NovaStar Financial Inc., the last subprime lender to rely heavily on off-balance-sheet securitizations accounted for as sales, is pulling back, at least temporarily.
Such securitizations were popular in the late 1990s but have fallen out of favor since, because they contributed to the collapse of several subprime lenders. Investors are still skeptical about these deals - because the immediate noncash gain-on-sale income they create can later disappear if the lender's assumptions about prepayment and credit risk prove too rosy. (Some of the accounting woes in the Puerto Rican banking market involve a similar issue.)
But NovaStar did not mention the skepticism as a reason it will do at least a few on-balance-sheet securitizations. Rather, the Kansas City, Mo., real estate investment trust says, in a rising interest rate environment, outsized profits on the derivatives used to hedge the net interest margin from its loan portfolio put it in danger of failing the percentage tests on the nature of income and assets required to be a REIT.
"Given the interest rate environment of the last couple of years, we've lost some flexibility," said Jeffrey A. Gentle, NovaStar's director of investor relations.
However, it has not ruled out future off-balance-sheet deals, which Mr. Gentle said still can offer better value.
Off-balance-sheet securitizations, which are recorded as sales, are a rarity for subprime lenders these days, in part because of a wave of REIT conversions a few years ago. Securitizing loans housed on a REIT's balance sheet provides a similar tax advantage to bond buyers as the main off-balance-sheet vehicle, real estate mortgage investment conduits.
New Century Financial Corp. securitized some loans off its balance sheet last quarter, as a result of widening credit spreads and weak whole loan pricing. Most analysts took the deal in stride, because it brought only a slight pickup in sales margins, and the Irvine, Calif., REIT said it has no plans to do so again soon.
Fremont General Corp. and H&R Block Inc.'s Option One Mortgage, neither of which are REITs, also occasionally do off-balance-sheet deals. Accredited Home Lenders Holding Co. of San Diego, another non-REIT, holds some residuals from off-balance-sheet deals but stopped doing the deals several years ago. A spokesman said it has no plans to resume them, though "it can be done right."
NovaStar said Friday that it had agreed to buy $940 million of nonconforming mortgages that it plans to securitize, on the balance sheet, next quarter. (Until then it will keep the loans in a warehouse line from the seller, which Mr. Gentle would not name.) Its first securitization of the year, a $1.35 billion deal also slated for next quarter, would also be an on-balance-sheet transaction.
Unlike the off-balance-sheet variety, such securitizations are recorded as financings and generate interest income over time. In the short term, NovaStar is giving up gain-on-sale income and must establish a loan-loss reserve. Over the long term, it says, it's a wash; the move would not materially affect full-year profits or dividends.
Greg Metz, NovaStar's chief financial officer, said in a press release that the two on-balance-sheet securitizations would add $2.6 billion to his company's REIT-qualified assets.
Mr. Gentle said a main reason NovaStar had stuck to the off-balance-sheet strategy is the lower leverage available in on-balance-sheet securitizations. With the latter, the amount of leverage on a residual is generally limited to rating agency assessments of what is needed to protect senior bondholders.
C. Douglass Garrett, the director of research at Flagstone Securities LLC, discussed a related issue on his company's blog.
"Due to arcane tax/legal variables, REITs with on-balance-sheet securitizations have typically been unable" to resecuritize net interest margin residuals, he wrote. "However, given NovaStar's capital markets acumen … we would not be surprised if they make use of an alternate NIM financing structure," a rare strategy that another Irvine mortgage REIT, ECC Capital Corp., used in September.
Bill Roy, the director of research at Jacob Asset Management of New York LLC, said the reduction in noncash sales gains, though not a complete shift, will "go a long way toward lifting the cloud of uncertainty over the stock, and could improve the valuation as a result."
His hedge fund, which has been both short and long on NovaStar, is neutral at the moment.
