The Intelligent Investor now says 'speculative buy' up to $1 for 3% of portfolio.
It�s been a rough three-week ride for those that took up shares in this company�s $2.50 float. The troubles are real but the market�s reaction looks overdone.
A brief glance at RAMS�s balance sheet would strike fear into the heart of even the most aggressive investor. At 31 March, its $13.1bn of liabilities slightly exceeded its assets � not normally a recipe for success. But the balance sheet of this business is highly misleading.
The liabilities are on its balance sheet because RAMS controls them, but hardly any of them actually belong to it. Likewise the assets. Let's explore this in more detail.
The company is best described as an originator of home loans � a middleman between the humble homeowner and global financial markets. In that role, it�s been remarkably effective. But before looking at what it�s built, let�s study the art of offering home loans without providing any money.
Non-bank lender and non-lender
RAMS doesn�t lend any money itself. It sets up a single purpose trust, or special purpose vehicle (SPV) in the lingo, to lend and borrow all of the cash involved. This SPV makes loans to homeowners and finances those loans by borrowing money from banks, long-term investors and the commercial paper market in the US (the professional money market). If this SPV receives more money in interest and fees than it pays in interest and expenses, RAMS collects the difference.
Real estate is a well-regarded asset and every single loan RAMS brings to the SPV has mortgage insurance. That means the SPV is highly rated and can, in normal circumstances, borrow very cheaply (both major financial ratings agencies, Moody�s and Standard & Poor�s, give the RAMS SPVs the highest possible rating � AAA or its equivalent).
After paying for insurance, commissions and running costs for the SPVs, RAMS has, historically, been able to collect about 1% on its total loan book. While that mightn�t sound like much, it adds up to a tidy revenue stream on $14.16bn of loans (the total loan book at 10 August). Considering RAMS doesn�t wear any of the risk, it�s a pretty attractive business. If a homeowner doesn�t pay, the insurance company is on the hook. And even if the insurance company goes bust, lenders to the SPVs have no recourse to RAMS.
Float investors fleeced
Attractive probably isn�t the adjective being used by punters who took up shares in the original float, though. They�ve seen their investment plummet by 65% in three weeks. To understand why, we need to take a closer look at where the SPVs get their money.
RAMS sources of funding Warehouse facilities $3.92bn Mortgage backed securities $4.07bn Short-term paper $6.17bn
There are three sources of funding. When a loan is initially provided, it�s financed using short-term warehouse facilities. These facilities, totalling $3.92bn at 10 August, are provided by banks on a short-term basis, on the understanding that alternative financing will be found. The longer-term funding comes from two very different sources.
The first is from issuing residential mortgage backed securities (RMBSs) to institutional investors. These are bond-like investments that have exactly the same profile as the underlying mortgages � when principal and interest is repaid it�s passed straight through to the bondholder. Of the $14.16bn total loan book, $4.07bn is financed by these bonds. The remaining $6.17bn is sourced from the short-term money markets in the US and here lies the source of RAMS�s current problems.
Basically, RAMS is borrowing $6bn from institutional investors that needs to be refinanced every 30 days. Its long-term assets, in the form of home loans, have been financed with rolling short-term credit. That wasn't a problem while the credit boom was raging, but it�s a problem now.
Caught short
On 14 August, RAMS announced that �disruptions� in the global credit market were increasing the cost of this funding. Then, yesterday, it announced that it couldn�t refinance the debt at all. The share price tumbled following the first bit of news and went into freefall following the second, touching a low of 55.5 cents.
Unfortunately it recovered from there very quickly, but we still think this is a good speculative opportunity at current prices.
The first question is: Will it survive? We�re pretty confident the answer to that is yes. While not being able to fund $6bn in debt sounds drastic, the consequences aren�t so dire. The previous loans, which were due to be refinanced, have an extension provision. The interest rate rises 25 basis points (0.25%) but RAMS gets to keep the money for another 180 days. Six months is a long time in financial markets and, while we�d never say never, it would be unprecedented if some sense of normalcy doesn�t return to credit markets within that time frame.
If it takes a full six months, the 25 basis points will cost RAMS $7.5m, or 2 cents per share. This business will probably survive, but what�s it worth?
As we pointed out in our review of the float on 4 Jul 07 (Avoid � $2.50), margins were already going to get squeezed by competition at the lending end. The end of the liquidity boom, now official, means it�s also going to get squeezed at the funding end � once the markets start working again, the cost of debt for the SPVs is still going to be higher than it was. But they can be squeezed a lot before the current price starts to look remotely expensive. The table below shows you the effect of changing commercial paper margins on profitability (the RMBS margins are already locked in for the life of the portfolio).
Increase in funding costs Profit after tax Current market capitalisation PER at $1.00 20 basis points $50.0m $306m 7.1 30 basis points $45.6m $306m 7.8 40 basis points $41.3m $306m 8.6 50 basis points $37.0m $306m 9.6 60 basis points $32.7m $306m 10.8
Stranger things have happened but, once the dust has settled, a 60 basis point blow out in funding margins for AAA-rated debt would be unlikely. And, even if it happened, RAMS still wouldn�t look expensive. It would also make a tasty morsel for one of the big banks (both Westpac and National Australia Bank are rumoured to have taken a close look before the company decided to proceed with a public offering).
This is not presenting a worst case, though. If mortgage default rates skyrocket and an insurer or two goes bust, the RAMS SPVs will no longer be AAA-rated, funding margins could skyrocket and RAMS might be worth nothing. Even in a more benign environment, the cost of insurance is on the rise which means new business won�t be as profitable as the loans that already exist (existing loans run off at the rate of 20% per annum). The publicity surrounding RAMS�s problems could also make new business more difficult to come by.
All up, though, this looks like an attractive speculative opportunity for those who are interested in such propositions, and who can cope with extreme volatility. The stock has already roared back from 55.5 cents, which is a pity, but we�re recommending a SPECULATIVE BUY up to $1.00 for up to 3% of your portfolio.
Increase in funding costs Profit after tax Current market capitalisation PER at $1.00 So based on a 37bps we have a PER of approx 8.5, sector PE of 14 - 15. So it seems undervalued.
FK
RHG Price at posting:
0.0¢ Sentiment: Buy Disclosure: Not Held
