Reggie on GE

Reggie Middleton has done a fairly thorough analysis of GE. His picks as to the good bits and the bad bits is not dissimilar to mine. The worst bit is real estate - which he thinks deserves a big write-down.

None of the rest is seriously problematic - but he thinks it deserves low multiples. For some of that - fair enough. For other parts I think GE financial has some truly superior positions deserving of a higher than average multiple. But my disagreements here are minor.

He also puts relatively low multiples on the industrial bit - which he thinks grows but nothing like as much as I think.

In his uber-bearish way he gets GE being fair value now.

I think- and maybe I am just old fashioned - that the infrastructure bit of GE - which grows super-fast and has the most massive tailwind - is worth more than 5% market premium on the average American manufacturing company.

And if the blue-sky bits work (ESBWR reactors, Cameco JV, ultra light jet engines etc) then a 5% premium will seem very light.

And that is the extent of our disagreement.

If you are into GE I recommend reading Reggie's piece.

MBIA holding company credit default swaps

Warning: This post needs serious modification to be correct. Several errors are in it and (like most my opinions) should not be relied on. A follow up is here.

As regular readers know I have no opinion as to whether Ambac and MBIA are long-term insolvent at the insurance company level. I really have no idea whether losses will be 2 billion or 20 billion. [I am long the stocks as of a few days ago - but I have no opinion about long-term solvency and when I purchased them I thought there was a reasonable chance that the end-game for both companies was zero.]

I believe that losses will be lower than is implied in the market prices of mortgages, but higher than is indicated in the loss reserves of most banks. That is a very wide band – and for detail within that band you are reading the wrong blog.

I do have something to say about the insanity of the market at the moment. It is about MBIA parent company credit default swaps… I think people holding that parent company default swap are insane.

Background

It is highly unusual in the US for the parent company of an insurance company to guarantee regulated subsidiaries. Fairfax Financial has guaranteed TIG in exchange for getting some Odyssey Re stock out. However that is the exception rather than the norm – and the (California) insurance regulator got the guarantee in response to a specific deal.

Most the time it is possible for the parent company to go bankrupt without the insurance subsidiary (as happened with Conseco) or for the insurance subsidiary to go bankrupt without the parent company (as happened with Freemont General).

It is possible after the bankruptcy of the subsidiary for the regulator to sue the parent company based on fraudulent conveyance or some other rule. But the regulator has no prima-facie right to go after the holding company. (The California Commissioner sued Fremont General arguing fraud. Fremont settled for a large sum of money - but the holding company is still not on the hook for the insurance company liabilities...)

So how is it with MBIA?

MBIA holding company to the best of my knowledge (and having read a few statutory statements) has never guaranteed the insurance subsidiary.

MBIA holding company has well over a billion in cash (including the recently raised money). It got this with its recent capital raising – and was originally going to inject that cash into the regulated subsidiary to maintain the AAA rating.

The rating agencies told MBIA that would not be sufficient to maintain the rating and so MBIA kept it at holding company. The insurance commissioner is peeved – but there is little he can do unless he can prove fraud.

So the MBIA holding company is loaded. Indeed the net cash holdings of the holding company is slightly larger than all holding company obligations. At some point (somewhat lower than here) MBIA becomes a Ben Graham stock.

The point however is that it is highly unlikely for the holding company to go insolvent. Moreover almost all of the holding company debt is due after 2012 – often quite a long time after 2012.

The credit default swaps on the holding company imply a very high chance (well over 50%) of holding company insolvency.

Is everyone mad?

How can MBIA holding company go bust?

I can think of a few ways the holding company can go bust:

• Well the first way that the holding company can go bust is to inject the holding company money into the insurance company and not be able to get it back. That is what Whitney Tilson – a vocal short – wants to happen. It is also what the insurance commissioner wants to happen but the insurance commissioner motivations are different.

• The second way is that MBIA uses its holding company loot to buy back lots of shares at the current price – and runs itself out of holding company cash. Certainly MBIA has indicated that it is interested in buy-backs – but I doubt they are that interested.
  
  
• A third way is for the company to inject the money into a new (and hence AAA rated) subsidiary and not be able to get it out of the new subsidiary. Ambac is trying to do that with its existing subsidiary (Connie Lee). However that money is to come from the regulated insurance company and not the holding company.
  

• A fourth way is that the insurance commissioner manages to successfully sue the holding company. That seems unlikely to me – but courts are a crap-shoot and anything is possible.

There are probably other ways that the holding company can go bust. I don’t know them all. But the holders of the credit default swap are awful sure that holding company insolvency is inevitable. Too sure.

Full disclosure: the position in Ambac is many times as large as the small position in MBIA. More so after yesterday's trading...

Can someone explain why Fifth Third started taking brokered home equity loans?

Recently I chatted with Fifth Third management.

Fifth Third started taking brokered home equity loans late 2006. They took 2.7 billion of them. They also took loans out-of-footprint (that is where they had no branches). They took 900 million of them.

The loss-given-default (severity) of the home equity loans is rapidly approaching 100 percent on the whole portfolio but the default rate for the brokered loans is many times the branch originated loans even though the branch originated loans are in bad states.

The branch managers at Fifth Third have profit and loss accounts and are remunerated in part on them – so it figures that the branch managers were much more sensible than the brokers in rejecting patently bad or fraudulent credits.

But can anyone (please) explain the cultural change at Fifth Third that allowed them to take out-of-area loans through brokers?

Thanks.

John

Christmas in July: a falling US dollar is just a bowl of cherries

Australia is sweltering hot at Christmas. Everyone sits down with extended family when it is 40C (104 Fahrenheit) and indulges in an excessive roast lunch. Christmas is sweat and family dramas.

The saving grace of a mid-summer Christmas is cherries. The cherries are just coming on in December and are fantastic. You buy boxes at roadside stalls as you drive the long distances to your home town and eat half before you see your family.

A Winter Christmas

There is a new emerging Australian tradition – which is to have a winter Christmas celebration. Christmas in July is hams, puddings and wood fire. This new tradition is really strong amongst Australians who have spent some time in the Northern Hemisphere and pine for a white Christmas.

But Christmas in July is without cherries and that doesn’t feel quite right.

Until now.

On Saturday night my wife and I went to a delightful Christmas in July. This was a stylish affair with fairy-tale lights and good bubbly wine. And we took a bowl of cherries.

The cherries came from California. And they were $15 a kilo (say $7 a pound) at Paddy’s Market. Five years ago they were unaffordable. But then the US Dollar halved relative to the Australian dollar and now we have affordable cherries in the depths of winter.

Cherries and the US current account deficit

And as I indulge in another bowl of cherries I think the falling US dollar is wonderful. And so does some Central Valley farmer. Of course my (incremental) purchase of American cherries drives the price up for most Americans (poor you). And so in the smallest of ways there is a shift in the American economy from US domestic demand to exports.

Exports are the only part of the US economy doing well. Export driven businesses are shooting the lights out. (If you don’t believe me read the Federal Reserve’s Beige Book.) If there is a single really good global trend it is away from US domestic driven businesses and towards US export driven businesses. It is symmetrically against foreign businesses that compete with US exporters. (Think GE over Siemens, Boeing over Airbus.)

The Bronte Capital thesis on this is as follows:

• The US current account deficit is huge

• The subprime crisis has shown that you can’t endlessly and profitably lend to American consumers therefore the economy will need to shift to radically bring down the current account deficit.

• This means you need to avoid US domestic sectors and fall in love with US export driven sectors.

• Alas rising oil prices are driving up the current account deficit slightly faster than the changing terms of trade are driving it down which means we are only beginning on the export driven trend.

If you want a decade long trend its US exports.

You should be on it. And life will be a bowl of cherries.

A blog milestone

This is the fiftieth blog post - a completely arbitrary milestone.

I look in wonder at long-time bloggers who are up to 6000 posts. I have already had to correct one decent mistake (that I have identified). If you can identify more I am very happy to issue corrections.

Since I started tracking visitor numbers we have had 3788 visits and almost 6000 page views. (I did not track readers for the first few weeks - so total visitors are larger.)

There have been just over 2000 absolute unique visitors. That means that most people visit once and do not return.

If you have visited more than twice you are likely to have visited more than 15 times. Also I have about 80 subscribers using feed-burner - so there are some loyal visitors. (The feedburner subscribers do not count in the visitor numbers unless they click through to something.)

Visits come from 672 "cities" in 58 countries. The cities are as defined in Google analytics and include what most people would call suburbs. The biggest concentrations of readers are in the United States, the UK and Australia in that order. Within the US the concentrations are New York, Connecticut, Chicago and New Mexico.

All of these numbers are beaten in a single day by popular blogs. I don't yet have a technorati rank - but Wikio ranks me as the 20,677th most influential blog on the web. There are relatively few investment blogs in the top 1000 but a lot of dodgy blogs have rankings very much higher than mine...

The most popular post is the first post on Barclays. Google correctly identifies that and links to it when you google Bronte Capital.

The second most popular post is the post about the fraudulent hedge fund in Santa Fe. As stated above I have a cluster of readers in New Mexico. Many of those readers lost money in the scam. Its been quite disconcerting to know how hard it is to raise hedge fund money as an honest hedge fund and how many people will willingly give their money to a total fraud. There is something there that I am learning about human nature.

I would like to know more about my subscribers and regular readers. Drop me an email.

And thanks for reading.

John Hempton

PS. There have been 7728 advert impressions served by Google on this blog. Only 32 of you have clicked. My impression - Google targets the adverts very poorly. More about that in a later post.

A correction on Sydney Airport

My post on Sydney Airport missed an important part of the capital structure.

Sydney Airport debt structure includes 1.45 billion in redeemable preference shares stapled to the ordinary shares (held by Macquarie Airports) and hence which are justifiably considered equity. Funnily I knew this from past looking at the accounts and had forgotten it. This is also very typical of Macquarie structures so I should not have missed it.

The coupon on those RPS is 13.5%. The negative cash flow of the airport is roughly the coupon on those debts. Indeed if you don’t include the coupon on the RPS as an interest cost then Sydney Airport was slightly cash flow positive including capex during 2007. That was also true in 2005 when the Airport did minimal capex.

If we were to restructure the RPS as equity (which is fair enough as it is subordinated and stapled to the equity) then Sydney Airport is solvent with flat traffic volumes for a few years. However to be worth anything to MAP holders it remains true that revenue has to go up and hence traffic volume has to rise for Sydney Airport to pay the coupon on the subordinated debt – let alone anything on the equity. It remains true that Macquarie has figured rising traffic volume over the long term into its thinking and it remains true that the oil price is causing them issues.

Sydney Airport will still be insolvent with a large fall traffic volumes but a few years of flat to slightly declining volumes is probably supportable provided that there are no short term maturities and the coupons on the subordinated debt get halted. (The listed entity - Macquarie Airports - would still get smashed under these circumstances - but the bond insurers would be OK.)

It also remains true that the debt of Sydney Airport has gone up more or less every year since the Macquarie takeover - and the distributions have been funded by debt.

That can't continue with (a) bad credit markets or (b) falling or even stable traffic.

So the weather channel is worth 3.5 billion

GE and partners (presumably knowledgeable partners) have purchased the Weather Channel for an undisclosed amount reputed to be $3.5 billion.

This is less than the $5 billion mooted before the credit crisis hit – but it seems an awful lot of for my beloved GE to pay.

I got one question: if the weather channel is worth that much what is this portfolio worth?

FOX Business Network
Fox Movie Channel
FOX News Channel
FOX College Sports
FOX Sports Enterprises
FOX Sports En Espanol
FOX Sports Net
FOX Soccer Channel
FOX Reality Fuel TV
FX
National Geographic Channel United States
National Geographic Channel Worldwide
Speed
Stats, Inc.

There is something wrong here. Either GE paid too much or News Corp is a steal at this price or both.

Pet suspicion: both.

Warning: see comment on News Corp in my first "things I stuffed up" post.

Weekend edition: having a whale of a time

On Sunday my wife and I walked from Bronte to Maroubra with a coffee at Coogee.

There was about 15 people on the headlands above Maroubra Beach with binoculars and a telescope. They were watching a large group of humpback whales.

The whales were the better part of a mile offshore and if you looked carefully the most that someone with my deficient eyesight could see was spray from their blowhole.

Here is a much magnified photo. It’s a smudge – but hey I am excited!

Mish comments on finance for machine tools

Mish has posted on his blog an email from a friend who is complaining about not being able to finance machine tools:

An emerging trend this year is the sudden scarcity of capital from banks & machine tool finance companies. We planned to purchase two new machine tools this year. It now appears that we can obtain financing for just one, in spite of a spotless corporate credit record and continued sales growth. The lenders seem to be over-tightening because of the recent credit crisis. As I told my banker, “You guys seem frightened of your own shadows!”"

Mish rightly points out that the main problem is not (as the email author suggests) that the banks are "frightened" rather the problem is that the finance companies can't finance themselves.

Now I might be a little dopey - but this looks awful good for a company that (a) makes capital equipment and (b) can afford to finance it.

Did anyone say General Electric?

Time to hide the valuables under the mattress and buy a shotgun

Dana Milbank of the Washington Post asked Phillip Swagel (US Assistant Treasury Secretary) whether it is time to "hide the valuables under the mattress and buy a shotgun". And Swagel did not hit it out of the park.*

At the same time we have the CEOs of major banks saying that they are profitable despite the headwinds.

With due respect - there is plenty of work in Washington for out-of-work CEOs good at spinning BS. Your country needs you.

The full video is here and is worth a watch. (Hat tip to the Big Picture.)

Memo to Phillip Swagel: practice saying the fundamental strengths of the United States are undiminished... even if you don't believe it. Its not good for someone in your position to talk down anything...

*My original wording was "Swagel does not hit it for six". But then I am Australian and therefore a cricket fan.