iBankCoin
Tokyo based, expat Cape Bretoner. Learning to live in a de-leveraging world. Better suited to the crusades. CFA & FRM charter holder. Disclaimer: @Firehorsecaper reminds investors to always due their own due diligence on any investment, and to consult their own financial adviser or representative when warranted. Any material provided is intended as general information only, and should not be considered or relied upon as a formal investment recommendation.
Joined Jun 23, 2015
77 Blog Posts

DIGICEL: EM BONDS – TIME TO BUY?

Denis O’Brien, Ireland’s richest native ($4.3bln) is the 94% owner of Digicel Group. Digicel Group offers telecommunications (wireless, cable, and business services) media and entertainment services to 14 million subscribers in 32 markets, primarily in the Caribbean and Central America. Largest markets; Haiti (16% revenues), Jamaica (16%), Papua New Guinea (13%), Trinidad & Tobago (6%).

Digicel bonds have been the worst performing emerging market bonds of 2018, losing 30% of their value year-to-date.

Macroeconomic/FX Risks:

The strengthening US dollar had been a big factor and analysts expect the effect to be ongoing, lessening top line revenues by as much as $220mm and EBITDAR by approx. $100mm per annum. A full 95% of Digicel’s debt is US dollar denominated whereas 50% of revenues are either USD or from markets where the currency is pegged to the US dollar.

Bond information:

DLLTD 8.25% 9/30/2020 RegS. Issue size; $2bln. Maturity 9/30/2020 (2.05 years) sub 2 year duration. Net leverage 7.0x (up from 6.4x prior year). Recent price $69.76, current yield 11.83%, yield to maturity 39.33%. Fitch downgrade 8/24/2020 to B-, neg. outlook. It remains to be seen what the bond market reaction will be to Fitch’s downgrade of Friday past, but I suspect it will be muted. Bond CUSIP USG27631AD56.

Digicel Group Limited (DGL) debt, of which there is $3bln total outstanding is structurally subordinate to $3.7bln of debt held in 2 other Digicel entities, 2.3bln in senior unsecured Digicel Limited debt and $1.4bln in senior unsecured terms loans/revolver at DIFL (Digicel International Finance Limited).

Potential sources of refinancing:

The market is anxiously awaiting the game plan from Mr. O’Brien on the refinancing of the DLLTD 8.25%’s of 2020. The fact that the market is trading at the current level of distress (i.e. sub $70.00) may offer opportunities for restructuring Digicel. Given the large issue size of $2bln, a successful tender for the bonds at $80.00 could save Digicel $400mm. XTract Research recently released a report eluding to this possibility, but as I understand it no price indication has been proposed. One potential value catalyst noted in the XTract report (I have only seen an exerpt) is rolling in the assets of the currently unencumbered Digicel Pacific Limited entity.

-It is possible that $1.2-1.3bln of additional secured debt could be raised related Digicel entities.

-Denis O’Brien has eluded to the possibility of an equity infusion in the past. When Digicel was “rolling in clover” as they say, Mr. O’Brien took out $1.1bln in dividends from Digicel, the bulk ($950mm) in the form of a special dividend. This action (an equity infusion) would be in keeping with O’Brien’s plans to eventually IPO Digicel. Denis last attempted the IPO route in 3Q 2015, but it is doubtful he will try again before 2H2019 when leverage can be brought down to a more manageable level of 5.7x. Fitch and the other rating agencies note there is a lot to like in the competitive positioning of Digicel which operates largely in duopoly markets boasting a market share of 50% in many (not to mention 40% margins). What the rating agencies are more concerned with is the liquidity situation of the group with $158mm in cash/near cash versus an annual interest expense of $456mm, approaching 50% of EBITDA (Note: IF Digicel were a US company their interest expense would only be partially tax deductible as the 2017 Tax Cuts and Job Act caps/limits the tax deductibility of interest to 30% of EBITDA).

-Asset sales. Digicel recently effected a sale/lease back on their cell phone towers which helps at the margin, but with net proceeds < $100mm the effect is minimal in the grand scheme of things. Beyond the 450 towers covered by the sale/leaseback details have been scant of the other $400mm O’Brien has eluded to (i.e. $500mm total asset sale program).Perhaps more important is getting capex back to 14-15% of FCF from the recent highs of 21% due to heady network investments.

-Cost cutting. No further meaningful cuts are achievable as 25% of the group work force was retrenched in 2017.

Value comps: EV/EBITDA; C&W (bought Liberty) 11.2x, Columbia (bought) 9.6x, AT&T (T) 8.5x, American Mogul (AMX) 5.3x, Telefonica (TEF) 5.4x, T-Mobile (TMUS) 6.2x, Orange (ORAN) 5.6x = avg. 7.4X.

Conclusion:

The DLLTD 8.25%’s 2020 have traded as low as $62.90 in 2018. The minimum lot size for the bond issue profiled is $200k (par value), hence if one were to buy the bond at $70.00, the initial investment would be $140,000 (plus accrued interest of almost $7k), qualifying as a substantial investment for an account sized at $5mm (i.e. 3% of invested capital). Too much single name risk for me, $100k par value is more typical. JP Morgan’s EM bond ETF, ticker EMB would offer similar exposure for individual investors with more modest account size. The ETF has $13.6bln in AUM with a dividend yield of 4.62% and a ytd -5.13% return in 2018.

Digicel (B2, neg. outlook). A total return >35% is attractive, especially when compared with the paltry 7.7% yield on longer duration single B3, neg. outlook credits like TESLA (i.e. TSLA 5.3% August 2025 bonds last traded at $87.20 to yield 7.7%) which carry much higher interest rate risk (TSLA’s 5.8 year duration versus sub 2.0 year for Digicel). Tesla’s current EBITDA is -326.2mm (analysts estimate $3.2bln in EBITDA for 2019) hence a potential double headwind of EV subsidy cessation and loss of interest deductibility. Shorting TSLA is too expensive and foolhardy, but you don’t have to own it for certain.

Follow me on twitter @firehorsecaper

Safe trading. JCG

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SUB-PRIME AUTO LOANS; GET OFF THE GAS: SHORT VIA $CACC

$CACC – Credit Acceptance Corp has been in the subprime used auto loan game for a long time, since 1972. The company currently sports a market cap of $7bln (enterprise value of almost $10.5 billion, inclusive of $3.45bln in debt), with a P/E of 15 on earnings of $24* a share driving a current market price of $360. The short thesis that will be laid out in this article will be driven by a steep drop in earnings on a go forward basis due to an increase in realized credit losses. One would expect P/E multiple compression to be a factor as well, once the rally has crested.

*Tax Cuts and Jobs Act accounted for $5.10 per share in ’17 GAAP (one-time effect).

The US consumer is more heavily indebted than at any other time in history. The unemployment rate has rarely been lower at sub 4% and all states are currently sub 7%. Consumer debt stands at $12.96 trillion. Student loans are at a record $1.36 trillion, sporting an 11.2% delinquency rate (Powell put?). Auto loans outstanding stand at $1.21 trillion ($282 bln to sub prime borrowers) with worsening delinquency stats; 5.8% > 60 days (higher than through the global financial crisis where rates peaked at 5%). Underwriting standards have tightened overall, but the numbers for non-bank subprime auto are worse at just under 10% delinquent (per Equifax). As one might guess, used cars do not result in high recovery rates when things go pear shaped. 107 million Americans carry auto loans at present, +35% since 2012.

This folly can of course continue for a while longer. $CACC’s cost of debt is currently just over 4%. Their most recently completed $450mm subprime auto loan securitization (non recourse) was well received. Zerohedge recently wrote on the phenomenon “Junk in the trunk” and included the recent auto loan delinquency table. Similarly generically named (i.e. ACME Auto) Consumer Portfolio Services, Inc.  (CPSS) recently completed a $40mm securitization of their residual interests in 13 previously completed securitizations. Feed the ducks when they are quacking, indeed.

Credit Acceptance Corp (CACC) 5 year chart – a thing of beauty.

Things that should worry the bulls:

1.) Credit quality of CACC’s loan portfolio:

Similar to strategies like selling volatility, lending money on easing terms to sub-prime borrowers can be a recipe for lackluster investment returns, if not outright disaster. Credit Acceptance Corp clearly has the data to provide further stratification, but instead disclose that 95.6% of their clients are sub-prime (< 650 FICO score).

Car loan term extension. 5 year ago the average car loan was 48 months. No more …. over 40% are now 61-72 month and 32.5% are 73-84 months. Moving on to the used segment, terms have also been extended. CACC’s average loan term for advances on used cars stands at 50.4 months (almost 20% longer on a rolling 5 year basis). Cars financed at 20% interest rates do not yet easier to own with the passage on time.

2.) Shareholder Distributions:

Considerable time is spent in the annual reports of CACC on the merit of stock buybacks versus dividends.

A sample from the most recent 2017 report:

“Like any profitable business, we generate cash. Historically, we have used this cash to fund originations growth, repay debt or fund share repurchases. We have used excess capital to repurchase shares when prices are at or below our estimate of intrinsic value (which is the discounted value of future cash flows). As long as the share price is at or below intrinsic value, we prefer share repurchases to dividends for several reasons. First, repurchasing shares below intrinsic value increases the value of the remaining shares. Second, distributing capital to shareholders through a share repurchase gives shareholders the option to defer taxes by electing not to sell any of their holdings. A dividend does not allow shareholders to defer taxes in this manner. Finally, repurchasing shares enables shareholders to increase their ownership, receive cash or do both based on their individual circumstances and view of the value of a Credit Acceptance share. (They do both if the proportion of shares they sell is smaller than the ownership stake they gain through the repurchase.) A dividend does not provide similar flexibility. Since beginning our share repurchase program in mid-1999, we have repurchased approximately 33.4 million shares at a total cost of $1.6 billion. In 2017, we repurchased approximately 610,000 shares at a total cost of $123.5 million.”

It is separately disclosed that CACC is fully restricted in paying any dividends by its Lenders ($3.45bln and the Lenders get paid 1st from a priority of payment perspective). Dividends matter and CACC management can not claim to be Warren Buffett, despite the impressive track record CACC has logged. There is no portfolio effect to be relied upon in this instance. CACC finances used cars to insolvent borrowers at above market interest rates in the hopes that the net margins secured over numerous economic cycles compensates for the considerable risk assumed. Estimating the intrinsic value of CACC at any point in time is poppycock as a result. Caveat emptor, especially CACC themselves in buying their own stock. Red flag.

CACC have not repurchased shares since $220. CACC, “If we are inactive for a period, shareholders should not assume that we believe our shares are overvalued.”

3.) Management turnover:

President from 2007 Steven Jones retired mid 2017. Founder and former Chairman Don Foss has sold $450 million in CACC stock since exiting.

Car Trouble;

“They Had Created This Remarkable System for Taking Every Last Dime From Their Customers”

 

 

 

 

4.) Relative valuation comparisons:

$CACC’s  P/E of 15 seems quite punchy for a sub-prime auto lending operation. Much better diversified banks are lower; WFC 13.6X, RY 12.5X and WBC 11.7X. In the exact same space the valuation asymmetry is even more marked. Santander Consumer USA Holdings Inc. ($SE) has a similar market cap ($6.9bln) yet sports a P/E of 5.9x

GM bought AmeriCredit (ACF) for a 24% premium to the then public equity valuation in July 2010, 1 year post a $50bln bailout by the US government while still 61% owned by the US Treasury. In this space, silly can remain silly, approaching ridiculous at times.

Action plan:

Monitor Credit Acceptance Corp. ($CACC). Short interest is relatively high (12%) and the high-beta rewarding market we currently enjoy could see CACC reach towards $400 in calendar 2018 as the indices pinch higher. Remarkably, the only down month for CACC historically is October. With spot at $360 I’d think September might offer a good entry point for a short:

Spot price: $361.15

9/1/2018 projection $380 (short entry target)

Take profit (TP) $210 (I buy where CACC buys)

Stop-loss (SP) $418

Risk reward (R:R): 4.5:1

Follow me on twitter @firehorsecaper

Disclosure: Flat $CACC, monitoring for initiating a short position of 2-3% (of overall portfolio).

Caleb Gibbons

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HOW TO GET YOUR KIDS OUT OF THE HOUSE BEFORE AGE 25, WITHOUT YOUR POCKETS INSIDE OUT

Don’t get me wrong, I love my kids. We all love our kids, but the circle of life dictates that they leave the nest, eventually. Young adults should be encouraged to make their way in the world, independently, as soon as feasible possible. Problems that have beset youth for the ages appear even more acute present day (“smart” phones, an oxymoron, youth unemployment, mass medication … Adderall, etc., student loans). Parents need to take a deep breath, but accept responsibility for their spawn, and set a course for successful launch. Getting this right will dictate your personal Q4 financial future. Emotionally, even more so, as you can only be as happy as your unhappiest child, as the old adage goes.

Teenage years. Difficult admittedly, but just as with spouses, this is “for better or worse”. Teenage brains are not yet fully developed (especially male brains). While under your roof there should be some rules; no tattoos (not a prude, 1/4 sleeve, but at such a tender age, life changing errors are common; mis-spelling, hand, neck, etc., hard no is the best policy), pastel colored hair (Fortnite pro gamers, FB whistleblowers – exhibit A below), piercings (nose, lip, eyebrows) or other forms of bodily mutilation, also hard no’s.

Homestay and study abroad. Highly recommended. A broader world view and a passport go a long way. For undergrad at least, Canada should be given strong consideration, as even for international students, the all-in cost is much lower than lesser school in the US (think 1/2 off, in order of magnitude). For the truly adventurous, domiciles further afield are also accepting of foreign students; think Germany, Taiwan, Belgium, Austria and Norway. For advanced degrees back in the USA is likely a great choice and typically the degree of financial support is higher for Masters / PhD level programs (big brain, small pond). For advanced degrees, it is also worth checking out Denmark, Sweden and Finland as well who restrict foreigners for undergrad, but are more accepting for graduate studies.

Have your sprog learn a 2nd language. Unless you or your spouse speak a foreign language, go with Mandarin (Chinese). A lot of people speak Spanish, but in comparison to Mandarin, Spanish is a vacation language. French is a dying language (130mm fluent speakers globally, 70mm restaurant French speakers), as an aside. Knee deep in Japanese at present due to both my domicile and spousal influence (spoken by 126mm people, primarily Japanese, funny that) but on a do over, Mandarin hands down winner.

When the time comes, focus on degrees and educational institutions that offer co-op programs (study/work). The job placement rate for co-op programs is much higher than traditional degree programs (>90% for the top quartile) with the added benefit of incremental income from work placements. Approximately 60% of students take 5 years to complete a 4 year Bachelors program at present, hence the extra time required to graduate from a co-op program should not be an overriding concern. What employer would not like to test drive the candidates that have the exact academic credentials they seek? A win/win scenario, where the students go in eyes wide open and the employers see the practical application of their academic prowess in real time.

A university degree is a good idea from a lifetime income perspective, but college is not for everyone. Vocational programs and trades should not be overlooked for children with a less academic leaning. Coupled with a community college course in small business management and bookkeeping, this track can be a home run for those inclined. Like any field these days, there is premium pay for those that can pass a basic drug test in the US, with upwards of 40% of candidates failing, making them unemployable for jobs where security bond must be secured.

Wage inflation has been nascent for ages, but that is about to change under Trump. Especially in areas such as IT, the number of H1-B (temporary work visas) visas, issued to largely Indian (and to a much lesser extend Chinese) nationals has been greatly curtailed. As with “winning” with trade, reality does not spin on a dime like the Matrix, the fix is possible, but has a time line well beyond the election cycle. F-1 (student visa) to Indian nationals are down 40% over the last 2 years with China not far behind, which means US “Young, Dumb and Broke” has a better chance of college acceptance and a mid 5 digit, low 6 digit student loan obligation upon exit.

Have your children learn to code. There is a myriad of language choices of course, but I would recommend Python, given the broad nature of the applications it can be used for. There are great online courses (Udemy and Datacamp, to name a couple) and if the coding bug bites, there are many on-site camps that can solidify their acquired on-line learning and show the staircase to the next level.

As possible within your budget, save for your kids education through a 529 education plan. The latest tax bill, enacted by Trump, greatly expanded the utility of 529 plans by expanding eligible withdrawals to include K-12 ($10,000 per child, per year), in addition to post secondary education. All 529 plan administrators direct payment for K-12 directly to the plan sponsor (the parent in most cases, but grandparents can play too), hence it is your responsibility to retain receipts for qualifying tuition payments. The trends in education funding are clear, the public education system currently gets funded like private ($), but produces literacy instead of excellence, by most global metrics. As with retirement (Social Security representing 50% of retirement income for 70% of recent survey respondents), much lies at your feet in terms of the steak versus hamburger option. Policeman of the World is an expensive undertaking, clearly. The military budget is slated to get a healthy increase in the most recent budget proposal.

With Betsy DeVos as Secretary of Education it is difficult to see the way forward for public education in the US. Private and charter schools will clearly see a boost with incremental 529 sourced funding a done deal, but such options are lacking for the bulk of the US population. John Arnold, Co-chair of the Laura and John Arnold Foundation has some progressive ideals about how we can move the needle (i.e a 20% pay hike in exchange for walking back unsustainable union driven post retirement and OPEB agreements). Mr. Arnold’s ideas will likely fall on deaf ears, as more tender ears grow dumb due to lack of adequate stimulation.

There is now $1.5 trillion in student loan debt outstanding with the average US  household student loan debt balance standing at $46,000. You know job prospects are suspect when the degree granting institutions undertake the wholesale slashing of programs, as we are now seeing evidence of. The latest is the University of Wisconsin, which plans to cut 13 majors including english, history and philosophy. Japan is going through an extensive overhaul at up to 50 of their universities, culling programs in the humanities and social sciences in favor of more vocational focussed degrees.

As an aside, Japan is also revising in 2018 the official age of adulthood to 18 from the current 20 (although they still will not be able to smoke or drink until the age of 20).

Lessening the debt burden our kids carry into young/mid adulthood, within our respective means, is both a compelling gesture and lessens the chances of the dreaded boomerang trade.

The games the kids/young adults play today are off the charts amazing. I’d likely not have left my parents basement if such things were on offer in the mid to late 80’s. Games have permeated modern life, but instead of throwing up your hands, one must embrace the technology. Angel Rich (her real name) has developed “Credit Stacker” which is a fantastic app for teaching topics in financial literacy. Ms. Rich is focussed on inner city US, but clearly this has clearly global application. There is not enough of this critical information available to our kids to properly arm them (knowledge wise of course)  for the modern world upon which we intend to thrust them.

Financial literacy app; Credit Stacker.

http://www.getwealthylife.com/

Current; A novel debit card with some financial literacy and budgeting architecture. You will soon lose track of the $20’s doled out so better to send the cash electronically and create a virtual classroom out of the calamity;

Teen debit card;

https://current.com/

SAT prep;

https://www.amazon.com/Official-SAT-Study-Guide-2018/dp/1457309289/ref=sr_1_3?ie=UTF8&qid=1515930026&sr=8-3&keywords=official+sat+study+guide+2018+edition

Sadler vocabulary series; Because LMFAO and LOL might not result in a living wage in any jurisdiction in the world of tomorrow (also useful for SAT above).

https://www.amazon.com/Vocabulary-Workshop-Enriched-Student-Level/dp/0821580108/ref=sr_1_1?s=books&ie=UTF8&qid=1515930115&sr=1-1&keywords=sadler+vocabulary+workshop

Caleb Gibbons. Follow me on twitter @firehorsecaper A long and winding road ahead with our 1st five years out from college, 2nd eight, but best to think ahead ….. time flies.

 

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INTEREST RATE SWAPS FOR THE MASSES – ERIS SWAP FUTURES

Few things are viewed with as much distain as US Treasuries, or more generically the “rates” market for 2018 and beyond. Finding the correct instrument to short the rates market and perhaps more importantly choosing the right tenor (target duration) is difficult for the average investor.

10 year UST sold off by 7bp today and went out yielding 2.55%, the cheapest of the year (near term target 2.625% aka 2 5/8%). Estimates are for a 3 handle and even 4% 12-18 months out. Barron’s recent poll saw 10 year UST estimates ranging from 1.95% to 3.10% with the median estimate 2.65% (not likely within the range let alone correct on a stand alone basis).

HT Patrick Burbon @pbourbon

All the “big guns” have declared open season on the long duration US rates market, it appears:

Gundlach holds the current title of bond king having built Doubleline from scratch post TCW to > $100bln in AUM in just a few years. DSL, Doubline Income Solutions is only $2bln of this AUM, but continues to impress (writer up 25% on initial purchase, 15.7% blended across two). Jeff is calling the current environment the era of quantitative tightening, driven by a hawkish ECB. Stateside Gundlach sees a US$1.9tln in 19′ bond supply (no ultralongs). He also noted that it is a very poor time to buy corporate bonds (high yield bond index yield 4.93%) and Gundlach sees a negative return for the S&P in 2018 as the rates rout eventually gives the equity market the yips. Gundlach see the 10 year UST yield getting to 3.25% in short order. Everyone seems to need to comment on bitcoin too, Jeff thinks the highs have been printed.

Bill Gross (same age as my Dad) from Janus Capital Group, who built his >$1bln wealth at Allianz’s Pimco and was the bond king ($270bln AUM at its zenith) until Gundlach wrestled it from Gross’s arthritic hands, is also a bond bear. Gross stated today that 25 year trend lines in both 5 and 10 year treasuries have been broken, signaling a bear market.

Sovereign buyers (China and Japan in the press most recently) are taking pause with respect to incremental UST purchases as the hedging costs to bring the assets back to their home currency have become prohibitive, in some cases. The big players are reticent to place large UST positions on unhedged given most are marked to market, with the degree to which they are offside promptly reported. Significant career risk indeed.

While 10 year UST closed out 2017 almost the same yield as 2016, much has transpired with respect to curvature, namely curve flattening. 5-10’s closed the year sub 0.20% (20 basis points), whereas 2-10’s went out at 0.518%, from a relatively steep 1.28% to start 2017. Best to stay clear of long bonds on any bearish bets, as term preference and relative value (versus peers like German bunds) could see yield well contained in the long end, on a relative basis (i.e. 10-30’s inverted, from +12bp currently).

While bond bears are numerous, the view in not unanimous (thankfully, one needs someone to take the other side, as it were). The California Public Employees Retirement Systems (Calpers) at $342.5bln AUM is the largest public pension fund in the USA (as social security is not funded, opting for a “pay as you go” approach). Calpers made a watershed move to INCREASE their bond allocation to 44% from 19% in November of 2017. Calper’s resultant return expectation has been lowered by 0.5% to 6.5% to reflect the more conservative asset allocation, leaving their funded status at an unimpressive 68%. Outright losses on a bond allocation of this magnitude would result in overall Calpers returns being impaired by more than 50bp, for the actuaries out there. The new allocation went into effect January 1, 2018 and changes are made every 4 years.

If you are in the bond bear camp, the next decision is your optimal means to short the bond market. There are several alternatives.ProShares UltraShort 20+ Year Treasury (TBT) has $2bln in AUM and provides an ETF solution to shorting the US treasury market. The payout is -2X the daily performance of the ICE U.S. Treasury 20+ Year Bond Index. ETFs are a fully funded solution. I am leaning towards, for tactical positioning, is interest rate swaps (paying fixed 10 year). Just as the natural inclination for the stock market in a given year is positive (approx. 65%), the natural interest rate curve is positive, as in upward sloping.

Positioning for higher interest rates via shorting treasuries or paying fixed on an interest rate swap are negative carry trades. There is a trading adage that the road to hell is paved with positive carry trades (i.e. selling vol as an example). It is important to know the mechanics of the trade you are contemplating entering. To show this by way of an example, if one were to pay fixed on $500,000 notional 10 years you would pay 2.612% in the current market. In exchange for paying fixed you receive 3 month USD Libor flat (current setting 1.70%), hence for the 1st 3 months of the interest rate swap you have a negative carry of 91.20bp (0.9120%), approx. $1,140 on $500k notional. Each 3 month forward rate agreement (FRA) going forward will reset at the then current 3 month Libor (less negative carry as Libor sets higher) and if you are correct about fed fund futures underestimating the pace of Fed rate hikes the trade will “flip” at some stage, earlier than expected by the market, to a positive carry trade as 3 month Libor sets above the fixed rate you agreed to pay at trade inception. At trade inception, the difference between the fixed rate payments committed to and the expected floating rate payments should be equal to zero (NPV=0).

Interest Rate Swap Futures 101 for IB (1)

Product_Summary (1)

Interactive Brokers (IB) is now offering ERIS swap futures platform access to their 400k + person account base. This is an exciting development as the margin requirements are modest and there is no better way to replicate over the counter (otc) swaps available in the market at present. The uses are varied; those in an adjustable rate mortgage (ARM) can potentially hedge their interest rate risk for much cheaper than a refinancing. Those long credit with concerns about the rate market can hedge their rate exposure, creating synthetic floating rate notes (FRNs). Those looking to speculate of further a further sell-off in the rates market can participate with surgical financial precision. Trading hours are New York, but this is to be expected for a US dominated product. Most would hedge in New York hours regardless, but stops could be executed cross market in a pinch (i.e. buy 10 year Treasury to hedge a stop loss on a pay fixed swap position).

Follow me on twitter @firehorsecaper

JCG

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PUTIN’S LONG ARM – CORE VENEZUELA ENERGY ASSETS UNDER RUSSIAN CONTROL

While much of the US populace navel gaze over “he said, he said”, rear view mirror stuff with the 2016 US Presidential appointments/elections, real world carnage is taking place, in real time. Venezuela’s communist government slinky has run out of gravity and steps, falling at the feet of mother Russia. Venezuela has defaulted on $60bln of debt, officially termed “selective default” at present by the rating agencies. Russia is not sure what all the noise is about as their bi-lateral payments have been made on a full and timely basis? Ditto for China.

Caracas is 3,317 miles from Washington, versus the 4,861 miles from Moscow to Washington, DC (and much closer to key US energy assets in the Gulf of Mexico). Beijing is 11,158 miles fromWashington, for reference. Russia/China having strategic energy assets so close to the US should be a point of concern both for the current administration and for the bigger US GOM refiners. Billions of US dollars are flowing into Venezuela from Russia and China, along with a brain trust of skilled workers numbering in the thousands to ensure both execution and return bogeys are met. Russian war ships are on the way to Venezuela as we speak, a strong sign of Russia’s support for the struggling communist nation and the “financial aid” Russia has extended. Putin must have a good giggle daily at having a South American domiciled Ukraine-like foothold without an argument, let alone a public conflict with the US (for now). Back in August, Trump stated publicly that he could not rule out a military option with respect to dealing with the struggling South American nation.

Venezuela has a population of 31.6 million, about 15% less than Canada’s. Venezuela boast the largest conventional oil reserves and the second largest natural gas reserves in the Western Hemisphere. Venezuela’s non-conventional deposits are approximately equivalent to the world’s reserves of conventional oil. The majority of Venezuela’s domestic energy needs are met with hydroelectric power.

Bahrain has requested assistance from neighboring Saudi Arabia and UAE. Saudi Arabia has taken a page out of Brazil’s playbook with “Car Wash 2.0” anti-corruption crackdown. Zimbabwe overnight has seen a coup. Fun times to have the VIX in the low teems (12.6, up 9%). Sovereign EM is not the only story here as EM corporates are the ones with the more heady issuance of late, US$8bln a week at the  most recently clip. IG EM US$ bonds returns have been stellar thus far in calendar 2017 with 5 nations clocking > 10% returns year to date; Uruguay, Panama, Peru, Mexico and Kazakhstan. So much room to fall from here. Not a sky is falling comment, buy many assets are priced for perfection when we have blemished prospects for continued/further levity.

Back to Venezuela, recovery rates are very hard to handicap in EM credit, especially when the key assets that would result is some recovery have been sold to Russia and China respectively. VENZ, sovereign rating “D” standing for default,  (bond ticker, Benz with a V) 7% 1 December 2018 sold off 40% to trade $32/$35, (seems high given scant recovery prospects). Plenty of info in the popular press on the “deals” that have been struck between Petroleos de Venezuela (PDVSA) and Russia’s Rosneft in the run up to Maduro’s most recent restructuring  announcement.

The pace of EM bond issuance will be greatly curtailed, if not ceased near term. The US$ EM bond craze we have seen evident since the GFC has seen US$3 trillion of new debt issued. Little wonder high yield ETF’s have taken a knee in recent sessions, the dry heaves are coming. Calpers most recent tactical asset allocation back into bonds from DM equity will not be soon enough or far enough down the ratings spectrum to provide an air bag for the coming head on collision.

Venezuela, for their part, have been very critical of the rating agencies, “”In the last 36 months, Venezuela has canceled, for the concept of Reimbursed Capital and Paid Interest, the amount of $ 73, 359 billion, an immediate consequence of each payment and each compliance has been the increase of country risk by rating agencies risk, which have been deeply inefficient to prevent scandalous financial setbacks in financial power centers in the United States, Europe, and Asia, but which are used as an instrument of devious action against our country: the more we have paid, even though we have always been timely in honoring our payments, risk rating agencies, following the pattern of financial blockade undertaken by the Trump Administration, makes it expensive with reports devoid of any form of rigor and veracity, the cost of our debt and intervene to hinder Venezuela in its condition of good payer and solvent country, access to external financing, common and frequent for almost all countries of the world”

Only 2 non muslims nations are included in Trump’s most recent travel ban. North Korea and Venezuela. Good luck getting plug nickel out of Venezuela near term if you are a US$ bond holder. Dalio’s call on gold, increasing his weighting significantly, seems precinct. A number of geopolitical fuses have been lit, we just don’t know which one goes boom first.

Credit wider, bond steady / curve to stabilize, equity vol to spike, global equities softer, gold firmer.

Follow me on twitter @firehorsecaper

Don’t forget, cash is an option from an asset allocation perspective.

JCG

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MUNI DEBT: SALT IN THE WOUND FOR HIGH TAX STATES

tRump’s GOP tax plan is not sitting well with the high tax, blue leaning states of California (11.4% rate for State and Local Taxes, aka SALT), Connecticut (11.4% SALT), New York (12.6%) and New Jersey (12.3%). These four states account for 22% of the US population and 23% of US GDP. I frankly expected a higher percentage GDP wise, with so much of the vast contiguous states dedicated to energy production (1000 gallons a second in demand) and animal husbandry (9 ounces a day per capita).

With the proposed changes to the US tax code, removing the deduction of SALT payments from ones Federal tax bill going forward, the effective tax rate for the wealthy will be increasing significantly on passage of the bill in close to its current form. This will greatly enhance the attractiveness of municipal debt and has resulted in a stonking rally in muni bonds this week. Early innings with respect to the rally, unless the federal deduction for SALT survives in the final drafting. Rolling back SALT deductions offsets approx. 1/3 of the $1.3tln “hole in the bucket” left by the proposed GOP corporate and individual tax cuts (largely paid for by the 3% resultant GDP growth). The rally moves in muni credit will likely be muted on the heels of the ongoing Puerto Rico default/debacle, hence there is time to put in the work and do the analysis required to come up with a rational investment decision.

https://ibankcoin.com/firehorsecaper/2016/04/10/puerto-rico-the-spoils-of-war/#sthash.uTYSeX6D.dpbs

The initial read of Trump’s tax reform plans appeared to be hemlock for muni debt, driven largely by lower absolute tax rates, with the highest 39.6% (solo income >$418.4k, joint filer >$470.7k) bracket moving to 33%. With key tweaks to the tax reform plan on the deductions side, as many as 25.5% of taxpayers could see their taxes increase from current levels under the currently tabled tax reform plan. It appears the 39.6% bracket will likely be kept for those earning above 7 figures.

As an aside, NJ, post election, is expected to re-institute the millionaire tax for resident making > $1mm (2% effective surcharge on income > 1mm). In addition to the egregious existing taxes NJ levies, for no good reason other than winning geographic roulette in being commutable to NYC, one should expect a portion of NJ’s millionaires (7% of the population on net worth metric, much lower % on income) to pull up stake, taking a page out of Tepper (formerly #1 NJ taxpayer, now in Florida) playbook. With nine states credit watch negative, including NJ, a betting man would place odds on more downgrades than upgrades going forward.

For muni bond investors in the 4 high tax states profiled, there are a bevy of state specific funds that cater you your investment needs, if purchasing bespoke muni bonds is beyond your ken. The advent of on-line trading platforms is improving the state of play, but the bid/offer spreads on muni bonds is high, both outright and compared to taxable peers.

https://www.marketaxess.com/trading/municipal-bonds.php

Two funds with comparable scale and liquidity are BlackRock Muni Holdings New Jersey Quality Fund, Inc. ,MUJ  and Nuveen New Jersey Quality Municipal Income Fund, NXJ. The big daddy is a Vanguard offering, 4x bigger at $2bln +; Vanguard NJ Long-Term Tax-Exempt Inv., VNJTX, yielding 3.46% (Federal and NJ tax exempt) which may seem paltry, until you calculate the taxable equivalent basis (TEB). Speaking to investment income, a NJ taxpayer in the top tax bracket in all categories pays 39.6% in Federal tax, 8.97% in direct NJ State Tax and Obamacare 3.8% tax on investment income (muni bonds are exempt). Adding up this stack gets you to 52.4% in taxes, coincidentally the same as the Province of Ontario in Canada (ditto on distress, save the pension funding shortfall issue).  Vanguard, and other veritable institutional investors have online calculators for TEB for those not mathematically inclined.

In my rudimentary NJ example, the VNJTX yield is 3.46% and the denominator is 0.476, resulting in a taxable equiv. yield of 7.27%. A quick perusal of global fixed income markets will find many gobsmacked to realize how high a 7% taxable yield is in the current environment.

US state pensions remain woefully underfunded in aggregate (70% funding rate, > $1 tln unfunded) and the public pension gravy train keeps on chugging, at least for now. Even for a $18 trillion dollar US economy, so many debt tallies in the trillion plus club should give the non-billionaire adults in the room cause for pause, if not reflection. Student loan debt; $1.3 tln, auto loans $1.2 tln and credit card debt (“revolving”, at least in theory) $1.1 tln. Those reticent to buy NJ domiciled muni debt and or NJ dedicated funds can of course give NJ a wide berth from an investment perspective. The rub is that your tax exempt muni yield will be only federal tax exempt, not state tax exempt. Following on my previous NJ example, your TEB (aka, your taxable basis “bogey”) becomes 6.11% instead of 7.27%.

The same analysis should be done for potential muni investors in “the big 4”, NNCC, as you are spoiled for choice in terms of muni debt and/or state specific funds (mutual, closed-end and ETF forms) to choose from.

When things get really interesting, “cross over” buyers, those that can not use the US tax exemption, find it compelling to buy US muni credit versus other investment options available in their home market. I’m a holder of BlackRock Taxable Municipal Bond Trust, BBN in my IRA (the underlying bonds are taxable hence distributions, currently yield 6.75% is taxable in non tax sheltered accounts). Pension obligation bonds, issued by states attempting to improve their pension funding % (in lieu of also paring benefits, which other countries do on a near 50/50 basis, until fully “funded” from an actuarial perspective) are also taxable.

With equities “off the leash”and vol compressed due to medicated markets, munis have a valid place in the asset allocation for US taxable investors (likely a multiple of gold and/or crypto). The US municipal bond tax exemption is one of the few near-free lunches on offer in global investable fixed income markets.

Keen to address any questions, as I know this space well. Follow me on twitter @firehorsecaper. Good to be back.

Caleb Gibbons, CFA

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BARINGS BANK REDUX: SANTANDER BUYS BANCO POPULAR FOR €1.

Barings Bank was sold for £1 to ING back in 1995, but the comp is close one has to admit.

Spanish regulators red carded Banco Popular, selling them to Banco Santander for €1 (US$1.13). The mechanics of a resolution mechanism provide us with a potential road map for the future. It appears subordinated bond investors were not charging enough for the tail risk being assumed.

Santander press release:

“07/06/2017

Banco Santander today announces that it has acquired Banco Popular. The acquisition takes place following an auction conducted by the Single Resolution Board and FROB in which Santander was selected as the successful bidder, paying a notional consideration of €1. As part of the transaction Santander will complete a rights issue for a total amount of €7 billion. This will cover the capital and provisions required to strengthen Popular’s balance sheet. Existing shareholders will be given preferential subscription rights. The rights issue is underwritten.”

The focus of the popular press (pun intended) has focused on the equity component of the capital structure, but the real story has been on the debt components, both senior and subordinated.

Along with the common equity, as one would expect with an outright sale at €1, addition tier 1 (AT1) bonds have been totally cancelled (traded high $50’s $ price to effectively zero). Tier 2 Popular subordinated bonds have been voided through conversion to equity @ €1 (in totality, along with existing common shareholders). Senior debt has been protected in this scenario, with the 2’s of 2020 trading up $12 to $102, at the time of publication.

Look for other challenged issuers’ AT1 bonds to “adjust” to this news (read: not higher in price) over time, although initial reactions appear to be muted.

Follow me on Twitter @firehorsecaper JCG

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ILLINOIS GO’s (Baa3/BBB-): JULY FIREWORKS AHEAD; JUNK SALE LIKELY

Illinois is in a serious bind. The road to perdition has been well lit, and signposted. 8 downgrades in 8 years for the General Obligation (GO) liabilities of the state, with another drop down to junk likely as soon as July 1st, the beginning of their 2018 “fiscal” year. Moody’s and S&P last moved June 1st taking the GO ratings to 1 notch above junk with the ominous warning that they will not be timid if further downgrades are in order. Illinois remains with a negative outlook and on negative watch with both major rating agencies. The unfunded pension liability of Illinois’ five state plans now exceeds US$130bln. IL State now has the lowest funded pension percentage (ranging from 37.5% to 44.2%) of all 50 states. All 5 plans have been achieving investment results well shy of their actuarial assumptions, the most prominent, State Employees’ Retirement System of Illinois (SERS) by -1.75%, returning 5.5% versus a 7.25% bogey (reduced modestly in 2013).

Each Illinois taxpayer is on the hook for almost $50,000 in unfunded liabilities (pensions and post retirement health benefits). Illinois is the 5th most populated state in the union at 12,800,000, for reference. Same ranking for income (for now). Illinois has proposed a 20% privilege tax on investment management services (read; hedge funds) which was tabled in February 2017, approved by the House Revenue and Finance Committee in March and if enacted becomes effective July 1, 2017. The taxation of carried interest is highly topical at both the Federal and State level presently with both NY and NJ considering similar legislation (CT and FL are gladly accepting hedge fund refugees at the time of publication).

In addition to the pension woes, Illinois has not passed a balanced budget for 3 years in a row, as required under their constitution. This has resulted in the untenable situation whereby the state has accumulated $14.5bln in “accounts payable”, on which they will owe $800mm in interest and fees as of June 30, 2017. The cascade effect (i.e. it rolls down hill) has been very damaging. Chicago Public Schools (CPS) are owed nearly 1/2 billion from the state ($467mm to be exact) and must resort to “Grant Anticipation Notes” to bridge the funding gap created. CPS are hoping to keep the cost below 8% which is the usury cap in effect for some school budgets. Chicago accounts for a full 20% of K-12 (Kindergarten through grade 12) enrollment but a more modest 15% of the IL state budget. Laughably, the Chicago teachers are not covered by the state Teachers Retirement System. Chicago Teachers Pension Fund (CTPF) is also a basket case, as you might surmise and in addition to a number of other issues led Illinois’s largest city to be downgraded to junk status in May 2015.

Bond investors have taken note. Spreads on Illinois debt to MMD (Municipal Market Data, the yield curve of the highest rated, AAA/Aaa  municipal bonds, as published by Thompson Reuters) have widened. The eventual downgrade to junk, aka non-investment grade, will make IL debt ineligible for investment for some of their major institutional investors (one of which has already called for a boycott of Illinois debt) which are restricted by mandate to purchase only investment grade muni bonds. There are of course high yield muni funds, but they tend to be smaller in terms of AUM and have had some performance hiccups (Puerto Rico) which have curtailed investor inflows. Suffice it to say there will be more sellers than buyers on a downgrade to junk status for Illinois.

Municipal investors are a conservative bunch. Not a lot of crypo-currency investors in this lot. They are typically older investors in the highest Federal tax brackets (39.6% & 35%), let’s call them the 3%. An increasing portion of muni bond portfolios are Separately Managed Accounts (SMA’s), but the majority are still via mutual funds and closed end funds. ETF’s have made some inroads, but modest in market share terms. 10 year Illinois debt is yielding approximately 4.3% (Federal tax exempt, State tax exempt for IL taxpayers and not subject to 3.8% Obamacare investment tax). Converting this to a TEB (Taxable Equivalent Basis) a non-IL resident in the top tax bracket would need to invest in a corporate bond yielding 7.6% to match. Note: HYG the $20bln high yield ETF yields 5.13% in comparison, hence you might need to buy an out of favor sector like bricks and mortar retail, otherwise non-rated is likely where you will find >7% in the US domestic bond market.

The same negatives that sent Puerto Rico (importantly not a State, technically a Protectorate https://ibankcoin.com/firehorsecaper/2016/04/10/puerto-rico-the-spoils-of-war/) on tilt recently are evident in Illinois as well, namely rampant crime and failing schools. Many schools are years behind in even tabulating scoring tests, which would be required to confirm their bottom quartile performance. To rival the record for shootings in Chi-town you have to go very far afield to places like Kabul.

Kentucky born Lincoln might hide the other half of his face if he were privy to the folly that has befallen “Land of Lincoln”.

Tread lightly, tread carefully. This is July business, post downgrade to junk for the GO credit. Remember, the highest yielding bond is often not the best “value”. Cross-over buyers that can not readily utilize the US Federal tax exemption (i.e.; foreigners, hedge funds) might look to the Build Illinois Sales Tax Revenue Bond which offers enhanced security (and ratings) from the dedicated sales tax pledge (This was also the thought with PR’s COFINA bonds which interest was recently suspended on by the courts, but you get the idea). The PO’s (Pension Obligation) bonds of Illinois are also taxable and will likely swoon a bit on a GO downgrade to junk status. Those looking to structured deals can vet Illinois tobacco settlement bond “Railsplitter” which was structurally superior on issue in 2012 as it could withstand smoking cessation rates of 4% wrt debt service (over $55bln of tobacco bonds have been issued across all 50 states).

Follow me on Twitter @firehorsecaper JCG

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AMERIZUELA: $FNMAS FANNIE MAE – ONLY ONE OUTCOME, RULE OF LAW MATTERS

While a number of “Mom and Pop” investors were also caught in the downdraft of Fannie Mae and Freddie Mac’s Conservatorship in September 2008 (10 year anniversary next year!), the largest current law suits appear to be from the hedge fund community at large. Fannie and Freddie had $36bln in preferred shares o/s when they were placed into Conservatorship, with community/regional banks the largest aggregate holder.

Bruce Berkowitz’s Fairholme Capital appears to be the most “all-in” with respect to position sizing with 35% of the fund’s capital deployed long Fannie and Freddie subordinated preferred shares. AUM for Fairholme is currently approximately $3bln (they were managing $19bln at their pinnacle), making this a 10 digit wager.

In Fairholme’s words:

“Fannie Mae and Freddie Mac. We believe that these two companies may be the most important financial institutions in the United States – perhaps the world – and directly support housing affordability and accessibility, including the uniquely American 30-year fixed-rate mortgage. They are a major reason why our country did not descend into a second Great Depression. Millions of American families depend on Fannie Mae and Freddie Mac to lower the costs and improve access to homeownership. In times of stress, these two have helped to ensure the continued functioning of the U.S. housing market. They have no substitutes. Fairholme’s investment in Fannie and Freddie demonstrates a commitment to ignore the crowd and invest in valuable, systemically important institutions – even those that are politically unpopular.”

Richard Perry’s Perry Capital (in wind down), is also long the prefs, exclusively.

Bill Ackman’s Pershing Square is much less committed, in terms of size of position at least (but still a sizeable swing at 9%), and has chosen to purchase the common shares of both Fannie and Freddie (although he has been rumoured to be selling common in favor of the prefs). Both GSE’s applied to be de-listed in 2010 from the NYSE and now trade over-the-counter on OTCQB, the “venture” stage marketplace for early stage companies that report to a US regulator.

The original government bailout of Fannie and Freddie was $187.5bln and they have now remitted in excess of $265bln back to the Treasury ($78bln more than the amount of the bailout). Fannie Mae accounted for $116.1bln of the $187.5bln and have repaid $159.9bln total to date (owned + $43.8bln surplus via net worth sweep).

The mechanics of the tithe were changed in August 2012 when the 3rd Amendment to the GSE Conservatorship  was passed (both GSE’s were paying a 10% dividend to the US Treasury on the Senior Preferred shares up until that point). The 3rd Amendment, as it became known, called for a “Net Worth Sweep” which is to be kept, in effect, for perpetuity. The golden geese have remained tagged since and the $ have been rolling in. Earnings for both GSE’s have been bolstered by an increase in guarantee fees as the fees on new mortgages exceeds the fees on those in the existing portfolio. Both have seen growth in their total guarantee portfolio, along with underlying mortgage origination and finally both have experienced lessening credit losses as their aggregate portfolio level credit metrics improve. An amazing turnaround story, were it not for the gold eggs being sent to corporate (aka Treasury) while they are still warm from being laid.

Fannie Mae had a profit of $12.31bln in 2016 as a point of reference. One potential fly in the ointment, in terms of reported earnings going forward, relates to deferred tax assets (DTAs). This is a bigger issue for Fannie than Freddie because of the relative size of their DTAs and the potential impact of Trump tax reform (corporate rate from 35% to 15% proposed, but many handicapping a final rate of 20%). Fannie Mae’s DTAs stand at $35.1bln and Freddie Mac at $18.7bln. Steve Eisman, who disclosed owning Fannie Mae prefs in smalls,  implied on TV this week that the DTAs could prove to be a catalyst for action, implying the US Treasury would be called upon to make the GSEs whole on the potential DTA value impairment due to the proposed Federal corporate tax cut. I may have misinterpreted Mr. Eisman’s call on this, but one thing is 100% for sure, the status quo is not sustainable. The US Treasury can ill afford to assume an additional 5-6tln of debt by nationalising the GSEs when the non revenue neutral programs on the table already get the USA to the mid 20’s (trillion) in Federal debt.

The lawsuits have not been going swimmingly for the hedge fund dominated plaintiffs to date. Shares of both GSEs have dropped >25% in the last 2 months months after an appeals court upheld a ruling against shareholders challenging the legality of the government’s Conservatorship. Shareholders continue to argue that the government’s net worth sweep of all GSE profits in perpetuity is unconstitutional.  An overturn of the perpetual full profit sweep is  the only viable alternative leading to a non zero-valuation for both the common shares and junior preferred shares of Fannie Mae and Freddie Mac. This is a binary, legal based outcome, hence not for the faint of heart. Ackman’s take, “We believe that Fannie and Freddie offer a compelling risk-reward as there are various scenarios which will generate a many-fold multiple from current levels. While a total loss is possible, we believe the probability of a total loss is relatively modest, and has become lower in the new political environment.”

Catalysts for a positive outcome:

1.) The U.S. Supreme Court overrule previous court decisions and overturn the net worth sweep.

2.) Trump and Treasury Secretary Steven Mnuchin recapitalize Fannie and Freddie, returning control to shareholders.

The 2nd scenario is the one that has boosted the stock since Trump’s win in November. FNMA and FMCC spiked as much as 250% (from $1.65 to $4.40) before settling in at the current $2.65 level (+50% from November).

Nobody is better suited to craft and execute GSE reform than Mnuchin, aka “The Loan Ranger”. Post Goldman, he purchased failed Pasadena, CA IndyMac,  doubled its capital base (via additional acquisitions) renamed it One West and sold it to CIT for a tidy profit.

https://cei.org/blog/mnuchin-must-bring-transparency-fannie-mae-and-freddie-mac

Mnuchin has publicly stated:

“[We have got to] get Fannie and Freddie out of government ownership. It makes no sense that these are owned by the government and have been controlled by the government for as long as they have. In many cases this displaces private lending in the mortgage markets and we need these entities that will be safe. So let me just be clear we’ll make sure that when they’re restructured they’re absolutely safe and they don’t get taken over again but [we have got to] get them out of government control.” (Footnote: Nov. 30, 2016)

“[…] it’s right up there in the top 10 list of things that we’re going to get done and we’ll get it done reasonably fast.” (Footnote: Nov. 30, 2016).

Mnunchin’s right hand man is Craig Phillips, a near 40 year Wall Street veteran (most recently at venerable Blackrock) but he ran the Mortgage Securities unit at Morgan Stanley in the lead up to the GFC (May 2006, about a year before the wick was lit on the MBS woes to follow).

With Housing Finance Reform a top 10 priority, in terms of timing this likely makes it 2018 business (prior to 2018 midterms). The Trump tantrum we saw in the markets yesterday provide a potential entry point for punters willing to take Mnuchin et al at their word. FNMAS, the most liquid Fannie subordinated pref traded off by 5.6% to $6.75 yesterday (17-May-2017). The 52-week range has been a wide $3-$11, reinforcing the speculative nature of the proposed foray. The low was close to 9/11/2016, the 8 year anniversary of the prefs going ex dividend on 9/11/2008. The Trump Bump sent the Fannie prefs prices skyward, from lower left to upper right as Gartman would put it, approaching $11, appropriately, on Valentine’s Day 2017. FNMAS now at $6.75 have since given back 38% from the February 2017 $11 high.

This is the appropriate time to ask, “What is the upside on an investment in Fannie Mae subordinated prefs (FNMAS)?”, given that the downside has been shown to be zero. Fannie Mae did not file for Ch. 11. It was placed into Conservatorship, along with Freddie Mac. The capital structure remains legally intact, under which the subordinated prefs rank behind the US Treasury senior prefs, but importantly ahead of the common (which is to be diluted by 80% …. the US Treasury mandated “deal” when placed into Conservatorship). Also worthy of note, at the time the GSEs were placed into Conservatorship all senior and subordinated debt of the GSEs was paid/matured at 100 cents on the $. Before the US Treasury prefs can be extinguished (legally) it highly likely the dividends on the subordinated prefs would have to be reinstated. There are 16 discrete series of Fannie Mae subordinated prefs, FNMAS just happens to be the most liquid. None of the prefs are cumulative (i.e. no legacy dividends are owned once they start to pay again). The coupon on FNMAS is Max (3 mth Libor +4.25%, 7.75%) with a par value of $25.00. Cessation of the net worth sweep would see FNMAS trade back to par ($25) in short order for a 3.7x return on invested capital. It will likely take Fannie Mae time to build a capital buffer once/IF the net worth sweep is nullified. The US Treasury, despite the windfall seen via the net worth sweep will likely mandate the timetable for their senior prefs to be repaid. FNMAS, on a dividend reinstatement would pay 7.75% until Libor gets to 3.495% (good things are happening if/when we get 3mth Libor back to a 3 handle, I assure you), at which point L+4.25% would become the MAX, hence the applicable coupon. Given how high the rate is versus current market rates, it stands to reason that steadfast FNMAS investors could well see the market price trade well above par. I like the potential payout on a positive outcome for FNMAS  (3.7-4.5X invested $) much better than FNMA common. FNMA common traded off 3.3% yesterday to $2.65 and with some analysts guessing on an equity value of $15 post net worth sweep that would get risk-seeking investors a 5.66x return on their money. The pick-up versus the subordinated prefs does not seem worth the substantial additional unknowns and the known capital structure inferiority in terms of priority of payments.

Mnuchin is scheduled to speak today on GSE Reform in front of the Senate Banking Committee. Nobody is holding out for 100% clarity, but in a land increasingly filled with mere whispers, a clear voice can go a long way in setting the future course for perhaps the #3 priority for the Trump administration (just behind healthcare and tax reform).

Follow me on twitter @firehorsecaper

JCG

Disclosure: Long FNMAS, 2% allocation @ $6.75.

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HOME CAPITAL GROUP: $HCG – REALITY CHECK FOR LONGS

Equity investors in HCG have been heartened by the 70% rally seen thus far the week of May 8, 2017. To put this dead cat bounce in context, the stock, after rallying 70% this week, remains down 72% year to date. Home Capital Group trades on the TSX in Canadian dollars, last traded C$8.76 (US$6.40 with USD/CAD at 1.37) and started 2017 at just under C$32 (high print was a 55 handle in 08/2014 when USD/CAD was at 1.08!). There is an otc listing in US$, HMCBF as well but I’d use it for tracking only, given the lack of liquidity evident.

I would argue there is too much Home Capital equity glee evident.

The costly (>20% all-in with full fee stack) HOOP (Healthcare Ontario Pension Plan) liquidity facility for C$2bln was the bullfighters spear in this drain spiral. In addition to onerous monetary terms, the degree of overcollateralization HCG had to agree to (2x, i.e. a 50% haircut on Home Capital’s uninsured mortgage collateral) means that access to funding will have a terminus when HCG has no additional collateral deemed finaceable. Short of the HOOP facility terms being re-cast (near zero chance), it appears the days of HCG holding mortgages on their own balance sheet are long past. The company has admitted such in their latest press releases, and have entered into an arrangement with their competitor MCAP (as reported in the press, not by HCG) to on-sell mortgage commitments and renewals, initially for C$1.5bln with the potential to expand the program. Quebec pension plan (you can’t make this stuff up) CDPQ part owner of MCAP has responded that MCAP is the not the end buyer rather is a facilitator for the sale of the mortgages (MCAP will manage and service the loans for the buyer). MCAP have > C$61bln in AUM with a speciality in Canadian mortgage assets.

HCG currently has C$18bln in mortgages on balance sheet, currently largely funded by C$12.7bln in GIC deposits (including brokered GICs) which are eligible for Canada Deposit Insurance Corp (CDIC) coverage. Home Trust’s May 24th deposit notes traded in a range of $89.75-$94.875 on May 5, 2017, as reported in the popular press. Taking a mid off this wide trading range get us to a price of $92.3125. Assuming the CDIC insured 100% of the GICs in question, this would represent a liability of C$976.3mm of the aggregate insured deposit note program (C$12.7 * (100-92.3125)). This implies the Canadian government (via CDIC) is a bigger stakeholder than HCG equity holders, given the mkt cap of C$562.4. Based on the rally in HCG equity since May 5, 2017, secondary GIC levels have likely improved, but this example is more to show that this is a more of a razor’s edge scenario than most “hold my beer” financial journalists are acknowledging. HCG has a market cap of C$562mm and a mortgage portfolio of C$18bln, meaning just over $3 in price for the book wipes the equity out (C$18bln * 0.03 = C$540mm). Fraud naturally tends to widen bid/offer spreads as potential buyer naturally require a safely buffer for the unknown.

HISA funding has largely rolled off, and will not likely be a source of funding going forward. HCG also have the noted HOOP C$2bln liquidity back-stop (more than 70% drawn 2 weeks from establishment) which effectively served to replace the hole in their bucket from HISA redemptions. Home Capital’s  bigger problem may be they are NOT too big to fail. In my view, there would be little public support within Canada for a bail-out of HCG, either directly or through backing white knights (domestic or foreign). Why did the Canadian cross the road? To get to the middle. Not going to happen, especially in light of the blanket Moody’s downgrade just announced for all the Canadian banks, although still very highly rated versus global peers (RY to A1 from Aa3). Moody’s pointed to the banks collective exposure to over-indebted consumers and high home prices, and all remain on negative outlook. Distressed situations call for IRR’s in the low 20’s (HOOP’s facility is estimated at 22.5%, GS and FIG participated in the syndicated deal, and rarely accept less).

Home Capital is a regulated mortgage lender, and is the largest non-bank mortgage lender in Canada. This distinction is as critical as it was during the global financial crisis. Non-banks lack critical access to wholesale funding and access to the central bank funding window (The Fed in the US and the Bank of Canada in Canada).

Liquidity: Bear Stearns was sold to JP Morgan in March 2008 via arranged marriage for $2 a share ($236mm). The deal was announced over the weekend to quell global market nerves ahead of the Asia open. Bear closed at $30 a share (0.38x of $80 book value) on the Friday before the deal was announced at $2 (note: later revised to $10 as further due diligence could be conducted, the NYC headquarters of 85 year old Bear Stearns alone was worth $1bln). The Fed provided a $30bln back-stop to JP Morgan to better digest the thorny prey. Bear Stearns traded as high as $172 a share in 2007 and as an aside bought back $1.6bln in stock in 2007 alone.

Leverage: Fannie Mae was levered at 20:1 coming into the GFC. An increase in their loan loss experience from 4 basis points to 52 prompted both Fannie and Freddie to be placed into conservatorship where they remain. Leverage accentuates the negative by more than most can envision.

It remains to be seen if the poison laiden HOOP spear is lethal for HCG, but I’m confident that the stock is worth less than it is trading for now, and near fully certain it is not a 2.5 bagger from here (CIBC Asset Mgmt have tripled down on their initial long position and own 15% of the common). The only institutional investor that owns more of HFC stock is Turtle Creek Asset Mgmt  which holds a concentrated bet (25 positions in total) for 19% of the embattled lender. Turtle Creek’s flagship funds is at approximately C$2bln (closed to new investors) and it should be noted their track record to date has been stellar, boasting a 23.7% CAGR (1998-2016). I’ll be sure to check if they are open to new investors in 2018.

This blog post in being penned in Tokyo which is 13 hours ahead of North America, but a big day lies ahead for all involved in the HCG story. Delayed quarterly earning for Q1 are due and more importantly management is expected to shed more sunlight on recently announced transactions, including the price terms and cpty on the C$1bln mortgage sale. The other disclosure investors are keen to hear is on HCG’s announcement that they will be “tightening our lending criteria and replacing some of our broker incentive programs and expect that will result in a decline in our originations and renewals.” There have been daily tweaks to the rule book this week, but local mortgage brokers report Home Trust is still in business. New business is being written, with a few caveats; Best pricing has been eliminated (called Ace pricing), the max mortgage amount is C$600,000 which it was noted is not that useful in Toronto, their lowest rate is 4.69% with a 1% fee and their non conforming rate is 6.5% (noted as off market). Other B lenders have raised rates as well resulting in a widening gap between the A and B rates. Smaller competitor Equitable (who scored a liquidity facility on much better terms than HCG) is going flat out and not taking refinancings right now due to volumes. As of Wednesday May 10th Home Trust was also just doing purchases (no refinances). Broker finder fees were reduced this week as well (as HCG noted they intended to do).

The press is Canada, to my mind, has been too sanguine about the risk to the HCG story playing out well for retail HCG equity investors. Most analysts have given the situation a wide berth of late. TD presented an analysis this week showing their thoughts on HCG equity valuation for different valuation levels for the C$18bln mortgage portfolio; at $91.00 (a $9 discount) they saw equity as worth $0. At $95.00 (a $5 discount) they saw C$9.70 (close to where we are now at C$8.76) and a sale at par, $100 resulting in an equity valuation of $21.68. Put another way, to make 2.5x your money you need all the stars to come into alignment and see Home Capital get 100 cents on the dollar for their mortgage book. Hope is not an investment strategy.

Those long intent on riding this out should get up the curve on CCAA (Companies’ Creditors Arrangement Act), Canada’s equivalent of Ch. 11.

Follow me on twitter @firehorsecaper. JCG

Disclosure; Currently flat, as borrow for a short position has been unavailable from my current broker (IB).

 

 

 

 

 

 

 

 

 

 

 

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