A company no longer in need of a few charts

The folks at the Mortgage Lender Implode-O-Meter made what will probably be the final entry in the page they set aside for California-based FirstFed Financial.

Update - 2010-01-07: FirstFed Financial Corp., the former holding company of First Federal Bank of California, has filed for bankruptcy. Reuters reported the move comes "less than a month after its banking unit was shut down by federal regulators." From the LA Business Journal:

"The Federal Deposit Insurance Corp. on Dec. 18 announced that First Federal's 39 branches and their deposits were being acquired by OneWest Bank FSB, the Pasadena bank created from the assets of failed IndyMac Bancorp. First Federal had about $6.1 billion in assets and $4.5 billion in deposits as of Sept. 30."

The failure of First Federal Bank of California will cost the FDIC's deposit insurance fund an estimated $146.3 million.

Normally, the travails of individual lenders are left to others to comment on (and the Implode-O-Meter has sure had an exciting time in doing so over the last few years) but, once in a while, a special interest is taken here.

Such was the case for FirstFed.

In fact, it was after reading a text-only account of their condition in BusinessWeek a few years back that it was thought their current condition (and possible futures) might be better understood using what is obviously a much older version of MS Excel.

A Story in Need of a Few Charts
Tuesday, February 06, 2007

When reading this BusinessWeek report about Santa Monica based mortgage lender FirstFed Financial (FED), it just screamed for some charts to go along with the words and numbers.

The company's stock has been soaring lately, up more than 30 percent since September, as investors speculate on its future. Some believe the company to be a takeover target, others feel that the housing market is poised for a rebound and their bottom line will improve, while short sellers bet that it will all come tumbling down around them.

Something is sure to happen soon at the boutique lender with the unique loan portfolio.

In the fourth quarter, mortgage originations plummeted by 66.8%, to $365 million—one of the steepest declines among all lenders. Cash from operating activities dropped into the red in the third quarter (the most recent data available), falling from $49 million in 2005 to negative $77.1 million a year later. Meanwhile, the number of problem loans more than quadrupled last year.

FirstFed's foundation could crack even further. The biggest problem: Its mortgage portfolio is packed with risky loans known as option ARMS. These adjustable-rate mortgages allow borrowers to make smaller monthly payments than they would normally owe by deferring the principal and adding the difference back to the balance. That may make a house more affordable at first. But when the balance hits a certain level, payments often jump significantly, and borrowers can run into major financial trouble.

FirstFed potentially faces darker days than peers who play in the same niche. For one thing, all of FirstFed's mortgages are for homes in California, where prices have cratered and foreclosures have skyrocketed. Also, 80% of its loans have little or no documentation to prove the borrower's income or assets, according to a recent company presentation. The bank uses credit scores to screen for elite borrowers.

But skeptics are starting to question the quality of FirstFed's earnings. The bulk of FirstFed's income is derived from noncash earnings, largely from the deferred principal on its option ARMs. That so-called negative amortization constituted $223.9 million, or 68.4%, of the bank's income before taxes in 2006, compared with 1.3% in 2004. In essence, FirstFed is booking profits on money it hasn't collected. The fear is that the bank will never collect, given the high delinquency and foreclosure rates in California. Says Frederick Cannon, managing director at Keefe, Bruyette & Woods Inc.: "The bearish view is that all the earnings are coming from money they didn't get yet."

FirstFed admits the environment is tougher today, but says its borrowers have stellar credit and can afford to keep up with the option ARMs' rising payments. Indeed, FirstFed's loan portfolio, with a higher credit quality and lower delinquency rate, is holding up better than those of larger competitors such as Countrywide Financial (CFC ) in Calabasas, Calif., and Washington Mutual (WM ) in Seattle. FirstFed CFO Douglas J. Goddard says the bank fully expects to collect on its loans. "In our nearly 25 years of offering this product, we have yet to find where payment shock' caused a default," he explains.

Still, given all the red flags, it's no wonder short-sellers have pounced. Some 40% of the company's 15.3 million shares have been sold short. That dynamic may have helped boost the stock. As it climbs, hedge funds and others rush to buy more shares to cover their money-losing short position, pushing the stock higher.

And as it goes up, the stock is attracting new buyers. "I constantly see momentum players buy financial companies because they hit some screen, but they don't really know what they own," says Richard Eckert, senior research analyst at ROTH Capital Partners in Newport Beach, Calif. "They are not distinguishing between cheap, and cheap for a reason."

With borrowers sporting higher credit scores, FirstFed Financial does not appear to be a sub-prime lender in the traditional sense - at least not yet.

Apparently catering to the market for which stated income and negative amortization loans were originally intended - small business owners or independent contractors with large but hard-to-document and/or unpredictable income - the company is faring better than most sub-prime lenders today.

Tomorrow, however, is an entirely different matter.

Their clientele likely includes the professional real estate speculator crowd that was in early on the California real estate craze - some of them have clearly lingered too long.

Not to be confused with your typical equity-rich Southern California homeowner who took the plunge with investment property in 2004 or 2005 after being convinced that real estate only goes up, this group of borrowers has probably been in the game for many years now and has done quite well.

Until now. Just like the craps tables at Vegas, it's hard to know when to stop.

While FirstFed Financial may not currently be a sub-prime lender, with four times the number of problem loans as a year ago sure to impact their customers' credit score, they may turn out to be one after-the-fact.

Wow. That was written almost three years ago. How time does fly.