Tag Archives: Banks

HSBC rights issue–post mortem

April 6, 2009 By in Banks, rights issue Tags: , , , , , , Leave a comment

The Financial Times reported today that 97% of the HSBC rights were taken up by investors.  The issue price for the new shares is 254 pence.  The other 3%, the rights that lapsed, became the property of  the underwriters and sub-underwriters.  These rights were exercised by them.  The resulting shares were sold this morning for 448 p. each.  

How did the sub-underwriters make out?  For each share they underwrote, they received a 2% fee, or 2.08p.  But, as I pointed out in my earlier writing about the issue, the fee is not the main source of income for the sub-underwriter.  For the 3% of the shares that the sub-underwriters took possession of, they received a profit of 194p per share, which works out to 5.82p for each share underwritten.

About AIG’s Business Products

March 20, 2009 By in Current Market Thoughts Tags: , , , , , , Leave a comment

Early in my career I remember hearing stories about a fellow portfolio manager who fancied himself an expert billiards player.  He regularly trounced the salesmen from brokerage houses he dealt with when they met socially for dinner and a game or two.  Then he changed jobs, to become an investment strategist for a broker, that is, a colleague of his billiards buddies rather than a client.  As I heard it, he never won a game again.

Stunningly Large Losses…

I don’t know very much about AIG other than what I’ve read in the  news.  But the sheer magnitude of the losses AIG’s Business Products division rolled up implies operating ineptitude of heroic proportions.  As my story above suggests, it’s a standard strategy for a trading counterparty to downplay his own competence and inflate your ego.  After all, you trade more often and less cautiously if you think you’re outsmarting the other guy, rather than worrying that he knows more than you.   But everyone on Wall Street should know this and try to apply a little objectivity in assessing business relationships and one’s own job performance.  Apparently AIG didn’t. 

If AIG was such a bad trader, why did counterparties overload it with losses and kill the goose that was laying golden eggs?  It’s possible they saw the big bonuses AIG traders were collecting and misread the extent of its losses.  It’s also possible they thought the AIG people were so bad as to be beyond saving, and that if they didn’t take AIG’s money someone else would.

 

..But A Bonus Plan Where Losses Hardly Counted

I’ve also just skimmed, courtesy of the government, the AIG bonus plan.  (Here’s the link, if you’re interested:

http://www.house.gov/apps/list/press/financialsvcs_dem/employeeretentionplan.pdf)

Several things strike me about it:

1.  The plan is called a “Retention” plan.  Employees were to share 30% of Business Products’ profits, with no cap set on the maximum paid, and with a minimum guarantee.  That guarantee, which presumably was the amount paid out for 2008, was set somewhat below the amount paid out for 2007.

Any realized losses above $225 million are not applied against 2008 earnings.  Instead, they’re carried over to following years and reduce a given year’s bonus pool by a maximum of 30% of that number, or $67.5 million.  The minimum guaranteed bonus is also reduced by the overhang of past years’ losses, again at a rate of $67.5 million per year.  Given that this unit appears to have realized losses of, in round numbers, $200 billion in 2008,  the guarantee shrinks to nothing in at most two or three years.  The overhang of losses looks like it lives on, depressing bonuses, into the twenty-fourth century.    All the plan really seems to do is to allow one more round of large bonuses, before encouraging anyone who can get another job to leave.  So it is a “Retention” plan only in the sense that it “retains” a final year of undeserved incentive pay.

2.  The plan is dated December 1, 2007, and replaces an earlier plan.  The differences are not described.  I would bet, however,  the main change is that the earlier plan did not limit, as this one does, the extent to which realized losses could shrink the bonus pool.

3.  Bonuses are based, not on economic profits, but on realized gains and losses, that is, on transactions that were closed out during the year.  I find this very unusual.  The bonus pool can easily be inflated by cashing out profitable trades and keeping losers on the books.  The plan specifically states that unrealized losses are excluded from the bonus calculations.

4.  It’s hard to see why AIG’s management would okay a plan like this, other than that 70% of the Business Products’ so-called profits become earnings of the parent company, on which presumably top management’s bonuses are calculated.

5.  It’s also hard to see how former Secretary of the Treasury Paulson, a veteran Wall Street manager, did not hear the alarm bells that this bonus plan sets off.

An Ugly Story

The losses are huge.  The bonus plan is shameful.  No one in government or new management caught on.  Retroactively changing the tax code may be emotionally satisfying, but  it doesn’t seem to me that punishing Wells Fargo or JPMorgan employees for something AIG did helps the country a lot.  A better direction of attack might be maintaining that in trying to “game” the system with this bonus plan, AIG violated its obligations to shareholders.

One more thought on the House action.  Is the House really being as hysterical as its rhetoric and voting make it appear?   Doesn’t it realize it is putting at risk any future private-public cooperation in rebuilding the financial system?  Or is it calculating that it can be as bombastic as it wants, because the retroactive tax increase doesn’t have the votes to pass in the Senate?  My guess is that our representatives are relatively unaware of the risks, but are actively betting that nothing they resolve will survive the Senate.  The coming week will most likely tell.

HSBC

March 19, 2009 By in Banks, Industry Analysis, Strategy Tags: , , , , , Leave a comment

HSBC is raising equity through a rights issue (see my Basic Concepts post on rights issues).  At over $17 billion, it is the largest in the history of the UK stock market.  Given this size, the damage any rights issue can do to a stock’s price and management’s denial of the need for a capital raising last October, the issue must be of utmost importance to HSBC.  Why is the company raising this massive amount of new capital?

Cynics say that the true reason is that the damage from buying subprime consumer lender Household International (including Beneficial Finance, too) is far greater than the bank cares to disclose.  It’s worth looking at why the bank says it’s raising money, however, since their reasons would have important implications for the banking sector over the coming decade.

First, HSBC points out that the banks rescued by their home governments will likely end up with the strongest balance sheets in the industry.  They will, in theory at least, have a powerful competitive advantage over banks which have not needed rescuing, unless those banks also strengthen their capital–as HSBC is now doing. 

The second reason has, I think, a lot more implications for investors.  HSBC figures the governments which have ploughed huge amounts of money into their banks (this includes the US, UK, France and Germany) are not going to allow that capital to be used as the the foundation for loans outside the home country.  And they are going to armtwist the banks to lend, not just keep it parked on the balance sheet for just in case.  

Two implications:

The rescue markets may turn fiercely competitive, as newly-healed banks strive to keep out of the regulatory hot seat by making loans  (we’re already starting to see how ugly the US hot seat can be).  This will be great for non-financial enterprises in those countries.  Ready availability of credit at low prices will make the areas preferred destinations for any global business to set up manufacturing or service operations.  But it’s not so great for bank profit growth.

Also, assume we thought the major commercial banks that might have a history of and might want to lend overseas have roughly zero capital apart from what their governments have given them.  Therefore, those banks would have roughly zero ability to do so.  This leaves the field wide open in the developing world for banks like HSBC.  In fact, these markets may be more profitable than before because there will be less competition.

A professional investor will ask himself three questions in response to what HSBC is saying:

       1. Does the market believe this is true?

       2. Do I believe this is true?

       3. (Probably the most important!) Do I need to have an opinion about this?

I think the answer to #1 is no.  I think the market is still trying to sort out which banks will live and which will die.

#2?  I have no idea, although what HSBC is saying sounds plausible.

#3.  There are really two issues here.  Do I need to own a bank?  Maybe I can just avoid the industry or, if I’m a relative performance person, mimic the index, thereby eliminating stock-specific risk.  If I do have to own a bank, however, then, all other things being equal, I should own a bank in an emerging market.

Rights Issue–What Is It?

March 4, 2009 By in Basic Concepts, rights issue Tags: , , , , Leave a comment

Rights Issues Are Common Overseas

In the US, investors generally want companies to finance new projects using debt, not equity.  When a new stock issue is needed, the company finds an investment banker, registers the issue and sells the stock at close to the prevailing market price to whomever is willing to buy it.

Most of the rest of the world thinks this is very peculiar, in two ways:

–Foreign markets typically want expansion to be funded through equity, not debt.

–Investors also don’t want their percentage interest in the company to be diluted without their say-so.  They expect companies to give the first chance to buy any new stock to existing shareholders, in proportion to the amount of stock they hold prior to the new issue.  This second expectation is usually enforced through company by-laws that require all equity issuance above a certain size be done through a “rights issue.”

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Banks and Book Value

February 24, 2009 By in Banks, Industry Analysis Tags: , , , , , Leave a comment

Financials are either the hardest kind of companies to analyze or the easiest.

* They’re hard because they’re in a lot of different lending businesses–mortgages, credit cards, personal loans, business loans–for all kinds of customers, from blue chip to sub-prime.

*The assets they hold, that is, the loans on their books, can have long lives.  Some loans will doubtless go bad, so there’s always the question of how quickly the bank catches them and how accurately it marks them down to realizable value.

*In addition, since the repeal of Glass-Steagall, the banks have been able to do extensive proprietary trading and other investment banking activities, which present more complicated management control and reporting issues.

 

 For smaller financials, limiting themselves either to only a few products, or dealing with a small range of customers, or operating in a limited geographical area, a generalist analyst can probably get his arms around the main issues.  For the largest, multi-line, multi-customer, maybe multi-national firms, even a financial company specialist may have his hands full.

 

 

The structural opacity of financial companies has always bothered me and has generally kept me away from investing in financials, except for in emerging markets, where the institutions tend to be simpler and much less mature than their counterparts in the OECD.  These companies present their own set of issues, but that’s not what I want to write about today.   

 

Suppose you want to buy US-listed financials.  An institutional money manager can do his own reading and  then call in a specialist analyst from a brokerage house to explain the ins and outs of the major firms in the industry.   But everyone believes (correctly, I think) that industry analysts form strong biases in favor of the areas they cover.  So at the very least you’ve got to give a sanity check to what they say.  But not everyone is big enough to have in-house analytic help to guide them.  And, of course, not everyone is able to get a sell-side analyst to come to visit.

 

 So what can you do?  –what portfolio managers always do.  Simplify.  Try to describe in the most general terms what the companies do and find a variable that, conceptually, should correlate well with stock price.  In this case, use book value.  Why?

Financials are middlemen in the purchase and sale of a commodity, namely, money.  Money is money.  It stays money.  It doesn’t get old, or wear out or become obsolete, like a machine or a building can.  So, assuming–and this may be a big “if”–the company, assisted by its auditors, accounts roughly correctly for unrealized gains and losses, then the value stored up in the firm should be the money it originally started with, plus profits not paid out in dividends, plus any new equity raised along the way.  In other words, shareholders equity or book value.   As a further support for this view, one might remember that this is (or at least is supposed to be) a heavily regulated industry.  So even if the managements and the auditors don’t keep good records, the regulators will find this out and fix the problem.

Book value, then, could serve the same function that a PE ratio would in another industry. One could compare the profits of companies in the industry as a percentage of book and award higher or lower multiples of book value to the better or weaker competitors.

 I think that this is actually the way non-specialist portfolio managers look at financials.  One refinement:  we should use tangible book value, i.e.,  exclude brand names or other “intangible” things that find their way onto the company’s balance sheet as a result of acquisitions.  We’ll factor in these sources of value through the multiple of book value we decide to pay for the stock.

 

What do we get if we do this?

 

This chart lists a a number of big financial companies and compares their stock prices with book value, as taken from the company’s latest filings:

 

                                recent price            recent book value                price/book         

Goldman                   80.00                        108.00                                    74%                         

Morgan Stanley      18.82                            30.25                                    62%                         

Wells Fargo              11.50                            12.70                                    91%                       

JP Morgan                19.51                            38.00                                   51%                         

Citigroup                    2.14                             12.50                                   17%                           

Bank of Amer. 1       3.91                             11.40                                   34%                          

Bank of Amer. 2       3.91                              9.00                                    43%                           

 

(I’ve shown Bank of America in two ways:  the BofA1 book value is the company’s reported tangible book at 12/31/08, shortly after the Merrill acquisition was announced.  BV has no impact from Merrill in it.  BofA2 book value assumes BofA issues 1.25 billion new shares, but that the value of Merrill ends up being precisely zero.   This isn’t a forecast.  I have no reason to believe that this will be the outcome of the acquisition.  Positive value to Merrill would make BofA2’s book value higher and its price/book lower than I’ve shown above.)

 

 

What does looking at book suggest the market is saying about these stocks?

 

Starting with the most straightforward comment,

 

*The price to book numbers are very low, across the board, relative to patterns of the last ten years.  Good banks have traded in the past at more than 2x book.  The “value line” for Goldman used by the Value Line Investment Survey is 1.3x book.  Less than six months ago, BofA and its investment bankers thought Merrill Lynch, a second-tier franchise in my opinion, was worth buying at 1.8x book.

*The market thinks brokers are more valuable than banks, which is a reversal of traditional form.

*They all look like closed end funds, trading a discount to net asset value.

*Extending the closed end fund analogy, most would in theory get a price boost if they announced they were going to liquidate and return assets to shareholders.   Taxable investors would be better off in all cases, except maybe Goldman and Wells Fargo, but tax exempt investors, like pension funds, would clearly benefit in all instances.  

*The numbers are all over the map.  Some figures, like those for Morgan Stanley, are audited; most are not, since their reporting year ends in December.  It may be that price to book will rise, once the annual audit results are known.

*Information may be in the “bad” numbers, not the “good” ones.  Citigroup really stands out.  If you could wave a magic wand and liquidate the company right away and get the balance sheet value for the assets, you’d get almost 6x your money.  It seems to me that if the balance sheet is a picture of the company, the market is saying Citi’s is a Dali or a Pollock, not a photo.

*A weird thought–Citigroup might be cheap, not necessarily on the value of tangible assets, but on “intangibles,” the value of its brand name and retail distribution network.  For this to be so, however, you’d have to believe that the tangibles have a value as high as zero and that the firm would be held in management hands that  know how to exploit the brand.    Irrelevant but interesting, I think–Let’s say tangible assets are worth minus $1/share.  If the government takes a 40% stake in a firm at a price of, say, $1/share, then the existing shareholders are better off, in that they’re only underwater on the tangibles by 25 cents.  But the government now owns 40% of the brand name.