Circle of Competence

Today I’ll talk a bit about another big investing mistake (remember I mentioned that I invested in AHM before its bankruptcy) I’ve made, recently, that I still hold today. I figure I’ll get my mistakes out of the way early, that way you all know what an idiot I am and that you should probably never listen to me. In fact, the blog should probably be called “Blow-Ups” since that has been a good theme to my investing life so far.

A primer is that I’ve been learning investing on my own for a few years now, and finally opened up my portfolio about a year ago. Since then, I’ve learned the value of Warren Buffett’s advice to run one’s own portfolio, in real life, rather than on paper. In about a year I’ve learned more about investing than I could have learned in a lifetime of paper investing or just reading about it. Having one’s skin in the game is vital to success in running a business or merely learning about investing. Since my start, I’ve totally lost two investments:

1. American Home Mortgage, a now bankrupt mortgage lender. This was a “trying to catch the falling knife situation,” and I didn’t do a tenth of the necessary research…this was one of my first investments and I chalk it up to inexperience in research and analysis.

2. Short term (7 months) Discover (DFS) calls I bought after the spinoff, something I’d never even consider doing it again; I blame it on too many readings of You Can be a Stock Market Genius! I learned, in fact, that I am categorically NOT a Stock Market Genius…
I’d consider LEAPS (options with a life of 2 years or more) now, but at the time I was not so smart. A bad decision, but a great learning opportunity.

Another disastrous investment, so far, has been First Marblehead (FMD). (Are you starting to notice what type of company is not in my circle of competence?) First Marblehead is a company that packages student loans into billion dollar+ securitizations and sells them off to Wall Street. They hold a residual from the securitization, often the lowest rated portion, and thus are last in line for payment. They also originate student loans through a bank that they wholly own, a part of their business that is now becoming increasingly important. FMD recognized revenue in two ways. The first was a structural advisory fee earned in cash up front, the other was the present value of the future expected residual cash flows. The earnings quality of the latter had come into question numerous times by the analysts covering FMD.

I initially read up on FMD on Tom Brown’s bankstocks.com. I did own my research through the company filings, and I felt confident the stock would be worth much more in the coming years. Their bonds had performed admirably, management seemed honest, and the stock was selling at a terrific price, considering their unbelievable profitability. Demand for student loans has been, and remains, on the rise so business had been booming until mid last year. I figured that, even if their securitization margins got killed, the amount of loans they were securitizing was growing so fast that their earnings would continue to rise, albeit at a slower rate.

However, FMD being squarely outside my circle of competence, I did not correctly weight their reliance on the securitization markets, and what could happen if that market closed (which it did). I did not have the ability to analyze their outstanding securitizations and make an edcuated decision on how strong they were and the cash flows they’d most likely throw off. I can read the annual report of a retailer, a manufacturer, a restaurant, etc. and know what I need to know, be able analyze the strength of the company and its evaluate its future cash flows. On the other hand, the cash producing assets and cash consuming liabilities of a financial entity like FMD or AHM have many unknowns that I’m not yet equipped to deal with. I understand that now, but didn’t when I invested in them. Heed Charlie Munger’s advice and learn as much as you can from others’ failures rather than your own; don’t leave your circle of competence.

What Went Wrong

Soooo… FMD is down from the 30’s to about 4 right now. While I highly respect Tom Brown, and I think he’ll rebound strongly from his awful year last year (his hedge fund was down about 50%), his bet on FMD has gone to hell since late 2007. He has been a vocal bull on the company for years now, and his thesis had been completely right until the securitization markets shut down last year. With the option of securitizing and selling the loans shut off, FMD is bleeding a bit right now and suffering write-downs on their residuals as student loan defaults have increased.
TERI, The Education Resources Institute, is the financial guarantor that backs FMD’s securitized loans. About 6 years ago FMD bought, from TERI, their 20 year database of data regarding student loan payments, defaults, prepayments, etc, and feels that this data is a major competitive advantage in originating and securitizing student loans. As well, loans to be guaranteed by TERI are required to meet their underwriting criteria (FICO above 720 and so on).

When FMD securitizes, TERI opens a pledge fund and deposits a certain amount enough to cover expected defaults on the securitized pool. Problem is, TERI miscalculated and may run short of cash to cover the actual defaults. That doesn’t bode well for FMD, for obvious reasons. TERI has filed for bankruptcy to protect themselves from other creditors, in hopes that they will continue being able to guarantee the bonds. In their PR following the Chapter 11 notice, the CEO of TERI stated:

“It’s essentially kind of your classic liquidity situation,” Hulings said. “This was the best action for us to take in order for us to preserve both our company as well the rights of all the creditors against one’s contractual right to cash.”

At the end of last year, First Marblehead went ahead and received a large capital infusion from Goldman Sachs’ private equity arm. The deal was a $260mm equity investment, and a $1b line of credit. The equity would help them survive the crisis, and give them added cushion until securitization was available. The LOC would allow them continue funding the strong demand for student loans under their own brand, Astrive. Unfortunately, Goldman’s equity investment is limited to 25% of FMD’s book value. Well, with FMD facing looming write downs due to the TERI bankruptcy, the Goldman investment will now shrink. At Dec 31 07, FMD had $770mm of these residuals (listed under “Service Receivables in the 10-Q). So let’s say FMD writes them down by a hypothetical 30%; they are now left with only $539mm in residuals, and book value goes from $921mm to $690mm. That limits Goldman’s possible investment to $172.5mm. That guess is probably optimistic right now. To add to it, FMD stated that they will not tap the LOC offered, for reasons I cannot figure out (if anyone knows, please pass it on).

The Future

As for FMD as a viable company, if they want to securitize future pools of loans in the near future, they will need a new guarantor. In the meantime, they will hold billions of dollars in loans on their balance sheet and collect payments, just as any thrift would do. In effect, their very low capital needs changed to very high capital needs, as they used to be able to clear their balance sheet in one fell swoop, and now it will balloon as they must hold the loans they are originating. They are funded for at least another 2 quarters (According to man
agement in the last conf. call), and will probably need capital beyond that unless the securitization market opens up before then. They may also need a new source of funding to continue originating loans. Otherwise, they’ll have to put that on hold. They are collecting on their originated loans, which have a very nice coupon, so I don’t believe the company is imminent for bankruptcy, but they will need to change and adapt. Their business model was all securitization, and for the time being that is not possible.

I think that Tom Brown had a good thesis of an undervalued company, but he did not foresee either that the securitization market would basically stop functioning or that FMD was so susceptible to a shut down (I would guess the former over the latter). If FMD does survive this nightmare intact, the stock will be worth several multiples of its current price. If they get new capital and/or funding, or they manage to securitize, FMD will be worth much, much, more than the current price. At $4 a share the downside is indeed zero here, but as a new FMD investor you’d have to work out the probabilities of that 0 actually occurring. I’m not so sure about it myself. I’m holding on because I believe that the company will make it through this; their balance sheet remains relatively strong, and the demand for student loans is through the roof. It’s a very tough decision, and I may be proven wrong even further. Intrinsic value is very muddy, but within a 2 or 3 quarters it will become much clearer, in which case I can make a more informed decision. In any case, a company that earned $3.92 a year ago and currently sells for $4 makes for an interesting case study. Soon enough, I’ll talk about some investments which I am a bit more optimistic about.

This makes for a good study of why circle of competence is so important. I strayed, and I paid.

Disclosure: Author owns a position in FMD.