Friday, January 25, 2008 7 comments ++[ CLICK TO COMMENT ]++

Are swaps the future for hedge fund value managers using concentrated portfolios?

I know I'm on the opposite trade from Bill Ackman when it comes to the monolines (grr, I wish he would cover his position and take his 90% profit. I know MBIA probably screwed him over before but personal vendettas can be deadly), but he is considered to be a savvy investor who is supposedly a value investor so I pay attention to him. I noticed Bill Ackman's strategy of using swaps in parallel to his stock purchases/sales (thanks to Todd Sullivan's Value Plays for the mention).

In this example, Pershing Square is taking a long position in the stock of Borders Group (BGP) (i.e. buying the stock), while also entering into bullish swap positions that will yield a profit if BGP's stock price rises. Bill Ackman is basically leveraging himself without buying more stock. He is also using CDS (credit default swap) alongside his short positions in MBIA and Ambac.

Swaps such as CDS are one of the fastest growing part of the derivatives world. If you are a value investor who runs a concentrated portfolio (Ackman would fit this bill, just like Buffett, Munger, etc), is it the future for these investors? These investors are very confident with their call so does it make sense for them to leverage returns further by betting in the same direction as their main stock holding? Note that Warren Buffett has often used convertible bonds alongside his stock positions. The classic example is GEICO, where he owned both the stock and the convertible bond (if I'm not mistaken). Is the use of swaps something similar or not?

I'm curious how all this will work out in the end. The big difference with derivatives obviously is that you have no direct economic interest or control over the underlying entity. Pershing Square seems to always buy a stock (in the case of BGP) or short a stock (in the case of MBIA) while entering the swap positions, so they still have control over the business. But their potential profits and losses are far greater than their economic interest (i.e. stock position). If the stock declines, a conventional equity-only investor can sit and wait for the situation to improve; someone using swaps (bullish position) are going to take big losses if the stock price drops. In the cited example, if BGP drops below $9.99, the stockholders can wait and hold, but Pershing Square will take losses.

Or is this strategy (i.e. using swaps alongside stock positions) only a fancy scheme for activist investors? Note that many activist investors only take a small position in a business while attempting to project influence far greater than their ownership position. So leveraging any positive result from small changes is very attractive for them.

It remains to be seen if other "value" investors start using derivatives in the future?

(On another note, if I feel like it I'll critique his letter to the rating agencies about the monolines in a future post. The big thing I notice is that, although his criticism is strong and worth considering, he is using market prices to draw conclusions (completely against Whitman and Eveillard were saying in my prior post). Rating agencies are supposed to evaluate the credit quality of a company. The fact that, say, MBIA's surplus notes plunged after issuance means little (MBIA got the capital; it's down to what they can do with that)).


7 Response to Are swaps the future for hedge fund value managers using concentrated portfolios?

January 25, 2008 at 2:36 PM

Honestly, I'm about ready to lose my mind. The things you hear on TV - it's unbelievable. For some reason everybody seems to think that scratching a few numbers on a napkin gets you an automatic invitation into the muni bond insurance club. Next week, they say, there will be no less than 3 or 4 new entrants.

Right now, a guy from Egan Jones is stating that 200 billion is needed to bail out the monoliners. For the industry, he expects 40 billion in losses, with Ambac getting hit for 10.

Add in Ackman, Cramer, Middleton, Mish, Naked Capitalism, every blogger on Alpha FT, CNBC.

Here's a humorous example from yesterday on CNBC TV. Wisconsin's insurance head Dilweg was being interviewed about Ambac.

Dilweg: Ambac is a good company. We are in contact with them daily. They are currently in talks with credible parties.

Ratigan/CNBC: Who?

Dilweg: Well,for obvious reasons, I can't really talk about who.

Ratigan: Then, excuse me, sir. Why are we having this conversation?

Dilweg: Uhh, because you invited me.

I don't know. Besides myself, if it hadn't been for such a major screw up, I'm almost feeling sorry for Ambac & MBI. Everyone talks about how great this country is because of our willingness to step up and take risks. Ironically Ambac takes a chance insuring that risk, loses and gets vilified for it. They aren't responsible for the subprime meltdown. We are.

They've become a convenient scapegoat for this event. Stupid.

January 25, 2008 at 3:09 PM

Usually I don't care about all the news that floats around but the problem is that it is impacting the stock price precisely when Ambac needs capital. If Ambac can raise $1 to $2 billion (my original expectation several months ago was for them to raise $2 billion) then it'll be down to the economic fundamentals.

Egan Jones has been bearish for many years on the monolines. He is in the Ackman camp of $7b-$10 billion in losses for Ambac. Ackman and Egan Jones know the situation so I would put weight to their thoughts. I think they are grossly exaggerated but it remains to be seen what happens.

Others like Reggie Middleton, Mish, Naked Capitalism, etc, have an overly simplistic view of the situation. I would put Cramer into that camp as well. I mean, just look at their opinion regarding Berkshire Hathaway Assurance. They think that Berkshire is going to crush Ambac, MBIA, and others. Well, that may happen but not any time soon. Berkshire is only licensed in one state (maybe a few more by now) and it is capitalized with $100 million. How much are they going to cover with that? Even if you go with 100-to-1 ratio, that's only like $10 billion (about 1/4 of the annual US muni bond market if I recall). Others speculating that private equity is going to set up shop and take market share will also be proven wrong. Things may happen but it will take a long time (years). It's hard to get licensed in all the states and to develop the risk models to do anything.

There are some government hearings being set up. Not sure what to make of that...

If Ambac can get around $1.5 billion around the current stock price, it won't be too disastrous. It's not great but it isn't as crazy as when the stock was $5.

On another note, I don't think the original party that Ambac probably had lined up (before the Moody's threat undid everything) was Wilbur Ross. My impression is that Ross started to seriously investigate the monolines recently (but he did make a comment about a month ago to Bloomberg where he said that whoever that survives will do very well).

January 25, 2008 at 5:23 PM

It is refreshing to find a blog that is interested in the truth rather than storytelling. Whether or not you lose money on ABK, your best reward is already from the learning experience. Welcome to the lonely world of contrarian investing - its not for everyone. Your ABK position will do fine - ABK will be around in one form or another. Focus on what is important, ignore the chatter, and hold on until the dust settles.

January 25, 2008 at 11:15 PM

I don't know if Wilbur Ross is going to invest in any of the monolines or what shareholders will get out it; but some writers are asking if he is crazy...

Funnily, some were asking the same thing about him in 2003 regarding other industries...

January 26, 2008 at 1:18 PM

Ironically, here's a Fortune article calling Ross a genius!


January 26, 2008 at 1:35 PM


and here


January 26, 2008 at 1:37 PM

glanced over this--

"Representatives of Ambac and MBIA met in Washington on Thursday with staff members of Dodd's Senate Banking Committee and the House of Representatives' Financial Services Committee, said an association representative.

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