Taking Stock / Tefahot's Secret

Few financing corporations in Israel, or anywhere else, made record profits in 2002. Most faithfully followed the long-term trend of the last five years, and did badly.

Bank Tefahot had a record-breaking year, though. Well, that is, it made record earnings of NIS 211 million in 2002, against NIS 202 million in 2001, it said Tuesday. Tefahot, the biggest mortgage bank in Israel, said its profits represented a 12 percent return on equity, a level that Israel's other financial bodies will apparently leave unmatched.

But Tefahot is not alone. While the commercial banks reported collapsing profits or even a slide to the red in 2002, their mortgage arms did beautifully. In the case of Tefahot, which comprises more than half the operations of its parent company, its profits will boost those of the entire United Mizrahi Bank operation.

What is its secret? How did the mortgage banks make money in a market characterized by narrow margins and protracted recession?

The conventional wisdom is that the mortgage banks are well-oiled commission machines. Tefahot, for instance, makes NIS 300 million a year from commissions. Of that, NIS 124 million comes from risk-free credit collection from the state, and another NIS 125 million from life and home insurance policies that it aggressively markets to home-buyers.

Not from commission alone

But that can't be the whole answer. The commercial banks are just as skilled at luring customers with ostensibly attractive proposals, while making tremendous amounts from commissions and fees, some of which are hidden.

No, the difference between the commercial and mortgage banks lies in certain bad habits that the mortgage banks did not adopt:

l The mortgage banks did not extend loans for the purchase of housing and assets for sums far, far beyond their market value, based on the borrower's forecast that the price of the house/asset would rocket when he issues it/sells it to the next chump.

The commercial banks, we learn anew every day, lavished credit on companies - not based on any proven ability to generate profits, but on expectations/hopes/estimates that their entrepreneurs would take the company public or otherwise get rid of any hot potatoes. Yitzhak Tshuva's Green Venture Capital, and Gilat Satellite Networks' (NASDAQ:GILTF) Starband network, and Mentergy (Nasdaq:MNTE) received tens of millions of dollars based on promises of that ilk.

l When borrowers from Tefahot default on interest or principal, they get severe reprimands from the bank. If they withhold payments or fail to advise how they mean to make them, the bank throws them out and forecloses on the house.

The same holds for the commercial banks only in the case of small, or medium-size, borrowers. When it's a customer owing hundreds of millions, or billions, the banks turn cautious. They usually extend another loan to pay the interest on the first loan. One glaring example is fresh loans Bank Leumi extended to the Dankners, to pay interest and principal on earlier loans.

l When Tefahot's borrowers fail to make interest or principal payments, they are dunned for the amount immediately. Their chance of getting a fresh loan based on a "reevaluation" of the asset, stating that its value has climbed, is remote.

The method routinely accepted by the commercial banks, of accepting reevaluations by appraisers or accountants or local or foreign investment banks, for the sake of new loans, doesn't work with the mortgage banks.

l Mortgage banks don't allow their borrowers to daisy-chain mortgages, meaning, to take a mortgage in order to buy an asset that is already mortgaged to the hilt, or to buy a company that holds a company that holds a company that holds a company that owns a piece of property, with each company owing more than the last.

No, that method, which is accepted practice for the commercial banks and the basis for their business with the likes of the Peled-Givony group, won't fly here.

l The mortgage banks don't have to contend with borrowers who used the loans to increase their consumption, instead of buying assets. The commercial banks have to do just that - contend with dozens of giant corporations whose managers and shareholders robbed them blind, squandered the money and left them dangling, with shrunken kitties and giant loans. Not at the mortgage banks, no sir. You get money to buy assets, or not at all.

l Mortgage banks demand their borrowers prove they can repay. They want to see income tax statements, they want to see pay slips. They want to see how much cash goes into your bank account each month.

If you show up with a pro-forma or Ebitda report, or any other report showing a diminutive salary but forecasts of high earnings to come, they will smile understandingly and show you the door to their parent companies, the commercial banks, which have granted huge loans based on creative financial statements and glossy presentations. Bank Hapoalim, for instance, lent $200 million to Lumenis (Nasdaq:LUME), even though it had been cash flow negative from operations for five years.

l The mortgage banks hand over most loans only after the borrower has made his father, his mother, his brothers and sisters, his uncles and cousins and next-door neighbor's dog's fleas sign personal guarantees. The day the borrower starts to lag in payments, they'll all get letters of warning. At the end of the day, the bank will get its money, from somebody.

The commercial banks, on the other hand, handed over billions without signing a soul onto a thing - not mom, not pop, not the sibs or pets, nor did they even demand the personal guarantee of the borrower, sometimes. In banking argot, that's called non-recourse lending, and in plain English: If a problem arises, the money goes bye-bye. It is the bank's problem, not the borrower's.