AEC has now reversed a 1% down day, trading flat.

Quarterly earnings announcement is just minutes away…

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Alright, the moment of truth is at hand. I’ve sat here silently suffering in AEC, as multiple analysts have come out with downgrades based upon what strikes me as no deep or well-researched understanding of the company, and even less reasoning provided short of “people don’t seem to like the stock.”

Well, thank you, analysts, for those life altering insights. I could not POSSIBLY have reached that conclusion without your considerable prowess of surmising. I hope you’ll be well paid when AEC finally gets big enough to force your upgrade.

Tomorrow, AEC reports earnings. I am expecting:
1) no reported earnings per share (the losses are one of the attractions, for me)
2) level/consistent occupancy rates
3) increasing rental premiums/rates
4) massive cash flow INTO the company (I do not care about depreciation in a real estate company after a housing collapse, people)

In the face of those outcomes, I will declare absolute victory, and continue to march unrelenting at any analyst who dares quote standard metrics or moving averages as excuse to downgrade such a business. Should one of my assumptions fall, I will reassess, and perhaps begin offering apologies to those who, in hindsight, I shall have unjustly injured.

However, reading some of the opinions on AEC that have come out this last week and noting their unfamiliarity, I have some suspicions:

a) paid analysts are using standardized computer algorithms / interns to offer prepackaged opinions on small companies, without ever bothering to actually check their published conclusions. I understand, there’s only about 9 minutes in between the front and back nine…
b) all analysts springboard off one another’s findings, so a single analyst offering a mass produced opinion can create a waterfall of lockstep conformity

But hey, tomorrow’s just a night away. Let’s see who’s right…

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Late yesterday, at about 3:30, Associated Estates Realty Corporation (AEC) came out and announced that they were going to raise some money through a public offering of 5.5 million shares (comes out to about $76 million, or $14.40 per share).

Based on the market’s reaction, you would have thought they had announced that AEC was actually secretly a Chinese lumber company.

The stock immediately shed 2%, plummeting from $15.20 into the close. Last night was a bloodbath. It ended up opening today at $14.41. In a single night, AEC lost 5% of its market cap.

HOLY SHIT! They’re raising cash, so the market sets the company share price at what they’re getting from the underwriters?? Are you people high?

It seems we need to have a little discussion about raising money, and what it really implies.

But first, grab all those little books you have on capital raises, where savvy sounding professionals wearing douchebag-y clothing while waxing philosophical on the front cover, recite three hundred years worth of “rules of thumb”. Throw them into a pile, douse them in gasoline, and set them on fire. Then gather up the ashes, and ever so fastidiously, cram them up your ass.

That’s how many out-of-context Warren Buffet quotes I want to see in my comments section. You have been warned.

Rather than assuming that all capital raises are inherently bad, evil, dilutive things, let’s instead ask a simple question: when, exactly, do capital raises hurt outstanding investors?

Well, when they cut into a companies value. So anytime the shares sell for less than they’re worth. That’s bad.

Or when they cause the company to give away earnings to too many different places and suddenly any premium is overpriced and cash flow expectations are overpriced. That’s bad.

Or when the new capital has rights or priviledges that undermines the rights of existing shareholders, and sidelines them into an unfair position. That’s bad too.

Or perhaps when the capital raise is smoke tipping off something that’s very wrong with the company. All bad.

Or maybe when there’s some kind of fraud going on, because the company isn’t being honest about how many investors are really oustanding, and the sale is actually a red flag that your company is managed by criminals. That’s really bad.

So let me ask you; what’s the big fucking deal?

It’s not like AEC is desperate for cash, on Death’s door with the harpies flying overhead. They’re a $700 million dollar entity sitting on $6-13 million. They have annual expenses of $140 million, revenues of $172 million, and are modestly leveraged with debt equal to 70% of their total assets (all at insanely cheap rates, courtesy of the Fed). And they’ve secured enough credit lines to weather their debt load for several years.

Oh yeah, and AEC is a cash cow. While reporting that they’re losing money, their operations are generating a cool $50 million a year in untaxable cash flow. So they’re doing what any sensible company with deep pockets and record low prices would do – they’re buying everything they can. In fact, because they’re running with the black hole-budget accounting methods that are depreciation adjustments in a real estate centered environment, their net cash flow is up 70% inside of four years.

All of that money is going straight back into the company. In fact, they generated surplus revenue from also refinancing/closing/restructuring their debt. All of that $50 million a year right now is going out, buying up properties, and building AEC into a steadily larger, more competitive organization.

Which brings us back to the idea of capital raises. Why are you such a squirly little bitch?

Let’s say I have a company – we’ll call them Opportunistic Co. – that has a book value worth $900 million with 900 million shares outstanding, or $1 a share of value, including too little cash to really do anything with. Now let’s say an awesome investing opportunity comes along; the price tag is another $100 million. Opportunistic Co. has a choice to make – they can pay up for that opportunity (which based on Associated Esta – oops, I mean Opportunistic Co.’s – track record would generate a cool 16% ROI annually before taking into account any debt extinguishment or unrealized property appreciation), or they can puss out and go home.

So let’s say Opportunistic Co. decides, “hey, I want to take advantage of this” and they raise that $100 million by selling shares for $2.00 a pop.

Oh God! No! dilution…!

They take that $100 million that they raised by selling 50 million shares on the open market and put it on their books. And low and behold, they now have a $1 billion value, with 950 million oustanding shareholders.

And shares worth $1.05 apiece.

That’s right, miscreants. If you did the math, Opportunistic Co. just raised their book value, because the people who bought into the idea, and thereby their company, did so at a premium.

Now, I know this isn’t fail safe. Lots of companies trade at big premiums to their value, because people are banking on high growth rates. Capital raises can be a real threat to them, because if that money isn’t applied correctly and doesn’t generate enough funds to pull its own weight, suddenly those growth rates aren’t enough to justify the high price.

DOES AN REIT COMING OUT OF A HOUSING RECESSION SOUND LIKE A FUCKING GROWTH STOCK TO YOU?

AEC’s shares are trading very reasonably, just a little greater than their net worth. Their price to earnings is low. They’re operating income and revenues, from sky high occupancy rates and increasing rents, are running higher. They are a stealth-growth company trading like a utility.

And besides, both Opportunistic Co., and in real life AEC, already know what they’re going to do with the God-damned money. They already have the investment lined up, people. AEC said right when they were raising the cash, “hey, same shit…”. They have been killing it. Why should I be worried, without evidence, that they’ve suddenly forgotten how to manage a real estate company?

And if at any point, some or all of these properties start to actually go up in price…well then taking the time to raise the money, and make the call, will be a boon to ALL the company’s shareholders, probably better than if they hadn’t made the purchase at all.

So excuse me for thinking that MAYBE sometime between now and the end of time, we might just have a real-estate recovery.

But here’s what really bothers me.

Let’s have another little example. Let’s say there’s this other company – Superstar-Bullshit-Celebrity Managers Enterprise – who are also worth $900 million, with 900 million shares outstanding. And let’s say, for the humor of it, that a third group of investors beats both companies to the draw and acquires the opportunity first.

This third group raises the $100 million (raising capital, incidentally) by soliciting what happens to be $2 a share from an underwriter and forms the new corporatation – Sucker’s Buy Co. – which has 50 million shareholders

Now a not-meaningful amount of time passes, and the super smart SBC Enterprise managers decide, “hey, you know what, we’d like to have that property owned by Sucker’s Buy. I think we should buy it.” Never mind that Sucker’s Buy has been in business for like, a month, and has already given away all their revenue in the form of special dividends. So they get the paper work in order, and start the M&A process.

But of course, we can’t just buy Sucker’s Buy at market price – how would Sucker’s Buy’s investors be rewarded for their precious month of time? No, we need to run a leveraged buyout on these fuckers, giving them $2.50 a share. It’ll all be worth it later on, after all. SBC Co. can leverage SB Co’s operation to optimize synergies, and shit…

So SBC purchases the same thing – exactly, identically, the same thing – for an extra $25 million than it’s listed. And all financed, naturally.

And after goodwill gets rectified, SBC’s shares will be worth only $0.97.

But you and I both know, in this situation, SBC’s bullshit stock would rally.

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I’m almost obligated to get into this affair with Dimon & Co. However, I promise you I’ll save you the self-righteous lectures, which are so well versed and recorded at this point to fill a small history book or ten.

It’s not that I don’t agree with much of what’s being said. Or that I have anything against those of you who are saying it. More that, since you are all so on top of this, I don’t have to be.

Instead, let’s talk about something a little more practical.

Dimon mentioned that they have a $2 billion loss, presumably unrealized, over a 6 week period. We know that the position is composed largely of derivatives. So, we have a timeline, and we have a medium. But we are missing a quantity. That’s unfortunate, as it would be let us know how deep JPM is, and what they need to do or have happen in order to unwind it.

But hey, let’s just guess.

What do we know happened about 6 weeks ago? Well, looking at yields of major bonds, that was about when both Italian and Spanish 10 years reversed hard off their, up until then, descent from the ECB LTRO operation. We also know that buying those bonds, betting on further depressed yields was a VERY popular trade amongst the financier elite. Look at Corzine – who has deep ties to Dimon.

In fact, JPM was clearing Corzine’s trades in the MFGlobal affair, if I recall, so some of this position could even be a legacy. That would be fascinating. But that is WILD speculation on my part, so let’s get back on track…

It seems reasonable to guess that the culprit of this blow up is European debt. It was a popular target. The timeline’s right. So, assuming it is EU debt (specifically Spanish and Italian bonds), what does that tell us?

Well, Italian 10 years are currently trading up 50 basis points. Spanish 10 years are trading up 100 basis points. .5% and 1% – those are our defining numbers.

Rather than trying to blend them, let’s just assume that the entire position was either all Spanish 10 years, or all Italian 10 years, with the truth being somewhere in the middle.

Now, I know from looking them up that CDS coverage on an Italian 10 year will run you about $450 to insure a $10,000 notional bond. That’s a 1% profit spread for the bond holder. And I know that CDS coverage on a Spanish 10 year will run you about $500 – again a 1% profit spread for the bond holder.

So, if JPM had a prop position in Italian or Spanish CDS betting bonds were going to swing the other way, how big would it have to be to generate a $2 billion loss?

Well, for Spanish debt, which have rallied 1%, the move in CDS, assuming that same 1% profit spread for bond holders, would be from about $400 for coverage, to the current $500. That’s a 25% loss on any uncovered position JPM might be holding.

For Italian debt, which have rallied .5%, the move in CDS, assuming that same 1% profit spread for bond holders, would be from about $400 to $450. That’s a 12.5% loss on any uncovered position.

Now, in order to actually determine the size of the position, remember that their loss will be equal to the amount they’re losing on the mark-to-market aspect of the position, minus any positive carry trade they get up front for the CDS. The quickest way to do this is a solver method. I’m not going to bore you. I did it on the side.

For Spanish debt, the position would only have to be about $9.5 billion to generate these size losses. But, for Italian debt, the position would have to be much bigger – probably $23-24 billion in CDS.

So, I feel I can say pretty confidently that JPM has a $10-25 billion uncovered position in CDS, betting on better yields for EU bonds.

Now, JPM probably doesn’t feel very comfortable right now. Between the limited number of sizable buyers of CDS and the idiotic moves that EU countries have been making to restrict the rights of CDS holders, plus the fact that everyone knows JPM has this big position, the odds that they manage to unwind this thing at current prices are nil.

So Dimon says he’s going to offset the losses (which could still grow significantly, especially if EU bonds keep getting hit) by realizing some $1billion or so gains from equity markets.

Well, markets (were) up 10% in the first quarter of this year. So if Dimon thinks he has $1 billion in gains, just swinging with a wide guess here, that’s about $10 billion in assets he thinks he’s going to be able to sell.

To put things into perspective, if Dimon somehow managed to get on the sell side of 1 out of every 2 trades of a still very liquid stock like AAPL, it would still take him more than three days and 18 million shares to offset things. Assuming he somehow didn’t also collapse the market, which over a 3 day period he most certainly would.

Should Dimon manage to sell 1 in 10 shares of average trades in AAPL, keeping with our little game, it would take him more than 2 weeks to offset this.

And, being more reasonable still, if Dimon can only sell 1 in 100 shares of the average trade volumes of AAPL without risking collapsing that particular market, then it would take him over 4 months, in terms of AAPL, to cover his ass on this.

And if things get worse for JPM, with current estimates the losses could get as high as $4 billion, then naturally JPM would have to unload even greater equity positions to offset that. The total amount of assets they would need to sell, (and there by the expected reasonable time line for doing so), could triple, or even quadruple.

I know that $10 billion, $20 billion, or even $40 billion does not sound like that much in this day of trillion dollar bailouts that we live in. However, each of these is equivalent to a fairly large hedge fund entering a full-blown margin liquidation.

So, in summary, I would guess there’s going to be a powerful put over this market for at least a few months. Firstly because they will definitely have to be selling stock directly, which will lead to lots of momentum stocks like AAPL breaking down and lots of future setups that traders favor getting disappointed as “the JPM put” is in effect.

And secondly because, from the standpoint of the CDS, there are only two ways for JPM to get out – they can buy back the CDS directly, or they can go short the corresponding bonds to close the position. Well, $10-25 billion in CDS would be covering $200-600 billion in euro bonds, wouldn’t it?

Even if JPM only tries to close out a tenth of that, that’s still between 2-6 weeks worth of funding for a Spain or an Italy. They’re having enough time trying to sell their own debt directly; imagine having to compete with short sales by JPM?

So, what I’m saying here is this. This is not an LTCM “holy hell, we just destroyed the world with $1 trillion notional exposure” kind of event. But it is serious, and it does come at a most inopportune time. Particularly should equity markets begin to sell off, JPM might actually start to sink European bond auctions scrambling to save itself. This could at worst spark the next LTRO round, or on a lesser level the need for a $50 billion or so injection from the ECB.

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In a major blow to mindless punditry, all indications are that high oil prices and European debt crises do, in fact, matter to economic productivity, regardless of whether or not they come gradually, or with a big, flashy fireworks display.

The signs are all there, as two major international companies and key users of petroleum, Exxon Mobile and Dow Chemical, have experienced serious earnings contraction.

XOM, despite having higher revenues, saw an 11% drop in earnings, contributed to by lower production. Having gasoline demand on level with the late ‘90’s probably doesn’t help.

And Dow Chemical, faced with dropping revenues and lower profits, had to take a full 30% drop in earnings so that they could closure plants across the US, Europe, and Brazil, thanks to weak demand from Europe and higher input costs.

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In light of today’s GDP print, the data out of China, as well as the Spanish numbers, please revisit this post from yesterday.

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First Quarter Same Community Revenue up 5.9 Percent
First Quarter Same Community NOI up 9.4 Percent
Quarter-End Same Community Physical Occupancy 97.3 Percent

Unadjusted FFO per share, $0.25, versus $0.23 for the same period 2011. Adjusted FFO per share of $0.29, thanks to loan prepayment costs totaling about $2 million.

Dividend has been raised by 5.9%, to $0.18 quarterly.

Funds available for distribution to shareholders are up 31% from 2011, to $11.728 million. Which, thanks to depreciation and one time expenses, still led the company to generate a $0.05 loss on the books this quarter (totally meaningless). What is meaningful is that all that cash flow is subsequently tax free.

Fuck you, fuck you, and fuck you.

Company apartments are full, almost literally, and they are looking ahead to continue ambitious acquisition and construction plans.

Now I’m going to go down some scotch before this erection wears off…

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