Bronte Capital

Kodak, Bill Gates and efficient markets

2009-12-30T11:58:00.001+11:00

I am just back from my summer holidays on the New South Wales South Coast. To my (mostly) Northern Hemisphere readers I should boast about warm water, perfect waves, beaches in national parks with only one or two pairs of footprints on them and no people, fish that seem to suicide on your lines, etc – but that would just be boring.

In the middle of every day – when the heat became too much and the surf had waterlogged me I read. On my kindle of course. And some books which I had never read I read happily made easy mostly by the kindle’s large font options. One of those books was Alice Schroder’s too long but otherwise excellent biography of Warren Buffett. There was plenty there – I just want to share a single throw-away observation.

Warren Buffett has a group of his best investing friends get together once a year. He originally called it the Graham group in honour of his mentor Ben Graham who presented at the first annual meeting in 1968. By 1991 the group had expanded somewhat to include not only the original fabulous stock pickers but some business luminaries who could help enlighten the group on the nitty-gritty of their industries. One regular attendee was Bill Gates of Microsoft fame. From here I will quote Alice Schroder:

After a while Buffett asked everyone to pick their favourite stock.

What about Kodak? asked Bill Ruane. He looked back at Gates to see what he would say.

“Kodak is toast,” said Gates.

Nobody else in the Buffett Group knew that the internet and digital technology would make film cameras toast. In 1991, even Kodak didn’t know it was toast.

Gates was right of course – and since 1991 Kodak has been a terrible stock – and I would have counted Bill Gate’s comments as “knowledge” in as much as a statement about markets and technology could be knowledge. But it would be an awful long time before that “knowledge” would be reflected in stock prices. Here is a graph of the stock price since 1 Jan 1990.

If you had taken Gates to heart in 1991 and shorted the stock then for almost ten years you looked like toast. If you sold the stock because of something Bill Gates said then you looked silly for six or more years unless you purchased something better.

Indeed if you had the “knowledge” probably the best thing to do with it was to use it just to avoid the photography sector altogether. That would mean you might outperform the market – but that outperformance was slight. [If avoiding that sort of catastrophe was your mechanism of making money you probably needed an enormous amount of “knowledge”.]

Anyway there is little question that if you understood the implications of digital photography in 1991 you were – at least on that item – the smartest guy in almost any room. And it did not help you make (much) money.

The market could stay wrong for a very long time. Maybe as long as some blinkered academics could continue to believe in strong versions of the efficient market hypothesis.

John

When regulators can’t do math: gas pipeline edition

2009-12-10T10:51:00.001+11:00

The Federal Regulatory Energy Commission (the FERC) is charged – amongst other things – with regulating the rate of return on interstate natural gas pipelines. Rates on these pipelines are by-and-large regulated so as to achieve a targeted return on equity.

Quite of its own volition the FERC has called for a judicial review of on three Midwestern gas pipelines including Natural Gas Pipelines of America (NGPL). In its last rate case (1996), NGPL’s target rate of return was set at 12 percent.

This is a peculiar review because – unlike past reviews – the review was called by the Commission itself and without a complaint from any of the customers using the gas pipeline. [Customers for gas pipelines tend to be large oil and gas companies or large utilities and are usually not shy about calling for a review when rates are out-of-line.]

The FERC has argued – from publicly available documents – that the returns on the NGPL are (just) over 24 percent – and hence (and these are their words) are “unjust and unreasonable”. They use lots of emotive language and have petitioned a judicial review to get the rates cut. You can find the full document here. A good press summary is here.

To put it bluntly the FERC stuffed up. It simply got the math wrong because it does not understand rates of return and depreciation – a staggering oversight for a body charged with regulating pipelines. Worse – on the math presented – the rates on the NGPL should be increased in order to allow for the FERC mandated 12 percent return.

This is a pretty nasty allegation – so I need to explain the basic mathematics of regulated returns. I will start with the simplest of models that I can.

The simplest pipeline model

Imagine a pipeline that cost $100 to build. It lasts 2 years. The regulators have to allow the pipeline to recover an amount (say $x per year) so that the present value of $x per year adds up to $100.

Now $x has to be more than $50. Why? Because over 2 years the pipeline has to recover at least the $100 that it cost to construct. Depreciation alone is $50 per year – and having the pipeline recover only $50 per year would mean it made no profit.

We could (naively) presume that because $100 is employed the pipeline needs to make $12 per year profit in order to get 12 percent return. So we would set $x at $62. That unfortunately gives us a little too much return – because – in the second year the pipeline only has $50 of capital employed (they have recovered $50 through depreciation). You can do the math here (and you assume for simplification that the cash is all received at year end) then the $62 received after year one would be worth $55.36 discounted at 12 percent and the $62 received in year 2 would be worth $49.43. Add those up and you get more than $100.

I used the “goal seek” function on Excel to work out the required annual return on the pipeline under the simplifying assumption that the annual payment is received in two equal increments. I have linked the original spreadsheet (to convince you that I have done this correctly).

In this case note that the required cash flow each period is $59.17c. You can discount this if you want by 1/1.12 in the first year (getting $52.80) and by that squared in the second year ($47.17) and lo – these numbers add up to $100.

Now here is the clinch – which is that we know – by initial assumption here – that the return on equity for this project over its life is exactly twelve percent.

But what is the return on average equity in the second year?

Return on average equity in the second year!

The cash return in the second year is $59.17 cents. [It needs to be that every year to provide a 12 percent return on equity over the life of the project.] The pipeline depreciates by $50 per year over its two year life. So the measured profit during the second year is $9.17 (the return less depreciation).

Capital employed commenced the second year at $50 (being the cost less the $50 of accumulated depreciation). It ended the second year at $0 – as the whole pipeline had been written off by then. The average capital employed for the second year is thus $25. Given the stated profit is $9.17 the return on average equity for the second year – as recorded – will be 36.7 percent.

This return will be observed even though the return on the project over its life is only 12 percent.

There is nothing sinister about an observed 36.7 percent – and more generally there is nothing “unjust and unreasonable” in the observed returns of 24 percent of the Natural Gas Pipeline of America. These returns are simply a mathematical artefact of the allowed return on equity of 12 percent over the life of the pipeline. The observed ROE of 24 percent does not warrant a rate case – it is as to be expected. Indeed as the pipeline in question is more than half depreciated I would have been surprised if the observed ROE was below 24 percent – and the 24 percent ROE does not represent a problem or a failure of regulation.

What we have here is a regulator who has failed to understand the basic math of the business which they are meant to be mathematically regulating.

The deskilling of American regulators

I am no longer surprised at the general deskilling of American regulators. This post demonstrates that the regulator – whose job it is to regulate the rate of return on gas pipelines – has no idea at all of the basic high school mathematical implications of that regulation. I am used to SEC officials who can’t read a balance sheet or can’t see the Madoff fraud when it is laid out in front of them. But the rot spreads more widely. We have bank regulators who were blind or stupid and now we have utility regulators who can’t do basic math.

A more generalised formula for what should be the observed returns on a pipeline

Warning – seriously wonky – here I do the math to show what the observed ROE should be. You don’t need to read this – just accept the regulator has their math shockingly wrong. But here is a way of working out precisely how wrong!

Being a nerd I thought I would help the regulator out with their math – and indeed it is not too hard to derive a generalised formula for the right observed return on a pipeline. But hey – why bother when Wikipedia does it for you? Wikipedia gives the present value of a stream of n paymnets of value A as follows:

PV(A) is the present value of the stream of payments – which in this case should be the construction cost of the pipeline.

i is the rate of return – which in the case of FERC should be the regulated rate of return (12 percent), and

A is the annual cash return on the project, and

n is the number of years over which the project receives its return (which should be the depreciable life of the pipeline – or in the above example 12 percent).

Now I would never use a formula out of Wikipedia without checking it (which I did by derivation) but for my readers I thought I should just plug in the above example – where the cost of the pipeline is $100, the annual payment is $59.17, i is the usual 12 percent and n is two years. Plug the following into your calculator – it checks out just fine:

Now we can rearrange this standard formula to determine A:

Now we can also work out what the year-end capital employed (E) in year j of n is. That is trivial – it is

Income in any year (Y) is equal to the annual payment less than depreciation. In the formula below I just assume that the original cost of the pipeline depreciates in a straight line over n years.

Now the FERC is really obsessed by the observed return on equity on the pipeline (in this case about 24 percent). But lets work out what the observed return on equity should equal:

You can rearrange and simplify this equation any way you like – I can’t really be bothered – I am lazy. But hey we now have enough to work out what the observed rate of return should be. Assume that the initial cost of the pipeline is 1 (it would cancel from top and bottom of the above formula). The depreciation in the FERC document for the pipeline is 50 years – so n is 50. The pipeline originally cost $3.728 billion but has accumulated depreciation of $2.273 billion – so we are in 35 of 50 – so in the above formula j is 35. We are going to allow the regulated rate of return – which is 12% – so i is 0.12. Plug this in and we get the following:

Just to check that I am not wrong I have done the same in a spreadsheet – which I have linked here. But the lesson is that the observed rate of return should be 33.47 percent even though the project actually only returns 12 percent over the life of the project.

An observed rate of return on 24 percent – the rate that FERC is complaining about – is too low.

FERC is right of course – the tariffs on these gas pipelines are “unjust and unreasonable” – they unjust and unreasonably low. On FERC’s own numbers they are not adequate to provide the lifetime 12 percent return on equity that FERC mandates.

What are the options here?

I guess the easiest options for the owners of the pipelines are to allow the FERC numbers as to depreciation and capital employed to go to the judge uncontested. They do not seem out-of-kilt with reality. They then should present the math straight (and there are plenty of mathematicians who will do a better job than me) and they should ask for a rate increase!

I do not think the judge will have any problem giving it to them. But it is not the public policy objective here – and we wound up in this spot because of the mathematical incompetence of the FERC. It is time to stop the rot at the FERC.

Stopping the rot at FERC

And it should stop relatively quickly. Barrack Obama appears to have appointed a competent man to be the head of the FERC. Whilst Jon Wellinghoff may have spent most of his career as an attorney he has – according to his CV – an undergraduate degree in mathematics (University of Nevada 1971). He should be more than capable of checking the math in this post.

I have contacted his office and given him a copy of this post. Jon Wellinghoff endorsed and press released the review of the rates for the various gas pipelines. He is however more than capable of withdrawing his request for a review. Indeed I think he has to before the FERC is made a laughing stock as the SEC was after Madoff.

I will happily announce when he has reacted appropriately.

John

PS. The pipelines who would have had their returns slashed under this review include Northern Natural – which is owned by Warren Buffett’s Berkshire Hathaway. I have not received or asked for a consulting fee but Berkshire holders (many of whom are my readers) should be sending their thanks...

PPS. I am serious about the deskilling of US regulators. I have spent only a few hours thinking about the mathematics and accounting of rate of return regulation in my life – and I spotted and roughly quantified this error within five minutes. Regulators who do this all day every day should simply not make mistakes like this.

Gratuitous advertising time: The Nick Hempton band is playing in New York

2009-12-05T11:53:00.002+11:00

The distinctly cooler Mr Hempton (my cousin Nick) is doing a gig (with his band) at Smalls Jazz Club Saturday night. Its 183 West 10th street – and it starts at 7.30.

He may not know much about the capital needs of regional banks – but – as one good newspaper review once said – he looks like a movie star and plays like Charlie Parker.

Getting it wrong about getting it wrong about coffee

2009-12-03T17:43:00.001+11:00

One of the joys of the blog is that I have several readers who are WAY smarter than me. One pointed out that I did NOT get it wrong in my Peet’s short. [To get the background you simply must read this post first.]

I thought that Peet’s was overpaying for a license to put their coffee in k-cups. I was wrong.

But my smart reader thought that either

(a). the license to put coffee in k-cups was written as expected (favourable to Green Mountain but unfavourable to Diedrich) – in which case Peet’s was overpaying for Diedrich or

(b). the license was favourable to Diedrich – in which case you could bet that Green Mountain – a much richer company than Peet’s – would simply and massively overbid Peet’s to own Diedrich.

If Peet’s was overpaying for Diedrich then I was going to win on my short.

If Peet’s was not overpaying for Diedrich then they would wind up in a bidding war with Green Mountain – in which case I could cover at a profit anyway.

Now tell me why I did not short Peet’s big time when they bid for Diedrich? Stupidity I guess.

John

Getting it wrong over coffee

2009-11-28T23:29:00.001+11:00

Money management can be one of the most interesting careers in the world. At best it gives you lots of unstructured time to think about how the world really operates – and to make bets based on your hypotheses. You get to conduct uncontrolled but real time experiments in the social sciences.

But never forget this is social science – not physics – and a little dogmatism about your rules or positions can result in getting it spectacularly wrong.

This was one of the more interesting places I have got it wrong lately – and so I thought I would write it up. It was also a surprising case of getting it wrong – because despite the analysis being totally stuffed I managed to scrape a (small) profit out of the trade.

The case involved three coffee companies (Diedrich, Green Mountain and Peet’s Coffee). I will explain what these companies do later – and how they are involved – but first I want to digress a little on the oddity of American coffee chains.

Starbucks failure in Australia

As an Australian the success of Starbucks (or Peet’s in San Francisco) puzzles me. Australia is blessed with a plethora of interesting and sometimes quirky, often very stylish cafes. For those who are interested here is a photo of my local (Bronte) strip of coffee shops. They are better than any strip I know of in New York, SFO or Chicago. The coffee is better too – and that is widely commented on by visitors to our shores.

It’s not that Australia is even a particularly coffee addicted country. Per capital consumption is not huge by developed country standards and is lower than the United States. We just have a better coffee scene.

It puzzles me why. There are awful lot of things that the United States does (substantially) better than Australia so this is an oddity deserving some explanation.

American coffee chains (particularly Starbucks but also some of the donut variety) have tried to break in and mostly failed. Starbucks closed most of its stores last year after multi-million dollar losses. They couldn’t cope with the Australian competition. Which is odd because in most things the US is a far more competitive market than Australia – and US senior management tend to be more battle hardened than their Australian peers (see my piece on the use of American CEOs in the Australian context). Its just the competition in cafes is far more fierce here.

I would love to be corrected – but I think the reason has to do with our wage structure. American low-end wages are very low indeed whereas Australia has minimum wages at quite high levels. Hiring unskilled labour to run a coffee shop according to a formula (and devoid of in-store entrepreneurial talent) works in America but does not work in Australia. Also entrepreneurial talent in America has too many opportunities to waste itself in a coffee shop – whereas small-time competent entrepreneurs will open a small coffee shop in Australia. [Maybe one of the good things about America is that it uses entrepreneurial talent well.]

Anyway this leads me to believe that some businesses that look bullet proof (running simple chains of shops which sell an addictive and brand loyal product) might actually be more vulnerable to quite strange social and economic trends than you would think. Coffee shops look impregnable (and Peet’s typically trades with a 30 times price earnings ratio) but coffee shops can be beaten back by small entrepreneurial talent for reasons that are hard to articulate.

The Green Mountain Keurig Cup

Another thing that coffee shops are vulnerable to is easy-to-make-at-home quality coffee. Nescafe and other instant brands distribute a large amount of caffeine – as for that matter does the Coca-Cola company. But against a well made espresso (diluted with frothy milk to taste) it just can’t cut it. Our funds management business requires its morning coffee (which we buy from an excellent and entrepreneurial local cafe). That said – American coffee is just not that special – and perhaps is more vulnerable than you think.

One thing it is vulnerable to is the Keurig Cup (or K-cup). K-cups are a plastic and coffee device you put in a special espresso machine and it makes you – instantly and with minimum mess and fuss – a very good espresso with very few traps for the unwary. Its certainly a better drink than instant – and matches in quality a better cafe (though there are some tricks with milk frothing that the k-cup does not match).

K-cups are a truly amazing business. Once you have sold the machine you get to sell the cups (an addictive product no less) ad-infinitum with astonishingly fat margins. And you don’t need to rent expensive real estate to do it. This is like cigarettes – but with a growing market and without the litigation (and without actually killing your customers).

The first time I saw a k-cup was when a pretty young woman in a department store offered me a free coffee (brewed in a k-cup). I noticed the razor-and-blades business model and determined that I did not want to be a sucker to that machine. Alas – and to my endless shame as a stock picker – I did not even consider buying shares in the company which owned the k-cup business. After all as a stock-picker you would really want to be on the receiving end of a razor-and-blade business selling a new addictive product.

That company is Green Mountain Coffee Roasters – and – since I first saw the machine the stock is up over five thousand percent. A five thousand percent gain would – of course – somewhat have improved my finances and the finances of my clients...

The attraction of the k-cup business is not unnoticed by the market – Green Mountain trades at a PE ratio around fifty. Still that is less than one times earnings on the price it was when I first saw a k-cup.

The k-cup license holders and Diedrich Coffee

Four companies have licenses to produce and sell k-cups. Only one of those companies (Diedrich) is listed. A license to sell k-cups is a license to share to some extent in Green Mountain’s very rapid growth however the terms with which you share are unknown. As a default position I would expect that Green Mountain – the technology holder – would extract its pound-of-flesh for granting such a license and whilst a license holder might grow very fast you would not expect it to be outrageously profitable. However – as I said the terms of the license are unknown and have never been published. If Green Mountain – in the infancy of the k-cup business – gave out the licenses on stupid terms then owning one of the four licenses to produce k-cups would be getting most of the benefit of being Green Mountain – but without even the expense of subsidizing the espresso machines or of hiring the pretty-young-woman sales people to sell new espresso machines.

It seemed however unlikely to me that Green Mountain – who have a truly fantastic product – would ever have signed a contract with Diedrich – or anyone else for that matter – which was truly unfavourable. After all Green Mountain held the aces.

Moreover Diedrich has truly strange accounts. It was an unsuccessful owner of a coffee shop chain (Gloria Jeans) which they sold off and the balance sheet has about 50 million in accumulated losses. Sales were flying – but half those sales were back to Green Mountain (for whom they out manufactured product). Moreover the accounts were truly strange in other ways (it was for instance very difficult to get a handle on tax expense). There was a truly frightening article that appeared on Seeking Alpha which went through the accounts in great detail – and – if you took all the suggestions in that article at face value – then you would probably conclude that Diedrich was a fraud. (The Seeking Alpha article has since been removed.)

None of that stoped Diedrich being a truly explosive stock – indeed before I had even looked at the stock (and in about six months) it has gone from 21c to just over $30. You don’t need too many of them in your lifetime…

Now this move looked truly bizarre given (a) the fact that it did not even own the k-cup technology and (b) the bizarre accounting as outlined in the Seeking Alpha article.

I thought (possibly incorrectly) that Diedrich was probably a stock-promote rather than a business as per the suggestion in the Seeking Alpha article – but I did not bother to do any of the work to prove or disprove that case. That work came later.

The Seeking Alpha article was anonymous and hard to verify (as discussed below).

The danger of shorting frauds

The reason I did not do any of the work to confirm or deny the Seeking Alpha article was that shorting frauds (especially well publicised frauds) is possibly the most dangerous thing you can do on Wall Street. Take for example a fraudulent oil company in Africa – but one that really has some oil. The company has oil – so it can show flows to visiting analysts. It has pictures and local politicians are excited to hob-nob with the management. But there is no real way of telling whether they have 1 million barrels or 10 million barrels. They may have 3 million barrels (which would be valuable – but not earth shattering) but tell the market they have 20 million barrels. There really are very few ways to tell – and if they are determined they can exaggerate at will. Moreover suppose you have worked it out (or at least have suspicions) – it doesn’t help you. If someone is going to fake the existence of 17 million barrels of oil there is not much that stops them from faking the existence of 170 million barrels of oil. If you are short and they “announced” a 100 million barrels (or a few trillion cubic feet of gas) and the market believes them then you are stuffed. The stock could go for a monstrous run – and you will be forced to cover at a shocking loss.

The problem with shorting frauds is that there is nothing to keep the fraud grounded – and hence there is nothing to limit your losses. If you short a real company (say Dell) and Dell sells less computers than it anticipated it will tell the market. The stock will probably go down. If it sells more computers than anticipated at better margins the stock will go up. But it is vanishingly unlikely to sell ten times as many computers as anticipated. You can be short and whilst you might lose money if you are wrong you will not do serious damage. Frauds – because there is nothing to keep the claims grounded – can cost you an enormous amount as a short.

There was a possibility that Diedrich was a fraud – but it was a high-growth with a substantial short interest. There was simply no way that I was going to short it because the potential losses looked vast. Given that I did not bother to fact-check the Seeking Alpha article.

The rare safe time to short a fraud

There is only one time that it is relatively safe to short a fraud – and that is when a real company is suckered into buying it. That happens – and the cannon-example was when Mattel purchased The Learning Company.

The Learning Company (TLC) was (and remains) a children’s educational game software maker. It has real games and real sales. In that sense it was similar to my African oil company with a few million barrels. It however had accounts which were peculiar – and several short sellers were convinced it was mostly fraudulent. [I had never heard of the company so I cannot vouch for their views.]

Eventually Mattel purchased TLC. The purchase was made from weakness. Mattel used to have a great franchise in toys for young boys (think Matchbox cars). There is simply no way I could interest my nine year old in Matchbox cars anymore – not when they have a Playstation or a Wii. Boys toys were dead and computer games killed them.

Mattel was desperate to join the computer game revolution – and it paid a fortune for what really was a dodgy property. The losses were in the billions. Wikipedia tells the story quite well. It was one of the worst acquisitions ever on Wall Street – and not only did it cost Mattel over 3.5 billion (mostly in stock) but it revealed the underlying (and fundamentally incurable) weakness in Mattel’s business. It also cost the CEO (Jill Barad) her job. Jill made her career promoting and marketing Barbie dolls and her claim to fame was that she was brilliant – possibly amongst the best ever – at marketing bimbos. (A company insider once noted to me that that included herself.) Jill was however absolutely useless at assessing a computer game company. [Personally though I think she should have been kept on as CEO but limited to Barbie… She really did deserve that job and did it well.]

A short seller’s dream is when a real company – preferably one which is a little dopey and in an old industry (matchbox cars as compared to computer games) buys something hot, sexy and fundamentally dodgy.

Peet’s bids for Diedrich

I thought I had my own repeat of Mattel and The Learning Company. Peet’s – a well run but simple coffee chain around the Bay Area bid cash (debt funded) and stock to buy Diedrich. Ah – here it was – a simple company with a simple model – whose margins seemed to be declining (for reasons I have not fully identified) which bids for a well promoted company with massively complex (and potentially misleading) accounts.

To say I was excited is understating it. This is precisely the sort of thing that excites a short seller. At worst what would happen was that Peet’s – a company with less than 200 coffee shops (and owning only the brand and fittings) would have roughly 140 million debt and a business (Diedrich) that – depending on the contract with Green Mountain – might not be worth very much at all.

In the bad-case Peet’s stock – trading at 30 times earnings – could lose 80 percent of its value. [That was what happened to Mattel.]

So I did some work. I went back to the Seeking Alpha article and tried to verify every claim in it. Alas I could not. There were a few simple (and innocent) explanations for some of the red-flags highlighted in the Seeking Alpha article. However with respect to some of the claims in the article I had to acknowledge that the author had a point. He wasn’t right with respect to everything – but he was right on some points. Diedrich’s accounts were (and still are) pretty aggressively stated.

I shorted some Peet’s. Not a lot – but maybe a third of the final position I hoped to have. I intended to do a little more work (especially as the debt covenants were published). Besides – in the Mattel case there were many quarters as The Learning Company disaster unfolded. There were plenty of opportunities for a short seller in Mattel to test their thesis on the way down. This was a small position – but as it unfolded I hoped to make it a big position.

Now the observant will notice there is a missing detail. I still do not know the terms of the contract between Green Mountain and Diedrich. If the terms are highly favourable to Diedrich then shorting Diedrich (or the new owner of Diedrich) is spectacularly misguided. In that case Diedrich is just a cheap way into Green Mountain’s (fantastic) business.

Not knowing the terms of that contract was the key weakness in all of my analysis. And I knew it.

Peet’s had a conference call when they announced the purchase. They indicated that the terms of the contract were acceptable but they refused to detail what they were. Paraphrasing Mandy Rice Davies “well they would say that wouldn’t they”.

What I was looking for in future quarters (as a guide to increasing the position) was evidence that the Green Mountain contract was favourable to Green Mountain.

Well I was wrong

I started this by stating that most of the analysis was wrong. And it was – in a very specific way. My biggest concern was always the contract Green Mountain had with Diedrich. And only one party outside Diedrich knows that contract and understands its economics intimately. That is Green Mountain.

And they proved me wrong. Green Mountain overbid Peet’s for Diedrich - $30 per share – all cash.

Oops – now I know I am wrong. Green Mountain wants to bring that contract back in house. They want it in-house for about a quarter of a billion dollars in cash! Remember ultimately all that Diedrich has is a few tax losses, a small manufacturing facility for K-cups, a couple of second-rate coffee brands and THAT CONTRACT.

Peet’s overbid – bidding $32 a share ($20 in cash the rest in stock). Green Mountain upped its bid to $32 per share ($265 million) all cash. Remember this stock was trading earlier this year under 25 cents! This is one hell-of-a-valuable contract.

Needless to say events have shown I was wrong about Diedrich with respect to the only thing that mattered (the worth of the k-cup contract with Green Mountain). I covered my short and thanked luck that it was not (much) worse.

Of course this bidding war drove down the value of Peet’s stock. So I was wrong and made a small profit.

Money management – lucky or smart?

Given I was wrong I can hardly say I was smart. But Peet’s was not a bad candidate for a short. It has a very thin balance sheet (almost all profits have been used to buy back stock). It does not own the sites of its stores. It was paying cash so it was going to incur debt with only intangible assets (its brand really) to back that debt. And it had a 30 PE.

Given all of that I could be wrong in lots of ways but still make a profit.

But I should not get carried away. I was wrong – proven wrong – and the profit is nice but it shouldn’t be used to ignore the fact that my hypothesis was simply inconsistent with observation.

Back to scratching around (often fruitlessly) for things that might make money.

John

The Ides of March and the Fed exit strategy

2009-11-25T16:03:00.001+11:00

The dollar bears (and inflation mongers) are all over the blogosphere and press at the moment. It is almost a consensus that the US dollar is doomed and that gold is a great investment. Sure there are doubters – but few are as vocal as Paul Krugman who refers to inflation as the phantom menace.

Anyway I thought I would have a brief analytical foray.

Over this crisis the Federal Reserve increased the money supply by literally trillions of dollars and several hundred percent. In an ordinary world this would have caused very rapid inflation – but suffice to say that this is still not an ordinary world. Short term interest rates are stuck at zero and medium term rates are pinned very close to zero. People (and financial institutions) are willing to hold (and not spend) inordinate amounts of money. Liquidity preference is very high and it has absorbed all the extra money the Fed has printed.

Obviously some day liquidity preference will wane (though Japan tells us that day might be very far into the future). When the liquidity preference has waned all that money that was printed will be excess and might turn into inflation. The Fed will need an exit strategy. Inflation hawks are already worried that inflation is inevitable. Gold is a favoured investment of many – including some hedge fund managers who I think have very fine minds.

Ok – I think the inflation hawks are wrong and I think gold will be a lousy investment. But I need to explain why.

The Fed printed money to buy lots of riskier assets. Often these were assets owned by banks and the banks borrowed the cash from the Fed secured by these assets. About a trillion of the assets were qualifying mortgages guaranteed by Fannie and Freddie. Whatever, there is a huge increase in money supply (liabilities of the Federal Reserve) offset by an equally huge increase in assets held by the Federal Reserve.

The Fed has an exit strategy – a natural exit strategy. When people’s liquidity preference wanes they will want to hold risk-assets rather than cash. And the Fed owns trillions of dollars of risk assets. The exit strategy is simply to sell those risk assets and take back (and destroy) the cash that they created during the ciris.

The right speed to do this is also – in some sense – naturally determined. The right speed is at the speed the general public wants to hold mortgages and other risk assets again.

Now all of this presupposes something utterly critical. It presupposes that the assets on the Federal Reserve balance sheet (loans to banks secured by risk assets, Fannie and Freddie mortgages and paper) are good. If the assets held by the Federal Reserve are worthless then the Fed cannot use those assets to buy back the excess money supply precisely because those assets were a wipe-out.

The Fed has an exit strategy – but only if the asset side of its balance sheet is solid.

And this brings us back to the middle of March when the system was collapsing around us. The Fed was the only source of liquidity – they were lending to big banks secured by almost anything the big banks had unencumbered. They even lent to big banks secured by (of all things) recreational boat loans.

If everyone was insolvent then those loans to banks will be no good. The Fed will have no capacity to withdraw the excessive money supply because the asset side of their balance sheet will be stuffed.

However if the crisis was a liquidity crisis and not a solvency crisis then, come the time to exit quantitative easing, the Fed will have a sufficient balance sheet to do its part.

The determining factor as to whether the end game here is inflation is whether March was a liquidity or solvency crisis.

This blog has been consistent. I do not believe the US banking system was insolvent in March. I never did believe it. And I thus believe the Fed has an exit strategy. Given that belief I think that gold is a lousy investment from here (though thankfully I have not been short it).

More generally I think there are serious problems with believing both of the following:

(a) the financial crisis was essentially a solvency crisis – the banks were mass insolvent in March and a bailout was inevitably going to impose very large long term costs and

(b) that inflation is not a large risk.

However Paul Krugman seems to believe both these things, and he has a Nobel Prize in economics and is clearly smarter than me. So please take all of this with a grain of salt.

The missing details: Bronte Beach edition

2009-11-15T16:46:00.001+11:00

Saturday afternoon and I had volunteer lifesaving duty. My (broken) collarbone is knitted enough to be able to go in for a swim in modest surf – but if there were a difficult rescue I would pass the duty onto someone else. Really I am a pair of eyes – the job is to watch and assess – not to make a hero of myself.

I was sitting chatting with Rod, a fellow lifesaver at the North end of the beach watching quite a large crowd and getting modestly annoyed when the (fibreglass) board riders were sailing too close (or into) the flagged bathing area. (Swimmer’s heads tend to come off badly when hit with a fibreglass surf board.)

At the very south end of the beach is a rip (a current that goes out to sea) and some lifesavers were standing around chatting around the rip. This is the same rip where the Muslim men were rescued last November.

There was someone swimming in the rip – with quite good – even stylish strokes. But he was getting nowhere. Rod and I were debating whether he was even likely to get into trouble. The stroke was – as I said – strong – but given the current what he was doing was futile. We watched for about a minute when I decided to walk down the other end of the beach and see what the other lifesavers wanted to do about it. I was not worried.

As I walked the guy stopped swimming – just gave up – and started to drift out to sea at about 1.5 metres (5 feet) per second. I got to the lifesavers about the time I thought it was actually going to be necessary to go in and get the guy – but the professional lifeguard on the beach had run down, got a rescue board and was already on his way to effect the rescue. These are the same lifeguards from the TV series.

The victim was still treading water, the surf was not rough – and I suspect if he knew what he was doing (that is knew to swim across the current) he could have rescued himself. But I was still a little peeved at myself for missing the easiest of board rescues (and the kudos/self congratulations that would go along with it).

Ex post we realised there were a few missing details:

First – the lifesavers at the South end of the beach simply did not notice the guy caught in the rip. Maybe they noticed his fine swimming stroke and assumed he was not a “customer”. Maybe they were looking at pretty women in bikinis. Maybe they were just preoccupied. Whatever – they did not see.

Second – the customer was from Bavaria. He was a tourist. He had once swum competitively (hence the stylish swimming stroke) but he had never swum in the surf. He simply did not understand his predicament and he had no idea how to get out of it.

Third – the customer was wearing cut-off cotton jeans – not a nylon swimming costume. That makes it just so much harder – and an amazing proportion of our rescues are of people who go in fully or partially clothed. [The fully clothed are often Muslims.]

Fourth – the customer had had a couple of beers.

If I had known these four details I would not have walked to the other end of the beach – I would have run as fast as I could. Those details – none of which were readily apparent – changes the interpretation of the guy in a rip from “interesting and slightly comic” to “life-and-death”.

The existence of a problem was obvious to me – and I (incorrectly) presumed that it was similarly obvious to my fellow lifesavers. I just assumed because I had noticed everyone had noticed – and hence I acted almost apathetically to the danger. Moreover I assumed away my four missing details because the customer had a fine swimming stroke which created an illusion that all was under control.

That is I suspect a very human mistake…

John

The media market has a conservative bias

2009-11-07T20:23:00.001+11:00

Here is a sequence of numbers to bring tears of joy to a stockholder and tears of rage to a liberal pundit.*

197

262

211

194

249

275

282

284

289

337

330

313

379

428

429

434

495

It’s the quarterly operating profit of the cable network programming for News Corp in millions of dollars as reported since September 2005. It’s not all Fox News – but Fox News is the main driver.

I love reading Talking Points Memo, the Daily Kos, Paul Krugman and Brad Delong – but its quite clear that the mass audience and the dollars are elsewhere.

And whilst there are some nice new liberal media sites (including many I read) and I think people like Josh Marshall have reinvented part of American journalism that is all a delusion. The media market has a conservative bias.

Just to make the point further I have met a few media barons – including briefly the Sun King himself. My impression of media barons is that whilst they have political views (often quite strong ones) there real bias is to things that are profitable. Rupert is in my home town this week (Sydney) and he is personally expressing views associated with asylum seekers in Australia that are associated with the left of Australian politics. They are not views expressed in his local newspapers.

Therein is the rub. He is quite happy to have his newspapers express views contrary to his own when it sells papers. The media market determines media bias – and – as the above string of numbers show – the media market has a conservative bias and that bias is getting stronger. Media bias follows the money-making bias of media owners. People who proclaim liberal media bias are just not following the dollars.

I hope – sincerely hope – that Josh Marshall, Markos Moulitsas and others of the new media liberal elite can make a go of it. But the conservative side generates operating profits of half a billion per quarter and that gives them a longevity (and power) that the new media – for all its obvious intelligence – can only watch in gob-smacked wonder.

John

*In this case I am both a liberal pundit and a stockholder. I don’t know whether to cry or to cry.

Fannie Mae’s results – oh, and what if Bank of America reported the same way…

2009-11-06T14:44:00.004+11:00

There have been some mathematical corrections to this post discussed in the comments. My pencil notes had the numbers right. By the time I got to writing it out errors had entered. Sorry.

Fannie Mae just put out awful looking results based primarily on massive (and increasing) credit loss provisions. Indeed their provisions this quarter were the largest thus far in the cycle.

Its worth looking a little closer because – like it or not – all Americans are owners of Fannie – both the downside (their current book) and the upside (if any) through taxpayer ownership of the common stock.

The nature of credit loss provisions

Each quarter almost every financial institution takes some charges when loans they have made settle at less than 100c in the dollar. At the moment charge-offs are at historic highs.

Every quarter a company makes an estimate of future losses – a “provision” if you will.

Provisions by definition are estimates – whereas charge-offs are real and mostly final.

The difference between provisions and charge-offs goes to a “reserve for future losses” or more commonly just “reserves”.

Most financial institutions are taking more provisions than charge-offs – in other words they are building reserves. This is necessary because there are a lot of delinquencies and a lot of loans in the foreclosure process and – just frankly – a lot of loans that common sense tells you will end in charge-off.

Most institutions build reserves relatively slowly. Bank of America for instance – in broad numbers – has had 13 billion of provisions per quarter for the last three quarters and charge-offs of 6,8 and 9 billion respectively. If the charge-offs skyrocket (say to 20 billion) at bank of America then it will find itself under-reserved – and will wind up having to report very big losses. However if charge-offs slowly level off around 13 billion per quarter then BofA will – ex-post – look OK.

The honest answer in the case of BofA is that we really do not know where charge-offs will wind up but we can make educated guesses. In the last conference call BofA thought charge-offs would peak about the first quarter of 2010. If they are right then their current reserving is right and BofA is probably a steal as a stock right now. If however charge-offs continue to rise for another 18 months peaking out at say $35 billion per quarter then BofA will need to be recapitalised further and may wind up as government property.

I am inclined to think that BofA’s current educated guess (charge-offs peaking early next year) is a little optimistic – but not very optimistic and I am happily long Bank of America common shares. This is – as I stated – an educated guess. Other people I respect have different educated guesses. The (very smart) Chris Whalen has a completely different view arguing (amongst other things) that the liabilities for fraudulently sold securitisations at Countrywide and Merrill will produce losses large enough to render BofA insolvent. I think he is spectacularly wrong – but difference of opinion makes a market.

In BofA’s case 13 billion per quarter is sort of a magic number because it happens to approximate the pre-tax, pre-provision profitability of the bank. Provided actual end charge-offs remain around or below 13 billion per quarter BofA will be able to earn its way of its mess. If charge-offs go to 25 billion per quarter they can’t earn their way out – and hence just the implicit government guarantee they currently have will not be enough to save them.

I note that current charge-offs are comfortably within the 13 billion per quarter so all is well for the moment. As to the future – all we can take are educated guesses. And that is all bank provisioning is. In BofA’s case the 13 billion (plus or minus a couple) of provisions taken each quarter seems a little optimistic to me – and you can understand why when the gun is pointed at the executives head they manage to (miraculously) pick their provisions to roughly match their pre-tax, pre-provision profit. But as I have noted I think the provisions in BofA’s case are only slightly optimistic – and the end charge-offs won’t go very far above 13 billion per quarter.

Analysing the Fannie Mae result in this light

Fannie Mae – as stated - took an enormous loss this quarter. The key to this loss was a credit charge of $22 billion. This credit charge can be broken into two broad categories – which are (a) the actual charge-offs taken, (b) the addition to reserves.

Like BofA, Fannie (and Freddie and just about everyone esle) needs large reserves because – frankly losses and delinquency are still getting worse. The amount you need to add to reserves is an estimate. If your reserves are large enough (which doesn’t seem to be the case in any financial institution I look at outside the GSEs) then you don’t need to add and you might even be able to run the reserves down a little.

In Fannie’s case this quarter there is one more thing complicating the reserves versus charge-offs picture. Fannie changed the way it accounts for one of its loan modification programs (the “Home Affordable Modification Program” or the HAMP) such that when loans are acquired from securitisation trusts for modification they are written down to market. This loss (which Fannie calls a “loss on acquisition”) is not a final loss (as per a normal charge-off) but rather an estimate of the future charge-offs they would take on those loans.

So lets break up the credit charge.

The provision for credit charges was 21.96 billion – which I will round to 22.0 billion – given that the nearest 100 million seems close enough. The charge offs were 10.9 billion (see table 10 in the 10Q). Note 3 to that table tells us that of that 10.9 billion 7.7 billion came from the “loss on acquisition” on the HAMP. The actual loans that were charged-off (final) were 3.2 billion. They were probably a bit higher because there were some HAMP charges taken last quarter and maybe some were finalised this quarter.

But nonetheless the way to think about this is that final losses this quarter were 2.2 billion. Provision for future losses (HAMP losses and provision build) were 19.8 billion. Similar ratios have applied every quarter since Fannie Mae went into conservatorship.

Now I am going to make the obvious point. Bank of America provides roughly 1.5 to 2 times its charge-offs each quarter. Fannie Mae provides 7 times (and has been closer to 10 times in past quarters).

If Bank of America were to provide at the same rate its quarterly losses would be 50-80 billion and it would be completely bereft of capital – it would be totally cactus. It would be – like Fannie Mae – a zombie government property.

What I think is going on…

I think what is going on here is a different standard for Bank of America. And for Wells Fargo. And for Citigroup. And for PNC and for every other major bank in America. There is also a different standard for Goldman Sachs. That standard is different to Fannie Mae. BofA (like everyone else) gets to choose its reserving ratios – and to be a little optimistic. Fannie Mae chooses ratios that are so-off-the-scale high that it is different.

Remember provision build is an estimate not a fact – and Fannie is estimating extraordinarily bearishly and Bank of America’s estimates are slightly generous. But regulators are controlling Fannie in such a way that keeps it down. They are allowing Bank of America to act as if all is well whilst Fannie Mae appears to be a complete zombie. Which I think corresponds roughly to the new policymaker consensus that what is good for big banks is good for America.

It is clear why BofA has chosen the 13 billion of provisions per quarter – which is that it roughly corresponds to their pre-tax pre-provision income. Moreover – in my view the 13 billion per quarter is not far wrong so the decision is defensible.

It is not clear why Fannie has chosen to reserve quite so aggressively. My guess is that there is no active conspiracy – but the pressure to make extraordinary provisions at Fannie is very high for a variety of non-commercial reasons. These provisions are defensible only if you believe the housing market gets substantially worse from here. That seems to belie the evidence on the ground – at least for now. Housing markets in the core bubble states have clearly stopped deteriorating. Current provisions (including mark to market provisions on the HAMP) are now 6 years current charge-offs. They are only 18 months or so at most banks including BofA.

Am I being too harsh?

Is it too harsh to apply the same provision to charge-off ratio to Bank of America as it is to apply it to Fannie Mae? Well if the credit was deteriorating faster at Fannie that BofA I would be too harsh. But if the credit were deteriorating faster at BofA then I would be too generous. The best test of that is non-performing loans.

At year end BofA non-performing loans were 18.2 billion. They were 31.9 billion by the end of the third quarter – a rise of 75 percent.

Fannie Mae NPLs were 111.8 billion at the end of the year (20.4 on balance sheet, 98.4 off balance sheet). They were 197.4 billion at the end of the third quarter – a rise of 76 percent.

75 percent versus 76 percent – I will call that a wash.

Indeed almost however I cut it the situation is getting worse for BofA at roughly the same rate as it is for Fannie Mae.

Except for one thing. The government wants BofA alive. Lots of people want Fannie Mae dead.

My views

Bank of America survives now but for the good grace of the quasi-government guarantee. So do all banks. But Bank of America is – in my view (a view open for dispute) ultimately solvent. Its provisions are optimistic – but not (in my view) excessively so. If the cash losses per quarter rise to (say) 30 billion dollars then BofA will die and will cost the taxpayers a lot of money. I think that is unlikely but it is not impossible. Provision additions are always just an educated guess – not a science.

If the same standard were applied to Fannie Mae as bank of America Fannie would still have needed government assistance. It started with less capital and more levered than BofA. But the position would not look anything like as bad as it does.

You can of course interpret this to suggest that the Fannie Mae standard should be applied to BofA – and indeed to the rest of the financial system. You would (in my educated guess) be wrong. But I would have little ground to dispute it.

Disclosure: Long preference shares of the GSEs, long Bank of America. Could be wrong about both.

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.

2009-10-31T12:10:00.001+11:00

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!

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]@usdoj.gov

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 insult – Mr Paul Keating – and Company B. The Paul Keating original is about being flogged with “warm lettuce”.

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

2009-10-28T16:05:00.001+11:00

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.

John

The goldsmith as retail bank

2009-10-22T14:51:00.001+11:00

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.

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

2009-10-16T21:34:00.002+11:00

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.

Enjoy.

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…’

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

2009-10-05T19:16:00.001+11:00

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.

Background

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.

John

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.

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

2009-10-02T16:34:00.001+10:00

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.

The new rapid SEC

2009-10-01T07:15:00.001+10:00

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.

Politics makes people believe the strangest things – so let’s try make money from their stupidity

2009-09-19T14:21:00.001+10:00

I knew I was stepping into heavily political ground when I wrote my impressions piece about Australian semi-socialised medicine. Most responses (including emails) were reasonable – but some were so ideologically blinkered as to be perverse.

On the right there was much selective looking at data to argue that America does not produce (in aggregate) relatively poor health outcomes for the dollars spent. You can pick individual conditions and show America is better-than or worse-than average. But any reasonable overview of the American system will come to what I think is a non-exceptional conclusion.

On the left there were several people who argued that pharmaceutical research done by capitalist drug companies was simply not important – citing the development of cosmetic and “me too” drugs and ignoring substantial research. They argued real medicine is done by governments and universities – in other words good research is a socialist or semi-socialist activity. That is simply blinkered. One of my close friends – who has spent his adult lifetime doing cutting edge genetics research for profit (and who grew up under Chinese communism) simply responded that there are plenty of people who still believe communism is a good idea.

Anyway one of the things that is patently obvious about America and its stock market (at least looking from Australia) is that it produces fantastically innovative companies. American Capitalism gave us semi-conductor capital equipment producers, Google, the planes that enabled cheap commercial jet travel and mass marketed chewing gum. More than a few of these involve some research. Even the most cursory look at the product set of Amgen – a major drug company – would suggest that American capitalism funds some impressive drug research.

Strange views like these exist in all countries – but the extent to which irrational right wing views are not controversial in the right and irrational left wing views are not controversial in the left is hardly a recommendation for America’s democracy. (Americans call it polarization.) The question is what are you going to believe: the prima-facie thing that is consistent with your ideology or your own lying eyes?

At the moment ideological belief that is inconsistent with reality is (far) more pervasive on the right as seemingly serious right wing politicians pander to Rush Limbaugh’s lack of nuance or to anti-scientific creeds such as creationism. But it is not always going to be that way – and some of the responses to my post suggest that there is a latent left wing Limbaughism too.

But this is just tearing wings off butterflies. There are plenty of stupid and/or ideologically blinkered people out there. Pointing them out has about the same level of charm (and general interest) as making fun of “creation scientists”.

I write an investment blog – and I have no reason to be interested in where commentators in the blogosphere are demonstrably wrong because they argue from their ideology rather than observable facts. I have a really big interest – a money making interest – in where people are wrong in markets because they rationalize from ideology rather than observable facts. These things happen – for many years market driven ideologues thought that the securitised mortgage market was fine because it was done by private sector participants (and it mostly dealt in mortgages that Fannie Mae and Freddie Mac were prohibited from dealing in). They were wrong. Anyone who hung out with a half dozen mortgage brokers and saw the trash they were underwriting could have (and should have) worked out that this was a disaster. Ideology trumped facts on the ground. And it gave some stupendous money making ideas. People made hundreds of percent returns on their money shorting the AAA strips of CDO squared securitisations and other high-finance dross. I know someone that made billions (yes billions) of dollars betting that subprime lending would end in a crisis – and they only had to risk tens of millions of dollars to make that money. Stupid ideology gave huge profit potential. That stupid ideology came from the right because at the moment there is (much) more stupid ideology on the right – but again it was not always that way and will not always remain that way.

So – here I am begging my readers. Much as I like reading about creationist astronomy and postmodernism and the Sokal Hoax and other people made stupid by their ideological blinkers - I would prefer find market sensitive stupidity. If people can reply with ideas and the easily observable facts that prove them wrong I would be thrilled. Emails acceptable. But please no argument based on your ideology versus their ideology. I am only interested in argument which is “their ideology versus readily testable fact” and then I am only interested if we can make money out of it.

John

PS. Don’t mention Zion Oil and Gas. I have already covered that one.

Hoisted from the archives – my old post on Freshwater and Saltwater macroeconomic theory

2009-09-17T12:52:00.001+10:00

Long before Paul Krugman elevated the central schism in macroeconomics to the front page I wrote about it on this blog.

My old post is reprinted below (with a few trivial modifications to make it more readable than the original):

Freshwater and Saltwater: macroeconomic theory and losing money

Background for the non economists. In 1976 Robert Hall christened the central schism in macroeconomic thought as being between the freshwater and saltwater schools. The division was picked by their location (on the Great Lakes and Rivers versus the coastal schools). The division exists today – and indeed is being played out in Krugman’s (saltwater) blog and by the Chicago economists who think he is a bozo idiot.

Having got through the background here is the post…

Does everyone agree that Greenspan kept monetary policy too loose for too long?

I thought so!

When I did economics at University (admittedly at that Freshwater school on the Molonglo River called the Australian National University) that was meant to end in inflation – not deflation.

I like my theory to accord at least loosely with reality. Especially if I am going to bet real money on the outcome – rather than pontificate in papers from the ivory tower of academia.

More to the point – I thought (in true Freshwater style) that sustained low interest rates were a sign that monetary policy had been tight and that sustained high interest rates were a sign that monetary policy had been loose.

Given that basic understanding of macroeconomics I thought that regional banks that made more than half their profits out of carrying the yield curve would be carted out when loose monetary policy did eventually lead to higher interest rates. I was short a lot of banks – and whilst that was good – I spent a long time being short interest rate plays (whereas I should have been short the credit sensitive banks). I have detailed that mistake here. Bill Gross made a similar mistake declaring (early) the 25 year bull market in long dated treasuries over – so despite Bill Gross’s saltwater location at Newport Beach I was wrong in good company.

Now the subject of freshwater, saltwater and other macroeconomic elixirs is the subject de-jour amongst economic bloggers – but I have conducted the experiment – with real money – and I can confidently say (brutally backed by less-than-ideal-financial outcomes) that the saltwater guys were right.

John Hempton

PS. I know that the inflation junkies are still predicting hyper-inflation – but they were also predicting it in January when I wrote the original post. The Freshwater guys are still wrong. Will the backers of the Freshwater school please put out a testable timetable?

PPS. A reasonable summary of the issues I lived can be found in Justin Fox’s book. Whether Krugman should have referenced Fox in his magazine article is an open question – but I think Fox’s summary is right… Krugman lived the issues in the book and did not need Justin Fox to explain them to him…

Vested self interest and the future of Fannie Mae and Freddie Mac

2009-09-13T19:31:00.001+10:00

Fannie Mae and Freddie Mac take credit risk and interest rate risk.

They take credit risk primarily by guaranteeing mortgages.

They take interest rate risk primarily by owning mortgages and financing them on their own balance sheet. They also trade the interest rate risk of that book using derivatives.

The anti-GSE lobby always asserted (and I once erroneously believed) that Fannie and Freddie Mac would come to grief on their interest rate risk. Taking interest rate risk is what the once-extensive anti-GSE lobby meant by charter creep.

Well the anti-GSE lobby were wrong. So was I. Fannie and Freddie did not blow up on interest rate risk – they blew up on credit risk. Mainly they blew up on credit risk from non-charter mortgages but they still have had no noticeable interest rate problems during this cycle.

The Anti-GSE lobby always had an agenda

Wall Street always hated Fannie and Freddie taking interest rate risk – it encroached on the profitability of Wall Street trading desks. Trading interest rate risk is the core business of Wall Street trading desks – and they hated having GSEs (with funding advantages) crowding them out of their own game.

But Wall Street loved Fannie and Freddie taking credit risk – that meant that Wall Street could splice and dice mortgages all they like – and know that eventually Uncle Sam will pick up any credit losses.

So they always pushed for limits on the interest rate risk that the GSEs could take. I never heard FM-Watch or other anti-GSE lobbyists arguing for limits on GSE credit risk acceptance.

When the anti-GSE lobby now say “I told you so” they are lying. They said the GSEs would blow up on interest rate risk and they were wrong – but they are falsely claiming intellectual credit anyway. It helps their lobbying.

So how do the proposed reforms of Fannie and Freddie look?

All public proposals for GSE reform have the same feature. They all allow Fannie and Freddie (or their replacement entities) to stay in the credit risk business by guaranteeing mortgages – but they insist that Fannie and Freddie shrink their balance sheet – and hence take less interest rate risk.

In other words they leave all the credit risk with the GSE – solving nothing from a taxpayer perspective and give all the interest rate carry (and most the revenue) to investment banks. They do nothing to solve the problems that caused the GSEs to fail.

That is also the structure of the conservatorship agreement by Hank Paulson forced the GSEs to sign – an agreement constructed by the staff of Morgan Stanley. The agreement gave Wall Street precisely what it wanted – which is not surprising because it was drafted by Wall Street investment banks.

The Mortgage Bankers’ Association proposal is even more egregious – but that is the subject for another post. Even the Government Audit Office report leans heavily towards the wishes of investment bankers. (You would think they would be better than that – but it seems they are only as good as the people lobbying them.)

So here is a hope for the Obama administration. Be very sceptical of the the vested self-interest behind anyone making GSE proposals. [Whilst that includes me I am just shooting from the sidelines. Investment bankers drew up the conservatorship agreement in the interest of investment bankers. That sort of power should not go unchecked in America.]

Fannie Mae and Freddie Mac – closing the modelling sequence

2009-09-11T11:24:00.000+10:00

The last post – which was incredibly difficult to write – received remarkably little comment – and almost no feedback. So I am going to close the modelling sequence early – and write a few posts about the politics of Fannie Mae and Freddie Mac as standalones. Almost all the proposals for “reform” seem to leave most of the credit risks with the government and give much benefit to Wall Street bankers. That includes the original proposals implicit when Paulson – the once King of Wall Street – put them into conservatorship. I will later expose those for the vacuous positions that they are. I want to write the politics sequence so you do not have to have closely read the modelling sequence – because I know these will appeal to different audiences.

But for now I will note that most the well-informed comment has indicated that I have underplayed the role that tax losses have played in putting Fannie and Freddie into the position they are. Certainty as to their future will enable them to write back the charges against tax assets they have taken. 18 months of profitability (which they will have) plus some certainty to the future will allow approximately 30 plus billion dollar write backs at both GSEs. That will leave the GSEs with positive net worth (and able to repay government loans) in time for the 2012 election. I will leave that to the politics sequence.

I said in the first post that I will close with a comment that was once left on my blog by “Bondinvestor”. This was the only comment I have ever censored because it stole my thunder… here it is… [with annotations in square brackets and blue colour]. I pleaded on the blog for Bondinvestor to contact me – but with not much luck. Bondinvestor summarises my arguments quite well – though I think the same applies to Fannie Mae – albeit with less force.

You should take a deeper look at FRE. it was a very well run company before the crisis - and not just on the portfolio side. [I was – well before Bondinvestor left this comment.]

Look at their credit statistics. the 90+ delinquencies are high relative to history, but far below the rest of the industry - as well as Fannie Mae. [I noted this in Part III.]

The tragedy at Freddie is that they purchased non-agency AAA MBS in an attempt to meet their housing sub-goals. [I noted in Part II that the losses came primarily from the Private Label Securities.] Their calculus was that the inherent subordination in the AAA's would protect them in a credit Armageddon. [Well we got credit Armageddon and the Private Label Securities business did cause huge losses for the GSEs.]

What is fascinating about FRE is that the jury is still out on what the actual realized losses in their non-agency book will be. The AAA private label pass throughs that the agencies bought were specially designed for them. The balances were all conforming; the pools had lower CA/FL concentration than the rest of the non-agency universe; and - most interestingly - the loans underlying the GSE's AAA's were segmented from the AAA's that were sold into the public market, though they shared the same subordinate tranches. what this means is that catastrophic losses in the Type II bonds do not necessarily imply catastrophic losses in the Type I bonds (the GSE-eligible AAA's). [Analysing this was the point of Part IX. They will incur losses – just nothing like as bad as they provided for.]

If you go look at remit reports, you'll see that the delinquencies underlying the agency-eligible bonds are much lower than the DQ's underlying the non-agency bonds. [Actually I have done so – and whilst the DQs are lower in the agency-eligible pools they are not much lower. The biggest advantage that the agency eligible pools have going for them is that they retain far more excess collateral against their delinquencies.]

Now, part of the problem is that the atrocious performance of the non-agency pools will eat up the subordinate tranches, thereby depriving the GSE-bonds of their fair share of the enhancement. [They have almost entirely done so in the series I analysed in Part IX] but, given the relative performance of the loans underlying the GSE bonds, it may not matter. [It will matter with respect to the series that I have looked at – but the excess protection in the agency-eligble pools means that the GSE losses will be under half the losses incurred by the AAA strips of the non-agency eligible pools – in many cases less than 15 percent of the normal AAA losses.]

Anyway, all this is a very long winded way of saying that the actual realized losses in Freddie's $150B portfolio of private label MBS may not approach anything like the huge mark they have taken on this book (and which destroyed their capital base in the early innings of the credit cycle). [Freddie thinks about 30 billion will reverse as described in Part IX – I think it will be less – but I am having a very sophisticated conversation with one reader who thinks it will be more – and provides modelling to prove his points… I think I could be twisted to agree with him – and will put up a technical post if we (jointly) ever get around to writing it…]

I know folks inside FRE who think that the "shadow equity" that comes back on the balance sheet as the PLS portfolio pays down is on the order of $70B. that is more than enough to retire the convertible preferred note the government took as part of the conservatorship. [I know no such folks. I worked this out on my own. But I think the shadow equity is closer to 50 billion – say 25 billion that will reverse on the private label securities and the other temporary impairment plus about 30 billion in tax losses but less the 10 billion or so more reserves I think they need to take over time on the traditional business.]

Now, none of this is to say the losses on the guaranty book won't be large. but the company discloses enough information to come up with a reasonable estimate of what they could be. You just have to look at the 06/07 vintage curves and make a judgment about how long it will take those books to season. the realized cumulative losses will most likely be somewhere between $30 and $50B. they already have a loan loss reserve of $22B. so they have some wood to chop, but it's not an egregious amount. [Well I did that modelling in Part VI. I agree with the numbers Bondinvestor comes up with – actually I think the end losses will be less.]

A much bigger issue for the company than the actual credit losses is the terms of the senior convertible preferred. If the coupon is 10% if paid in cash, and 12% if they take the PIK option. That's $5B a year after tax and it wipes out all of the normalized profits of the enterprise. it's a far more egregious rate than any of the other pieces of paper the government bought in the midst of the crisis, and it was put there by the bush admin to prevent the GSE's from organically rebuilding their capital bases. [Again I agree – the object of the conservatorship terms were to wipe Fannie and Freddie out – the takeover was political in execution. However the current income of Fannie and Freddie is way above trend – and this will not be a problem if the high revenue is sustained.]

FRE preferreds trade at 1-3 cents on the dollar. they are basically warrants on the ability of the company to one day retire the government note. with a payoff function of 100x, i think it's a speculation worth taking. [They trade higher now – but I was buying at these prices.]

In summary – working through my models I will be wrong if

(a) the running income halves

(b) the end losses are higher than I thought and

On those I am most insecure on the running income as I discussed in Part V – but the running income is already running far faster than I anticipated when originally buying these securities.

The GSE takeover will wind up costing government surprisingly little. I think it will wind up being profitable. The future of the GSEs is not determined by their insolvency. That I think, time will take care of. It is determined by politics.

I will do a political series later – and they will have a wider audience. Wall Street wants to carve the GSE business up for the benefit of Goldman Sachs et al. The Wall Street political lobby is very effective and the terms of the GSE conservatorship prevent the GSEs from lobbying on their own behalf – which means that unless we are careful the Wall Street lobby will get what Wall Street wants. But that is for future political debate – and the Obama administration has sensibly put off decisions as to the GSE future until next year – and ideally they will put it off until even later.

I hope I have achieved what I wanted to with this series – which is to stop the model-free GSE bashing that had become the popular line of thought of the press and the blogosphere. Later I hope to take on the vested self interest behind that GSE bashing – showing them (especially the Mortgage Bankers Association) for the egregious self-interested participants that they are.

Betting on – or against – Obama hatred

2009-09-11T00:46:00.001+10:00

I run an investment business – and my blog is about investing. Sometimes (quite often) investing requires that you have a dispassionate look at politics, political trends and political decisions – even if those trends and decisions are anathema to you.

This is one of those times.

In March the US economy was in dire risk. Everyone who sold discretionary consumer products – especially high value discretionary consumer products – was watching their business implode about them. Well not everyone – but almost everyone.

One sector was having a rollicking boom – an off-the-scale big boom. It was recreational handguns.

A large number of Americans allowed themselves to be convinced that Obama was going to take their guns away. Or maybe they were convinced that socialists were taking over the country and that you needed to protect yourself. They may have even been convinced that Nazis were taking over the company (evidenced by eugenics policies under the Trojan horse of nationalised health care). Whatever… they bought guns. Lots of them. Here is a presentation from the Ruger AGM…

(Some corrections – the sales are probably on first quarter 2009 running at about 1.5 billion at the moment… this boom is MUCH bigger than show in in this graph).

I do not need to tell you a billion dollars (the current projected 2009 sales) represents a lot of handguns. Its up ~~250 percent~~ [see correction – but about 400 percent] since 2003. Very few consumer products (that are not made by Apple) can claim that.

The Obama-hatred inspired boom in handguns was so large that manufacturers simply could not keep up and handguns had to be obtained on order. The companies had exploding forward order books. As Smith Wesson said in a press release dated 22 June…

Our firearms backlog continued to increase dramatically during the quarter, and reached its peak at $268 million dollars by the end of April. That level is $218 million dollars higher than the same quarter one year ago.

More generally, Smith & Wesson deserves special mention. They have taken as their marketing guide the success of Harley Davidson – a company producing marginally inferior (but iconic) products and turned it into a mass-market product for wanting to rebel (and recapture youth) middle-aged baby boomers. What is more they have done so with some success – as evidenced by their shoot-the-lights-out record sales this quarter.

Dispassionately if you thought Obama hatred of the most extreme ilk was going to continue to grow like topsy you would buy Smith and Wesson and its ilk – and become a gun seller. As a committed Liberal I might not like the second amendment and I might like the second amendment supporters even less – but – we owe a duty to our clients to make money – and we might even do it owning the shares of a gun manufacturer.

Fortunately though that is not the decision we have taken. I am not sure I would be comfortable being a gun seller – and some of my clients might also have strong views. We prefer to short this…

The proof of Obama is there to see. Obama is (despite the protestations of Rush Limbaugh and his ilk) turning out to be a middle-of-the-road centrist. [Strong Liberals wanted change they could believe in… Smith & Wesson just wanted to sell guns.]

And they have. Smith and Wesson sales were good but their forward order book took a dive. To quote Wednesday’s press release

Our firearms backlog was $177.5 million at the end of the first quarter. Cancellations reduced backlog by approximately 10% during the quarter. It is important to note that our backlog always represents product that has been ordered but not yet shipped. As a result, it is possible that portions of the backlog could be cancelled if demand should suddenly drop.

The warning about the backlog not being binding is new – and it is clear from the new disclosure that they are having massive problems during this quarter with order cancellation.

The backlog dropped from $268 million to $178 million – a drop of 90 million. Ten percent of that (say $27 million) was order cancellation – but a net $63 million of sales came from the backlog. Total sales were 102 million – and less than 100 million in firearms. The rate at which Americans are placing orders for new Smith and Wesson handguns is collapsing.

The company did not tell us the current forward order book. At that rate of collapse what they are facing is a disaster.

Whether that says anything about the size and intensity of belief of the Rush Limbaugh right – well I will leave that for my readers to discern. We just want to make money for our clients – so we are short Smith & Wesson.

Modelling Fannie Mae and Freddie Mac - Part IX

2009-09-07T21:27:00.001+10:00

I am sorry for the couple of weeks delay in publishing the continuation of this series. It was caused at least in part by my collarbone* and in part by just how difficult the next two posts have been to write.

In this series I have shown that the biggest source of losses (actually realised) so far at Fannie and Freddie have been private label securities (notably senior tranches of subprime and alt-a securitisations). The traditional business (insuring well secured and well documented qualifying mortgages ) has caused very few losses thus far (though substantial provisions have been taken).

The dross in other words was in the private label securities.

Now I stated in Part II that whilst Fannie and Freddie have made their biggest losses in private label securities they happen (perhaps by dint of better underwriting) to have the better end of the worst part of the mortgage market. The next couple of posts aim to explore that statement and measure it against the provisions which Fannie (and particularly Freddie) have taken thus far. I am conducting a robustness check on Part II and hence a check on the robustness of the starting balance sheet used in the model presented in Part VI.

Fannie’s statements about better underwriting of private label securities

Fannie Mae has publicly argued that whilst they have losses on private label mortgage securities their losses are far less severe than market. I have not done the work on individual securitisations at Fannie Mae to back that statement – but I will reproduce a graph from Fannie’s credit supplement comparing Fannie owned Alt-A private label securities with market private label securities.

Note that the cumulative defaults of the pools on which Fannie Mae owns the AAA strips are running just under half the cumulative defaults of the market average Alt-A securitisation.

They appear to have this better result without huge differences in the indicators by which they have selected the loans. From the same page in the supplement here is a comparison of Fannie Alt-A credit characteristics with market Alt-A credit characteristics.

The biggest difference is that they did fewer adjustable rate and negative amortizing loans – that is they purchased fewer loans with payment shock (when payments reset).

I do not have any real analysis of how Fannie managed to pick Alt-A loans that were so much better than the market. I would welcome informed comment. But the obvious place to look is at Fannies’ relationship with Indy Mac. Fannie had a close (and costly) relationship with Indy Mac – and the above data suggests that Fannie was allowed to cherry-pick Indy Mac’s book.

That said, the close relationship between Fannie Mae and Indy Mac (which seemingly allowed cherry-picking of Indy Mac’s book) did not give Fannie good mortgages, just a better calibre of dross.

Freddie Mac’s better than average class of dross

Fannie claim to have better-than-average Alt-A private label securities. Their mark-to-market provisions have however been lower than Freddie Mac – and I have not compared individual securitisations to Fannie’s marks as reported in their accounts.

I have made that comparison for Freddie Mac. Freddie Mac has taken very large marks in their accounts for private label securities (and by the end of the first quarter of 2008 Freddie had reported larger losses than Fannie based primarily on these marks).

Freddie do however have a (legitimate) claim for better-than-average selection of (bad) AAA subprime securitisations. There will be write-backs based on this.

Let me however introduce you to the Long Beach Mortgage 2006-11 (subprime) securitisation.

Long Beach Mortgage was the subprime mortgage company associated with Washington Mutual. The loans were way too risky to put on Washington Mutual’s balance sheet – and the performance of these loans is many times as bad as the performance of Washington Mutual’s own balance sheet.

Moreover, the later securitisations were done in the subprime bubble the worse they performed. Pools that were originated late in 2006 (such as 2006-11) behave considerably worse than pools that were originated even as late as early 2006. There is a reason for this. If you were a borrower who borrowed in 2005 and you could not repay your mortgage in 2006 you did not default. Instead you simply took another mortgage (often taking cash out on refinance) and repaid the old mortgages. Early 2004 and 2005 pools showed few losses for some time even though the underwriting standards were atrocious. The reason was that the bad loans rolled into later securitisations. The cynics (correctly) observed that “a rolling loan gathers no loss”. The late 2006 pools are truly atrocious because they contain not only the bad loans originated in late 2006 but also refinances of the bad loans originated in 2004 and 2005. The ability to refinance a bad loan just ended – with the result that the late 2006 vintage is especially atrocious.

So when we look at subprime mortgages originated by Long Beach Mortgage in late 2006 we are looking at amongst the worst credit originated during the whole bubble.

Freddie Mac took a large exposure ($408 million I gather) to AAA strips backed by this appalling pool of mortgages. They will lose money on that – and have taken provision. But surprisingly they will not lose quite as much as you would at first glance think – because - despite playing in the sewer - Freddie Mac took some measures to ensure that they could at least keep their nose above the sludge.

You will find the original offering documents for the 2006-11 series here. Much of the rest of this post is dependent on unusual features in those offering documents. So here goes.

Most mortgage securitisations (or credit card securitisations or the like) had a single pool of mortgages (or credit cards) and tranched them into many strips (often 15 or more). Credit defaults were attributed to each strip in order. So if there were a small number of defaults junior tranches (originally rated maybe BB) would wear those defaults. If there were more defaults mezzanine tranches (often originally rated A) would bear those defaults. Only if there were very large defaults would the senior tranches (originally rated AAA) suffer.

Often AAA tranches had 15 percent of protection – meaning losses had to be 15 percent of original outstanding before the senior tranches lost a penny. It was argued that it was inconceivable that say 30 percent of mortgages in a pool would default. And it was inconceivable that the loss given default (severity) would be more than 50 percent – so (it was argued) it was doubly inconceivable that there would be enough losses to affect the AAA securitisations.

Alas we now know that to be false. Many AAA strips are seriously impaired as defaults and severity have been substantially higher than what was considered even conceivable just a few years ago.

The long beach securitisation(s) look just like this except for one thing. Instead of having one underlying pool of mortgages they have two underlying pools – Group 1 and Group 2. These individually support their own AAA strips but collectively support mezzanine and junior strips. Now this strange structure was done for a reason – the reason being that the GSEs (notably Freddie Mac) wanted to ensure that they had more protection than the average subprime pool investor. These loans were real dross – but they wanted the better end of the dross. This is explained in the (2006-11) prospectus.

The trust will acquire a pool of first and second lien, adjustable-rate and fixed-rate residential mortgage loans which will be divided into two loan groups, Loan Group I and Loan Group II. Loan Group I will consist of first and second lien, adjustable-rate and fixed-rate mortgage loans with principal balances that conform to Fannie Mae and Freddie Mac loan limits and Loan Group II will consist of first and second lien, adjustable-rate and fixed-rate mortgage loans with principal balances that may or may not conform to Fannie Mae and Freddie Mac loan limits.

Now don’t think the loans in Group 1 conform to Freddie’s normal loan standards. They do not. But they are better than the Group 2 loans. We know this in a couple of ways – the most important is that the average original principal balance for the Group 1 loans is $185,000 versus $273,000 for the Group 2 loans. Also the concentration in California is lower for group 1 loans (28 percent versus 54 percent).

Now I started this with a (hyper bullish) view that whilst the Mezzanine strips of various loans might be trashed, the Group 1 loans – being pre-selected might be OK even though the Group 2 loans (the publicly traded high rated parts of the securitisation) might be very bad. Alas that is not the case. Indeed the surviving Group 1 loans are very bad (though not as bad as the Group 2 loans).

Anyway here is the cumulative distributions and realized losses for the various tranches of the 2006-11 securitisation – these distributions and losses covering both groups of loans. Note that this is a very-late-cycle securitisation and would have high expected losses as a percent of original outstanding…

This data comes from a Deutsche Bank (as trustee) monthly statement to holders of securitisation paper. You can find the trustee report here…

The way to read this is that the mezzanine strips have been almost entirely wiped out – and the losses are coming very close to imposing on the senior strips. For example the M4 strip had an original face-value of $24.75 million. That is how much investors paid for that interest in the mortgage pool. They have on that investment received $2.344 million in interest but their principal has now been wiped out. They are gone – and there is no recovery. However so far the losses have not been big enough to actually reduce the principal owing to the A strips. The 1A strip (which I gather is owned by Freddie Mac and is backed by the better mortgages) was originally just over $408.0 million. They have received all interest owning, 6.8 million of scheduled principal repayments and $143.8 million of unscheduled principal. The are still owed $264.3 million of the 408 million invested. On the money they have received back (in cash) they can take no losses – the money is in the bank.

The collected Group 2A strips originally invested (332.1+136.4+243.2+91.5=) 803.2 million of which ( 53.0+136.4+243.2+91.5= ) 524.1 million remains outstanding…

We also know how many loans were originally in each group and how many remain from this table…

And now we see the big advantage of Group 1 over Group 2. Group 1 has 326.2 million in loans outstanding backing 264.3 million in Group 1A certificates outstanding. Group 1 can absorb mortgage losses of $61.9 million before Freddie Mac (as the AAA strip owner) loses a penny.

By contrast Group 2 has 534.2 million of principal balance outstanding supporting 524.1 million in AAA strips. They can only lose a further 10.1 million before the AAA takes cash losses.

The better-than-pool collateral backing the Group 1 certificates has helped Freddie Mac because even now – with huge losses already incurred – Freddie has taken no cash losses and still has 23 percent excess collateral. They still have considerable protection.

I was hoping to stop this post just here - but

Note that Freddie still has considerable extra collateral backing their exposure to one of the junkiest pools in the whole subprime mortgage bubble. I was hoping that excess collateral was enough – and that Freddie might – through dint of clever structures and preselecting the best loans in a pile of dross be able to get through the whole subprime thing with only mark-to-market losses that would soon reverse. In other words I was hoping for a hyper-bullish reversal of most of the losses discussed in Part II of this series…

Alas the remaining loans are truly atrocious and 23 percent excess collateral is not enough. I know it is unlikely to most readers to assume you could pick a bunch of loans have more than 50 percent default and 50 percent loss given default – something that would be necessary to impair Freddie’s Group 1 AAA certificates. But – this is a late 2006 Long Beach securitisation. Unlikely as it might have seemed just a few years ago the losses will be much worse than that. Here is the delinquency data for the Group 1 loans.

This delinquency is almost 20 times as high as Freddie Mac’s conventional (non-credit enhanced) mortgage book. Different pools of mortgages can have a delinquency and default difference by a factor of 20 depending on underwriting – and unfortunately the underwriting at Long Beach mortgage was bad – even for the Group 1 loans (which were pre-selected to be better).

There is 12 percent (and flat) early stage delinquency, 16 percent (and rising) late stage delinquency, 13 percent (and falling) foreclosure and 6 percent (and flat) bankruptcy and REO. That is 47 percent problematic loans.

I have only educated guesses as to how many of these will eventually default – but an upper end assumption is that end default should be 1.2 times current delinquency. Not all the early stage delinquents will default of course – but there will be new delinquency and some non-delinquent loans will eventually default. Anyway a reasonable (though high-end) guess is that 56 percent of outstanding principal will eventually default.

Still 56 percent default would not impair us dramatically if loss severity were only 50 percent. After all we still have considerable excess collateral left on this loan pool before the AAA securitisation tranches are impaired. Unfortunately severity is running MUCH higher than 50 percent. Here is the severity for both the Group 1 and Group 2 loans.

Note severity is running about 75 percent. That is implausibly high and suggests very bad loan servicing. [The severity data is the subject of the next post.]

Still this suggests that the end loss from the Group 1 pool to come is very high – 56 percent default and 75 percent severity – suggesting 42 percent of the remaining pool will be lost.

I am not going to go through this but it is substantially worse for the Group 2 loans (the ones Freddie rejected). The delinquency for Group 2 loans is even higher.

What this means for Freddie

Remember above I showed that there were 326.2 million in Group 1 left outstanding. We think the loss on this will be 42 percent or 137.0 million. There is however 61.9 million in excess collateral protecting the AAA certificates. That will all be lost and 75.1 million in losses (137.0-61.9) will be visited on Freddie Mac.

Freddie Mac has a $264.3 million outstanding balance – they will lose (75.1/264.3=) 28.4 percent of the outstanding balance. The structure protected them – Group 2 loans will have much bigger losses – but losing 28.4 percent of the outstanding balance is still atrocious. Its a better class of dross.

Generalising the 2006-11 series

I have fiddled with a lot of Freddie Mac securitisations in the course of writing this series. As a rule Freddie securitisations had structural features which meant that Freddie Mac losses were smaller than market losses but are large nonetheless.

However the 2006-11 series is a particularly bad series (subprime, late in the boom). Most series have losses for Freddie below 25 percent of outstanding balances remaining as of June 30. Any mark worse than that and they are going to write back the excess over time.

Here are the marks as reported in the last 10Q:

Note the amortised cost of the subprime exposure is 63.9 billion and the gross unrealised loss is 24 billion. That is a 37.5 percent mark. After careful looking through securitisations I cannot find a single securitisation where I think Freddie will lose above 30 percent – and 25 percent is more common. On that count there is 8 billion which should run back through the accounts as they have marked-to-market and the losses will be not as bad as the market.

The model I presented in Part VI calculated losses and income from the current position of Freddie’s balance sheet. However here we appear to have found another 8 billion improvement on Freddie’s initial balance sheet – that is the real position of Freddie Mac is 8 billion better than I modelled in Part VI.

Freddie Mac reckon that about 10.4 billion of the losses they have booked are “temporary impairment” and should reverse. It is plausible – but my 8 billion is a lower number.

Cumulatively Freddie’s accounts show about 31 billion of temporary impairment – losses that they think will reverse. Outside subprime I have made no effort to test that number – but it seems high to me. Moreover some of this impairment seems to come back through the currently inflated revenue line and I do not want to double count this benefit.

Summary

I noted in Part II that Fannie and Freddie had incurred their major losses to date on their Private Label Securities. However I also asserted that Fannie and Freddie picked private label securities that were better than market – that is confirmed and alas it did not stop them from incurring very large losses.

A careful look at some bad securitisations suggest that those losses are more than full provided for (and hence Freddie in particular is slightly more solvent than this series suggests).

John

*I thank the many people who have wished me well, inquired about my broken collarbone and – in some cases – asked how my treatment fitted in with my analysis of Australian socialised medicine. The short answer is that I am going well. My break is one of the 90 percent that current practice suggests do not require an surgical pinning. So I have put my arm in a sling, taken huge doses of painkillers and waited for the bone to mend. The painkillers are not pleasant. There are lots of side-effects listed on Wikipedia including elation, hallucinations, itchiness, constipation, and excessive sweating. I seem to have all the unpleasant side-effects and none of the pleasant ones. I cannot fathom why people take these drugs recreationally. The painkillers are however better than the pain – which was overwhelming.

I have yet to reduce the painkiller doses – but I am expecting the side-effects to be unpleasant when I do so. I will write this up later for those that are interested – especially how my experience fits in with my views on socialised medicine.

Sorry – no posting for a while…

2009-08-31T07:33:00.001+10:00

I broke my collarbone in a bicycle crash.

Fannie and Freddie series to be continued…

If we want to change the world – we can… we just have to think we can. Kaupthinking was beyond thinking…

2009-08-26T23:11:00.001+10:00

I used to look at awed wonder at the insanity of Icelandic banks – but I never heard of this advert (for Kaupthing Bank) until after the collapse and the destruction of Iceland’s economy and I saw it for the first time only recently. It spreads virally amongst finance types – but I think it will be new to my Talking Points Memo readers…

Kaupthing was – I believe – the worst bank in the whole crisis… and has since been shown to be corrupt. But a good proportion of the employees really believed that they were doing something worthwhile which says more about cults than banking (except in as much as modern financial practice is littered with cult-followers).

Hat Tip to Felix Salmon, thence to Ultimi Barbarorum, but really to Lara Hanna Einarsdottir – who writes in Icelandic but who once left some (deservedly nasty) comments on my blog…

Finally – I note with fear that the bank doubled in size in a year – every year for 8 years. I considered shorting Kaupthing several times – but did not (in part because of the cost and difficulty of borrowing the shares). Banks like Kaupthing might be insane criminal organisations – but they were also impossible to short because they might stay solvent longer than you… Three doublings and your short has become very painful – even if you are paid in the end. Add to that a 25 percentage point borrow cost for the shares and there was little chance of making money unless you shorted right at the end. Oh, and your profit (if any) was realised in Icelandic Krona – and they turned out to be worth much less than you would have hoped. It is hard to make money of this stuff – even when the end-outcome is obvious.

Modelling Fannie Mae and Freddie Mac – Part VIII

2009-08-25T17:10:00.001+10:00

In Part VII I did an “idiot check” on my credit loss numbers. They appear pretty robust. This post does an idiot check on the pre-tax, pre-provision profit estimate. Here I am less confident.

The massive rise in GSE pre-tax, pre-provision profits is one driving factor behind my assertion that the GSEs can recapitalise. In the Freddie Mac 10Q from the first quarter was this (often quoted) and profoundly bearish line.

Our annual dividend obligation, based on that liquidation preference, will be in excess of our reported annual net income in nine of the ten prior fiscal years. If continued to be paid in cash, this substantial dividend obligation, combined with potentially substantial commitment fees payable to Treasury starting in 2010 (the amounts of which have not yet been determined), will have an adverse impact on our future financial position and net worth, and will contribute to increasingly negative cash flows in future periods.

This line – or variants on this line are repeated multiple times in the recent 10Q.

This is a blunt statement that Freddie could never repay the government because it owed the government $5.2 billion per annum and that was more than the earnings in almost every prior year.

There is a little that is disingenuous about this statement – possibly deliberately. The statement compares the obligations to the Treasury to the post-tax, post provision income for the past decade. In most years the pre-tax, pre-provision income of Freddie was in excess of $5.2 billion (which would have allowed some repayment). But far more to the point – the current pre-tax, pre-provision income is in excess of $15 billion. After write-backs they dealt with over 8 billion of the 50 odd billion outstanding in one quarter in Q2 – but they are not permitted to make the actual repayment (more on that in a later post).

Here is a cut-down version of the profit and loss account from the last quarter:

Revenues – net of mark-to-market swings – are up from 2.3 billion to 4.4 billion. Administrative expenses are down slightly. Pre tax, pre provision profits are probably running above $4 billion per quarter.

But that of course nails down the problem. The situation is so rosy for the preferred (and survivable for even the common stock) precisely because the pre-tax, pre-provision income is so high. If the high pre-tax, pre-provision earnings go away so does the taxpayers’ chance of getting repaid on their Fannie and Freddie bailout money – and – for that matter – so do the preferred securities that we at Bronte Capital have so carefully (and cheaply) accumulated.

First lets see what the margin is for

Fannie and Freddie make their margin two ways -

1. By charging guarantee fees for mortgages that it guarantees, and

2. By holding mortgages and earning a spread.

The guarantee fee margins were a fifth of a percent of outstanding balances or less for as long as I remember. I always thought that those margins were insanely low – and indeed the very low margins for insuring credit risk is (in my opinion) the main reason why Fannie and Freddie were in long-term-trouble. Banking systems without enough profitability cannot survive bad times. I have blogged about that extensively – see here for a (controversial) example. Those guarantee fees are going up but by no means enough. It would not be unreasonable to charge 0.4 percent however under Conservatorship and even with an absence of competition fees have not risen to that level. In the absence of competition Fannie and Freddie should be able to raise guarantee fees sharply. They should too – otherwise the fees are not reflective of risk. However the fees have not risen by quite that much – and the only explanation I have is political interference. (Again you will need to wait for another post.)

However with a guarantee book of less than 3 trillion dollars guarantee fees – whilst important – are not the way in which this company recapitalises. Guarantee income was about 700 million last quarter. Not small change to anyone but Fannie and Freddie – but not enough to produce the profit stream necessary to cover forthcoming defaults and to repay the government. My guess is that the guarantee fees rise over time but only if the regulator allows them to rise.

The driver of high-pre-tax, pre-provision profitability is high interest rate spreads. They are high because of lack of competition. Interest margins are rising pretty well everywhere in banking – but not as intensely as at the GSEs. There is roughly 900 billion on the book. Making 1.2 percent on that – which does not seem unreasonable but is much higher than the traditional Fannie or Freddie margin will get you to solvency – however solvency for the GSEs emerges after say 7-8 years under this normalised income scenario. The current spreads are way higher than normal – unsustainably high. Those unsustainably high spreads might lead to very rapid recapitalisation.

Now obviously some of the excess spread is due to the steep yield curve. That will go away – but if the company were solely playing the yield curve the spread would be much higher than it currently is. Last I looked the spread between floating rate Fannie obligations and wholesale guaranteed mortgages was several hundred basis points.

The income is also inflated at the moment because charges that were taken as the companies went into conservatorship is being reversed through the net interest income line. I wish I knew how to quantify this. (I described this issue in Part II.)

Unfortunately at some point the trend in income will be down. When income goes down so does the ability to repay. Close observation of the margin between GSE treasuries, GSE debt and wholesale guaranteed mortgages indicates that the margin peaked a couple of weeks ago. Two-weeks of data is not convincing – but my guess is that pre-tax, pre-provision operating income will be about flat (maybe slightly down) in the third quarter and will trend down (perhaps slowly) from there.

Risk of being forced to shrink

The first and obvious risk is that the GSEs will simply – by government fiat – not be allowed to earn the spread. When the GSEs were put into conservatorship they were obliged to shrink their balance sheet fairly rapidly after the first two years. If Fannie or Freddie shrink their balance sheet they will shrink their spread income. If this is done rapidly enough they will never repay government. The requirement to shrink the balance sheet has been reduced dramatically – and is unlikely to be enforced in the absence of a robust private sector mortgage market. Obviously the reality (that these companies are by far the dominant mortgage providers at the moment) has sunk in. Shrinking them now would blow up a good part of the recovery. But I suspect that some politicians will want them to shrink. (Others will have different feelings – again the subject of a later post.)

When the Republicans (for example Spencer Bachus) want to force the issue on Fannie and Freddie right now, that is what they are suggesting. If you allow them to shrink they inevitably die – and they cost government when they do so. Indeed it appears that the Republican agenda was always to destroy these companies. I will discuss the politics in a later post. The politics is interesting – as in the Chinese curse. We live in interesting times…

The second risk to the GSE income is that somehow competition comes back into the mortgage market. I suspect that is a few years away. We only need to last a few years for the securities to be visibly money-good. Nonetheless I can’t imagine the spreads remaining this wide indefinitely.

The third risk is that Fannie or Freddie massively stuff up their interest rate hedging and fail to adequately hedge the mortgage refinance risk or the short term interest rate risk on their book. Fannie had a (relatively) minor hedging problem I think in 2002 in which they were short duration and interest rates moved against them by about 10 bps in one day. My count at the time was that they lost $8 billion. They could do that again. I have no way of estimating the chance of that – but I am relatively comfortable with the interest rate risk in the book at the moment. [Losing $8 billion in a day is relatively minor only when compared to the losses that Fannie has had on the credit cycle. Interest rate risk is part of these businesses.]

The commitment fee

At the end of this year the government has the right to charge Fannie and Freddie a commitment fee (mentioned in the quote above). The size of this fee has not been determined. This fee does not change the end loss to taxpayers but it may change the value of Fannie and Freddie’s preferred and common stock. An excessive fee could lead to a fifth amendment complaint by preference shareholders. However it is a real risk to this thesis.

Summary

I am a preferred shareholder and – as a shareholder in anything – nearly always worried about risk. But if I had to tell you what keeps me awake at night it is essentially political decisions crimping Fannie and Freddie’s ability to earn revenue. In particular they may not – by government fiat – be allowed to charge adequate guarantee fees. They may – by government fiat – have to shrink their book very radically thereby reducing spread income. They may – also by government fiat – be kept perpetually insolvent by way of the forthcoming commitment fee.

John

Post script

A note… I was a little more sloppy about the costs at Fannie and Freddie in Part VI than I should have been. Some accurate criticisms have been received as to how I broke up cost items. However I note that costs are seldom more than 12-15 percent of revenue at the GSEs. The GSEs are large wholesale institutions – buying bulk mortgages and doing finance in bulk. Costs do not matter much. What matters is revenue (this post) and credit losses (last post). When it comes to the 10Qs I have always read the cost section relatively fast as it is relatively unimportant.

The real risks to my thesis are on the revenue line and in the credit cost estimates.