The Position Makers

first off, thanks to calculated risk for bringing the letter to my attention.my initial reaction is that it’s fine for the CEO to be writing this letter and it’s at an important time the company history. many of the criticisms on calculated risk are defensible, particularly when they call into question the “awareness” of CDO risk (i’ll include a few quotes below). i also have to say it’s really ashame that at the same time mr. perry is claiming to accept blame, he’s dismissing and transferring that blame on to others. is this a big, red flag; should we assume that it’s natural human behavior, especially when you’re at top of the pyramid?

The housing bubble, caused primarily by the low interest rates for ARM mortgages fostered by the Fed’s accommodative monetary policy and even lower rates for fixed/long-term mortgages due largely to tremendous global liquidity, combined with strong demand by institutional investors for assets with higher yields, resulted in a “systemic” underestimation of credit risk..

Lenders didn’t see that things were going too far, partly because we were too close to it, but mostly because objective evidence of this credit risk did not show up in our delinquencies and financial performance until it was too late to prevent significant losses. And there were many events along the way that confirmed for those of us who believed that innovative home lending was possibly a paradigm shift (similar to widespread ownership of stocks by consumers) and definitely a legitimate marketplace: major financial institutions were offering these products and spending billions to purchase companies who specialized in these products…

simple question, mr. perry, didn’t your parents ever ask you, “if all your friends are jumping off a bridge, would you follow”? [that’s actually a pretty funny question because most of the time, we are expected to be conformists; otherwise, we couldn’t even have a society to begin with.]

It is also important to understand that the rapid rise in housing prices is one of the key culprits in this current housing and mortgage crisis. In modern times, housing prices have declined in certain regions of the country but never on a nationwide basis. As a result of this fact and the important social and economic benefits that are clearly derived from homeownership, the government (first through FHA/VA programs and then through the GSEs) encouraged a USA mortgage market built upon very high leverage, with LTV ratios nearing 100% for first-time homebuyer programs. However, as home prices decline, either regionally or nationally, the leverage in a home loan, combined with the leverage of a financial institution or securitization structure, can result in significant losses for financial institutions, investors and consumers. Add to this mix a housing market that has not had a single regional market decline in over 15 years and, in fact, had a huge boom in prices from 2003 to 2006, and you can begin to understand how home lending was impacted. Automated risk-based models, on which the entire market relied, replaced portions of traditional underwriting and credit evaluation, and only in retrospect is it now clear that these models did not perform…

i’m not sure if he’s saying that computers replaced all humans in the risk-assessment department or not; i suspect it’s another attempt to redirect the attention to the banking and finance industry in general and even justifying the mistakes as naivety in trusting computers to handle the work. “garbage in, garbage out,” mr. perry.

it’s not all bad news:

In other words, $970 million pre-tax (or $591 million after-tax) of Indymac’s credit provisions/costs in 2007 are related to losses that were not realized in 2007, but which we project to realize in 2008, 2009 and beyond. Based on the establishment of these unprecedented credit reserves and, to a lesser extent, on the collapse of our non-GSE mortgage banking business, Indymac lost $609 million for the year, the first annual loss in our 23-year history.

that certainly is good news. there was quite a bit more as concerns the economy. i’ve been curious for some time about the expectations of a protracted recession. mr. buffett put his money where his mouth is by offering to support the muni-bond industry. as maiden with the sydney hearld says, it’s a good deal for buffett.

mr. perry goes on to say:

With the above said, in a recent New York Times Magazine article, Federal Reserve Chairman Ben Bernanke discussed the Fed’s role in fostering the mortgage crisis. He was of the viewpoint that the mortgage fiasco “had many fathers” and also expressed his dislike for perfect-hindsight-type judgments. I feel the same way. It is time to move on and discuss Indymac’s plan for successfully maneuvering through the rest of this crisis period and rebuilding shareholder value.

i have to agree with this. there simply was too much general excitement to pinpoint the culprits of subprime meltdown. if it’s the bankers’ fault, or the fed’s or bush’s, it’s certainly joe and sally down the street and every other person that bought at least one property with the expectation of it rapidly increasing in value that ultimately drove our nation to this point.

consider for a moment that home ownership rates are currently around 68.6% plummeting from about 69.3% after all the foreclosures going on nationwide (2.1 million homes!!), whereas the 2000 census has it hat 66% which would mean that much of the hysteria about owning homes has either a) been erased or b) was only represented margin growth but underpinned by a bunch of house swapping. meaning, it was mostly current home owners selling their homes to buy other homes. speculating and gambling are a slippery slope, and lately it’s hard for me to tell the difference.

i guess i can only hope i’m not being “greedy or stupid.”

the best for last, right?

But our overriding goal for 2008 is pretty simple: keep Indymac Bank safe and sound with strong capital and liquidity levels, stem the losses and return to profitability, and preserve as much of our $16, or so, of book value per share as we can. If we can do that, our stock should move from its current levels back up towards book value per share.

ding, ding, ding! did mr. perry just say that his company is undervalued by 50% on a per-share basis? let’s rewind a bit and look at some earlier statements too:

The only good news is that, even with this significant loss, we remain in a fundamentally sound financial position as a result of raising $676 million in equity capital in 2007: $500 million of bank perpetual preferred stock with an 8.5% coupon in the 2nd quarter, $146 million of common equity (at an average price of $20 per share in the 3rd and 4th quarters) and $30 million of holding company trust preferred securities. Our capital levels continue to exceed the levels defined as “well capitalized” by our regulators. At year end, Indymac’s core capital ratio was 6.24%, and our total risk-based capital ratio was 10.50%, down from 7.39% and 11.72% at December 31, 2006. In addition to maintaining strong capital, Indymac now has $2.4 billion in credit reserves, or four times the $619 million it had at December 31, 2006, which puts us in a strong position to return to profitability sooner than later. Indeed, based on our new business model (which I discuss more thoroughly below), we are forecasting a small profit in 2008, even including the Q1-08 staff reduction and office closing costs, and we believe we can maintain our “well-capitalized” capital ratios even under worsening industry conditions…

the market cap is $666 million–same as what they raised in last 12 months, amounting to almost none of the assets–and if the dividend remains in tact, pays 12% dividend. that’s nothing to cough at. it’s definitely worth looking deeper into the actual sec filing. this may indeed pan out to be an opportunity for the “little guy.” buffett’s complained quite a bit about the difficulties of investing when your net value is in the billions, greater than many market caps of entire companies. (lol) but, taking the prudent approach to looking for undervalued companies with a strong core business (and a future!) is the best, intelligent way to make “frothy” returns on an investment.

i’ll keep everyone posted on this. it’s extremely juicy.