This week's bank collapse

FDIC Friday - and another bank was taken over by the FDIC. The number so far is relatively small - because the bad mortgages are not in the banks. (The bad mortgages were sold to the securitisation market as this blog has made clear several times.)

Anyway this bank collapsed due to commercial real estate. That matters as the CR loans are in regional banks.

Calculated risk has a nice post observing that this collapse - whilst small - is probably going to be representative of this cycle. I have short positions in a few CRE exposed banks.


J

Berkshire risk aversion - a follow up

Thanks for all the people who followed up on this. I think we can safely conclude that the factual background in the original post was correct. Mostly GEICO sells household insurance as an AGENT for Travelers. It may or may not take on umbrella policies through other Berkshire subsidiaries.

I really appreciate the confirm from my readers. Disagreements about facts should be easily sorted [provided of course I remain adequately circumspect about what constitutes knowledge]. I expect disagreements about interpretation to be much more difficult.

This is a follow up from my Berkshire risk aversion post.

I have received an email from a finance guy who has a homeowners insurance policy attached to his GEICO auto policy. In some states (notably Florida but also possibly other states) this policy may actually be written by Berkshire - but mostly it is a policy whereby GEICO acts as an agent.

Can people with umbrella and homeowners insurance policies from GEICO tell me who the underwriters are for the homeowners component - and what State they are in. Also useful would be the number of years that they were policy holders.

Thanks.


J

Some depressing thoughts

The position of this blog has been stated several times. Subprime credit is a pig-in-the-python. It got bad very quickly – and it will get better very quickly. The losses on some pools (particularly loans originated in early 2007) will look implausibly large – but 2005 pools will be much tamer.

Prime credit by contrast is deteriorating at an increasing rate and there is no obvious end in sight. It is not able to be modelled. It is very scary.

The thinking behind that is detailed here and here.

Wish it were so simple. The prime credit is looking every bit as bad as all that. But the trend in subprime credit is also less clear than a month ago. In some pools (not all) the trends are less good. Short dated delinquency is rising in some places. Losses look a little larger than they might have looked a month ago. The improvement trend was three months old. And one month does not a cycle make – but my level of comfort is falling.

Risk aversion – Berkshire style

Chatting with a well known blogger yesterday who made the (common) assertion that all insurance companies eventually go to zero. The world – it is argued – is full of surprises – and if you take even a small chance of blowing up then eventually your number will be up and you will blow up.

Then our protagonist argues all insurance companies take a small chance of blowing up – and eventually there number is up.

This I think is too simplistic. I think some types of insurance have realistic (albeit small chances) of blowing up. Others (rarer) do not.

Take for example household versus auto insurance.

Household insurance is subject to super-catastrophes. Big earthquakes are theoretically possible anywhere (although vanishingly unlikely in some locations). Hurricanes happen as well and the 250 year storm seems to happen fairly regularly.

But auto insurance is not generally subject to super-catastrophes – cars drive away from hurricanes and bounce around in earthquakes. The only catastrophes that regularly affect cars are hailstorms – and the biggest hailstorm claim in insurance history happened in my home town (check this out about 3 inch hailstones).

Has anyone noticed that Berkshire does auto insurance (GEICO) but does next to no household insurance (it writes a few policies in Florida which it tries regularly to cancel – but regulatory rules force it to renew).

If you write household insurance there is the mega-storm that could bankrupt you. Buffett has said that storms substantially bigger than Katrina are possible. Buffett won’t do it even though GEICO could probably – if it chose to be – become the most profitable household insurer in the US.

Also take life insurance

Any student of human history knows that plagues – real devastating plagues which wipe out very large numbers of young healthy people happen irregularly but often enough to be a real risk.

The insurance industry have gotten quite complacent about them – because the only new plague of our lifetime did not affect life insurance companies. HIV is – within the West anyway – primarily a disease of gay men, IV drug users and haemophiliacs. None of these people were regular buyers of life insurance. Had HIV been a disease of middle age men who visit prostitutes because they don’t get it at home it would have selectively targeted the core market for life insurance companies – and every life insurance company in the Western World would have gone bust. In Thailand HIV morphed into such a disease – but surprisingly or not life companies have not been heavily impacted in the West.

Note that if you think plagues are inevitably going to happen then most life insurance companies have a finite life.

Notice that Berkshire does not insure mortality at a primary level and does almost no mortality reinsurance. Swiss Re is the dominant player in that business. Buffett has the capital and the expertise and he does not play.

By contrast annuities are not subject to plagues or shock risk – they can cost you money as life extends due to medicine – but that looks like a continuous process – not a shock process like plagues. Berkshire will write you an annuity online (see http://www.brkdirect.com/)

Again a small risk of blow-up and Buffett will not play.

The Gen Re debacle

The terrorist attacks of 2001 were a true shock to Buffett. General Re was taking a chance of complete wipe-out and had the attack been nuclear there is a fair chance that Gen Re would have folded. Buffett wrote about that in a special letter to shareholders – see this quarterly report which differs from other Berkshire quarterlies as it contains a shareholder letter...

Buffett criticises Gen Re for writing risks that could have been lethal. His company broke the first Buffett rule of risk aversion. [Despite the joke that the rule is don’t lose money – the rule really is don’t blow up. Buffett is quite prepared to lose 5 billion on a single policy.]

Note that almost none of this involves mathematical models. It involves stress tests. And the stress is not a selected 99% probability stress test – it’s a complete implausible debacle stress test.

And when most people do stress tests the process is “well what happens if property prices drop 30%?” and someone says “what if they drop 40%?” and the response is – they can’t go that far.

The Buffett question for a risk manager is “what if they drop 70%?” You might say it can’t happen. One word: Japan.

I know how you live by the Buffett stress test with a diversified portfolio – when I open a fund it will live by that test. (No intolerable concentrations of long only banks or life insurance companies.) But I have no idea how you run a life company by the Buffett stress test. I don’t think you can. That doesn’t mean the businesses shouldn’t exist – but they probably never be considered completely safe. And a portfolio investor should never be totally weighted there even if that is their field of expertise.

John

Market puzzles - Fannie Mae and Freddie Mac

Crank your mind back to 2006. You are a run-of-the-mill hyper bear (as I appeared at the time). Someone told you that in 2008 there would be a crisis at Fannie Mae and Freddie Mac. The Secretary Treasury would ask for and get an essentially unlimited pool of government money to ensure that the senior debt of those institutions did not fail. [He said nothing about the preference shares or common.]

What would you have thought would happen?

To me it seemed obvious. The senior debt would now be as safe as Treasuries and the spread on the senior debt would come in to maybe 30bps from crisis levels.

But the whole scenario would be very bad for the US dollar because the implied debt of the Federal Government just rose an awful lot.

So what did happen?

Well the spread on Fannie and Freddie securities widened not narrowed, and the US dollar got strong.

The widening of the spreads on Fannie is either irrational or a rational bet that the US Government cannot be trusted to honour its promises. But if it is the latter why is the USD strong?

What is happening now is every bit as weird as what happened in the bubble.

I blame the one child policy: explaining the brokers part II

This is going to look very tangential – but I know someone who is a demographer. And just as I think everything in the world comes down to banks (because that is what I understand) he think that everything in the world comes down to demographics.

He has a better chance of being right than me.

And the biggest thing going on demographically in the world is the one-child policy.

Asian style industrialisation and current account deficits

Pretty well every Asian tiger economy has gone into large current account deficit whilst it industrialises. Savings rates may have been 20-25 percent of GDP but the investment rates were higher. The high levels of current account deficits have left those countries vulnerable to current account crises – and they got their crisis in 1997.

China is different. The investment rate is higher in China then elsewhere. Chinese statistics are abnormally patchy – but Chinese investment may have got has high as 40 percent of GDP. (You can see this in the performance of various capital equipment exporters in the West.)

And yet China never managed to get a current account deficit. That is really strange.

We have investment of 40% of GDP and a large current account surplus. This means that the average Chinese person is saving maybe 46 percent of their income. Now once when I had a very high income I saved that much. But we have poor people saving half their income.

I ran this idea past a Chinese friend of mine (now resolutely middle class). He remembers his family saving money furiously whilst he was hungry for lack of food.

Question: what is it that makes them save so much?

Answer: fear.

In most poor jurisdictions there is a simple method of saving for old age. Have six kids. They will have a few each and if you survive there will be lots of grandkids trained to respect their elders who will look after you.

This does not work in China. Indeed if everyone has only one child there will potentially be four grandparents per grandchild. You can’t expect to get supported.

In most developed countries people trust the system to look after them. Mutual funds are well developed, there is often a social security savings net, and a lot of people (perhaps falsely) expect to sell their house and live in clover.

But in China you can’t trust that either. So you save. And save. And save…

Chinese families save because they have a gun at their head. They save an amount that is almost incomprehensible by Western standards.

I point this all out because there is a lot about excessive spending in the west (and the spending has been excessive). But for all this excessive spending there has to be an area with excessive savings. Japan has it. Petrodollars have it – but the big incremental excess savings of the last five years has been China.

And for that I blame the one child policy.

I am going to give Mr Bernanke a plug here. Before the crisis started Ben used to talk about excess savings in the world. He figured the bad lending in the US happened not because people were venal or stupid in the US – but that there was just an endless supply of investable funds because the world had excess savings.

I think he was right. Go look at a Japanese bank now and you still see excess savings. We discovered that we can’t lend them endlessly in America without substantial credit losses. But that doesn’t mean the excess savings aren’t there.

It is a strange reversal to blame bad lending on the people in China who wanted to take no risk with their savings – but it is the reversal that interfluidity made in one of the best blog posts of recent times. It’s a reversal I believe in too.

My thesis - which will be expanded in future posts is that the brokers have become the intermediaries between this endless demand for products to save in (China, Petrodollars etc) and the endless willingness of the profligate in the West to spend. What they do is - through their trading, their securitisation and through other things they turn the complex financial instruments of the West (mostly but not entirely debt) into vanilla instruments that the Chinese and petrodollars want to buy.

How they did that intermediation will be the subject of the next couple of posts – but it begins to explain why they got so big. This is the biggest demographic feature of the world and the brokers made themselves front-and-centre. (They may not have even understood what they were doing - but that is also subject of another post.)

Indeed how they did it altogether and its implications are for later in this series.

John Hempton

Rick's rats on its clients

I gather the kiss-of-death for any brothel owner is to blow confidentiality. You do that once - and nobody much has any incentive to keep you in business.

The kiss of death for a "adult entertainment venue" is much the same. So it is with great interest I read this extract from the 3Q earnings release for Ricks - a listed consolidator of strip joints:

Eric Langan, President and CEO, said: "Both our internal growth and expansion by acquisition programs continue on course and we are looking forward to a strong performance at Rick's Cabaret Minneapolis in our fourth quarter, which should benefit from the Republican National Convention in early September." He noted that the company's cash position increased to approximately $13 million at the end of the quarter due to strong cash flow and a recent capital raise.

Are RICK's executives ratting on the Grand Old Party? Is this sensible?

In the mode of Fox News: "We report - you decide".

I might turn up at the next conference call to ask the poisonous question: how much did turnover in Minneapolis go up around the convention? But only after the obligatory congratulations for a great quarter guys...

John

Rick’s Cabaret – a Gentlemen’s Establishment with a private jet

This blog does not usually comment on small caps – but following Jeff Matthews I couldn’t resist. Ricks Cabaret is a listed consolidator of strip joints. Yeah – you read that right. The business consists of renting crappily constructed barns on the edge of towns (Houston, Vegas etc) and getting gals to jiggle their silicon around. They do own a fine-dining strip joint in NYC.

Despite having compiled an index of the price of hookers in various Eastern European locations I don’t usually hang around these businesses. I had never heard of Rick’s before Jeff’s post.

The stated premise for Rick’s Cabaret is that being a listed company gives Ricks (RICK:NASDAQ) access to capital and hence provides an exit for the thousands of strip club operators throughout the land. This of course ignores the other exits that Jeff Matthews points out (busted for prostitution, non payment of taxes etc).

But let’s take them at their word and look at the accounts as given. Here is the balance sheet:

CURRENT ASSETS:
Cash and cash equivalents	13,191,087
Accounts receivable
Trade	1,339,413
Other, net	722,868
Marketable securities	2,225
Inventories	1,706,544
Prepaid expenses and other current assets	975,067
Total current assets	17,937,204
PROPERTY AND EQUIPMENT:
Buildings, land and leasehold improvements	44,031,599
Furniture and equipment	11,463,950
	55,495,549
Accumulated depreciation	-7,288,117
Total property and equipment, net	48,207,432
OTHER ASSETS:
Goodwill and indefinite lived intangibles	60,272,095
Definite lived intangibles, net	1,322,111
Other	761,753
Total other assets	62,355,959
Total assets	128,500,595
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
Accounts payable – trade	912,190
Accrued liabilities	4,390,849
Current portion of long-term debt	1,561,244
Total current liabilities	6,864,283
Deferred tax liability	16,278,165
Other long-term liabilities	508,579
Long-term debt, less current portion	28,877,816
Long-term debt-related parties	1,260,000
Total liabilities	53,788,843
COMMITMENTS AND CONTINGENCIES
MINORITY INTERESTS	3,359,595
TEMPORARY EQUITY – Common stock, subject to put rights (461,740 and 215,000 shares, respectively)	10,935,020
PERMANENT STOCKHOLDERS' EQUITY:
Preferred stock, $.10 par, 1,000,000 shares authorized; none issued and outstanding	--
Common stock, $.01 par, 15,000,000 shares authorized; 9,272,237 and 6,903,354 shares issued, respectively	92,722
Additional paid-in capital	52,807,479
Accumulated other comprehensive income (loss)	-11,123
Retained earnings	8,821,839
Less 908,530 shares of common stock held in treasury, at cost	-1,293,780
Total permanent stockholders’ equity	60,417,137
Total liabilities and stockholders’ equity	128,500,595

Now I am a dopey sort of guy – more used to bank balance sheets than strip joints. But there are a few things that are odd about this one.

The first is that there is over 60 million in goodwill on the balance sheet. That is 60 million paid to owners in excess of the value of couches and other fittings. That is a lot of goodwill for strip joints and leads you to the conclusion that if you want to be a multi-millionaire forget hedge funds – start a strip joint and sell it to RICK.

Indeed despite selling considerable common stock in unregistered sales to institutional investors the company manages to have almost no net tangible net worth. [The cash flow statement shows 27 million raised from sale of equity in the quarter – but I can find only one SEC 8K for about half that amount.]

The second thing that jumped out at me was the large deferred tax liability. The deferred tax liability of 16.2 million.

My first reaction was whoa – a deferred tax liability happens usually because profit for GAAP purposes is substantially higher than profit for tax purposes. This could be accelerated depreciation or some other tax incentive (though why the IRS/congress might give tax incentives for strip joints is beyond me) or it might just be that the company is declaring income for accounting purposes but not for tax purposes. There is of course a problem with faking your income up – which is that you tend to have to pay tax on the phoney income – unless you tell something different to the IRS.

In the quarter the prima facie tax was over a million but the payments were just over half a million. There is no large current tax liability to note – so there is prima-facie suggestion of overstating GAAP vis taxable income. Indeed the cash flow statement benefits from 632 thousand being added to the deferred taxes during the quarter… This does not surprise me – but it is not the main reason that that there is a large deferred tax liability. This company peculiarly tax effects the goodwill purchased – a treatment I have not seen elsewhere – but then I am used to looking at financials. [Anyone known why you would do this?] To quote:

Included in the Company’s deferred tax liabilities at June 30, 2008 is approximately $14,400,000 representing the tax effect of indefinite lived intangible assets from club acquisitions which are not deductible for tax purposes. These deferred tax liabilities will remain in the Company’s balance sheet until the related clubs are sold or impaired.

This led me to think that the company might be doing something very strange like buying the clubs and not the corporate structures that the clubs reside in. That indeed would be sensible because it would absolve the acquirer from unpaid taxes and penalties (criminal and otherwise) that might live with the old owners. That might give a peculiar GAAP treatment of goodwill. And indeed they are – as this 8K shows . If there is any accounting expert here – can you explain this.

But this still gives us a residual of 1.8 million of deferred tax liability that comes from another purpose. This implies GAAP income of about 5 million more than cumulative taxable income over the history of the firm. I will make the point that this is roughly the half cumulative profit of RICKS. When in doubt (and where I can’t see a good explanation for deferred tax liabilities) I tend to prefer the income people report to the IRS than their stated income. (Maybe that is something I just learnt in the mortgage market!)

Now the premise for listing this thing is – I presume – access to capital. But you got to wonder the extent to which a bank or for that matter typical financial market type might lend money to a strip joint whose tax accounts don’t match their GAAP accounts. Well for the most part they don’t lend that way. Indeed almost every strip club they consolidate they do with high interest vendor finance. This is typical:

On November 30, 2007, in connection with the acquisition of Miami Gardens Square One, Inc., (see Note 9), the Company entered into two secured promissory notes in the amount of $5,000,000 each to the sellers (the "Notes"). The Notes bear interest at the rate of 14% per annum with the principal payable in one lump sum payment on November 30, 2010. Interest on the Notes is payable monthly, in arrears, with the first payment due thirty (30) days after the closing of the transaction, which occurred on November 30, 2007. The Company cannot pre-pay the Notes during the first twelve (12) months; thereafter, the Company may prepay the Notes, in whole or in part, provided that (i) any prepayment by the Company from December 1, 2008 through November 30, 2009, shall be paid at a rate of 110% of the original principal amount and (ii) any prepayment by the Company after November 30, 2009, may be prepaid without penalty at a rate of 100% of the original principal amount.

Most the long term debt is pretty short term – 30 November 2010 won’t get them to a time when bank lending standards drop enough. So they better have the cash when they get there. And that is not the only "long term debt" on the books.

Indeed access to capital looks questionable when the CEO has to personally guarantee corporate debt:

In connection with the acquisition of the real estate in Dallas related to the acquisition of Hotel Development Ltd., on April 11, 2008 (Note 9), the Company issued a $3,640,000 five-year promissory note (the "Promissory Note"). The Promissory Note bears interest at a varying rate at the greater of (i) two percent (2%) above the Prime Rate or (ii) seven and one-half percent (7.5%), and is guaranteed by the Company and Eric Langan, the Company’s Chief Executive Officer, individually.

Come to think of it – this company also purchased its private jet on hock:

In February 2008, the Company borrowed $1,561,500 from a lender. The funds were used to purchase an aircraft. The debt bears interest at 6.15% with monthly principal and interest payments of $11,323 beginning March 12, 2008. The note matures on February 12, 2028.

Hey – the interest rate on a private jet (presumably secured by the jet) is almost 8 percentage points better than the interest rate on a strip joint secured by the strip joint. Impressive.

Summary

So what have we got?

• A company in a seedy business usually infiltrated with the sort of people who you would not want to have marry your daughter.
• A company whose tax returns do not match their GAAP accounts
• A company with no obvious access to capital and with a lot of debts that mature quite shortly and pay high interest rates,
• A company who has no reason to be listed but manages to buy a private jet

People own this stock? Search me as to why…

That this is listed and retains a market cap over $100 million tells me that this market has a long way to fall. I shorted a token number last night.

A positive: the company has a code of ethics

I can’t be all negative.

Rick’s must be the only strip joint with a public stated code of ethics. You can find it here. However at Rick’s ethics tend only to apply to financial matters. The code is also only applicable to the following persons:

1. The Company's principal executive officers; 2. The Company's principal financial officers; 3. The Company's principal accounting officer or controller; and 4. Persons performing similar functions.

I will leave it to your imagination what other unethical behaviours might happen at a strip joint and who might perform them.

I wonder if you can think of any ethical violations that might involve the private jet.

I thought you could.

John

Explaining the brokers Part I

Don’t read this series if you expect clear tradeable answers. I don’t have them (yet?) and really this is just the beginning of another intellectual journey. It may be a dead-end.

For someone that might open a fund I am about to do something profoundly stupid. I am going to have a peek at the broker balance sheets in public without being entirely sure what I will find. This series might go nowhere – or it might wind up being very interesting. I am trying to get readers to help me pick apart the brokers.

I have to say that I got a lot of email on Fannie Mae when I did the series there – almost all expressing religious belief on whether Fannie is OK or not. Not much counted as analysis and less contained methods which are testable..

I hope my readers are better this time – but I am not counting on it.

Before I start my instinct on Wall Street Brokers is hyper-bearish. It is not that I think they have solvency problems (on that I have no opinion). It is just that I think that their stated business and their actual business differ substantially. When companies can’t explain clearly what they are doing then I get bearish – and nobody seems to explain brokers clearly.

With Fannie at least I could explain how the business was meant to work. With Goldman Sachs I don’t even start with that.

Part I is just going to leave everyone with a puzzle. Why are the broker balance sheets so big – and what business inflated their size to such grotesque levels? I think this is the key issue wit the brokers – but for the moment I will just give you some numbers.

The FED flow of funds data gives type of debt outstanding in the US at any time. At the last release (Q1 2008) there was 30.8 trillion of non-financial sector debt outstanding. [You don’t want to count financial sector debt because you are double counting though I have known a few reputable people who have done just that.]

Of this “only” 14.0 trillion was to households and “only” 10.6 trillion was mortgages. The mortgage growth rate had slowed to 3 percent. The fastest growing category was the Federal Government (up at over a 9% annual rate). That hardly bodes well for the US. 5.2 trillion of Federal Government debt outstanding. Private sector debt was 24 trillion. I want you to keep that number in head for the reason I am about to bold

• 24 trillion – total private sector debt – is the maximum about of debt that it possibly makes sense in any way for financial institutions to intermediate. Brokers can’t make money intermediating government debt.

The second set of statistics is about the sheer size of broker balance sheets:

• The Goldman Sachs balance sheet is 1.09 trillion in size at the last quarter (admittedly a slightly different date to the Fed Flow of Funds data).
• Lehman is 0.639 trillion – and that was after some questionable moving of items off balance sheet.
• Merrill Lynch is 1.04 trillion at the closest quarter
• Morgan Stanley is 1.03 trillion.

On top of this there is probably almost a trillion of investment banking assets at Citigroup, over a trillion at JPM (including Bear Stearns) and another trillion at Barclays Global Capital.

Somewhere investment banks got on their balance sheet maybe 7 trillion in assets which is very large compared to the total assets that could theoretically be intermediated in the US.

Goldman Sachs has a balance sheet the same size as a smaller Japanese megabank.

One thing is for sure – you don’t hold all these assets because you are facilitating trades on behalf of your customers. I have seriously been told my investor relations at investment banks that the reason they hold so many assets is to facilitate client transactions.

I might be young and naïve – but I am not sure I was ever that naïve…

The investment banks are full of people considerably smarter than me. But the shareholder letters are not very explanatory. (These companies fail Warren Buffett’s test of clear shareholder letters.)

They don’t do what they say they do. So what are they? We all deal with them so we think we have some idea – but the places that I deal with don’t produce balance sheets that look anything like Wall Street. I have some answers – but I know before I start that they are not complete answers – moreover my answers are hard to test.

Some exploration (but probably few answers) coming in Parts II, III etc…

If people have suggestions I will include those (with some analysis) in later parts. Email me please.

John

Weekend edition: the somewhat cooler Hempton

My cousin got the movie star looks and the saxophone. I got the penchant for reading accounts of banks. I think he got the better deal!

I suppose he got the girls too! And he got the MySpace page with the cool jazz soundtrack.

For my NYC readers - he is back in NY -

22 Sep 2008, 07:30 PM
183 W10th st @7th Ave, New York, New York
Cost : $20 incl. a drink!