Street Capitalist: Event Driven Value Investments

Apologies for the blog being quiet this week. I’ve been following most of the bailout news that’s come out. The revised plan seems better (the added pork — not so much). From the voting numbers, it appears to have passed:

WASHINGTON – The House voted 263-171 to pass the $700 billion financial-markets rescue bill, two days after the Senate passed the legislation. Several prominent members of the House who voted against the measure Monday announced their support for the revised bill, giving it well more than the the 218 votes needed.

Earlier, House Republican leaders expressed confidence about the prospects for the House vote, but had stopped short of predicting the legislation would pass.

House Passes Bailout Bill (WSJ)

I know that there was some doubt out there about whether we needed a bailout or if it would be possible to wait longer. Warren Buffett indicated that it really needed to happen soon, or the problems could quickly become worse, even saying that he might have to go back to his paper route! I think the way he put it best in his interview with Charlie Rose:

Charlie Rose:

So we come down to the close of this conversation and you have been warning
us about certain kinds of things. I hear from this conversation too this
plan is essential now. Otherwise we’re in a very, very difficult place and
each week we go beyond not doing something we get deeper and it becomes more
irreversible.

Warren Buffett:

And, yeah, whoever said, you know, an ounce of prevention is worth a pound
of cure understated it and I you know a pound of cure that’s delayed another
six months is going to need a ton of cure later on I mean it would be crazy
not to do this. It will not produce dramatic results though in the economy.
That’s what people have to understand. You’re going to see unemployment go
up. You know, you’re going to see lousy earnings in many businesses. And
they’re not –

Charlie Rose:

You’re going to see people unemployed.

Warren Buffett:

You’re going to see more people unemployed. But the difference Charlie if
we bottom this thing out at seven percent unemployed versus nine percent,
that’s three million people, that’s three million people that if we do it
wrong you know lose their jobs unnecessarily in my view I mean you know I’ve
never been unemployed. I’ve never been very fully employed either but just
think of what it’s like, you know, to go home with a mortgage payment you
know and kids and everything else. My dad had that happen to him in the
early ’30s. It you know you don’t want to create three million people more
unnecessarily. But I don’t think you –

Charlie Rose:

That’s the depression –

Warren Buffett:

It really is. And you can’t help some increase from this point. I don’t
want any viewer to go away think a magic wand exists in Congress. So they’re
going to see some more bad news. But if we do this, we’re doing the right
thing. And if — the system will work over time. There’s no — we got a
wonderful system.

I’d recommend the whole interview to anyone who’s interested, a link can be found here.

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.”

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.

via After Frantic Day, Wall St. Banks Falter (NYTimes)

Lehman Brothers Holdings Inc., once the fourth-largest U.S. investment bank, said it intends to file for bankruptcy after Barclays Plc and Bank of America Corp. abandoned talks to buy the crippled firm.

Lehman, one the biggest underwriter of mortgage-backed securities, plans to file a Chapter 11 petition in the U.S. Bankruptcy Court for the Southern District of New York, the firm in a statement today. The filing will be by the holding company and won’t include any of its subsidiaries, Lehman said.

Lehman Brothers to File for Bankruptcy After Suitors Drop Out (Bloomberg)

via Lehman Brothers Bankruptcy Press Release (PDF)