Variant Perceptions

Category: distressed

Charting Banking XXIII: tangible common equity

More than 3 years after Lehman, I continue to get involved in board discussions over the uses of the tangible common equity (TCE) and its close relative the TCE ratio.

TCE ratio = Tangible Common Equity / Tangible Assets

I am not a fan of using TCE for valuations, very seldom you will encounter a bank going through an orderly liquidation. In good times earnings show and in distressed times, like the ones we live, is precisely when banks can not liquidate orderly. They either,

  1. Survive: and go on to live better times
  2. Dilute: increase capital to navigate bad loan issues
  3. Sell: to a bidder with the balance sheet to navigate the bad loans
  4. Collapse: so who cares about valuation after a wipeout

Surprisingly, most capital raised has been negotiated around TCE multiples, usually close to 1x TCE. To have a future it is first essential to survive the present so capital sets the rules. I will argue though that with credit issues declining fast, current and potential earnings multiples should increase in importance. The age of TCE multiples should and will recede.

The second use of TCE, and the one that I personally use, is the TCE ratio. A measure of leverage and its close cousin: excessive risk taking.

Why the TCE ratio and not all the other capital ratios that regulators use for capital adequacy, like tier 1 leverage, tier 1 capital, total risk? I am old-fashioned, and I think it is important to be skeptic of measures that open opportunities to hybrid capital, that is partly debt, or use “risk” weighted measures of assets, when there are no “safe” assets only safe underwriting. When financial booms come, hand in hand with financial deregulation argued for by the banks themselves, exoteric metrics can easily hide or tempt risk taking.

Leverage is not the only way that banks can take risks, bad loans and investments are even worse. But a risk taking bank will pull all levers and high leverage is a good warning signal. For example, let’s see the TCE ratio for American banks at the bottom of the 2009 crisis.

It does not look like all banks were pushing the envelope but what about the Big 4! Some will argue that these are precisely the banks with high pre-provision profitability to cushion the crisis, with Warren Buffett one of them, and it has some truth.

Dick Kovacevich specifically told me to ask you your views on tangible common equity.

What I pay attention to is earning power. Coca-Cola has no tangible common equity. But they’ve got huge earning power. And Wells … you can’t take away Wells’ customer base. It grows quarter by quarter. And what you make money off is customers. And you make money on customers by having a helluva spread on assets and not doing anything really dumb. And that’s what they do. (…)

You don’t make money on tangible common equity. You make money on the funds that people give you and the difference between the cost of those funds and what you lend them out on. And that’s where people get all mixed up incidentally on things like the TARP. They say, ‘Well, where’d the 5 billion go or where’d the 10 billion go that was put in?’ That isn’t what you make money on. You make money on that deposit base of $800 billion that they’ve got now. And that deposit base I guarantee you will cost Wells a lot less than it cost Wachovia. And they’ll put out the money differently.

Even more, I would argue that this set of banks was not even very responsible for the bubble. Investment banks and other banks that had already collapsed should carry more of the blame.

But add a fizzing real estate bubble to large real estate loan and securities portfolios. Who should you trust with this mounting evidence of too much risk taking? Or as Buffett would say

banking is a very good business unless you do dumb things

So with all the complaining about the new emphasis on the TCE ratio in the dark days of 2009, I wonder … what was new? Banks lobby for deregulation and more leverage only later to complain of regulation “overreach” . The system flatlined only because they asked for the rope to hang themselves.

And let’s not forget that capital for the whole system is important. Capital works as a cushion and help banks to recognize loses faster instead of gambling on a rosier future. To be the lonely good bank, and most were prudent, when the national banking system is collapsing is no consolation. As the Bank of Ireland sadly learned.

The flip side of the TCE ratio is that its improvement also signals banks reducing risk, voluntarily or not, and the progress has been spectacular.

What about Europe? As is public knowledge, European banks have their issues. And it is not just the sovereign debt exposure. Some big banks need capital and the TCE ratio is one if several guidelines that hint on this despite all their complaining.

Does this mean that the American banks are threatened? Good banks but sadly part of a collapsing global banking system?

Not so fast. Retail banking crisis are more of a local/national affair connected to local/national deflation. International assets  are usually not big or risky enough in retail banks balance sheets. But that is an assumption that must be checked, specially with the Big 4 taking more investment banking roles, as we will do in a future Charting Banking.


MPG Office Trust: recap

More than a year ago, I wrote a thesis for the MPG preferred equity and left some open questions on the value of the common equity. A sharp price recovery discontinued that series; nobody likes much to write about stocks sold or priced too high.

Some recent events, specifically the resignation of the CEO Nelson Rising, prompted a selloff so it is a good time to continue the series and answer those open questions:

  • “Not much in recourse obligations left, the OC strategy should restart cash flow generation, and there is cash, unencumbered land, a 20% participation in a profitable JV and large NOLs to carry them through the turnaround. The preferreds must be an easy kill, is there more value left for the common?”
  • Do we think that the common is not only undervalued, but has more upside than the opportunity cost: the potential 3x of the preferreds and its higher preference in the capital structure?

As we discussed at that time, Maguire is a highly indebted REIT that is barely cash flow breakeven. Since that write-up,  the company has practically eliminated all recourse debt and corporate guarantees so MPG may loose some valuable properties in the process but each mortgage is independent so a cash flow positive core will always survive.

The continuing debt restructuring is not the only recent news. The company also has a new name, MPG Office Trust, consequence of the firing and disentanglement of most business relations with Mr. Maguire, and a new CEO David Weinstein consequence of the divergent capital structure views of Mr. Rising and the board.

Over the last year my main worry with MPG has been a potential dilutive capital injection. I am not opposed to it at a property level, with a couple of asset sells if necessary, but I do oppose a capital raise at the corporate level because at the current valuation defeats the purpose of the well conceived debt structure.

Well, this worry has been mitigated with the leaks following the CEO resignation. I think it is pretty clear that the board had the same worries and is defending shareholders.

But Mr. Rising believed the company also needed to sell equity to stabilize its balance sheet, people familiar with the situation said. Other REITs were doing this. But MPG shares were at such a low level, board members felt that it would be too dilutive, these people said. Mr. Rising also had discussions with possible suitors interested in buying the company. But the board felt the price would be too low because of the company’s high debt load, these people said. – Wall Street Journal

Some of you will challenge this view that the market may be missing something. After all, MPG is not your usual small cap. It is widely known in the competitive REIT sector so it should not lack suitors if it had substantial value left.

The thing is, there is a long line of suitors. For a start,

  • Winthrop Realty Trust was a large holder of preferreds and showed interest on a more active role before selling.
  • Brookfield Properties has been mentioned as interested in several articles, including the WSJ article on the resignation of the CEO. One of their analysts has been a staple in recent MPG’s conference calls.
  • Appaloosa has a very large position, close to 10%, in the common and most probably in the preferreds too.
  • Third Point had a large 10% position that was sold. Daniel Loeb in one of his tirades complained about the company rejection of a $20 buyout offer in June 2008.
  • Baliasny Asset Management, besides being implicated in the recent insider trading scandal, bought a 5% position between Q4 2009 and Q1 2010
  • Robert Maguire, founder and former CEO, increased his position to close to 10% (prices between $1.4 and $2.5) while firing a 13D between February and March this year.

Quite substantial blue blood interest, specially for a company valued at only $100 million. The question is what are they seeing here. If you go the traditional way of valuing a REIT by using a multiple of NOI (net operating income) you would be disappointed. There is not much NOI.

At the same time, that method misses that MPG was known for their subpar NOI generation compared to its NAV (net asset value). The reason is that downtown leases were not paying enough while absorbing for decades the CRE bubble from the 1980s. Though, on the positive side,  there is no new supply expected for years and, in the meantime, the office vacancy is below 20% in downtown LA so it will be absorbed rapidly after the downturn ends.

No new supply and continued downtown growth. I wonder what will happen next.

Past history is the way I have seen people arguing on behalf of MPG. They extrapolate its share price before the Orange County acquisition and conclude that it is worth more than $40 per share. But that is not right either: the OC debacle cost MPG significantly since they had to refinance and extract equity from the core Los Angeles CBD to buy those properties … properties that are being hand over.

There is value, substantial value, but it is going to take a long analysis. Please bare with me and let’s hope that this time the price does not jump before we finish the series.

Long MPG

This article was published in CGI Value two weeks ago

Two slides from Brookfield’s investors day

Nothing to add

Remembering a predator

“We’re in the business of buying assets of great quality at less than replacement cost” – Bruce Flatt

That is not a quote from Flatt’s Whitman business school presentation but from the recent interview “The Perfect Predator”. Predator is a good metaphor to what is needed when investing in commodities and hard assets: waiting while on the hunt for that few transactions that make outsized returns.

I wish I had not learned it the hard way. The 1982 Latin American debt crisis was devastating for Chile with an official unemployment rate higher that 30%. And that 30% included the benefits of the government employment programs: the kind that dig a hole only to fill it later.

The largest Chilean business groups were hopelessly levered having used their control of the largest banks for interrelated loans.  With some few notable exceptions. The most important one: Anacleto Angelini.

He was not a political man. It was whispered that his modus operandi was to contribute just enough to all political parties to avoid making enemies.

When banks were nationalized and distressed assets had to be sold not all predators were like him. Others used their political connections to grab some of those distressed assets on preferential conditions. A useful remainder that the word predator is not normally used as a compliment.

Mr. Angelini preferred to let cash do the talking and cash was responsible for his biggest coup: the acquisition in 1985 of Copec and its flagship Celulosa Arauco.

I had the fortune of meeting the man a couple of times when he was not the man but just a family friend. Still, he made an impression on that child. He drove himself the same old car and lived in the same old house. He avoided media and newspapers, that got tired of speaking of him only by hearsay and printing the same old picture… there was no other one.

But most important, he imprinted one motto in my mind even before the acquisition:

lowest cost wins – Anacleto Angelini

Celulosa Arauco’s long fiber pulp total costs are less than $300 per ton and the current market price is almost $1,000 per ton. It takes 20 years to grow radiata pine in Chile, it is not even commercially exploitable in the northern hemisphere (50 to a 100 years). Eucalyptus is ready in 12 years at a fraction of the time of the Canadian and European hardwoods.

That is what I call an unfair advantage, an unfair advantage he was ready to buy at the right price.

The acquisition transformed his financing arm Antarchile into a multibillion commodity conglomerate and, over time, Mr. Angelini became the richest man in Chile and South America. A nice ending for an Italian immigrant that drove trucks in Abisinia and spent time in a British concentration camp during the Second World War.

Anacleto Angelini died in 2007. He was fair and honest. He was not a visionary. He was a predator. One of the best.


Bruce Flatt on investing in hard assets

Link to video

It is one year since we mentioned Maguire Properties Group as a potential opportunity only to be followed some months later with a specific recommendation to buy the preferreds. It has bothered me that the series was interrupted by a sharp price increase before I could disclose the common equity thesis. Now it is time to make amendments, so next week we will continue that series and hopefully end it this time.

The company has gone through some big changes in this period. It has a new name, MPG Office Trust, and a new CEO. Also the common stock is not as cheap as it was in December last year but is cheap enough to make it worthwhile to dust off those notes that I thought were not going to see daylight again. And if the price gets away once again so be it.

As an introduction, I thought that this  overview by Brookfield’s CEO Bruce Flatt was one of the best presentations I have seen on the issue of investing in hard assets.

What is Brookfield’s way? The best explanation I have read comes from the interview “The Perfect Predator”

Flatt laid out his new game plan: the giant squid of a holding corporation would focus on operating in just three sectors—real estate, power generation and infrastructure, areas that could deliver consistent revenue, locked in by long-term contracts, and where assets tended to rise in value, making them relatively cheap to finance. With this simplified focus, Flatt invited pension funds to put money into Brookfield-run investment funds, with the resulting management fees serving as a cushion for the company’s own investment returns.

When we review MPG next week please keep this presentation in mind. Do not miss his discussion on 245 Park Avenue (yes, the one in the picture):

  • Great location: downtown Manhattan
  • Acquisition price: bought in 1995 for $500 million ($250 per sqf)
  • Market perception: Due to the internet most people will work at home
  • Variant perception: People want to work close to other people
  • Current valuation: $2 billion ($1000 per sqf)
  • Profit: 4x enterprise value, 10x equity due to leverage, plus rent income

The Q&A follow-up session is also very good – $1,000 per sqf replacement cost estimate for downtown Manhattan- and of course take note of the 8 principles that guide Brookfield’s operations. Mmm, maybe I can be of help with that:

  • Buy great assets: look for good locations with good fundamentals even if that means paying a premium
  • Buy on the assumption of owning forever: allows to avoid fads, think long term and compound tax free
  • Prudently finance your assets:  Long term and investment grade financing to avoid situations when you can not get financing. Live to see another day (I would add non-recourse)
  • Never become too positive or too negative: Toughest rule to follow. Assets revert to the mean and seldom the mean changes. Technology in the few cases that it has an impact it takes time.
  • Invest against the common trend: prepare for the great opportunity. Look for the 1% of business activity that generates outsized return. In normal times, be prudent.
  • Build with quality people: turbulent times test the cohesiveness of a team.
  • Execution, execution, execution
  • Never deviate from the first 7 principles: the consequences of short term solutions can be sometimes, not always, business threatening

    Freddie Mac and the mortgage market

    UPDATEBachus is not very keen on this program arguing against the cost to taxpayers and Fannie and Freddie are not cooperating. Hey, was not it voluntary?

    To complement Pershing Square’s presentation on the state of the mortgage market, Freddie Mac includes in its quarterly results a review of the housing market that is always very interesting. It starts on page 12.

    Regarding Freddie Mac the situation seems to be stabilizing, some would say improving, with almost no draw last quarter (only $100 million in Q3). Very good considering the 10% interest of the government senior preferreds. Not only that, Freddie Mac’s single family delinquencies peaked in February 2010 at  a 4.2% and then improved seven months in a row.

    The FHFA also released projections that show a future where Freddie Mac might be profitable. Most positive if compared to Fannie Mae for example. To add insult to humiliation, they also reduced the estimated total cost of the GSEs bailout – between $221 billion and $363 billion is the latest tally – slowly recognizing that it was a completely made up number at the beginning while still raising doubts on this most recent count.

    At the same time, the Obama administration is trying to persuade the GSEs, through the FHFA, to participate in a program that allows banks and other creditors  to write down mortgages and hand off the reduced loans to the FHA. The objective is to find a way to deal with the loans that are severely underwater: almost 1 of every 10 mortgages is more than 25% underwater. This looks like part of the arm twisting of the banks to also participate. The issue is that the GSEs would relinquish their options of collecting from mortgage insurers or putting back loans to banks when a loan defaults. These news might explain the strong performance of the mortgage insurers today.

    Long FRE preferreds

    Pershing Square on the mortgage market

    The health of  the banking and housing sectors are critical for a sustained recovery and both could be interesting sources for ideas given the distress and forced selling. Most interesting, both sectors are interrelated especially with the Big 4’s high percentage of their loan portfolio in mortgages.

    Though, I am of the opinion that it is still possible to have a banking recovery without a complete housing recovery so most of the blogging efforts have gone in that direction… but how to ignore a data-packed presentation on the housing and mortgage issues especially when prepared by Ackman/Pershing Square.  That saves a lot of time. (Source: Dealbreaker)


    David Tepper at Carnegie Mellon

    And concluding the series on David Tepper, a small surprise: a 40 minutes presentation he did probably around November 2007 at Carnegie Mellon, more specifically at the Tepper School of Business [add favorite Argentinians joke here]. It shows another side of him instead of the loud and profane publicized by the media. Specially interesting are his lessons from

    • the Russian crisis, bomb threats included
    • politics at Goldman Sachs, and his love affair with Jon Corzine
    • the use of cash as a hedge, actually the best hedge.

    And it is time to go back to company analysis…

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    RR: The video was removed but here is a transcript thanks to Santangel’s Review

    David Tepper on investing under uncertainty: practice

    We discussed how David Tepper protects his positions. However, at the same time when have your heard a value investor saying anything remotely like this:

    We’re not afraid to lose money. Hence the plaque. I should say, we’re not afraid to make money – David Tepper

    The thing that comes to mind with him is not his defense. In complete contrast to Seth Klarman for example his record is consistently inconsistent … as he would be the first to recognize. He has several years of average or below average returns punctuated by home runs every five years or so. As Seth Klarman is the master of being fearful when others are greedy, you could say that David Tepper is the master of being greedy when others are fearful… an important ability to learn if you ask me.

    All the points that we discussed on how he protects his downside came into fruition in his now famous March 2009 trade:

    Tepper was sitting on a pile of cash, having sold out of most of his positions in the spring of 2008, and didn’t have any debt. So when the U.S. Treasury put out a white paper in February 2009 announcing its Financial Stability Plan, which included the Capital Assistance Program designed to shore up the capital of banks, he took his time and read the fine print.

    The white paper and term sheet said the preferred stock the government was buying in the banks would be convertible to common shares at prices far above current trading levels at the time — which meant it was indeed a time to buy, buy, buy.

    So he did. The fund began amassing sizable positions in bank-related securities: common and preferred shares, and junior-subordinated debt, to be exact. His targets, Bank of America and Citigroup in particular, as rumors circulating that the banking behemoths would be nationalized in early 2009 edged the stocks to near collapse.

    Tepper was able to buy Bank of America preferred shares at just twelve cents on the dollar and Citigroup bonds at just nineteen cents. As those stocks rallied by the end of 2009, Appaloosa raked in the billions.

    Appaloosa also was able to buy about a billion dollar’s worth of AIG’s commercial mortgage-backed securities at nine cents on the dollar. Currently trading at about ninety-three cents, the “AIG ace” was a major coup and contributor to the firm’s success in 2009.

    “Most of the upside was on the preferred and debt side, “ he says. “That’s perhaps why so many people missed this trade. They just couldn’t see it.” – NetNet profile

    Let me emphasize this last point: most of his bets on banks and AIG  were on the preferreds and debt side.

    He also  bought substantial stakes in common and preferred equity in several zombie REITs (NCT, GKK, MPG). We discussed one of these REITs and I hope to have showed that it had a margin of safety.

    This is a sample of other moments:

    • 1989 Junk Bonds Collapse: “After the market imploded in 1989, most banks dissolved their high-yield trading desks. But Goldman’s survived, in part because Tepper, who had worked his way to head trader, helped take the edge off with a canny move: purchasing underlying bonds in the financial institutions that had been crippled by the crash. When the banks emerged from bankruptcy and the market picked up again, the value of the bonds soared.”
    • 1998 Russia: “Tepper bought a bunch of Russian debt on the assumption that the Russian government wouldn’t default. When it did and the ruble collapsed, it cost his fund hundreds of millions of dollars. But even as the market tanked, Tepper kept buying the ever-cheaper bonds, and a few months later, his tenacity paid off: The fund went up 60 percent.”
    • 2002 Junk Bonds Collapse Again: “when the junk-bond market collapsed for a second time. Tepper lost 25 percent, but made up for it the following year, when bonds he’d purchased in bankrupt companies went up 150 percent, Tepper’s big score in 2003. Tepper had purchased the distressed debt of the three then-largest bankruptcies in corporate history: Enron, WorldCom, and insurance giant Conseco. When they emerged from bankruptcy and the debt appreciated, Appaloosa went up a whopping 148 percent.”
    • 2010 Quantitative Easing: “You talk about when you get moments, this might be one of those—kind of (…) Either the economy is going to get better by itself in the next three months…What assets are going to do well? Stocks are going to do well, bonds won’t do so well, gold won’t do as well. Or the economy is not going to pick up in the next three months and the Fed is going to come in with QE. (…) What, I’m going to say, ‘No Fed, I disagree with you, I don’t want to be long equities?’ Sometimes is that easy, not all investment decisions are difficult ones”


    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?