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More on why you need to Consider the Position of French Banks to Buy Canadian Oil Stocks

Just a quick note before I head off for the day.  The following was reported in the WSJ this morning.

“We can no longer borrow dollars. U.S. money-market funds are not lending to us anymore,” a bank executive for BNP Paribas, who declines to be named, told me last week. “Since we don’t have access to dollars anymore, we’re creating a market in euros. This is a first. . . . we hope it will work, otherwise the downward spiral will be hell. We will no longer be trusted at all and no one will lend to us anymore.”

The full article is available here for subscribers.  For non-subscribers, FT published some thoughts here.

I’m surprised that so far the market is taking this in stride.

The article goes on to explain the source of the concern.

BNP, Société Générale and Crédit Agricole together hold nearly $57 billion in Greek sovereign and private debt, versus $34 billion held by the largest German banks and $14 billion at British banks. And then there is Spain and Italy. French banks held more than €140 billion in total Spanish debt and almost €400 billion in Italian debt as of December, according to the latest figures from the Bank for International Settlements. If either of these governments were to default on their debts, their banking systems could collapse and take the French system along with them. BNP, Société Générale and Credit Agricole all say that their finances are in order and the market worries are unfounded.

In the event of a Greek default the French will need to bailout their banks just as the Germans will need to bail out theirs.

The problem is that the French banks are so large compared to French GDP.  This is the question FT asks.

Now, let’s say the French government is forced to recapitalise its banking sector. What would that mean for its AAA rating?

It would not be good for it.

The situation in Europe is evolving and not in a good way.  I think that the market opening up today presents another good opportunity to reduce risk.

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Week 10: Back above Par

While the markets continue to shake and shudder, my 10 week old tracking portfolio put in a yeoman performance last week, bucking the trend and returning to the black.  In the period since my portfolios inception (July 1st, 2011)  the TSX is down 7.1% and the S&P is down 13.8%.  So on a relative performance basis I am doing ok.  I would like to be able to make money again some day though.  Of course, that is difficult when it seems that the best place to put your money is in cash.

I made one trade last week.  I bought Collosus Minerals.  Its hard not to be enticed by the momentum of the gold stocks.  In my actual portfolio I did more tweaking by reducing my positions a bit further in Arcan and Equal.  As I have said before I will not tweak in this practice portfolio because the commissions are too high.  In my actual accounts I also increased my banking hedge by adding to shorts of Bank of America and UBS.

In a related note, Don Coxe had an excellent conference call this week.  He is finally beginning to see Europe as negatively as I am.  He is also still a strong believer in gold.  Its worth a listen.

My Attempt to Understand Gramercy’s CDO-2006

Gramercy Capital finished up on the week while the rest of the market slumped.  The reason is the continuing recognition by the Street that the company’s settlement of Realty opens the door of potential.

What the news of the settlment does is it allows investors to begin to evaluate the company based on what is left without having to wonder what they might eventually have to subtract.  And what is left is a company with a lot of cash, a number of commercial real estate holdings on their balance sheet, a management fee that more than covers Realty expenses, and the equity level stakes in 3 CDO’s filled with primarily commercial real estate securities, 2 of which are paying back significant sums of cash.

Let’s Go Back to the Beginning

I came across Gramercy by way of a few degrees of separation.    I actually happened on the analysis from another site, Above Average Odds (AAO).    I had originally discovered AAO when I was scouring the net researching Equal Energy.  Above Average Odds agreed with me that Equal Energy was undervalued, and just as importantly they recognized the value in the up-and-coming Mississippian play that the market was (and is continuing) to ignore.   Their work, in particular their early understanding of the potential of the Mississippian, impressed me enough to continue to follow the site.

Well as it turns out Equal has been the poorest of my oil and gas stocks (I should really know better than to invest in debt laden juniors), though the value is still there.  But that’s another story… the point here is that the Equal Energy story led me to a future post from AAO on Gramercy Capital. This post was not written by AAO but my another blogger, PlanMaestro, who writes his own blog called Variant Perceptions.  When I initially bought Gramercy, I did so on the basis of the analysis written up by PlanMaestro.

At the time I did some leg work of my own to wrap my head around the story.  I read through the 10-K (which was actually the 2009 10-K) and sifted through posts on yahoo and investors hub.  It was clear to me that the stock was cheap, that the risks were not as high as perceived, and that was enough for me to buy a piece in the company.

But I didn’t really delve as deeply as I do with most of my investments.  I think the reason was that the inner workings of a CDO seemed quite opaque to me, and so I found it kind of intimidating to jump into that pool.  This weekend I decided to get a better grasp of the CDO and in particular Gramercy’s CDO’s.  On Friday night I printed out the information that was available (a set of the March 2011 managers reports for CDO-2005 and CDO-2006 that someone was so kind to post on googledocs), waited until everyone had fallen asleep, and sat down with a drink and an open ended time frame that I wasn’t going to bed until I understood how these things worked.

It actually didn’t take too long.

In retrospect, I regret not having done a more thorough analysis sooner.  It prevented me from recognizing just how much potential this stock has.  And while I own a good chunk of the stock right now, I would have undoubtably bought more if I had spent the time to actually understand the CDO’s sooner.

So what did I learn?

The first thing I learned is that CDO’s are not as complicated as their reputation makes them out to be.  And Gramercy’s CDO’s are even less complicated then most.  As with most seemingly inaccessible subjects,  the opaqueness of a CDO revolves around the inaccessibility of the language (mostly acronyms) used.  To put it simply, there are a bunch of indsutry lingo used and who the heck knows what they mean.  But once you know those definitions you realize the concepts are actually quite straightforward.

Before I talk about the Gramercy CDO’s in particular, I’m going to point to a few basic primers on what a CDO is and how it works.

First, this video and this video are both great.

Ok, so lets look at Gramercy’s CDO’s.  I’m going to focus here in this post on CDO-2006.  CDO-2005 and CDO-2006 are, the sense of structure, the same.  If you understand how the one works you understand the other.  Same structure, with each one comprised of different loans and securities.  Now there are a few impotant differences between the two in terms of performance, but I will discuss that more at the end.

Onto GKK CDO-2006!

So when Gramercy created CDO-2006, they got together $1B of investment capital, put it into what is called a special purpose vehicle (which is just a fancy name for what effectively amounts to a holding company), and bought $1B worth of commercial mortgage securities.

The $1B of investment capital was obtained by the selling of notes that were divided up into classes (or tranches) based on the seniority of who would be paid back first.  The tranches created and the amount of notes in each tranche were:

The highest tranche (1A A-1) gets paid back first.  But the highest tranche also receives the lowest return.

And here we get to the first interesting point about CDO-2006.  The interest paid to the notes.  To put it plainly, the interest being paid to these notes is a steal.  Below I have snipped the interest being paid on each tranche of notes for the March quarter.

All of these notes are tied to 3 month LIBOR.  If you look at the largest (and highest rated) tranches, their spread to LIBOR is small.  Thus, with LIBOR rates non-existent right now, the interest paid for the capital is equally small.  I’m sure that in 2006 when the world was rocking these notes seemed like a reasonable investment, but right now they seem like very low returns for the risk of investing in US commercial real estate.

Which is all the better for Gramercy.

What about going forward?  Well, who am I to predict the future, but one thing that does make it easier to predict is when you are told what it is going to be.  The Fed said they are keeping rates look for 2 years.   There’s little to think that the economy could accelerate so quickly as to put the Fed’s word in doubt.  I think its safe to say that’s Gramercy’s extremely low cost debt funding train is going to continue.

Below is what 3 month LIBOR has done over the last year.

Looking at the first quarter report, the CDO paid out $1.5M in interest to the tranches not held by Gramercy.  That means that they are paying an annualized $6M interest in return for the access to $900M of capital.

When you think about what’s really going on here you have to admit its a little crazy.  Compare what Gramercy is getting capital for to your typical high yield industrial company (think Tembec and their issue of longer term debt at 9+%).  Gramercy is getting a tremendous deal here.   And its all non-recourse.

In CDO-2006 Gramercy owns the J and K notes, as well as the preferred.  These would be considered to be the equity level tranches.  The J and K notes pay higher interest than the senior tranches at about 3.5% and 7%, but it is the preferred that is the real money maker.  The preferred keeps all the excess interest beyond what needs to be paid to the more senior notes.  When you are investing $1B in real estate and pay out less than 1% for that capital, there tends to be a lot of excess interest.

Below are the interest payments to the J, K and preferred for the March quarter:

The CDO paid out $7.6M in the quarter to Gramercy in the first quarter.  About $30M annually.

One thing that is worth pointing out is that the CDO delivered these returns while holding $158M of its assets in cash.  For the sake of interest, lets just do a back of the napkin calculation of how much more interest the company could generate if they put that cash to work at similar interest rates to the assets they already have.

Total interest distribution was $9.1M on total performing CDO assets of $881M.  So interest was an annualized 4.1% of assets.  The $158M of cash at 4.1% would generate another $6.5M per quarter.  All this would go straight to the preferred.  So potentially, the 2006 CDO has the opportunity to almost double its return to Gramercy.

Moreoever, my understanding is that a lot of CRE loans are closer to the 6% range.  So a 4.1% assumption is likely quite conservative.

At any rate there is the potential to make a lot of money from CDO 2006.

There is however, a limited amount of time forthe cash to be invested.  Both CDO-2005 and CDO-2006 are structured such that there is a window in which new cash (from principle payments) can be put towards new investments.  After this period ends, once a loan is paid back the proceeds need to be used to pay back the note holders, starting with the most senior first.  For CDO-2005 that time has passed.  For CDO-2006 that has passed as well, but it passed in July of this year.  So we don’t know yet what investments Gramercy has made with the cash.  Hopefully its something that pays good interest.

The other stipulation on both CDO-2005 and CDO-2006 is that they both must pass a number of tests before money can be passed on to the equity tranches.   The CDO has to pass what is called an overcollateralization test and an interest coverage test.

Both of these tests are straightforward and are exactly what their names suggest.  In the case of the overcollateralization test all of the assets currently held by the CDO are added up, any delinquent assets are given a recovery value, and that number of total assets is divided by the amount of notes that has to be repaid.  This is done for the various tranches, so for the lower tranches the upper tranches are included in the amount because they will be paid first.  Thus, the overcollateralization test for the lowest tranches (F/G/H) is the hardest to pass.

CDO-2006 passed the overcollateralization test in the March quarter.

The defaults are an interesting story in themselves.  You can see from the above tables that the defaults are being valued at a little over 25% of their whole value. Its interesting to see why this is the case.  Here is a list of the defaulted loans/securities from the same managers report:

Ok, so first of all, the 3 CDO notes from Gramercy 2007 can be ignored.  CDO-2007 is a lost cause, and so the fact that these 3 notes are being valued at about 10% is probably right.

Taking a Bit Closer Look at the Defaults

To get a sense of what these defaulted securities might be, let’s look instead at the largest default.  Fiesta da Vida.  A bit of searching turns up a court document from a couple of weeks ago that describes the current state of the loan:

Gramercy Investment Trust versus Lakemont Homes Nevada

The documentis the ruling of an appeals court to the original decision that Lakemont Homes Nevada owes Gramercy for the loan they were made by them.

The story is:

Fiesta da Vida, LLC, owned real property located in Riverside County which was to be developed by FDV Investment LLC. In order to obtain financing for the project, title to the property was transferred to FDV Investment LLC (the borrower). The borrower was an entity managed by Lakemont Homes, Inc., a California corporation. On March 30, 2007, Gramercy lent $35 million to the borrower, and the loan was secured by a deed of trust. The loan agreement provided that it would be governed by the laws of the State of New York.

But then real estate in California collapsed and Lakemont Home didn’t repay the loan.  So Gramercy went to court.

On February 3, 2010, Gramercy made a motion for summary adjudication of issues as to the second cause of action against two of the Lakemont defendants.4 On May 20, 2010, the court granted the motion. Judgment in favor of Gramercy was entitled in the amount of $33,537,994.65, plus costs. On July 22, 2010, Lakemont appealed.

The interesting ending to this saga is that the apellate court ruling on the appeal affirmed the judgement in favor of Gramercy.

So what does this all mean?  I don’t know enough to say.  While the court affirms that Gramercy should get their money back, for that to happen the money has to be there.  I did some searching for Lakemont Homes and FDV Investment LLC, who seem to be the borrowers here, and I can’t find more than a name referencing the company.

And when I look at Riverside real estate prices, it doesn’t give me the warm fuzzies about the area (these are residential prices mind you):

On the other hand, one would think that for Gramercy to spend the time in court there must be some carrot they are chasing.  We shall see.

Anyways, I digress…

What is CDO-2006 Made of?

The last thing that I want to talk about is what the CDO-2006 is actually comprised of.  Luckily, this information is all available in the managers report (note: I originally had posted a breakdown in loan data that I was told was better left un-posted.  What remains is the general aspects of the loans, which is still sufficient for drawing the conclusions I looked to draw).

The CDO contains 54 different investments as of the end of March.  Most of these are whole loans, while the rest are collateralized mortgage products.  You can see the breakdown in the table below:


A few points that I made note of as a perused the contents of CDO-2006:

  • Many of the loans are simple first lien loans against a property.
  • There are 3 Gramercy CDO-2007 notes in CDO-2006.  These were bought in 2009.  They are lower tranches (would either be mezzanine or equity) and so I think they are dead in the water.  I wonder why they bought these?
  • The three biggest whole loans on their books $48M, $45M, $42M.  So they are not overly leveraged to any particular CRE property.

One point that is worth spending some time on is just what type of CMBS and CDO’s are owned by CDO-2006.  The first thing I note is that of the CMBS and CDO’s owned, all except for the NSTAR 2006 carry interest rates of above 5%.  This is good as long as they are performing (which most of them are).  But it also implies that these are very low tranches and may not see full recovery.  So lets look for a second at what the ratings are on these notes.  I made the following table from a larger table provided in the report.  I reduced it to only include CMBS and CDO’s.


Moody’s ratings system is as follows (taken from Wikipedia):

It looks like $92M of the securities are not investment grade (includes 2 securities not rated by Moody’s but by S&P).

What does this mean for Gramercy?   The tranches of notes that Gramercy owns are the lowest, and they make up the final $96M of the total notes sold.  So to eventually recover principle on the CDO, Gramercy needs some of these non-investment grade securities to pay up.

That’s not an impossible task, particularly considering that many of the non-investment grade securities are at ratings on the cusp of investment grade (Ba1, Ba2 and Ba3).

One final piece of information about the properties owned that is relevant is where these properties are.  You can go through the list individually to determine this information, but some general location information can also be gleaned by a few of the CDO requirements tests.  CDO-2006 has some requirements about how much real estate can be owned in any particular state.  As part of the managers report there are a number of tests to see whether these requirements are met.  These tests, and the amounts owned in the central loan states, are in the table below:

So What did I Learn?

This started off as a mostly educational exercise for me.  I wanted to understand how a CDO worked and CDO-2006 was my lab rat.  And I think I achieved my goal.  I now have a much better understanding as to what a CDO is comprised of, what its liabilities are, how its interest is paid, and what how its solvency and liquidity tests are calculated.

As it more specifically applies to Gramercy, I learned the following:

  • The interest that the CDO is paying on much of the $1B in capital makes this extremely cheap money
  • The equity tranche of CDO 2006 is much more leveraged to performance than I anticipated.
  • The cash level that CDO-2006 had in March is perhaps the most important element of the CDO.  That cash could be converted into significant extra dividends to the Gramercy owned preferred once that cash is put to work
  • The eventual recovery of principle in CDO-2006 depends on the recovery of a number of CMBS and CDO securities that are not currently investment grade and so full recovery is no sure thing.

What’s Next?

the next thing I want to write-up is CDO-2005.  As I said at the start, the structure of CDO-2005 is similar to CDO-2006.  However, there are key differences in their current state.  CDO-2005 was, for quite some time, failing its overcollateralization tests.  But it was just barely failing, and there was a news release at the beginning of August that it had begun to pass again.  Now I need to spend some more time crunching the numbers on CDO-2005, but as a first pass it looks to me like the CDO should return between $5M to $6M quarterly to the holder of the preferred shares once the over-collateralization test is passed.

See the thing is, when the CDO fails its overcollateralization, all the interest to equity gets diverted to paying off principle of the senior notes until the test begins to pass again.  So Gramercy hasn’t gotten anything from CDO-2005 for quite some time.  If I’m right about my numbers (and please take them with a grain of salt at this time because i have not gone through CDO-2005 in the detail I did CDO-2006) then that is another $20M to $25M in yearly cashflow to Gramercy.  That is 40-50 cents per share, which is nothing to scoff at.

But that is yet another story.  This post was about CDO-2006 and learning about how CDO’s work.  I think I’ve said enough about that already.

Another Hit for Coastal Energy

Oh, but if it wasn’t for the credit crisis…

I like to take big positions in stocks where I see an outsized opportunity in comparison to the risks.  Jump all in.  I believe that the advantage that active investing has lies in the opportunity you have to scale into a name where you see such an outsized reward.  It is in doing so that I have had my greatest success.  It has worked for me before with such stocks as Aur Resources, Avion Gold, Mercer International, etc.

That sort of opportunity exists with Coastal Energy…

If only it wasn’t for the credit crisis.

Coastal put out a news release today that showed some excellent results.

The Bua Ban North A-05 well was drilled to a total depth of 5,650 feet TVD.   The well encountered 81 feet of gross sand and 35 feet of net pay in the Miocene reservoir with 27 percent average porosity.   The well tested the Miocene reservoir on the eastern flank of the Bua Ban North A field.   The oil water contact in the well was seen at 3,770 feet.   The results of the A-05 well add an additional 1,200 acres to the structural closure area.

The A-05 tested the far northern extents of the “North-A” structure.  The following screen capture from the Jennings report put out today shows the location of the A-05 relative to other North A wells.  The light blue outline delineates the expected extent of the reservoir that Coastal has discovered.  You will quickly note just how much bigger the A-05 pool is compared to the other North A pools.

Coastal estimates that there is 108MMbbl of OOIP in the new pool.

Applying  a 30% recovery factor to the OOIP gives us 32MMbbl of recoverable resource.  The company just keeps adding resource at an incredible rate.  Overall, Coastal has discovered 90+MMbbl of recoverable resource this year.  This for a company that had 27MMbbl of proven and probable reserves at the end of 2010.

First Energy raised their estimate of proved and probable reserves for Coastal to an expected 82MMbbl by the end of the year.  They arrived at this number with the  addition of 10MMbbl from the new A-05 reservoir, which is conservative given the overall size of the resource.  First Energy raised their risked NAV for the company to $25 per share.  Jennings has a NAV of $21 for the company.

Based on company specifics alone, each well makes the investment more and more of a no-brainer.  If we take First Energy’s estimate Coastal is trading at about $12/bbl of reserves.  This is cheap for any oil company, but it is very cheap for a company that is growing at the rate that Coastal is.

So I continue to own a large position in the stock. Its just so unfortunate that Europe makes owning anything a hair raising experience.  If it wasn’t for Europe my position would be much larger.

A Very Important Day for Gold Stocks?

I have been working on a write-up of Argonaut Gold over the weekend.  I was expecting to post that write-up today, but circumstances have arisen that make other more basic questions more pertinent (by the way, the essence of my soon-to-come post on Argonaut Gold is the stock is cheaper relative to other gold stocks than I first thought).

However, first things first:

This looks a lot like the beginning of August.

Meanwhile the price of gold is up again.  It is almost at $1900/oz.  One of the popular gold related articles I have seen over the weekend is about how pension funds have no exposure to gold at all.  A bit of a buzz appears to be beginning.

Meanwhile, on Friday gold stocks staged a breakout.

Putting all of this together, Tuesday looks like a very important day in gold stock land.

Look, I have written before about how torn I am to own gold stocks right now.  I have sold down everything else in anticipation of the European mess getting worse.  In my actual account I have shorted banks to hedge the market exposure of my remaining oil stocks (I cannot short in the practice account I post to this blog so this account is more exposed than I actually am).  But I have held the gold stocks.  This is partially because it makes sense to me that gold will go up as the Euro disintegrates.  It is partially because, thus far, gold stocks have worked.  But I always hold in the back of my head the recollection of 2008 when gold stocks got hit just as hard (harder?) than the rest of the market.

So what will it be this time?

Clearly, unless things change drastically over the next few hours, North American stock markets are going to be routed on Tuesday.  And since Europe is the epi-center of that rout, it is reasonable to bet that the price of gold will continue to be higher on Tuesday.

Gold stocks can only do one of two things.  They can follow gold and confirm their break-out from Friday, in which case I would argue that this is only the beginning (if gold stocks do decouple from the market then I suspect this will be the confirmation to many that things are different this time and that gold stocks are an inverse correlation to the evolving euro-crisis).  Or they can fall back, demonstrate it was a false breakout, and show that they will fall with the market just like in 2008.   In this case they will likely end up falling hard as all the momentum buyers from last week run for the exit.

Its quite a stark set of outcomes.

And that is why I suspect tomorrow is a very important day for gold stocks.

Week 9 Portfolio Update: Par!

Well almost.

I am $300 from being back to even.  Considering that the portfolio was created at the beginning of July, and that since that time the market has been somewhat horrendous, I do not think this is too bad of a result.

But it would be nice to start making money again.

There was not much action in my portfolio this week.  I sold a bit of Arcan, a bit of Coastal, and a bit of Lydian International.  In all 3 cases my selling had nothing to do with the company performance and everything to do with Europe.  Its unfortunate that I have to make investment decisions based on Europe.  I would much rather just pick stocks.

It is an interesting to think of what my portfolio would look like if Europe wasn’t on the verge of implosion.  I think it would look quite different.  First, I would own much more of Coastal Energy, and some more of Arcan Resources.  I would also own a decent position in Second Wave Petroleum.  I would likely have held on to Leader Energy Services.  And I don’t expect gold would be going through the roof, so while I would probably still own Jaguar, OceanaGold and Lydian, and Argonaut, but I would have smaller positions in all 3.  These stocks would not be as enticing if gold was still at $1200/oz, which I expect it would be ex-Europe.

The real upside in the gold stocks is the upward revaluation to reflect something closer to spot, along with the ever present possibility (as long as Europe is still the EU that is) that spot will continue to go higher.  If Europe was just being Europe (dull 1% growth), I would likely prefer to own other commodities that were leveraged to emerging world growth.  But alas, Europe has taken on the mask Faust, choosing a devil’s bargain over boringly flat GDP, and the outcome looks to be much the same, with the EU being on its way to hell on earth.  So gold stocks it is.

Goldman Research Note to Hedge Funds

Goldman Sachs published a research note a couple weeks ago that did a very good job summarizing what is frightening about the  state of the world economy right now, and why I have reduced my exposure to everything but gold stocks and a few special situation oil stocks and banks.

The research not is discussed on FT here:

And the actual powerpoint was posted by ZeroHedge here:

While the powerpoint focuses on 3 distinct items (the US economy, the European debt problems and China’s potential credit collapse) I think the most important points for us investors are made with regard to Europe.

Europe’s problems have the potential to evolve into something really bad, it could happen really quickly, and the outcome would be widespread among all stocks.   Its the sort of situation where we will wake up one morning and the world will have made a dramatic change for the worse.

So those problems need to be at the forefront of every investment decision right now.

I have snipped 3 slides that I thought were particularly poignant.

First, this slide demonstrates how leveraged the European banks have become.  They have grown assets well in excess of deposit growth.

To cover the gap between deposits and assets, the banks increased their wholesale borrowing.

The problem is that wholesale borrowing is short term.  A “bank run” is much easier to precipitate when your funding is made up of overnight, 7 day and month long durations.  If you ask me, this is a recipe for a nasty storm.  High leverage to likely insolvent assets that have been bought with funds that can be pulled away in an instant?  Yikes!

Last slide I’ll post.  PIIGS debt.  Whether or not the German courts and German government agrees to EFSF, you have to remember that the size of the EFSF is not big enough to handle Italy and Spain.  I have a feeling that if the market gets euphoric next week when the EFSF gets the head nod from Germany, it won’t last long.

So obviously, Italy and Spain are the keys here.   Further signs of stress in those countries is a sign to get out.  And ominously, Italian and Spanish bonds are rising again…
Italy:
 
Spain: