Puerto Rico conjures up images of beach life and relaxation, but some of the island's bankers have been sending shock waves, not sunny thoughts, to Wall Street.
Doral Financial Corp. and R&G Financial Corp. recently announced that a change in the way they value interest-only strips would force massive earnings restatements. Their stock prices plunged, and shareholders sued.
Where does the blame lie? Partly with the fact that Puerto Rico's mortgage market is different. Fingers also point to the way executives managed growth. Finally, questions are being raised about the banking companies' auditor, PricewaterhouseCoopers LLC.
On April 19, Doral said that the value of its IO strips would fall by $400 million to $600 million, and that it would restate earnings as a far back as 2000. R&G followed a week ago with a preliminary estimate that its IO valuation would fall $90 million to $150 million and that it would restate the last two years' of earnings.
The banking companies both changed the way they value this particularly interest-sensitive part of their securities portfolio, pegging value to expected future interest rates rather than the actual Libor rate.
Highly profitable when interest rates fall, the interest-only strip left after selling or securitizing a mortgage loan can be dangerous when rates rise, as they have lately.
The $15.1 billion-asset Doral valued such securities at $878.7 million at Dec. 31, after selling approximately $536.6 million worth of IO strips in the fourth quarter. R&G, with $10.2 billion of assets, held IOs worth $195 million. Last year Doral took $131 million of charges related to impairment of its IO strips; R&G's impairments totaled $10.9 million.
The trouble with IO strips is nothing new for mortgage lenders, but as the market capitalization of Doral and R&G erodes, the latest development raises the question: Is it a Puerto Rican thing?
"Our mortgage market is somewhat different than the typical U.S. market," said Jorge Junquera, the chief financial officer of Popular Inc., in a telephone interview Wednesday.
Popular is the island's largest banking company but only its third-largest mortgage lender, after Doral and R&G. Together the three control 90% of the island's mortgage market.
All three major Puerto Rican mortgage lenders keep interest-only strips, but R&G and Doral own variable-rate IO strips, while Popular's are fixed-rate, and therefore less rate-sensitive.
(Popular's IO portfolio is worth $69 million, Mr. Junquera said. He is comfortable with that valuation because the securities have just recently been put on the books, he said. "We are not anticipating the future reevaluation to be of any consequence," Mr. Junquera said. "The creation of origination of IOs is very small; it has never been more than 1% to total assets.")
In Puerto Rico, mortgage loan delinquencies are higher but loan losses are lower. Customers often refinance to consolidate household debt rather than chase interest rates. Most important, housing demand, and with it purchase mortgage origination volume, is rising faster than on the mainland.
None of these factors alone would be a huge problem for lenders, bankers and analysts said, but some of them contributed to the crisis facing Doral and R&G.
The different refinancing pattern results in a more constant prepayment flow from mortgage customers, Mr. Junquera said. Prepayments are an important factor in establishing the future value of IO strips, and analysts criticized Doral earlier this year for counting on the speed of prepayments to remain low.
Mario S. Levis, Doral's treasurer, told investors during a conference call on March 17 discussing the company's 2004 results: "Certain analysts feel that the prepayment assumptions and the discount rates used to value our IOs are too optimistic. We stand by our assumptions and believe that these analysts are incorrect."
Yet five weeks later Doral changed its methodology for calculating the value of the securities.
Rosemarie Conforte, an analyst with Moody's Investors Service, said the problems created by the IO strips reflect an apparent lack of management expertise at Doral in dealing with complicated balance sheet instruments.
Others agreed.
"Part of the blame lies with management," said Bain Slack of Keefe, Bruyette & Woods Inc., who follows all the major Puerto Rican banking companies. "It wouldn't surprise me to see some management changes" at R&G, he said. "They have got to beef up their risk management, at minimum."
Doral declined comment; R&G did not return phone calls.
The magnitude and timing of the problems also raise questions about how much attention PricewaterhouseCoopers paid to the methodology Doral and R&G were using to value their IO strips, several observers said.
"The auditors got caught off guard and are now behind the curve," Mr. Slack said.
PwC audits both companies, as well as Popular and other Puerto Rican banking companies. The accounting firm signed off on Doral's and R&G's annual financial statements just weeks before the companies said they would have to restate results.
The law firm Scott & Scott LLC in Colchester, Conn., filed a shareholder class action against Doral on April 24 and said it may add PwC as a defendant. PwC declined to discuss the matter.
Since news of the restatements, the companies' stock prices have been hammered. (See chart, page 1). That's a stark contrast to the last two years, when soaring earnings made Doral and R&G darlings of Wall Street. Doral's 2004 profits were up 52.4%, to $489.6 million, while R&G's net income jumped 22.3%, to $160.2 million.
R&G said that it future it will keep mortgages on its books instead of selling or securitizing them. Doral said it would sell fewer mortgages.
Popular and First BanCorp, also in San Juan, were both wholesale buyers of mortgages originated by Doral and R&G, but both companies said the pullback would not impact their business much.
"We are originating between $70 million to $80 million mortgage loans a month," Angel Alvarez-Perez, the chairman, president, and chief executive officer of First said in an interview Thursday. "With those originations we feel comfortable that we would make up for whatever they don't sell us," he said. Commercial loan demand is rising, he added.
For now, Doral and R&G have contracts binding them to sell at least some of their mortgage production to First BanCorp. Mr. Alvarez declined to say how much but said the sum is "substantial."
Many analysts said that Doral's and R&G's fundamentals and business strategies are solid, and that they are likely to recover from the shock of the last couple of months.
But many analysts hope that both managements have learned at least one lesson: to communicate better with investors.
R&G never had a conference call with investors, and the first call Doral organized was when shareholders were already selling the stock. "That is highly unusual for companies their size," KBW's Mr. Slack said.
Ms. Conforte said such calls not only help investors and analyst to understand management's strategy tell management what investors are worried about.
Neil Abromavage, a Deutsche Bank AG analyst, wrote in a March 21 research note that Doral's stock had plunged partly because of the company's "inability to manage analyst expectations."
