By Forrest Lowell

There is one more shoe to drop before the market can truly move higher in a convincing way. In my view this Shaquille O’Neal sized shoe is the commercial real estate market. The troubles of General Growth Properties (GGP) has been well publicized, but what about the other similarly structured companies? Just as a quick comparison I have included screen shots of General Growth’s and Simon Property Group’s balance sheets. Look at the two balance sheets and tell me which one is trading at 40 cents and which one is trading at $31.50.

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As was widely reported today GE’s credit rating was downgraded to AA+ by S&P.  For the sake of argument (heavily sarcastic tone) we will assume that the ratings agencies are not criminals that deserve to be thrown in jail, but are actually highly trained professionals in the science of risk management.  GE’s credit ratings had been rated with a “negative” outlook for the better part of the credit crisis with S&P probably the first of the three ratings agencies to downgrade the company to one notch below the highest possible.  This change of ratings is actually a relief for me as a shareholder and here is why.  There has been some speculation, and I agree, that the ratings agencies have over corrected to being too conservative after being almost criminally negligent for the better part of the middle years of this decade.  So if in this environment GE’s stock has been pummeled because of their perceived exposure to further credit risk, and an overly conservative ratings agency gives it a rating of AA+ with a stable outlook, how can you not love the company!?  In the worst credit market in the past 70 years GE is still rated only one notch below the debt of the United States government, not bad GE.

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Tomorrow the FASB is possibly going to issue guidance on how to apply the mark-to-market rule for the financial industry.  Right now assets on a bank’s balance sheet have to be valued at what the bank could go out to the market place and sell them right now.  Of course the problem being that there is almost no market right now for securitized mortgages in the US with “bad” loans in the portfolio.  This is forcing the banks to write down the value of these assets to very low levels which affects the amount of capital that they have to provide in order to properly leverage their balance sheet.  Capital is basically the banks own money, they keep this money in a big room and then loan out the depositors money.  If a bank has $50 billion in capital and $500 billion dollars in outstanding loans then their leverage is 10 to 1.  the problem over the past year is that the value of the mortgages are in question.  If the bank lent a person 100% the value of the home and the value of the house has fallen 50%, the homeowner might choose to walk away from the house and let the bank sell it.  If this happened to 10% of the mortgages the bank owns they would have to “write off” 25 billion dollars against their capital, decreasing their total capital to 25 billion and while only decreasing their loans outstanding to $450 billion.  This would increase their leverage to 18x, even though 90% of their loans are performing just fine.

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Here is a scary statistic that Bryce pointed out to me this past week from Yahoo finance, GE’s tangible book value is $7.9 billion and their total liabilities are $693 billion giving a 88x multiple.  For comparison Fannie Mae as of December 31st has a comparable multiple of 96x.  It is pretty much accepted that FNM has no common shareholder value even though it is trading around $0.36 per share.  So why is GE also not trading in the penny range if it has leveraged its balance sheet to a similar degree?

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One of the problems with many companies today is that their business model has been broken.  No one is quite sure how the Goldman Sachs’s of the world are going to return to their previous sky high profit (and bonus pool…) with the new era of increased regulation and oversight.  And I have frankly still not heard a convincing argument for the viability of the large car manufacturers or their suppliers.  Even the proverbial king of American capitalism, General Electric, appears to only be able to come up with half-hearted responses where their business model of the modern conglomerate is called into question.  All of this could make even the most confident CEO question his or her own business model, unless of course you see no end in sight for the demand of a product you sell.  This is exactly the situation that Portfolio Recovery Associates finds itself in.  Yahoo finance summarizes their business as follows,

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