Street Capitalist: Event Driven Value Investments

So the Treasury unrolled their plan earlier this morning. The gist:

First, Treasury and FHFA have established Preferred Stock Purchase Agreements, contractual agreements between the Treasury and the conserved entities. Under these agreements, Treasury will ensure that each company maintains a positive net worth. These agreements support market stability by providing additional security and clarity to GSE debt holders – senior and subordinated – and support mortgage availability by providing additional confidence to investors in GSE mortgage backed securities. This commitment will eliminate any mandatory triggering of receivership and will ensure that the conserved entities have the ability to fulfill their financial obligations. It is more efficient than a one-time equity injection, because it will be used only as needed and on terms that Treasury has set. With this agreement, Treasury receives senior preferred equity shares and warrants that protect taxpayers. Additionally, under the terms of the agreement, common and preferred shareholders bear losses ahead of the new government senior preferred shares.

These Preferred Stock Purchase Agreements were made necessary by the ambiguities in the GSE Congressional charters, which have been perceived to indicate government support for agency debt and guaranteed MBS. Our nation has tolerated these ambiguities for too long, and as a result GSE debt and MBS are held by central banks and investors throughout the United States and around the world who believe them to be virtually risk-free. Because the U.S. Government created these ambiguities, we have a responsibility to both avert and ultimately address the systemic risk now posed by the scale and breadth of the holdings of GSE debt and MBS.

Statement by Secretary Henry M. Paulson, Jr. on Treasury and Federal Housing Finance Agency Action to Protect Financial Markets and Taxpayers (US Treasury)

So far, Paulson has stated that he doesn’t know what the Fannie Mae (NYSE:FNM) and Freddie Mac (NYSE:FRE) bailout will cost US taxpayers. Part of that has to do with the fact that it’s almost wholly dependent upon the how long it takes for the housing market to stabilize. Keeping in mind this:

The GSE’s common stock and existing preferred shareholders will bear any losses ahead of the government. In exchange for entering into these agreements with the GSEs, Treasury will immediately receive the following compensation:

** $1 billion of senior preferred stock in each GSE

** Warrants for the purchase of common stock of each GSE representing 79.9% of the common stock of each GSE on a fully-diluted basis at a nominal price

It’s pretty safe to say holders of the common are in a terrible position right now. So what went wrong? Roger Lowenstein penned a really great essay this weekend about the connection between Long Term Capital Management and what’s been happening as a result of the credit crunch. He says:

More recently, housing lenders — and the rating agencies who put triple-A seals on mortgage securities — similarly misjudged the correlations. The housing market of California was said to be distinct from Florida’s; Arizona’s was not like Michigan’s. And though one subprime holder might default, the odds that three or six would default were exponentially less. Randomness ensured (or so it was believed) a diverse performance; diversity guaranteed safety…

If 100-year floods visit markets every decade or so, it is because our knowledge of the cards in history’s deck keeps expanding. When perceptions change, liquidity evaporates quickly. Indeed, the belief that one can safely get out of a “liquid” market is one of the great fallacies of investing.
This lesson went unlearned. Banks like Citigroup and Merrill Lynch felt comfortable owning mortgage securities not because they knew anything about the underlying properties, but because the market for mortgages was supposedly “liquid.” Each firm would write down the value of its mortgage investments by more than $40 billion.

Long-Term Capital: It’s a Short-Term Memory (NYTimes)

The article is a great read. At the end, Lowenstein says that “Investors, meanwhile, could help themselves by preparing for the next 100-year flood.” This made me think of Warren Buffett’s requirements when looking for a new CIO:

Over time, markets will do extraordinary, even bizarre, things. A single, big mistake could wipe out a long string of successes. We therefore need someone genetically programmed to recognize and avoid serious risks, including those never before encountered. Certain perils that lurk in investment strategies cannot be spotted by use of the models commonly employed today by financial institutions.

The last line is quite prophetic. How do you avoid risks that have never been encountered? I found some good guidelines in Guy Spier of Aquamarine Capital Management’s 10 investing principles. Principle #10 is called “Prepare for Black Swans”. He states:

My goal is to invest in such a way as to minimize the impact of negative black swans, or highly unpredictable events, and to maximize the exposure to positive black swans. If black swans are, by definition impossible to forsee or predict, how is it possible in practice to guard against the bad ones and simultaneously increase the likelihood of benefiting from the good ones?

Spier breaks this down into 6 factors:

In my case, avoiding negative black swans comes down to investing in businesses that are likely to survive any social, economic, political, or natural disaster. That means investing in companies that:

1. Are run by honest management
2. Have a strong balance sheet and/or significant financial flexibility
3. Enjoy enduring assets that are exceptionally hard to impair and nearly impossible to replicate
4. Are geographically diverse
5. Have a moat that is growing wider over time
6. Make a positive contribution to our civilization

I wrote previously about using a checklist when determining what to invest in and Spier outlines a great checklist. He explains later that he specifically looks for companies that are cash-generating machines because it enables them to weather economic storms and poor market cycles. Screening for factors like high amounts of free cash flow and low debt would be a good place for investors to start.

Going through Spier’s checklist, you’ll see that most of the firms that have blown up recently fail to meet criteria #2. Investors should scrutinize this area heavily, they not only need to look at the amount of assets, but the type of assets. Part of the problem here is that the values assigned to some of these assets widely diverged from their true value. Sticking to your circles of competence is essential, so that you don’t decide to blindly throw your faith behind assets that you really don’t understand.

Right now is the time for investors to exercise patience when searching and studying potential companies. Many have been caught up in the action of it all and chose to quickly buy stakes in companies that fell substantially in a short time span. This may have forced them to relax some of their analytical standards and miss critical details. Take your time and remember this quote from the master himself:

I call investing the greatest business in the world because you never have to swing. You stand at the plate, the pitcher throws you General Motors at 47! U.S. Steel at 39! and nobody calls a strike on you. There’s no penalty except opportunity lost. All day you wait for the pitch you like; then when the fielders are asleep, you step up and hit it.
- Warren Buffett

According to the Wall Street Journal the Treasury is going to release the details of the bailout plan for Fannie Mae (NYSE:FNM) and Freddie Mac (NYSE:FRE) Sunday afternoon. It looks like they want to announce it before Asia commences trading Sunday evening, a bit like they did with the news release about Bear Stearn’s acquisition.

Here is some specific news regarding shares and dividend payments:

The Federal Housing Finance Agency, Fannie and Freddie’s regulator, is to use its legal powers to put the companies under conservatorship. Those powers allow the FHFA to run the companies indefinitely, under certain conditions, such as when the regulator finds that they are likely to be unable to meet their financial obligations. Fannie and Freddie have run up combined losses totaling about $14 billion over the past four quarters and face heavy additional losses amid the worst surge in U.S. home-mortgage foreclosures since the 1930s.

Fannie and Freddie own or guarantee more than $5 trillion of U.S. home mortgages, nearly half of the total outstanding.

Dividends on the companies’ preferred stock are likely to be suspended, people familiar with the plan say, and those on common shares to be eliminated. Any injection of capital by the Treasury would likely greatly reduce or wipe out the value of common shares currently outstanding.

Treasury to Outline Fan-Fred Plan (WSJ)

Just who owns Fannie and Freddie’s debt?

Asian investors were among the most important groups to soothe because central banks, financial institutions and funds in the region own $800 billion of Fannie Mae and Freddie Mac’s $5.2 trillion in debt, according to data compiled by the Treasury. U.S. officials were concerned that sales from the region would push lending rates higher, said the people, who declined to be named because the discussions were confidential…

Freddie and Fannie rely on foreign institutions. Investors and central banks outside the U.S. own about $1.3 trillion of Fannie and Freddie’s corporate and mortgage bonds, according to the Treasury. Chinese institutions are the biggest holders in Asia. European investors own $300 billion of the securities.

“If they stop buying the agency debt, then yields would increase,” Ajay Rajadhyaksha, the head of U.S. fixed-income strategy at Barclays Capital in New York, said in reference to Asia investors. “The costs would get passed to the consumers.”

Fannie’s Mudd Soothed Asian Investors as Yields Rose (Bloomberg)

The US Government’s backing is key here. Without it, we’d likely see the kind of selling that the Bloomberg article describes as a possibility. From the way the plan looks to me, bond holders (our foreign friends) will be completely protected which should keep rates from rising and assuage some fears about our creditworthiness. The WSJ still paints a mixed picture for the equity holders - it does mention however that if the Treasury chooses to recapitalize Fannie and Freddie with a new class of shares, the shares will fall to near $0 while limiting moral hazard and tax payer losses.

Politicians from both sides of the aisle are explicitly talking about using plans that would protect tax payers, so the probability of a scenario like this occurring should be high. All of the language used to describe the plan thus far seems worded to leave no doubt that the government will completely protect bondholders, which makes me believe Fairfax’s credit default swap positions on FNM and FRE will go to 0.

I don’t have a stake in either of these companies, but the implication of a bailout will indeed have effects on the economy. A few well known value investors took the bait on them:

No question, this panic-state among financial stocks has resulted in current portfolio pain. However, history reminds us that extreme valuation opportunities occur in world-class franchises like Freddie and Fannie only when most investors have given up on them. In our own 12-year history we have taken advantage of this phenomenon many times; several of our portfolio holdings were outstanding businesses that we were able to purchase at a fraction of their fair value due to the conventional wisdom at the time.

Looking at this list we can recall the market sentiment surrounding each at their weakest points, and the characteristics are eerily similar to that surrounding the GSEs today; current bad news, uncertainty about the likely duration and depth of the bad news, management missteps, accounting shenanigans, and stronger / better competitors. It is precisely because investors tend to focus exclusively on the struggle of the moment that real analysis becomes the province of the very few daring to question the crowd. This commitment to analyze when everyone else has given up is the fundamental force that drives the excess long-term returns for value investors, and is why we believe Fannie Mae and Freddie Mac are extraordinary values.

FREDDIE MAC AND FANNIE MAE: A SPECIAL UPDATE (Pzena Investment Management)

Pzena states that extreme valuation opportunities occur when investors give up on them, but that really wasn’t the case here. The equity holders of FannieMae (NYSE:FNM) and FreddieMac (NYSE:FRE) were buying ownership of as Barack Obama likes to call it a “weird blend” of private and public entities. When you do that, you open yourself up to the risk of the government having to step in and bailout the company if things go wrong. When that happens, you (the equity holder) are not bailed out because they are not obligated to do so. Instead, their primary focus is only keeping these companies up and running and that was the real worst-case-scenario for their valuation, not fair book value but $0.

In the context of tough credit markets and a poor housing market, I’m unsure of how an investor could have really perceived a true margin of safety with either of these companies because of their relationship with the government. Still, there are conflicting views on what shareholders will get, according to Bloomberg:

Shareholder Fate

Washington-based Fannie and Freddie dropped in after-hours trading. Fannie fell $2.25, or 32 percent, to $4.79 at 5:50 p.m. in New York Stock Exchange trading and Freddie slumped $1.40, or 27 percent, to $3.70. Fannie is down about 66 percent since the end of June as concerns about the companies’ capital grew. Freddie has fallen about 69 percent.

Fannie’s market capitalization is now $7.6 billion, down from $38.9 billion at the end of last year. Freddie’s has fallen to $3.3 billion, from $22 billion over the same period.

The Washington Post reported that the government would make quarterly injections of funds as the companies’ losses warranted, avoiding a large up-front taxpayer cost, citing sources it didn’t name. Debt and preferred shares would be protected, and common stock would be diluted while not wiped out, the Post said.

The New York Times said most or all of both the common and preferred shares would be worth little or nothing.

One of the things I’m curious about is the effect of this on credit default swaps. My largest holding, Fairfax Financial (NYSE:FFH) owns credit default swaps on both Fannie and Freddie. I’ve been wondering about how this might turn out for those positions. According to the New York Times:

As UBS analysts point out, because Fannie’s and Freddie’s subordinated debt is used when they calculate capital — the financial cushion regulators require to support the companies’ operations — interest payments on the debt may have to stop if a bailout occurs. Such a hiatus could last up to five years.

While this would hurt subordinated debt holders, a deferral of interest payments has even broader ramifications. Halting those payments would put the bonds into default and force payouts on credit insurance that has already been written. In the debt market, this is known as a “credit event.”

Because nonpayment of interest would be seen as a credit event, UBS added, entities that have bought protection on Fannie’s and Freddie’s subordinated debt would be entitled to payment by the entities that wrote the insurance. This, even though taxpayers are standing behind Fannie’s and Freddie’s debt, not allowing it to fail. Talk about the laws of unintended consequences.

However:

It is possible, of course, that a Mac ’n’ Mae bailout will be structured so as not to force credit default swap payouts. Or regulators could step in and require parties on both sides of the Fannie and Freddie credit insurance trade to unwind their stakes at heavily discounted levels. Such has been the nature of recent deals struck by financial guarantors like Ambac at the behest of the New York State Insurance Department. In one deal, the credit default swap buyer got just 13 cents on the dollar; in another deal, the buyer got 61 cents.

What Will Mac ’n’ Mae Cost You and Me? (NYTimes)

So it seems like until we get more details about the bailout plan, CDS holders will be left wondering about what happens. Hopefully that will come till monday. If anyone has a different view on how the CDS positions will be affected, feel free to comment.

Below is a cool chart I found in the bailout article:

U.S. Rescue Seen at Hand for 2 Mortgage Giants (NYTimes)

A great graphic that shows us the change in the number of credit cards worldwide:

via Outside U.S., Credit Cards Tighten Grip (NYTimes)

I have to wonder what the long term effects of credit cards will be in some of these BRIC/Emerging markets. On one hand, the increased access to credit will somewhat help certain individuals within an economy. It’s possible that you could see pockets of increased consumer spending. At the same time, like the article discusses - certain card holders could accumulate too much debt which could lead to protectionist measures by local governments.

The other problem that I see is that many of the countries reporting large changes in credit card numbers are ones with economies tied to the bull market in commodities. If that turns south you should expect credit card usage to go down as well.

Either way, it’s something worth taking a look at when trying to find positive tailwinds for your investments abroad.