FBR's Latest First Marblehead Downgrade Makes No Sense

Allow me to state the obvious, and observe that financial services stocks are in the midst of a painful bear market. To put a number on it that in some ways understates the damage that’s been done, the S&P Financials have fallen by 22% in just five months; many individual names are off by much more than that.

And as bear markets go, this one’s a classic. In this version, as in all bear markets, fear is investors’ default emotion. Regardless of the new piece of news or analysis that emerges, investors won’t fail to interpret it in the worst possible light—and will keep on selling. This is of course the mirror image of what happens during bull markets, when new news tends to be perceived as positive, and investors send stock prices to levels that, only in retrospect, turn out to be unsustainably high.

When fear is the dominant emotion, often negative media stories and bearish analyst reports can have unusually large short-term downward impacts on stock prices--just like bullish stories and analyst comments have an inordinately positive impact during bull markets.

But in both cases, the overreaction doesn’t become clear until time has passed. Go back for a moment to the last sustained bear market in financials, in the late 1980s and early 1990s, and you’ll see what I mean. In October of 1990, after bank stocks had been going straight down for five years in a row, news emerged that Warren Buffett had accumulated a position in Wells Fargo that added up to 10% of the entire company.

Seventeen years on, it’s obvious that word of Buffett’s Wells holding is about as bullish a piece of news as investors might hope for. At the time, though, people simply didn’t see it. Here’s what Barron’s John Liscio had to say in his “Trading Points” column on October 29^th: “Buffett won’t have to worry about who spends his fortune much longer, not if he keeps trying to pick a bottom in bank stocks.”

Sure enough, the week prior to Liscio’s comments had brought more dismal performance by bank stocks, and came on top of a harrowing few months that saw many key names fall by 50% or more. But soon enough--on November 1, 1990, to be exact--the stocks began an incredible bull market that lasted for years. For the record, Buffett paid $1.90 each for his shares on a split-adjusted basis. They lately trade around $30. Warren Buffett’s investment in Wells Fargo is up by a factor of fifteen!

My point: it’s easiest to be the most negative on a company after its stock has been falling for an extended period, just as it’s easiest to be extremely positive after it’s had an extended bull run. You don’t need to have an advanced degree in psychology to understand why, either. Investor fear maxes out when stock prices make new bottoms, just as greed goes into overdrive at tops. At market extremes, investors become overly sensitive to what, they find out later, is mere noise.

All of which is an introduction to my take on FBR analyst Matt Snowling’s negative report on First Marblehead (FMD) Monday. In his note, Snowling raised two concerns about the company and downgraded the stock to “underperform” from “market perform.” This being a bear market the downgrade had a predictable effect: in a market that was down 2.3% Monday, and in which the S&P Financials Index fell by 4.0%, First Marblehead’s stock lost 10%.

Snowling’s first concern is that he’s worried that credit losses on student loans Marblehead securitized from 2004 through 2006 are running well above expectations, to the point that they’ll exhaust the reserves of the loans’ guarantor, The Education Resource Institute (TERI). Second, he raises the same worry he highlighted back in August, which is that the credit markets are so challenging at this point that Marblehead will not be able to do a planned securitization in the fourth quarter, which would mean that its earnings this quarter will be disappointing.

I happen to emphatically disagree with Snowling’s first point, and am unconcerned about his second. As to the company’s ability to do a deal anytime soon, first of all, a delay won’t affect the long-term business value of the company’s franchise unless you believe a complete shut down of the credit intermediation process will continue indefinitely. As to possible higher-than-expected losses on those 2004 through 2006 deals, his numbers are simply wrong, as I’ll show in a minute.

I don’t think Snowling has intentionally written a research report that is analytically faulty. But I do believe that, because we’re in the midst of a bear market, investors (both long and short) have accepted his conclusions too quickly, without giving them adequate thought. In my book, this is the classic bear market overreaction--so let’s take a closer look at what Snowling had to say.

I’m not going to spend a lot of time discussing whether First Marblehead will or won’t get a deal done before year-end because, as I say, the issue doesn’t bear on the company’s long-term value, unless you assume that the current credit market freeze lasts a long, long time. Frankly, that’s not a big concern of mine, since 85% of the bonds issued in prior securitizations have been rated AAA and all tranches have performed at or better than expected. As far as that goes, soon after the last time Snowling raised this issue, back in August, Marblehead sold its biggest deal ever.

But with respect to Snowling’s comments on student loan defaults, losses, and lack of reserves at the TERI, his analysis is simply way off base, and needs to be addressed.

You can imagine the ramifications that unexpected credit problems could have on Marblehead’s ability to generate earnings and cash flow. For starters, a TERI default would immediately impair the value of the residuals on Marblehead’s balance sheet. In addition, higher-than-expected credit problems would likely hurt Marblehead’s ability to facilitate student loans in the future and then securitize them.

All of which would be very concerning, clearly. Only, if you walk through Snowling’s numbers, you’ll come to the exact opposite conclusion. Defaults are not likely to be the big problem for TERI that Snowling says. And not for a particularly complicated reason, either. Snowling has simply miscalculated a key number: recovery rates for loans already in default.

I’ll run through some numbers, and you’ll see what I mean. Snowling has gone through the nine trusts Marblehead has issued since it began securitizing in 2004, through 2006. He sees no problems for TERI with four of those, but does see potential credit risks for the other five. Let’s look at one of those five, the first public trust Marblehead sold, 2004-1; it’s the most seasoned and thus most likely to be the best indicator of future performance of all the trusts.

Snowling says that when all is said and done, the 2004-1 trust will generate losses of $8.7 million in excess of the $35.2 million pledge fund that TERI set up to guarantee the bonds at time of sale. Here are his numbers:

So if you tally up future losses from current delinquencies that go bad at some plausible rate, plus loans now in forbearance that default at some plausible rate, and so forth, and add those losses to the $28.5 million in defaults the trust has already experienced, the TERI pledge fund will end up $8.7 million in the hole.

There’s just one problem with all this. Take a look at Snowling’s table again. Note how he assumes a 40% recovery rate in future defaults. That’s in line with the assumptions that TERI and Marblehead made at the time of the trust sale, and is actually conservative compared to Marblehead’s own experience. But when Snowling adds in the trust’s actual historical losses to date, he assumes that the recovery rate the trust has experienced so far—which is all of 12%—won’t rise over time.

Which is, in a word, crazy. TERI’s 12% recovery rate on existing defaults is almost certain to rise to the 40% that Snowling assumes for future defaults.

I’ll explain why in a minute. But first, a little background. The default-recovery process in private student lending is very, very different than it is in other types of consumer lending. The process can take years. In auto lending, by contrast, when the borrower defaults, the car gets repossessed, and the lender might sell it a few weeks later. The recovery proceeds are in hand before you know it. In mortgage lending, the process takes a bit longer, but isn’t likely to last much more than 18 months.

But student lending doesn’t work that way. In student lending (which is unsecured, don’t forget), experience shows that material recoveries take place over several years following the default. You probably don’t have trouble figuring out why, either. For starters, many delinquent borrowers will eventually apply for a mortgage—the first ones might just four or five years after they graduate--and will want to get that student loan derogatory off their credit files in order to get their loan. Or a borrower’s earnings power will eventually rise (over four or five years, say) to the point where he can service the loan without much financial strain. For whatever reason, recoveries take place over many years. Remember, the loans are not dischargeable in bankruptcy, so there’s never a time when it’s not worth the lender’s time and effort to keep dunning.

Someone please send Snowling the chart below, which is taken from a recent Marblehead investor presentation. It not only shows the long duration of recoveries on private student loan defaults, it also shows that, while Marblehead assumes a 40% recovery rate at time of securitization, the company’s actual experience has been considerably better than that. Net of cost to collect, Marblehead’s historical recovery rate is more like 60%!

So when Matt Snowling assumes that the 12% recovery rate of 2004-1 trust won’t rise over time, he’s making an assumption that isn’t just unreasonable. It’s idiotic. Material recoveries on 2004-1 will take place over the next several years.

And if you go back and plug in a 40% recovery rate for loans already in default, rather than the 12% rate that Snowling uses, the pledge fund shortfall that so worries him simply disappears. More numbers on 2004-1:

The story is basically the same, by the way, on all the other trusts that has Snowling so worried. Plug in a 60% recovery rate, and it should be even more clear that the TERI pledge fund is more than sufficient.

So there’s simply no problem here. As if to underscore that, Snowling himself admits that even under his own wacky numbers, the trusts in aggregate figure to generate positive cash of $20 million or so over their lives. Given that the pledge fund is sized to simply cover total net losses, this would imply that, overall, the credit quality of Marblehead-facilitated loans is actually better than expected using Snowling’s own numbers, and not worse, as he maintains.

Put it all together, and I don’t buy Snowling’s concerns. The recovery assumptions he’s making are way out of line with historical experience—and even then, the results that would occur aren’t as bad as he implies. I believe smart investors will see the stock’s weakness for what it is: an opportunity to add at attractive prices.

Disclosure: Author has a position in First Marblehead

Tom Brown is head of BankStocks.com.

Comments

[FIG trader_:]

Focusing on FBR's downgrade in and of itself is just masking the real reasons for the stock's total collapse, well beyond the average financial stock in 2007. One can be forgiven for being early or late to a stock; But one shouldn't be forgiven for not accurately assessing the considerable downside risk to a stock (50% in this case). Bill Miller has repeatedly said so about his own call on homebuilder stocks. In the case of FMD, "all the potential good news" was priced in the stock in late 2006, and none of the bad: credit market contraction, valuation compression; potential change in default patterns. Granted, I'll be the first to admit that for bears its been a "perfect storm". And there may well be another round trip to $50 a share. The markets are really that fickle. But I doubt it given the frost in the credit markets. My sense is that there is one more leg down in this stock, given the break yesterday coincident with the downgrade. So for value 3 to 5 year buyers, wait for high teens. Mid to low twenties was my original price target under "good conditions".We don't have them now.

2007 Nov 28 10:06 AM

[meta:]

what a trivial and half-a$$ed reply to brown's very detailed retort to snowling's blatantly misguided analysis. do you have anything to bring to the table other than your 20/20 hindsight, tangential quotes by bill miller and urging to not focus on the FBR report (the latter of which was the entire point of this post mind you)

specifically, where is brown incorrect? where is YOUR analysis? if you can only support yourself with terribly obvious macro insight (frozen credit markets, financial sector in toilet) and lack the wherewithal to back up your claims with some legit analysis you should not have the opportunity to moderate and participate in this forum.

you're clearly a successful FIG trader - support yourself!

2007 Nov 29 09:31 AM

[meta:]

what a trivial and half-a$$ed reply to brown's very detailed retort to snowling's blatantly misguided analysis. do you have anything to bring to the table other than your 20/20 hindsight, tangential quotes by bill miller and urging to not focus on the FBR report (the latter of which was the entire point of this post mind you)

specifically, where is brown incorrect? where is YOUR analysis? if you can only support yourself with terribly obvious macro insight (frozen credit markets, financial sector in toilet) and lack the wherewithal to back up your claims with some legit analysis you should not have the opportunity to moderate and participate in this forum.

you're clearly a successful FIG trader - support yourself!

2007 Nov 29 09:31 AM

[FIG trader_:]

First if all, why do people like you think you are the only ones with the right to speak, by bullying or attempting to silence opposing views. (See Dec 2006 posts for original short thesis on figtrader.blogspot.com.) If you had followed my arguments repeated here on seekingalpha numerous times since, you would not be a current disgruntled bagholder. Others have, and have thanked me for it. For the record Second Curve Capital has reduced its position as of 9/30 according to filings reported by Bloomberg. Rather than follow Tom Brown's advice so blindly, do a little thinking for yourself, listening to opposing views, regardless of whether they focus on what you think is relevant. Clearly you/he was wrong on this time. Admit it, and re-evaluate your assumptions

2007 Nov 30 01:59 PM

[FIG trader_:]

website is figtraderintelligence....

2007 Nov 30 02:41 PM

[meta:]

i am not a disgruntled bagholder, so no need to make assumptions - however, i am solely responding to your reply to tom brown. i also have not brought up the past year's performance (again, thank you for the stunning 20/20 highsight). however, i do believe brown's latest post has some good points backed up by real analysis which you somehow disregard. i will say it again - if you disregard his analysis (via your call that the stock will drop substantially farther than snowlings $26 target based on faulty assumptions/math) then back it up with your own...once again, your thoughts are worthless if you are unable to do so.

2007 Dec 03 10:10 AM

[FIG trader_:]

After slogging through several hundred words about bear markets in financials, I finally got to the part where Tom Brown provides a thorough exegesis of Snowling's "too late to be useful" analysis and stock downgrade. (For those so inclined, the stock was in a position to break right at that technically important $30 level when the report came out. A coincidence I suspect.) It's another one of those "shoot" the messenger explanations that Tom Brown never gave (while others did) in his days as the best bank analyst on the Street. He is giving Snowling too much credit for the stock's drop. While there is some tangential relationship (keeps potential buyers out of market for few days), analyst ratings are not the ultimate determinants of a stock's price. Proof is the subsequent 30% up move off the intraday lows ($25.+ change). I take no major issue with Brown's analysis of Snowling's assumptions; only the relevance to the stock price. He is just shooting the messenger. The difference between TB's, and MS's assumptions (tens of millions in cash flow/earnings) doesn't explain the variation in the stock's market capitalization on that day, or for the prior 365 days. (Again, please reread FMD short sell recommendation from 12/2006;The Bear Case on First Marblehead on figtraderintelligence..... No hindsight here, if I may humbly say so.) I am 100% in agreement with TB that the financials (broadly speaking) have bottomed (see capitulation piece in November) and that buying on weakness is great idea. I have just lowered my low-end target for more suspect names, in which I include FMD. Many people refuse to believe that this is a financial and price/book a relevant data point for this company. They are at liberty to do so. They can ignore my posts if they wish. But I have yet to read adequate explanation for the stock's 50%-plus decline since 2006. (I am also at liberty to not debate issues not always the most relevant to a stock's direction or ultimate value, such as Tom Brown's assessment of Snowlings' mis-assessment). For the record the stock is probably much closer to a bottom than a top, though I would have to do more homework before recommending it. Dissing it has just been too easy to pass up.

2007 Dec 04 11:31 AM

[meta:]

what a trivial and half-a$$ed reply to brown's very detailed retort to snowling's blatantly misguided analysis. do you have anything to bring to the table other than your 20/20 hindsight, tangential quotes by bill miller and urging to not focus on the FBR report (the latter of which was the entire point of this post mind you)

specifically, where is brown incorrect? where is YOUR analysis? if you can only support yourself with terribly obvious macro insight (frozen credit markets, financial sector in toilet) and lack the wherewithal to back up your claims with some legit analysis you should not have the opportunity to moderate and participate in this forum.

you're clearly a successful FIG trader - support yourself!

2007 Nov 29 09:31 AM

[altidude:]

I guess I'm still not buying the bear case here.

Until FMD's recent inability to securitize its loans, the firm never showed any chinks in its business armour. On the contrary, cash profits (i.e., when you totally ignore the effect of non-cash revenue from the income statement) have been growing nicely for the past 5 years, hitting $370mn (pretax) in 2007, up from $19mn in 2003.

As for its inability to securitize loans this quarter, that is a concern. But--to me--it's a slight one right now. I wouldn't expect them to do a new securitization when a ratings agency has some of their past debt tranches under review. We'll see if FMD can close a securitization when that review is over. If not, that would be a serious concern, unless it is able to monetize its business in other ways.

As for the ratings agencies, Fitch's has recently reiterated its ratings on FMD's various tranches of debt and Moody's has (I believe) just the non-AAA tranches under review. Well, those non-AAA tranches traditionally represent about 12% or 13% of the value of the private student loans securitized. The vast majority of the tranches are AAA rated, and those are not under review. So, it seems that the vast majority of FMD's securitization debt financing is solid.

Even if Moody's perceives a problem with the non-AAA rated tranches, it looks to me like FMD has the financial wherewithal to effectively address any potential concerns. FMD's cash profits (again, that's cold hard cash, ignoring the effect of non-cash revenue) have generally amounted to about 5% of the value of the private student loans it has securitized in any given quarter / year. So, one way to alleviate any potential concerns might be to use some of that money and provide an extra cash cushion in the trusts. If FMD provided an extra 3% cash cushion in the trusts, would that alleviate potential concerns of the non-AAA bond holders? (That would be an additional 3% relative to the non-AAA bonds that represent about 12% or 13% of the private loans, so that extra cash cushion would amount to about 25% of the total value of those loans in the trust! That seems pretty substantial.) I'd point out that if FMD did this, they might get that 3% out on the back end of the trusts, provided the student loans performed as they expected.

Furthermore, it seems to me that if FMD received feedback (from the ratings agencies, debt investors, or the student loan performance) that they weren't making profitable loans, it seems like they could just change their underwriting criteria. Jack up the interest rates on any "problem" borrows for future loans they make. Or just don't loan to them at all. FMD controls the underwriting (with TERI), so they can just change the criteria to avoid the "problems" in future securitizations.

As for putting numbers on a valuation, here are my major assumptions:
DCF model
Average volume growth over next 8 years of 17% annually (incorporates loss of BofA and JPM at current contract ends, roughly 20% industry volume growth otherwise, and 35% volume growth in 2008)
Upfront fee yields dropping to 4.8% for all future securitizations (represents additional 3% cash cushion left in the trusts--and this 4.8% yield is relative to 7.8% achieved in 2006 and 8.7% achieved in September 2007 securitization)
Residual yield of 1.3% for all future securitizations (relative to 6.5% in 2006 and 5.8% in September 2007 securitization)
Balance sheet residuals of $800 million are worth only $96 million in real economic value (i.e., haircut of 80% and then after tax)
Expenses growing 30% in 2008 and then growing with rate of revenue growth thereafter
Balance sheet cash value of $237.5 million
Discount rate of 10%

Using these assumptions, I'm getting a no-growth value (based on projected 2008 results) of $20 per share. I get a value of $35 per share using an 8-year forecast. And I think FMD stands a very good chance of significantly overachieving these assumptions.

Of course this assumes that FMD has a viable business, it will be able to conduct future securitizations on reasonable terms (i.e., leaving an extra 3% cash cushion in the trusts), and will continue to operate indefinitely.

But based on this information, it looks like FMD is a bargain at today's $18 per share.

2007 Dec 10 11:42 AM

[FIG trader_:]

Needless to say, if you liked at $35 in November as you did, you have to think it is a bargain at $16 (or $18). But there is no bear case at $16. It was made by myself and others at $50, $45, $35. No bears left at this price, just sellers, and lots of them. After yesterday, seems like even BV price target is not out of question. That is a price target that not even the loudest of the growling bears could have hoped for six months ago. The funny thing (or not so funny if you are bleeding money every day and on margin), is that the guys that loved this thing at $50 are selling, and the guys that shorted it and thought it was worth half of $50 are buying (i.e. covering). Twisted world.

2007 Dec 11 07:18 PM

[altidude:]

FIG, I did like it at $35 and do think it looks like (even more of) a bargain here (below $15 now). Market cap is $1.4bn.

FMD had $163mn in net cash plus $1.14bn in Loans held for sale and Service Receivables (although that book value is potentially overstated) on its last quarterly balance sheet. It's pretax cash profits were $106mn and $135mn in 2005 and 2006. (Pretax cash profits in 2007 were $370mn, but they benefited from BBB-rated tranches in the securitization trusts that are no longer saleable at similar prices.) FMD had another $168mn and $241mn in pretax profit from non-cash revenue in 2005 and 2006. These are financials that seem to be able to support a market cap much higher than $1.4bn, IF the future looks like even a small fraction of the past.

FIG, do you think the securitization market is gone forever for FMD? Or, do you think it will remain a viable way for FMD to monetize its business? And do you have a view on a "fair" price for FMD's shares today?

I've enjoyed reading your posts (both here and on your blog). Would love to hear your thoughts on a "reasonable" price today, if you think it's worth "doing more homework".

2007 Dec 12 09:04 PM

[FIG trader_:]

Well certainly, Street has come down to a loss of $.15, from almost a buck last year. Coincidently that was when the risk was the highest, and the bearish case the strongest. But, if they (and you) were so far off last year, why would anyone rely on forward estimates including March and June quarters of around $1.00? Having been a bottoms up analyst, I'm aware of the blinders analysts put on, marrying a name, and not divorcing it early enough. My advice is to stay on the sidelines, re-evaluating new "business model". I don;t have a case, bullish or bearish, for that matter at this time. The old business model imploded, as I predicted. There are plenty of "ideas", especially among financials, with less volatility in the earnings stream, the real issue here

2007 Dec 14 09:16 AM

[altidude:]

Well, FIG, it'll be interesting to see where this is in a year's time. I'm personally less concerned about FMD missing a securitization this quarter and more interested in its prospects to maintain a profitable business going forward, which I feel are much better than the market seems to be implying at $14 per share. Count me in the bullish camp.

2007 Dec 17 02:44 PM