Variant Perceptions

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


Banking quick review: income statement

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

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

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

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

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

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

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

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

Other Non Interest Income observations:

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

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

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

Bill Moreland


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

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

However, Bill rightly notices  some weak spots:

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

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

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

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

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

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

Banking quick review: assets and liabilities

First of all, thanks to Bill Moreland from BankRegData that granted us permission to post his latest commentary. Every month, he chooses some graphs from his service to address some critical issue. If you are not subscribed I suggest you doing so.

His latest installment tackles the latest results of the banking system. We will start sharing his view on the balance sheet, leaving the income statement for a follow-up.

I have added a few comments at the end.

This week reviews the Banking Industry 3rd Quarter 2011 performance for Assets, Liabilities and Income/Expense. The next mailing in a couple weeks will cover Asset Quality, Loans, Restructures and REO.

Total Assets industry wide climbed $208.28 Billion over Q2 and are now at $13.84 Trillion. This is the second highest number ever and just shy of the peak of $13.89 Trillion set in 2008 Q4.

Please note the $252 Billion bump in 2010 Q1 up to $13.36 Trillion. The number would have shrunk were it not for the $291 Billion lift from the international Credit Card balances being brought on to the Call Reports. Note the impacts of this on Pre-Tax NOI & NIM in tables coming up shortly

Goodwill and Other Intangibles make up the majority of the drop in the Other Assets category.

The growth in Net Loans & Leases, while considerably lower than Securities, Trading and Fed Funds, does mark the second consecutive quarterly increase. This is the first time that has happened since 2008 Q2.

That said, banks are becoming less and less focused on lending.

The chart above details Net Loans as a percentage of Total Assets. I did a spot check on the FDIC data going back to 1992 and could not find a number lower than this quarter’s 51.70%.

Deposits grew $233 billion Q on Q (2.38%) and surpassed $10 Trillion for the first time. In 3 years, deposits have grown $955.84 Billion, since 2003 Q1 they have grown $4.34 Trillion.

Other notable items from the Liabilities & Equity side of the Balance Sheet:

  • $38.18 Billion increase (12.92% Q on Q) in Trading Liabilities
  • $26.25 Billion increase (7.34% Q on Q) in Other Liabilities
  • $106.85 Billion decrease (-10.87% Q on Q) in Other Borrowed Monies ($17.91 Billion drop (-5.25%) in FHLB Advances)


What do we make of this?

  • What Liquidity Concerns?: the banks are flooded with deposits and what they are lacking is loan demand.
  • Loan Growth Anemic: banks are still hoarding but there are some initial signs that it could be restarting.
  • Goodwill Written Down: improving the asset quality. There has been a lot of focus in tangible assets and equity, but the issue is becoming less important by the day.
  • Franchise Value Increasing: assets are growing, deposits are growing. If the assets are good, the franchise value is also growing

The bad news is that the same large liquidity and lack of loan generation is starting to affect the banks’ net interest margin, but that is an issue we will tackle in the follow-up.

Gramercy Capital: back in business

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

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

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

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

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

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

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

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

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

Indaba 13D

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

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

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

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

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

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

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

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

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

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

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

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

What is Indaba?

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

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

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

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

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

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

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

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

For sale

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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.

Quiet, dignity and grace

A little comic relief after a couple of heavy value investing weeks. As you can imagine not the right attitude. Stop it! stop that! stop it! you’ll kill him!

Vodpod videos no longer available.

Gramercy Capital: it’s alive?

They say that the best investing is dispassionate. Fundamentals improving? buy. Fundamentals deteriorating? sell. No celebrations or funerals, just cold hard facts. I have to recognize though a sense of relief that Gramercy reached a positive settlement for Realty and will soon file its financial statements.

You might wonder why relief and not joy, was not the settlement a positive outcome?

It was. The thesis supposed a complete loss of Gramercy Realty and hinted the possibility of a legal struggle that could have taken months. Instead, the uncertainty has been completely removed with Gramercy receiving $10 million in management fees and at least $3.5 million in incentive fees for administering Realty. We do not know all the details but this is much better than getting nothing.

Even more, if you are following closely the situation you might have heard that CDO 2005 excess interest income is flowing to corporate. In case you miss that important point let me repeat it. CDO 2005 is alive and its cash flow faucet is open, Fitch broke the news a month ago.

Since last review, the CDO exited its reinvestment period. Six assets are no longer in the pool, including four CRE CDO securities sold at a loss; one mezzanine loan paid in full; and one real estate owned (REO) office property, which was exchanged for a performing office loan, as allowed under the transaction documents. While all overcollateralization tests are now passing, as of the June 2011 trustee report, the CDO was previously failing at least one test since March 2010 leading to the diversion of interest payments due on the junior classes to pay down class A-1.

But the investing emphasis in downside protection takes its toll. It’s a life of more question marks than exclamation marks and the feeling when proven right is not the joy of a Young Frankenstein surprised by his creation.

Months of checking and double checking the thesis while being patient creates anticipation with no uncertainty. Actually, the goal in investing is to avoid surprises. Good downside protection analysis should provide as much certainty as possible. And with it, it should bring the death of joy.

What do we get in return? A smirk in the face, a little gloat and relief. Being human I suppose that’s the consequence of enjoying more the process than the outcome.

Earnings Power

I have been receiving lots of questions about the consequence of the Gramercy Realty deed-in-lieu of foreclosure agreement. The following is my best guess of Gramercy’s current earnings power. Please corroborate the numbers as soon as we get the financial statements. There may have been some big changes over the last year … it has been a long time.

NII net of preferred dividends 53M – 63M
CDOs Excess Cash Flow 60M – 70M
Preferred Dividends (7M)
Fees 17M – 20M
CDOs Senior Collateral Management Fees 3.5M
Gramercy Realty Management Fees 10M
Gramercy Realty Incentive Fees 3.5M – 6.5M
SG&A (28M)
FCF pretax 42M – 55M
FCF pretax per share $0.8 – $1.1
Unrestricted Cash 150M

Using the current market multiple for Newcastle Investments NCT, that  is a very similar company to Gramercy, we arrive to a target valuation between $6.6 and $7.7 per share. And I consider NCT very cheap indeed.

Market Cap 392M 160M
Unrestricted Cash 34M 150M
FCF pretax 84M 42M – 55M
FCF multiple 4.3x 4.3x
Price Target $4.9 $6.6 – $7.7

Granted, Newcastle NCT is already paying a dividend of $0.4 per share and we are still waiting to know what Gramercy decides on this issue. At the same time, Gramercy has a better risk profile with a large percentage of its value consisting of cold hard cash and fees.

So the answer to your question readers is yes. Gramercy Capital is cheap and safe.

What’s next?

The answer is simple: here come the catalysts. And it should be an avalanche over the next few months.

  1. Financial Statements: The company already announced that we will have a 10K before the end of September. It will be time to know what has been going on the last year and to finally see the large unrestricted cash consequence of selling the Corporate New York leaseholds … if there are no other large material transaction besides the preferred buybacks and the healing of CDO 2005.
  2. Preferred Share Dividend: including the payment of 12 quarters of arrears. As you can imagine, that by itself make the preferred shares trading at par a very nice opportunity. I hope that after all the Gramercy write-ups you understand why I am looking for more by buying the common.
  3. Common Equity Dividend: Gramercy is in no hurry to reestablish them considering the recent very large accumulated loses and the large pipeline of opportunities in the CRE space. However, considering the experience of similar companies like RAIT Financial RAS and Newcastle Investments NCT, I would not be surprised with a small dividend of around $0.3 per year (30% of FCF) that would permit Gramercy to tap the capital markets in the future for the plenty of available accretive opportunities. Hey, I would not mind that FCF reinvested at 20% ROIs.
  4. Foreclosing Good Collateral:  With lots of cash, two CDOs cash flowing and management fees, there should be no worries about the future and Gramercy can be more aggressive. One way is taking control of cash flowing collateral by using the replacement strategy. Instead of continuing to extend these CDO loans why not take control of the property at great prices. Compared to banks we don’t have regulator pressure to sell them and can receive rent income instead (ie: RAIT Financial RAS). Yes, we can benefit of deed-in-lieu of foreclosures, we are not just on the receiving end.

With Gramercy Realty’s uncertainty resolved and CDO 2005 cash flowing ahead of schedule, two big mysteries were solved. But I start to wonder about the dog that has not barked … what will Gramercy do with all that unrestricted cash?

Gramercy Corporate has not been in the news in any big transaction, except for the curing of CDO 2005, and has not filed an 8K detailing one either. Without financial statements I am in the dark as everyone else but it seems Gramercy has not done much with that cash.


It is not for lack of opportunities or not enough time to close them. For example, competitors have been active over the last year. My impression is that Gramercy is preparing something big but needed to resolve Realty first before committing.

What could that be? I wish I knew but let me throw one possible scenario just for the sake of showing the range of possibilities that open up after the Realty settlement.

What if Gramercy is planning something massive like buying a large part of the dead parrot CDO 2007 bonds?

Let me repeat, this is pure speculation. But I have seen other non agency mREITs buying tranches of their non cash flowing CDOs not because they want to cure them but just because it is good allocation. When an mREIT has other sources of income, like fees and other flowing CDOs, it can take advantage of the acceleration of principal payments for the CDO senior notes.

Gramercy is both a lender and a operator of real estate, and is able to buy its debt at a discount so nothing stops it. And competitors NorthStar Financial NRF and Newcastle Investments NCT have done it too.

It might also explain why the Realty negotiations reached port so soon after a change of Roger Cozzi’s and Tim O’Connor’s incentive package that instead seemed to tip that Gramercy was preparing for a long protracted negotiation. The widening spreads of the last weeks may have provided a large buying opportunity that might have convinced Gramercy to soften a tough negotiation stand. Add that the difficult economic conditions might make difficult a turnaround of Realty … and voila?

After seeing recently buybacks of  flowing CDO bonds at 50% of par, it would not be a shock if senior CDO 2007 bonds are below 40% and that would be great. But I do not know for sure.

What can go wrong?

Gramercy has been in the news lately with the fight over two distressed loans Jameson Inns and Hilton Las Vegas. And more will probably come. However the situation is much different from 2008-2009 when delinquent loans could have compromised the viability of Gramercy. Now Gramercy can negotiate from a position of strength when the worst that can happen with a defaulting loan is a quarter or two of CDOs not cash flowing but in return Gramercy can take control of good properties at bottom prices.

In terms of macro, a Japan type of scenario with interest rates at zero as far as the eyes can see could be positive. Banks with large concentration of CRE loans have been restricted by tough regulators of lending more to the sector, so the conditions have been fantastic for the remaining lenders with 5% plus CRE loans’ yields.

The only bad scenarios that I can foresee at the moment is a 1930s depression or a large capital misallocation. And there is no evidence that we are facing either of those.

Charting Banking XXII: three years after Lehman

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

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



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

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

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

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



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

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


And not including reestructured loans:



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



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



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

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

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

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

Munger on ideology

Another thing I think should be avoided is extremely intense ideology because it cabbages up one’s mind. You see it a lot with T.V. preachers (many have minds made of cabbage) but it can also happen with political ideology.

When you’re young it’s easy to drift into loyalties and when you announce that you’re a loyal member and you start shouting the orthodox ideology out, what you’re doing is pounding it in, pounding it in, and you’re gradually ruining your mind. So you want to be very, very careful of this ideology. It’s a big danger.

I have what I call an iron prescription that helps me keep sane when I naturally drift toward preferring one ideology over another and that is: I say that I’m not entitled to have an opinion on this subject unless I can state the arguments against my position better than the people who support it. I think only when I’ve reached that state am I qualified to speak. This business of not drifting into extreme ideology is a very, very important thing in life

Of course the self-serving bias is something you want to get out of yourself. Thinking that what’s good for you is good for the wider civilization and rationalizing all these ridiculous conclusions based on this subconscious tendency to serve one’s self is a terribly inaccurate way to think.

Of course you want to drive that out of yourself because you want to be wise, not foolish. You also have to allow for the self-serving bias of everybody else because most people are not going to remove it all that successfully, the human condition being what it is. If you don’t allow for self-serving bias in your conduct, again you’re a fool.

Darwin paid particular attention to disconfirming evidence. Objectivity maintenance routines are totally required in life if you’re going to be a great thinker.

USC Law Commencement 2007 

I do not like  to discuss political and macroeconomic issues in this blog, much less religious ones, considering the highly ideological component. You convince no one, learn little, and in return do not make many new friends … though some might say that is the whole point of blogging.

But considering the seriousness of the situation, and its implications for investors, let me post the question. Should not we at least be thinking about the disconfirming evidence of the last few months and see if they fit our mental models?

  • Treasuries rally after an S&P downgrade
  • TIPS 10y at 0% despite the spending and monetary stimulus
  • Business investment and consumer spending anemic despite the free money

Munger on financial innovation

It all started with an asinine bubble. The cause was a combination of megalomania, stupidity, insanity, and I would say evil on the part of bankers and mortgage brokers.

And it was widespread. Alan Greenspan was a smart guy, but he totally overdosed on Ayn Rand when he was young. You can’t give bankers the freedom to create gambling games.

Clever derivatives broke dozens of companies. It killed them. Bankrupt. We don’t need these kinds of innovation in finance. It’s OK to be boring in finance. What we want is innovation in widgets.

I bet Richard Fuld doesn’t have an ounce of contrition. It’s just megalomania. When it’s like that, you need rules to prevent catastrophe. When banks are borrowing the government’s credit rating, you need rules to prevent stupid things.

I don’t want to sell credit to people who are going to hurt themselves with it. You should only sell products that are good for the people who use them. Some disagree with this, but I know I’m right. That is to say, you’re talking to a Republican who admires Elizabeth Warren.

Fancy computers are engaging in legalized front-running. The profits are clearly coming from the rest of us — our college endowments and our pensions. Why is this legal? What the hell is the government thinking? It’s like letting rats into a restaurant.

None of us should fall for the idea that this was constructive capitalism. In the 1920s they called it bucket shops just the name tells you it’s bad and they eventually made it illegal, and rightly so. They should do the same this time.

Charlie Munger, Morning with Charlie 2011