PEAS, PIES & PEARS – II

Richard Bliss: ‘You are probably too young to remember the Peter Cook/Dudley Moore routine about their restaurant ‘The Frog and the Peach.’ Its only two dishes were Frog a la Peche and Peche a la Frog. Asked if he has learned from his mistakes, Peter Cook replies, ‘Oh yes I have learned from my mistakes and I am sure I could repeat them exactly.’ Most investors have at one time or another felt just that way.’

☞ Now that you remind me, of course I remember it. Who could forget? So let’s call Peas, Pies, & Pears a subconscious homage to the absurdist cuisine of Cook and Moore.

MORTGAGE REALITY

Even now, argues Chris Johnson, a mortgage loan originator in Ohio, the industry is treating as excellent risks borrowers who are, in fact, marginal. He walks us through the example of a young man four years out of college earning $37,000 a year with a fine credit score (731) buying a $138,000 condo.

His analysis concludes:

. . . he’ll be left with $468 per month-best case-to spend $108.00 a week (if he drives 250 or fewer miles per month) to spend on food, clothing, surprises. This assumes that his car never needs maintenance. He won’t be able to miss a single day at work, it will be years before he can really and truly afford this home.

The way our market works, this guy is the BEST BORROWER ON THE PLANET!

. . . Until FNMA and FCMLC radically change how they underwrite, the problems are still growing-not shrinking. Nothing is contained because of the antiquated underwriting models that both of these agencies employ.

This is why we’re not even at the beginning of the end. Our borrower is considered ‘not risky,’ solid and safe. If a major event happens, he is in a severe tailspin, but the current Fannie Mae underwriting model gives him preferred rates and reduced mortgage insurance. A lot of people with even thinner credentials were given these loans.

The underwriting models are still wrong. There is no disposable income test, there are people like this that are advised that this is a ‘smart’ decision, and the current underwriting model thinks that this is a ‘safe’ borrower. So, the worst is yet to come, until we include ‘disposable income,’ in the advice that we dispense along with debt ratios.

☞ This particular borrower could do just fine. A bright guy, he might get a $3,000 holiday bonus and steady raises over the next few years. We all hope does (whoever he is). But for every story like that, there may be another young man who gets laid off; or who encounters other more modest difficulties – but lacks any real margin to absorb them.

WAL-MART

Here‘s a story from the Plain Dealer (thanks, James Musters) about 6,000 people applying for 300 jobs at a new Cleveland Wal-Mart Supercenter. When you read stories like this, it’s hard to believe that the economy is quite as robust as the Administration says – or that Wal-Mart is quite as bad a place to work as its critics say. Yes, the economy could be worse (just wait, I fear); and, yes, Wal-Mart could pay better (if we don’t mind paying a little more when we shop there). But I think a story like this tells a sobering tale.

FMD . . .

. . . dropped 10% yesterday on an analyst’s downgrade. It is now barely above the price we first paid.

My FMD guru responds:

Clearly not a pleasant day all around. As far as Mr. Snowling [the analyst] at FBR is concerned…..he is the most notorious “stirrer of the pot” on FMD and has been to date as wrong as anyone could possibly be on the operating performance of FMD. Why an analyst with such a systematically flawed record for predicting operating outcomes still has such sway over the stock price confounds me – and, in my opinion, raises other questions.

As far as TERI is concerned, their IFS rating (Insurer Financial Strength) was lowered to A from A+ a month ago in an expected development that was widely considered unnoteoworthy. Most of the increased risk was attributed to the rapid growth of the private student loan industry and the relative concentration of industry risk generated by FMD and resident with TERI. (See here.). Also, keep in mind that FMD effectively “bought” supplemental insurance from AMBAC on their last securitization to cover any increased risk to interest or principal.

Now….with all of that as preamble, there remains very real short term risk in FMD’s business model associated with their ability to consistently and profitably access the Asset-Backed Securities markets. This is the risk I have always pointed to as the one we really had to watch out for. Right now, with the mortgage meltdown and fear of associated recession, the ABS markets appear to be somewhat paralyzed – and not just for mortgage paper. Funding for auto loans, credit cards and potentially student loans could also be affected. Importantly, FMD should be in the process of bringing their second fiscal quarter securitization to market as we speak – with a usual announcement of volume and pricing expected sometime in the early part of December. Results of that announcement (or lack there of) may exhibit extraordinary influence over the price of the stock in the near term….in either direction. In the medium and longer term, the ABS markets should inevitably settle down and stabilize… and any increased risk associated with funding student loans should be reasonably priced into the cost of the loan.

More importantly, in the medium to long term, there should continue to be impressive growth in the private student loan industry – and FMD possesses some very real, sustainable and exploitable competitive advantages in that space. In my view, the medium and long term FMD story remains compelling – however the near term price action could be highly volatile.

☞ Or put another way: kids are still going to go to college; cheap government loans will pick up only a fraction of the cost; FMD is smarter about underwriting student-loan risk than its competitors; so this might be a better time to buy than sell – but only with money you can truly afford to lose.

WRONG PRINCE

In early editions of yesterday’s column, before several of you gently corrected me, I had the wrong prince acquiring Citicorp shares at $10. I said Bandar. I should have said Alwaleed.

 

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