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The letter continued, “Through such practices, Allied has presented to the public a completely inaccurate view of the strength of the company and its investment portfolio. This fraud allows Allied to grow continually—as its most recent stock offerings demonstrate.” Since my speech in May 2002, Allied had raised about $470 million from issuing roughly 22 million shares, or 20 percent of the company.

I concluded the letter by urging the SEC to be more aggressive toward Allied: “Allowing Allied to persist in this behavior is fundamentally unfair both to investors and to competing investment companies that keep honest books and fully disclose negative information concerning their investments. We request that you investigate Allied’s practices and take appropriate action promptly and publicly to correct Allied’s misleading disclosures and overstated financials.”

Then, like always, we waited. While we were waiting, Allied announced that BLX had a bad third quarter in terms of loan originations and profits. For the quarter, BLX’s origination volumes declined 21 percent and earnings before interest, taxes and management fees fell 53 percent to only $6 million, compared to $12.9 million the previous year. On the conference call announcing the results on October 28, 2003, Allied management began by trumpeting that BLX obtained PLP status from the SBA in all markets, including Puerto Rico and Guam, before explaining that, to improve its securitization execution, it needed to diversify its industry concentration. It appears BLX’s loans were too concentrated in gas stations and motels. This “strategic shift” to reduce the overconcentrations caused the decline in origination volumes and profits. Management thought the problem would persist as the “diversification efforts will take some time.” Notwithstanding this obvious bad news that the company admitted would persist for a while, Allied further expanded the enterprise valuation of BLX from $465 million to $476 million.

These were important numbers. As discussed in Chapter 12, Allied’s initial description of how it valued BLX was absurd. Now, with Allied’s announcement of the enterprise value, we could compare that old valuation of BLX to this new, even more fanciful one.

As Table 20.2 on page 190 shows, originations and operating profit before management fees (EBITM) had fallen over a full year. BLX incurred more bank debt. Even so, Allied dramatically increased the valuation of its own investment. The valuation multiples, which we believed to be unreasonable a year earlier, expanded dramatically. Allied’s expansion of BLX’s multiples, even as the results deteriorated, reached absurdity.

Table 20.2 BLX Valuation Comparison

We were also able to follow the circular money trail between Allied and BLX. Allied recognized more in fees, interest, and dividends than BLX generated in EBITM, none of which was cash. We pieced together all the SEC filings and found that BLX burned through $32 million in cash before paying Allied anything the previous year. BLX borrowed this money from its credit line, which Allied co-signed. BLX then “paid” Allied $39 million in interest, fees, and dividends. That money showed up on Allied’s books as income, boosting its earnings per share. Allied used it to pay its distribution. At the same time, Allied invested an additional $39 million in BLX. It was a spinning circle of money.

On November 18, 2003, I asked Walton about BLX’s cash flow at an investment conference sponsored by Merrill Lynch. He responded, “It is generating enormous amounts of cash” and “is generating great cash flow, great earnings and pays a dividend.” Walton’s statement was a gross mischaracterization of the facts. As shown in Table 20.3, Allied’s SEC disclosures indicated that BLX actually burned cash, since 63 percent of revenues and 181 percent of EBITM were non-cash. BLX required additional bank loans and further direct investment from Allied to fill the hole.

Table 20.3 BLX Noncash Revenue

Note: Dollars in millionsTotal Revenues108.3(A)% Cash Including Cash from Residuals83%(B)Cash Revenue Incl. Cash from Residuals89.9(C) = A * BCash from Residuals49.3(D)Cash Revenues40.6(E) = C – DNoncash Revenues67.7(F) = A – EEBITM37.5(G)Noncash Revenue/Total Revenue63%(H) = F / ANoncash Revenue/EBITM181%(I) = F / G

We were able to estimate that BLX recognized revenue of approximately 15 percent on every loan it originated. How could loans with a four-year average life and an interest rate cap of prime plus 2.75 percent be worth 15 percent more than the face value of the loan? Here’s how: The SEC filings revealed that BLX achieved average origination fees and premiums of about 6 percent for selling the guaranteed pieces, plus BLX booked approximately 9 percent of non-cash residuals on every loan. Considering that BLX sold the most valuable portion—the guaranteed piece—it was not reasonable to book the smaller, riskier, unguaranteed piece, and the servicing, at such a high value. BLX could only achieve this through the magic of gain-on-sale accounting supported by super-aggressive assumptions.

While we waited for the SEC to act, Steve Bruce from Abernathy McGregor, Greenlight’s public relations firm, suggested we meet with Kurt Eichenwald from The New York Times. Eichenwald had a reputation as an intelligent bulldog, unafraid of investigating crooked companies, and was in the process of writing Conspiracy of Fools about the Enron fraud.

Eichenwald invited us to Dallas, where he worked, to meet. Bruce, Jock Ferguson of Kroll, and I flew to Dallas to meet Eichenwald in October 2003. We met at the Crescent Hotel in Dallas for about five hours. We presented the Allied and BLX stories of fraudulent loans and accounting. Ferguson went through the Kroll report with Eichenwald, and we also gave him a copy of some of the SEC letters and the BancLab report.

“Take me through this,” he asked Ferguson. “How did this work?”

Eichenwald seemed interested in the drug den motel loan and the Detroit gas station frauds. He wanted all the details. Eichenwald’s questions were excellent. He had seen this before and knew how to report this kind of story. He was energized and intrigued. Sitting on the couch reading the documents, he was animated. “This is unbelievable,” he said. “Wow.