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Vitaliy Katsenelson
Vitaliy Katsenelson

Lloyds TSB, Still a Good bank but cautious…

May 14, 2008 | About:

My firm sold Lloyds TSB Group (NYSE:LYG) a couple of weeks ago. I still think it’s one of the best run banks in the world, but its exposure to loans underwritten by other banks made us pause and rethink our thesis.

LYG has a securitization conduit called Cancara. It uses the conduit to securitize some of the loans it generates. There’s no problem there. LYG has proven to be very conservative in its underwriting and that’s why it sports a very rare AAA rating by S&P (if it means anything anymore).

However, about two thirds of the $25 billion Cancara conduit are loans that have been generated by other banks. For a fee, LYG allowed other banks to fold their loans into Cancara and LYG basically insured those loans by its own balance sheet. Call me paranoid, but other banks have little incentive to care about the quality of the loans. Now, LYG is on the hook, not them.

This was my reasoning to sell the company I praised for a very long time. Again, there’s a good chance this may end up being nothing. We’ll monitor the performance of Cancara loans for awhile and may buy LYG back at some point in time.

Income Pie Implications

The NY Times came up with a very interesting way to look at consumer spending. In the long run, consumer spending is a function of consumer income. Though since early 2000 it did not appear to be the case as consumers financed their spending by borrowing against their future income. If you believe that consumer spending is likely to stagnate but the cost of food, healthcare and energy is likely to increase (it did in 2007), then something has got to give.

In other words the income pie is not growing; some slices are expanding at the expense of “X.” And that is the question that this NY Times diagram may help to answer: at the expense of what?

Several categories come to mind right away: new car sales - yes we will be driving older cars (maybe we should look to used car or auto parts stores). We’ll be eating out less which will likely impact the full service restaurants by a large degree. Fast food may get hurt by this trend as well but at the same time, some may chose to downgrade to fast food from full service restaurants. In regards to travel, the vacation homes and hotels are likely to be another casualty.

Plane Lessors Headed to the Desert

This article in Forbes about aircraft leasing companies names some publicly traded stocks that appear cheap: Genesis Lease (GLS), AerCap (NYSE:AER), and Aircastle (AYR). But that cheapness may be a bit deceiving.

Plane leasing looks like a great business. Despite U.S. and global economies facing a slowdown and oil prices making all time highs, demand for planes is still very strong.

However, the more I think about it, the more I realize that this business cannot escape the fate that mirrors its customers - the airlines. I could be wrong, but this business doesn’t really have a sustainable competitive advantage. It’s basically just an arbitrage business: a lessor needs to be able to borrow at a low rate than airlines and lease planes to an airlines at a rate greater or equal to what they could borrow. Airlines get to keep planes off the balance sheet, show high return on capital, but may try to renege on the lease when times get tough (many did that after 9/11).

I think this is where things get dicey. A global slowdown and a recession will do what it does every time: send airlines in a place so frequently visited by them - bankruptcy. They’ll renege on the leases and leasing companies will get their planes back. But unless they decided to start flying those planes themselves, demand will not be there. Planes will make their usual pilgrimage to the desert.

About the author:

Vitaliy Katsenelson
Charlie Tian, Ph.D. - Founder of GuruFocus. You can now order his book Invest Like a Guru on Amazon.

Rating: 3.6/5 (10 votes)


David Pinsen
David Pinsen - 9 years ago    Report SPAM
Thanks for the thought-provoking column, Vitaliy. I hadn't thought of aircraft leasing as a form of arbitrage, but your explanation of it that way makes sense. One note about Aircastle: The group Peter Briger headed at Goldman Sachs, before he joined Fortress, was buying airplanes after 9/11, so presumably he remembers the pilgrimage to the desert.

The NY Times inflation graphic is great too. Thanks for linking to it.
Brinsley premium member - 1 year ago

The Cancara conduit is just shy of 50% of the market cap of LYG.

To what extent does LYG remain responsible for the loans it securitises into the Cancara conduit once the loans are sold on. To what extent is LYG responsible for the loans it puts in from other banks. These liabilities are governed by the covenant which is contained in the securitisation instrument.

You have made a strong assertion. Can you give more detail on the covenant?

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