Springleaf Finance Corp (formerly known as American General Finance) is a leading consumer lender that focuses on sub-prime borrowers.  They operate a nationwide network of ~1,200 branches and have ~1.1 mm customer accounts.

Until November 2010, Springleaf was a direct wholly owned subsidiary of AIG.  In August 2010, AIG and Fortress announced a definitive agreement whereby Fortress would indirectly acquire an 80% economic interest in Springleaf.  Fortress bought the business for ~$120 mm – a deep discount to the $2.4 bn price AIG had been valuing the business at.

Springleaf historically originated 4 types of loans:  a) branch real estate loans, b) centralized real estate loans, c) branch non-real estate loans, and d) branch retail sales finance loans.

The branch business segment is the core of the Company’s operations. Through its 1,118 branch offices and its centralized support operations, the employees of the branch business segment serviced 1.0 million real estate loans, non-real estate loans, and retail sales finance accounts totaling $9.7 billion at December 31, 2011.  (At the beginning of 2012 the Company ceased new origination of real estate loans so that it could focus on its other consumer lending products – i.e. products with higher interest rates and as such more profitable business to Springleaf.)   

The decision to exit real estate lending business was driven by lower returns (<10%+ vs. 20% in non real estate lending business), higher required operating resources (in terms of servicing requirements etc.) in the real estate lending business, and significantly greater personnel time required to close real estate loans.

Real estate loans are secured by first or second mortgages on residential real estate, generally have maximum original terms of 360 months, and are usually considered non-conforming.

Non-real estate loans are secured by consumer goods, automobiles, or other personal property or are unsecured, and are generally fixed-rate, fixed-term loans with maximum original terms of 60 months.

Non real estate loans often taken out by consumers to pay expenses such as tuition, medical expenses, or used to consolidate other consumer debt.

Springleaf purchases retail sales contracts and provide revolving retail sales financing services arising from the retail sale of consumer goods and services by retail merchants.  Retail sales contracts are closed-end accounts that represent a single purchase transaction.  Revolving retail are open-end accounts that can be used for financing repeated purchases from the same merchant.  Retail sales contracts are secured by the real property or personal property designated in the contract and generally have maximum original terms of 60 months.

Frequent personal contact with borrowers has driven strong knowledge of their customers.  This high-touch approach has been key to the Company’s superior underwriting performance.  As a result, Springleaf’s delinquency levels have been significantly lower than the market overall.

In Springleaf’s words:  “We lend to people with sub prime credit – we did not make sub prime loans.  We look at how much credit a customer can afford . . . We verify the customer’s historical payment history and the collateral we’re secured by . . .we are a cheaper alternative at 20%+ than a payday lender . . . we target customers by internet advertising, mailing to former customers, and word of mouth referrals . . . our target customer tends to NOT have significant access to credit . . . The average length of our non real estate loans is 2 years.”

I believe the 2 most important credit metrics to measure and consider are delinquency rates (as a way of predicting default rates) and “refreshed” loan to value ratios (as a way of predicting future losses when/if a borrower defaults).  On both measures, Springleaf compares favorably on an absolute and relative basis.

Branch real estate loans at 09/30/12 were $5.36 bn and the 60+ day delinquency rate at 09/30/12 was 6.40%.  The 60+ day delinquency ratio has been flattish over the course of 2012 and peaked at 7.62% in the fourth quarter of 2009.

Centralized real estate loans at 09/30/12 were $3.71 bn and the 60+ day delinquency rate at 09/30/12 was 9.40%.  The 60+ day delinquency ratio has been declining over the course of 2012 after peaking at 10.31% in the fourth quarter of 2012.

As a point of historical comparison, at the end of 2009 Springleaf’s real estate weighted average 60+ day delinquency ratio was ~7% vs. HSBC’s 60+ day delinquency ratio of ~17% and vs. subprime FRM 60+ day delinquency ratios of ~25% and vs. subprime ARM 60+ day delinquency ratios of ~43%!

Ahead of the housing crisis, management appears to have tightened lending standards in overheated markets and avoided concentrations in states with high property price declines.  For example, Springleaf originated only 22% of its real estate loans in CA, FL, NV, and AZ – the other 78% of the real estate loans Springleaf originated were in other states.  The peak to trough housing price decline was ~37% in those overheated markets vs. ~9% in other states.

Springleaf largely avoided risky mortgage products, no documentation or limited doc loans and negative amortization loans. 

By limiting its exposure to overheated real estate markets the refreshed LTVs on Springleaf’s real estate loans have only increased modestly from original underwriting levels.  While impossible to know the original LTVs and refreshed LTVs on the portfolio as whole information from a recent Springleaf $860 mm RMBS new issue provides a directional clue.  In the underwriting docs, Springleaf provides their analysis of the loans in the securitization.  Specifically, loans in the pool that original were at an ~80% LTV as of April of 2009 stood at a weighted average LTV of 87% as of March of 2012. 

We know that in the 2q and 3Q of 2012 existing home sale prices increased on the order of 5-10% on a year over year basis (i.e. 2Q12 vs. 2Q11, 3Q12 vs. 3Q11) as measured by NAR, Corelogic, Case-Schiller, etc.  Forecasts vary but suffice to say market forecasts are for continuing price appreciation in 2013.

The underwriting performance of the branch non-real estate loan business and branch retail sales finance business has been stellar.  60+ day delinquency rates on the non real estate loan business were only 2.90% as of 09/30/12 (after peaking at 5.09% in the third quarter of 2009).  Similarly, 60+ day delinquency rates on the branch retail sales finance business were a very low 2.71% as of 09/30/12 (after peaking at 6.1% in the first quarter of 2010).

These very low delinquency rates seem all the more impressive when considering the borrower – subprime borrowers or borrowers with a FICO credit score of ~650.  The yield on the branch real estate loan book was ~24% as of 09/30/12 and the yield on the retail sales finance book was ~15% as of 09/30/12.  As a point of comparison, the yield on the branch real estate loan book and centralized real estate loan book was substantially lower at 9% and 5%, respectively.

So let’s go to the specifics of my investment recommendation.  I am recommending the Springleaf 6.90% bonds of 2017.  In reality, I like all of the bonds in the cap structure – at this point though only the 2015, 2016, and 2017 maturities provide a yield to maturity in excess of 8%.  The 2017 bonds are a $3 bn issue and the “benchmark”  (i.e. largest and most liquid) bond in the Springleaf cap structure.  The bonds last traded around 87 and yielded about 10% to maturity.  I believe an investment in the 6.9s of 2017 is likely to provide a low to mid-teens total return opportunity over the course of the next year.  In summary, I like the business, see an improving credit story, believe the bonds are cheap and that there are several potential catalysts that should drive further price appreciation.

~35% of the consumer credit market is non-prime.  There is a large supply/demand imbalance for non-prime credit as banks and other lenders have exited lending to non-prime borrowers and been focused on extending credit to prime customers.  Previously non-prime customers were primarily serviced by finance companies.  The vast majority went bankruptcy, were acquired, or have substantially limited non-prime financing (companies like MBNA, Thornburg, Household, CitiFinancial, etc.). 

As such, Springleaf is poised to growth the business by taking advantage of the scarcity of consumer credit by growing non real estate originations through the branch network and by re-establishing branch based retail finance marketing programs.  That is the market opportunity.

As we noted earlier the performance of the loan book in each of the Company’s respective business lines has been stable to improving on an overall basis.

Springleaf’s opportunity to grow the business has been hampered by significant near term debt maturities and the consequent need to satisfy liquidity requirements to meet upcoming debt maturities.  Springleaf has been focused on putting in place cheaper and longer term financing in place that will provide the Company with the liquidity for growth.  The debt maturity schedule has been and will continue to be significant.

In 2012, Springleaf had and has (in aggregate) ~$2 bn of bonds scheduled to mature.  In 2013 and 2014, Springleaf has ~$2.1 bn of maturing debt (the majority in 2013 actually; the maturity schedule in 2014 is relatively light), in 2015 and 2016 Springleaf has ~$1 bn of maturating debt, and in 2016 and 2017 Springleaf has $7.5 bn of maturing debt (~$3.75 bn of term debt and the remainder unsecured bonds).

On the refinancing front, Springleaf has completed 3 securitizations in 2012 (vs. 1 in 2010 and 1 in 2011).  Each successive securitization has been at a higher advance rate and lower weighted average interest rate.

The 2.80% weighted average yield (“WAY”) of the most recent transaction (October 2012) compares favorably to the 3.59% WAY of the August 2012 securitization and the 4.38% WAY of the April 2012 securitization.

In October 2012, Springleaf effected a private securitization transaction to sell $787.4 million of mortgage-backed notes of Springleaf Mortgage Loan Trust 2012-3 (the 2012-3 Trust), with a 2.80% weighted average yield, to certain investors. They sold the mortgage-backed notes for $787.2 million and ~$110 mm subordinate mortgage-backed notes were initially retained by Springleaf.

Springleaf has said that they are really focused on continuing to securitize assets going forward.  The securitization market provides a significantly more attractive cost of capital than the leveraged finance market.  The Company is focused on attempting to securitize or otherwise secured non real estate loans.  The securitization market for non real estate loans is “not developed” but the Company is probably exploring opportunities to securitize or otherwise secure non real estate loans (assuming they can do so at an attractive rate).

Springleaf management emphasized to me the attractive advance rate (76% and higher than the advance rate than in earlier 2011 and early 2012 transactions) and 2.8% duration weighted yield of the most recent securitization transaction).

Springleaf noted that they had the ability to free up collateral (beyond the currently reported unencumbered asset number) by potentially refinancing the Company’s existing term loan and/or previous securitization transactions (e.g. the transactions entered into in 2010, 2011, and early 2012).  In other words, were they able to refinance those transactions at a higher advance rate they would be able to pledge less collateral against the amount of borrowings (or borrow more money against the same collateral).

Springleaf appears to only have ~$600 mm of non real estate receivables pledged to the $3.75 bn term loan (with a borrowing base of $5.6 bn).  At 09/30/12, Springleaf had $2.2 bn of unencumbered non real estate receivables (vs. $2.8 bn of outstanding non real estate loans.  The Company’s term loan has a borrowing base of ~$5.6 bn of receivables at a ~65% weighted average advance rate (3.75/5.60 = ~65%).  The term loan covenants allow the Company to have up to 35% of the borrowing base advances collateralized with non-real estate receivables. 

The key point is as follows – the term loan covenants allow the Company to change the composition of the borrowing base of the term loan – as such they could shift the borrowing base to include a much greater percentage of non-real estate collateral thereby freeing up additional real estate receivables to securitize (likely at a higher advance rate in a new securitization than under the term loan covenants put in place in May 2011).  Per the term loan covenants, Springleaf could have up to 35% of the borrowing base advances comprised of non-real estate collateral (or ~$1.31 bn of the $3.75 bn term loan or $2.6 bn of non real estate receivables at ~50% advance rate vs. the ~$600 mm of non real estate receivables they have pledged at present).

Springleaf also hinted that they might seek to re-price the existing term loan (L+425 with a 1.25% LIBOR floor) and/or seek covenant changes and/or seek a smaller term loan as part of a refinancing because the bank loan (5.5% all in interest rate) is significantly more expensive than where their last securitization priced.   Prospective covenant changes could include increasing the 65% advance rate ($3.7 bn TL vs. $5.1 bn in finance receivables).

Non-agency RMBS bond prices rallied significantly throughout the third quarter of 2012 as investors seeking yield increased the capital allocation to the Non-Agency sector.  Spreads in this market continued to tighten due to supply demand technicals driven by shrinking pool and investable bonds. Specifically as legacy Non-Agency RMBS continue to pay down there has been very limited supply created to replace this run-off.

Springleaf emphasized they had seen robust demand on all of their 2012 securitizations (and on their last securitization transaction in particular).  One selling point – there are few if any other issuers who are in the market securitizing seasoned sub prime mortgage paper.

Beyond just technicals driving the non-agency RMBS market, there has also been an improvement in fundamentals, which bodes well for Springleaf and more broadly the prices of RMBS bonds.  Home prices appear to have stabilized and are increasing in most major markets.

News of successful securitizations and the leveraged finance markets belief /expectation that the securitization market should provide Springleaf with an attractive/low cost opportunity to refinance unsecured bonds has driven price outperformance in the Springleaf bond complex. 

So the specific catalysts I would look for in the next 3-6 months are news around new securitizations or bank/bond refinancings in the leveraged finance market.

I expect further tightening (i.e. bond prices to increase) when additional securitizations and/or when a term loan refinancing is announced. 

In terms of fundamental credit analysis and how I assess the credit risk in owing the bonds I look at a couple different measures. 

First, I look at free cash flow generation.  Free cash flow generation at Springleaf is positive (~$200 mm a year) but very modest compared to overall debt of ~$15 bn.  But that’s a positive investment consideration, nonetheless. 

Second, I attempt to generate a simplified liquidity roll-forward schedule by on a yearly basis taking beginning cash and then adding principal collections that Springleaf expects to receive (in essence the maturities of Springleaf’s outstanding loans), and deducting new originations that I expect Springleaf to make.  Netting originations against collections gives me a net portfolio runoff number.  By adding the net portfolio runoff number to starting cash and then by adding the cash flow from operations and then deducting the debt maturities that Springleaf has maturing I get to an ending cash number.

At 09/30/12, Springleaf Finance had $1.5 bn of cash and a note receivable of ~$500 mm from the holding company. 

My conservative assumptions show Springleaf having the liquidity to meet all of their debt maturities though 2016 (absent any ability to refinance existing maturities).  Of course, as we have noted Springleaf seems to have multiple avenues to refinance maturities (the securitization and leveraged finance markets in particular).

Springleaf also has multiple levers to generate more liquidity – those would include ceasing all new originations (they have been originating ~$400 mm of new originations per quarter in 2012), selling their retained interests in existing securitizations, an improvement in the advance rate from a potential term loan refinancing, etc.  Further, the stated maturities of consumer loans/principal collections to Springleaf is very conservative relative to the repayments Springleaf is likely to see.  Customers typically renew, convert, or pay in full a substantial portion of finance receivables prior to maturity.

So in summary, a basic liquidity roll forward analysis shows that Springleaf should have the runway to refinance all of its bonds through 2016 (in the absence of any refinancing market) and further that there are multiple avenues for Springleaf to refinance (rather than repay) upcoming debt maturities.

In terms of measuring credit relative value – i.e. where should Springleaf bonds trade -- there are few truly comparable high yield comps.  iStar Financial is also a high yield financial but a significantly different business than Springleaf.  That being said, iStar recently came to market with a 7% new issue – significantly tight to the 10% yield on Springleaf’s existing 2017 maturities.  While there is greater visibility around iStar’s business outlook because the Company is publicly traded I would argue that the delta between the yield on iStar and Springleaf’s respective bond issues is far too great especially considering that Springleaf is free cash flow positive at present while iStar is still free cash flow negative.

On an absolute basis, I also would venture that Springleaf’s bonds are cheap.  Consider the fact that the 2017s are yielding ~10% and would likely see a very high recovery in a bankruptcy (I would guess between 80 cents very conservatively and more likely closer to par).  Springleaf’s total shareholder’s equity at 09/30/12 was $1.3 bn and the “refreshed” loan to value on the Company’s real estate loan book was likely around 90% (and the LTV on the non real estate loans was almost certainly at a lower LTV).  More typically the average unsecured bond recovery rate in a bankruptcy is around 30 to 40 cents on the dollar.  So my perspective is as follows – a bond yielding 10% (on a YTM basis), with an improving fundamental credit story given improvements in housing prices and unemployment rates (that should reduce the likelihood of default), and a bond that would likely see a high recovery were the Company unable to refinance its debt maturities (as opposed to a bankruptcy caused by a recession/double dip, etc.) I would represent as cheap and as such very attractive.

One final note.  I expect that over the course of the next 12 months Fortress will be more visibly engaged in articulating their investment thesis and go forward strategy around Springleaf.  Fortress and the Company have been relatively silent on these topics to date.  Springleaf does not conduct bondholder earnings conference calls or attend leveraged finance conferences (they did attend a recent asset backed conference).  That may change when the new CFO replaces the “retiring” Springleaf CEO in the 1st quarter of 2013.

On September 19, 2012, Donald R. Breivogel, Jr., SVP, CFO, and a director of Springleaf, advised the Company of his intent to retire and to resign as an officer and director of the Company and its subsidiaries on or about December 31, 2012.  “The Company anticipates that Macrina Kgil, a Vice President of Fortress Investment Group, an affiliate of the Company, will be assuming the position of Chief Financial Officer upon Mr. Breivogel’s retirement.”

I think the bonds trade where they do – too cheaply – is because of the minimal visibility that investors have around the Company’s/Fortress’ go-forward strategy.  There are also a significant number of investors that believe that Fortress’ interests are not aligned with bondholders.  Or put differently, that Fortress might attempt coercive exchanges or otherwise seek to hurt bondholders to advance their own interests.  I believe these concerns are misplaced.    Fortress, had an opportunity to pursue coercive exchanges when bonds were trading at much lower prices (early 2Q of 2012) and did not seek to do so at that time – with the bonds trading at much higher prices there would seem to be significantly less motivation to do so at this time.  Further, I believe that Springleaf needs to be able to continue to lower their cost of debt capital to improve their going forward net interest margin to advance a more compelling prospective equity story to equity investors.  “Screwing” bondholders would not help Fortress advance that objective (in fact it would be contrary to that interest).

I would expect the Company/Fortress become more active articulating the go-forward strategy as Fortress looks to monetize their investment in Springleaf.  Recall that in the middle of last year Springleaf had filed to go public as a REIT.  Obviously given the change in strategy (no longer originating real estate loans) going public as a REIT is not going to happen but I think a prospective public equity offering is still a real possibility as a potential exit strategy for Fortress.  (That’s my conjecture but look at the history around Nationstar for guidance. Nationstar is a Fortress controlled Company that went public in March of 2012.)

It’s my view that Fortress has and likely will be secretive about their go forward business/capital markets strategy (as they have to date)– that is until they decide it’s in their interest to talk up the story.  

I believe that the Springleaf capital structure will tighten further when the equity story and the Company/Sponsor’s business/capital markets strategy become more readily apparent to the market at large.  

News around new securitizations or bank/bond refinancings in the leveraged finance market.

Potential IPO.