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]