ECRO (ECC Capital) is the shell of a sub-prime mortgage company that just delisted to reduce filing costs. This puts it at smack in the intersection of two powerful investor terrors, fear of the crumbling sub prime market and of illiquidity. Or as I like to describe it, where Opportunity Avenue meets High Returns Street. Earlier this year ECRO sold it’s origination business and it’s 2006 loans to Bear Stearns (Bear being always so eager to get into the sub prime business), and entered into a de facto liquidation process. What’s left is their 2005 securitizations and a few odd assets and a small number of employees to manage the remaining assets. Note: Earlier this year management made estimates of future distributions to investors. We are ignoring those estimates as the sub prime market has gotten much worse than they anticipated. But it's interesting to note that the CEO purchased shares for about $1 early this year.

Right now ECRO should be viewed in two parts. The assets associated with the 2005 securitizations, and everything else. The 2005 securitizations are comprised of Mortgage Loans held for investment, Accrued Mortgage Interest, REO (Real Estate Owned), Derivative instruments and Long term debt. Since these assets and liabilities are securitized, they are non-recourse to the company, so their value can never be less than zero.

Let’s start by looking at what remains on the balance sheet. Removing the 2005 Securitizations gives you the following.

Or a book value of $18,797, 19 cents at the most recent share count of 97M (due to a share buyback from FBR). Now book value isn’t liquidation value, so we have to determine the real value of assets & liabilities. Cash is cash, restricted or not. The residual interests in securitizations actually represents previous deals (03 & 04) that are almost completely completed. Their loans were written before the big runup in real estate prices, are still generating income as of July and have released collateral as recently as Q1, so it seems unlikely we’ll see any writedowns. But in a worst case scenario we’ll assume a 20% loss.

Prepaid expenses actually includes $4M in deferred bond costs which we ignore, the remainder appears to be the cash value of an insurance policy. Assets of discontinued operations includes some REO, and some mortgages. Writing them down by 35% in a worst case scenario leaves us with $13.6M. ECRO has reserved $2M for loans sold the buyers want to force ECRO to buy back, but actual claims are $6M, so we’ll reserve another $2M in our worst case scenario.

Subsequent events to this balance sheet include the repurchase of stock and settlement of claims with FBR for $2.3M (at a nominal stock price of 34 cents per share). From the monthly filings for the 2005 Securitizations we know ECRO received $7M in cash during Q2 & $1.3M in July, and about $1.3M in July from the 03/04 trusts. We’ll estimate operating costs for the remainder of the year at between $1.5M & $3M, given 40 remaining employees. And lastly, ECRO has $25M in claims pending against Bear Stearns, both a $5M arbitration claim and $20M suit. We’ll assign a value of $5M to both in a best case scenario.

Lastly we need to estimate off balance sheet liabilities. ECRO seems to have $4.2M in deferred compensation liabilities and $6M in lease liabilities. Some of the def comp may go away with layoffs. Some of the lease liabilities can be lessened through sublease and some will be accounted for in burn rate, so I’m going to count between $2.5M and $5M from best to worse case.

In the end our best case scenario produces a value of $6.8M, our worst, $7.3M, or between 17 and -3 cents per share. Not very interest yet? Well remember, that’s without imputing any future value to the 2005 securitizations. So what are they worth?

On the surface, the situation is scary. Losses are increasing rapidly, 60 day delinquencies are over 10%. Losses on liquidated loans are approaching 35%. Total over-collateralization (O/C) is only $87.5M on $2.37B in loans, less than 4%. The O/C is also part of our remaining value of the 05s, if it’s used to cover loan losses the only value the 05s will have is the cash they can produce before losses overwhelm their income and O/C. Excess cash flow available to ECRO is dropping rapidly. The last four months have gone from $3M, to $2.1M, to $1.7M, to $1.3M.

What makes the situation much more interesting is the fact that the 05 securitizations are four separate entities. Two that are in good shape, one decent, and one in terrible condition. It’s helpful to think about what is driving sub-prime delinquencies and apply it to the 05s to get an overview. The riskiest sub prime loans were written in 2006, when the Case-Schiller real estate price index peaked (in June/July 2006). Even now the index is roughly equivalent to Oct/Nov 2005. Properties supporting mortgages written in 2006 is likely to be worth significantly less now. Properties supporting 2005 mortgages, esp. early 2005 mortgages is still likely to be worth what was paid, or possibly more.

Also, most of the loans in the 05 securitizations were 2 year arms. Their loan rates have reset as high as 9% on average, so we have the dual forces of increased interest income being offset by increased losses as some borrowers can’t make the new payments. The earlier the securitization, the more likely it is that borrowers have adapted to the payment shock. An early 05 securitization likely contains loans written as early as late 04, so it’s further along in the process. A late 05 or 06 securitization hasn’t even reached the storm yet.

Look at the four 05 securitizations individually, we see the newest is in terrible shape, while the first three are doing okay.

Each trust can release OC, specifically when the class 1A and 2A notes are fully repaid. But OC can’t be released if a “trigger event” occurs, i.e. delinquency or loss rates are too high. Here is my table of the three healthy trusts and my estimates for OC release.

05-1 could release $13M (13 cents per share) by the end of the year. 05-3 could release another $17M by February, due to contractual language 05-2 can’t release before June 08. Now please note these are just estimates. It’s possible that principle paydowns may slow, or that I’ve misinterpreted the complex language around the release provisions, or how defaults/delinquencies are calculated. In the case of 2005-01, the specific language makes it appear the default trigger doesn’t start until February or March of 08, but ECRO has warned me trustees have interpreted it differently, if they do 2005-1 may be trigger it by fall. I recommend anyone investing here undertake their own due diligence to confirm this. Prospectus’s for the 2005 trusts can be found through the SEC Edgar database under “Encore Credit”. Monthly trust reports to verify how much cash flow the 2005 trusts are generating and how much principle is remaining can be found at

http://encore.lewtan.com/_mem_bin/formslogin.asp?/priv/Deals/BrowseIssuer.asp?tab=deals&Partner=EC&AssetClass=HQ

So it looks possible we could see as much as 30 cents per share in OC released by early 2008. But what if this doesn’t happen? Right now 05-1 to 3 have total O/C of $66M, or almost 70 cents per ECRO share. They are generating over a penny per share in cash per month (but that is declining rapidly). Even if OC isn’t released early, we clearly have some value remaining and the questions to ask are, how much cash flow can we count on, how much O/C will remain when each securitization gets it’s cleanup call and how long will that take?

Cash Flow: It’s not just 05-4 that’s hurting, 05-2 is the next weakest and it’s cash flow is almost zero. But 05-1 & 05-3 are earning about $1M per month between them, and that’s been somewhat stable the last three months. I think it’s reasonable to estimate we’ll see at $3M-$5M more in future cash flow since 05-1 & 05-3 should generate that alone over the next three to four months. Plus we still have income from the 2003 and 2004 trusts to help reach this goal.

OC Safety: So how much can O/C be reduced by losses? First, before hitting O/C, losses are absorbed from excess interest income. I estimate the first three trusts are earning excess cash flow after fees and interest payments of $2.7M per month, or 2.7% per year.

05-1 has 10.6% of loans in foreclosure. Let’s assume they all go through liquidation, it would produce a loss of 3.7%, assuming loss rate of 35% on liquidated loans (average has been 23% but in Q1 it reached a high of 32.6%). About 4% of loans are over 60 days delinquent. If this represents about 6 months of delinquencies, and if half of these loans enter liquidation, S1 would produce further losses of 1.4% per year. Over the next two years excess cash flow of 3.1% per year would cover almost all of the existing foreclosures plus new liquidations barely nicking O/C (.4% out of 5.86%), reducing O/C by 7%. Of course this is a static analysis, as refinancings continue the mix of defaulted loans may increase. O/C as we have pointed out will also grow as a percentage of the trust. But it seems likely that O/C is not in any great danger. One data point supporting this is that total realized losses for S1 were $730k in July, a run rate of $8.5M per year and less than cash flow at present time. To create OC losses seems to require a big increase in loss rates.

So where does this leave us? Let’s assume both the 05-2 & 05-4 trusts end up worth zero. But we still earn a reasonable amount of trust income from all the combined trusts before they go plooey, and in the end we lose two thirds of the 05-1 & 05-2 value to losses. Our worse case scenario ends up at todays prices.

In reality I think our worst case is extremely conservative. Everything has to go horribly wrong. Even if almost everything goes wrong, but we get half the OC released from the two ‘good trusts” makes our worst case scenario 27 cents. To sum up, ECRO isn’t a slam dunk easy to understand value proposition. It’s got lots of moving parts each with intriguing value. On the whole it appears the value easily outweights todays price. Whether it turns out to be a great investment is dependant upon how much and how rapidly OC is released.