Street Capitalist: Event Driven Value Investments

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The play here looks familiar to other theses that I’m seeing from hedge funds. Namely, that after TARP and the government’s intervention, the worst is over for a company like Citi. It does not have to worry about failing and now, an investor just has to look at their prospects for income generation from newer loans to pay for loan losses:

Michael Breen: Speaking of mulligans, you just bought a firm that probably wish it had one for the past couple of years: Citigroup. Maybe you can let us know how you got comfortable with that, because a few years back, you were speaking about how you couldn’t get transparency on the big banks and the financials.

So is it a case of the blind now being able to see, or have things been shored up to a point that anybody can get comfortable with it? Why don’t you give us the thesis for Citigroup?

Bruce Berkowitz: I think it’s a bit of both. In the U.S., this was not a bankruptcy, but it’s gone through a scrubbing process, very similar to a bankruptcy, by the U.S. Treasury. Citigroup has spent a good amount of time with the U.S. government and many of its financial regulators, going through every liability and asset in the books.

After such a period of time, you normally are able to count the cockroaches. That is, the liabilities have been under a microscope for quite a period of time. There’s been huge capital injections by the government. There’s been a massive amount of dilution to old shareholders. And you’re starting to see some stability, the beginnings.

It’s very much what I call now the pig in the python. You have to look at their liabilities. So you have to look at their bad debt, and you have to continue to watch how the company is digesting its bad debt.

At the same time, you have to see the new debt that’s coming in, the new loans that they’re giving out. It’s fascinating. It amazes me, with financial institutions, the extent, the amount of new loans that are being created in relation to the total loan portfolio.

So it’s just now, in my opinion, a question of time, an ingestion period, where how many more quarters is it going to take before the new loans start to outweigh the old, existing loans?

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Breen: And so for Citigroup, it’s safe to say they are far enough out of the woods that you’re comfortable with the equity, where, with the real-estate debt, with the bankruptcy, it’s a different situation, and you’re taking a different spot on the capital structure.

Berkowitz: Right. We’re in there. Our major partner is the U.S. government. I mean, Citigroup is woven into the fabric of the United States. Citigroup will be around. I hope it will be around in a smaller form. It will be around in a better form, it most likely will be around with different management, and Citigroup will move on.

How Berkowitz Got Comfortable with Citi (Morningstar)

Quick Notes:

-Wells Fargo has done exactly what they said they could do. Their $40B of pre-provision earnings could handle large losses of $20B.
-The government did the right thing in acting fast in the financial system

Q: Why the share split?
A: We wanted to give a cash and stock option for the shareholders of Burlington Northern. It was an easy decision.

Q: Berkshire Hathaway a member of the S&P 500?
A: Never talked to S&P about it. It would be a plus for shareholders.

-Wells runs a terrific bank. A very customer oriented bank. Their revenues will come through. When the stress test was done, the people evaluating them were way off on the revenues. Wells felt that people did not understand their revenue ability. Wells will never disappoint on revenue.

Q: The Bank tax?
A: I don’t understand that. Some banks like Wells were forced to take it. The government made a lot of money off of banks with TARP, where they will lose money is with the automakers.

Q: What about the AIG bailout?
A: The banks got paid but so did millions of other contract holders.

Q: Should the banks be backstopping commercial and investment banks?
A: I don’t think the government should be backstopping Morgan Stanley or Goldman Sachs.

Q: How do you get around the idea where the commercial bank is with the investment bank? This notion of too big to fail.
A: The banks that were too big to fail had management problems at the top. The board of directors should have something where if the bank has to go to the federal government to be saved, the CEO and CEO before of two years should sign something where they get wiped out. The CEO should say: If this place goes down, I’m busted.

Q: You are saying guys like Chuck Prince?
A: Yeah.

Q: Should there be a split forced by Congress? Or the director plan like you said?
A: I would like what I just suggested. I think banks should be reigned in on leverage and activities they can’t engage in.

-Buffett trusts the Fed. to do more financial regulation on banks.
-Congressional elections are a reflection of voters, they don’t feel good about the health bill and the economy. Those feelings converged with feelings on the candidates.
-American people’s expectations were probably too high on the economy. To President Obama’s credit, he tried to dampen their feelings too. When it grinds along, they unreasonably expected better things by this point and that wasn’t in the cards.
-The stimulus bill could have been used in a way that has a faster more immediate impact.
-Some of the benefits of the stimulus bill were wasted because they were Washington as usual.

Q: Does legislative uncertainty affect corporate hiring?
A: At Berkshire, we are down 25,000 in employment off of base in the last year–year and a half. Our carpet business is down to 6,500 people. That is concentrated to a small area in Georgia. We will hire people when the orders come in. We have 1,000 people down from the peak in our Acme Brick business. We hire based on what is happening in our order book. We aren’t getting orders yet so we aren’t hiring. Unemployment will be a tough figure.
-Until things improve for the economy, the American people will remain unhappy. The Christmas tree approach to legislation where you add on earmarks is not encouraging to the American people.

Q: What do you think about the Kraft deal?
A: I feel poor. They sold a fine pizza business – Kraft sold it for what they said was $3.7B for it but because it had practically no tax basis they really got $2.5B when Nestle is willing to pay $3.7B. That business earned $280M pretax last year, they sold it 9X pretax but then paid 13X EBITDA for Cadbury. They are paying more than that, EBITDA is not earnings, depreciation is a very real expense. Then on top of that they are spending $1.3B on rearrangements at Cadbury, $390M of deal expenses, they are using 260M of stock that their own directors are saying is significantly undervalued, when they calculate the 13 they are using market price not what they think it is worth. So, the actual multiple is 16 or 17 and they are selling earnings at 9X.

If you looked back at the S&L crisis, sharp investors like Gerald Ford managed to make huge returns by acquiring the carcasses of failed banks, infusing them with capital, and picking off credits from weaker banks in their geography. Ford himself made over $1B personally with his Golden State bank deal.

Now, it appears as if other investors (including J.C. Flowers, Paulson & Co, MSD Capital, and Soros) are seeing the attractiveness in acquiring failed banks:

Of the 140 banks closed by the government this year, private investors have acquired only two outright—IndyMac and Florida’s BankUnited. Private equity investors argue that they should play a bigger role, as their funds’ billions in unspent capital could bolster the banking system.

Part of the test will be how well OneWest works with financially troubled homeowners, especially under the Obama administration’s loan-modification programs.

OneWest is already generating hefty profits. For the six months ended Sept. 30th, it posted net operating income of about $700 million, according to filings with the FDIC. In 2007 IndyMac, saddled by troubled mortgages, posted a $614 million loss.

During the FDIC’s roughly eight-month control of IndyMac before selling it, the agency cleansed the bank of some of its bad loans through asset sales and write-downs, shrinking it by about 27%, according to filings. It also reduced the bank’s headcount by about 45%.

The FDIC also agreed to share in losses with the ownership group in both the IndyMac and First Federal deals.

OneWest’s improved performance allowed it to bid aggressively for First Federal. The owners didn’t invest additional money to acquire the bank’s assets; rather, the money came from cash on OneWest’s balance sheet.

OneWest paid $401 million, or a 6.6% premium, for First Federal’s assets, according to FDIC documents. That makes it among the first FDIC-arranged deals in which a premium was paid for a failed bank’s assets—many are sold at a discount to their assets.

Investors Reshape IndyMac (WSJ)

It is difficult to throw a dart at the board and scoop up good banks, especially smaller, more regional banks. Many of these banks have not properly written down the value of CRE loans on their books. Still, some banks are poised to do well. The ones that are now overcapitalized and acquiring the assets of failed banks should offer opportunity for investors. A lot of this depends on good stock picking, you need to look at the quality of their loans, what they are acquiring (and the deal terms), and also the quality of their management teams. You need to seek out bankers who are disciplined but enterprising enough to enter the fray and take market share. This requires more effort than simply picking up an ETF, but it should be rewarding.