The Dow dropped 416 points yesterday, which is either one of those hiccups that scares a lot of people out of the market (it could easily drop another couple hundred points in the first few minutes of trading today) and then, after some ups and downs, is soon forgotten . . . or it could mark the beginning of a rough patch for the market (but when has the market ever not had the occasional rough patch?) . . . or it could be the first chickens in a large flock coming home to roost.
If I had to guess, I’d bet on the hiccup or the rough patch, not the roosting flock. But that last is certainly possible and arguably long overdue – which is why investing is a serious business and risks are not to be taken with money that cannot prudently be risked.
The rich get richer in part because they are generally better able to hang on through adversity, perhaps even retaining the cash to scoop up real bargains once true panic sets in. Not that it will – but it could. A dip in confidence could lead to an even tougher housing market and more foreclosures, leading to a further dip in confidence, lower stock prices and a recession, leading to even larger deficits and an ever tougher housing market and more foreclosures . . . and who knows what could happen with Iraq, Afghanistan, Iran, oil, and the rest?
All this is above my pay grade.
Maybe you co-signed a loan to help your kid borrow tuition from a lender partnered with First Marblehead, stock symbol: FMD. It then bunched that loan together with thousands of others and sold them off as a package to institutional investors, ‘securitizing’ them. (That is, turning the loans into a financial security, like a stock or a bond or, in this case, a bundle of student loans.) Upon sale, it booked a nice big profit in anticipation of all the fees it would get over the years as your kid paid it off.
It’s a complicated business, and a lot of really smart hedge fund managers (and some maybe not so smart) are short the stock, which was $25.50 (adjusted for a 3-for-2 split) when it was first suggested here about a year ago and closed last night, down a nickel on the day, at $44.25.
Even as the market was stumbling yesterday, my FMD guru was e-mailing me this upbeat assessment:
As you are probably aware, FMD released their preliminary estimates for their third quarter ’07 securitization this morning. The results were substantially stronger than even I had anticipated (and as you know, I was far more optimistic than the analyst community) – the most important elements being a continued expansion in margins and increased upfront cash flows. Unless something changes dramatically in the next several days (usually I wouldn’t expect that, but given today’s market activity who knows!), it would seem that fiscal ’07 earnings should be comfortably north of 4.00 a share. Also, given that the CEO signaled that he was buying stock himself (albeit a relatively small amount), I wouldn’t be surprised to see some aggressive corporate buyback activity this quarter. In my opinion, the investment thesis is gaining strength, not weakening.
So what do the shorts think?
I got to spend some time with one of the smartest of them recently. He’s lost a good chunk of change this past year as FMD has risen more than 70%. He gave these basic reasons for expecting an eventual collapse:
1. He’s never seen a company with ‘gain-on-sale’ accounting ultimately work out.
2. First Marblehead’s profits are based on the assumption of students taking a long time to repay their loans . . . but that once they graduate, he thinks banks will start competing for their business and that they’ll refinance the loans at lower rates, forcing FMD to take big write-downs.
3. The few big banks that now account for much of FMD’s business will begin cutting FMD out of the picture to make all the profit themselves.
To which my guru replied:
1. I agree with him for the most part on the history of companies that stake their future on the accounting benefits of gain-on-sale arithmetic. The difference here is that the cash flow is real, not phantom profits implied by some future Net Present Value assumption. FMD is a cash generating machine – and three to four years in on some of the older vintages, the residual values seem to not only be holding up, but releasing greater than anticipated cash flows (but the story here is the upfront cash, not the residuals). Management has been very conservative in recognizing this residual income at the time of the securitization, so the trusts can tolerate an elevated level of prepayments and still perform very solidly.
2. The prepayment argument is an interesting one, but I don’t see substantive risk here: The original loans have an average duration of 20 years, the vast majority of the original loans are cosigned by parents, and almost all are guaranteed by TERI (if you check the trust vintage data available on the FMD website, you will see that they have yet to recognize their first dollar in credit losses). FMD also prices their loans variably based on risk and offers customers reasonably tight spreads given the risk of the loans. I’m not sure how a rational bank, that needs to demonstrate solid performance expectations to rating agencies in order to get access to funding on the open market, could possibly undercut the original pricing in a material way given that the student’s parent will most likely NOT cosign at this point and the loan will not be guaranteed. Plus if there are behavioral changes in loan prepayments, those changes will be taken into the upfront pricing assumptions on newer vintages, and – given the growth rate of the market and this business that I addressed in an earlier email – the newer vintages will overwhelm the older stuff, significantly muting any earlier miscalculation. Also (and the lack of focus by the bears on this argument mystifies me): If, in fact, private student loan consolidation becomes a threat, wouldn’t FMD be in the best position to refinance these loans given their substantive competitive advantages and their proximity to the customer?
KEY POINT: It’s the relative level of respect for these proprietary advantages and a solid understanding of how they can be applied that are really at the core of this debate.
3. The concentration of institutional partners is an issue, but it has improved a bit over last year and, mainly, what the shorts fail to appreciate is the value of the expertise imbedded in FMD’s database. There’s no quick way for competitors to gain this knowledge. Without it, they’re better off partnering with FMD.
Who will be right? My money’s on FMD – but not so much of it that I’d have to forego color on this website if it goes the wrong way.
Have fun today. If you’re in the market for the long-term, remember that you’re in the market for the long-term. If you’re in the market with money you’ll likely need to draw on in the next two or three years, remember that you shouldn’t be in the market at all.
Quote of the Day
We're not trying to outsmart the smart guys. We're trying to sell bonds to the dumb guys.~alleged remark of the head of a Wall Street mortgage-bond group
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