Call Options

A stock can be decomposed into simple vectors, a scalar, Strike Price, and an expiration date. Call Option: A vector that begins at the strike price, ends at the termnal price, and extends upward until expiration. Put Option: A vector that begins at the strike price, ends at the termnal price, and extends downward until expiration. It's value is -price. Strike Price: A scalar representing the starting price of the options. Stock=Call+Strike(Cash)-Put Often referred to as Put/Call Parity. Most important: Stock+Put=Call+Cash.

And There's More .....

The FRBNY announced more sales on June 18th.

In addition, they announced (finally) that all the Maiden Lane loans (including ML I) had been fully repaid with interest.

It now seems likely that AIG will receive at least their $5 billion principal investment and $600 million interest by early july.

The current pace of sales, if it continues, will work through the remaining securities in a matter of weeks. 

My current guess is that AIG will have $7 billion in cash available for an early July purchase of Treasury shares. 

Additional Maiden Lane III Sales

On 5 June, 2012, the FRBNY announced that they were accepting bids for about $7 billion face value in CDO's.

Combined with the previous announced CDO sales, the cash from this offering should go a long way towards repaying AIG's $5 billion equity position in Maiden Lane III.

This is entirely consistent with my 26 May posting regarding sources of cash.

Below are the remaining holdings:

ILFC - The Basics

AIG has been reporting ILFC as if it were a stand alone entity in anticipation of an IPO.

Financial statements are available on its investor relations web page.

AIG has taken almost $3.5 billion in impairment charges over the last two years (roughly 10% of the book value of the fleet).

Selected Financial Data from 2011 10k:

General observations:

The revenue is reasonably stable.

AIG was too aggressive with respect to depreciation, leading to the impairment charges in 2010 and 2011.

AIG has reduced unsecured debt by almost 50% and total debt by roughly 20%.

There is no compelling reason for AIG to be in this business, and their decision to sell makes sense. The only issues are how soon and how much.

AIG - Sources of Cash

This is not particularly subtle or controversial. The only 'news' is that I am predicting that AIG will recover the principal from the ML III sooner than some may expect.  AIA is fairly certain regarding timing and amount -- the $7 billion based on current market prices.  ILFC is the least certain regarding both amount and timing. All the figures are intended to be conservative with respect to amount.

Strictly from these sources, AIG would be able to buy about a quarter of its shares at $29/share by September 4th of this year using only the $12.6 billion.

My personal guess is that AIG is more likely to buy at least half of the Treasury stake of 1.08 billion shares, with the rest sold in a public offering by early September. This would assume that the financial markets stabilize by then. Under more difficult financial conditions, this process will take longer.

Sources/Assumptions:

1. ML III - See earlier posts.
2. AIA - based on AIG ownership of 18.6%, Market Cap of 300 billion HKD, and an exchange rate of 7.76.
3. ILFC value selected based on book value (7,630,639 @ March 2012)
  @

Maiden Lane III - What's Left

The FRBNY releases a list of assets, including their face value, on a quarterly basis. The Marcy 31 listing is the current release. The list includes a very brief description, the CUSIP, and the face value of the security.

Assets currently include High Grade CDO's, Mezzanine CDO's, and a residual collection of debt securities where were primarily acquired as a result of the breakup of CDO's and subsequent distribution of assets.

At March 31:

CDO's                     $45,590
Misc                        $     817
Total                       $46,407

Subsequently, FRBNY has either sold or is offering for sale a significant number of CDO's.

Excluding those CDO's, at March 31 valuations, the face values were:

CDO's                     $33,584

Misc                        $     817

Total                       $34,401

The estimated fair value of these securities is $11,617. 

 

Without putting too fine a point on it, the larger CDO holdings contain a smattering of 2004 vintage as well as 2005 and 2006. 

It also seems reasonable that the FRBNY can continue selling CDO's and generate $5 to $6 billion in cash sales relatively quickly. this would allow AIG to recover its original stake of $5 billion plus accrued interest.  

With respect to providing AIG with cash to participate in Treasury sales of its stock, the timing of asset sales and distribution of proceeds may be more important that variances the ultimate cash sales of the portfolio. 

Maiden Lane III - 18 May 2012

Federal Reserve Balances show the Maiden Lane loan balance has dropped from $7,962 to $2,768, as it looks like the FRBNY received cash from the MAX CDO sales and applied it to the loan balance.

Bids for the sale of $1.7 billion face value Duke Funding CDO's has been delayed, pending distribution of more information by FRBNY.

However, bids for the sale of $691 million of Putnam CDO's are still due on Tuesday 22 May, 2012.

The Treasury announced the delay as follows:

May 18, 2012
The New York Fed decided to postpone its auction of ML III's holdings in the Duke CDO after it became aware that there was additional information concerning the Duke CDO that had not been made available to the bidders.  The New York Fed's auction of ML III's positions in the Putnum CDO is proceeding as announced on May 11.

If the net sales price on the roughly $4.9 billion of securities sales which have not yet been either announced (TRIAXX) or completed (Duke Funding, Putnam), is in the low 70% range, this should be enough to fully pay down the principal and accrued interest on the FRBNY loan:

As far as the assumption that the cash sales prices will be close to $3.5 billion, the TRIAXX CDO's were recorded at 31 December 2011 at a fair value of about 71% of face value. Given that the press releases have commented favorable on pricing, it does not seem unreasonable to assume that the final results will be around 70% or more. 

Payment of the Principal and Accrued Interest on the FRBNY loan will provide the basis for a nice headline when they are finally announced. 

Of note is that the estimated AIG recovery from Maiden Lane III or $7.6 billion is 16% of AIG's market cap @ $28/share (closing price on the NYSE, 18 May is $28.33). Although there is an argument for focusing on variances in results in the ongoing businesses, assets for sale, including stakes in AIA and the Aircraft Leasing business make up over 40% of AIG's current market value and are subject to material fluctuations which may be positive. 

  

Maiden Lane III - Two Weeks Later

The FRBNY is proving to be a diligent and determined seller of Maiden Lane III assets. Maiden Lane III will soon be able to pay back it's loan from the FRBNY in full. After it pays the principal and interest to the New York Fed, the next approximately $5.6 billion is cash from sales will flow directly to AIG.

At the pace of sales, this could happen closer to July 1, 2012 than the previously estimates discussed in the financial press of the end of the year.

This is important for AIG because Maiden Lane III assets are approximately 14% of AIG's market cap. These sales continue to support the view that their accounting has been conservative, that they are more liquid than thought, and there is potential for modest upward surprises like the current estimate of a $2 billion profit for AIG.

In addition, a full or partial payoff to AIG in the July timeframe could support the Treasury public offering of 400 million shares, with AIG taking 200 million in the next 60 days or so. Another dent in the 'overhang' and another simplification to a description of how the Treasury is making money on this deal and what needs to happen to wrap it up.

Since my prior post, consider the following activity:

1. FRBNY has announced a successful auction of TRIAXX CDO's. Results of the auction of the CDO's with a face value of $2.5 billion may net as much as $2 billion*.

2. FRBNY announced on 11 May, 2012 an auction of 2 CDO's (CUSIP 26441EAL5 and 25441EAA9), with a face value of $1.67 billion, with bids due on 17 May, 2012.

3. FRBNY announced on 11 May, 2012 an auction of 5 CDO's (CUSIP 746860AH9,  746860AK2, 746860AM8, 746860AP1, 746860AR7, and 746860BE5), with a face value of $0.69 billion, with bids due on 22 May, 2012.

The likely cash proceeds from these auctions combined with that of the MAX Commercial Real Estate CDO's is likely to be between $8.5 billion and $9.0 billion.

Maiden Lane III's pro forma balance sheet, assuming a payment of $8.5 billion:

So, the FRBNY principle will be paid off soon. Accrued interest is almost paid off. And future sales will flow directly to AIG until their $5.6 billion 

Maiden Lane owns over 100 CDO. A Partial listing including the largest 10 is shown below includes the usual suspects. Davis Square, Jupiter, etc. :

This includes mezzanine tranches as well as 'high grade' CDO.  They can get fair value by selling for less than 33 bp of face value. Given the current market conditions, I expect the FRBNY to just keep selling these unless the market backs up significantly. 

And, I don't expect any windfalls, although additional modest gains aren't unlikely. 

Sources:

1. Federal Reserve Balances, H.4.1 

2. Maiden Lane III balances

3. ML III Year End Report 2011.

4. Holdings Report, March 31, 2012.xls

* At year end 2011, the fair value of the TRIAXX was shown at 71% of face value and has presumably improved subsequently. 

Annals of AIG - Maiden Lane III

Current Status, April 30, 2012

On April 26, 2012, the FRBNY announced the sale of the MAX CDO holding from Maiden Lane III in a competitive bidding process.

The New York Fed announcement included everything BUT the sale proceeds, which will be announced as part of the quarterly report scheduled to be released on July 16, 2012.

However, enough information is known to have a reasonably good idea of what the CDO holdings sold for as well as the status of the Maiden Lane III transactions.

The biggest obstacle is to organize the information in one place. The New York Fed actually does a good job with this, but insist on withholding data in advance of their established reporting scheme.

Structure of the Special Purpose Vehicle:




At inception, AIG put up an equity interest of $5 billion, and the FRBNY loaned $24.3 billion to purchase $29.3 billion in CDO's  from AIG. $29.3 billion was the fair value at the time of purchase,

If the CDO's were simply held to maturity, then the loans and interest would be paid off based on the priority of claims (FRBNY senior, AIG junior), and any profits would be split 2/3 to the FRBNY, 1/3 to AIG.

MAX CDO valuation as of 12/31/2011

Commercial Real Estate CDOs : 


                                                                     Face Value                    Fair Value @ 12/2012


MAX 2007-1 A1                                         2,096,537                      1,162,320
MAX 2008-1 A1                                         5,403,463                      2,995,680
Total                                                             7,500,000                      4,158,000

Maiden Lane as of 4/25/2012

Current Status of Maiden Lane III LLC

If we assume that the FRBNY got $5 billion for the MAX Commercial Real Estate CDO's, and assume no change in the Fair Value estimate at April 25th, then:

1. The current outstanding Senior Loan Balance with Accrued Interest will be paid down from $8.701 billion to $3.781 billion.

2. ThePortfolio Holdings at fair value are reduced by $5 billion to $14.805 billion.

3. The coverage ratio of the FRBNY's loan approximately 4.

4. Assuming that the accrued interest owed AIG is $700 million, then the estimated profit is $5.4 billion, to be divided $3.6 billion to the FRBNY and $1.8 billion to AIG.

5. AIG will receive $7.5 billion, which includes their equity interest of $5 billion, $ .7 billion interest, and $1.8 billion profit.

If MAX CDO's sold for more than was assumed in the April 25th estimate, then AIG may split additional profits.

After the April 26th Sale:

The sale of the MAX Commercial Real Estate CDO's has substantially reduced the uncertainty regarding the likelihood of both the FRBNY and AIG fully recovering their contributions to ML III as well as accrued interest.

In addition, the successful sale sets the stage for future sales which may materially speed up the final resolution of ML III.

AIG has stated that they intend to use the proceeds of ML III to repurchase stock from the Treasury as it unwinds its equity interest in AIG. The earlier ML III is fully unwound, the sooner Treasury can divest its equity interest in AIG.

Financial Impact of ML III

AIG carries ML III at fair value. Per the AIG 10K (page 64),  ML III has had the following impact:

The cumulative change in fair value is about $2 billion. This is a significant portion of the favorable re-estimation of AIG's total proceeds from ML III.

At 12/2012, per the AIG 10K (page 47), the total shareholder equity was $104,951. ML III, booked at roughly $7 billion, is a significant component of shareholder equity, as well as any capital ratios using shareholder equity.

Conclusion

Almost all of the pieces of this transaction are publicly known.  However, the supporting documentation is scattered. The entirety of the published material lends a sense of the reduced risk remaining regarding ML III as well as the potential for favorable surprises regarding the timing of unwinding this entity.

David Sokol and Berkshire Internal Controls

The David Sokol situation has raised any number of issues -- not the least of which is the nature and efficacy of Berkshire internal controls. Interestingly, Sokol discussed them in some detail during his March 31 CNBC interview.

JOE Kernan: There's a lot of, there's other employees as well. This brings up, or begs the question to a lot of people about what Berkshire's internal controls are on employee purchases —

.....

SOKOL: I mean, Warren and (Berkshire CFO) Marc Hamburg furnish us a list of stocks that we are restricted on. Any companies that, you know, that apparently Warren or historically Lou Simpson, or now Todd Combs, or whoever, is invested in, ah, that, you know, we can't ever buy or sell without first contacting Mark. This certainly wasn't one of those companies.....

.......

SOKOL: That's right. In fact, I have no authority whatsoever. I couldn't spend a dollar of Berkshire's money buying, buying a security tomorrow.

It is not publicly known if Berkshire audits the trading activity of its named insiders with respect to companies on the 'list'. But if not, it could be accomplished in a relatively short time. It is reasonable to believe it could be done in a matter of hours -- with the cooperation of insiders, if it hasn't already been done.

Piecing together Berkshire's investment process, it is based on extreme concentration of decision making regarding capital allocation. Buffett (and Munger) make the decisions, with Simpson and Combs running a small portfolio.

Buffett is also famous for what is an unusual decision making style. These are well known and include:

1. Doesn't do auctions or hostile takeovers.

2. Doesn't talk (extensively) without a selling price.

3. Isn't interested in pitches involving publicly traded companies.

4. Extensively uses publicly available financials.

5. Uninterested in the types of work done by most stock analysts.

Of special note is this comment which has been included in his published acquisition criteria for years:

We are not interested, however, in receiving suggestions about purchases we might make in the general stock market.

Considering this as well as the new information that Berkshire uses a control system for public companies based on a list -- the effectiveness of Berkshire's systems in the past are explainable.

If Berkshire insiders refrain from trading in stocks on the list, and given that Buffett/Simpson/Combs are the only decision makers regarding publicly held companies, then the only real possible candidates for "front running" are Berkshire acquisitions of public companies in which Berkshire currently has no position.

Over the last decade, that has included Clayton Homes and Burlington Northern (which would have presumably been on the 'Hamburg' list) which makes for a very short list.

This approach is an interesting variant on the well known separation of duties principle. It is reasonable to assume that Berkshire has established industry standard accounting controls. Their overall thrust is to eliminate the opportunities for insider trading.

Contrast this with a typical asset manager. They have their own analysts, use proprietary data, methods, and processes, and delegate significant parts of the process over a number of employees.

Berkshire's home office has only 20 employees, none of them (except Marc Hamburg) senior executives. I would assume that they are aware of numerous proposals -- so many that it is likely that they would be of little value to typical traders. Among other things, Berkshire is frequently mentioned in the press as a potential savior of a doomed company -- the last hope of imploding companies.

So -- how does this relate to Sokol?

One thought is that Sokol, who has no experience in financial or investment firms outside the totally unique environment of Berkshire, inferred that anything not proscribed by the Hamburg list was fair game. Of course this is speculative, but Sokol's behavior is very difficult for me to explain any other way.

More specifically, he lacks the usual motivation and associated behavior associated with insider trading. He doesn't need the money, and the amounts involved, while significant, are not material to Sokol's personal wealth -- and certainly not sufficient for him to take huge personal risks. More importantly, he made no effort to hide his trading.

His actions are consistent with that of a person that was simply unaware of the significance of his trading. This is not an excuse, but a hypothesis.

The 'Hamburg' process -- a proscribed list of publicly traded securities -- may be a clue to how an intelligent man could behave so recklessly.

Berkshire has a system that explicitly proscribes insiders from trading in specific securities. The also have a principle based standard that no one should do anything that they would be uncomfortable reading about on the front page of the New York Times. Sokol has now had the opportunity to to do exactly that. Whatever else is said, it couldn't have been comfortable.

Normalized Earnings - Berkshire Hathaway 2010 Annual Report

Warren Buffett is fantastic at making arcane accounting accessible to an average investor. But it can be hard to go from his big picture analogies to the detailed figures that make up the published financials.

This year he introduced an important new metric to the report -- Normalized Earnings. He offers no details on how he came up with the figure, ($12 billion), but it is simply another approach to separate the noise of short term fluctuations from the underlying, core value of the firm.

This figure is another approach to complement the two principle metrics he has always used. That is -- for the short term, operating earnings and for the long term, change in book value (shareholder equity).

Buffett defines normalized earnings as, "... a year free of a mega-catastrophe in insurance and possessing a general business climate somewhat better than that of 2010 but weaker than that of 2005 or 2006." And he has selected a figure of $12 million as his estimate.

He once again discusses the long term (46 years) metric he has consistently shown at the beginning of each annual report -- change in Book Value.

"To eliminate subjectivity, we therefore use an understated proxy for intrinsic-value – book value – when measuring our performance....Yearly figures, it should be noted, are neither to be ignored nor viewed as all-important. The pace of the earth’s movement around the sun is not synchronized with the time required for either investment ideas or operating decisions to bear fruit."

To demonstrate the value of this metric over intermediate time periods, the report (page 5) includes the exact same data aggregated into rolling 5 year periods. This exhibit is striking in regard to the extent to which the figures stabilize and present a much clearer picture of past performance.

This works particularly well for Berkshire, since it doesn't pay dividends. Book value is the aggregate of the entire financial history of the firms -- and includes all capital gains -- both realized and unrealized. And all the exceptions that are typically excluded from operating earnings.

Later in the report, a discussion of operating earning vs net earnings repeats numerous prior discussions:

"Operating earnings, despite having some shortcomings, are in general a reasonable guide as to how our businesses are doing. Ignore our net income figure, however. Regulations require that we report it to you. But if you find reporters focusing on it, that will speak more to their performance than ours."

Net earnings are a GAAP figure that is meaningful for most businesses, but is severely flawed for a firm with a large investment portfolio and atypical derivative contracts. Operating earnings exclude the change in derivative liabilities as well as realized capital gains and losses.

Since 2006, Berkshire has issued a press release with the non GAAP operating figures reconciled with the GAAP net income figures. They have included this statement (from 2007):

"In our earnings summary, we distinguish between what we call “operating earnings” and investment and derivative gains/losses. Berkshire possesses a huge reservoir (about $35.5 billion on June 30, 2007) of pre-tax unrealized investment gains. The cashing of these in any given quarter (or the realization of losses, for that matter) can materially distort net income figures as well as comparisons between periods. We do not wish investors to mistakenly focus on a bottom-line number affected by large investment gains that do not stem from economic accomplishments during the reporting period and that have no concurrent impact on the intrinsic value of the company. Both trends in our operating businesses and their health are best judged by income before all investment gains or losses."

The only thing missing from this explanation is the implicit assumption that the only additional information is the latest quarter's data. Everything else has already been published and presumably included in valuation of the company. Another way of stating this is that over a single quarter, operating earnings are much more appropriate for a firm like Berkshire than GAAP net income. The quarterly press releases stress this both in quarters where the headline net income figure is higher as well as lower than operating earnings.

Page 33 of this years annual report:

This is a GAAP exhibit and reconciles the balance sheet to the income statement -- and illustrates the various items that impact the change in book value other than net income. The largest is 'Other Comprehensive Income" and includes unrealized capital gains -- which is shown in detail on page 33:

Note that over the 3 year period, the largest items - unrealized capital gains/losses and their tax impact - net to a modest figure. This reflects the market crash in 2008 as well as the stock market recovery in 2009 and 2010.

Net income is clearly a better proxy for earning power (for lack of a better term) than comprehensive income. However, it includes realized capital gains/losses and derivative gains and losses. And also remember that GAAP is designed for all businesses in all industries -- and most businesses don't have any derivatives and have modest capital gains/losses.

" After-tax investment and derivative gains/losses were $1.87 billion in 2010, $486 million in 2009, $(4.65) billion in 2008, $3.58 billion in 2007 and $1.71 billion in 2006."(page 27)

The net income for 2010, 2009, and 2008 of $13.0, $8.1, and $5.0 billion, less derivative and investment gains/losses, are the operating earnings of $11.1, $7.6, and $9.6 billion. The three year average net income was $8.7 billion vs average operating earnings of $9.4 billion.

The 2010 operating earnings of $11.1 billion as well as the three year average of $9.4 billion provide a lot of support for the new metric, normalized earnings, estimated at $12 billion.

[end of part 1]

BP -- Relief is Two Weeks Away

It is likely that two developments during the first half of July could effectively end much of the uncertainty regarding the oil spill. The first is the relief well, which is, according to BP technical executive Kent Wells, proceeding better that anyone could have hoped for.

Since June 17th, when the #1 relief well was drilled to 15,900 feet (measured distance from sea level), the following progress has been made.

1. The 13" casing was set in cement.

2. The remaining distance of less than 2,000 feet has been drilled to within 600 to 800 feet measured distance to the planned intersection point.

3. The distance from the Macondo well has been closed from about 200 feet to about 16 feet.

4. 3 or 4 ranging runs have been completed. A ranging run involves pulling the drill string and attaching a special ranging tool to determine the exact location vis a vis the Macando well.




Remaining tasks include the following:

1. Drill 600 to 700 feet parallel to the Macondo well.

2. Take ranging runs as needed.

3. Stop within 50 feet of the planned intersection and cement the final casing (liner).

4. Intersect the well bore and kill with mud, then cement.

Based on the success of the past two weeks, it is reasonable to expect that the relief well operation will continue to make relative rapid process.

In addition to the relief well, which would end the leakage into the Gulf, the BP subsea containment effort is close to capturing the vast majority of the remaining leakage. The current liminting variable is their ability to process oil brought to the surface.



To that end, BP has all the infrastructure in place to connect the Helix Producer to the kill line from the blowout protector, attached to subsea manifolds and a floating riser, and increase their processing capacity by about 20,000 b/d.

It is likely that this will result in all the oil that can be produced using the current 'top cap' can be processed. If this is done and if the total leakage is less than 45,000 b/d, then the amount of oil leaking into the Gulf will be minimal. In addition, the uncertainty regarding the well float rate will be resolved with a high level of confidence.

According to BP, the only issue regarding implementation of the Helix Producer are high seas from Hurricane Alex. They have said they need 3 days with seas of 3 feet or less (the current waves are in the 6 feet to 8 feet range.

Based on recent history, the BP subsea containment effort has consistently run into delays, so the possibility of problems using experimental technology remains high.

The investment thesis of this is based on the fact that the media is taking an very pessimistic view of the likely outcome of the oil spill. And, there are still risks involved. All the things that have been discussed at length in the popular media could happen. The worst case is not reflected in the current price of the stock.

However, the relatively better outcomes discussed in this post will be discounted sooner rather than later. Take advantage of uncertainty while it is still weighing heavily on this stock with the knowledge that better outcomes are significantly more likely than relatively worse outcomes.
________________________

The primary sources for this are BP and Government press releases. Diagrams modified from BP diagrams. The author has options positions on BP.

Off Topic - A good way to Bicycle in the North Chicago Suburbs

It is so simple, I can't believe it took me so long to figure it out.

1. Drive with your bike to Sheridan Road.,

2. Park.

3. Ride around on the other side of Sheridan. Toward Lake Michigan.

The older suburbs on Lake Michigan are great places to cycle. On the other side of Sheridan, there is no on street parking (at least in places like Lake Forrest). So, park on the other side of the street and you can bike in a fabulous setting.

These suburbs don't do something gauche like have gates. They carefully filter out the traffic and people by subtle barriers. By the time you get to Sheridan, you have made it. They use all tactics -- one way streets, 3 increasingly more efficient ways of going north/south (I94, 41, Green Bay Road) to discourage through traffic. etc.

I just started biking close to my vehicle since the weather has been shaky lately. This encouraged me to just randomly park the vehicle (too embarrassingly large to admit-but a rental) on an attractive street and just go from there. I keep as close as it seems prudent to the vehicle and just explore.

The streets next to the Lake are very well maintained. The landscaping is immaculate. Very little traffic. This is the perfect place to casually cycle.

From the Archives:

On May 8th of last year, Richard Kline had this to say to me:

May 8, 2009 at 6:12 am
So cap vandal, there are so many problems with the putative positives you advance here regarding the stress-less tests that I’m going to pass on the rest of that list. But let’s just review:

No one said that most of the $8T in assets in the banking system are bad. The problem is that the concentration of loss is in the major financials which are holding the rest of the system, the government, and the country hostage to their busted dreams. Your rhetorical attempt to stuff the desperate losses of the Big Few under the skirts of the weary solvent many does you no credit.

Your reference to mortgage backed securities and their supposed absence from the system as a cause for relief is misconceived. This is well known, yes: most of that paper was on-sold. —And then the Big Lost Few turned around and wrote CDS swaps against those securities for face or against the bonds of those securities purchasers for face, so guess where the ‘loss’ on those securities will progressively boomerang back to? Now the bulk of those losses haven’t been realized yet because the tranching structures of those MBSs were designed to absorb the first losses internally and on the small players. Which is exactly why the Big Few are putting us through this whole dismal charade of ’solvent today, my friends’ to raise capital _before those swap losses_ are put to them. Think that THOSE exposures were adequately accounted for in these ‘tests,’ my friend? If so, I’m sure that Citi has a slice of preferred they’d love to sell you cheap. Or even dear (I mean why not, the public gets the bill?).

Then there is the matter of securitized LBO debt you haven’t managed to drag into the discussion, quite a lot of which is left on the sometime ’speculation’ banks (which is what they should be called). Think that those are marked to market, especially when the minders of accounting standards were dragooned into ‘mark and let mark’ practices?

In view of these small further matters, without even going into other relevant Concerns, that $6B at Wells, yes that $75 headline ARE COMPLETELY MEANINGLESS NUMBERS. They are numbers for the media and the rubes, but not meaningful estimates of probable losses. If you added a zero on the right end to that Wells raise we might be talking the real money. If it was indeed large private capital standing on the sidelines about to buy in to the six at Wells, I would tell its deployers, Please don’t: start your own clean major bank with it, and make a killing. Although given all the money floating around from the public put to the Big Few which they aren’t investing in the real economy, I suspect that we will have considerable shadow purchases funneld through the hedges to prop up each others equity, here. No smart money is going to buy into Wells, but others in the same boat have every incentive to take public money and quitely support each others’ capital to make the whole show go on.

The problem we have here, my friend, is that the entire core of the financial system has become an aggregated slime mold of formerly distinct Enrons, bloated 100 times larger.

And your assurance that large private capital would ne-eev-eerrrr invest in the banking system again if they were nationalized is . . . music to my ears, that sounds about right. We need a banking system which serves the country, not a greed parade that hollows it out. Most of those folks: they’re working with Other Peoples Money anyway, not their own. That money will flow to real return, and real returns will return to the banking system to attract them when said banking system is sound. Which it is not and will not be so long as sham shows like this ‘fooled yah’ examination are promoted by a government which still, as of today, refuses to regulate the financial industry in any meaningful fashion. And that outcome, my friend, sucks dynamite.

I'm not going to address Richard's points in detail. In fact, as critics go, his post was articulate and representative of the better as opposed to the worse [from my perspective] commenters.

It sounds alarmist today. On May 8th, it wasn't far from the blogosphere mainstream.

That's one reason I quit blogging. I just didn't have the energy to keep up with the shrillness. Plus, some of my premature bullishness started to be confirmed by the markets, and just sitting on my long positions was proving more profitable than trading.

What a difference in 4 months.

I'm Back....

To my loyal readers, I am back from an extended break.

No one wants to hear, "I told you so." and being right is not a good way to be popular. Still, there are times that you just can't resist.

As far as I can tell, I'm the only financial blogger that praised the "stress tests." The KBW index looks good since May 7th.

So, I'll just say it.

I was right. Find someone else with something good to say about the stress tests from that period, if you can. Or else, a little credit from my critics on "naked capitalism"

Especially those that accused me of hopeless naivete. That plus being oblivious to the facts and an apologist for banking swine.

However, owning long positions for one's own account and acting on one's opinions can provide a certain highly pleasurable reward that is MUCH better than extracting some sort of recognition from the blogosphere.

More on Roubini....

With regard to the stress test being consistent with the IMF estimates, consider the following from the blog Alea:

Still, it is useful to know whether our estimates are consistent with what has been found by others. Two studies released within the last few weeks essentially bracketed the supervisory estimate. The International Monetary Fund estimated lifetime losses that would imply a loan loss rate for U.S. banking firms of about 8 percent in a stressed scenario. One of the major rating agencies estimated an annual loan loss rate of about 4-3/4 percent in a stress scenario for the next two years.  More broadly, our informal survey of the results of a considerable number of private-sector studies and analyst reports published over the past several months generally placed our projected loss rates for key portfolios near the midpoints of the ranges of these independent estimates.

Major Roubini Goof

Professor Roubini stated that: 

The IMF recently estimated that retained earnings (after taxes and dividends) for all US banks – not just these 19 ones – would be only $300 bn total over the 2009-2010 period. The stress tests – instead – assumed much higher retained earnings - $362 bn - for these 19 banks alone for the 2009-2010 period in the more adverse scenario. Since these 19 banks account for about half of US banks assets if one were to use the IMF estimate of net retained earnings for these 19 banks their net retained earnings for 2009-2010 would be $150 bn rather than the $362 bn assumed by the regulators. While the IMF may have been too conservative in its estimates of net retained earnings it appears that regulators may have been too generous to these 19 banks in forecasting their earnings in an adverse scenario.

Professor Roubini should realize that you don't pay taxes on losses, and the funds available for loan losses are much higher than $362 billion.  The IMF figure includes dividends, which you don't pay if you are in financial difficulty and loss provisions.   In 1Q2008, BAC had about $18 billion in loan losses and pre tax, pre dividend earnings and Wells had about $10 billion. That's $28 billion for the two per quarter or or $224 billion over the two years from these two banks alone. This figure may be way too optimistic, but $150 billion from the two banks certainly isn't.

Some of the banks may have to book huge portions of their pre tax, pre provision earnings but that is a big number.  Just consider the $8 trillion in RWA and use a conservative net interest rate margin (say 2% per year) and you end up with $320 billion over the two years.  

More on the Stress Test

As the only blogger that had anything close to unequivocally favorable to say about the stress tests, I did manage to get a few hits, but not many.  I suppose people are just sick to death of yesterday's news.

There is no upside in saying anything favorable and to appear to take it seriously is to risk seeming hopelessly naive.

However, I think betting against the Fed/Treasury is a bit naive.  

The way to read it is to start backwards.  Total 2 year losses of $600 billion.  Together with the $400 or so that have already been booked, thats $1 trillion.  If these financial institutions have 1/3 of the assets exposed to the "crisis" -- that would put the total at $3 trillion.  Or big enough to be in the range of plausibility.

The next step is looking at how the $600 is going to be "funded."  I already went through this in the last post, and it seems reasonable.  

I read a bit of the RGE monitor (Roubini) and he is heavily invested in his scheme to do a "good bank/bad bank" reorganization.  Not a bad idea, but I have a feeling that he simply doesn't understand banks.

In fact, most of the disagreements seem to be people who equate banks with New York investment banks and see the rest of the financial sector as simply an appendage of New York.  I tend to see New York and investment banking as a separate business.  A lot of it could disappear with no consequence.  It already has.  The flip side is that the majority of abuses were associated with investment banking and they managed to almost blow up the world financial system.  

Investment banks don't make normal loans.  The only stand alone investment banks are GS and MS.  they have a lot of exposure to securities but not much to loans.  They don't do credit cards.  They don't deal with retail lending customers.  They did facilitate a lot of lending, but no one wants to buy these sorts of products anymore.  The so called originate to distribute model.  

As far as banks that make loans -- they seem to be making them.  I am at a loss regarding whether they should lend more or tighten standards, but they seem to be doing about the right thing.  That is, no more really stupid loans.  They do seem pretty aggressive about loaning to people that can pay them back -- but those people don't especially want to borrow.  

The general playbook of the Treasury/Fed is to subsidize interest rates and force people to either accept zero returns or start taking some risk.  This is all they can do and they are doing it in every way imaginable.  It is also directionally right as a policy move.  In fact, you have fiscal stimulus via deficit spending to go with the liberal monetary policies.  

That is the right thing to do directionally, and they seem to be doing a lot of it, which is, for lack of a better word, good.

Berkshire's 1Q Earnings Announcements

First the basics on how earnings are reported in US GAAP.  This is a big picture, non accountants overview.  They get split into two parts -- one labeled net income and the other labeled other comprehensive income (OCI).  The idea is to put normal stuff in the first bucket or items that have some finality -- like cash losses.  The other bucket gets things like unrealized capital gains and losses, which will fluctuate and make it more difficult to see how the firms operations are trending.

This treatment of unrealized capital gains and losses is not in the least controversial.  For Berkshire, the infamous long term put options would logically fall into OCI (other comprehensive income) -- since they are intended to be held for over a decade, and quarterly movements are noise.

Instead of trying to change accounting, Berkshire has developed a very simple non GAAP metric that it refers to as operating earnings.  Every quarter it puts out a statement opening with operating earnings and reconciling to GAAP.  Operating earnings exclude derivatives as well as other financial "bets" like currency trades.  They are, in fact, operating earnings, which is really what GAAP net income would like to be, if it weren't trying to be uniform across all businesses.    

Right now the volatility of the derivative book they totally overwhelms the changes in the core business earnings.  The Berkshire release saves investors and the media from having to make these adjustments themselves.

This quarter was a bit different.

1.  The earnings release was a week after the annual meeting.

2.  A "preview" of earnings was released, with the emphasis on operating earnings. They were down modestly from $1.9 billion to $1.7 billion.  Given the economy, not bad.

3.  The final published figures contained additional losses of $2 billion ($3 pre tax).  This is based on unrealized capital losses, but since Berkshire has announced that it will sell enough COP stock to get a $600 million tax refund, it labeled these losses as OTTI (Other Than Temporary Impairment) losses.  This means that they can be booked in net earnings BEFORE the stock is sold.  

4.  This huge OTTI clears the decks regarding realized capital losses for the remainder of the year.

The headline numbers should really be Berkshire's non GAAP 'Operating Earnings'.  It is the best way to make sense of the results, and any competent stock analyst would perform a similar set of adjustments.  

The press never seems to read and report on Berkshire's released operating earnings.  This year, it's all that was available when the quarter was discussed at the annual meeting.

Plus, Buffett threw in the kitchen sink by booking the OTTI when 1Q is old, old news.   This is as close as you are going to see Buffett come to spinning bad news. Nothing misleading about it, and in fact, it gives a more accurate picture.  At least the operating earnings.  Taking the OTTI losses as early as possible is something that most CEO's would like to do and Buffett can afford it.  Equity markets hate uncertainty and booking bad news ASAP tends to be good for the stock price.  Buffett may not care very much, but now the foundations have to sell some Berkshire on a regular basis, and there is an economic motivation to keep the stock price at a fair value. 

Ten Reasons the Stress Test doesn't SUCK

Before anyone gets too critical, they should actually read it. And review the spreadsheet.   A good list of the flaws can be found at naked capitalism: Yet More Stress Test Doubts.

This is an alternative point of view.

1.  After the extra extraordinary measures taken in the fall, especially the passage of the $700 billion TARP bill, the public needed some documentation. Something beyond Paulson's single sheet of paper.  Even if this is just an elaborate back of the envelope estimate, it is a single set of figures in a single document.

2.  Define "To Big To Fail"?  It has now been done.  Any "bank holding company" meaning financial institution with a banking license that has over $100 billion in assets.  It's 19 and it includes an auto finance sub (GMAC), a Life Insurer (Met), and a credit card company (American Express).  Two investment banks, two hybrids with investment and commercial banking (C, BAC).   

3.  What do the big 19 have in common?  Nothing other than size.  Most of the public outcry has been over excesses in New York Investment Banking.  Anyone think that USB's Minneapolis based bankers routinely get million dollar bonuses?  People should chill with the generalizations.  Or maybe just quit calling New York financial activity banking and the people that do it bankers.  There is an important distinction that has been deliberately blurred, and community bankers aren't happy about it.   

4.  It is a very big chunk of the traditional banking system. The two biggest, BAC and WFC have well over 20% market share of insured deposits.  I don't mind size as long as it is just vanilla banking scaled nationally.  Like the old Bank of America, when  they avoided investment banking.  A firm like Wells should think about splitting out it mortgage servicing business.   

5.  Maybe the traditional banking system really isn't the problem.  They are only involved with 20% of total lending. Per Jamie Diamon:

Traditional banks now provide only 20% of total lending in the economy(approximately $14 trillion of the total credit provided by all financial intermediaries). Right after World War II, that number was almost 60%.

 We have reps for all the players in the 'shadow' banking system.  Investment banks that did securitizations.  A credit card firm.  Brokerages that underwrite bonds.  

6.  A sense of how things could really play out.  People will either agree or disagree, but at least they have some numbers to talk about that are ground up rather then the economic aggregates tossed around by the economists.  

7.  $8 trillion in assets.  An estimate of $600 million in losses.  Two numbers that tie into published financials of specific firms.  Remember that a lot of assets were sold to non banks.  If this is 20% to 25% of the total assets exposed to losses, that corresponds to $2.4 to $3 Trillion that the economists talk about.  A lot of the worst stuff was sold off, so the $600 billion figure is big enough to be more than plausible. 

8.  What about the zillions in level 3, toxic CDO's?  Less than 2% of the total.  

At the end of 2008, the 19 BHCs held $1.5 trillion of securities, more than one‐half of which were Treasury, agencies, or sovereign securities, or high‐grade municipal debt, and so are subject to no or limited credit risk. Only about $200 billion was in non‐agency mortgage‐backed securities (MBS) and only a portion of these were recent vintage or were backed by riskier nonprime mortgages.

How much hand wringing has there been over this topic when discussing banks? Way too much, it seems. It isn't like there aren't problems, but most of the problem assets aren't owned by banks, and those that are were pretty much written down over the last year and a half.  It is a big problem, but one that was sold around the globe.  The banks thought they held the best CDO's and they definitely sold stuff that was materially worse then they kept.

9.  Just like Japan?  There are $60 billion or about 10% of the estimated total losses that have already been booked via purchase accounting adjustments associated with the larger mergers.  This includes WB, MER, WM, CW and a few others.  

You work through $600 billion in big chunks over a couple of years.  As noted above, 10% is done.  There is capital in excess of regulatory requirements right now, if needed.  This was done using 12/31 data, and over $100 billion has been done during that period.  We have 7 more quarters of earnings to use for loss provisions.  Finally, there is the $75 billion of additional common equity that is required to be raised.  

10.  Everyone can apply their own judgment against these figures.  However, I think that it isn't the banks.  It's the real economy.  People might be able to chill about banks and start thinking more about jobs, etc.  

Maybe it is just too optimistic.  If so, a next step could be to relax capital requirements IF there is strong evidence the economy has turned.  The economy is cyclical and there are lags.  Do we need to have banks that are capitalized above the regulatory level at the trough of a monster recession?  Capital is there for a reason and there are times that you relax the requirements and let the levels drop.  If you can NEVER use it, why have it in the first place.