NFI: Jacob's comment in Barrons
A good example is NovaStar Financial. They are a sub-prime home-equity originator, but instead of selling the loans they don't keep in their portfolio for cash, they securitize everything they originate and keep the credit risk on their portfolio. They are one of the few remaining sub-prime home-equity companies that still employ gain-on-sale of accounting. There was a whole class of sub-prime home-equity companies in the late 'Nineties that used gain-on-sale accounting and went bankrupt after the capital-markets crisis then. NovaStar has a lot of non-cash reported earnings. The trick is they are a real-estate-investment trust and have to pay 95% to 100% of their earnings as dividends. Here is a case of a company that has to pay out most of their earnings, but their earnings aren't in cash form. They have tremendous capital needs because they have been growing like mad and need cash to do securitizations. On top of that, they have to raise capital just to pay dividends. Their dividends appear to be very high but we think they are somewhat deceiving and unsustainable if the capital markets get less friendly. The other thing that could go wrong at some point is credit quality. Their credit risk piles up on their balance sheet as securitized loans. For this thing of beauty, you pay three times book value. When volumes in the industry slow and credit losses start hitting the industry, we think NovaStar is the most exposed.
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About Jacob:
WE FIRST BECAME ACQUAINTED with Jacobs during the real-estate crisis of the late 'Eighties, when he was a crack bank and thrift analyst on Wall Street, beginning at Salomon Brothers and ending at Alex. Brown & Sons. Now he's running a hedge fund and managing about $125 million in a long-short market-neutral strategy in his Manhattan-based JAM Partners Fund. With yet another possible real-estate debacle in the making, it seemed a good time to get reacquainted with an old pal. Especially fitting, too, since his fund has enjoyed quite a lot of success in the decade since it started. Now closed to new investors, the fund is up 14% after fees so far this year and has delivered 17.1% a year on average from its inception. We found Jacobs busy battening down the hatches for a coming storm in financial stocks fueled by fallout from a flattening yield curve.
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Source: Barrons (subscription based)
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