Games Banks Play - Number Three

Over the next couple of years, many banks will fail and be taken over by the government or larger institutions. This will be an agonizing process that some banks will try to avoid at any cost. I will explain in a multi part series what to watch out for:

Held for Sale Account - When a bank intends to sell a loan, it puts it into an account called "held for sale." A bank may use this account to stuff poorly performing loans. Accounting rules say a charge to the Allowance for Loan and Lease Losses (ALLL) must be made at the time the loan is transferred if the loss is due to credit factors. If the decline is the result primarily from interest rate fluctuations or changes in foreign exchange rates, known as market factors, it should be recorded as a charge to a noninterest expense account. I suppose an unscrupulous bank management can hide losses by claiming a decline in value due to "market factors" rather than "credit factors."

Part One

Part Two

Games Banks Play - Number Two

Over the next couple of years, many banks will fail and be taken over by the government or larger institutions. This will be an agonizing process that some banks will try to avoid at any cost. I will explain in a multi part series what to watch out for:

Other Real Estate Owned (OREO) - Banks will take title to many properties during this downturn and put them into a category called Other Real Estate Owned (OREO). This real estate must be recorded upon foreclosure at fair value, with the difference between the recorded amount of the loan and the fair value of the property charged to the allowance for loan losses. I suppose that some Banks will fudge on this "fair value" deduction and try to keep the loss as small as possible. Future writedowns of the OREO must be charged against operating income. Therefore, there will be two hits against banks regarding real estate. First, the difference between the loan outstanding and the fair value at the time title is taken, and second, the difference between this fair value at foreclosure and what the property is finally sold at.

I attended a banking conference in February and was told that current offers for OREO by buyers are in the range of 40-50 cents on the dollar, and that at this time, most banks aren't accepting such offers.

Part One

Eliot Spitzer Round Two?

Both tabloids in New York City are reporting the bust of a second high end call girl ring. This one is called Wicked Models NYC and it is not clear yet if the former Governor was a client. The web site for the agency is at:

Wicked Models NYC

but it looks like it has already been taken down. If you go to a web site called the Wayback Machine and put in the web site for Wicked Models, you can see archived copies of the site. Here is the direct link for it:

Click Here

Grant's Interest Rate Observer

Bloomberg just did an in depth interview with James Grant of Grant's Interest Rate Observer.

Interview

He discusses the Federal Reserve, calling its balance sheet an "economists nightmare," and comments on Gold and other investments, and the pernicious effects of a collapsing dollar on the Global economy.

Bear Stearns Poll Results

The results from my first blog poll are in. Just as a reminder, the question I posited last week was "Why is Bear Stearns trading way above the JP Morgan offer price of $2.00 per share?" Forty four votes were recorded and the winner by a plurality was that "People are stupid." The results:

Short covering 4 (9%)
A higher bid will come 12 (27%)
Bondholders protecting themselves 11 (25%)
People are stupid 17 (38%)

As we all know now, a higher bid did come in, in this case from JP Morgan, the original bidder. So it would seem that people aren't that stupid after all.

Games Banks Play - Number One

Over the next couple of years, many banks will fail and be taken over by the government or larger institutions. This will be an agonizing process that some banks will try to avoid at any cost. I will explain in a multi part series what to watch out for:

Delaying recognition of non accrual loans - Banks are required to put loans into non accrual status when full repayment of interest and principal is not expected, or when loans become 90 days or more delinquent. Some institutions will convince themselves that repayment of interest and principal is still possible and delay putting these loans into non performing status. Some loans should be put in non accrual much earlier than 90 days based on observations and facts that the banks recognize.

Obviously, it is hard to detect these shenanigans, but one should be aware anyway.

New Poll on Bear Stearns

I just added a poll to the blog just to the right of this post. There have been many reasons offered to explain why Bear Stearns stock is trading way above the $2.00 per share offer (or $2.34 offer based on the closing price of JP Morgan on 3/18/08). Please vote, and if you have any other theories make a comment.

Auction Rate Securities

Two small cap companies got tripped up in the problems impacting the Auction Rate Securities market. 4Kids Entertainment (KDE) and Ballantyne of Omaha (BTN) both reported problems in its latest earnings reports:


4Kids Entertainment (KDE)

“As of 12/31/07 the company held auction rate securities having an aggregate principal amount of approximately $60 million. The auction rate securities held by the company are private placement debt securities with long term nominal maturities and interest rates that reset monthly.”

"As of Feb 29, 08, the company unrealized loss on its auction rates securities has increased by $7.9 million to $11.9 million based upon statements provided by an investment bank through which the company holds such securities. Given the failed auctions many of the company’s auction rate securities are currently inliquid. Accordingly, the company has reclassified approximately $20.4 million in auction rate securities from current to non-current assets in the balance sheet due to the fact the company deems the liquidity of these securities to be restored in the period longer than 12 months."

Ballantyne of Omaha (BTN)

"The company ended fiscal 2007 with total cash and cash equivalents and investments of $17.2 million including $13 million of investments in AAA rated auction rate securities."

"Ballantyne has no reason to believe that any of the issues of these securities are presently at risk or that the AAA rated credit quality of the assets backing the securities are impacted by the current reduced market liquidity of these securities. Ballantyne also believes that it maintains sufficient liquidity to run our business via its cash position that we hold in a commercial bank and our ability to draw on our line of credit. Effective with the fourth quarter and for the full year 2007 we have reclassified these securities from cash and cash equivalents to investments in accordance with current accounting guidance."

Both companies are still receiving interest on the investments.

Transcripts are from Seeking Alpha.

Bear Stearns Mystery Caller

I was just reading the JP Morgan - Bear Stearns transcript and read toward the end an exchange from a mystery caller that the transcript identified as an individual investor called "Brian."

Brian

I was just wondering how this valuation helps the Bear Stearns shareholders as they go through Chapter 11 and the orderly liquidation of the assets of the company?

Answer

I’m afraid you’d have to ask that question to Bear Stearns.

Brian

I vote not to approve this sale.

A disgruntled employee perhaps?

Festival of Stocks - # 80

I am glad to once again host the Festival of Stocks. This is the 80th festival and the fourth one I have hosted. Thanks to George at Fat Pitch Financials for keeping this going. This was an unusual festival in that I received only two entries related to a specific stock. I have also decided to group the entries by category this time.

Dividend Stocks

Dividends4Life presents Stock Analysis: Consolidated Edison, Inc. (ED) posted at Dividends4Life. This is a stock I have owned for years and Dividends4Life presents his usual detailed analysis on the stock.

Passive Income Investor presents Investing In AeroGrow's Gourmet Herb Gardens posted at LIVING OFF DIVIDENDS. Aerogrow does not pay a dividend yet, but the Passive Income Investor likes its prospects for the future.

Personal Financial Advice

Charles H. Green presents Review of Rules to Break and Laws to Follow by Peppers and Rogers posted at Trust Matters.

Jose DeJesus MD presents Financial Planners - Choosing the Right One for Your Needs posted at Physician Entrepreneur.

Steve Faber discusses the option of taking money out of your 401K early at his post entitled - 401k Early Withdrawal – Should You?, Penalties and More.

FIRE Finance gives more practical advice in his post Three Good Habits of Successful Retirees posted on his blog called FIRE Finance.

Raag Vamdatt presents Start saving early and gain from Compounding - Early bird gets the worm posted at RaagVamdatt.com - Financial Planning demystified.

Debbie presents HOW TO BUY BIG-PRICED ITEMS ON A STRICT BUDGET posted at American Consumer News.

Rio presents Buckle your seatbelt for the turblent market posted at Get Financially Fit!. Rio advocates ignoring the short term volatility and focusing on a five year time horizon.

Dorian Wales presents 10 Sure Ways to lose 50% of your investment posted at Personal Financier. Dorian presents a top ten list of things to avoid doing in the market.

Teachings of Warren Buffett

George presents Sneak Preview of The Four Filters by Bud Labitan posted at Fat Pitch Financials.

Maria Palma presents Warren Buffett: 3 Lessons From the World's #1 Billionaire posted at Fully Stocked.

GBlogger presents So A Slow-Moving Ape Can Beat The Market? posted at CAN I GET RICH ON A SALARY. GBlogger discusses an academic paper that says that Warren Buffett is a large cap growth investor.

General Investing

Silicon Valley Blogger presents You've Got Money: Invest It All or Dollar Cost Average? posted at The Digerati Life.

Moneywise presents 10-year index fund returns posted at The Real Returns.

vitalstarts presents Institutional Ownership posted at Vital Starts Investing.

Larry Russell presents 7 Ways to Pick the Best Noload Mutual Funds and ETFs posted at Best No Load Funds.

Aussie Investor presents Stock Market For Beginners posted at Stock Market Investing For Beginners.

Jed Norwood presents Forex Trading The News | Tips and Tricks posted at Forex Trading Blog.

MBB presents Top Online Discount Brokers posted at Money Blue Book.

Fixed Income

Barb A. Ryan presents Bond Mutual Fund Fees posted at Bond Market Index Funds.

Federal Reserve

Leon Gettler presents Will Bernanke's Rescue Plan Work? posted at Sox First. Leon explains why the $200 billion fix will only work short term, and that long term credit problems still exist.

Super Saver presents Fed Actions Will Only Delay The Inevitable posted at My Wealth Builder.

Bear Stearns sold for $ 2.00 per Share?

The Wall Street Journal is reporting that JP Morgan Chase is buying Bear Stearns for $2.00 per share. This must be a joke - the Headquarters alone is worth $1.2 billion, which is four times the reported deal value of around $226 million. Bear Stearns would be better off filing for Bankruptcy and then taking a chance that after it liquidates and sells its assets and settles its liabilities, it would return more than $226 million to shareholders. By the time Bear sold its assets the market for mortgage backed securities may even have unfrozen.

Whom the Gods Destroy

"Whom the gods would destroy, they first make mad."

Everyone knows by now the saga that has befallen Eliot Spitzer, the Governor of New York. What you don't know is that both Eliot Spitzer and I went to the same High School in New York - Horace Mann. Until Eliot Spitzer became famous, Horace Mann was known for Marty Whitman, the manager of the Third Avenue Fund and a graduate of the class of 1942.

Eliot Spitzer was the Class of 1977 and I was 1980. When he first became well known a few years back, I dug into my old boxes in the garage and came up with the yearbook from 1977 and found his yearbook page. I posted it years ago on the Internet, as it was my first feeble attempt to make money off Google Ads. The page has been out there for years, but here is the original page, and I also posted the page at the bottom of my blog post.


Eliot Spitzer Senior Page

Look at the last quote on his page.

"The worst thing about political jokes is that some of them get elected."

Indeed.

Hume Bank Bites the Dust

The Federal Deposit Insurance Corporation (FDIC) announced very quietly the failure of a bank in Missouri:

Hume Bank Fails

As I have said before, this will be the first of many failures over the next year. The Hume Bank was founded in 1909, and survived the Great Depression, but apparently not the “Great Deleveraging.”

So let’s look at Hume and see where they went wrong. Hume is a small bank and its failure will not directly affect the financial system, except to the extent that it may go down in history as one of the first banks to fail this cycle. All the data is as of 12/31/2007.

Hume had only one branch and $13 million in deposits.

Total loans and leases 90 days or more past due plus loans in nonaccrual status, as a percent of gross loans and leases, was 6.99%.

The bank had total charge offs as a percent of loans at 1.28%.

Hume had total equity capital of $2.7 million.

Hume had total net loans of $13.6 million, with half of them in Real Estate. One interesting point about the loan portfolio is that the bank had $2.5 million in loans for “farmland,” and $ 4 million in “farm loans.” I would assume that these loans would be in great shape due to the bubble prices beginning to form for many agricultural commodities, and the strong increase in prices for farm land the last few years.

Here are the capital ratios for Hume Bank

Equity capital to assets - 14.96%
Core capital (leverage) ratio - 7.63%
Tier 1 risk-based capital ratio - 10.28%
Total risk-based capital ratio - 11.57%

All these ratios are well in excess of regulatory limits for being well capitalized. In fact, the terrifying thing is that Hume had a larger capital cushion than Citicorp, which reported the following ratios at year-end:

Tier 1 Capital - 7.12%
Total Capital (Tier 1 and Tier 2) - 10.70%
Leverage - 4.03%

So what killed Hume Bank? It’s hard to say. The FDIC press release did not go into too much detail. If I had to guess, I would say that it was a large loan that went bad, and may have wiped out much of its capital of $2.7 million. After deducting $1.4 million in good will, Hume only had $1.3 million in tier one capital, not much of a cushion.

On sad fact is that at the time of closing, Hume Bank had approximately $1.1 million in 33 deposit accounts that exceeded the federal deposit insurance limit. Those depositors need to get in line now with other unsecured creditors of the bank.

Keweenaw Land Association

Last August, we wrote about a pink sheet company called Keweenaw Land Association Ltd. The original post is here:

Keweenaw Land Association Ltd.

The company is a timberland company in Michigan that owns 158,000 acres of land in the Midwest and trades under the symbol KEWL.PK. I passed on buying it because I thought that KEWL would be categorized as a "real estate" company and would be dragged down with the rest of the sector. It was selling at $215 per share.

It seems that KEWL has attracted an activist investor who is agitating for change at the company. The stock is now up to $263 per share.

Ronald S. Gutstein, a private investor, has announced his intention to seek two board seats at the upcoming meeting in July 2008. The other nominee is Scott Frisoli, an associate of his. You can read his letter here.

Gutstein said, “Keweenaw has massive mineral reserves. Despite record demand and rising prices, management has done nothing to take advantage of current, unprecedented market conditions. Instead, they have been content to remain a small timber company and real estate developer. If management was determined not to exploit its extensive mineral reserves, at a minimum, they should have taken advantage of the tax benefits from becoming a REIT.”

KEWL fired back by releasing early the Chairman's Letter that is to be included in its annual report.

It stated in part that "we have reviewed this option (REIT) several times but there are two significant problems: 1) we would have to distribute all of our retained earnings (over $12 million), which would force us to sell assets to raise the money for this distribution, and 2) on an annual basis we would have to distribute 95% of earnings, which would preclude us from growing the company out of earnings."

KEWL also defended its pace of developing its mineral resources.

"The process of bringing a mine to production is a very long and expensive procedure. There is a very tedious and time consuming permitting process, plus tremendous opposition from anti-mining groups. Any given mining company needs to weigh all these factors when making the decision to go forward with a mining project"

Gutstein then countered in a press release yesterday:

"In his letter Mr. Ayer (Chairman of KEWL) states that as a REIT, Keweenaw would have to distribute 95% of earnings to shareholders. This was in fact true prior to 2001. Since 2001, however, REITs have been required to distribute only 90% of earnings to shareholders. Mr. Ayer and his advisors appear to be unaware of changes in the tax law made more than seven years ago.”

"Responding to Mr. Ayer’s claim that REIT dividends are not eligible for the favorable qualified dividend tax rate of 15%, Mr. Gutstein stated: “The Plum Creek Timber Company in its February 2008 press release states that its dividends should qualify for a 15% rate because the income generated by the sale of timber is considered long-term capital gain. In any event, all other things being equal, shareholders are always better off without the corporate double tax.”

So what does this all mean? At the end of 2006, KEWL did an appraisal on its land holdings and came up with a value of $118 million, based on a single transaction approach. Using a present value of cash flows, it derived a slightly higher value of $121 million. Management admitted that this appraisal understated the land value that the company holds because it ignored the development value of the land, the appraisal used a low intensity harvesting for the DCF approach, and it completely ignore any mineral value of the land the company owns.

KEWL owns mineral rights on 406,200 acres of land in Michigan, a huge potential given the history of mining in the area. In the 1950's a study was done on two deposits, and it was determined that the company has significant deposits left of iron ore, silver and copper. It was decided to wait until technology allowed better opportunities to exploit these minerals. Certainly now, 50 years later and with a much higher commodity price, it is now feasible to develop these minerals commercially.

The market cap of the stock is $169 million, higher than the appraised value of the land, but maybe a value play if you put some future value on the minerals. There is also another mineral play, although I don't know enough about KEWL's land holdings to know if this adds value to the company. There are significant natural gas reserves in Michigan in a play known as the Antrim Shale, which is located in Northern Michigan.

Keep this company on your radar during 2008.

Whitman Throws Down the Gauntlet

The latest shareholder letter from The Third Avenue Fund has Marty Whitman firing back at William Ackman, a hedge fund manager I have written about previously, over MBIA:

"...invested in MBIA Surplus Notes at a yield to call of slightly over 14% per annum. The MBIA Surplus Notes appear to carry very small, or non-existent, credit risk, and thus are considered by management to be a near-cash investment (albeit the MBIA Surplus Notes, unlike cash equivalents, are subject to market price fluctuations)."

"On February 11th, TAVF acquired from MBIA, 10,610,425 shares of MBIA Common at $12.15 per share. This brought the Fund’s holding to 23,148,845 shares of MBIA Common, or about 10% of the issue outstanding.MBIA is now strongly capitalized. It ought to qualify easily for an AAA rating with a $17 billion claims paying ability. If so qualified, MBIA would be in a position to underwrite a large amount of profitable new business."

And then Whitman gets the knives out:

"Ackman does not seem to understand the Property and Casualty (“P&C”) Insurance business and its sources of profitability. Ackman believes that the Bond Insurer Model does not work because the insureds are able to buy an AAA credit rating so cheaply. The facts are that Bond Insurance is one of the more profitable P&C businesses."

"(Ackman) argues that prices, as determined by marks to market, or mark to model, always deserve 100% weight. This is arrant nonsense. Market prices do deserve dominant weight in an analysis where the portfolio consists wholly of common stocks and non-performing loans held in trading accounts. Market prices deserve little or no weight, when the portfolio consists of performing loans, and in force policies, to be held to maturity."

"(Ackman) pays little attention to the rules of seniority and priority of payment in evaluating, or understanding, senior tranches of debt. The argument that if an entity is in trouble, every liability on the balance sheet of that entity is also in trouble is strictly “amateur hour”. Frequently, senior issues sail through troubles unscathed."

Here is my post on MBIA from February 2008.

Our Sovereign Wealth Fund

An article today in the Wall Street Journal about the cash hoard of $600 billion on corporate balance sheets:

"The increase over the last decade in the amount of cash, as a percent of total assets, for the companies in the Standard & Poor’s 500-stock index has been steep. One study shows that the average cash ratio doubled from 1998 to 2004 and the median ratio more than tripled, while debt levels fell. According to S.& P., the total cash held by companies in its industrial index exceeded $600 billion in February, up from about $203 billion in 1998."

This is just the S & P 500 mind you. It occurred to me that this is actually the equivalent of a Sovereign Wealth Fund for the United States, less the Sovereign part of course.

What I mean is that in most of the countries that have large Sovereign Wealth Funds, the government usually owns a significant part of the economy, such as a National Oil Company, etc. Here in the United States, wealth accrues to the private sector, which is where our cash and wealth resides. Just imagine for a moment, if there was a National Oil Company in the United States that held all of its reserves of oil and gas.

What's the point of this diatribe? Sovereign Wealth Funds are not taking over the world. Stop listening to alarmist articles and commentators who are saying this.

Buffett Letter - Favorite Quotes

My favorite quotes from the annual Berkshire Hathaway letter:

"To date, Dexter is the worst deal that I’ve made. But I’ll make more mistakes in the future – you can bet on that. A line from Bobby Bare’s country song explains what too often happens with acquisitions: “I’ve never gone to bed with an ugly woman, but I’ve sure woke up with a few.”

"The best anecdote I’ve heard during the current presidential campaign came from Mitt Romney, who asked his wife, Ann, “When we were young, did you ever in your wildest dreams think I might be president?” To which she replied, “Honey, you weren’t in my wildest dreams.”

"Charlie and I are not big fans of resumes. Instead, we focus on brains, passion and integrity. Another of our great managers is Cathy Baron Tamraz, who has significantly increased Business Wire’s earnings since we purchased it early in 2006. She is an owner’s dream. It is positively dangerous to stand between Cathy and a business prospect. Cathy, it should be noted, began her career as a cab driver.)"

"There’s been much talk recently of sovereign wealth funds and how they are buying large pieces of American businesses. This is our doing, not some nefarious plot by foreign governments. Our trade equation guarantees massive foreign investment in the U.S. When we force-feed $2 billion daily to the rest of the world, they must invest in something here. Why should we complain when they choose stocks over bonds?"

"Our country’s weakening currency is not the fault of OPEC, China, etc. Other developed countries rely on imported oil and compete against Chinese imports just as we do. In developing a sensible trade policy, the U.S. should not single out countries to punish or industries to protect. Nor should we take actions likely to evoke retaliatory behavior that will reduce America’s exports, true trade that benefits both our country and the rest of the world. Our legislators should recognize, however, that the current imbalances are unsustainable and should therefore adopt policies that will materially reduce them sooner rather than later. Otherwise our $2 billion daily of force-fed dollars to the rest of the world may produce global indigestion of an unpleasant sort."