Bond insurer – has airport to sell

I wrote about Sydney Airport here. Funnily enough various news source aggregators (such as Wikio) filed the article about a financial crash landing with real airplane crashes. Bronte Capital must have got a few perplexed visitors.

That said – my original post is pretty convincing on the notion that if air traffic in Sydney falls over any sustained period the airport will default.

I have no idea how sharply air-traffic will fall here. Air traffic is one of the most consistent of all variables. It just rises. The reason of course is that the cost of flying in real terms has fallen for decades. When I was a kid people who flew from Sydney to London were regarded with some awe – they were the “jet set”. Now they are “cattle class”. To fly to London cost AUD2000 and average household income was about AUD10000. It costs less in nominal terms to fly to London now...

But if the recent trend in oil prices is permanent and continuing the era of ever-rising air-traffic volumes is over. We will again refer to people who fly long-haul as the jet-set.

There is some listed subordinate debt in Sydney Airport – the so called SKIES (see my last post). Beyond that are a AUD3.7 billion of medium term notes of which AUD2.9 billion is drawn and AUD884 million of inflation indexed bonds with two maturities (2020 and 2030). My sting: all these instruments are insured by Ambac and MBIA.

I see the advert: Bond insurer – selling airport in glitzy long-haul destination.

If oil goes to $400 they will take a loss on this. But otherwise it should be fine.

Whitney Tilson on MBIA

There is a great Whitney Tilson post on MBIA on Seeking Alpha.

To me the key difference between the AA guarantors and the AAA guarantors was that by-and-large the new players in this industry (such as ACA Capital Holdings) had to post lots of collateral in the event of problems - accelerating liquidity concerns and hence bankruptcy. The AAA guarantors by-and-large had to pay when the liability fell due.

This is a huge difference. I have argued several times (see here and here) that the price of various bits of paper in the secondary market is irrational. However I have no idea what the rational price is. Nor does anyone else - not the shorts, not the longs - not anyone.

If you have to mark to market the books of financial institutions they are almost all insolvent. There is an enormous amount of paper that is 20 bid, 90 offered, price you could actually get something closer to 20. If you have to collateralise based on actual values you could get in a trade now (or sell illiquid assets to buy liquid ones for use as eligible collateral) you are stuffed. Simply stuffed.

But if you can sit it out then you are possibly OK. The reason - the defaults might be much lower than currently anticipated in market pricing. Regular readers will know my view is that defaults will be lower than current market prices. I just don't know how much lower and hence I don't know what the end-game is for someone who is levered to this stuff but does not need to post collateral.

ACA Capital Holdings had contracts that demanded it posted collateral and that smashed them up - simply smashed them. Their website is indicative of what happened to the company. But the case for Ambac and MBIA was that by-and-large they did not have to post collateral and hence had hope.

However we now know that MBIA in particular has large collateral requirements. I know of a few more contracts that potentially involve collateral at MBIA. Cumulatively they matter a great deal.

If you are thinking about the bond insurers as a buy (and I am) the collateral requirements are the critical issue. If you don't have collateral requirements then the end points are all that matter. If the things you have insured default at a (much) lower rate than the market currently thinks (something that is possible) then you will make money.

For now you have the hope of much lower end-point defaults. Hope means the stocks have value. Option value only - but as the end outcome is a long way away and a lot of things can happen there should be quite a lot of option value. [One possibility for instance - there is a lot of inflation over say ten years which reduces the real value of the liabilities or increases the nominal value of the assets that back them. That could be a blessing to a bond insurer.]

If you have collateral requirements then end-point solvency is not all that matters. You need to be continuously solvent and on current market prices you are not solvent right now. Whitney Tilson's article is the first widely available and easy to follow discussion of the collateral requirements of MBIA. And this is the critical issue for the stock. Read it.

Now please please contact me if you have done a similar run through Ambac. I have not - but I knew of far less that was collateralised at Ambac than MBIA. And that matters. It's why I sometimes think I want to punt on Ambac. [Indeed I have at various times - but have hedged the position shorting Ambac debt and made good profits by sheer luck. Those were not super speculative positions. Buying Ambac common without shorting the debt is a massively speculative position.]



John

A note - the saga of MBIA saying for years that they had few collateral requirements and then revealing billions of dollars worth of them tells you about trusting management. I can't just ring up Ambac management and ask them about collateral requirements. If you had done that with MBIA you got creamed.

Indeed some very fine fund managers got creamed doing precisely that.

Ronald Regan was right: "trust but verify".

=======================

Post script: I do not agree with everything that Whitney Tilson writes in his Seeking Alpha article. I strongly disagree with his assertion that MBIA has an obligation to downstream the $900 million sitting in the parent company. The buyers of guarantees from MBIA purchased them backed by stated regulatory assets of MBIA's insurance subsidiary not the MBIA parent company. I see no reason why MBIA parent company should increase those regulatory assets unless they are contractually obliged to do so.

Of course Whitney (talking his book) has a different view. I have a suggestion: next time Whitney invests in a stock that goes to zero he should pour more of his clients' money in just to make the creditors happy. (He argues that MBIA should do this with shareholder capital and its insurance subsidiary). If Whitney acts as irrationally as he is demanding the management of MBIA act then I am sure the creditors of his bankrupt investment would thank him.

For once - and perhaps the first time - I find myself strongly agreeing with Tom Brown of Bankstocks.com. [I can't tell you how many times I have thought Tom is speaking nonsense.]

Drink deeply of the poison: another look at Fifth Third Bank

Fifth Third was a well run bank with a cult following. Now it is up on hard times. I have looked at it numerous times with an eye to buying it - but never purchased. I blogged about that here.

I was so blinded by the past glories of the company that I couldn't even make money shorting it.

The true believers however really drank the Kool-Aid. In 2000 it was priced it at 7 times tangible book plus excess capital.

So now I am back having a look at Fifth Third. Investor Relations didn't return my email (which is disappointing) but so far I have positives and negatives.

The biggest negative is location. It is big in tough states - having three of its state concentrations in three of the worst five states for property foreclosure.

The second biggest problem is an huge error of judgement on behalf of the management. They spent a large part of 2007 drinking the Kool-Aid themselves repurchasing $1.1 billion in shares at seemingly low prices during 2007 only to issue a billion in converts at even lower prices in 2008. They paid an average price above $40 a share and issued around $10.

There is a phrase for that. Its called believing your body odour is perfume.

But at the moment I want to accentuate the positive. There is plenty of positive - and some of it reflects well on management.

This post focuses on the origination of mortgages with negative amortisation features and high loan to valuation ratios.

Fifth Third and Negative Amortisation loans

The 2007 annual report includes the following paragraph:

The Bancorp does not originate mortgage loans that permit customers to defer principal payments or make payments that are less than the accruing interest

That tends to cheer you up in this environment.

The 2006 annual report was slightly different:

The Bancorp does not currently originate mortgage loans that permit principal payment deferral or payments that are less than the accruing interest.

The "does not currrently" line also appears in the 2005 annual report.

So sometime they stopped originating that sort of loan - and they did it years before the credit crisis broke. In other-words management did not lose their minds as all about them lost theirs.

High loan to valuation mortgages

Another indication of quality management was that they slowed origination of high loan to valuation mortgages much earlier than most of their competitors. They have a category for mortgages with a loan to valuation ratio above 80 percent and no mortgage insurance. Mortgage originations for this were as follows:

2004 1286 million
2005 1245 million
2006 679 million
2007 265 million

The company slowed its origination in this category from mid 2005 and slowed it dramatically before the credit crisis hit. That reflects very well on management. Very well indeed.

So given this - I could drink the Kool-Aid. If you dear reader see good reasons to stop me please let me know. I write this blog at least in part for the comments and emails - and I don't get enough of them.

Meanwhile: memo to IR - its good to return phone calls and emails.



John

Citigroup thinks Barclays needs more

Well you don't say:

June 27 (Bloomberg) -- Barclays Plc, Britain's fourth-biggest bank, may need an additional 9 billion pounds ($17.9 billion) to absorb credit-related writedowns and bring its capital in line with U.K. peers, Citigroup Inc. said.
The London-based bank will raise 4.5 billion pounds in a share sale announced earlier this week, lifting its core-equity Tier 1 capital ratio to 5.8 percent from slightly below 5 percent, said London-based analysts led by Tom Rayner in a research note today. That will lag behind Royal Bank of Scotland Group Plc and make Barclays Europe's ninth weakest bank in terms of capital, said Rayner, who has a ``sell'' rating on the stock.
``With credit market conditions continuing to deteriorate globally, we believe it is simply a matter of time before further significant writedowns are taken,'' Rayner said.
Barclays spokesman Alistair Smith couldn't immediately be reached for comment.

Sack Bob Diamond. Sack him now.

The Associates - Sandy Weill's greatest miss

People seem to have decided that the merger of Citigroup and Travellors was a failure - indeed the great failure of Sandy Weill's vision.

That may be true - but given that JPMorgan is buying Bear Stearns Citigroup effectively buying Salomon Brothers might just be "prescient".

Anyway - everyone appears to have forgotten the most awful Citigroup acquisition of all time - The Associates.

The Associates (or more correctly Associates First Capital) was the financial arm of Gulf and Western. It was later purchased by Ford - and then spun to Ford shareholders in 1998.

Less than two years later Citigroup purchased it for stock and wound up giving away more than a tenth of Citigroup.

Yes that is right - long term shareholders of Ford who did not sell out now own a large amount of Citigroup - and that is worth more than the residual Ford holding.

You make your money in the stock market often in odd ways.

--

The history of the Associates is here.

--

Associates had two main businesses - a leading US subprime mortgage business and a Japanese consumer lending business.

It was the Japanese consumer lending business that most attracted Weill. The press release announcing the merger is headlined about Citigroup growing its overseas consumer finance business. To quote:

"This transaction, which will be accretive to Citigroup earnings by at least $.10 per share in the first year of combined operation, accelerates our consumer financial services expansion globally," said Sanford I. Weill, Chairman and Chief Executive Officer of Citigroup. "In one step, we catapult our international earnings in these rapidly growing segments by more than 40%. We are particularly excited about The Associates' strong presence in Japan, where it is the fifth largest consumer finance company, and in Europe, where it has more than 700,000 customers.

The Japanese consumer lending business however has almost been regulated out of existence - it is unprofitable (having once had an 80% ROE) and Citigroup is trying to close it. They are by repute having difficulty doing so.

In the end the Associates was probably worth less than zero.

Warren Buffett complains endlessly about having given away 1.6 percent of Berkshire for the essentially worthless Dexter Shoe business. I have never heard the top brass of Citi make the same complaint about the Associates - but I have heard it from upper-level Asian Citigroup executives.

That is the true legacy of Sandy Weill.

Resources: For those that don't remember The Associates - this linked press article should be sufficient...

A slight difference in statements: Chart Industries and Energy World Corporation

I wrote previously about the strange Energy World Corporation (EWC). See “Getting oil on my shirt”.

Some follow up is warranted – as I left the question as to who had the technology open. But I think we can decide pretty quickly who is telling the truth. Here are some direct quotes from EWC and Chart Industries.

This is from the last EWC annual report:

The Company has placed contracts with Chart Energy and Chemicals Inc (Chart) for four 500,000 tonnes per annum liquefaction plants and associated major equipments. As subcontracts to Chart the motor-driven MR compressors will be supplied by Siemens AG, Germany. These contracts which are within the original capital budgets, and programmed equipment deliveries will permit the production and delivery of LNG from our gasfield in Sengkang during the second half of 2009. Once installed and operating the trains will have the capability of producing 2 million tonnes of LNG per annum.

This is the Chart Industries press release:

Chart Industries to Supply Four LNG Liquefaction Trains in Indonesia for Energy World Corporation Equipment orders exceed $100 million

CLEVELAND, July 2 [2007] /PRNewswire-FirstCall/ -- Chart Industries, Inc. (Nasdaq: GTLS) announced that its wholly-owned subsidiary, Chart Energy & Chemicals, Inc. ("Chart E&C"), has been awarded significant orders totaling in excess of $100 million from Energy World Corporation Limited ("EWC") to supply Cold Boxes, Brazed Aluminum Heat Exchangers, Air Cooled Heat Exchangers and ancillary equipment for four 500,000 tons per year Liquefied Natural Gas ("LNG") Liquefaction Trains to be installed by EWC in Southeast Asia. The trains are intended to provide LNG to meet the growing demand for LNG in Indonesia, the Philippines, China and Japan as the economies in these regions grow. The first two trains are scheduled to come on stream in the second quarter 2009.

Do you notice any difference between these statements?

Well – there is some difference between an “LNG Plant and associated major equipment” (as per the EWC statement) and “Cold Boxes, Brazed Aluminum Heat Exchangers, Air Cooled Heat Exchangers and ancillary equipment” as per the Chart release.

For a start nobody has mentioned purification (essential because otherwise the carbon dioxide that exists in all gas freezes in the cold-boxes and blocks the equipment), storage tanks, port facilities, pipelines to the gas field or anything else. The storage tanks are particularly expensive.

John

As an afterword: Funnily enough there is no point using Google to find anything put out by EWC. They format all their releases as PICTURES not as text – which makes them impossible for Google’s bots to dictate. I had to retype…

Further EWC doesn’t maintain a website – something that is unusual for a multi-billion dollar company.

Saving a General with a fresh set of batteries

Mish asks today whether battery technology (and electric cars) can save General Motors. I think that answers itself.

But maybe Mish is focussing on the wrong General. GE is doing really interesting things with hybrids and GM is merely hoping to come along for the ride...

One of the big problems of the Prius is that it has very limited towing capacity. The specifications are essentially none.

The other American General (Electric that is) is working on mega-hybrids - busses and would you believe tug boats. No lack of grunt there.

Not quite the profit making potential of low costs nukes (see ESBWR). But hey - mega-batteries, public transport and low cost nukes. That is an American future.

GM will try to tag itself on - the dream GM electric car will use those batteries. But the profits will belong to the other General.

Why Bronte?

Several people have asked me why I use the moniker Bronte Capital?

Its where I live.

Sydney Airport: waiting for a (financial) crash landing

Warning - this post has a major error - explained in this later post. Sorry.

The Macquarie acquisition of Sydney Airport through its satellite vehicle – Macquarie Airports – is perhaps the seminal infrastructure deal of our times.

• It was by the leading acquirer of infrastructure in the world (Macquarie Bank).

• It had a private equity type structure – Macquarie did it on someone else’s balance sheet and ripped out enormous fees.

• An absolutely enormous sum was paid – and was roundly criticised at the time as these 2002 press reports indicate here and here and here and here.

• It was in Macquarie’s home town (Sydney) and so was super-visible.

• Australian mums and moms and pops were the ultimate holders of the risk – so the high levels of visibility and the bad press mattered,

• It was geared with an amount of debt that meant that the debt holders were taking large (possibly insane) risks for minimal returns (something which is reminiscent of the entire private equity boom).
  

What is more – the acquisition for about a billion dollars more than the number 2 bidder – was unequivocally a winner. Traffic and hence revenue went up. Funding costs went down and the large amount paid seemed to drop into distant memory.

Macquarie runs a mean-lean-profit machine

There is little doubt Macquarie ran the airport well. They hired uber-public servant Max Moore Wilton to run the place – and he did his political duty (scotching all sorts of regulatory interference – and a possible competing second airport). He also lived up to his public service moniker “Max the Axe” and ran the place as a lean profit machine.

When Bethany McLean wrote her piece on Macquarie she praised Sydney Airport’s profit ethos:

… so, about a month later, I arrived at Australia's Sydney Airport - which is owned by a Macquarie fund - during the early-morning rush hour, groggy after a long flight.

If you did the same thing, you might trudge through customs, not noticing much, perhaps, beyond the A$4 - gasp - it costs to hire a luggage trolley. But if you took the time to explore, you would realize that the airport is not a run-of-the-mill ripoff but an eerily efficient moneymaking enterprise.

You don't have to go far out of your way to buy souvenirs or coffee, because the airport's owners have studied how far you'll be willing to deviate from your path (five meters). You might buy a duty-free item not because you want one, but because doing so will shoot you into a special, speedy customs line. And should you drive to the airport, you would discover that parking your car in the shade ("the premium shaded parking product") costs an extra A$4.

Not that all this efficiency lessens the irritation that some users experience. As I shut the door of my cab, the driver begins an unsolicited rant about the fees he has to pay to wait at the airport. "Macquarie Bank owns it," he says. "They own too much."

Bethany was right. Sydney Airport has been run brilliantly – and there is no more old public service culture fat to take out. They have done it.

It was Sydney Airport more than any other deal that justified the validity of the “Macquarie Model”.

Macquarie Airports has booked its profit

All of this says that Macquarie’s seemingly overpriced 2002 purchase was in fact a bargain. That is why this – the highly controversial and visible purchase - is the seminal infrastructure deal of our time. It showed just how much public infrastructure run as “an eerily efficient money making enterprise” is worth”. The success of the Sydney Airport was lauded by countless (and possibly mindless) imitation.

Macquarie however – being the leverage junkie it is – borrowed vastly more money (approximately $2 billion) against the airport and paid a massive dividend to Macquarie Airports (the listed trust/ultimate owner). This debt – like most debt in most Macquarie vehicles has limited recourse – it has recourse only against Sydney Airport and no other assets.

Given that Macquarie Airports (MAP) has received in cash more than they paid in cash and they can’t be forced to make good Sydney Airport debt then MAP has made a profit. A big one – and a real one - one that can't be reversed. Even if Sydney Airport were to go bust tomorrow it would have been on OK deal – at least assessed on a standalone basis. MAP holders will have done OK. Banks and other guarantors would have done their dough – but that is them. Those are the joys of non-recourse finance.

So what is left at Sydney Airport?

The short answer is a very well run airport and a lot of debt. Here is the balance sheet:

Yes - the shareholder equity is negative nearly half a billion. Tangible shareholder equity over a billion negative.

You can calculate the debt according to your own definition of debt. Maccqaurie picks a lower number because they think the fixed coupon subordinate (the SKIES) are equity. (That is funny given their name: Sydney Kingsford-Smith Income Equity Securities.)

And here is the P&L.

Yes it did lose 182 million last year!

Note in the P&L the operating profit (ie before depreciation) is only 10 million larger than the interest bill. After even basic maintenance capex the airport is cash-flow negative. That is an amazing debt load.

Macqaurie runs lots of its assets this way – though Sydney Airport is the clearest example. They have run it with those sort of debt load since inception – and it has always been OK in the end because traffic and volume have risen every year. Costs have been kept (well) under control and everything has turned out roses despite negative initial cash flow. Indeed Macquarie values the equity in the loss making airport at several billion dollars on the assumption that traffic volumes increase.

But the summary is clear: Sydney Airport requires increasing traffic to be solvent - let alone be worth anything like the claimed amounts.

Is traffic increasing?

Well it has increased every year. But this year is somewhat problematic. Australia is almost the ultimate long-haul destination. North Asia is still booming so traffic volumes should be going up. But the cost of flying is going up too due to fuel and airlines are cutting flights. Further tourists generally don’t like the strong Aussie dollar.

There are plenty of press articles to that effect. See here and here and here and here. These cutbacks are all relatively recent.

So does Macquarie have another trick?

Well the biggest problem now is how well Sydney Airport has been run. Its too good.

I doubt that there is any fat left to cut. I doubt that there are many additional revenue opportunities. I could be wrong – but this looks very difficult for debt holders and guarantors in Sydney Airport.

The fall-off in air-traffic could be temporary. Air traffic has dipped before – but only for short periods. Maybe this will all blow over. If air traffic resumes its historic upward trend then this post should be ignored.

However the oil price hike looks fairly permanent. Does that make it difficult for Macquarie? Well a profit has already been made in cash on the airport. So from 8 miles high it doesn't look like a problem. From ground level - well I report - you decide.

The preposterously expensive WestAmerica Bancorp

In my post of Fifth Third I described WestAmerica as perhaps the most astounding unbroken story in American banking.

Here is its balance sheet from the last quarter – note that almost every category is shrinking:

The company is not shrinking because it is forced to by lack of capital. Contrary - almost alone amongst banks it is buying back lots and lots of stock. This is not a bank that is going to use its superior performance to build capital and buy its competitors in crisis.

The management is comfortable with shrinking. Even deposits are shrinking deposits (somewhat by choice). WABC would rather keep cheap deposits than compete for them on price and service. (Unfortunately their competitors are not so kind.)

Indeed the good stuff is all shrinking. Deposits are shrinking. No interest deposits (of which this bank is rich) are shrinking. Loans are shrinking. Equity is shrinking.

The bad stuff is also shrinking – particularly investment securities.

Everything is shrinking except the stock price.

The credit performance is great – amongst the best in North America. The local economy (driven by agriculture) is probably better than most. (They are in that great food bowl - the Central Valley of California.)

The bank is really hard to fault.

But it is preposterously expensive. Tangible shareholder equity (equity less goodwill) is 280 million. The market cap – 1.54 billion. Just under six times book. I have seen banks trade at that before – but not for a while. However those were banks priced for growth. This bank is negative growth. [The bank is over six times tangibles if you think deposit premiums are equivalent to goodwill.]

More to the point – the market cap is roughly half the (shrinking) deposits. Never seen that anywhere. Gosh we get excited at funds managers (who don't risk capital) when they trade at 10% of assets. We are at about 50% here. And fund managers with shrinking FUM tend to trade at very small percentages.

Further the earnings quality is not all its cracked up to be. The bank carries approximately 1.5 billion in investment securities – well over 5 times capital. About half these investment securites are pledged to provide floating rate financing – that is the bank is just running a big margin account to get some earnings. This is common in regional banks - and it works – but you would hardly want to pay a high teens multiple for those earnings. Most of the securities in this case are GSE debt, state and local debt, some mortgage backeds and some other "asset backed securities".

Still when banks are losing their shirt everywhere – this bank has come through remarkably unscathed.

Especially the stock price.

A piece of a company can go bankrupt - Mish on MBIA

I really like Mish's blog - but today he makes an assertion that is plain wrong. MBIA has held $900 million in the parent company rather than downstreaming it to the insurance subsidiary.

This has caused much consternation amongst regulators and rating agencies. But is - in my opinion - in the interest of MBIA shareholders. It clearly reduces the strength of the operating subsidiary but increases the strength of the holding company. Mish disagrees:

The statement by Moody's that the parent company is stronger because it is not funding its insurance unit is ridiculous. A piece of a company cannot go bankrupt.

Mish is obviously not an insurance regulatory guy. Pieces of companies go bankrupt in this space all the time. For instance:

• Conseco holding company went bankrupt - but its insurance subsidiaries continued operating without any bankruptcy filing.
• A long while ago Baldwin United went bankrupt - but its subsidiary (Ambac would you believe) maintained its AAA rating
• More recently Fremont General had two businesses - an insurance business and a dodgy lender. The insurance subsidiary went bankrupt - but it took several years for the dodgy lender to catch up with them.

If anyone has done a decent analysis of the holding company and non-holding company obligations of MBIA I am really interested. Like begging. (I have an email...)

Its a very painful task to do it - and somehow I doubt Moodys have done it properly either. But Mish just dismisses this as a necessary part of the analysis - and in that Mish is wrong.

Things that stun me: Fifth Third Bancorp

I know a very successful fund manager who is utterly stunned by the problems at AIG. He thought that the company had “more there than that”. I had been watching what they do (rather than what they did) since 2000 and was not overly enamoured. I didn’t short it – but the problems were not a surprise.

My surprise came with Fifth Third Bancorp – a bank I once held out as – indeed still do hold out as – the best managed regional bank in the world. Given the wags are now calling it “Three-Fifths Bancorp” either I was wrong or something changed.

I contend that it was change. However the extent of the change – and the resulting problems amaze me.

The bank I hold out as the best managed regional bank in the world changed radically around the year 2000 in response to problems caused by its own success. These changes created a very different bank. I still maintain that Fifth Third circa 1990 was the best managed bank I have ever seen.

I shorted the stock once – above $60. A short made despite being totally enamoured of the management. I made pennies and was never truly committed. In my eyes we shorted the bank because its success was at an end – not because we thought it had major problems.

I noticed minor issues – but Moody’s rating agency did not. Moody’s mooted upgrading Fifth Third to AAA – a ranking that they have never come close to assigning to any other mid-size regional bank.

I didn’t drink the Kool-Aid completely. As the stock fell I was always looking for an opportunity to buy – remembering past glories. But thankfully I never pulled the trigger.

The old Fifth Third

I am doing this a little from memory because I (foolishly) tossed some of the old annual reports.

The bank arose from a pre-prohibition merger of a Fifth Bank and a Third bank of Ohio. I gather they were called Fifth Third because Three Fifths referred to a particularly strong liquor – and that was considered ungodly.

There was a major management change/restructure about 1975-76 (noted now only in the incorporation of the name Fifth Third Bancorp in 1975). However that was the beginning of one of the great stock runs in history.

After the 1975 restructure the bank operated the bank in a very entrepreneurial fashion. The bank was broken into small banks with about $3-5 billion in assets. The small banks purchased back office and other services from the mother-ship – and the mother-ship also sold back office services to third parties. Everything was expected to be market-best - and market signals were used to ensure it.

When a division got too big they broke it into two divisions. The division managers competed against each other and were paid as entrepreneurs. Part of the remuneration was paid in arrears and dependent on credit quality.

The culture had its minuses. For instance if you were from one part of Fifth Third and you wanted to use a photocopier people got a little stroppy. Why? Because your photocopy would go on their cost account. (I am not exaggerating – the businesses were sufficiently small and entrepreneurial they were worried about trivial costs.) But it was pretty hard to argue with success.

The outsource back-office businesses were not too bad either. The credit card processing facility – Midwest Payment Systems – was particularly good. It was to my eyes the best in the world – and was very profitable on the out-source service it sold. It has since been renamed Fifth Third Payment Solutions – I think as much to distinguish itself from MPS – the Bank of America payment business.

Fifth Third did small fill-in acquisitions in the four Midwestern states in which it had operations. Generally the small bank was entrepreneurial and stayed entrepreneurial after acquisition. Its cost structures however improved as it wound up with Fifth Third's exceptionally good back-office services.

The stock run was extraordinary. The stock was a 600 bagger from the restructure to 2000 (and more than 1000 bagger to peak). You don’t need to hold too many of those in your life. It even came through the 1992 debacle almost unscathed. [These stock runs include hypothetical reinvestment of dividends - the general point however still holds. This was the best performed bank in the world.]

Its utterly superior economics had nasty effects on other midwest banks. The other banks competed not by being better but by accepting worse credit. The poor credit culture at National City has its origins there. (For those not following National City is one of the banks worst hit in this crisis. The same observation with less stregth applies to Keycorp.)

I never held it – which is a great pity - however one company did hold a substantial stake in Fifth Third – that was the local (high quality) insurance company – Cincinnati Financial (Nasdaq:CINF). The combination of fairly good underwriting and a super-powered stock portfolio driven by Fifth Third (and to a lesser extent fellow Cincinnati company P&G) meant that CinFin was also a great stock. At various stages I have owned CinFin for pennies of profit.

Here is the balance sheet of Fifth Third from the 10K for 1999 – which was issued two years shy of the peak of the stock run. Whilst the run continued the problems set in after this balance sheet was issud.

The are a few things to note. Firstly that the bank was very small despite the massive stock run. The loans outstanding were under $25 billion. That would place it today as a small – even one state – regional bank.

The second thing to notice is how overcapitalised it was. The shareholder equity was over 4 billion on those loans. The bank could easily have run at half the capitalisation. The bank used its excess capital to speculate in securities – but as the yield curve in 2000 was fairly flat there was not much profit there.

On that balance sheet there is simply no way that Fifth Third was getting into trouble. Moody’s later mooted the AAA rating – but it could easily have been awarded then.

The post-tax profits for 1999 were 668 million. Not a large number – but a fine return on $2 billion of capital and $2 billion of excess capital.

Profits would have gone up sharply over the next few years without the bank doing anything much. The yield curve would steepen and the $12 billion in securities which were carried at very little spread became highly profitable. The bank unfortunately felt compelled to do things.

The bank’s problem

I am going to make the strange assertion that the bank’s biggest problem at this stage was its stock price. The price was in the high 30s at year end 2000 (along with most other banks that were at low prices as tech stocks dominated). But by late 2000 the stock price was just shy of $60. The market cap was over 18 billion and the PE ratio almost 30. [Note the 3 for 2 stock split in 2000 when checking my numbers.]

Four and a half times book might not have seemed unreasonable – but it was more accurately described as seven times book plus excess capital. This was a period when banks traded at less than a third this price. This was – by far – the most expensive bank in North America.

The high stock price meant high expectations which the management sought to meet. The excess capital couldn’t be solved by buying back stock (as the stock was so pricey). Instead they went to grow by acquisition.

The home markets – the four states which they had previously conquered – were saturated with Fifth Third. Fifth Third had used its superior economics to get the superior credits. Banks that had to compete with Fifth Third wound up on the worse end of pretty well every credit. Fifth Third had pristine credit.

If Fifth Third grew in the home states they would have to take some business that they had previously rejected. Growing in the home market would have turned Fifth Third into National City.

So they went to Florida as well as neighbouring Kentucky and West Virginia.

They used their inflated stock and excess capital to purchase things – but nothing they purchased was as good at the old bank. Moreover the rate of purchase was very high, the prices often puzzlingly high.

The real problem though was that the management system that had served Fifth Third so well through the glory years became unwieldy. The bank when I started following it had 8-10 businesses all competing against each other. I stopped following when this got to 71 businesses. The internal bickering about cost allocation became thunderous.

My short – when I had one on – was not predicated on the failure of Fifth Third – but the slow demise of the business model.

Well we got the near failure of a natural AAA bank. The story is well told by Mish and others – and I am not going to repeat it here.

Lots of its businesses have blown up. The credit card processing business is not as good as it was. Midwestern credit is awful. The stuff they purchased in Florida is worse. But worst of all was that they grew hard into it.

Whereas Fifth Third was almost perfect during the 1992 banking debacle its been a total mess this time.

Count me as surprised.

There are a couple of other pristine stories in North American banking - notably WestAmerica Bancorp, and Mortgage and Trust Bank (MTB). The former is remarkably expensive (and successful) for a well run but otherwise undifferentiated regional bank in the Central Valley of California. The latter has non other than Warren Buffett vouching for the management. Berkshire is the largest shareholder.

I look at these companies and I can't fault these banks. But that wouldn't have saved a Fifth Third shareholder.

But if WABC were to blow up - then I would be feeling deja vu all over again.

Steve and Barry's and what the #$%@#% is GE doing

Only a few days ago I expressed complete puzzlemement over a $125 million dollar loan that GE had made to Kinney Drugs. Here is my post - and here is the GE press release.

This was not a one-off. In March this year GE provided almost $200 million to Steve and Barry's.

That loan is already rumoured to be default - and Mish - bless him - has pointed out just how much of a Ponzi scheme Steve and Barry's turns out to be.

Mish concludes by saying:

If it seems like GE trades like a finance company, it's because GE is a finance company (masquerading as a conglomerate).

In this case Mish is probably right. The two press releases (Kinney Drugs, Steve and Barry's) have the same contacts:

Jeff Wilson
+1 203 229 1887
Jeffrey.Wilson@ge.com

Ned Reynolds
+1 203 229 5717
+1 203 837 0699(mobile)
ned.reynolds@ge.com

You got to wonder about an asset backed (which I think means stock backed) loan for $200 million which goes bad in four months.

The first question for Messers Wilson and Reynolds is what GE is going to do with $200 million of cheap apparel.

The second question: why does this business continue to exist - and who gets fired?

Mish's general assertion however - that GE is a finance company masquerading as a conglomerate is wrong. They can turn Italian crap into electricity - and no finance company can do that.

They might have a worse time though turning Steve and Barry's old rags into cash.

John

Getting oil on my shirt: Energy World Corporation

Energy World Corporation is an oil and gas company based in Australia with approximately AUD2 billion in market cap.

As soon as I mentioned it one of my friends who follows the Australian market and is long-only he suggested that there was no point looking at small Aussie oil and gas companies because if you spilt oil on your shirt you could have a market cap of $500 million.

Against his advice I have been playing with oil – and maybe some has got on my shirt.

Background

In a previous life EWC was a developer of project financed power stations burning gas in out-of-the-way locations. It even partnered Enron and (the now defunct parts of) El Paso.

It very nearly went bust – and the stock bottomed below 3c. Then stepped in two white knights, James Packer and Standard Chartered Bank.

EWC was left with gas reserves. Not much doubting of that. They are just in awkward locales like Sulawesi.

The gas price is low in Indonesia.

They burn this gas through relatively inefficient turbines (8666 heat rate quoted – 9000 from appearance) to generate local electricity under take-or-pay arrangements. The revenue from burning the gas can be back-calculated – but it is not large. EBIT is about 12 million per annum - and there is considerable debt.

Here is a picture of the power station:

This power station and the gas reserves that support it are the key assets of EWC.

Please excuse the observation – but I don’t see $2 billion here.

EWC’s big plans

That was it for EWC until very recently.

EWC has joined the mega-engineering crowd. It plans to build an LNG plant.

It raised over 160 million through Tricom (a stockbroker with a super-aggressive reputation) to fund this. The purpose of the plant is to liquefy the remaining gas and get a good price for it. They plan on building to 2mtpa capacity – about 100bcf of gas. Reserves are about 700bcf (but there is probably more) and the above power plant (and one other they are installing) will burn about half of those reserves over the next twenty years of take-or-pay contract.

This gas is worth a fortune liquefied. Liquefied 100 billion cubic feet of gas is worth something over USD1 billion. An LNG plant could turn these (small) reserves into a cash machine.

The problem is that LNG plants are VERY big and VERY expensive pieces of kit. Massively so. Santos (an Australian company) and Petronas (the Malaysian company with the famous skyscraper head office) plan on spending almost $8 billion building a 3-4 million tonnes per annum train in Gladstone (QLD). Here is the link from Santos’s site.

So how much does EWC think they need to spend to build the plant. Well according to Tricom (when they did the raise):

EWC is planning to construct a 2.0Mtpa LNG project at Sengkang in four 500,000tpa phases. The modular construction and the use of off-the-shelf technology from Chart Energy & Chemicals and Siemens should enable the company to keep capital costs low. EWC has estimated the construction cost of the 2.0Mtpa LNG project at US$350M with an additional US$110M in costs associated with the development of the gas field. [Source: Tricom note dated 1 May 2008 author Hayden Bairstow.]

Oh dear – this runs at roughly 10 percent of the cost of the Santos/Petronas project per unit of gas. Moreover if it can be done that cheaply in Indonesia Petronas (the Malaysian company) should know about it.

I was immediately sceptical. That is my nature. But Siemens says that they received a massive parts order – see this press release. The order was placed by Chart Industries whose 10K confirms EWC as a major customer. Funnily enough a EWC release attaches the Siemens press release but the attached release differs slightly and has a different number. The attached release was never actually released by Siemens.

I am not going to express any positions as to truth – just implications of possible beliefs. After all there is a Siemens release and Chart - a reputable company - does quote EWC as a major customer.

Suppose EWC can produce a 2mtpa LNG train including gas field development for USD350 million. The implications are as follows:

• There is a lot of stranded gas in small pockets in the world – like Indonesia.
• If it could be liquefied cheaply and quickly as per the EWC/Siemens/Chart plan then all the big LNG plants of the world (of which there are many) are diabolically bad investments. LNG prices will plummet. Big oil (which is funding huge plants) is being profoundly stupid.
• Siemens and Chart have a way of producing cheap LNG plants. That would mean that Siemens and Chart will just rule the roost for ages. The core technology would have to be with Chart as Siemens is just placing orders. Chart, like EWC – the pioneer in these super-cheap LNG plants does not have a large market cap. It must be a steal.

Chart’s website does not place their technology in this range. They have never sold 2mtpa LNG plants.

There is a possibility though that EWC can’t do it. Maybe the note from the Tricom broker on which they raised 150 million is just wrong. In that case the implication is simple:

• Siemens has an order for a plant that can’t be funded, and
• shareholders are stuck owning the above-photographed tin-pot gas turbine.
• I have no idea of the implications for Chart Industries.

I will leave that decision as to veracity to you dear readers.

John

Why don't people buy AAA strips at 80c in the dollar? Top five reasons by request

Peter - whoever he may be - but I would like an email - made the following comment:

John,

Do a post of the top five reasons why people aren't buying this stuff. I don't fully believe the we-can't-get-financing argument, or at least I question how important it is here. What are the actual yields at 80 cents on the dollar? The i-banks are financing sales of this stuff, too.

I think there is also fear about fraud, chaos (the servicers can't compile the true delinquency data) and political/legal fears connected to loan-mods etc.

What think you?

Peter is right of course. There are several bits of paper which can't be trusted because the servicing sucks. I once had a big short on MTG - and part of the reason was that they owned C-Bass and its terrible Litton loan servicing business. Litton simply could not keep records of who owed them what.

In the days before Litton blew up I used to speak to consumer lawyers/bankruptcy lawyers about Litton. They would tell me that clients could prove Litton had their money - they had banked checks (cheques if you are an Australian) and Litton would be asserting it was still owed money. Litton was as nasty and reprehensible as they come. You can find out plenty here. And here is a not-atypical story.

Yes Litton/CBass paper - which was "scratch-and-dent" in the first place - could - and probably will default to a 50c in the dollar range.

So yes - some due diligence is required buying the non-standard paper.

But take a look at some companies who are not bankrupt and whose paper is very bad (such as Washington Mutual). Does anyone really believe that WaMus systems are as bad as Litton? How about Countrywide?

Long Beach Mortgage (ie WaMu) sucked as a credit originator - but I suspect they can collect the loans quite effectively.

So reason 1 why people don't buy this paper: the servicing sucks. But not in all instances. You need to be selective. Maybe that is beyond the skill of most people. This should not apply to banks who have to mark their books to market because quite often they control the servicing anyway.

Reason 2 is that there might be legislative change to let people out of their mortgages if sold to them at a predatory level. That is a pretty big statement - and it seems to me unlikely. If it happened then pretty well every bank in America would also go bust. Making the paper accross the board worth less than say 68c in the dollar (12 % credit protection and a 20% discount) just does not seem likely. So I will dismiss that.

Reason 3 is more subtle. Some of these loans will fail now - but at the moment the BBB strips and others are receiving coupons. The money that really should be for the AAA strips is being used to support BBB strips. A legislative change which forces interest holidays or forbearance will keep loans technically current for longer and increase the payments to the BBB strips at the expense of the AAA strips. Given you can buy BBB strips for pennies at the moment if you believed that you should be doing the trade. Its a real possibility and its one I can't discount. I mentioned it obliquely in the original post.

Reason 4 that people are not buying this stuff is that those people with the expertise burnt their wallet out eight months ago at worse prices. I know some people who were very good at assessing scratch-and-dint loans. They still are. But they spent all their money at 85c in the dollar where if they waited they could have purchased the merchandise at 65c in the dollar. They will make a profit - but a small one - and they could have made a motza. They were precisely the sort of people who should be buying now - but can't. I think this is in fact one of the major reasons why this stuff is hard to move. There is so much of it - and the people who do this are either full-up or have problems of their own.

Reason 5: This is the main reason. Its just not that attractive. If you take a AAA strip that originally yielded treasuries plus 30bps. You buy it at 80c in the dollar you will get treasuries plus 30bps times 1.25 for it. Oh, your yield goes from 5 to 6 and a bit. That is not much fun. You will however make back say another 10% over time because the loans will repay at 90c in the dollar and you purchased them for 80c in the dollar. Oh - so you get 8-9% if the loans last five years. And they could last much longer.

That is just not attractive for an unlevered player. I am a sophisticated sort of guy and I want returns above that. Those returns are fine if you can lever them 5 times and borrow at 50bps over treasuries. But try and buy a bunch of distresses mortgage securitisations and lever them 5 times. Can't be done. It used to be easy - but it can't be done now. Leverage is absolutely required at these prices to make the investment attractive.

The prices fall until the yields are attractive enough for an unlevered buyer. That is not me at these prices. It is however me at the right price.

I really think that is the end of the story.

In praise of fraudulent accounts

I wound up having a chat about Barclays with the head banking analyst from a major European broking house. He hit me with the “how is it possible” line about the assets being as miss-marked as I privately think. He talked about auditors and regulators and the like.

I thought that was shockingly naïve – because I am not even sure that miss marking is now the point.

Go back to my first substantive post on this blog. It was about scoping the US mortgage crisis. Seeking Alpha – who I originally sent the column to – changed the heading of this post to imply that the mortgage crisis is not as bad as it seems. (Did they read it?)

Anyway – in that post I note that it is quite common to be able to buy AAA strips of diversified non-standard (but not intentionally subprime) mortgage securitisations for 80c or less on the dollar.

This implies a shocking level of system losses.

In the old days a typical mortgage securitisation had 12 percent “protection” before you got to the AAA strip. For the AAA strip to default you needed something like 30 percent of the loans to default with a loss-given-default (or severity) of 40 percent. This was unthinkable – and so it was considered reasonable that the AAA strips covered 88 percent of the pool. I noted in the first post that for many Alt-A issuers I could not have ex-ante faulted that logic.

Well the unthinkable has happened. There are numerous pools where the defaults will be greater than 30 percent or the severity greater than 40 percent. But it is not obvious that the average non-GSE mortgage will look that bad.

However the market is trading quite a bit worse than that. It is very common to find the AAA strips trading at 80c in the dollar. To lose money on a strip trading at 80c in the dollar you need the losses to be fully 20 percent worse than the above 30 percent of 40 percent scenario.

If 50 percent of the pool defaults and you have a loss given default of 50 percent then you STILL make a profit buying the AAA strip at 80c in the dollar. [Ok – the technically minded will tell you that some of your loot could go to junior strips. But offsetting that you get a high yield in the early periods.]

The meaning of an 80c AAA strip is clear. The market is implying an absolute debacle – something beyond the scope of the really bearish (including me) to contemplate.

I do not think it will happen. I don’t know anyone else who does.

So why does the market keep pricing the AAA strips at 80c? Well I explain in the first post – but it really comes down to “you can’t borrow to buy this paper any more”. The deleveraging will stop when the assets are patently attractive to unlevered buyers – and they are not there yet.

Meanwhile the market seems to imply something that looks insane to me. The market is implying that more than 50 percent of diversified mortgages (not originally deliberately subprime – but not GSE suitable) will default at a severity greater than 50 percent.

So what is the implication of mark-to-market accounting?

Above I argue that the market is insane. It’s a dangerous thing to argue – but I argued the market was insane when subprime mortgages were trading at 101c in the dollar because they had high yields. And I will argue it now when securitisation paper is trading as if losses across the whole US will be greater than 50 percent of 50 percent.

It was insane (but technically correct) for investment banks to mark their book to market when the price of a subprime mortgage was 101. If you believed those accounts you would take on lots of risk and declare immediate profits. Anyone who managed their business as if that was a permanent state is now bankrupt.

It is similarly insane (but technically correct) for anyone subject to fair value accounting to mark a levered book to the current implied market default rate for mortgages.

The market was wrong then and it is wrong now. But fair value accounting required mark to insanity then and similarly requires it now.

If you do mark to the current insanity and you have a lot of mortgages your accounts will show you as breathtakingly insolvent.

So what do you do? Reclassify the assets as level three and mark them to model. It is technically fraud to do this when the assets can be priced – but no more wrong in my opinion than valuing the subprime mortgage at 101 in the first place.

The most obvious such example is Freddie Mac putting over 150 billion of its assets in the level three bucket. Almost all of those assets have a market. It is just that Freddie Mac (justifiably) doesn’t like the price and so marks-to-something-other-than-fair-value.

But it is not just Freddie Mac who is in this position. Everybody with a substantial list of stressed financial assets is. And everybody marks to model. And the models bear little resemblance to fair value as defined in accounting standards.

But if the model makes reasonable probability weighted estimates of the present value of what you will receive in cash on the asset then I can live with the mark-to-model (fraudulent as it is). In fact I will defend it – hence the title of this post.

Unfortunately there is a problem. Once you have decided to commit fraud (as I believe almost every financial institution has) then you might find yourself “in for a penny, in for a pound”. Having decided that you do not want to mark to “fair value” it is not far to decide that you want to mark to total myth. For instance you might (rationally) decide that it is not sensible to mark the mortgage to a 50 percent default and 50 percent severity. But that is no excuse to marking it to a 3 percent default and 15 percent severity. In for a penny…

The level three decision made by Freddie Mac is fraud. They can find a fair arms length value and they chose not to do so. But it is a reasonable fraud – and it is in the interests of Freddie Mac, its shareholders, probably its creditors and certainly its regulators. The accountants are happy to sign off on it too. I wish I knew what reality was and how far from reality Freddie’s models are. I don’t – and so I will not be buying Freddie Mac stock.

Freddie’s fraud is the same fraud committed by everyone who has a substantial amount of financial assets to mark to models.

So how to assess a financial institution?

Having decided that almost all financial institutions are fraudulent the question for a long or a short-seller is not is there fraud or not (as per my European banking analyst). The question is “how much fraud – and just how bad is the book really”.

This is a real problem. Whilst I do not think that the mortgages will have a worse than 50 of 50 outcome – I do believe that it will be worse than 30 of 40 in a wide range of circumstances.

Every one (reasonably) decided to ignore the illiquid markets. Here are a couple of places where they have degenerated into unreasonable myth:

• Barclays manages to produce almost no losing trading days.

• Royal Bank of Scotland has 10 billion dollars of second lien mortgages in the Midwest on which their provisions imply an almost zero loss rate and where the secondary market is way less than 40c in the dollar and where the house prices have fallen to zero.

• Barclays had some private equity loans that they originally intended to originate-and-sell. They are stuck with them. They are stretched. The model prices remain in the high 90s where the companies are cash-stretched right now.

I could go on. These are by no means the atypical myths.

• I crossed the bridge ages ago when I decided that financial institutions mark to things that don’t look like reality at all. (My UK banking analyst friend has not got there yet. That seems to me to be a willing suspension of disbelief.)

• I crossed the bridge this year when I decided that the fraud was OK. I know my morals have slipped. But I will say it again. Some fraud is fair and reasonable.

• I have also decided that you need to grade the fraud from “white lie” to “mark to hope” to “mark a myth so far from obvious reality it is comic”.

David Einhorn in his latest book demonstrates Allied Capital does a lot of marking to a myth so far from reality it is comic. Reading his book is great fun (though living it would have been somewhat rougher).

Unfortunately I think that mark to comic myth is becoming the norm for UK banks as well. The main problem is that the UK banks are much more levered than Allied Capital. Mark-to-myth at 40-50 times leverage is a recipe for tragedy.

Post note: In this post I say a few things that are dangerous - and which I do not believe except within the narrow context of other financial institutions (not me). For instance I say "some fraud is fair and reasoable". I wish never to be quoted out of context.

Its time for a short version of yesterday's post

Got lots of emails about gnarly little things in GE Capital. Those appear to be true of all financials. Nothing that really stresses me - but the miss in GE Capital in the last quarter is probably not the last miss.

But the post really comes down to this. There are two GEs - the beautiful one and the ugly one.

How about I give you both from Michigan.

GE is installing a nuclear reactor for Detroit Edison. The press release is here.

This is a really special nuke. The design is new. The costs are (supposedly) much lower than conventional light water reactors and the safety level higher. The GE spiel is reproduced in this Wikipedia article.

If GE can produce a nuke that is (a) much cheaper and (b) much safer than the existing stockpile then they will rule the roost. That is a business proposition that should make you salivate. If the US gets serious about greenhouse gasses then there could be an awful lot of coal and gas replacement.

[Any engineers out there wish to comment on GE's specs? I am not an engineer and I have been fooled by engineering stocks before. GE is however usually fairly good at their engineering word.]

Just up the road GE is trying to sell a 400 home multi-family. I am not rigging it. Half the housing GE is trying to sell on its website is in Michigan.

Here is a picture.



The home price in that zip code (48192) has not gone to zero - but is not high. Try this search. Note that the most expensive home in the zip is about USD250 thousand.

GE sure is a pretty girl to be found in this house. Don't really know what she is doing there.

John

What’s a nice girl like you doing in a place like this? A comment on General Electric’s corporate lending business

Avid readers will know that I rather like General Electric at these prices.

Here I point out just how good the weak USD is to them.

And here I point out just how fantastic GE’s asset sales have been. [Just imagine if GE still owned FGIC and Genworth. The former is in deep trouble. The latter is merely problematic.]

Regular readers will also know that I subscribe to the GE press-release blog which you will find here.

But when I am long a stock I always look at what is wrong with the story. Indeed the central investment trap I fall into is to ignore the positives in my shorts and ignore the negatives in my long. This post is a conscious effort to correct that.

The negatives

With GE I point to a few negatives:

• The acquisitions in medical have a head-scratching character – as Jeff Matthews points out here.

• The domestic media business is not exactly great either.

• The real estate business in GE commercial finance (discussed at some length below).

Indeed my summary of GE is as follows:

• If it is US domestic driven it is bad.

• If it is export driven it is good

• If it something China needs, where the competitor is European and where GE produces the most thermally efficient product it is stunningly good. There are plenty of examples in GE.

• If it is consumer finance it is much better than it would have been had GE not taken all the asset sales (but remains problematic), and

• If it is corporate finance driven its not bad to the best of my knowledge but I am left scratching my head about bits of it.

So I get a little puzzled at this press release.

In it GE announces that it has lent Kinney Drugs $125 million secured by some undisclosed assets to finance (of all things) the employee stock ownership plan. My interpretation – GE is financing the exit by the existing management of part of their holding – purchased by staff.

Apart from the fact that this deal reeks of late 2006 early 2007 when financing LBOs was all a rage it is very hard to see what GE brings to the table other than spondulick$.

But first let me digress into good-and-bad corporate finance businesses at GE and elsewhere.

Xerox – the model of a bad corporate finance business

Once upon a time (that is just a few years ago), Xerox used to sell lots of copiers to small businesses. Their once-grand marque had been superseded by the Japanese. There was no particular reason to buy a Xerox copier over a Fuji or a Ricoh or Cannon or any of a few brands. Xerox had inferior technology in colour and had formed a joint venture with Fuji (Fuji-Xerox) to sell that stuff. This was mostly a mix of Fuji technology and Xerox distribution.

This all appeared to work well. The copiers were sold by salesmen with maintenance contracts – which were really finance contracts. The sales kept up with something reasonable and the stock was fairly strong.

The problem was that the inferior technology and price proposition was being masked by a superior sales proposition led by credit. A large number of customers (small businesses and the like) shopped with Xerox because they did not have the finance to buy from another supplier.

To tell this as an investor you probably needed to get your fingers dirty and study the business well. It was not easy. But the problem sequence was a classic – with minor problems in the finance business leading to a tightening of credit standards and a loss of sales. The stock came crashing down. The stock went from over $60 to under $5 in a matter of months wiping out a decade of good (but in retrospect dodgy) gains.

It is iconic in investing that you need to be very scared of any manufacturing business which sells inferior technology to inferior credits backed by its lending business. Some would also say the Lucent backing of One-Tel (a bankrupt Australian mobile phone company) was the same sort of arrangement.

By contrast let’s describe some good equipment finance businesses:

• Suppose you have the superior product (say the most fuel efficient jet engine) and

• Suppose the product needs regular contracted maintenance or it kills people (such as a jet engine) and

• Suppose the product is able to be repossessed and resold and because you have the best distribution system you have the best ability of anyone to repossess it. Besides because of the maintenance schedule you know exactly where it is (like a jet engine).

• Finally suppose that the technological obsolescence cycle is say a decade or more so when you repossess it the product is worth something – so you can’t be stuck in the position that Lucent was when it repossessed One-Tel’s mobile phone system. Hey – like a jet engine.

Then you have the makings of a truly brilliant finance business. It can make good money almost regardless of the economic cycle of its customers.

Notice that this finance business does not even require the airlines to be solvent. It only requires that the product has a technological edge, can be repossessed and does not lose too much value when remarketed. Moreover the best sales network for new product is also probably a good sales system for repossessed product. GE has a competitive advantage in engines (which I think is beyond dispute), is good at selling them and hence has a competitive advantage in financing them.

There have been lots of airline insolvencies but the GE finance business skated through unscathed.

One step down from jet engines is say how the hospital business works. GE sells big kit (x-rays, cat scans, MRIs etc). The kit requires installation and training to work (which sounds like a jet engine). The buyer is a hospital or a consortium of doctors. The finance of the hospital is sometimes difficult – but even when they go bust they continue to operate. The kit requires some staff training to use and some maintenance.

If you have a superior finance/training package the hospital administration will buy your package. You will clip the coupon when the patient (or their insurance) pays several hundred dollars for a scan. Its going to be less good when the government cuts back on medicare rebates for radiology. But it is not the sort of business that can really kill you. GE can sell the equipment offshore. People still need their MRIs and the equipment can be repossessed without baseball bats.

It’s a good finance business then if what you bring to the table is adequate technology, the ability to repossess, and the customers are the sort that are not going to default. That is what the medical business looks like.

That is – to the best of my knowledge – most of GE commercial finance. [It is not the state of their consumer business. The consumer business is far more problematic but I do not believe can really hurt.]

The credit data in the last accounts suggests that the credit at GE commercial finance is not too bad. The conference call transcripts note that commercial finance delinquencies are 136bps up 10bps from a year ago – which was historic low levels. I have been comforted by that – there being no obvious problem in commercial finance.

Well there is one obvious problem in commercial finance – the real estate business.

The commercial finance business owns quite a deal of straight property as well as loans. The owned portfolio is about 40 billion worth. They used to roll a bit of this off every quarter – and lo-and-behold make a profit. Pure speculation in my view even though the annual report describes GE has having world beating expertise in commercial property.

General Electric found out last quarter that they couldn’t do the deals towards the end of the quarter – and that was – according to the conference call transcript – the most obvious problem in the finance business and the core reason for the failure of GE to meet its earnings even after guiding well a few weeks prior. Here is an extract from the conference call:

Jeff Sprague - Citigroup – Analyst and one of Wall Street’s Finest

I guess one thing we will all be struggling with here today is just trying to get comfortable that we have got a baseline we can have some confidence in and I guess just a couple of things that I am wondering is although you are looking for lower gains, if you could give us some sense of how important gains still are in your earnings outlook for the remainder of the year?

Keith Sherin - General Electric Company - Vice Chairman & CFO

I think the biggest place here is real estate, obviously, Jeff. If you look at our real estate book, about 50% of the assets are debt and about 50% are equity. The real estate business made about $2.3 billion last year as I said. They are going to be down somewhere between 15% and 20% we would anticipate and the gains are going to be 60% of their year probably. So we are selling a lot of real estate. We are lowering what we thought we would have. We had as we entered the year an embedded gain of over $3 billion in the properties that we have. We have still got a pretty robust global market, but we are counting on real estate property sales as part of that business model to continue to be a significant piece of those earnings.

At the same time, all the investment we are making is on the debt side of the business to remix it and that gives us more of a spread business going forward. So we sat down with Mike Neal and Ron Pressman and the commercial finance team. Obviously, we spend a lot of time on this and these numbers take into account the pressure they have seen and what they think will happen as we go forward on real estate. And certainly as far as visibility into the second quarter, we think we have got our hands around what the second quarter looks like and we have got pretty good confidence on that for commercial finance. So there is still more in the quarter to get done and more in a year to get done, but we think we have captured what that exposure is for us.

Now I know the transcript is a mess – but that is the final transcript as downloaded from the GE website. (Does anyone read these things?) But the earnings from the real-estate business are in my view going away. That is $2.3 billion (pre-tax) that is disappearing. That will offset – at least this year – most of the good stuff.

This business has a (profitable) past. At one stage – unbelievably in my view – well over a percent of GEs profits came from self-storage facilities. They sold most of them for big profits.

Lets get really horrible and assume the real estate business is all bad. The real estate bit has been an increasing part of GE Commercial Finance. This is the extract from the last annual report:

There are 79 billion in real estate assets – about half loans and half equity according to the conference call transcript above.

That does not look pretty. If the real-estate falls by 30% (which does not seem unreasonable) then the debt is probably worth 90c in the dollar (for a loss of $4 billion) and the equity gets cut by the full 30% (for losses of about 12 billion). These losses would be offset by the $3 billion in unrealised gains as at the end of the year – but the pre-tax losses would be about 11 billion compared to 26.5 billion of pre-tax earnings (24 billion before the real estate business) for the whole of GE.

Nothing here looks unmanageable – but the possibility that GE loses six months income – say $13-15 billion pre-tax on this business – is not zero. The bears out there (and there are plenty) would think it likely.

If you look at GE Real Estate’s website http://property.gerealestate.com/ and you click through to property for sale (which is stuff they own) there is not much. Indeed when I clicked through there were only 4 properties in the whole USA – but they were all duds. Indeed they were all multi-family residential including such gems as a 200 apartment building in Michigan. (If you read my post on Royal Bank of Scotland and Charter One you will know what I think of Michigan.)

But the encouraging part of this is the website only has 4 properties for sale in the USA. According to the last annual apartment buildings were only 14% of a 40 billion dollar portfolio. Half was office buildings and only half was in the North America.

This can hurt but it cannot kill. However if you don’t expect GE to take some (large) charges you are not thinking. Here is the disclosure from the last annual report:

REAL ESTATE: . We review our real estate investment portfolio for impairment regularly or when events or circumstances indicate that the related carrying amounts may not be recoverable. Our portfolio is diversifi ed, both geographically and by asset type. However, the global real estate market is subject to periodic cycles that can cause significant fluctuations in market values.

While the current estimated value of our Commercial Finance Real Estate investments exceeds our carrying value by about $3 billion, the same as last year, downward cycles could adversely affect our ability to realize these gains in an orderly fashion in the future and may necessitate recording impairments.

(Memo to Jeff Immelt. We are waiting. Accounting integrity here = charges.)

The other ugliness in GE Commercial Finance

There is in my opinion no real reason why GE is in direct real estate ownership. They don’t seem to bring anything to the table except a AAA credit rating. But hey – I can own real estate myself. The obvious thing to do is to sell the real estate – take the $10 billion charge and use the 30 billion freed up to buy back another $20 billion in stock. I can’t see under any reasonable circumstances – why GE is capital impaired if they take $10 billion in charges.

But the press release at the beginning of my article – that is a real head scratcher. I will repeat it all here.

GE Corporate Lending Provides $125 Million Asset-Based Credit Facility to Kinney Drugs

NORWALK, Conn.--June 3, 2008--GE Commercial Finance Corporate Lending today announced it provided a $125 million asset-based credit facility to Kinney Drugs, a NY-based drug store chain. The loan will be used to fund the company’s employee stock ownership plan. GE Capital Markets arranged the transaction. GE also provided the company with interest rate risk management.

Kinney Drugs opened its first store in Gouverneur, NY, in 1903. Since then, the company has grown into a regional drug store chain, operating more than 80 locations throughout NY and VT.

“We valued GE’s industry expertise specific to drug store retailing,” said Craig Painter, chairman and CEO for Kinney Drugs. “They worked closely with us to understand our needs and provided the capital to meet our requirements.”

"An in-depth knowledge of the retail sector means smarter capital for our clients,” said Jim Hogan, managing director of GE Corporate Lending's Retail group. “Whether the borrowing need is for working capital, acquisition finance, turnarounds or ESOPs, we are dedicated to finding the right solution to help companies execute their business plans."

Industry Specialization

To better meet the unique financing needs of customers, GE Corporate Lending has a team of Industry Leaders supported by research analysts. These industry experts help build smarter financing solutions for companies across key industries: Aerospace & Defense; Automotive; Chemicals & Plastics; Construction; Food, Beverage & Agribusiness; Financial & Business Services; Forest Products; Metals and Mining; Restructuring; Retail; Technology & Electronics; and Transportation.

About GE Corporate Lending

With $16 billion in assets, GE Commercial Finance Corporate Lending is one of North America’s largest providers of asset-based, cash flow, structured finance and other financial solutions for mid-size and large companies. From over 30 offices throughout the U.S. and Canada, GE Corporate Lending specializes in serving the unique needs of borrowers seeking $20 million to $2 billion and more for working capital, growth, acquisitions, project finance and turnarounds. Visit www.gelending.com/clnews to learn more.

Can somebody please tell me what – if anything GE brings to the table here. I cannot work out a single reason why GE has a competitive advantage in this business. Its not turbines or tubine finance. Its not the good finance business I described above.

The only saving grace. This business is small.

Finally – its time for GE investor relations to contact me

When investor relations at a company like GE go “radio silent” its usually a very bad sign. Ambac went radio silent before they blew up. (I know – I like and still respect the former CEO Robert Genader. He didn’t answer my emails though.)

I have been trying to get GE investor relations to return my email. No luck. Will somebody please contact me.

My address is attached to the “about me” section of this blog.

If you don't allow a bull to tell the story then you leave the door open for the (usually prescient) Reggie Middleton to tell the story. Reggie is far more bearish than I would be.

Barclays in denial

There is a lovely article in the Daily Telegraph about Barclays being in denial about the size of the losses that it needs to take.

One thing that caught my eye was the following:

It has even been suggested that Barclays chose not to offload its Alliance Boots debt, when others in the banking syndicate took a 10 per cent valuation cut to get the assets off their books, because Varley and Diamond wanted to protect the minimal writedowns on leverage loans.

Well you might say that. I couldn't possibly comment.

Anybody looked lately at their consumer lender exposure in Japan? I couldn't possibly comment.

How about just the almost total absence of losing trading days in the investment bank. I couldn't possibly comment.

Anyone you know carried an 800 billion pound investment bank portfolio and not lost money on at least some days... I couldn't possibly comment.

How about the LBO exposures. Well apart from Boots I cannot possibly comment.

Stephen Cooper - a follow up

I didn't need to look for impropriety at American Home Mortgage to guess that it should be considered if you were to make an investment in their defaulted paper. They appointed Stephen Cooper CEO. Stephen Cooper is who you appoint when you do not want the bankruptcy management looking at your past. See my last post.

The Wall Street Journal has however beaten me to the story. In an article about two Bear Stearns executives that face indictment is this little throw-away:

Federal prosecutors in Brooklyn are investigating whether the Swiss bank UBS AG improperly valued its holdings and whether the collapsed mortgage lender American Home Mortgage Investment Corp. of Melville, N.Y., engaged in accounting fraud, people familiar with the matters have said. Prosecutors in Manhattan and Los Angeles are respectively probing whether mortgage lender Countrywide Financial Corp. engaged in securities fraud or loan fraud. None of the companies have commented.

Some things are so predictable...

Stephen Cooper's Business: The past is prologue

Stephen Cooper runs companies in bankruptcy or financial distress. Past clients include Enron, Krispy Creme, and Collins and Aikman.

Current clients include American Home Mortgage as this press article indicates.


So how does Stephen Cooper get all the best clients?


Well he is competent in business administration even if he thought he could make a viable business of Enron.

But there are plenty of people competent in business administration and they didn't think that they could recover anything viable from Enron. Krispy Kreme (another Cooper business) has not turned around even though Stephen Cooper collected his "success fee". In that case - and I am not kidding - Stephen Cooper's definition of success was the elapsing of sufficient time.

There is however a simple way that Stephen Cooper gets his business. He never sues past management.

When he was appointed to the Enron position he simply disavowed any responsibility to sue past management. The New York Times article cited above quotes as follows:

But Mr. Cooper emphatically refused to speculate on what brought Enron down.

''It's literally of no interest to me,'' he said. ''I'm not going to spend time here looking in the rear-view mirror.''

This was despite the fact that one of the best avenues for recovery for Enron creditors was to chase past management - some of whom were never prosecuted and have huge fortunes. (See for example Lou Pai who is reported to have well over $100 million and married his stripper girlfriend.)

There were similar failures to even consider prosecuting past management in the Krispy Kreme case (even though there were plenty of allegations of impropriety).

Indeed Stephen Cooper is who you appoint if you have something to run from. Whilst the past is of no interest to him - it is prologue for anyone who is a creditor or shareholder in a Stephen Cooper run shop.

The saga of how Cooper got to this position is well told in this book by Lynn LoPucki.

Given that liquidation is a big business - and some of us want to make money buying the defaulted paper of firms in bankruptcy - its worth understanding Stephen Cooper.


The Marsh & McClennan connection


Stephen Cooper has now sold his business (even though he remains the CEO). The owners are Marsh, Mercer, Kroll - part of the Marsh & McClennan empire.

The busienss of selectively electing not to sue past management may be legal (I guess - though I am not a lawyer). However it is not obviously in the interests of creditors and I would have thought that the administrator has to act in the interests of creditors.

Nobody I know has taken the step of suing Marsh & McClennan (NYSE:MMC) for the behaviour of their subsidiary. Again I am not a lawyer - so maybe it is not actionable.

All I want to comment on is despite broker commissions kickbacks exposed by Spitzer, paying the CEO of the NYSE too much money (exposed by Spitzer) and late trading at Putnam (exposed by Spitzer) it is possible that not all was done.

Someone needed to look into the Kroll, Zolfo, Cooper subsidiary.

Spitzer may have been caught after his pants were down - but in my view he was caught before he finished the job.

Short post today: Barclays and fraudulent hedge funds

This is just a short post - to tie in some loose ends I have.

I wrote yesterday about Barclays Global Capital.

I have written twice about a fraudulent hedge fund (New World Capital management) - see here and here.

Barclays has developed quite a business marketing hedge funds. They compile a ranking of hedge funds. Here is the current ranking of their currency funds.

Now here is my sting: at one stage New World Capital Mangagement was ranked Number One on Barclays Hedge fund rankings.

Barclays - strange, stranger and truly opaque

Barclays is the financial institution in the world that most scares me. Indeed it petrifies me. It is huge (currently the second biggest institution in the world and substantially larger than Citigroup). It is highly levered. And it is in all the places you don’t want to be at the moment.

Barclays may be “too big to fail” but it is also probably “too big to bail out”.

You will have to forgive me a long post but this is one of the most important stories in the world today – and I am groping a little in the dark. Wall Street is currently (correctly) obsessed by Lehman Brothers – but they should be similarly obsessed by Barclays Global Capital. Barcap is a far more interesting and important beast. Moreover the standard hypothesis these days is that Barclays will buy Lehman. See this press report for an example.

If you follow Lehman you should also follow this – just to see how strange this hypothesis is.

I posted my old notes on Northern Rock to warm you up for this. If you haven’t read them read them before reading this.

What went wrong in UK Banking!

UK banking has been a true disaster. Far worse than the US – or even than the much maligned UBS. The stock price of Royal Bank of Scotland for instance has been much worse than UBS. The stock price of Barclays is not quite as bad – but is still ugly. That is despite the UK banks not declaring substantial losses. Quite strange.

The origins of this disaster lie in the collapse of UK mortgage margins. UK mortgage margins have fallen and fallen. The different banks had different responses to this fall. Halifax – which was originally a pure mortgage bank – made the most sensible call of all – which was to buy Bank of Scotland. It hasn’t saved them entirely from the crunch – but the shareholders of Halifax have done far better with BOS than they would have done alone. RBS purchased lots of businesses in the US (with which came a subprime problem). One kind way of describing their behaviour was that they were last seen standing by the side of the road with a sign that read “anywhere but here”. Abbey National gave up and sold itself to Santander. Northern Rock decided to make up the margin collapse with more volume – and we know where that got them.

Barclays decided to become a debt trading investment house. About half of its profits now come from the sort of activity that Lehman does.

This market is hostile to pure debt trading investment houses. Barcap should be having a truly awful time. But the remarkably the management are quite upbeat - declaring their investment banking division profitable - this quote headlining the 15 May trading statement (my emphasis):

“Our 2008 performance continues to benefit from the diversification of our business in recent years. In Global Retail and Commercial Banking, our UK businesses performed well. There was very strong profit growth in Barclaycard and we continued to expand our international businesses rapidly. Our Investment Banking and Investment Management businesses were profitable in challenging market conditions. ”

Pay up for talent

Barclays did not buy an investment bank. There were persistent rumours that they would buy Lehman – but it never happened. The way that they built the bank was to steal whole teams from lots of investment banks – offering what investment bankers respond best to – lots of filthy lucre.

One year they put on a thousand staff at over 250 thousand pounds average salary. That seemed like an aggressive hiring spree to me. The next year they doubled it and I think (but cannot confirm) they continued to expand on this pace. This is a lot of cost base to add to a retail bank with declining margins.

I know they offered guaranteed bonuses – so when they slow this beast down the staff costs do not go away.

Barclays has some good businesses – notably the i-shares that are so beloved of hedge funds. But most of what they do is just looks like a standard debt driven investment bank.

Steroids got nothing on this growth – lets look at gross derivative exposures

Having employed all these people and told them to trade. Unsurprisingly they did. Now I am just going to extract a few things from the annual reports. Here is the derivatives exposure from the 2007 annual:

I encourage you to click for detail.

These numbers are as they seem. The total gross derivative exposure is 29 trillion pounds. I deal with banks – but I am not used to dealing in trillions of pounds. I don’t think anyone is.

The gross credit swaps are 2.4 trillion pounds – but mysteriously the fair values (both assets and liabilities) are low. Only the fair values go in the consolidated balance sheet so if you were to mark these like some people do the balance sheet would be much larger. (There is mismarking in someones book - but it may not be Barclays).

The CDS are up from a mere 1.2 trillion at year end 2006.

The scale of the growth is best seen by looking at the same disclosure in say the 2003 table (snipped from the 2004 annual report):

Again I encourage you to click for more detail.

In four years our derivative exposure (total face) has gone from 5.9 trillion pounds to 29.2 trillion pounds. Our credit derivative exposures have gone from 43 billion pounds to 2.4 trillion pounds. [I keep needing to watch myself when I type this. I am not use to this many zeros – and I deal in Japanese banks which account in yen.] Anyway this is about 50% annualised growth - reflective of the great Barcap hiring spree.

It is not just the derivatives that they grew. The on balance sheet exposures grew to astronomical size too. Here is the summary from the Barclays annual report of Barcap.

Lets stress how weird this is. You have 3.8 billion pounds of “trading income” and only 42 million pounds of “value at risk”. The balance sheet however – and this is ON BALANCE SHEET exposure is a mere 840 billion pounds. That is about the same size as the whole of Citigroup! In the income statement they took a net 795 million pounds of charges against US subprime exposure. That is 19 times their value at risk.

Oh, and you got all this income with a trading team you hired with guaranteed bonuses into the most crazy-for-talent market that has ever happened. When I saw the bonuses some of my friends were being promised - well I wondered why I wasn't going to Barclays.

They were pretty good traders all up too. Unlike anything I do they made money almost daily. Below is the value at risk over 2005-2006 with the number of positive and negative trading days.



I love this - almost EVERY day they made money.

It was a little rougher in 2007 - as the 2007 annual makes clear

Analysis of trading revenue

The histograms show the distribution of daily trading revenue for Barclays Capital in 2007 and 2006. Revenue includes net trading income, net interest income and net fees and commissions relating to primary trading. The average daily revenue in 2007 was £26.2m (2006: £22.0m) and there were 224 positive revenue days out of 253 (2006: 243 out of 252). The number of negative revenue days increased in 2007 largely as a result of volatile markets in the second half of the year. The number of large positive revenue days also increased but these were spread across the year

Oh well - in bad times you get some losing days at Barclays.

Of course it all depends on how you mark the exposures. Barclays held - and continues to hold lots of nasty stuff. Their marks on the super-senior CDOs are implying only a fraction of the problems at Ambac or AIG. How do I put it? When is it mark to model and when is it mark to myth?

They put out a interim trading report. Its here. You look at the marks - and see if they make sense to you. The statement is here (warning pdf).

They got the true subprime thing happening here. They own Equifirst - a true subprime lender. Or at least it was a true subprime lender - it now does FHA loans and the like. They purchased in March 2007 when it was early in distress. They got a few billion pounds of loans with the acqusition that they meant to securitise if the market reopened. Oops.

They got the lot. Just read the appendix to the trading statement. And compare to AIG.

I got much more on this thing. But this is a blog and meant to be light hearted. Enjoy.

John

You must forgive me my tactlessness: New World Capital Management - a follow up

Short post - and an apology. I previously posted on Fun and games in hedge fund land. That post was about a fraudulent (and now disappeared) hedge fund.

The title of the post was needlessly offensive. What New World Capital did was not fun and games. I have been contacted by someone who lost a considerable part of their net worth in that fund. To them it is a tragedy.

Greg Duran (the guy who ran New World) took real money which was the embodiment of real people's financial aspirations - sending their kids/grandkids to college etc.

This blog is read primarily in hedge fund centers. My readers are clustered in New York, Connecticut, San Francisco, London. There is also a cluster of readers in Santa Fe and Alberquerque. [I am using Google analytics to map my readers.]

The readers in Santa Fe stay longer than the ones in New York - and they all read the post on New World. They are in pain. I posted as if New World was just an interesting scam. I guess it is until you are actually scammed.

To those readers - please accept my apology.

John

Australia is different: Macquarie Bank edition

Macquarie Bank runs a "wrap" product by which Australian retail investors can invest in a range of funds and have all their tax compliance done for them. The website describing this product is here.

Customers naturally enough carry some cash. The cash has traditionally been managed in a AAA rated fund holding mostly government and quasi-government and other short-dated high rated securities. The Macquarie cash fund behaved quite well - unlike say Macquarie Fortress.

But Macquarie has pulled a bait-and-switch. The attached newspaper article tells the story:

http://business.smh.com.au/macquarie-finds-1b-under-nose-20080609-2o13.html

I have repeated the first part of the article here for your edification:

MACQUARIE GROUP just found a cool $1 billion under its bed to address the high price of debt - or actually, under the beds of pensioners and superannuation investors.

With little fuss, Macquarie has converted the cash accounts of investors in its super manager and pension manager "wrap" investment products into deposits in Macquarie Bank.

Investors with a total of $1 billion in cash accounts have been given little choice in the matter: the switch occurred in May whether or not the investors wanted to make the move.

Or, as Macquarie told its investors in a leaflet about the change: "No action is required from you."

Investors have been swapped from the AAA-rated Macquarie Treasury Fund - which invests in a variety of money market products - into a deposit with Macquarie Group's banking division, which is rated two notches lower at A-1.

Investors have to deliberately opt out of the move by switching their cash into another cash fund if they do not want to become a depositor with the bank. Even then, they will have to maintain a minimum of $2500 in the cash account as a deposit in Macquarie, as part of their participation in the "wrap" investment platform.

For a bank, more deposits are a bonus because they are a cheaper source of funding than is available on the wholesale debt-funding market.

I don't want to breach copyright - so for the rest of the article you will need to click through to the Sydney Morning herald. Here is a link.

My old notes on Northern Rock

In 2005 I travelled to the UK to study the UK banks. I should have shorted the lot of them. But I didn’t. But for the record here are my notes – written on a slow English train – about Northern Rock – and never finished. I have edited it only to remove references to my actual sources.

I put this up not to gloat (but its nice). Rather I am going to do an expose of another UK bank shortly.

I cannot gloat too much - because whilst these notes are amazingly prescient I did not make a fortune on the stock. I predicted rain - but its making an ark that counts!

===================================================

Quote:

Northern Rock – leverage mortgages to the max

Northern Rock is a very simple bank. It has only one strategy and it makes no bones about taking this strategy to its absolute limit. They are completely non-forthcoming about where the limit of this strategy might be – but we will see that later.

The strategy of Northern Rock is to grow the mortgage book. Fast. All decline in margin is to be made up by volume growth. They are absolutely explicit about this – the corporate objective is:

• Grow the asset base by 25 per cent per annum plus or minus 5 per cent
• Grow earnings by 15 per cent per annum plus or minus 5 per cent.

It is pretty clear that they have even de-emphasized the old building society funding base which is I think might be actually shrinking before “hot money” high rate deposits and foreign deposits[1]. At the conference they told us how they were still concentrating on the deposit base but it had the tone of protesting too much. Besides its clear that rating agencies and bond markets want some deposit based liquidity.

I am also not exaggerating in the slightest about what the corporate strategy actually is. The management must have used these two bullet points five times in my presence (and I was not with them long).

Well it is pretty clear that growing the balance sheet by 25 per cent per annum grows risk by something near 25 per cent per annum (the company will deny this – more on that later). Growing profits by 15 per cent per annum means that capital will wind up growing by 15 per cent per annum (give or take a little).

If you grow risk by 25 per cent and profits and capital by 15 then either

• You will run out of capital and the regulators or rating agencies or bond markets will not allow you to fund your growth – in which case the growth fizzles out at best, or

• You will eventually be taking so much risk that the return on capital will not be rational in an ex-ante basis. Some point ex post you will blow up, possibly spectacularly.

If you think I am exaggerating what this strategy is then here are the five year summary numbers from the annual report. Ten year numbers were reported at the conference and they had pretty well the same appearance.

INSERT [sorry I wrote this on the train and had a hard copy of the annual. I never bothered putting the actual table from the soft copy in the report]

Note there is no credit data here. Nowadays credit losses are negligible in UK mortgage banking.

Obviously you should notice the massive expansion of leverage in this book. The asset number to look at is the “total assets under management”. This number includes securitised mortgages where the residual credit risk is at Northern Rock. (The main buyer of this paper are Japanese banks both major and regional.[2]) The total leverage of book has moved from 27 times to 42 times. Obviously this can’t go up for ever but I suspect it can go for quite some more time. (You will see that 43 times leverage is not unusual for a UK bank.)[3]

When I was with the company I tried to explore the limits to the strategy and got nowhere useful. It would be nice to know though because when the company reaches the limit of its leverage it would be a safe short (unable to grow and possibly facing further margin erosion). Until then its probably a better long then a short as there seems no impediment to earnings increasing at at least the teens and the PE is only XXX now.

That said – here goes for my discussion about the limits to Northern Rock’s growth. The company told everyone at the conference that mortgages were safer than conventional loans probably deserving a 33 per cent risk weighting. In Australia and the US the standard is 50 per cent risk weighting for mortgages with no insurance less than 80 per cent loan to value (LTV ratio) so by international standards 33 per cent is aggressive.[4] That said Northern Rock suggested that there mortgages were substantially safer than the average (measured delinquency at about half the market rate) and hence they should have half the risk weighting – call it 17 per cent. They even went as far as to say that the regulator agreed with them. [Some comments have been removed here because they report indirect comments from regulators. I cannot vouch for them on this blog.]

Now if your mortgages require only a 17 per cent risk weighting then you can be 84 times levered with a Tier One ration of 7 per cent. [Figures: 1/(.17*.07)]. If a third of your tier one capital is subordinated debt (not uncommon in banking these days especially in the UK) then your total leverage ratio might be well over 100. I did this calculation for them and they were quite uncomfortable – because they are hardly wanting to telegraph to the rating agency that they will one day be 100 times levered. (It would increase the cost of their funds now and hence further compress their margin.)

I did not get any useful feed on where the limits to growth are. However looking at the other banks (discussion later) I suspect that the limit is roughly 60 times levered. That would suggest (growing capital at 15 and earnings assets at 25) that there are four to five years left. However by that point the bank has almost ₤200 billion in assets – large compared to the UK mortgage market. Its funding would be totally ridiculous. [Comment deleted because a senior executive of another UK bank thought Northern Rock would go bust in 2007. I just do not want to dump him in it.] Something will crack – but in five years earnings could double again and the stock could be an abysmal short.

If you look at the five year summary above you will notice that the mortgage originations in any year the gross lending is substantially larger than the net lending. In 2004 gross lending was GBP23 billion - about 45 per cent of the total managed book at the end of 2003. Asset growth is only about 45 per cent of net lending.

This leads into the way that the lending is done. Its TEASER RATE lending. In the UK new mortgages (especially from this bank) tend to have a “teaser rate” which applies for two to three years (mostly two years). The fashion of late is to have two year fixed rate loans on very low spreads (the yield curve is flat in the UK) and to offset the spread a little bit in up-front fees. The loans revert to old fashioned (and fat margin) standard variable rate (SVR) at the end of the teaser rate period. The profitability of this business is determined by how many of the loans you manage to keep on your books after the teaser rate wears off and on any incidental products you might sell to the mortgage holder. If the loan comes in through a branch rather than an IFA the loan might be more profitable because it does not cause a broker fee. Internet channels are also relatively profitable.

The way that Northern Rock grows so fast is that it is the king of the teaser rate. It has however very poor retention. Bradford and Bingley told me that Northern Rock would boast about their 400 retention staff (they will cut your rate if you ring up because the alternative is for you to go elsewhere and a cut rate loan is more profitable than a new brokered loan). The competition also target Northern Rock customers. Natwest (HBOS) have regular advertisements on TV showing people on a rollercoaster with very low mortgage rates about to swing up wildly (and quite graphically make them sick). They suggest that you are nuts if you take this swing up and offer you GBP100 if you are an Alliance & Leicester or Northern Rock customer (not a B&B customer) and your rates refinance and you do not want to pick a Natwest mortgage. Its clear that Natwest however is trying to get people through the (lower cost) direct channels. (This sort of competition exists in deposit pricing too.)

There is a test as to whether all this teaser rate activity produces long term customers. Just look at the implied fall off in loans versus the originations two years ago. In 2004 it appears that over GBP10 billion repaid. Gross lending two years ago was 12.5. There is clearly some but quite limited success in retaining the customers. When pushed on accurate data on this issue Northern Rock were simply not forthcoming.

There is one more thing that is quite revealing about Northern Rock – and that is the effect of International Accounting Standards (IFRS) on balance sheet and profitability. UK companies are being forced to adopt IFRS and whilst it is an issue with a lot of noise for many companies the differences are small. They are not small at the Rock. In particular IFRS requires that income and expense charged as a fee but which relates to some period gets amortised over the period. Now remember that the shift in the market has been from floating rate teaser products to fixed rate teaser products with high fees. The Rock has been booking those fees up front inflating earnings and book value. IFRS will (under the guidance given at the conference) reduce book value and earnings by about 10 per cent. (Leverage is probably closer to 47 times – and using a sixty times limit the company probably has only three years rather than five.) The company seems to think that IFRS is a bad idea (aren’t the fees cash). But I am never quite sure whether the mix of fees and spread has shifted driven by accounting considerations or whether its driven by the realisation that churn is going to remain incurably bad or get worse. (Obviously enough up front fees are a good idea if you are scared of churn.)

All of this was enough to make me pretty bearish on the stock. But it got worse. They simply stretched numbers to say what they do not. If it were not for the low standards of America I would say they lied – but I suspect just being economical with the truth was closer. I have referred above to the notion that their delinquency is half the industry average and therefore (as they argue) they deserve only half the regulatory capital charges of the competition. The problem is that a delinquency rate simply does not make sense when your growth has been as rapid as the Rock. I tried to tease out of them the notion of a “growth adjusted delinquency rate”. No luck. I tried to work out what the delinquency by age of mortgage was so I could do the numbers – no luck. They simply were not forthcoming and even attempted to mislead me.[5]

The place however they misled most blatantly was on the margins both historic and prospective. The company stressed that I should not just look at interest margin – rather I should look at fees plus margin over assets – especially as they had shifted to fixed rate low margin loans with relatively high fees. Ignoring the IFRS issue (as they did) the average margin on the book is 125bp and it has fallen every year – most notably during 2004. They wanted to tell me that the INCREMENTAL margin was 110-120bp. This is much higher than the competition tell me the margin is (40-80bps) and simply cannot be squared with the margin figures in the above table. The problem is that they will soon hit limit leverage constraints (but they would not tell me what those constraints were) and were aware that their margins (hence earnings and ROE) would continue to drop once they hit those limits.

As for credit risk. The company told me that they had a position in the broker market as offering the cheapest loans to the best credit. I have one reason to disbelieve them. The Rock has a lower rating and hence a higher funding cost than several competitors – and hence would naturally have a relative advantage further up the risk spectrum (its hard to do good credit well with a low rating). Also they told me in another breath that they had industry leading margins (which did not reflect in the accounts). Stuffed if I know. They seem to think that they will be alright with a 20 per cent fall in the property market. They seem to get concerned when you talk about a 30 per cent fall – and they seem to think that a 35 per cent fall is impossible. I heard all the old hoary clichés: “they are not making any more land in the South East” etc. I should get the stock brokers to organise me some chats with mortgage brokers and IFAs. But I am – until that – inclined to believe that the threshold for pain is about a 30 per cent fall in the property market – and that falls beyond this range could lead to a wipe-out because the loan book is new (hence has not had the chance to get much appreciation into it) and is so levered. [Ok – I was wrong here – they went bust on funding.]

You do have to give the bank credit for one thing though. They have got their costs quite low – 38bp of assets and probably lower under IFRS. This is one of the lowest cost structures in the world. The management will point this out as almost their crowning achievement. They had to do it (had they kept their old cost structure the squeeze in margins would have wiped them out). It does however look difficult to keep reporting lower costs – this looks a lean operation.

Do I want to short it? I wouldn’t object – but I suspect we can do better with timing. The investment bankers are convinced that if something went wrong it would be purchased at 80 per cent of book on the way down. Maybe that is true now – but it will not always be so. I was staggered by the lack of sophistication of the staff – I met the CFO and he was either dumb or a liar or just assumed I was dumb. This company is totally dependent on the goodwill of financial markets. I put to them that they were dependent on the kindness of strangers – and they bristled. They thought that people invested in UK mortgages because they were good investments. Why – so they thought would you invest in Italy?

For discussion.

---

[1] The shrinkage does not show in the numbers – but the deposit base includes €2.5 billion in French deposits which are really hot-money commercial paper and some Japanese deposits. The claimed retail deposits in the five year results page I reproduce (17239) does not match the balance sheet (20342) and I am assuming the difference is roughly the above €2.5 billion and other quasi wholesale money. I can’t tell how much “hot money” there is but Northern Rock were pretty keen to advertise a 5.4 per cent rate. The shrinkage is a guess – but the company was not far from admitting the same when pushed on the issue.

[2] Amazingly the CFO was prepared to name the six Japanese banks which purchased the paper. I told him we had an interest in the Japanese banks and it would help me understand their books. He did not remember their names but he had been on a roadshow to Japan. I have virtually never had a company volunteer this sort of information. Its pretty naïve to do so as there is more than one way to interfere with a banks funding. If he had thought about it clearly it was just as likely I was short Northern Rock than long it. It was part of a general attitude I came across in Britain (nobody appears at all concerned about the vulnerability of funding bases). I pretty well floored Michael Oliver (the very experienced IR guy at Lloyds TSB) when I told him this when I took him out to dinner.

[3] The US tends to have a regulatory limit on leverage at 20 times. Any further and the informal rule is that you can expect an intrusive visit from the regulator. [Some comments deleted here.]

[4] [Regulatory footnote removed – partly because it is wrong – and I am embarrased.]

[5] On the train between Leeds and Leicester I chatted to a woman in her fifties about the banks. She had a mortgage on SVR (an old high margin mortgage) with Lloyds TSB. I asked her why she did not refinance it and she told me a story about weakened credit. Her husband no longer worked and her income paid the mortgage and supported the family. She had plenty of equity in the house but she (erroneously) thought that she could not refinance. Refinance would have saved her GBP500 per year. It was an easy decision had she been informed. Lloyds is hardly going to inform her. But there is a lesson here – the back book are going to have higher delinquency than the front book but without necessarily worse credit. It self-selects this way in part. The comparison that Northern Rock had on their delinquency rate was at best grossly misleading. (There is a possibility that they believed it though which would suggest incompetence. In this case they misled so transparently they might well just have been dumb.)

Its a sh-t business - but hey - the dollar is falling

I subscribe to the GE Press release/blog. Indeed they have a nice page of ordered feeds to become part of your Firefox bookmarks.

Many of the releases are seemingly inconsequential - at least in a company the size of GE. Here is an example in which GE (through its Jenbacher Engine business) turns farm waste (ie sh-t) into electricity.

The individual project is inconsequential - a megawatt of capacity - so probably couple of million dollars powered by - and I am not kidding - 20 cubic metres (700 cubic feet) of cattle effluent and 50cubic metres (1700 cubic feet) of other biomass daily.

Its good to know that GE sales and development staff have their hands in the muck.

What is consequential about this project is that it is not in Iowa. It is in Italy.

The competitors to GE in Italy would have mostly Euro costs. This may be (literally) sh-t business, but it is certainly more attractive when your costs are in dollars and your competitors costs are in Euro.

Places to be bullish

One way of interpreting the current financial crisis is as the first stage of the huge current account adjustment that the US is going to have to go through. Consumers in the US have had high levels of borrowing. These were mathematically unable to be sustained indefinately - but they could be sustained for a long time.

The subprime crisis is - in one view - the first indication that a long time has passed. Endless consumer lending is no longer good business. The US current account (which ran somewhere near 6%) will reduce (over time) to a more standard 2%.

This will involve a lot of movement from domestic sectors (housing, retail, medical, domestic finance) to export orientated sectors. If this adjustment happens slowly you will get what the press refer to as a "soft landing". If it happens fast you get a recession. If it happens very fast you get a true crisis (as per Argentina where the Peso almost became worthless).

If you want to get bullish about the US you want to be bullish about the sectors where the economy will be moving to - export or import replacement orientated. The current account deficit is nowhere near 2% now - and so this trend has years left to run.

The places with the best long term trends are products that America does well - that the Chinese need - and where the competitor is European and has Euro costs and US dollar sales.

Did anyone say aeroplanes, jet engines etc? Well Boeing hasn't been a bad stock over five years though it has been a bit rough of late. But even better is the technology that involves saving energy - or shifting stuff around more efficiently. And has anyone noticed that GE engines tend to be better at that than most the competition?

If you want to get bullish about the US these are the places to get bullish - really bullish. The problem with GE is that they have domestic businesses. Medical business is doing relatively poorly in the last result on domestic performance - and NBC - which is purely domestic has results that suck. The domestic part of the finance business is not doing great either - but it is doing much better than it would have done had Immelt not pruned it so hard.

But for the moment lets wallow (if that is not too graphic) in the good stuff - in American knowhow turning Italian cattle-crap into electricity.


J

Joe Gutnick: a first follow up OR Why pay stock shills when you can have News Corp for free

Joe Gutnick plans to list his Legend Mining in Australia. And THE AUSTRALIAN (News Corps orignal flagship newspaper) has taken his numbers at face as shown in this linked article.

Which leads to an interesting question: why bother paying stock shills USD2500 when the News Corp will take your adverts without payment?

The article of course makes it plain:

The company sees a local listing as logical, considering the operations will be based in Queensland.

But this would involve trading existing shares -- there are no plans for any immediate capital raising here.

So Joe is going to sell existing shares in Legend to the Aussies. The $2500 stock shilling in my last post is the pump. The sale to Australian fund managers is - well a way of getting some cash into existing shareholder pockets. Maybe its a good deal for all. After all Joe has struck gold and diamonds before. Still paid stock shills do not in general outperform.

Now Bronte Capital has always had the best interest of Australian Investors at heart. So - seeing this as we do - we have have purchased the Google search terms "Joseph Gutnick", "Joe Gutnick" to link to this blog.

My adverts will cost a lot less than $2500.

A colourful charachter stoops to paid stock shills

Joseph Gutnick - better known as Diamond Joe Gutnick - is a colourful charachter.

Here is a lovely profile from Forbes Magazine which in 1996 described his fortune and his (major player) status in Israeli politics.

In the article it was pretty clear that the relationships Diamond Joe had were mutually beneficial. Joe spent his money on conservative Israeli causes and famous conservative New York Rabbis and Israeli Prime Ministers promoted him and his stocks.

Joe's fame does not end there. He was the target of a purported (but real) al-Qaeda assassination plot. Indeed his name turned up in the notebook of an al-Qaeda operative on trial in France as recently as last year.

I have to be careful about what I say about him though. He sues people so this will be a post lacking in colour. He famously sued Dow Jones (ie Barrons) in the Australian courts for something they put on the internet about his business interests. He won. The High Court of Australia (equivalent to the US Supreme Court) judgement is here.

Barrons has removed the story - so I can't even link it.

Joe Gutnick has run several gold and diamond exploration companies - with some success and some failures. He spent 9 years on the BRW Australian rich list though unusually for a successful miner he has dropped off. At other times ventures have become very problematic - as this story about the insolvency of Centaur mining will attest.

He received the "Diggers Award" at the (famous) Kalgoorlie Diggers and Dealers conference.

The Rabbi/shills even went so far as to predict where he will find diamonds and/or gold. Australian fund managers were once accused of taking those predictions too seriously - because they were often right. Yes - he did actually find diamonds. And his gold companies actually produced gold proving Mark Twain wrong. (Twain's definition of a gold mine: a hole in the ground with a liar on top.)

Investing with Joe is speculative - but he has form both as an explorer/miner and as a stock promoter.

So imagine my surprise when I find that Diamond Joe's latest venture is being promoted in PAID penny stock adverts. I have a junk email address which I use to subscribe to dodgy stock emails. I don't look at it much - as there are literally thousands of emails in the box. But this one caught my eye:



So far nothing unusual - but the contact detail really caught my eye:

Legend International Holdings Inc Mr. Joseph Gutnick, +011 613 8532 2866 Chief Executive Officer Fax: +011 613 8532 2805 josephg@axisc.com.au or New York Office General Manager Business Tel: 212-223-0018 Fax: 212-223-1169 legendinfo@axisc.com.au

Visit Legend International Holdings Inc.
Website: www.lgdi.net

And the last disclaimer

This email was sent to you from STOCKGROUP's Newshotline. If you wish to take yourself off from the subscription (Investor), please use this link to cancel future deliveries. Thank you. The Information in a Stockgroup Media Inc. Newshotline is A PAID ADVERTISEMENT and is for the viewers information only. Legend International Holdings Inc. has paid a fee not exceeding $2500.00 in cash or stock to have their corporate information featured. The corporate information is purely and solely the responsibility of Legend International Holdings Inc. and it is neither commented upon, researched, or in any manner the responsibility of Stockgroup Media Inc, whose only function is as a supplier of media facilities. Any information provided by the advertisers of Stockgroup Media Inc., through its media services, is not to be construed as a recommendation or suggestion or offer to buy or sell securities, but is provided purely as an informational media service. Stockgroup Media Inc. makes no warranties or undertakings as to the accuracy or completeness of this information. All due diligence should be done by the reader or their financial advisor. Investing in securities is speculative and carries risk. Persons who wish to buy or sell securities should only do so in consultation with their registered securities advisers.

Oh how times change. Once Diamond Joe could get an Israeli Prime Minister to shill for him. Now he is stuck using StockGroup's News Hotline as a PAID ADVERTISEMENT.

(Disclosure: no positions.)

Will General Electric get its advanced materials back?

Jeff Immelt gets some bad press these days. But I am not convinced he is all that bad. In the financials area (the area which I know well) he is brilliant.

He sold FGIC (a competitor to Ambac). It has since imploded and S&P rate it as junk.

He sold/spun out his mortgage insurer. Also a good deal.

He sold the crappy business of insuring people against the need to go into nursing homes. (It went with the mortgage insurer - and it is the best player in a very bad space.)

He has got rid of his business taking long term litigation risk. That will probably be OK.

He has however made some head-scratching purchases - particularly in medical. Jeff Matthews points out a shocker.

In the last results - much pilloried - the finance business did poorly (but way better than it would have had Immelt not pruned it so hard). The businesses that sell things outside America where the competitor is European (jet engines, rail, turbines etc) all shot the lights out. And medical was awful. Maybe Jeff Matthews is onto something.

But for the moment I just want to pick on what looks to have been a very good sale - the GE Advanced Materials business sold to Apollo (Private Equity). The buyers paid $3.8 billion in a mixture of cash, securities and left GE with a 10% interest. GE received just over 3 billion in cash - and (to the best of my knowledge) still holds $400 million in pay-in-kind securities. The business was renamed Momentive and has a new website - but also uses the GE Silicone Website.

The sale was part of the GE Plastics exit. And in this case I suspect Immelt got a very good price indeed. Momentive blames its problems on rising input costs - but those apply to the competitors too. Moreover the competitors are more European - and hence have a huge currency swing against them. This should have been a winner for private equity but they just paid too much.

That renouned business paper the (Albany) Times Union reports that they are now paying the PIKs in kind rather than cash.

Score that to Immelt.

At some stage though we are going to learn whether the sale of Advanced Materials was strategic or opportunistic. The biggest creditor when this defaults will be GE. With little difficulty GE will own the business again - if they want it.

Disclosure: long a small amount of GE. My biggest worry with GE is that the business that Immelt should know best (medical) is the problem child. I don't understand how his calls in finance could be so good - and then he does the acquisition that Jeff Matthews refers to. Jeff knows the medical as well as I know the finance.

Follow up: Momentive have filed a 10K. It is pretty ugly - with over $3 billion in debt - a few PIKs whcih can only be paid in cash after 2010 and a lot of finance leases (which look like debt as well). Leverage is over 10 times.

GE retains a $400 million debt instrument - but I seriously doubt it will get paid. It is not of the same class as the PIKs - instead it is a 2017 zero coupon.

Now we get to test whether GEs accounting is up to much. If they valued that zero at zero then they have no charge. If they valued it at something near par they better take a rather large haircut.

Watching with interest.

Australia really is another country: Part 2

I have previously written about the proposed takeover of St George bank by Westpac. I think Westpac is crazy – somewhat ameliorated by the fact that they are paying stock.

But there is one aspect of that takeover which makes you wonder what the board is could possibly be thinking. I know (and like) the Chairman (Ted Evans) and am very puzzled by this. [First disclosure: when Ted Evans was Secretary of the Australian Treasury I used to work for him.]

The thing that puzzles me most is the CEOs conflict of interest.

Gail Kelly- the superstar CEO of Westpac – was previously the CEO of St George Bank. Yes that is right. Only a few months ago.

On the plus side she probably knows more about the strength and weakness of St George than anyone. However you can say that about every deluded bank CEO of the last boom.

On the minus side she is financially conflicted. Gail Kelly – the CEO of Westpac – and who made an unprompted offer for St George – owns almost AUD40 million in St George shares. And it takes the online media to state the obvious: here.

Could this happen in America? Or is Australia really another country.

John

[Second disclosure: no interest in any stock mentioned.]