Eric Boughton_

First Federal: Soon-To-Be Sub-Prime Lender?

Thanks for the post, Tim.... there is even more to the story.

At first glance, this is a sleepy community bank with 32 branches, founded in 1929. A closer look reveals dramatic acceleration in mortgage loan production between 2003 and 2005, as the bank more than doubled total assets with almost no growth in branches. What’s more, these loans have characteristics which we see as huge dangers for the company.

1) FirstFed operates in an area where home prices are at record levels, based on any metric. In many California communities, the median home price is 6-7 times the median income, compared to 3.5-4 times nationally, and 2.5-3 times five years ago. Our thesis is that many borrowers, even those deemed good credit risks, will walk away from their homes if and when home prices fall substantially.

2) 90% of FirstFed’s loans are ARMs. FirstFed has positioned itself as “the” ARM source in Southern California. As the falling originations highlight, this is great when option ARMs are popular, but can dry up pretty quickly.

3) 80% of loan originations in 2006 were 40-year mortgages, another sign of a stretched consumer desperate to minimize a monthly payment. A longer mortgage period means lower payments and more opportunity to default.

4) Many of FirstFed’s loans have negative amortization features. Aside from the increasingly evident risk that borrowers will have to default as soon as the rate resets, negative amortization in FirstFed’s case means that operating cash flows are consistently negative, even though EPS looks healthy. (BKUNA is another name we are short for the same reason.) There was $216 million of neg-am included in 12/31/06 loan balances.

5) As you point out, half of the loans on FirstFed’s balance sheet are “liar loans”, with either no income or asset information requested, or no verification of the borrower’s stated financial situation. An additional 33% are “SIVA”, with assets verified, but income not verified.

6) FirstFed gets half of their loans from wholesale loan brokers, meaning there is much more room for the “predatory lending” Congress is currently whining about, and also meaning that FirstFed can easily be misled by fraudulent brokers, who seem to come out of the woodwork in a downturn.

7) FirstFed seems to have under-reserved for problem loans. Non-performing assets jumped from 0.05% of total loans at the end of 2005 (absurdly low) to 0.23% at the end of 2006 (still lower than most banks). FirstFed also has NO valuation allowance for impaired loans, relying on SFAS 114, which they read as not requiring a valuation allowance for loans under $1 million.

8) FirstFed finances loan production with high-cost and “flighty” CD’s. In fact, they are one of the largest internet advertisers of high CD rates. This makes perfect sense—after all, one can hardly expect $1.5 billion in “sticky” customer deposits from only 32 bank branches to support $8.5 billion in loans! This may be a great business model when there is a high interest spread between CD’s and mortgages, and when defaults are low--neither is the case today.

9) The average FICO score for FirstFed borrowers in 2006 was 714, solidly in Alt-A territory. When an Alt-A borrower tries to afford a “prime” house, the borrower may as well be sub-prime.

10) To top things off, FED has seen high insider selling recently.

Full disclosure: our hedge fund is short this name.