Thursday, June 7th, 2012
by Peter Tchir, TF Market Advisors
We all know how to kill a vampire and a werewolf. For vampires you need to either trap them in sunlight or drive a wooden stake through their heart. For werewolves, you need a silver bullet. Or at least you did before the Twilight series came out. But killing a zombie bank isn’t necessarily as easy.
We all get caught up in the moment. Every tick down in the stock market adds to the fear and anxiety. Every tick up sends waves of relief through the economy. The reality the stock market and economy move at dramatically different speeds, and that is the case for bank failures as well.
While it is true that occasionally banks or companies default overnight or in very short order, that isn’t the norm. Even Lehman was a known problem for ages. Its debt traded very wide off and on for a year ahead of the eventual default. It was on the cusp when Bear Stearns got saved. Lehman got saved that time without a dime being given to it. It squandered its chance and failed to raise money in the 6 months after Bear, but it did last a long time.
Weak banks can linger for a long time, especially if someone is willing to provide them liquidity at non market (stupid) rates. Rescap affectionately known as Rescrap, although not a bank is a great example.
A solvency problem can’t be solved by liquidity, but if there is a lender willing to provide as much liquidity as it takes, and rates that make no sense for the risk, the default can be pushed off for a long time. It can be delayed much longer than we think and in some cases, avoided all together. While Rescap finally met its fate it should probably have met in 2007 or 2008, MBIA seems to have turned the corner.
MBIA has lasted this long because it didn’t require much funding and time has given it the chance to earn carry and avoid payouts.
While neither Rescap nor MBIA are banks they are decent examples of how long it can take to play out.
In the U.S. only Lehman and Washington Mutual failed. At the last moment Bear Stearns and Merrill were “saved”. Others have lingered along in various states of disrepair for a long time with full government support.
That is the key when looking at the crisis in Spain or at Bankia in particular. A solution of lots of fresh equity capital tomorrow would be ideal. But just because we don’t see capital injections tomorrow doesn’t mean it is about to default or go into full unwind mode. Unlimited 3 month LTRO and other ECB and Spanish facilities can keep it alive for quite some time, so expecting it to be an immediate catalyst to a huge down move is as likely to be true as those that hope for some magic plan from the ESM to make it all better.
Time is the key, and horrible headlines aside, it is easier to kill a vampire or werewolf than it is to kill a bank with an unlimited supply of cheap money.
Central Bank Activity
Our scorecard from yesterday continues to fill in. We didn’t get global swap lines, but we did get a China rate cut, so +1. We didn’t get a rate cut, so -1/2, but they did mention some members had voted for a rate cut, so take that as a zero, with a running total of +1.
Unlimited 3 month LTRO, wasn’t on our list but call that a +1/2. 3 year would have been better, but the focus on unlimited was good. So we are at +1.5 so far in total.
Away from that, the ECB didn’t really do much else, but Germany or someone floated a rumor that the EFSF or ESM could lend to some Spanish entity other than Spain which could then recapitalize the banks. I don’t know the source and it is so convoluted that it is unlikely to work, yet convoluted enough it seems likely some politician is really looking at it. Call that +1/2 max, but when coupled with further rumors that ESM will either get a banking license or have a lots of ECB support, lets call all the rumors and “wink wink” signals as a +1 in total. That gets us to 2.5.
The ECB did put it back on the politicians, but not as belligerently as they could have so only -1/2.
Extremely dovish Fed comments added back at least +1, giving us a current total of +3 heading into Bernanke’s testimony.
After yesterday’s comments, by Yellen in particular, it is hard to imagine anything other than an actual announcement by Ben doing a lot for the market and he could easily undo the work done by Yellen.
Still Targeting May 11th Prices
In addition to the central bank push encouraging risk on, and the overreaction to the Spanish banking crisis, I was surprised that the Spanish sovereign debt auction got done. I suspect that the banks were told to buy and some CDS short covering bids were put in, but it is still a minor positive and far better than pulling the auction.
I was also surprised just how short the market seemed to trade. I thought we were oversold, but the market traded even more short than I would have guessed.
I think the banks can be a catalyst for yet another leg higher. Clearly I’m getting nervous back up at these levels, but I think we can achieve the May 11th prices. Everyone again seems to be fading this rally or too bitter that we are moving up on a Chinese rate cut. No one has embraced the trade off the lows and too many funds seemed to have gotten whipsawed that the pain of this up move isn’t quite over.
Look for a continued bounce in HY and EM debt denominated in dollars. U.S. treasury rates aren’t going up any time soon, the search for yield will resume, and high yield will benefit from a sluggish, but stable economy, and EM will benefit from the “reflation” trade the central bankers so desperately want to see happen.
Copyright © TF Market Advisors
Tags: Bank Failures, Bear Stearns, China, Cusp, Fear And Anxiety, How To Kill A Vampire, Lehman, liquidity, Mbia, Norm, Rescap, Silver Bullet, Solvency Problem, Stock Market, Tick, Twilight Series, Vampires, Werewolf, Werewolves, Wooden Stake, Zombie
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Thursday, May 17th, 2012
by Peter Tchir, TF Market Advisors
I wish we could go into just the facts, but frankly we don’t know the facts, so here is my best guess at piecing together what happened and what some of the consequences might be. I hope it is mostly correct, which means it is balanced and not sensationalized like so much else that is out there on this subject.
Short High Yield Market
Last year, I think they went short the high yield market globally, primarily through CDS. They generally wanted to buy cheap jump to default (“JTD”) risk, so they focused on the short end of the curve, and on first loss tranches. This created trades in a variety of series of XOVER and HY.
The trade worked well, and defaults in names like Eastman Kodak and American Airlines came quickly and helped make a lot of money. Some other distressed names saw a flattening or even inversion of their curve on the back of that, generating yet more money.
With the ECB announcing LTRO and data in the U.S. looking okay, and overall policy response in Europe improving, they were worried about being too short. At this point they could have cut their short. That was clearly a choice, but a choice they decided not to make by the looks of it.
Why not? Maybe they still needed the high yield short against core positions? Maybe they needed it for the Fed stress tests which were very punitive for the high yield market. Maybe they just thought this trade was the best short by far out there and wanted to see if there was a good way to keep the short, and all the benefits for stress test purposes, without as much risk of loss in a spread tightening environment?
It looks like they decided, primarily that JTD, while cheap in high yield, was priced too high in investment grade and sold that protection. Maybe they thought names like MBIA which drive the pricing of the lower tranches of IG9 had curves that should have been steeper. So in various forms they took the other side of the HY trades.
They likely added new traded, by the end, this trade likely had at least 20 significant line items, spread across indices, tranches and straight indices, and points along the curve.
The trade, as far as I can tell should do well in a stressed market. It had a fair degree of idiosyncratic risk which in the near term could cause some problems, but in a stressful environment it should have delivered good returns, and certainly would have looked great on the Fed Stress test results.
If we had a significant tightening, the trade would probably lose some money, but nothing like an outright short, even a smaller outright short would have lost, and it would ideally be offset by gains in the bond and loan positions held by JPM.
So What Went Wrong?
Something did go wrong, the trade lost money. But it didn’t go “horribly” wrong. To me, “horribly” would mean a money losing quarter for the firm. They did something so big and so stupid they wiped out the entire firm’s earnings for the quarter. That did not happen. In fact, the loss seems in the right order of magnitude when you look at gains that group has delivered. This isn’t even a case where one big loss wipes out 5 years of small gains. This group is still up over time and had JPM monetized some more AFS gains held by that group, he could have shown a $5 billion profit for the CIO office.
The only thing that we can safely say is that this trade, ignoring other positions held against it was down about $2 billion this quarter, as of sometime last week. We don’t know when the $2 billion was calculated, we just know that is what we were told on last Thursday. It is impossible to know what has happened since then, and it could even be a gain now because of the hedges of hedges put in place prior to and after the call.
The trade was large, and small moves against each of the legs could easily cause the losses seen so far. That is the key here. The decision wasn’t horribly wrong. It’s not like they bought something that dropped 30 points. They have lots of longs, some of which moved several points against them, while some large shorts also moved against them. It sucks, but there isn’t a single long/short trader in any market who hasn’t had this happen at least once.
Key Issues and Questions?
The trade was too large. In spite of the effort to spread the trade around the globe and across so many indices and tranches, it just got too big. The off the run indices that suited the view best, were too small and illiquid relative to the size they needed. Their trading also stuck out like a sore thumb so the market was over time able to figure out what trade they had on. Why did they let it get so large? That is a question that needs to be answered and is a reason the group is being shifted. This was bad risk management, but it is possible they believed they had spread the trade across so many line items that it wasn’t as outsized and it now appears it was.
Marks and Growing the Position to control the price. One concern would be if they were growing the position in an effort to influence the price. I do not like the fact that the indices they were allegedly doing trades on were trading very rich. Even if selling the tranches, there should have been a concern about selling tranches on an index that is trading rich. Maybe there was and maybe they thought the tranches were so mispriced that it was worth doing. That is reasonable. If on the other hand, they continued to grow their position in an attempt to control the marks and their losses that is another issue. I’ve never understood why the market is so happy about “window dressing” since the difference between trying to influence a mark and “window dressing” seems to be a very fine distinction. If the trading was really being done to aggressively control the marks, then there are bigger issues for the traders concerned. While just getting too large, but with approval is not smart, this is much worse. No idea if it happened, but that angle does need to be investigated internally at the very least.
Risk Management and the VAR jump. I assume these positions all fell within their limits or were appropriately approved. If they were somehow hiding the scale of the trade, then there are issues, both with them for attempting to do that, and with JPM for not having limit controls that picked up this level of activity. I would be shocked if these positions were being done covertly, and assume from the press conference that wasn’t the case, or else the tone would have been much worse, and the so far reasonably amicable changes to the CIO office wouldn’t be occurring.
That leaves us to figure out why the VAR may have jumped. There are a couple of reasons that I can think of that make some sense, though it is a bit of a stretch. If HY spreads were modeled as being highly correlated with investment grade spreads, and that correlation was then reduced, we would have a spike in VAR. On the portfolio, with a high correlation between IG and HY, the trades would have largely offset each other in a VAR calculation. As the correlation was reduced, there were be a greater risk that the trades don’t offset and VAR would increase.
Tranches are strange in that they have a “leveraged” exposure. Did the new model underestimate the VAR on IG tranches or overestimate it on HY tranches? Did they not use enough leverage? Did they not account for the change in leverage as price moved? Something strange happened to VAR, and assuming it wasn’t purposeful mis-booking (which would be a massive issue for those involved), this “new” model was doing something incorrect. Although no answer is ever likely to be forthcoming to mere investors and owners of the company, at least the Fed should be able to find out why the VAR jumped.
What now for JPM?
I think the market has already started to overcome the initial fear of the trade. Investors are able to put it into the correct context – $2 billion just isn’t that big or meaningful at JPM. It is bad and changes need to be made, but it isn’t even a disaster for the quarter. So the market is digesting this. Will there be more questions and problems with this trade? Possibly, but I truly believe it is contained.
Things I cannot understand or what is Jamie’s real intent?
For a man who typically comes across as so “confident” he has been very contrite about this. Is “Contrite Jamie” scared of the Fed? Is he that embarrassed by the loss? Something about his language and behavior and the entire press conference just don’t ring entirely true. Maybe he was simply so stunned by the loss, but I can’t help think he has some agenda that just isn’t obvious yet.
Which leads to the other big question, why take a loss at all and why not monetized unrecognized profits in the AFS book? The AFS book seems like it has over $7 billion of gains just waiting in accounting limbo to be harvested. Why not take more, have no loss and not need to have a conference call? It is almost like he wanted to have this conference call, that he went out of his way to ensure he had to discuss this. Had he booked more profits, they wouldn’t have had to change their guidance. Weird that they chose to go this route, and again makes me wonder if there isn’t a bigger plan in place here.
That leads to my final question. Does the market really believe that Jamie Dimon and his advisors had no clue how the market might perceive the call? That some “investors” would take a run at driving the positions even further against him? It seems like a no brainer that he would anticipate that potential reaction. Read the transcript very closely. He seems to go out of his way to highlight they could have more losses, but throws in the possibility of it turning into a gain, that they won’t necessarily take it all off, and that some other “economic” hedges would or were in place. If your goal was to spook the market and profit from it, those all seem like nice little caveats that your lawyer would want you to include. This is getting a little more out there, but his almost naïve sheep being led to the slaughter attitude about the position just doesn’t feel right either.
Was it a Hedge?
That is another question and in reality is the wrong question. When did everyone get so focused on what is a prop trade or a hedge or a position. Every loan is a prop trade. It is a bet that you will get paid back. On a portfolio level it is that you will make few enough individual mistakes that the interest earned covers your costs and losses and leaves you with a profit.
The only way to ensure that you don’t lose money on a loan and never have any potential P&L issues from it during the lifetime, is not to own it. Otherwise any hedge creates basis. The more “perfect” the hedge, the higher the cost. In the end, we don’t really care if banks lose some money, we just don’t want them to lose LOTS of money.
Banks need to hedge the stress scenario. That is when too big to fail becomes an issue for all of us. So let’s keep ensuring that banks can’t fail, and let the relatively small losses occur if they need to.
What is Mr Dimon’s Job?
And the next person who says Mr. Dimon’s job is to lend money to make the economy better, should really just stop, step away from the keyboard or microphone and think about what his real job is. That is to maximize shareholder value over the long run. To take actions that give the share price the best chance at appreciating over the long run. That is his job. He is supposed to work for the shareholders and no one else. If you don’t like the risks he is taking, don’t invest in his bank, but he, nor the bank are tools for public policy. And in spite of the stock price decline on the back of this announcement, it is hard to find any other bank that is close to its 2007 prices.
Tags: American Airlines, Best Guess, Consequences, Core Positions, Curve, Curves, Eastman Kodak, ECB, high yield, Inversion, Investment Grade, Mbia, Nbsp, Policy Response, Stress Test, Stress Tests, Test Purposes, Tf, Trades, Xover
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Friday, January 13th, 2012
From Peter Tchir of TF Market Advisors
It’s An Upside Down World… Or So Much For “Decoupling”
Italy has “successful” bond auction and for all intents and purposes, JPM misses earnings.
Stocks failed to respond to a “successful” Italian bond auction. The market isn’t giving them much credit for placing bonds that mostly mature in the timeframe covered by LTRO. The auction results are good, but the market is taking a wait and see attitude towards them as everyone is fully aware of how much LTRO money is out there, that Italian banks in particular issued bonds to themselves to get financing and are “indebted” to the government and ECB (in more ways than one).
JPM’s earnings may be enough (or not enough as the case may be) to end the rally in financials. The numbers were not great and no matter what the official analyst numbers were, everyone was set up for them to beat. Weak earnings in trading does not bode well for other banks. It was a decent quarter for the markets (with volumes and volatility far higher than what we have seen so far this year), and JPM is big in the US new issue market, so has a competitive advantage, so their performance is concerning. DVA give back was about 30% of what they had taken as a gain in Q3.
I think Morgan Stanley in particular is exposed as I doubt they did significantly better than JPM in investment banking, they had a settlement with MBIA that will show up as a big hit (spun as one time, even though the associated earnings were never spun as one time) and they have a much larger DVA give-back.
So as European sovereign debt shows signs of stability (manipulated stability, but stability nonetheless) the US is disappointing on earnings. With the “decoupling” trade so prominent, the US markets are set up to be very weak relative to Europe. This is second day in a row where the decoupling thesis is taking a beating (yesterday’s economic data was weak).
Tags: Auction Results, Bond Auction, Bonds, Competitive Advantage, Decoupling, Earnings, ECB, Economic Data, Intents And Purposes, Investment Banking, Italian Banks, Jpm, Mbia, Misses, Morgan Stanley, Q3, Sovereign Debt, Timeframe, Upside Down World, Volatility
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Wednesday, September 8th, 2010
Here is the transcript Consuelo Mack WealthTrack interview with Bruce Berkowitz - August 27, 2010
CONSUELO MACK: This week on WealthTrack’s Great Investor series, Morningstar’s Fund Manager of the Decade Bruce Berkowitz is always diving for hidden investment treasures, but could his recent deep dive into financial stocks blow up in his face? A rare interview with Fairholme Fund’s Bruce Berkowitz is next on Consuelo Mack WealthTrack.
Hello and welcome to this Great Investor edition of WealthTrack. I’m Consuelo Mack. This week we have a rare TV interview with one of the hottest mutual fund managers around. He is Bruce Berkowitz, portfolio manager of the Fairholme Fund which he founded in 1999, and whose assets are now climbing toward $20 billion. The five star Fairholme Fund is ranked in the top one percent of all large blend funds by Morningstar for the past three, five and ten year periods. Over the past ten years, it has delivered average annualized returns of over 12%. That’s 13 percentage points a year better than the S&P 500.
But market and peer beating performance are not the only reason that Morningstar named Berkowitz Domestic Stock Fund Manager of the Year in 2009 and its first Domestic Equity Fund Manager of the Decade. It also considered his ability to minimize the risks he took to achieve those results. And it’s that risk avoidance quality that some say he has now lost with his most recent investment choices. As money has poured into Fairholme, Berkowitz has been making a huge bet on some of the most battered financial companies. Just under 60% of his stock holdings are in companies such as AIG, Citigroup, Bank of America, Goldman Sachs, CIT Group and bond insurer, MBIA.
Now the recent history of the group is certainly dramatic. Before the financial crisis, the S&P financial sector accounted for over 22% of the S&P 500 index. By August 2010, its position had shrunk to just over 16%. From peak to trough- October 9, 2007 to March 9, 2009- the financial sector fell about 83% versus a nearly 57% decline for the S&P 500 overall. The recovery that followed was even more spectacular. From the low of March 2009 to the 2010 high on April 23rd, the S&P financials soared 170% versus 80% for the overall market.
But despite that huge recovery, from the 2007 market peak to the April 2010 high, financials were still down about 53% versus some 22% for the market. Is this flight from financials warranted or are there overlooked treasures in these pariahs? In a recent interview, I asked Bruce Berkowitz why he has invested so heavily in what even he calls “mostly hated” financials.
BRUCE BERKOWITZ: There are two parts to the investment equation. There’s sort of what you give and what you get. So we’ll start out with what you get. We’ve had this most extreme period in the financial history of the United States. Some say we came very close to another Depression. And the U.S. government and its agencies just did a great job of pulling us away from that cliff. And, for the last couple of years, companies have gone through tremendous stress, the financials. But today, their balance sheets are stronger than ever, their earnings power, their pre-tax, pre-provisioning power is stronger than ever. And, you have to think about loans and the life of loans. You know, most loans go for between two and five years, whether it’s an individual loan, commercial. So there’s been this two-year stress period of burning through all these bad loans. And at the same time, they’ve had these two years of good loans, because they’re in very stressful periods. That’s normally when they put on their best loans.
So, the financial system came to the brink. U.S. Treasury, New York Fed, Congress did amazing job. I mean, with hindsight, you know, you could criticize a little here and there. But they did an amazing job. Now it’s up to private enterprise to take it over from here. And traditionally, that’s going to be our banks and our brokers leading the way on this nascent recovery. And there are going to be fits, and there are going to be starts. But again, their balance sheets are strong; the potential earnings power is huge. They’ve battled hard, and it’s a trite saying, but whatever doesn’t kill you makes you stronger is quite true. And for those financial institutions still standing, and the ones we’ve invested in, will get through this period and move on to a more normal earnings period.
CONSUELO MACK: So, what’s the biggest risk that you’re taking, in having this sort of a concentration in these companies that have been through the grinder?
BRUCE BERKOWITZ: Well, the biggest risk would be the correlation risk, that they all don’t do well. Which would mean, you know, a severe double dip in the entire financial system of the United States, totally melts down, malfunctions, no longer exists. So, it’s hard to see that.
But, on the other hand, when you take a look at our fund today, one-sixth of the fund now is cash equivalent. Another one-sixth of the fund is in fixed income securities. So, we’re only two-thirds invested. So we have billions of dollars of cash ready to take advantage of whatever further stresses may come our way. And then, as I was mentioning to you, the other part of the equation is what you give. And by “most hated,” I meant that the financial institutions are not very popular today, given what’s happened in the past couple of years, and their price reflects it. So, we’re paying a pessimistic price for institutions that are essential to the country, and that will lead us, as they usually do, out of the recession.
CONSUELO MACK: Some of your competitors, including Don Yachtman, of the Yachtman Funds, who has a terrific track record as well, you know, recently told me that he doesn’t understand what you’re doing because he feels that financials are black boxes. That, in fact, you can’t possibly know what Citigroup’s loan portfolio really looks like. And that, he feels that you’re taking a tremendous amount of risk that is kind of contrary to what your prior practices have been. You don’t think they’re black boxes? I mean, you actually think that you know what Citigroup owns and what its debts are?
BRUCE BERKOWITZ: It’s our belief that enough time has gone by now, as I’ve said, that you’ve had the vintages, the various loans for a given year. You start to see, you know, the bad parts, the delinquent loans. You get to see the cash yields on the bad debt. You know, one thing that’s nice about getting older is that you start to see certain cycles before, and this is very reminiscent of ’91, ’92, when people thought Wells Fargo was going to go under because of commercial real estate. Citigroup, again. And, it’s perverse psychology. You’ve had so much strain in the system, so many balance sheets; individuals have been hurt, that it’s just very hard to look at them in a positive way.
But, with time, you start to see the patterns and the recovery, and you also have to give credit to the regulators, to the auditors, to the executives, to the oversight committees of the Congress. I mean, these institutions have been studied in the last two years. They’re under a microscope. Every element has been studied. And when you’re in stress mode, and when your institutions are shrinking, it’s very difficult to hide bad news. Everything comes out in shrink mode. But the good news is, when you’re shrinking, cash flows build up. You’re able to pay off the bad debts, and you’re able to fight another day. And, you see it now with the institutions.
CONSUELO MACK: Bruce Berkowitz and the Fairholme Fund’s rule number one is don’t lose money. And then, rule number two and number three is pay attention to rule number one. So, given the current strategy that you’re following, in the Fairholme Fund, are you still adhering to the rule number one and two and three, of don’t lose money?
BRUCE BERKOWITZ: We believe we are. At the prices that we’re paying for securities, we just don’t see the downside. We don’t see death, we don’t see bankruptcy, we don’t see significant losses. In the case of the banks, we’ve been buying below book values. We’ve been buying single-digit earnings yields. I mean, at some point, the banks will start to have a more normal earnings period.
It’s amazing, when you think of a Bank of America and all of the organizations they have merged with over time, including Merrill Lynch and MBNA, it’s tremendous. The amount of value and wealth is just tremendous in a Bank of America and in fact, it’s essential to the rebuilding of the country’s balance sheet. And so is Morgan Stanley and Goldman Sachs, and Citigroup and Regions Financial and CIT. All the companies that we purchased during their stressful periods.
CONSUELO MACK: So, Bruce, what would convince you to sell? I mean, is it going to be a price decision with some of these companies?
BRUCE BERKOWITZ: It’s going to be a price decision.
CONSUELO MACK: It is a price decision.
BRUCE BERKOWITZ: It’s going to. It’s just so cheap, relative to what you’re getting. And eventually, if we’re right in our understanding and we don’t have that dreaded double dip, going back into the Great Depression, then there’ll be a more normalized earning period. And then, that’ll be a tough part to determine, at what point our investments start to equate to T-bill type returns.
CONSUELO MACK: And so, when you look at, you know, a Citigroup, for instance. Let’s just take them one at a time. I mean, it’s value now. Do you think that there’s still a lot of value left?
BRUCE BERKOWITZ: Yes. Citigroup has the ability to earn a dollar a share, which would put it at $10, let’s just say. And you compare it to where it’s trading today, four. Under four.
CONSUELO MACK: And Bank of America, again, same?
BRUCE BERKOWITZ: All the same.
CONSUELO MACK: Same equation.
BRUCE BERKOWITZ: With Merrill Lynch, with all the operations they’ve purchased. Citigroup, with its International Banking Franchise.
CONSUELO MACK: Bruce, AIG.
BRUCE BERKOWITZ: A great company that stumbled, for various reasons, that still has intact franchises, that still has the ability to repay taxpayers, New York Fed, the U.S. Treasury, and will hopefully emerge a smaller, yet streamlined organization, with Chartis and the old Sun America. And, we’re, you know, sad, but some very valuable divisions will be sold. AIA, Alico. But we see the company having the ability to pay back taxpayers over time.
CONSUELO MACK: The other, you know, company that I’m really intrigued with, for two reasons, MBIA, which a cousin of mine actually co-founded and left many years ago. I’m not a shareholder. But MBIA has now been split up into two companies. It’s in litigation over that decision to have two different companies. I mean, why MBIA? You know, what’s the attraction? What’s the value there, first of all?
BRUCE BERKOWITZ: Well, the value, if you ask the individuals and institutions who have probably received between four and five billion dollars of proceeds from MBIA, for guaranteeing the bonds–
CONSUELO MACK: Municipal bonds, right.
BRUCE BERKOWITZ: –they’ll tell you that MBIA’s had tremendous value, and they have kept their word to all of their insureds. They continue to keep their word. And, unlike a rating agency, what I like about MBIA is, besides giving the investor the good housekeeping seal, they’re also putting their money where their mouth is. And as they continue to pay, and I believe be the advocate for individual investors, how can an individual investor claim, if they have to follow or they’re unhappy about something, they just don’t have the scale to talk with counterparties, where MBIA is going to be their advocate. So when all is said and done, we expect MBIA to regain their franchise value.
CONSUELO MACK: In the municipal bond insurance business?
BRUCE BERKOWITZ: In the municipal bond area, and in other areas also, where it makes sense for them to do business. Granted, all the financial institutions made the mistake of starting out with a very good idea and slowly changing it to the point where you’ve reached an illogical extreme.
Now, with hindsight, you can actually say, well, how could the banks and insurers, how could they have gone from A to B to C to D? It makes no sense now. But, there were slow changes. So I think everyone realizes mistakes of the past, and they’re going to get back down to their basic business. And, with a little bit of luck, they’ll be able to get the right price for the product, the insurance. And they’ve clearly shown that the insurance is worthwhile, and they’ve clearly kept their word about paying the insureds. So, it’s now just a question of working through it. And even if they don’t write another bit of business, which I believe they will, the runoff value alone of the institution is such that I don’t see how our shareholders lose money.
CONSUELO MACK: Let me ask you about a recent Wall Street Journal article about you. It talked about how you were breaking Wall Street’s rules and making other mutual fund managers look bad, by doing all the things they say can’t be done. And this is your style. Can’t time the market- do you time the market?
BRUCE BERKOWITZ: No. We don’t predict. We price. So if timing the market means we buy stressed securities when their prices are way down, then yes. Guilty as charged. But, again, we’re trying to compare what we’re paying for something, versus what we think, over time, we’re going to get for the cash we’re paying. And, we try not to have too many predetermined notions about what it’s going to be. And then we go, once we come up with a thesis about an idea, we then try and find as many knowledgeable professionals in that industry, and pay them to destroy our idea, and tell us–
CONSUELO MACK: You try to kill your investments before you invest in them.
BRUCE BERKOWITZ: Right. We’re not interested in talking to anyone who’ll tell us why we’re right. We want to talk to people to tell us why we’re wrong, and we’re always interested to hear why we’re wrong. Because one day someone’s going to do our shareholders a big favor and tell us why we’re wrong, and we’re going to be wrong. We want our ideas to be disproven.
CONSUELO MACK: Another Wall Street kind of conventional wisdom that, again, this Wall Street Journal article said that you are breaking this conventional wisdom, is that you shouldn’t hold a lot of cash in equity funds. Well, the Fairholme Fund has a history of holding a lot of cash. And I remember you telling me that cash is your financial valium.
BRUCE BERKOWITZ: Yes. Well, the worst situation is if you’re backed into a corner and you can’t get out of it, whether for illiquidity reasons, shareholders may need money, or you have an investment that, as usual, you’re a little too early, and you don’t have the money to buy more, or you don’t have the flexibility. That’s a nightmare scenario. And this is nothing new. I mean, the great investors never run out of cash. It’s just as simple as that. And we’ve learned this is nothing new. We haven’t re-created the wheel here, but we always want to have a lot of cash, because cash can become awfully valuable when no one else has it.
CONSUELO MACK: The third thing that you’re doing that supposedly is making other mutual fund managers mad, Bruce, is that they’re saying you shouldn’t put too much money into a few stocks. And, you know, your top 10 holdings or something represent two-thirds of your fund, currently?
BRUCE BERKOWITZ: Yes. Almost all of the equities. Probably all of the equities, which would be about two-thirds. A little under two-thirds of the fund.
CONSUELO MACK: So, is this going to be something that shareholders of the Fairholme Fund, they’d just better get used to the idea that you’re going to, heavily focus the portfolio?
BRUCE BERKOWITZ: I think we always have focused. And we’re very aware of correlations. And, look what we faced in the last two years. When times get tough, everything’s correlated. So, we’re wary. But we’ve always had the focus. Our top four, five positions have always been the major part of our equity holdings, and that will continue.
CONSUELO MACK: There’s a saying on Wall Street as well, is that size is the enemy of performance. Investors have been flocking to the Fairholme Fund because of your stellar performance, at a time when most other equity funds are losing investors. So what can you tell, especially the newer owners of the Fairholme Fund, about the way you’re going to run their portfolio?
BRUCE BERKOWITZ: Everything that we do for our funds, we do with the shareholders in mind. We try and put ourselves into the shoes of our shareholders. And we do that by being large shareholders of the funds. And what I could tell our shareholders is, we think about this every day. And, the important point is that, as the economy still is at the beginning of a recovery, and there’s still much to do, and continued stresses, we can put the money to work. The danger’s going to be when times get better, and there’s nothing to do, and the money keeps flocking in. That obviously is going to be a point we’re going to have to close down the fund. But, close down everything.
But of course, it’s more than that. Because if we continue to perform, which I hope we do, 16 billion’s going to become 32, and 32′s going to become 64. And then it’s not really an issue about closing down the fund. It’s just the size. But I have no idea where we’ll all be investing five or 10 years from now. It’s a high-class problem which we’re focused on, and I hope that we will take the right actions before our shareholders tell us what the right action is. And a lot of our shareholders are concerned about it. It’s a question that comes up all the time.
CONSUELO MACK: About size.
BRUCE BERKOWITZ: Of size. Right. But right now size matters.
CONSUELO MACK: And right now, has the size, you know, as you approached 20 billion under management, has the size affected the way you can do business yet?
BRUCE BERKOWITZ: Yes. It’s made a real contribution. How else could we have committed almost $3 billion to GGP, or to have done an American Credit securitization on our own, or help on a transformation transaction with Hertz, or offer other companies to be of help in their capital structure, or invest in CIT, or be able to go in with reasonable size? It’s helped, and we think it will continue to help, and we hope it will be noticeable to most people over time.
CONSUELO MACK: You’re going to be a target. The more successful you are, the more of a target you are for the naysayers. So, the comparisons now are being made that they look at other super investors, like, you know, Bill Miller or Bill Nygren, or Ken Heebner. And they say, these people had, you know, multi-year, spectacular runs, and then had a couple, two or three years of disastrous results. Do those comparisons worry you? Do you feel like, you know, gee, you know, my time’s coming too? Is that a concern?
BRUCE BERKOWITZ: What worries me is knowing that it’s usually a person’s last investment idea that kills them.
CONSUELO MACK: Explain.
BRUCE BERKOWITZ: Well, as you get bigger, you put more into your investments. And, that last idea, which may be bad, will end up losing more than what you’ve made over decades. So I’m more concerned for our shareholders than I am for myself. That is why, if you look at the fund today, to me, it looks more conservatively positioned than it’s ever been. We’re two-thirds invested in equities today. That is not exactly what I would call a kamikaze strategy. And when you look at the prices that we’re paying for securities and look at the prices where they were five or 10 years ago- granted, they may not be exactly the same companies- it looks like we’re getting some bargains.
But we have too much respect for our shareholders. And we say to ourselves every day, we don’t mind if our shareholders fire us for underperforming on the up side. But it would be tremendously disappointing if we made some kind of bonehead maneuver which cost our shareholders a lot of money. That would be tough to live with. And that’s more important than the money.
CONSUELO MACK: Now, you know one thing that will happen is that a lot of the people that are coming in after you’ve had this, you know, string of 13% annualized returns over the last 10 years is that they’re going to expecting that kind of performance. So if they don’t get that kind of performance, you’re going to see a lot of that money leave, correct? Or is there some way that you think that you can avoid that from happening to you, what seems to happen to just about every successful investor out there
BRUCE BERKOWITZ: I’m hoping- I mean, famous last words, but I’m hoping we can come close to that performance. I mean, I just don’t want my mother to fire me again. That’s all.
CONSUELO MACK: When did your mother fire you?
BRUCE BERKOWITZ: Oh, about 2008, when times were tough.
CONSUELO MACK: So Bruce, it’s time for me to ask you the question about the one investment that everyone should have in a long-term diversified portfolio, and I know the one investment that you would choose is your own fund, the Fairholme Fund, because that’s what you invest in. But you can’t recommend your own fund. So what would you have us own some of in a long-term diversified portfolio?
BRUCE BERKOWITZ: I think the one very interesting investment we have today is MBIA. If you believe the numbers and the auditors, the company has a value significantly above where it’s trading today, even if it just runs off and doesn’t write another dollar of business. The company has some tremendous arbitrage possibilities, and they’re really taking the right business actions. But, small. Small part of the fund, because it’s a small company. And by law, the Fairholme Fund, we can only own 9.9% of an insurance company. So it’s not a relatively large position for the fund. But it is a most intriguing, controversial investment which we believe is going to do quite well. And we have a lot of faith in Jay Brown and his team.
CONSUELO MACK: Controversial it is. And for a risk-averse guy, a lot of people are looking at your portfolio at the Fairholme Fund and saying, what is he doing? But I think you’ve just given us the best answers that you possibly can on why you think that you’re following your traditional, risk less, or less risk type of approach. So Bruce Berkowitz, great to have you here on Wealth Track again. Thanks so much for joining us.
BRUCE BERKOWITZ: Thank you. It’s been great.
CONSUELO MACK: As Berkowitz told us as he was leaving the interview, the really interesting conversation will be next year when we find out how the financials have done!
And that concludes this edition of WealthTrack. I hope you can join us next week when I sit down with T. Rowe Price chairman and fund manager Brian Rogers, a “Great Investor” with an excellent track record and a philosophy of old-time American values. Until then to watch this program again, go to our website, wealthtrack.com to see it as a podcast or streaming video. Thank you so much for visiting with us and make the week ahead a profitable and a productive one.
Tags: Bank Of America, Bond Insurer, Bruce Berkowitz, Cit Group, Consuelo Mack, Consuelo Mack Wealthtrack, Domestic Equity, Domestic Stock, Fairholme Fund, financial stocks, Gold, Goldman Sachs, Investment Choices, Investor Edition, Large Blend Funds, Mbia, Morningstar, Mutual Fund Managers, Rare Tv, Risk Avoidance, Stock Fund, Stock Holdings, Wealthtrack
Posted in Gold, Markets | Comments Off
Thursday, November 20th, 2008
Bill Ackman, founder and CEO, Pershing Square Capital Management, and now infamous and highly successful activist hedge fund manager of nearly $6-billion in assets, appeared on Charlie Rose, November 11, 2008.
In 2002, Ackman started a public campaign questioning America’s bond insurers, in particular MBIA. that work uncovered among other things the possibility of a looming systemic problem in the credit market. In September he wrote a letter to the Treasury Secretary Henry Paulson, suggesting ideas for reforming Fannie Mae and Freddie Mac.
Click the play button viewer to see the interview in its entirety:
Tags: activist hedge fund manager, America, Bill Ackman, Ceo, Charlie Rose, Credit, Credit Market, Fannie Mae, Freddie Mac, Hedge Fund, Henry Paulson, interview, Mbia, Paulson, Pershing Square, Pershing Square Capital Management, Treasury Secretary, usd, Video
Posted in Bonds, Credit Markets, Markets | Comments Off
Wednesday, February 13th, 2008
Feb. 13, 2008 – Warren Buffett, live on CNBC, proposed to buy the muni-bond portfolio from the monoline insurers, an offer, which if accepted would be very good for muni-bond holders (as it would protect the bond’s AAA ratings and their pricing) and Berkshire Hathaway, and would effectively leave the CDO portfolios right where they are. This could in no way be misconstrued as a bailout. This is Warren Buffett doing what he does best. Ahhhh…Capitalism at its finest.
Here is the excerpt of the transcript from CNBC.
Becky Quick: We know Warren that you’ve already put a plan out where you are, in fact, a bond insurer yourself. You have a new company that’s doing that. But beyond that, Ambac, FGIC and MBIA, they all have some significant problems. What do you think needs to be done?
Warren Buffett: Well, last Wednesday, as you know we have formed a new bond insurer. And last Wednesday, Berkshire Hathaway made a firm offer to the three largest bond insurers, who in aggregate I think, insure about 800 billion (dollars) of tax exempt bonds.
And what we said we would do is, and we gave a copy of this, of course, to the Superintendent of Insurance of New York. We said we would form, we would add to our company’s resources five billion dollars. That five billion dollars in the new insurance company, we would pledge that there would be no dividends or any kind of distributions or management fees taken out of that for ten years, so all the earnings of that company would be retained to build up the claims-paying ability.
And we offered to take over the liabilities for the whole $800 billion of these three companies for a premium that would be equal to, essentially, one-and-a-half times the remaining premium left over the life of the bonds. They have what they call an ‘unearned premium reserve’ which reflects the original premium less the amount that’s been proportionately earned. And we said, for one-and-a-half times that amount, we would take away all of their liabilities so that the $800 billion in bonds would carry a real triple-A insurance, and would sell in the market as if it had real triple-A insurance. Whereas now the bonds sell at significant discounts.
And we provided additionally that if they felt that this premium was too high or that they could do better that for thirty days, they would have the backstop of our offer which would be totally firm, and if they came up with anything better for themselves and for the holders of their insured bonds, that for a break-up fee of one-and-a-half percent of the premium, that they could go and take the other deal. So that the world would know that, one way or the other, that that the municipal bond insurance problem was behind it. It would be either with our offer or some other offer that they went out and obtained.
So, we put that out there to the three largest insurers and if they should decide to take it, eight-hundred billion of bonds that are now selling as if they were uninsured, or even in some cases a little worse. They’re probably selling on balance maybe 5 percent below where would sell for if the insurance was regarded as good, which is 40 billion on 800 billion. We will see what happens.
Good Luck Mr. Buffett, and good luck muni-bond holders…
Tags: ABK, Bailout, Becky Quick, Berkshire Hathaway, bond insurers, capitalism, CDS, Credit, Credit Market, Dollar, Earnings, Insurance, Mbia, municipal bond insurance problem, New York, risk, Superintendent, usd, Warren Buffet, Warren Buffett
Posted in Bonds, Credit Markets | Comments Off
Sunday, February 3rd, 2008
Feb. 3, 2008 – The nature of the economic strength and stability of the BRIC (Brazil, Russia, India, China) countries is a less well known or understood fact among investors. There remains a wide gap between perceptions and reality.
Remember 1997 and 1998? Many investors, excited about the growth of Asian and emerging countries in the late nineties and invested their money found out about credit related risk first when the 1997 ‘Asian Contagion’ occurred and was followed upon by the Long Term Capital Management bailout which unfolded in 1998. These events destabilized global markets and investors were taken by surprise as markets melted down.
For this reason, its important to go back to that time and re-examine Malaysia and Thailand, as examples, of where investors were excited by the rapid economic growth, but ignored the then inherent high credit risk, much to their expense. A decade ago (yes, a decade ago) when all of this was happening, only 3% of the grand total of emerging markets sovereign debt was rated as investment grade by any of the ratings agencies.
In 1997, only 10 out of 120 companies that form the MSCI Emerging Markets Index, had ADRs.
Excited by the G7 debt-financed growth, investors made bets that were inherently risky to their preservation of capital, not simply volatile. Circa 1997, emerging markets were in debt to the industrialized world by about $100-billion in the current account deficit column, and dependent on the kindness of their G7 financiers.
When the Malay and Thai governments were unable to meet current account obligations, and started printing money in order to meet them, the Fed blew the whistle upon discovering that sufficient reserves were not available to support the currency valuations. Hence the overnight slashing of Asian currencies.
At best, the general sentiment surrounding emerging markets has remained sceptical, and for this reason, as fundamentally sound as the BRIC countries economies are today, the market has been adopting the BRIC investment story very gradually. This time though, it is credit worthiness that is being overlooked.
Source: Merrill Lynch October 2006
Source: Merrill Lynch, October 2006
Today, emerging markets sit atop a current account surplus in excess of $700-billion, and it is the industrialized G7 who are in debt, by the same amount. Longer term surpluses in excess of $3-trillion are to be found on the balance sheets of mostly the BRIC countries today in the form of Foreign Exchange surpluses, and trade surpluses. China alone now nurses a trade and forex surplus nearing US$1.5-tillion. Russia, has managed to build up reserves of US$450-billion as well as Putin’s US$150-billion ‘contigency’ fund, set aside so that it may sidestep any kind of financial shock. India has amassed a forex surplus of around US$275-billion. Brazil’s forex reserves now stand at US$178-billion.
BRIC countries have been financing the debt, and driving the growth of G7 countries for the last 5-7 years. China has emerged as the worlds manufacturing hub, while India has come on very strong as its counterpart hub in services, both providing Western firms access to inexpensive educated and -or- highly-skilled labour. Russia, under Putin, has successfully emerged as a highly profitable energy and raw materials producer, second in oil and gas reserves to Saudi Arabia. Brazil has changed the regional balance in the Americas by turning itself into the winds of east-west trade in hard and soft commodities and using its strength to bolster its new economic clout in relation to North America.
China’s growth is less dependent on the health of the US economy, as is commonly perceived. A recent Economist article points out that China’s true exports-to-GDP ratio is actually below 10%, that China has been quite successful to date at rebalancing its economy in favour of domestic growth as a driver. As for India, 87% of its GDP is consumed domestically, making it quite independent from the risk of the US threatened consumer hegemony. Russians are enjoying three times the disposable income of 7 years ago and driving consumption growth, as are Brazilians.
North American and European companies are looking to these consumers to drive demand and growth to their top and bottom lines.
In a word, things have changed.
They have changed in a very meaningful, very important way. The relationship that now exists between emerging markets and G7 countries is ‘symbiotic.’ and interdependent.
Source: Merrill Lynch, October 2006
Today, around 60-70% of emerging markets sovereign debt is investment grade rated and all 120 companies that form the key MSCI Emerging Markets Index have ADR listings.
In 1997-1998, the world’s biggest western banks took advantage of bailout conditions to take ownership of Asian banks, once protected by thousand-year-old protectionist laws. Today, powerful and wealthy Sovereign Wealth Funds (SWFs) are bailing out the same banks, Citigroup, Merrill Lynch, and Morgan Stanley.
On Wall Street in the past few weeks, the sums have been bigger and the actions more benign—at least so far. This week Merrill Lynch and Citigroup became the latest to get the sovereign-wealth treatment, picking up a further $6.6 billion and $14.5 billion respectively, much of it from governments in Asia and the Middle East (see article). Sapped by the subprime crisis, rich-world financial-services groups have been administered nearly $69 billion-worth of infusions from the savings of the developing world in the past ten months, according to Morgan Stanley.
Commodities are not the only source of sovereign wealth. Many Asian emerging markets have been running current-account surpluses at the same time as they have been managing their exchange rates. As they have mopped up dollars, using government bonds, they have accumulated reserves. At first these went into safe, liquid assets like American Treasury bonds—the Asian financial crisis of 1997-98 was still a recent memory and many countries were keen to amass reserves. But economies like China, South Korea and Taiwan now have more reserves than they need to defend themselves against shocks. Their governments understandably want to earn a higher return than Treasury bonds will pay, so they create a fund to manage their assets. Source: The Economist, Jan. 17, 2008, Asset-Backed Insecurity
It has become such that neither Emerging Markets nor the G7 can allow each other to be destabilized, as evidenced by the large, noted, SWF investments, as they have each other’s economic ‘lives’ in the balance.
You might get the idea that emerging markets are correlated more to the US than they actually are, when you see that they have suffered like western stock markets, from a selloff. Their correlation is low, between .30 and .40, not zero or negative. There are those who would have us believe that the decoupling thesis is suffering from the same disease as the bull market. Those are probably the same folks, who last year began to re-write their theses from decoupling to recoupling to suit themselves this year, as the need to raise cash by selling the last two year’s profitable trades became an increasingly inevitable requirement, in order to shore up balance sheets.
Our expectation is that the credit squeeze ailing the market will come to a reversal point, at some point over the next 2-4 weeks as the banks round the corner on the cash call that has forced the wholesale liquidation of emerging markets and commodities related investing.
Emerging Markets are strong, and some of their [inflationary] growth pressures may get somewhat solved by a slowdown in the US, in the form of an imported soft landing. This is by no means advice, but if you subscribe to this thesis, then there is reason (for those of us on the buy-side) to believe that there will be a recovery in the decoupling thesis, and thus emerging markets equities throughout the second half of the year, from the current lows.
First, however, until the cash call is complete, and the future of the monoline insurers (MBIA, ABK) is resolved in the form of perhaps a bailout, we may continue to see more downside.
Now may prove to be a good time to nibble at emerging markets and commodities again and add or gain exposure as they are far more attractively priced. Here are a variety of ETFs and open ended funds (Canadian fund companies with offerings) that provide broad (diversified) and narrow exposure (country and regional funds) to BRIC and emerging markets.
On the AMEX
“Total” Emerging Markets ETFs
iShares MSCI Emerging Markets Index Fund (EEM)
PowerShares FTSE RAFI Emerging Markets Portfolio (PXH)
SPDR S&P Emerging Markets ETF (GMM)
Vanguard Emerging Markets ETF (VWO)
Dividend Emerging Markets ETFs
WisdomTree Emerging Markets High-Yielding Fund (DEM)
Multi-Region (but not Total) Emerging Markets ETFs
BLDRS Emerging MKTS 50 ADR Index Fund (ADRE)
Claymore/BNY BRIC (Brazil, Russia, India, China) ETF (EEB)
streetTRACKS SPDR S&P BRIC (Brazil, Russia, India, China) 40 ETF (BIK)
iShares MSCI BRIC Index Fund (BKF)
Latin America Regional ETFs
iShares S&P Latin America 40 Index Fund (ILF)
SPDR S&P Emerging Latin America ETF (GML)
European Emerging Markets Regional ETFs
SPDR S&P Emerging Europe ETF (GUR)
Middle East and Africa Regional ETFs
SPDR S&P Emerging Middle East & Africa ETF (GAF)
India – Barclays iPath India ETN (INP)
On the Toronto Stock Exchange
Claymore BRIC ETF (CBQ.T)
Open Ended Funds (Canadian)
Broad Mandate Emerging Markets
Tmpleton Emerging Markets
AGF Emerging Markets
Pro FTSE RAFI Emerging Markets Index
TD Emerging Markets
United-Emerging Markets Pool Cl A
CI Emerging Markets
United-Emerging Markets Pool Cl W
BMO Emerging Markets
Brandes Emerging Markets Equity
CIBC Emerging Markets Index
National Bank Emerging Markets
Excel India Fund
Excel China Fund
Excel Chindia Fund
Excel Emerging Europe Fund
Templeton BRIC Fund
Tags: ABK, ADR, Americas, Amex, Asia, Bailout, Banks, Blog, BMO, Brazil, BRIC, BRICs, Canadian Market, China, CIBC, CIBC Emerging Markets Index National Bank, Citigroup, Commodities, Consumption, Correlation, Credit, Credit Market, Credit Risk, Currency, de-coupling, Dividend Emerging Markets ETFs WisdomTree Emerging Markets High-Yielding Fund, Dollar, driver, Economist, Economy, Emerging Market, Emerging Markets, Emerging Markets ETFs WisdomTree Emerging Markets High-Yielding Fund, energy, energy and raw materials producer, ETF, ETFs BLDRS Emerging MKTS 50 ADR Index Fund, Euro, Fed, FTSE, FTSE RAFI Emerging Markets, G7, GAF, GDP, Government Bonds, India, inflation, Investment, Latin America, Long Term Capital, Long Term Capital Management, Malaysia, Markets, Markets ETFs iShares MSCI Emerging Markets Index Fund, Mbia, Merrill Lynch, Middle East, Morgan Stanley, MSCI BRIC, MSCI BRIC Index Fund, Msci Emerging Markets, North America, oil, Oil and Gas, oil and gas reserves, Open Ended Funds, P Latin America 40 Index Fund, profitable energy, Putin, raw materials producer, recent Economist, Recession, Region/Country Mandates Excel India Fund Excel China Fund Excel Chindia Fund Excel Emerging Europe Fund Templeton BRIC Fund, Regional ETFs iShares S&P Latin America, risk, Russia, Saudi Arabia, Slowdown, South Korea, Sovereign Wealth Funds, started printing money, Stock Markets, SWFs, Taiwan, Thailand, Thesis, Trillion, United States, Us Federal Reserve, usd, Valuations, Wall Street, wisdom, worlds manufacturing hub
Posted in Bonds, Commodities, Credit Markets, Emerging Markets, ETFs, Markets, Oil and Gas, Outlook | Comments Off
Friday, January 25th, 2008
Jan. 25, 2008 – Watch out below. There is sure to be more volatility to the downside in the coming weeks, as the carry trade and proprietary traders continue to unwind profitable trades.
Finding themselves unable to collect on credit default swaps vis-a-vis AMBAC, MBIA, ACA, large institutions (banks) and hedge funds are finding themselves under pressure from a substantial cash call.
An example of this danger came to light when a little-known firm called ACA Financial Guaranty caused some of Wall Street’s biggest banks to write down billions of dollars in holdings, restating their value on corporate balance sheets. ACA revealed last month that it had promised to cover $60 billion worth of mortgage and corporate debt, but had enough cash to cover only a fraction of that. Merrill Lynch, Citigroup and financial institutions in Canada and France, which had all sold swaps to ACA, set aside billions in case the firm collapsed.
Most of the strength that the market is witnessing is due to short covering and this will manifest itself over and over during the next two to four weeks.
Institutions are still unwinding their profitable trades to raise cash. The market goes down. Then short covering occurs, and you get what appears to be a bounce or recovery in stock prices. The problem is that as long as the cash call remains larger than the outstanding short positions the market will continue to trend lower.
Don Coxe, in January’s Basic Points, puts it in these terms:
Sadly, the central bankers have been forced into injections of all-time record amounts of liquidity. Jim Cramer and some other prominent apologists for Wall Street glitterati screamed, “The Fed doesn’t get it,” and demanded bailouts for their buddies who faced demotion from Croesus status to morally cretinous status. The biggest benefi ciaries from these bailouts were not overstressed homeowners, but the biggest, baddest, borrowers who had made the biggest, baddest, bets through use of complex derivatives.
Despite strong openings today, both the Dow and TSX look unable to hang on to gains. You also have to look at trading volume for clues about the weakness of the recovery. Volumes are down 20% at the NYSE and 15% at NASDAQ.
Assuming you agree with the idea that there is more downside in the market, there are some relatively new and interesting ways that you can take positions on the short side to reduce downside that do not involve derivatives or short positions. In particular there are a new breed of ETFs that provide short exposure to various sectors and country bets. These are aptly referred to as ’short’ and ’double-short’ ETFs.
ProShares has created ETF’s that trade inversely with the markets. These allow investors and traders to hedge against market downturns or that want to bet against the market. These ETFs are very liquid and actively traded and are designed to go up when indexes go down. As a reminder, the SHORT funds use no leverage, but the UltraShort funds employ leverage. Here is partial list by Fund (Ticker):
- UltraShort QQQ (AMEX: QID)
- UltraShort Dow30 (AMEX: DXD)
- UltraShort S&P500 (AMEX: SDS)
- UltraShort MidCap400 (AMEX: MZZ)
- UltraShort SmallCap600 (AMEX: SDD)
- UltraShort Russell2000 (AMEX: TWM)
- UltraShort MSCI EAFE (AMEX: EFU)
- UltraShort FTSE/Xinhua China 25 (AMEX: FXP)… short selling FTSE Xinhua 25 index (FXI).
- UltraShort Basic Materials (AMEX: SMN)
- UltraShort Consumer Goods (AMEX: SZK)
- UltraShort Consumer Services (AMEX: SCC)
- UltraShort Financials (AMEX: SKF)
- UltraShort Health Care (AMEX: RXD)
- UltraShort Industrials (AMEX: SIJ)
- UltraShort Oil & Gas (AMEX: DUG)
- UltraShort Real Estate (AMEX: SRS)
- UltraShort Semiconductors (AMEX: SSG)
- UltraShort Technology (AMEX: REW)
- UltraShort Utilities (AMEX: SDP)
- Short MSCI Emerging Markets (AMEX:EUM)
- Short MSCI EAFE (AMEX: EFZ)
- Short QQQ (AMEX: PSQ)
- Short Dow30 (AMEX: DOG)
- Short S&P500 (AMEX: SH)
- Short MidCap400 (AMEX: MYY)
- Short SmallCap600 (AMEX: SBB)
- Short Russell2000 (AMEX: RWM)
On the TSX in Canada, Horizons BetaPro Funds have launched ‘double-short’ ETFs that trade inversely with the market (they also have corresponding ‘double-bull’ versions of these). Canadian investors and traders can use these to protect against downturns or simply bet against the market.
- Horizons BetaPro COMEX® Gold Bullion Bear Plus ETF (TSX: HBD)
- Horizons BetaPro S&P/TSX Global Mining® Bear Plus ETF (TSX: HMD)
- Horizons BetaPro DJ-AIGSM Agricultural Grains Bear Plus (TSX: ETF HAD)
- Horizons BetaPro S&P/TSX 60® Bear Plus ETF (TSX: HXD)
- Horizons BetaPro S&P/TSX Capped Financials® Bear Plus ETF (TSX: HFD)
- Horizons BetaPro S&P/TSX Capped Energy® Bear Plus ETF (TSX: HED)
- Horizons BetaPro S&P/TSX Global Gold® Bear Plus ETF (TSX: HGD)
- Horizons BetaPro NYMEX® Natural Gas Bear Plus ETF (TSX: HND)
- Horizons BetaPro NYMEX® Crude Oil Bear Plus ETF (TSX: HOD)
- Horizons BetaPro COMEX® Gold Bullion Bear Plus ETF (TSX: HBD)
- Horizons BetaPro S&P/TSX Global Mining® Bear Plus ETF (TSX: HMD)
Look at it this way; if you already have long positions that have appreciated, but you’ve got a longer term holding period in mind that is not determined by market conditions, this may a viable option to capture some of the potential downside.
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Tuesday, January 22nd, 2008
Jan. 22, 2008 – Phew! Finally some sense prevailed at the Fed with an astonishing cut of 75 bps and 25 bps from Bank of Canada. What a turn of events. There hasn’t been a rate cut like this since the eighties.
Well, here we are in the midst of a global panic, and the media has been all over it, doing its best to carry the news of the panic. That’s why its really important to keep a clear head here, and cut through the clutter.
Emerging markets and commodities are still the strongest bets globally. Emerging markets have been operating from a higher quantum of growth roughly 2-3 times that of industrialized economies. In fact, emerging markets have been dealing with inflationary pressures. A recession in the west relieves some of that pressure, and that is good news. Fact is, the BRIC will still be in need of the raw materials, metals, oil and food, and that demand growth is expected to continue well into the next two decades. So why are they selling off?
The headlines say that demand from emerging markets for commodities will decline and that’s why they are getting hit hard. The real story is that they have been the best performing assets out there, and that is the easiest place to raise cash given the outstanding obligations of the credit market. Those responsible plain and simply need the cash, to refinance their obligations, and to shore up their balance sheets.
Who is doing all of the dumping of stocks? It is most certainly NOT you and me, or the average investor. We are just supposed to stand by and watch this happen.
Its a cabal of large institutional so-called ’smart money’, hedge funds, and currency traders that have driven this market to its present levels.
The credit market (subprime) meltdown, and the credit default swap meltdown, with the failures of MBIA, AMBAC, and ACA, that is following on its heels is the first part of this. The losses at the investment banks are precipitating the repatriation of capital in order to shore up balance sheets. The large proprietary traders are selling off their fundamentally strongest holdings with the biggest gains, in such things as commodities and emerging markets, to accomplish this. This amounts to a giant MARGIN CALL against these obligations. So, Canada and Emerging Markets are not selling off because there is something terribly wrong with them; it is because the biggest players need to get their hands on cash.
Cut through the clutter and you get to the unwinding of the carry trade. This most likely is the largest contributor to the ’round the world’ sell-off.
The slide of the dollar as a result of out-of-sync interest rate cuts, the late start in cutting rates by the Fed to get around the subprime and CDO meltdown, followed on by the ECB and BoJ’s reluctance to cut rates or print money is now leading to a wholesale unwinding of yen/dollar carry trade. And it is BIG. This, in our humble opinion, is the real source of indiscriminate selling of equities which explains why we have seen the kind of volatility we are seeing in the BRIC, emerging markets, and Australia and Canada.
Here’s what’s at the heart of it.
Tuesday January 22 2008
By Masayuki Kitano
TOKYO, Jan 22 (Reuters)
…The dollar hit a 2-1/2-year low of 105.61 yen on electronic trading platform EBS early on Tuesday, but later pared its losses and stood at 106.16 yen as of 0322 GMT…
The euro fell to a five-month low of 152.32 yen on EBS, while sterling fell as low as 204.87 yen the lowest since April 2006. They later rebounded off those lows.
“…It’s a combination of carry unwind and repatriation, as well as little or no chance of rate hikes being priced into the high-yielders,” says Gerrard Katz, head of North Asia FX trading at Standard Chartered.
“…Yen carry unwinding might, say, account for about 5 out of 10 of the entire move, with short-term speculators accounting for the other 5 or a bit more,” said a vice president for foreign exchange sales at a European bank…
From Bloomberg – Jan. 21 (Bloomberg)
“…What we are seeing now is investors pulling out of their profitable trades because of risk aversion,’’ said Bilal Hafeez, London-based global head of currency strategy at Deutsche Bank AG, the world’s biggest currency trader. “You see the euro coming off, a decline in emerging-market assets and a rally in the yen.
They are typical signs of carry trades being unwound…’’
“…Investors are likely to continue to liquidate their carry trades in coming weeks, said Neil Jones, head of European hedge fund sales at Mizuho Capital Markets in London. Jones predicts that a weekly close below 154 yen (vs. Euro) will “trigger a wave of sell signals’’ for the euro. He said the yen could rise to 100 per dollar by the end of March…”
To wit, in advance of the unwinding, you can bet that some of these ’sophisticated’ investors who borrowed in yen to invest in higher yielding opportunities elsewhere, covered their own backsides with short positions which they will undoubtedly cover once they are through unwinding their yen carry trade bets that are taking the market down. Hold on to your seats for now…and bet on a bounce at the other end.
This may prove to be the contrarian opportunity of the year to get some (more) exposure of those hard hit commodities and emerging markets. As per Dennis Gartman and Doug Kass, lets be careful out there.
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