Friday, August 14, 2009

Lots of reading and viewing for the weekend

Before I get into this weekend’s links and videos I wanted to make a quick comment about my most recent post on John Paulson and bank stocks. I assume that some of you who read my commentary on his purchase of shares of Bank of America had the thought: “Wait, I thought we knew he paid around $10 a share?” However, from the research I have done, it appears that the number is just a whisper number and is based on nothing more than speculation. So while the $10 figure has been bandied about throughout the blogosphere, I don’t think there is any confirmation of that number available. Lucky for you, I have an inside source that indicated that $10 is in the ballpark of his cost basis. So, with the stock trading above $17 his purchase is way in the money.

Now, onto the links. I know there are a lot. I know it is daunting. But there was just way too much great material today to leave stuff out. I advise you to take the information in doses and am fine with you spreading out the reading over the weekend. If it is too much and you want to read or watch one thing, make sure it is the CNBC interview with Richard LeFrak on commercial real estate. Enjoy the weekend!

Commercial real estate bust-- Coming to a city near you: I found the link to this article on the upcoming commercial real estate debacle on Seeking Alpha. This is totally the slow moving train wreck that everyone sees for miles (in this case years) away but can’t or don’t know how to get out of the way of. In this case, the tactic of doing nothing and hoping for the best is unlikely to produce a positive outcome. Yeah, maybe cap rates will go back down and sales will pick up as liquidity returns to the market. Maybe rents will go back up and cause debt service coverage ratios to go back above 1. But then again maybe not. This article identifies 10 cities that could be at risk of a further downturn if things don’t start turning around. The most important one for most investors interested in REITs is New York:

New York: Those lavish Wall Street bonuses you've been hearing about are going to a lot fewer bankers. The financial industry, Manhattan's mainstay, has contracted by about 7 percent over the past year. Other industries have lost even more jobs, causing a sharp reversal in what used to be one of the world's hottest real estate markets. Office rents skyrocketed in 2006 and 2007, when Wall Street was at its peak, but REIS expects them to fall 28 percent between 2008 and 2010. REIS's vacancy data for New York include only office space, so the combined vacancy rate including retail space is probably higher than 12 percent.

Non-performing loans (NPLs)continue to haunt the banks: This Bloomberg article on the regional banks highlights the major issue facing banks all of the world right now. What to do about the seemingly incessant rise in NPLs. I see the problem as twofold:

(1) While it depends on an individual banks' definition of an NPL, most of the time these loans have stopped accruing interest and the borrowers have stopped paying interest. So, aside from the potential of not getting the loan principal back in full, the diminished income stream reduces revenue precisely at the time when the banks need to bolster their capital positions through profit generation.

(2) When a loan becomes an NPL banks are supposed to take a reserve against that loan in anticipation of not getting repaid 100 cents on the dollar or not being able to sell the loan at face value. This reserve diminishes equity and tangible equity when the banks’ capital levels are already dicey.

What is the key NPL percentage threshold that can send a bank over the edge? This article suggests that 5% is the magic number. I happen to believe that a bank with only 5% NPLs would receive a good about of regulatory forbearance given the circumstances. So, these days I look at the really troubled banks as the ones with NPLs above 7%. My how things have changed. I remember that 3% seemed outrageous when I first started following the sector. Compare that to Corus who currently has two-thirds of its loan categorized as NPLs. Obviously Corus is not going to make it but how should we think about banks that are in the 5-10 % range?

While 5 percent can be “fatal” for home lenders, commercial real estate lenders may be able to withstand higher rates, said William K. Black, former lawyer at the Federal Home Loan Bank of San Francisco and the OTS. Commercial loans carry higher interest rates because they’re riskier, he said.

“At the 5 percent range, you’re probably hurting,” said Black, an associate professor of economics and law at the University of Missouri-Kansas City. “Once it gets around 10 percent, you’re likely toast.”

Disparity in bank asset valuations is troubling: The latest piece from Jonathan Weil of Bloomberg has been cited all over the blogosphere during the last few days. So, I am not going to re-hash the view of others. However, what did stand out most to me is that the discrepancy between the fair value of assets and the value on the balance sheets seems to be growing. I would have assumed that the rally in numerous markets and the overall increase in liquidity would be pushing fair value closer to stated value. Apparently not though:

Bank of America Corp. said its loans as of June 30 were worth $64.4 billion less than its balance sheet said… Wells Fargo & Co. said the fair value of its loans was $34.3 billion less than their book value as of June 30. The bank’s Tier 1 common equity, by comparison, was $47.1 billion.

The disparities in those banks’ loan values grew as the year progressed. Bank of America said the fair-value gap in its loans was $44.6 billion as of Dec. 31. Wells Fargo’s was just $14.2 billion at the end of 2008, less than half what it was six months later.

Also, these banks are obviously marking similar assets at different values. Take Citigroup for example. It is logical to assume that since Citi is basically owned by the government the management team has had to be much more aggressive on the marks.

The trend in banks’ loan values is not uniform. Twelve of the 24 companies in the KBW Bank Index, including Citigroup Inc., said their loans’ fair values were within 1 percent of their carrying amounts, more or less. Citigroup said the fair value of its loans was $601.3 billion, just $1.3 billion less than their book value. The gap had been $18.2 billion at the end of 2008.

What this says to me is that some banks that are not under the government’s watchful eye are still marking assets at what look like fantastic values in relation to what they could be sold for. This is not stop-the-presses, breaking news. But, I fear that until we can understand the true nature of the assets these banks are holding there will continue to be a wholesale lack of confidence in the financial system as a whole.

Say goodbye to Colonial: As is being widely reported today, Colonial BancGroup has failed and the FDIC has brokered a deal in which BB&T will take over some of CNB’s assets and/or deposits. This is not a surprise as the bank was severely undercapitalized and is now facing a criminal probe of its accounting practices. In the NY Times today Floyd Norris has an article (hat tip to Zero Hedge) about Colonial that describes the bank’s rise and fall. Just the same old story of over-expansion and aggressive lending. But, one specific aspect really stuck out in my mind:

The Colonial story is not over, but one lesson is an old one: banking profits can be ephemeral. From 1995, when Colonial first expanded outside Alabama, through the first quarter of 2008, its last profitable quarter, it reported $1.7 billion in earnings.

In the five quarters since then, it has reported losses of $1.6 billion. And that is before any adjustments are made for the accounting investigation that the Justice Department has begun.

In the article Norris notes that the man who started it all, Robert Lowder, made millions of dollars as result of his ability to grow the bank’s footprint and lending operations. Assuming he is not convicted of fraud or is forced to pay a settlement as result of the current inquiry, Mr. Lowder gets to keep all of that money despite the fact that in 5 quarters the bank lost an amount about equivalent to 13+ years of profits. I guess what continues to amaze me is how much all of the profits these banks made were no better than paper profits in reality. But, unlike all the people who have lost the paper gains in their 401Ks over the past 2 years, people like Mr. Lowder have actual money in their bank accounts that only loses value if the Fed succeeds in inflating away our purchasing power. I know I have said this and you read this all the time, but somehow that doesn’t seem fair.

RBS predicts a dramatic reversal in the stock market: After reading a long analysis of the economy by Bob Junjuah on Zero Hedge, I came across this article in the Telegraph. Although I suggest reading the commentary posted yesterday on Zero Hedge, this Telegraph article presents the Cliff’s Notes version:

Britain's Uber-bear is growling again. After predicting a torrid "relief rally" over the early summer, Bob Janjuah at Royal Bank of Scotland is advising clients to take profits in global equity and commodity markets and prepare for another storm as winter nears.

How bad a storm does he foresee?

This time he expects the S&P 500 index of US equities to reach the "mid 500s", almost halving from current levels near 1000. Such a fall would take London's FTSE 100 to around 2,500.

Clearly, that’s close to a 50% drop from the current levels on the S&P. Before you dismiss him as a mindless bear you should keep in mind that he called the major rally we have seen. I think the duration of the aforementioned rally has surprised him a bit (he said we were near the tail end of the rally in June), but he was prescient enough to call for a sharp reversal to the upside when everyone else was bearish. There is no way to know whether his contrarian position will prove to be right this time but the reasons for his pessimism are worth keeping in mind.

We already miss Montier: The link below is to a post from The Pragmatic Capitalist that contains a chart from James Montier when he was still at Soc Gen. Now that he has joined up with Jeremy Grantham at GMO I fear that we will not be privileged enough to get access to Montier’s invaluable analysis and commentary. However, this particular chart highlights economist’s poor track record when it comes to forecasting GDP. This is no different from stock analysts’ pathetic track record in regards to predicting earning per share. Humans are incapable of knowing the future. All we can do is make educated guesses that inevitably turn out to be no better than flipping a coin. Accordingly, this chart should remind you to be skeptical when you hear that 90% of economists think the recession is over or that some pundit is predicting 3% GDP growth in Q3 2009. In fact, even if you think the economy is still sinking you should take specific forecasts that agree with your assessment with a huge grain of salt.

Does the Fed owe this country an apology? Simon Johnson sure thinks so. He believes that the fact that the Fed missed all the signs of the housing bubble and excess leverage in the system and subsequently kept interest rates too low for too long is grounds for an apology:

Our top monetary policy makers completely missed the true nature of the Great Bubble and its consequences, until it was far too late. They should apologize for that and we can start work on redesigning the institution, its decision-making, and how financial markets operate, to make sure it won’t happen again. And it would also be nice if the Fed could avoid adding insult to injury – and stop opposing the administration’s consumer protection proposals.

Honestly, I am not sure what good it would do. I have been very critical of Bernanke and Greenspan but I am sure that neither of them is pleased about what started and perpetuated under their combined watch. I would much rather have an admission from both that bubbles can and will occur and that in the future the Fed will be much more conscious of the way that excessively cheap credit can fuel speculative asset bubbles.

Common sense solution to health care is not the answer: I stole the link to this piece in the NY Times Economix blog from James Kwak of The Baseline Scenario. He linked to this article to reinforce his assertion that people can simultaneously hold contradictory views on the same topic. As an example he cited Uwe Reinhardt’s analysis of the solution to our health care conundrum from a common sense perspective.

To be responsive, then, to the “simple common sense” of the American people, any proposed health reform must not reduce the revenue of hospitals, lest some neighborhood hospital may have to close; or of doctors, lest some doctors might refuse to see patients; or of the manufacturers of health products, lest they are unable to innovate; or of anyone on the supply side of the health sector, lest they go out of business and have to lay off employees.

At the same time, the “simple common sense” of the American people dictates that any health reform that fails to bend down the growth curve of future health spending — the current jargon for controlling health spending better — is unacceptable, too.

Obviously, any attempt at reform cannot include reduced overall costs without actually reducing outlays to different sectors of the industry. Yet, that is what people want. They want the same access to services and better quality of care at a lower cost. However, there is no free lunch. In this one case the efficient market devotees have it right. Thus, if we want to reduce the cost of health care and create a sustainable system we are going to have to make some tough choices when it comes to spending. Sorry to be the bearer of this somewhat obvious bad news.

Obama’s next challenge according to Krugman: During the campaign Obama claimed that he wanted to close the divide between Blue America and Red America as well as between Congressional Democrats and Republicans. Whether you think that was just rhetoric he used to get elected or not, we can all agree that he has certainly not achieved that goal. One of the more conflict-ridden issues is obviously health care reform. Apparently Sarah Palin and Charles Grasserly have recently weighed in with some comments that did nothing but misconstrue the intent of certain proposals and served to misinform the public. Overall, this looks like it is going to be a long, ugly fight.

So much, then, for Mr. Obama’s dream of moving beyond divisive politics. The truth is that the factors that made politics so ugly in the Clinton years — the paranoia of a significant minority of Americans and the cynical willingness of leading Republicans to cater to that paranoia — are as strong as ever. In fact, the situation may be even worse than it was in the 1990s because the collapse of the Bush administration has left the G.O.P. with no real leaders other than Rush Limbaugh.

In this case I don’t really have an opinion about who is right and who is wrong. I don’t know if Obama’s plans are brilliant or potentially disastrous. What I do know is that the approval rating of Congress is dismal and the fact that members never stop sniping at one another seems ridiculously petty given the headwinds this country is facing. I certainly don’t want the Republicans to roll over and let Pelosi and Obama pass any legislation they want. But I also don’t want Rush Limbaugh’s incessant negativity and acrimony to poison the entire Republican party and induce it to fight necessary reform. We need a balance. I already know the answer to this but I am going to ask it anyway. Why can’t these people put aside their differences to come up with prudent legislation that will help this country get back on the road to a sustainable recovery?

WWWD?: No, this is not a reference to weapons of mass destruction or worldwide wrestling. It is the title (What Would Warren Do) of Megan McArdle’s new piece on Warren Buffett in The Atlantic. For some reason she is only now writing about her experience in Omaha during the weekend of the Berkshire annual meeting in May. My guess is that she has been busy writing about the economic and financial crisis that continues to unfold. At least I can vouch that she was there. I saw her and made a note to look at her material before I had read anything by her.

For anyone who follows Buffett or is a value investor, this article won’t give you any new insight. It feels a bit like an introduction to Buffett for people who don’t know him. Having said that, McArdle concludes to article with a curious question:

Right now, the academic literature suggests that value investing has a modest advantage over a broader market strategy. Better information, more widely available, may continue to erode that edge. But the principles of prudence, patience, and thrift will always, in the end, offer a better chance at outsize returns. The question is whether, once Saint Warren passes, his followers will find the courage to stick to them.

I’ll answer that right now Megan. I think I speak for all value investors when I say that there is absolutely no doubt that value investing will survive the passing of The Oracle. Ben Graham’s teachings are timeless and even though we will mourn the loss of the most monetarily successful value investor ever, we will continue to stick to the principles and disciplines regardless of what the market throws at us. Amen!

Markets are on a “sugar high”: At least according to PIMCO co-CEO Mohamed El-Erian in this short video from CNBC. His claim is that the market has gotten ahead of the recovery. Of course he and Bill Gross are bond guys so they have a reason to tell people not to be bullish on stocks. But, in response to Joe Kernen’s accusation that he is only looking at coincident indicators when evaluating the economy and thus is the reason he is so bearish, he claimed that his views are based on forward looking data that will cause him to be too early rather than too late (like value investors often are). Finally, in response to the idea that France and Germany will recover faster than the US, El-Erian asserted that their reduced dependence on leverage and greater access to Asian growth have been huge benefits. Wait, leverage is a killer? Who knew?

More troubling commercial real estate data: New negative data from CNBC. Wait, I thought they didn’t report bad news? Someone must be asleep at the wheel.

U.S. commercial real estate values in the first half of 2009 fell more steeply than UK values, said IPD, which analyzes commercial real estate data in global major markets.

"For global real estate investors this may come as a surprise, given that Britain was the most significant real estate market to suffer in 2008," IPD Managing Director Simon Fairchild said in a statement.

U.S. values in the second quarter declined by 6.9 percent, easing somewhat from the 10.8 percent drop in the first quarter, IPD said.

The man who knows about commercial real estate says watch out: Wow, more realistic assessment of what is really going on from CNBC. This is quite the rare day. My advice: watch this video of Richard Lefrak (along with the lovely and articulate Ivanka Trump) on Squawk Box. If you want to understand the problems facing commercial real estate in the US then you must devote 8 minutes to this clip. You might not need to read or watch anything else. For those of you who do not recognize the name, the LeFraks own a tremendous amount of real estate in the New York City metro area. This means he knows what he is talking about.

What problems does he see? Well first, he says that the industry became addicted to the securitization market for financing. But, unfortunately that hasn’t worked out too well:

“The shadow banks have evaporated,” LeFrak told CNBC. “They were supplying 35 percent of the capital in the industry and they just disappeared.”

That’s a ton of liquidity that has just left the market. No wonder there is so much pressure on prices. With no financing there are no transactions and prices will continue to fall as vacancies increase and rents go down. Lefrak also has an interesting anecdote about PPIP. Apparently they are teaming up with Wilbur Ross in an attempt to raise money that will be used in this government program. However, according to LeFrak it is taking forever due to the bureaucracy. Surprise, surprise. Well, they better figure out something before things get meaningfully worse.

(Picture of El-Erian courtesy of