FOOL ON THE HILL
Another Financial Scandal?

Is Farmer Mac the next perpetrator of falsely inflated earnings? Whitney Tilson examines the evidence, analyzes the Q2 conference call, and offers his take on the loan purchaser and guarantor. As they say, if it walks like a duck and talks like a duck... And from where he stands, the Farmer's quacking.

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By Whitney Tilson
August 7, 2002

In my recent column, More Stocks to Avoid, I warned:

More than any other type of company, financial companies... have immense discretion regarding what earnings to report. Why? Because loss rates, which are typically the primary driver of profits, occur in the future and thus can only be estimated. Of course, auditors and actuaries provide some degree of oversight, but the reality is that managers of most financial institutions such as those mentioned above can pretty much report whatever earnings they want, within reason.

Little did I know that one of the companies I cited, Farmer Mac (NYSE: AGM), would provide such a wonderful case study only a few weeks later. Let's take a look.

Every quarter, Farmer Mac purchases farm loans and issues guarantees (called long-term standby purchase commitments) on farm loans held by other financial institutions. Of course, some of the loans Farmer Mac buys or guarantees will eventually default. Typically, farm loans take three to five years to reach peak default levels. Thus, Farmer Mac, like any financial institution, estimates future losses and sets aside reserves to cover them. Prior to last quarter, Farmer Mac's overall reserves equaled 45 basis points (that's 0.45%) of total loans and guarantees outstanding since the company began to take first-loss risk in 1996.

Whether these reserves are sufficient is one of many issues vigorously debated among short sellers (myself included) and management, supported by -- surprise! -- Wall Street analysts. Rather than take up the debate here, weigh both sides by reading two reports by Gotham Partners (who are short the stock), reviewing a transcript of the conference call, in which management responded to critics, and listening to the conference call.

Second-quarter earnings and reserving
Regardless of whether you believe management or Farmer Mac's critics, there's no question that the stock and the company are under immense pressure. More than 45% of the stock's float is sold short -- one of the highest figures I've seen -- and the company is under investigation by its regulator, the Farm Credit Administration, as well as the General Accounting Office (at the request of the Senate Agricultural Committee). Thus, I suspect that management felt the need to report a very strong quarter.

How can a financial company do this? Easy. Simply write a lot of new business, reduce the reserves and -- presto! -- huge reported profits. I believe this is exactly what Farmer Mac did to produce what appeared to be a blowout quarter, in which the company trumpeted in the headline of its press release: "Farmer Mac Achieves Record Earnings; Operating Earnings Per Share Up 50%."

The following table shows, for each quarter beginning in 1997 through the first quarter of this year, Farmer Mac's net increase in reserves divided by the net increase in post-1996 loans and guarantees:

Incremental Quarter Reserve (bp)*

Q1 97       38.5 basis points
Q2 97       51.3
Q3 97       40.5
Q4 97       27.7
Q1 98       60.4
Q2 98       32.4
Q3 98       61.7
Q4 98       31.2
Q1 99       13.4
Q2 99       84.7
Q3 99      172.6
Q4 99       23.7
Q1 00    1,208.3
Q2 00      184.1
Q3 00       26.5
Q4 00       82.2
Q1 01      199.4
Q2 01       14.5
Q3 01       68.8
Q4 01       55.4
Q1 02       47.4

AVERAGE:    45.0**

* Calculated by dividing incremental increase in reserves for each quarter by the net new business written in that quarter (defined as loans purchased plus Agricultural Mortgage Backed Securities plus Long-Term Standby Purchase Commitments). For example, in Q1 '02, Farmer Mac increased reserves by $1.13 million and took on $239.0 million of net new loans and guarantees, so the incremental reserving was 47.4 basis points.

** Over these 21 quarters, Farmer Mac increased reserves by $16.4 million and took on $3,633 million of net new loans and guarantees, so the incremental reserving was 45.0 basis points.

We can see that Farmer Mac's reserving has been erratic, but averaged 45 basis points over more than five years. What was the figure last quarter, with so much pressure to produce strong earnings? 17.8 basis points, 60% lower than the company's overall average reserving level of 45 basis points. The company took on $736 million of net new business -- more than the previous three quarters combined -- yet increased reserves a mere $1.3 million.

Had the company reserved its average -- though still, in my opinion, woefully inadequate -- 45 basis points against its net new business in the second quarter, reserves would have risen by $3.3 million, not the reported $1.3 million. This $2.0 million difference allowed Farmer Mac to report 50% growth in operating income rather than a mere 16%. Quite a contrast, eh?

Management's response
When asked on the Q2 conference call to explain Farmer Mac's unusually low reserving last quarter, CEO Henry Edelman replied:

We have several reasons. First of all, we do not feel a need to immediately increase reserves every time we take new loans onto our balance sheet and onto our guarantee. Instead, we look at an ongoing average, the same way we would not reduce loans if they were to reduce reserves -- if they were to pay off. If reserves were increased by $2 million during this quarter, and what we do, in essence, is sometimes bring on seasoned loans (as we did in this case -- $490 million were seasoned loans)... in that situation, the charge-offs reduced the balance of prior reserves, but our total reserve methodology is to look over the longer term and not to react to the addition of loans and suddenly change our reserves. We look very hard at this on an ongoing basis, and, of course, if we were to see a shift in the need for reserves, we would make that, even if we weren't adding loans to our guarantee.

I've listened to and read Edelman's answer many times, and I'm still not sure I understand what he's saying, which reminds me of something Warren Buffett once said (I'm paraphrasing from memory): "If I don't understand it, it's probably because management doesn't want me to."

Conclusion
Among financial companies -- already a dangerous type of investment for outsiders, due to the factors noted above -- the most dangerous of all are those like Farmer Mac that are both rapidly growing (since growth masks rising delinquencies) and writing "long-tail" business (e.g., losses do not appear for many years). Again and again, in situations like this, investors have been burned by managements that -- sometimes unwittingly, but often deliberately -- under-reserve, book wonderful (but artificial) profits and growth, cash in their stock options, and are long gone by the time higher-than-expected delinquency rates send their companies into a tailspin.

While it's impossible for an outsider to know with certainty whether this is happening at Farmer Mac, there's a great deal of circumstantial evidence to support it. (For more than 100 pages of this evidence, see the two Gotham reports.)

The larger lesson for investors here is how easy it is for financial companies to manipulate earnings, so only invest in such companies when you have total confidence that management has the highest degree of competence, integrity, and conservatism.

Guest columnist Whitney Tilson is managing partner of Tilson Capital Partners, LLC, a New York City-based money management firm. He was short Farmer Mac at the time of publication. Mr. Tilson appreciates your feedback at Tilson@Tilsonfunds.com. To read his previous columns for The Motley Fool and other writings, visit http://www.tilsonfunds.com. The Motley Fool is investors writing for investors.