ARMed And Dangerous?

FirstFed's portfolio of risky mortgages has the short-sellers pouncing

FirstFed Financial Corp. (FED ) may be the riskiest mortgage lender around, but investors don't seem to mind. The stock of the tiny Santa Monica (Calif.) bank has soared more than 30% since September.

Why the feeding frenzy? Some are betting the housing market is poised for a recovery. There's also speculation that FirstFed is a takeover target, given that Wall Street has spent $3 billion on specialty lenders in the past year. Others say the stock is too cheap to pass up. At 68, FirstFed trades at just 8.5 times 2007 earnings, compared with 18 times for bigger banks. "You either take your chances on small caps or go with an incredibly expensive traditional bank that probably has more mortgage risk than you bargained for," says Joseph Pappo, a senior portfolio manager at Lotsoff Capital Management in Chicago.

The fervor over FirstFed isn't based on what's happening in the business. In the fourth quarter, mortgage originations plummeted by 66.8%, to $365 million—one of the steepest declines among all lenders. Cash from operating activities dropped into the red in the third quarter (the most recent data available), falling from $49 million in 2005 to negative $77.1 million a year later. Meanwhile, the number of problem loans more than quadrupled last year.

FirstFed's foundation could crack even further. The biggest problem: Its mortgage portfolio is packed with risky loans known as option ARMS. These adjustable-rate mortgages allow borrowers to make smaller monthly payments than they would normally owe by deferring the principal and adding the difference back to the balance. That may make a house more affordable at first. But when the balance hits a certain level, payments often jump significantly, and borrowers can run into major financial trouble.

FirstFed potentially faces darker days than peers who play in the same niche. For one thing, all of FirstFed's mortgages are for homes in California, where prices have cratered and foreclosures have skyrocketed. Also, 80% of its loans have little or no documentation to prove the borrower's income or assets, according to a recent company presentation. The bank uses credit scores to screen for elite borrowers.

But skeptics are starting to question the quality of FirstFed's earnings. The bulk of FirstFed's income is derived from noncash earnings, largely from the deferred principal on its option ARMs. That so-called negative amortization constituted $223.9 million, or 68.4%, of the bank's income before taxes in 2006, compared with 1.3% in 2004. In essence, FirstFed is booking profits on money it hasn't collected. The fear is that the bank will never collect, given the high delinquency and foreclosure rates in California. Says Frederick Cannon, managing director at Keefe, Bruyette & Woods Inc.: "The bearish view is that all the earnings are coming from money they didn't get yet."


FirstFed admits the environment is tougher today, but says its borrowers have stellar credit and can afford to keep up with the option ARMs' rising payments. Indeed, FirstFed's loan portfolio, with a higher credit quality and lower delinquency rate, is holding up better than those of larger competitors such as Countrywide Financial (CFC ) in Calabasas, Calif., and Washington Mutual (WM ) in Seattle. FirstFed CFO Douglas J. Goddard says the bank fully expects to collect on its loans. "In our nearly 25 years of offering this product, we have yet to find where payment shock' caused a default," he explains.

Still, given all the red flags, it's no wonder short-sellers have pounced. Some 40% of the company's 15.3 million shares have been sold short. That dynamic may have helped boost the stock. As it climbs, hedge funds and others rush to buy more shares to cover their money-losing short position, pushing the stock higher.

And as it goes up, the stock is attracting new buyers. "I constantly see momentum players buy financial companies because they hit some screen, but they don't really know what they own," says Richard Eckert, senior research analyst at ROTH Capital Partners in Newport Beach, Calif. "They are not distinguishing between cheap, and cheap for a reason."

By Mara Der Hovanesian

    Before it's here, it's on the Bloomberg Terminal.