Wednesday, May 28, 2008

Royal bank of Scotland and Charter One - a first follow up

Short post: RBS has taken very few charges on its HELOC buiness. I have pointed out that - at least for some houses the price has fallen to near-zero - and the HELOCs are worthless.

This is true for about half of Detroit (an area laden with Charter One branch originated HELOCs).

I will leave you one factoid from todays Wall Street Journal:

For the first four months of this year, home sales in Detroit, excluding suburbs, totaled 3,360, up 48% from a year earlier, according to the Michigan Association of Realtors. The average price dropped 56% to just $20,514. That average is so low because many of the sales involve decrepit homes in neighborhoods with few jobs.

Does anyone believe - even remotely - that Fred Goodwin or Larry Fish have an iota of credibility? Advice to the board: terminate them for cause. Then resign yourself.

Sunday, May 25, 2008

Fun and games in hedge fund land (or what does it take to go to prison?)

Forgive me for a non-stock post. But it will cover the dubious goings on off Wall Street - and is fun.

A while back I went looking for a new name for a fund. In passing I came accross New World Capital Management - the most intriguing hedge fund you have never heard of. The fund was run by someone who called themselves Greg Duran - and who hailed from New Mexico.

Their record was unbelieveable. Below I have extracted from their marketing materials the records for their two funds. The equities fund monthly return is below:

The return for the multi-curreny fund is below:

In both cases you should click for more detail - just to show how truly extraordinary these returns are. In July 2007 the multi-currency fund claims to have scored a 66% month.

The first cockroach

It is sometimes said there is never just one cockroach. But the first cockroach I found was a doozy. The annual returns in this table are not consistent with the monthly returns!

In particular the monthly returns in the 2007 currency fund compound to more then the stated annual return. Similar mathematical errors exist throughout their documentation.

Some due diligence

Given the very attractive returns listed I figured maybe I could give up the game altogether and put my money with Mr Duran. But of course I would need to do some due diligence.

Mr Duran made this fairly easy. His literature listed (for the currency fund) the Prime Broker as Ikon Global Markets, the auditor as Spicer Jeffries LLC, the legal council as Pillsbury Winthrop Shaw Pittman.

As a basic due diligence I thought that I would approach these firms. In particular the auditor is expected to stand behind the accounts that they sign - so they would be good people to approach.

The Prime Broker's less than Prime response

The Prime Broker's (reasonable) response is repeated below:

Mr. Hempton:

Thank you for contacting us regarding this situation. As per our privacy rules, we cannot disclose details regarding client’s of the firm unless directed by the client. IKON is a prime broker for FX trading and acts as a counterparty for FX trades. In this capacity, we do not endorse, verify or audit the returns or claims of any client (individual or fund). If the fund is rated, then you can research their results through the rating agency. You can also ask to speak to their auditor, legal advisor or request further information. I am sorry we cannot be for further assistance and I recommend that you do thorough research and due diligence before you select any money manager.

Thank You

Diwakar Jagannath

Managing Director/CEO


99 Wall Street, 11th floor

New York, NY 10005

What Ikon did next however staggers me. They contacted Greg Duran - and I received an indignant email from New World. [If it is a fraud - why tip-off the perpetrator? Confidentiality applied to the customer but not to me.]

The auditor

The auditor was at least polite - but at first had never heard of New World. It turns out that a partner had discussions with Duran about becoming his auditor - but that no appointment had been made and Spicer Jeffries had never audited any New World accounts. [This was despite New World literature asserting that Spicer Jeffries had conducted such audits.]

I would have assumed that an auditor would want to protect the integrity of the statement "audited by us" and called the police. No such luck. I think they were interested in protecting a potential client.

Further conversation with Greg Duran

As Duran now knew I had contacted his Prime Broker he might as well know that I had contacted his auditor as well. This led to the following fascinating exchange:

I started the fund in 2005 with myself and two small investors. We built up a track record up till April of 2007, when we launched the fund LP. We started taking clients accounts in November of 2007. In November of 2007, we hired on Spicer Jeffries to do our audits. Because it is an LP, we have a choice of whether to do an audit at the end of the 2008 or do an audit now. We are in the midst of getting feedback from our current investor base to determine if they want to wait to do the audit or, if they want to do it now. The investor pool has to decide since they are paying for the audit. Now, we started a relationship with Dranger Capital, whom is our CTA and who also gave us notice to the contact you had with IKON's Manager so that they can speak on our behalf.

The plot is thickening here. Note this email has him starting the fund in 2005. He gives (above) records for the 2003 and 2004 years. Peculiar.

Does the fund exist?

This is a good question. Greg Duran seems to exist. Indeed he was often good for a quote in the Santa Fe New Mexican - by a journalist called Bob Quick - who seemed to put his stories out that way. Here is an example where Greg Duran is seen (in January this year) backing the solidity of Thornburg Mortgage. (He got that wrong.)

Indeed Quick quotes Duran more than once. Lazyness is the nicest explanation I have - though I rang Bob Quick up and suggested to him that - just perhaps - Greg Duran was the local story. There was no follow up.

Who was suckered?

I do not know how many people were suckered by New World - but one New York based fund-of-hedge-funds gave him money. They were kind of embarrassed when I spelt out the problems. I do not know whether they have recovered some or all of their funds.

Duran quite quickly realised I was doing a proper due-diligence - and he realised that maybe New World was not a "good fit [for me]". I do not know anyone else who was suckered.

Their website has now gone dead. The phone number that they gave me now rings through to someone called "Dranger Capital". Dranger Capital might be a legitimate operation - but they woud hate to know that the number of New World is being forwarded to them.


I didn't just tip off Bob Quick. I went to journalists with some leading publications. I copied full details to the SEC and to the New Mexico AG.

Nothing seems to have happened.


Due diligence - just a little digging - will save you most errors.

Obvious frauds are not prosecuted. (This was an obvious fraud - and the authorities were told.)

Just because it is not prosecuted doesn't mean its not fraudulent. If you can't verify you should not put your money there.


The website may be gone. The phone may ring to a new venture. But you can still see their logo here.

Full disclosure: this is for amusement only. Had the fund checked out I would have given them some money. But it didn't check out and that was that.

My main interest here is how easy it appears to get away with it. Unless that is changed then the capital markets will remain unsafe and deserve lower valuations.

Thursday, May 22, 2008

Australia really is another country

St George Bank is the number 5 bank in my home country (Australia). It is currently subject to an all-stock offer by Westpac - but if you were an American you might wonder why you would want it.

After all - St George is probably the only bank in the English speaking world which still advertises zero-downpayment mortgages on TV. Here is the description from their website.

I suspect the description will disappear sometime - so below is a snip preserved for posterity:

Note that St George will "sell" you a zero-down mortgage to buy vacant land. I do not think Indy Mac or Countrywide allowed that.

But why stop at zero down loans. The company will also do limited documentation loans - but with an 80% LTV restriction. This is the page from their website - but again I wish to preserve a snapshot:

Again you should read the small print. This is not a normal amortizing low-doc. Its a low doc line of credit.

Hopefully of course you should get a big-fat-margin for lending low-doc line of credit. But you would be wrong. St George is so keen for volume that they offer the low-doc line of credit at a discount to the standard rate in Australia. Below is an extract:

So can someone please explain to me again why Westpac is so keen to buy this bank? I don't get it. There is no big problem in the Australian mortgage market - so maybe this is just June 2006 redux. But Westpac buying St George smells awfully like Wachovia buying Golden West.

John Hempton

Full disclosure: No position in any stock mentioned.

Tuesday, May 20, 2008

Sir Fred Goodwin death watch: Part 1

The biggest bank in the world is Royal Bank of Scotland.

Double-take. Hold your breath. Think that John Hempton has lost his mind.

A mere ten years ago RBS was a regional Scottish bank. Then Sir Fred Goodwin came along. He almost never saw an acquisition he did not like.

And now RBS is the biggest bank in the world.

It is not the largest market cap in the world.

It is not the largest shareholder equity in the world.

But it is by far the biggest bank in the world by assets. By assets – the total assets (meaning loans and other things) on the balance sheet is the real test of how big and important a bank is. Big banks lend more and get their fingers in more pies (and borrow more) and thus have big balance sheets.

At year end – translated to USD at year end exchange rates – RBS total balance sheet footings were USD3.8 trillion. Citigroup – a mere bagatelle – was “only” USD2.2 trillion. The putative Japanese giant (MUFJ) was only USD1.9 trillion.

Admittedly RBS consolidated the interests of Santander and Fortis in the ABN Amro acquisition – but even net of those minorities RBS remains the biggest balance sheet in the world.

So what?

The so-what is obvious.

In times of a credit crisis – when seemingly safe AAA rated assets are defaulting – big balance sheets are likely to have big problems.

They do – and the stock price is telling you. RBS stock is startlingly weak. The company however seem to believe everything is fine – and only miniscule charges have been taken.

The management of RBS are delusional. Utterly delusional. They are sitting on big losses. They are wilfully blind. The CEO should be sacked for cause – and denied his retirement benefits.

The board is ineffective and unable to control the charismatic CEO. They should also resign.

The Bronte Capital Blog plan

This blog is going to detail little bits of RBS’s accounts – spelling out just how delusional the management team is. A death watch for Sir Fred Goodwin – the worst CEO of any big bank anywhere.

Delusion part 1: RBS’s US Home Equity Line of Credit (HELOC) Business

RBS has done about 100 acquisitions in the USA. The most important of these was Charter One Financial - for about 12 billion in cash. It will be a surprise to most readers - but RBS is the 11th biggest bank in the USA. The statutory accounts of RBS Citizens can be found on the FFIEC site for the top 50 bank holding companies. Follow this link:

Click here: FFIEC top 50 bank holding companies

Lurking in RBS Citizens is a home-equity line of credit business. This was largely acquired with Charter One. Charter One aggressively opened banks in under-served neighbourhoods - garnering previously unbanked or lightly banked clients. Those neigbourhoods were unbanked for a reason. They weren't exactly rich.

The bank orginated (and still originates) HELOCs out of those branches. It has (and you will need to follow the statutory filings to their source data at the FDIC) 11.0 billion of mortgages secured by second liens and 9.3 billion of HELOCs (as at year end 2007).

They are still originating them and to date their provisions against them are trivial. The management still think this is good business.

This is however arguably one of the worst HELOC businesses out there. It was aquired with Charter One.

I will play a game with you. Lets follow this link and buy some houses.

Click here: Real estate search Toledo Ohio

In Toledo the houses don't cost much.

Now lets look where RBS is originating the loans. Here is a Google Map of the location of Charter One branches in Toledo.

The overlap gets worse when you follow individual houses for sale under $1000 and the location of Charter One branches that originate HELOCs.

Am I being unfair picking Toledo? After all Toledo is where the bankrupt auto parts company (Dana) has its operations.

Not really - I could pick Akron or outer Cincinnati, or Detroit or any other city that Charter One was big in.

So where is RBS on all this?

Answer: delusional. They have taken no charges and all the goodwill from the Charter One acquisition remains on RBS's balance sheet unimpaired.

But worse than delusional. The head of RBS's US business (Larry Fish) wrote an editorial in the Washington Post in December 2007 in defence of subprime lending. Here is the link:

Larry Fish defending subprime lending in the Washington Post in December 2007 - ie after it all blew up

You work out what planet he is on. It is hardly the same one as me.

And Fish is no lightweight. He is an executive direcctor on the board of the biggest bank in the world - the parent board.

Summary: It is time to sack the lot of them

Disclosure: RBS is big, problematic and cheap. I am neither short nor long. Because it is so big and so cheap it looks a little like buying Citigroup in 1992. I would prefer be long than short. However with this delusional management team in place – I am just watching (and blogging) from the sidelines.

Friday, May 16, 2008

Japanese regional banks - a mirror on America

77 Bank is a regional bank in Sendai (the capital of Miyagi prefecture). The Japanese guys I know think of Sendai as a backwater – a place where the “cool guys” hang out on motorcycles wearing purple clothes. Economically it is just another rapidly aging backwater where the young (other than those that hang out on motor cycles wearing purple clothes) are moving to Tokyo.

The name 77 Bank harks to tradition. During the Meiji restoration the Emperor gave out numbered bank charters. Traditional regional banks still label themselves by the number. and many other numbered sites belong to banks.

77 Bank has a very large market share (near 50%) in Sendai. The market is more concentrated that the great oligopoly banking markets of Canada, Australia, Sweden etc. It should be profitable – but isn’t.

Here is its balance sheet:

(click for a more detailed view).

Note that it has USD42.6 billion in deposits. This compares to $35.8 billion for Zions Bancorp – as close to an American equivalent as I can find.

77 only has USD26.4 billion in loans though. If you take out the low margin quasi-government loans it probably has only USD20 billion in loans.

This bank seems to be very good at taking deposits – but can’t seem to lend money.

This is typical in regional Japan. It is also a problem – because when interest rates are (effectively) zero the value of a deposit franchise is also effectively zero.

So – guess what. It sits there – just sits – with huge yen securities (yields of about 50bps) doing nothing much.

It’s a big bank. It has next to no loan losses because it has no lending.

Here is an income statement:

(click for a more detailed view)

Profits were USD87 million on shareholder equity of 3251 million. You don’t need a calculator – that is a lousy return on equity for a bank without credit losses.

You might think that given that they have no profitability and no lending potential they might be returning cash to shareholders. Obviously you are new to Japan. Profits are 27 yen per share and the dividend is 7 (which they thoughtfully increased from 6).

In a world where banks everywhere are short of capital 77 bank is swimming in it. Here is the graph of capital ratios over time:

This bank has an embarrassment of riches – and nothing to do with them.

Welcome to regional Japan.

An American Mirror

The title of this post was “An American Mirror”. And so far I have not mentioned America.

America is a land with little in deposits and considerable lending. There are similar lands – such as Spain, the UK, Australia, New Zealand and Iceland.

There are also mirror image lands – 77 is our mirror image.

Macroeconomic investing calls

We live in a world with considerable excess (mostly Asian) savings. Banks with access to borrowers made good margins because the borrowers were in short supply. Savers (or banks with access to savers) were willing to fund aggressive Western lenders on low spreads.

77 Bank has been the recipient of those low spreads. It has not been a fun place for shareholders as the sub 3% return on equity attests.

The economics of 77 Bank (and many like it) will change if the world becomes short on savings. There is NO evidence that that is happening now – and so 77 Bank will probably remain a lousy place for shareholders.

The market produces what the market wants

This is an aside really. We live in a world with an excess of savings. This is equivalent to saying that we live in a world with a shortage of (credit) worthy borrowers. So we started lending to unworthy borrowers – what Charlie Munger described as the “unworthy poor [whoever they might be] and the overstretched rich”. We know how that ended.

Unfortunately the financial system cannot make worthy borrowers. It can only lend to them when it can identify them.

This Subprime meltdown heralds the death (for now) of lending to the unworthy. The shortage of the worthy however is as acute as ever – and money for the worthy is still very cheap.

The subprime meltdown does not solve 77’s problems.

Thursday, May 15, 2008

Scoping the mortgage crisis

Why not start with big ideas. How do we get a grip on how big the mortgage crisis is and/or will be?

Lets start at the beginning. In December 2006 the mortgage crisis was but a glimmer in the eye of a few maniac short sellers. (I would like to gloat here - but given I predicted it I made nothing like enough money.)

At that date there were 9854 billion dollars of mortgages outstanding in the US. (Source - the historical tables in the latest release of the Flow of Funds document at the US Federal Reserve site.)

Fannie May guaranteed 2526 billion (source: 2006 Fannie Mae annual report).

Freddie Mac guaranteed 1477 billion (source: 2006 Freddie Mac annual report).

Ginnie Mae (ie the US Government) guranteed 410 billion (source Ginnie Mae annual).

Veterans Affairs (also the US government) guaranteed 203 billion (source - notes to the Veteran Affairs report to congress).

That adds up to 4616 billion which has a government guarantee or where the loss will wind up being Fannie Mae's or Freddie Macs (or the government when they bail out those entities).

So there is 5238 billion to which the private sector is potentially exposed.

So how big could the losses be?

Well lets get really extreme - gargantuan extreme. Suppose 40% of ALL of these mortgages default - and that the loss given default is 40%. That suggests a maximum (non-GSE, non Government) loss of 838 billion.

Its NOT going to be that large.

In 2006 the pre-tax profits of the S&P listed financials were 420 billion - so the losses could be absorbed by two years pre-tax profits. Moreover many of the losses are offshore - and so they would be absorbed by non-S&P pre-tax profits.

All this suggests that the problem is manageable from a system perspective.

I ran this analysis past a friend of mine who made $4 billion shorting subprime debt. He said that I understate it because he was shorting stuff to European banks (and AIG!!!) and his gains were their losses. Losers losses could be larger than the system loss (as he -and some other smarties - have gains).


Another way of looking at this was that there was about $1200 billion of subprime outstanding at December 2006 - and maybe $1.4 trillion of Alt-A (which was just less-than-prime). The losses on the subprime might be 60% default and 50% loss given default for $360 billion. (That is pretty extreme - a 60% foreclosure rate). The losses on the Alt A are not likely to be much more than 200 billion.

Again you get to a number that is manageable within the pre-tax earnings of the financial system.

What is odd here

What is odd here is that the market is already (at least with respect to secondary pieces) pricing this stuff roughly at this worst case.

A typical sort of pricing is a piece of ALT A originally AAA rated strip priced at 80c in the dollar.

Lets go through the maths. It originally had 12% of retained strip protection. The rating agencies though this was legitimately AAA because it would require 30% defaults and 40% loss given default to eat through that protection. (I couldn't fault the notion it was AAA when written!)

The defaults will be higher than that - but lets suppose that they are 50% with a 50% loss given defualt. That is utterly extreme. Then the total loss will be 25%. The AAA strip will lose its protection (12%) and its next 13% off the top. But it is priced at a 20% discount. You will make money buying the strip here.

It originally yielded essentially the treasury rate (it was AAA). However you are buying it at 80% - so it now yields 1.2 times the Treasury rate. You will also get 7% (or more) recovery on this. If the losses are less extreme you will get up to 15% recovery. So all-up you might get 4-5% more than the Treasury rate.

Oh great 9-10%.

Its cheap - but hardly exciting.

In the old days it would be money-for-jam. Reason - you would borrow money to buy this stuff. Todays Problem: nobody will lend you money secured by this any more.

So there are forced sellers - and no leveraged buyers. This is what is known as "waves of delevering". The only buyers are ones with huge excess cash (read Warren Buffett!) and even then he can afford to be selective.

The question: when is it worth selling your liquid and easily priced General Electric stock to buy illiquid but pretty sure to earn you 9% problematic Alt-A formerly AAA rated securities?

When I put it that way - its pretty clear that the market is mispricing the mortgages - but it will not be me who closes the arbitage.

A hope to emulate Jeff Matthews - and not make it up

This is my first (serious) attempt at an investing blog. There are numerous out there - some good - some truly dreadful.

I am a (semi) retired fund manager - but I can't seem to keep my thoughts to myself. So I have started this blog.

The investing blog I most admire is Jeff Matthews - who - as his title says - doesn't make it up - except when he says he is making it up!

If I can gather half the readers he does I will be happy.

Now is the task: quality ideas that people want to read!

General disclaimer

The content contained in this blog represents the opinions of Mr. Hempton. You should assume Mr. Hempton and his affiliates have positions in the securities discussed in this blog, and such beneficial ownership can create a conflict of interest regarding the objectivity of this blog. Statements in the blog are not guarantees of future performance and are subject to certain risks, uncertainties and other factors. Certain information in this blog concerning economic trends and performance is based on or derived from information provided by third-party sources. Mr. Hempton does not guarantee the accuracy of such information and has not independently verified the accuracy or completeness of such information or the assumptions on which such information is based. Such information may change after it is posted and Mr. Hempton is not obligated to, and may not, update it. The commentary in this blog in no way constitutes a solicitation of business, an offer of a security or a solicitation to purchase a security, or investment advice. In fact, it should not be relied upon in making investment decisions, ever. It is intended solely for the entertainment of the reader, and the author. In particular this blog is not directed for investment purposes at US Persons.