Goldman Sachs and the Financials

A few thoughts on Goldman's two announcements last night.

First off, I find it somewhat amusing that the entire financial arena is trading up in the pre-market on Goldman's earnings release (except Goldman which is trading slightly lower). Most of Goldman's business segments registered declines in the quarter. The quarter was really driven by a blowout performance in the fixed income, currency and commodity (FICC) trading group, where revenues more than doubled year-over-year. On the conference call, Goldman made a point of stressing that FICC benefited from less competition.

So, the business lines that the large competitors operate in are still in decline. The one bright spot is a business line that the competition pulled back from. This competitor retrenchment meant outsized profits for Goldman, but it also means that the competition won't be enjoying the same boost to revenue and earnings. Let's not forget that trading is extremely lumpy. Projecting this type of performance forward would not be prudent.

Goldman clearly benefited in the quarter due to an opportunity that the competition provided. Does it really make sense to view Goldman's report as bullish for the entire sector?

Also, Goldman reported that they will be raising $5 billion in equity to help fund the repayment of the TARP capital. The TARP funds cost Goldman 5% for the first 3 years and then 9% afterward. So, Goldman wants to dilute its shareholders to the tune of 8% to pay back funds that are costing it 5%. There is no way that Goldman could get access to a cheaper $10 billion right now.

Recall, the preferred deal that Buffett struck with Goldman last September. That will cost Goldman 10% (on $5 billion) every year. In addition, Buffett received warrants on $5 billion of new Goldman shares. So why isn't Goldman using the funds it will raise from the offering to pay off the Buffett preferred? Goldman would have to pay a 10% penalty, so the cost today would be $5.5 billion, but it would save $500 million a year. Over 5 years, that would work out to $2.5 billion. Instead, Goldman wants to repay TARP. A $5.5 billion repayment of TARP would save $275 million over the first three years (at 5% interest) and $495 million over subsequent years.

To sum up, paying back Buffett would save $2.5 billion over 5 years while paying back a comparable amount of TARP would save just over $1.8 billion over 5 years. Goldman could save $685 million over the next 5 years by paying back Buffett instead of the Treasury. The only logical explanation is that the cost of the TARP funds is more than just the 5% financial cost. Goldman doesn't want the government dictating how it runs its business. More specifically, I suspect, Goldman doesn't want the government limiting their compensation.

It looks like shareholders are getting a raw deal. They are being diluted to raise funds to repay inexpensive funds so management can extract more value from the company in the form of higher compensation which will be paid by the same shareholders. Furthermore, the folks at Goldman are bright people. They're not selling stock here because they think its cheap. If they're selling, I'm not buying.

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The Market Rubbernecker is affiliated with Aspera Financial, LLC, a registered investment advisor. Please read the disclaimer on the home page of the Market Rubbernecker site.

Fama On Bank Recapitalization

There were many factors to consider when choosing an MBA program, but the truth is that I settled on the University of Chicago because that's where I could study under Eugene Fama. The two classes I took with him have proven well worth the price of admission (I am not receiving a referral fee from the University).

Fama has recently started a blog (with his colleague Kenneth French) which is the latest addition to my must-read list. His most recent piece on bank recapitalization discusses the impact that various forms of equity injections have on the U.S. taxpayer and bank stakeholders. It's not the lightest read, but he makes some very good points.

Link to article

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The Market Rubbernecker is affiliated with Aspera Financial, LLC, a registered investment advisor. Please read the disclaimer on the home page of the Market Rubbernecker site.

Citigroup Bailout: Payback For Wachovia?

If you can't beat 'em...

I'm having some mixed feelings this morning. I've repeatedly expressed my frustration with the serial bailouts by the government and the Fed, and this morning we wake to learn that Citigroup will be added to our Bailout Wall of Shame. On the one hand, it pains me to see more taxpayer money being wasted.

On the other hand, I bought shares of Citigroup late last week for our more aggressive clients. This was my first foray into financials on the long side in quite a while, and I can't say that the purchase (a modest position) was made with an extreme amount of confidence. I viewed the purchase of the common more like a call option with (hopefully) no expiration.

It was clear to all that Citi was too big too fail. It was also clear later last week that the company was likely to need some government assistance, if for no other reason than to shore up confidence. The questions were how extensive the support would be and how much dilution would occur to the existing shareholders.

Now it's time for a little conspiracy theory. My sense was that Citigroup had a "get out of jail free" card to play. Recall, Citi had reached a deal to buy Wachovia with a government backstop not too dissimilar from what they are now receiving. That Wachovia deal was eventually scuttled when Wells Fargo came in with a counter offer. Citi then filed but soon dropped a $60 billion lawsuit to block the Wells deal. Why concede Wachovia so quickly, and why drop the suit? I can't help but think that Citi was assured of some preferential treatment in the future for quietly stepping aside in the Wachovia fight.

Whether or not there was any backroom agreement, Citi is certainly getting some good terms with this bailout.

• Citi is getting another $20 billion in cash from the Treasury.
  
• Citi will also get governement guarantees on a $306 billion pool of garbage assets. Citi will eat the first $29 billion of losses on this pool, and the government will cover 90% of additional losses. The guarantees are for 10 years on residential assets and five years for nonresidential assets.
• The government receives $27 billion of preferred shares yielding 8%. This is a higher yield than the Treasury is receiving from its first round of preferred share issuance under the TARP plan, but it's less than Warren Buffet is receiving from his GE and Goldman deals (10%).
  
• The government also receives warrants to buy 254 million common shares of Citigroup at $10.61.
  
• Citi essentially has to eliminate its dividend, which is something it should have done anyway.
• There will be some controls placed on executive compensation.
• No management changes at Citi are required.
  

This strikes me as a great deal for Citigroup considering the market value of the company was only $20 billion heading into the weekend. This deal certainly doesn't guarantee that Citi will now prosper. They have a huge balance sheet beyond the $306 billion pool that will be covered by this agreement, and with the economy flailing, the company is sure to experience continued difficulties in the near-term.

This agreement does, however, buy Citi more time to address its balance sheet. The pressure will continue for the company to shed some of its assets. Buyers will be hard to come by, but just today we're hearing of potential interest from HSBC in some of Citi's foreign assets. Any asset sale would probably be greeted warmly by the market.

As for what to do now with this position given today's news, I plan to sit tight. I still view it as a call option - hopefully now a LEAP. It's nice that it's in-the-money (at least for the moment), and if it had an expiration (bankruptcy) date, that date has now been extended into the future. The government has explicitly signaled today that Citigroup is clearly too big too fail, and importantly, the government wasn't interested in wiping out the shareholders. Perhaps they feared that wiping out Citi's common shareholders would only make it harder for other banks to raise new equity capital.

Disclosure: The Rubbernecker is actually long a financial but still short the poor U.S. taxpayer.

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The Market Rubbernecker is affiliated with Aspera Financial, LLC, a registered investment advisor. Please read the disclaimer on the home page of the Market Rubbernecker site.

Tis The Season

It's been a slow week posting-wise thanks to a busy week earnings season-wise. Earnings season is always a bit of a mind-numbing experience. Every day is met with a barrage of press releases, numerous analyst rating changes, and back-to-back conference calls with management explaining how their quarterly earnings would have been an all-time record if you just ignore the write-offs, higher commodity costs, lawsuits, accounting system transition issues, margin shortfall, higher tax rate, options expense, weather impact, goodwill amortization, order push-outs, and poor feng shui. It makes for some long days.

Of course, there are companies reporting good earnings -- mostly commodity-related companies, those benefiting from international growth and the weak dollar, and those that operate pawn shops. Those with the most excuses are the financials. The typical bank conference call this quarter can be summed up as follows:

We’re disappointed to report a record loss of 12 kajillion dollars, but our core business is performing strongly as you can see if you strip out the mark-to-market losses and the charge-offs.

Well, if I ignore my lack of buoyancy and my inability to breathe in the water, then I'm a world-class swimmer. They’re a bank! The purpose for their existence is to attract deposits/funds and invest the proceeds in securities and loans. It’s like Microsoft saying, “We had a great quarter aside from terrible software sales.”

Let’s be very clear. When a bank has to charge-off a good chunk of its loans, it's an admission that prior period earnings were overstated. Prior earnings benefited from these loans back when borrowers were actually making their payments and the bank wasn’t adding to reserves. These guys want the benefit of the overinflated prior period earnings but no penalty for the current period charge-offs. It would be genius if it weren't so ridiculous.

Despite some truly poor earnings in general from the financial sector this quarter, we did witness a very robust rally in the group. This wasn't terribly surprising. As I wrote on July 15^th in my Trader VIX post,

...the VIX has had an uncanny ability to predict short-term rallies (lasting between 2 weeks to 3 months) in the S&P 500 (top chart) each time it has exceeded 30 in the past year. As the VIX has approached this level, I've been less inclined to initiate new short positions and more inclined to cover existing shorts. Note that the intraday high for the VIX today was 30.81.

It seems I wasn’t the only one watching the VIX. Almost as soon as the VIX crossed 30, the market made its most recent low and began its latest bounce. With financials having been sold-off so brutally over the prior 2 ½ months, it was no surprise that they benefited the most from the rally.

Also from the Trader VIX post,

In general, I'm expecting plenty of earnings misses and fairly restrained (to put it mildly) earnings guidance over the next month. But, with cash on the sidelines and a pervasive sense of gloom in the market, an earnings season short of cataclysmic may be just enough to spur the next bear market rally.

This also turned out to be the case. Prior to Thursday, the S&P 500 rallied more than 6% over a mere 6 trading days. Generally speaking, the earnings results from the financials were awful, but since they turned out to be less terrible than feared, the group enjoyed a powerful rally.

The other strong move of note this month has been the sell-off in practically every commodity and commodity-related company. I’ve been cautioning that this would happen at some point and that this is normal bull market activity. I had pared back exposure to the group and have been keeping some dry powder ready for just such a pullback.

In recent days, I’ve been gradually putting some of that dry powder back to work, adding to some energy, metals, and agriculture names. I anticipate adding further should investors continue to bail out. As for the financials, I've had no interest in chasing the latest rally. For now, I'm on the sidelines, but should the group rally further, I'll be looking to rebuild a short position in the sector.

My writing is likely to continue to be a little thin over the next couple of weeks since we're in the meat of earnings season. I'm not as effective or coherent a writer when I'm in an earnings release-induced state of catatonia.

Disclosure: The Rubbernecker is long commodities and caffeine and very short sleep.

Dear Freddie

Dear Freddie,

By the time you read this, I’ll be gone. I’m sorry for doing this, but it’s for the best. I know this might come as a bit of a surprise to you, especially since I’ve been so happy lately. I’ve certainly benefited from our relationship, but I’ve gotten as much out of it as I should reasonably expect. Although we could have dragged this out a little longer, I think it’s in my best interest to move on.

I’ve come to realize that our association isn't healthy as it was built only on lies, misleading communication, and our differences. Even when it came to finances, we never really clicked. I’m financially independent and you’re not. I’m fairly frugal, but you just can’t stop spending. I care about quality and value while you like chasing the latest fad. I prefer to save, and you prefer to borrow. Furthermore, you’re not nearly as popular as you used to be, you don’t make as much money, your credit score is falling, and you’re always arguing with your supervisor.

Anyway, I’m going online to peruse the Edgar filings for some new friends. I’d still like to keep in touch. Who knows. In another time under different circumstances, maybe I’ll look you up again.

Yours,

MR

P.S. Rumors that I've been seen hanging out with your cousins, Fannie and Sallie, are completely false. They're both girls of low moral character.

Ok. Let's get serious. Per my recent quarterly portfolio commentary, I began reducing short positions in the financial sector at the end of last quarter, and I mentioned that I would be looking for opportunities to further reduce exposure if the sector continued selling off. Today's 20%+ decline in Freddie Mac shares provided just this opportunity.

FRE - One year

FRE Today

credit: BigCharts.com

From the New York Times today:

Shares of Fannie Mae and Freddie Mac, the largest providers of funding for United States home mortgages, plunged Monday on concern the companies need to raise more capital amid larger-than-expected losses.

The corporate “federal agency” debt obligations and mortgage-backed securities guaranteed by the companies also plummeted relative to government debt as investors thinned positions, analysts said.

Today's collapse holds a special place in my heart. My first post on the Market Rubbernecker actually dealt with FNM and FRE and the issue of their capital adequacy. In that post, I took issue with the sharp rebound that the shares experienced in mid-March (see chart above) following the announcement that their capital requirements were actually being reduced which would allow them to expand their portfolios in the midst of a housing bust.

Those concerns about capital adequacy have clearly been weighing on investors after that mid-March climb as shares have lost about 50% since then, with another 20% getting lopped off today. As I stated back in March, there is a very good chance that the equity holders of FNM and FRE will be wiped out, and I still believe that may happen. Despite that, Aspera's clients have had a very nice gain from the FRE short, and I usually prefer to exit a position a little early and leave a little something for the next guy (FRE was sold today in the $11.30-11.40 range).

I still have a short position in Wachovia, but I've now covered most of the financial shorts. I also reduced exposure to TWM intraday for clients that were overweight the position (double inverse Russell 2000 ETF) as it was up another 5% over the past few days.

We need to remember that bear markets are always punctuated by strong short-term rallies like we experienced this past spring. It would not be at all surprising, from a contrarian stance, to see another rally in the near future given the increasingly pervasive bearishness in the market. Regardless of which way the market moves in the near-term, I suspect that the increased level of volatility will result in further outstanding investment opportunities, both long and short.

AIG: The Success of Failure

"Go for a business that any idiot can run -- because sooner or later, any idiot is probably going to run it." Peter Lynch

Last night, we learned that AIG's former Chief Executive, Martin Sullivan, whose "retirement" was announced on June 15th, will be receiving a $47 million severance package. Poor AIG. Imagine how much better the shareholders would have fared if, instead of Sullivan, the board had promoted "any idiot" to the CEO position 3 years ago.

What exactly did Mr. Sullivan do during the past few years as CEO to "earn" such a ridiculous severance package? According to AIG's press release, "Martin successfully led AIG through the crisis it faced when he became CEO in 2005, and he has made significant contributions over the past three years in executing AIG's strategy and building on its global franchise."

"Significant contributions...in executing AIG's strategy"? Seriously? Does that mean that the management and Board got together three years ago when Sullivan was promoted to CEO and laid out a 3-year plan that included wiping out $70+ billion in market value, taking $20 billion in write-downs, destroying the balance sheet, and being investigated by the Justice Department? That's what I call setting the bar low!

It gets better. In 2005, the year in which he became CEO, Mr. Sullivan "earned" a tidy $13.8 million. In 2006, Mr. Sullivan's total compensation jumped to an astounding $23.5 million. Despite AIG's net income falling an eye-popping 55% in 2007, Mr. Sullivan still pulled down $12.3 in total compensation. Add to this the $47 million severance package, and Mr. Sullivan has pulled down a cool $96.6 million over the past 3.25 years! If we ignore present value and we assume income growth of 2% per year, it would take the average U.S. household 184 years to make as much money.

AIG is a huge financial services company that was generating $9.8 billion in the year before Sullivan became CEO. Let's assume for simplicity's sake that Peter Lynch's "any idiot" was hired as CEO in early 2005, and rather than actually showing up at the office, he spent all of his time on geocaching, Mad Libs, and naked karaoke. A business of AIG's scale could easily grow 3% per year for a few years just through benign neglect. In this example, net income would have totaled $34 billion between 2005 and the first quarter of 2008. Under Sullivan's tenure, net income actually totaled $22.9 billion over this period, so Sullivan actually underperformed "any idiot" by $11.1 billion as CEO. Imagine what the Board would have paid this guy if he had actually added value!

Of course, the Board didn't recognize in 2005 and 2006 just how ugly things would become, but AIG had to take an $11 billion charge in the fourth quarter of 2007 and the company reported a $5.3 billion loss that quarter. Still, Sullivan received $12.3 million for 2007?! Even more outrageous is the fact that $4 million of his severance package is a BONUS for the portion of 2008 that he worked! A $4 million dollar bonus in a year in which he was "down-sized" and in which the company has so far lost $7.8 billion. You can't make this stuff up.

Let's take a look at AIG's stock price. Over Sullivan's tenure as CEO, AIG's stock collapsed by 40% (ignoring dividends). The S&P 500 was actually up 15% (also ignoring dividends) over this same time period, so AIG underperformed the market by an amazing 55% when Sullivan was CEO. "Any idiot" would be hard-pressed to fail so gloriously.

This is beyond comprehension. In Saudi Arabia, citizens who pick-pocket get their hands chopped off. In the U.S., CEOs pick-pocket their companies, and it's shareholder value that gets chopped. The system is badly broken. Incentive pay does not work in its current form, and institutional investors are generally too lazy to use the power of their votes to do anything about it. No wonder the typical individual investor is disgusted with Wall Street and the executive pay issue.

In a fair and just world, here's what should happen:

• Sullivan should be fired rather than allowed to retire. Tarring and feathering should at least be openly debated.
• He should have to forfeit all prior compensation that was based on results that we now know were inflated.
  
• He should receive no severance for such terrible performance. Actually, he should have to live in the average household and toil at the average household wage for 184 years with all of his earnings going to shareholder restitution.
  
• He should be sentenced to community service during which time he would have to learn and then teach remedial math to under-priveleged subprime loan originators.
• AIG investors should vote out the entire board of AIG and replace them with far more qualified candidates, such as corpses.
  

The bottom line is that AIG shareholders were ripped off. I would have been willing to do as poor a job as Mr. Sullivan for half the pay.

The author is short lazy institutional voters, AIG's board, and asinine severance packages.

When The "Expert" Needs An Expert

How comfortable would you feel with your plumber if he had to call another plumber to fix his own running toilet? How about a CPA who hired another accountant to do her taxes? What if your pediatrician didn't feel competent enough to examine his own child?

These are the questions that immediately came to mind today when I read that Wachovia has just hired Goldman Sachs to "perform analytics on our loans to evaluate various alternatives." I think Saturday Night Live's Seth and Amy can probably sum it up best. "Really?! Wachovia. Really?"

I wonder how the good folks at Wachovia are responding today to customers walking into their branches around the country.

"You'd like to open a savings account? Um, can you hold on a minute while I call the teller over at Bank of America to find out what our rates are?"

"Yes, we can offer auto loans, but would you mind running over to Vinnie's Used Cars and Bait Emporium to see what size loan we can offer you?"

"A personal loan? Well, let me see if I can get in touch with the CEO who I think plays golf with one of the senior bankers over at Morgan. I'm pretty sure that guy has a gardener who knows a personal trainer who thinks he heard some rumor about whether we're still offering those."

"A mortgage? No, we don't do those anymore."

This is just sad. I'm embarrassed for Wachovia and its employees. If you're a large bank with a large securities and investment banking division and you don't feel qualified to evaluate your own balance sheet or market your own portfolio, isn't it pretty much time to just hang it up and go into the dog grooming business? No offense to dog groomers.

The only thing cushioning my pain is that I've been short Wachovia these past few months. I was thinking it might be time to cover. Now I'm not so sure.

The author is short Wachovia and long dog groomers and emporiums.

JP Morgan - Will the Real EPS Please Stand Up

I just finished going over the JP Morgan earnings release and listening to the conference call. Here's a summary of what stood out to me:

• The company reported EPS this quarter of $0.68 versus expectations of $0.64. This is down from $1.34 for the same quarter last year. That's a 49% decline. Furthermore, $0.27 of this quarter's earnings came from a one-time gain from the sale of Visa shares in its IPO, so operating EPS was more like $0.41.
  

• This next part is a little tricky. According to fair-market accounting rules, firms get to report a gain when the debt that they've issued weakens. According to a recent Barrons article, "Here's how the accounting works: When a company's credit weakens and the yield on its debt rises relative to risk-free Treasuries, the debt becomes worth less to the holder. The financial company, which is the debt issuer, then takes a gain, because theoretically it could buy back its debt below face value." This quarter, JPM recorded a $949 million benefit from this accounting treatment in its investment banking treatment. Management stated that there was an offsetting amount in several other business lines to the tune of "several hundred million dollars." No one followed up on this during the call, so we don't know the exact figure, but let's assume that the company's net benefit from this was $500 million. That works out to about $0.10 of EPS.

• Any financial company has a bit of latitude in massaging its earnings due to their control over the amount of money they set aside for loan losses. This is as much an art as a science. Overall, JPM added $2.5 billion to its credit reserves which isn't terribly surprising. When you look a little closer at the pieces, however, there are a couple surprises.
• The Card Services division actually had a lower provision for losses (by $112 million) this quarter than last quarter even though net charge-offs increased from 3.89% to 4.37% and the 30-day managed delinquency rate was 3.66% vs 3.48% last quarter. Given the stress on the consumer in the current economic environment and the fact that the company's loss experience is deteriorating, I would think the loss provision should be increasing. The managed portfolio did shrink by 4% over this period, but the reserving here could have been much more conservative.
• The allowance for loan losses in the Commercial Bank segment was essentially flat with last quarter at $101 million even though nonperforming loans increased by $300 million. The net charge-off rate rose sharply from .21% last quarter to .48% this quarter.
  
• Every $100 million in loss provision works out to about a $0.02 swing in EPS.

• The Commercial business is growing nicely. This could be a bit concerning given the deterioration in the economy. The company stated that they're not doing much real-estate related business, and they specifically mentioned government and non-profit business as areas of recent focus. The charge-offs in this division have started rising, so this needs to be watched closely. The company claims this recent increase is just a normalization from very low levels of losses. We'll see.

• Their page on Prime Mortgages was very disconcerting. The 30-day delinquencies have been moving up strongly from just under 1.00% last June to over 3.00% this quarter. The company has obviously been tightening underwriting standards, but this is troubling.
  

• The Bear Stearns acquisition remains a big question mark. It's expected to close June 30, 2008. Time will tell whether this turns out to be a terrific buy or an albatross.

JP Morgan management made it clear on the call that they're open for business, and they're using the current financial turmoil to opportunistically expand their business. Should the financial markets and economy not suffer a severe recession, JPM stands to be a big winner. However, if we do suffer a severe recession and credit deterioration continues to expand, their purchase of Bear and continued balance sheet growth could do some serious damage. This is ignoring the potential ramifications of their huge derivatives book. Either way, JPM is clearly too big too fail.

I expect this stock to move with the financials which will continue to be subject to violent swings in sentiment. We seem to alternate between "The worst is behind us. It's time to buy!" and "Run for cover! Here comes another wave of write-downs!" At some point, the financial sector in general will again be a buy, but for the time being I'm comfortable opportunistically adding to my net short position.