I blame the one child policy: explaining the brokers part II

This is going to look very tangential – but I know someone who is a demographer. And just as I think everything in the world comes down to banks (because that is what I understand) he think that everything in the world comes down to demographics.

He has a better chance of being right than me.

And the biggest thing going on demographically in the world is the one-child policy.

Asian style industrialisation and current account deficits

Pretty well every Asian tiger economy has gone into large current account deficit whilst it industrialises. Savings rates may have been 20-25 percent of GDP but the investment rates were higher. The high levels of current account deficits have left those countries vulnerable to current account crises – and they got their crisis in 1997.

China is different. The investment rate is higher in China then elsewhere. Chinese statistics are abnormally patchy – but Chinese investment may have got has high as 40 percent of GDP. (You can see this in the performance of various capital equipment exporters in the West.)

And yet China never managed to get a current account deficit. That is really strange.

We have investment of 40% of GDP and a large current account surplus. This means that the average Chinese person is saving maybe 46 percent of their income. Now once when I had a very high income I saved that much. But we have poor people saving half their income.

I ran this idea past a Chinese friend of mine (now resolutely middle class). He remembers his family saving money furiously whilst he was hungry for lack of food.

Question: what is it that makes them save so much?

Answer: fear.

In most poor jurisdictions there is a simple method of saving for old age. Have six kids. They will have a few each and if you survive there will be lots of grandkids trained to respect their elders who will look after you.

This does not work in China. Indeed if everyone has only one child there will potentially be four grandparents per grandchild. You can’t expect to get supported.

In most developed countries people trust the system to look after them. Mutual funds are well developed, there is often a social security savings net, and a lot of people (perhaps falsely) expect to sell their house and live in clover.

But in China you can’t trust that either. So you save. And save. And save…

Chinese families save because they have a gun at their head. They save an amount that is almost incomprehensible by Western standards.

I point this all out because there is a lot about excessive spending in the west (and the spending has been excessive). But for all this excessive spending there has to be an area with excessive savings. Japan has it. Petrodollars have it – but the big incremental excess savings of the last five years has been China.

And for that I blame the one child policy.

I am going to give Mr Bernanke a plug here. Before the crisis started Ben used to talk about excess savings in the world. He figured the bad lending in the US happened not because people were venal or stupid in the US – but that there was just an endless supply of investable funds because the world had excess savings.

I think he was right. Go look at a Japanese bank now and you still see excess savings. We discovered that we can’t lend them endlessly in America without substantial credit losses. But that doesn’t mean the excess savings aren’t there.

It is a strange reversal to blame bad lending on the people in China who wanted to take no risk with their savings – but it is the reversal that interfluidity made in one of the best blog posts of recent times. It’s a reversal I believe in too.

My thesis - which will be expanded in future posts is that the brokers have become the intermediaries between this endless demand for products to save in (China, Petrodollars etc) and the endless willingness of the profligate in the West to spend. What they do is - through their trading, their securitisation and through other things they turn the complex financial instruments of the West (mostly but not entirely debt) into vanilla instruments that the Chinese and petrodollars want to buy.

How they did that intermediation will be the subject of the next couple of posts – but it begins to explain why they got so big. This is the biggest demographic feature of the world and the brokers made themselves front-and-centre. (They may not have even understood what they were doing - but that is also subject of another post.)

Indeed how they did it altogether and its implications are for later in this series.

John Hempton

Rick's rats on its clients

I gather the kiss-of-death for any brothel owner is to blow confidentiality. You do that once - and nobody much has any incentive to keep you in business.

The kiss of death for a "adult entertainment venue" is much the same. So it is with great interest I read this extract from the 3Q earnings release for Ricks - a listed consolidator of strip joints:

Eric Langan, President and CEO, said: "Both our internal growth and expansion by acquisition programs continue on course and we are looking forward to a strong performance at Rick's Cabaret Minneapolis in our fourth quarter, which should benefit from the Republican National Convention in early September." He noted that the company's cash position increased to approximately $13 million at the end of the quarter due to strong cash flow and a recent capital raise.

Are RICK's executives ratting on the Grand Old Party? Is this sensible?

In the mode of Fox News: "We report - you decide".

I might turn up at the next conference call to ask the poisonous question: how much did turnover in Minneapolis go up around the convention? But only after the obligatory congratulations for a great quarter guys...

John

Rick’s Cabaret – a Gentlemen’s Establishment with a private jet

This blog does not usually comment on small caps – but following Jeff Matthews I couldn’t resist. Ricks Cabaret is a listed consolidator of strip joints. Yeah – you read that right. The business consists of renting crappily constructed barns on the edge of towns (Houston, Vegas etc) and getting gals to jiggle their silicon around. They do own a fine-dining strip joint in NYC.

Despite having compiled an index of the price of hookers in various Eastern European locations I don’t usually hang around these businesses. I had never heard of Rick’s before Jeff’s post.

The stated premise for Rick’s Cabaret is that being a listed company gives Ricks (RICK:NASDAQ) access to capital and hence provides an exit for the thousands of strip club operators throughout the land. This of course ignores the other exits that Jeff Matthews points out (busted for prostitution, non payment of taxes etc).

But let’s take them at their word and look at the accounts as given. Here is the balance sheet:

CURRENT ASSETS:
Cash and cash equivalents	13,191,087
Accounts receivable
Trade	1,339,413
Other, net	722,868
Marketable securities	2,225
Inventories	1,706,544
Prepaid expenses and other current assets	975,067
Total current assets	17,937,204
PROPERTY AND EQUIPMENT:
Buildings, land and leasehold improvements	44,031,599
Furniture and equipment	11,463,950
	55,495,549
Accumulated depreciation	-7,288,117
Total property and equipment, net	48,207,432
OTHER ASSETS:
Goodwill and indefinite lived intangibles	60,272,095
Definite lived intangibles, net	1,322,111
Other	761,753
Total other assets	62,355,959
Total assets	128,500,595
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
Accounts payable – trade	912,190
Accrued liabilities	4,390,849
Current portion of long-term debt	1,561,244
Total current liabilities	6,864,283
Deferred tax liability	16,278,165
Other long-term liabilities	508,579
Long-term debt, less current portion	28,877,816
Long-term debt-related parties	1,260,000
Total liabilities	53,788,843
COMMITMENTS AND CONTINGENCIES
MINORITY INTERESTS	3,359,595
TEMPORARY EQUITY – Common stock, subject to put rights (461,740 and 215,000 shares, respectively)	10,935,020
PERMANENT STOCKHOLDERS' EQUITY:
Preferred stock, $.10 par, 1,000,000 shares authorized; none issued and outstanding	--
Common stock, $.01 par, 15,000,000 shares authorized; 9,272,237 and 6,903,354 shares issued, respectively	92,722
Additional paid-in capital	52,807,479
Accumulated other comprehensive income (loss)	-11,123
Retained earnings	8,821,839
Less 908,530 shares of common stock held in treasury, at cost	-1,293,780
Total permanent stockholders’ equity	60,417,137
Total liabilities and stockholders’ equity	128,500,595

Now I am a dopey sort of guy – more used to bank balance sheets than strip joints. But there are a few things that are odd about this one.

The first is that there is over 60 million in goodwill on the balance sheet. That is 60 million paid to owners in excess of the value of couches and other fittings. That is a lot of goodwill for strip joints and leads you to the conclusion that if you want to be a multi-millionaire forget hedge funds – start a strip joint and sell it to RICK.

Indeed despite selling considerable common stock in unregistered sales to institutional investors the company manages to have almost no net tangible net worth. [The cash flow statement shows 27 million raised from sale of equity in the quarter – but I can find only one SEC 8K for about half that amount.]

The second thing that jumped out at me was the large deferred tax liability. The deferred tax liability of 16.2 million.

My first reaction was whoa – a deferred tax liability happens usually because profit for GAAP purposes is substantially higher than profit for tax purposes. This could be accelerated depreciation or some other tax incentive (though why the IRS/congress might give tax incentives for strip joints is beyond me) or it might just be that the company is declaring income for accounting purposes but not for tax purposes. There is of course a problem with faking your income up – which is that you tend to have to pay tax on the phoney income – unless you tell something different to the IRS.

In the quarter the prima facie tax was over a million but the payments were just over half a million. There is no large current tax liability to note – so there is prima-facie suggestion of overstating GAAP vis taxable income. Indeed the cash flow statement benefits from 632 thousand being added to the deferred taxes during the quarter… This does not surprise me – but it is not the main reason that that there is a large deferred tax liability. This company peculiarly tax effects the goodwill purchased – a treatment I have not seen elsewhere – but then I am used to looking at financials. [Anyone known why you would do this?] To quote:

Included in the Company’s deferred tax liabilities at June 30, 2008 is approximately $14,400,000 representing the tax effect of indefinite lived intangible assets from club acquisitions which are not deductible for tax purposes. These deferred tax liabilities will remain in the Company’s balance sheet until the related clubs are sold or impaired.

This led me to think that the company might be doing something very strange like buying the clubs and not the corporate structures that the clubs reside in. That indeed would be sensible because it would absolve the acquirer from unpaid taxes and penalties (criminal and otherwise) that might live with the old owners. That might give a peculiar GAAP treatment of goodwill. And indeed they are – as this 8K shows . If there is any accounting expert here – can you explain this.

But this still gives us a residual of 1.8 million of deferred tax liability that comes from another purpose. This implies GAAP income of about 5 million more than cumulative taxable income over the history of the firm. I will make the point that this is roughly the half cumulative profit of RICKS. When in doubt (and where I can’t see a good explanation for deferred tax liabilities) I tend to prefer the income people report to the IRS than their stated income. (Maybe that is something I just learnt in the mortgage market!)

Now the premise for listing this thing is – I presume – access to capital. But you got to wonder the extent to which a bank or for that matter typical financial market type might lend money to a strip joint whose tax accounts don’t match their GAAP accounts. Well for the most part they don’t lend that way. Indeed almost every strip club they consolidate they do with high interest vendor finance. This is typical:

On November 30, 2007, in connection with the acquisition of Miami Gardens Square One, Inc., (see Note 9), the Company entered into two secured promissory notes in the amount of $5,000,000 each to the sellers (the "Notes"). The Notes bear interest at the rate of 14% per annum with the principal payable in one lump sum payment on November 30, 2010. Interest on the Notes is payable monthly, in arrears, with the first payment due thirty (30) days after the closing of the transaction, which occurred on November 30, 2007. The Company cannot pre-pay the Notes during the first twelve (12) months; thereafter, the Company may prepay the Notes, in whole or in part, provided that (i) any prepayment by the Company from December 1, 2008 through November 30, 2009, shall be paid at a rate of 110% of the original principal amount and (ii) any prepayment by the Company after November 30, 2009, may be prepaid without penalty at a rate of 100% of the original principal amount.

Most the long term debt is pretty short term – 30 November 2010 won’t get them to a time when bank lending standards drop enough. So they better have the cash when they get there. And that is not the only "long term debt" on the books.

Indeed access to capital looks questionable when the CEO has to personally guarantee corporate debt:

In connection with the acquisition of the real estate in Dallas related to the acquisition of Hotel Development Ltd., on April 11, 2008 (Note 9), the Company issued a $3,640,000 five-year promissory note (the "Promissory Note"). The Promissory Note bears interest at a varying rate at the greater of (i) two percent (2%) above the Prime Rate or (ii) seven and one-half percent (7.5%), and is guaranteed by the Company and Eric Langan, the Company’s Chief Executive Officer, individually.

Come to think of it – this company also purchased its private jet on hock:

In February 2008, the Company borrowed $1,561,500 from a lender. The funds were used to purchase an aircraft. The debt bears interest at 6.15% with monthly principal and interest payments of $11,323 beginning March 12, 2008. The note matures on February 12, 2028.

Hey – the interest rate on a private jet (presumably secured by the jet) is almost 8 percentage points better than the interest rate on a strip joint secured by the strip joint. Impressive.

Summary

So what have we got?

• A company in a seedy business usually infiltrated with the sort of people who you would not want to have marry your daughter.
• A company whose tax returns do not match their GAAP accounts
• A company with no obvious access to capital and with a lot of debts that mature quite shortly and pay high interest rates,
• A company who has no reason to be listed but manages to buy a private jet

People own this stock? Search me as to why…

That this is listed and retains a market cap over $100 million tells me that this market has a long way to fall. I shorted a token number last night.

A positive: the company has a code of ethics

I can’t be all negative.

Rick’s must be the only strip joint with a public stated code of ethics. You can find it here. However at Rick’s ethics tend only to apply to financial matters. The code is also only applicable to the following persons:

1. The Company's principal executive officers; 2. The Company's principal financial officers; 3. The Company's principal accounting officer or controller; and 4. Persons performing similar functions.

I will leave it to your imagination what other unethical behaviours might happen at a strip joint and who might perform them.

I wonder if you can think of any ethical violations that might involve the private jet.

I thought you could.

John

Explaining the brokers Part I

Don’t read this series if you expect clear tradeable answers. I don’t have them (yet?) and really this is just the beginning of another intellectual journey. It may be a dead-end.

For someone that might open a fund I am about to do something profoundly stupid. I am going to have a peek at the broker balance sheets in public without being entirely sure what I will find. This series might go nowhere – or it might wind up being very interesting. I am trying to get readers to help me pick apart the brokers.

I have to say that I got a lot of email on Fannie Mae when I did the series there – almost all expressing religious belief on whether Fannie is OK or not. Not much counted as analysis and less contained methods which are testable..

I hope my readers are better this time – but I am not counting on it.

Before I start my instinct on Wall Street Brokers is hyper-bearish. It is not that I think they have solvency problems (on that I have no opinion). It is just that I think that their stated business and their actual business differ substantially. When companies can’t explain clearly what they are doing then I get bearish – and nobody seems to explain brokers clearly.

With Fannie at least I could explain how the business was meant to work. With Goldman Sachs I don’t even start with that.

Part I is just going to leave everyone with a puzzle. Why are the broker balance sheets so big – and what business inflated their size to such grotesque levels? I think this is the key issue wit the brokers – but for the moment I will just give you some numbers.

The FED flow of funds data gives type of debt outstanding in the US at any time. At the last release (Q1 2008) there was 30.8 trillion of non-financial sector debt outstanding. [You don’t want to count financial sector debt because you are double counting though I have known a few reputable people who have done just that.]

Of this “only” 14.0 trillion was to households and “only” 10.6 trillion was mortgages. The mortgage growth rate had slowed to 3 percent. The fastest growing category was the Federal Government (up at over a 9% annual rate). That hardly bodes well for the US. 5.2 trillion of Federal Government debt outstanding. Private sector debt was 24 trillion. I want you to keep that number in head for the reason I am about to bold

• 24 trillion – total private sector debt – is the maximum about of debt that it possibly makes sense in any way for financial institutions to intermediate. Brokers can’t make money intermediating government debt.

The second set of statistics is about the sheer size of broker balance sheets:

• The Goldman Sachs balance sheet is 1.09 trillion in size at the last quarter (admittedly a slightly different date to the Fed Flow of Funds data).
• Lehman is 0.639 trillion – and that was after some questionable moving of items off balance sheet.
• Merrill Lynch is 1.04 trillion at the closest quarter
• Morgan Stanley is 1.03 trillion.

On top of this there is probably almost a trillion of investment banking assets at Citigroup, over a trillion at JPM (including Bear Stearns) and another trillion at Barclays Global Capital.

Somewhere investment banks got on their balance sheet maybe 7 trillion in assets which is very large compared to the total assets that could theoretically be intermediated in the US.

Goldman Sachs has a balance sheet the same size as a smaller Japanese megabank.

One thing is for sure – you don’t hold all these assets because you are facilitating trades on behalf of your customers. I have seriously been told my investor relations at investment banks that the reason they hold so many assets is to facilitate client transactions.

I might be young and naïve – but I am not sure I was ever that naïve…

The investment banks are full of people considerably smarter than me. But the shareholder letters are not very explanatory. (These companies fail Warren Buffett’s test of clear shareholder letters.)

They don’t do what they say they do. So what are they? We all deal with them so we think we have some idea – but the places that I deal with don’t produce balance sheets that look anything like Wall Street. I have some answers – but I know before I start that they are not complete answers – moreover my answers are hard to test.

Some exploration (but probably few answers) coming in Parts II, III etc…

If people have suggestions I will include those (with some analysis) in later parts. Email me please.

John

Weekend edition: the somewhat cooler Hempton

My cousin got the movie star looks and the saxophone. I got the penchant for reading accounts of banks. I think he got the better deal!

I suppose he got the girls too! And he got the MySpace page with the cool jazz soundtrack.

For my NYC readers - he is back in NY -

22 Sep 2008, 07:30 PM
183 W10th st @7th Ave, New York, New York
Cost : $20 incl. a drink!

Foreigners selling Fannie and Freddie debt

I wrote here about what seemed to be the irrationally wide spread on Fannie and Freddie debt. We are after the Paulson plan. The US Government has promised it stands behind these entities. But the spreads still widen.

Widening spreads will cause the end - because Fannie and Freddie need to borrow humungous piles of money.

Now Naked Capitalism has a nice post on foreigners selling Fannie and Freddie debt. That seems irrational to me - but it is still happening - and that is not good news for the GSEs.

J

Estonians trash their flash cars: can't make the lease payments

The most read post ever on this blog was "Hookers that cost too much, flash German cars and insolvent banks".

In it I predicted a future for the Baltic States where the middle class rioted and Swedbank (the Swedish bank most responsible for funding the bubble) was trashed either by depreciation caused default or just by default.

Anyway I love this story. An insurance company in Estonia is having troubles with customers trashing their flash cars because they can't make the lease payments.

It gets worse and worse and worse from here.



J

PS. I mentioned the geopolitics in the first post on this subject... I said I was "loudly calling the likely collapse of a politically sensitive country". Well now the Estonian press is actively speculating about a Russian takeover. I think it is unlikely - but do not forget the Bronze Soldier.

For those with a real interest I know enough history to be dangerous. My version comes from the perspective of some Jewish relatives who were holocaust survivors. My relatives saw the Baltic States as containing particularly enthusiastic Nazis. (They tend to site Lithuania over the others but I think that was bitter experience. Lithuania had a gruesomely effective holocaust). Whether the Balts were more enthusiastic Nazis than some other Europeans is something I have no real knowledge of. Indeed the initial Russian-Nazi treaties gave Lithuania to the Germans but the Lithuanians refused to participate in the invasion of Poland and passed to Rusian influence until the Nazis reinvaded...

The Russians still look on the march into the Baltic States as a liberation from Nazism. They revere their Bronze Soldier. Many Baltic people see the same Bronze Soldier as a symbol of Russian oppression.

When the Estonians moved the statute there were deadly riots. These wounds are still open.

My Jewish relatives however wound up living in an apartment building in Bondi Australia one floor above some post-war Lithuanian immigrants. They became firm friends . And both could see the other's point of view...

Article in Portfolio magazine on British banking

I haven't written much on UK banking - an article about Barclays, one on Alliance and Leicester and one on Northern Rock.

But I got quoted in this neat and accurate story in Portfolio magazine.

All I noted was that the UK had taken Maggie's philosophy to heart and decided that if financial institutions didn't have much capital the market wouldn't deal with them. The result is that UK institutions got to run with much less capital than their American counterparts and that left them vulnerable.

That is clearly true. But the journo found a better story about why wholesale financing arrangements shouldn't be regulated... that lovely cliche about "consenting adults".

Hey you know what happens to "consenting adults"...

I thought you did...

Things that make you go hmmm...

Fannie Mae conducted one of its regular "benchmark note" auctions today. Here is the relatively non-descript Reuters report.

The spread over Treasuries was 122bps.

In the old days when Fannie debt was explicitly not backed by Treasury it was about 60bps or less.

The US Government has made it clear that it backs Fannie - so this extra-wide spread is surprising...

Unless people no longer trust the US Government.




John

PS. The investment implications are not good. The only plausible buy case for Fannie at the moment is that its not much to pay for a franchise with a US Government guarantee. If nobody trusts the guarantee there is no franchise...

The crudest of models for Fannie Mae cumulative losses – (Fannie Mae Part III)

As explained in the “modelling post” there is very good reason why you cannot sensibly estimate prime mortgage losses. They are getting worse at an increasing rate.

I didn’t want to make it up. So I asked my readers for guidance. Nobody much helped me – but several people pointed to Jamie Dimon’s various statements on the subject. Those statements come down to Dimon’s broad guess that losses will triple.

We know the trends look awful.

But I have a model. Its crude – but in the face of radical uncertainty it is about the best I can do. So I will present it.

Below is a chart of the type that most thrill me as a bank analyst. It’s a cumulative loss chart as presented in Fannie’s last quarterly results.

What this chart shows is the cumulative loss on loans versus the time the loan was originated. It’s a sort-of-generalisation of the securitisation cum-loss charts with which I am so familiar.

This chart contains several trends that are representative of the whole mortgage industry. The 2007 pools are radically worse than the 2006 pools which are in turn radically worse than the 2005 pool. The 2004 pool is OK but turning a little sour at the edge…

I have a pet theory as to why the 2007 pools are so much worse than 2006. Its not that the lending was any more stupid in 2007 or that property prices had gone one step too far. It was that there were many bad loans made in all years after 2002 however the bad loans didn’t default – they were refinanced. They all thus wound up in the later pools and hence the later pools preferentially contained the bad loans. They are thus awful.

Anyway Fannie Mae doesn’t give us this data in tabular form – but here is my simple model.

Data:

• The 2006 pool is currently behaving about 3 times worse than the 2000 pool.
• The 2007 pool is currently behaving about 6 times worse than the 2000 pool
• The rate of deterioration of prime delinquency is increasing
• Fannie Mae took credit risk on 615 billion of mortgages in 2006 and 746 billion of mortgages in 2007. We do not know how many of those mortgages are still outstanding – but total mortgages outstanding are a bit over 3 trillion.
• The baseline 2005 pool wound up with cumulative loss of 1.25% plus a trivial amount in the out-years.

Assumptions

• That the outstanding mortgages from 2006 are 450 billion reflecting some repayment to date. (This is a good educated guess – if Fannie publishes the data somewhere I have no memory of it…)
• That the outstanding mortgages from 2007 are 650 billion reflecting some repayment to date (another educated guess…)
• That the relative performance of the 2006 and 2007 pool vis the 2000 pool remains the same – which means if it starts 3 times worse it ends 3 times worse.

Calculations

• The 450 billion outstanding from 2006 will wind up a further 2 times 1.25% worse than the baseline 2000 year. That is 3 percent of 450 billion – say 15 billion.
• The 650 billion outstanding from the 2007 year will wind up a further 5*1.25 worse than the baseline 2000 year. That is 7.5% of 650 billion – or 49 billion.
• That totals 64 billion.

Some notes on the model

There will be a few losses from 2005 and other years – but they are small.

The numbers could be MUCH worse than this – because as I have noted the rate of deterioration is accelerating – which tends to indicate much worse.

They could also be worse than this if the mortgage insurers who are the frontline protection on the high LTV loans fail. [Mortgage insurance is already built into the base line losses.]

There are also a few things that Fannie is currently doing in loan modifications that look like loss deferral and that could further mean my numbers are conservative.

Against this, losses could be better than these calculations because there could be a pig-through-the-python effect in the conventional mortgage market just as I believe there has been in subprime. [Indeed there is some evidence that the 2007 pool is so bad precisely because a lot of bad loans did one last refinance into Fannie Mae. That is proof that Fannie’s management is incompetent. But it would cause a pig-in-python effect and mean my loss estimate for the 2007 pool is overstated.]

But – in the absence of a better model based on better data (something I think the world cannot provide us at the moment) I suspect that there is about 64 billion in excess losses coming through at Fannie Mae.

That is enough to render Fannie Mae insolvent. Indeed it is nearly enough to render Fannie Mae as “profoundly insolvent”. Not quite – but close.

I am not buying the stock here. If given a guess I would be on the short side – but I can find plenty more to short that I think is easier and more likely to be right than this.

Personal conclusion

My a-priori expectation was that Fannie was going to be better than that. If you had put a gun at my head and asked me would I prefer be long or short I would have said long.

Now I would say short.

I have no position and it is likely to stay that way. But for once I do not think the shorts are grotesquely overstating their case.

To my readers

Thank you for coming on this intellectual ride. Its caused me some grief as I have promised you a model which I could barely deliver. And it scares me to pretend I know more about the future than I do about the past and present.

But I have learnt something – and I hope you have too.

To the several people out there (including friends) who just knew in their gut what the answer would be - all I can say is your gut is more knowing than mine...

John