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Tuesday, October 13, 1998

An Investment Opinion
by Dale Wettlaufer

Asset-Backed Carnage, Part 3

In this final installment of "Asset-Backed Carnage," I want to point out why so many companies that operate in niche lending markets have blown up. The relative crumbling of fixed-income markets for things other than Treasury obligations is the most readily ascertainable reason why, but that logic pre-supposes a knowledge of how some lenders work.

In the first part of this series, we showed how Criimi Mae (NYSE: CMM) retreated into Chapter 11 bankruptcy so quickly because of a bad balance sheet squeeze. What connects one balance sheet to the next are the income statement and the statement of cash flows. Depending on the methods of accounting, the income statement can be a reliable indicator of the change in a company's financial position. With some accounting regimes, though, the income statement doesn't tell you much. An insurance company, for instance, might under-reserve for losses and show a large amount of net income, but in subsequent years pay out large amounts of cash for insured losses. Lenders can show large amounts of net income on fast-growing asset bases, but if their estimates of future behavior by the their borrowers are off, then the income shown in one period can be overstated.

Such is the case with many companies in the specialty finance sector. The pattern of asset accumulation and big earnings has held true enough, but we can look at their cash flows to see that the earnings were predicated on accrual-heavy accounting that depended on a continual re-infusion of cash to show earnings growth. When the cash dried up last quarter, the share prices of these companies took a one-way ticket south.

Here's how Criimi Mae went so quickly:

For the six months ended, June 30:

Net cash provided by operating activities...$16,482,103
Net cash (used in) investing activities...($905,018,750)

Pretty heady negative free cash flow for a company starting the year with $445 million in shareholders' equity and $1.43 billion in liabilities.

Similarly, companies such as United Companies Financial (NYSE: UC) have run large negative operating cash flows and negative free cash flows while reporting healthy earnings relative to shareholders' equity. In thousands of dollars:

DECEMBER 31,                    1997       1996
Total assets..............$1,337,208 $925,273
Total liabilities............856,579 504,996
Total stockholders' equity...480,629 420,277

Net income...................$74,600 $81,660

Net cash used by continuing
operating activities........(242,787) (201,732)
Net cash provided (used) by
investing activities.........(22,715) 95,866

Since United Companies sold an insurance division in 1996, judging the company's recurring free cash flow generating abilities from that year's results isn't the best way to look at the company. Looking at 1997's free cash flow gives a better picture as to how these companies operate. Most of the revenues and earnings these companies generate go straight into the balance sheet as increased assets. What looks like a positive on the income statement is not positive at all. It's a negative number when it shows up on the cash flow statement.

In fact, when a company securitizes a large amount of loans, it actually sucks up cash because the company has to deposit funds into a securitization to enhance the security of the pool of loans to its investors. How does the company finance its balance sheet if free cash flow is not sufficient, then?

For United Companies, the largest inflows from financing come from large net issuances of debt:

                             1997       1996
Net cash provided by
financing activities.....$257,557 $114,646

The largest components of this in 1997 were:

Proceeds from issuance of subordinated notes...$146,855
Increase (decrease) in revolving credit facilities....$192,550

Now, this financing growth isn't such a big deal. That's how business works. But a problem comes about when your earnings are predicated on the continuation of the securitization treadmill. If you can't access capital markets or you have to sell your loans at a price that you don't like, you get into serious problems. When you securitize, your earnings and cash flows have a bunch of very complicated moving parts. And machines with more moving parts tend to break more often than those with fewer moving parts.

When you securitize loans, you package them up into pools that then issue securities to investors. Different tranches (literally, slices) have different maturities and coupons that they pay. If I'm a fixed-income money manager, I might only want short-term maturities or I might want securities that are more sensitive to a change in interest rates. The securitizing company makes assumptions about how the loans underlying these securities will perform.

Based on those assumptions, the company takes a gain on the sale of loans to those securitization pools. These assumptions are based largely on default rates and prepayment rates. Based on the difference between what those securities have to pay to investors and the amount investors have to pay for those securities, a company books the gain on sale -- that is to say that those securitization pools are supposed to make a profit on their own if they were on the balance sheet. But in selling them, accounting regulations dictate that the company recognize upon the sale the net present value of all the net income that would flow from these loans.

If those loans don't perform the way the company estimates, then it runs into serious problems. The company isn't off the hook, by the way, if things go wrong. As of the end of last year, the contingent liability of United Companies Financial for its pools was $1.3 billion. Compared to its year-end shareholders' equity of $480.6 million and assets of over $900 million that arose from gain on sale accounting, this is a substantial overhang. That's especially true when delinquency and default rates on older pools of loans have run into the high teens as a percentage of loans originated.

Within the last quarter, the market has lost almost all faith in the viability of these companies' business models. Part of this is due to the fact that it's not easy to separate what is really return on capital and what is return of capital in the cash flows of these companies. How much is going to make whole obligations in older securitization pools and how much is being earned after all contingent liabilities are taken into account is not readily apparent. When the realizable value of assets equal to almost twice your owners' equity is contingent upon certain things happening, investors are going to start leaving when those things aren't happening and when your sources of positive cash flow start to dry up.

Of course, this happens to many companies. The realizable value of inventories and receivables are also contingent on certain things happening for a large chunk of corporate America. But most of the financial statements out there are somewhat easy to read after gaining practice at it, and the liabilities of most companies are readily ascertainable. However, the gain-on-sale accounting rule for selling loans has really done little to enlighten the economics of the specialty lending sector. Banks, for that matter, have to treat these things in the same way, but they don't have such a narrow asset base. The accounting rules mandating gain-on-sale have actually obscured things, as the real profitability of these companies is obscured. Given a certain set of uncontrollable events in the world combined with a deteriorating set of competitive fundamentals in the specialty lending category, the blow up in this sector isn't really surprising.

Related Articles:

-- Asset-Backed Carnage, Pt. 1
-- Asset-Backed Carnage, Pt. 2