By DEBORAH CROWE - 1/1/2007
Los Angeles Business Journal Staff

It was one of the strongest years for U.S. public markets since the dot-com crash – and L.A.’s community of mostly small and middle market public companies in 2006 more than held their own.

Skechers U.S.A. Inc. was the only company with a billion dollar-plus market cap to see percentage share gains in the triple digits. But others weren’t far behind, such as DirecTV Group Inc., which rose steadily on improved revenues from a strategic turnaround to end the year up 77 percent.

Of course, there were more than a few duds, and some big ones at that. Once high-flying homebuilders such as KB Home saw their shares fall by almost a third, mirroring a slowdown in the housing market. And even a long-term stellar performer such as Amgen Inc. suffered the big pharma blues as questions abounded about its long-term growth prospects.

Still, as of the close of trading on Dec. 27, local stocks measured by the LABJ 200 Index rose 18 percent for the year, narrowly beating the Dow Jones industrial average’s 16 percent gain and leaving the Nasdaq Composite Index’s 9 percent appreciation in the dust.

And barring a catastrophic event that sends financial markets into a tailspin, this year is likely to be similarly healthy for growth.

“You also saw a lot of turnarounds that had been in the works for a couple of years, especially post-dot-com bubble, that are showing results this year,” said Ken Tang, director of institutional sales for B. Riley & Co. “As long as that continues and the M&A activity keeps up we should have a good year next year too.”

In addition to a thriving mergers-and-acquisition environment that helped drive the markets’ growth, companies based in Los Angeles’ diverse regional economy benefited last year from increased defense and homeland security spending, record import-export business at the ports and a hot commercial real estate market.

Shares of busy Torrance aerospace contractor Hi-Shear Technology Corp. tripled – the best performance of any local company trading above $5 a share. Hi-Shear’s stock reached as high as $18.90 before falling victim to profit-takers, ending the year at around $9.

More typical of the top gainers was Los Angeles-based PeopleSupport Inc., which was only a few years old when the market crashed. It struggled in the early part of the decade before turning around its global outsourcing service business.

The company, which provides a variety of business services such as accounts receivable, made two January acquisitions that enabled the company to gain more than 150 percent this year to trade at $21.62. It separately acquired companies providing fast-turnaround transcription and captioning services in 15 languages.

PeopleSupport, with its $483 million market cap, is among the lucky small- to mid-sized companies to attract the attention of Wall Street analysts; 11 firms cover it. That attention helps support enough trading volume for a reasonably healthy market in its shares.

New blood in the executive suite also paid off in exciting investors. A revitalized Walt Disney Co. ended the year up more than 44 percent to $34.54. The smooth transition from the Michael Eisner era to his hand-picked successor Robert Iger led to accelerated new media initiatives. And Iger’s success in mending fences with longtime creative partners such as Steve Jobs enabled Disney to juice up its flagship animation division with the acquisition of Job’s Pixar.

Sector struggles

Meanwhile, the diverging fortunes of the residential and commercial real estate markets could easily be seen in performance of local public companies in those sectors.

The weakening home sales market contributed to 29 percent and 25 percent declines respectively for homebuilders KB Home and Ryland Group Inc. That was largely responsible for a 13 percent decline in the construction-engineering sector that not even a 22 percent jump in the shares of Jacobs Engineering Group Inc. could counter. Jacobs, like Hi-Shear announced a succession of government contracts during the year.

It was a far different story in the local commercial real estate sector, dominated by real estate investment trusts, property management companies and brokers. That sector saw 65 percent appreciation for the year. Typical was CB Richard Ellis Group. Inc., which capped a string of acquisitions by swallowing Houston institution Trammel Crow Co., and saw its stock rise more than 70 percent over the year.

Even the county’s largest companies saw strong share appreciation this year, with only Amgen and energy utility Edison International among the 10 largest by market cap not to see double-digit gains for the year.

In fact, Amgen lost ground and that made the biotech-pharmaceutical sector the area’s biggest loser, shedding 16 percent. It joined only five sectors among the 18 different industry categories that comprise the LABJ 200 Index to post negative returns.

Amgen, whose stock gained 24 percent in 2005, was on track to end 2006 down 13 percent. Amgen suffered because it could not meet Wall Street expectations for returns more in line with a small, fast-growing tech than the mid-size pharmaceutical company it has become.

A similar drag on the sector was Abraxis Bioscience Inc., the area’s second largest biotech, whose stock was down 28 percent for the year as the market showed impatience at lagging sales growth for its lead cancer drug.

Only two of 12 companies in the sector – drug developer MannKind Corp. and nutritional supplement maker Natrol Inc. – saw their stock appreciate during the year. MannKind’s gains this year have largely been driven by heightened expectations for an inhaled insulin system that has yet to receive FDA approval.

Energy and utilities was in the middle of the pack among the sectors, showing a 21 percent growth as a whole.

Occidental Petroleum Corp. was in line with that average, riding the wave of record-high oil prices to end the year just under $50 a share, a 24 percent gain. But energy utility Edison, whose shares rose 34 percent in 2005, saw only 5 percent appreciation in 2006, now trading at around $46.

Edison, the parent of electric utility Southern California Edison, has seen lackluster earnings and faces a variety of risks from rising natural gas prices, a vulnerable regional power grid and potentially costly state regulation of greenhouse gas emissions.

By David Streitfeld
Times Staff Writer

December 11, 2006

EVERY day, Will Hertzberg owns a little less of his three-bedroom house in Corona.

Like hundreds of thousands of other homeowners around the state, Hertzberg has a mortgage that lets him choose how much he pays each month.

Like many of them, he always chooses to pay as little as possible.

For the moment, this allows the 56-year-old Hertzberg to continue living in his tract home despite being only marginally employed. But his debt is swelling, and his mortgage company controls his fate.

“I am rather screwed,” he said.

Alarmed regulators recently have attempted to force lenders to cut back on loans like Hertzberg’s. Even some industry executives are beginning to wonder how these borrowers will handle their added debt, especially if housing prices stay flat or fall.

If it turns out that many can’t, it would be a major blow to the housing market. In the worst outcome, it could drag down the overall economy.

Hertzberg could sell now, but his lender would charge him an $11,034 prepayment penalty — money he doesn’t have. Yet if he stays, the housing market may tank, vaporizing what little equity he has left.

“I made choices, and they happened to be the wrong choices,” said Hertzberg, a big guy who lives alone amid the clutter of decades of memorabilia.

The real estate boom of the last few years has made it very easy to become overextended.

Earlier generations bought houses knowing they had no choice but to keep paying at the same rate for three decades. Their reward: the ability to sleep well, knowing their payments wouldn’t abruptly adjust upward.

As interest rates rose in the early 1980s, many borrowers couldn’t afford these traditional loans. Lenders responded with adjustable mortgages that offered lower introductory rates.

A few years ago, as home prices began escalating sharply, lenders pushed loans that let the homeowner pay only the interest for an initial period.

When even that was too onerous for some borrowers, they offered loans such as Hertzberg’s, often called “pay option” loans.

One of his options is to pay $2,513 a month. That would cover the principal and interest as if it were a traditional 30-year loan.

A second possibility is to pay $2,279, which would cover only the interest.

But each month he always takes the cheapest option: paying $1,106 and promising to make up the shortfall later.

Essentially, option loans are bets that good things will happen. Maybe the mortgage holder will get a big raise, or sell a script to Hollywood, or inherit a chunk of change. When the borrower has to start paying off the loan in earnest in five years, the plan is that he or she will somehow be able to handle it.

At a minimum, the borrower is betting the housing market will be better in a few years than it is today. If the house goes up in value, it will be possible to refinance and the day of reckoning can be put off once again.

In 2003, only about 8 of every 1,000 people buying a home or refinancing a mortgage in California got a pay option loan, according to San Francisco-based data tracking company First American LoanPerformance.

Last year, 1 in 5 loan applicants got one.

In the first eight months of 2006, even as the real estate market began to weaken amid fears of a downturn, the appeal increased again. Nearly 1 in 3 California loan applicants are now choosing them. The state boasts about 580,000 active pay option mortgages, about half the U.S. total.

After four years of escalating prices, they’re the only way some first-time buyers can get into the market. But another group flocking to option loans are homeowners who find themselves stretched. For those beset by calamity, these are the loans of last resort.

HERTZBERG bought his house 11 years ago for $129,995, immediately after his second divorce. (He has no children.) Since then, Corona and the Inland Empire have boomed.

Comparable homes in his neighborhood fetch more than $400,000. With fresh paint and a few repairs, Hertzberg could probably sell his place for $275,000 more than he paid.

He would see little of that, however, because he’s already seen so much. Over the years he has taken out $190,000 in cash through refinancings.

Hertzberg’s home equity paid off his credit cards, financed trips around the world that allowed him to indulge his passion for photography, bought a $32,000 Toyota Avalon and enabled some lousy investments. He bought dot-com stocks and lost money. To recoup those losses, he bought commodities — and lost money faster.

“Free money always has the unfortunate effect of making people go overboard,” said Hertzberg, whose living room is strewn with financial publications including American Cash Flow Journal and Donald Trump’s “How to Get Rich.” “You’d be surprised how fast $190,000 can go.”

The money wasn’t really free, of course. It just seemed that way, the result of a radical shift during the last decade in how people view their homes.

“Homeownership has become like auto leasing, where the price of the car doesn’t matter,” said Rick Soukoulis, chief executive of LoanCity, a San Jose lender that funded $7 billion in mortgages in 2005. “All that matters is the size of your monthly payment.”

Lenders say these new loans are all about payment choice, but Hertzberg is far from the only borrower who invariably chooses the smallest payment option. Washington Mutual Inc., which has one of the nation’s largest portfolios of pay option loans, said 47% of its borrowers in this category last December took the minimum option.

Few people intend to become deeper in debt every month. Hertzberg certainly didn’t.

“I assumed my future and my retirement would be taken care of by the company I worked for,” he said. “I trusted corporate America.”

He used to make a six-figure income selling vacation packages to corporations that would use them as customer incentives and employee bonuses. After the 9/11 terrorist attacks, the business soured.

His current sources of income include selling comic books on EBay and freelance photos to golf and travel publications. “Once you’re over 55, what employer wants to hire you?” he asked. “I’m a dinosaur.”

Last fall, he went to a mortgage broker and refinanced again to make his payments easier to bear. He thought he would have a five-year window before the principal started coming due.

But the day of reckoning is arriving early. By paying the minimum, Hertzberg has increased the size of his loan in a little over a year from $320,000 to $332,616. His lender, Calabasas-based Countrywide Financial Corp., recently sent him a letter warning that when his loan hits 115% of its original size he’ll run out of credit with the company.

That will happen in about two years if he continues to take the smallest payment option. Then his minimum payment will automatically go up 150%, to $2,848 a month.

“If I could afford that,” he said, “I wouldn’t have needed this loan in the first place.”

It’s a sorry situation, and Hertzberg is generous in assigning responsibility for it. To start with, he blames his mortgage broker, who didn’t advise him how risky these loans were.

Few brokers do, U.S. Comptroller of the Currency John Dugan says.

In an October speech, Dugan said the marketing materials for payment option loans often “emphasized the low initial payments but glossed over the likelihood of much higher payments later.” He also said some lenders were not evaluating the borrowers’ ability to handle the inevitable higher payments.

Although Dugan and other regulators are taking steps to address both problems, Hertzberg said they never should have allowed these loans to become so prevalent in the first place.

“The government wanted to keep the housing party going,” he said.

Yet who didn’t want that? Hertzberg admits he was a willing co-conspirator.

“I got spoiled and complacent and was not prepared when the bottom fell out,” he said.

COUNTRYWIDE sees little risk of widespread foreclosures, saying its pay option customers have good credit scores, indicating a high degree of financial stability. But at a company investment conference in September, Chairman Angelo R. Mozilo seemed to indicate that these borrowers might be naively optimistic.

“The average age of our borrowers is about 38 years old,” Mozilo said. “They have never in their adult lives seen values going down. The concept is alien to them.”

Just how many of these homeowners will end up in trouble is the big unknown for the housing market and the economy. Although many economists expect the loans to prompt a certain degree of turmoil, they don’t think it would cause a recession.

Hertzberg is much bleaker. He’s become a connoisseur of doom, a subscriber to websites and newsletters that predict the economy is headed for both recession and inflation.

The bears’ speculation: A rapid increase in foreclosures will flood the market with cheap homes, putting all of real estate into a tailspin. That would push up unemployment among builders, lenders, home improvement warehouses and furniture stores. That, in turn, would stall the economy, which is already slowing.

Although Hertzberg has lost his complacency, he hasn’t been compelled to act.

He estimates it would cost about $22,000 to fix up his house for sale, and he’d have to upend his life. The sales agent would take another chunk of money, and he’d have to undercut the crowded market to secure a buyer. Texas and Panama, two places he has thought about moving, aren’t so appealing that he wants to be broke there.

When the year-over-year appreciation numbers in Corona start heading down, he says, he’ll do something.

If Hertzberg is living on borrowed time, there’s small comfort in the home finance industry’s endless inventiveness. It’s certainly trying to tempt him. Several times a week, he gets a refinancing offer in the mail.

The latest one suggested a certain unfamiliarity with basic English, proclaiming, “Economic forecast suggests you Interest Rate will increase 1.00% every six months.” But its central message was clear: “We can solve your problem in 15 minutes over the phone.”

Hertzberg always looks at these fliers, hopeful in spite of himself. “I’m waiting for a 100-year loan,” he said. “My heirs can worry about paying it off.”