11/01/2002 National Century Financial Services *

The stock market generally enjoyed another week of gains. For the week, the Dow gained about 1%, while the S&P500 and Transports ended only marginally higher. The Utilities gained 3%, and the Morgan Stanley Cyclical index added 1%. The “defensive” Morgan Stanley Consumer index actually dipped 1%. The broader market, however, was strong. The small cap Russell 2000 increased another 3% this week, while the S&P400 Mid-Cap index gained about 1%. With Microsoft lagging, the NASDAQ100 added 2%. The technology sector rally continues, with the Morgan Stanley High Tech index surging 6%. The Semiconductors gained 7%, The Street.com Internet index 3%, and the NASDAQ Telecommunications index 4%. The Biotechs were up about 1%. The financial stocks were mixed, with the Securities Broker/Dealer index about unchanged and the Banks up about 2%. With bullion up $5.30, the HUI Gold index jumped 6%.

With economic news going from bad to worse, the Treasury market now discounts a next week Fed rate cut. For the week, two-year Treasury yields sank 22 basis points to 1.77%, while the five-year yield dropped 17 basis points to 2.86%. The ten-year Treasury yield declined 9 basis points to 4.0%, while the long-bond saw its yield drop four basis points to 5.04%. Performing well, benchmark mortgage-back yields dropped 12 basis points, while implied yields on agency futures sank 17 basis points. The spread on Fannie’s 5 3/8% 2011 note narrowed 6 to 53, while the 10-year dollar swap spread narrowed 3.5 to 56. December three-month Eurodollar rates sank 19 basis points to 1.46%. Dropping almost 2% this week, the vulnerable dollar did not react favorably to the poor economic news.

November 1 – Bloomberg: “ING Groep NV, the largest Dutch financial-services company, said a lack of demand from investors prompted it to scrap plans to raise as much as 500 pounds ($780 million) through a bond sale.”

October 29 – Financial Times: “No sector, it seems, can escape the gloom infecting the US stock and bond markets this year, certainly not structured finance. Many investors had hoped that with trouble in the corporate bond market, the structured finance markets, where securities are backed by assets or structured into packages, would remain safe but in much of the market, that has not happened. There were an unprecedented 280 downgrades of US asset-backed securities in the third quarter – more than double the 132 of the second quarter… In all of 2001, there were only 245.

October 28 – American Banker: “Ask about the outlook for U.S. housing prices after five sizzling years of growth and lenders consistently reply that a bubble in overall values is not high on their list of concerns. But aim the question locally and the response changes a bit. Not so much in words, but in the action of bankers who are selectively tightening underwriting standards and building loan-loss reserves against increases in real estate loan delinquencies and defaults… Overheated markets include the San Francisco area and Silicon Valley, Las Vegas, Denver, Phoenix, Dallas, Atlanta, Washington, D.C, Boston and some parts of New York City… Keith Gumbinger, the vice president of HSH Associates, a Butler, N.J. , mortgage research and consulting firm, said the quiet but growing concern among lenders represents a turning point in the real estate debate: ‘It's just amazing how fast perception changes. As recently as a couple of weeks ago it was hard to get anybody to acknowledge that home prices might even be a problem.”

October 28: “Fitch Ratings downgrades the class A, class B, and class C notes…issued by Metris Master Trust. The actions affect approximately $4.2 billion of $8.8 billion credit card backed securities issued… The ratings actions primarily reflect persistent weakness and expected further deterioration… In September, gross chargeoffs reached 16.83%, compared to an average of 12.8% in 2001 and 11.18% in 2000.”

Today, subprime auto lender Union Acceptance filed for bankruptcy. The company has issued about $2.3 billion of asset-backed securities.

ABS player H&R Block saw its stock price drop today on reports of undisclosed major lawsuits.

This week from Philip Barach, President and CEO of (mortgage REIT) APEX Mortgage Capital: “Late in the 3rd quarter and into October interest rates dropped dramatically as investors feared the economy would enter into a recession. The 10-year U.S. Treasury note dropped to a yield approaching 3.5 percent, its lowest yield since the 1950s. In this environment, the actual anticipated level of mortgage prepayment rates soared to record heights as homeowners rushed to refinance their loans. This ratio of the mortgage (duration) index shortened to under one year, its shortest ever. Apex’s strategy is to purchase long-term mortgages, leverage them, fund them in a reverse repurchase agreement market, and hedge them with interest rate swaps and U.S. Treasuries. As interest rates fell, the duration of the mortgages in the portfolio kept on shortening, while the duration of the liabilities remained constant. In previous times of sharp interest rate declines, the spread on interest rate swaps generally widened, which would offset some of the duration shortening of the mortgages. However, this time swap spreads remained constant or even narrowed. Over the course of the quarter, the company took steps to realign assets and liabilities. We covered our Treasury shorts at losses, while we sold at gains shorter and higher coupon mortgages for longer, lower coupon mortgages that would afford more call protection. Because of the lag effect, the company knew that the maximum level of prepayments would ultimately hit the portfolio – would occur in the 4th quarter or even later. The attempt to protect the portfolio from prepayments in the 4th quarter, which can seriously impact the company’s free cash - and in an attempt to bring the duration of the portfolio's assets and liabilities closer - the company during October sold a substantial portion of its 6 ½ coupon pass-throughs and purchased 5 ½ coupon pass-throughs in their place. Shortly after completing this restructuring, interest rates reversed course and started increasing rapidly, and the duration of the mortgage index and portfolio started to extend, resulting in a decline in the company's capital base and further increase in leverage. The company decided that in this environment the prudent step was to bring leverage in line with historical levels of prior periods by selling assets. Seven hundred million of mortgage pass-throughs were sold, bringing the company’s holdings down to approximately $2.5 billion. The impact of this is the company will earn less on a go-forward basis starting this 4th quarter.”

Weekly bankruptcy filings were reported at 31,718, up 12% y-o-y. Ford October vehicles sales sank 31% y-o-y, with car sales down 34.2% and trucks down a notable 30.3%. GM sales sank 32%, with Chrysler down 31%. Ford and GM bond spreads widened again this week. Broad money supply increased $6.4 billion, with demand deposits up $2.6 billion and savings deposits up $4.2 billion. Retail money fund deposits increased $1.8 billion and institutional money fund deposits increased $2.8 billion, while large time deposits declined $4.4 billion. Repurchase agreements declined $5.4 billion, while Eurodollar deposits increased $5.4 billion. Total commercial paper borrowings dropped $11.8 billion, with financial sector borrowing down $13.9 billion. Bank Credit increased about $11 billion, with securities holdings up $21.4 billion offset by a $10 billion decline in “loans and leases.”

When it comes to appreciating the deep structural problems now afflicting the U.S. (global) financial system and economy, “Monetary Processes” is one of our treasured economic concepts. On one hand, imagine financial nirvana where stable and rather mundane capital markets finance sound and balanced capital investment, while the prudent local banker allocates limited lending capacity to those enterprises most likely to generate long-term positive cash flows. It’s not a bustling environment for the economy (or the speculator) and it is not immune to business cycles, but it is generally stable. Importantly, the quality of financial sector assets remains high, with the financial system sound and generally immune to the requisite intermittent (short and shallow) business downturns. On the other, we have today’s wildly unstable financial markets dominated by sector binge lending excess, interest rate and performance-chasing speculation. Credit and speculative excess beget additional excess and unpredictable (in the current case, elongated) boom and bust cycles. Over time the financial system has become hopelessly dysfunctional, as unlimited finance is directed to sectors providing financial returns (interest rate spreads available in mortgage and asset-backs, for example) rather than economic profits. Faulty Monetary Processes – how and where money and Credit are created and directed into the economy – become increasingly indelible, ensuring that the quality of the increasing quantity of new debt is poor, and deteriorating. It is only a matter of to what dimensions Credit and speculative excess is allowed to run, and to what degree it impacts the underlying economy.

While few are willing to recognize and admit the overarching problem, it really comes down to an unprecedented ballooning in non-productive debt throughout the system. Since the beginning of 1996 (26 quarters), total Credit market debt has increased $12 trillion, or 65%. From this total, financial sector debt has jumped 130% to $9.8 trillion. Non-financial Credit market borrowings are up 46%. To make matters worse, this Credit explosion has run concomitant with a shrinking manufacturing base. Sure, a community with an over- active Credit mechanism does afford the seductive opportunity to “profit” from giving each other back rubs and preparing each other meals (while importing all the goods desired from elsewhere). And the resulting financial “wealth” will likely be transferred to rising home prices and a self-reinforcing boom. But this mirage of prosperity only survives as long as additional money and Credit are forthcoming. At the end of the day, the backrubbers and cooks are left with a pile of financial claims and not a lot of economic value supporting them.

The problem is that there is too much debt of exceeding poor quality. It’s not a growth issue, and certainly not a case of insufficient money and Credit. It’s just too much wasted finance that should have never been created in the first place. It’s not so much a debt deflation, as it is a necessary revaluation. Yet, some would like to pronounce “deflation” as today’s major dilemma. If only we had more lending, we could continue to enjoy prosperity by giving each other backrubs and dabbling in fine dining. But as an economy we will have no choice but to cut way back on the dilly dallying and start producing things that we and our trading partners would like to consume. There will come a time when Keynesian-type policies will help temper the unavoidable distress of transitioning from backrubbers to producers. But until the current spell is broken and this necessary transition has commenced, such policies are a classic example of throwing “good money after bad.”

In his most recent Grant’s Interest Rate Observer, Jim provides an excellent definition of deflation: “Deflation is a comprehensive state of economic contraction characterized by falling prices and wages, shrinking credit, vanishing asset values, collapsing profits and declining GDP.” Yesterday’s GDP number and today’s 0.4% (almost 5% annualized) rise in personal income provide additional evidence that deflation is not today’s problem (confirming Jim Grant's view!). It is Jim’s view that, going forward, “the Fed will be willing and able to facilitate the work of creating not just enough credit, but an excessive and inflationary increment besides.” Here, the jury remains very much out.

The problem going forward will be the difficulty (impossibility?) for the impaired U.S. Credit system to generate sufficient monetary stimulus to sustain the maladjusted economy. The nineties boom was fueled largely by non-bank Credit creation – much of it marketable securities – outside of the control of the Federal Reserve. Indeed, while total Credit market debt increased $12 trillion over the past 26 quarters, Federal Reserve assets increased about $240 billion. It’s the big “trillions” number of new Credit that matters more than the “little” billions of Fed balance sheet expansion.

This week, despite mounting financial pressures, the market was assured that Sears retains “unfettered access to the ABS market.” Similar assurances have been given for Ford and others. This only solidifies our view that there is today much riding on the soundness and continued liquidity of the asset-backed securities marketplace.

With this in mind, we were intrigued by an announcement from Moody’s late last Friday: “Moody’s investor Service downgraded 19 classes of securities ($3.35 billion) issued by NPF XII and 7 classes of securities issued by NPF VI. Additionally, the securities remain on review for possible downgrade. NPF XII and NPF VI are subsidiaries of National Century Financial Enterprises (NCFE) and are bankruptcy-remote corporations that issue notes backed by healthcare receivables… Accordingly, this rating action reflects Moody’s concern about NCFE’s financial stability, its ongoing ability to service the receivables and its role in directing transaction cash flows for NPF XII and NPF VI. The unique forms of dilution and credit risks associated with healthcare receivables necessitate a transaction structure and servicing that insulate the investor from these risks.”

From Dow Jones’ David Feldheim: “No ratings Rx appears in sight for National Century Financial Enterprises (NCFE) amid concerns about revenue streams backing some of its securitizations. In the 11-plus years since its inception, NCFE has become the largest financier of healthcare receivables, according to its spokesman Jim Nickell. Over this period NCFE has securitized in excess of $6 billion of healthcare receivables, and it has bought substantially more than that from providers. It has also drawn recent scrutiny from the ratings agencies who rate those securitizations. Fitch Ratings said over the weekend that it has been informed by interested parties that NCFE directed the trustee to reroute certain funds intended for the NPF XII reserve accounts in order to fund the purchase of new receivables. ‘The company's apparent willingness to disregard the documents and commit such a serious breach, causes Fitch to question NCFE’s viability.’”

A Bloomberg piece (Elizabeth Stanton) quoted a Fitch managing director: “We normally have information where we can peg a rating. At this point, we lack sufficient information to say what the ratings could be lowered to.” (Fitch downgraded these issues this summer) A Moody’s analyst stated, “If National Century is experiencing liquidity problems, then so will the hospitals. That’s why we took action on both trusts. National Century’s financial stability is crucial for continuing to fund the hospitals.”

And then from the October 28th issue of Forbes (Seth Lubove): “As a financier of last resort to the health care industry, National Century Financial Enterprises has made its owners rich, but not without controversy. The bucolic burg of Dublin, Ohio is headquarters for Wendy’s International, the hamburger chain, and for another firm, less well known but far more controversial: National Century Financial Enterprises. This 11-year-old outfit has become the nation’s largest purchaser of hospital, physician and other health care receivables. NCFE buys the paper, then pools and sells it in the form of asset-backed securities to institutional investors. NCFE boasts of purchasing $15 billion in receivables since its founding, and, with help from Credit Suisse First Boston, securitizing $6 billion of them on Wall Street. The bonds end up in the portfolios of the esteemed Pimco funds, Fremont Mutual Funds and UBS PaineWebber's fund family, among other places.”

Yesterday’s Washington post quoted from a memo written by a CFO of a local hospital organization: “For a period of time, the hospital has not received the funding to which it believes it was entitled under the NCFE program. This has inhibited the hospital’s ability to make regular payments to its creditors. (The Downgrade) has further impacted its [NCFE’s] ability to fund the hospital.” Also from the article: “The memo said the hospital would now ask payers, such as health insurers and the federal government Medicare and Medicaid programs, to pay it directly.” This type of talk is not what ABS holders want to hear.

Considering the mounting problems in the ABS marketplace (NextCard, Metris, Conseco, Household, Capital One, etc.), I wanted to learn more. The ABS marketplace is certainly vulnerable to fraud. Could NCFE and healthcare receivables be one more body blow to the vulnerable ABS marketplace? While I am not today sure of how important all of this is, I can say that that this has a very bad smell to it. It is certainly intriguing.

As background, National Century Financial was founded in 1991. With the other two original founders gone, the company is run by Lance Poulsen. This story has lots of “subplots.”

There’s a company by the name of PhyAmerica Physician Group – formerly Coastal Healthcare Group (CCHC) – that was delisted from the NYSE in early 1999. This company has been run by Steven Scott, who earlier this year took the company private with the stock basically worthless. Coastal Healthcare was a Wall Street darling after coming public in 1991. For some time, CCHC has received funding from NCFE. From the Company’s September 30, 2001 financials: “The company’s primary financing source consists of 3 accounts receivable sale programs with affiliates of National Century Financial Enterprises… the company received $74 million related to billed receivables and approximately $187 million related to future receivables... Including the new agreements, the purchase commitment has been increased to $295 million on these facilities, there is approximately $34 million of remaining availability… Under a separate loan and security agreement, an affiliate of NCFE has agreed to provide the Company a revolving line of credit of up to $20 million… For the foreseeable future, to continue as a going concern, the Company will depend upon NCFE to fund its working capital needs…”

PhyAmerica is lucky to have such generous friends. Financial statements had an accumulated deficit of $350 million, with assets (excluding $12 million of goodwill) of $62 million. It appears virtually all of the almost $250 million of liabilities are owed to NCFE.

From The Record (Bergen County NJ), January 2002 – Mary Jo Layton: “In 1999, the company borrowed $69 million to purchase Sterling Healthcare Group and changed its name to PhyAmerica to distance itself from its turbulent past… The next year, the shareholders filed suit, alleging that Scott and National Century Financial Enterprises -- the company that has been providing millions to keep PhyAmerica afloat -- were actually draining it. They alleged that Scott and Lance K. Poulsen, National Century’s president, had an agreement: Poulsen would fund Scott’s spending while Scott ‘looks the other way while Poulsen improperly diverts the company’s cash into NCFE’s coffers.’ Even as the company’s finances deteriorated, PhyAmerica bought one corporate jet for $6.6 million and leased another for $848,000 -- expenses that benefited Scott because he owned the aviation company that provided the jets, shareholders said.” Also from the article: “There was a report on ‘60 Minutes’ accusing…Dr. Steven Scott, of hiring doctors who had been disciplined or sued for malpractice.”

From Executive Intelligence Review 3/16/2001 (Anton Chaitkin and Edward Spannaus): “In North Carolina, a class-action Federal racketeering (RICO) suit was filed by shareholders of the PhyAmerica Physician Group… The suit charges NCFE and its CEO Lance Poulsen with ‘a pattern of racketeering,’ filing false reports with the Securities and Exchange Commission, and diverting millions from the health-care company, while conspiring with PhyAmerica’s chief executive to bail him out of failure by letting him steal millions.”

Sterling Healthcare Group has an interesting history. It was a fledgling company until it was merged with Frost Hanna Halpryn Capital Group, “a publicly held corporation formed in 1992 to effect a business combination with an operating entity” – a shell company. (Apparently, partner Richard Frost went into the shell company business, along with fellow stockbroker Halpryn, with the encouragement of his uncle, Ivax chairman Phillip Frost). Investors hit pay dirt four years later in 1996 when FPA Medical Management (originally FPA Capital Group) acquired Sterling Healthcare Group in a $200 million stock and debt transaction. FPA was a small physician group before being brought pubic in June 1994. Although it was a hot stock through 1997, FPA filed for bankruptcy (“amid allegations that it had overstated earnings”) and was delisted in 1998. Steven Scott’s Coastal Physician Group, with financing provided by Poulsen’s NCFE, acquired Sterling from FPA for $69.3 million during 1999. It is interesting that Coastal had any borrowing power at all after suffering combined operating losses of $240 million from 1996 through 1998 (and negative book value!). Other FPA assets were purchased by a separate Scott entity, Stoneybrook Capital.

NCFE has also provided significant financing to Med Diversified. The company had changed its name from e-medsoft earlier this year and from Medtech in 1999. The stock was delisted from the AMEX in July, after jumping from about $5 to $25 during 2000. NCFE’s Poulsen is the largest holder with about 12 million shares. From Med’s 10Q: “The company has certain financing agreements with National Premier Financial Services, Inc., and other subsidiaries of National Century Financial enterprises… At December 31, 2001, the unpaid balance was approximately $107 million…” Between 3/31/01 and 12/31/01, accounts receivable increased from $9 million to $94 million, while “related party debt” (to NCFE) jumped from $3 million to almost $110 million. Med Diversified reported a net loss of $26 million during the quarter and a $341 million loss over the previous four quarters. “The company has consistently had negative working capital from continuing operations, including approximately $151.7 million at December 31, 2001… On December 5, 2001, we pledged and assigned to NPF X, Inc. 3.0 million shares of our common stock…” Med Diversified ended 2001 with an “accumulated deficit” of $399 million.

NCFE also has close ties to controversial Doctor’s Community Healthcare (DCHC), with allegations that DCHC is a “front company for NCFE.” They, together with NCFE, have been accused of “racketeering” and “looting” hospitals. From the Executive Intelligence Review (EIR): “The Stench of corruption cannot be hidden, in the attempt to shut down the top-flight District of Columbia General Hospital. By the evidence given in lawsuits filed by hospitals and other of its victims, the group trying to take over and shut down the capital’s only public hospital, has amassed a fortune stolen from health-care institutions through classic gangster methods of embezzlement and fraud, under cover of money-lending… Behind the D.C. General takeover and shutdown is the National Century Financial Enterprises, which is part owner, financier, and operations partner of the hospital-management company, Doctors Community Healthcare…” DC Watch published a piece in February 2001, “The Case Against Contracting With Doctor's Community Healthcare Corporation, stating DCHC “is deeply in debt and unprofitable” and has suffered “steep annual losses for the last three years.” DCHC was founded back in 1991 by Paul Tuft, with NCFE financing many of its acquisitions. Also in an EIR report related to the DC controversy: “In response to citizen protests against turning over three of Washington’s hospitals to these outfits charged with wholesale looting, the District of Columbia Financial Control Board tells the news media that they have ‘checked out DCHC and Wall Street gives them an excellent rating.”

Curiously, there have been allegations of improprieties for some time. From The Columbia Dispatch, May 26, 2000: “A major credit-rating agency has launched an investigation into the operations of Dublin-based National Century Financial Enterprises after receiving three anonymous letters alleging fraudulent activity at the company.” About this time the relationship between NCFE and one of its investment bankers, Deutsche Bank, was terminated. From the Asset Sales Report: “While Moody’s was concerned about the allegations against the company contained in a series of anonymous letters that surfaced this past May, the rating agency’s own investigation and trust of the company gave it confidence to go ahead and rate the current deal.” A Moody’s analyst was quoted: “We require complete disclosure from the company vis-à-vis the allegations of fraud, and we felt that what they offered us was very forthright and plausible.” It was the first NCFE deal rated by Moody’s, a rating that came at an especially critical time.

The March 12, 2001 Asset Sales Report “Whispers” column is quite interesting: “National Century Financial Enterprises has a $300 million health receivables-backed ABS on track to issue by the end of March, ABS sources said. The receivables for the two-year FRN are currently warehoused in Credit Suisse First Boston’s Alpine ABCP (asset-backed commercial paper) conduit.

Now this brings frightening thoughts to mind. With NCFE having lost access to the markets, could the company’s receivables today be “warehoused” in funding corps that are owned by money market funds? Well, well, well. As I wrote above, this thing has a foul smell to it. While we have no way of knowing its scope, there are surly problems with NCFE’s asset-backed securities and its privately issued debt. There are clearly many entities involved, and at the minimum we will see a number of hospitals and healthcare providers with liquidity problems. This, then, could become an issue for those that have insured hospital debt issues. If this does become a funding corp/”conduit” issue, there could be problems associated with insuring these vehicles or providing liquidity guarantees. One way or the other, there appears to be a lot of bad paper out there somewhere.

And we’ll have to wait and see how this shakes out in the ABS market. How on earth an entity such as NCFE comes to be an issuer of billions of ABS is quite troubling, and does bring the issue of the integrity of the marketplace into question. We certainly don’t see this as good for already weakened confidence, and may even incite one more jump toward heightened risk aversion and demands for transparency. There are lots of loans that should never be securitized, and perhaps going forward investors will not be so willing to take Wall Street's and Moody’s word that it’s all triple-A caliber. The Credit noose is tightening. Getting back to the “deflation” discussion: If the ABS market and “structured finance” falter, the probabilities of a true deflationary environment rise considerably. But then there’s the nagging issue of a faltering dollar…

In the meantime, things get even more intriguing with the Salt Lake City Deseret News reporting (Cox News Service) that Gov. Jeb Bush in September flew to Melbourne on a National Century Financial jet.