Responding to ACAS 3Q Comments

Thanks for showing up and taking the time to comment. The third quarter definitely got people's attention, and mostly for the worse. ACAS presented today at Merrill Lynch, and you can catch both the presentation and the Q&A on webcast. Make sure to look at the slides.

Kawa asked:

I thought a company incurs a liability when the board declares a dividend; so even though the record date of Q308 dividend is in October, I still expect to see a dividend payable line in its balance sheet dated 9/30/08. In the conference call when being asked, they replied that GAAP doesn't require it, but the analyst can do their on calculation and trade the stock themsevles; I'm a bit concerned/confused why they choose such response.

I was sort of surprised that when this question came up, the discussion turned to a discussion of materiality. I think the questioner and the answerer were talking past one another. I certainly can't explain why the questioner was fixated on an unpaid future dividend that had not gone ex- by quarter-end when he seemed to agree it wasn't an enormous amount of money, or why it was important to the questioner that management express an opinion on accounting that might be required under Delaware law. I also can't explain why -- other than hypothesizing unpreparedness due to surprise -- management chose to tell the analyst to go build his own pro forma financial statementss and to value the stock on their basis if he didn't like the accounting ACAS believed required by GAAP. I tend to suspect management didn't understand the question as having any purpose than to allege the balance sheet understated liabilities, which would explain why materiality would be offered as an argument and why home-made pro formas would be offered as a solution.

My own take is that everyone is probably right. Different accounting is used at different times for different purposes. Tax accounting is rather different from the accounting that is used to gauge internal performance (some of this internal performance accounting, particularly within portfolio companies, might not even use currency units as its functional unit of measure), and the accounting required by the SEC is surely different than the statutory accounting that might be required by Delaware law. With respect to state-law accounting schemes, I offer a little perspective: insurers are required to apply a statutory accounting scheme that values assets with huge discounts to the values of liquid investments. This doesn't mean that the insurers must report these values when filing GAAP financial statements with the SEC, this simply means that the insurers must balance their books with the statutory accounting tools and have these books ready in case they are demanded by someone making a lawful request for inspection of the state-law accounting. You probably will never see these accounting products for any insurer, because they are different from the accounting required by the SEC and aren't required to be made publicly available. It's not fraud, it's just different accounting. Indeed, publicly-traded companies don't show the public the tax accounting they do, and they all do tax accounting in addition to the SEC-required disclosures. Moreover, if investors reading financial statements filed with the SEC expect the statements to be comparable, it's important that some standard -- even one with clear flaws -- be used across the board. No matter what Delaware would want an accounting produced (say, in litigation over the value of a closely-held corporation) with one set of rules and effective dates for future payment obligations, it's clear that whatever standard obtains with the SEC is what should be in SEC-filed statements.

I don't pretend to have special expertise in accounting for future dividends -- I've never declared a dividend or accounted for it -- but there are explanations more plausible than "evil conduct" that have the advantage of also explaining all the observed conduct.

All these accounting principles have a purpose, all have some legitimate use, and all give different numbers. The reason I bash FAS-157 is that it tends to cause strange problems unconnected with investment performance. Warren Buffett doesn't have to report from quarter to quarter what GEICO would be worth if he had to liquidate it, and he doesn't have to report what that Israeli tool manufacturer would be worth if liquidated. Berkshire Hathaway accounts for these in a much less responsive fashion, and the best you can hope for is to see earnings. The book values BRK gives for acquisitions are simply not numbers you can trade on. Indeed, reading Buffett's letters, it's clear that some of the numbers Berkshire has published (or, has been required to publish) are straight-up fictions -- whether done to appease accounting standards, or whether discovered after the fact as hard-to-value assets' values became clearer. The difference is that with fewer assets Berkshire must mark to market, the effect of comparables pricing isn't visible.

Also, since Berkshire isn't levered (it entered the financial blowup chock full of cash), and isn't regulated to 1:1 leverage, nobody is worried about Berkshire having a liquidity problem brought on by net asset value throwing debt-to-equity ratios into chaos. The fact that organizations that aren't BDCs can avoid some of the liquidity challenges ACAS faces are a reason Malon Wilkus gave a long and rambling answer to the question about BDC status: BDC status is great for some things and has done well by investors, but it also creates problems.

Then, Kawa said:

I have no problems with cancelling the dividend to weather this financial storms with better capital position; I am delighted to see their NOI results; I think they have managed well given the tough mark to market and bond yield analysis rules. I can see the NAV for Q408 might go down another $1000M (20% down with market, 200M of dividend?, offset by realized gains and potential increase in NAV due to ECAS deal); however, I also think they'll successfully amend their ~1.3B credit facilities with Wachovia even though the covenant is breached. All in all, what is your view of a potential NAV range and why are many people stating management is losing their credibility?

I'm not sure how banks will view amendment's to ACAS' credit line. I think ACAS wants to maintain a big credit line so that as the current multiples compression expands, and as bond-yield analysis begins re-inflating ACAS' debt holdings' value, ACAS will be able to quickly produce cash to make attractive deals even if share price remains below NAV. Therefore, I expect ACAS to try as long as possible to cling to the current credit facilities. It wouldn't take much more abuse from the marketplace (in terms of FAS-157 valuations using bond yield analysis and comparables-based pricing) to bust the current debt covenants. I think management recognized that, which is why I believe Wilkus brought up operating with no leverage at all while answering questions. He's looking at the possibility of disaster on the horizon, and planning accordingly.

Management's credibility has taken a hit for several reasons. First, the stock price last summer nearly hit $50, and it's threatening now to scrape $5. People are scared. Yes, ACAS announced a NAV close to $25, but let's face it: on the date that NAV was calculated, the share price was close to $25. Heck, the NAV was just under $25 and the price was just over $25. And the share price is now about $6. Management's comment that ACAS was trading above NAV at quarter end tends to frighten people into wondering about present NAV -- a topic ACAS didn't provide insight on because calculating NAV for quarter-end takes lots of time for a three-digit number of people, and ACAS doesn't calculate NAV for any other purpose. However, failing to deliver a current NAV number leaves the door open for frightened investors to speculate that ACAS might still trade above NAV. But perhaps the biggest reason management has taken a credibility hit is management's own rhetoric. ACAS has long pointed to its dividend as evidence of ACAS' ongoing and increasing profits. ACAS has repeatedly stated that the paid dividends are a performance measure that cannot be faked in the marketplace and cannot be restated. ACAS has essentially instructed the public to look at ACAS' dividend as proof of management's competence and good faith. Cutting the dividend simultaneously admits that management was mistaken about its ability to set dividends at levels that would never require reduction and reduces to zero the performance metric management had been holding out as the gold standard and indisputable proof that management continued to execute successfully on behalf of shareholders.

The concern about management is therefore not without basis. However, management could have done what others have done and cooked the books -- but did not. Management produced the ugly numbers of increased debt:equity, and published the unvarnished FAS-157 writedowns exactly as required by the regulations governing its structure. Moreover, management didn't say that it had everything in the bag and all was hunky-dory, it admitted frankly its view that the economic situation was likely to continue forcing write-downs as multiples compression and bond-yield-analysis painted worsening pictures of existing holdings even though they performed as underwritten. In other words, ACAS openly stated that there is no good-case surprise scenario in which its effective due diligence would protect the company from writedowns: it repeated that regardless of credit quality, the existing accounting rules would cause ongoing mounting of paper losses provided the economy continued as badly as management expected. This kind of brutal honesty -- which as ACAS' chart shows does not help share prices during the quarter and doesn't set up ACAS to issue equity above NAV -- is not what one expects of a management that is out to cheat its shareholders. Openly admitting that ACAS' tax status is a subject of potential future review tends to reassure investors that management is willing to look at every option in order to keep the company operating for the long run, while in the short run driving out investors who invested in ACAS in tax-advantaged accounts and liked getting paid pretax dividends.

Management is clearly looking to the long term and not the quarter, and it doesn't conceal this when it explains its behavior or gives guidance.

Peachberry_Tea wrote:

The thing I hate about ACAS is that it's opaque. You really can't see how the portfolio companies are going, and it seems like management won't say anything in reassurance except they're "continuing to perform".

...

I listened to the conference call and it didn't sound anything like ACAS management was letting the quarter's numbers go to hell for the long term good of the company. To me it sounded like they screwed up big time and they didn't exactly just come out and admit it. I had a lot of faith in management with the deleveraging they've done, but today I didn't get the impression that management was being honest and upfront. With a black box company like ACAS, again, this should be cause for worries for shareholders.

I'm as disappointed as you that ACAS has been slammed like it has. For the reasons I state above, though, I don't think the 3Q2008 quarterly conference call or the subsequent presentation to analysts at Merrill Lynch are indicative of character flaws or of poor judgment. I can't imagine anyone planning to model for a VIX of 90. I myself got slammed as the markets tanked. Being levered less than 1:1 was a great benefit when considering that firms like Merrill Lynch that were levered 40:1 have already failed (Okay, been bought by a bank that itself is on sale and taking federal handouts), and management's prescience to have entered the quarter at even less leverage probably meant the difference between surviving the quarter and being destroyed in a liquidity crisis.

ACAS' willingness to announce it plans to use cash to de-lever is an admission that it will be focusing defensively on surviving for the future, rather than snapping up bargains now in the hope that a quick turnaround will make it possible to eke by with clever accounting. ACAS is really working to reduce its risk, not to play games or pray for federal deliverance. Nowhere in the conference call did I hear false hope offered to investors. ACAS did stress that its assets were performing, but was clear that this didn't protect it from FAS-157 in an environment of severe and widespread financial recession.

Peachberry_Tea also wrote:

The fact that they confirmed the dividend a few weeks back, and now all of a sudden this - this certainly shows cracks in their armour. Assuming management really believed that they would be able to fund the dividend a few months back, the only thing that could've caused the dividend to stop altogether is that some of their investments exits have seriously turned sour. Which again points to the health of ACAS' portfolio companies. I think this and the possibility of a prolonged recession should have ACAS investors worried.

I don't think the only explanation is that ACAS' due diligence proved faulty. Especially in light of the continued NOI and ongoing syndication of senior debt, it seems that the investments are performing and that third-party buyers (who are buying senior debt at par rather than at FAS-157 discounted rates) also see the investments as performing. Rather, the FAS-157 valuation reductions have caused a liquidity crisis of the sort I described in earlier posts (such as after the second quarter's report). With its debt-to-equity ratio regulated as a BDC at a maximum of 1:1, ACAS need not have investments fail to perform as anticipated (i.e., it need not suffer a reduction in operating earnings) in order to face a liquidity crisis. Moreover, the debt covenants create a further cause for concern.

As for the worries facing investors in the form of a prolonged recession: investors in anything should consider worry. Gold isn't safe, as the destruction of so much value by the financial implosion could cause deflation. Debt instruments aren't safe, as the valuation concerns that decrease the market value of ACAS' deb holdings will hit anyone's debt holdings (except, haha, for banks which are allowed to carry performing loans at face value) and credit deterioration could endanger repaymet prospects. Heck, with benchmark interest rates heading into the toilet to make money available in the economy, inflation is a serious risk -- especially as the turnaround gets underway and credit actually becomes available. Many vendors are in danger as consumers threaten to tighten their belts and unemployed people have to hock their belts for bread. Investing in criminal defense or bankruptcy representation might be an angle. Of course, betting on short-play instruments isn't safe: multiples are so compressed and investments are so historically undervalued that one would need great care in choosing an exit, or one would risk being slaughtered as prices return toward historically more common multiples.

On the news I heard that safes and firearms are currently enjoying a sales boom. This is probably a sign that many people view the investment markets broadly as a place to avoid. While this sentiment persists, where will investment come from?

If you have the skill to time the market, God bless you -- it'll be a fantastic opportunity as the market's gyrations unfold. I have no claim to such skill and am simply working to ensure I have no leverage with which a crazed market can destroy my portfolio without my having to have picked poor investments. Interestingly, this seems to be exactly what ACAS' own management is doing: de-levering to reduce risks generated by third-party pricing lunacy.

Although some folks have lost confidence in ACAS' management, and it's certainly worth running for the doors if your investment thesis has been undermined, I haven't gotten there yet. I bought ACAS because Berkshire Hathaway was too big to capitalize on the small opportunities that are ACAS' bread and butter. I wanted a company that was able to find something to do with its cash, and didn't have to sit on tens of billions because no good deals were big enough to bother. Obviously from the standpoint of a short-term trade, BRK.B would have been far superior to the performance we've gotten from the stock price of ACAS over the last year. On the other hand, ACAS turned in $0.74 in operating income last quarter, or more than 10% of the current share price; BRK.A earned just $1335 per share, which given today's $97,000 share price (a 2-year low) is still less than 1.4%. Derivatives contracts weren't much more gentle to Berkshire Hathaway than to American Capital, but just looking at operating earnings, it looks like ACAS is the one in the sweet spot.

Moreover, Berkshire Hathaway has been on a buying spree -- including in financials -- as the market has gone into a panic. Buffet doesn't claim to time markets, he claims to spot deals. The fact that Buffett can find "deals" in companies so large they are worth his time to invest in (read his letters to the shareholers about this; the company just can't make material amounts of money on little deals) offers serious reason to rethink the hypothesis that nobody can find deals, even if they are willing to look in illiquid, hard-to-value, smaller companies. I think this latter class of companies offers a better long-term return. I love Berkshire's management, I just wish they were small enough to make money on the little deals where the explosive growth lay. In the meantime, since BRK.B doesn't have mark-to-market pressure because it doesn't have a requirement to place quarter-by-quarter values on its portfolio companies (it's not a BDC), nobody is going mad over Berkshire's "losses" (because it isn't required to report them as losses; it's just, you know, depreciating goodwill and that kind of thing). Instead, Berkshire has suffered a substantial operating earnings haircut as its main-line business (insurance) comes under pressure. ACAS, which has nearly three hundred portfolio companies, hasn't got this kind of risk concentration in one industry.

Consider ACAS' requirement to apply FAS-157 across the whole of its portfolio with this comment about Berkshire's need to apply it to a couple of classes of investments:

The company has disclosed many derivative contracts tied to the performance of the Standard & Poor's 500 and three foreign stock indexes, and to the credit quality of high-yield bonds. Accounting rules require Berkshire to regularly report unrealised gains and losses on those contracts.
Reuters, "Berkshire Hathaway Q3 Profit Down 77pc"

Instead of having its operating income of $1335/sh turned into a quarterly profit of $682/sh, imagine how FAS-157 would have caused a massive loss as Berkshire Hathaway's performing intra-holding-company loans had to be written down, and the value of its numerous holding companies had to be slashed as multiples compression killed the value of tool makers, ice cream franchisers, print newspspers, and insurance companies. Were Berkshire Hathaway required to apply FAS-157, what kind of haricut do you think it would have?

So I don't think ACAS is somehow bad at managing a portfolio of companies, or has bad investement picks, or the like. ACAS' transparency makes it an easy target for people afraid of the market as a whole and who don't want to wait around to receive operating earnings from profitable portfolio companies and think they must liquidate everything, now, to obtain value from holdings. Frankly, I think that's crazy.

Peachberry_Tea offered:

So there is a lot of uncertainty with regards to ACAS. I'm not sure that it deserves the valuation it does ($6 a share now) but then again, even firms without this uncertainy are priced this way at this time.

Insiders like the pricing created by this uncertainty. Why shouldn't I?

Peachberry_Tea concluded:

I honestly think your analysis of ACAS has been excellent. But as to what to do with one's money in this market, there are certainly better places for your money than ACAS. That would be my take on this.

I'm all ears on investment ideas. I'm particularly keen on ideas that call for solid earnings growth through a severe recession. I don't invest for a living, so I don't end up with tons of investment ideas. ACAS has been a long-term pick of mine, and remains one. I've not sold. If I should see my thesis collapse -- that ACAS is an underpriced way to buy a diverse lot of medium-sized companies which have been selected through a gruelling due diligence process to offer outstanding opportunities to provide a return -- then I'm sure I'll bail. However, I am not inclined to bail from fear of near-term pricing. Moreover, I'm still confident that I'm no good at all at picking entry points, and will continue to have to make due understanding the companies in which I risk an investment.

That said, if you want to be sure you have money at the end of the recession, the value of a safe and an array of firearms with which to defend its contents is probably not as volatile as the value of most of what you might buy after reading the financial section of the newspaper.

AmEx Holds Out Hand In Bank Bread Line

Not too terribly long ago, American Express spun off American Express Bank and all its related financial services (offerings include checking accounts, financial advice, brokerage services) under the name Ameriprise.

Now, American Express announces it wants to become a bank holding company again, and quick.

What's with the sudden change of heart?

American Express runs a credit card franchise of which you may have heard. Although American Express once was a payment card but not a credit account (one paid balances monthly), AmEx issues a vast array of credit and non-credit charge cards that are functionally challenging to distinguish from cards issued by banks under the Mastercard or Visa marques. Consequenly, American Express has lots of small cardholders making charges to (and hopefully payments on) revolving accounts. This means that American Express needs money to loan these borrowers. So ... where does it come from?

Historically, American Express' clientele were thought to be of a better caliber than regular bank card customers, and to offer superior credit risk. American Express had little trouble issuing commercial paper intended to provide liquidity for the period in which it expected the card accounts to be repaid. Longer-term debt offered other alternatives: buyers looking for a decent return lined up for American Express' offerings of bonds secured with American Express' revolving credit accounts. Now that even inter-bank lending has taken a hit due to confidence concerns in financial-sector firms, American Express hasn't got such easy access to the cash it needs to keep making disbursements under its revolving credit agreeements. Without the cash outlays, AmEx can't generate the fee income it earns from the cards, and without payment on customers' demand to vendors around the world at all hours of the day and night, AmEx would kill the value of its brand. AmEx must keep making payments.

American Express wants some of the government's easy money, and wants to be able to grow deposits (a relatively cheap source of cash, but not without risks).

AmEx is a long-term solid company, one that attracted investment by Warren Buffett when it was battered to irrational levels by news of scandal, and it's a company that bears watching as the economy drives financial companies into the toilet. While entering an investment in a financial just now seems hard to contemplate -- credit markets aren't yet normal again, and financials' capacity to carry on regular business depends critically on the function of credit and capital markets -- it's a situation that is likely to bear a good buy down the road.

AmEx is a definite to watch.

ACAS: 3Q2008 Report

In the quarterly announcement, ACAS' management explicitly addressed the liquidity threat created by the tangible asset value in its recently-renewed debt agreement.

Performance for the quarter
Net Asset Value at close of quarter was $24.43, down from $27.01 at the close of the second quarter; the reduction is driven chiefly by FAS-157 writedowns of unrealized depreciation resulting from multiples compressions as the worldwide markets' pricing decreases, the drop in price of shares of publicly-traded companies to which portfolio companies are compared, and the effect of changing interest rates on valuations generated with bond-yield-analysis techniques. Because ACAS is not a bank and is not permitted to carry performing loans at face value, but must re-value fully-performing loans on the basis of market factors that are beyond ACAS' control or that of its paying obligors, the risk remains that these wrote-downs will continue evan as portfolio income remains strong and debt obligations continue to be paid.

Net Operating Income -- a number that will be more important going forward due to announced changes in dividend policy -- increased sequentially from $0.71 to $0.74 per share, though it was down from $.81 in the year-ago quarter. It's worth noting that in 2007, ACAS' operating income involved a rather

Pretax Earnings were $0.98 compared to a projected $1.05 for the quarter; however, because ACAS elected to retain capital gains and was obliged to pay on behalf of shareholders the taxes on the "deemed dividend" represented by this retained amount, the earnings involve a tax charge, reducing the earnings to $0.72. Even the $0.98 is below estimate, though: ACAS expected to close deals that didn't close, and missed out on some realizations as a consequence.

Shareholders of record on September 30, 2008 are entitled to a $0.25/share tax credit (this means when one files an individual Form 1040 for 2008, one is entitled to claim having already paid $0.25/share in taxes above whatever else was paid or withheld for the 2008 tax year), and also to adjust their basis upward $0.49 per share (which only helps at exit). This is a result of retaining long-term capital gains that would have been payable under the prior dividend policy.

Realized Earnings -- the number that drives ACAS' BDC-related dividend-paying requirement -- were $0.72 for the quarter after taxes associated with the deemed dividend and other items.

GAAP Earnings -- the SEC-reported "earnings" that reflect mark-to-market price changes as if they were realized -- were negative to the tune of $2.63, giving rise to the NAV decline of $2.58 to $24.43. Due to ACAS' changed dividend policy, dividends will be driven by NOI rather than net taxable income, and will still bear no definite relation to the "earnings" reportable under GAAP. The GAAP earnings will be as crazily out of whack with dividend-paying capacity later on, when multiples expand and asset values explode beyond actual earnings.

Although ACAS' management claims that its net realizable value is hundreds of millions of dollars above GAAP values, the utility of this measurement seems slight in light of the fact that it represents neither ACAS' current liquidation value for the assets, or ACAS' expected actual return on exit. (The number sounds like that, but when faced with a question last quarter about the losses baked into the non-GAAP valuations given, management said it didn't expect to realize those losses, either, and that it expected the future to hold, in fact, some other undisclosed return.) The non-GAAP numbers are thus not so much a beacon illuminating the coast as yet another siren amidst the rocks, offering only puzzlement.

ACAS' portfolio company exits were within 1% of the prior quarter's valuations. The thesis that ACAS' management is lying about valuations seems further weakened by actual sales performance. This doesn't mean there's not a case to be made against ACAS, but it's not based on malfeasance by management in stating portfolio company valuations. The best thesis against ACAS is the thesis against any financial: the economy is heading into the crapper.

Management believes the company is operating amidst in a severe recession and is conducting itself accordingly, including by de-levering. Valuation drops pushed ACAS' debt:equity ratio back to 0.9:1, and management is working to reduce it again.

ACAS is addressing the liquidity threat with several initiatives
In a return to its older dividend policy, ACAS will retain capital gains (and pay taxes on them) rather than pay this portion of earnings to shareholders. ACAS needs the money to cushion its asset value's distance from bare-minimum debt-covenant levels. Future dividends will be driven by operating income, not capital gains. This dividend policy is far more apt to result in steadily-increasing long-term returns than a policy in which all gains are distributed, preventing increases in invested capital. Interestingly, the incentive of ACAS was reversed when shares ordinarily traded materially above NAV. Under the DRIP at prices well over NAV, ACAS kept more money by keeping pretax capital gains and issuing shares than it did by retaining post-tax capital gains and then reinvesting only operating income pretax. The policy of paying all earnings was sustainable only to the extent that above-NAV share pricing remained the normal state of affairs. In the last year, above-NAV trading has gone from uncertain and unpredictible (between the announcement of a share-buyback program in January due to the below-NAV share prices, and the next trade above NAV, was sixty-one days) to doubtful (ACAS has continuously traded below NAV for months).

Rather than announce in advance a schedule of dividends and stick to it, ACAS has announced that its board will set quarterly dividends after each quarter, based on quarterly results. Consequently, the pre-announced $1.10 dividend projected to be paid for the fourth quarter of 2008 will not be declared as predicted; any dividend to be paid on the fourth quarter of the year will have to be set after the quarter is over. Given management's repeated discussion of protecting capital, I would not expect to see a dividend from ACAS regardless its quarterly performance for some time. The benefit of longer dividend retention is lowered cost of cash: ACAS is borrowing it interest-free until earnings turn into declared dividends. When ACAS' shares traded above NAV, dividends didn't result in loss of liquidity, but in the issuance of shares above NAV. With a share price below NAV, cash dividends sap investable equity and threaten liquidity and drive the company toward the minimum tangible asset levels established in its debt covenants. Do not expect to see ACAS with a pre-annouced all-income dividend again; the procedure of having the Board set dividends following each quarter will place ACAS in the best possible position to game the dividend game on the basis of share price, market conditions, and tangible net asset value. The new policy is wiser and more fiscally conservative in addition to being more flexible.

The ECAS Transaction
Assuming all the necessary approvals are reached, asset volatility attributable to share volatility in ECAS -- whose below-net-asset-value price of its publicly-traded shares has given rise to terrible volatility in ACAS' portfolio value -- will be subdued in a financial engineering exercise in which ACAS will purchase ECAS' outstanding shares in an all-stock (1 ACAS share will buy three ECAS shares) transaction; the result will be the destruction of the NAV discount in ECAS and the increase in ACAS ownership of ECAS, which will mean an increase of about $1.25 per share in NAV for ACAS (and presumably the elimination of expenses related to ECAS' publicly-traded status). The 11.5 million ACAS shares issued in this transaction would bring ACAS' outstanding shares to 218.5 million shares, meaning that the anticipated $300 million in net operating earnings being rolled from 2008 into 2009 for payment of dividends would be about $1.37 in operating income ACAS would be required to declare by the end of June for payment by September 30, 2009.

Tax Status
ACAS addressed a question about its tax status with a long exposition about the fact that BDC status had been good for a long time, and that many investment forms (banks, BDCs, REITs, C-Corps like F, government-chartered entities like FRE, you name it) had suffered during the quarter, and that careful thought would need to go into long-term decisions on issues raised by the last forty or so days. It became clear that abandoning BDC status in favor of treatment as a bank or investment holding company or some other form of investment was not being clearly taken off the table as an option, and that management would continue to evaluate all the options available when deciding how to protect shareholder value in light of developing conditions.

Conclusion
ACAS' share price (under $8 as I write) is less than a third of its NAV. ACAS continues to enjoy liquidity from investment exits, its debt portfolio is performing extremely well for an economic catastrophe such as that we see now (nonperforming loans are less than 3% of marked values), and its net operating income appears strong. The 2008 profits rolled forward into 2009 must -- in order to avoid threatening ACAS' status as a regulated investment company -- be declared as a dividend by the end of June 2009 and paid by September 30, 2009; these appear to be approximately $1.37 per share. Assuming ACAS paid no other dividend in 2008 besides this minimum regulatory requirement (if ACAS retains its RIC status, 2009 profits would face a similar distribution requirement but with dates in 2010), ACAS would still have a double-digit dividend yield in 2009. ACAS' plan to use returning profits to reduce debt will protect ACAS from liquidity emergencies, ensuring that ACAS isn't placed in a "forced sale" position that would destroy the investments ACAS has made, and obliterate the prospect of participating in these companies' return to performance as the economy improves. The slowdown in exits -- and I believe there has been a slowdown in exits, as evidenced by the deal closings that didn't occur, no doubt related to the contraction in liquidity on the part of buyers -- makes ACAS' strong NOI that much more attractive. (ACAS has deliberately invested in counter-cyclical portfolio companies as the recession approached, and NOI continues to look good even though it is dwarfed by FAS-157-related writedowns that haven't been realized as losses and may well never be realized as losses.) As a long-term investment, ACAS at about a third of NAV and in light of its steady NOI seems a solid holding.

Management seemed to warn of expected future FAS-157 writedowns as the economy continues in recession. It's possible that ACAS will consider steps such as abandoning its BDC status and becoming an entity whose accounting enables it to value its assets differently, in order to avoid liquidity pressure caused solely by accounting issues and not by investment performance. (Becoming a bank, for example, would allow ACAS to carry performing loans at face value rather than at a value modeled on the basis of bond yield analysis; being treated as an ordinary C-Corp would enable ACAS to retain earnings like most corporations, and support its value with earnings accretions; and so on.) ACAS is battening down the hatches for a financial storm, and as usual is willing to upset analysts in the current quarter in order to protect long-term interests.

Summary:
Management takes a dim view of the current economic environment and its future, but is impressed by continued performance of portfolio companies, including some selected for being acyclical or countercyclical. Credit market issues will likely cause further FAS-157 writedowns in irs debt portfolio -- not because of credit or performance issues, but because bond yield analysis will drive down current holdings' values as credit becomes less available (more costly) to current credit seekers in a worsening economic market. ACAS cannot be treated as a dividend stock until further notice. At one less than one third its NAV, and with new access to earnings for reinvestment and for de-leverage, ACAS' shares represent an opportunity to make a value play at a diversified portfolio of well-managed middle-market companies that are still making good money in a crummy market, and allows participation in a diverse debt portfolio.

In the short run, more scares lie ahead. In the short run, multiples compression and debt-revaluation on the basis of bond yield analysis will continue to threaten equity levels, requiring earnings retension and forcing debt retirement. Expects shorts to return in droves, no longer fearful of having to cover ACAS' dividend as they bet on a financial meltdown at ACAS. In the long run, this company will do extremely well on investments made at a bargain and as holdings are re-valued in economic environments that support higher P/E multiples.

New Boss: Same As The Old Boss?

The anti-establishment lyric of The Who's classic hit Won't Get Fooled Again came to mind when I started reading about the folks President Obama is tapping to advise him on the problems facing Americans. The new boss may look different, but is his policy really new?

The prevailing theory on the success suspected from the sitting lame-duck's successor is pretty simple: it was so bad it couldn't be worse, and you can't fall off the floor. It's got to be better.

But ... do the signs really give reason for this optimism?

During the campaing, fact-checkers discredited efforts to link Obama to Freddie Mac executives. Obama apparently wanted to offer the nation a clean slate, a team in which the public could have confidence. With the first several names appearing already for President Obama's top advisory team, we get some insight what kind of group will be contributing to the internal dialogue on how to address the nation's ills.

Top Pick
First, President Obama named Rahm Emanuel for Chief of Staff. Explaining the choice, Obama said, "I announce this appointment first because the chief of staff is central to the ability of a president and administration to accomplish an agenda, and no one I know is better at getting things done than Rahm Emanuel." The Reuters article describing the appointment also described the office: "chief of staff ... is a top White House appointee whoserves as one of the closest advisers to the president and typically can decide who gains access to the president, while also developing administration policies." So: a gatekeeper and policy advisor both. According to the Sun Times, "[w]ith Emanuel, Obama gets an enforcer, a bad cop who loves the f-word[.]" So, what might we expect from Mr. Emanuel?

Through his [Richard Daley campaign manager David] Wilhelm connection, in 1991, Emanuel joined the Clinton campaign as a fund-raiser, rewarded with the White House political director post. He flamed out in a few months, to be resurrected and end up as a senior adviser to Clinton.

After seven years in Washington, Emanuel moved to Ravenswood, making millions of dollars as an investment banker in a few deals, and making more money when tapped by Clinton for a plum spot on the Freddie Mac board.

Lyn Sweet, via Sun Times

With regard to that plum appointment to the Board of Freddie Mac -- a corporation which as described here has been chartered by Congress to facilitate confidence and liquidity in housing morgages, whose management's unrealistic predictions drove out famously "forever"-holding investor Warren Buffett, and which sits now in conservatorship as a condition of a massive taxpayer bailout -- a brief look might be warranted. Freddie's oversight agency (the Office of Federal Housing Enterprise Oversight) said the Board on which Emanuel sat "failed in its duty to follow up on matters brought to its attention." The blogger Jammie Wearing Fool suggests that if Emanuel were a Republican, everyone would be up in arms over his appointment to a key post (mentioning not only Freddie, but other issues that might make one wonder).

Emanuel, who already has a spokesman to field embarrassing questions about his past performance, is ducking Freddie Mac criticism with the claim that he was on the Board of Freddie for the "relatively short period of time" of just over a year. Well, quickly dumping plum jobs wasn't new to Emanuel by the time he dumped the Freddie gig, though it was longer than a few months. Despite stating that Emanuel "believed that Freddie Mac needed to address concernes raised by Congressional critics[,]" his spokesperson did not describe any steps taken to ensure that Freddie's bookkeeping was honest, that its guarantee pricing was rationally risk-adjusted, that the special oversight body created by Congress to keep Freddie on a leash actually received appropriate information, that Freddie's investment objectives didn't interfere with the mission to which it had been chartered .... These things would have required careful work. They would have required diligence. They would have required responsibility. They would have reflected a genuine belief in accountability.

Not seeing those things in Emanuel's hummingbird-like flit from post to post is, of course, enturely unsurprising for a politico looking to increase his juice in the District, or the nation. However, Obama didn't run on a platform of elevating good-looking young politicos in the District or the nation. Obama ran on the claim he would bring fundamental change to the District of Columbia and to the United States. Is Emanuel evidence Obama is merely a new Chicago political insider, doing Chicago political insider things, and not really changing anything substantive?

Maybe Emanuel's stick-to-it-iveness has improved and he'll keep the Chief of Staff job long enough to evaluate his contributions. And maybe those contributions will be more impactful than his contributions at Freddie Mac. On the other hand ... maybe not. Being a skeptic of professional politicos, I'm not exactly gushing with excitement about Obama's pick of Emanuel for a position that demands serius judgment: gatekeeping for the President of the United States has a serious implication for the range and quality of viewpoints that can go into top-level policy evaluation. Assuming that groupthink is a major factor in the Charlie Foxtrot we've ... ahem ... enjoyed ... heh, heh ... over the course of the outgoing administration, a gatekeeper known for loyalty and making a good guard enforcer is a serious reason for concern.

Getting Solid Financial Advice
As mentioned in interviews linked on this old post, Obama's supporters include the legendarily risk-averse and long-term investor Warren Buffett. Optimism is warranted: steady, long-term, risk-averse analysis is definitely what is called for in the job of protecting the public fisc. Waiting to see just how Buffett's pre-election confidence would prove justified won't take long: Obama has begun naming members of a financial advisory committee, called his Transitional Economic Advisory Board.

So, who's on this economic advisory committee? What track record have they got?

President Obama's economic advisors include Robert Rubin. A board member of Citigroup, Rubin's advisory services failed to stop the company from pursuing a course of business that caused the company's dividend to fall from 54¢/q to 16¢/q (a 70% decline) while the stock price dropped from the mid-fifties to the low teens ... um, lower: eleven-and-change is still double-digits, but it's not the teens; the stock dropped over 70%.

Had Rubin's oversight included comments about the propriety of lending to people who don't bother to substantiate their incomes, or the wisdom of valuing quarterly fees above long-term capital risk, we would surely have heard about it. The upside: the stock didn't go bust. On the other hand, the quietness involved in the federal purchase of $150,000,000,000 in stock of the nation's largest banks, including Citibank, means that the public can't easily determine how desperate Citibank was for the money when the government decided that the company -- and all banks -- needed their public confidence improved.

In similarly desperate fashion, Rubin's alma mater Goldman Sachs has had trouble. Rubin was an architect of the proprietary trading expantion that left Goldman holding the bag on a bunch of derivitive instruments whose counterparties were bust, plus an inventory of never-syndicated home mortgage CDOs whose liquidity has gone to zero and whose ultimate performanc may turn on the largesse of those with their hands on the faucet of the Treasury's money vat. Although Rubin's personal investment of firm capital may have been largely in arbitrage trading, he had a tremendous impact on the firm's risk exposure during his stint as the seventieth Secretary of the United States Treasury.

As Treasury Secretary, Rubin opposed regulation of derivitives when Brooksley Born at the Commodity Futures Trading Commission proposed oversight. Successfully keeping such instruments as Credit Default Swaps (CDS) unregulated, opaque, difficult to value, and illiquid was a key factor in the confidence collapse that destroyed so much value in the financial sector this year. With regulation, CDS could potentially be standardized in such a way as to be subject to trading like standard options -- a common derivative instrument which can be used in complex combinations to make risk-limited hedges against legitimate portfolio risk, and which generally have a knowable value because their regulation and standardization render their performance, liquidity, and valuation subject to everyday and mundane analysis. Instead, like health coverage through non-state-regulated employee benefit plans, the participants have rather less idea at any given time where they stand and what the contracts are worth.

As observed by The Economist, Rubin's dismantling of the Glass-Steagall legislation that had kept a firewall between banks and other financial institutions had the effect of driving financial institutions into new businesses in which they lacked prior expertise. Taking on risks they did not appreciate, while acquiring a multiplicity of regulators with no familiarity with such combined entities, did not create an environment in which the public's interest in financial stability had an effective voice. The trouble with financial behemoths wasn't that they would scoff at small customers and price them out of the marketplace in the hunt for big fish, but that they led to a regulatory mess that needed as much help as the Glass-Steagall-era financial institutions needed improvement in diversity:

But the price of financial services will surely not rise: new technology, especially online financial services, is too powerful a force in the opposite direction. There is a bigger worry, though. Why, if politicians are at last to do something about the Depression-era rules that govern financial firms, have they not tried to update America’s supervisory structure at the same time?

Meanwhile, derivatives exposure was exploding in a non-regulatory environment championed by Mr. Rubin, magnifying risk and decreasing liquidity and transparency.

Kaboom.

Getting Rubin on-board might have been a great idea under the theory that he should offer a close-up view of how the system was augured into the ground. However, this assumes he was looking at the world about him rather than in a college textbook. Rubin's longstanding credentials as a faithful Democrat didn't lead him toward any policies that seemed calculated to help the little guy; rather, he helped endanger the financial institutions that make everything in his life affordable. Instead of playing the traditional Democratic song of increasing government regulation, or the idealistic notion that government regulation might be made more efficient, Rubin agitated to have his own field de-regulated. (And wasn't this what Obama said was wrong with his Republican opponents? Too chummy with the folks who created the mess?) Maybe Rubin was overly optimistic about the effectiveness of his colleagues and competitors in navigating a wild and woolly new combined financial environment, or didn't appreciate the purpose of insurance and bank regulation (solvency) because he was so long steeped in the culture of investment banks and their priorities (profits from fees and trading).

The Jaded Consumer isn't particularly excited with what's come to light so far. Perhaps there are some truly exciting members. If I should hit more information on them, I'll surely try to post it here.

If the nation's financial advice comes from the mouths of those who architected the collapse, confidence in an effective solution being developed might understandably wane. While the re-appearance of sound federal financial .... uh, right -- when was that? Okay; it'd be nice to feel the public fisc were in better hands, but it honestly looks like this is a point on which evidence will need to be collected before we become excited about the crew manning the tiller.

Monument or Minefield?

John Gruber's short entry on the election result opens with Hunter S. Thompson's disgust with the Nixon defeat of McGovern, and seems to declare Thompson's observations about the pathetic state of the nation obsolete.

I hope so.

My worry is that like other mortals, the politicians sent into office as a result of this election will be tempted to use their office as their predecessors have used their offices. I am impressed by the excitement -- not merely among ardent party backers, but the broad population -- that this election cycle has engendered, but I worry that the giddy proclamations that a new era has opened merely set impossible dreams as the new expectation; I worry that ordinary mortals -- even well-intended -- will advance policies based on weak assumptions, or to advance political agendas that lack the benefit of solid analysis. I note that the new President badly misundestands issues, including basic arithmetic, that are essential to crafting a functional solution for complex issues bothering Americans and central to the debates during the election cycle.

On the one hand, the momentum toward departure from Iraq appears virtually unstoppable regardless who won, so a major concern of Americans will be met: Americans will be (mostly) out of Iraq. On the other hand, this is also likely to be a cause for embarrassment down the road: where Americans have achieved material success (a free Germany; a free Japan; a free South Korea), Americans are still present. (Maliki heroically argues the opposite lesson will be learned from a departure, but our propaganda machine is so bad we'll never pull that off.) It will be very hard for anyone -- and I point out here that McCain would have had no better success on this point, and indeed may have had a worse time with it -- to claim Americans left Iraq in anything but defeat. Granted, America never intended annexing a fifty-first state in Iraq; but America never defeated the people who were behind the ongoing killings of Americans there, and the new president seems more willing to attack allies in the area than its enemies (though presumably selling them more bull semen will be A-OK). America's influence in the region will potentially be limited to restraining the conduct of existing allies, leaving enemies to act with a free hand. On the other hand, if the new President is willing to bomb allies' territory, one might hope he'll act when he sees a legitimate target in enemy lands. The new President is -- at least for the time being -- willing to admit publicly what kinds of attacks he thinks Kosher. We might have a bigger hawk in the new President than popularly imagined.

On the other hand, we have the domestic front. Will the current batch of politicians -- presumably led by the same majority leaders who held power for the last two years -- do any better than in the past? Seriously? I could go into specifics, but I think that argument is short enough, and to the point enough, that I should let it stand. Innovation on the domestic front will come, if at all, from unelected advisors brought in to sell solutions to those with votes. Let's hope the right people are recruited, eh?

For the next two years, we face a Congress that fears no veto pen -- the pen's wielder hasn't rebuffed his Party in the past -- and it's not like the face of Congress has become less influenced by monied interests. Stopping business-as-usual sellout of the United States Congress to the highest bidders at the expense of the public isn't going to occur overnight. Government is corrupt for a reason -- the structures that lead to the status quo have not changed, so the output will not change. The result? Will we have a reckless charge into programs and policies.

I fear more of the same kind of inefficiency, waste, corruption, and scandal that we've enjoyed. The question is simply whether the Democrats will be more successful than the Republicans in preventing this from utterly debasing their brand, and returning the country to the same tired pessimism with government that we've long been used to seeing.

On the other hand, my mind drifts back to the impossible dream: a government that does what people want; that isn't for sale; that spends resources solving problems instead of innovating new ones. It's so wild an idea ... so idealistic ... and so American.

So: I hope.

Media as Norm-Setting Tool

After reading at The Onion about using mainstream media to desensitize Americans to brutality, you can read at CNN about using television to indoctrinate children to become impregnated as a teen.

The first may be a bit of a joke ... almost ... but the second is quite real.

Just like kids who learn how to lie on television (and don't realize how transparent they are at it, how bad, and how easily caught) and learn it wrong, naïve kids without perspective on normal relationships apparently learn from shows like Sex and the City and Friends that it's normal to play musical beds, and that you end up with a ginormous New York home worth a fortune if you do. Something for parents to think about when they decide to let the television substitute as a bargain-priced baby sitter. Maybe the price is higher than they reckon.

AGNC: High-Yield Income For Market Bears

After releasing its 3Q2008 quarterly results, and fielding questions in a conference call with analysts, American Capital Agency (AGNC) is now trading above net asset value. As described before, AGNC is a REIT that owns no real estate. AGNC, rather, makes money investing in government-backed home mortgage instruments. The relatively modest rates paid on home morgages doesn't support outsized returns without leverage; AGNC's portfolio being comprised solely of high-quality agency-backed securities, it is capable of supporting enough leverage that even modest spreads support high net returns. However, management made clear in the call that the industry is in "the midst of what we would call a 'deleveraging vortex'" and that a REIT levered 15x will look in this environment as overleveraged as a REIT levered 25x in prior days.

In order to get ahead of this delevering curve, AGNC has delevered.

During the third quarter, AGNC reduced its debt:equity ratio from 8.3:1 to 5.4:1, selectively reducing borrowings under agreements whose terms management thought least favorable. Since revenues from holding debt are a function of leverage and rate spreads, one reasonably asks whether AGNC's income will be torpedoed by its relatively conservative leverage. Volatility may make a high debt:equity ratio dangerous, but it creates other opportunities.

During the last quarter, a dramatic increase in volatility placed AGNC in the happy position to make money selling options. Because AGNC invests only in agency instruments, and not in complex hard-to-value CDOs or the like, the quality and transparency of its holdings enable it to negotiate options agreements with potential buyers. By writing (in effect) covered call options against a few hundred million dollars' worth of the portfolio, AGNC collected substantial premiums (because volatility increases options premiums, and AGNC was selling) with which to protect shareholders against portfolio valuation risk. In the event the options are exercised, AGNC will sell securities for cash at a price above the market value at the time the options were issued. Considering AGNC's view that the market for agency securities remains liquid, and that there are numerous opportunities to be had in a market that has become inefficient (e.g., fifteen and thirty year notes trading at the same price for the same yield), the possibility of becoming a shopper with cash isn't such a bad risk.

There is an annual limit to the fraction of non-real-estate income that a REIT can earn while maintaining its tax status, but management indicated on the call that it was managing options income with that limit in mind. Moreover, AGNC did not anticipate long-term opportunities to use options rather than debt to achieve its desired leverage; management expected to maintain conservative leverage, but to enjoy increased spreads, resulting in adequate returns without the need of leverage levels that seem risky in the current market. AGNC's management observed that federal government intervention has thus far only had the result of widening rate spreads. Consequently, AGNC takes the (pessimistic) view that the mortgage market will continue to suffer. AGNC's strategy to profit from the mortgage market seems to benefit from mispricing, high mortgage interest rates, and other features of an ill home mortgage industry.

AGNC invests in what management described during the call as the highest-quality fixed-income securities in the universe. Following the Freddie/Fannie bailout, all AGNC's investments are in effect agency securities, backed by the United States government for the timely payment of principal and interest.

As foreshadowed in an earlier post here, AGNC intends retaining some earnings (within the REIT distribution limits) in order to moderate volatility in the dividend. AGNC's net asset value has actually increased since June 30, from $17.45 to $17.85. Management stressed that as AGNC grows, its results should improve because many of its material costs are fixed -- accounting, compliance, etc. -- and that its financial tools are intended to handle a much larger portfolio. AGNC's seemingly comprehensible strategy, its government-backed portfolio, and its apparently rosy future have bouyed AGNC's shares above NAV, something that ACAS' other managed but publicly-traded fund (ECAS) hasn't achieved, and something ACAS itself lost within the last few quarters. I imagine AGNC issuing shares to capitalize on dislocations involving investements with a long-term horizon, improving its margins, and enhancing existing shareholders' total returns.

The fact that AGNC is trading above NAV and is cranking out large cash dividends is probably a very good sign for AGNC's manager, ACAS, which holds something near 50% of AGNC's common stock. ACAS' holdings -- 7.5 million shares -- provide both dividend income (on the order of $7.5 million per quarter) and management fees (1.25% of the net asset value, payable in monthly installments, on approximately $265 million would be nearly another million per quarter), and both stand to increase as AGNC grows in value and profitability. The dividends and management fees are slightly above the 4¢ per ACAS share estimated here previously. AGNC's results -- and its premium share price -- imply an understanding of the current market that has not been attributed thus far by the market, in the form of per-share pricing, to ACAS. Part fo the pricing difference is a result of ACAS' increased opacity (investors would have a hard time understanding the hundreds of businesses which drive ACAS' results, and since those companies don't have individually-disclosed financials, investors are left to worry that performance might be silently slipping as the economy is jolted by economic shocks), and part of it is a result of AGNC's simpler-looking investment portfolio (valuing agency-backed mortgages is less uncertain and less speculative than valuing illiquid and more individually distinctive private companies). The issue here is comprehensibility: especially in a market panic, people fear what they do not understand. People have run for the doors in ACAS, and it won't be clear until November 10 whether fear led to safety or to abandonment of a good investment. The repeatedly-recurring allegation that ACAS' numbers result from fictitious accounting should tend to lose credence as ACAS and its publicly-traded managed funds continue to produce taxable income and continue to pay outstanding dividends.

As in ACAS conference calls, passing emergency vehicle sirens could be heard intermittently in the background. I wonder if management is saving rent money by buying in a bad neighborhood, or if the ACAS offices are simply near a hospital. Malon Wilkus appeared briefly on the call with a prepared statement, but the water was clearly being carried by specialists in mortgage instruments and not Mr. Wilkus. Mr. Wilkus' statement was fairly generic:

Despite the turmoil experienced in the financial markets during the third quarter of 2008, AGNC was able to navigate the market and deliver strong results to our shareholders. Our relative value approach to investing in agency securities and prudent management of our balance sheet has allowed us to produce excellent results for our shareholders while reducing our overall leverage.
--Malon Wilkus, Oct. 29, 2008

By contrast, some detail was offered by AGNC's Chief Investment Officer Russ Jeffrey:

Given the turmoil within the financial system in the third quarter of 2008, AGNC felt it was prudent to proactively manage our balance sheet through opportunistic sales of agency securities, which lowered our leverage ratio to 5.4 times. Market volatility created the opportunity for AGNC to develop and execute an option strategy, which was accretive to both ROE and earnings per share while allowing us to further reduce our risk profile. Overall, we remain optimistic about our ability to navigate these markets while delivering an appropriate risk- adjusted return for our shareholders.
-- Russ Jeffrey, Oct. 29, 2008

The specific solution utilized by AGNC to create value during the recent volatility -- options -- would not have been available to AGNC were its portfolio comprised of less liquid investments, and it is almost certainly not the solution ACAS could itself have used. ACAS' individual vestments -- debt and equity interests in privately held companies -- are not liquid. However, ACAS has a portfolio of nearly three hundred companies, and at the time of the last conference call was in the process of selling twenty-two of them. The question for ACAS is essentially whether its ability to achieve exits in a challenging environment is as solid as management seemed confident in August; other sources of liquidity seem unlikely to bear fruit for ACAS in this environment. On November 10, we'll know.

As for ACAS' managed company AGNC, the result is in: deft leverage management and successful underwriting has allowed ACAS to achieve a solid result in crazy times. The market's answer is clear: AGNC is worth more than the sum of its assets. AGNC's opportunities seem especially rosy as credit dislocations and market mispricing continue to create opportunities to identify solid values. The solidity of these values isn't based solely on federal guarantees, but careful underwriting and financial modeling that so far have played out quite well.