Saturday, December 10, 2011

Sumo Wrestling China Agritech's Quality of Earnings and the Glickenhaus Defense

Sumo wrestlers cheat.

I have never seen a sumo wrestling match and I don't know any sumo wrestlers -- hell, I have never been to Japan. Yet, I know they cheat. Why is that?

Well it turns out that sumo wrestlers, just like any other professional athlete, can make a lot more money if they are on top of their game. A small increase in wins can translate into thousands of dollars a month.

You might be thinking, "Well Josh, that doesn't make a lot of sense." Sumo matches are viewed in a large stadium, there are referees, and if you actually knew anything about sumo wrestling, you would know it's part and parcel of the Shinto religion. Not only is it absurd to say there is cheating but it's also sacrilege.

Yet, they still cheat and here is why.

In sumo wrestling, they have 15 matches; if a wrestler wins 8 matches he moves up the respect ladder and the income ladder quite dramatically. The difference between 8 wins and 7 wins could mean five thousand extra dollars a month.  So if a wrestler has a 7:7 record, he has a lot more to gain than a wrestler with an 8:6 record has to lose. Match records show that 7:7 players go on to win 75% of their next matches, but the probability would imply a 50% chance of winning.  This means there is a statistical blip when it matters the most for the sumo wrestler. Some defend the statistical blip by saying the 7:7 player really wants to win and that's why the statistics shoot up.


However when they meet again, the 7:7 player typically loses to the 8:6 player. This implies that the 8:6 player deliberately lost the first encounter because there is a quid pro quo relationship going on in the world of sumo wrestling. They even have a word in Japanese for these match-fixings; they call it yaocho.

What's interesting about this is you don't have to be Japanese or spend time in a sumo stable to know there is cheating. It's in the numbers, and if you able to interpret the numbers and incentives it stares you straight in the face.


Quality of Earnings by Thornton O'glove helps educate the analyst into looking into the quality of the earnings, not so much the quantity of earnings in and of itself. After all, Enron showed GAAP earnings, but how much quality do you think they had?

Looking first at the quality of the earnings, as opposed to the quantity of the earnings, is a simple concept, but for whatever reasons, it seems to escape most people.

There are several things to look for when analyzing a company's financials for malfeasance:

  • Cash flow from operations is consistently lower than net income. 
  • Profit margins are significantly greater than the industry average.
  • The company is consistently paying large sums for acquisitions that end up growing goodwill.
  • Acquisitions come from related parties. 
  • Accounts receivables and inventory are rising at a higher rate than revenue.
  • There are off the balance sheet liabilities.
  • The company depreciates their assets much slower than industry averages for similar assets.
  • The company funds acquisitions via debt offerings even though they show large cash balances. 
  • The valuation of the assets doesn't hold up to reality since similar assets would deserve an impairment charge. 
  • The shareholders don't own the equity of the operating company -- they own the contract rights to the underlying business. 
  • The company has a much lower property, plant and equipment asset size versus the size of their business and/or employee base.  
  • The cash and assets of the company are held in countries where using your property rights as a shareholder could be very difficult to execute.
  • The management constantly uses common stock to pay for acquisitions or as a bonus to employees rather than cash.
  • The company sells their assets to related parties.

Not one of these in particular means the company is obfuscating the quality of their financials. Things need to be put into context and possibly clarified with management. Yet it's important to be skeptical of the management's explanation and remember that things have to take common sense into account. No matter how mouth watering the financials may be to would-be-investors, if there is no quality, the quantity becomes useless.


In late 2010, reports started to get published about fraud in Chinese companies listed in the US. Lucas McGee published his own report about China Agritech. John Hempton then published a blog post questioning China Agritech as well. It turns out that a money management company called Glickenhaus & Co. had owned China Agritech before the report came out and started to do their own investigations about the fraud allegations of China Agritech; Bloomberg even had a story about this and did a fairly long video interview with them. The youngest of the three Glickenhauses, Jesse, went off to China to personally ferret out the validity of the allegations. He went on to publish a youtube video of his findings and a research report  which concluded that China Agritech was very much a real company and Lucas McGee was nowhere to be found.

I had no dog in this fight and was just a spectator. Time rolled on and the uproar of China Agritech and China fraud caps was silenced by problems in Europe and the general short term attention span of the market.

Then, last Tuesday, I received a comment on my blog for an old post on China Agritech.

James Glickenhaus

The first link was to a press release sent from BDO China that said they found the Lucas McGee research factually wrong and China Agritech was very much a real company, which would appear to confirm Jesse Glickenhaus's investigations in China. The second link was to a Bloomberg interview with James and Jesse Glickenhaus discussing the story of China Agritech and what had happened so far.

If you watch the video you get a sense of how he did his analysis. When asked how he got into China Agritech, he said it was part of the big picture that the world is getting bigger and the world will eat more; therefore, buying fertilizer companies was a natural extension of that thesis.

To me this thinking is overly simplistic. It's obvious the world is getting bigger, but it's important to do the next step in the analysis: what price do you pay? Just like everyone knew cars and radios would be a big thing in the early 20th century, or the internet would be in the late 20th century, now we all know the world is getting bigger. Fertilizer companies are a natural extension of that, but you have to ask yourself, "What price should I pay?"

To James's credit, he did say he looked at the financials and they were on track to earn $1 a share and the company was growing. Now, this sounds like he did the next step of the analysis, but this also seems to be too shallow. When I look at the financials, I see red flags pop up all over the place. I keep on thinking, "What did he look at?"

Notice the operating cash flow being far lower than net income on a yearly basis.

When you have a company that consistently shows negative operating cash flow, versus net income, this is a huge red flag.

Notice accounts receivable growing faster than revenue.

Revenue and receivables should grow aligned with each other. Although the difference isn't large here, it could start to look a bit funny.

Notice where the company gets its cash.

Doesn't it seem a little odd that the company is garnering cash more from issuing stock than operations?

Notice the high level of revenue growth versus PP&E.

The company is generating $76.13M in revenue over just $8.62M in PP&E. That's pushing eight dollars and 81 cents in revenue for every one dollar in PP&E. To show why this looks a bit odd, if you look at CVR Partners, which Clickenhaus mentions as UAN, in 2010 they had annual revenue of $180.47M and PP&E of $433.36M. That's 42 cents of revenue per PP&E compared to eight dollars and 81 cents with China Agritech!

You might say it's unfair to compare China Agritech with any business -- I mean, it's in China and don't you know everything in China is highly profitable, and people are industrious and efficient? (I don't.) Let's look at this metric with Coca-Cola, a company that manufactures high profit non-alcoholic beverages with some equipment that's been around for a while (depreciated). Their 2010 revenue was $35.1B and their PP&E was $21.7B; that's one dollar and 61 cents of revenue per PP&E. Still, China Agritech is a marvel of efficiency at eight dollars and 81 cents.

Maybe it's because the PP&E isn't accounted correctly and it's more than what's stated on the balance sheet. But why hide it? Why continue on with such a high discrepancy? There are possible good reasons for this -- but still, the point is, it's a red flag and it stares you right in the face.


From the outside, it looks like there could never be any cheating in sumo wrestling: there are referees and there are fans watching. Yet, if you take a look at their numbers you can get a good sense that not everything is right. The same thing can be said for China Agritech: if you look at their financials there are definite red flags. Jesse Glickenhaus even went all the way to their factory and reported back that there was no cheating going on. Yet, wouldn't a reporter say the same thing if he went to a sumo stable?

I wish Glickenhaus & Co. all the best of luck with China Agritech. They might even get lucky and someone will buy out the company -- there have been a handful of Chinese stocks that have had similar characteristics, i.e. the financials didn't look good, but they still got bought out. Of course, even if someone does buy China Agritech and does extensive due diligence, even to the level BDO China and Jesse Glickenhaus did, they still might get Richard Heckman-ed.

There are a lot of things I'm jealous about when it comes to James Glickenhaus. He gets to be interviewed on Bloomberg; I have blogspot. He manages almost two billion dollars; I manage 26 Taiwanese students. He drives a 4 million dollar Ferrari he bought from Italian designer Pininfarina; I drive a 15 year old scooter I bought from a Malaysian international student.

The one thing I am not jealous of is his analysis.

Monday, November 14, 2011

BAC sells almost their whole stake in CCB

Bank of America has sold almost their whole stake in China Construction Bank. They currently hold only 1% of CCB, which is actually 1% more than they should but it's much better than owning 9%.

The selling of CCB de-risks, one of the most risky portions of capital that Bank of America had disclosed. There might be more assets like CCB that I believe could be over valued, but at the moment, I don't know of any.

I still own an amazing about of BAC.A warrants, but I think it would be more reasonable for me to buy 2013/2014 leaps on BAC.

Tuesday, November 1, 2011

Old Louis Rukeyser interview on Charlie Rose

Love watching/reading old articles about the market/economy. Here is 1995 interview with Louis Rukeyser. Some things just tend to repeat themselves and they show after watching old clips.In the beginning of the interview, they started to talk about Washington's bickering about the deficit. Reminded me how commentators and markets felt about the last debt ceiling fiasco.

Saturday, October 15, 2011

Taipei real estate prices; sell gold buy expensive real estate

Today on a trip to Carrefour (the Franco-Sino version of Walmart) we saw a lady passing out brochures for a condo for sale. The lady wasn't a real estate agent, more like a street sweeper who was getting paid to hand out brochures to anyone she can. (When I first came to Taiwan they used to pass out the advertisements to only to the people with cars, now they give them to the scooters. Last month I saw them passing out brochures to college's just ridiculous.)
Here is page from the brochure

Brochure detailing the size and the layout of the condo. 

The 39 ping house was $14,000,000NT which is 1,387 square feet for $462,000 USD or 333 US per square foot. The 48 ping house was $18,000,000NT which is 1,705 square feet for 594,000 USD or 322 US per square foot.

These prices are just insane. I ask my Taiwanese friends what is a high paying salary in Taiwan, they say it's 100,000NT a month or an annual US salary of around $39,603USD. Honestly, I think that number is high - according this site the GDP per capita of Taipei is $48,400 USD. Now, to me that number is ridiculously high. There are definitely very wealthy Taiwanese people who are skewing this statistic and I am highly skeptical of that number, but I know plenty of people living on 500USD to 1,100 USD a month. Yet, for the hell of  it let's use the $48,400 as the our annual salary. In order to buy a 1,387 square foot apartment you have to pay 9.5X your salary! 

There are plenty of empty luxury apartments all over Taipei. I really don't get why these apartments are so freaking expensive.

Brochure explaining real estate is a better investment than god

 According to this - if you want to save the value of your currency you need to purchase real estate. The price of everything is going up: electricity, water, food - so the best way to protect yourself is to buy your own piece of real estate.  So in this advertisement they are trying to scare people into purchasing real estate to protect the value of their savings.  For whatever reason they say buying real estate is a better protector than gold. Their appeals to fear really irks me.  I'd bet in 10 years from now, most people who purchase these houses will not be happy with their "investment."

Saturday, October 1, 2011

BAC A Warrant Idea: (1) Greenblatt, (2) Berkowitz, (1) BAC A Warrant summary

I've decided to link 4 documents.
(1) An excerpt of "You Can Be a Stock Market Genius" where Greenblatt describes his reasoning for buying LEAPs on Berkowitz's analysis 
(2) The original analysis Berkowitz made on Wells Fargo that Greenblatt based his analysis on.
(3) Berkowitz's analysis of Bank of America, June 1, 2011 AAII conference 
(4) The details of the Bank of America class A warrants.

Warning: Just because Berkowitz was right on Wells Fargo in the 1990s doesn't mean he will be right about BAC this time around. The risks associated with Bank of America is centered around litigation. Also, I believe the warrants are currently "expensive", it might be better to own long term call options. I might sell some of my warrants to purchase new Jan 2014 call options when they come out.

BAC write up from Mike Gattnar of Pavis Capital

Read a good BAC write up from Mike Gattnar of Pavis Capital on SumZero.  With his permission I have posted it below. The format came out a bit funky, but there is a link to a Google PDF of the write up.

Thanks Mike for letting me post this.

Note. The share prices for refers to the 11/29/10 share price which is the date of the write-up. We believe the thesis continues to hold at current prices. Please refer to the attached write-up for the charts.


BAC represents an opportunity to invest in one of the most diversified and attractive U.S. financial services franchises at an attractive valuation: BAC trades at <10x 2010 EPS (2000 – 2009 average of 11.7x) and .85x tangible book value per share (2000 – 2009 average of 3.0x). The Company provides a broad array of financial services products including: retail banking, mortgages and insurance, credit cards, commercial banking, global investment banking, and wealth management. Additionally, BAC has either a #1 or #2 market position in almost every capability offered to its customers. We believe the strength of the BAC franchise should position the company to generate >15% returns on tangible equity over the long term. Improvements in the credit quality of the loan portfolio should support EPS growth from a 2010E of $1.28 to $2.23 by 2013 (a +20% CAGR). We value BAC at 12x our 2013 EPS estimate of $2.23 per share or $27 (a 137% return or 33% annualized CAGR vs. 11/29/10 closing price of $11.31). We note that an investment in BAC is likely to require a long term investment horizon as it will take years to resolve many of the issues creating an overhang on the stock (e.g. mortgage reps/warranty liability) and for credit quality to stabilize.

Bank of America Corporation provides a diversified range of banking and nonbanking financial services and products through six business segments: Deposits, Global Card Services, Home Loans & Insurance, Global Commercial Banking, Global Banking & Markets (GBAM) and Global Wealth & Investment Management (GWIM), with the remaining operations recorded in All Other. At September 30, 2010, the Company had $2.3 trillion in assets and approximately 284,000 full−time equivalent employees. On January 1, 2009, the Company acquired Merrill Lynch & Co., Inc. (Merrill Lynch) and, as a result, has one of the largest wealth management businesses in the world with over 16,700 financial and wealth advisors, an additional 3,000 client−facing professionals and more than $2.1 trillion in net client assets. Additionally, BAC is a global leader in corporate and investment banking and trading across a broad range of asset classes serving corporations, governments, institutions and individuals around the world.
As of September 30, 2010, BAC operates in all 50 states, the District of Columbia and more than 40 foreign countries. The Company’s retail banking footprint covers approximately 80 percent of the U.S. population and in the U.S., serves approximately 57 million consumer and small business relationships with 5,900 banking centers, 18,000 ATMs, nationwide call centers, and leading online and mobile banking platforms. The Company has banking centers in 13 of the 15 fastest growing states and has leadership positions in seven of those states. The Company offers industry−leading support to approximately four million small business owners.

Investment Highlights
Substantial EPS Expansion: BAC is positioned to grow EPS from a 2010E of $1.28 to $2.23 by 2013 (a +20%). We expect declining bad debt provision expense to contribute $1.24 of incremental EPS during the period as provision expense declines to a more normalized level of 1.7% of average loans vs. 3.0% in 2010. We believe BAC has realized over 80% of the losses on its mortgage loans. BAC’s high exposure to early cycle credit (~18% of loans are credit card), low exposure to late cycle credit (7% of loans are CRE) should allow BAC’s credit losses to decline faster than median large cap banks in 2011 and into 2012. Additionally, we believe there are a number of earnings growth levers which we have not factored into our model:

 Expense reduction: We believe there is meaningful room for BAC to reduce expenses as the credit environment normalizes and it completes the integration of legacy acquisitions (MER). For example the Company believes it can reduce headcount by ~20,000 (this area alone could represent >$1.0B of cost reductions) over the long term and has guided to $7.0B of cost reduction associated with the Merrill Lynch acquisition (3.3B run rate realized at year end 2009). We also believe litigation related expenses are substantial and likely at inflated levels. Management has guided to a 2013 – 2014 expense ratio of 55% - 60% vs. 60% in our model at 2013. A 55% expense ratio would represent an incremental $4B in annualized earnings power, $0.45 in incremental EPS, or an additional $5.43 of shareholder value at a 12x earnings multiple. We note that expenses may actually increase in the short term due to heightened litigation associated with rep/warranty put-backs and the “robo-signing” scandal.
 Loss mitigation efforts: Our model assumes a $3B adverse impact as a result of regulation E and the Durbin amendment. While we have assumed the full impact of these adverse regulatory changes, a number of analysts believe BAC’s loss mitigation efforts (revised customer pricing, new products, cost reduction) may mitigate as much as 50% of the lost revenue.
 Long term debt reduction: BAC inherited a substantial amount of high cost long term debt as a result of legacy transactions. Management believes it can reduce long term debt by $150B - $200B over the next several years or an incremental $75B - $150B vs. what is reflected in our models. This could add an incremental $0.08 - $0.15 to 2013 EPS or $0.92 - $1.83 of value.
 Reduced level of mortgage put-backs: Our model assume $3.5B - $4.1B of mortgage put-back expense in the 2010 – 2013 period. We would expect mortgage put-back liability to substantially diminish over the long term. The ongoing cost of mortgage put-backs represents $0.31 of earnings power in 2013 or $3.74 of potential incremental value per share.
EPS Bridge: Refer to chart
Premiere Franchise:  BAC is a market leader across almost every service it provides to its customers. While the breadth of BAC’s service offerings provides a level of diversification to the earnings stream, the strength of the Company’s competitive position is an asset we believe will enable to Company to capture share going forward and generate excess returns over the long term. For example, BAC’s retail banking franchise (~50% of revenues) has the largest deposit base; lowest rate paid and lowest expenses per dollar deposit. We believe this is a source of competitive advantage as it implies a lower marginal cost than competitors on the bank’s core source of funds and provides a level of stability to BAC’s balance sheet. We expect BAC will emerge from the credit cycle a dominant player in domestic retail broking and international investment banking, and mortgage servicing. The slides below summarize the scope and competitive position of BAC across its major customer facing segments.
Refer to write-up for charts
Improving Credit Quality and De-risked Balance Sheet: BAC has de-risked its balance sheet with over 80% of estimated lifetime losses realized thus far through the cycle. This compares favorably vs. analyst estimates of only ~55% for the banking sector and ~70% for the large-caps banking sector. The Company has also seen reduced delinquencies across all major credit categories and is experiencing declining charge-offs across both consumer and commercial segments (refer to charts below).

Cross Selling Efforts/Opportunity: BAC has recently been investing in sales resources and realigning compensation structures in an effort to drive synergies from the Merrill Lynch acquisition and cross sell the full breadth of its services to its client base. We believe this represents an opportunity for the Company to drive incremental revenue across high net-worth clients, institutional clients, and international clients. We note that the Company has already begun to experience share gains across each of these client segments. While we believe these efforts will drive incremental share gain and accelerate growth, we have not (and believe the analyst community has not) given BAC any meaningful credit for these initiatives.

REFER to Write-up for charts

Regulatory Risk:
 Regulation E: In November 2009, the Federal Reserve issued amendments to Regulation E, which implements the Electronic Fund Transfer Act (Regulation E). The new rules have been in place since July 1, 2010. These amendments change the way banks may charge overdraft fees; by limiting the ability to charge an overdraft fee for ATM and one- time debit card transactions that overdraw a consumer's account, unless the consumer affirmatively consents to the bank's payment of overdrafts for those transactions. Under previously announced plans, BAC does not offer customers the opportunity to opt−in to overdraft services related to non−recurring debit card transactions. However, customers are able to opt−in on a withdrawal−by−withdrawal basis to access cash through the Bank of America ATM network where the bank is able to alert customers that the transaction may overdraw their account and result in a fee if they choose to proceed. The impact of Regulation E in the third quarter was a reduction in service charges of approximately $375 million pre−tax. The 2010 full−year decrease in revenue related to the implementation of Regulation E and the impact of overdraft policy changes is expected to be approximately $1 billion after−tax. The Company has implemented a number of changes in an attempt to mitigate the impact of Regulation E including pricing accounts on an activity basis and offering customers new products.

 Debit Interchange Rules: On July 21, 2010, the Financial Reform Act was signed into law. The legislation, which provides the Federal Reserve with authority over interchange fees received or charged by a card issuer, requires that fees must be “reasonable and proportional” to the costs of processing such transactions. In addition, the legislation prohibits card issuers and networks from entering into exclusive arrangements requiring that debit card transactions be processed on a single network or only two affiliated networks, and allows merchants to determine transaction routing. Management believes that debit card revenue will be adversely impacted beginning in the third quarter of 2011 and estimates approximately $2.0 billion of lost annual revenue as a result of the legislation. The Company recorded a non−tax deductible goodwill impairment charge for Global Card Services in the three months ended September 30, 2010 of $10.4 billion. The Company expects to implement a number of actions that will mitigate a good portion of the impact when the laws and regulations become effective.
 Card Act: On May 22, 2009, the Credit Card Accountability Responsibility and Disclosure Act of 2009 (CARD Act) was signed into law. The majority of the CARD Act provisions became effective in February 2010. The CARD Act legislation contains comprehensive credit card reform related to credit card industry practices including significantly restricting banks' ability to change interest rates and assess fees to reflect individual consumer risk, changing the way payments are applied and requiring changes to consumer credit card disclosures. Under the CARD Act, banks must give customers 45 days notice prior to a change in terms on their account and the grace period for credit card payments changes from 14 days to 21 days. The CARD Act also requires banks to review any accounts that were repriced since January 1, 2009 for a possible rate reduction. The provisions in the CARD Act have negatively impacted BAC’s net interest income, due to the restrictions on BAC’s ability to re-price credit cards based on risk, and card income due to restrictions imposed on certain fees. The bill went into effect on February 22, 2010, nine months after it was enacted. The 2010 full−year decrease in revenue is expected to be approximately $1 billion after−tax.
Mortgage Putbacks: The most significant and difficult to quantify risk facing BAC relates to the representations and warranties made with regards to loans it previously sold to investors. Generally, an investor can put back the mortgage to the originator for the full unpaid principal amount if the loan contains an origination defect or was fraudulently originated and has defaulted. We estimate cumulative put-back losses of $15.8B (~$3B of losses have already been incurred). For modeling purposes we use the Morgan Stanley cumulative loss estimates of $21B. For context BAC has a reserve of $4.4B and estimates $750M of quarterly expenses over the next few years (our model assumes $3.5B - $4.1B through the 2014 period per Morgan Stanley estimates). Below we provide our estimates and Morgan Stanley’s estimates of the mortgage put-back liability, a summary of the different classes of investors that have an ability to put back loans to BAC, and BAC’s experience with each class of investor.

 GSE: From 2004-08, BAC/CFC sold $1.2 trillion of loans to the GSEs. It has received $18.0 billion of repurchase claims on lot (1.5%). It resolved $11.4 billion (63%) of these claims with a loss experience of 22% ($2.5B). The areas of greatest dispute have been the reasonableness of stated income, occupancy, and undisclosed liabilities. Its reserve for the GSE reps and warranties exposure is computed to cover both the existing pipeline of claims and a projection of future claims it might receive on loans that have already defaulted, and on future defaults predicted by its loss-forecast models. It expects its repurchase rate with the GSEs to increase. Still, it estimates repurchase claims to date represent more than two-thirds of claims expected on 2004-2008 vintages.
 Private Label Securities wrapped by monolines – Note, each of these reps and warranties counterparties has different contractual rights. It sold $160 billion of loans into monoline-wrapped transactions. This included $73 billion of first mortgages (33% paid off) and $87 billion in second-lien (60% paid off). In addition, of the first liens sold, it estimates $38 billion were sold as whole loans to other institutions, which subsequently included these loans with those of other originators in private label securitization deals in which the monolines typically insured one or more tranches. To date, $4.8 billion (3%) of repurchase claims have been received. Of this, $4.2 billion remain outstanding of which $2.7 billion has already reviewed and declined to repurchase and $550 million approved for repurchase (looking at the remaining $1.5B). It noted it has had limited engagement with most of the monoline insurers in its repurchase process, which has constrained its ability to resolve the open claims. Also, certain monoline insurers have instituted litigation against CFC and BAC, which further constrains a normal business relationship. Without this engagement, it believes it is not possible to reasonably estimate its future repurchase experience and the liability that may exist in connection with these securitizations. Still, it has used its experience with a subset of the monoline universe as a basis for computing a reserve on existing and future claims.
 Whole Loan Investors/Private Label Securitizations - BAC stated that it believes many of the losses observed in these deals have been, and continue to be, driven by external factors, like the substantial depreciation in home prices, persistently high unemployment and other economic trends, diminishing the likelihood that any loan defect, assuming one exists at all, was the cause of the loan’s default. From 2004 through 2008, BAC and CFC (mostly) sold $750 billion of loans (40% paid off). It has received $3.9 billion of repurchase claims ($2.9B resolved), with $1.0 billion remaining outstanding (of which $0.5B already reviewed and declined to repurchase). Approximately $1.0 billion has been approved for repurchase. Many of the claims that it has received so far are from whole loan investors. With respect to claims from private securitizations it acknowledged if it were to get a better sense of its experience with this segment, it would increase its reserve. We estimate that BAC is about >20% through its cleanup. We have baked in our estimates for remaining reps and warranties costs of $16 billion in our model through 2014 . This is higher than what management is guiding towards (it suggests an average of $750 mill per quarter, with volatility likely between $500mill to $1bill, no time frame given on end dates).
o BAC’s shares fell 10% relative to the S&P 500 the week of 10/19/10 based on news a group of investors including Blackrock, PIMCO, Wamco and the NY Fed among others publicly announced a notice of Non-Performance to Countrywide Servicing (Master Servicer) for its servicing of 115 loan pools totaling $47 billion. We discuss this group of private loan investors separately given the size of the litigation and the recent impact on the share price. The investors claim that Countrywide Servicing is not adhering to its PSA agreements. Assuming our estimates for the non-agency assets (30% of the portfolio delinquent or in loss, a weighted average success rate of 33% and a 60% weighted average severity), we estimate BAC's cost of remedying losses on these pools would be $2.8 billion (implies an incremental $2B liability vs. our $6.7B estimate for private loan losses). If we use BAC's experience to date, this implies $176 million. If we double BAC's severity and defect rate, then we get to $353 million. We believe the potential for loss against these pools is captured in the Morgan Stanley $16 billion future reps and warranties costs factored into our model through December 2014.
While it is difficult to estimate the liability associated with the private and mono-line securities, we expect the ultimate liability will be relatively lower than that experienced with the GSE’s. Private label investors do not benefit from the same degree of protection as the GSE’s and there are a number of logistical impediments to centralizing claims which should mitigate losses relative to what has been experienced with the GSE securities:
 GSEs benefit from direct access to the loan files, while private label investors must aggregate claims to request a review of loan files (typically must own 25% of the MBS).
 GSE’s need to demonstrate only that a breach in their conforming underwriting standards has occurred. Private investors must also demonstrate that the breach drove the loss.
 GSE’s have lower hurdles for breaches of representations and warranties due to the relatively higher standard of loan underwriting.
 Private label securities often lack some of the representations and warranties common to agency securities.
 The length of time a loan performs prior to a default is an important consideration as well. The longer a loan performs, the less likely an underwriting reps and warranties breach would have had a material impact on the loan’s performance or that a breach even exist.
 The terms of private securitizations vary substantially. Thus, we would expect not broad classes of settlements but a multi year- long, loan-by-loan fights in court, suggesting a lower request rate and success rate than was the case with the GSEs.
 The rate of put-backs associated with private loans should increase as lawyers and investors become better organized and are better able to coordinate access to loan files.
 The credit quality of the private loans is lower than the GSE loans implying a greater incentive on the part of private investors to put back the loans and greater severity in the case of successful put-backs relative to the GSE experience.
 Issues related to the robo-singing scandal or foreclosure moratorium could embolden private investors to pursue litigation (although we do not expect judges to view private investors in the same light as homeowners) or increase the success rate of putbacks.
However, even if the liability is higher than the estimates we have modeled, it is likely to be spread over a number of years and therefore the likely impact on capital will be muted as a result. During these years we expect BAC to continue to churn out $10+ billion in earnings and as net charge-offs continue to trail down the losses from those claims should be absorbed.
Foreclosure Moratorium: In 23 US states, the foreclosure process requires the lender to prepare an affidavit containing details of the mortgage, and to sign it in front of a notary who has to verify the information in the affidavit. The bank then has to approach a court and obtain an order before it can commence foreclosure proceedings. However, a number of instances have been discovered recently where a large number of affidavits were notarized by a small set of individuals (the so-called robo-signers) without any verification of documents. As a result, a number of banks have halted foreclosure proceedings in these states where a court order has to be obtained in order to strengthen their operations on this front. On October 1, 2010, BAC voluntarily stopped taking foreclosure proceedings to judgment in states where foreclosure requires a court order following a legal proceeding. On October 8, 2010, BAC stopped foreclosure sales in all states in order to complete an assessment of the related business processes. These actions did not affect the initiation and processing of foreclosures prior to judgment or sale of real estate owned properties.
BAC has completed its assessment of the foreclosure affidavit process in the 23 states where foreclosure requires a court order following a legal proceeding. As a result of that review, BAC has identified and is implementing processes to ensure that affidavits are prepared in compliance with state law and have begun a rolling process of preparing and resubmitting, affidavits of indebtedness in pending foreclosure proceedings in order to resume the process of taking these foreclosure proceedings to judgment in those states. BAC estimates this process of resubmitting affidavits will take at least several weeks and could involve as many as 102,000 foreclosure proceedings that were pending as of October 1, 2010. Once these affidavits are resubmitted, there may be prolonged adversary proceedings that delay certain foreclosure sales. BAC continues to assess its processes in the other 27 states and intends to implement enhancements as appropriate. Subsequent to its announcements that it was temporarily suspending foreclosure sales, law enforcement authorities in all 50 states and the United States Department of Justice and other federal agencies have stated they are investigating whether mortgage servicers have had irregularities in their foreclosure practices. Pavis Capital believes the “robo-signing” scandal could trigger a number of risks/challenges for BAC and the banking sector as a whole:
 Bad precedence in some court cases could drive foreclosure buyers away and they could potentially start demanding a much higher discount for distressed sales to counter the remote risk of losing the home at some later time.
 The issue has exacerbated political risk. There have been calls to impose nationwide foreclosure moratoria and some concern that attorneys general could use this investigation to try and accelerate loan modifications by banks.
 The investigations by the attorneys general could result in fines, penalties or other remedies and result in significant legal costs.
 Additional borrower and non−borrower litigation and governmental and incremental regulatory scrutiny (for example class action suits related to foreclosures or increases in mortgage put-back related litigation).
 Costs will likely increase in the fourth quarter of 2010 and will continue into 2011 as a result of the additional resources necessary to perform the foreclosure process assessment, revise affidavit filings and implement operational changes. A congressional oversight panel estimated that incremental costs from foreclosure irregularities could range from $1.5 to $10.0 billion for the entire industry.

 The time to complete foreclosure sales may increase temporarily, which may result in an increase in nonperforming loans and servicing advances and may impact the collectability of such advances and the value of BAC mortgage servicing rights asset.
The worst-case scenario is considerably grimmer. In this view, which has been articulated by academics and homeowner advocates, the “robo-signing” of affidavits served to cover up the fact that loan servicers cannot demonstrate the facts required to conduct a lawful foreclosure. In essence, banks may be unable to prove that they own the mortgage loans they claim to own. The risk stems from the possibility that the rapid growth of mortgage securitization outpaced the ability of the legal and financial system to track mortgage loan ownership.
At this stage the “robo-signing” scandal appears to be a largely a procedural matter since there is little debate around whether the borrowers of these properties have actually defaulted. We believe that the number of loans with documentation issues is not likely to be material and the impact is likely to be limited to a delay in the charge-off process and potentially higher operational costs to strengthen the back end. BAC anticipates over the course of this pause, less than 30,000 foreclosure sales will have been delayed. As was the case for its judicial state review, BAC’s initial assessment findings show the basis for our foreclosure decisions is accurate. It noted in 3Q10, 80% of borrowers had not made a mortgage payment for more than one year (on average borrowers were 18 months delinquent), and 33% of properties were vacant.

Impact of Long Term Bond Compression: Compression in long bond is a challenge for all banks as it drives lower reinvestment rates in RMBS and, in first lien mortgages (less because there are more adjustables in bank-owned portfolios). These are the two asset classes most impacted by the decline in the long bond. BAC’s residential mortgage exposure is only slightly above the median for both of these metrics for large cap banks. BAC has been able to drive a fairly consistent NIM in volatile rate environments over the past several years. Part of this is changing business models and part of this is changing investment strategy. We expect that BAC will be able to mitigate some of the yield curve pressure on its NIM through reducing higher cost of funds as its balance sheet shrinks (management has suggested a $95 billion long-term debt decline at 3% swap adjusted cost of funds yielding a 15bp positive impact, all other things equal, or 5% to NIM over next 10 quarters), reinvesting in AFS loans rather than securities, reinvesting liquidity as Basel 3 rules known. However, the mitigants are over time, while the sharp decline in the long bond will negatively impact NII over the next few quarters. We are modeling a q/q decline in NII of 1% and 4% in 4Q10 and 1Q11 driving a $150 million and $500 million sequential decline in NII. We note that BAC has been able to maintain fairly stable NIM levels over a long time series across multiple cycles.

Trading Profits: BAC generates ~15% of pre-provision revenue from trading related activities. We believe there are a number of risks associated with this revenue stream: 1) lost revenue as a result of the implementation of the Volcker rule, 2) we believe the revenue associated with proprietary trading activities to be of lower quality, 3) both proprietary trading and client driven revenue are volatile and difficult to predict. While we have not been able to disaggregate the proportion of revenue that is driven by proprietary trading vs. client revenue, commentary by management and press releases on trading related headcount suggests that the vast majority of trading related profits is linked to the facilitation of client trades. Additionally, any reduction of proprietary trading revenue associated with the Volcker rule would likely be mitigated via the sale or redeployment of the balance sheet capital used to drive the revenue. While we believe the client driven portion trading revenues is also volatile and difficult to predict, we believe the risk/reward associated with the BAC investment more than compensates us for that volatility. The 2 charts below summarize the risk associated with BAC trading business:
The histogram below is a graphic depiction of trading volatility and illustrates the daily level of trading−related revenue for the three months ended September 30, 2010 as compared with the three months ended June 30, 2010 and March 31, 2010. During the three months ended September 30, 2010, positive trading−related revenue was recorded for 100 percent of the trading days of which 89 percent were daily trading gains of over $25 million. This can be compared to the three months ended June 30, 2010, where positive trading−related revenue was recorded for 81 percent of the trading days of which 59 percent were daily trading gains of over $25 million, eight percent of the trading days had losses greater than $25 million and the largest loss was $102 million. For the three months ended March 31, 2010, positive trading−related revenue was recorded for 100 percent of the trading days of which 95 percent were daily trading gains of over $25 million.

The chart below highlights daily trading revenue and VAR over the 9/30/09 - 9/30/10 period:

Mortgage/Credit Demand Contraction: The decline in the housing market and pace of home sales coupled with a broader trend of deleveraging by corporations and consumers has led to an environment of relatively weak loan demand. Lower mortgage/credit demand ultimately limits BAC’s ability to redeploy the capital on its balance sheet into higher yielding assets and could ultimately lead to lower net interest income growth or even a decline in net interest income. We believe both Pavis Capital and equity analysts projections for loan growth are relatively muted and adequately incorporate and more muted loan demand environment.
Litigation: We believe BAC faces heightened litigation risk. While we have discussed the impact of foreclosure and mortgage put-back litigation, we would also like to highlight that BAC is facing a number of class action lawsuits in Florida and California related to overdraft litigation. We will continue to monitor this litigation given the political and media attention that has been paid to overdraft fees and the potential for lawsuits to generate substantial liability.

 Implementation of dividends and share buybacks – Management has stated a desire to begin paying out dividends and buying back shares “as soon as possible. The company has targeted 30% dividend payout and is not planning on making acquisitions going forward. Excess capital would likely be used to repurchase shares.
 Improving credit quality and reduced put-back liability.
 Resolution of mortgage put-back liability overhang.
 Negative short term catalysts include: higher costs associated with robo-signing related issues, short term analyst estimates may be aggressive (particularly in the other revenue category), wiki-leaks release.

Variant View
We generally agree with the sell side consensus. Key issues that could adversely affect the thesis include: mortgage put-back liability being substantially higher than estimated, compression in long term bond yields, and continued stress in the housing market. Please refer to the attache write-up for a more detailed discussion of risk factors.

Friday, September 30, 2011

Chairman of China Construction Bank on Charlie Rose - asked about the real estate bubble

Guo ShuQing, the chairman of China Construction Bank was on Charlie Rose.  Charlie asked him about the real estate bubble @ 17:00. 

Charlie asked him if he thought the real estate bubble would burst. The chairman said, he doesn't expect it to burst because they will give it a "soft landing"...oy vey

To be honest, I haven't read CCB's financial filings so maybe I should shut up. Yet, I can't help feeling extremely anxious about BAC still having their stake in CCB. I've never heard of a real estate bubble having a soft landing - maybe there is an example of one, but I sure as heck don't know of one.

Monday, September 26, 2011

Buffett Squashes My 100K A Share Dream

It's not everyday a billionaire squashes one of your dreams, but when Buffett announced Berkshire will repurchase shares when they are trading below 110% of book, he pretty much kept me from ever buying a Berkshire A below 100,000 USD.

Fox News, does this count a class warfare? I'm sure you could spin it somehow.

It's not surprising that Buffett is signaling Berkshire is cheap, but it is surprising he is willing to repurchase shares. Maybe this will be like 2000 and he will never need to pull the trigger, but if he ends up repurchasing it would be historical. Repurchasing shares is essentially a liquidation of a business and a way to give capital back to your shareholders. With so many interesting opportunities in terms of large high quality companies, I thought Berkshire would never point the gun to themselves, but I guess at these prices Berkshire is too good to be true.

Tuesday, September 6, 2011

Screenshot of Westpac's market cap > BAC's market cap

Last week, my friend just got back from Melbourne. We met up in Taipei to catch up. Then he said something absolutely crazy. His cousin had just purchased a $750,000 AUD home. He has three children and his wife is a homemaker. His salary is $60,000 AUD.  That's right, his cousin's house is 12.5X times there pre-tax income.  That's absolutely ridiculous. This is all anecdotal, so maybe they are just outliers of the average Australian new home-buyer.  I hope they are, and I hope my anxiety isn't warranted.

Bronte Capital has a great post with some Australian bubble pictures, it's pretty jaw dropping.  The Inoculated Investor had written up an analysis of the Australian banks in 2009. It's a bit dated now, but worth the read.

I've had a negative point of view on Australia and Australian banks for quite a while (for fun I think about Australia...I need a real hobby).  On August 23rd something pretty memorable happened. The equity market cap for Westpac was actually larger than the equity market cap for Bank of America. I thought this was so strange I took a screenshot of it.

Bank of America's August 23, 2011 (equity) Market Cap of 63.54B

Westpac's August 23, 2011 (equity) Market Cap of 63.58B

In five years from now we will see how different the delta is.

Saturday, August 27, 2011

(VIDEO) An important trait for an equity analyst

Short story from a Richard Dawkin's documentary about the ability to change your hypothesis when the facts change.

Thursday, August 25, 2011

Buffett said BAC deal is reminiscent of his youth? GEICO & American Express trades

 If you are a Buffett nerd you know how profitable his old American Express and GEICO trades where.  I'm going to take a cold shower, and remind myself that Buffett also invested in Irish banks and lost his shirt and it's only my analysis that matters...not Buffett's.

I might be taking more than one cold shower. 

Issuing high credit ratings...Buffett's new profitable job. BAC's pound of flesh.

 At first, it was great seeing Buffett had made an investment in Bank of America. I felt a great deal of validation, but after a night thinking about this, I have developed very mixed feelings about his investment.

Basically, I feel Brian Moynihan had payed a very dear price for capital that's both expensive and disadvantageous for the common equity holder. For one, Buffett purchased preferreds not common, so if reps & warranties do go out of hand, Buffett's investment could still be safe. Also the capital from preferreds is not nearly as flexible as capital from an equity raising. In fact, with current low interest rates, Buffett's preferreds will help eat up BAC's NIM . Also the amount of capital Buffett has invested in preferreds is negligible to the overall company...only 5 billion dollars. The company can basically self generate this capital in two months.

Of course, it isn't just the preferreds Buffett bought, which tick me off, it was the 700 million dollars in warrants at a 7.14 dollar strike.....they have a TEN YEAR EXPIRATION.  Those warrants Bank of America gave out were instantly profitable. I'm not an expert on warrant pricing but, the 2019 BAC-A warrants with a 13.30 strike price and an Jan 2019 expiration sell for 4 dollars.  In all likely hood, Buffett could go around and sell 700 million warrants anywhere for 6-12 dollars (depending if the strike decrease with dividends. )  Now it would be very unBuffett of him to turn around and sell the warrants like that. To add insult to injury, Buffett isn't going to exercise those warrants until the very end (due to time value, and the ability to use his capital for other opportunities for the next 10 years without it being preoccupied)  and when he does, BAC surely won't have needed the additional capital.

Looking at the cost and I am a bit cynical about Buffett's investment. If Moynihan believes in the 12.60 net tangible equity per share number and no need for capital raising. Then Moynihan should have never taken Buffett's call. I mean first of all, if Buffett's calling know you are going to get screwed on the price. Call it the Buffett Bite, and it's a big one.
So why the hell would Moynihan do such a deal? I'm guessing it's because Bank of America is willing to pay lots of money for a high credit rating. If you don't want people calling you up about your perceived counter party risk, you are tired of taking phone calls from analysts and you just want the talking heads on TV to say something good about your can give Buffett millions if not billions of dollars for his seal of approval.

Granted, Buffett called Moynihan, it wasn't Moynihan who called Buffett, but I would have been much happier of Moynihan took the phone call, told Buffett Bank of America wasn't interested raising capital at those nose bleed levels, and then issue an (unscrupulous) press release stating Warren Buffett offered to invest money in Bank of America, but we turned him down because we don't need the capital.  That's a much cheaper seal of approval.

I'm off to see the doctor about this pound of flesh missing from my portfolio.

Wednesday, August 24, 2011

Fortune Article on Brian Moynihan

Fortune did an article on Brian Moynihan on July 7, 2011. I would suggest reading it if you have an interest in Bank of America.

Moynihan landed the CEO job during a secret interview at the Four Seasons hotel in New York City in November 2009 by promising the board's search committee that he would follow a rigid set of principles: Sell virtually every asset unrelated to bedrock banking. Forget all acquisitions, now and forever. Don't grow total loans, but do change the mix so BofA won't be overexposed to risky consumer credit in a bad cycle.

Saturday, August 13, 2011

Berkshire Hathaway looks cheap: operations have a 3.3X implied multiple

Originally, I wrote a post about Berkshire's valuation and made a very stupid mistake (double counted.) I would like to thank that reader for quickly pointing out my mistake, you know who you are.

I have decided to give the Berkshire valuation another shot. This time  with the help of Augustin Chieh of Chieh Capital. Augustin probably has the most extensive Berkshire valuation of anyone I know and I was lucky to have his help. Augustin definitely did help me on this, yet any mistakes in this analysis are all my own.

Berkshire Hathaway's Value: = Investments + Operations
  • Investments = 153.18B¹
  • Operations  [insurance underwriting operations] + [non-insurance operations] = [1.4B*12] + [5.93B * 15] = 105.75B² 
  • Equivalent class A shares outstanding: 1,651,284, as of July 28, 2011
  • Currently, the Berkshire A's go for 107,600 - the Berkshire B's go for 71.52
153.18B + 105.75B = 258.93 Intrinsic Value.  That's 156,805 per A share or 104.53 per B share
Market’s current implied multiple on the operating business when backing out investments is 3.3X.
([market cap] – [investments]) / [operations earnings] = ([178B] – [153.18B]) / [7.33] = 3.3  =   current implied multiple for Berkshire’s Operating Businesses          

Conclusion: Berkshire is currently selling at a reasonable value. There are a few possible catalysts. First, Berkshire Insurance subsidiaries have excess capital in order to generate new float which if written conservatively can translate to an instant increase of Berkshire's value. The second, Berkshire's investment portfolio is filled with blue chip companies which are selling at historical lows; if blue chip stocks start to rise, Berkshire’s portfolio will rise with it. Thirdly, about a billion dollars in housing earnings has disappeared since 2006 – which will eventually come back.
 ¹ I am assuming the major investments Berkshire holds will not be sold, leaving no capital gains tax This is of course, very debatable. I am also assuming 1 dollar of no cost float equates to 1 dollar of equity.  

² The 15 multiple for Berkshire’s non-insurance operations since Berkshire’s operating subsidiaries are handpicked by Buffett himself and a multiple close to the long term average S&P 500 multiple seems reasonable.. The 12 multiple is for the insurance underwriting operations. Although Buffett’s insurance operations have continued to grow float intelligently and at low costs, most insurance business don’t have a competitive advantage and are highly susceptible to market forces.  Operation numbers come from the annual report page 67, results from operations. The underwriting profit is the normalized underwriting profit from 02’-08’to include a full insurance pricing cycle. The underwriting profit also excludes 9/11 since policies now exclude 9/11 type costs, unless customers explicitly pay for them.  

Friday, August 12, 2011

BAC & Berkowitz: Webcast + Transcript

The live blogging for the BAC/Berkowitz conference call was very spotty. I suggest reading the transcripts at Morningstar and/or listening to the webcasts.

Tuesday, August 9, 2011

(VIDEO) Recent Daily Show segments on the market and Bank of America & update

I'm a big fan of The Daily Show. Especially liked their 2008-2009 segments called "Clusterf#@k to the Poor House"  Last Monday they did two great financial segments. Enjoy financial nerds.

update: I've been thinking about a few more posts. There is another Chinese company I find interesting. I also want to do a post on Berkshire Hathaway: congratulations for anyone who stole the B shares for 67 dollars yesterday.  I have also increased my position in the Back of America - A warrants, but I was asleep when they were selling for ~2.6.