Wednesday, June 25, 2008

Money for Nothing

Confessions of a Subprime Lender
By Richard Bitner
(Wiley, 186 pages, $19.95)

Three years ago, I had lunch with several mortgage-bond traders and analysts at Bear Stearns. The investment bank, already a huge trader and underwriter of securities backed by mortgages, had recently begun making home loans to consumers via brokers. I wondered why my hosts were getting even deeper into what seemed like an increasingly risky business.

After all, home prices couldn't keep soaring forever, and lending standards were growing more and more lax. Mortgage lenders were congratulating themselves for finding "innovative" ways to help people buy homes that, by traditional standards, they couldn't afford.

The Bear Stearns people dismissed my questions with ill-concealed contempt. Their computer models told them that home prices wouldn't fall much and that few people would default on their loans, barring another Depression.

About the same time, Richard Bitner, the co-owner of a small subprime mortgage bank in Dallas, was coming to a different conclusion. Mr. Bitner wasn't relying on mathematical formulas. He was dealing with actual subprime borrowers, including one named Johnny.

As Mr. Bitner recounts in "Confessions of a Subprime Lender," Johnny worked at a gas station, and his wife, Patti, was a cashier. By living with a relative for three years, they had managed to save $5,000 for a down payment on a house. But their dismal credit scores showed that "paying bills had never been a priority for them." The mortgage payments would eat up more than half of their combined pretax income.

Despite his misgivings, Mr. Bitner made the loan. Shortly after the couple moved into the house, Patti got sick and lost her job. They had no medical insurance and chose to pay their hospital bills rather than the mortgage. With a sick feeling in his gut, Mr. Bitner took the keys from Johnny and wrote off his losses on the loan.

Within a few months, Mr. Bitner sold his stake in the mortgage company and began work on his memoir. The result is an unflattering portrait of an industry that claimed to be all about helping people like Johnny achieve the American Dream but was really about grabbing loan-origination fees and foisting the dud mortgages on investors.

Yes, borrowers like Johnny made poor decisions and needed to learn their lesson. But so did the lenders, brokers, rating agencies, regulators and Wall Street financiers who all thought, or pretended, that Johnny was a good bet. To his credit, Mr. Bitner owns up to a fact that many lenders still haven't admitted: Just because Wall Street was willing to supply endless funding for crazy mortgages didn't mean that lenders were forced to make the loans. "We decided whether a borrower was a good credit risk and we funded the loans using our own money (before selling them to investors). No one else made that final decision," he writes.

Not everyone in the business was corrupt, of course. But too many were. After giving a concise overview of how mortgage loans are made and sold, Mr. Bitner exposes some of the industry's dirty little secrets for making borrowers look more creditworthy than they are:

- A large car payment keeps a couple from qualifying for a loan. But, in a fluke, car debt is recorded by only one credit bureau; the loan officer simply "drops that bureau from the borrower's credit report and the debt disappears."

- If a borrower's credit score is too low, it can be manipulated. "A person with good credit is paid a fee for each account they let someone else use. The person with the challenged credit doesn't get access to the account, just the benefit of the performance history that comes with it." (A spokesman for Fair Isaac Corp., a provider of technology for credit scoring, says that a new formula, being adopted this year, will thwart such abuses.)

- Does the borrower's bank statements show bounced checks? Never mind. Just give the underwriters copies of the first page from each month's statement, leaving out the grisly details.

- Is the borrower's income too low? "Desktop publishing programs allow for near-perfect replication of pay stubs and W-2s."

Mr. Bitner also offers proposals for reform. Among the better ones:

- Require people who have regular salary income to document it with pay stubs and tax forms. Reserve "stated-income" loans – those that don't require proof – for self-employed people with fluctuating incomes. But they should qualify only if they have good credit scores and plenty of savings.

- Require brokers to disclose from the start – to the borrower – how much compensation they will get from arranging a loan. That way there should be less incentive to push the types of loans that are more profitable for brokers but less favorable for borrowers.

- Certify the expertise of loan originators – whether independent brokers or bank officers – with training standards akin to those required for certified public accountants.

As for Bear Stearns, losses from mortgage investments and other risky trades sank the firm in March, prompting its eventual sale to J.P. Morgan Chase. More than 7,000 jobs vanished. The Bear mortgage mavens would have been better off listening to Mr. Bitner or Johnny three years ago than relying on their computer models. They had plenty of brainpower but fell short on common sense. I look forward to reading their confessions.

Kodak to Use Tax Refund for Buyback


Eastman Kodak Co. received a $581 million windfall from the Internal Revenue Service and said it will use it to help fund a stock buyback of as much as $1 billion, spurring a rebound in its long-depressed stock.

The tax refund covered taxes paid on the 1994 sale of its Sterling Winthrop subsidiary and $300 million in interest since then. Kodak's claim of losses on the sale was initially disallowed, but it had appealed. It said subsequent IRS regulations provided the basis for its refund.

Kodak stock, which had been trading near 40-year lows, jumped 14%, or $1.69, to $14.03 in 4 p.m. New York Stock Exchange composite trading Tuesday. Kodak's market value had fallen Monday to $3.7 billion, and it said the buyback could potentially reduce its shares outstanding by about 25%.

Kodak's sales last year fell 2.5% to $10.3 billion, and it posted a loss of $205 million from continuing operations after restructuring charges. The company's stock has fallen steadily over the past six months. Analysts said some large institutions that have held the stock in hopes of a turnaround have been selling steadily.

Ulysses Yannas, a broker with Buckman, Buckman & Reid Inc., a longtime Kodak follower, called the buyback, coming when the stock was trading just 30% above book value, "masterful" -- and "it's half with money the government gave them." Mr. Yannas says that if Kodak's printers for consumers and commercial printers take off as he expects, Kodak could have earnings of as much as $3 a share by 2011. However, he said Kodak is unlikely to buy shares aggressively if the stock rises.

Some analysts weren't so ebullient. "The share repurchase will provide some support," said Shannon Cross of Cross Research Group, Livingston, N.J. But she said, "At the end of the day, they need to improve fundamental results to bring in new shareholders."

Kodak has remade its business in recent years as its highly profitable film business was hammered by consumers' shift to digital photography. Kodak makes a successful line of digital cameras, but they are much less profitable than film sales. An ink-jet-printer business started last year doesn't have enough of an installed base to generate profitable ink-cartridge sales in large volume.

Kodak also took on heavy debt to build a new graphics-communications business by buying companies that make presses and supplies for commercial printers. It paid off much of that debt last year with the proceeds of the sale of its health-care imaging business, and at the end of the first quarter it reported $2.2 billion in cash.

This year, Kodak has been forced to raise prices of its aluminum plates for printers and consumer and movie film by up to 20% because of soaring prices of aluminum and silver. It has also spent heavily on promoting its consumer printers.

RIM Enters Risky Arena

BlackBerrys Move
Beyond Business;
Fickle Consumers
June 25, 2008; Page C20

With shares of Research in Motion up 150% over the past year, investors are saying there is almost nothing that can trip up the fast-growing BlackBerry maker. The problem with that: RIM's business is getting riskier every quarter.

The Canadian company, which reports fiscal-first-quarter earnings Wednesday, is increasing its exposure to the consumer market, a fad-driven arena that has caused even the best handset makers to stumble.

RIM's results, along with any profit forecasts, will likely be buoyant and could push the company's shares even higher in the near term. But investors gauging the longer-term direction of the stock may want to zoom in on a number RIM typically doesn't include in its published financials.

This number, often given by an executive on the company's conference call, is a breakdown of RIM's subscriber base. It shows how many of RIM's customers have been given the handset by their employers. The remainder are individuals who paid for a BlackBerry out of their own pockets -- the consumer market.

Analysts have been crunching these data to estimate how fast consumer subscribers are increasing. In its fiscal fourth quarter, which ended March 1, RIM's consumer subscribers grew an estimated 150% from a year earlier. Corporate subscribers were up an estimated 55%.

This consumer growth has happened as the demand for BlackBerry-type devices has expanded beyond corporate users.

RIM is better placed than its rivals to benefit from that change in the cellphone market. Indeed, the popularity of products like the BlackBerry Curve has shown RIM has the savvy to capitalize on mounting consumer demand for keyboard-phones.

Because of this success, analysts now expect RIM to earn $3.88 a share in the year ending February 2009 -- a 70% jump over the previous period. With growth like that, the stock, trading at 36 times forecast earnings, doesn't look expensive.

But there are good reasons why that high growth may never materialize. Perhaps the most important: There could be less room for growth in the U.S. consumer market than the bulls think.

Morgan Keegan analyst Tavis McCourt estimates that RIM supplied AT&T and Verizon Wireless with as many as 1.5 million handsets each during RIM's fiscal first quarter, which ended in May. That would represent a substantial 13% to 20% of the two carriers' handset sales, excluding free phones, in the period.

"RIM has little ability to dramatically improve its share at its two largest customers," Mr. McCourt wrote in a recent research note. He says that RIM's sales to Verizon and AT&T may have accounted for as much as 40% of RIM's revenue in its first quarter.

Another worry that doesn't appear to be in the stock price is competition in the smart-phone market from Apple and Nokia.

In theory, RIM, which declined to comment, could beat off competition with another doozy of a product like the Curve. But the next big product launch for RIM is the Bold, a device that works on the third-generation, or 3G, wireless technology. "I'm not sure the Bold drives new users; it drives upgrades," Mr. McCourt says. Indeed, a big risk is that instead of upgrading, consumers will grab a now-cheaper iPhone.

While the BlackBerry is a great product, it is hard to see why RIM should have a price-earnings ratio above Google's 27 times. RIM is ripe for a fall.

Saturday, June 21, 2008

Understanding 5-Year Rule for Roth Withdrawals

I am over 59½ and am planning to convert my traditional IRA to a Roth IRA over the next several years. Will each conversion start a new five-year clock? Will I have to track the investments each year so I can separate out the conversion amount from the earnings on each yearly conversion?

--John Low Meredith, N.H.
* * *

I have been considering converting a large portion of my regular IRA to a Roth IRA. All the contributions were pretax; I am 71 and have assets outside my IRA to pay the taxes.

Both my IRA custodian and IRS Publication 590 seem to indicate that I must wait five years for any tax-free withdrawal from the Roth IRA. But if I read your column correctly, I can withdraw principal at any time if I am over 59½, and only have to wait five years before taking out any income. Can you point me to any definitive articles or rules that can resolve this issue?

--Bert Mochel, Morrison, Colo.

Our recent answers to questions about Roth IRA contributions sparked a new round of questions about the so-called five-year rule -- the amount of time you generally must have a Roth individual retirement account open before you can withdraw earnings tax-free. Your age, and whether you're making an original contribution or are converting assets from a traditional IRA, affect the way it works.

In a nutshell, you can withdraw your original contributions to a Roth at any time with no tax or penalty. The five-year clock for earnings on regular contributions starts the year you open your first Roth IRA, and it doesn't reset each time you make a contribution or open another Roth, says Ed Slott, an IRA consultant in Rockville Centre, N.Y. (If you opened a Roth between Jan. 1 and April 15 of 2008, for example, as a 2007 account, the five-year clock would start Jan. 1, 2007.) You also have to turn 59½ years old to avoid a 10% penalty for early withdrawals on any earnings, along with income tax.

The five-year rule works a bit differently for assets you convert to a Roth IRA from other IRAs: You have to hold those assets in a Roth for five years or until you turn 59½, whichever comes first, to make penalty-free withdrawals of your converted amounts. Each conversion has its own five-year clock.

But if you've already reached age 59½ and you convert traditional IRA assets to a Roth, you can withdraw the assets you convert at any time without worrying about a five-year deadline or penalties. It's a different story with any earnings on those assets: Again, you have to have held a Roth account for five years to withdraw any earnings tax-free. But you don't need to worry about separating the converted funds from the earnings, since the withdrawal rules for Roth IRAs say that any distributions first come from contributions, then from conversions, and finally from earnings, Mr. Slott says.

What about the reader in the second question above? Again, withdrawals of converted Roth assets are always tax-free. To withdraw the earnings tax-free, you have to hold the Roth IRA for five years (and be at least 59½). The reader above, who is 71, simply has to have the Roth IRA open for five years to withdraw all the funds tax-free, Mr. Slott says.

One note: Since you are 71, you are required to take minimum distributions each year from your traditional IRA. Those distributions can't be converted to a Roth IRA. In the year you wish to convert, you must first withdraw your required distribution, and then you can convert any or all remaining funds to a Roth. Remember, to qualify for a Roth conversion, your modified adjusted gross income must be no more than $100,000 a year, either for an individual or married couple filing jointly. Starting in 2010, there are no income limits for Roth conversions. Neither your required minimum distributions nor the funds converted to the Roth would count toward that $100,000 income limit -- but they do still count as taxable income, says Mr. Slott.

IRS Publication 590 at is the most comprehensive source of information about IRAs. On page 65 -- in the section titled, "Are Distributions Taxable?" -- the first sentence indicates that distributions of contributions -- including converted amounts -- aren't taxable. The next section, "Additional Tax on Early Distributions," addresses the assessment of the 10% early distribution penalty -- and implies that you are able to withdraw converted amounts at any time, says Mr. Slott. And on page 67, the "Ordering Rules for Distributions" section spells out that contributions come out first, then converted amounts, then earnings.