FirstFed Financial (FED) is a medium-sized bank with operations entirely within California.
Its most recent earnings report was quite bleak. Severely delinquent loans (90+ days past due) and foreclosures more than doubled in this past, from $180.4 million to $393.6 million. Real-estate owned ("REOs") went from $21 .1 million to $45.5 million, also more than doubling.
A look under the hood of the company's recent financial statements and at the underlying economic trends in California reveals nine other reasons why this stock is a compelling short play.
(1) Most of FED's portfolio consists of “Liar Loans.” Of the company’s $4.5B single family loan portfolio, 10.8% is completely no doc, 62.2% is either stated doc or stated income, and only 27% is full doc.
(2) Borrowers with very poor credit histories. 9.6% of FEd's loan portfolio is from borrowers with sub-660 FICO scores, indicating that at the time the loan was extended the borrower likely had a substantial history of late payments and non-payments on their credit report. An additional 1.3% had no credit score at all. Besides these borrowers’ previous bad history of paying their bills, low credit scores also mean they will be less likely to be able to obtain credit elsewhere to deal with financial problems, and more likely to default as soon as financial problems occur.
(3) A majority of residential loans are underwater now, or soon will be. The company estimates that as of 12/31/08 that 2.6% of its borrowers had current loan to value ("LTV") of more than 100%, and this is the most recent date the company is willing to conjure up an estimate. There are several measurements of price declines since then, but the most timely seems to be from consulting firm Dataquick, which shows an additional decline of 12% between December and April in median California housing prices. This would mean that as of April more like 23.4% would have an current LTV of 100% or more. (These LTV figures are only estimates because of the way the company only reports its own LTV estimates in ranges, but are unlikely to be off by much more than one percentage point.)
If California prices continue to decline at the Dec-Apl rate of 3% a month, then by the end of the year, an astounding 73.6% of its current single-family loans will be underwater, and about 78% will be in a position where they cannot sell their home at its current estimated value without bringing money to closing to pay the 6% listing commission. This may be unduly pessimistic, but even a moderation to a monthly rate of California home price declines to only one half the rate of December-to-April rate would render these two numbers 56% and 68%.
An alternative way to divine the percentage of the company’s loans that are or soon will be underwater is start with the fact that as of 3/31/08, 74.1% of the company’s mortgages were originated in 2005, 2006, or 2007. In most of California we are already well below 2005 prices, with the worst parts of the state down 25-50% from these prices and flirting with 2002 and 2003 prices. According to Dataquick, the January 2005 median California price was $415,000, well above the current $354,000 in April 2008. In fact we are only a tad bit above the Jan 2004 average of $343,000. Another 15% of the company loans are 2004 vintage.
(4) Neg-am loan recasts. “Substantially all” of the company’s adjusted rate portfolio are neg-am loans. These are very risky loans because payments almost double on average when they recast, and further because loan balances increase every month for the majority of customers during the negative amortization period, further eroding current LTV. The company projects that it will have $607 million in Neg-Am loan recasts, with 48% of these borrowers facing monthly payments that will MORE THAN DOUBLE.
(5) Management showed its poor judgment with ill-timed share buy-backs. FED is trading around $15. Yet as the company’s quarterly report says, during “2007, the Company repurchased 3,140,934 shares at an average price of $48.48 per share.” The company’s total loss on this share buyback is so far $105 million.
(6) Foreclosure-related expenses are growing. Compared to Q1 of 2007, “legal expenses” and “real estate owned operations” increased by a total of $1.27 million. While not a gigantic amount, they will likely increase further rest of the year, adding 15 to 20 cents to the company's losses for each of the next few quarters.
(7) FED's April update shows negative trends continuing. On 5/21/08, FED released its regular intra-quarter update showing selected data as of 4/30/08, one month more recent than its quarterly report, and the most timely information investors have about the company’s current situation.
The report shows that rapid deterioration in the company’s loan portfolio disclosed in the first quarter continued into April. Most notably, non-performing assets as a percentage of total assets increased more than 10% in just 30 days, from 6.20% to 6.85%. With Neg-Am recasts and an extremely weak macroeconomic environment, especially in California, I see no reason why this trend won’t hold up, if not get considerably worse, for the rest of the year. If this ratio continues to increase at 0.65% per month for the rest of the year, by December 31st the company will have non-performing assets of 12.05%. If the company is still in business by then, 2009 can only be a grimmer year as option-ARM resets will come in even larger volumes next year.
(8) Most loans were brokered, not in-house. While FED now has about 34 branches, it was largely a “virtual” mortgage bank during the bubble when it extended most of its loans, lending money via wholesale mortgage broker referrals rather than originating them in-house. The past two years have shown the folly in this strategy: mortgage brokers seek to maximize their own commissions, not the safety of the banks they sell loans to. It also means company loan officers usually don’t live in the communities where they are loaning money, making mortgage fraud and plain-and-simple unwise lending decisions much more common. Since the brokered non-prime residential lending business is now quite dead, and has been so for nearly a year, the company has responded by trying to expand into retail branch banking, commercial lending, and high-quality (and low margin) conforming loan lending. In doing so, it is spending what much of what remains of its equity cushion on entering a fiercely competitive market that is rapidly shrinking as California enters a period of negative economic growth and the volume of mortgage lending declines with home sales, which are now much less than half the amount of peak months.
(9) Phantom tax benefit accounting may be overstating the company’s equity. The company’s most recent annual report showed a net tax asset of $80.7 million, and in the first quarter of 2008 the company took an additional $50.3 million income tax benefit, suggesting this figure is now about $151 million, or more than one quarter of the equity that it is now reporting. Current trends suggest that by June 30th this figure will exceed $200 million, even while equity decreases by another $60-90 million, leaving more than 40% of the company’s book value consisting of nothing more than a “tax asset” that is worthless unless the company has adequate other capital to generate income for these tax loss assets to offset. The company admits as much in its annual report, noting that the tax benefit is contingent on that company’s judgment that “it is more likely than not [the tax benefit] will be realized due to the existence of loss carry-backs and expected future earnings.” I don't expect these future earnings to materialize, rendering this large asset completely worthless.
You can’t compare FED against its peers based on P/E ratios since FED and its peers all have negative earnings. Price-to-book and price-to-sales ratios, however, are possibly useful metrics. Like its peers, the company currently trades for well below stated book value because substantial losses are certain to wipe out more and more of that book value as time progresses, and because, as discussed above, much of this book value consists of questionable and very illiquid income tax benefit.
Nonetheless, FED seems overvalued based on these metrics when compared with other troubled mortgage finance stocks. FED in my opinion is most comparable to two other banks with large non-prime and negative amortization loan portfolios in weak markets, Downey Savings (DSL) and Bank United (BKUNA). DSL trades at 0.15 to book and 0.39 to sales, while BKUNA is at 0.17 to book and 0.4 to sales. FED’s stock price looks quite rich by comparison, trading at 0.35 to book and 0.84 to sales. FED would need to fall another 50% from current prices to reach the same relative valuation of these two negative-amortization peers. FED’s ratios are also substantially richer than Countrywide (CFC) and National City (NCC).
I think about half half of the company’s resetting neg-am loans will go into default. The company simply does not have the equity to absorb the losses here. There is nothing the Federal Reserve can do to bail the company out either, since the company’s issue is not liquidity, but solvency.
To put it bluntly, the combination of these extremely risky and low-quality loans, the weakening economy in California, phantom tax assets, and the company’s degree of leverage leads me to conclude that the bank will fail and be taken over by the FDIC, possibly in less than 12 months, and almost certainly within 24, an event that would wipe out shareholders and send the stock to 0.
FED is so heavily shorted right now that it is hard for brokers to find shares available, indeed I personally have a second brokerage account only because this broker has been very good at finding me shares to sell of hard-to-short stocks. I have no idea what will happen to the stock in the short-term, but I am confident in a strategy of shorting the stock as shares become available, and then holding the position for at least 12 months as the stock declines. This strategy has served me well in my short sales of other real estate finance companies such as TMA, DSL, BKUNA, NCT, and FBR, all of which have suffered massive declines in price, even while enjoying the occasional short-term bear rally.
All data used in this article unless otherwise noted comes from the company’s most recent quarterly report.
Disclosure: Author holds a short position in FED