August 20, 2007
Some of the Red Flags to look out for
Analysis of:
How Missed Signs Contributed to a Mortgage Meltdown | www.nytimes.com
This analysis is solely the work of the author. It has not been edited or endorsed by GLG.
Implications: The debacle in subprime bonds was side stepped by some investors. They were able to spot warning signs while others ignored or missed them. A lot of this information was in plain sight. Others could have found the same red flags, if only they knew what to look for
Analysis: Always look at the cash flow from operations in the cash flow statement. Interest income is earned income and not the same as cash income. A gap can arise if there are delinquencies but the loans are still accruing interest because the lender has not placed them on non-accrual status. The lender will reverse the accrued interest income ONLY after the loans are placed in non-accrual status. This is allowed under GAAP accounting, and can cause a timing problem for investors.
Also, a mismatch will exist between earned and cash interest income, if interest is being capitalized as a result of negative amortization. GAAP accounting allows the full amount of earned interest to be recognized, even though the actual interest received may be lower. Pay option ARM's, a popular mortgage loan type with many lenders are a prime example of a negatively amortizing loan. Examples of mortgage lenders that have a lot of negatively amortizing adjustable rate mortgages on their balance sheet: Countrywide Financial, Washington Mutual, Downey Financial and FirstFed. For instance, investors who scrutinized American Home Mortgage Investments financials would have seen that the REIT's over reliance on pay-option ARMs, could result in a cash flow problem.
Analysis: Always look at the cash flow from operations in the cash flow statement. Interest income is earned income and not the same as cash income. A gap can arise if there are delinquencies but the loans are still accruing interest because the lender has not placed them on non-accrual status. The lender will reverse the accrued interest income ONLY after the loans are placed in non-accrual status. This is allowed under GAAP accounting, and can cause a timing problem for investors.
Also, a mismatch will exist between earned and cash interest income, if interest is being capitalized as a result of negative amortization. GAAP accounting allows the full amount of earned interest to be recognized, even though the actual interest received may be lower. Pay option ARM's, a popular mortgage loan type with many lenders are a prime example of a negatively amortizing loan. Examples of mortgage lenders that have a lot of negatively amortizing adjustable rate mortgages on their balance sheet: Countrywide Financial, Washington Mutual, Downey Financial and FirstFed. For instance, investors who scrutinized American Home Mortgage Investments financials would have seen that the REIT's over reliance on pay-option ARMs, could result in a cash flow problem.
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