Outside The Box

America First

           Subsidized housing projects were the bread and butter of E.F. Hutton’s tax shelter business. Under the programs in effect at that time, apartment developers could receive a 7 1/2% thirty-year mortgage from the government. In return, they had to make 20% of the units available to lower income tenants at reduced rates. There were other subsidies as well. These included faster tax write-offs for investors and rental assistance payments for tenants. HUD, the Department of Housing and Urban Development, administered all this.

           Participation in the program could theoretically be discontinued at any time, but the mortgage had to be prepaid. The story many developers told investors was this: “We’ll participate in the government program so long as you get special tax advantages. After 7 to 10 years, when the tax benefits are gone, we will refinance the mortgage and get out of the program. We will convert 100% of the units to market rate apartments, or we will sell off the apartment units as condominiums.”

           The Government made the mortgages. They were an asset of the U.S. Treasury. When Reagan came to power, his advisors were looking for ways to raise money. They decided to sell the mortgage assets. Something like $40 billion was to be sold at auction.

           Interest rates were 12% in 1984. For those unfamiliar with how discounted financial instruments work, suffice it to say that you would much prefer a long term receivable bearing 12% interest to one bearing 7 1/2%. So if you can get 12% anywhere, why would you buy something giving you 7 1/2%? You wouldn't, unless you didn’t have to pay 100¢ on the dollar. In fact, the 7 1/2% instrument will be discounted in the marketplace until the yield on the investment is 12%. The longer the term, the bigger the discount is.

           If interest rates remained at 12%, the mortgages would sell at auction for 75¢ to 79¢ on the dollar of remaining principal balance, depending on the remaining term. Now look what happens if a mortgage is refinanced. In a refinancing, the entire remaining principal balance must be paid off. So if a mortgage is paid off early, your return is increased. If it prepays in a year, you get 12% interest on your 75¢ investment plus $1.00 back at payoff.

           We had used Bob Wickman as a consultant on that due diligence investigation sparked by Forbes. HUD had identified Bob as the most frequently used consultant in subsidized housing. He lived in Omaha. He came to my office one day, and told me about the auction. He suggested we get a few investors together and bid on the mortgages on some of the more attractive properties. I thought, a few investors? How about a few thousand investors.

           Paul Bagley had told me E.F. Hutton was in the market for a first mortgage fund, and had given me the prospectus for one. I proposed participating in the auction instead. Wickman would be employed to identify which mortgages would prepay. Paul said he couldn’t support the idea because he and I were too close. But, he said, if I could convince the Marketing Department, he wouldn’t oppose it.

           With the help of others, I prepared reams of projections, detailing projected yields at all kinds of prepayment levels. E.F. Hutton’s Marketing Department approved the concept, and the idea for what would become known as the America First Federally Guaranteed Mortgage Fund was born.

           We needed someone qualified to act as General Partner of the Fund, and I approached numerous people, including a local banker named Mike Yanney. Yanney had the requisite hefty balance sheet plus proven business experience as Executive Vice President of Omaha National Bank. He had resigned from Omaha National and had engineered the acquisition of smaller banks.

           Yanney and his affiliates, E.F. Hutton and I owned America First Companies in approximately equal shares.

           The mortgages to be sold at auction were to be federally guaranteed. We knew that institutional investors wouldn't buy interests in a limited partnership, and we wanted a product that institutions could buy. We needed a rating, and believed that Standard & Poor’s would never rate a partnership interest. So I invented a new security called the Exchangeable Passthrough Certificate.

           The mortgages were placed into a trust, and all mortgage payments were made to the Trustee. The Passthrough Certificates were direct participations in the Trust. They did not run through the Partnership.

           Investors could freely exchange interests in the Partnership for Passthrough Certificates. The fees were the same and the interests were functionally equivalent. We worked with Standard & Poor’s, and they agreed to rate the Passthrough Certificates “AAA.”

           On the eve of the effective date with the SEC, I received a call from the  man at Standard & Poor’s. He said they were having trouble distinguishing the Passthrough Certificates from the Partnership interests. I thought, “Oh, no, they are going back on their agreement to rate us.” I told him there wasn’t any substantive difference between the two; it was just a matter of form. He said, “That was our conclusion, too. We think we could rate the Partnership interests if you would like us to.” And so, we became the first partnership ever rated.

           The Stanger Report was the principal advisory service for investors in partnership interests. We went to Bob Stanger’s office in Shrewsbury, New Jersey, and worked to structure our fees and compensation in such a way that we could receive an A rating (the highest). There were several ways we could tweak the offering. For example, a “fee” affected the rating adversely more than a “nonaccountable expense allowance”, but they amounted to the same thing.

           We went to market with an A rating from Stanger Report and an AAA rating from Standard & Poor’s. We had a Federal guarantee of principal and interest. We had a product that was easily understood by account executives. It was essentially the flipside of what they had been selling for years. All these factors combined with hard work and a good prospectus to create the most successful partnership offering in history.

           We got lucky. Interest rates started to fall. Reaganomics was working. Over a period of 18 months, interest rates fell from 12% to 8%.

           Now our mortgages were just 1/2 point below the market, compared to 4 1/2 when we began. Rather than being worth 75% of par they were worth 95% of par. What we had done was to catch a declining interest rate with a discounted security.

           We decided that there was no reason to wait. We liquidated the portfolio and ended up with a 15% internal rate of return in the hands of investors.

           America First organized the first investment limited partnership to acquire a financial institution. We raised $120,000,000 and bought Eureka Federal Savings & Loan Association. Eureka had 26 branches in the San Francisco Bay area. It had no business in or near Eureka, California.

           We put two Executive Vice Presidents from Bank of America in charge. One had been head of California branch operations for B of A and the other was head of mergers and acquisitions.

           Between 1987 and 1997, we focused on our core business, residential home mortgage lending. We opened new branches until we had a total of 46.  We also traded our existing branches with other institutions so that our network was better organized. We renamed  ourselves EurekaBank.

           FSLIC had given us Eureka in exchange for providing $100,000,000 in capital to the institution. The government did not receive anything for the purchase. EurekaBank was sold to Bay View Federal Savings & Loan at a $400,000,000 profit to investors.

    THE RETURN