Description

I recommend a short in the equity of Investors Financial Services Corp. (IFIN or “the Company”). IFIN is a bank that provides asset administration services (e.g. custody arrangements, multicurrency accounting and mutual fund administration, stock lending) for the financial services industry. This business makes virtually no money. In the last two quarters it generated pre-tax income of $1.5 million (adjusted, more on that later). For the nine prior quarters, the average pre-tax loss from the custody business was ($6.3 million) per quarter. IFIN makes all its money by betting on interest rates, specifically, it buys mortgages, predominantly 3 and 5 year ARMS (mortgages that are fixed for 3 or 5 years and then adjust annually) and finances the purchases with deposits or repo. With the back up in interest rates, IFIN is sitting on a time bomb that is likely to go off in the not too distant future.

At this point, let me note that Sunny 329 mentioned IFIN as a short candidate this summer in the NLY thread. Since he hasn’t posted the idea in the intervening 4 months, I am taking the liberty to do so now.

Business: Total client assets processed by IFIN was $956 million at 9/30/03. The Company charges about 3.5 basis points per annum on these assets. In other words, IFIN’s fee income is in the mid-$80 million per quarter. IFIN’s problem is on the cost side. If we assume that IFIN’s mortgage position costs 20 basis points per annum to manage (roughly the operating expense of mortgage REITs), then operating expenses for the custody business are also in the mid-$80 million per quarter. It is just not a very good business. Assets under management shrunk with the decline in equity markets and have increased with the recovery in equity markets. Hardly a growth story.

Where has the growth come from? IFIN’s earnings have come from an ever increasing bet on interest rates. Indeed, more than 100% of the profit of IFIN over the last several years has come from interest margin. At the same time, IFIN’s balance sheet has ballooned to maintain its earnings momentum. Since 3/31/01, investment securities have practically doubled. As we all know, it was a very good time to be long fixed income securities, especially if your supposedly hedged portfolio had a slight long bias (as IFIN’s did and does). Since June, the reverse has been true. This can be seen clearly in IFIN’s expanding duration gap (As interest rates increase, mortgage prepayments slow and the duration of the mortgage securities is extended). At 6/30, IFIN claimed that its duration gap was 2.4 months (1.24 years for assets vs. 1.0 years for liabilities). Rates backed up by 40 basis points in the quarter (5 year US Treasuries) and the duration gap extended to “approximately” 6 months (1.5 years for assets vs. 1.0 years for liabilities). This is noteworthy in that it demonstrates that IFIN just sat on its hands as regards its asset/liability management. By sitting on its hands, IFIN has made its interest rate bet bigger and riskier. Since the end of the quarter, rates have backed up even faster than in Q3 (53 basis points on the 5 year). Based on my conversations with mortgage traders, the duration of the types of mortgages in IFIN’s portfolio have extended by another 5 months or so. My guess is that IFIN’s assets now have a duration of almost 2.0 years and the liabilities remain at 1.0 years.

Now this is a huge problem for IFIN. The size of the problem can be glimpsed in the mark to market adjustments of IFIN’s investment portfolio. IFIN holds approximately half its securities in available for sale accounts and half in held to maturity accounts. Under GAAP, changes in the value of IFIN’s investment portfolio do not run through the income statement. However, changes in prices in the available for sale securities do run through the equity account via changes in accumulated other comprehensive income (Changes in prices of held to maturity securities do not appear anywhere absent a permanent impairment in value). For the quarter, the change in accumulated other comprehensive income (pre-tax) was $12.0 million. My guess is that the more volatile securities are in the held to maturity account and the less volatile are in the available for sale account. However, even if we assume that the two accounts mirror one another, the mark to market loss on the portfolio was around $25 million. Bad, but not the end of the world. The back up in interest rates since quarter end has probably resulted in another $40 million of pre-tax mark to market losses. That equals almost half of IFIN’s LTM pre tax earnings. Things are definitely getting worse.

But what effect does this have on the earnings of IFIN? The change in rates is going to play havoc with IFIN’s interest rate margin. Let’s say that IFIN wanted to close its duration gap today, that is, lock in financing for that second year. The interest rate on that financing would be about 2.8% at prevailing rates. But IFIN’s assets only yield 2.99%. In other words, IFIN’s interest margin for that period would be only 19 basis points (Actually, it would be less than zero if the accounting accurately reflected the negative optionality of holding mortgage securities, but that is another, longer story). Quite a comedown from the 202 basis points it has averaged over the last 4 quarters. Presumably, GAAP would require that this financine be taken into account over the life of the assets, which would reduce net interest margin by almost half.

What Else? Is management trustworthy? I was agnostic on this until the most recent earnings conference call. In Q3, management extolled the Company’s performance in controlling expenses. Specifically, compensation and benefits declined sequentially by 20%. Management was pressed several times about this. Was their a headcount reduction? No. Well, how could comp go down by 20%? Management stated that it was a change in bonus accruals, which highlighted the flexibility of the business model. The math just didn’t add up. As the Company subsequently confessed after the conference call, it was not just a change in bonus accruals, but was primarily a REVERSAL of bonus accruals from the first 2 quarters. Hmmmmm . . .

To top it off, IFIN is a heavy options abuser. For the last three years, fair value accounting of options would have reduced Net Income by almost 20% per annum. That seems a little high for a commercial bank.

Valuation: IFIN’s valuation is so high that the downside should be limited. At 4.5x book and 26x 2003 projected earnings, it is hard to see how much further the stock can rally. If I’m right about the “true” interest margin, IFIN’s net interest income drops from a run rate of $141mm to $93mm. Further, if one backs out the bonus accrual reversal, then “true” run rate earnings drop from $1.60/share to around $1.00/share, approximately flat with 2002 earnings. Where does a growth financial that stops growing trade? Well, 2x book value and 15x run rate earnings equates to $15/share.

Catalyst

The increase in interest rates has created a significant duration gap for IFIN. IFIN must either close the gap, which will cause its interest margin to collapse, or be revealed as nothing more than a highly leveraged bet on 2 to 3 year interest rates.