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Mortgage Put-Back Exposure at H&R Block

One stock that has missed the media spotlight so far in the latest foreclosure fiasco has been H&R Block. But, traders have not missed the fact that the tax preparer is exposed to mortgage put-backs. The stock was hit hard last week, down 9.7% or 45% year to date and the lowest level since Q1 2001.

H&R Block's world headquarters in Kansas City, Missouri.
AP
H&R Block's world headquarters in Kansas City, Missouri.

While H&R Block is not exactly in a growth industry, the company did announce an acquisition last week — a deal for 2SS Holdings valued at $287.5 million. But the reason for the sell-off is really about mortgage put-back exposure from its days as owner of Option One Mortgage Corporation. H&R Block sold “Option One” (now called "Sand Canyon Corp.") back in April 2008 to American Home Mortgage Servicing, an affiliate of WL Ross & Co. for approximately $1.3 billion. But the exposure lives on.

Bill Carcache, who covers H&R Block at Macquarie Research, explained H&R Block's exposure in his most recent research note:

Exposure could be significant but still too early to know for sure. Although management indicated that it could face rep and warranty exposure on $33 billion of principal balance outstanding (down from $50 billion originally), it believes that time is on the company’s side given that the likelihood of a repurchase claim declines as a portfolio seasons.

According to Bill’s report, the company has $188 million of repurchase reserves against the potential $33 billion exposure. Market cap close of business 10/15 stood at $3.8 billion.

Chief Financial Officer Jeff Brown did confirm that as of July 31, 201 H&R Block had $188 million as an "appropriate reserve" against future potential liabilities from the loan origination business the company had sold. When I pressed him on whether that would be enough to cover a potential $33 billion liability he said you cannot know what a future loss would be (full text of his comments below).

Volume on Friday was nearly 17 million shares, about 3-times its average daily volume over the past 3-months. Scott Fullman, Director, Derivatives Investment Strategy at WJB Capital Group notes that implied volatility for some HRB options was extremely high at over 90%, the put/call ratio was 2.42 and total put volume had spiked to 21,385 contracts vs. average daily volume of 4,300 contracts.

Comment VIA Email From: Jeff Brown CFO, H&R Block

Our subsidiary, Sand Canyon Corporation (SCC) completed its exit from the mortgage loan origination and servicing business in April 2008.

SCC made certain representations and warranties with respect to the transfer of loans during the period it originated such loans. In the event that there is a material adverse effect on the purchaser's, investor's or insurer's interest in a loan which resulted from a valid breach of those repesentations and warranties, SCC may be obligated to repurchase the loan or otherwise indemnify those parties for losses incurred as a result of loan liquidation.

SCC records a reserve for contingent losses relating to representation and warranty claims by estimating loan repurchase volumes based on both known claims and projections of future claims. Projections of future claims are based on an anlysis that includes a combination of reviewing historical repurchase trends, recent repurchase activity, actual defaults and loss expectations, inquiries from various third parties and the probability that a future claim will be a valid breach of a representation and warranty.

At July 31, 2010, SCC had recorded a reserve for loan repurchase and indemnifcation obligations pertaining to claims of breach of representation and warranties of $188 million. This reserve represented our estimate of probable loss for both asserted and unasserted claims, which in the case of a repurchase of loans, would be net of the estimated value of collateral upon liquideation.


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