Has Bill Miller really gone insane?
The famed head of Legg Mason Value Trust setting a record 15 years of beating the S&P 500 bets big on Freddie Mac largest single share holder reportedly increased his holdings in August as everyone was saying the GSE's days were numbered and he gets crushed today. What the hell was he thinking?
O.K. I'm a Value Trust holder and long time Bill Miller fan he's made a lot of controversial calls in his day and a good number have paid off handsomely so instead of just assuming he lost his mind I try to understand what he was thinking.
Well I think I can guess his case pretty easily by using an analogy from Tom Brown who I'm going to go back to in a minute anyway. The problem loans from 05-07 are like a pig in a python you just have to wait for them to work their way through before things get back to normal. So I'm thinking the Bill Miller case for being bullish on Freddie is something like my team has spent months scouring through their financial statements and other all available information and we have come to the conclusion that they only need a modest amount of new capital which they are having trouble raising in the market right now due to extreme paranoia but all comments from Treasury and their regulator seem to suggest they understand this and will arrange financing on reasonable terms when (if) the time comes.
So Paulson decides to seize the GSE's apparently under pressure from Bill Gross and a slew of foreign debt holders and there seems to be pretty much unanimous opinion that shareholders will be wiped out by the warrants accounting for 80% dilution. It doesn't matter that shareholders should still have 20% of normalized earnings in a couple of years the government will take the last 20% eventually. Even though Paulson stated he had no intentions to exercise the warrants there is nearly unanimous opinion that the GSE's are going to need so much help he will have to exercise the warrants and wipe out shareholders probably just to keep up appearances.
But I'm pretty sure Bill Miller did some pretty exhaustive research that lead him to believe they only need moderate help (if any at all) so who is right Bill Miller or the rest of the universe? Now I get back to Tom Brown another contrarian who has had a rough year and I look back a few months ago to when the bond insurers were no hope gonners only a fool would buy these guys. Well Tom Brown was such a fool and interestingly enough he runs a web site called bankstocks.com where he posts his thoughts on the financial industry and when everyone and their brothers were convinced Ambac and MBIA were toast he was here is one of many articles he put out defending his decision to buy these stocks.
2. MBIA’s insurance subsidiary doesn’t have sufficient capital or claims-paying ability. Whitney and the other shorts keep saying this, and I don’t understand why. Here are the facts: MBIA’s estimate of the net present value of its future losses and impairment, for which it has reserved, is $2 billion. The rating agencies estimate losses will be $6-7 billion. But the company’s actual claims-paying ability—not what it’s reserved for, but the amount it could pay even if losses soar far beyond its expectations--is $16 billion. That is not a typo: $16 billion! There is simply no dispute on this point.
Apparently the market is finally starting to see what Tom Brown saw based on the chart below.
Even though it's been a rough year for Tom Brown he's posted a lot of really interesting analysis such as digging through the ABX index and showing that the headline default rate are misleading as the way they are calculated makes them a lagging indicator of actual default rates. He was ignored for a long time but the financial press has finally been acknowledging that rate of increase in sub prime defaults does appear to be coming down as Tom has been preaching for months. He also did an interesting exercise with the ABX data where he demonstrated that if you eliminated loans already repaid or foreclosed assumed 90% of whats currently delinquent eventually gets foreclosed for like 50 cents on the dollar then in order to get to the ratings agencies stress case assumptions for sub prime losses 75% of the loans not yet delinquent would have to be foreclose for like 50 cents on the dollar. His point isn't going to happen.
So what does this have to do with Bill Miller and his controversial Freddie investment. Well he's a bottoms up kind of guy like Tom Brown he's known for making controversial calls that usually pan out and he must have been convinced that concerns about the amount of capital Freddie would need to raise were overblown (as he stated recently) and that when (if) the time came the government would arrange for capital on reasonable terms and when the pig finally made its way through the python and the GSE's got back to normal earnings everyone would understand. Tom's done a pretty good job of demonstrating that someone willing to dig into the data can find that the facts don't always support conventional wisdom and maybe just maybe Bill Miller in digging deep found something everyone else is missing. Thats pretty much what Paulson was saying until he was more or less forced to make a move no?
Well it looks like none of that matters the perception that the GSE's are toast trumped his idea of reality and Paulson was pretty much forced to seize them. But what if contrary almost unanimous opinion the GSE's just need moderate financing that they could not get thorugh the markets due to paranoia and not the massive infusion that is assumed? Does the government then still take their 80% or 100% as the market is pretty much assuming right now? Do you think Bill Miller and some of the other large shareholders in the GSE's are not going to point out the disproportionate compensation? Do you think the government is going to want to look like they are profiteering.
Maybe just maybe conventional wisdom is wrong? I don't own the GSE's except in my CAPS portfolio based on Bill Millers thumbs up. I just though I'd play a little devils advocate.