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Wally Weitz on credit problems and corporate buyout financing, Washington Mutual

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Wally Weitz on credit problems and corporate buyout financing, Washington Mutual


Wally Weitz, known as the other Oracle of Omaha,explained the current credit mania on Wall Street. This is a recommended reading for all readers. He said that "There are signs that serious credit problems exist and markets are reacting fearfully."

Wally Weitz is President of Wallace R. Weitz & Company. His company manages 8 mutual funds. Weitz himself manages and co-manages four of them. For the 12 months ended on June 30, all of his four funds gained about 20%.. Over the past 20 years, his funds outperformed S&P500 by more than 3% per year. His firm manages about $6 billion of assets.

Also living in Omaha, Wally Weitz's investment philosophy has a lot similarities with Warren Buffett. He tries to buy shares at a large discount to the company's underlying business value, hopes that the business value rises over time and the stock price follows. Also he tries to stay within his "circle of competence, that is "knowing what you don't know".

These are his recent commentaries on the financial market, credit problems and corporate buyout financing

Wally Weitz: Market Commentary—Credit Problems Continue to Dominate Financial News

In the late 1990’s we experienced a technology stock “bubble.” Agood idea—“the Internet will change the way we all communicate and do business”—was carried too far. Investors paid ridiculously high prices for “” companies with little substance and the episode ended badly as the Nasdaq Composite dropped roughly 70% and the rest of the market followed.

Over the past few years, a surplus of capital has been generated by corporations, individuals, and repatriated trade deficit dollars (spent on foreign oil and manufactured goods). This excess capital created an enormous demand for income-producing assets—loans, bonds, real estate, etc. Wall Street, always eager to accommodate, created new mortgage products for real estate buyers and helped facilitate a boom in leveraged buyouts. Again, generally good ideas were carried too far. Credit quality slipped as lenders found ways to sell the loans they created, thus divorcing themselves from the risk of loss if borrowers defaulted.

In the first quarter of 2007, several dozen subprime mortgage brokers failed because the loans they originated and sold performed so badly that buyers returned them for refunds. The under-capitalized brokers were unable to buy them back so they filed for bankruptcy or sold their companies to others with deeper pockets. We discussed this phenomenon in the last letter.

What happened next requires a little background explanation. Mortgage-backed securities (MBS) were invented years ago and were a very good idea. A pool of mortgages is placed in a trust and bonds, secured by the principal and interest payments on the mortgages in the trust, are sold to investors. This frees up capital to make more mortgage loans, facilitating the American dream of home ownership. Creating MBS generates fees for Wall Street firms which are quite creative when fees are involved. Soon mortgage loans were made available to less credit-worthy borrowers (subprime mortgages). Again, initially this was an idea with great social merit. These mortgages bore higher interest rates and could be “securitized” into even more profitable MBS. Then, these mortgage-backed bonds were pooled into new trusts and securitized again, creating collateralized debt obligations (CDOs) and more fees. Credit risk was thus moved further and further from the originator of the loans.

During the second quarter it was investors’ turn to make news. Two hedge funds sponsored by investment bank Bear Stearns had invested in subprime MBS and had borrowed lots of money to enhance (leverage) their returns. One fund borrowed roughly $9 for every $1 of investor equity. It is very hard to value many of these securities, since each issue is unique and transactions are infrequent, so as the creditworthiness of subprime mortgages began to be questioned, investors sensed trouble and asked for their money back. Bear Stearns tried to sell some of the portfolios’ securities with very limited success and decided that it had to suspend redemptions pending a re-calculation of the funds’ values. In the past few days, Bear Stearns has come to the conclusion that investors in the more conservative of the funds would lose 91% of their money while investors in the other would lose 100%. These hedge fund clients’ losses are regrettable, but the much larger issue is whether the hundreds of billions of dollars worth of MBS and CDO paper held by others, often in leveraged vehicles, are being similarly mis-priced. This remains an open question.

One of the reasons that investors bought all these securities without really knowing what they were getting is that the bonds were rated by Moody’s and Standard and Poor’s. Based on historical loss experience in the mortgage market, 70-80% or more of the bonds secured by subprime mortgages were rated “investment grade.” The majority were rated AAA, the highest rating, signifying very low probability of loss. Unfortunately, historical data turned out to be irrelevant since underwriting standards had been compromised so thoroughly.

After the Bear Stearns disaster, Moody’s and Standard and Poor’s belatedly issued a flurry of downgrades of subprime MBS and CDO’s. The downgrades will probably create additional selling pressure since some investors are bound by their own policies to sell securities if their ratings fall below a certain level, regardless of price.

It is very difficult to know how low the prices will go or who the ultimate owners of the problem mortgages and securities will turn out to be. What we can know about our mortgage-related companies is that subprime lending was a relatively small part of their businesses; that they have historically been better than average underwriters of credit risk; that they are long-term players who would not “bet-the-ranch” for a quick profit; and most importantly, they have strong enough balance sheets to absorb losses and avoid any liquidity problems.

Wally Weitz: Corporate Buyout Financing

Another aspect of the credit markets that is beginning to tremble is financing for corporate buyouts. Leveraged buyouts are not new, but the number and size of the transactions in recent years have been unprecedented. Buyout firms, now referred to as “private equity” firms, raise funds of capital from investors, primarily pensions, endowments and wealthy individuals. They use this capital, along with large amounts of borrowed money, to buy public companies. They “take the companies private,” try to make them more profitable and thus more valuable, and sell them again to the public, to other companies, or even to other private equity firms. If they can buy a company for $100, using $20 of equity and $80 of borrowed money, then sell it for $120, the $20 profit represents a 100% return on the original $20 of equity. Magic.

Lenders with excess capital have been competing with each other to provide credit for these deals. As a result, the lending terms have been relaxed considerably (“covenant-lite”) and the interest rates charged have fallen to record low levels in relation to “risk free” U.S. Treasury bond yields. With cheap debt financing available and pressure to get their funds invested (so they can collect their fees and start another fund), private equity firms can (must?) make higher bids for companies than strategic buyers (who want to grow their businesses) or passive shareholders (like us). Some have observed that the only limit to the price that can be paid for a given acquisition is the amount that can be borrowed. Frenzied takeover activity provides an occasional small windfall for us, but it also leads to some measure of inflation in stock prices that makes it difficult for price-sensitive value investors like us to find attractively priced investments.

There are signs that lenders are becoming more demanding and that financing may not be available for some of the recently announced deals. This is reminiscent of the late 1980’s when “leveraged buyouts” were in vogue and Michael Milken could seemingly raise unlimited amounts of capital for takeovers by selling “high yield” (junk) bonds. When the United Airlines deal fell through in late 1989 for lack of financing, it was as if the music stopped in a game of musical chairs. At that point, it became clear that quite a few stocks were selling at prices that depended on takeovers that were not going to happen.

Wally Weitz: Washington Mutual (WM)

We first bought Countrywide Financial and Washington Mutual (WaMu) in the early 1990’s. Countrywide has gained market share through internal growth and very efficient operations. Washington Mutual grew through acquisitions, and while it was not as strong as Countrywide from an operating perspective, it grew steadily and treated shareholders well with a combination of generous dividends and stock buybacks. Both have been very good investments for us. We sold our WaMu in the first quarter of (calendar) 2007 because of its exposure to subprime and Alt-A (what some refer to as "the mysterious middle ground between subprime and prime" ) and because we had less confidence in management’s ability to successfully cope with a crisis in the mortgage industry.
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