Michael Durante Western Reserve Blackwall Partners 1Q12

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Michael Durante Western Reserve Blackwall Partners 1Q12

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Michael Durante Western Reserve Blackwall Partners 1Q12

  1. 1. BlackwallPartners1QTR 2012- Update April 19, 2012 Detroit - Just the New Fannie Mae? Negative Yield Gaps Persists… Historically Unsustainable! Blackwall posted a 30.0% net performance for the first quarter of 2012. As we are focused on financial firms, we have been dealt a hand that is fundamentally perfect… yet few recognize this and consequently the sector endures a faux uncertainty that has exacerbated volatility. The hand we have been dealt is one of fundamental strength, low valuations, under-ownership and high volatility. It’s a winning hand, a royal flush… but we must be patient. Right now, it is time to buy these undervalued franchises and thus “let the pot build-up.” The fundamentals of these financial firms are so strikingly appealing that we already can anticipate the future pangs of regret that we know we will feel when this historic opportunity set begins to fade. Currently, there is an overwhelming and ubiquitous public presumption that low beta and high returns are sustainable. This has been the case recently in low or no growth investments such as REITs, bonds and commodities… but we’ve been around the track a few times and we know better. There is no such thing as sustained out performance with low risk and no volatility. The low risk / low volatility investments of REITs, bonds and commodities are affectively a mirage in the desert and those that thirst for shelter from volatility doom themselves to continue to drink the sand. Investors do so, not because they don’t know its sand, but because they don’t think they have a choice in a world of cyclical “performance chasing.” In our view, it is unwise for these investors to continue to equate volatility with risk. The performance chart (top right) illustrates our career-length performance over the last decade plus. Manager Career Performance 298 246 35 80 143 127 0 50 100 150 200 250 300 See: Chart footnotes on last page… Our classic “Jones-style” fundamental long / short investment strategy has produced a net total return of 146% from 1999 to the present. This is markedly superior to 43% for the HFRX Equity Hedge Index; 27% for the HFRX hedge fund absolute return index; a loss of 20% for the S&P 500; and an otherwise devastating 65% decline in the S&P financial composite respectively. Needless to say, over the worst decade for financial stocks since the Great Depression; we are pleased with having handily bested our benchmark composite index as well as both the larger market indices and the other major hedged strategy benchmarks. This is despite our being focused on financial services. “Assets can fluctuate greatly in price and not be risky as long as they are reasonably certain to deliver increased earnings power over their holding period. And as we will see, a nonfluctuating asset can be laden with risk.” – Warren Buffett Hypothetical Growth of $100M Invested with Durante (1999-2012)
  2. 2. 2 Equity Risk Premium & the Yield Gap Recently, we were intrigued by Goldman Sachs’ (GS) global strategy research piece dated March 21, 2012 – “The Long Good Buy; the Case for Equities” Goldman states - “After more than a decade of de- rating, equities are implying unrealistically large declines in growth and returns into the future.” No sector embodies this reality more than U.S. financial stocks, many of which currently trade at market values below their net cash-on-hand! In other words, these stocks are trading as though they have “no going concern” value. This is the ultimate “de- rating” of future growth and economic returns. Nobody can select a royal flush in a card game, it just comes to you. But one must recognize it in order to capitalize on it. A novice might mistake it for a hand lacking any pairs. Goldman goes on to warn investors who are obsessed with yield (“pairs”) and lite on growth (equities) – “The ex-post equity risk premium has been strikingly poor in recent years. Annualized ten and twenty year relative returns between stocks and yield-centric investments have been at their most negative in over a century.” Over a century! In other words, Goldman has calculated that the equity risk premium has all but completely collapsed. This hasn’t been witnessed since World War I. The “yield gap” is a measurement of the yield on stocks minus the yield on bonds. Today, the yield gap is negative. According to Yale finance professor Robert Shiller, the last time this gap was negative was in 1982 which was the beginning of the greatest stock market bull run in history (1982-1999). On these topics, Buffett once suggested the following in an investment letter of his dated early 1982… “The long-run historical evidence suggests that the equity risk premium is almost always positive and that… investors ignore periods of negative yield gaps at their own peril.” – Warren Buffett It is interesting to note that stocks still have out- performed bonds since the year 1900 by 1.7 to 1. This out performance is despite the “lost decade” that stocks have recently encountered. Yet all we hear from the pundits is the delusion of a “new norm.” This seems all the more in-step with BlackwallPartners’ supposition as we’ve patiently watched the U.S. financial sector repair their balance sheets and set-up for the bull run of a career. Today, financial firms hold more liquid capital than at any other point in history. In fact, greater than half of all of the liquidity (cash) in the United States (a.k.a. M1) is held at The Federal Reserve. But not held by The Fed as an asset but as a liability! This cash is held on account by its largest member banks - J.P. Morgan (JPM); Wells Fargo (WFC); Bank of America (BAC); Goldman Sachs (GS); Morgan Stanley (MS) and Citigroup (C) et al. In central banker parlance, this capital is referred to as “excess reserves” as these are monies voluntarily held in a member bank’s reserve account at the central bank. This is capital that is in excess of the minimum reserve requirement. We often hear pundits misappropriate these monies as being excessive liquidity in the economy when in reality they are idle or untapped. Put simply – these are monies that are not in circulation and thus not levered by the “money multiplier” within our fractional reserve banking system. The fact that banks have stock-piled so much liquidity should be of no surprise as we all witnessed the onslaught of attacks on the bankers by politicians since 2009. Consequently, bankers have
  3. 3. 3 understandably been reluctant to lend. Why would banks subject themselves to additional financial ratio criticism (due to the lessening of their capital via lending) in an ultra-low rate environment? They can earn a near commensurate return on over-night funds and at zero risk! It is simply the mechanics of risk and reward amplified by the unintended consequences of a government rife with anti-business policies. A government that has overreached into the private sector economy like no living American has ever encountered before. The good news is that this is not a negative for banks and banking stocks. The reality now is that this exercise is now a positive. Banks are minting profits at no risk while they merely await a reversal of the overreach. This already showed-up in first quarter profits as JPM and WFC reported RECORD quarterly profits… and this has been followed by one strong bank earnings report after another. Yet, their valuations remain materially below their empirical average let alone their historic high. This combination of low valuation multiples applied to cyclically low earnings affectively positions a “double leverage” effect. Similar circumstances were seen coming out of the Savings & Loan Crisis which resulted in a dramatic 900% return for financials in the 1990’s. The Federal Reserve in an abundance of caution continues to “stress test” these banks and is slowly allowing them to release these massive excess reserves in the form of paying dividends and buy-ins of their stock. We suspect that the Fed’s slow and steady approach is largely ceremonial in an effort to signal to the public that the Fed is applying the greatest of care in their larger capital assessment process. A certain degree of “theatre” is necessary in this post “financial crisis” world. But with that being said, it is getting harder and harder to justify all this capital and liquidity. Blackwall has published extensively over the last number of years on mark-to-market accounting and illustrated in great detail the false inflation of bank credit losses. These “losses” were inflated to the tune of seven-fold at the height of 2008-2009 crisis. In addition, we perpetually run our CAMEL analyses of financial firms which indicate an historic opportunity per the de-coupling of valuations and fundamentals in the sector. Only now are these facts beginning to pierce the veil of some main stream thought. Fortunately there are far more skeptics than factual observers in the investment world regarding financials. The evidence of this lies in the utter lack of both institutional and retail ownership of these stocks. Currently, financials remain barely off the lowest valuations they’ve encountered in history. They are as under weighted by investors as has been seen in several generations. Soaring Bank Dividend Yields (%) 0.5 1.5 2.5 3.5 4.5 5.5 1Q00 1Q02 1Q04 1Q06 1Q08 1Q10 1Q12E 1Q14E 1Q16E US Banks S&P 500 Source: SNL Financial; Guggenheim Securities LLC; and BlackwallPartners The chart above is quite straight forward. Banks historically pay higher dividend payout ratios than the average US publicly traded non-financial corporation. This is due to the nature of their recurring revenue and low capital expenditure needs. Inherently, banks produce very high levels of internal capital generation as has been illustrated since 2009 in their massive liquidity and capital builds. In regard to this point,
  4. 4. 4 this is reflective of how quickly bankers were able to repay TARP whereas the carmakers have yet to repay the taxpayers. Nevertheless, as a function of public opinion and political expediency in the after-math of the “financial crisis”; U.S. banks were required to cease paying dividends in an effort to grow their capital and support their financial ratios. (See the dotted line decline on the chart above.) What began as a prudent balance sheet exercise by banks escalated into the hoarding of capital. This cash hoarding was exacerbated by the open demonization of the banking industry by either unwitting or unscrupulous politicians. The remainder of the chart outlines what will happen if banks merely returned to “normal” payout ratios - the yield-spread is going to widen to a record level even if the banks did nothing but continue to collect a riskless spread moving forward. Therefore, from our perspective there is much to look forward to for the contrarian or brave bank stock investor. Banks will provide both a growth and a high income opportunity. This will become very attractive to many types of fund strategies as this becomes apparent to investors. As we noted in our last musing, we believe the attacks on the banking industry and on free market capitalism have peaked. U.S. banks have focused on building iron-clad balance sheets to withstand even the most Bolshevik of “end-runs.” Even in the most unlikely of scenarios, where one assumes no earnings growth for U.S. banks (despite both earnings and valuations currently positioned as a two-fold “coiled-spring”); the yield spread over the S&P 500 would soar to a record of nearly 400 basis points. So, when considering the historic yield spread for banks relative to the S&P 500, even a simple dividend discount calculation portends the sector rising 200% by 2014. Therefore, whether it is the yield hungry mob we referenced earlier or the repurchase of their stock from the banks themselves… one way or the other… we anticipate these bank stock prices rising significantly beyond the 200% default of a basic dividend-discount calculation. Blackwall strongly suspects that not only will US bank payout ratios increase materially but free cash flow will also see substantial growth acceleration. We anticipate the untoward regulations that have been holding back normal banking activities will be largely watered-down if not repealed in total. This will be the result of a pro-growth agenda returning to Washington and these steps will be instrumental in ushering in a substantial economic recovery. The opposition to President Obama’s regime has openly acknowledged that these reforms and unwinds will be an immediate priority. Surprisingly, few fund managers have signaled any enthusiasm to add US financial stocks to their portfolio. We find this curious on the one hand; however, we are well aware that the intoxicant of recency bias can have a powerful effect on even the most sober of managers. So what does this all mean for financial stocks? It means that some short term volatility is par for the course but it will pay off in a big way. The earnings acceleration that we just referenced will eventually drive the sector from under-ownership to normal weights and then ultimately to over-ownership. Valuation expansion will track this step-by-step. Naturally, investors that currently equate volatility with “risk” will miss the boat. Period! Detroit… another Government Subsidized Bubble? As our review of the facts should clearly outline, we believe GM is not being managed in their shareholders’ best interest. There is a cozy and questionable relationship between the federal government directly subsidizing financings for GM’s dealers and customers which is akin to Fannie Mae and Freddie Mac. We believe a traditional reorganization-style bankruptcy is likely for GM should this “arrangement” with the federal government come under scrutiny, a serious risk factor
  5. 5. 5 in our view. Under such a scenario, the current equity of GM could be substantially impaired and perhaps wiped out. My father mentioned several months ago that he was going to buy a new Cadillac after having surveyed numerous other competing foreign brands. I asked him – why the newfound interest in Cadillac? His short answer (no pun intended) sort of surprised me. He quipped, “I’m taking from the government hand- out machine since I’m paying for it anyway.” I believe this behavior is what is more commonly referred to as “capitulation to wealth transfer economics.” What he was referring to was the taxpayer owned and funded de facto finance arm of GM and Chrysler, formerly known as GMAC, now mysteriously renamed - Ally Financial. Ally offered my father zero money down, 0% interest and 72 months of “free time” to repay the loan if he took the Caddy instead of the BMW. And he’s a cash buyer. They also offered him a couple grand below MSRP. My father, a pragmatic engineer and business owner, clearly sees through what is taking place at GM. The question is… How long will the unwitting taxpayers continue to provide car buyers with zero down, zero interest “APR” and 72-month free financing? We suspect few Americans yet realize that this is the quid pro quo “arrangement” that is in place between the current Administration and the UAW, oddly now GM’s largest shareholder. Eventually, we believe others, even politicians, will catch-on to the fact that Detroit’s “come-back” is driven, in large part, by a sizeable taxpayer subsidy. Is this just another Freddie Mac? Ultimately, we suspect that Detroit’s taxpayer subsidized financing of both dealer and end market car buyer will be cut-off. If this were the case, the competitive advantage of being run by a government with an “open checkbook” would abruptly end. And at that very moment, sales, earnings and capital would be discounted closer to reality. GM’s cost structure remains non-competitive in the global auto marketplace without the “juice” from Washington. Question: Why was General Motors Acceptance Corporation (“GMAC”) renamed Ally Financial? We only can hypothesize… but no theory rings true other than political expediency. We also would note that GM’s joint venture in China, “Shanghai GM” has some promise, but we can’t see it offsetting a reshuffling of the way the company finances its dealers and car buyers in the world’s largest market without the U.S. government subsidy. Chart of GM’s Stock Since 2010 IPO Source: Bloomberg Should the taxpayer subsidized financings be pulled, we believe GM could find itself again in a serious spot of trouble. Artificially subsidized financings are
  6. 6. 6 driving the sales at GM. It’s a classic “sales finance” short. Smart Money magazine recently ran this cover… “How Car Buyers Can Land the Elusive 0% APR” - Smart Money; Dumb Taxpayers… As Smart Money pointed out – “Try to find 0% deals on more popular European luxury models or Japanese compact cars and it will be an exercise in futility.” Now, you can call us sticklers for those pesky details, but aren’t there U.S. anti-trust laws like the Sherman and Clayton Acts that protect companies from price predation? Zero percent loan rates are below a bank’s marginal cost and therefore they are a potential breach of prevailing law. Not to mention a moronic idea if you’re a banker. It’s no wonder Ally Financial scored DEAD LAST on the Fed’s recent “stress test.” The government of course is no ordinary banker. They are none other than the “visionary venture capitalists” that invested in LightSquared; FirstSolar; Ener1; Solyndra; Fisker and the Chevy Volt et al. So one may ask… what’s a few upside-down car loans? Well, Ally Financial provides approximately $50 billion of financings per year or the lion’s share of Detroit’s sales through put and that’s all on the taxpayer’s dime… dimes that we suspect the taxpayer may not substantively recover. This may pressure an unwinding of the current relationship between Ally and GM at some point, perhaps very soon. Blackwall’s negative call on GM is a simple one – if a new, more fiscally responsible administration takes hold in Washington, then we suspect that this subsidized financing arrangement by the taxpayer would likely end. Detroit’s on-going “bail-out” gets cut-off and pop-goes-the-weasel. As an aside, AmeriCredit was a small, very well managed and profitable subprime auto lender based in Fort Worth. This was before they were acquired by GM (at the eleventh hour) just prior to their IPO, so they could then be used as what appears to be nothing more than a “prop.” AmeriCredit, now “GM Financial” remains a small subprime car lender based in Fort Worth, Texas. But the “heavy lifting” financings of GM’s sales are being done by Ally Financial out of Washington. And Ally Financial just flagged the Fed’s stress test by 100%! The Fed’s stress test indicates that their Tier 1 Common equity ratio came-in at just 2.5% under stress or half the minimum 5% threshold. For Ally to be recapitalized to meet the Fed’s “stress test” minimum, its owners, the taxpayer, would need to chip in another $40-$50 billion or more by our calculations. We don’t believe there’s much political appetite for this to happen. Ally has $19 billion in equity and $19 billion in intangible assets or no tangible common equity. Treasury, perhaps seeing this Ally problem arising has been “shopping” it around if the rumors are true. GM has been sighted as the natural buyer, but GM can’t afford to become a “SIFI” and thus be regulated by the Federal Reserve and thus also subject to the “stress test.” Ally needs as much as a $50 billion capital infusion and GM has net negative short term assets and negative tangible common equity itself! GM cannot be the buyer. So, it’s shaping-up to be a rather dicey situation in our estimation. A Swindle for the Ages? ---------------------------- General Motors Company announced pricing of the public offering of common stock of $33.00 per share on November 17, 2010. GM’s common shares began trading on the New York Stock Exchange and the Toronto Stock Exchange on November 18, 2010. ----------------------------
  7. 7. 7 The UAW sold an astonishing 89 million shares on the “new” GM IPO, netting the union a windfall of $2.9 Billion. And again, the UAW sold 13.4 million shares in December 2010 (just shortly after the IPO) for net proceeds of some $437.2 million. Not too bad for an organization that previously had NO EQUITY OWNERSHIP in this company… that is, no equity ownership prior to the Obama Administration getting heavily involved in a pre-packaged bankruptcy which resulted in the “redistribution” of the ownership of the company which many called into question legally. Major Insider Holders in GM’s Stock (After the Pre-Packaged Bankruptcy) But Pre-IPO Holder Shares % of Shares UAW -- 20% CANADA GEN INVESTMENT CORP -- 12% US TREASURY -- 61% Other 7% All Insiders 100% Source: company reports; Securities & Exchange Commission Major Insider Holders in GM’s Stock Today Holder Shares % of Shares UAW 160,150,000 10% CANADA GEN INVESTMENT CORP 140,084,746 9% US TREASURY 186,876,283 12% All Insiders 54% Source: company reports; Securities & Exchange Commission The U.S. Treasury (taxpayers) recovered less than $5 billion in the GM IPO. This is a fraction of what has been put into the company by taxpayers (See: Next Page “bail-out” table). The U.S. taxpayer has seen its ownership in GM fall from 61% pre-IPO to only 12% today with virtually nothing to show for their ownership percentage decline. And in April 2011, it appears the U.S. government may have ceded back 113 million shares of GM and received nothing in return. Did the U.S. taxpayer “cede” or “forgive” some ownership? The UAW sure didn’t. For their inclusion in the GM bankruptcy reorganization, the Union walked away with cash proceeds exceeding $9 billion and 20% of the company’s stock. The Canadian government sold 36 million shares as part of the IPO to net some $1.2 billion. Canadian taxpayers are also badly “in-the-hole” on their GM investment. However, they are not nearly as bad off as American taxpayers. Pre-bankruptcy, GM bondholders held some $27 billion of senior debt (SECURED). They ended up with 10% of the stock, worth only $4 billion today. Therefore, the bondholders recovered only 15% of their invested capital and yet they were the most senior in the capital structure of the company. By amazing contrast, the UAW held UNSECURED claims estimated at $20 billion and they ended up with 18% of the company; $9 billion in cash; cashed- in $3.3 billion so far in stock and still hold $4 billion worth of stock at currently market values. So, all told, the union has RECOVERED 82% of the value of an UNSECURED credit while secured bondholders recovered 15%. At the IPO price, the Union would have recovered approximately 100%... thus being “made whole.” Pretty astonishing when one considers that secured creditors received only 15c on the dollar. The U.S. taxpayer netted just $5 billion in cash recovery in the IPO after being relieved of 80% of our ownership position. The $5 billion the U.S. taxpayer has recovered from “Detroit” is less than 3% of our
  8. 8. 8 investment. And it’s questionable where the $5 billion loan repayment from GM actually came from. It, in effect, came from other monies the taxpayer provided the company through TARP e.g.. We don’t believe the U.S. taxpayer has been repaid anything at worst and at best is still over $100 billion in the whole regardless. Adding probable insult to injury, U.S “car czar,” appointed by President Obama, Stephen Girsky personally netted $312,002 from the GM IPO. And interim CEO Ed Whitacre netted over $500,000 in the GM IPO. Nice work if one can get it. And as if all of this wasn’t concerning enough, GM recently paid out bonuses to UAW workers on “profits” that are the result of the upside-down lending at Ally Financial. In other words, we don’t think GM’s reported profits are sustainable or, in effect, “real” in this regard due to the arrangement with Ally. Total Estimated Auto Industry Bail-Out Federal Program $Billions Auto Supplier Support Program: General Motors Suppliers Chrysler Suppliers $3.5 $1.5 Automotive Industry Financing Program: General Motors Chrysler Suppliers GMAC Chrysler Financial $49.9 $15.2 $13.5 $1.5 TALF Term Asset-backed Securities Loan Facility Car Allowance Rebate System Advanced Technology Vehicles MFG Total $5.0 $15.0 $3.0 $25.0 $133.1 Source: U.S. Treasury; CBO, BlackwallPartners and White House Essentially, losses at Ally incurred in the price predation car loan program are offset as GM books a sale and a profit. By our observation, the taxpayer owns the losses and the union owns the profits. Today, GM’s total market capitalization is about $40 billion. This is less than 20% of the combined injections by the U.S. and Canadian governments through the various auto “bail-out” programs. The two sets of taxpayers only own about $8 billion at prevailing market values… or about 4% of what was injected! This is a shameful taxpayer swindle to the tune of approximately $133 billion for US taxpayers. GM shares have sunk 38% since the IPO and any significant recovery for the U.S. and Canadian taxpayers appears increasingly less likely. And obviously, we believe there is a potential serious risk that the shares have a lot further to drop if the subsidized financings are pulled. As Barron’s wrote - “Never has an American union done so well at the expense of shareholders and creditors.” ----------------------------------------------------------------- Barron’s also of note that of the 779 Chrysler dealerships that were closed as part of Chrysler’s reorganization… 778 had made no donations to democrats or democrat causes. The one standout? They donated to Hilary Clinton. ----------------------------------------------------------------- Steal You Blind (Until the Money Runs Out)? United Nations Conference on Sustainable Development What many investors in GM may not realize is that the United Nation’s “Agenda 21” which calls for wealth redistribution is now ingrained in how General Motors Corporation appears to be governed and run. “Sustainable” is nomenclature for wealth redistribution whether it be shareholder capital or profits distribution. GM pays no dividend e.g. Yet,
  9. 9. 9 the company’s union workers received lucrative bonuses from GM in 2011, but neither the salaried employees nor the firms’ stockholders received any bonus or “dividend.” In part, this makes GM now the world’s largest corporation governed by United Nations edict “Agenda 21.” This is corporate governance through wealth redistribution conveniently and benignly referred to as “sustainable” management. In the real world, this might appear more akin to “highway robbery” of shareholders in any reasoned person’s view. GM investors should be aware that this is how their company is being managed. We believe that the objective of the firm and the way in which it is currently being managed is not in any way in sync with stockholder interests. Would you invest in a company that espouses the edicts of an organization as backward and corrupt as the United Nations? If invested in GM stock, you indeed are investing in a company that puts the United Nations’ agenda ahead of you as a stockholder. This issue is a key component in why we believe there is the serious risk that GM will fail to deliver for shareholders. The following sections are highlighted on GM’s investor relations website. GM Sustainability Report Our inaugural annual Sustainability Report is a discussion of our global economic, social and environmental responsibilities, and industry challenges and opportunities. Source: www.gm.com Why would a public company whose sole purpose is to reward capital investment need a “sustainability report”? There is the Rule of Law that protects all other parties from any wrongful acts or omissions by companies such as GM. The law isn’t enough? GM Foundation The GM Foundation helps communities across the U.S. through investments in Education, Health/Human Services, Environment/Energy and Community Development. Source: www.gm.com Why would a public company just coming off the brink of collapse and bankruptcy reorganization need a foundation that supports outside endeavors? How can shareholders afford this? And when will taxpayers be repaid for such “community” endeavors described? This is very much “Agenda 21” sounding. Diversity at GM Diversity is an integral part of our culture and success. Learn how we drive diversity for the benefit of our customers, employees, communities, suppliers and dealers. Source: www.gm.com And while diversity is important in our society, there are laws that govern such. Why does GM see a need to intrude on the diversity policies of its customers; suppliers; dealers and communities? And what right do they have to do so? Shouldn’t GM be managed to just be concerned with compliance with the law as it relates to GM and its shareholders? These “policies” smack of a conflict of interest or perhaps an alternative agenda for the management of GM. BlackwallPartners believes these “policies” are inherently adverse to stockholders’ interests. Ally Financial: The New Fannie Mae? The following outlines the taxpayer subsidy that nobody seems to talk about… we believe this could very well force GM into a proper reorganization under a potential new administration in 2013-2016. This is the same type of reorganization that the President’s likely opposition has advocated on the campaign trail. Therefore, this is a large and tangible
  10. 10. 10 risk to the current stockholders of GM. An election could change everything abruptly. Since we have raised concerns about how the managing of General Motors is in-step with stockholders and creditors (such as the U.S. taxpayer), let’s take a closer look at Ally. Can GM prosper or even survive without it? Regardless of the name change, Ally Financial continues to act as Detroit’s “captive finance” arm and they continue to lose money. As previously referenced, they are doing so through subsidized loans to both car buyers and car dealers at rates below market including 0% APRs. Is this not overt sleight of hand? All of the following are simply not carried on GM’s balance sheet and income statement, but they are the taxpayer’s growing liability. And a potential re-shifting of these liabilities back to GM could be disastrous for GM’s stockholders. Here are the facts: • Ally Financial in 2011 has continued to be the nation’s #1 automotive financier • Ally did $43 billion in automobile loans in 2010 and over $50 billion in 2011, which represents approximately 60% of all of GM and Chrysler’s throughput car sales • Ally grew car loan receivables by over 70% in 2010 and another 40% in 2011 • Less than 30% of Ally’s balance sheet is core or “deposit” funded and thus it survives merely off of an implied taxpayer backstop in the credit markets • Including original issue discount (OID) amortization, Ally has lost $billions over the past several years including 2010 and 2011 • Ally’s net interest margin is ONLY 1.4% compared with normal consumer finance bank margins of 5% to 8% due to their underpricing credit terms • Ally in 2011 increased its dealer floor plan lending by 90% to potentially “channel stuff” inventory… this was some 2.9 million cars financed for GM and Chrysler dealers… • By contrast, Ally financed actual purchases by consumers of 0.9 million units, so there was over 1 million (unaccounted for) car sales reported by GM and Chrysler that “sat” in dealer inventory… yet still counted as a “sale”… and union workers’ bonuses were based on these economics • When recently “stress tested” by The Federal Reserve… Ally came-in dead last with only HALF the minimum capital required, yet they keep on growing loans as the major support mechanism underwriting Detroit’s “miracle” recovery; And at a breakneck pace that is unsustainable • Ally’s net interest margin has plummeted 40% between 2009 and 2011 amid the low and no APRs offered… thus “taxpayer subsidized financings” • Earning asset growth at Ally was 17x that of the private sector banking industry in 2011; was it perhaps “necessary” to keep sales up at Detroit automakers politically? • Despite the heady asset growth, Ally’s provision for bad credit (credit loss reserve) has dropped to nearly zero in recent quarters, clearly not sustainable • Yet, Ally’s loan loss reserve stands at just 1% of loan receivables or an inadequate 67% of delinquent loans; typical losses on
  11. 11. 11 car loans are as high as 50%, so Ally is potentially massively under-reserved for future losses, a taxpayer liability that could be and perhaps should be transferred to GM at some point • If an adequate loan loss provision were in place right now… Ally would be losing $billions annually • And this at a time when the “stress test” scored their capital adequacy the lowest in the large scale finance industry • Ally’s parent company liquidity at the end of 2010 was ONLY 109% of debt maturities over the coming 24-month period… thus providing no margin for error Conclusion – Ally Financial is on very shaky financial footing as the recent Fed “Stress Test” has indicated. Our analysis suggests that a major recapitalization from the taxpayer at some point in time may be inevitable. This is assuming that Ally continues to be used by the federal government as the primary support underlying the recovery of GM (and Chrysler). It’s no wonder that Ally Financial failed to price an initial public offering in late 2011 as was their initial plan. They don’t have the financial footing to support the private sector scrutiny involved in going public. Should a new administration take office in 2013 and “cut-off” this massive government subsidy for Detroit, we believe GM’s sales and “profits” would be materially pressured. As a result, we would anticipate the strong possibility of another trip through bankruptcy reorganization. If this occurs, this is a serious threat to the stock. Bonds and REITs… Big Bubble We are ending a bond bubble the likes of which was last seen post-1929. The question is how close to the end are we? Equities Over-Discounting Profit Growth -6 -4 -2 0 2 4 6 8 10 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 Implied Earnings Growth % Source: Goldman Sachs; BlackwallPartners The chart above implies that investors actually believe (discount) U.S. corporate profit growth will be the worst in a hundred years. Investors are so over loaded in yield strategies that the valuations of growth strategies (stocks) have been discounted dramatically and in some sectors to Armageddon levels. The peak in bonds (and what many managers have been substituting for bonds – REITs) is at a multi- generational top. We would argue that this is likely near an end (the top) given the following facts… • There are massive stores of excess liquidity on the sidelines of the U.S. economy which are earning virtually nothing • The empirical reality previously outlined of a negative yield gap… historically speaking, this has never been long sustained • The overwhelming adherence to low volatility fixed income or yield strategies by portfolio managers and asset allocators despite the
  12. 12. 12 valuations of such securities reaching absurd levels by historic standards In addition to the bullet points above, the approaching presidential election is paramount. The result of this election could end what many view as the most anti- business period in our country’s history since FDR. The potential pain that would follow in the bond (and bond proxy) market could be epic. In the event that this election ushers in a new pro- business administration, it is likely that trillions of dollars currently sitting in cash will be reallocated to more productive asset classes. This will have an upward force on interest rates which poses a great risk to the very asset classes that have garnered so much cash (REITs and bonds) over the last three years. Accordingly, BlackwallPartners is short long-tailed bonds and traditional REITs. US stocks have been rising of late because US companies, inclusive of our banks, are now “lean and mean” as a function of self-preservation. They have honed their survival instincts after three years of incessant attacks, an ever changing and unpredictable regulatory and tax environment, and weak end markets. As a result, the upside in financial stocks is heavily levered to even the smallest ray of economic sunshine. In addition, the cost structure of financial firms is so "tightly wound" that every single dollar of revenue has an incremental margin of a de facto 100%. U.S. stocks are much cheaper than advertised as most investors do not realize that financial firms’ earnings "power" is like a “coiled-spring.” Fortunately, this is the case in a number of sectors and industries in our American services based economy; but none so much as the financial sector. The fuel for economic recovery and releasing this “coil” of earnings power lies in the record amount of unproductive cash and other forms of fungible monies and near monies sitting on the sidelines awaiting relief from this government. Regards, Michael P. Durante Managing Partner Blackwall Partners LLC 1 The manager's historic gross performance record above reflects his performance while at AIG/ John McStay Investment Counsel (1999 - 2002) and at Western Reserve Capital Management (2004 - 2010). The "Gross" data in the benchmark analysis and the corresponding charts above reflect cumulative performance data for each year illustrated and does not reflect all fees and expenses. 2 A limited partner's net return would be dependent upon when that LP entered and exited the fund relative to their high water mark and thus their "net" return after management and performance fees.The "net" performance above is estimated for (1999-2002) as McStay was long-only institutional separate accounts and Western Reserve was long/short. All historic performance results are audited and are AIMR / GAAP compliant. Past performance is not indicative of future performance. 3 To more accurately reflect the manager's performance while Western Reserve was distributing assets, an expense ratio consistent with AUM of $25M for the final trailing twelve month period (July 2009 thru June 2010) was applied to performance calculations. 4 S&P Financial Services Composite consists of equally weighted long-only Financial Indexes. Components include KBE and RKH.

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