Will the CDO Machine Destroy Public Equity? Part I

Christopher Whalen wonders Will the CDO Machine Destroy Public Equity?". The first half of his article is about Credit Default Swaps and if they are symptomatic of something.

Briefly, an introduction to the Credit Default Swap CDX market. CDX are contracts for insurance on bonds. In exchange for a fixed premium you can purchase protection against default on a notional $10 million of bonds. A CDX is a put option on a corporate bond that can be exercised upon a credit event. The person who sells the CDX gains exposure to default risk, and the person who buys the CDX loses exposure.

A really big market for credit risk has emerged fueled by some people who want to get rid of credit risk and a greater number who wish to take on credit risk. In theory the spread of CDX contract plus a risk free bond should equal the yield of the underlying bond. This is based on the assumption that the interest rate on a risky bond is equal the risk free rate plus a premium for credit and investment risks. Therefore CDX can be used to create synthetic positions which can then be arbitraged against real positions.

Just like in the futures market, the number of people who want to speculate on commodities is far greater than the number of people who actually need to hedge commodity risk. This has resulted in a grand shift away from Keynesian Normal Backwardation to a semi-permanent state of contango (forwardation). In the past, speculators demanded compensation for taking on commodity price risk, today they pay a small premium for exposure.

The same thing is going in CDX for popular credits. There is more demand for exposure to General Motors (GM) and Ford (F) credit risk than organically exists in the form of Ford/GM debt. Often it is cheaper to buy and sell CDX than the underlying bonds.

A huge industry of capital structure arbitrageurs has emerged who busy themselves with buying and selling CDX, debt, and equity, to take advantage of perceived mispricing of credit risk between senior and junior parts of the capital stack.

The net result is that there is a huge market for CDX, and it is not uncommon for the notional value of the CDX on issuer to far exceed the total amount of debt outstanding. This can lead to a humorous situation in which there is mad scramble for the defaulted bonds of the obligor because these are needed to redeem the CDX.

An additional source of demand for CDX is the synthetic collateralized debt obligation [CDO] market. Remember that a risk free asset plus a CDX is equivalent to the risky asset (in theory!). The bond market is not very liquid and bond dealers like to rip off clients who seek specific bonds and loan participations. So it is both cheaper and faster to set up a pool of treasury bonds and paper over it with CDX, than it is to go out and actually buy the equivalent amount of debt.

All this newly created synthetic debt can then be bundled into a CDO. The CDO is financed with low yield investment grade debt in many tranches ranging AAA to BBB and it leaves behind a highly leveraged equity tranche and management fees for the issuer.

The CDO can be highly structured to give every certificate holder what they want in terms of credit risk and return in the financing of the underlying portfolio. For complex reasons too technical to explain here, (involving reinsurance of the upper AAA tranches), a synthetic CDO is often more profitable than a real CDO. Faster, more profitable, and with high fee's which is just what Wall St likes to see.

So now we understand why the CDX market has grown so much. There is great interest in credit speculation. There are arbitrageurs and dealers creating a liquid market. And there is huge demand for the high returns from CDO equity and bonds from the investment grade tranches.

Whalen then asks if the fact that CDX spreads for certain (GM)/(F) bonds is less than spread on the bonds themselves is a problem. He seems to concludes that it is symptomatic of a dangerous appetite for risk. Are tight CDX spreads a problem and are they caused by a dangerous appetite for risk? No. The tighter CDX spreads can be explained by a liquidity and utility premium.

Part two of this series will discuss the second half of Whalen's article, which wonders if the CDO market might finance the takeover of the world. (Maybe)

His plan proves successful

His plan proves successful and Judy agrees to tolerate him as "her new man," securing Victor's place high atop the neighborhood's social pecking order. At the same time, Obi-Wan's investigations lead him to a water planet where he discovers the creation of an army unlike anything he has ever seen before. The result is the only thing it can be, given its market and the Dobbs character; a lame comedy raunch romp which goes straight for the crotch.

From the camoflage text of a recent penny stock spam. This one mashed-up various movie reviews. Marcel Duchamp would have a blast with this stuff.

An investment opportunity with sleepover possibilities

"There’s an overriding sense of impermanence. This is a fashion choice. No one will buy one of these gloomy spaces and say, ‘I want to have kids here. I want to grow old and die here.’ This is simply an investment opportunity with sleepover possibilities."

Condos of the Living Dead by A.A. Gill, October 2006

I'm reminded of a quote from Warren Buffet that you should only buy something that you'd be perfectly happy to hold if the market shut down for 10 years.

What is interesting is that as soon as the leveraged IPO market dries up, the entire private equity model that relies upon it for an exit dies too. This has many implications for certain sectors whose values are fluffed up as from constant M&A speculation: think Equity REITs (ICF), Base Metals (XME), and Steel (SLX).

Theft in the Afternoon: the Reckson Associates Realty (RA) story.

Shares of Reckson Associates Realty (RA) have lifted on news that a syndicate of Carl Icahn and Macklowe Properties plan to offer $49 in cash for RA shares compared to SL Green's (SLG) current offer of $31.68 in cash and 0.10387 of an SLG share. SLG's offer was worth $43.31 a share at the time, being a slight discount to Reckson's closing price of $43.95 at the time the deal was announced.

SL Green's plan for Reckson Associates was to keep Reckson's Manhattan portfolio while selling off the remainder of Reckson to a team lead by the former management of Reckson Associates.

Carl Icahn/Harry Macklowe are not stupid, and they understand what SL Green is doing. Assuming the Manhattan real estate markets stays strong, Reckson's assets will organic growth from rent roll-ups estimated at 5%-8% per year for the next seven years. If you net out the cash received from the management buyout of residual properties against SL Green's cash payment for Reckson's shares this deal is almost wholly financed with SL Green common stock at 2%.

The 2% solution

The chance to acquire a big slug of trophy Manhattan properties, at below market prices, with long term financing at 2% is irresistible.

On the back of an envelope, 80.15 million Reckson Associates shares at $31.68 is 2.55 Billion. Less $2.1 billion from the MBO, equals a total cash contribution of $455 million. The enterprise value of Reckson Associates is about $6 billion total. So with today's low rates who needs a gun?

The total cash equity contribution is piddling, therefore SL Green doesn't need to be too picky about the sale of the other 75% of Reckson. It is better that SL Green leave something for Reckson Management so that they will be motivated to do the deal. The fight is for the crown jewels in Manhattan and the opportunity to raise rents on hundreds of thousands of square feet of prime office space in a supply constrained market.

Although Reckson claims that they shopped the non SLG portfolio around, ran a competitive auction for the whole company and so forth. I don't really believe it. Because if Reckson management did what they said, an offer like Carl Icahn's would have been made and accepted. Had Reckson's management had been serious about getting full value for the company they would have used more independent advisors with a better valuation process. That Citibank (C) is in discussion with Reckson MBO syndicate about post deal financing is evidence an obvious conflict of interests while they are in charge of bidding process for the whole company.

I am not impressed with the fairness letter/board presentation from Goldman Sachs (GS) either. Firstly, Goldman Sachs is not disinterested party, and never will be in anything they touch. Like all investment banks they will have their hands on both sides of the deal. There is financing to arrange, consulting services to offer, and IPO's to underwrite. All this business depends on staying friendly with everyone on Wall Street. Getting in the way of a deal by saying that it is bad for Reckson shareholders doesn't win friends with people who do business with Goldman Sachs.

The Manhattan Transfer

Goldman's analysis was based on MBA type discounted cash flows and multiples analysis based off of Reckson's stock vs. other office REITs. It was not based on a serious analysis of the market value of Reckson's real estate portfolio. SLG surely did this analysis, but Goldman didn't.

RA is one of two public REITs with a New York City focus. Reckson owns one of kind NYC assets that not comparable to assets of any other REITs besides SL Green. Note well, that SLG trades at serious premium to other office REITs which gives a hint of just how valuable pure NYC real estate is. A sum of the parts analysis would have shown that Reckson Associates was worth more than SLG's $43 cash and stock bid. Icahn's bid of $49 in cash confirms it.

At a deep level, Goldman Sachs' analysis had no imagination about the real way to value a dead REIT. After you remove the management premium (discount!) the value of the REIT is its liquidation value at current market prices. This means doing a granular assessment of the entire portfolio on a property by property basis. After you figure out what a reasonable person would pay, you demand more. And if the buyer won't overpay, then you don't sell.

That an outsider is willing to pay 15% more than SLG before seeing confidential information, suggests that the entire sales process was flawed. The right people weren't invited to bid, and a lowball offer from SL Green was accepted without reservation. Reckson Associates is still worth more than Ichan/Macklowe's $49 bid, but that is a good starting point.

PID and Tiparillos

A reader asks:

Hi MP. I found you when I was searching for info on [PowerShares International Dividend Achievers] (PID). I am intrigued with it, but I've never bought anything outside my ROTH or 401k before. Do you think it's a bad idea for a taxable account?

Investment returns stem from capital gains and dividends. Under the current tax structure long term capital gains and qualified dividends are favored with a 15% tax rate. Bond interest, dividends from REITs/BDCs and short term capital gains get taxed as ordinary income. As a matter of strategy you should put things like REITs and bonds inside of IRAs/401k while putting less tax sensitive assets in taxable accounts.

Mostly I like PID because it is a source of dividends and growth that is less sensitive to the results of the US economy and US dollar. Most Americans have plenty of exposure to the US economy, because they live and work here. Hence they need safe global exposure.

For a core equity position I recommend about 30-50% exposure to non-domestic assets. I think PID fits that role quite well, being a diversified set of US-listed companies with a history of rising dividends. It performs nicly and yields a little bit more than the iShares MSCI EAFE Index Fund (EFA) does.

Douglas Emmett and the 1.4 Billion Dollars.

Douglas Emmett (DEI) is attracting the attention that biggest REIT IPO of 2006 does deserve. DEI's portfolio of trophy office property in Los Angeles and Honolulu is unmatched. The company is profitable from the get-go with prospects for internal growth. DEI is going to become a core holding for investors in BIGREITs: the large actively traded real estate investment trusts that make up the Cohen & Steers Realty Majors Portfolio (ICF).

The underwriters increased the size of Douglas Emmett's IPO from 55 million shares to 66 Million shares, and priced them at $21 per share. The top end of the proposed IPO range. Substantial money was left on the table as DEI shares opened trading at $23.50. This IPO set a record for the largest REIT IPO ever, raising $1.4 billion dollars.

Assuming a starter dividend of $0.175 per quarter, DEI is yielding 3.0% at the current price of $24 a share on book value of $17.81. I think this is bit pricey for investment purposes, but not unreasonable when compared to the rest of the (ICF) universe. Instead of repeating myself, I will quote myself pointing out that:

As Benjamin Graham observed: "the Margin of safety is always dependent on the price paid. It will be large at one price, small at some higher price, non-existent at some still higher price." I think these valuations, including the out of the gate valuation of DEI, give investors a negative margin of safety.

While Douglas Emmett is a very nice REIT; real estate and even very nice real estate has risks and should trade a yield premium to risk free assets. If online savings accounts are paying 5.0% or more, is 3.0% with no safety of principal compelling?

Most of DEI's future growth comes from fully leasing up the few buildings in its portfolio that are partially vacant, and rolling leases. Most of DEI's growth is internal. That is good because such growth is low risk, but internal growth tends to converge (revert to the mean) of CPI+1% or so. Going forwards Douglas Emmett will have a hard time buying new properties for reasonable prices in its target markets.

This is where professional real estate investors and the common public part ways. If you were to hand Douglas Emmett's management a term sheet for a deal that had %3 yield with 4% annualized growth, they would reject it. But if you give the public that same term sheet, it gets bought out for a premium.