Accounting Reflects Housing Market Reality

  “Subprime” mortgage lending is a disaster unfolding before the eyes of financial market participants. Subprime refers to the practice of providing home mortgages to those with spotty credit histories in return for a few extra basis points of interest.

The Mortgage Lender Implode-O-Meter Web site has gained a wide following as an online obituary for the most aggressive, irresponsible lenders. This site, maintained by concerned citizen Aaron Krowne, has only been up shortly. Yet the site’s headline flashes the statement “21 lenders have now gone kaput” since about December 2006. Krowne really cuts to the chase in his description of the unfolding disaster:

“It appears what had to give is now finally giving: the latest subprime loans are going delinquent the quickest, and it seems likely that their prior kin will soon follow (and many of these will likely end up in foreclosure). Further, I expect a large swathe of prime loans to go bad (the prime/subprime distinction is quite fuzzy anyway). Originators cannot handle the buybacks, and so when challenged by them are immediately folding [emphasis added]. The phenomenon is just getting started. What will the banking industry — often all or part owners in these enterprises — do? Stay tuned.”

Lending in the NEW Century

Most of these companies concentrate on the “origination” side of the lending business, because it’s considered the sweet spot. You simply approve your customer’s credit application, perhaps buy some sort of “credit enhancement,” and sell the mortgage to Wall Street, where it will be bundled together with similar mortgages and sold to some poor sap managing a bond portfolio at an insurance company.

One subprime lender in particular, New Century Financial, has been caught with its pants down and now faces financial restatements, shareholder lawsuits, and an uncertain future.

New Century is a “canary in the coal mine” for the entire mortgage industry. Its recent struggles should not be ignored as company-specific. NEW stock is a good gauge of the credit market’s willingness to fund high-risk mortgages:

The availability of subprime credit is drying up as fast as this stock is falling. So what does Implode-O-Meter Web master Aaron Krowne mean when he says, “Originators cannot handle the buybacks?” New Century provides an example. The latest (300-page) 10-K explains:

“We sell whole loans on a nonrecourse basis pursuant to a purchase agreement in which we give customary representations and warranties regarding the loan characteristics and the origination process. We may be required to repurchase or substitute loans in the event of a breach of these representations and warranties. In addition, we generally commit to repurchase or substitute a loan if a payment default occurs within the first month or two following the date the loan is funded, unless we make other arrangements with the purchaser. The majority of our whole loan sales are sold on a servicing-released basis.”

Last week, New Century announced that it hasn’t been accounting properly for what it calls “early payment defaults.” Scores of borrowers are defaulting before the ink on their mortgages even dries. So now New Century is responsible for repurchasing untold numbers of loans backed by homes that are not only illiquid, but probably worth less than the mortgage’s face value.

To make matters worse, New Century is facing a liquidity crisis by violating several covenants on its own lines of credit. Creditworthiness is a rather important characteristic for lenders to maintain. The laundry list of Wall Street firms providing these lines probably agrees (we’d hope) and are likely to balk at extending credit at the time New Century needs it the most.

In a final toss of cold water on the widely anticipated housing recovery, New Century management says that these “early payment defaults” had not bottomed, and had in fact reaccelerated in the fourth quarter of 2006.

Many aggressive mortgages are turning sour so fast that, hopefully, regulators and accounting authorities will crack down on the aggressive accounting tactics that have inflated New Century’s earnings figures.

Other suspected earnings inflators are Countrywide Financial, Downey Financial, and FirstFed Financial. Negative amortization mortgages have been popular among these institutions’ customers because they feature advertisements like “Get a $500,000 mortgage for $250 per month.” But the fine print describes how the difference between this payment and a realistic payment is added to principal — hence “negative” amortization. The principal grows over its life, rather than contracting like a conventional mortgage.

These three players have been booking their customers’ payment procrastination as real earnings. Since this behavior is a good indicator of future default, how should such loans be recorded on their balance sheets? They may be “performing” now, but a big chunk of them will stop performing in the near future. The housing market is fresh out of greater fools to bail out overleveraged speculators. At such time, most of the earnings that have been booked from these toxic mortgages will be erased.

Nobody seems to have a clue what the real earnings are in this business, since executives have plenty of leeway to play around with “lost reserves” accounting, making earnings what they want.

HSBC: Oops! Our Accounting Doesn’t Reflect Reality

On the same day as New Century’s announcement, mortgage giant HSBC Holdings announced a major increase in loan loss reserves, which will directly hit earnings. HSBC’s press release explains:

“The impact of slowing house price growth is being reflected in accelerated delinquency trends across the U.S. subprime mortgage market, particularly in the more recent loans, as the absence of equity appreciation is reducing refinancing options. Slower prepayment speeds are also highlighting the likely impact on delinquency of higher contractual payment obligations as adjustable-rate mortgages reset over the next few years from their original lower rates.

“We have reviewed critically the impact of these factors in determining the appropriate level of provisioning at Dec. 31, 2006, against the Mortgage Services loan book. We have taken account of the most recent trends in delinquency and loss severity and projected the probable effects of resetting interest rates on adjustable-rate mortgages, in particular in respect of second-lien mortgages. It is clear that the level of loan impairment provisions to be accounted for as at the end of 2006 in respect of Mortgage Services operations will be higher than is reflected in current market estimates.

“We now expect that the impact of increased provisioning in this area will be the major factor in bringing the aggregate of loan impairment charges and other credit risk provisions to be reflected in the accounts of the Group for the year ended Dec. 31, 2006, above consensus estimates by some 20%.” [Emphasis added.]

HSBC and New Century executives are sending very clear messages about future mortgage default risk, so why are two key purchasers of default risk choosing to merge? And why doesn’t their accounting reflect worsening real-world conditions?

MGIC and Radian Increasing Exposure to Defaults

On Tuesday of last week, mortgage insurer MGIC Investment Corp. (MTG) announced that it will be merging with rival Radian Group Inc.. Radian shareholders will receive 0.9658 shares of MGIC in the formation of the new “MGIC Radian.” MGIC was the subject of my last Whiskey & Gunpowder article, “Holding the Housing Market Bag, Part II.” Wall Street seems to love the deal, sending the stock up sharply:

But the market is “missing the forest for the trees” by celebrating the cost savings of this deal. The “forest” is the risk in the existing book of business and the “trees” are the operational cost savings (i.e., redundant worker layoffs).

On the conference call the day of the announcement, both management teams extolled these cost savings and that popular M&A buzzword “synergies.” But I expect that they will regret being distracted by a complex integration when they should have battened down the hatches in preparation for this year’s mortgage defaults. So I found it interesting that Radian CEO S.A. Ibrahim, who will become MGIC Radian’s CEO in a few years, can’t wait to lead the charge into even more exotic credit insurance markets:  

“We have an opportunity in the traditional MI [mortgage insurance] area, as well as in offering new kinds of credit enhancement solutions, because the market can no longer really be defined as traditional MI alone. Really, the market for credit enhancement should be viewed as much broader than MI. it’s somewhere between the traditional MI which is a $600 billion [market] and the $9 trillion in mortgage debt outstanding, and it is going to be defined by the companies that can define that frontier.” [Emphasis added.]

Neither management team mentioned risk on the call — only opportunities. Would the analysts on the call bring it up? A grand total of two questions out of about a dozen focused on reserve accounting and risk in the existing books of MGIC and Radian. The first came from Goldman Sachs analyst Andrew Brill:

Q: “Do both companies use similar claims factors in their reserves? What have you factored in terms of reserve changes that might be needed as the books get combined?”

A: “We have very similar approaches, but we go about it differently. But ultimately, we get to a reserve base based upon experience on the claims side and severity, and as we looked at the actuarial reports that [MGIC] prepared and [Radian] prepared, [we determined that] the range of the reserve, in theory, is very close. We have different approaches for it, but ‘net-net,’ the average case basis is very similar when you look at the detail [so we do not believe that there will be any reserve adjustments].”

Management basically reiterated their reserve accounting policy of looking through the rearview mirror at the wonderful boom times in the housing market. This is likely to come back and bite them. Another analyst, probably from the buy side, asked the only other difficult question:

Q: “What is the strategic rationale for this merger outside of the cost reductions, considering the likely management distraction at a time of worsening losses?

A: “We have the issue of running the business. Relative to the business itself, I’m encouraged by what’s going on in the business with the return of insurance in force growth as persistency increases with higher rates and the increasing penetration of MI… The loss side of the business is there. I think both [MGIC’s and Radian’s] portfolios are well managed. We both thought, looking at our books, that [paid losses] would be up about 10%. But we think that’s well controlled.”

By the end of this conference call, you can tell which analysts are helping management sell MGIC stock to the public with softball questions and which analysts are really trying to properly balance risks and opportunities.

In a presentation a week earlier at Citigroup’s 2007 Financial Services Conference, MGIC CEO Curt Culver addressed the issue of default risk. He stated confidently that the trend in future defaults will be highly correlated with the job market. He expects MGIC to emerge from the subprime disaster unscathed because the company did not overly expose shareholder capital to the riskiest mortgages.

But this housing cycle went far beyond any past cycle. Near the peak of the housing bubble, a huge proportion of buyers were investors with no intention of ever moving into the homes they were buying. This inflated purchase prices and lowered the margin of safety for buyers actually intending to move in. Clearly, the higher the mortgage payment required to get into a house, the lower the household’s ability to consistently make that mortgage payment.

Merger Accounting Muddies the Water

A great example of how merger accounting can misrepresent reality is the experience of Tyco Intl. investors. Wall Street loved former CEO Dennis Kozlowski’s voracious appetite for acquisitions, hailing the company as the “next GE.”    

That is, until early 2002. Then, the seams fell apart as the Enron scandal and a recession combined to shed light on the real value of the hundreds of businesses Kozlowski had rolled up.

This rollup strategy included an accounting tactic called “bootstrapping earnings.” Here’s how it worked: Tyco used secondary issuances of its high P/E stock to acquire low P/E companies in stodgy, “old economy” industries. After the books closed on these acquisitions, Tyco would automatically show higher earnings per share. Throughout the 1990s, this conglomerate consistently produced investor-pleasing earnings growth: 

How was this wave of acquisitions treated on Tyco’s balance sheet? Whenever an acquiring company pays a premium above the target company’s book value, the difference usually ends up as “goodwill,” an intangible asset on the acquirer’s balance sheet. Goodwill and other intangibles cannot fund dividends quite as consistently as capital assets, like plants. Tyco’s intangible assets swelled from $6.4 billion in 1998 to $35.3 billion in 2001.

This was a big red flag. How could investors possibly asses the intrinsic value of the underlying businesses? Tyco is not a software company, in which nearly all assets are contained in minds of programmers and lines of code. As such, the explosion of intangible assets was not justified.

It turns out that a good chunk of Tyco’s performance in the 1990s was function of a virtuous feedback loop: high investor expectations led right back to even higher expectations as follows:

The past few years have been a period of discovery about the real value of Tyco’s conglomeration of businesses. As of early 2007, Tyco management is seeking to speed up the process by splitting up into separate operating units. Apparently, the magic of “synergies” no longer applies.

Tyco is an extreme example of the shenanigans that can occur behind the smoke screen of complex acquisition accounting. While Tyco is a portfolio of manufacturing businesses, New Century is a portfolio of subprime mortgages, and the new MGIC Radian will be a portfolio of insurance policies on $290 billion worth of home mortgages, they all share the common trait of being difficult to value. Now, MGIC Radian’s merger accounting will make it even more difficult to value.

MGIC and Radian both trade for 9-10 times earnings, so Tyco-style “bootstrapping” will not be a factor. Changes to loss reserves are the factor that really moves the needle on EPS in the mortgage insurance business

I wouldn’t be surprised to see MGIC management slip in an impairment charge or increase loss reserves as the MGIC and Radian financial statements join in holy matrimony. Merger accounting would provide a convenient diversion. I’ll be watching closely for management to update their accounting to match reality in the housing market.

Good investing,
Dan Amoss, CFA

February 15, 2007