This post is an excerpt from the 1st Quarter Investor for my hedge fund. If you would like to receive a full copy of the letter, please send me an email at derek.pilecki@gatorcapital.com.
I started a short position in Walter Investment during the last week of the quarter when they announced a huge unexpected acquisition. Walter Investment was successfully spun-off from Walter Energy in early 2009. The company operates a sub-prime mortgage servicing business that had been an affiliate of its former parent’s home building division. Walter closed the home building division prior to the spin-off. Walter Investment’s servicing platform has a good system for collections, and the company had always retained its own loans, so underwriting stayed strong compared to the rest of the industry.
Since the spin-off, the company had been looking for a way to grow. Because Walter had closed down its home building business and lending platform, the company did not have a natural way to originate or add loans to its servicing platform. The existing portfolio of loans throws off attractive but declining cash flows, so Walter pays an attractive dividend but cannot increase it. The company’s strategic plan had been to purchase small portfolios of mortgage loans from distressed banks in the Southeast to grow its portfolio of loans. Management thought they could find some bargain portfolios to purchase and use their strong mortgage servicing platform to rehabilitate the purchased mortgages.
Although it had completed a small deal or two in this area, late in the 1st Quarter, the company announced the very large acquisition of Green Tree Credit Solutions, which owns a mortgage servicing portfolio and platform focused on special servicing of problem mortgages. Special servicing is a high-touch servicing of delinquent loans. In its investment presentation, Walter points to the growth of special servicing business and the large earnings per share accretion in the deal as compelling reasons for the acquisition. I believe Walter is making a poor strategic and financial decision by acquiring Green Tree. Here’s my short thesis:
1. Buying Green Tree at the Peak of the Cycle – The special servicing business has grown as the balance of outstanding delinquent mortgage loans has grown. However, we are seeing delinquencies decline industry-wide as the flow of newly delinquent loans slows. Walter’s own investment presentation shows slowing growth of the addressable market as the flow of new mortgage delinquencies declined from $1.9 trillion in 2009 to $1.7 trillion in 2010 and is projected to further slow to $1.4 trillion in 2011, $1.0 trillion in 2012 and $0.8 trillion in 2013.
2. The Acquisition creates Massive Tangible Book Value Destruction – Walter’s management team points to the earnings accretion from the deal, but the book value destruction of the deal is devastating. Walter’s current tangible book value is $21.54 per share. I estimate that the book value will drop close to zero per share. The payback of book value from the earnings accretion will be 15-20 years.
3. Sellers are Taking 97% of Deal in Cash – The current owners of Green Tree do not see the value of holding a stake in the combined entity. Instead, they are willing to pay taxes to get cash now. I suspect they see their growth slowing and are happy to walk away with a decent multiple on peak earnings for a very cyclical business.
4. Green Tree’s platform duplicates Walter’s existing platform – Walter gains close to nothing with this acquisition because Green Tree’s servicing platform is so similar to Walter’s existing platform. Plus, the expense synergies are almost completely wiped out by higher taxes as Walter moves from a REIT to a C-corp.
Walter is trading at only 7x pro forma earnings, so the stock is inexpensive if I am wrong that these are peak earnings for Green Tree. However, Walter’s management is buying upwards of $1 billion worth of intangible assets on a $500 million equity base. The margin for error here is low with little downside protection.
This morning, I was interviewed by a local student about credit scores. Here is the Q&A:
1. What are the implications of having either a positive or negative credit history? (give specific examples)
Answer: Your credit score clearly affects your ability to get access to credit. A few years ago, a low credit score simply meant you paid a higher interest rate on your car and mortgage loans. Today, a low credit score likely means you can’t get a loan at all. Also, financial companies besides lenders use credit scores as well. Apartment landlords will use credit scores to determine whether you’ll fulfill the terms of a lease. Insurance companies will use your credit score to determine if you are good risk for car and home insurance. While a credit score measures how much debt you have, it is mostly based on your record of making bill payments on time. Insurance companies have proven statistically that people with low credit scores are more likely to have accidents and make claims than people with higher credit scores. They rationalize that people who make sure to pay their bills on time are probably cautious in other aspects of their lives like driving and will have fewer claims.
2. What would constitute a responsible use of credit?
Answer: A good use of credit is to make a purchase that will either increase your income or reduce your expenses. For example, you may live in an area where there are no jobs within walking distance, so you borrow money to purchase a car. Now, you are able to drive to get to a job that will pay you enough income to repay the car loan and have money for living expenses.
3. What are three (or more) inapproriate uses of credit?
Answer: An inappropriate use of credit is to make consumable purchase that you cannot afford. For example, you live paycheck-to-paycheck without any saving any money. You decide to purchase several new outfits because fashions have changed. You reason the minimum monthly payment required by the credit card company is only $25. This is inappropriate because you may not be able to make the payments and the amount of time it will take to repay the credit card will exceed the time the clothes are still useful.
4. When selecting a credit card, what factors should one consider?
Answer: When selecting a credit card, the factors that matter most are the annual fee, the interest rate charged, the length of grace period, and any rebates or rewards offered by the credit card company. Personally, I use the American Express Blue Cash Card because I payoff my bill every month, I don’t even know what my interest rate is. However, I know that I have no annual fee and get 1.5% cash rebate back on all of my purchases.
5. Do you think high school students should have credit cards? Why or why not? Explain.
Answer: High school students should not have credit cards because most do not have any income for repayment of their credit card debt. Another reason high school students should not have credit cards is the peer pressure young people feel for conspicuous consumption. In today’s society, there are constant marketing messages about successful people enjoying their money through spending. It is as though you need to spend to show that you are successful. Well, you can also borrow money to spend so that you look successful. In my business of giving financial advice to people, I meet many people who drive BMWs but they don’t have enough savings to become my client. The way to financial independence is through savings. This lesson is not taught to high school students. I fear the pressures to spend would lead too many high school student to use credit inappropriately. In today’s cashless society, high school students may not want to use cash for normal purchases, so I would suggest getting a student or free checking account at a local bank and asking for a debit card linked to the account. This way the student will only make purchases when they have money in the account.
Over the weekend, Richard Thaler wrote an article in the New York Times endorsing a proposal from Michael S. Barr, Assistant Treasury Secretary for Financial Institutions to require financial institutions to offer “plain vanilla” mortgages along side exotic “rocky road” mortgages. The rocky road mortgages would have extra warning labels to protect consumers. Under this proposal, most consumers would be steered into plain vanilla mortgages.
Barr’s proposal will certainly help people at the margin, but it misses the root cause of the mortgage crisis. The root cause was easy credit in the global financial markets led to easy credit in the mortgage market. Easy credit in the mortgage market led to an explosion in Alt-A mortgages, where incomes and jobs weren’t documented. Consumers and speculators took the Alt-A mortgages to bid up home prices. Rising home prices led to more people rushing into the market to make money, and the easy credit available in the form of Alt-A mortgages meant lenders didn’t turn anyone away. With an Alt-A mortgage, a consumer wasn’t constrained by their income, so they could either buy a larger house or big the same house up to a higher price.
Alt-A mortgages, had a much larger role in driving home prices higher than the mortgage loans Barr and Thaler are trying to prevent. An Alt-A mortage could look like a plain vanilla 30-year fixed rate or a 5-year ARM, except the lender never asks the borrower to document his income or job. There is no harm done to the consumer. In fact, it is an easier transaction for the consumer because they have to provide less paperwork to the lender.
When credit is easy, borrowers will take out loans no matter what the warnings are. It is similar to Warren Buffett’s famous quip about under pricing insurance: “If you offer an underpriced insurance policy and are sitting in a rowboat in the middle of the Atlantic Ocean, an insurance broker is going to find you.” It is the same with easy credit and borrowers. When credit is easy, borrowers are going to find ways to borrow.
The entire financial crisis wasn’t caused by unwitting consumers who were duped into taking out rocky road mortgages. The crisis was caused by easy credit which also led to bad commercial mortgages and bad leveraged buyout loans. In fact, it was LBO bank loans that started the the first seeds of the crisis in August 2007. Certainly the borrowers in the commercial real estate and private equity worlds were sophisticated and still succumbed to the siren song of easy credit.
Barr is certainly noble minded in his pursuit of trying to save the consumer from bad mortgages, but Thaler is overstating the benefits of this solution by implying that the finanacial crisis would have been averted had consumers stuck with plain vanilla mortgages. Their solution will certainly help consumers in the future, but I’d venture to guess it’ll be at least a decade before any rocky road mortgages are sold to consumers.
If Barr and Thaler really want to help the economy by bringing stability to the housing market, they should propose that Fannie Mae and Freddie Mac must not buy any mortgage loan unless the borrower’s income, job and other assets are verified. This would prevent Alt-A mortgage market from ever coming back to the size it was in 2006 and 2007.
The task of taming the credit cycle to prevent future periods of easy credit is a tougher problem. However, due to our collective experience over the last 24 months, it is not a problem we’ll have to deal with again in the next few decades.
