More Doom and Gloom: Homebuilders Making Better Money as Hedge Funds than Home Builders

Could you imagine if a hedge fund or private equity firm started
building houses of a living, and more than a quarter of their income
(growing at a very rapid clip) came from such activities as their hedge
fund business produced losses for nearly 5 years in a row? In addition,
imagine it looked as if the hedge fund business would be dead in the
water for the foreesable future. What would you call this entity, a
dying hedge fund or a burgeoning home builder? Well, if you reversed the
situation, you get to answer that quiz yourself, because the most
profitable division of one of this country’s largest home builder’s is
none other than a highly leveraged private equity/hedge fund! Of course,
this only makes sense when you have to build homes in an environment
with headlines such as Sales of U.S. New Homes Held at Second-Lowest Level on Record Last Month, of worse yet bloggers get in the MSM and start throwing those damn FACTS around on international TV: Yes, Housing Prices Have Much Farther to Fall. We’re Talking Years…

We looked into Lennar to see the impact of the distressed investments group (which is the companies’ Rialto segment) on its operations. Key observations regarding the same are summarized below:

• Rialto segment which the company started reporting (from 1Q10) is
  described by the company as, “Our Rialto segment provides advisory
  services, due diligence, workout strategies, ongoing asset management
  services and acquires and monetizes distressed loans and securities
  portfolios. In its 3QFY10 transcript with regard to segment’s
  description the management said, “Simply put, we purchase large and
  small portfolios of loans and REO at distressed prices and then we work through those assets one at a time to resolve them at retail payoff. It’s
  all about making money by managing the process of purchasing wholesale
  and selling retail – purchasing in bulk and selling one at a time. Admittedly, the assets are a little bit more complex, but this is where we excel.”
• For 3QFY10 the segment reported total revenues and operating
  earnings of $38.0 million and $18.5 (includes $10.8 million of net
  earnings attributable to non-controlling interests), representing 4.6%
  and 29.1% of the company’s total revenues (of $825.0 million) and
  operating earnings before corporate, general and administrative expenses
  (of $63.4 million), respectively. For nine months ended August 2010
  the Rialto segment accounted for $72.9 million of revenues and $32.3
  million of operating earnings (including $20.4 million of net earnings
  attributable to non-controlling interests), which represent 3.3% and
  25.8% of the company’s total revenues (of $1,944.3 million) and
  operating earnings before corporate, general and administrative expenses
  (of $124.8 million), respectively.
• The $7.7 million of 3QFY10 operating earnings (after non-controlling
  interest of $10.5 million) for the Rialto segment are derived from the
  company’s 40% share in the profits from the FDIC loan portfolio
  transactions, and its Public-Private Investment Fund activities (PPIP)
  with AllianceBernstein and the U.S. Department of Treasury; and the
  management fees from both of these programs.

o   The break of 7.7 million as provided by the company is: $8.9
million from the 40% share of FDIC portfolios, plus $7.1 million
earnings from PPIP, offset by $8.3 million of G&A and other
expenses.

• Though, the company does not provide detail for the distressed
  portfolios they hold under various transaction in the Rialto Segment, it
  is expected that the company will continue to report healthy profits
  from the segment in the coming quarters.

o   As of 3QFY10, under its FDIC loan transaction the company had
resolved over 200 assets (of the total 5,500 loans purchased in February
2010) and bought in over $120 million of cash. Additionally, as per
the company over half of these resolved assets had been at levels at or
higher than the full outstanding principal amount due on the loans
because the company has been able to collect past due accrued interest
and late fees, in turn realizing an average resolution price of $0.90 on
the dollar. Moreover, the company has already contacted with borrowers
representing almost 90% of the combined outstanding loan balances to
work out a monetization process.

o   The PPIP fund has invested $4 billion to buy $6 billion in face
of residential and commercial mortgage-backed securities that were
originally issued with AAA ratings or the equivalent, with a focus on
acquiring securities with resilient cash flows with the goal of
collecting a mid- to high-teens return by holding these assets until
maturity. Through July 31, 2010 based on a mark-to-market of the
underlying collateral and principal and interest collected to-date, the
fund has operated at a gross 27% annualized internal rate of return.

o   The company is working toward building a team of professionals
for the Rialto segment. As of August 31, 2010, the segment had
approximately 90 associates focused on portfolio operations, including
loan workout, property asset management, servicing finance and
back-office operations in three main offices in Miami, Atlanta and New
York, as well as a few satellite offices

• Analysts are also viewing this as a profitable move for the company.

o   Credit Suisse analyst Dan Oppenheim expects the Rialto segment to
add $22.5 million to operating profits this fiscal year with even more
in fiscal 2011. In a recent client note he stated , “This should help to offset the challenging home-sales environment“.

o   According to Raymond James analyst Buck Horne, “The company’s
distressed land acquisition subsidiary, Rialto, contributed $8 million
(U.S.) to the quarter’s profits and will continue to do so in future
quarters”.

Here are some more tidbits…

In February 2010, the Rialto segment acquired indirectly 40% managing
member equity interests in two limited liability companies (“LLCs”), in
partnership with the Federal Deposit Insurance Corporation (“FDIC”),
for approximately $243 million (net of transaction costs and a $22
million working capital reserve).

The LLCs hold performing and non−performing loans formerly owned by
22 failed financial institutions. The two portfolios consist of more
than 5,500 distressed residential and commercial real estate loans with
an aggregate unpaid principal balance of approximately $3 billion and
had an initial fair value of approximately $1.2 billion. The
FDIC retained a 60% equity interest in the LLCs and provided $626.9
million of notes with 0% interest, which are non−recourse to the
Company. (In accordance with GAAP, interest has not been
imputed because the notes are with, and guaranteed by, a governmental
agency. The notes are secured by the loans held by the LLCs.)
Additionally, if the LLCs exceed expectations and meet certain internal
rate of return and distribution thresholds, the Company’s equity
interest in the LLCs could be reduced from 40% down to 30%, with a
corresponding increase to the FDIC’s equity interest from 60% up to 70%.

I actually went to the meeting that debuted this plan in which
Bernanke spoke to the financial professional  constituency of the
Congressional Black Caucus. It appears as if we were not intended to get
a piece of this sweet tasting pie. I also warned about the dangers of
collusion in the program both at the meeting and on the blog (which is
probably why I wasn’t invited to join the program and get my taste of
the zero percent, non-recourse leverage pie! See Reggie Middleton’s Overview of the Public-Private Investment Program and I’m headed back to DC, with blogger’s opinions in hand!
In the latter piece, I even went so far as to illustrate, step-by-step,
the risks of price distortion and collusion in this program. Again,
there is no wonder why I wasn’t called back to participate! Mayhap I
should stop trying to play honest Johnny and just get in their and make
me some real money with the big boys… Alas, I digress. Back to the
matter at hand, as excerpted from the rather prescient PPIP piece that I
penned well over a year ago (I’m headed back to DC, with blogger’s opinions in hand!, interested parties really should take the time to read it):

The distortion of natural market pricing and its inevitable results

The second issue, which is truly a most significant issue, is that
the nature of the non-recourse loans offered by the government acts as
an implicit put option (a sort of derivative insurance policy, similar
to CDS) for the investors who purchase the products (and by default,
potentially the banks/insurers, etc. as sellers). The significance of
this is that it can, and most likely will, distort the risk taking
behavior of the buyers of these assets (the investors). It is apparent
that the government is counting on this distortion to a certain extent
(hence the reason for the inclusion of non-recourse loans) to achieve
the maximum pricing of the loans and the legacy assets. This distortion,
unfortunately, fails to lead to true “price discovery” in the market,
for the entire market cannot borrow at the Treasury’s cost of funds,
and at up to an implicit 14x leverage that the chosen participants of
the PPIP plan can. Most importantly, the entire market will not be able
to borrow with the implicit put option that is a non-recourse loan.
Most of us will have to act with considerably more prudence when
levering up, if able to lever up in this environment, simply because we
will be on the hook not only for our equity investment, but for the
monies borrowed as well.

…

The potential and incentive for TALF participant collusion and the
“gaming of the system” is high, and incentivized by the implicit put
options that are the high leverage and the non-recourse nature of the
loans

The plan specifically provides for the exclusion of SIVs (off
balance sheet Structured Investment Vehicles of banks) from investing
in the bank’s legacy assets through PPIP by excluding affiliates of banks participating in distressed assets. So technically a bank cannot set up an SIV with a more than 10% stake and overbid for those assets.

However there is no such mechanism as such to prevent private
investors to engage in collusion and overbid for securities, risking
tax payers’ money since both the parties stand to gain in such an event
(out of this three party affair). The participants of such collusions
can stand to gain simply by mutually overbidding (as in two banks
bidding against each other) to boost the asset values of what they are
bidding on, or a bank can sell a under-priced swap (ex. customized CDS)
to a private bidder (say a hedge fund or private pool of capital) to
indemnify that investor against the losses of its 3 to 6% equity
investment of the entire levered purchase. This benefits the bank by
allowing it to sell assets at higher than prudent levels, and can
benefit the buyer by allowing it profit from the gain of the CDS above
and beyond the relatively miniscule equity investment that was made.
Since the loans are non-recourse, the equity investment partner need
not worry about losses taking on the entire purchase, and just needs to
be made whole on their relatively very small equity slice. The
leverage inherent in an underpriced CDS would serve that purpose and
allow the equity partner to actually profit handsomely as the US tax
payer takes a bath, in very cold water to boot! In order for such to be
the case, the bank and the investor would have to collude, for the
pricing and structure of the CDS (or other contingent insurance/false
hedge) mechanisms is paramount. It would not be possible to get such a
deal through an exchange traded product, thus it will have to
negotiated over the counter.

Below, you can find an example of the effects of two banks colluding
to increase asset prices, and the effects it would have on the
taxpayer:

Seller Bank A					Seller Bank B
Face value		100.0			Face value		100.0
Price determined by auction		80.0			Price determined by auction		90.0
Current fair value in books, cents to dollar %		60.0%			Current fair value in books, cents to dollar %		80.0%
Debt-Equity ratio		6.0			Debt-Equity ratio		6.0
Debt FDIC Guaranty		68.6			Debt FDIC Guaranty		77.1
Equity by private investor, Bank B		5.7			Equity by private investor, Bank A		6.4
Equity by treasury		5.7			Equity by treasury		6.4
Interest on FDIC Debt		4.0%			Interest on FDIC Debt		4.0%
Fair value, cents to dollar %, actual at EOP		25.0%			Fair value, cents to dollar %, actual at EOP		30.0%
As seller of Legacy Assets to PPIP
	Bank A						Bank B
Gain on sale to PPIP	20.0						10.0
Bank B (assuming it has purchased Legacy asset of Bank A
		Value at EOP	Gian (loss)		Interest on FDIC debt	Gain to equity investor	Gain / loss to Private investor*	% return	Gain / loss to Tax Payer
75% discount on FV		$25.0	($55.0)		$2.7	($57.7)	($5.7)	(100.0)%	($52.3)
Bank A (assuming it has purchased Legacy asset of Bank B
		Value at EOP	Gian (loss)		Interest on FDIC debt	Gain to equity investor	Gain / loss to Private investor*	% return	Gain / loss to Tax Payer
70% discount on FV		$30.0	($60.0)		$3.1	($63.1)	($6.4)	(100.0)%	($56.9)
Net Gain (Loss) Bank
	Bank A	Bank B	Taxpayer
As seller of Legacy Asset	$20.0	$10.0			<–As long as bid value is greater than economic value banks stand to gain as seller
As Investor	($6.4)	($5.7)			<–Maximum loss as pvt investor is only to the extent of equity
Net Gain (Loss) Bank A	$13.6	$4.3	($109.2)		<–Maximum loss to tax payer virtually unlimited. Banks stand to gain both from sale of legacy asset and as investor.

In the model above (which you can download for free for your own use: PPIP full model, with collusion and implied leverage 2009-03-26 01:00:41 202.00 Kb)
we have assumed that Bank A and Bank B both participate in the PPIP
program. Current fair value of Bank A’s asset are at 60 cents on the
dollar while Bank B’s assets are at 80 cents on the dollar. However
during the auction Bank A’s and Bank B’s assets are sold at 80 and 90
cents on the dollar, respectively. Bank A purchases Bank A’s asset with
equity investment of $6.4 while Bank B purchases Bank A’s asset with
equity investment of $5.4. At the end of period the actual value for
these assets of Bank A and Bank B (originator) were 40 cents and 60
cents on the dollar, respectively.

Although both the banks lost 100% of their respective equity under
the PPIP they were considerably better off (and I do mean considerably)
selling each other their legacy assets, (effectively, selling them to
the Treasury) with tax payers taking the ultimate hit. This should be
safeguarded against.

---

Well, enough of this. It looks like I need to find some no cost, no
recourse, high leverage loans to boost my returns for the year. For
subscribers who wish to see our work on Lenner, look below. If you
recall, BoomBustBlog was the first and at the time only financial
publication or analyst that called Lennar and the other home builders on
the unconsolidated off balance sheet that was held. Up until that
point, the sell side and practically everybody else failed to recognize
debt liabilities and contingent liabilities that were not held
explicitly on balance sheet. Once consolidated, there was a big
difference. Interested parties can click here to subscribe.

Lennar Forensic Analysis and Valuation update – 2/2009 hot! 02/10/2009

Lennar Update 02-07-08 02/09/2008

Lennar Fully Consolidated Analysis 01/02/2008

A opinion of Lennar, with all entities fully consolidated.

Comments

[ZackLo]

"Mayhap I should stop trying to play honest Johnny and just get in their and make me some real money with the big boys"

That sir is why I get a little more faith in this world Reading your articles...Because without people like you telling the truth and breaking down the ponzi schemes...We would be so fucked....another great article man keep it up!

[NotApplicable]

“Simply put, we purchase large and small portfolios of loans and REO at distressed prices and then we work through those assets one at a time to resolve them at retail payoff. It’s all about making money by managing the process of purchasing wholesale and selling retail – purchasing in bulk and selling one at a time. Admittedly, the assets are a little bit more complex, but this is where we excel.”

I'm starting to see local developers/companies that were doing distressed RE purchases blowing up too, as they aren't selling jack. Of course, they don't have access to free-money and are not buying portfolios of loans, but rather a property at a time on the courthouse steps.

It's bizarre enough seeing large properties foreclosed here, but watching the same ones go again barely a year later is kind of surreal. When falling knives are made of brick and mortar, it's time to break out the serious hard-hats.

Maybe Lennar will sell me one of their unused ones?

[Downtoolong]

No money down, heads I win, and tails you (the taxpayer) lose. Deals like this are what got us into our present crisis. Now is they are even more blatant, public, and fully backed by the government in advance.

You really have to wonder why the government needs to make these deals so sweet for their private sector partners. There’s lots of money out there right now settling for lower yield and higher risk than this deal with Lennar. Why can’t the gov tap some of those funds, or put another way, let some of the rest of us in on it without having to bail out Lennar in the process too? If I had opportunities like this deal available to me, I would be a billionaire in 2 years. I think any investor with average smarts would.

[Village Idiot]

"Ulcer" article of the day.  Fucking guys. otoh - if they are generating profits from zirp so they can make payroll to all those (would like to be) hard working crews, fine.  Kinda' doubt it, though.  Yeah, don't believe it at all.

[Hephasteus]

This has got GMAC written all over it.

[Commander Cody]

Can you say 'facism'?