Saturday, October 31, 2009

Zion sent their lawyers to get us. It is like being flogged with Jericho lettuce. I drop one on them. They can’t psychologically handle it.

Oh no! Zion sent their Lawyers to get us.

It's like being flogged with Jericho lettuce!

The Feral Fundamentalists have

Come to savage us!

They must be ravenous!


Meddling Mediocrity, from the Televangelist Aristocracy,

Rip off merchants from Hal Lindsey Ministries,

But Old Dozy knows when I've got 'em,

They fail to reply when I drop one on 'em.

It's somethin' they can't psychologically handle.

Them and their band of shareholder wealth vandals.*

Last week I had an exchange with Zion Oil and Gas’s lawyers.  Zion it seems objected to my characterisation of the Ma’anit-Rehoboth #2 Well as dry.  They accused me of deliberately misinforming the market and of stock manipulation.  They threatened to report me to regulators.

I asked whether the well did show hydrocarbon flows – and if so how much?  After all they have been up and down this well with equipment many times and if there were hydrocarbons they would detect gas in those trips (so-called “trip gas”).  Eventually they said through their lawyers that they had found hydrocarbons in this well.  (Note that their position appears to have changed since early this week – as this weeks drilling report denies the finding of hydrocarbons.)

The three letters that they sent me are reproduced here (1), (2) and (3). 

Zion are currently issuing shares under a rights issue.  Selectively informing me of a hydrocarbon find is of course an offense.  Not informing the market of such a find during a rights issue is similarly an offence.  Likewise would be failing to inform the market that the well was substantially dry.  Whatever, I agreed with them the regulators should be informed.  They had been keen to turn me in.  So I sent them this reply:

Dear David [Aboudi – Zion’s lawyer in Israel]

It is clear that you are intending to report me to the regulatory authorities for my blog post on Zion oil and gas.

I think we should proceed quickly.  I have copied this letter to Stephen J. Korotash---Associate Regional Director of the SEC office in Fort Worth in charge of enforcement.  This is the appropriate regional office with jurisdiction over Zion.  I have previously copied him all three of your emails to me and my blog post.

Could you suggest a time that is appropriate for a conference call?

I have not invited Tim Johnson who is the US Attorney for South Texas which has venue over Houston based issuers, however if you wish to include him his email is [withheld]

I look forward to our discussion.

Thanks in advance.


John Hempton

I have heard nothing more from them.

They drill for oil in the Promised Land.  I sit at the arse-end of the earth.  But good religious folk like them should know it is rude not to reply. 

I am waiting for the next warm Jericho lettuce flogging.




PS.  I send a draft of this post to company for comment.  They have since made much clearer statements as to the hydrocarbons in this well.  They are testing zones of porousity so they still have hope – but they note that:

As yet, no hydrocarbons have been ‘Produced to Surface’…

[However] with regard to our log analysis, an independent log analyst noted that the Ma’anit-Rehoboth #2 well does have a specified amount of potential “net pay”…

The analyst was careful to comment that the results of his analysis … should not be considered ‘quantitative’ due to the effects of borehole washouts on the input logging measurements used for his analysis.

He noted that the existence of any hydrocarbon-bearing, open-hole fracture porosity in the formations inferred from the effects of borehole washout on the conventional wireline log data analyzed was tenuous at best, as such reservoir properties are impossible to identify or quantify directly from conventional log data alone.

The analyst recommended testing the seven zones…

You will appreciate that, until such time as we recover hydrocarbons at the surface (or not), we are not able to give any estimates of what (if anything) we believe we may recover.

Given no hydrocarbons have been produced to the surface and the indications are tenuous at best I will now amend my original post to the well being probably dry.  Their legal threats demanding I withdraw the assertion the well was dry seem hollow.

Moreover their lawyer in a letter to me (and copied to the Zion’s CEO) said:

Our client has clearly indicated in its public filings relating to the Ma’anit-Rehoboth #2 well that the well logs indicate the presence of hydrocarbons in identified 'zones of interest'.

There is an inconsistency between Zion’s latest statement to the market and their lawyers statements to me.  That was a sustained exchange so the disclosure to me was not an accident.  However Zion’s comments during the rights period now appear to be appropriate – I think in no small measure due to this blog.


PPS.  Zion are Dallas (not Houston) based.  The right USDOJ official would be James Jacks.  That is good – he is probably more aggressive than Tim.


*Apologies to the former Australian Prime Minister and the master of insultMr Paul Keating – and Company B.  The Paul Keating original is about being flogged with “warm lettuce”.

Wednesday, October 28, 2009

The new GSE as zero meme – laying the assumptions bare – and a modest plan for Obama

There have been a few broker notes out suggesting that the GSE preferred stock is going to zero.  The preferred stock itself has been dreadful lately – retreating almost to our original purchase price. 

I think the broker notes are wrong – but lets do this formally because if you look at the assumptions in my model and the assumptions in the broker notes you can make up your own mind.  [I will lay out their assumptions and my assumptions clearly – you decide.]

The first “GSEs are zero” broker note was produced by Keefe Bruyette & Woods (one of the few brokers left covering the stocks).  I have reproduced the note here (and claim fair comment use for doing so). 

The core assumption is that the GSEs are closed – and that they are put into very rapid run off – and that they do not earn much money during this run off period.  Here is the revenue model for Freddie Mac.

(You will need to click all the tables in this note for details.)  



There are implicitly a lot of assumptions here. 

The first core assumption is that the net interest yield (after hedging costs) on the retained portfolio will be about 1 percent over the long run.  I agree.  In the bad-old-days Fannie Mae used to report about 120bps, Freddie Mac used to report about 80bps.  When they restated their results Fannie restated the results down and Freddie restated them up.  The right number was about half way between the Freddie and Fannie numbers – so 100bps is as good an estimate as any.

The second core assumption is that the short run hedged interest margin is also 1%.  This is flat wrong.  Fannie and Freddie are getting absolutely record interest spreads at the moment – absolutely shooting the lights out.  I detailed this here.  This model assumes that Freddie has net interest income of $8 billion this year – which is rather difficult because they are currently getting over $4 billion per quarter.  The high current net interest margin is a function of three things:

  • Firstly – and most obviously – the lack of competition in the mortgage market.  That is not going away in the short term – and it would be crazy to assume that net interest margins compress to 1 percent rapidly.

  • Secondly the Fed is being more than generous with the shape of the yield curve.  That is going to end – but possibly not that rapidly.

  • Thirdly – and this is important – there were several charge offs of derivatives which were used to hedge the net interest margin when the businesses went into conservatorship.  Those hedges are still there (but they have been written off up front rather than amortised over the life of the product).  As a result reported net interest margins will be higher in the short term. 

All up I would expect the net interest margin over the first two years to be maybe 12 billion dollars cumulative higher than this model.  Indeed as those numbers are currently being reported it is perverse to argue otherwise.

The third core assumption is that the company is put into massive and sudden runoff.  This is a political decision that – as far as I can tell – has not been made.  You can see this in the numbers because the owned portfolio (and for that matter the guaranteed portfolio) is assumed to drop 20 percent per year from now.  This is a far more aggressive assumption than the government is currently indicating for Fannie or Freddie.  Indeed last month Freddie’s owned portfolio actually rose a little.  Moreover no government official has so far indicated that Fannie or Freddie will have to get out of the guarantee business – and this model assumes that they must leave the guarantee business.

In my long series I made it clear that the value in the preference shares depended critically on the companies being allowed to stay in business – at least for a few years.  That is true of the value of almost every bank in America – in that the whole sector is dependent on the pre-tax, pre-provision profits from their current business to cover their credit losses.  If it were not for pre-tax, pre-provision profits even big (and sacred) companies like GE would not really be viable. 

If we just assume the portfolio remains flat for three years we can add another 10 billion to Freddie’s pre-tax, pre-provision profits.

Now it is possible that the Government might choose to put the GSEs into rapid run-off (and there are Wall Street firms who crave the interest rate hedging business and who would like it) but if the GSEs are put into rapid run off it would have profound (and negative) effects for the price of conventional mortgages and for any housing recovery.  I think it is reasonable to assume that they are not insane – so I think three extra years income is a reasonable assumption.  However again I am just exposing the assumptions.

The fourth issue is simple double counting.

Freddie in the KBW model is assumed to write no new business.  If it writes no new business it can incur no credit losses on that business.

However KBW assumes 5bps of credit losses and 5bps of credit-associated costs. 

They are going to have credit losses on the old business (but they count them below).  Counting additional credit losses is double counting.

It would (of course) be reasonable to assume credit losses would be incurred on new business – but KBW is asserting that there will be no new business.

The extra credit costs in the KBW model add up to another $6 billion over ten years. 

I think on reasonable assumptions – including a rapid run off of the book after three years the pre-tax earnings of Freddie are thus 28 billion higher than in the KBW note.  Nonetheless I am just reporting the assumptions implicit in the argument that Fannie and Freddie are permanently impaired.

Credit losses in the KBW note

There is no real model of credit losses for the existing book in the KBW note.  However they do give a chart with base case, stress case and best case.


Note the cumulative loss in the best case is $33.7 billion at Freddie Mac.  My model was a little worse than the best case - $37.6 billion of losses still to incur (so over 40 billion cumulative losses on the book).  Since I wrote that, there has been a solid bounce in the demand for houses around the $200-300 thousand dollar mark (that is largely GSE foreclosures) in the key bubble states.  This video from Jim the Realtor (who is usually a dour bear) explains just how strongly the San Diego area has bounced. 


It is pretty clear from stories like this (and there are many more) that it is much easier to clear inventory.  My model assumed that it was going to get much harder and that severity on the book would rise from the current 43 percent to about 50 percent. 

Now this bottom-end housing bounce could be “the mother of all head fakes” – but again – like the interest margin – I am only reporting what is happening now.  The housing market could take another big swan dive and then my model will be wrong.  That is the bet I spelt out in the long series. 

Anyway we should look at the current losses – and projected forward losses.  The last Freddie Mac quarterly credit supplement gave the credit losses, provisions and reserves by quarter. 



In the second quarter the cash losses on the Freddie guaranteed mortgage book were $1.907 billion.  Cumulative cash losses have been a bit over 5.8 billion dollars. 

My model assumes that the future losses will be roughly 6.4 times losses booked to date.  That is my estimate is consistent with the housing market getting dramatically worse.  The evidence for that is thin.

Not only is the anecdotal evidence (such as Jim the Realtor) pointing the other way, but foreclosures are up only 5 percent from summer to fall.  Housing bears treated that news as evidence of crisis – and I thought it was a remarkably good number.  The foreclosure moratoriums have expired and we are not swamped by foreclosures.  My estimate that cash losses on the existing book are likely to be about 6.4 times the so-far-recorded losses does not seem low.

That said – the base case in the KBW note have cash losses being 10.1 times already booked losses.  That seems unreasonably high with the strong evidence of a turn in the housing market.  The stress case (which are the Congressional Budget Office numbers) are for end losses to be 24 times the amount of losses already recorded.  If you believe that then depressive illness is probably the best diagnosis.  Surely you should not be doing stock analysis – and it puzzles me why the CBO should be putting out such patently ridiculous estimates. 

That said – KBW uses their base case in their model (59 billion of cumulative losses) and I use my base case (37 billion).  There is a further 22 billion difference between my assumptions and theirs.

I note that they do not justify their 59 billion number – and I went to great lengths to justify mine.  However if the housing market takes another massive turn downwards theirs (not mine) will be right.  If the housing market continues to bounce (as it has) then we will both be wrong – losses will be lower than either of our estimates.

The non-mention of write-backs on the private label securities

The KBW note does not make any mention of the possibility of write-backs on the private label securities.  I went to some lengths to show why – at least in Freddie Mac’s case – those write-backs were likely.  I produced an estimate of about $10 billion.  These write backs are reflected in part in current market prices for these securities. 

This adds another 10 billion difference between my model and the model used by KBW.  The total difference is thus $60 billion. 

You can do a little bit better than that too – because Freddie will earn some return on the 60 billion it does not lose – but lets ignore that.

KBW’s solvency model

KBW then presents a solvency model for Fannie and Freddie.  I reproduce it here:


There are some nuanced differences between my model and their.  My model of losses is a model of losses not yet recognised whereas they provide an estimate of end-cumulative losses.  That differs by the losses recognised to date ($5.8 billion though KBW state incorrectly that they are 8 billion).   These add to the difference between the KBW model and my model. 

Also Freddie Mac currently has a 7 billion dollar positive capital position (remember it made a profit last quarter and it had write backs of the private label securities).  KBW has ignored that (something I consider another pure date-input error).  So you could add another 15 billion benefit to Freddie on my assumptions over KBW.   

Nonetheless my model of Frannie is – on fairly easily justifiable assumptions – 60 billion better than the KBW model. 

Add the 60 billion to the net capital position as estimated by KBW (the –39 billion at the bottom of the table) and it is pretty clear that Freddie can repay the shortfall and make the preference shares whole.  Add in the remaining 15 billion (being the chargeoffs to date and the current net worth of Freddie after profits last quarter) and it repays easily.

A plan for Obama

Reform of the GSEs is quite tricky at the moment.  The jury is still out on their end losses.  Moreover the ether is full of self-interested lobbyists who want to take the good bit of their business (mostly interest rate risk management) and leave the bad bit (credit risk management) with the government. 

Winding down the GSEs right now runs the risk of killing the nascent recovery in the housing market.

The sensible course of action is to just wait.  This is policy that can be delayed without any real additional risk to the government.  (The government is already on the hook for the losses.) 

If my math is right – and I think it is – then the GSEs will appear solvent in time for the 2012 election.  The government can demand (and receive) almost 100 billion in capital to be repaid from them (which will make the budget look good and undermine the only viable Republican argument that the Democrats are irresponsible).  It will make the government look like good conservators of key institutions.  It will make Obama look like safe hands for running America. 

The anti-GSE lobby knows this is a possibility and they are determined to capture as much GSE business as possible right now – so they are vociferous in their claims.  Sensible people should ignore them.




Thursday, October 22, 2009

The goldsmith as retail bank

The parable of the evolution of private banking comes about with a story about a goldsmith.  The goldsmith has the strongest safe in town – so people deposit their gold for safe keeping.  People consider the certificates of deposit equivalent to gold.  The goldsmith however lends the gold in the vault for a fee.  That is real gold.  And thus banking acts as a gold multiplier.

These days of course it happens with paper money.  I have never borrowed gold – and nor has anyone in my usual social acquaintance. 

But I am not Indian.

Extracted from the State Bank of India annual report:

Gold Banking

• The Bank has taken several initiatives to undertake bullion business in a big way.
• The number of branches for retail sale of gold coins has increased from 250 in 2008 to 518 in 2009. The Scheme will be extended to cover all important centres of the country in 2009-10 by increasing the number of branches selling gold coins to about 1100. The Bank also undertakes supply of customised gold coins to corporates.
• The Bank has re-launched Gold Deposit Scheme at 50 branches to mobilise gold from domestic market for deployment as metal loans to jewellers.
• The Bank is in the process of setting up a dedicated Bullion branch at Mumbai to undertake bullion business in a focussed manner.

Friday, October 16, 2009

Whatever pleased the Lord, he did, in heaven and on earth, in the seas, and all the depths…

After considerable exchange with Zion's lawyers I have amended this post. The well is "probably" dry. For an explanation see this post.

For a small exploratory oil company with limited funds a dry well is really bad news. Three dusters and it is game over. Two and – well – you probably should be looking elsewhere.

And so I want to report to all that Zion Oil and Gas has had a probably dry well.

Zion is a special company drilling for oil in a special land. An alliance of fundamentalists Jews and fundamentalist Christians are fleecing their flock with a string of rights offerings to fund drilling in essentially non-prospective land in Israel. The company’s promotional dross is simply funny. This you-tube clip is simply a gem…

Zion however has reported the main well they were drilling to be dry. But – even funnier than the video is the press release announcing the bad news.


25 September 2009 – Operations Update # 20

As noted last week, we have successfully drilled this well to a depth of approximately 17,913 feet (5,460 meters).

This past week, we ran a ‘velocity survey’ in order to help increase our understanding of the geology of our license area.

A ‘velocity survey’ is a type of seismic survey where the seismic travel time from the surface to a known depth is measured. Geophones are lowered into the wellbore and a pulse wave sent out from ground level; the resulting signals are then recorded.

The velocity survey data will be used to correlate specific formations to reflections seen on the seismic sections that we used to map the Ma’anit structure.

We have decided, for the present, not to drill any deeper in this well and are now analyzing and establishing the priorities of the seven zones that warrant completion testing. However, the well bore is in excellent condition and it is possible that we will drill this well deeper in the future. Next week, I will comment further, but I’ll mention that this week Zion’s Chairman, John Brown, gave me a note with the reference Psalm 135:6 – ‘Whatever pleased the Lord, he did, in heaven and on earth, in the seas, and all the depths…’

Monday, October 5, 2009

Are the Spanish banks hiding their losses? Looking at the American data

Whether the Spanish banks are hiding their losses is a major debate going on in the blogosphere and has been detailed at length in  the Financial Times.  The stakes are very high – this is a debate about the stability of the Eurozone and possibly of Europe itself.


I have a lot of American readers whose interest in finance stops at the American border.  I need to outline what is going on. 

Spain had a monstrous building boom – a building boom on (at least) Californian standards based very much on coastal development.  The building boom has slowed considerably.    The building boom attracted relatively unskilled labour – as building booms are apt to do – and about 40 percent of all migrants to EU settled in Spain.  Wikipedia (I wish I could read the original Spanish source) state that the foreign population in Spain has gone from about half a percent of the population in 1981 to over 11 percent recently.  This change in racial mix has resulted in only minor tensions (with the possible exception of the large terrorist attack in Madrid).  

The financial crisis has hit Spain hard.  Unemployment is about 20 percent – though this overstates the GDP contraction.  A lot of the new immigrants are now unemployed

Twenty percent unemployment would normally result in large bank losses – indeed you would expect bank insolvencies.  However this has not happened.  The two giant Spanish banks (Santander and BBVA) appear amongst the most profitable in the world and have substantial market capitalisation.  Strangely Spain looks solvent despite its apparent economic catastrophe.  Part of the explanation might be that the economic problems in Spain fall mainly on the newer immigrants and the unskilled end of the labour market – and that these people are not the loan customers of the bank.  In this formulation the Spanish recession is about the same depth as the American recession – and the 20 percent unemployment rate is just an artefact of the migrant economy. 

Either way both big banks are depleting loan reserves (at least compared to delinquency and non-performing loans).  But both banks are reporting low losses and low loan arrears.

The banks however could be lying.

The stakes are enormous.  The bears (led by Spanish resident Economics Professor Ed Hugh and the financial research house Variant Perception) argue that the Spanish regulators and banks are conspiring to hide Spain’s insolvency – and when Spain turns out like Argentina either the European central bank (that is the old German central bank) will bail out Spain at great cost to the Central Europeans or the European monetary experiment – and possibly the whole European political experiment will be challenged as Spain fails economically and socially.  It’s alright to bail out Latvia after its economic disaster.  Latvia is small.  Spain however is large and important in a European context.   Ed Hugh would argue that it is best to deal with the problem now – because delayed it will get much worse.

Do not for a minute think that the stakes here are overstated.  Full blown economic collapses (eg Latvia, Iceland, Argentina) usually lead to riots and governments falling.  Where ethnic tensions run high those riots often have a racial element (rioting crowds find scapegoats).  Europe can paper over the Bronze Solider riots in Estonia (which pre-date the crisis).  They can paper over riots in Iceland and Latvia because the economies are small.  But an economic disaster in Spain would pose major difficulties – difficulties I think European Union would survive – but which would stress the system to its core.

To be this bad though the banks would need to be hiding their losses on a grand scale.  Most banks in crises hide a few losses (and spread them over time).  However the bears are truly apocalyptic.  The Variant Perception report is an absolute classic of hyper-bearishness.  If it really is that bad then either central European taxpayers are going to be stuck with a huge bill or the core political union in Europe is vulnerable

Less worried folk have pointed to inconsistencies in both Ed Hugh and Variant Perception’s data analysis.  An ordinary level bank failure could be dealt with by Central European taxpayers with only minor stress – however if you believe Variant Perception we are not looking at an ordinary level collapse – its way bigger than that.  Ibex Salad – a blog with the unlikely topics of the Spanish Stock Market, Spanish Economy and the olive oil business is the counterpoint to Ed Hugh and Variant Perception.

The data is mostly ambiguous – as the bears would argue – the data is largely faked anyway – finding inconsistencies in the data is to be expected.  They would argue that common sense – and the overbuild visible when you open your eyes – indicates that there is a serious problem here.

I really do not know.  I am not close enough to the ground in Spain to know – and – frankly – analysing (supposedly) faked data in a language I can’t read from a desk in Australia is unusually difficult.  But there seem to be four variants.

(a).  The Spanish banks are telling the truth – and this is a storm in a teacup,

(b).  The Spanish banks are doing a normal amount of bank over-optimism in the face of a crisis – and whilst the banks are really stretched (but not telling us) the banks are ultimately solvent – and the European experiment is fine,

(c).  The Spanish banks are in fact diabolical – and the losses are maybe 15-20 percent of a year of Spanish GDP – in which case a bailout by (effectively) German taxpayers is possible or

(d).  Variant Perception is in fact unreasonably bullish – and Spain will collapse economically and socially and we will be thankful if all we get back is someone like the Generalissimo.  The modern European experiment will be deemed to fail because a single European Union with a single currency can’t hold together in a crisis because Germany won’t or can’t bail out Spain, Italy and Greece in a crisis.

Instinctively I am in camp (b) above.   However I acknowledge all of the above are possibilities.   

Migration, racism and currency union

I am going to do a little further explaining of the stakes here.  The threat to currency union in Europe always was ultimately racism. 

When you have currency union you can no longer have a high interest rate in Spain or Italy (when those economies warrant a high rate) and have a low rate in Germany when Germany is recessed.  You have a single interest rate across the currency zone. 

The underlying state of most of the past 15 years was Spain booming, Germany mildly recessed.  Currency shifts or shifts in value between the Deutsche Mark and the Peseta can – by dint of currency union – no longer happen.   The main mechanism of economic adjustment is removed.

America has always done that.  The same interest rate applies in the rust belt, in the sun belt, in California and in Boston.  And we know how economic adjustment happens.  Americans move.  A vast number of Americans do not live in their home town and the bulk of the world’s busiest airports are American.  Internal American migration is massive.

However migration within Europe has always involved more issues.  The languages are different.  Several countries have histories of nasty endemic racism.  There are large cultural barriers.

Monetary Union – whether by design or just outcome was always going to confront those barriers.  And it was always going to be slow.  There is a reason why the German/Spanish imbalance was so long lasting last decade – which was that it is much harder for a German to move to Spain than it is for say a Hoosier to move to California. 

The changing racial mix of Spain throughout the boom seemed to show that massive shifts in racial mix and massive internal migration could be accommodated without the tensions of Europe’s dark past.  They were the embodiment and a proof of the European political experiment.  If Spain collapses beyond bail-out (as per Argentina) then monetary union is over – and economic union with racial harmony will be challenged. 

As I said – the stability of Spain is a big issue and the crux point is the losses in the Spanish banking system.

The Spanish American data

Sitting at my desk in Bondi Australia I have no real advantage in answering the big questions about the solvency of Spain and whether Spain really is the black hole in Europe’s balance sheet. 

But I can add to the debate.  The Spanish banks have American operations – and using reasonable comparisons we can work out whether the Spanish banks are hiding their American losses.  So far I have not seen any analyst do this – but it is surely worthwhile.  I am going to focus on BBVA because I once had a detailed understanding of their American operation (Compass). 

Several years ago BBVA paid a premium to buy Compass to form BBVA Compass.*  This is how they describe the bank:

BBVA Compass is a leading U.S. banking franchise located in the Sunbelt region. BBVA Compass is among the top 25 largest banks in the U.S. based on deposit market share and ranks as the third largest bank in Alabama and the fourth largest bank in Texas. Headquartered in Birmingham, Alabama, it operates 579 branches throughout Texas, Alabama, Arizona, Florida, Colorado and New Mexico

This bank files US statutory filings (better known as “call reports”).  There is no reason to presume that the Spanish regulator is conspiring with American regulators to fake the accounts of a bank headquartered in Alabama.  Moreover there are other sunbelt banks to use as comparisons – whereas in Spain you can only really compare BBVA to Santander – and the bears would argue that there is no point checking for faked data by comparing it to other faked data.

If BBVA is telling the truth in America then there is a reasonable chance they have a culture of truth telling.  That would suggest that they are probably telling the truth in Spain.

However if BBVA’s American accounts are riddled with deception (or at least an overly-optimistic prediction as to their losses) then it is likely that BBVA has a culture of understating losses – and that that culture extends home to Spain.

Of course the truth could be (and I would normally expect the truth to be) somewhere in the middle.  A little bit of excessive optimism is normal behaviour for a banker in a crisis.  But a little bit of excessive optimism does not imply bank or national insolvency – just some difficulty.  The European experiment can survive that. 

So what does the BBVA Compass call report say?  Is BBVA hiding its American losses?  If so – how bad loss hiding culture.

I have posted the key Call Report to Scribd

Here is a a comparison – comparing BBVA USA ratios to a sample of similar bank holding companies chosen by the FFIEC.  (You will need to click for the complete picture with all three tables in this post.)






The instant conclusion is that BBVA has higher delinquencies than the competition but has lower loan loss provisions and is charging less off than the competition.  This conclusion is robust almost no matter how you cut the BBVA USA data.  I think we can safely conclude that BBVA is hiding its losses.  If anything it is slightly worse than the above indicates because nobody in their right mind thinks that the comparables (larger American regional bank holding companies) are honestly stating their losses.  But if the comparables are understating losses then BBVA is understating them more

This puts me firmly into camps (b), (c) or (d) above.  The question is no longer whether they are hiding the losses – but whether the scale of problems (in Spain) is sufficient to cause major political ructions or whether it is just an issue for the stock market.  [Disclosure: I am short BBVA and the position is modestly painful as the stocks have appreciated.] 

How are BBVA hiding their losses in America?

There is a time honoured way of hiding losses in banking – a method that Variant Perception suggests is being done on a breathtaking scale in Spain.  The method is rather than call a bad loan bad – to just extend it a bit more credit.  If the borrower can’t pay the interest give them a bigger loan or line of credit.  They will use the loan to become current.  The slogan is that a “rolling loan gathers no loss”.  Even the most diabolical subprime mortgage book in the US showed only small losses until the market stopped rolling the loans. 

We have some evidence that BBVA is rolling bad loans.  Here is the loans outstanding by sector (again you will need to click for detail):



The level of rolling loans is not at the alarming levels that Variant Perception alleges are present in the Spanish economy.  Then again Alabama and the other states in which Compass is large do not have 20 percent unemployment.  The aggression which BBVA grew the book in the past five years however is breathtaking.  You can see where all that Spanish risk comes from and why Spain had such a monstrous property boom

Construction loans – a perspective from the American book…

The main allegation in the Variant Perception report is that the Spanish banks are massively overweight construction loans – and that they are extending those loans rather than allowing default.  The core statistic is given in the following paragraph:

Consider this: the value of outstanding loans to Spanish developers has gone from just €33.5 billion in 2000 to €318 billion in 2008, a rise of 850% in 8 years. If you add in construction sector debts, the overall value of outstanding loans to developers and construction companies rises to €470 billion. That's almost 50% of Spanish GDP.

They add that they think that most of those loans will go bad (which implies a Spanish crisis many times worse than America – and implied bailout requirements that are similarly bad).  

Construction loans at almost 50 percent of GDP is a truly astonishing figure.  The entire US mortgage market is roughly 10.4 trillion dollars – or about 75 percent of GDP (and as the crisis has shown that seems too large).  The idea that construction loans are nearly 50 percent of GDP had me falling off my chair.  I tried to confirm this figure (as it felt like garbage).  Alas I could not.  However Iberian Securities has done some legwork:

Variant picks-up a classic wild-card to spice-up the report. Specifically, they say most of the €470bn in outstanding loans to developers/construction (50% of Spain’s GDP) could go bad. The report forgets to mention- however- that a chunk of the €32 bn in outstanding loans to developers does not necessarily involve residential lending but commercial lending (which is relatively safe in Spain , in our view). It does not say either that a not-low percentage of construction activity in Spain involves public works, so a proportion of the construction-related debt (€141bn) should be attached to that public sector accordingly. Also it is worth considering that residential work-in-progress in Spain — one of the biggest contributors to the €320bn figure — is generally collateralized (with Spanish major developers reporting LTV of 50-65% approx). Factor-in these and the final loss on this portfolio should be a fraction of what Variant claims. In our models, we assume a 15% peak NPL ratio on Developers (7.6% in 1Q09) and a 10% NPL ratio on Construction loans (6.7% in 1 09).

Even at 6.7 percent of GDP construction loans are too big relative to GDP and the time in the cycle – but they are not big enough to cause problems for Spain.  I still cannot reconstruct the data to get construction loans that small in Spain.  There are over 600 thousand homes under construction in Spain – and most of those are financed.  Add the finance on those loans to other easily identifiable construction loans and you get over 10 percent of Spanish GDP.  I am not confident with the Iberian Securities estimate.

However we do get clean numbers in America for BBVA’s subsidiary – and it is clear that they are into construction loans in a fairly big way – and that their construction loan book is not good and they hiding the losses. 

Here is the composition of BBVA’s American lending book versus its American peer group. 


Its pretty clear that BBVA USA is not afraid of construction loans relative to peers – and – on the evidence presented here – is probably rolling them (and hence deferring losses).  This is nothing like the scale alleged in the Variant Perception report but it suggests that the basic Variant Perception allegation of hiding construction losses is more likely than not to be true

I should note that the construction loans are 10.64 percent non-accrual (which is slightly less than peer).  It seems unlikely you would willingly be expanding lending in this category with those credit statistics.  Its far more likely that the company is hiding losses by rolling non accrual loans.

A note on scale

All these problems of the same type that Variant Perception alleges in Spain – but none are of the scale Variant Perception alleges in Spain.  In other words I can unequivocally support the notion that the Spanish banks are hiding their losses – but support for the notion that these losses are so large that France and Germany will be left “holding the bag” is not to be found in the US data. 

What the Spanish bankers have been telling us about their credit is – at least on the American data – easily shown to be lies.  We just don’t know whether they are big lies.

For the sake of Europe I hope they are not.






Post script:  I have linked to a few blogs here – but the important ones are Ibex Salad, and A Fistful of Euros.  These blogs disagree with each other – but they are of the highest quality.  If you are interested in this stuff then put them on your blog roll. 

*A few disclosures are necessary here.  All the key players in the blogosphere debate (hyper-bears and moderates) are my “Facebook friends”.  In this day-and-age you don’t have real friends – just computer friends.  I do not know what they will think of me after this post.  I expect disagreement and I will post follow-ups.  Some I am sure will disavow my “friendship”. 

Second - at Bronte we have a small position short the Spanish banks – it has not been profitable.  Moreover we are deliberately short them on the US stock exchange – which means we are short the banks long US dollars.  That has been particularly bad of late because the US dollar is weak.  However in a true crisis the Peseta (and yes I mean the Peseta) will be really weak – and we would rather be short them on a US listing where the cash balance is held in US dollars than on a Spanish listing where the cash balance is Euro converted into Peseta at an unfavourable exchange rate.  

Just like with Charter One – BBVA caused me more than a dose of heartache.  I was short Charter One when Sir Fred Goodwin and his RBS idiots came and purchased it at a massive premium.  That was the single worst day of my career.  Similarly I confess to being short shares in Compass when BBVA bid for them (admittedly for a much smaller premium).  Nonetheless, it was – as they say – not a good day at the office.

Finally it is a long weekend public holiday in Australia.  You can tell a nerd when he writes 3350 words on Spanish banking when he is meant to be on holiday.

Friday, October 2, 2009

Ducks in sewerage treatment works, drug resistance, dumb luck and investing

The day the swine flu story broke in the global press I wrote up for the blog a possible influenza hedge.  It was a stock I thought would make money – but I did not really want to win big on.  It would be nice to profit – but not because of mass influenza deaths.

Biota Holdings is an Australian small-molecule drug development company whose core asset is that they own a 7 percent royalty on all sales of Relenza.  Relenza is a distant number two influenza antiviral drug.  As explained in the original post the drug is taken through a “turbo-inhaler” which is less marketable than a tablet – but more marketable than an injection.  The difficulties taking Relenza meant that Tamiflu dominated the market. 

The story I posted was nuanced and accurate.  It was only possible to write that story because I had followed Biota before the Swine Flu outbreak and had been considering purchasing the stock anyway.  Swine Flu forced the decision.

In our quarterly client letter I wrote a follow up story which I think deserves a wider circulation. 

Firstly our clients were really lucky.  Whereas personally I purchased the stock the day the swine flu outbreak happened our clients purchased a few weeks later.  Why?  Because we could not purchase the stock for them until we received our Australian Financial Services License.  The following graph shows the advantage that they received:




The lower purchase price (dumb luck) meant the clients purchased more.  The very strong Australian dollar has meant that our US based clients have well over doubled their money. 

The luck continues

Tamiflu drug resistance (something alluded to in the original post) turned out to be the critical ingredient in the story.  It has both policy and investing implications.

In Japan, where Tamiflu is widely prescribed, the active compound (oseltamivir carboxylate) is excreted by the body (in urine) or is activated by the biological processes at the sewerage treatment works itself.  Water at and downstream from the sewerage treatment works is high in oseltamivir carboxylate.  That is really bad news because birds (especially ducks) like to bathe in the nutrient rich waters.  Those ducks are the hosts in which new influenza viruses breed – and because the water is rich in antivirals the Japanese are breeding new strains of Tamiflu resistant influenza.  This is not good news because the US government and other drug stockpiles are heavily weighted to Tamiflu – and there is a reasonable chance that the next global flu epidemic will be Tamiflu resistant.

Whilst that is not good news for the world – it is wonderful news for Relenza sales and hence our clients’ position in Biota.  And it is nothing that we anticipated.  If you told me my blog would wind up being about ducks in Japanese sewerage works I would have laughed.  From the perspective of our clients it is plain luck – but that will not stop us profiting from it.

Luck is pervasive in the investing game.  We did not figure on Tamiflu being a serious environmental pollutant.  It was just as likely that Relenza would be a pollutant.  Then, rather than showing profits we would be explaining losses to our clients.  A story about ducks in sewerage treatment works causing us losses would not sound plausible (even if true). 

Anyone with good investing results who does not admit to a dose of luck is lying.  The world is a complex place – and I would never have guessed that ducks in Japanese sewers had anything to do with our portfolio. 

Thursday, October 1, 2009

The new rapid SEC

Mary Schapiro has not got great press amongst financial bloggers – however this time she beat me to the punch.

Emergent Health Corp was a heavily promoted pink-sheets biotech which (fraudulently) claimed to have a pill (yes a simple oral pill) that would stimulate the production of stem cells in adults and hence cure everything from paraplegia to heart disease to leukaemia. Here is just one of their press releases:

Emergent Health Corp. (Other OTC:EMGE.PK - News), a diversified holding corporation focused on the biotechnology sector, announces the Company has received approval from the U.S. Patent and Trademark office for their adult stem cell nutrition product Neuvitale(tm) Life Support.

An Emergent spokesperson commented, ``The Company is pleased to announce a license to market a formulation with ability to increase adult stem cells naturally from a person's own bone marrow has been allowed by the U.S. Patent and Trademark office. Now that this patent has been allowed, Emergent will seek further corporate and joint venture opportunities with firms capable of assisting entry into this untapped estimated Multi-Billion dollar market currently dominated by drugs with high costs.''

By 2004 the world market for Colony Stimulating Factor products, Neulasta(r) and Neupogen(r) marketed by Amgen was valued at $3.6 billion, a growth of 11% over 2003. That market has grown at an average annual growth rate of 16% over the previous 5 years. This is cited only as a market size barometer.

In addition to this product, the Company is actively exploring additional investment projects involved in the adult, umbilical cord, and embryonic stem cell sector to add to its growing portfolio of biotechnology ventures.

On these press releases the stock popped rising from about $1 to about $4.

The claims were outrageous of course – but you can still buy their products online.  Some of their online adverts make equally outrageous scientific claims.  Others – like this YouTube video – have a disclaimer at the end.



I tried for the last few days trying to find a borrow – any borrow in the stock.  [You need to borrow the stock so you can short sell it.]  Apparently there was a borrow on Monday but I was on holiday – and so I never managed to short the stock.  [I was planning to donate the profits to charity.]

After that I was going to write a letter to both the Food and Drug Administration and the Securities and Exchange Commission and see which organisation shut this fraud down first.  It was going to be an uncontrolled experiment to see if the SEC could live up to Mary Schapiro’s promise to be more responsive.

Alas – and this is good news for America and bad news for my favourite charity – the SEC acted fast on this one.  They just suspended the shares in EMGE

Whilst Mary Cox Schapiro is dragging her feet on a much bigger fraud I have shown her I got to give credit on this one.  The SEC did this quicker than they ever would under Mr Cox’s stewardship failed regime. 

The SEC has only civil powers.  EMGE rises to the level of criminal fraud.  This improvement means nothing if the prosecutor can’t back up.  And therein lies the next set of problems.

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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.