NovaStar Financial (NYSE:NFI) certainly has been making the headlines lately, and it is hard to find much good news. Quite a turnaround, given that 45 days or so ago the company's stock was trading up to $70, on news of a record 2003 and record January and February originations. So how did it all turn so quickly, and how did perception get so skewed?
The perception
For more than a year, CBS Marketwatch's Herb Greenberg has been writing critical stories about the company, but the blow that sent the stock reeling was an article written in The Wall Street Journal. The Journal depicted NovaStar as a non-compliant "subprime mortgage lender that makes high risk loans to people with poor credit" teetering on the edge of financial ruin complete with phantom branch locations that didn't actually exist and regulators hot on their heels. NovaStar shares dropped more than 30% that day.
Not more than two days later, the hoard of killer lawyers descended upon NovaStar led by none other than the notorious law firm Milberg-Weiss. Milberg enjoys the distinction of being labeled modern day "squeegee boys" by one Florida judge. Even more notable is an investigation about their representation of a plaintiff in a San Francisco court. It seems that the lead plaintiff suing a company for stock fraud was actually a hedge fund heavily short the stock and ready to profit from a fall.
NovaStar fell further after the company disclosed an informal SEC inquiry -- essentially a predictable information request asking for clarification of some of the WSJ allegations. Despite the SEC's warning to not construe the investigation as an indication that any laws have been broken, some seem ready to lock NovaStar in solitary.
Investors in American Capital Strategies (NASDAQ:ACAS) and Allied Capital (NYSE:ALD) are probably nodding their heads in unison, as the presence of Herb Greenberg articles, class action lawsuits, SEC investigations, and short sellers seems all too familiar. Indeed, these companies have been accused of a variety of misdeeds, which also include risky lending, lack of disclosure, funding the dividend with public stock offerings, and of course the obligatory shouting of Ponzi! Ponzi!
The funny thing about NovaStar in particular is that if you actually read their first quarter report -- nestled in-between a few Herb Greenberg articles and some class action announcements -- their numbers are actually quite good, and beat analyst estimates handily. The company reported a record dividend, record liquidity, record loan production, increased loans under management, and increased earnings. Not too shabby for a company supposedly going down in flames.
The reality
One problem is that NovaStar is greatly misunderstood by many investors. Mortgage REITs (real estate investment trusts) are a special type of REIT that don't actually own property, but invest in mortgages in a variety of ways. NovaStar originates mortgages in the non-conforming market with a focus on debt consolidation loans. NovaStar splits up the loans into their respective principal and interest portions, packages the principal portion as bonds, and sells them to institutional investors. The interest pieces are held in a portfolio of securities that represent the spread between the rates on the securities they sell and the loans they originate. This mortgage investment portfolio is responsible for 88% of the dividend and is a key metric for growth.
As a mortgage originator, some may be quick to point to the "risks" of rising rates. Originations will drop, the dividend will fall, and the short sellers will laugh all the way to the bank -- that's the theory, anyway. As always, reality is a bit different than traditional wisdom. First, subprime borrowers are typically less sensitive to interest rate adjustments than prime borrowers, so the overnight demise of subprime originations is likely overstated.
Secondly, as interest rates rise, more borrowers will be bumped into the subprime category since the cost of borrowing will be greater, thus increasing the population of subprime borrowers.
Third, NovaStar relies on debt consolidation more than any other type of loan. As long as mortgage interest remains tax deductible and lower than consumer financing rates, this will likely remain a popular option for borrowers.
Lastly, the all-important mortgage investment portfolio is stocked with interest only (I/O) strips. The curious thing about I/O's is that they become more valuable in a rising rate environment. This is because as rates rise, refinancings drop off the map, so the expected life of those interest securities becomes much longer. Just think: Who would refinance a mortgage at 6% to one at 8% if they could avoid it?
The company's detractors also suggest that NovaStar will be eaten alive by delinquencies. Again, a quick check of the facts indicates otherwise. While originating high quality non-conforming loans is tricky, NovaStar has managed to keep delinquencies in check. In fact, as of Sept. 30th last year, NovaStar had a portfolio delinquency rate of 2.8%. Not impressed? Countrywide (NYSE:CFC) had a rate of 3.75% across its entire portfolio and 12.57% in its subprime portfolio for the same time period.
NovaStar's success has not gone unnoticed as Moody's recognized NovaStar's lending arm with a SQ2 rating, the second-highest rating in the industry. The award cited the company's "strong collection ability, above average loss mitigation on loans, and average foreclosure timeline management." Additionally, for 2003, Standard & Poor's rated NovaStar's loan servicing program as "strong" which is their highest rating.
In April, NovaStar's already high short interest spiked from roughly 4.4 million shares to a stunningly high 5.5 million shares, and that's for a company with just fewer than 25 million total shares outstanding. With a whopping yield north of 16%, it could be quite an expensive short to carry.
Now, I won't pretend the topics of structured finance, securitization, and mortgage-backed securities are easy to understand, but understanding certainly isn't helped when the norm is innuendo, half-truths, and outright factual errors.
One recent example is how the WSJ erroneously reported that NovaStar uses public offerings to pay their dividend, which is untrue and was debunked by the company the very next day. The WSJ article also stated that Novastar paid out more than they earned in 2003. This statement is also provably false and requires only a quick look at the company reports and a basic understanding of the difference between taxable and GAAP earnings. Taxable earnings for 2003 were $5.54 per share, and the company actually paid $4.87 per share in dividends.
Finally, Greenberg wrote an article with the headline stating that Novastar had been sued by their mortgage insurer. This was completely false as Novastar actually filed claim against their insurer, not the other way around. After this report was published, shares tumbled four points, and it took 40 minutes for the article to be corrected.
A beacon of light
Investors seeking to alleviate some of the confusion decided to create websites about mortgage REITs. One such site is www.mreits.com that includes a daily recap of events for mortgage REITs to include a handy comparison based on yield. FYI, NovaStar is trading at a 59.2% discount to peers currently.
As always, don't forget the Fool's Real Estate & REITs discussion board for some insightful conversation.
Fool contributor Craig Cunningham owns shares of NovaStar Financial. He went from the happiest place on earth in the Hudson Valley of New York to a place known only as Bliss in West Texas. Please send him some words of encouragement. The opinions represented here are not necessarily the opinions of The Motley Fool. NovaStar is currently under SEC inquiry. Investors beware. The Fool has a disclosure policy.
