Description

ECC Capital (ticker ECR) is a really beat-up stock trading significantly below book value and significantly below a reasonable estimate of today’s liquidation value. Assuming management uses even a mild level of common sense, from this price the stock should not only have little downside risk but should be able to bounce 50-100% in short order. However, there are many unknowns, and being a financial stock it is to some extent a leveraged black box, so at the end of the day this idea must still be treated as pretty risky. This is how we look at it: It makes for a very interesting small position; certainly if one could put on a portfolio of 50 stocks with risk/reward characteristics like ECR, we would expect the portfolio would work out quite well.

ECR is at $1.30, versus last reported book value of $3.58 (as of 9/30/05) and a reasonable estimate of current liquidation value of around $2.50. So the stock is at 36% of last reported book value and around 50% of estimated current liquidation value. The stock is down over 30% in the last few weeks and 70% over the last 6 months. The stock is now at its all-time low. While the company is having serious issues, we think the recent sell-off is overdone. Given ECR’s significant discount to its likely NAV, we think plenty of serious parties are probably taking a hard look at a recapitalization or outright purchase of ECR. We would imagine that activist-oriented hedge funds, private equity funds, real-estate opportunity funds, and maybe even strategic acquirers are looking at ECR right now. ECR is experiencing a crisis, but a crisis that should be fixable, especially by a third party who would be willing to gut the mortgage banking infrastructure and take other reasonable steps to preserve the tangible value in the company. Most importantly, senior management owns almost 30 million shares (around 30% of the stock), and should be highly motivated to take prudent actions to cut the company’s losses and preserve some of what they have left.

ECR is a sub-prime mortgage loan originator and investor. Its originations grew from $4.6 billion in 2003 to $9.4 billion in 2004 to $14.0 billion in 2005. ECR did its IPO in February 2005, at which time the company converted to a REIT. Today ECR consists of a sub-prime mortgage origination business (mortgage banking) at the taxable sub level, and a portfolio of loans originated in the past and financed with long term securitization financing (at the REIT level).

The REIT portfolio consists of $3.7 billion of mortgages held for investment, which are financed by non-recourse long-term debt (securitized bonds). In total ECR has about $150 mm of capital, or around $1.50/share, tied up in the REIT portfolio, which includes the residuals in these “on-balance sheet securitizations”, the residuals from some “off-balance sheet securitizations”, and related assets. This REIT portfolio has been producing substantial positive net income, although we would expect that the REIT earnings rate will be drifting downward due to increases in cost of funds and pay-downs on the underlying mortgage assets. Recently FBR estimated that the REIT would earn $0.61 of EPS in 2006, although we wouldn’t put any real stock in that number – although it helps illustrate that there’s still a lot of value left merely from the REIT assets (assuming management isn’t so dumb as to infuse the REIT’s capital into the money-losing taxable sub described below).

The rest of ECR’s capital is tied up at the sub -- the mortgage banking operation. It consists of an origination platform and the associated cost structure, and a portfolio of mortgages “held for sale” which are financed with warehouse lines. Around $200 mm of ECR’s capital is tied up in the mortgage banking operation. Recently ECR has been originating about $4 billion of loans per quarter. Most are sold in the whole loan market. The mortgage banking operation holds an inventory of loans that it collects a spread on until they sell or securitize these loans. As of 9/30/05 the mortgage banking business had $3.81 billion of mortgages held for sale, supported by this $200mm of capital. The problem is that as the Fed has raised short term rates, whole loan pricing has come down. (Sub-prime whole loan pricing is to a great extent determined by the slope of the yield curve, in combination with competition. As the curve flattens, the profitability of doing securitizations vanishes (since competition makes it tough to increase coupons sufficiently to offset increased funding costs), and as such, the parties that buy loans to do securitizations now can’t pay as much for the whole loans.) Additionally the spread they earn on loans in inventory has come down. In Q3 2005 they sold loans at $101.84, which compares to $102.14 for the first 9 months of 2005 and $103.56 for the first 9 months of 2004. Given it costs ECR over $102.00 to originate loans, ECR is now generating losses from loan origination (although some of that is made up with the spread on loans held in inventory).

This mortgage banking business lost about $11 mm pre-tax in Q3 2005. But whole loan prices have gotten worse since Q3, and as a result the losses in the mortgage banking business have gotten worse for ECR. Q4 2005 results have not been reported yet (ECR has indicated they will report Q4 results in March, but hasn’t given a specific date yet). In early January 2006 they announced a reorganization which will reduce the size of the operation meaningfully (but probably not enough).

Significant carnage in the stock occurred February 27, when ECR announced a revised dividend policy, saying “because of losses in its mortgage banking segment it will not distribute a dividend on its common stock for the first quarter of 2006.” Duh. The funny thing is that this is a good thing, but the market clobbered the stock anyway, as the mindless people still holding for the dividend blew it out. Interestingly, ECR expects to continue to generate positive REIT taxable income in 2006, which would normally require dividends to be made, but in light of the company’s capital crisis, ECR may need to de-REIT and preserve all its capital. They said: “Any future distribution of dividends will be made at the discretion of the board and will depend on such factors as the performance of the mortgage banking segment, its desire to maximize corporate liquidity, its maintenance of REIT status and any other relevant factors….. Given current conditions in the whole loan market and the operating losses in our mortgage banking segment, we plan to retain capital and liquidity in order to provide greater flexibility in the disposition of our held-for-sale loan portfolio and the prudent operation of our business.”

Clearly things are not going well, and ECR has a need to retain liquidity, likely to make their warehouse lenders feel better about continuing to finance the held-for-sale portfolio given the decline in whole loan pricing.

Flagstone Securities (a boutique investment banking and research firm focused on mortgage REITs) makes the case that liquidation value is probably around $2.50 today – with the biggest punitive assumption being that the mortgage banking operation is effectively shut down with all inventory at the mortgage banking sub being liquidated at par rather than at “normal” selling prices of $101-102. You can read their reports to get much further into the details. There’s certainly more to the picture, but that’s the biggest “take-away”. If we were in management’s shoes, with a big portion of our net worth’s on the line, we would immediately sell (if possible) or totally shut down the mortgage banking business (unless someone is willing to ride to the rescue with some sort of capital infusion to preserve the future potential value of such business).

Here’s the key: Two top guys own $73 mm of stock (using $2.50 as the value), and unlike in a normal “operating” company, we think they have the ability to immediately stop the bleeding, and preserve that amount (either that, or mindlessly watch it melt away rather rapidly). What would you do if you were in their shoes?

Also note that this is not a situation like in 1998 when all non-prime lenders were in a crisis mode and there was a real shortage of risk capital to go around. Certainly other sub-prime lenders have been affected by the change in whole loan pricing, but ECR has been particularly impacted because of a small capital base relative to a huge and unprofitable mortgage banking operation. And right now, there are massive amounts of capital looking for returns. Hardly anybody is in a crisis. Risk capital is plentiful. There’s got to be a ton of firms looking at ECR and trying to figure out how to make money on it.

Caution: We don’t know exactly what is going on here, and we are not holding ourselves out as experts. Please don’t bother asking us about a lot of minute details. This is a big picture “thesis” on a troubled (but fixable) leveraged semi-black box. But we aren’t pounding the table on this either. This thing really could melt down to practically nothing. But stepping back and thinking rationally about this situation, we just think it ought to work out. At least if you had a portfolio of 50 different ECR’s, that portfolio ought to work out very well.

Disclaimer: We and our affiliates are long ECR, and may increase or decrease our position at any time. We have no obligation to inform anybody of any changes in our views of ECR.

Catalyst

Reasonable and prudent action by management to stop the bleeding and salvage their own net worths.

Potential deal struck with third party equity providers or acquirers.

Any sort of news that demonstrates that the company isn’t “blowing up tomorrow” -- combined with the existing big discount to BV and liquidation value, and reasonable trading liquidity in the stock (for small cap guys like us) -- could cause very sharp rise in stock price even without any other catalysts.