Thursday, November 29, 2007

A Tribute to Minsky, Part I

Hyman Minsky is someone who I have mentioned a few times on this blog, yet I've noticed that I have not ever shared my own interpretations on his work. So in Part 1 of my tribute to Hyman Minsky, I will be going over "The Financial Instability Hypothesis", and what I have built on his idea.

The first thing to understand is the idea of debt-income relationships. This term refers to the idea that a borrower's debt relies on the borrower's income to get paid back. But I think underlying this is an even more general and important relationship: price-value. Below is a chart I came up with.

For now, we will focus just on debt and investment ( I threw the idea of consumption in there just because I know it too plays a part and to remind myself about this later) Debt is a relationship whose value is derived from the borrower's income, and an investment is similarly has its value derived from the underlying cash flow. Now there are some differences between these two. For example, with debt the upside is capped. The borrower's income can triple, but he will most certainly not start paying any increased amount to his bank. But in an investment, any increase in cash flow accrues to the owner. So, we see that:

With Debt, the maximum upside is known and quantifiable. All that exists is downside.
With Investment, the range of values is infinite, meaning there is no limit to your potential gain.

Nassim Talib described this phenomenon as negative and positive black swans. (debt and investment, respectively. See Post) Otherwise, I think you can see that the relationships are fairly similar.

Now the essence of Minsky's work revolved around the idea that debt-income could be characterized into 3 broad categories- hedge, speculative, and ponzi. In hedge financing, the borrower's income can cover both his interest payments and his eventual principal payments. In speculative financing, the borrower's income can cover his interest, but he must either refinance or sell assets to pay the principal. Finally, in Ponzi financing the borrower's income can not cover either the principal or the interest payments. Some people might already be thinking something along the lines of:

"Hey, not even able to afford their interest payments? Isn't that what is causing this mortgage crisis right now, with loans being made to people who could not afford it?"

With the answer being yes. But what is interesting for value investors is that these three classifications apply to the broader price-value spectrum as well. Let's take common stocks for example. We have a purchase price, which is the market capitalization we are paying, and we have the value, which is the company's cash flow. If the company's cash flow can cover both our interest (cost of capital) and the principal (purchase price), then we have a hedge financing relationship. Worded differently, if we can discount the cash flow(cost of capital) and get a value more than the principal (purchase price), then we are hedge financing. Sound familiar? It should, because this is the dictum that value investors live by: A common stock is worth the discounted value of its future cash flow. Our goal is to buy something for less than that.

So let's move down the chain a bit. A speculative arrangement in stocks would mean that the cash flow can cover the cost of capital, but it can not cover the purchase price. And with Ponzi, the cash flow can not even cover the cost of capital. Now in the world of stocks, this environment has usually been referred to as a bubble. Think of the tech bubble as an example. Many companies were trading at earnings yields of 2% or less, while treasury rates were north of 6%. So, an investor in common stocks at that time could not cover his cost of capital out of cash flow.

This analogy has helped me describe the current mess we're in as a true Credit Bubble, or as Minsky would say a Ponzi. Loans were made on a large scale to people who could never afford to make the true cost of interest out of their incomes, yet adjustable rate mortgages helped mask this for some time.

Now some people have tried to claim that the problem will not be so bad because these loans are secured by homes, which have real value. But again, we can apply the all too familiar concept from value investing to show this is not the case. An asset is worth the discounted sum of its future cash flows. We've seen how this is the case for common stocks. A home is the same thing, although with the value being derived from the property's rent. And using current rents, homes as an asset are also in a Ponzi relationship, not being able to cover the cost of capital.

Now it is important to also realize that just because current cash flow does not cover interest doesn't mean it is necessarily a bad deal. I'll use another stock example to make the point. It is perfectly reasonable for me as an investor to invest in Coke at lets say a 4% earnings yield when the cost of capital is 6%, and for it to still be a value. This is because I expect Coke's cash flow to continue to grow into the future. So although currently my cash flow can not cover interest, in the near future it will. If I am correct and Coke's Net Present Value is greater than the price I am paying for it, then it is in actuality still a hedge financing arrangement.

So is there a similar hope for mortgage debt and housing? Well, mortgage debt is based off borrower's income. And housing is derived from rent, but rent is also a function of income. So for these loans to work out, we would need to see incomes rise in the future. And the recent trend is not encouraging. Below is a graph of REAL household income from 1967 to 2005. Nominal would be more appropriate, but I could not find a chart for it, and real incomes is suitable. Since 2000, household incomes have actually declined. An important factor in this has likely been globalization, which I have discussed in the "Tectonic Shift" series. With the competition of the entire world's labor market, it is difficult to assume incomes will be able to rise considerably in the near future.

So for now, that is the dilemma we face. In part two, I will try to expand on this concept and describe some of the possible effects.

Wednesday, November 28, 2007

Hoisington Third Quarter Review and Outlook

Hoisington Investment Management has released their Third Quarter 2007 Report. I am a big fan of their work and I share very similar opinions as they do. I think those who read this to the very end will find this very informative. Some notable remarks:

More amazing, perhaps, is the fact that over the past 5 1/2 years, $1.1 trillion in equity has been extracted from homes. This represents 46% of the increase in total consumer spending over the same period (Table 2). The tightening of credit standards and declining home prices will virtually guarantee that $1.1 trillion will not be extracted in the next few years. Consequently, slower consumer outlay growth can be expected for an extended period.
The Fed’s reduction of short-term rates serves to lessen slightly the finance charges of these massive debt burdens, but it does not reduce the magnitude of those obligations relative to income. Moreover, the reduction in short-term interest rates will not serve, at least for the next year or two, to make the household debt more manageable in relation to home prices to which those debts are also directly tied. Thus, credit losses stemming from the debt binge of this decade are far from being realized, and the recent tremors of the credit markets may be a sign that all is not well.

Four considerations suggest that the current housing depression will continue for at least the next two years. First, home prices remain near record highs in spite of the largest yearly decline on record...

Second, housing starts and building permits are still well above prior cyclical lows, despite the 42% decline in both...

Third, there is a record inventory of unsold homes relative to sales--nearly ten months for existing homes and 8.2 months for new homes...

Fourth, nearly $800 billion of adjustable rate mortgages will reset between October 2007 and December 2008, with the peak in the first and second quarters of 2008....

While a decline in wealth would be spread out over time, the housing sector would impair consumer spending in other ways. Falling home prices will result in additional losses for the financial sector, which, in turn, will tighten lending standards and reduce credit availability for consumer spending. Also, job losses in housing and related sectors will limit the growth in household income, putting consumer spending under downward pressure. Accordingly, domestic demand growth should continue to weaken, serving to transmit the U.S. growth recession to the rest of the world.

A continuing contraction in both the growth of total reserves and the transactions-based monetary aggregates, as well a downturn in the velocity of money, suggest that monetary conditions remain restrictive. These monetary considerations, combined with greater slack in the labor markets, will serve to put additional downward pressure on the inflation rate. Even though a weak dollar and increases in commodity prices suggest that inflation will rise, this is not likely to be the case. Demand will be too weak to allow cost increases to be passed along to consumers. Thus, weakness in domestic demand suggests that profit margins will be compressed in this environment.

Yellow BRK'er Party Information

I am not planning on attending the Berkshire annual meeting this year, but those of you who are should consider this:

Yellow BRK'er Party Information Details (Friday, May 2, 2008)

Yellow BRK'er Party Information:

2008 Meet & Greet Happy Hour

Date: Friday, May 2, 2008
Time: 4:00 pm - 7:00 pm
Place: DoubleTree Hotel, Omaha

Berkshire Hathaway shareholders from all online communities are welcome.

If you feel most comfortable wearing a suit, go for it. With that said, it's Omaha; please feel under no such obligation. This is a casual atmosphere, with light snacks available. It's a "happy hour" type of gathering - not a formal dinner or anything of that sort.

The DoubleTree is located on 16th and Dodge. There may be some street parking, otherwise, one can use the parking garage with an entrance from the South at 16th & Dodge street, just east of the First National Bank.



Directions to venue:

About Yellow BRK'ers:


2008 Official Berkshire Hathaway Annual Meeting Press Release:

Sunday, November 25, 2007

Remember the Frog

CR: What is Subprime?

The main impact of subprime lending on the overall mortgage business was the take-out function. As subprime lending grew, you saw better “performance” of prime or near-prime mortgage portfolios. This was not because subprime lending did away with the traditional default drivers of job loss, illness, divorce, or disorderly conduct; it was because loans in that kind of trouble had a place to go besides foreclosure. Prime lenders could and did congratulate themselves on their low foreclosure rates as if it were a matter of their superior underwriting skills, but that involves a high degree of naiveté. It’s really important to understand this issue, because it gets to the heart of the “contagion” thing. It is not that subprime delinquencies are “spreading” to prime loans as if some infectious agent were in play. It’s that the drain got backed up: when subprime lenders go out of business, or investors won’t buy subprime loans, there is no place for the inevitable prime delinquencies to go except foreclosure. Prime delinquencies become “visible” because they don’t move out of the prime portfolio via refinance into the subprime portfolio, where we “expect” to see them.

Friday, November 23, 2007

Prem Watsa: He Has Never Been More Bearish

In a rare interview, the chairman of Fairfax Financial Holdings Ltd. said he thinks it's possible the United States is on the cusp of a prolonged market slide, similar to the one endured by Japan between 1990 and 2003, when the Nikkei index plunged 80 per cent.

Mr. Watsa suggested the decision to put 75 to 80 per cent of Fairfax's portfolio .into government debt - "for the first time, I think, ever" - reflects his view that credit markets will take a long time to digest the problems in the U.S. real estate and mortgage business.

"We don't know how bad the recession's going to be, so credit is going to be tough," he said. "You're going to have these big losses, the banks are going to have big losses. So we are worried."

Mr. Watsa took particular aim - not for the first time - at the structured-products industry on Wall Street and Bay Street. Many of those securities got high ratings from the credit agencies, but have cracked under the strain of rising U.S. mortgage defaults.

The Fairfax chairman said the products were always flawed because they shifted the risk away from the person making the lending decision - which encouraged auto finance or mortgage companies to give loans to almost anyone, since they would not have to bear the losses on defaults.

Positive Black Swans

As I received my copy of The Black Swan back last night, I began flipping through some of the pages just as a refresher. I luckily came across one of my favorite paragraphs, and a concept which I had almost forgotten:
Learn to distinguish between those human undertakings in which the lack of predictability can be (or has been) extremely beneficial and those where the failure to understand the future caused harm. There are both positive and negative Black Swans. William Goldman was involved in the movies, a positive-Black Swan business. Uncertainty occasionally pay off there.
A negative-Black Swan business is one where the unexpected can hit hard and hurt severely. If you are in the military, in catastrophe insurance, or in homeland security, you face only downside. Likewise, if you are in banking and lending, surprise outcomes are likely to be negative for you. You lend, and in the best of circumstances you get your loan back- but you may lose all of your money if the borrower defaults. In the event that the borrower enjoys great financial success, he is not likely to offer you an additional dividend.
Aside from the movies, examples of positive-Black Swan businesses are: some segments of publishing, scientific research, and venture capital. In these businesses, you lose small to make big. You have little to lose per book and, for completely unexpected reasons, any given book might take off. The downside is small and easily controlled. The problem with publishers, of course, is that they regularly pay up for books, thus making their upside rather limited and their downside monstrous. (If you pay $10 million for a book, your Black Swan is it not being a bestseller.) Likewise, while technology can carry a great payoff, paying for the hyped-up story, as people did with the dot-com bubble, can make any upside limited and any downside huge. It is the venture capitalist who invested in a speculative company and sold his stake to unimaginative investors who is the beneficiary of the Black Swan, not the "me too" investors.
I had forgotten this idea of positive Black swan type businesses, and I came up with a little exercise: Could you recognize the potential in Google, a real positive-Black Swan business, and invest in it at its IPO?

In 2002, Google had revenues of 439 million and 185 million in income before taxes.
In 2003, Google had revenues of 1,465 million and 346 million in income before taxes.
In the first half of 2004, Google had revenues of 1,351 million and 325 million in income before taxes.

If you annualized the first half of 2004 numbers, you get about 430 million in net income. Now, taking into account its growth prospects, what value would you pay for the company at that time?

Well, the market capitalization of Google at its IPO was 27 billion. So you were paying 62 times earnings, a multiple which would make many value investors cringe. And there was only 1 billion in shareholder's equity, leaving no safety in the traditional Ben Graham sense. But Google was also doubling its revenues and earnings each year, and it offered great value to both consumers and businesses. Today, the company is earning 4 billion a year, so the initial valuation seems actually very cheap.

How has Google defied logic and built a such a profitable internet company? Where is the moat? Well I guess (and I'm no expert) what makes it different from other internet companies is the fact that nearly everyone sets a search engine as their home page. And although other search engines now have similar performance, the fact that Google had the best engine first has made it "sticky"- every time a consumer opens his web browser it pops up, and they really have no reason to switch. In contrast, there is exogenous factor compelling me to go to Expedia every time I want to book air travel. I believe this is what has allowed them to keep their market share and hence make it the most valuable company to advertisers.

I looked at Google at its IPO and I knew it was a positive-Black swan type business. But I also knew that "paying for the hyped-up story, as people did with the dot-com bubble, can make any upside limited and any downside huge." So I passed because I thought it was too expensive and couldn't see the moat. But if you saw the competitive advantage, then the valuation of Google really depended on the potential for the online search and advertisement market, and that was much more obviously enormous. In the end, there are two important points to remember. One, the most important factors are the value a business provides and the moat around it. Two, keep your mind open.

Wednesday, November 21, 2007

Brick Income Fund 3rd Quarter Report

This one almost slipped by me considering there was no news report on Yahoo. Thankfully it was a pretty good report.
We are very pleased with our third quarter and year to date results. Sales remain strong, reflected in our seventh straight consecutive quarter of same store sales growth, driven by a strong promotional calendar. As we had in the first half, we continued to make good progress on managing key revenue and expense line items. In its most simple terms, our strong quarter was driven by more effectively executing against strong written sales. We have improved our supply chain, reduced inventories, improved our cash position, and narrowed our focus to driving sales and maximizing customer satisfaction. Management remains excited not so much by what we have done, but more so by what we believe the future holds.

The strong Canadian dollar has been killer for SFK. But in the case of the Brick, the benefit has been twofold. One, because the Brick does its retailing business in Canada, the value of its profits and its business increases for me, a US investor. Two, because some of their purchasing costs are in US dollars, the Canadian rise has decreased their costs and so also helped to boost their profits. I'm reminded of something Pabrai said at his annual meeting, which was approximately- "We don't try to specifically hedge for events in our portfolio, it just ends up working out that way."

Tuesday, November 20, 2007

Updated- More Pulp News

Yesterday, Pope and Talbot filed for Chapter 11:
Pope & Talbot, Inc. (PTBT.PK) announced today that, in order to address its financial challenges and to support efforts to be a more efficient organization, the company has filed voluntary petitions for reorganization under Chapter 11 of the United States Bankruptcy Code...

Persistent record low demand for lumber, high priced pulp chips and sawdust, the appreciation of the Canadian Dollar and the high cost of debt service have combined for an untenable business environment.
And today, the company announced wood pulp price increases:
Pope & Talbot, Inc. today announced a $30 price increase to its customers in North America and Europe.

Concurrently prices into Asian markets will be increased by $20 per ton. All prices are effective December 1st and valid until further notice.

This is on top of the $20 price increase in November, and will bring the new price to $900 in North America. In addition, the Canadian dollar has finally eased from its relentless climb. These are encouraging trends for SFK Pulp. By my calculations, Pope and Talbot's pulp operations would still require another $50 in price increases just to make them EBITDA neutral (Assuming 1.01 CAD/USD exchange rate). It will be interesting to see in the coming months whether they will be able to exert even more pricing power.

But in the meantime, SFK did cut its distribution down to $.01 unit, and at the current pace the 4th quarter numbers look like they will be very weak.

From Tembec's 4th quarter earnings report:
Reflecting the strength of the pulp market, inventories were at 19 days of supply at the end of September, down from 20 days at the end of the prior quarter.
And from Catalyst's Earnings Report:
Global NBSK pulp markets continued to be strong with global
pulp shipments up5.2% in Q3 year-over-year and 2.7%
year-to-date. Strong demand and low inventories prompted
NBSK price increases of US$10 per tonne to US$30 per tonne,
effective September 2007. The average Northern Europe NBSK
benchmark price in Q3, 2007 was US$810 per tonne, up US$27
per tonne, or 3.4%, from Q2, 2007. Compared to Q3, 2006,
the average benchmark price increased US$100 per tonne, or

Monday, November 19, 2007

Peter Eavis Is At It Again

Long term shareholders of Fairfax Financial surely remember Peter Eavis, journalist who repeatedly claimed the company was under-reserved, unethical, low on cash, and heading for bankruptcy. The allegations and the bias got so bad that Sanjeev Parsad from the Berkshire Board wrote a response letter to explaining the problems with many of his claims. But this didn't stop Eavis' reports from causing panic and hurting Fairfax's share price in the short-term.

That was back in 2004. Flash forward to today and we see the same thing, but with a different company. Almost a week ago Eavis published an article criticizing Fannie Mae's credit loss ratio accounting as "fuzzy math", and claiming "Uh-oh. It's Enron all over again." It was enough to send the share price diving nearly 20% and compelled the company to hold a conference call explaining the reason for the change. After the conference call though, Eavis maintained his original position and published his second article reaffirming his original claim.

In comes Tanta from Calculated Risk to the rescue with her response- Fannie Mae's Credit Loss Ratio: Fuzzy Math or Fuzzy Reporter?.
This is going to be a long post. It is going to attempt to answer the question stated in the post title. It is also going to function as further proof of the old axiom that you can create quite a ruckus in 150 badly-chosen words, but it takes ten times that many words (at least) to return some sanity to the discussion. “Gotcha” reporters of course know this, which is why they do what they do. Most people don’t have the time or desire to wade through the high-attention span Nerd part to evaluate the reporter’s claim. That it’s a deadly serious business for anyone who owns shares in a publicly-traded company being compared to a criminal conspiracy on the basis of a misunderstanding of accounting rules doesn’t seem to bother writers who just want a “scoop.”
After exposing the flaws in Eavis' argument, she concludes with the following:
I firmly believe in beating the press up a little when they do egregiously bad reporting, but that’s largely because I care about understanding what the real story is. And I hate being distracted by red herrings in my personal quest for understanding. Yesterday I spent over two hours rooting through SEC disclosures and listening to a 57-minute conference call trying to independently verify Eavis’s point; today I’ve spent a couple of hours writing this post. I am willing to believe that very few people have the time and the expertise to do what I just did. I therefore feel compelled to share my point of view with the rest of the world, in the interest of a worthwhile public discussion of financial and economic matters, which is the purpose of this blog. So I didn’t start out with the goal of catching Eavis being a lousy reporter; I started out with the goal of reading about Fannie Mae in a CNN Money article. But I believe that I did discover hyped, misleading, and ignorant reporting, and I believe it is fair to say so in public. (my emphasis)
I think Tanta summarizes the dilemma well. The truth takes more than 150 words, but most people still want their news in such shortened form. And as long people want the truncated version of things, then they will have to live with occasionally mixing up some of the bad with the good. Since I am in the midst of reading a book on Einstein, I will end with one of his relevant quotes: "Blind respect for authority is the greatest enemy of the truth."

Friday, November 16, 2007

Tectonic Shift, Part III

The idea of the tectonic shift first came from Mohnish Pabrai's Mosaic, in which he mentions:
There is currently a broad tectonic shift going on- businesses are profiting while jobs are being outsourced, but white- and blue-collar wages are eroding.
This is Part III in our look at this effect being caused from globalization. (Links are here for Part I, Part II) I recently finished reading Robert Reich's The Work of Nations, which takes a close and honest look at this problem. Below are some key points from the book.

The economic well-being of Americans no longer depends on the profitability of the corporations they own, or the prowess of their industries, but on the value they add to the global economy through their skills and insight. This is because today capital and goods can flow nearly uninhibited. So, corporations seek to invest where the skills they require can be attained for the lowest cost.

There are 3 broad categories for American jobs:
1. Routine production services - repetitive tasks, done over and over again, performed in the high-volume enterprise. These face competition from worldwide labor and require little skill, and so these jobs are quickly moving to areas with the cheapest labor.

2. In-person services - Like routine production services, in-person services also entail simple, repetitive tasks. Their pay is also a function of hours worked or amount of work performed, they are closely supervised, and they need not have acquired much education. The big difference is that these services must be provided person-to-person, and thus are not sold worldwide. Included in this category are retail sales workers, waiters and waitresses, hotel workers, janitors, cashiers, etc. Because of this local requirement, their wages are not deteriorating as fast as routine production services, but supply and demand still does not bode well for them. As routine production services move offshore, there is a larger supply of workers looking for these in-person service jobs.

3. Symbolic-analytic services - includes all the problem-solving, problem-identifying, and strategic-brokering activities. Examples include consultants, specialists, engineers, bankers, scientists, etc. This group is adding the most skills to the global economy and can not be easily replicated.

There is a growing inequality, as the skilled get richer and poorest get hurt by competition.
The law of supply and demand does not bode well for routine and in-person services.
Differences in education has played a very large part in wage outcome.

The important skill is learning how to conceptualize problems and solutions. There are 4 basic skills: abstraction, system thinking, experimentation, and collaboration.
1. Abstraction- making sense of all the data that surrounds us.
2. System-thinking- relating abstraction to different information; seeing the whole.
3. Experimentation- continuously trying out new things.
4. Collaboration- working with peers to share information and expand knowledge.
From then on, knowledge comes from doing.

There are two reasons America will stay ahead of the pack:
1. No nation educates its most fortunate and talented children as well as America.
2. No nation has the same agglomerations of symbolic analysts already in place, with the ability to learn continuously and informally from one another.

America has several large cities with special skills; think Hollywood for film production, Silicon Valley for technology, New York for finance and law. More talent is encouraged to these areas because there are more opportunities and there is a large network to informally learn from.

The role of the nation within the emerging global economy should be to improve its citizens' standard of living by enhancing the value of what they contribute to the global economy. The problem is some Americans are adding substantial value, while most are not. This is leading to growing inequality, and the bottom four-fifths requires the fortunate fifth to share its wealth and invest in the wealth-creating capacities of other Americans. Ironically, as the rest of the nation grows more economically dependent than ever on the fortunate fifth, the fortunate fifth (the symbolic analyst) is becoming less and less dependent on them.

Finally, just a particular quote I like from the book:
The predictable failure of all prediction notwithstanding, the public continues to pay attention to stock analysts, trend spotters, futurologists, weather forecasters, astrologers, and economists. Presumably such respect is due less to the accuracy of their prophecies than to the certainty with which they are delivered. The reader of these pages is duly warned...

Delta Financial: New Financing

A few days ago, I mentioned the following about Delta Financials 3rd Quarter Report:

But the very poor delinquency performance of their securitizations this quarter show two things. One, their equity is in danger of being wiped out, and that another cash infusion at very unfavorable terms will probably be necessary. Two, Delta's niche underwriting in the sub-prime market might not be as good as they made it out to seem.

Today, we got confirmation of 'One'.

Delta Financial Corporation (the “Company”) entered into a letter of intent, dated November 15, 2007, with an affiliate of Angelo, Gordon & Co., one of the Company’s principal stockholders...

If the proposed transaction is completed, an affiliate of Angelo, Gordon & Co., AG Special Situation Corp. (“AGSSC”) will purchase from the Company a new series of 10% Senior Secured Notes. The maturity of the notes will be three years after issuance. The initial aggregate principal amount of the notes will be equal $100.0 million, minus the principal amount outstanding under the August 2007 residual financing facility as of the issuance date of the notes. The Company currently estimates that if the transaction closes in December 2007, such principal amount will be approximately between $45 million and $49 million, such that the initial principal amount of the 10% Senior Secured Notes will be between $51 million and $55 million. Interest on the notes is expected to be payable on a payment-in-kind basis until the first anniversary of the closing date. In connection with the proposed note issuance, the Company will issue to AGSSC 40 million newly issued shares of common stock as additional consideration, which may be initially issued in the form of convertible preferred stock or convertible debt securities. The Company will also reduce the exercise price of Angelo Gordon’s warrants to purchase 10.0 million shares of common stock to $1.00 per share. The warrants remain due to expire in February 2009.


If the transaction closes as planned, Angelo Gordon will be the beneficial owner of approximately 61.4% of the Company’s outstanding common stock, and approximately 66.5% of the Company’s outstanding stock if it exercises all of its warrants. Upon the closing of the transaction, subject to certain limitations intended to comply with certain state lending regulations, AGSSC will obtain the right to elect a majority of the Company’s Board of Directors. AGSSC will also obtain registration rights with respect to the new shares of common stock, and preemptive rights with respect to the issuance of new shares of the Company’s capital stock.

The company had about 24 million diluted shares outstanding at the end of the 3rd Quarter. The company is giving Angelo Gordon 40 million new shares just for the ability to borrow money- $55 million at 10%.

Thursday, November 15, 2007

Wells Fargo CEO: Housing Slide Not Over

Here is a link to the article.

Wells Fargo & Co. President and Chief Executive John Stumpf said Thursday the housing market is experiencing its worst decline since the Great Depression.
Stumpf said the weakening market is due to a combination of factors, ranging from too much demand for homes during the first half of the decade to an increase in fraudulent loans and risky loan products.

Wells Fargo has increased loss provisions in recent quarters to cover increasing defaults on mortgages and home-equity products. Declining home prices have led to larger losses in Wells Fargo's portfolios, though so far, the increased losses are related more to severity than increased frequency of losses, Stumpf said.

The slides and audio for this conference can be accessed here. Some notable information from it:

- Unprecedented decline in national home prices
- Increase in losses in Q3’07 primarily a severity issue
- Certain markets with more housing stress – e.g. Midwest and CA Central Valley
- Correspondent channel: 7% of portfolio at 9/30/07, yet 25% of Q3’07 losses
- Disproportionate losses in correspondent channel. Contributing factors:
1. Acquired closed loans from third party originators
2. Typically purchase-money loans
3. Higher CLTVs at origination
4. Average CLTV at 9/30/07: 74% total home equity portfolio. 87% correspondent portfolio
5. Largely concentrated in 2006 and first half 2007 vintages
6. Largely sourced in MSAs that experienced steep, sudden
declines in housing values

Briefly, the retail channel refers to loans made by a company's own loan officers, while wholesale and correspondent loans are made by third-party brokers/salespeople. There is an UberNerd on Mortgage Origination Channels which explains this in detail, as well as some of the problems that it has caused, much better than I ever could.

Wednesday, November 14, 2007

Bancinsurance 3rd Quarter Earnings

This was not a typical filing. I'm going to separate this discussion into two parts, the operational side and the legal side.

Operationally, this quarter was a blast. The news reported premiums were down, but a closer look shows that they are writing more premiums than ever- they are just ceding more to their Producer-Owned Reinsurance Companies (PORC's).

Now, these ceded policies do earn a nicecommission:

During the three months ended September 30, 2007 and 2006, ceded reinsurance decreased commission expense incurred by $1,571,611 and $300,420, respectively, and $4,456,986 and $1,061,833 during the nine months ended September 30, 2007 and 2006, respectively.

Overall, earnings were boosted by a low tax rate and hurt by a realized loss on an investment, the effects of which approximately cancel each other out. But "normalized" earnings for the quarter of about $1.6 million was a big improvement. During the quarter the expense ratio dropped to 31.4% from 44.6%, which was one of the expectations in the original analysis. Meanwhile, book value per share increased to $39.4 million, and the stock is currently trading at a market capitalization of about $30 million. So on a pure-numbers we see this is definitely cheap.

Now, the legal front is where some uncertainty arises. With respect to the discontinued bond program, this statement from the last 10-Q was still present:

Highlands has provided loss information to the Company with respect to alleged losses for bail bonds issued in the State of New Jersey and for federal immigration bonds. Highlands has indicated in filings that it has additional exposure for bail bonds issued in states other than New Jersey. Highlands has not provided sufficient information for the Company to quantify these additional losses. As of September 30, 2007, the Company is reserving to its best estimate of future Highlands losses based on the most recent loss information received from Highlands with respect to immigration bonds and New Jersey bail bonds only.

Meanwhile, on a slightly more positive note:

In October 2006, the Company commenced arbitration against Ernst & Young LLP (“E&Y”), the Company’s former independent registered public accounting firm, in accordance with the terms of the engagement letter between the Company and E&Y. In the arbitration, the Company alleges that E&Y improperly withdrew the Company’s audit reports for the 2001 through 2003 fiscal years. The Company is seeking monetary damages in excess of $21 million. E&Y has counterclaimed, seeking to recover in excess of $475,000 from the Company for unpaid invoices and additional costs. An arbitration panel has been constituted and the hearing is currently scheduled for December 2007. The Company does not believe the ultimate resolution of this dispute will have a material adverse effect on our financial condition or liquidity. See Note 14 to the Condensed Consolidated Financial Statements for subsequent events related to the E&Y arbitration.


In connection with the Ernst & Young arbitration disclosed in Note 10, on November 12, 2007, the Company and Ernst & Young tentatively agreed to a settlement of this dispute whereby the Company would release its claims against Ernst & Young and Ernst & Young would agree to pay the Company $20,000 and forgive its counterclaim of $475,000. Upon execution of a settlement agreement, which is currently anticipated to be sometime during the fourth quarter of 2007, the Company would record a pre-tax gain of approximately $0.5 million related to the Ernst & Young settlement.

This was surely settled though just to save them both from a big legal battle. The sum being paid was very insignificant, so we can not assume any particular strength to Bancinsurance's claim. I mention this as important because the following was also new in this 10-Q:

On October 23, 2007, the Company and certain of its current officers (Chief Executive Officer, Chief Financial Officer and Vice President of Specialty Products) received a “Wells Notice” (the “Notice”) from the staff of the SEC indicating that the staff is considering recommending that the SEC bring a civil action against each of them for possible violations of the federal securities laws. The Notice provides the Company and each officer the opportunity to present their positions to the staff before the staff recommends whether any action should be taken by the SEC. The Company continues to cooperate fully with the SEC and intends to continue to do so in an effort to resolve this matter.

Pursuant to separate undertaking agreements dated November 12, 2007 between the Company and each officer who received the Notice, the Company has agreed to advance reasonable legal fees and expenses incurred by each officer in connection with the ongoing SEC investigation. The undertaking agreements require each officer to repay the amounts advanced if it is ultimately determined, in accordance with Article Five of the Company’s code of regulations, that the officer did not act in good faith or in a manner he reasonably believed to be in or not opposed to the best interests of the Company with respect to the matters covered by the SEC investigation. A copy of the form of the undertaking agreement is attached to this report as Exhibit 10.2 and the foregoing discussion is qualified in its entirety by reference to Exhibit 10.2. Under the Company’s code of regulations and Ohio law, the Company may also be required to indemnify each officer in connection with the SEC investigation.

That is something that I was hoping would not happen. You can read up more about Wells Notices (in general) here. We know from the 10-Q that this case "concerned the chronology, events and announcements relating to Ernst & Young LLP (“E&Y”), our former independent registered public accounting firm, withdrawing its audit reports for the years 2001 through 2003 for the Company." Finding out how costly this can be will be important in judging its ultimate impact. Overall, while the business showed improvement this quarter and valuations became more compelling, a new risk has also popped up with regards to this SEC matter.

The Logician

Plato, through the character of Socrates, has a specific method of presenting his position on a given topic. His method of argument being comprised of three steps:

1. Starting with certain premises
2. Through a process of reasoning, leading his opponent to
3. His conclusion

The only way to dismantle the so-called “Socratic method” of argument is also a three-step process:

1. If the truth of the first is challenged successfully
2. And if the remaining premises that are based on original premise follow logically
3. The conclusion is false

Now the first time I read this, I didn't really understand its significance. It seemed to me a pretty obvious statement. But while sitting in class a few days back I had a striking thought about this quote and about technical analysis. What are the initial premises which form the basis for technical analysis? It appears to be the idea that a stock's future price can be dictated by its past price action. But that premise can be so easily challenged, and there seems to be no way to show how or why past price action has any effect on future stock price. The only thing I was able to think of is that if you see large volume of buying, that perhaps this signifies a big buyer is trying to accumulate stock and so this should push the price upwards in the near term. But this is easily challenged, too. 1) You have no idea whether this buyer is done buying or not. 2) If you are basing your logic on the fact that you are following buyers who have come up with their own sound reasoning, then that is flawed too- everyone has opinions, most will likely be wrong. And for every buyer there is a seller, so someone else is obviously disagreeing.

Now compare that to the idea of value investing. By value investing I don't mean buying beat-up companies or companies that appear cheap. I mean buying companies for less than their expected discounted cash flow. You can challenge this by asking, "what's to say a company will eventually trade at its DCF?" There is a solid response to this though: the company can use this cash flow to pay out dividends, ensuring that an investor will recognize the value of his investment. "What if they don't pay out their cash in the form of dividends?" Then investors can get on the board and force this to happen. "What if the board and founders own a majority stake and refuse to treat shareholders properly?" Well, in that situation, you might be out of luck. Still, we see that the foundation for value investing is based on a much more solid framework.

Now despite this shakiness to the ideals of technical analysis, there is no shortage of people who have faith in this system. Just turn on CNBC one morning and you will see for yourself. And they have come up with elaborate techniques and fundamental rules, yet they don't realize that the foundation of their entire belief structure is suspect.

And unfortunately, I think this is prevalent in society. And a lot of bad habits are taken up because people will just accept a certain premise and never challenge it, and then go all their life never looking back on it. Warren Buffett has said every year you should throw away at least one of your most cherished beliefs. So, the past few days I have stopped every now and then and asked myself, "hey, why am I doing this or why do I believe that?", and it has been a very enriching exercise that I recommend to others. If you are honest, it will help you to better understand yourself and the world around you.

Friday, November 09, 2007

Delta Financial 3Q Report

The fate of Delta Financial does not look too promising based on its third quarter earnings report. Due to market disruptions, the company could not continue with its traditional approach of securitizing and retaining the excess interest. Instead, the company needed to securitize and unload everything, at a steep 10% loss to the company.

And, I would look at their balance sheet in the following light. Take their 115 million in equity and add the 75 million in allowance for loan losses, giving you 190 million in "adjusted" equity.

Now, they have 6,630 million in securitized loans plus 62 million real estate and 32 million trustee receivables, adding up to 6,724 million. The debt balance that these loans secure is 6,510 million. That leaves approximately 214 million in "at-risk" capital in their securitizations, which counts on their balance sheet towards equity. You can judge how at-risk it is based on their current delinquency numbers:

The 214 million is only about 33% of 90 day + delinquencies, meaning there is a strong likelihood that most of this capital be wiped out. The only hope would be that some of the earlier securitizations will perform better than others, leaving some capital to be returned to Delta.

Meanwhile, Delta also has 480 million in pre-securitized loans which are backed with about 475 million in warehouse facilities and other borrowings. If the conditions in the market have not improved since the end of the 3rd quarter, then Delta will probably also take a further hit in capital from the sale of these loans. We saw in that in the 3rd quarter they were taking 10% losses on these loan sales.

Delta has been increasing the interest rate on its loan, and they just cut a quarter of their staff to lower their costs and loan production. So we can hope that fairly soon the ongoing business can stabilize. But the very poor delinquency performance of their securitizations this quarter show two things. One, their equity is in danger of being wiped out, and that another cash infusion at very unfavorable terms will probably be necessary. Two, Delta's niche underwriting in the sub-prime market might not be as good as they made it out to seem.

Wednesday, November 07, 2007

A Practical Look at Bond Insurers

A bond insurer provides credit protection by giving its guarantee to pay any unpaid principal and interest payments in a default. By giving its guarantee, a debt security can then be issued with a higher rating, usually AAA, and this lowers the interest cost of the debt. Now, I'd argue that if you take a close look at the competitive forces these companies face, you'll come to the conclusion that this is a mediocre business at best.

The most obvious competition is from other bond insurers and there really is no moat within this group. The AAA credit-rating is favorable because it lowers the cost of guaranteed securities to almost government treasury rates, but there are a few insurers who have this rating. Otherwise, the business is strictly based on how much capital you have and what price you are willing to pay. MBIA mentions in their annual report that it "also competes with other forms of credit enhancement, including senior-subordinated structures, credit derivatives, over-collateralization, letters of credit and guarantees."

But an even more significant competitor is "Mr. Market" himself. An issuer of debt likes bond insurance because it diminishes the investor's risk, and so it can potentially lower the issuer's interest costs. It all depends on cost of the insurance, and the spread between what the market will charge the issuer and what the market will charge its guaranteed security. If the cost of insurance is less than the spread, then the bond insurer gets new business and the issuer lowers his borrowing cost. But if the cost of insurance is more than the spread, then there is no transaction- the issuer would be better off selling the debt directly to the market. Thus, we see that credit insurers are competing against the market's perception of risk. Effectively, the bond insurer is saying that they have expertise and can profit by being better judges of a security's risk than the overall market.

Now that is plausible. But for one, these insurers are doing this with a large amount of money, making it more difficult to earn out-sized returns. And two, before the recent turmoil in the credit markets, spreads on risky securities were at unprecedentedly low levels.

So taking into account the competition, the large capital base, and the credit spread tightening, you would think that these companies would have been marginally profitable recently. But instead, these companies have been recording record profits with very healthy margins.

MBIA, 2002- 2006 ratios

Loss and LAE ratio

9.7 % 10.0 % 10.0 % 10.0 % 10.5 %

Underwriting expense ratio

26.6 24.7 21.5 22.2 22.9

Combined ratio

36.3 34.7 31.5 32.2 33.4

So that begs the question of how a credit insurer was able to underwrite so profitably(loss reserves at 10% of premiums) in an environment where "Mr. Market" was so willing to buy risky debt. And I guess you can say part of the answer lies in the fact that a bond insurer's loss reserves are very much up to judgment. In traditional property and casualty insurance, you typically have a very good sense of what your total losses will be by the second year. But in bond insurance, the time horizon is much longer. For example, we know that the average of MBIA's insured debt outstanding is over 10 years. That means that at anytime within those 10 years, a credit contraction could reveal that their reserves are drastically inadequate. This makes investing in a bond insurer sort of like a black-box, because you never really know what you are getting without knowing their loss assumptions.

Many bond insurers have lost 50 to 75 percent of their stock value in the last 6 months. (See MBI, ABK, AGO) Perhaps at these prices they are actual values, and maybe I am missing some factor that allows them to underwrite so effectively. All I know is based on these competing forces and the leeway available in their accounting, that it is very likely they have been under-provisioning for future losses, and that I can not tell you by how much. As I was writing this though I did come across this post on Calculated Risk- Egan Jones: Expect "Massive" Losses for Bond Insurers.

Sunday, November 04, 2007

PetroChina Shares Triple in Shanghai Debut

This one caught my eye... (Link)
Shares in PetroChina, which raised $9 billion in the world's biggest initial public offer this year, nearly tripled in their market debut and far exceeded analysts' forecast, buoyed by the company's position in the world's second-biggest energy market.

The opening price gave PetroChina a total market value of $1.1 trillion, making it the world's largest listed company by market capitalisation, more than double the second biggest, Exxon Mobil, at $488 billion.
It'll be interesting to see whether the US-listed shares will follow their Chinese counterparts tomorrow morning. We know Buffett thought PetroChina was too expensive and recently sold his entire stake. So either Buffett was 300% off on his Intrinsic value estimate, or the Chinese are in a full-blown bubble.

Friday, November 02, 2007

The Importance of Loan Loss Reserves

Last post I said:
I'm going to have to make a post comparing this [Exchange Bank of Santa Rosa's] reserving with some of the companies Fairfax owns credit default swaps against. The allowance for loan losses doesn't even cover the 90+ day delinquencies for many of these companies, even after some very large loan loss provisions recently.
Well today, I made the comparison using two other household names in Fairfax's CDS portfolio: Countrywide Financial and Washington Mutual. Before going into that though, I want to comment that it was very difficult to find these numbers in their earnings report, and 30+ delinquency numbers could only be found by using FDIC Call Thrift Data. And for Countrywide and WaMu, getting a true understanding of their financial conditions is very complex.
(Numbers in 000's)

First to reiterate, is Exchange Bank of Santa Rosa's at the end of Q3:

Exchange Bank of Santa Rosa
(Numbers in 000's)

Gross loan portfolio: 1,173,194
Allowance for loan losses: 20,930
30-89 days delinquent: 1,327
90+ days delinquent: 7,890

30 day + delinquencies / gross loans = .78%
90 day + delinquencies / gross loans = .67%
Allowance for losses / gross loans = 1.78%

Now let's look at Countrywide Financial. First, a few things to note about Countrywide. One is that Countrywide is seperated into a mortgage originating and a banking operation. The originating business doesn't provision for losses, because they expect to sell their loans. For purposes of this exercise, we will only look at their banking operation because that involves the loans they plan on holding on their balance sheet. But it should also be remembered that Countrywide's originating business pumps out loans at very high multiples of equity. For example, in the latest quarter they produced 90 billion of loans. Annualize the rate and compare it to 15 billion in total equity, (traditional banking included) and you start to see what I am talking about. So at any given point, Countrywide is also holding a large amount of loans that it does not consider part of its portfolio and so doesn't reserve for. And because in the current credit turmoil, we saw them transfer 12 billion of loans to their banking portfolio this quarter in order to avoid selling them at current market prices. But anyways, I will be using only the banking operation numbers today.

Another thing to note is that since Countrywide does not provide 30 day delinquencies, I had to look them up using Call Thrift Data. For one, the most recently available report is from the 2nd Quarter, so the numbers are slightly lagging. Second, the numbers slightly differ between what the company reports, likely because of other subsidiaries. So do not accept these as precise, but very rough estimates. If anything though, it is underreporting delinquency numbers.

Countrywide Banking
(Numbers in millions)

Gross loan portfolio: 80,430
Allowance for loan losses: 1,127
90 days + delinquent at end Q3: 1,433
90 days+ delinquent at end Q2: 941

30-89 days delinquent at end Q2: 1,790

So we see that 90+ delinquencies shot up between the 2nd and 3rd quarter, which means 30-89 day delinquencies probably went up in Q3 too. But if we just assume the same 30-89 day numbers for Q3, we get:

30+ day delinquencies / gross loans = 4.00%
90+ day delinquencies / gross loans = 1.78%
Allowance for losses / gross loans = 1.40%

Now a few other things (I told you this was going to be complex). The gross loans number of 80.4 billion is inflated because Countrywide transferred 12 billion in loans over during the quarter from their originating business. But most of these loans were made recently, so they would either not be delinquent yet or they went delinquent during the third quarter, for which the figures aren't available (remember we had to use Q2). So these numbers are slightly inflated in that respect. Second, Countrywide holds 45 billion in Adjustable Rate Mortgages (ARMs), with many of those being Pay-Option ARMs. These are much more difficult to go delinquent on because any payment that can not be made is just added to the principal balance. But either way, we see that Countrywide's reserving is still inadequate.

With all that cleared up, it should be much easier to explain Washington Mutual. The same issues mentioned above apply here, with respect to originating vs banking business and the 3 month lag in some of the numbers.

Washington Mutual Banking
(Numbers in millions)

Gross loans = 227,348
Allowance for loan losses = 1,889
Non accrual loans at end of Q3= 4,577
Non accrual loans at end of Q2 = 3,443

90+ days delinquent and accruing at end of Q2 = 245
30-89 days delinquent at end of Q2 = 2,910

Using the same Q2 numbers going into Q3, we get:

30+ days delinquencies / gross loans = 4.58%
90+ days delinquencies / gross loans = 3.40%
Allowance for losses / gross loans = .83%

Again, Washington Mutual also has 138 billion in ARMs, with 56 billion of them Pay-Option ARMs, which do not normally go delinquent until much later on. Calculated Risk recently provided this chart with regards to recent deteriorating in ARM performance.
We see the recent trend has been much worse. So to summarize the point of this entire post, I'd say look at two percentage figures:
1. Allowance for loan losses to 30 day delinquencies, and
2. Allowance for loan losses to 90 day delinquencies.

Basically, the percentage which your allowances cover delinquent loans. The higher the better, and remember this is giving a lot of benefit to the doubt to CFC and WM. (lagging delinquencies, ARMs)

1. 228%
2. 266%

1. 35%
2. 79%

1. 18%
2. 24%

The significance of all this is that an under-reserved bank has no cushion for declining credit performance and will have to provision more for losses in the future, meaning their current earnings figures and equity are likely inflated and unreliable. Conversely, a well-reserved bank has a cushion for any adverse credit trends and the income figures are much more stable and protected.

Thursday, November 01, 2007

Earnings Roundtable

Four of my companies released earnings today. Unfortunately I have not yet listened to the conference calls for any of these companies, so I will hopefully be able to expand on this commentary shortly. For now...

SFK Pulp Fund
First, the bad. SFK's earnings have and continued to get hit by the relentless rise in the Canadian dollar (see chart). This has the effect of lowering their revenues, which are based in terms of US dollars, while their costs remain the same. The thesis has basically been that 90% of NBSK pulp capacity is in Canada or Europe, so the entire industry is getting squeezed by the recent rise. And SFK represents a very low-cost competitor on the production curve, and worldwide demand should continue to grow into the future. So the timing has so far been off, but Pope and Talbot recently filed for creditor bankruptcy. Either the prices they charge will have to increase or their going to have to disband operations, because their EBITDA (Earnings before interest, taxes, depreciation and amortization) was negative 5 months ago before the Canadian dollar run-up. On that note, they did announce a $20 increase for this month as well. As for where the Canadian dollar is going from here, that is something I feel like looking into.

Harvest Natural Resources
There is not much to talk about in this one, especially without listening to the conference call. Since Chavez signed the contract after the third quarter ended, the company will not record the benefit and the results of the operations on their financials until the next quarter.

Exchange Bank of Santa Rosa
This report probably went by unnoticed because it is still not published on their site, but it is available on the FDIC Call Thrift Data. Overall, I continue to be impressed. Earnings per share for the quarter came out to $3.14, and $9.73 for the last 9 months. But more importantly, the loan underwriting and reserves continue to be phenomenal.

30 day + delinquencies / gross loans = .78%
90 day + delinquencies / gross loans = .67%
Allowance for losses / gross loans = 1.78%

I'm going to have to make a post comparing this reserving with some of the companies Fairfax owns credit default swaps against. The allowance for loan losses doesn't even cover the 90+ day delinquencies for many of these companies, even after some very large loan loss provisions recently.

Fairfax Financial
Fairfax reported exceptional earnings today. The insurance operations had an underwriting profit of $62 million for the quarter, the holding company now has $836 million in cash, and debt continues to fall. Simply put, the team at Fairfax has done a remarkable job to get Fairfax where it is today.

With respect to the credit default swaps, the portfolio had a fair value of 546 million at the end of September. If we compare the last two numbers of the table in this post, we can see that since quarter end these spreads have widened significantly more. The question on current value will almost certainly be brought up on the conference call tomorrow, but I'm not so certain they will answer that. Last quarter they mentioned the updated fair value of the CDS portfolio in their earnings release. It would seem uncharacteristic of them to release this number on a conference call, where some people will certainly hear it before others. The management at Fairfax will probably avoid giving any updates in order to avoid speculation in their own shares.