Boring Sells GNT
January 28, 1998

Bore Portfolio Selling 200 shares of Green Tree Financial

When the Boring Portfolio invested in Green Tree Financial <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: GNT)") else Response.Write("(NYSE: GNT)") end if %> two years ago, the company was almost entirely in the business of financing consumers' purchases of manufactured homes (MH) and, to a lesser degree, servicing MH retailers' needs with "floor plan" financing. Green Tree also provided financing for purchases of other fairly large-ticket items -- everything from horse trailers to pianos.

As growth slowed somewhat in these niches that Green Tree dominated, the company moved rapidly into new business lines -- ones that were highly competitive -- such as home equity and home improvement loans and, to a smaller degree, credit card issuance. A $190 million charge taken in the fourth quarter of 1997 together with a surprising restatement of 1996 results reducing earnings for that year by $200 million (pre-tax) reveal (to me, at least) that Green Tree's internal financial systems and accounting procedures were not up to the task of managing such rapid growth responsibly.

SOME REASONS NOT TO SELL

A number of moves that Green Tree has just announced constitute important steps in the right direction. In particular, the company has increased its assumptions about loan prepayment speeds to reflect the environment of low interest rates and cut-throat competition in which it operates. Green Tree also recognizes now that it needs to beef up its board of directors; a more independent and well-qualified board might have helped guide the company more effectively through its period of rapid diversification.

One can also argue plausibly (as I have myself) that the company's stock price has been hammered down to the point where it more than reflects all the recent bad news. At current prices and in light of the company's leading position in the MH finance market, Green Tree could present a target of opportunity in the rapidly consolidating financial industry.

MY REASONS FOR SELLING

That said, two indisputable facts, plus two arguable reasons, lead me to the decision that the Borefolio should cash in its investment in Green Tree. Before detailing those points, however, I want to make clear that the purpose of this report is not to recommend that anyone else sell their Green Tree stock. For that matter, I'm not claiming that Green Tree is necessarily a bad investment. To the contrary, for risk-tolerant investors who salivate over broken-down stocks with significant potential upside, Green Tree could be made to order.

For a Boring Portfolio that is intended to provide reasonable growth without gut-wrenching volatility and that aims to invest in companies whose operations and financial statements are comprehensible to a reasonably diligent individual investor, however, Green Tree doesn't fill the bill.

If it's taken me longer than your average Joe to figure that out, all I can say is that it wasn't for a lack of effort. Indeed, that's part of the problem. When an investment takes as much effort as this one has to figure out, it probably means that either the company is not providing all the information you need, that the business is inherently complex, or both. In Green Tree's case, I think it's some of both -- or at least it has been.

GAIN-ON-SALE ACCOUNTING. The first indisputable fact is that companies such as Green Tree that employ gain-on-sale accounting are inherently difficult to understand and are liable to take some major lumps when notoriously unforecastable factors -- such as interest rates, prepayment speeds, and delinquency rates -- move contrary to the company's expectations.

SUSPECT SYSTEMS. The second indisputable fact is that Green Tree's accounting systems have not been up to the task for some time now. Green Tree earlier admitted that their systems incorrectly booked refinanced loans as new loans, with new ID numbers. Yesterday they blamed the $200 million reduction of 1996 earnings on their failure to capture the financial consequences of partial prepayments (i.e., customers who make payments above the amount due in order to pay off their loans faster). Forgive me, but to this nonexpert these matters do not appear to be ones that should be beyond the capacity of an S&P 500 specialty finance company to comprehend. Green Tree claims that they now have their arms around the problem and that this is the "last" writedown of this magnitude that they'll have to make. But then they said that in November, and they were wrong then.

STILL VULNERABLE? Third -- and I may turn out wrong on this -- I've concluded that Green Tree remains vulnerable to additional problems down the road. In particular, the charges and writedowns may take care of problems associated with loans booked in 1996 and earlier, and the increased prepayment speed assumptions may safeguard business booked in 1998; but at least one analyst who has been dead on throughout this ordeal, Steven Eisman of CIBC Oppenheimer, sees the same possible pitfall that even I see: namely, the 1997 business. Green Tree insists that its MH loans made in 1997 are prepaying at speeds substantially below the assumptions they are using with respect to their 1998 loans. Eisman has provided data he claims disputes that. So far, Eisman's been right and Green Tree's been wrong. I take no pleasure in saying that, believe me.

CREDIT DOWNGRADES? Finally, I'm concerned that credit rating agencies will downgrade Green Tree to the point where its costs of funding make it difficult for the company to achieve even the $2.50 per share in earnings it expects to make this year.

A PERSONAL NOTE. One other thing, entirely personal: I'm uncomfortable with the odor of the home equity loan business. Green Tree is probably the cream of the crop in this business, but in general it's not a business that suits me. As I say, this is entirely a matter of personal taste. Your mileage may vary. If there's a larger point here, it's that with perhaps 7000 stocks to invest in, you might as well like the stuff you buy.

BOTTOM LINE. I've lost confidence in Green Tree's management and their financial projections. When that happens, I bail -- regardless of how much of a "bargain" the stock may appear to other folks.