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Minyan Mailbag: Homies Collateral Damage


Some of the banks tied to the unfolding housing implosion are just too dangerous to short.



A couple of questions:

1. The builders have been relatively active buyers of their own stock. A lot of them at relatively higher prices. I know that it has the effect of boosting earnings - smaller denominator. What is the effect of the large capital losses? Am I correct that it only has an effect on the balance sheet and not on earnings? Who looks at balance sheets?

2. I have thought that the next great overvalued area has to be the banks. If the housing market goes into the crapper, then I assume that a number of financial institutions are going to have more bad loans than they are presently calling for. So far the Street hasn't (judging from the price action of the banks) agreed with my scenario. I am short Corus Bankshares (CORS) and Wells Fargo (WFC). Do you have any comments or better suggestions of stocks to be short?

3. Do you have any suggestions on how to play the demise of the home building bubble besides being short the homies?

I welcome your comments.

Thank you

Minyan Duke

Hi Minyan Duke –

With respect to your first question, you are correct that the share buybacks tend to increase reported Earnings per Share. That is why I find it far more useful to look at Net Income to determine the growth trend of a company's business. EPS is useful for valuation purposes but does not tell you as much about the business momentum.

When shares are bought back at prices higher than the subsequent prevailing market price, companies do not incur capital losses the same way shareholders do when a stock's price falls. If share buybacks are undertaken with cash on hand, they return cash to shareholders much like a dividend would (but without the tax consequences), and they have no impact on the intrinsic value of the company. The shares repurchased are simply canceled and there is no impact on the balance sheet. Looking at the balance sheet is, IMHO, critically important, especially when it comes to companies with high debt levels, or with non-liquid assets that are often valued by management through very rosy lenses. The classic example is the land banks of homebuilders, which – again, IMHO – wildly overstate the book value of these companies. Take a look here for more vibes on using "Book Value" as a yardstick to value homebuilders.

As for collateral plays on the continuing demise of homebuilders, I wish I had an easy answer. Many companies directly connected to homebuilders have already commensurately taken it on the chin. You are right that so far bank stocks seem to ignore the dangers that the housing market poses to them, but ultimately I believe the "no underwriting standards" of the last few years will come home to roost.

That being said, I am resisting the temptation of shorting housing related banks for several reasons: first, I am concerned about the current buy-out frenzy. Golden West Financial (GDW) was the poster child for an ugly looking portfolio of housing loans, but it did not matter to Wachovia (WB) when it bought it out at a fat premium. Those loans are now WB's problem but within a much broader and diversified asset base.

Second, I think it is very dangerous to short names that are "closely held" by management and that are already heavily shorted. Corus Bank is both. The Glickman family controls 39% of the shares outstanding, and 42% of the float has already been shorted. The shorts are a natural source of support for the stock price, and the Glickmans (which have a reputation for being a rather "aggressive" bunch) would likely have no trouble taking the company private if they wanted to. Look at what happened with William Lyon Homes (WLS) for a template.

Next is the "what am I missing" dilemma. Take BankUnited Financial (BKUNA) for example:

  • They are a smallish S&L that operates in Miami-Dade, Broward, and Palm Beach counties, Florida; pretty much ground zero for the current housing implosion.

  • More than half of its loans consist of option ARMs.

  • 18% of its loans are to Non-Resident Aliens for purchases of investment properties.

  • In the last quarter a full 1/3 of its net interest income came from non-cash negative amortizations.

  • ARM's loans can negatively amortize up to an LTV of 84% of the original "la-la land" appraised value, meaning that if property values were to fall 16% below "la-la land" appraisals, BKUNA would be upside down on those loans.

  • Despite all of the above, BKUNA's current loan loss reserves are laughable relative to an objective estimate of its portfolio's risks.

  • And to put the final coat of lipstick on this puppy, BKUNA's general counsel is the law firm headed by BKUNA's CEO.

IMHO, this is as close as you can get to the making of a train wreck. So how does the stock behave? It's up more than 50% since October. What am I missing?

If one absolutely wants to get involved with the lenders, there are very thinly traded and expensive options on the KBW Mortgage Finance Index (MFX). With 32% of the weighting going to Fannie (FNM), Freddie (FRE), GDW, and Countrywide (CFC), it lacks the really "implosive" potential of the sub-prime lenders. I do have a position in these options, but so small it's mostly for "entertainment" purposes.

In short, despite the beating already taken by the homebuilders, the best way I see to play the homies demise is still to play the homies demise. But, as I have vibed recently, I think the leg down we have seen since early April in the Philly Housing Index (HGX) needs a pause, and – right or wrong – I am going to wait for better prices to get involved again.

-Prof. Zucchi

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