Bill:

Ladies and gentlemen, thrilled to be joined by Derek Pilecki of Gator Capital. If you don’t know who he is, you will shortly. And Derek, thank you very much for making the time.

Derek Pilecki:

Thanks for having me on, Bill.

Bill:

I think it only took me about three years of reading your letters and then listening to a podcast where I think I understand the name Gator now. And correct me if I’m wrong, but it symbolizes waiting for an opportunity and then pouncing when you see it. Is that fair?

Derek Pilecki:

I think so. I think that that’s fair. I think Gators are aggressive animals and that’s how I think about my investing style.

Bill:

Is something that’s interesting to me as someone who’s followed you for a while is, as a financial specialist, I wouldn’t perceive it to be the sexiest choice in the world, but your reputation speaks for itself. And I’m curious, if you don’t mind giving some background on how you got into it and why you think it’s the right place for you to be, I guess would be the way to say it.

Derek Pilecki:

So I got interested in investing during college. I went to Duke, but in the fall of my freshman year I was waitlisted at Duke and I was granted January admission, so I had that semester off. And so I grew up in Northern Virginia and I took some classes at American University and my classes were spaced out during the day, so I just sat in the library and read books, and I read investing books that fall. So I really got interested in all different stock types of investing in, it just started my path to becoming an investor.

As I went through my twenties, I got a job at Fannie Mae working in their asset liability strategy. And Fannie Mae used to be one of the aspired companies in America, but it’s a different company nowadays and went through a tough time 15 years ago. But when I worked there in the mid-nineties, it was a great, an admired company and I worked for some great people and I learned all about the fixed income markets. One thing that we didn’t do was stock investing, when we just invested mortgage backed securities and we funded those with agency debt. And so, I continued to do reading at night and just kept reading about stocks and investing and read Lowenstein’s Buffet biography, The Making of American Capitalist, and that really propelled me to… I want to run a portfolio one day. And so just, you knew that it was going to be a long path to becoming a hedge fund manager.

And since I had worked inside Fannie Mae, inside a big financial institution, it made it easy to follow financial institutions or banks when I came out of business school. They said, ‘What sector you want to cover?” And I was like, “Well, I know financials,” so that’s where I’ve added the most value. And I was a financials analyst the whole time I worked on the buy side for other people. And so then when I went to go start my own fund, wanted to stick with what I knew, I didn’t think people would pay me to pick healthcare stocks. Had the specialized knowledge that… and when I started my fund really in 2008, kind of like today, financials were a distressed area. And so there was a lot of opportunity there. I was surprised that they weren’t done to going down yet.

I started in July 1st of ’08 and financials still had a long way to go down from there. It seemed like they were undervalued when I launched. But there’s always just been a lot of opportunity within the sector. I even think till today there’s a lot of people who were portfolio managers during the financial crisis that have shunned financial stocks. And so I continue to see ongoing opportunity within the sector, just for specialists to pull value out of the sector because there’s a lot of companies and a lot of different business models that takes a lot of specialized knowledge to follow the sector.

Bill:

Do you want to describe what your definition of a financial is so that people understand the things that you’re looking at?

Derek Pilecki:

Classically, it’s the banks and insurance companies, but I also include in anything in the financial index and including real estate investment trusts, because when I started, REITs were part of the financial sector. So I’ve kept those within the financial sector. From time to time, I’ll include companies that have significant financial operations. So when eBay owned PayPal 12 years ago, I included eBay in my definition of a financial.

So GE is a classic example of industrial company, big financial operation, anything that has something like that. But there aren’t too many of those these days. A lot of those companies have separated financial firms out. I guess Harley Davidson’s still out there, CarMax is still out there.

Bill:

But something like Caterpillar maybe. But-

Derek Pilecki:

Yeah, John Deere has a big financing operation.

Bill:

That makes sense. Well, when I said it wasn’t necessarily the sexiest, I think there’s so much attention on tech and growth or I think there still is, but I remember once upon a time I was sitting at a table with Bruce Greenwald and I told him that my background was in agriculture, and he said, “That’s a fantastic industry.” And its taken me a while to understand why he said that, but I think it’s similar to financials in that there’s cycles that you go through and there’s opportunities within the sectors.

And as I’ve watched your writing and read what you’ve had to write over the years, it’s been really interesting to see the opportunities pop up. And I guess the most prominent and recent example that I can think of, if you don’t mind talking about maybe the last five years of evolution, but with Silicon Valley Bank and what you saw that made you change your mind, if I can say that in the right way, because I know you admired their franchise for a while and then at some point you said this might get a little bit dangerous here. So I’d just love to hear you riff on that and how quickly things might be able to turn in financials.

Derek Pilecki:

So I was long Silicon Valley back 2018, 2019. So I even owned it back when I worked for GSAM back in 2007. So I followed the company for a long time. I thought they had a very good franchise. They really had a hammerlock of, I think they banked 60% of all venture funded companies and an equivalent market share amongst venture capital firms. And so, you just had this great network effect within the valley of they connected people and got business because of that. And these venture firms left their deposits in the bank for very low interest rates because they got other value from the bank. And I just thought it was a great franchise. And they also grew with venture funding and venture funding was booming.

So I thought that in the late ’18, ’19 timeframe, I thought that the stock was undervalued. It was trading for around 10 times earnings. They were levered to higher interest rates, and I thought rates would go higher. I thought that people overly discounted the Warren income. And so I thought it was cheap and they were growing. People were calling for the top of the venture cycle in ’18, and I didn’t have a strong view on that. It just didn’t feel like it was the end right then. So I owned the stock, got into COVID and fed cut rates and Silicon Valley went down and there was a lot to do. And so it became a source of capital for me in 2020. And admittedly, I sold it way too early. It went on a huge run with the venture cycle. So, there were other things to do. There was a lot of distress in banks and I just didn’t think, I thought there was other higher, better uses of the capital.

But I continued to follow the company, regretted selling it still followed it, thought I’d get an opportunity one day. During 2022, the stock was selling off and the bubble was, the SPAC venture bubble was imploding. And in 2022, the stock was off, and so I started taking a more serious look at it, especially with rates going up. And I was surprised by their securities portfolio, they had all this excess cash and you could see in their financial statements, they had large marked to market losses on their securities portfolio. And quickly did a little bit of digging and it was clear that they had just bought mortgage backed securities. And as those prepaid, they continued to reinvest in mortgage backed securities. So whereas they might have started out with 4% coupon mortgages, they ended up with one and half percent coupon mortgages. And so as the rates started going up, they had these huge losses and it was frustrating.

I didn’t own the stock, but it was frustrated because I admired the company and admired the franchise and that they had just dug themselves this huge hole. So after the third quarter earnings release last year, I looked at it and I was like, “Oh, they’re insolvent.” Their securities losses are big enough that they’re technically insolvent for regulatory capital purposes. Regulators ignore the mark to market losses on held and maturity securities. So they didn’t show a gap negative value, but if you did the math with their $14 billion loss on the held and maturity securities, they had a negative $4 billion equity account.

And so, I actually tweeted that back in November, “Is today the day the market realize the Silicon Valley’s insolvent?” And the stock didn’t move. It just actually rallied. It rallied in January from 200 to 300. And I was like, “Okay, I guess the market’s just going to ignore this loss.” And I was really frustrated with the management team. And then everything happened in March and just finally, when they tried to raise capital and the depositors got scared and pulled money, and of course it imploded, but I admired the franchise. I’m really sad what happened to the bank.

Bill:

Is there a logical reason that regulators would not count mark to market? I understand how silly it sounds in retrospect, but maybe other than fighting the last war, what might have they been thinking as to why mark to market shouldn’t matter for regulatory capital purposes?

Derek Pilecki:

I think it goes back to the financial crisis. There’s a scenario where there’s a lack of liquidity in the market. When all the subprime mortgages, mortgage backed securities went down in value and people were saying, “Hey, the prices of these securities are way below what the ultimate cash flows are going to be. So we should ignore that the market price because the cash flows are going to be higher.” I think that’s where it came from, and that was because a lack of liquidity. And just no institutions had enough liquidity to pay fair value for those securities. And that turned out to be the case. Anybody who bought subprime mortgage securities post, I don’t know, October of ’08 realized a lot more cash flow than they actually paid for price.

And so I think what ignoring mark to market does, it allows banks to take more risks than they really should. So like Silicon Valley had a deposit base where it was all on demand checking accounts, and so people could pull their money out. As we saw, 40 billion the first day and a hundred billion was lined up for the second day of withdrawals. They shouldn’t have been in 30 year mortgage backed securities. They should have been in short term treasuries. Maybe they should have gone out one or two years on treasury securities because the market for the treasuries, short term treasuries doesn’t really move that much. But I think that it goes back to the financial crisis of why people were saying, we need to ignore mark to market because of the way the market price subprime securities back in ’08.

Bill:

Something that I’ve realized through watching this is there’s an assumption on the duration of your deposits. So it seems to me that some management teams will potentially try to barbell the approach. And that’s nice on a computer model until the depositors start to flee and then it becomes a real problem if they do. And you’ve written about, and I think anybody that’s looked at it, Bank of America, Schwab, it’s interesting to see some of these portfolios, but it appears as though maybe the deposit assumption is a little more sound.

Derek Pilecki:

I think there’s been a real change in what the duration of deposits is. During ’08, when WAMU had its initial stages of its run before it was sold to Chase, I think over a 10-day period, $17 billion came out of the bank versus Silicon Valley, $40 billion came out in one day. So I think with technology and everybody having smartphones and apps, it’s really easy to move money nowadays. And I think those assumptions about what the duration of checking accounts is, has to change. It has to be massively shorter. And I would extend this to say that I’m an advocate for increasing deposit insurance. I think clearly 250,000 is way too low. It hasn’t been adjusted for 15 years, hasn’t been adjusted for inflation.

We have these reciprocal deposits like IntraFi or Cedars where you can get FDIC insurance through your original bank because they put the deposits out to other banks. I think that’s just getting around the rules. We should just increase the deposit insurance amount for companies and individuals that should go to a million or $2 million. And for operating accounts for corporations, you can make it unlimited. And so that way we really would eliminate bank runs. If you think about who benefits from a bank run, nobody does. It’s just a negative thing for society. Why should we have bank runs?

And I don’t think you can expect depositors to evaluate the risk management practices of a bank. So look at Silicon Valley, at a $260 stock price, $20 billion market cap, two days before it failed. What depositor’s going to look at that market cap and say, “Oh, my deposit’s at risk,” or, “I don’t like their bond portfolio.”? That’s just not a good use of society’s resources to have depositors worry about that. That’s why we have regulators. The regulators should be in there saying the bank has too much risk. You should reduce risk. It shouldn’t be up to depositors. So, I think we should have more deposit insurance to eliminate bank runs.

Going back to your question about duration of checking account deposits, it has to be, banks just have to assume it’s shorter, with rates going up so much, everybody’s repricing, are you moving excess cash to higher yielding accounts? I think I totally agree with your premise.

Bill:

The one argument that I’ve heard against moving deposit insurance to something unlimited is like, does that take away from some of the smaller banks. Said differently, do some of the smaller banks benefit from the incentive to spread deposits out to different banks and is that a good or a bad thing? How do you think about that?

Derek Pilecki:

I actually think deposit insurance would benefit small banks because then you can leave your money… Bigger… Depositors wouldn’t be worried about a small bank. They’d say, “The FDIC and the regulators are looking at the small bank. I’m totally protected if I leave $2 million here, I don’t need to have an account at a big bank.” So actually, I think it would help small banks to have unlimited deposit insurance or higher, much higher limits.

Bill:

I think the flight to the large banks would probably support your hypothesis. Because it seems as though that deposits just went to the CFIs once the run happened. It seemed like everybody was looking for the big banks to put their money in.

Derek Pilecki:

I think the argument against higher deposit insurance is banks might risk loving banks or risk loving management teams, would take, raise deposits and invest in very risky projects. So during the financial crisis, there was a bank in Chicago called Chorus that was the number one funder of condo developments. And they had a huge portfolio of condo developments both in Chicago and Miami. And so if they had unlimited deposit insurance, would they be able to fund just more and more condo developments? And my argument there is, well, it’s up to the regulators to limit the amount of money they have in any one asset class or to evaluate the risk management practices. So like deposit insurance, unlimited deposit insurance could allow a bank to grow too fast. But I would say the regulators should be there to stop that.

Bill:

So speaking about the regional bank or commercial real estate and condos generally, I can’t help but have a conversation about banks and financials without asking you about what’s going on with, specifically office, but how big of a deal do you think this upcoming refi wave is going to be and how are you taking a step back and thinking about things from first principles?

Derek Pilecki:

I think it’s in a big issue. Rates have moved a long way. So I think there’s a lot. And we also have the banks less willing to refi people out of other people’s loans. They’ll extend existing loans in their own portfolio, but they’re not going to take other people’s loans off their books. So I think it’s going to be a difficult wave we’re going to go through here, especially with leases burning off and occupancy going down, [inaudible 00:19:47] going up. I think it’s going to be very tough. I think it totally depends on who holds the note. If a bank holds the note, they can work with the borrower, they can be flexible, they can extend the note.

If the note’s sitting in a commercial mortgage backed security, there’s not that much flexibility. The special servicer has to try to get maximize proceeds for the underlying bond holders. I think they are just handcuffed of how much they can do to extend the note and to work with the borrower. And so a lot of times they’ll just take it to auction, they’ll just foreclose and an auction off the property. And so I think that’s going to be tough. I think there’s going to be a lot of big… And you think about the central business districts, Chicago, New York, San Francisco, those big towers in those central business districts, those notes tend to be in commercial mortgage backed securities. There’s not a lot of banks who can make loans that size.

Bill:

Your hold size would be huge.

Derek Pilecki:

They’re just huge loans. And the big banks are pretty low risk-takers as far as… I don’t see JP Morgan or Bank of America are holding Office Tower notes in their portfolios. I think that they just let those go into to commercial mortgage backed security. So I think it’ll be a big issue for the commercial mortgage backed security market. And I think there’ll be a lot of foreclosures and a lot of auctions. I think it’s going to be tough. Just in the news last three weeks in San Francisco, Park Hotels turned back the keys of to two big hotels in San Francisco. There’s a mall that just got turned back. I think we’re going to continue to see more of that.

Bill:

And what does that look like practically speaking? And then the person that wins the auction comes in and they are likely financed by bank debt? Or is it private credit? Who steps into some of these transactions, do you think?

Derek Pilecki:

I think it’ll be a lot of private credit. They could have some bank debt, but I think it’ll be a lot of vulture funds that’ll come in and buy those properties. And they’ll generally use private credit. They might use a little bit of bank debt, but the LTVs on bank debt are so low that it’s probably not the most attractive financing for those vulture funds.

Bill:

Well that’s one of the things when I’ve been looking at, I like to look at M&T, I don’t own it. I don’t know anything about financials for real, but I know that they have a very positive reputation. And the LTVs appear, they’re only as good as the assumption of the value. But it seems as though there’s some equity cushion even in some of the regional bank’s portfolios that I think people are maybe a little bit overly scared. I’m not sure whether or not that’s true, but I know that you’ve identified some opportunity in regionals.

Derek Pilecki:

So, I think the banks, the regional banks have done a good job with disclosure around CRE. The amount of disclosure in Q1 earnings versus Q4 earnings just multiplied. So almost every bank put out a slide of here’s our CRE exposure, here’s our office exposure, here’s our essential business district exposure. And so you can really compare and contrast different banks. It seems like office exposure tends to be 3% to 5% of the portfolios. You have to subtract out owner occupied office from investor owned office, you have to subtract out medical office, which the vacancy on medical office properties is a lot lower than typical office properties.

So there’s a lot of mitigating factors, and I think that banks have improved their disclosure around that subject. So I think that’s one of the things I like about banks. So I don’t feel like there’s a lot of scams being run by regional bankers. They tend to be in their jobs for a long time. They’re regulated entities. They all expense stock options. They’re all, I feel like the disclosure is pretty good within the sector. They’re all regulated entities. They all have published call reports that has even more information than what’s in their SCC filings. So I think, to the extent that there’s other distress in the real estate sector, I expect the banks to disclose that.

Bill:

If somebody was interested. Where do you find stuff like the published call reports and some of the public filings that are not like the 10K or whatever? [inaudible 00:24:44].

Derek Pilecki:

I use CapIQ, write minutes. I don’t know if their bank regulatory modules enabled for everybody else, but it’s enabled in my subscription and that’s what I use. But the fdic.gov is where all the call reports are available. You can do searches and find it.

Bill:

I think a writeup that you put out a while ago that I liked because it shows how many assumptions there are in any given number in financials, and I think about what you’re saying right now, but I believe it was the Ambac liquidation. Just to watch your adjustments through that, it was really interesting. And I don’t know how that turned out for you, but your perception of the market, value of the stock versus where it was trading and the amount of assumptions, financials is fascinating because it’s a black box in a way, but I see you cut through a lot of the darkness.

Derek Pilecki:

Unfortunately, Ambac didn’t work out as well, and I don’t think it was because of those adjustments or the sum of the parts didn’t work. There was a legal case, a related legal case that had an opinion that Bank of America was able to use against Ambac to keep the settlement to a lower number than I had hoped for. But I think that’s one of the things I love about financials. You can go through the numbers and sometimes there’s value just sitting there. One of my early hits when I first started the fund back in 2010 was commercial mortgage reits had issued a bunch of CLOs or CDOs and you could go through. And some of the debt, all the senior debt was non-recourse to the equity.

So I remember this one had 10 securitizations outstanding. You’d go through each one and say, “Okay, for these six, the equity’s worthless. But on these last four, I think they’re going to recover some value for the equity.” And it had to report a negative book value because of the marks on the senior debt of the first six securitizations. But since they were non-recourse, you could eliminate that and you could get… the stock was trading for 80 cents. You could get six bucks on the book value if you would limit… but the reported book value was -15. So you could do the math and say, “Hey, as soon as everybody realizes this is non-recourse debt, the stock should be much higher.” And so occasionally, you get those types of opportunities within financials.

Bill:

I have seen you write or talk about, and I’ve talked to my friends about some of the mortgage reit preferreds right now, which is interesting in a similar way. Do you want to talk about those at all?

Derek Pilecki:

So mortgage reit preferreds, they issue these fixed to floating rate preferreds and mortgage reits had a really tough 2022 with mortgage spreads widening. The book values declined. And then there was a little hiccup in August and September last year where spreads just blew out. And when when spreads blew out, the preferreds always trade down like they’re distressed because if the equity goes to zero, then the preferreds get the next hit.

And so, when the equity all took 15% to 20% hits the book value during Q3 last year, the preferreds never took any losses. So they traded down. And then they traded down again in December on tax loss selling, and then they traded it down on Silicon Valley again. So this is a third bite of the apple, these mortgage reit preferreds. They’re on fixed to floating rate periods, and the fixed rate periods coming to an end and they’re going to reset to three month LIBOR plus a spread. And a lot of the spreads are 5% or 6%. So with the preferred trading at 75 cents on the dollar, they’re going to reset to 10% yields. And that works out to a current yield of 14% or 15%.

And so, I think as they reset to the floating rate periods in a year or two years from now, they’ll trade closer to par. And so there’s a couple that you can get 75% return or 45% returns over the next year as they trade closer to par during the reset period.

Bill:

Why would they not trade at par?

Derek Pilecki:

I think it’s just a small market. There’s small issues. I think mortgage REITs are, they’re not squirrelly companies, but they’re not operating companies. It’s just a few guys on a Bloomberg. So it’s just like an investment fund. It’s not like a bank. They trade well outside where bank preferreds trade, even with the distress in banks. And so, I think that’s pretty interesting because mortgage reits aren’t really distressed right now. They’re earning money, yes, spreads are wide, but it’s not like people are worried about liquidity in the repo market right now. So I think it’s an interesting opportunity.

Bill:

It seems to me like the consumer’s in good shape, the duration is extended, because rates have already gone up. So I don’t know, a lot of the risk that you take when rates are lower I think is e-risked. Now, of course it can always go higher, but it’s an interesting concept, especially when it’s trading at a discount to where it should go when the security starts to flip to a floating rate.

Derek Pilecki:

I would even say that with mortgage, the debt spreads this wide. There’s only really one way that could you go, is tighter. And so that would be good for the equity. So I don’t think the next news on mortgage reits is going to be necessarily negative. I think it could be positive with tighter spreads as we get into a better liquidity environment.

Bill:

How much of your job is focusing on stuff like consumer, the strength of the consumer and macro forces versus… I guess what I’m saying is the bottom up and the macro seem to be connected when you’re talking about financials. Is that fair?

Derek Pilecki:

Yeah, but the macro doesn’t change for me often. So consumer credit goes on long trends where it’s not like it’s going to turn on a dime of if the Fed raises 25 bps, my view of the consumer’s changed. My view of the consumer has been pretty steady for the past 10 years. I’ve long thought that we are going to have a long economic expansion. We’ve had a couple hiccups. We had the hiccup around COVID, which was unexpected. But absent that, since the financial crisis, we really haven’t had a recession. And I think it’s going to be a while before we have a recession. I think credit quality is pretty good. I’ve been worried about a recession more in the last three months than I have in the last 15 years because I worry that bank lending getting shut off could cause a recession.

When you think about recessions, ’90, ’91 and ’08, ’09, were pretty deep recessions. And both those times banks cut off lending. In ’01, ’02, it was a pretty mild recession. It was more a capital markets, CLEC debt, telecom debt implosion that caused the recession, not so much bank lendings stopping. So to the extent that banks stop lending because of liquidity right now, I’m more worried about a recession now than I have been. It doesn’t seem like… The stock market’s gone straight up. So the market’s not worried about a recession. And it seems like there’s enough banks still lending that the big banks can still lend. It doesn’t seem like we’re having a credit crunch right now, although I’m wary about that. Because I hear a lot of banks slowing down their lending and they need to raise capital or just their capital ratios grow, so they’re just going to stop lending. But I agree with you that macro and bottom up financials analysis is very similar in my sector.

Bill:

And when you talk about the liquidity, your concern about lending due to liquidity, is that because of these held the maturity or the mark to market losses, creating a scenario where they need to build capital buffers for the short term in case there’s another run on deposits or something like that?

Derek Pilecki:

Yeah. So, I think bank runs scare bankers. And so, that’s death for a banker. And so, I think the banking industry, everybody’s like, “I need more liquidity. I need to retain capital.” So I think a lot of banks have slowed down lending, they’re not doing anything in the edges, everything. I’ll take care of my core customer, but that’s about it. I’m not going to do anything to try to really grow aggressively here. So I think that’s the slowdown. It’s just self-preservation amongst bankers.

Bill:

One of the things that I was shocked by, and perhaps I shouldn’t have been, but I was , because I’ve had people on this podcast that I’ve talked about how good First Republic’s franchise was and qualitatively, I talked to customers and they’d say how much they love them. But that first weekend I was eating lunch at my grandma’s community and there were two gentlemen next to me and they were looking at their accounts and they said, “Why do we have this many deposits sitting there earning nothing and incurring risk when we could be moving it to risk-free treasuries earning a lot more?”

And I think one of the things that I learned was whether, I guess deposit diversity is so much more important than maybe, I mean, maybe this is banking 101, but I just didn’t realize that having a customer base of really wealthy people could actually become an Achilles heel if they are technologically savvy and all reading the same paper. What I thought was actually its greatest asset, I think maybe in a way became what brought it down. And that was an interesting learning.

Derek Pilecki:

I think it’s also the overlap of customer bases between Silicon Valley and First Republic. They’re both were headquartered in the Bay Area. I think they banked the same people to the extent that people got scared because of Silicon Valley and they also had big accounts at First Republic. It’s the same people. So I think you bring up an important point about diversity of customer bases. Because I met with a few banks in May, and these were banks in the middle of the country, Illinois, Louisiana, Tennessee.

And they were talking about to their customers after Silicon Valley, and their customers were like, “Why are you calling me?” And as the news came out there, the customers eventually were like, “Oh, I’m glad you did call me, since I got scared, but you had already called me and I felt better.” But there’s a lot of, middle America, this was not a Middle America event. This was a Bay Area, a venture community event. This was not… But certainly there’s large depositors in every community that got scared about their bank for a minute and they don’t seem to have left their bank. They seem to have asked their bank for higher rates or asked, “Can we do something to increase my deposit insurance?” But for the most part, depositors have not left their banks.

Bill:

Well it turns out middle America is not sitting on Twitter getting, people scaring them, which is something that I took issue with while it was going on, but that’s neither here nor there.

To what extent do you think of the increase? Because you mentioned the banks may have to pay depositors more now. How much do you think of that as credit tightening? Because I would think that if they’re going to pay depositors more, they’re going to have to ask for a higher rate on their loan, otherwise their NIM goes away. So that almost by definition decreases the amount of credit that they can extend, I would think.

Derek Pilecki:

It’s also going to limit the amount of demand that the borrowers have if they have to… instead of paying six and a half percent, they have to pay eight and a half. There’s a lot of projects that don’t pencil at eight and a half. So I think there’s also, it’s both sides. The bankers don’t want to lend and the borrowers don’t want to borrow at the higher rates. So, I think the banks are going to have a tough quarter this quarter on deposit costs. I think we saw some of it in Q1, but it was really just a one-month effect of Silicon Valley happened in March. You get three months in this quarter of deposit pressures. I think it’s going to be a tough quarter for profitability for the banks. Just deposit costs are higher. I think the whole, having the media say, “Bank crisis, bank crisis, bank crisis” and talk about rates. Rates have moved a ton, 5% on T-bills. People are asking for higher rates. And so I think that it’s going to be a tough quarter.

I think we’re going to get to, either as Q2 or Q3 is going to be the bottom, it’s going to get better from there, but this quarter’s going to be ugly. I guess the one thing that we’re was interesting, and Morgan Stanley had a conference a couple weeks ago, and a lot of banks gave negative outlooks for NIM in Q2 and not all the stocks went down. So when stocks stopped going down on bad news, is that a bottom? Banks have had a nice little rally since Mid-May. Are they a little ahead of themselves or is that just correcting, overshooting? It’s not really clear to me yet, but I think it’s interesting on some of those negative mid-quarter updates, the stocks didn’t necessarily go down.

Bill:

That is interesting. When you’re building a long-short portfolio and you have a bank, and it may not be as black and white as the question that I asked, so I apologize if there’s not enough nuance. But say you like one bank, do you try to pick a bank to short against it, or will you say banks generally are relatively undervalued relative to asset managers or something like that? How do you think about constructing a long-short portfolio when you’re constrained a sector?

Derek Pilecki:

I don’t pair off sub sectors within the portfolio. I’m sure plenty of banks. I think this opportunity right now is interesting because there’s great banks that have gone down. Banks are down 30% year to date. So there’s great banks that have gone down that don’t have interest rate problems. They might have some pressure on the deposit side, but it’s not life altering.

And so, I think that’s the opportunity alongside these high quality banks. But on the short side, there’s a lot of banks that are still shorts. There’s still a lot of banks that have fixed rate loans, that have big securities portfolios that are under capitalized. So, I’m not sitting here thinking regional banks are the opportunity, I’m not going to short any regional banks. I’m still shorting plenty of regional banks that have mismanaged interest rate risk and the stock should be lower. And so, that’s what’s so unique about this opportunity, is there’s opportunities on both sides, long and short.

Bill:

I think it’s interesting. And it’s interesting to think about, I’ve talked to somebody who said, he was actually a financial specialist, and he said a couple PMs wanted to go short NASDAQ because they wanted to do a value play. And he’s like, “I don’t want to do inter sector shorts and longs. If I’m a financials guy, I want to be…” So I was curious how you think about pairing up your longs and your shorts.

Derek Pilecki:

I try. I guess one thing that you can get caught in from time to time is, I short a lot of companies that are high, that trade at high multiples that I think that are just average businesses or that are okay businesses. And so, you can get caught up into high quality risk factor. If you think about it, risk factors, quality is a factor and value is a factor. And sometimes you can get caught up of you have too much of one factor versus another, and you might have the same trade on implicitly on both sides of the book. So I don’t want to be long on value and all quality. I want to make sure that I match better than that.

Bill:

Because being long mostly value would imply that the value, quality gap is too wide. So then if you were shorting quality, you would be doubling down on the same bet, right?

Derek Pilecki:

Correct. And sometimes that works. From mid-May to mid-June, long value, short quality worked within financials. If you look at the insurance brokers or Visa, MasterCard or S&P and Moody’s, they all lag the regional banks for four weeks. Now, does that continue? Probably not. Those are great companies. There can be episodes where it happens.

Bill:

Do you mind talking about Genworth? Because I think it is a really great example of how long… Actually Genworth is why I thought of you as the gator that waits. So I’d be curious if you’d talk a little bit about how long you followed it before you saw the opportunity.

Derek Pilecki:

So, I owned Genworth from 2012 to 2014, and then it went off into the wilderness and was trying to get acquired by a Chinese insurance company. And I just followed the company. It bounced between three and four bucks from ’14 to 2020. And then I was listening to earnings call and they were talking about buying back stock. The deal had fallen through finally, and they had IPO’ed, enact their mortgage insurance subsidiary. So I started listening to the calls more closely and just doing the sum of the parts. Genworth, the holding company, was trading at a discount to its publicly traded subsidiary enact. And so I waited eight years to buy the stock back. Genworth talked about in, I think it was January 2020, they said, or maybe it was March 2022, they said they’re going to buy back stock later that year. And that was the catalyst for closing the discount to the sum of the parts.

Genworth has two businesses, the mortgage insurance and then life insurance. And life insurance is dominated by their long-term care insurance business, which is terrible, a terrible business. It’s selling insurance policies to 60 year olds when they might go into a nursing home at 85. So it’s like a 25 plus year insurance policy. And everybody underestimated the cost, the percentage of people who would go into nursing homes and what the cost would be. And so they just lost oodles and oodles of money on those policies. They’ve stopped selling them and they’ve raised rates. So been able to reprice a lot of those policies. And I think the cumulative amount of their repricing is $23 billion. And there’s still a question of whether that life insurance subsidiary is solvent, even though they’ve raised prices $23 billion.

And so, there’s 6 billion of equity capital in the life insurance subsidiary. So in some of the parts, I value that at zero. I don’t know that it’s zero. I think that’s the upside in Genworth, is have they salvaged some value out of that life insurance subsidiary, so they’ll continue to raise prices on that book of business? Those people, some of the older policies, people are finally dying and the policies are going away. Some of their biggest cohorts of policies, people are just approaching the years where they’re going to make claims. So the next couple of years will have a better view of what the policy costs are on their bigger cohorts.

If they can salvage some value out of that life insurance subsidiary, there’s some real value there of the life insurance. So to give you an idea, they have about a half billion shares outstanding. And so the book value of the life insurance subsidiary is about $10 or $12 a share. The stock trades for $5 a share. So at $5, it’s just what the value of the mortgage insurance subsidiary is. So there’s some real upside, but it’s going to take a long time before we get any cash flow out of the life insurance subsidiary, if we get any at all.

Bill:

Is life insurance generally, I know that I got sold term. I was pitched on whole or whatever, but is it possible that life insurance has repriced enough or that the market will reprice enough? First of all, is it still marketed? And second of all, my question is, is it possible that it’s actually going to be a good business at some point, but it’s been so bad for so long that no one wants to touch it?

Derek Pilecki:

They’re trying to make it an asset-like business. So it’s different from just life insurance, is long-term care insurance business. I don’t think the way they used to write the policies is a good business at all. It’s a terrible business. So they’re trying to reuse, they have a claims infrastructure that could potentially be valuable. So if they can make long-term care insurance business priced like health insurance, and where it gets repriced every year, it could potentially be a decent business. UnitedHealthcare has been one of the best stocks in our lifetimes. So if they can get that same model, it could be pretty interesting. But I don’t know. We’ll see if the regulators will go for that. It’s going to take multiple years before they can try to implement that on a wide scale.

Bill:

It’s tough, man. I watched my grandma go through it. Getting old is not cheap and it doesn’t appear to be getting any cheaper. And the labor is very, very difficult to find. So competent people, you’ve got to pay them. And it’s a real kink in the system. So I don’t know. We’re going to have more and more people that need facilities like that, and it seems like we just don’t have a sufficient amount of nurses around.

So, it’s going to be interesting to watch. I’m sure capitalism will solve it. Prices will go up. But it’s interesting.

Derek Pilecki:

It’s tough. I think immigration’s a real issue in the country, number of new residents coming to the country that wouldn’t normally help out in industries like that is making it harder.

Bill:

It’s not a particularly glamorous job to help people die.

Derek Pilecki:

It’s a hard job.

Bill:

And emotionally taxing too. It’s a lot of getting connected to people to then just watch them leave. So I don’t know, it’s interesting.

Derek Pilecki:

It’s hard. It’s hard. Hard business.

Bill:

Huh. One idea that I heard you talk about that really, it really reframed the way that I think when I heard you talk about it was the Puerto Rican banks. And when you talked about them versus Hawaii and the regional oligopolies. And I thought it was so interesting because so much of what I read about Puerto Rico is not positive, that I’m curious how you’ve seen opportunity and what seems to be a lot of negative headlines, for lack of a better term

Derek Pilecki:

So Puerto Rico is an interesting place. It’s a US territory. It’s not a state, but the banks there are regulated by the FDIC. So they’re effectively US banks and all of them have operations in the mainland. And the island’s just been in this 15 year recession. And since the tax laws changed where the pharmaceutical companies didn’t get tax breaks for manufacturing the island, the island’s just been in recession. And so populations left. They’ve gone to Florida and New York. And I think there’s a lot of people, there’s a lot of Puerto Ricans who live on the mainland who would love to go back home if they could work. They’re here because they need jobs, but they prefer to be on the island.

And so I think there’s this opportunity for Puerto Rico to really turn around if jobs went back to the island. And so, we’ve gotten a little bit of a start on that. The reconstruction from the hurricanes has lit a little spark in the construction industry there. There’s potential for reshoring healthcare facilities. So there’s 25 manufacturing facilities on the island, to the extent that we reshore pharmaceutical medical devices from China back to the US. Puerto Rico and Indiana are the two big territories or states that will benefit from that.

So that’s another potential spark to Puerto Rico. And then there’s a lot of, the government being too indebted and going through this bankruptcy is limited growth. And to the extent that they’re coming out of that and improving their infrastructure, that’s another avenue for growth. So I think those are all positive things. And in the meantime, you’ve had this consolidation of the banking sector. They’ve gone from 11 or 12 banks down to three on the island. And just, like you mentioned, the oligopoly is just creating this pricing umbrella that makes banking much more profitable. Banking was unprofitable or marginally profitable for a long time in Puerto Rico. There’s just too much competition and now there’s a lack of competition or just the banks just don’t need to fight with each other, to the extent that there’s only three of them.

Bill:

It reminds me a little bit of Buffett’s airline bet in a different way, which maybe arguably didn’t work, but I think it’s a little too early to see whether or not his bet worked. But that consolidation to an oligopoly structure in a local market, I thought it was very insightful. So thank you for sharing that.

Derek Pilecki:

Thank you. So hopefully it works out like Buffett’s railroad bet.

Bill:

That’s right. That’s right. Indeed.

One time, and we don’t have to talk about it, but when we were talking, you had mentioned that your firm, you went through a period where managing the portfolio, managing the business created an interesting tension in your life. And I wanted to talk to you about that because I think there’s a lot of listeners that are trying to manage that. And if you don’t mind sharing some of your learnings and what you went through, that’d be great.

Derek Pilecki:

So when I started Gator, I had this vision of I’m going to start this portfolio and I’m going to start raising money, and then I’m going to reinvest the cash flow to grow the business. And that was my vision of, I want to grow a business. I don’t want to milk it. I want to reinvest and just grow it. So I thought that we could have four or five PMs and we’d all be managing a couple billion dollars and it would be a great business to have. And so we started going down that path, and I started growing and hired a former colleague from GSAM to start a fund for him.

And there was a couple of things going on. I had very good performance the first five years of the fund, and then I started growing. And so just growing my own product took demands of my time of new investors. People wanted to talk to me with performance. And then at the same time, I hired this other person and was trying to grow the firm. We hired a few additional employees, and then you have to keep raising money to pay off those investments. And so at the time, I would’ve said, I can handle it all. I can. I got the investing down, I’m expanding the firm. These other investments don’t take a lot of my time. Right about that time, my performance, my fund turned down, there was 18 months where I underperformed the sector in the market. And in hindsight, I think those stresses of raising money for my own product and then also trying to expand the firm and managing this other PM created a lot of stress that affected my performance.

I can’t look at anything specifically and said, “Oh, I made that mistake,” but there was a series of investment decisions that didn’t work in a row. And I have to think that I was, that pressure affected my investment performance. And so, I got to, after about a year and a half, I realized I wasn’t going to be able to raise money for the second pm. And so I closed his fund down, had to let him go, which was stressful as a friend. And-

Bill:

Yeah, that’s tough.

Derek Pilecki:

I had spent a lot of money trying to do it, trying to hire him and raise money for him. And then closing his fund was like, it’s like the stunk cost. All that money’s out the door. I’m never going to recover it. I think I spent about $800,000. And so I look back at it, I live in Tampa and the beach is about 45 minutes away, and I don’t own a beach condo because I tried to start this other fund.

And so, I think about it in those terms of like, “Oh, I tried to open this fund for my buddy instead of buying a beach condo.” And buying the beach condo wouldn’t have aligned with my values at the time. I was very much of, I want to reinvest the cash flow into the firm. And so that’s what I wanted to do, and it didn’t work. And so, since then I’ve narrowed the scope, my vision of Gator, just my fund. It’s financials only. We’re not going to be anything else. We’re not going to have other products. I’m just going to be focused on putting up the best numbers I can for my fund. And so it was a humbling experience, it was lost of money, didn’t give my investors good performance during those 18 months. So all that is just a learning experience that has kept me focused in the years since.

Bill:

Well, I appreciate how honest you were. I went back and looked, and I would argue that your investors are still probably okay, but it’s tough. There’s demands. I’ve noticed it with some of my friends that are out raising and I’ve got one friend that might be close to closing his fund. And I’m hopeful for him because I think it allows you to get back to the drawing board of what is just the investing side of it rather than the business side, which can be taxing.

Derek Pilecki:

The investing side’s what we all love, and that’s what produces the value. So you need to stay focused on that because the whole thing unwinds if the investment side doesn’t work.

Bill:

So I do have to ask, what is going on with the mutual fund that you run? What was the purpose of taking that over?

Derek Pilecki:

So I had started a mutual fund in 2013 as part of the business expansion. And so when we got to 2017, I got this opportunity to take over this other mutual fund. So it’s the Caldwell & Orkin fund. It’s the oldest long-short mutual fund. So it started in 1992, and Michael Orkin ran it and Michael was going to retire. And so I won the bake off to the board, just selected me to take over the fund. And the idea was I already had a mutual fund. I have the hedge fund, long-short investing, I was the best position to run a long-short mutual fund. And I thought it could add to my firm, because I talked to advisors who want to put their clients into the hedge fund, but then they’ll have some clients that don’t qualify for the hedge fund. Not everybody has 2 million liquid to go in the hedge fund or kids accounts or whatever.

So the mutual fund serves a purpose of, an advisor can keep their clients in the same type of investment. The qualified investors can go into the hedge fund, and then the smaller clients can go in the mutual fund. And so that’s the idea behind the mutual fund. The overlap between the portfolios is significant. It’s not exactly identical, the hedge fund uses a little bit of leverage. And the hedge fund invest, because the hedge fund only has monthly liquidity. It can invest in some smaller cap companies. So those are the two big differences between the two products, the mutual funds out there and trying to build the performance and grow that fund. But I think of it as, it’s not distracting from managing money, it’s just two vehicles. We also manage some separate accounts for some clients. So just, it’s all investing.

Bill:

It’s symbiotic. It had to be rewarding to win the bake off. That’s a cool fun to take over. And that’s neat. I would think that it would be, I don’t know. That would be somewhat validating. I don’t know if you need it. I need validation in my life. I like to win and sometimes hear nice things about myself.

Derek Pilecki:

It’s interesting. I think the mutual fund business is dying. I’ve been involved in it for about 10 years now, running my own mutual fund for 10 years and the ETF structure is such a better tax structure that, I don’t know, mutual fund won’t die because people have unrealized gains. They won’t liquidate. They’ll just leave them out there. But I don’t think, it makes sense to start new mutual funds from here. I would not advise anybody to open a mutual fund. It’s just, they’re trying to raise money and the way the platforms make it hard to get on their platform, the cost or having to have advisors sponsor you to get on the platforms and then have to pay the platform’s money makes it very difficult, I think.

Bill:

Distribution is a hard part of this business. I would think that you would have plenty of distribution, but I don’t think that’s reality. It’s not as easy as my returns are X, put me on your platform. It’s a lot harder than that.

Derek Pilecki:

I think the mutual fund is five stars and nobody’s calling up and saying, “Hey, we need your five star fund on our platform.” They’re like, “Pay me $25,000 and we’ll think about putting you on our platform.”

Bill:

That’s wild. I was going through, I’ve gotten an annuity, which is the bane of my existence, but it’s a nice thing to, you inherit something. It’s not the end of the world, but I was looking through and it’s like the same managers are all of the options. And I just got to thinking to myself, I wonder what these guys are all paying to be the choice. It doesn’t take a whole lot of digging to see the backroom dealing or whatever that goes on with being carried. It’s crazy.

Derek Pilecki:

It is crazy.

Bill:

But the nice thing is, I think with platforms like this or podcasts, education is widespread, I think people are starting to wake up to some of it. It’ll never go away. And you’ve got to have business to business relationships. But I don’t know, some of the paying for placement rubs me the wrong way in the financial industry. It should be more pure than that.

Derek Pilecki:

[inaudible 01:01:53]. I guess the brokers get away because they’re not technically fiduciaries, but it’s serving their own interests rather than their client’s interests.

Bill:

And it’s upsetting because I talk about her sometimes. I’m not trying to throw her under the bus, but my mom, she’s like, “Oh, well this is carried by this person. They must be good.” And it’s like, “No, that’s not at all what’s going on. And also, look at the fees that they’re charging and these…” But there’s a… what is it? It’s almost like an authority bias when somebody recommends somebody else’s. It’s like, “Well, they came vetted through this person, so they must know what they’re talking about.” It’s like, “No, it’s just, a lot of it’s a grift, ma. I don’t know what to tell you.”

Derek Pilecki:

But I think, you use your mom as an example. I’m hopeful that the younger generation sees through that more. I think there’s a little more cynicism or more, “Tell me for real why this is happening.” So I’m hopeful that younger generations just see through that.

Bill:

I am somewhat too, the only thing that I am not particularly optimistic on is it requires reading the documents. And I don’t know that people love to read the docs. I don’t know, maybe ChatGPT and Bard can read the docs for people and tell people what’s really going on.

Derek Pilecki:

Yes.

Bill:

That may be a really good thing to come out of AI. Who knows? One question, I got it from a buddy, that I wanted to ask you. What is your view or how should I think about, in your opinion, some of these rent a bank type structures? Where does finance…? Is this a new phenomenon? Is this an old phenomenon happening again? What’s going on with that?

Derek Pilecki:

So rent a bank, mean banking as a service?

Bill:

Yeah.

Derek Pilecki:

People like these FinTechs using banks.

Bill:

Right. Like Chime has a bank that it uses in another state. And I’m not trying to pick on them, it’s just a structure that I see a lot of places.

Derek Pilecki:

Well, I think a lot of banks have gotten into that, thinking the whole, with 0% interest rates, they’re like, “Oh, look at all these deposits we’re going to pick up.” And I talked to a bank just last week, I talked to a bank that’s heavily into the banking as a service, and I think they have 12 programs. Three are onboarded and they’re constantly talking to new fintechs to… And they’re like, the cost of these deposits is super high.

Because the FinTechs have these contracts and they’re renegotiating the banks against each other that it’s going to turn out that these banking as a service, all these banks that are getting into it are going to not be happy with the cost of the deposits. So I think there’s a lot of growth or there’s a lot of interest amongst banks to rent out their balance sheets, but at the rates they’re going to have to pay for these deposits, it’s not going to be interesting. So I don’t know if that makes banks less interested in them, but I think the winners there will either be the consumers or the FinTechs, will capture that surplus and the banks will not be winners.

Bill:

Because it’s got to result in spread compression. Or I guess if you don’t want your spread to compress, you take more credit risk or duration risk. You got to get paid for something, right?

Derek Pilecki:

Right. Yes. I think it’s interesting. I think, it’s because the FinTechs will own the customer relationship, so they get the value. The banks, it’s a wholesale relationship for the banks, so they’re not customer facing. They’re not going to get the value. I think that’s one of, if you go, you know how we have Apple Pay now and all the banks let you put your credit card on Apple Pay and then you can use your phone to… I think that was bad on the bank’s part to just allow to sign up and say, “Hey, we want to be on Apple Pay, put your credit card on Apple Pay.”

Because I think it takes a lot of the… allows Apple to have the customer facing relationship with the customer. And so I think Apple is going to extract a lot of value away from the credit card banks on that relationship. So I think the banks just, they haven’t given away the store, but I think that they gave up too much in that scenario. And I think the same thing with these FinTech banking as a service things, the fintechs are going to capture the value.

Bill:

Well, there is no greater fox to let into the henhouse than Apple. And I hear what you’re saying. People say, “Oh, Apple Pay is so easy.” They don’t say, “Paying with Bank of America via Apple is very easy.” No one is thinking of it in that way. They’re just thinking, oh, “Apple Pay is the best.” So then if Apple gets a certain transaction volume, then they go to Bank of America and say, “Well, everybody’s using my format, so I don’t care that it’s your customer. It’s really my customer.”

Derek Pilecki:

And so Apple’s going to go to the banks and say, we want a bigger cut of the interchange fee, and the banks live on the interchange fee. So, there is a limit to that because the consumers get a lot of the interchange fee in the form of rewards or airline miles or whatever, but it makes interchange fees a lot less profitable for the banks to have Apple involved.

Bill:

And those are pretty high margin fees. That’s not like the kind of fees that you want going away, I wouldn’t think.

Derek Pilecki:

Correct. Yes

Bill:

Interesting. Well, I don’t know. What do you think, just generally, ALT managers had such a good run. What do you think that higher rates and the ability for people to find yield does to some of the, I guess, private equity and alt managers, if anything? The answer may be nothing, but just curious for your thoughts on that.

Derek Pilecki:

That’s interesting question. I think alts have this mind share amongst institutional investor where they’re like, “We can provide returns for you that are higher and with no market to market. So there’s new volatility, higher returns with less volatility.” And we know that it’s actually a more volatile asset. It’s just not marked to market. But I think there’s some consternation amongst institutional investors right now of, that they’re over exposed to alts. They’re not liquid. They gave VCs too much money. The returns on the 2020, 2021 vintage VCs are going to be severely negative.

And I think the institutional investors are going to eat that. Are they going to continue to be… I looked at some of the fundraising numbers in the last year or two for the big private equity firms, and they don’t seem to be lights out. It seems like they raise funds, they’re not upsizing funds. Maybe a few funds didn’t quite meet their fundraising targets. I do think that the private equity firms generate good returns overall, and I think that we’re just in part of the cycle where the returns, the forward returns don’t look ideal because rates have moved up so much. But I think some institutions will retain some liquidity. They’ll probably increase the allocations, the fixed income and liquid fixed income to meet their return targets and improve their liquidity. So I think there might be a little bit of air pocket for alt fundraising here, but…

Bill:

That would make sense. Almost like a short term cyclical dip in a potentially secular long. Look, if I was an allocator, I would like to get wined and dined by private equity firms. So I don’t… And it’s nice to not have to mark your book to market, as we’ve learned in the last year or two.

Derek Pilecki:

So I would say the number of IPOs and number of small companies are way down from the mid-nineties. We’re down to 3,000 or so publicly traded companies down from 5,000. A lot of that stems from the Spitzer investigations. You can’t pay research analysts for investment banking deals. So there’s not that hamper conquest or the Montgomery Securities out there, Alex Brown’s or whatever, bringing small growth companies to market. They’re just going into private equity firms or private equity funds because it’s more efficient to raise capital through private equity than it is the public markets.

And so that’s going to continue. You can’t pay for research through stock trading commissions. That business model’s gone. So firms aren’t bringing small firm… investment banks aren’t bringing small growth companies to market like they used to. And so that’s a bull case for private equity, but they’re just a more efficient capital vehicle.

Bill:

Eventually, you would think that you got to flip it to the public market once it gets to the biggest firm, I guess. You got to have some liquidity events sometime, but it seems as though they’ve been able to flip the assets to each other or extend and refi out. I don’t know. But it’s been interesting to watch. And one of those things that I’ve heard forever is going to come to a halt, but I just continues to go on, which I’m learning more and more things just tend to go on for a lot longer than people say they can.

Derek Pilecki:

For sure. For sure.

Bill:

So, look, I want to say thank you to you so much for coming on the program. It’s an honor to do a program that deserves a guest like you. And I have followed you for such a long time and I just appreciate you coming on. So thank you.

Derek Pilecki:

Thanks for having me, Bill. Really enjoyed our conversation.

Bill:

Indeed. We’ll be in touch and should you ever want to come on again, just let me know.

Derek Pilecki:

Sounds great.

Bill:

All right.

A second but higher risk opportunity is in select regional banks. Coming into March, regional banks were already at the low end of their long-term valuation range. In March, the regional bank index declined 29%, and many well-run regional banks declined more than the index. We admit there are many new negatives for regional banks in the aftermath of the Bank Crisis. Still, we think they have become too cheap and have the potential to outperform as we get clarity on the going forward business model.

 

We see four new negatives for regional banks: 1) uninsured deposits will decline unless deposit insurance limits are increased, 2) banks will operate with higher liquidity going forward, 3) deposit repricing is accelerating, and 4) regulatory uncertainty is high.

 

One of the largest surprises from the Bank Crisis of 2023 was the high level of uninsured deposits that all banks held. We believe that the concern regarding deposit haircuts at SIVB has caused anxiety among depositors across the country. Unless deposit insurance limits are raised, which looks doubtful at the moment, we think the banks will operate with lower deposit levels as uninsured depositors find more comfortable places for their cash.

 

We think the FDIC should raise the limit on deposit insurance to $1 million for consumer accounts and $5 million for commercial accounts. The $250k deposit insurance limit, put in place in 2008, has not been adjusted and is now too low. For any small to medium-sized companies, there is variability in their cash flow that prevents them from keeping bank account balances below $250k.

 

The main argument we’ve heard against raising the deposit limit is “moral hazard.” We think this is an unsound argument. Commentators use moral hazard to scare people into believing that if depositors don’t monitor a bank’s counterparty risk, then bank management will run amok and take too much risk. However, in our career, we have never heard a bank management team say, “We dialed down risk because we couldn’t get this big depositor to keep his money in the bank.” The people who scream moral hazard are putting forth the argument that depositors should be responsible for monitoring their bank’s risk management. This is the job of bank regulators. As we saw with SIVB, these bank regulators did a poor job of supervising the bank. The bank’s equity and debt holders should therefore serve as another line of defense in risk management after the regulators. We would argue that the equity holders at SIVB also did an inadequate job of forcing the bank to take less risk. We do not believe depositors should act as the risk managers for banks, and as such we are in favor of higher deposit insurance.

 

We think higher levels of deposit insurance will help regional banks retain deposits. The U.S. economy needs regional banks because they play an important role in creating credit for the economy, specifically for small and middle-sized businesses. If deposit insurance limits are not increased, then regional banks will likely have to shrink, which will reduce the availability of credit. Less credit means the economy will grow more slowly or even possibly shrink.

 

Banks are going to run with a higher level of liquidity. For a banker, there is nothing more terrifying than a liquidity scare. We will have a period of lower loan growth while bankers transition to more liquid balance sheets. Once bank balance sheets reflect higher liquidity, banks will generate lower profits due to the decline in loans as a percentage of deposits. Bank securities portfolios will be shorter in duration and more liquid and will yield less, but the banks and the banking system will be safer.

 

Deposit costs are accelerating for banks. The media focus on the Bank Crisis of March 2023 has caused bank customers to search for higher yields on their excess cash. As you know, banks were slow to raise the interest rates they paid on deposits. During the low interest rate environment of the last 15 years, bank customers had gotten used to holding excess cash in their checking accounts because searching for  higher yields was not worth their time. With money market rates approaching 5%, depositors had started to change their behavior and were looking for higher yielding places to keep their cash. The bank failures in March accelerated this phenomenon and deposit costs across the banking industry increased.

 

Our fourth headwind is the uncertainty of new capital and liquidity regulations targeted at regional banks. In the current environment we believe buybacks are off the table for the industry. With the need for capital across the Financial sector, we believe it is unlikely that bankers are going to buy back much stock in this environment even given the low equity prices. However, we have identified a few banks that are down more than 20% that have small securities portfolios, meaning they don’t have any of the mark-to-market issues that SIVB had. These select regional banks have been strong performers historically.

 

Despite these four new negative issues for banks, we believe regional bank stock prices have overshot to the downside. We estimate these four issues will cause a 10% decline in earnings, which is not bad compared to a 30% decline in stock prices. We believe the banks will be able to overcome some of these negatives with wider spreads on loans going forward. We believe we must focus on the best management teams that have shown the ability to grow while maintaining discipline on expenses.

 

Some banks we have identified include Axos Financial, United Missouri Bank, Webster Financial, and Pinnacle Financial. These banks are strong performers and don’t have the same problems that SIVB and others had with their bond portfolios. These banks have strong deposit franchises and have posted strong loan growth for many years. We believe they will be able to balance the demands of the new banking environment and post strong results.

 

We see two main opportunities in the aftermath of the Bank Crisis of March 2023: 1) non-bank financials and 2) select regional banks.

The best near-term opportunity is non-bank financials. The whole financial sector was down 10% in March. For comparison, regional banks were down 29%. Several of our favorite non-bank financials were down more than 15% despite having little in common with regional banks. These non-bank financials don’t have bank deposits and are not facing increased regulatory scrutiny.

We believe that non-bank financials declined in sympathy alongside the regional banks because some market participants were using Financials sector exchange-traded funds (“ETFs”) to hedge or short the sector. The ETF selling put pressure on all of the stocks held by the ETF whether they were regional banks or not. Also, we believe some market participants who were large holders of regional banks had to trim their overall equity exposure and reduced their positions across all Financials as a result, including non-bank financials.

We like Virtus Investment Partners and OneMain Financial. Virtus is an investment manager trading at 6x earnings with zero net debt. The company has been using their cash flow to make acquisitions of smaller investment managers and to repurchase their own stock. Virtus was down 16% in March despite their assets under management increasing in both March and in Q1. OneMain Financial is a sub-prime lender and is not a bank. The company funds its balance sheet in the capital markets and is fully-funded with mostly fixed-rate liabilities. The stock was down 15% in March and trades at 6x earnings.

We would have included Genworth Financial and Sallie Mae in this group, but as of the writing of this letter, they have fully recovered.

We think the opportunity in non-bank financials is a temporary one. This opportunity is disappearing as non-bank financials get bid to higher prices. We think this opportunity will be largely gone by the time earnings season is over as investors realize the underlying strength of these businesses.

The bank run by depositors on Silicon Valley Bank (“SIVB”) was shocking. After the bank announced an equity offering and the sale of a portfolio of mortgage-backed securities (“MBS”) on March 8^th, depositors withdrew $40 billion in a single day on March 9^th and made requests to withdraw another $100 billion on March 10^th. Since SIVB did not have enough cash to meet these depositor requests, bank regulators shut down the bank the morning of March 10^th. SIVB went from having a $16 billion stock market valuation on the afternoon of March 8^th, to getting closed and placed into FDIC receivership by the morning of March 10^th.

 

SIVB was primarily focused on the venture capital community. Venture capital investors and their portfolio companies comprised the majority of their customer base. As a result, the deposit base was much more concentrated than that of an average regional bank. An estimated 95% of SIVB’s deposits were not insured by the FDIC. When the venture capital firms decided to withdraw their deposits from SIVB, they strongly suggested to the management teams of their portfolio companies that they also withdraw their deposits. The combination of a concentrated depositor base, rapid spread of information over social media, and the easy accessibility of bank transfers on mobile phone apps led to a rapid drain on deposits from SIVB.

 

Other banks, such as Signature Bank, PacWest Bank, and Western Alliance, also focused on serving venture capital clients. Venture capital firms and their portfolio companies reduced their deposits at these banks as well, as they were worried about taking haircuts on their uninsured deposits if these banks failed. At Signature Bank, there were too many deposit withdrawal requests, which prompted the regulator to close the bank over the weekend of March 10^th. Both PacWest and Western Alliance’s stocks declined by over 60% during this time period, but they were able to meet depositors withdrawal requests.

 

We are disappointed by the demise of SIVB. We had admired the bank’s franchise for a long time. You may remember that we published our bullish investment thesis on SIVB in our April 2019 letter. We sold SIVB during the onset of the pandemic in 2020 because we thought there were better investment opportunities. We continued to track SIVB’s progress and were amazed by the strong deposit growth at the bank. We never repurchased a position because we were worried about the red-hot venture capital environment. We were short SIVB during the Fall of 2022, but we were not short SIVB during 2023.

 

We are frustrated about SIVB’s management taking unnecessary risks that ended up destroying the franchise. Because SIVB had such a great deposit franchise, the bank only made loans for about 50% of its deposits. A typical regional bank is more balanced and lends out 90% to 100% of its deposits. Additionally, SIVB should have invested its excess deposits in short-term bonds. SIVB’s management instead invested almost the entire securities portfolio in long-term agency Mortgage Backed Securities (“MBS”). As interest rates troughed during 2020 and 2021, SIVB’s management continued to reinvest the bond portfolio in lower coupon MBS. They ended 2021 with a portfolio made up almost entirely of 1.5% and 2.0% yielding loans at a time when interest rates were at multi-generational lows. When interest rates rose in 2022, the value of these long-term MBS declined by 20%, which caused the bank to be technically insolvent as far back as last September. This was evident from the bank’s Q3 earnings release. However, bank regulators did not declare SIVB insolvent last Fall because of an arcane accounting rule which allowed SIVB (and other banks) to ignore the mark-to-market losses on the portion of its bond portfolio allocated to its “Held to Maturity” account when calculating its GAAP equity and regulatory capital. Due to the flexibility allowed by this accounting treatment of ignoring mark-to-market losses, SIVB and other banks took imprudent risks and bought long-term, low yielding bonds.

 

SIVB is not the only bank to damage their franchise by buying long-term MBS with low coupons. We think Bank of America, Charles Schwab, and Zions Bancorporation have all impaired their franchises by taking on too much interest rate risk in their bond portfolios. Specifically, these banks purchased a large amount of low-coupon MBS. With the increase in interest rates, the homeowners paying on the underlying mortgages have strong incentives to stay in their homes and keep their low mortgage rates, thus extending the duration of the MBS to 10+ years. These banks will therefore have to hold onto these underearning MBS for a considerable amount of time. At the same time, short-term interest rates have risen and made bank customers much more aware of the potential to earn higher returns on their cash balances. Unsurprisingly, there has been an acceleration of customers seeking higher short-term yields. These banks may earn a negative spread by funding these low-coupon MBS with high-cost deposits and borrowings for years.

Garrett Brookes:

Good afternoon everyone, and thank you for joining us. My name’s Garrett Brooks with Slingshot Financial. Slingshot is a Colorado registered investment advisor. We also serve as a fee-based representative to institutions for specialized investment managers. And I’m very excited to have with us today our partners at Gator Capital Management. Joining me is Derek Pilecki, the founder of Gator Capital Management, the firm which he founded in 2008. He’s currently the portfolio manager for the firm’s long short equity, which is a financials focused strategy. Obviously, we’ll get more into that. But really excited to have Derek with us here today. He manages his portfolio in a variety of structures, both private and public. Slightly different fee structures for each and liquidity constraints. But the same kind of principles, philosophy drive the investment process for each.

He’s received numerous accolades over the years for top of its class or category. And I think in an environment like we’re in right now, where the easy money and the Fed tailwind is not quite in place anymore, I think you really have to think differently. You have to specialize and really understand how to pick your spots, and manage risk in order to outperform on a risk adjusted basis. And I think Gator’s strategy offers some great opportunities. So we’re going to get into that a little bit here in a second. I would say if you have any questions, go ahead and put them in the chat and we’ll answer them as they came in at the end. But to get things kicked off here. Hey, Derek, thanks for joining us.

Derek Pilecki:

Hey, Garrett, thanks for hosting the webinar.

Garrett Brookes:

Glad to. And again, glad you could be here with us. To get things started, would you mind telling us a little bit about your background, how you came to form Gator. And I guess some of the experiences along the way which have shaped your investment philosophy and process?

Derek Pilecki:

Yeah, so getting to the point of starting Gator, Gator’s going to celebrate its 15th anniversary this June. But it was a long process to get to start Gator. When I had my first finance job after college, it was working for Fannie Mae, the mortgage company. So I was in their asset liability strategy group and I was an analyst. I ran the company’s risk-based capital stress test. And back in the mid ’90s, Fannie was one of the most admired companies in the country. And it was a great learning ground to learn about the fixed income market. Fannie’s basically long mortgage backed securities and short agency notes. And they were on the cutting edge of structured notes. We’d issued structured notes and swap out at the whatever interest rate payment it was back to LIBOR minus 12 or whatever the street was offering.

And so, it was a great way to learn about the whole fixed income market. And while I was there, I was doing a lot of reading on my own about stocks in the stock market. I came across Roger Lowenstein’s biography of Buffet, The Making of an American Capitalist, and just fell in love with the idea of having a small hedge fund. But I knew in my mid ’20s, I wasn’t ready to do it. I needed to get a little bit more training. So I went on this process where I went back to business school. I went to the University of Chicago, got my MBA, and used business school as a transition period to move from fixed income into equity research. And so, I worked at a couple small value shops after business school and it really made sense for me to cover financial companies, because I had worked inside a big financial company, and knew about interest rate risk management, and the like.

So I started covering financials on the buy side and then a classmate of mine from Chicago, who had gone to Goldman Sachs Asset Management, recruited me. He called me off and was like, “Hey, our bank analyst is just retired. And we own a bunch of Fannie Mae, will you please come interview?” And so, I moved to that. The Goldman job was actually in Tampa. They had bought a manager that had been previously part of Raymond James. And so, I moved to Tampa in 2002, 20 years ago, and worked for GSAM for five years covering financials for their team. And that team managed about $25 billion in growth stocks. I was one of two financials analysts on that team. Great training ground. I would say their investment philosophy was like a Charlie Munger style, buy great by great franchises, own them forever.

And so, I had my value roots and then influenced by a manager who followed Charlie Munger. And so, in 2008, it wasn’t so fun being an analyst at an equity shop, a growth shop following credit sensitive financials. So I’m not the favorite child, so I used that as an opportunity to start Gator. And so, I launched Gator. So we started our financials long short strategy in 2008.

Garrett Brookes:

That’s great. That’s a heck of a time.

Derek Pilecki:

Yeah, it was a crazy start. Yeah, I launched 10 weeks before they short Lehman Brothers, so that was a crazy time. But there was also a ton of opportunity [inaudible 00:05:37]. So I was able to maximize.

Garrett Brookes:

Yeah, it’s certainly a good time to be able to short.

Derek Pilecki:

Yeah, but that rally in 2009 was really tough to shorten too.

Garrett Brookes:

Right. Yeah.

Derek Pilecki:

You had a view the credit markets would heal and they weren’t going to nationalize any more big banks. I was able to call the turn in ’09. And so, we just have continued to find opportunity in the financial sector since then. So one of the outcomes of the financial crisis is there’s a lot of generalist portfolio managers who don’t love financials. They lost a bunch of financials in ’08, and they kind of just ignore the sector, or they don’t really dig deep into it. And so, I was always surprised by the number of good franchises that trade at cheap valuations in my sector.

Garrett Brookes:

As just a result of less analyst coverage, less fund managers covering. And then it’s also, if I’m hearing you correctly, a fairly good amount of dispersion among the constituents in your universe. So you kind of stack opportunities there to grab some premium.

Derek Pilecki:

Yeah, I mean I always think the opportunity sets right now is as good as it’s ever been with these changing interest rates, and companies, and financials… People say, “Oh, financials are an interest rate play.” Well, not every financial company responds to interest rates the same way. You have a lender that’s making fixed rate multi-family loans, and they have hot CDs as their funding base. They’re not going to benefit from higher rates like a bank that has commercial floating rate loans, and a really strong core checking account deposit base. So I think there’s a bunch of dispersion amongst returns within my sector, which is good for a long-short manager.

Garrett Brookes:

Absolutely. Absolutely. So you formed Gator in 2008 and began with the private fund, as well as some separately managed accounts, individual portfolios. And from there then assumed management of a mutual fund, a legacy mutual fund. And this is in November of 2017.

Derek Pilecki:

Right.

Garrett Brookes:

And then over the course of a year, transitioned the portfolio to your strategy as it is now, which was complete I guess in Q1 of 2019, if I’m not mistaken.

Derek Pilecki:

Correct. So Michael Orkin retired and started our process in 2017 to identify as a successor manager. I won that process and started on an interim basis. Took it over in November, 2017. The proxy was official in February of 2018. And Michael had run the portfolio as a bear market fund that he had really protected well on the downside in the internet bubble and the financial crisis. But that’s just not my style of investing. So I agreed with the board in early 2019 to transition the portfolio to be more similar to how I run my main strategies. And so, now it reflects my investment style. And there’s heavy overlap between the mutual fund, Caldwell & Orkin Gator Capital long-short fund, and my private fund.

Garrett Brookes:

Great. And actually I just checked on Morningstar before we jumped on here, and you are top 5% for the three year, and well within the top decile for the five year amongst your peers. So there is a clear change when you institute your portfolio on the legacy fund and it really bears out.

Derek Pilecki:

Yeah, I mean I think there’s been a good opportunity over the last few years and we definitely have been able to create some value over the last five years, and looking forward to the next five years because I think there’s still a lot of opportunity out there.

Garrett Brookes:

Yeah, and I am too. So with that being said, do you mind talking a little bit about your investment process and idea generation? I know it’s a bottom up portfolio and would really like to hear your thoughts as a specialist on how you go about constructing the portfolio.

Derek Pilecki:

Yeah, so we’re looking for stocks that are misunderstood. So usually that means they have a low valuation because people are ignoring them. They have a view that they’re just dead or the earnings are going to evaporate. We take a look at the low valuation stocks is okay, if these earnings can maintain and the street changes its view of what the value of that earning stream is, then we can get a higher multiple. So a five PE stock goes to an APE stock, that’s a pretty big return. And we’re also looking for some kind of catalyst that’s going to make that change. So an example would be Genworth Financial. We bought this stock last year. We had owned Genworth from 2012-2014.

And back then, the real issue was the mortgage insurance subsidiary ,where they’re going to have to raise additional capital to fill a cap potential capital hole in mortgage insurance. And that stock played out well as it became clear that mortgage insurance was just going to be fine, housing marketing was clearly recovering. Well, the stock kind of blew up on long-term care insurance in late 2014, early 2015. Long-term care insurance is a really tough business. You’re selling policies to 60 year olds for when they potentially go in a nursing home at 85. And so, they’ve written these policies 25 years ago that people are just making claims on, and the claims were way higher than anybody expected. So they kind of went through a long period.

If you look at the stock chart from 2014 to 2022, the stock flatlined. And during that period there was an aborted attempt to buy a Chinese insurance company to acquire them. They weren’t able to get that past regulators. And so, the stock flatlined around three or $4 a share, and investors just lost interest. I mean their socks were moving all over the place and Genworth’s just sitting there.

But during this time we had been following, Genworth had been doing a good job of raising prices in their long-term care insurance business. And they also were able to get the mortgage insurance subsidiary separated from the life insurance business, and they actually did an IPO of the mortgage insurance subsidiaries now enact holdings, which 20% trades on the New York Stock Exchange and Genworth still owns an 80% stake. And so, Genworth was fixing its capital. And then on the Q4 call last year, they said, “Hey, we’re getting this cash in. We’re going to our debts get paid down to the level where we’re comfortable. We’re going to start using excess cash now to buy back stock. And we’re going to probably make an announcement on Q1 earnings.”

And stock didn’t really respond. And so, we bought a position, they announced it on Q1 earnings, stock still didn’t respond. It wasn’t until they actually started implementing the stock buyback in late 2022 that the stock started going up. So it’s an example of follow things for a long time. For a long time there was nothing to do in Genworth, but then when the catalyst came of we’re going to start the stock buyback, we took a position and move forward. So cheap stock trades for… I mean I think it trades for three times earnings now. I think there’s creating value.

There is potential that long-term care, they could salvage some value out of that business. To own the stock here, you don’t really need that. They’re probably going to spin off the mortgage insurance business. And so, just a hated stock, couple billion dollar market cap, people weren’t paying attention, and we were able to make some money in a pretty tough stock market last year. So that’s just an example of the type of things we do. I would say right now, only about 20% of the portfolio has a market cap above $10 billion. So we have a lot of small mid-cap companies in the portfolio.

Garrett Brookes:

Yeah, and that’s actually been a great spot to be so far year to date.

Derek Pilecki:

It has. And if you look at the style boxes on Morningstar, they classify us as a small cap value style box. And when I think about positioning our mutual fund in a portfolio, I mean I think it’s a replacement for small cap value. We’re not just hugging the index with a lot of unique stories within small cap land. I think small cap is a place where active management still pays it. You can extract alpha if you’re following companies. The streets pull back on research efforts as big firms have experienced outflows due to shift from active to passive that there’s less buy sign analysts on the street. So I just think that the opportunity in small caps is still robust.

Garrett Brookes:

And in the same spirit, you know came from one of the large firms, one of the gorillas really just before forming Gator, and then larger firms before that as well. Do you think that you have any additional advantage in having your own firm? And is there anything else that you’re able to do that you couldn’t do at some of the larger firms, I guess?

Derek Pilecki:

Yeah, I think large firms have resources and they have a lot of people to throw at problems. I think one of the main advantage of a small firm is the lack of bureaucracy. I mean, I don’t have my day filled with administrative meetings. I spend a large percentage of my time focused on investment research. I don’t spend the month of the July writing 360 degree reviews of 15 team members. I give feedback instantly to my small team of four. And we’re not spending hours in meetings rehashing things or trying to posture. I mean, I’m doing investment research. So I think I go through more names, I spend more time on names. And I think that’s a real advantage.

Garrett Brookes:

Yeah, absolutely. Well you mentioned just before a little bit about the profile of the mutual fund. And in the spirit of having some fun here and also disclosure, I also am an investor in Gator long-short. And so, we work together. I’m also an investor in the strategy, and I thought my style is probably not very different than some of the investment advisors on the call here, and the other folks that I talk to on a daily basis. And so, I thought it’d be fun to give you an idea of my insight and the [inaudible 00:17:17] portfolio in.

And so, I’ve always been… I’ve shared this with you and just about anybody I’ve talked with, I’m a big fan of alternative strategies. My own portfolio could best be described as a risk-based asset allocation model. I use both active and passive. I dedicate a specific allocation to alternative strategies. They’re all liquid in a public format. And in the fourth quarter of last year, preparing to rebalance for Q1 here, I had decided that I wanted to reduce my traditional exposure in favor of increasing the alternative strategies.

And so, along the way throughout last year with the increase in vol, I had basically pulled out of some of my opportunistic equity allocations, you could consider them satellites I guess. Just because the vol became unpalatable for me. And also to dovetailing on your point, I tend to favor for the foreseeable future here, small value in favor of small growth. And so, what I did was actually removed small growth beta, a small growth beta position, and with the proceeds from that combined with some of the sold out of opportunistic equity, invested in the Gator long-short strategy, and included that in my liquid alternatives allocation.

Derek Pilecki:

Yeah, I mean I think that makes a lot of sense. You remember back from the internet bubble when small growth blew up, it was years. It was like a good 10 years before small growth showed any relative performance. I mean value went on a multi-year run after the internet bubble and we could see the same thing here. You look at some of the values of small growth companies and it’s still pretty high. And so, I think that makes a lot of sense.

Garrett Brookes:

And I just think also with… Certainly we could say, you could argue that liquidity will be pulled out of the system. It’s certainly not being added as it has been for the past 10 years. And so, I think that some of the more speculative, higher flying names, large cap as well as small caps, it’s going to be a little bit tougher. And so, I think that the value space is where you’re able to really extract some excess return for the level of risk.

Derek Pilecki:

Yeah, I agree. I think that makes a lot of sense.

Garrett Brookes:

So now some of the fun parts. Where are you seeing opportunity? What do you like right now?

Derek Pilecki:

Yeah, so in the portfolio, I really like midcap banks. So there’s many mid-cap banks that are growing earnings, they’re growing loan growth. That they’re well run, I think the underwriting’s conservative, and they’re trading for six or seven times earnings. And so, last year was really interesting. Banks came out of the gate the first January, February, hey rates are going up, banks are going to outperform. They outperformed the S&P by like 12% in January and February alone. And then Russia invaded Ukraine and they gave up all that outperformance through the end of June. And then from June on they kind of tracked the broader market. So super disappointing year last year for banks, especially given that rates are higher.

But with higher rates, earnings are higher on average for banks. Not every bank but on average for banks. And so, right now we have the cheapest valuations I’ve ever seen with for banks or not ever, but going back to the mid ’90s cheap. And so, I just don’t think these mid-cap banks should trade it for six or seven times earning. And so, examples are Pac West, Western Alliance, East West Bancorp, Webster Financial. So really excited about this group of banks. And I think that there could be easily a scenario where these banks trade for 10, 11, or 12 times earnings. So going from six, seven times earnings to low double digits would get a nice return. And in the meantime they’re growing their business and low growth is attractive.

I guess the negatives that people point out is, “Oh, well there’s deposit funding, costs are ramping up.” And yes, that that’s happening, but at some point that will level off and they’ll earn their normal margin. And in the meantime they’ve compounded their growth through continuing to put up one growth in the high single low double-digit area. A tangentially to that, I really like Puerto Rico for the banking environment. So Puerto Rico is a US territory. Banks there regulated by the FDIC, they issue press releases, they attend the American banking conferences. They are US banks.

Puerto Rico only has three banks on the island. So it’s an oligopoly. And if you go back to the pre-financial crisis, there were 11 banks in Puerto Rico and it was super competitive. And so, if you look at another island banking market, Hawaii, there’s four banks in Hawaii. And each of those four banks earn wide margins, and they have high returns, and they have premium valuations. But the Puerto Rican banks trade in line to at a slight discount to US banks. So I think that we’ve already seen evidence that their margins are going up and their returns are increasing. I think it’s a matter of time before the multiples go to a premium. So really think Puerto Rico’s interesting.

I think there’s selective opportunity in asset managers. So the two groups asset managers. Alternative asset managers, private equity firms. And then traditional asset managers, they publicly traded. They manage mutual funds or vehicles that we’re familiar with. And so, I think I see opportunities in both groups. So in alternative asset managers, I really like Carlyle. Carlyle had a phenomenal 2020, 2021 as all the private equity managers did. In 2022, Carlyle took a step back. They botched their CEO transition. So the founders had appointed dual CEOs five years ago. One left to become governor of Virginia. The other one, they didn’t renew his contract, so the founders stepped back in and took over management of the company last year. And the stock got crushed because of it.

It was like the street took this view of like, “Oh, it’ll never be fixed. People will leave Carlyle without a CEO,” which is just nonsense, I think. I can think there’s investment professionals that are there at Carlyle, they’ve been there their whole lives. They’re not going to leave just because there’s a little bit in transition. Well, the new CEO finally got appointed yesterday. And he’s a former Goldman guy. I think he’ll bring some credibility to Carlyle. One of the knocks on Carlyle is they’re less profitable than the other the private equity shops. Carlyle had always managed their business where we run and operate the business on management fees. So we spend all our management fees trying to grow the business. And then we pay ourselves on the incentive fee. Well, when that was fine, when they’re privately traded partnership, but now that they’re publicly traded, and Blackstone, and KKR showing huge profitability on the management fee line item alone, Carlyle changed.

And so, they’ve shown a ton of operating leverage the last three years, that transition’s happening. I still think there’s some probably excess expenses in Carlyle’s expense base. I think the new CEO will come in and attack that and they’ll show even more operating leverage. So I really like Carlyle valuation came down to nine or 10 times fee related earnings, and then you get all the incentive income for free. So I just think that’s way too cheap. Normally people, they do some of the parts and they buy 15 or 18 times to management fees, and maybe a two or three multiple to incentive fee. So I think there’s a lot upside with Carlyle. Within the traditional asset managers, I like Vertice and I like Victory Capital. Both are acquisitive firms. They buy smaller managers, they consolidate the back office and the sales teams, they hold onto the assets they acquire, and they’re hugely creative deals.

And so, I think it’s a little bit of financial engineering. They’re able to get these small managers cheap because traditional asset managers are so out of favor because we have the shift from active to passive. But it just works in an acquisition strategy. So they both trade at six times the EBITDA. I think that’s too cheap. I think they’ll continue to make a creative acquisitions, and they’ve been smart with their capital management.

And then on the long side of the last thing that I like, is the selective life insurance companies. So I already mentioned Genworth, another one I like is Jackson National. It’s a classic spinoff type story. It was a subsidiary of Prudential UK, the British Insurance company, they decided to spin it off. Prudential UK, of course, trades in London. When they spun off the shares, the shares traded in US. So you had a bunch of UK investors all of a sudden end up with this tiny position, this unloved newly spun off US insurance company. So the valuation came on the first day of the spinoff, came out super cheap. Still trades at a cheap multiple. Management team’s been very aggressive with capital management, buying back shares, paying an attractive dividend. It’s an ugly business. Variable annuity platform is… There’s a lot of downside risk when the market goes south, but I think they’ve done a good job of managing the risk and managing their capital. So those are the ideas I like on the long side.

Garrett Brookes:

And I think you’re hammering home just how differentiated the different drivers of excess return within the financial space. Myself and other kind of macro level asset allocators, I think we tend to look at financials as a pure yield curve shape play or kind of a price momentum. And this really is kind of eye-opening that there are deeper value situations here and different ways to add some premium.

Derek Pilecki:

Yes.

Garrett Brookes:

How about… Oh, I’m sorry.

Derek Pilecki:

Oh, I was just going to say the view that you want to only buy financials when the yield curve steep, you miss all these stories. There’s a lot of stories that are not driven by interest rates.

Garrett Brookes:

Yeah. How about on the other side, the short side?

Derek Pilecki:

Well, I think the most glaring obvious thing is office. We have a problem with offices. I mean, people aren’t going to go back to work. If they go back to work, they’re not going every day. While there might be the investment bankers, and the advertising executives, and the attorneys need to be in the office, so they do their apprenticeship model. There’s a lot of people who are not going back to the office. Law firms that you should have 10 floors in midtown Manhattan, their back office people don’t need to be in-person, they’re going to work from home. They’re going to take seven floors when their lease renews.

And so, what we’ve seen is people are paying their leases when they expire, they’re going to take less space. That’s a problem for office owners. So the bull case on office rates is, oh well they trade a huge discount to NAV. Well an NAV implies private market values are real. I totally disagree with that. There’s a problem. We have too much office space in the US. It’s an acute problem in the central business districts, New York, Chicago, and San Francisco. The commutes are too long. People aren’t going to do make those commutes anymore. Excuse me.

Garrett Brookes:

Sure.

Derek Pilecki:

So I’m sure at every office street, I think it’s a huge opportunity on the short side.

Garrett Brookes:

Yeah, and that’s a great point because you do… That is what you hear. If you listen to the financial press, they’re already a discount to NAV. Well, that’s a great point. What is the NAV? And I think we’ve talked about this before and there’s just not a lot of transactions in office right now. So those are probably kind of due for markdowns, those NAVs.

Derek Pilecki:

Right.And we also see it from the bank lens. We talked to banks. Banks are starting to call out what their office exposure is, what the LTVs are, how big the portfolio is, how much is suburban versus central business district. They’re all talking about we’re not making new office loans. And when capital leaves a sector like we saw with oil and gas, when you cap service sector, stock valuations do not work. Stock prices do not work. And so, if they can’t get loans rolled over, it’s just not going to work.

Garrett Brookes:

That’s great. Thank you.

Derek Pilecki:

And I guess on the other short opportunity is there’s been a lot of new companies that have come public through SPAC or IPO over the last two or three years. And so, some of those business models are untested, some of them are flimsy. So I think a lot of them got crushed in 2022. But with this junk rally in early 2023, we’re revisiting some of those stories that we’re going to get a second bite at the apple wall. So I think that’s pretty interesting

Garrett Brookes:

That’s interesting. That’s a great point. This kind of risk on rally that we’re seeing has giving you a new entry point for the shorts.

Derek Pilecki:

Definitely.

Garrett Brookes:

Well, thank you. Thank you for the time. Like anybody has any questions here? I’m going to again open up this chat and field a couple as they came in. Looks like there’s just a couple in here. Okay. So I think what this one is getting at is, can you talk about what drives long versus short percentage or allocation in your strategy?

Derek Pilecki:

Yep. So right now the mutual fund is 90% gross long and we’re 30% gross short, so the net 60. I would say that’s pretty typical when I look back through the history of my strategies, can’t say that changing the net exposure has added a ton of alpha. Really the alpha has been from stock picking. And so, we focus on that. I would say it’s driven from a bottom up perspective of if we find more shorts, our net exposure will be less. We do not use leverage to the extent that we don’t make gross longs above a hundred percent.

So I think about this level is about what you would expect. Maybe it’ll go to 50, maybe it’ll go to 75 or 80, but in the 60 range is what I would expect the normal course would be. I think that there could be a scenario where if I got uncomfortable with underwriting in the banking system generally, where I thought that there was going to be real problem with credit losses, we could get our net exposure way down. I don’t anticipate that happening. I think everybody still has PTSD from the financial crisis and underwritings staying strong, that regulators are solo over the banks. The Dodd-Frank Bill has gotten a lot of the more risky lending outside of the banking system. And so, I don’t envision a scenario where banks will really loosen up underwriting in the near term.

Garrett Brookes:

That’s great. And you already answered the next one, which was about do you employ leverage? And so, we have one more here. This is a fun one. Do you think we will see more mergers in the asset management space?

Derek Pilecki:

I do think it’s going to be a consolidating industry. I think there’s a couple things driving it. I think there’s some headwinds with the shift from active to passive. I think we have some generational turnover, And so, people are going to be looking for exits. I think there will be continued consolidation in that space. Yes.

Garrett Brookes:

Great.

Derek Pilecki:

Yeah, we know how hard it is for small managers to get started, and consultants are really driving the market, and flows gravitate to the bigger managers. So I think there’s a real case for scale and asset management.

Garrett Brookes:

Yeah. Great. And I guess we can wrap it up here. It doesn’t look like there’s any more. Obviously, if anybody has questions, specific things that they’d like to talk about offline, feel free to reach out to me. You could also just quickly pop a message here into the chat and I’ll catch up with you at a convenient time. But any parting words here, Derek?

Derek Pilecki:

No I mean, I appreciate everybody’s attention. We’ve been running the mutual fund for five years. We’ve been running our broader strategy for 15 years. I think there’s a lot of opportunity and long short financials, especially in the small midcap area. So appreciate everybody’s time today.

Garrett Brookes:

Fantastic. And I think there’s a ton of opportunity as well. All right, everybody, thank you for joining us. And hope to talk to you again and join us for future programs here. Take care.

SCT ID#’16442915

Several preferred stock issues of different mortgage Real Estate Investment Trusts (“mREITs”) appear attractive. mREITs had a very difficult 2022 because mortgage spreads widened significantly. Mortgage spreads widened because the Federal Reserve stopped buying mortgage-backed securities (“MBS”) as part of their Quantitative Easing Program. Since mREITs own MBS on a leveraged basis, when mortgage to-Treasury spreads widen, the book value of mREITs decline. Also, higher interest rates are a headwind for mREITs and their related preferred issues.

In September 2022, mortgage spreads gapped out. Investors in mREIT preferreds became worried that the losses would cause book values to decline and possibly impair the value of the preferreds. For the preferred to be impaired, it would mean 100% of the book values were wiped out. When mREITs reported their book value declines for the September quarter, they were only down 15-20% across the industry, so no mREIT preferred issues were impaired. Since September 30th, mortgage spreads have tightened (or declined), which has been positive for book values. Now, the mREIT preferreds have more equity protecting them. But, the preferred values only marginally recovered through year-end.

Another interesting aspect of the mREIT preferreds is the market seems to be ignoring the upcoming Fixed-to-Floating resets. Most mREIT preferreds are structured with an initial 5-year fixed rate term. Then, the coupon resets to a floating rate such as the 3-month Secured Overnight Financing Rate (“SOFR”) plus a spread. On mREIT preferreds, the spread is usually around 5%. With 3-month SOFR at 4.7%, these mREITs are going to reset to a coupon around 9.7%. To me, it looks like the market is ignoring the upcoming resets. Instead, the market is pricing these mREIT preferred issues based on the yield on the fixed rate coupon because most of them are trading at a similar current yield of 9%. But, if we look at the yield after the reset, they are trading with yields between 10% and 13%. Some of the resets are within the next two years, while others are still more than 4 years away. We note that the mREIT issues that have already gone from fixed to floating trade close to their par value.

We like the total return potential on the mREIT preferred issues as they approach their fixed-to-floating reset dates.

We are short the shares of several Office REITs. We believe the demand for office space will stay very low as the workforce adjusts to hybrid working conditions. Most office leases are multi-year leases. As these leases burn off, we believe companies will demand less space. We think this presents a long-term problem for owners of office space as the demand for future office leases will be materially lower compared to pre-pandemic.

We think it’s difficult to see how much value destruction there is in the financial statements of office REITs because their tenants are still paying their current leases. But, we have leading indicators that demand destruction is taking place, such as

1. keycard swipes by workers are running about 40% occupancy per day versus 80% prepandemic,
2. the amount of office space available for sublease is quite high,
3. we have seen several office REITs cut their dividends, and
4. we are seeing some banks noting problems with office buildings in their loan portfolios.

We think there is an especially acute problem in major gateway cities such as New York City and San Francisco, as the workforce does not want to return to commuting into these central business districts. But, we do not think there is a safe place to hide for owners of office buildings.

We started a new position in Carlyle Group (“Carlyle”) during Q4. Carlyle is a name-brand private equity firm. We like the private equity business because 1) the sector is taking market share with investor portfolios, 2) the business results of private equity firms are asymmetrical in bull markets versus bear markets, and 3) the locked-up client capital is more durable than traditional investment managers.

Carlyle’s stock had a tough 2022. Private equity firms had very strong years in 2020 and 2021 as investors recognized the attractiveness of the business model. They bid up multiples to unattractive levels. Then as the bear market of 2022 unfolded, investors pulled away from the stocks of private equity firms due to the firm’s equity exposure. The high market valuations made it unattractive for private equity firms to make new investments, and, at the same time, the declining stock market made it difficult to monetize existing investments.

Carlyle underperformed the other private equity firms for a couple of reasons: 1) the company botched the CEO transition from the three company founders to the next generation, and 2) fund raising slowed after raising several large funds in 2021. Investors are understandably concerned about the botched CEO transition from several angles: 1) the firm will have trouble attracting and retaining talent, or 2) large investors will be reluctant to commit to new funds. We believe Carlyle’s founders will resolve the CEO issue in the 1st half of 2023. Once a new CEO is in place, investors should feel more comfortable buying the stock.

At its current valuation, we are buying Carlyle at about 10x fee-related earnings (“FRE”). FRE measures all costs of the company against the management fees to estimate earnings without regard to incentive or performance fees. So, even if Carlyle never earned a performance fee in the future, we’d be paying a reasonable multiple for the FRE income stream. Of course, this is simplistic because if Carlyle never earned a performance fee in the future, then the firm would never raise another fund, and the management fee stream would melt away. We fully expect Carlyle to earn performance fees in the future, but we view them as free options.

Another potential upside to Carlyle is improved operating margins. When Carlyle was privately owned, the firm’s operating model was to run the business at break-even on a management fee basis, and the partners would get paid on performance fees. As Carlyle and other private equity firms became publicly traded, it became obvious that the other PE firms were profitable on a management fee basis versus Carlyle’s model of break-even. We have two thoughts about Carlyle’s practice of running the firm breakeven on a management fee basis:

1.  Carlyle probably has a bloated cost structure as the managers thought of the management fee line item as their potential budget because they did not have to show a profit margin on that revenue, and
2. Carlyle’s valuation was handicapped when sell-side analysts began using sum-of-the-parts analysis to value the PE firms. Carlyle has moved away from operating at break-even on a management fee basis, but their operating margins are still significantly lower than their peers.

If Carlyle were to bring in an outside CEO, we believe there is an opportunity for them to improve Carlyle’s operating margin and improve its valuation. Carlyle is unique amongst its peers with its opportunity for margin expansion.

We believe the opportunity in growth regional banks remains compelling. We believe investors are missing three things by not buying regional banks at these valuations: 1) margins may widen or shrink, but they will settle down once the Federal Reserve (the “Fed”) stops raising rates, 2) loan growth is very good and is the main earnings driver over any time period greater than 2 years, and 3) loan credit quality is likely to be better than sell-side estimates for 2023 and 2024.

Bank stocks had a disappointing year in 2022. During January and February, banks outperformed the broader market. It looked like the thesis of banks benefitting from higher interest rates was going to be the story of 2022. Then, in March, the tone around bank stocks changed with the Russian invasion of Ukraine and the tougher talk from Fed Chairman Powell. Instead of banks operating in a goldilocks environment of higher rates and growing economy, investors priced in higher credit losses due to a possible recession. Also, in March, the Federal Reserve became more hawkish in response to rising inflation numbers. With the Fed rapidly raising interest rates, the positive story for banks of higher interest rates leading to wider margins shifted to rapidly increasing rates causing deposit costs to rise faster than expected.

 

Now, regional bank stock valuations are at the bottom end of the historical range. According to Stephens, the median price-to-earnings ratio (“P/E ratio”) of regional banks is less than 9x forward estimates. This is an unusually low valuation. Historically, banks have traded at this low valuation or cheaper just 5% of the time. When the banking industry has traded at this low of a valuation, the forward returns have been very strong on average. We think investors are concerned about potential credit quality issues in banks’ loan portfolios and rising deposit costs. However, we think select regional banks, such as AX, WAL, WBS, and CNOB, are attractive due to their loan growth outweighing near-term margin pressures.