J.G. Wentworth IPO: Down the Pre-Crisis Rabbit Hole

NEW YORK (TheStreet) -- Gone are mortgage originators like New Century Financial, Countrywide Financial and HSBC's  (HBCHousehold International, but stock investors dreaming of the good old days of originate-to-distribute finance can rejoice: J.G. Wentworth's parent company, JGWPT Holdings, is preparing for an initial public offering of up to $268.4 million.

J.G. Wentworth of Radnor, Pa., buys structured legal settlements, lottery winnings and annuities owed to consumers, that are to be paid out by highly rated counterparties, and sells them to debt investors through asset-backed securitizations. The company relies on $600 million in warehouse credit facilities to finance its acquisition of assets and upon securitization markets to unload them.

While the company doesn't take on big credit risks -- a contrast to mortgage departments at the epicenter of the housing bust -- its use of a leveraged balance sheet to acquire hard-to-value assets and its reliance on securitization markets for sales is similar to the originate-to-distribute lending model that permeated the U.S. housing market prior to the crisis. That type of business simply captures a spread from the process of creating and then selling an asset.

In that sense, J.G. Wentworth's IPO provides a rare glimpse into the types of financial structures that existed prior to the collapse of firms like New Century, Lehman Brothers and Bear Stearns.

One would assume that in the wake of the crisis, investors would shun such deals. But J.G. Wentworth will give those who continue believe in the cash-generating and the seemingly low-risk mechanics of originate-to-distribute businesses another opportunity to invest.

Earlier in October, Springleaf Financial (LEAF), a subprime consumer lender backed by private equity firm Fortress Investment Group (FIG), conducted a similar IPO.

It should be no surprise that both listings come at a moment when some on Wall Street are questioning whether the Federal Reserve's loose monetary policies are causing investors to chase the riskiest deals seen since the financial crisis.

How It Works

According to J.G. Wentworth's IPO documents, the company derives its earnings from the spread between the discount rates it uses to acquire assets and those implied in its securitizations. The company also takes residual interests in the subordinated tranches of the securities it sells.

"We act as an intermediary that identifies, underwrites and purchases individual payment streams from our customers, aggregates those payment streams and then finances them in the institutional market at discount rates below our cost to purchase," J.G. Wentworth says in its S-1 filing with the Securities and Exchange Commission.

The company believes those earnings streams are sustainable because it operates at an industry-leading scale and in a niche market that provides real services for those seeking cash on assets that pay out over an extended period.

During recent years, J.G. Wentworth has recovered from a 2009 bankruptcy and reported growth in its revenue and net income. On a pro-forma basis to include acquisitions and changes that will take place after its IPO, J.G. Wentworth turned from a moderate net loss to a $106.6 million profit in 2012, as revenue rose sharply. Those profits and revenue have trended higher in the first six months of 2013, albeit at a slower pace.

J.G. Wentworth's cash flow is even more impressive. The company generated $314.8 million in cash from its financing activities in 2012, up significantly from 2011 levels.

The company's J.G. Wentworth and Peachtree brands also carry high ratings with The Better Business Bureau

Leverage and Liquidity

The notion of building a business to help individuals cash out on their settlements or lottery winnings has an economic rationale. In fact, the firm's asset-backed securities are generally given Aaa ratings and have posted loss rates below 1%, a far lower level of losses than most mortage-backed securities.

While few investors appear worried about the quality of payment streams that J.G. Wentworth buys and sells, the manner in which it does so creates a host of risks for the company's prospective shareholders.

If J.G. Wentworth's warehouse credit lines or the securitization markets it relies on to unload assets were dry up, the company could find itself in a liquidity crisis, as its S-1 filing makes clear. The company went bankrupt during the 2009 credit crunch when its committed credit evaporated and securitization markets stalled.

"[Our] results in 2008 and 2009 were impacted by the financial crisis, which resulted in a lack of purchasers of our asset-backed securitizations and a resultant lack of capital availability from our warehouse facilities. We were forced to limit transaction volume without access to the securitization market and with limited warehouse capacity. We significantly scaled back new transactions, resulting in insufficient cash flow relative to our leverage," the company states in its S-1.

Sound familiar?

Since emerging from bankruptcy, J.G. Wentworth has increased and diversified its warehouse financing capacity, a positive development according to ratings agency Moody's.

Still, the firm's business model hasn't really changed.

"The pressures on the legacy companies' ability to originate assets and access liquidity during the interruption in securitization markets in 2008-2009 highlight the risks embedded in JGW's funding structure," Moody's said in August.

Liquidity isn't the only risk J.G. Wentworth faces in its financial arrangements.

When it comes to leverage, J.G. Wentworth's private equity owner JLL Partners doubled down after firm's bankruptcy emergence.

In a January leveraged recapitalization, the company took out a $425 million term loan that paid its private equity owners $309 million in dividends. Moody's (MCO) rated the deal "Caa1," a deeply non-investment grade rating and characterized the company's financial management as "aggressive" and with "high cash flow leverage."

In May, J.G. Wentworth increased the term loan by $150 million to pay out additional dividends to its PE-owners.

The company expects to have $421.3 million in total debt outstanding, including the IPO proceeds, which are expected to allow the company to repay $151.9 million in debt and give the company a further $29.2 million for general corporate purposes. Current investors will be paid $47.0 million through the offering; however, JLL Partners will remain a majority holder, owning roughly 56% of the company's outstanding shares.

Discount Rates and Paper Earnings

J.G. Wentworth's earnings, meanwhile, are derived from an opaque spread that it generates in buying individual settlements and selling them as a bundle, in addition to quarterly marks the company takes on investments it makes in the subordinated tranches of the asset-backed securities it sells.

The marks J.G. Wentworth takes on its earning assets are based on discount rates the company uses to value its settlement assets and financing liabilities. Most of those assets and liabilities are held in variable interest entities (VIE's) and are characterized as Level 3 -- those whose value is unobservable and reflect the company's own assumptions.

As of 2012, J.G. Wentworth carried $3.61 billion in residual VIE assets at a discount rate of 3.99% and $3.23 billion in liabilities at a discount rate of 3.43%, according to its S-1. Changes to those discount rates and VIE asset and liability balances are a significant piece of J.G. Wentworth's overall earnings and cash flow.

"Our ability to monetize our structured settlement, annuity, and lottery payment stream purchases and pre-settlement funding depends on our ability to obtain temporary and/or permanent financing at attractive rates, especially relative to our purchase discount rate," J.G. Wentworth states.

"If the cost of our financing increases relative to the discount rate at which we are able to purchase assets, our profits will decline," the company notes, highlighting rising interest rates or its own corporate credit spreads as key sensitivities of its discount rates.

As of June 30, J.G. Wentworth would post a near $50 million loss were interest rates to rise 1%, according to a pro forma sensitivity analysis appended to its S-1. Most of the impact would come from negative fair value marks to its residual interests. Unfortunately, the company has financed the acquisition of those residuals, ultimately leveraging a crucial element of its earnings and cash flow.

A balance sheet loaded with Level 3 assets and significant long-term debt doesn't just pose a risk to J.G. Wentworth's earnings. It also is an issue of solvency.

Since J.G. Wentworth's asset and liability values and consequently its equity are derived largely from the discount rates that the company uses, investors have few tangible assurances that the company will be able to pull though a market disruption.

Were the company to be forced to sell its settlement or lottery assets on the open market, there is no guarantee that proceeds would match carrying values on its balance sheet. J.G. Wentworth's $421 million in pro-forma debt, its warehouse credit facilities and its interest rate swap contracts, however, represent real financial commitments.

"If we are required to sell our residuals to pay down debt or to otherwise generate cash for operations, we may not be able to generate proceeds that reflect the value of those residuals on our books or that are sufficient to repay the related indebtedness. In addition, a sale of the residuals under those circumstances would likely generate taxable income without sufficient cash to pay those taxes," J.G. Wentworth states.

"[The] esoteric nature and illiquidity of JGW's financial assets may impact time to sell and pricing if the Company needs to sell assets to cure or prevent debt covenant breaches. Moreover, the Company's assets are encumbered and its cash flows are highly leveraged, with the vast majority of cash flows utilized to support securitization structures' debt servicing requirements, further restricting its operating and financial flexibility," Moody's said in its August ratings report.

Rising Interest Rates, Falling Profits

While J.G. Wentworth has reported rising profits through the first two quarters of 2013, it said in a recent amendment to its S-1 that a third-quarter rise in interest rates and increasing debt burdens have provisionally turned the company toward a loss.

J.G. Wentworth estimates it will book between $92 million and $98 million in revenue for the third quarter, a drop of over 14% from a year earlier, which could lead to a net loss for the quarter. That loss would largely be attributable rising interest rates and the impact such market movements have on the company's discount-rate-based earnings.

"The estimated decline in quarterly revenue is due primarily to decreases in unrealized gains on VIE and other finance receivables, long term securitization debt and derivatives as a result of an increased interest rate environment, as well as realized and unrealized gains (losses) on marketable securities, net," J.G. Wentworth said.

Cash flows derived from J.G. Wentworth's financing activities also appear to be slowing through the first six months of 2013.

Given an expected rise in interest rates as the Federal Reserve begins to taper its easy monetary policies, J.G. Wentworth's slowing earnings are a troubling sign.

Reasons To Be Wary

JLL Partners' capital infusion in J.G. Wentworth during its bankruptcy appears to have been a very canny investment.

The PE-firm has already used debt-financed dividends to more than double its initial investment and it will continue to hold a majority investment after J.G. Wentworth's IPO.

If JLL Partners can raise additional equity to pay down the debts J.G. Wentworth took on, it will have been a smartly calibrated use of debt and equity markets during the Fed's recent spat of bond buying.

Five years after the financial crisis, demand for J.G. Wentworth's IPO could also signal that there are stock investors out there who are willing to put their money in financial services firms that contain many of the risks exposed during the mortgage meltdown.

This deal may stand out as a referendum on the impact of the Fed's loose monetary policies. In an effort to reflate the U.S. economy in the wake of the Great Recession, the Fed may have created conditions in the stock and debt markets that created the crisis in the first place.

J.G. Wentworth will list on the York Stock Exchange with a ticker of "JGW."

-- Written by Antoine Gara in New York

Follow @antoinegara

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