The "Texas Ratio" & FirstFed Financial

There was a great article on bank failures written by Alistair Barr several days ago over at MarketWatch.  While the whole article was of interest, I found the section describing Gerard Cassidy’s “Texas Ratio” to be especially interesting.  Cassidy, who is at RBC Capital Markets, developed the ratio during the 1980s while covering a large number of banks out of Texas.  With the help of a booming economy, the region gave birth to a number of successful banks all of which rapidly expanded their balance sheets in the hopes of making large amounts of money.  When the price of oil collapsed in the mid 1980s the banks quickly ran into trouble as their loans quickly deteriorated in quality.  According to Cassidy, the “Texas Ratio” acts as an early warning system for banks that are in trouble.  In the early 1990s, the ratio proved its usefulness by identifying many of the banks that got into trouble in New England.

The MarketWatch article defines the “Texas Ratio” as the following:

 “The ratio is calculated by dividing a bank's non-performing loans, including those 90 days delinquent, by the company's tangible equity capital plus money set aside for future loan losses.”

The current situation in California is very similar to the situation that occurred in Texas in the 1980s.  Over the last decade or so, the economy in California has been driven in a large degree by the construction industry and the prospect of ever-rising home prices.  In Texas, the economy in the 1980s was dependent on the oil industry and the ever-rising price of oil.  The stock price of Texas banks in the early 1980’s was very similar to the stock price of Californian Banks following the dramatic reduction in interest rates by the Federal Reserve in the first part of this decade.  The banks in both time periods experienced a significant expansion in their market capitalization, driven by a surging economy and rapidly expanding balance sheets.  The rapid expansion of the balance sheets of many of the Californian banks has gotten them in trouble, just as Texas banks in the 1980s.  While many of the Californian bank stocks have declined, I believe that they have much further to fall.

While I was not aware of the “Texas Ratio” until the MarketWatch article, I immediately put it to test on several of the Californian banks.  What I found was slightly horrifying and goes along well with my belief that Californian banks are in terrible shape, which I have wrote previously about here.

One bank that is in especially poor shape is FirstFed Financial Corp. (FED).  For the period ended 12/31/07, FirstFed Financial had non-performing loans of $180 million.  The next step in determining the “Texas Ratio” is to divide $180 million by the bank’s equity capital and its allowance for future loan losses.  FirstFed Financial as of 12/31/07, had an equity base of $654 million and $127 million in loan loss allowances for a total of $781 million.  If you divide $180 million by $781 million you can find the “Texas Ratio.”  For the period ending 12/31/07, First Fed Financial had a “Texas Ratio” of 23%. 

Now lets compare this to FirstFed Financial’s “Texas Ratio” on 3/31/08.  The company had non-performing loans of $395 million.  Now turning to look at the bottom numbers, FirstFed Financial had shareholders equity of $586 million and $233 million in loan loss allowances.   These numbers give you a “Texas Ratio” of 48%, a substantial increase from the previous quarter and a sure sign the bank is being put under tremendous stress. 

The situation in California today is however slightly different then the situation in Texas during the 1980s.  That is why I believe that a “California Ratio” needs to be created.  While I am not sure what it should be, I do know that it needs to include three things, both of which are exemplified in FirstFed Financial.  First, it needs to include the real estate owned as the banks are quickly accumulating foreclosed homes, which are incredibly hard to value and are worth nowhere near the value of the mortgage taken out on them.  As of 3/31/08, FirstFed Financial had of over $45 million dollars of real estate on its books, in my opinion this should be subtracted from the equity portion of the balance sheet, or at the very least discounted.  

Another key issue for the Californian banks is the number of impaired loans that they have.  If I understand the term correctly, one way a loan can be impaired is if the collateral behind the loan no longer supports the loan.  For example, a house that has not yet been foreclosed on but is worth far below the mortgage still being paid on by the homeowners can be considered to be an impaired loan.  In the period ending on 3/31/07, FirstFed Financial had $131 million of impaired loans and I would imagine that in any new “California Ratio” would need to have these taken into account, as they are surly a harbinger of the future level of non-performing loans.

Probably the most important reason why a new ratio is needed is that the "Texas Ratio" fails to account for loans that are less then 90 days delinquent.  If this metric were to be included it would show that FirstFed Financial is in a precarious state.   Most banks, unlike FirstFed Financial, that to its credit has done a good job of disclosing issues to its shareholders, fail to disclose the number and dollar figure of these loans.  One thing that I noticed though was that the loans that were less then 90 days delinquent tend to not show up in the majority of bank's quarterly reports.   The non-performing loans that show up in the quarterly reports are by and large only those that are more then 90 days delinquent.  In order to come up with the less then 90 day figure you must go to the FFIEC website and input the name of the bank (not the publicly traded holding company), I discussed the FFEIC website in greater detail in my First Marblehead article which can be found here.

In valuing FirstFed Financial by the “Texas Ratio,” we see that currently 48% of its shareholders equity has been impaired and will likely be lost.  However, if we use any type of “California Ratio” that limits the value on the asset side provided by the real estate owned portfolio as well as that of the impaired loans and includes the impact of the loans that are less then 90 days delinquent we can see that shareholder equity at FirstFed Financial has been largely eliminated, giving the stock price a value of zero. 

If you have any ideas or suggestions on what additional aspects should be included in a “California Ratio,” please feel free to comment.           

For Further Review

MarketWatch Article on the "Texas Ratio"

FirstFed Financial's 10-Q

Disclosure: None

UPDATE: This Article was updated in July of 2008 to correct inaccuracies in my calculation of the Texas Ratio for FirstFed Financial.  The Texas Ratio was updated to reflect what it would have been at the time this article was originally written.  I incorrectly included loans less then 90 days delinquent in my calculations.  I still believe the article's thesis to be correct despite the correction.    

Quest Resource Corp: A Marcellus Shale Sleeper Play & More

Quest Resource Corp (QRCP) is a fast growing natural gas driller.  Quest Resources recently revamped its corporate structure with the packaging of its upstream and midstream operations into two MLPs, Quest Midstream Partners (which is not publicly traded) and Quest Energy Partners (QELP).  Quest Resources owns the general partners of its MLPs as well as significant limited partner interests.  Quest Resource’s interests in these two MLPs provide the company with significant cash flow that has allowed Quest Resources to begin drilling on land that it owns in the fast growing Marcellus Shale area centered in western Pennsylvania.  I believe that the marketplace due in part to the company’s complicated corporate structure and the recent concerns regarding its proposed merger with Pinnacle Gas Resources (PINN) has significantly undervalued the company.  While the merger, which was poorly thought out by Quest Resource’s management, has been called off.  Significant value nonetheless remains in the stock, even after its recent move following the breakup of the merger. 

Quest Resources owns 12.1 million units of Quest Energy Partners and 4.9 million units of Quest Midstream Partners.  Based on the market value of the company’s stakes in Quest Energy Partners and the sale price of the Quest Midstream Partners units, Quest Resources appears to be undervalued.  The company’s stake in Quest Energy Partners is worth about $194 million and the company’s stake in Quest Midstream Partners is worth somewhere around  $91 million dollars.  This gives a total value of $285 million to Quest Resource's holdings in its subsidiary companies.   

Quest Resources also owns the general partners of Quest Energy Partners and Quest Midstream Partners.  The general partnership of Quest Energy Partners has 25% of the incentive distribution rights (IDRs) for Quest Energy Partners.  The company also owns the general partnership interest for Quest Midstream Partners; this general partnership has 50% of the incentive distribution rights for Quest Midstream Partners.  A common rule of thumb that I used to value these general partnerships is to give them the value of what would be their stake in the limited partnership if they were units instead of incentive distribution rights.  For example, the general partnership of Quest Energy Partners should be valued at 25% of Quest Energy Partner’s market capitalization.  This is a common valuation in the industry as seen in the market caps given to other companies in the sector. 

This puts the value of Quest Resource’s stake in Quest Energy’s general partnership at about $85 million and the company’s stake in Quest Midstream Partners general partnership at about $124 million.  The company only owns 85% of Quest Midstream Partner’s general partnership so that stake needs to be reduced by the appropriate amount, giving you a total value for the general partnership of about $105 million.  Both general partnerships are still in their early IDR splits so to be conservative lets assume the general partnership interests to be worth 50% less than our estimates.  Although this will likely expand with time as the company grows to its potential.  This would put the total value of Quest Resource’s general partnership interests at about $95 million.

If you combine the value of the general partnerships ($95 million) and the limited partnership units held by the company ($285 million) the company, on these attributes alone, should be worth $336 million (this takes into account the company’s $44 million in debt).  Even though this figure ignores Quest Resource’s Marcellus Shale acreage it still leaves the company significantly undervalued given its current market capitalization of only $240 million.  Quest Resources will receive $25 million in cash flow from its MLPs this year, giving the company the resources it needs to expand and develop its holdings in the Marcellus Shale.

Another point worth noting is that the value of Quest Resource’s general partnership interests are likely to grow at an incredible rate as the value of the underlying limited partnership units increase in value.  In most cases the market capitalization of upstream limited partnerships have been known to rise significantly as a result of the limited partnerships frequently using their stock to finance acquisitions.  While this may dilute Quest Resource’s holdings in their subsidiary companies it should causes the general partnership interest, which holds the IDRs, to soar in value. 

Take Linn Energy (LINE) as an example, Linn Energy’s market capitalization has risen from $583 million at its IPO in January of 2006 to roughly $2.6 billion today.  If Quest Energy Partners is able to sustain a similar growth rate to Linn Energy then Quest Energy Partner’s market cap could be at $1.5 billion by 2011, making Quest Energy Partner’s general partnership (held by Quest Resources) worth somewhere around $400 million by 2011.  If the success of other publicly traded companies that hold general partnerships and MLPs can be used as an example, there is clearly significant growth potential in Quest Resource’s general partnerships.

As I briefly mention above, Quest Resources is using its significant cash flow from its MLPs to drill in the Marcellus Shale play, which is rapidly gaining notoriety for its productivity.  There are many companies with significant acreage in the play.  Atlas Energy Resources (NYSE:ATN) (I have talked about its parent company here, which is at worst a larger Quest) probably has the most exposure to the Marcellus of any large companies.  Atlas Energy Resource’s market cap is $2.6 billion and Atlas Energy Resources has 551,000 Marcellus acres with about half of them in SW Pennsylvania.  Quest Resources has a market cap of $238 million and Quest Resources has 52,100 acres with all of the acres in SW Pennsylvania.  It would appear that Quest Resource’s acres are then just as valuable as Atlas Energy Resources but they maybe even more valuable as all of Quest Resource’s acres lie in SW Pennsylvania.

Figuring out how much the acres are worth is difficult, yet in doing so the true value of Quest Resources becomes apparent.  Wachovia has estimated the NPV of Atlas Energy Resource’s Marcellus acres to be at least $6000 per acre, if you were to value Quest Resource’s acreage at $6000 an acre one would arrive at a value of $313 million.  There is likely to be upside to the $6000 per acre number as the Marcellus play is further proved through drilling.  Acreage in the well proven Barnett Shale typically is valued at between $20,000 to $30,000 per acre so that should give you an idea of the upside potential of the Marcellus area should the deposits pan out in a manner similar to the Barnett Shale.  Atlas Energy Resource’s drilling results appear to be fairly comparable to the types of results achieved in the core area of the Barnett so it seems likely that acreage values will rise from current levels.  Nevertheless, it is important to remember that the value of any company’s land will depend on exactly where it is located in the area.  To be conservative, lets assume Quest Resource’s acreage is only worth $3000 per acre, half of what Atlas Energy Resource’s valuation according to Wachovia, if the $3000 dollars per acre figure is used Quest Resource’s is sitting on $156 million of land.

In recent months, an impending merger with Pinnacle Gas Resources (PINN) has negatively impacted Quest Resource’s stock price.   Since management announced the deal, the company’s stock dropped from $11 to below $7 a share.  The Pinnacle Gas Resources transaction would have diluted Quest Resource’s valuable assets and cash flow by issuing the company’s shares to purchase a large amount of undeveloped land in the Powder River Basin.  Fortunately, management recently saw the error of the deal, or perhaps feared that it would not get shareholder approval, and scuttled the merger.  Even after Quest Resource’s recent run up, the company has still lagged the natural gas index substantially over the period since the merger was announced.  Quest Resources seems to be very undervalued but the Pinnacle Gas Resources transaction has to make a person question the wisdom of the company’s management and probably justifies the current discount to its fair value seen in the stock price.

Today, Quest Resources appears to own assets that should make its equity worth $491 million or $21 per share.   These assets, as mentioned above, include the company’s holdings of its limited partnership units, it stake in the limited partnerships general partner and $156 million in Marcellus Shale acreage, with debt of course being subtracted out.  A slight discount to this estimate is probably reasonable considering management nearly made a terrible blunder in regards to the Pinnacle Gas Resources acquisition.  The current stock price of $10 seems excessively low to me and reflects far too great a disconnect from the stocks true value.  I think a price in the high teens for QRCP would be justified based on the current holdings and numbers being put out by the company.

Going forward there appears to be significant growth potential from both the company’s Marcellus acreage and its general partnership interests.  In the hands of competent management Quest Resources could easily be worth two to three times the $21 it appears to be worth now, once the value of the company’s Marcellus Shale acreage and future growth in the area and general partnership interests has been fully realized.

For Further Review:

Termination of Merger Agreement

10-Q

10-K

Disclosure: Long QRCP

Understanding First Marblehead's Bank

The future of First Marblehead (NYSE: FMD) as most investors already realize is tied to the reopening of the student loan ABS market, GS Capital’s investments and the company’s ability to expand its direct to consumer lending platform.  Another incredibly important development for the company will be whether or not it is successful in its quest to expand its wholly owned bank subsidiary company.  Union Federal Savings Bank is a community bank out of Rhode Island that First Marblehead acquired in late 2006.  While a detailed analysis of the bank’s financial position can not be found in First Marblehead’s annual or quarterly report, one can be found by going to the Federal Financial Institutions Examination Councils website, which can be found here and by searching for “Union Federal Savings Bank”. 

The most recent report for the quarter ended 3/31/08, put online this last week, shows startling signs of a management team that is acutely aware of the struggles First Marblehead is facing.  The manner in which management is using the bank shows a glimmer of hope for the company’s future.  With the current student loan ABS market unavailable for securitization, the company, in order to keep originating its private label student loans must have stable funding sources.  The deposits down at the subsidiary bank along with the easily accessible loans under the category “other borrowings” (which are most likely borrowings from other financial institutions) have allowed First Marblehead to begin working towards a secure funding source free from the whims of the credit market.  If management can keep up what they have been doing at the bank during the last quarter for the remainder of the year, they just might get through this dark period in the company’s history.   

Companies like First Marblehead are offered two sources when originating loans.  They can either place them on warehouse loan facilities or fund them through deposits at subsidiary institutions.  Using warehouse loan facilities is considerably riskier then using deposits based funding methods.  Generally warehouse loan facilities require large upfront fees, carry considerably higher interest rates then bank deposits and can be pulled by the lending institution relatively easily leaving a company like First Marblehead exposed.  Deposits at a bank subsidiary, especially if they are longer term CDs, pose none of these dangers.     

First Marblehead first began to seriously exploit the benefits offered by having a bank subsidiary late last year.  This can be seen in the report for the period ended on 12/31/07.  During the last quarter of 2007, the company borrowed $240 odd million dollars in the form of “other borrowings” (which is likely borrowings from another financial institutions).  When these borrowings (which are practically the same as deposits) are coupled with the $150 million in deposits already at thee bank, First Marblehead was able to have the bank raise the number of student loans it held to nearly $350 million.  In a curious side note that should not be unexpected, Union Federal Savings holds only student loans on its balance sheet with commercial and residential loans virtually nonexistent.  It is safe to say that Union Federal is not exactly your local community bank.  The bank’s equity stood at about $52 million at 12/31/07 giving Union Federal a tier one capital ratio of 10.95% with cash on hand of abut $76 million. 

In the most recent report filed with FFIEC and posted online earlier this week, the bank’s balance sheet showed significant growth.  The report shows that management is aware of the issues that the company is facing and has begun to work towards a long-term stable funding source in the form of bank deposits.  For the quarter ended 3/31/08, the bank had “other borrowings” of about $240 million.  While “other borrowings” was flat for the quarter, deposits soared to over $270 million an increase of over $120 million from the previous quarter.  It is unclear where these deposits have come from but I would imagine that they have been brokered.  I would not be surprised to find out the Goldman Sachs helped with this as they have already completed their first investment in First Marblehead and certainly don’t want to see that $50+ million dollars turn out to be a total loss.  In addition, Union Federal showed an equity increase of $66 million for the quarter bring the bank’s total equity to $118 million as opposed to $52 million in the quarter ended 12/31/07.  First Marblehead likely contributed this capital to appease bank regulators and support further deposit and loan growth.  The new deposits and equity contribution allowed the bank to expand the number of student loans that it held at the quarter ended 3/31/08 to nearly $500 million, $150 million more then the quarter ended 12/31/07.  The bank’s tier one capital ratio stood 17.98% for the quarter up substantially from 10.95% the previous quarter and well above the bare minimum of 6%.  This leaves the bank with ample room to increase its balance sheet, especially with cash on hand of nearly $120 million.  While owning a bank stuffed full of student loans may seem strange it could potentially prove to be a unique advantage for First Marblehead.  While student loans do become delinquent, they are for the most part fairly safe, as they cannot be wiped off by bankruptcy.  In the quarter ended 3/31/08, the bank had net income of over $2.5 million driven by the substantially higher interest rates on student loans as compared to other forms of bank loans.  As the loans age and the students who hold the loans leave college and enter the workforce and the deferment on their student loans stop the cash flow at the bank subsidiary should soar.   

With the addition of further brokered deposits in the current quarter, First Marblehead should find itself as well positioned as could be hoped for given the circumstances going on in the credit market.  The current deposit base and the future growth that will likely occur over the next several quarters at a minimum signals First Marblehead’s survival as a private consumer based student lender.  While the deposit base leaves much to be desired it is a start in the right direction, I only wish that the company had the ability to purchases Fremont’s bank division that was sold to CapitalSource (NYSE: CSE) at a fire sale price earlier this year. 

Please check the next report filed with the FFIEC in mid August, as it should tell an interesting story and will likely go a long way to letting us know whether or not First Marblehead will survive as an independent company.  In the meantime, we can as investors in First Marblehead only hope that the remainder of Goldman Sach’s investment closes in June and that the student loan ABS market begins to open.       

For Further Review:

FFIEC Website    

Disclosure: Long FMD                   

Are the Losses at AIG Accelerating?

American International Group’s (NYSE: AIG) announcement on Tuesday that it would undertake an additional capital raise highlights the precarious nature that the company currently finds itself in.  The $20 billion dollar capital raise shows management to be incapable of running the company.  In raising more capital so soon after the last capital raise management has managed to lose all credibility with the market.  It is truly sad to see such an iconic American company fall so far from grace.  I have written previously about its fall to mediocrity, that article can be found here.

In raising $20 billion dollars within the last quarter, $7 billion coming with the most recent announcement, management has allowed the market to raise significant questions about Martin Sullivan’s ability to run the company.  The increased level of capital raised can be the result of two things in my opinion.  Either the losses in their credit default swap portfolio have expanded or the core insurance business is deteriorating.  I tend to think that the losses are accelerating, particularly if they tried to hedge their exposure after the most recent quarterly report.

The core business itself may also be deteriorating as last quarters numbers, as discussed in my previous post on AIG, were not good.  It is highly likely in my opinion that management has been so distracted with the losses in their credit portfolio that they have failed to adequately run the insurance business.  David Merkel’s article on breaking up AIG, which can be found here, is the right thing to do in my opinion.  Clearly, current management is unable to run such a complex company with so many moving pieces.  If AIG were to be broken up, I would imagine that it could easily follow the Altria (NYSE: MO) example and split into a domestic and international divisions.  This would simplify the company, while at the same time allowing investors to invest in an insurance company that is well positioned in some of the world’s fastest growing markets.

In light of the most recent capital raise and the resulting loss of credibility, I must reiterate my opinion that AIG should trade a percentage to book value and not at book value.  Management simply cannot be trusted.  I would not want to own a position in AIG at its current price.

For Further Review:

Bloomberg Article on AIG

David Merkel's Article on AIG

Disclosure: None

Resource America: Unfairly Punished by the Credit Crunch

Since late July, nearly everything related to the financial sector has been sold off by panicky investors fearful of finding themselves holding worthless paper.  Securities that have been particularly hard hit have been those related to the new alphabet soup of recently invented financial instruments, such as ABS CDOs CLOs & TruPS.  The firms that hold these securities have been hammered indiscriminately, while some have gone under those that were well balanced have been left behind at ridiculously low valuations.  Resource America (NSDQ: REXI) fits squarely into both of these categories.  Resource America’s connection these troubled securities poses no real balance sheet risk as it is purely an asset manager, collecting only large amounts of fees that result in a large free cash flow.  The asset management division coupled with the company’s other divisions makes the company incredibly attractive with a low level of risk at its current price. 

Resource America is first and foremost an asset management company that manages investor’s funds with long-term contracts through subsidiary companies targeting three different asset classes: financial funds, real estate and commercial leasing.  The benefit of Resource America’s asset management model is that while Resource America manages some funds in toxic areas, Resource America is not exposed to any credit risk directly.  The majority of Resource America's current value however comes from the funds that it manages that invest solely solid asset classes.

Resource America, like most management companies, charges an annual management fee based on the assets in the funds it manages with additional performance based incentive fees.  Thus, even in markets that are harmful to the funds Resource America manages, it can still collect management fees and if the fund blows up, which is not likely, none of the credit risk will flow up to Resource America.  The vast majority of the liabilities are thus essentially quarantined in Resource America’s subsidiary funds and not at the holding company level.    

Managing assets owned by others is a very lucrative business.  By managing funds holding the assets of others and taking the resulting cut of the profits, Resource America is essentially gaining the benefits of leverage on the assets it manages without being exposed to the downside risk.

Financial Funds

Resource America’s financial funds segment has been hard hit by the credit crunch.  The revenue generated from this segment has been impacted by asset write-downs.  Resource America’s publicly traded REIT, Resource Capital Corp (NYSE: RSO), originates and invests in commercial loans.  Resource Capital has held up better than most finance REITs due to Resource Capital’s funding being derived solely from long-term loans and strong credit performance in the securities it holds.  Resource America has been using the recent market dislocation to secure management contracts for new funds in the financial product space. Including the recent $1.3B addition of CLO funds, assets under management in the financial fund space have grown 22.8% over the past year.  However, revenues have been impacted by asset write-downs and dropping incentive performance fees.  Financial fund management was formally Resource America’s largest division prior to the credit crunch.  However, in the current environment, cash flow from this segment has declined.  As credit markets turn around in late 2008 and early 2009, this division of the company should be able to increase its growth going forward.

Real Estate Funds

Resource America’s real estate management segment manages real estate investments for investors.  Primarily, these funds manage apartment buildings.  Resource America has also been using the recent real estate market dislocation to add to its assets under management in this area.  Assets under management in the real estate segment are up 31% over last year.  This business segment is quite stable.

Commercial Leasing

Resource America’s commercial leasing company LEAF Financial is the real crown jewel of the company.  LEAF Financial uses investor funds to purchase office, medical, dental, industrial & HVAC equipment and LEAF then leases this equipment to businesses.  LEAF Financials services are also used by vendors who want to provide leasing arrangements to their end users.  The division has also managed to build significant relationships with regional leasing firms. 

For the LEAF Financial division to have any real problems would not only require widespread business failures resulting in significant businesses going bankrupt but also would require LEAF Financial to be unable to find new customers that need to lease its equipment. Such a deep recession is not likely, as the Federal Reserve has shown its willingness to mitigate such an event.  Commercial leasing has historically been one of the most stable areas in the financial sector.  Industry wide, commercial leasing's strong performance can be seen in the continuing low default rates.  Another trend in the industry has been for larger and more credit crunch exposed companies to begin selling off their leasing operations and lease portfolios.  One example is CIT Group; this trend will allow Resource America to expand its market share significantly in the coming years.

Resource America’ has used the credit crunch to expand substantially the assets under management at LEAF by purchasing the leasing operations of many distressed companies.  Even more important, LEAF's ability to raise capital through its investor partnership program continues to exceed management's expectations.  This gives LEAF a unique ability to access cheap capital to expand when most companies are just trying to raise liquidity to prevent bankruptcy.  Resource America also uses investor partnership programs to raise funds in other areas as well.  Raising substantial investor funds through partnership programs requires a huge network of dealers and a long history of solid performance the combination of which is difficult for other companies to replicate.  This represents a significant moat for the companies business as well as allowing for significant cost advantages over its peers. 

Resource America built from scratch a similar leasing operation in the late 90s called Fidelity Leasing.  Resource America sold Fidelity Leasing in August of 2000 for $152M plus the assumption of all of its debt.  At the time, Fidelity Leasing had assets under management of $479 million and Fidelity Leasing was originating at the rate of about $500 million a year.  Today, LEAF Financial is managing $1.7 billion and originating in excess of $1 billion per year.  These metrics make LEAF appear to be worth somewhere north of $400 million.  The value in this division alone dwarfs that company’s market cap. 

Resource America has also been expanding its efforts in the management of distressed loan funds and distressed real estate.  This has been a popular area for many companies to expand into.  The company has decades of expertise to draw on in this area while most firms are just starting their operations.

Ownership of Other Publicly Traded Firms & Real Estate

Recently, Resource America has filed an IPO for a blank check company named RAI Acquisition Corp. that will focus on acquiring banking assets.  Resource America owns 7,187,500 shares of RAI, which will IPO sometime in the coming months at $10 a share, this will make Resource America’s stake worth almost $72 million. Once RAI acquires assets, it will also further increase the funds that Resource America is receiving management fees on.  Resource America owns 2 million shares of Resource Capital and 118 thousand shares of The Bancorp (NSDQ: TBBK).  These positions are worth a little more than $20 million.  By the end of the year, Resource America should own control over $90 million dollars worth of publicly traded companies, all at the holding company level. 

Resource America also owns real estate that is worth in excess of $30 million that is on its books for about $15 million.  As for debt, Resource America is only responsible for $70.0 million of corporate level secured revolving debt; and $16.8 million of other debt, which is principally mortgage debt secured by properties owned by the company's subsidiaries.  Management anticipates being able to reduce or eliminate all of this debt by the end of the year due to the firm’s large free cash flow.

Valuing the Company’s Assets

So, what is Resource America worth?  In short, it is worth a large multiple of the current stock price. Resource America’s market capitalization is a mere $142 million.  Below are the easy to value segments of the company:

$400 million for LEAF

$72 million for REXI's RAI acquisition shares

$20 million for the RSO & TBBK shares

$30 million in real estate

$11 million in unrestricted cash

Minus corporate level debt of $87 million. 

If you add up the following figures you well get a current book value of nearly $450 million or $24 dollars a share, if everything were liquidated today.  It is important to note that this assigns zero value to Resource America’s financial funds & real estate management segments.  It also does not included is the company’s plan to repurchase $50 million worth of its own shares, representing an impressive 35% of the total company.

Valuing the Company’s Cash Flow

Another important aspect of the Resource America story is the large level of free cash flow that is spins off.  The company generated $35.15 million in adjusted cash flow from operations in the last two quarters and had capital expenditures of $5.5 million for the last two quarters.  If you expand these figures Resourced America will be generating about $59 million in free cash flow for the year, a rate that is likely to only increase.

In valuing Resource America’s free cash flow, I believe that Brookfield Asset Management (NYSE: BAM) can be used as an example.  Brookfield is generating almost $2 billion in free cash flow per year.  The company’s current market capitalization is $22.4 billion giving Brookfield a multiple of 11.2 times free cash flow.  If Resource America were trading at the same multiple it would be worth $660 million or $35 per share.  Again, this doesn't take into account the 35% share buyback Resource America will be undertaking for the year or the fact that its growth rates are substantially higher then Brookfield.

Understanding the Current Valuation

The current market capitalization of Resource America is well below the figures I have outlined above, this is for several reasons. First, Resource America’s management of a number of alphabet soup financial product funds has probably enticed many investors to sell first and ask questions later.  Secondly, a firm by the name of Spencer Capital Management has dumped about 600,000 shares over the last 2 months.  This should not be viewed as a vote of no confidence for Resource Capital.  Spencer Capital has had a poor year with large holdings in Borders Group (NYSE: BGP), Sears Holdings (NYSE: SHLD) and TavelCenters for America (AMEX: TA) all collapsing in share price.  I would imagine that such poor results have resulted in large redemption requests.  More importantly, Spencer Capital was purchasing Resource America shares as recently as late February so the firm clearly saw value in Resource America prior to their Q1 08 redemptions.  

The CEO of Resource America has purchased over $600,000 worth of shares over the last 6 months with a purchase as recent as 3/31/08.  On an interesting side note, Resource America is run by the Cohen family, which has this tendency to print money with their investments.  They currently control the following:

REXI, RSO, ATLS, AHD, APL, ATN, AFN, RAS & TBBK

One worry for Resource America is the coming restatement for its Trapeza subsidiary, which manages CDOs.  Worst case, Trapeza is basically a call option on the return of the CDO market.  I think CDOs, in some form, are here to stay as they have allowed for significant financial innovation, when the CDO market returns Trapeza will likely be a strong growth area for Resource America in the future. 

Catalysts

One possible catalyst that Resource America could see over the next 12 months is the spinoff of LEAF Financial.  LEAF Financial alone is probably worth 2 to 3 times Resource America’s entire market capitalization.  Resource America’s last spinoff, Atlas America (NSDQ: ATLS) (which I have written about here), has risen from a split adjusted $6.88 per share in 2004 to over $70 today, implying that Resource America’s management has the profound ability to create shareholder value.  Atlas America’s market capitalization is currently more than 13 times Resource America’s market capitalization.  I would expect LEAF Financials future to be just as bright.

Whether Resource America should be worth $24 or $35, I cannot be certain.  Regardless, Resource America is trading at a substantial discount to what it should be worth.  With Resource America’s solid history of creating value and strong positioning in the low risk asset management industry, Resource America’s stock is a value I find too good to pass up.

Disclosure: Long REXI, ATLS, AFN

For Further Review:

Resource America 10-Q

Resource America 10-K

The Article of the Week

Doug Kass over at thestreet.com had an interesting article late last week that focused on Berkshire Hathaway (NYSE: BRK.A) and Warren Buffett.  In his article, Kass lays out the basis for his short position in Berkshire Hathaway.  While such a position may seem absurd due to Buffett’s past success in the markets, Kass does a great job in outlining his reasoning for such a position and the article is well worth a read.      

While Kass readily admits that he is a huge fan of Buffett and all that he has done over the past four decades his suggestion that Buffett is going through a period of style drift, as seen in his large exposure to currency markets and derivatives is fairly accurate in my opinion.  Style drift as a term can be defined as occurring to an investor when they undertake a significant change to their investment philosophy.  Buffett certainly has done this over the past several years, this has in part occurred because he has been so successful in expanding his pool of capital.  Berkshire Hathaway is now so large that he can no longer invest in the vast majority of securities.       

While smaller investor’s certainly do not have the problem of having too much capital to invest they nonetheless will always fall victim to style drift.  I see Buffett’s recent style drift as merely a sign that he is actually human, prone to the same strong desire to do better then the year before as any other investor.  Yet, when investors go through a period of style drift it is usually a bad thing as rampant speculation is often the result.  Kass’s sense of opportunity in Berkshire Hathaway’s shares is as a result undoubtedly warranted.        

Time will only tell whether or not Buffett’s shift into derivatives and currencies will be successful.  While he may be just smart enough to pull it off the average investor (including myself) is not and I would advise everyone to remain focused on their area of expertise regardless of how long your run of bad luck has lasted.  Kass has an interesting article and it is worth a bit of your time.  

For Further Review:

Kass's Article at thestreet.com

Buffett Should've Picked Owens Corning

I have been a holder of Owens Corning (NYSE: OC) for a little over a year now.  I was first attracted to the company after Warren Buffett began to build a position in USG Corp. (NYSE: USG).  USG and Owens Corning are very similar as both are tied a great deal to the U.S. economy and the housing market in particular.  Yet, in comparing the two it is clear that Owens Corning is the better investment.  The most recent quarterly report by Owens Coring reinforces this view of the company.  I won’t go into the quarterly numbers in detail as a great write up, written by Todd Sullivan, can be found here.  Instead I just want to talk about why Owens Corning is a better investment then USG. 

Over the last several years, both USG and Owens Corning have emerged from bankruptcy protection.  USG emerged first and was financed in part by Warren Buffett who bought a stake in the company to help get it out of bankruptcy court.  Owens Corning emerged soon after but with far less fan fair as the company simply decided to list itself on the NYSE without doing an I.P.O.  Both of these companies were forced into bankruptcy by asbestos liabilities.  These liabilities, upon emergence from bankruptcy court, have been removed from both company’s balance sheets.

Both companies are heavily involved in the construction business and have as a result been beaten down by the collapse of the real estate bubble in the U.S.  However, when the market turns both companies will offer considerable value to shareholders.  I personally believe that Owens Corning offers the most upside potential of the two from these levels.  To understand how I’ve come to this conclusion it is important to see how much better off Owens Corning is when compared to USG.

Owens Corning is without a doubt much more diversified then USG both in terms of the number of products that it offers and the markets in which it operates.  While Owens Corning is certainly involved in all aspects of residential and commercial construction and renovation, it also has a composite business that has grown up out of its innovations in insulation.  The media is currently doing a fairly good job of hyping up this business because of its ties to the wind industry.  While the wind industry is an important end user of these products, it is most certainly not the only one. 

With the firm’s recent purchase of Saint-Gobains, an international composite company, Owens Corning has managed to have succeeded in shifting its focus into higher growth international markets that well most likely help drive the company in the future.  This international exposure will limit their dependence on the U.S. housing market in the future and allow the company to achieve higher margins.  The Owens Corning business that remains tied to the U.S. housing market well likely recover quicker then USG’s because of the fact that a large chunk of the company’s business comes from renovations.  In addition, the company is also making a big push to convince the public that its products are energy efficient and environmentally friendly.  The company’s insulation products are a great example of this as they allow homeowners to dramatically cut down on heating costs over a long period of time with only a relatively small initial investment.  I would imagine that these types of products would be appealing in any economy but particularly so in one as troubled as the U.S. economy.               

USG on the other hand is still tied to a large degree to drywall prices in the U.S.  Drywall is unfortunately a largely commodity product resulting in USG having no real pricing power.  In addition the company’s products tend to be used more in new home construction.  This will delay the company’s turnaround as people will likely be more willing to renovate before buying a newly constructed house of questionable value.

I hope that it is clear to you by now which company is the better investment.  Investing in Owens Corning represents an opportunity to out smart Warren Buffett and his purchase in the sector.  I am confident that Owens Corning will outperform USG in the future and I recommend a position in the stock on any pull back if one is seeking exposure to the sector.  I would furthermore not be surprised to see Buffett take a stake in the company as it is currently trading a discount to book value and represents an opportunity to become well positioned for the recovery in housing.  

For Further Review:

Todd Sullivan's Quarterly Review of Owens Corning

Disclosure: Long OC

Finding a Great Regional Bank

The current credit crunch has decimated America’s banking sector and the list of casualties seems to expand by the day.  Yet, I profoundly believe that investors need to have some exposure to financials, particularly regional banks, as the sector has and well continue to produce extraordinary amounts of wealth.  Due to the hybrid nature of the U.S. banking system, with both state and nationally chartered banks, there are still a considerable number of participants in the marketplace and while bank consolidation has been occurring nearly continuously for the past twenty years there is still significant consolidation that needs to take place.  This consolidation will likely occur between the local and regional banks as the money center banks such as Bank of America (NYSE: BAC) and Citigroup (NYSE: C) lack the resources and the ability to expand into every market.  With the current difficulties being experienced by the weaker regional and local banks, the ones that remain strong and well capitalized well likely benefit greatly over the next several years as they are able to gain market share.

In order to participate in this sector it is important to know what you are looking for while researching any particular regional bank.  After all, you do not want to end up picking the next blowup or IndyMac Bancorp (NYSE: IMB).  I am going to try to write about some of my favorites in the coming weeks but first I wanted to give my readers an idea of what I am looking for.  I strongly believe that regional and local banks are incredibly cheap right now, especially with the artificially low interest rates being put in place by the Federal Reserve and I urge every investor to take a second look at the sector.  It is only a matter of time in my opinion before the large institutional investors and mutual funds begin to take positions in some of the better banks.  Here is a link to a blog entry I wrote discussing the start of the mutual fund inflows into the sector, you may find it worthwhile.  Interest by institutional investors in the sector, coupled with strong earnings well likely prove to be a catalyst for the stock price of the better regional banks.

One of the most important characteristics of a strong regional bank is the strength of the bank’s management team.  Management should have considerable experience in the field, a long time association with the bank they are presently employed with and a significant ownership interest in the company.  I have found in the past that the management has been especially effective and therefore protective of the bank’s capital if they are members of the founding family or investor group; during times like these this is definitely something you want in management.  This is because a strong capital position ensures that the bank’s management has the ability to take advantage of opportunities that will likely present themselves in the future.

The second most important thing that should be considered when looking at regional banks to invest in is the bank’s loan portfolio.  I have found that the best regional banks generally steer away from residential loans in favor of commercial loans.  Banks tend to do this because commercial loans tend to have higher interest rates, higher levels of collateral (that tends to be more liquid), and allow for the building of better and more intimate client relationships.  Along with looking at the bank’s loan portfolio, make sure to evaluate the banks level of non-performing assets to loan loss allowances and the credit quality of the portfolio in general.  If there is anything funny looking I would stay away.  A large number of construction and/or land loans should be considered a warning sign as well. 

Management’s commitment to the bank can be measured by the plans for the future that the bank has.  All well run banks are continuously looking to expand their geographic footprint as well as to enter market places where they have some kind of distinct advantage that well allow them to succeed.  Their quest for deposits should in no way be discounted, as they will provide the bank with the resources it needs to expand its loan base.  Often times the best banks will partner with local business leaders and/or community banks when first entering the marketplace.  If you find this, I would bet almost anything that you have found a winner.  Partnering like this should not be viewed as a sign of weakness but as a sign of strength, as it shows that management realizes its limitations and is reaching out to others in order to over come these limitations.

When you are buying most bank stocks you are in actuality buying the bank’s holding company.  It will therefore be important to determine the financial health of the holding company, as it can be a point of major stability for the main bank.  Furthermore, if the holding company holds other financial service businesses this should be seen as a good thing as it adds diversification to the holding company.  Some of the better banks own insurance companies, brokerage firms and other specialty finance companies.  For the most part their liabilities usually never fall down to the bank and instead tend to use the bank’s client base as their own, increasing the holding company’s revenue per client.  

Now for some numbers, I strongly advise that you find local and regional banks with a return on equity of between 12% and 15% and a tier 1 capital level of over 10%.  If you can find a bank with a return on equity of over 15% with no issues and of similar characteristics to those I mentioned above you have found a winner.  Good luck with your search, I’ve got a couple banks I’ll try to write about over the next several weeks so remember check back in at my blog in the future.         

Another Great Quarter for Atlas America

Last week Atlas America (NSDQ: ATLS) reported results for the first quarter of 2008 that shows the continued success of the Atlas America story.  The company has long been a favorite of mine and a more detailed opinion of it can be found here.  For the most recent quarter, the company reported adjusted earnings per share of .46 cents driven by its 48% ownership interest in Atlas Energy Resource (NYSE: ATN) and its 64% ownership interest in Atlas Pipeline Holdings NYSE: AHD).  The dividends, management fees and incentive distribution rights for the quarter resulted in Atlas America receiving over $25 million dollars from its subsidiaries. 

Another notable piece of news from their report was their purchase of 600,000 units of Atlas Energy Resources at a price of $42 a share.  This purchase will bring Atlas America’s ownership interest in Atlas Energy Resources up to 49%.  This will help to expand the company future cash flow, as these units will have a considerable yield.  At the end of the quarter, by my calculations the holding company had a little over $105 million in cash on hand available for future dividends, investment in Lightfoot Capital and share repurchases. 

The relatively low yield being given to Atlas Energy Resources signals that the company now has a great currency, in terms of its shares, to go out and acquire new assets.  This will help Atlas America in the future as the company stands to benefit considerably from the management fees and incentive distribution rights that it derives from Atlas Energy Resources as well as Atlas Pipeline Holdings.      

Please take a look at the Atlas America story as it is a great one.

For Further Review:   

Q1 Press Release for Atlas America

The Case For Further Inflation in the Economy

In my previous entry, which can be found here, I briefly touched on my thoughts on inflation.  Today I would like to spend a little more time explaining some of the macroeconomic factors that I believe are currently converging that could lead to a dangerous increase in the rate of inflation in the future.  These factors include the increase in energy prices, the weak dollar and current US monetary policy.

The most straightforward inflationary factor that is contributing to the threat of inflation is the seemingly unrelenting rise in oil prices and other commodities.  The surge in oil prices in reminiscent of the stagflation during the 1970s caused by the '73-'74 oil embargo following US support for Israel during the Yom Kippur war. Rising energy prices across the economy led to rising prices and became the quintessential example of “cost-push” inflation as the cost to produce and transport products increased dramatically.  

Adjusted for inflation, the price of oil reached $105 in 1980 this is less then the current price of a barrel of oil, which stands around $124.  In order to understand the effects of the most recent rise in the price of oil we must take into account the percent of GDP that can be attributed to oil expenditures.  In the early1980s, oil expenditures topped out at 8% of GDP, in 2000, before oil undertook its most recent run-up oil expenditures bottomed out at about 3.5%.

However, the price of oil averaged about $28 in 2000.  Today, oil prices stand about 4.5 times the price of oil in 2000.  This run up has naturally had a significant effect on our economy and has resulted in an increase in the percentage of GDP consumed by oil expenditures.  In 2008, the U.S. economy had a GDP of approximately $14 trillion dollars; this is compared to a GDP of $10 trillion before the rise in the price of oil that began in 2000.  Now for some rough math, if you multiply 3.5% (the percent of GDP taken up by oil expenditures in 2000) by 4.5 (the increase in the price of oil from 2000 to 2008) you get 15.75%.  If you then multiple this number by $10 trillion divided by $14 trillion (or just 10/14) you can then account for the economic growth between 2000 and 2008. 

The resulting figure is 11.25%, substantially above the 8% that occurred during the 1970s.  Therefore, we can plainly state that if oil remains at these high levels for the remainder of the year the percent of GDP spent on oil expenditures will likely surpass the former peak that was achieved in the early 1980’s.  As a result, it should be clear that rise in the price of oil is clearly inflationary and could lead to similar inflation problems as the ones that occurred in the 1970s and early 1980s. 

In addition, it is worth noting that the rising oil prices of the 1970s was caused largely by an oil embargo, an event that did not last forever.  Today's rising oil prices and the prices of all commodities in general has been caused by an inability of the oil drillers and other producers to keep up with the rising demand for oil and the other commodities from China, India and the rest of the developing world.  This situation could improve as new production sites come online but there is only so much oil and other commodities out there.  The recent economic growth put on by China, India and the other developed countries will not be subsided in the future and will not be going away as the oil embargo did.

Another factor impacting the price of oil is the weak US dollar.  A week dollar affects more than just the price of oil though as it increases the cost of all other goods that are imported from overseas.  The three most important factors impacting the value of the dollar are the trade deficit, the level of US interest rates relative to rates in the rest of the world and the U.S. economy in general.  These factors all point to a weak dollar for the next six months to a year, as it will likely be only then that some of these variables begin to change. 

When the trade deficit is negative, it means that on balance more dollars are being traded for foreign goods than foreign currencies are being traded for domestic goods.  As dollars are being moved overseas, foreign companies have then had to trade their dollars for their own currencies forcing them to sell their dollars.  This has put downward pressure on the price of dollar and has helped to keep it down.  The trade deficit is still near all-time high and does not appear to be shrinking.  This is partially driven by the fact that the US imports so much oil, as the higher the price of oil goes the larger the trade deficit becomes, limiting the effect of increased exports caused by a weak dollar.

Low interest rates in the US also put downward pressure on the dollar.  This is because investors will tend to want to invest their money in countries with higher interest rates instead of in places like the US with their low interest rates.  In addition, the downward trajectory of the dollar versus the upward trajectory of the euro impacts the returns that investors receive further, pushing investment flows away from the US and towards other countries.

The dollar has been falling for the last three plus years; however, the prices of foreign goods has not skyrocketed.  This is primarily because foreign manufactures in an attempt to maintain market share have let their profit margins shrink.  It is doubtful that this trend will continue as countries begin to reexamine their own currency policies, China’s recent actions that have allowed the Yuan to appreciate is but one example.   

The final driver of inflation is US monetary policy.  The Federal Reserve and Bernanke are stuck in a very difficult situation where he has been forced to cut interest rates and increase liquidity not because the US economy is in a recession but because of the burst housing bubble and the related credit crunch in the banking system.  If the entire economy were doing poorly then a stimulative monetary policy would be a warranted.  However, when most of the economy is doing fine and only a handful of sectors needs stimulation you are forced either to stimulate the entire economy or not to stimulate anything.  In trying to fix the credit crises Bernanke has been forced to allow inflation to creep higher in other areas of the economy proving the point that there is no such thing as a free lunch.  A direct result of Bernanke’s low interest policy will be an increase in inflation.  I agree that allowing the banking system to fall apart is completely unacceptable and that Bernanke is using the correct approach; nevertheless, as with any government policy there will be unintended consequences. 

Bernanke and Greenspan have both used stimulative monetary policy to fight the problems plaguing the economy during their tenures.  Greenspan used it to fight the deflationary effects of rapid productivity growth and job outsourcing and Bernanke has been using it to help solve the credit crisis and the pain associated with the housing bubble.  However, just as Greenspan’s policy had unintended consequences so will Bernanke’s and that is why as investors we must be aware of the strong possibility that inflation will creep higher in the year ahead.

If the Federal Reserve is successful in combating the credit crisis and the asset bubble the corresponding inflation may not be a bad thing as the Federal Reserve will be forced to raise interest rates which will in turn strengthen the dollar, lower the price of commodities and encourage foreigners to invest in the United States.

For Further Review:

Department of Energy Website

Thoughts from the Past Week

It would appear that the U.S. dollar has abandoned its freefall and is now in the process of consolidating before moving higher.  Two recent articles, one by the Wall Street Journal’s online addition and the other by Business Week provide support for this argument and help explain why the dollar has reached a bottom.

It has been nearly a month since the world’s central bankers and finance ministers got together at the G-7 meeting to discuss the freefall of the dollar that has occurred over the last year.  The ministers, fearing that their currencies strength would limit their country’s exports and slow their economies coupled with their fear that a collapsing dollar would wreck havoc on the world’s financial markets compelled them to begin efforts to support the dollar.  The dollars recent stabilization is a telling sign that they have been successful.  Through talking down their own currencies, signaling to the markets the detrimental nature of a free falling dollar and in some cases the outright buying of dollars, the members of the G-7 along with the developing world have succeeded in provided support for the dollar.  Since the meeting, the dollar has appreciated by a little more the 2.5%, reversing a multi year slide.  The dollar’s poor performance and the most recent period of stabilization and recovery can be seen in the charts below:

3-year chart of the U.S dollar

1-year chart of the U.S. dollar

In addition to the efforts of the world’s finance ministers, the dollar has also been supported by the view that the Federal Reserve will likely not cut rates further.  The U.S. Economy while have weakend considerably still has not officially entered a recession.  The article by Business Week points this out, highlighting the May 2^nd unemployment data as an example.  If the U.S. economy can remain flat, avoiding negative growth (aka a recession) the dollar will likely continue its current consolidation.  It is likely that the Federal Reserve will have no choice but to raise interest rates at some point in the future, probably sometime in late 2008 or early 2009, to offset surging commodity prices and the corresponding inflation, this will provid further support for the dollar in the year ahead.

Whether or not the G-7 meeting or the likely end of interest rate cuts and a surprisingly resilient U.S. economy were the cause of the stabilization in the U.S. dollar is irrelevant.  The point is we have reached a bottom and as investors we must be prepared to begin to act accordingly over the next six months to a year.

For Further Review:

WSJ.com Article

Business Week Article 

From Blue Chip to Mediocrity: The AIG Story

The quarterly report put out by American International Group (NYSE: AIG) on Wednesday was horrendous and is yet another example of our country’s financial institutions getting themselves into trouble by taking positions in financial instruments that they have no business being involved with.  The current credit market calamity is a strong reminder that banks and insurance companies need to be run like the conservative entities that they are.  AIGs large level of pure speculation in credit default swaps runs contrary to the simple mission given to insurance companies, which is to help their policy holders manage their financial risk.  Yet when an insurance company can’t manage their own house, as in the case of AIG, can they really be trusted to manage the risk of others?  The current management led by Martin Sullivan clearly has lost all creditability and I would imagine the clock is ticking for him and his team at AIG. 

For the quarter the company reported a net loss of $7.81 billion dollars, primarily related to unrealized losses in their credit default swap portfolio.  However, even if you take these losses out the company still had a terrible quarter as nearly all of its business units were hit with significant declines in their operating income.  These declines were primarily related to poor underwriting, high losses, a drop in investment income associated with lower interest rates and in some cases a drop in revenue and premiums.  Clearly, the company is facing much more significant issues then losses in its credit default swap portfolio as the company has lost direction under the stewardship of the current management team.  Another possibility though is that the company has simply become too large and is therefore in need of a significant reorganization.

Below I have highlighted the operating results for the quarter of the majority of AIG’s divisions.  It should be clear to you that the company is simply using losses in its credit default swap portfolio as cover for larger underlying issues.

-AIG Commercial Insurance saw its operating income decline 48.3% to $958 million.  With premiums declining 14.9%

-The Personal Lines division saw operating income decline 93.3% to $7 million.  Auto insurance premiums were flat while the private client group saw premiums rise 4.8%

-United Guaranty Corporation, AIG’s mortgage insurer, saw an operating loss of $352 million for the quarter.

-AIG’s Foreign Insurance division saw its operating income decline 6.4% to $818 million even though the U.S. dollar spent the majority of the quarter near record lows.  Just think how bad this division’s numbers would have been had the dollar not declined!

-Domestic Retirement Services had operating income of $663 million, with no growth from the year ago period.

-AIG’s Foreign Life Insurance and Retirement Services showed operating income of $1.46 billion a decline of 4.1%.  Again, just think about how important the low U.S. dollar was to this division.

-American General Finance showed operating income of $11 million down 78%.

-AIG Consumer Finance Group showed operating income of $11 million down 50%. 

-The Asset Management division showed operating income of $154 million down 80%. 

Of course, we cannot forget the Capital Markets division, which showed a loss of $8.85 billion for the quarter.  Overall, the company had only two divisions that showed significant growth for the quarter.  The Domestic Life Insurance division saw operating income rise 17.8% while the Aircraft Leasing division saw operating income climb 40.9%. 

It was without a doubt a terrible quarter for AIG and one that will likely force management to reexamine the way they run their business.  This much is clear though, they should no longer be regarded as the blue chip they once were as management and the company clearly have significant issues that they must examine and address.  In my opinion when the integrity of an insurance company or a bank for that matter is questioned the company as a whole cannot be valued above book value.  As such, I do not find American International group attractive at any level above $30 dollars a share, even then I wouldn’t touch the stock until after the next report as it is entirely possible that the core business may continue to deteriorate along with the companies credit default swap portfolio.

While it may not yet be time to bring back Hank Greenberg it is clearly time for the board to take a proactive look at managements failings and the possibility of spinning off some of its subsidiaries in an effort to simply the AIG story and return it to its past glory.   

 For Further Review:

AIG Quarterly Press Release

Disclosure: None

 

Are the Commercial REITs Stabilizing?

It would appear, at least from the recent quarterly reports of four commercial REITs that the credit market, at least in the ways that it affects the commerical REITs is beginning to stabilize.  Here is a list of the four REITs that, when you consider what has happend over the last year, have reported incredible reports over the last week:

Rait Financial Trust (NYSE: RAS)

Resource Capital Corp (NYSE: RSO)  

CapitalSource (NYSE: CSE)

Alesco Financial (NYSE: AFN)

The quarterly reports put out by these four companies are all worth a read as they show four companies that are well positioned to begin expanding their businesses after a brief but sharp contraction caused by the turmoil in the credit markets last August.  In looking at the reports of these four companies, we see that all are now relatively free of short-term financings, poor performing CMBS & RMBS securities and nonperforming whole loans.  They are all undoubtedly preparing to expand into new areas of the commercial loan market in the future as their cash situations allow.  While shareholders wait for the companies to begin expanding again, the dividends of these four respective companies can be collected as they are quite safe at their current levels.  The adjusted earnings of the four should all cover the common stock dividends for the foreseeable future.

For the most part theses companies have removed a large majority of the questions that have been surrounding them, especially after taking the appropriate write-downs over the last year.  The assets that remain are all of high credit quality and show no signs of increasing delinquency rates.   For example Rait Financial Trust now has no net short term liabilities on its balance sheet and its residential mortgage portfolio, which totals $3.96 billion, has only experienced $3.1 million in losses since its inception three years ago.  In the case of Resource Capital, their quarterly report showed their business of commercial real estate and commercial finance lending has continued to thrive as can be seen in their increase production.  It does not hurt that Resource Capital is now benefiting from a fairly wide yield curve, thanks to the Federal Reserve's actions.  CapitalSource is another example of a company that has addressed its problems through proactive measures designed to protect its funding base.  Its purchase of Fremont’s bank in Californian (minus its loans) has ensured that the company has quite possibly the deepest and widest funding base of any of the publicly traded commercial REITs.  Finally, Alesco Financial has managed to limit loan losses and preserve cash as it prepares to either acquire new assets to maintain its REIT status or convert to a more capital efficient entity.

To close, the results of these companies should not be ignored as they show credit market dependent companies surviving and in most cases growing, if only slightly.  As the Federal Reserve’s policy of low interest rates begin to open up the credit market these companies will be well positioned to benefit.      

For Further Review:

Rait Financial Press Release

Recource Capital Corp. Press Release

CapitalSource Press Release

Alesco Financial Press Release      

 Disclosure: Long CSE & AFN

Can Fannie Mae Survive?

There was a great piece Tuesday morning put out by Charles Duhigg of the New York Times, Duhigg's article was an examination on the precarious nature that Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE) are now finding themselves in after substantial losses in their mortgage portfolios and the mortgages that they insure.  The article was perfectly timed to coincide with Fannie Mae’s earnings release Tuesday morning.  

Fannie Mae’s earnings were a little worse then some analysts were expecting but on the whole they showed a company that was still functioning quite well and doing a fairly good job of adjusting to the new environment it has found itself in.  The headline numbers of course were not encouraging as the company lost $2.18 billion for the quarter and stated its plan to raise $6 billion in new capital.  Another challenge the company has been struggling to deal with as a government mandated corporate entity has been the capital requirements that come along with being such an entity.  This has been a difficult for the company as shareholder equity dropped from $44 billion at the end of 2007 to $38.8 billion at the end of last quarter.  The level of core capital, which is measured slightly differently then shareholder’s equity, stood at about $42.7 billion at the end of the quarter giving the company a capital surplus of about $5.1 billion. 

While it is clear that Fannie Mae is facing a challenging environment there were some bright spots in its quarterly report that have gone relatively unnoticed and believe likely point to the company surviving its current ailments.  One bright spot, can be seen in the dramatic drop in interest rates caused by the Federal Reserve's cuts, Fannie Mae is now dramatically benefiting from low short-term interest rates and a widening of its interest rate spread.  For the quarter net interest income climbed to $1.69 billion up $554 million from the previous quarter’s total of $1.14 billion.  Management stated in the investor summary section of their quarterly report that they expect this trend to continue well into 2008, resulting in a substantial increase in net interest income over the prior year.  The graph below can be found in management’s supplemental material to the quarterly report and shows the impact of the Federal Reserve's recent interest rate cuts.   

The expansion of net interest income, coupled with the other bright spot in the company's report; higher fees and premiums related to Fannie Mae’s guaranteeing of 2.4 trillion in mortgages should help the company expand its revenue base in the coming year.  The insurance side of Fannie Mae saw its premiums jump $130 million for the quarter to $1.75 billion.  While the revenue growth in the two areas mentioned above will not be enough to prevent further capital raises, they will give management something to sell to investors and regulators. 

Fannie Mae’s inability to take gigantic write downs or loan loss provisions will undoubtedly force it to raise capital on probably a semi annul basis to ensure that it meets its regulatory capital requirements, these share offerings will likely be in a similar to what was announced this week.  I would under no circumstances want to own shares in the company as dilution will likely severally impair the value held by current shareholders.  However, I strongly believe that it is important to understand how the company works as it plays an incredibly important role in the American economy.  

Is a full-scale bailout going to be necessary as some individuals have speculated?  Its hard to say but I don't think so, while the company either holds or guarantees $51 billion in sub-prime mortgages and $344 billion in Alt-A mortgages the company has been facing delinquency rates of only about 1.15% as of last quarter, which is still fairly low.  Furthermore, 42% of the sub-prime securities it has ties with are rated AAA by the rating agencies (for what its worth), as are all of the Alt-A mortgages the company is on the book for.  

Time shall tell whether or not Fannie Mae will be able to offset some of its loan losses and mark-to-market losses with new revenue streams and the rest of the losses through capital raises, it will likely be close, but I believe the company will remain an independent entity a year from now with a shareholder base that will likely have expanded considerably.    

For Further Review:

New York Times Article             

Fannie Mae Q1 Investor Summary            

Fannie Mae Press Release    

Disclosure: None

Contemplating a Microsoft Buyback

This weekend’s news that Microsoft (NSDQ: MSFT) has withdrawn its offer for Yahoo (NSDQ: YHOO) after deciding that it would not be appropriate for the company to raise its offer will likely begin a familiar discussion on what Microsoft should do with its huge cash position. From the outset, the deal was questionable as it was clear early on that Microsoft shareholders were not in favor of buying Yahoo. Any other acquisition that would be as dilutive is now also unlikely as Ballmer & company are clearly on the defensive in their quest to build shareholder value at Microsoft. What is Microsoft to do then?

One option in my opinion is to undertake a substantial share repurchase, similar to the one conducted several years ago, in the hope of giving the company’s earnings per share figure a boost. It is by far the safest option for management, as it poses no integration risks and allows management to stay focused on software. Currently, the company has about $26 Billion in cash and short-term investments that yielded a little less then $1.5 Billion or so over the last year. As such, any calculation made to try to figure out the company’s earnings per share would have to take the loss of this income into account. In addition, if the company were to take on debt to expand the repurchase those figures would also have to be set and taken into account. In my analysis, I had Microsoft issuing bonds with a 20-year maturity at about 6% with the principal repaid evenly over the period. The 6% figure would likely be high, as triple A rated corporate debt is in large demand right now.

Here are some of my calculations:

Level of Share Repurchase	EPS Total for Next 4 Qs (Previous 4Qs EPS Total was 1.81)	Shares Outstanding
None	$19.17 Billion or $2.06	9.30 Billion
$26 Billion in Cash & No Debt	$17.67 Billion or $2.10	8.40 Billion
$26 Billion in Cash & $10 Billion in Debt	$16.57 Billion or $2.06	8.05 Billion
$26 Billion in Cash & $20 Billion in Debt	$15.47 Billion or $2.01	7.71 Billion
$26 Billion in Cash & $30 Billion in Debt	$14.37 Billion or $1.95	7.36 Billion
$26 Billion in Cash & $40 Billion in Debt	$13.27 Billion or $1.89	7.01 Billion
$26 Billion in Cash & $80 Billion in Debt	$8.87 Billion or $1.57	5.63 Billion

From the extremely rough calculations above, it is clear that it will be very hard for Microsoft to add significant value for its shareholders regardless of what it does. Yet, a large share repurchase, financed with $26 billion in cash on hand and another $20 to $40 billion in debt would go a long ways to pleasing shareholders, as it would add earnings leverage to Microsoft for the first time in decades. Microsoft’s large cash flow generation would allow it to repay the debt much faster then the 20-year figure I used in my calculations. This gives them the ability to undertake a large repurchase without the fear of analysts or investors hammering the company’s stock price to severely as the earning per share would likely climb considerably within 3-5 years as the debt is repaid faster then a normal bond issue. 

While getting money from banks to undertake the buyout is clearly out of the question (a term loan would be preferable as it would be easier to repay then bonds), I’m sure the bond market would easily digest an offering from Microsoft as it would likely be as safe as a Treasury and yield slightly more. With interest rates at near all time lows, this just might be the time for Microsoft to undertake such an action. If the Federal Reserve is forced to raise rates substantially later this year or at the start of 2009, Microsoft’s repurchases would undoubtedly look quite smart. This would leave the remaining shareholders benefiting tremendously from the effect of organic growth and the power of inflation to help long term fixed rate borrowers.

Will Microsoft be this aggressive though? Likely not, as they have a stated policy of keeping considerable cash on hand for such things as R&D, legal expenses, operations and acquisitions. However, it is fun to speculate nonetheless.

For Further Review:

Microsoft's Most Recent 10-Q

The Article of the Week

Financials have had without a doubt one of the worst years in recent memory.  From the first hint of trouble in February to the credit markets near collapse in August and the continuous write down of assets by banks from August to the present, it has proved to be a very bad year for banks and their stockholders.  Investors who bought financial stocks in August were likely under the impression that they were getting deep discounts on their shares, and they were, but from levels that were no longer relevant.  The same can be said for those investors who had the misfortune of purchasing the financials in November.  However, with February’s decline and the subsequent level of support that has been established the question arises; is now finally the time to buy financials?

Apparently, it is.  At least according to Harry Lange, the manager of Fidelity’s Magellan Fund who had a story written up about him on Bloomberg.com this week.  The subject of the piece was his recent purchases in the financials and in such names as Bank of America (NYSE: BAC) and J.P. Morgan (NYSE: JPM).  This is the first piece in the financial press, to my knowledge, that has shown a large mutual fund manager beginning to purchase financials or at the very least acknowledge to be buying financials in bulk.  I wonder if this will mark the beginning of a new inflow of capital into the financial side of the market as mutual funds begin to chase the value that they perceive to be in financials.  If a shift in sentiment is occurring it is incredibly important that private investors begin to shift into financials as well so that they can catch the momentum that the large mutual funds will likely create once they begin to expand their holdings in the industry.   

While it is clear from the many “bottoms” in financials over the last year is that it is next to impossible to call a bottom, the news that a fund such as Lange’s Magellan is beginning to increase its exposure to the financials should be seen as encouraging news.  While their primary picks mentioned in the article are Bank of America and J.P. Morgan are both interesting given their relatively strong position among their peers.  I believe that better value exists in the regional banks and that this is where investors should focus their exposure to the sector.  I plan on discussing my favorite regional banks in the future but for the time being I would give the following guidelines to those looking to invest in this part of the industry:  Stick to the area east of the Rockies, west of the Mississippi and to the areas south of the Mason-Dixon line in the Southeast, with the exception of Florida.  If you find a bank east of the Hudson, it might be worth looking into as well.  Whatever you do, please pay no attention to the West Coast, Southwest or Ohio Valley banks as they are in considerable trouble. 

If you have the time, please take a look at this short article and contemplate increasing your exposure to banks prior to the rush of mutual funds that are likely seeking to do the same thing.  The regionally sound economies of the areas listed above, coupled with low interest rates should help the banks in these specific regions produce strong results in the last half of this year.

For Further Review:

Magellan Buying Financials

       

Continued Success at the Atlas Companies

I have for sometime been a fan of Atlas America (NSDQ: ATLS) and its publicly traded subsidiary companies, Atlas Energy Resources (NYSE: ATN) and Atlas Pipeline Holdings (NYSE: AHD).  The Atlas companies as I will refer to the three, are some of the best-run energy companies available to private investors.  The Cohen family, which manages all three as will as several other publicly traded companies have this profound ability to turn everything the touch into gold.  Atlas America is no exception to this rule.      

I prefer Atlas America as an investment because it allows you to gain exposure to all of the Atlas companies through its role as a holding company.  I have previously talked in detail about Atlas America and a review of the company and my opinions of it can be found here.  Today, I thought I would highlight the superb results that came out last night from Atlas Energy Resources of which Atlas America owns a 48% interest.  

For the quarter ended on March 31st Atlas Energy Resources reported a 189% jump in EBITDA from $21 million during the same quarter last year to $79 million this year.  Distributable cash flow, which is incredibly important to valuing Atlas Energy Resources as it is a limited partnership, jumped 196% to $53 million from $18 million in same quarter last year.  Revenues as a whole, which is derived primarily from natural gas production, jumped 85% on a year over year basis.  The firm is clearly showing dramatic organic growth and a profound ability to successfully integrate its 2007 acquisitions.

Several points in the press release which I believe should be of special interest to investors are the company's statements that organic growth in its appalachian division was 26% for the quarter  while the firm's margins improved by 30% as a result of the success of its partnerships.  For those of you that are not aware of Atlas Energy Resource's unique partnership model I would advise looking into it as it allows the company to conduct substantial amounts of drilling without investing significant amounts of its own capital, leaving more money for shareholder dividends and future growth. 

An example of the size and importance of these partnerships can be found in the companies launch of a new partnership fund that is expected to bring in $236 million.  The partnership arrangement cannot support all future growth as seen in the companies dramatic increase in capital expenditures to $42 million for the quarter from a mere $13 million a year ago.  These investments will undoubtedly help to lay the groundwork for the firm's future success.  This quarter's results make Atlas America (as the majority owner of Atlas Energy Resources) as compelling as ever, the firm is without a doubt worth some of your time as it offers a rare opportunity to outperform the market with less risk over the long haul.                

For Further Review:

Atlas Energy Resource's Quarterly Report

Are Californian Banks Really that Bad?

In short, the answer to the question in the title above is an emphatic yes.  If the results put out by Downey Financial (NYSE:DSL) in mid April did not confirm this, further support can be found in the most recent quarterly report put out by PFF Bancorp (NYSE:PFB).  The report was absolutely terrible as it showed that the bank was taking on gargantuan losses in its loan portfolio requiring it to dramatically increase its loan loss provision and forcing the company to seek additional support in the form of loans from other commercial banks.  PFF Bancorp began the quarter with a book value of approximately $360 million, which has likely dwindled to a third of that after taking a $200 million dollar loan loss provision this week.  The news of these write downs sent the stock down over 30% on the day leaving it down 90% for the year, yet even with this decline there is still no value in this bank as the likelihood of increasing loan losses will eventually lead to the banks insolvency.  

With the addition of these reserves, the bank now has about $270 million in loan loss reserves on its balance sheet.  With total loans of somewhere around $4 billion the company has a loan loss reserve ratio of a little over 6%.  While in normal times this high of a rate would be considered excessive it should be clear by now that we are not in normal times.  The bank is still likely under funding its reserves as it has substantial exposure to various homebuilders and raw land.  Here is a breakdown of the banks more questionable loans:

 -300+ million in land loans

-200+ million in subordinated debt (probably second mortgages)

-600+ million in 1-4 family construction projects

-200+ million in revolving loans (probably home equity lines)

Even if you exclude the majority of their mortgages PFF Bancorp has over a quarter of their loans tied up in areas that will likely continue to perform poorly.  While the bank's loan loss reserves are now a little over 6% of assets there remains significant risk because of the potential for loan losses in the above listed areas.  If loan loss reserves were to be brought up to 10%, the bank would eliminate its equity base forcing the FDIC to take action to protect the bank’s depositors. 

If Downey Financial can be seen as a harbinger of future loan loss rates in California, PFF Bancorp and other banks in California will be in significant trouble.  For the most recent quarter Downey Financial had over 12% of its loans classified as non-performing with this rate likely to jump substantially higher in the months ahead as housing prices continue to fall and mortgage rates reset to higher levels.  If PFF Bancorp’s loans were to perform at the same level as those of Downey Financial, bankruptcy would be all but assured for the company.

What I have found especially troubling is the speed by which PFF Bancorp has managed to collapse.  The company only recently began taking large loan reserves after taking barely any in 2006 and the first part of 2007, which has forced it to play a painful game of catchup.  The most unsettling part of PFF Bancorp’s story though is that its own estimated loan loss reserves for the quarter nearly doubled between April 1^st to May 1^st.  This suggests that further deterioration has been occurring in the California market.  

Right now, I think that the banks out west will likely need to take a minimum write off of 10 to 20% of their loan portfolios.  Even at these high levels, I would not be surprised to see the losses taken by these banks climb above this range should the U.S. economy enter into a protracted recession. 

Below is a list of other California Banks and Savings and Loans that I am watching:

-FirstFed Financial Corp (FED)

-Wachovia Corp (WB) (via their acquisitions of Golden West)

-Pacific Capital Bancorp (PCBC)

-UnionBanCal Corp (UB)

-UCBH Holdings (UCBH)

-Cathay Genearl Bancorp (CATY)

For Further Review:

PFF Bancorp Press Release