As I've mentioned before, one of the great things about maintaining a blog is the reader interaction. My last post on Downey Financial Corp. (DSL) regarding the 13D filed by Gerald Ford's Hilltop Holdings (HTH) resulted in some great insight provided by some readers.
One reader brought up the situation regarding E-Trade Financial Corp. (ETFC) and suggested that it could serve as an interesting proxy for DSL's loans given that hedge fund Citadel effectively purchased ETFC's loan portfolio for $0.11-$0.27. I hadn't been following ETFC closely and had focused mainly on the headlines such as the New York Times' "E*Trade Hit By Fallout of Subprime" and CNBC's "E-Trade Shares Nosedive on Subprime", which led me to think ETFC was more of a subprime issue than it really was. Early reports mentioned a $3B portfolio that included just $50MM of AAA-rated paper, so without doing further research I told the reader I didn't think it was necessarily an apples to apples comparison with DSL given DSL's prime loan book. However, another astute reader pointed out that ETFC's portfolio was actually much more comparable to DSL than I thought and upon seeing the links provided (Calculated Risk, SF Chronicle), I really wanted to take a closer look.
In addition to ETFC, Wells Fargo Corp. (WFC), generally considered a very well-run bank and immune to subprime problems, recently recognized a $1.4B writedown to what was an entirely prime $11.9B loan portfolio. I think that news, along with ETFC, provide significant insight as to the kind of haircut DSL could be facing with its loan portfolio.
WFC's $1.4B writedown was recognized against an $11.9B portfolio that was originated through indirect sources (i.e. mortgage brokers) and consisted of prime rated home equity loans. Although WFC did not release the average FICO of this specific portfolio, the average FICO score for WFC's home equity loan portfolio is 750. This $11.9B portfolio included about $4.6B in loans with a loan to value ("LTV") of 90%+ and according to WFC's November 27th, 2007 8-K, "are largley concentrated in a few geographic markets that are experiencing the most abrupt and steepest declines in housing prices." The $11.9B in loans is being placed into a liquidating portfolio and it appears that WFC is over-reserving by $400MM as the bank expects to lose about $1B on this portfolio. This conservatism is consistent with WFC's history and is what's made WFC a well-regarded bank.
Further, WFC is a "real" bank and generally didn't get caught up with other more exotic products that really were about risking dollars for a few extra pennies. In the early-mid 90s, WFC over-reserved for losses related to the California housing downturn and astute investors that seized upon that opportunity (like Buffett) made incredible returns. This posting is about DSL, however, and the reason for discussing WFC's $11.9B portfolio is because it can serve as an interesting proxy for what DSL may need to recognize in the coming quarters. The following list highlights some interesting similarities between the WFC portfolio and DSL's loan book:
1.) WFC's portfolio is $11.9B while DSL's portfolio is worth $11.7B when including its loans for investment and loans held for sale.
2.) Both are prime loan portfolios with DSL's average FICO score for its $11.2B residential portfolio at 696 and WFC's portfolio having been confirmed as prime by the company.
3.) Both portfolios are concentrated in geographies that are among the most volatile in terms of pricing corrections. While WFC doesn't provide any additional insight beyond that, DSL's loans are concentrated mostly in southern California.
4.) Most of WFC's $11.9B in loans were originated through third parties or acquired by WFC. According to DSL's 2006 10-K 81% of the bank's residential mortgages were originated or purchased through outside brokers.
5.) Both portfolios are comprised mostly of residential loan products. In WFC's case, the $11.9B appears to consist of mostly home equity loans while in DSL's case, the vast majority ($11.2B) of its loan portfolio is in residential mortgages secured by real estate. Home equity loans are a very small part of DSL's loan portfolio based on page 39 of its latest 10-Q.
The above points demonstrate that the WFC portfolio and DSL's loan portfolio offer striking similarities. The main differences appear to be in the type of residential loans in the portfolio and I'd argue that DSL's loan portfolio is actually riskier because the bulk of its portfolio consists of option ARMs that allow for negative amortization.
According to WFC's latest 10-Q, due to WFC's "responsible lending and risk risk management practices...we (WFC) do not originate any negative amortizing mortgages, including option adjustable-rate mortgages (ARMs). We have minimal ARM reset risk across our owned loan portfolios." This is in stark contrast to DSL's loan portfolio which is loaded with option ARMs that allow for negative amortization.
So we know that WFC is taking a $1.4B provision against a portfolio that is roughly the same size as DSL's entire loan book and shares many of the same characteristics. While WFC's portfolio consists mostly of home equity loans which account for a very small portion of DSL's loan book, an argument could be made that this is much more than offset by the lower credit quality of DSL's loan book vis a vis its heavy concentration of option ARMs. DSL's latest 10-Q shows that $7.1B or 89% of its residential loans subject to negative amortization have balances greater than the original loan amount. In addition, DSL maintains $2.5B in interest-only loans, nearly double the amount from Q3 2006. This amounts to about $8.6B in mortgages that could be difficult to sell or off-load irrespective of their FICO score/prime classification. This is akin to the 20/90 bid-ask that David Einhorn of Greenlight Capital has discussed in recent months and what essentially occured in ETFC's deal with Citadel.
What we also know is that WFC has a history of being forthright about its problems and the Street is probably comfortable that WFC took this charge that should cover the full extent of WFC's problems and is moving on. Further, this $1.4B provision is a drop in the bucket given WFC's capital base and the overall portfolio is just 3% of WFC's total loans outstanding as of 9/30/07. That's not the case with DSL. This troublesome portfolio for WFC is effectively the same size as DSL's entire loan book and if DSL were to recognize a pre-tax provision of $1.4B, the effects would be disastrous to its capitalization.
Table I: DSL CAPITALIZATION RATIOS 9/30/07
Table I is from page 55 of DSL's latest 10-Q and highlights the bank's capitalization requirements across various classes of capital. The Street has anchored to the excess levels of capital that DSL appears to have and at first glance DSL appears to have significant excess capital against the regulatory mandates. However, ETFC's deal and WFC's latest news, which I believe is really an incredible comparable to DSL's entire loan book, provide real numbers in regards to what type of marks these portfolios are recognizing. I highlighted the Well Capitalized Requirement to keep those figures in mind while trying to figure out what kind of damage recognizing a provision of similar value to the WFC provision would do to DSL.
With 75% of DSL's fiscal year over with, I took some broad assumptions regarding what it's final year P&L would look like. Forget about capitalized interest and quality of earnings, this was just a basic attempt to come up with some easy numbers to work with which are presented in Table II.
Table II: DSL FYE 2007 ESTIMATES ($MM)
So let's assume DSL recognized a $1.2B provision for its portfolio. I used $1.2B given the slightly smaller size of DSL's portfolio against WFC's and I placed it after interest income as opposed to making an adjustment to net interest income. I actually think my 2007 FYE estimates may be overstating what DSL puts out because more recent events illustrate even more aggressive deceleration against prior comparisons. I also don't know what DSL's tax treatment would be so have used it's historical 40% rate and assumed it would result in a benefit against its operating loss. If those assumptions are correct, DSL's book equity would be reduced by $585MM. This is not a precise figure but let's just say that assuming $1B-$1.5B in provisions would result in an after-tax impact of about $600MM-$900MM against DSL's book equity.
So book value of DSL could easily be $16-$30 per share in this scenario but the real issue is that the bank's capitalization ratios would be at risk. As Table I illustrated, DSL's Core and Risk-Base Capital ratios give the bank about $750-$830MM in cushion. If it's capital base takes a hit at anything close to what recent deals have indicated, DSL would be either under regulatory capital requirements or dangerously close. Sure, assets would shrink by the net allowance but given the 10:1 assets/equity gearing, it would be of little consequence in preventing DSL's capitalization from significant erosion. One final piece of information I've found peculiar is that DSL's excess ratios have increased in recent months which is presented in Table III.
TABLE III: DSL HISTORICAL CAPITAL RATIOS (click to enlarge)
What I found peculiar about DSL's historical capitalization ratios is the trend that shows the bank becoming "safer" over time. Book equity has grown at a healthy clip in recent years as the bank has become capitalized well in excess over regulatory mandates. That is the impression one could get from reviewing the trend presented in Table III. The problem is that book equity which is the regulatory capital item (adjusted for Core and Risk-Based requirements) has grown at the expense of earnings quality.
As I've mentioned in previous writings, since 2003 capitalized interest from negative amortization ("CINA") balances have become an increasing part of DSL's net interest income. CINA was just 2.7% of net interest income in 2003 but through 9/30/07 is 82.1% of interest income. These figures flow through to book equity and Table III presents an accounting reality that is far different than DSL's economic reality. I interpret the growing excess ratio as a statement that DSL has yet to take a "real" provision against its portfolio which is why this illusion persists. Once that provision is recognized, DSL's ratios will be much closer and possibly below regulatory guidelines.
I suspect DSL will take the UBS approach where they spread this massive provision and try to manage it across quarters to blunt the impact to investors. It won't matter because the size of those quarterly writedowns will still cut into EPS and book equity and I think investors will eventually capitulate. There are other banks (like WFC) that do the "one-and-done" with an aggressive provision and investors will have much more trust in placing money there rather than the constant nicks and cuts over 4-6 quarters with no real numbers to trust. In the near-term, there's plenty of broader financial news regarding the potential plan to freeze subprime resets (and will probably be applied to prime option ARMs as well), Citigroup's (C) deal, and of course the expectation of a Fed rate cut that could prop up DSL's shares, but in the medium to longer term I think DSL is in much more serious trouble than its current share price of $40 indicates.
DISCLOSURE: AUTHOR MANAGES A HEDGE FUND THAT OWNS DSL PUTS