Description
Business Description: Fremont General is a California based bank specializing in subprime residential originations (RRE) and commercial real estate (CRE) loans. 85% of its pre-tax earnings are derived from it residential real estate operation, with the remainder from CRE. Within RRE, Fremont purchases subprime mortgages in the wholesale channel, from mortgage brokers, funds them with warehouse lines, and primarily sells them for a cash gain on sale to Wall Street institutions, who then securitize them into ABS paper. Last year, Fremont originated $14 billion in RRE loans. The commercial real estate portfolio ($4 Billion) primarily consists of bridge and construction loans, also originated through regional brokers. About 40% of all loans originated are California based.
Fremont set to see strong earnings growth within subprime residential real estate:
-Originations should exceed $20 billion in 2004 (vs. $14 billion in 2003). Given that the firm did $1.7 billion in December 2003 alone, which is usually the slowest month of the year, the number could be conservative. Fremont is benefiting from both an expansion of its capacity (the firm hired 600 new employees in 2003, up 50% yoy from 1,200), and a continued favorable market for subprime originations.
Earnings forecast:
I believe that the company can generate $5.60 in earnings in 2004 and $6.60 in 2005. At a $27 stock price, I think this is an undervalued name.
On book value, the company now trades at 3.0x 2003 EOP equity. However, the company’s equity suffered from large write-downs in a legacy insurance book (see below), such that current BV understates the earnings power (40-45% ROE) of the company. Book value growth is so strong that BVPS will be north of $20 by the end of 2005, barring an increase in the dividend payout rate.
Valuation/Price Target: $43
ROE/COE valuation: 35% ROE (38% in 2003, 45% in 2004E), discount rate of 7.8%, g of 1.5% (prime mortgage market grows at 7% per year): Price to book of 5.3x, yielding a $46 target
P/E multiple of 7x (the subprime mortgage peer average) on 2004, $5.80 in earnings: $41.
High short interest (10% of float, 7 days to cover) due to legacy insurance unit:
-Fremont has carried a significant short interest for the last two years due to problems in its legacy property/casualty insurance book.
-Prior to 2001, Fremont's insurance business faced adverse loss reserve development in its California worker's compensation book. This was due to more to political/regulatory issues, rather than the company's negligence.
-Since that period, the company has transferred all liability of the discontinued insurance operation off balance sheet, and has no incremental exposure to the business.
-In 2002, they paid a one-time $80 M charge to pay for future liabilities over the next six years. --
-Post a July 2002 agreement, the DOI of California was permanently put in control of the run-off book of business.
-The only remaining risk would be if a new insurance commissioner would fight to rescind this contract, and make Fremont pay for additional claims. In doing this, the government would have to remit the $80 M charge that Fremont already paid, which makes this scenario unlikely.
Clean-up of syndicate loan portfolio:
-Similar to many regional banks, Fremont got in trouble during the last credit cycle by participating in the large commercial loan syndications. The company has reduced this portfolio to only $7 million of the total loan portfolio, so further exposure is minimal.
Capital: Given the 40% ROE that the company is generating, and management's reluctance to pay down remaining long term debt, the company is likely to return capital to shareholders either in the form of stock buybacks or a dividend hike (currently a .78% dividend yield, or a 7% payout ratio).
Increased coverage: FMT is currently coveredby two sell-side boutiques, Sky Capital and Hoefer Arnett. I am hearing that management may go back marketing on the road in the near future.
Risks:
A rapid rise in short term interest rates, or dramatic flattening of the yield curve could slow borrower demand for subprime mortgage loans.
-Briefly, the subprime product is priced as ARMs off the 2-3 yr Treasury, so customer demand is somewhat correlated to level of short term interest rates.
-Also, lower long-term rates make fixed rate mortgages relatively more attractive. More details of the subprime market are included below.
Execution risk:
-The firm has rapidly grown its workforce over the past year (1,200 to 1,800), given the demand for the residential product.
-Management also has a checkered past. Whether or not it was their fault, management has had two efforts (syndicated loans and property casualty insurance) generate outsized losses.
-Thus far, the company has been prudent with the subprime business: it now sells the majority of its residual interests in the securitizations as cash NIM transactions. In addition, it is slowly adding to the residential real estate portfolio.
The company faces credit risk in its CRE portfolio and its growing subprime portfolio:
-Within its CRE portfolio, Fremont lends to the riskier segment of commercial loans, including bridge and construction loans for office and hotel space. However, it appears as if the cycle is turning in this market.
-It is also starting to portfolio some of its subprime real estate loans, which could perform poorly if foreclosure rates increase.
Overview:
Brief overview of Fremont's subprime product, and the subprime market:
75% of Fremont's RRE production is ARM. These loans tend to be 2/28's or 3/36's, loans with a 7.5% coupon with fixed rates for 2-3 years.
-Average FICO score is 611, Avg. LTV is 80%.
-In terms of credit grade, Fremont originates in the upper tier of the subprime market, in high B's and Alt-A segments.
-Competitors include New Century, Accredited, Ameriquest, Option One, Saxon, etc.
-Because these loans are priced off of 2-3 yr. Treasuries, the demand is tied to the short end of the yield curve, vs. the long end (10 yr) for conforming fixed rate mortgages.
-However, the level of originations in the subprime market is much less dependent on rate fluctuations than conforming loans, for several reasons.
-Subprime borrowers tend to refinance to lower their average debt costs, i.e. to pay down credit cards and other sources of consumer debt. The loan acts much more like a home equity line.
-Moreover, most subprime borrowers will refinance the loan once it becomes floating, which results in a steady stream of refi's each year (average life is 3-3.5 years).
-Industry originations (B&C lending) have grown at a steady rate of 15% over the past 10 years. Unlike the conforming market, which fluctuates wildly due to the refi cycle, there has been only one yoy decline in subprime originations. In 2000, the extreme flattening of the yield curve depressed the relative demand of the ARM product, leading to a 10% yoy drop in originations.
-B&C industry originations were $250 billion in 2003.
A rise in interest rates is correctly perceived as a negative, but is not as troublesome as the prime market
-Short-term rates need to rise substantially (200-300 bp) in order to choke off demand from consumers.
-A severe flattening of the curve would make fixed rate mortgages more appealing. This would also stifle demand from consumers.
-As refi booms slow, the concern is if the prime players (Countrywide, Wamu), become more competitive in the subprime sector.
-Rates rising may make it more difficult for borrowers to pay on ARM mortgages. However, FMT only has $800 M in subprime originations portfolio'd on its balance sheet, so the credit risk for FMT is minimal.
The main worries for the industry are an increase in competition, and lower housing market values
-Increased competition leads to lower gain on sale premiums to the Wall Street institutions. This usually involves either giving a lower coupon to the mortgage broker for a specified loan, or Wall St. brokers bidding less for the loan pools. Loans are typically sold for a 3.8-4.5% premium of par in the secondary market.
-Although depreciating home values could increase the number of borrowers that are non-conforming (as LTV's increase above 80%), loss rates are likely to rise. This could weaken demand from the secondary market (Wall St.) and lower gain on sale margins.
Current conditions:
-Competition has increased from existing subprime players (NCEN, Ameriquest) who have bid for lower coupons to the mortgage brokers.
-However, demand from both the sellers (the mortgage brokers) and the buyers (Wall St.) remains very solid. Subprime borrowers continue to show strong demand for loans. Wall Street has also shown a healthy appetite for yield, given the 7.5% coupons.
Specifically, Fremont has seen very attractive demand for its product:
-Management notes that in the first quarter, it is generating sale premiums of 4.75% to 5.00% in 1Q, vs. 3.8% in 4Q. Generally, 4Q and 1Q are the weaker quarters for demand, due to seasonality.
-However, management is already seeing the market open up in the early months of this year, and said that March and April look to be very strong. FMT's net operating gain on sale (net of origination expenses) was 1.91% in the fourth quarter. If current market conditions persist, the company should generate net margins of 2.50% to 3.00% going forward.
Forecast:
Origination guidance looks conservative:
-The company originated $1.7 billion in December 2003, one of the slowest months seasonally, with one less week of potential volumes.
-Thus far, the company is targeting $20 billion in originations for 2004, and $5 billion for 1Q 2004. If December is any indication of demand, then originations could prove to be well over the company's estimates.
Fremont's RRE loan strategy:
-Fremont is now portfolioing about 5-7% of originations on balance sheet, as a source of recurring earnings. The offset to this is income is less front-loaded, and Fremont is now exposed to the credit risk on the loans. The loans tend to season over a 12-36 month period. The company now has $800 million in HTM RRE loans on it balance sheet and wants to build it to $2 billion by the end of 2004.
-In a given quarter, Fremont sells 80-85% of the loans it originates. This has led to a growing HFS portfolio, now at $3.7 billion.
-Up until 3Q 2003, Fremont sold all of its originations as whole loan, cash sales on a servicing released basis. It is now securitizing 10-15% of its sales.
-Importantly, with regard to its off balance sheet securitizations, Fremont is immediately selling 80-85% of the residual asset for cash in a NIM transaction. Currently, it has only $7 million in residual assets on it balance sheet.
-Fremont securitizes to keep its funding options diverse, and in case the economics of the NIM transaction are better than a sale in the whole loan market.
-Fremont does service $9.5 billion in loans, however, this revenue accounts for only 2% of the company's total. The company services loans in its portfolio, HFS loans, and those it has securitized.
Projections for the RRE portfolio:
$597 M in gain on sale income in 2004, up 94% yoy. This is based on originations of $22 billion and operating gain on sale spreads of 2.3%. (GOS spread in 2003, 2002: 2.02%, 2.5%)
-Balance sheet RRE assets of $8.05 billion by end of 2004, up 81% yoy. The company desired to have $2 billion in HTM loans by the end of 2004, so the remainder ($6 B) is HFS loans.
-The RRE portfolio will generate $434 Million in interest income (gross of interest expense), assuming yields of 7.2% vs 7.5% yoy.
Commercial Real Estate:
-Fremont has $4 billion in CRE loans, which comprise the majority of its HTM loan portfolio.
The loans are virtually all adjustable, priced off of 6-month Libor.
-40% of the loans are generated from California.
CRE loans by real estate type:
Office: 34%
Industrial: 14%
Hotels: 12%
Retail: 11%
Comm'l Mixed: 10%
Multifamily: 10%
-The loan portfolio has grown steadily, 8% in 2003, with particular strength in construction lending.
CRE loans by product:
Bridge: 41%
Permanent: 32%
Construction: 20%
Single Tenant: 7%
Credit quality is improving in the CRE book, and the company has reserved conservatively:
-CRE loans are the source of most of the company's reserves, which now stand at 4.5% of loans.
-The net charge-off ratio was only 0.98% in 4Q, down from 1.2% in 3Q.
-NPL/Loans (excluding HFS) was 2.31% in 4Q, down from 2.85% in 3Q.
-Fremont has steadily built up its reserve allowance, from 3.99% at the beginning of 2002 to 4.45% in 4Q, due to the deterioration in the CRE market.
Importantly, most of the non-performers in CRE are pre-2000 vintage, and according to management, the newer loans are performing much better than expectations.
For a loss ratio of 1.0%, a 4.46% allowance is very high, and it is likely that the auditors require the firm to lower this ratio.
Consequently, while it won't release reserves, I believe that company will allow provisions to match charge offs, which would result in a lower allowance % as the loan book grows.
Projections for the CRE portfolio:
-I have the CRE portfolio growing 8% yoy in 2004 to $4.35 billion.
- I have loan yields staying unchanged, at 7.8%
-I have provisions matching charge offs of 1.00%. This will lower the ALL % to 4.0% from its current 4.5% level by the end of 2004.
Cost of Funds:
-The company just extended $1.5 billion in warehouse lines for its residential real estate platform, which should be adequate to fund originations.
-For the CRE portfolio, the company uses a mix of non-core deposit funding and FHLB debt. Given its commercial bank charter, it is prohibited from offering consumer demand deposits, which have lower interest rates.
-CD's yielding 2.5% comprise 56% of interest bearing liabilities. The company intends to grow these in line with the CRE portfolio. It is now bringing in $100 M per month in net new CD's.
-The remainder of their operational borrowings are 50/50 split between FHLB loans and savings deposits, which both yield 2%
-All else being equal, I have the cost of funds staying in the 2.15% range, vs 2.20% in 2003.
Corporate interest expense:
-The company has $22 M left of 2004 Senior notes at 7.7% which will paid off in March 2004.
$190 M of Senior notes 2009, will stay on balance sheet as they currently trading at a 5% premium to par.
$100 M in trust preferred with a 9% dividend
-As most of the remaining debt is trading at a premium to par, the company is thus far reluctant to buy back in the rest.
Catalyst