DSL: Risk to the Trade

On Apr 11, Sterling Financial Corporation (STSA) of Spokane, WA announced it is buying North Valley Bancorp (NOVB) of Redding, CA. Both are savings and loans.

The offer is $25.14 per share of NOVB, which was a slight premium to the market price. NOVB is much smaller than Downey, with a ~$180M market cap vs Downey $1.72B. So, the difference in size is approximately 10x.

Importantly, this offer puts the P/B at around 2.4; significantly above Downey's 1.23x. Obviously, it would blow out our Downey short if a buyer paid anywhere near 2.4x for Downey.

However, NOVB is more of a commercial lender (8-K). In fact, only 6.1% of their portfolio is residential mortgage loans.

And, although I'm sure that commercial loans will have problems in time, NOVB probably doesn't give no-doc, negative amort commercial loans.

Savings & Loan Crisis I

New Century's financing was provided by its warehouse lenders: big investment banks. They pulled the plug once the subprime problem became obvious.

In contrast, the banks and S&L's mortgage portfolios are financed by depositors - owners of savings accounts or CDs. And these depositors needn't worry about what management is doing with their money, since the federal government guarantees that they will be made whole.

"The major indirect cost of deposit insurance comes from its potential to subsidize inefficient types of bank risk-taking. Deposit insurance undermines the incentives of depositors to monitor and police bank risk-taking. This is the problem of moral hazard..." (Kane 2002[pdf])

This problem of moral hazard has occured before:

"Back in the early 1980s when Ronald Reagan deregulated the savings and loan industry, Texas became the nation's biggest cesspool of S&L crookery. At the core of their thieving strategy was a little trick they described thusly: 'A rolling loan gathers no loss.'

"These wily Texas coyotes had figured out a win/win situation. S&L operators could help their buddies "borrow" money from their S&Ls, not pay it back, and still allow the S&L to book loan fees and other profits, upon which the S&L executives based their salaries and bonuses.

"Ah, you say, but wouldn't bank regulators notice that the loans were in default? No. Because each time a loan came due the S&L would "roll it over" -- renew it -- adding all interest due into the new loan and booking it as income. The loans got bigger and bigger, and never got paid off. The bankers got rich, the borrowers got rich, American taxpayers got the bill. A classic Texas "win/win" business deal."

This is from Stephen Pizzo's blog. He is the author of Inside Job: The Looting of America's Savings and Loans. There are a couple of choice pieces from the book:

"Of the 56 banks that failed in the U.S. between 1959 and 1971, 34 had passed their most recent examination in a 'no-problem' category, and 17 of the 34 had been given an 'excellent' rating." (Rep. St Germain, qtd in Pizzo p. 475)

"Buttoned-down appraisers, plugging along in boring jobs... learned that by simply raising their opinion of a property's value to match a borrower's needs or desires, they could raise their own standard of living as well - and the higher the opinion, the bigger the paycheck."

The parallels here are too numerous to count. Decades from now, it will be difficult to remember the difference between S&L Crises I and II.

Meanwhile, while I was on a long road trip and hence not posting, Cramer was pounding the table about these garbage stocks. Anyone who doesn't already know about his track record can look at this previous post.

I didn't make any trades as a result of the rally in these Alt-A stocks. You can look at the data coming in at the Crucial Credit/Housing Sites and see what is really going on.

DSL vs NEW Comparison

Most of the NEW stats are 2005 data; DSL stats are from the previous filing as reported on this blog.

Downey Anecdote Illustrates Endemic Underwriting Laxity

I had lunch today with a real estate broker I used to sell a house two years ago.

I remember him buying about a dozen houses in the Phoenix metro, using Option ARMs. He would just hold them, not rent them out. I mean, why bother when the rent is so much less than even the negatively amortizing payment?

Back in 2005, he would call me to see whether I wanted to buy houses in newly opened communities sight unseen, with just hours to make a decision.

He was the inspiration for this paragraph from an August 2006 research report on New Century:

"Mr. Levered-long is playing a different game. He got all the fliers in the mail offering to refinance his house and let him take cash-out, but instead of spending the $50K a year he was “earning” by living in his house on something he didn’t need, he asked himself why only one house? Wouldn’t he make more if he owned more houses? So he cashes out his equity and uses the money for a down payment on another house. He doesn’t care that the mortgage payment is $500 dollars more than the rent he gets from the house. It’s more than paid for by the money “earned” from the appreciation. Because he is a savvy real estate investor he does that every six months for four years."

I asked him what mortgage lender he had used when buying houses. "Downey Financial."

Downey never looked closely enough at the apps to wonder how a moderately successful real estate broker could afford a dozen houses. He also used Downey to finance his clients.

I asked, "Did you ever have any garbage paper you couldn't push through Downey?" He just laughed.

It is amazing that we both set out, for different reasons and at different times, to find the loosest mortgage lender and independently found Downey.

Delinquencies Surge in DSL's and BKUNA's Markets

These are the 25 communities where the 30-day delinquency rate for all mortgages has increased the most since Q4 2005. (Take a look at the great dataset at the WSJ.)

Remember, this data includes all types of loans. That means that prime loans are probably bringing down the average, and the Alt-A and subprime delinquency rates are even higher than listed.



Modesto, Stockton, Vallejo, etc. - that's Downey Financial. Except their delinquency rate is probably significantly worse, because their portfolio is 88% stated or no-income, 85% option-ARM, etc.

And when you see those FL cities, think BKUNA.

Also note that DSL and BKUNA had Q4 operating cash flow of
-$100M and -$126M, respectively.

CS "Mortgage Liquidity du Jour" Highlights

I assume that our readers from the Street have read Ivy Zelman / Credit Suisse's "Mortgage Liquidity du Jour" report from March 12, but here are some highlights for everyone else:

• 1-year hybrid ARMs represented 28% of Alt-A purchase originations in 2006.
• Investors and second home buyers represented 22% of Alt-A purchase originations last year, which is the largest non-owner occupied share among all the mortgage market segments.
• NV, CA, AZ, FL, and VA represented 75% of builder operating profit in 2005.
• The prevalance of subprime, Alt-A, IOs, and Option ARMs has been disproportionally weighted towards the most overpriced markets.
• CS is calling for a 35-45% drop off in new starts from the peak, which is revised from their 25% estimate in September 2006.

Quick Facts about BankUnited Financial Corp

Downey Financial is a great, pure play on SoCal Option ARMs. But what about other states?

BankUnited Financial (BKUNA) is a Coral Gables, FL based bank that primarily writes 1-4 family residential loans (84.7%), but also has home equity (3.3%) and land (2.8%) exposure.

Of the residential loans, FL represents 60.23%, with CA 6.06% and AZ 5.58%.

From a recent BKUNA investor presentation: "Tony Villamil echoed what we believe, Florida with it’s diverse economic influences and nationally leading population and job growth is the best banking market in the country."

Hmm. Is that claim sustained by the facts? "Florida had the most homes in the foreclosure process nationwide in February, according to RealtyTrac, which reported a two-fold year-over-year gain in delinquencies —more than 19,144 statewide." That is from the Florida Association of Realtors April newsletter. Per capita they have the 3rd most foreclosures.

Let's go to the 10-Q for a survey of facts:

87% of their 1-4 family residential loans are ARMs. 69.3% are option ARMs, 17.7% are non-option ARMs, the rest are fixed rate.

"The average LTV of the option ARM portfolio at inception was 73.67% with the adjustment for coverage of Private Mortgage Insurance (PMI)."

"Option ARMs represent 60.9% of BankUnited’s total loans outstanding as of December 31, 2006. ...Option ARM loans with a balance of $5.6 billion were negatively amortizing with approximately $129.7 million of their principal balances resulting from negative amortization. As of September 30, 2006, Option ARM loans with a balance of $5 billion were negatively amortizing with approximately $89 million of their principal balances resulting from negative amortization."

Their net income was $27M for 4Q 2006, but negative amortization balances increased by $40.7M. NegAm was 151% of net income.

BKUNA has a 115% cap for negative amortization.

"Upon reaching this limit the monthly payment increases to require full repayment of principal over the remaining term of the loan. The borrower has other options that would allow him to pay interest only or a higher amount that would reduce the outstanding loan balance in any month."

Risks to the trade:

• Watch out, because BKUNA sells for a bargain basement 0.98 P/BV ratio.

Fil Zucchi has a post on BKUNA at Minyanville.

Default Rates and Recovery Rates

There is a well-recognized financial principle that credit bubble lenders are going to experience soon: default rates and recovery rates are inversely correlated.













This is from a Moody's report [pdf] on corporate bonds, but it will apply to residential lending also.

Moody's offers two reasons for this: "One, higher default rates increase the supply of defaulted debt and thereby decrease its price. Two, when the market price for distressed debt is low, distressed companies find it more difficult to obtain financing and default more frequently as a result."

WSJ: "Payment Woes Worsen on Riskiest Mortgages"

From the WSJ: "The number of borrowers in the U.S. falling behind on the riskier types of home mortgages continues to grow...For Alt-A loans ... the late-payment figure rose to 2.6% in January from 2.3% in December and 1.3% in January 2006."

Check out Market Ticker for good analysis of this data.

Meanwhile, I got ahold of the First American Loan Performance report that the WSJ based the article on. Here's two choice graphs:

These two graphs show the delinquency rate for the two types of Alt-A loans (adjustible rate, interest only; and adjustible rate, option) that comprise the vast majority of Downey Financial's (DSL) loan portfolio.

As you look at this chart, remember 19% of DSL's loans were originated in 2006 and 40% were originated in 2005.

The 2006 IO ARMs are over 3% delinquent!

Meanwhile, the 2006 option ARMs are just scratching 1% delinquency. I think this is because the option ARM borrowers are scraping by with the minimum negative amortizing payment - although that is becoming untenable for them at an increasing rate.

More and more of the option ARM borrowers are going to be hitting the negative amortization 110% cap. (Tanta at CR has a great explanation of this recasting process.)

When the option ARMs recast and the payments skyrocket, the delinquency rate is going to skyrocket.

James J. Cramer: Mad Money, Indeed

People always ask me what I think of Jim Cramer and his show "Mad Money" on CNBC.

The best perspective I can give is a speech, "The Winners of the New World," that he gave on February 29, 2000.

"You want my top 10 stocks for who is going to make it in the New World? You know what? I am going to give them to you. Right here. Right now. OK. Here goes. Write them down -- no handouts here!: 724 Solutions, Ariba, Digital Island, Exodus, InfoSpace.com, Inktomi, Mercury Interactive, Sonera, VeriSign, and Veritas Software."

Cramer goes on to say:

"...you have to throw out all of the matrices and formulas and texts that existed before the Web. You have to throw them away because they can't make money for you anymore, and that is all that matters. We don't use price-to-earnings multiples anymore at Cramer Berkowitz. If we talk about price-to-book, we have already gone astray."

There he is on record, seven years ago, saying that profitable business models and earnings don't matter.

"So, if you can't own the retailers, and you can't own transports, and you can't own banks and brokers and financials and you can't own commodity makers and you can't own the newspapers, and you can't own the machinery stocks, what can you own? A-ha, that just leaves us with tech. That's why we keep coming back to it. That's why, despite the 80% increase in the Nasdaq last year, we are looking at another record year now."

And how did his top 10 stocks perform? Only a few are still in business.

M&T Bank News Spells Trouble for Downey Financial

See this Calculated Risk post. M&T Bank - which is partially owned by Warren Buffett - is being forced to markdown and repurchase its Alt-A loans.

From the MTB 8-K: "Management of M&T believes that the value of the Alt-A residential mortgage loans it holds is greater than the amount implied by the few bidders presently active in the market. As a result, $883 million of Alt-A loans previously held for sale... were transferred in March to M&T’s held-for-investment residential mortgage loan portfolio."

Does anyone think that a bank owned by Buffett does worse underwriting than Downey? What does this imply about the value of Downey's portfolio of Alt-A loans?

Standard Pacific's Model Homes and Options

Standard Pacific is already dumping Model Homes at auctions:

"Desperate to avoid still more losses, home builder Standard Pacific sent upgraded model homes to auction last Saturday with a bargain price tage."

"'These homes are priced well below anything in Elk Grove,' said Keith McLane of West Coast Home Auctions. 'The seller is looking to sell 6-homes very quickly.'"

"They sold alright: a 4 bedroom home went for $440,000, a good $150,000 less than it sold for 18 months ago."

They have $155M model homes as of 31-Dec. Unfortunately, we don't know exactly what the 25% discounts to retail mean for BV impact. (Although we could estimate based on historical profit margins.)

Next, I was pretty close on my land/lot option leverage factors, with 10 and 15, respectively:

"At December 31, 2005, we had cash deposits and letters of credit outstanding of approximately $134.3 million on land purchase contracts having a total remaining purchase price of approximately $1,433.6 million.," and, "cash deposits and letters of credit outstanding of approximately $49.6 million on option contracts having a total remaining purchase price of approximately $718.2 million."

It occured to me that SPF is in a double bind on the lot options since they will either (i) walk away from the deposits or (ii) exercise them and cause even more economic damage, since the options are out of the money.

I have known land acquisitions people (both for landbanks and builders), and I have never known them to walk away from options readily. Even if exercising them meant throwing good money after bad, sunk costs.