Update on ACCREDITED HOME LENDERS (LEND)

LEND has stopped originating loans and is reducing employment to approximately 1,000 as compared to the 4,600 level in 2006. LEND claims that: “With this restructuring and the recently announced trade of approximately $1 billion of the Company's loan inventory with a right to repurchase, Accredited believes that the cash flows from the Company's securitized loans, servicing income and other income will enable the Company to maintain its downsized operations until market conditions improve and the Company can resume loan origination operations.”

Lonestar’s defense in the upcoming breach of contract trial is that LEND was disproportionately adversely impacted by the deterioration of the mortgage industry. If LEND can actually “maintain its downsized operations until market conditions improve” it will have survived the mortgage crisis much better than the more than 80 mortgage firms that have gone bankrupt this year. Thus, Lonestar’s defense would fail.

The question is whether cash flows from LEND’s securitized loans and servicing income will allow it to maintain its downsized operations. LEND will also be receiving a federal income tax refund of about $100 million within the next three quarters. To evaluate the likelihood that LEND can continue indefinitely we must first estimate what its' ongoing operating expenses will be. Last year LEND’s total expenses were $511 million. However, that included a non-cash write-down of $142 million representing the charge-off of goodwill from the Aames acquisition. Thus, 2006 operating expenses were about $368 million. Assuming that operating expenses can be reduced in proportion to the reduction in workforce, that would imply that LEND would need about $80 million per year.

Last year LEND had a gain on the sale of loans of $202 million. That is gone. The only revenue for now will be net interest income and servicing income. To be conservative we can ignore any net interest income on loans still held for sale. There probably will still be some such income since the interest rates on the mortgages held for resale exceed the rate on the financing for those loans. Furthermore, the amount of financing levels outstanding obviously is now less that the amount on the loans.

The net interest income on the loans held for investment and the servicing income on the $8.4 million loan portfolio will be the only significant sources of cash. Estimating the net income available to LEND from those sources is easy, in that all of the loans held for investment are in the wholly owned REIT.

In 2006 the REIT received $571 million in interest and paid $373 million. After provisions for losses of loans held for investment of $39 million the REIT had net interest income of $159 million. There was about $3 million in other income, giving the REIT about $162 million before payment of management and servicing fees to LEND. We can ignore the management and servicing fees that the REIT pays and LEND receives. Thus, the only income available to LEND will be the REIT’s net income of about $162 million. This should be enough to allow LEND to remain in “hibernation” for the foreseeable future.

The investment implications of LEND’s apparent ability to avoid bankruptcy are positive for LEND common shareholders in that Lonestar’s defense will be damaged by LEND’s avoidance of bankruptcy. It is also positive for LEND’s 9.75% preferreds. LEND will declare the dividend on the preferred shares early in September, which may come as a surprise to those who are not familiar with the structure and guarantees of the preferred. We would continue to be buyers of the preferred up to prices of 160% of LEND’s share price. The best case target scenario is that if LEND ends up with the $15.10 per share the preferred should be around $25. On a worst case scenario it should be kept in mind that the preferreds are entitled to $25 before the LEND common gets anything.

EARLIER COMMENTARY

Accredited Home Lenders, Inc. (LEND) has been trading its entire float every few days. It has attracted the attention of legions of speculators on both sides. The tremendous amount “gamblers” involved in the stock has brought it into a dampened equilibrium situation where it is trading around the half way mark between zero and the $15.10 that Lone Star has agreed to pay for it in a definitive merger agreement.

Nothing about the LEND situation is normal. Essentially people are betting either that Lone Star will renege on the deal or that it will go through. Much speculation has centered on whether Lone Star can walk away from the deal, possibly by paying a $12 million fee or as Jim Cramer has asserted the deal is “iron-clad” and that LEND could sue for specific performance as long as it complied with all aspects of the agreement.

More interesting that the question of whether Lone Star can legally get out of the deal, is the question of whether the would want to if they could. Our analysis suggests that a compelling case can be made that the deal is still attractive for Lone Star. We think that people who a short LEND based on the recent liquidity crisis in the mortgage market may be fundamentally misunderstanding the effect of the 11 securitizations that LEND issued totaling about $10.9 billion in the last three years.

A simplistic reading of the most recent financial data from the company’s 12-31-06 10-K could suggest there is no value left. Total assets were $11.349 billion with only $556 million in stockholders’ equity. The $556 million book value is not that much larger that the $400 million that Lone Star agreed to pay in the buy out agreement. On March 16, 2007, LEND sold approximately $2.7 billion of loans that were being funded by warehouse facilities and equity. It is estimated that the sale resulted in a pre-tax charge of $150 million.

More significant, a simple calculation suggest that a 5% reduction in the value of the remaining assets would wipe out the equity. However, the mathematics of securitization-based financing indicates that the discounted present value of the net cash flows that LEND’s assets are likely to generate are substantial. Even though securitizations are treated as debt for accounting purposes, they are legally sales.

The REIT that issued the securitizations should never have to liquidate any of the underlying mortgage assets to satisfy any obligations under the securitization financing. Thus, each of the 11 securitizations is an “option” in which the REIT has the right to receive excess cash flow generated by the trust. This excess cash flow is derived from two sources: excess interest and return of overcollateralization. If there is any shortfall, in any individual pool, that would reduce the excess cash flow below zero, the REIT is not responsible for it. Thus, if 10 out of the 11 securitizations had so many defaults that there was no excess cash flow, but if even only one of them was generating positive excess cash flow, the REIT would have positive cash flow.

It is likely that Lone Star is basing its bid of the favorable math of securitizations. LEND has already sold $2.7 billion of its mortgages held for resale and paid-off its warehouse credit lines and has already written off the $142.4 million in good will from the Aames acquisition and approximately $111 related to the doubt that the company will be able to fully utilize their net operating loss carry-forwards. What remains, on an option-adjusted net present-value-of-cash-flows basis may very well be worth more than $400 million, even assigning a zero value for the future mortgage origination and securitization business.