Optimism Porn – used car prices

There is so much bad news out there that I thought I might start a little bit of optimism porn to counter the pessimism porn that is becoming so common.

So here is your first dose of optimism porn: the used car business is holding up surprisingly well.  This was mentioned in the Federal Reserve’s Beige Book – but also in the Manheim index of used car prices at auction.  This index spiked up last month!

The biggest single determinant of losses in a subprime auto finance book is not loss rate – it is severity – the loss after the car is auctioned.  I am not about to buy non distressed auto securitisations or anything – but if you want to play in the distressed stuff this is clearly good news. 

 

John

PS.  One comment from below deserves highlighting:

that is great news. anyone in NY want to buy a 2003 mazda protege with 55k miles really cheap? i bought it to commute to my hedge fund job and don't need it any more.

Voodoo maths and GE

Keith Sherin – the GE CFO – put out a press release that you can find here.  I just want to extract one paragraph.

Mr. Sherin said he expects the financial services business to be profitable for the first quarter and full-year 2009, and he addressed questions on the Company’s position on cash generation and loss reserves:  "Over a three-year period here, we expect GE Capital to be profitable, even after $35 billion of losses and impairments. We're looking today for GE’s total cash flow to be around $16 billion for the year. In our stress case we could be down in the $14 billion level.  In either scenario, we can fund the company. If conditions were to deteriorate beyond what is in our stress scenario, we also have the option of scaling back originations in GE Capital to conserve cash and capital."  Emphasis added.

Now when I pull apart GE I get embedded losses above 35 billion.  The more bearish get losses at 65-70 billion.  I am not convinced about such numbers but 55 is plausible.  Losses of course are unknowable - but 35 is plausible.

$35 billion in losses and impairments over three years may have sounded nonchalant.  This is substantially higher than 2008 where losses and impairments were only 7.5 billion.  

In other words Sherin is predicting a substantial downgrade in GE profitability.

No surprise there.  The market knows it.  However Keith Sherin’s prediction (reasonable – but high estimate of profitability in my view) is wildly inconsistent with Jeffrey Immelt’s shareholder letter.  Immelt’s shareholder letter says that they are “targeting returns [in GE Capital] to be about 15%”]  

$35 billion in three years is not consistent with 15% - so somewhere the message changed.  

Has the CFO just dumped the CEO in it?  No- the stock market did that first!

Now if the losses are going to be that elevated (and they will) then GE should be taking the provisions when it deems them likely.  That is when they are incurred.  If they were to do that then the tangible capital of the whole of GE goes negative.

However if they take the extra provisions over three years then pre-tax, pre-provision earnings (ie Voodoo maths) will see them through. 

Oh, if the losses are where the bears think ($60 billion range) and if the government supports GE’s liquidity (likely in my view) then voodoo maths will still see GE through – but the time period is five years and the dividend gets cut to zero.  

The stock may not be a buy - but on those sort of numbers the CDS is unnecessarily wide - and Warren Buffett will make money on his preferred.

Jon Stewart's takedown of CNBC

Has been linked by many people but it is worth it.

http://www.thedailyshow.com/video/index.jhtml?videoId=220252&title=cnbc-gives-financial-advice

Weasel words from Keith Sherin

Keith Sherin is the CFO of General Electric.  He was just interviewed on CNBC.  I have only seen highlights of the interview.  

Anyway here is just one of the money quotes – courtesy the CNBC website.

"We have an incredibly strong liquidity position," Sherin told CNBC.  "We've got $45 billion of cash; we have no triggers that we could see that would have any call on our cash in the short term."

Read it again.  It does not say that they do not have ratings triggers.  It does not say what rating the triggers cash in at and how much.  In fact it says nothing really.  Weasel words.

Ok – I got a single challenge.  General Electric’s old insurance company wrote AAA rated guaranteed investment contracts (or GICs).  GICs were standard for AAA rated insurance companies and were written at Ambac, MBIA and AIG.  In all those cases they caused trouble – potentially parent company liquidity trouble in the MBIA and AIG cases.

The GIC contracts almost always contain ratings triggers that require collateral to be posted on certain rating declines.  

The assets backing the GIC contracts and old annuity obligations are about 5 billion underwater (see note 9 in the GE annual report).  There is almost certainly a rating trigger.  That trigger (undisclosed and obscured by Sherin) might cause $5 billion in liquidity call.

Can we have a disclosure as to what the trigger is rather than a statement that the ratings triggers we have we can’t see causing us a problem?

Please.

In the interview Keith Sherin talked about how transparency would restore confidence in GE and then proceeded to hide behind weasel words.

This does not inspire confidence.

Are there more ratings triggers than the GIC one?  I have no idea as there is no disclosure.

Sherin's weasel words continue a fine tradition.

Polish hookers don’t cost too much

Once I wrote a post about Swedbank and Latvia.  The title was “Hookers that cost too much, flash German cars and insolvent banks”.  Roughly I predicted a disaster in Latvia based on – you guessed it – the price of hookers.  I was right.  Latvia's economy has now entered a true depression.

The logic was that Latvia was running an unsustainable current account deficit and borrowing in a currency which was not its own (it was borrowing in Euro intermediated by Swedish banks – notably Swedbank). 

The normal solution to an unsustainable current account situation is to devalue – but if you have a lot of foreign currency borrowings that solution too becomes difficult as the domestic currency amount of your foreign currency borrowings goes up as your currency goes down.  You become competitive and simultaneously go desperately bankrupt.

If all that is required to restore competitiveness to your domestic industry is a small devaluation then that is just fine.  Sure the notional value of your debt goes up – but 15% is still manageable – especially as the devaluation should drive domestic incomes up. 

But if the amount of devaluation needed for domestic competitiveness is large and the foreign debt is large then there is a true disaster in the making.  Devalue enough and you bankrupt almost everyone.

Now how do I measure the competitiveness?  Well I want a reasonable cross-border comparison of labour costs of labour of roughly equal skill.  I guess I could use the price of an electrician – but I don’t know how to find that.

So instead I use the price of prostitutes.  Sure Latvians might be better looking than most – but the prostitutes were frightfully expensive (at least by Eastern European standards) and (according to several comments I received on the blog and by email) were also providing poor service.  [Honestly I don’t know.]

This brings me to Poland.  Poland is the subject of the latest Eastern Europe scare mongering.  Its a large part of the GE/Eastern Europe story for instance.

A large proportion of domestic mortgages are priced in Swiss Francs – and the Zloty has devalued sharply against the Franc.  It is bad in Poland.  But it would be far worse if Poland had started with high cost structures. 

Now I have not tried to manufacture anything in Poland – but using my usual index (the price of prostitutes) it appears that Poland is now quite reasonably priced.  Sure it is not Thailand – but hey – they look to be offering the best deal in Eastern Europe.  Get your Ryan Air flight now.

I will thus make a prediction.  It is not going to be as bad in Poland as Latvia.  And whilst GE will lose money in Poland (possibly a lot of money) it will not lose as much as some of the more vehement bears are arguing.

 

 

 

John

Good behaviour and General Electric

I tended to judge GE by their behaviour (cutting risk, getting rid of dangerous businesses) rather than their accounts (which are deeply rubbery).

Let me just fill you in on a single deal.  GE once had a very bad American Visa/Mastercard portfolio.  Deep subprime.  I was short GE in those days (above 50!)

They sold that portfolio to Metris Companies.  Metris was a desperately subprime credit card company that grew out of the mail order catalog sales business of Fingerhut.  (You are going to need a deep knowledge of people selling electronics, toys, kitchenware and comforters on monthly payment plans to have any knowledge of them.)  

Anyway, Metris had an insane average balance of over $4000.  ($4000 average balances at 30% yields where the average balance goes up sharply each year suggests that a lot of the loans will not be repaid.  Many balances had blown above $10 thousand and minimum or no payments were made.)

I shorted Metris and made a lot of money.  Unfortunately I kept a bit of the position on from 20 to 2 via 40 and then back up to 7.  It felt like burning in hell when the short doubled to 40.  And sheer (foolish) stubbornness meant that I did not cover the Metris at two or three dollars.

Metris should have crashed and burned.  It was first-rate cactus.  But it was bailed out by the master of the dumb subprime bailout.  Yes HSBC in the guise of its US Household Operation purchased GE’s old diabolical business at a premium to par.

So when you see HSBC raising money that is in part to cover losses that GE cleverly avoided.

Funny – you can’t tell in GE’s stock price.

John

PS.  For those that really want to know - the credit provided implicitly in Fingerhut's catalog business is now provided by CIT.

An uncomfortable observation for GE common

One of the cases for GE is that GE does not guarantee GE Capital Services (GECS).  GE has less than 40 billion in debt outside the GECS structure – and if you buy GE and they let GECS go you get

1. The industrials business which – as GE points out – makes about 17 billion in cash a year and requires only 3 of capital expenditures, and
   
   
2. NBC Universal – which happens to own a few nifty (and well watched on Wall Street) cable channels.
   

This sounds like nice downside protection – except that the FDIC tied General Electric up.  Not that I am used to saying anything nice about Sheila Bair – but the FDIC guaranteed debt that GE Capital issued has a guarantee from the parent company – at least as per this disclosure in the GE Capital Services form 10K.

At December 31, 2008, GE Capital had issued and outstanding, $21,823 million of senior, unsecured debt that was guaranteed by the Federal Deposit Insurance Corporation (FDIC) under the Temporary Liquidity Guarantee Program. GE Capital and GE entered into an Eligible Entity Designation Agreement and GE Capital is subject to the terms of a Master Agreement, each entered into with the FDIC.  The terms of these agreements include, among other things, a requirement that GE and GE Capital reimburse the FDIC for any amounts that the FDIC pays to holders of debt that is guaranteed by the FDIC.

Sheila Bair protected the taxpayer – but at the expense of crisis residual value in GE.  

Of course this is only operational if GECS fails.  And whilst I have worked quite hard on that - and my prima-facie view is that it does not - I will admit I just do not know.

John

Hey guys – you can make a much better investment than Warren Buffett

Warren purchased some GE converts a while ago.  Got what looked like a sweet deal at the time – a big yield and a nice conversion.

With where GE and GE debt is trading now you can – by buying debt and equity – produce a hybrid instrument that is (a) senior to Warren, (b) has a higher yield than Warren and (c) has better effective conversion terms than Warren.

Warren has stuffed up before.  He purchased Irish banks last year.  He purchased oil companies when the oil price was high.

But GE – wow.  Maybe his ability to analyse it is no better than any of ours.

From the wonderful vaults of General Electric

You need to do something special to get into the GE Annual report.  Ordinary revenue producers do not get a photo.  You need to be special.

And so – with a sense of foreboding – I give you an image from the 2005 GE annual report.  I do not have a soft copy because this report was restated and GE does not keep a soft copy on the web.  

So I scanned it.

The image I think is Ortakoy Mosque and the Bosphorus Bridge.  Turkey.  I have never been there so I stand to be corrected.

Snow on the Bosphorus was a memorable image and I doubt I would have remembered the photo without the snow.

The likely lads in the photo are Charles Alexander, President of GE Capital Europe, Ergun Ozen, Chief Executive Officer of Garanti Bank, Ferit Sahenk, Chairman of the same bank and Dmitri Stockton, Chief Executive Officer of GE Consumer Finance, Central and Eastern Europe.  

Central and Eastern Europe - and Charles Alexander's UK mortgage business are amongst the main areas of concern of people shorting General Electric.

The last guy (Stockton) at least is still in his position.  This is either a darn good sign (he hasn’t blown up and was really clever avoiding a freight train) or a darn bad one (he has blown up – but the powers that be haven’t worked that out yet).  

Informed comment wanted.

Memo to Jeffrey Immelt – if you are going to lie you have to do it more convincingly than this

• GE sold its mortgage insurance business before the crisis broke.  That was high quality risk aversion.

• They sold their bond insurer (FGIC) to a combination of private equity and PMI Inc.  I figure the private equity buyers are hurting – PMI trading at less than a dollar surely is.  Again this is the mark of superlative judgement.

• I know the guys who run the Australian mortgage business.  They started cutting back risk very early.  The staff who used to get paid on volume are very unhappy indeed because – well – as credit standards tightened volume dropped.  Another mark of superlative judgement.

• They sold their life reinsurance business to Swiss Re.  I suspect Swiss Re is hurting - and indeed Swissy had to sell a big stake in itself to Warren Buffett - I suspect to partly cover those losses.

• They sold their P&C reinsurance business as well.  That is probably doing OK – but it carries a long tail risk.

• They sold their long term care insurance business.  That player – now part of Genworth – is the best company in the world in one of the worst businesses in the world.  The risks were high.
  

GE Finance in other words cut back on risk.  A lot of risk.  Mostly the right risks.  And they cut back on risk early – before the crisis hit – when they got good prices for rubbery assets.

I have argued at times that Immelt is the best CEO in the world for that. I even owned the stock for some of the fall in the price (though I have not owned it for a while). 

It was an article of faith for me that when you see consistent bad behaviour by a bank or an insurance company in one area it is usually rife.  You can’t know everything in a bank balance sheet.  Not even the CEO and CFO have a hope of that.  

Symmetrically if you see consistent good behaviour then you can guess that the good behaviour pervades the book.

When analysing a financial all you can judge is the culture – and if the culture was cleverly cutting risk in areas you knew really well it was probably cutting risk everywhere else.  

GE looked pretty good to me.  The behaviour exhibited was smart and consistent.

The problem

In finance you make profits in normal times by carrying risk.  The more risk you carry generally the higher your "normal time" profits are.

If you cut risk – as GE did – then your "normal time" profits will fall.  GE Capital profits did not fall as they cut all that risk.  That was very strange.

There is no question that GE fudged its results a little bit in order to keep reported profit momentum when actual profits were falling.  Gradient Analytics did a solid report on GE showing how they had systematically stripped reserves in many businesses.  

The bears travelled from the analysis of fudged accounts to guessing (and it can only be a guess) that GE must be full of toxic assets.  

I thought the negative reports were overly bearish.  I watched what they did more than I watched the accounts and what they did told me they were very good.  

The summary was that they were doing the right thing and their profits were falling for good reasons – and they were lying about the profit fall.  

Normally I have the view that a company that lies about its earnings in small ways has a lot to hide – there never been only one cockroach – but I was desperately impressed at the big-picture things that GE was doing.  To the accounting junkies GE was diabolical – because they lied.  To them sanctity of accounts is the true mark of quality of a business.  I am a little less pure than that – but maybe I should listen more.  I went long GE in the thirties.

Now my buy case for GE depended on them being a capital equipment exporter with costs in US dollars and with Asia growing like crazy.  This was the decoupling fantasy that cost a lot of investors (including me in this instance) some pretty coin.  As the world now knows China fell into the economic abyss sometime in the third or fourth quarter of last year and the upside case for GE (capital equipment sales) collapsed.  I sold for a bad loss – but it would have been a worse loss had I held.  

Anyway it is not true that GE kept cutting back risk.  They took a few too many risks in commercial property and even Immelt admits problems in UK mortgages.  The risk de-jour though is that they tied themselves up in Eastern Europe – and until very recently they were boasting about as a presentation show made in September last year shows.  (That presentation seems to have disappeared from their website).

Still according to Immelt’s letter GE Capital made $9 billion last year.

Sorry – I do not believe it.  Indeed the claim is comical.  Here from GE’s recently released annual report is a table of non performers and reserves.

In almost every financial company reserves have had to rise faster than non-performers over the past year.  Why?  Well consider how a non-performer becomes loss.  We will do it in the case of a mortgage:

1. The customer stops paying full interest.  They do this because they have had a hiccup in their business or life that is temporary or semi-permanent.  If they are an electrician and fell of a ladder you can bet that once their broken leg is healed the non-performing loan will again perform.  But if they are an auto worker who loses their job they might not get another one for a year or two.  You are probably going to foreclose.  The chance of a non performer defaulting goes up with unemployment.
   
   
2. Then once the loan defaults you need to sell the property.  If you haven’t noticed the loss given default has gone up sharply.  

In summary the chance of a non-performer turning into a loss has increased sharply so the ratio of reserves to non-performers should go up sharply.

What if I told you that the reverse was true at GE.   In many of the lines of business reserve coverage went down – often down sharply.  Not great.  Not even plausible.

Real GE profits

The funny thing is that it never needed to be this way.  GE was still – even on my adjusted numbers – profitable last year.  I have seen some bear-case estimates of the loss on the ground in various GE businesses and they look high to me.  These are guys who estimate losses by looking at accounts – and the losses GE will take are – in my view – substantially less than market because – on the ground – I have seen them operating in a lower-risk manner than their competitors.  

The problem of course is you do not know.  Summary: mostly good behaviour – bad accounts.  Sure I have heard some instances of bad behaviour – but they are thinner on the ground than the good things.  

Jeffrey Immelt in his letter says that he takes responsibility for the loss of reputation of GE.  If that were an operational responsibility he would resign.

And on the basis of his accouting he should.  

But I am not calling for his resignation.  On the risk management described at the top of this blog post he remains possibly the best CEO in the space - and he is way better than any obvious replacement.

GE as a parallel for America

Speaking as an outsider I have to agree - America at its best is a wonderful place.  It is amazingly productive.  The degree of specialisation of people and the cities they live in is wondrous.  The innovation is jaw-dropping and it has changed the world.  

Silicon Valley is a wonder of the modern world.  But so are half a dozen fecund places in America.

So is General Electric.

America has plenty to recommend it - and if I did not love Australia so much you would see me on the plane yesterday.

But the accounting sucks.  It sucked when the broker certified the taxi driver's income at $350 thousand for the purpose of the no-doc loan and it sucks when Immelt certifies the reserves in GE's accounts.  

It sucked when the Bush administration regularly and systemically misestimated the US budget deficit and it sucked when the SEC went after truth-telling short sellers rather than easily provable frauds by powerful people.  

But beyond all that accounting when the mess is cleaned up the good stuff about America will probably still be there.  

Will GE will still be there?  Well I think it will probably will - but without a huge run through the accounts and without your lie-detector running full blast - well it is very difficult to know.

I am trying to do the work.  But hell - this one is really hard.  Six Sigma precision - that I cannot deliver.

John

Disclosure: no position but leaning long.