Variant Perceptions

Month: September, 2010

David Tepper on investing under uncertainty

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Be greedy when others fearful: David Tepper edition

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Commercial Real Estate

Here is some recent information on commercial real estate transaction prices as background information to the Sam Zell interview,. The market is behaving much better than residential real estate and it looks like the next shoe will not drop. Housing remains a concern.

Sam Zell speaks

… and we ponder his thoughts on commercial real estate.

Sam Zell at the 2010 BMO’s Real Estate Market Conference

  • Investors waiting for waves of distressed real estate assets to hit the market may be waiting forever
  • Low interest rates encourages banks to hold onto assets since the cost to carry is very low
  • The incentive to foreclose has also been reduced for properties that still pay some interest
  • New construction is historically low and keeps supply in check
  • In Chicago for example, it would take $45 per square foot in rent to justify a new building, while most buildings are around $28 per square foot right now (replacement cost)
  • Large amount of capital is targeting a small amount of quality assets so as long as supply remains low high quality assets will continue upward
  • Investment in core CBD property in the US might be good investment for pension funds, but for many investors the returns will not be as good as they could be in other parts of the world

Charting Banking XX: short history of the last 25 years

US Bancorp is a great bank, did a great job navigating the crisis and is a Buffett stock. I just wish it was cheaper.

This March 2007 presentation on the business of banking was first shared by Noise Free Investing and I was reminded of it while looking for some info for the Charting Banking series. Some of the interesting points are:

  • Importance of fee income
  • Sector consolidation after the 1987-88 crisis
  • Branches are still a key asset
  • Non bank competition / shadow banks share (the info I needed)
  • New risks in modern banking
  • Regulation as a friend and a barrier to entry (Walmart?)
  • Customer loyalty and how to measure it
  • Supermarket banking shortcomings

P&C insurance historic profitability

One industry that has been mentioned in passing in this blog, and which I am following for signs of better pricing and a cyclical bottom, is property and casualty insurance. We mentioned in a previous post how several players are priced well below book value consequence of a soft market with ROEs below cost of capital. This situation should be unsustainable and the big question is when is going to reverse.

This nice chart from a recent W.R. Berkley Corporation presentation illustrates not only the under performance of the industry in terms of ROE but also its dependency on investment profits to achieve those returns. With interest rates at the end of a secular 30 year decline – they can not go below zero, can they – the question is when and how much pricing and underwriting profits should recover.

These are some estimates of which lines will be most impacted and the price elasticity to compensate for the investment income shock. Oh, and thanks Mr. Berkley for that nice  checklist too.

My favourite banker

A little comic relief from all the boring banking analysis. Some people use Monthy Python as their comic guide to the world. I am more of a Yes Minister guy and Sir Desmond Glazebrook is a reminder that the old times may have been boring but not exempt of bankers, stupidity and financial scandals.

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Charting Banking XIX: history of financial crisis

Via Barry Ritholtz we get precisely the information we were looking for: how recurrent are financial crisis. I only have one question: where is the Latin American debt crisis in this chart? OK, American banks  suffered and their stress appears just there at the beginning of the 80s, but where are Mexico, Argentina, Brazil, Chile, Bolivia, etc. At least it does not change the point that these crisis are very frequent.

FSI: Financial Stress Index; Source: IMF Direct

This point is very much related to Martin Wolf’s question: must large capital inflows always end in crisis?

Capital inflows can distort loans to deposits ratios and end in underwriting terrible loans. And every time the banking system is compromised there are consequences. The excellent book by Kenneth Rogoff and Carmen Reinhart shows how pervasive are these occurrences.

I am not an economist and will not dare to attempt to answer Martin Wolf’s question. However, as an investor I wonder:

  • Given that not even a sophisticated American financial system managed to isolate the banks from these inflows, what chances other countries have of avoiding a financial crisis?
  • Given how recurrent are these episodes, is not there a possibility of waiting for the next episode, profit from it, move then to safe investments, and wait for the next crisis?

Charting Banking XVIII: historic ROE and ROA

How fast can a bank profitability recover after a deep recession? If the experience of the US at the end of the 80s (and Latin America 1982, Scandinavia 1992, Mexico 1994, Asia 1998, Argentina and Brazil 2000) is any guide, it can happen pretty fast. Japan is probably the only modern deposits-guaranteed exception to the rule  and we will get to discuss eventually Japan, that very misunderstood and important case – other possible exemptions are welcomed.

How can this be the case? The thing is that most banks while they are solving their issues they are still doing their business: pooling deposits to loan while earning a spread. The moment you end reserving for your past sins and you made it to the finish line with enough capital

  • deposits are still there
  • most assets are still there
  • most loans are still there
  • many competitors are not there

This does not mean that several banks will not go bust and capital should not be infused. After all bad loans were made and someone has to pay for them. But you can also pay them through the so called extend and pretend, that can work up to a certain extent if  assets are performing and your sins are not so bad. With a business that is still a going concern, 4 years of no returns (USA 1990) can pay for 10% of total assets going bad (assuming a conservative 50% recovery of bad loans and 1.2% ROA)

What is counter intuitive for many people is that banks in these bad harvest periods are also seeding  the good harvest years. Lot of competitors are out so banks are making the best loans ever and taking over these competitors deposits.

The risks of investing in banks are very high when bank hot money chases yield, lower  their standards and the costs of those overstretched loans are unknown. That is not what is happening today.

Charting Banking XVII: loans to deposits history

Now that we are on the subject of loans to deposits, I could not resist sharing this historic data from the gold standard era. For those of you that know what happened in 1920, maybe some Ben Graham fan out there, check the high 1919 levels.  The panic of 1907 was another famous episode. As I said, a high loans to deposits ratio is a good prognosticator of an overextended banking system. In the era when the banking system was just banks this was even more true.

Figure 1. Graphic Chart Showing Ratio of Loans to Deposits of New York Clearing House Banks

Figure 1. Graphic Chart Showing Ratio of Loans to Deposits of New York Clearing House Banks

Source: Banking Principles And Practice, Ray Westerfield