A contributor, the Mysterious Dr. M, generously donated this book to the library in the Value Vault–Financial Shenanigans by H. Schillit. This is a great book to improve your accounting and analysis skills. It doesn’t get better than this.
Thanks to Dr. M’s generosity!
Old Republic (ORI) pulled their spin-off and looked what happened
What changed? I would advise you to listen to the current conference call: http://ir.oldrepublic.com/phoenix.zhtml?p=irol-eventDetails&c=80148&eventID=4797341 which will be available until July 3, 2012. It is a classic of how analysts view the stock price and the owner/operator/management views the reality of their business. Old Republic (“ORI”) announced a spin-off of their money-losing Mortgage Guaranty Insurance business (“MGI”) but then on Friday decided not to go through with the spin-off for various reasons.
As you can see above in the short-term chart of ORI, the stock moved up upon announcement of the spin-off and the price neared $11 before plunging to below the pre-announcement price.
No matter what your assessment of intrinsic value was or is now, the mathematics of future cash flows has never changed. Actual risk hasn’t changed, but the PERCEPTION of risk has. If you read through the conference call transcript, you will see that several analysts/investors do not understand how run-off insurance operates. Run-off means that no new insurance is underwritten while claims of the old (past) insurance are paid down from stated reserves. ORI will pay claims initially at 50 cents on the dollar as per the orders of their insurance regulators.
Ironically, management (Aldo Zucaro – Chairman of the Board, Chief Executive Officer) bought shares last month around $9 to $10 per share probably never guessing that shareholders would respond to the announcement as they did. Note his exasperation in having to repeat over and over that the economics of the business have not changed. Note the gap between perception and reality. I have highlighted certain passages of the transcript for emphasis. Markets are efficient?
Case Study of reality vs perception for Property Insurer Old Republic_
Review of Old Republic here: ORI_VL, ORI_May 2012, 1Q12 FINAL Financial Supplement, and ORI_Morn_Spin
Details of Old Republic’s Mortgage Guaranty and Consumer Credit Indemnity Businesses renamed Republic Financial Indemnity Group, Inc. (RFIG). This will help you understand ORI’s deferred payment obligation (“DPO”) for the run-off of its MGI business. The DPO keeps the Mortgage Indemnity Insurance unit SOLVENT via the orders of the insurance regulators and in terms of STATUTORY ACCOUNTING.
The Statutory Accounting Principles are a set of accounting rules for insurance companies set forth by the National Association of Insurance Commissioners. They are used to prepare the statutory financial statements of insurance companies. With minor state-by-state variations, they are the basis for state regulation of insurance company solvency throughout the United States.
You will then understand the lack of risk to the rest of Old Republic. Statutory accounting is the reality not GAAP. financial_supp_stat_exhibit_032112 and the Press Release of Old Republic’s Partial Leveraged Buyout and planned spin-off of its RFIG subsidiary’s stock to ORI shareholders: may_21_2012_ori_press_release
Some say the market is efficient. What do YOU think? Who are the sellers?
Post Script: I am backed up this week so I might be light on the posting. Be well and keep learning every day.
NEW YORK (AP) — Moody’s Investors Service on Wednesday lowered its senior unsecured debt ratings for Old Republic International Corp., citing the company’s decision to withdraw plans to spin off a subsidiary.
The Chicago-based insurance underwriter announced last week it changed plans to spin off Republic Financial Indemnity Group Inc. The move came after stakeholders raised concerns that the spinoff would not be in their benefit.
The reversal prompted Moody’s to downgrade Old Republic’s senior unsecured debt ratings one notch to “Baa3” from “Baa2.” That’s the lowest possible investment-grade rating on Moody’s scale.
The ratings firm also lowered the insurance financial strength ratings of Old Republic subsidiaries Old Republic General and Old Republic Title by one notch to “A2” from “A1.”
Moody’s has a negative outlook on the ratings for Old Republic and its principal subsidiaries, which means there’s a 40 percent chance that the ratings could be lowered in the next 18 months.
The ratings firm said its outlook reflects continued risk of liquidity strain at Old Republic International, should regulators find that capital levels its subsidiary, Republic Mortgage Insurance Co., falls short of requirements, triggering an early redemption of the parent company’s senior notes.
Moody’s believes liquidity options exist in such a scenario but said such an event would still place pressure on Old Republic International.
“The intended spinoff would have helped protect Old Republic’s bondholders and insurance policyholders from further deterioration at the troubled mortgage insurance operation,” Moody’s analyst Paul Bauer said.
The risk of financial strain at Old Republic International could strain its subsidiaries’ financial flexibility, Moody’s noted.
Moody’s affirmed Old Republic subsidiary Manufacturers Alliance Insurance Co.’s insurance financial strength rating of “A3.”
It also maintained an “A3” rating on Pennsylvania Manufacturers’ Association Insurance Co. and Pennsylvania Manufacturers Indemnity Co.
Old Republic shares ended regular trading down 4 cents at $8.29. The stock added 5 cents to $8.34 after hours.
By Jochelle Mendonca and Sharanya Hrishikesh
(Reuters) – Old Republic International reassured investors that scrapping plans to spin off its money-losing mortgage insurance business would not lead to a liquidity crisis as regulators were unlikely to seize the unit.
The insurer had planned to separate the unit and had even entered into a deal to sell a fifth of the business in a leveraged buyout but shelved the plan following stakeholders’ objections.
The company’s stakeholders include its regulators, the government-backed Fannie Mae and Freddie Mac and bank customers.
Regulators in North Carolina have already placed the unit under supervision. It is now only allowed to pay claims at 50 cents on the dollar to preserve capital, leading to investor fears that the unit would be seized, triggering a default under the company’s debt covenants.
Old Republic eased those concerns on a conference call to discuss the canceled spinoff.
“We’re comfortable, based on our discussions (with our regulators), that receivership is not in play,” Chief Executive Aldo Zucaro said.
He expressed confidence that the company would be able to either refinance its debt or amend the terms, should a default occur.
Old Republic said the mortgage insurance (MI) unit, which stopped writing new business when its capital levels cratered last year, would continue to lose money for the next two years.
“By (2014), our total loss since 2007 will have been $1.7 billion, versus the total accumulated profit of $1.8 billion booked in the first 26 years … of our mortgage insurance journey,” Zucaro said.
The company said almost all its statutory capital – the standard claims-paying metric – comes from deferred claim payments ordered by regulators. Deferred payments count as a liability under generally accepted accounting principles.
On a reported basis, the company said its mortgage insurance unit has no capital and that it does not have the funds to add to the business.
“To just keep the company solvent, you’d have to come up with $250 million, which we are not committed to doing,” a company executive said.
UNHAPPY INVESTORS
But even as the MI unit’s stakeholders got their way with the scuttled spinoff, many Old Republic shareholders are unhappy at the prospect of being saddled with the business for the foreseeable future.
Investors from hedge funds SAC Capital, Anchor Capital, Divine Capital and others grilled company executives on options for the unit, including voluntarily placing it into receivership.
“Why is it not better to simply spin this out and go out to your bondholders and amend the covenants if necessary or to go in receivership?,” Darius Brawn from SAC Capital asked on the conference call.
Even a sale of the business to investors specializing in run-off situations, where they just manage the existing book till the policies are exhausted, seems unlikely.
“I think the possibility of a runoff (investor) buying a mortgage guarantee business with regulatory approval is remote,” an Old Republic executive said on the call.
The company said it sees no need to amend its debt covenants in advance of a seizure, something shareholders asked it to consider, because it does not believe the default will occur.
“One of our sayings around here is that you don’t just jump off the roof because you’re afraid you’re going to fall off,” CEO Zucaro said.
“We don’t think we’re falling off the roof. So we’re not jumping.”
(Reporting by Jochelle Mendonca and Sharanya Hrishikesh in Bangalore; Editing by Viraj Nair, Anil D’Silva and Supriya Kurane)
We can all become better investors if we become better sellers and, especially, if we avoid bad businesses, we can reduce our mistakes. Studying short selling will improve your analytical abilities and help you be a more flexible investor.
Forensic accounting can a fun—like solving a puzzle and it provides a moral framework in which to look at public disclosures.
Kathryn Staley at the 2007 CARE Conference (video)
A lecture from the author of “The Art of Short Selling” given in 2007 at Notre Dame.
You want to learn how to sell even if you don’t want to be a short seller.
Staley’s book on short selling: http://www.amazon.com/When-Stocks-Crash-Nicely-Selling/dp/0887304974/ref=lh_ni_t
Short Selling Research Reports from Offwallstreet http://www.offwallstreet.com/research.html There are examples of good forensic accounting research here where you can also download the financials of the company mentioned so you can understand the analyst’s research. Try downloading a company’s financial report to find the problems BEFORE you read the corresponding research report. Create your own case studies! Hard work, but you will learn to improve your skills.
Blog on Chinese Stock Frauds:http://www.muddywatersresearch.com/
http://brontecapital.blogspot.ca/ (China’s Kleptrocracy)
www.fool.com on shorting stocks: http://www.fool.com/FoolFAQ/FoolFAQ0033.htm
White Collar Fraud: http://whitecollarfraud.blogspot.com/2009/12/overstockcom-and-patrick-byrne-have.html
Reuters – Special Report: From Hannibal Lecter to Bernie Madoff by Matthew Goldstein
Gary Weiss – Novastar and Overstock in the News
Howard Schilit’s Financial Shenanigans: http://www.amazon.com/Financial-Shenanigans-Accounting-Gimmicks-Reports/dp/0071386262/ref=sr_1_1?s=books&ie=UTF8&qid=1339591819&sr=1-1
Thorton O’Glove’s Quality of Earnings (Joel Greenblatt uses this in his Special Situations class) http://www.amazon.com/Quality-Earnings-Thornton-L-Oglove/dp/0684863758/ref=pd_sim_b_4
Forensic Accounting Book: http://www.amazon.com/The-Financial-Numbers-Game-Accounting/dp/0471770736/ref=pd_sim_b_9
Earnings Magic: http://www.amazon.com/Earnings-Magic-Unbalance-Sheet-Financial/dp/0471768553/ref=sr_1_1?ie=UTF8&qid=1339592203&sr=8-1
A plug for Earnings Magic: I try to read various books on the subject of manipulating or managing earnings to enhance my analytical abilities. Because the GAAP rules give executives certain freedoms, it is valuable to know the true story behind these numbers. I like how this book educates readers on where to look to find clues for earnings management. For me, the chapter on pensions and other postemployment benefits was beneficial. During the current economic crisis, many companies struggle with their defined benefit plans, and this chapter educates readers better how to read through financial notes to gain better understanding of the pension status. – Mariusz Skonieczny, author of Why Are We So Clueless about the Stock Market? Learn how to invest your money, how to pick stocks, and how to make money in the stock market
Overall, our evidence suggests that the information short sellers exploit mainly concerns the market’s misperception of these firms’ fundamentals. Research_Shorts Signal Misperception
If you know the enemy and know yourself, you need not fear the result of a hundred battles. If you know yourself but not the enemy, for every victory gained you will also suffer a great defeat. If you know neither the enemy nor yourself, you will succumb in every battle. –Sun Tsz 2,500 years ago
When you come to the market, bring your investment discipline; bring your analytical powers; bring humility.–the Two Cents Philosopher
June 7, 2012 at www.nytimes.com
This article illustrates the importance of converting accounting information into economic reality and the pitfalls for both management and investors when ignored.
Back when I was studying accounting at Columbia University’s business school, the professor had a handy way to determine whether it made sense for a company to recognize revenue: Had it completed the hard task in its business?
GAAP — generally accepted accounting rules — were not so simple, he said, and sometimes let companies record revenue — and post profits — far too early. Companies that took advantage of such rules could well be reporting earnings they would never see.
The hard task varied from business to business, he said. For a farmer, the hard part was done when the crop was harvested. Even if it had not yet been sold, there was a ready market for corn or soybeans or whatever, and money had been earned. For a manufacturer of tourist tchotchkes, making them was the easy part. Persuading someone to buy them was the difficult part, and revenue recognition should be delayed.
Over the years, I’ve seen any number of accounting disasters, ranging from Enron to subprime mortgages, where that simple principle was ignored. Sometimes that accounting was within the limits of GAAP and sometimes it was not. In all cases, it produced profits that vanished before they were actually realized.
Now there is another example at MF Global, the brokerage firm that Jon Corzine ran into the ground.
The accounting maneuver allowed MF Global to buy bonds issued by European countries and book profits the same day. That is the rough equivalent of a farmer’s booking profits as soon as he plants the crop.
To be fair to MF Global, it did disclose what it was doing in a footnote to its financial statements. The accounting appears to have been proper under accounting rules that are now being reconsidered.
In a minute, I’ll explain exactly what the company did and how the accounting rules came to make it possible to report profits that were at best premature and at worst fictional.
But for now, consider the effect such rules had. MF Global, when Mr. Corzine took it over in 2010, was unprofitable. Here was a way to report instant profits and make the financials look better. There is no way to know whether the firm would have taken fewer risks without the foolish accounting, but perhaps it would have. In any case, regulators and investors might have seen a less rosy — and more realistic — picture in the months leading up to the firm’s failure last fall.
The transactions were laid out this week in reports from two trustees trying to unravel the MF Global mess and return as much money as possible to customers.
The fact that there are two trustees, one appointed by the Securities Investor Protection Corporation, which provides reimbursement for brokerage customers under some circumstances, and the other by the bankruptcy court judge, only begins to address the complexities of the mess made by Mr. Corzine. There are also “special administrators” in London, since many of the trades were carried out through a British subsidiary. The three sets of trustees and administrators have spent a lot of time fighting one another.
“Among the lines of business that Mr. Corzine built up to attempt to improve profitability at MF Global was the trading of a portfolio of European debt securities,” states the report by the SIPC trustee, James W. Giddens. “These trades provided paper profits booked at the time of the trades, but presented substantial liquidity risks including significant margin demands that put further stress on MF Global’s daily cash needs.”
How, you might wonder, could MF Global report profits immediately? Shouldn’t it wait for interest to be paid on the bonds, or at least for the market value of the bonds to rise?
To my old professor, the answer to that would have been yes. But that is not what the rules said.
To explain how that worked, we must venture into the world of repos. But don’t let your eyes glaze over. A repo in reality is usually just a loan. The lender gets an agreed rate of interest, and it gets possession of the collateral while the loan is outstanding. That way, if there is a default by the borrower, the lender can sell the collateral and not have to wait to be paid.
MF Global having bought a Spanish government bond, for example, would then repo it, meaning it would turn over the bond in return for a loan. MF Global would get the cash, but it retained all the rewards and risks of owning the actual security. If the bond defaulted, MF Global would suffer the loss.
Most repos are accounted for as loans. But sometimes they are accounted for as sales. One such case involves what are called “repos to maturity,” or R.T.M.’s, in which the repo does not expire until the security matures. MF Global called these transactions R.T.M.’s even though they expired two days before maturity. That was because a London clearinghouse, which was on the other side of the trades, was not willing to lend the money for that long. It wanted to be repaid before the bond reached maturity, so as to be protected from loss if the bond went into default at maturity.
Under the rule, MF Global could say it had sold the bond, not just lent it out. And with a sale, it could post a profit based on the fact that it borrowed more than it paid for the bond. Theoretically, it should have also taken a reserve for the fair value of the default risk it was taking. The details are not clear, but it appears that reserve was not very large, leaving MF Global with a profit to report.
Just now, that seems truly absurd. But the Financial Accounting Standards Board says that until MF Global failed, no one had complained about the rule. Since then, the chief accountant’s office at the Securities and Exchange Commission has voiced concern, and the board hopes to propose a new rule later this year.
I wondered how that rule came to exist. The answer, as in many cases of abused accounting rules, seems to be that FASB was trying to stop a different abuse.
That abuse came years ago, when United States Treasury securities were trading at large discounts to face value.
That was because interest rates had risen, not because anyone doubted the bonds would be repaid. Under the accounting rules, owners did not have to take losses on the bonds so long as they held onto them, no matter how low the market price was. But if they sold them, they had to take the loss.
Enter the clever strategy. The owners would do repos on the bonds, and treat them as loans. The repos would not expire until the bonds matured.
For all practical purposes the owner had sold the bonds at a loss, been paid for them and moved on to other investments, but no loss showed up on his financial statements.
The FASB ruled that a “repo to maturity” was really a sale. In the above case the owner of the bond would have to report a sale, not a borrowing, and report the loss.
The accounting board provided guidance indicating that if the repo ended very close to maturity, that amounted to the same thing. That made sense if you ignored default risks, and in those days repos were usually of very high-quality bonds with little or no chance of default.
That is the rule that MF Global was able to use, except that rather than avoiding a real loss, as in the previous case, this time it was reporting a profit that would arrive only if the countries were able to pay their debts.
As everyone knows now, people grew nervous about sovereign credit over the last couple of years. Regulators worried about the risky nature of the sovereign debt forced MF Global to maintain higher capital levels, which the report by the bankruptcy trustee indicates the firm tried to evade by shifting some of the positions to an unregulated subsidiary.
But the firm still needed more and more cash to meet margin calls as the market value of the bonds fell. In the end, it ran out of cash, and — intentionally or otherwise — seems to have misappropriated hundreds of millions of dollars from customer accounts.
It would be wrong to say bad accounting caused MF Global to fail. But it did both encourage and obscure risk-taking that ended in collapse and scandal.
Floyd Norris comments on finance and the economy at nytimes.com/economix.
Posted in Accounting
Tagged Accounting Scandal, business, climate, economy, MR Global
S.A. Nelson’s little book, The ABC of Stock Speculation, cites the basic opportunity for manipulation in these words: “The great mistake made by the public is paying attention to prices instead of to values.” What do we mean by paying attention to prices rather than values? Human nature is one of the few constants in an ever-changing world: “It is only fair to say that the public rarely sees value until it is most markedly demonstrated to them, and the demonstration comes generally at a pretty high price. It is easier for them, as experience shows, to believe a stock is cheap when it is relatively dear, than to believe it is cheap when it is more than cheap.”
I have been thinking about return on capital. My understanding is that one thing Greenblatt is trying to do come with in his Magic Formula is an incremental return on capital – that’s why he excludes things like goodwill. He’s arguing that it’s the return he can get on the assets that actually exist that’s important.
JC: True
I’ve expressed scepticism about this before, arguing that increases in earnings often come through acquisitions, and therefore goodwill was/is a true capital cost (if the company didn’t need to spend money on goodwill, then why did it?).
Well, this got me to thinking – if what you’re really trying to ascertain is a company’s incremental return on capital – then why not CALCULATE an incremental return on capital, rather than some surrogate? The formula is simple enough (and nothing new, I didn’t invent the idea):
(EPS1-EPS0)/(ASSETS1 – ASSETS0).
JC: AGREED!
There are some nuances, like whether you want to use EBIT figures or net income, adjusting for share issues, and so on. But you could use something like EBIT in the numerator, and total capital in the denominator.
What are your thoughts on this?
JC: You should look at a company both ways. What are the returns on the net tangible assets employed AND what are the incremental returns on capital employed in the business. We only have a few more chapters in Competition Demystified and then I will begin a long series on valuation-the death march.
For now, you may get some insight here:Dale Wettlaufer on ROIC and MROIC, EconomicModel of ROIC_EVA_WACC and ROIC and the Networking Industry.
You are not the only investor to be skeptical about IGNORING GOODWILL. See page four in this article:Why bad multiples happen to good companies. Cisco (CSCO) CSCO_VL, for example, has a high ROIC–so you will find it on http://www.magicformulainvesting.com/welcome.html but much lower ROC (Return on total capital) due to many acquisitions that were acquired with goodwill. Yes, investors are laying out real dollars, so you need to track the success over time (rolling average of a few years) of those acquisitions.
OK, very interesting John. I’m reading the book Book-on-Buffett-Methods-of-Clean-Surplus . I’ve only got to page 65, but I’m seeing the idea. The author uses a LOT of words to describe a very simple concept.
JC: Agreed. The author says in 230 pages what he could say in 3.
What’s very interesting is that by stuffing a lot of so-called one-off charges through the P&L, a company is able to “juice” its returns for the year, creating an artificially high ROE for subsequent years. Does it mean that clean surplus accounting paints too rosy a picture of a company? The answer is: probably not. With clean surplus accounting, all that “juicing” gets accumulated into the retained earnings of the company, so that in subsequent years, assuming the absence of further exceptional items, returns will actually come out lower. So in effect, clean surplus accounting isn’t being fooled by these non-recurring charges into over-estimating ROE.
The drawback seems to be that you have to go back into the mists of time to find out what the true retained earnings should be, and scrupulously adjust for capital issues, and suchlike. To make matters worse, you need a good set of accounts, which you can probably only get for 5 years. Sites might give you net income, but they wont give you comprehensive income – information which you need to see what’s been shifted around where.
JC: Well, once you are interested, you can always go back at least ten years with the SEC filings. Also, watching margins, buybacks, prior use of capital allocation can give you a further clue. Also, how clean is their accounting? Track what management says vs. what they do. You have to put together a mosaic on the company.
Also, what’s you view on goodwill? Should it be treated as a non-recurring charge?
JC: No, because some businesses like Cisco (CSCO) or Seacor (CHK) are making acquisitions as part of their ongoing operations. Better to understand the particular business rather than apply a one-size-fits all approach.
What about exceptionals that seem all-too-frequent? Would you treat them all as non-recurring, or might you assign a proportion as recurring, and a proportion as non-recurring? Maybe you could say a proportion of sales would count as non-recurring, and a proportion as recurring. Maybe you could take a proportion as recurring – say 20% – and the rest non-recurring. You could, of course, argue that over the long term, all exceptional items are recurring to a first order of approximation.
JC: I am a little lost on this question. Can you provide an actual example? In the end, you are trying to get to “normalized” earnings. What is the basic owner’s earnings (cash you can take out of the business without hurting the business in its competitive environment). Many businesses are too tough to figure out what their normalized earnings will be so you walk away. There is a reason why Buffett invests in a chewing gum company (Wrigleys) and not Microsoft. He wants to know where the business will be in ten years. People will still chew gum but will they still increase their use of Microsoft Office? I am not implying that you not invest in Microsoft–just be ware of the risks in your assumptions.
JC: We will have a long, brutal slog in analyzing how to value growth in a few weeks. You have to know this as an investor, but the real fun is in understanding a business so you can have some confidence in your assumptions.
Thanks for the questions.
A reader sent me this link of a great blog on forensic accounting. There are lessons here from morality, survival instincts, to overplaying a hand, to accounting shenanigans and to my loss of yet another value investing icon–Prem Watsa. Did he engage in a sham transaction to save his company from collapse during 2003? See for yourself.
The dark side of a well known value investor
Fairfax’s purchase of 4.3 million shares of Stamford, Ct.-based Odyssey Re, increasing its stake to just over 80% from 74%, was the most consequential transaction in Watsa’s career. Though few understood it at the time, the March 2003 deal allowed the then money-losing Fairfax to take advantage of a little understood maneuver called “tax consolidation,” enabling Fairfax to claim (and receive) the profitable Odyssey Re’s tax payments.
Between 2003 and 2006, these payments amounted to more than $400 million.
That cash stream helped Fairfax avoid a brutal accounting charge that might have proven its undoing and boost its share price over several months to almost $250 from a January 2003 low of $57.
Ecstatic investors and nine-figure wealth was only the half of it for Fairfax and Watsa: The company launched a furious legal campaign in 2006 against a group of short-sellers who had (in some instances) quite publicly bet on the insurer’s demise, a campaign now entering its sixth year. Though developments and rulings in the case have recently been sharply unfavorable for Fairfax, its opponents have been silenced and their short-sales unprofitably covered. (Lessons here for Short-Sellers and investors in insurance companies)
With the breathing room the cash afforded, Fairfax was able to access the capital markets, allowing it the flexibility to wager more than $340 million on credit default swaps that exploded in value as the credit crisis worsened in 2007 and 2008. The bet paid off brilliantly and Fairfax ultimately reported a $2.1 billion gain, completing a five-year metamorphosis that saw almost $6 billion added to its book value.
Fairfax is now a full fledged cult stock among value investors, and its success led at least one well-known investor to announce his switch from being short to proudly owning the shares (he has since sold the stock.)
Because of insurance losses from the September 11 attacks, the need to increase reserves and a bad acquisition, Fairfax’s auditors at PWC had concluded that an arcane tax asset then crucial to its balance sheet was going to have to be written down.
Called net operating loss carryovers (NOLs), they represent a company’s accrued operating losses that can be applied against future income to lower the company’s taxable income. Here’s how they work: a company with $500 million in taxable income and a $250 million NOL could apply it to cut the amount of taxable income in half. NOLs are certainly handy but they come with a firm proviso: they have a defined shelf life and can be used only when a company is “More likely than not” to generate the income to offset them, usually within seven years.
In other words, PWC had real doubts Fairfax could generate enough income in the future to warrant keeping the NOLs attributable to its U.S. operations. So in February 2003, the auditors informed the company that as of June 30, they were recommending half of its $795 million worth of U.S. NOLs on the balance sheet–or $348 million–be written down.
To be sure, companies large and small are constantly shifting the value of assets on their balance sheet for dozens of valid reasons.
PWC was demanding a material valuation allowance which would be accounted for as a charge against earnings. The charge would have given Fairfax their second massive annual loss in three years and prompt further share price declines–its market cap was around $1 billion at the time, and had dipped down to about $750 million that January–but where the real trouble lay was in the specter of credit downgrades, both on its corporate debt and its financial strength ratings, a key barometer of its claims paying ability. In early 2003, declining liquidity prompted Standard & Poor’s to reduce Fairfax’s credit ratings even further below investment-grade. Its insurance ratings from A.M. Best were affirmed only after the Odyssey Re deal was complete, a process Ambridge had spent weeks communicating with A.M. Best’s Joyce Sharaf about.
Thus buying the 4.3 million Odyssey Re shares that would take them to 80% ownership and tax consolidation was no longer an option, but a necessity.
There was a hitch, however, as Fairfax didn’t have the cash to spare.
To get around this, Fairfax’s Watsa and his staff, in conjunction with a Bank of America Securities team, came up with a three-step, cashless (oh no!) proposal whose final iteration was this:
1. NMS Cayman Services Ltd., an offshore affiliate of Bank of America Securities, borrowed the 4.3 million shares from 10 different institutions and then re-loaned the stock to Fairfax.
2. In lieu of cash, Fairfax issued a $78 million note to the same BAS affiliate as payment.
3. Fairfax then pledged the newly acquired Odyssey Re shares back to Bank of America Securities as collateral for the notes.
To outsiders, the Odyssey Re note deal was designed to appear like a convertible bond: It bore an interest rate and in March 2005 (two years after the transaction) was exchangeable into Odyssey Re stock, giving the holder–NMS, the Bank of America Securities affiliate–the right to swap back into the shares.
To insiders, including Bank of America’s credit analysis unit and Fairfax’s leadership, there was little doubt that the exchange would be made in two years: The Fairfax bonds carried a below-market interest rate of 3.15% and, according to then CFO Trevor Ambridge, the bonds represented “an inferior risk exposure” for Bank of America. Had Bank of America Securities held the bonds and not exchanged them back into stock, they would have been short 4.3 million, or 33% of the remaining Odyssey Re float, something the firm estimated would have taken 20 months to buy back in the open market and, quite likely, cost their trading desk tens of millions of dollars in losses.
Per Ambridge, in a July 2003 E-mail to a PWC partner, the transaction was structured to secure a block of stock for a limited amount of time for tax consolidation purposes without reducing the public “float,” or shares available for trading. He did not even want the extra 6% worth of Odyssey Re’s earnings included in Fairfax’s income statement since it was inevitable that Bank of America would exercise its exchange privilege and take the shares back in two years.
The transaction’s structure also casts doubt on whether Fairfax’s Odyssey Re maneuvers allow it to claim true ownership of the stock.
Robert Giammarco, a Bank of America Securities banker who helped design the deal, noted in an E-mail to colleagues that one of the transaction’s “disadvantages” was it “Does not provide true economic ownership” of the Odyssey Re stock to Fairfax. [Giammarco would go on to serve a 19-month term as CFO of Odyssey Re before joining Merrill Lynch prior to its purchase by Bank of America Securities in 2008. Fairfax asserted to the New York Times that he recanted his description of the deal in a 2011 deposition.]
Recall that Bank of America Securities did not sell Fairfax the securities, but borrowed the shares and then “sold” them to Fairfax for what both parties understood was to be a defined period; neither party ever exchanged cash as part of the deal because of the anticipated use of the conversion feature. Fairfax did not own them in any broadly understood sense of the word since it was not entitled to profit or loss from the 4.3 million Odyssey Re shares nor could they re-lend (or, in Wall Street parlance, re-hypothecate) them out. The company was also forbidden to sell any of the share block. Put simply, for all the deal’s complexity and hard work, the additional shares gave Fairfax no obvious economic privileges nor exposure to Odyssey Re.
Similarly, in agreeing to compensate Bank of America Securities for all of its hedging costs or losses, Fairfax was engaging in economic behavior entirely outside of market norms for a purchaser of securities. Edward Kleinbard, Third Point Management’s expert witness, noted in his opinion, “No bona fide owner of stock would agree to cover a short-sellers cost of maintaining its open short sale.”
The economic exposure argument is key since it appears there was no way Fairfax could profit from the Odyssey Re deal. If the stock price went up, Bank of America Securities would simply exercise their conversion privilege, without incurring any additional cost. On February 7, 2003, Prem Watsa wrote an E-mail to Sam Mitchell (a friend who would later become an executive with Hamblin Watsa, Fairfax’s investment subsidiary, and a board member of companies Fairfax had substantial investments in, Odyssey Re and Overstock) discussing an earlier version of the deal, noting that the “Purchaser [of the notes, i.e. seller of the stock] maintains upside/downside in ORH….”
The one benefit that Fairfax did obtain from the Odyssey Re transaction was voting rights. Looked at plainly, however, the applicable law governing tax consolidation, IRS code 1504(a), offers the company little comfort, stating that tax consolidation applies only to companies owning 80% of the value of shares outstanding and 80% of the total voting power of those shares. At the end of the transaction, Fairfax still owned 74% of the shares outstanding and had constructed a proxy on 6.6% of the rest.
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The circular path to regulatory approval for the March 2003 Odyssey Re deal began with Trevor Ambridge’s assertion to Ernst & Young–hired to write an opinion of the deal–that Fairfax “Will acquire good and marketable title to the Purchase Shares, free of any mortgage, lien, charge, encumbrance or adverse or other interest.” To comply with the IRS regulations above, Ambridge also wrote that, “Members of the Fairfax Consolidated Group will own Shares [of Odyssey Re Stock] representing at least 80 percent of both the total voting power and the total value of all of the issued and outstanding shares of Odyssey Re’s stock.”
Fortunately for Ambridge and Fairfax, E&Y’s opinion was entirely based on the assumption that share ownership was a settled matter.
Richard Fung, part of the E&Y team that worked on the opinion for Fairfax, said in a deposition that much of his firm’s work was based on a so-called rep letter from management asserting exactly what Ambridge claimed above. According to Fung, E&Y never examined how Fairfax obtained the shares and, had he and his colleagues understood that the entire goal of the transaction was based on exchanging the shares back to Bank of America Securities in two years, their opinion likely would have been different.
In a footnote at the end of Kleinbard’s opinion, he discusses his examination of Fairfax’s E-mails and internal correspondence in light of their assertions before the Internal Revenue Service about the transaction.
According to Kleinbard, Fairfax broadly misrepresented the deal to the IRS.
One example cited was the company’s claim that, “Fairfax had complete risk of loss with respect to the purchased shares, and the possibility of benefiting from their long-term appreciation.”
Ambridge, in the July 2003 E-mail above, argued a very different conclusion to the PWC auditors.
Even if the Odyssey stock price drops sharply, he wrote, there is no valid economic reason for Bank of America Securities to elect to hold Fairfax’s low interest-rate, then junk-rated debt. He estimated that the Odyssey Re “break-even” share price, or the point at which it would be reasonable to hold off on the exchange and keep Fairfax’s 3.15% debt, was $13.49. Even so, Ambridge (as Kleinbard argued) the price would be likely much lower than that since a drop to that level–Odyssey was then trading at about $18–would certainly imply Fairfax was also under economic stress, making ownership of its subordinated debt an even riskier proposition than taking the stock back.
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A casual observer would conclude that Prem Watsa and Fairfax have matters well in hand.
The ledgers run thick with black ink (with some exceptions due to spikes in catastrophe claims) and if the lawsuit against short-sellers has not proceeded seamlessly, Watsa certainly has a much better reputation among investors than fellow short-selling litigants Patrick Byrne of Overstock and Eugene Melnyk of Biovail, both of whom have poor track records of building shareholder value.
So the IRS Whistleblower suit from 2007 pressing claims about the Odyssey Re transaction more than nine years later might well look futile given the scope of Watsa’s recent achievements with Fairfax. Investors, enjoying the recent elevation of the share price, and Fairfax’s legal and media advisors, who have earned tens of millions of dollars in fees from its legal, reputational and regulatory battles, may well downplay a complaint filed in an office known for its lethargy.
But it is unlikely Prem Watsa will. After all, few executives should have a keener appreciation of how narrow the line really is between good and ill fortune and desperation and the miraculous.
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Fairfax was approached for comment on this article via E-mail through its longtime outside public relations advisors at Sitrick & Co. They declined comment.
A few words of disclosure: I was the first reporter to write about this transaction in July 2006 and I am the financial journalist described in their suit against analysts and hedge funds. In the summer of 2011, Fairfax subpoenaed me for a deposition but I fought it and won.
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The whole saga is an amazing case study and morality tale:
http://www.thefinancialinvestigator.com/
I’ll send Mr. Watsa this: http://www.youtube.com/watch?v=XgyMUChgcbU&feature=related
Posted in Accounting, Investing Gurus, Risk Management, Valuation Techniques
Tagged Accounting Shenanigans, Fairfax, Fruad, Prem Watsa, Short-Selling
“To invest successfully, you need not understand beta, efficient markets, modern portfolio theory, option pricing or emerging markets. You may, in fact, be better off knowing nothing of these. That, of course, is not the prevailing view at most business schools, whose finance curriculum tends to be dominated by such subjects. In our view, though, investment students need only two well-taught courses – How to Value a Business, and How to Think About Market Prices.”
“Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now. Over time, you will find only a few companies that meet these standards – so when you see one that qualifies, you should buy a meaningful amount of stock. You must also resist the temptation to stray from your guidelines: If you aren’t willing to own a stock for ten years, don’t even think about owning it for ten minutes. Put together a portfolio of companies whose aggregate earnings march upward over the years, and so also will the portfolio’s market value.” (1996 Chairman’s Letter–Warren Buffett
Many weeks ago I mentioned and posted a book on using clean (taking out the “dirty” stuff like one-time accruals) surplus accountinghttp://wp.me/p1PgpH-Fx
The gist of the method is to use clean surplus accounting to calculate the company’s true return on equity that makes it easily comparable to other companies. Then invest (at the right price) in companies with better than average ROEs than the market’s average ROE (13%) if you want to outperform an index of stocks.
Obviously, if a company sports a relatively consistent ROE above 15% without too much debt, then the company probably operates with competitive advantages.
For those who wish to learn more: You can listen to radio segments http://www.buffettandbeyond.com/radio.html of the promoter of “Buffett and Beyond.” Yes, a bit promotional, but the concept the Professor is explaining is sound.
For a list of companies that fit the investment parameters go here: Parameters_for_Investing_the_Buffett_and_Beyond_way
A consolidation of past articles: Clean surplus article
If you have a method that makes sense, you know how it works, and you have confidence in its LONG RUN performance, then you are better off than 99.9% of all investors in the market.
I am not promoting the above method as THE best way to invest, just suggesting that you develop your own investment philosophy and method that YOU believe in. This post is just an example of how you might go about developing your method.
Posted in Accounting, Risk Management, Search Strategies, Valuation Techniques
Tagged Buffett and Beyond, Clean Surplus
| http://www.libertyclassroom.com/ Courses on History/Economics |
| http://www.libertyclassroom.com/category/blog/ Sample Course Videos |
| http://www.burtfolsom.com/ A blog on history |
| http://mises.org/Literature/ A free library on Austrian Economics |
Posted in Accounting, Economics & Politics, Valuation Techniques
Tagged Fulsom, History Classes, Investing Blogs, Thomas Woods
In a boom fortunes are made; individuals wax greedy and swindlers come forward to exploit that greed–Charles Kindleberger in Manias, Panics, and Crashes
I once went to a Yale University Graduate Business Seminar on Investing in Cuba. After four hours of hearing all the amazing “opportunities” available in Cuba that the students uncovered, I asked, “What return would you require to invest in Cuba?” A commotion ensued as the calculators whirred and then students cried out, “12%, 15% even 20%.” “OK” I replied, “If your deal is estimating a 20% annual return, what is your cost of capital now-as I tore up the imaginary contract into tiny pieces and then threw the confetti in the air?” SILENCE.
By the way, to this day Cuba has defaulted on ALL their TRADE DEBT! What good is a cost of capital calculation with no rule of law? Don’t be a lamb lead to slaughter.
Muddy Waters Fraud School
http://www.muddywatersresearch.com/wp-content/uploads/2012/04/MW_FraudSchool_20120410.pdf
To steal ideas from one person is plagiarism; to steal from many is research.–Steven Wright
We discussed the Xerox (XRX) here: http://wp.me/p1PgpH-zH.
Is the company over-leveraged?
You can download my comments here: http://www.yousendit.com/download/M3BsUXVpeFUwMEdLRmNUQw
Our goal is to have you practice skimming through the 10-K to find the critical information for making a particular judgment. There is no clear black or white answer since most investing requires judgment honed by practice and experience.
When determining the appropriate leverage, we have to understand the terms and conditions of the debt as well as the quality/cash flows of the assets being financed by that debt. Segment the different types of financing to gain a clearer understanding of the business and credit risks.
This wasn’t the best example, but the more you practice reading a 10-K the faster you will be able to organize your time.