Tuesday, October 30, 2007 0 comments

Some Estimates on the Needed Housing Inventory Reduction

UPDATE: Here is an article from BusinessWeek talking about the housing inventory.

WSJ Economics Blog refers to Richard Berner of Morgan Stanley who is forecasting the needed decline in housing starts and prices to bring a balance to the industry.

Brace for a much deeper housing retrenchment: Builders may have to cut 40% more from single-family housing starts to balance out supply and demand, Morgan Stanley chief economist Richard Berner says. At the same time, real home prices will have to drop by 10% to make housing more affordable. “Neither that construction decline nor its potential effect on economic activity seems to be in any forecast,” he says in a note to clients today.


I don't have access to research reports (except some free ones from my discount broker) so I'm not sure what they are saying. But this is the first time I have seen some concrete numbers for the decline that is needed.

Already, housing starts have dropped by almost a third over the last year to an annual rate of 1.19 million in September. And sales of both new and existing homes are off sharply. Tighter lending terms are depressing demand even more now. A 10% drop in prices might clear half of the excess housing supply from a total overhang that amounts to 600,000 vacant homes, Mr. Berner says. The other 300,000 would have to be cleared by builders cutting back activity.


The homebuilders haven't ratcheted down their starts to balance the market. The inventory overhang is the biggest threat and until that is brought into balance, homebuilders and related industries are quite risky. The bottom may be early next year.

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Monday, October 29, 2007 0 comments

Doubts about Tribune Deal

Reuters has an article where some analysts are questioning whether the Tribune deal will go through.

"The banks require that guaranteed debt be less than 9 times EBITDA as of the last measurement date before closing," Newman said.

"The latest data point should bring a sigh of temporary relief to equity holders," he said. However, "we expect questions will persist about Tribune's ability to meet the 9 times covenant requirement."


Although this is a requirement that one needs to worry about, the real big threat isn't even mentioned in the article. That being, the FCC approval to continue the waiver for Tribune to own TV stations as well as newspapers in the same market. That decision is likely in mid-December and I suspect the stock will trade near its takeover price when approved (if FCC doesn't agree, the stock price may collapse and the deal needs to be re-structured (possibly have to divest some media holdings)).

Gimme Credit analyst Dave Novosel, meanwhile, said that the economics of the deal remain in question, with the buyout price of $34 per share likely too high.

"If I look at the state of the business and the free cash flow that Tribune is likely to do for the next two years, I just don't see how (Zell) makes anywhere near a respectable return on this," Novosel said.

"It's hard to image how he will have the free cash flow to make this thing work," he said.


Unlike the analysts, I don't believe that Sam Zell is concerned with the price. He is a savvy businessperson and he wouldn't have negotiated the original deal if he didn't like the price. He will also have legal problems if he were to re-negotiate the deal. In some of his comments since the deal was announced, he has been behaving as if this deal were to go through.

The real risk always has been with the bankers. If they can't raise the financing then they may want to lower the price. But I'm not sure who pays in that case. Would it be Sam Zell or Tribune?

For those following the situation, the stock is trading around 13% below takeover price right now.

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Sunday, October 28, 2007 0 comments

Thoughts on Housing, Bullish Market Stance, and the Loonie

Am I Ever Going to Stop Talking About Housing?

I don't think I'm going to stop talking about housing until... oh... late 2008. On top of it impacting the economy, it also presents potential opportunities. Housing-related sectors are some of the most contrarian sectors out there.

Paul Krugman of New York Times recently summarized some key housing charts in his blog entry. The charts easily illustrate the high-level view of what is unfolding. Check out the link to get a quick overview of the unprecedented boom in housing, and the inevitable unprecedented collapse that is unfolding.

All the charts that were referenced by Paul Krugman are important but the one that contrarians may want to pay attention to is the one on defaults by mortgage origination year. The key insight, to me, is that securitizations before 1995 were fairly good--even for subprime. But anything after 1995 (or thereabouts) is highly questionable. I am thinking of investing in Ambac (ABK) (I reviewed it yesterday) and one reason I have greater confidence in ABK's ability to survive and do well is because most of their insured securities are pre-1995 securities.

The real question for contrarians is how much further can this sector get hit.


(source: finance.yahoo.com)



The chart above is of some homebuilder stocks that have price data back to the early 90's. There was a housing collapse and a recession in 1990/1991. Interestingly there was also a Savings & Loan crisis which wiped out many banks and the present situation sounds eerily similar. I'm reading John Neff's book, John Neff on Investing, and he talks about how Citigroup (called Citibank back then) was beaten down badly in 1991 due to the financial crisis arising from housing. He analyzed the company and thought that it was being sold off for the wrong reasons. His investment in it turned out to be a success. I'm thinking that some of the leading Wall Street businesses, whether it is Bear Stearns (BSC) or Merril Lynch (ML), or mortgage lenders like Countrywide Financial (CFC), or whatever else, may be home runs for some investors. I personally think Ambac (ABK) may be similar to what Citigroup was in 1991 (although ABK has much lower upside). Read my investment evaluation of ABK yesterday if you are interested in my feeling (I have no position in ABK but may take a position).

A quick look at that chart shows that homebuilders have declined as much as they did during 1990/1991 (do note that the companies would not have been the same back then so this is just a very rough guide). Since the present housing boom is the largest in a many decades, I suspect homebuilder stocks can decline even further (but probably not much further). John Neff says that a contrarian should buy something like 6 months(??) before signs of a turnaround. My guess is that the best time may be between now and 2Q08. There is a big inventory of homes that need to be worked off, along with big ARM mortage resets early next year, but I am guessing that the market will price that in within two quarters. Practically every leading publication has been talking about housing non-stop for many months now.

John Mauldin also shares some thoughts (req: e-mail registration) on the subprime lending in this week's write-up. He also refers to the Fortune article that I wrote about here. The article by Allan Sloan is one of the best write-ups on the doings--and undoings--of ABS securities so check it out.


Bullish Stance of the Market

Of late--although this has been the case for last for the last 3 years--the market is betting on cyclicals, commodities, and emerging markets. I believe there are two reasons for this.

One reason is the belief by some that inflation is going to high given the Federal Reserve rate cuts (the JCB is also changing their tightening stance and I believe the Yen carry-trade has a bigger impact than even the Federal Reserve). This is why commodities keep going up very few changes on the economic front. For instance, oil has been going up a lot lately but a huge chunk of that is due to the US$ decline. I personally don't think inflation is going to be high in the future.

The other reason, and this is what I was going to talk about, is the view that the rest of the world will hum along while the US economy slows down. The hope is pinned on the BRIC countries. My view right now is that USA will impact the rest of the world. I don't see how the rest of the world can keep their economies going when most of them are export-oriented. Michael R. Sesit of Bloomberg shares my view:

China's growth has been fueled by exports and investment, not consumers, whose share of the country's gross domestic product is declining. From almost 80 percent in the first half of the 1980s, Chinese household consumption fell to 46 percent of GDP by 2000 and shrank further to 36 percent in 2006.


A lot of investors simply look at the overall growth rate in China but fail to realize that most of the growth is due to exports or fixed-investment (fixed-investment refers to building roads, stadiums, etc). It is questionable that emerging markets can keep chugging along at a high growth rate if USA slows--and it looks like USA will slow down (consensus GDP estimates are below 2% for the last quarter right now).

Furthermore, the size of their economies are small:

Although developing countries are projected to account for about three-quarters of global growth in 2007, their size is still too small to power the world economy. Take the four BRIC nations: Collectively their GDP amounted to $5.6 trillion at the end of 2006. That's 43 percent of U.S. GDP, 56 percent of the 13- nation euro area's and 130 percent of Japan's.

When it comes to stock markets, the gap is even wider. The aggregate free-float value of the Brazilian, Russian, Indian and Chinese stock markets is a mere 4.9 percent of world market value, according to Morgan Stanley Capital International. The four BRICs are 12 percent of the U.S. market value, 16 percent of Europe's and 56 percent of Japan's.


The GDP of developing countries in raw terms is quite small as mentioned above. In PPP-adjusted terms they are much larger but the raw numbers are what drives corporate sales numbers for multinational companies.

Nonetheless, ``there are still plenty of vulnerable economies in the emerging-market space,'' says Gray Newman, New York-based senior Latin America economist at Morgan Stanley. South Africa, Turkey, Hungary and the Czech Republic have run current-account deficits averaging more than 4 percent of GDP for three years, while Turkey, Poland, Hungary and India have posted fiscal deficits of 3 percent to 8 percent of GDP in the last three years.


The aforementioned countries are vulnerable and one should be careful investing in them in the near-term. On top of economic issues, countries like Turkey seem to be developing some political problems of late.


Flight of the Loonie

The Loonie for those not familiar refers to the Canadian dollar. It is named after the Canadian bird (loon) that is on the $1 coin:
(source: Image courtesy P199 at wikipedia.org)


The Canadian dollar is up around 30% in the last 2 years, with most of the gains coming this year.

(source: stockcharts.com)


The CDN$ appreciation has killed my portfolio since I hold mostly US$-denominated stocks. But offsetting portfolio losses is the fact that my earnings are in CDN$ (since I'm in Canada). Given that my portfolio is small relative to my (admiteddly somewhat low) working-class salary, this is an overall positive for me. I am bearish on commodities and that's why I don't avoid US$-denominated stocks. The Canadian stock market is heavily concentrated in commodities and financials, and has run up a lot in the last 5 years. I had been expecting the US$ to appreciate (or at least hold steady) this year but that has been completely wrong. Even now, I think the US$ may hold off any losses if the US economy slows.

My long term stance is a bullish call on the Japanese Yen. I have written many times on why (mostly due to the massive Yen carry-trade). My long-term plan is to move more of my money into Japanese stocks. My strategy is to start researching more Japanese stocks, think about their economy and their business climate next year. I'm also planning to read some books (not that books necessarily mean anything). Right now I'm concentrating on the beaten-up housing-related sectors (homebuilders, mortgage lenders, mortgage insurers, housing material suppliers, etc).

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Investment Evaluation: Ambac (ABK)

Ambac (ABK) Investment Evaluation

Initially Written: October 27, 2007
Last Updated: - Oct 27, 2007


I’m just a newbie investor with a contrarian tilt so feel free to e-mail or post comments to correct any mistakes or to improve things. Do not blindly base any decisions on anything I say; I don’t know what the hell I’m doing ;) . Also, since I write over a period of time, some facts and numbers may change from when I first looked them up (this is definitely the case with any market-price info e.g. P/E ratio).

Summary

Ambac (ABK) is the second largest debt insurance company, after MBIA Inc (MBI). Its business is to insure interest and principal payments on various debt for governments, infrastructure projects, mortgages, and so forth. Generally it doesn't insure the value of the debt, and only insures the payments. This is important because, given the credit problems in the mortgage and the ABS market, ABK will be spared the losses on the value of the debt.

Due to credit issues and various other problems, the stock has sold off sharply and is down almost 40% for the year. This sell-off made me investigate the stock and I have come to like it a lot. I'm planning to watch it closely and likely take a position in it in the future (although no guarantees on any future move).

I have to note that I'm not good an analyzing financials (accounting is too complex and can be manipulated) and all my opinion is based on some cursory analysis.


Industry Comparison

Sources: Bloomberg.com, finance.yahoo.com, bigcharts.com, Morningstar reports, S&P reports, grahaminvestor.com, company reports



There are 5 operators in the debt insurance industry, with MBIA and Ambac being the two largest by far. I decided to include Radian (RDN) because Martin Whitman has taken a position in it. He also took a position in MBIA back in July. All the stocks are down quite a bit since then and assuming Martin Whitman hasn't changed his mind, it gives me greater confidence in these companies. Radian is highly speculative in my eyes but it has massive potential. Ambac places very nicely against MBIA.

The table below, courtesy Morningstar.com, provides a 10 year view of valuation:

(source: morningstar.com)


ABK's current P/E is a 10 year low; so is its price-to-book-value. From a historical valuation point of view, ABK screams a buy. The reason the stock, along with others in the sector, has been beaten-up is because the market is worried about future losses from housing-related debt (CDOs, subprime debt, consumer ABS). I'll discuss this further down but one has to decide whether the risk is exaggerated or for real.

Earnings have been growing at 15% for the last 5 years, and 12% for the last 10. One of the most important metric for any business is book value growth. A lot people look at earnings growth but book value growth is arguably even more important (book value also has the luxury of being more difficult to manipulate than earnings). ABK has a 5 year book value growth rate of around 15%, and has been growing it around 13% for the last 10 years.

Ambac is AAA-rated so its debt to equity is very low and financial strength isn't a question. The only downside is that they have to keep a lot of capital on the books and can't leverage themselves as much as other companies. Returns can be somenwhat depressed because of that.

In terms of intangibles, ABK has been in the business for decades and has a strong reputation that is hard to replicate. It, along with MBIA, sit alone at the top of this industry--although large insurance companies can ramp up their operations in this area. Given all the uncertainty and turmoil in the credit arena, Ambac is well positioned.

Valuation

I'm not sure how one should be valuing insurance companies. I typically do a rough calculation with DCF but that is mostly useless for these type of companies.

Simply looking at valuation metrics over time, we can see that ABK is at the low point. As mentioned above, P/E and P/BV is at a low point. I think ABK can keep growing near its past rates. There may be some competition and difficulty entering foreign markets so a pessimistic growth rate may be around 12%. Even then, that's pretty attractive for a AAA-rated company. I personally have no problem picking up a company at a P/E of 6 and P/BV of 0.75 with ROE of around 13%.

One is basicaly looking at a total return of around 14% per year (13% ROE + 1% dividend yield). Since the stock is beaten down, there is even greater return potential if there is P/E expansion. You might end up with around 15% total return per year over a 10 year period. My opinion is that it is worth buying ABK below book value (it is around 25% below book value right now).

CDO and Subprime MBS Risk

The real question is whether any of the assets are impaired and whether large losses will have to be written down given the credit issues unfolding in the background. ABK has the largest exposure to the CDO market and that is why the market does not like this company. Let's look at ABK's CDO and subprime RMBS exposure.
(source: Ambac CDO document)


As can be seen from the graphic above, most of ABK's holdings are higher quality CDOs. The rating agencies are downgrading the higher quality CDOs and MBS but one other thing in Ambac's favour is that most of its exposure is from pre-2005 vintages:

Vintage dispersion:
2005 and earlier: 45%
2006: 46%
2007: 9%
Fixed rate borrower %: 48%
Average FICO score: 644
(source: Ambac CDO document)


A lot of the mortgage asset problems are with securities that were created in the last 2 years. As is generally the case, most of the shady agreements and questionable deals, likely driven by greed, are done during the late stages of a bull market (just like how a lot of the technology IPOs in 1999 and 2000 were terrible compared to the ones in 1995 and 1996). In housing, the peak was in 2005 and a lot of the problems are with the post-2005 securities.

Furthermore, a lot of the borrowers are at fixed rates and this is a good thing. There is a looming threat of resets on adjustable rate mortgages and ABK isn't as vulnerable to rate changes.

Another concern is with ABK's subprime exposure. Ambac's subprime MBS exposure has been declining over the years, from around 40% of total MBS to around 20% in 2006.
(source: Ambac sub-prime MBS exposure document)



There will certainly be some increased risk due to increased subprime default rates. But I am confident that ABK can weather through the storm. If you can tolerate the risk, this doesn't seem like a big deal. It looks like the market is treating ABK as if it were another fly-by-the-night operator, or as if it were as risky as mortgage lenders or CDO funds.

There was also some question about Ambac's $743 million writedown this week but this mark-to-market loss isn't a real loss. The following comment from Fitch Ratings (document posted on Ambac's website) reiterates their stance that mark-to-market losses aren't real losses:

Fitch remains consistent in its view that mark-tomarket losses from CDS within a financial guarantor’s insured portfolio do not have direct ratings implications for the industry, given that the underlying CDS transactions still remain very highly rated (often well-above minimum ‘AAA’ thresholds), and are not expected to realize actual claim losses in the future. In fact, from an underwriting perspective, the widening of credit spreads actually improves the financial guarantors’ pricing prospects on future business they may insure going forward. That said, the widening credit spreads generating the negative mark-to-market losses has been caused in part by significant problems being experienced in the U.S. subprime mortgage markets. Currently, many of those problem assets support CDS transactions insured by a number of financial guarantors, especially ABS-CDOs that maintain a heavy concentration of recent vintage subprime mortgage collateral.

Deterioration of the underlying collateral is expected to reduce credit enhancement levels in many of the ABS-CDOs insured by the financial guaranty industry over the intermediate term. This deterioration may not directly impact the underlying
ratings on many of these ABS-CDOs, since many of these transactions have significant credit subordination over and above minimum ‘AAA’ thresholds, although those
guarantors heavily exposed to this sector will be monitoring their portfolios closely over the near- to intermediate-term.
(source: Financial Guarantors — A Review of Recent Mark-to-Market Losses, Fitch Ratings Special Report, October 11, 2007)


So this clearly looks like a case where the market is discounting any company that mentions 'CDO' or 'subprime'. I suspect a lot of daytraders, who really don't understand the details behind any of these companies, are likely shorting some of these companies heavily. I'm not saying that there is zero chance of adverse developments for ABK; all I'm saying is that as of this time, the stock price decline looks overdone by a large magnitude.

After looking through these documents and thinking of the risk exposure, I feel that ABK is pretty safe. Its earnings may be weak due to mark-to-market losses in the future but those are misleading numbers. Unlike mortgage lenders and some of the smaller debt insurers, there is zero risk of this company going bankrupt or running into severe financial stress.


Bull Case

Long History and Solid Balance Sheet

ABK is one of the top companies in the debt insurance business. It is financially solid and should be able to weather any storm. It is a higher quality company than the market perceives. As I speculated above, short-term traders are probaby hammering this stock without knowing anything about the company. This doesn't mean the stock price won't decline further but the fundmentals look solid.

Near All-time Low Valuations

The stock is down almost 40% in the last year. Book value per share is in the $50's and adjusted book value (read company presentation for full definition) is in the $80's. Remember, this was a company that every single analyst thought was worth $100 a few months ago. Analysts aren't necessarily right all the time but losing half its value without any material fraud or scandal is crazy IMO. Financials typically trade at low P/Es but ABK's is extremely low right now. Earnings will weaken in the future but even then ABK looks cheap.

Not As Sensitive to the Economy

Like most insurance companies ABK is not too sensitive to the economy. A slowing economy may impact some government infrastructure products and the like, but it is unlikely to have a big impact on the industry. Since I'm bearish on the economy, this is a good industry to be in. If the present high-flyers (cyclicals, commodities, emerging markets, etc) come crashing down, there is a potential for P/E expansion here.

Good ROE

It's not spectacular compared to other industries but ABK has an industry-leading ROE of around 14%. Even if ROE declines to around 12% over the next 10 years, this is a great number. I typically use ROE to measure the attractivenss of a business. This company is one of the best businesses I have seen that has been sold off in my short investing career. I see a lot of cyclicals and growth stocks with high ROE being sold off at times but they have wildly fluctuating ROE, whereas ABK's ROE has been consistently around 14% for 10 years.

Will Benefit from Widening Spreads

Even though the credit problems are a short-term issue for this company, it actually helps this industry. Debt insurers do well when credit spreads are widening. Spreads have been very low for several years now but it looks like they are widening now. ABK should prosper in that environment.


Bear Case

Not a Classic Contrarian Case

Although the stock is down around 40%, analysts are still bullish on this stock. I generally don't like it when most analysts have buy rating on a stock. One might want to wait a few weeks or months to see if analysts lower their ratings before considering this. I personally think it is worth buying below book value (right now) but watch for sell-offs during any rating downgrade.

Further Write-downs

There is a possibility that further write-downs may occur. Although exposure to questionable debt seems low, it is hard to say for sure. After all, ABK is the largest CDO insurer and most of the problems are with the CDO securities. If the economy goes into a recession and far greater number of people default on their RMBS, ABK will likely take a hit. If losses are taken then ABK will need to raise capital to maintain AAA rating.

Low Growth

Although returns are solid, the growth rate looks to be decelerating slightly. Future potential growth is uncertain. There is great potential in developing overseas markets but that is blue sky potential more than anything.

No Catalyst

There may be no catalyst to propel the stock upwards. The stock can stagnate for years and there may not be a P/E expansion. In such a case, one will simply match (or slightly outperform) the market with a return of around 12%. You won't get rich off that.


Worst Case Scenario

Ambac may take massive losses due to the credit problems. Although the mark-to-market losses aren't real, I wonder if there are possibilities for real losses due to other unknown issues. Any weakening of credit or reputation may result in loss of future customers.
Ambac may also lose some market share to new entrants and new product developments. Instruments like credit default swaps may eat into Ambac's traditional insurance (Ambac also uses CDS but I'm thinking that CDS may be supplied by new entrants).

Is this a Low Risk, Highly Uncertain Investment?

Mohnish Pabri likes businesses that he considers 'low risk, highly uncertain'. I have picked up this thinking and look at investments in that light.

I think this fits the low risk, highly uncertain investment philosophy. I think the risk is low because the stock is at least 25% below book value for a AAA-rated solid company. The chance of this company going bankrupt or facing severe financial distress is pretty low. So the risk is low.

But ABK is highly uncertain--that's why the market has sold it off. The market seems to be scared of any company that utters words like 'CDO', 'MBS', 'ABS', or 'subprime'. This creates great uncertainty.


Investment Thesis

I remember Warren Buffett saying something like 'if you can find a company with an ROE of 20% and trading at a discount, you should snap it up'. His investment in Coca-Cola was an example of a beaten-down company with high ROE. Looking at these numbers, it seems like ABK fits that criteria to a small degree. It isn't 20%+ ROE like Coca-Cola but then again it has low debt and hard to dislodge business (anyone can enter the industry but hard to get a AAA-rated reputation). I get this feeling that this is a steal. One isn't going to get rich off this (upside is not huge) but it looks like a solid company that can grow forever.

Once the market prices in all the credit problems and seperates the good from the bad, I suspect companies like Ambac will recover. There is a risk that this stock may sell off over the coming months if analysts cut their ratings and/or due to tax-loss selling in November and December.

I think it’s worth buying the stock below book value, which is around $50. Right now the stock is trading at $44 and I think it is worth considering for long term investors. Depending on how much money I have and other opportunities that materialize, I will consider taking a position within a few months. I already own a reinsurance company (MRH) so I also have to decide whether I want another insurance company, albeit in a different type of insurance. If I take a position, it will likely be for the super-long-term (i.e. 5 to 10 years). One of the risks is that ABK may not go anywhere for years but long term investors should be fine.

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Saturday, October 27, 2007 0 comments

Big Economic Events Next Week

A true value investor doesn't pay much attention to economics (that's what Buffett and others say*) but I'm not one so I pay attention to economics. Next week is shaping out to be a huge week. It might actually be the most important one for the year given the calamity over the last few months. The important ones in my eyes are the following:

  1. Oct 31 2:15 PM FOMC policy statement: The market is pricing in a cut. I sold my bonds (TLT) last week and my feeling is that a 0.25% cut is likely. However, due to a bunch of conflicting signals, it is not as clear as many think. WSJ Real Time Economics Blog has a brief overview of the different possibilities.
  2. Nov 1 8:30 AM Core PCE Inflation September: Consensus is 0.2% with last month's being 0.1%. I'm in the disinflation camp so I expect inflation to be low.
  3. Nov 1 10:00 AM ISM Index Oct: Consensus is no change from last month's 52. ISM index is one of the the most important econmic indicators. I posted a while ago about some recession indicators that John Hussman was looking at to see if we are entering a recession. At that time, everything was negative except ISM (needs to be below 50 to indicate contraction in the economy).
  4. Nov 1 10:00 AM Pending Home Sales Sep: There are a million home sales indicators and this is just another data point. Since I'm looking at house-related stocks, I pay more attention to the housing numbers these days.
  5. Nov 2 8:30 AM Nonfarm Payrolls Oct: Consensus at 90,000. Very important number for the market



We'll see how things transpire next week. For now, I'm concentrating on studying ABK. This looks like an amazing opportunity to me (not huge but seems safe). If anyone has any thoughts on ABK, post some comments (click near the end of this post).


(* Although Buffett generally ignores economics, do note that he reads trade journals and thinks of business conditions. I suspect he picks up economic conditions by sensing them from the bottom, by knowing how corporate profits are behaving, how currency fluctuations are impacting his businesses, and so forth. I personally am not a true value investor so I pay attention to economics. Although I get into trouble by thinking too much about economics (my bond and inverse TSX investments have been disasters because of it), I find that it also helps to avoid certain things. For example, a lot of value investors like Bill Miller have been seriously hurt (on paper) by the collapse in homebuilder shares. I suspect that if he had put more emphasis on economics as opposed to looking at the individual business, he would have avoided it. Homebuilders have been classic value traps over the last 3 years. They had very low P/Es, high ROE, high free cash flow, and were attractively priced relative to tangible bookvalue. But from an economic point of view, housing was a waiting disaster with people who can't afford homes somehow buying them, and young people and lower classes being totally priced out of homes.)

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Friday, October 26, 2007 0 comments

To Watch: Ambac (ABK)

I wasn't around back then but it seems like the current plague infecting financial stocks is similar to the savings & loan crisis. I have read books/articles where investors said that solid banks were being sold off along with the trash. I'm reading John Neff's book on investing and he was saying how Citigroup was literally being given away even though it was a solid company. I feel like the present situation is similar the way the market is treating companies like Merril Lynch (ML) and Countrywide Financial (CFC).

Anyway, literally anything related to mortgages, debt, subprime, and the like, are being sold off sharply. The latest sub-sector seems to be debt insurers. These are companies that insure debt--similar to insurance companies. One company that caught my eye is Ambac (ABK), which is a very large debt insurer.

(numbers from Yahoo Finance and may be misleading (need to double-check))

Market Cap (intraday)5: 4.47B
Trailing P/E (ttm, intraday): 5.82
Forward P/E (fye 31-Dec-08) 1: 5.37
Price/Sales (ttm): 2.52
Price/Book (mrq): 0.74

ROE: 13.75%
Debt/Equity: 0.3

This company looks interesting and I'll take a quick look to see if it's worth investing in. The problem with financial companies for me is that I don't understand them. They are very opaque and highly vulnerable to accounting manipulations. Nevertheless I'm drawn to them since they are being sold off and companies like this one are less sensitive to the economy.

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Jim Rogers Still Bullish on Agricultural Commodities and Bearish on US$

Jim Rogers appears to be still bullish on commodities. I recall some concern he had about overheating in the commodities markets but he still seems to like them. In this article by IHT, he says he is moving out of the US$ and into the Renminbi. He is also moving into precious metals and away from the US$. This isn't anything new to anyone who has heard him talk. He has maintained that view for many years now. The information I find worth pondering are the following:

Agricultural Commodities

As with Marc Faber (they are both friends), Jim Rogers seems to like agricultural commodities.

Rogers said he remains bullish on commodities because "that's where the big fortunes are going to be made in the world in the next five, or 10 or 15 years. The current bull market is going to last until sometime between 2014 and 2022."

Commodity prices have surged as demand for raw materials, especially from China, rose faster than producers were able to increase output. Agricultural prices have led recent gains, including a record high for wheat last month and a three-year high in soybeans.

"The number of hectares devoted to wheat farming has been declining for 30 years. The inventory levels of food are at the lowest level since 1972," Rogers said. "Suppose we start having droughts again. God knows how high the price of agriculture is going to go, so that's where I'm putting more of my money now than in other things."

He added, "I think I'm going to make more money in agriculture than I make in precious metals."


He thinks agricultural commodities will outperform other commodities like base metals and precious metals (he doesn't say base metals in the article but he has said that in the past). I'm not entirely sure about Jim's view of declining agricultural land use in the past leading to price increases now (it matters a bit but don't think it's going to be the big reason). Of all the commodities, agricultural commodities have historically deflated more on a consistent basis than anything else. This is mainly due to improvements in technology, better land use, and so forth (crop yields are higher now than, say, 40 years ago).

Having said that, I can see agricultural commodities doing well simply because most of the developing countries are poor. As someone who comes from a poor country, I can tell you that food is a bigger issue than anything else. Investors seem to be tripping over themselves for consumer goods companies but I suspect there will be more money made on agricultural goods. Unlike wealthy countries, a big chunk of the budget in developing countries are dedicated to food. People in countries like China, India, etc, will increase the quality of their food intake long before they spend money on consumer goods. The Street always talks about the middle class in countries like China and India, but the middle class is tiny compared to the lower classes. There is far greater potential if you can capitalize on the lower classes than on the middle class (think Wal-mart vs Nordstorm's or JC Penney in 90's).

The risk with agricultural commodities is that they are localized. The food that people eat in different parts of the world can be different. So if you are going into commodities, make sure you target properly. For example, corn is huge in USA but isn't as big in Asia. In contrast, rice is huge in Asia but not really a big deal in USA. So if you buy, say, an ETF that contains corn instead of rice, the results will be materially different.

If you are bullish on agricultural goods, there are many ways to play it:

  1. agricultural commodities
  2. farmland
  3. farm suppliers
  4. farming capital goods makers
  5. distributors/facilitators


Jim Rogers generally prefers the commodities themselves but they tend to be risky, harder to access, and have roll-yield problems. The advantage of commodities is that they have low (sometimes negative) correlation to the broad markets. They will do well during stock market corrections whereas stocks of all stripes can get hit during a correction. In contrast, agricultural stocks or farm equipment stocks often track the broad stock market. These days there are a lot of ETFs and exchange-traded notes (ETNs) that track agricultural commodities (these are just a selection):

  1. PowerShares agricultural ETF: DBA
  2. BGI iPath ETNs: JJA, JJG
  3. Elements ETNs: RJA (this family of unpopular ETNs track Jim Rogers's commodity indices)


Volume on these ETFs and ETNs can be very thin so watch out. Expense ratios are also high for some of them.

Yen Unwinding

He says that the Renminbi will go up 3x or 4x and I find that to be quite a lot. The part I found beneficial to me is his view of the Yen:

Rogers also is buying Swiss francs and Japanese yen, which he said have been "pounded down" because of the so-called carry trades...

The carry trades in yen and francs will "unwind someday," which will send the currencies "straight up," Rogers said. "I'm buying the yen."


I'm also bullish on the Yen and am trying to invest in Japanese stocks. You don't need to invest in Japanese stocks to benefit from the Yen but it's better than just holding Yen-denominated bonds. Once I get through reading some classic investing books, my plan is to read some books on Japan. I would like to check out the following books but it depends on which ones are available in the library (I'm cheap :) ) and which ones I have to buy:


  1. Japan On The Upswing: Why the Bubble Burst and Japan's Economic Renewal
  2. The Japanese Money Tree: How Investors Can Prosper from Japan's Economic Rebirth
  3. Saying Yes to Japan: How Outsiders are Reviving a Trillion Dollar Services Market


As usual, I'll post book summaries once I read them. Right now I own Takefuji (PK: TAKAF, TSE: 8564) and my idea is to look at REITs and consumer product companies in Japan. One thing to note is that if the Yen ever starts appreciating, Japanese exporters will suffer significantly. The high-flyers in Japan right now, such as Toyota, are the exporters who benefit immensely from the low Yen and I can see these struggling (it depends on how these companies adjust to a rising Yen of course).

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Thursday, October 25, 2007 0 comments

Buffett: Best Investment You Can Make

What's the best investment one can make in life? According to Warren Buffet...

"The best investment you can make is in yourself," he said in response to one question from an employee about investment strategy, urging his listeners "to develop your own abilities." That, he added, "will do far more for yourself" than any single stock or other such investment.

This is something I need to start following. I need to develop my skills, especially when it comes to career and love. Both of those are going nowhere and it's about time I started improving myself...

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Wellcare Health Plans (WCG) Drops 50% On FBI Raid

Wellcare Health Plans (WCG) is a large managed healthcare provider for the US government Medicaid and Medicare programs. The stock is down around 60% today and that's a lot for a company that was originally valued at around $4 billion. I'm taking a quick look. I don't know much about the medical field so I may pass on this but it's worth checking it out.

Ticker: WCG
Market cap: $2 billion
TTM P/E: 11
Forward P/E: 8
P/Sales: 1.01
P/BV: 7

ROE: 38%
Debt/Equity: 0.2

The risk here is that they do all their business with the government, and being on the wrong end with the government will severely hurt their future. This is also the type of business where bad publicity can be lethal. Here is a news article providing some background info.

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Wednesday, October 24, 2007 1 comments

Subprime Mortgage Debt Investing 101

I ran across an excellent article by Allan Sloan of Fortune (Oct 16 2007) on the workings of a subprime mortgage debt instrument. Anyone contemplating investing in closed-end funds and trusts that hold mortgage debt of any sort should read the article. What I quote below does not do justice to the article. John Mauldin and others have written articles on ABSes, CDOs, and mortgage debt, but this article presents a case study examining the details of why--and how--these things were created.

I have to point out that the authors picked one of the worst ones out there so it may not be entirely representative of the securities that are out there. However, as investors looking to capitalize on these security sell-offs, we should consider a bad case like the one studied in this article.

This issue, which is backed by ultra-risky second-mortgage loans, contains all the elements that facilitated the housing bubble and bust. It's got speculators searching for quick gains in hot housing markets; it's got loans that seem to have been made with little or no serious analysis by lenders; and finally, it's got Wall Street, which churned out mortgage "product" because buyers wanted it. As they say on the Street, "When the ducks quack, feed them."


LOL Can't stop laughing at the ducks comment because it's so true. If there is a demand, Wall Street will satisfy it. It's a characteristic of a free market after all.

In the spring of 2006, Goldman assembled 8,274 second-mortgage loans originated by Fremont Investment & Loan, Long Beach Mortgage Co., and assorted other players. More than a third of the loans were in California, then a hot market. It was a run-of-the-mill deal, one of the 916 residential mortgage-backed issues totaling $592 billion that were sold last year.

The average equity that the second-mortgage borrowers had in their homes was 0.71%. (No, that's not a misprint - the average loan-to-value of the issue's borrowers was 99.29%.)

It gets even hinkier. Some 58% of the loans were no-documentation or low-documentation. This means that although 98% of the borrowers said they were occupying the homes they were borrowing on - "owner-occupied" loans are considered less risky than loans to speculators - no one knows if that was true. And no one knows whether borrowers' incomes or assets bore any serious relationship to what they told the mortgage lenders.


Think about the amount an average person put into their home in this case: 0.71%! Unbelievably low number. Homeowners have practically no downside and massive upside (sort of sounds like stop options for executives).

The article goes into how mortgages are sliced and diced into different tranches. The tranches, from least risky to the most risky, are: A-1, A-2, A-3, M-1 to M-7 (called mezzanine), B-1, B-2, and X. The lower tranches get blown up first due to adverse changes. In this case, four of the lower rated tranches lost their full value, while the AAA-rated tranches were lowered to BBB.

How is a buyer of securities like these supposed to know how safe they are? There are two options. The first is to do what we did: Read the 315-page prospectus, related documents, and other public records with a jaundiced eye and try to see how things can go wrong.

The second is to rely on the underwriter and the credit-rating agencies - Moody's and Standard & Poor's. That, of course, is what nearly everyone does.

In any event, it's impossible for investors to conduct an independent analysis of the borrowers' credit quality even if they choose to invest the time, money, and effort to do so. That's because Goldman, like other assemblers of mortgage-backed deals, doesn't tell investors who the borrowers are.

One Goldman filing lists more than 1,000 pages of individual loans - but they're by code number and zip code, not name and address.

Even though the individual loans in GSAMP looked like financial toxic waste, 68% of the issue, or $336 million, was rated AAA by both agencies - as secure as U.S. Treasury bonds. Another $123 million, 25% of the issue, was rated investment grade, at levels from AA to BBB--.

Thus, a total of 93% was rated investment grade. That's despite the fact that this issue is backed by second mortgages of dubious quality on homes in which the borrowers (most of whose income and financial assertions weren't vetted by anyone) had less than 1% equity and on which GSAMP couldn't effectively foreclose.


The problem with these securities in the first place was that there was no way to figure out the true risk of any of these things. As Fortune points out above, even if we were to read through all the documentation, it is quite difficult to pin the risk.

How does toxic waste get distilled into spring water? Watch. It's all in the math - and the assumptions about how borrowers will behave.

These loans, which are fixed-rate, carried an average interest rate of 10.51%. After paying the people who collected the payments and handled all the other paperwork, the GSAMP Trust had ten percentage points left. However, the interest on the securities that GSAMP issued ran to only about 7%. (We say "about" because some of the tranches are floating-rate rather than fixed-rate.)

The difference between GSAMP's interest income and interest expense was projected at 2.85% a year. That spread was supposed to provide a cushion to offset defaults by borrowers. In addition, the aforementioned X piece didn't get fixed monthly payments and thus provided another bit of protection for the 12 tranches ranked above it.

Remember that we're dealing with securities, not actual loans. Thus losses aren't shared equally by all of GSAMP's investors. Any loan losses would first hit the X tranche. Then, if X were wiped out, the losses would work their way up the food chain tranche by tranche: B-2, B-1, M-7, and so on.


The real culprit behind all the mispricing of risk lay with the assumptions that went into default rates. The credit rating agencies never really had a true understanding of who the borrowers were, what they were doing, and the risk that it all entailed.

If you had borrowed 99%-plus of the purchase price (as the average GSAMP borrower did) and couldn't make your payments, couldn't refinance, and couldn't sell at a profit, it was over. Lights out.

As a second-mortgage holder, GSAMP couldn't foreclose on deadbeats unless the first-mortgage holder also foreclosed. That's because to foreclose on a second mortgage, you have to repay the first mortgage in full, and there was no money set aside to do that. So if a borrower decided to keep on paying the first mortgage but not the second, the holder of the second would get bagged.

If the holder of the first mortgage foreclosed, there was likely to be little or nothing left for GSAMP, the second-mortgage holder. Indeed, the monthly reports issued by Deutsche Bank (Charts), the issue's trustee, indicate that GSAMP has recovered almost nothing on its foreclosed loans.


Reading the above makes one think why anyone would even consider these things in the first place. But that's the nature of investing. People do a lot of crazy things. Investing in second mortgages where the homeowner put down less than 1% seems like the dumbest thing ever.


Through all this, Goldman Sachs actually somehow made money:

Goldman said it made money in the third quarter by shorting an index of mortgage-backed securities. That prompted Fortune to ask the firm to explain to us how it had managed to come out ahead while so many of its mortgage-backed customers were getting stomped.

Goldman's profits came from hedging the mortgage securities it keeps in inventory in order to make trading markets. It said in a recent SEC filing, "Although we recognized significant losses on our non-prime mortgage loans and securities, those losses were more than offset by gains on short mortgage positions."

As we interpret this - the firm declined to elaborate - Goldman made more on its hedges than it lost on its inventory because junk mortgages fell even more sharply than Goldman thought they would.



The graphic below illustrates what actually happened to the mortgage security that was studied:


You can see from the graphic how the lower tranches ended up losing everything, while the higher ones were downgraded.

If we are to invest in these things, the thing we need to realize is that it is highly likely that the tranches will not recover their rating in the near future--if ever. If I were to invest, it will be solely on the view that the price is much lower than what the true risk is. I don't think anyone should invest in BBB and expect it to go back to AAA. However, if the security truly deserves a BBB rating, and the price implies, say, a CCC rating, then it is worth checking out. It is still a statistical game (you are investing in a black box where you don't know what's in the mortgages) but at a low enough price it may be profitable.

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Tuesday, October 23, 2007 0 comments

Marc Faber Interview with Bloomberg

You can find a Bloomberg video interview with Marc Faber here (approx 32 min). Marc Faber for those not familiar is a superbear who is famous for his generally bearish views.

I don't see anything new in the interview (compared to his prior views), with Marc warning about the US$ and still being bullish on commodities (although he says there will be corrections, like the 50% drop in nickel in the last few months). Most of the interview is about Marc's negative view of central banks. I don't necessarily share his views of central bank interventions. Marc Faber also thinks the bubbles in China and India may collapse between now and the Olympics in China next year. However, he makes it clear that the Chinese markets can go up 2x from here even though they are in a bubble.

He recommends cash and says people should hold some gold. He retains his contrarian bullishness for the US$, although he thinks it will weaken compared to gold.

The bigger, longer-term, theory of his is that inflation is going to be an issue as we move forward. He says there was price inflation in goods in the 70's then inflation shifted to assets in the 80's and 90's, and now it is going to move back into goods prices.

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Sold: 20 yr US Treasury bond ETF (TLT)

I sold my iShares 20 year US Treasury bond ETF (TLT) today. I don't know what to make of this investment. Overall it was a dissapointment (it was a loss) but I learned some valuable lessons (currency fluctuations; don't invest based on the economy). The return was positive in US$ but negative in Canadian dollars (my local currency and what really counts).

The original thesis for investing turned out to be only partially correct. I invested in TLT because I thought that bond yields will decline due to a slowing economy and a stock market correction. I was targetting a 20% return based on a 1% drop in the yield (duration of the bond is roughly 20 years and each 1% change in yield results in roughly 20% change in price). I also thought that the Federal Reserve will start cutting rates in mid-2007 and there will be capital flight into the bonds.

Well it never really turned out as I anticipated. The stock market never really corrected and the economy never slowed to the degree I thought it would. The Federal Reserve did cut and I think they will cut further but it didn't happen as quickly as I thought it would. The yield probably dropped about 0.4% from my purchase (my goal was 1%). I still think there is more upside but I feel that there are better opportunities (I'm thinking of adding to my TRB risk arbitrage position).


Sale Price: US$ 90.21
Purchase Price: $85.08

Total Return (US$): 10% (about 6% capital gains + 4% interest)
Total Return (C$): -7.05%

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Should Central Banks Target Asset Prices?

WSJ Economics Blog has posed a thought about whether central banks should target asset prices? Right now most central banks try to influence inflation and employment, but not asset prices. The question being raised is whether asset prices, the two being suggested are stock prices and real estate prices, should be targetted as well.

Economists have over the years established considerable theoretical justification for stabilizing consumer prices — it reduces “menu costs” (the effort of frequently updating prices), it helps consumers and businesses distinguish between relative price changes (which signal whether to reallocate resources) and inflation (which does not), and it helps smooth the business cycle because when inflation is high it also tends to be volatile, requiring more frequent, and aggressive, responses by monetary policy.

The theoretical justification for doing the same with asset prices is less developed. A bubble does distort the allocation of capital, but when does a rise in asset prices reflect a bubble rather than benign forces raising the present discounted value of the asset’s income-generating capacity? A central bank that tried to stabilize asset prices in the latter case would do more harm than good.


It's an interesting thought but I suspect that it is going to take decades of economic research before anything concrete can be implemented. I'm not an economist but the problem I see with asset price targetting is that a big chunk of it is psychological. One can never be sure what is "overvalued" and what isn't.

All I know is that when asset prices are targetted--if they ever are--it will narrow the gap between the "capitalists" and the "non-capitalists". By "capitalists" I'm talking about people who rely on asset price increases to make a living, while the "non-capitalists" generally live off salaries and wages. I'm not trying to start a class war here and simply using this as an illustration. I'll be the first to admit that everyone who has positive savings is a bit of both. Right now a huge chunk of the public is into investing and speculation on the hope of getting rich. Even people like me probably fall into that category. If asset price targetting materializes, I suspect it will be extremely difficult to get rich off investing.

The upside for the economy is that it will be more stable. Instead of massive booms and busts in various assets that seem to crop up every decade, those will be a rare thing. I can see this happening but probably not in my life. Maybe in 500 years from now, prices on the stock market, or for real estate, or whatever else, will be so stable that future humans will look at present investors and speculators--all reading this blog--as something mysterious. This is not as crazy as it seems. Note that bond prices used to be quite volatile a hundread or two hundread years ago. Yet bond prices hardly ever move much these days (obviously there will be some low quality bonds that will always be volatile).

(Of course, if we start practicing a political system similar to anarchism or libertarianism then it is questionable whether we will even have central banks or governments in 500 years :) )

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Monday, October 22, 2007 0 comments

WSJ Interview with Sam Zell

Sam Zell did an interview with WSJ on the weekend. I'll quote things I found worthwhile.

Mr. Zell says, while insisting that he's told everyone he didn't try to deliberately pick a market top so much as weigh the offer against what his own instincts told him was the right price. "Somebody made an offer that was wide by a significant margin of my own valuation. So I'm looking in the mirror, and any day you don't sell, you buy, and I wasn't willing to buy at the price they were willing to pay, so I sold it."


Interesting way of looking at a selling price: if you won't buy something at a certain price, it may be worth selling.

"An adequate description of me would certainly be a professional opportunist," he smiles, "I've always had my own perceptions of value, and I've always been willing to go forward and risk my own capital on whatever basis I believed. And on many of those occasions, it was really lonely. You turn around and look behind you and there's nobody else."

When he and his partner began buying distressed assets in the late 1980s and early '90s, they had hardly any competition. Many of the buildings were so empty they became known as "see-throughs," and most savvy investors would have sooner jumped off the Golden Gate Bridge than touched some of their early acquisitions. "You know, you can really be a macho guy," he says, "but in the end, you think, well, 'I'm sure I'm right, aren't I?' But I was always pretty sure I was right."


Sam Zell is a prototypical contrarian. It's not easy to be one...

"See, I'm a professional risk taker, but I'm a professional risk taker who understands all the risks he takes. A lot of people don't."

The same economic principles cross all boundaries, he says. "Other than designing rocket engines, or biotech or some high-tech stuff, business is business and risk is risk. And the ability to incur risk and the ability to make things happen, they are all the same."


Risk is something that I have a hard time understanding. I have a feeling that the verdict on my success or failure will be based on whether I understand the risks I take. Unlike some, I have no problem risking capital. But I sometimes have a habit of not understanding the risk I'm taking.

He sets one whirring to life. The song it emits, to the tune of "Raindrops Keep Falling on My Head," begins "Capital is raining on my head / Everything is liquid / we're awash in cash to spend . . ."

That's how he saw things in 2005. What has changed now is not the existence of liquidity -- there's plenty -- but the will to use it. The problem isn't a sudden lack of money, but a lack of confidence from the people who control it. Resurrecting that confidence will be the key, and it's unlikely to happen in the near-term.


Clearly investors are scared of deploying capital right now. All of my posts on the credit problems in the ABS market shows that clearly. It's not that people don't have enough money to invest in ABS securities but that they don't want to. This is one reason I think central banks increasing liquidity by cutting rates won't have much impact (other than some tangential effect).


"We haven't even begun to see the fraud that went on here," he continues, pausing to put on his best Professor Risk face. Imagine you're a broker on a starter home in California and it's a $500,000 loan to a guy who makes maybe $45,000 a year, he says, and someone just changes the numbers and the loan goes through. "Two days later, some investor in Poland owns it. You're out. You got your money . . . What disciplines you?"

So did we get carried away with the notion of homeownership as part of the American dream? "If you need to come up with some kind of a really sophisticated journalistic approach, I think what you could basically conclude is that the country can't afford more than 65% homeownership, and that when we start pushing . . . you create a disaster. You push a bunch of people who can't afford it into the homeownership dream, you have builders overbuilding, you have brokers overselling and it always ends up badly."


Pretty much sums up Sam's view on what happened with housing. I think a lot of politicians, including many liberals on the left (I'm a liberal-libertarian BTW), like to think that increasing home ownership is somehow good for the country. As Zell points out, if you try pushing it, it ends up as a disaster. If people can't afford houses, they can't afford it! It's as simple as that. There is little benefit in trying to change that. (If governments wanted to change things they should increase the incomes of the lower classes by cutting taxes).

Mr. Zell sees some homeowners taking double-digit losses because they're forced to sell, but many won't sell if they don't get their price. And as long as employment holds up, he says, the housing market may be soft for many months to come, but there won't be a national fire sale. He also notes the oversupply is worse in some markets than others. Miami was hit badly, while cities like Seattle and New York have carried on with hardly a dip."


There is a big 'if' in there: if employment holds up. If the economy slows, I wonder if Zell's view of no-firesale will be true. If there are no firesales, I wonder how long it will take to work down the inventory.

Some fun stuff:
To get away from it all, there's always Zell's Angels, his very own motorcycle gang that takes trips around the world together, most recently riding the Dalmatian Coast from Trieste to Albania and back. Mr. Zell has about 15 motorcycles for his purposes, he says, but they're all the same basic kind, he tells me -- sport bikes -- fast and with a lot of torque. He knows exactly what he's dealing with. "I'm about as focused a motorcycle rider as you have ever seen."

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Sunday, October 21, 2007 0 comments

Potential Loss of Interest Payments on ABS Securities

One of the huge risks with any ABS investment is the potential loss of interest payments. It's one thing to take some capital loss but if you lose the interest payment then it's just a piece of paper. Here is a good article by Vikas Bajaj of New York Times talking about the potential for the cut-off of interest payments on CDOs. The article gives a good overview of the risks that haven't materialized yet.

For all the pain in the mortgage market, investors who hold bonds backed by risky home loans have continued to receive their monthly interest payments — until now.

Collateralized debt obligations — made up of bonds backed by thousands of subprime home loans — are starting to shut off cash payments to investors in lower-rated bonds as credit-rating agencies downgrade the securities they own, according to analysts and industry executives.

Cutting off the cash flow, which is governed by rules and mathematical formulas that vary by security, is expected to accelerate in the months ahead.


As the article points out, mortage-backed bonds, CDO instruments, and others, haven't really cut distributions yet. That's why some of them have annualized yields of like 20% right now (The Canadian trust I was looking at, GII.UN, is not paying anything due to the lockup in the ABCP market, but if it were paying distributions, the annualized yield is around 50%(!) right now.) Chasing yields with these things is a risky business. I remember reading Jason Zweig's comment in The Intelligent Investor that investing for yield is like marrying someone for sex. When sex dries up, it's all downhill. If you invest based on yield, and if the yield dries up, it's all downhill.

Some bonds, for example, may go from being valued at, say, 70 cents on the dollar to becoming largely worthless overnight, bankers and analysts say.


Talk about a scary scenario. Going to zero overnight is not something any investor looks forward to...

A majority of the bonds have high credit ratings, and the trustees of the debt obligations typically shut off lower-rated bonds first to accelerate payments to investors holding higher-rated debt.


This is what is confusing about these trusts and open-ended funds that hold CDOs. The ones I have looked at hold a lot of securities, generally 100+, and some are rated AA or better while others are lower quality. It's not clear what the impact on interest payments for those trusts will be. Even if lower quality interest payments are lost, is it worth investing just to get the interest payments on the higher quality holdings? Since none of this is transparent, not to mention the fact that the ratings are unreliable and being revised down on a regular basis, it's difficult to gauge what a realistic yield on these instruments will be.

Yet for all the damage that has already been done, the real stress for investors in these securities lies ahead, industry officials say.

Most mortgage securities have not yet had significant losses, which are only recorded when homes are foreclosed and sold. Up to two years can pass between a borrower’s falling behind on payments and an auction. Each mortgage security has a reservoir of excess cash to draw upon to pay bondholders when borrowers do not make monthly payments.

“As far as the security is concerned, it’s only once the property is effectively sold that a loss is recorded,” said Nicholas Weill, chief credit officer at Moody’s. “The process of foreclosure is a long process. It doesn’t just happen overnight.”


The comments above are not reassuring to me. If I were to invest in these ABS funds or trusts, it would be because I am sure that the worst is behind me or is happening right now. If, as the article suggests, there is a lot of uncertainty for up to two years, I will not find these attractive. There is nothing worse than investing in these things and then waiting two years to see what the value is based on foreclosure rates.

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ABX Chart

I have been thinking hard about the Canadian ABS trust that I mentioned in my prior post. I'm one of these people who likes to think a lot and I hope this isn't a case of thinking too much for my own good. It just looks like the ABS market is such an attractive proposition right now. It' scary and very risky but it also looks like a unique opportunity.

The main thesis for investing in these beaten-down ABS securities is the expectation of a rebound in the ABS prices. Check out the price declines of various home equity (HE) ABS indices (Thanks to MattWright at the Morningstar.com forum for providing a link to markit's ABS charts):

(source: markit.com)


The price has been dropping since default rates started increasing back in July. The real question is how much further these things will drop.

Even without knowing anything about the details of the underlying ABS instruments, I personally think that the prices have dropped too much. I can see assets rated BBB or lower dropping, but it just doesn't seem right that AA and A have dropped so much. Yes, the rating agencies are downgrading some of those higher rated debt but we are talking huge drops in prices here.

My plan now is to read the prospectus of the securities I mentioned yesterday (TSX: DG.UN; TSX: GII.UN) and figure out if I'm comfortable with these assets. Initially I felt that DG.UN was a better buy for sure since its stock price is about half its NAV, but now I'm thinking that GII.UN may be worth looking at even though its price is slightly above the NAV. I changed my mind because I have this feeling that, since the market for ABS assets has dried up, some of the NAV price estimates are likely misleading. If there is an illiquid market, the prices can be ridiculously low during crises (think trying to buy PinkSheet stocks during a market correction).

Anyway all of this is just an idea at this point. All of this is very complicated and no one, including professionals at the top investment banks, have no idea what is going on...

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To Watch: Some Canadian Opportunities... Priszm Income Fund and ABCP-embroiled Trusts

Here are some ideas running my head. As usual they are contrarian and one of them is very risky (it's only risky because I don't understand it; if I did, then it wouldn't be risky :) ).

Priszm Income Fund

Priszm Income Fund (TSX: QSR.UN) runs 400+ market-leading fast food restaurants, such as KFC, Taco Bell, and so on, in Canada. It licenses the brands from US-based Yum! Brands (YUM). It has been struggling lately due to a bunch of issues. The stock is off 50% in the last year and looks attractive. I haven't done much homework but this looks like an amazing opportunity if you believe the economy will slow in Canada (starting with a US slowdown). I have been looking for some good companies that will do ok if the economy slows and this fits that profile. Although I think this gets classified as consumer discretionary, I don't think consumers will cut back that much given that fast food is low-end and many people depend on it.

If anyone is interested in this company, be careful and note that this a trust and pays out most of its cash flow. Its growth rate is likely to be very low and you can't really compare it to a normal restaurant business. There are a lot of interesting ideas in my head so I'm not sure when I'll get around to evaluating this but it'll be high on my list.

ABCP-Embroiled Opportunities

American (and other) investors may not realize but there is a credit crisis in Canada centering on the ABCP (asset-backed commerical paper) market. Google for it if you are interested in details but basically the August credit crisis dried up the market for non-bank commercial paper. Similar to CDOs with subprime exposure in the US, investors don't want to buy ABCPs issued by non-banks. This has caused all sorts of problems, including negative impact on money market funds (if you thought money market funds were safe, this crisis shows that they are not). The companies that issued the commercial paper are unable to roll over their debt so anyone holding something tied to them have been hit badly.

I came across two trusts (not to be confused with the Priszm mentioned above or other trust structures like oil&gas royalty trusts) issued by National Bank which have fallen around 70% in the last few months.

(source: globeinvestor.com)


These trusts hold various assets, including US mortgage-backed securities, CDOs, and so on. The two securities are Global Diversified Investment Grade Income Trust (TSX: DG.UN) and Global Diversified Investment Grade Income Trust II (TSX: GII.UN). I think I am only interested in GD.UN because a press release states that GII.UN's NAV is $0.74 on Sept 30, 2007 (stock price is above that), while DG.UN's NAV is $7.61 (stock price is below that). (Go here and here and check out the NAV section.) The quoted NAV may be completely wrong since some CDOs, MBSes, etc, in the US are hard to price right now.

There are two issues affecting these trusts. One is that the ABCP market is locked up right now. The other is that the underlying assets are questionable (CDO/subprime/etc issues in the US). These are two distinct issues! In contrast, someone in the US looking at the CDOs, MBSes, etc (read my prior post on low quality credit instruments) only faces the latter problem. The commercial paper problem doesn't really exist in the US (or at least not to the degree in Canada).

The reason both issues impact DG.UN is because of the way the underlying nature of the trust (I hate these protected PDFs that you can't even copy&paste grr :( ). DG.UN holds CDS (credit default swaps) with a side entity, MMAI. Since the commerical paper crisis started in August, MMAI has been unable to re-finance.

There is a working group that is trying hard to resolve the commerical market issues. It has made some progress and hopes to solve everything by mid-December. But it won't be easy:

To get a deal by mid-December, the restructuring faces many obstacles. The biggest challenge is that some classes of ABCP are worth more than others because they either are backed by stronger assets, such as mortgage or car loans, or are supported by stronger bank loan agreements, or have fewer complicated derivatives trades. Another urgent problem is that some of the ABCP issuers have received calls for more collateral because the value of some of their underlying assets has declined.

The people said investors with healthier ABCP are balking at any plan that would call for them to share the pain with holders of more-troubled classes of ABCP. However, these sources said, the committee is seeking to convince reluctant investors to join a collective bailout.


The plan by the group is to convert the ABCP into long term debt with a haircut (small loss). One would have to figure out the impact of any agreement on DG.UN.



Before investing--if investing--the other issue is to figure out if the underlying assets held by the trust are worth more than the stock price. The graphic below shows DG.UN's holdings:

(source: PDF linked above)



The graphic is already scary-looking :) Instead of simply listing S&P ratings, it says "S&P equivalent". Hope there isn't anything shady with that. Apart from that, you can see that most of the assets are residential and commercial MBS. We just don't know what the quality of the assets are. But if one were to really invest, they are obviously doing it because they feel that the asset values are much higher than the stock price.

If I were to invest, I would have to do it quickly--before December for sure. One would want to buy the security before the ABCP deal goes through. One can't be certain that the stock price will run-up on the deal but you just never know.

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Saturday, October 20, 2007 1 comments

Timely Look at Gold: Still High Correlation to Broad Markets

(UPDATE near the end)

I tend to follow the gold market on and off, although I'm not really a goldbug and not really sold on its long-term merits. I sold off my only gold holding for no gain shortly after buying it and have missed the gold rally completely.

For what it's worth, the gold holding that I sold (and incidentally led to me missing the gold rally), Harmony (HMY), is not doing so well it seems. The stock is back near the levels I bought it at, while the gold market is rallying sharply. I still don't think I made a mistake in selling because my thesis for investing in gold did not materialize as you will see below (i.e. gold is still tracking the broad markets, albeit with a higher beta, so it can still collapse with the broad markets).

I think it's timely to look at the gold market right now for a few reasons. The broad markets have rallied sharply in the last couple of months, since the credit crisis. Practically everything has gone up but perhaps the biggest increase has been in the inflation trade (eg. cyclicals, commodities, gold, oil, commodity producing emerging markets, etc). It's still too early to say but if the last couple of days mean anything, it may be that the bear is starting to take a swipe here and there.

The main reason I sold out my gold investment just before gold took off is because I felt that gold was still correlated highly to the broad markets (I also did not buy the inflation argument so that's a second reason). I have little interest in gold or gold stocks if it is simply tracking the broad market with a higher beta. This may be some people's game but not mine. If gold is simply tracking the broad market, I find it more attractive to invest in broad market stocks who generally have better profitability.

So the question in my eyes is whether gold is going to correct if the broad markets decline. To figure this out, I took some data from Yahoo Finance and calculated the correlations (you can do this in Excel with the built-in Analysis toolpak). The table below shows correlations between various ETFs (EEM=emerging markets; GLD=gold bullion; SPY=S&P 500; XLE=oil stocks).



I calculated the correlations (R-squared are shown) before September and after September. Before I forget I should note that the number of data points after September is quite small (only around 30 trading days) so the numbers aren't as statistically rigorous as the pre-September numbers (in fact I wouldn't use these numbers for anything serious and I just use it as a rough guide).

Unless there is something wrong with my calculation (or the source data), gold's correlation with broad market stocks has gone up significantly since the credit crisis. This is not good news for gold investors in my opinion. If the broad markets correct, I suspect gold is going to go down. Given that gold has a higher beta, it will plummet way more than broad market stocks.

All gold has done in the last month is simply go up when the broad market went up. There is nothing to indicate from my work that gold is moving independently of the broad markets. Some people seem to think that gold is moving on its own but I suspect they are being fooled by gold's high beta and various psychological reasons (such as some people placing higher significance when gold breaks even numbers like US$700).

None of this means that gold is or is not a good investment for you. If you want to play a declining US$ it is not a bad bet. But people like me would rather use something else to play a weakening dollar (eg. foreign stocks).

Gold and Stocks: No More Mortal Enemies--At Least For Now

UPDATE: Coincidentally, I ran into an article by Mark Hulbert at the New York Times on the relationship between gold and stocks. My comments were for the last two months but Mark Hulbert refers to a study which points out that gold and stocks have been moving together in the last few years. Historically gold has done well when inflation expectations were high, which generally also meant stocks did poorly; whereas gold and stocks have done well in the last few years while inflation expectations are low.

The theory given by the authors of the study is that rising incomes in developing countries has altered gold consumption. They expect this link to sever in the future. This is a view I share. In my opinion, people in developing countries like India consume a lot of gold because that is generally the best investment available (stocks and bonds are not readily accessible and most people distrust the government (particularly when it comes to currencies losing value all the time)). But I think as those markets develop, people will have greater access to stocks and bonds, and will finally realize that stocks are the #1 asset class. The governments in those countries have also significantly improved their economics, with more stable currencies (in fact the Indian Rupee has been rising lately).

I think all of this means that gold isn't what it was in the 70's. A lot of goldbugs invest as if massive inflation is around the corner but they may be in for a shock. The declining house prices alone should cause massive disinflation or deflation (typically, declining real estate causes huge downward forces on inflation).

(While on the topic of gold moving together with stocks, I suspect another reason, a minor one, is due to hedge funds putting on pair trades with gold. I'm sure that investors have funnelled a lot of money into gold to hedge their trades. I have no proof of any of this and most of the happenings in the hedge fund world is murky and happens in the dark.)

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Friday, October 19, 2007 1 comments

Homebuilders... Plus Buffett's Comment on Them...

(UPDATE: One point unrelated to this post was when Warren Buffett was asked what his best investment of all time was. He remarked it was probably GEICO, the insurance company with the likable green lizard mascot. Based on my little understanding of Buffett and his history, I would have put that near the top of his best investments list as well. Interestingly, Benjamin Graham also made more money on GEICO in an earlier era than with anything else.)

Wild week in the markets but anyway, some notes on homebuilders.

Warren Buffett Comments on Homebuilders

The new business television network in the US, Fox Business, snatched an exclusive interview with Warren Buffett. Thanks to Reflections on Value Investing for the heads up and providing some useful links. You can find excerpts of the interview here (search for Buffett near the bottom). There is some partial transcription at Wall$treetFighter, which mentions some stuff not in the video.

I thought it was interesting to hear Warren Buffett's comments on homebuilders:

I didn’t buy a share. I look at them. I look at their debt, their equities. I look at everything. I’m waiting until they’re under priced. That’s what I look for with any security. And, I don’t think they’re undervalued. Starting 30 minutes, ending 18 months ago – that year – we probably had more home builders offer to Berkshire where the managements wanted to see the business that I’ve ever seen in any industry. A significant percentage of the publicly-owned home builders, when their stock was flying high and their management was talking bullishly, were trying to sell their companies. Apparently they knew what was going on or likely to go on. Though, I don’t think they saw it coming as extensively as it did.
(source: Wall$treetFighter; original television interview by Fox Business)


As I bolded above, Buffett thinks that homebuilders are not cheap yet. I share a similar opinion. The homebuilders are sitting on a lot of inventory and until I see that starting to decline materially, it isn't time yet IMO. If one wants to make decent money, they need to act long before Buffett does. Usually, but not always, when news of Buffett initiating a position in something becomes public, the whole sector runs up quickly.

Quick Notes on the Housing Situation

Business had a good article on housing that you can find here (as I pointed out last week in a lengthy post, it's front page stuff so maybe it's a good contrarian indicator). Housing is making the news everywhere so most of the article may be repetitious but one should read it if they want to get a feeling for the situation. Here are some things I found interesting:

Even though the five-largest publicly held residential builders have cut the value of their land and unsold homes from $49.7 billion in 2006 to $41.9 billion today, that inventory as a percentage of sales has soared 33% during the past year, according to Banc of America Securities.


I'm quoting this to point out that, even after paring it down, outstanding inventory is massive. In my newbie opinion, this is the #1 danger to investors in this sector. The numbers being bandied about are just staggering compared to past housing cycles. It is going to be difficult to unload all this inventory without marking it down or getting rid of it somehow. Someone (can't remember where) actually remarked that when homebuilders bulldoze their homes, we know housing has hit a bottom (supposedly it happen in Texas during the housing collapse in the late 80's). All this inventory has to be written off and book value is going to get destroyed big time. Pepople probably shouldn't just barge into the sector based on the low price-to-bookvalue of the homebuilders.

A year ago builders' debt payments were roughly the same as their cash flow. Now debt is 2.5 times cash flow.


This is something I don't understand (if you do, please leave a comment below and explain it). How can you have debt payments way above cash flow? Even one year ago, if cash flow was equal to debt payment, doesn't that mean that there would be no money leftover for shareholders? But how come these companies posted earnings an year ago? Something looks weird with the quote.

With a slew of risky, adjustable-rate mortgages still to reset next year, foreclosure rates could climb even higher. That's a big reason why the stocks of the nation's 20 largest homebuilders have fallen an average 65% since the start of 2007.


The ARM resets next year are the next big question mark. Long bond yields actually declined sharply this week, as the stock market sold off, so who knows how things will be early next year. Interest rates need to be accomodative by early next year or else things are going to be far worse.

But there a few weak rays of light at the end of the tunnel. Builders are taking the painful step of cutting production. Permits are down 49% from the market's September, 2005, peak. That's half the time it took to reach this point in the last decline. "Builders definitely responded more quickly this time, and that's a good thing," says Banc of America Securities analyst Daniel Oppenheim. "But the inventory overhang is so great, it's going to take a long time to work through this. They still have a ways to go before there's a recovery."


I think the market interprets declining permits as being bearish for homebuilder stocks (since that lowers potential profits) but it is healthy for the sector. Given the huge inventory, builders have to ramp back down to levels they were operating at before the big boom. Some of the homebuilders will also likely go bankrupt in the process. The risk of bankruptcy, along with potentially several years of losses or weak profits, is what makes me look at the homebuilder bond (PHA in my case).

(source: stockcharts.com)



PHA is right now trading around 25% below its par value and has a yield of around 9.5%. For it to have a yield of around 13%, price needs to drop to around $14. I would only consider it attractive around that price.

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Tribune Under Discussion at the FCC

(Update: Here is a detailed article by New York Times on what the FCC is doing)

I haven't posted much lately since I didn't find anything worth posting. The markets are selling off, with big time weakness in financials, and I wonder if this is the start of a big correction or not. Oil prices are hitting highs and at some point they should start impacting the economy.

Anyway, it looks like Tribune (TRB) is under discussion at the FCC.

Commission Chairman Kevin Martin, a Republican, this week said he wants to resolve by December whether to ease restrictions on how many media properties a company can own in a single market...

But FCC Commissioner Michael Copps, a Democrat, on Thursday said Chairman Martin "has indicated he won't grant any waivers pending a vote on major revisions of the commission's media ownership rules," the paper said.

""To say we have to change the media ownership rules so we can get the Tribune deal done does not strike me as ... a good way to make public policy," the paper quoted Copps as saying.


The biggest risk with the Tribune deal is FCC approval (the second biggest risk is banks not being able to finance the deal; chance of Zell backing out is close to zero). Obviously I, being a shareholder banking on the takeover, is hoping the FCC acts in Tribune's favour. The expectation is that some Democrats will be hesitant to vote for easing the media ownership rules while the Republicans are in favour. Ignoring my vested interest, I personally think it's about time the government got rid of cross-ownership restrictions. Newspapers and radio are struggling, and television is next. The media landscape has changed so much that these companies aren't as powerful as they were in the 1900's. Based on the referenced article, it looks like the FCC decision will be made in December.

The stock is down 5% today (I suspect partly due to this news and partly due to the weak market) and I'll be adding whenever I can save up some money. As I indicated before, I'm thinking of selling my US Treasury ETF (TLT) and buying TRB. The long bonds have rallied sharply in the last few days. The futures, which are generally not very good at predicting things, have something like a 70% chance of another Federal Reserve rate cut during the October meeting (it jumped from something like a 40% chance last week to 70% now).

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