Saturday, December 27, 2008

What does US debt imply about the future?

Here is a not so lovely plot showing the total US debt as a fraction of GDP from the early 1920s to the present.

Yves, at nakedcapitalism has a nice post on this here (the origin of the plot).

The debt is now roughly $54T with a rough breakdown household debt $14T, non-financial businesses $11T, state and local government, $2T and US federal government $10T, financial businesses $17T.

Another source of various charts and figures is
here .

One should keep in mind that it is not really the total amount of debt that matters but rather the carrying cost of that debt. For example, if interest rates are zero, then it doesn't really matter how much debt you have since your interest payments are practically negligible. Interest rates have been dropping steadily since the Volcker recession in the early 1980s and are now essentially at zero.

Now have have clearly reached one of those great turning points in economic history. What is to happen next?

Well, if the US were not the powerful economic and military superpower and holder of the reserve currency the outcome would be fairly obvious. We would suffer the same fate as Iceland or Argentina. Other countries would stop lending to us and refrain from investing in our country. Our currency would plummet and interest rates on our debt would sky rocket. Since a lot of our debt would be in other currencies, devaluing our currency would only alleviate our problem to a limited extent. We would go begging to the IMF for a bailout and would receive it only by accepting their terms which would include higher taxes and in effect a lower standard of living.

However, the US is not Iceland. The US debts are almost entirely in US dollars. The US dollar is also the reserve currency of most central banks. The US is not only the sole military superpower, it is the largest source of consumer demand in the world economy. If any central bank or ALL central banks decide to sell off their dollar denominated holdings and give up the US dollar as reserve currency, the dollar will drop and there will be major economic as well as political consequences.

  • Loss of competitiveness in exports as US exporters benefit

  • Loss in the value of US dollar reserves

  • Major restructuring costs as the world economy rebalances

  • US power decreases as it can no longer run large deficits

  • Power shifts eastward, the consequences of which are uncertain

The politicians of Asian countries (China in particular) might not be able to withstand a large loss of jobs in exports. For this reason they might not be too keen in allowing the dollar to weaken. This is not a question of whether it is better for them in the long run. It is a question of whether they can throw a lot of people out of work and still remain in office. The European's might not like the monetary situation which empowers the US but probably prefer it to one in which Asia hold more power. They after all share a common culture and are military allies. Likewise Japan and Saudi Arabia (among others) depend on the US military and so have reason to sustain the current situation. So it seems that it is unlikely that any drastic change in the US dollar as reserve currency will be precipitated from abroad. It doesn't appear to be in the best interests of these countries. Asia is too dependent on exports to the US and if Asia does not dump the dollar it is unlikely that anyone else will since that would just allow for a further loss in competitiveness to Asia.

But, one way or the other, the US needs to restructure its debt. Fortunately, there is a way. The Federal Reserve can simply print money and monetize the debt. It could if it wished, simply buy every outstanding loan and then restructure the loan any way it wished. It could simply forgive all the debt and in doing so reduce the debt to zero. This is of course the extreme case but there is nothing in principle stopping the Fed from devaluing the dollar and reducing the real value of this debt load. Some people have a knee jerk response that this is preposterous and would never work. They say, it would cause our foreign debt holders to immediately sell their Treasuries which would cause yields to spike. But this is incorrect. The Fed has unlimited amounts of dollars and could choose to buy every US treasury at 0% yield if they wished. This would effectively make Treasuries and dollars exactly equivalent. If our foreign debt holders wish to sell them, they would simply end up with dollars. They would have to spend those dollars in the US boosting US exports or buy US assets like stocks and real estate.

Now of course this is highly inflationary. The US money supply is roughly $10T. If the Fed converted $50T in debt to $50T in dollars, this would increase the money supply roughly by a factor of six. Every real asset would be about 6 times more expensive. That would be the cost of eliminating all of our debt. However, even in this extreme scenario, this is not really hyperinflation. A devaluation by a factor of six is roughly the same as was experienced in the US between 1960 and the present. It is not like Zimbabwe whose currency has an inflation rate (Dec 2008) of 516 quintillion percent (516 followed by 18 zeros).

Now, the Fed need not erase all of the debt. It would be enough to reduce household debt by $5T which would put the US household back to where it was in the late 90s. It could also do things like buy up all the credit card debt from the US banking system (there is about $2.6T) and refinance it at a fixed 5% interest rate. Keep in mind that the average interest rate on credit cards is about 17%. This would greatly reduce the interest payments for US consumers and keep the debt from growing too quickly. They may even be able to pay it off. It could also offer to buy any outstanding mortgages at face value (or some reasonable discount to that) and refinance them at a lower principal to reflect the lower home price. This would keep many of these people in their homes and repair the balance sheet of the American homeowner. It would also be a giant bailout for the US banking system. Businesses then would also want some kind of bailout. Where this stops is hard to know. The point is, that the Fed has almost unlimited power in terms of printing dollars and spending them wherever they want. If they lack certain powers, the congress can vote to give them new ones. But the US itself has the power to determine the real value of their debt since it is entirely in their own currency.

Foreigners can gripe out how we have duped them. They have traded real assets for pieces of paper and then we devalued those pieces of paper. But they can't simply blame us. They knew what they were getting into. They never expected us to act in any other way then what was in our own best interest. The situation is akin to a bank who makes loans to people unable to pay them back. They deserve to share the pain. There is really no other way. They may be harmed even more if the US does not prevent deflation from setting in. Deflation in the US will simply spread to every other country.

What will result from this however is that we will have to give up forever the idea that we operate under a capitalistic system. We will have to admit the role of the Federal Reserve as massive central planner. What looks like capitalism is really play-capitalism and when the play gets too rough, mommy comes in and breaks it up.

The result of all of this is likely to be a more balanced world economy. The world will be a lot more reluctant to lend money to the US. But the US will have less need to borrow since its debt load will be reduced. Perhaps the dollar will remain devalued and the US can export more and erase the trade deficit. Of course lots of things can go wrong. But one should keep in mind the tremendous power of the Federal Reserve in being able to create as many dollars as it wishes. The outcome will not be determined simply by economic factors. Political factors are at least as important for an economy with a fiat monetary system.

Would printing by the Fed be fair? Well, if your attitude is that anyone who borrows is morally obliged to pay it back then the answer is no. But the world isn't fair. Countries all act in their own best interest. That should not surprise anyone who is a realist. Paying back our debt in full value is not in the best interest of the United States and might not even be in the best interests of our debtors. Likewise, since bankruptcy is always an option, it benefits banks to restructure the loans to consumers so that they can service them. Obviously, some ways of restructuring the debt are more fair than others. It is uncertain how far the Fed would go or how far they would need to go.

So what are the investment implications? Well, the Fed probably won't be able to act too aggressively until the situation has worsened further. They need political cover in order to convince the US and foreign politicians that there is no other way. So stocks will likely fall further as earnings vanish. The weaker businesses will fail and other banks will be brought down. Panic is likely to rise as the world economy approaches the brink of complete meltdown. The near term outlook then is for deflation. At some point however there will be no more deflation plays. Yields on treasuries will have approached zero. Stocks will have fallen to extremely low valuations. Bonds will be in a bubble. At this point, the Fed will act aggressively to reflate the economy. So stocks will be a good bet here and also commodities. Gold should do well as there will be great uncertainty of the future monetary system and the dollar is likely to end up devalued. Stocks that may do the best are those with low debt and plenty of foreign currency exposure. In particular, ones with less exposure to bad, or at least uncertain, economic conditions. JNJ, CL, KO come to mind. Times of economic and political turmoil will likely be good for the consulting agency ACN. Energy companies should do fairly well though probably less well than the past few years. I will revisit this in more detail in the future.

Tuesday, October 7, 2008

Nikkei back to 1984 prices

The 1980s were an incredible decade for Japan. From 1984 to 1990 the Nikkei rose fourfold from 10000 to 40000. Today it is at 9444. It has gone up and down and 24 years later it is right back where it started. Pretty depressing. Is it time to look at some Japanese stocks?

Over the same time the Dow went from about 1100, peaked around 14,000 and is now about 9447. The Dow and Nikkei are almost exactly at the same level. But in the case of the Dow it is up by a factor of 8.6.

Sunday, October 5, 2008

Notes on valuation of AIG

This post is to collect various notes on valuing AIG.

This story attempts to estimate a break-up value for AIG.

"CreditSights estimates that the company's general insurance business is worth $95.2 billion, its life insurance and retirement services business is worth $147.7 billion, its financial services business, including its aircraft leasing unit, is worth $9 billion and its asset management operations are worth $3.6 billion, said Haines. That valuation, which assumes limited stress in the financing markets, comes to a total of $255.5 billion."

That works out to $19/share after the 80% dilution. That seems much higher than any other estimate. I am also not sure of they are including the mark-to-market losses. Probably not. If we take out another say $30B for CDS losses, that would still be $16/share. The book value as of last 10-Q was $5.80/share including the dilution.

Recently (after the bailout) Bill Ackman, the hedge fund manager of the Pershing Square, bought AIG. I think he paid around $3.50. He
book value to be around $6. This estimate takes into account the mark-to-market losses and the 80% government dilution. He also thinks there is a chance that some of the dilution can be reversed if AIG pays the loan back very soon. I agree.

The real valuation of AIG would have to include the following:

1) Figure out what they are going to sell and what they will get for it and how long it will take them to pay off the loan. Also consider the interest on this toxic loan.

2) Figure out what the real losses will be on the CDSs. Also consider the fact that the mark-to-market losses could get worse. They could also reverse if the TARP bailout moves these MBS priced higher. This will have some effect on liquidity and might effect how much of the company they have to sell.

3) Then figure out the earnings and earnings growth of whatever is left over and model it in the usual way with a DCF.

4) Estimate the actual dilution that the government will demand. Will they take the full 80% or something less.

5) Think of anything else that could go wrong.

################# UPDATE ###############

They are reworking the deal. This info comes from the Wall Street Journal.

Lets go over the details. They are scrapping the original deal. Now the are giving AIG a 5-year loan for $60B at LIBOR plus 3% which comes to about 6% given that LIBOR is about 3%. That is much better than the original 14% loan. They are also giving them $40B in preferred stock with 10% dividend yield. Not sure if it is cumulative. In addition they are injecting $50B in common capital. The government still will keep a 79.9% equity stake. I assume that means common equity but I am not sure.

First of all this is pretty good so far. Instead of paying 14% on $85B or $11.9B pretax per year, they will pay $3.6B pretax in loan interest and $4B aftertax for preferred dividend. At 40% tax rates that saves them about $1B per year after tax. Not a big difference but it helps. The real advantage is that this increases total capital by $90B which will greatly improve the capitalization of AIG and should raise their credit rating. Also it increases common capital by $50B. So instead of giving away 79.9% of the company in exchange for just a loan, common shareholders get $50B common capital in return. This seems a lot more fair to me. At least it is better than before. Now they will have to sell roughly $40B worth of assets over the next 5 years to pay back the loan. That is only half of the $85B in asset sales that was required by the first deal. Plus, they get 3 extra years in which to get it done.

Then the story gets a bit more complicated. The government is setting up one "vehicle" to handle AIG's CDSs on CDOs and another to handle the securities lending business. The first one will be capitalized with $30B from the government and $5B from AIG. That would take on the $70B CDS porfolio on the CDOs. As of last credit presentation, they has $57.8B net exposure to multi-sector CDOs including subprime and $22.5B in multi-sector CDOs without subprime for a total of $80.3B. This may have shrank down the $70B quoted in the journal. It is not clear if this capital is in addition to the other capital injected into AIG. I think almost certainly not. So this would be setting aside $30B out of the total $90B in new capital and $5B of current AIG capital. In addition it says that AIG (or presumably this new vehicle) will attempt to buy the insured CDOs from their counterparties for 50 cents on the dollar so that it can tear up the CDS contracts. The notional exposure (before AIG's subordination) was $112.6B as of last presentation. So 50 cents on the dollar would be $56.3B. If it buys the CDOs back, it gets the collateral back that it had to post.

I can't say I understand this bit. There are 112 different transactions. What makes them think that the counter parties want to take a 50% hit on these if they can make AIG pay anything over the subordination level. AIG's average subordination on the CDSs including subprime is 23.9%. The subordination on CDSs without subprime is 16.3%. So if we just take the ones with subprime, those counterparties can only take a 23.9% hit before AIG covers them. So why sell it back to AIG for a 50% hit? Is it because they don't think AIG could actually pay them off? Perhaps it has more to do with asset reduction. This is confusing.

The other vehicle would be set up to handle the problems in the securities lending facility. AIG lent out securities to short sellers and took in collateral. It used this collateral to buy mortgage backed securities collateralized by subprime loans. Pretty dumb move. When the short sellers closed their shorts (presumably because of the short selling ban and/or deleveraging), they wanted their money back and AIG couldn't sell the RMBSs. So they borrowed money from the Fed to pay back the shorts. The new vehicle would take $20B from the government and $1B from AIG and buy the illiquid RMBSs from AIG at 50 cents on the dollar. So does that mean that AIG will realize a $21B loss on those or is some of that money simply for liquidity?

So the first part of this is good news. The second part concerning these two vehicles is confusing. It sounds like this will improve AIG's liquidity, solve the securities lending problem and protect them from future CDS losses. But what is the cost to AIG? It isn't clear to me what this unwind will cost them. They have already written down about $30B to cover these losses. Will this result in losses above that?

Lets do a rough calculation. Lets say that this unwind results in a $50B total loss. That is $20B on top of what was already written down. Last 10-Q showed $78B in equity. So after the unwind that would be $20B pretax and maybe $12B after tax so that would make equity $66B before the equity infusion. They added $90B but appear to putting $35B on this into the first vehicle. So that leaves $55B of equity left in AIG. Total equity is now $121B including the $40B preferred stock leaving $81B in common equity. Original shareholders own only 20% of that which is $16.2B. There are 2.7 billion original shares so book value per share would be $6/share.

If this is correct (a big if), the stock should be worth at least book value and so should go roughly to $6/share but probably not right away. If the break up value by CreditSights is correct, then it should be worth even more.

A worst case scenario might look like this. Assume the $70B in CDSs are completely worthless and are written off entirely. This is $40B in additional write-downs pretax and $24B after tax. Even this leaves book value per share at $5.11/share. Seem like the stock is a good investment at less than $3/share. I expect it will trade above $3 tomorrow morning.

There are other stories out now saying that if the securities purchased at 50 cents on the dollar result in profits, the government will share them with AIG but keep 2/3 of them. This adds a little more value to AIG.

Time for America to refinance their debt

Why should the US go on a borrow and spending spree?

The US consumer is in debt in a major way. The typical american has a mortgage at say 6% interest. Most have credit card debt at say 14%. Many have a home equity loan at 9%. I don't know the weighted average interest being paid but it is probably about 10%. So why don't we all just refinance? The government can borrow at 4% and send us all a "stimulus package" to pay down their higher interest debt. Sounds good to me. This is a kind of arbitrage of refinancing. It works as long as people are willing to buy treasuries at these low rates.

This is actually not a bad idea. After all, the stimulus package can be structured to give fixed amounts to American middle class families. The bill that gets stuck with the taxpayers gets payed in the normal progressive fashion. That is, rich people pay more of it. So this acts to redistribute wealth from the rich to the middle class which is exactly what is needed. This is inevitable anyway if the economy is to survive. The only other option is mass bankruptcy which effectively does the same wealth redistribution. If someone who is underwater by $100K declares bankruptcy, he becomes richer by $100K and his creditor becomes poorer by the same amount. If we use tax policy or inflation to reduce their debt load we can fine tune the wealth redistribution more gradually.

Monday, September 29, 2008

The dollar must die

What is the inevitable conclusion to this world financial crisis?

1) The US dollar must drop but it will drop slowly over the next decade or so. It will not be caused by a sell off in Asia.
2) This will increase US exports and decrease the US trade deficit.
3) This will slow global growth and so most commodity prices will not increase much in dollar term despite the dollars weakness.
4) US nominal wages will rise and US denominated debts will shrink in real terms.
5) Gold should increase in dollar terms as it becomes a more stable source of money.
6) China will suffer as it needs to decrease exports and increase consumer spending as a percent of GDP.
7) US treasury yields will increase but not very much. The Federal reserve will absorb more and more treasuries and allow the dollar to weaken as it needs to do.
8) A long period of slow growth and poor returns to capital will prevail.
9) The best sectors will be US exports with foreign currency exposure and recession resistant business models, healthcare companies should do the best, JNJ, PFE, MDT etc.
10) US military spending will decrease. US will rely more on its allies for security.

Saturday, September 27, 2008

The wrong-headed media coverage of AIG

The media has been writing all kinds of garbage about the fall of AIG. The general themes are that 1) AIG didn't know how to handle risk. 2) They should not have stepped outside of their familiar territory, insurance, and ventured into credit derivatives and 3) They were brought down by massive CDS losses related to mortgages.

Lets start with the first one that AIG does not know how to handle risk. These CDS derivatives that everyone is blaming for the collapse in not what brought them down. They have experienced very little actual losses on these instruments. What brought AIG down was the confluence of mark-to-market accounting with overly aggressive credit rating agencies combined with a panicked credit market leading to a liquidity crisis. I will get back to this later.

Now on to the second one, that AIG should not have ventured into the market for these credit default swap, CDSs, that were the specialty of investment banks like Goldman Sachs. People say, they should have stuck with what they know, insurance. The reason this is absurd is that CDS ARE insurance contracts. The opposite conclusion should be reached that ONLY insurance companies should be writing these instruments NOT banks. CDS are contracts where the writer agrees to make a payout when some event of default occurs. This is no different from when an insurance company agrees to make a payout when a fire occurs. They just need to estimate the chance of such an event and be sure that they are adequately capitalized to handle the losses. In fact, Eric Dinallo, the New York, Superintendent of Insurance is now pushing for CDSs to be classified as insurance and demanding that anyone writing such contracts get an insurance license.

Now let me explain why CDS losses did not bring down AIG.

AIG had $441B worth of CDSs as of last quarter, June 30, 2008. $307B (3/4 of the portfolio) of these are "regulatory capital" related. These are not risky by any means. In short AIG agreed to accept some of the risk of bank loans in order to allow banks (about half of them European banks) more room to lend until the new Basel II regulatory capital changes go into effect in about a year. Generally speaking, AIG will start to suffer losses on this portfolio when loss rates on these loan portfolios hit 23%. This is for bank loan portfolios. Since banks are generally leveraged about 10 to 1, a 10% loss on a portfolio are usually fatal for banks. Losses like this generally only happen during major depressions like the Asian financial crisis or the Great Depression and have never happened all over the world at the same time. Losses as large as 23% are that much rarer. It has never happened and short of nuclear armageddon, never will. Losses to date on this $307B regulatory capital portfolio is $125 million or 0.04% of the portfolio. To put this in perspective, AIG makes about $10B/year from insurance and probably more than a billion dollars from the premiums on these very contracts.

So that takes care of 3/4 of their CDS portfolio. There are three other parts of this CDS portfolio that I will discuss, corporate credits, CDOs with subprime and CDOs without subprime.

CDSs on corporate credits of which they have $54B of exposure. These are CDSs which will pay out in case certain companies go bankrupt. Losses to date have been about $1B or less than 2% of the exposure, which is about the same as losses experienced on a typical corporate bond portfolio. This can easily be made up by having yields 2% higher than risk-free treasuries. So far these have likely been very profitable just like the regulatory capital related CDSs discussed above.

Then there is the CDSs on the multi-sector CDOs which can be broke up into subprime related and not subprime related. The exposure of the part not related to subprime is $22B. The "losses" to date have been $3.5B. The CDSs related to subprime have an exposure of $57B with "losses" to date of $21B.

Now I will discuss these "losses" and explain why I put this in quotes. One needs to understand a bit about how these losses are calculated. I will also explain a bit about how these CDSs work. The CDSs are insurance contracts against defaults in things called CDOs. The CDOs are the instruments which receives the cash flows from underlying mortgage backed securities which are pools of mortgages. I won't go into the details here but the key thing to understand is this. If the CDOs start producing losses then the writer of the CDS, that is AIG, has to pay the CDO holder the cash that was not received. So far, hardly any of these CDOs have defaulted. That has to do with the fact that these are "super-senior" CDO tranches. This means basically that there are other less senior tranches that need to be wiped out completely before they lose any money at all. That is the issue of subordination. It is like being in the 10th row of the British army. If you get attacked, the people in front of you will get the bullets and you won't get shot at until all of them are dead. It affords protection.

So if the CDOs have not defaulted, then why do they have "losses". This is due to so called mark-to-market accounting. Basically this is because the CDOs are marketable. Parties occasionally, but rarely, sell them. The accounting rule FAS 157 requires that the CDOs be marked to the market prices. The CDS writer needs to assume that these prices are correct in predicting what the losses will be in the future. So regardless of what the losses actually will be, the CDS writer can be brought down simply by the market panicking and selling off these CDOs which is exactly what happened to AIG. So the trouble is not really that AIG underestimated the risk of losses on these instruments. It is that they did not foresee the effect of market panic of the value of their insurance contracts because usually this has no bearing. For example, if there is a major hurricane like Katrina, people often and irrationally get more risk averse to hurricanes. They think that maybe global warming will result in more dangerous and more frequent hurricanes. This may be true but the event of a hurricane does not change the truth of it.
If insurance contacts traded on the market, you would find that they would increase in value and that the writers would experience large losses. But they don't trade on the market and insurers do not account for hurricane insurance contracts in this way. Insurance companies are allows to estimate their own losses and keep reserves for what they think they will be. This has been the way insurers have accounted for losses as long as there has been insurance and accounting. So far, it has worked pretty well as long as they are regulated by insurance commissions.

If CDSs were only written by insurers, they would likely be accounted for in the same way. If they were accounted for like insurance contracts then AIG would not have taken large losses, not yet anyway. AIG has estimates that their losses from CDSs related to subprime loans would be less than $8B even in extreme circumstances. They have been forced to mark down $25B due to the market panic and sell off in CDOs. I won't even get into all of the facts that explain why AIG's losses will be much smaller than people think.

What happened to AIG was this. Due to mark-to-market accounting, they have to write down their CDS portfolio to unrealistic levels. Because of this, they had to raise capital to avoid credit rating downgrades from companies like Moody's and Standard and Poor's and Fitch. These companies being accountants cared only about the numbers and the rules and not the reality of the situation. Credit rating downgrades would force AIG to come up with cash collateral to give to those holding the CDS contracts, mostly New York investment banks like Goldman Sachs and Morgan Stanley. The credit ratings agencies realized that AIG might not be able to raise the cash to do this. Because of this, they saw this as a major business risk. A downgrade and a collateral call would cause a default which would cause a bankruptcy event at AIG. Because of this new risk, they felt AIG needed to be downgraded anyway. It was a catch-22 of sorts. If they were vulnerable to a liquidity run, then they were not deserving of their current rating. Because of this the downgrade the liquidity run was assured. So the credit agencies gave AIG a short amount of time to find the cash. Once the markets became aware of AIG's situation, AIG because radioactive. No one would be first to put in any cash if they were not sure that others would join in. If you put in cash and it wasn't enough, then your money might get locked up in bankruptcy and you might not even get it back. So the liquidity run began on AIG. S&P gave AIG just three days to sell off some of their subsidiaries to raise the cash to avoid a downgrade. AIG was not able to do this in time and as a last resort went to the Federal reserve. The rest is history as the Fed seized 79.9% of the common shares in return for a high interest collateralized loan. Such was the fate of AIG.

So in summary, the media is reporting all kinds of non-sense about AIGs fall. The reality is that AIG did not anticipate the difference that mark-to-market accounting would have on their CDS insurance contracts as opposed to their typical insurance contracts. They did not underestimate the risk of losses. They underestimated how a market panic could create fictitious losses that would have real effects, ultimately fatal ones, on their business.

Friday, September 26, 2008

AIG, is there any hope?

The credit agreement on AIG's toxic government loan is now out . It is spelled out clearly that the treasury is going to own and control 79.9% of the company. I don't see any way around this. So must we give up our last bit of hope that this massive dilution can be undone?

Let us quote Lady Galadriel from Tolkiens's "The Lord of the Rings".

"Even now there is hope left... But this I will say to you: your quest stands upon the edge of a knife. Stray but a little and it will fail, to the ruin of all. Yet hope remains while all the company is true."

There are a few options left. These are 1) The practical option 2) The political option 3) The legal option

The practical option: a capital injection.

The first of these options is that the shareholders can still try to find an alternative source of capital to inject into the company. If they are able to find say $100B of capital (say from Sovereign Wealth Funds) they might try to buy out the company. Obviously, if they are going to do this, they will need the government to take back their loan money, and give back their 79.9% equity position. So they need to have enough capital so that the government has no worries that AIG will need further cash. Now you need to think of the Fed and Treasury's incentives. They don't really want to be lending AIG money, nor do they want ownership of an insurance company. I think they will feel that the taxpayers would rather get AIG off the government books since this will be the minimum risk position for taxpayers. Taxpayers don't want a high risk, high return opportunity. That is not what the Treasury is for. I think if the shareholders can find such a group willing to invest such a large sum of money, the deal will probably happen. However, I think the chance of this happening is no better than 5%. Even if it does happen, the current shareholders are not likely to get more than 30% of the company. So this is not much better than the current situation. The chance of us getting 100% of the company back through this kind of deal is basically zero.

The political option.

There is a chance that the powerful shareholders of AIG can exert pressure on politicians to act to reverse some of this deal. Remember the Treasury is subservient to Congress and the President. If it turns out that AIG's losses on CDSs are minimal and that we find that its demise was caused by some conspiracy of hedge funds attacking the stock and CDS market to create a panic, there might be some sympathy for AIG shareholders. It would seem somewhat unfair, I think, if AIG comes out of this with massive dilution and other companies like Goldman get saved by some kind of bailout. This might seem kind of arbitrary and there is a chance that politicians will act to correct some of the things that were done. Perhaps they would reduce the government stake from 79.9% to 50%. Again, I think the chances are small, maybe 3% that this will happens.

The legal option
This might be our best option since there are so many ways to go about it. Clearly the shareholders are going to sue a lot of people, the management, the BOD, the Fed, the government, etc. They might even be able to sue certain hedge funds for manipulating the stock. Who knows how this could turn out? I think it is very likely that they will win some judgements. How much this will produce for shareholders is hard to say. The chance of getting the credit agreement pronounced invalid is probably very small but could be maybe 2%.

Overall, I would say there is still maybe a 10% chance of some kind of upside coming out of the various possible ways to undo some (probably not all) of the dilution. This should be factored into the price of the AIG stock. However the most likely situation is that the dilution will stick. So one needs to try to value the company as it is and then divide by 5 to come up with a price for the diluted common stock.

I won't go into detail here abut this. It depends on many things. If this bailout goes through where the government buys up illiquid MBSs, then the CDS marks that we have now will probably reverse. We will end up paying out some cash losses on the CDSs but they may be smaller than it would be if the government stayed out of the housing market completely.

I think it is fairly conservative to say that the CDS and MBS losses will be less than $30B. That is only another $5B mark from last Q which leaves total tangible equity around $60B or $4.40/share. However this is probably not the right way to value AIG. People have estimated the breakup value of AIG from $150B-$180B. Lets use $130B due to the loss of brand value from all of this and the illiquid marketplace. Lets take off another $30B for mortgage related losses and another $10B for interest payments on their toxic government loan. So leaves about $90B or $6.60 per diluted share.

The current price is about $3 and so it seems relatively attractive. However there are still risks to this. How valuable is AIG as a company controlled by the government? How much damage will be done to the brand? Will a credit crunch result in mostly fire-sale prices for their subsidiary assets? Are the CDS losses really greater than we think? All of these worries should keep the price of AIG well below the "rational" value of the company for some time. I think what really needs to be done is that these CDS contracts get unwound. But what price will AIG have to pay to do this? Does the government have the incentive to act in the interests of shareholders or will they act more in the interests of the financial system as a whole? That is a scary question.

Given all of these uncertainties, the stock looks fairly priced at $3.

Wednesday, September 24, 2008

The Rape of AIG: Open Letter to Mr. Paulson

To Mr. Henry Paulson, Treasurer of the United States,

A few days ago, the nation's largest insurance company, AIG, came to New York Fed and said, "We need help. We are having a liquidity crisis. If we are not given a loan, we are going to default on our collateral calls to Goldman Sachs, Morgan Stanley and other investment banks and declare bankruptcy". The company and the Fed knew that this would be the fatal blow to Wall Street and, in fact, the world financial system. If AIG had chosen to file for Chapter 11 bankruptcy (reorganization not liquidation), their $400B+ in credit default swaps (CDSs), a guarantee of sorts, would have been declared not-secure. The counter-parties to these would then have to mark these instruments down as the guarantee would no longer have firm backing. Three quarters of this CDS portfolio was for "regulatory capital relief" for banks all over the world; half of it from European banks. These banks offloaded much of the risk on their own loans to AIG so they could grow their asset base faster than their capital base while waiting for the new Basel II capital accords which will allow for higher leverage ratios. These banks would instantly be undercapitalized and unable to loan.

But even more pressing would be the crisis that would hit Goldman Sachs. Goldman has survived, unlike Bear Stearns and Lehman Brothers, because they have effectively hedged their exposure to subprime lending by buying this insurance from AIG. Many people, including myself, Ben Bernanke and yourself have claimed that the "fire-sale" prices for mortgage backed securities is not indicative of the true value of these securities. However it is these "fire-sale" prices, combined with mark-to-market accounting that have damaged the balance sheet of companies like AIG and the investment banks. The difference, however, between AIG and Goldman is that Goldman has been able to hedge its exposure. That is, it's mortgage backed securities may have been marked DOWN to unrealistic levels but its CDSs with AIG have been marked UP to unrealistic levels. In other words AIGs pain has been Goldman's gain. If AIG had instead chose the protection of Chapter 11 bankruptcy, then Goldman would be instantly insolvent and the last two of the New York Bulge Bracket firms would have failed.

What did AIG get in return for agreeing to the Fed's offer of a loan and saving Wall Street and the world financial system? It got 80% of its equity stolen and handed to the Fed. AIG did not have a solvency problem. They had a liquidity problem. AIG's breakup or liquidation value has been estimates at $180B after paying off its liabilities. That would have corresponded to roughly $66/share. Maybe we would have only received half of that, $33/share, in a bankruptcy auction and restructuring. Instead our shares trade at $4/share now that the government owns 80% of the company and effectively controls it. Whose interest was it really to enter into this deal?

Lets compare this to the way Goldman Sachs, the company you led as CEO from 1998 to 2006, was treated when they ran into a liquidity crisis earlier in the year. Goldman along with the other investment banks normally raise their funds through commercial paper and relatively short terms bonds. That is because, despite the names, they are not banks. They do not pay FDIC insurance premiums, cannot raise deposits and do not normally have access to the Fed's discount window. They are regulated by the SEC not the Fed, FDIC or OTS that regulate real banks. In fact, they are no more real banks than the subprime mortgage lenders who went bankrupt from a liquidity run earlier in the year. These, you might recall, were thrown to the wolves by the investment banks when the IBs decided that the business model would no longer be profitable. "Well, that's capitalism!", I guess you can say. No one ever promised them a guaranteed line of credit. I guess it was their fault for not securing longer term lines of credit.

So when Goldman Sachs and the other IBs (with 30-40 times leverage) discovered that the commercial paper market was effectively shut off for them, what might one expect to happen to them? Bankruptcy? Perhaps the Fed, to protect the financial system from freezing up would give them a toxic loan, like AIGs, at 11% and take 80% of their equity? Is that what happened? No. Instead the Fed and treasury made unprecedented changes to the entire Federal Reserve System in order to accommodate these companies. They created the Primary Dealer Credit Facility (PDCF) so that the IBs could borrow funds at the discount rate 2.25% (lower than the commercial paper rate they were issuing before) against "good collateral". Eventually the "good" part was removed and any collateral was OK, even common stocks. Then they were given access to the discount window. Then, the Term Auction Facility was created where you just auctioned off money at rates not far above the discount rate to these "banks". because the "banks" said that going to the discount window created a stigma for these "banks".

So instead of punishing these companies for their greed, poor management and investing mistakes, you did everything in your power to bail them out. Despite the fact that they are not real banks you let them borrow directly from the Fed at lower rates than real banks (who pay into the FDIC) can get on their certificate of deposits. When Bear Stearns and Lehman brothers actually became "insolvent" (and who can tell anyway at 40 times leverage), they were allowed to fail but not Goldman and Morgan Stanley. They just had a liquidity crisis. They are solvent and so deserve your protection, right? And AIG? You claimed that because they are just an insurance company, they don't deserve the same protection. After all, they don't pay into the FDIC. They might look like a bank, but they are not really a bank. So you gave them a toxic loan and took 80% of their equity so that they would not declare bankruptcy and destroy the remaining members of the Wall Street money club. You derisively called AIG a "hedge fund on top of an insurance company". Well what is Goldman? It is a giant hedge fund on top of nothing and has four times the leverage of AIG. The difference in treatment between AIG and Goldman is no doubt due to your giant conflict of interest as a Goldman lifer and former CEO and now the secretary of the treasury.

Now you ask for a $700B bailout from the taxpayers so that Goldman can dump mortgage assets worth maybe five times their equity at "hold-to-maturity" (read: wishful thinking) prices. I think the tax payers are going to want a few terms with that. How about 80% equity in Goldman Sachs and Morgan Stanley. They have been already been bailed once by completely restructuring the Federal Reserve System. Then they were bailout out again by convincing AIG to avoid bankruptcy. Now you want another $700B handout? Not without 80% of Goldman. If you don't like those terms, well, that is what bankruptcy protection is for.

David Johnston
An AIG shareholder and a taxpayer

Friday, September 19, 2008

AIGs bailout and what it means for investors

As an AIG shareholder, I was shocked an dismayed at the crisis at AIG and bailout from the Fed. Now I sit here with an enormous loss on my hands and an AIG stock worth only $2. So what to do now? Sell or hold? How much is this ghost of AIG worth?

I have no idea nor does anyone else. The reason why is that there has been no clarification of what really happened and what this deal with the Federal Reserve really entails. Nor do we know what really caused the liquidity crisis and whether the bailout has helped or hurt their cash problems. AIG is now a laughing stock and people appear to be pulling their money out as fast as they can.

So let me try a few scenarios to try at a valuation. First the simplest one. Before the liquidity crisis, I had estimated the stock to be worth about $40/share. So if the shareholders get to keep only 20% then the stock should be worth about $8. Of course everything has changed. AIGs reputation has been severely damaged. They may still face a liquidity problem. On the flip side, they may be liquidating a lot of their subsidiaries and so the AIG reputation may not matter as much. Also the break up value of AIG may be even higher than my estimated fair value. People have estimated the break value at $150B. Others say $180B. There are $2.7B shares so that is $11/share even with the 80% dilution, using $150B for the total. Of course all of this depends on the final losses from the CDS portfolio. Still, I have estimated these to be less than $20B. Certainly not $100B that would be required to come up with the current price.

So even with the 80% dilution, there is a chance that the company is worth substantially more.

However the real reason that people might consider investing in this cigarette butt of a stock is that this deal with the NY Fed may not stand. If AIG can liquidate assets quickly or find the money somewhere else, they may be able to get back that 80% equity stake.

Before I discuss how this is possible, let me comment on the deal. We don't really know the facts since there is no term sheet or anything in the public domain. From press releases from the Fed and AIG we know that the loan is 8% above LIBOR and has a 2-year term. There are some loan covenants but they are not disclosed other than that the Fed reserves the right to prevent dividends to shareholders. There is also some vaguely worded mention that the taxpayers will get "up to" a 79.9% equity stake. There was an 8-k from AIG saying that they issues a warrant to the Fed and that this required a shareholder vote. Then another 8-k came out to correct this and simply said that shareholder action would depend on the form of the equity. In other words it is not clear at all and the deal is likely still being formed.

There has been some
from corporate lawyers on whether any of this is legal. It is possible that the Fed will screw it up and create an illegal contract which can be thrown out in court later on. There isn't exactly a lot of precedence on this kind of thing.

There is talk that some major shareholders led by Hank Greenberg are trying to come up with an alternative plan. Greenberg mentioned on the Charlie Rose Show that they could raise capital in various ways: from sovereign wealth funds, from selling assets, from current shareholders etc.

So lets looks at this and try to game how it is likely to work.

First of all lets look at the incentives of shareholders. Anyone holding AIG shares likely believes that the CDS losses are manageable. If not, they would probably not still be holding shares. So they likely believe that the company is worth at least $60B and so losing 80% to the government would be a major and avoidable loss. They would likely want to do everything they can to undo this deal including investing more of their own capital.

Same with SWFs and other PE investors. They likely see the value in AIG as long as they can provide the needed liquidity. With a recession looming and the $700B federal bailout coming, an insurance company with 60% of sales overseas looks like a great place to invest long term.

The main thing to look at is the incentives of the NY Fed and the US government. This is much harder to figure out.

They clearly didn't want to give this loan. If someone else could come in and take over they might be happy about it. However, they need to be sure that this party provides enough liquidity so that failure is not possible. That is because they don't ever want to be in this same situation again. So this might require something like $150B. It needs to be an overwhelming amount of money so that AIGs credit worthiness is completely secured.

There is the issue of the warrant (if it exists). Naturally the Fed does not want to give up an asset that may be worth $50-80B. An assets is an asset after all and nobody gives them up for nothing in return. However this asset might be more trouble than it is worth. There could be all kinds of legal action on the part of AIG shareholders. There is the issue of liability. A warrant does not usually mean ownership however the marketplace is not likely to see it this way. As long as the Fed has this loan outstanding and the warrant in place, the world will expect the Fed to keep AIG functioning.

There is the issue of making an example of AIG. People (i.e. taxpayers and homeowners) are mad and want blood. It looks good for Paulson to say that he was hard nosed with AIG just like he was with Lehman and FNM and FRE. However there are problems with this as well. A couple of days after AIG they announced the mother of all bailouts. Coincidentally, this was when the fires had reached the gates of Goldman Sachs where Paulson was CEO. That doesn't exactly look hard nosed. It looks rather self serving and inconsistent. Why is it OK to save Wamu, Goldman, Morgan Stanley and others but take 80% of AIG? AIG is actually the only one of these that is probably solvent. Their problem was liquidity not solvency. If they were a small company they likely would have gone into Chapter 11 until they could obtain financing and come out unharmed. Avoiding Chapter 11 likely had more to do with systemic issues.

If the party led by Greenberg can present an alternative plan that gets some or all of this equity back, then Paulson and company might go for it. It would relieve the government of the problem and might help them in a couple of ways. It would show the world that private capital still exists and is still willing to invest in US companies. It would likely be good PR for Paulson as it would be a step away from the socialist tactics that they have been forced to apply. Although the loan to AIG probably has no real risk (since it is a senior loan with a company that has a trillion in assets), the public probably doesn't understand this.

If the Fed refuses to give up their equity stake, can AIG shareholders play hardball? Perhaps. Remember that the executives at AIG are also large shareholders. What if they all threaten to quit? What would happen to AIG then? They may figure that they have lost 90% of their value now. What is another 10%? I think that if they acted with solidarity, they could exert enormous pressure on the government. How could the Fed run AIG if everyone knowledgeable quit and refused to give them any information. They could also threaten to refuse the loan and take the company into Chapter 11. It is possible that they can get foreign governments to put pressure on the US government. Do foreign leaders want AIG controlled by the NY Fed? I doubt it. How powerful is Greenberg really? He used to be the worlds most powerful businessman. Does he still have this kind of power? Is he as shrewd as he used to be? I am betting that Greenberg will play hardball if needed.

So overall, I think there are many reasons to be hopeful that the AIG stock will recover. It is far from a certainty but even with a 20% chance of success, this adds enough speculative value to the stock to make it worth far higher than $4 where it is trading now.

New valuation

Ok, so lets assume that the government gives in and lets this group of investors replace the loan with capital. What kind of deal might be expected from new investors? Well, probably not a very good deal. Lets do a new valuation assuming this deal happens.

First we need to value the company as is. The equity of the company as of last Q was $78B. The real equity is probably somewhat higher. Lets just say $80B as a round number. There are 2.7B common shares. The normalized earnings for AIGs core company is about $4/share or $11B/year after ignoring the financial products group fluctuations. That is a ROE of 13.5% which is about average for the company (using $80B for equity).

Such a company is generally worth about 1.5 book value. That is about $120B. Valuing it on 9 x earnings would put it at $97B. A DCF would be much higher since the interest rates (i.e. discount rate) is so small. Lets say it is valued somewhere between these as $100B. This of course assumes that they become essentially an insurance company again with plenty of capital. Lets call this valuation V so we can some up with a formula.

So lets say the investors want to put in C=$60B of new capital. Then it would be worth about V+C=$160B. Let say they demand some haircut, H, on the value. Perhaps they will pay only H=60% of the value of the total company. This determines the percentage of the company that they get to own, P. The present owners get to keep 1-P. The haircut is given by

H= C/((C+V)*P) and so P=C/((C+V)*H). Using H=60% and C=$60B and V=$100B, this is P=62.5%. Current shareholder would keep 37.5%.

That would mean that our share of the company should be worth $160B*0.375=$60B or $22/share.

The full formula for the value of the share price is given by

PPS = (1-C/((C+V)*H))*(C+V)/2.7 = [V+ (1-1/H)*C]/2.7
where C and V are expressed in billions of dollars.

A more extreme case would be a that they only pay H=40% for the value they get back. What a deal! That would be PPS=$3.70/share. That is below the current price. This shows how sensitive the PPS formula is to H. You can see that P=1 when H=C/(C+V). So current shareholders have no incentive to do this deal when H is greater than or equal to this.

Probably the most likely haircut would be H=50% which gives PPS=$14.8. This would be a great deal for the new investors and still a pretty good deal for the current investors given that the current share price is about $4.

The alternative to this would be just leaving the deal with the government as is. In that case the shares might be worth $8 or so depending on how the deal goes. That value should be considered a floor for the stock. Assuming that the government deal has a 80% probability of sticking and therefore the buyout deal has a 20% chance of going through, I come up with a weighted average PPS of $9.36. That is about twice the current share price which not coincidentally is about the same haircut demanded for the new investors. It may take a couple of years to reach this price since the company may see a lot of trouble in the year ahead.

Other info about the governments stake (both positive and negative)

First the good news. There has been lots of contradictory information on the form of the governments stake. Reading between the lines and interpreting all of this leads me to conclude that the 79.9% equity stake is a worst case scenario, not the most likely scenario. They might not yet even have the deal completed. I think they have structured this so that the company has the incentive to raise capital, sell assets and pay off the loan as quickly as possible. For example the WSJ mentioned that the form is an equity participation note . Today the new CEO said on CNBC that the government has convertible preferred shares. Obviously, I have no idea. But the CEO also said that IF they can't pay off the loan, the government will get 79.9%. So I don't know what to think but it appears that the 79.9% stake is a threat and not a certainty.

There is however something I am quite afraid of. There is the possibility that Paulson and company will decide to use AIG as the sacrificial lamb. Paulson is after all the former CEO of Goldman Sachs. Goldman is probably the biggest counterparty to AIG's CDS contracts. The New York Times has just reported on this meeting of shareholders today to discuss an alternative to the Fed's plan. Here is a quote:

"One person involved in the planning, who spoke on condition he not be identified, said that in the worst case, winding down the unit’s affairs could consume the Fed’s entire $85 billion loan."

So basically, the Fed could decide to make AIG pay off the counterparties in return for cancellation of the contracts. This could easily erase all of the equity of AIG. This would be great for Wall Street, great for the economy and terrible for AIG. AIG is much better off holding their subprime CDSs to maturity and paying them off as defaults happen.

Wednesday, September 10, 2008


Martin+Osa is a new retail concept by the teen retailer American Eagle Outfitters (AEO)

The M+O concept is aimed instead at an older demographic 25-40. The theme of the clothing is "refined casual". The design of the clothes by San Francisco designer Deborah Hampton are clean and simple but with subtle detailing and fine tailoring. The clothes use luxurious fabrics such as silk, organic cotton and cashmere but are priced reasonably, about the same as J-Crew.

My wife and I are big fans of M+O and we also are AEO shareholders. I have personally visited 4 of the 28 M+O stores. The store designs themselves are quite impressive. The store is made of hard wood and the front is simply a wall of wood with a minimalist blue glass stripe running through it. The store (and the clothes) smell of freshly chopped wood.

The changing rooms which are about as big as my old college dorm room (to allow for baby strollers) have high ceilings and a button where you can call the extremely helpful sales staff. The customer service at M+O is similar to what you would receive in a luxury boutique. They give out free Fiji Waters just for visiting the store. (Recently J-Crew has copied this tactic.)

I have mentioned that I love the store and the clothes. But how is the brand being received by other customers. To answer this question, I went through a lot of the reviews at . This was slightly painful since Yelp divides their reviews by store (in some particular city) and not by brand. So I had to go through and search for each store. I managed to find 13 stores that had at least one review. There are 65 reviews in all and 33 of them are from the San Francisco Store. I think this is where Yelp originated. The reviewers choose a star rating from 1-5 and then submit a written review. I have constructed a table below showing the average rating for each store and the number of reviews. The weighted average review is shown at the bottom and is 4.24 stars out of 5. That is excellent, I think, for a still developing brand. Consider that some reviewers hate the store for whatever reason and give it 1 star. Most people love the store and give it the highest rating. To really get a feel for the customer response to M+O, I suggest you click on the store link and read the reviews yourself.

To summarize the reviews, everyone loves the stores and appreciates the excellent service. Most people like the clothing. Most appreciate the quality of the clothing. It is not cheap but you get good value for your money. Some people feel the clothes are a little boring, the opposite of flashier J-Crew. However the store concentrates on basics and casual clothing. You won't find glittery golden dresses or animal print shirts at M+O. If you are looking for clothes to build a solid wardrobe, M+O does this very well.

Store Number of stars
(out of 5)
Number of reviews
San Francisco Store 4.3 33
West Los Angeles Store 4.5 6
Glendale CA Store 4.0 4
Newport Beach, CA Store 3.5 4
Burlington, MA Store 4.5 4
Skokie, IL Store 4.5 3
McLean, VA Store 4.0 3
Schaumberg, IL Store 4.5 2
Santa Clara, CA Store 3.5 2
Raleigh, NC Store 4.0 1
Las Vegas Store 4.0 1
Austin, TX Store 4.0 1
Dallas, TX Store 5.0 1
Total Number of Reviews 65
Weighted average 4.24

Ok, so this sounds great so far. Beautiful stores, great service, high quality, fashionable clothing at a reasonable price. But are these stores going to be profitable? This is after-all an investment blog not a fashion blog. These stores are expensive to build and those large dressing rooms increase rental costs. High quality salespeople must be paid better than the teenagers they hire to run AEO stores.

Well, they are getting there. Like any startup, the brand stumbled a bit at first. The first few clothing lines were a little dull and underwhelmed most shoppers. Naturally, its started with no brand recognition and the opaque store-front keeps many from seeing inside. Some people think it is a spa or something. The retail sector of course is terrible right now and this demographic in particular has been hit very hard from the housing bust. So sales per square foot (the key gauge of success for a retailer) was pretty low at first. This caused many on Wall Street to declare the brand a failure. Few people on Wall Street think this brand is going to succeed and many have been calling for AEO to write it off and be done with it.

However not all is lost for M+O. Each clothing line has gotten better since the first one. Same store sales have been growing at 21% (last quarter) and 55% (the quarter before that) from this low base last year. I think they are starting to hit their stride.

There are a few reason why SSS are improving so quickly. First, as I mentioned, the clothing lines continue to improve steadily. The other main reason is that customers who purchase clothing are happy with their purchases and return to the store even as new customers come in. Making customers happy and getting them to make repeat purchases is the crucial thing for any retailer. Since I am a regular M+O customer I know why people come back. First of all the clothing is of excellent quality. As a guy, I'll admit that when shopping, I didn't always inspect the stitching on pants, marvel over the fabrics, or note the quality of the seams. But when you take your M+O clothes home, you notice these things over time. I'll bet women notice this even quicker. You notice not only the quality of construction but the subtle design details. You begin to appreciate the difference between this brand and the mass produced junk that is sold at most places at slightly lower prices. For example a pair of shorts that I bought at Target the other day split at the seams, the first day I wore them. They cost $15. I can buy M+O shorts on clearance for about the same price. J-Crew and Banana Republic produces some good quality clothing at similar prices but M+O offers a different aesthetic. They do their niche, "refined casual" better than either of the other two in my opinion. But what really sets them apart is the quality of the shopping experience. Try going to the tiny J-Crew stores with a baby stroller. It is not very fun. I think over time M+O will retain their customers and slowly build up a loyal following.

American Eagle Outfitters CEO Jim O'Donnell says that their goal is to reach four-wall break-even by the fourth quarter of this year, 2008. He says that this will occur at sales of $375 per square foot. Last quarter he said that they were basically on track for somewhere between $350 and $375. Four-wall break-even means breaking even when you exclude the overhead of clothing design and brand development costs. O'Donnell has said that they intend for the brand to fully break-even by 2010.

So it appears that if things go as planned that the investment in M+O will take a long time to pay off. The good news however is that this could be a very durable brand. The clothing styles are classy and classic and are not likely to go out of style. Polos and denim have attained a permanent stature in American fashion. So they might have a long period of profitable growth ahead of them fueled by steady cash flows from the now saturated AE brand. It is said that there is little barrier to entry in retail. While that is true, it will be difficult to replicate something like M+O without a lot of capital and a lot of patience, two things that are in short supply right now in the business world.

M+O is starting to advertise heavily in a few cities: Chicago, San Francisco and LA. I have seen the first billboard here in Chicago. This should have the effect of driving higher traffic to the stores and if the product is right, this should lead to higher sales even in this miserable retail environment. I will be watching this closely.

Tuesday, July 22, 2008

The Inyx forgeries

Jay Green of Inyx submitted to Westernbank a letter of credit allegedly from Pareto Securities which provided a $300MM short-term bridge financing for a buyout of Inyx. The letter was signed H. Suain, International Operations. Green identified him as Harald Suain.

The CFO of Pareto in an affidavit claimed that 1) There has never been any H. Suain or Harald Suain. 2) The letter is not authentic and not even on authentic Pareto letterhead. 3) Pareto never offered any such letter of credit to Inyx.

In other words, the letter is a forgery. This would be the third accusation of forgey against Kachkar. Apparently he submitted similar letters of credit from Countrywide Bank and also Mellon Bank in the UK. Countrywide has also called the letter a complete forgery.

Who is Harald Suain? The only record that I can find for that name is a guy in Europe who is an agent for a Norwegian Soccer Coach, Trond Sollied. Well Kachkar is a big soccer fan as he tried to buy the Marseille Soccer with the forged Countrywide letter.

The forged Pareto document is online so we can have a look at this signature and see if it resembles the handwriting from the usual suspects, Kachkar, Green or Benkovitch.

Monday, July 21, 2008

Growth and reversion to the mean

Here is an update of the previous post on whether a high 5-year growth rate predicts the next 5-year growth rate. The answer is still No but now with more statistical significance.

I have collected more data. Now I am using every stock on the NYSE, NASDAQ and AMEX.

I require that there is 10 years of data and that in each 5-year period, there is at most one year with earnings data not available or earnings that are negative. If earnings are negative (or unavailable) that one year, I ignore it and fit the growth rate to the remaining four data points. So there is a slight bias towards higher growth rates but this bias is the same in both periods so this should not cause any correlation. Growth rates above 50% or less than -50% are discarded. The results are insensitive to increasing this number 50% to 80%.

There are 2206 stocks that meet these requirements. Here is the result. (Click for higher resolution)

The top panel just shows the last 5-year growth rate versus the growth rate 5-years previously. As before there appears to be little if any correlation. The red dashed lines show the median growth for each period which is 10.5% for the last five years and 7.1% the five years before that. This higher growth in the latest period is probably real and is expected since the period 1998 to 2002, the internet bubble, went from a boom period to a recessionary one and the last five years 2003-2008 included the recovery and housing bubble. It looks like we are now going into another recessionary period due to the housing bust. The Pearson's correlation coefficient is -0.0953. This slight negative correlation is explained below.

The lower panel is even more informative. The stocks are sorted by the growth rate in the previous period and divided into 19 percentile groups. That is, each group has equal number of stocks and has similar previous 5-year growth rate. For each group, I calculate the median of the previous 5-year growth rates and the corresponding median of the last 5-year growth rates. These two median growth rates are plotted versus one another with error bars indicating the error due to having a finite sample. Clearly, there is no indication that the median growth rate in the next period has anything to do with the median growth rate in the previous one. The blue line shows the y=x relation that would be expected if the best predictor of future growth rate was the past growth rate. Clearly this is NOT a good fit to the data. The red horizontal line just shows the median growth rate in the last 5-year period. This fits the data points quite well. This would indicate that the hypothesis that "Future growth rates are independent of past growth rates" is consistent with the data. There is one deviant point which has the lowest growth rate in the previous period and in fact the highest growth rate in the more recent period. I haven't yet looked into this in detail but these may be highly cyclical companies such as oil, energy etc. This point probably is the cause of the slightly negative Pearson's correlation coefficient.

Overall, this study points toward mean reversion. Companies that are growing at higher or lower than average rates will most likely revert to average growth rates in the future.

The application to investing also seems to support the "value investing" method rather than the "growth method" at least in their simplest incarnations. That is, stocks that have grown rapidly and (usually) sport a high valuation on earning probably will not grow any faster than the stocks that have grown only slowly or even had negative growth. So paying a higher valuation for "growth stocks" does not appear to be logical. I will investigate this in more detail in future posts.

Monday, July 14, 2008

Does past growth correlate with future growth?

I did a little test to see if the past 5-year growth rate correlates with the "future" 5-year growth rate. Since I don't have access to the future data, I will use the earnings data from the past 10 years split into two parts. I have a list of stocks whose earnings I have looked at over the past few years. This is not a random sample by any means but should not be terribly biased. If there is any bias it might be that I typically look for companies with consistent results which might bias things in the direction of positive correlation.

Here is the list of tickers. There are 157 stocks. All have been pruned to have at least 9 years of data.

aa aame abk adp aeo afl ahm aig ajg all anf apol appb axp azn ba bac bax bbby bbt bcs bdx bmy bni bpop brl bro bud c cat cc cfc chc cinf cl cle clx cors crft csco ctas ctx dd dell deo dhi dis drl e educ eth expd faf fast fbp fdc fdx fitb fnm gd ge gfr ggg gm gsk hasx hban hd hsy ibm intc intu ir jnj jpm k kbh kcli key ko ksws leco lfg liz mbi mcd mdt mer mhp mlea mmc mmm mo mrk msex msft mtb mtg mth mxim ncc nke nsec nte nwlia ofg orcl ori pep pfe pg phm plxs pmi ras rdn rf rgf ri rt ryl sbux sial snn stc sti stj strt swm syy t tbl tgic tma tmk tol tsn tss tues ug uhco unh ups usb ust utmd utx vz wat wb wdfc wfc wfmi whi wmt wwy xom

For each of these I calculate the 5-year (annualized) growth rate of earnings in the most recent five year period (years 5 to 9) and in the more distant 5-year period (years 0-5). The growth rate is calculated by using all of the points and fitting an exponential curve to these points. I throw away growth rates greater than 50% or less than -50% to avoid have large numbers skew the averages.

Here are the results:

The mean annualized growth rate in the first 5-year period is M1=11.9% and the standard deviation is S1=15.2%.
The mean annualized growth rate in the second 5-year period is M2=13.9% and the standard deviation is S2=13.9%.

The Pearson correlation coefficient R is -0.0329.

R = 1/(N-1) * Sum_i (G1_i-M1)/S1 * (G2_i-M2)/S2
with N=157

So there is a small (and probably negligible) NEGATIVE correlation. Thus, there is no evidence at all that the 5-year growth rate is useful in predicting the growth rate of the next five years.

This study does not claim to be conclusive by any means but it shows that if there is such correlation, it is not very strong.

See scatter plot below of the growth rates plotted versus one another. No correlation is apparent.

Monday, May 5, 2008

Bank profitability at WHI

My last post on banking profitability can be readily applied to W Holding (WHI).

WHI has a leverage ratio assets/equity of about 14.6. In addition it has preferred equity nearly equal to common equity. So equity/common-equity is about 2.

So to build value for common shareholders and pay a small dividend we want to have return-on-common-equity at least 5%. If we cannot reach at least ROCE=5% then we can't really claim even to be worth common book value. The borrowing cost, BC, of preferred shares originally was about 6.7%. We can use the following formula (the the last post) to figure out the ROE that is required.
Using the above numbers, the required ROE is 5.85%. Lets call it 6% for simplicity. Using the above leverage ratio, this requires ROA of 0.4%.

Now 0.4% might seem like a pretty easy target for a bank. Normally a good bank can generate ROA of 1% or so. However WHI has some serious problems that are difficult to overcome. Lets try to see why. We will look at our ROA profitability formula.

ROA = (1-T) * [ (1 - ER + NII) * NIM - L]

T = Tax rate = 40% for WHI
revenue = Net Interest Income + Non-interest income = 260MM (4x the first quarter)
ER = efficiency ratio = Non-interest expense divided by revenue = 67% for WHI (last quarter)
NII = Non-interest income divided by revenue = 10% for WHI (last quarter)
NIM = Net interest margin = net interest income divided by total earning assets = 1.3% for WHI (last quarter)
L = provisions for loan losses divided by total earning assets = 0.72% for WHI (assumes 30MM provisions per quarter)

Current ROA = -0.1%
Given, these number the bank is unprofitable. The only reason it booked a profit in the first quarter was because it had a tax benefit from carrying back losses to previous years earnings. However because it has to pay out preferred dividends, it is even worse. The common equity is going to shrink if it can improve profitability.

What went wrong for WHI over the last few years when it had ROA > 1%? Basically everything that can go wrong. The tax rates went up, efficiency got worse, NIM went down and loan losses went up. WHI never was a high NIM bank but it was very efficient and had excellent underwriting and it made use of lots of leverage. This leverage was great when it was profitable but now acts like an anchor slowing their recovery.

If we go back just a couple of years we have ER=33% and L=0.005 and NIM=2% and T=30%. This gives ROA=0.73%. In 2001, NIM was 2.7% and ROA was almost 1%.

The tax rates went up when they changed the Puerto Rican laws on the taxability of the securities portfolio. This was previously tax free but is now partially taxed. They have also increased the tax rates. This may improve in the future but there is no guarantee. Effective tax rates were also lower because a higher percentage of earnings was coming from the tax-free (or at least tax-efficient) securities portfolio. Now it generates negative earnings as borrowing costs have risen against these fixed rate securities. Only loans are profitable and they are taxed at the full rate.

Their main problems are poor NIM and high loan losses. Loan losses will likely be high for the remainder of the year but should improve in 2009. The poor NIM is probably temporarily low due to loans resetting before deposits. However the deposit scenario is poor for WHI since they rely on brokered deposits and Repos. Even though the Fed has cut rates, brokered CD rates are still high. Much of their Repos are locked in for a year or more at nearly 5% rates.

NIM may get back to 2% by years end but likely will not improve beyond that for quite a while. If they keep their securities portfolio small, it will be higher than previously and they will be a more normal looking bank: less leverage, less reliance on Repos for funding. Expenses will also stay high due to legal expenses and restatement expenses. They should probably improve ER to 50% by years end and improve by a little beyond that.

So by years end, if we adopt these numbers, NIM=2%, L=0.7%, ER=50%, that would bring us to ROA=0.1%. This is still poor and will not lead to a profitable year. However there may be enough in tax benefits from charge offs to make the tax rate temporarily about zero. This would result in a temporary ROA of 0.16% which is slightly better but still might result in shrinkage of equity.

If 2009 is much better, we may see NIM=2.2%, L=0.5%, ER=42% and that would be ROA=0.6% which would be good enough to build value and send the stock back above book value. However it is unlikely to result in rapid growth. Their days of 25%+ growth rates are probably over.

Banking profitability and leverage

There is a fairly simple formula for banking profitability. Return-on-assets, ROA, given by

ROA = (1-T) * [ (1 - ER + NII) * NIM - L]


T = Tax rate
revenue = Net Interest Income + Non-interest income
ER = efficiency ratio = Non-interest expense divided by revenue
NII = Non-interest income divided by revenue
NIM = Net interest margin = net interest income divided by total earning assets
L = provisions for loan losses divided by total earning assets

So the general strategy for banking is always to try to increase non-interest income if it doesn't increase non-interest expense too much. You want to keep your non-interest expenses as low as possible. Then you want to have a high NIM which usually means low deposit costs. Then you want good underwriting i.e. low loan losses. You usually can't do much about taxes. That is really about all there is to banking. The devil of course is in the details of how you actually do this better than your competitors.

Return-on-equity, ROE, is just
ROE = ROA*(assets/equity)
where (assets/equity) is the leverage factor. This leverage factor is limited by banking regulators. It must be less than 25 and is usually required to be less than 20 to be consider "Well capitalized". Most banks try to get it around 12-15. If a bank is profitable, i.e. ROA > 0, then they usually benefit from more leverage. However this can be more dangerous because if things turn bad, the bank may become unprofitable and this leverage will magnify losses to equity. If the bank pays no dividend and retains earnings it can grow at a growth rate equal to ROE, if all of these ratios above stay fixed. It is pays out a fraction PR of earnings as a dividend, then it can grow at (1-PR)*ROE while continuing to pay the dividend at the same payout ratio.

It is also possible to leverage up the shareholders equity by raising other forms of equity such as preferred shares. This requires a fixed dividend payout to preferred shareholders which comes after tax. This involved another leverage factor
EQ/CEQ = (equity/common-equity).
The preferred equity, PE, is the difference between equity and common-equity, PE =EQ-CEQ. If the bank goes bust, the preferred share holders are paid back this preferred equity before common shareholders get anything.

The return-on-common-equity ROCE is given by

where BC = the borrowing cost or the dividend yield of the preferred shares.

If you set this to zero you you can solve for the condition where the bank's total equity stays the same size (before payment of any common dividend). That is
ROE = BC (PE/EQ). For example of PE/EQ is 1/2, then the bank's common equity and total equity stay the same when the ROE is half the borrowing cost. When this is true the bank stays the same every year. If you want it to stay the same size after paying a dividend, you replace ROE with (1-PR)*ROE.

When can the common shareholders grow their common-equity faster by issuing preferred shared? Just set ROCE equal to ROE and solve and you find this is equal when ROE =BC. So your ROE had better be higher than your borrowing cost or issuing preferred shares is not worthwhile.

If you want to know the growth rate of common equity, this is equal to ROCE. If there is a common dividend, just replace the ROE with (1-PR)*ROE. That tells you the growth rate of retained common equity. If you keep issuing preferred shares to keep the ratio EQ/CEQ the same, and the other ratios remain the same, you can grow the whole bank at this faster rate. Like the usual leverage ratio, banking regulators put limits on this leverage factor. Usually they want at least half the equity to be common equity.

Ok, lets do an example. Lets assume:
NIM = 3%
ER= 50%

This results in ROA = (1-T) * [ (1 - ER + NII) * NIM - L] = 0.78%. Now lets assume assets/equity =15. This results in ROE = 11.7%. Now lets suppose the bank pays a dividend at a payout ratio of PR=25% of earnings. Then it can grow at G=(1-0.25)*11.7 = 8.78%. Mid to high single digit growth rates are fairly typical for banks. Now, what about issuing preferred shares? Lets suppose it can sell preferred shares at a yield of 6%. Since ROE > 6%, this sounds promising. Lets say that it raises total equity to twice common equity EQ/CEQ=2

ROCE = ROE * (EQ/CEQ) - BC (EQ/CEQ-1) = 17%
The growth rate after paying preferred and common dividends will be
G = (1-PR)*ROE * (EQ/CEQ) - BC (EQ/CEQ-1) = 11.6%. So as long as they continue to issue preferred shares to keep EQ/CEQ=2, and everything else stays the same, then they can grow at this faster rate. In reality, of course, nothing stays the same but that is a different matter.

Now what if the economy goes into recession and the loss ratio, L, goes to 2%? Now ROA=-0.12%. It is now slightly unprofitable. ROE=-1.8%. Equity of the bank has contracted by -1.8% before payment of preferred and common dividends. ROCE=-9.6%. The leverage due to the preferred shares has magnified this loss. Common equity has dropped by -9.6%. That is a pretty big hit for just 2% loan losses. The bank will likely cancel the common dividend payment and if this goes on for another couple of years, it will have to raise common capital and dilute the interest of current shareholders in order to keep the leverage ratio below the regulatory limit.

Saturday, May 3, 2008

W Holding - Analysis of the 1Q 2008 Call Report

Ok, I finally got some time to go over this. Here is what I see, starting with the income statement. (all numbers in millions, rounded)

Loans rates have reset lower by about 100 bps (from 2007 1Q) but deposits rates have increased by about 26 bps. This is squeezing net interest income. NIM is only 1.28% down from 1.915% 2007 1Q and down from 1.656% last quarter. Net interest income is down 20 from last quarter. This will likely improve next couple two quarters. We would like to see NIM closer to 2%. Expenses are higher by 10 due mostly to legal/FDIC/advisory expenses. I am glad this isn't higher. We lost 7.7 before the tax benefit of 47 but 39.7 after taxes benefit. Additional loss in comprehensive income (i.e. doesn't flow through income statement) of 9.6 probably due to balance sheet restructuring.

Total equity capital is 1097 versus 1072 or a gain of 25. This is $3.43/share of book value.

Securities were completely restructured. It appears that they simply sold most of them and bought some shorter term securities to match their remaining liabilities. Total is 5342 down from 6542 last Q. In addition, they now have 2135 expiring in 3 months or less and another 1025 expiring in one year or less. They also sold or retired all of their structured notes 170.

This reduces assets and combined with the gain in capital, the capital requirement ratios are much improved. The tightest one is still Tot Risk based cap = Tot_risk_based_capital/Tot_Risk_weighted_assets which is now 11.33%. This is above the 10% Well-capitalized level by 146 and 366 above minimum. If after next quarter they do not replace their retiring securities they will be 189 above Well cap. if there is no change in capital. If they make about 30 next quarter,as I expect, they will be 219 above well capitalized. If so they might actually be able to buy back shares. I think they only need a buffer of about 160-180 above Well cap.

Now, Past due and non-accrual. This is actually not looking good. Non-accruals dropped from 481 to 467 but 30 days late increased to 215 from 31. Thus total NPAs increased to 682 from 512. Now some of these will probably be cured but much of it will go into non-accrual. Part of the reduction of Non-farm non-res non-accrual was El Legado. But what about Pueblo, Syroco and others? I was hoping for a larger reduction. Are these loans still in non-accrual or have they been replaced by others? 55 of C&I loans are 30 days late. That is worrisome because they could be ABL loans and could lead to large losses. Construction loans 30 days late increased from 1 to 11. Provisions for the quarter was 30 which is close to what I expected. Overall, it looks like there could be a second wave of losses coming next few quarters as the US recession affects Puerto Rico. Is this what we are seeing in the 30 day lates?

Overall, the report is mixed. The bad news is non-accruals still being higher and 30 day lates increasing sharply. Also the poor NIM due to loans resetting faster is slowing our recovery.

The good news is that we are much better capitalized and this will only get better next quarter. We are still profitable. This is partly due to the tax benefits from our charge-offs offsetting high provisions. Allowance for loan losses is still 217 which will allow for more tax benefits as some of this is charged off. Interest income should improve as deposit costs come down as long as non-accruals do not increase by a lot. We might actually be able to buy back stock. Given that the stock price is 1/3 of book value, this can greatly increase BV/share.

So to conclude, it is a decent report and bolsters my case for holding this stock. We are on track to make 150 for the year which is what Stipes said he expects to do. That would put BV/share at $4.1 and EPS at $0.91 (or 0.7 after subtracting preferred dividends). If so and we get current with the SEC we should sell at around $5/share.


See my posts on profitability. After reviewing this further I no longer think they will make much in 2008. They are being hit on profitability on all fronts: NIM, expenses and loan losses and I don't see these improving much for a few quarters at least. The tax benefit from first quarter is likely much larger than what they will book in the quarters to come. I think it may take them until 2009 to improve substantially. I think they will probably linger around $1 until they get current with the SEC. After that, they will still probably stay around $2 until profitability improves after which they will return to book value. It may take them a few years to get back to $5. Still, this would make them a good long term investment. I think the chance of them buying back any stock is small. Still, they should consider it as long as they can foresee improvements in the future. Even 30MM of buybacks near $1 would increase shareholder value by a lot and probably not endanger capital ratios.

Friday, March 14, 2008

Friday, February 29, 2008

Houses for the banks

What will be the result of this whole housing bubble blow up? I will try to describe the whole thing is very broad terms.

Around 2000, the demand for real estate started to increase rapidly. Demand for real estate comes from three different sources. First of all, a population increase can cause this. There can also be demand from people who want to own more than one house. There can also be a change in preference between renting and buying. The first reason, population increase, has been fairly steady over US history and are not the main driver of the recent housing bubble.

The demand for second homes certainly increased. People, in recent times, think of second homes as an investment. After the stock market crash of 2000, the dot-com blowup, people looked for alternatives to stocks. They noted the wonderful returns that they or their parents may have received by buying during or before the inflationary 1970s. This current demand was aided by the very low interest rates following the stock market crash. The two sources of this were Greenspan's Federal Reserve as well as the "vendor financing" resulting from the rise of the US trade deficit. In short, China sends us products, we send them dollars and they buy US financial assets such as US mortgages and US Treasuries. This helped keep interest rates down leading to a refinancing boom and a boom in first home purchases.

This was the first stage of the housing bubble. The number of homes of course didn't change as rapidly. This change in the supply-demand balance lead to the beginning of the price appreciation bubble. This of course feeds back and enticed more people to think of housing as a good investment which led to more buying.

The next stage of the bubble came from converting more renters into buyers. Traditionally people would rent while they were young and save money for a down payment on a home. This is what I learned when I was young. Typically this would be 20% of a house price. This was demanded from banks to create an equity cushion. Mortgages are non-recourse loans that allow the buyer to simply stop paying the mortgage and giving the bank the right, in turn, to foreclose or take back the collateral. The equity cushion provides the incentive for the buyer to do whatever it takes to avoid default. It also allows the bank to suffer as much as a 20% loss on resale without suffering a net loss.

Due to this dramatic run-up in house prices, the banks relaxed their lending standards to allow for lower down-payments. In addition, since house prices were rising rapidly, they were not too concerned about suffering any loss on the value of the collateral. There was no need for a 20% down payment if the house would be worth 20% more next year. Many of these loans were resold to investors anyway. So it would not be the problem of the originating bank or mortgage originator once it was sold off, if the payments were not made.

The worst of this was the subprime lending industry. Fueled by short-term loans from Wall Street banks, these lenders would give loans to just about anybody capable of fogging a mirror. The lenders were extremely profitable because they could sell off the loans very quickly. A 1% gain on a home loan isn't that great if it takes you a year to do it but if you can turn-over 10 such transactions in a year, that is a 10% annual gain on your capital. Better yet, if you can leverage up your assets to 10 times capital, that is a 100% return on capital. What a business model? So faster turnover from the buying mania and leverage created this wonderful business opportunity. However it depended on insatiable demand for houses as well as a plentiful supply of borrowed money from Wall Street and finally demand for these securitized mortgage products in the secondary market.

All this time, the homebuilders were ramping up their building. There was more demand for homes and so this resulted in higher profit margins. These profits created more capital that could be used to buy more land and build more homes. The end result would of course be a much larger supply of houses.

Home prices rose. Economic activity was vibrant with all this building and buying and selling. There were profits all around. Builders made a killing. Banks made a killing. Even the buyers made a killing if you counted the capital gains on the houses. All of these were extremely leveraged. The buyer bough with little or no money down. Putting down 5% (1/20th of the house) and getting a one-year appreciation of 20% meant a 400% return on invested capital. Who needs to work when you can get returns like that just by signing on the dotted line? Bank loans are always leveraged transactions. They are allowed to leverage their capital by about a factor of 10%. Builders were leveraged as well by borrowing from the banks.

Of course this all had to come to an end. Eventually prices got so high that most people simply could not pay the mortgage payment. They could not even pretend anymore. Monthly payments were as much as twice what it would cost to rent the same house. This was almost 50% of the average persons take home wages. The supply of people that could be converted from renters to buyers or single home owners to second home owners began to dwindle. The excess supply of new homes relieved some of the pressure on home prices.

So eventually home price appreciation stopped. Then the whole process which depended on rising home prices would come apart in dramatic fashion. Now we are in a period of falling prices. Now the total supply of houses is much larger than before. The supply of people willing to speculate on house prices has evaporated. The supply of banks willing to make low down payment loans has contracted. The fact that prices are clearly dropping removes any incentive to buy now. The deflationary mindset sets in. Why buy now when you can buy cheaper next year? The supply of houses for sale is even larger due to a massive wave of foreclosures.

What is the endgame for all of this? House prices will eventually bottom. They will do so when it becomes cheaper to buy then to rent. It will do so when a person can buy a home and rent it out for a profit. The trouble is that this break even point between buying and renting seems quite a ways off.

So who is the winner and loser from all of this? Like all bubbles, this has resulted in a miss-allocation of resources. This results in a inefficiency and so a decrease in GDP. Basically, houses will end up on the balance sheet of banks who will have to auction them off at a loss. So banks will have lost money which will easily erase all of the profits from the proceeding years. People who owned before the bubble will have seen their house value go up and down. Many of these will not be impacted. However, some of these may have borrowed against their home and now find themselves with a much higher debt/equity ratio. They may now have to work longer than they had planned in order to retire and so may spend less in the coming years. Again , this will reduce GDP.

Some people with good credit and secure jobs who bought near the peak will have to pay higher than normal mortgage payments for the rest of the life of the mortgage. Some people may have lost all of their net worth by having bought at the wrong time and now have to sell for whatever reason.

Who are the winners? For every losing speculator there is a winning speculator. Some people who bought and sold at the right time made a small fortune.

Young people and renters are winners. They will in the future be able to buy houses much cheaper. There are a lot more houses now and not that many more people.