Memory Lane

As promised, I’m going to share the key statistics from a Flagstone Securities “Weekly Performance Digest” of the mortgage investment stocks we could invest in back in September of 2006.

Offhand, I’d say the most striking thing about the list is the disappearance of most of the names, and even several of the categories.  Needless to say, there are a number of members of the all-time investment Hall of Shame here.

The first group on the list were called “Active Originators and Nonprime Investors.”  They sported total market cap of $5.6 billion at the time, and that doesn’t even include the Wall Street firms whose captive subsidiaries made these guys into bit players in that market.

Under the title Active Originators and Nonprime Investors, the companies were Aames Investment (AIC), Accredited Home Lending (LEND), Delta Financial (DFC), ECC Capital (ECC), Fieldstone Investment (FICC), New Century Financial (NEW) Novastar Financial(NFI), Origen Financial (ORGN) and Saxon Capital (SAX).

At the time (September 1, 2006) of the report, two of names on the list had already turned toward losses.  Aames and ECC capital each lost money in 2005.  Among those still earning money, the big numbers were being put in by Accredited, New Century and Novastar.  At the time, the bond investment world gave Accredited and Novastar respect as first tier quality (shown by bond investors by bidding their new issue bonds at a slightly lower yield). They shared that distinction with the subprime division of Wells Fargo bank, while both Aames and ECC were known as “third tier” lenders.

New Century had a 10% market share as a middle tier lender, making it the only one in the publicly traded group that came close in volume to the big Wall Street captive companies.  As we found out a couple of quarters later, New Century was putting up its big numbers by faking its accounting.

From mid 2007 through mid 2008, the financial press and unfortunately luminaries like Ben Bernanke were convinced that all the problems, and the evils, of subprime lending was the fault of this group of publicly traded companies.  That was absurd, given the fact that Wall Street captive lenders had about two thirds of the market at the time.

The CEO from Novastar responded to a questioner in one conference call asking why they weren’t insisting on higher quality loans or charging higher interest rates by saying “We only have a 2% market share.  That means we are price takers, not price makers.”

The companies that set the terms of the subprime lending business were the Wall Street outfits, led by Lehman, Bear, Goldman, Citi (Salomon), Merrill, UBS, Countrywide, the Morgans (JP and Stanley) and RBS (Greenwich).  Even the large independent originators like New Century, Ameriquest and WaMu had to take Wall Street terms for their lending, since the Street had a monopoly on selling the bonds, which was key to the originate-to-securitize business model.

The next group in the report were called “Active Originators and Prime Investors.”  These were companies whose main competition was the traditional banking business, because these type of loans were the bread-and-butter portfolio holdings for Savings and Loans, community banks, and large retail banks.  The very largest of these portfolio holders were doing the same thing these public mortgage companies did by originating and securitizing.

With some prime deals holding out only 1% of the principal below the BBB ratings level, these companies achieved nearly 100-1 leverage even if they didn’t sell off the excess interest.  That explains why they collapsed so quickly when the housing collapse tsunami hit their “prime” borrowers.  Worse yet, the “prime” business had split into two parts, and the growth in one of those parts (alt-A) was based almost purely on house price appreciation.

The infamous “liar loans” were the main element of the growth of this market sector to about $800 billion at its peak.  The theory was that these high-FICO borrowers had the means to carry their loans, so they needn’t justify the loan based on documented income.  Of course, the other key feature of these loans was how fast they could be approved.  When there were bidding wars on houses or condos in “hot” areas, the alt-A borrowers could often win the day.

What was really making these loans work was the increase in housing prices in the bubble, and those high-FICO borrowers who were aggressively bidding for prime properties were, many of them, simply buying to “flip.”

Just like stock investors caught in the dot-com bubble, lenders and borrowers alike were caught in the lending bubble.  It didn’t matter if you wanted to limit your lending to prudent loans.  If you were in the lending business, your choice was to match the terms of the aggressive lenders or quit lending.  I’m sorry, but I don’t know many people in business who decide to quit their business when others are making a fortune.

The Active Originators and Prime Investors listed in the Flagstone report were American Home Mortgage (AHM), HomeBanc (HMB), MortgageIT Holdings (MHL), and New York Mortgage Trust (NMT).  They had $2.4 billion in aggregate market cap in that report, with over half of that in AHM ($1.5 billion).

Like the subprime group, they have all disappeared except a couple that were salvaged as shell companies. Also like the subprime originators, these companies were small potatoes compared to Wall Street and bank-owned companies. The biggest players were the Street, plus Downey Savings, IndyMac Bank, Wamu, and the 800-lb independent gorilla, Countrywide.

Another group in the report was called “Correspondent Originators and Investors,” and this group would have been split in market perception between two “super prime” mortgage investors, Redwood Trust (RWT) and Thornburg Mortgage (TMA), and two alt-A investors, Impac Mortgage (IMH) and Luminent (LUM).

Redwood and Thornburg are perhaps the most interesting story in this group, since the crisis was fully underway when one of them spectacularly collapsed under margin calls (TMA), and the other suffered a near-death experience (RWT).  What makes their stories most interesting is the fact that they still had virtually no credit losses in their portfolios when they were taken out and shot.

That super-prime credit performance was supposed to protect these guys, but the general spread widening of the Bear and Lehman liquidity events left them with nowhere to turn except their shareholders.

I believe Thornburg was killed by its “friends” on Wall Street because they had allowed the Street to raise a serious amount of capital in 2007, which was invested in super-senior AAA bonds from alt-A deals, most of which were issued by Wall Street itself.

Six months after the capital raise (almost to the day), Thornburg was wiped out by margin calls on those super-senior bonds.  My guess is that Wall Street wanted to clear its inventory, and sold Thornburg the bonds with six month’s financing.  When that repo rolled off, the mark-to-market was lower than the amount borrowed, and therefore the company needed to sell more assets than it had to cover the shortfall.

Redwood survived by selling more equity to its shareholders.  It did not buy structured alt-A bonds with the proceeds, but de-levered.  Of course, when Redwood raised its additional capital, most of the crisis had already washed over the market, so they knew better than to buy any new bonds, especially those depending on historical performance of low-doc and no-doc loans.

Of the other two, Impac offered its preferred shareholders the choice of taking a serious haircut in converting to common, or death of the company, and Luminent basically stopped being.

Of the four, only Redwood can be called the same company, though Impac seems to be making noises like it will get back into the business of buying mortgages.  Redwood was actually the first “green shoot” in the securitization business since the crisis began, launching a super conservative deal with Citibank “relationship” high net worth borrowers as its pool.

Just to keep things in perspective, this group of four companies had $4.8 billion in market cap in September 2006, while the amREIT group of five companies were bumping along with only $2.8 billion in market cap.  Thornburg’s $2.5 billion was almost equal to the entire maREIT group, in other words.

The amREITs of 2006, called the RMBS Investors in the Flagstone report, consisted of five companies, four of whom survive today.  The five were Annaly (NLY), Anworth (ANH), Capstead (CMO), MFA Mortgage (MFA) and Opteum, Inc. (OPX).

The Big Dog of the group, Annaly, was a $1.5 billion company at the time, just the same size as American Home (AHM).  Today, NLY is over $10 billion in size, and getting big enough to move the meter on the Agency MBS market if they decide to favor one coupon over another or shift from one sector to another.  AHM is a servicing husk owned by vulture investor Wilbur Ross, and pitched as the reason that IVR will succeed as a non-agency mREIT.

Opteum is gone because they strayed from the righteous path of quasi-government credit.  They even changed their name to Bimini when they shifted to the subprime originator/securitizer business model at exactly the worst time.  They shouldn’t be held to too much ridicule, though, given the fact that Morgan Stanley bought Saxon at a premium in early 2007, and that Merrill bought First Franklin, and Bear bought ECC.

Still, having lost money with Opteum/Bimini as they chose the wrong way to go in the storm, I have to admit that the rise of a new mREIT headed by the same CEO doesn’t have me salivating for the chance to invest.

The last group, called “Diversified Investors” in the Flagstone report, includes a couple of companies that were wolves (LBO specialists or hedge funds) in sheeps’ (mREIT) clothing, along with two others that were playing the mortgage REIT game in the credit specialty weeds.

The two largest were my “wolves,” notably lead by KKR Financial (KFN), the famous takeover specialists using the mREIT game to raise equity capital.  As I recall, they even had a “two-and-twenty” management fee.  Their concept was to hold a big enough pile of MBS to use the non-mortgage “bucket” to buy and sell companies the way they had been doing since the 80’s.

KFN sported a $1.9 billion market cap, while the whole group was only $2.9 billion.  Most of the rest of the capitalization ($680 million) was in Deerfield Triarc (DFR), which was really a junk bond and below-investment-grade bank loan CDO manager.  Like KFN, they had fat management fees with large incentives, and owned mortgage bonds in large enought size to let them do their billion dollar CLO deals and hold the equity piece of those deals.

The last two, Resource Capital (RSO) and Sunset Financial (SFO) were almost afterthoughts in this group.  Resource survives today, primarily because it chose to get involved with commercial leases to big banks that wanted to divest real estate, and rent the branch offices they once owned.  RSO stuck to their knitting, in other words, and the naturally slow cycle time of commercial real estate revaluation kept them from being drowned in the first wave.

They even declared a nice dividend recently (25 cents), but the market is still not convinced that they will survive, as evidenced by the 18% dividend yield.  Still, it is the most likely to succeed (IMO) among the Philadelphia Cohen clan’s remarkable mini-conglomerate that included REITs and real estate funds, brokerage, and an asset manager.  Perhaps the most surprising thing about its position today is the $230 million market cap, quite close to the $250 million in market cap it had in 2006 at the time of the Flagstone report.

The other diversified financial was another of the Cohen companies, and it has been merged to within an inch of its life.  In 2006 it merged with Alesco Financial, symbol AFN, still managed by Cohen Brothers.  Recently that merged with Cohen & Company, so the survivor trades under the the symbol COHN, and now finally has the management company and the investment fund are in one place.

Having come full circle, we now have many of the same people executing several of the same strategies as in times gone by.

I guess it just proves there is really nothing new in world, even if investors need a program to keep up with the substitutions.

Maybe you can see why I ask who the people are when someone tells me about another new mortgage investment in the form of a stock.

I tend to believe that all teams named Cardinals should play in St. Louis, too.



3 Responses to Memory Lane

  1. Patrick says:

    Oh my. Steve DeLaney’s infamous Flagstone Securities Report. I used to read that blog as if it were the Bible. Honestly, it was full of good information that taught this fledgling mREIT investor quite a bit. I’m glad Steve’s with JMP and still covering the sector.

    • hhill51 says:

      The one I’m looking at has half the companies covered by Garrett (all the subprimes, plus the super-prime private lable MBS guys, and Anworth)….

      Do you know what happened to him (her)?.

      • Patrick says:

        I think Doug Garrett left Flagstone in late September of ’06 and got out of the business altogether.

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