Submitted by Rolfe Winkler of OptionARMageddon
Reader Note: Last fall, I published a detailed (recent) history of BankUnited in the pages of Housing Wire Magazine. With the bank’s future likely to be settled over the next week, I thought NC readers might appreciate a look at the piece. Thanks to HW’s Paul Jackson for allowing me to re-publish.
No Option on Financial Pain
Florida’s BankUnited Faces Tough Choices in an Even Tougher Mortgage Market
September was a bad month for BankUnited Financial, Florida’s largest regional bank (Nasdaq: BKUNA). The company’s regulatory capital status was downgraded, it fired 12 percent of its employees, and it received a cease and desist order from the Office of Thrift Supervision. BKUNA has thus far failed to raise capital to protect its balance sheet and, with its stock at 55 cents as of this writing, appears likely to join the ranks of imploded lenders.
Marked by poor quality of earnings, nepotism, self-dealing and managerial incompetence, BKUNA’s story makes a fascinating case study—one that’s highly relevant for analysts studying the financial statements of America’s big banks.
BKUNA’s lending business is concentrated in Florida, California and Arizona, states that have been hammered by the housing bust. And 60 percent of the company’s $12 billion loan portfolio is made up of pay option adjustable rate mortgages, a particularly toxic loan that put thousands into houses they couldn’t afford.
Option ARMs are like credit cards: Borrowers have the option to make a minimum payment each month, with any unpaid principal and interest added to the balance of the loan. When the borrower pays less than the interest and principal due, the loan is said to be “negatively amortizing.”
And few of BKUNA’s borrowers regularly make full payments—only 9 percent as of June 30. Eighty percent of the rest were paying the minimum.
But according to GAAP, any interest owed is earned, including any portion the borrower chooses to defer. The lender recognizes the full amount as revenue with any unpaid balance added to receivables.
During the three fiscal years ending Sept. 2007, BKUNA recognized $360 million of pretax income. Over that same period non-cash interest income was $270 million.
In a perpetually rising housing market, the lender isn’t concerned about the collectability of this revenue. Eventually the borrower will refinance his loan, paying off all outstanding principal and interest. But if house prices fall 40 percent, the borrower goes upside down, complicating collections.
BKUNA executives defend their lending practices saying they didn’t engage in “subprime lending” and that borrower FICO scores averaged over 700. But as analyst Zach Gast of RiskMetrics Group notes, “borrowers with less equity in their homes have a higher probability of default regardless of credit score.”
And this makes perfect sense. A borrower with zero equity making a minimum payment is effectively a renter with an option to buy. If the house price goes up, the borrower can refinance the original loan and capture any incremental equity. But if the price goes down, it makes more sense to mail your keys to the lender, letting the option expire worthless. The lender is left with a defaulted loan to write down and a pile of non-cash interest income to charge off.
Even if house prices stay flat, an option ARM borrower making minimum payments will have another incentive to walk away: When the loan balance grows too large, the payment schedule automatically recasts, forcing the borrower to make a (usually much higher) fully-amortizing monthly payment. Call it the option ARM emergency override. Theoretically it protects the lender by capping the growth of the loan’s balance; in reality, it’s the moment when the loan goes toxic. The borrower suffers severe payment shock and has extra incentive to default.
Fit for a Minsky
Stepping back for a moment, it’s worth pondering how negatively amortizing loans inflated the last stages of the housing bubble. For this we turn to the late economist Hyman Minksy and his financial instability hypothesis. In a nutshell, Minsky theorized that stability destabilizes because it encourages imprudent risk-taking. Stability becomes instability in three stages, with three corresponding types of debt—so-called hedge units, speculative units and Ponzi units. The debt products perpetuating the housing bubble fit this mold perfectly.
A “hedged” debt unit is one where the borrower’s income is sufficient to pay interest and principal in full each month. He should be able to pay off his mortgage on schedule, regardless of price fluctuations.
A “speculative” debt unit is one where the borrower’s income is sufficient to pay interest but not principal. The borrower is speculating that the value of the collateral will not decline, and that sale proceeds will be sufficient to pay off the principal. If prices climb, the borrower ‘s bet pays off.
A “Ponzi” debt unit is one where the borrower’s income is insufficient to pay down either interest or principal. The borrower is speculating that the house price will go up, and that sale proceeds will be sufficient to pay off principal and unpaid interest.
Over the last 10 years, mortgage finance progressed from hedge units (fixed rate, 20 percent down mortgages) to speculative units (interest-only, 10 percent down), to Ponzi units (negative amortization, zero down). Towards the end of the bubble, prices got “too high” because marginal buyers had no hope of paying off their mortgage without further price appreciation. Eventually there are no greater fools looking to buy and the Ponzi scheme implodes. Option ARM lenders bankrolled this, the last stage of the housing bubble, by pumping Ponzi-finance into the market.
And BKUNA was the “option ARM specialist extending loans beyond all others,” according to RiskMetrics’ Gast. He says other lenders specializing in option ARMs—Downey Savings and Loan, FirstFed Financial, Countrywide, WaMu and Wachovia’s Golden West Financial—slowed such lending by Fall 2006. BKUNA kept at it for another year.
And while all competing in the space played fast and loose with accounting rules, BKUNA was particularly aggressive. At the end of the June quarter, BKUNA’s loan loss reserves were a puny 2.5 percent of loans held. That compares to Downey’s six percent, and FirstFed’s four percent.
Lastly, because BKUNA’s option ARMs were largely originated through outside brokers, accounting rules allow them to defer and capitalize origination fees. As BKUNA writes down its exposure to option ARM loans, it must also expense any corresponding origination costs in one shot. This may prove a fatal hit to shareholder’s equity—35 percent of which is accounted for by deferred costs.
A question of when, not if
Much of the Florida and California property market is in full-fledged depression, and BKUNA’s financial picture is just as ugly. Consider their June 10-Q filing with the SEC:
- Non-performing loans as a percentage of total loans were eight percent, up from one percent at the start of 2007.
- Shareholder’s equity of $575 million was off 30 percent since its high last September.
- The stock, which traded as high as $28 last year, is now under a dollar.
And the situation will only grow worse. Gast says peak defaults for BKUNA’s Option ARM loan book won’t arrive until 2010.
BKUNA has managed to stay afloat with brokered deposits and Federal Home Loan Bank loans. But even these sources of capital have now been cut off. The FHLB cut BKUNA’s credit line in July and OTS eliminated its access to brokered deposits in September, downgrading the bank to “adequately-capitalized.”
Now BKUNA is racing to raise $400 million. At the current market price, they’d have to sell 700 million new shares. Only 35 million are outstanding today. Is it any wonder the stock is below $1? If the bank succeeds in raising capital, existing shareholders will be diluted to zero. If it doesn’t, the bank will likely get seized.
Until late October, BKUNA’s executive ranks had been remarkably stable, thanks to a dual-class share structure that left CEO Alfred Camner with voting control. As recently as August, Camner continued to defend his bank’s lending practices, telling the New York Times that option ARMs “for a very long time [were] an excellent performing package.” For qualified borrowers, “it was an excellent loan.”
By “very long time” does he mean the four years his bank was writing these loans?
As for borrowers’ qualifications, how would he know? According to BKUNA’s investor presentation, the company verified employment, income and assets for less than 20 percent of its residential borrowers. Incidentally, the Times also quoted him dismissing concerns about the bank’s lending practices as “completely absurd” and “idiotic.”
Back in June, Camner offered to relinquish his Class B shares if a white knight should sally forth with the $400 million. But no investors stepped up. On Oct. 20, he resigned.
He’ll receive a year’s pay, health insurance, $12,000 towards the lease on his car, $50,000 towards an office and an assistant, and up to $25,000 to reimburse legal expenses. Additionally, the company will buy back 340,000 of his Class B shares at “market value.” All of the above add up to a meaningful sum for a company desperately in need of cash, even if Camner only gets $0.55 per share for his stock.
Luckily for Camner, he has another gig to fall back on. Besides being CEO of BKUNA, he’s also senior managing director of law firm Camner, Lipsitz and Poller, which has billed BKUNA $12 million in legal fees over the last three years. (For this nugget, see “related party transactions” in the 10-K. There, you’ll also find that Camner’s daughter Errin is CLP’s managing director.)
Another of Camner’s daughters, Lauren, was a BKUNA senior vice president and board member. At 33 years old, she was the youngest director on a board the average age of which is 61. She resigned the same day as her father. A third daughter, Danielle, was BKUNA’s vice president for government affairs from 2001-2004, according to a resume published on social network website LinkedIn.
Replacing Camner as CEO is Ramiro Ortiz. As president and COO of BKUNA since 2002, Ortiz played a key role building up the bank’s option ARM loan book.
Not too big to fail
Eighteen months ago, it was thought BKUNA’s retail franchise and deposit base would help it survive the housing bust. If the situation deteriorated, an acquirer with designs on Florida would buy them out. But back then, Gast says analysts were assuming loan loss rates of 4-5 percent. Today it’s clear loss rates will be substantially higher. It’s hardly surprising that acquirer banks are waiting for targets to be seized and for the FDIC to absorb losses before they move in.
One exception is Wells Fargo, which plans to acquire Wachovia’s toxic loan book with no guarantees from the government. Before Wachovia acquired them in 2006, Golden West Financial was one of the largest purveyors of option ARMs nationwide, having pioneered the loan product 20 years ago. Wachovia’s legacy option ARM loan book from Golden West was $122 billion prior to the merger announcement, making it the largest option ARM lender by dollar volume. Concentrated in California, those loans may have to be written down 50 percent over time, according to industry analyst Mark “Mr. Mortgage” Hanson.
Perversely, Golden West’s more liberal lending policies are helping it delay write-downs. Banks like BKUNA, Downey and FirstFed typically force option ARM borrowers to make a full mortgage payment after 5 years or when the loan balance reaches 115 percent of its original value, whichever comes first. When borrowers face this payment shock, they default in large numbers.
But Golden West’s option ARMs allow the loan balance to grow for 10 years or to 125 percent of original value. Borrowers can continue making minimum payments longer so loans don’t “default” for years. Though this ultimately puts Wachovia on the hook for steeper losses, it also delays the day of reckoning.
Why would Wells Fargo take on Wachovia’s loan book with no government guarantee? According to Hanson, it’s an “all or nothing bet to make themselves too big to fail, to grab deposits, and to take advantage of both new tax laws and the potential generosity of the government with taxpayers dollars.”
Taxpayers have already been generous to Wells, to the tune of a $25 billion equity injection. The TARP will likely throw billions more their way to deal with Wachovia’s toxic paper and Wells’ own $180 billion book of HELOCs, prime jumbos and subprime. Throw in the tax benefits from the write downs on Wachovia’s assets and Wells might just come out ahead.
However the deal comes off, with $1.4 trillion of combined assets, Wells-Wachovia won’t be allowed to fail. With only $14 billion of assets, however, the same probably can’t be said for BankUnited.