[ARCHIVES] David Einhorn: The Joker In Allied Capital's House Of Cards

From the archives…

David Einhorn’s work on Allied Capital Corporation (NYSE:AFC) is up there as far as short theses go. This is the thesis that he wrote:

David Einhorn: The Joker in Allied Capital’s House of Cards

There’s trouble brewing at Allied Capital Corporation (NYSE:AFC), and its name is Business Loan Express.

Business Loan Express, the second-largest originator of loans in the Small Business Administration’s popular 7a program, was formed in late 2000. Allied Capital paid about four times book value for its publicly traded predecessor, Business Loan Financial, and combined it with Allied’s own SBA lender, Allied Capital Express.

Representing Allied’s largest investment, Business Loan Express is 94% owned by Allied Capital. It represents 17% of Allied’s net asset value and is expected to kick in 50 to 60 cents of Allied’s per-share earnings this year, and also contributed $20 million to Allied Capital Corporation (NYSE:AFC)’s mark up of assets in the second quarter. Business Loan Express adds almost 10 cents per quarter in management fees and interest and added 20 cents in the second quarter when it marked up the value.

Business Loan Express is what is known as a gain-on-sale securitizer of its loans. Gain-on-sale securitizers book profits on loans at the time of securitization. A securitization is when loans are grouped into pools, and each pool is carved up among different investors according to their risk tolerances. Business Loan Express keeps the riskiest, most junior piece of the securitization, called the residual, and values it using a discounted cash-flow analysis based on its expectation of how the underlying loans will perform. If the expectation proves accurate, then the residual eventually pays off. If it doesn’t, a write-off follows.

After several gain-on-sale securitizers such as Cityscape rose to high valuations based on rosy securitization assumptions and then blew up when the assumptions proved too optimistic, new audit rules were imposed a few years ago that required companies to disclose the underlying assumptions used in the gain-on-sale calculation in the footnotes to their audited financials. Despite many requests from investors, Allied has declined to disclose Business Loan Express’ assumptions and escapes the required disclosure because it’s an unconsolidated subsidiary.

In terms of consolidating Business Loan Express, Allied said in a June press release, “Fact: The consolidation issue is absolutely black and white. Since Allied Capital Corporation (NYSE:AFC) is a BDC [business development company] , the SEC rules for accounting for investment companies is quite clear.” However, Business Loan Express’ predecessor, Allied Capital Express, was consolidated. In addition, when I attended Allied’s Aug. 1 analyst day, a senior Allied executive told me, “BLX should be consolidated. There is a way we could do that if we wanted to.”

Allied discloses very little about how its SBA 7a loans perform. On the most recent conference call, it cited a delinquency rate of 7.9%, below industry averages and setting an average loan loss rate of about 1% over the past five years. Although that sounds like an enviable record, Business Loan Express’ rapid growth appears to be masking poor loan performance. Its servicing portfolio has grown fivefold from June 1999 through March 2002.

Most of the few companies that persist in using gain-on-sale accounting, such as Harley-Davidson Inc (NYSE:HOG), Household International, AmeriCredit, New Century Financial and H & R Block Inc (NYSE:HRB), disclose static-pool analysis. What’s that? Say you have a portfolio of $100 million of loans, and 10% are in default. If you add another $100 million of fresh loans that haven’t had time to default, the reported default rate immediately falls to 5%. Loan additions have similar effects on delinquency rates. Static-pool analyses strip out the masking influence of subsequent new loan growth by evaluating loan performance based on the time of origination.

I obtained a static-pool analysis of Allied’s SBA 7a loans originated between 1998 and 2001. The data comes from BancLab LLC’s DataBanc, which includes loan performance data on more than 400,000 SBA 7a loans. At our request, DataBanc captured $662 million of Allied Capital Corporation (NYSE:AFC)’s SBA 7a loans and compared the performance to its national pool of about $33 billion of loans originated during the same time period. (For the full report, see greenlightcapital.com.) As the table shows, Allied’s loans have more than twice the default rate of the national average. However, when I asked Chief Operating Officer Joan Sweeney recently how Business Loan Express compares in defaults and losses on a static-pool basis, she replied, “They perform in line with the national average.” Additional discussion with Moody’s has confirmed that gross defaults in Business Loan Express’s static pools are twice the national average.

While default doesn’t necessarily equal loss, DataBanc also captures recoveries on defaulted loans to calculate loss rates. Here, Allied Capital Corporation (NYSE:AFC) performs even worse, with loss rates of more than three times the national average.