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.