Street Capitalist: Event Driven Value Investments

Today, the New Yorker has a review by Malcolm Gladwell on Steve Rattner’s Overhaul, his own accounts of what went down during his tenure as auto czar when he helped restructure the American auto industry. I actually picked up a copy of Overhaul recently and started reading it myself. It’s an interesting book, but its scope is limited to Rattner’s own view of things. Gladwell seems to have picked up on this in his review:

Wagoner was not a perfect manager, by any means. Unlike Alan Mulally, the C.E.O. at Ford, he failed to build up cash reserves in anticipation of the economic downtown, which might have kept his company out of bankruptcy. He can be faulted for riding the S.U.V. wave too long, and for being too slow to develop a credible small-car alternative. But, especially given the mess that Wagoner inherited when he took over, in 2000—and the inherent difficulty of running a company that had to pay pension and medical benefits to half a million retirees—he accomplished a tremendous amount during his eight-year tenure. He cut the workforce from three hundred and ninety thousand to two hundred and seventeen thousand. He built a hugely profitable business in China almost from scratch: a G.M. joint venture is the leading automaker in what is now the world’s largest automobile market. In 1995, it took forty-six man-hours to build the typical G.M. car, versus twenty-nine hours for the typical Toyota. Under Wagoner’s watch, the productivity gap closed almost entirely.

Most important, Wagoner—along with his counterparts at Ford and Chrysler—was responsible for a historic agreement with the United Auto Workers. Under that contract, which was concluded in 2007, new hires at G.M. receive between fourteen and seventeen dollars an hour—instead of the twenty-eight to thirty-three dollars an hour that preëxisting employees get—and give up all rights to the traditional retiree benefit package. The 2007 deal also transferred all responsibility for paying for the health care of G.M.’s retirees to a special fund, administered by the U.A.W. It is hard to overstate the importance of that second provision. G.M. has five hundred and seventeen thousand retirees. Between 1993 and 2007, the company paid out a hundred and three billion dollars to those former workers—a burden unimaginable to its foreign competitors. In the 2007 deal, G.M. agreed to make a series of lump-sum payments to the U.A.W. over ten years, worth some thirty-two billion dollars—at which point the company would be free of its outsized retiree health-care burden. It is estimated that, within a few years, G.M.’s labor costs—which were once almost fifty per cent higher than the domestic operations of Toyota, Nissan, and Honda—will be lower than its competitors’.

Steven Rattner and the rescue of General Motors (New Yorker)

As much as I would like to complain about the management teams of the Detroit automakers, you have to admit that Wagoner had a lot on his plate when he became the CEO of GM. He ended up taking control of a company burdened by legacy costs and the company made significant inroads in reducing them. GM’s joint venture in China is notable because the Buick tends to be one of the best selling cars there. In a rapidly expanding auto market, that’s a good spot to have.

Gladwell seems to also take aim at the private equity business model:

Team Auto’s idea was to bypass the traditional bankruptcy procedure, in which the entire company would be restructured through a protracted process of negotiation with creditors. Instead, the company would be divided into two. “Old G.M.” would contain the unwanted factories and debts and unused assets—all of which would be wound down and sold over time. The best parts of the automaker would be transferred to “New G.M.,” an entity funded and owned by the American taxpayer. The task of carving out the new entity was enormously complex, and involved rewriting countless contracts with unions, suppliers, and creditors. To minimize disruption to the company’s operations, Team Auto worked with lightning speed…

It is not hard to understand what is going on here. Team Auto was engaged in an act of financial engineering: it used the power of the bankruptcy process to rid G.M. of some of the liabilities that had been holding it back. This was cleverly and swiftly done. It was badly needed. But, at the end of the day, cleaning up a balance sheet is cleaning up a balance sheet. Kristin Dziczek, of the Center for Automotive Research, estimates that the “new” G.M. is roughly eighty-five per cent the product of the work that Wagoner, in concert with the U.A.W., did in his eight years at the company and fifteen per cent the product of Team Auto’s efforts. That seems about right: car companies stand or fall, ultimately, on the strength of their product, and teaching a giant company how to build a quality car again is something that can’t be done on the private-equity timetable. The problem is that no private-equity manager wants to be thought of as a mere financial engineer. The mythology of the business is that the specialists who swoop in from Wall Street are not economic opportunists, buying, stripping, and selling companies in order to extract millions in fees, but architects of rebirth. Rattner wants us to think of this as his G.M. “As we drafted press statements and fact sheets,” he writes, “I would constantly force myself to write that ‘GM’ had done such and such. Just once I would have liked to write ‘we’ instead.”

The whole review is worth reading and I think Gladwell counter-balances some of Rattner’s own views of the situation. Will Overhaul make you an expert on the auto industry? I doubt it. But I think it will give you a good view of what was going on in the auto industry and what had to happen in order to help them overcome some of their problems. Even if it was a lot of financial engineering.

On the hedge fund industry

ROSE: What’s happening, in your judgment, to this industry?

ACKMAN: The answer is it depends on what you benchmark the industry against. You know, the markets are obviously having a difficult year, and also something extraordinary happened to hedge funds. Hedge funds generally go long and they go short. And hedge funds woke up on a Friday in September. All of a sudden it was illegal to be short. That caused hedge funds to lose enormous amounts of money, as they were surprised that something that was perfectly legal for many years became illegal.

ROSE: This is so important. I’m going to have you do the definitions, even though we talk about this all the time, here on this program and other places. Tell us what a hedge fund is and going long and going short.

ACKMAN: A hedge fund is really an investment partnership. The difference between a hedge fund and a mutual fund is that the manager is compensated largely on performance. A manager typically gets 20 percent of the profits. A manager typically has a very large investment alongside his investors. I would say that’s the principle difference.

ROSE: And he gets two percent fee, two in twenty?

ACKMAN: One to two. It’s a good business.

ROSE: Yes. It’s a good business because you got it going both ends. You’re going to make your money, and if it goes up you get 20 percent of it. If it goes down –

ACKMAN: You’re out of business at a certain point. So you won’t get that two percent for long.

ROSE: Right. So it was a huge thing for how many years?

ACKMAN: The hedge fund business or short selling?

ROSE: Hedge fund.

ACKMAN: Hedge funds really started — Ben Graham, going back to Warren Buffett’s mentor, He was a hedge fund manager in effect. He went long and occasionally he went short. But it didn’t become a real industry where there are thousands of participants until five, six, seven years ago.

ROSE: And going long and going short means?

ACKMAN: Going long and going short — going long is making an investment. You buy a stock on the exchange. Going short is borrowing a stock, selling it on the hope you can buy it back on a lower price.

ROSE: You were a very good short seller.

ACKMAN: Occasionally we got it right.

ROSE: You were a very good short seller.

ACKMAN: Not always. It’s a difficult business.

ROSE: When the government shut it down for a while, it was terrible for people in the hedge fund business.

ACKMAN: It was more that the rules of the game were changed mid- stream. I think if the government had said, look, we’re going to phase out short selling over a period of time, it wouldn’t have been disastrous for an industry. But if you have investors who commit to their partners to stay balanced, they don’t want to be more than a certain amount long versus the amount that they’re short. You lose the ability to insure yourself. Short selling is really a form of protecting yourself from the market going down. By taking away that very important tool, managers got imbalanced. They were actually forced to sell their long positions.

We’re not large short sellers shorting stocks. Most of our short selling we do through derivatives, another topic. But something called a credit-default swap is a way to be short.

On the credit crisis

ROSE: What did you see and when did you see it, to paraphrase Howard Baker’s famous question of the Nixon administration people? What did the president know and when did he know it?

ACKMAN: I was princely a long investor for the first ten years of my investment career. In 2002, I came across a company called Farmer Mac, which is a GSE, not that different from Fannie and Freddie, but that operates in the agricultural credit market. It was recommended to me as a long investment, something I should buy. The more I looked, the more I concluded that this was a good short. And without going into too many details, I bought a credit default swap and it turned into a profitable bet.

I then looked at Fannie and Freddie. Actually in 2002, I made short bets through credit default swap market on Fannie and Freddie, but ultimately gave up because I thought of them as too big to fail. But as part of that research, I was looking for other companies that had Triple-A ratings, where perhaps they didn’t deserve their rating. I came across a company called MBIA, which is a bond insurer. It’s a company that started out in a very low-risk business, guaranteeing California bonds, for example. And over time what you see with financial institutions is that as markets become more competitive, they’re forced to take on more risk to make their share holders happy.

The bond insurers were started out as almost cooperatives. They weren’t for profit in a conventional sense. But in the early ’90s, most of them went public. They had demands from their share holders and management was compensated with option. They started to look for other avenues of profit. They had a Triple-A rating from the rating agencies.

So Wall Street got ahold of them, and said, look, you guarantee California bonds. You guarantee hospital bonds. Why not grantee corporate risk? Why not guarantee mortgages? Over time, they started to enter a market they knew less well. They’re very leveraged companies. What struck me when I first opened the annual report of one of these companies is they had a Triple-A company, yet over 100 to one in leverage. That just didn’t compute.

ROSE: Unbelievable, doesn’t compute. We think of 30 and 40 to one as high.

ACKMAN: Yes. But the world up until recently was a world that believed, you know, the financial markets were –

ROSE: What does that mean, the world believed.

ACKMAN: Where investors would buy a bond based on its rating. They’d buy a CDO. They’d buy a complex security. It was too difficult for them to analyze. They outsourced the analysis to three companies, the rating agencies.

On ratings agencies

ROSE: One person after another has come to this table and just cast huge criticism at the ratings agencies.

ACKMAN: Yes.

ROSE: It’s all deserved?

ACKMAN: It’s deserved.

ROSE: How did it come to that?

ACKMAN: You know, I think the rating agencies perform what amounts to almost a regulating function. Determining the credit worthiness of a bond is something that the SEC uses to determine the capital adequacy of an investment bank. So they got an almost sovereign like-status, but they were for profit entities. That for profit nature of what is a quasi- regulatory body caused them I think to push for production. And, you know, the incentives of trying to meet next quarter’s earnings can cause someone to — in a competitive marketplace perhaps to sign off on a rating that wasn’t deserved.

There was a lot of rating shopping. An investment bank would walk into Moody’s and say, look, here is a risk. We’re looking for a Triple-A rating. It would be analyzed by Moody’s and they’d say, OK, it’s Triple-A. The investment bank would say, what, if I throw this in, is it still Triple-A? They would say, looks Triple-A to us. What if I threw in a few more bad mortgages, is it still Triple A? At some point Moody’s would say, it’s no longer Triple-A. They’d say OK. Then they’d walk across the street to S&P. They’d take a look at it, and if they said yes, they’d get paid a 600,000 dollar fee. Yes, it’s Triple-A. If they said no, they wouldn’t make any money.

ROSE: That raises a big question about what’s going to happen to rating agencies.

ACKMAN: I think they’ve become a lot less relevant.

ROSE: People have to do their own credit analysis.

ACKMAN: You can’t outsource credit analysis. The problem with the rating agencies is that these monikers, the good house-keeping seal of approval of a Triple-A rating has lost its value. That was exported around the world. So it’s almost like regulators around the world deferred to the rating agencies, and that caused securities that probably should not have been sold to spread around the world. And the crisis that we’re in now is largely because people took their — if you think about the Internet bubble, when people lost a lot of money, it wasn’t as bad –

ROSE: There were no earnings.

ACKMAN: The Internet bubble, people were taking not their savings they needed to make mortgage payments, they took their highest-risk assets. They knew they were taking a risk when they were buying floose.

ROSE: They were betting on the comp, so to speak.

ACKMAN: But people who invested in Triple-A obligation, these CDOs and asset-backed securities, took their lowest risk money. It was the money that banks didn’t have to hold capital against. It was the retiree who said I want to make sure I have enough in my retirement. The result is people have lost confidence, because they took their safest, most important nest egg funds. They put it in stuff that’s supposed to be risk-free, and it turned out to be far from risk-free.

On hedge fund redemptions

ROSE: Couple things. One, how much redemption is going on with hedge funds?

ACKMAN: A lot.

ROSE: Explain what that means?

ACKMAN: Hedge funds are not — the capital isn’t permanent. It’s a little more permanent than a mutual fund. You could call up Fidelity and tomorrow you can liquidate your entire account. The hedge fund, you have to give notice. It depends on the fund. Some funds have five-year lockups. Some have two-year lockups. Some have 90-day lockups. As investors have lost — as hedge funds have lost money — this year, perhaps, you’re right. The average hedge fund might be down 20 or 25 percent. Investors are concerned. They’re looking for sources of liquidity. And they put in a redemption notice to hedge funds.

What that means is the manager has less money. He has to sell what he owns.

ROSE: In order to pay back the persons.

ACKMAN: Which puts pressure on the market, which puts pressure on funds, which causes more redemptions.

ROSE: Do you know a lot of people that are experiencing terrible margin calls.

ACKMAN: No, I actually don’t hang around with people who use a lot of leverage.

ROSE: Really?

ACKMAN: Really. There has been too much leverage in the system.

Is it time to invest?

ROSE: This is a time of opportunity for people with money, is it not?

ACKMAN: Absolutely. It’s the single best time in my career that I’ve seen to invest.

ROSE: To invest. There’s more value out there than you could ever imagine.

ACKMAN: The spread between price and value is the widest in many years, 30 or more years.

ROSE: Prices are way below value.

ACKMAN: Yes. Not every case.

ROSE: Why do I hear so many stories — I am a babe in the water — about people sitting on cash, cash, cash, cash. They’re just sitting on it. You’re saying there are tons of great investments to be made and there is a greater spread between value and price than there’s ever been. And yet they’re sitting on cash.

ACKMAN: Yes. A couple reason, one, if you don’t know how much money your investors are going to ask you for, you have to put aside money to take a conservative point of view. Very few people have permanent capital. Mr. Buffet is about the most fully invested we’ve ever see him. He spent 50 billion in the last few months. I mean, it’s hard to keep track. He can do that because his capital is permanent. Most investors in the marketplace, mutual funds, hedge funds, managed account managers –

ROSE: His capital comes from money that comes into –

ACKMAN: Every day.

ROSE: From businesses he owns.

ACKMAN: That’s right. And that’s unusual. So in a marketplace where your capital isn’t permanent, people have to be on the defensive.

On Government bailouts

ACKMAN: I’ll say the Federal Reserve and the secretary of the Treasury. I focus on the TARP. The 700 billion dollars, that authorization from Congress, I think so far has been spent well. Two hundred fifty billion dollars going into some of the best banks in the country so they’ve got more capital to lend, so that there is more confidence in your counter-parties is a very important first step. So I like that.

Second thing is the government taking steps to cause the rate at which companies borrow to decline. So the Libor rate, versus the interest rates that the Fed funds rate has — that spread has narrowed, which means that the cost of funding for businesses has come down. That’s a positive. So I think we’ve taken some positive steps.

I do have some concern about, you know, what you read about in the newspaper, in terms of other things they’re thinking about.

ROSE: Like?

ACKMAN: I’m concerned about G.M. Why am I concerned?

ROSE: G.M., the car company?

ACKMAN: There are reasons to be concerned, but this is a very important company for the country. It competes in a global marketplace. It’s been hamstrung for years because it has too much debt and it has contracts that are uneconomic.

ROSE: It’s in the health care business.

ACKMAN: That’s right. The way to solve that problem is not to lend more money to G.M. That just creates another Fannie or Freddie problem. The way to solve that problem is to use the reorganization system of the country. I don’t think –

ROSE: So reorganize G.M. for me.

ACKMAN: What should happen is they should do a prepackaged bankruptcy. The equity holders have been largely wiped out already.

ROSE: Because the stock is selling at two dollars or something?

ACKMAN: It’s a four or five dollar stock today. It’s maybe a couple billion dollar market cap. The debt trades at 30 cents on the dollar.

ROSE: You can buy all of general motors for two billion dollars.

ACKMAN: And you’re over-paying.

ROSE: You’re over-paying.

ACKMAN: You’re over-paying.

ROSE: That’s why nobody has bought it.

ACKMAN: What you need to do is reduce the amount of debt at General Motors to a level that the company can support, and the debt holders, in exchange for giving up their debt claim, will end up owning the business. What you want is a General Motors that can compete. You don’t want to lend tax payer money to an insolvent company so they can pay interest to the people who lent them money five years ago. That’s not a solution to the problem.

I’d rather the government’s money be used to retrain employees for other jobs, for infrastructure. You know, the welders at General Motors are going to be — can help on the infrastructure of the country. That’s a much better use of tax-payer money than lending money to an insolvent company. So we can’t be afraid — the bankruptcy word scares people. It’s simply a system. I have no economic interest either way in General Motors. But I guess for the good of the country I have an interest in General Motors. I’d like to see General Motors have a capital structure.

ROSE: Should it merge with Chrysler?

ACKMAN: If that would make the company more efficient, it should. It’s just like Fannie and Freddie. You have two companies that effectively perform the same function. My guess is there’s significant –

ROSE: What about Ford?

ACKMAN: If it makes sense, I think we should design –

ROSE: One great American auto company.

ACKMAN: We should design an auto company that can compete on a global scale.

ROSE: So you buy into the recapitalization program when you think the auto companies ought to be reorganized.

ACKMAN: There’s a viable business at General Motors, but it needs a different –

ROSE: It seems like what you’re basically saying is that the federal government is making a mistake.

ACKMAN: Yes.

ROSE: And Congress is making a mistake, if, in fact, they think that just pouring money into AIG or into General Motors will solve the problem.

ACKMAN: AIG is a little different from the other two, but you have to start with — once you’re done with the tax- payer putting in — if you look at the bank bailout, it was done very well because the government didn’t go invest. It put preferred stock in only solvent institutions. Right? They’re not — they’re letting — 17, 18 banks have failed. They’re letting them fail, because there is no hope of rescue.

ROSE: Should Lehman Brothers have been allowed to fail?

ACKMAN: It’s a complicated question. I would say my regret with Lehman Brothers is if you — once Bear Stearns was saved, the message on Wall Street was we’re going to let shareholders die, but we’re going to protect counter-parties. As a result, when Lehman failed and the counter- parties lost 90 cents on the dollar, more money was lost, in my opinion, than should have been lost. If the government had said, look, we saved Bear because we didn’t have time to figure it out — it was over the weekend. They had plenty of time to know that Lehman had issues and they should have let the market know, this is the last — we’re not going to save every counter-party.

ROSE: My impression is Lehman went around looking for buyers and, in fact, there was a South Korean buyer that might have been in place for a while, et cetera, et cetera.

ACKMAN: Apparently Buffett made a proposal that was rejected. I think Lehman could have been saved, but I think the management loved their institutions too much to take money on terms they thought was unfair. And ultimately it cost the institution.

ROSE: They didn’t realize that the failure to take that deal would be the consequence they found.

ACKMAN: Also, investment banks were never 30 to 40 to one levered institutions until more recently.

The future of investment banks
ROSE: Where are we with investment banks today? I’ve had one guest after another, Ace Greenberg, among others, saying investment banks, as we have known them, are gone forever.

ACKMAN: I think that’s right, as we have known them recently. I think we’re going back to the old model.

ROSE: In terms of Morgan Stanley and Goldman Sachs.

ACKMAN: I think there are some very profitable investment banks in the old model. Lazard is a very profitable investment bank.

ROSE: It’s like a boutique, though.

ACKMAN: It doesn’t take enormous — it’s not a 40 to one. People pick on hedge funds for being levered. Many Wall Street firms became hedge funds.

ROSE: What was the leverage at Goldman Sachs.

ACKMAN: High, 30 plus. When your competitor is levered 30 to one, you have to do the same.

ROSE: Paul Volker has questioned this program, the model of big investment banks that have hedge funds under the umbrella. Big investment banks should or shouldn’t have hedge funds?

ACKMAN: Actually, in my view, investment banks became hedge funds.

ROSE: That’s what some have said to me. Some have said to me that private equity firms are the new investment banks.

ACKMAN: Yes. Yes and no. I think there are some issues there, too. Too much leverage. I think that, you know, we went through a period of time where the consumer, the investment bank, the business got attracted to very low-cost money.

ROSE: There is a problem right there. It was too much easy money, in part.

ACKMAN: That’s right.

ROSE: That got to be such a distance between the person who was making the loan and the person who was asking for the loan.

ACKMAN: Exactly right.

ROSE: Credit risk got way out of whack.

ACKMAN: Correct. Fueled again by the rating agencies.

When will the housing market turn around?

ROSE: And the housing market will turn around when?

ACKMAN: OK, I’ll try to be optimistic because I’m an optimist. Come the turn of the year, we have a new president; we have much lower interest rates than we’ve had for a long period of time; housing prices have come down a lot; it’s the spring; you’ve been wanting to buy a home for years. You’ve saved money. You’ve been a good citizen. You’ve not borrowed too much on your credit cards. A house that used to cost 600,000 dollars is now available for 280,000 dollars. Fannie and Freddie are in business.

ROSE: And money is at one percent.

ACKMAN: Money is cheap.

ROSE: What is money at?

ACKMAN: The answer is it’s less so much the cost of money. There is money for a good credit consumer that puts down a 20 percent down payment. The problem –

ROSE: That’s right.

ACKMAN: It’s really in the corporate world. What’s causing the economy to weaken is that companies are not concerned they’re not going to be able refinance their debts they have coming due.

ROSE: Because banks aren’t lending money.

ACKMAN: That’s right.

ROSE: Banks don’t lend money, they can’t pay their debts. They can’t pay their debts, they can’t make their products. They can’t make their products, they can’t pay their employers. They can’t pay their employees, they’re out of business.

ACKMAN: That’s right. We need to fix that problem. We’re on our way. We’re not there yet.

ROSE: Have we turned the corner though?

ACKMAN: I think we have certainly turned the corner.

The new presidential administration

ROSE: So you’re optimistic because we’ve turned the corner?

ACKMAN: I’m optimistic we’ve turned the corner. I’m optimistic about the new administration.

ROSE: Why are you optimistic about the new administration other than it brings optimism to the country?

ACKMAN: First of all, that’s important. A lot of what’s going on is driven by mood. Confidence plays an enormous role.

ROSE: Trust and confidence?

ACKMAN: Not just the consumer level but at the business level. If an executive feels like he can grow his company, he will spend money. So I think having a leader that can inspire the people, having a leader that can stand up and say, “the only thing you have to fear is fear itself,” it reminds me of a — the U.S. is a turn around now. We invest in turn arounds. They can be difficult, but we’ve got a lot of wonderful assets here.

We have a country that people want to live in. The U.S. government is incredibly solvent. People get concerned about an extra trillion or two of debt. That’s a very big number, but you have to remember that the government owns 35 percent of every corporation because they have taxing power. The government owns 40 percent of every wealthy individual’s earning power. That’s a big off-balance sheet asset.

We’ve got a solvent government. We borrow in our own currency, and the new CEO of America is not going to be afraid to make big decisions, because he doesn’t have to live with any legacies.

(Edit: Transcript is here)

I managed to catch Bill Ackman’s interview on Charlie Rose last night. Ackman manages Pershing Square Capital Management, a $6 billion dollar hedge fund. The interview really did not cover too much new ground, he mostly discussed his perspectives on the credit crisis; ranging from the Fannie Mae and Freddie Mac bailout to the current TARP program. I’ll be sure to post a link to the video and have more of the transcript later. For now, here’s an interesting bit on General Motors (NYSE:GM), Ford (NYSE:F), and the possibility of a Detroit automaker bailout:

Charlie Rose: Where are we today?
Bill Ackman: We made progress. The TARP ($700B) has been spent well so far. $250B to banks was an important first step. 2nd, the Gov taking steps to make cost of spending go down is a positive. We have some concern about other things they’re thinking about.

Charlie Rose: Like?
Bill Ackman: I’m concerned about GM. This is a very important company. It has too much debt, uneconomic contracts. The way to solve this problem is to use the bankruptcy reorganization process for the company. Do a pre-packaged bankruptcy. The equity holders have been largely wiped out. Debt trades at $0.30 on the dollar. Equity guys are overpaying right now. Reduce the amount of debt to a level that the company can support. Debt holders will own the business. You want them to compete. Not so that they can borrow taxpayer money and pay interest to people who they owe money to from 5 years ago. We can’t be afraid of bankruptcy. I have no economic interest except for the good of the country.