Variant Perceptions

Category: arbitrage

David Tepper on investing under uncertainty: theory

Much like Eddie Lampert was able to see value in Kmart when everyone else wrote the company off. Tepper is great at identifying the true value of a company when the company looks like it is worthless- David is able to extract value where others cannot see or understand. And the exit strategy is simple thereafter! – Frank DeRose, Ferrata Capital

David Tepper is not the investor most easy to understand: media shy and does not like to talk about specific positions. His is a bond shop so the 13Fs only show a small part of his portfolio. Incredibly, Appaloosa’s offices are in New Jersey overlooking a mall parking lot. Even in politics he keeps his cards close to the chest: tell me the rules, just make them stable and certain.

Nevertheless, I decided to dissect the few resources available and see if there was anything to learn from him. The reason? over the last two years it was very surprising to me how often sectors, companies and even specific ideas that got my interest were part of his portfolio. Only that his results, given the size of his portfolio, were nothing short of amazing and I usually was one step behind.

He was a boundary-pusher, loud and profane, and a know-it-all – NY Magazine Profile

Some of you may wonder on what could be the use of investigating the habits of a former trader? David Tepper’s education was trading at Goldman Sachs but I take issue on that he is just a trader. His public equity positions have been medium to long term -Bank of America and other banks securities were bought in March 2009 and  still has them- and  has been active in several situations looking to improve companies finances -ie: Delphi and General Motors-. And that combination makes him interesting and someone from whom to learn a couple of tricks.

Distressed debt is Tepper’s specialty. He has mentioned that distressed is very similar to risk arbitrage. Actually the much descredited but still interesting Robert Rubin, who was head of Goldman’s risk arbitrage some time ago, was somewhat of a mentor so why not pick Rubin’s book and see what he says of this discipline:

In arbitrage, as in philosophy, you analyze, look for holes in the analysis, and seek conclusions that hold together. However, while analytical rigor may be sufficient for philosophy, it’s not enough for arbitrage -as in policy making- you also have to be able to pull the trigger, even when your information is imperfect and your questions can’t all be answered. You have to make a decision: Should I make this investment or not? You begin with probing questions and end having to accept that some of them will be imperfectly answered -or not answered at all. And you have to have the stomach for risk. – In an Uncertain World, Robert Rubin

Some would say this is reckless, and profane Tepper would probably interject balls to the wall. However, if you look more deeply he protects the downside and lives to fight another day when he is wrong.

  • Bond shop: he looks to the whole capital structure for opportunities for the best risk/reward tradeoff. Bonds and preferreds provide better protection, and in times of panic their rewards can still be substantial.
  • Themes are macro but investments are micro: He has a view on the financial difficulties and perspectives of a country, but the quality of the specific ideas he finally invests in provides another layer of protection.
  • Do not fight the government: And that means not just the FED. In March 2009, he trusted a federal government document detailing the banks bailout. You wonder if this only works in the USA, I am sure I would not trust other countries governments not to brake the law.
  • Sell fast if you make a mistake: probably a heritage of his trader days, he is willing to recognize he is wrong fast and close his positions. This sometimes has put him in awkward situations like Delphi: “pushed, with the grace and diplomacy of a battering ram, to play a central role in the reorganization of the company, only to turn tail and manufacture an excuse once they lost interest.”
  • Do not use leverage: for Russia 1998 he had leverage, but it was low and he learned his lesson. If his recent results are any evidence, leverage is not needed for high returns.
  • Hedge: if there is a possibility to filter the thesis in a pure way, hedge. At the end, was not this what hedge funds were about?
  • Markets adapt, people adapt: And if all that does not work, markets tend to heal themselves

I got a headache because I was listening to one guy talking about how there’s gonna be hyperinflation. And then after him there was some guy telling me there’s going to be a depression and deflation. Neither—neither—is most likely going to happen. The point is, markets adapt, people adapt. Don’t listen to all the crap out there – Ira Sohn conference May 2010

But the one thing that I would like to emphasize, and this comes straight from Rubin’s book, is the importance of scenarios, probabilities and downside for distressed investing and we are going to look next some of his famous moments to see how this all works… do you think you can make decisions with trees?

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Voice from the Past: Lynch on Fannie and Freddie ($FRE, $FNM)

After realizing that one of the potential outcomes of this Freddie Mac preferred case is the possible conversion of the preferreds to equity, I decided to investigate how good was the GSEs business. I understand that many are skeptical of the GSEs’ future but I argue that you do not need to bet on their success. You just have to make sure that the prefereds are grossly undervalued relative to the common and do a market neutral pair trade. Word of advice before you try this at home. This is my first one and waited for years for a no brainier and still, I am  using puts on the short side to avoid nasty surprises.

While doing my research, I stumbled upon Peter Lynch that wrote a whole chapter on Fannie Mae in his book “Beating the Street”. Most value investors have a world view based on Buffett, Klarman and Graham. They have shaped my way of thinking too. However my hero in the 90s was Lynch. Yes, he was a little of a momentum investor but how well he played the auto, retail and financial sectors and his books have plenty of excellent advice. Here are some quotes rearranged and classified. Just swap the references to Fannie Mae for Freddie Mac and enjoy.

Description

  • Every year since 1986, I‘ve recommended Fannie Mae to the Barron’s panel.
  • It’s no accident that there’s a snapshot of Fannie Mae headquarters alongside the family photographs on the memento shelf in my office
  • Maxwell was determined to put a stop to Fannie Mae’s wild swings…This he hope to accomplish in two ways: by putting an end to borrow short – lend long, by imitating Freddie Mac
  • Freddie Mac has stumbled onto the newfangled idea of packaging mortgages
  • Before mortgage-backed securities (MBS) came along, banks and S&Ls were stuck with owning thousands of little mortgages. It was hard to keep track of them, and it was hard to sell them in a pinch
  • There were two different businesses here: packaging mortgages and selling them, and originating mortgages and holding on to them.

Competitive Advantages

  • It occurred to me that Fannie Mae was like a bank, but also had major advantages over a bank. Banks had 2-3 percent overhead. Fannie Mae could pay its expenses on a .2 percent overhead
  • Thanks to its status a quasigovernmental agency, Fannie Mae could borrow money more cheaply than any bank, more cheaply than IBM or GM or thousands of other companies.
  • No bank, S&L, or other financial company in America could make a profit on a 1 percent spread
  • As long as people were paying on their mortgages, Fannie Mae would be the most lucrative business left on the planet

Credit Risk

  • A new fear crept in: not interest rates, but Texas. Crazy S&Ls down there had been lending money in the oil-patch boom. People in Houston who’d gotten mortgages with 5 percent down were leaving the keys in the door and walking away from their houses and their mortgages. Fannie Mae owned a lot of these mortgages
  • While banks like Citicorp were making it easier to get mortgages with little documentation -no-doc mortgages, low-doc mortgages, call-the-doc mortgages- Fannie Mae was making it harder. Fannie Mae did not want to repeat the Texas mistake. In that state, it was promoting the no-way-Jose mortgage
  • With fewer competitors buying and selling mortgages, the profit margins on loans had widened. This would boost Fannie Mae’s earnings.
  • Thirty-eight Fannie Mae employees were working in Houston alone to get rid of these houses. The company had to spend millions on foreclosure actions, and million more to cut the grass and paint the stoops and otherwise maintain the abandoned houses until buyers could be found.
  • What was the worst that could happen to it? A recession that turned into a depression? In that situation, interest rates would drop, and Fannie Mae would benefit by refinancing its debt at lower short-term rates
  • Even if new houses weren’t selling, the mortgage business grows. Old people would move out of old houses and new people would buy the old houses, and new mortgages would have to be written
  • I couldn’t imagine a better place to be invested in the twilight of civilization that Fannie Mae

Interest Rate Risk

  • Borrow short and lend long….When interest rates went up, the cost of borrowing increased, and Fannie Mae lost a lot of money
  • You can’t get very far by borrowing at 18 to make 9 (In 1981)
  • This one of those rare periods when a homeowner could say: “My house is OK, but my mortgage is beautiful” (the complete opposite of today)
  • Fannie Mae had begun to “match” its borrowing to its lending. Instead of borrowing short-term money at the cheapest rates, it was offering 3-, 5-, and 19-year bonds at higher rates.
  • Management now talked about “the old portfolio” and the “new portfolio”
  • Fannie Mae was reducing its interest rate risk by issuing callable debt. Callable debt gave Fannie Mae the right to buy back its bonds when such a move would be favorable to the company, especially when interest rates fell and it could borrow more cheaply.

The Stock Performance

  • When a company can earn back the price of its stock in one year, you’ve found a good deal
  • Was Fannie Mae an obvious winner? In hindsight, yes, but a company does not tell you to buy it. There is always something to worry about.
  • For a stock to do better than expected, the company has to be wildly underestimated
  • You have to know the story better than they do, and have faith in what you know I was comforted by the fact that whereas Fannie Mae’s foreclosure rate was still rising, its 90-day delinquencies were falling. Since delinquencies lead to foreclosures, this fall in the delinquency rate suggested that Fannie Mae had already seen the worst (this is the indicator to follow!)
  • The stock rose from $16 to $42, a two-and-a-half-bagger in one year. As so often happens in the stock market, several years’ worth of patience was rewarded in one.
  • I’m submitting this result to the Guinness Book of World Records: most money ever made by one mutual-fund group on one stock in the history of finance

Market Madness: Freddie Mac edition ($FRE)

The bailout companies are back on the news and this time they are not at bottom of the pile. The appreciation of AIG, Citibank, Fannie Mae and Freddie Mac stock is leaving people scratching their heads. Were not these companies bankrupt?

I was of the same opinion until I read Bronte Capital’s in-depth analysis of Freddie Mac and could only say wow. He conservatively estimates that the government is only going to be $56 billion in the hole. Well, maybe only is not the right word but every pundit is talking of loses beyond our imagination while this order of magnitude is within this Frankenstein’s cash flow capability. It could well be alive.

To see why, a quick reminder of the equity structure of Freddie Mac at its $73 stock price high in December 31, 2004.

  • Preferred: $14.1 billion
  • Common Equity: $47.9 billion
  • Equity Value: 62 billion

And that begs the rhetorical question: would not be some value left for the preferred and common stock after all this ends? That sure would be a variant perception and a profit opportunity. Considering the obvious political uncertainty, where I have no particular insights, I decided to play some ketchup finance and see if at least the market was pricing these securities correctly on a relative basis.

In all the following scenarios I will suppose that the preferred stock eventually gets its dividend reestablished, so it trades at par. The reason is that the preferred is the fulcrum security after the subordinates were bailed out . The preferred unexpectedly is priced 6 cents on the dollar, so before the equity gets anything the preferred has to appreciate more than 16x (!). The following is a top down analysis to see if the common justifies its August 30 $2.4 price per share .

Scenario A: FM pays back the principal of the government senior preferred over five years, the equity stays at current prices over this period and the preferred is made whole (remember 16x performance)

  • Preferred: $14.1 billion
  • Common Equity: $1.6 billion
  • Government Warrants: $6.4 billion
  • Government Senior Preferred: $56 billion
  • Equity Value: $78.1 billion

Clearly it does not look reasonable: it is a much higher valuation than Freddie Mac’s peak and the performance is 16x the preferred versus 1x on the equity. There must be something else the market is expecting.

Scenario B: Let’s try to think a positive scenario for the common. Let’s say the government pardons the warrants but Freddie Mac still has to pay the senior preferred to keep receiving financial support from the federal government. That is huge handoff, no 80% dilution.

  • Preferred: $14.1 billion
  • Current Common Market Value: $1.6 billion
  • Government Senior Preferred: 56 billion
  • Equity Value: 71.7

That gives another above peak valuation and another substandard performance versus the preferred. Could the market be betting on a government pardon of the warrants and some more?

Scenario C: So let’s see what would be the scenario to justify the current disparity between common and preferred. A scenario where equity has the same 16x performance and we will keep the condition that the warrants are pardoned

  • Preferred: $14.1 billion
  • In-your-dreams Common Market Value: $25.6 billion
  • Government Senior Preferred: 56 billion
  • Equity Value: 95.7

No comments.

Conclusion: Only extreme scenarios could justify the current relative price of Freddie Mac’s preferred and common. I imagine the situation is similar with Fannie Mae.

This is market madness it looks like two-quart bottles of ketchup are selling for less than twice the price of one-quart bottles. I let you decide if there is a relative arbitrage situation. I made my bet already.

Disclosure: Long FRE prefs, Short FRE common