Here is our latest comment FYI. Barry is wandering the wilds of Michigan and will be back soon with lots of channel observations. Chris
April 23, 2009
“What’s right about America is that although we have a mess of problems, we have great capacity – intellect and resources – to do some thing about them.”Henry Ford II
(1917 – 1987)
First, next Thursday, April 30, 2009, we will be participating in an important event in Philadelphia, “The Financial System, Banks & Economy: After the Storm…Where Are We Now?” The morning program includes Barry Ritholtz of Fusion IQ, David Kotok and Bob Eisenbeis of Cumberland Advisers, William Poole of CATO Institute and Diane Swonk of Mesirow Financial. For more information or to register, please click here: http://www.interdependence.org/Event-04-30-09.php
Next, we wish to thank the FDIC for the quick response to our last comment (“Can Citigroup Be Restructured Without an FDIC Resolution?”), where we suggested that the public record of the US banking industry is incomplete. We revised same to reflect their views. Bottom line is that the FDIC is presenting the bank unit data gathered from insured depository institutions correctly and consistent with GAAP.
Trouble is, while the current methodology may be precisely correct in a compliance and GAAP sense as it applies to federally insured legal entities, in our view and from a portfolio perspective, the FDIC dataset still is missing significant historic loss data, not just in 2008 but in previous years. Part of this situation stems from the “survivor bias” in the data. More, the impact of the timing of certain transactions and the use of GAAP purchase accounting has created some seemingly significant anomalies in both the historic record of the industry’s loss experience and in how GAAP accounting creates hidden reserves for acquirers, reserves that largely are invisible to retail investors but seemingly create distortions in reported earnings.
One reason that we took the risk of pissing off our friends at the FDIC by persisting with questions about the accounting treatment of the purchase of Wachovia Bank by Wells Fargo (NYSE:WFC), for example, is not only because the Q4 2008 industry data does not, in fact, include the charge-offs from Wachovia, realized losses that total into the tens of billions dollars. No, we were also interested in understanding how WFC got a little side benefit – a “cookie jar” in earnings terms – that is an effective subsidy for WFC to help absorb the cost of remediating the Wachovia portfolio.
Jonathan Weil of Bloomberg News wrote a very good analysis of WFC that puts the size of the cookie jar at $7.5 billion: http://www.bloomberg.com/apps/news?pid=newsarchive&sid=a6sv0hG.nW7g
For those not familiar with the cookie jar concept, we turn back the pages of the proverbial comic book to pre-2004, when Sanford I. Weill was the King of the Citi and the folks at the SEC were sound asleep when it came to hidden reserves. During Sandy’s shopping spree to build the great financial bodega now know as Citigroup, Weill accumulated a number of acquisitions and, thanks to the benefits of good legal advice and purchase accounting, was able to amass a considerable, undisclosed reserve position.
According to a senior Citibanker who worked at the organization during the past two decades, the impact of GAAP and purchase accounting on acquired reserves allowed Citi to significantly understate its loss rates for years. And remember that, even with this hidden loss offset, C remained an outlier in terms of large bank credit loss rates. So, for the sake of argument, say the Weill cookie jar provided a 25bp difference in average charge-offs, that difference could have made a significant difference in the perception of investors and rating agencies.
But on to the main course. Last week, after we were done with nearly an hour of blissful economic dialog with Tom Keene on Bloomberg Radio, we ended with a thought about William Clay Ford, Chairman of Ford Motor Co. (NYSE:F). We recalled the 2005 Annual Meeting in Wilmington, DE, when Billy Ford patiently managed the flow of shareholders and activists who come each year. But near the end of the meeting, Bill’s cousin Charlotte stood up and, with tears in her eyes and speaking on behalf of the entire Ford family, declared her support.
“This company means everything to us,” she said. “We had no idea when you took over in 1999 that the industry would become so cutthroat and so difficult. We put all of our trust in you six years ago and you have it today.”
Those were pretty dark days for F, Billy and the Ford family, and the entire industry. But following that nadir, Bill Ford did two things that proved decisive. First, he restructured F financially, raising cash when it was available and, in effect, placing the entire risk of the enterprise with his creditors. Every asset that could be leveraged was levered so that today the creditors pretty much have divided up all of the available collateral.
Second, he hired Alan Mulally from Boeing in 2006, placing the operational restructuring of F in the hands of a tough, competent outsider with no ties to the past management team. By taking the risk of reaching outside the sometimes overly insular F family, Bill Ford breathed new life into the enterprise begun and grown by Henry and Edsel Ford, and cared for by Henry II and a long line of Ford Men like James Couzens, Ernie Breech, and Lee Iacocca, essential outside leaders of whom Mulally is the most recent. And today all of the departed Ford Men would probably say to Billy Ford: “Well done.”
Watching General Motors (NYSE:GM) and its former affiliates like Delphi and GMAC twist in the wind, the difference in position now enjoyed by F seems remarkable compared with several years ago. Who would have predicted two years ago that F would be the survivor in the North American auto market? With a government imposed deadline facing GM, its bond holders and the recalcitrant unions, it appears that the predictions of GM being the default winner were wide of the mark. More, perhaps the other troubled financials and industrials should look at the key decision that has saved F from the current financial mess, namely a financial restructuring that has essentially given the economic ownership of F to its creditors.
Look at the financials for GMAC, which included a $12 billion gain on the extinguishment of debt in its 2008 results. It is hard for us to imagine how this new bank holding company can possibly survive as a going concern much less following a GM bankruptcy filing. GMAC may well be the weakest BHC in the Stress Test group, even weaker than C. And yes, GMAC is the parent of GMAC Bank, which was rated “F” by the IRA Bank Monitor as of year-end 2008.
GMAC Bank is the institution that is banging away on national TV and radio ads, trying to attract deposits to keep its struggling parent afloat. Only 58% of GMAC Bank’s $32 billion in assets were supported by deposits at the end of 2008, with nearly 30% supported by advanced from the FHLBs. The bank’s default rate is not awful at 115bp, but the Economic Capital model in the IRA Bank Monitor assigns a RAROC of -26% to GMAC Bank because of the composition of assets on the investment book.
As in the case if GM, we think it is time for President Obama to suggest to the bond holders of GMAC, C, Bank of America (NYSE:BAC) and other weak BHCs that they need to start talking about a conversion plan into equity. Just as negotiations are now underway between GM and its bond holders, and Chrysler and its creditors, GMAC and the other newly minted BHCs like Goldman Sachs (NYSE:GS), Morgan Stanley (NYSE:MS) and American Express (NYSE:AMX) need to start a conversation with the true “owners” of these companies, namely the bond holders.
The good news is that as and when an adult conversation does begin between the bond holders and the managers of these zombie BHCs, we will be on the path to recovery. Remember, whether you talk about GS or MS or any of the other “new” BHCs, paying back the TARP equity is not the issue. The key issue is where can these BHCs fund themselves in the capital markets without a government guarantee? Point is, F has already restructured itself financially and thus can now focus entirely on rebuilding its operations. The rest of the marketplace needs to take notice of the F example.
We suggest that until there is an explicit understanding between the debt holders of the major BHCs and commercial companies such as GM, the managers and the US government, all of this talk about repaying TARP equity and a recovery in financials is pointless. Ultimately the choice facing bond holders at C, GM, GMAC and even GS is conversion or liquidation.
To us, until the debt holders stop whining and step up to the plate to support these enterprises in the same way that F’s creditors have helped that large automaker, we cannot end the crisis of confidence that will prevent all of these wounded firms from funding themselves in the private markets. When that decision is eventually made, however, the recovery will have well and truly begun.
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