Turnaround Specialist Bets on Financials

Wilbur L. Ross Jr., chairman and chief executive officer of W.L. Ross & Co., often sees opportunity where others see risk. A turnaround specialist, his investments have ranged from steel to auto parts to textiles and, now, the financial services industry. Last year he invested heavily in Assured Guaranty Ltd., parent of monoline Assured Guaranty Corp.

Ross, educated at Yale University and Harvard Business School, earned his reputation as the “King of Bankruptcy,” leading the bankruptcy advisory group at Rothschild Inc. After 24 years at the investment bank, in 2000 he set out on his own.

Ross earlier this month discussed with The Bond Buyer his thoughts on the economy, government management of the financial crisis, bond insurance, and other topics. An edited transcript of his comments appears below.

BB: How do you think the Obama administration has performed so far in its handling of the economic crisis?

Ross: I think they have an attitude that corresponds better to the definition of the problem than I feel the old administration had. They recognize that it’s really big and it may take a lot more resources [than] even they already deployed to solve it. And I think that’s correct.

I think the old administration was being too cautious in their assessment, too low in their assessment of how big it was. The second thing I think they’re doing right is trying to go to cure the cause, which to me was basically falling residential real estate, as opposed to only curing the effects — the credit crunch and the dislocations of the various credit markets. So I think, attitudinally, at the 20,000-foot level, I’m much more in sync with what they’re trying to do than the Bush administration.

I think there are a couple of structural problems with what they’re trying to do. One is they’re trying to do an awful lot of things all at one time. And I think to try to superimpose societal objectives, however worthy they may be, on the quick fix that’s needed for the economy complicates things and could create increasing problems in the Congress as they go forward. So I would have preferred a more narrow focus.

The [Term Asset Lending Facility] I think will be a success if the rates of return are high enough that we would be participants. As you know, they’ve announced the first one for Nissan. I think that’s a good move. We do have to start unlocking consumer credit. We do have to do something to start unlocking the auto industry problem.

And I think, in a sense, that will be the first real test that they have. I think some people are saying they didn’t think the TALF would work. I think it’s a good idea. I think at the end of the day it’s not going to cost the government anything, but it will help to unclog the asset-backed commercial paper market. That would be a powerful statement that the ABCP market can function for at least one good issuer, at least for $1.5 billion. I feel that is well conceived.

Next off the drawing board will be the one we’re even more interested in, which is some concept of fairly highly leveraged, non-recourse to the troubled assets. That’s a dicey universe — they’re a lot harder to analyze, there are a lot fewer buyers. But I think it’s an important program.

The third thing they’ve put in, I agree with part of it, and I think could be a bit improved. The thing I agree with — this is about the home mortgage modification — I think modifications are very often a very good idea. The program that’s been put forward pretty well deals with Fannie Mae, Freddie Mac, Ginnie Mae, all the GSEs’ paper. I think it will do a lot to start to stabilize that market. It’s not going to prevent all foreclosures.

And I think the program is not quite adequate in that you have about $4 trillion in so-called private securitizations. Subprime, Alt-A, HELOCs, and Jumbos. The paperwork by which those were created mostly isn’t very helpful when you’re trying to do large-scale modifications. So the servicing industry — of which we’re a substantial part, as you’re aware — has requested that there would be these safe-harbor provisions, which would essentially say that if within whatever are the bounds of normal industry practice, if the servicer does make modifications within those limitations, it can’t be sued by some dissident hedge fund.

My belief is that reducing the homeowner’s payment to a reasonable percentage of their income is important, but if the face amount of the mortgage is still in excess of the fair value of the house, it’s a hard thing to get the guy to keep making payments. And the way you accomplish that is extending it past 30 years.

Then the fellow says to himself, “My God, I may not even live 40 years and I’m still feeding this monster that’s underwater.” Plus if you don’t reduce the principal amount and just stretch it out, you end up paying more over time because it’s so many more years more worth of interest. And the final thing is, they acknowledge they may have to go down to 2% interest payments.

If you have to give the guy a 2% interest rate and a 40-year mortgage, doesn’t that tell you the mortgage is the wrong size? I think you need a little more fine-tuning to be a little more aggressive about the principal amount. And I think that will reduce the rate of recidivism.

My take of it of is from 2000 to 2006, median income in this country inflation- adjusted actually declined slightly, so people got nowhere. But everybody wants to live a little better each year. And the solution the American public came to is to borrow. So we’re going through a very painful process of deleveraging America. And in a sense, we’re redistributing that overleveraging to financial institutions by way of losses and ultimately to the government by way of some losses. That’s the fundamental cause of the economic problem. So I really think it’s the consumer that started this and I think it has to be the consumer that ends it.

BB: You recently invested in First Bank and Trust Co. of Indiantown, Fla., and said you’re interested in investing more in financial services. What sort of things are you going to be looking for?

Ross: We think of the 8,000 banks that are roughly in the industry now, probably from start to finish of the crisis something approaching 1,000 banks will fail. You’d think quite a few would have failed already if it hadn’t been for the (Troubled Asset Relief Program). TARP provided capital on a much cheaper basis than private equity would be prepared to do.

We think some of the banks that got TARP money are going to have run through and are going to need more money. And we think to the degree the private sector is willing to provide it, the government shouldn’t prevent that.

The Bush administration, strangely, seemed to want a government-only solution. The Obama administration seems much more willing to look at the concept of public-private partnerships.

I think that’s the good way to do it, and it’s a good way for a couple reasons. Many American private equity firms, including ours, have proven they can turn banks around.

We bought a bank from the Japanese government, a bank in Osaka called Kofuku (Bank Ltd.), we turned it around in 12 months, renamed it Kansai Sawayaka, and merged it with a regional bank there. And to this day, it’s one of the better performing banks in the whole country.

 It’s very strange that American private equity firms have already shown they can do it with banks in foreign countries — why doesn’t it make sense to let them do it with banks in America? But the current restrictions are very difficult for private equity firms.

The bank that I bought in Florida, I just bought for myself. The rules on bank holding companies are such that if a fund buys more than 24.9% of a bank, it becomes a holding company. And if you’re a holding company, I’d have to divest the auto parts, I’d have to divest the coal, I’d have to divest the textile, and could never again be in non-financial businesses.

Well, we’re not going to do that, and neither is any other big private equity firm. I’ve been in favor of having the Federal Reserve relax the percentage of ownership rule. And I think if they would do that, there would be a lot of capital made available to the banks without the government having to write a ticket. And there’s a big advantage to letting private equity control. We’re used to monitoring management. We’re used to changing managements where it’s needed.

The whole TARP program, the government really doesn’t have any power over the institutions. It has moral suasion, but to the extent the institution isn’t working, it’d be better to have somebody really in charge of it who’s got his own money on the line and who has a track record of turning things around.

BB: Assured Guaranty just got approval from its shareholders to issue shares to Dexia and to give the board members the power to issue shares to you if need be. What do you think the impact of the Financial Security Assurance transaction will be?

Ross: I like the deal. We did not have to support the deal in that the preconditions of our original investment commitment to (Assured) — remember, when we put money in we put in $250 million and then put in another $750 million. But a precondition to the $750 million is that it stayed triple-A stable with all three agencies. Moody’s has now downgraded it to Aa stable, so that commitment is no longer in tact. But we voluntary decided to backstop them here, for several reasons.

One, I believe credit enhancement is a very important thing, especially to the municipal bond industry. And I think it is important there, because the average municipal issue is around $30 million in size. There would be no market access, there’d be no after-market liquidity, if you didn’t have some form of credit enhancement.

The main rival to monolines is bank letters of credit. But it’s very difficult for banks to write really long-term letters of credit, and a lot of municipalities would like to issue 30-year bonds. Thirty years is not an unaccustomed duration for a monoline. And second, I think the short quantity of letters of credit that have been put out, at some point the banks aren’t going to be that eager to continue issuing letters of credit. So I think there will be more of a need for monoline insurance specifically in the municipal segment.

With the demise of so many companies, we now have about an 80% market share at Assured. The other 20% is essentially Warren Buffett at Berkshire (Hathaway). But Buffett is not in the market every single day, he’s not doing all the little issues. That’s fine. He’s a good guy to have as competition.

We frankly wouldn’t be upset if there were one or two other monolines, so you had more breadth to the industry, so you didn’t have issues of concentration. But the rating agencies seem to be very, very nervous about giving ratings to the ones that are trying to start out. Macquarie’s been seeking this for quite a little while, Ambac and MBIA have been trying to do it for quite a little while, and now there’s litigation over MBIA, and if it hasn’t already begun, my guess is there will be litigation over the Ambac split.

So I don’t wish them ill, we would like there to be other players, but there aren’t a lot of triple-A players around. And it’s hard to imagine that the rating agencies, given their criteria, would give a total start-up company a triple-A rating; it doesn’t make a lot of sense. So we think we’re going to continue for a while with very few monoline insurers. And while the market has shrunk, the fact that we’re now 80% of it is providing us with a ton of business. And the FSA transaction puts us in quite a huge size, quite a huge scope, and FSA had some relationships that Assured didn’t have. So I think it’s an accretive transaction to the earnings of Assured. So I’m happy with the transaction, obviously not happy with the way the Assured stock has traded. Assuming they need our support, we will be averaging down. Our original cost was around $23; if we closed tomorrow, we’d be in there at $6. I don’t want to be in the position of touting the stock, but I’m very happy with what they’ve been doing. And I’m extremely happy with the FSA deal because of the way it positions the company.

BB: Did you get a chance to read Buffett’s letters to shareholders? What about his concern that insurers could be at risk because insured issuers will act differently than uninsured issuers have in the past, placing the burden on the insurer rather than taxpayers and other stakeholders?

Ross: Given that he’s continuing to write the insurance, I find it odd that he’d be saying that it’s a bad thing to do, and yet he’s doing that. So I didn’t quite get that. But the suggestion that any municipality would deliberately default just to take advantage of some insurer doesn’t correspond to my sense of the average municipality. These are not hedge-fund wheeler-dealers that run these municipalities.

BB: What is your outlook for municipal issuers in general?

Ross: I bought quite a lot of municipals a while back, as you’re probably aware. Most of them are long-dated. Also bought quite a lot of the state housing authority bonds that were backed by the GSE underlying mortgages, because you could buy those state housing authority issues — which to me are very good quality issues — at north of 7% to maturity, because they generally had about a 5% coupon and were generally available at around 70 cents on the dollar. It seemed to me that was silly.

I think municipal bonds are grievously undervalued relative to corporate and relative to Treasuries. Historically, they traded at a lower yield than Treasuries did. And what created a lot of problems in the industry is you had these specialized hedge funds that would go long on munis and short Treasuries on the theory spreads were too wide. Well, spreads got even wider, so they got hosed. And a lot of things that we bought came out of those holdings.

But let’s face it — Obama is raising the marginal tax rate, or at least proposing to. That has to make the tax exemption even more valuable than it was before. Second, I don’t believe the theory that there are going to be wholesale defaults in the municipal area, even the Californias and New Yorks. So there may be more agitated moments, but I just don’t see a big state defaulting. Do you bail out AIG and let California go into bankruptcy? It doesn’t make much sense.

BB: What needs to be done with the rating agencies?

Ross: The payment mechanism itself is one thing. That’s a complicated issue, who should pay them to do it. But I think the more relevant issue is the payment of management of the agencies and the staff, particularly those who do the rating. And I think a lot of their compensation, especially the bonuses, shouldn’t be tied to the revenue they bring in. It should be tied instead to how accurate are the ratings over an extended time period, maybe three years or five years. You might be notionally aware of the bonus, but it only vests as it turns out the ratings are right. And not just if they don’t get downgraded.

Underrating and then having a subsequent upgrading is just as bad as overrating them. If you would tie the rating executives and the rating people’s comps to the quality of their performance, then you’d really get somewhere in terms of improving the decision making.

So basically, people in private equity don’t get rewarded if they make bad decisions. And it’s equally important that people at rating agencies should be paid on the same basis. 

For reprint and licensing requests for this article, click here.
MORE FROM BOND BUYER