Working as the only analyst in a small broker dealer means you occasionally get some interesting projects.  There are many hucksters out there, and if they drop by your bitty broker-dealer to run their deal, skepticism, not hope, is the proper reaction.  “Why are we the lucky ones?” should be the skeptical question.

Anyway, here are three responses that I gave to my bosses over a four month period on deals that were brought to them.  Names have been obscured where possible.

Project 1

This was a deal that attempted to securitize life settlements, i.e. life insurance policies where the owner has sold off his interests to a third party.  The biggest problem was all of the money sucked out of the deal that would not be invested to earn a return.  Here is what I wrote:

Dear Boss,

Notes on the deal

I have read the Overview and the Private Placement Memorandum [PPM], and have scanned everything else.  Here are the main points:

1. The key page of the entire document is page 18 of the PPM.  In it we learn: the zeros get a 4.07% return, but the collateral has to earn 11.72% net of fees in order to make this deal pay off.  Also, 65.52% of the proceeds go to other than investment purposes.  Why so large?  (As an aside, this yield is at a discount to Treasuries.  An equivalent length treasury zero yields 4.55%, AAA Aid to Israel – ~5%.)
2. The continuing fees are hefty – Servicing 1%/year of Face?  Origination – 1%/month of the Matured Policy Increase Amount [MPIA - essentially a measure of cash flow profitability]?  Administrative expenses as well to third parties.  I can’t tell how big those are, or how much the collateral would have to earn to make the bond pay off.
3. The residual value guarantor, AAACO, is not in good shape.  The central bank of CN has taken over the assets and liabilities for now, but it does not seem that they have guaranteed the liabilities permanently. They are rated “B” by AM Best – not a sound rating.  On taking over the group that owned AAACO, S&P said that it was a big enough rescue that they might have to downgrade CN from its A rating.  They have since reaffirmed the rating as stable, but Moody’s now rates CN as Baa1.
4. The residual value policy doesn’t do much if there is a modest deviation from perfect performance by the originator or servicer, the policy won’t pay.
5. We don’t have all of the documents, such as the Blocked Account Control Agreement.  But beyond documents, we don’t have any sort of cash flow analysis.  How are they going to earn so much on so little invested capital?
6. We don’t have any data on the life policies, insurers, etc.  Some insurers fight life settlements.
7. The Overview dramatically oversells the virtues of the deal.  Many of the things it lists as protections are weak.  Points 3 and 5 are the same points, but it makes them sound different.  Further, CN do not own AAACO, they have it in a form of semi-receivership.  If they did own it, AM Best would give it a better rating.
8. BBB is the actuary, but she owns the originator and the servicer. [Origco & Servco]  She is not bound to continue with the deal till maturity if it gets originated (she will be 75 herself then).
9. Servco and Origco have defaulted on prior deals, and they weren’t able to get enough interest on the first deal to make it work.
10. Origco is basically broke.  They have assets of $500K, and liabilities of $2 million.  The assets are receivables from Servco.  Servco owes $16 million that it can’t pay off either.
11. Origco and Servco do not use accrual accounting.  They could not pass a GAAP audit.  Even with accrual accounting, they would not be a going concern.
12. Origco and Servco have existing default judgments against them, and no way to pay them.
13. If Servco or Origco default, the residual value policy does not pay.
14. Servco and Origco have no significant staff.  If this gets originated, there will be a significant risk as they staff up.   They also don’t have licenses.  This is not a bond, it is seed stage venture capital.
15. They have had run-ins with the SEC, Texas Securities Commission, and Securities Division of North Carolina.
16. The notes are deemed equity for tax purposes, which seems aggressive to me.

If you want, read page 18, and scan the risk factors section of the PPM (pages 19-57).  It is my belief that this is something that we don’t want to get mixed up with, at any price.  I can understand why no underwriter wants to take this on, and why they are looking to smaller broker-dealers.  But if you want to look into this further, have them forward to me their cash flow analyses.  I can’t imagine how they get this to work.

I have this phrase that I use sometimes, “Holding my nose as I hit the delete key.”  That is when something smells so bad, the odor can even travel over the Internet.  This feels like the attempt of some desperate people who are deeply in debt, and need one “grand slam” to bail themselves out of debt
and have a happy retirement.

Postscript: this deal not only did not get done, but the boss apologized for bringing it to me.

Project 2

This was a case where someone was willing to offer us $5 million in capital if we gave them $1 million.  What an altruist!  Not.  Yes, the value of shares if you could sell them all at the “last trade” was worth $5 million, but the company was basically a warrant on the success of a technology, and the balance sheet was horrendous.  This is what I wrote:

Dear Boss,

This doesn’t smell good.  Here’s my commentary, together with excerpts from their recent 10-K and 10-Q:

$6250 Stock Trading Volume per day

Negative earnings, cash flow, and net worth.  Little to no liquidity – huge negative net working capital.

1-100 reverse split

Auditors comment for 2008 10K: The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 11 to the consolidated financial statements, the Company has a significant working capital deficit, has recognized significant operating losses in each of the years in the three year period ended December 31, 2008, and will need significant amounts of investment funds to fully develop its oil and gas leases. Management’s plans in regard to these matters are described in Note 11. The financial statements do not include any adjustments that might result from the outcome of this uncertainty.

The Company currently has three full-time employees.

Risk factor: The Company has incurred net operating losses since 1997. However, the Company currently has operations that provide working capital. The Company is also seeking further project based financing to develop its existing projects. There is no assurance that the Company will be able to secure adequate financing to fund those operations.

High compensation to management for not much of a company.  $5 million in 2008.

The Company failed to timely file a current report on Form 8-K upon the occurrence of the Default Notice and Acceleration Notice under the Credit Agreement with CCC, and the July 22, 2008 Limited Forbearance Agreement pursuant to which Gas Rock agreed to refrain from pursuing remedies for a limited time.

NOTE 7 – Note Payable – CCC CAPITAL LLC

The Company entered into an advancing term credit agreement for $30,000,000 on April 13, 2006 through its subsidiary DDDa, LLC with CCC Capital, LLC to fund the purchase of the EEE Field in GGG Oklahoma. This agreement was increased to $50,000,000 on April 2, 2007. The balance at December 31, 2008 was $13,423,221, net of debt discount of $41,077, and the Company paid interest of $1,957,294 for the year ended December 31, 2008. The note is secured by all of DDDa’s assets and certain personal assets owned by EEE, CEO of the Company. DDDa’s assets are cross-collateralized on a $3,469,000 loan made by CCC Capital, LLC to FFF, a related party. This loan is currently in default, with interest only payments being made.

On April 9, 2008, CCC delivered to the Company a Notice of Events of Default and Unmatured Events of Default (“Default Notice”) under the Credit Agreement. Due to these claimed Events of Default, interest under the Credit Agreement began accruing at the Default Rate of 15% and 100% of DDD’s Net Revenues were applied to Debt Service and other Obligations as of April 9, 2008. On April 16, 2008, CCC delivered to the Company a Notice of Acceleration (“Acceleration Notice”) under the Notes due to the continuing claimed Events of Default under the Credit Agreement. The Acceleration Notice declared the amounts due under the Note to be accelerated and due and owing in full as of April 16, 2008.

On July 22, 2008, CCC, DDDa and FFF (“FFF”, and together with DDDa, the “Borrowers”), entered into that certain Limited Forbearance Agreement, pursuant to which CCC agreed, subject to the terms thereof, to forbear from pursuing remedies under the Credit Agreement and Notes in respect of the Events of Default claimed as of that same date until the earlier of (i) November 15, 2008 and (ii) the date that CCC gives DDDa notice of any additional payment default under the Credit Agreement. FFF is controlled by the Company’s CEO and is a guarantor of the DDDa Obligations under the Credit Agreement. CCC is also a lender to FFF under an Advancing Term Credit Agreement (the “FFF Credit Agreement”, and together with the Credit Agreement, the “Credit Agreements”.

The Forbearance is subject to the following conditions to be fulfilled:

1) On or before November 15, 2008, (i) the Borrowers must repay all Obligations (as defined in the Credit Agreements) or (ii) DDD must have entered an agreement for the full or partial sale of the EEE Field, the proceeds of which would fully repay the Obligations owing under the Credit Agreements, and such sale shall close and repayment of the Obligations shall be made by December 31, 2008;

2) If the Obligations are not repaid by November 15, 2008, DDD must assign a 5.0% net profits interest in the EEE Field to CCC, effective as of November 1, 2008. The form of this assignment and the potential assignments discussed in paragraph 3, below, will be substantially in the form of the Conveyance of Net Profits Overriding Royalty Interests, attached as Exhibit A to the Forbearance Agreement;

3) If the Obligations are not repaid by December 15, 2008, DDD must assign an additional 1.0% net profits interest in the EEE Field to CCC, effective as of December 1, 2008, and will assign to CCC an additional 1.0% net profits interest each subsequent month if the Obligations are not repaid by the 15th of such month;

4) DDD shall escrow one 5% net profits interest conveyance and five 1% net profits interest conveyances to ensure it’s delivery of any potential obligations under paragraphs 2 and 3, above;

5) Any and all Net Proceeds (as defined in the Forbearance Agreement) from any equity issuance, refinancing, or asset sale will be applied first to outstanding fees and expenses of CCC, second to the accrued and unpaid interest on the Notes, and third to the outstanding principal balances on the Notes; and

6) The Borrowers must ensure that its hydrocarbon purchasers make payments relating to any of CCC’s overriding royalty interests in the EEE Field directly to CCC.

NOTE 11 – Going Concern

The Company has reported operating losses aggregating $9,877,016 for the two (2) year period ended December 31, 2008. At December 31, 2008, the consolidated balance sheet reported a working capital deficit of $23,887,172. The Company must raise significant amounts of cash to pay its current liabilities and to provide investment funds to continue development of its oil and gas leases. There can be no assurance the Company’s management will be able to secure funding.

David here: There is little assurance that an immature development stage company like this will ever be worth anything.  I am no expert on hydrocarbons but this company is overindebted, and it is likely that debtholders will own the assets within a year or two, and equityholders get nothing.

DDD shares would not, not, not be an asset to our firm.

Postscript: 6 months later, the stock worth $5 million is worth $300,000.  And will be worth zero soon.

Project 3

Another life settlements securitization.  The originator seems to be honest, but is using the securitization to get a cheap commercial mortgage loan.  What I wrote:

Dear Boss,

I’ve read through the whole document.  Here are my thoughts:

Summary Notes

The officers of the company have no experience at all with life settlements.  They do have some experience with multifamily housing.  They are using a life settlements securitization to facilitate loans for their multifaqmily housing expansion plans.  To me, that is pretty convoluted.  Why not simply go out and borrow the money?

I realize the offering memorandum is preliminary, but there are several things that need to be clarified:

• Need to see the financials of the GGG enterprises
• Correct address for their website.
• Who is HHH Capital Management?  Can’t find them – the portfolio managers.
• Need fees, policy data, and expected cash flows
• What are they doing to source portfolio 2?
• Need actuarial projections
• Exactly what are the trusts receiving as collateral for the loans?  I need pro-forma financials on the property(ies) to be developed…
• Where are the related party transactions?
• If this deal is 3x overcollateralized, where does the excess money come from?  Who is the equity, and what are their motives?

That’s all for now.  Looking forward to more data.

After the response, I wrote:

Dear Boss,

I realize the offering memorandum is preliminary, but there are several things that need to be clarified:

I have three tentative conclusions (with questions):

1.      The largest asset is a 9 year fully amortizing 2.7% loan on the $40,000,000 to the sponsoring company.  It is a hidden source of profit to them, but the full amortization makes the loan more secure, it they can make the first few payments.  That said, they would need 12% cash flow on the loan to make the payment, and where will they get that?

2.      The deal would need a 6.1% return on the Life policies to get a Treasury yield on the certificates.  8.0% return to get T+100.  15.75% to get T+500.  What would it take to sell these notes?

3.      There is a low probability of full payment of principal.  A margin of $25 million on a $250 million principal payment is skimpy, and in my opinion, decidedly not investment grade.  I assume these aren’t going to be rated, right?

And I have additional data needs:

4.      Who is HHH Capital Management?  It looks like a new firm – do they have the ability to do their part?

5.      I need fees, policy data, and more detailed expected cash flows. Where is Appendix B?

6.      How were the life expectancies calculated?  That’s hard to do right.  Second opinions?

7.      I need actuarial projections, with considerable detail. That would mean a copy of the JJJ review.

8.      Exactly what are the trusts receiving as collateral for the $40 million loan?  Pro-forma financials on the property(ies) to be developed… And, I would need to see the financials of the GGG enterprises.

I think this deal will prove hard to complete.

Postscript: we went further with this group than the other two, but when faced with my data requests, the originator gave up.

After this happened to me, I talked with an investment banker who is local, and has many contacts like mine.  He commented on how small broker dealers get hit up with slick pitches, any one of which if accepted, could destroy the broker-dealer.  The trafficking of blocks of life settlements is endemic, and is a search for what lemming has the lowest discount rate — has mis-estimated the risks.

He also mentioned how these groups toss around big names as those that will buy the senior certificates.  I experienced that myself.  Kuwaiti Investment Authority, indeed.

So, in four months time, I kept my firm from making dumb decisions three times, any one of which might have severely damaged or destroyed the firm.  What did I get get for my efforts?  The best thing of all: gratitude from my bosses, and knowing that I did my best for those that hired me, protecting the interests of all stakeholders of the firm.

Skepticism is a necessary aspect of investing, particularly as the complexity level rises.  Aim for simplicity, and put safety first in your investing.  It is easier to protect value than to try to earn back losses from mistakes.

To phrase it another way — in order to work through these deals, I had to read through over 1000 pages of data.  Don’t let the multiplicity of words dull you to the risks that exist.  Even for small investors I would say avoid complexity.   Where there is complexity, there is a much higher risk of loss, almost always.  Stick to simple investments, and let the complex stuff be bought by experts, who will turn away most of the charlatans.

I read every email sent to me, and every comment  written at my blog.  But much as I would like to, I can’t answer them all.  One comment to my last piece on this topic questioned the validity of accrual entries in insurance accounting.  I would like to say that the standards for GAAP reserve accounting are pretty good.  They need some tweaks here and there, but they do the job fairly well.

One of the things you learn as a fundamental investor is that the quality of accounting derived from accrual entries is always lower than that for cash entries.  There is an implicit assumption behind every accrual entry that someone will make good in the future to pay cash, whether the amount is fixed or estimated.

Accruals vary in quality.  Accounts Receivable are more reliable than inventories.  Who knows what fixed assets, property, plant and equipment are worth?  Pension obligations are squishy, the assumptions can be manipulated within reason.  Deferred tax assets rely on the ability to earn more money, but most companies with the deferred tax assets have lost significant money in the past.  Will the company bounce back?

And there are intangibles.  Goodwill is only worth something if a company earns cash from operations in excess of net income over the long run.  Capitalized R&D, software costs, must produce cash flows that justify capitalizing the expenses, otherwise capitalizing is merely deferring losses.

So there are tests such as normalized operating accruals that for industrial companies and utilities can flag many companies that look cheap, but may not be, because too much of their income comes from accrual entries.

With financial companies, the problem is worse, because financial companies are a bag of accruals.  What are the loans worth?  What are those weird structured securities worth?  And with insurance it gets tougher.  What level of claims do you expect to pay out and when?  Will you recover the amounts that you invested in acquiring the policies that have been written?

Tough questions, but they are what accounting rules have been designed to try to answer.  Because there is complexity, unscrupulous management teams can take advantage of the flexibility.  That does not mean the rules are wrong, though.  No human system can be both consistent and comprehensive.  There are tradeoffs between modeling the details of a company’s financials accurately, and doing the accounting consistently across corporations.  To what degree do you make accounting “cookie cutter” versus tailored?  That is the tough question that vexes those that set the accounting standards.

I would add that insurance accrual quality is subject to three factors:

• Length of the accrual — longer is worse.
• Uncertainty of the contingency in question — uncertainty of amount and timing?
• Does the law of large numbers apply?  What is uncertain in specific, may be more predictable in aggregate.

I received another comment, and initially I said, “I can’t get that done.  Yes that would be good but….”  Here is the comment:

Doug Says:

May 24th, 20109:10 am at Edit

It would be interesting to normalize the reserve charges two ways:

1) Adverse reserve development as a % of beginning reserves.
2) The ratio in #1 above compared with the industry.

While these reserve charges were bad, long-tailed P&C insurers were taking similar reserve charges – even the more “responsible” ones.

Look at the results of one of AIG’s smaller competitors – W.R. Berkley. Similar business mix and a charismatic CEO to boot. Same string of reserve charges, but the CEO is still there, and investors got a nice 20% annual rate of return from 2000. The difference? AIG was trading at 4x book value in 1999, while Berkley was trading below book.

So I went and did it, choosing eleven peer companies that were large, having long tailed liabilities.  This was the peer group:

• ACE — ACE Limited
• BRK — Berkshire Hathaway
• CB — Chubb
• CINF — Cincinnati Financial
• CNA — CNA Financial
• MKL — Markel
• PRE — PartnerRe
• TRV — Travelers
• WRB — W. R. Berkley
• WTM — White Mountains Insurance
• XL — XL Capital Limited

I could have chosen more, but I thought these were representative of stockholder-owned insurers and reinsurers that write long-tailed P&C business.

So what did I find?  I found that AIG was among the worst of major P&C insurance companies in terms of having to strengthen reserves from 1993 to the present.  AIG had to strengthen its reserves 2.1%/yr versus my peer group average of 0.6%/year.  CNA did worse, and White Mountains (a company that talks a lot about conservative accounting) was slightly behind.

Note that the four companies that did not stretch all the way back to 1993 in terms of reported numbers likely would have looked better, because they missed some favorable underwriting years.

Here is the graph of the twelve companies, and the average:

And here is the graph of the companies that were not as good as the average:

The clear conclusion is that AIG was among a group of P&C insurers that were less conservative in reserving than most of their large competitors. CNA and White Mountains were much smaller companies — AIG was dropping a boulder into the pond.

Among all the other difficulties that AIG had, from a yield-seeking derivatives subsidiary, to life and mortgage insurance subsidiaries in trouble, this was just another facet of a company that played it fast and loose.  They under-reserved their P&C divisions, and there can be no reasonable defense on that topic.

PS — I like investing in P&C insurers and reinsurers that regularly release reserves for the business of prior years.  Conservative companies have high earnings quality, and are reasonable investments, despite all of the uncertainty.

Full disclosure: long PRE, CB

Should regulation be dumb?  In one sense yes, in others, no.  It really depends on how well the regulators understand the risks involved, and how much they can encourage professionalism among profit center heads and risk managers.  As those two increase, regulation can be smart.  “Follow these detailed rules to calculate the capital you need to be solvent 99% of the time.”

But when either of those two aren’t true, dumb regulation may be in order:

• Strict leverage limits, reflecting the worst outcome from underwriting poor quality loans.
• Disallowing risky types of lending, regardless of capital level.
• Disallowing liabilities that can run easily.
• Disallowing products that commonly deceive buyers.
• Disallowing certain types of contracts that fuddle accounting.
• Those regulated may not choose their regulator.  The highest regulator assigns a regulator to you.  The highest regulator must evaluate the jobs that lower regulators are doing, and eliminate/lessen regulators that do not use the powers they have been granted, and get co-opted by those that they regulate.

If everyone were smart, things could be different.  Deceiving people would not take place, and managements would not take undue risks.  Limits could be looser, and products would be designed for discriminating buyers.

But, face it, we are dumber than we think, myself included.  Consumer choice is a good thing, though it implies that some will be deceived, no matter where one places the line of demarcation.  Along with that, some bank will not fit the rules and go insolvent, though it previously passed the solvency tests.

Dumb Regulation: Insurance in the US

My poster child for relatively good dumb regulation is the insurance industry in the US.  The industry is far less free-wheeling than the banking industry, and under most circumstances, the solvency margins are set high enough to have few insolvencies.  There is room for improvement, though:

• Make risk based capital charges countercyclical.  Perhaps tinkering with the Asset Valuation Reserve would do that.
• Have some sort of rigorous testing for capital relief from reinsurance treaties.
• Ban surplus notes in related party transactions.
• Ban all forms of capital stacking, especially where the transactions go both ways.  I.e., subsidiaries can’t own securities of any companies in their corporate family.  All subsidiaries must be owned by the holding company.
• More rigorous testing for deferred tax assets.
• Assets as risky as equities, including limited partnerships, should be a deduction from capital.
• Securitized bonds that are not “last loss” should have higher RBC charges than comparable rated corporates, because loss severities are potentially higher, and assets that are originated to securitize are always lower quality than those held on balance sheet.
• A standardized summary of cash flow testing results should be revealed.

As for the banks, they need to do that and more:

• Insurance companies list all of their assets.  Banks should as well.
• Intangible assets should be written to zero for regulatory capital purposes.
• Risk-based capital standards need to be tightened to at least the level of insurance companies, if not tighter.
• Some sorts of lending to consumers should be banned.  I am talking about complex agreements, that individuals with IQs less than 120 can’t understand.  Insurance policies have to be Flesch-tested.  Bank lending agreements should be the same.  If some argue that the poor need access to credit, I will say this: the poor need to get off of credit.  Credit is for the upper-middle-class and rich.  Poor people should not go into debt.
• Standardized summaries of terms and fees must be created for consumer lending, with large, friendly letters, and simple language that all can read.

What I am saying is that accounting has to be more conservative, and that regulators have to require larger amounts of capital to support their business, particularly at the banks.  Financial products must be made simpler for consumers to understand.  More transparency is needed everywhere, and if the financial companies complain, tell them that they will all be in the same goldfish bowl, so no one will gain an unfair advantage.

Preventing Too Big to Fail

As part of preventing too big to fail, the Risk based capital [RBC] percentage should rise with the amount of risk-based capital.  Say, when RBC gets over $10 billion, the percentage of capital needed for RBC grades up to 50% higher than the level needed at $10 billion by the time RBC gets up to $50 billion.

Here is my example of how it would work:

I have assumed that firms undertake their highest ROE projects first, and do progressively lower ROE projects later.  Now, by raising capital requirements on bigger firms, a common response is, “Well, then they will just take on riskier loans to compensate.”  Sorry, but that dog don’t hunt.  If they take on riskier loans, their RBC goes up even more rapidly, because loan quality is reflected (or, should be reflected) in RBC formulas prior to adjustment for bank size.

More Dumb Regulation

Dumb regulation bars certain lending practices, and raises capital levels higher than is needed over the long run.  So be it.  Smart regulation is far more flexible, and trusting that companies and consumers know what they are doing.  Unfortunately, when financial firms fail, there are often larger repercussions.  It is better to limit regulated financial companies to businesses where the risks are well-understood.  Let the less understood risks be borne by those outside the safety net, and bar those inside the safety net from holding any assets in those companies.

That brings me to the Volcker Rule, which is a good example of dumb regulation.  My preferred way would be to do something similar through adjusting the risk-based capital formulas — Equity-like risks should be funded through a 100% allocation of equity. Few banks would take on that level of speculation at that level of capital used.

If you need proof, look at the life insurance industry. Companies used to hold a lot more equities prior to the tightening of RBC rules. Now they hold little, except at a few mutual companies that are flush with capital.

That also has preserved the insurance business in this crisis, leaving aside mortgage and financial risks, where the state regulators still have no idea what they are doing — that a proper reserve level would leave most of the companies insolvent today, but had it been implemented ten years ago, would have preserved the companies, but eliminated much of their profits.

At the Treasury meeting with bloggers in November 2009, I commented that the insurers were better regulated for solvency than the banks.  One of the reasons for that is that they do harder stress tests, and they look longer-term. Life and P&C insurers survive the process because of better RBC standards, and “scaredy cat” state regulators. What a great system, which prior to the crisis, was criticized as behind the times.  (I suspect that if we ever get a national regulator of insurance, there will be a big boom and bust, much as in banking at present. It is easier to corrupt one regulator than fifty.)  The more state involvement in bank regulation, the dumber (better) bank regulation will be.

What to Do

So, if one is trying to regulate banks for solvency, there are seven things to do:

• Set risk-based capital formulas so that few institutions fail.
• Make it even less likely that larger institutions fail.
• Limit the ability of financial institutions to invest in other financial institutions.
• Regulators must benchmark the underwriting culture, and raise red flags when underwriting is poor.
• Insure that equity is truly equity.
• Institute a code of ethics for risk managers.
• Make sure that balance sheets fairly reflect derivatives.

It is almost always initially profitable to borrow short and lend long.  That said, it is a noisy trade.  Who can be sure that short rates will remain below the rates at which one invested long?  Another component of a good risk-based capital formula is that there is no investing in assets that are longer than the liabilities that fund the financial institution.  (For wonks only: regulated financial institutions should be matching assets versus liabilities as their most aggressive posture.  Unregulated financials can do what they want.  And no investing in unregulated financials by regulated financials.)

One of the great subsidies banks get is the cheap source of funds through deposits.  It is only cheap because depositors know the FDIC is there.  The FDIC should raise its fees to absorb that subsidy back to the taxpayer.  Keep raising it until you see banks begin to shift to repo and other short-term sources of funding.

As a clever old boss of mine once said, “A banks liabilities are its assets, and its assets are its liabilities.”  The idea is this — banks that focus on their deposit franchises have something of real value — that is hard to replicate.  But any bank can invest their funds aggressively, which will lead to defaults with higher frequency.  It is true of insurers as well, most financials die from bad investing policies, and short-term liabilities that require complacent funding markets.

That’s why there has to be a focus on liabilities in regulating solvency.  Financial institutions, even simple ones, are opaque.  Most die from the deadly combo of illiquid assets and liquid liabilities.  Those that have funded the bank in the short run refuse to roll over the loans at any price.  Assets can’t be liquidated to meet the call on cash, and insolvency ensues.  Those that have read me for a long time know that I don’t buy the malarkey that some managements will trot out, “We’re not insolvent; we merely have a liquidity crisis.”  Hogwash.  You took too much risk, because the first priority of risk control is liquidity management.  Assets are only worth what you can sell them for, or, what cash flows they can generate.  If assets can’t generate cash flows or sale proceeds adequate to service liabilities, then you are insolvent, not merely illiquid.

Cash flow testing for banks should focus on the ability of the bank to finance itself without recourse to selling assets.  To the extent that selling assets is allowed in modeling, they must be Treasury quality assets.

The essence of a good risk-based capital formula is that it forces intelligent diversification, and forces adequate liquidity.  No assets should be bought that the liability structure of the bank cannot hold until maturity.  There should be no concentration of assets by class, subclass, or credit, that would be adequate to lead to failure.

My view is that a proper risk-based capital regime would start with asset subclasses, and double the capital held on the largest subclass, and 1.5X the capital on the second largest subclass.  After that, within each subclass, the top 10 credits get twice the level of capital, the next 10 1.5x the level of capital.  Having managed assets in a framework like this, I can tell you that it creates diversification.

Beyond that, no modeling of asset correlations would be brought into the modeling because risky asset correlations go to one in a crisis. Any advantage derived from diversification should be accepted as earned, and not capitalized as planned for.

Securitization deserves special treatment: risk based capital should higher for securitized assets versus unsecuritized assets in a given ratings class, because of potentially higher loss severities, and assets that are originated to securitize are always lower quality than those held on balance sheet.  Capital charges should be raised until banks don’t want to securitize as a matter of common practice.

Eliminating Contagion

In order to avoid systemic risk and contagion, banks should not lend to or own other financial firms.  That would end contagion.  At least that should be limited to a percentage of assets, or through the RBC formula. Think of it this way, financials owning financials is a form of capital stacking across the country as a whole.  In a stress situation it raises the odds of a deep crisis.  Setting a limit on the ability of financials to own the assets of financials is the single most important step to avoid contagion.  I would set the limit at 5% for equity, and 20% for debt.

Regulating Underwriting

Most of the real risks came from badly underwritten home mortgage debt, whether conventional, Alt-A and Jumbo, or subprime.  Underwriting standards slipped everywhere.  Commercial mortgage lending hasn’t yet left its marks — there is a lot of hope that banks can extend maturing loans rather than foreclose and take losses.

For much but not all of this crisis, it was not a failure of laws but a failure of regulators to do their jobs faithfully.  Regulators should have looked at indicators of loan quality, and raised red flags when they saw standards deteriorating.  Where I worked, 2003-2007, we saw the deterioration, and were amazed that the regulators had been neutered.

Let Equity Be Equity

Beyond that, there was a dearth of true equity, and a surfeit of preferred stock, junior debt, trust preferreds, and particularly, goodwill.  Equity has to reflect assets that are high quality and that are not needed to support short-term obligations from the cash flow tests.

Code of Ethics for Risk Managers

One reason the banking industry is worse off than insurance, is that they don’t have many actuaries.  Actuaries have a code of ethics.  They tend to be “straight arrows” telling it like it is.  Bank risk managers need the same thing, together with the rigorous education that actuaries receive.  Accept no substitutes: CFAs and CERAs are no match for FSAs.

Reflect Derivatives Properly

Derivatives must come onto the balance sheet for regulatory purposes, revealing leverage increases/decreases, counterparty risk, overall sensitivity to the factors underlying the contracts.  Any instrument that can cause cash to flow at the regulated entity should be on the regulatory balance sheet.

Other Issues

I would not create a prospective guarantee fund. The insurance industry has a retrospective fund that has worked fairly well.   Do you really know what it would take to create a macro-FDIC, big enough to deal with a large systemic risk crisis like this one?  (The FDIC, much as it is pointed out be an example, is woefully small compared to the losses it faces, and it is not even taking on the large banks.)  It would cost a ton to implement, and I think that large financial services firms would dig in their heels to fight that.  Also, there would be moral hazard implications — insured behavior is almost always more risky than uninsured behavior.

Though it is not bank reform, we need to end the Greenspan/Bernanke Put.  The Fed encouraged risk-taking by the banks by not allowing recessions to damage them.  They tightened too late, and loosened too early, and that pushed us into a liquidity trap. Monetary policy that is too loose creates perverse incentives for the solvency of financial institutions in the long run.

Bonuses to executives skew incentives.  Bonusing a financial executive on current earnings creates perverse incentives.  It is a form of asset/liability mismanagement, because cash flows in the short run, while the value of the institution is a long-run issue. Far better to incent using long dated restricted common stock.  The only trouble is, it doesn’t incent as well as cash.  Tough, sorry, but that is a loss that must be accepted for the good of the system as a whole.

Summary

Dumb regulation is good regulation.  Regulators should be risk-averse, and take actions that limit ROEs for banks in order to promote solvency, and reduce the likelihood of liquidity crises.  The remedies that I have proposed here will do just that.  May we use them to regulate our financial sector better, for the good of all in our nation.

Carl Felsenfeld: Do we know what the problem is?  What are we trying to solve?  Antitrust does not deal with Citigroup/Travelers, it should deal with Bank of America/Fleet, Wells Fargo/Norwest.  But it didn’t deal with those bank acquisitions.  The regulators were out to lunch.

Jesse Markham: Antitrust can only do so much. It also does not do so well where size is due to organic growth.  (DM: like Google or Microsoft.)

Zephyr Teachout: Antitrust should be based on size.  The DOJ is less subject to regulatory capture, and more inclined to prosecute.

Paul Kaplan: These ideas are against current trends in antitrust.  Perhaps a more rigorous application of the Sherman Act would be more effective.  Organic growth to a large size is still a problem, but how do you avoid punishing success?

(DM: just met Colin Barr of Fortune.  Nice to put a face to the name after all these years.)

Discussant: Canada disallowed securitization for the most part, and stopped more mergers with their banks.

False Assumptions

William Black — Control Fraud & Systematically Dangerous Institutions -Accounting values can be fudged.  RBC as well.  Difficult to detect Control Fraud.  Originating bad loans allows a bank to grow rapidly.  Need forensic accountants.

(DM: look for fast growth — quality, quantity, price. Look for new products.)

Lawrence Baxter — When Big Becomes a Problem.  – Worked ten years at a major bank that went through  a ton of mergers.  The self-regulations with each bank having its own risk model doesn’t work.  The regulators don’t understand them, and spend time learning what is going on.

(DM: fascinating that no one has talked about why the US bailed out holding companies, rather than letting them fail, and merely backing up the operating subsidiaries.  Also, few have fingered the Fed’s monetary policy.)

Shawn Bayern — False Assumptions in Law and Economics — Innovation in the banking is not always a positive.  Bonuses to executives skew incentives.  (DM: it is a form of asset/liability management.)

Russell Pearce — discussant — Business is self-interested, and short-term greedy.  Profit-making is maximized, not even long-term greedy (DM: maximizing the net present value of profits).  (DM: incent using long dated restricted common stock — trouble is, it doesn’t incent as well as cash.)

Mark Gimein — discussant — 3 questions a) What of a big rogue banker?  The market is good at absorbing single failures.  (DM: but not multiple failures.)  b) who should do the regulation?  Tough to get bright men who are tough who won’t go to work for the banks, or buy into the banks logic. c) Control Fraud is hard to prevent; human nature is that way.  No systematic approach to dealing with fraud.

Detecting Fraud — check for adverse selection, honest businessmen won’t do business that way.  Also, it never make sense for a secured lender to accept inflated appraisals.

(DM: Look for gain-on-sale accounting.  Analyze management culture for short-termism.  Remember you can never get pricing, volume and quality at the same time.  Financial companies are in a mature industry, so beware sompanies that grow fast.  Be aware of long dated accruals.)

Discussant — are we worse off today than in the robber baron era? Not necessarily.

Holmes bad man theory — the law exists to constrain bad men.

I gave a 3-minute rant on how insurers are better regulated than banks.  I’ll write more about that tonight in a piece that articulates my views on banking reform.

I think earnings quality is one of the great neglected concepts of investing.  Why do many growth investors blow up on seemingly promising companies?  The answer is often that the investors did not review earnings quality.  Why do value investors fall into value traps?  The answer is often that the investors did not review earnings quality.

I have reviewed a number of books, and written many articles about earnings quality  Because so much of the investment world is blind here, the idea still has punch.

Thornton O’Glove hits at the subject in a traditional way — accrual accounting entries are always more suspect than cash entries.  He focuses on:

• Being skeptical — don’t trust management, analysts, auditors.
• Look for inconsistencies in disclosure.  Who tells a happy story broadly, bet is serious in regulatory filings?
• Who plays games with one-time events?  What companies push the limits in determining what is a one-time event?
• How do companies play with their accruals in order to report income?
• Is taxable income significantly out of whack with GAAP income?

The book was written in the Mid-1980s, before it was easy to review SEC filings.  That has changed, but few really review filings today, even though it is easy to do so.

This is a good book, and you can learn a lot from it, but many of the references are dated, as in the classic version of “The Intelligent Investor.”  I mean, I recognize most of the examples, but many readers will say, “Huh, I’ve never heard of that company!”

Do you want to improve your investing?  Look to earnings quality.

Who could benefit from the book?  Any investor could benefit from the book, particularly those that analyze fundamentals.

If you want to buy the book, you can buy it here: Quality of Earnings

Full disclosure:  I bought this book.  I review books old and new.  This old book still has value, and I recommend it.  It will require more effort than most investors are willing to put forth, but I believe it will yield value to those who work with it.  This is simple stuff, but it is work, and there is always a barrier to entry around work.

Also, anyone entering Amazon through my site and buying anything — I get a small commission, but you don’t pay anything more.  I love it when both my readers and I win.

Insurance is probably the most complex industry as far as accounting goes.  Why?  When you sell the policy, you have a vague  idea of what the costs will be, and when those cash flows will occur.

That leaves room for a wide variety of games as far as the accounting goes.  Because hitting operating return on equity targets is often the “be all” and “end all” of management reporting, one of the holy grails was taking capital losses and turning them into operating income.  Net result on income is zero, but it looks like you are making a lot of returns off of operations.

At one company that I worked for, the new CEO want to great pains to declare how ethical the new CFO was.  I murmured to my boss, “Not ethical, but clever.”  He gave me a smile.  She had pulled that very trick, and if one reconciled the Statutory and GAAP accounting, the chicanery was obvious.

At AIG, my managers were quite concerned about what went above the line and below the line.  If an accounting item didn’t figure into net income my managers didn’t care about it, even if it diminished shareholders equity.

As an investor, this made me skeptical about income statements.  But if you don’t have an income statement, what do you do to estimate profitability?

Well, you could look at the change in tangible net worth due to common shareholders, and add back dividends, including the value of spinoffs, and net money spent on buybacks.  That is what a shareholder earns, in book value terms.  Back when I was an analyst of the insurance industry, there were companies run by value investors that would present their returns that way showing the the growth in fully converted book value over time.  In a sense , Berkshire Hathaway does that as well, but it doesn’t pay a dividend, so it is simply the increase in book value.

In the short run the market is influenced by net income due to common shareholders.  But there is a difference between the two measures of income, and I call the difference “cram.”  Cram is the amount of extra income reported through the income statements that does not makes its way through the balance sheet.

That said, I have another measure that I nickname “jam.”  Jam is the amount of money gained/lost from buying back stock.  In general, when companies buy back stock they dilute value for investors.  Better to retain and reinvest.

How do I know this?  I have been working on an accounting quality model, which is still a work in progress.  An aside, I have had my share of calls from consultants who tell me they have an earnings quality model that covers the whole market.  When they call me I ask them how they analyze financial companies.  I get the intelligent equivalent of a shrug.  The reason is that accruals on the financial statements of industrials and utilities are quite similar, but for financials, they are quite different.

Here are some of the results of my model on the S&P 100:

The data covers the last 4 3/4 fiscal years.  Why did I use fiscal years? Because data capture with companies is most complete at fiscal year ends, when they file their 10Ks.

What did I find?  In general, most companies lose money off of buybacks, whether it is 24% of cumulative net income, or 32% of final tangible net worth.  Individual company performance varies a great deal.  More surprising to me was that cram on average was only 1% of cumulative net income.  Maybe GAAP isn’t so bad on average after all.  But averages conceal a lot of variation — I would not want to own companies that lose a lot of money off of buybacks, or those that inflate net income versus growth in tangible book.

If buybacks ceased, companies might have a lot of slack assets on hand.  I know that companies keep themselves slim to avoid takeovers,  A large amount of slack assets invites others to come in and buy the assets to manage them.  Still, it seems that most buybacks waste the money of shareholders.  This seems to be another example of the agency problem, wheremanagers take an action that benefits them, but harms shareholders.

I would be negative on both cram and jam.  Good companies don’t report earnings in excess of what shareholders obtain, and they don’t buy back stock except when it is cheap.

Full disclosure: long ALL COP CVX ORCL PEP

In the Fall of 2005, I was at the Annual Meeting of the Casualty Actuarial Society in exotic Baltimore, Maryland.  The Keynote address was by Roger Lowenstein who did a talk on two topics.  Warren Buffett the great investor, and the looming problems from the demographic crisis.

At the end of what was arguably a good talk, he asked for questions.  No one raised their hands.  After a pause, he asked for questions again, and I raised my hand.  I commented that he should have given his talk to the Life actuaries — they are the ones concerned about longevity and health costs, and if he really wanted to do a favor for casualty actuaries, don’t talk about Buffett the investor — talk about Buffett the P&C insurance CEO.

He commented that he was asked to speak about the topic by the CAS.  I like Lowenstein, so if you are reading this Roger, my apologies for making the comment.

Warren Buffett on Business is one step closer to the book I would like to see — I would like to see a book on Buffett as an insurance CEO.  Buffett is a great insurance CEO, and deserves a lot of credit in that capacity.  (Warren, I doubt you are reading this, but if you would like me to write that book, please e-mail me.)

But Berkshire Hathaway is an insurance/industrial hybrid, unique among companies.  Warren Buffett on Business ignores Buffett the investor to take up issues that are just as significant: Buffett the business owner and manager.

The words in the book are Buffett’s.  The man who organized the book took Buffett’s words over the last 25-30 years, and organized them into categories regarding management issues.  The topics include:

• Berky acts like a partnership even though it is a corporation.
• Corporate Culture and Governance
• Competent Managers and Honest Communication
• GEICO and Gen Re acquisitions (personally I think Buffett got hosed moving to terminate financial contracts  at Gen Re rapidly.  There is a rule of thumb that says negotiations on illiquid contracts should be undertaken slowly, unless the other side is panicking.)
• Assessing and Managing Risk
• Compensating Management
• Time Management
• Crisis Management
• Acquisitions — Buffett gets to own a wide number of unique corporations, because the one selling out wants the culture preserved, and if the price is right Buffett will do that.
• Ethics in Business
• And more…

Both in the chapters and in the appendices, the words of Buffett shine forth as a way to manage corporations for the best long term results, even if things don’t work so well in the short run.

Quibbles

Much as I like the words of Buffett, I prefer a second voice adding analysis.  Let the words of Buffett star, but let someone else add color and history, because Buffett’s own words are not complete enough.

Also, an analysis of how Buffett managed the insurance lines of his enterprise would be welcome.  Even for those looking exclusively at investment issues, the insurance enterprises offered Buffett the balance sheet he needed to buy assets that could take a while to work out.

Who would benefit from this book: Any manager of any company would benefit from this book.  Buffett lovers, if you have read the last 25-30 years of annual reports from Buffett, and notable things he has said outside of that, you likely do not need this, unless you have specific questions on management that you want answered by Buffett, and you can’t remember what he said in the past.

For most of the rest of us, this will still be a valuable book.  If you want to buy this book, you can buy it here: Warren Buffett on Business: Principles from the Sage of Omaha

Full Disclosure:  I review books because I love reading books, and want to introduce others to the good books that I read, and steer them away from bad or marginal books.  Those that want to support me can enter Amazon through my site and buy stuff there.  Don’t buy what you don’t need for my sake.  I am doing fine.  But if you have a need, and Amazon meets that need, your costs are not increased if you enter Amazon through my site, and I get a commission.  Win-win.

When I wrote for RealMoney, I would sometimes do Columnist Conversation [CC] posts that would be entitled “Miscellaneous Notes,” or “Odds and Ends,” etc.  Occasionally my editor would chide me saying that I should be able to come up with better titles.  I don’t know; I have a wide vista of interests in investing.  It is hard to make me focus on a single issue for a long period of time.

So here are some miscellaneous notes.  It is my website, after all.

1) A recent comment on the piece On Vanilla Products:  David, doesn’t Vanguard and Fidelity offer a low fee VA product using in house funds?  At some point I another low fee insurace offering was out there (under 50bps+fund fees) for no fee planners, but cannot remember the name for the life of me.  I think they worked with Rydex to grab traders assets.

I agree it’s a great way to retain sticky assets.

A dear friend of mine told me that Jackson National was offering such a product.  No jealousy from me; any product that I think should exist makes me grateful when it comes into existence.

2) A reader commented on the the piece, Recent Portfolio Actions: It sounds as if you’re more bearish now than in 2003.  Why?  It is doubtful that the Fed will remove liquidity any time soon.  While there may be headwinds in terms of value, the consumer, and real estate, the appetite for junk bonds keeps growing.  As long as that’s the case, the likely-to-become-insolvent crowd will be able to meet short-term payments, and asset bubbles could continue to grow.

That’s a very good question, and it is one that makes me wonder in the present environment.  The comparison should not be 2003, but 2001-2003.  It is rare for the fixed income market to have a V-shaped recovery.  More often than not, the recovery is a W, or a pair of Ws.

Also, in 2003, when I looked at the credit troubles remaining, there were few of them.  in 2009, there are a lot of them, in residential housing, in commercial real estate, in junk bonds, etc.  I don’t care about the current speculative wave; bear market rallies are sharp and severe.  Big as it is, I believe that we have experienced a humongous bear market rally.

3) Because I am a fan of James Grant, that does not mean that I have praise for him on his recent WSJ op-ed.  If you had said this 6-10 months ago, when I recommended buying junk bonds, I would be impressed.  But most of the rally has already happened, and bear markets often have multiple bottoms.  This bear market has only had one bottom, and there are many more defaults to come in this recession.

4) One reader said to me regarding this piece: David, I know what you mean.   But I’m curious in this context about the role of absolute valuation strategies in what you recommend.   Is it a) no role (relative valuation rules!), b) plays a role, but only within the 10% stretch band, c) matters, but one can always find a portfolio’s worth of low absolute valuation stuff (if one doesn’t worry about the implied adverse selection bias that when everything else is pricey, the cheap stuff is much more likely to be cheap for a good reason), or d) something else?

I don’t have a good answer here.  I use a blend of absolute and relative valuation criteria.  I would like to use absolute valuation all of the time, but that does not give enough opportunities.  I live in an era where the competition is much higher than it was for Ben Graham, or Warren Buffett, when he was starting his partnership.

I will say this, though: absolute valuation can be an excuse for investors that are not willing to do the digging necessary to unearth more complex values.

That said, I like to buy companies below 2x book, and below 14x earnings.  Multiplying them, as Graham did, most of my companies trade below 22.5x book times earnings.  That helps protect against companies that manipulate earnings or the balance sheet, if one relies on a joint criterion.  Behind that, I review the cash flow statement.  Clever companies can fuddle two of the three main statements; no one can fuddle all three.  Accounting fraud usually can be seen from the cash flow statement being less positive than the income statement.

Before I begin this evening, I would like to give a big praise to Calculated Risk.  CR and his readers do a great job of highlighting stories in economics and real estate; I get a lot of data from that blog.  Some articles cited this evening have sprung from links on a CR post; my non-citing of CR is not a lack of respect for what CR does.

1)  We are at the beginning of seeing large commercial properties slide into default where equity sponsors have concluded that there is no use throwing good money after bad.  Recourse typically does not exist on commercial loans, aside from the smallest loans.

• Commercial real estate death watch
• S.F. tower’s owners will forfeit it to lender
• Lender takes Palo Alto’s Bordeaux Centre in auction
• Calpers Takes Another Property Hit
• Outbound Mail: USPS Targets Thousands of Branches for Closure

The last article is interesting to me, in that the ability of the US Postal Service to walk away from leases is greater than I previously thought.  It is also interesting to contemplate the economics of a collapsing postal service.  Will the postal service charge a differential rate to serve rural areas?  It would align revenues with costs, but politically I can’t imagine it is feasible given the US Senate.

2)  Of course, those defaults have large negative implications for large and small banks, as well as CMBS and Commercial REITs.

• A concrete problem (The Economist)
• Toxic Loans Topping 5% May Push 150 Banks to Point of No Return
• Most Failing Banks Are Doing It the Old-School Way
• Widening Commercial Real Estate Crisis Hits U.S. Banks
• Commercial Real Estate’s $1 Trillion Time Bomb

The difficulty for banks is different because they do not hold their Commercial Real Estate [CRE] loans at fair value.  So long as the loan is performing, it can be held at par.  The accounting does not require anticipating failure, no matter how likely on average that failure would be.

The banks have writeoffs to take which the CMBS market is already anticipating.  Absent a larger rally in CMBS, there will be significant writeoffs at the banks eventually.

For a broader look at the troubles the banks face, look at this article: Q2 2009 Bank Stress Test Results: The Zombie Dance Party Rocks On.

3)  When the price of properties are down 36% from the peak, it implies that most recent lending, 2006 and beyond, is under water, and 2005 is iffy.

4) $165 Billion in Commercial Loans are Due in ‘09.  Banks will extend the loans, whereas CMBS special servicers will foreclose on some and extend others — the balance sheet of a CMB Securitization is not as flexible as that of a bank.

5) “What evil lurks in the heart of Commercial Real Estate loans?  The Shadow Supply knows.”  Whether it is condos in Manhattan, or apartments in the same, the problem of underemployed real estate weighs on the market, waiting for a moment to sell, and making the recovery that much longer.

6)  Goldman Sachs is the key component of the oligarchy that controls the US Government and sucks the blood of the American taxpayer for profit.   Now they are planning to repeat their clever pillage of residential housing in the commercial sector.

Look, GS is clever, and they will make money they can.  I never supported any of the bailouts, but if the government sets the rules inadequately, and GS finds holes to profit off of, where does the blame go, but to the government who set loose rules.

7)  Goldman also sees hard times ahead for Commercial REITs, as I do.  Prices are too high relative to NAVs.  There will be significant loan defaults.  Shall I mention that Deutsche Bank agrees?

At such a time, as is normal, underwriting standards rise, and loan volumes decline.  It adds insult to injury, but banks have to protect their balance sheets.

9) This is also affecting pension plans, which are large investors in commercial real estate, both equity and mortgages.

10)  And looking at the architectural billings index, any turn in commercial real estate will not be soon.

I will be considerably more bullish when these problems are half solved.  Until then, I am still a bear on financials.

I don’t really have one unified article type when I write here.  Sometimes I have a really strong conviction about something, and then it flows.  At other times, I gather data, do an analysis, and come up with a way of motivating it.  Then there are the Seven, Eight, Ten, Twelve, Fifteen, Twenty Points/Notes/Comments articles.  Tonight’s piece is one of those.

(An aside — the numbers stem from a comment from an editor of a Canadian business publication — he told me that certain numbers grab people’s attention more.  True?  Not sure.  I do know that one of my editors at RealMoney felt that some of my quirky titles lost readership.  Even today, my editor at SA freely revises my titles, sometimes making something an emphasis that I had not intended.  Whatever; she titles better than me.  What intrigues me is that other sites sometimes pick up her title, not mine, even when they link directly to my blog.)

I don’t do linkfests.  I don’t do them not because they are not valuable, but because others do them better then me, like Abnormal Returns.  So, I do something different.  As I troll the web each day, I tag articles for future comment.  I then wait until I have a critical mass of articles on a given topic, and then I publish one of the “XX Points” articles.  This enables a greater range of facets on a given issue.  I also allows me to give more of an integrated explanation of how I think it all fits together.  Now, the price is that some of the articles are dated.  I think they are fresh enough to highlight trends.

Enough explaining.  On to tonight’s topic, real estate and its effect on the real and financial economies.

1)  Principal forgiveness — it is what underwater homeowners want, and what they are unlikely to get.  Principal forgiveness means that a loss has to be taken by someone now.  Adjust the rate, adjust the term, adjust the amortization — it is all tinkering, even if it lowers the payment slightly, because the owner is still inverted on his mortgage.

Ideas like lowering the principal, but giving the bank a large chunk of the price appreciation at sale, or say 30 years out, would be cute, but still, the bank (or juniormost MBS certificate holder, who usually directs the servicer) would take a loss now.

So, I’m not surprised when I read articles like these:

• Mortgage Servicers Are Under Pressure to Modify More Loans
• Lucrative Fees May Deter Efforts to Alter Loans
• U.S. Effort to Modify Mortgages Falters
• Foreclosure Plan Is Off to a Bumpy Start
• Foreclosures Are Often In Lenders’ Best Interest

Governments have power, but it is very difficult to fight the economics of the situation.  One further note, as is mentioned by a few of the above articles, is that the most profitable situation for the lenders/servicers, is that the property teeters on the edge of solvency, not only paying the mortgage slowly, but pays additional fees in the process.

2)  Will there be a second foreclosure wave?  Maybe.  First American CoreLogic argues that it will be the existing wave continuing.  I tend to agree with CoreLogic for the following reason: when you have enough of the mortgaged homes of the country underwater, it is difficult to slow the rate of foreclosure, because foreclosures happen to properties that underwater where one of the following occurs:

• Death
• Divorce
• Unemployment
• Disability
• Disaster
• Strategic default (buy a nicer home cheaper, and stop paying off this overpriced garbage)
• Debt reset/recast

3)  The GSEs, despite the rally, are still in lousy shape.   Fannie lost $14.8 Billion, and tapped the Treasury for liquidity.  Freddie earned less than $1 billion, but only because they revalued assets $5 billion higher.  Their regulator believes that they won’t be able to repay all aid that the US has granted them.  My verdict: the common of each company is an eventual zero.  Stay away.  Thrillseekers that like zero shorts, don’t do it; the odds are good for a zero, but the payoff is asymmetric.

4)  What percentage of homeowners are or will be upside-down or underwater?

• 24 or 32% (now and soon)
• 30% (Zillow — soon)
• 32% (First American CoreLogic — now)
• 48% (Deutsche Bank — in two years, challenged by Lawler)

I favor the estimates of First American CoreLogic.  First, they have great data.  Second, my view is that properties with greater than 90% LTVs are likely upside-down in a sale due to closing costs.  The inflection point in mortgagee behavior occurs between 90-100% LTVs, not at 100%+.

That’s why we are in such deep trouble.  With 32% of all mortgages inverted, there will be many more foreclosures, and prices should still head downward, even on the low end.

5)  But maybe things aren’t so bad, at least on the low end.

• Home inventories fell in July.
• In some markets, on the low end, foreclosures are selling fast.
• New home sales increased in June.
• Bottoms are longer than we would like to expect.

6)  All that said, the high end isn’t seeing much action, and prices continue to sag.  There aren’t many move-up buyers.

7)  What characterizes the underwater borrower?  Cash-out refinancing, and home equity loans.  The home as an ATM always relied on the “greater fool” theory implicitly — that there would always be a greater fool willing to buy out the home at a greater price than the new amount of leverage.  On the home equity loans — banks are doing all that they can to avoid recognizing losses.  With home equity loans, losses are usually total.  The only thing that surprises me here is that it has taken this long to get to realizing the losses.

8 ) So you want appraisers to be honest, but not yet?  Appraisers, auditors, etc. — third party evaluators are conflicted — he who pays the piper calls the tune, and no one is willing to have the buyer pay for the appraisal.  So now the appraisers try to be honest and business can’t get done?!  Those who hire appraisers, make up your minds; do you want a few short term deals, or do you want reliable long term business?

9)  On the dark side, many option ARMs will default before the payments recast.  That means the recast wave will be more gradual, but it won’t be any less troublesom in aggregate.

That’s all for this evening.  Absent something else pressing, I will write about commercial real estate on Monday night.