With 47% of the IndyMac’s (IMB) float having been sold short and the stock down 30% year-to-date, true believers in the company are thin on the ground. The naysayers seem to be everywhere, while buyers are on strike. Dare I try to make a case that the market has got it wrong?
Some background: Indymac is an “Alt-A” mortgage lender based in Pasadena California. That Alt-A moniker itself nowadays is likely to be reason enough for a lot of people to short the stock. On top of that, the company is also the country’s seventh-largest mortgage originator (with $90 billion in production last year) and has a small subprime platform as well. Now you should know all you need to understand why the stock is so heavily shorted.
So why am I so intrigued by Indymac? After, all, the problems in the mortgage business are well-documented, originators seem to be closing left and right, and margins are extremely depressed. Volumes going forward are questionable to say the least.
But one basic fact about cyclical businesses can’t be disputed: staying power is the key. If you are one of the survivors, you will reap big rewards when the cycle finally turns. We see this over and over again across one cyclical industry after another.
So I start with the most basic question: will Indymac survive this downturn?
For mortgage companies, the answer to that question hinges on their liquidity.
A core reason why the shorts are so excited about Indymac is that they expect a replay of the liquidity crunch that subprime mortgage REITs endured earlier in the year. On that score, the shorts are 100% right. Liquidity has been a huge issue for the mortgage-lending industry. Too illustrate, here is an excerpt from the IndyMac shareholder letter discussing this very topic:
IndyMac met all the terms of its credit agreements and remained in good standing with all of its lenders, but saw its access to capital temporarily evaporate as its ability to borrow, securitize loans or raise equity was severely hampered. Lenders, pulling back from this market, required companies like IndyMac to pay down debt, which resulted in losses on asset sales, write-downs and other business restructurings.
Except that this excerpt is from Indymac’s 1998 letter. In fact, as this most recent fad for converting mortgage lenders into REITs unfolded, maybe someone should have called Indymac CEO Michael Perry to get his opinion. Why? His company was a mortgage REIT in 1998 and saw its warehouse lenders leave it high and dry in the time of its greatest capital need. That’s not too different than what we saw happen in March of 2007.
When you have such a near-death experience and see your market value evaporate by 65%, you learn a few things.
The main lesson that Indymac learned is that, as a leveraged lender, diversity of funding sources is your friend. So the company de-REITed and acquired a thrift charter. The results have been striking. Here’s how the company’s funding mix has changed over the past nine years:
As you can see the company has changed its borrowing mix dramatically since 1998. Just 5% of its borrowing base now comes from the fickle repo lenders. On top of this, the company recently raised $500 million in trust preferreds which, combined with its excess capital of $300 million, leaves it with a war chest of liquidity. Management has hinted it might use some of this to buy back stock; my advice, though, is that in the near term the company should-stay on the sidelines, wait for the dust to settle in the secondary markets, and then deploy the cash.
Unlocking of Value
Another intriguing part to Indymac that’s not well appreciated is a business it owns, a reverse-mortgage originator called Financial Freedom, that sits on its books for $80 million. Financial Freedom is the largest player in the reverse mortgage space. This is an area of tremendous opportunity and market focus. As the population ages, the reverse-mortgage business has been booming and is widely expected to grow at 20% or more annually for years. There’s lately been a lot of interest both from private equity and strategic buyers. For example, earlier in the year Seattle Mortgage, the third-largest player, was bought by Bank of America.
Indymac had bought Financial Freedom from Lehman Brothers for $112 million in 2004. The acquisition has been a home run: last year First Freedom earned $54 million. Should Indymac decide to sell this business, it’s not hard to imagine a price of, say, 15 times trailing earnings, or $800 million. To put that into context, Indymac’s total market capitalization is $2.3 billion. For myself, I’d be delighted to see the company sell a minority stake to show the value of this business.
But the main reason I’m high on Indymac has to do with credit. We hear all the time that Alt-A loans are going to unravel just the same way that the subprime loans written over the past 2 years have. In fact, say the bears, Alt-A will be worse, since loan documentation is even iffier. Indymac stands to be the biggest loser.
But when it comes to Alt-A lending, it’s not always easy to separate lore from facts. Ask 10 different people what Alt-A lending is, and you’ll get 10 different answers. My definition is simple: an Alt-A loan is a loan to a borrower with a high FICO score who has lots of equity in the house but with a higher debt-to-income ratio than the typical prime. That’s often why Alt-A borrowers chooses to use alternate doc types. Does that make him a prime borrower? No—but that’s why we have risk-based pricing. To further articulate my point; here is a vintage curve that I think speaks volumes.
The chart shows three different deals from Indymac, from March, 2005, February, 2006, and October 2006, and compares them to New Century and Fremont deals from April, 2006 and while foreclosures at New Century are now at 8.5% and rising, the worst-performing deal for Indymac is at 1.25%.
Here’s the profile of a typical Indymac deal:
I don’t mean to imply that Indymac didn’t get carried away in the mortgage lending boom. Like other major lenders such as HSBC, Washington Mutual, Bear Stearns, Citigroup, Merrill Lynch, Countrywide (and on and on) the company occasionally went overboard in writing certain loans last year. It’s now paying for those excesses. My point, though, is simply that the fear that is priced into this stock as a result of that excess is way overdone; the reality is not that harsh.
If you doubt it, look at the stock’s valuation. Indymac lately trades at just 1.13 times book value, compared to a historical valuation range of 1.6 to 2 times. Similarly, it trades at just 10.5 times this year’s trough earnings, even though the company has generated solid, 20-plus-percent earnings per share growth for the better part of a decade.
There are many more facets to this story, including the outlook for its residuals (another sticking point for the bears), but I will stop here for now, and will address the balance sheet risks in more detail the next time around.
As always your input and insight would be greatly appreciated.
Disclosure: We hold a position in IMB