One day in 1990 my entrepreneurial son, Jeff, called to advise me to open passbook savings accounts at mutual savings and loan associations. Why would I want to tie up money at 5 percent when I was earning 20 percent? Jeff answered, “How would you like a little piece of a few billion dollars of value no one owns?” I said, “Keep talking.” And he explained how it worked.
There were at that time a couple of thousand mutual savings and loan associations around the country. They began as associations formed by depositors who pooled their money, allowing the members to borrow as needed, meanwhile paying interest on their loans to those who had money in the pool. The depositors owned the association “mutually,” which meant that the business value that built up during operation was also “owned” by the depositors. As time passed, depositors came and went, but upon leaving they left their share of the business behind. No mechanism existed for extracting this value.
The giant slow-motion collapse of the US savings and loan industry, starting in the late 1970s and continuing through the 1980s, created a need for capital to buoy weakened institutions, capital to exploit the new opportunities to fill the void left by failed institutions, and capital to compete with the new larger consolidated savings and loans that were appearing.
The mutuals could raise capital only by attracting more depositors, a slow and uncertain process, but their rivals, the “stock” savings and loans, were corporations owned by shareholders. They could get more capital from the marketplace, as they needed it, by selling shares. Facing such competition, some of the more entrepreneurial managers of mutuals decided to “convert” to stock companies, and this began the process of extracting billions of dollars that no one could previously claim.
Here’s how it is done. Imagine a hypothetical mutual savings and loan, which we’ll call Magic Wand S&L, or MW, with $10 million in liquidation or book value, and net income of $1 million per year. If MW were a stock bank with one million shares outstanding, each share would have a book value of $10 and earn $1 per share, which is 10 percent of book value. Suppose that if there were such a thing as MW stock, it would, as is typical, trade at one times book value, or $10 per share.
Management decides to “convert” MW to a stock savings and loan and issue for the first time one million shares of stock at $10 per share, for proceeds of $10 million. After this initial public offering, or IPO, MW has $10 million in new cash plus the $10 million in equity previously owned by the depositors, for a new total of $20 million in equity. Each share now has a book value of $10 cash plus $10 in contributed equity, for a total of $20.
What will the new shares sell for in the marketplace? The contributed equity ought to be worth $10 based on the current market price of comparable stock S&Ls and the $10 in cash ought to be worth another $10, so once the public understands this, we expect the new stock to trade at about $20.
Buy a $20 stock for $10. Who loses? No one, but those depositors who do not purchase enough stock on the offering to capture their share of the pre-IPO equity they “owned” give up some of the gains to the others, who then are able to get more. Fortunately, the IPOs are generally structured so depositors have priority over other classes in applying for stock. Usually only one class has still higher priority. Who? You guessed it! The insiders: officers, directors, and employee stock option and benefit plans. This allows the insiders to capture some of the depositors’ value, which provides a powerful motivation for management to convert.
Suppose we had the foresight to become a depositor in Magic Wand S&L before the deadline for eligibility to participate in the IPO. Sometime after the eligibility deadline, the bank announces its intention to convert, chooses an investment banker to manage the stock offering, and gets regulatory approval. Magic Wand creates a temporary department called the conversion center, which issues a package of documents including a prospectus with the terms of the conversion and information including which groups can participate, their level of priority, and background data including the financial statements of the bank for the last few years. The stock order form in the package allows us to apply for up to 1 percent of the ten million shares offered, or ten thousand shares, at $10 a share. We wire $100,000 to the conversion center, hoping to get our full allotment of ten thousand shares but knowing from experience that anything between zero and ten thousand shares is possible. A couple of weeks later we learn that we bought nine thousand shares. We get a stock certificate in the mail and deposit it in our brokerage account. We also get a check for $10,191.78, $10,000 of which is a refund for the one thousand shares we requested but didn’t get, and $191.78 for interest earned during escrow at, in this example, 5 percent on our $100,000 while waiting fourteen days for the deal to close.
What happens to the price of our stock? It opens at $12 and over the next few weeks slowly moves up to $16, still below the $20 per share paid for comparable stocks that have traded for a while in the market.
It doesn’t quite make it to $20. Why not? First, the net cash to Magic Wand is a little less than $10 per share because the underwriters get a few percent of the proceeds, so the new book value is a little less than $20, perhaps $19.30 per share. Second, the market price of S&Ls fluctuates and the group has been a little weak lately. The price has dropped a couple of points below book value. Third, it will take management time to put the new cash to work, so earnings won’t reach $2 per share for a year or two. Even so, we made 60 percent in a few weeks.
Many of the players in this game, so-called flippers, take their profit in the first few days and move on. On the other hand, I will hold a well-managed company for months or years. If the stock continues its rise toward book value, this gives further gains. Also, waiting more than a year to sell gives a long-term capital gain, with less tax to pay.
Overall, S&L IPOs have been profitable for the buyers, but most deals aren’t as good as MW. The short-term profit has been in the 10 to 25 percent range, with a few small losses.
Services are available to help you analyze deals and avoid the poorer ones. Or you can judge them yourself.
Jeff and I each opened hundreds of savings accounts. Some of this was done by mail, but much of it had to be done in person. Whenever we went on a business trip we checked our database to see which S&Ls we should visit.
In one case, a very large S&L looked ripe for conversion so the IPO would be big. The bank required that accounts be opened in person, rather than by mail, which reduced the competition. Jeff urged my son-in-law Rich and me to fly to Dallas for the day.
When we arrived, sitting next to us also waiting to open accounts were a thirtysomething hotshot from Beverly Hills and his girlfriend. Acting obviously secretive, like an incompetent CIA agent, Mr. Sunglasses chatted us up, learned we were from out of town, and wondered if we were playing the S&L game like he, the expert, was. We acted naïve, and he importantly gave us a business card. Amused, I saved it, and, a few months later when a financial piece about me appeared in Newsweek, mailed him a copy with a note saying I enjoyed meeting him at the bank. A year later, I was $85,000 better off from spending the day in Dallas.
I visualized opening accounts as planting acorns in the hope of getting a crop of oak trees. Only these were strange acorns. They could lie dormant for months or years, perhaps forever; but once in a while, at random, a mighty tree of money would explode out of the ground. Was this “farm” worth operating?
Our hundreds of accounts took capital away from other investments. Paid low interest rates on our passbooks and certificates of deposit (CDs), we sacrificed an expected 10 to 15 percent differential to maintain our accounts. We also had expenses and the so-called opportunity cost. Fortunately, Judy McCoy in my office managed the project competently and efficiently.
The harvest from our crop of S&L accounts sometimes netted a million dollars in a year. The game has slowly wound down over the last two decades. Mutual S&Ls have converted, leaving fewer opportunities.
The gain has also diminished because more people have opened accounts, thus spreading the profits among more players. Investors also have posted larger balances in CDs, savings accounts, and checking accounts in the hope of being allocated more shares in a future conversion. Tying up more capital increases the cost to stay in the game. Our profits have been dwindling. Currently we’re keeping our old accounts but are spending less effort in trying to open new ones. Even so, a quarter of a century after we began opening accounts, 2014 was a good year.
Meanwhile, my other investments have done well. One of them is Buffett’s Berkshire Hathaway.