Thursday, March 26, 2009

Buy of 50 WBS: Lottery Ticket/The Long Tail Contract/AIG FP & Lack of Adult Supervision/TGB upgrade

1.  The Importance of the Long Tail Contract:  What do I mean by a long tail contract?  I thought that I would give an illustration using two examples. First, last night I discussed the possibility of adding to my position in a senior bond issued by a title insurance company, First American (FAF). Most people who have bought a home are familiar with title insurance.  At closing, a settlement sheet has an entry for the purchase of title insurance, usually at the insistence of the mortgage insurance company to protect it against defects in title. A one time premium is paid to purchase the policy.

While I have certainly not read every title insurance policy, I have read a couple. The policy has a long tail, meaning a claim can be made to collect on it years down the road when a defect in the title becomes known.  

Now if a valid claims comes up years down the road and the title insurance company has to pay say $10,000 for a policy that it received a $400 one time premium, then that policy was not profitable for it.  Now, what if the employee who worked on the issuance of the policy was paid 50% of the initial premium as their share of the "profit". Would that compensation scheme be based on illusory or potentially illusory profits?  

The second example of the long tail contract is the credit default insurance policies written by AIG's Financial Product unit.  The individuals responsible for that debacle received large percentages of the revenues generated by the product sold by them (Just read this one page from a NYT article to see what I mean: These contracts had long tails. They also had provisions requiring the posting of collateral in the event the financial products insured went down in value, or the rating agencies lowering AIG's credit rating, which collateral AIG did not have as it turned out.  Even more problems were revealed in the WSJ this morning about AIG's Financial Product unit in Paris  The profits generated by AIG's FP unit were entirely illusory for the long tail credit default insurance policies.

In addition, the employees who were paid a percentage of the revenue took no risk themselves which was born entirely by AIG, and there was no clawback of any monies paid to them in the event the contracts blew up. It is clear that this compensation scheme actually encouraged irresponsible risk taking with no meaningful checks and balances.  

I could make the same point about independent mortgage brokers who were paid based on a loan that they generated, when the loan would be packaged and sold by the mortgage company to a Wall Street firm who would then repackage it and sell it as part of a pool to investors who had no involvement in the origination of the mortgages.

Compensation would be paid at the time each transaction along this chain was completed, to the mortgage broker, the original mortgage company funding the loan, the appraiser who valued the home,  the Wall Street firm that bought the loan allowing the mortgage company to replace the funds and then do it again, and the rating agency that rated the pools of mortgages sold by Wall Street.  The mortgage had a long tail, possibly as long as 30 years, but the risk of loss was being transferred away from the parties receiving fees for completing the transaction along the chain.

This type of transaction divorces risk and compensation which creates an environment, in the absence of meaningful regulation, where the incentives are to engage in irresponsible and even fraudulent transactions. Basically in this kind of reward system for long tail contracts, where risk and compensation are separated, it is virtually certain that the losses will end up to be catastrophic based on known traits of the human species, though it may take a few years for the catastrophe to develop.

2.  First American Bond in the TC PJS: I have mentioned several times that I will research a company before buying a bond.  For First American, this would include reading analyst reports and SEC filings. The report on FAF from Morningstar is probably the best that I read.  FAF is now the largest title insurer.  The margins on title insurance policies issued on refinancings are lower than for a new home due to differences in premium. The title does not cost as much for a refinancing for the simple reason that one policy has already been issued for the property. This is a link to the annual report. Form 10-K  I have not owned the common stock in FAF for at least two years but I did own shares in its subsidiary, FADV, for a trade more than a year ago.  

3.  Youngsters at AIG's Financial Products Unit: From what I can gather, many of the employees of AIG's FP unit were youngsters. Jake DeSantis whose resignation letter was discussed in an earlier postMore discussion on Bonds: Purchases and Sell Decisions/BAC/AIG's International Lease Finance,  started working for AIG in 1998, apparently after graduating from MIT.

I do not know his age, but maybe he is in his early 30s.

One of the WP articles described the staff at AIG's FP as relatively young individuals in their 30s.

Now, I am not going to argue against someone receiving a million or more a year within a decade or so after leaving college and possibly for many years prior to their 30th birthday.  Nor am I going to make a point that the risk of loss is on their employer, and the employer provides them with an office, perks and the opportunity to develop a "book of business".  All that I am saying in this post is that age coupled with decades of experience has more value, assuming a capability to learn from a long lifetime of experiences which in itself may be a rarity, and there does not appear to have been competent leadership at the top of AIG's FP to restrain and supervise the youngsters. 

4. Missive by Economists Carmen Reinhart and Kenneth Rogoff: I like to mention the opinions of economists in this post.  I read an article yesterday written by a couple of practitioners of that particular brand of philosophy or theology as I prefer to characterize it, in this week's Newsweek. Newsweek Business |  The two economists who authored this missive, Carmen Reinhart and Kenneth Rogoff, examined eight centuries of financial crises including prior banking crises in such places as the Phillipines, Columbia, Indonesia & Malaysia, and concluded that the U.S. has a long way to go before recovering from the current meltdown.

While acknowledging that comparing the U.S. with emerging market economies might be viewed as "hyperbole" (or just plain silly), they insist that "hard evidence" proves the similarities between a banking and credit crises experienced by Columbia in the past and the U.S. now.   I would not quarrel with their assessment that the debt of the U.S. will skyrocket, but do we need an economist to make that point?

5. Taseko Mines: One of my lottery tickets, TGB, was upgraded to buy by Canaccord Adams. TGB: Summary for TASEKO MINES LTD - Yahoo! Finance

Best Buy is having a spirited rally today after reporting earnings.  

6.  RB Focusing on Buying Lottery Tickets in Distressed Bank Stocks: For whatever reason, Mr. Right Brain wants to focus on buying lottery tickets in banks stocks. He narrowed today's choice down to two banks, Webster Financial and Virginia Commerce Bancorp.  The last earnings report from Virginia Commerce showed an acceleration of loan losses and delinquent accounts.  As a result of an infusion of capital under TARP, the bank claimed to have as of 12/31/2008 a Tier 1 ratio of 13.07% and a qualifying capital ratio of 14.44%. It operates in the relatively affluent area of Northern Virginia and is headquartered in Arlington, Virginia which is a suburb of Washington, D.C. The market cap of the bank is less than 100 million.  The current estimate for 2010 is for earnings of just 28 cents  and a loss for 2009-not good. o even buy a lottery ticket in these small regional banks, there has to be some faith in a recovery starting later this year and that the worst is behind us.  Right Brain (RB) is always optimistic, willing to not only throw caution out the window but also to bury it where Left Brain (LB) can not find it again.  VCBI reached its high in 2006 at over 21 and the decline started to accelerate in April 2007.

The stock shows a lot of weakness, now trading below its 200 and 50 day moving averages.  The 200 day moving average was broached on the downside in 2006, so this is a strong and long downtrend showing no signs yet of reversing.  

7. Buy of WBS at $4.58  The other stock considered by RB was Webster Financial (WBS).  This one looks more solid, though under a lot of stress.  This is the largest bank in New England that sold for over $50 a share in 2007 and was still over 40 when the bear market started.

It really started to tank in September 2008.  The problems accelerated with a 300 million dollar loss in the 4th quarter of 2008 consisting of an assortment of charges including goodwill impairments, write-downs and loan losses, the usual potpourri.

One error by the bank was to venture into acquiring home equity loans generated by third party sources, always a bad idea in my book.

As you would expect in that loosey goosey corner of the mortgage market, sensible rules were not exactly followed, meaning there would be no income verification  and the loan to value ratio would be 90%.  However, the companies book of mortgage business with its banking customers appears sound with loan to value ratios as of November of 49% and an average FICO score of 731.  The bank also operates in a relatively affluent area of the country.  The dividend has already been cut to a penny a quarter so that piece of bad news is already baked into the stock price. Barclays downgraded the stock to underweight after the last earnings report, and I would not criticize that decision.  The target price was $10 from that firm as of 1/09.  

8.  Other Lottery Ticket Purchases of Bank Stocks by RB:  RB does not weigh pros and cons, just brings the idea to LB for analysis by the deep thinker.  If RB could decide, it would have picked Virginia Commerce because it likes the name Virginia. LB, however, firmly in control of the keyboard here at the trading desk picked WBS for a 50 share lottery ticket purchase filled at $4.58. 
This is the third lottery ticket purchased this month that purports to be common shares of a bank, the prior ones were RF at $3.47 and WL at $9.98.  To avoid violating the rule that lottery tickets can not cost more than $200, RB raised the limit to $300.

  I am not a financial advisor but an individual investor trying to navigate my way through a difficult market. I have never worked for a financial institution and never will.  In these posts, I am acting as an unpaid financial journalist and an occasional political commentator.   I am also aggregating financial news stories that I view as important and providing any reader of these posts, assuming there are more than a couple, with links to those articles, sort of a filtered, somewhat intelligent, free search engine.  Any discussion made by me of particular securities  is not a recommendation to buy or to sell.  Trade at your own risk.  Consult with your financial advisor prior to making any purchase or sale. I will try to identify my sales too but it may take a few minutes after I implement them to create a post explaining my reasons.  The sale may before or after the post.  Before buying or selling any stock, even one recommended by a trusted financial advisor,  please research it and make up your own mind which is what I always try to do.  Research would include reading reports, reviewing financial records, earnings estimates, sec filings and prior earnings releases and news.  In this post, and all others by me, I am merely describing my reasons for purchasing  or selling securities, and the potential pitfalls that I identified prior to purchase or the reasons for a sale.  The securities mentioned in this and all posts written by me may not be suitable for others based on their unique financial position and risk profile.  By way of example, it is unlikely that I will ever need the funds contained in my retirement accounts. Always read the prospectus before buying a Trust Certificate, bond, preferred stock or other bond or bond like investments.  Information contained in my posts has been obtained from sources believed to be reliable but cannot be guaranteed.  These posts by me do not constitute investment advice, nor shall they be construed as a guarantee of future results, or as an offer of any transaction in securities.   All content in these posts is provided for informational and entertainment purposes only, and it is a form of entertainment for me.