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

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

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

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

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

From the wonderful vaults of General Electric

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

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

So I scanned it.

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

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

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

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

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

Informed comment wanted.

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

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

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

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

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

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

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

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

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

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

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

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

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

The problem

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Real GE profits

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

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

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

And on the basis of his accouting he should.  

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

GE as a parallel for America

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

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

So is General Electric.

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

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

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

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

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

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

John

Disclosure: no position but leaning long.

They read me in Washington!

The latest leak from the WSJ about the details of the Geithner plan should sound very familiar to readers of the "long post".  Even the numbers are the same as the long post.  To quote:

These private investment managers would run the funds, deciding which assets to buy and what prices to pay. The government would contribute money from the $700 billion bailout, with additional financing likely coming from the Federal Reserve and by selling government-backed debt. Other investors, such as pension funds, could also participate. To encourage participation, the government would try to minimize risk for private investors, possibly by offering non-recourse loans.

The public-private partnership grew out of the "bad bank" concept, an idea popular among some economists that would have required the government alone to buy up the troubled assets.

Maybe they read me in Washington - even if it is only briefly.  

Calculated Risk thinks its a bad idea - but say 100 billion of private money lying in front of public losses is a real capital injection into the banking system.  Big money too.

That seems better to me than all the capital coming from the goverment.  If you are ideologically hooked to the nationalisation solution then private money is bad.

Calculated Risk's objection is that the money is non-recourse.  But all banking capital is non-recourse with the taxpayers - through the FDIC bearing the downside.  As long as a fair bit of capital is required (as it should be required for banks) this is not dissimilar to new private money starting banks.  

I doubt Calculated Risk would have an objection to that.  The issue is not non-recourse - it is the ratio of private to public money because if only a slither of private money is required there is little real risk transfer to the private sector.  If a lot of private money is required there is real risk transfer and this plan is the real-deal, but would reduce the chance that the private money could be found.

I gave ratios of 6.5 to one or 7 to 1 because those were about a third where banks were allowed to operate and these funds will hold what on average will be riskier assets.  Numbers - not the concept - should be the realm of debate.

John

Wrong again - on AIG

There is only one piece of AIG that is still highly valuable – which is the core American P&C business (including some auto businesses).  AIG has for instance merged AIG Direct into its fully owned 21st Century – a California Insurance Company.  That business is still a very effective competitor – but their website no longer mentions those three letters (AIG) – I guess to protect the value of that business.

Life companies (ALICO etc) are not anything like as valuable as they were.

I posited in this post that the Feds were taking their interest in direct ownership of the valuable bits of AIG – so that they could let the mothership go.

I was wrong.  The Treasury announcement contains this phrase:

The Revolving Credit Facility will be reduced in exchange for preferred interests in two special purpose vehicles created to hold all of the outstanding common stock of American Life Insurance Company (ALICO) and American International Assurance Company Ltd. (AIA), two life insurance holding company subsidiaries of AIG. AIG will retain control of ALICO and AIA, though the New York Fed will have certain governance rights to protect its interests. The valuation for the New York Fed’s preferred stock interests, which may be up to approximately $26 billion, will be a percentage of the fair market value of ALICO and AIA based on valuations acceptable to the New York Fed.

If the government wanted to protect taxpayers it would take control of the really valuable bits of AIG through this sort of structure.

They are not doing so.  

Taxpayer protection bought to you by Geithner, Obama and Moral Hazard’s other friends.

As for investment theses - I have gone through a few iterations thinking AIG debt might be worth par to my recent view that it might be worth zero to my current view that it is worth whatever Mr Geithner will make available for you.  

John

HSBC are to blame

Of all the ways to lose money – one of the most painful is to be right and lose money.

It doesn’t happen to unlevered longs.  If you have no leverage (financial and operational) you can buy a share – and if it goes down on the way back up you will be fine.  If you are a trader (who almost always operate with some leverage) that won’t help you.

But on the short side you can be in a stock which goes from 10 to zero via 20.  That is what happened to me with Conseco.  I held on – but it was painful.  Very painful.  In some instances (notably Calpine) I did not do much of a job of holding on.

But even worse is when some bozo idiot (in my case the idiot was often Sir Fred Goodwin) comes in and buys the company out at a massive premium when you are short it because of looming disaster.  Then you can’t recover (except perhaps by shorting the bozo idiot acquirer).

My story

I once shorted Household International from 50 to 20 via the mid 60s.  It took a long time to play out and for a long time I was losing money.  

I covered – not for any particularly good reason but that I wanted my capacity for other shorts.  

HSBC came in and bid for Household subject to due diligence.  I thought that they would find enough on due diligence to make them run (and run and run).  So I reverse arbitraged the takeover – going long HSBC and short Household in the hope that HSBC would come to its senses.  In this case if I was wrong the deal would close and I would lose the spread.

If I was right Household would probably have failed right then.  If HSBC thought Household was not worth buying then its doubtful anyone else would have financed it.  

So if HSBC had come to its senses then I would have made a little over 100% on my position.  Fantastic really.  

But HSBC were bozo idiots and they completed the trade.  I lost the spread.

HSBC are now forced to raise huge amounts at a highly dilutive rights issue to make good the losses.  But their pain does not refund my clients.  Intellectual satisfaction is nice – but I really would prefer that refund.

A counterfactual

Had HSBC done a proper due diligence on Household and understood what they were purchasing they would never have done the deal.  I would have made out like a bandit.

Household – then the biggest subprime mortgage company in the world - would have failed in 2002.  

People would have (correctly) understood that subprime mortgages and securities backed by subprime mortgages were dangerous.  The capital markets would have been (far) less open for dodgy mortgage paper.

And the mess we are in today would thus be far less intense.

The real purveyors of moral hazard

People deride governments and central banks for bailing out bad banks.  The critics argue (fairly) that those bailouts encourage risky behaviour (by failing to punish it) and hence make the next crisis far worse.

All true enough – but by far the biggest bailout last cycle was the bailout of Household – the world’s biggest subprime mortgage company – by the respectable HSBC.  

By contrast the US Government let Ameresco, Conti Financial and a few other mortgage companies fail.  Compared to Household however these companies were tiny.

HSBC are the villains here.  They provided the assurance that got this subprime mortgage thing really rocking.  They are who you should blame.

The shorts

There is a lot of nasty things said about short sellers.  And short sellers say a lot of nasty things about the companies that they are short.

I said nasty things about Household to anyone that would listen.  I had a bet with a UK analyst that HSBC would close or let Household (which was not guaranteed) fail before 2007.  I lost.

But sometimes – just sometimes – the world would be better off if short-sellers were taken more seriously.

John 

Restructuring AIG – letting the mothership go

The rumoured AIG restructure should make the hardline – hit-em-where-it-hurts-and-get-rid-of-adverse-selection crowd happy.

The government is going to swap its debt in the parent company into an interest in each of the subsidiaries.

As a result it is subordinating all parent obligations to the Government’s claim.  

Once you do that you can let the AIG parent company go.  The parent company debt is trading above 50c in at least some maturities.

I once thought the AIG parent company debt was probably money good.  I suspect it is now probably zero.

Not too bad a thing either – because the AIG parent company is not systemically important.

Four times slaughtering a dead horse

Editors note

This is the fourth post on a quarterly set of numbers from Bank of America.  That post sent my in-box on fire.  The disagreement was absolutely vehement.  Even when I mention global warming I do not stir up passions like this.

If you want to follow the saga read the posts in reverse order.  Start with this post, then this and then this.  Finally get to this current post.  However if you are willing to accept my assertion that bank margins are rising regardless of subsidies then just ignore all but the first post.

I fully agree that – if at the moment – the FDIC guarantee were removed then Bank of America would fail.  That failure would happen regardless of whether Bank of America is actually capital adequate or not.

However if the guarantee were removed the few banks around that were considered solvent would be flooded with money from people who wanted to put it there.  

They would get those deposits very cheaply.  Really cheaply.  Free in fact.

The lending situation would be truly diabolical though.  The rate customers would pay would go up sharply.  

Bank margins would be truly spectacular.  The problem would be survival to take advantage of those margins.

There is only one reason at all you are paid interest on bank deposits.  It is that they are guaranteed.  

Go to Bankrate.com.  Look up the highest rate you can find.  It is usually Corus Bank – which as noted here – is truly diabolical.

If you want to attract deposits you have to compete with Corus Bank.  Corus Bank has those deposits and has the ability to attract them purely because it is guaranteed.

Note this.  The guarantee raises the number of serious competitors in the deposit market.  It raises the cost of deposits and it hence lowers bank margins.

Yes I stand by the assertion that if the guarantee were removed bank margins would rise – and deposit costs would fall.

Access to funds at all would be the issue.  Not their price.  Offering to pay for funds would not help (see the Akerlof Paper on the Market for Lemons for a good theoretical explanation).  

Now when is it that my readers - usually with good economics training - stopped believing that the main determinant of margins is competition - and that subsidies given widely do not increase the income of the receiving industry - but just get competed away?

Trying to thrice slaughter a dead horse

Bank of America’s stock price in July last year was still $25.  It was above 30 for most the first quarter.  

In those days nobody seriously talked about a Geithner put on Bank of America.  Certainly the average Bank of America depositor did not think about the FDIC guarantee.

Both those quarters were record revenue quarters (other than trading revenue).  

The Geithner put does not explain the rising margin of Bank of America in those quarters.  

Bank revenue has been rising fast across the board since the first glimmers of the subprime crisis.  It has happened even in parts of the bank that are not guaranteed.  

It is a global phenomenon.  Well except in Japan.

It is not surprising at all.  The margin collapsed when money was freely available and banks were grovelling to lend money.

Now banks are able to (a) tighten credit standards, (b) raise rates and (c) have customers come begging.

Banks have the upper hand when dealing with loan customers and it shows in their numbers.  

Once banks wined and dined potential customers.  Now potential customers wine and dine bankers.

Bank revenue is rising.  It is rising faster when governments guarantee their funding – but it is nonetheless rising pretty well across the board.  The explanation for that rise is at best in part taxpayer subsidies.  But that is not the only explanation.  The competitive dynamics are far more important in explaining why revenue should rise.

Why is it that people have given up believing that competition is the main determinant of margins?

John

Ideology over numbers

Simple observation required here.  Almost every comment on my post about widening interest margins argued that they were only widening because of guaranteed funding by the Federal Government.

It is simply not true.  Look at the numbers and the interest margin was widening sharply until the third quarter of 2008.  Indeed interest revenue was a record every single quarter of last year – and that was the case at most banks.

Bank of America did not get any guarantees until that point.  You can do the maths on the guarantee and they cannot explain the massive surge in the fourth quarter (too little money, too late).  In the Bank of America case most of the guarantees were backstop after they purchased Merrills.   They happened this year and hence outside the fourth quarter.  

Revenue is rising at pretty well every bank I look at.  Doesn’t matter if it is in America or not.  It doesn’t matter whether it got a lot of government assistance or not.

Just accept it – for franchise banks – those that have good access to deposits or other sources of funds – revenue for a bank is rising.

It rises faster if the government will lend you wholesale money at government interest rates.  But it is rising regardless.

This should not surprise people but there is resistance.  In the boom there was no government assistance – and yet interest margins went down and down and down and down.

The banks levered themselves up further and further to get what they deemed acceptable ROEs.  

At the moment the reverse is happening.  Margins are going up and up and banks can’t de-lever themselves fast enough to survive.  

 

John

PS.  Just to further rub in the numbers - a liquidity trap means people save cash rather than spend.  That is the macro problem.

So deposit balances are growing sharply.  Bank of America deposits were up from 492 to 583 billion over the past year.  I think that is good news for Bank of America.  The cost of those deposits on average was down sharply.

Further - the non-interest bearing deposits were up by 25 billion.  The bank gets to lend those new deposits at marginal loan rates slightly above their average loan rate of 560bps.  One and a half billion dollars of the rise (annualy) is explained just by those numbers.  The vast increase in the extra low-rate deposits explains a good proportion of the rest.

If you think that bank revenue is rising simply because of the government guarantees then you are letting ideology get in the way of the numbers.  Bank deposits are rising.  The cost of those deposits is falling.  Banks with good franchises are finding that they don't need to chase to get zero rate deposits.

The opportunties in banking are wonderful - provided you can survive to take advantage of them.