Business newspapers these last few months have been filled with negative news on housing and on damages which have been created by loose lending standards of mortgage bankers. The low interest rates and hot housing market have created the ideal environment for a "credit bubble".
The weakest home buyers have been lured by subprime mortgage banks with exotic proposals with strange names such as "interest only" loans, option or hybrid ARMs which a have a common point: very low first installments, then, when the installment is reset and reaches its normalized level, monthly payments that surge suddenly and start to cause the default of many borrowers and an ugly hole in the lenders balance sheet (see L.A. Times column of 8/15/06 "Sub-Prime Lenders' Shares Fall" or WSJ column of 8/30/06 (sub. req.) "Mortgage Market Begins to See Cracks As Subprime-Loan Problems Emerge" ).
Despite (the contrarian investor would say 'thanks to') this gloomy environment, some gems can be discovered in the trash. If you dig a bit, you may find a niche player in the subprime lending market with a very conservative business model, a solid balance sheet and a safe income stream.
The company is called Delta Financial Corporation (DFC).
DFC is mortgage subprime lender based in Woodbury, New York. It's a small cap (about $210 million).
The company has been founded in 1982 and it sells mortgage loans to so called "subprime lenders" which means consumers that either have high debt/equity ratio, poor credit history, weak or volatile income. In exchange of this extra-risk DFC charge higher interest rates and fees than a "prime lender". Loans are backed by a first mortgage on one to four-family residential properties. In Q2 2006 average interest rate on the loans was 8.85% and loan to value ratio was around 78%.
Their customers are using these loans mainly (86% in Q2 06) as "cash out" and debt consolidation.
This means that they are using the loan to consolidate their credit card debt, pay for college or health costs, finance their lifestyle etc...
The company originates loans through about 11 retails offices and a network of about 3,000 independent brokers.
In 2005 they originated $3.8 billion loans. In the first 6 months of 2006 they originated $1,915 billion loans.
Geographical breakdown originated in Q2 2006 (very similar breakdown for the full year 2005 origination):
36% New York, New Jersey, Pennsylvania
6% New England
11% West (less than 2% in California)
Once the loans have been originated they are kept on the company book till when they are either securitized (once a quarter) or sold on whole-loan sale basis.
- Whole-loan sale basis (about 15% of the loan volume): it's a simple straight sale against cash of the loans on a "non-recourse" basis which means that if a borrower default, the loan buyer cannot ask DFC to pay on behalf of initial borrower (unless misleading or fraudulent documents are attached to loan ).
- Securitization (about 85% of the loan volume): loans are sold to a Trust which finance this purchase issuing bonds called ABS (asset backed securities) to institutional investors (banks, hedge funds...). DFC retains a very small equity interest in the Trust.
It also issues a bond backed by this small interest in the Trust called NIM (net interest margin).
Note that both ABS and NIM bonds have no recourse on DFC assets. Which means that, unless documents attached to the loans are not correct or are lacking, DFC is free of any liability and bonds holders can try to recover their money only from the borrowers assets or from the very residual interest DFC has in the Trust in certain circumstances.
What makes DFC different ?
1) Business model
They originate almost half their loans (47% in 2q 2006) through their own low cost retail channel, balance is originated through their wholesale channel. The subprime industry usually originates a vast majority of their loans on wholesale basis which is a more expensive than the retail channel.
2) They are mainly a "fixed-rate" shop
Contrary to the vast majority of the subprime mortgage lenders, DFC originates mainly fixed-rate loans (about 86% of their portfolio). In the most recent quarter (2q 2006) the exotic (and often toxic) Interest Only Adjustable Rate represented less than 1% of the loans originated and conventional Adjustable Rate loans 14%.
What are the benefits ?
- Fixed-rate lending in subprime mortgage market is a niche. They are out of reach from the huge stocks of capital backing the subprime subsidiaries of HSBC, GMAC, Countrywide and Washington Mutual or their bigger subprime mortgage listed monolines competitors such as New Century Financial ($2.1 billion market cap, about $56 bil. origination) or Accredited Home Lenders ($700 million market cap, $16.6 bil. origination) or privately owned Ameriquest (75 bil. origination).
- Fixed-rate is more difficult to sell to borrowers especially in an historically low-interest environment. A mortgage broker will find much easier to lure potential borrower with a lower-initial installment obtainable with an adjustable rate mortgage loan.
- DFC has historically built a strong relationship with brokers which have access to customers interested in this type of loans. They also have built a retail channel able to approach this small portion of subprime mortgage borrowers.
- Prepayments and default rates are lower on fixed-rate mortgages than on ARMs. Therefore prices fetched by fixed-rate mortgages in securitizations and whole-loan sales deals are higher then ARM.
- Fixed rate borrowers are less interest rate sensitive.
Higher securitization income (due to premium fixed-rate mortgages pricing plus lower-than-industry "loan to value" ratio) less lower cost origination (almost 50% of loan originated via low-cost retail channel) = high profit margins.
GAAP accounting undervalues real book value and profitability of the business:
1) Real value of equity is undervalued
At first look, their last balance sheet (on 6/30/2006) is frightening.
$5.525 billion subprime mortgage loans are balanced by $5.429 billion liabilities and only $144 million shareholders equity.
Right, but remember that ABS bonds have no claim on company assets in case of loans default.
Even in case the whole loans default book equity would remain exactly the same.
So why insert both bonds and loans in balance sheet? Because the company is using from 2004 a very conservative accounting method called "portfolio accounting" (more below).
In the meantime, note that in every 10K SEC report the company is required to state the fair market value of their assets and liabilities.
In the last 10K which refers to fiscal year ending Dec. 2005 guess what ? The official GAAP accounting rules underestimated assets by $92 mil. and overstated liabilities by $49 mil. So marked-to-market book value on Dec. 31st 2005 was underestimated by $141 mil. (on Dec. 2004 it was underestimated by $123 mil).
The gap between GAAP BV and marked-to-market BV should be wider now but let's stick with $141 mil. and let's calculate the true P/BV ratio:
$210 mil. market cap / ($144 mil. GAAP BV + $141 marked-to-market adjustment) = 0.74.
In other words the company sells at 75% of its liquidation value. For this reason private equity investors or competitors may consider DFC as a acquisition candidate if management which owns 30% of the comany agrees.
2) Conservative cash profits expected for next 12 months
First let's come back to "portfolio accounting" mentioned before. The true moment of value creation in mortgage lending industry is when loan is originated.
The usual accounting method to calculate this value is called "gains on sale" (or GOS) accounting.
In GOS accounting the loans and ABS securities are not carried out on balance sheet and a profit is registered upon the sale of loans to a Special Purpose Vehicle using "best guess" estimates. If during the life of loans valuation assumptions regarding default and prepayment rates differ from real loans behavior profits or losses charges will be registered in the income statement when they occur. This accounting method has been a source of many investor disappointments expected profits did not materialize due to rosy prepayment and default expectations.
In portfolio accounting you book the profits not upfront but during the whole life of the loans deducting cash paid to ABS holders from loan installments by borrowers. So the profit booked are real, cash ones. Once loans are on the books they deliver over a 3-4 years time span cash profits on automatic pilot. To give you an idea, DFC expects that the sole loan portfolio already in the books on June 2006 ($5.6 bil.), should bring till June 2007 a stream of future net interest income of $80 mil.
This portfolio income due to loans securitized since 2004 will reach its full speed in 2007-2008 (loans remain usually 3-4 years on the books).
Quick back of the envelope calculation of a yearly earning power of the origination platform (which excludes income from loans on portfolio):
Origination volume $4 bil. (+5% over 2005 volume but origination on 1q06/1q05 +13% and 2q06/2q05 +10%)
GOS Margin (assuming all loans sold for cash on whole loan sale basis): 1% (1.4% Q3 05, 1.4% Q4 05, 1.1% Q1 06, 1.3% Q2 06)
Origination GOS margin: $40 mil.
Warehouse margin (loans are not sold the day they are originated but they are packed together and resold say once a quarter, spread is higher than GOS since we are talking about very short term financing backed by freshly underwritten secured loans): 1 bil. quarterly loans x 2.5% spread x 2months average warehouse period: $12.5 mil.
Origination profits: $52.5 mil. less 39% tax bill divided by 23.7 mil sh. = $1.35
In other words, DFC is trading at only 6.6 times its origination business excluding the $5.6 bil. loan portfolio.
1) Interest rates: DFC customers need cash either to pay for important expenses (health care, college...) or to repay credit card debt which will always carry much higher debt interest rates than mortgage loans. They are not willing to lower the interest rate of their previous mortgage loan.
The refinance boom which affected lenders to prime customers last couple of years did not affect the DFC market.
DFC expected default rate would be only marginally affected since only less than 15% of their loans are ARM.
Higher interests rates means higher installments so the size of the overall market demand could be reduced.
2) Labor market: this factor can affect both existing loans (default rates) and future business prospects (less customers meeting income standards). Trend of unemployment rate should me carefully monitored by investors in DFC.
3) Housing: the real housing bubble is concentrated in few markets. The average housing prices nationwide should weather a period of very moderate or very light decreasing in the next 1-2 years. The 78-80% of loan to value ration provides enough protection to DFC in case they have to proceed to foreclosure.
We are coming out of an ideal situation of low rates, booming housing market and strong employment market. Credit markets already incorporate a future weakening in these 3 keys variables.
Main concern regarding DFC should regard the employment market since on the other variables their business model concentrating on fixed rate loans, geographical distribution (less than 2% of their loans are in California but have a 17% exposure to Florida) and underwriting standards should be able to allow them to weather a temporary deterioration of macro economic environment.
Overall the industry is in full retreat mode after the last 3 bubble years. Abundance of capital, strong competition in the hottest markets (mainly California but also Florida, Nevada...) , loose underwriting standards (see huge originations of exotic "interest only, option ARMs etc...) and concentration on volume growth instead that profitability are starting to create some serious damages.
Ameriquest is restructuring (closing 229 branches and eliminating 3800 jobs), New Century Financial has now an activist on the board (which suppose will have an hard look at underwriting criteria)...
The small size of the fixed-rate market protect somehow DFC from players supported by financial powerhouses at their back.
Hugh Miller is CEO for the past 21 years, while the CFO, Richard Brass, has been working with DFC for 14 years. Insiders own 30% of outstanding shares, therefore their interests are aligned with those of shareholders. This is a good sign that underwriting standards will remain high.
No long term debt or convertible stocks on balance sheet. Loans on the books have no recourse on company assets (except very marginal cases of misrepresentation of loan documents).
Future income stream on loans on portfolio will help DFC to weather some possible downturn in its origination business.
name: DELTA FINANCIAL CORP.
market cap.: $210 mil.
stock price (on 09/14/06): $9.01
adjusted Price/Book (see above): 0.74
trailing P/E: 7.55
forward P/E (Dec. 07): 5.81
dividend yield: 2.2%
target price: $14 (8 x 2008 GAAP estimated earnings)
Disclosure: Author does not have a position in the securities discussed in this article at the time of posting.