Kyle Bass (Trades, Portfolio) is the founder and principal of Hayman Capital Management. He became well known after predicting the credit crisis of 2008 and profiting from credit default swaps and subprime mortgages.
Bass has recently been shorting a company called United Development Funding IV (UDF, Financial) because he believes it to be a Ponzi scheme. Thursday, the FBI raided the offices of United Development Funding indicating that the company has been under investigation for fraudulent activities. Shares of the company tumbled 54% as a result.
Hayman Capital Management has posted a slide deck on UDF IV that is helpful in understanding how a fundamental investor researches accounting red flags. The slide deck is titled “How UDF Management Has Not Recognized Realized Losses in a Public Affiliate.” Hayman discusses UDF IV but actually uses another company, United Mortgage Trust (UDMG, Financial), for an example. Below is a chart showing UDF’s business relationships. It should be noted that the chairman and CEO of UDF IV have ownership interests in UMT Services (box 1). If you follow the lines, you can see that UMT Services has an ownership interest in UDF IV (box 12) and an adviser relationship to United Mortgage Trust (box 7).
If we look at United Mortgage Trust’s most recent 10Q, we can see that its Balance Sheet has three notable line items that comprise ~85% of total assets. Those items are “Lines of credit receivable, related parties,” “Recourse obligations, related parties” and “Deficiency note, related parties.”
What stands out are the big dollar amounts of those line items and also the phrase “related parties.” For the “Lines of credit receivable, related parties,” we can see what comprises the balance in the table below; $71 million comes from UDF III which is box 10 in the first chart. In other words, the lending company has a relationship with a borrower who influences its lending policies.
From company 10Q
United Mortgage Trust explains, "Our portfolio includes obligations of affiliates of our adviser, which we refer to as ‘Recourse Obligations’ and ‘Deficiency Notes.’" The point is that this company is loaning lots of money to its advisers. For more color, here’s a key passage:
"The company has made loans in the normal course of business to related parties and nonrelated parties, the proceeds from which have been used to originate underlying loans that are pledged to the company as security for such obligations. When principal and interest on an underlying loan is due in full, at maturity or otherwise, the corresponding obligation owed by the originating company to the company is also due in full. If the borrower or the company foreclosed on property securing an underlying loan, or if the company foreclosed on property securing a purchased loan, and the proceeds from the sale were insufficient to pay the loan in full, the originating company had the option of (1) repaying the outstanding balance owed to the company associated with the underlying loan or purchased loan, as the case may be, or (2) delivering to the company an unsecured deficiency note in the amount of the deficiency."
To simplify, deficiency notes and recourse obligations are unsecured promises to repay or “IOUs.” What Hayman claims is that, when borrowers can’t repay United Mortgage Trust, the company has not recognized the loss on its income statement. Instead, it simply puts the loss on its balance sheet in the form of recourse obligations and deficiency notes.
Furthermore, Hayman points out that United Mortgage Trust charged “related party” borrowers much less than “nonrelated” borrowers on the deficiency notes. For the related parties, United Mortgage charged interest rates of 1.75% and 2.7%.
"Effective Jan. 1, 2015, UMT entered into a loan modification agreement ('Agreement') with UMTH in which the UMTHLC indebtedness is evidenced by two notes – Note 1 which bears interest at the rate of 1.75% and Note 2 which bears interest at the rate of 2.70%."
For the nonrelated parties, United Mortgage charged interest rates of 14%.
"As of Dec. 31, 2014, the company had two deficiency notes with nonrelated parties totaling approximately $3,258,000. One note in the amount of approximately $1,725,000 bears interest at a rate of 14% per annum."
To sum up, United Mortgage Trust is lending to businesses whose management advises them. It lends to these businesses at interest rates far below market value. In addition, it has not recognized losses from loans from these related businesses but instead keeps the losses on the Balance Sheet. Hayman claims the same dynamic is happening at United Development IV, the company it is shorting.
Final takeaways
Avoid companies where the explanation of material line items doesn’t make sense. Often times when management makes financial disclosures confusing, there’s a reason. United Mortgage Trust had unusual items on its balance sheet called “Deficiency Notes” and “Recourse Obligations.” Those terms sound technical and formal, but an investor who read the definitions and used common sense would have realized the red flags.
Question headline numbers. United Mortgage Trust has a Price-to-Book ratio of 0.15 which appears attractive at first glance. However without reading the financial statements, investors would not realize the company’s questionable accounting practices which inflate the book value.
There can be risks in complicated ownership structures. For instance, many energy MLPs have complicated structures where management owns and manages multiple entities that conduct business with one another. There may be times when one company gets overly favorable terms from another company owned by the same people. It would be a good idea for investors to check for potential conflicts of interest.
Footnote: Quotes are from United Mortgage Trust's September 30, 2015, 10Q
