Death of a Model?

While the Chicken Littles of the financial world have been relatively quiet in the past few months, there continue to be pockets of anxiety. Perhaps the name most mentioned in the past few weeks is CIT.

This relatively obscure financing company deals in what they call “middle market business and commercial loans, financial services and solutions”. So we’re talking about Small Business Administration Loans, Factoring (lending with receivables as collateral), leasing, etc. Middle sized companies, like retail chains, service providers and specialty manufacturers turn to these guys for money. On the consumer side, they finance student loans.

So basically no “mortgage meltdown” here, although the recession has affected their loan and lease portfolio and write-downs put the company’s results into the red for the last few quarters (not unlike most financial institutions). CIT received TARP money last year (again…like everyone else).

The balance sheet appears to be solvent, with $64 billion in liabilities to $6.1 billion of equity. Hardly levered compared to most, you could say. Cash flow is quite positive.

Nonetheless, CIT tethers on the edge of bankruptcy. Why?

The problem is funding. For years, CIT has financed its operations by issuing notes and commercial paper to the “market” and then using those proceeds to lend out. They call it the “wholesale model”. Get money in the market at 4, 5, or 7%, lend it out at 9-12% effective rate. Live happy ever after.

Of course, something happened on the way to the bank (or middle market finance company). The credit freeze happened. All of a sudden the “market” for CIT’s paper was no longer there. CIT did a few things, like issuing commercial paper with a government guarantee (for a while) and converting to a bank holding company, which allows it to get FDIC-insured deposits. Additionally, CIT reduced its portfolio (essentially lending out less than it was collecting).

But it hasn’t been enough. Notes issued in previous years are coming due at a quick pace ($13 billion for the next 12 months). Funding has not been forthcoming quickly enough (deposits at the CIT bank are only $5 billion). At least not CHEAP funding.

There is a price for everything and CIT recently got a SECURED $3 billion credit line from Barclays and a syndicate of banks. But at a price: LIBOR plus 10%, with a 3% LIBOR floor. (That’s a 13% floor and there are other fees associated,too). They got some of the cost back buying back some notes at a discount, but it doesn’t offset that much.

This is obviously not a permanent solution. CIT can’t operate funding at over 13%. And of course, while its liquidity problems remain, it can’t fund cheaply. S&P already has them at CC.

It’s a catch-22. CIT can’t get the money it needs because it has no money. Rinse, lather, and repeat. Can the “wholesale model” escape this circle?

Of course, CIT itself is lobbying quite clearly for a bailout. Just check out its website. HERE. They have a point. How is CIT that much different from another banking holding company (Citi? Morgan Stanley?) or GE Capital for that matter (GE continues to get TALF support). On the other hand, shouldn’t the “market” have a market-based solution for this?

If CIT is indeed solvent as it’s balance sheet indicates (you can never be sure), shouldn’t there be a buyer for it? And also if so, shouldn’t CIT be able to return to its original business model (selling notes at “normal” yields).

Of course, there is an investment opportunity here. These “survival” plays tend to carry a very interesting risk/reward ratio. CIT’s stock has been volatile for sure. But a bailout could carry a hefty price in terms of dilution, so no simple solution there. Potentially large payout, however, CIT trades at a market cap of only $600 million (excluding the TARP money…which could convert).

And there are bonds, of course. Bets on “survival” generally have worked well since Lehman collapsed last year. Solvent companies with liquidity problems can find buyers (as was the case with Nova Chemicals) or a government hand if they are “too big to fail” (Banks, AIG and subsidiaries) or something in between (Ford Credit. GMAC).

In any case, CIT paper maturing in the next 2-4 months is trading at 60-70% of par. Putting down 60 with an upside of 100 in a few months, with only one major outcome in play (survival), is a tempting bet. In the case of bankruptcy, CIT’s long-term notes, trading at around 45-47%, would seem to indicate that the expectation of recovery is relatively high.
So overall, I kind of like those “pot odds”.

My Wife’s Junk

In one of my posts (one of the non-Stanford posts a few of you read), I wrote of my wife’s no-hassle junk bond portfolio. And I also wrote a post about bonds overall. I’ll link to that.
If you’re new to this, start there. LINK.

Only us junkers have noticed, but JUNK has been ON FIRE lately, so this portfolio is up on average about 10% this year. A few of the bonds have become pricey over the last weeks.

But I still think it’s a good example for investors who may be new to bonds or junk bonds. Fixed income can be more than a CD. And should be. My wife put this together with a little help from me and as I explained she is NOT a financial expert. So with a little work (and money), you could too.
Click on the table to get a bigger version.



Here we go:

1. Advanced Micro Devices. This is actually a convertible bond with the “convertible part of it worth very little (convertible at 20…stock is around 3). So forget that. AMD is Intel’s only real competitor these days. Things aren’t that great for AMD these days with high debt and sales down,, but they have a solid backer in an investment firm from Abu Dabi. This is the high-risk play of the portfolio. A coin flip, if you will. But the wife thinks the odds of AMD of surviving are better than of it going under. So she made the call.

2. Alcoa. The large aluminum company. This bond is actually “investment grade” according to S&P. My wife calls this an industrial “too big to fail”. I thought the balance sheet was a bit heavy in debt…but they cut the dividend, so that means more money for bondholders.

3. Chiquita Brands. The longest maturity in the portfolio with 5 ½ years left. Bananas. My wife likes bananas.

4. Corrections Corp of America. These guys operate jails for a number of states. Anyone think that business is in a recession? Of course, there is no such thing as riskless. Nice short term bond.

5. Davita. I mentioned this bond in my J-Word Junk bond primer/rant. These guys operate kidney dialysis centers. As far as necessities go, that’s a service that is hard to do without.

6. Home Depot. It seems my wife single-handedly expects to keep these guys in business. She loves Home Depot. This is a bond that she might actually sell. It was bought below par and with less than 2 years left is at 102-104%. The highest graded bond in the portfolio at BBB+.

7. Jo-Ann Stores. This is an arts and crafts and sewing material retailer. Nothing is recession-proof, but these guys do ok when people make their own clothes or other stuff. The wife liked the stores, I liked the balance sheet. They have a credit line in excess of three times the bonds outstanding. And they have been buying the bonds back. S&P says CCC, the wife says…buy, buy, buy.

8. Owens Illinois. Only a year left on this one. Glass maker. Wife thinks they’ll make the payment too.

9. Seagate Technologies. Disk Drives. My wife takes WAY too many photos and has too much music. Always running out of space. Seriously though, business isn’t great, but these guys managed to issue new debt to the market so they should be able to refi by the time these bonds mature.

10. Starwood Hotels. Sheraton, Westin and several other brands. My figures that the collateral is good and if it comes to the worst we can turn in the bonds for a time-share or something.

That’s it. A nice little collection of junk, if you ask me. Short maturities. Somewhat diversified (no financials…hmmm) and a yield to maturity of 10.27% if nothing goes wrong. Too good to be true? The wife doesn’t think so, and neither do I.

The J-Word

(ED: A few days ago, I wrote about bonds, in general. Follow this link. It’s an easy read).

JUNK. JUNK. There…I wrote it. A financial slur. This one regularly tossed at “high-yield” bonds…those “outcasts” of the investment world.

And “high-yield” isn’t necessarily right, either, because the yield may not be THAT high.
The right term would be “low-rated”, because junk bonds are only “JUNK” because someone has deemed them to be such. That “someone” is none other than the rating agencies (i.e. masters of the universe – holders of the absolute truth), S&P, Moody’s and Fitch. Yes, these are the same people who told us that MBS (mortgage backed securities) were AAA and Lehman Bros was “investment grade” (until it wasn’t).

S&P Ratings Explained

The S&P rating system is simpler than it looks, think grade school: letters and pluses or minuses. A twist is that you can have more than one letter. Rules of thumb: Higher letter, better, more letters better; a plus sign beats no sign and minus is worse than no sign.
So A beats B; BB- beats B+; and B- beats CCC+. Get it? If not wikipedia will answer.
BBB- is the limit of respectability…everything below that is labeled with the J-Word.
D is for default and not death, because there IS life after default.

Why do they rate bonds as “junk?”

Usually, these issuers or bonds have some imperfection or flaw. Either the company is small or its in a tough industry, it might have a significant amount of debt or maybe it isn’t familiar or “American” enough. In other words, there is more risk that it may default (in the opinion of the credit agencies).

So what?

It’s just someone’s opinion, right? The same as if an analyst said BUY, HOLD or SELL on a stock, right? Unfortunately, NO.

The problem is t that the “junk” label is almost a curse. There are serious consequences to carrying it.

The media calls these bonds “too risky” and “only for pros”. Regulators tend to concur and it can be considered an “inadequate” investment for a conservative investor (advisors can be sued for recommending them). There are a considerable number of brokers/banks who REFUSE to offer “high-yield” bond recommendations. Additionally, junk bonds cannot normally be used as collateral for a margin loan, while any old stock over $5 will usually do. Only a handful of online brokers will offer them as an alternative to clients. Furthermore, a number of pension or retirement funds have statutory prohibitions concerning investing in “junk” while they can buy all the equities or leveraged hedge funds they like. More than a label, it’s a stigma.

This is incredibly unfair. Let’s not forget that bonds AS A CLASS are less risky than stocks. But the stock of the SAME issuer can be considered an “adequate” or even “conservative” investment suitable for everyone, while its corporate debt (bond) is deemed to be “junk” and only the “pros” are allowed to go near them.

Here’s a practical example, straight from my wife’s (junk) bond portfolio:

She holds Davita bonds carrying a 6.625% coupon, maturing March 15, 2013 (about 4 years), currently trading at about 97% to yield 7.3%. (high yield? hardly) These bonds are rated B+ by S&P, so they are not “borderline”, they are solidly in “junk” territory.

FYI, DAVITA is a company that operates kidney dialysis centers. It’s a stable business (if you need it, you need it) and sadly also a growing business. Recession-resistant? Probably. Doesn’t seem like a discretionary expense.
Notwithstanding, the company has a significant amount of debt (not unlike a utility) and default is always a possibility.

Oh...and Davita’s stock is also publicly traded (DVA). Currently at $43, it has weathered the crisis relatively well and is considered to be “defensive” for obvious reasons.
No broker or advisor would be open themselves up to liability if they recommended this stock to a conservative investor. But if they recommend (or buy) the bond…it’s junk and they open up a fiduciary can of worms (if it goes bad, of course).

For those who don’t get just HOW unfair this is; Davita STOCK would have to go practically to ZERO before default is a factor for the bonds. And EVEN in the event of default, bondholders can expect to come away with something. But Davita stock is “defensive” and you can use it for margin while its bonds are “junk” and worthless as collateral.

This is exactly what happens when regulators use a third party opinion (the credit agency) as the basis for policy. And investor “protection” takes on a whole new meaning when those investors willing or needing to take a little more risk for a higher return, end up invested in offshore CDs, hedge funds, REITS or high-risk equities…instead of some good old boring bond, which could have served them well. Just because somebody called it “junk”.
It’s financial bigotry at its worst.

So, as an equal opportunity investor…I like junk, I wish it were more available, had better markets and were easier to acquire and trade. It deserves a place on the menu and certainly a better rap.

And as a believer in free markets, I wish that some day, stocks and bonds -investment grade and junk (and even distressed)- along with derivatives of all kinds could join together and trade freely in more efficient and transparent markets, for the benefit of all.
Without the J-word.