August 2007 – Page 4 – The Aleph Blog

The Current Market Morass

Posted on 9 August 200710 August 2007 by David Merkel

Over at RealMoney, toward the end of the day, I commented:

		David Merkel
		Many Hedge Funds are Systematically Short Liquidity
		8/9/2007 5:43 PM EDT

You can look at Cramer’s two pieces here and here that deal with the logjam in the bond markets. Now, there are problems that are severe, as in the exotic portions of the market. There are problems in investment grade corporate bonds in the cash market, but spreads haven’t moved anywhere nearly as much as they did in 2002. The synthetic (default swap) portion of the market is having greater problems. Oddly, though high yield cash spreads have moved out, they still aren’t that wide yet either compared to 2002. The problems there are in the CDS, and hung bridge loans.

Most hedge funds that try to generate smooth returns are systemically short liquidity and volatility. If these funds are blowing up, like LTCM in 1998, then liquidity will be tight in the derivative markets, but the regular cash bond markets won’t be hurt so bad.

I agree with Michael Comeau with a twist… this may end up being good for the equity markets eventually, but in the short run, it is a negative.

Let me try to expand a little more here. A good place to start is Cramer’s last piece of the day. Part of what he said was:

But first you have to recognize that I am not talking about opportunity. We need the Fed simply to issue a statement like it did in 1987, that it would provide all of the liquidity necessary to get things moving in the credit markets.

All of those who think the Fed is helpless are as clueless as the Fed. A statement like that would eliminate the fear all over town that committing capital is going to wipe your firm out.

The European action seemed desperate today, but it’s a bit of a desperate time, and they did what is right.

If we had made the right call on Tuesday at the Fed, we would have maneuverability over the next month to help.

Now we can’t. Not for another couple of months, [sic]

Unfortunately, Cramer is wrong here. The ECB only did a temporary injection of funds, which will disappear. The Fed also did a similar temporary injection of funds today, which brought down where Fed funds were trading. It will disappear as well, but both the ECB and Fed can make adjustments as they see fit. There isn’t any significant difference between the actions.
There have been notable failures and impairments, for sure. Let’s run through the list: the funds at BNP Paribas, funds at AXA, Oddo, Sowood and IKB, Goldman Sachs, Tykhe Capital, and Highbridge (and more). With this help from DealBreaker (most of the comments are worth reading also), I would repeat that most hedge funds that try to generate smooth returns are systemically short liquidity and volatility. Another way of saying it is that they have a hidden short in credit quality, and this short is biting bigtime.

Okay, I’ve listed a lot of the practical failures, but what classes of hedge fund investments are getting hurt? Primarily statistical arbitrage and event-driven. (Oh, and credit-based as well, but I don’t have any articles there.) The computer programs at many stat arb shops have not done well amid the volatility, and there have have been significant M&A deals that have come into question, like MGIC-Radian. Merger arbitrage had a bad July, and looking at the Merger Fund, August looks to be as bad. (Worrisome, because merger arb correlates highly with total market confidence.) As for statistical arb, I know a few people at Campbell & Company. They’re bright people. Unfortunately, when regimes shift, often statistical models are bad at turning points. Higher volatility, bad credit, and the illiquidity that they engender doom many statistical models of the market.
So, how bad is credit now? If you are talking about securitized products and derivatives, the answer is extremely bad. If you are talking about high yield loans to fund LBOs, very bad, and my won’t some the investment banks take some losses there (but they won’t get killed). High yield bonds, merely bad — spreads have widened, but not nearly as much as in 2002. Same for investment grade corporates, except less so. Now the future, like say out to 2010, may prove to be even worse in terms of aggregate default rates of corporates, because more of the total issuance is high yield. This is just something to watch, because it may imply a stretched-out scenario for corporate credit losses.

The Dreaded Subprime

Subprime mortgage lending has had poor results. I would even argue that early 2007 originations could be worse than the 2006 vintage. This has spilled over into many places, but who would have expected money market funds? The asset-backed commercial paper [ABCP] market is a small slice of the total commercial paper market, and those financing subprime mortgage receivables are smaller still. The conduits that do this financing have a number of structural protections, so it should not be a big issue. The only thing that might emerge is if some money market fund overdosed on subprime ABCP. I’m not expecting any fund to “break the buck,” but it’s not impossible.

I generally like the writings of Dan Gross. He is partially right when he says that the effects of subprime lending are not contained. Many different institutions are getting nipped by the problem. But I think what government officials mean by contained is different. They are saying that they see no systemic risk from the problem, which may be correct, so long as the aggregate reduction in housing prices does not cause a cascade of failure in the mortgage market, which I view as unlikely.

Perhaps we should look at a bull on subprime lending? Not a big bull, though. Wilbur Ross has lent $50 million to American Home Mortgage on the most senior level possible. That’s not a very big risk, but he does see a future for subprime lending, if one is patient, and can survive the present slump.

A note on Alt-A lending. There’s going to be a bifurcation here; not all Alt-A lending is the same. As S&P and the other rating agencies evaluate loan performance, they will downgrade the deals with bad performance, and leave the good ones alone. The troubles here will likely be as big as those in subprime. Perhaps the lack of information on lending is the crucial issue. Colloquially, never buy a blind pool, or a pig in a poke. Information is supremely valuable in lending, and often incremental yield can’t compensate.

Summary Thoughts

I think 1998 is the most comparable period to 2007. There are some things better and worse now, than in 1998. In aggregate it’s about the same in my opinion. Now with hedge funds, the leverage in aggregate is higher, but could that be that safer instruments are being levered up? That might be part of it, but I agree, aggregate leverage is higher.

In a situation like this, simplicity is rewarded. Complexity is always punished in a liquidity crisis. Bidders have better thing sto do in a crisis than to figure out fair value for complex instruments when simpler ones are under question.
Another aspect of liquidity is the investment banks. As prime brokers, their own risk control mechanisms cause them to liquidate marginal borrowers whose margin has gotten thin. This protects them at the risk of making the crisis worse for everyone else as the prices of risky asset declines after liquidations. Other investors might then face their own margin calls. The cycle eventually burns out, but only after many insolvencies. My guess: none of the investment banks go under.

Finally, let’s end on an optimistic note, and who to do that better than Jim Griffin? As I said before, simplicity is valued in a situation like this, and stocks in aggregate are simple. As he asks at the end of his piece, “What are you going to buy if you sell stocks?” I agree; there will be continued problems in the synthetic and securitized debt markets, but if you want to be rewarded for risk here, equities offer reasonable compensation for the risks taken. Just avoid the areas in financials and hombuilders/etc, that are being taken apart here. The world is a much larger place than the US & European synthetic and securitized debt markets, and there are places to invest today. Just insist on a strong balance sheet.

Buybacks and Yield Should be Byproducts of Free Cash Flow

Posted on 9 August 2007 by David Merkel

There’s a lot of talk about the superiority of yield-based strategies, and that has been true in hindsight, particularly since interest rates have fallen for pretty much the last 25 years, while corporate profits and free cash flow have generally grown, allowing for greater dividend capacity.? A potent mix that has favored yield, but what if the environment changes?

I don’t go looking for yield, but stocks with some yield tend to find their way into my portfolio.? Why?? Companies with stable business models, strong balance sheets, and good earnings quality tend to produce free cash flows in excess of their reinvestment needs.? That cash can be given to shareholders as dividends, or used to buy back stock.

But there is something positive about what a dividend does to a company’s management team, which in the American context, is viewed as a pseudo-obligation.? This makes the cost of capital tangible to the management team, which will be more careful about how they use their cash.? After all, they have a dividend to maintain.

Now, yield in itself can be manipulated.? Leverage can be increased to pay dividends, and with low quality companies that often happens.? Smart investors look to see how well a company’s dividend yield is covered by the earnings.? Avoid the shares of a company that isn’t likely to earn its dividend, particularly if the have to compromise the balance sheet to do it.

A yield in itself does not make a company more safe; if the yield is high enough such that there are naive yield investors in the stock, that yield can actually make the stock more risky, if a disappointing earnings report puts the dividend in jeopardy.

Finally, as an aside, a quick note on intelligent vs. dumb buybacks.? Intelligent management teams have an estimate of what they think their firm is worth, and they don’t buy back stock, unless the stock is trading below that level.? The management team won’t tell you that level, but they might tell you if they follow such a strategy, if you ask them.

After that, you can find out where they are buying stock back.? If you look in the cash flow statement, under cash flows from financing, you can see how much they spent buying back stock, and in the statement of shareholders equity you can see how many shares they bought back.? Those two figures will enable you to calculate the average buyback price.? This figure can be important even for traders, because it can indicate a level where a management team is willing to buy buy shares when they have free cash, and as a result, can become a support level for the stock.

Good fundamental investing means looking at more than just a few summary variables, like yield.? You have to dig through the financial statements to see how the business adds value.? If that means that your stock gives you a yield, like most of my stocks do, that is icing on the cake.

Nine Global Macroeconomic Trends: Watching the Currency Speculation, Watching the Inflation Pot Boil

Posted on 9 August 2007 by David Merkel

This piece is a little dated, but I’m using it to illustrate the nature of consumer surveys in the US.? If rates have been rising, those polled extrapolate the current trend.? As it was, that particular poll was close to the short-term turning point on inflation expectations.? I feel more comfortable trying to tease out inflation expectations by looking at the relative spread of TIPS to nominal bonds.? Right now, that’s not moving much.
I’m already on record that I don’t like the concept of core inflation, and that I think current methods of measuring inflation understate it, though now I would say only by 1%/year.? But regarding core inflation, there are many who say there are better ways to remove volatility from the estimation of central tendency.? Use of a median or trimmed mean are superior methods to excluding whole classes of goods, like food and energy, which conveniently have been rising faster than most other good in the CPI.
Inflation is rising in many places.? New Zealand is one example.? This is one of those temporarily self-reinforcing situations where foreign investors are willing to invest because of high nominal rates, while discounting any possibility of the currency moving against them.? In the short run, the more people who believe this, the less likely that an adjustment occurs.? But the additional liquidity stimulates the economy, raises inflation, and makes the central bank want to tighten more, leading to higher rates in which foreign investors want to invest.? It will only break when the high rates slow the NZ economy to a crawl, or, for some unexpected reason, the currency starts depreciating, and it feeds on itself.? Personally, I would not be long the Kiwi.
The Economist has noticed many of the same trends, adding in Latvia and Iceland to NZ.? In the short run, so long as foreign investors have confidence in the currencies of these three nations, their central banks are impotent.? But in some sort of crisis that would disrupt global capital flows, all of these currencies would be at risk.? No telling when that will happen, but once the adjustment happens, like those who borrowed at teaser rates, they will be sorry they invested in high interest rate currencies, and borrowed in low interest rate currencies.
China.? Easy to underestimate.? Easy to overestimate.? Hard to get a fair picture.? Their Central bank keeps tightening, but doesn’t let the currency adjust upward.? As a result, inflation keeps rising there… too much credit is chasing too few goods produced for domestic consumption. (Diseases affecting pigs, and high grain prices don’t help.? Food is a larger portion of the budget of the average person in China.)? Exports dominate Chinese economic policy, and with an dirty-floating undervalued currency, trade surpluses build up almost everywhere, except the Middle East and Japan.? The Chinese economy keeps rolling ahead, growing at near-record rates if you can believe the statistics.? (Which I largely believe, the current account surpluses don’t lie.)? That has costs, though.? There are costs to the environment, food safety, working conditions, etc.? The communist party has in some ways transformed themselves in a bunch of crony capitalists.? Those at the top get the favors, and the rest trickles down, but not as well as in the US.? In the short run, that can produce amazing economic results, but can’t produce a society that is truly creative, and self-sustainingly productive.? What will happen to China when it no longer has incremental cheap labor to deploy?? Productivity will drop?? Already I am hearing of some manufacturers decamping to Vietnam, and other cheaper places.
The reported US Government deficit is shrinking.? Good as far as that goes.? Corporate taxes are filling much of the gap.? We still have the Iraq/Afghanistan Wars off-budget, and Social Security on budget, both of which reduce the true size of the deficit.? On an accrual basis, counting everything in, we are running deficits at near record levels.? Promises are being made for the future the aren’t getting counted today.? Corporations would have to accrue them, but the government does not.
And now a word from our sponsors, the optimists.? Let’s start with the ISI Group.? They have ten reasons why we won’t have a recession soon.? I have been arguing for a recession in 2008, but as GDP growth remains positive each quarter, it gets harder to maintain that a recession is around the corner.? Though inflation is rising, credit spreads are widening, and the US Dollar is falling, the US economy has been resilient, credit spreads and implied volatilities have not been out of control.? And housing finance is not good, but most of the lending risk is concentrated in the hands of a few speculators.? The US economy is seeing export-led growth for the first time in a while.? There are reasons for optimism here; just because it is easier as a writer to be a skeptic and a pessimist, doesn’t mean you should invest that way.
Why do I like most but not all emerging markets here?? They are better managed on both fiscal and monetary bases than many developed economies, and capitalism is finally becoming a sustainable ideology.? That’s why amid the rise in credit spreads for junk grade corporations here in the US, many emerging market spreads have tightened.? Going back to points 3 and 4 above, those that don’t have strong fiscal and monetary policies, like Turkey, may very well get whacked, after a disruption in capital flows, war, or some event that changed the willingness of investors to take currency or sovereign risk.
What if we try to get away from currencies, and focus on commodities instead?? Metal scrap prices are robust.? Aluminum beer kegs are getting sold for scrap, among other things.? In another place, Historian Niall Ferguson tells us that we should not worry about running out of oil, but out of arable land for farming.? Personally, I’m not worried about either.? Rising food prices will slow the development on arable land, and in some cases, redevelop land for farming.? Further, contrary to the over-estimated Malthus (whose great contribution in life was giving inspiration to Darwin), we have been able to grow agricultural productivity considerably faster than population, in areas where capitalism is allowed to thrive.? That said, I am bullish on the prices of food products; in the short run, there will be more excess demand.

Eight Great Straight Points on Real Estate

Posted on 7 August 20078 August 2007 by David Merkel

So Moody’s tries to clean up its act, and finds itself shut out of rating most Commercial Mortgage-backed Securities [CMBS] deals? That’s not too surprising, and sheds light on the value of ratings to issuers and buyers. With issuers, it’s easy: Give me good ratings so that I can sell my bonds at low yields. With buyers, it is more complex: We do our own due diligence — we don’t fully trust the ratings, but they play into the risk management and capital frameworks that we use. We like the bonds to be highly rated, and misrated high even better, because we get to hold less capital against the bonds than if they were correctly rated, which raises our return on capital. Moody’s was always in third place behind S&P and Fitch in this market, so it’s not that big of a deal, but I bet Moody’s quietly drops the change.
The yields on loans are not only going up for LBOs like Archstone, leading to further deal delays, but yields are also rising on commercial real estate loans generally. Here is an example from one of the big deals. The risk appetite has shifted. Is it any surprise that equity REITs are off so much since early March? The deals just can’t get done at those high cap rates anymore.
An old boss of mine used to say, “Liquidity is a ‘fraidy cat.” It’s never there when you really need it, and with residential mortgage finance now, the ability to refinance is being withdrawn at the very time it is needed most. What types of mortgages are now harder to get? No money down, Jumbo loans, Alt-A, more Alt-A, and you don’t have to mention subprime here, the pullback is pretty general, with the exception of conforming loans that are bought by Fannie and Freddie. For (perverse) fun, you can see how detailed the guidance to lenders can become.
Should it then surprise us if some buyers of mortgage loans have gotten skittish? No, they forced the change on the originators. A buyers strike. But maybe that’s not the right move now. Let me tell you a story. When I came to Provident Mutual in 1992, the commercial mortgage market was in a panic. The main lines of business of Provident Mutual, hungry for yield, had accepted low-ish spreads from commercial mortgages from 1989-1991, because it improved their yield incrementally. The Pension Division avoided commercial mortgages then, because they felt the risks were not being fairly compensated. In 1992, the head of the commercial mortgage area came to the chief actuary of the pension division, and told him that unless the Pension Division bought their mortgage flow, they would have to shut down, because the main lines couldn’t take any. The chief actuary asked what spreads he would get, and the spreads were high — 3% over Treasuries, much better than before. He asked about loan quality, and was told that they had never had such high quality loans; only the best deals were getting done because of the panic in the market. The chief actuary, the best actuarial businessman I have ever known grabbed the opportunity, and took the entire mortgage flow for the next two years, then stopped. (Saving the Mortgage Division was icing on the cake.) Spreads normalized; credit quality was only average, and the main lines of the company now wanted mortgages. The point of the story is this: the firms that will do best now are not the ones that refuse to lend, but the ones who lend to high quality borrowers at appropriate rates. It’s good to lend selectively in a panic.
Eventually the ARM mortgage reset surge will be gone. Really. We just have to slog through the next two years or so. This will lead to additional mortgage delinquencies and defaults. We’re not done yet. There is a lot of mis-financed housing out there, and unless the borrowers can refinance before the fixed rate period ends to a cheap-ish conventional loan, I don’t see how the defaults will be avoided. Remember houses are long-term assets. Long term assets require long-term financing. Floating rates don’t make it. Non-amortizing loans don’t make it.
Should it then surprise us that the downturn in housing prices is large? No. With all of the excess supply, from home sellers and homebuilders, current prices are not clearing most of the local real estate markets, and prices need to fall further. (Maybe we should offer citizenship to foreigners who buy US residential real estate worth more than $500,000. A win-win-win. Excess supply goes away. Current account deficit reduced. Wealthy foreigners get a safe place to flee, should they need it. 😉 )
As a result, the homebuilders are doing badly. They aren’t making money on the hgomes they build and the value of the land (and land options, JVs, etc.) that they bought during the frenzy is worth a lot less. Sunk costs are sunk, and though you lose money on an accounting basis, in the short run, it is optimal to builders to finish developments that they started.
Could I get John Hussman to like this Fed Model? It’s from the eminent Paul Kasriel, and it compares the earnings yield of residential real estate and Treasury yields, and he suggested in early June that residential real estate was overvalued. There are limitations here; no consideration of inflation and capital gains, no consideration of the spread of mortgage yields over Treasuries. The result is clear enough, though. Don’t own residential real estate when you can earn more in Treasuries than you can in rents. (I know real estate is local, frictional costs, etc., but it does give guidance at the margins.)

Dealing with Underperformance

Posted on 7 August 20077 August 2007 by David Merkel

Over the past seven years, my broad market strategy done well against the S&P 500. I reach the seven year anniversary at the end of August, and should business prospects require it, I will get the results audited. But since the start of the quarter, the strategy has not done so well, trailing the S&P by a little less than 4%. Why have the results been so bad?

My portfolio has concentrations in a number of areas. I have a slight overweight in financials (though only one company affected by the current crises), a large overweight in energy, and an overweight in cyclicals, though cyclicals targeted at foreign demand, not US demand. These areas have underperformed, and so have I. Industries are 60% of the performance of the market in my opinion, so when you run a portfolio that concentrates industries, there will be periods of underperformance.

Value is out of favor at present as well. My approach is “all cap” value; I don’t care about the size of companies that I buy. I’m only 2% or so behind the Russell 1000 Value, but I am more than 4% ahead of the Russell 2000 Value. Small cap value has gotten smashed, and I am a partial casualty along with it.
So, maybe I’m not doing that badly. What I do at times like this is to try to identify the factors leading to underperformance and ask whether those factors are likely to persist for a year or more. Let me go through my major exposures, updating what I wrote previously:

Energy ? Integrated, Refining, E&P, Services, Synfuels. I am still a bull here; we aren’t finding enough energy supplies to meet the needs of our growing world. (15%)
Light Cyclicals ? Cement, Trucking, Chemicals, Shipping, Auto Parts. These areas are undervalued, given the way our world is growing. (20%)
Odd financials ? European banks, an odd mortgage REIT [DFR]. Largely insulated from the credit crises, and cheap. (10%)
Insurance — AHL, AIZ, SAFT, and LNC. All of them cheap, and with good earnings prospects. (10%)
Latin America ? SBS, IBA, GMK. All are plays on the growing buying power in Latin America. (8%)
Turnarounds ? SLE, JNY. Give them time; Rome wasn?t burnt in a day. (5%)
Technology ? NTE, VSH. Stuff that is not easily obsoleted. (5%)
Auto Retail ? LAD, GPI. Out of favor. (5%)
Cash (15%) — 5.25%/year is not bad.

That’s 93% of my broad market portfolio. Three other miscellaneous companies make up the rest. You can find the complete portfolio here.
After writing this, my tentative conclusion is that my methods still work, but that I am fighting temporary setbacks from value being out of favor, and from financials getting taken out and shot, even if there is no connection to the current credit crises. Therefore I soldier on, trusting the methods that have brought me this far.

Full disclosure: long LAD GPI NTE VSH SLE JNY SBS IBA GMK AHL AIZ SAFT LNC DFR

Does Greg Ip Still Have an Inside Line on the FOMC?

Posted on 7 August 20077 August 2007 by David Merkel

During the tightening era, a number said that the Federal Reserve Open Market Committee [FOMC] would telegraph their views through Greg Ip of the Wall Street Journal. If so, today’s article should be a concern to those favoring the view that the FOMC must loosen in order to ~~keep the speculative frenzy going~~ preserve the integrity of the markets. Leaving aside the issue of whether it is even desirable to have any intervention in the market, such as Fannie and Freddie buying more mortgage loans, it seems like the debate has shifted to the question of encouraging moral hazard, something foreign to Alan Greenspan, who thought he could micromanage monetary policy.

The consistent throwing of liquidity at crises lulled investors into complacency over financial risk. Economies work best in the long run when risk-taking is moderate, not absent or crazed. It is good to have a bear market every now end then; it keeps investors honest. It is even good to allow failures of financial institutions, particularly risky ones at the fringe of the financial system for the same reason. Financial firms are opaque by nature, and investors should be skeptical of those furthest out on the risk spectrum, particularly when credit spreads are tight.

To those who favor using monetary policy to bail out dud (primarily) non-banks, I say two things: first, are we capitalists only for our profits and not for our losses? Are we the hypocrites who privatize our gains and socialize our losses? Second, it’s not in the FOMC’s charter. Alan Greenspan violated the purposes of the FOMC when he used it for any thing other than low inflation, low unemployment, and preservation of the portion of depositary financial system overseen by the Federal reserve.

Score me in the camp that sees no substantive change in the FOMC’s direction, but sees a nod in the statement toward the current troubles, and a little more in the minutes, but keeps the focus on inflation. I still don’t think the FOMC is moving in 2007.

The Great Substitution of Equity for Debt, Formerly Led by Private Equity

Posted on 7 August 2007 by David Merkel

When I do a review of links, I try not to do a linkfest, as much try to share my ideas, while annotating places where you can get more data.? I keep topical clipping folders.? Today’s review is on the Great Substitution of Equity for Debt, Formerly Led by Private Equity.? Usually I organize by subtopic when I write, but tonight I will do it by time, because it took me seven weeks to get back to this, and a lot has happened over those weeks.

Go back to mid-June.? 10-year Treasury rates were challenging 5.25%.? Rates all over the world had risen, and some predicted they would go higher, and choke off the private equity boom.? In hindsight, not a good argument, not because Treasury yields fell, but because junk credit spreads are more critical to private equity than treasury and high-grade yields.? In the short run, junk debt yields don’t react much to Treasury yields.? So most didn’t worry at the time.

Give Andy Kessler credit for timing. He expresses skepticism for private equity before Blackstone comes public, suggesting that all they do is borrow money against the assets of the target companies, and then foist them on the retail public later.? Well, that’s not all of what private equity does, but to a first approximation, that’s 90% of the deal.? He takes both sides of the issue, suggesting that conditions are stretched from a valuation standpoint, but suggesting that the insanity could go on for a while longer.

Failed deals often represent turning points, and by the end of June, both Thomson Learning and US Foodservice pulled their debt deals. The appetite for yield had diminished considerably, versus the need to protect capital.

In the short run though, the market is bouncy, and more deals piled up into early July, even as junk spreads began to widen.? I love the closing quote in this WSJ article: “It’s all worth keeping in mind as the market hits its rough spots. Roger Altman, chairman of Evercore Partners points out, for instance, that by any historical measure, the interest rates for junk bonds remain very cheap.? Barring a very steep climb in rates, Mr. Altman says, private equity ‘is a permanent feature of the capital markets. Nothing foreseeable can change that.'”? Mr. Altman is a bright man, no doubt, but turning points are only clear in hindsight.

Now, 2007 had already surpassed 2006 for private equity deals. Maybe completed deals are another issue.? Going to something more mundane, Mark Hulbert points out some research showing that companies that buyback their stock outperform the market.

By mid-July sentiment was definitely shifting in the debt markets, even as the equity markets rose.? More deals were having trouble getting done.? The willingness of lenders to take risk was declining, particularly on PIK bonds and Toggle notes.? Personally, I find it amazing that high yield investors buy instruments that may not pay interest in cash, given the dismal credit experience of such structures.? What would you expect from a company that doesn’t have enough money to make interest payments in cash?

The next article is a vision of the future. Five or so years from now, who will buy all of the new IPOs generated from today’s flood of private equity?? Then again, with the over-borrowing to make deals work, maybe not so many will come to market in the future, at least, not at the size that they left.

Take a look at the seven bad times to buy equities from John Hussman.? The last five of them came at times when the “Fed Model” would have told you to be in bonds.? The first two were close, but in the long haul, one was better off holding common stock through the declines.

By mid-July, we are a little past the recent peak, and buybacks are taking the place of LBOs in the market for shrinkage of the supply of equity.? With investment grade bond yields falling from mid-June, it seems like a reasonable thing to do.

I would never want to be a dedicated short investor.? Shorts are perpetually short the capital structure option, which the equity holders can exercise to lever up, when it is to their advantage to do so.? In this article, the difficulties of being short are explained, with the risks of private equity buyouts, and getting crowded out by naive shorts running 130/30 funds.? Jim Griffin at RealMoney takes an allied approach, suggesting that with equity getting replaced by debt, that equities are possibly a good deal here.

With rising junk spreads in the credit markets, by late July the buyer of choice for takeovers had become investment grade corporations because they could finance the purchase cheaply.? Private equity had gone quiet.? Things were bad enough, that investment banking bridge lenders wondered whether it wouldn’t be cheaper to drop out and pay the breakup fee on Texas Utilities rather than fund the deal personally.? The potential losses from many deals were mounting at the investment banks.? 46 deals had been pulled, versus zero in 2006.

So private equity is dead now, right?? I see it more as a sorting process.? Deals that make economic sense at higher lending rates will get done, and those that don’t make sense will be funded by the investment banks, or shelved for now, depending on the bridge lending deal terms.? It won’t be as big of a force in the market, but buybacks among investment grade corporations will continue to shrink the overall equity supply of the market for now.? I am still a moderate bull on the equity market.

A Tale of Two Insurance Companies

Posted on 6 August 20076 August 2007 by David Merkel

As I write this, I am listening to a replay of the RAM Holdings Conference Call that happened on Monday.? RAM Holdings did not have a good day in the market yesterday, losing 44.5%? of their market value.? What went wrong?

Investors are more attuned to subprime, and so the merest hint of trouble sends them running for the exits.
They are more attuned to CDOs, and so the merest hint of trouble sends them running for the exits.
They commented that premium volume might decline over the remainder of the year.
They only met the earnings estimate.
The cost of their soft capital facility has risen to LIBOR+200, the maximum, leading them to question whether they can’t replace the facility with something better.?? (My guess? No.)
The conference call focused on subprime, CDOs, and the more shadowy bits of their guarantees.

So what does RAM Holdings do?? They reinsure the primary AAA financial guarantors.? They are the only AAA reinsurer that does not compete with the primary insurers.? Typically, they try to take an equal slice of all of the business that MBIA, Ambac, FGIC, FSA, and the three others produce each year.? In that sense, you can think of them as a small version of what the average of the financial guarantee industry would be like if it were a single company.? Unlike a P&C reinsurer, losses kick in only after a threshold is met, and then a lot of losses get paid, with RAM Holdings, the losses are pro-rata from the first dollar.? The primary insurers would have no advantage passing them bad business, because they would be more affected by the bad business.

I’m reviewing RAM Holdings as a possible purchase candidate.? If I were running a small cap fund, I would definitely start tossing some in now.? Why?? It’s trading at less than 35% of adjusted book value, and the balance sheet is good in my opinion, and the opinions of S&P and Moody’s.?? If I were running a hedge fund, I would buy RAM and short equal amounts of MBI, ABK, SCA and AGO.? Why?? If RAM is really in this much trouble, it is likely that MBIA, Ambac, Security Capital and Assured Guaranty are in the same trouble.

Aside from that, their subprime exposure is small-ish and seasoned.? Their CDO exposure is almost all AAA, with super-senior attachment points (i.e. non-guaranteed AAA bonds would have to lose it all before thet pay dollar one of guarantees).? Honestly, I’m probably more concerned about the BBB HELOC and closed-end second lien mortgage exposure.? I would need more data on that before I could act.

Then there’s Safety Insurance, which was up 12.0% on Monday.? What went right?

Unlike Commerce Group, which missed, they beat estimates handily.
They raised their dividend by 60%, from $1.00 to $1.60.
They announced a $30 million buyback (and they have the money to do it).
The asset side of their balance sheet carries little credit risk.

Now, Safety faces its challenges as the Massachusetts auto insurance market possibly partially deregulates, but Safety has successfully competed in a variety of different market regimes in the state.? The current management team has shown itself to be very adept at adjusting to changing conditions.

Even with change, Massachusetts will still be the most heavy handed state in the US with auto insurance.? It won’t attract a lot of new entrants.? And, it is possible that no change will happen… previous deregulatory plans have come and gone, though this one has more political clout behind it.

Safety is still cheap to me at 1.0x book value, and 7.6x 2008 estimated earnings.? I’m hanging around for more.

Full Disclosure: long SAFT

Blog Notes

Posted on 4 August 200722 June 2017 by David Merkel

I have more good stuff coming next week. For those with a subscription to RealMoney, be sure and catch my article Monday morning.

I have added Feedburner to the blog as an option for receiving my posts, and comments from readers, via RSS. If this is an aid, let me know, and if this is something you would rather not see, let me know. I want to maintain a balance between functionality and simplicity.

I plan on responding to blog comments and returning e-mails early next week. Much as I thought leaving my employment would free up time, many other demands have intervened. Thanks for reading, and keep giving me feedback; it only improves what I do.

Dissent on the Significance of the Bear Stearns Call

Posted on 4 August 20075 August 2007 by David Merkel

I know that Cramer and many others consider the news from the Bear Stearns call to be the financial equivalent of nuclear meltdown, but it’s not true: Exhibit 1 is the graphic above from The Wall Street Journal (full story here). If you look closely at the graph, junk bonds had a small positive return last week. That would not be true in a crisis.

So what is the crisis? The crisis is in the exotic stuff.

Subprime ABS [asset-backed securities]
Credit default swaps and other derivatives on Subprime ABS
CDOs that contain Subprime ABS and certain high yield bonds and loans
LBO debt that some of the investment banks are stuck with.
Some high yield bonds and loans on deals that got done before the music stopped
Derivatives on broad classes of instruments like LCDX and CMBX.

But for the most part, for most high yield debt, almost all investment grade debt, and vanilla structured securities, the market is functioning. If anyone knows differently please contact me.Natively, I tend to be a skeptic and a bear. But I try to be a realist above all. I was managing a large portfolio of corporate bonds 2001-2003, and a large portfolio of CMBS (with a little ABS and RMBS) from 1998-2001. In 2002, the investment grade bond market shut down briefly on the mornings of two days, in July and October. (I remember my favorite broker saying to me each time, “The markets are offered without bid. What would you like to do? I had spare capital for the occasion and offered enough lowball bids to satisfy the extreme liquidity needs of the frightened.) At that time, the VIX and other systemic risk variables were thorough the roof. Those variables aren’t there now. After 9/11, the whole fixed income market was closed for five days, and even once it re-opened, it took two weeks to approach anything near normal. (People told me I was courageous/stupid to offer lowball bids on day two after the market reopened. They turned out to be good trades. I have stories from that period… as a bond manager, I am at my best in crisis mode.)

In 1998, when LTCM blew up, the bond market shut down. Only the highest quality stuff traded for about three weeks. I remember buying some AAA CMBS for almost 2% over Treasuries. We aren’t there at present; not even close.

Bear Stearns can make the statements that they did because they have a concentration in areas that are affected. They also want to make it look like as much of a market problem as possible, and not a Bear Stearns problem. For Bear Stearns, this very well could be the worst bond market for them in 22 years. Just not for the Street as a whole, at least not yet.

I write this not to make people bullish, but just to point out that characterizing the bond market as a whole is tough, and that things are rarely as bad as they seem. From my angle, I will say that I have seen it worse.
PS — A final note. After any crisis, how does the fixed income market comes back? It start with trading of bonds that are high quality, high simplicity, and short in duration. As the crisis abates, bond managers get tempted by the high yields of bonds that are lower in quality, lower in simplicity, and longer in duration. As the risk appetite expands, eventually the whole bond market comes back.