Capital One’s ING Direct Acquisition Terms Are Attractive
Jun/110
After Thursday’s close, Capital One (COF) announced the acquisition of ING Direct and the terms are favorable for Capital One shareholders. Capital One will be paying tangible book value after the mark-to-market of ING Direct’s balance sheet. The deal will be accretive to tangible book value and earnings immediately. Capital One claims the IRR is greater than 20%. In addition to the financial benefits, the operational and strategic benefits for Capital One are:
- substantially reduces risk on liability side of Capital One’s balance sheet,
- reduces future acquisition risk,
- puts capital to work in a low risk manner,
- fixes a mistake Capital One made 8 years ago by allowing ING Direct to become the leader in direct banking, and 5) makes sense because Capital One is the logical acquirer for the national direct banking footprint of ING Direct.
Read the rest of this article on SeekingAlpha.com: Capital One’s ING Direct Acquisition Terms Are a Pleasant Surprise.
Newcastle Liquidation Analysis Updated for Q4
Mar/110
Here is an update to my liquidation analysis of Newcastle Investment Corp (NCT). On September 23rd (and updated on December 14th), I posted a liquidation analysis of Newcastle showing that if Newcastle sold all of its assets at the fair value listed in the securities filings and paid off its liabilities at par, how much cash would be left over for shareholders. This is conservative because it does not make sense to pay off the liabilities at par when their fair value is much lower.
| 2010 Q4 | 2010 Q3 | 2010 Q2 | 2010 Q1 | 2009 Q4 | |
| Recourse assets | $74.4 | $101.9 | $79.3 | $54.5 | $155.8 |
| Recourse liabilities | 59.5 | 56.3 | 55.8 | 77.9 | 183.6 |
| Net recourse assets | 14.9 | 45.6 | 23.5 | -23.4 | -27.8 |
| CDO note holdings | 348.5 | 80.0 | 25.7 | 1.5 | 1.0 |
| Borrowings from other NCT CDOs | 108.8 | 0.0 | 0.0 | 0.0 | 0.0 |
| MH deal equity | 71.2 | 65.8 | 64.6 | 63.6 | 26.0 |
| Preferred stock | 61.6 | 61.6 | 61.6 | 61.6 | 152.5 |
| Liquidation value | 264.2 | 129.9 | 52.2 | -19.9 | -153.3 |
| Shares outstanding | 62.0 | 62.0 | 62.0 | 53.6 | 52.8 |
| Liquidation value per share | $4.26 | $2.09 | $0.84 | -$0.37 | -$2.90 |
There is a new line item to the analysis this quarter, “Borrowings from other NCT CDOs”. NCT repurchased the entire senior tranche of CDO VI. The purchase was split up by different NCT entities. Some of this tranche was purchased by NCT outright for cash, some was purchased by other NCT CDOs, and some was purchased by NCT with financing. There were two sources of financing: a repurchase facility with Bank of America and borrowings from other NCT CDOs. These borrowings must be taken into account in the liquidation analysis.
There was a nice improvement during the 4rd quarter. The main sources of improvement were cash flows received from the CDOs, increases in fair values of assets held outside the CDOs, and more CDO notes held by NCT being “in-the-money”.
The other table from the September post was showing the value of CDO notes held by NCT in a liquidation. Here’s a similar table comparing Q4 to Q3 to Q2:
| CDO | Q2 Fair Value Collateral | Q2 NCT CDO Note Liquidation Value | Q3 Fair Value Collateral | Q3 NCT CDO Note Liquidation Value | Q4 Fair Value Collateral | Q4 NCT CDO Note Liquidation Value |
| IV | $290.3 | $1.6 | $290.9 | $1.6 | $274.3 | $11.6 |
| V | 275.0 | 0.0 | 267.7 | 0.0 | 266.8 | 0.0 |
| VI | 215.6 | 0.0 | 214.4 | 0.0 | 221.8 | 180.9 |
| VIII | 548.4 | 23.1 | 605.3 | 47.8 | 630.1 | 47.8 |
| IX | 512.0 | 0.9 | 560.8 | 30.6 | 590.1 | 108.3 |
| X | 963.2 | 0.0 | 1004.2 | 0.0 | 1049.0 | 0.0 |
| Liquidation Value to NCT | 25.7 | 80.0 | 348.5 |
During the 4th Quarter, NCT repurchased $316 million face value of their CDO notes for $190 million or just over 60% of face value. This produced an accounting gain during the quarter. Unlike in Q3, most of these notes look to be in-of-the-money notes. The largest purchase was the entire senior tranche of CDO VI. The other large increase during the quarter was the in CDO IX, which came from a combination of increases in collateral value and a repurchase of $50 million face value of the second-most senior tranche of the deal.
NCT’s stock price has appreciated 168% since my original post on September 23rd. I still own it for clients.
Disclaimer: Please do your own research before purchasing NCT. There is not enough information in this post to make an informed decision on the purchase of this security. My holdings may change at anytime without further update.
Disclosure: Long NCT.
Updated Newcastle Liquidation Analysis for Q3 Earnings
Dec/100
In response to a few reader requests, I am posting an update to my liquidation analysis of Newcastle Investment Corp (NCT). On September 23rd, I posted a liquidation analysis of Newcastle showing that if Newcastle sold all of its assets at the fair value listed in the securities filings and paid off its liabilities at par, how much cash would be left over for shareholders. This is conservative because it does not make sense to pay off the liabilities at par when their fair value is much lower.
| 2010 Q3 | 2010 Q2 | 2010 Q1 | 2009 Q4 | |
| Recourse assets | $101.9 | $79.3 | $54.5 | $155.8 |
| Recourse liabilities | 56.3 | 55.8 | 77.9 | 183.6 |
| Net recourse assets | 45.6 | 23.5 | -23.4 | -27.8 |
| CDO note holdings | 80.0 | 25.7 | 1.5 | 1.0 |
| MH deal equity | 65.8 | 64.6 | 63.6 | 26.0 |
| Preferred stock | 61.6 | 61.6 | 61.6 | 152.5 |
| Liquidation value | 129.9 | 52.2 | -19.9 | -153.3 |
| Shares outstanding | 62.0 | 62.0 | 53.6 | 52.8 |
| Liquidation value per share | $2.09 | $0.84 | -$0.37 | -$2.90 |
There was a nice improvement during the 3rd quarter. The main sources of improvement were cash flows received from the CDOs, increases in fair values of assets held outside the CDOs, and more CDO notes held by NCT being “in-the-money”.
The other table from the September post was showing the value of CDO notes held by NCT in a liquidation. Here’s a similar table comparing Q3 to Q2:
| CDO | Q2 Fair Value Collateral | Q2 NCT CDO Note Liquidation Value | Q3 Fair Value Collateral | Q3 NCT CDO Note Liquidation Value |
| IV | $290.3 | $1.6 | $290.9 | $1.6 |
| V | 275.0 | 0.0 | 267.7 | 0.0 |
| VI | 215.6 | 0.0 | 214.4 | 0.0 |
| VIII | 548.4 | 23.1 | 605.3 | 47.8 |
| IX | 512.0 | 0.9 | 560.8 | 30.6 |
| X | 963.2 | 0.0 | 1004.2 | 0.0 |
| Liquidation Value to NCT | 25.7 | 80.0 |
During Q3, NCT repurchased $48 million face value of their CDO notes for $1 million or just over 2% of face value. This produced an accounting gain during the quarter, but most of these notes look to be far out-of-the-money notes of CDO VI. For any of these notes to receive principal payments, the underlying collateral would have to appreciation 60% from the value at September 30. It seems unlikely, but it is impossible to tell without reading the trustee reports (which are not publicly available) to understand whether the collateral has the potential to appreciate 60%.
NCT’s stock price has appreciated 117% since my original post on September 23rd. I still own it for clients.
Disclaimer: Please do your own research before purchasing NCT. There is not enough information in this post to make an informed decision on the purchase of this security. My holdings may change at anytime without further update.
Disclosure: Long NCT.
FHFA implies Freddie Mac will be profitable in 2011
Nov/104
On October 21st, FHFA released projections showing a range of possible additional draws from the U.S. Treasury required by Fannie Mae and Freddie Mac. The report was interesting because it included projections about the companies’ future revenues, expenses and net income. Although the projections are not detailed by income statement line item, they do imply that Freddie Mac will be profitable in 2011 and Fannie Mae will be profitable in 2013 in the base case scenario.
How do you conclude Freddie Mac will be profitable in 2011?
In the FHFA’s projections, the regulator shows a chart projecting future draws from the Treasury for each company. Here’s Freddie’s chart:
By focusing on the base scenario (or Scenario 2 in the chart), we can see that the FHFA projects Freddie Mac to require a $10 billion draw from the Treasury in the 2nd half of 2010, a $3 billion draw from the Treasury in 2011 and no draws in 2012 and beyond. The draws included payments made back to the Treasury for the Zombie Dividends* on the Treasury’s senior preferred stock, which has the usury rate of 10%. The draws from the Treasury are equivalent to Net Income Available to Common Shareholders.
“Net Income” is more useful than “Net Income Available to Common Shareholders” in determining whether Freddie Mac is a viable entity because it is not obscured by the Zombie Dividends paid to the Treasury. I reviewed the reasons why the Treasury should reduce the dividend rate on its GSE senior preferred stock in previous articles.
| 2H10 | 2011 | 2012 | 2013 | |
| Previous cumulative draw from Treasury | -63 | -73 | -76 | -76 |
| Net Income | -7 | 4 | 7 | 7 |
| Treasury Zombie Dividends | -3 | -7 | -7 | -7 |
| Net Income available to Common Shareholders (i.e., current draw from Treasury) | -10 | -3 | 0 | 0 |
| Cumulative draw from Treasury | -73 | -76 | -76 | -76 |
Using the similar information for Fannie Mae, the FHFA implies that Fannie will turn profitable in 2013.
How can you say Freddie Mac will be profitable but still require draws from the Treasury?
I am most focused on whether Freddie Mac can report profits before dividend payments to the Treasury. I view the net income line item of Freddie Mac as the best indicator of the profit earning capability of the corporate entity. I view the senior preferred stock issued to the Treasury as an expensive form of capital that can be restructured if the underlying company is profitable. For example, if Freddie restructured the Treasury’s stake in a similar manner to the AIG restructuring, the Treasury’s senior preferred would be converted in common stock and the Zombie Dividends would be eliminated.
What happens if the scenarios in the FHFA’s projections are too optimistic?
If anything, Freddie’s results might be better than the base case scenario of these projections because the assumptions behind these projections are conservative. Here are the possible areas of conservatism:
1) Zero growth in credit guaranty business – Although growth in this business has been negative single digits for the past year, this will not always be the case. With the housing market weak, mortgage debt outstanding has been falling. Plus, the FHA has recently raised prices, so I would expect for more market share for the GSEs in the short-term. The private-label mortgage securities is years away from becoming a competitor again. Growth in this business will resume with the continued recovery in the housing market.
2) No additional retained portfolio business – Although this business is mandated to shrink, I believe this assumption is more aggressive than the mandated decline in the mortgage portfolio. The portfolio is the main way the GSEs are generating revenue right now. These revenues are offsetting the losses in the credit business. I think it is foolish to shrink this business since the FHFA itself has said most of the losses came from the credit business.
3) No recognition of Deferred Tax Asset value – Based on the limited information in the projections, it does not appear as though the GSEs are given credit for a revaluation of their deferred tax-asset once they demonstrate a return to sustained profitability. Recognizing this asset will create capital in the near-term to allow an accelerated payback to the Treasury.
4) 5% drop in ABX and CMBX – This assumption has already proven false since we know these markets have been strong since the June 30, 2009 start of the projections.
5) Regulator has incentive to be conservative – Government projections have been consistently conservative coming out of the financial crisis. No one at the FHFA has any desire to raise expectations and have to reverse course down the road.
Conclusion
Fannie and Freddie are not endless black holes of losses. The total loss is becoming clear with passage of time. Eventually, the Treasury may get paid back for its capital investment into the companies. Profitable companies with poor capital structures lead to restructuring opportunities.
The point of this article is there a potential restructuring opportunity in Freddie Mac’s capital structure because the corporate entity will turn profitable in 2011. The potential reform of Freddie Mac and Fannie Mae will be near impossible as liberals want a full nationalization of the companies and conservatives want complete privatization. Neither scenario is pragmatic. The clearest path is to do no damage to the housing market and modify the current form of Fannie and Freddie. This is the path of least resistance politically and the least risky option economically.
Possible options for modifying Fannie and Freddie are to improve their business practices: 1) prohibit low doc and no doc lending, 2) prohibit investment in private label mortgage securities, and 3) give the FHFA authority over both housing goals and safety and soundness with a priority on safety and soundness.
Disclaimer – Please do not buy the common stock because you read this article. I believe the common stock does not have much upside because 1) the Treasury owns an 80% warrant on both companies, 2) there is a potential for additional dilution through a preferred for common swap to restructure the Treasury’s senior preferred stock, and 3) one or both of the GSEs could be put through receivership and wipe out common shareholders entirely.
* – Zombie Dividends – I call the dividend payments on the Treasury’s senior preferred stock Zombie Dividends because Treasury Secretary Paulson wanted the GSE’s dead at the time he put them into Conservatorship. He forced them to pay a 10% dividend rate to the Treasury on its senior preferred stock investment. No other financial institution has had to actually pay to the government a 10% rate like the GSEs have. The commercial banks pay a 5% rate on the TARP preferred stock. AIG initially had to pay a 10% rate, but it was restructured into a non-cumulative preferred stock and AIG Board of Directors has chosen not to pay the dividend since early 2009.
Disclosure – long Freddie Mac preferred stock and Fannie Mae preferred stock
Citibank Should Have Split-Off Student Loan Corp with an Exchange Offer
Oct/100
This post is an excerpt from my 2010 3rd Quarter investor letter. If you would like to see the entire letter, please send me an email at derek.pilecki@gatorcapital.com.
In early August, I posted an article on the Internet arguing that Student Loan Corp was undervalued. I did not have to wait long as seven weeks later the company was sold to Discover Financial. The gain was 24%. I had purchased Student Loan because it appeared abnormally cheap for a profitable lending company. At the time of purchase, it was trading for 35% of tangible book value. Credit quality appeared manageable given that 75% of the loan portfolio was government guaranteed.
The question surrounding STU was: How desperate was its 80% owner, Citibank? Citi had stated that Student Loan was part of its CitiHoldings and therefore on the block to be sold. I thought the market was too pessimistic about how desperate Citi was to sell down its CitiHoldings assets. I thought Citi would not sell STU unless they received a price higher than the current stock price and potentially at least at book value. My thesis was that Citi could extract at least the current stock price from earnings and release of capital in as little as 10 quarters if they put STU into run-off. My model was the Primerica transaction earlier this year where Citi created a growth company from a slow growing life insurer by retaining most of the existing term life policies on its balance sheet and allowing the policies to run-off naturally. In the Primerica example, Citi showed that it was not desperate and structured a smart transaction that created value for its shareholders.
I was both right and wrong about Citi’s desperation. Citi did sell Student Loan for higher than the then current stock price, but they still sold it for only 45% of book value. The acquisition which will close in Q4 is a complex four-party deal between Student Loan, Citi, Discover and Sallie Mae. To make it simple, Citi essentially gave the government guaranteed student loan portfolio to Sallie Mae for little premium. Then, Citi gave Discover about $400 million, a perfectly good private student loan lending platform that had scarcity value and a portfolio of the recently originated, pristine-quality private student loans at par. Finally, Citi booked a $500 million loss and still kept all of the risk by retaining questionable quality 2006-07 vintage private student loans.
There was a better solution for Citi shareholders that could have still moved the assets off of Citi’s balance sheet without Citi retaining the same risk. Citi should have made STU an independent company. STU is too small relative to Citibank to spin-off the shares directly to Citi shareholders because a Citi shareholder would only receive 1 share for every 1,500 Citi shares held. Instead, Citi should have proposed an exchange offer where Citi shareholders could choose to swap 4.5 of their Citi shares for 1 share of STU owned by Citibank. This would have put STU into the hands of shareholders who made an active decision to own STU. This exchange transaction would have moved STU’s assets off of the CitiHoldings balance sheet and Citi shareholders would have benefitted from 72 million share reduction in Citi shares outstanding, but Citi would have still had a $6 billion loan outstanding to STU. After the exchange offer was completed and STU was independent, STU’s management and shareholders could have decided on the best way to pay off Citi’s loan to STU and create value for STU shareholders. Either they could have found another lender to take out Citi’s loans to the company and continued to originate new student loans, or they could have run-off STU’s loan portfolio and paid-off Citi from the natural pay-down of their loans. Either way, both STU’s and Citi’s shareholders would have been better off with an exchange transaction than they are with the deal to sell STU’s assets to Discover and Sallie Mae.
At the end of the day, Citi did not help its own shareholders with this transaction. They had an undervalued asset and gave it away to competitors, but Citi still kept all of the risk. They sold STU at such a cheap price in order to demonstrate that they are making progress in reducing the assets of CitiHoldings. However, this is a bill of goods because Citi kept all of the risky assets and gave away capital that could have covered the losses from those risky assets. I would argue that this transaction increased the risk at CitiHoldings. If regulators were awake and truly concerned about risk instead of asset size, they would stop Citi from consummating this transaction. Of course, it is deplorable that Citi’s management doesn’t recognize the poor economics of this transaction and stop the transaction themselves.
You Don’t Want Berkshire to Pay Dividends
May/090
This year Carol Loomis asked the question whether Berkshire should start paying dividends since the stock price hasn’t risen in 5 years. This was in reference to Buffett longstanding quote that he will pay a dividend when he thinks he can’t create at least $1 of market value for each $1 of retained earnings. Jeff Matthews refers to this as a question that Buffett avoided answering in this thought provoking blog post.
My opinion is who cares whether Buffett answered the dividend question. If you are even asking the question, you should sell your Berkshire stock. The reason to own Berkshire is to get access to Buffett’s capital allocation decisions. Based on his well-documented track record and his well-know thought process, most Berkshire investors think Buffett can make better investment decisions and/or has access to better investment opportunities than they do. The last thing Berkshire investors should want is to have Buffett return the cash back to them in a taxable transaction. Then, the investors will have to decide how to allocate the returned cash.
Historically, investors have wanted management teams to pay dividends because they don’t trust management to spend the free cash flow from the business wisely. The business may be not need capital reinvestment, like Coca-Cola, or it may be a business in secular decline where the best thing to do is harvest the cash rather than reinvest. Shareholders of these businesses probably want managements to pay dividends to make sure they don’t destroy value.
Since the main reason to own Berkshire is to get access to Buffett’s capital allocation skills, if an investor wants Berkshire to pay dividends, then they should sell the stock instead because they obviously don’t believe in Buffett’s ability to create value by allocating capital.
There is a scenario where it makes sense for an investor to want Berkshire to pay a dividend. Maybe an investor thinks Buffett destroys value but think Berkshire is so undervalued that they can make a return by owning the stock and getting him to change his dividend policy. I don’t think Berkshire is anywhere close to a valuation level where this would make sense. At $91,500 per share, Berkshire trades at 1.4x tangible book. It would have to trade below tangible book value for this strategy to make sense.
The reason to invest in Berkshire is get access to Buffett’s skills as a capital allocator. If you want him to pay a dividend, you shouldn’t own the stock. You should ignore the 5-year rolling test about whether he adds more $1 of value for each $1 of retained earnings. He is never going to pay a dividend because he’ll never admit that he can’t add value. If he ever does decide to pay a dividend, you won’t want to own Berkshire.
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