Street Capitalist: Event Driven Value Investments

The demise of Washington Mutual (NYSE:WM) is being well covered in the financial press today. When I heard about it, I wondered what would happen to the company’s credit default swaps. If you remember, Fairfax Financial (NYSE:FFH) may own some of these securities and stands to profit from the company’s fall.

Here’s a look at the WaMu’s credit default swaps:

Hopefully Prem and the rest of the team Fairfax will keep us in the loop as they do some selling, they did so last week and it was great news to shareholders who have been patiently holding the company. I still think Fairfax is undervalued, the company is still not trading like its peers (1.5X book value) but I’m extremely pleased with the progress that we’re making right now.

It feels good to own a company that is well protected from Mr. Market’s turmoil!

While Warren Buffett of Berkshire Hathaway (NYSE:BRK.A) has mostly come out with praise for Henry Paulson’s bailout plan, he has reserved some criticism aimed at the “hold-to-maturity” price that tax payers would be footing the bill for:

JOE: It’s just that, you know, they want these details, Warren. They said — Paulson says there’s the hold-to-maturity price and there’s the firesale price. We’re going to go somewhere in between, get a much better price but still leave enough for the people that are buying it to make some money. That can be done in principle? There’s a way to do that, do you think?

BUFFETT: I think what I would be looking for -- I heard that hold-to-maturity price. I’m not as excited about that. I basically like a market, or something very close to a market-related price. And there are ways to determine that and I don’t think that Uncle Sam should be in the business of paying somebody a whole lot more than it’s worth in the market today. And if the guy that bought it doesn’t like it, he doesn’t have to sell it, and it was his problem, he bought it in the first place. I think a market price will enable people to be leveraged. The problem they have now is that some of the institutions, they’re loaded with this stuff, they’re having trouble funding, and they’re worried about being able to sell a ton of it. But take the Merrill Lynch deal. Merrill Lynch had to take back 75 percent of the sales price. Well, they didn’t want to take back that 75 percent. I would let ‘em sell it for the same price, but I’d pay them the whole thing in cash. So they’d be a lot better off if they could have sold the whole thing at that same price but gotten paid a hundred percent in cash instead of having to take back 75 percent. And I see the government fulfilling that kind of a function.

CNBC INTERVIEW TRANSCRIPT & VIDEO, Part 3: Warren Buffett Explains His $5B Goldman Investment (CNBC)

We know that Buffett announced his investment in Goldman Sachs (NYSE:GS) shortly after details about the bailout plan actually emerged. It’s easy to see why. The government would be purchasing the cancerous toxic assets that have infected financial institutions and forced them to write down their values. Buying these assets at fire sale prices makes sense, even Buffett thinks that there may be opportunities in this area and on CNBC expressed that he would love to have $700 billion to go buy them up.

Unfortunately though, fire sale and hold-to-maturity prices are quite different and are likely to be spread vastly apart. It’s simple to see why he’s not enthusiastic about this aspect of the bailout plan. Warren Buffett is a value investor, he hunts for bargains. Bargain hunting means investing in securities with a sufficient margin of safety or the spread between what a security is selling for and its intrinsic value. Investors usually wish to find wide margins of safety in case something unintended happens, perhaps a problem grows worse than you expect or that you overlooked some aspect of the company your analysis.

The lack of market prices reduces any margin of safety that the government could obtain on these assets and puts taxpayer money at risk for losses. The folks in Washington should try to do something to avoid it. So far, Congress seems to be resisting Paulson’s plan and may have some room to make modifications. They seem to be fighting for basically a few added options - equity stakes in the companies that are bailed out, market pricing, and curbed executive pay. I can see the merits in the first two, equity stakes would provide the government with an upside when bailing out these financial firms. After all, once those toxic assets are taken away many of these companies have nice businesses.

I feel like the executive pay idea is a little too rhetorical and may be too small of a problem when compared to everything else Congress has to worry about. Plus there is the added risk that Congress would waste taxpayer money on the hiring of compensation consultants to tackle the problem which brings to mind a funny quote by Charlie Munger- “I would rather throw a viper down my shirtfront than hire a compensation consultant.”

Even though I’ve mostly been posting about AIG (NYSE:AIG) and their impending liquidation and business line sales, one interesting situation that I monitored was Constellation Energy (NYSE:CEG). The Lehman Brothers bankruptcy had a highly negative impact on CEG’s stock because the company had received $150 million in financing from Lehman. I thought the situation was weird because in the context, that amount of debt is small. $150 million when the overall package was for $2 billion. The stock subsequently dropped 60% as a result of market jitters over what would happen to the company.

Today though, it’s been announced that Warren Buffett’s Berkshire Hathaway (NYSE:BRK.A) is acquiring CEG. Berkshires subsidiary MidAmerican Energy Holdings is doing the deal, and for all cash.

DES MOINES, Iowa & BALTIMORE, Sep 18, 2008 (BUSINESS WIRE) — MidAmerican Energy Holdings Company and Constellation Energy today announced the companies have reached a tentative agreement in which MidAmerican will purchase all of the outstanding shares of Constellation Energy for a cash consideration of approximately $4.7 billion, or $26.50 per share. The companies expect to enter into a definitive merger agreement by close of business, Sept. 19. Upon signing a definitive merger agreement, Constellation Energy will issue $1 billion of preferred equity yielding 8 percent to MidAmerican…

“We strongly believe this transaction is in the best long-term interest of our investors, employees and the customers and communities we serve,” said Mayo A. Shattuck III, chairman, president and chief executive officer for Constellation Energy. “The financial services sector and energy commodity markets have witnessed unprecedented volatility. Backed by the significant industry expertise and financial stability of MidAmerican and Berkshire Hathaway, Constellation Energy will build on its reputation as a first-choice energy solution provider for our many customers.”

“MidAmerican has been a wonderful steward of its energy assets and the acquisition of Constellation Energy, when completed, will prove beneficial to all constituents,” said Warren E. Buffett, chairman, Berkshire Hathaway.

MidAmerican Energy Holdings Company Reaches Tentative Agreement to Acquire Constellation Energy (Market Watch)

MidAmerican’s purchase price of $26.50 per share seems like a good deal. Only a week ago the company traded at $60! This just shows you the fragile nature of leveraged companies operating in a market that lacks liquidity. Any adverse move to their financing, even small amounts, can put the whole company in jeopardy:

The business relies heavily on its ability to access financing, which is highly sensitive to Constellation’s credit-worthiness. While Constellation has a credit line of $150 million with Lehman Brothers Bank, it also has about $2 billion in other liquidity available, according to the SEC filing.

Still, some analysts pointed to credit concerns exacerbated by recent market turmoil.

Constellation “remains under significant pressure [yesterday] as investors remain concerned about the company’s potential loss of access of liquidity and the potential evaporation of trading counterparties for its commodity business in the wake of financial market turmoil,” JPMorgan analyst Andrew Smith wrote in a research report yesterday.

He noted that increased costs to insure Constellation’s debt also may be adding to liquidity concerns.

Constellation stock falls 36% on vague fears about financing (Baltimore Sun)

The Constellation acquisition may be the first of many for Buffett during this crisis. His strategy may be to simply buy good companies in safe industries (non-sub prime) that were affected negatively by financial factors rather than economic factors. Buffett has a huge advantage over corporate acquirers because unlike them, he’s able to complete deals in a much faster time frame than corporate boards. That, combined with Berkshire Hathaway’s enormous cash horde, really makes this Buffett’s market.

While I was never a believer that Warren Buffett would infuse capital in AIG (NYSE:AIG), or buy the company, I did think that he would be interested in Steven Udvar-Hazy’s aircraft-leasing unit International Lease Finance Corp. (ILFC). This belief mostly rode on two facts:

1. ILFC is a great business with a great moat that Berkshire Hathaway (NYSE:BRK.A) is not a part of.
2. Udvar-Hazy is the type of manager that would fit perfectly with Berkshire’s culture. No news has surfaced about Buffett or Berkshire and ILFC so far, but today the WSJ reported that Udvar-Hazy is attempting to buy ILFC from AIG:

Mr. Udvar-Hazy and other top ILFC officials have been in around-the-clock discussions with potential investors since late Sunday. Among the candidates for capital are private equity, pension funds, European banks, sovereign wealth funds and other non-U.S. equity. The discussions have involved a variety of options, ranging from an outright purchase to the potential of buying the bulk of the leasing company’s assets.

Mr. Udvar-Hazy and his management team are widely considered to be one of the most important ingredients behind ILFC’s ability to move nimbly in a daunting credit market. According to people familiar with the situation, he and other senior executives at ILFC have concluded that it would be virtually impossible for the leasing company to remain competitive as long as it is part of AIG. The deterioration of AIG’s once-impeccable AAA credit rating has raised ILFC’s borrowing costs to the point that the company would be unable to prosper in an increasingly crowded leasing market, the thinking goes. On Monday, Standard & Poor’s cut AIG’s long-term credit rating three notches to A-minus from AA-minus, and even with the federal loan it is unlikely that the insurer would be able to quickly restore its creditworthiness to previous levels.

Mr. Udvar-Hazy, a Hungarian immigrant, pioneered ILFC’s leasing niche when he founded the company 35 years ago with the help of countrymen Leslie and Louis Gonda, a father-and-son team. The founders sold ILFC to AIG in 1990 for $1.3 billion in stock, and Mr. Udvar-Hazy was given the reins to run the company in an entrepreneurial way…

ILFC officials have been frustrated for months that ILFC has been dragged down by the parent company’s woes, even as the leasing unit turned in record profits. In March, Mr. Udvar-Hazy began pursuing a corporate divorce, but was persuaded to hold off by AIG’s new top management team. As AIG’s position continued to deteriorate in recent days, it put further pressure on ILFC to begin exploring options that would allow the firm to disentangle itself from its parent.

ILFC Chief Is Trying to Buy Company Back From AIG (WSJ)

The article lists a varied group of financial entities that could be interested in helping Udvar-Hazy purchase ILFC from AIG. However, the company’s large debt load makes me believe that a private equity buyer will be less likely. Usually the PE model involves picking companies that can be leveraged to the hilt, not companies that are already highly leveraged.

Sovereign wealth funds on the other hand may be better suited for this kind of acquisition, at least for once they’d be purchasing a good company that has a nice competitive advantage for years to come - unlike the wave of capital infusion deals they made this last year or so.

Finally, a corporate buyer makes a lot of sense too because the current dealmaking environment seems more conducive to corporate deals over private equity deals. General Electric (NYSE:GE) is the owner of GECAS (GE Commercial Aviation Services) which is ILFC’s competitor and has an aircraft portfolio worth $45 billion dollars versus ILFC’s portfolio of $48 billion. Berkshire Hathaway is again positioned well for an acquisition like this. They have their AAA rating and a cash horde that could easily handle ILFC’s debt. Outside of these two, there are a host of financial firms who may see ILFC as an attractive business based on its strength, it could bring a safe stream of earnings.

This will be a good situation to keep watching, just to see how it plays out. It’s always insightful to see a great manager working to make his company better and I think we’ll be able to learn quite a bit from Udvar-Hazy’s actions as he tries to save ILFC from AIG’s problems.

Yesterday, I posted that AIG (NYSE:AIG) was barely holding on to their AA- rating. Now that’s gone:

The pressure on troubled insurer American International Group intensified Monday night as a credit rating agency downgraded the firm.

Another cut could prove very costly to AIG, which is scrambling to raise much-needed capital.

Fitch Rating downgraded AIG to A, from AA-, saying the company’s ability to raise cash is “extremely limited” because of its plummeting stock price, widening yields on its debt, and difficult capital market conditions.

The company could be required to post $10.5 billion of additional collateral if it is downgraded one notch by one of the other major rating agencies and $13.3 billion of collateral if downgraded by both, Fitch said in a statement, citing AIG’s July 31 estimates.

AIG downgrade could prove costly (CNN Money)

Unfortunately, S&P has also chosen to downgrade the company (but only its counterparty rating):

American International Group Inc.’s long-term counterparty rating was cut to A- from AA- by Standard & Poor’s.

The U.S. rating company in a report cited a “combination of reduced flexibility in meeting additional collateral needs and concerns over increasing residential mortgage-related losses.”

S&P also lowered AIG’s short-term counterparty credit rating to A-2 from A-1+, and cut its counterparty credit and financial strength ratings on most of AIG’s insurance operating subsidiaries to A+ from AA+. The ratings remain on watch for a possible further downgrade, S&P said.

AIG Rating Cut to A- by S&P; Remains on Watch Negative (Bloomberg)

With the New York Times reporting that “if AIG does not raise cash and is downgraded by ratings agencies, it may have only 48 to 72 hours to survive” some kind of deal needs to be announced by tomorrow before things take a turn for the worse.

AIG’s management should have released a clear plan for asset sales to raise capital today, but they did not. Rather, they chose to announce that they were granted the ability to use subsidiary assets as collateral, to try to keep functioning. Now reports are circulating that Goldman Sachs (NYSE:GS) and Morgan Stanley (NYSE:MS) will be leading an effort to grant AIG $70-75 billion in loans to help support the company. So far these measures have faced difficulty. Like with Lehman Brothers (NYSE:LEH), parties simply do not want to loan money without the backing of the government:

AIG has also held discussions in recent days with private-equity firms about providing an infusion of cash. But some firms balked at putting in money absent a Fed bridge loan, and at this point, private-equity firms such as TPG and Kohlberg Kravis Roberts & Co. are more interested in buying specific AIG assets rather than contributing money to a capital infusion, according to people familiar with these firms’ thinking.

The company also talked with Warren Buffett, chairman of Berkshire Hathaway Inc. which has a number of insurance businesses. The talks didn’t result in specific plans, and it wasn’t clear if they were ongoing.

AIG Seeks Huge Loan As Stock Dives 61% (WSJ)

The situation appears as if management at AIG is hoping to keep the company totally intact by securing large commitments of capital in the form of a bridge loan or some kind of support from the Fed. On the other hand, private equity firms and Buffett are offering AIG cash, but only for specific business units. This logic is very typical of Buffett, he has no reason to bail out AIG because he does not want or need the whole company. He is looking for good businesses run by good people, which means only certain groups within AIG.

The game AIG’s management is playing right now, by not committing to any quick deals, seems akin to the style employed by the management of Lehman Brothers this weekend. We know how that turned out. Maybe these guys will smarten up and start making some more practical decisions.