Thinking about investing in US banks? a short answer to David Merkel

In the comments section to the post Three Years After Lehman I got this deceptively simple question from David Merkel, the author of the classic The Aleph Blog,

I recommend that you try to talk with M3 Partners, Chris Whalen or Hovde – if they will talk to you. They know banks far better than I do, and I am pretty certain they are bearish.

I’m no expert on banks. I only have a few question marks:

• Exposure to Europe
• Exposure to repo lending/borrowing
• Lack of clarity because of illiquid assets, and lack of mark-market accounting.
• Home equity lending
• Over-reliance of clipping pennies from the Fed, at a time when the front end of the yield curve has collapsed.

Basically, I don’t trust the accounting. Why should I buy bank stocks when I can buy safer insurers at similar or better discounts, where I know the accounting is mostly fair, and the liability structures are stronger?

Sincerely,

David

My first thought was that it was nearly impossible to answer all David’s “few” question marks in the comment section but surely I could answer his insurance versus banking question. How wrong I was. When the short answer became two pages long it was fairly obvious that it was the stuff for a post. It probably needs editing but the short answer was already taking too much time:

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David,

I am sure others do not feel as comfortable as you with insurance accounting and underwriting standards. I certainly do not and you have been my man when I want corroboration on those issues (smile)

I imagine that when you mean investing in insurance companies, you are referring to insurance companies where you personally feel comfortable with their underwriting and their history. Besides basic rules of thumb to check reserves, the accounting will not help much predicting future losses.  Also I suppose that there are some sectors that you would not trust like life insurers with large guaranteed annuities portfolios or some mortgage insurers.

That reaches a central point of investing in financial firms: some leap of trust is almost always needed. For insurers you cannot know every single policy, for banks you cannot know every single loan. There are a couple of mREITs that I know all their loans but those are an exception.

There are several investment approaches to this “leap of trust” thing:

1. Do not trust any financial firm ever: that has been the path taken by several good investors. They prefer to keep it outside their circle of competence and I will not try to convince them to change. You have to pick your spots. At the same time, there is a leap of trust in any type of investment (BP/security, NWSA/ethics, HPQ/acquisitions) even if you trust the accounting, that as we know it is not always the case. I personally have lost money investing in some simple businesses, in simple industries with lots of net cash, and instead made substantial returns in some complex distressed situations.
2. Buy great companies with great teams: Because of some accident an investor may get to know in depth some financial sector (you insurance, me banking) and get comfortable with some teams. Good teams can avoid disasters for decades and the top of them can regularly achieve 12%+ average ROE and grow. That is a recipe for fantastic returns. I consider this approach risky. Historically many have had style drift like AIG and also be exposed to nationwide cataclysms. For example, Bank of Ireland was the best of Irish banks but that did not help much. Besides, it can nurture complacency and abdication on the part of the investor.
3. Wait for the earthquake and look for survivors: that combined with signs of a new management team doing what is necessary (exiting marginal business, manage for capital and cash flow, reducing legacy assets significantly) can be a powerful combination. You are NOT trusting management, you are seeing it in action and following its progress.

As you have probably noticed this blog is mostly devoted to turnaround investing and that means point #3. It is a way of trying to avoid the pitfalls of #2 by waiting to see the order of magnitude of the cataclysm and watch management in action not just in words or reputation.

One key historical advantage of approach #3 for banks is that damaging credit bubbles are usually tied with real estate booms, deregulation, overvalued or even fixed exchange rates (for countries not indebted in own currency), and sustained current account deficits. Some recent examples are Latin America 82, Scandinavia 90, Mexico 94, Asia 96, Argentina 00, Subprime 08, Eastern Europe and PIGS 11. Bubbles driven by excess internal depository savings badly invested are much more rare and different in their consequences (Japan 1990s, maybe China today).  That provides several advantages to an informed investor:

• Avoidable: Real Estate is a big proportion of banks’ balance sheet and usually with deregulation capital is lobbied to be thinned. Most crisis in other categories are usually sideshows: they are not big enough or risky enough. So by only following a couple of categories it is possible to avoid 90% of banking crisis.
• Measurable: when the punctuation hits Real Estate, the other categories follow linear processes that can be measured and followed for a sign of a turn (with the exception of C&D, always one big if):
1. Pricing and collateral of new loans are improved
2. Regulators are tougher
3. Bubble loans become a lower percentage of portfolio over time
4. Cash and liquidity increases
• Scope limited: wherever real estate goes (residential or commercial depending on the type of bubble) that is where the banks will go. If the government does not intervene, watch out (1932). If the government delays or avoid the devaluation of a fixed currency (Greece, Ireland, Spain today) watch out. Loans that are non-performing are difficult to hide. They will show in regulator reports, the cash flow statements or real estate industry reports.
• Time limited: CRE and MBS from bubble times become a lower percentage of the total portfolio over time, while the new loans should be perfectly OK with the improved underwriting and pricing.
• Hated or unloved: headlines do not help and many people were financially burned, so you can wait for confirmation before investing. People get trapped in the morality tale just when it is already in the past. Also it is not like buying the dip is a must, there may be several opportunities. The important part is to improve the probability of a hit because the upside is enormous anyway.
• Replicable: learn one running play and play it ad infinitum. There is always a country suffering undeserved short term capital inflows, misusing them, and becoming the next candidate for a banking blow out  … with the following renaissance. Just look at Greece or Australia. There are twists here and there, like for example countries indebted in their own currency like the US, but isn’t it nice to have a perpetual compounding machine?

The funny thing is that at the moment there is not a single bank stock in my portfolio. It is circumstantial because I have had small and medium banks on and off over the last year and I think the banking sector today is fertile ground indeed.

In this blog I have tried to bounce and structure ideas on approach #3, the turnaround approach. It needs more work, pragmatism and flexibility than what is normally understood as value investing. Its success is tied to avoid investing in every single opportunity but only the high probabilities, and there must be several high probabilities in the banking sector today:

• Good industry: there is a bank in every Western film. There is a bank branch or an ATM in every commercial location. That is how critical and entrenched are banks in a modern economy and even its history. It is oligopolistic at the local level, without technology obsolesce, and has high regulatory barriers to entry (just ask Walmart). Chris Whalen may not like the oligopolistic setup but I am not seeing many advocates of a utility model. And the alternative of too much dumb private competition was one primary reason of the mess we are in. A highly regulated and oligopolistic model has historically worked.
• Pool of good businesses: retail banking is a local business where you want strong local market share (or a collection of strong local market shares like Bank of America and Wells Fargo). There are plenty of cheap banks with local dominance funded by long-term low-cost deposits with margin to absorb negative shocks. It is not like Bank of America is the only option, actually I think there are better risk-adjusted alternatives with similar upside.
• Hidden downside protection: I am finding multiple cash flow positive banks that are most probably overcapitalized and over-reserved. There is some regulatory risk (pushed to dilute) but at the current prices the upside is big even with some dilution.
• Emphasis in the core business: loose times, loose capital. Tight times, tight capital. The best example of all is Bank of America selling stakes in Canada, Europe and China (that also reduces Private Equity and Credit Card exposure) while redoubling their efforts in the good old USA. Heavy emphasis on the core business, even if it shrinks a company, is a sign of a management that gets it. It improves profitability in the long term and reduces risk.
• The investor has time to close the loop: I usually prefer small and mediums firms because they are less followed and their turnarounds are easier. But hate can also provide time to confirm that all skeletons are out of the closet … and banking is the most hated sector today. There are still not many in the media realizing that most banks are improving. Even the smart Chris Whalen, that has been positive of medium banks, is probably missing the improvement in the Big 4 normal operations and capital ratios most probably because of too much attention to the off balance sheet putback liabilities (issue that would require a whole new post to give it justice).
• First cash flow statement, then balance sheet, finally income statement: And the banks cash flow is at several years highs.You can distrust the balance sheet but it is much more difficult to lie with the cash flows statement. If these loans and operations are so bad, why they are so profitable? It is not like there has not been enough time for bad loans to explode.
• Look for stable or improving earnings potential: In non-financial firms l prefer stable or growing revenues targeting a turnaround based on cost reductions. For banks I look for stable or growing assets and deposits with provisions reducing over time. Most banks’ franchises are still intact and legacy issues are getting reduced. For example, the much maligned Bank of America has been increasing total deposits and core deposits.

And as I argued in Three Years After Lehman, the sector turnaround seems to be going full speed ahead. At this speed that means most of the US banking sector legacy issues should be behind in a year or so.

Therefore, any criticism of the banks should be focused on things off-balance sheet like putbacks or new shocks like Europe. Measuring their order of magnitude should be a piece of cake but I am not seeing many doing that calculation and much less balancing it against the capital, reserves and profitability of each bank. That is the game.

I will not try to convince you David out of insurance companies especially when they are cheap and right in the middle of your circle of competence. Actually, I think it is an interesting sector to follow these days:

• Insurance sector valuations:  http://variantperceptions.wordpress.com/2010/06/05/insurance-sector-price-to-book/
• Insurance sector historic profitability:  http://variantperceptions.wordpress.com/2010/09/13/pc-insurance-historic-profitability/
• Insurance sector as an investment possibility:  http://variantperceptions.wordpress.com/2010/06/05/thinking-about-investing-in-insurance-companies/

But if the American commercial banks are safe, they are a lot cheaper than the American insurance companies. For example, if Bank of America survives – and I am not saying it will – it generates close to $40B in pre-tax pre-provision earnings and is priced around $80B. I do not know of any such disparities in the insurance sector (maybe you do?)

Also the situation is a little different, closer to investing in insurance companies after asbestos … the shenanigans are out in the open! You are faced with the more simple task of evaluating the trustworthiness of the companies projections without short term time pressure.

That is one huge advantage. Some time has passed and you are seeing how some of those projections have performed. Actually some competitors have gone down the drain that is also good for the survivors enjoying improving interest spreads.

With insurance companies, I personally do not know the shenanigans in this soft pricing market. Some have said that AIG was an example of a company too aggressive on pricing backed by the government but from my novice point of view they are not doing so bad in this catastrophic year. Conclusion, I do not know where are the insurance sector hidden bombs and to go by reputation and a track record is not usually my style, a style that shuns complacency.

Hope this answers your question David. Maybe next time I will post the answer to the few question marks …it is already running three pages long.

Quiet, dignity and grace

A little comic relief after a couple of heavy value investing weeks. As you can imagine not the right attitude. Stop it! stop that! stop it! you’ll kill him!

Young Frankenstein – Quiet Dignity & Grace, posted with vodpod

Gramercy Capital: it’s alive?

They say that the best investing is dispassionate. Fundamentals improving? buy. Fundamentals deteriorating? sell. No celebrations or funerals, just cold hard facts. I have to recognize though a sense of relief that Gramercy reached a positive settlement for Realty and will soon file its financial statements.

You might wonder why relief and not joy, was not the settlement a positive outcome?

It was. The thesis supposed a complete loss of Gramercy Realty and hinted the possibility of a legal struggle that could have taken months. Instead, the uncertainty has been completely removed with Gramercy receiving $10 million in management fees and at least $3.5 million in incentive fees for administering Realty. We do not know all the details but this is much better than getting nothing.

Even more, if you are following closely the situation you might have heard that CDO 2005 excess interest income is flowing to corporate. In case you miss that important point let me repeat it. CDO 2005 is alive and its cash flow faucet is open, Fitch broke the news a month ago.

Since last review, the CDO exited its reinvestment period. Six assets are no longer in the pool, including four CRE CDO securities sold at a loss; one mezzanine loan paid in full; and one real estate owned (REO) office property, which was exchanged for a performing office loan, as allowed under the transaction documents. While all overcollateralization tests are now passing, as of the June 2011 trustee report, the CDO was previously failing at least one test since March 2010 leading to the diversion of interest payments due on the junior classes to pay down class A-1.

But the investing emphasis in downside protection takes its toll. It’s a life of more question marks than exclamation marks and the feeling when proven right is not the joy of a Young Frankenstein surprised by his creation.

Months of checking and double checking the thesis while being patient creates anticipation with no uncertainty. Actually, the goal in investing is to avoid surprises. Good downside protection analysis should provide as much certainty as possible. And with it, it should bring the death of joy.

What do we get in return? A smirk in the face, a little gloat and relief. Being human I suppose that’s the consequence of enjoying more the process than the outcome.

Earnings Power

I have been receiving lots of questions about the consequence of the Gramercy Realty deed-in-lieu of foreclosure agreement. The following is my best guess of Gramercy’s current earnings power. Please corroborate the numbers as soon as we get the financial statements. There may have been some big changes over the last year … it has been a long time.

NII net of preferred dividends	53M – 63M
CDOs Excess Cash Flow	60M – 70M
Preferred Dividends	(7M)
Fees	17M – 20M
CDOs Senior Collateral Management Fees	3.5M
Gramercy Realty Management Fees	10M
Gramercy Realty Incentive Fees	3.5M – 6.5M
SG&A	(28M)
FCF pretax	42M – 55M
FCF pretax per share	$0.8 – $1.1
Unrestricted Cash	150M

Using the current market multiple for Newcastle Investments NCT, that  is a very similar company to Gramercy, we arrive to a target valuation between $6.6 and $7.7 per share. And I consider NCT very cheap indeed.

	NCT	GKK
Market Cap	392M	160M
Unrestricted Cash	34M	150M
FCF pretax	84M	42M – 55M
FCF multiple	4.3x	4.3x
Price Target	$4.9	$6.6 – $7.7

Granted, Newcastle NCT is already paying a dividend of $0.4 per share and we are still waiting to know what Gramercy decides on this issue. At the same time, Gramercy has a better risk profile with a large percentage of its value consisting of cold hard cash and fees.

So the answer to your question readers is yes. Gramercy Capital is cheap and safe.

What’s next?

The answer is simple: here come the catalysts. And it should be an avalanche over the next few months.

1. Financial Statements: The company already announced that we will have a 10K before the end of September. It will be time to know what has been going on the last year and to finally see the large unrestricted cash consequence of selling the Corporate New York leaseholds … if there are no other large material transaction besides the preferred buybacks and the healing of CDO 2005.
2. Preferred Share Dividend: including the payment of 12 quarters of arrears. As you can imagine, that by itself make the preferred shares trading at par a very nice opportunity. I hope that after all the Gramercy write-ups you understand why I am looking for more by buying the common.
3. Common Equity Dividend: Gramercy is in no hurry to reestablish them considering the recent very large accumulated loses and the large pipeline of opportunities in the CRE space. However, considering the experience of similar companies like RAIT Financial RAS and Newcastle Investments NCT, I would not be surprised with a small dividend of around $0.3 per year (30% of FCF) that would permit Gramercy to tap the capital markets in the future for the plenty of available accretive opportunities. Hey, I would not mind that FCF reinvested at 20% ROIs.
4. Foreclosing Good Collateral:  With lots of cash, two CDOs cash flowing and management fees, there should be no worries about the future and Gramercy can be more aggressive. One way is taking control of cash flowing collateral by using the replacement strategy. Instead of continuing to extend these CDO loans why not take control of the property at great prices. Compared to banks we don’t have regulator pressure to sell them and can receive rent income instead (ie: RAIT Financial RAS). Yes, we can benefit of deed-in-lieu of foreclosures, we are not just on the receiving end.

With Gramercy Realty’s uncertainty resolved and CDO 2005 cash flowing ahead of schedule, two big mysteries were solved. But I start to wonder about the dog that has not barked … what will Gramercy do with all that unrestricted cash?

Gramercy Corporate has not been in the news in any big transaction, except for the curing of CDO 2005, and has not filed an 8K detailing one either. Without financial statements I am in the dark as everyone else but it seems Gramercy has not done much with that cash.

Why?

It is not for lack of opportunities or not enough time to close them. For example, competitors have been active over the last year. My impression is that Gramercy is preparing something big but needed to resolve Realty first before committing.

What could that be? I wish I knew but let me throw one possible scenario just for the sake of showing the range of possibilities that open up after the Realty settlement.

What if Gramercy is planning something massive like buying a large part of the dead parrot CDO 2007 bonds?

Let me repeat, this is pure speculation. But I have seen other non agency mREITs buying tranches of their non cash flowing CDOs not because they want to cure them but just because it is good allocation. When an mREIT has other sources of income, like fees and other flowing CDOs, it can take advantage of the acceleration of principal payments for the CDO senior notes.

Gramercy is both a lender and a operator of real estate, and is able to buy its debt at a discount so nothing stops it. And competitors NorthStar Financial NRF and Newcastle Investments NCT have done it too.

It might also explain why the Realty negotiations reached port so soon after a change of Roger Cozzi’s and Tim O’Connor’s incentive package that instead seemed to tip that Gramercy was preparing for a long protracted negotiation. The widening spreads of the last weeks may have provided a large buying opportunity that might have convinced Gramercy to soften a tough negotiation stand. Add that the difficult economic conditions might make difficult a turnaround of Realty … and voila?

After seeing recently buybacks of  flowing CDO bonds at 50% of par, it would not be a shock if senior CDO 2007 bonds are below 40% and that would be great. But I do not know for sure.

What can go wrong?

Gramercy has been in the news lately with the fight over two distressed loans Jameson Inns and Hilton Las Vegas. And more will probably come. However the situation is much different from 2008-2009 when delinquent loans could have compromised the viability of Gramercy. Now Gramercy can negotiate from a position of strength when the worst that can happen with a defaulting loan is a quarter or two of CDOs not cash flowing but in return Gramercy can take control of good properties at bottom prices.

In terms of macro, a Japan type of scenario with interest rates at zero as far as the eyes can see could be positive. Banks with large concentration of CRE loans have been restricted by tough regulators of lending more to the sector, so the conditions have been fantastic for the remaining lenders with 5% plus CRE loans’ yields.

The only bad scenarios that I can foresee at the moment is a 1930s depression or a large capital misallocation. And there is no evidence that we are facing either of those.