Description

Investment thesis:  We are long FED at 0.35x tangible book value with significant reserves against expected future loan losses.  Not all California thrifts recklessly abandoned mortgage underwriting standards in 2006-7.  Cumulative losses on FED’s option ARM portfolio would have to exceed 50% (highly unlikely) to justify today’s valuation.  Losses of 25% or less are a more reasonable expectation.  Management is being proactive with restructuring non-performing loans.  100-200% potential upside justifies the low risk of the stock being further impaired.

Business:  FED is a small thrift in Santa Monica, CA, with 35 branches and a loan portfolio consisting of pay option ARMs and small balance multi-family loans.  The market capitalization is $200mm, total assets are $7B, deposits are $4B, and tangible common equity is $586mm.

Value:  The stock currently trades at around 0.35x tangible book value per share of $43.  Earnings are depressed, as you would expect, by considerable losses in the option ARM portfolio.  A sustainable ROE for this business is in the range of 9-12%.   The company added substantially to loan loss reserves in Q1 ’08.

At 35% of book value, clearly the stock is pricing in a high probability of going to $0, which is evidently the belief of the huge 65% short interest.  However, in our view, there are three possible outcomes:

1.      Loan losses overwhelm reserves and equity and the stock is worth $0.

2.      FED is forced to raise dilutive equity to bolster its balance sheet.  Depending on the size and price, stock could be worth $10-15 in this scenario.

3.      Loan losses are absorbed by reserves and pre-tax, pre-provision earnings.  Book value in two years is similar to the current level and the stock is worth $35-45.

Short of a sharp increase in unemployment in California, #1 is unlikely; I put the odds at 5%.   #2 is also unlikely; odds of 15%.  20-25%+ defaults are consistent with #3 and I consider it by far the most likely outcome.

Forecast:  The outcome will be determined by one simple fact: eventual cumulative losses on the company’s option ARM portfolio.  Several factors are working in their favor: they pulled back substantially in late 2005, they maintained underwriting guidelines that allowed them to avoid some of the more toxic loans, and they have been in the option ARM business since the 1980s.  Moreover, they are being proactive in restructuring loan terms where the borrower has a willingness to stay in the house, and foreclosing quickly and liquidating the property where the borrower has no ability or willingness to make payments.

At March 31, 8.75% of FED’s single family loans were non-accrual.  I expect up to 25% of the pre-2008 mortgages to default; at 40% severity this would be approximately 10% cumulative losses on their single family portfolio.  At this level of defaults, the company should end 2009 with a book value at roughly the same level as today.  Even if 40% of the mortgages default and severity is 50%, FED will have 5.4% tangible equity/ assets at the end of 2009 and probably avoid raising equity.

Further evidence supporting the supposition that FED will not join the heap of defunct California mortgage companies: their single family loans are repaying at a 24% annualized rate, single family loans 30-59 days delinquent declined in April, they are making new jumbo mortgages at very good terms and high spreads (prime hybrids, not pay option).

FED has substantial capital to weather the storm with: 8.28% tangible equity/ tangible assets and 3.83% reserves/ loans.

Funding is not a risk: their deposits and FHLB advances are stable and they have very little repo and senior unsecured debt.  Management is relatively good: they are shareholder-friendly, proactive about managing loan problems, and did nothing skeezy during the mortgage boom.  They have no construction loans or unsecured consumer credit and 30% of the loan portfolio is in small balance multi-family loans where the loss content is extremely low.

Catalysts:  Delinquencies tail off, giving investors more clarity as to total loss content of the option ARMs.  California home prices eventually show a bottom.  A potential massive, self-perpetuating short squeeze.

Catalyst