Another Way to Profit from the Coming Plague of Busted Banks

Earlier this month in DailyWealth, I predicted hundreds of banks would soon fail.

I suggested the best way to profit from this "plague" of bank failures would be to buy stock in the neighboring banks that assume the failed banks' operations.

Last week, I found another great way to profit…

The FDIC is the government agency in charge of cleaning up failed banks. When a bank fails, the FDIC lines up another bank to take over the deposits, branches, and loan portfolio. It also acts like a garbage can for the most toxic pieces of the failed bank. It assumes responsibility for all the nonperforming loans and the foreclosed real estate. (Other banks aren't interested in loans that aren't paying interest. Nor do they want to invest in foreclosed real estate.) Take City Bank of Lynnwood, Washington for example…

Last weekend, the FDIC seized City Bank. The FDIC merged this failed bank with a neighboring bank, but not before it removed $185 million in foreclosed property and $95 million in delinquent loans from the deal. The neighboring bank would not have agreed to take on these troubled assets.

Over the past three years, more than 218 banks have failed. As a result of these failures, the FDIC has accumulated nearly $40 billion in junk loans and foreclosed property on its books. But this is only the beginning…

If I'm right and hundreds more banks are going to fail, the FDIC's portfolio of junk mortgage loans and foreclosed property stands to swell even further.

What will the FDIC do with this gargantuan pile of junk loans?

It wants to sell these assets to private investors, of course. The FDIC is not in the business of managing portfolios of nonperforming loans, foreclosures, and subprime mortgages. It has no expertise in this business. Besides, it needs the money to pay out insurance claims.

Here's the problem: Who's going to buy these junk loans? The FDIC has accumulated these loans from all over the country. You might have a delinquent mortgage on a doublewide trailer in Sacramento, California, mixed in with an abandoned apartment in Hialeah, Florida. There will be subprime mortgages, prime mortgages, and everything in between. Some will have defaulted already; some might still be paying interest.

The FDIC isn't going to sell these mortgages one by one, like suits at your local thrift store. It wants to sell thousands at a time. Banks certainly aren't going to touch these assets. They're not in the collections and repossession business. What about hedge funds? They'd be interested at the right price… but how will they deal with a scattered portfolio of troubled home loans? I can't see a New York hedge-fund manager, for example, evicting Mr. Smith from his condo so he can put it up for auction or sending Mr. Jones in Tuscaloosa his second late-payment notice. Not a chance…

In short, the FDIC has turned to the mortgage servicing industry as the customer of last resort for these assets.

A mortgage servicing company performs all the mundane administration behind a mortgage loan. They send out the bill. They collect the payment each month and pass it on to the lender. They operate a website where borrowers can make online payments and check balances. When a borrower misses a payment, they assess the fee. And in the case of a default, the mortgage servicer handles the collections, eviction, and sale of the property.

Basically, mortgage servicing companies are professional debt collectors. They are the only companies capable of dealing with the high volumes of delinquent mortgages and foreclosed property the FDIC needs to dump.

In the past six months, the FDIC has completed a dozen transactions. All of them involved a mortgage service company. And in each case, the FDIC is dumping these assets at spectacularly low prices…

This is a typical example: Three weeks ago, the FDIC gave a company called RoundPoint Mortgage Servicing a 50% ownership stake in a basket of mortgages with an unpaid principal balance of $490 million. Half the mortgages aren't paying interest, says the FDIC. But RoundPoint paid just $34 million for this stake.

The best way to make money from the coming plague of busted banks is to own stock in the mortgage servicing companies – like RoundPoint Mortgage Servicing – that are going to help the FDIC digest its pile of "toxic" bank assets.

Unfortunately, RoundPoint is a private company. But there are publicly traded alternatives. Ocwen Financial (OCN) is the largest pure-play mortgage servicing company in America, with a market cap of $1.2 billion. I don't believe it's doing business directly with the FDIC at this point, but a quick news search shows it closed tons of new mortgage servicing deals recently…