The magnitude of the problem – here is a link to the Eleventh Periodic Mortgage Fraud Case Report, addressed to the Mortgage Bankers Association. According to this document, losses for 2008 will be between 15 and 25 billion. Of course, readers have become inured to big numbers: a billion is now chump change, we need to talk in trillions when addressing the magnitude of our financial woes. That apparent imbalance will be addressed later in this article, when discussing the multiplier effect of mortgage fraud.

Insurance Company Evidence – Insurance against mortgage default has been issued in a number of different forms. Mortgage insurance companies, such as MGIC (MTG), Radian (RDN) and PMI (PMI) insure individual mortgages against default, and in addition have done bulk transactions. Financial Guarantors have written insurance, often in the form of CDS, on RMBS and CDOs containing RMBS.

As losses have accumulated, mortgage insurers have investigated the underlying transactions, finding fraud at a rate that I estimate at 15-20% of all insured mortgage loans. They rescind coverage when they find evidence of fraud.

Here is a slide from Radian's Quarterly Presentation.

Structured Finance – not surprisingly, the worst of this material found its way into structured finance. Indeed, the apparent ability to pass the inevitable losses on to an endless stream of naïve investors has enabled this trend toward fraudulent transactions to continue far longer than it would have otherwise. MBIA (MBI) insured many of these transactions, and has been active in litigating against fraud. Here is an excerpt from a recent suit against Credit Suisse:

After reading a number of similar complaints, as well as listening to conference calls from MBIA and Ambac (ABK), I form the impression that about 25% of all underlying collateral in private label securitizations was created by fraudulent transactions.

Inadequate interest rates - interest rates around 5% are entirely inadequate to compensate for fraud at a rate somewhere between 15 and 25%. Efforts to restore the housing sector under these conditions are not going to be effective. They will simply compound the problem.

Multiplier Effect – Economists who advocate juicing the economy with fiscal stimulus frequently cite a multiplier effect: every dollar spent by government creates X dollars spent by the private sector. There is a similar multiplier for mortgage fraud: a dollar of mortgage fraud creates many times that amount of loss to the economy.

Property values would never have become so inflated if the spending power fueled by the ability to secure mortgages by fraud had not propelled them upwards. Nor would they have plunged so rapidly if the inevitable foreclosures had not glutted the market with distress sales.

Synthetic securities exacerbated the problem. Not content with creating toxic waste, the investment banks went on to duplicate it, as if by using a photocopy machine to create bogus bonds. Briefly, CDS referencing subprime RMBS were bundled together in synthetic CDOs. CDS are in point of fact insurance transactions, and should be regulated as such, with a requirement of insurable interest on the part of the buyer. Otherwise, problems arise with moral hazard, similar to permitting an arsonist to buy fire insurance on his neighbors house.

Synthetic CDOs in effect were collections of insurance policies that were not backed by insurable interest, and were instead designed and contrived to duplicate losses for the benefit of those who held the CDS protection.

I estimate the multiplier effect at 7X, just like the ratio of the tip of the iceberg to what lies underwater. And mortgage fraud is the iceberg that will sink the Titanic. In point of fact the US economy is listing badly and may still be shipping water.

Futile Fulminations – the American character has become corrupt. The moral backbone of the country has turned to jelly. Anything goes, there is no more right or wrong, the dollar is the only measure of success in life.

Indeed, the meaning of any man's life lies in his accumulated wealth. Here is a success story: “ A man was born. He lied, cheated and stole until he accumulated a fortune. After he died, others enjoyed the fruits of all that he had done. The end.” Here is a story of failure: “A man was born. He didn't have enough street smarts and the fruits of all his labor were enjoyed by those who lied to him, stole from him, and cheated him. He died in poverty. The end.”

A society that is not built on a foundation of mutual trust has no cohesion: when the ship sinks, it's every rat for himself.

Pragmatic solutions – Unless we wish to continue to outdo Nigeria as the home of fraudulent enterprise, laws will need to be passed and enforced.

The normal lying that goes with commerce in residential real estate - exaggerating your income so you can buy a bigger house, mis-stating intended occupancy so you can control a house long enough to flip it, filling out the application with answers the applicant would not have given if asked, inflating an appraisal so the transaction can go through, holding your nose while you package the stuff into a bogus bond - will have to be punished by jail time.

It would do something for the economy: those who are jailed can't hold jobs, making employment available for those who are unconfined and unemployed. Some could become teachers, instructing the public in the consequences of formerly acceptable but now illegal behaviors. Off course, many prisons would need to be constructed. Perhaps they could be designed for dual functionality, the buildings could be used for educational institutions to promote the acquisition of marketable skills in a new world. And prison personnel would be in high demand. Supervising a bunch of white collar criminals would not be anywhere near as dangerous as regular prison work.

Best of all, when mortgage fraud is contained, the multiplier effect will stop destroying wealth.

Life Insurance issues – as mentioned in my article on Metropolitan (MET), life insurers have become somewhat suspect due to their exposure to MBS, CMBS, CRE, and exposures to the equity markets due to guarantees included in their variable annuity products. As the economic outlook has become clearer and somewhat more favorable, these companies have started to revert toward their normal valuation metrics. The question would be, how far will this process go?

Valuation – using a projected 5 year average EPS, working off 3&3/4 years actual and 1&1/4 projected I get 4.34 X 19.5 = 85 as a midpoint target based on historical ratios. I used S&P's estimate of 5.55 EPS for 2010: my own would have somewhat higher.

Working off book value is a little more difficult. Readers know that I am a fan of nonGAAP metrics for financials, basically taking the view that mark to market losses have been exaggerated and will tend to revert toward amortized cost over time. Like others in the industry, PRU provides a nonGAAP Book Value excluding Accumulated Other Comprehensive Income (Loss). BV ex AOCI stood at 47.46 per share at the end of the last quarter, to which I added 4.33, relying on the company's estimates of the value of the Wachovia lookback. The sale shows these estimates were accurate.

Using BV ex AOCI as adjusted, I get 52.09 X 1.16 = 60 as a midpoint target based on historical ratios.

From 60 to 85 is quite a difference between the two metrics. If earnings are high enough to suggest that PRU should be valued higher than 1.20 X BV ex AOCI, it is probably because they are chasing yield, saving money on hedging, or otherwise increasing the amount of risk assumed in order to increase earnings.

My guess is that PRU will head toward 85 as conditions improve and memory fades. However, it might be a good idea to start reducing exposure if and when it gets up over 60.

Facts and Figures – the company held an investor's day on 12/10/09, and the slide show was filed on an 8-K with the SEC. It's a long one, with a lot of factual information. My impression was favorable: I believe the issues PRU has in common with its competitors have been clarified and dealt with sufficient to make risk/reward attractive at today's prices.

Outlook – conditions going forward should be favorable for life insurers due to 1) the demographics of the baby boomers creating demand for retirement products and 2) the demand for insurance from new middle classes in emerging markets.

Strategy – PRU sports a beta of 2.6. Implied volatility stands at 39.7%, while historical volatility clocks in at 110.6%. The market's perception of the risk involved seems to be decreasing. Implied volatility is sufficient to make selling calls attractive, suggesting a covered call strategy. Suspecting that PRU would dive if the market tanks, the Jan11 40 calls make sense to me as a substitute for owning the shares. The thinking is, with a 52 week low of 10.63, it is very convenient to be able to limit downside risk.

Disclosure – net long PRU and MET, no position WFC

...the company anticipates sales of $24.5 billion to $25.5 billion, with organic sales volumes growing 5 to 7 percent and currency effects adding 2 to 3 percent to sales for the year. 3M also expects that 2010 earnings will be between $4.85 and $5.00 per share. 2009 earnings per share are expected to be between $4.30 to $4.35 per share, or $4.50 to $4.55 per share excluding special items. Refer to 3M's October 22, 2009 press release for a complete list and explanation of special items for the first nine months of 2009.

Organic Sales Growth - market response has been unenthusiastic, with the stock trading down by 2% to as low as 76.00 in early trading. This is another case where Mr. Market is missing the point. The point is, organic sales volumes are projected to grow 5 to 7 percent. With all the complaints that companies have been growing profits at the expense of revenue, it is good to see a company that believes they can actually sell more product.

Margins - an issue that needs to be kept in perspective. In 2006 and 2007, 3M reported net income as a percent of revenue at 16.7% and 16.8% respectively, very high by any standard. I estimate that figure at 13.2% for 2009, while the guidance implies 13.9% for 2010. If management meets guidance, they will have increased organic sales while increasing margin, a commendable accomplishment under today's economic conditions.

Valuation – using projected 5 year average EPS, consisting of 3&3/4 years actual plus guidance through 2010, I get 4.97. Over the past 7 years MMM has typically traded around a midpoint of 20 on this metric, while it is currently priced at about 15 X. Looking forward to a year of improving margins and organic growth, there is no reason why the company should not revert to its historical valuation, suggesting a target price of 99.

Opportunity in Blue Chips - The easy money has been made on small tech and beaten down value strategies. Going forward, with interest rates low and business conditions uncertain, large, well-capitalized and relatively steady performers will command a premium. There is a steady drumbeat of recommendations for companies such as JNJ, PG, UTX, KO etc. MMM has been coming up on these lists and deserves the same consideration.

Equity market risk - In common with competitors Prudential (PRU) and Hartford Financial Group (HIG), MET has an exposure to the equity markets arising from guarantees provided on variable annuities. When the markets tanked, the sector was hammered. MET hit a 52 week low of 11.37, very nearly 70% below where it is trading today. Life insurers deal with these exposures by hedging: however, that can be expensive and from time to time hedges go awry, resulting in unexpected losses. In the wake of the difficulties, the companies are reducing the scope of the guarantees offered.

MET carries a beta of 1.9. suggesting it will move a lot faster than the S&P 500 in either direction. So, given the equity exposure created by the variable annuity guarantees, this stock is only suitable for those who have an optimistic view of the progress of the S&P 500. Historical volatility stands at 97.0%, vs. implied volatility of 40.1%. The market does not expect that MET will be as volatile in the future as it has been in the past.

Residential and commercial mortgage risk – insurance companies invest heavily in bonds, to include RMBS and CMBS. In addition, they frequently have exposure to CRE. These exposures are reflected in large mark to market losses, with much ongoing debate as to the extent to which these will eventually revert to amortized values. To get a handle on this risk, it is helpful to compare Book Value excluding All Other Comprehensive Income (BvexAOCI) to GAAP. Most insurance companies. provide this information in quarterly supplements on their websites.

 

GAAP book value has been increasing, and a continuation of the meet in the middle process would result in a book value of 40 to 41 by both metrics. The mark to market values were an over-reaction that has been correcting over time. But the process could reverse if the economic recovery is not as strong as expected.

Valuation – Applying a P/E of twelve to midpoint guidance, I get 4.20 X 12 = 50. Applying a P/B of 1.20 to a meet in the middle book value I get 49. This target could be met by the end of next year, implying a very nice 30% price appreciation. If MET were to revert to historical valuations based on 5 year average EPS a price in the 60-80 range would result. When things are going good, how quickly we forget.

Positives – demographics in the US suggests strength in retirement products. Baby Boomers, badly burned in the stock market, will be attracted to the security of such guarantees as the Life Insurance Industry can safely grant. International/emerging markets constitute a growth opportunity as new middle classes become a market for financial security products.

Strategy – selecting an entry point depends on the investor's view of the trajectory of the S&P 500 and the housing and CRE crises. Possibly the market will defer the long overdue correction until the 1^st quarter of the new year, in which case the cautious investor can look at another quarter's earnings and guidance before making a commitment.

The use of LEAPs, the Jan11 25 or 30 calls, as a substitute for owning the stocks makes sense to me in this case. The thinking is, if the market tanks the downside risk is limited by the strike. Also, if implied volatility spikes, very likely in a difficult market, the increase of time value will provide some downside protection. The sale of out of the money calls, with shorter expirations, can be used very similar to writing covered calls, for income or as a way of funding the time cost of maintaining the LEAPs position.

At the time, with the S&P at 950, Corporate Profits suggested that a more normal level for the index would be 1,200. As the situation developed, the S&P has since made substantial progress closing the gap. Today's revision of GDP updates Corporate Profits through the end of the 3^rd quarter, and it is now possible to develop a revised target or normal level for the S&P based on the new information.

Here are updates of two charts: the first plots the two sets of data over time; the second is a scatter chart which derives a formula for the S&P as a function of Corporate Profits.

The Magic Number - Corporate Profits came in at $1,356 billion, up a startling 14.5% for the quarter. Applying the formula from the chart, I get 1,356 X .80 = 1,084 + 181 = 1,265, round to 1,250. From yesterday's close of 1,106, this implies a further increase of 13%. Under this scenario, equities are still an attractive investment, although the 30% that was out there in July has mostly been realized and from here the risk/reward ratio is less attractive.

Refinements – this approach has the advantage of simplicity. In an effort to improve predictive power, it is possible to introduce other variables into the equation. Interest rates and unemployment are two primary concerns: the first can be related on a mathematical basis, the second is more of a judgment item.

Interest Rates – for purposes of comparing equity earnings yields to bond yields, I am using the Moody's Baa corporate bond rate, available daily or weekly from the Federal Reserve. This number displays a strong inverse correlation with the S&P. As you might expect, consideration of current interest rate levels suggests a higher target. After fiddling with the numbers a while, I get a target value of 1,321, round to 1,300.

Unemployment – Also displays an inverse correlation with the S&P. The period of time used does not include any episode of high unemployment comparable to what we have today. Developing a formula that accounts for both interest rates and unemployment, and that tracks history acceptably, I get an indication of 1,035, round to 1,050. The question here is about unemployment as a trailing indicator, vs. the intuitive view that the economy cannot recover without an increase in employment.

Corporate Profits increased 14.5%, in spite of the unemployment. Or perhaps because of the unemployment. If you fire people faster than your business declines, profits will increase. My feeling is that corporations have become much quicker to lay off in the face of slowdowns, or even when business conditions are acceptable but higher profits are desired. The attitude of management is, let them sleep under bridges, we are going to make a profit. It seems to be working, and I am unable to rule it out as a possible ongoing trend.

The jobs may reappear in China, elsewhere in Asia, or in other low cost areas. Outsourcing or EMS may be beneficiaries as well. American citizens may take back jobs that were relegated to more willing workers, illegal immigrants.

Public policies aimed at creating employment may have some success when developed and implemented. Incentives to make capex in America, I mean building factories here and installing state of the art machinery here, attractive would be a big help. American public policy is a patchwork, with the states bidding against each other in an effort to attract business investments, and no uniform and coherent policy to ensure that this is done most effectively to maximize employment for the nation as a whole.

The US has a more than adequate supply of housing and the last time I saw figures on it there were more registered vehicles than licensed drivers. Excessively lenient credit policies drew several years worth of demand forward and it is not realistic to look for a strong rebound in employment until consumer deleveraging and supply absorption have run their course.

Conclusion – after putting this through the blender, I plan to invest along lines that will be profitable if the S&P ranges from 1,050 to 1,250 by the end of 2010. I will continue to monitor Corporate Profits and revise my thinking based on developments.
 
Disclosure - no positions mentioned, the author is net long equities

From “The Intelligent Investor,” here is a brief discussion:
 

...here we found – contrary to our investment philosophy – that companies that combined major size with a large good-will component in their market price did very well as a whole in the 2 1/2-year holding period. (By “goodwill component” we mean the part of the price that exceeds the book value.) Our list of “good-will giants” was made up of 30 issues, each of which has a good-will component of of over a billion dollars...the group...acquitted itself best among the 20-odd lists studied.
 

As used in this passage, by goodwill he did not mean the accounting residue that accumulates from serial acquisitions, all too often lingering until a downturn in the fortunes of the business results in large write-downs. What he was looking at was something else that is not on the balance sheet, the intangible strength that lets Coca-Cola (KO) profit hugely from carbonated water loaded with high fructose corn syrup. Or that makes Proctor & Gamble's (PG) soaps an endless source of profit. It's a powerful combination of brand strength and well-earned consumer trust, the accumulated benefit of years of successful marketing and product development.

Warren Buffett was trained by Graham and has developed his own principles. His picks frequently reflect a preference for goodwill giants, such as KO and PG which are fixtures of his portfolio. Also owned by Buffett is Nike (NKE) famous for athletic footwear. The company has a history of making fine profits from selling sneakers, endorsed by an endless series of high profile athletes. I have been long Nike since August this year, when I added it to my portfolio while restructuring to more conservative type stocks. The position has performed beyond my expectations, and now I am beginning to suspect that Nike too is a goodwill giant.

Five Metrics – based on Wednesday's closing price of 63.64
 

Valuation – my methods include a consideration of 5 year average EPS, typically consisting of 4 years history and one year of projections. My current estimate is 3.27. While I am usually looking to pay less than 15X on this metric, I have noticed that some of the best quality companies trade around an average of 20 X, with the high around 30 and the low seldom going to less than 15. In the case of Nike, the stock never went below a multiple of 17 on 5 year average EPS from 2004 to 2008. Of course during the March meltdown it briefly reached a multiple of under 12, but is now trading around 64 it is back up in the area of 20 X on my preferred metric.
 

Growth stalled due to the economic downturn and financial meltdown, and I estimate going forward they can grow at 7%, supporting a price in the 65 area. However, if growth were to get back to the 9% level the company achieved in the past, a price around 75 would be in order.
 

Strategy – from the 10-K:

Our goal is to deliver value to our shareholders by building a profitable global portfolio of branded footwear, apparel, equipment and accessories businesses. Our strategy is to achieve long-term revenue growth by creating innovative, “must have” products; building deep personal consumer connections with our brands; and delivering compelling retail presentation and experiences.

...Since the adoption of this long-term strategy in 2001, on an annual compounded basis, NIKE, Inc.’s revenues and earnings per share have grown 9% and 14%, respectively.

R&D – again from the 10-K:

We believe our research and development efforts are a key factor in our past and future success. Technical innovation in the design of footwear, apparel, and athletic equipment receive continued emphasis as NIKE strives to produce products that help to reduce injury, enhance athletic performance and maximize comfort.

In addition to NIKE’s own staff of specialists in the areas of biomechanics, chemistry, exercise physiology, engineering, industrial design and related fields, we also utilize research committees and advisory boards made up of athletes, coaches, trainers, equipment managers, orthopedists, podiatrists and other experts who consult with us and review designs, materials and concepts for product improvement. Employee athletes, athletes engaged under sports marketing contracts and other athletes wear-test and evaluate products during the design and development process

Endorsements – the company has many well-known athletes and teams under contract. Their endorsement contractual obligations are 711 million for 2010 and extend out well into the future, totaling over 4 billion. These amounts are not reflected on the balance sheet. Based on past performance, the sums expended for these purposes have been well spent.

The amounts involved are large and the investor needs to develop an opinion as to how effective these contractual future expenditures will be in promoting revenue growth.

Entrepreneurial Accounting Analysis – In situations where the investor suspects that R&D or advertising may be creating value, it may be helpful to consider some of these expenses as investments, in effect looking at them as going to the balance sheet. The thinking would be, if R&D and/or advertising/endorsements are contributing to future sales then they should be capitalized and amortized over the periods where the resulting revenue is realized. This is not according to GAAP but can be useful in developing an appreciation of how and why a company makes money.

Demand creation expense, consisting of advertising and promotions and including endorsement contracts, came to 12.26% of revenues in fiscal 2009.

This is what Graham was seeing in the results for “goodwill giants.” Of course the invisible asset can be tarnished, witness Coca Cola's difficulties with the revised formula and return to “Classic Coke.” But if properly nurtured, the out-performance and competitive advantage can last a very long time.

Dividend and Share Repurchase – Nike pays a dividend of .25 quarterly, currently yielding 1.55%, and has a 5 billion share repurchase plan in place. Share counts have decreased in recent years, and dividends have been increased from time to time. Average repurchase price based on the 2009 10-K was 54.87 per share, well under the current price. Long term debt is trivial. The largest constituent of shareholder's equity is retained earnings.

Investment implications – Nike is a good long-term holding for conservative, dividend growth type investors. Possibly it is a good will giant, along the lines suggested by Ben Graham.

Disclosure - net long NKE and PG, no position in KO