Recently the financial markets were shrieking in fear of the settlement of Lehman and Washington Mutual credit default swaps. Yet the settlement dates have past and there seems to be no impact apparent to the market. What happened? Is the CDS question overblown? Are the risk controls in place that the market is discounting?
There a few reasons to believe that the issues are still looming large in the market…
1) Just like the LTCM meltdown, it is not the settlement but the collateral requirements that will kill you
The OCC reports that investment banks believe they are hedged up to 85% of notional value of CDS.
This means the last 15% can swing in as a profit or loss, assuming no counterparty risk. For many of these hedge funds and banks, particularly for AIG, as market falls the collateral requirements on their positions must raise parabolicly. In the case of 123B loan from the US government to AIG, “tens of billions of dollars to post collateral with other financial institutions, as required by A.I.G.’s many derivatives contracts”. The "assets in a box" with the clearing bank will need to be replentished. But where will that come from in an environment like this? I am sure there are firms that are dead right now but just waiting on the banks to come seize assets on loans that are not performing.
2) Creditor will vampire the dead firms rather than kill them
The last thing any prime broker or bank needs is exposure that another client is not performing. Thus any attempt will be made to defer the inevitable while doing everything they can to obtain as much collateral before the fall. Look at how the home builders like Beazer have continued operations with no prospects of returning to profitability in the next few years. In the book Traders, Guns, & Money, the Das recounts how mid sized Indonesian firm, facing huge losses, created follow on agreements to amortize the debt with interest over longer periods of time. Whenever possible, this deferred payment plan disguised as an additional trade will be the best option for many of the major banks if they think the party will be able to last through the crisis.
3) The counterparty risk makes hedging calculations dubious
Take the UBS vs. Paramax court case where we find that UBS propped up a hedge fund and then bought CDS protection from them. The idea that hedge funds, as leveraged parties, can hold significant quantities of these securities creates a systemic risk. So if banks have 15% directional exposure, and additional 10% risk due to possibility of counterparty failure, then what are the real capital requirements that the banks need to call themselves solvent? I don't think any of the major credit default swap brokers have achieved this level of captial safety.
4) Lack of transparency to risk concentration is a riddle in itself
Yes, there were only $72B of Lehman CDS to be settled, and only $5B of that changed hands. But we do know there are 63T CDS outstanding amongst all banks. JP Morgan, BofA, C account for 15T by themselves. The 15% exposure of this notional value is worth more than the market cap of all of these banks combined. So what that we turned over one shell in this shell game and there was less than what we expected? Later we might turnover a shell and find more than what we expected. Or we find a case like AIG where they took only the side of writing protection?
The risk is very real.
In conclusion: Stronger transparency to collateral requirements will make the CDS market viable in the future when risk assessment criteria is formalized and enforced. But over 90% of existing CDS contracts span in length from 1 to 5 years. Thus there will be tremendous risk that will need to be flushed through the market that will keep the environment tenuous until industry can be considered viable, stable corner of the capital market.
This article is written in response to Felix Simon’s article “CDS the less you know the worse they look?”
Thursday, October 30, 2008
Tuesday, October 21, 2008
Where do we really need the bailout? Hint: It is not the banks
All over the world $1.3T has been provided by governments to bolster the balance sheets of banks. Although this averts any immediate crisis by providing padding to the capital base of many of the most leveraged banks, it is a knee jerk reaction that does not address the root of the cause. It has been observed that the problem with banks is that the value of assets continues to go down in relation to leveraged balance sheets.
But if you gave the banks an infinite amount of money, would the issue be resolved? I contend no, because the real leverage is not tied to the lending institutions, but instead the consumers who provide the collateral to the transactions that the banks perform. The banks, for years, have tried to monetize the value of the undercapitalized consumer through interest rate hikes and extending the length of repayment. Now, with credit unavailable to finance these undercapitalized (regardless of credit rating) commitments long term, the banks are now starting to reflect the same financial situation that has been the case with the American consumer for years. Too many commitments served by way too little actual capital.
Thus before any type of resolution can occur in the credit markets, there will need to be a recapitalization of the American consumer. No more zero collateral purchases of cars, boats, homes, etc. A simple stimulus check providing $1200 is just one month worth of the payments that will need to be provided to float the American consumer. It will require at least 20 of these stimulus packages to get American family to stable balance sheet. What is the lesson in the temporary boost?
In conclusion, I approve of the use of $750B to recapitalize banks to avert an immediate destruction of the financial system. But I also approve a middle class tax cut bigger than what Obama is proposing and lots of personal bankruptcies as steps necessary for Americans to find their footing in a new, disciplined credit environment. The real "Bank of America", the wallets of the American consumer, will never truly be solvent until the people of America realize what fiscal solvency really requires.
But if you gave the banks an infinite amount of money, would the issue be resolved? I contend no, because the real leverage is not tied to the lending institutions, but instead the consumers who provide the collateral to the transactions that the banks perform. The banks, for years, have tried to monetize the value of the undercapitalized consumer through interest rate hikes and extending the length of repayment. Now, with credit unavailable to finance these undercapitalized (regardless of credit rating) commitments long term, the banks are now starting to reflect the same financial situation that has been the case with the American consumer for years. Too many commitments served by way too little actual capital.
Thus before any type of resolution can occur in the credit markets, there will need to be a recapitalization of the American consumer. No more zero collateral purchases of cars, boats, homes, etc. A simple stimulus check providing $1200 is just one month worth of the payments that will need to be provided to float the American consumer. It will require at least 20 of these stimulus packages to get American family to stable balance sheet. What is the lesson in the temporary boost?
In conclusion, I approve of the use of $750B to recapitalize banks to avert an immediate destruction of the financial system. But I also approve a middle class tax cut bigger than what Obama is proposing and lots of personal bankruptcies as steps necessary for Americans to find their footing in a new, disciplined credit environment. The real "Bank of America", the wallets of the American consumer, will never truly be solvent until the people of America realize what fiscal solvency really requires.
Monday, October 20, 2008
10 Good Reasons to Short Bank of America
Bailout or no bailout, banks need to be profitable to survive. Bank of America has tremendous resources and connections to stay viable in the long term. But here are 10 good reasons to assume the BAC common stock will continue to fall through 2009 before the crisis abates.
#1 Bank of America also has a huge book of loans to homebuilders. It is time for at least a few to go bankrupt, this will be another severe dent in their portfolio. (Mish Shedlock quotes a minimum 7B+ in writeoffs coming)
#2 Bank of America must buy back $5B of auction rate securities. This is a cash transaction that takes away from their ability to lend in other areas, crimping income.
#3 Bank of America bought MBNA credit cards at the top of the market (2004). Thus Bank of America holds a very large exposure there to consumer spending decreases or increases in unemployment.
#4 In their distress with deteriorating loans, Freddie and Fannie have said that their top priority is to find recourse with fraudulent loans that have gone sour. If fraud is found, then the loan and the loss will be sent back to the originator. Until 2008, Countrywide originated over 25% of the countries loans.
#5 Countrywide has $25B in option arms still on the books that BofA is still liable for.
#6 Countrywide has $38B in debt outstanding. When Bank of America (BofA) took over Countrywide, BofA did not commit to guaranteeing the debt would be paid.
#7 When one of the Big Three automakers goes bankrupt, directly or indirectly this will mean at least a $5B hit to Bank of America
#8 Commercial Real Estate exposure is very significant
“Now what about financing of malls, retailers, office space, etc etc. A modest 10% writeoff across the board (highly likely IMO) would mean another $33 billion in writeoffs are coming from commercial real estate.”
http://seekingalpha.com/article/94896-bank-of-america-credit-weakness-spreading-to-commercial-loans
#9 The sheer arrogence of the Merrill Lynch purchase at $26/share for a company about to go bankrupt.
http://seekingalpha.com/article/94896-bank-of-america-credit-weakness-spreading-to-commercial-loans
#10 Bank of America has huge credit default swap counterparty risk
Bank of America currently holds over $1T in nominal credit default swaps. With deleveraging of hedge funds, parties that took the other side of their trades may not be able to pay out the insurance. In particular, if a party cannot payout on regarding a different CDS event, then the value of that party as an insurer of any other CDS contract becomes void. This could become a huge hole for BAC on many of their commercial loans.
What kind of opportunity is available for those interested in shorting the stock???
Assume a $124B market capitalization for the stock, referring to one year revenue based on 2007 revenue.
Subtract $5B writedown for homebuilder loans
Subtract $30B writedown in commercial real estate
Subtract $10B writedown of credit default swaps due to counterparty risk
Subtract $1B net writedown for auction rate securities
Subtract $5B writedown of Countrywide option ARMs
Subtract $5B writedown on prime mortgages from BAC legacy business
Subtract $1B from boomerang loans from Fannie and Freddie
Subtract $10B writedown to defease Countrywide and Merrill Lynch debt
Subtract $3B in credit card writedowns from legacy MBNA business
Subtract $5B writedown for commercial loans (industrial and especially automakers and their auto industry supply chain partners)
All of these negative events aside, within three years, Merrill Lynch and Countrywide will start to have a positive impact on earnings. But this year, we should expect the market cap of Bank of America ($124B cap) to absorb over $75B in writedowns and losses to net a market cap of $50B, which is approximately a fair value of $13/share.
Thus Lockstep Investing is recommending initiating a short position once Bank of America crosses $26 / share, exit when the stock crosses $12 / share.
#1 Bank of America also has a huge book of loans to homebuilders. It is time for at least a few to go bankrupt, this will be another severe dent in their portfolio. (Mish Shedlock quotes a minimum 7B+ in writeoffs coming)
#2 Bank of America must buy back $5B of auction rate securities. This is a cash transaction that takes away from their ability to lend in other areas, crimping income.
#3 Bank of America bought MBNA credit cards at the top of the market (2004). Thus Bank of America holds a very large exposure there to consumer spending decreases or increases in unemployment.
#4 In their distress with deteriorating loans, Freddie and Fannie have said that their top priority is to find recourse with fraudulent loans that have gone sour. If fraud is found, then the loan and the loss will be sent back to the originator. Until 2008, Countrywide originated over 25% of the countries loans.
#5 Countrywide has $25B in option arms still on the books that BofA is still liable for.
#6 Countrywide has $38B in debt outstanding. When Bank of America (BofA) took over Countrywide, BofA did not commit to guaranteeing the debt would be paid.
#7 When one of the Big Three automakers goes bankrupt, directly or indirectly this will mean at least a $5B hit to Bank of America
#8 Commercial Real Estate exposure is very significant
“Now what about financing of malls, retailers, office space, etc etc. A modest 10% writeoff across the board (highly likely IMO) would mean another $33 billion in writeoffs are coming from commercial real estate.”
http://seekingalpha.com/article/94896-bank-of-america-credit-weakness-spreading-to-commercial-loans
#9 The sheer arrogence of the Merrill Lynch purchase at $26/share for a company about to go bankrupt.
http://seekingalpha.com/article/94896-bank-of-america-credit-weakness-spreading-to-commercial-loans
#10 Bank of America has huge credit default swap counterparty risk
Bank of America currently holds over $1T in nominal credit default swaps. With deleveraging of hedge funds, parties that took the other side of their trades may not be able to pay out the insurance. In particular, if a party cannot payout on regarding a different CDS event, then the value of that party as an insurer of any other CDS contract becomes void. This could become a huge hole for BAC on many of their commercial loans.
What kind of opportunity is available for those interested in shorting the stock???
Assume a $124B market capitalization for the stock, referring to one year revenue based on 2007 revenue.
Subtract $5B writedown for homebuilder loans
Subtract $30B writedown in commercial real estate
Subtract $10B writedown of credit default swaps due to counterparty risk
Subtract $1B net writedown for auction rate securities
Subtract $5B writedown of Countrywide option ARMs
Subtract $5B writedown on prime mortgages from BAC legacy business
Subtract $1B from boomerang loans from Fannie and Freddie
Subtract $10B writedown to defease Countrywide and Merrill Lynch debt
Subtract $3B in credit card writedowns from legacy MBNA business
Subtract $5B writedown for commercial loans (industrial and especially automakers and their auto industry supply chain partners)
All of these negative events aside, within three years, Merrill Lynch and Countrywide will start to have a positive impact on earnings. But this year, we should expect the market cap of Bank of America ($124B cap) to absorb over $75B in writedowns and losses to net a market cap of $50B, which is approximately a fair value of $13/share.
Thus Lockstep Investing is recommending initiating a short position once Bank of America crosses $26 / share, exit when the stock crosses $12 / share.
Friday, August 22, 2008
Fannie, Freddie : Beyond the Balance Sheets
1 Kings 19:11-13
“The LORD said, "Go out and stand on the mountain in the presence of the LORD, for the LORD is about to pass by."
Then a great and powerful wind tore the mountains apart and shattered the rocks before the LORD, but the LORD was not in the wind. After the wind there was an earthquake, but the LORD was not in the earthquake. 12 After the earthquake came a fire, but the LORD was not in the fire. And after the fire came a gentle whisper. 13 When Elijah heard it, he pulled his cloak over his face and went out and stood at the mouth of the cave.”
The story of Elijah is a spiritual example of how investors need to demonstrate discipline and discernment. Each of the seemingly apocalyptic events that occurred in front of Elijah could have caused him to react prematurely or fear something not worthy of fear.
On a much more worldly level, such is the case with Freddie Mac (FRE) and Fannie Mae (FNM) preferred shares. In the past few months, the din of negative assessments of the GSEs situation has been deafening. Stories of representatives of foreign sovereign financial institutions calling Paulson himself to explicitly guarantee the US government financial backing for the FRE and FNM are accepted as truth. There has been an unprecedented selling of FRE and FNM preferred share securities, over $12B worth, in just a few weeks. For any smaller or non-government entity, this would be a sign that the corporation was worth no more than junk.
Even more telling is estimates regarding the net worth of GSEs. By many mark to market measures, there is negative net worth to the organizations. No one really disputes this, but many market participants expect that this is grounds to seek bankruptcy proceedings for these entities. The roar of the critics and investors disillusioned by the state of the credit markets expecting honest reporting and vindication for predictions of this outcome of easy credit is deafening.
Yet this is all noise. The authority, the US government has completely different agenda. The US government must maintain the stability of the US and implicitly the US housing and credit markets. The calculation of the net worth of FRE and FNM completely discounts the goodwill value of having a government organ able to keep mortgage markets from freezing up completely and starting the economy in a free fall. To the government, FRE and FNM are one of the few remaining levers to keep the markets moving. How much is that worth? In a whisper, that value is beyond the value of any bailout cost in dollar terms.
Why keep value in the preferreds and even the common then? Scream any profanity appropriate about how unfair it is for investors not to pay for their faith in insolvent corporations, but what about the intangibles? The biggest currency the US government has right now is faith that it is a good place to invest and that it will pay whatever debt is owed. A tremendous amount of the preferred securities were purchase based on the implied backing of the US government. To repudiate that assumption at this point will to risk total loss of faith in the US government as debtor. How much is that worth?
Why hasn’t the authority spoken to revive faith in these institutions and let all this noise come out speaking of their demise? In the financial classic “"Manias, Panics, and Crashes: A History of Financial Crises" the author, Kindleberger, explores how financial crises unfold and what is the options of those seeking to alleviate the crisis. A reviewer gives a synopsis of Kindleberger’s conclusion…
“What, in the end, is Kindleberger's moral? …. The solution, he believes, lies in having a lender of last resort. The trick, of course, is to avoid moral hazard and prevent the public from gambling due to the reassurance of a lender of last resort. The answer is ambiguity: the lender can come in and save the day but investors should never be certain that help is forthcoming."
Elijah never knew how many dramatic events would occur before he would hear The Lord speak. Such is the case with FNM and FRE, there is no motivation for the government to establish a floor because of the risk of inspiring moral hazard in the market is too great.
In the end, some time soon the cacophony of market opinions will subside and the market will realize that FNM and FRE serve a purpose much larger than just what balance sheets suggest. Then, at that grand final moment, the authority in this matter will honor the faithful.
Disclosure: Lockstep Investing is long FRE Y Series and Z Series preferreds
Lockstep Proposed Position: Buy FRE Y Series preferreds below $9 / share.
“The LORD said, "Go out and stand on the mountain in the presence of the LORD, for the LORD is about to pass by."
Then a great and powerful wind tore the mountains apart and shattered the rocks before the LORD, but the LORD was not in the wind. After the wind there was an earthquake, but the LORD was not in the earthquake. 12 After the earthquake came a fire, but the LORD was not in the fire. And after the fire came a gentle whisper. 13 When Elijah heard it, he pulled his cloak over his face and went out and stood at the mouth of the cave.”
The story of Elijah is a spiritual example of how investors need to demonstrate discipline and discernment. Each of the seemingly apocalyptic events that occurred in front of Elijah could have caused him to react prematurely or fear something not worthy of fear.
On a much more worldly level, such is the case with Freddie Mac (FRE) and Fannie Mae (FNM) preferred shares. In the past few months, the din of negative assessments of the GSEs situation has been deafening. Stories of representatives of foreign sovereign financial institutions calling Paulson himself to explicitly guarantee the US government financial backing for the FRE and FNM are accepted as truth. There has been an unprecedented selling of FRE and FNM preferred share securities, over $12B worth, in just a few weeks. For any smaller or non-government entity, this would be a sign that the corporation was worth no more than junk.
Even more telling is estimates regarding the net worth of GSEs. By many mark to market measures, there is negative net worth to the organizations. No one really disputes this, but many market participants expect that this is grounds to seek bankruptcy proceedings for these entities. The roar of the critics and investors disillusioned by the state of the credit markets expecting honest reporting and vindication for predictions of this outcome of easy credit is deafening.
Yet this is all noise. The authority, the US government has completely different agenda. The US government must maintain the stability of the US and implicitly the US housing and credit markets. The calculation of the net worth of FRE and FNM completely discounts the goodwill value of having a government organ able to keep mortgage markets from freezing up completely and starting the economy in a free fall. To the government, FRE and FNM are one of the few remaining levers to keep the markets moving. How much is that worth? In a whisper, that value is beyond the value of any bailout cost in dollar terms.
Why keep value in the preferreds and even the common then? Scream any profanity appropriate about how unfair it is for investors not to pay for their faith in insolvent corporations, but what about the intangibles? The biggest currency the US government has right now is faith that it is a good place to invest and that it will pay whatever debt is owed. A tremendous amount of the preferred securities were purchase based on the implied backing of the US government. To repudiate that assumption at this point will to risk total loss of faith in the US government as debtor. How much is that worth?
Why hasn’t the authority spoken to revive faith in these institutions and let all this noise come out speaking of their demise? In the financial classic “"Manias, Panics, and Crashes: A History of Financial Crises" the author, Kindleberger, explores how financial crises unfold and what is the options of those seeking to alleviate the crisis. A reviewer gives a synopsis of Kindleberger’s conclusion…
“What, in the end, is Kindleberger's moral? …. The solution, he believes, lies in having a lender of last resort. The trick, of course, is to avoid moral hazard and prevent the public from gambling due to the reassurance of a lender of last resort. The answer is ambiguity: the lender can come in and save the day but investors should never be certain that help is forthcoming."
Elijah never knew how many dramatic events would occur before he would hear The Lord speak. Such is the case with FNM and FRE, there is no motivation for the government to establish a floor because of the risk of inspiring moral hazard in the market is too great.
In the end, some time soon the cacophony of market opinions will subside and the market will realize that FNM and FRE serve a purpose much larger than just what balance sheets suggest. Then, at that grand final moment, the authority in this matter will honor the faithful.
Disclosure: Lockstep Investing is long FRE Y Series and Z Series preferreds
Lockstep Proposed Position: Buy FRE Y Series preferreds below $9 / share.
Monday, July 28, 2008
Crocodiles smile at Bank of America
“Crocodiles are ambush hunters, waiting for fish or land animals to come close, then rushing out to attack. As cold-blooded predators, they are lethargic, therefore survive long periods without food, and rarely need to actively go hunting.”
In this time of pain and turmoil, investors need to come out of their defensive positions and find easy prey. The J series preferred shares of Bank of America (Ticker:BAC-PJ) are that prey.
For investors, the recent banking turmoil is both a blessing and a curse. On one hand, castrophic losses have threatened the viability of the US banking system. On the other hand, for the surviving companies, there will be tremendous opportunities with reduced competition. This conclusion was presented during the recent JP Morgan Q2 conference call where analyst Mike Mayo, observing the opportunities of big banks to take advantage of weakened competition, approached JP Morgan CEO Jamie Dimon with a point blank question.
“You have been waiting your whole life for this environment,” Mayo asked, so what is holding JP Morgan back from growing through mergers with so many competitors hurt?
Bank of America is in a similar position. Despite the significant downside exposure of the Countrywide purchase, Bank of America deposits-on-hand is enough to weather any major storm. Although common shares may ebb and flow with the distress of the credit crisis, there are lower risk areas that pay premium amounts for capital. Thus, the recent opportunities to buy Bank of America preferred shares at reduced prices have been tremendous.
Any investor in this security will receive a 7.25% coupon with a par value of $25 a share for five years ending 2012. If the investor can buy the shares for less than the par value, then the yield on the shares will be higher. During the recent sell off in financial stocks in July, the shares dropped to $16 which meant a yield of 11.3% on any share purchased.
The J series preferred shares are non cumulative, meaning Bank of America can suspend paying the dividend at any time and will not incur any liabilities. For the investor, this is the downside risk of preferreds. Yet banks often issue their shares as non-cumulative because under accounting rules it allows them to use proceeds of the preferred issue toward their Tier 1 capital reserves. In most cases preferred share dividends are not cut unless common shareholder dividends are reduced to zero and/or bankruptcy occurs. In comparison, even the Bear Sterns non-cumulative preferred shares are still being paid out by JP Morgan without disruption. As of July 28, 2008, Washington Mutual (Yahoo! Ticker: WM-PR) is still paying out their preferreds shares at a 16% yield. Although I view dividend cuts to Bank of America common stock over the next two years very likely due to Countrywide exposure, credit card exposure, and real estate exposure, I do not foresee a total suspension of the dividend in any scenario.
There will only be a few times when high quality will be available at discount price. The turmoil that brought the shares down to $16 will happen again, probably sooner rather than later, and probably in relation to a bank bigger than Indymac. In most cases, the general market will be in fear of complete collapse or unknowledgeable about the opportunities that abound at this time. I recommend waiting until these preferred shares once again reach $16 / share before buying. In most cases, the general market will be in fear or unknowledgeable about the opportunities that abound at this time. Only crocodile investors who wait until the conditions are appropriate will be astute enough to identify this opportunity and enjoy the best returns.
Transparency: Position initiated on Oct 10, 2008 at $16 / share. On that day the security reached an intraday low of $15.50 / share.
In this time of pain and turmoil, investors need to come out of their defensive positions and find easy prey. The J series preferred shares of Bank of America (Ticker:BAC-PJ) are that prey.
For investors, the recent banking turmoil is both a blessing and a curse. On one hand, castrophic losses have threatened the viability of the US banking system. On the other hand, for the surviving companies, there will be tremendous opportunities with reduced competition. This conclusion was presented during the recent JP Morgan Q2 conference call where analyst Mike Mayo, observing the opportunities of big banks to take advantage of weakened competition, approached JP Morgan CEO Jamie Dimon with a point blank question.
“You have been waiting your whole life for this environment,” Mayo asked, so what is holding JP Morgan back from growing through mergers with so many competitors hurt?
Bank of America is in a similar position. Despite the significant downside exposure of the Countrywide purchase, Bank of America deposits-on-hand is enough to weather any major storm. Although common shares may ebb and flow with the distress of the credit crisis, there are lower risk areas that pay premium amounts for capital. Thus, the recent opportunities to buy Bank of America preferred shares at reduced prices have been tremendous.
Any investor in this security will receive a 7.25% coupon with a par value of $25 a share for five years ending 2012. If the investor can buy the shares for less than the par value, then the yield on the shares will be higher. During the recent sell off in financial stocks in July, the shares dropped to $16 which meant a yield of 11.3% on any share purchased.
The J series preferred shares are non cumulative, meaning Bank of America can suspend paying the dividend at any time and will not incur any liabilities. For the investor, this is the downside risk of preferreds. Yet banks often issue their shares as non-cumulative because under accounting rules it allows them to use proceeds of the preferred issue toward their Tier 1 capital reserves. In most cases preferred share dividends are not cut unless common shareholder dividends are reduced to zero and/or bankruptcy occurs. In comparison, even the Bear Sterns non-cumulative preferred shares are still being paid out by JP Morgan without disruption. As of July 28, 2008, Washington Mutual (Yahoo! Ticker: WM-PR) is still paying out their preferreds shares at a 16% yield. Although I view dividend cuts to Bank of America common stock over the next two years very likely due to Countrywide exposure, credit card exposure, and real estate exposure, I do not foresee a total suspension of the dividend in any scenario.
There will only be a few times when high quality will be available at discount price. The turmoil that brought the shares down to $16 will happen again, probably sooner rather than later, and probably in relation to a bank bigger than Indymac. In most cases, the general market will be in fear of complete collapse or unknowledgeable about the opportunities that abound at this time. I recommend waiting until these preferred shares once again reach $16 / share before buying. In most cases, the general market will be in fear or unknowledgeable about the opportunities that abound at this time. Only crocodile investors who wait until the conditions are appropriate will be astute enough to identify this opportunity and enjoy the best returns.
Transparency: Position initiated on Oct 10, 2008 at $16 / share. On that day the security reached an intraday low of $15.50 / share.
Monday, July 14, 2008
One day the Smogbirds will come back
"I like to go for cinches. I like to shoot fish in a barrel. But I like to do it after the water has run out."- Warren Buffett in Oct. 2003 talking with Wharton MBA students
The Position of the Month
Stock: Grupo Aeroportuario del Pacifico S.A.B de C.V. (Ticker: PAC)
Position: Long
Opening Price: Below $21.50
Expected Closing Price: Above $60
Sometimes it actually rains in Southern California, or just becomes overcast during January and February every year. During that time the depressed residents of this area enjoy nothing more than a trip to balmy climates just south of the border where there dollar goes a little further and the SPF 50 cocoa butter is plentiful off season. Grupo Aeroportuario del Pacifico S.A.B de C.V. (Ticker: PAC) is a company that welcomes the Smog Birds of Southern California to their airports on their way to the vacation resort of their choice.
GAP is one of three airport operators (the other two are Ticker: ASR and Ticker: OMAB) concessions in Mexico created in 2005 with the privatization of the airport management entity. It has 12 airports under management in the Western part of the country including Guadalajara (third biggest in Mexico), Puerto Vallerta, Los Cabos, Tijuana and smaller locations Mexicali, Hermosillo, Agaucalientes, Bajio, Morelia, La Paz, Manzanillo.
With monopoly status, the fortunes of the company are directly indicated by the number passengers passing through their airports. The 2007 annual report for the company reported passenger growth at Guadalajara over a three year period and Los Cabos over a five year period of 11% and 14% respectively. At Los Cabos, 75% of the increase consisted in higher margin international passengers.
At the end of 2007 and early 2008, the company continued to believe traffic growth will continue at previous rates unabated. As such, the company has been investing in capital expansion projects in Guadalajara, Los Cabos, Puerto Vallarta, and Tijuana airports with the intent of capturing new commercial revenues. Overall passenger growth and commercial growth were estimated at under 10% and 13-16% respectively. Customer traffic has been increasing to GAP airports due to increased international exposure of Mexico’s resort destinations and explosion of the Low Cost Carrier (LCC) industry in Mexico over the last few years. LCC traffic represented 30% of all domestic passenger traffic in Mexico at the beginning of 2007 and over 43% by the end of 2007. Given this, management entered 2008 optimistic.
But the best laid plans of mice and men go awry. The spike in oil has caused a severe pullback in airline carrier operations at GAP airports that directly effects the amount of passenger traffic.
Airport and carriers which either ceased or significantly reduced operations at this location include…
Tijuana (Aviacsa, Aeromexico, Mexicana, Avolar and Aerocalifornia)
Mexicali – (Aviacsa)
La Paz – (Avolar and Aeromexico)
Guanjuato – (Volaris, Aviacsa)
…and there are more…
The LCCs are getting directly hit from oil and, as is prudent, abandoning the smaller airports retreating to the hubs and where their cost advantages serve them well. The discontinuation of routes and operations at smaller GAP airports due to jet fuel prices make the routes unprofitable, especially for the LCCs. Even though GAP continues to see increases in traffic at its four biggest airports from this LCC consolidation trend, the net effect is overall decrease in passenger traffic overall for GAP.
This trend is reflected in the GAP stock price. From Oct 2007, GAP has moved inverse to oil. With oil now at skyrocketing to $142 / barrel and continued stress in the energy markets for the foreseeable future, a major economic downturn in the US and particularly Southern California, the major question for GAP what will be the rock bottom price of GAP as the dust settles. Even if the downturn moderates the oil price, even $80 / barrel is a cruel and unusual punishment for well funded international carriers and low margin LCCs. Additional discontinuation of routes and failures due elevated energy costs will cause significant disruptions in passenger traffic in GAP locations. For example, the American Airlines “no fly” episode cost GAP a bundle due to the fact that AA flights make up 14% of total passenger traffic at Los Cabos airport alone.
There is no better example of the future prospects of GAP than the Smog Birds of Southern California. The company also manages the second most important international route in Mexico, the Guadalajara-Los Angeles route. The broader context of a US recession aside, focused stress in the Southern California economy is bound to particularly hit GAP in terms of international passengers to resort destinations but also as So Cal residents with family ties to Mexico are impacted by decreased economic prospects.
GAP, as a monopoly, is what Warren Buffett would describe as having a “wide moat”. Strictly from a balance sheet perspective, GAP boasts assets including the airport concessions and land valued at over $1.5B. In 2007 it improved operating margins 3.4% to 45%. The company has completed capital projects that support expansion sure to come in future years. The company earned $161m last year on $320m in revenue, a cash machine. Yet due to concerns over oil the company currently holds a market cap of $1.4B. In June GAP sunk below its IPO share price of $31/share and now stands at $26/share.
I am expecting a prolonged period of pain for GAP due to oil and a US consumer led recession, and thus my recommended purchase price is below my estimated market value for the company. Despite the energy markets run up the company will still easily meet dividend commitments which are $2.01/share for ADRs which make the company always a buy, but at a particular price. I recommend accumulating GAP at $21.50/share (1.15B market cap) will provide a 9.3% yield. At this price, an investor can stay defensive long enough addresses any economic risk, oil shock risk, or carrier risk that could occur if events similar to the 1970s energy debacle are repeated. While you wait, the grittiest of Smog Birds will continue their annual migration route until their traditional margarita watering holes filled again with chattering about the 101, the 5, the 405 and the latest Hollywood gossip.
http://www.aeropuertosgap.com.mx/index.php?tpl=list§ion=REPORTES_ANUALES&tema=579&menu=INVERSIONISTAS&lang=eng
http://community.investopedia.com/news/IA/2008/Check_Out_Mexicos_Check-In_King_PAC.aspx?partner=YahooSA
http://biz.yahoo.com/prnews/080708/mxtu006.html?.v=5
http://biz.yahoo.com/prnews/080606/mxf002.html?.v=84
Transparency: The author bought a long position at $21/share.
The Position of the Month
Stock: Grupo Aeroportuario del Pacifico S.A.B de C.V. (Ticker: PAC)
Position: Long
Opening Price: Below $21.50
Expected Closing Price: Above $60
Sometimes it actually rains in Southern California, or just becomes overcast during January and February every year. During that time the depressed residents of this area enjoy nothing more than a trip to balmy climates just south of the border where there dollar goes a little further and the SPF 50 cocoa butter is plentiful off season. Grupo Aeroportuario del Pacifico S.A.B de C.V. (Ticker: PAC) is a company that welcomes the Smog Birds of Southern California to their airports on their way to the vacation resort of their choice.
GAP is one of three airport operators (the other two are Ticker: ASR and Ticker: OMAB) concessions in Mexico created in 2005 with the privatization of the airport management entity. It has 12 airports under management in the Western part of the country including Guadalajara (third biggest in Mexico), Puerto Vallerta, Los Cabos, Tijuana and smaller locations Mexicali, Hermosillo, Agaucalientes, Bajio, Morelia, La Paz, Manzanillo.
With monopoly status, the fortunes of the company are directly indicated by the number passengers passing through their airports. The 2007 annual report for the company reported passenger growth at Guadalajara over a three year period and Los Cabos over a five year period of 11% and 14% respectively. At Los Cabos, 75% of the increase consisted in higher margin international passengers.
At the end of 2007 and early 2008, the company continued to believe traffic growth will continue at previous rates unabated. As such, the company has been investing in capital expansion projects in Guadalajara, Los Cabos, Puerto Vallarta, and Tijuana airports with the intent of capturing new commercial revenues. Overall passenger growth and commercial growth were estimated at under 10% and 13-16% respectively. Customer traffic has been increasing to GAP airports due to increased international exposure of Mexico’s resort destinations and explosion of the Low Cost Carrier (LCC) industry in Mexico over the last few years. LCC traffic represented 30% of all domestic passenger traffic in Mexico at the beginning of 2007 and over 43% by the end of 2007. Given this, management entered 2008 optimistic.
But the best laid plans of mice and men go awry. The spike in oil has caused a severe pullback in airline carrier operations at GAP airports that directly effects the amount of passenger traffic.
Airport and carriers which either ceased or significantly reduced operations at this location include…
Tijuana (Aviacsa, Aeromexico, Mexicana, Avolar and Aerocalifornia)
Mexicali – (Aviacsa)
La Paz – (Avolar and Aeromexico)
Guanjuato – (Volaris, Aviacsa)
…and there are more…
The LCCs are getting directly hit from oil and, as is prudent, abandoning the smaller airports retreating to the hubs and where their cost advantages serve them well. The discontinuation of routes and operations at smaller GAP airports due to jet fuel prices make the routes unprofitable, especially for the LCCs. Even though GAP continues to see increases in traffic at its four biggest airports from this LCC consolidation trend, the net effect is overall decrease in passenger traffic overall for GAP.
This trend is reflected in the GAP stock price. From Oct 2007, GAP has moved inverse to oil. With oil now at skyrocketing to $142 / barrel and continued stress in the energy markets for the foreseeable future, a major economic downturn in the US and particularly Southern California, the major question for GAP what will be the rock bottom price of GAP as the dust settles. Even if the downturn moderates the oil price, even $80 / barrel is a cruel and unusual punishment for well funded international carriers and low margin LCCs. Additional discontinuation of routes and failures due elevated energy costs will cause significant disruptions in passenger traffic in GAP locations. For example, the American Airlines “no fly” episode cost GAP a bundle due to the fact that AA flights make up 14% of total passenger traffic at Los Cabos airport alone.
There is no better example of the future prospects of GAP than the Smog Birds of Southern California. The company also manages the second most important international route in Mexico, the Guadalajara-Los Angeles route. The broader context of a US recession aside, focused stress in the Southern California economy is bound to particularly hit GAP in terms of international passengers to resort destinations but also as So Cal residents with family ties to Mexico are impacted by decreased economic prospects.
GAP, as a monopoly, is what Warren Buffett would describe as having a “wide moat”. Strictly from a balance sheet perspective, GAP boasts assets including the airport concessions and land valued at over $1.5B. In 2007 it improved operating margins 3.4% to 45%. The company has completed capital projects that support expansion sure to come in future years. The company earned $161m last year on $320m in revenue, a cash machine. Yet due to concerns over oil the company currently holds a market cap of $1.4B. In June GAP sunk below its IPO share price of $31/share and now stands at $26/share.
I am expecting a prolonged period of pain for GAP due to oil and a US consumer led recession, and thus my recommended purchase price is below my estimated market value for the company. Despite the energy markets run up the company will still easily meet dividend commitments which are $2.01/share for ADRs which make the company always a buy, but at a particular price. I recommend accumulating GAP at $21.50/share (1.15B market cap) will provide a 9.3% yield. At this price, an investor can stay defensive long enough addresses any economic risk, oil shock risk, or carrier risk that could occur if events similar to the 1970s energy debacle are repeated. While you wait, the grittiest of Smog Birds will continue their annual migration route until their traditional margarita watering holes filled again with chattering about the 101, the 5, the 405 and the latest Hollywood gossip.
http://www.aeropuertosgap.com.mx/index.php?tpl=list§ion=REPORTES_ANUALES&tema=579&menu=INVERSIONISTAS&lang=eng
http://community.investopedia.com/news/IA/2008/Check_Out_Mexicos_Check-In_King_PAC.aspx?partner=YahooSA
http://biz.yahoo.com/prnews/080708/mxtu006.html?.v=5
http://biz.yahoo.com/prnews/080606/mxf002.html?.v=84
Transparency: The author bought a long position at $21/share.
Wednesday, May 7, 2008
No credit for Capital One
The Quote of the Month
““It takes a man a long time to learn all the lessons of all his mistakes. They say there are two sides to everything. But there is only one side to the stock market; and it is not the bull side or the bear side, but the right side. It took me longer to get that general principle fixed firmly in my mind than it did most of the more technical phases of the game of stock speculation.” Jesse Livermore, “Reminiscences of a Stock Operator”.
The Position of the Month
Stock: COF
Position: Short
Basic Position Opening Price:
Above $55
Basic Position Expected closing price:
Below $40
Advanced Investor Position Opening Price:
Buy COF $50 Jan 10 puts at $10
Advanced Investor Position Closing Price:
Sell to Close at $14 / contract
The Summary
Capital One is a leveraged lender with high percentage of low quality cardholders.
The Story
Any investment related to credit cards is a bet on the American consumer. When the American consumer can hold a job, they can maintain their credit card balance. In this case, credit card companies profit on carrying fees. If Americans lose their job, then credit card costs spiral out of control. In this case, credit card companies lose money from charge offs, lost income streams, and decreased portfolio quality.
Off balance sheet securities performing poorly(1) 4/13/08 “Off-balance sheet item ($49B) has a default rate of 5.8% where the base portfolio is 3.26%.”
Credit card charge offs still at low levels considering economic outlook(2) 4/10/08 “Now, as the "almost-affirmed" recession is upon us, delinquencies will rise along with foreclosures and bankruptcies. This will surely trickle down to the lenders as the inflows they receive dwindle, outflows grow and non-recoverable debt increases. While a 6% rate may seem historically high, back in 2003, Capital One posted rates closer to 8% as the U.S. was starting on the road to recovery from a difficult 2 years of recession and the fall off from the domestic stock markets averaging near -50%.”
COF insiders are selling
(3) 3/24/08 “COF insiders are dumping shares. Whether planned or not, insiders reduced their positions by 10% during the past few months. Keep in mind that this company announced, back in February, a massive buyback program planning to redeem 10% of the total market cap. This points to the obvious strategy of the company’s management to help keep shares artificially high as they are selling. Institutions have also had the same idea and have sold off over 23 million shares during the past 6 months, effectively reducing their positions by 7%”
Americans revolving credit increasing as economy suffers
(4) 4/25/08 “Revolving debt, which typically comes from credit cards, has increased at a faster rate than overall debt since the summer of 2006 -- right about when the housing market began to implode.
The trend seems to suggest consumers are using credit cards to patch up holes in revenue that once could be filled by refinancing or selling a home. Now that home values have dropped sharply and are predicted to fall further, at least over the short term, consumers are left without the housing crutch they once relied upon.”
The story is very simple. If you think the unemployment rate is going up, then credit card companies will suffer in direct proportion to the increase in unemployment.
To underscore the link, look at the graph below and think about how it corresponds to home equity cash out phenomenon. As equity transferred from homes to consumer spending, credit cards benefited from increased revenue and lower defaults.
Moreover, projections are that credit card charge offs will continue return toward the mean in terms of historical charge off rates.
(5) "Despite these negative macroeconomic trends, credit card delinquencies and charge-offs have just recently returned to their long-term averages following a two-year period of exceptionally strong performance in the wake of the implementation of new bankruptcy legislation in 2005," Cynthia Ullrich, a senior director at Fitch, said in a statement.
The Conclusion
This investment hinges on the pretext that the credit unwind will directly effect the American consumer in terms of economic contraction and reduced leverage in household spending. Considering the current situation, this looks like a low risk investment with many different scenarios leading to the predicted outcome.
Sources
(1) Andrew Horowitz, http://seekingalpha.com/article/72030-capital-one-outlook-not-as-rosy-as-analyst-describes
(2) Andrew Horowitz, http://www.bloggingstocks.com/2008/04/10/capital-one-financial/
(3) Andrew Horowitz
(4) TheStreet.com, 4/25/08, http://www.thestreet.com/_yahoo/funds/saving-money/10413643.html?cm_ven=YAHOO&cm_cat=FREE&cm_ite=NA
(5) “Fitch study shows credit-card delinquencies and charge-offs rising, will pressure securities”
Wednesday, April 30th, Reuters, http://biz.yahoo.com/ap/080430/fitch_credit_cards.html?.v=1
““It takes a man a long time to learn all the lessons of all his mistakes. They say there are two sides to everything. But there is only one side to the stock market; and it is not the bull side or the bear side, but the right side. It took me longer to get that general principle fixed firmly in my mind than it did most of the more technical phases of the game of stock speculation.” Jesse Livermore, “Reminiscences of a Stock Operator”.
The Position of the Month
Stock: COF
Position: Short
Basic Position Opening Price:
Above $55
Basic Position Expected closing price:
Below $40
Advanced Investor Position Opening Price:
Buy COF $50 Jan 10 puts at $10
Advanced Investor Position Closing Price:
Sell to Close at $14 / contract
The Summary
Capital One is a leveraged lender with high percentage of low quality cardholders.
The Story
Any investment related to credit cards is a bet on the American consumer. When the American consumer can hold a job, they can maintain their credit card balance. In this case, credit card companies profit on carrying fees. If Americans lose their job, then credit card costs spiral out of control. In this case, credit card companies lose money from charge offs, lost income streams, and decreased portfolio quality.
Off balance sheet securities performing poorly(1) 4/13/08 “Off-balance sheet item ($49B) has a default rate of 5.8% where the base portfolio is 3.26%.”
Credit card charge offs still at low levels considering economic outlook(2) 4/10/08 “Now, as the "almost-affirmed" recession is upon us, delinquencies will rise along with foreclosures and bankruptcies. This will surely trickle down to the lenders as the inflows they receive dwindle, outflows grow and non-recoverable debt increases. While a 6% rate may seem historically high, back in 2003, Capital One posted rates closer to 8% as the U.S. was starting on the road to recovery from a difficult 2 years of recession and the fall off from the domestic stock markets averaging near -50%.”
COF insiders are selling
(3) 3/24/08 “COF insiders are dumping shares. Whether planned or not, insiders reduced their positions by 10% during the past few months. Keep in mind that this company announced, back in February, a massive buyback program planning to redeem 10% of the total market cap. This points to the obvious strategy of the company’s management to help keep shares artificially high as they are selling. Institutions have also had the same idea and have sold off over 23 million shares during the past 6 months, effectively reducing their positions by 7%”
Americans revolving credit increasing as economy suffers
(4) 4/25/08 “Revolving debt, which typically comes from credit cards, has increased at a faster rate than overall debt since the summer of 2006 -- right about when the housing market began to implode.
The trend seems to suggest consumers are using credit cards to patch up holes in revenue that once could be filled by refinancing or selling a home. Now that home values have dropped sharply and are predicted to fall further, at least over the short term, consumers are left without the housing crutch they once relied upon.”
The story is very simple. If you think the unemployment rate is going up, then credit card companies will suffer in direct proportion to the increase in unemployment.
To underscore the link, look at the graph below and think about how it corresponds to home equity cash out phenomenon. As equity transferred from homes to consumer spending, credit cards benefited from increased revenue and lower defaults.
Moreover, projections are that credit card charge offs will continue return toward the mean in terms of historical charge off rates.
(5) "Despite these negative macroeconomic trends, credit card delinquencies and charge-offs have just recently returned to their long-term averages following a two-year period of exceptionally strong performance in the wake of the implementation of new bankruptcy legislation in 2005," Cynthia Ullrich, a senior director at Fitch, said in a statement.
The Conclusion
This investment hinges on the pretext that the credit unwind will directly effect the American consumer in terms of economic contraction and reduced leverage in household spending. Considering the current situation, this looks like a low risk investment with many different scenarios leading to the predicted outcome.
Sources
(1) Andrew Horowitz, http://seekingalpha.com/article/72030-capital-one-outlook-not-as-rosy-as-analyst-describes
(2) Andrew Horowitz, http://www.bloggingstocks.com/2008/04/10/capital-one-financial/
(3) Andrew Horowitz
(4) TheStreet.com, 4/25/08, http://www.thestreet.com/_yahoo/funds/saving-money/10413643.html?cm_ven=YAHOO&cm_cat=FREE&cm_ite=NA
(5) “Fitch study shows credit-card delinquencies and charge-offs rising, will pressure securities”
Wednesday, April 30th, Reuters, http://biz.yahoo.com/ap/080430/fitch_credit_cards.html?.v=1
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