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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2 Response to CNBC Roundtable with William Ackman

May 12, 2008 at 6:56 AM

MBIA per share loss of 13.03

May 12, 2008 at 10:11 AM

Stock is up... at some point the losses will be priced in. I'm not sure if we are there yet but today's action sort of indicates that this wasn't a huge surprise to the market even though it missed analyst estimates by a wide margin.

I have to look deeper into their released stuff to say if these numbers are very bad or if they are similar to Ambac's numbers. MBIA has high exposure to commercial real estate (Ambac does not) and I'm curious whether that part is falling off a cliff as well.

I'm actually impressed that MBIA wrote insurance $97 million worth of premiums (compared to $171m last year). With Berkshire Assurance, Assured Guranty, and FSA totally untainted and having the market to themselves, it's quite impressive to see their net revenue drop only 50%. Practically all of Ambac's new revenue last quarter (what little of it there was) came from reinsuring existing monoline insurance (I assume the ones that were downgraded). I'm curious to see if MBIA's underwriting is from similar sources or if they managed to write new muni bonds.

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