Martin Whitman Forbes interview

Thanks to Simoleone Sense for picking up an interview with Martin Whitman, conducted by Forbes. The original article was cited by vinvesting.

You can find the interview by going to this link (grr I hate Forbes and their intrusive advertising and poorly laid-out webpage :(). I want to pick up a few interesting comments he made.


(source: Marty Whitman Buys American Distress, by David Serchuk. April 10, 2009. Forbes)

Forbes: Your firm recently got back into buying distressed debt--where are you seeing the most opportunities and how do you expect this to shake out?

Whitman: The most opportunities are in performing loans that are likely--a 70% to 90% probability--that they will remain performing loans. Their yields to maturity are at 25% or better. If we're wrong about performing loans, we'll probably do OK in the reorganization. In distress, there are four businesses; performing loans that are going to stay performing loans. There are small cases for reorganization or liquidation. There are large cases for reorganization or liquidation, or making capital infusions into troubled or under-capitalized companies. There are great opportunities in all four areas of the business. But we're mostly involved with performing loans that will stay performing loans.

Martin Whitman is an expert in distress investing so anyone following his distressed picks should be really careful. Having said that, it's not clear to me if he considers bonds to be "performing loans" or if he is only referring to 'loans'.

Forbes: Many value investors have caught falling knives in this market. What's wrong with the typical value investing strategy in markets like these?

Whitman: Beats me. Frankly I would divide value investors into two types. Those where there had been permanent impairments, value guys who bought AIG or Fannie Mae, or Lehman Brothers or Bear Stearns. And those where the market has just crashed, but there was no permanent impairment of the business. We've been lucky, we've had no permanent impairments. I think I may be stuck with one or two, so far there's been no real permanent impairments.

I think Whitman is exaggerating his investments here. I do think that some of Whitman's investments have also seen permanent impairments. The bond insurers certainly have seen permanent losses and even some of his Hong Kong real estate companies may have seen permanent impairments. I suspect that HK real estate, like almost everywhere else, was overvalued in the recent past. Whitman purchased many of his companies a long time ago so he likely hasn't taken any losses; but if you measure the present from 2 years ago, I think many of these real estate companies have been permanently marked down--and all this without China facing a crisis.

Forbes: How can you tell which from which?

Whitman: For us, the principal test is credit-worthiness--don't buy common stocks of companies that need continuous access to capital markets. Or where customers or counter-parties can discontinue relationships at little or no cost. That has been the bulk of permanent impairments. With the shorts being so powerful, almost any company can be brought down, if it needs continuous to capital markets. Even companies like Goldman Sachs or General Electric.

Yep... from now on, and forever, I'll try to avoid companies that need to continuously roll over their financing. My newbie view a few years ago was that real estate companies where the ones that were heavily dependent on continuous financing but, man, I never would have thought that a company like GE lived off commercial paper. If it weren't for the US government, GE probably would have been bankrupt in October or November of last year. I'm not even talking about potential losses from their Eastern European loan operations or the British loan exposure; I'm simply talking about how it would have gone down because the commercial paper market locked up.

Forbes: You've said that equity investors have to learn to understand credit worthiness. How does an investor learn to judge credit worthiness beyond the ratings assigned by agencies?

Whitman: Wiley is publishing my book on March 31! It isn't that hard, really. Just emphasize a balance sheet. It varies company by company, but it really isn't too hard. Let's say, for example, when we do high-tech, I don't think we did common stock where the cash alone was not well in access of total book liabilities. That's a very strong financial position to be in. If we do real estate, it has to be financed with non-recourse financing against its specific income producing property. It's hard for us to do retail. It's hard to get creditworthiness in most manufacturing companies, though it's sometimes possible.

It's hard to do retail, but I would say Wal-Mart is extremely well financed. You pick 'em out. If we do banks, they all have to have under Basel II, with 20% risk-capital ratios. They have to be strongly capitalized for regulatory purposes.

With most insurance investing, we've gone to companies that try to underwrite to a zero loss ... Indeed, in financial institutions, it is very hard to find super strong financial positions, because the companies are structurally financed poorly. Virtually all the public common stocks are of holding companies, and the principal assets of most financial holding companies as a parent company are the common stocks of highly leveraged, highly regulated subsidiaries. This makes it hard for banks holding common stock, insurance common stocks, to qualify as well-financed. You have to get cash out of their highly leveraged subsidiaries, it can be extremely tough.

A couple of insightful points...

It's very hard to find "good" high-tech companies with cash greater than total liabilities. It's basically Benjamin Graham territory. Obviously many companies in such a situation will be distressed or under a cloud of poor earnings and burning a ton of cash. You will rarely find high-tech companies with genuine growth or leadership position trading like that. If I remember correctly, Whitman invested in a bunch of semiconductor companies fitting that criteria in the late 90's or early 2000's.

Whiman says he prefers insurers that underwrite to a zero loss but those companies have been absolutely decimated lately. The classic ones are the monoline bond insurers who have been underwriting with a zero-loss strategy for 30 years but have completely fallen apart lately. It's not clear to me zero-loss underwriting is safer than the conventional multiline underwriting which assumes a small loss. Although the bond insurers have been hit really hard, we have also seen how multiline insurers like AIG, not to mention the countless other life insurers such as Hartford, facing serious problems as well.

Forbes: What's your take on Timothy Geithner and his Public/Private Investment Partnerships that he hopes will create a market for mortgage backed securities?

Whitman: All I know, I'm very high on it. It gives attractive financing. This nonsense about toxic assets being hard to value, is really nonsense. Most toxic assets are probably going to be performing loans, and will stay performing loans. And you've got a good market play for people looking for cash-carry, looking for a spread between interest income, and low rate interest the government's going to provide with insured loans. So the portfolios of performing loans will be pretty easy to price, and pretty attractive for the buyers ... From what I know, I think the thing's very promising.

The main reason I decided to write this post is to highlight Whitman's comments above.

Whitman is one of the rare ones that actually thinks that the toxic assets will remain performing! This is such a radical view given how almost everyone thinks that the toxic assets are next-to-worthless. I don't know if Whitman is right but this is consistent with his stance with the bond insurers. If most of the toxic assets remain performing loans, the bond insurers will survive if their underwriting wasn't too bad.

There seems to be a lot of skepticism over Timothy Geithner's PPIP plan but Whitman comes out strongly in favour of it. I have suggested that the plan is very similar to what Warren Buffett had suggested before. My opinion is that the plan will work but American taxpayers need to be sure that the government isn't simply giving away free money. I also think the government should pay careful attention to conflicts of interest. Speaking as an outsider, if it were up to me, I would ban any affiliated party of the banks selling the assets from participating in the program. It's ludicrous, in my eyes, to see plans being drawn up by divisions of the distressed banks to participate in the program.

Some skeptics wonder what the point of the public-private partnership is if the government is subsidizing and taking risk. Well, the key point missed by the critics is the following: the private sector can price assets far better than the government can. Private investors are not perfect but they will be better. Instead of one government official, or a government agency, deciding what a toxic asset is worth, having a bunch of private investors seeking to maximize profits will be much better. Private investors will also bid against each other based on their interpretation of profit potential. In contrast, if the government (say the hypothetical bad bank) buys assets, they won't be bidding against anyone.

Forbes: What would be intelligent regulation?

Whitman: The most intelligent regulation in existence is the Investment Company Act of 1940, as amended. The upshot of that regulation is that the public gets great substantive protections they can't get in any other investment vehicle. They get that, while at the same time, promoters such as myself are allowed to get ungodly rich. Having a mutual fund management company is like having a toll booth on the George Washington Bridge all for yourself. There's no credit risk, no overhead. Nobody meant it that way. But it's the only thing in existence where there is tremendous protection for the investor, a Bernie Madoff is inconceivable. It couldn't happen under the Investment Company Act. While at the same time, the managers, promoters are able to fare quite well. That would be the object of regulation: Protect the public, protect the U.S.A., but allow the entrepreneurs to be amply rewarded.

I think generally the SEC does a pretty good job in terms of maintaining orderly markets and providing more than adequate disclosure to investors. You ought to have the same sort of thing in regulating banks, insurance companies. There ought to be some oversight of fiduciaries and quasi-fiduciaries.

Many who lean towards the freer side of the free market are skeptical of government regulations and government itself. I see many near the extreme, such as Libertarians, maintain a skeptical view of government. But it's amazing that they don't realize how government regulation also evens the playing field and has made capital markets more transparent. The strong arm of the government called the SEC has actually increased disclosure and made it easier for investors, certainly small investors, to have greater faith in documents produced by businesses. If it weren't for these, admittedly onerous at times, regulations and an agency like the SEC, small investors would be investing in the wild west, akin to the Chinese stock market right now, or the pre-1930's American stock markets.