Making Money With Fannie and Freddie: Bank of Ozarks' Conference Call

Never heard of Bank of the Ozarks? You will. Bank of the Ozarks Inc. (OZRK) made a lot of money this quarter buying up deeply discounted bonds and making almost immediate, huge profits on them. From OZRK's Q408 conference call:

In the fourth quarter our total investment securities portfolio grew approximately $223 million with purchases of investment securities more then offsetting the $34 million decrease in those temporary tax exempt securities. This growth was primarily due to our purchase of highly rated municipal securities having what we believe are unusually favorable prices and yields due to market conditions at the time of purchase.

The vast majority of those securities are municipal housing authority bonds and the underlying bonds are Ginnie Mae, Fannie Mae, Freddie Mac, VA, FA, or USDA rule development guaranteed mortgages. All of the mortgages underneath those credits are guaranteed… 80% [are] AAA.

We just found a gigantic aberration in the market in October and November on these things. At that time in October and November a Ginnie Mae was trading in the low five’s, Fannie and Freddie mortgage-backed securities were trading in the mid to upper five’s and we were buying, and that’s new origination stuff, we were buying this very seasoned stuff a lot of which was in pack structures and we were buying it at deep discounts to yield a six plus yield, probably on average about a 6.25, 6.50 yield to the absolute final maturity.

Assuming that there was never a payment on any mortgage and you went all the way, 20, 15, 30 years to the absolute final and with any sort of reasonable prepayment speeds, we were generating yields in the seven, eight, nine’s on some of it.

The average CMO trader who trades taxed CMOs never looks at anything tax exempt and the analytic sources, are not on Bloomberg and your other analytic sources… you have to do some manual work on it.

I’ll give you an example. We bought some more bonds in one of these same issues we had bought earlier and we bought them just a few days ago and paid $0.89 on the $1 for them and even though they are the exact same credit as a taxable Ginnie, Fannie, or Freddie, they are still trading 100 basis points in yield north of that. At one time that’s almost 200 basis points on some of these things.

In the same day we paid $0.89 for some of this paper, we saw some trade away at another transaction at $0.94. So the market has caught on to this and this anomalies like that typically don’t exist very long but we were very fortunate to pick up a couple of hundred million of that product at huge discounts and to give you an idea, December 31 we have $233 million of increase in securities portfolio most of which that was in that type of paper and our discount on that was $29 million so we bought that on average $29 million less then par value

The other reason we had that big mark-to-market adjustment swing is because with the feds action to lower mortgage rates and the expectations that there is a significant refi boom on the way it has increased projected prepayment speeds on our old long-standing Fannie Mae and Freddie Mac mortgage-backed securities portfolio in which we have an $8 million plus discount so as the expectation comes that those things are going to pay off much more quickly then was expected three months ago, that has also contributed very positively to that quarter to quarter mark-to-market swing.

One analyst was worried that this was just a one-time anomaly and it would be difficult for the bank to maintain earnings on these kinds of volatile transactions that may not present themselves again. Another cautioned that much of the misery in the financial industry was caused by this kind of risk-taking:

Q: No one seemed to know what the heck was going on and no one really cared as long as the party kept going, now we look back, we’re all shocked at what’s happened… In the environment that we’re in the concern is in areas that lack visibility is that it all works until it doesn’t work.

A: A Lehman Brothers, a Bear Stearns, and a Morgan Stanley and a Merrill Lynch and all these guys… are not very good credit guys. They’re just deal guys. And they’re funding this with a combination of short-term commercial paper and bank debt... highly volatile borrowings.

We’re funding this with retail deposits, FHLB advances, you’ve got the Federal Reserve back up, you’ve got broker deposits, there’s a litany of well developed deposit sources that we have… I’ve been doing credit for 30 years and this is good credit. And these are great yields and great returns on that credit… We’re buying it at deep, deep discounts and we’re buying the good stuff.

Why would I say 'well, gosh I’m a bank, I oughta just take deposits and make loans,' when I can make more money buying these couple hundred million dollars of securities then I’d make buying loans. So if market doesn’t give us any credit for it, to heck with the market. We’re going to make money, we’re going to build capital, we’re going to build shareholder value, and as I compound that income year after year, I’ll get credit for it. We’ll get credit for it as shareholders.

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Comments

[Guero:]

Risk arbitrage in the Ozarks?

Jan 21 10:35 AM

[SA Editor J...:]

Dear Guero,

I couldn't decide if I should respond to your comment with "yeah, look what we've come to" or "don't laugh, those guys did pretty darn well!"

Judy

Jan 21 10:39 AM

[JKC1967:]

Great article - Bill Gross in his outlook for 2009 said the best strategy is to "shake hands with the Government, buy what they are guaranteeing, and try to get there first" (I'm paraphrasing here). Sounds like these guys at Ozark did excactly that, I wish my fund manager had thought of it, believe me.

Jan 21 02:46 PM