Bond insurer – has airport to sell

I wrote about Sydney Airport here. Funnily enough various news source aggregators (such as Wikio) filed the article about a financial crash landing with real airplane crashes. Bronte Capital must have got a few perplexed visitors.

That said – my original post is pretty convincing on the notion that if air traffic in Sydney falls over any sustained period the airport will default.

I have no idea how sharply air-traffic will fall here. Air traffic is one of the most consistent of all variables. It just rises. The reason of course is that the cost of flying in real terms has fallen for decades. When I was a kid people who flew from Sydney to London were regarded with some awe – they were the “jet set”. Now they are “cattle class”. To fly to London cost AUD2000 and average household income was about AUD10000. It costs less in nominal terms to fly to London now...

But if the recent trend in oil prices is permanent and continuing the era of ever-rising air-traffic volumes is over. We will again refer to people who fly long-haul as the jet-set.

There is some listed subordinate debt in Sydney Airport – the so called SKIES (see my last post). Beyond that are a AUD3.7 billion of medium term notes of which AUD2.9 billion is drawn and AUD884 million of inflation indexed bonds with two maturities (2020 and 2030). My sting: all these instruments are insured by Ambac and MBIA.

I see the advert: Bond insurer – selling airport in glitzy long-haul destination.

If oil goes to $400 they will take a loss on this. But otherwise it should be fine.

Whitney Tilson on MBIA

There is a great Whitney Tilson post on MBIA on Seeking Alpha.

To me the key difference between the AA guarantors and the AAA guarantors was that by-and-large the new players in this industry (such as ACA Capital Holdings) had to post lots of collateral in the event of problems - accelerating liquidity concerns and hence bankruptcy. The AAA guarantors by-and-large had to pay when the liability fell due.

This is a huge difference. I have argued several times (see here and here) that the price of various bits of paper in the secondary market is irrational. However I have no idea what the rational price is. Nor does anyone else - not the shorts, not the longs - not anyone.

If you have to mark to market the books of financial institutions they are almost all insolvent. There is an enormous amount of paper that is 20 bid, 90 offered, price you could actually get something closer to 20. If you have to collateralise based on actual values you could get in a trade now (or sell illiquid assets to buy liquid ones for use as eligible collateral) you are stuffed. Simply stuffed.

But if you can sit it out then you are possibly OK. The reason - the defaults might be much lower than currently anticipated in market pricing. Regular readers will know my view is that defaults will be lower than current market prices. I just don't know how much lower and hence I don't know what the end-game is for someone who is levered to this stuff but does not need to post collateral.

ACA Capital Holdings had contracts that demanded it posted collateral and that smashed them up - simply smashed them. Their website is indicative of what happened to the company. But the case for Ambac and MBIA was that by-and-large they did not have to post collateral and hence had hope.

However we now know that MBIA in particular has large collateral requirements. I know of a few more contracts that potentially involve collateral at MBIA. Cumulatively they matter a great deal.

If you are thinking about the bond insurers as a buy (and I am) the collateral requirements are the critical issue. If you don't have collateral requirements then the end points are all that matter. If the things you have insured default at a (much) lower rate than the market currently thinks (something that is possible) then you will make money.

For now you have the hope of much lower end-point defaults. Hope means the stocks have value. Option value only - but as the end outcome is a long way away and a lot of things can happen there should be quite a lot of option value. [One possibility for instance - there is a lot of inflation over say ten years which reduces the real value of the liabilities or increases the nominal value of the assets that back them. That could be a blessing to a bond insurer.]

If you have collateral requirements then end-point solvency is not all that matters. You need to be continuously solvent and on current market prices you are not solvent right now. Whitney Tilson's article is the first widely available and easy to follow discussion of the collateral requirements of MBIA. And this is the critical issue for the stock. Read it.

Now please please contact me if you have done a similar run through Ambac. I have not - but I knew of far less that was collateralised at Ambac than MBIA. And that matters. It's why I sometimes think I want to punt on Ambac. [Indeed I have at various times - but have hedged the position shorting Ambac debt and made good profits by sheer luck. Those were not super speculative positions. Buying Ambac common without shorting the debt is a massively speculative position.]



John

A note - the saga of MBIA saying for years that they had few collateral requirements and then revealing billions of dollars worth of them tells you about trusting management. I can't just ring up Ambac management and ask them about collateral requirements. If you had done that with MBIA you got creamed.

Indeed some very fine fund managers got creamed doing precisely that.

Ronald Regan was right: "trust but verify".

=======================

Post script: I do not agree with everything that Whitney Tilson writes in his Seeking Alpha article. I strongly disagree with his assertion that MBIA has an obligation to downstream the $900 million sitting in the parent company. The buyers of guarantees from MBIA purchased them backed by stated regulatory assets of MBIA's insurance subsidiary not the MBIA parent company. I see no reason why MBIA parent company should increase those regulatory assets unless they are contractually obliged to do so.

Of course Whitney (talking his book) has a different view. I have a suggestion: next time Whitney invests in a stock that goes to zero he should pour more of his clients' money in just to make the creditors happy. (He argues that MBIA should do this with shareholder capital and its insurance subsidiary). If Whitney acts as irrationally as he is demanding the management of MBIA act then I am sure the creditors of his bankrupt investment would thank him.

For once - and perhaps the first time - I find myself strongly agreeing with Tom Brown of Bankstocks.com. [I can't tell you how many times I have thought Tom is speaking nonsense.]

Drink deeply of the poison: another look at Fifth Third Bank

Fifth Third was a well run bank with a cult following. Now it is up on hard times. I have looked at it numerous times with an eye to buying it - but never purchased. I blogged about that here.

I was so blinded by the past glories of the company that I couldn't even make money shorting it.

The true believers however really drank the Kool-Aid. In 2000 it was priced it at 7 times tangible book plus excess capital.

So now I am back having a look at Fifth Third. Investor Relations didn't return my email (which is disappointing) but so far I have positives and negatives.

The biggest negative is location. It is big in tough states - having three of its state concentrations in three of the worst five states for property foreclosure.

The second biggest problem is an huge error of judgement on behalf of the management. They spent a large part of 2007 drinking the Kool-Aid themselves repurchasing $1.1 billion in shares at seemingly low prices during 2007 only to issue a billion in converts at even lower prices in 2008. They paid an average price above $40 a share and issued around $10.

There is a phrase for that. Its called believing your body odour is perfume.

But at the moment I want to accentuate the positive. There is plenty of positive - and some of it reflects well on management.

This post focuses on the origination of mortgages with negative amortisation features and high loan to valuation ratios.

Fifth Third and Negative Amortisation loans

The 2007 annual report includes the following paragraph:

The Bancorp does not originate mortgage loans that permit customers to defer principal payments or make payments that are less than the accruing interest

That tends to cheer you up in this environment.

The 2006 annual report was slightly different:

The Bancorp does not currently originate mortgage loans that permit principal payment deferral or payments that are less than the accruing interest.

The "does not currrently" line also appears in the 2005 annual report.

So sometime they stopped originating that sort of loan - and they did it years before the credit crisis broke. In other-words management did not lose their minds as all about them lost theirs.

High loan to valuation mortgages

Another indication of quality management was that they slowed origination of high loan to valuation mortgages much earlier than most of their competitors. They have a category for mortgages with a loan to valuation ratio above 80 percent and no mortgage insurance. Mortgage originations for this were as follows:

2004 1286 million
2005 1245 million
2006 679 million
2007 265 million

The company slowed its origination in this category from mid 2005 and slowed it dramatically before the credit crisis hit. That reflects very well on management. Very well indeed.

So given this - I could drink the Kool-Aid. If you dear reader see good reasons to stop me please let me know. I write this blog at least in part for the comments and emails - and I don't get enough of them.

Meanwhile: memo to IR - its good to return phone calls and emails.



John

Citigroup thinks Barclays needs more

Well you don't say:

June 27 (Bloomberg) -- Barclays Plc, Britain's fourth-biggest bank, may need an additional 9 billion pounds ($17.9 billion) to absorb credit-related writedowns and bring its capital in line with U.K. peers, Citigroup Inc. said.
The London-based bank will raise 4.5 billion pounds in a share sale announced earlier this week, lifting its core-equity Tier 1 capital ratio to 5.8 percent from slightly below 5 percent, said London-based analysts led by Tom Rayner in a research note today. That will lag behind Royal Bank of Scotland Group Plc and make Barclays Europe's ninth weakest bank in terms of capital, said Rayner, who has a ``sell'' rating on the stock.
``With credit market conditions continuing to deteriorate globally, we believe it is simply a matter of time before further significant writedowns are taken,'' Rayner said.
Barclays spokesman Alistair Smith couldn't immediately be reached for comment.

Sack Bob Diamond. Sack him now.

The Associates - Sandy Weill's greatest miss

People seem to have decided that the merger of Citigroup and Travellors was a failure - indeed the great failure of Sandy Weill's vision.

That may be true - but given that JPMorgan is buying Bear Stearns Citigroup effectively buying Salomon Brothers might just be "prescient".

Anyway - everyone appears to have forgotten the most awful Citigroup acquisition of all time - The Associates.

The Associates (or more correctly Associates First Capital) was the financial arm of Gulf and Western. It was later purchased by Ford - and then spun to Ford shareholders in 1998.

Less than two years later Citigroup purchased it for stock and wound up giving away more than a tenth of Citigroup.

Yes that is right - long term shareholders of Ford who did not sell out now own a large amount of Citigroup - and that is worth more than the residual Ford holding.

You make your money in the stock market often in odd ways.

--

The history of the Associates is here.

--

Associates had two main businesses - a leading US subprime mortgage business and a Japanese consumer lending business.

It was the Japanese consumer lending business that most attracted Weill. The press release announcing the merger is headlined about Citigroup growing its overseas consumer finance business. To quote:

"This transaction, which will be accretive to Citigroup earnings by at least $.10 per share in the first year of combined operation, accelerates our consumer financial services expansion globally," said Sanford I. Weill, Chairman and Chief Executive Officer of Citigroup. "In one step, we catapult our international earnings in these rapidly growing segments by more than 40%. We are particularly excited about The Associates' strong presence in Japan, where it is the fifth largest consumer finance company, and in Europe, where it has more than 700,000 customers.

The Japanese consumer lending business however has almost been regulated out of existence - it is unprofitable (having once had an 80% ROE) and Citigroup is trying to close it. They are by repute having difficulty doing so.

In the end the Associates was probably worth less than zero.

Warren Buffett complains endlessly about having given away 1.6 percent of Berkshire for the essentially worthless Dexter Shoe business. I have never heard the top brass of Citi make the same complaint about the Associates - but I have heard it from upper-level Asian Citigroup executives.

That is the true legacy of Sandy Weill.

Resources: For those that don't remember The Associates - this linked press article should be sufficient...

A slight difference in statements: Chart Industries and Energy World Corporation

I wrote previously about the strange Energy World Corporation (EWC). See “Getting oil on my shirt”.

Some follow up is warranted – as I left the question as to who had the technology open. But I think we can decide pretty quickly who is telling the truth. Here are some direct quotes from EWC and Chart Industries.

This is from the last EWC annual report:

The Company has placed contracts with Chart Energy and Chemicals Inc (Chart) for four 500,000 tonnes per annum liquefaction plants and associated major equipments. As subcontracts to Chart the motor-driven MR compressors will be supplied by Siemens AG, Germany. These contracts which are within the original capital budgets, and programmed equipment deliveries will permit the production and delivery of LNG from our gasfield in Sengkang during the second half of 2009. Once installed and operating the trains will have the capability of producing 2 million tonnes of LNG per annum.

This is the Chart Industries press release:

Chart Industries to Supply Four LNG Liquefaction Trains in Indonesia for Energy World Corporation Equipment orders exceed $100 million

CLEVELAND, July 2 [2007] /PRNewswire-FirstCall/ -- Chart Industries, Inc. (Nasdaq: GTLS) announced that its wholly-owned subsidiary, Chart Energy & Chemicals, Inc. ("Chart E&C"), has been awarded significant orders totaling in excess of $100 million from Energy World Corporation Limited ("EWC") to supply Cold Boxes, Brazed Aluminum Heat Exchangers, Air Cooled Heat Exchangers and ancillary equipment for four 500,000 tons per year Liquefied Natural Gas ("LNG") Liquefaction Trains to be installed by EWC in Southeast Asia. The trains are intended to provide LNG to meet the growing demand for LNG in Indonesia, the Philippines, China and Japan as the economies in these regions grow. The first two trains are scheduled to come on stream in the second quarter 2009.

Do you notice any difference between these statements?

Well – there is some difference between an “LNG Plant and associated major equipment” (as per the EWC statement) and “Cold Boxes, Brazed Aluminum Heat Exchangers, Air Cooled Heat Exchangers and ancillary equipment” as per the Chart release.

For a start nobody has mentioned purification (essential because otherwise the carbon dioxide that exists in all gas freezes in the cold-boxes and blocks the equipment), storage tanks, port facilities, pipelines to the gas field or anything else. The storage tanks are particularly expensive.

John

As an afterword: Funnily enough there is no point using Google to find anything put out by EWC. They format all their releases as PICTURES not as text – which makes them impossible for Google’s bots to dictate. I had to retype…

Further EWC doesn’t maintain a website – something that is unusual for a multi-billion dollar company.

Saving a General with a fresh set of batteries

Mish asks today whether battery technology (and electric cars) can save General Motors. I think that answers itself.

But maybe Mish is focussing on the wrong General. GE is doing really interesting things with hybrids and GM is merely hoping to come along for the ride...

One of the big problems of the Prius is that it has very limited towing capacity. The specifications are essentially none.

The other American General (Electric that is) is working on mega-hybrids - busses and would you believe tug boats. No lack of grunt there.

Not quite the profit making potential of low costs nukes (see ESBWR). But hey - mega-batteries, public transport and low cost nukes. That is an American future.

GM will try to tag itself on - the dream GM electric car will use those batteries. But the profits will belong to the other General.

Why Bronte?

Several people have asked me why I use the moniker Bronte Capital?

Its where I live.

Sydney Airport: waiting for a (financial) crash landing

Warning - this post has a major error - explained in this later post. Sorry.

The Macquarie acquisition of Sydney Airport through its satellite vehicle – Macquarie Airports – is perhaps the seminal infrastructure deal of our times.

• It was by the leading acquirer of infrastructure in the world (Macquarie Bank).

• It had a private equity type structure – Macquarie did it on someone else’s balance sheet and ripped out enormous fees.

• An absolutely enormous sum was paid – and was roundly criticised at the time as these 2002 press reports indicate here and here and here and here.

• It was in Macquarie’s home town (Sydney) and so was super-visible.

• Australian mums and moms and pops were the ultimate holders of the risk – so the high levels of visibility and the bad press mattered,

• It was geared with an amount of debt that meant that the debt holders were taking large (possibly insane) risks for minimal returns (something which is reminiscent of the entire private equity boom).
  

What is more – the acquisition for about a billion dollars more than the number 2 bidder – was unequivocally a winner. Traffic and hence revenue went up. Funding costs went down and the large amount paid seemed to drop into distant memory.

Macquarie runs a mean-lean-profit machine

There is little doubt Macquarie ran the airport well. They hired uber-public servant Max Moore Wilton to run the place – and he did his political duty (scotching all sorts of regulatory interference – and a possible competing second airport). He also lived up to his public service moniker “Max the Axe” and ran the place as a lean profit machine.

When Bethany McLean wrote her piece on Macquarie she praised Sydney Airport’s profit ethos:

… so, about a month later, I arrived at Australia's Sydney Airport - which is owned by a Macquarie fund - during the early-morning rush hour, groggy after a long flight.

If you did the same thing, you might trudge through customs, not noticing much, perhaps, beyond the A$4 - gasp - it costs to hire a luggage trolley. But if you took the time to explore, you would realize that the airport is not a run-of-the-mill ripoff but an eerily efficient moneymaking enterprise.

You don't have to go far out of your way to buy souvenirs or coffee, because the airport's owners have studied how far you'll be willing to deviate from your path (five meters). You might buy a duty-free item not because you want one, but because doing so will shoot you into a special, speedy customs line. And should you drive to the airport, you would discover that parking your car in the shade ("the premium shaded parking product") costs an extra A$4.

Not that all this efficiency lessens the irritation that some users experience. As I shut the door of my cab, the driver begins an unsolicited rant about the fees he has to pay to wait at the airport. "Macquarie Bank owns it," he says. "They own too much."

Bethany was right. Sydney Airport has been run brilliantly – and there is no more old public service culture fat to take out. They have done it.

It was Sydney Airport more than any other deal that justified the validity of the “Macquarie Model”.

Macquarie Airports has booked its profit

All of this says that Macquarie’s seemingly overpriced 2002 purchase was in fact a bargain. That is why this – the highly controversial and visible purchase - is the seminal infrastructure deal of our time. It showed just how much public infrastructure run as “an eerily efficient money making enterprise” is worth”. The success of the Sydney Airport was lauded by countless (and possibly mindless) imitation.

Macquarie however – being the leverage junkie it is – borrowed vastly more money (approximately $2 billion) against the airport and paid a massive dividend to Macquarie Airports (the listed trust/ultimate owner). This debt – like most debt in most Macquarie vehicles has limited recourse – it has recourse only against Sydney Airport and no other assets.

Given that Macquarie Airports (MAP) has received in cash more than they paid in cash and they can’t be forced to make good Sydney Airport debt then MAP has made a profit. A big one – and a real one - one that can't be reversed. Even if Sydney Airport were to go bust tomorrow it would have been on OK deal – at least assessed on a standalone basis. MAP holders will have done OK. Banks and other guarantors would have done their dough – but that is them. Those are the joys of non-recourse finance.

So what is left at Sydney Airport?

The short answer is a very well run airport and a lot of debt. Here is the balance sheet:

Yes - the shareholder equity is negative nearly half a billion. Tangible shareholder equity over a billion negative.

You can calculate the debt according to your own definition of debt. Maccqaurie picks a lower number because they think the fixed coupon subordinate (the SKIES) are equity. (That is funny given their name: Sydney Kingsford-Smith Income Equity Securities.)

And here is the P&L.

Yes it did lose 182 million last year!

Note in the P&L the operating profit (ie before depreciation) is only 10 million larger than the interest bill. After even basic maintenance capex the airport is cash-flow negative. That is an amazing debt load.

Macqaurie runs lots of its assets this way – though Sydney Airport is the clearest example. They have run it with those sort of debt load since inception – and it has always been OK in the end because traffic and volume have risen every year. Costs have been kept (well) under control and everything has turned out roses despite negative initial cash flow. Indeed Macquarie values the equity in the loss making airport at several billion dollars on the assumption that traffic volumes increase.

But the summary is clear: Sydney Airport requires increasing traffic to be solvent - let alone be worth anything like the claimed amounts.

Is traffic increasing?

Well it has increased every year. But this year is somewhat problematic. Australia is almost the ultimate long-haul destination. North Asia is still booming so traffic volumes should be going up. But the cost of flying is going up too due to fuel and airlines are cutting flights. Further tourists generally don’t like the strong Aussie dollar.

There are plenty of press articles to that effect. See here and here and here and here. These cutbacks are all relatively recent.

So does Macquarie have another trick?

Well the biggest problem now is how well Sydney Airport has been run. Its too good.

I doubt that there is any fat left to cut. I doubt that there are many additional revenue opportunities. I could be wrong – but this looks very difficult for debt holders and guarantors in Sydney Airport.

The fall-off in air-traffic could be temporary. Air traffic has dipped before – but only for short periods. Maybe this will all blow over. If air traffic resumes its historic upward trend then this post should be ignored.

However the oil price hike looks fairly permanent. Does that make it difficult for Macquarie? Well a profit has already been made in cash on the airport. So from 8 miles high it doesn't look like a problem. From ground level - well I report - you decide.

The preposterously expensive WestAmerica Bancorp

In my post of Fifth Third I described WestAmerica as perhaps the most astounding unbroken story in American banking.

Here is its balance sheet from the last quarter – note that almost every category is shrinking:

The company is not shrinking because it is forced to by lack of capital. Contrary - almost alone amongst banks it is buying back lots and lots of stock. This is not a bank that is going to use its superior performance to build capital and buy its competitors in crisis.

The management is comfortable with shrinking. Even deposits are shrinking deposits (somewhat by choice). WABC would rather keep cheap deposits than compete for them on price and service. (Unfortunately their competitors are not so kind.)

Indeed the good stuff is all shrinking. Deposits are shrinking. No interest deposits (of which this bank is rich) are shrinking. Loans are shrinking. Equity is shrinking.

The bad stuff is also shrinking – particularly investment securities.

Everything is shrinking except the stock price.

The credit performance is great – amongst the best in North America. The local economy (driven by agriculture) is probably better than most. (They are in that great food bowl - the Central Valley of California.)

The bank is really hard to fault.

But it is preposterously expensive. Tangible shareholder equity (equity less goodwill) is 280 million. The market cap – 1.54 billion. Just under six times book. I have seen banks trade at that before – but not for a while. However those were banks priced for growth. This bank is negative growth. [The bank is over six times tangibles if you think deposit premiums are equivalent to goodwill.]

More to the point – the market cap is roughly half the (shrinking) deposits. Never seen that anywhere. Gosh we get excited at funds managers (who don't risk capital) when they trade at 10% of assets. We are at about 50% here. And fund managers with shrinking FUM tend to trade at very small percentages.

Further the earnings quality is not all its cracked up to be. The bank carries approximately 1.5 billion in investment securities – well over 5 times capital. About half these investment securites are pledged to provide floating rate financing – that is the bank is just running a big margin account to get some earnings. This is common in regional banks - and it works – but you would hardly want to pay a high teens multiple for those earnings. Most of the securities in this case are GSE debt, state and local debt, some mortgage backeds and some other "asset backed securities".

Still when banks are losing their shirt everywhere – this bank has come through remarkably unscathed.

Especially the stock price.