Monday, April 28, 2008 0 comments

Quick Thought On Ambac: Losses Shifting to HELOCs and CESes

Looked deeper into the Ambac results and, although the losses are dissapointing and large, what is happening is not as surprising as it may seem. This isn't any consolation for any shareholder but here is how I see things.

What is happening is that losses are "shifting" to HELOCs and CESes (for those not familiar, HELOC stands for home equity line of credit (basically people withdraw money by pledging their house); and CES stands for closed-end second lien (a mortgage backed by a subordinated claim on the house). This is not to say that CDOs aren't taking losses but the "surprisingly" large losses are showing up in HELOCs and CESes. This actually shouldn't be a surprise but given the magnitude of the numbers involved, it will shock anyone. Even some of the shorts are surprised by the large losses being posted.

There are essentially two areas that can bankrupt the monolines: CDO-squareds and HELOCs/CESes. Depending on the insurance underwriting quality, there will be losses elsewhere as well but losses in those areas may be contained. The CDO-squareds are lethal because many of them have underlying assets that are mezzanine CDOs, and any mortgage payments will accrue, instead, to the senior tranches. It looks like Ambac has accounted for most of the potential CDO-squared losses.

The HELOCs and CESes can also result in massive losses because, again, mortgage payments will accrue to the first-lien and other obligations first. Unfortunately for Ambac--and MBIA as well--the HELOC and CES exposure is massive and has no seniority rights or other legal protections.

Here is where Ambac stands (pulled from their presentation):

Direct RMBS ($46.7 billion)
– Closed-End Seconds $5.0 billion
– HELOC: $11.4 billion <--- this is a scary number
– Mid-Prime (Alt A): $6.5 billion
– Sub-Prime: $8.1 billion

CDO of ABS (>25% MBS) portfolio ($32 billion)
– High-Grade CDO of ABS: $26.0 billion
– Mezzanine CDO of ABS: $0.5 billion
– CDO of CDOs: $2.5 billion
– Includes commitment to provide a financial guarantee on CDOs: $2.9 billion

The HELOC is a scary-looking number and was mostly originated in 2006 and 2007--precisely the worst years to be insuring any mortgage!!! Here are some charts showing the HELOC and CES insured assets by vintages and ratings:

MBIA has an even worse HELOC exposure (although I'm not sure about their underwriting skills) and that is one of the reasons it posts large losses under the rating agency tests. If it weren't for the HELOCs and CESes, MBIA would be far better investment than Ambac (Ambac is heavily involved in CDOs, which are more opaque and complicated than direct RMBS.)

It'll be quite ironic if Ambac collapses, not because of its CDO exposure, which everyone thinks is the worst invention ever, but because of its really dumb strategy of insuring HELOC and CES.

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Sunday, April 27, 2008 2 comments

The Next Wilbur Ross?

"It's a little like a brick coming through your window..."
-- Marshall Morton, Media General CEO, on Phil Falcone's Move
(source: April 2008 BusinessWeek)

When it comes to vulture investors, Wilbur Ross is arguably one of the best of all time. Well, this BusinessWeek article makes me think that Phil Falcone of Harbinger Capital Partners is going to be the next Wilbur Ross. The article makes for a good casul read (thanks to DaveinHackensack for the original mention in a message board post.) Here is an excerpt:

(source: The Midas of Misery, by Emily Thornton. April 24, 2008. BusinessWeek)

Falcone is a Midas of Misery. With $19 billion—nearly 760 times the grubstake he started out with seven years ago—he is snapping up troubled assets in bankruptcy, shorting distressed bonds, and using huge stock positions to agitate for change at underperforming companies. His holdings read like a who's who of market castoffs: media companies, utilities, and steelmakers... "He will look at anything," says one investment banker who works with Falcone. "If it's cheap, he'll buy it."


At times, vultures like Falcone can be brutal on the companies they bite into. But with so much money, they could turn out to be an essential element of a recovery after one of the worst financial disasters since the Great Depression. Already they are providing critical cash to stalled markets by swallowing up piles of unwanted mortgages and loans used to fund buyouts. Additionally, they are buying the stocks of companies hampered by huge debt loads and offering lines of credit to desperate businesses. With much of Wall Street still frozen in fear, big vulture bets are among the first signs that the markets are beginning to thaw. And that, in turn, could be good news for the economy.

Basically Phil Falcone made a killing shorting subprime mortage assets.

Although vulture investors have a bad rap, I actually like reading about them and their strategies. The main reason is because they are probably the ultimate contrarian investors. They tread into areas that others never will. Vultures, like hyenas, have a bad reputation in world of nature ;) but they clean up the mess that no other animal will touch. Similarly, I also feel like that, although vulture investors are often short-term oriented and very selfish, often not caring about society, workers, corporate culture, fellow (existing) shareholders, and government, they increase efficiency of businesses and bail out businesses that otherwise would have gone bankrupt.

For instance, no one, including skilled investors with tons of cash sitting around like Warren Buffett would have touched the steel industry in the 90's. But you had someone like Wilbur Ross turn around some of the steel companies. He probably received some flak for laying off workers, eliminating a lot of the manufacturing services, and trampling existing shareholders and bondholders, but some of these companies would have closed up shop long before if it weren't for some vulture investors. Similarly, some of these vulture investors are cushioning the blow from the housing crash by investing in mortgage lenders, mortgage bonds, and so on (the irony, of course, is that some of these vulture investors made a lot of money by shorting these companies initially.) Phil Falcone, similar to Sam Zell, is also investing in media companies that are hard hit by a lack of capital, not to mention new business strategies for the modern world.

If you are in the mood for something fun, BusinessWeek also has this quick slideshow of the key vulture funds. The problem I see with some of these funds is that they are so big that they are going to have problems putting their money to work. A lot of distressed assets, even if they are large companies, have low valuations because the share price has collapsed (eg. Although it isn't a truly distressed company, GM with $188 billion in sales and 260,000+ employees only has a market cap of around $12 billion). If you have a lot of money, I think it's going to be difficult for these vultures to generate high returns in the future. However, the looming economic slowdown, along with the credit crunch, is the perfect time for vulture investors to find distressed assets.

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Friday, April 25, 2008 0 comments

Ambac Management Doesn't Believe AAA Rating Under Threat

I haven't had enough time to analyze Ambac's earnings call (or even listen to it fully). I'll try to go through them by this weekend (although I still have to do my taxes (I'm in Canada) so I'm not sure when I'll get to it. In the meantime, I ran across a very good, and lengthy (30min), interview with Michael Callen, Ambac CEO, conducted by Bloomberg. Anything from management is likely to be sugarcoated, but, nevertheless, it sheds some light on the current state.

You can also find the write-up summarizing some of the interview here (if the video in the first link doesn't work, go to this page and click on the link in the top-right section). To sum up, a big issue at the top of every shareholder's list is the AAA rating. Management rolled the dice with massive dilution in the hopes of maintaining the rating so the consequences are huge. Management doesn't believe its AAA rating is under threat (S&P and Moody's also reaffirmed their views yesterday.)

Ambac is a really tough investment for me. And I'm not even talking about the huge plunge in price. The difficulty is that everything is shrouded in mystery. This is one of the rare investment cases where the company can be insolvent long before it is bankrupt. Unlike a typical industrial company or even a financial company that will collapse under liquidity problems first, the monolines really don't face liquidity problems. Everything depends on what may or may not happen with widely diverging results based on small changes. The reason obviously is because this is a long-tail probability case (small probability of massive losses far into the future). Although some of the bears, not to mention the short-sellers, like to pretend that massive losses are imminent and highly probable, the fact of the matter is that the losses are spread out and they are low probability.


Something New From The Auction Rate Security Crisis: Student Loans That Pay Almost Nothing

We have all heard about "municipals" (which can include quasi-government entities) pay extremely high interest rates on their auction rate securities due to the collapse of the ARS (auction rate security) market. Well, now we have the truly bizarre opposite scenario of student loans that pay close to zero percent interest (on somewhat risky loans). Bloomberg has a good story on one of the side-effects of the collapse of the ARS market.

(source: Auction-Bond Flops Stick Student-Loan Holders With 0%, By Michael B. Marois and Jeremy R. Cooke. April 25, 2008. Bloomberg)

More than $9 billion of auction- rate bonds sold by student-loan agencies in U.S. states from Pennsylvania to Utah have trapped investors in debt that's not paying interest...

The bonds pay nothing because of a formula designed to ensure that borrowers don't pay more interest on their debt than they receive from their student-loan clients. The mechanism kicked in as rates climbed above 10 percent since February, when dealers stopped buying securities that went unsold at auctions...

A Utah State Board of Regents bond with interest that changes every 35 days jumped to 16.58 percent on March 5, up from 3.8 percent in January. The same bond's interest then dropped to 0 percent on April 9, when the provision took effect.

Rates on $97 million of bonds sold by the Pennsylvania lending agency more than doubled to 9.85 percent on March 7 before falling to 0 percent this month.

Fortunately, it seems like these zero or near-zero rates are for the short term and will change.

As I have said before, I think the ARS market is likely to die off. The collapse of the market is partly due to the credit squeeze faced by the investment banks, and partly due to the loss of investor confidence in monoline insured bonds (making investors flee almost any bond where bond insurance may be involved). I don't work in the industry or understand the details but the whole notion of using an auction to determine rates seems really dumb. One of the first things investors will learn when they start investing in anything is that irrational things happen quite frequently. Classic cases will involve investors paying ridiculous amount of money for something of dubious quality, while conversely not willing to pay anything for something valuable. Such events will make ad-hoc systems like auctions fail easily so I'm not sure why this system became popular.


Bill Miller 1Q 2008 Commentary

Legg Mason released Bill Miller's first quarter 2008 commentary for his mutual fund shareholders and, in line with what he has been saying over the last few months, he thinks the worst of the credit crisis may be over. The big wild card, according to him, is commodities. If commodities rise much further, they can wreck the world economy; but if they decline, they will provide relief to the markets. He suggests that the Federal Reserve should avoid further rate cuts (his view is that further rate cuts won't help with the credit problems.)

(source: Bill Miller April 2008 Commentary - April 23, 2008. Legg Mason)

For investors who are trend followers, or theme driven, or who primarily build portfolios around forecasts, or who employ momentum strategies, price is dispositive. When they do badly, it is because prices moved in a direction different from what they thought. For value investors, price is one thing, and value is another. When prices move against us, it usually means that the gap between price and value is growing, and our future expected rates of return are higher.

This is especially the case in momentum-driven markets, such as we have been in for the past two years. In such markets, price trends persist, and wide gaps open up between price and value. That is why fertilizer stocks such as Potash can go from the $20s to the $200s in two years,
and why Microsoft can bid over 60% more than where Yahoo! was trading and still be getting a great deal.

The problem for newbies like me is identifying when the share price decline isn't implying a drop in actual value. I'm sure there is a big gap between value and price in many stocks but one needs to avoid those who actually lost their value along with price. As stockpickers, that's our goal--and that's what I'm trying to learn.

Momentum strategies typically dominate when there is perceived distress, such as the past year or so in credit and financials and this year in equities globally (in the first quarter, not a single S&P sector was up), or there is euphoria, such as tech in the late 90s or commodities and materials today, or when valuation spreads between industries are narrow, as has been the case for most of the past two years. So it’s been a great time for momentum and a lousy time for value.

The problem is that momentum strategies (such as trending) can go on for much longer. The Potash (fertilizer company) example cited by Miller before kind of points out the effect of momentum. No doubt Potash is a great company but I find it hard to believe that Potash will become the largest company on the Toronto Stock Exchange soon (it needs to rise a little bit more than others like Royal Bank of Canada). I never would have expected a fertilizer company to be worth more than the Canadian big banks or oil&gas companies. Potash is a top-notch company in its industry but it is in a cyclical industry. Once the current food price ascent declines, it's all downhill. The market has the company valued with a current P/E of around 60 and forward P/E of around 16--this for a cyclical company. Anyway, this isn't to bash Potash (I don't follow it closely) but to point out the performance of momentum investing.

I think we will do better from here on, and that by far the worst is behind us. I think the credit panic ended with the collapse of Bear Stearns, and credit spreads are already much improved since then. If spreads continue to come in, the write-offs at the big financials will end, and we may even have some write-ups in the second half instead of write-downs...Most housing stocks are up double digits this year despite dismal headlines, a sign the market had already priced in the current malaise. I think likewise we have seen the bottom in financials and consumer stocks, but not necessarily the bottom in headlines about the woes in those sectors. Although the economy is likely to struggle as it did in the early1990s, the market can move higher, as it did back then.

The wild card is commodities.

I wouldn't put much faith on his predictions. As Bill Miller himself says, forecasts are useless. But getting others to confirm my thinking is benefitial.

What we are seeing are diverging opinions regarding the future of the stock markets. If we just look at value investors, those on the bearish side (who expect financial conditions to deteriorate further) include Prem Watsa (Fairfax Financial), William Ackman (Pershing Square), while those on the bullish side (think financial crisis is near a bottom) include Bill Miller (Legg Mason), Martin Whitman (Third Avenue) and Bill Nygren (Oakmark). My impression is that Warren Buffet is neutral (he says deleveraging will be sizeable but doesn't think the market is overvalued as a whole). Master contrarian investor David Dreman thinks the worst may be over regarding the credit crisis. Other types of investors have differing views as well. Macro/trend investor/trader Jim Rogers thinks the worst is still in front of us (particularly with respect to a massive dollar crisis--which will cause a collapse in US$-denominated assets). Contrarian investors Marc 'Dr Doom' Faber thinks the situation will also get much worse but he seems more sanguine about the US markets (I've seen him lately imply that the US$ and US$ assets may be more attractive than the rest of the world).

One of the huge risks with relying on any successful investor is that their strategies that worked in the last 20 years may not work as well in the future (this can be true given that we were in a huge bull market in bonds (i.e. interest rates falling) while that is unlikely to be true for the next 20 years). Although value investors don't succumb to this problem as much as other type of investors, those with a contrarian focus can easily pay a price. For example, Bill Miller is very contrarian and buys beaten-down stocks, often with seemingly weak moats and competitive strength (eg. Kodak, Countrywide Financial, Yahoo). If the situation in the future is nothing like the past 20 years, these companies may go nowhere or actually fail. Similarly, David Dreman, being a contrarian, is favouring companies like Fannie Mae and Freddie Mac. If we actually enter a massive housing bust (like Japan; or USA/Europe in 1930's) then I can easily see Fannie and Freddie investors losing everything (government will bail out the companies but equityholders get close to zero).

Investors like Bill Miller are well versed in history and would know the past but I just wonder. I notice a lot of those on the bullish side expect a scene that resembles the early 90's. Those on the superbearish side, in contrast, are almost of the opinion that the current situation is similar to the 1930's or the Japan in 1980's (or the inflationary 1970's).

I get this feeling that the times are changing... it is quite possible that no one will make much money for a long period of time (i.e. possible sideways bear market.) None of this means that one should not invest, but just that it is going to be much tougher than the past 20 years. Nobody said investing was supposed to be easy anyway ;)

Wednesday, April 23, 2008 0 comments

Another Disastrous Quarter For Ambac

Ambac reported its first quarter results and it was a disaster no doubt. It's a lot worse than what I, or the market, was expecting and the stock is down another 30% today. The really bad news is another $1 billion in actual expected losses.

I'll summarize the key points from the 1Q management presentation below (the conference call is at 11AM EST.) I'll post more from the presentation later so if you are interested in Ambac check back later. Ambac's presentation is very detailed and finally presents some loss curves of some of their transactions.

  1. GAAP 1Q loss: $1.66 billion (this is the amount that includes mark-to-market)
  2. Essentially zero new business
  3. RMBS impairment: $1.046 billion
  4. CDO impairment: $0.9404 billion
  5. Investment agreement business loss: $95 million (last thing I need to hear is a loss in some side business :( )
  6. Most of the direct RMBS losses coming from, not surprisingly, CES (competitors like MBIA will probably post massive losses on HELOCs as well)
  7. Seeing deterioration in CES, HELOC, Alt-A (mid-prime)
  8. RMBS downgrades by rating agencies has not slowed, and this may result in CDO-squareds with underlying mezzanine CDOs as collateral being liquidated by the senior tranche holders. These CDO-squareds may result in 100% loss.
  9. CLOs, student loan ABS, subprime auto loan ABS deteriorating but within Ambac expectations presently.

Overall the high impairment is dissapointing to shareholders but not shocking (like the prior quarter.) As most have been expecting, the losses are almost entirely within CDO-squareds, HELOCs, and CESes.

I'm not sure if the 1Q losses will threaten Ambac's financial strength ratings but it remains to be seen. I'll post a lot more later tonight.

Tuesday, April 22, 2008 0 comments

Good Example of Contrarian Stock Performance

One of the key points I learned from reading the excellent contrarian investing book by David Dreman, Contrarian Investment Strategies in the Next Generation, is that out-of-favour stocks do exceptionally well during bear markets compared to favoured stocks. The expectations are so low for beaten-down stocks that mild positives can cause them to rally. We have a really good example of this unfolding before our eyes.

This may come surprising to many but one of the best peforming industries right now is homebuilders! The industry is up around 15% year to date while most of the market is slightly positive to negative. There is so much negativity around them yet they are rallying in the face of bearish news. Check out the analysis by Bespoke Investment Group (courtesy SeekingAlpha):

Who knows if this rally will last but the point is that out of favour stocks can do well in the face of negative news. A newbie investor or someone who doesn't understand the psychology of the market would never expect most of the homebuilder stocks to be up 15% to 30%.

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Monday, April 21, 2008 0 comments

Barrons Jim Rogers Interview

Barrons conducted an interview with Jim Rogers last week and if you are a fan of Jim Rogers, check out the interview. It's a very good interview so even if you are not a Jim Rogers fan, you may find it interesting. Here are some excerpts along with my thoughts:

(source: Light-Years Ahead of the Crowd: Interview With James B. Rogers, By LAWRENCE C. STRAUSS, MONDAY, APRIL 14, 2008. Barron's.)

Barron's: Why not live in China?

Jim Rogers: The pollution is so horrible and, at least in the cities where we wanted to live, we just couldn't bring ourselves to move there. Singapore is a terrific place. They don't speak as much Chinese here as we would like, but they speak plenty of it.

Out of the top 10 most polluted cities in the world, China has 3 or 4 of them (depends on definition of pollution.) Not that I am anywhere near Jim Rogers in terms of wealth or ability to move, but I would never move to a totalitarian country like Singapore. Jim Rogers is basically sacrificing his American freedoms for wealth. As long as you keep your mouth shut and don't dissent, you'll be fine in any of these countries. Most businesspeople are like that anyway.

B: Why are you so bullish on China?

JR: China is going to be the next great country. The 19th century was the century of the U.K. The 20th century was the century of the U.S. The 21st century is going to be the century of China. Even if I'm wrong, there are 1.5 billion people who speak Chinese every day, so it's not as if our daughter is learning Danish. Even if she winds up working in a Chinese restaurant, she is going to be the maitre d' -- not the dish washer.

B: What else intrigues you about China?

JR: China was in decline for 300 years and then around 1978 Deng Xiaoping said, "OK, let's find something new." He reintroduced entrepreneurship and capitalism to a country that has had a long, long history of both. In China they save and invest more than 35% of their income; in America we save less than 2%. The Chinese work from dawn to dusk. When they come to work, they don't say, "How many holidays do I get?" They want to live like we do in America and they are willing to work hard, save and invest for the future.

The Chinese work ethic is one thing that will propel China far beyond most other countries. They have a lot of issues in front of them (environmental pollution and degradation for example) but China will probably become the largest economy within a hundread years.

Here is what he is investing in:

JR: Perhaps the safest investment is the renminbi, the Chinese currency. I don't see how the renminbi should not go up against the dollar, anyway, for the next several decades. Commodities, of course, are a great way to invest in China...

Agriculture...The same goes for power generation. Another growing industry is tourism...

...short the U.S. investment banks by using the Amex Securities Broker/Dealer Index [ticker: XBD]...also been short Citigroup [C] and Fannie Mae [FNM]. I'll short some more if we get nice rallies in any of them. I am still short some of the U.S. homebuilders like Lennar [LEN].

I, as well as others, have mentioned these positions before. Elsewhere in the article he states that he is still bullish on commodities. The most interesting thing to me is the following tactic:

B: Anything you like?

JR: The airlines, mainly international airlines like Lufthansa [DLAKY], Austrian Airlines [AUA.Austria], SAS [SAS.Sweden], Iberia [IBLA.Spain], Japan Airlines [JALSY] and all the Chinese airlines. I fly a lot and see that the planes are filling up and that the fares are going up. I also realized that Boeing [BA] and Airbus are sold out and that you can't get a new plane for five to seven years. Rising oil prices are a problem, but the airlines can pass on the cost increases.

I find his airline strategy quite interesting. Airlines historically are poor investments. In fact, four of them declared bankruptcy a few week ago. They also tend to struggle when oil prices are high, which Jim Rogers is calling for. Yet, Jim Rogers expects that the airlines can pass on the costs.

One of the death knells for the airline industry in the past has been overcapacity. Jim Rogers suggests that this may not be a problem this time around because the airline manufacturers are sold out and can't build more airplanes.

It'll be interesting to see how this plays out. I personally don't see much future in this sector, even for the Asia-oriented airlines.

B: Why have you sold most of your emerging market holdings?

JR: ...Having said that, right now there are probably 15,000 MBAs on airplanes flying around the world looking for emerging markets, some of which are now called frontier markets. I've been investing in these markets for many years and all of a sudden they have a name. That's why I have sold all my emerging markets except China and Taiwan.

But I hope I'm smart enough that if and when there is a big correction, I'll be able to buy back some of those holdings.

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Bond Insurer Earnings Calls On Tap

Starting this week, the monoline bond insurers will be releasing their 1st quarter earnings. Ambac is the first one to report on Wednesday. Here is an Associated Press article summarizing the industry in the 1st quarter:

(source: Market Spotlight: Bond insurers see altered landscape, By Stephen Bernard. Monday April 21, 2008. Associated Press)

Assured Guaranty and Financial Security Assurance are among those writing the most new business, said Richard Tortora, president of Capital Markets Advisors, which provides bond advisory services for municipalities in the Northeast. Both were among the smallest players before ratings agencies started worrying about the sector's financial strength.

The two insurers have been cashing in on their newfound strength, with their premiums in some cases more than doubling, Tortora said, as their trading value in the secondary markets has enabled them to charge more...

As a result, both Ambac and MBIA are expected to post first-quarter losses. Analysts polled by Thomson Financial, on average, expect Ambac to lose $1.50 per share and MBIA to lose 16 cents...

Despite the rapid changes, things are settling down, Tortora said, adding that new business is expected to rebound during the second quarter from the lows seen during the first three months of the year.

Ambac and MBIA could easily miss their earnings estimate (to the downside) due to mark-to-market losses. Citigroup and Merrill Lynch wrote down a chunk of their hedges from monoline insurers. I'm not sure how much of that is from Ambac and MBIA, as opposed to FGIC, ACA, or others.

As I wrote about before, the key thing is to see if there is any credit impairment, particularly related to CDOs and HELOCs & CESes. I don't know if management will elaborate on them but I'm wondering how the non-mortgage ABS market is performing.

I am really curious about over the next few months is what happens to structured product insurance. It's not clear if any of Ambac's competitors are writing business in that area or if insurance for the ABS of credit card loans/student loans/auto loans/etc has completely dried up.

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Sunday, April 20, 2008 2 comments

When Is It Worth Investing in High Yield Bonds?

A question for my readers...

Does it make sense to invest in extremely long-term high yield bonds rather than stocks? Let's assume risk, and other qualities are similar between the stock and the bond (since this is junk bond, it is almost like a stock anyway). I'm just wondering about yield on a bond versus stock. For instance, would it ever make sense to invest in a 35 year bond with a yield of 13%?

Investing in bonds is generally a bad idea because bonds pay fixed coupons whereas the returns from stocks increase over time. For example, a stock with a 3% dividend yield with a 10% growth in dividends per year will result in a dividend of 10.3% (on the original cost basis) in 14 years. The biggest enemy of long-term bonds is inflation but junk bonds have a relatively high yield so they are somewhat compensated. So does it ever make sense to invest in long-term junk bonds?

I'm not sure how to answer this question based on superinvestors' actions. Warren Buffett likes convertible bonds and he is more than willing to buy 10+ year convertibles with a yield of 10% if he thinks it is low risk (eg. Salomon, Gillette). He also has bought junk bonds if the duration is relatively short (eg. Amazon, Level 3 Communications). So the impression I get is that Buffett would not invest in a long-term bond but would invest in short-term junk bonds or long-term convertible bonds.

If I look at someone like Martin Whitman, he invests in long-term junk bonds. However, Martin Whitman invests in the bonds in a distress situation, often hoping to gain equity ownership in a restructured firm. He does, nevertheless, invest in long-term bonds if the yield is high. Most recently he has invested in MBIA, a monoline bond insurer, surplus notes (around 15% yield) and Standard Pacific, a homebuilder, long-term bonds (around 20% yield). So my opinion is that Whitman buys long-term bonds that have 15%+ yields.

I'm contemplating investing in a 35 yr high yield bond with around 13% to 15% yield (haven't made a decision yet). Does it make sense? Ignore default risk since I'm primarily thinking of whether a bond in general makes sense rather than the stock. Any thoughts?

Saturday, April 19, 2008 0 comments

Dumb Mergers

(Illustrated by Kevin Kallaugher for The Economist)

I can't help but crack up laughing at that excellent cartoon by Kevin Kallaugher of The Economist. I mean, who came up with the dumb idea to merge two struggling airlines? Didn't we go through that phase in the 90's and it ended up with poor results for shareholders (not to mention taxpayers and travelers)?

It almost seems like the airlines always end up merging at the worst possible moment: right before an economic slowdown that can seriously wreck their balance sheets. How many want to bet that these two airlines are going to be worse off in 5 years than now? The stock market certainly isn't betting on good news. The stocks of both companies dropped when the deal was announced earlier this week. Maybe this has to do with the fact that management isn't promising any major cost cutting, other than some operational synergies (even that is questionable given that Northwest and Delta use different airplanes, with one being exclusively Airbus.)

An even worse merger is the proposed combination of Blockbuster and Circuit City. In a rare move, Blockbuster, which I perceive as being weaker, is bidding for the slightly stronger Circuit City (at a big premium to market price as well). I can the potential for cross-selling and synergies in this combination but it's a high risk strategy. Blockbuster, a company that couldn't get its own house in order, now supposedly can fix Circuit City.

Of course, all these mergers can work out in the end. But by rolling the dice with their risky strategies, they can be spectacular blow-ups as well. I feel like the chances of bankruptcy (i.e. shareholder return of -100%) is actually elevated by these mergers than if they were standalone companies. In contrast, the management and bankers pushing the deals argue that these deals lower the risk and expect better returns.

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Thursday, April 17, 2008 1 comments

Merrill Lynch Write-down Foreshadows Bond Insurer Mark-to-market Losses & Any Fair Value Accounting Fans Still Left?

Merrill Lynch released its first quarter earnings today and the stock is trading up. The news probably wasn't as bad as some were expecting. Merrill Lynch is cutting 10,000 workers so its not good news for workers in the industry but if housing doens't deteriorate much further (I don't think it will) then we are likely past most of the big write-downs. Do note that successful investors have different views on how much worse the situation can get in housing.

The main purpose of this post is to point out the markdowns that Merrill Lynch took due to the monoline insurer hedges:

Merrill's results reflected $1.5 billion in write-downs on CDOs, bringing the total over the past nine months to more than $18 billion on those securities alone. The bank also took a $925 million write-down on leveraged loans and a $3 billion loss on hedges with bond insurers.

Merrill Lynch's $3 billion loss due to the monolines may indicate further deteriorating for the monolines. It gives some idea of what is looming for the monolines' earnings calls over the next few weeks. One thing to note, though, is that Merrill Lynch had high exposure with nearly-bankrupt SCA so we don't know if this loss is due to the SCA's weak insurance underwriting or if it is due to expected losses from credit deterioration of the underlying RMBS.

Merrill still holds some $26 billion of CDOs, offset on its books by $20 billion of short positions. Thain aims to sell off the positions, but indicated Thursday he doesn't yet see buyers bidding at prices at Merrill will accept.

ML will likely have to hold onto those CDOs until the credit crisis is over and I suspect ML investors are pricing that in.

If you want to see another flaw with mark-to-market accounting, here is a bizarre result:

Merrill's loss would have been a lot deeper had it not been for a $2.1 billion gain booked on the declining value of the bank's own debt. The move, while counterintuitive, is a legitimate quirk of mark-to-market accounting. Merrill's Wall Street peers also book such benefits, though Merrill's was unusually large.

I'm not an accountant and I have no idea if it's makes sense in accounting for you to post a profit just because your debt value declines, but this seems quite bizarre. I suspect the mark-to-market accounting fans will dwindle to a fan club consisting solely of accountants pretty. I found an excellent blog dedicated to trashing fair value accounting. There are still some fans of fair value accounting, such as Dave Merkel of Aleph blog, but, boy, if the the subprime losses projected by marks (and hence causing businesses to raise capital at extreme prices) don't turn out to be true, it's going to be one of the biggest disasters caused by the accounting profession in history. What happened with Enron and Worldcom, or tech firms fiddling around with accounting statements, is going to look like a joke compared to the steep price the accounting profession is asking the financial (and other distressed) firms to pay.

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How Can You Tell A Growth Investor From A Value Investor?

This is partly tongue-in-cheek so don't take it too seriously (in some sense, there is no such thing as growth or value investing--it's related)... What sort comment would you expect to hear only from a growth investor? Here is an example of a post by someone on the MarketWatch message response to a story on Merrill Lynch:

MER's loss is in the billions and down only 1.8% today, but NOK qtr profit rises 25% and is down 11%. I wonder if it is to late for NOK to get into the subprime market?

I hate to criticize fellow investors because I'm just a newbie who makes questionable decisions as well, but this one is way too obvious. Clearly, the poster doesn't understand the notion of market expectations. Typically I hear comments like this from momentum investors or growth investors. Some investors are actually surprised when a stock drops even though profits rise substantially. The problem, which is endemic in growth investing, is that rosy scenarios may be priced into the stock. So even if profits are strong, it may not be enough. This is one of the issues that value investors try to avoid by looking at cheaper stocks.

Wednesday, April 16, 2008 0 comments

A View Into Merrill Lynch's CDO Risk Mitigation Via the Bond Insurers

Anyone following the bond insuers, or having the misfortune of being a shareholder of one of them, is probably aware that XL Capital is trying to cancel its insurance contract with Merrill Lynch. Thanks to Naked Capitalism for a post about a Merrill Lynch story from the Wall Street Journal shedding some light on why XL feels it was screwed.

I don't know what the fair use limit on quoting news stories is but I'm going to quote the whole section dealing with the bond insurers.

(source: Merrill Upped Ante as Boom In Mortgage Bonds Fizzled, By SUSAN PULLIAM, SERENA NG and RANDALL SMITH, April 16, 2008; Page A1. The Wall Street Journal)

As the CDO business slid, Merrill's top managers embarked on a new plan, referred to as the "mitigation strategy." The aim was to find ways to hedge exposure through deals with bond insurers. This would reduce the size of write-downs Merrill would otherwise have to take.

Through August, Merrill insured $3.1 billion of CDOs against losses in a series of transactions with bond insurer XL Capital Assurance Inc.

In August, Merrill proposed that XL insure about $20 billion more of its CDO exposure, according to papers XL filed in court after their relationship deteriorated. "Pick your size. It's a very nice deal for XL and a big help for ML," a Merrill salesman told an XL employee, according to the papers XL filed in federal court in New York. XL declined the additional business.

Merrill turned to another bond insurer, MBIA Inc. MBIA agreed to insure around $5 billion of the securities. But it wouldn't cover interest payments; it would only cover principal payments when they come due in more than 40 years.

Continuing to scramble, Merrill got a tiny insurer called ACA Financial Guaranty Corp. to insure about $6.7 billion of its CDOs. The problem was that ACA was poorly capitalized. It was insuring more than $60 billion of debt securities -- a third of which were mortgage-related -- yet had only about $400 million of capital and few other resources to cover claims.

Some other firms, including Lehman Brothers Holdings Inc., had already set aside reserves against their hedges with ACA, concerned that ACA would be unable to cover losses on the bonds it insured. Lehman wrote down its exposure to ACA during the first half of 2007.

Merrill's deals with the insurers helped it to show a reduction of about $11 billion in its CDO exposure in last year's third quarter. Coupled with CDO-related write-downs of $6.9 billion in the quarter, this brought Merrill's CDO exposure down to $15.8 billion, from $33.9 billion in June. The bond-insurer deals thus helped reduce Merrill's third-quarter net loss, although it was a still-hefty $2.3 billion...

In December, Standard & Poor's cut its financial-strength rating of ACA to junk level. That forced Merrill to write down its CDO hedge with ACA by $1.9 billion in the fourth quarter, leaving questions about why it had turned to such a thinly capitalized partner.

XL Capital's agreement to insure Merrill CDOs is embroiled in litigation. XL sought to walk away from the deal, contending Merrill had violated the terms. Merrill sued last month to force XL to honor the agreement.

In a countersuit, XL said the purpose of the bond-insurance deal was simply to enable Merrill to report that its CDO exposure was lower. "Merrill Lynch undertook a rushed campaign to find parties willing to hedge or provide protection on its remaining CDO positions," the suit said. A spokesman for Merrill says XL "makes assumptions that are, very simply, wrong."

The article illustrates how Merrill Lynch was really desperate and trying to unload all the super-risky CDOs onto the monolines. Some smart thinking at MBIA seems to have limited the damage in this instance (MBIA has enough dumb mistakes with their HELOCs and CESes though), but XL Capital and ACA fell victim to these risky CDOs.

Any bond insurer with exposure to 2007 vintage CDOs, especially the last half of the year is going to take massive losses. As of December 31, 2007, Ambac has 2.3% of its total exposure in 2007 vintage (closing date). This represents about $6.5 billion of CDOs and around $2.4 billion of CDO-squareds. Thd CDO-squareds--all of them CDOs of mezzanine CDOs--may end up being total losses. The real question is regarding their CDO performance. But a lot of it will come down to the legal structure and the quality of underlying asset. As the story points out, MBIA was willing to insure principal and not interest payments, where the payment for principal could be as long as 40 years away from now. If the tainted monolines have to make distant payments like that, the situation won't be as bad it seems. No one really knows the details of the contracts and I suspect the companies themselves don't know. As I pointed out in a prior post, Warren Buffett says you may need to read 750,000 pages of documents to understand one CDO-squared. I am not sure how many people (including the experts at the monolines) have gone through the documents and really know the legal framework. This whole thing is a mess and I don't even know why I got myself involved in the thick of things. It would have been much easier to go and invest in Citigroup :)

I don't really know how easily John Thain will repair Merrill Lynch's balance sheet and its reputation. This whole mess leads to me believe even more strongly that management is less important than it seems. Warren Buffett always pays close attention to management but even he is going to be utterly wrong on many things when all is said and done.

For instance, I'm sure Buffett likes the management of Moody's since he is their largest shareholder. Buffett wouldn't have invested so much in Moody's otherwise. Although Moody's stock price decline may not show it, they have done arguably more damage than almost any other company (except someone like Bear Stearns--collapse of Bear would have been a disaster).

Buffett has also praised Jeffrey Immelt, the CEO of G.E., and said he is one of the top executives in the world. I don't follow G.E. but if their financial division is actually what created the profit growth at G.E. in the last decade, and if the financial division is as risky as some rumours state, then G.E. is going to have a rough time in the future. Jeffrey Immelt, who many would have said is one of the best CEOs, is going to turn out to be no different than many others. If a big portion of G.E. actually turns out to be a toxic financial division, Jack Welch is also going to be tarnished. (For what it's worth, I don't have a strong opinion of G.E. Also note that G.E. is more diversified and larger, so it isn't going to collapse or anything.)

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Tuesday, April 15, 2008 1 comments

Random Articles For The Week; Plus My Thought on Outer Space

Here are some articles I ran across that you may find interesting... one on how misleading CDS impacting the underlying bonds... a reference to an article about the best hedge-fund manager of all time... The Economist's round-up of IMF GDP projections... and a rambling post about my views on space exploration...

Frankenstein's Monster: The Impact of CDS on Bonds

I hate to beat a dead horse to death but I won't give up until everyone understands how misleading some of the CDS (credit default swaps) and their indexes are. Here is a snippent from an article from Bloomberg summing up the situation:

Some credit-default indexes have morphed into what Wachovia Corp. analysts led by Glenn Schultz call ``Frankenstein's monster'' because they now often drive prices in the so-called cash bond market, rather than the other way around. Fearing a repeat of losses, banks are refusing to support new indexes that would allow investors to wager on everything from auto loans to European mortgages, reining in a market that's about doubled in size every year for the past decade.

``The indices are just trading on their own account with no relationship whatsoever to an underlying cash market that's ceased to exist,'' Jacques Aigrain, chief executive officer of Zurich-based Swiss Reinsurance Co., said...
(source: Swaps Tied to Losses Became `Frankenstein's Monster', By Neil Unmack and Sarah Mulholland, April 15 2008. Bloomberg)

Best Hedge Fund Investor Of All Time?

Best hedge fund? Recently I visited the home of the world's best-ever hedge fund manager and I often re-read his writing on investment topics. On my way to his house I saw some black swans on a lake which seemed appropriate and later ate at a restaurant that had run out of rice which appeared even more significant. It is sometimes the minor data points that lead to major opportunities...

Translated adages from his main book:
"Market action is more important than news."
"Prices do not reflect actual value."
"Buys and sells are decided on emotion not logic."

Not quite up to Warren Buffett standards but an interesting article written by Veryan Allen. I highly recommend everyone read the article when they have some time. I don't necessarily agree with everything in the article (and it's not really tailored towards contrarian investing.) Nevertheless, it's insightful and interesting.

The Economist GDP Outlook

In its recent semi-annual World Economic Outlook, the International Monetary Fund sees few silver linings in the storm clouds gathering over the world's richest economies. The world economy as a whole is expected to grow by 3.7% this year, well down on the fund's last estimate in January of 4.2%. America is expected to enter a mild recession this year—its growth forecast has been cut from 1.5% to just 0.5%. The prospects for Spain, Canada and Italy are also gloomy. But the forecast is sunnier for the developing world, whose economies are predicted to grow by 6.7% in 2008, led by China and India.
(source: A Mixed Outlook, Apr 14 2008. The Economist)

These are IMF numbers and, like most economic forecasts, may or may not turn out to be right. Usually the aggregate numbers (i.e. world GDP) is close but the individual numbers (i.e. GDP for a particular country) is off. Also note that (i) developing countries tend to have higher growth, and (ii) the market may be pricing in all the profit potential from expected high growth. Just to give you an idea of why high growth in developing countries don't mean much, believe it or not, the IMF considers a growth rate below 3% to be a recession. Such a number would be near max potential for developed countries. Part of the reason for the need for a higher growth rate in developing countries is because their population growth is higher. Unemployment will rise and people will be suffering if growth rate in some developing countries were 3%.

Fun Stuff: Space Competitiveness

This probably belongs on my general blog but thought I would stick it here since it has way more readers :) and is somewhat economic. I see that I'm not the only idiot thinking way too far ahead and dreaming of space (instead of worrying about my present life and fixing it ;) ). Here is a chart from The Economist dealing with space competitiveness, courtesy of Futron:

(source: Stars in their eyes, Apr 7 2008. The Economist)

Not surprisingly, the only country to have landed on the moon is way ahead of the competition (for those of you waking up from deep sleep, that would be USA :) ). For America, even though government and public funding of space is tapering off, commercial spending is increasing. The X Prize, along with the present attempt to send commercial flights to space should help USA in the long run.

The surprising thing to me throughout the years is why Japan was always weak. They would have been the prototypical country to rapidly advance towards space flight but they never did. Japan has historically been more tech-savvy (even now, their consumer products are way ahead of the rest and some don't even make it to the rest of the world); they were good at industrial robotics; and they had top-notch scientists, although not many in physics, astronomy, or astrophysics (as far as I can tell). My guess is that their avoidance of nuclear technology (some of it due to international regulations and US control) may have played a role. Although you don't need nuclear technology to pursue space, a lot of the theory and research is intertwined with nuclear physics.

The developing countries have made a big push of late on this chart. Most of it is likely based on economic growth more so than any big advances in space-related technology or commerical endeavours. It's hard to say if countries like Brazil, China, and India can keep their economic growth going, in order to pursue advanced science.

Assuming China doesn't fall apart (like Japan or countless others who had a bright future), China will likely make the most advances in space-related science & technology in my life (not counting USA). A lot of people think China just copies others' stuff but forget that the Chinese were very inventive a thousand years ago. Most people forget that the rocket was invented in ancient China (actually there is debate over the original rocket but anything resembling the modern day rocket with a propellent (gunpowder back then) comes from China). Going back to space would be, in a crude sense, a continuation of the past. China plans to do a human landing on the moon within a decade and that will be their first big test. I hope they make it into a scientific mission rather than the US-style propaganda mission (i.e. let's land; let's plant a flag; let's go home and call it quits :( ). USA really should have put a huma outpost on the moon (yes it would have been expensive but it would have benefitted USA in the long run in my opinion).

Countries like India, which is poorer than many African countries, probably won't make much headway into space. Apart from the smaller and less efficient economy, there will be very little enthusiasm from the public for supporting space programs when most of the citizens are poor and suffering. I'm not an expert but India also doesn't have the technology and engineering skills to do much for the time being. As far as I could tell, India hasn't had much success with space (either now or a few thousand years ago). However, there are some important Indian scientists who are American, British, etc who have played big roles in astrophysics and astronomy. Perhaps the most significant in my eyes is Subrahmanyan Chandrasekhar, an American (born in India), who developed the so-called Chandrasekhar limit (the Chandrasekhar limit determines whether a star that runs out of energy late in life collapses into a black hole, neutron star, or becomes a white dwarf. Anyone who reads about black holes will run into this concept). India doesn't have much going for it but it is planning to launch some unmanned probe to the moon or other planets (not sure if this mission will ever get off the ground.) I'm actually in favour of developing robotics for space rather than using humans. Humans are too expensive and inefficient in space (no offense to humans :) ). Unmanned missions provide the best bang for the buck and might also result in robotics technology that can be used on earth in other applications.

Countries like Brazil and Russia may also do something on the space front but their economy is too small for the time being. Russia might join the EU at some point...

I really hope space development doesn't devolve into a weapons race. If someone develops planetary weapons, it's going to turn into a disaster for all. Unlike Hiroshima and nuclear bombs, space weapons likely won't be localized and may mess up the whole planet (eg. if you release radioactive elements or biological agents into the atmosphere (as speculated in sci-fi novels/movies/etc), it can easily spread across the whole earth). Since space technology is highly advanced, any big advance will likely have massive weapons potential. Unfortunately, I'm quite skeptical that development of military weapons can be avoided for the time being. I'm hopeful that it won't happen in the distant future--if it does happen, humans will die for sure because it will just take one "mistake" (as always, it wouldn't seem like a mistake while the weapon is being unleashed).

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Monday, April 14, 2008 2 comments

Warren Buffett Fortune Interview

Thanks to magalengo's forum post at for the original mention of the following Fortune article on Warren Buffet. It's a quick read and it provides Buffett's thinking on the current crisis. Here are some excerpts of what I find interesting:

(source: What Warren thinks..., By Nicholas Varchaver, April 11, 2008. Fortune)

...I would like to tell you about one thing going on recently. It may have some meaning to you if you're still being taught efficient-market theory, which was standard procedure 25 years ago. But we've had a recent illustration of why the theory is misguided. In the past seven or eight or nine weeks, Berkshire has built up a position in auction-rate securities [bonds whose interest rates are periodically reset at auction; for more, see box on page 74] of about $4 billion...

Here's one from yesterday. We bid on this particular issue - this happens to be Citizens Insurance, which is a creature of the state of Florida. It was set up to take care of hurricane insurance, and it's backed by premium taxes, and if they have a big hurricane and the fund becomes inadequate, they raise the premium taxes. There's nothing wrong with the credit. So we bid on three different Citizens securities that day. We got one bid at an 11.33% interest rate. One that we didn't buy went for 9.87%, and one went for 6.0%. It's the same bond, the same time, the same dealer. And a big issue. This is not some little anomaly, as they like to say in academic circles every time they find something that disagrees with their theory.

So wild things happen in the markets. And the markets have not gotten more rational over the years. They've become more followed. But when people panic, when fear takes over, or when greed takes over, people react just as irrationally as they have in the past.

The ARS market problems were caused partly due to the collapse of confidence in the monoline bond insurers. In any case, it is totally irrational for so-called "municipal" bonds to trade at such high yields. From what I understand, the resets are generally for a short period of time but it just goes to show how fear can drive the market.

The collapse in the yields of T-bills (i.e. investors fleeing to safe bills at ridiculously low rates) at certain points in the last few months is another highly irrational behaviour.

Question: What advice would you give to someone who is not a professional investor? Where should they put their money?

Warren Buffett Well, if they're not going to be an active investor - and very few should try to do that - then they should just stay with index funds. Any low-cost index fund. And they should buy it over time. They're not going to be able to pick the right price and the right time. What they want to do is avoid the wrong price and wrong stock. You just make sure you own a piece of American business, and you don't buy all at one time.

Buffett, like Benjamin Graham, has repeated the view that the vast majority of people should be passive investors (preferably in low-cost index funds). I personally am seeing if I'm cut out for this stuff, and if I don't feel I can do well within the next 5 years, I'm going to go passive.

Interviewer: The scenario you're describing [regarding the credit crisis] suggests we're a long way from turning a corner.

Warren Buffett: I think so. I mean, it seems everybody says it'll be short and shallow, but it looks like it's just the opposite. You know, deleveraging by its nature takes a lot of time, a lot of pain. And the consequences kind of roll through in different ways. Now, I don't invest a dime based on macro forecasts, so I don't think people should sell stocks because of that. I also don't think they should buy stocks because of that.

Buffett is quite pessimistic on the current crisis. Buffett usually doesn't make good macro calls but it is still worth paying attention to him. The big scary thing about the current crisis is that America is going through a massive credit bubble. Typically credit bubbles result in massive dislocations. The optimistic case rests on the fact that corporate balance sheets are strong and stock market valuations aren't bubblicious.

As Buffett alluded to, it's not worth trying to invest off these scenarios of what may or may not happen. The situation should be considered but if something is undervalued and is strong, it should do well.

I read a few prospectuses for residential-mortgage-backed securities - mortgages, thousands of mortgages backing them, and then those all tranched into maybe 30 slices. You create a CDO by taking one of the lower tranches of that one and 50 others like it. Now if you're going to understand that CDO, you've got 50-times-300 pages to read, it's 15,000. If you take one of the lower tranches of the CDO and take 50 of those and create a CDO squared, you're now up to 750,000 pages to read to understand one security. I mean, it can't be done. When you start buying tranches of other instruments, nobody knows what the hell they're doing. It's ridiculous. And of course, you took a lower tranche of a mortgage-backed security and did 100 of those and thought you were diversifying risk. Hell, they're all subject to the same thing. I mean, it may be a little different whether they're in California or Nebraska, but the idea that this is uncorrelated risk and therefore you can take the CDO and call the top 50% of it super-senior - it isn't super-senior or anything. It's a bunch of juniors all put together. And the juniors all correlate.

The peanut gallery often put forth theories stating that banks, bond insuers and bond rating agencies were maliciously deceiving people with these structured products. I don't work in the field but I believe most of the problems are due to the complexity--or stupidity, if you are one that equates too much complexity with stupidity. Buffett points out how you may have to read 750,000 pages to understand a CDO-squared thoroughly. Since we can be certain no one ever read through the documents for one CDO-squared, let alone two or three or twenty, a lot of these instruments were likely analyzed using computer models. Instead of reading through 750,000 pages for each CDO-squared, so-called finance professionals likely relied on some automated system.

If the computer modeling falls apart--as it ended up happening--no one knows what a CDO-squared is worth. You can see why no one, including the experts at the monolines, can credibly argue against skeptics like William Ackman: no one has any clue what a CDO-squared's behaviour will be or what its likely loss will be. I suspect the complexity of CDOs--not its potential losses but its complexity--may be one big reason Martin Whitman, Warburg Pincus, and others, picked MBIA over Ambac.

The only two things that will save the monolines are (i) losses don't have to be paid out for a long period of time for many insured products, and (ii) favourable legal structure allows payments to flow to the senior tranches.

(For what it's worth, I don't think William Ackman even knows what the losses on the CDOs and CDO-squareds will be. Remember that he shorted (via CDS) the monolines 4 years ago, not because of the subprime mortgages but because of muni bonds. He felt that the muni bond insurance made no sense. He was actually wrong! Very few doubt the viability of muni bond insurance (this argument died soon after Buffett entered the market basically indicated that there is a viable industry here.) What caused the collapse of the monolines was subprime insurance written in late 2005 or afterwards. Ackman shorted long before the problematic insurance was written. I'll give credit to Ackman for his call on the monolines. I'm not taking anything away from that. My point here is that I doubt that even he can peg a price on these CDOs or CDO-squareds. In other words, I don't think anyone knows for sure one way or the other what these CDOs and CDO-squareds are worth.)

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FGIC Planning To Start New Bond Insurer

It's quite speculative at this point but FGIC is planning to start a new bond insurer:

The company, parent of struggling bond insurer Financial Guaranty Insurance Co., said it's started talking with potential investors about strategic alternatives, including launching a new business that would focus on the global municipal bond market.

This new company would also assume FGIC's existing muni bond and international infrastructure business, it added.

Starting a new bond insurer--it's actually more like spinning off the muni bond business--is consistent with what FGIC has indicated in the past. The main strategy being pursued by FGIC is to split its muni bond business from the structured product business.

Its FSA bond insurance unit lost its AAA rating so "spinning off" the muni bond business would make sense. FGIC is one of the top 3 bond insuers so it has extensive expertise and infrastructure to write municipal bond insurance. Without the AAA rating, all these resources are wasted and they need to be sold off, spun off, or some such thing.

The real question is how the split will be structured. I think the monolines will be able to split to some degree. I posted about how property & casulty insurers such as Cigna "split" in the past. Unlike the Cigna case where the parent was well capitalized and was simply trying to ring-fence the asbestos and tainted soil liabilities, I'm not really sure how the claims-paying ability will be split for the monolines. The argument against the bond insurers is that they are undercapitalized so a split probably requires further capital injection, which is probably the last thing anyone involved in the industry want to do now.

My guess is that the split will not occur. Instead, FSA will go into run-off and the muni bond assets (buildings, brands, etc) will be sold, along with the employee committments to some other party. Berkshire Hathaway would be the obvious target but Buffett has indicated that he doesn't want anything to do with those that got into this mess in the first place. Another likely party to take over FGIC's operations (assuming my views are correct) is Assured Guaranty or CIFG. It would be a coup for AGO if it can buy all the assets of FGIC (likely at distressed prices).

In the short term a successful split or liquidation of FGIC is bad news for Ambac. The last thing Ambac needs is the formerly #3 bond insurer rise from the ashes with the new backing. In the long run, none of this has much impact because, if the split is successful then Ambac can do the same thing. In fact, MBIA is planning to split within 5 years.

Sunday, April 13, 2008 3 comments

Jim Rogers Barron's Interview via SeekingAlpha

Barrons conducted an interview with Jim Rogers, and since I don't have access to it, I'm going with a summary from SeekingAlpha. It doesn't seem like anything new. According to Eli Hoffman's summary, Jim Rogers is bullish on the Chinese renminbi, which you can go long through the CNY exchange-traded note, commodities like nickel, and Boeing (BA). He is short Citigroup, Fannie Mae, Brokers/Dealers, and homebuilders. Supposedly he has exited the emerging markets for the time being.

I was heavily influenced by Jim Rogers a few years ago (actually I was really influenced by Marc Faber, but both of them share similar views.) I never really utilized his suggestions to maximum effect but I probably woudln't have invested in gold and oil stocks if it weren't for that influence. Lately, however, I don't really share the same opinion as Jim Rogers (or Marc Faber). I just don't feel comfortable with commodities. I feel like they have run up too much and resemble a bubble. I have been bearish on commodities for over an year (that's why I'm short the TSX via the inverse fund) and been completely wrong.

As for China, I think it has the potential to be the next big economic power but it will go through some growing pains. There is far more risk in China than anyone--including Jim Rogers--admits. In particular, I feel like the political risk is not being priced properly. The government is run by a totalitarian government which can arbitrarily change its views. Remember one of the near-truisms in econopolitics: when economic times are good, politics is good; politics only starts to become an issue when the economy isn't so good. There have been more revolutions, collapses, wars, and government coups that occurred when the economy ran into problems than at any other time. A few examples include Serbia (Milosevic fell, not due to the war, but because of the economic problems), USSR (Yeltsin gained popularity after some economic problems), Indonesia (Shuarto fell when the economy fell apart, and not when he was committing mass abuses), and so on. I would even argue that the (likely) change in government in present day Zimbabwe, which has been ruled by a dictator for decades, is occurring because of economic problems. The citizens of Zimbabwe couldn't topple Mugabe in the prior 20 years even though he was just as bad back then (his racist policies have seriously hurt whites lately but from an economic or political point of view, he was a disaster 15+ years ago too). Sorry about the rant but the point is that you never know how stable the government is until you run into an economic problem.

I really feel that the market is not discounting the political risk in China. I feel Jim Rogers is also not discounting the risk. China is not that bad so I'm not saying it is equivalent to Zimbabwe or something. Nevertheless, the weak property rights, totalitarian government, and lack of history dealing with economic problems (China has been growing at a high rate for a long time) makes me nervous. I would get more comfortable with China after seeing how it handles an economic slowdown or recession.

I have high tolerance for business and industry risk (witness Ambac; or GM bonds a few years ago) but I am wary of political risk. I wouldn't mind investing in a turnaround situation where a country is struggling mightily. But I personally feel (this is just a newbie opinion) that political risk is pure gambling. For example, I really feel like an investment in Venezuela is closer to gambling than anything (it depends on sector but I'm thinking about natural resources.) When someone like Mohnish Pabri invests in Harvest Natural Resources (HNR), I feel like he is gambling that the government isn't going to nationalize the company. In contrast, it is a totally different matter if you were taking a similar high risk in Ambac by betting that the subprime mortgage defaults will stabilize or improve. Both are high risk and involve trying to figure out probabilities but the political risk is worse in my eyes because it can have "irrational" outcomes.

What I am about to say is probably controversial but I feel that the wealthy often do not value freedoms to the same degree as the lower class. I hate to paint with a broad brush so do not interpret what I am saying as some sort of an attempt to start a class war. For instance, I notice a lot of wealthy people hold Singapore and Dubai in high regard, even though you have literally no freedoms in those countries. I suppose all these people are putting money above freedom and expect to flee if there are any serious problems. In my opinion, it's a dangerous game these people play...

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The Downside to Value Investing

Let me present some of my impressions relating to the downside of being a value investor. I personally don't consider myself a value investor, but am heavily influenced by it; I consider myself a contrarian with a value tilt. Now, the definition of a value investor varies greatly but one common characteristic I find in value investors is their avoidance of macroeconomics. This is the cause of the major downside to value investing.

Pure value investors do not pay much attention to macroeconomics because you can never predict the future--which is precisely what most of macroeconomics deals with. Who really knows if things are going to be much worse now than before? We are just pretending to be soothsayers, are we not?

The macro picture still enters the investment decision of value investors but usually with a lower emphasis. Warren Buffett, for example, doesn't care what the Federal Reserve does or what the future expectation of GDP growth in China is, but he reads a lot of industry journals (supposedly). So, he actually gets a feel for the macro picture from industry trends.

The downside of ignoring the macro picture (or at least not putting much weight into it) is that you will invest in seemingly questionable assets than can blow up. For example, if one looked at the macro picture in the US over the last few years, it would have been hard to invest in homebuilders (Bill Miller), building material suppliers (Warren Buffett), retailers (William Ackman), and bond & mortgage insurers (Martin Whitman). People wonder how these superinvestors can invest in those companies (PHM, CFC, USG, TGT, RDN, MBI, etc) and I suspect it's because of the de-emphasis on the macro picture. Having said all that, what seperates these superinvestors from newbies like me is that they can evaluate the value of the business to a reasonable degree of accruacy, and end up buying the business with a large margin of safety. If anyone thought about the importance of margin of safety, it is precisely in these circumstances where it helps.

In addition, value investors tend to miss "macro trends" which can yield hugely profitable investments. For instance, very few value investors have capitalized on the recent commodities boom. Yes, you had Warren Buffett invest in PetroChina and ConocoPhillips; yes, you had Jean-Marie Eveillard invest in gold; etc. But these investments are a small portion of their portfolios. Similarly, very few value investors (except Bill Miller) capitalized on the technology and internet boom in the 90's.

I personally pay attention to macro quite a bit. I likely miss out on a lot of opportunities this way, but I also avoid a lot of problems.

Before I get trashed, I should make it clear that I'm just pointing out the downside of value investing so that investors are conscious of what can happen with value investing. This post does not deal with the upside. Needless to say, the upside is far greater than the downside so value investing is attractive in the long-run.

Saturday, April 12, 2008 0 comments

Martin Whitman Roundtable Discussion at Syracuse University

Thanks to for the original citation of a roundtable discussion with Martin Whitman at Syracuse University. Martin Whitman, who generally speaks his mind (sort of like Charlie Munger) :), gives his thoughts on the current environment. If you have been following him lately, most of his comments repeat what he hsa been saying lately. I do find him insightful and reinforces some of my thinking. So check it out if you have some time.

I was also searching the Syracuse University website (Martin Whitman sponsors the university) for older material and came up with the 2006 Whitman Day talk. I find this 2006 talk a lot more interesting. I think you can learn a bit more about Martin Whitman's thinking from this talk.

I'm still a newbie trying to figure out what investing style suits me and whether I'm cut out for investing. I haven't paid much attention to Martin Whitman in the past (in fact, I remember posting on some message board a few years ago that I didn't know Martin Whitman). Back then, I was more influenced by (not in any order) Marc Faber, Jim Rogers, David Dreman, Charlie Munger, and Warren Buffett. Now, however, I find myself paying more attention to Martin Whitman almost as much, if not more, than any of those I mentioned. One of the reasons is probably because I have extracted all the knowledge I can from other superinvestors. For example, I feel like I know exactly what Jim Rogers or Marc Faber are thinking and doing. Similarly, I feel like Warren Buffett is beaten to death and there isn't much new. This is not to say I know everything (I still have to read his past shareholder letters) but I kind of know what Buffett will say. Whitman, on the other hand, is more of an enigma to me.

The big downside to following Martin Whitman is that most of his strategies are next to impossible to execute for a small investor. Whitman focuses on restructurings, bankruptcies, and so forth, and it's really hard to invest in any of that without a lot of money or without working in the industry. However, as Whitman often remarks, he is more of an OPMI (outside passive minority investor) than Warren Buffett (this means he is actually closer to a small investor than Buffett). A lot of people don't realize that, although Buffett doesn't take direct control of firms he invests in, he actually has big influence on them--something you or me will never have (at least with our present feeble state ;) ). For example, when Buffett invested in Coca-Cola, he was able to joing the board of directors. In fact Buffett often meets/talks with CEOs of his companies on a regular basis and provides suggestions. This is something that Martin Whitman generally doesn't do (except as a control party in a restructuring.)

Friday, April 11, 2008 0 comments

Is Iceland the Present-day Thailand?

The 1997 Asian Flu (aka Asian Financial Crisis) started with the devaluation of the Thai Baht (Here is a July 3, 1997 article from The New York Times mentioning the gamble of the Thai central bank. Obviously the gamble totally backfired, although it is debatable what other strategies would have worked).

Well, Iceland is going through a severe crisis (manufactured or not) right now. The chart below from the Financial Times illustrates why Iceland is faltering:

(source: Cool under fire: Iceland takes the fight back to finance,
David Ibison, Published: April 8 2008. Financial Times)

Although the Iceland situation has little in similarity to the Thailand problems back in 1997, I wonder if this is a precursor of further problems in other emerging markets...

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Largest US Municipal Bankruptcy Looms... Jefferson County

Joe Mysak of Bloomberg thinks that the largest municipal bankruptcy is almost imminent. If it happens, Jefferson Country in Alabama will overtake Orange County as the largest municipal bankruptcy in US history.

(source: Largest U.S. Municipal Bankruptcy Looms in Alabama, Joe Mysak, April 11, 2008.

They're talking more about Chapter 9 municipal bankruptcy in Jefferson County, Alabama, the home of the largest city in the state, Birmingham.

Who can blame them?

The county is now being whipsawed by an ill-thought-out debt policy and the collapse of the bond insurers...

The bankruptcy will be the biggest in the municipal market's history by virtue of the county's debt load, according to the News. Jefferson County has $3.2 billion in sewer debt; Orange County lost $1.6 billion in its investment pool.

Well, chaulk another one up to the derivatives monster. Like other unfriendly derivatives monsters elsewhere, this one hasn't been too kind to the victim.

No doubt the government will attempt to pass the blame and liability onto the bankers who sold the swaps to the municipality. But the fact of the matter is that the county accepted these deals. They were trying to save money but my guess is that they probably couldn't have carried out some of the projects without the lower costs (or would have had to scale back the projects.) So, it is easy to blame bad bets but my suspicion is that the involved parties knew what the worst case would have been.

I had been following this story for a while because it involves the monoline bond insurers. FGIC and XL Capital have insured the county's bonds and a municipal default is probably the last thing either of those monolines expected right now.

This default, although bad for the county and involved monolines, may turn out to help the bond insurance industry. There have been some question marks raised lately about the need for bond insurance. Assuming FGIC and XL pay the bond claims, this might increase the appetite for bond insurance from investors.


Ambac 1Q08 earnings call on Wed Mar 23

Ambac Financial Group, Inc. (NYSE:ABK) (Ambac) announced that it will host a conference call for investors on April 23 at 11 a.m. Eastern to discuss first quarter 2008 earnings which are scheduled to be released at 6 a.m. that morning. The dial in number for the call is 877-407-0782 (U.S.) and 201-689-8567 (outside the U.S.).

Participants may submit questions in advance of the call by sending an email to

Last time Ambac had their conference call, all hell broke loose (actually it was their advanced earnings announcement but the conf call didn't exactly calm down anyone)... hopefully things will be better this time around ;)

The key things to watch:

  1. New loss reserves: I'm sure there will be some additional reserves taken for losses but as long as it is very small (I'm thinking less than $200m) it would satisfy me.
  2. HELOC and CES performance: In addition to the CDO-squareds, the other potentially lethal problem is HELOCs and CESes. The problem is that losses will likely be (close to) 100% with these exposures; in contrast, a typical RMBS and CDO likely has some positive recovery value (say 30% to 80%). The potential for massive losses for HELOCs is one reason MBIA sometimes posts worse theoretical losses than Ambac in some rating agency stress tests.
  3. New business: Market share dropped to 1% in the first quarter so that's not news but the real question is whether they were able to write any new business. Ambac was shrouded in a cloud for the first two months but I am curious to know how things looked late in March as well as early April.
  4. Foreign business: They may not break it out but I'm curious to see if there is some new business in the foreign markets.

Stay tuned for another chapter in the life of Ambac...

Wednesday, April 9, 2008 0 comments

Japan's Real Estate Correction

I have been following the Japanese real estate market closely and Bloomberg had a good recap of the present situation. To sum up, Japanese real estate is going through a big correction as can be seen from the chart below. Unlike the US, I feel that the Japan market has the potential to rise (but potential does not necessarily translate into reality.)

The chart plots the TOPIX (a broad stock market index) against a real estate index and the TSE REIT index. You can see that the real estate indexes ran up quite a bit in the last two years.

Although I find Japanese real estate worth investigating, one of the looming risks is their shrinking population. Given that Japan has literally no immigration (it's run like a "fascist" state in a minor sense), the declining population will exert a downward pressure on real estate. This means that the attractive real estate is in the cities. I would stay away from the countryside at all costs.

(source: Akira Mori's Real Estate Riches Retreat in Japan Credit Squeeze By Kathleen Chu, April 9, 2008.

Akira Mori, Japan's richest man, spent a record 231 billion yen ($2.3 billion) buying Tokyo's Toranomon Pastoral Hotel last September. He now says it's worth closer to 200 billion yen.

``The boom we've enjoyed for the past few years is over,'' said the 71-year-old chief executive officer of Mori Trust Co., who teamed with K.K. DaVinci Advisors, a 1.2 trillion yen Tokyo- based property fund, for the acquisition. ``Investors were convinced that prices would keep rising, so in about six months, they'll probably rush to get out regardless of price.''

The interesting thing to note is that Akira Mori implies that investors still haven't bailed and will attempt to do so. If that thinking is correct, it is prudent to stay on the sidelines for the time being.

Cracks are emerging in a market that generated annual returns averaging 14 percent since 2003. The Tokyo Stock Exchange REIT Index dropped 16 percent this year and 40 percent from its peak in May. Twenty-six of 42 property trusts are trading below their initial public offering price, according to data complied by Bloomberg.

That might sound scary to most investors but it's good hunting grounds for contrarians and value investors. I have been looking at a much of Japanese REITs but am having problems figuring out which ones are "good". One of the advantages of stock market corrections or economic slowdowns is that it gives one the opportunity to pick up brand-name companies or market leaders at decent valuations. Early on (an year ago), when I was looking at Japanese companies, I was looking at small and mid-sized real estate companies (that's how I came across the scandal-plagued Suruga Construction). But now there is no need to go with the riskier, smaller, ones. You can find some seemingly decent REITs run by big-name investment banks that have fallen in price (but note that a decline in price doesn't necessarily mean they are cheap given that many of their IPOs were during the boom at likely inflated prices.)

(What I said about brand-name, well run, companies being cheap is true for other beaten-down sectors in America as well. Instead of looking at small-caps and mid-caps, I'm looking more and more at market leaders these days. In particular, instead of concentrating on small-cap retailers, you actually have a shot at picking up solid large-cap retailers at seemingly attractive valuations. Unless your stockpicking skills are good, the small-caps will also get whacked during any economic slowdown so large-caps are more attractive right now.)

Japan's previous property boom lasted 16 years, making Mori's father Taikichiro Mori the world's richest individual in 1991, according to Forbes...

The crash was equally spectacular as Tokyo commercial land prices plunged more than 50 percent in five years and the Nikkei 225 Stock Average lost three quarters of its value.

Rents in Marunouchi, Tokyo's most expensive business district, peaked at 100,000 yen per tsubo in 1991 before dropping to as low as 35,000 yen in 2003, according to Colliers Halifax. The rate averaged 65,000 yen last year. A tsubo, the standard measure of property in Japan, is 3.3 square meters, or 35.5 square feet...

``Japanese investors suffered a severe shock when the last bubble burst, and because they lived through the crash, they're bound to be cautious now,'' said Junko Miyakawa, a senior analyst at Tokyo-based Shinsei Securities Co.

Regulators at the Tokyo-based Financial Services Agency may have sought to curb lending to prevent a new bubble from forming, said Katsuya Takanashi, CEO of Secured Capital Japan Co., which manages about 550 billion yen of real estate assets...

Soured property loans devastated Japanese lenders in the 1990s, forcing the government to spend more than 9 trillion yen on an industry bailout. Tumbling real estate prices helped trigger a decade of deflation that the world's second-biggest economy has yet to fully shake off.

Sums up what I believe is the largest real estate bubble in history.

Even though the situation doesn't seem good, some foreign investors are snapping up real estate in Japan:

Global investors led by General Electric Co. and Morgan Stanley sense a buying opportunity in a nation where Real Capital Analytics estimates the value of transactions was just 7 percent that of the U.S. last year.

GE's real estate unit may buy as much as $10 billion of Japanese property this year, anticipating tighter credit and rising borrowing costs will prompt local trusts to accelerate asset sales and drive down prices. GE uses its own cash to invest in property, unlike REITs and private funds that borrow money.

The advantage small investors have is precisely what gives G.E. an advantage. We don't have to finance ourselves (assuming we have savings) and we won't be getting margin calls if the asset price falls in the short term.

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Tuesday, April 8, 2008 0 comments

What Will Ambac Do When It Runs Out of Space?

Here is evidence of the legal system run amok...

What will Ambac do when it runs out of space? Smaller font? Does anyone even read these things?

While I'm at it, can everyone stop trying to protect public PDF files? It accomplishes nothing for the reader and makes it difficult to extract slides from presentations. If it is confidential then go ahead; but for public presentations?

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What Will Stabilize the US$

One of the reasons the US$ must decline is because of the huge trade deficit. As long as the trade deficit is large, the US$ will be under pressure (as it has been for the last few years). I have always felt that the trade deficit was unsustainable and bound to shrink when the US economy slowed down. It looks like it is finally happening.

The following chart, courtesy Calculated Risk, seems to indicate that the US current account deficit has been flat for the last one and a half years:

(source: Calculated Risk)

The trade deficit excluding petroleum products has been rising sharply over the last year. The imports will continue to decline as the US economy slows. I have been bearish--and been wrong--on oil for over an year. I maintain my view that oil will start showing weakness once the economic slowdown is underway. Petroleum deficit will also likely stop growing once the US$ stabilizes somewhat. A lot of the run-up in oil prices during the last 6 months is due to the US$ decline.

The final action that is required for the current account deficit and the US$ to stabilize is for the US government fiscal deficit to be reduced. The US government deficit is also unsustainable in my eyes and will have to shrink. This isn't a matter of if but when.

Unfortunately, nothing is likely to happen on this front for years. Democrats, who, like most left-leaning parties, have always been viewed as fiscally irresponsible, are actually quite good balancing the books. It's quite interesting that the left-leaning parties such as the Democrats in the US or the Liberal Party in Canada have historically reduced spending more so than the Republicans (or the Conservative Party in Canada). They tend to do this, not by reducing spending necessarily but, by avoiding large tax cuts or discretionary spending on large wars. I think a Democrat win may result in a reduction in the fiscal deficit within the first term. However, it will be difficult for either party given the fairly large spending on Iraq. If Iraq spending increases, or if the bogus war on terrorism is expanded to Iran and other places, then it will be difficult to contain the fiscal spending regardless of who is in power.

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