Welcome to the Subprime Dead Pool

Apr. 3.08 | About: Fremont General (FMT)

In testimony before the Joint Economic Committee Tuesday, Fed Chairman Ben Bernanke said that the US economy would return to growth in 2H 2008. But looking at the US banking sector, it appears that lenders are rapidly moving from whining about self inflicted mark-to-market wounds to feeling real cash loan losses. We'll talk more about this next week in our interview with Josh Rosner.

Subprime lenders are feeling the pain most sharply. Last week, for example, the FDIC announced that Fremont General Corp's (NYSE:FMT) $8 billion asset Fremont Investment & Loan unit, which has been an aggressive player in subprime real estate markets around the US, was categorized as an "undercapitalized" depository institution. Under the order from the FDIC, FMT must either raise funds to increase capital to acceptable levels or put its bank unit up for sale.

The announcement illustrates how the FDIC and OTS are taking a proactive approach to dealing with institutions which are headed for trouble. It also shows how the softening US real estate market is starting to seriously affect lenders. But more than anything else, the story of FMT reveals how banks attempting to extract supra-normal returns by trading up the risk curve often get into trouble, especially when the economy turns sour.

FMT is a $0.50 stock, down from $13.80 in June 2007. The bank is under investigation in Massachusetts and other states for predatory lending. In fact, the Massachusetts AG has put an injunction in place preventing FMT from selling assets originated in that state.

Under the Economic Capital model in The IRA Bank Monitor, as of year-end 2007 the FMT bank unit earned a "Stressed" counterparty risk rating and a RAROC of 4.1%, with a ratio of Economic Capital to Tier One Risk Based Capital of 4.13:1 - the same neighborhood as JPMorgan Chase (NYSE:JPM). The 40% of total assets in private label MBS is a big reason for the poor Economic Capital metric.

For users of fundamental screening tools such as The IRA Bank Monitor, the troubles at FMT's bank unit are no surprise. The first telltale sign is the gross lending return, which has been several standard deviations above-peer for years. At the end of 2007, the FMT bank unit reported a gross spread of almost 1,300bp, more than 3 SD's above peer.

Now you might think that a big spread is a good thing, but in a small lender with 99% of total loans in real estate, a gross loan yield above 1,000 basis points strongly suggests a subprime lending operation. Banking is a commodity business, so when you see any bank earning above-normal returns - especially in mortgage lending - this is a red flag that any diligent analyst, regulator or investor must pursue. Sadly, few seemingly did so. Remember that the average mortgage lender has a gross loan yield less than half that of FMT's bank unit.

The next key clue was the bank's default history. During the mortgage boom years, FMT's bank unit was reporting below peer loan defaults, but an above peer gross loan spread. Hmm, what's wrong with this picture? In the first two quarters of 2006, for example, FMT reported zero defaults vs. less than 60bp for its asset peers calculated by The IRA Bank Monitor.

Question: Where were the OTS, the FDIC and FMT's auditor two years ago when the bank was reporting these incredible results in regulatory filings? By the end of 2007, FMT's bank unit was reporting an annualized 180bp of defaults vs. 60bp for its peers and this after reporting 700bp of charge offs in Q2 2007. Yikes.

Loss Given Default is likewise not a pretty picture, with the FMT bank unit reporting 90% plus losses net of recoveries in most quarters going back 7 years. In the 2006 boom period, when Florida real estate madness was peaking, the bank reported negative LGD for several quarters, meaning that recoveries exceeded defaults, but then went right back to the 90% plus LGD range that is the natural home of subprime and credit card lenders. Remember, with much of the portfolio in real estate, the high LGD is a screaming red flag.

Another question: Just how did Jay Sugarman, founder of Istar Financial (NYSE:SFI), decide last year to buy the commercial lending assets of this high flyer? Did anyone at SFI bother to do any type of financial due diligence on the FMT business? Keep in mind that the FMT business has been an outlier vs. its asset peers for years, back to before 2000, and that this information is publicly available on the FDIC web site.

The moral of this sad story is that when a bank looks smarter than everyone else in a given market that often means that there is something amiss with the business model choices being made by management. With state regulators and prosecutors in Massachusetts and other states looking at FMT's lending practices, our bet is that it will be next to impossible for this bank to raise cash or sell itself. Add this name to the Subprime Dead Pool.