Without Cash, Instant Profits Were No Help

By FLOYD NORRIS
High & Low Finance
The New York Times
August 3, 2007

The problem faced by American Home Mortgage Investment in the weeks before it collapsed was aptly summarized 134 years ago by Walter Bagehot, the English journalist:

“Every banker,” he wrote in “Lombard Street,” his exploration of the banking world, “knows that if he has to prove that he is worthy of credit, however good may be his arguments, in fact his credit is gone.”

So as American Home — a big mortgage lender structured as a real estate investment trust — faced a crisis, it kept quiet and tried to act as if all was normal.

For three weeks, it struggled to meet margin calls on its highly leveraged portfolio of mortgages and mortgage securities, but said nothing to its public shareholders. To admit that it was having such problems would only have encouraged other creditors to demand their money.

But hanging over it was the fact that it had promised to pay $30 million in dividends to common stock holders last Friday, and an additional $3 million in preferred dividends this past Tuesday. Not big numbers for a company with $20 billion in assets on its books, perhaps, but more than American Home could raise.

So after 10 p.m. on Friday, it announced that it was delaying payment of the dividends “in order to preserve liquidity.”

Of course, as Bagehot knew, such a delay assured that any liquidity it might have possessed would vanish.

It was not until Tuesday afternoon that American Home Mortgage started to come clean. It was, it said, “currently experiencing a hindering of access to its traditional credit facilities.” That meant no one wanted to lend it money. It had “substantial unpaid margin calls.” It would not make at least $750 million in mortgage loans that it had promised.

Yesterday, the company gave up and said it would make no more loans. “Our business is no longer viable,” said Michael Strauss, the chief executive. The common shares are likely to be worthless.

American Home had ranked No. 13 in mortgage lending in America, well behind the No. 1 lender, Countrywide Financial, which decided last night that it needed to prove its credit was sound. Countrywide said in a news release that it has “significant short-term funding liquidity cushions.”

Bagehot would not have been happy to hear Countrywide thought that was necessary.

At American Home, there had been clues that all was not well.

The company managed to report a first-quarter profit only by changing accounting policies in a way that allowed it to report profits on sales of mortgages before it had, in fact, managed to sell them.

It had disclosed that it was borrowing money with shorter maturities than previously — a possible indication that lenders were getting a little nervous — and that it had fully drawn down a line of credit intended to finance working capital needs.

Some of its mortgages were reeling because customers with good credit scores — not subprime borrowers — were allowed to buy homes with little or no money down, no proof of income and payment terms that did not even require them to pay the full amount of interest being accrued. In April, Mr. Strauss promised that no more such loans would be made.

But, says Zach Gast of the Center for Financial Research and Analysis, the company did not disclose how much of its reported profits came from such phantom interest payments, even though it was supposed to do so if the amounts involved were significant.

One lesson that should be learned is the hazard of new accounting rules — like the one American Home Mortgage used to report a quarterly profit — that allow companies to report earnings when the market values of their assets rise.

Such market values are what investors need to know, but the rules provide an invitation for companies to make very generous estimates, particularly if the company is trying to cover up what it hopes will be a temporary problem.

Some analysts figured out that things were going wrong. Donald Fandetti of Citigroup put a sell on the stock on April 9, after it disclosed the first-quarter numbers. That did not, however, stop Citi from acting as the sole underwriter for the company’s April 30 offering of four million shares, at a price of $23.10 each.

In connection with that offering, the company made one disclosure that turned out to be prescient:

The company’s borrowings “are collateralized by the value of our portfolio of mortgage assets,” it said. “If the value of the assets falls, we could face margin calls that we are unable to meet, in which case our assets would be liquidated on unfavorable terms. In such event, we would likely experience large losses of our equity and sharply reduced income or losses from our portfolio assets.”

Having given the warning, however, the company was very slow to let on that the threat had come true. During the three weeks that it was facing margin calls quietly, 56 million shares traded, and the stock fell from $17.58 to $10.47.

That is more than the 54 million shares outstanding, and an indication that American Home’s travails were not a secret to all.

It was those who trusted the company and its management who were left holding the bag.