Variant Perceptions

Category: valuation

Charting Banking XXIV: pre-tax pre-provision earnings

If tangible common equity multiples have their issues, what is a good valuation alternative?

If you trust the bank to survive its credit headwinds while at the same time its total revenues are growing, or at least stabilizing, I think it is fair to use some sort of multiple of normalized earnings. And if that is the case, pre-tax pre-provision earnings are a good start.

  • Why pre-tax? Two reasons. First, with all the recent losses many banks are not going to be paying taxes for a couple of years. And second, it makes easier the comparisons among banks and across time when taxes paid are fluctuating.
  • Why pre-provision? Provisions are the main way credit issues get reflected in the income statement, building up reserves for consequent charge-offs. Therefore, if we want to isolate the earnings power from the credit issues this is the main line to subtract. The other way credit issues impact earnings is loses related to sales of real estate owned REO.

And the idea is that after getting a standardized PTPP, you can use your personal estimate on steady state provisions and taxes to get to an estimate normalized earnings. We will get to that later.

There is one little problem though: that is all the consensus on PTPP there is. Each analyst and company do their own adjustments:

  • One-offs like goodwill write-downs and gains or loses on securities sold
  • CVAs and other mark to market distortions
  • REO gains and loses
  • Depreciation and amortization
  • Credit related operating expenses like mortgage servicing

And there is no consensus even on how to name pre-tax pre-provision earnings:

  • pre-tax pre-credit earnings
  • pre-tax pre-provision income
  • pre-provision operating income
  • core earnings

And of course each one of those come with its own abbreviation.

That makes life hard because you are not sure what each company or analyst is including and how to compare across companies and analysts. My opinion is that there is no way around it: you have to get your own estimates … and I will share one fast, but not very precise, recipe:

  1. Get cash from operations from the cash flow statement, and reverse the following adjustments
  2. Subtract back all working capital adjustments that are usually the lines that start with “increase” or “decrease”
  3. Subtract back stock compensation
  4. Subtract back tax provisions from the cash flow statement
  5. Subtract the equipment purchases (capex) from cash from investing
  6. Add back taxes (taxes provisions) from the income statement

Or the same, start from net income in the cash flow statement and add depreciation, amortization, provisions, one-time loses/gains, taxes, and subtract equipment purchases. Each company has different line disclosures in the cash flow statement so you still have to season to taste. But at least is much more standardized than using analysts and company estimates.

At the end, you get something very similar to what Buffett refers as owner’s earnings only that it does not include taxes. Among its benefits, it excludes non-cash charges and is somewhat conservative because it does not adjust for high administrative expenses related to foreclosures and REO administration (ie: Bank of America has 30,000 FTEs entirely dedicated to solving mortgage issues).

These are the numbers I am using as estimates for the Big 4 and the big challenger. Use them only as a reference. As I said, there is no way around it: you have to get your own estimates.

Do not try to be overprecise, I usually round up numbers trying to sin on the conservative side. Better to be roughly right than precisely wrong.

One way to double check the estimates is to compare profitability ratios  (do it with tangible figures if you prefer) across companies and across time to have a better idea of the earnings power of the bank. These are some high level numbers across companies,

Now how to get from PTPP to a normalized valuation? Well, the long way is to do a discounted cash flow with normalized provision, taxes and growth. I will recognize that I prefer simplicity, with some common sense, and generally use a 10x multiple of PTPP:

  • Very simple to calculate.
  • 10x pre-tax is close to 15x after tax.
  • 15x historic earnings multiples imply growing at the same rate as rest of the economy and returning just cost of capital.
  • Big banks cannot grow a bigger share of the economy forever so a conservative multiple looks good.
  • Substantial non-earning assets.
  • Some of them still have high cost financing (prefs, trups, tarp), despite high liquidity, that will be reduced over time.
  • The banks that I am interested in, the ones under some distressed valuations, will not pay taxes for years.
  • Non crisis provisions of around 0.3% of revenues are less than what many banks pay in mortgage mess related expenses.

There is at least one big exception to these oversimplified assumptions, banks heavy in credit cards or similar lines based on a model of high normalized provisions in line with high net interest margins. A clear example of this is Capital One. My recommendation, go to previous 10Ks and double check the normalized provisions.

Having estimated a normalized value, it is good practice to go through the credit/legal issues and estimate how many years would take to solve  them, apply your preferred margin of safety discount based on the company’s specific risks and growth prospects, and voilà.

That was today’s look inside the sausage factory.

Long BAC, C

PS: criticism of these numbers based on real figures is very much welcomed!

PS 2: I adjusted USB PTPP to reflect its 2011 growth after comments at the Corner


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.

Thinking about investing in US banks? a short answer to David Merkel

In the comments section to the post Three Years After Lehman I got this deceptively simple question from David Merkel, the author of the classic The Aleph Blog,

I recommend that you try to talk with M3 Partners, Chris Whalen or Hovde – if they will talk to you. They know banks far better than I do, and I am pretty certain they are bearish.

I’m no expert on banks. I only have a few question marks:

  • Exposure to Europe
  • Exposure to repo lending/borrowing
  • Lack of clarity because of illiquid assets, and lack of mark-market accounting.
  • Home equity lending
  • Over-reliance of clipping pennies from the Fed, at a time when the front end of the yield curve has collapsed.

Basically, I don’t trust the accounting. Why should I buy bank stocks when I can buy safer insurers at similar or better discounts, where I know the accounting is mostly fair, and the liability structures are stronger?



My first thought was that it was nearly impossible to answer all David’s “few” question marks in the comment section but surely I could answer his insurance versus banking question. How wrong I was. When the short answer became two pages long it was fairly obvious that it was the stuff for a post. It probably needs editing but the short answer was already taking too much time:



I am sure others do not feel as comfortable as you with insurance accounting and underwriting standards. I certainly do not and you have been my man when I want corroboration on those issues (smile)

I imagine that when you mean investing in insurance companies, you are referring to insurance companies where you personally feel comfortable with their underwriting and their history. Besides basic rules of thumb to check reserves, the accounting will not help much predicting future losses.  Also I suppose that there are some sectors that you would not trust like life insurers with large guaranteed annuities portfolios or some mortgage insurers.

That reaches a central point of investing in financial firms: some leap of trust is almost always needed. For insurers you cannot know every single policy, for banks you cannot know every single loan. There are a couple of mREITs that I know all their loans but those are an exception.

There are several investment approaches to this “leap of trust” thing:

  1. Do not trust any financial firm ever: that has been the path taken by several good investors. They prefer to keep it outside their circle of competence and I will not try to convince them to change. You have to pick your spots. At the same time, there is a leap of trust in any type of investment (BP/security, NWSA/ethics, HPQ/acquisitions) even if you trust the accounting, that as we know it is not always the case. I personally have lost money investing in some simple businesses, in simple industries with lots of net cash, and instead made substantial returns in some complex distressed situations.
  2. Buy great companies with great teams: Because of some accident an investor may get to know in depth some financial sector (you insurance, me banking) and get comfortable with some teams. Good teams can avoid disasters for decades and the top of them can regularly achieve 12%+ average ROE and grow. That is a recipe for fantastic returns. I consider this approach risky. Historically many have had style drift like AIG and also be exposed to nationwide cataclysms. For example, Bank of Ireland was the best of Irish banks but that did not help much. Besides, it can nurture complacency and abdication on the part of the investor.
  3. Wait for the earthquake and look for survivors: that combined with signs of a new management team doing what is necessary (exiting marginal business, manage for capital and cash flow, reducing legacy assets significantly) can be a powerful combination. You are NOT trusting management, you are seeing it in action and following its progress.

As you have probably noticed this blog is mostly devoted to turnaround investing and that means point #3. It is a way of trying to avoid the pitfalls of #2 by waiting to see the order of magnitude of the cataclysm and watch management in action not just in words or reputation.

One key historical advantage of approach #3 for banks is that damaging credit bubbles are usually tied with real estate booms, deregulation, overvalued or even fixed exchange rates (for countries not indebted in own currency), and sustained current account deficits. Some recent examples are Latin America 82, Scandinavia 90, Mexico 94, Asia 96, Argentina 00, Subprime 08, Eastern Europe and PIGS 11. Bubbles driven by excess internal depository savings badly invested are much more rare and different in their consequences (Japan 1990s, maybe China today).  That provides several advantages to an informed investor:

  • Avoidable: Real Estate is a big proportion of banks’ balance sheet and usually with deregulation capital is lobbied to be thinned. Most crisis in other categories are usually sideshows: they are not big enough or risky enough. So by only following a couple of categories it is possible to avoid 90% of banking crisis.
  • Measurable: when the punctuation hits Real Estate, the other categories follow linear processes that can be measured and followed for a sign of a turn (with the exception of C&D, always one big if):
    1. Pricing and collateral of new loans are improved
    2. Regulators are tougher
    3. Bubble loans become a lower percentage of portfolio over time
    4. Cash and liquidity increases
  • Scope limited: wherever real estate goes (residential or commercial depending on the type of bubble) that is where the banks will go. If the government does not intervene, watch out (1932). If the government delays or avoid the devaluation of a fixed currency (Greece, Ireland, Spain today) watch out. Loans that are non-performing are difficult to hide. They will show in regulator reports, the cash flow statements or real estate industry reports.
  • Time limited: CRE and MBS from bubble times become a lower percentage of the total portfolio over time, while the new loans should be perfectly OK with the improved underwriting and pricing.
  • Hated or unloved: headlines do not help and many people were financially burned, so you can wait for confirmation before investing. People get trapped in the morality tale just when it is already in the past. Also it is not like buying the dip is a must, there may be several opportunities. The important part is to improve the probability of a hit because the upside is enormous anyway.
  • Replicable: learn one running play and play it ad infinitum. There is always a country suffering undeserved short term capital inflows, misusing them, and becoming the next candidate for a banking blow out  … with the following renaissance. Just look at Greece or Australia. There are twists here and there, like for example countries indebted in their own currency like the US, but isn’t it nice to have a perpetual compounding machine?

The funny thing is that at the moment there is not a single bank stock in my portfolio. It is circumstantial because I have had small and medium banks on and off over the last year and I think the banking sector today is fertile ground indeed.

In this blog I have tried to bounce and structure ideas on approach #3, the turnaround approach. It needs more work, pragmatism and flexibility than what is normally understood as value investing. Its success is tied to avoid investing in every single opportunity but only the high probabilities, and there must be several high probabilities in the banking sector today:

  • Good industry: there is a bank in every Western film. There is a bank branch or an ATM in every commercial location. That is how critical and entrenched are banks in a modern economy and even its history. It is oligopolistic at the local level, without technology obsolesce, and has high regulatory barriers to entry (just ask Walmart). Chris Whalen may not like the oligopolistic setup but I am not seeing many advocates of a utility model. And the alternative of too much dumb private competition was one primary reason of the mess we are in. A highly regulated and oligopolistic model has historically worked.
  • Pool of good businesses: retail banking is a local business where you want strong local market share (or a collection of strong local market shares like Bank of America and Wells Fargo). There are plenty of cheap banks with local dominance funded by long-term low-cost deposits with margin to absorb negative shocks. It is not like Bank of America is the only option, actually I think there are better risk-adjusted alternatives with similar upside.
  • Hidden downside protection: I am finding multiple cash flow positive banks that are most probably overcapitalized and over-reserved. There is some regulatory risk (pushed to dilute) but at the current prices the upside is big even with some dilution.
  • Emphasis in the core business: loose times, loose capital. Tight times, tight capital. The best example of all is Bank of America selling stakes in Canada, Europe and China (that also reduces Private Equity and Credit Card exposure) while redoubling their efforts in the good old USA. Heavy emphasis on the core business, even if it shrinks a company, is a sign of a management that gets it. It improves profitability in the long term and reduces risk.
  • The investor has time to close the loop: I usually prefer small and mediums firms because they are less followed and their turnarounds are easier. But hate can also provide time to confirm that all skeletons are out of the closet … and banking is the most hated sector today. There are still not many in the media realizing that most banks are improving. Even the smart Chris Whalen, that has been positive of medium banks, is probably missing the improvement in the Big 4 normal operations and capital ratios most probably because of too much attention to the off balance sheet putback liabilities (issue that would require a whole new post to give it justice).
  • First cash flow statement, then balance sheet, finally income statement: And the banks cash flow is at several years highs.You can distrust the balance sheet but it is much more difficult to lie with the cash flows statement. If these loans and operations are so bad, why they are so profitable? It is not like there has not been enough time for bad loans to explode.
  • Look for stable or improving earnings potential: In non-financial firms l prefer stable or growing revenues targeting a turnaround based on cost reductions. For banks I look for stable or growing assets and deposits with provisions reducing over time. Most banks’ franchises are still intact and legacy issues are getting reduced. For example, the much maligned Bank of America has been increasing total deposits and core deposits.

And as I argued in Three Years After Lehman, the sector turnaround seems to be going full speed ahead. At this speed that means most of the US banking sector legacy issues should be behind in a year or so.

Therefore, any criticism of the banks should be focused on things off-balance sheet like putbacks or new shocks like Europe. Measuring their order of magnitude should be a piece of cake but I am not seeing many doing that calculation and much less balancing it against the capital, reserves and profitability of each bank. That is the game.

I will not try to convince you David out of insurance companies especially when they are cheap and right in the middle of your circle of competence. Actually, I think it is an interesting sector to follow these days:

But if the American commercial banks are safe, they are a lot cheaper than the American insurance companies. For example, if Bank of America survives – and I am not saying it will – it generates close to $40B in pre-tax pre-provision earnings and is priced around $80B. I do not know of any such disparities in the insurance sector (maybe you do?)

Also the situation is a little different, closer to investing in insurance companies after asbestos … the shenanigans are out in the open! You are faced with the more simple task of evaluating the trustworthiness of the companies projections without short term time pressure.

That is one huge advantage. Some time has passed and you are seeing how some of those projections have performed. Actually some competitors have gone down the drain that is also good for the survivors enjoying improving interest spreads.

With insurance companies, I personally do not know the shenanigans in this soft pricing market. Some have said that AIG was an example of a company too aggressive on pricing backed by the government but from my novice point of view they are not doing so bad in this catastrophic year. Conclusion, I do not know where are the insurance sector hidden bombs and to go by reputation and a track record is not usually my style, a style that shuns complacency.

Hope this answers your question David. Maybe next time I will post the answer to the few question marks …it is already running three pages long.

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.

Gramercy Capital: the mystery


We finally get to the mystery part. Most of the recent stock fluctuations have been related to Gramercy Realty’s several short term extensions since March of the $790 million mortgage and mezzanine loans by lenders Goldman, Citigroup, KBS, and SL Green. Gramercy paid $3 million for these extensions but they ended a week ago with the properties not yet foreclosed and uncertainty about the ultimate result of the negotiations.

Information is fuzzy and most of it comes from reading between the lines the recent 8Ks of Gramercy and KBS. However, all seems to indicate that they are negotiating a deed-in-lieu of foreclosure, a peaceful handing of the properties to the lenders with some reciprocation to Gramercy for good behavior. This does not exempt the possibility of foreclosure if the parties do not agree.

Gramercy Realty is the inheritor of American Financial Realty Trust AFR, the REIT they acquired beginning of 2008 for $1.1 billion at a discount to AFR book value and at good cap rates since this was a year after the top of the market. Realty’s book value is $537 million ($10.6 per share) and tangible book value is $842 million; and those valuations assume $120 per square feet for the 25.5 million square feet of mostly bank offices and branches.

The thing is that despite some decent numbers everything indicates Gramercy Capital can or will lose its Realty division. We do not know why that is the case. It could be that the lenders’ conditions for an extension were too high or they just simply wanted to take the properties. Maybe Gramercy overplayed its hand or the Gramercy’s opportunities on the lending  side – Gramercy Finance – were better so why not cut Realty loose. Or there is another possibility, that they are trying to reach middle ground. The short answer is I don’t know; so we plan for the uncertain future.

The key is that these loans are non-recourse to Corporate so the worst pain that the lenders can inflict to Gramercy is a foreclosure on the Realty division collateral, with all the legal costs for the lenders. That is why they may be negotiating a deed-in-lieu of foreclosure with something for Gramercy for good behavior.

Given its importance, I will post in its entirety the critical paragraphs of the loan agreement modified in August 2008 related to the recourse issue; so you will see that it is not that I trusted management’s word and the 10K. These are key points to watch for:

  • Guaranty: This potential recourse against Gramercy are the usual protections against bad conduct by a borrower, and nothing indicates that is the case with Gramercy.
  • Environmental indemnity: Near zero possibility because these are bank offices and branches.
  • Bankruptcy: this section protects the lenders against Gramercy Capital deciding to use chapter 11 to protect its interest in Realty against lenders as General Growth Properties did.
  • Section 5.24: This section is about the prompt release of properties in default encumbered under this loan. I included links to the loan agreement and modification if you want to explore this issue farther.

In conclusion, anything we can get from Realty is mana from heaven, and the potential negative consequences to corporate should be very much limited.

It is important to notice that the Borrower are several entities listed at the end of the loan agreement. All these affiliates are legacy entities from old AFR except for GKK Stars that was the merger vehicle. Gramercy Capital is the Sponsor.

 9.19.       Recourse.

(a) The Loan shall be fully recourse to Borrower.  No recourse shall be had for the Loan against any other Person, including any Affiliate of Borrower or any officer, director, partner or equityholder of Borrower or any such Affiliate, except for (i) claims against Sponsor under the Guaranty and (ii) claims against Borrower and Sponsor under the Environmental Indemnity.

(b) Borrower shall indemnify Lender and hold Lender harmless from and against any and all Damages to Lender (plus the legal and other expenses of enforcing the obligations of Borrower under this Section 9.19) resulting from or arising out of any of the following (the “Indemnified Liabilities”), which Indemnified Liabilities shall be guaranteed by Sponsor, jointly and severally, pursuant to the Guaranty:

  1. any intentional material physical Waste with respect to any Property committed or permitted by any Borrower, the Sponsor or any of their respective Affiliates;
  2. any fraud, willful misconduct or intentional material misrepresentation committed by any Borrower, the Sponsor or any of their respective Affiliates;
  3. the misappropriation by any Borrower, the Sponsor or any of their respective Affiliates of any funds in violation of the Loan Documents (including misappropriation of Revenues, Distributions, security deposits and/or Loss Proceeds and the violation of the last sentence of Section 5.7(d));
  1. any breach by any Borrower or the Sponsor of any material representation or covenant regarding environmental matters contained in this Agreement or in the Environmental Indemnity;
  2. the failure of any Borrower, at any time, to comply with Single-Purpose Entity requirements hereunder, in any material respect;
  3. any failure to pay income tax liabilities of non pass-through entities comprising any Borrower or its Affiliates;
  4. the failure of any Borrower to fully discharge prior to the Closing Date any liabilities, contingent or otherwise, associated with assets that were owned by Borrower or any of its Affiliates prior to the Closing Date (including all employee liabilities), other than the Properties and direct or indirect equity interests therein;
  5. failure to structure and consummate the Merger in a manner that does not give rise to a shareholder lawsuit;
  6. any liability of AFRT or its subsidiaries under any recourse carveout under any Encumbered Property Debt, guaranty or similar obligations, in each case in respect of Borrower, AFRT, Operating Partnership or any holding company;
  7. any failure by Borrower to cause each holder of Encumbered Property Debt to add Lender as a party to whom all notices of default must be given under the Encumbered Debt Documents; and any failure by Borrower to instruct each holder of Encumbered Property Debt to accept any payment from or action taken by Lender during the continuance of a default thereunder as if it were received from or performed by the applicable Property Owner; and any failure by Borrower to remit to any holder of Encumbered Property Debt any amount proffered by Lender in order to cure a default thereunder pursuant to Section 5.21;
  8. any assumption fee, foreclosure fee or similar amount (and related expense reimbursements) owed by Lender to any holder of Encumbered Property Debt or related loan servicer as a result of, or in order to permit, a foreclosure or transfer in lieu of foreclosure of Collateral; and
  9. any failure of the representation made in Section 9.14 to be true and correct.

In addition to the foregoing (x) the Loan shall be fully recourse to Borrower and Sponsor, jointly and severally, upon 

  1. any Transfer of Collateral or any Property, voluntary or collusive Lien on Collateral or any Property, or Change of Control which is prohibited hereunder or 
  2. the occurrence of any filing by any Borrower, Junior Mezzanine Borrower or Property Owner under the Bankruptcy Code or any joining or colluding by any Borrower or any of their respective Affiliates (including Sponsor) in the filing of an involuntary case in respect of any Borrower, Junior Mezzanine Borrower or Property Owner under the Bankruptcy Code; and 

(y) in the event AFRT shall fail to comply with Section 5.24, the Loan shall be recourse to AFRT and Sponsor, jointly and severally, in an amount equal to the Release Price of the applicable Property, plus all related enforcement costs and any Damages resulting from a failure to release such Property pursuant hereto.


Time to sum up where we stand. These are the valuations of the different parts with the uncertainty increasing as we move down the list. I included, almost at the end because of its high uncertainty, an item that estimates an above normal return for the unrestricted cash considering the opportunity of CDO bonds repurchases.

I do not want to push a upside valuation number as scientifically precise. There is no need for such precision when there is such good downside protection. I would say though, CDO 2006 is in excellent shape and CDO 2005 has a very good chance of recovery with the consequent upside.

Some may wonder, considering that Gramercy is a REIT, why I have not used instead a free cash flow analysis to establish a sustainable dividend. The problem is that this approach can easily lead to very aggressive valuations in a market where most non-agency REITs have dividend yields of 10% or less.

Some of Gramercy peers like Northstar Realty NRF (9.2% yield), Redwood Trust RWT (6.5% yield) and Resource Capital RSO (15.2% yield) are paying almost all their free cash flow in dividends and using windows of high valuations to raise capital. With a CRE market where is possible to obtain double digit unlevered ROI, these equity injections have been accretive but valuations are still very aggressive for a value investor soul who is always worried about chasing yield.

Instead, I will compare Gramercy’s FCF to a peer that seems conservatively valued and that some may actually consider cheap: Newcastle Investment NCT.


There are several companies similar to Gramercy such as Arbor Realty ABR, Northstar Realty NRF, Newcastle Investments NCT, Capital Trust CT, Resource Capital RSO, RAIT Financial RAS and Redwood Trust RWT. I chose Newcastle for a head to head not because it is expensive but because it is cheap. Derek Pilecki at Gator Capital has shared much analysis on Newcastle and concludes the same.

Another reason was that it looks like both companies had a similar track record with their CDOs. Two of Newcastle’s CDOs are comfortably passing OC Tests like CDO 2006, another two are close to their OC test triggers like CDO 2005, and its last two are busted CDOs like CDO 2008 (actually three, one was so bad that it is not consolidating). So we can see the current world and potential for Gramercy by analogy

Newcastle’s investments have a very similar mix of CMBS, whole loans and mezzanine loans to Gramercy’s and it also suspended dividends so it is trading, as it should be, at a discount to dividend paying mREITs (like Northstar Realty NRF and Resource Capital RSO)

I made some adjustments to make the comparison fair:

  1. CDO excess cash flow to corporate: Provides the excess cash that is really flowing to corporate and includes the collateral manager fees. This line does not affect the free cash flow multiple but it is important to determine if the CDOs are delevering and if corporate is burning cash.
  2. Net interest income: The preferred equity dividend was subtracted for both company’s considering that it is another form of long term fixed income financing.
  3. Realty’s corporate expenses: A large portion of Gramercy’s corporate activity is for the Realty division so it is expected that SG&A will be reduced in case of loosing Realty. I preferred for conservatism to keep the full amount.
  4. Preferred equity arrears: Gramercy still owes $18 million in accumulated dividends while Newcastle reestablished those payments a couple of quarters ago. I chose to subtract those arrears from the unrestricted cash.

The following comparison is not meant to be an exhaustive analysis, since there may be some GAAP things that I may be missing about NCT. At the same time, I think the direction is very much OK.

Let me repeat, I chose Newcastle because it was cheaper compared to its peers. Surprisingly, Gramercy valued at a similar FCF multiple as Newcastle would be worth $310M or $6.2 per share. Not only that, Newcastle had no problems in March to raise $80 million at a higher valuation.

I must recognize that Newcastle has been more transparent and is probably a couple of quarters ahead in terms of solving its legacy issues. However, considering these points, Gramercy looks very cheap even without Realty.


But Mr Market can completely misjudge a situation like Gramercy’s. Gramercy’s situation provides almost a checklist of all the items that can confuse investors, institutional or retail, to sell their stakes significantly below true value. This is the value investor’s opportunity if true value can be found.

I can only say Lollapalooza! and profit from the situation. To a value investor “issues” are often “catalysts” – elements that when solved can unlock true value. Here are some of those:

  • Dividend cut: Especially a REIT with common and preferred dividends suspended. They have to distribute 90% of taxable income and its dividend paying peers are priced at very high cash flow multiples.
  • Uncertainty: Gramercy Realty’s negotiation outcome is still a mystery. It might be wise to keep some powder dry in case the market misunderstands the effects of losing it.
  • Large hidden asset: $89 million in cash from December 2010 sale does not appear in most recent 10Q so people see things worse than they are.
  • Complex accounting: Muddling a simple downside protection thesis.
  • Ick factor: Alphabet soup stigma (CRE, CDO, CMBS) coupled with opaque CDO information.
  • Headline headaches: Manageable hits but in front page (Stuveysant, Suncal/Lehman, Atlantic Yards).
  • Index Rebalancing: Deleted once from the major indexes, with index funds forced to sell, Gramercy is now even consider as a possible addition to the Russell 3000
  • Delinquent financials: Scares some, but should be a short-term issue that will be resolved when Realty’s outcome is clarified.
  • Threat of delisting: Scary, but easily solved with updated financials.


With a good margin of safety in Corporate cash, it is hard for me to think of ways to lose money on this investment. However, while playing the game of “thinking the unthinkable, and predicting the unpredictable” this is a list of potential negative issues that could impact at least short term:

  • Bad capital allocation with so much cash
  • Second credit crunch including more delinquencies
  • Gramercy deciding on an offensive but uncertain Chapter 11 to defend Realty (aka GGP)
  • Gramercy deciding to expend cash to keep Realty while FCF keeps deteriorating
  • Capital raise at these low prices despite the large cash cushion
  • Conflicts of interest with SL Green
  • On a more technical issue, a drop in price after an announcement of Realty’s foreclosure
  • Legal costs of a messy foreclosure
  • Management lying about Gramercy Realty’s non-recourse and signing a secret amendment to the loan agreement

So the issues are mostly of two types: macro and management. With such balance sheet strength though, savvy management would take advantage of a relapse of bad financial conditions. I am sure they would love to have the opportunity once again to buy CDO and CMBS bonds at 80% discounts to par but those times are in the past.

So all boils down to one thing: management, and this management track record I think speaks for itself. But of course, I will speak for it.

Long GKK

Be greedy when others fearful: David Tepper edition

Comments coming later

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Banks on my Mind: NewBridge Bancorp

This is the second part of Banks in my Mind written for the Complete Growth Investor a couple of weeks ago .

The following are direct quotes from the latest earnings report. They seem to show a well capitalized bank that once again is profitable and where loan problems peaked almost a year ago while provisions and non performing loans seem to have stabilized and started to decline. It is almost impossible to believe that this bank is priced at 0.35x tangible equity (TE) and 0.5x tangible common equity (TCE).

  • Local Market Share: With approximately $2.0 billion of total assets, NewBridge Bank is one of the largest community banks in North Carolina, and based on deposit market share is the largest community bank in the Piedmont Triad Region of North Carolina. The Bank has 33 offices in the Piedmont Triad Region of North Carolina, the Wilmington, NC area and Harrisonburg, VA.
  • Growing Core Deposits: increased 7% in the quarter to $886 million
  • Well Capitalized: tier one capital as a percentage of average assets was 9.02% and total capital as a percentage of total risk weighted assets was 12.44%, well above the levels required to meet the “well capitalized” standards of 5% and 10%, respectively.
  • Well Reserved: Allowance for credit losses was $35.5 million, 2.48% of total loans, or 63% of nonperforming loans. Excluding loans for which the full anticipated loss has been charged off, the allowance for credit losses totaled 108% of nonperforming loans, compared to 105% at December 31, 2009.
  • Nonperforming Assets Stabilizing: increased $462,000 to $86.0 million, or 4.40% of total assets, at March 31, 2010, from $85.6 million, or 4.40% of total assets, at December 31, 2009.
  • Nonperforming Loans Declining: declined 11% from June 2009 peak to $56.7 million or 2.90% of total assets
  • Profitable: We achieved a first quarter improvement in pre-tax income of $7.0 million from the quarter ended March 31, 2009, to $476,000 from a loss of $6.5 million.
  • High Net Interest Margin: increased 98 bps over prior year’s first quarter, 34 bps over fourth quarter 2009, to 3.97%
  • Net Interest Income Increasing: 23% over prior year’s first quarter
  • Provision Expense Declining: 56% from prior year’s first quarter
  • Efficiency Improving: excluding $1.7 million expense/loss related to Other Real Estate Owned, efficiency improved to 70% in the quarter comparing favorably to 84% for the three months ended March 31, 2009.”
  • Bolt-on acquisitions: We are actively exploring opportunities to grow noninterest income through acquisitions such as Bradford Mortgage, although organic recruitment of talent is likely to remain our best opportunity for growth in the near future.
  • Low Interest Rate Risk: NewBridge Bank maintains a largely neutral interest rate risk position and would generally be unaffected by most rising interest rate scenarios.

It seems too good to be true, so I tried a more stringent capital ratio: tangible common equity over tangible assets (TCE/TA) to avoid including the preferred equity and intangibles. And it is a healthy 5.5%, better than several national banks.

Next, having seen how some banks hide non performing assets (NPAs) problems by selling fast and furious their Other Real Estate Owned (OREO) and taking big equity hits, I checked the common equity trend. And it has stabilized, even though the expected loss for a significant part of their non performing loans has been charged off.

Tangible Common Equity per share

Q1 2010         $6.85

Q4 2009         $6.83

Q3 2009         $6.94

Q2 2009         $6.98

Q1 2009         $7.38

And what about the future? The review of the loan portfolio risk profile is unavoidable in these times. The 12.1% of the portfolio in construction and development loans (C&D) seems OK in my book. The only reason I could find for this bank deep discount, besides the new regulation uncertainty, is the 29.7% in commercial real estate loans but this does not include the risky CRE construction and development loans that are included in C&D. As we have discussed the risk profile of these loans is much safer than C&D and bad underwriting should be transparent by now; but simply it is not there in the numbers.

Did I mention the insider buying? This is another small bank where its CFO has been buying shares: 40,000 shares over the last year with the last few in May. And consider the optimistic outlook after several quarters of conservative guidance:

Through the first three months of this year our financial results have closely tracked our 2010 profit plan. We are optimistic we will have a profitable year that will reward our shareholders. Tough actions we took early in this credit cycle are resulting in improvements thus far this year. We made realistic mark-to-market adjustments on our problem assets and established strategies to reduce expenses and improve our operating margins. These factors should benefit us for the rest of the year. While our net interest margin has steadily grown over the last four quarters, the benefits of lowering deposit costs has largely been realized; therefore, we anticipate a flattening but stable net interest margin in the range of 4%. NewBridge Bank maintains a largely neutral interest rate risk position and would generally be unaffected by most rising interest rate scenarios. The strong expense controls demonstrated throughout 2009 are continuing in 2010 as we maintain our disciplined cost management culture. We are actively exploring opportunities to grow noninterest income through acquisitions such as Bradford Mortgage, although organic recruitment of talent is likely to remain our best opportunity for growth in the near future. – NewBridge Bancorp CEO


Wilbur Ross on the Sun Bancorp acquisition and more

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Not that I watch too much CNBC, but it was time to know what Wilbur Ross is thinking. Just to clarify, the $100 million investment includes other investors like the Brown family, one of  Sun Bancorp’s largest shareholders. W. Ross is expecting some further losses but bought at half tangible book value allowing for further contingencies.

New Jersey is the most affluent state in terms of household income in the country, some $72,800 average family income. And the family income has been growing more rapidly there than it has in most other states.

Sun Bank is a 3.6 billion institution and in New Jersey there are another 110 banks all of them under $2 billion in size individually and $48 billion collectively. So real potential for a roll up for these other little institutions

Wilbur Ross has also some interesting comments on the prospects of the economy and housing, and how it is affecting his banking investments.


More on the Gulf of Mexico

So how dependent is the USA on ultra deepwater production? I ask that question to have a sense on the government’s flexibility for a short term production moratorium and tough new regulation. This scenario is what the market seems to be predicting as an almost certainty. Well, this is how relevant is the Gulf of Mexico crude production:

30% of crude oil production and 19% of its reserves. If you include all liquid fuels the numbers are better but still big, with offshore GOM representing 8% of production and 15% of reserves. If you also consider that ultra deepwater production is not marginal anymore the probability of a production moratorium without real evidence of widespread negligence and corruption is probably low .

Long term, onshore reserves are a real alternative. It  comprises a large percentage of the US crude reserves but it includes secondary recovery techniques like waterflooding that may be more expensive to extract. So expensive regulation of ultra deepwater drilling may be forthcoming.

The outlook for natural gas in the Gulf of Mexico once again surprises. Perhaps counter intuitively, its lower environment impact and less dependency could make it a target for grand standing and short term measures.

Some natural gas GOM E&Ps like McMoRan Exploration have been hit as a consequence of the Macondo blowout and the suspension of exploratory drilling. MMR production is mostly in shallow water but their exploratory efforts are in ultra deep gas.

No position

Charting Banking VII: historic price to book

So where are bank valuations in terms of the credit cycle. The following is a graph from a recent Tom Brown post:

As you can see bank’s are close to the historic 25 year lows valuations. The big questions are

  1. Is the book value stabilizing or even improving?
  2. Is that good quality book value?
  3. Are the banks well capitalized or will they need value destroying new capital or a reorganization?

I hope to have already addressed the first question by showing how the industry profits have rebounded and how the supposedly next shoe to drop have been grossly exaggerated in its impact while the real culprit seems under control. Regarding the second and third questions give me some time. We are only in part seven of the series.

What are the implications for investors? Well you can ask those three same questions for an specific bank. And if you can answer those positively,  you probably have found an opportunity because most banks multiples are at their lows. Here is a small sample with some large banks.

No position at the moment