I have been bearish on FirstFed Financial (FED) for sometime and despite the stock’s recent run up and what would appear at first glance to be a slight improvement in the company’s underlying fundamentals, I believe that the short case for the company bears reiteration. FirstFed, like all California mortgages lenders, has been absolutely devastated by the terrible events out in California. The company specializes in ARM mortgages and has only recently been making an effort to move into the traditional mortgage market in scale. While this has definitely been a good decision on the part of management, I am not sure that it will be enough to prevent the company from being forced to do a massively dilutive share offering in the near future. Such a transaction would be in the best interests of the depositors of the bank and I cannot imagine why management has not already tried to sell shares of the company into the recent strength shown by the company’s stock.
The management of FirstFed, in stark comparison to that of other banks, has been brutally honest with its shareholders and the investment community. In a commendable act of baring it all to the investment community, management releases monthly updates on the health of their company. In the most recent report, the bank at the end of July showed that it had $123.3M in loans 30-59 days delinquent as opposed to $126.2M in loans delinquent at the end of June. This brief bit of news, coupled with a decline in loans that were regarded as non-accrual from $491.6M in June to $437.1M at the end of July sent the stock soaring, as investors believed it would be capable of surviving the current turmoil in not only California but also in the financial and credit markets as a whole. Nevertheless, the company’s July report leaves out critical data points that are needed to analyze the company properly. Some of the more important number’s left out was the level of the bank's capital base, the amount of charge offs taken during the month, the number of impaired loans and the amount of real estate held on the banks book’s as a result of foreclosure proceedings. In addition, I believe that a more detailed discussion of the bank’s deposit base would be warranted given the dramatic change in its composition. Some of these concerns and the metrics that support them can be found in the company’s quarterly report, which came out slightly before the July update.
For me the two most glaring numbers that showed up in the company’s second quarter report were the number of loans that had become impaired and the surge in the bank’s real estate owned portfolio. At the close of the second quarter the bank had $332M in impaired loans and $96M in it’s real estate owned portfolio. In comparison, in the first quarter the bank had $131M in impaired loans and $45M in it’s real estate owned portfolio. To me this is emblematic of the sharp deterioration that is occurring in the bank’s loan portfolio and I would imagine that the dollar value of loans that are delinquent should begin to rise again going forward.
In addition, the company also provided information in its most recent quarterly report related to the losses that it has realized in its ARM loans that have reset over the last six months. According to the company, the bank had $648.6M of loans reset of which $308.7M were modified by the bank. It appears that during the modification process the bank took a loss of $26.3M or about 4% on the total value of the loans that reset during the first half of the year. If this trend were to hold steady the bank should expect losses of $10-12M because of the modification process in the second half of 2008 and $25-30M during 2009. This will have a significant impact on the company’s equity base. The holding company currently has a book value of $550.8M so an additional $35M in losses would add further strain on the company, especially given its current loan portfolio.
Two additional questions that I had relating to the July report were the amount of charge offs that that the company will be taking going forward on its loan portfolio and what exactly happened to it's deposit base. A good portion of its non accrual loans will likely need to be charged off going forward as banks typically begin to aggressively charge off loans 120-180 days after they go non-accrual. By my best guess, I would say that a good-sized portion of the bank’s non-accrual loans would be eligible sometime in the third quarter. Typically, bank regulators do not like to see banks with an overly large non-accrual loan portfolio so I would not be surprised to see charge offs growing significantly going forward. The second concern that I had with the bank’s July update was their deposit base. According to the company, the number of wholesale or brokered deposits jumped to $1.247B in July from $691M in June, while retail deposits declined from $3.169B to $2.912B in the same period. As a result of this action, the bank likely has a high level of uninsured deposits. This has been a trend at the bank and I am disappointed to see it continue. As a reference, at the end of June the bank had over $800M in uninsured deposits, I would not be surprised to see this figure grow in the next quarterly report. Such an unsteady deposit base will likely make the bank prone to liquidity issues going forward should its wholesale depositors ever get nervous.
In a previous article, I talked a little bit about the “Texas Ratio,” which was developed by Gerard Cassidy and the “California Ratio” which I came up with a while back in an effort to try to have an even earlier warning system for distressed banks. A description of the Texas Ratio and what goes into calculating it can be found here. My article on the need for a “California Ratio” can be found here.
Cassidy defines the “Texas Ratio” as the following:
“The ratio is calculated by dividing a bank's non-performing loans, including those 90 days delinquent, by the company's tangible equity capital plus money set aside for future loan losses.”
At of the end of the second quarter FirstFed Financial by my calculations (which you might want to double check) had a “Texas Ratio” of 60.7%.
I have defined a “California Ratio” (and its still a very rough metric) as the following:
“Calculate the California Ratio by dividing the bank’s non-performing loans (including those less than 90 days delinquent) by the company’s tangible equity capital and the money set aside for future loan losses. The tangible equity capital should be marked down to account for a reduction in value for the bank’s real estate owned portfolio and its impaired loans. The bank’s real estate owned portfolio should be marked down to 50% of its stated value while the bank’s impaired loans should be carried at 80% of their stated value.”
At the end of the second quarter FirstFed Financial had a “California Ratio” of 101%.
While FirstFed has not quite yet hit the “danger zone” set by IndyMac’s failure, where the firm failed shortly after it's “Texas Ratio” hit 150%, the company is nevertheless in a precarious position going forward. I would expect that the firm’s charge offs will begin to take a toll on FirstFed’s capital base over the next several quarters causing its capital ratios along with it’s Texas and California Ratio’s to deteriorate. In addition, the firm’s large level of wholesale deposits could also cause the bank to take rapid loses should these depositors begin to flee the bank with their uninsured deposits and force the bank to sell parts of its loan portfolio at a significant discount to face value. The bank is simply in the wrong market at the wrong time. The stock is clearly one that should be avoided and for those adventurous souls I would advise shorting the stock at these levels.
For Further Review:
The Company's Most Recent Quarterly Report
Disclosure: None
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