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New York Times, November 18, 2007 column


The New York Times




November 12, 2007


Fair Game

Creative Loans, Creative Compensation

THINGS aren’t going very swimmingly for investors in NovaStar Financial, a subprime mortgage originator in Kansas City, Mo. Its stock plummeted last week on news that the company lost $64.05 a share in the third quarter, that it had canceled its preferred stock dividend and that it was no longer able to reap the tax advantages of a real estate investment trust status.

The stock ended the week at $1.72, down from $40 in June.

Equally troubled are many holders of NovaStar mortgages. As of Sept. 30, some 6 percent of the company’s loans held in its own portfolio were at least 30 days delinquent. And 5 percent were in foreclosure.

Happily, though, there is one NovaStar constituency that is doing just fine — the one that consists of its top executives and co-founders. Over the years, they have pocketed millions in compensation, based largely upon loans that probably should never have been made.

NovaStar, one of the nation’s top 20 mortgage concerns, was about as freewheeling a lender as there was during the recent boom. “Did You Know NovaStar Offers to Completely Ignore Consumer Credit!” screamed a flier sent by NovaStar to brokers in 2003.

Indeed, by 2006, the combined loan-to-value ratio on the company’s mortgages was 87 percent, up from 81 percent in 1998. And last year, almost 53 percent of its mortgages had not required documentation of a borrower’s income, up from 35 percent in 1998, according to the company.

Then there was the NovaStar branch office system that was too busy generating loans to bother applying for the pesky licenses that some states required. Tiresome regulators — didn’t they know that NovaStar’s entrepreneurs had a company to run?

Alas, the NovaStar party ended this year, for its shareholders, anyhow. Its executives, however, are somewhat better off.

Consider last year’s pay for NovaStar’s creators, Scott F. Hartman, the chief executive, and W. Lance Anderson, the president. Both earned $1.7 million in salary, bonus, stock grants and other compensation in 2006. This followed $1.6 million that each earned in 2005 and $1.7 million each took home in 2004.

Wait, there’s more. Check out what awaits Mr. Hartman and Mr. Anderson in their deferred-compensation accounts. As of the 2007 proxy, Mr. Hartman’s deferred compensation totaled $9.9 million, while Mr. Anderson’s came in at $5.8 million.

And my how the numbers grow. In 2006 alone, Mr. Hartman’s deferred-compensation account generated $1.4 million — more than he earned in salary and bonus combined. Mr. Anderson’s account earned $711,386 last year. Sweet.

But NovaStar, known for creativity in its lending practices, also came up with a novel element of executive pay: cash dividends were accrued and paid to top executives on their stock option grants.

Got that? Even though the executives did not yet own the underlying shares, they received cash dividends on them.

Dividends are commonly paid to executives who receive restricted stock, but dividends on options? Brian Foley, an expert in executive pay who runs his own firm in White Plains, called the practice nonsense.

“If you want to pay the dividend it should not be payable until and unless the option vests and is exercised,” he said.

GIVEN that NovaStar was a real estate investment trust and required to pay out all of its so-called REIT income to shareholders, these dividends were substantial. According to the company’s 2006 annual report, some $2.2 million was taken out of shareholders’ equity to cover the dividends, known as dividend equivalent rights. And in 2005, shareholders’ equity was docked $4.1 million to cover the dividends.

Mr. Foley said the cash dividends mean that even though NovaStar executives will probably never be able to exercise those options because the stock has fallen, they have still banked some serious cash.

Interestingly, in previous years NovaStar paid its dividend equivalent rights in its own stock, not cash. It had also required that the options be exercised before the dividends were paid.

All that changed on Jan. 1, 2005. On that date, the company set up cash payments that began accruing the moment the options were granted to its executives. And the bosses were paid when the options vested, even if the executives never exchanged them for underlying shares.

Dick Johnson, a NovaStar spokesman, said that neither Mr. Hartman nor Mr. Anderson was available for an interview. When I asked whether either executive planned to return any of his recent pay to the company’s shareholders, given the company’s difficulties, Mr. Johnson said such an action had not been discussed.

He did say that both founders held considerable amounts of NovaStar stock and that their deferred-compensation accounts contained company shares, although he would not say how much. The result, Mr. Johnson said, is that both men are experiencing pain alongside their shareholders.

In a statement, Mr. Anderson said: “Obviously we are in a very difficult time in an industry that has basically imploded. Like everyone else who has been reporting large losses recently we are fighting through a difficult situation and doing the best we can.”

Indeed, it is a testament to the power of positive thinking that shares of NovaStar stayed afloat as long as they did. One reason for that performance was the company’s enormous following of small investors in love with its big REIT payouts. NovaStar was also a favorite in online chat rooms, and its defenders in those forums maintained almost to the end that a turnaround was nigh.

NovaStar was also routinely called a takeover target. Even as recently as this past summer, buyout rumors helped keep the stock buoyant.

NovaStar also enjoyed the backing of some big, savvy institutional investors. Last July, MassMutual Capital Partners along with Jefferies Capital Partners, invested $48.8 million in a convertible preferred stock issued by NovaStar.

“This equity commitment to NovaStar fits our focus on strategically investing in business opportunities, particularly in the financial services industry, where we have significant experience and expertise,” said Larry N. Port, president of MassMutual Capital Partners. “We view NovaStar as a well-managed company with long-term potential.”

Another bull on NovaStar was Howard B. Hill, a member of the quantitative management group at Babson Capital, a unit of MassMutual.

Mr. Hill was an active poster on Web sites proclaiming NovaStar’s bullish prospects, and in June 2006, he had this to say on a Yahoo board about subprime mortgage lenders generally and NovaStar in particular: “I’m more bullish than I’ve been for more than a year on the group and NFI, but that’s all I can or will say on that.”

NovaStar’s shares were at $31.29 that day.

Last January, Mr. Hill published a report on Babson’s Web site about subprime mortgage securities. “We look at the glass as being 90 percent full now, with the potential to drop to only 80 percent,” he wrote.

As the months wore on, Mr. Hill kept the faith. Fears of a subprime meltdown were overblown, he said in a July interview with Bloomberg News.

Babson held a 2.14 percent stake in NovaStar, according to the company’s most recent securities filings. It bought more stock in the quarter that ended on Sept. 30.

When asked how MassMutual and Mr. Hill viewed NovaStar’s prospects now, a company spokesman declined to comment.



Copyright 2007 The New York Times Company




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