IndyMac NDE S
September 20, 2005 - 9:38am EST by
2005 2006
Price: 40.78 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 2,590 P/FCF
Net Debt (in $M): 0 EBIT 0 0
Borrow Cost: NA

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NDE is presented as a short idea. IndyMac is a mortgage bank/thrift hybrid based in Los Angeles that is the 11th largest originator of residential mortgages in the US, with 81% of their mortgage business being non-prime. Like DSL and FED, they have large exposure to California real estate, and yes, they are involved in 12 MAT option ARMs, but negative amortization is just a small piece of a bigger puzzle. The reason to short NDE stems from two unsustainable trends. One is easy credit and the other double-digit home appreciation. The combination of these two influences has created a dangerous spiral that even Alan Greenspan has been forced to acknowledge.

Let’s start with easy credit because easy credit is the mother of all bubbles. Obtaining a mortgage has become so easy that fraud is on the rise. BusinessWeek has published a good article in its September 5, 2005 edition entitled, “Sharks in the Housing Pool,” that details the rise in housing scams. This is just an indication of broader issues. There has been a boom in refinancing, and it is not always about interest rates. In 2nd Quarter 2005, over 60% of IndyMac’s mortgage originations were refinancings, and 38% of total originations were cash-out refinancings. 11.5% of loans originated had initial payments below the interest-only mark, meaning that 1 in 9 of IndyMac’s mortgages issued last quarter had negative amortization from the start. Consumers are literally betting their home on rapid, future appreciation of the home.

The most glaring problem with this biennial refinance game is an over-extended consumer. Let us look at the numbers for a fixed rate 30-year mortgage vs. Flexpay option ARM. Let’s start with a few assumptions:

Median California household income: $68,000 or $5,667/month
Median mortgage amount at NDE: $307,000
Mortgage rate: 5.50%
Assume taxes and insurance (T&I) are $600/month

Normal 30-year fixed rate mortgage would be $1,743/month or $2,343 with T&I loaded. That represents 41% of gross household income. Using the flex pay ARM teaser rate of 1% from NDE, the mortgage payment is $987/month, and fully loaded, the $1,587/month is 28% of household income. There is a huge difference between those two payments. Option ARMs have created an elaborate 2 year rental scheme. The consumer takes out an option ARM mortgage, gets two years of easy payments, home appreciates, they refinance, take out a bit of that newly minted home equity like it was an endless ATM and life is copasetic.

As the yield curve has flattened, traditional ARM mortgage rates are only 50 bps lower than the 30-year fixed rate. Borrowers who do not qualify for fixed rate mortgages at the current low rates are dependent upon these option ARM’s. If home appreciation slows, borrowers engage in a game of musical chairs between option ARM lenders. This is a game that will not end nicely. To see why this will happen, check out this research article about the correlation of low affordability and high risk and see where IndyMac fits into the picture:

The ability to refinance with easy credit is a large reason that credit defaults are so low. As long as the underlying asset appreciates at double-digit annual rates, it is a self-perpetuating cycle. Lenders have been able to lower loan loss provisions simply because loan-to-values have decreased via rising home values. For an extreme example of this, look at Novastar Financial. You can see the changes in default rates on p. 14 of NFI's 2Q05 earnings slide show and also see the original assumptions in the 2004 10K on p.27 for their securitizations:

NMFT 2003-4_______5.1%____1.1%
NMFT 2004-1_______5.9%____1.7%
NMFT 2004-2_______5.1%____1.9%

The problem with easy credit is that it eventually ends. As home prices slow down, serial refinancers will have to face some ugly realities. Further, IndyMac’s management is drinking the same Kool Aid as their customers. Here is a direct quote from the latest 10-Q:

On average, U.S. mortgage debt outstanding has grown approximately 7% to 8% per year over the last two decades and is projected, based on economic demographics, to continue this level of approximate growth. At this rate, mortgage debt outstanding roughly doubles every decade. We believe, based on our confidence in our employees, hybrid thrift/mortgage banking business model, capital strength and ability to gain market share, that we are positioned to grow earnings per share at a compounded growth rate of approximately 15% over the long run, or approximately double the rate of the industry. In fact, IndyMac’s historical track record has exceeded this target over the last twelve and half years with compounded annual growth of 28% under its current senior management team.”

Intuitively, two decades of 7% to 8% expansion in mortgage debt is worrisome compared to the lower growth rate in wages. The September 5, 2005 issue of Barron’s has an excellent interview with Lee Mikles and Mark Miller that talks about the relationship of home prices to wage growth. To quote Mikles:

“"It costs about 8% in the current environment to carry a home....Every year that house doesn't appreciate 8%, the consumer is losing ground if he is going to call it an investment. With wage growth at 2%, that' s unsustainable. Common sense tells you house prices and wage growth have to track one another."

This is actually covered in the May 16, 2005 Report to FDIC Board of Directors:

“Our analysis indicates that, over the long run, home prices tend to increase roughly in line with personal income. Historically, most housing price booms have not ended in a bust, but rather with a period of price stagnation that has relatively mild economic effects. However, the widespread adoption of new, innovative mortgage market products may increase the current risk to home prices. For example, subprime mortgages more than doubled as a percent of originations in 2004, to nearly 20 percent of the market. Meanwhile, interest-only adjustable rate mortgages have proliferated in recent years, particularly as a means to qualify borrowers in high-priced housing markets. “

You can read the full report at:

With home prices and mortgage debt rising much faster than wages, eventually the debt becomes excessive. Alan Abelson’s August 29, 2005 column mentions research by Paul Kasriel, chief economist at Northern Trust. Kasriel indicates that from World War II through the mid 90’s, the average US household has run surpluses from income being greater than expenditures. For the past ten years, though, US households have been running deficits where expenses exceed income, which is now at a negative gap of 12%.

Having reviewed the broader issues, let us drill down into the particulars facing IndyMac. First, IndyMac is a combination of two different businesses. One is the thrift business where they gather the deposits, but also make more traditional mortgages, including consumer home construction and lot financing. The other side is the Mortgage Bank (MB) which primarily originates mortgages and securitizes them. When seeing the numbers split out between the two segments, the MB part looks worse and that is important because it generates the GOS. Here are some key points:

- When comparing NDE’s 2nd Qtr 2004 results to 2nd Qtr 2005 results, interest income minus interest expense decreased from $103.8 million to $94.0 million. Most of the earnings improvement came from GOS, which went from $66.1 million in 2nd Qtr 2004 to $159.4 million in 2nd Qtr 2005.

- The net interest margin (NIMS or spread) for the MB actually decreased from 4.16% in 2Q04 to 2.35% in 2Q05 [THAT IS A BIG DROP COVERED UP BY VOLUME]. Given the last Fed hike in early August, those margins should be lower in the coming quarter.

- Prepayment speeds in 2nd Qtr 2005 were higher than assumed due to a drop in mortgage rates. This becomes in issue within securitizations because the older, higher spread securitizations are called and resecuritized at lower spreads.

- 69% of deposits are CD’s, which is a concern. CD’s are not core deposits because they are very interest rate sensitive, and tend to follow the short-term rates. They are getting squeezed as the Fed rate rises, meaning they need to pay higher CD rates in order to compete for deposits, while the 10 yr Treasury remains steady, meaning mortgage rates have remained steady.

- The MB accounts for 80% of mortgage originations, and 80% of that is ARM. 39% of MB production is the 12 MAT option ARM, and they note 37% of these mortgages are making payments below the interest-only (I/O) payment. Put another way, 11.5% of their current production has negative amortization from the start. A lot of the MB loans are sold off balance sheet (b/s) to a QSPE. They now have $45 billion in off b/s loans.

- Only 31% of their loans originated in the last quarter are full doc, which is down from 49% just one year ago. While NDE has an on-line mortgage app for direct to the consumer, they also have on-line apps for mortgage brokers, as well. [THIS IS A WEAK LINK WHEN CREDIT QUALITY DETERIORATES.]

- Credit defaults are at an all-time low, which has contributed to increased earnings. As credit quality decreases, so will earnings.

- 81% of production is Alt-A. Their average FICO score is 711 (sub-prime < 620).

- 45% of current production is CA while next 3 largest states representing a combined 21% of production are NY, FL and NJ.

- In their mortgage portfolio, 32% is from SoCal, 20% from NoCal, about 20% in NY, FL and NJ. To see why this is a concern, check out p.4 of this research report:

- 20% of loan production is for homes under construction.

- The Chairman of the Board began exercising options and 100% selling since the beginning of August.

- Finally, there are mortgages available with negative points:

- NDE is well hedged against interest rate changes
- their income forecast for remainder of 2005 assumes 10 yr Treasury rates of 4.26% in 3rd Qtr and 4.29% in 4th Qtr
- they have a 52% efficiency ratio which is good
- they raised their EPS forecast


- slow down in home appreciation, particularly in CA
- rise in defaults
- decrease in refinancing
- reduced earnings due to lower originations and smaller spreads
- option ARM borrowers get smacked
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