A canary in the commodities coal mine? 5 signs the rout has only begun.

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I’ve looked at the financial world through a new lens ever since reading the fantastic book Fooling Some of the People All of the Time by David Einhorn of Greenlight Capital. In dramatic fashion, Einhorn exposed the fraud at Allied Capital and ultimately profited by short-selling the company’s wildly overvalued stock.

Could a similar story be unfolding at the Hong Kong commodity trading company known as Noble Group?

The Noble Group has hit a rough patch – especially in the shale oil business. It’s stock has fallen 60% since July of 2014 and the short sellers are are winning. The Financial Times detected the whiff of Noble’s corporate shenanigans in it’s US edition on Thursday.

Mining

Using the template provided by Einhorn is his famous campaign against Allied Capital’s fraudulent practices, here are 5 classic signs that something is amiss at Noble Group:

1. Aggressive recognition of income. Companies that consistently book future revenues in current quarters start raising red flags. It seems that Noble has perfected this game. Noble Group has reported $2.5 billion in profits since 2009, yet cash flow over the same period has been a paltry $118 million. Yes, that’s an “m”.

2. Inflated value of a subsidiary. Noble Group owns a 13 percent stake in Australian miner Yancoal. The company is traded publicly and has a market value of $95 million. Instead, Noble carries Yancoal on its books at $322 million.

3. Opaque mark-to-market accounting. Noble makes no explanations for its valuations of long-term commodity deals in their financial statements. They have hired PwC to produce a more detailed analysis. If a commodity trader needs to be told how to mark positions to market by an accountant, it doesn’t exactly inspire confidence. This sounds like a good stalling tactic to allow investors to exit before the business implodes or to buy time for the market value of the trades recover.

4. Company owners create a smokescreen by buying shares. As with the Allied fraud exposed by Einhorn, Noble Group has thrown up the red herring that the company must be in good shape because insiders are buying stock. Richard Elman, the Chairman, has recently bought shares.

5. Attack the messenger. The most vocal critics of the firm have been Iceberg Research and the short selling hedge fund known as Muddy Waters. The S&P has also chimed in that Noble needs to improve disclosure or it will face a downgrade. Instead of disclosure, Noble alleges that the information presented to Iceberg is the work of a disgruntled Noble employee who was fired in 2013. Not coincidentally, this same former employee is being sued in Hong Kong by Noble. Einhorn was able to rattle cages at Allied by bringing a “whistleblower” suit. Such legal remedies are probably not available in Hong Kong.

As an aside, shouldn’t S&P downgrade Noble now? I mean, if they produce the transparency, they can be upgraded again. Right? Aren’t ratings companies supposed to be the ones who alert investors first?

In Noble’s defense, the FT provided few opportunities for the company to rebut the claims publicly. Also, Richard Elman is a cagey operator who started the Noble 30 years ago and began in Britain’s scrap industry during the 1970’s. His survival ability probably should not be underestimated by overconfident short sellers.

If nothing else, the FT piece is a canary in the coal mine that many other traders and miners may not be portraying accurate valuations in what has become a commodities bloodbath. If some of the trading firms start to unwind positions rapidly, it could lead to major market disruptions… and opportunities….

Is real estate riskier than you think? Don’t look for clues in corporate bonds.

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Corporate bond spreads do not offer much insight into the relative risk levels of commercial real estate mortgages.

The table below shows credit rating criteria from Standard and Poors as of January 2015. In this chart, ratings are based on interest coverage levels of smaller non-financial service companies with market capitalizations less than $5 billion.

greater than ≤ to Rating is Spread is
12.5 100000 AAA 0.40%
9.5 12.499999 AA 0.70%
7.5 9.499999 A+ 0.90%
6 7.499999 A 1.00%
4.5 5.999999 A- 1.20%
4 4.499999 BBB 1.75%
3.5 3.9999999 BB+ 2.75%
3 3.499999 BB 3.25%
2.5 2.999999 B+ 4.00%
2 2.499999 B 5.00%
1.5 1.999999 B- 6.00%
1.25 1.499999 CCC 7.00%
0.8 1.249999 CC 8.00%
0.5 0.799999 C 10.00%
-100000 0.499999 D 12.00%

For many apartment development projects, lenders require a debt service coverage ratio of between 1.25 and 1.35. This means that for every $1.00 of debt service, your property has to generate $1.35 of net operating income. However, according to the S&P chart above, if real estate mortgages were priced like a corporate bond, they would be rated at C – “or junk”. Such a mortgage would trade at a whopping yield of over 10.3% with an 8% spread over current treasuries.

Thankfully, commercial real estate loans – much like home mortgages – are priced at a spread over treasuries somewhere between 185 basis points and 250 basis points depending on the lending environment. Today, a 4.35% is a widely available rate.

So why does this disparity exist between the interest coverage ratios of mortgages and corporate bonds?

The answer is found in the long run historical data for collateral recovery rates.

Surprisingly, the default risk of commercial mortgages is much higher than one might expect. Howard Esaki’s study of data from 1972 to 2002 showed that the average default rate of all commercial mortgages was 19.6% for loans in service over 10 years.

In the short term, the annual chance of default compounds by what is known as the “hazard function”. For example, if a loan has a 1% chance of default in year one, then it has a 2% chance of default in year two, and a 3% chance of default in year three, and so on. Esaki found that this level generally stabilizes at a 16% default rate after 15 years.

hazard rates

What mitigates lenders against this high default risk?

The recovery rate is the key factor in the data that have allowed insurance companies, government sponsored entities and commercial mortgage backed security firms to price mortgages at a spread in the range of 2% over treasury yields.

Loans are originated as a percentage of estimated values. Loan-to-value ratios do not exceed 80% at origination. Experience has shown that only in rare occurrences have lenders over-estimated values to the extent that their loan balances could not be recovered in the event of default.

So, even if the loan has a 5% chance of default in year 5, the lender will have collected 4 years of interest plus the principal balance recovered in a foreclosure process. In long run studies, even the distress sale of a commercial property has been sufficient to make the lender whole.

Mr. Esaki’s numbers may yet prove to be understated. Many wise observers have noted that the aggressive underwriting of the late 2000’s has not truly been revealed. In 2016 and 2017 the ten-year mortgages originated in the crazy pre-Lehman days begin to mature. This loan maturity problem may push the Federal Reserve into another quantitative easing program to lower long term rates and assure that mortgages can be “rolled over” without default.

Looking for Red Flags in Corporate Reporting

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In spite of the financial crisis of 2008, regulators continue to be ill-equipped to tackle corporate malfeasance.

I read David Einhorn’s Fooling Some of the People All of the Time (for a second time) over the past week. Einhorn is the founder of Greenlight Capital and has been known to discover short selling opportunities among many companies with dubious financial reporting. In a courageous position, he questioned Lehman Brothers’ health while the stock still traded at $60 per share in 2007.

Einhorn

But his most famous short, and the subject of the book, is his seven year campaign to expose the fraud at Allied Capital. The book is part detective story and part financial thriller. Unfortunately, it is not a work of fiction. It depicts regulators asleep at the switch – if not willfully ignoring misconduct. It shows the lengths to which a corporate leaders will stoop to manipulate the system (ultimately Allied admitted to even hacking the phone records of Einhorn and various investigators). It shows how investment banking analysts and rating agencies can be easily led astray by the corporate party line in the face of bold malfeasance. And the book depicts the conflict of interests among government agencies and politicians.

Here are the red flags that serve as warnings to all investors. These are scents that Einhorn and other skeptics picked up on their bloodhound path through corporate swamps of misinformation:

Red Flag #1: The off balance sheet subsidiary with opaque financials. Just like the Andy Fastow’s “Raptor” vehicle at Enron that hid losses from the market, Allied used BLX to shield losses on SBA and USDA loans from the public. Ultimately, the lack of transparency not only concealed poor underwriting and inflated values, it hid outright fraud.

Enron logo

Red Flag #2: Failure to mark assets to fair values. This was Einhorn’s major discovery that led him to the conclusion that Allied was lying to investors. It formed the basis of his short position and was the subject of his introduction to the public at a charitable investor conference in 2002. Allied systematically held assets that should have been written down in spite of non-performance or deterioration. Instead, they carried the assets at cost, in some cases for as long as ten years, before admitting the loans to portfolio companies could not be collected.

Red Flag #3: Gain on sale accounting. BLX would originate SBA loans, sell the government guaranteed portion to banks and securitize the non-guaranteed portion. They would also include the present value of future servicing revenue in their current income for the quarter. This worked fairly well until it became clear to banks that the loans were poorly underwritten and stopped puchasing loans at a premium. BLX started keeping more of the non-guaranteed positions on their books and increased their present value recognition of higher future servicing fees. Over time, more and more of the gain on sale events were non-cash calculations of future residual values. Most of them never materialized.

Red Flag #4: Smoothing quarterly results. Allied was careful to “write up” many assets at the same time that they gradually wrote down assets over many years, thus concealing the true loan portfolio condition.

Red Flag #5: Paying distributions or dividends in excess of net income. Allied came to rely on selling winners and holding losers in their portfolio to subsidize a dividend that was unsustainable from basic operating earnings,

Red Flag #6: Continual equity raises. Allied bordered on the edge of a Ponzi scheme by continually issuing stock that was billed as dry powder for new asset origination. Instead, much of it was used to prop up the failing BLX and fund the distribution.

Red Flag #7: Revising stock option plans to unfairly benefit employees. Allied shifted to a cash compensation structure when it became apparent that most options would soon be under water. It also prevented the dilution of current shares outstanding. It decoupled the executives from having “skin in the game”.

As a parting word, to me, the most shocking area of the book relates to the failure of the media to expose the story. Not only did financial journalists balk at publishing corporate malfeasance due to its complexity and lack of “sexy” headlines, the openly hostile reception of venerable publications such as the Wall Street Journal and the Washington Post calls into question the objectivity of media and the undue influence wielded by corporations. The end result of such “journalism” amounts to little more than a friendly public relations piece rather than a full vetting of the facts. Einhorn even sadly recounts his presentation to a Harvard Business School professor of his detailed investigation in order for the prestigious business school to produce a case study. Once the case study was published and reviewed by students, Einhorn was shocked to read Allied was portrayed in a favorable light.