Citi-advised SIVs --- It seems like a decade ago

Remember back in the day when Citi had a little problem with off balance sheet assets. Remember theMaster-Liquidity Enhancement Conduit, or MLEC?  And the Citi SIV?  It is now mostly over, with the remaining assets ($17 billion) folded into their balance sheet.  $17 billion isn't much, but in the 15 months that this has been in the process of liquidation, the stock went from a market cap of $200 billion to $25 billion.  Their announcement states: 

In order to complete the wind-down of the Citi-advised Structured Investment Vehicles ("SIVs"), Citi announced today that, in a nearly cashless transaction, it has committed to acquire the remaining assets of the SIVs at their current fair value, estimated to be approximately $17.4 billion, net of cash.

Lessons learned? Stupidity trumped greed. It wasn't the SIV, it was everything else. And finally, they really made virtually nothing on this, prior to the blowup. Maybe that's the definition of greed -- risking everything for nothing. From Barrons: 

SIVS earn narrow spreads estimated at 0.30 to 0.40 percentage point. This means that Citigroup, which had $100 billion of SIV assets this summer, might have netted $300 million annually, perhaps split 50/50 between Citigroup and the outside equity holders. The equity investors were getting a relatively modest 8% annual return.

Citi's factsheet on the SIV's was relatively upbeat.  As December, the SIVs had $62 billion in liabilities, less $13 billion in cash and $2.5 billion in junior notes (which take the first hit) for a net exposure of $57 billion.  I looked through the earnings announcements, and didn't notice that there were significant losses related to these assets.  Very difficult to tell without heavy digging.  I'm sure the $2.5 billion was wiped out (SIV junior notes) and they did mention a few hundred million.  Under a billion unless it was hidden somewhere else.

The assets had a maturity of 3.5 years, so I would think the remaining ones would have a lower duration.  And there may be another haircut or two on the $17 billion.  They obviously can't sell them easily, so they may have to just hold them and see what happens.

In conclusion, they didn't make much on these things.  They may not have lost more then a billion or so on them.  They might get most of the remaining $17 billion back.  In the meanwhile, they managed to lose money on virtually every other part of their balance sheet.  The remaining assets are all in areas that look sensitive to the economy.  

If we assume that the SIV WASN'T THAT BAD, (note that I could easily have missed billions in writedowns - but lets just say it's true), then it is possible for the company to be correct -- it isn't that bad, and the critics wrong about the SIV.  But being right about the SIV (assuming it is true) doesn't mean that they (and you if you believed them) were right about the company.  It was other stuff.  Huge numbers of things.  Other structured finance securities, marks for the failed monolines, general loan losses, etc. etc. 

Follow Up:

Here is where we are now:  City tries to put itself up for sale.

The had a market cap of $200 billion.  The raised $50 billion in private capital.  They got $25 billion from TARP.  

Result, market cap, $25 billion.  

And it still isn't clear how much (if anything) they lost on the stupid SIV.  I remember that every time Citi said ANYTHING about the SIV, their stock dropped by 10%.  I have a possibly demented idea that if they had just moved it to their Balance Sheet in August, 2007, they might have kept under the radar screen, become the 3rd or 4th worst money center bank, and maybe even thrived.  Probably not, but the SIV -- the way they handled it -- killed them as a serious business.  Please let me know if I am missing something regarding SIV specific losses.

  

One Rumor Down.....

Brief follow up on yesterdays discussion.

Hypothesis on Berkshire:
1. Derivatives lose value ---> ratings pressure ---->collateral calls ------>ratings pressure

Since this happened at AIG, I suppose it is the first thing on everyone's mind.  

Facts regarding Berkshire:
2. Collateral Calls on derivatives -----> Not with these derivatives.

These contracts don't have collateral calls under any circumstances.*

How do you refute a rumor without raising more questions? BRK today announced that it has nominal exposure to collateral calls on derivatives.  Less then 1% of capital, worst case.

*nominal doesn't mean $0, since it seems that if you do enough of anything, there will be exceptions.  The equity puts very likely have NO collateral requirements.  A few of the CDS's seem to contain contract language requiring them -- so it isn't zero.  Let's just say it rounds to zero.

It is hard to drive a stake through a rumor without raising more questions.    

Felix Salmon's Musings on Berkshire Hathaway AAA

 Felix Salmon's musings on Berkshire Hathaway reifies the blogosphere regarding this subject, but basically gets it wrong.

This is the crux of Felix's musings:

A downgrade could be very, very bad for Berkshire, depending on how its collateral agreements are worded. At some point, Berkshire's counterparties are going to be able to ask it to put up a lot of collateral against the derivatives contracts it has written -- not only the CDS contracts, mind, but quite possibly also the long-dated put options it's written on broad stock-market indices. Such collateral calls could be extremely harmful to Berkshire's business model -- and that's before taking into account the loss of business at its new monoline subsidiary.

I don't know where to start.  First, a downgrade would have very little effect on its operating businesses.  Secondly, most of its derivative contracts do not require posting collateral under any circumstances.  Thirdly, Berkshire's monoline subsidiary is an opportunistic venture which produces modest profits currently and is not a major business.  It is a Statutory Insurer with a dedicated balance sheet in its own Legal Entity.  Berkshire Hathaway Assurance is regulated by the State of New York, and could, if needed, support a AAA rating independent of Berkshire's corporate rating.  Finally, Berkshire does not rely on external financing for the majority of its business.  Its modest debt is either borrowed on a non recourse basis by its utility subs, or is borrowed to support the Clayton manufactured home finance business, which is neither large nor particularly important (but has been very profitable).  

Let me go through the points:

"depending on how its collateral agreements are worded"       

From the 3Q 10K:  

" However, Berkshire is not required to post collateral with respect to most of its long-dated credit default and equity index option contract liabilities."

 You could debate what "most" means, but I believe it means some of its credit default swaps and none of its equity index options.  The idea, as Felix put it, that "Berkshire's counterparties are going to be able to ask it to put up a lot of collateral" is pure conjecture.  It is highly likely that the potential collateral, under the most highly stressed scenario, would be modest in the context of  Berkshire's finances.  

From the 10Q:

 "As of September 30, 2008, BHAC had approximately $1 billion in capital and has received the highest rating available from two credit rating agencies. BHRG is pursuing opportunities to write financial guarantee insurance on municipal bonds. In its first nine months of operations, BHAC produced $315 million of written premiums. The impact of this new business on underwriting results was nominal."

 Berkshire could easily maintain the entity as AAA regardless of the ratings of other units.  Further, the premiums are earned over a number of years and the impact on current profits is "nominal."  Therefore, this has to be considered an opportunistic rather then a strategic business.  Buffett has expressed the intention to quit writing new business if/when it becomes less profitable.

Most Property Casualty Insurance and Reinsurance is written by companies with ratings significantly lower then AAA.  For example, Munich Re has an S&P rating of AA- .  The Chubb Corporation, a highly regarded primary insurer, has Senior debt is designated A by Standard and Poor’s and A2 by Moody’s.  Chubb's insurance subsidiaries are rated highly for claims paying ability, but the notion that a AAA rating is critical for successfully writing property casualty insurance is incorrect.  The ONLY insurance business that requires a AAA rating is bond insurance, which is a small potatoes for Berkshire.

Berkshire's capital of $120 billion at September 2008 supports a balance sheet of $160 billion in liabilities.  Of course, it is apples and oranges, but banks typically have capital ratios in the neighborhood of 10% of assets.  (note that traditionally, balance sheet uncertainty in banks is on the asset side, and property casualty insurers have their uncertainty on the liability side).  Nevertheless, Berkshire is very well capitalized, does not significantly rely on borrowing (except for the non recourse loans associated with utility assets), and does not rely on holding company credit ratings for its core businesses.

And all this conjecture is based on what?  An quoted price on over the counter market for CDS's that isn't regulated and does not disclose transactions in meaningful detail.  We have seen cases where companies have been in a situation where ratings downgrades triggered collateral calls which further stressed the company and resulted in lower ratings.  Perhaps that is on everyone's mind, but Berkshire's situation is similar only if one focuses on the superficial analogies and ignores facts of substance published in the companies SEC financial statements.

However, an attack by shorts could damage the company.  The only plausible ratings action would be a credit watch or negative implications, but I am not seeing any basis for a downgrade.  Anything that significantly weakens the stock price reduces the flexibility of Berkshire to do deals with stock or raise equity capital if he so desires (unlikely).  This kind of negative attention isn't good, regardless of the facts.  Facts are always complex and subtle -- conjecture can fit a simple story that is hard to shake.  

Followup:

Nov 20 (Reuters) - Berkshire Hathaway Inc:

* says has 'nominal' collateral requirements that would take effect were credit rating agencies to reconsider triple-A rating - spokeswoman
* collateral requirements would total 'far below 1 percent of assets' - spokeswoman

That settles it. Most have no collateral requirements means there are only nominal collateral requirements.

AIG CDS Solution: Financing Entity #2

What is commonly referred to as AIG bailout #2 has been ripped by bloggers.  One of the more articulate rants by Yves Smith at naked capitalism, is titled AIG, the Looting Continues.

The crux of this rather long post is that the "...treasury is going to buy crap assets at amazing (high) prices..."

A price of 50 cents on the dollar for CDOs across all tranches, particularly when the objective is to buy the dreckiest dreck (the ones where AIG's losses on its CDS guarantees would be greatest) is simply breathtaking. It's a wet dream for anyone who owns them.

Remember, this would be the price across ALL tranches. Recall that in Merrill's not-all-that-long-ago sale of its super-senior CDOs (the very best tranches) it got a nominal price of 22 cents on the dollar, but that did not accurately represent the economics of the transaction. The hedge fund Lone Star paid only 25% of that amount (or 5.5 cents) in cash, the rest was contingent on performance. So Merrill might have sold the CDOs for as little as 5.5%.

However passionate the argument, the facts simply don't support this criticism.  The problem is that AIG wrote credit default swaps to insure them at par.  They also plan on buying them at par, putting them into a SIV and commuting the credit default swaps.  

Here is what the press release says about this "vehicle."

Reduction of Exposure to Multi-Sector Credit Default Swaps: AIG and FRBNY will create a second financing entity that will purchase up to approximately $70 billion of Multi-Sector CDO exposure on which AIG has written CDS contracts. Approximately 95% of the write-downs AIG Financial Products has taken to date in its CDS portfolio were related to Multi-Sector CDOs.

In connection with this transaction, CDS contracts on purchased Multi-Sector CDOs will be terminated. AIG will provide up to $5 billion in subordinated funding and FRBNY will provide up to $30 billion in senior funding to the financing entity. As a result of this transaction, AIG’s remaining exposure to losses on the Multi-Sector CDOs underlying the terminated CDS’s will be limited to declines in market valueprior to closing and its up to $5 billion funding to the financing entity. As with the securities lending program, FRBNY and AIG will share in any recoveries in the market prices of assets.

They also have a little graphic on the slides they used at their earnings announcement.  Unfortunately I can't seem to upload pictures, so just go to page 5.

Basically they have a notional value of $70.  They are insured for $70.  AIG will buy them for $70, then put the collateral of $35 billion in the SIV, throw in another $5 billion, and borrow up to $30 billion from the FRBNY.  

The interesting thing will be those situations where the purchaser of the CDS doesn't own the underlying CDO.  They will either have to find them in the market, buy them and book the profit.  Or work out a value with AIG.

Then the CDS's will be in a SIV.  They will then sit until they amortize (not much chance of a sale)  and the Fed gets their cash back first, having $40 billion subordination.  As I recall, that was the original idea of the bailout -- buying bad assets and getting them out of the system.

The owners of the CDO's will no longer have any counter party risk.  They also will no longer have to pay premiums to AIG.  AIG won't be getting collateral calls.  The actual cash losses on these CDO's has been minimal to date.  There will no longer be any argument regarding what they are worth, since they will just amortize.

Like it or not, I don't see how this can be construed as looting.  But whatever, the idea that the price that the holders of the CDS's get isn't much of an issue.  That was settled by contract when the CDS was written (no doubt for a hundred basis points or some pathetically small premium).     

Update:

I read the conference call transcript.  Although they talked a lot about how this would be done, they never came out and said they would have to buy them at par.  I suspect the reason is that every deal is unique and they will try to drive the best bargain possible.  Particularly when the CDS holder doesn't own the underlying.

Anyway, it was clear that they would have AIG directly settle/commute with the CDS holder at "market value" and then the new SIV would buy the CDS at "market value".  Not saying that the two "market values" would be identical.  

The one thing that was clear is that the SIV will just buy assets (multi sector CDO's).  They won't assume the liability for the CDS's.  AIG already has written down the CDS's by $30 billion of the $72 billion.  

Anyone that really wants to know what these things are can look at AIG's financial supplement.  The CDO's in question still have about 20% subordination.  They consist of 137 "transactions" which I assume means CDS contracts.  The transactions would have to be on specific tranches of CDO's if they are quoting subordination percentages.

They also are publishing the results of their "roll rate model" for estimating ultimate credit losses and say that it is $12 billion compared to the "accounting" estimate based on CDO market prices.    

Post Mortem: Berkshire Acquires Gen Re, 1998. Part 3

What the hell happened to Gen Re after the deal???

1. Reinsurance was underpriced in 1998.
2. Underpricing was associated with under reserving, so the balance sheet was too optimistic.
3. Terrorist Attacks, 2001.
4. A lot of hurricanes in 2004-2005 capped off by Katrina.

Once again, here is some data:



The 10 year cost of float has been $6.7 billion over the last 10 years. On the chart, I have this split out into losses from prior years (under reserving, under pricing), Terrorist attacks, and Hurricanes. I am assuming that one mega property catastrophe is likely, but the under pricing, under reserving, and terrorist attacks are unlikely to happen again.

This would put the normalized 'cost of float' at about 1%.

Over the course of the decade, I would be very surprised if the total return on float wasn't significantly higher then 4%. The excess returns are profit.

As far as what didn't happen (but could have happened) are significant recapitalization or dilution.

Post Mortem: Berkshire Acquires Gen Re, 1998. Part 2

What Berkshire gave up when it traded its shares for Gen Re's:

Let's just look at some numbers. Here is the historical balance sheet at the time of the merger, with all entries shown in dollars per Class A share rather then dollars.*



A couple of numbers stand out: The equity portfolio of $33,402 per share and the $9,957 deferred tax liability. One of the main motivations for Buffett's buy and hold strategy is the almost $10k per share in deferred taxes from unrealized gains on the equity portfolio. However, the downside is that the large cap stocks in the portfolio are very richly valued in June of 1998. Here are the major holdings as of 12/1998:


And here is the portfolio at 12/2008:


In order to avoid doing a lot of heavy lifting, I would just point out that Coca-Cola, American Express (3 for 1 split), and The Washington Post account for a hefty chunk of the portfolio and haven't done anything for the last decade (except pay modest dividends).

However you want to value BRK at June 1998, it is hard to argue (especially in retrospect) that paying any premium over book value for a large cap investment portfolio doesn't make much sense. Therefore, the price to book ratio of 2.7 ($80,400 price, $29,621 book) didn't make a lot of sense. If you assume that the stock portfolio made up 50% of Berkshire's value and assign it a value of 1xmarket price, then the price book ratio on the remaining half would be 5.4!

The bottom line is that there is no way that BRK couldn't be considered richly valued at the $80,400 price used to calculate the conversion ratio in the Gen Re merger. The two points here are that Buffett sold high, and in coming to this conclusion, it's easy to get a feel for the value added by the shifts in the investment portfolio facilitated by this deal, from richly priced stocks to bonds and cash.
____________________

*This balance sheet differs from the actual pro forma balance sheet in omitting the 'adjustments' column which primarily adds $12 billion in goodwill. Omitting goodwill from the deal more accurately reflects the economics of the combined company.

RE: How Much is General Re Worth, Anyway?

Before I get totally buried in the fog of accounting arcana, lets briefly run through Jeff's post and address the major points, one by one.

He starts out quoting Buffett on the Dexter Shoe acquisition for stock:

What I had assessed as a durable competitive advantage vanished with a few years. But that’s just the beginning: By using Berkshire stock, I compounded this error hugely. That move made the cost to Berkshire shareholders not $400 million, but rather $3.5 billion. In essence, I gave away 1.6% of a wonderful business – one now valued at $220 billion – to buy a worthless business.

In the case of Dexter, he bought the business, it made no money, and became worthless. There are three things to note: Buffett bought a bad business, he used stock instead of cash, and the stock (with no help from Dexter) went from roughly $10k per share in 1993 to over $100k today. Not that different from selling Apple stock in 2000 and buying Enron stock. Two bad decisions, selling a winner and buying a loser.

In the case of Gen Re, he bought a profitable business which contributed to BRK's current share price. He issued stock priced at $80,400 10 years ago, and is now selling for $125,000. The 267,750 shares of stock issued to buy Gen Re at today's price makes the cost $33.5 billion rather then the $40 billion quoted by Jeff. If you stick to the metrics used when Gen Re was purchased, the float over the 10 years has increased from $15 billion to $23 billion, right in line with the 50% increase in the stock price. From this simplistic perspective, everything is a wash.

After making points about the deal being awful in regard to regulatory issues, which I agree with, he then finishes with the assertion that, "It is hard to imagine that for $40 billion, Warren Buffett could not have re-created General Re, with money to spare." I don't know how to answer that except to say that it is hard to imagine creating a global direct reinsurer like General Re period. Gen Re (along with Munich Re and Swiss Re) are franchises of a sort that can't just be created out of thin air.

The real story is classic Buffett. A deal with compelling economics meets with awful luck and becomes just a reasonable deal. The bad luck include awful timing, since reinsurance pricing in 1998 was worse then anyone realized at the time. As a result, Gen Re was under reserved by $2 billion and business on the books was underpriced by another $2 billion. This was followed in 2001 by the September 11th terrorist attacks which cost another $2 billion. And then, two of the worst hurricane years on record, 2004 and 2005 capped off by Hurricane Katrina.

At the time of the acquisition, Gen Re had about $15 billion in float or investable assets from policy holder supplied funds. They also had a tangible book value of $7.5 billion. This is $22 billion in new investment funds amounted to $84,000 in investments per share for each of the newly issued shares. This increased the investments per share of the combined entity, as noted in the 1998 Chairman's Letter, " During 1998, our investments increased by $9,604 per share, or 25.2% [to $47,647]."

And of course, Buffett went from the tailwind of the 1990's equity markets to the headwinds of this decade. Putting $20 billion in investable funds in Buffett's hands seemed compelling in 1998. In 1998 over a third of Berkshire's stock portfolio consisted of 200,000,000 shares of KO (Coke), then valued at over $13 billion ($13.4 billion out of $37.3 billion at 12/98). A decade later, that holding is valued at $11 billion. So the new money had to do some heavy lifting to get Berkshire to its current level of investments per share of $90,000.

As far as the 'bad luck' that Gen Re suffered over the last decade, they are unlikely to suffer from under pricing or under reserving. A reasonable expectation for catastrophes is more like one $2 billion event (for Gen Re) rather then the two they suffered. However, the real benefit of a company like General Re in Berkshire's portfolio is that it will not need additional capital, but will continue to generate investable cash. What's not to like about that?