The Value Investing Congress - West was held last week in Hollywood, and Mohnish Pabrai's "fish" that he threw out to attendees was subprime freakazoid Delta Financial (DFC), a company that has been mentioned here a few times.

http://www.fool.com/investing/general/2007/05/18/blog-buzz-v...

'Nick' mentioned some of other picks by other money managers here. Several are familiar from Value Investor Insight.

http://www.valueinvestingnews.com/any-news-out-of-value-inve...

The deeper you look into DFC, the more it seems like an investment too complicated to meet Pabrai's requirements for simplicity. Therefore I'm led to believe that his investment thesis is built on something simple but yet counterintuitive.

So I'm dying from curiousity about this presentation. Tilson eventually sends most of them out with VII, but I would be thankful if any VIC attendee(s) would be kind enough to summarize some of Mr. Dhando's data points here. If nothing else it would be an interesting follow up to the earlier discussion.

BBQ

The deeper you look into DFC, the more it seems like an investment too complicated to meet Pabrai's requirements for simplicity. Therefore I'm led to believe that his investment thesis is built on something simple but yet counterintuitive.

I looked pretty hard at DFC just recently when the stock was down (it has since popped about 40%). As far as subprime lender and securitizers go, they are relatively simple. They focus on fixed-rate loans, and their origination and securitization schedule is like clockwork -- very regular, every quarter, with steadily increasing numbers. The insider ownership and tenure are also unusually good, it's essentially family-run with large insider ownership.

As with all of these companies, the accounting is tortured, and it is like solving a Rubik's Cube to get from the accounting to the business reality and back. The VIC write-up (which I believe was penned by Pabrai) does a good job of explaining this in relatively simple terms, but still it is far from straightforward.

I didn't invest because Q1 was such a total disaster for everyone in the sector, especially subprime, and I was waiting to see what DFC announced for the quarter. Surely, I thought, we'd see some write-downs, disruptions in the secondary market, spikes in default rates, and at least a taste of the problems that have been plaguing everyone else in the industry, subprime and prime alike.

But, miraculously, the company announced the same steadily upwards-marching figures that they always have (albeit with a small hiccup in earnings). Volumes increased, no problems with any loans or selling any securities, no fraud, etc. Maybe I've become too jaded, but the results seemed a little too good to be true to me.

I did a bunch of channel checks on the company, talking to several loan officers and sales managers, and asked them what kinds of loans they wrote with Delta. The typical answer was something like, "Delta? Man I only send them my crap. Last year I got a 95% LTV loan on a double-wide trailer done with them, and the borrower had credit of 550. They were the only ones that would touch it."

These were just isolated data points, of course, and it could be that Delta doesn't do a lot in the wholesale channel, so maybe these examples were just outliers. Checking these stories against their filings, I found that many of the sketchy programs (such as high LTV and mobile housing loans) were terminated in years past. But, generally, I couldn't find anything that indicated that they were any different than other subprime lenders. The main claim to fame of the company is the fixed rate loans.

It could be that 99% of the problems in subprime happened in variable rate loans and thus Delta missed it all, or that there is an inherent advantage in doing only fixed rate loans that goes beyond the numbers -- maybe this puts them in markets that are somehow insulated from the widespread problems in the industry. I was never able to identify anything, and simply taking a father-and-son management team's word wasn't enough for me. Given the complex accounting of the business, I can't say with certainty that there isn't a fish in the closet.

T

"'I did a bunch of channel checks on the company, talking to several loan officers and sales managers, and asked them what kinds of loans they wrote with Delta. The typical answer was something like, "Delta? Man I only send them my crap. Last year I got a 95% LTV loan on a double-wide trailer done with them, and the borrower had credit of 550. They were the only ones that would touch it.'"

Tidd -- I like your style man. That's good stuff.

Thanks for your feedback, T. Your experience resembles other opinions that I've read about the company, as well as what I uncovered on my own. In fact, the deeper you dig the more unattractive the stock becomes as a potential investment.

That's why I'm so curious about Pabrai's business case. If he can present DFC to a room full of legit value studs in under an hour, also allowing for plenty of time to talk up his Dhando-ness ahead of it, then it must have been pretty simple. Perhaps Delta's true exposure to the subprime meltdown was less than it seems for a reason that I don't yet understand, but knowing Pabrai it is probably a "Doh!" factor that is staring me right in the face.

BBQ

That's why I'm so curious about Pabrai's business case. If he can present DFC to a room full of legit value studs in under an hour, also allowing for plenty of time to talk up his Dhando-ness ahead of it, then it must have been pretty simple. Perhaps Delta's true exposure to the subprime meltdown was less than it seems for a reason that I don't yet understand, but knowing Pabrai it is probably a "Doh!" factor that is staring me right in the face.

Well, there is no contesting Pabrai's record, or his AUM for that matter. But I often have these kinds of questions about his investments, leading me to believe that he either has unique insights that I don't have, or is more risk tolerant.

With DFC, there may well be a probabilistic play here -- say a 20% chance of impairment and an 80% chance of above-average performance. And if you make 20 investments like that, the chances are high that you'll come out ahead.

I personally have trouble investing in anything where I think there is a 20% chance of a loss, but that is just me, which keeps me away from things like this (and is maybe why I'm posting here on TMF and Pabrai is preaching to a room full of value investing studs!).

But it is really hard to make even this kind of 80/20 determination if you feel that the reported financials don't give a good picture of the business. And if you have 100 companies in an industry, and 99 of them have problems and one does not, meanwhile the reporting is not transparent, it just raises a lot of questions that are very hard to answer.

I also think that there may be a nonzero "Pabrai halo" effect. He focuses exclusively on small cap stocks, and he is very well followed among the value investing and hedge fund communities, and his stock choices are imminently follow-able -- he makes few of them and they're reported quarterly. For example, how many people ran out of that conference and bought DFC? Not at all suggesting that this has a major impact on his results, but it probably has a nonzero impact.

T

For example, how many people ran out of that conference and bought DFC? Not at all suggesting that this has a major impact on his results, but it probably has a nonzero impact.

Pabrai was the first speaker 5/8/2007. Check out the DFC chart for that week.

http://tinyurl.com/2sgtsr

Tilson joked the next day that he was sure everyone had done their due diligence.

Rog

The VIC write-up (which I believe was penned by Pabrai)...

Pabrai wrote up the CRYP idea, but DFC was submitted by tbone841. Perhaps this is Mr. T-Bone himself, Warren Buffett. But seriously, I don't have any insight as to who this fellow is.

BBQ

I don't know Pabrai Mohnish's thesis and didn't attend the VIC, Hollywood pow-wow. But I don't think that there's a clearer example of an industry in greater distress with as high amount of uncertainty as the sub-sprime mortgage business and/or home building industry.

Two of Pabai's favorite hunting grounds for buying businesses at deeply discounted prices are distressed industries/businesses and high short term uncertainty/low risk which is detailed in his book Dhandho . If the subprime mortgage industy wasn't hitting the point of maximum pessisism less than 3/4 months ago then I don't know what "point of maximum pessisism" is frankly. And that so few have the true conviction to invest at such times, even if they know exactly why they'd be entering the Chakravyuh, is a prime reason why people like Pabrai will continue to kick the shit out of the market over the long haul and the vast majority of all other investors. Fear's also a big reason why most individuals will never become wealthy via the stock market unless they start there.

On a side note, Buffett has said that one should judge themselves based on how well they invest based on the context in taking part ownership in real businesses versus be swayed by mere "movements in stocks." This is another area where Pabrai scores really high. me thinks.

In regards to Delta Financial, this is a company with exteremely capable and able management that take a long term approach to their business. They also have extremely high ownership stakes. They've got the experience of already once manuevering this business through nadirs of morbid curiosity and extremely dire conditions over 10 years ago when they were less prudent than they are today.

I think the problem with most people looking at a company like Delta or MDC holdings (another Pabrai holding) is that it's hard to put the companies in pretty little spreadsheets where one can extrapolate the earnings at XYZ for XYZ years, etc. But businesses are living entities that come with all kinds of starts and fits, and I think most forget that and then panic when a company they hold all of suddden doesn't fit perfectly into their idealistic world. Pabari has owned/owns real businesses and knows this as good as anyone...I won't bother with the Buffett adage that I'm a better investor...

At any rate, while most other businesses in the subprime space were playing the institutional imperative game (like Accredited buying another Lender just before the malaise took place and selling truly ridiculous loans while competing on shear volume in places like California and Florida) Delta has just plodded along the road less traveled. Meanwhile, today, they hold the majority of their loans on a non-recourse basis that creates a recurring revenue stream.

The financials are very difficult to understand but the business is very simple. As with most finanical companies, you have to have an extemely high conviction in management. Here's where Delta scores very very high. I believe the only way one can invest in a business like Delta is with a high degree of confidence in management. No matter how long you look at the financials, one small accounting error, deceipt, fraud, etc. that creates a minuscale hit to assets will completely wipe out the equity. So I believe a huge belief in management and management incentives is probably a huge chunk of Pabrai's thesis...that it's a pretty big bet that Hugh Miller and company will create enoromous shareholder value as the uncertainty disspates and they create a stronger company in the wake of their competitors as they have been dropping by the wayside. There's those that beleive this is not a wealth creating industry but then again, how many people felt that way about the steel industry? Delta's got one of the lowest costs to originate in the business, when pricing reverts someday this company could potentially make huge piles of cash for its owners (meanwhile, they already do a good job of that).

Century Management, has said, that their biggest returns come in companies that have widespread fear and digust priced into their stocks. THey only wish they could find more of them. I believe that's just another mental model for "points of maximum pessism" and "high short term uncertainty" and "distressed industries/businesses." All great stuff/great breeding grounds for business investors. Marty Whitman has also said that there's been no widespread depression since the 1930's and it's unlikely we'll see one. However, Whitman says that if you look at just about any industry since 1930 almost all of them have gone through depressions almost as large as the great stock market collapse and those are the times to get really interested.

I believe Pabai's a pretty shrewd guy who gets interested at the right times.

VPMan

Stewart is interesting, as are the insurers and re-insurers that are trading at like 5.5x-6x PE. Obviously there's big event risk there, but 6x PE on very profitable companies....man that looks interesting.

Flagstone RE as one example.

Naj

Pabrai was the first speaker 5/8/2007. Check out the DFC chart for that week.

http://tinyurl.com/2sgtsr

Tilson joked the next day that he was sure everyone had done their due diligence.

Rog

I think a bigger factor was that DFC posted 1st quarter results the morning of the 8th.

random observations before I tackle TJX:

Two of Pabai's favorite hunting grounds for buying businesses at deeply discounted prices are distressed industries/businesses and high short term uncertainty/low risk which is detailed in his book Dhandho . If the subprime mortgage industry wasn't hitting the point of maximum pessimism less than 3/4 months ago then I don't know what "point of maximum pessimism" is frankly. And that so few have the true conviction to invest at such times, even if they know exactly why they'd be entering the Chakravyuh, is a prime reason why people like Pabrai will continue to kick the shit out of the market over the long haul and the vast majority of all other investors. Fear's also a big reason why most individuals will never become wealthy via the stock market unless they start there.

fwiw, this may be out of place on a board like this but I'll mention a small opinion anyway - I think what Pabrai suggests doing - namely, investigating distressed industries/businesses - is unwise for the vast majority of typical investors. It takes an unusual skill and intelligence to both rapidly learn a new industry and to have the courage and conviction to invest a substantial part of net worth in any particular name. It is far easier to learn an industry and then wait for opportunities to develop.

The financials are very difficult to understand but the business is very simple.

And this just highlights the point - there are thousands upon thousands of simple businesses with easy to understand financials. These business go up and down in value too.

I would never ever ever consider looking at any sub-prime business. It would be ridiculous of me to consider it. I think this is true for the vast majority of investors out there too. Obviously this creates great opportunities for those with the skill-sets to investigate these sorts of things.

yet: I think the problem with most people looking at a company like Delta or MDC holdings (another Pabrai holding) is that it's hard to put the companies in pretty little spreadsheets where one can extrapolate the earnings at XYZ for XYZ years, etc.

I'll admit that I would NEVER invest in a company where i couldn't put together a pretty little spreadsheet (though I own one like that today - Berk, and it is has done pretty long-term). I don't think most people should. And plus, I think that a VERY LARGE percentage of investors would benefit if they COULD put together those pretty little spreadsheets themselves, cause hardly anyone does...

I don't think most people should. And plus, I think that a VERY LARGE percentage of investors would benefit if they COULD put together those pretty little spreadsheets themselves, cause hardly anyone does...

I think most people should dollar cost average into an index over decades or do an automatic program like the magic formula or hire someone.

I think for most people there are way too many data points in spreadsheets for them to understand - and then even if they can this illicits all types of things because it takes an unsual amount of skill and intelligence to do this really well too...like really shrewd judgment, termperament, time to do it, etc. even were most people to understand the data points. I agree with you that most WOULD benefit if they COULD/CAN. I think drilling down on intrinsic value or however you may assess a situation is obviosuly very prudent and wise.

A lot of people also might simply benefit investing in baskets of companies in distressed areas...but this illicits all kinds of stuff too.

I think what Pabrai suggests doing - namely, investigating distressed industries/businesses - is unwise for the vast majority of typical investors. It takes an unusual skill and intelligence to both rapidly learn a new industry and to have the courage and conviction to invest a substantial part of net worth in any particular name. It is far easier to learn an industry and then wait for opportunities to develop.

I agree. Continuing with the MBS industry example, I think everyone knew there was too much fear in this sector during the meltdown earlier this year, and there were some great bargains to be had, but I don't think your average investor would be able to pick apart these companies and tell you that New Century would soon be out of business and LEND would make it through the woods OK.

To give you another example, a couple years ago there was mass uncertainty with integrated power producers. Calpine filed Chap. 11 and most people wouldn't even touch their debt with a 10-foot pole. And these were experts in the industry, hedge funds, and seasoned investors. Today this defaulted debt trades way above par!

Even for industries that are easy to understand this takes unconventional skill. I couldn't tell you right now whether or not MOVI or Blockbuster will be out of business by 2010 or will be 5 baggers from here. It makes sense to capitalize on uncertainty, but figuring out the winners and losers is not as easy as it might seem.

I agree. Continuing with the MBS industry example, I think everyone knew there was too much fear in this sector during the meltdown earlier this year, and there were some great bargains to be had, but I don't think your average investor would be able to pick apart these companies and tell you that New Century would soon be out of business and LEND would make it through the woods OK.

I think we need to add something very important to this. Considering the list of subprimers that are still alive AND also those that imploded, there are tons that have either sold or have been put on the block, and bought by IBs, HFs, buyout funds or peers. This exit strategy and speculation thereon is not a proper investment thesis. You can't go long these stocks expecting they'll get bought out. No one could have foreseen the degree of appetite to buy them. As an example, looking at Tom Brown & LEND (and I admit I don't know what he knows) it looked like for a moment there, Tom was not on the ball. He would not have bought the stock before very bad news if he truly knew what he was doing.

So...really, people didn't know and still don't. Today's rally based on FMT selling their commercial biz is yet another example. People don't take the time to read that what FMT sold has nothing to do with subprime and everything to do with how the government, basically, didn't want existing management running the biz anymore. So there was a short squeeze in the peer group. Instead, the market could have looked at NTBK and panicked. But FMT ruled the wires.

So whoever goes either long or short any of these is likely bigtime speculating. except maybe DFC where (at least IMO) you're taking a risk but not "bigtime".

And this just highlights the point - there are thousands upon thousands of simple businesses with easy to understand financials. These business go up and down in value too.

Spock -- this is a great point. As much as I like and have been influenced by Pabrai, I have only one holding in common with him. To me, his portfolio is full of political risk, customer concentration, and intractable financials, but it certainly must make sense to him. My portfolio is similar in terms of concentration and long uncertainty/short risk to Pabrai, but the businesses are much simpler and easier to understand, at least for me.

Other people -- not you, Spock -- keep getting hung up in trying to understand the thesis behind each of Pabrai's holdings, when in fact many of them appear very hard. Just understanding the concept of dhando, and applying it to easy-to-understand businesses, is so powerful that I don't need to be able to understand DFC to have gotten a lot out of studying Pabrai.

Best,
Redneck

To me, his portfolio is full of political risk, customer concentration, and intractable financials

Thank goodness someone else said that!! I was starting to feel pretty dumb for having a list of underpriced stocks that I could not comprehend the investment cases for...

-Mike

I have been hoping to make time to do an extensive write up on DFC here because I have posted about it frequently trying to find the value that Monish has seen. As a mortgage banker and admirer of Pabrai this was very interesting to reverse engineer. I have tried very hard not to let any personal biases from having been in the business since 1985 effect my thinking and have regularly asked other MB's to look at the underwriting with me and do a reality check.

Since I don't have time to post that kind of write up, I will invoke the words of Seth Klarman from Margin of Safety:

Near-term security prices also matter to investors in a troubled company. If a business must raise additional capital in the near term to survive, investors in its securities may have their fate determined, at least in part, by the prevailing market price of the company's stock and bonds. (Chapter 8 contains a more complete discussion of this effect, known as reflectivity.)

“Fundamental analysis seeks to establish how underlying values are reflected in stock prices, whereas the theory of reflexivity shows how stock prices can influence underlying values.” In other words, Soros's theory of reflexivity makes the point that its stock price can at times significantly influence the value of a business. Investors must not lose sight of this possibility.

Most businesses can exist indefinitely without concern for the prices of their securities as long as they have adequate capital. When additional capital is needed, however, the level of security prices can mean the difference between prosperity, mere viability, and bankruptcy. If, for example, an undercapitalized bank has a high stock price, it can issue more shares and become adequately capitalized, a form of self-fulfilling prophecy. The stock market says there is no problem, so there is no problem. In early 1991, for example, Citicorp stock traded in the teens and the company was able to find buyers for newly issued securities. If its stock price had been in the low single digits, however, which could have resulted in its eventual failure. This is another, albeit negative form of self-fulfilling prophecy, whereby the financial markets' perception of the viability of a business influences the outcome.

The same holds true for a highly leveraged company with an upcoming debt maturity. If the market deems a company creditworthy, as it did Marriot Corporation in early 1991, the company will be able to refinance and fulfill the prophecy. If the market votes thumbs down on the credit, however, as it did with Mortgage and Realty Trust in 1990, that prophecy will also be fulfilled since the company will then fail to meet its obligations.

DFC is cash flow negative and filled that gap last year by issuing more stock in an unfavorable market for its shares


Contrary to what was in the VIC presentation, there is positively no moat IMO. DFC likes to pitch the fact that so much of their business is fixed rate and is therefore a better book of business.... yet it pays off very fast. (the portfolio has an avg weighted life of 13 months). What is counter intuitive in this business is that NO ONE believes they will be sub-prime long enough for fixed rates to matter. If one makes 6-12 months of timely payments many borrowers will qualify for prime loans. What kind of borrower takes a fixed rate that is 300 bps higher than a conforming loan when they may qualify for something dramatically better in a short period? So is DFC really dealing with a smarter version of sub-prime borrower? True, arms are dangerous and I don't recommend them for most people but the most popular loan in sub-prime is a 2/28 that has traditionally not been outstanding long enough to reset. Fannie mae is buying lots of "Expanded Criteria" loans that are in DFC's sweet spot. Based on the investor presentation on the web site, it looks like 57% of DFC's book is above a 600 FICO score and with an "Avg LTV" below 80%. Those borrowers are right in the Fannie /Freddie sweet spot. I looked at one of our customers whose credit suffered from a divorce. She got a Fannie mae loan at 7.875% with a mid fico of 534 on a 70% LTV and then refinanced that to a lower rate in 5 months because her scores improved so dramatically. DFC's current avg coupon i 9%. Fannie and Freddie would love to be the white knights here. This whole mess will be a highly charged political debate and the outcome is not a forgone conclusion.

If all goes well DFC will be a fantastic investment due to the expanding portfolio that will hopefully become stickier. Monish thinks it's worth $35 at some point. I would love to get a comfort level with this and have it be a 3 bagger +

Particularly troubling to me was that they were down right evasive on the most recent call when they got some intelligent questions looking for more transparency. This is not exactly the secret formula to coke and it's hard to claim proprietary issues as a reason to be difficult here IMO. They could and should do a much better job.

For my purposes, I still believe at this point that DFC is a speculation on the following:
* The overcapitalization rates staying stable and not expanding requiring more capital to get securitizations done. Pressure on the rating agencies and delinquencies will determine the above
* The 2005-2006 book of business. Defaults on ALL mortgages (prime and otherwise) don't usually happen until years 3-7. Fixed rates defaulted in droves in the late 80's/early 90's when home prices declined in the Northeast. (DFC thinks a concentration here is a strategic advantage because they do less in FLA and CA than others). The recent data (2000-2006) is pretty meaningless because there has been no historical precedent for the type of lending that was done lately.
*A Regulatory Tsunami and a belief that they can stay out of trouble (this is not their history). Also of note,DFC's main servicer is Ocwen and it is my experience that they are a very nasty place. See the write up under troubled lenders here
http://ml-implode.com/
*The cmo/cdo markets remaining sanguine without further turmoil or contagion. Netbank essentially failed this week and they were a perfectly good and legitimate A thru Alt A paper wholesale lender that had been around a very long time (previously known as RBMG).

So much for brevity...

Cheers
Ish

Also of note,DFC's main servicer is Ocwen and it is my experience that they are a very nasty place.

Ocwen spelled backwards is Newco.

jkm929

What kind of borrower takes a fixed rate that is 300 bps higher than a conforming loan when they may qualify for something dramatically better in a short period? So is DFC really dealing with a smarter version of sub-prime borrower?

I lost you there. Are you talking about fixed subprime now vs fixed prime later, or fixed subprime now vs. ARM subprime now?... also, how popular will 2/28s be in the future? how do we know that answer...

Regarding the secondary market, isn't the proof ultimately in the pudding? Why were did they ride Q1 so well? It seems that a "conspiracy theory" would be needed to argue that they're outright hiding their problems, considering that the entire industry suffered a pretty bad hit in all points of view, and a public torching.

As far as a moat goes, it seems all wholesale-funded securitizers lack one but they've been around for long. So what has their moat been in the past? Perhaps a superior origination platform has been the answer but there are other moving parts (warehousing costs, securitization costs, and just margins in the secondary market). So perhaps Wall Street has now noticed the potential to break that link and force a company like DFC to "hand over" the benefits from the origination moat. If you're an efficent originator, you shouldn't necessarily have an easy time warehousing and securitizing. Right?

I just stumbled upon this thread. Good thoughts regarding DFCs risks in this thread. Someone previously mentioned that they had done some digging and essentially heard that DFC was a "lender of last resort". Not sure if DFC is fudging their numbers or not, but I'm inclined to believe that maybe the loan officers/sales managers that provided this information have a biased view. I have an insurance background and have worked for a highly profitable, conservative insurance carrier. I found that many of the brokers we used (akin to the loan officers/sales managers in DFCs case) viewed us as a "carrier of last resort" when the market was "soft" and competitive (much like the subprime environment for the past few years). In this type of environment, it is often true that the crap gets sent to the conservative players, but they maintain their pricing and underwriting integrity. When the market turns (again, much like the recent subprime industry), capacity dries up and the conservative players who have a short-sighted reputation for writing crap get to clean up, write lots of good business as great prices, and growth mushrooms for a while. Brokers, loan officers, etc tend to get a biased view because their incentives aren't aligned with the underwriters. I guess those guys are saying that all the good business went to DFCs now defunct competitors, eh?

I've been a DFC shareholder since January and made some notes from Pabrai's DFC thesis in his VIC presentation. Some of his points were as follows:

• Severely distressed industry – DFC stock is at a throwaway price despite being different
• Half of loans originated at retail centers with ultra-low costs
• 78% average loan-to-value and 92% of loans are fixed rate
• Conservative accounting – revenue recognized over life of loan but expenses are recognized immediately
• Mostly a re-fi lender. Not affected much by housing starts. Low California exposure.
• 1/3 owned by insiders. Solid, conservative, owner-oriented management.
• Securitized fair value is over $8 per share, excess book is another $4, and the mortgage banking earnings engine generates $1.50 per share
• Less competition now so earnings will grow. DFC has been hiring and growing recently.
• Earnings could be much higher than $1.50 in 2 to 3 years. With a 15X multiple the intrinsic value is about $35 – more if earnings grow. Once the cloud passes over the industry the stock price should rise.

For the record, I think that DFC's stock could work out to be valued at substantially higher prices in the future.
High Uncertainty does not always= High Risk.
In this case, I believe that I am within my circle of competence and although I could probably make a convincing decision tree type of power point slide, I do not think I could accurately assess the probabilities of the various outcomes. Others may be able to so that and that's probably why they have not put me in charge of a nuclear power plant. When I am guessing I do not sleep well. In this case, it may be an issue of knowing too much about an industry or having been a cat that watched a lot of other cats sit on hot stoves…….at the end of the day, no matter how many times I look and listen to this thing I simply cannot get comfortable….yet (remember I am from Boston and like a certain former governor I might change my mind)

I lost you there. Are you talking about fixed subprime now vs fixed prime later, or fixed sub-prime now vs. ARM subprime now?... also, how popular will 2/28s be in the future? how do we know that answer...

Well, I am referencing all of the above. If you are a quasi rational sub prime borrower, you are going to look at the cost of a fixed rate now versus a 2/28 now. If the adjustable is cheaper and you think that you can make 12 continuous timely payments over the next 24 months, would you really willingly pay a rate that is significantly higher for the security trade off of not having to handicap interest rates? Every mortgage broker OR retail loan officer will be very happy if they can refinance you to something better in 12 months ( unless they have a comp schedule with disincentives) Remember, the mall is like a casino to many of these folks. They are use to gambling that somehow everything will work out if they just keep shopping and eating out… Similarly, most everyone believes they will get out of this loan and in fact the majority DO move on to something else or DFC's portfolio would have a longer average weighted life than 13 months. My point was not that DFC cannot continue to write fixed rate sub-prime loans as long as they can convince the MBS buyer that they are better. I am also not advocating for 2/28's. My point is that these borrowers are not really that different than the average sub-prime borrower……maybe just a little less self confident or more easily sold into a loan that brings a much fatter yield spread premium than an adjustable rate. I cannot handicap when or if the market will come around to that truism. I am thinking it may be sometime around months 24-36 in the seasoning of the 2006 book.
……………………………………………………………………………………………………………………….

Why were did they ride Q1 so well? It seems that a "conspiracy theory" would be needed to argue that they're outright hiding their problems, considering that the entire industry suffered a pretty bad hit in all points of view, and a public torching.

I don't believe it's a conspiracy. I think they are evasive because they have a certain group of MBS buyers who want to be believers and that's what makes markets. If you can borrower the money in Japan and reinvest it in MBS at fat yields than you have an incentive bias to continue to believe. I am not willing to bet that they will continue coming to that church every Sunday…I am not saying that they won't either. I DO know that management has been promotional when it comes to the additional credit enhancement associated with the Fixed rate Sub-Prime borrower.
I think that increasing your volume by 30% in a given quarter is a significant accomplishment, but I also noticed a significant up tick in delinquencies and a significant decrease in earnings.
………………………………………………………………………………………………………………………..

As far as a moat goes, it seems all wholesale-funded securitizers lack one but they've been around for long. So what has their moat been in the past? Perhaps a superior origination platform has been the answer but there are other moving parts (warehousing costs, securitization costs, and just margins in the secondary market).

For my purposes, a moat is a durable competitive advantage.
Fannie and Freddie have moats due to their GSE status and the Wall Street players have recently given them a huge run for their money via the Alt A space (What is that Peter Lynch saying about idiot nephews….)
Chase, Citi, Wamu, and others have NO MOAT. I have witnessed them enter and exit the business repeatedly over the last 20 years. (They will always be involved to the extent that they have to meet CRA requirements, but that is a different animal). Wells has a brook in front of its mortgage banking castle due to its huge nation wide sales force. Countrywide is probably the world's best known independent mortgage banker and no one will crave a Countrywide loan if they are gone next week. DFC is a castle made of straw with a red carpet leading from the front lawn to the crown jewels in terms of competitive advantage. If Lehman Brothers decides that they really want their niche next week, they could come take it before lunch.

Regards,
Ish

When the market turns (again, much like the recent subprime industry), capacity dries up and the conservative players who have a short-sighted reputation for writing crap get to clean up, write lots of good business as great prices, and growth mushrooms for a while. Brokers, loan officers, etc tend to get a biased view because their incentives aren't aligned with the underwriters. I guess those guys are saying that all the good business went to DFCs now defunct competitors, eh?

It is entirely possible that the rank-and-file employees don't really have a good strategic view of the company.

But the thing about subprime lenders is that they all believe that they are different -- it's Lake Woebegone, where every subprime lender is above average. Everyone claims to have the cheapest origination costs, the lowest LTV's, the best underwriting, the most conservative accounting, etc. Clearly, they can't all be above average. Compare Delta's claims to those of their competitors -- every subprime lender's investor presentation shows a chart showing that they are among the best in all of these categories.

And it could be that even being way above average doesn't mean you don't take heavy losses. Another thing about subprime lending is that there is nothing saying that the industry as a whole can't take substantial losses for a while, in which case average or above-average participants will still lose money.

The one thing about DFC that is definitely different is the focus on fixed-rate loans. But if this were the secret to success, it could be easily replicated by numerous competitors. And for example their LTV and credit scores are just the same as everyone else. Their accounting is perhaps more straightforward and easy-to-understand than most, but there is still plenty of room for them to bury costs and such in a way that you'd never know.

I am flatly suspicious of their incredibly regular results, given the huge rise and fall in subprime volumes and profitability over the past 5 years or so, I don't see how they can defy the trends to such an extent. The best performers in other difficult industries (consider Southwest in airlines for example) are still subject to the market forces around them.

T

Tiddman,

To some extent I share your concerns, but I say that it is only to SOME extent because there are reasonable and realistic explanations for DFCs competitive position and good results amid the market turmoil.

(I'm new to the boards and have no idea how you guys are putting other people's quotes in italics, so I've just put them in quotation marks. Any advice about how to use italics would be appreciated.)

"But the thing about subprime lenders is that they all believe that they are different -- it's Lake Woebegone, where every subprime lender is above average. Everyone claims to have the cheapest origination costs, the lowest LTV's, the best underwriting, the most conservative accounting, etc. Clearly, they can't all be above average. Compare Delta's claims to those of their competitors -- every subprime lender's investor presentation shows a chart showing that they are among the best in all of these categories."

While it is true that all suprime lenders (or other companies, for that matter) claim to be the best at what they do, it is absolutely not true that they all claim to have the lowest LTV's or the cheapest origination costs. Those items are quantifiable and therefore any claims that a company isn't able to back up with numbers would ruin there credibility with such false statements. The same may also be said about conservative accounting. DFC is either at the front of the pack or leads the pack in these quantifiable areas. I'm not aware of any other subprime lender whose origination costs are even close to DFCs, but if you are please let me know. To me, that's the most important figure because the origination platform is where most of DFCs value lies. The market is currently ascribing a value of zero to it, but since they are the low-cost producer there is immense value in their mortgage banking operations -- potentially two to three times the current stock price, just for the mortgage bank.

"And it could be that even being way above average doesn't mean you don't take heavy losses. Another thing about subprime lending is that there is nothing saying that the industry as a whole can't take substantial losses for a while, in which case average or above-average participants will still lose money."

Again, I can't say that I agre with you. If the industry as a whole continues to get incessently pounded with losses, ALL capacity will dry up (i.e. there will be no subprime industy). Not to say that more pain isn't ahead, but the players who have done sensible lending need not worry. One possible exception to that would be if the securitization market dries up for more than a couple of quarters, in which case DFC and others would be squeezed so hard that it could spell the end for them. It is notable that DFC saw marked improvements in their Q2 securitization pricing and terms, as compared to Q1. No sign of things getting worse for the securitizations.

"The one thing about DFC that is definitely different is the focus on fixed-rate loans. But if this were the secret to success, it could be easily replicated by numerous competitors. And for example their LTV and credit scores are just the same as everyone else. Their accounting is perhaps more straightforward and easy-to-understand than most, but there is still plenty of room for them to bury costs and such in a way that you'd never know."

If only it were that simple. The "herding mentality" isn't limited strictly to the stock market. For the most part, subprime lenders were drawn to exotic mortgage products, ARMs, and so on because that's where all the growth opportunities were. Most of the lenders were doing these stupid loans like crazy. It will happen again in a few years. It's cyclical. Many other industries are susceptible to this kind of nonsensical competition as well. DFCs focus on fixed-rate loans isn't necessarily the "secret to success", but it definitely was under these specific industry conditions. Now, I imagine, what competition remains WILL focus mostly on fixed-rate products, or on conservative "exotic" products at the very least. Regarding your comment about their ability to bury costs, it is worth mentioning that ALL financial institutions share that risk. I think Charlie Munger has said something about how the integrity of management is of utmost importance in financial institutions because you HAVE to have faith in their estimates in loan losses and so on.

"I am flatly suspicious of their incredibly regular results, given the huge rise and fall in subprime volumes and profitability over the past 5 years or so, I don't see how they can defy the trends to such an extent. The best performers in other difficult industries (consider Southwest in airlines for example) are still subject to the market forces around them."

Because of their accounting methods, they recognize interest income (a large chunk of their earnings) on a regular basis, which helps smooth them. I'm not a big fan of financial engineering, but I don't believe that this type of accounting would qualify as such. At any rate, that is largely the reason for their regular results. Also, their portfolio is still young and losses have been good. Management has stated that as their portfolio matures, losses will increase. Presumably, they have built these expectations into the numbers/estimates. DFC is subject to market forces, they've just intentionally avoided the worst part of the market.

I'd be interested in feedback, but I'm sure I'll have to just agree to disagree with some of you.

cowboy,

I think you have it right. Also, on second thought, perhaps the argument I made about origination & funding moats is exactly wrong. An origination moat probably results in the originator's ability to play warehouse lenders off each other (if there truly are no games being played).

The point about taking crap in good times for good compensation is very strong. I am still worried about the IBs though, from another point of view, namely, you said:

• Less competition now so earnings will grow. DFC has been hiring and growing recently.

I think there's less pure play competition but maybe more IB competition. So it's not that IBs would pull DFC's lines; it's that they can just go in and originate in the first place.

Tidd,

It's true that they all claimed to be among the best but in that case, by definition, a couple of them are simply not lying. There are ways to verify some of this. Some originators BS more than others. Yet, it's true that DFC still sounds very optimistic.

Ish,

Regarding 2/28's 3/27's and plans to refinance before 24/36 months are over, Borrower-wise it sounds right but lender-wise, you're supposed to make a loan that you're comfortable holding without prepayment being the solution. Otherwise it's just speculation, essentially like flipping. So to the extent lenders have treated some subprime or even ALT-A loans as bridge loans, there will have to be a compression of aRM volume, perhaps much, much more than what we've seen. And more competition in fixed. That's just an impression of mine - maybe you can shed more light.

And finally, two things:
1) Munger's point about financial stocks = management judgement is obviously extremly important
2) cowboy, in order to do italics you type: < i > but without spaces, and < \ i > when you;re done with the italicized paragraph. For bold use the ame thign with letter b

Ish,

Regarding 2/28's 3/27's and plans to refinance before 24/36 months are over, Borrower-wise it sounds right but lender-wise, you're supposed to make a loan that you're comfortable holding without prepayment being the solution. Otherwise it's just speculation, essentially like flipping. So to the extent lenders have treated some subprime or even ALT-A loans as bridge loans, there will have to be a compression of aRM volume, perhaps much, much more than what we've seen. And more competition in fixed. That's just an impression of mine - maybe you can shed more light.

My point here is that the jury is still very much out on the performance of this portfolio. How can anyone make the claim with a straight face that these loans have significantly better delinquency characteristics when they have only been seasoned for 13 months? While it is definitely true that a fixed rate is safer than an arm for lender and borrower, rising interest rates have not been responsible for the defaults in the 2005-2006 book.
That dilemma leaves one to dig thru the DFC underwriting manual. Here, the conclusion of myself and my peers was that there was significant gamesmanship in semantics. For example, management is promotional about not doing stated income loans, yet when a knowledgeable party examines their "LIC" (low income check) and "NIC" (No Income Check) loans there is really a very minute difference between DFC and the rest of the sub-prime world.
True, these programs have not been a huge part of the portfolio's, (28.9% of 2006) but they do them at aggressive LTV's.....Which brings me to the transparency issues. The Average LTV that every one hangs their hat on is relatively meaningless. The low LTV's that help create that average will never be a problem. It's the high LTV's that will kill you and this is where the transparency s*cks.
If you cannot get transparency on these issues, than you are like Mungers one legged man in an ass kicking contest IMO.

It is clear to me and my mates that DFC is betting the ranch on the borrowers housing payment history. In other words, 'what do we care if they don't pay the credit cards or the doctor, as long as they have demonstrated a fear of getting thrown out'. Since 85% of their business is cash out refi's, that is very sound underwriting logic and with the right level of transparency I would make a bet on that with them.

The problem is that I do not believe that logic will hold true on those loans with high LTV's when the borrower realizes he is house poor from a monthly cash flow standpoint and 'upside down' or 'sideways' in terms of the homes value in relation to his loan balance. Getting good loan level transparency is not difficult or that uncommon.( An example of good transparency would be the that provided by the mortgage insurers)

The reason that this is so important is the waterfall effect embedded in how DFC gets paid. Essentially, everyone when gets paid before them. So the Net Interest Margin (NIM) and the overcapitalization required to sell NIM Notes will be dramatically effected by defaults.(You should really go back and re-read this section of the 10k if you were taking solace in the non-recourse aspect of the securitizations) Add in the fact that the rating agencies are taking heat on these issues and I cannot for the life of me figure out why they are not more forthright. As my southern mortgage banking friends like to say: “Ish, that dog just don't hunt”

To sum up, here is what I believe anyone needs to know in order to make a rational assessment of whether this is a worthy investment:
• What are the LTV's and Credit Scores broken out by product type, loan purpose, documentation type and origination date. It is crucial to know how much product they have that is NIC, LIC or Stated at what LTV and Credit score
• How will they be able to deal with the OC's increasing in the future, assuming high likelihood of a much tougher whole loan sale environment?
• How much dilution will the market accept as this seems to be the preferred method of dealing with all of the above?


If you can figure all of that out based on the call's and the information provided by management than God Bless you.

Guys -

Interesting thread. I have been thinking abt taking a DFC position, and found this useful. As a quick "reverse" back of the envelope valuation, if they have 36m shares and 72m of cash and net warehoused loans at 6/30, does that mean that cash and cash equivalents represent $2 of book value? if so, then given stock price today of 4.6, that means the market is pricing all of DFC's non-cash current assets to be a~2.6 per share or ~93m. If Angelo Gordon and Pabrai invested a combined ~70m, that implies an advance rate of ~75% for DFC's mortgage certificates. I am no expert but I doubt Gordon/Pabrai would give 75 cents on the dollar in a subprime effected mortgage market that is fast collapsing - assume for a sec that they gave 50 cents on the dollar, book value itself is ~$7 representing a ~30% MOS (ignoring the upside potential all together for now). Did I do that right?

AAATBond

Given that the stock is at an all time low (~$1.5) a,d Angelo Gordon is in the process of building a 60% stake with additional shares priced ~1, is this is a good time to buy? Seems better than ever, except if the subprime exposure pushes this firm to bankruptcy..what are the chances of that? Intuitively i think heads i win tails i lose little based probabilistic thinking could prevail if one were to invest now

Given that the stock is at an all time low (~$1.5) a,d Angelo Gordon is in the process of building a 60% stake with additional shares priced ~1, is this is a good time to buy? Seems better than ever, except if the subprime exposure pushes this firm to bankruptcy..what are the chances of that? Intuitively i think heads i win tails i lose little based probabilistic thinking could prevail if one were to invest now

I'm not quite sure how your second statement ("heads i win tails i lose little") reconciles with your first statement ("except if the subprime exposure pushes this firm to bankruptcy"), unless a total loss falls under ones definition of "lose little." That said, it makes at least as much as sense as those who were claiming Delta to be a "low risk, high uncertainty" investment when it was north of $10.

Given that the stock is at an all time low (~$1.5) a,d Angelo Gordon is in the process of building a 60% stake with additional shares priced ~1, is this is a good time to buy?

Well let's look at the terms of the deal. There are new senior notes bringing the total of that up to $100M up from the existing $45-49M. These carry a coupon of 10%, payable in kind for the first year. As senior notes, they are ahead of the common stock, and they are secured by all of DFC's residual and excess cash flow assets.

Then 40 million new shares of stock will be issued to Gordon, the terms of which haven't been determined, and the existing 10 million shares in warrants will be re-priced to $1.00 from $5.00. Let's assume for the sake of illustration that the 40 million new shares will be convertible at close to market prices (i.e. $1.50-1.80).

DFC had book value of about $115M in the most recent quarter. I think that includes the $45-49M of the previous debt from Gordon. Assuming for the moment that there are no impairments there (an optimistic assumption), about $51-55M of that is now offset by new senior notes.

On 11/6/2007, there were 23.6M shares of stock out, which I don't think includes the 10 million prior warrants to Gordon. So in combination with these new 40 million shares, that is 50 million additional shares being issued, representing dilution of about 211%.

There is also Pabrai's convert, which was for $10M, 2 million shares at $5.00. I haven't seen any notice of this being re-priced, in which case our unfortunate Mr. Pabrai is behind both Gordon's debt and equity.

And the hapless common shareholder is behind everything. So the $115M in book value is now reduced to around $60M minus any further impairments. Fully diluted share count is around $83.6M shares, putting fully diluted book value per share at around $0.71.

Meanwhile, there is little assurance that Delta will be able to make any money for a few quarters. Once they do, they'll have to overcome all of this new financing before they see any returns.

So, I'd say that buying DFC at these prices provides you with the opportunity to earn a little or lose a lot...

T

Re-reading what I wrote, I think I made a mistake in that Gordon's new deal probably means $51-55M of fresh capital into the company. So the hit to book value isn't as bad as I stated, initially the new $51-55M liability for the senior notes would be offset by cash of the same amount. The liability for this debt will grow by about 10% over the first year, which is to say $10M, as the debt pays in kind, and then will pay cash at I guess $11M per year.

However, it is likely that the company will consume cash over the next quarter or two. It will be interesting to see the book value on the next quarterly statement, which will include this financing and their next securitization.

I also wonder what Pabrai thinks about this development. Currently it appears that Gordon came in and undercut him both in debt and equity -- the debt was placed ahead of Pabrai's preferred, and the new stock and warrants probably have a strike lower than Pabrai's $5.00. I wonder if Pabrai was approached about participating in this deal but refused, or if he wasn't contacted at all.

T

Then 40 million new shares of stock will be issued to Gordon, the terms of which haven't been determined, and the existing 10 million shares in warrants will be re-priced to $1.00 from $5.00. Let's assume for the sake of illustration that the 40 million new shares will be convertible at close to market prices (i.e. $1.50-1.80).

Thought it isn't certain, a better guess is probably that if the 40mm common has to be issued as a convert the price will be closer to $0.01. They probably would have just issued the stock outright but for potential regulatory issues. But the deal as written looks like they are selling a little less 2/3 of the equity in the business in exchange for a $55m three year loan @ 10% with no additional consideration (aside from the $1 warrant strike).

There is also Pabrai's convert, which was for $10M, 2 million shares at $5.00. I haven't seen any notice of this being re-priced, in which case our unfortunate Mr. Pabrai is behind both Gordon's debt and equity.

Already converted to common in October.

Already converted to common in October.

I thought so too, but the Q2 10-Q shows 23,604,761 shares outstanding as of 8/6/2007, and the Q3 10-Q shows 23,611,861 shares outstanding as of 11/6/2007. I had expected a ~2 million share increase. Though the Q3 10-Q also clearly states that the convertible notes were converted into 2 million shares of common on 10/4/2007, and this corresponds with a filing from Pabrai increasing his ownership.

So Pabrai got converted at $5.00 prior to this deal, and Gordon's equity got re-priced from $5.00 to $1.00 as part of his new deal.

T

And the hapless common shareholder is behind everything. So the $115M in book value is now reduced to around $60M minus any further impairments. Fully diluted share count is around $83.6M shares, putting fully diluted book value per share at around $0.71.

There is also $320M ish (or was in August) of over-colateralization in the trusts they have claim to. Add the $50M in new cash and you have a pro-forma book value of $430M or $4-$5 of book value. Of course they aren't likely to get all that OC, but you would think they could get a lot of it. If that's true, it begs the question, why do the Gordon refinance? Why not just liquidate? On a 25M share count you have net assets of over $10 per share.

The answer is either, the OC is really bad, or mgmt thinks the upside of being the last man standing in subprime mortgages is better than liquidation even with triple dilution, or Gordon is a hypnotist. These are just my thoughts as I'm starting my research, and haven't check the Oct. trust reports.

My rough calc for DFC's book value:

115m book value plus ~$55m new cash injected by AG minus ~$50m senior notes owed to AG equals ~120m of book value. Based on ~23.6m existing sharesplus 50m new shares to be issued (40 + 10m for warrants) the # of shares outstanding is ~73.6m. That means DFC’s book value is ~$1.64 per share, i.e. right around market value

Therefore, this means that the market is not attributing any value to DFC’s original / OC / other business activities – maybe this means a Heads I win, tails I don’t lose much after all….

Thoughts? Tiddman? Others.

Thanks

AAATBond