Monday, March 5, 2007

How To Do A Liquidation Analysis of New Century Financial

When I got to work at 7:30AM this morning, I fired up Yahoo! finance and grabbed a quote for New Century Financial (NYSE: NEW). It didn't look good. Premarket activity showed the stock trading down about 60%, around $6 per share from somewhere in the $14 neighborhood where it had closed on Friday. New Century is one of the subprime mortgage lenders I have blogged about in the past, and that have been making all the financial news headlines lately.

I fired up the bloomberg machine when the market opened at 9:30 to check on NEW's trading levels, and that guy was going ballistic. The volume was through the roof, and the stock was off 60%.

The company is now officially on the verge of bankruptcy. It's a casualty of the capitalist system, and its fate is no longer in the hands of management. It's no longer in the hands of the company's owners, the stockholders... Its fate is now in the hands of NEW's creditors. That's right, those boring people who loaned money to the company, and made it promise to return that money after a certain amount of time, with interest. Like the smart lenders they were, they have the whole thing in writing.

When a company borrows money from someone, it usually makes a few covenants with them. These are just promises. "I promise I won't lose money for two quarters in a row," is a covenant New Century made to 11 lenders. The company is now saying that the odds are that it already broke that promise, which is known in Wall Street Jargon as a breach of covenant. The good news is that six of the 11 lenders said "you know what, NEW, that's ok that you broke that promise. No biggie. I'm not going to sue you and make you pay me all of the money you owe me. I'd rather you keep on keepin on so you can get through this rough patch of business." This is known in Wall Street Jargon as a "waiver."

However, five of the other lenders have yet to make up their minds.

These lenders are thinking to themselves right now "Oh snap, this company is hitting the crapper. There's an SEC probe, there are civil lawsuits, subprime borrowers are defaulting left and right... I don't know if I'm going to be able to get my money back if this nastiness keeps up for long." This is known in Wall Street Jargon as "credit analysis."

If one of these lenders decides not to grant a waiver, that lender can force NEW into bankruptcy. Most likely what that means is that NEW will be is forced to sell all of its assets (which are mainly mortgage loans), a process known on Wall Street as "liquidation."

That's why you have all of the stock analysts doing liquidation scenarios, and that's what the market is pricing in to NEW's stock today. Basically, people are trying to figure out "If all of NEW's creditors get paid off, what's left over for equity holders?" The price NEW closed indicates that the general consensus of the market is "not a hell of a lot."

If you're curious, a quick back-of-the envelope calculation that gets you in the neighborhood of New Century Financial's Liquidation value might go something like this:

1) Go to www.ncen.com and click on the investor relations link. Click the link for financial information. Notice the funny disclaimer that pops up "In light of New Century Financial Corporation's February 7, 2007 news release (New Century Financial Corporation to Restate Financial Statements for the quarters Ended March 31, June 30 and September 30, 2006), the financial information related to the quarters ended March 31, June 30 and September 30, 2006 should not be relied upon and is included on this Web site for historical archive purposes only." Agree to that and go on to the company's financial statements. We're looking for a balance sheet, and we've found one here, New Century Financial's Most Current Balance Sheet, courtesy of its third quarter 10-Q filing. You can find it on page 8 of this document.

2) Value its assets.

The company lists all of its assets first, which is very standard for a balance sheet. Our goal is to guess how much it could get for all of these assets if it had to sell them for cash in a relatively short period of time. Once we have that amount, we assume the company uses all of the cash to pay off its debtors. Whatever is left over belongs to the stockholders. Sorry folks, but stockholders are on the end of line when it comes time to collect in a liquidation.

This is the part that takes time, so be patient, I promise we're getting to a point here.

Total assets were $25.059 billion as of September 30, 2006. Of course, the disclaimer noted above tells us that this number might be bogus, but it is the best we have for now. Some of these assets are already cash and they do not have to be sold. So we'll take $409 million and $572 million as a given. (I'm going to bold these numbers as we go along, so we can add them up easier. I'm also going to round them off to make it even easier. What's a few million among friends?)

Next we come to the meat of the company's balance sheet... the mortgage loans. You know how Robert Kiyosaki is always fond of saying "a mortgage is an asset on the bank's balance sheet, but a liability on yours?" Well, this is why. This is that asset on the bank's balance sheet, in the flesh. NEW has all of this money it lent to subprime people that it can expect to be paid back in the future, with interest. They are listed at $8.9 billion and $14 billion. We won't distinguish between mortgages held for sale or investment here. Let's just lump them together into one nice round $22.9 billion sum. And since subprime mortgages aren't exactly the hottest item flying off the shelves these days, lets assume that NEW would have to discount them by 5% if it wanted to sell them. I don't know if that's a good discount. It's just a guess but being in finance and knowing that these are basically fixed income securities with known default rates (that are rising as of late) and payment schedules, I'm going to assert my wisdom and say 5% is the discount. So lets say that NCEN can get $21.76 billion (22.9B x .95) for these mortgages.

An aside here, Wall Street calls the 5% a "haircut." So, vulture investors (those who swoop in to profit off of potential bankruptcies like these) might say they're "Assuming a 5% haircut" when they do this liquidation value of NEW. Discount, haircut, 5% off sale... call it whatever you want.

OK, continuing down the balance sheet... another aside: you might notice something else here. The less liquid something is (ie the less cash-like and easy to sell), the further down it is listed on the balance sheet, in general. So, if you were listing your assets, you would probably list that $20 bill your grandmother gave you at the top of the list, followed by your collection of state quarters, followed by your furniture, followed by your picture of dogs playing poker, followed by your house, followed by your "mojo." Notice how the things get progressively less easier to sell as you move down the list? The same thing happens on a company's balance sheet, and believe it or not, companies do list their "mojo," only they give it a fancy Wall Street name: "Goodwill" or "Intangibles." This means the big haircuts must be coming up fairly soon.

The next item is "mortgage servicing assets." I have an MBA in finance and I have no idea what the hell that means. So, I did a ctrl+f to search for that term in the document, to see if it is defined somewhere else. It is explained in the footnote on page 24: "The Company records mortgage servicing assets when it sells loans on a servicing-retained basis and when it sells loans through whole loan sales to an investor in the current period and sells the servicing rights to a third party in a subsequent period." This gets us into the nitty gritty of the mortgage world. If I wasn't just trying to do a back of the envelope, I'd look into this, swear to God. But to be honest nothing could possibly seem more boring to me at the moment. So lets just say this is a "loan type product" for the moment and lump it in under the 5% discount.

OK, who am I kidding? There is nothing in finance an idiot using 10% of his brain can't understand. Let's dive into servicing rights via this article on servicing rights that I found on the google.

"Servicing rights -- the right to bill for the loan and collect payments -- are worth about 1 percent of the total loan amount for a 30-year mortgage. But when interest rates go down, borrowers pre-pay their loans and the value of the rights evaporates.

Booking the rights as an asset removes a cushion many mortgage lenders use to soften rate-induced swings in their business. In slow times, when rates are relatively high, lenders like to sell rights garnered from originations done in low-rate, boom times, injecting some previously unrecognized earnings."

OK, so servicing rights seem to be something you can sell about as easily as you can sell a loan. I'm going to keep them in the 5% haircut camp. I'm probably wrong and it might be more than that, but I'm not doing any more work on this. 95% of $60 million is $57 million. Big freakin deal.

Real estate owned is $84 million dollars. The only way a mortgage company gets a hold of actual real estate is... you guessed it... foreclosures. Someone defaulted on a mortgage, and NEW got the deed to the property as a result. If you listen to the radio, you'll know that foreclosed properties can often be had for a steal. Im torn between a 15% and a 25% discount here, so Im going to guess NEW can sell these foreclosed properties for 80% of their current balance sheet value. I'm guessing these prices might make some radio listeners very happy. That $84 million becomes $67.2 million.

Next esoteric asset on the books is "accrued interest receivable," weighing in at $109.6 million dollars. I don't have much of that lying around my house, so I had to dive into the footnotes to figure out what it represents. My first guess was that this represents interest receivable on some kind of asset, such as a bond, that NEW owns. This is the same principle as when I check my ING direct account and see the "interest earned this month" at the top of my account screen, even though I haven't been paid that yet. I figured that was a slam dunk, money in the bank with no haircut... but then I thought to myself "why is this so far down on the list?"

So I did some more investigating and I found this letter from the Office of Thrift Supervision, which led me to believe this is a little riskier than I first thought. I've had my fair share of run-ins with the OTS when I used to work for a bank, so I know one of the things they do is keep tabs on the kinds of assets banks hold.

I'm not going to make this much clearer, but basically NEW sold off some kind of loans or something to a trust which packaged and sold them to investors in some manner, and interest gets paid back through the trust to NEW. However, this line in the OTS letter is what gave me pause "any of the accrued fees and finance charges that the institution collects generally must be transferred to the trust and will be used first by the trustee for the benefit of third-party investors. Only after trust expenses (such as servicing fees, investor-certificate interest, and investor-principal chargeoffs) have been paid will the trustee distribute any excess fee and finance-charge cash flow back to the seller, at which point the seller may or may not realize the full amount of its AIR asset."

So basically the letter is saying NEW might want to pull money out of this thing, but there are a few people in line who will want to get paid first, and NEW might not get the full value of that asset. Further on down the letter, it says that "The seller's right [ie: NEW's right] to the excess cash flows related to the AIR assets is similar to other residual interests in securitized assets in that it serves as a credit enhancement to protect third-party investors in the securitization from credit losses." Well I'll be danged. The AIR is used to protect third party investors from credit losses. And since New Century peddles sub-prime mortgages, it is likely that there will be some credit losses that the investors will need protection from. I hereby discount this asset by another 20%. This puts accrued interest receivable at 87.68%.

Next on the list is the Income Taxes, net. I did some of my best sleeping in accounting classes where professors tried to show me how to calculate these things. I vowed I would never learn how to calculate an income tax asset, but I understand the general point of them. They basically make up for the difference between taxable income that is reported to the government, and taxable income that is reported according to GAAP on the company's financial statements. If it's an asset, it will provide a future benefit to the company in that it will reduce taxes in future periods.

NEW won't have too many future periods if it enters the liquidation process. Big discount here....let's go with 60%. Drops this down to $32.2 million from $80.5 million.

Office property and equipment is easy... 87 million sells for 60% of that (based on the fact that im sitting on a former office chair that I bought for $10 from this place full of liquidated office furniture) so it's $52.2 million.

Now... Goodwill! The company's mojo! If NEW was Derek Jeter, Goodwill would be his ability to deliver a big hit in a tight spot. That's right, it's an intangible. Yet, in accounting, they have found a way to put a dollar value on intangibles. Technically, goodwill is the excess amount NEW paid when it bought another company for more than its book value. Let's assume the current New Century can sell its name, its web address and the right to use its trademarks for something. I'm a pessimist so I'm going to say that value is $20 million, a nice round number and roughly 80% of the book value of its goodwill.

Prepaid expenses are hard, but not impossible to recoup. Lets say NEW paid $500 at the beginning of the year to insure the company Yugo from Jan - June. It liquidates in May and is entitled to get back a refund for the month in which it did not need the insurance coverage (June). Same thing goes for other things like medical insurance, lighting, and whatever else the company might have paid up in advance. I'll call this another 80% discount because Im getting really bored, but I promise there's a point to all of this. $360/2 = $180 million.

So add up all of the numbers in bold, and you come up with $23.1496 billion dollars, which is what we think we could get for NEW's assets, based on the analysis above.

For those of you who think better in pictures, this works out to a pile of one dollar bills, each one .0043 inches thick, reaching about 1,600 miles into the sky.

Total liabilites are about $22.995 billion so when the liability holders get through with that stack of bills, there will be only about 155 million of them left for common stockholders.

The front cover of the 10-Q shows NEW as about 55.5 million outstanding shares. So these starving shareholders will divide the $155 million equally amongst themselves, leaving about $2.79 per share.

Compare this with NEW's $4.56 closing price and you can make a few conclusions:

1) I did this wrong because I know little about mortgage finance. I will grant you that.
2) The market thinks NEW will get more for its assets than we calculated above. I will grant thats a possibility. There are people out there who can compute almost exactly how much these haircuts will be. They have experience doing it, and they know the markets for the assets.
3) Some people think that NEW will be able to avoid bankruptcy somehow, so they bid the price up above liquidation value. This is again, a possibility.

Anyway, all I wanted to illustrate was a back of the envelope calculation but I got a bit too into it and this would have to be one HUGE envelope to fit this blog entry on. Hope you found this useful. This is exactly the analysis many professional investors went through today as they made decisions to buy and sell NEW.

Me, I'm just glad I don't own the thing, and this doomsday scenario makes me glad that I favor investing in companies without much debt, because things get ugly if a highly-leveraged business stumbles.

By the way it's too late to check all of my math above. It seems right to me but if you see any mistakes don't hesitate to point them out. It's all simple calculations...

4 comments:

Anonymous said...

Great blog. Its nice to read someone who is knowledgeable and shares it.

MoneyMan said...

Thanks for the feedback! Always happy to hear that. This wasn't a precise analysis, but I think it shows the steps for someone who might want to go through it more thoroughly.

TFB said...

NEW closed at $3.21 today. It's getting closer to your back of envelope calculation. Amazing.

MoneyMan said...

Yes I noticed it was closer to my calculation when it closed on Friday. If it ends up hitting that target I would be more likely to call my estimate a lucky, but educated, guess.

The reason why it went down to $3.21 seemed to be more market sentiment that the company will not be able to avoid bankruptcy.

There's a whole lot of volatility around NEW lately and I'm sure we will see another few 20-30% moves before things calm down.