Whoa – here come the Japanese

Tokio Marine is a shockingly overcapitalised Japanese insurer. It consists of a vast excess of Japanese bonds and equities writing a fair bit of profitable Japanese business and some not so profitable business whenever it leaves Japan. (In that light it is oh-so-typical Japanese.)

It is buying Philidelphia Consolidated Holdings for an absurd price.

Philly is one of the best run companies I have ever seen. It has family ownership and control – with an old guy with too many heirs. It is a better risk selector than any in the business – and (despite a little bit of legerdemain with reinsurance) has generally written extraordinarily profitably. [For those with a memory – the legerdemain had to do with their Katrina losses. Herb Greenberg wrote about it…]

I have at various times been short the stock (and consistently lost money). This was not a management short – just a valuation story. Philly wrote at a combined ratio of 80 or so - in other words unsustainably well. And despite that it traded at one of the highest multiples in the industry. If they even reverted slightly towards normal the stock probably would have halved.

I am (thankfully) not short it now (plenty of other fish-to-fry). But you got to admire the family getting out now and finding a buyer.

Insurance rates are falling continuously – and so it is almost inevitable that they will not continue to underwrite at such super-profitable ratios. The right valation is probably $20 a share - not the $61 being paid...

The exit also solves the inheritance problem for the many heirs.

Lessons

First lesson: Valuation shorts are pretty difficult. Look for structural shorts instead.

Second lesson: The Japanese are willing to pay big prices for non-problematic businesses and reasonable prices for problematic ones. We should not be surprised at the big Japanese banks injecting capital into the highly problematic Barclays.

There will eventually be a Japanese exit for many American financials. Maybe the Japs will be tempted by the weak USD.

Warning

I have never noticed these Japanese financials being particularly well managed – but they are wealthy – and in the acquisition battle wealth beats smarts – at least for the next couple of years.

I would be far more excited if a Japanese insurer were to buy back 400 billion yen of one of its own shares… but hope doesn’t help you pick stocks.

The Oops Slide

Yesterday I noted that Ambac’s paid claims are running about 20 million a month – which is somewhat less than the 150 million a month that say MGIC is paying. I also noted that their claims paying capacity was a fair multiple of MGIC.

I didn’t include the real big Ambac problem. They insured a whole lot of CDO exposures which are currently non-defaulted but whose credit profile is deteriorating and on which the end losses will be large but are uncertain.

Here is what I refer to as the oops slide from Ambac’s last fixed income presentation. It breaks up the CDO exposure by original rating and Ambac’s current (self estimated) rating:

This slide alone explains why Ambac is so much more damaged than MBIA. It’s the reason why I might be mad with my Ambac holding.

Nothing much else in Ambac’s insurance company alarms me… but this is petrifying.

If someone has some granularity on the deals – both likely default rate and likely loss given default I would love to see it.

Please...

Whose definition of subprime?

There is no standard definition of subprime. I used to think of the world in terms of “Household International Subprime” and “Conseco Financial Subprime”. The guys at Household didn’t think you could ever write loans at the Conseco level profitably over a cycle (discussion in year 2000). The HI credit modellers I talked to were well aware of the risks of the business – but thought it was unlikely that there would be severe stress on it outside periods of large unemployment. (They were wrong!)

Nonetheless the year 2000 distinction between Household and Conseco could be given with FICO scores:

· Household Subprime was FICO620 to 680, and

· Conseco subprime was below 620.

I think the guys at HI were more-or-less right. The HI business might be profitable on average over long periods and the Conseco business was hopeless at the outset. [Profitable over long periods does not make it a good business.]

After that conversation the world changed and everyone started doing Conseco subprime. There were plenty of issuers who worked with FICOs of 575 and below. I was short several – not because I thought a blow-up was inevitable –just that that sort of business cannot be profitable over a cycle.

High FICO defaults – or why FICOs were misleading

FICOs have proved not to be a great indicator of default.

There are deals done with a weighted average FICO of 710 which are defaulting very badly – see the FICO in Mish’s bad deal for instance. These deals consisted almost entirely of refinances – often cash-out refinances. A person with very poor credit could show as having good credit if they always repaid their last loan. They can achieve this by sequential cash-out-refinances. (A rolling loan gathers no loss.)

Deals with average FICOs above 700 that are behaving that way usually contain a very large number of cash-out-refis.

Why I mention

One of my games is to look at the definition of subprime that people were using (particularly prior to the recent credit crisis). Lots of companies wanted to deny they did subprime loans – so all they did was define subprime to be a credit notch below where they were. Defining the loan as Alt-A doesn’t make the bad credit go away – but it made you look safe. [See IndyMac for a company that denied doing bad credit by defining good as what they did.]

Anyway here are two definitions that stand out for me. The first is from MGIC – a mortgage insurer. The second from Ambac.

Here is MGIC’s definition (2006 annual report):

A-minus and subprime credit loans are written through the bulk channel. A-minus loans have FICO scores of 575-619, as reported to MGIC at the time a commitment to insure is issued, and subprime loans have FICO scores of less than 575. [MGIC defined prime loans as having a FICO above 620.]

To me this definition was astounding. The whole of Households year 2000 business would be prime by MGIC’s definition.

Ambac drank the poison too. It drank less poison but was less aware that it was doing it. The word FICO never appears in the 2006 annual which is full of soothing words about how they had reduced their underwritings in the subprime area. By the 2007 annual report they included a FICO definition:

FICO scores range from 300 to 850. Though there are no industry standard definitions, generally FICO scores are as follows: prime (FICO score over 710), mid-prime (FICO score between 640 and 710) and sub-prime (FICO score below 640).

The entire MGIC midprime business and some prime business is subprime by Ambac’s definition.

I knew in advance that MGIC’s underwriting standards were worse than Ambac. Much much worse. I was short MGIC and had sold out of Ambac. [I always wanted to be long Ambac as much as anything because I liked the CEO. I just did not like the credit cycle and some deals they were underwriting - so I sold my position well before the top.]

MGIC will pay almost 2 billion in claims this year. They are paying less claims than they anticipated – but not for any good reason – it is just that state legislatures are passing bills to slow down foreclosure and the courts are jammed and there are delays.

Ambac pays about 20 million in claims a month (admittedly rising).

Ambac has many times the claims paying capacity of MGIC and a small fraction of the claims rate.

But MGIC is still writing business and Ambac has almost ceased.

They might both be bust – indeed I express no opinion about the insurance companies. But if MGIC remains solvent and Ambac fails then the world is a very strange place indeed. [I will explore MGIC in more detail in a future post. Suffice to say I have no position long or short and the world might indeed be strange.]

Changing tone on MBIA

I have just sold my small holding of MBIA. I have been convinced - following a careful examination of documents issued for GICs - that this post is incorrect in several important ways. In particular the GICs at MBIA have a larger effect on parent company liquidity than GICs at Ambac.

I still have no opinion whatsoever on the solvency of the insurance company. [I intend to do that work - and if I form an opinion that is worth having then I will again take a position in the stock.] I now however take the view that if the insurance company is bad the parent company is likely bad.

And that the statement by Jay Brown about parent company liquidity in a recent letter to shareholders is actively misleading.

I have retained my holding in Ambac.

I make plenty of mistakes. This sort of mistake I enjoy. I made a profit.

Interest rate risk, credit risk and a comment on bank margins

A theme of this blog is the interest rate risk and credit risk of American banks. As regular readers know I got the interest rate risk versus credit risk wrong of late.

But being wrong in the past won’t stop me trying to be right in the future. Besides it is worth considering what proportion of a bank’s margin comes from accepting interest rate risk, what portion comes from accepting credit risk and what portion comes from just servicing customers.

The current yield for interest rate risk

Currently you can buy an “on-the-run” Fannie Mae guaranteed 30 year fixed rate mortgage with a yield of 615bps. Before the Fannie Mae credit crisis it was still almost 600bps. Bloomberg gives a series of what the on-the-run mortgages yield – the so-called “perfect coupons”. You can find this sequence by typing MTGEFNCL on your Bloomberg – or just find a graph here.

Currently the intended Fed Funds rate is 200bps and (highly) secured borrowings will cost only (say) 50-100 bps more than Fed Funds.

Now if we presume that the Fannie Mae mortgage is guaranteed by the Federal Government (a good assumption after last week) and is hence riskless then you can earn approximately 300-350bps by taking only interest rate risk. All you do is borrow floating to buy “perfect coupons”. And you don’t hedge anything.

300bps levered 10 times and with 30% tax taken out will still give you a 20% post tax return on equity.

Unfortunately you take a shocking amount of interest rate risk to get that 20 percent return on equity. The mortgages will (at least in normal times) refinance if rates fall. They will however extend for an unknown but long period if rates rise. Pretty well all movements in interest rates are negative for someone taking that sort of interest rate risk. Indeed it is very easy to model insolvency for such a company.

It was my contention – wrong it seems – that the main risk taken by US banks was interest rate risk. You can see the gory details of my mistake here.

State of the banks

There are banks that take mostly interest rate risk and banks that take mostly credit risk.

Banks that take mostly interest rate risk tend to have floating funding and have assets that are either GSE securities or very secure mortgages. Extreme examples included Commerce Bancorp (something I was short on interest rate risk and lost), and New York Community Bancorp. [State Street also takes a surprising amount of interest rate risk whereas Bank of New York tends to prefer credit risk.] Banks that take mostly interest rate risk have had great relative performance. In the event of an inflationary spiral those same banks would under perform massively. [The jury is still out on inflation – another theme of this blog.]

Other banks however eschew almost all interest rate risk keeping their asset and liabilities of matched duration – which usually means keeping securities of short duration. If you took mostly credit risk and were reliant on wholesale funding your very existence is threatened at the moment. To some extent the way I am shorting now is to find smaller banks that were consciously rejecting interest rate risk two years ago – but still have fat margins. They had to have done something bad to maintain those fat margins…

Margins and risk

I mention all this for a reason. If you are earning more than 300-350bps of spread in a bank you are taking some funding or credit risk – because it is simply not possible to earn that in interest rate risk unless you own some very exotic instruments.

Contra: I know of one bank which issues callable funding to buy callable assets. This sounds like it is matched – but if rates go up the funding gets called and they lose (having to refinance at higher rates). The assets however stick around. If rates go down the assets get called – and the funding sticks around and they lose. This bank has held up remarkably well through the crisis because they don’t take many credit risks – even if they do take enormous interest rate risks. The bank could still wind up highly problematic but it won’t get that way on credit.

But short of such exotic behaviours if you are earning more than about 300-350bps you are taking credit risks. If you earn 350-400bps of spread and you specifically disavow interest rate risk then you are taking a very large amount of credit risk. Find me regional banks that rejected most interest rate risk two years ago and I will find you regional banks that are potential credit problems.

Hybrid banks

Most banks fall somewhere in the middle. To pick one of many examples, Webster Financial Corp is a bank which is pretty well run. It is headquartered in Waterbury Connecticut and its management are known to several Connecticut hedge fund types.

Webster made the same mistake as me. It thought that interest rate risk had to be avoided. So it reduced interest rate risk – quite sharply. It decided to take some (quite a small amount) of credit risk. You would call this risk diversification. The stock price shows the result.

Webster was early to recognise their mistake. As I said – they are pretty well run– and in the scheme of things they are hardly a bank that is likely to wind up owned by the Feds. But shareholders have hardly had a nice time.

Webster took mostly interest rate risk. This is its five year margin summary – which shows non-performers including real-estate owned reach the princely sum of 1 percent of assets (on their way quite a bit higher).

Note the interest rate spread was always below 350bps but still above 300bps.

That is very high by global standards because in most countries banks do not have huge refinanceable assets – and hence do not carry the sorts of interest rate risks that American banks take. Its a middling spread by American regional bank standards.

My regional bank

Last week I referred to a regional bank which I had been working on with a reader. Small cap – so we won’t mention its name. I wanted to short the subordinated debt – but couldn’t get a borrow so I shorted the common. It took me about 15 minutes to make that decision.

Here are the things that stood out:

1. It had specifically disavowed interest rate risk saying that it had shifted its security holdings towards FHLB securities because they could easily be pledged (as they contain little credit risk) and could be purchased with short durations,
2. It had massively grown its deposit base in deposits greater than 100K by using promotional rates,
3. After this promotional binge it was the bank most dependent on jumbo deposits that I have ever seen. Given the noise of banks failing the populace could get quite jumpy about jumbo deposits and I would not think that funding base is very secure,
4. Despite having expensive funding and not taking interest rate risk it had a margin of 4% (now declining) - which suggests it was doing something else to get the margin,
5. That something was (more or less obviously) accepting credit risk. It had 1.75 times its shareholder equity in home-equity-line-of-credit products, 1.7 times in real estate construction loans and one times its capital in loans secured by vacant property owned by developers. It grew its HELOCs sharply in 2006. In 2006 it also more than doubled its mortgages on unimproved land.

I think there is a fair bet that this regional bank is cactus. I really wanted to short its debt.

But hey – what do I know? The provisions through the income accounts were less than 10 million – and outstanding provisions are about 20. The non-peforming loans are only half Webster Financial – and they think the lending is so good that they expanded loans in every one of these categories during the last quarter.

This of course leads to the real reason I won’t name the bank. I smell a rat. A big, nasty hairy one, but I can’t quite identify what it is. On this blog we don’t want to make it up and want to correct our mistakes – and we will not blurt out quasi-fraud allegations against small regional banks unless of course we have three decent forms of evidence.

The Wells Fargo puzzle

So now I will leave you with a question for which I do not know the answer. How is it possible that Wells Fargo’s margin 450bps? Please – serious answers are gratefully accepted as I do not understand.

This is not unusual in the history of Wells Fargo. There have been several points where their margin was greater than the prime rate.

Wells Fargo’s margin is off-the-scale high by global standards – I once did a global survey and it was the fattest margin major bank in the world.

Prima-facie that is good. High margins allow you to take considerable losses and remain profitable.

But usually have to take some risk to get high margins – and as the calculations above show – it is unlikely to be all interest rate risk. When I did my survey the other super-fat margin financials were subprime credit originators (mostly autos and credit cards).

As I said – I do not fully really understand just why Wells Fargo is quite so profitable. Can someone help?

Please...

Babe – I can’t find a vein

Paul Kelly – an Australian poet troubadour howls about addiction: babe – I can’t find a vein.

I know how he feels.

One reader is working with me on some very small regional banks for shorting. I will not write about them – because they are just too small.

However we have found one where we think the subordinated debt is a fabulous short.

So here is my howl:

Babe - I can’t find a borrow.

The security in question is not on the SEC’s new list of things you can’t naked short – but still the discount broker is not giving me a borrow. They are usually pretty good – but sometimes they can’t maintain the borrow and they call me in.

Does anybody know a broker who will give me a naked short?

I thought not.

I will continue in the way of Paul Kelly

Little cloud little cloud way up in the air
Little cloud little cloud way up in the air
Well I ain't receiving, little cloud's moved on somewhere

Things I got right and wrong

In a previous post I referred to a history of US finance I wrote in the first half of 2007.

Most (but by no means all) of that document reads pretty well.

Time makes most predictions in the stock market look awful.

There are few here that bear repeating.

One paragraph is as follows:

For American banks in general there are few credit risks we can identify. [Oops - I really wrote that...] There are exceptions - regional banks with undiversified Florida apartment construction loans...

There is some redemption in that paragraph. The regional bank I was referring to was Bank United. See this stock price chart...

In the same document I noted Washington Mutual had a massive subprime mortgage exposure but I thought that it was not existentially threatened. Well its deeply subordinated debt is trading at 30c in the dollar - which sounds pretty existential to me.

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All this is to prove that there is a reason that stock-pickers shouldn't make too many public pronouncements. Humble pie will be the bloggers diet.

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I have a short idea I am working on. The company just put out a record profit. Humble pie coming up!!!

John

Thing that stuns me - Natixis: French turds and raisins

Alejandro Valverde a pre-race favourite who rides for the Caisse d’Epargne cycling team in le Tour de France blew up on the mountain top finish into Hautacam. He is down more than 4 minutes – and his chance of emerging a winner of the tour is now low.

Group Caisse d’Epargne – the sponsor - is a collection of mutual savings banks in France. The mutuals however own majority control of an investment bank with a big asset management business. That investment bank is Natixis. It used to be called Natexis but it merged with Ixis (which used to be outright owned by mutuals) and changed its name. Ixis is an asset management business. Ixis has since changed its name to Natixis Global Asset Management. They also own a none-too-bad wealth management group in there – La Compagnie 1818.

The blow-up of Caisse D'Epargne's subsidiary cyclist cost 4 minutes. The blow up of their susbsidiary investment bank is somewhat more expensive.

The Natexis investment bank is very bad. It had most of its business in securitisation where they were the suckers at the end of many deals. They are one of the more spectacular blow ups of Europe.

Howeer Ixis has some very good businesses in it. Ixis got that way by using the profits of the mutuals (which could not be distributed) to buy lots of good asset managers (often at high prices). The fund managers it owns include Harris Associates (Oakmark Funds) and Loomis Sayles. Ixis is the largest funds management group that you have never heard of. It manages about 600 billion euro - almost a trillion dollars. Natixis is a large proprotion of the size of UBS.

The asset management businesses must spit off cash. They would generate capital even in this environment. But Natexis has blown it and all. Natixis is doing yet another big capital raise - this one for USD6 billion.

This all leads to what I call the French banking question: why do very well run regional banks with perfectly solid wealth management businesses insist on being bad investment banks? It all reminds me of the Munger view of turds mixed with raisins. They are still turds.

I guess this is also the UBS question. UBS took the best wealth management business on the planet and mixed it with an enormous pile of turds. Natixis is just more problematic and much cheaper...

Now does anyone have any idea how you separate turds and raisins?

Mistakes

We all make mistakes.

I have made two substantial mistakes I know about in doing this blog. (There are probably more I do not know about.)

For one mistake I just annotated the post. The other mistake was so central to the argument I just deleted the post as a demonstrably false argument is not worth any reader's time. [That post was on Fannie Mae and Freddie Mac. If you remember it - just forget it.]

In this business mistakes cost money.

If any of my readers spot something that they know to be wrong - or even think to be wrong I would really appreciate an email. We might agree to disagree - but I will try to approach any position with an open mind.

I am not writing this blog to push positions. I would rather tell you of the warts in positions (such as GE Real Estate at GE). The world is complex and most good positions have a bit of hair on them. Intellectual honesty is - in my view - a key to good investing. I am trying hard to cultivate that trait.

So please readers - keep the emails coming.

Thanks

John Hempton

The peculiarity of Fannie and Freddie’s market cap

This post is deleted. It is wrong.

I much appreciate people indicating mistakes. I am kind of embarrased about that one...

J