Book Review: Fatal Risk

I am just going to get out there and say it: "Fatal Risk - A Cautionary Tale of AIG's Corporate Suicide" is the best book on the financial crisis, and probably my favorite piece of non-fiction work since Michael Lewis' The Big Short. Now to the review...

Fatal Risk is about the history of AIG and its downfall, with a specific focus on AIG Financial Products ("FP"), one of the subsidiaries that eventually caused AIG to need to be bailed out by the U.S. Government. Author Roddy Boyd traces how FP got started (for those that do not know, it was started by a bunch of Drexel guys), its interactions with Hank Greenberg, its many wins, and how, to chase a couple of basis points, they went on to insure hundreds of billions of dollars of the AAA tranche of CDOs for 8 months and effectively destroy the hard work of AIG's founder Cornelius Vander Starr and legendary CEO Hank Greenberg.

The reporting here is incredible. While reading the book, all I could think about was: I need to hire Roddy Boyd to do due diligence on companies for me. Apparently I'm not the only one: In the acknowledgments Boyd writes of Greenlight Capital founder David Einhorn: "A stout fellow, but then I knew that already, as I'd shared a trench with him on occasion on a few investigative projects I had been involved with."

What I loved about the book was its depiction of risk or the lack thereof, that ran through the culture of AIG. While I do not want to quote him on it, my feeling is that Boyd believes that if Hank Greenberg was not forced out by the AIG board due to the attacks and investigations of philandering (and megalomaniac) Elliot Spitzer, FP would have never been allowed to write insurance at single digit basis points, AIG's securities lending pool's fate would not have been tied to sub prime RMBS, and inevitably, AIG would not have failed.

And you know what, I agree with him.

In my day to day job, I am a generalist. I cover a wide variety of industries. But by far, my set of contacts, knowledge of companies, and skill resides in the insurance industry. To me, it is one of the most inefficiently covered sectors on Wall Street, and that creates value opportunities up and down the capital structure. When people tell me "These things are black boxes", I tell them they are not working hard enough. What other industry can a diligent analyst get a near PERFECT picture of the left side of the balance sheet (CUSIP data for daily pricing) and a very thorough understanding of the right side of the balance sheet. Yes - Catastrophes happen, storms hit where they should not, tragedies like the tsunami is Japan happens seemingly at random - but in the end, an insurance management team that understands risk, and can price it correctly, that's the kind of investment I can hold for years.

And of all the CEO's I've encountered or studied in the many years I've followed the insurance industry, Hank Greenberg was the best when it came to risk. Fan boy or not, Hank Greenberg is someone I truly admire in business, and this book (like Fall from Grace did with Michael Milken) gives the other side of the story that we, as New Yorkers, read in the Post for months on end in 2004/5.

Say what you will about the finite reinsurance deal that was struck with Gen Re (no proof every links Hank to the deal that was penned), but you cannot argue with me that Elliot Spitzer, in a bid to trump his last successes (many have eventually turned out to be duds) wanted to go after larger fish in the sea to better his chances at the governorship. And in the insurance world, the Great White Shark was Hank Greenberg. Spitzer, according to the book, threatened to go after the Starr Foundation unless Greenberg settled for $750 million dollars - all on the mistake of a summer intern that was working for Spitzer at the time.

As the book lays out Hank Greenberg's dismissal from the company he built, it moves into the complete lack of oversight Martin Sullivan had on the individual business units that eventually sunk AIG. What I found incredible was the fact that various business units at AIG did not communicate with one another - so when certain business units stopped dealing in subprime mortgages, other units happily invested in and insured the same stuff their counterparts across the company were saying were worthless. The author again postulates that Greenberg had such a immaculate understanding of EVERYTHING that was going on at AIG (apparently he chewed out a corporate bond analyst for a $10M loss when AIG's balance sheet was nearly $500 billion), he would have never let this happen.

Alice Schroeder, author of Warren Buffett's biography, "The Snowball", has said that the first thing that Warren Buffett thinks about when looking at an investment is the probability or chance of a permanent loss of capital on the business. If it is anything more than remote, he will pass on the investment. This is how Hank ran AIG from Day 1. Here is a great series of paragraphs from the book:

"He kidded himself not. Understanding risk was not something many, perhaps most, could readily grasp. So, with a healthy sense of paranoia, he had a staff that kept watch against the most obvious sorts of threads. One of the core ones was that Wall Street worked for you. At the end of the day, for 35 years at the helm of AIG, Wall Street brought his people ideas, came to them for favors, looked to his company for capital, and it was never the other way around. Everything AIG did was, in a sense, to become and remain self-supporting. He had never seen, not once, a company that was reliant of the capital markets not run into some epic trouble.

And the first thing that happened after he left AIG - pushed as he saw it, by ungrateful traitors on a board afraid of a power-mad attorney general - was that the company went to work for Wall Street. They hung up a shingle and happily solicited business insuring the most diabolical instruments Wall Street had ever cooked up, for pennies per billion dollars of risk.

Pure, unrefined risk."

Before I close with a final thought, my favorite description of Hank Greenberg was that "he valued information so highly - and discounted opinions so readily..." As investors, on a day-to-day basis we are bombarded with opinions from the sell side, friends, management teams, etc. While these may be starting grounds for research, you need to have FACTS to create your own insights on particular situation. Raw quantitative or qualitative data, whether from a 10K, or a credit agreement, a proxy, or a regulatory filing, is the bread and butter of great investors. We know Warren Buffett PORES over all the data that his subsidiaries bring him - how many rings Borsheims sold this month vs. last month, how many train cars were full for Burlington Northern this week, how many new NetJets customers were signed last quarter, etc. That my friend, is what makes him more effective, as a capital allocator, than ever.

As I stated in the first paragraph, Fatal Risk is one of the best non-fiction pieces I've read in sometime. I very strongly recommend it - you will not be disappointed. And I bet, like me, you'll start to think that Elliot Spitzer should really be the one to blame for the collapse of AIG.

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Advanced Distressed Debt Lesson: Fraudulent Conveyance and Tousa

In an earlier post, I explored fraudulent conveyance in concept and as it related to the current Tousa decision at that time. Our contributor, Josh Nahas, principal of Wolf Capital Advisors and moderator at the upcoming NYSSA Distressed Debt Panel, explores the issue in much more detail as well as adding updates to the Tousa decision with reversal coming from District court. This is a lengthy read where all distressed debt investors should learn a thing or two. Enjoy.

Fraudulent Conveyance and Lender Liability: Is the District Court’s Ruling in TOUSA a Pyrrhic Victory for Distressed Investors?

One of the more interesting consequences of the 2008-2009 distressed cycle was the rise in high profile fraudulent conveyance actions. The two most high profile cases thus far have been homebuilder Technical Olympic USA and newspaper publisher Tribune Inc., however, there have been numerous bankruptcies where junior and unsecured creditors have alleged fraudulent conveyance against banks, financial sponsors and senior lenders. Another prominent case In Re Yellowstone Mountain Club, LLC saw secured lenders come under stern rebuke from the Bankruptcy Court judge whose ordered imposed the rarely used remedy of equitable subordination. Fraudulent Conveyance claims seem to have risen partly due to the LBO boom in 2004-2007 resulting in some questionable transactions, at least in hindsight.

In TOUSA the Bankruptcy Court for the Southern District of Florida broke new ground with respect to fraudulent conveyance law and lender liability (see section labeled TOUSA I – Bankruptcy Court Decision). On appeal the U.S. District Court for Southern Florida found that Bankruptcy Court erred significantly on several important legal standards and the initial ruling was quashed (see section TOUSA II – District Court’s Reversal). The District Court’s decision reined in the Bankruptcy Court’s overreaching with respect to the duties of existing lenders to diligence the source of their repayment. Nevertheless, the reasoning employed by the District Court has implications that in the future could negatively impact distressed investors and creditors. The District Court has opened the door for debtors in financial distress to engage in all manner of transactions of questionable economic value in the avoidance of bankruptcy, even temporarily, as any action to stave off a bankruptcy filing allegedly confers sufficient economic benefit. Nor does the ruling does not bode well for distressed investors and unsecured creditors seeking to remedy transactions that took place when the debtor was insolvent or rendered the issuer insolvent upon consummation.

TOUSA Background

TOUSA was a Florida based homebuilder focused on the construction of single-family residences as well as townhomes and condominiums. TOUSA Inc and its subsidiary TOUSA Homes LP had also entered into a JV with Falcone/Ritchie LLC (Transeastern) that was funded by the group of creditors referred to by the court as the “Transeastern Lenders”. However, when the housing market began to turn down, the JV failed. As a result TOUSA wound up in litigation with lenders to the JV and ultimately agreed to a $420mm settlement. In order to pay for the settlement TOUSA raised a new first and second lien term loan facility. The loan was secured by essentially all of TOUSA’s unencumbered assets including its previously unencumbered subsidiaries (the subsidiaries were guarantors on the $700mm revolver). In January 2008, approximately six months after the closing of the new loan, TOUSA and is subsidiaries filed for Chapter 11 Bankruptcy protection. The Unsecured Creditors Committee (“UCC”) sought to have the new loan avoided as a fraudulent conveyance on behalf of the debtors’ estate and the proceeds paid out to the Transeastern Lenders returned for the benefit of the unsecured creditors. (1)

Overview of Fraudulent Conveyance Claims

While a full discussion of Fraudulent Conveyance actions is beyond the scope of this article, a quick look at the statutes is useful. Fraudulent Transfers can be pursued under both state law and under the Bankruptcy Code. The Bankruptcy Code also allows the trustee to rely on state fraudulent transfer law as long as there is at least one actual creditor in existence who would be able to attack the transfer under state law 11 U.S.C. § 544(b). Fraudulent transfers under the Federal Bankruptcy Code are addressed in Section 548(a)(1) of which provides that:

The Trustee may avoid any transfer of an interest of the debtor in property, or any obligation incurred by the debtor, that was made or incurred on or within one year (1) before the date of the filing of the petition, if the debtor voluntarily or involunatarily:

(A) made such transfer or incurred such obligation with actual intent to hinder, delay or defraud any entity to which the debtor was or became, on or after the date that such transfer was made or such obligation was incurred, indebted; or

(B)(i) received less than a reasonably equivalent value in exchange for such transfer or obligation; and (ii)(I) was insolvent on the date that such transfer was made or such obligation was incurred, or became insolvent as a result of such transfer or obligation; (II) was engaged in business or a transaction, or was about to engage in business or a transaction, for which any property remaining with the debtor was an unreasonably small capital; or (III) intended to incur, or believed that the debtor would incur, debts that would be beyond the debtor’s ability to pay as such debts matured. (2)

The following elements must be demonstrated in order to succeed in pursuing a fraudulent conveyance claim:

1. There must be a transfer of an interest of the debtor in property or any obligation incurred by the debtor;
2. The transfer must have been made or incurred within two years of the filing of the petition.
3. The transfer was made with the actual intent to hinder delay or defraud a creditor
4. The debtor was insolvent or made insolvent by the transfer, or the debtor would become insolvent because the transaction to be engaged in would incur debts beyond its ability to pay. (3)

Because it is difficult to prove that the debtor acted with intent to defraud its creditors, courts rely upon what is termed "badges" of fraud to prove intent. Some of these “badges” of fraud may include:

1. Insolvency of the debtor;
2. Theft of the proceeds of the transfer after their receipt;
3. Absence of consideration when the transferor and transferee know that outstanding creditors will not be paid;
4. A large disparity in value between the property transferred and the consideration received;
5. The existence of a special relationship between the debtor and the transferee.(4)

Constructive Fraud

Constructive fraud differs from outright fraud in that the debtor's intent is not taken into account in determining whether a fraud has occurred. In cases of constructive fraud the transfer is deemed fraudulent if:

1. The debtor received less than reasonably equivalent value in exchange for the transfer, and
2. The debtor was (a) insolvent on the date of the transfer or became insolvent as a result of the transfer, (b) the debtor was engaged or was about to engage in a business or transaction for which any property remaining with the debtor was an unreasonably small capital, or (c) the debtor intended to incur or believed that it would incur debts beyond the debtor's ability to pay as such debts matured. 11 U.S.C. § 548(a) § (1)(B).(5)

TOUSA I (Bankruptcy Court Decision)

Judge John K. Olson of the Bankruptcy Court for the Southern District of Florida handed down a sweeping ruling in October of 2009 (In re TOUSA, Inc No. 08-1435) requiring the previous creditors (“Transeastern Lenders”) to disgorge $420mm of loan proceeds paid to them on the grounds of fraudulent transfer. Moreover, these proceeds were deemed to have been paid from insolvent subsidiaries known as (“Conveying Subsidiaries”). The Bankruptcy Court held that the Transeastern Lenders had acted in bad faith and were grossly negligent when they received the payment for the loans from the 2007 financing transaction. Judge Olson, ruled that the lender “knew or should have known on the basis of publicly available information that TOUSA and its Conveying Subsidiaries were insolvent or perilously close to insolvency”. (6) The court ruled that the lenders had a duty to determine whether the payment to them was a fraudulent conveyance.

In addition, Judge Olson avoided the liens incurred on the new loan used to repay the Transeastern Lenders which was secured by interests in the Conveying Subsidiaries, as well as liens secured by a $207mm tax refund. Finally Judge Olson held the new lenders liable for any diminution in the value of the Conveying Subsidiaries assets securing the new loan as well as all principal, interest and fees received by the new lenders, including fees paid to advisors and costs of litigating the adversary proceeding.(7) The ruling also included an invalidation of “savings clauses”, which cap the liability of a guarantor at an amount that will not trigger an insolvency.

In reaching his decision Judge Olson examined whether the company and its subsidiaries were insolvent when the debt was incurred. Extensive use was made of expert reports and testimony, as well as evidence of market conditions at the time. The evidence included downgrades from the ratings agencies, negative research reports and the decline in TOUSA’s stock price form $23 in 2006 to below $4 by April 2007.(8) The court held that these factors gave a strong indication that the subsidiaries were insolvent at the time of the 2007 transaction. These factors while compelling, do not necessarily prove that TOUSA’s subsidiaries were insolvent at the time of the loan. Irrespective of that, the Transeastern lenders should not have been held responsible for diligencing these factors with respect to their repayment. Nevertheless, the contemporaneous market and financial conditions certainly seem to weaken the case for the 2007 lenders which is on appeal before U.S. District Judge Adalberto Jordan of the Southern District of Florida. Judge Jordan has already affirmed the Bankruptcy Court's dismissal of fraudulent conveyance claims brought by a Creditors Committee against the Revolving Credit Facility lenders and Citibank as agent.

In the context of the Fraudulent Conveyance claim the court examined whether the Conveying Subsidiaries received reasonably equivalent value for the obligations they had incurred. Judge Olson concluded that the Conveying Subsidiaries received no direct benefit from the transaction because the loan proceeds went to the parent directly. Furthermore, the court concluded that the subsidiaries received no indirect benefit, because they received nothing of value as a debtor.(9) Not recognizing any of the indirect benefits to the subsidiaries by its parent of not filing for bankruptcy contravened established precedent and gave the appearance of impartiality. Certainly some value was received, however, the question is was that value reasonably equivalent. Obviously in hindsight it was not, however, that is not the legal standard and the judge erred by incorporating it into his decision, if even only anecdotally. An argument can be made that the value received was not reasonably equivalent, which one assumes the unsecured creditors will make on appeal.

In his ruling regarding “Savings Clauses” Judge Olson’s decision broke new ground essentially invalidating the enforceability of a savings clause. Savings clauses appear frequently in secured loan documents and typically seek to limit the liability of a guaranteeing party up to an amount that would not render the debtor insolvent. In TOUSA the Bankruptcy Court held that because the Conveying Subsidiaries were insolvent even before the refinancing transaction, and received no value from the transaction, the liabilities and liens were not enforceable at all.

Judge Olson further went on to hold that even if the Conveying Subsidiaries had not become insolvent until after the refinancing, the savings clauses would still not be enforceable for two reasons. First, according to the court, the clause violated Section 541(c)(1)(B) of the Bankruptcy Code, which the Court viewed as nullifying the operation of the provision that attempted to disrupt the fraudulent transfer claims from becoming property of TOUSA’s bankruptcy estate. Second, the court held that the savings clauses were unenforceable ipso facto because “efforts to contract around the core provisions of the Bankruptcy Code are invalid”. Finally, the court held that the savings clauses were unenforceable under contract law, because with multiple savings clauses for multiple obligors, “it is utterly impossible to determine the obligations that result from the operation of any particular savings clause.”(9)

Another aspect of the 2007 Financing that the court scrutinized was the fact that half of the CEO’s target incentive bonus was linked to successfully closing the 2007 transaction. As an investor one could argue quite forcefully that avoiding bankruptcy through legitimate means is worth rewarding. The question becomes did that encourage the CEO to act negligently and breach his fiduciary duties? Without a smoking gun, this is extremely difficult to prove and in this case does not appear compelling.

The contingency arrangement with the firm performing the insolvency analysis also was also called into question. This issue was also raised in the Tribune case and while it appears compelling on the surface, upon further scrutiny is not so clear. In both the Tribune and TOUSA cases the fee for the solvency opinion was much larger if the company was found to be solvent, a fact that would appear to impugn the credibility of the solvency opinion. However, the real problem is not that the valuation firm gets paid a larger fee for the solvency opinion, they should. Issuing a solvency opinion exposes the firm to much greater legal liability and that risk is compensated for by the increased fee.

The real problem has to do with the fact that solvency opinions are predicated on the projections provided to the valuation firm by the issuer. The valuation firm does not independently verify management’s projections, nor seek to create its own bottoms up projections. One could argue that the valuation firm should come up with its own independent projections, however, it is hard to argue that they can project revenue and earnings better than the issuer. Moreover, the presence of different, presumably more conservative projection for the solvency opinion would be problematic for the underwriter and may expose the underwriter or the company to claims that it overstated its projections to get a deal one.

Some of the other more controversial aspects of Judge Olson’s ruling were his reliance and “Observable Market Value” of the company’s debt and equity securities for determining enterprise value, as well as his reliance on internal TOUSA documents not made available to the lenders. Overreliance on current market values is problematic for a distressed investor as there are often times when the current market price does not accurately reflect the inherent value of the business. The ability of creditors to litigate disagreements over valuation would be rendered obsolete if there is an over reliance on the current market price. If such a standard were to be uniformly adopted by the courts senior lenders would gain even greater leverage when seeking to cram down junior creditors. Additionally, Judge Olson’s reasoning that in hindsight the transaction did not avoid bankruptcy was rightly pointed out by the District Court as having no legal relevance.(10)

Implications

It is the author’s opinion that in the TOUSA case the Bankruptcy Court went a bridge too far in imposing a duty upon the Transeatern lenders to diligence the source of funds (new loan) that its loan was being repaid with and know that is constituted a fraudulent conveyance. If the precedent were to be followed in other jurisdictions lending and capital formation would be dramatically inhibited and the door would be opened to endless litigation. Additionally, the legal reasoning employed by the Court to reach its conclusion was tenuous at best and many elements were flat out wrong, particularly the ex post facto viewpoint that the transaction did not prevent a bankruptcy filing.

While the court went to great lengths to examine the value of TOUSA around the time of the transaction to determine reasonably equivalent value, it erred in assigning no consideration to the value of avoiding bankruptcy. Nevertheless, while there is value to avoiding bankruptcy, often times the optimal solution is for a company to file for bankruptcy to preserve the value for its existing creditors, rather than gamble with more leverage. Had the Bankruptcy Court carefully weighed the value of avoiding a bankruptcy versus a undergoing a court-supervised restructuring, that aspect of decision would have been at less risk for reversal by the district court. Depending on the results of the appeal to the circuit court, distressed investors may find themselves at greater risk to priming transactions. Likewise, distressed investor will have reduced bargaining leverage with debtors and underwriters when negotiating settlement as a result of having a stronger defense against fraudulent conveyance actions.

TOUSA II (District Court’s Reversal)

Upon appeal to the District Court, Judge Olson’s ruling against the Transeastern lenders was reversed and came under a scathing critique by Judge Alan Gold. The 2007 Lenders case remains on appeal in front of a different judge. The District Court’s decision to quash the Bankruptcy Court’s ruling as it related to the Transeastern Lenders was unusual and demonstrated how far overreaching the District Court believed the Bankruptcy Court had gone. Ordinarily, the District Court would have remanded the decision to the Bankruptcy Court for further proceedings consistent with the District Court’s opinion. Judge Gold’s decision held that:

1. The Transeastern Lenders, as recipients of debt payment had no legal duty to conduct extraordinary due diligence with respect to the provenance of the funds with which they were repaid. (11)
2. Payment to the Transeastern Lenders was not a fraudulent transfer because the conveying subsidiaries never exercised “actual control” over the 2007 Financing proceeds and accordingly had no property interest in the proceeds therefore there was no transfer. (11)
3. Creditors of the Conveying Subsidiaries could not recover the parent’s payment to its lenders when the subsidiaries, as members of the parent’s corporate family, received “reasonably equivalent value”. And that avoiding default as well as imminent bankruptcy constituted reasonable value. (11)
4. That the Transeastern Lenders had no liability in the absence of a voidable transfer. The transfer by TOUSA to the Transeastern Lenders of the settlement proceeds would not trigger liability under Section 550 because it was not a direct consequence of the liens granted by the Conveying Subsidiaries, but rather a separate settlement of a previously contracted and outstanding debt. (11)
5. The District Court also ruled that the transfers made by the Conveying Subsidiaries in connection with the 2007 Financing were in exchange for “reasonably equivalent value.” As a result, the liens were not avoidable under section 548 of the Bankruptcy Code.

The ruling addressed most of the controversial aspects of the Bankruptcy Court’s decision, however, the court avoided ruling on the savings clause which will hopefully be clarified on appeal.

Implications

While the District Court corrected many of the egregious aspects of the Bankruptcy Court’s ruling, particularly the responsibility of pervious lenders to diligence the source of the funds repaid to them, the ruling has several disturbing implications for distressed investors and unsecured creditors. The District Court appears to have granted broad latitude to debtors to use their subsidiaries assets in any way they deem fit, for the unquantifiable benefit of avoiding bankruptcy. Judge Gold cited a “totality of the circumstances” test as the basis for ruling that the new loan transaction conferred reasonably equivalent value to creditors by avoiding bankruptcy (at least temporarily). Since such a benefit is impossible to quantify all the debtor needs to do to establish a defense against fraudulent conveyance is have his advisors and counsel provide a theoretical valuation scenario that justifies a transaction. Distressed investors frequently are frustrated by the number of debtors who engage in transactions of dubious economic benefit that have the potential to diminish collateral value and enterprise value while avoiding a much needed restructuring. The District Court’s ruling will likely encourage more such transactions.

While it is true that option value is an economic benefit, particularly for shareholders and management, the disproportionate harm caused to creditors when firms in financial distress pursue these types of actions often times far outweigh the benefits received. Unfortunately, due to erosion of creditor protections, particularly with respect to the “zone of insolvency” and fiduciary duties owed towards creditors for distressed firms, these types of rulings are inevitable. Unless some balance is brought to the process, debtors will be more emboldened to pursue transactions of questionable long term economic value because the inherent benefit of avoiding bankruptcy confers enough value to provide a defense against fraudulent conveyance actions

Moreover, the ruling creates an almost insurmountable defense for debtors with regards to fraudulent conveyance claims as there are always enough plausible scenarios generated by bankers and attorneys to justify engaging in the transaction. The standard applied by the District Court will likely encourage debtors to push the envelope with their corporate assets and encourage those in financial distress to pursue financial and legal gamesmanship rather than a sensible restructuring. In the end, such practices will increase the cost of capital for borrowers and hurt recoveries for distressed investors as enterprise value is burned away while management or the owners hold out for option value rather than restructure. Moreover, distressed investors will have fewer remedies against debtors and lose a valuable bargaining chip in the bankruptcy negotiating process.

Conclusion

The District Court’s decision was certainly a victory, particularly with respect to lender liability for diligencing the repayment of borrowed funds. Nevertheless, elements of the decision were expansive with regard to the ability of debtors to encumber its subsidiaries and engage in transactions of questionable economic benefit in order to stave off a bankruptcy. The appeal to the Circuit Court as well as the District Court’s decision on the 2007 financing will be closely watched. Distressed investors may find themselves in the future with less ammunition to take action to preserve the value of their collateral and enterprise value with companies in need of a restructuring. Equity owners and company management have a long track record of “burning the furniture to keep the lights on” as was seen in Calpine and other high profile conflicts with creditors. Giving issuers greater protections will likely inhibit timely and sensible restructurings and lead to lower recoveries as enterprise value is eroded in order to preserve option value.

Notes:

1. Judicial Backlash Adds to Challenges Faced by Lenders. Edward Estrada, Reed Smith. The Journal Of Corporate Renewal, July/August 2010.
2. http://www.finkellaw.com/CM/PublishedWorks/Actions-Defenses.asp
3. Fraudulent transfers under the bankruptcy code. Jill Murch, Foley & Lardner The Challenge, an Illinois State Bar Association publication for Distribution to the Members of the Standing Committee on Minority and Women Participation, August 2002 Vol. 13, No.
4. Ibid.
5. Ibid.
6. Bankruptcy Court Voids Subsidiary Guaranties and Liens as Fraudulent Transfers. Wachtell, Lipton, Rosen and Katz. Restructuring Developments November 2, 2009.
7. Edward Estrada. The Journal Of Corporate Renewal, July/August 2010.
8. Wachtell, Lipton, Rosen and Katz. Restructuring Developments November 2, 2009.
9. Selected Current Issues in Fraudulent Transfer and Preference Litigation. American Bankruptcy Institute. Irving E. Walker and G. David Dean Cole, Schotz, Meisel, Forman & Leonard, P.A.
10. Edward Estrada. The Journal Of Corporate Renewal, July/August 2010.
11. In re TOUSA, Inc.: Commercial Lending and Debt Trading Markets Breathe a Sigh of Relief. Morrison Foster Client Alert February 17, 2011. Larren M. Nashelsky, Rafael L. Petrone, Geoffrey R. Peck, and Chrys A. Carey.

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Distressed Debt Research: Nebraska Book Bankruptcy

This morning Nebraska Book filed for bankruptcy in Delaware and announced an agreement with a number of creditors in a negotiated restructuring. For those that are interested, you can view the docket here:

Nebraska Book Bankruptcy Docket

In his affidavit to the bankruptcy court, Alan Siemek, CFO of Nebraska Book described the reasons for the bankruptcy filing, as well as the negotiated restructuring the company hopes to move forward with. For those that have not followed Nebraska Book ("NBC" or "the Company"), the company operates two divisions: 1) Its Bookstore division operates nearly 300 managed, leased or owned college bookstore selling new and used textbooks and 2) Its Textbook division which distributes textbooks nationwide. The company was purchased by its current equity sponsor, Weston Presidio in early 2004 with a small equity check and a substantial amount of debt.

Why did the company file? Their trade creditors tightened up on them in the face of a large, unanswered 2011 debt maturity coming due. According to the affidavit:

"Further compounding the Debtors’ refinancing efforts, the Debtors’ business model typically calls for publishers and other merchandise vendors to provide approximately $200 million of new books and other merchandise on normal credit terms in July and August in advance of the back to school" rush. These normal credit terms, which may not be available to the Debtors during the 2011 "back to school" rush because of the uncertainty regarding the refinancing of their debt structure, usually allow the Debtors the opportunity to sell the textbooks (or return them) and sell other merchandise priorto having to pay for the items. This trade credit has been less available to the Debtors in the last several months as publishers and vendors became increasingly concerned about the Debtors’ refinancing process. Absent some action by the Debtors to de-lever their capital structure, the Debtors believe that it is highly unlikely that the publishers and vendors will extend the normal credit terms during the upcoming "back to school" rush. In fact, in the weeks leading up to the Petition Date, all five of the Debtors’ largest suppliers of new textbooks requested that the Debtors pay cash in advance for new textbook orders."

When trade starts asking for cash up front, most debtors fates are sealed.

With the writing on the wall, NBC and its advisors approached interested parties and stakeholders to explore debt restructuring options. It seems the debtor has reached an agreement with 95% of its senior sub note holders and over 75% of their 11% senior discount notes. For reference, here is the corporate and capital structure before the filing (taken from the prospectus of the 2nd lien notes):

As of the filing date, $26M was outstanding under the $75M ABL credit facility (including LOCs).

Under the plan:

• The company has secured a DIP facility comprised of $75M revolving DIP facility and a $125M Term Loan (DIP Term Loan: L+700, 1.25% Floor - take that Dodgers!)
• Trade creditors will be paid in full
• 1st Lien ABL credit facility will be paid in full
• 10% Senior Secured Notes due 2011 paid in cash with adequate protection (more on this later)
• 8.625% Notes will receive a combination of $30.6M in cash, $120M new unsecured note, and 78% of the new company's equity (the cash coming from a new second lien note the company plans to issue)
• Holdco notes will receive 22% of the new company's equity
• Westin Presidio (the sponsor) will receive warrants to buy 5% of the company at a $550M enterprise value (if they agree to support the contemplated restructuring)

In addition, NBC announced that its FY 2011 results (ended March, 31st) with revenues of $598M and EBITDA of more than $60M. For reference, the company generated $75M in EBITDA in FY2010 and $72M the year before.

Near the end of the day, JPM put out markets for the bonds

• 10% Senior Secured Notes: 98.75-99.75
• 8.625% Senior Subs: 70.5-72.5
• 11% Holdco Notes: 5-10

While it hasn't been detailed yet, let's try to figure out the capital structure of the company post the restructuring:

Uses of Cash

1. ~$26M cash to ABL
2. ~$200M cash to Senior Secured Noteholders
3. ~$30.6M cash to Senior Sub Noteholders
4. Administrative fees

Sources of Cash:

1. New contemplated Second Lien Note offering
2. $125 Exit Facility (let's assumed rolled from DIP Term Loan)
3. Current Cash Balance ($20M) + free cash flow generated throughout the bankruptcy

You will note I did not add the new unsecured note as a source of cash as it looks like they will be receiving that without putting up new capital. If we assume free cash flow generated through the bankruptcy will pay down the DIP revolver usage and pay admin fees, the post restructuring balance sheet will look something like this:

• $125M rolled senior secured exit facility
• ~$100M second lien note
• $120M unsecured note

Or total debt of $345M. This seems high relative to $60M of EBITDA or 5.75x. The $345M is approximately equal to the prepetition debt less $150M (from the petition: "The RSA contemplates a pre-arranged restructuring in chapter 11 through which the Debtor will remove approximately $150 million in debt from their prepetition balance sheet while paying general unsecured creditors in full")

There are $175M of subs outstanding as of the petition date. At a current market price of 72 cents on the dollar, the market value is approximately $125M dollars. Remember the subs are getting $30.6M of cash and a $120M unsecured note and 78% of the company's equity. In essence, the market is saying that the unsecured note will trade well below par and the equity is near worthless.

Admittedly it is hard for me to say the company's equity is worthless: Assuming an onerous rate of 7% on the exit, 12% on the second lien and 18% on the unsecured notes, total interest expense will, at worst case, be around $40M. And with $5M of maintenance capex and negligible taxes, EBITDA would have to decline to $45M from $60M (higher if you adjust for PF cost saves), before the company burned cash.

With all that said, I prefer the margin of safety in the pre-petition Senior Secured (second lien to ABL) Notes as well as the DIP Term Loan (and possibly Exit Facility depending on the covenants). The Senior Secured Notes will be taken out at par with cash on the effective date of the restructuring. In addition, according to this filing, an Ad Hoc group of Senior Secured note holders will be receiving MONTHLY interest payments (at the non-default rate) as adequate protection as well as payment of ordinary fees / expenses.

The Senior Secured note holders were not even entitled to this under the pre-petition intercreditor agreement (section 5.4 of the intercreditor provides the only form of adequate protection Second Lien Note holders may seek are replacement liens and superpriority claims that are junior to the superpriority claims of the First Lien lenders). The filing states that the reason for the adequate protection payments in the form of cash money is to avoid litigation.

Please note: The document above only references the Ad Hoc group of Senior Secured note holders. I have yet to find something that supports retail or non Ad Hoc members receiving the same kind of treatment in terms of cash payment.

There is upside here as well if the plan falls through and second lien note holders somehow become the fulcrum, creating the company at a very low valuation. The downside is the plan completely blows up, the company liquidates, etc, something I view as unlikely. At a ~9-10% yield that seems very safe, it definitely looks compelling. The sub notes to me are a more speculative investment but still have an interesting situation with the package being granted. If I had to choose, I'd definitely play higher up in the capital structure in either the DIP Term Loan or Second Lien Notes of Nebraska Book.

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Distressed Debt: Weekly Links of Interest

What we're reading this weekend at Distressed Debt Investing:

Commentary on the Supreme Court's blockbuster decision in the Stern v Marshall case; Marshall for those not aware was better known as Anna Nicole Smith. More commentary here as well. [Weil Bankruptcy Blog & The Bankruptcy Litigation Blog]

Someone sees some potential value in Seahawk Drilling's equity [Oddball Stocks]

Note from Leaders in Investing Summit featuring Leon Cooperman, Larry Robbins, Bill Ackman, Howard Marks and more [Market Folly]

More red flags from Sino Forest [Bronte Capital]

The New Yorker looks at insider trading [New Yorker]

Greenbackd returns (!) with a look at "Profit and Value" strategies [Greenbackd]

Smaller is better, when it comes to hedge funds [Financial Analyst Journal]

A very detailed look at earnings multiples and their flaws [Value Restoration Project]

Incredible graph of the long term performance of treasuries vs. stocks. vs the Barcap Agg [Research Puzzle]

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Largest Weekly High Yield Outflow on Record

This afternoon, Lipper reported that high yield saw its largest weekly outflow EVER, with $3.4 billion leaving high yield funds on the week. To put it in context, here is the updated Top 5 weeks of all times in terms of outflows:

1. 6/22/2011: $3.4 billion of outflows
2. 8/6/2003: $2.6 billion of outflows
3. 5/12/2004: $2.2 billion of outflows
4. 5/12/2010: $1.7 billion of outflows
5. 6/15/2011: $1.6 billion of outflows

Apparently in high yield, you should only invest from January until April, go to the Hamptons early, and come back late August (unless of course this is 2008, and then you should come back in October/November).

Most market participants knew the number was going to be big. Rumors swirled on the desk of $2.5B+ so a large number was not a surprise. But I do think THIS large of a number was a surprise. With that said, while it has felt "squishy" throughout the week, it's been quite orderly. The curve has definitely helped, but according to the CS High Yield Index, there hasn't been that much pain:

Of course, I, more so than most, hate when people only show me one year of data. Let's put this chart in perspective a little bit shall we:

This is the same index (CS HY Index II Average Price) over the past 5 years. Our little draw-down looks quite small when you compare it to the carnage of late 2008. And if you look at the underlying statistics, of the most liquid bonds out there, you saw bonds retrace 1-2 points (more spread widening associated though with the move in rates). The cuspier names were definitely hit hardest; names that had the weakest performance over the past five days include names like Verso Paper, MBIA, Realogy, Rite Aid, and Hawker Beechcraft whose bonds dropped 3.5-5.5 points over the past five days.

One of the largest caveats market participants have with analyzing the AMG data is that it is backyards looking. This is true, but I must add that, in my experience, fund flows are a factor in determining how aggressive syndicate desks can be in terms of pricing new issues and covenant negotiations. Weaker flows means wider and sometimes pulled new issues (this week a number of deals were pulled). And because the new issue market is usually used as a comp from IG all the way down to bank debt, a back up in new issue spreads will push secondary spreads wider.

One particular nuance that I have felt throughout the past few weeks is that there is just not a whole lot of sellers of high yield credit. Since mid 2009, a number of players in the primary markets ranging from insurance to pensions to mutual funds have seen very weak allocations on "on-the-run" deals. And when they get these allocations, people are putting the bonds away never to be seen on the street again unless a real panic has set in and weak hands are forced to capitulate. That is definitely NOT happening here. We are still a ways away from that.

So while the AMG number is large, the only takeaway I have is that if you are playing the new issue market, you can use it to your advantage to ask for better terms on covenants and a wider discount to secondaries (in both HY and IG we've seen primary deals come THROUGH secondaries which is a sign of a frothy market). Maybe you pick up an event driven name one to three points cheaper, but nothing out there is indicating to me that people are panicked, or buyers are fully on strike. The meme that defaults will be low in 2012 and 2013 will keep strategist recommending the asset class and certain buyers buying it.

In my office at home, I have framed the cover of the New Yorker from October 20th, 2008. I have reproduced it for you below (the title of the piece is "Red Death on Wall Street":

When you see that sort of cover on major media covers, that's when you buy bonds (and stocks). To me, there are so many other places to find value in the market other than high yield bonds (large cap tech equity for instance), especially when you consider that high yield not only has to contend with a slowing macroeconomic picture, but also the risk that rates rise (not an unfathomable possibility). If I had to bet, I bet the total return on MSFT stock, which I own, will be higher than high yield over the next 5 years. Here is a chart of HYG vs MSFT since the beginning of last year:

But for those that have to put money to work in high yield (like me for instance in certain accounts), you will not get killed, and there are a few interesting situation out there playing make wholes, asset heavy companies as well as smaller issues at the top part of the capital structure (preferably secured bonds), playing the crossover trade (still one of my favorite strategies), and a smattering distressed situations such as Nortel, Capmark, Lehman, and some exit facilities and other off-the-run bank debt names. And of course, the Russell rebalance is tomorrow and a lot of illiquid post-reorg equities will see a nice bid come in from passive players. But for the retail investor, I would not be going out and buying JNK or HYG - there are more compelling ideas out there.

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My Favorite Takeaways from the Oaktree S-1

On July 17th, Oaktree Capital Group filed its S-1 with the Securities and Exchange Commission. Many times over the past few years, we have profiled Oaktree's Chairman Howard Marks and highlighted takeaways from speeches he has given and his fantastic memos on Oaktree's homepage. In addition, I just started reading Marks' "The Most Important Thing", described by Warren Buffett: "This is that rarity, a useful book." If it's good enough for WEB, it's damn well good enough for me. When I am finished, I will put up a thorough review of the book.

With all that said, I read through Oaktree's S-1 and thought it would be a useful exercise to pull out my top 10 takeaways from the document. For those that want to follow along, you can find the S-1 here: Oaktree S-1

Enjoy.

1) Oaktree explains value investing REALLY well

In their "Business Principles", Oaktree lays out a number of fundamental tenets that guide their operation as an investment manager (commonality of interests, management fee arrangements, etc). The first business principle is "Excellence In Investing" and they go for the jugular in explaining how they do it - i.e. value investing:

"Our goal is excellence investing. To use, this means achieving attractive returns without commensurate risk, an imbalance which can only be achieved in markets that are not 'efficient'. Although we strive for superior returns, our first priority is that our actions produce consistency, protection of capital, and superior performance in bad times."

To me this speaks massively of margin of safety and the first AND second rule of investing: "Don't lose money." Further down in the document, when speaking about the investment philosophy, this quote appears:

"We believe that the best long-term records are built more through the avoidance of losses in bad times than the achievement of superior relative returns in good times. Thus, our overriding belief is that 'if we avoid the losers, the winners will take care of themselves.'"

2) Oaktree likes to play in the top part of the capital structure

Similar to commentary we've seen out of Marty Whitman and the Third Avenue Focused Credit Fund, Oaktree likes to play high up in the capital structure to minimize their downside with the possibility of equity upside in the case of the seniors being the fulcrum. That is not to say that Oaktree is going out and buying par loans, but in recent cases where they have been active (Tribune, Universal Building Products, Almatis), they are playing in the most senior part of the capital structure and buying the debt significantly less than par. From the S-1

"Most of our investment strategies focus on debt securities and many of our funds’ investments reside in the senior levels of an issuer’s capital structure, substantially reducing the downside risk of our investments and the volatility of our segment’s revenue and income. Debt securities by their nature require repayment of principal at par, typically generate current cash interest (reducing risk and augmenting investment returns) and, in cases where the issuer restructures, may provide an opportunity for conversion to equity in a company with a deleveraged balance sheet positioned for growth."

3) Oaktree Knows When to Sell It Own Equity Well

In May 2007, Oaktree sold 15% (23,000,000 shares) of its company on Goldman Sach's private exchange valuing the company at $6.3B or a price of ~$40/share Here is the trading prices for the equity on that same exchange:

They struck while the iron was still hot in 2007 and did a service for their selling investors by not waiting. Of course they could have waited until today, but that 4 years can be a long time for people with high percentages of their net worth in illiquid stock. In addition, if you consider that at the end of 2006, when they were probably marketing this equity sale, their AUM was around $35B versus $80B today. The intrinsic value of the stock is substantially higher today that it was 4 years ago and they still sold at those levels. AND they had the thesis that we were going into an economic downturn to top it off (see next bullet point). Well played.

I also did not know they had sold equity prior to the 2007 listing; From the S-1: "We first sold a piece of Oaktree to outside investors in 2004 and again in 2006, when long-time clients acquired approximately 13% of the company."

4) They grow when the going gets (or is about to get) tough

Many times when speaking with new and emerging fund managers I hear the complaint that the best time to raise capital is when we are staring over the abyss, but at that point no one wants to allocate capital. The irony in asset management really is the best returns (and hence incentive fees) arise when its hardest to raise capital. Oaktree, and a number of other prominent distressed investors (Baupost for example) have bucked this trend. Sticky capital the answer? Here is an example from the S-1

"By way of example, from January 2007 until May 2008, in anticipation of an economic downturn, we raised $14.5 billion for two distressed debt funds, including $10.9 billion for OCM Opportunities Fund VIIb, L.P., or Opps VIIb. We commenced Opps VIIb’s investment period in May 2008 and then invested over $5.3 billion of its ultimate $9.8 billion of drawn capital in the 15 weeks following the collapse of Lehman Brothers on September 15, 2008. While that investment environment presented an outstanding opportunity for us to buy bank debt and other securities at distressed prices, the steep drop in the financial markets contributed to the $10.8 billion decrease in aggregate AUM market value in the year ended December 31, 2008. Markets recovered in 2009, resulting in aggregate appreciation of $19.1 billion and $8.7 billion in the years ended December 31, 2009 and 2010, respectively. The recovery in the financial markets continued into the first quarter of 2011, driving further aggregate market appreciation in AUM of $3.2 billion."

In addition, and the other side of the coin to this, is that they shrink when markets are frothy (I've noted in the past how they return capital early when opportunities do not exist). In the S-1, Oaktree comments that "this phase in the market cycle is likely to cause our AUM to decrease in the second quarter of 2011 and to then possibly plateau or continue decreasing in coming quarters, subject to net asset flows in other funds and fluctuations in market value across all funds."

5) Oaktree and I Think Alike on Distressed Debt

A fundamental tenet of my thought process on distressed debt investing is as follows: Increased and sometimes frantic demand for high yield paper (bonds and lev loas) is met by underwriters marketing weak companies, weak collateral, and weak covenants. This in turn leads to higher default rates and lower recoveries for credit on the aggregate which leads to lower pricing of the asset class as a whole. This is when you buy credit - not when an underwriter tells you he is marketing a covenant lite retailer levered 6x on ADJUSTED EBITDA and the book is 3 times oversubscribed.

From the S-1 (long one here - I apologize, it was too good to cut out any of it)

"One important factor we consider in assessing where we are in the cycle is the amount of debt issuance, such as high yield bonds and non-investment grade leveraged loans. We believe an increased volume of debt issuance, to the extent it reflects loosened credit standards, can foretell an increase in debt default rates and the distressed securities they often create. The chart below shows this historical correlation.

We size our distressed debt funds based on the above relationship, our assessment of the economic cycle and other factors. By sizing funds in this manner, we intend to avoid both managing too much capital when bargain purchases are scarce and too little capital when they are plentiful. As a result, we have achieved positive gross and net IRRs as of March 31, 2011 for each of our 15 distressed debt funds. The chart below illustrates two benefits of our approach to sizing funds: the consistency of our positive performance and that, in each cycle, our largest funds have tended to be our best performers. Each bar represents a distressed debt closed-end fund, the height of the bar corresponds to the fund’s gross IRR as of March 31, 2011 and the dollar amount below each bar identifies the fund’s committed capital.

In 2001 and again in 2007, we anticipated the possibility of market dislocation, based in part on the considerable amount of debt issuance in the preceding years. While we did not attempt to predict the timing of the downturn, we thought the volume of lending relative to the fundamentals created a dynamic in which issuers would likely have difficulty meeting their obligations, resulting in an increased default rate or other factors that could result in expanded investment opportunities for us. Accordingly, we raised considerably more capital than we had historically so that we would be prepared if the markets experienced financial distress, creating attractive buying opportunities."

6) Their results are incredible

I had never seen the below chart, where their distressed debt returns were showing in one listing. I had heard the rumors but never the data to back it up. Needless to say, this is a glorious chart (click through if its too small). And the thing that really sticks out at me: No negative numbers here:

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Distressed Debt: Weekly Links of Interest

Over the next few months, I am going to try to posts a weekly roundup of investment related content on the web. Some will be related to distressed debt, other to value investing in general, and maybe a few things that have to do with neither. During the weekend, I try to catch up on all the data that I've missed during the week (remittance data here I come?) and read articles forwarded to me by colleagues and friends that I may not have had time to read. Here's to hoping I add a little bit to your weekend reading stack. Enjoy

Profile on Howard Marks of Oaktree Capital [Bloomberg Markets]

RSAnimate illustrates the paradox of choice [Simoleon Sense]

Interviews with a number of prominent financial bloggers [Gannon on Investing]

Subcon and Nondebtor Entities [Jones Day]

Enchantment book review by David Merkel [Aleph Blog]

Small cap high yield panel at the Milken Institute Global Conference [Milken Institute]

Discussion on the upcoming maturity wall (hill?) [Weil Bankruptcy Blog]

Incredible presentations at the LSTA's "State of the Leveraged Loan Market" conference [LSTA]

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NYSSA Distressed Investors Market Panel

On July 19th, the New York Society of Security Analysts will hold a panel discussion on the distressed debt investing environment. It looks to be a fantastic event that all distressed debt professionals in the NYC area should attend. Here are the topics that will be discussed:

• Landmark bankruptcies and legal decisions, and their impact on the future of distressed investing
• Current credit markets and whether we are in the midst of another credit bubble similar to 2006 and 2007 with the return of covenant-lite deals and dividend recaps
• Where is value in the current market
• Issues in leveraged loan and high yield documentation that are likely to lead to problems or litigation in the next downturn
• How high of a hurdle could the impending “maturity wall” prove to be
• Potential impact on debt markets and the economy from inflation

One of our contributors, Joshua Nahas, Principal of Wolf Capital Advisors will be one of the moderators of the event. Panelists include:

• Varun Bedi - Tenex Capital
• David Jackson - Penn Capital Management
• Andrew Milgram - CIO and Managing Partner of Marblegate Asset Management
• Derek Pitts - Houlihan Lokey
• Justin Smith - Covenant Xtract

For more information on the event, you can visit: NYSSA 2011 Distressed Market Panel

In addition, if you are a member or guest of the Distressed Debt Investors Club, you can use the below document to get the NYSSA Member Rate (fax it in, or PDF/Email it). For all those that are interested in becoming a guest of the Distressed Debt Investors Club, it's free, anonymous, and you get access (albeit delayed) to our over 400 event-driven research ideas on the site. For a list of ideas currently on the site, go here: Distressed Debt Research and to register as a guest, visit here: DDIC Guest Registration

Distressed Investor's Market Panel DDIC July 19 (1)

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Post Re-Org Equities: Russell 1000/2000 Index Changes

In 2006, Baupost's founder and president Seth Klarman gave a talk at Columbia Business School. In his talk, Klarman noted that Baupost has analysts that focus on very specific events: spin-offs, post re-org equities, distressed debt, etc. One set of analysts that I had never heard of a fund employing: analysts that focused on the addition and deletion of stocks in certain indexes like the S&P 500. As one would expect, when a company gets added to the index, passive funds (mutual or ETF) must buy the quantity of stock needed to match the company's weight in the index. Conversely, a stock that is removed from an index will see "forced selling" of their equity as passive strategies sought to match the index components.

In fact, this is one of the reasons that Seth Klarman, arguable the best hedge fund manager out there and one of three people Buffett has said he would allow to manage his money (source: Bruce Greenwald), has said why indexing is such a dangerous strategy (from Margin of Safety):

"Another problem arises when one or more index stocks must be replaced; this occurs when a member of an index goes bankrupt or is acquired in a takeover. Because indexers want to be fully invested in the securities that comprise the index at all times in order to match the performance of the index, the security that is added to the index as a replacement must immediately be purchased by hundreds or perhaps thousands of portfolio managers. There are implicit assumptions in indexing that securities markets are liquid, and that the actions of indexers do not influence the prices of the securities in which they transact. Yet even very large capitalization stocks have limited liquidity at a given time. Owing to limited liquidity, on the day that a new stock is added to an index, it often jumps appreciably in price as indexers rush to buy. Nothing fundamental has changed; nothing makes that stock worth more today than yesterday. In effect, people are willing to pay more for that stock just because it has become part of an index...

A related problem exists when substantial funds are committed to or withdrawn from index funds specializing in small-capitalization stocks. (There are now a number of such funds.) Such stocks usually have only limited liquidity, and even a small amount of buying or selling activity can greatly influence the market price. When small-capitalization-stock indexers receive more funds, their buying will push prices higher; when they experience redemptions, their selling will force prices lower. By unavoidably buying high and selling low, small-stock indexers are almost certain to underperform their indexes. "

On June 10th, Russell announced their annual reconstitution preliminary additions and deletions. You can view the data here: Russell Reconstitution. On Friday, June 24th the reconstitution will go into effect.

We know over the past year that a number of post re-org equities have been listed on the exchanges. With that said, we would expect to see a number of post re-org equities in the addition column on the Russell indexes and that's actually what we see. Here are the list of post-re org equities, and the associated Russell (either 1000 or 2000) indices they are being added to:

• BKU - BankUnited (Russell 1000)
• GM - General Motors (Russell 1000)
• CHMT - Chemtura (Russell 2000)
• CHTR - Charter Communications (Russell 1000)
• FRP - Fairpoint (Russell 2000)
• LYB - Lyondell (Russell 1000)
• SEMG - SemGroup (Russell 2000)
• SIX - Six Flags (Russell 2000)
• VC - Visteon (Russell 1000)

What compounds the problem on some of the smaller stocks above, is that the free float may be a very small percentage of total shares outstanding. As some bankruptcy plan support agreements require fulcrum security holders to hold onto their stock for a certain number of days, the true liquidity of a stock may be quite small. Furthermore, there may be no equity holders, that participated in the bankruptcy, ready to sell the stock because a lack of value realization.

Let's take Six Flags as an example. Bloomberg lists 27.575M shares outstanding. The new proposed weighted in the various indices (Russell 2000, Russell 3000, and Russell 2500) will require a purchase of approximately $111M worth of shares, or approximately 1,500,000 shares as of today's close. Since the end of the 1st quarter, the average volume of the stock is approximately 160,000 shares. This is 9 days worth of volume just on the passive side. Rehan Jaffer's H Partners, a well know event-driven hedge fund, owns 6.6M shares or ~25% of the shares outstanding. If he (and BHR Capital, the #2 holder) decides to not sell into the passive investor's hands, there could be a squeeze for the shares pushing the price artificially higher.

I would expect a small bump in the stocks listed above in the last week of the month as Russell passive funds look to match the new index constituent lists. Likewise, while not post-reorg equities, a number of the very small companies that did not make the market cap minimum this year on the Russell 2000 will be deleted from the index. Somtimes already illiquid, investors may see some interesting value opportunities in the names. These include PCTI, TPGI, AMNB, HOFT, and CUTR. Happy hunting.

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Non-Agency RMBS: Maiden Lane II and Its Effects on the Liquid Credit Markets

In late 2006, the head of distressed debt at a large multi-strat fund called my former boss and said: "We have been buying protection of hundreds of millions of subprime and Alt-A. Get involved." So in early 2007, I started looking through prospectuses and shelves and we bought protection on a number of deals as well as both vintages of the BBB- 2006 ABX. I must have hit CLP GO ten thousand times in 2007 looking for the worst of the worst. For instance, here is the CLP screen for CWL 2006-8 (using M6 here)

And the CLC screen (Collateral Composition) - There are 12 other pages listing the range of rates, LTVs, size, maturity, etc on the underlying mortgages,

To give you reference, the most senior tranche of this deal was rated AAA by both rating agencies. It is now rated B-/Caa2.

At the time, we were too cheap to subscribe to Intex and would sometime go to other, larger fund's offices to run scenario analysis on many single name deals. We made a lot of money on the trade but unfortunately did not size it correctly like many funds not managed by Paulson & Co. Outside of covering our positions and watching the train wreck unfold as 60+ delinquency shot through the roof, I spent very little time in late 2008 through 2009 looking at this stuff.

In early 2010, I started talking to other analysts at some funds and buy side shops who were dipping their toes back into the market. I spent a little time here and there looking at BWICs coming off the various desks but nothing in earnest. I still saw a little value in stressed & distressed credit as well as special situation high yield and focused my efforts there. But as we got further and further into the year, and the risk trade was put on, and yields started really becoming unattractive in corporate credit, my interest was piqued further.

Josh Friedman, co-founder of Canyon Partners, in a recent panel at the Milken Institute's Global Conference gave his reasoning for being long this asset class (40% of assets in his funds long):

"You are fighting headwinds in the high yield market...where you have hundreds and hundreds of players in the market scrambling searching for yield...or buying high yield bonds where there have been massive inflows into the market. The nice thing structurally about this market is there haven't been natural inflows into the market, there have been natural sellers. You have multi-trillions of dollar of paper with nothing but sellers. Meanwhile, the supply side of the market is naturally speaking because of defaults and prepayments, so there is less and less and less of paper available. The market actually shrinks 1.5% every month..."

Go here for the video: http://www.milkeninstitute.org/events/gcprogram.taf?function=detail&EvID=2726&eventid=GC11 (minute 25 or so...the whole panel is incredible)

In March, AIG announced that it offered to purchase the Maiden Lane II portfolio from the Fed for $15.7 billion. The Fed purchased these assets in late 2008 for $20B. At that time, the par outstanding or face value of that collateral was $39B whereas as of February 2011, the par value was ~$31B. According to UBS: "As of March 2011 the fair value of the portfolio was $17bn, consisting mainly of non - agency subprime (54%) and Alt-A (29%) RMBS."

The Fed balked at the purchase price offered by AIG and instead announced that it would be using BWICS (bids wanted in competition) to liquidate the assets. While at first this tactic seemed to be working moderately well, it started to become impossible to wade through the BWIC lists with any sort of confidence in either the analysis (not enough time to run the numbers) and true clearing price. Fatigue set in, people started to get ancy, and then they had to de-risk. It got so bad that last week, ~50% of the bid list did not trade. Here is a fantastic chart from Bofa ML depicting the Maiden Lane II bid lists (click to enlarge - DNT = did not trade):

The problem of course, is that as buyers were already choking on non agency RMBS from Maiden Lane, there was no one to unload to. So instead, they started hedging themselves with our good old friend the ABX (all vintages) and CMBX. And as many people know, the ABX and CMBX are not the most liquid cohorts out there, but its the best in the bunch of an illiquid world. It has gotten so bad, that in their most recent "Securitization Weekly", Banc of America Merrill Lynch writes:

"Given the weakening of the economy since the sales started, we think the next logical step is to halt the sales altogether or sell the entire portfolio at once, and allow the market to reset to lower levels."

Continuing the point above, as macro worries arose, funds (and the Street) needed to lower their long exposure any way possible. So to get "less long" or de-risk (either sell or go outright short) they must turn to more liquid environments like credit (and equities). Specifically turning to credit, the most liquid options out there are the on-the run synthetic indexes (HY16 & IG16). Barclays noted in a recent strategy piece that the HY CDX trades 5x more per week, on average, than the ABX and CMBX indices combined. And according to DTCC, we've definitely seen an increase in HY CDX volume trading over the past 2-3 weeks.

In theory, both the HY and IG synthetic indices should trade, on price (or spread), at a level equivalent to the total underlying CDS in each vehicle. In fact, though, the HY CDX index is trading 1.5 points cheaper to where it should theoretically trade (called the intrinsic level) as hedgers have outnumbered outright buyers. While I'd expect this to close as entire funds and desks on the street are set up to arbitrage this away, it has been painful to watch as people have been tentative about doing anything. Cash has also been weak as outflows to high yield credit were quite significant last week and the risk trade has been off (for all the above reasons + macro concerns).

It remains to be seen what the Fed will do with further Maiden Lane II BWICs. It definitely has cheapened up a number of assets. As mentioned in a previous post, I do think that certain sectors of non-agency, specifically Alt-A and seasoned sub prime are interesting - but the technicals are a disaster. I'll continue to do my work and add selectively to position with full knowledge that it will be impossible to catch the bottom here.

A trader, playing in a similar space, sent me the below. Nonetheless it's going to be a very interesting summer in the credit and ABS markets:

"On top of your RMBS in your email I wanted to add a few comments in regards to the non - agency CMO market. Which in my opinion is one of the only asset classes that still has absolute upside along with attractive yields. We have seen CMO prices off 5%-10% since Feb.. due to a flattening yield curve and higher supply. Loss adjusted yields are still very attractive. Technically: Demand for NA CMOs picked up substantially in Jan/Feb of this year and appears to be here to stay. The new depth to the market has brought several of the early liquidity providers (e.g. central banks) to market. The most notable seller is the Fed (Blackrock managed) who is selling the Maiden Lane II portfolio. This additional supply has kept the market soft and should create some good buying opportunities this summer. Fundamentally: Recent housing news did not come as much of a surprise to anybody and it did not help. That said the feeling from the research I have seen is that there is more upside then downside. Based on the current market, I think remaining patient and accumulating dry power is smart. That said legging in over the summer could be the best avenue to take advantage of based on the recent sell off. The sense is another 1 or 2 points lower is where the buyers lie"

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Ira Sohn Notes (Part 2/2)

A few weeks ago, after the 2011 Ira Sohn Conference, I put up our first series of Ira Sohn notes, promising the second installment "tomorrow." Better late than never?

Steve Feinberg - Cerberus Capital Management

• This is the first time, outside of Chrysler conference calls back in the day, that I have heard/seen Steven Feinberg speak. With that said, I have heard of other recent public appearances as well. For those that aren't aware, Feinberg was a trader at Drexal and Gruntal, before co-founding Cerberus at the age of 32 with $10M of seed capital (it now has $22B under management).
• Feinberg touted RMBS mortgages. We've been hearing a number of distressed funds (Canyon for instance at the Michael Milken conference) recommend certain non-agency pools of mortgages. The thesis is quite similar: No natural buyers of the assets, many forced sellers, incredibly large market. In effect, RMBS is much more of a credit game than a game of estimating prepayment speeds and interest rate movements
• For instance, historically average FICO scores were important metrics for understanding underlying collateral strength...now its things like loan size. Larger borrowers are defaulting less frequently than would be predicted under previous models.
• Another reason he likes mortgage: There is a high barrier of entry to getting into the business - its difficult and requires math wizards on your team. Before the investment banks did all the research and told clients what to buy ... no longer is that the case.
• He discussed in detail an Amhearst shelf. Under conservative assumptions on CPR, CDRs and severities, the bond should yield 14%

Peter May - Trian Fund Management

• Peter May is the other face of Trian (Nelson Peltz being the other). In his introductory comment, May noted that Trian is interested in great companies with low risk profiles because of a powerful brand / franchise. For his pitch, and as an example of such a company with potential for "enormous price appreciation", he touted Tiffany & Co (TIF)
• The three factors that will cause this appreciation: 1) new store growth ... the brand is very underpenetrated 2) SSS from the sale of new products in new and existing stores 3) vertical integration (I was confused at this one). The company is generating a massive amount of cash flow and is plowing that cash flow into high ROC new store builds and an newly authorized share buy back program.
• Despite a significantly increased store base and ROEs, the multiple is still lower than it was 5 years ago - using that same multiple gets you to a $100 stock
• Further upside comes from a precedent transaction in Bulgari sale at 30x

Steve Eisman - Frontpoint Partners- Are US Financials Dead Forever?

• Steve Eisman is all over the news recently. It's been reported by the WSJ that he is leaving Frontpoint where he ran their financials fund to start his own hedge fund with his existing team and new hires. Steve Eisman was a feature in Michael Lewis' Big Short. Last year his pitch was shorting "For-Profit" eduction - slaughtered much?
• At first, I was sure Eisman was going to tout the banks. But then he pulled a 180 (citing the fact that the glorious 2012 everyone expecting, where mortgage deliquencies normalized, isn't going to happen), and started talking about the one sector I've been allocating 50% of my time to since Tohoku - the insurance sector...specifically the property reinsurance carriers and brokers. He beat me to the punch!
• He started with a slide comparing the two sectors. Insurance trades less than the banks on a P/E and P/TBV basis, and Eisman thinks property reinsurers/brokers have top line growth coming from the increase in rates as losses from the ridiculous number of cats we've had this year has lowered excess capital in the industry - and it's not even hurrican season yet
• Eisman believes a hard market (i.e. a one where rates increase) is upon us. For the past few years, we've been in a soft market where premiums have declined and multiples have contracted. Eisman believes this is about to reverse
• He also noted that RMS 11 (a model of expected losses for certain events), is having the effect of increasing expected losses to both primary insurers and reinsurers. Because of this, everyone has to buy more insurance further reducing industry capacity.
• Eisman noted that P/C companies trade at ~90% of book value and in a hard market, multiple will trade above book value
• The safe way to play it before the hurrican season is through the brokers (MMC, AON, WSH)
• If you want to add a little spice to your life the Bermuda reinsurers like RNR, RE, PRE and a few others which could see losses in the event of large hurricanes
• I REALLY want to write a series of posts on analyzing insurance equities and credit (Life, P&C, Financial Guantors, Mortgage Insurers) as well as portfolio management strategies one can employ to augment certain risk factors (i.e. buy CDS on one name overexposed to the disaster that is Florida and sell CDS on another, buy CDS on one name while simultaneously going long the equity). It is by far my favorite sector to talk about.

Jeff Gundlach - DoubleLine

• Before I get to the notes, and I apologize for being such a fanboy, but Jeff Gundlach is a genius. I think people think he's crazy - Have you looked at DBLTX recently? And you know who seeded him? Howard Marks...
• Gundlach started off the presentation noting that the key to investing is accounting for policy and behavioral changes. Two of the most important variables a mortgage investor needs to model/make an assumption on is prepayment speeds (especially when you are invested in IOs) and treasury rates (especially when you are invested in inverse IOs).
• Gundlach believes that as housing inventory stays in foreclosure longer, severities will increase (it's essentially a linear relationship), and losses will accrue into higher and higher tranches of MBS ... in fact he thinks the 2007 ABX AAA is worth zero but is trading at 40 - the correlation betwen the ABX 2007-1 AAA and BAC stock is very close because BAC is really just Countrywide that had a bunch of subprime in it
• He also noted that, the Fed / Congress is playing a game of "Wheel of Fortune" where everyone is trying to thread the needle. He was skeptical it would happen especially given the fact that we can't raise taxes right now but need to given the deficit
• Gundlach advocated a diversified approach: natural gas, dollars (flight to quality), gem stones (gold and silver are heavy), artwork, and a hedged bond portfolio
• Here is the slide from the presentation, where he advocated this hedged portfolio:

Bill Ackman - Pershing Square - Family Dollar Stores

• Instead of giving you summary thoughts on the speech from Bill Ackman, here is a transcript of the speech: http://www.insidermonkey.com/blog/2011/06/06/transcript-of-bill-ackmans-super-fast-speech-at-the-ira-sohn-conference/

Joel Greenblatt - Gotham Asset Management

• Joel Greenblatt founded Gotham in 1985. Since then he's seeded hedge funds (Scion Capital for instance), wrote a number of incredible books, and taught at Columbia. Rumor is he put up 40% annually for a number of years...
• Greenblatt spoke about "value weighted indexing" the subject of his most recent book (he gave out copies after the conference) - I expect in the future Greenblatt's new firm Formula Holdings, will launch these sorts of indexes - and I will buy them for all my friends and family.
• At the end of his presentation he noted a number of stocks which meet his characteristics of high free cash flow, low multiple: JWN, WLP, CVH, AGF, MET, HUM, GME, WAG, MRK, ABT, MHP, INTC, BBBY and WSM (I am personally long WAG & ABT)
• I think my biggest takeaway from his speech was his discussion on time arbitrage. David Einhorn has spoken about it in the past, but one of the key advantages a value investor has on his side right now is time. With funds so focused on short term (month to month) performance, many incredible bargains can be had for the patient. I will write a post about this and how it relates to distressed debt investing shortly

Mark Hart - Corriente Advisors

• I had never heaed Mark Hart of Corriente Advisors speak up until this point. Here is his bio from the conference website: "MARK HART III is chairman and chief investment officer of Corriente Advisors, which Mr. Hart formed in 2001. Corriente advises the Corriente Master Fund, a global macro hedge fund, the European Divergence Funds, which were formed to capitalize on rising European sovereign credit spreads, and the Corriente China Opportunity Funds, which are designed to profit from a slowdown in China. Mr. Hart also launched and co-managed the Subprime Credit Strategies Funds from 2006 to 2008 with Kyle Bass, which were formed to capitalize on the subprime mortgage market dislocation. Mr. Hart earned a B.A. in the Plan II Honors Program from the University of Texas at Austin in 1994."
• Hart's entire presentation was his thesis on why China is a bubble and the RMB is a short...the short takeaway: China is a credit fueled bubble where 50% of loans can't be serviced out of cash flow...It's a ponzi scheme
• The short stems from the fact that the devaluation to the RMB is the "path of least resistance"
• Corriente is long puts (you can buy at the money puts with very little money down and a massive upside given the skew

David Einhorn - Greenlight Capital - Two Longs: Two Different Types of Overhangs

• One of my favorite speach of the conference, especially since I am very long MSFT (time arbitrage?), and the fact that Einhorn started with $500,000 of capital given to him from his parents and turned it into ~$5B fund. If you haven't read his book, stop reading this right now, and pick it up.
• Again instead of notes, here is the transcript: http://www.insidermonkey.com/blog/2011/06/02/transcript-of-david-einhorns-speech-at-the-ira-sohn-conference/
• My biggest takeaway: I want to be like David Einhorn when I grow up

Note, I haven't included my notes from Carl Icahn, Eike Batista, Michael Price, or Marc Faber here). The first three I have individual posts coming up in the next few weeks. Stay tuned.

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