Moody's CDS-Derived Ratings Imply Lower Ratings for Ambac and MBIA

Not too surprising to anyone following the situation but Bloomberg has a story about an experimental division of Moody's that generates ratings based on CDS (credit default swaps). According to those CDS-derived ratings, Ambac and MBIA should be rated junk.

Moody's Investors Service has created a new unit that surprises even its own director.

The team from Moody's Analytics, which operates separately from Moody's ratings division, uses credit-default swap prices as an alternative system of grading debt. These so-called implied ratings often differ significantly from Moody's official grades.

The implied ratings frequently show that swap traders think debt is in more danger of defaulting than Moody's credit ratings signify. And here's the kicker: The swaps traders are usually right...


The credit quality of bond insurers, which have been at the center of the subprime storm, differ dramatically. The official ratings of these companies say the insurers are in great shape; the alternative ratings say they're in dire danger of defaulting on their debts...


Moody's implied-ratings group paints a completely different picture. Using the CDS market, Munves's unit rates both MBIA and Ambac Caa1. That's seven notches below junk and 15 below the official Moody's rating.


This isn't really a surprise to anyone given that CDS swaps have been extremely high for the bond insurers for over 6 months. The stock market also shares the CDS swap market opinion and that's one reason the stocks of the bond insurers have dropped so much without actual insurance claims or any liquidity issue.

It'll be interesting to see what actually ends up happening. I personally think there is a lot of irrational behaviour out there. For example, CDS on 1 yr MBIA and Ambac holding company debt implied high probability of default even though there was enough money at the holding company to pay dividends (optional--can be cut at will) and pay operating expenses. Having said that, the real question is the longer term (say 5yr) CDS and how correct they will end up being.

Munves says that over one year, the implied ratings have been a more accurate predictor of defaults than Moody's ratings. The Moody's unit reports that implied ratings for one year have a 91 percent accuracy ratio compared with an 82 percent ratio for Moody's official ratings.

``The Moody's accuracy ratio is consistently lower,'' he says.

He says Moody's company debt ratings are designed to remain stable so they aren't influenced by short-term ripples, unlike the more volatile swap-implied ratings.

``The CDS market often ends up coming back towards Moody's rating,'' he says.


I'm not really sure what the definition of accuracy is in the comment by the Moody's employee above. I'm not an expert on bonds or credit instruments but one thing to keep in mind is that the rating agency ratings are not volatile. They move in steps infrequently and only upon actual changes in the underlying company. In contrast, CDS is highly volatile and is a speculation on what may or may not happen at the underlying company. Because CDS prices change in real-time, they should be smoother and change gradually over time. In contrast, rating agency ratings can be abrupt with 3+ notch downgrades in one move.

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Canada's Economy Contracts in 1st Quarter

While the US economy seems to be stuttering along at slightly less than 1% GDP growth, the Canadian economy contracted in the first quarter, missing economic forecasts. The Globe and Mail reports:

Canada's economy contracted in the first quarter of the year, the first time in five years that the country's output shrank outright.

Real gross domestic product declined a harsh 0.3 per cent at an annualized rate, exposing an economy far weaker than economists' projections of 0.5 per cent growth in the first three months of the year.

Canada's contraction stands in stark contrast to the 0.9 per cent expansion registered for the first quarter in the United States, where recession fears weigh heavily.


The major weakness is from auto manufacturing, which is a large component of the economy. Stripping out the auto portion, the economy expanded marginally.

Major cutbacks in manufacturing activity, especially in the auto sector, were behind much of the poor performance, Statistics Canada said Friday, but bad weather was also to blame...

Much of the weakness in economic output at the beginning of 2008 was because the automotive sector was drawing down on inventories that had been accumulating for the previous two quarters, Statscan said. A strike at a parts manufacturer in the United States, American Axle, was also a factor.

Excluding the auto sector and its ripple effects elsewhere in the economy, output expanded ever-so-slightly from the previous quarter, the agency said.

Declines in manufacturing, mining and some parts of the transportation sector were only partially offset by increased activity in retail, accommodation services, finance and insurance.

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Thursday, May 29, 2008 0 comments ++[ CLICK TO COMMENT ]++

Sears Posts Large Loss

A stock I'm thinking of investing in, Sears Holdings (SHLD), posted an unexpectedly large loss. Consensus (Bloomberg) expectations of $0.15 were missed and the actual results were a loss of -$0.53. The stock was only down around 3.6% for the day so most of the negative news had been expected somewhat.

Sears Holdings Corp. posted an unexpected first-quarter loss as it increased discounts to clear merchandise in the face of increased competition and a softening economy.

For the quarter ended May 3, the Hoffmann Estates, Ill. parent of the Sears and Kmart chains posted a loss of $56 million, or 43 cents a share, from net income of $223 million, or $1.45, a share, a year earlier.

Shares outstanding fell 14% to 131.7 million. Revenue fell 5.8% to $11.07 billion from $11.75 billion. Excluding gains from sales of assets, the company's loss would have been 53 cents a share.

Analysts, on average, estimated the company would have earned 21 cents a share, according to FactSet Research. Sales also fell short of analysts' estimates of $11.3 billion.


Analysts have been completely wrong on this stock for a while, although most have been correct in the recent past with their sell/underweight/hold recommendations. Sears is heavily dependent on housing-related sales (white-box items such as appliances) so it isn't that surprising to see a big decline in sales. However, it has been underperforming the low-cost competition such as Wal-mart and Costco (admittedly those two only overlap in certain segments).

U.S. comparable-store sales fell 8.6%. U.S. same-store sales, which reflect results at stores open at least a year, fell by 9.8% at Sears and by 7.1% at Kmart. Demand weakened across most major categories, especially within the home appliance, lawn and garden and apparel areas, Sears said...

Its gross margin narrowed to 27.3% from 28.2%, the retailer reported.


Pretty weak numbers but I'll be curious to see what happens once housing stabilizes. Right now, they are neither the low-cost retailer (eg. Wal-mart) nor a higher-end one with quality and cachet (eg. Macy's). The weakening economy has hurt the middle segment more than the rest so far and it remains to be seen how much worse it gets.


Here are some excerpts from a bearish post from a bear who touches on the key themes surrounding Sears:

(source: Evan Newmark, Mean Street. WSJ Deal Journal blog)

Today’s awful earnings announcement confirmed the company’s many failings.

But the failings of Sears also reflect the failings of Wall Street. It is a textbook case of how Wall Street can promote a stock based on wishful thinking and myths rather than on the performance of the core business.

Until the core business deteriorates to a point where even Wall Street can’t promote the stock anymore.

A year ago, a share of Sears Holdings traded at $183. Today at $86, it trades at less than half that. How many of the half-dozen sell-side analysts saw it coming? None.


Sell-side analysts tend to be short-term-oriented with a 12 month stock price focus. I like to look at them from a contrarian view, where I prefer to have sell/underperform ratings than buy ratings. Most analysts are now bearish on Sears so that's good from a contrarian point of view for anyone that is contemplating a position in it.

For what it's worth, a lot of successful value investors are long Sears:

Ironically, along with Cramer, it has been other “genius” investors that have been Lampert’s biggest believers. Sears largest shareholders include Bill Miller of Legg Mason, Bruce Berkowitz of the Fairholme Fund, Richard Perry of Perry Capital and Bill Ackman of Pershing Square. That is a lot of genius invested in a shrinking retailer run by a hedge-fund manager. These managers may have investing angles they aren’t ready to reveal, but so far they have publicly voiced support for Lampert.


That's pretty good company to be in... but it doesn't mean that this is a good investment.

When I was trading shares last year, I tried shorting Sears a few times. Not a smart move. Sears trades like Amazon, another retailer with a high shareholder concentration and large short interest.

A handful of shareholders–Lampert, Legg Mason, Fairholme, Pershing Square and Perry Capital–control almost 75% of Sears’ outstanding shares. Couple this with a sizeable share buyback program and you get an erratic,volatile stock.

On a day when everything says Sears should be down, you often will get a dramatic late day run-up that probably is part buying and mostly short-covering.


If what this author is saying is correct, Sears' stock price would have been under even more pressure if it weren't for the concentrated shareholders. The upside is that the stock price may not drop too much; the downside is that if one of these main shareholders do decide to sell, the price can collapse easily.

But I wouldn’t be surprised to see the Sears share price continue to decline as the economy suffers. Down the road, when things look really bad, ESL could propose a buyout to take out the remaining public shareholders.


This is one of the risks with a major hedge fund owning most of the company: a take-under is more likely. However, this won't happen while the main set of present shareholders remain. Bill Miller is a patient, long-term, investor and unlikely to budge unless the price is good. And William Ackman is unlikely to sell out unless his own hedge fund is running into liquidity problems.


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Wednesday, May 28, 2008 7 comments ++[ CLICK TO COMMENT ]++

Sold/Tender Offer: Jaclyn... Plus BCE Thoughts

As I mentioned before, Jaclyn decided to go ahead with the forward-reverse split and the downgrade its stock listing to Pink Sheets OTC. I was slightly concerned a week ago about whether my purchase would run into problems because I'm in Canada (not clear whose account these shares are held) and I purchased two sets (249 each) under two different accounts I had. Well, it looks like it went through successfully and I received my payment. Good luck to Jaclyn in the future and all the best to its employees and shareholders. I will likely never hear about this company in the future given its tiny size and it being listed on the minor exchanges.

This risk arbitrage position has been successful in a short period of time. It's a small position due to the offer requirements but I'll take anything the way things are going : Average return of around 20% in C$ with currency losses shaving off about 2% (the unfashionable US$ still keeps declining ;) ). Big thanks goes out to Jeff, who runs the Circle of Competence blog, for bringing this to my attention. Often small investors feel like they are the underdogs--and we are--but situations like this allow us to capitalize on events that preclude the bigger players.

Sold: US$10.21

Total Return (1st account): 27.23% (approx. 29% in US$ terms)
Total Return (2nd account): 20.61% (approx. 22% in US$ terms)



Mixed Feelings on BCE Court Case

On another note, the bizarre situation surrounding the BCE deal seems to have entered unchartered territory with the Supreme Court of Canada willing to consider an expedited hearing. I'm not a "business guy" but there seems to be strong opinion in the business community here (as represented by newspaper, television, and magazine opinion) that the Quebec court decision was a mistake. We even have George Athanassakos, who teaches value investing at the Richard Ivey School of Business at University of Western Ontario, implying the BCE court decision was a mistake similar to the Bear Stearns bailout by the Federal Reserve. (I personally think the FedRes probably did the right thing with Bear Stearns but I think they made a huge mistake by not auctioning off Bear Stearns to the highest bidder (tramples shareholders) and shouldn't have guaranteed the Bear Stearns bonds (rewards creditors who finance highly leveraged institutions.)) There is still a high probability that the deal won't close successfully given that there are still big clouds over the bank financing.

Even though I would be financially hurt (in the short term; I think BCE will do fine overall), I don't think the court should hand down a rash decision. I think the Quebec court decision was a mistake but I do not think the Supreme Court of Canada should be rushing things since it has the last say on legal matters. I generally don't mind court cases dragging out at the highest level since the decision has an impact on many generations of future Canadians. To make matters worse, the Supreme Court can, in the future, refuse to hear a case without providing justification (the court does this all the time). So if they rule on something now, it can be very hard to overturn even if it's "wrong". Given that this is such an important matter where you are talking about the rights of bondholders versus shareholders, any decision can alter the face of Canadian business (although if the status quo is maintained then nothing is going to change).

It's a bizarre situation no doubt. Not only is this the biggest Canadian takeover in history, it is also very time-sensitive. I have no idea how the bondholders managed to delay the court case until the last minute but they somehow managed to do it. Interestingly, if we didn't have the credit crunch and the economic slowdown, the deal could be easily delayed. Unfortunately, as things stand now, the banks will do everything to avoid their financial commitment so delaying is equivalent to 'no deal'.

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Random Articles for the Week ending May 23

Here are some articles on various topics that interest me. Click through if any of the topics interest you:


  1. Vietnam: One of the worst markets this year but is there a big future?
  2. Consequences of government intervention: The Hugo Chavez example
  3. Alabama County: Update on what may be the biggest municipal bankruptcy in American history
  4. Perma-bears rule the world--for now


Vietnam

Marketwatch updates the state of the Vietnamese stock market and provides some opinion from various money managers. Needless to say, given that all of them work in that region, all of them are bullish. As a contrarian, I like to discount opinions about particular sector/region/asset from those money managers who specialize in them. You can get use them to generate ideas but if they say something like 'the future looks good', I would be wary.

What was once euphoria has turned to gloom. In a classic case of how emerging markets offer both risk and reward, Vietnam's stocks have tumbled more than 50% this year, making them the worst performer in their asset class, as the Southeast Asian country struggles to contain skyrocketing inflation and a hefty trade deficit....

Despite its rapid economic growth, Vietnam faces pressing short-term challenges: soaring inflation and a large trade deficit, which in turn have dented sentiment in the stock market. "The increasingly dire appearance of the economy started to attract people's attention," said Kevin Snowball, director of PXP Vietnam Asset Management Ltd, based in Ho Chi Minh City. "That has damaged sentiment, and now there is no bid in the market."

In early May, Standard & Poor's lowered its outlook on Vietnam's sovereign credit ratings to negative from stable, citing rising risks to macroeconomic stability from an overheating economy. "Hectic investment activity of recent years appears to have pushed the economy to the limits of its capacity," S&P said. Vietnam's trade deficit soared to $11 billion during the first four months of the year, or 90% of the deficit level for all of 2007. Inflation hit a 15-year high of 21.4% on a year-on-year comparison basis in April, the second highest in the region after Sri Lanka's 25%.


I haven't followed Vietnam--it's not exactly easy to invest or get information--but I'm citing this story because Marc Faber (and I think Jim Rogers too--not sure) were bullish on Vietnam over the last few years. It looks like Faber's call is completely off--at least in the short term--given that the stock market is down 50%. Admittedly, Marc Faber seemed to be bullish on farmland so maybe that is doing well given the rice shortage crisis. Whatever it is, the stock market is one of the worst markets this year.

Apart from valuations, one of the reasons I have been avoiding emerging markets is my concern over what is currently plaguing Vietnam: current account deficit and inflation. Some EM (emerging markets) run current account deficits (eg. India) while others don't (eg. China). So I don't think that is necessarily a big problem. Instead, the real big issue is going to be inflation. Given how EM governments often subsidize certain products or have price controls, the potential for a collapse is increasing by the minute as commodities soar. In addition to corruption, it is very difficult for politicians in those countries to eliminate the subsidies/price controls/etc because a huge chunk of an average person's costs are in food and transportation. For example, if you look at the following chart, you'll see that around 15% of consumer costs are for food in developed countries (using government price baskets), whereas it is as much as 60% in poor countries like India.



Investors investing in EM are probably compensated for the inflation risk (returns in those countries are much higher) but I don't think too many people account for the side-effects that can lead to a political crisis.


Chavez's Policies Unravelling Slowly

(if you don't want to hear my political views, skip this post :) )

I don't think too many of my readers are a fan of Hugo Chavez and you can criticize a lot of his actions but I'm going to stick with the economic side. He presents a good example of how excessive government intervention is detrimental to society.

For what it's worth, I don't think Chavez is as crazy as some media portray him. I certainly don't agree with most of what he does but he hasn't committed any mass killings, ethnic cleansing, or various other activities that have been carried out by other "democratically-elected" leaders in Latin America or elsewhere. Some of the leaders of the past including so-called pro-capitalist presidents (eg. Argentina, Colombia, Nicaragua) have been monsters. Similarly, "elected" leaders in other parts of the world, such as Robert Mugabe in Zimbabwe, have been a disaster of epic proportions (on top of ethnically cleansing whites and other minorities, he has literally jailed, tortured, and killed anyone that he doesn't like, printed money like it was going out of fashion, and seems to lack sense of morals or ethics of any sort). Chavez has actually been remarkably controlled in a Putin-like sense--for whatever that's worth. Given that Venezuelans seem to have voted to limit presidential terms, I think Chavez will accept that and hopefully just ride off into the sunset.

I touch on the Venezuela example because, unlike many other countries with similar results, Venezuela actually has seen booming oil revenue. Yet if you read the Bloomberg story I link below, you'll see that there are shortages of basic items.

(source: Chavez Price Controls Mean Record Oil Fails to Prevent Shortage, By Matthew Walter. May 23, 2008. Bloomberg)

``Venezuela is a place of paradox right now, the paradox of plenty,'' says Leopoldo Lopez, the 37-year-old, U.S.- educated mayor of the Caracas borough of Chacao and leader of opposition party Un Nuevo Tiempo. ``There's plenty of oil, and plenty of dollars coming in from the oil industry, but we don't have enough food.''


The cause of shortages can be traced to government actions, particularly price controls and limits of foreign exchange (hard for local companies to import items when they can't get enough US dollars to transact with foreign merchants). Other disastrous policies, such as seizing so-called "unused land" from landowners, have also contributed negatively to the situation. Fortunately, the free market forces are starting to be recognized by the government and it seems to be weakening some of its policies. There isn't anything investing-related per se but it's a good read for anyone who is in favour of heavy government intervention of free markets. You can see the side-effects of meddling in the free market.

Another Few Chapters In The Alabama County Saga

Bloomberg has a detailed article on the shady, corrupt, and possibly incompetent dealings with swap contracts in Alabama. This is a continuation of the story I have posted about in the past. We are essentially looking at the largest municipal bankruptcy in US history. Bankruptcy looked imminent a few months ago but some of the creditors seem to have forgiven some terms so the situation is still unfolding. The municipality problems started with the collapse of the bond insurers (FGIC and XL Capital in this case) and the insured bonds were downgraded by the rating agencies. Clearly, the county, as well as its advisors, didn't seem to account for the wild flucations and rating changes in the credit market.

Perma-bears Rule the World (For Now)

This is an interesting article and worth reading for casual interest. An excellent article from Bloomberg covers David Tice, the perma-bear who runs the Prudent Bear Fund. For those not familiar, David Tice has been predicting doom & gloom for over a decade. When I first started investing a few years ago, he was one of the first bears I encountered. He was wrong for years and was only saved by the commodities and precious metals boom (particularly gold). I have this weird feeling that even if David Tice is correct with his macro calls (I'll mention them below), his fund may end up as a disaster because commodities and gold, may collapse along with everything else.

Now, Tice says the Standard & Poor's 500 Index may tumble 40 percent during the next 12-24 months as the credit crisis undermines the economy, bankrupts households and companies and whacks profits. The drop would be worse than the 37 percent plunge in the index from 2000 through 2002.

Tice predicts U.S. equities will enter a bear market that may exceed the 15-year slump from 1965 to 1980. Moreover, he says if the Fed and Wall Street don't break their addiction to easy credit, the economy will eventually crash in a depression -- a condition marked by reduced purchasing power, unemployment and corporate failures.

The U.S. can't continue to inflate bubbles in stocks, real estate and other assets without crippling the financial system, Tice says.


(grr... I lost a huge post on why I thought short-selling is going to get tough but oh well :( )

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BCE Court Decision Taking Canada In A New Direction?

Ok, what I am about to say will look biased since I would have profitted from the closing of the BCE deal; but even if I had no economic interest, I would say the same thing.

The BCE court decision, handed down by the Quebec Appeals court, sets a bad precedent in my eyes. If it is upheld, it will take Canada in a new direction, away from established principles of other countries like USA. An opinion piece from Al Hudec, a lawyer at Farris, Vaughan, Wills & Murphy, summarizes the situation and questions the merits of the decision:

On what the court is saying...

In the course of its decision, the Quebec Court of Appeal ruled that the BCE board should have considered the interests, including the reasonable expectations, of the Bell Canada bond holders.

The court held that the BCE special committee's process was fatally flawed because the committee had not made a detailed analysis of the costs and benefits of the leveraged buyout -- not just for shareholders, but for other stakeholders too. In essence, the court found that BCE had not properly taken into consideration the adverse impact of the potential transaction on bond holders.


On how this can adversely impact future transactions...
If the Quebec decision is upheld, and this is indeed the law, then it is hard to imagine the board of a Canadian public company ever approving a share bid structured as a plan of arrangement, absent a concurrent bid for the company's outstanding bonds...

Until this decision, the common view would have been that Canadian law was similar to U.S. law as expressed in the seminal U.S. Revlon case of 1986.

The widely cited Revlon ruling established the basic deal principle that once a company is put in play, boards of public companies have a duty to achieve the highest price for shareholders.

The Quebec court held that this view was mistaken and that in Canada, the directors of a corporation have a more extensive duty.


On how bondholders vary from shareholders...
Unlike common shareholders, who generally do not enjoy the ability to negotiate their terms, debt holders have the ability to negotiate a panoply of rights and remedies to protect their interests. These extensive rights are protected by detailed contracts, known as trust indentures, which set out the reasonable expectations of the parties to the bargain, and a court should not readily extend the rights of bond holders beyond those for which they have bargained.

Sophisticated participants in bond markets have understood, since the multiple ratings downgrades of the leveraged buyout boom of the 1980's, that if they are worried about a rating downgrade as the result of a leveraged buyout, they can protect themselves in the covenants of a trust indenture.


Regardless of what happens to the BCE takeover, this is a bad ruling in my opinion. It will make future takeovers, particularly LBOs, extremely difficult.

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Thursday, May 22, 2008 1 comments ++[ CLICK TO COMMENT ]++

Francis Chou: The Best Bargain-Hunting Value Investor from Canada?

The Globe & Mail's investing magazine insert, Globe Investor, has a feature article profiling the Canadian superinvestor hardly anyone has heard of: Francis Chou of Chou Associates Management. Even many Canadian investors who follow the Canadian markets have never heard of him (and it's not as if we have too many successful investors up here). Those value investors somehow miraculously manage to become successful without drawing much attention (some Hollywood stars should take note ;) ).

The article is titled Is Value Dead? and uses the poor performance of value investing of late to ask some pointed questions about the Chou funds and value investing in general. It's a good read so check it out.

(source: Is Value Dead?, Rob Carrick, Summer 2008 Globe Investor)

Warren Buffett, a giant of value investing, has achieved an almost impossible compound average annual return of 21.1% from 1965 through 2007 with his holding company, Berkshire Hathaway Inc. (compared to 10.3% for the S&P 500 Index). Other masters, such as John Templeton and Charles Brandes, have also prospered using this approach, as have Canadian names like Irwin Michael, Peter Cundill, Bob Tattersall and Francis Chou. Until recently, that is. At some point in the past year or two, value investing stopped working. Example: For the 12 months to Feb. 29, three of Chou’s five funds were down 17% or more, as compared with the previous year. Could this be the death of value?


Francis Chou isn't alone; a lot of other value investors, such as Bill Miller, Edward Lampert, Martin Whitman, and so forth, have been suffering as well. Basically anyone that did not overload on commodities & emerging markets or short financials have been beaten up pretty badly...

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Sears Holdings Hitting Attractive Levels

Sears Holdings (SHLD) is hitting price levels that are quite attractive. I've been looking at Sears (and other retailers) lately. I have mostly looked at Sears from a credit point of view because I'm still thinking that the 7% Notes due 2042 trading on the Pink Sheets under the SBCKP symbol may be worth it (the concern is inflation more so than bankruptcy/default risk).

Sears is a good contrarian retailer to investigate. It's one of the retailers with bearish Street consensus. According to Yahoo Finance, 3 analysts rate it a Hold (a polite way of saying sell) and 4 rate it Underperform (more direct indication of a sell). Analyst median target is $87/share with a low target of $70. The current price is getting close to the $87 target.

I've also been waiting to see if I can consider buying it below book value. Given that some prominent investors, such as William Ackman, have indicated that real estate on Sears' books is understated, buying below or close to book value is almost a home run. Right now Sears is trading around 1.1x book value. Another 10% drop in book value (or 10% additional profit) will hit the 1x ratio.

The big downside is the credit contraction (started by the housing meltdown but likely to spread to credit card usage) and its negative impact on consumers. Sears seems to be one of the weaker deparment stores in terms of brand, shopping appeal, fun factor (yes, some people, especially women, consider shopping fun ;) ), and prices, so it will likely suffer more than some of its competitors. But its balance sheet is strong so it can easily absorb significant deterioration with their customers.

In terms of upside, I think an optimistic upside scenario (ignoring financial engineering with the real estate assets) is a profit margin of around 3%. Right now Sears has around 1.5% profit margin so you are looking at 2x increase in earnings. The TTM P/E is 15.5 and forward P/E is 24.8 so the optimistic case yields a P/E of around 12 (using the forward P/E). Earnings for nearly all retailers are likely below-normal levels so earnings will be higher over a full cycle with economic slowdown along with recovery thereafter.

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Court Rules Against BCE Deal

In a highly surprising move, the Quebec court ruled against the BCE deal arguing that bondholder interests weren't taken into account:

BCE Inc. shares plunged Thursday morning following a shocking Quebec court ruling Wednesday that threatens the company's planned $35-billion sale to a group led by the Ontario Teachers' Pension Plan. But several analysts suggested the company may be able to reach a financial settlement with balky bondholders who oppose the deal – for somewhere between $500-million and $1.3-billion.

As well, the head of the Canada Pension Plan Investment Board expressed concern about the precedent-setting court-ruling and its implications for Canadian capital markets.


I didn't expect the court to rule against the deal, after the lower court ruled in favour of the deal. I think it sets a bad precedent when bondholders without any conditions in their bonds can block shareholder actions. I suspect the ruling will be overturned at the Supreme Court (it it goes there) but it'll be too late and miss the deal deadline (so BCE may not pursue further).

One of the bondholders that sued BCE appeared to leave little hope the takeover could be salvaged after the court ruling Wednesday. "It's hard to imagine how it could be resurrected — the deal appears dead," said Hanif Mamdani, head of corporate bonds at Vancouver-based Phillips, Hager & North Investment Management Ltd.

However, analyst Jonathan Allen at RBC Capital Markets suggested in a note to clients Thursday that BCE might still be able to bring the bondholders on side at a cost of roughly $1.3-billion, financed by slightly reducing the $42.75-a-share offer.

“BCE could settle with bondholders through a tender offer at a price that puts bondholders back to a pre-transaction price ... potentially raising the proceeds through a lower equity price (roughly $1.64/share or a final price of $41.11),” said Mr. Allen, who calculates the face value of the affected BCE bonds at $5.1-billion.

That price would still be better than Wednesday's closing price of $37.12 and well above Mr. Allen's estimate of BCE's net asset value of $30 a share.

He noted, however, that lowering the offer price would require a new shareholder vote, which would likely take about 60 days, pushing potential closing beyond the current June 30 deadline.


The stock is down sharply, to pre-takeover levels. During my initial analysis of this M&A, my guess was a price of $31 if the deal failed and that turned out to be a good guess. As the analyst suggests above, BCE will have to re-negotiate a lower deal or call the whole thing off. Since only around $5 billion of bonds seem to be blocking the deal, BCE can easily buy out the bonds (however, someone should still challenge this in court because it is a terrible precedent IMO).

As far as I'm concerned, the deal is dead. The time frame is too short to do anything and given the liquidity problems at the banks, they will try to avoid re-negotiating the loans. This ruling probably saves the banks since successful completion of the deal likely meant billions in mark-to-market losses for the bankers. This is a failed risk arbitrage but I'll hold as I outlined before taking a position.

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Wednesday, May 21, 2008 0 comments ++[ CLICK TO COMMENT ]++

Moody's Computer Bug Leads To AAA Ratings for CPDOs

News keep getting worse on the credit front, with Moody's being accused of assigning and maintaining AAA rating on CPDOs even after the discovery of computer errors. I vaguely touched on CPDOs in a prior post where I was arguing that mark-to-market losses don't necessarily mean anything. In any case, Financial Times is accusing Moody's of rigging their rating of CPDOs after discovering a computer bug in their rating model (story from Bloomberg).

Moody's Investors Service said it's conducting ``a thorough review'' of whether a computer error was responsible for assigning Aaa ratings to debt securities that later fell in value.

Some senior staff at Moody's were aware in early 2007 that constant proportion debt obligations, funds that used borrowed money to bet on credit-default swaps, should have been ranked four levels lower, the Financial Times said, citing internal Moody's documents. Moody's altered some assumptions to avoid having to assign lower grades after it corrected the error, the paper said.

The allegations raise questions about internal controls at credit ratings firms as they face scrutiny from lawmakers and regulators for assigning their top grades to securities derived from loans to people with poor credit.


The interesting thing is that S&P also gave AAA ratings initially, while DBRS and Fitch didn't, so the computer error really isn't as serious as it seems. It wasn't as if Moody's was placing a rating way out of line with the competition. However it does raise questions about quality control and tarnishes the reputation of the firm. There will also be accusations of cover-up, with the government likely investigating the matter well after the fact (as usual). They are already investing the rating agencies, bond insuers, brokers, and others, due to the subprime implosion but they will probably spend more resources now. None of the allegations have been proven.

It's a serious accusation and, needless to say, Moody's stock is down around 14%. It simply erased the run-up in the stock price over the last week or so, and Moody's stock didn't hit any all-time lows or anything.

In terms of market impact, it's likely to be minor (except for select areas such as the monoline bond insurers or other rating-sensitive businesses). My understanding is most of the CPDOs were sold in Europe and they were liquidated in the last few months (with big losses for investors).

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Tuesday, May 20, 2008 0 comments ++[ CLICK TO COMMENT ]++

Bloomberg Article on CDS...Plus I think Buffett Is Wrong

I ran across a very good article on CDS, with some neat insight (such as how it is in the interest of CDS dealers to keep the market opaque; or how primitive the pricing system is (I'm actually shocked to see how lame it is.)) If you have time to kill (it's kind of long) and are interested in what was happening in the credit markets while Bear Stearns was imploding, I recomend reading the article. Here is a taste of it:

(source: Hedge Funds in Swaps Face Peril With Rising Junk Bond Defaults By David Evans, May 20, 2008. Bloomberg.com)

The banks played the role of dealers in the CDO market as well, and the breakdown in that market holds lessons for what could go wrong with CDSs. The CDO market zoomed to $500 billion in sales in 2006, up fivefold from 2001...

By the middle of 2007, mortgage defaults in the U.S. began reaching record highs each month. Banks and other companies realized they were holding hundreds of billions in toxic debt. By August 2007, no one would buy CDOs. That newly devised debt market dried up in a matter of months.

In the past year, banks have written off $323 billion from debt, mostly from investments they created.

Now, if corporate defaults increase, as Moody's predicts, another market recently invented by banks -- credit-default swaps -- could come unstuck. Arturo Cifuentes, managing director of R.W. Pressprich & Co., a New York firm that trades derivatives, says he expects a rash of counterparty failures resulting in losses and lawsuits.

``There's a high probability that many people who bought swap protection will wind up in court trying to get their payouts,'' he says. ``If things are collapsing left and right, people will use any trick they can.''


The article talks about the potential for a collapse in the CDS market due to the looming increase in corporate defaults. Corporate defaults have been extremely low in the last few years and that's one reason a lot of private equity takeovers were easily done (often via the use of junk bonds). In addition, several companies issued bonds and used the proceeds to buy back stock (this actually isn't a bad idea if you have low leverage and interest rates are low but it's still probably best for companies to buy back stock using their internal cash flow).

I still think that there is no way anyone is going to regulate OTC markets--especially if some of the players are unregulated parties such as hedge funds. I think the best thing would be for the government to ban regulated banks (commercial banks, investment banks, etc) from dealing with unregulated entities (such as hedge funds, foreign funds run from anonymous tax havens, etc). It will be very painful for JP Morgan, Citigroup, et al, to give up their lucrative involvment in the shadow world (shadow world refers to the unregulated world) but it would avoid any detrimental impact on the rest of the economy. You'll end up with parallel banks that are isolated from each other. If something blows up in the shadow world, well, that's capitalism ;) I think it's dangerous for a "normal" bank that has access to the Federal Reserve to load up on these unregulated derivatives. To make matters worse, these players are taking bank deposits and using them in unregulated business with very little knowledge of the true risk.

Having said all that, some people in the investing world don't think there will be much of a problem with the CDS market. You can add Buffett and Munger to that list. The most surprising thing I heard from Buffett and Munger in this year's annual meeting is their sanguine views on the CDS market:

(source: 2008 Berkshire Hathaway Shareholder's Meeting Notes. Transcribed by Peter Boodell; courtesy Reflections on Value Investing)

(WB = Warren Buffett; CB = Charlie Munger (yes, some newbies might not know who Warren and Charlie are ;) )

WB: I think there is no question that corporate default rate will rise. That has been included in price in writing this insurance. Will CDS market lead to chaos? Probably not, but if bear had failed you would have had chaotic conditions. A CDS is a payment by one party to another. When someone loses money on a loan, they’ve lost real money, but there is not a swap of dollars immediately when loan goes bad. In CDS, there is an exchange of cash. Whether counterparties fail -- I don’t think it will happen. We’ve had enormous collateral payments from one firm to another in this recent crisis. Fairfax Financial made $1bil in CDS. This means another guy lost $1bil. They have been most volatile of instruments – and it really hasn’t created a problem in system. If Fed must step in, I don’t think it will be due to CDS. It may cause big losses, but will be matched by big gains by others. There is a problem of an overnight disruption in the system (bear, nuke bomb) – where discontinuity and collateral postings inadequate. At that time, large CDS exposure could exacerbate chaos to considerable degree.

CM: Could we have mess in CDS? Yes, but stupidity not as bad as sweeping bums off skid row to give them houses. There is an issue of insuring against outcome of losing money on $100mil bond issue, when you have $3bil of contracts on $100m bond issue – there are incentives to manipulate the smaller loss to make big collection on the larger position. It used to be illegal to buy life insurance on people you didn’t know, with big payoffs in event of their death. Why did we want enormous bets to be made in unregulated markets? We have a major nutcase bunch of regulators and proprietors in this field.


Similar to what Buffett and Munger mentioned, I also think the final losses won't be too bad because derivatives are a zero-sum game. But if there are counterparty losses then it won't be zero-sum and can result in wealth destruction. My problem isn't so much that I fear losses. Some people are scared of derivatives because of the losses but I am not, given that they are a zero-sum game. My concern is that they can bring down a "normal" bank such as JP Morgan (#1 bank with derivatives exposure) or Citigroup or Merrill Lynch. Losing those banks--if it happens--will cause massive damage to the financial system. Overall, I actually think derivatives are a financial innovation and are good for the economy in the long run.

As a side note, I wonder if Buffett is starting to turn positive on derivatives now that he is embracing them a lot more. Buffett seemed to be almost vehemently against them a few years ago but now is using them quite a bit (including writing sizeable put options on some stock indices).

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CFIG Cut to Junk by Moody's

Moody's cut CFIG to junk and believes it doesn't have enough capital:

The bond insurance arm of CIFG Holding Ltd was slashed to junk status by Moody's Investors Service on Tuesday, due to concern about its capital position...

Moody's downgraded the insurance financial strength ratings of bond insurer CIFG Guaranty, CIFG Europe and CIFG Assurance North America, Inc to "Ba2," two levels below investment grade, from "A1," the fifth highest, and kept the ratings under review with uncertain direction.

The rating cuts "reflect the high likelihood that, absent material developments, the firm will fail minimum regulatory capital requirements," due to losses stemming from its debt and exposure to subprime mortgages, Moody's said.


CFIG is a small monoline insurer owned by Banque Federale des Banques Populaires and Caisse Nationale des Caisses d'Epargne. It was downgraded earlier this year to A1 (Moody's), AA- (Fitch) and A+ (S&P). I haven't followed CFIG closely but it looks like Moody's is saying that CFIG will fail regulatory capital requirements, which is quite serious.

The good news: less competition for Ambac... the bad news: Ambac or MBIA could be following the path of CFIG into oblivion if things get really bad (particularly if HELOC and CES deteriorates)...

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Saturday, May 17, 2008 1 comments ++[ CLICK TO COMMENT ]++

Random Articles for the Week; Plus Some Investment Thoughts

Here are some items that I find interesting, along with some thoughts running through my head:


  1. Jean-Marie Eveillard First Eagle Conference Call
  2. The Economist article on the financial crisis: Paradise Lost
  3. Would you average down into this stock?
  4. Junk bonds vs Stocks - still trying to figure out when junk bonds are better



Jean-Marie Eveillard Conference Call

Thanks to Fat Pitch Financials for referring me to the First Eagle conference call for their mutual fund owners (audio link on their site doesn't seem to work me but here is the text transcript). I never heard of Jean-Marie Eveillard until a couple of years ago (goes to show how much of a newbie I am) but I have started to like him a lot more than other commonly referenced superinvestors. He is a value investor with a different perspective on many things. He also tends to be more international than many others.

I recommend reading the conference call transcript if you are a newbie to investing, if you want some international ideas, or if you are looking at investing in Japan. If you have read some of my past posts on him or if you have heard some of his interviews on Bloomberg or something, there isn't anything new per se. It's a good, quick, read. Here is an excerpt to whet your appetite:

John Arnhold: “You’ve mentioned that First Eagle’s value style is a combination of Graham and Buffett. Can you provide an example of a new position that you would consider a Graham-type company and an example of a Buffett-type company?”

Jean-Marie Eveillard: Today, the Ben Graham-type companies, in other words, the deep value stocks, are not available, really, in the U.S. or in Europe. They’re only available in Japan. And then, the great majority of those deep value stocks are small stocks. In view of the size of our funds today, as you know, we are looking more so into buying medium caps or large caps. At the same time, we have been doing some work and we already own a few, have owned sometimes for years, a few small deep value stocks in Japan and we’re in the process of doing some additional work on more.

I mean there are stocks in Japan where net cash, cash and sometimes portfolio securities, net of all financial liabilities, net cash is in excess of market cap, which means that you pay less than nothing for the business. Now, as Marty Whitman likes to say, “There is always something that can go wrong.” In that case, if the company were to suffer a string of losses for the next five years, then of course five years from now the cash would have disappeared as a result of the losses.

In terms of a Buffett-type company, at the beginning of this year, we started looking at what had been then and what remains an extremely depressed sector, of course, is the financial sector. We were not interested in the banks and the brokerage firms which remain “black boxes” and also there are still major issues with them. But, we figured out that the financial sector was not homogeneous and that beyond the banks and the brokerage firms, you also had the insurance companies and money management firms and situations a little bit unique like American Express.



If you are a Benjamin Graham fan, Japan is a paradise for you. Half the companies in Japan are trading below book value. Not only that, as Jim Grant alluded to, you have world-class companies trading below book. My impression is that even when American companies were depressed and in a similar state back in the 1940's, they were nowhere near as good as the some of these Japanese companies. Unfortunately, most of these are small-caps and language is a barrier (hard to find English information). In addition, Japanese companies are not shareholder-friendly and unlocking the value could be harder than trying to convince George Bush there are no weapons of mass destruction in Iraq ;)


Paradise Lost?

This week's The Economist, titled Barbarians at the Vault, deals with the credit crisis engulfing the financial institutions. If you are a professional in the field, you might want to pick up the magazine since there are quite a few articles on the topic (all are available online as well). Paradise Lost is an excellent article detailing what happened and how things got totally out of control. If you haven't been following the financial sector closely, you might want to read the linked article. It'll bring you up to speed on how capitalism in America almost had a heart attack...maybe it did.


If the crisis were simply about the creditworthiness of underlying assets, that question would be simpler to answer. The problem has been as much about confidence as about money. Modern financial systems contain a mass of amplifiers that multiply the impact of both losses and gains, creating huge uncertainty...

One [amplifier] is the use of derivatives to create exposures to assets without actually having to own them. For example, those infamous collateralised debt obligations (CDOs) contained synthetic exposures to subprime-asset-backed securities worth a whopping $75 billion. The value of loans being written does not set a ceiling on the amount of losses they can generate. The boss of one big investment bank says he would like to see much more certainty around the clearing and settlement of credit-default swaps, a market with an insanely large notional value of $62 trillion: “The number of outstanding claims greatly exceeds the number of bonds. It's very murky at the moment.”

A second amplifier is the application of fair-value accounting, which requires many institutions to mark the value of assets to current market prices. That price can overshoot both on the way up and on the way down, particularly when buyers are thin on the ground and sellers are distressed. When downward price movements can themselves trigger the need to unwind investments, further depressing prices, they soon become self-reinforcing.

A third amplifier is counterparty risk, the effect of one institution getting into trouble on those it deals with. The decision by the Fed to offer emergency liquidity to Bear Stearns and to facilitate its acquisition by JPMorgan Chase had less to do with the size of Bear's balance-sheet than with its central role in markets for credit-default and interest-rate swaps...

The biggest amplifier of all, though, is excessive leverage. According to Koos Timmermans, the chief risk officer at ING, a big Dutch institution, three types of leverage helped propel the boom and have now accentuated the bust. First, many banks and other financial institutions loaded up on debt in order to increase their returns on equity when asset prices were rising (see chart 1)...Second, financial institutions were exposed to product leverage via complex instruments, such as CDOs, which needed only a slight deterioration in the value of underlying assets for losses to escalate rapidly. And third, they overindulged in liquidity leverage, using structured investment vehicles (SIVs) or relying too much on wholesale markets to exploit the difference between borrowing cheap short-term money and investing in higher-yielding long-term assets.


Anyone thinking of investing any of the financials need to keep the following chart in mind:

(source: The Economist)



The Wall Street banks are heavily leveraged! If you are thinking of investing in them, you need to seperate out these highly leveraged banks from the conventional lowly-leveraged bank you find on your street corner. Similarly, not that many would contemplate investing in these super-high-risk creatures, but monoline insuers also have something resembling massive leverage (since they are insurance companies they are kind of different but, nevertheless, small changes in expected losses on their insurance policies can wipe out the company). On a side note, although the leverage seems to have increased recently for some of the financials, it is not necessarily because they took on more risk; instead, it is likely because their shareholder's equity is getting wiped out and hence the leverage ratio increases.

Would You Invest in This?

Would You Invest in This? Is this going bankrupt?

(source: Yahoo! Finance)



Too bad that's a stock that I actually own--a big chunk of my portfolio as well :( This ugly-looking chart is for, none other than, Ambac. Did I catch a falling knife? I'm still not sure if I should average down into this. I don't have enough money and I would still like to diversify my portfolio more by investing in a retailer or a Japanese stock so I won't do anything for the time being. I think if Martin Whitman or Legg Mason (not sure if it's Bill Miller or someone else on his team) didn't have a positive view on the monolines, I probably would consider this a mistake and not think about averaging down.

Junk Bonds vs Stocks

One idea that I have been researching lately is junk bonds. It's still not clear to me what is a good yield for the bond. This isn't a big idea for me (in the end I might do nothing) but it's something that I'm investigating. Bonds are poor investments in taxable accounts, not to mention the fact that stocks can beat them easily due to compounding of reinvested earnings, so it isn't something I would use as a primary holding. I am primarily looking at it strategically as a contrarian opportunity.

I have been looking at how Warren Buffett, Martin Whitman, Jean-Marie Eveillard, Mohnish Pabri, among others, have invested in junk bonds. Junk bonds were very attractive back around 2002 and many of these investors invested in them. Eveillard, Pabri, and Buffett bought Level 3 Communications. Buffett bought Amazon and Nextel bonds at that time as well. Martin Whitman has always been a big buyer of junk bonds given that he is a distressed investing specilist (in the early 2000's, he bought K-mart bonds).

Of course, high yield spreads were higher in 2002 so junk bonds are not as appealing now. If we look at some select recent junk bond purchases, we see Buffett buying TXU with around 12% yield (I am trying to find out the maturity on these bonds and if anyone has any idea leave a comment). Given Buffett's insider knowledge of TXU, he probably treats this as a super-low-risk almost-cash holding. Some of Martin Whitman's latest investments have been the MBIA surplus notes (around 15% yield) and Standard Pacific (around 20% yield). Whitman considers MBIA surplus notes as almost-cash with low risk (but potentially illiquid). I'm wondering if a bond with around 13% to 15% yield is worth it?

The bond that I'm looking at (assuming it still pays interest) is the Sears Roebuck Accept Corp 7% Note 07/15/2042. It was delisted and is trading on the Pink Sheets OTC grey market under the ticker symbol SBCKP. It is thinly traded and has a yield of around 13% to 15%. I'm wondering if this is worth it; or whether Sears Holdings stock is better. The problem I have with this (assuming I can buy it for a reasonable price) is its long maturity. I think if it were due in the 2020's, I would be ok with it (inflation risk is a big concern for such a long-dated bond).

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Thursday, May 15, 2008 0 comments ++[ CLICK TO COMMENT ]++

Looks Like William Ackman Is Reducing His Monoline Short Positions

One of the key things required for the monoline insurers to improve is for the short-sellers to close their positions. This won't avoid losses (that's all up to fundamentals) but it will stabilize the equity price. Furthermore, it will increase confidence by customers. Yes, stock prices impact some customers since this is a confidence industry (who wants to pay insurance premiums to a company that is plastered all over the newspaper and may not pay out?).

Prem Watsa of Fairfax, who seems like he was heavily short the monolines, closed out his shorts (CDS holdings) late last year. The big, public, short-seller is Wiliam Ackman of Pershing Square and it looks like he scaled back some of his Ambac short positions. Todd Sullivan of valueplays picked up on Pershing's 13-F filing and it seems that he has scaled out of his put options on Ambac, and lowered some of his put option holdings in MBIA. I suspect Ackman is still heavily short via CDS and he probably won't unwind that any time soon.

In the meantime, Third Avenue (note that this is the company and not necessarily the fund that Martin Whitman runs) seems to be increasing its monoline insurer holdings. Assuming this info isn't out of date (it won't capture what was sold/bought since the filing), they have increased their position in MBIA, Ambac, and Triad (amazing that they have confidence in Triad, a company that Jim Grant presciently predicted was one of the mortgage insurers living on thin ice.) Interestingly they reduced their position in MGIC. I'm not sure why they dumped MGIC, while loading up on TGIC. It's interesting to see all the tactical moves in and out of the various distressed names.

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Jaclyn Proceeding with Reverse-Forward Split

Jaclyn announced that it is proceeding with the reverse-forward stock split in order to delist from the AMEX:

Jaclyn, Inc., a Delaware corporation (the "Company"), held a special meeting of stockholders on May 7, 2008. At the special meeting, a majority of outstanding shares of the Company's common stock, $1.00 par value per share, adopted and approved amendments to the Company's certificate of incorporation to effect a reverse stock split of the Company's issued and outstanding shares of common stock at a ratio of 1-for-250, followed immediately by a 250-for-1 forward stock split of the shares of common stock.


Nothing has happened to my shares but I hope it goes through successfully. I'm in Canada and I hope there isn't some complication with foreign holders. I also bought under two different accounts at two different brokerages (my regular investment account and my RRSP (similar to 401k/IRA in USA)) and I hope my shares get tendered (if it does fail, it would clearly be a case of too much greed on my part :) ).

Jaclyn is a good example illustrating how small companies don't release information in a timely manner and can disadvantage passive public investors. Their shareholder meeting occurred on May 7th but the filed this release with the SEC on May 12th. If this were a large company, information would have been filed more quickly. None of this mattered much in this case but it does show how information flow is limited with smaller companies.

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Saturday, May 10, 2008 2 comments ++[ CLICK TO COMMENT ]++

CNBC Roundtable with William Ackman

(UPDATE: Added a section on mark-to-market accounting)

William Ackman was part of a roundtable at CNBC so if anyone is interested in his opinions, check out the two videos below (thanks to The Big Picture for the original mention). The roundtable dealt with short-selling and it also had David Einhorn of Greenlight Capital, an Ackman friend and a superbear on monoline insuers.

First Part
Second Part

I always wondered whether William Ackman was a value investor or not. After hearing him in the first part of the video I think he belongs in the value camp (he isn't a pure value investor though). Classic signs that lead me to believe him to be a value investor include his de-emphasis of economic conditions and focus on long-term value of a business. The most insightful thing he said was with regards to retailers. A business is the sum of its future cash flows, and William Ackman pointed out how investors typically shun retailers going into an economic slowdown, even though the stock represents the value of the business over the next 50 to 100 years. The fact that a recession may or may not occur is less of a issue than the price at which you buy the business.

Still Not Sold On CDS

I think I made this point in a post a long time ago but Ackman re-iterated why buying CDS (credit default swaps) was so attractive over the last few years (he thinks he will make more money on the long side this year, whereas 100% of his profits were from the short side last year). Essentially, the downside of buying a CDS is very small; the upside, though, is massive. You might make 10x more on the upside than the loss on the downside. This is similar to other derivatives like going long call or put options.

I'm not a bond expert but it seems that either CDS on practically everything was underpriced over the last few years, or the credit market is quite irrational right now. If you think about the upside vs downside, it would have been lucrative to buy CDS on even the safest companies like Berkshire Hathaway or G.E. The CDS on those companies have widened (last time I checked a month ago) so you would have had a decent gain with low downside. If the market underpriced the CDS contracts then it could be a huge systematic problem with potential for massive losses by some parties. Fortunately though, assuming counterparty risk is close to zero (in specific cases it won't be), derivatives are a zero-sum game so someone will make money while others are losing.

Having said all that, I'm still not sure if using CDS is a good idea for value investors of any stripe. Using derivatives takes you closer to pure speculation (i.e. gambling). I will outline below why I think William Ackman was wrong in his initial bet on MBIA. If you look at other so-called value investors like Prem Watsa (Fairfax Financial) who had taken massive positions in CDS contracts (I think a chunk of them are unwound now), are you not simply speculating on the credit markets collapsing? It would have been hard to predict with any degree of certainty what happened. Instead, it would simply be a bet on something falling apart at some point in the future. What made the value investors buy CDS is the very low cost (as mentioned above, downside is low with massive upside.) But at some point this will turn out to be a real cost (i.e. company never defaults on its bond and hence you lose most or all of what you invested).

Who am I to question a successful investor like William Ackman but I also wonder about him buying call options on Target (TGT). Sure, you leverage your upside but if Target doesn't turn around then you lose all that. Isn't that just gambling? Although William Ackman made a lot of money on the monoline insuer CDS, I fee like he is going to take losses on his Target options and Borders CDS.

I'm just a newbie (an unsuccesful one at that :( ) but I feel like anything that detaches your econmic interest in a business (eg. derivatives) takes you further and further into a speculative arena.

Fair Value Accounting (aka Mark-To-Market)

I think there is a lot of confusion over the debate over the use of mark-to-market in valuing assets. Ackman, who is a good salesperson, capitalizes on the confusion. The real issue of mark-to-market is whether it is proper to use if you intend to hold the instrument to maturity. I don't think many people, including me, are talking about assets that are temporarily held on the balance. For instance, Ackman mentions how Goldman Sachs uses good practice and marks to the market but fails to point out that investment banks typically try not to hold assets to maturity. Instead, they are in the business of selling financial assets. Their assets that they mark, often called warehoused assets, are temporarily held while being in the process of being sold to investors (as a side note, a lot of the mortgage losses taken by banks are on these warehouse assets). In contrast, companies such as bond insurers hold assets to maturity.

Is it realistic to mark those assets being held to maturity? People like me, as well as prominent investors like Martin Whitman, think not. If you are holding an asset to maturity, the only thing to keep track of are credit impairments that are likely to be real. Otherwise, it is like a bond investor worrying about the market price fluctuations even though she'll be fine as long as the bond is paid in full at maturity.

There is no doubt that bond insuers, as well as diversified insurers (AIG for example), underwrote a lot of bad assets. I'm not saying that there won't be big losses posted by them (many already have). My point is that people like Ackman introduce further confusion in an already murky world. All I know is that some of these financial institutions will likely post huge profits in the future due to the reversal of the marks. We just don't know which ones. The real damage is that these companies would have severely hurt their shareholders (by raising capital at exorbitant rates) which would turn out to be not necessary at all.

As a side note, you see the confusing result of mark to market accounting if you look at Berkshire Hathaway's latest earnings. BRK posted a huge decline in earnings mostly due to a negative mark on their derivatives (their insurance business was weaker but the marks on the derivatives were the big standouts). But since Warren Buffett plans to hold these derivatives to maturity, it is crazy to factor this mark-to-market loss as something real and discount Berkshire's stock price. In fact, some of the negative loss reversed in the last few months (since the mark was reported) so Berkshire would post a slightly positive earnings in the next quarter if things stay the same. As Martin Whitman has alluded to in the past, things like this just confuse the investor even more. Anyone looking at Berkshire's earnings in the future will see wildly fluctuating earnings with very little resembling any real loss or gain. I'm not an accounting expert by any means but I suspect that if this fair value accounting scheme is further entrenched (the accounting profession seems to want to do so), the income statement will become almost useless for some industries and there will be a greater reliance on the cash flow statement. Maybe the income statment deserves to die given that it can be easily manipulated by management.

Ackman Initially Wrong About MBIA

This is really a moot point given that MBIA stock price collapsed and there are clouds about its future survival. However, I think William Ackman was wrong with his initial bet against MBIA. In the video he mentions how he was trying to get everyone to listen to his bearish stance on MBIA (later expanded to nearly all monoline insurers) back around 2002. I wasn't following the industry back then but I think he was completely wrong at that time.

Nearly all the problems faced by the tainted monolines come from 2005 to 2007 housing-related insurance. Even if there were to be (so far unknown) problems with student loans, credit card loans, auto loans, aircraft leasing loans, etc, they are likely to be in the 2004+ period (primarily because more and more of the principal gets paid off over the years.) Ackman was making his case back in 2002 when there were hardly any problems. Even if you include the 2002 to 2004 period, nothing lethal seems to emerge (yes, losses are higher but it's manageable.)

Ackman's initial thesis that the bond insurance industry doesn't make any sense was also wrong. The fact that Wilbur Ross and Warren Buffett entered the industry lends credence to view that this is a viable industry (these guys wouldn't be throwing money into something that's going to dissapear.)

William Ackman's contention that almost any financial company that grows around 10% to 15% per year ends up blowing up is partly wrong. First of all, a company like Ambac only had a return on equity of around 11% during its best year (even though Ambac had the highest profit margin in the Fortune 100 in 2006, its ROE is low because it has to hold a lot of excess capital in low-yielding, safe, bonds.) I think 11% isn't that extreme. Secondly, a financial company can keep growing at high rates if the underyling industry is growing. We have seen many financial companies in auto insurance, credit card servicing, equity trading, etc, grow well for a long time. This has certainly been the case with bond insurance.


To sum up, I think William Ackman was wrong with this initial bet on the monoline insurers but he profitted handsomely from really poor insurance underwriting in the 2005-2007 period. I only got involved in the bond insuers recently and most of their mistakes seem to be the post-2005 period (the verdict is still out on the consumer ABS instruments). If anything, I think the bond insurers never should have insured HELOCs and CESes. These assets go against the notion of the key bond insurance strategy of only insuring the super-senior assets (HELOC/CES are second-lien on a house so it is subordinate and likely to result in close to zero recovery). I have to give a lot of credit to William Ackman for his big bet on the bond insurers. I also have to point out that he was right about accounting irregularities at MBIA (MBIA actually had to settle with the SEC over that but this wasn't a huge issue.)



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Purchase: Jaclyn (JLN)

I purchased Jaclyn (JLN) as an arbitrage play. I evaluated the company in a post recently. The stock has been selling off over the last few days and I hope it isn't due to some bad news on the horizon. Some investors may be selling now that the stock is going to be demoted from AMEX to PinkSheets OTC but it's not clear. Since there are no arbitrage funds involved in this (only ownes with less than 250 shares get a cash offer) the price likely provides no signal regarding the buyout of minority owners.

Purchase Price: $7.80
Time Horizon: Short-term (special situation)

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Saturday, May 3, 2008 4 comments ++[ CLICK TO COMMENT ]++

The Debate Over Commodities

There is a huge chasm opening up in the value investing camp over commodities. There are several prominent value investors, such as Bill Miller, who avoided commodities completely over the last few years (and hence have underperformed severely). There are other value investors who are overweight commodities and believe they will outperform for many more years. (Non-value investors like Marc Faber, Jim Rogers, and others, have been bullish on commodities for almost 10 years now but let's just look at value investing.)

I have been bearish on commodities for over an year and been completely wrong. I used to be bullish a few years ago (mostly influenced by Marc Faber and Jim Rogers) but became bearish when I felt that it was driven by momentum and very little to do with any fundamentals (a good example is uranium, which is almost solely based on what may or may not happen in some of the developing countries.) I also switched my strategy from sector rotation to contrarian investing with a value focus, and commodities just weren't very contrarian.

From my readings, it seems most value investors avoid commodities or related businesses. If they are undervalued they may buy them, but in general they don't invest in them. Dereck DeCloet of The Globe and Mail, one of Canada's best business writers in my opinion, recently wrote a news story in the form of a fictional exchange between Warren Buffett and Seymour Schulich, a successful Canadian financier. The article touches on why value investors like Buffett avoid commodities. The points made by Buffett should be familiar to anyone who has looked at some past Berkshire Hathaway shareholder letters.

It'll be really interesting to see what happens over the next decade. Are we going to get something similar to the 70's, when commodities boomed and broad market stocks & bonds did terribly? Or are commodities going to collapse, while stocks & bonds do well? Or would everything collapse due to the unfolding credit contraction? My goal isn't necessarily to base investments on predictions but it's interesting to think about the possibilities.


On another note, CNBC blogged from the Berkshire Hathaway shareholder meeting:

Morning session
Afternoon session

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Special Situation: Delisting by Jaclyn (JLN)

Jeff, who started a new blog called Circle of Competence, suggested a special situation play with Jaclyn (JLN). Jaclyn, which is a clothing manufactuer with a market cap of around $20 million, is planning to delist from the AMEX in order to save regulatory compliance costs (supposedly up to $500k per year). In order to accomplish that they supposedly have to reduce the number of stockholders below 300 and are going to do it by going through a reverse split followed by a forward split with a ratio of 1-to-250. Anyone owning less than 250 current shares will be offered $10.21 per share (an upside of around 22% right now). Note that this size limitation pretty much rules out anyone with a big portfolio or a fund manager.

I have never participated in any deal like this before but am seriously thinking about it. I have only been investing seriously for a few years now and all of my past experience is with mergers & acquisitions (currently pending BCE, along with Tribune and ABN-Ambro (mom's portfolio) last year; unsubstantiated takeovers (really dumb investing) in 24/7 Real Media and PetroKazakhstan.) Jaclyn is a special situation play that is ideal for a small investor. Institutional investors and large investors will not try to take advantage of this buyback given the small size.

Average volume of trading is about 4500 right now. Given this thin trading, if you do buy this stock make sure you place a limit order or are confident that the market price won't budge because of your purchase. This is a less risky than many of the pending M&A deals in my opinion. Note that if you are intrested you should buy less than 250 shares, which translates to $2079.15 at today's price (249@$8.35).

My quick analysis of Jaclyn buyout based on Buffett's template that I have outlined in the past follows...

(Here is a recent press release outlining the situation. Anyone seriously looking into this should read the full documents filed with the SEC. Also make sure you read Jeff's blog post for additional insight.)


JLN takeover price: $10.31
Closing Date: Unknown (key shareholder vote on May 7,2008 so that's the earliest; latest probably 3Q08)
Current price: $8.35

Gain if deal closes: 22.28%
Loss if deal fails (guess): -28.14% ($6)
Probability of success (guess): 95%
Probability of failure (guess): 5%

Expected Return = 0.95*0.2228-0.05*0.2814= 19.75%

I place a high probability of success and the overall return seems attractive. I'll think about buying some shares (make sure to buy 249 or less).

Buffett's Four Key Questions

(1) How likely is it that the promised event will indeed occur?

I place a very high probability of success given that the steps Jaclyn needs to accomplish almost seem to be written in stone. In particular, as Jeff alludes to in his post, majority of shareholders seem to support the delisting so shareholder vote is likely to be successful; bank financing is not an issue; AMEX will easily satisfy the delisting after conditions are satisfied; getting listed on Pink Sheets OTC won't be a problem.

(2) How long will your money be tied up?

A few weeks to 6 months is my guess.

(3) What chance is there that something still better will transpire - a competing takeover bid, for example?

Zero.

(4) What will happen if the event does not take place because of anti-trust action, financing glitches, etc.?

What can cause a deal failure is if the company posts a huge loss or runs into some unexpected financial problems. The loss upon failure is hard to figure out in this case. Not only do I not know anything about this company or its industry, it is a thinly traded stock with huge price ranges. The 52wk low is $2.10 according to Yahoo Finance so the stock may drop as much as that (in an extreme case). I picked $6, which is roughly the average over the last 2 years, because there doesn't seem to be anything terrible with their earnings or balance sheet. JLN posted a large loss about an year ago but it seems to be on a good track for the last few quarters.


If the Deal Fails...

I have zero interest in this company. Sell if above cost (including commissions). Otherwise decide whether to hold or sell at an opportune time for a loss. The amount of capital invested isn't very large so locking up capital for a longer period is fine...

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