Doral Financial (DRL), a company that most people haven’t heard of, could be causing a downward re-valuation of many financial stocks. Doral is essentially a Puerto Rican thrift which had it all – strong growth, a great story and a premium multiple. The company had been growing at 15%+ because of the strong Puerto Rican housing market as well as their presence in the rapidly growing US Hispanic market. At its peak it traded at 4x book. Then it all came crashing down. The stock blew up recently from a high of $45 to a low of $15 because the company invested in Interest Only (IO) strips which declined significantly in value. The company will now be forced to restate earnings and take a write-off of a significant amount of their capital. The Doral problem is causing high volatility in other financial stocks.
DRL reminds me of Orange County in 1994. Management bought a financial product that they didn’t understand because a "smart" investment bank told them it was a good way to get some extra yield. Doral essentially originated mortgages in Puerto Rico, securitized them and sold them. Then they invested the proceeds in Interest Only strips. When the IOs blew up because of the flattening yield curve in the fourth quarter of 2004, Doral management initially said they would take a small write-off. However, they didn’t realize how illiquid the securities were. When they went to sell them, the value of the IOs dropped even more. The upshot is that Doral will have to take about a $500mln write-off of their $1.9 billion in capital. Doral has been a relatively well-run small bank but management’s reactions to this crisis and the flip-flop on IO valuations in the space of one month suggest they didn’t understand the risks inherent in a major portion of their own business.
The problems at Doral have been linked to weakness in other financial institutions such as KRB – which missed earnings but declined a stunning 15% yesterday. However, I think the IO problem was an issue with the management at Doral, not a systemic issue in every financial institution. To the extent that other financial institutions invested in IOs, I think the valuations of the IOs could be affected because of the problems at Doral. No one wants to buy IOs right now until they make sure they understand them. That makes an extremely illiquid market, even more illiquid. I’m guessing values for the IO strips have plummeted. So if MBNA, Citi or any other institution invested in IOs, those strips are probably worth less right now.
Could other management teams not understand IOs like Doral’s management team? Probably. But I doubt that MBNA would be one of those managements. I’m guessing we’ll see more volatility from financial institutions that are invested in IOs and perhaps a couple of more blow ups. However, I can’t imagine that larger financial institutions made the same mistakes or are so heavily invested in IOs that it would have a material impact on their finances to the extent that it did to Doral.