Variant Perceptions

Category: risk management

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.


Gramercy Capital: loose ends


The delinquent financials are hiding two big events since September 2010: a large 1 million preferred shares buyback in November 2010 (not retired yet) and the sell to SL Green SLG of several New York leaseholds owned by Gramercy Corporate including the famous Lipstick building.

I also considered that the unrestricted cash in Gramercy Realty was part of the mezzanine collateral and most probably lost in case of losing the division. This is my best estimate of the current unrestricted cash considering the lack of information since September last year.


There are two aspects to consider when valuing the preferreds:

  1. Suspended dividends accumulate: Gramercy suspended preferred dividends in December 2008 so it has accumulated 10 quarters of dividends. That is $5.07 per preferred share in arrears.
  2. December buyback: Gramercy offered to buy 4 million of the preferred shares for $15 per share. That is a 50% discount if arrears are included ($25 par + $5.07 arrears = $30.07) and 1,074,178 shares were tendered

Considering both events, this is an estimate of the new shares count and their total obligation. Let me remind you that the preferred equity is the only obligation at the corporate level.


The following is an estimate of the Gramercy CDO bonds that Corporate currently owns:


The two properties in Gramercy Corporate’s portfolio were the result of distressed transactions.  Gramercy and Lehman Brothers took ownership of Whiteface Lodge in Lake Placid on April 23, 2008 by a deed-in-lieu of foreclosure. Later on in July 2010, Gramercy acquired Lehman’s 60% equity interest financed in part with CDO proceeds. Makalei Golf and Land in Hawaii was foreclosed by two of Gramercy’s CDOs and Corporate took the opportunity and acquired it in an auction with a discounted credit bid.

Both transactions testify for the available  opportunities in distressed properties especially when you know the assets in depth.

Other mREITs are following aggressively this route and I would not be surprised that Gramercy follows that path too.  Arbor Realty Trust ABR is one lender that is taking advantage of this type of opportunities over the next quarters:

Additionally, as we mentioned in our last call, we started to acquire some of the real estate securing our loans and investment taking Type 2 properties in the first quarter totaling $132 million subject to $55 million our first lien debt. Paul will take you through the accounting related to these transactions in a moment.

Additionally, we acquired two sets of properties in the first quarter that were securing certain of our loans in the normal course of our lending operating. One of the acquisitions happened in February and was related to an $85 million performing loan secured by six resort hotels in Florida. The loan had a weighted averages interest rate of approximately $3.75% and a net carrying value of $71.6 million prior to the acquisition.

As a result, we recorded this asset on our books as real-estate owned at fair value and eliminated our loan in consolidation (RR: same thing happens with Makalei and Whiteface, you have to dig for the loan amount since it does not appear in the 10K) and we are now recording net operating income from this property including depreciation expense instead of interest income.

This is a tremendous benefit for Gramercy: it is both a lender and operator of real estate assets. Compared to banks, Gramercy can take control of properties in foreclosure and not be forced to sell to comply with regulatory guidelines. While compared to an average developer, Gramercy has long-term low-cost financing to finance the transaction with CDO 2007 still in its reinvestment period. Even when the reinvestment period ends, the replacement strategy can still be used for some financial wizardry.


Some CDO experts may wonder why I did not mention the interest coverage test; the other important test that can redirect cash flow. The reason is that it does not matter much in the current low interest rate environment.

The IC test is the ratio of the CDO interest cash flows against the interest payments due to the CDO bondholders. Its goal is to make sure that there is enough cushion to ensure interest payment to bondholders. However, with CDO 2005 and 2006 being variable rate instruments and a FED’s zero interest rate policy, the denominator is very low. The IC tests pass easily.

There are other portfolio requirements to ensure basic geography diversification and avoid concentration in exotic or risky real estate instruments. Both CDO 2005 and CDO 2006 pass them and any short term failure can be cured with a replacement strategy.


One concern that I have heard in similar situations is that debt discounts signal significant problems for the equity. Well, a good margin safety especially outside the CDOs, as in this case, should be enough to dispel this concern. Even more, I think sometimes discounts do not signal anything about the underlying assets.

To understand what is going on, it is good to remember that senior CDO bonds were AAA securities with very low interest rates when issued despite being non-recourse, non-marked to market, and long term financing. A very good deal to the borrower if you ask me.

Let’s move forward in time. Having gone through one of the worst financial crisis ever, CDO bonds liquidity is much lower, despite being marketable securities, and their AAA has gone away. Actually, there has been no CRE CDO bonds issuance since the start of the crisis. Most financial institutions are faced with regulatory restrictions on what securities can be used for repos and CDO bonds are not being used for that purpose any more. Also critical stakeholders, burned by other CDOs, just want to leave this episode in the past.

So you have a double whammy where institutions that bought these bonds very expensive are willing to sell them back to Gramercy for reasons beyond the current quality of the security. The compounded effect is a large discount to par just at the precise moment that Gramercy and other mREITs would like to buy them. And Gramercy does not need to buy 100% of those bonds, it just needs a small number of institutions under these very common set of circumstances.

In other words, there is not much demand beyond Gramercy’s own and there is supply. It is not like retail investors can or want to buy CDO bonds.

Also Gramercy has perfect information of what is inside the CDOs. Not many people can or want to do a detail analysis of the assets inside them. Despite CDO 2005 and 2006 demonstrating through out the crisis a good performance compared to other types of CDOs, panicky bondholders can have other reasons not to buy.

Concluding, Gramercy sold its lenders the CDO bonds at the equivalent of Florida real estate prices in 2007 and is buying them back at 2011 prices.


This potential risk was mentioned in the “Risks” section but it might be important to discuss it in a little more depth.Despite he mezzanine loan being non-recourse a foreclosure could still carry costs. Exceptionally these procedures can get messy specially if the borrower, in this case Gramercy Realty, decides to fight the foreclosure. The reason is that the threat of a messy foreclosure procedure is their negotiation card while discussing the terms of a died-in-lieu of foreclosure.

None of the parties would want a messy outcome. But still, if the negotiations break down, because of either party overplaying their cards, Gramercy might be pushed to start a legal fight. The lenders in turn would probably sue under the bad boy provisions or a possible fraudulent conveyance even if these have no merit. See for example the legal fight that iStar Financial is enduring with Rittenhouse.

This sounds worse than it really is and the legal costs should be more than affordable with the current cash hoard. But still, the legal costs can make some some dent on the margin of safety. My comfort is that I do not see Gramercy following this route if they think it could compromise the viability of the company.

Long GKK


CDO 2007

CDO 2006

CDO 2005

Was not CRE the next shoe to drop?

And having taken a look to the banks, I cannot avoid drumming another one of our recent themes.

Last year I ranted and complained about the air time given to this nonsense that CRE was the next shoe to drop. Check out the cap rates by sector (lower is better). CRE is doing badly indeed.   Hat tip  CRE Console

And the CRE news from the banking front are also very good. These are some indicators from bankregdata. Let’s start with the percentage of CRE loans non-performing. It peaked two quarters ago and has started to decrease.

And the percentage of 30 to 90 days delinquencies to total loans, an early indicator of potential problems, has been stable and stability is all the banks need to  improve. Remember that pre-tax pre-provision earnings are in the background increasing reserves and capital.

Also the banks, despite continuing a slow decrease of total loans, have stabilized the proportion and absolute amount of  CRE loans.

So much for impending doom. I think the ball is on the pessimist court and their only shot left is a contagion of sovereign defaults. Though, I have not seen any compelling case of a mechanism that would  infect American commercial banks.

Latin American, Canadian and Asian commercial banks were not affected by the 2008 crisis. Why American commercial banks would be affected by a European crisis with so much time to prepare? With several American banks priced for doom, I really would love to know.

Charting Banking XXI: nonperforming loans by category

I should have probably shown this information earlier in the series because an important skill when evaluating banks is identifying pockets of risks and their size.

Mortgages, the epicenter of the crises, are no small issue. Even considering that many of them were securitized there is no way around it; mortgages are one large key bank activity specially for big banks..

How bad are the non-performing loan issues for each category?  There are two protagonists and the rest are just secondary actors. These are the loan percentage by category that are non performing.

It is already more than three years into the crisis and regulators have been pushing hard NPL recognition. We can slice and dice nonperforming loan data and look at them from whatever side you want. The banking crisis has not spread to the same degree beyond residential real estate. Mortgages and risky residential C&D loans -CRE C&D in a smaller scale too-  are the crisis.

Considering that other type of loans do not look so threatening in isolation; blaming non-residential loans for the sector problems is like blaming the hangover on that last beer (after drinking a whole bottle of tequila).


CMBS delinquencies slowing down

More good news in the commercial real estate front. Bloomberg not only mentions the stabilization in bank CRE loans that we discussed a couple of days ago.

U.S. commercial real estate loan delinquencies and default rates continued to march toward new records in the third quarter, but the pace of growth slowed, in yet another sign of a nascent industry recovery.

The default rate on commercial real estate mortgages held by U.S. banks in the third quarter rose by 0.9 percentage point, one of the smallest increases since the downturn began, according to a report released on Monday by Real Capital Analytics.

Commercial real estate mortgage payments that were late by 90 days or more rose to 4.36 percent in the third quarter from 4.27 percent in the prior quarter, according to U.S. Federal Deposit Insurance Corp figures.

but also highlights that commercial mortgage backed securities (CMBS) are also showing signs of stabilization with a sharp slowdown in the increase of delinquencies,

The report was the latest evidence of stabilization in the U.S. commercial real estate market. Credit rating agency Standard & Poor’s said on Monday the delinquency rate for loans behind commercial mortgage-backed securities (CMBS) rose 3 percent in the third quarter, down a jump of 14.1 percent in the second and 30.2 percent in the first. A loan is considered delinquent if it is more than 30 days late.

At the end of the third quarter, $46.8 billion in CMBS loans were delinquent, or 8.32 percent, S&P said. The National Association of Realtors said that overall vacancy rates across most types of commercial real estate likely have peaked and may show small improvement by year end.

I am not going to deny that delinquencies of 8.32% are high but they are not the end of the world either. Especially considering that their securitization isolated commercial banks from the worse CRE lending. Not only that, but these securities that were considered toxic waste are now being targeted for growth with their better underwriting conditions as we mentioned in a previous post.

Holding banking doomsayers accountable

Third quarter 2010 earnings are out and with several banks revisiting one year lows you would think that the credit situation is getting worse. That is simply wrong.

The New York Times finally started following the story with its Friday’s article “Banks Start to Dig Out From Troubled Loans“. My only complain is the use of the word start, why journalists not only are late to stories but then downplay them. And do not take my word for it, the same New York Times printed a graph that shows troubled loans peaking almost a year ago.

Some will say that those numbers are still high but before you jump into conclusions let me make a couple of points.

First, the USA is not Japan

It took more than 10 years after the bubble burst for Japan non performing loans to peak at close to 10% of total loans and only then government pressures pushed banks to deal with the zombie keiretsu borrowers. In the US instead, non performing loans were recognized faster, peaking at  7% in less than 3 years. Not to mention that the Japanese real estate bubble was crazier with much higher loss severities. And even after all that, when the Japanese finally decided to deal with their issues the banking sector NPLs decreased rapidly and stock prices recovered.

The second point is that American banks are very well capitalized (equity plus reserves) to handle the non performing loans even at this high levels. For illustration purposes lets bring back our old tool the Texas Ratio courtesy of updated for Q3 2010 that keeps improving from already manageable levels.

So what is going on. My impression is this just is another installment of the Fear of the Dark, Fear of Death series. Human beings do not react well to uncertainty and banks are part black box so it is easy to say “there are many things to worry about banks”. I have no problem with that, everyone is in his right to invoke the not-in-my-circle-of-competence amendment. What disturbs me is that it usually comes with a litany of measurable and testable arguments that when proven wrong are just simply set aside to be replaced by the next litany that justifies the preconceptions.

For example, in this blog we have been very sceptic of the Commercial Real Estate is the next shoe to drop argument. Has anyone care to see its recent performance, well here it is. Already in the third quarter of 2009  CRE NPLs hit the second derivative and are stabilizing at less than 5% of total CRE loans well below the real issues: mortgages and construction NPLs.

Do you feel the fear? That is Elizabeth Warren probably around February 2010 when it was already clear that things were improving on the CRE front. Lucky for us she is more of a analytical doomsayer so she tried to support her points of view with a congressional oversight panel report. And surprisingly,  it is a very good report with very interesting data.

What made me skeptical of her conclusions was how easily she mixed and confused CRE construction and development loans, a real problem, with income producing CRE loans, a much smaller problem. Mixing both had the consequence of exaggerating the scale and scope of the problems.

This wrong thinking has been repeated again and again during the crisis. The confusion of resets with recasts was another one. Were not option ARMs and other recasts supposed to explode more than a year ago bringing down the banks with them? That must have been one of the most silent explosions I have ever heard.

As soon as one of the issues is proven wrong, the discussion moves to the new flavor of the month. Now the new issues are:

  • Europe: can somebody explain me the contagion mechanism, maybe not because there is no contagion mechanism this time.
  • Putbacks that even the worst loss estimate is less than one year of earnings
  • Foreclosure mess: that the banks badly mishandled. However, that has been usually the case in every real estate bubble in history and every time the banks managed to get their foreclosures.

Doomsayers sound smart and professorial but their ability to predict has been abysmal even for forecaster standards. Why? Partly because markets adapt, people adapt, and capitalist economies grow solving a lot of issues in the process. But hey, the bogeyman and hell are just around the corner.

I sometimes miss people like John Templeton  and Peter Lynch in 1989, right in the middle of the S&L crisis, sharing their optimistic long term perspective while grounded in the difficulties of investing. They were not just smart but wise. Instead we are now at the end of the beginning for banks and these celebrities keep playing on our fears without checking their thinking and numbers.

I am not going to say that some of these issues could not become real, even data driven people like myself are susceptible to over confidence. I prefer to be detached with an open mind since banks are still somewhat opaque and their issues in other situations are real, just look at Ireland or some specific American banks like Flagstar Bancorp that is going through their third capital injection.

However, when you see one hit wonder celebrities that have been all wrong since October 2008 jumping to the new thing that confirms their preconceptions -and I think you know who I am talking about – take a pen, a napkin, run some numbers, but specially check the logical steps. Even with the more professional and less self promotional, like the excellent and bearish Chris Whalen, you should do so because there is no substitute to thinking independently and thinking correctly.

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?

David Tepper on investing under uncertainty

Comments coming later

Vodpod videos no longer available.

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.

Vodpod videos no longer available.

Munger on financials

The beauty of a financial institution is that there are a lot of ways to go to hell in a bucket. You can push credit too far, do a dumb acquisition, leverage yourself excessively – it’s not just derivatives

Wesco Meeting 2002