgage production processes and systems to be in effect by August 1, 2015. Certain provisions of the Dodd-Frank Act and of pending legislation in the U.S. Congress may impact the operation and practices of Fannie Mae and Freddie Mac, and could reduce or eliminate the GSE’s ability to issue mortgage-backed securities, which would materially and adversely affect our business and could require us to fundamentally change our business model since we sell substantially all of our loans pursuant to GSE-sponsored programs.  The full impact of these developments may have on our business remains unclear; however, such developments could result in heightened federal regulation and oversight of our business activities, may result in limitations on our ability to pursue business strategies, increase our costs, result in increased litigation or otherwise adversely affect the manner in which we conduct our business. Furthermore, if we are not able to make the changes to our mortgage production processes and systems required by the Truth in Lending Act and the Real Estate Settlement and Procedures Act, our ability to originate loans would be severely decreased.

 

Investigations and Subpoenas

 

There has been a heightened focus of regulators on the practices of the mortgage industry, including investigations of lending practices, foreclosure practices, and loss mitigation practices, among other matters.  We are currently subject to inquiries, requests for information, investigations, and subpoenas as a result of our mortgage origination and servicing practices, including inquiries and requests for information from and investigations by regulators and attorneys general of certain states, the U.S. Department of Housing and Urban Development, the U.S. Attorney’s Office for the Southern and Eastern Districts of New York, the Committee on Oversight and Government Reform of the U.S. House of Representatives, and the U.S. Senate Judiciary Committee.  These inquiries are at varying procedural stages and there can be no assurances that additional claims will not be asserted against us as a result of these inquiries.

 

In addition, in October 2014 we received a document subpoena from the Office of the Inspector General of the Federal Housing Financing Agency (the “FHFA”) requesting production of certain documents related to, among other things, our origination, underwriting and quality control processes for loans sold to Fannie Mae and Freddie Mac.  While the FHFA, as regulatory and conservator for Fannie Mae and Freddie Mac, does not have regulatory authority over us or our subsidiaries, there can be no assurance that Fannie Mae and/or Freddie Mac will not assert additional claims as a result of this inquiry.

 

Existing Matters

 

We are defendants in various legal proceedings; including private and civil litigation as well as government and regulatory claims.  Existing matters that are pending resolution include, but are not limited to: (i) we have undergone a regulatory examination by a multistate coalition of certain mortgage banking regulators; (ii) we have been subjected to an administrative proceeding of the CFPB alleging our former reinsurance activities violated certain

 

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provisions of the Real Estate Settlement Procedures Act (RESPA) and other laws, and the administrative law judge presiding over the proceeding has issued a recommended decision to the director of the CFPB, which has been appealed by us and the CFPB’s enforcement counsel; and (iii) we are subject to pending private litigation alleging that our servicing practices around lender-placed insurance were not in compliance with applicable laws.  These matters are at varying procedural stages and the resolution of any of these matters may result in adverse judgments, fines, penalties, injunctions and other relief against us, payments made in settlement arrangements, as well as monetary payments or other agreements and obligations, any of which could have a material adverse effect on our business, financial position, results of operations, liquidity or cash flows.

 

In 2014, we have increased our reserves for legal and regulatory contingencies to reflect our estimate of the probable losses with respect to these matters. There can be no assurance that the ultimate resolution of our pending or threatened litigation, claims or assessments will not result in losses in excess of our recorded reserves.  For more information regarding legal proceedings, see Note 14, “Commitments and Contingencies” in the accompanying Notes to Consolidated Financial Statements.

 

The profitability of our Mortgage Production segment has been adversely affected by the increased mix of fee-based closings originated under our existing private label client contracts.  We are currently evaluating a number of alternatives to restructure these contracts to improve the economics of the underlying contractual relationships; however, there can be no assurances that we will be successful in these efforts.

 

Through our private label agreements, we earn contractually specified origination assistance fees from our financial institution clients for the performance of mortgage loan origination services.  Starting in 2013, we have observed a significant increase in our origination mix of fee-based closings, which is driven by the retention of certain loans by our financial-institution clients.  The increased mix of fee-based closings has adversely affected the profitability of our Mortgage Production segment as the revenue per loan on fee-based closings is generally lower than the revenue per loan on saleable closings.  Despite our efforts to align our cost structure with the expected mortgage production environment, based on the current market conditions and expected volumes, margins and mix, these contracts will remain unprofitable on a fully allocated basis.

 

We are evaluating a number of alternatives to remedy the profitability of these arrangements.  We are in varying stages of the negotiation process with each client.  Although these negotiations have continued to progress, we are mindful that these are complex contracts, and we are attempting to introduce meaningfully different pricing and operating models.  As a result, any such changes in the terms and scope of some of our Private Label relationships could have a significant impact on our re-engineering plans, our expected origination volumes and our profitability.  There can be no assurance that we will be successful in our efforts to amend or renew the contracts on more favorable economic terms, if at all, or that any new terms will have the impact that we intend.  Any failures to implement changes that meet our objectives, or in a timely manner, if at all, could have material adverse effects on our  financial position, results of operations and cash flows.  The amount of losses and negative cash flows that we may realize under these arrangements cannot be readily estimated as it is dependent on the volume of fee-based business we will experience, which may be impacted by the decisions of our financial institution clients towards fee-based production, as well as general market factors (such as interest rate levels) that drive the volume of loan originations, both of which are outside of our control.

 

We are subject to inherent risks associated with the sale of our Fleet business, including risks associated with our liabilities under the related agreements, with our tax position, and with the separation of the Fleet business, and we could be exposed to losses or liabilities in the future in connection with the sale.  These risks and uncertainties could have a material adverse impact on our business generally, including our client, employee, lender, vendor and counterparty relationships, as well as our results of operations, cash flows, liquidity or financial position.

 

The sale of our Fleet business was completed in 2014, and in connection with the sale, we have agreed to indemnify Element Financial Corporation (“Element”) for a breach or inaccuracy of any representation, warranty or covenant made by us in the purchase agreement, for any liability of ours that is not being assumed, for any claims by our stockholders against Element and for certain additional customary contingencies related to the sale agreement.  Significant indemnification claims by Element could have a material adverse effect on our financial condition or results of operations.

 

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In connection with tax amounts recorded related to the sale of the Fleet business, we assumed certain tax positions that, if not withheld under audit, could have a material adverse effect on our business, including the payment of additional tax amounts, penalties and interest, or other negative consequences.

 

The activities involved in separating our fleet and mortgage businesses, including those required under a transition services agreement with Element, may cause the diversion of a significant amount of management time and attention away from the daily operation of our business and the execution of our business plan, and may also have an adverse impact on our business generally, including adverse impacts on our client, employee, lender, vendor and counterparty relationships.  Further, we face risks related to our ability to successfully transition the performance of certain processes, including but not limited to, accounting, information technology, risk management and finance and the related internal and operational controls during the transition period.

 

We are substantially dependent upon our mortgage warehouse facilities and our servicing advance facility, a significant portion of which are short-term agreements.  If any of our funding arrangements are terminated, not renewed or otherwise become unavailable to us, we may be unable to find replacement financing on economically viable terms, if at all, which would adversely affect our ability to fund our operations.

 

We are substantially dependent upon our mortgage warehouse funding arrangements, a significant portion of which are short-term in nature.  Our access to and our ability to renew our existing mortgage warehouse facilities is subject to prevailing market conditions, and could suffer in the event of: (i) the deterioration in the performance of the mortgage loans underlying the warehouse facilities; (ii) our failure to maintain sufficient levels of eligible assets or credit enhancements; (iii) our inability to access the secondary market for mortgage loans; or (iv) termination of our role as servicer of the underlying mortgage assets in the event that (a) we default in the performance of our servicing obligations or (b) we declare bankruptcy or become insolvent.

 

We are also dependent on our servicing advance funding facility, PHH Servicer Advance Receivables Trust (“PSART”), which is a special purpose bankruptcy remote trust formed in 2014 for purposes of issuing non-recourse asset-backed notes secured by servicing advance receivables.  We have received notice from the committed purchaser of PSART that the counterparty’s current intention is to exit the mortgage financing business, and therefore they will not renew the revolving period of the facility upon expiration on March 31, 2015.  After the revolving period, the facility will go into amortization, and thereafter we are required to repay the outstanding balance through advance collections or additional payments, on or before the maturity date of April 17, 2017.  In February 2015, we received an extension of the revolving period through May 29, 2015, with a final maturity date of June 15, 2017. We are exploring alternatives for funding advances upon expiration of the revolving period of the facility. Our ability to maintain liquidity through issuing asset-backed notes secured by servicing advance receivables is dependent on many factors, including but not limited to:  (i) market demand for ABS, specifically ABS collateralized by mortgage receivables; (ii) our ability to service in accordance with applicable guidelines and the quality of our servicing, both of which will impact noteholders’ willingness to commit to financing for an additional term;  and (iii) our ability to negotiate terms acceptable to us.

 

Certain of our debt arrangements require us to comply with specific financial covenants and other affirmative and restrictive covenants. An uncured default of one or more of these covenants could result in a cross-default between and amongst our various debt arrangements, including our unsecured term debt. Consequently, an uncured default under any of our debt arrangements that is not waived by our lenders and that results in an acceleration of amounts payable to our lenders or the termination of credit facilities would materially and adversely impact our liquidity, could force us to sell assets at below market prices to repay our indebtedness, and could force us to seek relief under the U.S. Bankruptcy Code.

 

If any of our facilities are terminated or are not renewed, we may be unable to find replacement financing on commercially favorable terms, if at all, which could adversely impact our operations and prevent us from executing our business plan and related risk management strategies, originating new mortgage loans or fulfilling commitments made in the ordinary course of business. These factors could reduce revenues attributable to our business activities or require us to sell assets at below market prices, either of which would have a material adverse effect on our overall business and consolidated financial position, results of operations and cash flows. Most of our mortgage warehouse facilities mature within one year and generally, these facilities require us to maintain a specified amount of available liquidity from other facilities. As such, our liquidity profile and compliance with debt covenants depends on our ability to renew multiple facilities within a short time frame and our failure to do so could materially adversely impact our overall business and financial position, results of operations and cash flows.

 

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We may be limited in our ability to obtain or renew financing on economically viable terms or at all, due to our senior unsecured long-term debt ratings being below investment grade and due to a lack of history of operating as a stand-alone mortgage business.

 

Our senior unsecured long-term debt ratings are below investment grade and, as a result, our access to the public debt markets may be severely limited in comparison to the ability of investment grade issuers to access such markets. In addition, our historical results of operations have included the operations of the Fleet Management Services segment, which has represented a less significant portion of our Net income or loss, yet was a consistent, source of income and cash flows for our business.  After the completion of the sale, our access to the public debt markets, and our ability to obtain unsecured revolving credit borrowing capacity, may be more limited than our historical experience, or we may be unable to obtain such financing on terms acceptable to us, if at all.  We may be required to rely on alternative financing, such as bank lines and private debt placements, and may also be required to pledge otherwise unencumbered assets. Furthermore, our cost of financing could rise significantly, thereby negatively impacting our ability to finance our mortgage loans held for sale, mortgage servicing rights and servicing advance receivables. Any of the foregoing could have a material adverse effect on our business, financial position, results of operations, liquidity and cash flows.

 

Our ratings were downgraded in July 2014 after the completion of the sale of the Fleet business and we may be subject to further actions: (i) if our business and financial results deteriorate significantly or do not show improvement over an acceptable period of time; (ii) if we are unable to put in place sources of liquidity to fund our business satisfactory to the rating agencies; (iii) based upon regulatory reviews, investigations, proceedings or other claims and enforcement actions that result in material monetary exposures and/or other negative consequences, among other factors.  We cannot predict the impact any further negative debt ratings actions may have on our cost of capital, ability to incur new indebtedness or refinance our existing indebtedness or ability to retain or secure customers.

 

We are highly dependent upon programs administered by Fannie Mae, Freddie Mac and Ginnie Mae.

 

Our ability to generate revenues in our Mortgage Production and Servicing segments is highly dependent on programs administered by Fannie Mae, Freddie Mac, and Ginnie Mae that facilitate the issuance of mortgage-backed securities in the secondary market. These entities play a powerful role in the residential mortgage industry, and we have significant business relationships with them, including:

 

Production.  During 2014, 69% of our mortgage loan sales were sold to, or were sold pursuant to programs sponsored by, Fannie Mae, Freddie Mac or Ginnie Mae. We also derive other material financial benefits from our relationships with Fannie Mae, Freddie Mac and Ginnie Mae, including the assumption of credit risk by these entities on loans included in mortgage-backed securities in exchange for our payment of guarantee fees, the ability to avoid certain loan inventory finance costs through streamlined loan funding and sale procedures and the use of mortgage warehouse facilities with Fannie Mae pursuant to which, as of December 31, 2014, we had total capacity of $3.0 billion, made up of $500 million of committed and $2.5 billion uncommitted capacity.

 

Servicing.  We service loans on behalf of Fannie Mae and Freddie Mac, as well as loans that have been securitized pursuant to securitization programs sponsored by Fannie Mae, Freddie Mac and Ginnie Mae.  A majority of our mortgage servicing rights and loans serviced through subservicing agreements relate to these servicing activities. These entities establish the base service fee to compensate us for servicing loans as well as the assessment of fines and penalties that may be imposed upon us for failing to meet servicing standards.

 

Our status as a Fannie Mae, Freddie Mac and Ginnie Mae approved seller/servicer is subject to compliance with each entity’s respective selling and servicing guidelines and failure to meet such guidelines could result in the unilateral termination of our status as an approved seller/servicer.  Failure to maintain our relationship with each of Fannie Mae, Freddie Mac and Ginnie Mae would materially and adversely affect our business, financial position, results of operations and cash flows.

 

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Further, changes in existing U.S. government-sponsored mortgage programs or servicing eligibility standards could require us to fundamentally change our business model in order to effectively compete in the market.  Congress has held hearings and received reports outlining the long-term strategic plan for, and various options for long-term reform of the U.S. housing finance market, including changes designed to reduce government support for housing finance and the winding down of Freddie Mac and Fannie Mae over a period of years.  Legislation, if enacted, or further regulation which curtails Freddie Mac and/or Fannie Mae’s activities and/or results in the wind down of these entities could impact the pricing of mortgage related assets in the secondary market, result in higher mortgage rates to borrowers, and have a resulting negative impact on mortgage origination volumes and margins across the mortgage industry, any one of which could have a negative impact on our Mortgage production business.  There is currently uncertainty with respect to the extent, if any, of such reform, and the long-term or short-term impacts of such changes on the housing market, and the related impacts on our operations.

 

The private label originations of our Mortgage Production segment are substantially dependent upon a small number of client relationships, including those with Merrill Lynch Home Loans, a division of Bank of America, National Association, Morgan Stanley Private Bank, N.A. and HSBC Bank USA. The termination or non-renewal of our contractual agreements with certain of these clients would materially and adversely impact our mortgage loan originations and resulting Net revenues and Segment profit of our Mortgage Production segment, as well as our overall business and our consolidated financial position, results of operations and cash flows.

 

Our private label business channel is substantially dependent upon a small number of client relationships, and accounts for 72% of our total closings for the year ended December 31, 2014.  In particular, 24% of our total closings for the year ended December 31, 2014 were derived from Merrill Lynch Home Loans, a division of Bank of America, National Association, 21% from Morgan Stanley Private Bank, N.A. and 10% from HSBC Bank USA.

 

Our agreement with Merrill Lynch Home Loans is scheduled to expire on December 31, 2015 and there can be no assurances that the agreement will be renewed on favorable terms, if at all. We are currently in discussions with Merrill Lynch Home Loans about the future structure of this relationship, including our involvement in their mortgage origination services.  The non-renewal of this arrangement would negatively impact our mortgage loan originations volume, and would adversely impact our Net revenues and Segment profit of our Mortgage Production segment, as well as our overall business and our consolidated financial position, results of operations and cash flows.

 

Further, the loss or non-renewal of certain of our other private label client agreements, including Morgan Stanley which is scheduled to expire on October 31, 2016 and HSBC which is scheduled to expire on March 30, 2018, whether due to insolvency, their unwillingness or inability to perform their obligations under their respective contractual relationships with us, their termination of their respective contractual relationships with us due to our failure to fully satisfy our contractual obligations, or if we are not able to renew on commercially reasonable terms any of their respective contractual relationships with us, may materially and adversely impact our mortgage loan originations and resulting Net revenues and Segment profit  of our Mortgage Production segment as well as our results of operations and cash flows.

 

Our Mortgage Production segment is substantially dependent upon our relationship with Realogy, and the termination or non-renewal of our contractual agreements with Realogy would have a material adverse effect on our business, financial position, results of operations and cash flows.

 

Relationship with Realogy.  We are party to a Strategic Relationship Agreement dated as of January 31, 2005 between PHH Mortgage, PHH Home Loans, PHH Broker Partner, Realogy Services Venture Partner Inc. and Cendant Corporation (now known as Avis Budget Group, Inc.). Under the Strategic Relationship Agreement we are the exclusive recommended provider of mortgage loans to the independent sales associates affiliated with the real estate brokerage business owned and operated by Realogy’s affiliates and certain customers of Realogy. Similarly, PHH Mortgage is party to a marketing agreement with Realogy’s real estate brokerage franchises (Coldwell Banker Real Estate Corporation, Century 21 Real Estate LLC, ERA Franchise Systems, Inc., and Sotheby’s International Affiliates, Inc.) which provides that we are the exclusive recommended provider of mortgage loans and related products to the independent sales associates of these franchises.  PHH Home Loans is a joint venture that was formed for the purpose of originating and selling mortgage loans primarily sourced through Realogy’s owned real estate brokerage business.  The operations of PHH Home Loans are governed by the PHH Home Loans Operating Agreement.

 

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During the year ended December 31, 2014, 24% of our mortgage loan originations were derived from Realogy Corporation’s affiliates, of which 88% were originated by PHH Home Loans.  In addition, during the year ended December 31, 2014, PHH Home Loans originated residential mortgage loans of $7.0 billion and PHH Home Loans brokered or sold $3.3 billion of mortgage loans to PHH Mortgage under the terms of a loan purchase arrangement.

 

Contractual Agreements. Unless terminated earlier, our relationship with Realogy continues until January 31, 2055.  However, under the PHH Home Loans Operating Agreement, beginning on February 1, 2015, Realogy has the right at any time to give us two years notice of their intent to terminate their interest in PHH Home Loans. In addition, the Strategic Relationship Agreement and the PHH Home Loans Operating Agreement outline certain terms and events that would give Realogy the right to terminate the PHH Home Loans joint venture for cause.  These terms and events include, but are not limited to, if:

·                  we materially breach any representation, warranty, covenant or other agreement contained in the Strategic Relationship Agreement, the Marketing Agreement, Trademark License agreements or certain other related agreements, including, without limitation to, our confidentiality agreements in the PHH Home Loans Operating Agreement and the Strategic Relationship Agreement, and our non-competition agreements in the Strategic Relationship Agreement that is not cured following any applicable notice or cure period;

·                  we become subject to any regulatory order or governmental proceeding that prevents or materially impairs PHH Home Loans’ ability to originate mortgage loans for any period of time (which order or proceeding is not generally applicable to companies in the mortgage lending business) in a manner that adversely affects the value of one or more of the quarterly distributions to be paid by PHH Home Loans pursuant to the PHH Home Loans Operating Agreement;

·                  PHH Home Loans fails to make scheduled distributions pursuant to the PHH Home Loans Operating Agreement; or

·                  there is a change in control of us, PHH Broker Partner Corporation or any other affiliate of ours involving certain competitors or other specified parties.

 

Upon a termination of the PHH Home Loans joint venture by Realogy or its affiliates (whether for cause or upon two years’ notice without cause), Realogy will have the right either: (i) to require that we or certain of our affiliates purchase all of Realogy’s interest in PHH Home Loans at the applicable purchase price set forth in the PHH Home Loans Operating Agreement; or (ii) to cause us to sell our interest in PHH Home Loans at the applicable sale price set forth in the PHH Home Loans Operating Agreement to an unaffiliated third party designated by certain of Realogy’s affiliates. If we were required to purchase Realogy’s interest in PHH Home Loans, such purchase could have a material adverse impact on our liquidity. Additionally, any termination of the PHH Home Loans joint venture will also result in a termination of the Strategic Relationship Agreement, including our exclusivity rights thereunder and our other agreements and arrangements with Realogy.  Any such termination would likely result in the loss of most, if not all, of our mortgage loan originations and Net revenues derived from Realogy’s affiliates, which would have a material adverse effect on our overall business and our consolidated financial position, results of operations, cash flows and liquidity.

 

Certain hedging strategies that we may use to manage risks associated with our assets, including mortgage loans held for sale, interest rate lock commitments, and mortgage servicing rights, may not be effective in mitigating those risks and could result in substantial losses that could exceed the losses that would have been incurred had we not used such hedging strategies.

 

We may employ various economic hedging strategies in an attempt to mitigate the interest rate and prepayment risk inherent in many of our assets, including our mortgage loans held for sale, interest rate lock commitments and our mortgage servicing rights. Our hedging activities may include entering into derivative instruments. We also seek to manage interest rate risk in our Mortgage Production and Mortgage Servicing segments partially without the use of financial derivatives by monitoring and seeking to maintain an appropriate balance between our loan production volume and the size of our capitalized portfolio associated with mortgage servicing rights, as the value of mortgage servicing rights and the income they provide tend to be counter-cyclical to the changes in production volumes and the gain or loss on loans that result from changes in interest rates. This approach requires our management to make assumptions with regards to future replenishment rates for our mortgage servicing rights, loan margins, the value of additions to our mortgage servicing rights and loan origination costs, and many factors can impact these estimates,

 

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including loan pricing margins and our ability to adjust staffing levels to meet changing consumer demand.  Our decisions regarding the levels, if any, of our derivatives related to mortgage servicing rights could result in continued volatility in the results of operations for our Mortgage Servicing segment.

 

Our hedging strategies, including our decisions whether to use derivative instruments to hedge our Mortgage servicing rights, may not be effective in mitigating the risks related to changes in interest rates and we may not have sufficient liquidity to exercise our strategies. Poorly designed strategies or improperly executed transactions could actually increase our risk and losses, and could result in losses in excess of what our losses would have been had we not used such hedging strategies. There have been periods, and it is likely that there will be periods in the future, during which we incur significant losses as a result of our hedging strategies. As stated earlier, the success of our interest rate risk management strategy and our replenishment strategies for our mortgage servicing rights are largely dependent on our ability to predict the earnings sensitivity of our loan servicing and loan production activities in various interest rate environments, as well as our ability to successfully manage any capacity constraints in our mortgage production business and our ability to maintain sufficient liquidity to exercise these strategies. Our hedging strategies also rely on assumptions and projections regarding our assets and general market factors. If these assumptions and projections prove to be incorrect or our hedges do not adequately mitigate the impact of changes including, but not limited to, interest rates or prepayment speeds, we may incur losses that could have a material adverse effect on our business, financial position, results of operations or cash flows.

 

Changes in interest rates could materially and adversely affect our volume of mortgage loan originations or reduce the value of our mortgage servicing rights, either of which could have a material adverse effect on our business, financial position, results of operations, liquidity or cash flows.

 

Changes in and the level of interest rates are key drivers of our mortgage loan originations in our Mortgage Production segment and mortgage loan refinancing activity, in particular.  The level of interest rates are significantly affected by monetary and related policies of the federal government, its agencies and government sponsored entities, which are particularly affected by the policies of the Federal Reserve Board that regulates the supply of money and credit in the United States.  The Federal Reserve Board’s policies, including initiatives to stabilize the U.S. housing market and to stimulate overall economic growth, affect the size of the mortgage loan origination market, the pricing of our interest-earning assets and the cost of our interest-bearing liabilities. Changes in any of these policies are beyond our control, difficult to predict, particularly in the current economic environment, and could have a material adverse effect on our business, financial position, results of operations, liquidity or cash flows.

 

Historically, rising interest rates have generally been associated with a lower volume of loan originations and lower pricing margins in our Mortgage Production segment due to a disincentive for borrowers to refinance at a higher interest rate, while falling interest rates have generally been associated with higher loan originations and higher pricing margins, due to an incentive for borrowers to refinance at a lower interest rate. Our ability to generate Gain on loans held for sale, net in our Mortgage Production segment is significantly dependent on our level of saleable mortgage loan originations. Accordingly, increases in interest rates could materially and adversely affect our mortgage loan origination volume, which could have a material and adverse effect on our Mortgage Production segment, as well as our overall business and our consolidated financial position, results of operations, liquidity or cash flows.  In addition, changes in interest rates may require us to post additional collateral under certain of our financing arrangements and derivative agreements which could impact our liquidity.

 

Changes in interest rates are also a key driver of the performance of our Mortgage Servicing segment as the values of our mortgage servicing rights are highly sensitive to changes in interest rates.  Historically, the value of our mortgage servicing rights have increased when interest rates rise and have decreased when interest rates decline due to the effect those changes in interest rates have on prepayment estimates, with changes in fair value of our mortgage servicing rights being included in our consolidated results of operations. Our consolidated financial positions, results of operations and cash flows are susceptible to significant volatility due to changes in the fair value of our mortgage servicing rights as interest rates change. As a result, substantial volatility in interest rates materially affects our Mortgage Servicing segment, as well as our consolidated financial position, results of operations and cash flows.

 

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The industry in which we operate is highly competitive and many of our competitors have access to greater financial resources, lower funding costs and greater access to liquidity, which may place us at a competitive disadvantage.

 

We operate in a highly competitive industry that could become even more competitive as a result of economic, legislative, regulatory or technological changes.  Competition for mortgage loan originations comes primarily from commercial banks and savings institutions, as well as non-bank mortgage originators.  Many of our competitors for mortgage loan originations that are commercial banks or savings institutions typically have access to greater financial resources, have lower funding costs, are less reliant than we are on the sale of mortgage loans into the secondary markets to maintain their liquidity, and may be able to participate in government programs that we are unable to participate in because we are not a state or federally chartered depository institution, all of which places us at a competitive disadvantage.  Further, since we are not a state or federally chartered depository institution, we must comply with the licensing and regulatory requirements of states and other jurisdictions, we may incur increased compliance costs, and we are subject to increased compliance and regulatory risks than many of our competitors.

 

Other advantages of our largest competitors include, but are not limited to, their ability to hold new mortgage loan originations in an investment portfolio and their access to lower rate bank deposits as a source of liquidity.  Additionally, more restrictive loan underwriting standards and the widespread elimination of certain non-conforming mortgage products throughout the industry have resulted in a more homogenous product offering, which has increased competition across the industry for mortgage originations.

 

Our financial statements are based in part on assumptions and estimates made by our management, including those used in determining the fair values of a substantial portion of our assets.  If the assumptions or estimates are subsequently proven incorrect or inaccurate, there could be a material adverse effect on our business, financial position, results of operations or cash flows.

 

Pursuant to accounting principles generally accepted in the United States, we utilize certain assumptions and estimates in preparing our financial statements, including but not limited to, when determining the fair values of certain assets and liabilities, reserves related to litigation, regulatory investigations and proceedings, and reserves related to mortgage representations and warranty claims.  If the assumptions or estimates underlying our financial statements are incorrect, we may experience significant losses as the ultimate realization of value may be materially different than the amounts reflected in our consolidated statement of financial position as of any particular date.

 

For additional information on the key areas for which assumptions and estimates are used in preparing our financial statements, see “Part II—Item 7. Management’s Discussion and Analysis of Financial Condition and Results of OperationsCritical Accounting Policies and Estimates” in this Form 10K.

 

Fair Value.  A substantial portion of our assets are recorded at fair value based upon significant estimates and assumptions with changes in fair value included in our consolidated results of operations. As of December 31, 2014, 45% of our total assets were measured at fair value on a recurring basis, including $1.0 billion of assets representing our Mortgage servicing rights which are valued using significant unobservable inputs and management’s judgment of the assumptions market participants would use in pricing the asset.  The determination of the fair value of our assets involves numerous estimates and assumptions made by our management. Such estimates and assumptions include, without limitation, estimates of future cash flows associated with our mortgage servicing rights based upon model inputs involving interest rates as well as the prepayment rates and delinquencies and foreclosure rates of the underlying serviced mortgage loans. The use of different estimates or assumptions in connection with the valuation of these assets could produce materially different fair values, or our fair value estimates may not be realized in an actual sale or settlement, either of which could have a material adverse effect on our consolidated financial position, results of operations or cash flows.

 

Reserves and Contingencies.  Reserves are established for pending or threatened litigation, claims or assessments when it is probable that a loss has been incurred and the amount of such loss can be reasonably estimated.  In light of the inherent uncertainties involved in litigation and other legal proceedings, it is not always possible to determine a reasonable estimate of the amount of a probable loss, and we may estimate a range of possible loss for consideration in these estimates.  The estimates are based upon currently available information and involve significant judgment taking into account the varying stages and inherent uncertainties of such matters.  Accordingly, our estimates may change from time to time and such changes may be material to our consolidated results of

 

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operations, and the ultimate settlement of such matters may have a material adverse effect on our consolidated financial position, results of operations or cash flows.

 

Representations and Warranties.  In connection with the sale of mortgage loans, we make various representations and warranties that, if breached, require us to repurchase the loans or indemnify the purchaser for actual losses incurred in respect of such loans.  The estimation of our loan repurchase and indemnification liability requires subjective and complex judgments, and incorporates key assumptions that are impacted by both internal and external factors.  Internal factors include, but are not limited to, the level of loan sales and origination volumes, and the quality of our underwriting procedures.  External factors include, but are not limited to: (i) the political environment and oversight of the Agencies, and related changes in Agency programs and guidelines, (ii) borrower delinquency levels and default patterns, (iii) home price values and (iv) the overall economic condition of borrowers and the U.S. economy.

 

Further, a significant amount of our exposure to representation and warranty claims relates to loans that are subject to a new representation framework for conventional loans.  The full impact of our future loss experience under the new framework remains uncertain, and we will continue to refine our loss estimates as we monitor our experience with file reviews and claims under the new framework.

 

Our reliance on outsourcing arrangements for information technology services subjects us to significant business process and control risks due to the complexity of our information systems, any failures in our ability to manage or transition services under the arrangement, or if our outsourcing counterparties do not meet their obligations to us.

 

We entered into an arrangement to outsource our information technology (“IT”) services to a third party as part of an effort to reduce costs and obtain operational benefits.  Entering into an outsourcing arrangement for IT services subjects us to significant business process and control risks.  If our outsource partner fails to perform their obligations under the terms of the agreement, or if our transition and management of this vendor is not successful, we are subject to operational risk from our IT environment. We are heavily dependent on the strength and capability of our technology systems which we use both to interface with our customers and to manage our internal financial and other systems. Our business model and our reputation as a service provider to our clients, as well as our internal controls over financial reporting, are highly dependent upon these systems and processes.  In addition, our ability to run our business in compliance with applicable laws and regulations is dependent on our technology infrastructure.

 

Although we have service-level arrangements with our counterparties, we do not ultimately control their performance, which may make our operations vulnerable to their performance failures.  Any failures in our technology systems, processes or the related internal and operational controls, or the failure of our outsourcing providers to perform as expected or as contractually required could result in the loss of client relationships, damage to our reputation, failures to comply with regulations, failure to prepare our financial statements in a timely and accurate manner, and increased costs, the result of any of which could have a material and adverse effect on our business, reputation, results of operations, financial position, or cash flows.

 

A failure in or breach of our technology infrastructure or information protection programs, or those of our outsource providers, could result in the inadvertent disclosure of the confidential personal information of our customers, as well as the confidential personal information of the customers of our clients.  Any such failure or breach, including as a result of cyber-attacks against us or our outsource partners, could have a material and adverse effect on our business, reputation, results of operations, financial position or cash flows.

 

Our business model and our reputation as a service provider to our clients are dependent upon our ability to safeguard the confidential personal information of our customers, as well as the confidential personal information of the customers of our clients.  Although we have put in place, and require our outsource providers to follow, a comprehensive information security program that we monitor and update as needed, security breaches could occur through intentional or unintentional acts by individuals having authorized or unauthorized access to confidential information of our customers or the employees or customers of our clients which could potentially compromise confidential information processed and stored in or transmitted through our technology infrastructure.  In addition, we have highly complex information systems, certain portions of which we are dependent upon third party outsource providers and other portions of which are self-developed and for which third party support is not generally available.

 

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A failure in or breach of the security of our information systems, or those of our outsource providers, or a cyber-attack against us or our outsource partners, could result in significant damage to our reputation or the reputation of our clients, could negatively impact our ability to attract or retain clients and could result in increased costs attributable to related litigation or regulatory actions, claims for indemnification, higher insurance premiums and remediation activities, the result of any of which could have a material and adverse effect on our business, reputation, results of operations, financial position, or cash flows.

 

Risks Related to our Common Stock

 

Our existing Convertible note series, any future issuances of securities convertible into our Common stock and hedging activities may result in dilution of our stockholders or depress the trading price of our Common stock.

 

The voting power and ownership percentage of our stockholders will be diluted and the trading price of our Common stock could be substantially decreased if we issue any shares of our Common stock or securities convertible into our Common stock in the future, including the issuance of shares of Common stock upon conversion of any existing convertible notes or the issuance of shares of Common stock upon exercise or settlement of any outstanding share-based payment awards granted under our equity and incentive plans. In addition, the price of our Common stock could also be negatively affected by possible sales of our Common stock by investors who engage in hedging or arbitrage trading activity that we expect to develop involving our Common stock following the issuance of the convertible notes.

 

We did not enter into a hedge transaction associated with the issuance of our Convertible notes due 2017. Upon conversion of the Convertible notes due 2017, the principal amount is payable in cash and to the extent the conversion value exceeds the principal amount of the converted notes we are required to pay or deliver (at our election) (i) cash; (ii) shares of our Common stock; or (iii) a combination of cash and shares of Common stock.  The increase in, and any further increases in, the trading price of our Common stock since the issuance of those notes, will result in a required cash payment upon conversion of the notes or will result in a dilution of the voting power and ownership percentage of the Common stock held by our existing shareholders, either of which may negatively affect the trading price of our Common stock.  As of December 31, 2014, the Convertible notes due 2017 are eligible for conversion, and if all such notes were converted as of such date, we would be required to settle the note principal plus a premium of $214 million cash, 8.932 million shares of our Common stock, or a combination thereof (at our election).  A 10% increase in our stock price from the closing price of December 31, 2014, results in an increase in the required conversion premium of $46 million, or 0.930 million shares.

 

We also may issue shares of our Common stock or securities convertible into our Common stock in the future for a number of reasons, including to finance our operations and business strategy (including in connection with acquisitions, strategic collaborations or other transactions), to increase our capital, to adjust our ratio of debt to equity, to satisfy our obligations upon the exercise of outstanding warrants or options or for other reasons.  We cannot predict the size of future issuances of our Common stock or securities convertible into our Common stock or the effect, if any, that such future issuances might have to dilute the voting interests of our stockholders or otherwise on the market price for our Common stock.

 

Our share repurchase programs may affect the market for our common stock, including affecting our share price or increasing share price volatility.

 

On June 26, 2014, our Board of Directors authorized up to $450 million in share repurchases, including $200 million of accelerated share repurchases (“ASR”) and up to $250 million in open market purchases over the twelve months following the completion of the ASR.  The authorization requires that these programs expire no later than March 31, 2016.  Repurchases of our common stock pursuant to these programs could affect our stock price and increase its volatility.  The existence of share repurchase programs could also cause our stock price to be higher than it would be in the absence of such programs. Our share repurchase programs will utilize cash that we will not be able to use in other ways to grow our business.

 

In the third quarter of 2014 we entered into an aggregate of $200 million of ASR programs and have retired approximately 6.963 million of our common shares under the programs to-date.  The final settlement of shares repurchased from these programs will be determined at the completions of the programs, which is expected to occur in the first quarter of 2015.  Our counterparty to the ASR programs may complete various market transactions for

 

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its’ own account to fulfill the programs, including purchasing shares of our Common stock in the open market or entering into derivative transactions with respect to our Common stock, and such actions may affect our stock price and increase its’ volatility.

 

Although the Board of Directors has authorized an additional $250 million in share repurchases, we are not obligated to repurchase any specific dollar amount or to acquire any specific number of shares. The timing and amount of repurchases, if any, will depend upon several factors, including market and business conditions, the trading price of our common stock and the nature of other investment opportunities. The repurchase program may be limited, suspended or discontinued at any time without prior notice.

 

A change in control transaction or a fundamental change in our business may result in a number of significant cash outflows that could reduce the value of our business.  Further, certain provisions of our debt arrangements and the provisions of certain other agreements could discourage third parties from seeking to acquire us, could prevent or delay a transaction resulting in a change of control.

 

The net proceeds realized by our shareholders as the result of any change in control transaction or a fundamental change, may be negatively impacted as a result of required payments under our corporate term debt certain tax impacts or the potential termination of certain client relationships (if consents or waivers are not obtained), among other consequences.

 

The terms of certain of our Senior note and Convertible note debt agreements and indentures contain provisions that require us to offer to repurchase, for cash, all or a portion of the outstanding notes upon a change of control or fundamental change, as defined in such indentures.  Further, a change of control or fundamental change may constitute an event of default under certain of our debt agreements, including our mortgage warehouse facilities.  In addition, in the event of a make-whole fundamental change (as defined by the indentures governing our Convertible notes due 2017), the conversion rate for the notes may, in some cases, be increased for a holder that elects to convert their notes in connection with such make-whole fundamental change.

 

We may need to obtain consents or waivers from the GSEs, state licensing agencies and certain clients or counterparties, in connection with certain change in control transactions.  Additionally, the value of our Mortgage business could be reduced from any lost relationships and/or loss of our approved status as a Fannie Mae, Freddie Mac and Ginnie Mae approved seller/servicer in connection with certain change in control transactions.  Our agreements with Fannie Mae and Freddie Mac require us to provide notice or obtain approvals or consents related to any change in control transaction.  Our agreements with Realogy, including the PHH Home Loans Operating Agreement, state that Realogy may terminate PHH Home Loans if we effect a change in control transaction involving certain competitors or other third parties. In connection with such termination, we may be required to make a cash payment to Realogy in an amount equal to: (i) PHH Home Loans’ trailing 12 months net income multiplied by the greater of (a) the number of years remaining in the first 12 years of the term of the agreement or (b) two years.

 

In addition, agreements with some of our financial institution clients governing our private-label relationships provide our clients with the right to terminate their relationship with us if we complete certain change in control transactions with certain third parties.  The need to obtain waivers or consents from our clients in connection with a change in control transactions may discourage certain third parties from seeking to acquire us or could reduce the amount of consideration they would be willing to pay to our stockholders in an acquisition transaction, or could otherwise reduce the value of the business when separated.

 

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Provisions in our charter documents, the Maryland General Corporation Law, and New York insurance law may delay or prevent our acquisition by a third party.

 

Our charter and by-laws contain several provisions that may make it more difficult for a third party to acquire control of us without the approval of our board of directors. These provisions include, among other things, advance notice for raising business or making nominations at meetings and “blank check” preferred stock. Blank check preferred stock enables our board of directors, without stockholder approval, to designate and issue additional series of preferred stock with such dividend, liquidation, conversion, voting or other rights, including the right to issue convertible securities with no limitations on conversion, as our board of directors may determine, including rights to dividends and proceeds in a liquidation that are senior to the Common stock.

 

We are also subject to certain provisions of the Maryland General Corporation Law which could delay, prevent or deter a merger, acquisition, tender offer, proxy contest or other transaction that might otherwise result in our stockholders receiving a premium over the market price for their Common stock or may otherwise be in the best interest of our stockholders. These include, among other provisions:

 

§                  the “business combinations” statute which prohibits transactions between a Maryland corporation and an interested stockholder or an affiliate of an interested stockholder for five years after the most recent date on which the interested stockholder becomes an interested stockholder and

§                  the “control share” acquisition statute which provides that control shares of a Maryland corporation acquired in a control share acquisition have no voting rights except to the extent approved by a vote of two-thirds of the votes entitled to be cast on the matter.

 

Our by-laws contain a provision exempting any share of our capital stock from the control share acquisition statute to the fullest extent permitted by the Maryland General Corporation Law. However, our Board of Directors has the exclusive right to amend our by-laws and, subject to their fiduciary duties, and could at any time in the future amend the by-laws to remove this exemption provision.

 

In addition, we are registered as an insurance holding company in the state of New York as a result of our wholly owned subsidiary, Atrium Insurance Corporation. New York insurance law requires regulatory approval of a change in control of an insurer or an insurer’s holding company. Accordingly, there can be no effective change in control of us unless the person seeking to acquire control has filed a statement containing specified information with the New York state insurance regulators and has obtained prior approval. The measure for a presumptive change of control pursuant to New York law is the acquisition of 10% or more of the voting stock or other ownership interest of an insurance company or its parent. These laws may discourage potential acquisition proposals and may delay, deter or prevent a change in control of us, including through transactions, and in particular unsolicited transactions, that some or all of our stockholders might consider to be desirable.

 

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Item 1B.  Unresolved Staff Comments

 

None.

 

Item 2.  Properties

 

Our principal offices are located at 3000 Leadenhall Road, Mt. Laurel, New Jersey 08054.

 

Our business has centralized operations in approximately 555,000 square feet of shared leased office space in the Mt. Laurel, New Jersey area.  We occupy approximately 100,000 square feet in Jacksonville, Florida and approximately 40,000 square feet in Bannockburn, Illinois both of which are primarily used to support our mortgage production activities.  We also have a location near Buffalo, New York with approximately 55,000 square feet of total office space that is primarily used to support our servicing operations.  In addition, we lease approximately 45 smaller offices located throughout the U.S.

 

Item 3.  Legal Proceedings

 

We are party to various claims and legal proceedings from time to time related to contract disputes and other commercial, employment and tax matters.  For more information regarding legal proceedings, see Note 14, “Commitments and Contingencies” in the accompanying Notes to Consolidated Financial Statements.

 

Item 4.  Mine Safety Disclosures

 

Not applicable.

 

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PART II

 

Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

 

Market Price of Common Stock

 

Shares of our Common stock are listed on the NYSE under the symbol “PHH”.  The following table sets forth the high and low sales prices for our Common stock for the periods indicated as reported by the NYSE:

 

 

 

 

Stock Price

 

 

 

High

 

Low

 

January 1, 2013 to March 31, 2013

 

$

23.90

 

20.58

 

April 1, 2013 to June 30, 2013

 

22.13

 

18.82

 

July 1, 2013 to September 30, 2013

 

25.13

 

20.20

 

October 1, 2013 to December 31, 2013

 

26.76

 

21.95

 

January 1, 2014 to March 31, 2014

 

27.13

 

23.44

 

April 1, 2014 to June 30, 2014

 

26.02

 

20.98

 

July 1, 2014 to September 30, 2014

 

24.84

 

22.13

 

October 1, 2014 to December 31, 2014

 

24.71

 

21.66

 

 

As of February 17, 2015, there were 5,988 holders of record of our Common stock.

 

Restrictions on Share-Related Payments

 

As of December 31, 2014, we are not restricted in our ability to make share-related payments including the declaration and payment of dividends or the repurchase of Common stock.

 

We may be restricted in our ability to make share-related payments, or the amount of such payments may be limited, due to the provisions of our debt arrangements, capital requirements of our operating subsidiaries and other legal requirements and regulatory constraints.  Such share-related payments include the declaration and payment of dividends, making any distribution on account of our Common stock, or the purchase, repurchase, redemption or retirement of our Common stock.

 

The limitations and restrictions on our ability to make share-related payments include but are not limited to:

 

a)             Restrictions under our senior note indentures from making a share-related payment if, after giving effect to the payment, the debt to tangible equity ratio calculated as of the most recently completed month end exceeds 6 to 1; however, even if such ratio is exceeded, we may declare or pay any dividend or make a share-related payment so long as our corporate ratings are equal to or better than: Baa3 from Moody’s Investors Service, BBB- from Standard & Poor’s (in each case on stable outlook or better); and

 

b)             Limitations in the amount of share-related payments that can be distributed by us due to maintaining compliance with the financial covenants contained in certain subsidiaries’ mortgage warehouse funding agreements, including but not limited to: (i) the maintenance of net worth of at least $1.0 billion on the last day of each fiscal quarter; and (ii) a ratio of indebtedness to tangible net worth of no greater than 4.5 to 1.

 

In addition, we are limited in the amount of share-related payments that can be distributed due to capital that is required to be maintained at our subsidiaries.  The amount of intercompany dividends, share-related payments and other fund transfers that certain of our subsidiaries can declare or distribute to us or to other consolidated subsidiaries (and ultimately to us) is limited due to provisions of our subsidiaries’ debt arrangements, capital requirements, and other legal requirements and regulatory constraints.  The aggregate restricted net assets that are required to be maintained at our subsidiaries totaled $769 million as of December 31, 2014.

 

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We have not declared or paid cash dividends on our Common stock since we began operating as an independent, publicly traded company in 2005.  In 2014, we utilized the net proceeds from the sale of our Fleet business and our existing excess cash to repay $435 million of the principal balance of our unsecured term debt and we have returned capital to shareholders through $200 million of accelerated share repurchase programs, as discussed further below.  We maintain an unrestricted cash position to fund certain known or expected payments, to fund our working capital needs, and to maintain cash reserves for contingencies.  We intend to utilize our excess cash above these key requirements to grow the business and re-engineer the company as a stand-alone mortgage business. We also expect to utilize excess cash to return capital to shareholders to fund up to $250 million in open-market share repurchases that have been authorized by our Board of Directors, subject to market and business conditions, the trading price of our common stock and the nature of other investment opportunities.

 

The declaration and payment of dividends in the future will be subject to the discretion of our Board of Directors and will depend upon many factors, including economic and market conditions, our financial condition and operating results, cash requirements, capital requirements of our operating subsidiaries, legal requirements, regulatory constraints, investment opportunities at the time any such payment is considered, and other factors deemed relevant.

 

Purchases of Equity Securities by the Issuer and Affiliated Purchasers

 

On June 26, 2014, our Board of Directors authorized up to $450 million in share repurchases, including $200 million of accelerated share repurchases (“ASR”) through March 31, 2015 and up to $250 million in open market purchases over the twelve months following the completion of the ASR expiring no later than March 31, 2016.

 

On August 7, 2014, we entered into two separate ASR agreements to repurchase an aggregate of $200 million of PHH’s Common stock.  The initial shares delivered were 6.963 million based upon the minimum share delivery for the collared agreement and 80% share delivery under the uncollared agreement based upon the stock price at inception.  The final number of shares repurchased and purchase price per share will be determined based on the applicable volume weighted average price of the shares through the completion of this program, which is expected to occur in the first quarter of 2015.

 

The dollar value of shares that may yet be purchased under approved share repurchase programs is $250 million.  In the fourth quarter of 2014, we did not complete any share repurchases nor settle the delivery of any shares under the ASR.

 

See Note 15, “Stock-Related Matters” in the accompanying Notes to Consolidated Financial Statements for more information.

 

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Item 6.  Selected Financial Data

 

The selected financial data set forth below is derived from our audited Consolidated Financial Statements for the periods indicated.  Because of the inherent uncertainties of our business, the historical financial information for such periods may not be indicative of our future results of operations, financial position or cash flows.

 

In 2014, the Company sold its Fleet Management Services business. All Fleet operations have been recorded in held for sale or discontinued operations during 2014 and are presented comparatively for all historical periods below:

 

 

 

Year Ended and As of December 31,

 

 

 

2014

 

2013

 

2012

 

2011

 

2010

 

 

 

(In millions, except per share data)

 

Consolidated Statements of Operations

 

 

 

 

 

 

 

 

 

 

 

REVENUES

 

 

 

 

 

 

 

 

 

 

 

Origination and other loan fees

 

$

231

 

$

307

 

$

346

 

$

295

 

$

291

 

Gain on loans held for sale, net

 

264

 

575

 

942

 

567

 

635

 

Net loan servicing income (loss)

 

210

 

430

 

(53

)

(280

)

(12

)

Net interest expense

 

(88)

 

(115)

 

(121)

 

(87)

 

(72)

 

Other income

 

22

 

3

 

12

 

73

 

4

 

Net revenues

 

639

 

1,200

 

1,126

 

568

 

846

 

 

 

 

 

 

 

 

 

 

 

 

 

Total expenses

 

923

 

1,060

 

1,140

 

857

 

806

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income (loss) attributable to PHH Corporation

 

81

 

135

 

34

 

(127)

 

48

 

 

 

 

 

 

 

 

 

 

 

 

 

Basic earnings (loss) per share attributable to PHH Corporation

 

$

1.47

 

$

2.36

 

$

0.60

 

$

(2.26)

 

$

0.87

 

Diluted earnings (loss) per share attributable to PHH Corporation

 

1.47

 

2.06

 

0.60

 

(2.26)

 

0.86

 

 

 

 

 

 

 

 

 

 

 

 

 

Consolidated Balance Sheets

 

 

 

 

 

 

 

 

 

 

 

ASSETS

 

 

 

 

 

 

 

 

 

 

 

Cash and cash equivalents

 

$

1,259

 

$

1,126

 

$

758

 

$

392

 

$

176

 

Mortgage loans held for sale

 

915

 

834

 

2,174

 

2,658

 

4,329

 

Mortgage servicing rights

 

1,005

 

1,279

 

1,022

 

1,209

 

1,442

 

Total assets

 

4,296

 

8,853

 

9,605

 

9,779

 

11,267

 

LIABILITIES

 

 

 

 

 

 

 

 

 

 

 

Unsecured debt

 

$

831

 

$

1,249

 

$

1,156

 

$

1,339

 

$

1,212

 

Asset-backed debt

 

908

 

775

 

1,941

 

2,457

 

3,807

 

Total liabilities

 

2,725

 

7,163

 

8,043

 

8,318

 

9,689

 

PHH Corporation stockholders’ equity

 

1,545

 

1,666

 

1,526

 

1,442

 

1,564

 

 

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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

The following discussion should be read in conjunction with “Part I—Item 1. Business” and our Consolidated Financial Statements and the notes thereto included in this Form 10-K. The following discussion should also be read in conjunction with the “Cautionary Note Regarding Forward-Looking Statements” and the risks and uncertainties described in “Part I—Item 1A. Risk Factors” set forth above.

 

Our Management’s Discussion and Analysis of Financial Condition and Results of Operations is presented in sections as follows:

 

§                  Overview

§                  Results of Operations

§                  Risk Management

§                  Liquidity and Capital Resources

§                  Contractual Obligations

§                  Off-Balance Sheet Arrangements and Guarantees

§                  Critical Accounting Policies and Estimates

§                  Recently Issued Accounting Pronouncements

 

OVERVIEW

 

We are a leading outsource provider of mortgage services. We conduct our business through two reportable segments: Mortgage Production and Mortgage Servicing. Our Mortgage Production segment originates, purchases and sells mortgage loans through PHH Mortgage. Our Mortgage Servicing segment services mortgage loans originated by PHH Mortgage and acts as a subservicer for certain clients that own the underlying servicing rights.

 

As a result of our sale of our Fleet business, which closed effective on July 1, 2014, Fleet Management Services is no longer a reportable segment, and the results and operations of the Fleet business and transaction-related amounts are included within Income from discontinued operations, net of tax for all periods presented and Assets and Liabilities held for sale as of December 31, 2013.  See further discussion in “—Results of Operations—Discontinued Operations”.

 

Our business has experienced, and may continue to experience, high degrees of earnings volatility due to significant exposure to interest rates and the real estate markets, which impacts our loan origination volumes, valuation of our mortgage servicing rights and repurchase and foreclosure-related charges.  See “—Risk Management” in this Form 10-K for additional information regarding our interest rate and market risks.

 

In addition, we are monitoring a number of developments in regulations that are expected to impact our Mortgage segments, and there has been a heightened focus of regulators on the practices of the mortgage industry.  The full impact of regulatory developments remains uncertain, although we expect the higher level of legislative and regulatory focus on mortgage origination and servicing practices will result in higher legal, compliance, and servicing related costs, heightened risk of potential regulatory fines and penalties, and we could experience an increase in mortgage origination or servicing related litigation in the future.  For more information, see “Part I—Item 1A. Risk Factors—Risks Related to Our CompanyOur business is complex and heavily regulated, and the full impact of regulatory developments to our business remains uncertain. In addition, we are subject to litigation, regulatory investigations, inquiries and proceedings and we may incur fines, penalties, and increased costs that could negatively impact our future results of operations, liquidity and cash flows or damage our reputation.” in this Form 10-K.

 

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Executive Summary

 

Operating and Capital Strategy

 

We completed the sale of the Fleet business effective on July 1, 2014 for cash consideration of $1.4 billion, and realized over $550 million in net proceeds after taxes and transaction-related costs.  The net proceeds from the sale have increased our excess cash above key cash requirements, allowed us to reduce our unsecured debt principal by $435 million and return capital to shareholders.  We intend to continue to utilize excess cash by re-engineering the company as a stand-alone mortgage business and growing the business, and we expect to return additional capital to shareholders, subject to market and business conditions, the trading price of our common stock and the nature of other investment opportunities.

 

Mortgage Re-Engineering

 

We intend to deploy up to $200 million to re-engineer our operations and support infrastructure for a stand-alone mortgage business in a lower volume, home purchase driven mortgage market and are on track to deliver our expected annualized operating benefits from these initiatives.  If we achieve our Private Label contract negotiation objectives and expense reduction efforts, we would expect to generate a total of $225 million in annualized operating benefits.

 

Expense Reduction.  We expect to generate an aggregate of $175 million in annualized operating benefits over the next 6 to 24 months from expense reductions.  Our re-engineering efforts will be focused on our organizational structure redesign, facilities management, implementing process improvements in both origination and servicing operations and managing or consolidating our vendor relationships.    We believe that our actions to re-engineer our operations will simplify our organization while maintaining capacity to enable growth and flexibility to respond to ongoing regulatory changes.  As a result of our planned actions, we recorded $15 million of severance expense in 2014.

 

Private Label Contracts.  During the second half of 2014, we continued to make progress on our Private Label contract negotiations with our largest clients.  These agreements are complex contracts, and we needed to attempt to address pricing economics, appropriate risk sharing and more balanced terms and conditions.  Our discussions evolved to encompass a number of additional elements and our Private Label operating model and client contracts with our largest clients are likely to change in order to address the needs of all parties.  As a result, any changes in the terms and scope of some of our Private Label relationships could have a significant impact on our re-engineering plans, our expected origination volumes and our profitability.

 

Although none of our largest private label clients has executed re-negotiated agreements as of December 31, 2014, we have made significant progress in the first quarter of 2015.  As of February 17, 2015, we have achieved our target objectives with clients representing approximately 50% of our total 2014 private label closing volume.

 

For our remaining clients, we have extended negotiations to address their unique program requirements and potentially expand the scope of services to be provided. For clients representing approximately 30% of our total 2014 private label closing volume, we believe that we are in the late stages of the renegotiation process, and we should complete those negotiations to achieve our target economic objectives by June 30, 2015.  The clients that comprise the remaining 20% of our total 2014 private label closing volume remain highly engaged and we continue to work diligently with them to conclude these negotiations as soon as possible.

 

We remain cautiously optimistic that these contracts can be structured or renewed on mutually beneficial terms; however, we can make no assurances that our Private Label clients will ultimately agree to amend their contracts prior to renewal.  For more information, see “Part I—Item 1A. Risk Factors—Risks Related to our Company— The profitability of our Mortgage Production segment has been adversely affected by the increased mix of fee-based closings originated under our existing private label client contracts.  We are currently evaluating a number of alternatives to restructure these contracts to improve the economics of the underlying contractual relationships; however, there can be no assurances that we will be successful in these efforts.” in this Form 10-K.

 

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Growth Initiatives

 

We intend to invest up to $150 million in select growth opportunities over the next two years to enhance scale and profitability and diversify our revenue streams.  We believe these opportunities could generate up to $175 million in annualized operating benefits.  We will be focused on expanding our target market within the existing private label client base, but the timing of this effort may be impacted by the results of our ongoing contract negotiations.  In addition, we will focus on growing our origination volume through outsourcing opportunities with regional and community banks.  We believe that we can grow our share in the home purchase market through improved capture rates and additional investments in the Real Estate channel.  We will also be focused on pursuing subservicing opportunities.  We will evaluate selective inorganic growth investments to leverage our fixed-cost support infrastructure to expand our retail mortgage market presence in a home purchase market and grow our servicing portfolio.

 

Return of Capital to Shareholders

 

Our Board of Directors has authorized up to $450 million in share repurchases, and in the third quarter of 2014 we entered into an aggregate of $200 million of accelerated share repurchase (“ASR”) programs and have retired approximately 6.963 million of our common shares under the programs to-date.  The final settlement of shares repurchased from these programs will be determined at the completion of the programs, which is expected to occur in the first quarter of 2015.

 

We expect that the ASR programs will be followed by up to $250 million in open market purchases in the twelve months following the completion of the ASR, subject to market and business conditions, the trading price of our common stock and the nature of other investment opportunities.

 

For more information, see “Part I—Item 1A. Risk Factors—Risks Related to our Company— We may not be able to fully or successfully execute or implement our business strategies or achieve our objectives, including our initiatives to re-engineer and grow our mortgage business.” in this Form 10-K.  Also see “Part I—Item 1A. Risk Factors—Risks Related to our Common Stock—Our share repurchase programs may affect the market for our common stock, including affecting our share price or increasing share price volatility.”

 

Legal and Regulatory Environment

 

Consistent with other companies in the mortgage industry, we have experienced inquiries, examinations and requests for information from regulators and attorneys general of certain states as well as various government agencies.  In addition, we are working diligently in assessing and understanding the implications of the developments in the regulatory environment, and we are devoting substantial resources towards implementing all of the new rules and responding to inquiries, examinations, and proceedings, while meeting the needs and expectations of our clients.

 

During 2014, we increased our reserves for legal and regulatory contingencies by $28 million. We expect the higher legislative and regulatory focus on mortgage origination and servicing practices to continue to result in higher legal, compliance and servicing related costs, heightened risk for potential regulatory fines and penalties, and we could experience an increase in mortgage origination or servicing related litigation in the future.  The ultimate resolution of any particular matter could be material to our results of operations or cash flows for the period in which such matter is resolved.  For more information, see “Part I—Item 1A. Risk Factors—Risks Related to Our CompanyOur business is complex and heavily regulated, and the full impact of regulatory developments to our business remains uncertain. In addition, we are subject to litigation, regulatory investigations, inquiries and proceedings and we may incur fines, penalties, and increased costs that could negatively impact our future results of operations, liquidity and cash flows or damage our reputation.” in this Form 10-K and Note 14, “Commitments and Contingencies” in the accompanying Notes to Consolidated Financial Statements.

 

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We have undergone a regulatory examination by a multistate coalition of certain mortgage banking regulators (the “MMC”) and such regulators have alleged various violations of federal and state laws related to our mortgage servicing practices prior to July 2011.  In October 2014, we met with the MMC, along with representatives of certain state Attorneys General and the CFPB, to formally review the MMC’s examination findings and our response.  In order to resolve the findings and in exchange for a release of certain enforcement actions, the MMC has proposed that we enter into a Settlement Agreement and Consent Order that includes adoption of national servicing standards, payments to certain borrowers nationwide whose loans went into foreclosure during a stated period of time, other consumer relief and administrative penalties.  While we continue to believe we have meritorious defenses to the findings, we have indicated our willingness to adopt the servicing standards set out in the MMC’s proposal with certain caveats and continue discussions on other aspects of the proposal.

 

In January 2014, the CFPB initiated an administrative proceeding alleging that our reinsurance activities have violated certain provisions of the Real Estate Settlement Procedures Act.  We have increased our reserves related to the recommended decision that was issued by the administrative law judge in November 2014; however, we and the CFPB’s enforcement counsel have appealed the decision. We believe that we have complied with the Real Estate Settlement Procedures Act and other laws applicable to our former mortgage reinsurance activities. We cannot estimate the maximum amount of loss, if any, associated with this matter, and there can be no assurance that the ultimate resolution of this matter will not result in losses, fines or penalties which could be material to our results of operations, cash flows or financial position.

 

We are monitoring increases in litigation and settlements among our peers in the mortgage industry around servicing practices for lender-placed insurance, also called “forced-placed insurance”.  We are currently subject to pending litigation alleging that our servicing practices around lender-placed insurance were not in compliance with applicable laws.  Through our mortgage servicing subsidiary, we did have certain outsourcing arrangements for the purchase of lender-placed hazard insurance for borrowers whose coverage had lapsed.  We believe we have meritorious defenses to these allegations; however, the resolution of such matter may result in adverse judgments, other relief against us, as well as monetary payments or other agreements and obligations, any of which may be material to our results of operations, cash flows or financial position.

 

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RESULTS OF OPERATIONS

 

Continuing Operations

 

The following tables present our consolidated results of operations from continuing operations and segment profit or loss for our reportable segments:

 

 

 

Year Ended December 31,

 

 

 

2014

 

2013

 

2012

 

 

 

 

(In millions, except per share data)

 

 

 

 

 

 

 

 

 

Origination and other loan fees

 

$

231

 

$

307

 

$

346

 

Gain on loans held for sale, net

 

264

 

575

 

942

 

Net loan servicing income (loss)

 

210

 

430

 

(53)

 

Net interest expense

 

(88)

 

(115)

 

(121)

 

Other income

 

22

 

3

 

12

 

Net revenues

 

639

 

1,200

 

1,126

 

Total expenses

 

923

 

1,060

 

1,140

 

(Loss) income from continuing operations before income taxes

 

(284)

 

140

 

(14)

 

Income tax (benefit) expense

 

(99)

 

42

 

(37)

 

(Loss) income from continuing operations, net of tax

 

(185)

 

98

 

23

 

Less: net income attributable to noncontrolling interest

 

6

 

29

 

59

 

Net (loss) income from continuing operations attributable to PHH Corporation

 

$

(191)

 

$

69

 

$

(36)

 

 

 

 

 

 

 

 

 

(Loss) earnings per share from continuing operations:

 

 

 

 

 

 

 

Basic

 

$

(3.47)

 

$

1.21

 

$

(0.64)

 

Diluted

 

$

(3.47)

 

$

1.05

 

$

(0.64)

 

 

 

 

 

 

 

 

 

Segment (Loss) Profit:(1)

 

 

 

 

 

 

 

Mortgage Production segment

 

$

(141)

 

$

22

 

$

416

 

Mortgage Servicing segment

 

(103)

 

155

 

(464)

 

Other(2) 

 

(46)

 

(66)

 

(25)

 

______________

(1)             Segment (loss) profit is described in Note 21, “Segment Information”, in the accompanying Notes to Consolidated Financial Statements.

 

(2)             Includes expenses that are not allocated back to our reportable segments and certain general corporate overhead expenses that were previously allocated to the Fleet business.  All periods include pre-tax losses related to the early retirement of certain unsecured debt obligations.

 

Our financial results from continuing operations for 2014 reflect declines in industry origination volumes, margin compression, increased competition and a higher regulatory focus.  We are in the early stages of executing our strategy to re-engineer our operations and support infrastructure for a stand-alone mortgage business and evaluating select growth opportunities as discussed further under “—Mortgage Re-Engineering” and “—Growth Initiatives” in the Overview section.

 

Production. Net revenues of our Mortgage Production segment declined $356 million (43%) from 2013, reflecting a 31% decline in total closings, a 53% decline in IRLCs and a 62 basis point (18%) decrease in total loan margins.  The decline in total closings was primarily driven by a 52% decline in refinance closings, consistent with the relative interest rate environments and industry demand.

 

Our actions taken in the second half of 2013 and throughout 2014 to reduce staffing levels in our Mortgage Production segment in response to expected client and industry demand have resulted in salary expense reductions in production and overhead functions.  Despite the cost reduction efforts, the results of our Mortgage Production segment still reflected the industry-wide reductions in mortgage loan originations. While interest rates have decreased during the early part of 2015 leading to an increase in application volume and loan margins, we expect a highly challenging mortgage industry environment to continue throughout 2015 and our Mortgage Production segment will likely continue to be unprofitable and cash consumptive for the first half of 2015.

 

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Servicing.  Net revenues of our Servicing segment declined $216 million (57%) from 2013, primarily reflecting changes in the valuation of our mortgage servicing rights, net of the related derivatives.  During 2014, we recorded $238 million of unfavorable net changes in value, primarily resulting from a 71 basis point decline in the mortgage rate used to value our MSR asset and a flattening of the yield curve, compared to unfavorable net changes of $6 million for 2013.

 

The Servicing segment also experienced a $26 million increase in Other operating expenses, primarily driven by an increase in the liability for legal and regulatory contingencies that was recorded in 2014.

 

Other.  For both 2014 and 2013, our results also include losses not allocated to the segments for early repayment of unsecured debt.  During 2014, we recorded a $24 million pre-tax loss related to the early repayment of our Senior Notes due 2016, compared to a $54 million pre-tax loss during 2013.  Results for 2014 also include $10 million of expenses for severance costs related to the re-engineering of our operations and support infrastructure.

 

Income Tax Provision or Benefit.  Our effective income tax rate for the years ended December 31, 2014, 2013 and 2012 were (35.1)%, 29.8% and (264.7)%,  respectively.  Our effective tax rates differ from our federal statutory rate of 35%, primarily due to:  (i) amounts of net income attributable to noncontrolling interest (for which no taxes are provided); (ii) state benefits from the impact of applying statutory changes to apportionment factors and tax rate; and (iii) changes in valuation allowances.  For 2014, our effective tax rate also includes changes in liabilities for income tax contingencies driven by state tax filing positions expected to be taken related to the sale of the Fleet business.  For 2012, our effective tax rate differs significantly from the statutory rate due to the proportionate size of our loss before income taxes and income attributable to noncontrolling interest.

 

In connection with our sale of the Fleet business, we utilized all of our Federal net operating losses, which significantly reduced our deferred tax assets.  As a result, we do not have amounts of Federal net operating loss carryforwards to offset future taxable income.

 

See Note 12, “Income Taxes” in the accompanying Notes to Consolidated Financial Statements for further information.

 

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Discontinued Operations

 

During 2014, we entered into a Stock Purchase Agreement to sell all of the issued and outstanding equity interests of our Fleet Management Services business (“Fleet business”), and the transaction closed effective on July 1, 2014.  As a result of the sale of the Fleet business, Fleet Management Services is no longer a reportable segment, and the results of the Fleet business and transaction-related amounts are included within Income from discontinued operations, net of tax in the Consolidated Statements of Operations and have been excluded from continuing operations and segment results for all periods presented.  As of December 31, 2013, the assets and liabilities of the Fleet business are presented as Assets held for sale and Liabilities held for sale in the Consolidated Balance Sheets.  See Note 2, “Discontinued Operations” in the accompanying Consolidated Financial Statements for additional information.

 

The results of discontinued operations are summarized below:

 

 

 

Year Ended December 31,

 

 

 

 

 

 

 

 

 

 

 

2014

 

2013

 

2012

 

 

 

 

 

 

 

(In millions, except per share data)

 

 

 

 

 

Net revenues

 

$

820

 

$

1,642

 

$

1,617

 

Total expenses

 

774

 

1,541

 

1,517

 

Income before income taxes(1) 

 

46

 

101

 

100

 

Income tax expense(1) 

 

15

 

35

 

30

 

Gain from sale of discontinued operations, net of tax

 

241

 

 

 

Income from discontinued operations, net of tax

 

$

272

 

$

66

 

$

70

 

 

 

 

 

 

 

 

 

Earnings per share from discontinued operations:

 

 

 

 

 

 

 

Basic

 

$

4.94

 

$

1.15

 

$

1.24

 

Diluted

 

$

4.94

 

$

1.01

 

$

1.24

 

_______________

(1)       Represents the results of the Fleet business.

 

During the year ended December 31, 2014, we recognized a $241 million net gain on the disposition of the Fleet business which includes a gain of $22 million resulting from the reclassification of currency transaction adjustments from Accumulated other comprehensive income.  The income tax expense related to the Gain on sale of discontinued operations was $227 million for the year ended December 31, 2014, which includes $52 million of expense associated with the earnings of our Canadian subsidiaries that were previously considered to be indefinitely invested.  Upon the classification of the Fleet business as held for sale during the second quarter of 2014, the accumulated earnings were no longer deemed to be indefinitely invested and we recognized the tax expense related to the cumulative earnings of such Canadian subsidiaries.

 

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Mortgage Production Segment

 

 

Segment Overview

 

Our Mortgage Production segment provides mortgage services, including private-label mortgage services, to financial institutions and real estate brokers through PHH Mortgage.  The segment generates revenue through fee-based mortgage loan origination services and the origination and sale of mortgage loans into the secondary market.  PHH Mortgage generally sells all saleable mortgage loans that it originates to secondary market investors, which include a variety of institutional investors, and initially retains the servicing rights on mortgage loans sold.  We source mortgage loans through our retail and wholesale/correspondent platforms, as further described below.

 

Retail Platform.  Through our retail platform, we maintain direct contact with borrowers who are purchasing a home or refinancing a mortgage loan.  We operate either through our teleservices operation or our network of field sales professionals.  Within our teleservices operation, we provide centralized application and loan processing capabilities for our customers.  Our network of field sales professionals are generally located in real estate brokerage offices or are affiliated with financial institution clients around the U.S. and are equipped to provide product information and take mortgage applications.  We also maintain multiple internet sites that provide online mortgage application capabilities for our customers.  Our retail platform consists of our private label services and real estate channels.

 

The private label services channel includes providing outsourced mortgage origination services for wealth management firms, regional banks and community banks throughout the U.S, including Merrill Lynch Home Loans, a division of Bank of America, National Association, Morgan Stanley Private Bank and HSBC Bank USA.  We are a leading provider of private-label mortgage loan originations and in this channel, we offer a complete outsourcing solution, from processing applications through funding, for clients that wish to offer mortgage services to their customers but do not want to maintain the internal infrastructure to operate a mortgage platform.

 

The real estate channel includes providing mortgage origination services for brokers associated with brokerages owned or franchised by Realogy Corporation and other third-party brokers. Through our affiliations with real estate brokers, we have access to home buyers at the time of purchase.  Substantially all of the originations through the real estate channel are originated from Realogy and Realogy Franchisees.  For the year ended December 31, 2014, we originated mortgage loans for 16% of the transactions in which real estate brokerages owned by Realogy represented the home buyer and 11% of the transactions in which real estate brokerages franchised by Realogy where we have exclusive marketing service agreements, represented the home buyer.  See “Part I—Item 1. Business—Segment Overview” for a further discussion of our relationship with Realogy.

 

Wholesale/Correspondent Platform.  Through our wholesale/correspondent platform, we purchase closed mortgage loans from community banks, credit unions, mortgage brokers and mortgage bankers.  We also acquire mortgage loans from mortgage brokers that receive applications from and qualify the borrowers.  Wholesale/correspondent originations are highly dependent upon pricing margins and overall industry capacity.

 

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Outlook and Trends

 

The interest rate environment during 2014 has continued to negatively affect loan margins and origination volumes; however, interest rates have decreased during the early part of 2015 leading to an increase in application volume and loan margins. A variety of other factors have also continued to affect the industry, including an increasingly complex regulatory compliance environment and changes to mortgage backed security programs, including increases in guarantee fees.  Future conforming origination volumes and loan margins may be negatively impacted by higher interest rates and increases in guarantee fees.

 

During 2014, the origination environment reflected a lower volume, home purchase driven mortgage market. According to Fannie Mae’s January 2015 Economic and Housing Outlook, total industry loan originations declined to $1.2 trillion during 2014, a decrease of 37% from 2013 levels driven by a 55% decline in refinancing activity and a 11% decline in purchase activity.  Our refinance closings were down 52% during 2014 compared to the prior year, which was driven by lower overall consumer demand from relatively higher interest rates and a 76% decline in HARP closings.  While our purchase closings (based on unpaid principal balance) increased by 5% during 2014, our results of operations were negatively impacted by a 5% decline in the number of purchase closing units.  Fannie Mae’s Economic and Housing Outlook is projecting total loan originations of $1.2 trillion for 2015, with refinancing closings representing approximately 40% of the share.

 

A shift in the mix of our originations to a greater percentage of fee-based closings negatively impacted the profitability of our Mortgage Production segment during 2014.  Fee-based closings represented 66% and 51% of our total origination volume during the year ended December 31, 2014 and 2013, respectively.  Fee-based closings generally consist of higher average loan amounts than saleable closings and are impacted by the mortgage product and loan programs our PLS clients market to their customers, as well as the amount of mortgage loans our clients want to retain on their balance sheets.

 

See “Part I—Item 1A. Risk Factors—Risks Related to Our Company—The profitability of our Mortgage Production segment has been adversely affected by the increased mix of fee-based closings originated under our existing private label client contracts.  We are currently evaluating a number of alternatives to restructure these contracts to improve the economics of the underlying contractual relationships; however, there can be no assurances that we will be successful in these efforts.” in this Form 10-K for more information.

 

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Segment Metrics:

 

 

 

Year Ended December 31,

 

 

 

2014

 

2013

 

2012

 

 

 

($ In millions)

 

Closings:

 

 

 

 

 

 

 

Saleable to investors

 

$

12,389

 

$

25,675

 

$

36,022

 

Fee-based

 

23,572

 

26,692

 

19,562

 

Total

 

$

35,961

 

$

52,367

 

$

55,584

 

Purchase

 

$

20,105

 

$

19,141

 

$

17,549

 

Refinance

 

15,856

 

33,226

 

38,035

 

Total

 

$

35,961

 

$

52,367

 

$

55,584

 

Retail - PLS

 

$

26,015

 

$

35,136

 

$

31,239

 

Retail - Real Estate

 

8,593

 

12,221

 

14,280

 

Total retail

 

34,608

 

47,357

 

45,519

 

Wholesale/correspondent

 

1,353

 

5,010

 

10,065

 

Total

 

$

35,961

 

$

52,367

 

$

55,584

 

Retail - PLS (units)

 

54,105

 

89,137

 

89,980

 

Retail - Real Estate (units)

 

34,131

 

50,158

 

57,033

 

Total retail (units)

 

88,236

 

139,295

 

147,013

 

Wholesale/correspondent (units)

 

5,940

 

22,166

 

47,462

 

Total (units)

 

94,176

 

161,461

 

194,475

 

 

 

 

 

 

 

 

 

Applications:

 

 

 

 

 

 

 

Saleable to investors

 

$

16,895

 

$

29,851

 

$

47,600

 

Fee-based

 

28,696

 

28,973

 

24,790

 

Total

 

$

45,591

 

$

58,824

 

$

72,390

 

Retail - PLS

 

$

32,810

 

$

38,954

 

$

42,206

 

Retail - Real Estate

 

10,727

 

14,135

 

18,194

 

Total retail

 

43,537

 

53,089

 

60,400

 

Wholesale/correspondent

 

2,054

 

5,735

 

11,990

 

Total

 

$

45,591

 

$

58,824

 

$

72,390

 

Retail - PLS (units)

 

68,258

 

97,932

 

120,352

 

Retail - Real Estate (units)

 

42,123

 

57,897

 

71,373

 

Total retail (units)

 

110,381

 

155,829

 

191,725

 

Wholesale/correspondent (units)

 

9,015

 

25,227

 

56,266

 

Total (units)

 

119,396

 

181,056

 

247,991

 

 

 

 

 

 

 

 

 

Other:

 

 

 

 

 

 

 

IRLCs expected to close

 

$

7,262

 

$

15,387

 

$

26,599

 

Total loan margin on IRLCs (in basis points)

 

282

 

344

 

392

 

Loans sold

 

$

12,555

 

$

27,242

 

$

36,582

 

 

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Segment Results:

 

 

 

Year Ended December 31,

 

 

 

2014

 

2013

 

2012

 

 

 

(In millions)

 

Origination and other loan fees

 

$

231

 

$

307

 

$

346

 

Gain on loans held for sale, net

 

264

 

575

 

942

 

Net interest expense:

 

 

 

 

 

 

 

Interest income

 

38

 

63

 

84

 

Secured interest expense

 

(26)

 

(52)

 

(68)

 

Unsecured interest expense

 

(51)

 

(75)

 

(82)

 

Net interest expense

 

(39)

 

(64)

 

(66)

 

Other income

 

9

 

3

 

12

 

Net revenues

 

465

 

821

 

1,234

 

Salaries and related expenses

 

231

 

317

 

295

 

Commissions

 

78

 

110

 

124

 

Occupancy and other office expenses

 

31

 

34

 

31

 

Depreciation and amortization

 

12

 

13

 

7

 

Loan origination expenses

 

85

 

109

 

125

 

Professional and third-party service fees

 

34

 

39

 

42

 

Technology equipment and software expenses

 

3

 

4

 

4

 

Other operating expenses

 

126

 

144

 

131

 

Total expenses

 

600

 

770

 

759

 

(Loss) income before income taxes

 

(135)

 

51

 

475

 

Less: net income attributable to noncontrolling interest

 

6

 

29

 

59

 

Segment (loss) profit

 

$

(141)

 

$

22

 

$

416

 

 

2014 Compared With 2013:  Mortgage Production segment loss was $141 million during 2014, compared to a segment profit of $22 million during 2013.  Net revenues decreased to $465 million, down $356 million, or 43%, compared with the prior year driven by lower volumes of refinance activity, an increased mix of fee-based closings and lower loan margins and economic hedge results.  Total expenses decreased to $600 million, down $170 million, or 22%, compared with the prior year primarily driven by a decline in origination volumes which resulted in lower salaries and related expenses, commissions and loan origination expenses.

 

Net revenues.  Origination and other loan fees decreased to $231 million, down $76 million, or 25%, compared to the prior year.  A 37% decline in total retail closing units, primarily from lower refinance closings, contributed to a $41 million decrease in application fees, appraisal income and other underwriting income.  In addition, Origination and other loan fees were lower due to a $30 million decrease in origination assistance fees from our PLS channel resulting from a 39% decline in PLS closing units compared to the prior year.  Interest income and secured interest expense were lower by $25 million and $26 million, respectively, compared with 2013 which was primarily driven by a lower average volume of mortgage loans held for sale.  Allocated unsecured interest expense decreased to $51 million, down $24 million, or 32%, compared to the prior year driven by the completion of our capital strategy to reduce our corporate unsecured debt levels and reduce our cost of debt.

 

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Gain on loans held for sale, net was $311 million lower compared to the prior year driven by a $255 million decline in gain on loans related to a 53% decrease in IRLCs expected to close and a 62 basis points decline in average total loan margins, coupled with a $65 million decrease in economic hedge results.  Consistent with our expectations, the decrease in IRLCs expected to close and average total loan margins was attributable to lower consumer demand for refinancing activity and an increased mix of fee-based production (where we do not enter into an IRLC).  The $65 million decline in economic hedge results compared with 2013 was primarily attributable to a lower impact from pullthrough assumptions associated with a decrease in the average outstanding balance of IRLCs expected to close and lower execution gains on mortgage loans sold.  There was a $9 million favorable change in fair value of Scratch and Dent and certain non-conforming loans compared with the prior year which was primarily driven by lower repurchase activity.

 

Other income increased by $6 million compared to the prior year which was primarily attributable to a $5 million impairment charge recorded during 2013 related to a reduction in the value of our equity method investment.  There was no impairment charge recorded during 2014.

 

Total expensesSalaries, benefits and incentives decreased to $221 million, down $73 million, or 25%, compared to the prior year primarily driven by a decline in headcount and lower severance expenses.  During 2013, we announced actions to lower staffing levels in response to projected declines in industry origination volumes which resulted in $22 million of severance expenses that were recorded during the prior year.  Contract labor and overtime was $13 million lower compared with 2013 driven by a decline in overall closing volumes and our cost management initiatives.  Commissions were down $32 million, or 29%, compared to the prior year primarily due to a 30% decrease in real estate channel closings.

 

Loan origination expenses decreased by $24 million, or 22%, compared with 2013 due to a 29% decrease in the total number of retail application units.  Professional and third-party service fees decreased by $5 million compared with 2013 primarily due to lower outsourced service fees associated with our closing volume.  Other expenses decreased to $28 million, down $15 million, or 35%, compared to the prior year which primarily related to benefits from improved operating execution resulting in declines in customer service related expenses and lower costs from the realization of other corporate cost reduction initiatives.

 

See “—Other” for a discussion of the Corporate overhead allocation.

 

2013 Compared With 2012:  Mortgage Production segment profit was $22 million, a decrease of $394 million, or 95%, from 2012.  Net revenues decreased to $821 million, down $413 million, or 33% compared with the prior year primarily driven by lower loan margins and origination volume resulting from an increase in interest rates.  Segment profit was also negatively affected by a decrease in economic hedge results and a shift in the mix of our originations to a greater percentage of fee-based closings.  Total expenses increased to $770 million, up $11 million, or 1% compared with the prior year driven by higher salaries, benefits and incentives and corporate overhead allocations which were partially offset by a decrease in commissions and loan origination expenses resulting from lower closing volumes.

 

Net revenues.  Origination and other loan fees decreased to $307 million, down 11% from 2012 driven by a $16 million decrease in application fees related to higher HARP volume (which has lower fee income), a $6 million decrease in correspondent underwriting fees and lower overall fee income from a 12% decline in closing units in our real estate channel.  In addition, origination assistance fees from our PLS channel were $8 million lower compared to the prior year primarily due to higher HARP volume.

 

Gain on loans held for sale, net was $322 million lower compared to 2012 driven by a 42% decrease in IRLCs expected to close and a 48 basis points decrease in average total loan margins.  During 2013, our IRLCs expected to close were negatively affected by an increase in interest rates leading to lower consumer demand as refinance incentives and opportunities for prospective borrowers declined, as well as an increased mix of fee-based production (where we do not enter into an IRLC).  Economic hedge results were down $65 million, or 36% primarily driven by lower execution gains on mortgage loans sold.

 

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Total expenses.  Salaries, benefits and incentives increased by $34 million compared to the prior year which included a $20 million increase in severance expense associated with the planned actions to adjust our staffing levels to a lower overall origination environment.  In addition, we maintained excess origination capacity earlier in 2013 in preparation for the spring home buying season and the launch of our private label relationship with HSBC.  Contract labor and overtime was $12 million lower compared with 2012 driven by a decline in overall closing volumes.  Commissions were down $14 million, or 11%, compared to the prior year primarily due to a 14% decrease in real estate channel closings.

 

Loan origination expenses decreased by $16 million, or 13%, compared with 2012 due to a 19% decrease in the total number of retail application units.  Other expenses decreased to $43 million, down $7 million, or 14%, compared to the prior year which primarily related a decrease in the provisions for legal and regulatory matters and lower operating costs that were partially offset by increases in quality related customer service expenses.

 

The $20 million increase in corporate overhead allocations was driven by information technology-related expenses associated with private label implementations which are allocated fully to the Mortgage Production segment and higher professional and third-party service fees related to strategic initiatives and new outsourcing arrangements.  See “—Other” for a further discussion of the Corporate overhead allocation.

 

Selected Income Statement Data:

 

 

 

Year Ended December 31,

 

 

 

2014

 

2013

 

2012

 

 

 

(In millions)

Gain on loans held for sale, net:

 

 

 

 

 

 

 

Gain on loans

 

$

227

 

$

482

 

$

804

 

Change in fair value of Scratch and Dent and certain non-conforming mortgage loans

 

(12)

 

(21)

 

(41)

 

Economic hedge results

 

49

 

114

 

179

 

Total change in fair value of mortgage loans and related derivatives

 

37

 

93

 

138

 

Total

 

$

264

 

$

575

 

$

942

 

 

 

 

 

 

 

 

 

Salaries and related expenses:

 

 

 

 

 

 

 

Salaries, benefits and incentives

 

$

221

 

$

294

 

$

260

 

Contract labor and overtime

 

10

 

23

 

35

 

Total

 

$

231

 

$

317

 

$

295

 

 

 

 

 

 

 

 

 

Other operating expenses:

 

 

 

 

 

 

 

Corporate overhead allocation

 

$

98

 

$

101

 

$

81

 

Other expenses

 

28

 

43

 

50

 

Total

 

$

126

 

$

144

 

$

131

 

 

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Table of Contents

 

Following are descriptions of the contents and drivers of the financial results of the Mortgage Production segment:

 

Origination and other loan fees consist of fee income earned on all loan originations, including loans that are saleable to investors and fee-based closings.  Retail closings and fee-based closings are key drivers of Origination and other loan fees and the fee income earned on those loans consists of application and underwriting fees, fees on cancelled loans and amounts earned from financial institutions related to brokered loan fees and origination assistance fees resulting from our private-label mortgage outsourcing activities.

 

Gain on loans held for sale, net includes realized and unrealized gains and losses on our mortgage loans, as well as the changes in fair value of our IRLCs and loan-related derivatives.  The fair value of our IRLCs is based upon the estimated fair value of the underlying mortgage loan, adjusted for: (i) the estimated costs to complete and originate the loan and (ii) the estimated percentage of IRLCs that will result in a closed mortgage loan.

 

Gain on loans is primarily driven by the volume of IRLCs expected to close, total loan margins and the mix of wholesale/correspondent closing volume.  For wholesale/correspondent closings and certain retail closings from our private label clients, the cost to acquire the loan reduces the gain from selling the loan into the secondary market.  Change in fair value of Scratch and Dent and certain non-conforming mortgage loans is primarily driven by additions, sales and changes in value of Scratch and Dent loans, which represent loans with origination flaws or performance issues.  Economic hedge results represent the change in value of mortgage loans, interest rate lock commitments and related derivatives, including the impact of changes in actual pullthrough as compared to our initial assumptions.

 

Salaries and related expenses consist of salaries, payroll taxes, benefits and incentives paid to employees in our mortgage production operations.  These expenses are primarily driven by the average number of permanent employees.

 

Commissions for employees involved in the loan origination process are primarily driven by the volume of retail closings.  Closings from our real estate channel have higher commission rates than private label closings.

 

Loan origination expenses represent variable costs directly related to the volume of loan originations and consist of appraisal, underwriting and other direct loan origination expenses.  These expenses are primarily driven by the volume of applications.

 

Other operating expenses consist of allocations for corporate overhead and other production related expenses.

 

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Table of Contents

 

Mortgage Servicing Segment

 

 

Segment Overview

 

Our Mortgage Servicing segment services mortgage loans originated by PHH Mortgage, purchases mortgage servicing rights and acts as subservicer for certain clients that own the underlying servicing rights.  The segment principally generates revenue through fees earned from our Mortgage servicing rights, which are capitalized on our balance sheets, or from our subservicing agreements, which are not capitalized.  Mortgage servicing rights (MSRs) are the rights to receive a portion of the interest coupon and fees collected from the mortgagors for performing specified mortgage servicing activities, which consist of collecting loan payments, remitting principal and interest payments to investors, managing escrow funds for the payment of mortgage-related expenses such as taxes and insurance, performing loss mitigation activities on behalf of investors and otherwise administering our mortgage loan servicing portfolio.  For 2013 and 2012, our Mortgage Servicing segment also includes the results of our reinsurance activities from our wholly owned subsidiary, Atrium Reinsurance Corporation and the related losses on the termination of the contracts. Beginning in the second half of 2013, we no longer have exposure to losses from contractual reinsurance agreements.

 

We use a combination of derivative instruments to protect against potential adverse changes in the fair value of our MSRs resulting from a decline in interest rates. If the derivative instruments are effective, the change in fair value of derivatives is intended to react in the opposite direction of the market-related change in the fair value of MSRs, and generally increase in value as interest rates decline and decrease in value as interest rates rise.  The size and composition of derivatives instruments used depends on a variety of factors, including the potential decline in value of our MSRs based on our evaluation of the current market environment and the interest rate risk inherent in our capitalized servicing portfolio which requires assumptions with regards to future replenishment rates, loan margins, the value of additions to MSRs and loan origination costs.  Many factors can impact these estimates, including loan pricing margins, the availability of liquidity to fund additions to our capitalized MSRs and the ability to adjust staffing levels to meet changing consumer demand.  As a result, our decisions regarding the levels, if any, of our derivatives related to mortgage servicing rights could result in continued volatility in the results of operations for our Mortgage Servicing segment.

 

Our shift to a greater mix of subserviced loans has resulted in an increase in subservicing fees, which is partially offset by higher costs to support the growth in the portfolio.  The subservicing fee revenue is generally lower than the servicing fee received by the owner of the MSRs; however, there are lower risks in subservicing loans as opposed to owning the MSR asset.   In the long-term, we should experience benefits to our capital structure as we will require less capital to fund capitalized MSRs and related servicing advances. We expect that the increased mix of subservicing may result in lower Segment profit that is offset by a higher return on equity in the Mortgage Servicing segment since subservicing is less capital intensive than owning MSRs.  Furthermore, we expect that the growth in the subservicing portfolio would also result in lower MSR amortization, curtailment interest expense and payoff-related costs, which would reduce the earnings volatility from changes in interest rates.

 

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Table of Contents

 

Outlook and Trends

 

In recent years, the residential mortgage industry has been under heightened scrutiny from federal, state and local regulators which has resulted in, and will likely continue to result in, higher legal, compliance and servicing related costs across the industry.  In addition, our servicing operations have been negatively impacted by conditions in the housing market and general economic factors, including higher unemployment rates, which have led to elevated levels of delinquencies.  We have also experienced volatility in repurchase and indemnification requests and high loss severities on defaulted loans.

 

The transfer of MSRs and compliance with the uniform servicing standards issued by the CFPB has continued to be the focus of many federal and state regulators.  In particular, the New York Department of Financial Services terminated a bulk MSR sale of a large non-bank specialty servicer during 2014 over concerns about the servicer’s ability to adequately service the acquired loan portfolio.  On August 19, 2014, in response to a continuing high volume of servicing transfers within the industry, the CFPB issued a compliance bulletin and policy guidance (which replaced a previously released bulletin) outlining compliance requirements with federal consumer financial laws related to transfers of MSRs.  We are monitoring developments in this area, and are considering whether there may be limitations on our ability to pursue business opportunities as a result of these trends.

 

In January 2014, we adopted the CFPB’s rules to address mortgage servicing reforms and create uniform standards for the mortgage servicing industry.  These rules increase requirements for communications with borrowers, address requirements around the maintenance of customer account records, govern procedural requirements for responding to written borrower requests and complaints of errors, and provide guidance around servicing of delinquent loans, foreclosure proceedings and loss mitigation efforts, among other measures.  On September 29, 2014, the CFPB announced its first enforcement action under these new mortgage servicing rules.  The enforcement action was taken against a large savings bank and alleged violations of federal consumer financial laws related to the servicer’s loss mitigation practices and default servicing operations.  The servicer ultimately agreed to pay a total of $38 million in borrower restitution and civil money penalties.  Upon our adoption of these new mortgage servicing rules, we implemented changes in our servicing operations to address the requirements and we expect the CFPB to continue to closely monitor compliance with these new rules.

 

For more information, see “Part I—Item 1A. Risk Factors—Risks Related to our Company —Our business is complex and heavily regulated, and the full impact of regulatory developments to our business remains uncertain. In addition, we are subject to litigation, regulatory investigations, inquiries and proceedings and we may incur fines, penalties, and increased costs that could negatively impact our future results of operations, liquidity and cash flows or damage our reputation.” in this Form 10-K.

 

With respect to legacy repurchase and indemnification exposure, many of our larger competitors have announced settlements with Fannie Mae and Freddie Mac to resolve such repurchase matters.  During the fourth quarter of 2014, we entered into a resolution agreement with Fannie Mae to substantially resolve all outstanding and certain future repurchase and makewhole requests related to the sale of mortgage loans that were originated and delivered prior to July 1, 2012.  The resolution agreement did not cover loans with excluded defects, which include but are not limited to, loans with certain title defects or with violations of law.  The resolution agreement resulted in a $5 million provision during 2014 which was recorded in Other operating expenses.

 

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Table of Contents

 

Segment Metrics:

 

 

 

December 31,

 

 

 

2014

 

2013

 

2012

 

 

 

($ In millions)

 

Total loan servicing portfolio

 

$

227,272

 

$

226,837

 

$

183,730

 

Number of loans in owned portfolio (units)

 

712,643

 

824,992

 

882,591

 

Number of subserviced loans (units)

 

446,381

 

390,070

 

132,695

 

Total number of loans serviced (units)

 

1,159,024

 

1,215,062

 

1,015,286

 

Capitalized loan servicing portfolio

 

$

112,686

 

$

129,145

 

$

140,381

 

Capitalized servicing rate

 

0.89

%

0.99

%

0.73

%

Capitalized servicing multiple

 

3.1

 

3.4

 

2.4

 

Weighted-average servicing fee (in basis points)

 

29

 

29

 

30

 

 

 

 

Year Ended December 31,

 

 

 

2014

 

2013

 

2012

 

 

 

(In millions)

 

Average total loan servicing portfolio

 

$

226,438

 

$

210,379

 

$

185,859

 

Average capitalized loan servicing portfolio

 

123,090

 

134,028

 

146,379

 

Payoffs and principal curtailments of capitalized portfolio

 

18,463

 

33,328

 

38,307

 

Sales of capitalized portfolio

 

6,929

 

40

 

7

 

 

Segment Results:

 

 

 

Year Ended December 31,

 

 

 

2014

 

2013

 

2012

 

 

 

(In millions)

 

Net loan servicing income (loss):

 

 

 

 

 

 

 

Loan servicing income

 

$

448

 

$

436

 

$

449

 

Change in fair value of mortgage servicing rights

 

(320)

 

13

 

(497)

 

Net derivative gain (loss) related to mortgage servicing rights

 

82

 

(19)

 

(5)

 

Net loan servicing income (loss)

 

210

 

430

 

(53)

 

Net interest expense:

 

 

 

 

 

 

 

Interest income

 

4

 

7

 

7

 

Secured interest expense

 

(9)

 

(7)

 

(12)

 

Unsecured interest expense

 

(44)

 

(51)

 

(50)

 

Net interest expense

 

(49)

 

(51)

 

(55)

 

Other income

 

2

 

 

 

Net revenues

 

163

 

379

 

(108)

 

Salaries and related expenses

 

60

 

53

 

37

 

Occupancy and other office expenses

 

17

 

13

 

10

 

Depreciation and amortization

 

2

 

1

 

 

Foreclosure and repossession expenses

 

56

 

61

 

44

 

Professional and third-party service fees

 

31

 

24

 

19

 

Technology equipment and software expenses

 

16

 

14

 

13

 

Other operating expenses

 

84

 

58

 

233

 

Total expenses

 

266

 

224

 

356

 

Segment (loss) profit

 

$

(103)

 

$

155

 

$

(464)

 

 

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Table of Contents

 

2014 Compared With 2013:  Mortgage Servicing segment loss was $103 million during 2014 compared to a segment profit of $155 million in 2013.  Net revenues decreased to $163 million, down $216 million, or 57%, compared with 2013 primarily driven by unfavorable MSR market-related fair value adjustments that were partially offset by lower prepayment activity, net gains on MSR derivatives and a loss recorded in 2013 related to the termination of an inactive reinsurance contract.  Total expenses increased to $266 million, up $42 million, or 19%, compared to the prior year primarily driven by provisions for legal and regulatory matters, higher Salaries and related expenses and an increase in Corporate overhead allocations which were partially offset by lower Repurchase and foreclosure-related charges and Foreclosure and repossession expenses.

 

Net revenues.  Servicing fees from our capitalized portfolio decreased by $38 million, or 10%, compared to the prior year driven by an 8% decrease in the average capitalized loan servicing portfolio.  Lower refinancing activity in 2014 resulted in a 53% decrease in payoffs in our capitalized loan servicing portfolio, which drove a $24 million, or 62%, decrease in curtailment interest paid to investors and a $107 million decrease in MSR valuation changes from actual prepayments of the underlying mortgage loans.  Late fees and other ancillary revenue were $47 million, down $10 million, or 18% compared to the prior year which includes a $5 million decrease in tax service fee income related to lower closing volumes and a $7 million decline in other ancillary revenue from the total servicing portfolio due to a decrease in the number of loans in our capitalized portfolio, lower payoff activity and improving delinquencies.  These decreases in ancillary servicing revenue were partially offset by a $2 million net gain on the sale of existing MSRs during 2014.  Unsecured interest expense decreased to $44 million, down $7 million, or 14%, compared with the prior year which reflects a decline in allocated cost driven by a lower average balance of MSRs and the completion of our capital strategy to reduce our corporate unsecured debt levels and reduce our cost of debt.

 

During 2014, Market-related fair value adjustments decreased the value of our MSRs by $165 million.  During 2014, we observed a 71 basis point decline in the mortgage rate used to value our MSR asset and a flattening of the yield curve; however prepayments in our capitalized portfolio declined by 53% compared to the prior year as the refinance incentive decreased and prepayments became less sensitive to changes in interest rates. The declines from interest rates and the yield curve during 2014 were partially offset by a $44 million increase in the value of our MSRs from adjustments in modeled prepayment speeds.  During 2013, Market-related fair value adjustments increased the value of our MSRs by $276 million which was driven largely by a 128 basis points increase in the primary mortgage rate used to value our MSR and a steepening of the yield curve that were partially offset by a $35 million decrease from lower projected servicing cash flows for delinquent and foreclosed loans, a $26 million decrease from an update to our prepayment model and a $14 million decrease related to expected prepayment activity from HARP refinances.

 

Changes in interest rates during each period drove a net gain on MSR derivatives of $82 million during 2014, compared to a net loss of $19 million during 2013.  Our hedge coverage ratio increased during the fourth quarter of 2014 as interest rates declined to a level that created in the money positions in our MSR hedge portfolio.

 

Subservicing fees increased to $59 million during 2014, up $17 million, or 40%, compared with 2013.  The increase in Subservicing fees reflects the full impact from the $47 billion subservicing portfolio assumed during the second quarter of 2013, the execution of our MSR flow sale arrangements to sell a portion of our newly-created MSRs and a greater mix of fee-based closings.  Net reinsurance loss for 2013 included a nonrecurring $21 million pre-tax loss related to the termination of an inactive reinsurance contract.

 

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Total expenses.  We recorded a $2 million benefit for Repurchase and foreclosure-related charges during 2014, compared to a provision of $7 million during the prior year.  The $2 million benefit during 2014 was primarily attributable to a decline in the population of outstanding repurchase requests from private investors and a decrease in the actual and projected number of repurchase and indemnification requests to reflect more recent repurchase activity trends for vintage years that are not subject to the resolution agreement.  These declines were partially offset by a $5 million provision for Repurchase and foreclosure-related charges related to the resolution agreement with Fannie Mae. The $7 million provision for Repurchase and foreclosure-related charges during 2013 was primarily driven by expenses not reimbursed pursuant to government mortgage insurance programs that were offset by an improvement in actual and estimated future loss severities.

 

Salaries and related expenses increased by $7 million compared to the prior year which was primarily driven by an increase in the average number of permanent employees from the transfer of certain employees into our servicing operations when we commenced subservicing activities on the portfolio that was assumed in the second quarter of 2013.  We also experienced higher management incentives during 2014.

 

Professional and third-party service fees increased by $7 million during 2014, or 29%, compared with 2013 primarily driven by an increase in costs related to managing a larger subservicing portfolio and higher legal fees in connection with various legal and regulatory matters.  Foreclosure and repossession expenses decreased by $5 million compared to the prior year driven by a decrease in unreimbursed servicing and interest costs from delinquent and foreclosed government loans. Other expenses increased by $26 million compared with 2013 primarily due to $27 million of provisions for legal and regulatory matters.  Other expenses also included a $3 million increase in quality related costs from compensatory fees associated with foreclosure proceedings that was offset by a $5 million decrease in tax service fee expenses related to lower closing volumes.

 

See “—Other” for a discussion of the Corporate overhead allocation.

 

2013 Compared With 2012:  Mortgage Servicing segment profit was $155 million during 2013, compared to a segment loss of $464 million in 2012.  Net revenues increased to $379 million during 2013 driven by positive MSR market-related fair value adjustments resulting from an increase in mortgage interest rates during the period.  During 2012, Net revenues were negative due to unfavorable MSR market-related fair value adjustments as interest rates declined during that period.  Total expenses decreased to $224 million, down $132 million, or 37% compared to the prior year primarily driven by lower Repurchase and foreclosure-related charges that were offset by an increase in Foreclosure and repossession expenses and higher Salaries and related expenses primarily associated with the increased subservicing portfolio.

 

Net revenues.  Servicing fees from our capitalized servicing portfolio decreased by $42 million, or 10% compared to the prior year driven by an 8% decrease in the average capitalized loan servicing portfolio and a decline in the weighted-average servicing fee.  Our MSR replenishment rate was 80% during 2013 and loan payoffs with a higher total servicing fee were replaced by new production with lower servicing fees.  Lower refinancing activity in 2013 resulted in a 15% decrease in payoffs in our capitalized loan servicing portfolio, which drove a $6 million, or 13%, decrease in curtailment interest paid to investors and a $16 million decrease in actual prepayments of the underlying mortgage loans.

 

During 2013, Market-related fair value adjustments increased the value of our MSRs by $276 million compared to a decrease of $223 million in the prior year driven largely by changes in the interest rate environment during each period.  The primary mortgage rate used to value our MSR increased by 128 basis points compared to a decrease of 66 basis points during 2012.  While Market-related fair value adjustments were positively impacted by increasing interest rates and a steepening of the yield curve during 2013, our Market-related fair value adjustments reflect a $35 million decrease from lower projected servicing cash flows for delinquent and foreclosed loans, a $26 million decrease from an update to our prepayment model and a $14 million decrease related to expected prepayment activity from HARP refinances.

 

Loan servicing income for 2013 included a positive impact from the assumption of a subservicing portfolio with an unpaid principal balance of $47 billion in the second quarter of 2013.  Our subservicing fees were $42 million, an increase of $28 million compared with the prior year resulting from a 110% increase in the average number of loans in our subserviced portfolio and an increase in the average subservicing fee earned per loan.

 

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Table of Contents

 

During 2013 and 2012, Loan servicing income also included losses related to the termination of inactive reinsurance contracts which totaled $21 million and $16 million, respectively.

 

Total expenses.  Repurchase and foreclosure-related charges were $7 million during 2013, down $175 million from the prior year.  During 2013, the Agencies worked towards the Federal Housing and Finance Administration’s goal to be complete with all pre-2009 repurchase and indemnification requests by the end of 2013 which was reflected in our estimated reserve as of December 31, 2013.  The $7 million provision for Repurchase and foreclosure-related charges during 2013 was primarily driven by expenses not reimbursed pursuant to government mortgage insurance programs that were offset by an improvement in actual and estimated future loss severities.  During 2012, Repurchase and foreclosure-related charges were $182 million which was driven by a significant increase in the actual and projected number of repurchase and indemnification requests and a decline in our success rate in appealing repurchase and indemnification requests.  The total number of repurchase requests during 2012 increased by 52% compared with 2011 which was driven by the Agencies focus on clearing the backlog of previously requested loan files for the pre-2009 vintage years.

 

Salaries and related expenses increased by $16 million compared to the prior year which was driven by an increase in the average number of permanent employees in 2013 and the full impact of additional resources that were added throughout the second half of 2012 in order to implement new industry servicing and compliances practices.  The increase in permanent employees during 2013 was primarily driven by the transfer of employees of HSBC into our servicing operations when we commenced subservicing activities.

 

Professional and third-party service fees increased by $5 million during 2013, or 26%, compared with 2012 driven largely by the increase in the subservicing portfolio.  Foreclosure and repossession expenses increased by $17 million compared to the prior year driven by unreimbursed servicing and interest costs and other expenses associated with servicing delinquent and foreclosed loans (primarily government loans). Other expenses declined by $6 million compared with 2012 primarily due to a decrease in tax service fee expenses related to lower closing volumes and a decrease in the provisions for legal and regulatory matters.

 

See “—Other” for a discussion of the Corporate overhead allocation.

 

Selected Income Statement Data:

 

 

 

Year Ended December 31,

 

 

 

2014

 

2013

 

2012

 

 

 

(In millions)

 

Loan servicing income:

 

 

 

 

 

 

 

Servicing fees from capitalized portfolio

 

$

357

 

$

395

 

$

437

 

Subservicing fees

 

59

 

42

 

14

 

Late fees and other ancillary servicing revenue

 

47

 

57

 

62

 

Curtailment interest paid to investors

 

(15)

 

(39)

 

(45)

 

Net reinsurance loss

 

 

(19)

 

(19)

 

Total

 

$

448

 

$

436

 

$

449

 

 

 

 

 

 

 

 

 

Changes in fair value of mortgage servicing rights:

 

 

 

 

 

 

 

Actual prepayments of the underlying mortgage loans

 

$

(110)

 

$

(217)

 

$

(233)

 

Actual receipts of recurring cash flows

 

(45)

 

(46)

 

(41)

 

Market-related fair value adjustments

 

(165)

 

276

 

(223)

 

Total

 

$

(320)

 

$

13

 

$

(497)

 

 

 

 

 

 

 

 

 

Other operating expenses:

 

 

 

 

 

 

 

Corporate overhead allocation

 

$

33

 

$

24

 

$

18

 

Repurchase and foreclosure-related charges

 

(2)

 

7

 

182

 

Other expenses

 

53

 

27

 

33

 

Total

 

$

84

 

$

58

 

$

233

 

 

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Following are descriptions of the contents and drivers of the financial results of the Mortgage Servicing segment:

 

Loan servicing income is primarily driven by the average capitalized loan servicing portfolio, the number of loans in our subservicing portfolio and the average servicing and subservicing fee.  Servicing fees from the capitalized portfolio is driven by recurring servicing fees that are recognized upon receipt of the coupon payment from the borrower and recorded net of guarantee fees due to the investor.  For loans that are subserviced, we receive a stated amount per loan which is less than our average servicing fee related to the capitalized portfolio.  Curtailment interest paid to investors represents uncollected interest from the borrower that is required to be passed onto investors and is primarily driven by the number of loan payoffs.  In addition to late fees received from borrowers, Late fees and other ancillary servicing revenue includes tax service fees, the net gain or loss from the sale of MSRs and other servicing revenue, including loss mitigation revenue.

 

For 2013 and 2012, Net reinsurance income or loss represents premiums earned on reinsurance contracts, net of ceding commission, provisions for reinsurance reserves and losses on the termination of reinsurance contracts.

 

Changes in fair value of mortgage servicing rights include actual prepayments of the underlying mortgage loans, actual receipts of recurring cash flows and market-related fair value adjustments.  The fair value of our MSRs is estimated based upon projections of expected future cash flows considering prepayment estimates, our historical prepayment rates, portfolio characteristics, interest rates based on interest rate yield curves, implied volatility, servicing costs and other economic factors.  Generally, the value of our MSRs is expected to increase when interest rates rise and decrease when interest rates decline due to the effect those changes in interest rates have on prepayment estimates.  Other factors noted above as well as the overall market demand for MSRs may also affect the valuation.

 

Actual prepayments are driven by two factors: (i) the number of loans that prepaid during the period and (ii) the current value of the mortgage servicing right asset at the time of prepayment.  Market-related fair value adjustments represent the change in fair value of MSRs due to changes in market inputs and assumptions used in the valuation model.

 

Foreclosure and repossession expenses are associated with servicing loans in foreclosure and real estate owned and are primarily driven by the size, composition and delinquency status of our loan servicing portfolio. These expenses also include unreimbursed servicing and interest costs of government loans.

 

Other operating expenses consist of Repurchase and foreclosure-related charges, allocations for corporate overhead and other servicing related expenses.  Repurchase and foreclosure-related charges are primarily driven by the actual and projected volumes of repurchase and indemnification requests, our success rate in appealing repurchase requests, expected loss severities and expenses that may not be reimbursed pursuant to government mortgage insurance programs in the event we do not file insurance claims.  Expected loss severities are impacted by various economic factors including delinquency rates and home price values while our success rate in appealing repurchase requests can fluctuate based on the validity and composition of repurchase demands and the underlying quality of the loan files.

 

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Other

 

 

Overview

 

We leverage a centralized corporate platform to provide shared services for general and administrative functions to our reportable segments.  These shared services include support associated with, among other functions, information technology, enterprise risk management, internal audit, human resources, accounting and finance and communications.  The costs associated with these shared general and administrative functions, in addition to the cost of managing the overall corporate function, are recorded within Other and allocated to our reportable segments through a corporate overhead allocation.

 

Net revenues for 2014 include income associated with a transition services agreement in which we are providing Element Financial Corporation certain transition services after the closing of the sale of the Fleet business related to, among others, information technology, human resources and financial services for a period up to 12 months from the sale date.  A majority of the costs incurred by us to provide such transition services are included in Professional and third-party service fees and are billed to Element Financial Corporation based upon the terms of the transition services agreement.

 

The Net loss before income taxes for Other includes expenses that are not allocated to our reportable segments (primarily severance costs associated with our re-engineering efforts and losses related to the early retirement of debt) and certain general corporate overhead expenses that were previously allocated to the Fleet business.  Beginning in the third quarter of 2014, all costs associated with general and administrative functions and managing our overall corporate function were allocated to the Mortgage Production and Mortgage Servicing segments.  See “—Overview—Executive Summary” for a discussion of our efforts in re-engineering our support infrastructure.

 

Results:

 

 

 

Year Ended December 31,

 

 

 

2014

 

2013

 

2012

 

 

 

(In millions)

 

Net revenues

 

$

11

 

$

 

$

 

Salaries and related expenses

 

67

 

55

 

55

 

Occupancy and other office expenses

 

3

 

3

 

2

 

Depreciation and amortization

 

9

 

9

 

8

 

Professional and third-party service fees

 

62

 

48

 

27

 

Technology equipment and software expenses

 

18

 

15

 

13

 

Other operating expenses

 

29

 

61

 

19

 

Total expenses before allocation

 

188

 

191

 

124

 

Corporate overhead allocation

 

(131)

 

(125)

 

(99)

 

Total expenses

 

57

 

66

 

25

 

 

 

 

 

 

 

 

 

Net loss before income taxes

 

$

(46)

 

$

(66)

 

$

(25)

 

 

2014 Compared With 2013:  Net loss before income taxes was $46 million, compared to a loss of $66 million in 2013.  Net revenues were $11 million for 2014 which was driven by income from a transition services agreement related to the sale of the Fleet business. Total expenses before allocations decreased to $188 million, down $3 million, or 2%, compared to the prior year primarily driven by lower debt retirement premiums associated with the early retirement of debt within Other operating expenses that was partially offset by increases in Salaries and related expenses and Professional and third-party service fees.

 

Total expenses.  Salaries and related expenses increased by $12 million in 2014, or 22%, compared to the prior year primarily due to severance costs associated with the re-engineering of our operations and support infrastructure for a stand-alone mortgage business and higher management incentive compensation.  Salaries and related expenses attributable to our headcount were lower compared with 2013 which was driven by the actions we took during the second half of 2013 and the first quarter of 2014 to realign our fixed cost structure

 

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within our support and overhead functions and the initiation of outsourcing arrangements for internal audit and information technology.

 

Professional and third-party service fees increased by $14 million in 2014, or 29%, compared with 2013 which reflects costs for providing services under the transition services agreement and increases in costs for outsourcing arrangements for internal audit and information technology that were not in effect during most of the prior year that were partially offset by declines in nonrecurring expenses related to executive and risk management strategic initiatives.

 

Other operating expenses decreased by $32 million, or 52%, compared to the prior year primarily due to $30 million of lower losses associated with the early retirement of debt.  During 2014, we recorded a $24 million pre-tax loss related to the early retirement of the remaining $170 million of outstanding Senior Notes due 2016 compared to a $54 million pre-tax loss related to the early retirement of $280 million of outstanding Senior Notes due 2016 during the prior year.

 

2013 Compared With 2012:  Net loss before income taxes was $66 million, compared to a loss of $25 million in 2012.  Total expenses before corporate allocations increased to $191 million, up $67 million, or 54%, compared to the prior year driven by higher debt retirement premiums associated with the early retirement of debt within Other operating expenses and an increase in Professional and third-party service fees.

 

Total expenses.  Professional and third-party service fees increased by $21 million in 2013, or 78%, compared with 2012 which was driven by fees associated with risk management and strategic initiatives and higher information technology costs.  The increase in technology costs during 2013 was associated with private label client implementations in our Mortgage Production segment and costs related to a new outsourcing arrangement for technology infrastructure management and application development.

 

Other operating expenses increased by $42 million, or 221%, compared to the prior year primarily due to $41 million of higher losses associated with the early retirement of debt.  During 2013, we recorded a $54 million pre-tax loss related to the early retirement of a portion of the Senior Notes due 2016 compared to a $13 million pre-tax loss related to the early retirement of the Medium-term Notes due 2013 during the prior year.

 

Corporate Overhead Allocation(1):

 

The Corporate overhead allocation to each segment is determined based upon the actual and estimated usage by function or expense category.

 

 

 

Year Ended December 31,

 

 

 

2014

 

2013

 

2012

 

 

 

(In millions)

 

Mortgage Production segment

 

$

98

 

$

101

 

$

81

 

Mortgage Servicing segment

 

33

 

24

 

18

 

Other

 

(131)

 

(125)

 

(99)

 

Total

 

$

 

$

 

$

 

______________

(1)     In January 2014, we evaluated the overhead allocation to our segments based upon current revenues, expenses, headcount and usage which resulted in an increase in the rate of allocation to our Mortgage Servicing segment with a corresponding decrease to our Mortgage Production segment for the year ended December 31, 2014.

 

Following are descriptions of the contents and drivers of our financial results:

 

Salaries and related expenses represent costs associated with operating corporate functions and our centralized management platform and consist of salaries, payroll taxes, benefits and incentives paid to shared service support employees.  These expenses are primarily driven by the average number of permanent employees.

 

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RISK MANAGEMENT

 

We are exposed to various business risks which may significantly impact our financial results including, but not limited to: (i) interest rate risk; (ii) consumer credit risk; (iii) counterparty and concentration risk; (iv) liquidity risk; and (v) operational risk. Our risk management framework and governance structure is intended to provide oversight and ongoing management of the risks inherent in our business activities and create a culture of risk awareness.  Our Chief Executive Officer and Chief Risk and Compliance Officer are responsible for the design, implementation and maintenance of our enterprise risk management program.

 

Effective January 1, 2015, our Finance & Risk Management Committee and the Regulatory Oversight Committee were consolidated into the Finance, Compliance & Risk Management Committee which performs all functions that were previously performed by the two separate committees.  The Finance, Compliance & Risk Management Committee of the Board of Directors provides oversight with respect to our risk management function and the policies, procedures and practices used in identifying and managing our material risks.

 

Our Compliance and Risk Management organization oversees governance processes and monitoring of these risks including the establishment of risk strategy and documentation of risk policies and controls.  The Compliance and Risk Management organization operates independently of the business, but works in partnership to provide oversight of enterprise risk management and controls. This includes establishing enterprise-level risk management policies, appropriate governance activities and creating risk transparency through risk reporting.

 

Risks unique to our business are governed through various committees including, but not limited to: (i) interest rate risk, including development of hedge strategy and policies, monitoring hedge positions and counterparty risk; (ii) quality control, including audits related to the processing, underwriting and closing of loans, findings of any fraud-related reviews and reviews of post-closing functions, such as FHA insurance and monitoring of overall portfolio delinquency trends and recourse activity; (iii) credit risk, including establishing credit policy, product development and changes to underwriting guidelines; and (iv) operational risk, including the development of policies and governance activities, monitoring risks related to cyber security and business continuity plans and ensuring compliance with applicable laws and regulations.

 

Interest Rate Risk

 

Our principal market exposure is to interest rate risk, specifically long-term Treasury and mortgage interest rates due to their impact on mortgage-related assets and commitments.  Additionally, our escrow earnings on our mortgage servicing rights are sensitive to changes in short-term interest rates such as LIBOR and we are also exposed to changes in short-term interest rates on certain variable rate borrowings related to mortgage warehouse debt. We anticipate that such interest rates will remain our primary benchmark for market risk for the foreseeable future.

 

We are subject to variability in our results of operations due to fluctuations in interest rates.  In a declining interest rate environment, we would expect the results of our origination business to be positively impacted by higher loan origination volumes and improved loan margins while we would expect the results of our servicing business to decline due to higher actual and projected loan prepayments related to our capitalized loan servicing portfolio.  In a rising interest rate environment, we would expect a negative impact to the results of operations of our origination business, while we would expect a positive impact to the results of operations of our servicing business. The interaction between the results of operations of our Mortgage segments is a core component of our overall interest rate risk strategy.

 

Refer to “—Item 7A. Quantitative and Qualitative Disclosures About Market Risk” for an analysis of the impact of changes in interest rates on the valuation of assets and liabilities that are sensitive to interest rates.  See “Part I—Item 1A. Risk Factors—Risks Related to our Company—Certain hedging strategies that we may use to manage risks associated with our assets, including mortgage loans held for sale, interest rate lock commitments, and mortgage servicing rights, may not be effective in mitigating those risks and could result in substantial losses that could exceed the losses that would have been incurred had we not used such hedging strategies.” and “Changes in interest rates could materially and adversely affect our volume of mortgage loan originations or reduce the value of our mortgage servicing rights, either of which could have a material adverse effect on our business, financial position, results of operations, liquidity or cash flows.” in this Form 10-K for more information.

 

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Mortgage Loans and Interest Rate Lock Commitments

 

Interest rate lock commitments represent an agreement to extend credit to a mortgage loan applicant, or an agreement to purchase a loan from a third-party originator, whereby the interest rate on the loan is set prior to funding.  Our Mortgage loans held for sale, which are held in inventory awaiting sale into the secondary market, and our Interest rate lock commitments, are subject to changes in mortgage interest rates from the date of the commitment through the sale of the loan into the secondary market.  As a result, we are exposed to interest rate risk and related price risk during the period from the date of the lock commitment through (i) the lock commitment cancellation or expiration date; or (ii) the date of sale into the secondary mortgage market.  Loan commitments generally range between 30 and 90 days; and we typically sell mortgage loans within 30 days of origination.

 

A combination of options and forward delivery commitments on mortgage-backed securities or whole loans are used to hedge our commitments to fund mortgages and our loans held for sale.  These forward delivery commitments fix the forward sales price that will be realized in the secondary market and thereby reduce the interest rate and price risk to us.  Our expectation of how many of our interest rate lock commitments will ultimately close is a key factor in determining the notional amount of derivatives used in hedging the position.

 

Mortgage Servicing Rights

 

Our mortgage servicing rights (“MSRs”) are subject to substantial interest rate risk as the mortgage notes underlying the MSRs permit the borrowers to prepay the loans.  Therefore, the value of MSRs generally tends to diminish in periods of declining interest rates (as prepayments increase) and increase in periods of rising interest rates (as prepayments decrease). Although the level of interest rates is a key driver of prepayment activity, there are other factors that influence prepayments, including home prices, underwriting standards and product characteristics.

 

In determining the need to hedge the change in fair value of our MSRs with derivatives, we consider the estimated benefit of new originations on our production business’ results of operations to determine the net economic value change from a decline in interest rates, and we continuously evaluate our ability to replenish lost MSR value and cash flow due to increased prepayments.  A replenishment rate greater than 100% is one indicator of the benefit of mortgage loan originations offsetting lost MSR value.  This risk management approach requires management to make assumptions with regards to future replenishment rates, loan margins, the value of additions to MSRs and loan origination costs. Many factors can impact these estimates, including loan pricing margins, the availability of liquidity to fund additions to our capitalized MSRs and the ability to adjust staffing levels to meet changing consumer demand.

 

During the year ended December 31, 2014, our replenishment rate was 69% which reflects $8.9 billion of additions to our capitalized servicing portfolio compared to $13.0 billion of loan payoffs.  Consistent with our strategy to shift the mix of our servicing portfolio to a greater mix of subserviced loans, subsequent to initial capitalization of the MSR, we sold MSRs with a UPB of $3.5 billion pursuant to two MSR flow sale arrangements with counterparties who purchase a portion of our newly-created servicing rights while we continue to subservice the underlying loans.

 

See “Part I—Item 1A. Risk Factors—Risks Related to our Company— We may not be able to fully or successfully execute or implement our business strategies or achieve our objectives, including our initiatives to re-engineer and grow our mortgage business.” in this Form 10-K for more information.

 

Consumer Credit Risk

 

We are not subject to the majority of the credit-related risks inherent in maintaining a mortgage loan portfolio because loans are not held for investment purposes.  We sell nearly all of the mortgage loans that we originate in the secondary mortgage market on a non-recourse basis within 30 days of origination.  Conforming loan sales are primarily in the form of mortgage-backed securities guaranteed by Fannie Mae, Freddie Mac or Ginnie Mae.

 

Our exposure to consumer credit risk primarily relates to loan repurchase and indemnification obligations from breaches of representation and warranty provisions of our loan sales or servicing agreements, which result in indemnification payments or exposure to loan defaults and foreclosures.  The representation and warranties made by us are set forth in our loan sale agreements and relate to, among other things, the ownership of the loan, the validity of the lien securing the loan, the underwriting standards required by the investor, the loan’s compliance with

 

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applicable local, state and federal laws and, for loans with a loan-to-value ratios greater than 80%, the existence of primary mortgage insurance.  Investors routinely request loan files to review for potential breaches of representation and warranties.

 

In an effort to minimize losses from loan repurchases and indemnifications, we focus on originating high quality mortgage loans and closely monitor investor and agency eligibility requirements for loan sales.  Our quality review teams perform audits related to the processing, underwriting and closing of mortgage loans prior to, or shortly after, the sale of loans to identify any potential repurchase exposures due to breach of representations and warranties.  In the event a breach of these representation and warranties is identified by an investor, the investor will issue a repurchase demand and we may be required to repurchase the mortgage loan or indemnify the investor against loss.  We subject the population of repurchase and indemnification requests to a comprehensive review and appeals process to establish the validity of the claim and determine our corresponding obligation.

 

Trends in Repurchase Experience

 

In recent years, we have experienced elevated levels of mortgage loan repurchase and indemnification requests as the Agencies focused on completing their reviews of loans for pre-2009 origination years.  We believe the Agencies substantially completed their reviews of loans originated prior to 2009 by the end of 2013 and the number of repurchase and indemnification requests we received during the year ended December 31, 2014 was consistent with our expectations.   As a result, we have seen the unpaid principal balance of our unresolved requests for loans originated between 2005 and 2008 decline to $32 million as of December 31, 2014, from $143 million at the end of 2013.  During October 2014, we entered into a resolution agreement with Fannie Mae to resolve substantially all outstanding and certain future repurchase and makewhole requests related to the sale of mortgage loans that were originated and delivered prior to July 1, 2012.  After credit for paid claims and other adjustments, we paid Fannie Mae $13 million.  The resolution agreement does not cover loans with excluded defects, which include but are not limited to, loans with certain title issues or with violations of law.

 

Going forward, we expect a majority of our new repurchase and indemnification requests to be related to loans originated or delivered subsequent to January 1, 2013 and subject to the new representation and warranty framework for conventional loans.  During 2014, at the FHFA’s direction, the Agencies announced several changes to the framework in an effort to enhance transparency and clarify post-delivery quality control practices.  Specifically, the changes introduced in May 2014 included: (i) relaxing the 36 month timely payment history requirement to permit two instances of 30 day delinquency; (ii) providing alternative paths for mortgages to obtain relief under the framework which includes an acceptable payment history or a satisfactory conclusion of a quality control loan file review and (iii) providing alternatives to repurchasing a loan where the mortgage insurance coverage has been rescinded.  In October 2014, the Agencies further announced changes to clarify and define the life-of-loan exclusions that would require lenders to repurchase loans at any point.  The exclusions involve loans with: (i) misrepresentations, misstatements and omissions involving a minimum number of loans; (ii) data inaccuracies involving a minimum number of loans; (iii) charter compliance issues; (iv) lien and title issues; (v) legal compliance violations and (vi) unacceptable mortgage products.  While the Agencies have provided some clarity and transparency by issuing updates and guidelines for the new framework; the full impact on our future loss experience is uncertain. We intend to continue to monitor our experience with file reviews subject to the new framework to refine our expectations and loss estimates.

 

Established Reserves

 

We have established a loan repurchase and indemnification liability for our estimate of exposure to losses related to our obligation to repurchase or indemnify investors for loans sold.  This liability represents management’s estimate of probable losses based on the best information available and requires the application of a significant level of judgment and the use of a number of assumptions.  In limited circumstances, the full risk of loss on loans sold is retained to the extent the liquidation of the underlying collateral is insufficient. In some instances where we have purchased loans from third parties, we may have the ability to recover the loss from the third party originator.  See Note 13, “Credit Risk”, in the accompanying Notes to Consolidated Financial Statements and “—Critical Accounting Policies and Estimates” for additional information regarding our repurchase and foreclosure-related reserves.

 

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Actual losses incurred in connection with loan repurchases and indemnifications could vary significantly from and exceed the recorded liability and we may be required to increase our loan repurchase and indemnification liability in the future.  Accordingly, there can be no assurance that actual losses or estimates of reasonably possible losses associated with loan repurchases and indemnifications will not be in excess of the recorded liability or that we will not be required to increase the recorded liability in the future.

 

Given the inherent uncertainties involved in estimating losses associated with future repurchase and indemnification requests, there is a reasonable possibility that future losses may be in excess of the recorded liability.  As of December 31, 2014, the estimated amount of reasonably possible losses in excess of the recorded liability was approximately $20 million which relates to our estimate of repurchase and foreclosure-related charges that may not be reimbursed pursuant to government mortgage insurance programs in the event we do not file insurance claims.  The estimate is based on our expectation of future defaults and the historical defect rate for government insured loans and is based upon significant judgments and assumptions which can be influenced by many factors, including: (i) home prices and the levels of home equity; (ii) the quality of our underwriting procedures; (iii) borrower delinquency and default patterns; and (iv) general economic conditions.  Our estimate of reasonably possible losses does not represent probable losses and does not include an estimate for any losses related to loans from origination years where the Agencies have substantially completed or resolved their file reviews or related to loans with defects that were excluded from the resolution agreement with Fannie Mae.  Excluded defects include, but are not limited to, loans with certain title defects or with violations of law.

 

Repurchase and foreclosure-related reserves consist of the following:

 

 

 

December 31,

 

 

 

2014

 

2013

 

 

 

(In millions)

 

Loan repurchase and indemnification liability

 

$

63

 

$

100

 

Adjustment to value for real estate owned

 

16

 

22

 

Allowance for probable foreclosure losses

 

14

 

20

 

Total

 

$

93

 

$

142

 

 

The table below presents the trend over the most recent quarters of our repurchase and foreclosure-related reserves activity and the number of repurchase and indemnification requests received:

 

 

 

Three Months Ended

 

 

 

December 31,

 

September 30,

 

June 30,

 

March 31,

 

December 31,

 

 

 

2014

 

2014

 

2014

 

2014

 

2013

 

 

 

($ In millions)

 

Balance, beginning of period

 

$

103

 

$

110

 

$

120

 

$

142

 

$

180

 

Realized losses(1) 

 

(19)

 

(12)

 

(10)

 

(24)

 

(21)

 

Increase (decrease) in reserves due to:

 

 

 

 

 

 

 

 

 

 

 

Change in assumptions(2) 

 

4

 

3

 

(1)

 

 

(19)

 

New loan sales

 

5

 

2

 

1

 

2

 

2

 

Balance, end of period

 

$

93

 

$

103

 

$

110

 

$

120

 

$

142

 

 

 

 

 

 

 

 

 

 

 

 

 

Repurchase and indemnification requests received (number of loans)

 

168

 

192

 

194

 

382

 

1,017

 

 

_______________

(1)        For the three months ended December 31, 2014, includes $12 million that was paid to Fannie Mae related to the resolution agreement.

 

(2)        For the three months ended December 31, 2014, includes an $8 million provision for estimated losses related to the sale of existing MSRs.

 

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We subject the population of repurchase and indemnification requests received to a review and appeal process to establish the validity of the claim and corresponding obligation.  The following table presents the unpaid principal balance of our unresolved requests by status:

 

 

 

December 31, 2014

 

December 31, 2013

 

 

 

Investor

 

Insurer

 

 

 

Investor

 

Insurer

 

 

 

 

 

Requests

 

Requests

 

Total (4)

 

Requests

 

Requests

 

Total (4)

 

 

 

(In millions)

 

Agency Invested:

 

 

 

 

 

 

 

 

 

 

 

 

 

Claim pending (1) 

 

$

12

 

$

1

 

$

13