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Three Community Banks worth keeping an eye on Part II: Shore Bancshares

I owned Shore Bancshares earlier this year but don’t own it now. It was one of four banks that I bought back in January when I jumped into the community bank sector whole heartedly. While the other 3 banks I bought worked out to various degrees, Shore did not, and I sold out shortly after the first quarter results came out for a small loss.

At the moment I’m out, but Shore is not forgotten. I continue to review the company’s results and look for an improvement that would justify an entry point. Looking at the second quarter, while the eventual value proposition is still there, the company doesn’t seem to have quite turned the corner just yet.

Shore operates 10 branches in Maryland and 3 branches in Delaware. The majority of its lending activities revolve around the commercial and residential real estate market in these regions.  Shore has a particularly high percentage of commercial real estate loans.  Of the company’s $819 million in loans at the end of the first quarter, $315 million were commercial real estate, while $309 million were residential real estate and another $114 million were construction loans.

The loan book has been hit by the downturn in the economy in Maryland. Maryland’s economy is not doing badly, but it is also not doing particularly well. The economy has pretty much mirrored the US as a whole. Below is an Economy.com table of the key economic regions in Maryland. The table denotes each area as either being in recession, being at risk, being in recovery, or expanding.

Another informative research piece on Maryland’s economy was put out by JP Morgan. One point made that I found of particular note (and that is illustrated in the chart below) is that Maryland (not surprisingly) derives a larger than average percentage of economic activity from government.

This would have to be considered a headwind to growth going forward. As one Baltimore economist put it:

We know the decline in federal government outlays has just begun,” said Anirban Basu, a Baltimore economist. “The economic outlook, I think, is pretty grim.”

The article goes on to point out that “because Maryland gets a disproportionate share of federal contracting dollars and other spending, it’s likely to feel a harder hit from any reductions [in government spending]“

To drill down a bit further to the counties Shore operates, (Talbot, Dorchester, Kent, Caroline, and Queen Anne’s), you can see from the following unemployment charts that each fairly closely mimics the experience of the US, with some improvement from the worst levels of 2009-2010, but still an elevated unemployment level.

Talbot

Dorchester

Kent

Caroline

Queen Anne’s

The economic malaise shows up in the impaired loan book. Shore has $33 million in impaired construction loans (28.9% of outstanding), $30.9 million in residential real estate loans (9.9% of outstanding) and $30.6 million in impaired commercial real estate loans (9.7% of outstanding).

The problem with Shore remains what it has been for the last few years. How much longer will economy lead to deterioration of the loan book deteriorate?

Company CEO W. Moorhead Vermilye did not paint a terribly encouraging picture in his second quarter comments:

“The operating environment remains tough as we are not yet seeing a meaningful upturn in the real estate related activities that drive the Delmarva economy. We continued to work diligently to resolve and dispose of problem loans, as reflected in a higher level of troubled debt restructurings this quarter,”

So those are the negatives, and why I am not ready to buy Shore just yet. The positives with Shore is its valuation is compelling in the event of a recovery.

The potential when Shore recovers

A great deal of the current problems are priced in the stock. Shore has a tangible book value of over $12 per share.  Its trading at less than half of book. The underlying earnings potential of the franchise remains strong; if you ignore the effect of all the onetime charges due to bad loans, the underlying banking business (ex provisions, one time charges, and gains) has been producing earnings at over a $1 per share clip for the last few quarters.

But even this may underestimate the earnings power of a stabilized Shore. Again excluding the onetime charges, ROA and ROE are solidly below where they were before the financial collapse. This suggests to me that once (or I guess if) the bank has its problem loans under control, they can embark on a cost reduction strategy to size the bank to the new level of business.

You can see the same influence if you look at the efficiency ratio, which has been hovering around 100% for the last six quarters.

Not quite there yet

One positive for the second quarter was that Shore did see a significant reduction in charge-offs.  Charges were cut to half of what they were in Q1, extending the previous downtrend that had been in place before Q1.

I would be more excited about this reduction in charge-offs if nonperforming assets had shown an improvement. Unfortunately they did not.

Until I begin to see a leveling off and ideally a drop in the non-performing assets, its difficult to make a move into the stock.

Other risks

Apart from the economic risks I already outlined and the presumed impact on the loan book, there really isn’t a lot else to worry about with the business. Reading through the risk factors of the recent 10-K was mostly an exercise in the plagiarisms of the standard banking risk fare:

  1. Concentrated Commercial real estate loans are being affected by the economic downturn
  2. Interest Rates falling
  3. The market value of their investment portfolio declining
  4. Competition
  5. Funding Sources
  6. Key Personnel

The only item of any concern is the one I’ve already highlighted.  Their loan portfolio, and in particular their commercial real estate portfolio, needs a strong economy to right itself.  Its really just a wait and watch until the bad loan book stabilizes.

Waiting on my hands

The reason I am reluctant to buy Shore is because until they start to see a sustained downward trend on their nonperforming loans, the company remains at risk for panic. We saw that panic back last fall when the stock fell into the mid-$4s. It could happen again with the right confluence of European and US financial worries. Rightly or wrongly, the stock will likely remain range bound until the book turns around, and we won’t begin to see that until at best October, when the next quarterly is released. I, before then, the stock dropped another 15%, which would put it in the $4.50 range, I would be tempted to buy. Absent that, I will wait patiently on my hands.

Three Community Banks worth keeping an eye on: Part I

For those of you new to this blog, I have been investing in community banks since early 2011.  I described my foray into the sector in this post,  almost a year ago today.  To reiterate:

I got introduced to the idea of buying regional banks stocks about 6 months ago.  Two separate catalysts piqued my interest in the idea:

  1. Last summer I read the David Einhorn book, “You Can Fool Some of the People All of the Time”.  In that book, which is about a fraudulent business development company called Allied Capital, Einhorn spends a chapter outlining his investment philosophies.  One of the ideas he puts forth is investing in mutual holding companies.   Seth Klaman has been another proponent of investing in MHC’s.
  2. Tim Melvin’s trade of the decade.  Melvin, a fairly well known value investor, believes that the small regional bank stocks have been beaten up well beyond what is justified and that their recovery represents the trade of the decade.

I’ve had some good luck investing in community banks over the last year.   Some have turned out extremely well (Rurban Financial (RBNF) and Community Bankers Trust (BTC) have been more than doubles).  Others have been less prolific (Oneida Financial (ONFC),  Home Federal Bancorp of Louisiana (HFBL), Shore Bancshares (SHBI), Atlantic Coast Financial (ACFC)) but generally I have gotten out of with either a small loss or a small gain.  One of my biggest mistakes has been a lack of patience; indeed if I had held onto Oneida and Home Federal, I would have seen 20% gains from my purchases last year.

Community banks are simple businesses.  It makes them easy to compare and evaluate, and relatively straightforward to project into the future.  A community bank income statement generally looks like this:

Banks earn interest on the loans they make and the securities they buy.  The extent to which the interest earned exceeds the interest paid on funding (for community banks the vast majority of funding is deposits) is the banks margin, called the net interest margin.  With only a few other wrinkles, such as revenues received from originating and servicing mortgages, or in some cases from running insurance or investment wings, the degree to which the net interest margin exceeds the expenses associated with running a bank (called non-interest expense) is the profit of the bank.

How I’ve made money on the banks

There are plenty of solid banking franchises  trading at reasonably cheap prices.  You can probably make 10-15% per year by buying well run banks with low levels of nonperforming assets and reasonable return on assets and equity, and socking them away.

This was how I started with my own banking investments.  The first three banks I bought were Oritani Financial Corp (ORIT) Oneida Financial (ONFC), Home Federal Bancorp of Louisiana (HFBL).  Each is a solid franchise, each has a low level of loan losses, and each trades at or near tangible book value with decent returns on assets and equity.  I’m sure each will continue to go higher over the long run.

But I am always in the pursuit of the best returns and those are usually found a little further up the risk ladder.   One of the basic premises of my investing strategy is that while the price of risk is ultimately assigned by the market, the perceived quantity of risk involved varies, and can be reduced by research, critical thinking and sweat.

Going further up the risk ladder meant looking at banks that most investors would shun.  I studied the banks that had been hit the hardest by the financial crisis.  While a bank with non-performing loans above 3% is generally considered of questionable quality, I started looking at banks with 8-10% non-performing assets.  While banks with return on assets of 1% and return on equity of 10% might be thought to be worth considering, I looked at banks with negative returns, shrinking assets and dwindling equity.

This tact has proven to be fruitful.  Three stocks that I have bought have resulted in above average returns.  Two of them, Rurban Financial (RBNF) and Community Bankers Trust (BTC) have been in the neighborhood of a double so far.  The third, Bank of Commerce Holdings (BOCH) returned a quick 30% before I took the position off, though I am looking at adding it back at the right level.

My one regret has been not to have taken more positions in banks.  To give a couple of examples of banks I looked at but just couldn’t get comfortable with, First Financial Northwest (FFNW) has doubled from $4 to $8 in the last year and a half, while Heartland Financial (HTLF) has nearly doubled since last fall.

But even with some of the moves we’ve seen I think there is still more to come.  As the economy recovers banks should see improvements to their loan book and strengthening margins on the securities they buy.  And I continue to believe that the banks most likely to outperform will be those that were hit hard during the recession but that managed to survive.

3 Banks I’m Looking at

I have my eye on a number of banks that meet these criteria.   There are 3 in particular that I have been looking at this weekend.  While I am not quite ready to pull the trigger on any of the three, I am getting close, and I think the ultimate upside once they work through their books of problem loans is a multiple of the current share price.  I am going to look at each one individually in the upcoming 3 posts.

  1. Shore Bancshares (SHBI)
  2. Premierwest Bancorp (PRWT)
  3. United Community Bancorp (UCBI)

Next up will be a post on Shore Bancshares shortly.

The OceanaGold Gamble

I first bought OceanaGold at $1.80 at the end of May.  I originally bought it strictly as a trade.

The price subsequently moved up and I added to the position twice, first at $1.98, and later at $2.14.  You’ve heard me say it before – do more of what’s working and less of what doesn’t.

Well sometimes that backfires.   When gold got pummeled in mid-June, my position in OceanaGold got hammered back below $2.   It happened so quickly that I did not have time to react, and I ended up losing all of my profits and a little more on top of that.

Such is the difficulty of owning a trading stock with a secular thesis.

From that time until this week OceanaGold didn’t do much of anything.  It sat in the 1.80’s, would briefly rise into the 1.90’s but never for more than a few days.  I held, not wanting to sell near the low without justification and not having the time to do the work I needed to do to get that conviction.   But over the weekend (last weekend), I stepped through their recent reports and presentations, made a few runs at their numbers, and I decided I might just stick this one out.

Two reasons to stick it out

OceanaGold had a terrible first quarter.  Costs were up and above $1000 per ounce.  Production was down over 20%.  The mines that it is currently operating in New Zealand have been struggling with costs pressures for some time now.  But the first quarter was particularly bad.

Part of the bet I was making when I bought OceanaGold at $1.80 was that the first quarter was an aberration.  And, having stepped through that first quarter in some detail now, while I don’t expect costs to drop back to pre-2011 levels, I do find it plausible they they fall back into the low $900’s an ounce.  Similarly, production could easily return to 60,000 ounces plus per quarter.  The progress made in its second quarter earnings release on Thursday suggests this just may be in the process of playing out (note that I wrote most of this post before the Q2 earnings were released so I won’t be talking in detail about them).

The other part of the bet on OceanaGold is the expectation that the company will be reevaluated for the better once the Didipio project begins to produce substantial ounces.  Because of the by-product credits from copper production, Didipio will produce gold at negative cash costs for the first couple of years.

Let”s step through this two-pronged thesis in more detail.

Production Costs should come down

Productions costs on a per ounce basis were bad in the first quarter and they have been rising for some time now.

When you look closely at the rise in production costs over the last number of quarters you can attribute the rise to essentially 3 factors:

  1. Rise of the New Zealand Dollar
  2. Fewer Ounces produced
  3. Changes in the amount of the total costs that can be amortized as pre-stripping

I was quite astonished by just how much of the company’s costs increases could be attributed to these 3 factors.  In fact all of it.  If you look at the total operating costs in New Zealand dollars over the last few years, including costs that were amortized as pre-stripping, they are remarkably flat.

Note that I did this work before the Q2 earnings release so it is not included in the chart.

What the chart illustrates is that this a story of a company dealing with cost pressures due to their local currency appreciating and the natural evolution of the mine plan with changing grades and changing strip ratio.

Looking ahead, I don’t expect much further appreciation of the New Zealand dollar.  With a global slowdown at hand, it seems reasonable to expect the NZD to weaken against the US dollar.  The fewer ounces produced has been a function of various issues that occurred in Q1.  There were issues at the Macraes open pit, at Fraser underground and at Reefton.  The good news is that it appears the company made progress on all fronts in Q2 (production in Q2 was 55,000 ounces versus a little over 50,000 ounces in Q1) and expects production back to normal (which would be around 60,000 ounces per quarter) by Q3.  As the above chart of total costs  indicates, costs per ounce are primarily a function of ounces produced.  A return to 60,000 ounces per quarter would show a drop in costs to about $900 per ounce.

Didipio

The other part of the bet on OceanaGold is the expectation that the company will be re-evaluated once the Didipio project begins to produce ounces. Because of the by-product credits from copper production, Didipio will produce gold at negative cash costs for the first few years and over the life of the mine cash costs will be substantially lower than the existing New Zealand operations.  This is going to dramatically bring down corporate cash costs.  I expect that analysts will be more inclined to give OceanaGold an average mid-tier multiple once their cash costs settle in-line with other mid-tier producers.

In the table below I have estimated the impact of Didipio on corporate cash costs in 2013 and 2014.

By way of analogy, consider Agnico Eagle.  In the first quarter (again I wrote most of this post before second quarter numbers were out) Agnico recorded cash costs of $594/oz.  Agnico’s largest mine in terms of gold production for the quarter was Meadowbank, which produced 79,000 ounces for the quarter.   Meadowbank produced those ounces at costs of $1,020 per ounce.  Taken alone, Meadowbank would be a high cost producer and receive a low multiple.  But Agnico offsets the high costs at Meadowbank with costs of $278/oz at Pinos Altos and $216/oz at LaRonde.

Looking at the latest BMO report on Agnico Eagle, I note that the company gets a cash flow multiple of 10x.  This compares to OceanaGold at 4x cash flow excluding Didipio and 2x cash flow including it.

Clearly, there is room for an upside re-evaluation.

Gold Price

The last factor that is going to determine the future direction of the share price is the price of gold.  I have some thoughts there, but I am not going to go into them in detail here.  Suffice it to say that this is the piece of the puzzle that I am least confident about.  Its unfortunate that I am so uncertain about whether gold will continue to rise or whether it will stall out and potentially fall.  Because given the other factors at hand, OceanaGold would seem to be a good place to build a large position at today’s prices.

 

Week 55: Skittish

Portfolio Performance

Portfolio Composition

Click here for last two weeks of trades.

Portfolio Summary

I have reluctantly added some risk over the last couple of weeks  My cash position is down to $27,839 from $35,893 two weeks ago, which is a drop to 23% of total assets in my tracking portfolio.

The stocks I have bought have been added because I believe they are cheap.  I think that there is a reasonable chance that they will be worth significantly more over time.  But I do not add them with complete conviction.

The problem remains Europe.  And I remain wary of when the next shoe will drop.    Until Friday, the market had forgotten about Europe for the time being, but we have seen this happen before, and always with the same ending. Europe comes back and again trumps all else.  With Spanish yields rising to a new high on Friday (7.267%)  I am already questioning whether I have made a mistake by purchasing rather than selling stock.  I have already considered an about face.

You can see just how skittish I am by looking at how many trades I am second guessing myself on.  Three times in the last two weeks I bought a position only to sell it later the same day.  These weren’t planned “trades”.  I don’t play the day-trade game.  These were cases where I took the position and couldn’t handle the weight of it, and decided to sell instead of worrying about whether I had made a mistake by buying.

I am typically not so wishy-washy.  That the market has me going through convulsions speaks volumes to the uncertainty that exists at the moment.

As for the stocks I bought, those that I kept that is, I am confident that I got them at a decent price which, in the absence of more macro-malaise, will lead to eventual profits.  More on the individual position updates in the post below:

Company Updates

Radian Group (RDN), MGIC (MTG), MBIA (MBI): here

Arcan Resources (ARN): here

Phillips 66 (PSX):  here

 

Week 55 Update: The Insurers

The Insurers

I added to all 3 of my insurers in the last two weeks; Radian Group, MGIC, and MBIA.  Regarding Radian and MGIC, while the data this week was mixed, I still am of the mind that the worst of housing is behind us.  While I’m not ready to jump into home builders or lumber stocks or anything else that is dependent on a robust recovery in prices or demand, I am willing to make a bet on mortgage insurance companies that need things to just stop getting worse.   The insurers need prices to stop falling and defaults to continue to slow.  I am inclined (albeit skittishly) to believe that will happen.

The housing data this week, while not great, supported that thesis.  The market focused on the month over month decline in existing home sales (down 5.4%), but year over year the trend is still to higher sales (4.5%).  The trend, while not robustly bullish, appears to be of a bottoming nature.

Perhaps more importantly, inventory continues to decline and the year over year number is down a somewhat startling 24.4%.

Total housing inventory at the end June fell another 3.2 percent to 2.39 million existing homes available for sale, which represents a 6.6-month supply4 at the current sales pace, up from a 6.4-month supply in May. Listed inventory is 24.4 percent below a year ago when there was a 9.1-month supply.

Bill Mcbride (of CalculatedRisk) pointed out in a recent post that it is really the inventory number that we should be focusing on:

I can’t emphasize enough – what matters the most in the NAR’s existing home sales report is inventory; what matters the most in the new home sales report next week is sales. It is active inventory that impacts prices (although the “shadow” inventory will keep prices from rising). Those looking at the number of existing home sales for a recovery in housing are looking at the wrong number. For existing home sales, look at inventory first.

Meanwhile the monoline insurers (Radian and MGIC) are writing more  new business and this is some of the best business they have every written.  I have already written about how strong lending standards are these days.  Below is the trend for New Insurance Written (NIW) for the first 7 months of this year.

The returns on the new business should be quite impressive.  Mark Devries, the analyst from Barclays that covers the insurers, was quoted in this Bloomberg article on expected returns:

Firms that stay in the business may benefit from a return on equity above 20 percent on new coverage as the exit of some rivals allows remaining insurers to boost prices, and tighter underwriting standards limit claims.

Meanwhile the old book continues to wind down.  The delinquency bucket for both insures continue to fall.

The insurers are like those movies you see where there is a big explosion and the movie star starts running and there is this big fire ball behind them and its gaining on them but the movie star keeps running and eventually the big fireball burns itself out.  These insurers are trying to outrun their legacy business by printing as much new business as they can to overcome the losses on the legacy.  I think when they hit that point that new gains outrun old losses is when they really move.

As for MBIA, the company is less dependent on any specific economic dynamic then they are on  the outcome of their court cases with Bank of America.  There are signs these cases could be coming to a head, but of course they might not.  Its really difficult to say when this will end and whether a settlement will be reached before a verdict.  When I tried to analyze the deal between Bank of America and Syncora earlier this week and the conclusion I came to was that you couldn’t extrapolate much of anything to MBIA.

Week 55 Update: Arcan Resource

I’ve owned Arcan before, but I have always had trouble holding onto it.  I think that in the aggregate I have probably lost a few dollars on the stock.  Yet here I am again to take another stab at it.

Arcan is an excellent example of why I follow the rules of:

  1. Never add to a losing position
  2. Do more of what’s working and less of what isn’t

With Arcan, I eventually sold out for good on March 23rd at $4.75.  At the time there wasn’t anything in particular that you could pinpoint that would suggest the stock was about to fall by more than two-thirds.  But what concerned me was that the stock wasn’t doing what it should be doing if things were going well. That is, it wasn’t going up.

And then there was the CAPEX.  My skittishness with Arcan and most other oil juniors has always been based on their level of capital expenditures in relation to their cash flow.   As I outlined in this post back in February, Arcan has been spending multiples more money than its been taking in.  You can’t just keep doing that forever.  It will work as long as the market sees you as a “growth stock”, but as soon as that music stops, well so do your funding sources.

Arcan has gotten themselves in over their head with funding and now they are going to have difficulty meeting their growth expectations.  The near-term outlook for the company is not terribly clear.

So why buy?  Well the stock is off 75% from its highs.  I think its all price in.

As well the company appears to be changing (perhaps by necessity) its spendthrift ways.  President, Doug Penner, said the following in the first quarter press release:

“I am excited about implementing Arcan’s next stage of development.  Having expanded rapidly in our first nine years of operation, we are maturing as a company, ensuring that our continued growth also delivers value for our shareholders over time. We are focused on reducing down‐time, operating costs and G&A expenses as we work to bring our capital spending more in line with our cash flow. We are also looking at all of our assets  strategically, and we will consider divesting non‐core assets as opportunities arise.”

Of course, with reduced spending will come reduced growth, and that is one of the reasons the stock has been decimated.  At $1.50 per share, which is about what it cost me on average to buy a position, we are getting awful close to the value stock territory.  The company has a $7+ NPV of its reserves.   Their production numbers haven’t been stellar, but they are showing stability and they should be getting past the initial flush declines and into more stable exponential declines on most of their wells.  AS well, the company should begin to benefit from the infrastructure spending of the last year, as the pipeline from Ethel brings down operating costs and we begin to see the fruits of the waterflood at Ethel in the second half of this year.   As I pointed out in that same article earlier this year, there is a clear difference between the Ethel decline curves and that of Deer Mountain Unit, where there is waterflood.

Arcan is simply a bet that the stock has gone down too far.  A move back to $2 would be a 35% gain and I could see it happening with nothing more than a bit of improved sentiment.

Week 55 Update: Phillips 66

I have actually owned Phillips 66 (PSX) for a while now, just not in the account I track online. Phillips 66 is a spin-off from Conoco Phillips.  The company has 3 lines of business:

  1. Refining
  2. Midstream
  3. Chemicals

I originally came across the idea of Phillips 66 after reading a Barrons article that was posted on the Investorvillage.com BRY board.  Phillips was a recommended pick of Meryl Witmer.  The thesis outlined by Witmer was as follows:

Phillips’ 50% of PCChem could earn $1.30 a share this year. These earnings deserve to be valued at a 10 multiple, or $13 a share. The midstream segment owns and operates natural-gas processing facilities and fractionation plants, and a large and valuable natural-gas pipeline system. It also owns 50% of a master limited partnership. It should have free cash flow of $1.20 to $1.30 a share and about a dollar in earnings once it finishes up a couple of projects. It is worth 17 times free cash flow, or more than $20 a share…

So at $35 you get the refining business for free.

My original purchase a few weeks ago was somewhat vindicated after Warren Buffett noted in a Bloomberg interview that his company had bought a large position recently.

The interesting thing about Phillips is that they stand to benefit from the increased liquids production in North America.  Below is an excerpt from the company’s CEO at the Citigroup Global Energy Conference:

If you think about natural gas at kind of $2 a day and ethane that was 30 cents and going down I think the last time I looked at it. But ethane at 30 cents is about $5 a million BTUs. So we capture the upgrade from the wellhead at $2 to 5 bucks through the midstream business and then the petchems really pick up at $5 and go to essentially the crude level, which is what the rest of the world competes on when they’re buying naphtha. Think about that at $17 to $18. And while we don’t know exactly where that rent is going to get captured through that chain, by the ownership in DCP and CPChem, we benefit all the way through that chain in the ownership in capturing that margin upgrade. So we really like that position that we have there.

The thing that makes Phillips interesting is that, as was implied by the Meryl Witmer analysis in Barrons, based on the valuation of the company, investors seem to be treating the company as a refiner, when really only a third of the company’s business is refining.   Moreover, as the company pointed out at another conference recently, this time put on by UBS, the other two-thirds of the business, midstream and chemicals, have return on capital metric north of 20%.

My only problem with Phillips is finding a price to buy in at.  I bought into it in other accounts at under $32.  It pains me now to buy at $35-$36.  Perhaps we will get a further pullback, though after the Buffett endorsement I kind of doubt it.

Trying to Decipher what the Syncora deal means for MBIA

Yesterday Syncora and Bank of America announced an agreement to settle outstanding litigation with respect to the residential mortgage backed securities (RMBS) originated by Countrywide and insured by Syncora.  The essence of the agreement was as follows:

In return for releases of all claims the Company has against Countrywide and Bank of America Corporation arising from its provision of insurance in relation to five second lien transactions that were the subject of litigation and all of the Company’s claims in relation to nine other first and second lien transactions, the Company received a cash payment of $375 Million.

Obviously the settlement has importance to MBIA.  MBIA is also in the middle of litigation with Countrywide to settle RMBS insured by MBIA.

The outstanding question is what Syncora expected to get versus what they ended up getting.  Now what they got is easy.  Its $375 million.  What they expected is a bit trickier.

Alison Frankel, with the help of Barclays, took a stab at this in an article today.  She wrote the following:

Barclays analysis of the Syncora settlement estimated that Syncora’s lifetime losses on all of the 14 mortgage-backed securitizations the deal addresses are as much as $1.4 billion, which would mean that Syncora’s cash award of $375 million represents only 27 cents on the dollar.

But there was the following caveat:

But there’s yet another wrinkle. Syncora, which is a successor to XL Capital Assurance, bought back a lot of its obligations in a 2009 remediation campaign. According to a corporate press release, the insurer “achieved 68.4 remediation points,” which apparently means it bought back more than two-thirds of its policy obligations. The Barclays analysis does not seem to discount its estimate of Syncora’s lifetime losses to account for the remediation, which means its cents-on-the-dollar analysis is probably low.

I’ve looked through Syncora’s filing and the press releases and I think the Barclays analysts have it right.  Here’s my reasoning:

On slide 13 of the Q4 2008 Syncora Guarantee Inc. Insured Portfolio Summary it states that Countrywide was the largest exposure with $2.607 billion.

If I look back at the press releases associated with Syncora’s RMBS remediation campaign, Syncora was actually very forth coming and specified the total Aggregate Principle Balance being committed on a security by security basis.  That can be accessed here.

I parsed through these securities and filtered the Countrywide originations. Countrywide accounts for all of the Countrywide Home Equity Loan Trust and all of the Harborview Mortgage securities (for confirmation that Harborview was indeed a Countrywide entity, take a look at any of the SEC filings for Harborview, for example this one).   If you add up the aggregate principle balance of the Countrywide Home Equity and the Harborview Mortgage securities, it comes out to $1.258 billion.

Now the press release I got this data from was released before the tender was complete, but only by a couple of days.  If you add up the total committed principle specified in the press release you get $3.537 billion, whereas in Syncora’s final press release on the restructuring the amount was $3.8 billion.  So its close.

Subtracting the commuted exposure ($1.349 billion) from the total Countrywide exposure ($2.607 billion) you get $1.349 billion.  This is pretty much bang-on what Barclays had estimated.

Muddying Factors

What is less clear to me, and what I really have no way of determining, is whether the $350 million recovery should be compared against the $1.349 billion in securities, or against a much smaller amount.

As Frankel points out earlier in her article, the litigation that Syncora had against Bank of America was for 5 second lien transactions.

Syncora’s last amended complaint against Countrywide, filed in 2010, alleged that the insurer had paid out $145 million to policyholders in five Countrywide home equity-backed securitizations and had received another $257 million in claims from those five deals. That’s a total of $402 million

The complication is that in the press release Syncora talks about an additional 9 securitizations that aren’t a part of the litigation, but that are also part of the settlement with Bank of America.

…all of the Company’s claims in relation to nine other first and second lien transactions

Presumably the 5 plus the 9 securitizations add together to be $1.349 billion in total exposure.  And if all 14 securitizations are fraudulent, and Syncora could have expected to recover on all of them, then Syncora’s overall recovery is not that great.

But I’m not sure that is the right way to look at this.  There are a couple of considerations that paint a bit rosier picture of the settlement, and provide a bit more hope for MBIA.

First, having become rather familiar with MBIA and their history of litigation, its clear that MBIA was continually adding claims as they found them.  That Syncora did not do this, and instead limited the litigation to 5 of the 14 claims, suggests to me that perhaps the other 9 claims weren’t fraudulent.  If this is the case, that Syncora was able to release future claims on these additional 9 securitizations is actually a bit of icing on the cake.

A second point is that Syncora did not appear to be expecting anywhere near $1.35 billion in recoveries.  Going back to the lawsuit, Sycora was looking for a total recovery of $405 million.  In addition, taking a look at the last Annual Statement Syncora said it had put back $1.6 billion in total RMBS and that it expected to recover $212 million on these amounts (Page 14.35):

As of December 31, 2011 and December 31, 2010, the amount of mortgage loans that the Company is seeking sponsors to repurchase aggregated approximately $1.6 billion and $1.3 billion…As of December 31, 2011 and December 31, 2010, the Company estimated that it would realize a net benefit from such recoveries aggregating $212.1 million and $168.5 million, respectively.

These amounts included loans not only from Countrywide but from EMC and Greenpoint.  I imagine that these recoveries are in addition to the $405 million Syncora was looking for from the Countrywide litigation.  I also imagine that the 9 un-litigated securitizations would be included in this amount, which suggests that Syncora was not looking to recover very much from these 9.

A third and related point is that while the RMBS are experiencing default, it is unlikely that the entire RMBS is in default.  Claims will be lower than the total outstanding principle balance.  Taking a look at the notes to Syncora’s last quarterly statement, the company said that for the first lien securities:

A loss severity was applied to the first lien defaults ranging from 56.1% to 82.9% based upon actual loss severity observances and collateral characteristics to determine the expected loss on the collateral in those transactions.

For the second liens and HELOCs they did not break out the default so neatly into a percentage but still it could be said that th number will be somewhat below 100%.

Can you project to MBIA?

To sum it up, I don’t think that there was anything wrong with the Barclays analysis noted by Alison Frankel.  But I also think there are other mitigating factors that need to be considered before trying to project what this settlement means for MBIA.  Without more details as to which of the securities are fraudulent and therefore legitimate put-backs, and what the loss severity on each securitization is expected to be, its difficult to put a number to what the recovery is.  In the absence of such detail, I am inclined to take Syncora at its word, and assume that they expected recoveries of around $400-$600 million.  If this is the case, then the resolution was well within the range of what would be a nice payday for MBIA if they can settle on similar terms.

Why I am starting to like the Mortgage Insurers

The mortgage insurance business has been a tough business to understand.  I have been working for a number of weeks now trying to wrap my head around it, first with MBIA (which strictly speaking has a financial guaranty business not a mortgage business, but same diff), and then with Radian Group and MGIC.  Each company has unique intricacies that take time to work out.  Its been a slog.

But while the companies are different in their details, there are some common reasons for the difficulty:

  1. The accounting of the business (particularly in the case of financial guaranty) is complicated by derivatives that are mark to market and/or on the balance sheet but not fully recourse to the company
  2. The mortgage industry is soon to see regulations that will change its landscape (these go by the acronyms QM (quality mortgage), QRM (quality residential mortgage) and the future of the GSEs (Fannie May and Freddie Mac)).  The final details of these regulations are still very much up in the air
  3. The remaining legacy losses from the mortgage crisis are going to be determined by the future rate of default of the homeowners the companies have insured.  Given that what has occurred in the US Housing market is unprecedented, there isn’t a historical guide to help predict how those defaults are going to play out

Nevertheless, I am slowly working my way through each complication, and as I do the picture that is emerging is one that is certainly ugly but that also holds promise.  The reasons that make the mortgage insurance business difficult to understand are the same reasons the companies in the space are trading at bankruptcy like valuations.  To put this in perspective, Radian and MGIC both traded at $60 plus per share in 2007.  Today they are at around $3.  I doubt that either company is ever going to go back to its old high, but the basic business that led to those earlier valuations is essentially intact and with a few things going right, the stock price of each could be significantly higher than it is today.

That basic business, when you get past the accounting jungle, is really pretty simple.  These are insurance companies.  They write contracts where they agree to pay if a borrower defaults on their home loan.  In return they receive a fee (called a premium) either up front or on a periodic basic.  They are also required to have a reserve  put aside to pay out the claim  in the event that there is a default. Until a claim payment is required they earn returns on investing that reserve.  In the aggregate, as long that the cash that the insurer receives from its premiums and the returns on its investments exceed the amount that they have to pay out in claims, then the insurer will be making money.

Both Radian and MGIC are still performing that basic business.  What’s more, the volumes that they are writing, while down from their pre-crisis, pre-housing bust highs, remain substantial when compared to the current value of their equity.  Of late, these volumes are also showing substantial year over year increases.

To illustrate the potential, in 2011 Radian wrote new insurance that will provide $717M of premiums over its life time (compared to premiums collected on existing insurance of $680M).  Before the housing collapse caused claims to skyrocket, you could expect returns after claims of at least 10-15% on that insurance.  So maybe $70-$100M in earnings.  In addition Radian produced investment income of $225M in 2011.  Expenses and costs of the mortgage insurance division is about $150M.  Radian has about 133M shares outstanding.  Adding these elements together you can see that absent the legacy book of business, its not unreasonable that the company would be earnings over $1 per share.

Of course the problem with the insurers is the legacy book.  In the case of Radian, that legacy book produced $1.3B in provisions for loss and over $1.5B in actual claims paid.  These numbers dwarf the premiums Radian is receiving and any income its earning from premiums and on its investments.  The result is a massive loss, particularly on a per share basis.

You could run through the same analysis for MGIC and draw similar conclusions.

My thesis here is that the legacy book will not always be the problem it is now.  And it appears that defaults from the book have peaked.  House prices in many areas of the US have stabilized and in some areas they are rising.  And the regulatory framework being developed seems to creating more space for private mortgage insurance.

I’ll have more to write on both Radian, MGIC  and the current regulatory state of the US housing market in upcoming posts.  What I wanted to outline here is the potential.  It is the potential that makes these companies worth investigating further.  If the business does turn around, we are talking about multi-bagger potential.  Of course if it doesn’t… well they may be headed for bankruptcy.  Now I fully admit that I am still fuzzy on whether the business can turn around before the companies run out of cash to pay off claims in their legacy book.  But it appears that the carrot  is big enough to justify an attempt to figure that out.

Week 53: Betting on a Housing Bottom

Portfolio Performance

Portfolio Composition

 

The trades that took place in the last two weeks can be viewed here.

Summary of Portfolio

There were a couple of positions that had big moves over the last few weeks.  The first is Nationstar Mortgage Holdings (NSM).  Nationstar is now more than a double from my original purchase and up over 75% for the entire position.  Both Nationstar and Newcastle Investments (NCT) have been strong of late, and I think that’s likely due to the expectation that they will win the ResCap bidding war.  According to an 8-K filing that Nationstar made on Thursday, their bid for ResCap was raised $125M. At this point the risk is that they don’t win the bid and that the stock falls back.  However, I bought the stock well before the Rescap sale and I still believe that there is some upside even ignoring Rescap.  Even without the Rescap deal, Nationstar has grown substantially through the purchase of the Aurora portfolio and Bank of America’s servicing assets. I’m reluctant to sell any shares yet.

Another stock that has had quite a run is Rurban Financial (RBNF).  The last time that I talked about Rurban was mid-May, and I haven’t mentioned them since because, well, nothing has happened.  The stock is boring and goes up. I like that.  However if you had asked me back when the stock was $5 when I would consider selling I probably would have said around $8.  We are getting close to that number now.

As I wrote about earlier this week, I added positions in two monolines, Radian Group (RDN) and MGIC (MTG).  Of the two, I am most inclined to add to Radian on any pull back.  I’ve been reading whatever I can get my hands on about the mortgage insurance industry over the last week and I think I have wrapped my head around most of it.  The regulatory landscape is really quite mind-boggling, the changes that have taken place since 2008 quite tectonic and there are about a million acronyms used with many of their definitions not easily found.

Nevertheless, out of chaos come opportunity.

I really like what I see in the insurers; the leverage to a housing bottom (just a bottom, not a barn-burning recovery), the cheap price (close to being priced for bankruptcy),  insuring what are probably some of the best quality mortgages they have ever insured, margins increasing as their government owned competition, the Federal Housing Authority (FHA) raises their prices in an attempt to limit the government market share, and the insurers stand to benefit from the general stance that seems to have evolved that government should limit their role in the housing industry and that private insurance should take more of a role.

What holds me back from making these insurers larger positions is the economy itself.  A recession would not be good for housing.  Nevertheless, I am somewhat emboldened by the fact that the stocks I own that are dependent on the US economy (in addition to those discussed already I would put Community Bankers Trust (BTC) , MBIA (MBI) and PHH Corp (PHH) into this bucket as well) have held up quite well in this latest downdraft.

What I sold

I sold Mart Resources (CA:MMT) this week (note that while I sold the stock in the portfolio I track here, I do still own a position in other portfolios).  When I originally bought Mart four weeks ago I wrote the following

The company has two news events that I suspect are going to occur shortly.  The first is the potential for an announcement of a dividend.  I believe that such an announcement could result in a significant pop in the stock, as it gives credibility to what is otherwise looked on warily as a Nigerian story.  The second is a pipeline deal with Shell, which would allow Mart to increase their production, perhaps substantially, and allow the brokerages that follow the story to up their targets based on larger 2013 volumes.  Again, I am looking for an event to occur in somewhat short order, but I am not holding this stock for the long run.

Mart released news earlier this week that they were going to provide a quarterly dividend of 5 cents a share and a special dividend of 10 cents.  They announced the pipeline deal  a week before that.  The stock is still cheap; it trades at maybe 4x cash flow (which does not consider the production expansion that will come in the next year) and at a rather silly 14% yield.  I’ll probably buy back in at some point, maybe even soon.  I just don’t love the way the market is behaving, in particular the way that Spanish bonds have jumped back to nearly 7% and so I am reluctant to .  I also don’t rally buy this oil rally; it seems prefaced on Middle East tensions and that is fickle mate.  Mart, having moved so much higher so fast, seems like it would be likely candidate for portfolio trimming if oil drops again below $80.  I’ll wait this out and see what happens over the next couple of weeks.

I sold some OceanaGold (CA:OGC) in the last two weeks.  Part of what I sold was because I thought that Atna Resources (CA:ATN) had gotten too cheap again at $0.85 and so I moved money from OceanaGold to Atna.  I have also been researching Esperanza Resources (CA:EPZ) and I thought that they, having been hit from selling after a share offering but now having plenty of cash and owning my preferred heap leach deposit that will be low capital expenditures and low cash costs, were in a better position in this uncertain environment.  The other reason behind the selling was that these gold stocks just aren’t working.  The jobs report on Friday should have sent gold flying, but it didn’t.  The thesis I have expected isn’t playing out.  Whether that is because the Rupee is so low that Indian demand is sluggish, because investors aren’t willing to think of gold as a safehaven just yet, or because there is a nefarious plot to undermine gold being played out in smoky dim lit rooms on the outskirts of Washington, the bottomline is that it hasn’t been working.   And I always try to do more of what works and less of what doesn’t.

Finally, my adventures with Barkerville ended on Thursday when I sold out.  The deciding factors were that the stock wasn’t behaving like a stock should if it truly had a 10 million ounce deposit (though the alternative explanation that the weakness is being caused by warrant holders cashing out could be contributing), and that the data that is available from the company just doesn’t look like 10 million ounce material (if you look at the 7 sections that Barkerville has on their website, it looks like Cow Mountain has a number of narrow (albeit potentially high grade) veins. It also looks like the veins are somewhat sparsely populated across the length of the intercepts.

I honestly have no idea what Barkerville does or doesn’t have and so I have decided to make discretion the better part of valor until such time that I do.

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