'98 Year In Review
December 17, 1998

Loser #2 - Specialty Finance Companies

by Dale Wettlaufer (TMF Ralegh)
Featured Stocks Down 73.0% to 99.7% as of 12/15/98

Specialty finance companies have had a very difficult 1998. What a surprise -- given that certain types of specialty finance companies were also some of the biggest losers of 1997. Remember Mercury Finance, the auto finance company whose CEO went to jail because they were cooking the books? The collapse of that company's stock and its delisting presaged a collapse across the sub-prime auto lender category. Bankrupt Jayhawk Acceptance (OTC: JACC) was also one of the big losers in the category.

Well, this year it was the sub-prime mortgage lenders that got creamed in the great credit crunch of 1998. Some are bankrupt, some are barely surviving on life support. Here are some of the uglier stock price charts of 1998 (prices through 12/15/98):

FIRSTPLUS Financial Group (NYSE: FP). A Dallas-based home equity loan specialist buying loans in the wholesale market and through direct marketing. After a 52-week high of $56 per share, the stock is now at $3 1/4 per share. Chart

First Alliance Corp. (Nasdaq: FACO). Sub-prime first mortgage, second mortgage, and real-estate-secured credit card lender. The stock has a 52-week high of $20 1/2 per share and a current price of $3 5/8. Chart

Southern Pacific Funding Corp. (OTC: SFCFQ). Primarily a wholesale purchaser of sub-prime loans, Southern Pacific is down from a 1998 high above $16 per share and is now trading below one thin dime as a bankrupt company in the over-the-counter market. Chart

Aames Financial Corp. (NYSE: AAM): Aames is a sub-prime mortgage lender that originates loans through its own offices as well as through brokers. Trading at $1 9/16 per share, the company is down from a 52-week high of $15 11/16. Chart

United Companies Financial Corp. (NYSE: UC): A first mortgage sub-prime lender that originates the majority of its loans through its UC Lending retail network. United Companies trades at 3 15/16 per share, down from its yearly high of $25. Chart

How Could You Have Seen This Coming?

Don't pay all of your attention to earnings. Forget EPS growth. Investing is not about how much EPS will grow from one year to the next and for the next five years. You first have to find out about the quality of earnings before you put any stock in the earnings that are reported. Let's take a look, just as an example, at the income statement and cash flows of United Companies for fiscal 1997 ($ in 000):

Condensed Income Statement
Loan sale gains $265,122
Finance income, fees earned and other loan income 145,639
Investment income 24,230
Other 5,820
Total 440,811
Personnel 132,164
Interest 60,812
Other operating 121,928
Total 314,904
Income from continuing operations $80,581
Statement of Cash Flows
Cash flows from continuing operating activities:
Income from continuing operations $80,581
Adjustments to reconcile income from continuing operations to net cash provided by continuing operating activities:
Increase in accrued interest receivable (23,890)
Decrease (increase) in other assets (12,284)
Increase (decrease) in other liabilities 32,985
Increase in interest-only and residual certificates - net (277,642)
Increase in capitalized mortgage servicing rights (34,226)
Amortization of capitalized mortgage servicing rights 9,272
Investment losses --
Loan loss provision on owned loans 3,462
Amortization and depreciation 7,382
Deferred income taxes 45,465
Proceeds from sales and principal collections of loans held for sale 3,113,870
Originations and purchases of loans held for sale (3,205,180)
Decrease (increase) from trading securities 17,418
Net cash used by continuing operating activities (242,787)
Cash flows from discontinued operating activities (5,537)

Right off the bat, you can see this is a company that does not generate any cash flow from operations. In fact, it's negative by nearly a quarter of a billion dollars. Meanwhile, the company showed net income of over $80 million. So there's more than a $320 million swing between reported earnings and net cash from operations. That's always something of a warning sign. It's not the end of the world to run a cash flow negative company when it's growing. But when you encounter this situation, you have to look at the business model and ask if the current negative cash flow leads to something much larger and more positive down the road.

First, from a quality of earnings standpoint, these companies didn't do well at all. Look at the major line of revenues, "loan sale gains." What do those revenues mean, though? Is it cash that flows in, is it cash that will flow in within 30 days, or is it cash that will flow in over a number of years? If you answered either of the first two, you'd be wrong. It represents cash that is supposed to flow in over a number of years, given certain assumptions. But, in the meantime, it's not a cash inflow. They certainly are revenues according to Financial Accounting Standards Board pronouncement #125. Generally Accepted Accounting Principles (GAAP), however, dictate that revenues are recognizable when a sale is substantially completed and a company either has cash in-hand or a claim of cash in-hand for which the discounted present value is reasonably discernible. The present value of the claims that these companies receive has to be estimated and, in many cases, it was totally underestimated.

In a gain-on-sale transaction accomplished through the securitization of loans, the securitizing companies release ownership of the loans to the trust into which they sell the loan. But they usually retain the right to service the loan -- collect payments, make sure the loan is up-to-date, and pay the owners of the loan who are due their interest and principal. The securitizing company can also retain an interest in the stream of net interest income these loans will produce. Their interest is subordinate to the insurance companies, banks, trading desks, or whoever buys the securities backed by the loan. If the pool of loans is able to generate a net interest income above and beyond what is contractually due the owners of the securities backed by the loans, the securitizer gets to keep it.

The present value of servicing the loans and the net present value of the estimated residual, net interest income, is booked as a gain when the securitizer sells the loan. And that comes through the income statement as revenues, but it's not cash received. The credit to revenues on the income statement is shown in red, while the offsetting entry to the cash flow statement is also shown in red. That indicates these are really non-cash revenues. It turns into assets that then turns into cash over a period of time, just like accounts receivable do for your average company.

Through accounting shell-shifting, though (and this isn't saying companies that do this are shifty, but rather that the accounting standards board that mandated this accounting regime could have come up with a better way of doing things), the companies that securitize the loans get the assets off their balance sheet, generate non-cash income in doing so, show large amounts of net income that isn't cash-based in the least, and then start the process all over again each accounting cycle. What you end up with is a balance sheet that looks partially like this ($ in 000):

  Dec. 31, 1997 Dec. 31, 1998
Cash and cash equivalents $582 $ 14,064
Interest-only and residual certificates — net 882,116 604,474
Total stockholders' equity 480,629 420,277

184% of United Companies' owners' equity ended up as assets, the value of which was not entirely certain. Same thing with Green Tree Financial last year before insurer Conseco (NYSE: CNC) came in and acquired the company. Green Tree wrote down the value of these types of assets twice because they had overestimated the value of the assets and, thus, overstated net income. Upon closing the deal with Green Tree, Conseco took another big whack at the value of the receivables.

In United Companies' case, you had a continual buildup of what are basically receivables that aren't really converting to cash, because the income streams underlying those receivables didn't perform to expectations. 18% to 21.6% of prior-years' loan production was delinquent, in the process of foreclosure, or in bankruptcy. That's versus loss assumptions of 2% on adjustable-rate and hybrid loans and 2.5% on fixed-rate loans. While loan loss reserves equaled 10.8% of loans serviced, the losses experienced in older loan pools indicated that the current assumptions may not have been enough, especially since expenses for loan loss provisions were lagging delinquency and bankruptcy experience.

In high-risk lending, the losses experienced might be fine, but the interest rates charged to the customers of these businesses were not even close to what is needed to offset these risks. With interest rates under 11%, it's pretty hard to make money, even with the up-front points charged on the loans, when 20% of the loans go bad. As compared to the credit card industry, where cumulative losses are far smaller and interest rates can run more than 50% higher on average (and can re-price very quickly), the risk/reward in this business is off-balance.

The assets and the equity on the balance sheets were contingent on certain things happening -- a big part of that was prepayment speed on the loans in the securitization pools. With all of these companies running around offering to refinance debt at rates that did not match the risk in the loans (and were thus priced below what a rational market would set), and with a pronounced drop in interest rates this summer, prepayments ran well ahead of assumptions. With principal being paid out to holders of the principal-only tranches of the securitization pools (these are the people that made the correct bet on the direction of interest rates), the net interest income generated by these pools dropped. That cut into the realizable value of the assets on the balance sheets of these companies and, thus, cut into the cash stream these companies would receive from these assets

The off-balance sheet of contingent liabilities, in many cases, is huge. In the case of United Companies, from the company's 1997 10-K, "The maximum recourse associated with sales of home equity loans and manufactured housing contracts according to terms of the sale agreements totaled approximately $1.3 billion at December 31, 1997, substantially all of which relates to the subordinated cash and excess interest spread." That's a big number, compared to the gross value of the interest-only certificates on these balance sheets. Also from the 10-K, "Should credit losses on loans and contracts sold materially exceed the Company's estimates for such losses, such consequence will have a material adverse impact on the Company's operations." Yeah. That's not boilerplate, either.

The difference in the risk/reward comes out of the pocket of the securitizing company, as we've seen this year with the destruction of the equity values of these companies. Uneconomic business models can only go on for so long. With the crunch that occurred in the credit markets this summer, which particularly affected issuers of asset-backed securities, the ability of these companies to fund these transactions and keep the earnings treadmill going was shut down.

Is there value in this sector? One has to dive pretty deep into the filings to find out. As we said last year in discussing companies of this ilk, "When confronted by financials that are just plain hard to understand, an investor has two options -- increase his or her understanding of finance company financials, or just stay away." We won't modify our advice for 1999.

Related Links:
Get a Quote or Other Data on These Stocks
The Best & Worst of 1997 -- Specialty Finance Cos.
Asset Backed Carnage Part 1 -- Fool on the Hill -- 10/6/98
Asset Backed Carnage Part 2 -- Fool on the Hill -- 10/9/98
Asset Backed Carnage Part 3 -- Fool on the Hill -- 10/13/98

Next Loser -- Paired-Share REITs