Sunday, November 30, 2008 0 comments ++[ CLICK TO COMMENT ]++

Ever wonder why Jim Rogers prefers commodities rather than the commodity businesses... and why I'm bearish on commodities

This is very short-term and not indicative of any strong results but one just needs to look at the uranium market and see how the commodity has done well in the last few weeks while the stocks of uranium companies have not:

The spot price for uranium has surged 25 per cent over the past five weeks, a performance unmatched by the stocks of companies in the uranium sector. From a basket of 56 stocks tracked by Haywood Securities, for example, 42 fell over the last week, three were unchanged, and just 11 saw gains.


This example illustrates why Jim Rogers prefers owning the commodities themselves rather than the businsses. One just needs to look at the charts of various stocks in the referenced article to see how terrible the stocks have done. To make matters worse, I think some of those companies will likely go bankrupt or end up severely diluting shareholders even if uranium prices go up 50% or 100% from here.

The painful feeling for uranium company shareholders must come from the fact that the bankruptcy or collapse of some actually strengthens the price:

“These companies are putting out news that is good for the supply and demand situation, but hurts the individual companies,” said Dundee Securities analyst David Talbot.

Supply is shrinking as uranium producers, stung by the global financial crisis, have been closing mines, delaying developments and cutting production forecasts.


Commodity stock investing is going to end up looking like investing in growth stocks. That is, you will make a killing if you pick the right ones but wrong ones will likely cause massive losses. In contrast, in the last 10 years, you could have invested almost blindly and the market would have rewarded you as long as commodity prices kept going up, which they did.

I'm Still Not A Fan of Commodities

For what it's worth, I'm bearish on uranium and netural to midly bearish on commodities in general. Barring high inflation, I don't see them doing well (except possibly soft commodities.) My opinion is not based on projected fundamentals but due to history and psychology.

The bearish tilt due to history goes like this... If you look at the 70's, the commodity bull market lasted anywhere from 8 years to 15 years (actual numbers depend on the commodity and the index you are looking at; other time periods are mostly similar) If you look at the CRB index, the bottom was somewhere around 1968--note that the DJIA peaked in 1966--and the top was probably in 1981 (I'm just going with rough visual readings off the chart.) But indiviudal commodities differed, with some peaking near the end (oil & gold) while others peaked as early as 1974 (zinc).

The current bull market in commodities started in 1998, when oil (WTIC) was at $12 I believe. So we have had around 10 years of bull market in commodities. It is possible for the commodity bull market to last another 5 to 10 years. But that's an optimistic scenario. Furthermore, it is very important to keep in mind that some commodities may peak early. Maybe copper already peaked but maybe zinc did not. Who knows? Maybe uranium has already peaked? Maybe even oil has. Oil roughly went up from $4 to $40 in the 70's (10x) yet it has already gone from $12 to beyond $120 (10x). None of this means that oil, for example, won't go up. But how likely is it to go from $50 to $250 (5x) in the future? This is why the history is not on the side of commodity bulls right now.

The other big reason to be cautious about commodities is due to market psychology. It is often the case that once the market falls out of love with some sector, it won't return for a while. Immense wealth has been lost by commodity investors--if it's any consolation, other investors have lost huge sums as well--and how many are likely to return and buy up all these uranium, oil&gas, iron ore, or whatever, resource plays? I'll bet not many.

Some would argue that 'this time it is different'. After all, we have countries with massive populations, like China, India, Brazil, among others, growing rapidly. We never had such synchronized growth on this scale in world history. The problem I see is twofold.

First of all, the market already priced in this rosy future for commodities. This is a fact! If you don't believe it, grab mainstream magazines or newspapers from the last 2 years and see if the consensus wasn't for high growth from emerging markets. I'm not talking about some obscure news source; this is mainstream thinking--investors managing billions, such as pension funds and hedge funds, believe in it. Now, one can argue that the prices have collapsed recently and may not reflect past bullish views. That may be true but it still seems risky to me. For instance, even though oil is down to $50 from $140, it has still gone up 4x (say $12 to $50). That is a big increase and seems to imply that the market is pricing in some strong fundamentals compared to 10 years ago (before the rise of EM.) So it may be possible, although we cannot be certain, that the market is pricing most of the strong fundamentals in the future.

The other problem I see with the five most dangerous words in investing is that, although the world has not grown on such a large scale in human history, it has also not maintained any high growth in the past! Even during the glory days of USA's growth in the early 20th century, it was barely able to maintain 10% real growth rates. And when it did have high growth rates, it often ended up with contractions. China's current 9% real growth (up to 17% norminal growth) seems impossible to maintain. Not only has China not posted a negative number, whereas USA does from time to time, this growth rate seems really high. Admittedly, I will note that China may be more akin to USA in the 1800's (rather than the 1900's) so the comparison may be off. USA was also on a gold standard (or a quasi-gold-standard) so extreme contractions were the norm. Also China's numbers may be manipulated by the government so it's hard to say what is the truth. Nevertheless, I think my point that high growth rates seem impossible, even for a superstar growth story like USA in the early 1900's, is worth pondering.

I have no proof that long-term growth has to come down but my suspicion is that it has to come down. We have gone over various reasons in prior blog entries and I don't want to go over them again but let's look at one potential cause that is completely ignored by the mainstream, as well as commodity bulls. I feel that the culprit to the rosy EM growth scenario is going to be 'da environment'. What I am talking about is nature. It is virtually impossible for projected emerging market growth rates to materialize. On top of destroying all the arable land and wildlife, there would be so much pollution that we might actually end up with pollution wars. Ok, the pollution war idea is radical and too sci-fi but the rest of the point stands. If steel and iron ore bulls are betting on high growth in cars from China and India, has any of them considered what would happen if the projected cars actually made it to the streets? Major Chinese cities are already covered in soot and acid rain and if car usae goes up, well, it won't be a pretty picture. That is an example of how projections can make no sense in the real world.

You can still make money off commodities, just like you can make money buying mortgages right now, but consider some of what I have said in your investment decisions.

The Only Hope For Commodities

I think the only hope for commodities--I'm speaking in general; some specific commodities may do well--in the long run is high inflation. I'm not going to go there for the time being since I don't have a strong opinion on inflation. But, having given my bearish view on commodities that I have maintained for several years, commodities may still turn out to be a good investment if you expect high inflation. When I have formed my opinion of inflation, I'll post my views.

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Saturday, November 29, 2008 0 comments ++[ CLICK TO COMMENT ]++

Be careful with diversified bets on junk bonds

In one my posts from yesterday where I was expressing dissapointment at the inability to purchase select junk bonds at reasonable yields, the user BigBeluga suggests junk bond ETFs and shares of companies that deal in venture capital financing or distressed lenders (he suggests a company that I'm unfamiliar with: HTGC.) I thought this was an important issue for anyone looking at high yield bonds so thought I would write a post with my views. I don't like his first idea (junk bond ETFs) but his latter idea (shares of companies that deal in them) seems more attractive.

Not A Fan of Junk Bond ETFs

BigBeluga mentions the two popular junk bond ETFs: JNK and HYG. Both of them have posted horrible returns this year. For example, the iShares iBoxx $ liquid high yield index has an year-to-date return of -30.65% (not sure if this includes interest/dividends) versus -9.12% for the iBoxx $ liquid investment grade index; +11.7% for Lehman 3-7 yr Treasury index (HYG has average maturity of around 7 years); and -37.66% for S&P 500. None of this should be surprising given that junk bonds behave like equity. In fact the big sell off is what makes them attractive. So why do I not like the ETFs?

The common view when it comes to high yield bonds is to always invest in a diversified portfolio. But I'm trying to be a stockpicker and pick select specific ones. It's sort of like saying that I'm not in the game of picking mutual funds and, instead, only pick individual stocks. This is simply a personal reason.

Junk bond yields are high--higher than during the Great Depression if you look at spreads against Treasuries (but junk bonds were not common until the 80's; also Treasury yields are extremely low right now)--but the situation now is not the same. In particular, I have zero faith in all those covenant-lite LBO bonds that were issued in the last 5 years. I have no doubt that these bonds consist of a sizeable portion of these passive indexes. My impression is that the covenants had been relaxed so much, including some bonds which allow the debtor to pay you with more bonds (rather than cash,) that we may be looking at situation similar to the subprime housing situation (where a subprime mortgage from 2006 is not the same as it was in 2000.)

Furthermore, a bond ETF, just like when owning a mutual fund versus some stocks, could consist of bonds that one may be bearish on. Everyone has their opinion on what is and isn't worth owning. As for me, I would not want to own bonds associated with the auto industry, homebuilders, retailers, and so forth. I don't mind owning bonds of specific companies within those industries--say Sears bonds--but I don't want to own the industry.

Lastly, my whole purpose of looking at junk bonds is to get high returns in a company I like. You will only get this on specific bonds of specific companies. For example, I wanted the Sears bonds because they had yields of around 20% to 30% with some bonds even having yield to maturity of 40%. You can't get these numbers by buying the ETF. You avoid the risk of picking the bad apple but you give up all the upside. Given that stocks are quite attractive, a lower yield, say 15%, on the ETF is just not worth it. For example, you can find blue-chip companies with likely long-term earnings yields of around 8% to 10% (P/E close to 10). Companies ranging from Microsoft to 3M to Diageo to ExxonMobil have (likely long-term) P/Es around 12. So if I were to consider a high yield bond, it better have a sizeable yield to make it more attractive than stocks (recall that stocks have lower tax rate (at least in Canada) and can compound at the ROE rate.)

How About Alternative Strategies?

I don't know much about HTGC but that's something one may want to look at. Cursory look leads me to believe that it is a company that provides financing for risky firms (start-up financing, seed capital, bridge loans, etc.) Depending on how these companies source their capital, and how well management runs operations, it may be worth looking into these. I personally don't have an interest in them because it looks way too risky for me and it is not an area I'm familiar with.

Other alternatives to junk bonds is to look at closed-end funds that invest in junk bonds, leveraged loans, bank loans, and the like. I remember mentioning low quality bond ETFs and CEFs more than an year ago. At that time, I said we should watch low quality bond funds and consider buying them after they have been hammered down. Well, some of what I was speculating on, such as a slowing economy and a collapse in non-mortgage bonds, has unfolded. My view right now is slightly different from back then. An year ago I said we should consider buying low quality bonds after they have dropped. Right now, I believe you do not need to go for the low quality bonds anymore. News articles seem to indicate that almost everything has been sold off so you may be able to find good deals on high quality assets. I'm not sure how easy it is for small investors but senior bonds, corporate loans, trade credits, and the like, are probably better. (as a side note, if you are an expert and have access to the whole investment universe, then you may, as Jim Grant has suggested, consider buying select mortgage bonds (i.e. those not in the 'sand states', higher FICO scores, etc.)

So to sum up, I think an idea is to look for CEFs (closed-end funds) that invest in senior loans or something like that. Ideally, one should buy the CEFs when they are trading below what you think is the correct net asset value. The primary risks with such a strategy are the following. CEFs may use leverage so you need to be certain that they won't face funding issues. It's never clear if the management of these CEFs know what they are doing. In contrast, ETFs generally track a passive index so there is little room for management incompetence. Finally, even if you buy a CEF at a discount to NAV, one can never be sure if that discount will close in a reasonable time frame.

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Friday, November 28, 2008 2 comments ++[ CLICK TO COMMENT ]++

How bad is the situation in China and are we witnessing another Smoot-Hawley-type disaster?

Regardless of your views of the causes of the Great Depression--did the FedRes really cause it?--it is hard to argue against the notion that the Smoot-Hawley tariffs started the trade war that likely destroyed the US, and indeed the world, economies at that time. Some conservatives seem to feel that the incoming Democratic government of Barack Obama may pass a Smoot-Hawley-type legislation. Speaking as someone who is left-leaning but is not American, although there is strong support for tariffs from the left, I highly doubt the Democrat government would pass such legislation without being provoked. I'm concerned about some protectionism movement but I don't feel it is anything significant.

However, there is some rising concern that the party that is in position to make the mistake is not the US. Rather it is China. This is a radical thought that hasn't entered the mainstream consensus. China may end up doing what the US did in 1930. Yves Smith of Naked Capitalism references a post by Michael Pettis, a professor of Chinese finance at Peking University:

Export subsidies, depreciating RMB – all of this might seem to make sense if you look at China as divorced from the global balance of payments system. These measures to boost exports are, after all, pretty standard ways of increasing production.

But if you think of China’s role within the global balance of payments, it seems to me that this is little more that a form of Smoot-Hawley-with-Chinese-characteristics. Global demand is slowing, just as it did in the 1930s, and China as the leading source of global overcapacity is trying to address its global demand problem by shifting the burden abroad.


If you think of China as being the yesteryear USA, and USA as Europe of the 1930's, you can see where this argument comes from. Michael Pettis' post is well worth reading if you have any interest in macro issues or China so do check it out.

The skeptics and bears, including me, argue that China has massive overcapacity in manufacturing, among other things. USA in the 1920's had overcapacity in manufacturing and that is why they wanted to limit imports via a tariff. One of the proper things for USA at that time would have been increase local consumption to absorb the excess production capacity, while it also reduced its capacity.

If you go with the bearish view and assume China has excess capacity in production, the ideal solution would be for them to absorb it via internal consumption, along with some reduction in production capability. Yet, what China is doing is to keep propagating the excess capacity (the stimulus packages are an example of this.) If China devalues its currency--no sign of such plan yet--it would be similar to the Smoot-Hawley tariffs in (i) hurting all others and possibly starting a trade war, and (ii) maintaining the excess capacity.


The problem in China is serious. The issue is not so much that people are being impoverished and starving to death. This isn't USA/Europe of the 1930's or China of the 1970's. Rather, the issue is the maintenance of the totalitarian regime in power. You are seeing one of the reasons totalitarian governments eventually collapse. Contrary to what some Americans think, USSR did not collapse because of USA (although it helped.) Instead, it fell on its own after its economy couldn't mask the incompetence of the government apparatus. Anyway, the problem with China is that the Chinese government will do its best to maintain high growth. Doing so alleviates unemployment problems that may lead to an overthrow of the government.

So, how bad is the unemployment situation? The truthful answer is that no one knows. Like most numbers coming out of China, no one has any clue. The Economist does an admirable job trying to pierce through the clouds. It is an article well worth reading in order to understand what the numbers are hard to figure out. It cites a bunch of studies and has the following chart illustrating the situation:



There is good news and bad news. The good news is that the unemployment rate has steadily declined in this century. The official rate may show that unemployment was flat for the whole period--totally nonsensical given China's growth--but that's partly because it did not count layoffs at government-owned businesses.

The bad news is that the situation is projected to get worse. In fact some projections are for Chinese GDP to grow slower than at any point since the early 90's. The Economist also points out that the number employees hired per unit of GDP has declined over the decade. This is mainly due to productivity improvements, which results in less workers needing in the manufacturing-dominated Chinese economy. The only hope, it seems, is to increase service sector jobs since more jobs are created per unit of GDP than in manufacturing. Unfortunately, this is a very difficult shift so the Chinese government still seems focused on propping up its suffering manufacturers.

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Bond market: small investors not wanted

It looks like I'm going to have to dump my junk bond idea. A view I have held of the bond market was just reinforced. Namely, that it is not for small investors and is not efficient.

I investigated whether I could buy some junk bonds through my broker and it is not worthwhile for me. It should be noted that I'm in Canada and trying to buy an illiquid bond.

I requested some quotes from my discount broker, HSBC Invest Direct, for a couple of Sears Roebuck Acceptance Corporation bonds and their prices are horrible (quoted price includes commission.) The quoted a 6.7% bond maturing in 2012 at a price value of 68.84 while FINRA shows the latest price as 49.75. Another 7.5% is quoted at 85.74 while FINRA shows a transaction at 48.02. So, bonds that are yielding around 30% can only be purchased through my broker for yields of around 20%. That's a huge premium and it's simply not worth it for me. I'll see if Canadian bonds can be bought at attractive prices. If not, I'll look to see if I can buy some exchange-traded bonds.

I'll note that I'm looking at illiquid bonds but even then, the prices are not attractive--at least at my broker.

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Amazing how poorly managed some commodity companies have been

We all know how executives at financial companies, who incidentally were paid gross sums, didn't know what they hell they were doing. Sadly many still don't know what they are doing. Well, at least they have some excuses such as being distracted by the beauty of the ski slopes or by the elegant meal at the finest restaurants while the lending and derivatives businesses they were overseeing were getting out of control ;) But it's amazing how some commodity business executives have poorly run their businesses.

Mike Shedlock refers to a couple of cases of oil&gas companies seemingly facing cash flow problems. The two examples cited, Chesapeake (CHK) and Petrobras (PBR), are not some junior companies with weak balance sheets. Indeed they are not. What we have are two of the largest companies in their field--Petrobras is a supermajor; while Chesapeake is the largest natural gas producer in the US--being mismanaged and running out of cash, at least for the time being. Companies that were and should be minting money are ending up diluting their shareholders, at least Chesapeake is, to the tune of up to 20%, at depressed stock prices.

Being a contrarian, albeit not a very good one, this presents an opportunity for me--and you. I'm adding Chesapeake to my watch list for a potential investment in the future. I'll wait and see if Chesapeake runs into more trouble, which it may if natural gas prices don't recover, and then think of buying its bonds or possibly its convertible preferred shares.

Chesapeake (CHK) is not attractive enough right now IMO. Its bonds have yields ranging from 5% to 12%. That's too low for my taste so I'll wait.

There are also a bunch of exchanged-traded convertible preferred shares (CHK-D, CHK-E; PK-OTC: CHKDL) that one may consider if they think the company will survive and recover. Yields on these range around 8% to 12%.

I favour the bonds right now because of potential bankruptcy risk (not any time soon but in 2 years if natgas prices stay low.) But if one is bullish on the company then the covertible preferreds are worthwhile. All of this is assuming that prices drop a bit more and yields increase. I personally would not buy a bond with a yield of 8% when stocks of large-cap stocks are trading with yields of almost 10% (P/E of 10).

Chesapeake is highly leveraged. Its debt/equity ratio is only 0.9 (not that high) but it has total debt of $14.4 billion versus a market cap of around $10 billion. Its earnings and cash flow look good relative to its debt but you have to keep in mind that this is a cyclical. Natural gas prices are very volatile and there is nothing to say that they won't drop to $5 from the current $6ish price. Chesapeake seems to have hedged most of its production but that means nothing in the long run if prices drop and stay at $5.

The problem a lot of commodity businesses will face, assuming commodities are in a bear market (bear market can imply flat prices rather than a decline,) is that sizeable debt would have been incurred with high cash flow assumptions. If those cash flows don't materialize, these companies will have problems. Chesapeake has been trying to sell assets but that will only go so far.

Companies like Chesapeake have good assets (preliminary impression) so it's ok if the company bankrupt and you, if you are a bondholder, ends up with those assets. As Martin Whitman keeps saying, a huge chunk of the wealth in American capital markets in the last few decades was created by restructuring/spin-off/etc. Recall that Whitman's #1 investment of all time is Nabor industries, an oil&gas service company, which he acquired when it went bankrupt after the oil bust in the 80's.

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Thursday, November 27, 2008 1 comments ++[ CLICK TO COMMENT ]++

Where is the wealth destruction concentrated?

It goes without saying that we are in a massive crash of nearly all assets, except US$, Yen, and US government bonds, but where are most of the losses concentrated?

I'm going to speak from a US-centric point of view. The details differ across countries--for instance, the housing bubbles in China or Ireland have little in common with the subprime and Alt-A problem loans in the US--but the core problems started in USA, and since, contrary to de-coupling theory proponents, USA is the largest and most important country on earth, I don't think my views are too narrowly focused on USA.

Some people mistakenly believe that this is a housing bubble. It is not! Yes, housing in many countries was a bubble waiting to implode. Yes, the Subprime Virus, especially the collapse of two Bear Stearns real estate hedge funds in June of 2007, signalled the beginning of the crash. However, the subprime problem is, believe it or not, quite minor compared to the massive bubbles elsewhere. If subprime mortgages were all there was to it, very few outside the housing industry would be worried. Don't forget that subprime only makes up a small portion of the total mortgage industry. We would simply absorb the trillion dollars (or so) of damage and get on with life. But that's the case at all. The stock market collapse across the world alone has wiped out $30 trillion in wealth. Stocks of companies unrelated to housing would not collapse as much if this was just a housing problem.

The correct view--this is pretty obvious now but was not as recently as 6 months ago--is that we had a global bubble in many different asset classes. Some may disagree with some markets--some still believe commodities were never in a bubble for example--but I think it's hard to argue against reality. Of those that I follow or encountered in the past, the only three that implied we had a global bubble were Stephen Roach (economist at Morgan Stanley,) Marc Faber, and Jeremy Grantham. Roach kept warning about the unsustainable current account deficit in the US and how that was financing bubbles (especially in commodities); Faber was always vague so I don't give him much credit for any particular call, but he did keep saying that we were seeing a unique situation where almost everything (except US$) was rising; Grantham, well, completely nailed the call. I ignored Grantham at the time because his view seemed extreme but anyone influenced by him would have done well. He is a portfolio allocator and not a stockpicker per se, so it's hard to profit off his views but anyone macro-inclinded would do well to at least read some of his views.

One of the issues Grantham wondered about in his prescient It’s Everywhere, In Everything: The First Truly Global Bubble article had to do with the losses from the bubbles (scroll to the middle of this post). Namely, who is going to bear most of the losses?

(The heart of the bubble this time is probably private equity. In 10 years, it may well be described as the private equity bubble just as 2000 is thought of as the internet bubble. You heard it here first!)


I think he is wrong. (I assume he is not referring to hedge funds as private equity.) Private equity will suffer huge losses but it doesn't seem like the amount of assets they own are very large. They may take big losses in percentage terms but their dollar losses will be small. For example, if Chrysler goes bankrupt, Cerberus will lose $7.4 billion (its equity investment) for a 100% loss but that's not a whole lot compared to say the losses being posted in other assets by other investors (such as hedge fund losses on share ownership of oil companies where they are posting a lower percentage loss (say 50%) but the dollar losses are large.)

Let's look at who the potential losers and who may actually bear most of the losses:

Potential losers:
  • Governments/taxpayers
  • Homebuyers
  • Specialist lenders eg. mortgage lenders, credit card lenders, etc
  • Commercial banks
  • Investment banks
  • Public/retail investors
  • Private equity
  • Hedge funds
  • Mutual funds
  • Pension funds
  • Employees/workers
  • Future generations


Looking at that list, everyone will take losses but I think the losses will be catastrophic in hedge funds (often invested in risky assets with leverage), private equity (overpaid for assets,) and commercial/investment banks (those that provided leverage to hedge funds are not going to get paid).

I think the global bubble is more apt to be called a hedge fund bubble. If you look at the chart in this article, you will see the rapid rise in the amount of assets. It seems that hedge funds manage almost $2 trillion. If you apply leverage on top of that, you are looking at several trillion being invested in questionable assets that may never recover--ever! The losses being posted by mutual funds may simply be quotational losses whereas the hedge funds are likely posting real impairments. I think history will look back and notice the rise and fall of hedge funds.

Having said all that, we haven't seen the problems in the various markets resolved so it is possible that the biggest loser may end up being someone else (i.e. not hedge funds.) Just to give an idea, consider derivatives such as CDS (credit default swaps.) So far the CDS market has not blown up (Warren Buffett said a while ago that he is not as concerned about this market) but I am not certain that it won't explode. If some problems develop in the CDS market, you will easily see banks, such as JP Morgan, Citigroup, and others, jump to the top spot and end up with massive losses. The subprime mortgage write-downs will look like a joke if these companies start posting a percentage of losses on their CDS exposure. Remember that AIG was, arguably, the #1 insurer with sizeable assets, brand reputation, and resources, yet it completely collapsed due to their mispricing of their CDS contracts. Admittedly, AIG is an insurer taking a directional bet whereas the banks are just intermediaries so one would assume that the banks would hedge everything. But if their hedges end up not working then even a strong company like JP Morgan will take massive losses.

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Wednesday, November 26, 2008 5 comments ++[ CLICK TO COMMENT ]++

BCE deal collapses

It looks like the BCE deal has collapsed for an unexpected reason. The accounting firm KPMG claims that the BCE buyout does not meet solvency tests. Given the tight timing constraints (deal has to close by December 11th,) this probably seals the fate of the takeover.

Shares of telecommunications giant BCE Inc. plunged 40 per cent at the opening bell Wednesday after the company warned that its massive planned privatization is in jeopardy because it failed a preliminary solvency test conducted for its would-be purchasers, led by the Ontario Teachers' Pension Plan Board.

...

The rout followed a pre-opening announcement by the Montreal company that it has received a “preliminary view” from auditing firm KPMG that “based on current market conditions, its analysis to date and the amount of indebtedness involved,” it does not expect to be able to deliver an opinion on the closing date of Dec. 11 that BCE “would meet the solvency tests as defined in the definitive agreement.”

Unless this changes by that date, BCE warned, “the transaction is unlikely to proceed.”


Stock is off almost 40% and it remains to be seen what plan BCE will pursue. My plan was to hold this if it fails, rather than sell and take a loss as most professional arbitrageurs would, and I expect the stock to do limp along.

Andrew Willis of The Globe & Mail thinks that BCE's plan B will involve a big buyback and increasing the dividend:

But if the KPMG decision stands, and it likely will, Mr. Cope and his crew will quickly move to life without a buyout. The team, and the board, have prudently prepared for this day.

BCE is flush with cash after selling divisions such as Telesat and suspending quarterly dividends. A large portion of this money – anything up to $4-billion is easy to justify – can quickly be deployed on a share buyback. That can only boost the stock.

BCE can also reinstate its dividend, with a much higher payout rate than previously used. With investors desperate for income, this would be a popular move. One knock against the company under previous CEO Michael Sabia was a reluctance to boost the dividend – Mr. Sabia was cautious with cash after weathering a financial crisis. Mr. Cope can start winning back the market's affection by returning a healthy chunk of profit to BCE's owers.


I'm not sure if BCE will spend that much money buying back stock, especially given its weak position in the telecom market and potential future headwinds from a slowing economy. In any case, as Willis also points out, the real tough part comes afterwards. How will BCE compete in the tough telecom market?

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Tuesday, November 25, 2008 0 comments ++[ CLICK TO COMMENT ]++

The death of muni bond insurance

Joe Mysak of Bloomberg thinks that the muni bond insurance market died with the onerous requirement placed by Moody's, as outlined in their report The Changing Business of Financial Guaranty Insurance (Nov 20 2008).

Municipal bond insurance, which at one time covered more than 50 percent of the bonds sold by states and localities in the U.S., died last week at age 37.

The death was confirmed by Moody’s Investors Service in a research report titled “The Changing Business of Financial Guaranty Insurance,” published on Nov. 20. Municipal bond insurance had been in failing health since March 2007, after short-seller William Ackman questioned the business practices at MBIA Inc., then the biggest insurer.

“To achieve a stand-alone rating of Aaa, a municipal-only financial guarantor would need to demonstrate competitive advantages that allow it to generate consistently strong underwriting results, maintain its financial health and defend against encroachment upon its franchise,” Moody’s said, observing that it would be “quite challenging” for such an entity to survive.

Born in 1971 when the American Municipal Bond Assurance Corp. insured a $600,000 general obligation bond issue by Greater Juneau Borough, Alaska, municipal bond insurance spent its early years marred by extreme skepticism on the part of old bond men, who doubted the need for such a product. Even in 1981, a full decade after the sale of the first policy, insurance covered only 5 percent of the municipal bonds sold annually.


It is quite possible that the past leaders, MBIA and Ambac, may be permanently sidelined. I hope that isn't the case for my sake but they are in a big hole and survival is the name of the game for them. The question is what happens to the current leader, Assured Guaranty, as well as the market outside North America.

I have a suspicion that bond insurance is going rise up from the ashes in a decade. There is so much uncertainty over the CDS market, which is a distant relative of bond insurance, that the market will start to demand more formalized bond insurance. Although investors such as Warren Buffett have downplayed concerns about the CDS market, primarily because it is a zero-sum game, I have my doubts. The monoline bond insurers have problems even though they had capital (turned out to be inadequate for some of them) backing the contracts. In contrast, everyone and their dog have been writing CDS, which is unregulated, and who knows what is actually backing up their contracts. It was so bad that even AIG, the largest insurance company on earth (if I'm not mistaken) and a company that actually has billions of excess capital, didn't have enough money to post collateral as required by their contracts. If the US government didn't drop money from helicopters on top of AIG, you would have seen a massive dislocation in the CDS market. Now, think about all those non-insurance companies writing CDS contracts, such as hedge funds and investment banks. How many of them have the capital to back up their contract?

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My next great strategic idea: junk bonds

Last time I had a great idea, it ended up in a disaster. That idea was none other than Ambac, of course. It's still remarkable that Ambac still lingers on--barely--even with its massive exposure to subprime bonds. Someone that wants to make an extremely speculative bet on Ambac now has the option of betting on the mandatory convertible equity units (ABK-Z). It's thinly traded and extremely risky and it would be close to gambling but I just noticed that they were listed on NYSE.

Anyway, I'm thinking of making junk bonds one of my big strategic holdings for the next few years. One similar tactical move I made about an year ago was to allocate a certain percentage to risk arbitrage, whose verdict is still out (depending on how some of the outstanding deals close.) Do recall that I'm a total newbie when it comes to bonds and the only bonds I have owned in my life are Canada Savings bonds :) and GM junk bonds. I am attracted to junk bonds for the following reasons:


  • Can stabilize the portfolio: There is a possibility that we may enter a long, 10 year, bear market similar to the ones in the 70's or 30's-40's. Owning something that provides fixed income can stabilize the returns on the portfolio. (of course, this is assuming these companies don't go bankrupt.)
  • Massive fear in the credit markets: Everything I read seems to imply the investors are fleeing the credit markets, irrespective of fundamentals, and tripping themselves over for government bonds. It should be noted that the carnage in the bond market has been far worse than the equity market--the bond market is not supposed to be as volatile or decline as much. I feel that there is an opportunity for contrarians to take a position against the consensus.
  • Safer than shares: If the worst comes to pass and we enter a massive deflationary collapse, one might lose their shirt on junk bonds but they will still be ahead of shareholders. Even if companies go bankrupt, there is a possibility of bondholders ending up with equity in a reorganized firm or getting some proceeds of any liquidation.


The downside to bonds include the following risks: higher inflation will kill bonds (but I feel that the high yields of junk bonds compensates for that,) higher taxes (I'm trying to buy them in my tax-sheltered account,) and the inability to re-invest interest at original yields (I don't care about this because I can re-invest in other opportunities, including stocks.)

I think it is prudent to avoid recently issued bonds (say in the last 3 years,) that may contain light covenants. Since I don't understand bonds, it's hard for me to tell what is a cov-lite bond and what isn't, so I'm trying my best to avoid the cov-lite bonds used in the LBOs of recent years.

I am primarily looking at distressed companies, whose stocks I was already following or find attractive. In other words, one strategy is to buy bonds of companies that you don't mind owning. This is similar to my risk arbitrage strategy, where I prefer taking positions in companies that I don't mind owning if the M&A deal collapses. I'm purposely avoiding certain industries since due to various risks (e.g. financial companies because they are too hard to evaluate and some may have zero liquidation value upon bankruptcy; homebuilders because their book value may be overstated; forestry companies because the industry is shrinking; auto companies since the outcome after a collapse of The Big Three is hard to predict; etc.) The industries I like are newspapers and retailers.

As Benjamin Graham suggested, I'm only looking at bonds trading way below par. This is quite easy to do given that practically all high yield bonds, especially distressed industries, have been hit hard.

In order to mitigate any inflation risk, it is perhaps best to consider medium-term bonds (say 5 years.) However, I still haven't finalized my thinking on this issue. I'm still trying to figure out if it's worth buying long-term bonds if the yield is high enough.

The ideal bonds to buy are convertible bonds or mandatory convertible bonds (very risky)--you'll notice that Buffett almost always only buys convertibles--but I haven't found any that have a high enough yield and whose business looks like it will survive.

Currently, junk bonds yield around 20% so I'm targetting bonds with yields around that figure. If you are looking at the short to medium term, this is around 20% earnings yield of stocks, or a P/E of 5. (In the long run, stocks with earnings yield of 20% would earn far more than bonds with yield of 20% due to the ability of companies to reinvest at book value and compound without paying taxes.)

I'm still researching but the companies whose bonds I'm looking at right now are the following: Sears Roebuck Acceptance Corporation, New York Times, and Torstar.

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Jeremy Grantham no superbear anymore

We should always pay attention when a superbear morphs into a creature with some features resembling a bull. We should doubly pay attention when he is one of few who has actually been correct with some of the key elements of the stock market crash.

I remember encountering Jeremy Grantham's writings and interviews a few years ago, and thought he was crazy. He was extremely bearish and it seemed hard to believe anything he said. I wasn't a bull (that's why I owned US Treasuries for a while--got out too early) and was familiar with the bearish views of Marc Faber and Stephen Roach (Morgan Stanley economist who was "demoted" and sent off to Asia for his bearish views it seems.) But Grantham was far more bearish and had arguments to back it up. He reminds of another person of similar calibre, albeit possibly an opponent of sorts (Grantham is "liberal"): Jim Grant*. Similar to how half of what Jim Grant says is extreme and hard to believe, Grantham was that sort of a person. At least in my eyes.

Well, Grantham has been proven right on most counts, including his view that the 2003 rally was the "biggest sucker rally in history".

For those not familiar, Jeremy Grantham, chairperson and co-founder of GMO funds, is considered to be a "value investor" but I believe that is somewhat misleading. In contrast to most value investors, he is primarily a macro investor and is influenced by asset allocation. In contrast, most value investors are stockpickers with a bottom-up focus.

Thanks to Paul Kedrosky's Infectious Greed for pointing out this video interview of Jeremy Grantham on the Conselo Mark show. The video kept pausing/caching every 30 seconds so it was annoying. It could be my home internet connection but anyway, it is worth checking out the video. If you are macro-inclined, like I am, it is quite useful; but if you are focused on individual securities, it may be a bit too big picturesque for you. The points he makes are identical to what he says in his 3Q2008 quarterly letter.

Here are some of the key points from his television interview and various articles:


  • Finally bullish on stocks: Says that the stock markets are attracive for those that can handle the risk of volatility. He seems to think tha the S&P 500 has hit fair valuation and is worth buying here. He says the risk is that the market overshoots and goes down further but one cannot be certain of that. He says value investors are paid to buy assets at low valuations and not to time things perfectly: "if stocks are attractive and you don’t buy and they run away, you don’t just look like an idiot, you are an idiot." :)
  • Considers Alan Greenspan and the FedRes to be his nemesis: Pins a lot of the blame for the mess on the Federal Reserve under Alan Greenspan. He is also not fan of Bernanke and points out the example of when Bernanke was saying that housing was not in a bubble and was supported by fundamentals, yet, if one looked at the super-long-term Shiller housing prices, you would see an unprecedented rise in prices in the last decade. To him, the housing bubble was obvious yet the FedRes couldn't see it. I am not as criticial of the FedRes as him (or others are.) It is difficult to identify bubbles in advance or in the middle of it. Housing may have been a bubble (I felt that way 2 or 3 years ago) but the global bubble that Grantham (and others like Mard Faber) identified were hard to determine. For instance, people like me always felt commodities were in a bubble but it was difficult to be cerain whether it was really a bubble except in hindsight. Right now, after the commodity price collapse, the bubble seems obvious and investors clearly don't want to attach a valuation on commodities or commodity businesses that they did less than an year ago.
  • Future expected returns looking good: He is expecting around 8% real return for US stocks, while he expects up to 13% for EM. He expects high quality US stocks to post around 12% real return. These are all above the long-term historical US return of around 6.5% real return (inflation is roughly 3% in the long run so add 3% to get nominal returns.) All these numbers are with value-added performance and one should subtract around 2% if they are a passive investor or have poor investing skills. He expects high quality US and emerging market stocks to outperform. My impression is that, by high quality, he is referring to stocks like Microsoft, 3M, and the like (he didn't suggest those names but that's the type of stocks he likes.) He implied that stocks in the US, emerging markets, and Japan are attractive.


My views are somewhat similar to his. I think valuations are attractive but not super-cheap. I don't know about his emerging market call (I'm still bearish) but do like his high quality US and EM call. Many of the large caps with solid franchises have gone nowhere for a decade even though they have continuously increased profits. This is strictly my view and has nothing to do with Grantham but I suspect technology may be one area that could see some good returns in the future. I'm not talking about the high flyers of the last 5 years like Google or RIMM but am thinking of companies like Microsoft, Cisco, and Dell. To see what I mean, these three trade with P/Es close to or below 10 (and only Dell is cyclical.) Sure, they are not the growth stocks of the 90's but they are still growing, generaly have close to zero debt, and have high ROE.


(* Interestingly, Jim Grant and Jeremy Grantham both consider the Federal Reserve, particularly when it was run by Alan Greenspan, as their nemesis. I suspect that Grantham, being somewhat of a liberal, is more sympathetic to the concept of the institution whereas Grant probably would be happy if it dissapeared. Grantham is also in favour of the large government intervention to stem the crisis and actually says that the Jim Grants of this world are wrong in their extreme free market views.)

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The consequence of bailing out the worst run firms

Bailing out Citigroup was necessary given the path that the US government and others have taken over the decades (namely, excessive de-regulation with no oversight of the financial industry.) However, bailing out one of the worst run firms will have detrimental results as I mentioned in yesterday's post. I know the government is very reluctant to nationalize the failing banks for various reasons, including their inability to run these behemoths (if the private sector can't run, good luck getting the government to run them.) But they should penalize these firms heavily and change their failed strategies from the past. In the case of Citigroup, it means forcing it to break up and dump their past strategies. Instead we have the CFO proclaiming that they are sticking with their past plans:

And Citigroup still has many problems. Vikram S. Pandit, the chief executive, is making some progress in controlling costs and managing its sprawling operations, but the environment is tough. Executives say they have no plans to change their strategy.

Mr. Crittenden [CFO of Citigroup] said that the bank intended to keep itself intact and stay on the course it had been pursuing since at last spring and even longer under prior management, but that as a matter of practice the bank did not rule out any options.


This is just ridiculous. Although the current management team wasn't the root cause of the problems, they have still largely kep intact the prior megabank strategy. Note that one of the market concerns right now is not really the subprime mortgages on their balance sheet, which have largely been written off as far as I understand, but, rather, their trillion-dollar off-balance sheet assets. A lot of the off-balance-sheet assets seem to be from foreign operations (I'm not familiar with Citigroup but that's my impression.) The only way they can increase the market's confidence in the company is if they unload their off-balance-sheet assets, along with the foreign operations. Selling the foreign divisions is tough and won't result in a good price but they really have to start breaking up.

The quoted New York Times article also talks about the issue I brought up yesterday. Namely, other banks are disadvantaged and the US government has explicitly ended up bailing out a failing firm, which in hindsight seems to have had little control over risk.

Almost overnight, Citigroup went from being the sick man of the industry to an institution with an edge over its competitors. The government is guaranteeing $250 billion of risky assets and pumping an additional $20 billion into the bank.

With the government behind it, Citigroup may now be able to borrow money in the capital markets at lower interest rates than its peers.

“Citi has a decided advantage over them because of the loss-sharing agreement,” said John Kanas, the former chief executive of North Fork Bank of Long Island. While banks may hold out for now, it may be only a matter of time before they too line up, several analysts said.

Indeed, a big question is how Bank of America, JPMorgan Chase and Wells Fargo will respond. Spokesmen for Bank of America and JPMorgan Chase declined to comment on Monday. A Wells Fargo spokesman did not return telephone calls.

Each of these giant banks, like Citigroup, is sitting on piles of residential mortgages, credit card debt, and corporate and commercial real estate loans that are rapidly losing value. Each is trying to absorb new businesses that were recently acquired.

“Everyone is in the same soup,” said Meredith A. Whitney, a banking analyst with Oppenheimer who has been bearish on the industry for more than a year. “Citigroup has a host of problems, but Citi’s problem assets are not dissimilar from its rivals.”

Smaller banks could be even more disadvantaged. Depositors now have stronger incentives to put their money in bigger banks, given the government’s demonstrated willingness to intervene.

“It’s got to be frustrating for small banks. They don’t get special treatment,” said David Ellison, a mutual fund manager who specializes in financial companies. “If you are a big bank, you get special treatment. That is why everyone wants to be so big.”


The US government has to back the other big banks now. If there is a backlash (say massive runs on the small banks,) they may have to guarantee the small banks as well.


You may get the impression that I'm far more critical of Citigroup than, say, Lehman Brothers, and that's true. I hold so-called commercial banks to a higher standard of risk management than investment banks. Everyone sort of knows in the back of their mind, even if they don't admit it, that modern investment banks are simply gambling with the house's money (i.e. so-called proprietary trading is nothing more than this) and the fact that they are blowing up is not a surprise to me. However, banks like Citigroup, UBS, Royal Bank of Scotland, et al, can seriously harm the economy with their carelessness. Commercial banks should have higher risk controls anyway, since they aren't as profitable as investment banks during the good times.

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Monday, November 24, 2008 2 comments ++[ CLICK TO COMMENT ]++

Massive Citigroup bailout worth as much as $326 billion

The US government agreed to backstop Citigroup's assets in a bailout worth as much as $326 billion. The complex plan involves Citigroup limiting dividends to one cent per share for a few years and the government getting a say on future executive compensation. The government will also receive preferred shares and warrants with strike price about 5x above the stock price on Friday (unless the company can itself around the warrants will likely end up worthless.)

This is the type of deal that is necessary when banks have grown too large for their own good. This move will help in the short to medium terms but will be detrimental to the economy in the long run. By backstopping poorly run firms with questionable assets and business decisions, the government is indirectly penalizing the well-run firms.

I think Citigroup needs to give up on its megabank idea and start splitting up the company. Some people criticize the whole concept of the megabank idea but I think it can work. One just needs to look at HSBC and see how it has done well over the years. As the countries become linked, consumers and businesses will start rewarding those that have global capabilities. However, my impression is that Citigroup has failed at this task and is probably incapable of running a global megabank.

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Saturday, November 22, 2008 6 comments ++[ CLICK TO COMMENT ]++

How far can the FedRes go with its quantitative easing?

I just read a report from HSBC and it essentially says that the FedRes has shifted its focus to a quantitative easing strategy. You will recall that this has been the strategy followed by Japan in the past decade.

(source: The Fed’s balance sheet expansion by Ian Morris. Flashnote, HSBC Global Research. November 21, 2008.)

The week of 17 September is when for all intents and purposes the Fed unofficially shifted from interest rate strategy to quantitative easing, as it was from that time the Fed’s balance sheet exploded from USD900bn in early September to USD2.2trn now, or from 6% of GDP (which is about typical) to 15%. The catalyst for this strategy shift was the failure of Lehman Brothers and AIG. As evidence for the shift, it was also from mid-September that Fed funds began trading well below target on a sustained basis (the weighted average of daily trading has been about 0.3% recently). This is despite the Fed’s currently paying a 1% Fed funds rate of interest on reserves, which was meant to put a floor on how low funds could go, in theory (interest paid on excess reserves was initially set at -0.75 from FF, then changed to -0.35, and then finally on November 5 changed to a zero spread).


One the criticisms of Japan is that it did not do enough. So how far can the FedRes go with this strategy?

The Fed’s balance sheet has plenty of room to expand if things get worse, because there is no limit on how large it can go. It is well below the 30% of GDP peak that Japan saw in its deflationary experience, and arguably Japan did not do enough, so presumably an aggressive Fed could take it to 50% of GDP or even higher if things got dire.


HSBC says that the FedRes can possibly go up to 50% of GDP, which is around $6 trillion. The following chart from the HSBC report compares the present US Federal Reserve situation versus Japan:



This situation in Japan is not quite the same what American is facing. On the positive, Japanese citizens had high savings when the crisis hit. In contrast, the only one with high amounts of cash are non-financial American corporations. Japan also did not face a credit crisis in the middle of their real estate bust. However, assets, particularly equities, were severely overvalued in Japan whereas they are not in America. USA doesn't have one big problem that hit Japan. One of the serious problems for Japan--and this is why Japan may never recover--is that its demographics picture is very poor. Japanese population is shrinking and the hardship of the collapse in the early 90's made it even worse (many chose not to have kids due to weak earnings and difficulty affording housing, among other issues.) Demographics in America is pretty positive, partly due to immigration. So if America ends up in a deflationary collapse--I don't think it will--then it won't be quite like Japan.

(I'm actually coming around to the thinking that there may be a mild deflationary boom in America, assuming deflationa isn't severe. This is very rare in the world nowadays (it was more common when we had hard currencies) but I just wonder if the stars are aligning in America's favour. For instance, if the consumer was suffering when oil was around $100, I wonder what prices of around $50 will do. Just a thought at this point.)


Essentially what is happening is that the US government is leveraging up while the financial institutions are leveraging down. Unfortunately, I think this strategy is going to hit a brick wall when it becomes obvious that the government can't compensate for any de-leveraging from the consumer. The only hope, and it is only a hope because it is largely outside anyone's control, is that the consumer de-leverages over a few decades rather than in one or two years. If all the consumers in America cut back their spending and sharply increased their savings within an year or two, the world will go into a depression. I don't think it will happen because corporate balance sheets (of non-financial corporations) are strong and the eocnomy is mostly service. A large number of businesses would have to go bankrupt and layoff workers and I don't think it will happen.

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Friday, November 21, 2008 0 comments ++[ CLICK TO COMMENT ]++

Time to revisit Graham?

I am nowhere near being an adherent of Benjamin Graham's investing techniques, but I am influenced by his insightful thoughts. The Globe & Mail's Globe Investor magazine has a nice article questioning the performance of Graham followers and value investing in general.

Graham is widely acknowledged as the father of value investing—the school of thought that’s sober, numbers-based, and which aims to buy companies at hefty discounts to their intrinsic value, rather than according to the minute-by-minute mood swings of the investing public. So-called Mr. Market isn’t at all rational, showing up at your door every day and offering you a different price for your shares. Just take a look at the bipolar Dow this fall: down 777 points one day, up almost 1,000 a few days later.

“Graham used to talk about Mr. Market being a manic, paranoid, schizophrenic individual who goes up and down for any reason at all, unrelated to the fundamentals,” says George Athanassakos, director of the Ben Graham Centre for Value Investing at the University of Western Ontario. Our purpose as value investors is to find out what those fundamentals are, determine intrinsic value, and not be swayed by human emotions.”

In theory and results, a solid philosophy. In practice, very hard to pull off, because when everyone in a crowded movie theatre is shouting fire and fleeing for the exits, it takes nerves of steel to do the exact opposite.

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Snowball, Buffett's new biography

"The snowball just happens if you're in the right kind of snow, and that's what happened with me. I don't just mean compounding money either. It's in terms of understanding the world and what kinds of friends you accumulate. You get to select over time, and you've got to be the kind of person that the snow wants to attach itself to. You've got to be your own wet snow, in effect. You'd better be picking up snow as you go along, because you are not going to be getting back up to the top of the hill again. That's the way life works." -- Warren Buffett, on life


I haven't read it yet but for those that missed it, Alice Schroeder recently released a biography of Warren Buffett, Snowball: Warren Buffett and the Business of Life. As the title implies, this book is supposed to be about Buffett's personal life rather than his investing. The Globe & Mail has a review of the book so check that out if you want to get a feel for the book. It looks like an interesting book for those interested in Buffett's personal life.

The classic book on Buffett is Roger Loweinstein's Buffett: The Making of an American Capitalist. I highly recommend that book for any Buffett fans. Snowball seems to be in the same vein and I can't say how good it is until I read it.

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Thursday, November 20, 2008 2 comments ++[ CLICK TO COMMENT ]++

Recap of bond performance

Huge sell-off in the markets and there really isn't much for me to say. I have said in the last few weeks that the stock market was attractive but not exceptionally cheap. Right now, however, I think we may be hitting a cheap level. Anyway, I thought I would look at something different: bonds.

The following table from WSJ Market Data Center summarizes how various bond indexes have done:



Bond yields are hitting recessionary levels. I recall reading recently that junk bond yields just surpassed the 1990-1991 recession levels. Some say that bond yields are forecasting a depression but I don't really see that (except in some specific bonds or in the CDS market--but I don't trust CDS.)

Anyway, I'm investigating whether it is better to invest in junk bonds or stocks right now. Junk bonds yield between 15% to 20% so the question is whether stocks can beat that. One also needs to be concerned with inflation when it comes to a typical bond but this isn't a big issue with junk bonds due to their high yield.

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Ambac commutes two CDO-squared and two CDO deals

Ambac shares have taken a beating lately (what else is new?) but it announced one positive move yesterday. It commuted two of their most riskiest CDO-squared deals:

Ambac Financial Group, Inc. today announced that it has commuted two CDO of CDO of ABS (commonly referred to as CDO-squared) exposures and two high grade CDO of ABS exposures. The four transactions, with an aggregate of approximately $3.5 billion notional outstanding at September 30, 2008, were settled with counterparties in exchange for a total cash payment by Ambac Assurance Corporation (AAC) of $1.0 billion. The two CDO-squared transactions originally comprised collateral consisting of A-rated CDO of ABS tranches, and the two high grade CDO of ABS exposures originally comprised collateral consisting of asset-backed securitizations rated A- or higher. Most of the collateral had been downgraded to below investment grade since the inception of the transactions. All four of the transactions had been internally downgraded to below investment grade.

As a result of the settlements, Ambac expects to record positive adjustments to its aggregate mark-to-market and impairment reserves. In addition, the stress case losses in the rating agency capital models for these transactions combined exceeded AAC’s final payments; therefore, the settlements will result in an improved rating agency capital position for AAC.


To sum up, it pays $1 billion in cold cash to get out of $3.5 billion of exposure. It doesn't say which CDO-squared or CDO deals these are but, in general, CDO-squared deals are very toxic and we are talking about almost 100% loss. It doesn't state what the actual reserved amounts were. I hope the positive effect will be big (in the billions) but one needs to be conservative and assume the benefit may be as little as a few hundread million.

It's quite ironic but the worse the financial environment, the easier it is for Ambac (and others) to commute their insurance. I'm sure that some insurance buyers are desperate for cash and would cut a deal where they get a few hundread million right now. Six months ago these same parties likely would not have done that. One of the problems is that some say that the insurance buyers have bought CDS on Ambac (or shorted the stock) as a hedge so they don't care if the company collapses. The hedge also becomes less effective the closer the stock price gets to zero.

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Largest US Bankruptcy On Tap

It looks like the US government will not be bailing out GM. Republicans are strongly against any bailout and they have blocking power in the Senate. As for my opinion, I think a successful bailout is nearly impossible so any money spent directly on the automakers will be wasted. I would prefer if the government helped the workers with re-training, unemployment, welfare, and similar programs.

My guess is that GM will declare bankruptcy and the other two will follow suit a bit afterwards. Chrysler is rumoured to be in the worst state (it's private so we don't have access to their financials) and should go down first but it likely won't. Since Chrysler is controlled by Cerberus, they would not want to lose their multi-billion dollar investment and will play hard against the bondholders, UAW, and others. Whereas GM probably doesn't care too much about its public shareholders right now. Ford will probably declare bankrupty in 6 months to 2 years from now. It looks to be able to survive but if GM re-emerges from bankruptcy with lower production costs, Ford will get killed. If GM can easily take away most of the market share in Ford's strong areas: trucks and SUVs.

If GM declares bankruptcy, it will be the largest non-financial bankruptcy in US history (not adjusted for inflation.) You can get a listing of the largest bankruptcies since 1980 from BankruptcyData.com (I can't vouch for the accuracy of the data.) The ten largest non-financial bankruptcies according BankruptcyData.com are as follows:



The largest non-financial bankruptcy was Worldcom in 2002 with total assets of around $104 billion. If you include financial companies, it would be Lehman Brothers with assets of $691 billion. I think it's misleading to include assets of financial companies. On top of higher leverage (meaning they own non-physical "fictitious" assets,) reported assets of financial companies often don't belong to the company and are only held on behalf of customers. I personally would consider the bankruptcy of Lehman Brothers, as well as another that had higher assets, Washington Mutual, to be much smaller than Worldcom.

GM had total assets of $136 billion in June and, assuming assets at bankruptcy is similar, it would be much greater than Worldcom. GM has negative book value so I'm not really sure how this plays into reported assets upon bankruptcy.

(On another note, GMAC is converting to a bank and this should help it significantly. Martin Whitman took positions in GMAC bonds and, with borrowings from the government at low rates, it is unlikely that GMAC will default any time soon.)

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Wednesday, November 19, 2008 2 comments ++[ CLICK TO COMMENT ]++

Sign of a recession is here: Berkshire Hathaway stock crashes

Berkshire Hathaway shares have a habit of collapsing during recessions and stock market crashes. Well, it looks like Berkshire Hathaway shares are ringing in the recession:



Nearly all the insurers are getting hit hard this week so it's not a Berkshire-specific sell-off. However, some, such as Felix Salmon, suggest that the market is getting concerned with the possibility of Berkshire Hathaway losing its AAA rating. Felix is one of the best bloggers--too bad Portfolio is targeting a market that probably wouldn't buy magazines: high-end and oriented towards executives/wealthy--and makes some good points. But I doubt that Buffett and Munger would have written derivatives contracts that require collateral to be posted in the manner of AIG (or Ambac, MBIA, et al in their investment portfolios.) I am also not sure if Berkshire depends on AAA as much as someone like G.E. (except for their start-up monoline.)

In any case, Berkshire stock does poorly during recessions and market corrections as you can see below in the log graph:



Historically buying on the sell-offs have worked well. What is different this time is that Buffett and Munger may not be around in 10 years so the question of how Berkshire will be run in their absence takes on more prominence. I have never been bullish on Berkshire (this is just in the last 5 to 10 years; ever since I started following the markets) because it always trades at higher multiples than other insurance companies. It's more diversified than a typical insurance company so maybe it deserves a slight premium on that front. However, it is also somewhat like a closed-end fund and my understanding is that closed-end funds should trade at a discount due to their opaqueness. Clearly Berkshire trades at a premium because of Buffett but I don't invest based on individuals.

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Biggest US monthly price (CPI) decline since at least 1947

A lot of people bash the FedRes but Ben Bernanke has been right on one thing: inflation. His view, which was similar to mine, was that inflation will moderate as the economy slows. Recall that he was going against quite a few who thought that inflation was going to be high (this was when commodities were skyrocketing.) Inflation has certainly declined although I suspect no one expected it to drop this much:

U.S. consumer prices plunged by the steepest amount since records were tabulated in 1947, the Labor Department reported Wednesday.
Prices fell 1% in October on a seasonally adjusted basis, with energy prices plunging fully 8.6%.

Both the overall and energy decreases were the biggest since the government began keeping such records. Data on the overall CPI date back to 1947, and the energy data go back to 1957.

Meanwhile, food prices in October rose 0.3%, the smallest gain since May. Gasoline prices fell a record 14.2% last month. The data on gasoline date back to 1967.

The core consumer price index, which excludes food- and energy-price inputs, eased 0.1%, the first time there's been a decline in the core rate since 1982.


Core inflation rarely drops so we are witnessing a rare scenario. The reason for the big decline in price inflation is due to the drop in commodities, particularly energy. Economists expect the CPI to drop further in November. If the market is right--I have no reason to blindly follow it--deflation will persist for quite a while.

From an investing perspective, anyone that bet on inflation, such as going long commodities, has been absolutely decimated. There was a popular trend early this year of moving into commodities due to the immient rise in inflation. Some of the commodity stocks have dropped more than the financial institutions infected with the Subprime Virus (for example, a leading commodity producer like Rio Tinto (RTP) is down as much as Bank of America (BAC) this year (but if you look at the last 2 or 3 years, RTP would have done well.) Even gold stocks have been killed with the HUI goldbugs index down more than 50% this year (gold bullion is down 10% this year and underperforming cash.)

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Tuesday, November 18, 2008 4 comments ++[ CLICK TO COMMENT ]++

Opinion: Almost impossible for the government to bailout GM

I think it will be impossible for the government to successfully bail out GM. It's too late and the situation does not seem to have any positive outcomes.

The big problem is that, even if the government is willing to take a risk by putting up money, anything they do will end up nationalizing GM. For instance, GM's market cap is $1.77 billion right now, with its enterprise value being $31 billion. If the government injects, say, $25 billion, you would end up owning more than half the company. Now, does anyone want the government to own and hence run the company? Even many that are in favour of a bailout would likely not want the government running GM. On top of the difficulties of the government running it, it would open up a big can of worms and possibly lead to big trade disputes with other countries.

From a shareholder point of view, it goes without saying that the stock is likely to get wiped out. Bondholders are also looking at a big haircut given that worker liabilities, most of which you can't renege on, seem very high. It is likely that even if GM emerges from bankruptcy, a big chunk (possibly as much as 30%) will be owned by the union or a pension fund due to the worker liabilities.


On another note, if GM goes bankrupt, Ford and Chrysler likely follow suit. GM will get such a huge advantage on their costs that the other two wouldn't be able to compete. Long-term worker pensions will end up being picked up by taxpayers since, if I'm not mistaken, pensions are backed by the government during a bankruptcy. I don't think the government necessarily guarantees them post-bankruptcy but any surviving firm will have manageable pension exposure.

I don't care about nor pay attention to military matters (except from a political point of view--I'm very anti-war and non-interventionist) but I suspect the collapse of the all three American car companies will also weaken the US military slightly (thanks to the Economist's View for the original mention of the NYT article.) Although the car companies aren't as critical to the US military, they still produce many of the armoured cars from what I understand. Perhaps the best thing is if the auto manufacturers spin off them military divisions to the government during the bankruptcy. Although the government-owned division won't have the economies of scale or advance rapidly, the US government can at least have a functioning manufacturer. Even after the auto manufacturers re-emerge from bankruptcy, it is possible that they will be struggling for decades, like the airlines. If one thought Toyota, Honda, BMW, et al, were a big threat to the Big Three now, wait until you see what happens if consumers flee the bankrupt companies (there is a high chance of this if any emergent firm voids warranties or if dealers somehow void something that customers took for granted.)

If all three declare bankruptcy, this will likely be the biggest set of bankruptcies faced by USA since the countless bankruptcies during the Great Depression. Whole industries going bankrupt is pretty common (practically all the steel companies went bankrupt in the 80's/90's; many airlines went bankrupt in the 90's/2000's; and so on) but the automakers are a big chunk of the economy. For instance, GM, even with its declining market share and supposedly poor products, has total sales of around $166 billion (includes foreign.) If you apply a multiplier to capture all the parts suppliers, auto retailers, and so forth, you are talking something very sizeable. The economy in areas such as Michigan (or Ontario, Canada) are going to get hit really hard. It will have a big detrimental effect in the short-term but will likely be neutral to good in the long run.

It's just too bad that this is happening during a nasty recession and a financial crisis. Humans--I know this personally very much--have a habit of putting off issues until it is too late and this is a good example of it. Government, management, UAW, and shareholders did nothing even though the problems were obvious 5 to 10 years ago.

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Monday, November 17, 2008 0 comments ++[ CLICK TO COMMENT ]++

Rupert Murdoch definitely not a "doom and gloomer" when it comes to the newspaper industry

Well, at least one person is sticking with his bullish views of newspapers. This newspaper contrarian happens to be none other than Rupert Murdoch. In a lecture titled The future of newspapers: moving beyond dead trees, Murdoch presents his views of the future of the industry. Here is a quick recap:

Global media magnate Rupert Murdoch says doomsayers who are predicting the Internet will kill off newspapers are “misguided cynics” who fail to grasp that the online world is potentially a huge new market of information-hungry consumers.

...

Mr. Murdoch, the Australian-born chairman and chief executive of News Corp., said in a speech broadcast Sunday titled “The Future of Newspapers: Moving Beyond Dead Trees” that the Internet offered opportunities as well as challenges and that newspapers would always be around in some form or other.

“Too many journalists seem to take a perverse pleasure in ruminating on their pending demise,” Mr. Murdoch said in a speech, recorded in the United States and relayed nationally by the Australian Broadcasting Corp. It was the latest in an annual ABC series of lectures by a prominent Australian.

“Unlike the doom and gloomers, I believe that newspapers will reach new heights” in the 21st century, Mr. Murdoch said.


If you are interested in the full speech, you can grab the transcript and audio from the source here.

I have given up on my idea of investing in newspapers for the time being, given that high quality stocks in other businesses are beaten down. Nevertheless, newspapers are contrarian area to watch. This might go against consensus but I think they are actually a bit safer than financial companies.

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William Ackmans says AIG investment was a mistake

Reuters summarizes some of William Ackman's latest moves in this article. Essentially, it seems that the AIG investment was a mistake and Ackman sold out with minimal loss. He also sold out of positions in Sears Holdings, Canadian Tire, and several others due to controlling shareholders. William Ackman is an activist investor and he can't do anything when others have majority share ownership.

It's still not clear to me if William Ackman is a great investor or a speculator that is sometimes lucky. A lot of his returns look really great but he uses derivatives (which inherently contain high leverage.) One needs to be skeptical of hedge fund managers using leverage.

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Deflation a dagger to the heart of value investing?

I'm not in the deflationary camp--used to be but am neutral right now--but what if we face a deflationary bust? How would various investment styles work if we actually enter a deflationary period? It's not good to hear this but Seth Klarman supposedly thinks that deflation is a dagger to the heart of value investing. Let me quote a summary of Seth Klarman's book, Margin of Safety, by Ronald R. Redfield:

Sure enough he discusses deflationary environments. He [Seth Klarman] explains how deflation is "a dagger to the heart of value investing." He explains that it is hardly fun for any type of investor. He explains that value investors should worry about declining business values.


I don't consider myself a pure value investor but those that are, should pay attention to what he says. Klarman suggests the following items to keep in mind in a deflationary scenario:

Yet, here is what he [Seth Klarman] said value investors should do in this environment.

a. "Investors can not predict when business values will rise or fall, valuation should always be performed conservatively, giving considerable weight to worst-case liquidation value and other methods."

b. Investors fearing deflation could demand a greater discount than usual. "Probably let more pitches go by."

c. Deflation should give greater importance to the investment time frame.


The key risk is that asset values will be marked down. Not just once or twice, but continuously.

I wonder if this means that growth stocks will be easier to deal with. High quality debt is what typically does well in deflation. For example, Japanese investors who bought a 10 year bond in 1990 made a killing while stocks, real estate, commodities, and currency slid (I think the currency would have appreciated if the government didn't try to keep it down.)

Before someone gets the wrong impression, I am not in the deflation camp. However, the market is assuming we will face a deflationary bust. That's why 3 month T-bills are yielding 0.12%, 1 year T-bills yield 1.08%, 2 year Treasury yields 1.23%, and the 5 year Treasury is yielding 2.33%. Think about what the market consensus right now is. People are willing to invest for 2 years at 1.23%! If you want a real return of, say, 3%, then you are really expecting an inflation of -2.8% for the next 2 years.

The ultimate contrarian bet here is to go against the market and assume an inflationary scenario. But this is very dangerous because even if you ignore the deflationary scene in USA (and developed countries in general,) China may face a big deflationary bust regardless. So the simplest position for those macro-oriented is to stay neutral. Inflationary outlook is very risky as mentioned, but a deflationary scenario means you are paying a high price for comfort. A deflationary bet of buying US Treasuries may be the greatest investment for the next 10 years (as was the case in Japan--although rates were slightly higher in Japan at that time) but it could also turn into a disaster of epic proportions (especially if the US$ also declines.)

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Saturday, November 15, 2008 4 comments ++[ CLICK TO COMMENT ]++

Articles and thoughts for the week ending November 14th

Some articles you may find interesting, along with my thoughts...


  • Martin Whitman 4th quarter commentary (thanks to traderashish for original mention): I've not read it fully and if I get a chance, I'll make a separate post on this but quick items I noticed include his additioanl purchase of GMAC bonds and MBIA surplus notes, and sales of MBIA and Ambac common shares. He still seems to feel that the Asian property managers are trading at huge discounts.
  • Bill Miller 3rd quarter commentary (thanks to gurufocus.com for pointing it out): Bill Miller is having a terrible year and a lot of so-called "value investors" have written him off as a value pretender. I haven't read his commentary fully but he touches on some important points including the situation with Fannie and Freddie (Bill Miller was a big shareholder so he lost a lot.) I am in the minority camp that believes that the Bush administration, and Hery Paulson in particular, made a huge mistake in seizing Fannie Mae and Freddie Mac simply due to alternative accounting standards and their belief of what may happen. There are a lot of people who say that letting Lehman Brothers fail was the biggest mistake of this administration but I think it is their actions towards the GSEs. As Miller correctly points out, once the government seized the GSEs, even though they were about stautory requirements using the accounting they were using, it was all over for all other financial institutions. There is no way anyone was going to invest in any of them given the threat of seizure at will. For instance, there was nothing to stop the government from taking over Goldman Sachs (before it turned into a bank) based on what it may or may not do. Some brave souls with favourable terms, like Warren Buffett, may take their chance but no one else is going to inject any capital into common or preferred shares. The proper thing for the government would have been to seize the GSEs only when they breach any regulatory conditions.
  • Jim Chanos CNBC Interview (CNBC; thanks to valueplays.com): Todd Sullivan runs an interesting value investing website but it crashes my browser sometimes so be careful if you click on that link. Anyway, it's always good to get a short-seller's thoughts. The last video is interesting in that he is turning bearish on healthcare companies. There are quite a number of value investors who are bullish on healthcare so it'll be interesting to see how this plays out. In my opinion, healthcare is a disaster in the US. As Chanos alludes to, you have a system that doesn't cover everyone regardless of their wealth, yet it is one of the costliest in the world. The fact that healthcare has been growing faster than GDP for a while likely means that it will slow down substancially. Jim Chanos makes the insightful observation that healthcare opponents were limited to consumers and left-leaning individuals in the 90's but now consists of employers as well. If employers, who are half the system in the US, want to bring down costs, it's going to be rough for the healthcare industry. The fact that there will be a huge baby boomer retirement may not be enough to compensate for the pressure that will start being applied on profits.
  • Can China avoid a nasty recession? (The Economist): Pretty good article looking at all the different elements to the situation faced by China. As far as I'm concerned, the only hope for China is a deflationary boom. They seem to have overcapacity in manufacturing and fixed infrastructure. This will push down prices and China somehow needs to capitalize on that. Not an easy task.
  • Basic advice from Warren Buffett for investors (fortune.com): An excerpt from Jeff Matthews' book Pilgrimage to Warren Buffett's Omaha. Haven't read the book but the excerpt touches on one of the suggestions for newbies: read.

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Friday, November 14, 2008 1 comments ++[ CLICK TO COMMENT ]++

Who says commodities cannot be in a bubble?

(Do not construe anything I say as an attempt to gloat; rather I make these posts to illustrate fallacies.)

One of the arguments given by commodities bulls is that commodity businesses can never in a bubble like the dot-com bubble. The reasoning was that commodity businesses produce something "real" and there is always demand for that product, whether be it steel, or iron ore, or oil. I don't think too many are making that argument now but it was a common argument I heard over the last few years.

Well, let's look at uranium, which wasn't a popular commodity like copper or oil but nevertheless rose substancially. The thinking was that uranium was going to be in heavy demand due to the numerous Chinese nuclear reactors that are being built. As far as I know, nothing has changed with the Chinese nuclear reactors (as a side note, this is another reason oil consumption in China, where diesel generators for backup power is popular, won't be as great as some imagine.) Yet uranium prices have collapsed:


(note: I don't know much about uranium and there are different commodities. Also, uranium market is very small with most contracts negotiated business-to-business so these price charts are not necessarily indicative of actual economics.)


The prices started collapsing more than an year ago and equity prices followed, but the fundamentals are becoming evident now. Uranium One (TSX: UUU) was an upstart that just wrote off two billion worth of assets. The market awarded a market cap of around $4 billion to Uranium One a few years ago but investors have been heading for the exits of late, with the stock off 80% in the last year.



It's one thing to lose money investing in dubious mortgages but it must be painful to take massive losses due to changing fundamentals. The resources owned by these companies have not materially changed but the collapse in uranium price makes them uneconomic. The problem for these companies--this applies to all commodity businesses--is that the outcome is outside the control of these companies. Whether prices will rise in the future will depend on factors beyond the control of these companies. You can see why value investors tend to shy away from commodity businesses. If you do invest, you may have to pay more attention to macroeconomics.

The commodity area at possibly one of the greatest risks right now is the precious metals complex. A lot of gold, silver, and platinum mining companies had horrible economics while gold was in a bull market (I'm sure this is surprising to some; the problem was the rising energy and labour costs, which often rose faster than the gold price.) And things aren't going to get any better now. If the US$ declines substancially and gold rallies then these companies may recover but otherwise they will struggle. Gold investors are valuing these companies on the basis of gold in the ground. But, as was the case with the uranium companies, if the deposits are uneconomic, these companies will have to take charges and the deposits will be essentially worthless--until the next bull market, possibly in 20 years.

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M&A deal to watch: Centennial Communications (CYCL) buyout by AT&T

AT&T (T) announced last friday that it is buying Centennial Communications (CYCL). Haven't looked deeply at this deal but this probably has low financing and regulatory risk. I suspect that regulators will not have any issues given that Centennial is a small company. The majority shareholder, owning around 20% of the company has agreed to the deal. AT&T is paying a 100%+ premium so it is unlikely to be rejected (although I will note that this is an opportunistic offer given that the share price collapsed more than 50% within the last two months.

There is high risk if the deal collapses. On top of the share price dropping 50%, this company has negative book value so I'm not sure of its condition.

You can get the press release announcing the deal here.

Buyout price: $8.50 cash
Expected closing date: 2Q 2009

As for me, I'll do more research and wait. The deal is expected to close in 2Q2009 so no rush. You are looking at around 12% return, which is good but not spectacular given that it closes two quarters away (at best). This deal also poses curreny risk for Canadians (I wouldn't be surprised if the US$ drops 10% by then.)

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What to make of unintended consequences?

It's really difficult to do something right during a crisis. Opponents as well as those who speak in hindsight often come up with a million criticisms but it's a different matter at the instance a decision is made. Furthermore, the results are always debatable depending on one's econopolitical stance. A good example is how a lot of conservatives still claim FDR didn't help the economy during the Great Depression and some even claim that he made it worse, all speaking in hindsight of course, even though the reality of the situation was that GDP started growing almost as soon as he started his policies (check out the real GDP chart cited by Krugman.)

One of the problems faced by the Federal Reserve is what to do with the commercial paper market that has locked up. They decided to buy the highest quality commerical paper. Their actions related to, say, AIG or potentially GM/Ford/Chrysler, is nothing more than a bailout, but their actions in the commercial paper market is not really a bailout. The commercial paper actions are meant to minimize the impact of the financial crisis on the economy. Buying short-term commercial paper is not very risky for the taxpayer (unlike buying mortgage bonds or giving loans to failing financial institutions.) So, I'm supportive of their commercial paper strategy.

However, critics, especially American Libertarians such as Jim Grant, always argue that the problem with government intervention is that there are unintended consequences.

You are seeing an unintended consequence develop in the commercial paper market. The government decided to only buy high-quality paper. But this has placed the lower quality issuers at a huge disadvantage. Lower quality issurers like Honda, Texatron, Home Depot, Dow Chemical, and Nissan, are now claiming that they also should get access to the government program as well.

It's a tough situation for the government. Do you expand the program and take on taxpayer risk (not to mention the possibility of the system being arbitraged by profit-seekers)? Or do you just limit it to the A-1/P-1 paper which means you are practicing an unfair system?

This is an example of an unintended consequence. I'm sure no one thought of Dow Chemical being put at a disadvantage compared to, say, G.E. (GE is a high quality issuer). I'm still in favour of the program but policymakers need to be cognizant of these side-effects. I think they should expand the program or give a firm date for the closure of the program (closing the program will likely put a lot of stress on non-financial companies.)

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