Description

Fremont is one of the worst offenders in the subprime debacle, but the preferred stock is undervalued.  While the bank made its share of low-quality subprime loans, it differs from some of its bankrupt or soon-to-be-bankrupt peers in the following ways:

1)     It funded its loans with deposits (mostly retail CD’s), not warehouse lines, thus avoiding a liquidity crunch

2)     It sold all its residential loans each quarter, instead of keeping them on the bank’s balance sheet

3)     The total amount of subprime loans as of 12/31 was roughly $5.1 billion, or 3.5x equity, compared with 14x equity for peers such as New Century and Accredited

4)     It has committed to exiting the subprime business, and has already sold the majority of its subprime investments

5)     The investment is made through the preferred stock, not the common equity

The investment thesis is as follows.  We believe that Fremont, as part of exiting their subprime business, will take an after-tax charge of roughly $400 million, comprised of impairments of their held-for-sale loans (8% hit), residual holdings (written off completely), and potential early payment default repurchase obligations (8% repurchased with a 30% loss rate).  This will leave them with common equity of roughly $1 billion.  They will then be left with $6 billion of commercial loans, and $4 billion of additional loan commitments.   $8 billion of this is tied to residential construction, underwritten at 73% of loan-to-value.  For the preferred stock to be impaired, this pool of loans has to be written down to under 60% of construction cost (73% LTV – 3% loss reserve – $1 billion common equity/$8 billion loans), implying a 40%+ drop in condo prices.  This could happen, and we have hedged against it in various ways (including owning deep out-of-the-money puts on Corus, which currently trades at 1.2x book), but would imply a disastrous outcome for the US economy.  In addition, from the people with whom we’ve spoken, Fremont’s commercial underwriting is considered to be excellent (in stark contrast to their subprime residential).  Their deposit base is almost all retail CD's that have shown stable retention rates Finally, Corus, a significant competitor to Fremont, recently disclosed that it bought 3% of Fremont’s shares in the open market, which is, if not necessarily significant, at least interesting.  Given this, we believe that buying the preferred at 80% of par with an 11% current yield is an interesting investment.  Another thought is to short out FMT bonds, which trade at 94, as the capital structure is fairly compressed (1b common equity, 100m preferreds, 165m senior debt) and it is very unlikely that any impairment would hit the preferreds and not the bonds.

Catalyst