Saturday, August 4, 2007 0 comments ++[ CLICK TO COMMENT ]++

Credit problems & other weekly thoughts

Credit Problems Impacting the Markets

Finally the yields on low-quality bonds are rising. A lot of peole like me have felt that the yields were too low and didn't price risk properly. Bear Stearns, one of the 5 big Wall Street investment banks, is facing a series of problems due to the re-pricing of mortgage debt such as CDOs. Bear Stearns seems highly vulnerable since a big chunk of its dealings seem to be in the mortgage securities. The stock (ticker: BSC) is down more than 30% in the last few months and may drop more if further problems are revealed.

The real question is who else is impacted by these problems. The Economist has a good article on the winners and losers in the credit meltdown. It looks like a lot of banks may be vulnerable to some losses due to bridge loans they are holding (bridge loans are temporary loans that banks loan out while trying to sell debt to investors--if they can't issue debt then the banks are left holding the bag). I wonder if any Canadian banks are going to have any surprises. There have been a whole hoard of takeover deals over the year and some of them may run into problems if the credit markets remain tight.

Sowood Capital Losses Similar to LTCM

Sowood Capital is a hedge fund that made some bets--obviously poor ones in hindsight--on the mortgage market and lost big. Its capital was almost wiped out and it sold its funds at depressed prices to the much-larger Citadel hedge fund. What is interesting to me is that I see a subtle similarity between this blow-up and LTCM (Long Term Capital Management).

LTCM's strategies were correct but they didn't have enough time to weather the storm. Well after LTCM went bankrupt, one could verify that their positions were profitable. It's just too bad that LTCM couldn't handle the temporary move where the position went totally against them. Sowood Capital's strategy seems to have followed a similar path.

Here is what Sowood says their strategy was (source: MarketWatch article dated August 3, 2007):

Sowood had built positions in the senior debt and bank loans of companies. Those stakes were cushioned because these companies had other debt that ranked lower in their capital structure, Larson explained.

In many cases, Sowood shorted, or bet against, the subordinated debt and the equity of these companies. The firm was hoping that if the market declined and credit spreads widened on the senior debt, that widening would be much more pronounced for the lower-quality debt and would be accompanied by a drop in the companies' shares, Larson said.

"We saw relatively strong balance sheets, little to no chance of loss even in default, no near-term liquidity pressures, and no fundamental reason to expect extraordinary widening in those corporate credit spreads," he explained.

What I bolded above was the fund's strategy. It is something that I would expect to happen as well. Obviously it never happened in time:

However, in June spreads widened sharply on senior corporate debt, but the accompanying moves in subordinated credit and equities that were expected by Sowood didn't happen. The firm's hedge funds lost 5% that month.

That pretty much was the beginning of the end of Sowood Capital. Things just kept getting worse and the fund was doomed. In my opinion, the strategy is plausible. I think the yields on the lower quality debt would have gone up eventually. However, the fund obviously didn't have enough liquidity or a long enough time frame to simply wait. LTCM couldn't wait and neither could Sowood Capital. That pretty much sealed their fate. The ability to sit on a losing position, as many value and contrarian investors can, is a powerful advantage for the small investor--psychologically it's difficult though.

Just like the Russian default was the anamoly that did LTCM in, Sowood's culprit seems to have been forced selling of high quality positions by some hedge funds:

Larson didn't say why he thought markets acted in this way. However, several other hedge funds have been under pressure to raise cash in recent weeks. In weak markets, managers sometimes sell their highest-quality assets first because they can get better prices. If lots of people do that at the same time, that can knock the prices of high-quality assets more than lower-quality securities.

Another thing to learn from this debacle is that a strategy can be profitable early on and then fail spectacularly. In this case, it looks like Sowood had a 16% return in 12 months ending June. This is a lesson that most investors will learn in their lives. What seems to be working ends up being completely disasterous!

Jim Cramer Not a Happy Fellow

It looks like Jim Cramer, the popular commentator, blew a fuse. He seems to want the Federal Reserve to bail out his friends. I don't think the Federal Reserve should cut rates just to help out all these overleveraged individuals, whether they are hedge funds, investment banks, or house buyers. If the Federal Reserve is to cut rates, they should do so if the unemployment situation worsens while inflation remains low. Otherwise, they will a bad precedent and allow speculation to get out of control. The fact of the matter is that yields on high-risk assets are too low and a re-pricing of them (such as junk bonds, CDOs, etc) was bound to happen at some point.

New Contrarian Areas to Watch

Given all the carnage due to the credit debacle, I think some new contrarian areas have emerged. I think mortgage lenders, homebuilders, mortgage debt, and similar areas, are good places to watch.

One company I'm watching is Delta Financial (DFC), which is a pick by the value investor, Monish Pabri. It has sold off around 30% in the last couple of months and it might drop more if the market continues to sell off on credit worries. There are some good comments on the Yahoo Finance message boards (for a change, it isn't all trash :) ). I took a quick look at this company and I'm not sure what to make of it. The company, its revenue model, its accounting, and its competitive advantges all seem hard to pin down. Like most finance firms, the company just looks too hard to understand from an accounting point of view. However, I'll be watching it off and on...

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