Investing & Valuation

BP - heads I win, tails I don't lose much

2010-06-14T18:28:00.008-04:00

BP has been all over the news in the past months, and it feels like forever. Due to the recent and prolonged oil leak, they have done major and long-lasting damage to the US Gulf coast. People's lives and livelihoods are affected. The headlines are terrible. They are likely to remain terrible.

Analysts have thrown around some pretty large numbers for the total liability, up to $60B. BP stock has halved since the oil started leaking.

I think that BP stock represents a compelling long-term investment opportunity. Let me explain why.

Let's start with the nightmare case, which I think has close to 0 probability of happening. Say that BP is forced to shut down permanently. They currently have a tangible book of $81B vs. a market cap of $96B. First, BP earns about 20% on equity, so even in a liquidation they're likely to liquidate at a value higher than tangible book. Other oil & gas companies will buy their assets, not at BP's cost, but at the earning potential of the asset. But, let's assume they liquidate at tangible book. If their liability from this catastrophe is $60B, that leaves about $21B of tangible book for shareholders. So in this absolute-worst case, after a few years you'd get back around a fifth of your money. The government is understandably and rightly defending consumers and plaintiffs already, even at this early stage in the long claims process. Plaintiffs, state governments, and the federal government all have a strong incentive to not let BP die. They want BP to survive so that it can pay out any and all legitimate claims. If the liabilities end up being even higher than tangible book of $81B, BP is worth more alive than dead to the claimants. And they know this. Finally, a point on BP closing shop: 2/3 of their assets are outside the US, and the US doesn't have any jurisdiction over BP's leases and ownership of those assets. So even if the US goes completely nuts and pulls a "grim trigger," they can't force the shutdown of the entire company. Okay, so we understand that this nightmare scenario for shareholders is low probability, and pretty darn pessimistic, with events that, even if the US government does insane things, simply cannot occur. On to outcomes with higher probabilities...

Let's consider a more realistic negative case. Plaintiffs most likely won't want BP to close up shop -- after all, the company needs to remain solvent and profitable to pay the huge claims in front of it. BP has an established earning power of about $30B pretax annually. Let's say that they will never earn more than this -- neither because of inflation nor improvements in business nor investing in new projects. Let's say that they only earn $30B per year, again, pretax. Let's also assume that for the next 10 years, they do nothing with their profits but pay out claims. So over 10 years they'd pay $300B in claims, damages, fines, etc. -- and shareholders wouldn't see a penny. Okay. 10 years from now, they'd be back to earning $30B pretax, or $20B after-tax. At that point in time, they'd easily be worth 10x after-tax earnings, or about $200B. That's a doubling from current stock price levels. And that's a very negative case scenario.

Next, let's be a little more realistic about the business prospects and about the damages. Let's say that BP earns $30B pretax, but grows it at a very modest rate of inflation (assume 3%), plus some modest expansion. Okay, so let's say that $20B/year goes to pay claims and damages for a total of $200B over 10 years -- still over triple the highest estimate of the costs. That leaves $10B of pretax earnings. Last year, BP put up $20B of capex. Let's say that they put up a mere $6.5B of capex, because that is all of their after-tax profit. Now they'll be investing in the best possible projects out of the $20B or-so that they otherwise might have invested in if they had the money. Keeping their ROE of 20%, each $6.5B invested adds $1.3B in earning power. After 10 years, $65B invested (we're assuming that they won't invest any of their extra earning power -- that it'll just "disappear"), they'll have an additional $13B of after-tax earnings, on top of inflation-adjusted pretax earnings of $40B (after-tax of $26B), for a total of $39B. A 10.3x multiplier would imply a $400B market cap, or a quadruple from current levels over 10 years. That amounts to about a 15% return. Our liability assumptions are still quite negative. We're not counting a lot of earnings during the 10 year period -- we're pretending they'll disappear. I'd say this doesn't seem all that unreasonable as a middle-range expectation.

The positive case? They are "only" liable for the highest-to-date estimate of $60B that they pay out over a decade, and they otherwise continue their business uninterrupted -- dividend, capex, and all. In that case the business is worth maybe $160B today vs. a market cap of $96B (that's a 40% discount). In 10 years they might be worth $400B or more, perhaps much more, who knows... and owners will have collected a nice dividend.

To summarize:

Scenario	Likelihood	Long-term return
Nightmare	<1%	-100%
Negative	20%	7%
Neutral	60%	15%
Positive	20%	20%+

For a long-term view, these look like pretty good odds to me.

In the short-term, I have no idea what might happen. The leak could go on for more than another 90 days (when the relief well is scheduled to be ready), causing more panic around the stock. BP could suspend the dividend -- for good reason or because they are forced to. Congressmen, Senators, and the President can say and do some crazy things. Traders can just go nuts. The stock might trade in the single digits (as opposed to around $30 today). It can get ugly, very ugly. But the analysis from above, the so-called "positive" case aside, assumes that things get uglier than even the worst estimates of where BP is today.

Okay so what about the possibility of BP trading in the single digits, even on a temporary basis? Given the analysis above, that would offer a buyer tremendous returns from such a level. Shouldn't I wait? Well, a cheap stock getting even cheaper may or may not happen. What I do think is that the stock is cheap now. If it gets cheaper, so be it. Maybe I'd buy more. But if I recognize it as cheap and I don't act, and the stock begins to rise... then I wouldn't just look like an idiot, I'd really be an idiot.

Obviously, these are just my opinions and my analysis. The future is uncertain and unpredictable. Please do your own homework. If you decide to make any investment moves, they are, as always, on your own dime. You may lose money. Don't ever invest more than you can afford to lose.

Disclosure: I own some BP stock.

Bailout Nation Review

2009-05-27T00:06:00.003-04:00

I just finished reading Barry Ritholtz's new book, Bailout Nation. I couldn't put the book down.

Ritholtz is a very different thinker than I. He has his roots in Wall Street. He is not an investor in the sense that I regard myself, nor is he an academic. He is a trader. He is a trader's trader, much in the same vain of Nassim Taleb of Fooled by Randomness and The Black Swan fame (more on him on a later date). Ritholtz's perspective is well-positioned to tell this story.

I found Ritholtz's words to be entertaining and thought-inspiring. Going into it, I knew that I would disagree with some of his points, which was part of my motivation for reading it. Ritholtz does a commendable job of weaving together key historical facts, implications of those facts, speculations, and known voids of information. It really is a perfect brew for inciting vigorous thought.

One thing I realized when reading this book was there is a lot about the current situation that I did not know as the past 10 years were panning out, particularly 2007-2009. Ritholtz selects and collates information that gives the reader an excellent basis of information and arguments regarding the economic crisis its buildup.

This book is not a rigorous, logical deconstruction-and-reconstruction of the housing bubble. It is full of less-than-complete arguments and conclusions/proposals (e.g. "dot-com stock option penis envy"), as well as omittances (like why did so many government officials ignore the whistle-blowers?) or down-play of facts (as was the case regarding the fact that nearly all Americans believed that housing prices could go nowhere but up and certainly wouldn't go down).

There isn't a real, satisfying where-do-we-go-from-here-and-what-do-I-do-with-my-money section. It is also evident that the writing was hurried, though I wouldn't blame Ritholtz for this as he is attempting to cover near-real-time events (apparently he wrote this book three times to include unfolding phenomena). Hurried though it may be, the writing definitely made me snicker -- this guy's got some attitude!

I recommend that anyone with the desire to not be ignorant about one of the most extreme events of our lifetimes, or at least with the desire to be entertained, go out and read this book.

Oh, one last thing, the book way-overemphasizes the term "Bailout Nation".

My Letter to Representative Jerrold Nadler

2009-03-22T12:21:00.002-04:00

I wrote my representative today. I thought I'd share:

To Rep. Jerrold Nadler,

I am writing to you today to comment on the state of the economy, the role of the government, and the financial industry bailout.

Indeed the economy of the world is in distress. In the US, virtually every economic indicator, aside from money supply which is controlled by the Federal Reserve, is starkly negative.

Capitalism answers societal questions in a structured and yet sparse and decentralized fashion. How many plumbers should there be in a town? Who should be the town's plumbers? How many convenience stores should there be? Where should they be located? How many houses should there be? As Americans neither of us need a long series of lectures to tell us why questions such as these shouldn't be determined centrally – we see from history what happens when a young nation embraces the concepts of rule of law, a free market, and meritocracy.

With questions such as these being answered in a decentralized and continuous fashion by the free market, which consists of far-from-perfect human beings, we know that the free market will overshoot. Part of this comes from the vagaries and uncertainties of predicting the future. Part of this comes from human emotion: human greed and human fear. Booms and busts are natural consequences of capitalism. The booms drive creation of wealth, expansion, and improvements in the standard of living. The busts bring scarcity, clarity, and efficiency.

One lesson that the Great Depression teaches us, though, is that human beings in a free market are capable of discovering and settling on a semi-stable equilibrium far below maximum economic output and maximum employment. It takes a shock, like the Federal Reserve tightening the money supply during periods of economic distress or the onset of a world war, to change from one semi-stable output level to another.

Sir, this is indeed one of those times. Absent government intervention, I think it is clear now that the events that were unfolding in the early Fall of 2008 would have destroyed the US banking and shadow banking systems and sent the US economy spiraling in a terrible positive feedback loop towards an unsatisfactory, and that's putting it lightly, semi-stable equilibrium. Thanks to prompt action by various parts of the government, outright disaster was averted. The federal guarantees on money market funds, federal support for the commercial paper market, and the TARP legislation were all key to this triumph – indeed, it was a triumph. Our government by and large did the right things. The government continuous to do many right things now like the new economic stimulus and the TALF.

Unquestionably, it is the role of the US government to continue to monitor and react to economic developments both here and abroad and to use its full power to save the economy from a depression. It would be a real tragedy if this country, and the world, experienced a 15-25% unemployment rate for a decade. So much opportunity would be lost – for example consider how many people wouldn't pursue an education in the event of a depression that otherwise would. How would their lives be affected? How would all of our lives be affected?

What has gone on with the payouts at the bailed out AIG is most certainly a disgrace. The mistake was made when AIG was first bailed out and certain contracts it had were left as-is. The time to do something about this particular problem has passed. Introducing a law to effectively cap the pay of employees of bailed out financial firms is a waste of time, a dangerous insult to American values, and highly destructive.

The End GREED act is a waste of time because we are pointing fingers when the country should be coming together to solve its problems.

The End GREED act is an insult to American values because the government is deciding after-the-fact what the ultimate fate of a contract is. It is so very dangerous for the government to set this precedent and for people to operate going forward with the knowledge that their agreements are not binding.

The End GREED act is highly destructive. Sir, you and your colleagues who support this act are ignoring a crucial fact about employment: companies don't come attached to their employees. People have choice over where they work. If the 12-or-so bailed out banks effectively cannot pay more than a below-market rate for the labor of their employees, then they will lose their employees, starting with the ones with the greatest talent. Those employees will likely flock to firms that aren't subject to the End GREED act, like Deutsche Bank, Credit Suisse, and UBS.

I think that the passing of the End GREED act was an emotional knee-jerk reaction. Careful contemplation shows that it will not achieve anything useful, other than a warm fuzzy feeling about getting back at a particular group.

The country needs each and every one of these large financial institutions to survive and to play its proper role in the financial sector. The country needs to avert a depression. The country needs to be made whole on its past and future potential investments in these firms.

Federal Reserve Chairman Ben Bernanke recently made an analogy. He said, and I'm paraphrasing, it is like we have a careless and stupid neighbor who regularly smokes in bed. It may or may not be clear to all exactly what he has been doing. Even those who know what he is doing are reluctant or unwilling to do something about it. Surely, there should be a law of some sorts to tell this man and others like him not to smoke in bed.

Sooner or later, though, the man's house catches fire. The fire is burning very hot, and left unchecked will not only burn down the man's house, but also very quickly spread to all of the houses and decimate the town. It is clear that job #1 of every resident of this town is to put out that fire. It's counterproductive and highly costly to spend these crucial moments pointing fingers. There will be time for that. There will be time for new legislation to prevent this fire. Now is not that time.

While the economy is a complex adaptive system whereas the burning town is quite obvious to understand, the economy is really quite similar to the burning town in this respect. With the End GREED act, it is as though you are regulating the flow of water in the town while the town is continuing to burn.

The Federal Reserve, Treasury, judges across the country, congress, the states, virtually the entire government has this job as job #1: put out that fire; prevent a depression.

Words

2009-03-10T17:05:00.002-04:00

These words, spoken by William C. Dudley, president and CEO of the Federal Reserve Bank of New York, on March 6th, constitute by far the most insightful, cohesive, intelligent, and thought-provoking commentary I've heard so far on the present economic crisis:

Thank you for having me here today. It is a pleasure being back to speak at the Council. In the past, my Federal Reserve colleague, Governor Daniel Tarullo, gathered panels of Wall Street economists here at the Council to talk about economic issues. When he invited me to participate, it was challenging work because Dan always asked us about our economic forecasts! And he remembered and recounted our past mistakes (and our much rarer, more prescient forecasts)!
Before I begin, let me emphasize that my comments represent my own views and opinions and do not necessarily reflect the views of the Federal Open Market Committee or of the Federal Reserve System.
What has happened to the global financial system is momentous. We have seen—despite extraordinary actions by central banks and governments around the world—a severe impairment of the intermediation process between borrowers and savers. We have seen a massive deleveraging of the non-bank financial sector. We have seen a tightening in financial market conditions even as the Federal Reserve has pushed the federal funds rate down close to zero. The result has been a severe loss of confidence among consumers and business and a global recession.
Today I would like to talk a bit about what went wrong, where we are today, some new initiatives that are underway, what lessons we should take from the crisis and some steps we need to take so this doesn't happen again.
It is well-recognized that one important catalyst for this financial crisis was the easy credit and loose underwriting practices that fueled the boom in the U.S. housing sector. The ability of virtually anyone to get a loan to buy a house pushed up home prices significantly faster than incomes. To keep the boom going, underwriting standards were progressively relaxed, but even with that support to demand, inevitably the boom proved unsustainable.
As the boom reversed and housing prices began to fall, the bad underwriting practices and the mispricing of risk became readily apparent. When prices are rising no one needs to default, they always have the option of refinancing or selling the house at the now higher price. But when prices are dropping, there is no easy way out. The result has been a sharp rise in delinquencies and foreclosures as the bust has played out.
The fact that these poorly underwritten loans were used in the construction of very complex collateralized debt obligations or CDOs, with risks that were not well understood and grossly mispriced—made a bad situation even worse. Investors who thought they had purchased safe AAA-rated assets found that these assets were very vulnerable to a housing bust and that the ratings were unreliable predictors of the risk of loss.
The poor performance of these securities, in turn, made investors much less willing to invest in structured-finance products more generally. Secondary market liquidity evaporated, which exacerbated the difficulty in valuing the securities. This made the market even less attractive, causing risk premia to widen further, which only worsened the valuation problems.
As this process unfolded, the result was a virtual shutdown of the securitization market for residential mortgage assets not backed by the federal government directly (Ginnie Mae) or implicitly (Fannie Mae and Freddie Mac). The subprime and the Alt-A mortgage markets, which relied heavily on the securitization process dried up. Of course, this just reinforced the downward pressure on housing prices, which, in turn, led to increased delinquencies and foreclosures. This deterioration undermined the value of the securities further. It was a vicious feedback loop in action. The poor performance of highly-rated mortgage securities caused investors to begin to shun securitizations more generally.
The shutdown of the securitization markets led to significant pressure on bank balance sheets. Banks could no longer securitize non-conforming mortgages or the collateralized loan obligations associated with leveraged buyouts and other private equity activity that they had financed. Moreover, bank backstop liquidity lines were triggered as SIVs and conduits could no longer issue
asset-backed commercial paper. Finally, banks took large
mark-to-market losses on their trading books and had to increase their loan loss provisions.
As the crisis continued into 2008, the squeeze on bank balance sheets intensified. This was driven by several important developments. First, the demise of Bear Stearns increased the pressure on the other broker dealers to deleverage. They did this, of course, by becoming less willing to lend funds to their counterparties, such as hedge funds, and by shrinking their trading books. In the week leading up to Bear's demise a nasty feedback loop ensued: forced asset sales increased price volatility. This led to higher haircuts by dealers on their counterparties, which led to more forced asset sales and still higher volatility.
Second, the failure of Lehman in September accelerated the pace of this deleveraging process. Major bank intermediaries were frightened by what had happened and were unwilling to engage with each other. Prime money market mutual funds suffered large outflows. Investors fled as the news came out that the Reserve Fund had "broken the buck" because of large losses generated by its holdings of Lehman paper.
By late September we were in a very bad spot. Banks weren't willing to lend to each other even at very short term maturities. LIBOR—the London Interbank Offered Rate, which is the rate that banks offer to lend to each other—soared even as the Federal Reserve continued to lower its federal funds rate target and injected extra reserves into the banking system. Merrill Lynch agreed to merge with Bank of America. The equity prices of the two remaining independent investment banks—Goldman Sachs and Morgan Stanley—weakened, their credit default swap spreads widened and this began to undermine their ability to obtain funding. In response, Goldman Sachs and Morgan Stanley jumped over the regulatory wall and became bank holding companies.
Hedge funds were forced to liquidate assets as financing terms tightened. As a group, their performance deteriorated sharply beginning in late summer. This provoked investor redemptions—further accelerating the speed and scope of the deleveraging cycle.
Although housing and housing finance may have been at the epicenter of the crisis, it is important, however, to recognize that the crisis goes much deeper. In part, it was rooted in the overconfidence of investors and borrowers that paid little attention to liquidity and rollover risk and seemed blind to the risk of a global downturn. It was also rooted in the gaps in supervision and regulation that allowed a whole range of financial intermediaries and businesses to become more leveraged, in many cases funding long-term illiquid assets with short-term borrowing.
To some extent, what has happened can be tied to changes in the nature of the business cycle and how those changes influenced expectations. Put simply, when business cycles become more damped and recessions less frequent and less severe, this will cause financial market participants to take on more risk. This will not appear to be problematic during the expansion stage. But it will make the financial system much more vulnerable when the bust does occur. Occurring with less frequency, the bust will be a bigger surprise to market participants. They will be less well-prepared with the capital buffers and liquidity cushions needed to traverse an adverse economic environment.
The complete breakdown in trust across markets has been remarkable. Essentially, it has gone like this: Even if I think you are a good credit, I am not going to lend to you, because others may not share the same opinion. The problem is if no one else thinks you are good, I may not be able to get my money back if I need it. Conversely, others are not willing to lend to you, even though they think you are a good credit, because they are not convinced that I will do so. The result is that no one lends, financial conditions tighten and this exacerbates the downward pressure on the economy. As economic conditions deteriorate, this undermines the financial strength of the major financial institutions, further reinforcing the downward spiral in confidence.
Another bad dynamic that exacerbated the crisis has been the reluctance of some banks to raise the additional capital they might need should the economic outlook deteriorate sharply. Repeatedly over the past 18 months we have heard—from the GSEs, from the investment banks, from the commercial banks—now is not a good time to raise capital. This desire to postpone capital raising stems, in part, to the fact that bank executives often do not want to dilute the existing shareholders (which, of course, include themselves).
I believe that the management calculus has often gone like this: In good states of the world, I have enough capital. In bad states of the world, perhaps I don't. But to raise enough capital to guarantee I can endure all the potential bad states of the world, I will have to massively dilute my existing shareholders now. So the
self-interested thing to do is to avoid the dilution and hope for a good state of the world.
This does not always work well in practice. Once capital preservation becomes paramount, deleveraging intensifies and counterparties grow more wary about engaging. This dynamic, in turn, makes a bad state of the world more likely. What may be sensible for each institution individually, may collectively be a bad idea. That is because each firm does not internalize the cost that their decision not to raise capital has on the overall financial system.
A healthy banking system is always essential. But never has that been more true right now given what has happened to the securitization markets and the broad "shadow" banking system.
So where are we now?
In my view, the deleveraging process is still far from complete. Hedge fund redemptions have soared. It would not be surprising that when we're done, hedge fund assets (before leverage) will have fallen in half or more from their peak of about $2 trillion. Of course, the Madoff scandal and other episodes of misappropriated funds have further undermined confidence, reinforcing the redemption pressure.
Most importantly, the pressure on the financial system has been exacerbated by the deterioration in the economic outlook following the Lehman failure. Before last fall, the causality ran mostly from the turmoil in the financial system to the real economy. Since then, the real economy has contracted sharply and this has reinforced the balance sheet pressure on banks and the forced deleveraging process.
So where do we go from here?
Well fortunately, it is not all bad news—there are a number of programs that have been enacted that have already made a difference. And several new initiatives are being enacted now that should help to support and bolster the financial system.
Those areas where the Federal Reserve and the Federal government have responded in force are doing somewhat better. Banks and dealers have plenty of access to liquidity. The Term Auction Facility or TAF—in which funds are auctioned off to banks—and the Term Securities Lending Facility or TSLF—in which auctions are held to borrow Treasuries from the Federal Reserve—have recently been undersubscribed, indicating that the facilities have been sufficiently sized to meet the demand for liquidity. The FDIC has also guaranteed bank and bank holding company funding through its Temporary Guarantee Liquidity Program. As a result, bank term funding spreads have narrowed a bit this quarter.
However, while the Federal Reserve can provide liquidity to the banks and dealers and the FDIC can reduce counterparty concerns via its guarantee program, these steps cannot force banks and dealers to on lend these funds to their customers.
This is where several new initiatives may show the way forward.
First, the Federal Reserve has begun to bypass the banks and dealers, which are balance sheet constrained, and instead has begun to provide liquidity directly to borrowers. One of these programs, the Commercial Paper Funding Facility or CPFF has been up and running since late October.
Under the terms of the CPFF, the Federal Reserve offered to purchase A1-P1 rated commercial paper at 84-day maturity from issuers. Although A1-P1 rated paper is the highest quality stuff, it makes up almost all of the CP market. The only catch is that the CPFF will only buy at rates that are quite high compared to the rates one would expect in the market during normal times. The Fed has to charge a high rate and up-front fees to provide some equity in the fund to offset potential credit losses.
This facility has worked extremely well in restoring market function in the commercial paper market. Initially, there was a surge of issuance into the facility. Commercial paper rates in the market were high and the issuers wanted to extend the maturity of their obligations. But since that time, purchases have slowed sharply. Following the introduction of the CPFF, commercial paper rates in the marketplace dropped below the rates charged by the CPFF. As a result, issuance into the program has collapsed because many issuers can now raise funds more cheaply in the private market. About half of the maturing paper in the CPFF has not been rolled over. As a result, the amount of CPFF holdings, which peaked at around $350 billion in mid-January, has fallen by over $100 billion, to below $250 billion. To date at least, the CPFF has worked as planned and has been very successful in rehabilitating the commercial paper market.
Second, the Term Asset-Backed Security Loan Facility or TALF will provide balance sheet capacity directly to investors beyond the banking and dealer community. This program is designed to restart the securitization markets.
The TALF is being rolled out in two stages. In the first stage, which I'll call TALF Version 1.0, the Federal Reserve will provide non-recourse loans to investors against AAA-rated consumer asset-backed securities collateral. Primary dealers will serve as the contact point with these investors to make it easier for the Fed to interface with potentially hundreds of investors.
The AAA-rated securities eligible as collateral for this non-recourse lending program are used to fund a wide variety of consumer and business loans, including student , credit card, auto and small business administration loans. The market for these securities had dried up because the traditional investors in these securities—SIVs, bank-related conduits and securities lenders—have either disappeared or are balance sheet constrained. This has reduced the availability of credit for consumers and led to higher borrowing costs.
The first subscriptions for financing under TALF Version 1.0 will occur on March 17. The first batch of new securitizations will be funded on March 25.
TALF Version 2.0 will follow. This will broaden the TALF into new asset classes such as Commercial Mortgage Backed Securities. Development of this phase is still in its early days. But it anticipated that the size and scope of TALF will expand sharply in the months ahead.
So how will the TALF restart securitization activity and provide balance sheet capacity to the private sector? By providing leverage and 3-year term, non-recourse financing to investors, the TALF should increase the demand for AAA-rated securitizations. Yields of LIBOR + 400 basis points may not be sufficiently attractive on an unleveraged basis, but at 10 times leverage the returns become very attractive.
The non-recourse nature of the loans is also important. If the price of the security falls considerably, the investor just loses an amount equal to size of the haircut. For example, if the haircut was 10% and the value of the security was $100, the most the investor could lose would be $10. Thus, the facility eliminates much of the downside risk that would arise from a very deep recession or the fire sales of assets that could cause prices to drop sharply temporarily.
This is a very exciting program because it provides balance sheet capacity to risk capital that cannot currently get leverage. It goes beyond current programs. Just as important, once it is up and running it can be scaled up and out in many different dimensions. In principle, it could be applied to other distressed asset classes, it could move down the credit spectrum to lower-rated tranches, and it could be used to fund older vintage assets.
Two other important initiatives are also in train that deserve note.
Last week the Treasury and the major banking supervisors announced the details of a capital stress assessment process for all bank holding companies with assets in excess of $100 billion. This process is designed to ensure that the banking system has sufficient, high-quality capital to be able to absorb the losses that would likely be generated by an economic scenario considerably worse than generally expected. The stress assessment assumes an adverse economic environment. For example, under this scenario, the unemployment rate is anticipated to average more than 10% in 2010, considerably higher than the consensus economic forecast.
The stress assessment will unfold in three steps. First, each bank holding company will be asked to evaluate the credit losses that are likely to occur under an adverse economic environment. These losses would then be evaluated relative to the bank holding company's ability to absorb those losses.

Second, if this analysis indicated that the banking organization was likely to fall short of well-capitalized in the stress environment, the bank holding company would be able to obtain additional capital via mandatory convertible preferred stock purchased by the Treasury.
Third, if the stress scenario were actually to occur, generating losses that depleted common equity capital below what is deemed adequate, then the mandatory convertible preferred would be available to be converted into common equity. The government's mandatory convertible preferred investment is, in some sense, contingent capital that is available to be converted into common equity only as needed.
I believe this program is very important if we are to break the adverse dynamic that I outlined early. As I mentioned earlier, many bank holding companies don't have an incentive to raise sufficient capital to ensure that they can handle a very bad outcome. That is because such capital-raising would severely dilute existing shareholders. This implies that, left to their own devices, banks might end up being undercapitalized in a stress environment. The risk of this outcome makes these banks (and their counterparties) very cautious in terms of their behavior. This cautiousness, which is rational for each bank and counterparty individually, is bad for the system because it constrains the supply of credit and results in tighter financial conditions. This, in turn, makes the bad economic outcome more likely.
The stress assessment regime that is being implemented should help to break this dynamic. Banking institutions will end up with sufficient capital to withstand even an adverse environment. This should reassure banks and investors that the banking system will remain resilient. With more capital in place, more lending should take place. This, in turn, should reduce the likelihood that the bad economic scenario will, in fact, be realized. The result: a virtuous rather than a vicious circle!
The point of the stress assessment is not to pick winners or losers, but instead to ensure that the banking system and all the major banks have sufficient capital to withstand a very adverse environment. Following the conclusion of the stress assessment process, the government is committed to supplying whatever amount of capital is needed to ensure that all the major banks will remain viable.
The second major initiative that deserves mention is the PPIF or Public-Private Investment Fund. This facility, which would be underpinned by TARP capital and private capital, would purchase illiquid, legacy assets. Although the terms and conditions of the PPIF have not yet been announced, this facility should help put a floor under the prices of lower-quality assets and provide a means for banks to shed such assets from their balance sheets.

Despite all these efforts, I don't want to give you the impression that all will be well soon—that seems unlikely. It will take time for the deleveraging process to come to an end and, as the recent employment data have underscored, the economy has considerable momentum to the downside. But the Federal Reserve is prepared to do whatever it takes, within the bounds of its legal authority, to keep markets working and credit available and affordable.
Finally, what are the lessons to be learned from this crisis? What do we need to fix in order to make our financial system more robust and our economy less vulnerable? Let me offer up a short list of seven areas that we might focus on—recognizing that this list is by no means complete or exhaustive.
We need more transparency and homogeneity in securities. The difficulty in valuing opaque and heterogeneous securities has led to greater illiquidity, price volatility and market risk, bigger haircuts and more forced deleveraging. Opacity has also led to an undue reliance on credit ratings.

We need central counterparties or CCPs for over-the-counter derivatives in order to reduce settlement risk. To do this properly, we will have to work with international supervisors, regulators, and governments to achieve global solutions. On this score, lots of progress has been made in the credit default swap space—with several new CCPs likely to be up and running in months, if not weeks. But we can do much more in this area.

We need an accounting and disclosure regime that allows investors to meaningfully ascertain the risks they are taking. For example, the same assets are often carried on different bank books at different prices. If you can't trust the valuation marks on the assets, how robust can confidence be in the ability of the financial system to withstand stormy weather?

We need a resolution mechanism for bank holding companies and non-bank financial institutions—legislation is needed here. Judging from the actions of the past year, there are indeed institutions that are "too big to fail", at least in certain circumstances. Let's set up a resolution framework that is robust and transparent so everyone understands the rules of the road and likely outcomes beforehand. An ad hoc approach increases uncertainty and reduces policymaker credibility.

If large systemically important institutions are indeed too big to fail, then there needs to be an explicit quid pro quo for this. Otherwise, this implicit support will create moral hazard and discriminate against smaller institutions. In particular, important institutions cannot be allowed to stay outside in the sun during good times, but allowed to come inside the regulatory net when it is raining.

We need a more robust capital regime for banks. Measures of regulatory capital lag far behind the real-time market-based measures of capital and risk. Moreover, the capital regime is procyclical. Banks are constrained in the amount of reserves they can build in good times as a buffer against cyclical downturns. Finally, banks balk at cutting dividends to conserve capital or replenishing the capital they sorely need in the middle of crisis. These incentives reinforce the downward pressure on the financial system during times of stress.

We need a more effective regulatory system. We need a systemic risk authority that has both the responsibility and the powers to look across the entire financial system—both depository institutions and the capital markets. Our regulatory regime is incredibly balkanized, which makes coordination difficult and means that important information can fall between the cracks. It also leads to less accountability for supervisory shortcomings and failures, which is another area where we have to do better.
This list is just a hint of the agenda that lies ahead. We need to put our financial system into the repair shop for intensive reconstruction. We need to do this in order to rebuild confidence and to ensure that we do not repeat the type of financial boom and bust that has characterized this cycle.
Thank you very much for your kind attention, I would be happy to take questions.

Reference: http://www.newyorkfed.org/newsevents/speeches/2009/dud090306.html

Dell

2008-11-13T13:00:00.002-05:00

I originally bought Dell stock in 2006, thinking it presented a good value. That purchase was an investment mistake -- not because the price has come down over two and a half years, but because there was something I could have and should of known at that time that would have changed my conclusion.

In essence, Dell's economic moat wasn't as durable as I thought it was. Dell has turned out to be more of a turnaround story than I had thought early on.

In making my original investment in Dell, I saw a Geico: a long-term low-cost provider of a commodity who is low-cost by selling direct (i.e. is more efficient) when the competition cannot sell direct due to various reasons.

This at one point was true of Dell and is still true of Geico. But here's the crucial point, here is what I had missed: what has happened is that the price gap has narrowed significantly in direct vs retail PC's. For maybe 5-10% more than a $400 direct-sold Dell you can get a PC from the store and use it today (this used to be 30-40% more on a higher base, say, $1800). And along with the instant gratification you get someone explaining things to you in the store, a return policy, etc... basically a value-added retail experience at a tiny extra cost.

Dell has now started selling through retailers. So basically what has happened is comparable to (1) agent-based auto insurers narrowing the price gap and (2) average auto policy prices halving to the point where Geico now finds its best move to also sell through agents. The direct-sales moat is irrevocably impaired. That's where Dell is not like Geico: agent-based auto insurance is not going to get much more efficient, and auto policy prices trend up over time (exposure goes up because the underlying assets people insure, their cars and bodies, become more expensive to repair over time) increasing the absolute price difference.

What Dell has going for it now is its world-class supply chain and capital management, its customer relationships, its brand, and whatever it can continue to sell direct (which for now is the majority of its sales, but who knows for how long?).

Dell is still a low-cost provider of a commodity. And the market is heavily fragmented. According to wikinvest, the top four PC makers (Dell, HP, Lenovo, Acer) accounted for only 44% of the global PC market in 2006.

So far Dell's retail sales have shown good revenue potential but not-so-high profits. As they tune this model things could change for the better.

The stock is still cheap in my view, but this is only because the price has come down more than my perception of business value; i.e. it has remained cheap despite my assessment of the business prospects dimming.

Related: Warren Buffett's The Security I Like Best, published in 1951.

Real estate investing

2008-10-22T21:31:00.002-04:00

I was thinking I'd write up a short post on the topic of real estate investing, covering issues like costs, risks, headaches, liquidity, and rewards. As I was writing on the topic I determined that someone else has already done much better: I present to you a great three part series on real estate investing titled My Life In and Out of Real Estate Markets by Aaron Carey, on his blog, Fog Light Finance:

Enjoy!

Time to Upgrade Wal-Mart (the first 35% doesn't count)

2008-04-27T10:24:00.006-04:00

This bit of news made me laugh: http://www.gurufocus.com/news.php?id=26283

Joking aside, there were some serious points as well:

"I think [Wal-Mart stock] is nearing fair value at current levels..."
"...much of Wall Street's ratings "upgrades" and "downgrades" are nothing more that (sic) backward looking momentum calls or shallow extrapolation of recent trends."
"...we should avoid the noise, and simply buy good companies when they look cheap and sell them when they look expensive."

There is no such thing as inflation...

2008-04-26T21:23:00.001-04:00

...at least not the way it is commonly referred to.

What I am saying here is that inflation is not at all accurately described by one number. It can, however, be described by many numbers.

Inflation is defined in Wikipedia as "the percentage rate of change of a price index". The choice of price index is very important. "Core inflation" excludes volatile food and energy prices, and many people use it because it has fewer erratic swings of little consequence. In response to a question about core inflation, Warren Buffet once said "food and energy seem pretty core to me".

Any person who has to buy things nowadays inherently knows it: things we need are getting more expensive. That is where my first point lies. Inflation in a price index, thought of as a single number, completely misses what products or services in that price index are changing in price, and what their price elasticity is. Imagine a price index composed of 50% of things people need and 50% of things people want. If the price index increases 10%, but owing to a 20% increase in the price of the necessities and no change in the wants, that is very different from a 10% increase across the board. Food and energy inflation is necessarily harder to deal with than, say, luxury sofa inflation, even if each takes up a similar amount of a person's overall income.

My second point is that the effects of inflation are different on different people. For example, seniors generally allocate a large amount of their spending on their health whereas young and healthy people allocate far less. Things one can do to deal with inflation are different for different people as well. A young and healthy person could deal with unexpectedly high inflation by working more. A senior by comparison may not have this option. Everyone has their own sort of personal inflation situation.

In later post I'll try to extend this idea to businesses and investment results.

Bear Stearns

2008-03-17T14:04:00.002-04:00

"...a long string of impressive numbers multiplied by a single zero always equals zero." -Warren Buffett, Berkshire Hathaway 2005 Shareholder Letter

It is interesting to note that Bear Stearns had almost $12B of tangible shareholder equity as of November 30th, 2007. They sold themselves to JP Morgan today for about $270M.

An investor's attitude towards taxation

2008-02-16T11:43:00.000-05:00

I used to think that taxes, being a necessary for a functioning country, were designed:

to take a share of the economic value created by entities in the economy, representing a kind of pay-back for all the things that the government put in place to make such creation of economic value possible,
to discourage or encourage certain behavior, and
to fund the programs and initiatives needed by the nation

I know, I know... I was a dreamer. While it is an ideal, that's not how taxes are designed at all.

In reality, taxes are usually levied along the path of least resistance. Taxes are about re-election. The tax system in America is as much determined by the needs and abilities of the country as a whole as it is by the institutionalism and bureaucracy of the government presiding over it. The last statement is not to say that it's all wrong and has to be abolished or revolted against. It's only to say that the structure of democracy and all the good that is brings comes along with all of the things that are less than optimal.

As such, from the perspective of an investor, tax law is arbitrary. Tax law in the US is mostly centered around income, as opposed to either creation of economic value (not always the same as income) or consumption, which is when you commission society to do something for you.

For investors, there are two major kinds of taxes. Taxes on interest or dividends, and taxes on capital gains. The goal of an investor is neither to maximize pre-tax returns nor to minimize taxes nor both, but to maximize after-tax returns. After-tax returns are determined by (a) pre-tax results minus (b) taxes. That is to say that maximizing this "A - B" equation necessarily means that taxes are disfavored.

There's really no special philosophy here. We simply take taxes as a given and optimize what we do with the presence of taxes in mind.

Intrinsic value

2008-01-27T17:31:00.000-05:00

Intrinsic value, sometimes abbreviated IV, is the value contained within a security. This can be thought of what the security is, or, as one would find, should be, worth to hold onto during its remaining life. By holding an investment one expects to realize value -- get money -- in the future. This is why people pay money to own a stock or a bond.

The intrinsic value of a stock, bond, real estate property, business acquisition, option, warrant, contract, or any investment prospect is equal to the value of the cash flows one expects to put into and take out of that prospect during its remaining life, discounted at an appropriate rate. For a share of stock, cash flow means dividends, after taxes, that one expects to receive. For a bond issue, cash flows means interest payments, after taxes, and principal repayments that one expects to receive. For real estate, cash flows means rental income, after associated costs and taxes, that one expects to receive. For an option, cash flow means after-tax profit realized from exercising the option at the expiration date. And so on...

Notice two things:

We are only concerned with after-tax value (more on this in another post)
Liquidity of the issue is not mentioned (that is not to say it isn't important, but liquidity of an issue only affects the cash flows one can realize by owning that issue in subtle ways out of the scope of this post -- though it may be explained in a later post)

As for the appropriate discount rate, theoretically one should use the expected return of one's best available alternative. Another way -- and this part of investing is more art than science (though others, unsuccessfully in my view, try to make it science) -- is to use an easily identifiable risk-free rate, for example the yield on long-term bonds issued by stable governments, plus an extra allowance for risk assumed. Many investors use 8-12% as their discount rate -- but this depends greatly on the application and should be used as a guide and not a rule.

A quick but "mathy" example: If one applies a 10% discount rate to a prospective investment which will yield $1M at the end of the first year, $1.03M at the end of the second year, and so on increasing at 3% per annum forever, then the intrinsic value of the investment is about $14.3M. We derive this by using the formula for an infinite geometric series: (a0 / (1 - r)). In our case, a0 is $1M/1.1 or about $0.91M (since it pays out at the end of the first year). r is 1.03/1.1 -- the growth rate divided by the discount rate.

Now we have a definition of IV that we can move forward with.