Variant Perceptions

Category: variant perception

Munger on patience

How many different things has Wesco done since Blue Chip Stamps? We’ve only bought two or three companies and made a few big stock purchases. We’ve probably made a significant decision every two years.

But nobody manages money this way. For one thing, clients won’t want to pay you.

But this is not fun, watching and waiting, for people who have an action bias. Too much action bias is dangerous, especially if you’re already rich.

It takes character to sit there with all that cash and do nothing. I didn’t get to where I am by going after mediocre opportunities.

There are a lot of things we pass on. We have three baskets: in, out and too tough. A lot of stuff goes into the ‘too tough’ basket. We can’t do that if it’s a problem at a Berkshire subsidiary company, but if we don’t own it, we just pass. I don’t know how people cope trying to figure everything out.

We have to have a special insight, or we’ll put it in the ‘too tough’ basket. All of you have to look for a special area of competency and focus on that.

But our theory is that getting a real chance to invest at rates way better than average is not all that easy. I’m not saying it’s not moderately easy to beat the indices by half a percentage point every year, but the moment you seek higher returns, is a very rarified achievement.

The only way we know how to do this is to make relatively few investments of size.

It’s not so bad to have one’s money scattered over three wonderful investments.

Suppose you were a real estate investor with a 1/3 interest in the best apartment complex in town, the best mall, and the best office building. Would you feel like a poor, undiversified investor? No! But as soon as you get into stocks, people feel this way. Partly, people need to justify their fees.

Over many decades, our usual practice is that if something we like goes down, we buy more and more. Sometimes something happens, you realize you’re wrong, and you get out. But if you develop correct confidence in your judgment, buy more and take advantage of stock prices.


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.

Banking quick review: asset quality

The last part of bankregdata‘s review of the banks’ third quarter results. His emphasis is on asset quality and I do not think there are going to be many surprises for the readers that have been following the Charting Banking series despite the slightly different angle that Bill uses:

  1. Asset quality is improving fast
  2. Construction and development loans are a pain in the neck

In particular, I like his analysis of the real estate owned (REO) composition and the speed on how banks have been restructuring the most troubled loans (construction and development, and housing mortgages).


This week reviews the Banking Industry 3rd Quarter 2011 performance for Asset Quality, Loans, Restructures and REO.

Using the Texas Ratio as a measure of risk we see that (collectively) banks continue to improve:

A review by Asset Size shows some risk in the largest banks (where GAAP issues mitigate some of the concerns) and mid-size Community Banks between $250 and $999 Million.

Unadjusted Nonperforming Loans continue to drop and are at 4.21% of Total Loans. In terms of dollars, NPLs at $309.67 Billion are now 24.47% below the 2010 Q1 peak:

The Adjusted NPL numbers are dropping slightly quicker – more on that shortly.

Quarter over Quarter Nonperforming Loan Amount by Loan Portfolio:

Of the 13 largest Loan Portfolio types, every one experienced a drop with the exception of Individuals: Auto Loans which rose 1.98%.

A couple of thoughts regarding Construction & Development NPLs:

  • Even with a 10.10% drop in NPLs, Construction & Development loans still have a 14.57% NPL rate.
  • At $254 Billion C&D lending is back to 2003 Q1 levels and $377 Billion (59.69%) off the 2008 Q1 high.
  • In 2003 Q1 C&D made up 4.88% of all loans outstanding – today it is 3.46%.
  • Is this due to a lack of demand or the fact that banks won’t go near Constuction loans?
  • It’s hard to picture an expanding economy without an increase in Construction & Develoment loans.

One concern is that while there is good news with Charge Offs at $31.66 Billion (lowest quarter since 2008 Q3), Adjusted NPLs to Charge Offs has climbed to $7.09. Basically, there are $7.09 of Adjusted NPLs for every $1 of Charge Offs – banks are delaying Charge Offs relative to the NPLs earlier in the cycle.

If you go here you’ll note that it is the small banks struggling with the ratio. Home Equity and 1-4 Family Junior Liens are particularly a problem.

Restructured Debt inexorably climbs higher (and higher):

Restructured Loans to Total Loans is at 2.63%. All reported loan types experienced increases in the rate:

  • 1-4 Family Residential at 4.52%
  • Commercial Real Estate at 2.08%
  • Commercial & Industrial at 0.76%
  • Construction & Development at 5.93%

Once again, Construction & Development loans continue to be a problem area – especially with a 52.96% NPL rate on the restructured portion.

Other Real Estate Owned continues to slowly drop:

OREO is being liquidated and slowly coming down. Collectively, banks took a -$1,135,148,000 hit to Non Interest Income, however, they continue to offset it with Gains from Loan Sales.

OREO levels compared to Peak/Previous High by OREO Type:

And on that cheery note, I’ll end this much-too-long missive and wish you a Merry Christmas. If you have any questions or suggestions feel free to contact me.Ahh, yes, there is that pesky Construction & Development issue once again. Comparatively, the smaller community banks have worked through a higher portion of their Construction NPLs and charged them off to REO. The problem is that they are just sitting on the balance sheet – slightly more difficult to get rid of that partially built apartment building.

Looking at 1-4 Family Residential is a mixed bag. All 1-4 Family Residential has come down 19.38%, however, Foreclosed GNMA is still very high. The bigger problem for Housing is that banks are just not charging it off at the same clip – the inventory is being held out of REO. Once again, we look to the NPL to CO ratio which shows 37.34 for 1-4 Family Residential. That’s $37.34 of NPLs for $1 of Charge Offs – which is an 11 quarter high and the highest since the 46.00 put up in 2008 Q4 when the largest banks delayed charge offs to hit year end numbers.

Bill Moreland

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.

Gramercy Capital: a Graham stock wrapped in a mystery

There has been several discussions of the disappearance of Graham stocks in the current market. However, such opportunities still appear if we do some research and go beyond just screening.

What is a Graham stock? It can mean anything to anyone. In this case, I use it as a company that is very close to being a net cash: a company with more in cash and marketable securities than its enterprise value.

The company is Gramercy Capital GKK, a lender and operator of commercial real estate assets (CRE). Gramercy was formed in 2004 and it was the structured finance arm of SL Green, the New York REIT, with SL Green still holding around 10% of the common shares. It is a real estate investment trust (REIT) and it has two divisions: Gramercy Finance is the owner of the equity portion of three CDOs and Gramercy Realty owns offices and banks branches all across the country.

The contours of the situation are so interesting that Gramercy Capital would have been my pick for the Ira Sohn Conference if it was not for the $1 billion plus market cap limit (damn). I think Michael Price, Seth Klarman and Bill Ackman would have appreciated a cash flow positive Graham stock with a dividend catalyst. Well, can someone relay this write-up to them?


Despite the superficial complexity the thesis is simple: a margin of safety based squarely on ring-fenced liquid assets at the holding company. Let’s start with a rhetorical question: would you be willing to buy a $110 million market cap company with the following balance sheet

That simple and safe balance sheet is Gramercy Corporate’s balance sheet isolated from its two divisions.

Gramercy Corporate by itself is not a bargain but is cheap and it has two more cash flow positive divisions (Gramercy Finance and Gramercy Realty). However, with so much cash, fantastic CRE opportunities, and a discount to tangible book value I think Gramercy Corporate would still be a proposition that could trigger the curiosity of a value investor.  Well, it triggered mine and obviously the great thing was: there were more assets and all non-recourse!

These type of situation raises some typical questions:

  • Quality of the jockey: Roger Cozzi is an iStar Financial and Goldman Sachs alumni and SL Green still has a friendly relationship and stock participation. However, the most important point is that, despite appearances, the track record is quite good. We will review that track record in detail.
  • Corporate SG&A: it has a quite high annual run rate of $28 million but most of it covers the operations of the two cash flow positive divisions. If any of these divisions stopped producing, payroll most probably will be cut. In 2006, when they only had Gramercy Finance, SG&A was $16 million and headcount was less than 15 people.
  • Cash: with the 10K not yet filed, because of the uncertain Gramercy Realty division future, one important cash event is not included in the most recent financial statements. The selling in December of several New York leasehold agreements to SL Green netting $89 million in unrestricted cash. We will review the effect on total cash later on.
  • Real estate valuation: it consists of two properties acquired at distressed prices at large discounts over their stabilized appraised values.
  • Securities valuation: acquired in 2010 at a 50% discount to par. They are obscure securities – my type of asset – that are so relevant for Gramercy’s upside that we will discuss their potential in detail.
  • Preferred equity: the only liability is the $106 million preferred equity that has the benefit that is long term financing. It includes arrears since dividend payments were suspended ten quarters ago.
  • Size of the opportunity: Big! Double digit unlevered returns still exist and the whispered securities of two paragraphs ago being the closest and simplest of them.

Well, we will get to tackle those issues in more detail in due time, but first we will review Gramercy’s two divisions: Gramercy Finance and Gramercy Realty to get a handle of the potential upside.


Gramercy Finance is the structured finance division that started Gramercy Capital with the original mission of becoming a CRE lender by taking advantage of non-recourse, long term, non-marked-to-market, low cost CDO bonds. Gramercy owns the most junior tranches – the equity portion – and is the collateral manager of the three CDOs (2005, 2006, 2007 named by the year of their creation).

One thing I want to emphasize. All these CDOs are non-recourse to Corporate even if you do not believe squat about my expectations of recovery and profit. Non-recourse means that the lenders cannot go for more than the CDO assets to recover their principal. If there was still a deficiency, their only legal recourse is to sue the sponsor or manager for violating guarantees or not complying with the CDO covenants; but after close reading of CDO transactions I could not find any indication that Gramercy had violated either one of those. Non-recourse CDOs are not only the usual standard practice but also Gramercy heavily emphasizes this point in the 10Ks, corporate communications and the CDOs offering memoranda.

CDOs carry a deserving stigma from the abuses in the residential market and managers chasing yield. However, only a couple of CRE CDO REITs collapsed in the process (ie: Anthracite that invested in lowly rated CMBS and Crystal River that was heavy into residential mortgage backed securities RMBS) but most survived (Capital Trust CT, RAIT Financial RAS, Newcastle Investments NCT) and even recovered (Resource Capital RSO, Northstar Realty NRF,  Arbor Realty ABR, Redwood Trust RWT). So, I just prefer to see what is under the hood and reach my own conclusions.

Under that hood you will find that Gramercy’s CRE CDOs are some of the more simple CDOs. CDO 2005 and CDO 2006 have a reasonable probability of recovery and their assets are basically 80% CRE loans (including some mezzanine loans) and 20% CMBS (AAA when they were issued) and they have very little in exotic securities.

How CDOs Work

I  do not want to take too much space explaining how CDOs work, especially when others have done it so well.  The key is to understand how overcollaterization tests work (OC test or par test) and the implications of the reinvestment period. I am embedding some links but probably the most simple jargon-free explanation is this post:

CDOs are like subsidiaries. There are many variations of CDOs (cashflow, arbitrage, synthetic), I will only talk about the ones GKK has. They start out by the sponsor (GKK) putting up $100 million of equity (RR: it has been more, it has been less), much like how you would start a company. Then they borrow $900 million at L+0.5% (RR: issuing bonds called CDO bonds or notes). They can’t just turn around and take the $900 million out of the CDOs and into GKK corporate’s pocket. That is why you have restricted cash. Cash either stays in the CDO company structure, or they gets paid according to seniority (which GKK owns the most junior ones).

GKK as manager and equity tranche owner can decide what assets they want to invest in to earn a return. Of course we want the assets (called collateral of the CDO bonds) to generate a higher interest than our liabilities. No matter what GKK does with the $1 billion, the senior tranches will get their interest first, be it all in cash or REOs, CMBS, whole loans . The interest will be paid from the CDO’s assets (loans, CMBS, others).

GKK gets to keep any interest income over and above what is owed to the senior tranche holders (RR: what I call excess interest cash flow), as long as the CDOs pass an overcollateralization test. Which is a test to ensure there is enough collateral (assets) in the CDOs to pay off the senior tranche principal. (RR: the equivalent of a leverage ratio, if the test fails senior tranches will get paid their principal first and on down until it cures)

CDOs typically have reinvestment periods of 3-5 years after their birth, during which time principal payments from the loans we make can be rolled into new investments. The alternative is to pay down the senior tranche. This is like you being a landlord, when you receive rent, you first pay your mortgage, then you can decide to keep the rest or make additional payment on your principal. Of course GKK would want to keep more interest-earning assets in the CDO.

When the reinvestment period ends, all principal payment received will be used to pay down debt. As debt goes down, so does the CDO’s assets, therefore decreasing the total interest income and distribution to GKK. This is what we mean by “runoff”. Eventually, when all loans are paid back, GKK will get their $100 million back as well, barring any discount payoff/default.

All of Gramercy’s three CDOs pay fees to Gramercy for being the senior collateral manager ($3.4 million per year) but the real upside comes when a CDO passes its overcollaterization test (OC or par test) and distributes its excess interest cash flow, after paying interest to all the more senior notes, to the equity tranches. If it does not pass the test, it redirects that cash flow to reduce its senior CDO bonds to recover on the OC test and can start cash flowing to Corporate again.

How to value a CDO

Some ways to value a CDO would be using a multiple of its net interest income or excess interest cash flow but this could be misleading if the chosen multiple is too high. The problem is that CDOs, after the end of its reinvestment period, are in a loooong runoff where principal payments of the CDO assets go to reduce bonds. This process can last 6 to 8 years slowly reducing liabilities along the way and putting some pressure on cash flows over time. After the bonds are paid back the equity owner keeps the remaining collateral

Therefore, for valuation purposes I prefer the more conservative equity collateral with one caveat: the CDO must have a reasonable chance of recovery of that equity collateral. If not, because the loans will turn bad or the cash flow is not enough to reduce its liabilities, it is better to consider it a zero.

Equity collateral is the equivalent of book value. It represents the residual portion for equityholders if all assets are sold at par and the proceeds are used to pay the liabilities at par. In an environment where the liabilities (aka CDO bonds) are trading at 50-60% of par (keep note of that) while the assets (aka CMBS and loans) are trading close to par, I think it is a conservative estimate.

So let’s see this story of turnaround and profit to see if I can persuade the readers. At least CDO 2006 offers a story of profit with no turnaround needed.

CDO 2006

CDO 2006 is the crown jewel of Gramercy Finance. As of the first quarter 2011 it had $85 million in equity collateral with a reasonable expectation of payment of interests and an equity recovery at the end of the CDO’s life.

Despite taking some big hits – like a very junior Stuveysant mezzanine loan- it has proved resilient and has almost recovered to its original collateral levels. It is well above the OC test trigger of 105.15%, the level where it would have to redirect excess interest cash flow to reduce bonds instead of paying it to the equity portion, and CDO 2006 was consistently above that level during the whole crisis. CDO 2006 has been a cash flowing machine.

It actually improved the interest cash flow received by the equity portion after paying the more senior CDO bonds interest (excess interest cash flow) during the crisis. It also used principal maturities to reinvest in better loans and conservatively increased untapped restricted cash (restricted because it has to be invested in eligible securities for the CDO) in a period where it could instead have closed CRE whole loans at 6%+ interest rates.

To put that in perspective, CDO 2006 generated so much cash flow to Corporate that it more than paid for all Corporate SG&A (including the needed for both divisions) PLUS the preferred shares dividend (in arrear for the moment). And we still have $196 million in unrestricted cash, $3.5 in annual collateral manager fees, CDO 2005 in road to recovery (with an estimated $35 million in excess interest cash flow when/if it cures) and a Realty division that generates $60 million in free cash flow (that most probably will be lost).

However, as I mentioned before, for valuation purpose I prefer to use the more conservative $85 million equity collateral despite the very high $37 million excess interest cash flow (43% return over the equity collateral) and the $1.5 million in annual management fees of CDO 2006.

I will leave CDO 2006 at that for the moment but there is a lot more to talk about. It has a couple of distressed assets (Las Vegas Hilton Hotel, Jemal Properties in Washington, AFR Portfolio) but also much was reinvested after the crisis in very high quality loans while it has today in cash $141 million of its $950 million assets. With so much cash and the reinvestment period ending in August, CDO 2006 has another shot for a big improvement of its test by buying more assets at a discount to par/collateral value.

I would love to discuss more these issues if the idea sparks some interest in the comment section or emails (

CDO 2005

CDO 2005 is a CDO that is failing its OC test and its reinvestment period ended. Therefore, it is redirecting the excess interest cash flow to pay senior CDO bonds until the OC test improves and cures over time. That is what has been happening the last few quarters. The latest count was 115% in April 2011 so it is getting very close to passing its test.

I do not want to overpromise, but it seems like CDO 2005 is on track to heal which would redirect its excess interest cash flow to Corporate at a current rate of around $35 million per year. The equity collateral is a quite high $104 million. This is a CDO from the times when sponsors of the equity tranche were investment partners not just by-standing gamblers.

There are some potential setbacks (Coyote Land in San Jose, California is one loan that I worry about) but also Gramercy has some options despite the end of the reinvestment period. The most important of the options is to repurchase CDO bonds at a discount with Corporate cash and retire them. This reduces the CDO bonds and improves the OC test. Even more, the discounts are still big (40-50%) so it is very good use of unrestricted cash.

I mention some obscure securities bought in 2010 when we reviewed Gramercy Corporate balance sheet at the very beginning. Those were CDO bonds repurchases, the focus Gramercy’s use of unrestricted cash. Here is a good explanation of the incentives behind these repurchases.

CDO 2007

After reviewing the previous CDOs one gets the impression that the investment underwriting for the CDOs was not perfect but that Gramercy has a reasonable chance of recovery from both CDO 2005 and CDO 2006 Gramercy. Even after taking some heavily publicized hits (loan loses from Stuveysant, Cupertino Mall, Suncal/Lehman) the OC tests have not collapsed.

However, I think it is fair to ask how CDOs die and never recover. Or as an old sage would say: I want to know where I am going to die so I don’t go there. CDO 2007 is a good example of a busted CDO.

The problem with CDO 2007 was that it never got off the ground.

  1. Bought CMBSs too early: When the CDO was created, management moved fast to buy a large percentage of its portfolio into what at the time were liquid AAA CMBS trading at some discounts to par. Gramercy was too early in the crisis, with CMBS delinquency rates only recently stabilizing and above 10%.
  2. Thin Equity Cushion: besides the bad investment timing, Gramercy did not put too much equity in this CDO. It was more of a “heads I win, tails I do not lose much” investment.
  3. Fixed Rate Structure: And finally, CDO 2007 was structured as a fixed-rate instrument with hedges for the few variable rate assets. So it could not benefit from low interest rates like CDO 2005 and 2006 did (that are “libor plus” instruments) by using libor floors and other tools that can protect revenues while interest expenses kept going down.

The compounding effect was that CDO 2007 from the beginning did not generate enough cash to even pay the interest on the CDO bonds. It also invested in Stuveysant in a very junior mezzanine that got clobbered. So do not even ask if the redirected excess interest cash flow will in time reduce its liabilities and cure its OC test. It cannot. There is no excess cash flow. It is a dead parrot.

So the key point for a CDO aspiring to have a second life after failing an OC testis cash flow, cash flow, cash flow to reduce the CDO bonds and cure the OC test. In consequence, CDO 2007 does not have an opportunity for recovery but CDO 2005 and CDO 2006 do.

There is only one redeeming factor for CDO 2007: because it was created in 2007, late in the last credit boom, it is still in its reinvestment period and has very light covenants on the type of instruments and concentrations it can invest. Because it is failing its OC excess interest cash flow is redirected to reduce CDO bonds but since it is still in its reinvestment period it can still reinvest principal maturities. Therefore, if Gramercy needs funding for some creative financial engineering, CDO 2007 can be at the center of it.

For example, CDO 2007 can buy CDO bonds from the other CDOs (those obscure securities again) that are trading at a discount and providing such nice yield. Another example is if Corporate wants to negotiate keeping some Gramercy Realty properties in exchange for the deed-in-lieu foreclosure. CDO 2007 could provide a mortgage for those properties transforming its CDO restricted cash into Corporate unrestricted cash. The possibilities are endless with a good jockey managing those proceeds.

GAAP Accounting

Just a brief accounting note. We have discussed how CDOs 2005 and 2006 have positive net interest margin, with CDO 2006 cash flowing to corporate, and that the CDOs are non recourse to corporate assets. Surprisingly, given that the absolute worst case scenario should still leave some recovery for Gramercy, Gramercy Finance has a large NEGATIVE book value.

To understand more this distortion, here is some data from the most recent 10Q that compares the value of the assets and liabilities of the CDOs at carrying value versus fair value (market value).

The reason for the large CDO fair value discount has been the general run on “toxic” securities and the difficulty on deciding which were fine. That run was even more extreme for CDO bonds because of their opacity.

Granted, Gramercy is not going to be able to buy all its CDO bonds at 50% discounts: it does not have that much liquidity and just announcing their intent would cause a price increase. Though at the same time the negative carrying value is not realistic either: the securities are cash flowing and are non-recourse.

If you want to find more about GAAP impact on CDO accounting, a good place to start is REIT Wrecks. Next, we are going to review the mystery: the uncertain outcome of the valuable Gramercy Realty division

Long GKK

Update: ABC backtracking on Premier Exhibitions allegations

ABC News is preparing their fallback, after their key informant against Premier Exhibitions turned out to be employed by the competition and is backtracking from all the executed Chinese prisoners allegations. The original 20/20 report was on YouTube for almost two years, it is a pity that is has been removed.

The whole thing seems extracted straight from a P.T. Barnum playbook.

In testimony for the Florida lawsuit, Sun said he never delivered any bodies to Dr. Sui’s company, only to von Hagens and none of them were executed prisoners.Sun said he had lied to ABC News because “Gunther von Hagens told me [to do it]. I had no choice, you know. And also I thought it was no big deal if I told a lie to Americans, because it’s only, you know, tricks played between the commercial competitions. No big deal.” He also said von Hagens gave him a 10,000 Euro bonus for lying about his rival Dr. Sui.

In testimony for the Florida lawsuit, Sun said he never delivered any bodies to Dr. Sui’s company, only to von Hagens and none of them were executed prisoners. Sun said he had lied to ABC News because “Gunther von Hagens told me [to do it]. I had no choice, you know. And also I thought it was no big deal if I told a lie to Americans, because it’s only, you know, tricks played between the commercial competitions. No big deal.” He also said von Hagens gave him a 10,000 Euro bonus for lying about his rival Dr. Sui.

Nobody said that capitalism was a gentleman’s sport and we all know that the truth should not get in the middle of good TV.Wait, wait, I have one more cliche: lies, lies, in the hope something sticks.

In addition to his claim that he lied to ABC News, Sun also testified he was ordered by von Hagens in 2005 to concoct phony petitions and letters of protest that were sent to officials in Florida concerning a Premier body exhibition that was scheduled to open there. The lawsuit claims these “forged” papers were “intended to stop [the exhibition] from opening.”

Von Hagens declined to comment on these allegations.

I particularly like how ABC News cover their … incomplete reporting. At the end nobody was hurt. Right?

The ABC News report concluded there was “no hard evidence” that any bodies of executed prisoners were actually included in the Premier Exhibitions display.

Bruce Flatt on investing in hard assets

Link to video

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

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

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

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

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

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

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

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

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

    Freddie Mac and the mortgage market

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

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

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

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

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

    Long FRE preferreds


    I am having the fun of a lifetime with the BBC Sherlock, so my apologies if you do not like the arrogant and obnoxious new header of the blog. It will stay there for a couple of weeks as an experiment. And any suggestion that this show inspired the most recent banking post is probably right.

    PS: I am on the fence on the Asperger or Sociopath debate, it is just a good show

    Be greedy when others fearful: David Tepper edition

    Comments coming later

    Vodpod videos no longer available.