Could you imagine if a hedge fund or private equity firm started building houses for 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.

• 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.

• 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.

• 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.

• 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.

• 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".

• 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:

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.