Thoughts on Martin Whitman's 4Q07 Commentary

(yikes! I think some spyware infected my computer and is messing up my internet connection (it seems to have corrupted some driver). This finally makes me think I should upgrade to Windows Vista (rather than clean up XP). Hope Vista doesn't slow down this machine (only has 1GB of RAM))

Martin Whitman's Third Avenue Funds released their fourth quarter commentary, dated Oct 31 07 (although comments incorporate more recent events up to December). Thanks to CAK for pointing it out as soon as it came out but it took me a while to think deeply about what was said in the commentary. You know you are reading one of the greats when the points take a while to sink in.

I had been eagerly waiting for Martin Whitman's commentary because (i) he is one of the best and always insightful (although most of his strategies are hard to implement for small investors (eg. foreign stocks, distress investing, bankrupt credit instruments, etc)) (ii) he is bullish on the bond insurers (and I'm thinking of taking a position in Ambac). The commentary didn't dissapoint and I'll delve on the points I feel are insightful to me. Quotes are going to be messed up because I'm copying & pasting from a PDF that is formatted in columns.

CIT Common, MGIC Common, MBIA Common,
Radian Common, St. Joe Common and USG Common
are securities selling at ultra depressed prices because the
companies are directly involved with the residential
mortgage meltdown and/or the residential housing
collapse. For example, MBIA Common has been selling
at about a 57% discount from Adjusted Book Value, and
Radian Common has been selling around a 77%
discount from a book value written down to reflect $400
million of calendar third quarter 2007 unrealized losses
based on mark to market accounting. Both MBIA and
Radian appear to be very well financed.

MBIA used to trade at a lower discount to book than Ambac, but now it is trading at a deeper discount. I'm thinking that I should probably take a position in both Ambac and MBIA, instead of my original plan of just Ambac. I'm still sitting on the fence though.

As an aside, given current prices, TAVF
would probably not lose money if Radian or MBIA
were to go into run-off rather than remain going
concerns. Run-off, i.e., liquidation, simply is not a likely
outcome, however.

Clearly the bears think these companies will go bankrupt if they go into run-off. That is the predicament ACA Capital is facing right now. I think Whitman's point will be correct if losses on insured assets are reasonable. After all, adjusted book value for these companies is far above the current stock price. In theory, if these companies liquidated, the leftover value will be cose to the adjusted book value (with some money taken off for severance payments, layoffs, office closings, etc). Unlike industrials, manufacturers, and others, the book value of insurance companies is real money--IF they don't take massive losses in the future.

It would appear as if capital infusions would not become
necessary if the rating agencies were to rely on only hard,
quantitative data. However, this month, Moody’s
announced that in reviewing ratings it would also
consider soft qualitative data, much as Moody’s views as
to what “investor perceptions” are. Consideration of such
qualitative factors as investor perceptions seems to
increase the probabilities that Radian might seek a capital
infusion as was the case for MBIA. At December 21st,
TAVF owns 12.9% of the Radian Common outstanding,
and 8.0% of the MBIA common outstanding.

Interesting comment. It really comes down to whether you think the market action is rational or not. Investors like Reggie Middleton argue that the market price is what matters. I am of the view that the market is rational most of the time but during crises, it generally is not. That's how Warren Buffett is able to scoop up solid companies for cheap. With respect to the RMBS and CDO problems, we just don't know how correct the market is. I am of the opinion that the market is irrationally pessimistic here and that's why I'm thinking of going long.

At current depressed prices, the Fund would rather buy
common stocks from the companies than from company
stockholders. If rights offerings were to become available
not only for MBIA, but also others, TAVF might have
attractive buying opportunities.

I really don't understand this point. Why would an investor care whether he/she is buying directly from the company or from other shareholders?

In analyzing each of the financial institutions, Generally
Accepted Accounting Principles (“GAAP”) tend to be
quite misleading. This is because GAAP require that
derivatives such as the Credit Default Swaps be marked
to market – and market prices now are highly capricious,
to say the least.

Marks to market are the most appropriate, and helpful,
tool in the appraisal of publicly-traded common stocks
held in trading portfolios. Marks to market are an
inappropriate, and unhelpful, tool in the appraisal of
credit instruments held in portfolios where the intent is
to hold the credit instruments to maturity. MBIA and
Radian intend to hold their credit instruments to
maturity...

The real losses to MBIA and Radian will be determined
not by marks to market, but by
(a) the percentage of the portfolios that suffer money
defaults, plus
(b) how those money defaults work out after recoveries
from foreclosures, restructurings, refinancings and
reinvestments...

When I first trained as an
analyst – some 50 plus years ago – the primary role of GAAP
was to meet the needs of creditors who held credit
instruments to maturity. That’s all changed now. The
primary role of GAAP seems to have become to fulfill the
perceived needs of equity holders who are vitally affected
by day to day changes in common stock prices. As I’ve
pointed out in previous letters – What a waste! GAAP can’t
really be very useful to stock market speculators, but it can
hurt issuers like MBIA and Radian.

Obviously the shorts and the longs disagree on what the actual default rate is going to be.

Over the years, TAVF has been rather successful in distress
investing, the recent Collins & Aikman debacle
notwithstanding. The key to most of the distress successes
was the Fund successfully indentified, and acquired at
bargain prices, the fulcrum security of the troubled issuer,
i.e., the most senior security which would participate in a
reorganization. Our current housing crisis investments are
very much like our other distress investing (e.g., Nabors
Industries, Covanta, Kmart, USG) except here the fulcrum
security investment is
common stock rather than
credit instruments. To push
the analogy a little further, as a
return to normal times occurs,
it appears as if the common
stocks either will be reinstated
(i.e., the capital invested will
remain intact) or that there
will be a reorganization (i.e.,
companies will need capital
infusions.) A principal risk to
the Fund could occur if the
businesses seek capital infusions, and if such infusions are
on a basis that would be highly dilutive to existing
stockholders.

The key risk to investors (on the long side) is dilution. Whitman prefers rights offering or new share issuance, and plans to participate in them. He says that dilution will be small to nonexistent if his fund participates in these offerings.

The mortgage meltdown-housing collapse seems nothing
new for the U.S. economy. During the last 60 years,
virtually every sector of the American economy has gone
through depressions as bad as anything that occurred in
the 1930s. Remember the melt-downs during the past 40
years for, inter alia energy, banks, real estate, savings &
loans, Wall Street brokerages, row crops, steel,
automobiles, machine tools, etc. Unlike the 1930s, all
these depressions occurred without domino effect. The
probability seems to be that the next ten years in the U.S.
will be more like the last 40 than they will be like the
1930s. Put otherwise, the odds favor overcoming the
current crisis in residential housing and residential housing
finance without underlying damage to the U.S. economy.

Those into distress investing or some sort of contrarian investing will make or break the bank over the next few years. The US economy is slowing and things are really going to get interesting.


One key point is the fact that Martin Whitman added substantially to MBIA (and Radian) but not Ambac. I don't know if this means that he doesn't like Ambac. I also wonder if he might be holding off in case Ambac issues a rights offering. All I know is that Ambac has a ton of CDO exposure whereas MBIA's question mark is surrounding its RMBS insurance.