Friday, December 28, 2007

Martin Whitman Releases Annual shareholder Letter

Mr. Whitman's thoughts on the mortgage situation are just spectacular and more than worth the time to read. I get the letter by being a holder in the Third Avenue Value Fund (TAVFX)

Read the Whole Letter Here:


TAVF is investing heavily in the common stocks of companies suffering through the current housing crisis. These companies include financial institutions, a home builder, a building supplier, land banks and investment builders. The Fund’s reasons for this investment program provide a good case study as to how Third Avenue’s “safe and cheap*” approach works in practice:

First, the bad side of these investments:
1) The stock market pricing for these equity issues ischaotic. There is no way Fund management is able to pick a bottom for securities prices, or a near bottom.
2) Fund management has no good idea of how deep the crisis will become, or how long it will last. Our best guess is two to four years.

Second, the good side of these investments:
1) In each instance, TAVF is acquiring common stocks at meaningful discounts from readily ascertainable NAVs. In the case of certain financial institution common stocks – MGIC Common, MBIA Common and Radian Common, the prices the Fund is paying are no more that 40% of book value, or adjusted book value. For each of these companies, a normalized Return on Equity (equity equals book value) (“ROE”) ranges from 8% to 14%.

Assuming a 10% ROE sometime in the future, and no further dramatic deterioration in book value during the interim, probably a realistic assumption; and current pricing at 40% of book value, Third Avenue would be paying only four times future normalized earning power. There seems to be a reasonable probability, too, that TAVF is really paying less than four times normalized earnings, even assuming that future normalized earnings are fully taxed and even assuming some modest dilution of the common stocks.

2) Each common stock acquired, is acquired in a company which enjoys a strong financial position. While there can be no guarantees, the probabilities are that each of these companies will survive as solvent going concerns either without requiring major access to capital markets for new funding, or by obtaining new funding from others on terms that are only modestly dilutive for TAVF. On December 10th, MBIA announced that it is obtaining $500 million of equity financing from Warburg Pincus; and another $500 million from a rights offering which Warburg Pincus will backstop, i.e., underwrite. Assuming that Third Avenue participates in the rights offering and also takes advantage of any oversubscription privileges, the capital infusion should be, at worst, only modestly dilutive for TAVF.

3) Each company seems very well managed.

4) It is possible that the crisis will become increasingly deep, and prolonged; or rating agencies will start to place great weight on soft, qualitative considerations. In those events, the companies might need capital infusions to remain going concerns. TAVF has proposed to MBIA, Radian and USG managements that such infusions be in the form of equity, and that existing stockholders provide the equity via pre-emptive rights offerings. MBIA proposes to raise $500 million via a rights offering. If this were to occur, and if other portfolio companies were to follow the MBIA path, the capital infusions would be, for Third Avenue, mostly nondilutive, or anti–dilutive (if there are oversubscription privileges).

In the case of MBIA and Radian, it is crucial if they are to remain going concerns, that the national rating agencies continue to assign AAA and AA ratings, respectively, to each company’s bond insurance subsidiaries. As an aside, given current prices, TAVF would probably not lose money if Radian or MBIA were to go into run-off rather than remain going concerns. Run-off, i.e., liquidation, simply is not a likely outcome, however. It would appear as if capital infusions would not become necessary if the rating agencies were to rely on only hard, quantitative data.

However, this month, Moody’s announced that in reviewing ratings it would also consider soft qualitative data, much as Moody’s views as to what “investor perceptions” are. Consideration of such qualitative factors as investor perceptions seems to increase the probabilities that Radian might seek a capital infusion as was the case for MBIA. At December 21st, TAVF owns 12.9% of the Radian Common outstanding, and 8.0% of the MBIA common outstanding.

At current depressed prices, the Fund would rather buy common stocks from the companies than from company stockholders. If rights offerings were to become available not only for MBIA, but also others, TAVF might have attractive buying opportunities. In analyzing each of the financial institutions, Generally Accepted Accounting Principles (“GAAP”) tend to be quite misleading. This is because GAAP require that derivatives such as the Credit Default Swaps be marked to market – and market prices now are highly capricious, to say the least.

Marks to market are the most appropriate, and helpful, tool in the appraisal of publicly-traded common stocks held in trading portfolios. Marks to market are an inappropriate, and unhelpful, tool in the appraisal of credit instruments held in portfolios where the intent is to hold the credit instruments to maturity. MBIA and Radian intend to hold their credit instruments to maturity. Third Quarter 2007 mark to market losses recorded by MBIA and Radian were as follows:

Mark to Market Losses,

MBIA $222,000,000 / $1.80 PER SHARE
Radian $404,000,000 / $5.02 PER SHARE

Further, MBIA announced on December 10th that its mark to market losses for the fourth calendar quarter of 2007 will be significantly greater than they were in the third quarter.

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

MBIA’s fourth quarter 2007 reported losses will be staggering. In addition to mark to market losses, the preliminary indications are that case reserves will be increased by $500 million to $800 million pre-tax. The Company, however, will remain with a quite strong capital position. When I first trained as an analyst – some 50 plus years ago – the primary role of GAAP was to meet the needs of creditors who held credit instruments to maturity. That’s all changed now.

The primary role of GAAP seems to have become to fulfill the perceived needs of equity holders who are vitally affected by day to day changes in common stock prices. As I’ve pointed out in previous letters – What a waste! GAAP can’t really be very useful to stock market speculators, but it can hurt issuers like MBIA and Radian. In any event, TAVF, as a “safe and cheap” investor, will continue to place primary weight on “what the numbers mean” rather than on “what the numbers are”.

Though I feel very good about our investing program into U.S. housing related companies, TAVF is hardly “betting the ranch” on such investments. At October 31, the Fund had $1 billion, or 8.3% of its net assets, in such investments. In contrast, for example, the Fund had $3.2 billion, or 26.2% of its net assets, invested in the common stocks of Hong Kong-based companies involved with real estate and private equity.

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

Historically, financial guaranty insurance has been a highly profitable business for the monoline insurers, even though the insureds received a very attractive deal by being able to obtain AAA ratings at low cost. Insurance company profitability is measured by a combination of underwriting profits and net investment income. Underwriting profit is measured by the “combined ratio”, i.e., the ratio of the sum of losses and expenses to net premium income and net premiums written. Net investment income, usually all interest income, tends to be larger as long as loss liabilities are “long tail”, i.e., the losses do not have to be paid out until long after the insurance premiums have been collected and then invested in bonds.

Typically, MBIA’s insurance subsidiaries have enjoyed a combined ratio each year under 40%. Net investment income for the MBIA insurance subsidiaries has grown over the years to almost $600,000,000 per annum. The prospects appear quite good to Fund management that, once past the current housing difficulties, MBIA will return to its historic patterns of very attractive combined ratios and relatively steady growth in net investment income.

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

Martin J. Whitman

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