Continuing on, here are losses six through ten:

Dana Corp

In some ways, this one was pure slop on my part.  In September 2005, I thought the setback in Dana’s auto parts business was temporary, and bought a little more.  After the second dose of bad news, I looked at the statements afresh and kicked myself.  How could I have missed the growing negative divergence between earnings and cash flow?  I waited a few days for a rally, and sold.  As it was, Dana filed for Chapter 11 in March 2006.  This could have been a lot worse for me.

		David Merkel
		Dana Files Chapter 11
		3/3/2006 2:19 PM EST

How much can you lose on a $7 stock? Seven dollars. Dana (DCN:NYSE) just filed for bankruptcy, and trading is temporarily suspended. I think the common will get wiped out, so any long trades here are purely speculative. Unsecured debt is trading in the high $60s, so they look like they are the new owners of the company (but that’s just a guess).

Just another reason to not be afraid to take losses when you make a mistake. Same for PXRE Group (PXT:NYSE), which has continued to fall since my sales.

Don’t be afraid to take losses, if you know the situation is worse than the current price would indicate.

The common was wiped out when Dana recently emerged from bankruptcy in February of this year.  PXRE made out better, merging with Argonaut.

National Atlantic Holdings

I’ve written more than my share on NAHC, and for the good of my readers, probably too much.  Perhaps this one might be a good example of taking time to accumulate a position.  My average cost is $6.67, which means that if the deal goes through at $6.25, this isn’t one of my ten largest losses.  Tentatively, though, I plan on filing for appraisal rights if the deal goes through.

Consider the 1Q08 earnings conference call on Monday:

Operator:
And we have a follow up from David Merkel with Finacorp Securities.

<Q - David Merkel>: Hi.  Sorry to trouble you, one follow up. It’s basically the questions I asked on the last call.  Your loss reserves, there’s nothing there in terms of future development that should have been reflected in the first quarter that isn’t there in the statements, and your bonds are stated at their fair market value to the best of your knowledge.  You’ve got a high-quality portfolio there.

<A - Frank Prudente>: Yes we do, David.  This is Frank Prudente. I’ll take the second part of your question first if you don’t mind.  Our portfolio remains to be very conservative and very high quality.  With the implementation of the new accounting standard we’re at Level 2 two for all of our available for sale securities.  So we continue to feel very comfortable about our investment portfolio.  And as Bruce alluded to earlier, we do a comprehensive actuarial analysis every quarter which is further validated by the review performed by our external auditors each and every quarter.  And what I can tell you is we base our estimates of loss and loss adjustment expense reserves based on all of the most relevant data we have available to us for each and every financial statement close process.

<Q - David Merkel>: Thanks, Frank. I appreciate that. Take care.

Vishay Intertechnology

I am still invested in Vishay.  It earns money, generates free cash flow, debt is being reduced, and the balance sheet looks decent.  The sorts of electronic components that they make will be difficult to make obsolete.  I still like the name; I don’t think this one will be a loss for me in the end.

Tellabs

Tellabs looked cheap and got cheaper.  Almost every small tech company was getting thrown out; valuations reached record low levels by the end of third quarter 2002.  Tellabs had disappointment after disappointment, and I concluded that if it couldn’t earn money, the book value was overstated.  I sold, and bought stocks that I thought have more promise.

That said, my rebalancing discipline allowed me to reduce the overall losses from this volatile stock.  I didn’t lose nearly as much as a buy-and-hold investor would have.

Deutsche Bank

This was a failure to integrate my overall markets view, and allowing short-term valuation issues to dominate my decision.  I thought the investment banks wouldn’t do well, but I thought Deutsche Bank might escape the troubles.  Well, I was wrong.  European institutions mimicked Wall Street to a higher degree than most would have expected.

My last buy was a rebalancing buy, but as results came in from other European banks, I ended up selling Deutsche Bank, and RBS as well.  Time will tell how smart that was… the investment banks of our world are tied together through counterparty exposure — to a degree, they succeed and fail as a group… that’s why the Fed bailed out Bear Stearns.

Summary of Part II

I’ll repeat what I said in part one, and add a little.

• Don’t play with companies that have moderate credit quality during times of economic stress.
• Measure credit quality not only by the balance sheet, but by the ability to generate free cash.
• Spend more time trying to see whether management teams are competent or not.
• Cut losses when your estimate of future profitability drops to levels that no longer justify holding the asset.

The next two articles in this series will be about investments that went right.  They should come soon.

Full disclosure: long NAHC VSH

Two years ago I wrote at RealMoney:

		David Merkel
		In Bondage to Barclays plc
		6/21/2006 2:41 PM EDT

Roger, there is a reason to be aware the the ETNs issued by Barclays plc are notes. (or, bonds) If Barclays went bankrupt, the value of the notes would be impaired. From my limited glance through the prospectus:

The Securities are medium-term notes that are uncollateralized debt securities and are linked to the performance of the GSCI® Total Return Index (the “Index”).

and later…

The Securities are unsecured promises of Barclays Bank PLC and are not secured debt. The Securities are riskier than ordinary unsecured debt securities. The return on the Securities is linked to the performance of the Index. Investing in the Securities is not equivalent to investing directly in Index Components or the Index itself.

and much later…

USE OF PROCEEDS

Unless otherwise indicated in the applicable pricing supplement, the net proceeds from the offering of the notes will be applied for our hedging and general corporate purposes.

In essence, a holder of the ETN has bought a senior unsecured zero coupon bond from Barclays, with an ultimate payoff based off of the return on the commodities index less 0.75%/year. But unlike a bond, there is no floor on the implied interest at zero. If commodity indexes fall, the ETN would give a negative return.

I like Barclays. I own the stock. But there is more than one risk to the ETNs: commodity price risk (of course), and Barclays plc credit risk (surprise!).

Position: long BCS, and pondering the days when I used to read structured bond prospectuses regularly…

-=-=-=-

Now, today, I find it funny to see other retail investment commentators catching up with the credit risk angle of ETNs.  Perhaps it is my background in the Equity Indexed Annuity [EIA], Variable Annuity [VA], DC pension and GIC businesses — we had all sorts of guarantees and non-guarantees floating around, so we were used to analyzing the risks.

Now, what if the sponsors packaged the ETN with a default swap (written by third parties) to protect the investors if the company failed?  At that level, the ETN provider should buy Treasuries or Agencies, and layer on the futures or options as the case may be, creating an ETF, because all of the advantage from doing the ETN goes away.

Be wary of ETNs, at least to the level of asking how likely it will be for the sponsor to be in good shape when the ETNs mature.

Those who have read me for a long time know that my favorite insurance company is Assurant.  I’m not writing tonight about how they had great first quarter earnings, or how their investment portfolio suffered less than their competitors.  Rather, it springs from a Bloomberg article that is not available on the web.  It seems Assurant is talking to Countrywide about purchasing their Balboa Insurance Group.

What makes for an intelligent acquisition?  Two things: don’t overpay, or flub the integration.

On overpaying, it helps if you are buying:

• part of a business rather than the whole company
• a noncore asset of the target
• and offering noneconomic benefits (e.g. joining Berkshire Hathaway, because Warren doesn’t change the culture…)
• through a negotiation, not an auction (think of MetLife buying Traveler’s Life)
• something where you can get significant expense savings
• and you are known to be prudent and fair as an acquirer

On integrating, it helps if:

• you are integrating a business that differs from your business in at most one or two ways
• corporate cultures are similar
• the differences in technology are small
• you gain new markets or technologies that you can use in the rest of your business

Assurant has done very well through small in-fill acquisitions where they pick up a new line of business that they can grow organically.  They also have done well in occasionally buying scale in areas where they are already strong, for example, when they bought the pre-need (funeral) insurance business of Service Corp International (a very concentrated niche business line).

With Balboa Insurance Group, Assurant would deepen its penetration into lender placed homeowners insurance.  Assurant is #1, and Balboa I think is #2 because of its business with Countrywide.  Assurant has efficient systems — they will be able to take out costs, and deliver even better service to Countrywide / Bank of America.

Now, if Countrywide is interested in selling, it is likely that the best bid would come from Assurant, not because they will overpay, but because they can offer the best service, and take out the most in expenses.  Bank of America would likely find Balboa to be a small noncore asset, so their interest in retaining it would be low.

Here’s small excerpt from the Bloomberg piece:

“Certainly that is a business we would be interested in,” Assurant Chief Executive Officer Robert Pollock said today in a conference call with investors. “Until things between Bank of
America and Countrywide close, I don’t think that’s going to be a focus” for Bank of America.

Countrywide, based in Calabasas, California, reported a first-quarter loss of $893 million earlier this month, its third straight quarterly loss, as late mortgage payments and home
foreclosures rose. Bank of America said April 21 that its purchase, which would make the Charlotte, North Carolina-based bank the largest U.S. mortgage lender, remained on course forcompletion in the third quarter.

“Even in that case though, we still have to evaluate what we would have to pay for that business versus our ability to win” Balboa, Gene Mergelmeyer, president of Assurant’s specialty
property business, said in the call.

So, I look at this as a possible plus for both Bank of America and Assurant.  Balboa will be most valuable in Assurant’s hands.  Put it this way, why would another insurer want to buy Balboa when it is up against much superior competition?

PS — From the “don’t give a sucker an even break” file, Bank of America may not guarantee the debt of Countrywide.  This should not be a surprise.  They aren’t required to guarantee the debt, and Countrywide bondholders should just be grateful for the equity infusion.  If things get bad, though, Bank of America could walk away from Countrywide, and give it to the bondholders.

Full disclosure: long AIZ

1) Liberty Mutual buys Safeco?  Pays 1.75x book, and 11x estimated earnings?  Mutual companies have limited access to the credit markets, and have no equity to pay with, so it is mainly a cash deal.  They must have had a lot of cash lying around — might we wonder why they might not have enhanced policyholder dividends instead?  This is not an economic use of capital in my opinion. Kudos to those who owned Safeco — it was cheap, though in the negative part of the underwriting cycle.

I know this diversifies Liberty Mutual geographically and from a line of business standpoint, but I don’t expect there are a lot of costs to take out here. Intellectually, it is harder to grow organically, but at this point in the underwriting cycle, it is definitely preferred to acquisitions.  There are no equity investors in Liberty Mutual, but I would not lend them money on a trust preferred or a surplus note at present.  There are better places to put money at interest — remember, acquirers usually underperform.

But for those with a RM subscription, check out Cramer.  Off of Safeco, he likes Chubb.  Okay, I like Chubb too.  Great company, and cheap.   I prefer Allstate, HCC, or Safety, and if I wanted to speculate, maybe Affirmative.  Lots of cheap P&C names out there, but it is the wrong side of the underwriting cycle — premiums falling, losses coming in unabated.

2) I don’t get fundamental weighting on bonds.  With bonds, the best one can do is get paid interest and principal, if one is buy-and-hold.  With stocks, a buy-and hold investor can do better in the long run by buying better earnings streams (value), rather than accepting market value weightings.  With bonds, there is no such upside, so I don’t get the fundamental weighting, except perhaps in foreign currency denominated bonds, and using purchasing power parity, which is still a weak tool.  I wouldn’t go there.

3) I don’t get Bill Miller.  I’m a value investor.  I like companies that trade at modest multiples of book and earnings.  I agree in principle with the concept of deferred performance that he mentioned in his quarterly letter:

My friend Jeremy Hosking, who has delivered around 400 basis points per year of excess return over two decades at Marathon (in London), corrected me recently when I spoke about our underperformance. “You mean, your deferred outperformance,” he said. I thought it a clever line, but it contains an important point. For investors who are trend followers, or theme driven, or who primarily build portfolios around forecasts, or who employ momentum strategies, price is dispositive. When they do badly, it is because prices moved in a direction different from what they thought. For value investors, price is one thing, and value is another. When prices move against us, it usually means that the gap between price and value is growing, and our future expected rates of return are higher.

With stable, cheap businesses, this definitely applies, but as you step out onto the growth spectrum, it no longer applies.  Check out the beginning of the letter, he is only 41 basis points ahead of the S&P 500 on a ten-year basis.  At this rate next year, he might be behind the S&P over ten years.  Quite a flameout for one who was so lionized.  Could he be fired?  Yes, but not by Chip Mason.  They are too close.  If one succeeds unconventionally, there is less tolerance for failure, because they weren’t sure why it worked in the first place.

4) I’ll take the opposite side of this trade.  Financial literacy is a good thing, and most people would be better off knowing more about finances, so long as they can mix it with humility.  I’m a professional, and I think humility is a key virtue in handling money.  As I say in my disclaimer:

David Merkel is an investment professional, and like every investment professional, he makes mistakes. David encourages you to do your own independent “due diligence” on any idea that he talks about, because he could be wrong. Nothing written here, or in my writings at RealMoney is an invitation to buy or sell any particular security; at most, David is handing out educated guesses as to what the markets may do. David is fond of saying, “The markets always find a new way to make a fool out of you,” and so he encourages caution in investing. Risk control wins the game in the long run, not bold moves.

People who are educated will still make mistakes with their money, but they will make fewer mistakes on net.  Hey, I’ve paid market tuition, and it is painful.  But boy, I learned a lot, and I don’t repeat mistakes often.  (Repeating mistakes sometimes is bad enough… )

Full disclosure: long SAFT (not SAF)

National Atlantic has filed its Preliminary Proxy Statement. I’m only going to tackle one part of it here tonight — the section starting on page 24, “Opinion of the Financial Advisor.” Those who have read me for a long time know that I am neither biased for or against any “fairness opinion.” For those who want to go back to my early days on RealMoney, you can view what I wrote on the MONY acquisition by AXA. The fairness opinion was correct, and the contesting value investors were dead wrong. Part of the problem was not understanding the insurance accounting.

With National Atlantic, I think the fairness opinion does not truly represent the value of the company. Let me go through a few critical bits of the fairness opinion:

(Page 26)

     Selected Publicly Traded Companies Analysis. Banc of America Securities
reviewed publicly available financial and stock market information for National
Atlantic and the following seven publicly traded personal lines property and
casualty insurance companies with a market capitalization below $2.5 billion:

        o   Mercury General Corporation
        o   State Auto Financial Corporation
        o   Horace Mann Educators Corporation
        o   Infinity Property & Casualty Corporation
        o   Safety Insurance Group, Inc.
        o   Donegal Group, Inc.
        o   Affirmative Insurance Holdings, Inc.

Banc of America Securities reviewed, among other things, per share equity
values, based on closing stock prices on March 7, 2008, of the selected publicly
traded companies as a multiple of calendar years 2008 and 2009 estimated
earnings per share, commonly referred to as EPS, and as a multiple of book value
per share as of December 31, 2007 (in the case of Safety Insurance Group and
Affirmative Insurance Holdings, as of September 30, 2007).

Affirmative and Infinity do not belong in this group, because they are both nonstandard auto writers, which get lower valuations than standard writers. Donegal is mainly a commercial writer when last I looked… the rest are fine. I might have included Gainsco, Commerce Group, or Universal Insurance Holdings. In any case, it biases the calculation of the estimated price low.

     Implied Per Share Equity Value Reference Ranges for National Atlantic         Consideration
     ---------------------------------------------------------------------         -------------

          2008E EPS                                    2007 Book Value
       ---------------                               -------------------

        $3.27 - $4.20                                   $5.24 - $7.85                   $6.25

It also would have been better to do a scatterplot of Price-to-book versus expected ROE on compared companies. I will have to perform that analysis eventually.

(Page 27)

        Selected Precedent Transactions Analysis. Banc of America Securities
reviewed, to the extent publicly available, financial information relating to
the following twenty selected transactions involving property and casualty
insurance companies with a transaction value below $500 million:

  Announcement
      Date                                    Acquiror                                         Target
- ---------------       --------------------------------------------------    -----------------------------------------

     2/20/08          o    Meadowbrook Insurance Group, Inc.                o   ProCentury Corp.
      1/3/08          o    QBE Insurance Group Ltd.                         o   North Pointe Holdings Corp.
      4/4/07          o    Fortress Investment Group LLC                    o   Alea Group Holdings Ltd.
     3/14/07          o    Argonaut Group, Inc.                             o   PXRE Group Ltd.
     12/4/06          o    Elara Holdings Inc.                              o   Direct General Corp.
     11/22/06         o    Clal Insurance Enterprises Holdings Ltd.         o   GUARD Financial Group Inc.
     11/13/06         o    Tower Group Inc.                                 o   Preserver Group Inc.
     10/31/06         o    American European Group, Inc.                    o   Merchant's Group Inc.
     10/6/06          o    Affordable Residential Communities Inc.          o   NLASCO, Inc.
     10/3/06          o    Affirmative Insurance Holdings, Inc.             o   USAgencies, L.L.C.
     9/28/06          o    Arrowpoint Capital Corp.                         o   Royal & Sun Alliance Insurance
     8/16/06          o    QBE Insurance Group Ltd.                         o   One Beacon Insurance Group, Ltd.
      8/4/06          o    Delek Group, Ltd.                                o   Republic Companies Group, Inc.
     7/19/06          o    Inverness Management L.L.C.                      o   Omni Insurance Group Inc.
     11/4/05          o    General Motors Acceptance Corp.                  o   MEEMIC Insurance Company
     5/22/03          o    Liberty Mutual Holding Company Inc.              o   Prudential Financial Inc.
     5/22/03          o    The Palisades Group                              o   Prudential Financial Inc.
     3/26/03          o    Nationwide Mutual Insurance Co.                  o   Prudential Financial Inc.
     11/1/00          o    American National Insurance Company              o   Farm Family Holdings, Inc.
     10/25/00         o    State Automobile Mutual Insurance Company        o   Meridian Insurance Group, Inc.

The only deal here that would truly be a “comparable” might be Republic Companies. It was a company that was mainly a personal lines company, unlike many of the rest of these deals which are for commercial insurers and reinsurers (I am not familiar with all of them). Republic was sold significantly over its book value. And, where is Commerce Group? I know it is too big to meet the cutoff, but there is a sale of a single state insurer. I would think that valuation would be relevant.

                 Implied Per Share Equity Value
              Reference Ranges for National Atlantic            Consideration
            ------------------------------------------        ------------------
               2008E EPS             2007 Book Value
            ----------------       -------------------

             $5.36 - $6.30             $8.51 - $9.82                $6.25

So, I think these values are low as well. There is far more certainty to the valuation of the reserves of a short-tailed insurer, which usually deserves a higher valuation.

(Page 28)

     Discounted Cash Flow Analysis. Banc of America Securities performed a
discounted cash flow analysis of National Atlantic to calculate the estimated
present value of the standalone unlevered, after-tax free cash flows that
National Atlantic could generate during National Atlantic's fiscal years 2008
through 2012 based on the National Atlantic management forecasts. Banc of
America Securities calculated terminal values for National Atlantic by applying
terminal forward multiples of 7.0x to 9.0x to National Atlantic's fiscal year
2013 estimated GAAP earnings and of 0.40x to 0.70x to National Atlantic's
estimated 2012 year-end book value. The cash flows and terminal values were then
discounted to present value as of March 7, 2008 using discount rates ranging
from 15% to 17%. This analysis indicated the following implied per share equity
value reference ranges for National Atlantic as compared to the Consideration:

             Implied Per Share Equity Value
          Reference Range for National Atlantic             Consideration
     -----------------------------------------------  --------------------------
                       $5.42 - $7.42                            $6.25

I’d like to see them spill the guts of the calculation, and the other calculations above as well. Using “0.40x to 0.70x to National Atlantic’s estimated 2012 year-end book value” and “discount rates ranging from 15% to 17%” is too severe. This is a company with no debt. It’s marginal cost of capital, using the “pecking order” theory is low. Also, short-tail P&C companies under competent management teams don’t retain valuations below 0.8x book.

     Run-off Analysis. Banc of America Securities also performed a run-off
analysis of National Atlantic to calculate the net present value of dividends
that would be paid to shareholders over the remaining life of the company
assuming that it serviced its existing policies without writing any additional
policies or renewing any existing policies. Based on the assessment of National
Atlantic management that the company would not be permitted to pay annual
dividends by the New Jersey regulators, this analysis calculated the net present
value of the final dividend available for distribution to shareholders after all
payouts on loss reserves and losses on unearned premium reserves, estimated to
be approximately $88.0 million payable in 2016. Banc of America Securities
applied a sensitivity analysis to assess a range of values if the loss reserves
were inadequate by up to 10% or were overstated, showing a redundancy of up to
10%. The range of final dividend distributions were then discounted to present
value as of March 7, 2008 using discount rates ranging from 13% to 17%. This
analysis indicated the following implied per share equity value reference ranges
for National Atlantic as compared to the Consideration:

             Implied Per Share Equity Value
          Reference Range for National Atlantic             Consideration
     -----------------------------------------------  --------------------------
                      $1.36 - $3.60                             $6.25

Again, the discount rate is too high. Beyond that, they make the fatal assumption that the company can’t close its books until 2016. If National Atlantic stopped writing policies today, then, one year from today, it would receive its last premium. The company would operate with a skeleton staff for one more year, after which, the remaining book could easily be sold to a company specializing in run-offs. You wouldn’t get your money in 2016. It would be more like 2010. Six years of interest discount at 13-17% makes a huge difference in the price.

=-=-=-=-=-=-=-=-=–=-==-=–=-==-=-=–=-==–=

I have more work to do here, but my fundamental view is not changed. I will be voting against the deal, and encouraging others to do the same. Should the deal succeed, I will likely file for appraisal rights. As I have noted before, I believe that I have meritorious arguments for a better price.

Full disclosure: long NAHC SAFT

So Reinsurance Group of America missed estimates. Big deal; they’ve had good-to-excellent earnings for the last ten quarters; they have a bad quarter now and then when the “law of small numbers” catches up with them. Look at 2Q05 and 4Q01 for examples. The law of small numbers means that every now and then, you get a random gaggle of deaths with high face amounts, and the quarter is bad. This is often a good buying opportunity, because Wall Street, which only understands that the earnings missed, without understanding the underlying model, assumes that the miss will persist into the future. That has not been true of RGA.

I have met the CEO and CFO of RGA, and I think they know what they are doing, more than all of the other companies that do life reinsurance. They are the quality name in the space, including their more complex European competitors.

The stock price is currently way above my lower rebalance point, but I would be a buyer on weakness if I did not have a position. This is one of those stocks that you tuck away for 5-7 years, and you find that it doubles. The current oligopolistic nature of life reinsurance may shorten that timespan.

Full disclosure: long RGA

1)  Picking up on some comments from last night’s post, why I am I not concerned about counterparty exposure?  Because Wall Street has always been very good at cutting off overleveraged clients in the past.  LTCM was an exception there, and only because Wall Street gave in to their request for secrecy.  Wall Street grabs collateral first, and then lets the client argue to get it back.  The investment banks require a significant margin, and when there is significant concern about getting paid, the lines get pulled.

The real worry here is that the investment banks don’t have good enough risk controls for each other.  Note that Bear’s crisis started when other banks stopped extending credit to Bear, and the fear fed on itself.

I liken the investment banks to long-tail commercial casualty insurers.  No one knows whether the reserves are right.  No one can.  Confidence is a necessary part of the game, which is made easier at lower levels of leverage.  But high leverage and opaqueness are a recipe for disaster when volatility rises.

2) Should you worry about Fed policy?  Yes.  The Fed is steering away from the Scylla of a compromised financial sector, and into the Charybdis of inflation.  As I will point out later, that is already having impacts on the rest of the world.  As for now, there are a few ill-informed writers who say that a negative TIPS yield on the short end is a reason not to buy TIPS.  That might be correct if inflation mean-reverts.  Given the short-term resource scarcity building in our world, I don’t think that is likely.

3) Should you worry about the US Government budget deficit?  A little — oh, and worry about the real deficit, one that puts the wars and other emergency appropriations on-budget, and takes out the excess cash flow from Social Security.  In a macro sense, for the nation as a whole, the impact isn’t that great… but it sends a message to foreign creditors who wonder what the value of the dollars will be when they get paid back.  When they see the Fed running an aggressive monetary policy in the face of rising inflation and a weak dollar, it makes their heads spin, as they contemplate the hard choices the weak dollar forces on them.

4) Could the falling dollar cause a crisis in China?  Maybe.  China is levered to US growth, which is slowing, and their export competitiveness versus the US declines as the dollar declines.  And what will they do with all of those dollar reserves?  Beats me.  After a certain point, additional reserves are useless — it is akin to lending more to an entity that you know is insolvent.  My guess is that the yuan will get revalued after the Olympics, and then the real slowdown will hit China.

5)  What of foreign food riots; are they a worry?  (More, and more.)  A little.  They are a canary in the coal mine.  They point to the short-term scarcity of total resources in our world, which only becomes obvious as a large part of the world tries to develop.  But, one practical thing that it implies is that energy and food prices will remain high for some time.  We are one global market at present, and energy and food prices are interlinked through the energy and fertilizer costs of farmers, and through stupid ideas like corn-based ethanol.

6) What of flat crude oil  production?  Yes, worry.  As I have said before, the government oil companies of OPEC countries control most of the supply, but they don’t always manage their resources as well as a capitalistic oil company.  Mexico, Venezuela, and Russia have declining production, to name a few.  The Saudis may not want to produce more, because they don’t know what to do with all the US dollar reserves that they have today.  Or maybe they can’t…

7) Worry about falling housing prices?  Yes.  The problems in the housing market stem from overbuilding.  There are too many houses chasing too few solvent borrowers.  This will eventually affect prime mortgages, because declines of 15-20% in housing prices mean that many prime loans would be underwater in a sale.  Remember, an underwater loan becomes a default after a negative life event — unemployment, death, disability, divorce, and uninsured disaster.

Before all of this is done, one of the major mortgage insurers should fail.  We aren’t there yet.

8 ) What of falling residential real estate prices in foreign countries? Yes, worry.  For Europe, it could lead to the end of the Euro, as countries needing looser monetary policies get tempted to abandon the Euro.  If the Euro’s existence becomes questioned, it will be a systemic risk to the world.

9) What of credit card delinquencies?  Yes, worry.  It shows that total financial stress on the consumer is high, particularly when added to the problems in mortgage and home equity loans.

10) Should you worry about bank solvency?  A little.  All of these previously described stresses have some bearing on the ability of the banking system to make good on their obligations.  Be aware that the FDIC was designed to handle sporadic losses, not systemic crises.  The odds of these problems affecting the depositary financials is still low, but the protective measures will not be capable of dealing with the worst case scenario, should it arise.

Perhaps I have more to worry about.  As I close up here, I haven’t mentioned the PBGC, Medicare, and a variety of other problems.  But, I have to call it a night, and symmetry with last night’s piece is worth a little to me.

There are many that cover the markets that try to get you to worry about things that aren’t real problems.  Here’s a sampling for the evening:

1) Changes in accounting standards, or ineffective/opaque accounting standards.  Take Goldman Sachs and level 3 assets as an example.  The accounting standard is fine, so long as you understand it.  In general, the higher the level of level 3 assets, the more opaque the valuation of assets is, and a valuation haircut gets assigned to the stock.  This is proper, because it happens to all companies with high or cloudy accrual figures.  It makes it hard to estimate free cash flow.

Should we move from US GAAP to IFRS, it should not affect the valuations of stocks on average, though it will make it a little harder to do financial analysis.  What does not change is free cash flow, which is not subject to accounting rules.  The money that can be withdrawn from a business without harming its current prospects (free cash flow) is the key metric for understanding business value.

2) Counterparty risk.  In derivatives, for every loser, there is a winner.  So long as the appropriate margin levels are maintained at the main brokerages, and the main brokers don’t experience conditions that dramatically change their credit quality, counterparty risk is not a problem.  (Or maybe, I should say, worry about the brokers, not the other counterparties.)

3)  Investors moving to cash.  Money rarely leaves the market.  When funds raise cash (and here), others buy their shares at a discount.  Typically, they are stronger holders than those that sold.  I wouldn’t be too bullish over stories of investors moving to cash, but I certainly would not be bearish.

4)  Rating agency downgrades, unless they trigger a debt covenant.  For the most part, market spreads and yields are set independently of debt ratings.  Sophisticated investors dominate the market, not the rating agencies.  As an example, suppose the US were downgraded to Aa1/AA+/AA+.  After a week, I doubt yields would change much at all, because the fundamental view of the US would not be changed by a change in its rating.

5) High credit spreads.  Those are a reason to be optimistic, because it means pain has been taken already.  Spreads can’t get higher than a certain level, or companies start delevering, because it is profitable to do so.  So when you see spreads near record highs, that is a buying signal, at least for the debt.

6) Retailers in trouble.  Some retailers are always in trouble during hard economic times.  It’s a tough business model, so expect some defaults; it is normal and healthy for the economy as a whole.

7) Collapse of a large portion of the auction rate securities market.   Most borrowers will refinance.  In the interim, speculators are driving down the rates that get paid.

Downgrades of the major financial guarantors.  The market has priced it in, and perhaps we just run off MBIA and Ambac.

9) Tranche warfare in CDOs.  Read your prospectus with care, but when the seniors grab hold of a deal after and event of default, that is a step toward normalizing the market, though the mezzanine holders may ineffectively object as they end up getting nothing.

10) The ABX indexes, etc.  I’ve written about this before, but the various synthetic indexes — ABX, CMBX, LCDX, etc., are very hard to arbitrage against the cash market bonds that they represent.  The indexes should not be used for pricing as a result.  Whenever the synthetic market gets too much bigger than the cash market, it becomes a bettors market, and becomes incapable of delivering pricing signals to the underlying cash markets.

There are enough real things to worry about.  Perhaps I will write about those tomorrow.

For this quarter, I sold two my two placeholder assets, the Industrial and Technology SPDRs, and Arkansas Best, which had richened enough for me to trade out of it.

I had two rebalancing buys, Charlotte Russe and Avnet.  On Charlotte Russe, the rebalancing buy occurred because I tendered all my stock @ $18 in the Dutch Tender, and 45% of it got bought.  On Avnet, things aren’t as bad as the market thought on 4/15, in my opinion.  I had one rebalancing sell, Helmerich and Payne.  Just taking some off the table for risk reduction purposes.

Here is my final comparison file that was based off of data at the close of business on Monday.  To comply with the Bloomberg data license, all numeric fields remaining are ones that I calculated.  The columns of the file rank the 290 stocks on the following metrics (lower better unless noted):

• 52-week RSI
• Trailing P/E
• P/Book (2)
• P/Sales (2)
• P/2008E
• P/2009E
• Dividend Yield (higher better)
• Net Operating Accruals (2)
• Implied Volatility
• Neglect (higher better)

The grand rank sums up the ranks giving double weights to P/B, P/S, and NOA.  My current stocks are highlighted in yellow, except for the two middle ones, which are in orange.  Candidates for sale come from the lower half (high grand ranks), candidates to buy from the upper half.

Here were my purchases (P/2008E):

• International Rectifier — 9.5x
• Group 1 Automotive — 7.1x
• OfficeMax — 9.3x
• Universal American Financial — 5.8x

Cheap names all (and could get cheaper?).  If you asked me what my concerns might be over this group of names, I would say that credit quality is adequate but not stellar.  I would also confess a little doubt on Universal American.  It looks cheap, and lines of business they are in are stable lines.  They lost money on mezzanine subprime mortgage ABS.  I looked at the writedowns, and they seem adequate.  If you send the security vintages 2006-2007 to zero, this stock is still cheap, in my opinion.   What I can’t evaluate is whether they could have operational problems in their senior health insurance business.  It’s a good business, if managed properly.

As for International Rectifier and Group 1, I have owned them before.  With IRF, I like industrial technology — stuff that is harder to obsolete.  On Group 1, I looked at all of the small cap auto retailers, and picked this one.  I liked its business mix, and what seemed to be a clean balance sheet, with few immediate needs for liquidity.  The group as a whole has been smashed, and is discounting very unfavorable conditions.  I don’t think things are that bad, and besides, a lot of the revenues come from repairs and sales of used cars.

With OfficeMax, I think prospects are less cyclical than the market seems to believe.  Office supplies get purchased during bad economic times as well, and the current price already discounts  a lot of pain.

Well, those are my purchases.  Let’s see how they fare over the coming years.

Full disclosure: long HP CHIC AVT GPI UAM OMX IRF

I received this in the mail on Saturday:

ABC logo

March 31, 2008

Dear Investor,

I am writing to tell you that my firm is in very good financial condition. Normal market conditions would not require this correspondence. But I understand that many people are deeply concerned about the stability of their brokers at this time.

I have always tried to earn my clients’ trust by running the firm conservatively, with clients’ interests in mind. Today, 75% of the Company’s assets are in cash or cash equivalents and we have no debt. In addition, we have no investments in collateralized debt obligations or similar instruments. As a matter of policy, we do not carry positions or make markets.

Throughout the years, in making decisions about my business, I have always put the safety of my clients’ assets first. This is one of the primary reasons my firm clears on a fully disclosed basis through DEF LLC (DEF), a GHI company. DEF clears our clients’ trades and is in custody of their accounts. Their name appears with ours on monthly statements and confirmations. As of December 31, 2007, DEF had net capital in excess of $2.1 billion which exceeded its minimum net capital requirement by more than $1.9 billion.

In addition, when you do business at ABC, your account receives coverage from the Securities Investment Protection Corp. (SIPC) as primary protection for up to $500,000, including a limitation of $100,000 for cash. SIPC coverage is required of all registered broker-dealers. Since most “cash equivalent” money market mutual funds are considered securities under SIPC, investments in money market mutual funds held in a brokerage account are protected by SIPC along with your other securities to a maximum of $500,000. Of course, there is no protection that will cover you for a decline in the market value of your securities. You may visit www.sipc.org to learn more about SIPC protection.

Furthermore, DEF has arranged for additional protection for cash and covered securities to supplement its SIPC coverage. This additional protection is provided under a surety bond issued by the Customer Asset Protection Company (CAPCO), a licensed Vermont insurer with an A+ financial strength rating from Standard and Poor’s. DEF’s excess-SIPC protection covers total account net equity for cash and securities in excess of the amounts covered by SIPC, for accounts of broker-dealers which clear through DEF. There is no specific dollar limit to the protection that CAPCO provides on customer accounts held at DEF. This provides ABC clients the highest level of account protection available in the brokerage industry to the total net equity with no limit for the amount of cash or securities. And, unlike many other brokers, there is no “cap” on the aggregate amount of coverage for all of our customers’ assets. You may access a CAPCO brochure about “Total Net’ Equity Protection” at ABC.com [deleted]….

If you are concerned about the status of your assets at another brokerage firm, you might consider moving them to ABC. It is easy to transfer assets. If you have friends who are concerned about their brokers, you might consider referring them to us. We continue to offer free trades for asset transfer and referrals. If you have questions about anything in this letter, please feel free to call us at 800-xxx-xxxx from 7:30 a.m. –7:30 p.m. ET, Monday-Friday. Once again, thank you for your trust and your loyalty.

Sincerely,

President and Chief Executive Officer of ABC

I used to do business with ABC, and I presently do business with GHI. Both of them are good firms, doing business on a fair basis for their clients. To me, it is interesting to use financial strength as a marketing tool.

On another level, how many people actually check the solvency of their brokers before doing business with them? On a retail level very few, if any. On an institutional level, that’s a normal check for sophisticated investors.

That said, I would be surprised to see any major retail brokers go insolvent aside from those with significant investment banking exposure. Even there, accounts are segregated, and client cash typically has the option of being in a money market fund.

This is not something that I worry about in investing, but if I were worried about my broker, I would make sure that my liquid assets over $100,000 were in a non-commingled vehicle, most likely a money market fund.

What of Excess Insurance?

Now, I will add just one more note in closing. CAPCO is a nice idea, but I am always skeptical of small-ish insurers backing large liabilities with a remote possibility of incidence. There aren’t that many AAA reinsurers out there, and I am guessing that Berky is not one of them. Buffett does not like to reinsure financial risks, aside from municipal debt. That leaves the AAA financial guarantors — Ambac, MBIA, Assured Guaranty, and FSA (though I am open to a surprise here). I’m guessing it’s the first two, and not the last two. CAPCO is owned by many of the major brokers, but in a crisis, CAPCO has no recourse to its owners, but only to its reinsurers, should that coverage be triggered. The recent financial troubles have led S&P to place CAPCO on negative outlook, mainly because:

Standard & Poor’s assigns a negative outlook when we believe the probability of a downgrade within the next two years is at least 30%. The revised outlook reflects the challenging environment for broker/dealers and their parents. Deterioration in their credit quality and risk-management capabilities could affect CAPCO’s financial strength. In the past couple of months, Standard & Poor’s has revised the outlook on several of CAPCO’s members’ parents to negative. Also, the ratings on a couple of members are on CreditWatch with negative implications, which means there’s the potential for a more imminent downgrade. The capital of CAPCO’s members and–in some cases–their parents is an important resource for mitigating CAPCO’s potential payments for its excess SIPC (Securities Investors Protection Corp.) coverage.

It would be interesting to know for certain the underwriters and terms of CAPCO’s reinsurance. I’m not losing any sleep over it, though… there are bigger things to worry about, my personal broker is well-capitalized, and I have less than $100K at risk in cash, and that is in a money market fund. So long as accounts remain segregated, risks are small.