Portfolio manager’s Letter April 2010
Buffett had this to say about Berkadia in the Chairman’s Letter: “At the end of 2009, we became a 50% owner of Berkadia Commercial Mortgage (formerly known as Capmark), the country’s third-largest servicer of commercial mortgages. In addition to servicing a $235 billion portfolio, the Berkadia is an important originator of mortgages, having 25 offices spread around the country. Though commercial real estate will face major problems in the next few years, long-term opportunities for Berkadia are significant”.
“Our partner in this operation is Leucadia National Corporation, run by Joe Steinberg and Ian Cumming, with whom we had a terrific experience some years back when Berkshire Hathaway joined with them to purchase Finova, a troubled finance business. In resolving that situation, Joe and Ian did far more than their share of the work, an arrangement I always encourage. Naturally, I was delighted when they called me to partner again in the Capmark purchase. Our first venture was also christened Berkadia. So let’s call this one Son of Berkadia. Someday I’ll be writing you about Grandson of Berkadia”.
Before its Bankruptcy, Capmark’s best year was 2007 when they earned $280 million. In 2008 Berkadia lost $1.3 billion on bad commercial real estate loans. Then in 2009 Berkadia filed for bankruptcy. So 50% of this business is not going to be a huge deal for Berkshire Hathaway. But for Leucadia it might be a different story. After a bad year in 2008 Leucadia had a decent year in 2009 and earned $550 million. That puts Leucadia at about 12 time’s last twelve months earnings and 1.4 times book value and perhaps in a position where Berkadia might be able to move their needle.
There is much more detailed information on Berkadia in Leucadia’s 2009 10K. Leucadia’s 10k: “In December 2009, Berkadia, a joint venture between Berkshire Hathaway and the Leucadia, acquired the North American commercial mortgage origination and servicing business of Capmark. The Leucadia and Berkshire Hathaway each have a 50% equity interest in Berkadia, and each party contributed $217,200,000 of equity capital to fund the acquisition.
In addition, a subsidiary of Berkshire Hathaway provided Berkadia with a five-year, $1 billion secured credit facility, which was used to purchase outstanding mortgage loans and servicer advances from Capmark. The credit facility may be used to fund mortgage loans and servicer advances, to purchase mortgage servicing rights and for working capital needs. The Leucadia has guaranteed Berkadia’s repayment of 50% of the credit facility when due”.
“Berkadia acquired the commercial mortgage origination and servicing business from Capmark pursuant to an Asset Put Agreement (“APA”) entered into between Berkadia and certain Capmark entities in September 2009. Capmark paid Berkadia $40,000,000 for the right to require Berkadia to purchase the commercial mortgage origination and mortgage servicing business pursuant to the terms of the APA. Capmark subsequently filed for bankruptcy protection under chapter 11 of title 11 of the United States Bankruptcy Code and exercised the put option.
Although there were other parties interested in purchasing portions of the commercial mortgage origination and servicing business, Berkadia’s offer was the only offer for the entire business, which eliminated Capmark’s risk of disposing of the remaining business. In addition, Berkadia’s offer included a provision to hire the Capmark employees operating the business, thereby saving Capmark material employment related expenses”.
“The Leucadia accounts for Berkadia as an investment in an associated company and applies the equity method of accounting. Berkadia applied the acquisition method to account for the purchase of the commercial mortgage origination and servicing business and recorded the assets and liabilities acquired at fair value, which were principally mortgage servicing rights, mortgage loans and servicer advances. The fair values of the net assets acquired exceeded the amount paid, principally due to the amount received as a put premium and the reasons identified above.
This excess is treated as a bargain purchase that is recognized as a gain on the date of acquisition and included in Berkadia’s results of operations. For the period ended December 31, 2009, the Leucadia recorded income from Berkadia of $20,800,000 under the equity method of accounting, of which $24,400,000 represented the Leucadia’s share of the bargain purchase. At December 31, 2009, the carrying amount of the Company’s investment in Berkadia was $240,000,000″.
“The commercial mortgage servicing business provides primary, master and special servicing activities for commercial mortgage-backed securities (“CMBS”). In addition, Berkadia carries out servicing activities on a contracted basis for third parties such as insurance companies, banks and other financial institutions. Berkadia is an approved servicer of loans for Fannie Mae, Freddie Mac, Ginnie Mae and the FHA, and is one of the largest services of commercial real estate loans in the U.S. As of December 31, 2009, Berkadia had a servicing portfolio of approximately 33,000 loans with an unpaid principal balance of $236.7 billion summarized as follows (dollars in thousands):
|Number of Loans
|Unpaid Principal Balance
|Special serviced (*)
* Represents loans where Berkadia provides special servicing only. Berkadia is also the named special servicer on $27.6billion of loans for which it also acts as the primary or master servicer”.
“A primary servicer of a loan is the primary contact with the borrower and is generally responsible for carrying out all cash management functions relating to the loan, including providing monthly billing statements to the borrower and collecting and applying payments on the loan; administering reserve and escrow funds for repairs, tenant improvements, taxes and insurance; obtaining and analyzing operating and financial statements of the borrower and performing periodic property inspections; preparing and providing periodic reports and remittances to the master servicer or other designated persons; administering lien filings; and other specified functions”.
“A master servicer is responsible for administration of a pool of loans that is transferred to a trust or other special purpose entity in connection with a securitization transaction pursuant to a pooling and servicing agreement. A master servicer is responsible for ensuring that primary servicers act in a diligent manner when carrying out their collection and administration activities, and is also required to handle all remittance and reporting activities required by the pooling and servicing agreement. While some master servicer functions may be sub-contracted and performed by a primary servicer, as a master servicer Berkadia is ultimately responsible for the performance of any functions that have been sub-contracted to a primary servicer”.
“Master servicers are generally required to advance funds to cover any delinquent payments on the securitized loans and any taxes and insurance premiums not covered by borrowers’ escrow funds if it is determined that the advances will be recoverable in the future. These “servicing advances,” along with accrued interest, are treated as having priority over the rights of other investors in the securitization. In certain circumstances, Berkadia may have similar obligations to advance funds in connection with loans under which it is a primary servicer.”
The relative size of the comment in Leucadia’s 10K may indeed be a reflection of the relative importance of the joint venture to the two partners (Berkshire Hathaway said nothing about Berkadia in its 10K, limiting its comment on the venture to Buffett’s two paragraphs in his chairman’s letter). But, as Buffett says, “long-term opportunities for Berkadia are significant”. Still, it stands to reason that those opportunities would be a good deal more significant for Leucadia, with its $6 billion market cap, than for Berkshire, with its $202 billion.
Leucadia is a strange duck with a lot of moving parts. It is not easy to understand. Indeed, one gets the impression that its opaque nature is carefully cultivated by Cumming and Steinberg. While definitely deep value investors, they share none of Buffett’s compulsion to educate investors. GAAP accounting standards, when applied to Leucadia, are not at all helpful.
Unlike Buffett, Cumming and Steinberg like to buy and sell, so the Leucadia’s earnings are often distorted by long term gains and also by mark to market adjustments on some of their equity holdings. Even more than with Berkshire Hathaway, these mark to market adjustments, rather than contributing to transparency, distort the Leucadia’s earnings reports to the point that they become almost meaningless.
The advent of Berkadia and the fact that Leucadia remains undervalued gives us an excuse to have another look at the stock. To this end we have attached two tables: “Look-through Earnings” (which lists the income of Leucadia investees not included in Leucadia’s income statement) and “Valuing the Pieces” (which is an attempt to list all of the company’s different interests and to place some value on each piece). Market value was used for all of the interests that are publicly traded. Where there were no public trading values, figures were taken from Leucadia’s 10K, if found there. Otherwise, the original cost was used.
Cumming and Steinberg took over Leucadia in 1979 so their record it is about 15 years short of Buffett’s at Berkshire Hathaway. Since 1979 they have increased the Leucadia’s net asset value at an annual rate of 19%, and its market value at 21%. For the last ten years Leucadia’s performance has even been a little better than Berkshire Hathaway’s. With its $6 billion in market value today Leucadia is about were Berkshire Hathaway was in 1988.
While Leucadia may be a compliment to Berkshire Hathaway in a portfolio it is certainly no substitute. Leucadia has a very different investment philosophy. Leucadia will invest in startup iron ore mines (Fortescue Metals Group) in drug companies with no earnings (Sangart), or storm damaged Casinos (Hard Rock Biloxi) if the price is right.
Like Berkshire Hathaway, Leucadia widely diversified conglomerate and together these two companies offer the investor a lot of diversification both in approach and holdings. Leucadia is still well below its 2007 high of $57 but is no fifty cent dollar, so if you buy at today’s price you are paying a premium for its management, however the premium you are paying for this management is probably not as large as the premium you paid for Buffett if you bought Berkshire Hathaway in 1988.