FBC:  The “Holy @#^$” Bank

FBC might be the only bank in the world with the following features:

• 730 - 980m in annualized pre-tax, pre-credit cost income on a 580m diluted market cap.  Holy @#$^!
• Adjusted FD Common Equity BV of 850 to 910m with a tax asset valuation allowance of 330 - 310m.  Holy @#$^!
• Cumulative credit-related expenses over 2.9B since 2007.  In 2007, the bank had 14B in total assets.  Holy @#$^!
• Net capital raise since 2008 totaling over 1.5B in TARP + New Equity.  Holy @#$^!
• Currently running at 7-17 cents in earnings PER QUARTER.  Stock trades at 1.10.  Holy @#$^!
• Lastly, thanks to the fed, the most beautiful business plan of all time:
  • Lend money  (warehouse loan) to correspondent mortgage originators issuing @ 3.6% who have seen warehouse funding lines disappear
  • Buy correspondent’s 3.6% loan in exchange for extinguishing warehouse debt balance + some markup.
  • Sell loan into 1.8% yield environment to FNMA/Federal Reserve; receive newly minted USD.
  • Pocket enormous gain-on-sale margins.  Repeat ad nauseum.
  • holy @#$^!

The investment case for FBC is simple.  This is a terrible Michigan bank working through the (hopefully) tail end giant legacy credit issues trading at 64-68% of 3Q12 adjusted FD book value excluding a huge tax asset (whew).  It has a MASSIVE tailwind in it's nationwide mortgage origination operations (8th largest in the country by volume and gaining share), giving it an impressive amount of breathing room to work through its credit problems.  Should the current level of profitability and credit costs remain for the next four quarters (4Q12, 1Q13, and 2Q13), FBC's unadjusted tangible common book ought to increase from 1.65 per share to 2.10 - 2.30 per share by 2Q13 end (I'm counting 3Q12 as in-the-bag). 

At 1.02 per share, we're buying this thing at < 50% of 2Q13E book value for a company gaining origination market share and compounding book between 15 and 40% (which excludes the DTA rebooking!).  Should the mortgage boom then fade and FBC experience an additional 620m in write-downs/reserving, it doesn't seem unreasonable for FBC to trade at 80 to 90% of book, or, 0.60 to 1.00 per share of upside.  Obviously, if the mortgage market is still booming and/or credit costs fall drastically, this is going to be a lot higher than 80-90% of book.  Indeed this run-rate model bakes in monstrous credit costs over the NTM period.  Thats 4% of assets in one year!  To compare, WFC is provisioing about 0.5% of assets per year.

Should the origination boom fade next quarter, I'd expect FBC to trade back down to 0.70, or 30 cents of downside, which is less than 50% of 3Q12 adjusted book value.  Given my two scenarios, the market is giving me (2 - 3) to 1 odds that mortgage profitability fades in the very near term.  With the recent Fed action, that seems far too draconian, as I also detail below.

Why does this opportunity exist? 

Aside from being the suckiest bank in America to survive the crisis, the market gives little credit for the sustainability of profits in the mortgage origination segment.  Indeed, the analysts who cover FBC don’t believe the mortgage origination profitability will last more than two quarters (through 4Q12).  In fact, both suggest gain-on-sale revenue ought to fall by nearly 50%, beginning in 1Q13.

They aren’t the only ones.  The mortgage bankers’ association’s (MBA) forecast for mortgage origination volumes to slow from ~1.6T annualized currently to ~1T in origination amounts over the next year (MRFFT14F Index <Go>).  Driving this slowing origination environment is partly the MBA forecast for interest rates.  Currently, the MBA is forecasting the 30 year fixed conforming rates to rise straight up from the end of 3Q12 to reach 2013 to 4.4% by FYE 2013 (MRFFIRFR Index <Go>).

Ok analyst/industry community.  I get it.  We disagree.  But here’s the thing.  You haven’t updated your (FBC + origination) models for open-ended QE stepping on the neck of the secondary market for conforming loans.  Indeed, the effective yield on 30 year conforming paper is a rip-roaring ~ 1.7% in the secondary market.  Do you really think that issuance rates can go up 80-90 bps from here (25%) in 1.25 years?  Given the historical relationship between secondary and primary mortgage markets, a 4.4% issuance rate is roughly a 3.4 to 3.7% yield on the 30 year paper in the secondary market.  Did I mention that that rate is currently ~ 1.7%?

Let me say this one more time in a different way.  The MBA is roughly forecasting that the secondary market price for conforming mortgages, the same paper that the Fed has put a huge open-ended bid underneath, will effectively fall by between 40 to 50% over the next 1.25 years. Again, that seems crazy.

Here's a beautiful chart of this dynamic:

On the right side, you see the 30 year conforming mortgage contract rate and the 30 year conforming mortgage forecast from the MBA (yellow and orange).  As expected, they track pretty well (they're supposed to be the same number, after all).  On the left hand side, you'll see the effective coupon (yield) on the 30 year MBS in the secondary market.  You'll notice it tracks pretty well too at a spread, although the spread has widened significantly of late.  And lastly, notice the MBA forecast for the next year.  Is that forecast possible?  Maybe.  Given the Fed buying 40B in MBS (white line) per month?  Hmmm...

Just to highlight the potential fallibility of the MBA, they recently updated their previous 3Q12 origination forecast upwards, from 380B to 410B.  The new number still looks light given new agency issuance data over the same timeframe (IMBS <Go>), which is currently at 468B through September.  A word of caution - there may be a timing issue between origination and mbs issuance which could skew the IMBS data.  Historically, it looks as if IMBS issuance under-represents origination data, which would make sense if a) non-conforming mortgages existed (which they did) and b) mortgage origination rates were increasing (which they were?).  So I'm not entirely sure how accurately the IMBS data reflects the very current origination market, but it's at least a decent proxy.

Indeed, I'm simply betting that origination levels will remain like they have for a while, as more than 90% of the stock of MBS have a fixed rate at least 50bps higher than current origination rates, which, according to Credit Suisse, is a good enough incentive to keep people refinancing.  Furthermore, because the banks/lenders often don't retain mortgage ownership, they're out marketing refinancings to their customers (50 bps on a 200k mortgage is 1k per year in interest!  Save save save!).  Combined, I see no reason why origination volumes ought to slow until rates begin to move upwards.

Back to FBC.  Aside from the above, the recent weakness can be attributed to the 1-to-10 reverse split annouced required to keep the NYSE listing.  The float of this company is heavily retail owned, and a reverse split almost always means bad news for the retail community.  Indeed, FBC has done this r/s once before and the stock got creamed.  So naturally this investor base is skiddish.  The difference now is mortgage banking profitability.  I make no promises that this is the bottom of the drawdown given the volatility of this company's equity, but I consider the risk/reward to be very favorable given my outlook for mortgage origination volumes.  So long as the white line in the above chart doesn't tick up too much (say, to 2.3-2.5%), I remain a buyer at these prices.

Other interesting bullet points

• Credit costs have declined every year since 2009 but have increased this year.  Management changed their risk models in 1Q12 and have been recalibrating their balance sheet accordingly, whatever that means.  It's quite possible that this is the end of the road for extremely high credit costs, but we don't need that outcome to make money here.  Management is guiding to ~140m in credit costs (~58 prov, 27 asset resolution, 55 rep/warranty) for next quarter, which is still outrageously high.  But with a PTPP (i'm expecting) of 180 to 245 for the quarter, that doesn't really matter.
• If you run a regression using secondary market rates as the independent variable and origination rates as the dependent variable, you’ll (naturally) see a very high correlation and (interestingly) a historical beta of around 0.5.  That means for every 1 bp move in the secondary market, origination rates have moved by ½ bp.  In other words, historically, gain-on-sale spreads have widened as secondary market rates have fallen, and vice versa.  So we can continue to Thank Ben for his hard work.
• According to market rates, it’s now riskier to lend to the federal government than it is to lend to Fannie Mae for 30 years.  That is admittedly very bizarre.
• To further highlight the bizarre, the 5 year breakeven inflation rate is 2.8% right now.  What does a 1.7% effective coupon on 30 year paper mean in a 2.8% 5 year inflation outlook environment?
• I’m estimating ‘normalized’ PTPP at about 300m per year (down from 800m - 900m currently...).  At a credit costs 'normalized' at 1% of the balance sheet (hah! they're running 4x this amount right now...) and fully taxed that’s still 100m in 'normalzied' earnings on 820m in book value.  What kind of multiple does that deserve?
• The company is 65% owned by MatlinPatterson funds.  This has been MP’s major dog over the past few years.  They’ve sunk over 1B into the company, so their breakeven is about 2.75 per share.  I don’t expect any kind of major corporate action before the stock reaches those levels.
• Detroit & housing seem to be recovering, which ought to be a good thing for the 50m in Michigan CRE NPLs on their books...
• Management has been buying lately, albeit most at lower prices.
• I hate recommending anything that's run up so much, but it's hard to say no to 3x 2012 earnings...
• Look at the chart for NSM.  While they've got some interesting acquisitions in the pipe, you can bet that price rise isn't a function of increased legacy MSR profitability...

3Q12E Estimates

3Q12E Adjusted Tangible Book

Risks

Fed stops purchasing MBS.  Seems highly unlikely...

Origination rates tick up and volumes/profits collapse as predicted by the MBA? 

Company loses AGO litigation.  AGO is suing FBC for ~80m in breach of contract related to its MSR activity.  As of yesterday, the court allowed the case to go to trial, which is scheduled for early October.  It never ends with these guys, but the good news is, the maximum damages is only 0.75 to 2 quarters or so of earnings and/or <10% of book.  I understand this is 20-33% of the expected bump in book equity over the timeline of this thesis, so it's a real risk.  I have no idea how to handicap the litigation though.

I suppose legacy credit costs could increase over the 620 NTM expectation.  Man, wouldn’t that really suck - credit costs would be nearly as high as in 2010.  But, they've provisioned ~450m already for these expenses!  But did I mention that this legacy bank is the worst ever?  But!  But!  For the record, I think management is somewhat out of control of the provisioning/write-down, and that this process is largely guided by the regulators.  Part of me wants to believe that these markets have already cleared (detroit residential/commercial, california residential, every place else that saw prices fall by >50%...) but nobody really knows.

I have some concern about the rapid booking of the MSR asset, as it can only qualify as 10% of tier1 capital going forward.  But I guess ROE is ROE, and it's hard to argue with 20-40% ROE regardless of the asset returned.

The spellcheck appears to be broken.  Bad spelling is always a risk.

Disclosure:  This is not investment advice.  See Magritte.  And do your own diligence. We probably own this, although nothing is certain these days.

MBA/Analyst community adjusts forecasts origination volumes and/or earnings w/ gain-on-sale profitability remain elevated

Company removes DTA valuation allowance causing adjusted FD tangible common value to increase ~ 25 to 40% overnight (depending on NOLs chewed before re-booking).  I expect this by 4Q2012 or 1Q2013 at the latest assuming profitability remains.

Legacy credit costs decline.  Over the past 5 years, the company has expensed over 2.9B in credit costs.  For a bank with 14B in assets, that’s just crazy.  At some point, this phenomenon has to slow.  It seems reasonable that given a) a nascent recovery in housing b) recently revamped risk models and c) it's been 5 years, the time is nigh for these expenses to decline.

Company pays back TARP.  It’s not clear that this is on the horizon, but optically this would be very good for credit outlook.