U.S. Markets closed

Some new names in the financial sector

David Russell (david.russell@optionmonster.com)

Back on July 6, I recommended two emerging financial names to readers of our InsideOptions Pro premium service. Since then, both have significantly outperformed the S&P 500 and probably have plenty more upside in store. This is especially true because they remain barely known and could rally as their stories attract a following.

The companies are Nationstar Mortgage (NSM) and Ocwen Financial (OCN), which service mortgages held in large pools. Before the crash of 2008, major lenders such as Bank of America and Countrywide Financial focused on originating mortgages and treated servicing as an afterthought. This is one of the reasons that such confusion occurred when delinquencies and foreclosures shot through the roof after the bubble broke.

Banks are essentially retail institutions, focused on selling products. Their loan officers are compensated by origination, not the performance of a mortgage years down the road. That's why they never anticipated the kind of problems that eventually occurred.

The result is a giant opportunity for NSM and OCN. By selling the servicing rights, banks can stick with their core retail business while shedding a major headache. And investors get pure-play stocks focused on a business that was never independent before.

Based on the results so far, these stocks are major winners. They have been rapidly growing their loan portfolios and often stand to make more money when they successfully rehabilitate delinquent mortgages and prevent foreclosures. Even better, they are emerging at the sweet spot of the credit cycle as borrowers increasingly make payments on time and home prices recover.

NSM has another trick up its sleeve. Because it has access to more than 1 million borrowers, it is perfectly positioned to originate new loans through refinancing. That gives it a big advantage over most lenders, which must advertise to gain refis.

In other words, banks pay NSM to service loans. It then uses that opportunity to compete against the very same banks in the refinancing market.

Lender Processing Services (LPS) and Corelogic (CLGX) are riding a similar wave. They are not loan servicers, but also providers of data and software to companies in the industry. Both have beaten expectations in recent quarters and made bullish comments about the future.

Another reason I like these companies is that skeletons continue to fall out of the closets at the big banks such as JP Morgan and Citigroup. Whether it's Libor, robosigning, credit-default swaps, or even questionable dealings with foreign governments, the megabanks still remain under a cloud. Mortgage-servicing companies give investors direct exposure to the improving mortgage market without any of those legacy issues.

Most of these stocks are up pretty big recently, so it's probably smart to wait for a pullback. But they seem to be in the midst of a real bull market and could offer many trading opportunities in the next year.

Three other companies seem to be following a similar trend. One is Fortress Investment Group (FIG), which owns 75 percent of NSM. Second is iStar Financial REIT (SFI), which owns a basket of commercial mortgages. It trades for about half of book value and has a big short interest.

Lastly, Portfolio Recovery Associates (PRAA) is a collections agency that has been catching fire recently as debtors increasingly pay back overdue accounts.

(A version of this article appeared in optionMONSTER's What's the Trade? newsletter of Aug. 15.)

More From optionMONSTER