|Shares Out. (in M):||107||P/E||0.0x||0.0x|
|Market Cap (in M):||2,100||P/FCF||0.0x||0.0x|
|Net Debt (in M):||0||EBIT||0||0|
Profile: If Ally's name doesn't sound familiar to you, don't be surprised. The company used to be called General Motors Acceptance Corp, a name that may have been irrevocably tainted in our minds. After receiving $17 billion in bailouts from the U.S. Treasury, the company changed its name and sought a new start. But even with a name change, it seems the company has not escaped its legacy. All manner of securities associated with Ally have become distressed in the last month. A lot of the other pref stocks selling off in early Aug have rebounded, but Ally has lagged pretty noticably.
I started writing this when ALLY-A was trading for under $19. They have rallied very quickly to $21 in the last two days... My numbers here use the $19 price tag as a reference. Just as an aside, you can invest in Ally via the preferred (ALLY-B), the trust preferreds (ALLY-A), and a variety of debt, even four series of exchange traded ones. My favorite is ALLY-A and I'll go into a little detail later as to why.
In either case, to get your blood flowing a bit, here is what's being offered to you. ALLY-A is currently trading for about $19 per share ($25 par). At this price, you are getting $2.03 in interest per year (about 11% current yield). In 2016, I think there is a very good chance these shares will be called at par. Factoring in the capital appreciation, your internal rate of return is between 15% and 20% per year. Beneath you is a well-capitalized bank with Tier 1 capital of about 15%, tangible Tier 1 capital of 8.4%, and with its largest stakeholder being the U.S. Treasury. Therefore, you will get paid before Tim Geithner, which is a pretty nice perk. To be sure, there are some drawbacks, with the worst being the ongoing foreclosure lawsuits. That said, you are also benefiting from several events and trends that will put the bank on sounder footing in the next year or two.
The Road From 2008 to Today
It was a long and painful road transforming GMAC into Ally Financial. To say the old GMAC "blew up" is somewhat of an understatement. The firm was almost completely dependent on General Motors for its auto loans business, and had a multihundred billion dollar dodgy mortgage exposure to boot. The result is almost a cliche at this point. I won't belabor all of the details (and there are many), but in the end, the new entity:
In spite of all these changes, one thing remained the same: Ally retained the GMAC's mortgage servicing business, and is still one of the largest mortgage servicers in the country. Conceptually, these loans are not held on Ally's balance sheet and provide a decent stream of service revenues. Unfortunately, they also put Ally squarely in the cross hairs of government prosecutors in the ongoing foreclosure misconduct probes.
Nevertheless, as auto sales rebound from their recession nadirs, Ally is a much stronger company than it was a few years ago. Loan origination volumes are growing quickly, and credit losses have been tamed. In general, the various stripes of auto lending should not create heavy losses. After all, the company is lending against very high quality collateral that's easy to seize and resell if the borrower defaults. In addition, because of repeated equity injections, it is ironically one of the better capitalized big banks in the country.
That said, the company has one big weakness: Despite generating many more loans than before, it doesn't make a lot of money. Right now, the bank is just above break-even. Even if we adjust for the accounting treatment of a big debt exchange from 2008 (which inflates interest expenses temporarily), the company isn't doing nearly as well as it should be.
The root cause is pretty simple. In its new role independent from General Motors, Ally is essentially a bank. But unlike a "normal" bank, with lots of branches and people opening checking accounts, Ally doesn't have a lot of deposits. Therefore, in order to get money to loan out, it's forced to borrow from the capital markets. This is a problem because Ally has an awful history and a very junky credit rating (B+). It finds willing lenders, but only by paying through the nose. The bulk of its $140 billion of funding comes from the capital markets, costing more than 6% per year. Ally's overall cost of funds is 4% to 5%*, 2 or 3 times higher than a bank with an established retail deposit base. For example, Bank of America, that ugly stepchild of money center banks, has funding costs of around 1.25% once you include their zero interest checking deposits.
The difference between the two has immense financial consequences. Ally has about $140 billion in funding. Therefore, a 1% difference in cost of funds, all else equal, translates to $1.4 billion of pretax savings. Versus the bank's Tier 1 capital of $20 billion, or tangible equity of $12.6 billion, this is a significant number.
Taking this problem a step further, Ally is caught in a kind of Catch-22. It doesn't make much money, so the ratings agencies and lenders don't trust it. Therefore, they demand a big return when lending. But if they demand a big return, Ally won't be very profitable, and it can't build trust with lenders. How can it win here?
The Power of Online Banking
Fortunately, technology and the FDIC have offered Ally a way out of this predicament. For the last two years, Ally has spent a lot of time and effort building an online bank (Ally Bank). You may have seen its ads on TV or on billboards; I know they've been incredibly aggressive in Chicago. In either case, this method has been working. From the beginning of 2009 to last quarter, core deposits increased from $11 billion to $25 billion and are growing about 5% per quarter.
In this near zero interest-rate environment, it's surprisingly cheap for a bank like Ally to get customers in the door. Today, the bank is advertising checking account rates of 0.90%, and "high-yield" 12-month CDs of 1.14% for deposits of $15,000. These rates are exorbitant compared to the approximately 0% I get from my Bank of America account, but Ally can afford to pay them because it wants to replace a 6.5% bond with a 0.9% checking account.
Today, Ally Bank is still comparatively small. Core deposits of $25 billion cover merely 18% of the company's nonequity funding. That said, I see a lot of potential here. Core deposits are currently growing $5 billion per year. Over a few years, that adds up to some pretty impressive sums. Doing some simple math--$5 billion of new deposits costing 1% that allow Ally to pay off maturing debt at 6.5% brings savings of $270 million a year. Even factoring in new costs from running the bank and servicing the customers, Ally has a good thing going here.
Improving profitability does a few things for us. One, it strengthens the capital base of the company. Two, it may prompt investors and ratings agencies to put more trust in Ally. This shows up in ratings upgrades and a lower cost of funding, which enhances profitability even more, creating a virtuous loop.
The Importance of an IPO
Thanks to massive bailouts, the U.S. Treasury controls about 74% of Ally through ownership of common stock and mandatorily convertible preferred shares. Understandably, this is a sensitive political situation, and the Treasury been looking for ways to get rid of its holdings, preferably at a profit. In March 2011, the Treasury actually had an IPO of ALLY-A, which is why we are able to buy it. Today, there is no normal market for Ally's common stock, but an IPO has been in the works for months now. It was supposed to be done in the spring, but the offering was postponed because of poor market conditions. Still, the Treasury has continued to update the prospectus via SEC filings, and the IPO could resume at any time.
To the owner of preferred or trust preferred shares, the IPO is a very positive event. For one, it will entail a partial conversion of the mandatorily convertible stock, of which there is $6 billion outstanding with a 9% coupon, to common stock. Currently, these preferreds are draining $534 million of cash out of the company each year. Plus, a full conversion of the shares should enhance tangible common equity even further.
Moreover, conducting the IPO and having the Treasury out of the picture eventually opens up some interesting strategic options for Ally. Most obviously, it could sell shares into the public market if it gets in trouble, which preserves value for more senior securities. Secondly, I think it would be very interesting if Ally can use its shares as currency to acquire a deposit-rich "normal" bank. If regulators agree to this, it could solve a lot of problems, especially the high cost of funding. This is pure speculation at this point. But in any case, I consider an IPO to be a major catalyst for Ally securities holders.
Alternatively, Ally itself could become a target for a large deposit rich bank. If its loan pipeline can be plugged into a low cost funding base, you'd make a ton of money. This is all just conjecture at this point (and any potential transaction would doubtless be extremely politically sensitive), but it's a free option.
The Big Legal Overhang
Ally's poor profitability is not the only reason the trust preferred shares are trading under par. After all, in the very recent past, the shares actually traded at more than $25. Another very big overhang is the ongoing litigation regarding improper mortgage paperwork and fraudulent foreclosures.
The old GMAC was one of the largest mortgage servicing companies in the country. Even today, it has a $360 billion servicing portfolio. The servicing industry has been rife with abuses--most notoriously having employees "robosign" thousands of affidavits and other legal documents without actually reading them. As a result, the entire foreclosure process is mired in a legal swamp, with some families improperly evicted from their homes. The servicing industry is now being sued by a collection of states' attorneys general, with potential liabilities in the tens of billions of dollars.
It sounds pretty bad, but I'm less concerned about these liabilities than the market is. For one, we are dealing with fractious groups of litigants, each with its own agenda. The settlement talks between the banks and the attorneys general, which have dragged on for months, repeatedly broke down because different states want different things. Bank of America has broken off from the pack to negotiate a separate truce with the government, but has little to show for it so far. I don't know how it eventually will play out, but one thing is for sure: The banks have enormous resources, and will no doubt fight to the bitter end if the proposed settlement is too hard to swallow. Plus, even though the banks may have to pay a lot of money, it's to no one's benefit to put any of them under financial distress. That would be a Pyrrhic victory at best for the government, because it would then have to bear the cost of yet another bailout. If any of the really big banks is hit hard (and most of the big servicers are systemically important banks), the economy may falter even further. I'm sure everyone involved would like to avoid this outcome.
Furthermore, in the specific case of Ally, the majority shareholder is the U.S. government itself. Therefore, we have a comical situation where one arm of the government is suing another arm of the government. In this case, even though Ally is not a terrific bank, it's unlikely that the government essentially wipes out its own investment via lawsuits. Overall, I think two scenarios are likely. In the first, a settlement is reached, and though it's a large absolute number, it's easily absorbed by the financial system. In the second, litigation drags on for years, and the future profitability of these banks will cushion against the losses. In either case, if you own a more senior security in these institutions, you will be safe.
Lastly, I will note that Ally will be party to warranties and representations mortgage putbacks. The good thing here is that they have already settled with most of their counterparties, including the agencies. There will be litigation with the monoline insurers, but this litigation would likely drag on for many, many years as they are pushing for loan by loan review. The longer this drags on, the less relevant it would be to the capital base of this company.
Compare and Contrast Different Ally Securities
The preferred stock (ALLY-B) is trading about $1 below the trust preferred (ALLY-A). Plus, it receives a slightly higher yield at par. Unfortunately, it comes with two very big drawbacks. One, in terms of seniority, it's the low man on the totem pole. Two, its dividends are not cumulative. If Ally gets into trouble and is forced to suspend dividends, you are pretty much out of luck. For only a tiny bit of extra yield, I would not buy these over the trust preferred shares.
You of course can buy a variety of debt instruments, including four exchange listed ones --GKM, GMA, GJM, GOM. These trade for YTMs of maybe 8.5% to 9%, but I would stay away because they have massive durations and inflation risk. There are a lot of other debt out there, with similar spreads. These are lower risk-lower reward.
That leaves the trust preferred shares (ALLY-A). The current yield is nearly 11%. Because they were originally issued to the Treasury, they carry some pretty attractive terms. Not only is the dividend high, but they also carry inflation protection after 2016. Instead of a fixed dividend, you will be paid at LIBOR plus 5.785%, a very generous sum. Plus, the distributions are cumulative. So if Ally gets in trouble and suspends payments, you stand a good chance of eventually collecting some of the arrears. Lastly, unlike the preferred stock and the senior debt, you likely will make a quicker return on your money with ALLY-A because of new banking rules that will take effect in 2013.
Both Dodd-Frank and Basel III begin in 2013. The specific change that impacts us is that trust preferred stock no longer will be considered Tier 1 capital for regulatory purposes. This is very important, as it essentially means ALLY-A no longer will have a reason to exist. Legally, instead of being a tax-advantaged form of equity, it will become an extremely expensive source of debt. In most circumstances, there is no reason for Ally to keep these shares around. Indeed, since they are callable in 2016 at $25 per share, my guess is that they will be called. With the combination of high current yield and 30% capital appreciation, rates of return for shareholders should be above 15% per year.
I wouldn't call Ally a great company. In fact, if the company IPOs tomorrow, I wouldn't be interested in the shares unless they traded at a big discount to book. That said, by buying a much more senior instrument, you are merely betting that the company won't fall into severe financial distress, whether through litigation or another big recession. Given the capital levels and opportunities for credit improvements here, I think our chances to avoid this fate is good. I think the odds are that we'll clip a fat coupon and sail into the sunset five or six years from now with $25 bills in hand.
*Depends on how you tread the original issue discount stemming from the 2008 debt exchange. If you exclude this, the costs are nearer to 4%. The GAAP cost is nearly 5%.
|Subject||Question in ALLY-A vs. GJM, GKM, etc|
|Entry||09/01/2011 03:12 PM|
Hi, Nice write-up. What is the exact ticker for the ALLY-A and B on Bloomberg? I'm having trouble finding them.
You downplay the four exchange listed instruments - GKM, GMA, GJM, GOM, but aren't these more senior than the ALLY-A trust preferreds? For example the GJM prospectus says the notes are general unsecured unsubordinated obligations of the company (they're called PINES, or Public Income Notes). True the duration is longer, but with the "Gs" you're higher in the capital structure than with the trust preferreds, it seems, so the difference in yield is justified. Or does the trust behind the trust preferred hold securities that are pari passu with the PINES?
If Ally eventually IPOed, don't you think they'd like to get rid of these PINES since they're not exactly a cheap source of funding?
Will the implementation of Dodd Frank and Basel III have any bearing on how the PINES will be viewed for regulatory purposes?
|Subject||ALLY - new thoughts?|
|Entry||12/25/2011 07:20 PM|
Any new thoughts on ALLY? Any color on whether they decide to file for BK Rescap? Would Ally rally significant in your opinion if they file Rescap? Any new thoughts on how far off an IPO looks at this point? You like the fixed or floating rate TRUPS or exchange traded bonds better at this point?
|Subject||RE: RE: RE: Author Exit Recommendation|
|Entry||02/26/2012 05:40 PM|
Got it. Thanks for your response and for the nice writeup.