Variant Perceptions

Category: turnaround

Buffett on the imperfect turnaround

Can you think of an example of a retailer that was successfully turned around?

Broadcasting is easy; retailing is the other extreme. If you had a network television station 50 years ago, you didn’t really have to invent or being a good salesman. The network paid you; car dealers paid you, and you made money.

But in retail you have to be smarter than Wal-Mart. Every day retailers are constantly thinking about ways to get ahead of what they were doing the previous day.

We would rather look for easier things to do. The Buffett grocery stores started in Omaha in 1869 and lasted for 100 years. There were two competitors. In 1950, one competitor went out of business. In 1960 the other closed. We had the whole town to ourselves and still didn’t make any money.

How many retailers have really sunk, and then come back? Not many. I can’t think of any. Don’t bet against the best. Costco is working on a 10-11% gross margin that is better than the Wal-Mart’s and Sams’. In comparison, department stores have 35% gross margins.

It’s tough to compete against the best deal for customers. Department stores will keep their old customers that have a habit of shopping there, but they won’t pick up new ones. Wal-Mart is also a tough competitor because others can’t compete at their margins. It’s very efficient.

Warren Buffett, student visit 2005

Another addition to the turnaround toolbox so that I don’t forget the obvious and known even in tempting circumstances.

And these are tempting circumstances. There are two retailers that I like their owner operators and I like their prices. Is there a need to mention their names?

Running the risk of being repetitive, my opinion is that in comeback stories the balance sheet is better used to estimate the runway of a business rather than its value. Both of these retailers have decent runways but the problem is that neither is turning.

These were some thoughts from an old previous post on players facing external threats.

The prospects do not look so bright when you consider that for most of these companies, failure means their core business declines into oblivion. Also many of them may not have clients, hidden capabilities, or platforms to leverage.

A good financial position, like Dell’s or Yahoo’s,  can give them time to experiment and look for alternatives. But from the point of view of an investor even if the plan is successful the company will probably be a follower in the new industry, product, segment, business model: a shadow of its former self.

So the downside is not that well protected, the probabilities of success are not that good, and the upside will probably be limited: does not look like the recipe for successful investing. This is an area where I think value investors have to be careful.

I’m still curious about Dell and Yahoo. I’m still curious about these two retailers. Actually, at the moment there are dozens of interesting situations. However, my preferred style is to jump on businesses that are turning or have already turned at the risk of missing some… and there are some good ones out there.

Now, if they decide to liquidate abruptly or in willful steps … well, that’s not a turnaround.

Position: none.


A friend suggests me to read Mauboussin’s More Than You Know, Chapter 21 and I do. Retail and technology are not the best sectors to look for comebacks.

Exhibit 21.2 shows what happens to companies that realize a downturn. The sample includes almost 1,200 companies from the technology and retail sectors.

The data for the two industries are strikingly similar, and not particularly encouraging: Only about 30 percent of the sample companies were able to engineer a sustained recovery. (Credit Suisse defined a sustained recovery as three years of above-average returns following two years of below-cost-of- capital results.) Roughly one-quarter of the companies produced a nonsustained recovery. The balance—just under half the population—either saw no turnaround or disappeared. Companies can disappear gracefully (get acquired) or disgracefully (go bankrupt).

This analysis also shows how long companies experienced downturns. For both retailers and technology companies, roughly 27 percent of downturns lasted only two years, and for both sectors over 60 percent of downturns lasted for less than five years. In other words, the destiny of most firms that live through a downturn is determined rather quickly.

These mean-reversion and turnaround data underscore how strong and consistent competitive forces are. Most stocks that are cheap are cheap for a reason, and the likelihood that a business earning poor returns resumes a long-term, above-cost-of-capital profile is slim.


TARP warrants: let every eye negotiate for itself and trust no agent

A secret about the TARP warrants is starting to spread.

Most have heard of the adjustment to the strike price after dividends but there is more to the anti-dilution clauses than just the adjustment to the strike price. A few months ago I decided to cryptically suggest this insight in a visited message board, where many were buying TARP warrants, to see who else had caught it.

Actually, not many. One of the few, the author of today’s post.

Over the last few months we have discussed the anti-dilution clauses. He recently decided that it was time to confirm the major insights: discussed them with a few lawyers, that did not help much, and ran the math with one of the small banks that has TARP warrants. He finally put some of the insights, but not all, in a document. It starts with a great Mark Twain quote so how could I not like it. I am thankful that he accepted to share it in this blog.

Both Bruce Berkowitz and Francis Chou mention the secret in their most recent letters. It is mentioned so cryptically as if they did not want it to be known. In the same cryptic style, the author of this post asked to remain anonymous.

There is a lot more to the anti-dilution clauses than what is being discussed in the blogs, the press, and even this post. If you are interested, I suggest you separate several hours and READ the prospectuses fine print.  Also the numbers are from a few weeks back and not all warrants mentioned in the table are from TARP or even have the same fine print. There are no shortcuts in this investment, you have to read a lot.

For more information, I first mentioned the TARP warrants almost two years ago in the following post:

Disclosure, we both are long a few of the mentioned TARP warrants



I am frequently asked, “So what is XXXX’s edge?” I think it is possible that in some cases we eliminate 80% of the competition when we start by reading the annual report. It never ceases to amaze me, how frequently we find that an investor in a particular company did not bother to read the annual report, including professional investors.

Now get ready for some tedious reading! If you do not feel like chewing leather than you are well advised when I say you should skip the following two pages.

Recently, I realized again how few investors bother to read the primary documentation, when researching the TARP warrants of US banks. I expect analysts and investors in these warrants to be do more research than the average sophisticated investor in equities due to the offbeat nature of warrants. However, it quickly became clear to me that analysts, investors and the press clearly did not bother to read the prospectuses of the warrants. Samuel Clemens (a.k.a. Mark Twain) used to say that “A person who won’t read has no advantage over one who can’t read” and that certainly rings true here.

For the benefit of those that have not heard about TARP warrants;

  • TARP- Troubled Asset Relief Program
  • Warrant- The right to purchase an equity security for a certain period at a certain price.

TARP is one of the programs that the US government created to bail out the banks. For example it allowed the US Treasury to purchase newly issued preferred equity from various banks e.g. Bank of America. The US Treasury received warrants, called TARP warrants in this case, with these shares. In time the US Treasury either sold the warrants back to the respective companies or it sold it off into the market where lesser mortals like us can now buy them.

The warrants have some important features.

  1. They are long term; 10 year warrants expiring around 2018-2021
  2. They have various anti-dilution adjustments
  3. The exercise price when compared to current tangible book value is low.

Continuing with the BAC A warrants as an example,

You can learn this by simply reading the relevant prospectus.

Technically, in the case of BAC and others, it is not the prospectus that holds the important information, it is the supplement to the prospectus. When you read the anti-dilution adjustments you note that the exercise price is adjusted downwards in some cases (e.g. when a cash dividend is declared) AND the number of warrant shares (shares/warrant) is adjusted upwards.

You can learn this by simply reading the relevant prospectus.

Last year you could purchase the BAC warrants for as little as $2.00-$3.00 with an exercise price of $13.30. Today, BAC’s book value is $21 and tangible book value is $12. We are NOT advocating that paying $2.00- $3.00 for the right to buy BAC until 2018 for around current book value is a good deal, but it is worth investigating. Particularly if there is potential for the exercise price to be reduced AND the number of warrant shares to be increased every time a dividend is declared.

You can learn this by simply reading the relevant prospectus and looking up the price.

There seems to be a general misconception in the market that the anti-dilution adjustments only apply to AIG TARP warrants, mainly because Bruce Berkowitz spoon fed the market with a statement in the press about AIG. However, these adjustments are not exclusive to AIG TARP warrants; in fact the exact opposite is true.

You can learn this by simply reading the relevant prospectuses.

In the case of BAC it also pays to read the “prospectus” for the warrent, Warren Buffett negotiated for Berkshire Hathaway in Aug 2011. Warrent, Warren. Get it? Eh, ok, I will move on.

The warrent comes with a strike price of $7.14 and 700m warrent shares (6% of BAC outstanding shares) and has the same anti-dilution adjustments as the TARP warrants. It is quite plausible for the warrent shares to increase from 700m to 1Bn AND the exercise price of $7.14 to be reduced to $5.00 over the 9 years to 2021. What can we say? The Master strikes, yet again!

You can learn this by simply reading the relevant prospectus.

Those of you that stuck with me through the section on warrants either enjoyed it or must feel like the man that tried to commit suicide by drowning himself in a puddle of water, one inch deep. The good news is, it is almost over.

When you research the various warrants you should realize that all these warrants are not created equal and we have found the most significant differences are evident when

  1. you compare the relevant company’s current tangible book value with the warrant’s exercise price and
  2. the normalized dividend per share.

In the case of b) I mentioned that the warrant shares adjust upwards AND the exercise price downwards when a dividend is paid. Technically the relevant amount is the difference between the dividend per share paid and a threshold dividend per share. This threshold was set by the last dividend per share payment at the time the warrant was issued. Most of these warrants were issued in the depth of the financial crisis, which means that in most cases the “last” dividend that was paid was at a time of peak profitability and before very substantial share dilution. Therefore, it is prudent to adjust for this and when we do so we come up with the following comparison.

We reiterate, neither are we making a case for or against buying the warrants nor are we saying this is anything more than a simplistic analysis. As always you have to do our own homework! 

We are simply saying that the relationship between the exercise price and the current book value and the relationship between the historical dividend per share and the threshold for the dividend to give you the “kicker” are very different from company to company. Therefore the investor that has that knowledge most certainly has a huge competitive advantage and in the case of the TARP warrants we believe it is a minority that understands the differences. All it takes is for the investor to read the relevant prospectuses.

Munger on the perfect turnaround

GEICO is a very interesting model. It’s another one of the hundred or so models you ought to have in your head.

I’ve had many friends in the sick business fix-up game over a long lifetime. And they practically all use the following formula—I call it the cancer surgery formula:

  • They look at this mess.
  • And they figure out if there’s anything sound left that can live on its own if they cut away everything else.
  • And if they find anything sound, they just cut away everything else.
  • Of course, if that doesn’t work, they liquidate the business.
  • But it frequently does work.

And GEICO had a perfectly magnificent business submerged in a mess, but still working. Misled by success, GEICO had done some foolish things. They got to thinking that, because they were making a lot of money, they knew everything. And they suffered huge losses.

All they had to do was to cut out all the folly and go back to the perfectly wonderful business that was lying there.

And when you think about it, that’s a very simple model. And it’s repeated over and over again.

And, in GEICO’s case, think about all the money we passively made…. It was a wonderful business combined with a bunch of foolishness that could easily be cut out.

And people were coming in who were temperamentally and intellectually designed so they were going to cut it out.

That is a model you want to look for.

Bank of America’s big improvement

Brian Moynihan is not  the most charismatic of communicators but his prepared statement was excellent. You do not need the Irish gift of gab when you show results.

Some people have said that the Bank of America’s results were made of paper-mache. As any participant of a Mexican piñata can testify, paper-mache can be very robust. With its current capital situation, the piñata would need some serious beating to go down.

This time I am betting on the piñata. Yes, I am finally buying big banks and, as hinted more than a year ago, I did so by buying TARP warrants . It was about time to end this procrastination.

PD: good discussion of the results at the Corner of Berkshire and Fairfax.

The last 2 years, we’ve been executing on a huge transformation here at Bank of America. After 6 large acquisitions in 6 years during the mid-2000s, then the economic crisis and its aftermath, we set on a course to simplify the company, to streamline the company, to reduce the size of the company, to lower our risk and build a fortress balance sheet. During that, we set goals to have 9% Basel I Tier 1 common and 6% tangible common at year-end 2011.

We set goals to reduce our non-core assets. We set goals to bring our credit risk down and to address the mortgage risk related to the Countrywide acquisition. At the same time, we also set goals to continue to invest in areas where our company can grow and has this competitive advantage. Areas like our Wealth Management area, areas like our Preferred Small Business areas, where we’ve added Preferred Bankers and Small Business Bankers, areas like our Commercial Corporate and Investment Banking areas, especially in large corporate investment banking outside the United States.

Along the way, we had to address issues that came up in mortgage, the slowly recovering economy, which isn’t moving — which is moving forward but not as fast as we all like. The European crisis, a muted interest rate outlook and the revenue loss to the new regulations that have been passed. These then result in our focus on cost, and we announced early last fall our New BAC program and the goals that we had for it.

So as we think about 2011, we saw the following. First, on capital and liquidity. This quarter, our Tier 1 common equity ratio ended at 9.86%. Our tangible common equity ratio ended at 6.64%. In the case of each of these ratios, they are dramatic improvement from the beginning of the year. And we made these improvements while absorbing significant mortgage-related costs during the year. We have ratios that are in line with our peers, and we expect further improvement due to continued work on our balance sheet we’ll make during 2012.  In addition, our liquidity is and remains at record levels even after the downgrades we experienced in the fall.

Moving from capital and liquidity to our core businesses. On Slide 3, you can see, we continue to do what we’re here for. We simply serve our clients and customers and we do it very well. Our core business activity continues to move forward. During 2011, we continue to grow our deposits and our investment assets for our corporate and personal customers. We originated 20% more in small business loans this year, in 2011, than we did in 2010. This met our internal goals we had for that unit, but importantly, also met our $1 billion incremental goal we committed to the White House and the Small Business Administration a few months back. For our commercial clients and our corporate clients, we did what we’re here to do. We provided more loans, more capital and more market access here in the U.S. and around the world. For example, in the fourth quarter, you can see strong growth in our loan balances in our corporate area. And for our investor clients, we achieved the #1 Institutional Investor Overall Research ranking. Evidenced in the quality of ideas to match our capital to help them make their investments.

In our Mortgage business, we continue to reshape our operations to focus solely on origination of mortgages for our customers and to do it well. And importantly, we continue to help those who have difficulty making their payments in mortgages. We’ve now crossed over 1 million modified loans in our servicing portfolios.

The third area we focus on, after capital liquidity and the core businesses, was costs. It’s clear that we’re going to grind forward with the recovery in this country. Our clients continue to push forward and we’re seeing the activity continue to move forward, but a full recovery to what we would call normal, may take some time. So with that in mind, we begin to focus on bringing our cost down across the company.

Our cost structure for Bank of America has 2 broad elements today. First, the cost we incur to deal with the mortgage issues. And second, the remaining cost to run the rest of the company for the benefit of our customers. Overall, cost were down from 2010 to 2011, and we expect substantial cost savings in 2012. This quarter, you can see that starting to take hold. We made significant progress towards our overall FTE reduction goals. Our period-end FTE is down about 7,000 people in the fourth quarter compared to the third quarter. This is over and above the 2,500 people we added in this quarter for our Legacy Asset Services. There’s 2 things about this. One, this shows that our New BAC implementation has begun in earnest. And second, the good news is, that we expect that LAS is at and near its peak staffing.

The fourth area we’ve been concentrating on in 2011 was trading. Trading was strong in the first part of the year, but with the issues in Europe, the depth of U.S. downgrades, the downgrades of our company and changes in client risk appetite, results were weak in the second half, especially in the third quarter. However, during the fourth quarter, we partially recovered as Bruce will talk about later. Yet, we still reduced risk during the quarter to ensure we were well positioned to handle what might have come up. We still have work to do in trading, but the team got active this quarter, as the quarter unfolded, and we saw a stronger results.

From a credit risk perspective, you can see that our charge-offs and cover ratios continued to improve. We ended the year with strong ratios. And we’ll also end the year with $15.9 billion in rep and warranty liability reserves. We built significant litigation and other reserves in this area also.

So the 4 areas of 2011 was all about raising capital and liquidity, driving the core businesses, managing the cost and risk management.

Long BAC warrants

Eastman Kodak, legends of the past

Today is a day of sorrow. Eastman Kodak, the icon of American invention, filed for bankruptcy protection. And not only that, it has been an incredible waste of shareholders’ cash and resource over the last decade.

One of the first posts on this blog, and one that I am proud of, was a review of the dangers of Eastman Kodak as an investment. You will be able to read it in its entirety after the jump but first some comments.

To start, I am not going to say that I predicted Kodak’s demise because, as you will read, I did not. Instead it was

  • an example of the dangers of investing in companies under revenue stress based only on its assets
  • a call to avoid investing in turnarounds before they show signs of revenue stabilization.

What happened to those assets that supposedly provided a Margin of Safety? What those assets did provide was time, time to realize that things were not going well and get out! It was one reason I sold Premier Exhibitions: despite the very real possibility that they are going to sell the Titanic assets for a premium: cash and revenues started to decline.

Finally, there are several interesting situations today that fit the mold, priced well below book value but with revenues under stress, like Research in Motion and Sears Holdings. Both have much better chances than Kodak of surviving. Research in Motion revenues are even growing though at a much slower rate. But still be careful, turnarounds are not asset plays. There is no hurry, wait for revenues to stabilize first.


After a while Buffett asked everyone to pick their favourite stock. What about Kodak? Asked Bill Ruane. He looked back at Gates to see what he would say.

“Kodak is toast” said Gates. Nobody else in the Buffett Group knew that the Internet and digital technology would make film cameras toast. In 1991, even Kodak didn’t know that it was toast.

“Bill probably thinks all the television networks are going to be killed” said Larry Tisch, whose company, Loews Corp., owned a stake in the CBS network.

“No, it’s not that simple” said Gates. “The way networks create and expose shows is different than camera film, and nothing is going to come in and fundamentally change that. You’ll see some falloff as people move toward variety, but the networks own the content and they can repurpose it. The networks face an interesting challenge as we move the transport of TV onto the internet. But it’s not like photograph, where you get rid of film so knowing how to make film becomes irrelevant” – The Snowball

Maybe I gave some of you the wrong impression in my previous post. Turnarounds are not the Holy Grail so let’s start by reviewing a dog. Well OK, maybe not a dog dog but a company that I decided not to invest in given the few signs that the turnaround was turning. And that company is Eastman Kodak.

Is Kodak worth analyzing? Well it is a company that symbolizes the best of American innovation and mass marketing in the twentieth century. Kodak is even today one of the most recognized brands in the world with a book of patents that used to be the envy of every business. A great blog Distressed Debt Investing has his sight on this situation as a debt opportunity and irony of ironies, Bill Gates has invested aggressively in it.

Is Kodak toast? The short answer is I don’t know. But it is also the wrong question, we should ask on the probability of Kodak going toast. And the best way to estimate that probability is to hear the story: what management is trying to achieve:

Is your case based on Kodak’s entry into the inkjet-printer business? The new printer business is part of the thesis, which is that Kodak has introduced a technology that has the potential to disrupt the entire industry because it will be able to charge a lot less for ink cartridges — about half the current price.

What’s the rest of the thesis?
 It’s simple. Throughout this entire transition, during which sales from film have dropped by almost two-thirds, Kodak has continued to generate about $1 billion in free cash flow before restructuring charges. That’s because as film sales have dropped, its graphic-communications and digital businesses have improved. Investors today are valuing $1 billion of free cash flow at $14 billion to $15 billion in the marketplace. But Kodak’s market value is just $6 billion. Why is it so low? Because for each of the past four or five years, Kodak had cash restructuring costs — for environmental-cleanup liabilities, for the costs of closing plants, for severance when there were layoffs — that have totalled roughly $600 million to $700 million per year at the peak. There will be $500 million to $600 million in additional restructuring charges this year related to closing film plants and the sale of Kodak’s health-care business. Next year, there will be no restructuring charges. Unless the business gets a lot worse in the next year or so, Kodak will do $1 billion to $1.2 billion of free cash flow in 2008. And if that happens, the stock should be up 50% to 100% in that period of time. – Bill Miller 2007

So this is a story of new divisions (graphic communications and digital) taking the torch from the traditional film division that is being milked down. These are the divisions

  • Film Product Group is the remaining traditional film business, that will continue to decline. The decline rate will depend on the speed of the transition to digital in both the consumer and film markets.
  • Consumer Digital Imaging Group includes digital still and video cameras, digital devices such as picture frames, snapshot printers and related media, kiosks and related media, consumer inkjet printing, Kodak Gallery, and imaging sensors. CDG also includes the licensing activities related to intellectual property in digital imaging. Expenditure will likely be down until the recession ends and if past performance indicates future performance it is unlikely to carry the whole group
  • Graphic Communications Group serves a variety of business customers in the creative, in-plant, data center, commercial printing, packaging, newspaper and digital service bureau segments. Products and related services include workflow software and digital controllers; digital printing including equipment, consumables and service; prepress consumables; prepress equipment; and document scanners.

Here is a hint, the type of turnaround is critical. A turnaround based on closing or selling cash consuming divisions and cost cutting is usually much simpler than one that is based on new products, debt restructuring or business model innovation. Therefore, this is a difficult turnaround that merits a guilty veredict until proven innocent. What surprises me is that Bill Miller said so himself

There aren’t many companies that have been terribly successful making big technological transitions. How many typewriter businesses moved into computers? – Bill Miller about Kodak 2005

Besides having a credible story, the execution needs to measure up to the story because turnarounds usually do not have lucky breaks. You want to see the wheel turn. So what can we say about the Kodak execution


It seems that all divisions are struggling in the recession. A good point though is that the Film Products Group is not carrying the whole weight. Can the non-film divisions carry Kodak out of this difficult situation?


Well, maybe management was a little overoptimistic on these new businesses. Or maybe the new printers need more time to penetrate against strong competitors like HP and Lexmark. Also digital cameras are commodities with low margins and profitability. So it looks like this is a company carried by three motors, only one is working (traditional film) but it is stuttering and about to shutdown.

Also it seems that those restructuring costs are never ending.


So if we review a checklist summarizing the thesis of investing in Kodak the situation is bleak and deteriorating

  • New inkjet-printer business? Not ready for rock and roll
  • $1 billion in FCF before restructuring charges? Disappeared
  • Graphic-communications improving? Doing just OK
  • Digital businesses improving? Bleeding
  • No more cash restructuring charges? Continuing and no sign of abating

This is a difficult turnaround, innovation does not work very well under stress, but I would not dismiss it with a hand wave. IBM’s turnaround, one of the most remarkable success stories in the 90s, was the result of the surge of the business service division.

Instead I am waiting, and this is a key difference with the traditional value investor mentality. A traditional value investor when faced with an asset play with a sufficient margin of safety he would make a decision right there: Is it cheap enough? I argue instead for the value of

  • Waiting for confirmation instead of just buying
  • Adjusting the commitment as the probability and value is discovered instead of just holding

Is it possible to find a margin of safety in turnarounds like Eastman Kodak? Just look at the deterioration of Kodak’s assets the last quarters, and take into account that it had more $4 billion in cash less than two years ago.

ASSETS Q4 2008 Q1 2009 Q2 2009
Consumer Digital Imaging Group 1647 1498 1194
Film Products Group 2563 2408 2301
Graphic Communications Group 2190 2115 1826
All Other 8 1 5
Consolidated Total 6408 6022 5326
Cash and Marketeable Securities 2155 1319 1141
Deferred Income Tax Assets 620 587 639
Other Corporate Assets / Reserves -4 1
Consolidated Total Assets 9179 7929 7106

It is critically important to avoid investing in turnarounds as if they were asset plays. The key success factors, the dynamics and the character traits needed for both situations are very different. With few chances of liquidation, hope trumping reality and red numbers for years, buying based on asset value is asking for pain. I will argue in future cases that it is possible to have some margin of safety but not in the traditional Graham way.

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.

Banking quick review: income statement

As promised, this is BankRegData’s monthly comment follow-up. Some comments at the end.

Pre-Tax Net Operating Income hit $48.82 Billion (1.65%):

The quarter over quarter increase was $6.63 Billion. The $48.82 Billion figure is the highest since 2007 Q2 at $54.97 Billion (2.07%). The peak was $56.88 Billion in 2006 Q2 (2.29%).

Let’s look first at the big part of the pie which is Net Interest Margin:

Net Interest Margin is down $663 Million from last quarter. A couple of points here:

  • The $105.23 Billion represents the 6th straight quarterly decline from the Credit Card inflated peak in 2010 Q1.
  • Funding Costs continue to drop and are now sitting at 0.70%. Banks are clearing another $33 billion per quarter in lower Interest Expense costs compared to 3 years ago.
  • Interest Income (Yield) is dropping faster and sitting at 4.25% which is a historically low number.

So where did the increase in Pre-Tax NOI come from? Trading Gains:

Trading Gains once again made a disproportionate impact with a Q on Q increase of $5.55 Billion. JPM made up $4.55 Billion of the increase.

Other Non Interest Income observations:

  • Banks are once again finding ways to increase Service Charges income.
  • Investment Banking Income at $2.13 Billion is at least a nine year low.
  • Net Servicing Fees got hammered at a number of banks – especially JPM.
  • Income from Loan Sales is once again on the rise.

As an aside, Loans Held For Sale jumped $49.43 Billion Q on Q. Part of this ($8.14 Billion) is due to the conversion of OTS reporters (who did not previously report the item) to the OCC Call Reports. That means $41.28 Billion is newly marked for sale.

If you have any questions or suggestions feel free to contact me.

Bill Moreland


When discussing banks for the Charting Banking series I preferred to focus on the balance sheet (asset quality, capital and reserves). That was the key to assess if banks could manage the stress before regulators pull the plug.

It is about time to address the income statement. And yes, the banks in general are showing profits. Very large profits, even after provisions and write downs. And increasing.

However, Bill rightly notices  some weak spots:

  • NIM under pressure: both in absolute and percentage numbers. Lack of loan generation, pointed out in part 1, and all time low interest rates are starting to make a dent.
  • Large trading gains: that are not sustainable

Even without the jump in trading gains, the net operating income would have shown an increase over last Q ($43.2B adjusted for the increase) so I do not worry about the trading profits sustainability too much.

However, the net interest margin under pressure is very important and is a direct consequence of consumers delevering (fair to say they do not need more debt) and businesses not investing because of lack of demand.

The question is, when is loan demand going to jump start? I have an hypothesis, but for the moment I prefer to keep it to myself. At the same time this is not a life threatening issue with banks trading below tangible book value. Tangible book is a  good estimate of liquidation value so if the worse happens, and banks profits start to decline, the sector would still seem very cheap.

Bronte Capital was very early in noticing this possibility (while thinking it was not going to happen).  A very good example of hoping for the best but planning for the worst.

In fact he was so early that it was one of his first posts. At the time it was radical because everyone was fixed on the bad loans. He says he had only 20 readers. If that is the case I am honored!

Gramercy Capital: back in business

10K and 10Qs are available and I am not dreaming them. We armchair generals tend to complain a lot about management. For once, let me send a tip of the hat to Gramercy’s CFO and his team for providing all this information in such short notice.

And the best part of all, no surprises. Expenses were higher than expected, consequence of all the negotiations, and cash was used to cure CDO 2005 but still:

  • Lots of unrestricted cash at the Parent level: $133M after curing CDO 2005 and it does not include an extra $16m, reported in subsequent events, from a loan to an unencumbered Parent property.
  • CDOs 2005 and 2006 passing OC tests: but CDO 2005 barely so might probably relapse. Still, things improving.
  • Buying own senior CDO bonds at a discount: GKK has started to use some of that cash (finally), having more than $50M at par all at the parent level.  The 30% discount is average, other CRE mREITs have achieved better deals, but it is a start.

“During 2011, the Company repurchased $46,525 and $1,734 par value of bonds issued by the Company’s 2006 and 2005 CDOs, respectively including $20,000 par value of Class A-1 from the 2006 CDO, $17,067 par value of Class A-2 from the 2006 CDO, and $667 par value of Class B from the 2005 CDO, generating gains on early extinguishment of debt of $14,418.”

A and B tranches are the most senior of CDOs 2006 and 2005. Any OC test failing, or principal payments from loans, and they get accelerated payments of their principal. Very safe investment with interesting returns.

With no recourse debt and only preferred equity financing, the current $2.9 per share comes with all these assets:

  • Cash and marketable securities: More than $3.3 per share in cash and CDO bonds at market value after netting preferred shares’ arrears.
  • Management fees: $0.2 per share in annual fees, not including success fees, from managing the former Realty division for KBS.
  • CDOs 2005 and 2006: both equity tranches passing tests and are paying for all SG&A, preferred dividends and some more.
  • Encumbered properties: real estate owned distressed but with potential: Makalei Land, Whiteface Lodge, Ontario Office.
  • Encumbered bank branches: dozens of encumbered bank branches inherited from Gramercy Realty and for sale.

Crazy cheap, though that is not what I wanted to write about. Instead, I will write about an activist investor, that seems to have his intentions in the right place, and the leaked possibility of selling the business.

I also wanted to balance these positive news and discuss two CDO loans, Jameson Inn and Hilton Las Vegas, that have been in news lately and not for the right reasons … we should not forget that CRE is still in distress. But once again, my synthesis skills are running short so I will just link to the Wall Street Journals articles so you can reach your own conclusions:

Indaba 13D

One of recent events is the activism of a new hedge fund, Indaba Capital accumulating 806,815 preferred shares (23% of the outstanding) and 966,200 common shares (2% of the outstanding) since May. In total, around $23 million in Gramercy securities that, for a fund started in March with just $150 million, must be one of its largest positions if not the largest.

A letter was attached to the revised Indaba 13D at the end of September. It seems like Indaba is a force for good:they start the letter with a congratulatory tone and then they express their legitimate concerns in a courteous manner. Not what you would expect from an activist in the Carl Icahn and Dan Loeb mold. A good start.

We would like to begin by commending Mr. Cozzi, his management team, and you, the members of the Board of Directors (all of the members of the Board of Directors collectively, the “Board”) for navigating the Company through a period of exceptional market dislocation and also successfully repositioning the Company for the future. In our view, management has been creative, opportunistic, and tireless in its efforts to preserve stockholder value.

We strongly agree with management’s efforts to isolate the Company’s liabilities at the subsidiary level and effectively eliminate liabilities at or recourse to the “parent” Company. We respect the caution management has demonstrated in regard to conserving and building capital (cash) over the last several years. From our discussions with management and our review of publicly available information, we believe that the Company’s “cleanup” effort after an unprecedented commercial real estate downturn is very near completion. As stockholders, we congratulate Mr. Cozzi, his team, and the rest of the Board.

Gramercy’s team deserves that respect. They are achieving a remarkable turnaround after the AFR acquisition blunder. And to have investors that recognize management efforts, despite the short term incentives of a Hedge Fund, is nice to see for a change.

However, the short term incentives are there. Indaba’s thesis is based on the catalyst of reestablishing the preferred shares dividend.

The purpose of this letter is twofold. First, we would like to reiterate the message that we have communicated to Mr. Cozzi in person: we believe the Company is now able and prepared to pay all accrued but unpaid dividends to the holders of the Preferred Stock (the “Preferred Stockholders”) and that such payment is in the best interests of the Company and its stockholders, both the holders of its Common Stock (the “Common Stockholders”) and the Preferred Stockholders.

Second, we hereby provide notice that Indaba delivered to the Secretary of the Company, on the date hereof, a written request (the “Meeting Request”) that the Company call a special meeting of the Preferred Stockholders (the “Special Meeting”) to elect the Preferred Director (as defined below) and Indaba has nominated Derek C. Schrier (and reserved the right to substitute another person in Mr. Schrier’s place) as nominee to be elected as the Preferred Director at such Special Meeting.

The interest of the preferred-holders is not necessarily aligned with the common-holders’. The first praises Gramercy’s conservatism and asks for more of it. The latter have been wondering when Gramercy will start a more aggressive CDO bond buyback program and negotiate warehouse lending facilities to restart lending. But I think both would agree with the following paragraphs:

Given the high dividend rate on the Preferred Stock (8.125%, a spread of over 5.15% over the United States thirty year treasury rate), the Company’s cash liquidity (noted above), net asset value (detailed in the attached Appendix), and lack of debt at the “parent” Company, we can only presume that the Company’s failure to pay accrued but unpaid dividends to the Preferred Stockholders is the cause of the substantial discount in its market value.

The amount and timing of dividends that Common Stockholders expect to receive are primary determinants of the market value of the Company’s Common Stock. The Board’s failure to authorize payment of accrued but unpaid dividends on the Preferred Stock diminishes the market’s perception of the Company’s ability and willingness to pay dividends on its Common Stock. Indeed, the Company acknowledges in its 2010 Form 10-K that “in accordance with the provisions of our charter, we may not pay any dividends on our common stock until all accrued dividends and the dividend for the then current quarter on the Series A preferred stock are paid in full.” Accordingly, the discount in the market value of the Preferred Stock due to its “non­paying” status impairs the market value of the Common Stock. We believe that a reasonable valuation of the Company’s Common Stock, as outlined in the Appendix attached to this letter, illustrates this fact.

The letter is worth reading in its entirety and includes a NAV assessment that, in my opinion, is quite conservative since it gives little value to the CDOs equity tranches, but at the same time it is appropriate for an investor that has prioritized investing in the preferred shares. Even with those numbers I like what I read: $4.1-$7.1 per share NAV.

What is Indaba?

An indaba is an important conference held by the izinDuna (principal men) of the Zulu and Xhosa peoples of South Africa (…) The term comes from a Zulu language word, meaning “business” or “matter” – Wikipedia

Indaba is also a hedge fund based in San Francisco that just launched in March with 150M AUM and a stated event driven strategy. Derek Schrier is its principal and chief investment officer.

Derek Schrier is a former Managing Member at also San Francisco based Farallon Capital Management.  There he headed the Credit and Liquidations operations group, one of the four groups within Farallon, alongside William Mellin and Rajiv Patel. The other Farallon groups are Arbitrage, Real Estate, and Restructuring and Value so we are talking about a value investing shop here.

He has an MBA from Stanford and worked after graduation in the mergers and acquisitions department at Goldman Sachs before jumping to Farallon.  Farallon’s founder Tom Steyer is also a Stanford MBA and Goldman alumni, and this bit from an interview  might hint on Indaba’s investing DNA:

One of the things we want is for people to understand that we are incredibly serious about relationships with companies and investors. We’re not traders. We’re not hostile. In order to get these kinds of returns, we think people have to want you to be their partner. – Tom Steyer

A review of Derek Schrier’s 13Gs and 13Ds while at Farallon reveals some other interesting stuff:

  • Sector focused: Among the 23 filings, 15 were related to health care, mostly pharma, and real estate finance, mostly REITs. I suppose this focus is consequence of the catalysts imbedded in these sectors: drug approvals and dividends.
  • Only occasional activism: In the period 2005-2007 with more than nineteen 13Gs filed, it includes only four 13Ds: RAM Energy RAM, Arch Capital Group ACGL, City Investing Liquidating Trust, and Gardensburger. Surprisingly, no pharmas or REITs among those.
  • CRE mREIT experience: in 2006 they reduced a 5% plus position in Arbor Realty Trust ABR, a CRE mREIT mentioned in the Gramercy’s write-ups, at the top of the boom. Nice timing for that exit and might explain his conviction in Gramercy.

One strange thing for a hedgie background: he had an interesting non-investing life. He managed the elections research and polling for the African National Congress’s during the 1994 elections, the Mandela election, and he is a member of the African Leadership Foundation board. He is also an advisor for the Corporate Governance Roundtable at Stanford and his wife Cecily Cameron was formerly a vice president of strategic planning and business development at Old Navy.

For sale

This is one catalyst I did not expect. This kind of surprises are welcomed.

Gramercy Capital Corp., the real estate investment trust whose stock has more than doubled in the past year, may consider a sale of the company after it completes a debt restructuring, said two people familiar with the plan. The shares surged almost 10 percent.

Gramercy, which is working with Wells Fargo & Co. (WFC) and the bank’s Eastdil Secured LLC unit, plans to contact private-equity firms if it pursues a sale, said the people, who declined to be identified because the process is private. TPG and Angelo Gordon & Co. are among the firms that have previously expressed an interest in the New York-based REIT, one of the people said.

“Private-equity firms looking for a publicly traded real estate platform would likely have an interest in Gramercy,” said Ben Thypin, director of market analysis for New York-based Real Capital Analytics Inc. “With the company’s restructuring in place, Eastdil should be able to shop it as an opportunity to create or grow such a platform.”

It makes sense. There are benefits for a CRE mREIT to be associated with a large private equity firm with interests in the CRE sector:

  1. CDOs low-cost long-term financing: Gramercy still has CDO 2007 in its reinvestment period to provide financing for CRE equity adventures.
  2. Financing for CDO bonds buybacks: a PE firm can provide or negotiate much needed firepower to take advantage of this opportunity. CDO 2007 is limited on how much they could buy, and CDOs 2005 and 2006 are outside their reinvestment periods
  3. Extension of CDOs life: a PE firm can replace REO inside CDOs 2005 and 2006 extending the life of them … with very good financing
  4. Increase of negotiation power: a large firm can provide leverage in the negotiations of defaulted  loans like Hilton Las Vegas and Jameson Inn. The threat of foreclosing would be much more credible with the financing to take control of the properties.

And recent market trends seem to confirm that PE equity firms are interested in this type of vehicle.

Apollo Global Management LLC (ARI), Colony Capital LLC and Starwood Capital Group LLC (STWD) are among private-equity firms that have backed publicly traded REITs. The companies are valuable to buyout firms because they invest in property and loans and have access to low-cost capital through the bond market, Thypin said.

“Publicly traded shares give the firm and its investors more liquidity than they have with their private partnership interests,” Thypin said.

Buyout managers such as TPG and KKR & Co. have been expanding their real estate efforts as they seek to rely less on traditional corporate takeovers for profits. Blackstone Group LP, the world’s largest private-equity company by total assets, is raising a new property fund slated to total about $10 billion.

Let me add another example, Newcastle Investments NCT that is associated with Fortress Investment Group FIG. CRE mREITS are also of interest to CRE funds that want access to fixed income financing. For example, Capital Trust CT is associated with Sam Zell and RAIT Financial RAS and Resource Capital RSO with the Cohen family.

Recent changes to Roger Cozzi’s and Tim O’Connor’s severance packages seem to confirm that this is Gramercy’s preferred path. And it fits with the efforts of SL Green to disentangle from Gramercy.

Some history, SL Green hired in 2008 Roger Cozzi and Tim O’Connor, to separate SL Green’s CEO and CFO from their overlapping responsibilities in both companies. SL Green also canceled SL Green’s external manager fees and filed in 2009 their intentions to reduce their position and actually sold approximately 850K shares at the end of 2010. Gramercy is an insignificant position for SL Green, a position that comes with potential legal headaches as a consequence of the close relationship of both companies during the boom.

It is also important to remind everyone that Gramercy ran in 2010 a similar process to evaluate financial alternatives. Why it was not fruitful? It seems very clear from the 10K disclosure:

During the second quarter of 2010, our board of directors retained a financial adviser to conduct discussions with various third parties regarding potential transactions to recapitalize our company. We received indications of interest from several of these parties regarding a variety of potential transactions that ranged from the acquisition of our entire company to acquisitions of parts of our assets or business, joint ventures with either or both of our Finance and Realty divisions, externalization of our management function and investment of capital through new issuances of our equity or debt securities. Some indications of interest contemplated change of control transactions or, at a minimum, significant changes in the composition of our management team and board of directors. All indications of interest were subject to significant additional due diligence by the parties submitting them and to the satisfaction of substantial qualifications and conditions, including but not limited to eliminating various of our contingent and other liabilities, restructuring Gramercy Realty indebtedness, repurchasing certain of our equity securities (including our Series A preferred stock), selling certain of our assets and obtaining the approval of our stockholders.

After reviewing the indications of interest received, and conducting discussions to understand the likelihood that the indicated terms could be improved, our board of directors decided to discontinue discussions regarding the indications of interest because, among other reasons, each of the proposed transactions was subject to conditions and contingencies that made consummation highly uncertain and none of the indications of interest appeared to offer a level of value to our stockholders that our board of directors deemed acceptable.

So it looks like the main roadblocks were lifted. Now that Gramercy is clear of external duties … shall we start the bidding?

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.

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.


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.

Charting Banking XXII: three years after Lehman

Three years after Lehman concerns about the banks’ state of affairs have resurfaced once again. The strange thing is that the performance has been very predictable: a steady improvement in all fronts. Once again we are going to take advantage of the pret-a-porter graphs from (I am very lazy). But this time it includes a couple of new charts to address the capital ratios improvement.

Let’s start with our usual guests the Texas ratio and 30-89 days delinquencies.



It does not look like the crisis is deepening, doesn’t it? 30-89 delinquencies in particular are at levels not seen since Lehman collapsed. When people talk about the credit issues of the banking system it really surprises me. The fundamentals are definitely improving.

One of the most common accusations is that banks are “extending and pretending”. Well, loan  extensions are a normal part of a bank operation. Good clients with good credit normally get extensions. Despite all the talk of recent years, there is a good difference between liquidity issues and solvency issues.

But I understand people’s concern with restructured loans, if credit standards and interests payments are reduced for lenders  it might indicate credit deterioration. It is still part of good banking, especially when rates are zero so there is room for helping lenders while maintaining spreads, but it is an issue that should be addressed.

The problem is that the bankregdata ratio that I have been publishing includes restructured loans. It was the conservative way. Though, considering the improved conditions I think it is time to show the progress without restructured loans. And it has been dramatic.



I do not even know where the “extend and pretend” argument comes from. I understand that Japanese banks were very slow in recognizing their commercial lending problems in the 90s, because of cozy keiretzu connections, and all the resulting problems.

However, Japanese banks had non-performing assets reaching 8%. US banks are nowhere near those levels and most have been building reserves, modifying and extending good loans, charging-off the bad ones, foreclosing the zombie ones and disposing REO.


And not including reestructured loans:



It has not been a pretty process but all the headlines about robo-signing and wrong foreclosures are not the result of banks being slow. Even more, for most of them there is not even the incentive to delay when their capital ratios give them space for maneuver to accelerate issues and leave the crisis behind.



And I have not yet counted the very large reserves built over the last 3 years, maybe I should.



Most banks are most probably over-reserved.  It also hints that most current provisions, that are depressing banks’ earnings, are fake expenses.

Not that there is anything wrong with that, better be safe than sorry. An overcapitalized and over-reserved banking system is better for all of us. It reduces systemic risk and provides a buffer in case of external shocks … like Europe.

And from an investor point of view, these reserves can provide a nice margin of safety. Most of the credit problems have been recognized and more than 50% of them are already in the past. So if an investor underestimated some hidden issues … there are lots of reserves – and cash from operations – to take care of them.

We have to be careful though, each bank is its own animal. Maybe on the aggregate the system is being managed conservatively; but each bank as an investment has to be addressed individually.