Monday, December 29, 2008

More M2M

Today's WSJ has another article about M2M that is confusing, to say the least.  The journal says that FASB is considering widening M2M to include loans.  Per the journal, "FASB taking a more holistic view of accounting for loans, bonds, derivatives and stocks."

Meanwhile, the blog WebCPA noted:
FASB decided to loosen rules that kept banks from accounting for the cash flows they expected from mortgage-backed securities and other assets during impairment tests when they are categorized as available for sale, rather than just as held to maturity.
Note the major disconnect -- The Journal is implying that held to maturity loans might be marked to market. Meanwhile, the FASB is actually modifying rules related to assets held for sale. Huge difference.

The only modification I would propose is to revise the way that credit derivatives indices are used to value structured investments like CDO's. Plus a complete review of the use of credit derivatives as market proxies.  As far as the Journal's views regarding "fair value" -- it is safe to say that the world is converging on standards, and US GAAP can't let the IASB be the only body working on this issue.

Thursday, December 25, 2008

Accrued Interest Takes on M2M

 Mark-to-Market: Discussion minus the Zealotry is an attempt to get at a reasonable approach to M2M. AI brings up a number of points. Obviously, a lot of examples are didactic and don't reflect anything that is being done now.

Example 2:
Let's say that we have two firms, both have made loans to XYZ Retailer. But one is a bank which has made a traditional loan, and the other is a brokerage which holds a private placement bond. The broker almost certainly has to mark that loan to market, but the bank may not.
And in both cases, the rapid changing liquidity premium in the market place alters the "mark" for this asset. By this I mean, say the retailer is performing reasonably well, and thus the risk of non-payment remains remote. Given the weak economy, its obvious that the risk has increased by some degree, but given the extremely weak liquidity across fixed income products, the larger portion of the assets price decline would reflect liquidity. If the firms don't intend to trade the loan, is the changing liquidity premium relevant?
This is a problem where similar assets are booked at different prices. Here I would note that the bank would typically book the loan as a loan (intended to be held to maturity) rather then "loans held for sale." However, the brokerage's core business is trading and not originating and holding loans or similar assets to maturity. The bank is required to hold an "allowance for loan losses" on its balance sheet, which is an estimate. The broker's private placement bond doesn't trade, so credit derivatives would likely be an input into valuation. Note that there really isn't a direct market price for this asset. You have dueling models, one based on a bank's historical losses, judgment, and bank specific accounting guidance and the broker using a pricing model with the "observable" input being a credit derivative. As AI has noted, the bond price may include a liquidity premium which is clearly inappropriate for an institution that doesn't need or want liquidity -- the bank is simply going to hold and amortize the loan to maturity. If the broker really intends to sell the bond, then it should book to an estimate of today's market price. If the broker intends to keep the bond until maturity, then it has an issue, but not with accounting. From my perspective, you can have two different prices for a similar asset in this situation without a major problem. There might be "financial reporting" arbitrage opportunities. However, no one ever claimed that accounting should adopt modern portfolio theory.

Example 3:
There are other problems. Say you are a bank that has a private loan to a company with traded CDS contracts. Your best mark-to-market estimate would be to price the loan based on the cost of hedging out the credit risk. But in many cases, the CDS and cash bond markets have decoupled. Many bonds are trading a drastically wider levels than the CDS market, owing in part to easier funding of CDS. Take Amgen, where cash bonds are trading at a LIBOR spread of nearly 300bps, but the CDS are around 90bps. On a 10-year loan, that implies a valuation differential of about 15 points!

So here again, we have a situation where two firms can use "market" prices to price non-marketable assets, and come up with wildly different valuations. We hear mark-to-market and assume that the "market" is some kind of observable thing. But that is just not the case.
In this case, if the bank holds it as a loan, m2m doesn't come into play, so it is a moot point.   It looks like the CDS market is "broken" in that it doesn't model reality very well.  A synthetic bond would yield less then a natural bond.  That would imply an arbitrage situation where a firm would sell the synthetic bond or CDS contract and buy the underlying.  That is, if markets worked.  Which raises the point of why one would consider a "broken" market -- one that violates the arbitrage free assumption -- as a better representation of reality then other estimates. 
The idea of taking a real, natural loan and goofing around with a pricing model using credit derivatives seems silly.  The firm that owns bonds has to deal with the fluctuation in market price as part of the luxury of owning an asset with a real market price.  The bond is a true level 1 asset and has always and will always be booked at the market price.  This isn't m2m -- it's just accounting.  No one has ever asserted that securities that are traded on an exchange or in a relatively liquid market *not* be marked to market to my knowledge.  Here we would have the loan booked at $X (say par), a theoretical pricing model using CDS's that may value the loan at $X + something (but is never used), a real bond selling for a discount in a bona fide market, selling for $Y (say a lot less then par), and a synthetic bond (cash + CDS) that could be purchased for $Z (more then par).  In this case it is simple -- ignore credit derivatives.  I would like anyone to find examples where a company complained about booking real bonds at market prices.  This isn't M2M, it is vanilla GAAP that has been around forever.  

AI Concludes:
But what's the alternative? Those that are calling for an end to mark-to-market are out of their mind. First of all, there is no clear alternative. Second, we have enough trouble trusting firms' balance sheets as it is. Imagine if mark-to-market were suddenly suspended!
It's very important to note that booking listed stocks and bonds is vanilla GAAP and has nothing to do with m2m, FAS 133, and FAS 157.  No one wants to change this aspect of accounting.  Until we can find this straw man, people need to cool their jets.

However, most critics of m2m are people that, say, hold commercial real estate CDO's and don't want to book them at a huge haircut because of a credit derivative index.  They tend to have a legitimate beef, since there is a basis differences between their security and the index.  There are, once again, dueling models and arguing that credit derivative indices are a market is a stretch.  It is one input into a level 2 or level 3 pricing model.  To my knowledge, they don't want to book these at par.  They have their own models and they don't want to be forced to use credit index based models which may be worse then alternative models.  There is a problem in that these critics always want to book higher asset values, and in a declining market, are usually wrong.  At this point in the cycle.  


Wednesday, December 24, 2008

Mark-To-Market Liabilities - Citibank

From Citi's 10Q:

This is impossible to read without double clicking the schedule.  So here is the line, and it was $1.3 billion at 12/2007 and $2.2 billion at 9/2008, for 9/2008.
This may or may not be all there is. However, these particular fair value marks aren't counted in Tier 1 Capital. This schedule breaks out the components of Tier 1 Capital and therefore has the figure I'm looking for. Or something close to it.

I like the way the line reads -- attribtable to own (lack of) credit worthiness.  I also don't know exactly how one values one's debts to "market".  Does one simply look it up as a traded bond?  Or is this simply a haircut based on credit spreads from credit derivatives.  One could even imagine a bond selling for more then par -- what to do then?  

It isn't unreasonable for a firm that has assets like bonds issued by other banks that just got a haircut to want the same treatment for its own debt.  It's never that simple and the bond assets might be supported by deposits and the debt stands on its own  -- so they couldn't simply sell the asset to buy the debt in the open market.  In fact, if they had the cash to redeem the debt, it would probably be at par or par plus call provisions.  Really bad companies can do tenders on their own debt for, say 60%.  Like Level 3's recent tender.  

This is just an interim piece while I figure things out.  This is the best I could do in an hour, although I suppose I could have copied a lot of quotes on fair value.

One thing I will say is that this isn't something that Citi seems to want to make easy to understand and find.   Actually, there is a HUGE amount of information in these statements.  I wonder if management, outside of the financial reporting guys, actually read this stuff.    

Financial Buzz Words of the Year - Clawback

Last year, my favorite was tranche.  
The word tranche is French for slice, section, series, or portion. In the financial sense of the word, each bond is a different slice of the deal's risk.
The very notion of taking something that makes (at least a little) sense as a whole -- like a pool of assets, and then slicing them in complex ways that give the slices significantly different characteristics is suggestive of a general approach to life.  Tranches of love?  Very Post Modern.

The New York Times has a number of candidates in their annual article. I like the word malus (opposite of bonus), fail (as a noun, like a bucket of fail), TBTF ( too big to fail), and recessionista (Originally, someone who favored a recession as ultimately good for the economy.).

The fact that they all need explanations does not particularly recommend them. My vote would be for malus. It turns out that malus has been used in experience rating of personal lines insurance, but not primarily in the United States. Here everyone gets a discount or bonus and a malus would just be called a standard rate or price.

I'm going for something more/better then a simple malus. A clawback. Per investopedia, a clawback is an: .
...obligation represents the general partner’s promise that, over the life of the fund, the managers will not receive a greater share of the fund’s distributions than they bargained for. Generally, this means that the general partner may not keep distributions representing more than a specified percentage (e.g., 20%) of the fund’s cumulative profits, if any. When triggered, the clawback will require that the general partner return to the fund’s limited partners an amount equal to what is determined to be "excess" distributions.
The term clawback captures the mood of the public. They want accountability. They not only want to slash bonuses, but also to recapture the excess and unwarranted bonuses of yesteryear. And further, they don't just want them back -- they want them CLAWED back, which in the best case would include actual blood.

Like something from Kafka's Penal Colony.
"In the Penal Colony" is a story about the last use of an elaborate torture and execution device that carves the sentence of the man on his skin in a script before letting him die, all in the course of twelve hours. As the plot unfolds, the reader learns more and more about the machine, including its origin, and original justification.
I think this just about sums up the mood of the country.

Ultra Smart or Ultra Dumb?

2008 is the year of the ultra shorts. There is a good article by Eric Oberg in The Street.Com regarding friction and other issues with the ultra ETF's.

I won't repeat any of his observations, but note that the winning strategy is to go short the ultra long and vice versa. Or at least that would have been a winner last year.

Of course, that lets the little guy out who can't borrow shares or is doing it in his IRA. I like the sound of it, also -- Short the Ultra Short to go long and Short the Ultra Long to go short. Would have been a huge improvement over buying and holding these over the course of a year.

A better idea for amateurs would be to avoid leverage.

Sunday, December 21, 2008

Financial Blogs of the Year

1.  Calculated Risk

MTM - More to Come

I noticed that there are several important, but distinct aspects to the prior post:

1.  The facts that the logic of mark to market requires liabilities be handled the same as assets.  This conflicts with most people's understanding of mtm, since it is inherently less conservative then current GAAP.  Further, they don't believe it is logical, or they don't believe it is being done.  The fact that it is being done right now would be useful to further document and highlight.  

2.  The background of mtm and its cousin, fair value accounting, is rooted in derivative accounting.  People always want better accounting and also prefer conservative accounting to lax accounting standards.  However, they also tend to not be big fans of derivatives.  Unfortunately, mtm has been associated with writedowns which are more conservative -- all else being equal.  There is a sense in which people view mtm as conservative which is good, and therefore want to see more of it.  Also embedded in this view is a sense that markets are inherently efficient, liquid, and deep.  They are the best of all possible worlds regarding price discovery, etc. 

The truth is that mtm is Derivative Accounting, at its core.  People aren't big fans of leverage, and credit derivatives are particular unpopular among a lot of people. 

 A lot of people correctly associate derivatives with leverage and speculation.  The idea that accounting that was designed for derivatives should be a core principal of all accounting doesn't sound quite so benign.  Yet that's were we are heading with Basal II, etc.   

3.  The case against credit derivatives is much less clear cut then the above.  I don't like them in their current form.  Its too late to put the toothpaste back into the tube, but tight regulations regarding transparency is a minimum.  The more paranoid arguments against CDS's may be true, but aren't necessary to suggest significant reform.  In fact, regardless of the truth, speculation regarding organized efforts to short stocks detracts from the strong case that can be made for significant reform simply on its merits.

As a goal, I would like to substitute "Derivative Accounting" for "Mark to Market" and the various "fair value" proposals to be labeled as efforts to reduce capital requirements.  

Of course, this isn't uniformly the case, but the general thrust of Basal I and II and fair value reforms has been to put all financial entities on an equal footing.  Fair enough, but more then a little of it is a race to the bottom, with banks and insurance companies that are forced to comply with legacy, rule of thumb capital requirements believe they are inefficient and put their firms at a disadvantage.  Since there is little chance to regulate the competition, then their best strategy has been to level the playing field, which amounts to a race to the bottom.


Friday, December 19, 2008



Mark to market applies to both assets and liabilities. That is, in the "fair value" world of Basel, it isn't only assets that get a haircut. Liabilities also. What does this mean? If your debt is downgraded, then it has a lower market value and ergo, you have a windfall profit.

This isn't allowed in vanilla GAAP, which assumes a going concern will pay off its debt at par or no longer be a going concern. The default option has no value for the GAAP Luddites. A lot of people aren't going to believe this or take this at face value. So here is a real world example discussed in the blog, The Treasurer:
Barclays Capital has reported losses on credit market exposures of £2,831m but has then set against this gains on its own debt securities of £852m. In other words changes in market yields of its own securities have caused the mark to market valuation of its own liabilities to fall creating a windfall gain.
It isn't only the Brits that are doing this, per Bloomberg:

Merrill Lynch & Co., Citigroup Inc. and four other U.S. financial companies have used an accounting rule adopted last year to book almost $12 billion of revenue after a decline in prices of their own bonds. The rule, intended to expand the ``mark-to- market'' accounting that banks use to record profits or losses on trading assets, allows them to report gains when market prices for their liabilities fall.

Let's say you run a vanilla derivatives business, selling listed puts and calls on exchange traded stocks. Like the stuff retail investors buy. And lets say that's all you do -- no real world businesses confusing things. Then you want to know your net exposure at today's market value at the end of every day. So far everyone is on board, I assume.

Here is where I think we started getting lost. The various FAS regulations (133 and 157) refer to accounting for derivatives. Some people like the sound of "mark to market" since they think it isn't "mark to fantasy." The rub is that you have to actually have a market that works. It has to be relatively efficient, liquid and deep. Wanting to "mark to market" doesn't magically create a market. Further, and perhaps most important, do we really want to use accounting set up for the derivatives business to represent best practice? I would like to see a lot of the derivative business disappear along with the financial engineering that contributed to the current train wreck.
In the real world, we got into disputes when credit derivatives prices (or alleged prices) were used in asset valuations and the results were very unpleasant. People realized that a firm could go into a downward spiral based on thin, illiquid credit derivative market quotes -- especially when combined with credit rating agencies gone wild with new found zeal. There is more then one variation of this playbook that has been used to grind a firm's stock price to pennies in a few hours. As soon as people figured out that financial firm's financial position was based on their credit rating (collateral), which was connected to their stock price (ability to raise capital), which was tightly linked to CDS spreads -- then a stressed financial firm found it could evaporate in a matter of hours.

Some people were wondering WTF. How could XYZ be AA at 8 a.m. and fail the next day. When they saw the carnage and connected the dots, it seemed to point to the credit derivative Netherworld.

But this is the really galling part of the story.   After throwing XYZ under the bus and making handsome profits shorting XYZ's demise, the former long stock holders got a lecture about how credit derivatives are some higher form of truth. And anyone that didn't want the entire business world to be run like a derivative shop was some sort of liar.  

And then, given the buzzword of the year, every commenter on every blog gets into a moralistic rant about arcane accounting concepts. Stuff they couldn't even began to understand. I'm not claiming to be an expert here, either. This is genuinely complicated. MTM isn't motherhood and apple pie. Just boring regulations regarding how to account for derivatives.

The point of this post is that most people know a lot less then they think they know about this.  The accounting concepts have implications that are counter intuitive - like firms benefitting from a credit downgrade (but only investment banks).  There are also other counter intuitive aspects associated with m-t-m, but they will have to wait for another post. 

Thursday, December 18, 2008

Quantitative Easing?

The statement from the FOMC meeting included the following:
The focus of the Committee's policy going forward will be to support the functioning of financial markets and stimulate the economy through open market operations and other measures that sustain the size of the Federal Reserve's balance sheet at a high level. As previously announced, over the next few quarters the Federal Reserve will purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets, and it stands ready to expand its purchases of agency debt and mortgage-backed securities as conditions warrant. The Committee is also evaluating the potential benefits of purchasing longer-term Treasury securities. Early next year, the Federal Reserve will also implement the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses. The Federal Reserve will continue to consider ways of using its balance sheet to further support credit markets and economic activity.
Let's see if I get this. The spreads between treasuries and other debt are too high -- an effect of the flight from risk. So I can see buying agency debt and mortgage backed assets to increase demand, raise prices, and lower yields. This would help borrowers or potential borrowers.   But the treasury buying longer-term treasuries is going to accomplish exactly what?  Flatten the yield curve and reduce the costs longer term debt?  If the 30 year is at 3%, what more could be accomplished?  I don't get it.

However, an attempt to front run any Fed activity could result in investors driving down the price of treasuries.  This may be the problem with the "obvious" but obviously wrong strategy of shorting long term treasuries, like TBT.

They used to say,  "Never pick a fight with people that buy ink by the barrel".  Perhaps one shouldn't short the favored instruments of an agency that buys its ink by the barrel, prints money, and can change the rules mid game.  Something to ponder.

Financial Execs to Eat Their Own Cooking

No reason to do the "me too" posts, but this is too perfect.  
Credit Suisse Group AG’s investment bank has found a new way to reduce the risk of losses from about $5 billion of its most illiquid loans and bonds: using them to pay employees’ year-end bonuses.

The bank will use leveraged loans and commercial mortgage- backed debt, some of the securities blamed for generating the worst financial crisis since the Great Depression, to fund executive compensation packages, people familiar with the matter said.

These are the same individuals that signed off on the deals, and gave all the pitches about how it "isn't that bad," etc. Plus, any decent compensation plan has all sorts of deferrals and "golden handcuffs" -- so where better to dump some illiquid assets?

The creativity of capitalism never ceases to amaze.

Buy the Debt, Sell the Stock

Per the AP, again:
The company now expects to earn between $2.90 and $3.30 per share for the year. A company spokesman said the prediction includes the impact of the recent sale of a portion of its nuclear business. Constellation Energy Group agreed on Wednesday to sell half of its nuclear-power business to Electricite de France SA for $4.5 billion, scuttling a deal struck in September with Warren Buffett's MidAmerican Energy Holdings Co.

Constellation also said it may cut its dividend by 50 to 60 percent to improve cash flow and pay down debt. It last paid a dividend of 47.75 cents in October.
At this point I don't see the advantage of owning the stock @ 24 yielding a little over 3% when you could own the bond, cegpra @ $19, yielding 11%.   They would have to increase their dividend 20% a year for 5 years to get back to the 47.75 cents.  Meanwhile, their new sense of stewardship which is motivating them to pay down debt can only help the bond rating.  If by some chance they got the firm up to investment grade, it would be a windfall for the preferred.  If things don't work out as well, the debt is senior to the stock and we know someone would buy the other 1/2 of the nuclear plants.


Another New Low for the 10 Year Treasury

Per the AP:

The benchmark 10-year Treasury note's price, which moves inversely to its yield, rose more than one full point, pushing down the yield briefly to 2.04 percent , the lowest level since the early 1950s.

Is it time to go short?  Say PST, Lehman Ultra Short 7-10 Year Treasuries.

This is too obvious to work.  Plus the 10 year has been hitting records all month.  

Conference Call

Which I didn't bother to listen to.  Here is a link to their pitch slide. 

Everything sounded great except the dividend reduction of 50 to 60%.

With 200mm shares, the current dividend is about $380 million.  They offered guidance of $2.90 to $3.30.  Plus 6% to 8% compound growth for 5 years. 

And they want to cut the dividend of $380 million in half or more?  I suppose some dividend reduction is "prudent", etc.  Still, this is a utility and a lot of people own it for the dividend.

No wonder the stock price got killed.  Management needs to think its commitment to putting some cash in shareholder wallets.  People don't really want to wait 5 years for management to earn back the money they blew because of negligence.  How about a bonus moratorium or some sense of contrition regarding exactly how awfully they blew it.

They could think really hard before they do this.  Or not.

Wednesday, December 17, 2008

CEG Downgraded by Moody's to Baa3

Moody's cut CEG's credit rating this morning:
Moody's Investors Service on Wednesday lowered Constellation Energy Group's senior unsecured rating to Baa3 from Baa2 and kept Constellation's ratings under review for possible downgrade. The move follows an earlier announcement that Constellation and MidAmerican Energy Holdings have decided to terminate their proposed merger agreement. Constellation also said it reached a deal to sell a 49.99% interest to Électricite de France. "The rating downgrade incorporates the risks associated with CEG's decision to continue the restructuring of its sizable commodities business as a standalone entity, a near-term liquidity profile that appears weak in light of current volatile market conditions and the ramifications of the sale of a minority interest in its crown jewel assets" said Scott Solomon, Moody's vice president.
Baa is investment grade, but this year, CEG has slipped from Baa1 to Baa3.   The crisis that led to the Mid American offer was due to the implication of a credit rating cut to margin requirements for energy derivative positions.  From the SEC filing:
The actual amount of collateral that Constellation Energy would be required to post in the event of a multi-notch downgrade fluctuates based on market conditions and contractual obligations at the time of a downgrade. Management also announced an intention to sell the company’s upstream gas business and to sell or recapitalize its international coal and freight intermediation business, all as part of a broad effort to reduce the capital demands and perceived volatility of a portion of the company’s commodities business by reducing exposure to commodities counterparties, releasing a significant portion of posted collateral and monetizing certain derivative positions. Management took these actions after determining in early August that the amount of additional collateral Constellation Energy could be required to post in the event of a downgrade of its credit ratings was greater than previously estimated. On August 11, 2008, in its second quarter 2008 Form 10-Q, Constellation Energy reported the revised estimates of such potential additional collateral posting requirements as of March 31, 2008 at $129 million for a one-level downgrade, $844 million for a two-level downgrade and $3.23 billion for a three-level downgrade. The Form 10-Q also reported that as of June 30, 2008, these amounts were $386 million, $1.37 billion and $4.57 billion, respectively, and as of July 31, 2008, the amounts were $106 million, $681 million and $3.37 billion, respectively.
The "multi notch" downgrade was 2 notches or from Baa1 to Baa3. This is the exact downgrade that occurred today.  Per the 3rd quarter 10-Q, the results of a rating downgrade were: 1 level to Baa3 - $171 million  2 levels to Ba1 - $2.2 billion.  However, the report later stated:
The estimated collateral obligation amounts above have declined compared to those reported in our quarterly report on Form 10-Q for the quarter ended June 30, 2008. This decrease is due to changes in open positions, price movements, and posting of additional collateral requirements resulting from our credit ratings being downgraded in the third quarter of 2008. As of October 31, 2008, incremental downgrade collateral postings for a one level and two level downgrade have changed to $178 million and $1,865 million, respectively.
It's hard to say where they would be a month and a half later regarding their reduction of this exposure, but with any sort of prudent management and the decline in energy prices, one would hope that the amounts would be materially reduced.  From June 30 to October 31, the exposure from a downgrade to to Baa decreased from $4.57 billion to $1.87 billion.  

CEG is in a position where it needs to be able to fund a downgrade to "junk" in order for it to maintain its investment grade rating.  Not particularly unusual in the credit world where the criteria for a rating is the absence of the possible need for cash, and vice versa.  

The CEG energy traders had another month and a half to reduce their exposures, and have the Buffett billion (at the rate of 14%), an immediate infusion of $1 billion from EDF of $1 billion, and the proceeds of the asset sale of an additional $3.5 billion, less whatever they intend to repay.  

Moody's has no upside in optimism.  However, it is not at all unreasonable to think that any and all issues regarding collateral calls from energy trading are either solved or being solved.  Otherwise the board would have been highly imprudent in recommending the EDF proposal in an environment where all attention is being focused on that particular issue.  

A ratings upgrade to Baa1 wouldn't seem out of the question -- offering significant upside to the class A preferreds as well as the common stock.   

CEG - D Day

Interesting day. Trading halted, the company announced that it was terminating the MAE deal and doing the EDF deal. The stock responded by flirting with 30 and then falling to 23. It's obvious that anyone hanging around for an auction of the company needed to move on and the remaining arbs went home, leaving little liquidity for sellers. 

I don't think the negative market reaction tells us much more then people don't like uncertainty if it doesn't have a cap on the downside. This leaves us with the question, what is the company worth? I don't see the stock doing anything until people regain some confidence that the problems from September have been dealt with in a systematic way. CEG laid out a plan, but people want to see execution.

At the point where CEG can demonstrate some solidity, then it deserves a valuation that more closely reflects the value of its businesses.

I discussed CEG valuation in an earlier post. I even included a spreadsheet for your enjoyment. I had laid out EDF's proposal in another post.

The detailed EDF valuation would be my starting post to get a more in depth view of CEG's value.

Meanwhile, for those that are looking for value in fixed income, the preferred A shares are now yielding 12%, since the .08625 preferred is selling for $18/share ($25 par).

If the company can regain its footing with the $4.5 billion asset sale, today's preferred yield of 12% and the common yield of 7% are generous compared to peers. Personally I think buyers at these prices and better will do well, but it may take longer then anyone wants to wait.

Tuesday, December 16, 2008

Book of the Year

False Security: The Betrayal of the American Investor by By Bernard J. Reis New York, Equinox Cooperative Press Inc., 1937

People have a general sense of our current economic situation as parallel to that of the 1930's, in the sense that we are suffering from the unwinding of a credit cycle, speculative excesses of the recent past, etc.  The interesting part isn't so much the unwinding of excess.  We all know how that story goes.  The more fascinating part are the details regarding buildup of those excesses.  

Reis lays out an easy to read, systematic indictment of investment excesses during the 1920's, and more distressingly, the details of their failure.  The general sense is fat bankers tossing widows and orphans out of the Titanic's lifeboats.  

It is also surprising to see the popularity of mortgage backed securities in the 1920's, and their inevitable failure.  The current monoline insurers are direct descendants and have proven surprisingly robust in part based on reform to prevent the excesses of the 1920's.  Even though they are ruined, MBIA, for example, is still around and still has cash and is still paying claims.  I won't bother to argue that they will survive or that their claimants will be made whole -- just that they have proven remarkably robust.

The general themes:

1.  Corporate managers self dealing.
2.  Insured Mortgage backed bonds.
3.  Foreign Bonds (ala today's emerging markets)
4.  Investment Trusts
5.  Failure of Directors, Trustees, etc.
6.  Failure of Bankruptcy and Reorganization to protect investors.

These are all illustrated with detailed examples of the failure to protect individual investors.

I found the popularity of real estate speculation and securitization of mortgages to be the most surprising parallel to today.  The financial engineers of the 1920's weren't using arcane financial theory to create instruments of Byzantine complexity.  However, they were relying on the basic techniques of slicing up cash flows to appeal to new customers and to relying on the prestige of traditionally sound firms to obtain the confidence needed to sell these new products.

There is no one alive with direct experience as an adult in dealing with the excess/reform cycle of the 1920's - 1930's.   However, the artifacts remaining from the reform phase -- primarily financial regulation, is surprisingly intact.  It has suffered over the last decade plus, but is surprisingly resistant to change.  Most of today's excesses were enabled by simply going around or "disintermediating" the regulated institutions. 

This book provides a vivid and concrete view of the events that motivated New Deal financial regulatory reform.  In that sense, it fills the void formed by the inevitable loss of institutional experience over time.  

The overall sense is an eerie sense of familiarity with the practices of that time period.  And a strong belief that no one that had lived through this earlier era would have gone within a mile of a multi sector CDO.      

Even better, an extended preview is available on Google Book.  It is also available at libraries -- so it fits in perfectly with the new frugality.  You can find it here using Worldcat.
From the introduction:

This is in the neighborhood of 15% of GDP in 1930, which would be equivalent to $2 trillion today.  In those days a millionaire was rich and a billion was a lot of money.    

An interesting aside is that Bernard Reis was an Accountant and and art collector and the executor of Mark Rothko's estate.  

Was Letting Lehman Fail a Mistake?

There are a couple of blog posts today regarding this issue.  The Deal argues that it wasn't, for a number of reasons.

I would suggest that letting the banking/financial system collapse is a mistake, and that Lehman was too interconnected to fail.  However, prior to the failure of Lehman, there was no consensus regarding when and how to intervene.  Paulson and Bernake intervened in BSC and wiped out the stock holders but saved the debt and counter parties.  They intervened in the GSE's and saved the debt, but blew up the equity and preferred shareholders (which had the knock on effect of evaporating a lot of bank capital).  

All the while, there were huge arguments regarding moral hazard, free markets, the beneficial effects of failure, etc.  There was no political consensus to save the financial system from collapse.  There was a lot of denial and enough ideology being tossed around to choke a horse.  The quasi religious belief in markets was hanging tough.  

In fact, we needed a bright line -- a watershed event that would demonstrate the need for massive intervention.  Any intervention that worked had the disadvantage of failing to prove it was needed.  One could always argue that Bear Stearns would have worked out just fine if we had just let the markets deal with its failure.  Ditto for the GSE's, Countrywide, etc.  

We had to have evidence of sufficient urgency and severity in the financial system's problems.  Something had to fail with severe consequences --  or else the argument that subsidizing/rewarding  failure is always a mistake could not be addressed with anything but theoretical arguments.

In a sense, Lehman was perfect, since it was big enough and interconnected enough that its failure was costly.  But not fatal.    After Lehman, McCain could no longer say the economy is fundamentally healthy.  No politician could argue that the only thing the economy needs is less government -- at least in a serious manner.  

Something spectacular needed to happen to provide the basis for supporting a bailout.  People needed their "come to Jesus" moment.  And they got it.

Killing a canary wasn't enough, but you didn't want to blow up the system.  Enough of a taste of the "creative destruction" of capitalism to make the prospects of a painful cure seem better then letting the disease run its course.  

So, it wasn't a mistake.  Maybe not optimal, but letting AIG or C fail would have been much, much worse.  Ideally one would want enough intervention to allow an orderly unwind of excesses.  But to develop political support, especially in the face of strong ideologically motivated opponents, required a shock.  That was Lehman. 


All the news:

3.  Options expire Friday the 19th.
4.  The Meeting is Tuesday, Dec 23.

I tend to think that Buffett walks on this one.  The CEG board needs to make a solid deal with EDF and make it quickly.

What to do?  The company should be worth $35/share, minimum,  after the breakup costs.  However, the Buffett offer of $26.50 will no longer provide a floor.  There will be no bidding war.  Among other reasons, they really aren't competing offers.  Buffett wants to buy the company and considers it a "bolt on" acquisition for MEC.  He isn't interested in investing a lot of capital in Nuclear energy.  EDF only cares about Nuclear Power and doesn't seem to be interested in owning a utility.  

Management wants to keep their jobs.  

No one else has the capital and interest to make another bid for the entire company.



AIG Is Doing What it Said

As the only blogger that is remotely sympathetic to AIG, based on today's announcement, they have completed most of what they said they were going to do 3 weeks ago. They have taken huge losses on mortgage related assets over the last 4 quarters and moved the assets to government credit facilities. The writedowns give the government a decent chance of coming out whole or somewhat better.
In summary, AIG had two big mortgage related problems, that were only distantly related.  In their life insurance unit, they lent securities and invested the money in mortgage related securities.  They borrowed $19.8 billion for this credit facility to buy $39.8 billion face value mortgage related securities.  In total, the government put up $49.8 billion to buy mortgage related securities with a face value of $111 billion.  AIG is now done and won't have to deal with additional write offs on these securities.  

Based on their November presentation, the total new bail out consists of the following:

The credit facilities that have a shot at profitability.
$40 billion in preferred stock.
$60 billion loan.
Support for commercial paper program not unique to AIG.

As of November, a big chunk of the $60 billion loan hadn't been drawn.

The way I would think of this is that the insurance businesses are worth more then book value if the balance sheets have been cleaned up.  As soon as a business is sold, the sale generates cash AND it means that the remaining businesses need less capital.  So I'm thinking the government has a decent shot at coming out even or better.  

Monday, December 15, 2008

CEG After Hours - WOW

The Stock closes @ $27.30. 50,000 shares trade @ $26.80.  Thats $25k below the close for that trade.  Then this announcement from Bloomberg.  The stock moves up to $29.  I've taken a 50 cent beat down any number of times, so I don't feel too bad for Mr. 50k shares.  

That's the after market for you.  Wonder who dumped the 50k shares?

AiG Issues Press Release -- No Headlines

AIG did a pretty good job of explaining the situation, but it already seems like a year ago, and there are more exciting items to blog. Now it is how AIG get zillions while the UAW gets shafted. A quickie to try to explain the AIG Bailout.  This is from an AIG slide as part of the Nov 20 presentation on the revised "deal."  

What is really going on is that AIG had already taken writedowns in the $30 billion range on these CDS's. They had also posted collateral in the $30's. The way it was designed to work is that the $70 billion in blue is the nominal amount (par) of the CDS's.  About 1/2 of that had already been booked as losses.  A similar amount had already been posted as collateral.  The problem is that every quarter, there was a lot of hand wringing about how much more should be written down to "market" that, of course, wasn't functioning.  A theoretical solution would be to write them down to zero, but AIG doesn't $30-$40 billion to take an immediate hit.  So each quarter, another 5%, 10%, or 15% would be written down.  AIG might have wanted to just settle up or buy their way out of this exposure, but there was no one with the capital, regardless of value.  AIG insisted things weren't that bad, but had and have little credibility on this issue.

The  credit facility I keep referring to as a SIV is known by the name Maiden Lane III.  Per the National Underwriter:
Maiden Lane III L.L.C., New York, a Delaware limited liability company controlled by the Federal Reserve Bank of New York, has started to buy “multi-sector collateralized debt obligations” that AIG’s AIG Financial Products Corp unit guaranteed with CDS arrangements back when the economy was stronger, according to AIG, New York.
The New York Fed and AIG announced the creation of the $35 billion Maiden Lane III CDS program shutdown entity in November, in connection with New York Fed efforts to replace a 2-year, $85 billion New York Fed credit facility.
Here is a table of the multi sector CDO's from the 3Q 10K:
Since there is no way you can read it as is, you can click on it to view it in full size. This lays out the numbers in a much more understandable way. However, column 3 shows the Net Notional Amount of $71,644,000,000. Column 4 is the "fair value" of the derivative of $30,207,000,000 as of September, 2008 financial statements. That means that AIG had already booked losses of $30.207 billion as of September -- that is, written that portion off.

Per AIG:
Included within that $71.6 billion portfolio (notional amount as of September 30) is approximately $9.8 billion of swaps that were sold as credit protection on "synthetic" securities. The swaps on these synthetic securities are also referred to as "cash settlement" or "Pay As You Go" (PAUG) swaps because they are settled in cash as and when losses are taken.
Here is what AIG says about it in September:

"Cash Settlement. Transactions requiring cash settlement (also known as “pay as you go”) are in respect of protected baskets of reference credits (which may also include single name CDSs in addition to securities and loans) rather than a single reference obligation as in the case of the physically-settled transactions described above. Under these credit default swaps:

• Each time a “triggering event” occurs a “loss amount” is calculated. A triggering event is generally a failure by the relevant obligor to pay principal of or, in some cases, interest on one of the reference credits in the underlying protected basket. Triggering events may also include bankruptcy of reference credits, write-downs or postponements with respect to interest or to the principal amount of a reference credit payable at maturity. The determination of the loss amount is specific to each triggering event. It can represent the amount of a shortfall in ordinary course interest payments on the reference credit, a write-down in the interest on or principal of such reference credit or any amount postponed in respect thereof. It can also represent the difference between the notional or par amount of such reference credit and its market value, as determined by reference to market quotations.

• Triggering events can occur multiple times, either as a result of continuing shortfalls in interest or write-downs or postponements on a single reference credit, or as a result of triggering events in respect of different reference credits included in a protected basket. In connection with each triggering event, AIGFP is required to make a cash payment to the buyer of protection under the related CDS only if the aggregate loss amounts calculated in respect of such triggering event and all prior triggering events exceed a specified threshold amount (reflecting AIGFP’s attachment point). In addition, AIGFP is typically entitled to receive amounts recovered, or deemed recovered, in respect of loss amounts resulting from triggering events caused by interest shortfalls, postponements or write-downs on reference credits."

They disclosed it.  However, I will say that I didn't see the $9.8 billion of PAUG CDS's specifically addressed.  This is inherently confusing because AIG has chosen to isolate $71.6 billion net notional CDS's on multi sector CDO's as the problem.  There are other CDS's that weren't considered a problem, and it wasn't always clear to me which set of CDS's were being referred to in this section of the 10-K.  However, the diagram below, from the 10-K, lays out how the credit facility or SIV works.  The AIG-FP obligation is for the "Super Senior" tranche - the box on the right.  For Multi Sector CDO's, thats the layer that AIG wrote the CDS on.  There is $38 billion in subordination -- relating to the dark section on the bottom that is someone else's problem.    

For the CDS's on the Super Senior, Multi Sector CDO's, the "Gross Notional" is $108.5 billion.  The result of the credit facility is that when it is completed, AIG will have no net exposure.  They will have written off the entire amount, sold the remaining assets to the credit facility.  Here is my diagram (typo: change the $25 to $30):

The take away from this. First, that Super Senior meant about 1/3 subordination. Secondly, AIG has been writing this stuff off for 4 quarters, and a big chunk of it is gone. Thirdly, the NYFRB has about 75% subordination from the original CDO's, which doesn't sound that bad. Sounds like they have a decent chance to fully recover their money. After all, some people pay off their mortgages, and if not, some of the assets are recoverable. Settling a PAUG CDS on a synthetic CDO may be difficult, but someone needs to drive a good bargain and with the FRBNY, I don't see why it couldn't happen Fifth, this stuff is too complex for normal people. Given the low level of confidence and trust -- people are going to assume the worst. However, one would hope that the WSJ would put a little more effort into it.

Tuesday, December 9, 2008

AIG Reporting in the WSJ - Atrocious

I never set out to defend AIG, but this WSJ story is hopelessly confusing.  It sounds like what they are trying to say is that there are an additional $10 billion in losses, based unidentified sources, that have not yet been disclosed.
Fine, I suppose.  However, then they repeat parts of last month's SIV/bailout.  This is not news in any respect, but gets announced as if it hasn't already been reported, booked in AIG financials, etc.  The multi sector CDO's that AIG guaranteed via CDS's are being settled in such a way there is no material uncertainty.  Just like they announced.  As I described in an earlier post regarding the AIG bailout, they are just settling up $65-70 billion in CDS's.  Per the Journal:
As of Nov. 25, Maiden Lane III had acquired CDOs with an original value of $46.1 billion from AIG's counterparties and had entered into agreements to purchase $7.4 billion more. It is still in talks over $11.2 billion.
So the SIV is buying $60.3 billion in multi sector CDO's. That's less then $70 billion. The SIV is using a $5 billion investment from AIG, Up to $30 billion in FRBNY loan, and the rest is being written off by AIG. They had already written off most of this, so the new bad news in November was relatively modest.

The problem is that the WSJ staff writers don't seem to understand anything about accounting.  The "news" last month was that AIG was going to honor its CDS promises.  Once that fact sunk in (if it ever did), the exact mechanism is irrelevant.  That is, the counter parties were made whole.  If you bought a CDS from AIG on a $10 million multi sector cdo, then you get the $10 million and AIG got the cdo, which it then sold to the SIV at a discount.  It doesn't matter if you send the collateral back, mail in the cdo, and then get your $10 million.  Or if you keep $5 million in collateral, mail in the cdo, and the remaining $5 million.  You had an insurance contract for $10 million, and you got your $10 million.  However, the WSJ writers seem to get caught up regarding when the collateral was posted as if that was news.

The only new news is that there may be additional losses.  AIG said:
...that exposure has been fully disclosed and amounts to less than $10 billion of AIG's $71.6 billion exposure to derivative contracts on debt pools known as collateralized debt obligations as of Sept. 30

The WSJ writers are also hung up on whether a CDS is a speculative bet or a credit protection instrument. It is obviously both. How many times does AIG need a beat down in print over the same dumb mistake?

There is also some confusion about what I think might be CDS swaps where the purchaser didn't own the underlying.  It is impossible to figure out what the journal writers are getting at, but they want it to sound dramatic. 

There may or may not be additional AIG losses that haven't been disclosed.  However it would not be surprising if AIG's trillion in assets have taken a few hits since the 3Q financials.  A coherent discussion by the Journal might have shed some light on it.  But breathlessly rehashing last month's news adds nothing.


EDF vs CEG/Mid American Valuation

This is a first step comparison between the EDF pro forma valuation in their proposal letter and the CEG fairness valuation.

There is a big difference.  $5 billion vs. $10 billion.  

I put them on a spreadsheet for your enjoyment.

This is the first time I have linked a blog to a spreadsheet.  I'm hoping to add some depth and give people a little more for their time.  

I am only going to comment on the single biggest difference.  The fairness calculation used a minus $2 billion or $10/share for the energy trading valuation.  

Here is what the proxy narrative says:
In an effort to estimate the potential value that the company’s equity holders might realize if the company were to file for bankruptcy, Messrs. Collins and Thayer, together with other members of Constellation Energy’s finance department, estimated the potential fair values of the company’s businesses, other than the global commodities business, at between $12.0 and $13.0 billion. The estimates of fair value of the company’s businesses that were used reflected management’s knowledge of the company’s businesses and of the potential range of market values for such businesses. Such values did not reflect any material discount for the potential negative effects of a bankruptcy filing. Management did not value the global commodities business because it believed that the value of such business was highly unpredictable and would be subject to the greatest degree of volatility and uncertainty in a bankruptcy, however, it did take into account the potential change in valuation resulting from fluctuating commodity prices and the cost of capital. Management believed that it was reasonably possible that the global commodities business could generate a net loss of more than $2.0 billion following a bankruptcy filing, and therefore management concluded that a loss of this magnitude was the most appropriate number to utilize in its estimate of the potential fair value of Constellation Energy. In light of these estimates, management observed that if the global commodities business, following a bankruptcy filing, generated a net loss (and thus had a negative value) of more than $2.0 billion, then after repayment of Constellation Energy’s then-outstanding indebtedness of approximately $6.0 billion, the aggregate equity value for holders of Constellation Energy common stock would likely be less than $26.50 per share or $4.8 billion in the aggregate. Management’s conclusions reflected the following, which did not include any reduction in values to reflect the substantial expenses of a bankruptcy process or the disruptive and damaging effects on business that management expected would result from a bankruptcy filing:

• Fair value of businesses other than global commodities                 $ 12.0-$13.0 billion
• Less repayment of outstanding indebtedness                                    $ (6.0 billion )
• Less net loss (negative value) of global commodities business       $ (2.0 billion )
• Net equity value (before costs and expenses)                                     $ 4.0-$ 5.0 billion  

• Net equity value per share (before costs and expenses)       $ 21.82-27.39

Management observed that it could not reasonably assess the magnitude of potential deterioration in the value of the company’s businesses as a result of a bankruptcy filing, particularly if the company had to make an immediate filing without having a substantial debtor-in-possession loan in place to provide needed liquidity, or the impact of disruption to the business and the substantial costs and expenses of a bankruptcy process. Management also observed that the impact of a bankruptcy filing and of significant liquidity constraints would likely be most severe on the global commodities business. In addition, Mr. Collins expressed his belief that Constellation Energy would have difficulty managing its global commodities business as a result of the likely loss of counterparties willing to transact business with Constellation Energy following the initiation of bankruptcy proceedings. Additionally, Constellation Energy’s ability to manage its competitive supply business also would likely be materially impaired, as customers likely would not be willing to enter into new contracts, and Constellation Energy might not be able to manage the supply requirements of its existing customers. Management concluded that, in light of this information, and taking into account the uncertainties and costs of the bankruptcy process and the significant potential for such process to negatively affect the company’s business, it was likely that the $26.50 per share price proposed by MidAmerican was more than the company’s existing shareholders would receive in the event of a bankruptcy filing. Management also observed that a bankruptcy filing brought with it the potential to damage recovery by the company’s creditors, whereas the transaction proposed by MidAmerican was likely to avoid such a result. Management reviewed its estimates with Morgan Stanley.

From my perspective -- these are the key points

1. The last comment about creditors -- all well and good, but if bankruptcy is off the table, then it is no longer relevant.

2. $26.50 is a good number compared to bankruptcy -- ok, but bankruptcy is again off the table.

3.  the -$2 billion valuation for Energy Trading was based on bankruptcy.

Once again:
Management believed that it was reasonably possible that the global commodities business could generate a net loss of more than $2.0 billion following a bankruptcy filing
Reasonably possible doesn't mean highly likely. It doesn't mean probable. And it didn't explain exactly how this reasonably POSSIBLE value would occur.  Frankly, BK is bad and a lot of bad things are reasonably possible.  Still, in the 3Q financials, there were no material trading losses.  Right now, I would say that the negative $2 billion needs to go to zero.

There needs to be a serious consideration regarding how energy trading would be supported to guarantee no collateral induced meltdown.  

That leaves us with a $3 billion gap.  Or I would say more like a $4 billion gap.  That is -- EDF has a big Buffett haircut in the post deal valuation.  Plus, CEG's fairness opinion doesn't include a big cash sale of 1/2 the nuclear assets.  I would put the net of those at about $1 billion.

So we need to figure out if the Fairness number more accurate then the EDF number and by how much.

A key number is the valuation of BG&E at $4 billion.  Reasonable or optimistic as hell?  I'll save that for another post.

CEG is Talking to EDF -- Facilitating but not Encouraging

Today was a nice win for the CEG's badly mistreated shareholders.

The Stock went X Dividend, and every 47 cents counts these days.

Also, the board authorized discussions with EDF.  This is an interesting development, since it was clear from the proxy that CEG's board is limited regarding the extent to which it can "initiate, solicit, facilitate, or encourage merger proposals."  It isn't initiating or soliciting merger proposals, but it is facilitating one by authorizing discussions. 

The Mid American proposal must also get a shareholder vote before the deal can be terminated by CEG.  Upon termination, Mid American gets the $275 breakup fee and 16.7% of the stock (via issuing another 20%) -- and it sounds like Mid American can only keep 10%, requiring the additional shares to be paid out in cash.  Giving Mid American 10% of the stock and over 1/2 billion in cash.

But, it looks like it is Mid American can now consider the EDF proposal and if it can work something out, terminate the Mid American agreement.  Mid American, for its part, sounds like they *could* argue that the discussions allow it to terminate with prejudice and demand the cash/stock.  It isn't obvious from a casual reading exactly how an alternative proposal can be handled without Mid American having the right to terminate, we can see where this is going in practice.

That is, CEG is going to discuss EDF's proposal.  They will then either deem it a superior proposal and change their recommendation or not.  If they change their recommendation and Mid American insists on a vote, then if it is voted down, the deal is terminated.

In practice, the CEG board really calls the shots, since they should be able to get the votes to approve whatever they recommend.  

Here's the press release:

Constellation Energy Board Authorizes Discussions With Électricité de France (EDF)

BALTIMORE, Dec 08, 2008 (BUSINESS WIRE) -- Constellation Energy (NYSE: CEG) today announced that its Board of Directors has authorized the company to begin immediate discussions and exchange of information with Électricité de France (EDF) related to EDF's unsolicited proposal, which was received on Dec. 2, 2008.

Constellation Energy said the decision to begin discussions with EDF was made following consultation with its legal and financial advisors, and in a manner consistent with its fiduciary responsibilities to shareholders, as well as its responsibilities under its definitive merger agreement with MidAmerican Energy Holdings Company.

Constellation Energy's Board of Directors has not withdrawn, modified or qualified its recommendation that shareholders of Constellation Energy vote in favor of the merger with MidAmerican. The special meeting of shareholders to vote on the merger with MidAmerican remains scheduled for 8 a.m. on Dec. 23, 2008.

Monday, December 8, 2008

The Greater Depression?

I find myself offended by the constant media references to the US Great Depression of the 1930's.  It seems disrespectful to compare anything that is going on in the US today with those that suffered in the 30's.  Further, the sentimental baggage surrounding the GD just adds more noise to a chaotic situation.  

Finally, there are aspects of the GD that aren't talked about very much.  Everything I have heard about that period, of course, is second hand.  But one thing that doesn't get talked about much is that people with money did pretty well.  This was always followed by the comment that no one had any, or some other reference to hard times.  But, frankly, people with cash did well.  Anyone that kept a job and their pay level was better off.  A lot better off.  And smart enough to not flaunt it.

From the BLS, CPI:

              YOY Chg     Cumulative        Return on Cash
1930         -2.3
1931          -9.0                -11                        +12.4
1932          -9.9               -20                        +25.0
1933          -5.1               -24                         +31.5

A lot of wages were sticky and even though unemployment was very high, a lot of people still had jobs.  Those that kept their jobs and whose wages weren't cut had a 31% raise over this period.  Cash in a mattress had a 31.5% return.

The National Bank of Sealey was the hot investment of the time.  Some of the virtues of that generation -- avoid debt, avoid risk, save (hoard) cash, was an attachment to the winning strategy of the decade.  

For everyone waiting for deflation, remember that we have a Fed Chairman that has written extensively about doing anything to avoid deflation.  We have hedge fund guys running Treasury.  And we have people lined up to loan them money like people were begging for shares in the ipo of  The 10 year is at a 50 year low.  

This December, the Social Security COLA is 5.8%.  If we have 10% deflation, like the 30's, they get a 16% raise in real benefits.  Now some of this really needs to happen, since food and energy were ignored in the official CPI.  This is simply unmeasured inflation unwinding.  

Remember the Andy Hardy movies?

Dad was a judge.  A government employee.  And they always had a maid and a cook and seemed pretty prosperous.  Sure it was just the movies, but not much more of a distortion then the migrant photos.  

The point of this being that I don't see people on a fixed income getting a 30% increase in real benefits over the next three years.  I don't see hoarded cash earning 30%. 

I do see the Treasury borrowing money under 3% for 10 years and people are having a hard time counting the ways that we will employ fiscal stimulus.  I also see the Treasury being run like a hedge fund, with positive carry on all the bailed out assets, which have pretty decent haircuts.  Plus a lot of equity kickers.  

I don't want to be lending to the hedge fund of last resort.  

Friday, December 5, 2008

EDF has a great web site

Something a little lighter.  I'm not comparing Moody's with the reign of terror.  Not a single number either.

Also..... this is a non promoted blog.  One of the main reasons is that I haven't spent much time editing the posts and they have a number of typos, etc.  This, of course, runs contrary to the dictum, "Never Complain, Never Explain."   I may go back and spiff up a few things, just because even I have some (low) standards regarding sloppy prose.

Have a great weekend. 


The WSJ Does Some Reporting

After yesterday's critical article, it looks like the Wall Street Journal decided to actually hunt for some primary sources that know more then the fact that an industry analyst is supposed to have an opinion -- even if they haven't bothered to read the SEC Documents.

Here is probably a little more then "fair use" of a damn good WSJ piece.

PARIS (Dow Jones)--Electricite de France SA (1024251.FR) is confident that 20 of Constellation Energy Group Inc.'s (CEG) biggest investors share its view that the bid by Warren Buffett's MidAmerican Energy Holdings Co. for Constellation grossly undervalues the U.S. utility, a person close to the French company said Friday.

EDF is offering $4.5 billion for a 50% share of Constellation's nuclear assets whereas MidAmerican is offering $4.7 billion for the whole company. EDF has a 9.5% stake in Constellation, with which it has a joint venture to build nuclear plants in the U.S.

The person, speaking on condition of anonymity, said EDF and the investors that share its view hold around 50% of Constellation's equity. EDF's 9.5% stake cost the French state-controlled utility around $1 billion, the person said.

EDF and its bankers have had no contact with MidAmerican in recent weeks, the person also said. EDF expects the Constellation board to assess EDF's binding offer, which it says values the company at $52 a share, "objectively." The board has already accepted MidAmerican's offer of $26.50 a share when it was on the brink of collapse because of a liquidity crisis.

The person said EDF's offer is good value as it stands, based on conservative market benchmarks. That's before taking into account other factors such as extending the life of Constellation's relatively modern and efficient nuclear reactors, as well as the new nuclear plants it hopes to build, he said.

The person said that when MidAmerican made its bid in mid-September, EDF and its private-equity partners at the time weren't immediately able to come up with a competing, binding offer.

Regarding EDF's agreed GBP12.5 billion takeover of British Energy PLC (BGY.LN), the person said EDF is close to refinancing half of the GBP11 billion syndicated loan it has secured for the bid. EDF will launch a EUR2 billion bond, a CHF1 billion bond and a GBP400 million bond in December.

The refinancing will lower the cost of the British Energy transaction and relieve pressure on some of the banks in the syndicate.

-By Paris Bureau: Telephone: 33 1 4017 1740

Mainstream Press / Analysts Don't Get It

Per the Wall Street Journal, the EDFI deal presents a number of hurdles.  Let's look at at some of the assertions.

First, Andy Baker:
Constellation shareholders are scheduled to vote Dec. 23 on whether or not to approve MidAmerican's offer. That meeting could become critical to EDF's proposal, said Andy Baker, special situations trading strategist for Jefferies & Co.

Constellation Energy said Wednesday its board would review the offer "as soon as practicable." The company also said it hasn't withdrawn, modified or qualified its recommendation for its shareholders to vote in favor of the deal with MidAmerican.

Baker said a vote against the buyout would show support for EDF's proposal
However, if you read the prospectus, you will notice that EDFI had agreed last summer to vote its shares with the board. The 9.5% EDFI ownership plus shares controlled by the board would amount to about 20% of the shares.

Anyone that would have voted yes to the proposal would have been well advised to sell this week at $28/share. Why vote for a proposal that is LOWER then the current share price?

The prospectus describes the mechanism which would result in the board NOT recommending the Mid American Proposal. In summary, if the board is presented with a "Superior Offer" and it has a duty to shareholders to recommend that proposal, the change in the board's recommendation triggers MidAmerican's termination compensation.

At that point, MidAmerican has the right to submit a counter proposal within five days, or walk with its generous compensation of a breakup fee, 10% of the stock, about 1/2 billion cash, plus conversion of the 8% preferred to a 14% senior note due Dec 31, 2009.

Realistically, the vote doesn't particularly matter. The key is the recommendation of the board. Which should include input from the larger stock holders and institutions.

Then,  Les Levy weighs in with the insight:
But shareholders could see the continuation of Constellation, even with EDF's infusion of capital, as a more risky proposition than $26.50 a share cash offer, said Les Levy, a merger and arbitrage analyst for ICAP Corporates.
I'm wondering why Les didn't consider the wisdom of anyone preferring a certain $26.50 buyout to simply sell for $28 or higher. Maybe ICAP's arbs would rather wait 9 months for $26.50 (plus a buck and a half dividend), deal with uncertainty, instead of simply selling for $28 (plus) over the last two days. 

Then the Journal finds a skeptical analyst:
Also, questions remain about the value EDF puts on the deal. Deutsche Bank analyst John Kiani maintained a $30-a-share price target for Constellation in a note to clients Wednesday, writing he isn't convinced the implied price of $52 a share EDF claims is correct.
If the offer is between $26.50 and an implied valuation of $52 -- I would expect something more then "not convinced."  EDFI didn't just create the $52 out of thin air.  They go through a reasonably straight forward valuation that seems both solid and in some respects conservative.   The details of the valuation are available in an attachment to the offer letter[see annex a].  I would like to know which assumptions that John finds unconvincing and his alternative analysis that would lower the valuation to the extent that $26.50 seems superior.

Moody's weighs in its own questions in another short Journal piece:
Additional clarity is needed on EDF's offer to assess its impact on Constellation's credit rating, but initial information on the company's liquidity may result in an investment grade rating, Moody's said.
I can understand Moody's being cautious given the severe criticism it has received following its massive failure to anticipate the risk in billions of CDO's containing sub prime mortgages. However, it is hard to see how a few billion dollars in increased liquidity would be grounds for DOWNGRADING CEG.  It's comforting to know that billions of dollars of added liquidity might prevent a downgrade.

Given the reputation of Mr. Buffett, I am sure that his ownership of 20% of Moody's has no impact on their rating decisions.  However, this is a situation where Moody's might consider the appearance of objectivity by exhibiting extreme caution regarding their comments on competing proposals involving Mr. Buffett.

In addition, one of the reasons that CEG was forced to take Buffett's tough offer was the extreme time constraints that CEG was dealing with.  Moody's was inadvertently a contributor to some of the problems.  
In an attempt to satisfy the conditions of EDFI’s proposed equity investment, Messrs. Collins and Thayer contacted S&P and UBS Finance, each of which provided EDFI with the requested assurances. However, when Messrs. Collins and Thayer contacted Moody’s, they learned that Moody’s had already completed its credit review and was prepared to announce a two-notch ratings decrease to Baa3 (one notch above sub-investment grade), with a negative outlook. Constellation Energy urged reconsideration of the pending ratings downgrade and discussed with Moody’s the possible EDFI and MidAmerican investment proposals. Messrs. Shattuck, Collins and Thayer then made a subsequent call to Moody’s seeking to persuade it to change its view. On a subsequent call, Moody’s indicated that its rating committee had convened and was unable to resolve the company’s rating that evening and would take the EDFI proposal back to its committee again on the morning of September 19. However, Moody’s stated that it would not comment on whether a transaction with EDFI would alter its decision to lower Constellation Energy’s credit rating.
CGE was desperately trying to raise capital, and got cooperation from S&P. However, Moody's had already made a determination to downgrade two notches, was unable to discuss it's decision until the next morning, and refused to comment on the impact of CGE's obtaining an additional $500 million in capital in any event. I suppose that Moody's was under a great deal of pressure, but their inflexibility compared to S&P, delayed a potentially critical injection of $500 million in capital.

Moody's had essentially signed a death warrant on CEG, and was unable and unwilling to discuss remedies that could have allowed the company to maintain its independence. As the 3Q financial statements of CEG showed no significant trading losses, the entire issue was driven by a rating change triggering collateral calls. Moody's had gone from selling what amounted to indulgences on CDO deals to a guillotine happy Committee of Public Safety.

EFDI - The complete proposal

Term sheet from CGI SEC Filing:
On December 2, 2008, Constellation Energy Group, Inc. (“Constellation Energy”) received an unsolicited proposal from Électricité de France (“EDF”). The main components of EDF’s proposal are:

EDF would purchase a 50% ownership interest in the nuclear generation and operation business of Constellation Energy (excluding Constellation Energy’s existing interest in the UniStar joint venture) for $4.5 billion, subject to certain adjustments;

EDF would make an immediate $1 billion cash investment in Constellation Energy in the form of nonconvertible cumulative preferred stock, which subsequently would be credited against the $4.5 billion purchase price (with EDF surrendering the preferred stock to Constellation Energy as partial payment); and

EDF would provide Constellation Energy with additional liquidity by entering into an asset put option pursuant to which Constellation Energy could, at its option, prior to EDF’s acquisition of the 50% interest in Constellation Energy’s nuclear generation and operation business, sell to EDF non-nuclear generation assets having an aggregate value of up to $2 billion.

This is the complete deal and below is the valuation based on EDFI's proposal:
Annex A
Implied Constellation common stock valuation
Based on publicly available information, EDFI and its advisors have calculated the implied value of EDFI’s offer to the Company’s stockholders. Based on the calculation presented below, EDFI’s offer represents the equivalent of an offer of $52 per share of Constellation common stock.
The implied valuation of the Constellation common stock is based on a sum-of-the-parts valuation of Constellation’s individual business segments and calculates an implied value per Constellation common stock taking into account adjustments for the EDFI transaction. A separate, intrinsic valuation analysis of Constellation’s business segments using independent projections for the generation assets and projections for BGE that reflect the current rate environment resulted in a valuation range of $45 to $60 per share and confirmed the sum-of-the-parts valuation approach.

Valuation of Constellation’s business segments
$ billions

Valuation of non-nuclear generation assets
• 6,595 MW of non-nuclear power generation assets
• Based on individual $/kw multiples applied to the net owned MW capacity of each of Constellation’s non-nuclear power generation assets
• Implied average multiple of $862/kw, adjusted for pro rata share of negative hedge value15.7
Valuation of 50% of existing nuclear generation assets
• 3,869 MW nuclear power generation assets
• Based on individual $/kw multiples applied to the net owned MW capacity of Calvert Cliffs, Nine Mile Point and Ginna Station
• Implied average multiple of $2,234/kw, adjusted for pro rata share of negative hedge value 14.3
Valuation of BGE

• Based on 7.0 times estimated 2009E EBITDA of $593 million, based on equity research
• EBITDA estimate based on equity research estimate
• Multiple selected based on current trading levels of comparable transmission and distribution companies 4.2

Valuation of Global Commodities and Customer Supply
• Net derivative position disclosed in Constellation’s Q3 2008 investor presentation
• Assumes no additional value from ongoing business 0.3
Valuation of 50% interest in Unistar JV• Based on equity research estimate 0.3
Corporate overhead
• Based on 8.0 times estimated, additional corporate costs of $15 million based on equity research estimate (0.1 )
Total firm value before net debt and transaction adjustments (A) 14.7

Net debt deduction from firm value (before transaction adjustments)
• $6.7 billion of net debt at September 30, 2008 reported by Constellation (including $1 billion MidAmerican senior note)
• $0.2 billion of non-MidAmerican preferred stock and minority interests (6.9 )
MidAmerican transaction termination related adjustments
• Payment of $175 million MidAmerican termination fee
• Payment of $420 million to MidAmerican for shares in excess of 10%, for which it may not have received regulatory approvals by the time the MidAmerican merger agreement is terminated (0.6 )
EDFI transaction related adjustments
• Receipt of $4.5 billion of gross sale proceeds from EDFI
• Net proceeds of $3.2 billion, assuming a capital gains tax rate of 38.5% and an estimated tax basis of 25% of the sale value 3.2
Total net debt and transaction adjustments (B) (4.3 )
Implied total equity value (C) = (A) — (B) 10.4  
Implied value per Constellation common stock ($/share)
• Assumes 180 million diluted shares outstanding plus 19.9 million shares issued to MidAmerican upon conversion of the preferred stock $ 52
Implied value per Constellation common stock incl. potential synergies
• Assumes estimated $100 million per annum of potential nuclear JV synergies, capitalized at 6 times, shared equally between the partners $ 55
Consistent with to slightly conservative when compared to trading multiples for generation dominated companies that are investment grade rated and not going through liquidity-related or other extraordinary events.

Thursday, December 4, 2008

The French Want CEG's Nukes....Time for the CEG Board to Step Up

The narrative in the CEG "notice of special meeting" regarding the Berkshire takeover bid is really great reading.  Of particular interest is the section, Background to the Merger.  You couldn't make this stuff up.

The press seems to be getting a few things wrong.  First, the offer isn't really directed to the shareholders/voters at the Dec 22 meeting.  The CEG Board is voting EDF's 9.5%, and given the institutional ownership, it is hard to believe that whatever the Board recommends won't be approved.  Secondly, CEG is offering 4.5 billion for 1/2 the Nuclear vs. Buffett's $4.7 for the entire business.  However, the business has $7 billion in debt, so their offer isn't quite as high as it sounds.  That is, Buffett gets the company and the debt.  EDF is only bidding on assets.

Aside from that, the background is a comedy of errors.  By everybody but Buffett, who had the cash, a price, and a take it or leave it negotiation style.

From the perspective of EDF.....

1.  They bought about 9.5% in the open market for about $60/share.  That's almost a billion dollars that could have been done via new shares, injecting needed capital.

2.  They signed the agreement limiting their actions to basically deferring to the board: 
Électricité de France International, S.A. (which we refer to as EDFI) acquired Constellation Energy common stock through open market purchases in accordance with an investor agreement, dated July 20, 2007 (which we refer to as the investor agreement) between EDFI and Constellation Energy, entered into in connection with the joint venture arrangement between EDFI and Constellation Energy with respect to development of nuclear projects in the United States and Canada. Under the terms of the investor agreement, EDFI is permitted to acquire up to 9.9% of Constellation Energy common stock and has agreed to vote its shares in the manner recommended by Constellation Energy’s board of directors. EDFI also agreed not to, singly or as part of a group, directly or indirectly, without Constellation Energy’s consent, acquire any additional securities in excess of the 9.9% ownership interest permitted by the investor agreement, participate in a solicitation of proxies, join with any other parties to form a “group” with respect to Constellation Energy common stock (as determined pursuant to Section 13(d) of the Exchange Act), act alone or in concert with others to seek or offer to control or influence, in any manner, our management, board of directors or policies, or seek to make a proposal or public announcement with respect to a merger, consolidation or sale of all or substantially all of the assets or a majority of the outstanding shares of Constellation Energy common stock, or any form of restructuring, or any other proposal inconsistent with the terms of the investor agreement. Under the terms of the investor agreement, EDFI also agreed to restrictions on its ability to dispose of its shares of Constellation Energy common stock. According to the Schedule 13D filed by EDFI on September 8, 2008, as of that date EDFI owned approximately 9.51% of Constellation Energy common stock.
3. They (EDF) tried to buy another 5% to directly inject capital, but the NYSE said no.
Early that afternoon, Constellation Energy sought relief from the NYSE on the shareholder approval requirement, so that EDFI could (if it were willing) immediately invest a larger amount in Constellation Energy. Later in the day, the NYSE denied Constellation Energy’s request.
This is at the same time the Treasury and Fed are taking unprecedented interventions to stabilize banks. The NYSE won't approve a waiver to allow CEG to get a quick equity injection?

4.  EDF made their offer to inject the $500 million contingent on getting the rating agencies to agree to not downgrade if they raised the capital.  The rating agencies were in no mood to chat about hypothetical capital injections.   
In an attempt to satisfy the conditions of EDFI’s proposed equity investment, Messrs. Collins and Thayer contacted S&P and UBS Finance, each of which provided EDFI with the requested assurances. However, when Messrs. Collins and Thayer contacted Moody’s, they learned that Moody’s had already completed its credit review and was prepared to announce a two-notch ratings decrease to Baa3 (one notch above sub-investment grade), with a negative outlook. Constellation Energy urged reconsideration of the pending ratings downgrade and discussed with Moody’s the possible EDFI and MidAmerican investment proposals. Messrs. Shattuck, Collins and Thayer then made a subsequent call to Moody’s seeking to persuade it to change its view. On a subsequent call, Moody’s indicated that its rating committee had convened and was unable to resolve the company’s rating that evening and would take the EDFI proposal back to its committee again on the morning of September 19. However, Moody’s stated that it would not comment on whether a transaction with EDFI would alter its decision to lower Constellation Energy’s credit rating. Thus, Constellation Energy could not provide EDFI with the assurance it required. EDFI was quoted in Bloomberg as stating “EDF[I] has studied the opportunity of increasing its stake in Constellation Energy.... At this stage, EDF[I] considers that all conditions are not met to do so.”
This is just a taste of the various failed attempts to avoid the need to get a Pay Day loan from Buffett.

I suppose that it understandable that a French firm wouldn't realize the chaos in the US markets and the urgency of getting cash in hand.  

Meanwhile, Buffett drove a hard bargain.  In their defense, they didn't want to bail out CEG, just to get to participate in an auction.  Their offer made it very difficult for someone to come in with a higher bid.

Not only that, but the cost of a breakup was high.  A termination fee of $175 million.
Constellation Energy has agreed to pay MidAmerican a termination fee of $175 million if the merger agreement is terminated for any reason other than by Constellation Energy because of MidAmerican’s or Merger Sub’s breach of any representation, warranty, covenant or other agreement made by MidAmerican or Merger Sub.
A costly conversion of Buffett's preferred shares.
Upon the occurrence of a conversion event (as described below) and subject to the receipt of all required regulatory approvals, the Series A Preferred Stock will be automatically converted into (A) 35,679,215 shares of Constellation Energy common stock (representing approximately 19.9% of the number of shares of Constellation Energy common stock that were outstanding on September 22, 2008, or approximately 16.6% on an as-converted basis), subject to certain adjustments, and (B) $1.0 billion in aggregate principal amount of senior unsecured promissory notes of Constellation Energy due December 31, 2009 (which we refer to as the 14% Senior Notes). The Series A Preferred Stock pays dividends at 8% per annum compounded quarterly and payable quarterly in arrears.
The 8% preferred becomes a 14% note. And Berkshire gets 35 million shares of stock. 

However, the board can consider unsolicited offers.  But once/if it does, it becomes a conversion event.  Buffett can make another bid OR he can take his breakup fee, new 14% note and 35 million shares.

Nevertheless, the board still represents the shareholders.  In theory, at least.  They didn't (and couldn't) waive all rights regarding alternative transactions.  They can consider a "superior proposal."
A “superior proposal” means any bona fide written takeover proposal that Constellation Energy’s board of directors determines in good faith (after consultation with a financial advisor of nationally recognized reputation) to be more favorable (taking into account (i) all relevant legal, financial, regulatory and other aspects of such takeover proposal and the merger, (ii) the identity of the third party making such takeover proposal, (iii) the anticipated timing, conditions and prospects for completion of such takeover proposal, including the prospects for obtaining regulatory approvals and financing, and any third party shareholder approvals and (iv) the other terms and conditions of such takeover proposal) to Constellation Energy’s shareholders than the merger and the other transactions contemplated by the merger agreement (taking into account all of the terms of any proposal by MidAmerican to amend or modify the terms of the merger and the other transactions contemplated by the merger agreement) and that is reasonably likely to be consummated.
If the EDF proposal to buy 1/2 the US Nuclear assets for $4.5 billion isn't superior, then I would like to know what a superior proposal would look like.  EDF is primarily owned by the French government.  

The management and board made mistake after mistake prior to the Buffett rescue.  They now have an opportunity to get some additional money for the shareholders who were blown up by a lengthy series of incompetent management.  Time for the board to step up.

Unfortunately, the French probably don't want to just get a better deal for their shares.  The Buffett offer is worth $400 million to them, and another 20% wouldn't justify the efforts they are now making.

They want the nukes, and are willing to pay up big time.  The board just needs to take the money.