The Business Brew: Derek Pilecki – A Financials Specialist

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.