Be greedy when others are fearful, Francis Chou edition

From his latest letter, Francis Chou seems keen on financials, retail and pharma equities, and for financials he discloses his thesis for stock warrants of large banks.

Medium banks were easier to understand and bound, so that is where I focused first, but TARP warrants was how I expected to buy large banks when things became more clear. And things are becoming clearer by the day.

Large banks are an opportunity that I have been procrastinating for quite a while, in particular Bank of America that looks very cheap at 0.5 BV and 3x PTPP earnings. Large banks are sound with strong balance sheets but it is difficult to pull the trigger when probably there are more surprises coming. Francis Chou conveniently lists some of these potential negative events.

This is not an original idea, everyone that has read You Can Be a Stock Market Genius will remember Joel Greenblatt’s discussion on the use of LEAPs (long dated call options) for situations with binomial outcomes like the Wells Fargo turnaround in the 1990s. Greenblatt liked very much Bruce Berkowitz’s WFC thesis but had similar concerns to Chou’s today on the transparency of the balance sheets. Greenblatt decided to buy LEAPs, because in case of a collapse both common stock and LEAPs were worth zero, but you can commit less capital with LEAP derivatives for a similar upside to the common stock so the payoff proposition was much better.

Chou’s decided instead to buy warrants and it might be an even safer bet. The expirations are much longer and they include some very interesting anti-dilution clauses negotiated by the federal government that the general investor can now enjoy. We should still remember though that the attractiveness of these instruments also depends on the price and upside expected for each specific bank.

This is the excerpt from Francis Chou’s letter:

————————————

REVISITING THE BANKS:

In the 2006 annual report, we noted our alarm at the cavalier approach of financial institutions with regard to their lending standards, particularly to subprime borrowers. We also expressed concern with the widespread use of derivatives by financial institutions (…) Well, starting in 2007, financial institutions went through a cataclysm. Directly or indirectly, almost all of them had to be bailed out by the U.S. government. Looking back at the crisis, this is what we have observed:

1. The U.S. government will not let major financial institutions fail.
2. The financial institutions that survive will be the ultimate beneficiaries of any recovery in the economy.
3. Interest rates will be kept at artificially low levels for the foreseeable future. The spreads between what the banks are paying for deposits and borrowings in the market (like FDIC insured), and what they can lend at is enormous. After being severely burned, they have tightened their lending criteria and have been extremely cautious with their lending practices. In general, the quality of loans now being made are quite high and for the first time in many years, banks are being paid handsomely according to the risks they are taking.
4. Financial institutions in general are hoarding capital. This will provide them with ample cushion to absorb losses if a double dip recession were to occur.
5. The books of financial institutions were carefully examined by all kinds of government agencies, including regulators, before the government allowed them to repay the U.S. Treasury under the Troubled Asset Relief Program (TARP).
6. Most of the big banks are selling below 10 times their potential earning power in the future.

An Interesting Way to Invest in Banks

Please note: the investment described below is the view of the writer and should not be seen as a recommendation.

One of the more interesting ways to invest in the better capitalized banks is through the stock warrants that were issued to the U.S. Treasury by the banks when they received funds under TARP. The stock warrants give the holder the right to buy the bank’s stock at a specific price. When the banks repaid TARP funds to the U.S. Treasury, the U.S. Treasury either sold the stock warrants back to the banks or they auctioned them to the public.

So, what is so unique about these stock warrants?

1. They are long dated, with most expiring in 2018 or 2019. This time frame of eight- plus years allows banks to grow their intrinsic value to a high enough level to have an appreciable impact on the strike price of the stock warrant.
2. The strike price is adjusted downward for any quarterly dividend that exceeds a set price. Normally, you don’t see that in a stock warrant. This is a truly stringent condition. In this case we should give the government credit for extracting a pound of flesh. An example: for Bank of America, class ‘A’ warrants, the strike price is adjusted downward for any quarterly dividend paid exceeding one cent a share.
3. Many of the banks have excess capital on their balance sheet. When the economy settles down, we expect the banks to use this excess capital either for buybacks or a one-time special dividend that may reduce the strike price on the stock warrants if this provision applies.
4. The concerns over financial reform and its ultimate impact on the earning power of the banks may be somewhat exaggerated. We believe the banks will most likely be able to pass the majority of the costs to customers. For an economy to flourish we need sound financial institutions that can generate reasonable profits.
5. Investing in financial institutions requires a leap of faith. Mind you, this leap of faith is no greater than those we make on any company’s future prospects, its position in the industry and how well it will do in a future economy. Looking forward, as each year goes by, the quality of earnings of the banks should be higher, the books should be cleaner, the risks will be lower and management will be far more risk averse. Too bad we had to go through so much turmoil to get there.

Below, August 13, 2010 prices of some banks stock warrants.

Even so, everything is not hunky dory for the banks. Banks face many issues and challenges. I have listed a few here:

1. We still do not fully understand or trust the numbers
2. Financial regulatory reform may reduce earning power
3. New Basel rules may require more capital and reduce profits
4. There may be a double dip recession
5. The unemployment rate may go higher and create more defaults
6. Commercial real estate prices may fall dramatically
7. Banks are still not marking loans in their books properly
8. Residential real estate prices may fall further
9. States and municipalities are in bad shape

Our investing horizon is long-term – eight years or more for these bank warrants. Over that period, we believe the odds are it will work out to be decent investment – more so for the better capitalized banks. We view it as the glass being more than half full rather than being more than half empty.

No position

Bruce Berkowitz on Financials

Bruce on WealthTrack?  No, I still find it too familiar to call him Bruce even though most bloggers do so. OK let’s try again: Mr Bruce Berkowitz manager of the decade on Wealthtrack? Nah, too formal. One more time: Bruce Berkowitz on WealthTrack

Coming back to his roots and sharing the lessons of the S&L crisis for today’s environment. His thesis for Wells Fargo in the 1990s is something to read time and again side by side with Peter Lynch’s account. Below the fold, an excerpt of his views on banks but all the interview is worth seeing.

BRUCE BERKOWITZ: There are two parts to the investment equation. There’s sort of what you give and what you get. So we’ll start out with what you get. We’ve had this most extreme period in the financial history of the United States. Some say we came very close to another Depression. And the U.S. government and its agencies just did a great job of pulling us away from that cliff. And, for the last couple of years, companies have gone through tremendous stress, the financials. But today, their balance sheets are stronger than ever, their earnings power, their pre-tax, pre-provisioning power is stronger than ever. And, you have to think about loans and the life of loans. You know, most loans go for between two and five years, whether it’s an individual loan, commercial. So there’s been this two-year stress period of burning through all these bad loans. And at the same time, they’ve had these two years of good loans, because they’re in very stressful periods. That’s normally when they put on their best loans.

So, the financial system came to the brink. U.S. Treasury, New York Fed, Congress did amazing job. I mean, with hindsight, you know, you could criticize a little here and there. But they did an amazing job. Now it’s up to private enterprise to take it over from here. And traditionally, that’s going to be our banks and our brokers leading the way on this nascent recovery. And there are going to be fits, and there are going to be starts. But again, the balance sheets are strong; the potential earnings power is used. They’ve battled hard, and it’s a trite saying, but whatever doesn’t kill you makes you stronger is quite true. And for those financial institutions still standing, and the ones we’ve invested in, will get through this period and move on to a more normal earnings period.

CONSUELO MACK: So, what’s the biggest risk that you’re taking, in having this sort of a concentration in these companies that have been through the grinder?

BRUCE BERKOWITZ: Well, the biggest risk would be the correlation risk, that they all don’t do well. Which would mean, you know, a severe double dip in the entire financial system of the United States, totally melts down, malfunctions, no longer exists. So, it’s hard to see that.

But, on the other hand, when you take a look at our fund today, one-sixth of the fund now is cash equivalent. Another one-sixth of the fund is in fixed income securities. So, we’re only two-thirds invested. So we have billions of dollars of cash ready to take advantage of whatever further stresses may come our way. And, you know, we’re right. And then, as I was mentioning to you, the other part of the equation is what you give. And by “most hated,” I meant that the financial institutions are not very popular today, given what’s happened in the past couple of years, and their price reflects it. So, we’re paying a pessimistic price for institutions that are essential to the country, and that will lead us, as they usually do, out of the recession.

CONSUELO MACK: Some of your competitors, including Don Yachtman, of the Yachtman Funds, who has a terrific track record as well, you know, recently told me that he doesn’t understand what you’re doing because he feels that financials are black boxes. That, in fact, you can’t possibly know what Citigroup’s loan portfolio really looks like. And that, he feels that you’re taking a tremendous amount of risk that is kind of contrary to what your prior practices have been. You don’t think they’re black boxes? I mean, you actually think that you know what Citigroup owns and what its debts are?

BRUCE BERKOWITZ: It’s our belief that enough time has gone by now, as I’ve said, that you’ve had the vintages, the various loans for a given year. You start to see, you know, the bad parts, the delinquent loans. You get to see the cash yields on the bad debt. You know, one thing that’s nice about getting older is that you start to see certain cycles before, and this is very reminiscent of ’91, ’92, when people thought Wells Fargo was going to go under because of commercial real estate. Citigroup, again. And, it’s perverse psychology. You’ve had so much strain in the system, so many balance sheets; individuals have been hurt, that it’s just very hard to look at them in a positive way.

But, with time, you start to see the patterns and the recovery, and you also have to give credit to the regulators, to the auditors, to the executives, to the oversight committees of the Congress. I mean, these institutions have been studied in the last two years. They’re under a microscope. Every element has been studied. And when you’re in stress mode, and when your institutions are shrinking, it’s very difficult to hide bad news. Everything comes out in shrink mode. But the good news is, when you’re shrinking, cash flows build up. You’re able to pay off the bad debts, and you’re able to fight another day. And, you see it now with the institutions.

CONSUELO MACK: Bruce Berkowitz and the Fairholme Fund’s rule number one is don’t lose money. And then, rule number two and number three is pay attention to rule number one. So, given the current strategy that you’re following, in the Fairholme Fund, are you still adhering to the rule number one and two and three, of don’t lose money?

BRUCE BERKOWITZ: We believe we are. At the prices that we’re paying for securities, we just don’t see the downside. We don’t see death, we don’t see bankruptcy, we don’t see significant losses. In the case of the banks, we’ve been buying below book values. We’ve been buying single-digit earnings yields. I mean, at some point, the banks will start to have a more normal earnings period.

It’s amazing, when you think of a Bank of America and all of the organizations they have merged with over time, including Merrill Lynch and MBNA, it’s tremendous. The amount of value and wealth is just tremendous in a Bank of America and in fact, it’s essential to the rebuilding of the country’s balance sheet. And so is Morgan Stanley and Goldman Sachs, and Citigroup and Regions Financial and CIT. All the companies that we purchased during their stressful periods.

CONSUELO MACK: So, Bruce, what would convince you to sell? I mean, is it going to be a price decision with some of these companies?

BRUCE BERKOWITZ: It’s going to be a price decision.

CONSUELO MACK: It is a price decision.

BRUCE BERKOWITZ: It’s going to. It’s just so cheap, relative to what you’re getting. And eventually, if we’re right in our understanding and we don’t have that dreaded double dip, going back into the Great Depression, then there’ll be a more normalized earning period. And then, that’ll be a tough part to determine, at what point our investments start to equate to T-bill type returns.

CONSUELO MACK: And so, when you look at, you know, a Citigroup, for instance. Let’s just take them one at a time. I mean, it’s value now. Do you think that there’s still a lot of value left?

BRUCE BERKOWITZ: Yes. Citigroup has the ability to earn a dollar a share, which would put it at $10, let’s just say. And you compare it to where it’s trading today, four. Under four.

CONSUELO MACK: And Bank of America, again, same?

BRUCE BERKOWITZ: All the same.

Turnaround Cases: Premier Exhibitions Part 6

Seventeen years of litigation closing to an end.  We left Premier Exhibitions (PRXI) at the end of last year suspecting the granting of this award. With this  positive verdict and the slow but sure improvement in fundamentals it is about time to pick up where we left.

In turnarounds the outcome is asymmetric: the upside potential is a multiple of the investment. However, it comes with a problem: the expected payoff depends on the probability of success versus failure that is usually tilted to failure. So it is critical to look for situations with very few paths for a total loss and several ones for success. In this way the business has the ability to take hits without failing while leaving open the possibility of lucky breaks. In chess is called playing for two results; in football, catenaccio; in poker, being a rock; in investing, downside protection.

RULE #5 FORTITUDE IS A VIRTUE

One advantage of a good business is that it can take several hits, and Premier has taken several. No debt, cash in hand, high gross margins, and professional expenses that were only temporary meant that the Bodies core business did not need much in terms of revenues to survive or thrive. And this ability to take punches left open the possibility of a lucky break. The grant was one event that we planned for but there were other, like the potential upside of other exhibits like Dialog in the Dark that did not materialized. That is OK, those were free options.

The opinion is a fascinating document that should dispel any skepticism on management’s claims that there is value of the artifacts. It includes details on how the artifacts were appraised and why, in the opinion of the appraisers and judge, the valuation is considered conservative. It also includes prices of specific sold pieces and praises the effort to rescue the artifacts given the costs and risks of the expeditions. In passing, Arnie Geller gets his a ear twisted for his efforts to blindside the court, but that is old history.

How much is it worth? Difficult question to answer given that we still do not know the process for granting the award, how restrictive will be the covenants, or the potential upside over the appraised value. Above Average Odds is trying to get his hands on the monetary value, you might want to take a look at their post.

In case you do not have the time to read the 70 pages of the court opinion or listen the conference call, Chris Davino CEO released a short letter yesterday with his view regarding the verdict.  I am attaching an excerpt of the letter including the most relevant facts on the value of the artifacts and how the award could be granted (no later than a year from now).

Premier, through RMST, has been the salvor-in-possession of the Titanic wreck site since 1993, giving it the sole and exclusive rights to recover artifacts from the wreck. In 1993, a French maritime tribunal awarded RMST the title to artifacts recovered in 1987 (the “1987 Artifacts”). In 2007, the company sought a salvage award — either a payment of cash or an award of title to the artifacts — for its work in salvaging and conserving artifacts recovered in multiple dives after 1987 (the “Post 1987 Artifacts”).

….

Though the award may ultimately take one or more different forms, we believe, based on the language of the order itself and other legal precedents, the $110,859,200 is the minimum consideration Premier would receive as a payment for its salvage efforts. The Court can either satisfy the award in cash or in-kind (which would be achieved by conveying title to the Post 1987 Artifacts to Premier’s RMST subsidiary) and will make this determination no later than August 15, 2011. The total value to Premier of this award plus the 1987 Artifacts (estimated at a fair market value of $35 million based on an independent appraisal obtained by Premier in 2007) approximates $146 million.

As noted, one option available to the Court in satisfying this award is to sell the Post 1987 Artifacts to a buyer willing to pay the award amount and who satisfies any other conditions the Court may impose. If the Court were to pursue this approach, we believe it would likely conduct a sale of the Post 1987 Artifacts through an auction, where an appointee of the Court would be charged with identifying acceptable bidders who would be willing to pay, at a minimum, the award amount with the sale proceeds being paid, in cash, to Premier. The other option available to the Court would be to convey title to the Post 1987 Artifacts through an in-specie award. The award amount established by the Court is based on an independent appraisal obtained by Premier in 2009 that established a fair market value of approximately $110 million for this collection.

Should the Court issue RMST an in-specie award of title to the Post 1987 Artifacts, Premier has agreed to keep that collection and the 1987 Artifacts collection together. An in-specie award would effectively satisfy payment to Premier of the award amount through an in-kind payment of the artifacts themselves. Title to these artifacts would be granted subject to the conditions established by the Court which include:

• The 1987 and Post 1987 Artifact collections must be maintained as a single collection,
• The combined collections can only be sold together, in their entirety, and any buyer would be subject to the same conditions applicable to Premier, and
• Premier must comply with provisions which would guarantee the long-term protection of the artifacts.

In its desire to keep both the 1987 Artifacts and Post 1987 Artifact collections together as a single collection, the Court expressed concern in the ruling that an in-specie award would create the potential for ongoing litigation relating to the Company’s compliance with the covenants. Our management team and our board of directors are committed to allaying the Court’s concerns. To that end we have agreed to establish a preservation trust which the Company would fund over time to provide for the maintenance and conservation of the artifacts independently of Premier.

In addition to the artifact collections, Premier has also developed significant work product and other intellectual property related to Titanic, such as film footage of the wreck site, digital archives, dive records, mapping of the wreck site, a valuable database and other unique elements obtained over the last 23 years by the Company. The 2007 appraisal found approximately $44 million in additive value to the collection attributable to this intellectual property and to the Company’s undertakings such as the costs of salvage, lab operations and exhibition.

Letter to Shareholders, CEO Chris Davino

Long PRXI

Be greedy when others are fearful, Wells Fargo edition

In this blog we have shown a certain fondness for banking, commercial real estate, and debt. Well this is a trifecta, Wells Fargo is rebuilding what used to be Wachovia’s commercial mortgage backed securities business. It is a fantastic story. With all the talk of a bond bubble and the lack of safe instruments, CMBSs are rallying and there is simply no supply. These are the same instruments that were considered toxic waste one year ago and I can still remember the comments on how structured finance was not coming back.

“We believe there is going to be a resurgence of CMBS, and we are investing in anticipation of it,” said Blakey, head of commercial-mortgage lending and servicing. “Our pipeline is growing and we intend to be a leader of this market.”

Wells Fargo is pushing ahead in a market Wachovia controlled before it reported more than $2.1 billion of losses tied to CMBS in 2007 and 2008. Wachovia was the No. 1 underwriter from 2005 to 2007, with $81 billion of commercial mortgage-backed bonds, data compiled by Bloomberg show. Wachovia, based in Charlotte, North Carolina, structured the largest CMBS deal in history, a $7.9 billion bond that included financing for the 2006 purchase of Stuyvesant Town- Peter Cooper Village, Manhattan’s largest apartment complex. The buyers ceded control of the property earlier this year after failing to make debt payments.

Certainly there are advantages in issuing loans after a bubble collapse with a decimated competition.  Lending conditions and underwriting standards are much better.

Commercial property values have declined 39 percent from the 2007 peak, according to Moody’s Investors Service. The decline has made underwriting loans less risky, and banks can dictate more conservative terms and choose the most creditworthy borrowers, said Shrewsberry, head of the company’s securities and investment group.

“It’s a nice time to be originating loans, because you’re at a lower price point on the collateral, you can impose the right structure and there isn’t the frenzied competition” of a few years ago, Shrewsberry said.

I have no position in Wells Fargo, though I am certainly surprised that this great franchise is priced at 1x book value and 52w lows. What really attracts me to this story is that the securitization market comeback could have a positive impact in commercial real estate valuations trickling down to refinancings and banks’ capital ratios.

Starwood Property Trust Inc. Chief Executive Officer Barry Sternlicht said during an Aug. 10 conference call that “CMBS markets are wide open” and suffer from too little supply rather than lack of demand from buyers.

“There’s been good demand for the CMBS issues that have come out so far in 2010,” said Matthew Anderson, managing director at Foresight Analytics, an Oakland, California-based bank and real estate research firm.

Banks will aim to take advantage of loans maturing over the next five years, Anderson said. Almost $1.5 trillion in commercial mortgages on the books of banks or bundled into securities come due between 2010 and 2014, he estimated.

“The market possibilities have re-emerged in a way that’s conducive to doing some business,” Shrewsberry said. “This is a rejuvenation.”

Sinochem likes Potash Corp

The announcement is not very much of a surprise

Sinochem, the Chinese-state owned chemical group, said on Friday it would “pay close attention” to BHP Billiton’s $39bn hostile bid for PotashCorp, and added that it was “interested in overseas potash investment opportunities”

Given the confrontational history of BHP with Chinese government companies, this is only just one more chapter in the battle for control of key natural resources supporting the fast growth of the emerging economy.  More interesting is the description of the distribution monopoly used to control prices and provide a stable supply of fertilizers in China.

PotashCorp has strong links with China, the world’s biggest fertiliser importer. The Canadian company owns a 22 per cent stake of Sinochem’s listed subsidiary Sinofert, China’s biggest fertiliser maker and distributor and the country’s biggest importer of Potash. PotashCorp is a leading member of Canpotex, a cartel system that Chinese buyers favour because it ensures reliable annual prices….

… China considers agricultural self-sufficiency a matter of national security, but only produces enough potash to cover about half of its fertilising needs. The country also favours the current system of annual price contracts for potash. BHP has suggested it would shake up the nearly 40-years-old potash pricing system…

… Sinochem is China’s largest fertilizer distributor, and until 1998 held a government monopoly on fertilizer imports. Sinofert on Friday handles all of Sinochem’s fertilizer business, running 2,000 distribution centers throughout China. The subsidiary was listed on the Hong Kong stock exchange in 2005, and now has a market cap of HK$30bn.

This possible shake up is similar to the negotiations with BHP over iron ore. The Chinese are not standing still and they are moving to expand fertilizer capacity and access

Sinochem has been hungry for agribusiness opportunities abroad, but was humbled last year by its failure to secure a deal with Nufarm after six months of talks. After the Australian firm accepted a rival Japanese bid, Sinochem vowed to “continue to strengthen our co-operation with the world’s agrochemical enterprises and unswervingly push forward the globalization of our agrochemical business.”

China has been aggressively expanding the country’s domestic potash production, with output doubling between 2005 and 2009. China’s potash demand was 7.9m tonnes last year, down from a 2007 peak of 11.93m tonnes, said Wang Ling of China Fertilizer Market Week.

Some of you may ask why this interest in potash. Well, fertilizers is an industry close to my heart despite some people’s opinion that it is “by and large, an unexciting business” (Heidi Moore, WSJ). One person’s fish eggs are another person’s caviar. Non renewable limited resources, high barriers to entry, controlled by a few players can be a road to riches. Also, I stumbled upon one potash opportunity while researching mining stocks and with all the M&A hoopla might be time for a deep analysis. If readers have recommendations in the phosphate or potash industries I would gladly take a look.

Bloomberg on Potash

Short Bloomberg video on the importance of Potash

Charting Banking XV: Fed survey on lending practices

The Federal Reserve just published a week ago the quarterly survey on bank lending practices. Well, what is this survey?

Survey of approximately sixty large domestic banks and twenty-four U.S. branches and agencies of foreign banks. The Federal Reserve generally conducts the survey quarterly, timing it so that results are available for the January/February, April/May, August, and October/November meetings of the Federal Open Market Committee. The Federal Reserve occasionally conducts one or two additional surveys during the year. Questions cover changes in the standards and terms of the banks’ lending and the state of business and household demand for loans. The survey often includes questions on one or two other topics of current interest.

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In an historic perspective, the results were encouraging compared with other periods of tightening standards like the early 1990s and 2000s. They were also slightly positive for all type of loans: an improving trend with Commercial and Industrial loans ahead of the pack. Competitive pressures are being felt and this is the best incentive for banks to come back to the market:

The July survey indicated that, on net, banks had eased standards and terms over the previous three months on loans in some categories, particularly those categories affected by competitive pressures from other banks or from nonbank lenders. While the survey results suggest that lending conditions are beginning to ease, the improvement to date has been concentrated at large domestic banks. Most banks reported that demand for business and consumer loans was about unchanged.

In the next installment we will review total loans and the loans/deposits ratio to check if this willingness to lend is being reflected in the actual data.

Charting Banking XIV: more on bank failures

Barry Ritholtz has a weekly series where he tracks the number of accumulated bank failure with almost 276 banks closed already. This year is on track to surpass 2009 and we are on track to close around 200 failures. To put that into perspective, the FDIC insures deposits of 8305 banks and savings associations.

The good news is that we seem to have hit the second derivative and 2010 is probably going to be the peak year … and if  mortgages continue to stabilize it looks very unlikely that we will hit the 1000 failures that many projected in 2008. Some commentators are complaining about an FDIC slowdown caused by depleted reserves. The numbers do not seem to indicate that yet.

This does not mean that there were no capital deficiencies at the beginning and most of the initial problems were caused by large institutions  (ie: IndyMac and Washington Mutual).  However, it seems that TARP and capital infusions, some of them causing significant dilution like Citigroup’s, succeeded in softening the blow to this critical sector. In the next part we will share graphs from a recent SEC survey that seem to indicate that banks are becoming more willing to lend.

Source: Chart Store via The Big Picture

Fertilizer industry prospects

As part of the rejection of BHP’s acquisition proposal, Potash Corp (POT) released an interesting report about the fertilizer industry and its prospects. On the question of why a mining company could be interested in the fertilizer industry, it is worth remembering that this business is segmented in the three primary crop nutrients (nitrogen, phosphate and potash) and potash in particular is mined. Potash Corp controls 22% of the worldwide potash production capacity.

As side notes, Potash Corp is one of Mohnish Pabrai largest holdings and is interesting to see SQM, one of my first investments, as part of the melodrama. SQM is one of several minority participations that, according to Potash Corp, BHP’s offer is not valuing at their true worth.

The key phrase in the presentation?

Industry characterized by substantial barriers to entry, few producers and no known product substitutes

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No position

Charting Banking XIII: history of bank failures

Before continuing exploring the possibilities of our new tool, the Texas Ratio, I think it is important to have some historical perspective on the risks of bank failure. Banks are quite fragile leveraged institutions and bursts of financial failures are essential to consider for normal times bank investing. I much rather invest in banks at the end of a crisis, when the risks can be quantified and prices are cheap, but there is a case to invest in them in any case.

The extension of risky loans with overpriced collateral, thin covenants, to lenders with insufficient cash flow, and even in some cases becoming complicit or target of frauds, can lead to over leveraging a particular sector of the economy and reach unsustainable bubble prices.  In the old times, the boring banking times of the 50s and 60s, those four conditions were called the 4Cs of lending with fraud avoidance called character. Even in the old times, there were periods when these standards were breached and problems ensued.

However, as we can see from our most recent history, something different is going on lately. There are different views on the reasons, but I would like to emphasize the rise of credit scoring that was a much less costly and standardized way of lending that checking the character of a borrower. That it turn opened the possibility  for the rise of securitization, that is not as new as people think: the 1980s collateralized junk bond obligations or 1990s car loans securitizations being just two examples.

In theory, securitization helped banks to reduce risky assets in their balance sheets. But as we have learned it is not so simple: there is less control of potential massive scale frauds, an asset bubble deflation will still impact more traditional loans and banks can sometimes end up holding junk like in the S&L 1980s crisis. It all started with the best of intentions but we have to live now with the consequences.

A pile of junk is still junk no matter how you stack it – Margin of Safety, Seth Klarman