NOT AN ANALYST

Bank of America

 JP Morgan

 Provision for Credit Losses

Note: values are in millions of dollars.

Looking at 3Q 2009 earnings releases from JPM and BAC, it’s  noticeable that despite improving economic condition, credit costs remain high and continue to negatively affect earnings. Profits from trading, investment banking and brokerage fees are offset by losses related to deteriorating credit quality. Provisions for credit losses remain elevated compared to 3Q 2008 levels as the consumer continue to remain under stress, but the rate of increase is diminishing. Part of the credit losses are attributable to growth in loans (in 3Q 09, BAC extended 183.7 B in credit) and part to weak economic conditions in US and around the globe. Non-Performing Loans, or loans that are at least 60 days past due, and Allowance for Loan Losses, or an estimate of uncollectible loans, continue to climb as a percentage of total loans  (table above).

The business segments that are negatively impacting banks the most are:

Card services Delinquencies and losses related to credit card loan portfolio continue to climb as the consumer spend less on average and unemployment remain high.

Commercial and residential lending High unemployment rates and home prices declines continue to drive higher estimated losses related to the consumer and commercial lending.

Introduction CIT Group and CIT Group Funding Company of Delaware launched a Restructuring Plan on October 1^st to enhance the capital levels of the firm. We will first look at the capital structure and then at the terms of the Plan. 

Capital Structure CIT Group has all the characteristics of a High Yield Issuer. The Company is structured as a holding company, it relies heavily on short-term bank debt (JPM Letter of Credit, most of Senior Unsecured Notes, Senior Unsecured Term Loan and Credit Agreement are bank debt) and debt is borrowed at the parent level (the senior unsecured notes are issued by CIT Group which is the parent) but funds to pay the obligations are generated from operating subsidiaries.  The offering memorandum provides very useful insights however it’s 250 pages!

Only the face amount for holders entitled to vote in the offering are displayed

Restructuring Plan The Company’s principal objectives under the Restructuring Plan are to reduce leverage, return to investment grade rating, transfer business platforms to CIT Bank and recapitalization. Bondholders can elect to participate in the Restructuring Plan through consummation of the Offer or the Plan of reorganization. The Offering is conditioned upon achieving acceptable liquidity and leverage targets and the Plan of Reorganization is accepted if it reaches a certain approval percentage. The Company will file for bankruptcy protection without a prepackaged restructuring plan if the offer is not consummated or the plan of reorganization is not accepted.

Terrible deal Investors holding the Canadian Senior Unsecured Note or Structurally Senior Unsecured debt in the table above (for amount of $2,188 mm) are pushing for greater consideration from the Offering Plan as they are entitled to recover close to 100 cents on the dollar from the pre-packed Plan of Reorganization. Also Subordinated Bondholders (amount to $1,979 mm) are only offered Preferred Stock and are asking for more equity or extra money if the company will perform well. It’s important to note that the “New Preferred Stock” offered is not a preferred stock per se but it’s basically an equity stake in the company. The “New Preferred Stock” will have no stated dividend, no intention to pay a dividend, no maturity, it will not be listed on any exchange, it will not be subject to any sinking fund provision and only redeemable at the Company discretion. Should I go on? This Preferred Stock may very well be worthless if the company seeks Chapter 11 protection a few months after the offering.

Amendments and more On October 19, Carl Ichan offered to underwrite a $6,000 mm loan to rescue the lender after the offering was amended on October 16 to include some minor changes that are “sweetening” the offer. However, the company has major liquidity and operating issues and these actions are just postponing the problem. For the months ending on December 31 2009, there is $1,600 mm in notes maturing, including $800 mm due in the first week of November and for the months ending in August 31 2010, there is $7,600 mm of debt funds needed.

Little Hope Bankruptcy seems inevitable for CIT Group even if an out of court reorganization is implemented. The company’s ability to raise funds is impaired under two fronts: capital markets because the company has credit rating below investment grade and cannot issue short term debt like commercial paper (or it might be able to at high rates) to fund its lending business and bank deposits because the FDIC imposed a restriction called Cease and Desist Order on the CIT Bank ability to grow deposits as the regulator is concerned about the firm’s financial well being.

Covenants Restrictions The new notes are going to be subject to certain covenants that protect bondholders but will impair the ability of the Company to generate income.

• Restriction on the parent and its subsidiaries from incurring additional debt. This is obvious but there should be some tests implemented every quarter to check if capital levels are adequate (maintenance or debt incurrence test).
• Pay dividend. The Company has to retain income, if any.
• Make investments .This is my point, how is the company going to grow?
• Create liens or use assets to secure other transactions. A principal element of he Restructuring Plan is to “negotiate new or amend secured credit facility to provide additional liquidity” but this is not possible under the new notes covenants.
• Sell certain assets or merge. If the company ends up in trouble again, which I deem very possible, the only solution will be Chapter 11
• Transaction with affiliates. Part of the business Post-Restructuring Plan indicates that the “most likely scenario” is to transfer all “bank-like” operations (that takes place in other subsidiaries) to CIT Bank, but this is not possible under the new notes covenants and until the FDIC lift the restriction discussed above.

A breach of any of these covenants could result in a default under the New Notes Indenture.

Conclusion The Restructuring Plan doesn’t seem well drafted as some of the core objectives cannot be implemented due to the restrictive bond covenants of the new notes. The company may end up in court for bankruptcy under Chapter 11 as the Offering doesn’t look appealing to bondholders.

Take a look at the article below, it’s pretty good. I want to share it with everyone and discuss, but I am not going to talk about the good or bad of GS. Maybe you can.

From Economist.com “Heads I win, tails you lose”

“Much of the outrage over bonuses is unjustified. People who create wealth are entitled to be rewarded for their efforts”.

I agree but the statement is too general. First of all, how do you measure wealth creation? Is it calculated with higher revenue or with creation of good for the overall benefit? Also is it the company’s wealth or the shareholders? My take is that bonus payouts should be approved by shareholders through proxy voting and bond covenants should define acceptable ranges for packages. After all, the capital received from the issuance of a bond is used for operating and investing activities.

“The best solution would have been for the Government to have taken an equity or equity-related stake in every financial firm it helped when it bailed out the system last year”

I don’t disagree with the statement but it’s too easy to say now what could or would have been a better course of action a year ago. A decision needed to be taken promptly and the shape of the crisis was something that was never seen before. Of course now, few months after a huge bank rally, “the government missed out on much of the profit it could have made from a stake in the better firms that were saved”. It was almost impossible to distinguish a “good” bank from a “bad” bank a year ago.

 “This doesn’t look like a good outcome for Citi’s part-owner, the taxpayer” Commenting on the forced sale of Phibro.

I cannot agree more. The US Government does own more than 30% of Citigroup, which makes it an influential party, but it shouldn’t get involved with buying or selling of assets. But this is not all, the Government’s involvement can make things worse for Citigroup as it may force to sell Mexico’s Banamex Bank, a key element of the Company’s retail business, which contributed with $900M in profits for 2008. There is a law in Mexico that prohibits a foreign Government to own more than 10% of any bank that operates inside of Mexico. This would be a big loss for Citigroup as these bank deposits represent cheap funding, making them one of the least toxic assets. This can be good material for the next post.

Full and fair disclosure

Do you have any beneficial interest in the security or product reported. NO

Do you have any compensation agreement with a third party regarding the performance of the security or product reported. NO 

Do you have any outside relationships that might give the appearance of a conflict (e.g. board memberships, trustee positions) with the company reported. NO

A series of amendments were also part of the offering and were designed to eliminate the legal obligations of the issuer to pay dividends on the non-cum preferred stock even if some of the investors did not agree to the exchange and such securities remained outstanding after completion of the exchange.

Proxy Voting June 16, 2009 was the record date for holders of preferred securities to be eligible vote on the Common and Public Preferred Stock Proxy for a series of amendments.

Common Stock Proxy Non-cum preferred and trust preferred holders voted and it was passed. It authorized the increase of common shares from 15 billion to 60 billion, a reverse stock split and the elimination of rights solely related to preferred holders.

Preferred Proxy Statement Non-cum preferred holders voted and it wasn’t passed. It was supposed to authorize the elimination of the dividend blocker, waive the right to appoint two directors to Citigroup’s board under some circumstances and increase the authorized preferred shares.

Dividend Blocker It prevents the issuer from paying dividends on securities ranked equal or junior in the capital structure to preferred shares. Citigroup has to pay a dividend on the non-cum preferred remaining outstanding after the offer before the common dividend can be paid.

Director Amendment It allows holders of the non-exchanged non-cum preferred shares to vote for the election of two directors to the board of directors of Citigroup after the company defers the dividend on these outstanding shares for six quarters. This is important because these shareholders can exercise a level of influence over the management and governance of the company that is disproportional to the remaining economic interest.

Possible Scenarios The failure to pass of the preferred stock amendments is significant. There are still over 7mm shares of non-cumulative preferred stock outstanding after the completion of the exchange and some investors are speculating in a rise in price or clean-up offer. It is unclear when Citigroup will resume its common dividend but we assume that it will happen at the end of the 3^rd Q of 2011. Results of the exchange offer are available here.

Scenario 1 The shares are called at par right before a common dividend is paid or announced (3Q 2011). This scenario provides attractive returns but it is not likely to happen because even if the company reduces expenses by eliminating a dividend on the non-cum preferred shares, failure to do such for six straight months can incur in a loss of control per the director amendment. However it’s a possible case and should not be excluded.

Scenario 2 The dividend on the outstanding non-cum preferred shares is resumed after six quarters of deferred payments and the shares are called at par right before a common dividend is paid or announced (3Q 2011). This scenario is the most expensive for the company and therefore the highest payout to investors, however it might be an appropriate course of action for Citigroup to prevent loss of control.

Scenario 3 An involuntary exchange offer into common stock for all non-cum preferred shares outstanding is announced before the company defers the dividend on these shares for six straight quarters. This represents the best option for the company because it represents a an non-cash expense with minimal dilution but it would be subject to SEC scrutiny which might not approve the deal. Assuming the company offers 85% liquidation value for the outstanding preferred (it was 95% on the original offer announced in February) and that at the time of the announcement Citigroup common is trading at $5.00 per share, preferred holders of par $25 will receive 4.25 shares (4 shares plus cash) and holders of per $50 will receive 8.5 shares (8 shares plus cash).

It’s hard to speculate how much return preferred shareholders can get as it depends on what price the common stock will be trading after the announcement.

Conclusions Purchasing any of the outstanding preferred shares could score a significant profit as the prices can rise in speculation of a potential reorganization or exchange offer similar to one of the scenarios illustrated. It is a risky investment because there are a lot of uncertainties and variables involved. Liquidity can be an issue as the number of shares outstanding is limited and an investor could be stuck with an illiquid position for quite some time. 

Formulas

Annualized return formula= [1+ln (Par/Price)] ^1/ (Quarters/360)

Ln= Natural Log of return. Continuous time frame.

Quarters= Number of Quarters and 1Qis 90 Days.

Introduction The third quarter earnings season just kicked off few days ago and investors are looking for signs of an improving economy. Several companies are expected report good earnings but be aware that better then expected results doesn’t necessary mean good results. Here are some things to look for in the up comings earnings reports.

Guidance.It indicates the outlook for the future. If earnings figures are reported to be better then anticipated but the guidance is lowered, then you will see some heavy selling.

Good sales. Better then expected sales figures means that demand is stronger then originally thought. It’s probably going to be hard to see higher sales number versus a year ago so growing sales since Q1 is good news. Once it’s established that sales are increasing, look for drivers of sales growth.

For credit card companies and banks: revenue attributed to large reduction in doubtful accounts seems unjustified given this economic environment and it represents a warning sign for potential revenue overstatement.

For banks: Due to joint ventures, mergers and acquisitions, some financial companies may indicate higher asset values or one time gains in the income statement. Look for how much asset growth is attributable to goodwill and carefully monitor changes in reported goodwill. Absence of impairments in this tough economic environment or increase in goodwill is a sign of low quality earnings.

Retailers: large portion of revenue accounted to LIFO liquidation is not sustainable and should be removed. The company is no longer purchasing additional inventory (prices are high) and is depleting its old and cheap cost-base inventory. Once it runs out of cheap inventory, it will have to purchase new inventory at a much higher cost base.

Computer software companies: with providers of goods and services sometimes there is discretion on deciding when a service has been provided. Revenue attributable to large decreases in unearned revenue is another warning signs as the unearned revenue account could be built up during periods of strong growth (customers prepay for service) and tapped into when times are tough like now.

EPS. It’s not necessary a good indication of growth in this economic environment because better net income can be the result of heavy cost cutting or one time tax credits.

Conclusion. Earnings have a tendency to revert back to normal levels (mean reversion) and very low or very high earnings are not expected to continue in the future. This has an economic meaning as capital migrates to more profitable businesses, increasing competition and reducing returns. The net effect of these competitive forces is a return to “normal” earnings levels

Introduction Treasury auctions for long dated maturities have been closely watched by investors and market participants in recent months. The frequency of the auction for 30 Year Bond has been changed to monthly from quarterly and the size of each auction (for all maturities) have been significantly increased as an effort to increase liquidity.

Improving conditions in the equity markets and speculations about rising inflation in the near future, have risen concerned about the success of treasury auctions for long maturities like 30 Year Bond and 10 Year Note. However treasury buying has been very strong since the June auction, sending the 10 Year Note yield below 3.20% and 30 Year Bond yield below 4.00% on both 10/01 and 10/07 respectively, which are level not seen since the beginning of the year when the market was in worst conditions then now.

Bear Market A bear market for treasury bonds with maturities of 10 Years and higher can be on the way. The following are compelling reason for this thesis. Auction results are posted on table 1 at the bottom of the page or here

Recent Auctions The result of the last round of auctions was mixed. On 10/06 the 10 Year Note auction was very strong with a bid/cover ratio of 3.01 and high yield of 3.201 but the 30 Year Bond auction was weak for the first time in months with a bid/cover ratio of 2.37 and a high yield of 4.009%.

Trading Patter The week before the auction on September 28, equity market pulled back due to worst then expected manufacturing data and employment data, however treasury securities reaming unchanged, signaling a possible change of trend. Yields from 30 Year Bond closed on Friday October 02 at 4.011%, a small decline in yield from Monday’s close at 4.045%, the same situation happened for 10 Year Note where yields fluctuated from 3.302% on Monday to 3.221% on Friday

Geithner Factor Beginning in June, auctions experienced a sudden increase in demand from indirect bidders, giving the impression that foreign demand for domestic debt was stronger than ever. But in a little noticed switch on June 1, Geithner appears to have used some artifice in redefining ‘indirect’ buyers to include not only foreign entities but also domestic buyers who place orders to purchase Treasuries through a primary dealer. This “little change” of information reached bond desk just few weeks ago and now traders are speculating that foreign demand is not very strong after all and that yields could be too low at the moment to spur demand. If that’s the case, the fed will have no other option then raise rates.  

 Auction size Supply for recent actions reached levels. The auction size for 10 Year Note has been above 19B and above 11B for the 30 Year Bond since February 2009. The fed is probably going to reduce the auction size at the beginning of the 1^stQ 2010 which will cause a rise in yields, as the fear of inflation is rising and the foreign demand is now uncertain (see the Geithner Factor).

Conclusion Treasury yields are definitely on the rise with the 10 Year Note possibly reaching 4.00% and the 30 Year Bond reaching 5.00% in the 4^th Q of 2010.

10 Year Note Auction Results

30 Year Bond Auction Results

Table 1