Sunday, July 15, 2007

Subprime, Subpar: For Sale?

Published: July 15, 2007

NOVASTAR FINANCIAL, a subprime mortgage originator based in Kansas City, Mo., has had its share of setbacks. That’s not surprising, given the carnage in its industry.

What is surprising? NovaStar’s stock has been on a tear lately, rising from $3.80 in February to $7.63, at Friday’s close. Even though the mortgage lending business continues to sink and shrink, NovaStar’s market valuation has risen.

Perhaps that is because, last April, NovaStar said it was seeking “strategic alternatives” — otherwise known as a “lifeline.” The stock is up about 50 percent since then. Some investors may believe a buyout lies ahead. Last week, there were whispers that the MassMutual Corporation, a financial services firm that trades as a closed-end investment company, might put money into NovaStar.

The two companies are already connected. Babson Capital, a money management unit owned by MassMutual, is a big NovaStar shareholder; it owns about 770,000 shares, or 2 percent of the company. Most of those shares were bought in 2006; the average cost to Babson is $27.85 a share.

Another interesting tie: Howard B. Hill, a managing director at Babson since 2005, was a vocal bull on NovaStar for years, posting messages on Yahoo and other stock boards until about the time he joined Babson. Like John P. Mackey, the chief executive of Whole Foods Market, who used Internet chat rooms to promote his point of view, Mr. Hill has been an avid poster on stock message boards.

Unlike Mr. Mackey, Mr. Hill used his last name while posting. He urged investors to buy NovaStar shares, with the stock symbol of NFI, for its dividend. One post that Mr. Hill made on Yahoo was headed “NFI gets positive returns every year.”

Mr. Hill pretty much quit posting messages about NovaStar after he joined Babson. But on June 6, 2006, he wrote on the Yahoo board: “I’m more bullish than I’ve been for more than a year on the group and NFI, but that’s all I can or will say on that.” NovaStar’s shares were at $31.29 that day.

Officials at MassMutual Financial Group and Babson, including Mr. Hill, declined to comment. NovaStar declined to comment as well.

While NovaStar might appear to be a unlikely takeover target, we all know that anything can happen in mergerland. Still, NovaStar’s business is plummeting, and it faces a number of legal challenges. Its monthly loan figures for June, disclosed last Thursday, show total originations of $254 million, down from $1.06 billion for the same period last year. The company generated an average of $12.1 million in loans each day last month; in June 2006, that daily figure was $48.2 million, albeit with one more day in the month.

Delinquencies among the company’s loans, meanwhile, are rocketing. In June, some 12.4 percent of loans in pools less than one year old were more than 30 days delinquent. That’s up from 5.2 percent at the end of 2006.

Furthermore, NovaStar has problems that other lenders don’t. On June 27, for example, the company lost a lawsuit in California that will require it and two other lenders to pay $46 million. A jury ruled in favor of American Interbanc and its contention that NovaStar Home Mortgage Inc., a subsidiary, used bait-and-switch practices in its mortgage-quote Web site. (NovaStar shut down its subsidiary in mid-2006.) Lanny J. Davis, a lawyer at Orrick, Herrington & Sutcliffe who represents NovaStar, said the company believes the verdict is incorrect and has sought to have it reversed.

On other legal fronts, the company settled a class-action suit in Washington State on June 27, paying $5 million to some 1,600 borrowers who contended that NovaStar hid loan fees, according to Ari Brown, the lawyer at Bergman & Frockt in Seattle that represented them. A $5 million settlement certainly doesn’t cripple NovaStar, but it may just be the beginning of such suits. While NovaStar had only a small presence in Washington, it generated more loans in California than in any other state. And Mr. Brown has also sued NovaStar on behalf of two California borrowers who contend that its loan carried hidden commissions — meaning that the suit may become a class action there.

THE Washington case was settled to avoid unnecessary legal expenses, Mr. Davis said, “but there was no admission whatsoever that any of the claims made in that case were meritorious.” The company maintains that loan fees were fully disclosed to borrowers and that they did not suffer actual damages because they would have had to pay those fees or more in any event.

“Regarding the California case, we are confident it is utterly baseless, its allegations misstate facts and have no merits, and that the transactions referenced in that case were entirely consistent with California law,” Mr. Davis said.

If MassMutual does indeed invest more in NovaStar, it would be a vote of confidence in the company and in subprime lending. Mr. Hill, the Babson managing director, is, as his online postings show, a fan of NovaStar and its industry. On Jan. 24, he published a report on Babson’s own Web site about subprime mortgage securities. Calling the press coverage of the sector “unrelentingly depressing,” Mr. Hill argued for a more upbeat view.

“We look at the glass as being 90 percent full now, with the potential to drop to only 80 percent,” he wrote. “What we find is that people do not generally lose their homes to foreclosure, even if the mortgage balance is higher than the market price of the house. Basically, if they have jobs, they pay their mortgages.”

That rule of thumb worked in previous periods but seems not to be working now. In the more than six months since Mr. Hill wrote his report, foreclosures have risen significantly, notwithstanding strong employment figures.

Mr. Hill declined to talk with me last week about NovaStar, his postings on the company and Babson’s investment. But in an interview with Bloomberg News on Friday he called coverage of the subprime mortgage meltdown “a bit overblown.”

Certainly NovaStar’s shareholders would love to see MassMutual, or anyone whose money is green, throw them a line. But would it be good for MassMutual’s investors?