First Federal: Soon-To-Be Sub-Prime Lender?

When reading this BusinessWeek report about Santa Monica based mortgage lender FirstFed Financial (FED), it just screamed for some charts to go along with the words and numbers.

The company's stock has been soaring lately, up more than 30 percent since September, as investors speculate on its future. Some believe the company to be a takeover target, others feel that the housing market is poised for a rebound and their bottom line will improve, while short sellers bet that it will all come tumbling down around them.

Something is sure to happen soon at the boutique lender with the unique loan portfolio.

In the fourth quarter, mortgage originations plummeted by 66.8%, to $365 million—one of the steepest declines among all lenders. Cash from operating activities dropped into the red in the third quarter (the most recent data available), falling from $49 million in 2005 to negative $77.1 million a year later. Meanwhile, the number of problem loans more than quadrupled last year.

FirstFed's foundation could crack even further. The biggest problem: Its mortgage portfolio is packed with risky loans known as option ARMS. These adjustable-rate mortgages allow borrowers to make smaller monthly payments than they would normally owe by deferring the principal and adding the difference back to the balance. That may make a house more affordable at first. But when the balance hits a certain level, payments often jump significantly, and borrowers can run into major financial trouble.

FirstFed potentially faces darker days than peers who play in the same niche. For one thing, all of FirstFed's mortgages are for homes in California, where prices have cratered and foreclosures have skyrocketed. Also, 80% of its loans have little or no documentation to prove the borrower's income or assets, according to a recent company presentation. The bank uses credit scores to screen for elite borrowers.

But skeptics are starting to question the quality of FirstFed's earnings. The bulk of FirstFed's income is derived from noncash earnings, largely from the deferred principal on its option ARMs. That so-called negative amortization constituted $223.9 million, or 68.4%, of the bank's income before taxes in 2006, compared with 1.3% in 2004. In essence, FirstFed is booking profits on money it hasn't collected. The fear is that the bank will never collect, given the high delinquency and foreclosure rates in California. Says Frederick Cannon, managing director at Keefe, Bruyette & Woods Inc.: "The bearish view is that all the earnings are coming from money they didn't get yet."

FirstFed admits the environment is tougher today, but says its borrowers have stellar credit and can afford to keep up with the option ARMs' rising payments. Indeed, FirstFed's loan portfolio, with a higher credit quality and lower delinquency rate, is holding up better than those of larger competitors such as Countrywide Financial (CFC) in Calabasas, Calif., and Washington Mutual (WM) in Seattle. FirstFed CFO Douglas J. Goddard says the bank fully expects to collect on its loans. "In our nearly 25 years of offering this product, we have yet to find where payment shock' caused a default," he explains.

Still, given all the red flags, it's no wonder short-sellers have pounced. Some 40% of the company's 15.3 million shares have been sold short. That dynamic may have helped boost the stock. As it climbs, hedge funds and others rush to buy more shares to cover their money-losing short position, pushing the stock higher.

And as it goes up, the stock is attracting new buyers. "I constantly see momentum players buy financial companies because they hit some screen, but they don't really know what they own," says Richard Eckert, senior research analyst at ROTH Capital Partners in Newport Beach, Calif. "They are not distinguishing between cheap, and cheap for a reason."

With borrowers sporting higher credit scores, FirstFed Financial does not appear to be a sub-prime lender in the traditional sense - at least not yet.

Apparently catering to the market for which stated income and negative amortization loans were originally intended - small business owners or independent contractors with large but hard-to-document and/or unpredictable income - the company is faring better than most sub-prime lenders today.

Tomorrow, however, is an entirely different matter.

Their clientele likely includes the professional real estate speculator crowd that was in early on the California real estate craze - some of them have clearly lingered too long.

Not to be confused with your typical equity-rich Southern California homeowner who took the plunge with investment property in 2004 or 2005 after being convinced that real estate only goes up, this group of borrowers has probably been in the game for many years now and has done quite well.

Until now. Just like the craps tables at Vegas, it's hard to know when to stop.

While FirstFed Financial may not currently be a sub-prime lender, with four times the number of problem loans as a year ago sure to impact their customers' credit score, they may turn out to be one after-the-fact.

Full disclosure: Author has no position in FED at time of writing.

FED 1-yr chart:

Comments

[Eric Boughton:]

Thanks for the post, Tim.... there is even more to the story.

At first glance, this is a sleepy community bank with 32 branches, founded in 1929. A closer look reveals dramatic acceleration in mortgage loan production between 2003 and 2005, as the bank more than doubled total assets with almost no growth in branches. What’s more, these loans have characteristics which we see as huge dangers for the company.

1) FirstFed operates in an area where home prices are at record levels, based on any metric. In many California communities, the median home price is 6-7 times the median income, compared to 3.5-4 times nationally, and 2.5-3 times five years ago. Our thesis is that many borrowers, even those deemed good credit risks, will walk away from their homes if and when home prices fall substantially.

2) 90% of FirstFed’s loans are ARMs. FirstFed has positioned itself as “the” ARM source in Southern California. As the falling originations highlight, this is great when option ARMs are popular, but can dry up pretty quickly.

3) 80% of loan originations in 2006 were 40-year mortgages, another sign of a stretched consumer desperate to minimize a monthly payment. A longer mortgage period means lower payments and more opportunity to default.

4) Many of FirstFed’s loans have negative amortization features. Aside from the increasingly evident risk that borrowers will have to default as soon as the rate resets, negative amortization in FirstFed’s case means that operating cash flows are consistently negative, even though EPS looks healthy. (BKUNA is another name we are short for the same reason.) There was $216 million of neg-am included in 12/31/06 loan balances.

5) As you point out, half of the loans on FirstFed’s balance sheet are “liar loans”, with either no income or asset information requested, or no verification of the borrower’s stated financial situation. An additional 33% are “SIVA”, with assets verified, but income not verified.

6) FirstFed gets half of their loans from wholesale loan brokers, meaning there is much more room for the “predatory lending” Congress is currently whining about, and also meaning that FirstFed can easily be misled by fraudulent brokers, who seem to come out of the woodwork in a downturn.

7) FirstFed seems to have under-reserved for problem loans. Non-performing assets jumped from 0.05% of total loans at the end of 2005 (absurdly low) to 0.23% at the end of 2006 (still lower than most banks). FirstFed also has NO valuation allowance for impaired loans, relying on SFAS 114, which they read as not requiring a valuation allowance for loans under $1 million.

8) FirstFed finances loan production with high-cost and “flighty” CD’s. In fact, they are one of the largest internet advertisers of high CD rates. This makes perfect sense—after all, one can hardly expect $1.5 billion in “sticky” customer deposits from only 32 bank branches to support $8.5 billion in loans! This may be a great business model when there is a high interest spread between CD’s and mortgages, and when defaults are low--neither is the case today.

9) The average FICO score for FirstFed borrowers in 2006 was 714, solidly in Alt-A territory. When an Alt-A borrower tries to afford a “prime” house, the borrower may as well be sub-prime.

10) To top things off, FED has seen high insider selling recently.

Full disclosure: our hedge fund is short this name.

2007 Apr 10 08:07 PM