Hank Paulson Isn’t Operating His Financial Doomsday Machine
Sep/110
Current events in the financial markets have eerie similarities to 2008: looming defaults of large formerly riskless debt issuers, toxic debt that needs to be written down, elevated LIBOR rates, etc. The major difference is the current U.S. Treasury Secretary is committed to keeping the financial system functioning.
We all watched in horror as the events of September 2008 unfolded. Investors had been nervous all summer about the stability of the major financial firms. As we entered September, there were a couple of lingering issues (Lehman Brothers and the GSEs), but both had reasonable outcomes. In fact the markets were not signaling financial distress as the CBOE’s VIX Index entered the month at a reasonable 20.65.
First, Lehman Brothers was clearly in need of capital given its massive real estate exposures. Although it seemed unlikely they’d be able to raise additional capital, it was reasonable to assume a controlled sale of the firm similar to the Bear Stearns sale in March 2008 would transition the business to an acquirer. Since Bear Stearns bondholders were made whole, the financial system kept chugging along. The same could happen with Lehman.
Second, Fannie Mae and Freddie Mac were under pressure mainly because of their mortgage exposure and their political opponents sensed weakness and continued to pressure the companies through the media. The chatter was the GSEs were starting to pay higher rates on their weekly discount note auctions, but this was a not event because both companies had $700 billion of unencumbered debt that any repo lender would take as collateral. Plus, the situation seemed to be resolved over the summer with new powers for the Treasury Secretary to be able to inject capital into the firms, which he said he didn’t intend to use.
Instead of riding through a tough market, Hank Paulson turned on his Financial Doomsday Machine. Economist Anatole Kaletsky coined the term in a September 18, 2008 op-ed in The London Times:
“It is clear that most of the actions taken recently by regulators and governments have exacerbated the crisis. Instead of using his Government’s unlimited financial firepower to defend the financial system, Henry Paulson, the US Treasury Secretary, turned his guns on his own side, wiping out long-term investors who tried to support leading financial institutions, while rewarding speculators who tried to bring them down.
Mr Paulson was activating a financial Doomsday Machine, driven by a chain reaction of actions by stock market speculators, regulators, credit-rating agencies and accountants. The details of this mechanism are complex, but the gist is simple – if a bank’s share price falls below a critical level, its credit is downgraded; it has to sell assets at fire-sale prices; this further weakens its capital, leading regulators to question its solvency; this drives down its share price and the vicious circle takes another turn. What Mr Paulson did ten days ago was to hand to stock market speculators the key to this Doomsday machine.
This may seem an outlandish accusation – especially against a supposed financial mastermind who was a chairman of Goldman Sachs – but consider the event that triggered the market attacks on Lehman Brothers, AIG and HBOS. They all followed Mr Paulson’s punitive decision on September 7 essentially to expropriate the $20billion of capital injected into Fannie Mae and Freddie Mac by shareholders over the previous 12 months. Long-term shareholders made these investments, with the encouragement of the US Government, to stabilise Fannie and Freddie. Meanwhile, a host of short-term speculators were selling these same securities, convinced that the two companies would be driven into bankruptcy.
By rewarding short-sellers while wiping out investors who reckoned on a long-term recovery that would restore the mortgage giants to profitability, Mr Paulson sent the clearest possible message to financial markets around the world. Any investor who puts money into a US financial institution that might run short of capital would have it expropriated by the US Government. On the other hand, sellers of US bank and insurance shares would be richly rewarded if they could destabilise any financial institution sufficiently to force it to turn to the Government for help.
In the past few days the same pattern of perverse incentives has been repeated in the bankruptcy of Lehman and the “rescue” of AIG. In both cases, Mr Paulson decided to wipe out investors banking on a recovery while rewarding destabilising short-sellers.
The key question is whether this scorched-earth strategy will become a firm principle of Mr Paulson’s responses to future attacks on US financial institutions.”
Paulson committed the largest financial policy mistakes since the Great Depression by placing the GSEs into conservatorship and forcing Lehman Brothers to declare bankruptcy. Paulson had destroyed the potential for a private recapitalization of the banking system with his actions. The financial system quickly froze. Money-market funds stopped purchasing new commercial paper. AIG needed a massive bail-out two days later. Goldman Sachs and Morgan Stanley needed to obtain bank charters over a weekend. All of these events lead to the Great Recession as Main Street American consumers and business people started conserving cash and restrained their spending.
Back to the events of today, the current U.S. Treasury Secretary, Tim Geithner, is on a different course from Paulson circa Labor Day 2008. He was the New York President at the time and sat at the table watching Paulson make his mistakes. I see from his speeches and interviews that he will protect the financial system. I believe that he will not let major U.S. financial institutions such as Citigroup and Morgan Stanley get destroyed in a chain reaction to a default in Greece. The difference between Geithner and Paulson is why Greece will not be the equivalent of Lehman Brothers for the U.S economy.
Newcastle Disappointment
Sep/110
Yesterday was a sad day. My investment thesis on one of my favorite stocks blew up. It was Newcastle Investment. I’ve written about the company several times over the past 13 months. It is a commercial mortgage REIT that has come back from death’s door. Newcastle’s business didn’t blow-up. Instead, Newcastle’s management made a strategic shift at the same time as making a very poor capital decision.
Newcastle had been using their cash to repurchase their own CDO notes at attractive discounts. They were also making some new commercial real estate loans at attractive spreads. The stock trades at close to my calculation of its liquidation value and at a discount to my calculation of fair value.
In March, the story was derailed a little when they raised about $120 million in a follow-on offering of common stock. At the time, I thought it was a weird that management wanted to raise capital at what I perceived a discount to its value, but they claimed they had attractive investment opportunities in their CDO notes. Fine, the dilution wasn’t too bad and the capital allocation was consistent with previous capital allocation decisions. The deal was priced at $6.
Monday night with the stock closing at $5.65, Newcastle announced they were going to raise additional capital again. This was frustrating because the stock opened down 9%, so they were going to have to price the offering even lower than $6 to get the offering done. Plus, the number of shares they wanted to issue was higher than in March. In the morning, I held off on selling my shares because I wanted to better understand what they were seeing in terms of investment opportunities that was so compelling to sell additional stock at even lower prices.
What I heard from management was completely disappointing. They are going to use the new capital to purchase mortgage servicing rights on a pool of residential mortgages. This is a complete strategic shift, and it makes no sense for several reasons.
1. No expertise in interest rate risk – Newcastle is a commercial mortgage REIT. It specializes in commercial real estate credit risk. The few residential mortgage assets it holds are credit risk assets. Purchasing MSRs is an interest rate bet. If I want to make this bet, I can own American Capital Agency Corp. (AGNC) whose managers are experts in residential mortgage and interest rate risk. Plus, investing in MSRs has less flexibility than buying IO-strips. MSRs are relatively illiquid and would degrade the quality of NCT’s balance sheet.
2. Issuing stock at these prices takes upside from the existing business away from existing shareholders – Absent this offering, a fair price for NCT right now would be $7.50 with the expectation that it will rise closer to $10 as they recover value from their existing portfolio of commercial mortgage assets and continue to buyback their CDO notes at a discount. It looks like the this offering won’t get done above $5, so the company is selling shares at 33% below where I think it is fair. Plus, they are going to increase the number of shares by 30%, so any upside that comes from the commercial mortgage recovery will be spread over a greater number of shares.
3. Issuing stock at these levels shows the interests of Newcastle shareholders and Fortress have diverged – Newcastle has a third-party management contract with Fortress. Fortress benefits from Newcastle getting larger even if Newcastle shareholders are not better off. NCT hit $8.50 prior to the March offering. Without the March and now September offerings and the dividend announcements, I have no doubt that NCT would be above $8.50.
4. Expect continued dilution – Management makes it clear that this is the beginning of a large ramp into MSR investment. I expect additional share offerings from newcastle because Fortress will see “so many opportunities to put the capital to work” as the banks divest MSRs.
5. Mortgage Servicing is not an attractive business – a) New servicing rules are about to be released that could change the economics of the business. b) It is a commodity business that will be unattractive once MSR prices rise. c) The relationship between Newcastle and the Fortress affiliate that will be performing the actual servicing is undefined. What if the cost of servicing 6,000 delinquent loans costs more than the 6 bps the affiliate is going to be paid? d) Who is going to provide the credit to advance P&I on delinquent loans?
6. Residential REITs trade at lower multiples – NCT management will argue that the MSR purchase is accretive to the dividends. maybe the dividend rate will go from $0.60 to $0.84. This will move the yield on NCT to 17%. AGNC already trades at 19%. Plus, NCT has upside in its potential yield already. How much of the move in the dividend from 60 cents to 84 cents will come from the MSR purchase versus the existing CMBS business?
Maybe buying these MSRs at cheap prices will turn out to be good for Newcastle. It is too big a risk, in too different a business for me to wait around and see. It destroys the great investment story of recovery Newcastle had built from the lows of March 2009 at $0.27 of balance sheet recovery and taking advantage of opportunity in the CMBS market.
Citigroup: A Bet Against the End of the World
Sep/112
This is the first of a three part posting on Citigroup. The second part compared the opportunity in Citigroup to Bank of America. The final part will review a list of reasons why investors avoid Citigroup and how I overcome these objections.
Betting on the End of the World by shorting the major U.S. banks is not a winning strategy. This is not to say investors should blindly depend on policy makers to bailout the financial system every time there is an issue. We have clear, recent evidence from September 2008 that bailouts do not always come for investors. Also, I fear we will have a repeat of September 2008 in the future as anti-bailout proponents continue to gain power in Washington. However, the current financial policy makers (Geithner and Bernanke) will not repeat the mistakes of September 2008, so shorting the major U.S. banks now is a losing strategy.
The sellers of bank stocks at these levels fear the financial system will collapse if there is a hard default by Greece. Their thesis is if Greece defaults, major European banks will take losses directly and suffer additional counterparty losses from the failure of smaller banks. As the European banks take losses, risk aversion will rise and liquidity will drain from the system. Lower levels of liquidity will drive asset prices lower causing losses in both U.S. and European banks. These additional losses may cause a major a European bank to fail, and U.S. banks will suffer additional losses as a result. If the losses for the U.S. banks rise to a high enough level, we may see a major U.S. bank have to fire-sale assets and/or raise capital at dilutive stock prices.
I disagree with several parts of this thesis. Most important, I believe the current policy makers learned an important lesson from September 2008 and will not compound a crisis by letting their financial institutions fail due to a lack of liquidity. Plus, the major U.S. banks have liquidity and capital levels that will allow them to survive a severe downturn in the financial markets. I have been expressing my view by adding to my position in Citigroup.
My preferred way to implement my view that the financial system will not collapse is to own shares of Citigroup. I believe all of the large banks are attractive, including JP Morgan Chase, Bank of America, Goldman Sachs, Morgan Stanley and Wells Fargo. I own most of them, but my largest position is in Citigroup. My preference for Citigroup is due to its low valuation and its ongoing corporate restructuring which is generating excess capital.
I do not think the financial system is going to collapse due to the current European crisis. Political leaders have learned important lessons from the Lehman Brothers bankruptcy that orderly wind-down of major financial institutions is needed. I believe the distress in the financial system in September 2008 is etched on the minds of Geithner and Bernanke. They will not allow a major financial institution to fail due to a shock from Europe.
Treasury Secretary Tim Geithner consistently shows in his speeches and interviews that the lessons learned from September 2008 are well in grained. On September 19th, Geithner said in a Bloomberg interview, “I think you’re going to see them draw on the lessons of our crisis, draw on the lessons of things that worked here in the United States. I think you’ll see that reflected in some of the choices they make.”
In the end, I believe the European leaders have learned these same lessons. They will protect their own country’s banks from losses. It may be bumpy trip, but we see evidence that European political leaders are starting to get it. Merkel and Sarkozy released a joint statement saying that they “are convinced that Greece’s future is in the eurozone.” At the recent G7 meeting, the finance ministers stated their support for the banks, “We will take all necessary actions to ensure the resilience of banking systems and financial markets,”
In addition to the support from political leaders, I believe Citigroup is approaching a potential Greek default with much more solid liquidity and capital positions than. Here’s a look at the high level numbers:
| Dec 2007 | June 2011 | |
| Cash as % of Assets | 10.2% | 16.7% |
| Reserves/Loans | 1.9% | 5.3% |
| Deposits/(Loans+Securities) | 79% | 89% |
| Tangible Common Equity/Tangible Assets | 1.6% | 7.3% |
These are clearly stronger numbers and position Citigroup to handle a stressful environment better than 2008. In addition, Citigroup has spent the past 3 years reducing risk within its loan book. With the credit quality metrics declining, I get the sense that management has a much better sense of its balance sheet and the risks than it did 3 years ago.
I believe Citigroup is well positioned here to survive a stressful period in the markets due to a Greek default. With the stock at 60% of tangible book value, I believe it is an attractive stock. The reason it is at these low valuation level is the potential for potential problems in the financial system due to a Greek default. I do not believe
Disclosure: Long C, BAC, WFC & MS
Disclaimer: This is not investment advice. This intended to be a window into my thinking when analyzing Citigroup. Please do you own work before making an investment. My positions listed in the disclosure may change without further update.
Freddie Mac 2011 Q2 Earnings Review
Aug/1110
Last night Freddie Mac, which is in conservatorship, released its second quarter earnings. The headline numbers were a net loss of $2.1 billion and a requested draw from the Treasury of $1.5 billion. Although these results are worse than the first quarter report, there is an accounting entry which obfuscates the underlying progress Freddie is making in its return to profitability.
Freddie’s income statement shows more volatility than the underlying business because FASB requires the company to mark-to-market its derivative portfolio. When Freddie needs to issue long-term debt to fund its mortgage portfolio, it looks for the cheapest execution. It can either issue a cash bond with a fixed rate or it can replicate issuing a fixed-rate cash bond by entering into a pay-fixed swap and issuing short-term debt. In a pay-fixed swap, Freddie will pay the counterparty a fixed-rate and the counterparty will pay Freddie a short-term rate, which will be used to pay the rate on the short-term debt. Freddie will rollover the short-term debt until the pay-fixed swap matures. [I don't like this practice of substituting pay-fixed swaps for issuing long-term cash bonds because it exposes the company to financing risk. The company is constantly rolling over its massive portfolio of short term debt. It puts the company at risk when the capital markets close like in September 2008. However, it is what it is.] So over time, Freddie has entered into hundreds of billions of dollars of pay-fixed swaps. Every quarter, Freddie must mark-to-market this portfolio of pay-fixed swaps. When interest rates decline in a quarter like Q2, Freddie must report a loss, which it did to the tune of $3.4 billion.
If we are looking at Freddie’s income statement to get an idea of the company’s long-term performance and profitability, we need to ignore the derivatives mark-to-market line item. If rates rise the next quarter and this line item moves to a gain, then we’ll ignore it again. Eventually, this line item will be reflected in the income statement through net interest income. By ignoring the noise from the derivatives mark-to-market, we get a better sense of Freddie’s recurring earnings performance.
| 2011 Q2 | 2011 Q1 | |
| Net interest income | $4,561 | $4,540 |
| Loan Loss Provision | (2,529) | (1,989) |
| NII after Provision | 2,032 | 2,551 |
| Securities Impairment | (352) | (1,183) |
| Other non-interest income | 302 | 368 |
| Non-Interest Income | (50) | (950) |
| Non-Interest Expense | (546) | (697) |
| Income Before Taxes | 1,436 | 904 |
| Tax Benefit | 232 | 74 |
| Net Income ex-Derivatives | 1,668 | 978 |
| Other comprehensive income | 1,039 | 2,064 |
| Total comprehensive income | 2,707 | 3,042 |
So, from the table, we can see absent the derivative mark, the headlines should have read “Freddie makes $1.7 billion in the quarter and does require a draw from the Treasury.” I believe ignoring the quarterly mark on the derivatives portfolio gives a more realistic view of Freddie’s recurring earnings.
Here are some other observations from the Freddie’s 2nd Quarter earnings report:
1. Credit losses remained stable in Q2 at $3.1 billion compared to $3.2 billion and $3.1 billion in Q1 and Q4, respectively.
2. The loan loss reserve continues to look too high given the level of charge-offs. Freddie has more than 12 quarters worth of credit losses in its loan loss reserve. For comparison, Wells Fargo has 7 quarters of credit losses in its loan loss reserve.
3. I am not seeing evidence that Freddie has raised guaranty fee rates as the Treasury proposed in January this year. This may be because the rate is contracted with customers on an annual basis.
4. As of Q2, 46% of the portfolio was written after 2008. The legacy book is steadily declining and losses from the legacy book are declining.
5. Deliquencies for 30 days ticked higher in Q2, which reverses a multi-quarter decline in delinquencies.
6. Based on the interest rate moves in Q3, I would expect another sizable negative mark-to-market for the derivatives portfolio in Q3. It will probably cause Freddie to report another loss and draw again from the Treasury.
7. Q3 may be the last time Freddie has to make a draw from the Treasury if credit losses continue to stabilize or improve and the steep yield curve continues.
I continue to hold my positions in a few of the classes of Freddie Mac preferred stock. I think there is a chance that starting Q4, Freddie Mac will report profitable quarters and will be in a position to begin paying down the Treasury’s stake in the company.
Disclosure: Long FMCKJ, FMCKI & FMCCT
Disclaimer: There is no guarantee that Freddie Mac’s stock price will rise. There is significant risk that shareholders could be wiped out and you would lose all of your money. There are other reasons the stock may not perform. Please do your own analysis.
Updated Newcastle Investment Liquidation Analysis 2011 Q2
Aug/110
The last few quarters I’ve written about Newcastle Investment’s (NYSE: NCT) liquidation value. I believe this estimate is conservative because it assumes assets are sold at market value, but the liabilities are paid at face value. The liabilities currently trade at a discount to the face value, so if Newcastle’s management were to liquidate the company they would try to buyback the liabilities at a discount before paying them off at face value.
Here the table showing the liquidation value updated for the current quarter:
| 2011 Q2 | 2011 Q1 | 2010 Q4 | 2010 Q3 | 2010 Q2 | 2010 Q1 | 2009 Q4 | |
| Recourse assets | $318.0 | $269.7 | $74.4 | $101.9 | $79.3 | $54.5 | $155.8 |
| Recourse liabilities | $256.4 | 144.5 | 59.5 | 56.3 | 55.8 | 77.9 | 183.6 |
| Net recourse assets | $61.6 | 125.2 | 14.9 | 45.6 | 23.5 | -23.4 | -27.8 |
| CDO note holdings | $409.8 | 367.7 | 348.5 | 80.0 | 25.7 | 1.5 | 1.0 |
| Borrowings from other NCT CDOs | $81.3 | 95.8 | 108.8 | 0.0 | 0.0 | 0.0 | 0.0 |
| MH deal equity | $92.3 | 70.0 | 71.2 | 65.8 | 64.6 | 63.6 | 26.0 |
| Preferred stock | $61.6 | 61.6 | 61.6 | 61.6 | 61.6 | 61.6 | 152.5 |
| Liquidation value | $420.7 | 405.5 | 264.2 | 129.9 | 52.2 | -19.9 | -153.3 |
| Shares outstanding | $79.3 | 79.3 | 62.0 | 62.0 | 62.0 | 53.6 | 52.8 |
| Liquidation value per share | $5.31 | $5.11 | $4.26 | $2.09 | $0.84 | -$0.37 | -$2.90 |
My estimate of liquidation value increased about $0.20 in the quarter, plus, shareholders also received a $0.10 cash dividend at quarter end. The main driver was the net interest income earned during the quarter and the earned discount from securities that paid-off during the quarter at par. The underlying collateral of the CDOs did not increase during the quarter as the market for non-agency mortgage securities softened during the quarter. This is ok because the lower prices gives Newcastle’s management opportunity to buy additional assets at attractive prices.
One interesting item is the liquidation value would have been $0.10 higher if management had not repurchased $25 million of CDO X, Class A-3. In my CDO liquidation waterfall analysis, I assume that Newcastle receives no proceeds for this asset, but in the earnings release, management claimed they expect to receive par for this security at maturity. They purchased the security in Q2 for $8 million. If the $8 million had not been spent on this security, my liquidation estimate would have been $0.10 higher in the quarter. If Newcastle does receive par for this security, it will add $0.31 to shareholder value.
Another interesting point is my estimate of liquidation value increased only $0.20 in the quarter but GAAP book value increased $1.18. The main increase in GAAP book value was the deconsolidation of CDO V. I already accounted for this gain by assuming the CDO is non-recourse and shareholders will not lose additional money on Newcastle’s underwater CDOs. Eventually, my liquidation estimate and GAAP book value will converge to the same number.
At Friday’s (August 5, 2011) closing price of $4.77, I don’t see much downside given my calculation of a $5.31 liquidation value. I believe there is a meaningful margin of safety in buying Newcastle at these prices. It seems like the commercial mortgage REIT stocks are not performing well in the current market sell-off. Hopefully, management will continue to add value by buying back the CDO notes at a discount to face value. With the low stock price, management could also increase shareholder value by repurchasing the stock at current levels.
Disclosure: Long NCT
Disclaimer: There is no guarantee that the stock price will rise to my estimate of liquidation value. The value of the company’s assets could reverse course and start declining in value. Management could execute another follow-on offering. There is also a large conflict of interest between management and common equity holders of Newcastle because Newcastle managed by a third-party who make more money if Newcastle is a larger company rather than a more profitable company. There are other reasons the stock may not perform. Please do your own analysis. Maybe this analysis could be a starting point for your own analysis.
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