CertainRuin - a stock picker's record

Converting CPS to % U308 for Athabasca Basin uranium holes

2010-02-24T08:21:00.000-08:00

Here is a plot of Hathor's (HAT.V) data. x-axis is the scintillator counts per second and the y-axis is the final assay result for % U308.

A good relation is U = 4.1% * (CPS/5000)^2.2

See plot of data here.

And now the banks bail out the FDIC

2009-09-21T21:02:00.000-07:00

How crazy is THIS ?

Apparently the FDIC which is broke is going to borrow money from ...drum roll please ... The banks.

Huh?

Isn't the FDIC supposed to insure the deposits of the banks. So if bad loans make the bank fail, the FDIC is there to pay back depositors. But what if the FDIC itself makes up those loans? What if the FDIC can't pay back those loans and makes the bank fail which then needs the FDIC to bail out depositors?

Won't this mess up the whole space time continuum?

Well not really. The FDIC is not like a regular borrower. It is a borrower with an almost infinite ability to raise revenue kind of like the government itself. They can raise insurance premiums on the banks (just like a tax really) and eventually pay back whatever they borrow. Really this is all about extending the period over which the losses are taken. If they raise insurance premiums now to collect the money, this will hurt bank profitability and put more downward pressure on banks. So they just borrow the money and will raise premiums on banks in the future. More reasons why banks in the future will be less profitable. The price of not failing now is less profits over the next decade.

This all works because of the way the Federal reserve can print money out of nowhere and force interest rates to zero making banks very profitable and able to absorb losses.

Strathmore Minerals

2009-08-29T11:08:00.002-07:00

One of my stock holdings Strathmore Minerals (STM.V) just became somewhat more enticing. STM is a Uranium miner with properties in Wyoming and New Mexico. They have some good properties and excellent people and management.

One of my beliefs is that if you can't explain why an investment is a good idea with a simple explanation, it probably isn't such a good idea.

So here goes. STM owns land with about 150 million lbs of recoverable Uranium (hereafter U308) resources. The sales price (long term contract price, not spot price) of U308 is about $70/lb. STM's operating costs are likely to be about $20/lb since it can extract the uranium with either open pit mining or the in-situ leaching (ISL) process. No complicated underground mines required. STM purchased most of this land when U308 was only $7/lb to $15/lb and claimed that it would be profitable to extract the U308 at about $20/lb. They correctly predicted that the price would rebound.

So the operating profit might be about $50/lb.

There are about 72 million common shares. The stock price is about $0.52/share. My first purchase was at $0.20/share in March 2009. Market cap is therefore $37MM.

So a VERY rough estimate of the value (assuming all the U308 is extracted at a $50/lb profit) is 50*150 = $7500MM. Note that this is 202 times the market cap. Now, this may be an over estimate. There is no guarantee that U308 price will not fall or that operating expenses will not be higher. But even if you take $40/lb for a selling price and $30/lb for an operating cost, you get a value of $1500MM. Now, maybe discount that by a factor of three to take into account the time required for the cash flows to arrive and the risk. You still get a present value of $500MM or 14 times the market cap.

Basically the stock is priced as if the U308 will never be extracted. Actually it is priced as if it is ALMOST CERTAIN that the U308 will not be extracted. That is, even if the U308 price was so low that STM could not extract it profitably, the company should have option value just like an out of the money call option. That is, there is always a chance that the U308 price will sky rocket to say $100/lb (where it was just last year) or higher.

Another risk is that they can't raise the capital required to extract the uranium. I have never worried much about this risk. If there is money to be made, capital seems always to be available. The company already sold a 40% stake in their New Mexico, Roca Honda properties to Sumitomo, the Japanese conglomerate for $50MM. There is about 33 million lbs of U308 in Roca Honda or about 20% of their total resources. That would value that entire asset at $125MM or $3.75/lb of U308.

Remember the market cap of the whole company is only $37MM. Valuing it all at the price Sumitomo payed would be $562MM or 15 times higher.

Very recently, they sold another asset, Pine Tree & Reno Creek that holds about 20 million lbs. They sold it for $30MM in cash or $1.5/lb. Valuing all their U308 resources at this price would be $225MM or 6 times the market cap. But this is likely a very low price. They sold this land because they needed the cash to start operations on some of their core assets. The deal has not been finalized. It depends on the buyer obtaining financing. But if it goes through, they will have $30MM in cash. Cash should always be valued at full value on the companies balance sheet. So subtract $30MM from the market cap of $37MM and you have an Enterprise Value of only $7MM. It is costing you only $7MM in net cash to buy the whole company which will still have 120 million lbs of U308. Even if you only value the U308 at $1/lb, it is worth $150MM.

So there you have it. Now matter how you slice it, the company is worth many times it market cap. If you get lucky, the U308 price will remain high or go higher and the company will be worth a fortune. If the U308 price falls a lot, it still seems worth the current price even if the recent deal falls through.

Very little risk and the chance for enormous gains makes STM currently one of my favorite investments. I am glad I bought at $0.20/share but will be adding more at the current price.

The American Century? Hardly.

2009-07-27T17:46:00.001-07:00

There is a great website that I discovered called nationmaster.com . It has all kinds of data including economic data for lots of different countries. I was able to make the following plot of GDP per capita from 1820 to the present for a few different countries: US, Germany, France, Japan, Canada, China, India and Brazil.

The 20th century has often been called The American Century. The US did indeed do well over this century. They became the foremost economic and military power. However, when you look at GDP per capita (a measure of the wealth of a nation), you find that they don't exactly stand out. For example, France and Germany didn't grow their GDP must slower than the US over this period. In fact, they started out a few percent behind the US and ended up about 30% lower. Ok, but they were both nearly destroyed by world war. Germany lost both wars and suffered a period of hyperinflation in between. They both suffered from stagnant population growth unlike the US which grew population rapidly. In addition, the US had more abundant natural resources. Canada basically tracked the US. No one calls it the Canadian Century.

However, If GDP growth is your metric for naming centuries, you would have to choose Japan. Japan is basically equal to the US in terms of present day GDP per capita. But in 1820, GDP per capita was half that of the US. In 1900, it was 28% of the US. In 1950 (after losing WWII to the US) it was only 20% of the US. Now they are tied. So the GDP growth crown for the last century and especially the past 50 years has to go to Japan.

The darlings of today's investment crowd, China, India and Brazil have lagged miserably. In fact India has hardly grown real GDP per capita at all in almost 200 years. Brazil has done OK, since 1900 but was quite far behind.

Swine Flu

2009-07-22T19:17:00.001-07:00

Lets make some numerical estimates about how severe swine flu could be for the US.

Start with the US population which is about 300 million people.

Lets discuss two scenarios. One is the mild scenario and the other is the severe one. Obviously, it could be anywhere in between and even outside of these two bounds. But I would say, to my knowledge, that these two scenarios contain about 80% of the possibilities.

Lets pick a time scale. Assume it lasts about two years with some tail before and beyond that.

Now we need to estimate the attack rate. What percentage of the population will get it? From what I have read, I think this is between 20% and 50% of the population. These are my mild and severe scenarios.

Then you can discuss things related to the severity of the illness. For example, what percent of people infected will have it severe enough to require hospitalization. What percentage of those hospitalized will require a ventilator? What percentage of those infected will die.

Lets start with the death rate since it is pretty well studied wit this current strain. Most think it is between 0.2% and 0.5%. Obviously this is dependent on the quality of health care received which will be affected by the number of people that get dangerously sick compared to the heath care resources available.

So right off, we can estimate the number of people that will die using the mild and severe scenarios. This is

MIld case: 300 million x 0.2 x 0.001 =60 thousand Americans or 30 thousand per year
Severe case: 750 thousand Americans or 375 thousand per year

Obviously that is a huge difference. Consider that this flu seems to be more severe for young people rather than the usual target for influenza which is infants and the elderly. See age distribution below from a study in Mexico.

Lets look at the three age groups, 5-14, 15-24 and 25-34 who will probably suffer about half the case of H1N1. Lets look at their morbidity statistics, that is the chance of dying in any one year. This is usually done in deaths per 100,000 people. There are some numbers here for these age groups. It has all causes and individual causes including Influenza (which is linked with Pneumonia, see below).

So lets translate our numbers above in morbidity statistics and add them to these numbers. Our death rate per 100,000 individual per year (for each of the two years) is 100,000 x 0.2 x 0.001 x 0.5 = 10 for the mild case and 100,000 x 0.5 x 0.005 x 0.5 = 125 for the severe case. Lets put these in the table with All causes and normal influenza.

Age Group	All causes	Influenza	H1N1 mild	H1N1 severe
5-14	21.7	0.4	10	125
15-24	89.6	0.6	10	125
25-34	126.7	1.4	10	125

Even for the mild case, the number of people in these age groups that will die of influenza will be 7 to 25 times higher than usual. It will be the major cause of death next year for this age group. The mild case will increase the change of a 5-14 dying (of any cause) by 31%. The severe case would double the chance of dying for 25-34 year olds. For 5-14 year olds, the chance of dying has increases by a factor of 6.7.

People often say that the flu kills 36,000 people per year so this H1N1 is nothing to worry about. But this is wrong. First of all, as I mentioned Pneumonia is linked with Flu and "influenza-like illness". Flu by itself actually kills less than 1000 per year and less about 142 children under the age of 18. source .

Using these number above and assuming the average high school has about 1000 students, the mild case would imply that one in every five high schools will have a swine flu death (in two years). The severe case would say that every school would average 2.5.

Now on to another issue: health care and its ability to handle the situation. I will only focus on one issue, the availability of ventilators. Severe cases of swine flu require the patient to put on a ventilator in order for them to breath, sometimes for weeks. The US has about 100,000 ventilators and 80,000 are in use in normal times. During flu season, most of the others are in use as well. Lets look at how swine flu could impact this. For the mild case, we assumed that 0.1% of people who get swine flu will die. Lets assume that 10 times this amount are put on ventilators so that 90% of people that are put on ventilators will live. So this is 1% of swine flu cases requiring ventilators. If we assume that each requires it for a week, this works out to be 3,000 people needing ventilators for swine flu if you evenly distribute it over two years. However it won;t be evenly distributed. It will probably peak about three times this average so that is 9,000 ventilators. This is beginning to stress the system but is probably manageable with some rationing. For the severe case, there are five times more cases which means 14,000 ventilators are needed (evenly distributed) and maybe 42,000 in peak periods. Now we are talking major panic. There will have to be major rationing. The system is completely overwhelmed. Consider that the ventilators will not likely be in the optimal places. What if New York has too many but San Francisco has too few. Imagine the chaos and ethical dilemmas that hospital and politicians will face. Canadian hospitals have been reporting that young people suffering from swine flu have required a special kind of ventilator call an oscillatory ventilator rather than the usual kind. How many of those do we have?

Other questions to consider. How many does of Tamiflu and Relenza do we have? If we run out of that, the death rate will surely rise. There is the issue of vaccines. Hopefully these will be finished in time to slow the spread. I have my doubts.

Finally, there is the effect on the economy. With chaos ensuing and fear rising, most people will not fell like shopping. Many will stay home from work to take care of sick family members. Many will be sick themselves and some of course will die. The effect on the economy means, less spending, less consumption, less production.

UPDATE

The Washington Post has a story on the stress on the health care system.

Consider the following statistics which they give

The swine flu virus, also known as H1N1, could infect up to half the U.S. population, making as many as 1.8 million sick enough to need hospitalization, including as many as 300,000 who might need intensive care, according to a presidential advisory council estimate.
... "There will be millions and millions of people seeking care in a relatively short period of time," said Eric Toner of the University of Pittsburgh's Center for Biosecurity, noting that the nation has only about 85,000 critical-care beds.

What he didn't say is that most critical care beds are being used at all times. Hospitals don't plan to have many more beds than are usually needed. That would be too costly. So we might assume, optimistically, that 70% on average are being used at any given time which leaves only 26,000 free beds for possibly 300,000 critically ill people. Now, it might not be that bad. But even if it is 100,000 critically ill people with 33,000 available beds, that will be a disaster. Two-thirds of the sick people can't get an ICU bed and may die because of it. Now consider that as much as half of the healthcare workers could be out of work due to infection of themselves or their dependents. Can they even operate at 100% capacity with half the workforce and three times as many people needing emergency ICU care?

----------------- Update --------------

Looks like there is more evidence on the death rate being much, much smaller than first thought. Looks like it is more like 0.1% or maybe even 0.05%. So this would be even milder than my mild scenario. Lets hope this is correct.

US Private Consumption

2009-07-19T19:53:00.000-07:00

Here are the numbers for private consumption, in $ Trillion, for the US and some other areas

US 10.1
Eurozone 7.6
Japan 2.8
UK 1.6
China 1.6
India 0.6
Korea 0.5

Source: CEIC

Many economists expect the US, Europe and Japan to slow their consumption after this great loss in wealth and also due to demographics. They also expect emerging markets like China, India etc to pick up some of the slack.

Those three combined are $20.5T. Lets says, they reduce consumption by 10%. That is a loss in demand of $2T. If China, India and Korea were to pick up all of this slack, they would have to increase their private consumption by 76%. They would have to do this while their export markets (their largest employer) are undergoing this historic bust. Does that make sense to anyone? Of course not. There is no other consumer capable of replacing the US and European consumers. The conclusion is unavoidable excess capacity.

Real Estate Declines in Chicago

2009-07-18T20:40:00.001-07:00

My wife and I visited some friends of ours in nearby Portage Park, a neighborhood in Chicago. Portage Park has long been an immigrant community, mostly Polish in the past but now hispanics are prevalent there as well. The Park itself is rather nice and the neighborhood may be considered up-and-coming if not exactly there yet.

Our friends have had a foreclosed home right next door that had been on and off the market a few timed over the past couple of years. It has recently sold. Our friends couldn't remember exactly the sale price but they thought it was around $130K. They also told us that it once sold for $450K near the peak of the housing bubble. I thought that sounded a little far-fetched so I went to Zillow.com to try to find the sales records. Yup. he was right. Here it is.

4933 W. Byron
Sale History
05/04/2009: $134,000
03/21/2007: $450,000
05/15/2006: $390,000

That is a 70% decline between actual sales in two years.

Here are some more examples in that neighborhood.

For example, here is 4136 N. Monitor Ave. .
Sale History:
05/06/2009: $134,000
01/17/2007: $480,000
12/17/1998: $189,000

That is a 72% decline in actual selling price in a little over two years!

5146 W. Dakin St.
Sale History
06/23/2009: $90,000
11/03/2004: $289,000

A 69% decline between sales and that is only 2004, two years before the bubble peaked.

5706 W. Wilson Ave.
Sale History
01/22/2009: $174,000
06/29/2006: $410,000
12/08/2005: $337,000

A 57% decline in 2.5 years.

5919 W. Warwick
Sale History
09/17/2008: $5,000
06/25/2004: $340,000
08/29/2002: $240,000

This one takes the cake, a 98.5% decline! Ok, that might have had a tax lien or something but still.

6028 W. School St.
Sale History
03/23/2009: $118,000
09/11/2006: $425,000

A 72% decline in 2.5 years.

Amazing stuff. This area must have been big into the subprime lending fiasco. Most of these houses must have been foreclosures that were auctioned off or sold by the bank.

"Goldman as the enemy" seems to be catching on

2009-07-17T07:02:00.000-07:00

Glenn Beck

Jon Stewart

Krugman

WSJ

Taibbi

Long Beach Ports Traffic in June

2009-07-15T22:38:00.000-07:00

Here is a plot of the container traffic in June at Long Beach Ports which is America's second busiest seaport. Units are Twenty Foot Equivalent Units (TEU)s.

The number of TEU loaded in, a measure of imports, has declined 28% from last June and 39% from June 2007. This is a major contraction of imports and shows how dramatically the US consumers has put an end to their 20 year shopping spree.

Earnings and PE ratios in the Great Depression

2009-07-06T16:28:00.000-07:00

Stock prices have risen about 40% from the low a few months ago. The main reason appears to be that people think the recession will end soon and that stocks are simply pretty cheap. Though I disagree about the recession ending, I would have to agree that stock look pretty cheap with the emphasis on the look.

For example the 30 stocks in the Dow Jones Industrial average have an average PE ratio of about 13. It is about the same whether you use trailing earning or forward analyst estimates for next year. Well 13 is indeed pretty cheap compared to the long term average of about 15.

But looks can be deceiving. The question is what the earnings will be in the future. Corporate profits as percent of GDP were recently at an extreme value. The long term trend for real earnings (as compiled by Robert Shiller) puts the S&P 500 earnings at about 50. That would be the trend value not the value one might expect in a very deep recession. Typically earnings fall to about half the trend during deep recessions. So earnings for the S&P 500 might be more like 30 over the next few years. With the S&P 500 at 900 that would put the PE ratio at about 30. Not so cheap looking anymore.

Let's look at the data for the Depression years 1928-1936 as an example.

This plot shows the aggregate earnings (black), stocks prices (blue) and the (trailing) PE ratio in red. The data is from Robert Shiller's data-sets. The stock prices have been divided by 17.

In late 1929, the bubble popped and stock prices fell as market participants realized that corporate earnings would fall and that stocks were overvalued. The PE ratio fell quickly from about 20 in 1929 to about 13 by the beginning of 1930. People naturally expected a quick economic recovery and decided that stocks were cheap. After-all, a PE of 13 (just like today) is pretty enticing. So began the rally of 1930. The PE ratio jumped up to about 18 before the rally fell apart. The market then fell steadily with occasional rallies until the bottom in late 1932. The amazing thing is that the PE ratios never strayed far from 17 during the rest of the bear market except for right at the end when it fell quickly to bottom at 10. The blue line is price over 17 so the fact that the blue line traces the black line demonstrates this. It is just that earnings fell steadily until they fell to about 7 from the peak at 26, a 73% decline. The story of the great bear market was really one of corporate earnings not valuation.

The moral of the story of course is that a PE ratio is pretty meaningless by itself. What matters is where earnings will be in the future. The best guide to that is simply mean reversion. Corporate profits tend to revert to about 6% of GDP. They recently peaked at almost twice that. If they bottom at half this average that would be a 75% fall just like in the Depression. If that happens we might expect the S&P to fall to at least a PE of 15. The S&P 500 earnings peaked about about 85 so a 75% decline would be 21 and a 15 PE would bring the index to a horrifying 315 a 65% decline from here.

Of course this might be overly pessimistic or it might not. But the point is that stocks will follow future earnings and that those will likely go down from here. Stocks are not nearly as cheap as they look.

The savings rate

2009-07-01T21:25:00.000-07:00

The US personal savings rate might be the key indicator to tell us when the economy is at the bottom. Basically the savings rate needs to increase from its bottom of about zero in 2006 to its historical average of around 8%. In fact it may need to stay above 10% for a few years to rebuild much of the wealth that was squandered over the past decade.

So here is the data from the government's Bureau of Economic Analysis (BEA).

The good news is that we almost half way there. The bad news is that this is probably incorrect. Trim Tabs, an independent economic research firm says that the BEA data is flawed for a few different reasons. The main reason is that the BEA uses income data that is six months old. The real time data that Trim Tabs uses shows that incomes have been falling rapidly over the past few months. So the savings rate is actually more like 0.9% and not 6.9%. In other words, we haven't made any progress on saving. This is Irving Fisher's "paradox of thrift" in action. If everyone tries to save at once, incomes fall even faster and no one makes any progress on reducing their debt burden. That is probably an over-simplification but the point is that it does not appear that American's have made much progress on repairing their balance sheets. It does not appear that spending is reaching the bottom. Keep in mind that consumer spending accounts for roughly 70% of the US economy. Another 10% decline in consumer spending would take another 7% out of GDP. This doesn't bode well for an economic recovery any time soon. In fact we may only be half way through this recession.

trimtabs BLS

The best articles of the year.

2009-06-24T21:27:00.000-07:00

Here is what I think are the most important articles on the Crash of 2008 and the aftermath.

First former IMF chief Simon Johnson's critique of the Wall Street Oligarchs control over Washinton, published in the Atlantic magazine.

The crash has laid bare many unpleasant truths about the United States. One of the most alarming, says a former chief economist of the International Monetary Fund, is that the finance industry has effectively captured our government—a state of affairs that more typically describes emerging markets, and is at the center of many emerging-market crises. If the IMF’s staff could speak freely about the U.S., it would tell us what it tells all countries in this situation: recovery will fail unless we break the financial oligarchy that is blocking essential reform. And if we are to prevent a true depression, we’re running out of time.

Michael Lewis wrote a story in Portfolio.com about the subprime fiasco and the hedge fund manager Steve Eisman who bet against it. An excerpt:

For Eisman wasn’t raising his hand to ask a question. He had his thumb and index finger in a big circle. He was using his fingers to speak on his behalf. Zero! they said. “Yes?” the C.E.O. said, obviously irritated. “Is that another question?” “No,” said Eisman. “It’s a zero. There is zero probability that your default rate will be 5 percent.” The losses on subprime loans would be much, much greater. Before the guy could reply, Eisman’s cell phone rang. Instead of shutting it off, Eisman reached into his pocket and answered it. “Excuse me,” he said, standing up. “But I need to take this call.” And with that, he walked out.

Finally, there is a new story in Rolling Stone by Matt Taibii which portrays Goldman Sachs as the parasite on the American people that they are.
It is a story about how Goldman Sachs is the cause of every major bubble in the US Economy from housing to internet stocks to oil prices to global warming.

Here is a good quote

In other words, the mortgages it was selling were for chumps. The real money was in betting against those same mortgages. "That is how audacious these assholes are", says one hedge fund manager. "At least with the other banks, you could say they were just dumb - they believed what they were selling, and it blew them up. Goldman knew what it was doing." I asked the manager how it could be that selling something to customers that you're actually betting against - particularly when you know more about the weaknesses of those products than your customers - doesn't amount to securities fraud. "It is exactly securities fraud," he says. "It is the heart of securities fraud."

and another

If America is circling the drain, Goldman Sachs has found a way to be that drain.

and another

The basic scam of the internet age is pretty easy for even the financially illiterate to grasp. Companies that weren't much more than pot-fueled ideas scrawled on napkins by up-too-late bong-smokers were taken public via IPOs, hyped in the media and sold to the public for megamillions. It was as if banks like Goldman were wrapping ribbons around watermelons, tossing them out of 50-story windows and opening the phones for bids. In this game you were the winner only if you took your money out before the melon hit the pavement.

Great stuff!

Update. Here is another very good one.

What is really going on in China

2009-06-13T19:18:00.001-07:00

Chinastakes is one of the best places to read about economic trends in China. The latest article is a doozy.

Basically the Chinese are following America's example and flooding their economy with stimulus spending. In fact the majority of the stimulus is just the government directing their state run banks to lend money to anyone for any reason. Where is the money going to go when demand for manufacturing is plummeting? Speculative assets obviously. Here is the money quote.

“I began to invest my money in villas when orders began to decline in the second half of last year and my factory's production was cut by 1/3. The reason is simple. Under current economic conditions, investing in houses is safer than investing in factories,” said the owner of a private firm.

“Do you really think all those stimulus bank loans have entered the real economy?” queried a real estate dealer in Shanghai. “Of course not. They are still in enterprises’ hand, or have been invested in real estate and the stock markets. Some companies took money they scored on the stock market and invested in real estate soon after.”

Anyone with thorough knowledge of financial history knows how this is going to end.

UPDATE

Good story with links at
Zerohedge .

Whiney banks

2009-06-09T23:19:00.000-07:00

The banks are whining again. This time about buying back their TARP warrants. Remember, the tiny amount of warrants were issued to make it look like the taxpayer was going to get a little bit of the upside from their investment" in the banks. Now that they want out of TARP, they also want to renege on their contract and get those warrants back.

Listen to the whining

“We shouldn’t have had to pay a dime,” said Sun Bancorp Chief Executive Thomas Geisel...Taxpayers deserve a return for the risk they took on, but it wasn’t a risk to invest in us.”

"You shouldn't have to pay a dime, Tom?". Did you not sign a term sheet giving you tax payer financed capital in exchange for warrants? Now you want those warrants cancelled for nothing in return? Please show me in the term sheet where it says that the warrants will be cancelled.

Jamie Dimon, CEO of New York-based JPMorgan Chase, said June 1 that that the U.S. should cancel half the warrants it holds “out of fairness.”

Ok, Jamie and why don't we reduce everyone's mortgage balance by half out of fairness. Can I pay back half my credit card balance? That sounds fair to me. 50-50. Even steven. Meeting you half way. Apparently contracts are sacred to bankers except for the ones signed between the banks and the taxpayer where the banks have made concessions.

Long Term House Prices

2009-05-23T14:23:00.001-07:00

This is Bob Shiller's famous plot of the US housing bubble.

This is using Shiller's more accurate repeat sales method instead of median prices. You can see how house prices go up because everything goes up. This is called inflation.

Shiller made another study of repeat sales of identical properties along the canals in Amsterdam. This is also pretty fascination. There is no upward trend once corrected for inflation though there is lots of variation tracing the history of Holland. Here is a version in Dutch.

This is Bob Shiller's famous plot of the US housing bubble.

How banks plan to survive

2009-05-10T21:29:00.000-07:00

The banks have a survival plan and the Fed and Treasury seem to be on board. It looks like this. They are going to earn their way out of trouble. Sure, the capital they have now is probably not truly there if they really took all the marks that they should. But they will write it down slowly over the next few years and replace it with earnings.

They think they will be able to do this because of a few things

High interest rate spread. Their deposit cost is very low due to the Fed's zero interest rate policy.
They can raise interest rates on loans.
They can borrow cheaper in the capital markets because the government is guaranteeing their debt

Now lets look at these in detail to show how all of them are direct wealth transfers from individuals and businesses to the banks.

First, the Fed's zero interest rate policy (ZIRP), forces deposit costs down. People with money in the bank are now getting 0.25% or something instead of 3% or so that they were getting a few years ago. This punishes seniors and other savers including businesses with large cash balances. This results in about $200 Billion dollars per year of interest income getting shuffled from the savers back to the banks.

They can raise rates on loans. They are already doing this. Here are a couple links from the New York Times and ABC News talking about how they are increasing credit card rates on people with good credit. Why are they doing this? Simply because they can. The right question is why didn't they do this in the past. Well, the credit card business is very competitive and people frequently do balance transfers to get better rates. But in this deleveraging environment, no one wants new credit card customers. They would love it if their customers paid off their balance and dropped off the face of the earth. They are not growing these portfolios. They are trying to reduce them. So it is an easy problem for them. Raise rates and fees through the roof. Either you pay them and make them lots of money or you pay off your balance and they reduce their leverage and so reduce the amount of capital they need to raise.

How much does this get them? Well, there is $2.5 Trillion in US consumer debt. If they can raise interest rates (or fees) by 5%, that is $125B/year in extra income. And that is just consumer debt. Total household debt (minus consumer debt) is about $11.5 Trillion and there is another $7 Trillion of non-financial corporate debt. Banks owns about $5 Trillion of this. If they can squeeze another 2% interest rate out of that $5 Trillion, that is $100B/year. Again, if the borrowers don't like it, they can try to find a loan elsewhere. If they leave, the bank has successfully delevered. So raising interest rates on borrowers might get another $225B/year.

Finally, there is all the government guarantees on their debt and direct government lending. I won't estimate the impact on earnings other than to say that without it, they would probably cease to exists. Certainly the Wall Street "banks" would have failed just as Bear Sterns did without the access the discount window and other such programs.

So the impact of lower deposit cost and high interest rates creates a much larger spread which might be roughly $425B/year in extra income for the banks. This is money that is transfered from US individuals and businesses directly to the banks. Most estimates of US banks losses is around $1 Trillion. So the banks can replace this capital through higher interest income is roughly two years.

In summary, the Fed and the government have orchestrated a massive wealth transfer in favor of the banks. This, of course, is in addition to Federal bailout of the banks through the TARP and other such programs. The banks are able to so this because they have essential control over the US government and have power over the central bank with its ability to create money and determined interest rates that banks have to pay for deposits. The banks will probably survive and replace this $1 Trillion capital hole with our money but ownership of the banks will largely remain in the same hands.

There is perhaps a bigger point to be made here. Banks are really intermediaries between borrowers and lenders. They don't produce anything. When you deposit money in a bank, and your neighbor gets a mortgage from that banks, it is really you lending to your neighbor. The bank is a useful intermediary. It performs credit analysis and protects you (with final backstop from the FDIC) from losses. For this service, it collect a fee. But the fee that is collected is a cost to the greater society, i.e. the real economy. The economy therefore is better off with banks being less profitable. Large bank profits, result in capital piling up at the bank which leads to a need to produce more and more credit. This obviously leads to a credit bubble and a crisis when it collapses. At the top of the bubble financials produced 40% of all corporate earnings, without producing anything. This is up form the long term average of about 15%. Those bank earnings which could have been income or industrial earnings would have resulted in a stronger US economy. Instead we had a credit bubble. The lesson is that the banks should not be the dominant force in an economy. They should be the oil that greases the wheel not the wheel itself.

More real estate madness

2009-05-07T21:40:00.001-07:00

Jess and I used to live in a funny neighborhood of LA called Montecito Heights. It was basically Mexico hidden away in the hills above downtown LA. This is East LA where Cheech and Chong come from.

We used to go for a walk from our place and pass this boarded up place that looked like a former crack-house. It was basically a wooden box on metal stilts hanging on the side of a steep hill. I would doubt that even cock roaches would sleep inside. Very gross. These pics are not so great but, believe me, it doesn't look better from close up.

Yes, that is a chain link fence two feet from the front door. They are not much for zoning in the Montecito hills. To get in the front door, you open up the chain link fence and walk across a piece of plywood into the front door. If the plywood was not there, you would tumble down the hill rolling underneath the house. Lovely!

I looked on Zillow today to see how much it is worth. They say $300K. But funnier still is that it sold near the top of the bubble at over $700K. What utter madness, this housing bubble!

Swine Flu

2009-05-01T20:40:00.000-07:00

I had previously read a lot about the Flu of 1918 and so when I heard about the possibility of pandemic swine flu coming out of Mexico, I immediately got very worried. I expected people to start dying in the US. After a few days, no one died. The media started saying that the symptoms were mild, about the same as normal flu. So naturally, I calmed down a bit.

But maybe that was not the right reaction. There is the curious case of Dr. Gitterles. The doctor in Texas is saying that the situation is far worse than the authorities are saying. Read the email, especially this part

Since it is such a novel (new) virus, there is no "herd immunity," so the "attack rate" is very high. This is the percentage of people who come down with a virus if exposed. Almost everyone who is exposed to this virus will become infected, though not all will be symptomatc. That is much higher than seasonal flu, which averages 10-15%. The "clinical attack rate" may be around 40-50%. This is the number of people who show symptoms. This is a huge number. It is hard to convey the seriousness of this.

Taking this as face value, it means that the flu will likely spread around the world and infect maybe 20% of the world population or 1.2 billion people (60 million Americans) If the "clinical attack rate" is 40%, that means that 480 million people (24 million Americans) will get sick. Note that the US has only a million hospital beds. It has enough antiviral medicine (Tamiflu and Relenza) to treat about 50 million people. So we likely have enough medicine. But we don't have the capacity to treat so many people. In poor countries, they lack the medical capacity and the medicine. This scenario would likely lead to total chaos if not huge numbers of deaths.

The death rate is so far unknown but probably nothing like the 1918 virus. It seems to lack the key gene that made the 1918 flu do so much damage to the lungs. But viruses can mutate and it seems new viruses like this tend to mutate more easily. Who knows where that would lead. The 1918 flu started in a milder wave and came back as a much more deadly virus the following winter. How deadly can a flu get? The H5N1 bird flu killed 60% of infected people but thankfully did not spread easily between people. The death rate for the 1918 flu was probably about 3%.

For the time being, I am not going to freak out. But keep an eye on this and think about how you will respond if the facts begin to indicate that it is worse than we now think. Even if the death rate stays low, this could cause real problems.

Portfolio.com on Geithner

2009-04-22T15:21:00.001-07:00

Portfolio.com has a cover story on Tim Geithner which is decidedly negative.

Another ray of hope

2009-04-20T22:23:00.000-07:00

Neil Barofsky seems to be taking his job seriously as TARP watchdog.

He seems to be warning about the same kind of abuses that I am worried about. That is good news for Americans.

But it is bad news for bank stocks and probably bad news for the markets. It means that the banks are going to have a harder time swindling their way out of trouble and so the question of how to save the banks is back on the table. Sorry, it won't be by defrauding hard working Americans. On to plan B or it is M by now.

Strange NYTimes article

2009-04-19T19:44:00.000-07:00

This New York Times article is certainly strange. Apparently the Obama administration is floating the idea that they have more ammo for recapitalizing the banks than everyone thinks.

Oh,really? What is the latest shennanegans? Well, remember that $350B in TARP money that Paulson put into the 8 largest banks. Well, that was preferred equity shares. That is sort of like a loan that never needs to be paid back (except on liquidation) where the company must pay a fixed dividend to these shareholders before paying the dividend to common shareholders. The yield (annual dividend over the price) was a measly 5%. What a great deal for the banks! But if times gets tight, it can stop paying both dividends without there being an event of default. The shares are non-cumulative so missed dividends never need to be paid back.

Because not paying the preferred dividend is not an act of default, this is considered equity not debt. Preferred equity is not counted any differently than common equity in the three capital ratios that are used by bank regulators although there are guidelines on how high the preferred portion can be - more than half is frowned upon.

These rules are well established in banking. Until now that is. Now the Fed wants to redefine what equity means. Now they want to pretend that all that matters is tangible common equity, bank regulation tradition be damned. So now you can increase the tangible common equity by converting the preferred equity to common equity. Presto, the banks have more capital!

Huh? This does not increase the total equity by one bit. It does nothing to change ASSETS-LIABILITIES which is the definition of equity. They have just shuffled the form of the equity. Really, they have just lowered the standard of acceptable capital levels and made it so that the banks fit the lowered standard.

While they are at it, maybe they can change the definition of liabilities as well. They can redefine it as all debts except those to the federal government. There you go again, instant improvements in capitalization! Just ignore those liabilities when calculating capital ratios.

Honestly, what a joke! Do they really think the market is going to buy this nonsense. The market knows what capital means and they know these banks ain't got it.

Latest T2 Partners presentation on housing

2009-04-18T21:17:00.001-07:00

T2 Partners Presentation on the Mortgage Crisis-4!3!09 3 T2 Partners Presentation on the Mortgage Crisis-4!3!09 3 optionarmageddon

Publish at Scribd or explore others: Finance Business & Law subprime housing crisis

China's bubble economy

2009-04-13T10:43:00.000-07:00

While many people trumpet the strength of the growing Chinese economy, there are other signs that it is on the verge of collapse. Note the following Financial Times article .

Property prices in China are likely to halve over the next two years, a top government researcher has predicted in a powerful signal that the country’s economic downturn faces further challenges despite recent positive data.

The property market, along with exports, were leading drivers of the booming Chinese economy over the past decade and the slumps in both have taken a heavy toll.

Cao Jianhai, professor at the Chinese Academy of Social Sciences, a leading government think tank, said an apparent rebound in the property market was unsustainable over the medium term and being driven by a flood of liquidity and fraudulent activity rather than real demand.

He told the Financial Times he expected average urban residential property prices to fall by 40 to 50 per cent over the next two years from their levels at the end of 2008.

"being driven by a flood of liquidity and fraudulent activity". Hmm, why does that sound familiar? Ah, that's right. It sounds like our housing market in 2006.

Real estate agents in the residential property bellwether of Shanghai said the market seemed to have bottomed out as a result of government stimulus measures, falling prices and pent-up demand from owner-occupiers.

But Mr Cao said preliminary government investigations had turned up numerous examples of real estate developers using fake mortgages to offload apartments on to the books of state-run banks facing enormous pressure from Beijing to rapidly increase lending to boost the economy.

Does that sound like the basis of a sound economy? A sound housing market is one in which houses are affordable for the majority of the population. So how is that working out in China?

At a national level, average housing prices tripled between 2003 and the peak in mid-2008 and are now 10 to 12 times average income, which means 60 per cent of homebuyers’ monthly income must go to mortgage repayments, Mr Cao said.

Ok, I am pretty sure we all know how that story ends. Good luck China in your quest to prop up the world economy.

Here is more from the Times Online.

China faces a surge of bad loans and speculative bubbles as the country’s banks open lending and flood the market with record levels of money supply, economists are warning

... The peril appears to lie in the speed and geographical spread of lending: the mostly state-owned banks, scattered throughout both economically weak and strong parts of the country, are duty-bound to follow Beijing’s orders to lend. Few analysts believe that the banks have the mechanisms or expertise to assess the quality of the borrowers.

In short, China has a command economy. It doesn't have a real banking system. The "banks" in China are just state owned entities who don't know how to say no to loans. Even if China keeps growing due to this forced lending, it will eventually end badly. It is classic boom bust ponzi lending. Since capital is being allocated by fiat rather than based on economic soundness, it will result in inefficiency and waste and ultimately economic stagnation. Another result will be excess supply which will export deflation to the rest of the world which the boom finally goes bust.

William Black Interview

2009-04-12T21:49:00.001-07:00

Great interview on PBS with former banking regulator William Black.

Get the word out and forward this around.

Interesting fact about imports/exports.

2009-04-09T21:38:00.000-07:00

China sends us manufactured goods and we send them pieces of paper. No, I am not talking about US dollars or Treasury bills. We literally send them pieces of paper. Recycled paper is the biggest US export by ocean going container.

The list of biggest exporters and importers is here . Basically China and other high-export countries send us ocean going containers full of high value goods like TVs, cars, furniture etc, the stuff that gets sold at Walmart (the biggest importer). We send these shipping containers back filled with recycled paper which basically has little value. The Chinese turn the paper into cardboard so they can send us more cardboard boxes full of high-value goods. Pretty depressing huh?

We export lots of other high-value goods such as software, financial services etc. But not much in the way of tangible goods sent by ocean going container. Paper is pretty heavy though so many containers go back empty when ships hit their weight limit. Next time you want to take a trip to China, bribe some seaman to let you bum a ride in one of their empties.

Corporate Earnings plunging

2009-04-09T16:13:00.000-07:00

Here are the total quarterly operating earnings for the S&P 500 companies (annualized). This excludes non-operating write-downs. Actual "as-reported" GAAP earnings are worse. Quite a plunge! S&P estimates that earnings will rebound some in 2009. I have my doubts. The S&P 500 is currently (Feb 10, 2009) at 834. So if 2009 earnings come in around 55, and the S&P trades at 15 times that, we come up with 825 which is about the current price. If it comes in at 30 (basically where it is in Q4 2008), the S&P may drop to 450 using 15X earnings.

The S&P earnings for 2008 were $27.7 using the Q4 estimates with 85% of companies having reported. The S&P 500 is trading at 827 which puts the P/E ratio at 29.86 which is one of the highest ever. According to the trailing PE, stocks are not cheap. In fact, they are amazingly expensive. However, there is something wrong with that argument. It has to do with the way things are averaged. For example, if the average PE is 29, one might think that there must be roughly half of companies trading at more than 29 times trailing earnings. Well, lets look and see. In the Dow 30, there are three companies with negative earnings in 2008 (C, GM and AA). Ignoring these three, here are the five with the highest trailing PE ratio: JPM (18.1), KO (17.0), MCD (15.1), INTC (15.0), WMT (13.5). Hmm, this is a funny kind of average when the top 5 have a lower than average PE. What is going on?

Well, S&P calculates the total earnings of the 500 companies making up the average. Then it is calculates the total market value. The it divides both by the same number (about 8700, called the divisor, it doesn't matter really) to report the S&P stock market index value and also the "earnings". The idea is that people then know about what the average PE is. However, this is not the same as < P/E >. Rather it is more like < P > / < E>. The two are not equal. For example, lets suppose that one company (lets call it Citigroup) loses $1 Trillion next year and goes bankrupt but the other 499 companies make $1.2 Trillion. Together then have made a net $0.2 Trillion. Lets say the total market cap of the 500 companies is $10 trillion. That looks like a PE of 50. Wow, pretty expensive right? Well, not really. Citigroup's weighting for the S&P is currently 0.27%. So if C goes to zero it reduces the index by a 0.27%. But then it gets replaced in the index by some other company that is unlikely to lose $1 Trillion the following year. People owning the index say good riddance to Citigroup and move on. In reality, they own an index at 8.3 times earnings not 50. Stock holders have limited liability. If C goes to zero, it doesn't matter how many gazillions of dollars they lose. The stock holders are not on the hook for it. Stock's can't have negative value.

It is important to consider the earnings weighted by the same weighting used in the S&P index which is by market cap. These can be found here .
The top 45% of the index includes only two banks, JPM and WFC. If you wipe out the shareholders of JPM, C, BAC, GS and MS you have wiped out only 4.02% of the total index. That is just a bad day in the stock market these days. The S&P 500 companies have annual operating earnings of roughly $500B. These five banks could easily lose that much money in 2009 if they properly market down assets to market value.

So lets go back to the current situation and look at some numbers gathered from my Morningstar account. I screened for the largest 500 companies by market cap and trading on either the NYSE or NASDAQ which is a decent proxy for the S&P 500 companies. Then I can rank them by various quantities to get some statistics. Here are some results.

First the trailing 12 month PE ratios. The median is 10.0. The quartiles (25 and 75 percentiles) are 7.0 and 15.7. The median price-to-cash-flow is 7.3. The median forward PE is 10.3. So according to this, stocks are not particularly expensive. In fact those are below average valuations.

Of course, stocks could be expensive if earnings drop a lot and if analysts are wrong about next years earnings (almost certainly the case). For example the median price-to-book-value (P/B) is 1.9. The median return-on-equity is 18.7%. Both are pretty high still. For the major bear market bottoms of the 20th century (1920, 1932, 1949, 1974, 1982) the average P/B came down to roughly 0.5 almost four times lower than now. Profitability is still quite high. That is likely to change.

To see this, consider the ratio of corporate earnings to GDP. See chart here . This ratio should be mean reverting if capitalism is functioning properly. Excess profits should attract capital investment until the excess profits go away. This chart shows that the ratio peaked at 10% in 2007. The average value is about 6% with a low around 3%. It is probably best to assume that this ratio will drop to 3% before rebounding back to the mean of 6%. Looking at our chart above, we see that S&P 500 operating earnings peaked at about 90. So assuming constant GDP (a decent approximation), that means if the corporate earnings to GDP ratio goes to 3% before rebounding to 6%, the S&P 500 earnings will drop to 27 before rebounding to 54. The normalized earnings is probably close to this number, 54. The value of the S&P 500 is probably about 15 times this or 810 which is not far below today price of 827.

So stock are probably fairly valued. However it is still likely I think that they go lower. Usually after a period of over-valuation, there is a period of undervaluation. If earnings really hit 27 and the economy is really, really bad with unemployment over 10%, I would not be surprised for stocks to trade at 10 times normalized earnings or 540. If earnings drop to 27, that would be 20 times trailing earnings which might not appear cheap to people expecting the current conditions to continue indefinitely (which is human nature). That would still likely leave the average P/B above 1 which would well above previous bear market bottoms. Given the different nature of today's non-capital intensive, service oriented companies, that might make sense. If we have a depression, earnings could go lower still. Earnings were negative during the Great Depression. If we have something similar and earnings go negative, stocks will trade based on book value and if they fall to 0.5 book, that mean the S&P near 220. I don't see that happening but it is not outside of the realm of what has happened in the past.

####### Update ########
AIG is going to post a $60B loss for Q4 which is much worse than the $12B loss that analysts expected. This will bring done the Q4 number for the S&P by about $5.50. The trailing PE for the S&P is now about 36 which is the second highest ever. The only year that ended with a trailing PE this high was 2001 when it was 46.

######## Another update ###########
The Q4 is now done. I was right about AIG but underestimated other losses. The final tally for Q4 was -$23.25. Wow! S&P now estimates "as reported" earnings for the next three quarters. $7.32, $6.64, $7.46. Note that those three add up to only $21.42 so if they are right about these, the trailing 12-month earnings will be negative in Q3 2009.

Yes, I know, you can't make a sensible PE based on a negative number for earnings. For example the PE is predicted to be 1875 in Q2 and -450 in Q3. Ok, ok, lets look past "as reported" earnings and look at operating earnings which ignore one time losses and non-cash write-downs. We will make pretend that those things don't matter. S&P makes operating earnings predictions in two different ways: top-down estimates, looking at the macro picture and predicting total earnings and also a bottom-up picture, adding up the total earnings predicted by analysts of each company.

Using the top-down estimates, the forward operating earnings PE is 25 in Q3 and 18 thereafter. Using bottom-up estimates it is 18 in Q3 and about 12 thereafter. So there is a huge difference. I am more inclined to believe the top-down estimates especially if we are going to agree to ignore the "one-time" losses which have a habit of repeating themselves. I think analysts are making the incorrect assumption that companies can cost-cut their way back to profitability. I don't think this will work when everyone is doing the same thing. It just results in higher unemployment and less demand.

Stocks don't look so cheap to me.

Bingo!

2009-04-08T09:01:00.000-07:00

This article really nails it. It is one of the clearest explanation of what is going on, why it can't be stopped by traditional means and what we need to do to get out of it. In short, we are in a depression not a recession. The difference is that a depression is when people's collective action are self defeating. They all try to save, cut costs and avoid taking risk and this just results in economic collapse rather than the desired outcome of improved individual balance sheets.

The only solution is truly massive government intervention because only government can organize collective action. The trouble is that the Fed, US government as well as foreign governments have not yet come to this understanding. They are still resisting nationalizing the banks and undertaking massive fiscal stimulus. Yes, the Obama administration has passed a stimulus bill but this is not nearly enough. Nor are the stimulus packages from abroad large enough. It will also be necessary for all of the governments to coordinate this action. Government as well as the market in general is still convinced this is just a deep recession not a depression. The longer they deny this, the harder it will be to fix.

Sheila Bair to the rescue?

2009-04-07T07:44:00.000-07:00

The NY Times has a story in which Shelia Bair, head of the FDIC, says that the FDIC does not expect to absorb any net losses from Geithner's new PPIP idea. This restores within me a small bit of hope that the banks are not going to defraud their way out trouble at the taxpayer's expense, or rather not as much as the markets seems to be expecting.

Lets analyze this a bit at the macro level. If the FDIC does not take a net loss and the investors do not take a net loss then then the banks have to take the loss as they should. It is as simple as that... well sort of.

What the FDIC can do is raise their insurance premiums to collect back any losses in the future directly from the banks. If it has a cash flow problem, it is possible that they can borrow money directly from the capital markets with an implicit government backing.

If you trust Sheila Bair (I have a warm place in my heart for her) this cannot be good news for the banks or Wall Street. It means that the FDIC is not going to guarantee any loans in which it is likely to get screwed. That is, it is not going to guarantee any toxic asset purchases unless the price is low enough for the FDIC to come out OK in the long run. This probably means, lower prices and less leverage. Lower leverage means the investor's larger down payment will provide a larger first-loss cushion if the FDIC has to take over the assets.

Still, I think the FDIC will take some nominal losses. But I think they intend for the banks to pay for these losses through future FDIC premiums. This means that banks will be less profitable in the future even in they can survive. So really this is just a way for banks to postpone taking losses. Japanese lost decade, here we come!

Nice plot of total US credit market debt breakdown

2009-04-05T21:00:00.001-07:00

Some comments:

The Great Depression was partially caused by the vicious deleveraging of corporations and household. This time corporations are somewhat better off but households are worse and financials are a basket case. Remember, our money supply is determined by debt. Debt is money. If debt contracts, so will the money supply and this will lead to deflation.

Let's sum up the Geithner plan quickly

2009-04-03T00:22:00.000-07:00

Every trade is a zero sum game. There is a winner and a loser. One bets right and the other bets wrong even if it isn't clear immediately which is which. If there are three parties involved, it doesn't make a difference. The sum is still zero.

The pimps at Pimco are calling the Geithner plan a win-win-win plan. Everybody wins. The banks will make a profit, the hedge fund investors will make a profit and so will the taxpayer! Wow, that must be quite a plan to defy even logic itself.

The fact of the matter is that the banks are not dumb enough to lose money on this plan. The hedge funds are not dumb enough to lose money either. The only one dumb enough to lose money is the hapless taxpayer whose representative Tim Geithner is actually working for the other players.

The real American Patriot is a British guy

2009-03-28T12:09:00.000-07:00

No one does a better job at playing American Patriot against our parasitic banking system and their captive regulator, the Federal Reserve, than Willem Buiter of the Financial Times. After reading Buiter, you realize how morally bankrupt our financial system really is. No one in the American press writes as well as Buiter about the US financial system. There is no one defending the principles of Americanism better than this British journalist. Buiter's latest piece sums up the situation perfectly. I will be Bad-Blogger and quote it in its entirely. It is a must-read.

Willem Buiter of the Financial Times takes down Geithner and the Fed.

More on robbing the US tax payer and debauching the FDIC and the Fed

March 26, 2009 5:34pm
The US authorities have no money to fulfil their ambition of stopping large US banks from failing without taking them into public ownership. The $300 bn left in the TARP kitty is all that is available for recapitalising banks, purchasing toxic assets and providing other financial support. Congress has thrown its toys out of the pram and is unwilling to appropriate more funds for the rescue of the banking sector.

As an aside: it is astonishing that Congress and much of the US populace are apoplectic about $165 mn (perhaps $182 mn) of bonuses paid to AIG executives and employees, when $170 billion or so of public money is at risk (and tens of billions probably already gone out of the window) in the rescue of this most undeserving of companies. Perhaps you can only get indignant about what you can comprehend… .

The US authorities are reduced to begging, stealing and borrowing the rest of the funds they believe they will need. The two main proximate sources of funds are the FDIC and the Fed. The ultimate sources of funds will be (1) the US tax payer and the beneficiaries of future US spending programs that will have to be cut, (2) the holders of nominally denominated liabilities of the US state, including the monetary liabilities of the Fed and US Treasury bills and bonds.

Owners of dollar-denominated debt instruments will see the real value of their claims on the government eroded by future inflation if, as I expect, the recent and prospective future increases in the US monetary base (driven by credit easing and, in the future also be quantitative easing) cannot be reversed in the future. The main obstacle to such a reversal will be the US fiscal authorities, who are unlikely to let the Fed dump large amounts of US Treasury debt, acquired by the Fed as part of its quantitative easing program, into the markets.

I believe that the raids by the US Treasury on the FDIC and on the Fed are illegitimate and, in the case of the FDIC, quite possibly illegal.

The FDIC

The FDIC is supposed to be an independent agency of the US federal government. Its website tells us that “The FDIC receives no Congressional appropriations - it is funded by premiums that banks and thrift institutions pay for deposit insurance coverage and from earnings on investments in U.S. Treasury securities” . The FDIC also has no borrowing capacity except that granted it by the US Treasury.

The operating budget of the FDIC for 2009 is $2.24 billion, a big increase from the $ 1 billion set in 2008, but still a tiny number. Its current Treasury borrowing limit is $30 bn, again nowhere near enough to make an impact on the black hole that is the asset side of the balance sheet of the US cross-border banking system. With an insurance fund of just over $45 billion, the FDIC insures more than $5 trillion of deposits in U.S. banks and thrifts. The insurance fund is therefore less than one percent of the amount of insured deposits.

The near-demise of the US banking system means that, should even a single large deposit-taking bank go bust, there is not enough money in the kitty to pay off all insured depositors. The FDIC would have to borrow - hence the usefulness of the increase in the borrowing limit. It is both unwise and illegitimate to use that borrowing limit instead to subsidise potentially non-viable banks (likely to still be non-viable even after the subsidy) as well as the private investors who plan to purchase these banks’ bad loans through the Legacy Loans Program.

The FDIC’s Mission Statement is clear: “The Federal Deposit Insurance Corporation (FDIC) is an independent agency created by the Congress that maintains the stability and public confidence in the nation’s financial system by insuring deposits, examining and supervising financial institutions, and managing receiverships.” I don’t see anything there about guaranteeing debt from or loans to private entities wanting to buy bad loans from bad banks. The Federal Deposit Insurance Corporation Improvement Act of 1991 also does not, as far as i can see, authorise the FDIC to engage in the kind of quasi-fiscal activities it is engaging in through the Temporary Liquidity Guarantee Program (see below) and is about to engage in under the Legacy Loans Program.

But help is on the way! Senate Banking Committee Chairman Chris Dodd of Connecticut is proposing, in a bill submitted on March 5 2009 (the Depositor Protection Act of 2009) to increase the FDIC’s Treasury borrowing limit from $30 billion to $500 billion. With the deposit insurance limit now at $250,000 at least until the end of 2009 (up from $100,000) and so many large deposit-taking banks in the US insolvent but for past, present and anticipate future hand-outs from the tax payer, the increased borrowing limit of $500 bn may come in handy to make whole the insured depositors if and when one or more large banks keel over.

But this does not appear to be the use (the proper use) that the US authorities have in mind for it. Instead the increase in the FDIC’s Treasury borrowing limit to $500 billion is likely to be diverted to the entirely improper use of providing debt guarantees for debt used to co-finance the purchase bad loans from the banks under the Legacy Loans leg of the Private-Public Investment Program (PPIP). This quasi-fiscal role of the FDIC is on top of the earlier prima-facie illegitimate use of FDIC resources under the FDIC’s Temporary Liquidity Guarantee Program (TLGP), under which the FDIC guarantees newly issued senior unsecured debt of banks, thrifts, and certain holding companies.

The FDIC, under the TLGP also provides full coverage of non-interest bearing deposit transaction accounts, regardless of dollar amount. This is a legitimate use of its resources, albeit an unwise one. As of February 28, 2009 the amount of debt insured under the TLGP was more than $268 billion. After debauching the Fed to pay for the bail-out of insolvent US banks, the US administration is now subverting the purpose of another so-called independent government agency.

The debauching of the FDIC is, however, different in one respect from that of the Fed. The Fed has an independent source of revenue - seigniorage, that is, the revenue from issuing base money, part of which is non-interest-bearing (bank notes) and part of which (commercial bank deposits with the Fed) earns an interest below what the Fed earns on its assets.

The FDIC has no independent source of revenue (ignoring the premia charged for the deposit insurance, which is chicken feed). Getting the FDIC to guarantee loans is therefore just a cute and non-transparent way of having the US Treasury guarantee those loans. But it’s off the books, off-budget and off-balance sheet as far as the US Treasury is concerned. With a bit of luck the guarantees will not be called. And if they are called - well, that will be then and this is now. If the FDIC can insure $ 5 trillion worth of deposits with a mere $45 bn fund, think of what amount of lending the FDIC can guarantee when it borrows its full allotment of $500 bn! The bill will be presented to the tax payers later.

How large could the bill be, that is, how much money could be transferred from the US tax payers to the banks or the investment funds bidding for toxic assets?

The potential for subsidies to the private parties involved in the PPIP’s Legacy Loans and Legacy Securities Programs is truly astonishing. Jeff Sachs, in a recent Financial Times column, provides a representative calculation for the Legacy Loans Program. Note that this is targeted not at toxic assets (assets whose value is unknown) but on bad loans, whose (low) fundamental value can be ascertained without too much effort.

What follows paraphrases Jeff Sach’s argument and calculation. I put all of it in quotation marks, even though a few words have been changed.

“For every $1 of bad assets that an investment fund authorised under the PPIP buys from the banks, the FDIC will lend up to 85.7 cents (six-sevenths of $1), and the Treasury and private investors will each put in 7.15 cents in equity to cover the balance. The Federal Deposit Insurance Corporation (FDIC) loans will be non-recourse, meaning that if the bad assets purchased by the investment fund fall in value below the amount of the FDIC loans, the investment funds will default on the loans, and the FDIC will end up holding the bad assets. The investment fund is not responsible for part of the FDIC loan not covered by the liquidation value of the bad assets. At most it loses the equity it put in.

Consider a portfolio of bad assets with a face value of $1 trillion. Assume that these assets have a 20 percent chance of paying out their full face value ($1 trillion) and an 80 percent chance of paying out only $200 billion. The fair value of these assets is given by their expected payout, which is 20 percent of $1 trillion plus 80 percent of $200 billion, i.e. $360 billion.

Investment funds will bid for these assets. It might seem at first that the investment funds would bid $360 billion for these toxic assets, but this is not correct. The investors will bid substantially more than $360 billion because of the massive subsidy implicit in the FDIC non-recourse loan. The FDIC makes a “heads you win, tails the taxpayer loses” offer to the private investors.

With a little arithmetic, we can calculate the size of the transfer from the tax payer to the banks and the investment funds. In this example, the private investment fund will actually be willing to bid $636 billion for the $360 billion of fair value of the bad assets, in effect transferring excess $276 billion from the FDIC (taxpayers) to the bank shareholders.

Under the rule of the Geithner-Summers Plan, private equity investors and the TARP each put in 7.15 percent of the purchase price of $636 billion, equal to $45 billion each. The FDIC will loan $546 billion. (All numbers are rounded). If the bad assets actually pay out the full $1 trillion (which happens with 20 percent probability), there will be a profit of $454 billion, equal to $1 trillion payout minus the repayment of the FDIC loan of $546 billion. The private investors and the TARP will each get half of the profit, or $227 billion.

Since this outcome occurs only 20 percent of the time, the expected profits to the private investors are 20 percent of $227 billion, or $45 billion, exactly what they invested. Similarly, the TARP’s expected profits are also equal to the TARP investment of $45 billion. Thus, both the TARP and the private investors break even. As competitive bidders, they have bid the maximum price that allows them to break even.

The bank shareholders, however, come out $276 billion ahead of the game, while the FDIC bears $276 billion in expected losses! This transfer occurs because the investment fund defaults on the FDIC loan when the bad assets in fact pay only $200 billion, an outcome that occurs 80 percent of the time. When that happens, the investment fund is “underwater” (holding more in FDIC debt than it gets in payouts on the bad assets). The investment fund then defaults on its debt to the FDIC. The FDIC gets $200 billion instead of repayment of $546 billion, for a net loss of $346 billion. Since this outcome occurs 80 percent of the time, the expected loss to the taxpayers is 80 percent of $346 billion, or $276 billion. This is exactly equal to the overpayment to the banks in the first place.”

The problem of collusive behaviour between the private investment funds and the banks for whose assets they bid will undoubtedly rear its ugly head. Indeed, the banks could set up their own investment funds (through SPVs registered in places where information is even harder to obtain than in Liechtenstein) and so make sure the underpriced put provided by the FDIC through its non-recourse loan can indeed be exercised.

This is a very bad deal for the tax payer indeed. And the Legacy Securities Program works on the same principles, although the non-recourse leverage provided by the Fed will be less than that provided by the FDIC for the Legacy Loans Program.

The Fed

I have written at length before about the ever-expanding quasi-fiscal role of the Fed. This began as soon as the Fed began to take private credit risk (default risk) onto its balance sheet by accepting private securities as collateral in repos, at the discount window and at one of the myriad facilities it has created since August 2008. It is possible - I would say likely - that the terms on which the Fed accepted this often illiquid collateral implied even an ex-ante subsidy to the borrower. But the Fed is refusing to provide the necessary information on the valuation of the illiquid collateral, interest rates, fees and other key dimensions of the terms granted those who access its facilities, for outsiders, including Congress, to find out what if any element of subsidy is involved.

Should the borrowing bank default and should the collateral offered also turn out to be impaired, the Fed will suffer an ex-post capital loss on its repos and other collateralised lending operations against private collateral. It does not have an indemnity from the Treasury for such capital losses.

The Fed also created the Maiden Lane I (for Bear Stearns toxic assets), Maiden Lane II (for AIG’s secured loans and Maiden Lane III (for AIG’s credit default swaps) special purpose vehicles in Delaware. The losses made by Maiden lane II and III when the Fed paid off the investors (counterparties) of AIG at par, were, however, not booked on the balance sheets of the two Maidens, but were booked on AIG’s balance sheet, keeping Maiden Lane I and II, and the Fed, clean for the time being. The financial shenanigans used by the Fed (in cahoots with the US Treasury) to limit accountability for these capital losses are quite unacceptable in a democratic society. Clearly, the US authorities are using the financial engineering tricks and legal constructions whose abuse by the private financial sector led to our current predicament, to engage in Congressional- and tax payer accountability avoidance/evasion. To watch the regulators engage in regulatory arbitrage is astonishing.

With the onset of credit easing, the Fed now also takes private credit risk onto its balance sheet through outright purchases of private securities (including commercial paper and possibly corporate bonds) and by making non-recourse loans through the TALF (that is, though unsecured lending). There is no full (100 percent) Treasury guarantee for this credit risk taken by the Fed. In fact, the $1 trillion TALF has at most $100 billion of Treasury funds to back it up.

I don’t envy Ben Bernanke the extremely uncomfortable position he finds himself in. He can insists on minimizing the quasi-fiscal role of the Fed by insisting on a 100% US Treasury guarantee for any credit risk, other than the credit risk of the US sovereign, that the Fed assumes. In that case the amount of financial ammunition that the US state, broadly defined to include the US Treasury, the FDIC and the Fed, have at their disposal to deal with financial sector reconstruction is inadequate. Or he can compromise the independence of the Fed and let the central bank be used as an off-balance sheet and off-budget special purpose vehicle of the US Treasury, reducing transparency and undermining democratic accountability. Talk about a rock and a hard place.

Even faced with this kind of dilemma, however, certain practices are clearly improper and unacceptable. The (ab)use of the Maiden Lane SPVs to hide some of the losses made by the Fed and the US Treasury and to channel money non-transparently to AIG counterparties (in the case of Maiden Lane II and III is just plain wrong. So is the refusal to make public the information required to judge the appropriateness of the terms and conditions attached by the Fed to the use of its facilities.

Conclusion: we need banking; we don’t need these banks

The raiding by the US Treasury of the financial resources of the FDIC and the Fed is not just unwise, illegitimate and possibly illegal, it is also unnecessary. For some reason, perhaps an example of cognitive capture of the Treasury and White House policy makers by the spin doctors and skilled persuaders of Wall Street, Tim Geithner, Larry Summers, Ben Bernanke and Sheila Bair all appear to believe that to save the banking sector you have to save the existing banks as going concerns. Indeed, in view of the astonishing survival rate of CEOs and other top managers in the zombie banks, they may even believe that to save the banking system you have to rely on the continued contribution of those whose past best efforts brought us this crisis and debacle.

All that matters is banking as a function and activity, that is, new lending and borrowing by banks. When a massive disaster strikes the existing banks, it is essential to decouple the stocks of existing assets and liabilities from the flows of new lending and borrowing. The good bank model does that.

Both Fed Chairman Bernanke and US Treasury Secretary Geithner have called for the creation of a special resolution regime (SRR) with prompt corrective action (PCA) for non-bank systemically important institutions. Bernanke clearly had AIG in mind when he told the US Congress on March 20, that there was a need for a special insolvency regime that “permits the orderly resolution of a systemically important nonbank financial firm”. With a proper federal resolution authority, AIG could have been put into conservatorship or receivership and could have been unwound slowly, with not just the shareholders but also the unsecured creditors taking the haircuts (losses) justified by the financial condition of AIG. Bernanke’s words that a proper special resolution regime for non-banks would permit the Conservator or Administrator to “unwind it slowly, protect policymakers, and impose haircuts on creditors and counterparties as appropriate,” truly are music to my ears.

I also agree with Chairman Bernanke’s statement that “given the interconnected nature of our financial system and the potentially devastating effects on confidence, financial markets and the broader economy that would likely arise from the disorderly failure of a major financial firm in the current environment, I do not think we have had a realistic alternative to preventing such failures.”

But with a proper SRR, there can be orderly failures of major financial firms, banks and well as non-banks. The US has a proper SRR for FDIC-insured banks. That now includes all Wall Street banks. The orderly failure and resolution of one of more Wall Street banks need therefore pose no threat to financial stability. Indeed, with the limited resources the US authorities have at their disposal, the failure and orderly resolution of all dodgy Wall Street banks may well be the best way to stabilise the financial sector and to get financial intermediation - new lending and borrowing between banks and the non-financial sectors - going again. With the information the authorities now are acquiring (I hope) about the soundness of the large banks (whose balance sheets and financial fitness are being scrutinised as part of the Treasury’s Capital Assistance Program), the authorities will soon know which banks should be allowed to survive and which ones should be put out of their and our misery.

Why hasn’t the FDIC’s special resolution regime been used to resolve the large Wall Street zombie banks, but just the tiddlers in the boonies (OK, add WAMU)?

Any large, deposit-taking Wall Street bank (the old bad bank or OBB) with a significant amount of non-insured deposit liabilities on its balance sheet and a survival-threatening amount of toxic assets, can be split into a new good bank and a new bad fund virtually with the stroke of a pen, using the proposal by Bulow and Klemperer and Hall and Woodward (see also Buiter (1) and (2)). The new good bank gets the insured deposits and the non-toxic assets. If liabilities net of insured deposits of the OBB exceed toxic assets, the new good bank will have positive equity. Give that equity in the new good bank to the new bad fund. The new bad fund does not have a banking license and cannot make new loans or acquire any new assets. It simply manages down its portfolio of existing assets in the interests of its owners. It gets no further government financial support of any kind. If it fails, it goes into Chapter 11 or Chapter 7. Both the shareholders and the unsecured creditors can be expected to take a hit. That is as it should be.

If the new good banks needs additional capital, it can go to the market or obtain it from the government. Government guarantees (just from the Treasury, please) are only granted to new bank borrowing or bank lending.

Save banking. Allow the zombie banks to die.

The unsustainable rally

2009-03-28T10:33:00.000-07:00

The stock market has been in bull market mode for the past three weeks. Many are saying that we have seen the bottom are now in a bull market. I think this is all hogwash. Here are some reasons why this is not the bottom:

The economy is not improving nor is it likely to improve soon. We may be nearing the low in home sales and also auto sales. But that doesn't mean we will have a quick rebound in either. Sales of homes or autos require financing. While financing for either is available and at reasonable interest rates, it is only available for those with good credit and money for a down payment. That means that most Americans and businesses are excluded from more credit.

Nobody with good credit wants to borrow anyway. In an economy like this, there are few places to invest so why borrow money? Why would anyone borrow money to open a restaurant when so many are failing and closing down? Businesses are being penalized for having lots of debt so why would any business add more debt right now? House prices are falling so fast that it makes sense to wait to get a lower price in the future.

The key thing to note here is that you can only lever up once. Once you have turned the balance sheet of a country into a heavily indebted one, you can't add any further credit. The Fed and Treasury are desperate trying to find someone else capable of levering up and continuing the spending. Who is available? The government of course is one. The government can borrow and spend and offset the retrenchment in spending to some degree. But there are limits there. If they add much more Federal debt, the Fed will have to purchase it. This is obviously just printing money and eventually our foreign creditors will say enough is enough and stop buying dollar denominated debt.

The other party is private capital: hedge funds and private equity who will always borrow if they can be assured at getting a good return on the borrowed money. Geithner's plan is to lever up these groups in order to offload some of the toxic assets on bank balance sheets. This plan will face some obvious political problems. There is some serious danger that taxpayers will get stuck with some major losses which will make Geithner and Obama's chance of keeping their jobs quite slim. This plan can only work if private capital ends up making a profit. But if the profit is too large, this will stoke populist outrage and for good reason. It is already looking like a massive wealth transfer from the taxpayer to banks and private capital. Some have called this the biggest wealth transfer since the government gave away land to the railroads in the 19th century, the beginning of the last gilded age.

Even if this dicey plan works, they are really just ways of inflating out of the debt problem. Will the rest of the world who holds dollars as reserve currency put up with us debasing the currency to avoid paying the price of our profligacy? We will find out this week at the G-20 meeting. My guess is that this week will coincide with a loss of faith in the current rally. The market will realize that the rest of the world is not on board with the US plan of printing our way out of trouble. You just have to look ahead a little further. What is the Bernanke/Geithner plan really? What is the endgame? Is there really any reasonable way for this to turn out OK? I think not. I am using this really as a chance to sell stocks that are turning up due to the hope of economic recovery although I hold very few of them anyway. Gold is looking more and more attractive as is resource stocks like Uranium miners. Recession resistant, low debt, multinationals that have a high fraction of sales in other currencies also look good, like my long-held core position in Johnson & Johnson. Eventually I think China will get tired of buying treasuries and will start buying up our multinational companies in addition to commodities.

Why are there no homebuyers?

2009-03-22T10:05:00.000-07:00

House prices will continue to drop. The reason is simply supply and demand. There are lots of houses for sale and too few buyers. Why are their too few buyers? Lets list the reasons

1) The speculative buyers are gone. Speculative buyers are non-existent when prices are dropping. They know there is no point in buying until prices level off. They were probably at least 10% of the market at the top of the bubble.

2) The subprime and other uncreditworthy buyers can no longer get loans even if they wanted them. They were at least 20% of the market at the top of the bubble.

3) Before the bust, you didn't need a down-payment. Now you do. A 20% downpayment on an average $200K house is $40K. In addition, many banks now want to see enough liquid resources, cash, bonds etc, to cover 6 months of principal and interest. That adds another $6K for this house. How many people have $46K sitting around in cash? We don't need to speculate. A Met Life study was just published on this. The question was, "How long could you meet your financial obligations if you lost your job. Only 15% of people said longer than 6 months. For people younger than age 44, the natural home buyer demographic, the percentage is 9.5%. But to put down a 20% down payment you would really need this answer to be at least a year. The number who answered that was 10% overall and 5% for those under age 44. How horrifying is that statistic for those hoping the housing market will rebound? The stringent requirements on down payment and liquid resources now being demanded by banks can be met by about 5% of the natural home buying population!

4) If people had money before the bust, they probably lost much of it in the stock market. If you were young and were saving up money to eventually buy a house, you probably had most of that in the stock market. That is what your financial advisor would have told you to do. If you are young, you want a "risky" portfolio they said. You probably have about 40% less now.
If indeed you just lost 40% of your wealth, you are probably not looking to make major purchase, especially an asset that is still falling dramatically in value. In addition, you are probably worried about losing your job in this terrible economy. So why buy until the economy recovers and you are sure your job is safe.

So to sum up, about 70% of households do not have enough liquid savings to buy a house. This may be even higher for the subset of people that no not already own a house. The supply of possible home buyers is probably only 1/5 of what it was at the top. The supply of homes is only down about 20% from the peak. So supply and demand imbalances mean that house prices will continue to fall until a balance is reached. There is only two ways out of this situation. One is to wait several years for people to save money and for house prices to fall to more affordable levels. The other is for the government to subsidize housing and bring the uncreditworthy back into the market. I don't see that happening given all the anger at these junk mortgages being made in the first place.

Now there is mortgage insurance and FHA for people with no down payments but that adds more in fees on top of higher mortgage rates for people with poor credit. These people are probably paying 8% interest rates including MI. Why not wait? If you wait, you can save money to increase your down-payment, improve your credit score and in addition benefit from the fall in house prices. In addition, there is talk that the Obama administration will offer 4.5% fixed rate mortgages to help move housing inventory. If you wait a couple of years, save money, get a much lower interest rate and benefit from a 20% drop in home prices, you might reduce your mortgage payment by almost half.

So waiting is the obvious thing to do. Because of this, house prices should drop for another few years.

How to scam the Geithner plan

2009-03-21T19:27:00.000-07:00

The Geithner plan is nothing but a scam to stick the taxpayer with the losses that should go to the banks' shareholders first and the banks' bondholders second.

Basically the plan works like this. The Fed or Treasury loans money to some investor. This is a no-recourse loan with say 3% down on the part of the investor.

Yves at Naked Capitalism has already started this thread so lets take her example.

Lets say the bank, Citi for example, has an asset with face value $100MM carried on the books at $80MM and which is currently getting markets bids at $30MM. Lets say that it turns out to be worth $50MM and that it takes 5 years for this to become evident. So if Citi is forced to selling into the market now or mark-to-market they will take a $70MM loss or an additional $50MM loss from the present write-down. If they hold to maturity, they will lose $50MM total and $30MM from the current mark.

Now if some investor shows up and wants to make a bid at $75MM with the Fed's borrowed money, they are risking only $2.25MM (3%) of their own money. Citi now has to write down $5MM more on this sale. This plan saves them $25MM.

In this case, the investor loses their bet and ends up losing $2.25MM. The bank has the $5MM write down and the taxpayers loses $22.75MM. Clearly the bank is getting the best deal.

But what if no investor wants to bid? How can the banks scam this system? It is not hard to come up with ways. Let me list a few possibilities:

1) The bank could make a no-recourse loan to the investor. Now the investor really has nothing to lose. The bank can only lose the difference between their mark and the bid plus the loan to the investor.

2) Another way that Yves brings up is for the bank to sell a CDS to the investor that pays off if the assets go bad.

3) The investor bids high with intent to lose in some quid-pro-quo with the bank. Maybe the bank will give them a loan at low interest rate or some other favor. This would probably be completely undetectable.

4) The investor could just buy call options on the bank's common stock and then bid for all of their crummy assets at face value or even higher. How about that!? They would be throwing away all of their investment purposefully in order to buy a large piece (maybe even all) of a clean bank. This way would maximize taxpayer losses. It would not even have the involve conspiracy with the bank. It is really just a way of using the enormous leverage to manipulate the stock price of the bank.

The reason why it is so easy to think of ways to scam this system is that it is inherently a scam from the beginning. These hedge investors are sophisticated and are sure to find ways of hedging their exposure so that is a chance of a big return with no risk. It is a complete hand-out to them. It is obviously a hand-out to the banks. That is the whole point. The taxpayer is the fish at the table. They are obviously going to get screwed one way or the other. This plan stinks of corruption and must be rejected.

The tide is turning

2009-03-21T10:04:00.000-07:00

It is easy to conclude that Americans are stupid. How could they vote Bush into office twice? How can they not understand how Washington really operates as one party dedicated to maintaining the dominance of the financial elite. Well, Americans are not really stupid. Rather, they are just distracted. Americans work harder than any other people. A typical couple with children both work 40 hours a week or more. They have a long commute on top of that and when they are home, need to do all the business of running a household as well as spending some time with the family. In the their meager spare time, they try to relax. Most don't feel that they need to fully understand the functioning of the financial system or deep questions of political philosophy. When it comes to politics, most make up their minds quickly. They go with their gut. They certainly don't have time to do in depth research into the issues. That is what the news is for right? Well, that is the other problem. The news has become dominated by large corporations and doesn't offer a wide spectrum of opinions. This isn't conspiracy theory. They are just businesses and have learned that the most profitable business model is to focus on feel-good entertainment not highly controversial subjects. News stations have learned that you get more viewers when you focus on Eliot Spitzer's sex scandal than the UN oil for food scandal or the travesty in stealth bail outs of powerful financial firms.

But the times are a changing. People laid off from work, suddenly find themselves with more time to think about why they are out of work. The moral and financial bankruptcy of our way of life is becoming all to obvious. It was common sense after all, that a unsustainable trend could not continue. House prices couldn't rise forever with wages being stagnant. The Chinese wouldn't finance our over-consumption forever. Every adult who has ever dealt with their own household budget gets this now. That is why 45% of Americans think we will have a repeat of the Great Depression. This number is perhaps only 10% for actual economists who are supposed to know better. However what economists think doesn't matter. It is the spending and investment habits of ordinary Americans that will determine if demand returns enough to support the economy. If people think we will have a Depression and act accordingly, you can be assured that we will.

The Obama/Geithner/Summers/Bernanke plan of financial engineering our way out of this crisis has zero support. The people don't buy it. The markets don't buy it and even the news organizations, for example New York Times's Paul Krugman don't buy it.

It is all pretty simple when you look at the big picture. The wealthy class of the world, the net savers, made bad loans to the net borrowers and that money has been spent or transferred to others. Those loans will default and the money is not coming back. Therefore the wealthy lending class has lost much of their wealth. The Obama plan so far has been to make pretend that the money is not yet lost. If we could all just clap our hands and wish Tinkerbelle would come back to life, then Tinkerbelle will come back to life. And that might work, if people really are stupid, if they are able to ignore the fact that they are out of work and keep spending in an unsustainable way. If they can only ignore that their house and stocks have fallen in value by half. This of course is ridiculous. The Obama plan is on its last legs.

This wonderful video shows an interview of Brad Sherman, Democrat from California, telling the CNBC hosts that the emperor has no clothes. The Zeitgeist is prominantly on display. The CNBC hosts represent the old way of thinking; that the system must be propped up at all cost to avoid an apocalypse. This populist uprising will lead to the end of capitalism as we know it, they say. Sherman doesn't buy it. A system where capitalists can make outrageous profits but need the tax payer to remove all the downside risk is not capitalism at all.

What is wrong with the Wall Street culture?

2009-03-20T19:25:00.000-07:00

Goldman Sachs put on a little dog and pony show today to explain to the witless public that they had almost no net exposure to AIG and so the bail out of AIG was NOT a de facto bailout of Goldman.

This is how it works. Goldman and AIG had a special business relationship. Goldman bought junk mortgages from fraudulent, predatory lenders and other toxic assets and bundled them into securities to sell to some unsuspecting fool such as a municipal pension fund in Norway . To convince these utter marks that Goldman had some skin in the game, they held on to some of the mortgage exposure. See, if they are good enough for Goldman, they are good enough for your stupid Norwegian backwater. Except, they didn't really keep the exposure on the books. No way! They aren't stupid. They hedged this exposure with AIG. They bought insurance contracts with AIG, the so called credit default swaps (CDSs). So if the shit hits the fan in the mortgage market, Goldman will be OK even if the Norwegians get their cold white asses handed to them.

But then their business partner, AIG, started to look kind of sickly. Whoops. Looks like that hedge might not be reliable. How do we hedge our hedge? At this point there was no one else willing to write a big insurance contract against mortgage defaults since they were already defaulting. No one sells flood insurance during a flood. If AIG goes down, Goldman would as well. How would Goldman get out of this one? By shorting the bejesus out of AIG, that's how! They took out CDSs on AIG that would pay out if AIG went down. That's right. They bet that their business partner would fail so that if they did, on the whole, they would come out OK. So in the end, says Goldman, we couldn't care either way what happened to AIG, the fools getting foreclosed on or those dumb Norwegians. We took responsibility for our company and made sure that we would come out OK regardless what happened. So we are innocent of all these accusations of needing a stealth bailout.

What really amazes me is that they thought this would somehow convince people to leave them alone. See, we didn't need a bailout. We already bet that AIG would fail. In fact we bet that all of you would fail. We have no exposure to any of you. We are betting against Norway as we speak. Pretty sure they are going down. We should know since we are the ones that sold them all this garbage.

This culture of Wall Street is now about forming business relationships and then making sure you have no "exposure" to the fate of these partners. That is, business relationships are now like some disease that you are get "exposed to". Prudent business policy now is to actively bet against your business partner's very survival so that if they go down, you come out just fine. What kind of culture are we breeding on Wall Street. It is everyone for themselves. No one trusts anyone. No one is willing to form normal business relationships where you and your partner are truly in the same boat. Goldman's meeting today displayed this more clearly than I have seen before. The amazing thing is that didn't even consider that what they were admitting to was worse than what they were trying to defend their company against.

The Great Steve Keen

2009-03-14T12:34:00.000-07:00

Steve Keen wrote an article in February called The Roving Cavaliers of Credit which struck me as pretty brilliant and very deep.

The idea's expressed by Keen in this article perhaps are not novel but, as is frequently the case, sometimes brilliant writing is about summarizing what is already known, pointing out the importance of a particular point of view and demonstrating what the consequences must be.

Keen is an economist, that is, he has a Ph.D. in economics, but might be described as a rouge economist. He thinks most of what passes for economics is bunk; a view I happen to share. He wrote a book called "Debunking Economics: The Naked Emperor of the Social Sciences".

The main idea in his "Cavaliers" essay is that we don't actually have a fiat currency controlled by the whim and printing presses of central banks like many believe. Rather we have a debt based currency. Debt is money. Steve's blog is appropriately called Debt Watch. Therefore, the quantity of money and also economic growth has more to do with the willingness of people and institutions to borrow more so than the actions of the central bank. Eventually of course a debt frenzy has to reach a point where no one wants to borrow anymore even if interest rates are zero. No more debt is taken on and so no more money is created. At that point, deflation must occur and there is nothing a central bank can do about it.

The root cause of the crisis

2009-03-08T22:01:00.000-07:00

I have been trying to distill the most elemental cause of this great bust. There have been many things suggested such as: too easy monetary policy by the Fed, government intervention in the housing market, excessive greed by Wall Street, deregulation of financial markets etc.

Clearly, all of these things contributed. Most however are really cogs in the feedback machine. What is the root cause of it all?

Actually Alan Greenspan suggested what I think is the best explanation.

The US built up so much debt simply because it was cheap to borrow. Interest rates like all prices in a market economy are set by supply and demand. Now, its is true that central banks can manipulate certain rates in the short term. However most central banks claim to be targeting inflation. That means that they raise rates when they see inflation rising and cut rates when they see it ebbing which usually occurs when recession seems imminent. So in this view, central bankers don't really have much freedom. The best interest rate is the one that allows economic growth with low and stable inflation.

Long term interest rates are set in the market place and depend on the supply of loanable funds and the demand for loans. The interest rate is just the price where supply and demand meet. If inflation is high, fixed income investors demand a higher interest rate.

But inflation, at least the measure reported by the government, has been dropping even since the recession of the early 80s. The best explanation of why is probably the globalization phenomena and the cheap wages of developing countries like China and India. These countries provided cheap labor which resulted in cheaper priced goods which put an end to the wage-price spiral that dominated in the 1970s.

So when interest rates dropped, US debt doubled from 150% of GDP in the early 80s to nearly 300% now. Since the interest rate was lower, this large debt load was serviceable. For the household sector, debt service as percent of personal disposable income went from 11% to 14% which doesn't look as extreme as the total debt increase.

Now unfortunately this debt binge led to financial bubbles and the rest is history. However, the key economic feature is the disinflationary impact of the cheap labor from emerging markets providing a major source of global supply.

However, I think there is another economic phenomenon which gets much less notice. This is the rise of savings capital. The last 50 years has seen a huge increase in the percent of total assets held by institutions rather than individual. For example, pension funds, banks, insurance companies, central banks now hold the majority of the worlds financial assets. The decrease in inflation starting around 1980 accentuated this even further. The inflation which preceded it decimated the value of the fixed income investments held by these institutions. The disinflation which followed did the opposite. As interest rates fell, bonds rose in value. Stocks rose in value as well since 1982 marked a secular low point in the stock market. These institutions held many long dates bonds earning 15% interest rates or higher. These high rates were formerly offset by high rates of inflation but not these became excessively high real returns. The ultimate savers, institutions, got richer.

As these savings institutions got richer, they had more to invest and most had a mandate to invest mostly in fixed income investments. That is, they need to lend out their capital and they did. Low inflation and rising loanable funds, and low interest rates led to more debt for US households and businesses. The final bit was probably due to poor monetary policy as Greenspan juiced the market after the Tech crash, but the bigger debt bubble had been growing ever since inflation started to fall.

So in summary, the debt deflation that we are seeing now has its roots in the rise and fall of the Great Inflation of the 1970s combined with globalization of labor. Both of these pieces were needed and they are related since globalization is one of the things leading to lower inflation. If inflation did not moderate, interest rates would have stayed high and little new debt would have been take on. If there was no cheap foreign labor, the boom would have been arrested by rising wage inflation which would have led to higher interest rates.

What a real stress test would look like

2009-03-07T17:30:00.000-08:00

When Tim Geithner announced that banks would undergo a stress test, the press briefly took the view that he was being justifiably firm with the banks. If they could not perform under a dire economic scenario then they would be nationalized, the press figured. Financial bloggers, of course, were not fooled.

A few weeks later they announced the parameters of what such a stress test would look like. Here they are.

Lets focus on their more "adverse" scenario rather than their baseline scenario. The more adverse scenario is a GDP decline of -3.3% in 2009 and +0.5% in 2010. Average unemployment rate of 8.9% in 2009 and 10.3% in 2010. House price declines of -22% in 2009 and -7 in 2010.

First, GDP. Their adverse scenario is only one year of GDP decline. A -3.3% decline is about the same as the recessions in 1974 and 1982. Those were bad recessions but not once-every-50-years type events. For example in the great depression, the GDP decline in the four years following 1929 was -8.6%, -6.4%, -13%, -1.3% for a cumulative decline from 1929 to 1933 of -27%. The annualized GDP decline in the Q4 of 2008 alone was -6.3%. Q1 of 2009 is looking about the same.

Unemployment in the Great Depression reached 25%. Here is a plot of the unemployment rate back to 1948

The stress test is an average of 8.9% in 2009 and 10.3% in 2010. That would be about the same as 1982. It is 8.1% already in the beginning of March 2009.

Finally, lets look at house price declines of 22% in 2009 and 7% in 2010 which would be a 27% cumulative drop from here. This is about what I predict from extrapolating the Case-Shiller index.

So we can see that the adverse scenario is really not much worse than the 1982 or 1974 recessions with house price declines added on. Is this really a good representative of what the worse case scenario is going to be like? We have already shown that the Great Depression was far worse but that should not be surprising. Comparing to 1974 or 1982 is really not a good idea either. The 1974 recession was caused by the oil shock when OPEC raised oil prices considerably. It was alleviated when OPEC agreed to lower prices which lead to a quick recovery. The 1982 recession was engineered by Volcker's Federal Reserve in order to bring inflation down. In that case, ending the recession was easy. They just lowered interest rates and the economy came back strongly. Obviously we can't do that now since interest rates are already zero.

Is there any way that we can estimate what an adverse economic scenario would look like besides saying that it is likely to be worse than 1982 but better than the Great Depression? Well, actually we can. The key is focusing on other recessions in history that followed severe financial crises. Economists Reinhart and Rogoff wrote a paper on the economic aftermath of financial crises. They found about 20 cases and present statistical results that are relevant to what a stressed scenario would look like for the US over the next few years.

Here are some relevant statistics. The average house price decline from peak to trough was -35.5%. Ours seems likely to be slightly worse than that, maybe -40%. That is not surprising since housing was the main feature of our crisis. The worst, Hong Kong in 1997, was -53%.

The average GDP decline from peak to trough was -9.3%. The worst was the US in the Great Depression, about -27%, as we have said. The Fed's adverse estimate of -3.3% is only worse than 3 out of 15 (20%) of the historical examples. Seems hardly adverse. That is more like the rosey scenario.

The average INCREASE in the unemployment rate from peak to trough was 7%. Since we started at 5% unemployment, that would be 12% unemployment, worse than 1982 but not nearly as bad as the Great Depression. But that is just the averages not the adverse or worse than average case.

So now we can answer the question of what an adverse scenario would look like. Lets define that as roughly the 75 percentile (the average for the worst half) from this sample of post financial crises historical examples.

This would be (estimated from R&R's figures):

Real GDP peak to trough decline: -12% (3 years peak to trough)
Peak Unemployment: 16% (5 years peak to trough)
Real house price declines: -42% (7 years peak to trough)

Anyone think the banks would survive under this kind of scenario?

The old hood, Silverlake

2009-03-06T19:13:00.000-08:00

The neighborhood in LA that we used to live in is called Silverlake. Silverlake is a hip, gentrifying area along Hollywood boulevard between Hollywood and downtown. It was the about at the epicenter of the LA housing bubble. I was looking on Zillow.com today to see how real estate is doing. Well here is an example

811 Silver Lake Blvd
1228 square feet
3 beds, 3 baths

Since 2000, it has been sold seven different times!

Here is the sales history
--------------------
11/24/2008 $304,500
11/27/2007 $602,295
11/15/2006 $704,000
08/05/2005 $650,000
10/01/2002 $321,000
04/09/2002 $258,306
12/21/2000 $262,500

Here is a chart so you can appreciate the trajectory better.

The house price appreciation from start to finish is exactly 2% per year.

Now my wife and I rented a place about the same size in the same neighborhood for $1200/month. When this place sold for $704K in 2006, it would have had a monthly mortgage payment of about $4200/month. What were people thinking!?

The 10-year PE ratio

2009-02-27T10:22:00.001-08:00

One good valuation technique is the 10-year PE ratio. That is the current real price of the S&P 500 divided by the average of the last 10 years of real earnings per share. This is better than the trailing twelve month PE since it smooths over periods of excessive profitability or un-profitability. The following chart (from Robert Shiller's data) shows this ratio back to the 1880s. The red line shows the median value 15.68 and the blue line is at 10 which appear to be around where the troughs occur. Some were worse than this for example in 1921. Right now we are at 12.95 (S&P 500 = 745) which is somewhat below average but somewhat higher than most troughs. To reach PE(10)=10, the S&P 500 would fall to 575 or another 23%. To reach the lowest ever PE(10)=4.78, it would drop to 275 or another 63%. Lets hope that doesn't happen.

There is another way to look at this however. It is possible that the inflation correction is incorrect. There is an alternative inflation measure which claims to be closer to what was used for most of US history. This is from Shadowstats . The Shadowstats inflation measure is much higher than the government reported inflation rate, especially for the past few years. The following plot is the same as above but with the alternative Shadowstats CPI inflation correction applied to both earnings and price. The effect of this is that it makes stocks look cheaper since the correction to the current price is larger than the correction to 10-year earnings.

Which is correct if any? I don't know but would guess that the best measure is probably somewhere in between.

Conclusions: stocks are probably approaching their lows and buying solid blue chip companies is likely the right thing to do. Certainly, selling now look like the wrong thing to do.

The TALF. What hath God wrought?

2009-02-21T10:49:00.000-08:00

The New York times has a fascinating article on the Fed's new program. The Term Asset-Backed Securities Loan Facility or TALF is an attempt to jump-start lending in the economy. The reason for the credit crunch is not that traditional banks like Bank of America are not lending. The Fed has a fairly firm grip on the balls of the CEOs of these banks since all are on the verge of government takeover. If the Fed says lend, they say "How much?".

The trouble is that over the past few decades a new banking system has arisen. This so called "Shadow Banking System", a term coined by PIMCO's Paul McCully, is just the network set up to securitize credit instruments and move them off bank balance sheets and onto the balance sheets of hedge funds, insurance companies, pension funds and any other investors looking for fixed income type investments. Many but not all of these loans are made by commercial banks. There are also finance companies like AIG's American General Finance or GE's GE Capital. Hedge funds and investment banks were also involved in credit creation and securitization. Someone willing to start a small business could go directly to a hedge fund for capital rather that to Bank of America.

This shadow banking system has collapsed. More accurately, it still exists but has dramatically reduced the amount of credit that it is willing to extend. Insurance companies and pension funds are saying "thanks but no thanks" to those BBB rated tranches of securitized auto loans. They will stick with US Treasuries, thank you very much.

The Fed has concluded that growth cannot resume while this major source of lending has been shut off. So its solution is to try to get it going again by subsidizing it.

It works basically like this. From the New York Times.

"Under the program, the Fed will lend to investors who acquire new securities backed by auto loans, credit card balances, student loans and small-business loans at rates ranging from roughly 1.5 percent to 3 percent. Depending on the type of security they are borrowing against, investors will be able to borrow 84 percent to 95 percent of the face value of the bonds. Investors would not be liable for any losses beyond the 5 percent to 16 percent equity that they retain in the investment."

So in essence, the Fed is creating a new system of unregulated or lightly regulated banks from the stock of hedge funds and private equity investors around the world. To a hedge fund, it might look like this. You borrow at 2% and buy assets yielding 12%. Maybe your loss rate on these would be 6% so your final yield is 6% with a Net Interest Margin of 4%. Now you get to leverage this by a factor of 10. Now you are making 40% return on invested capital before expenses and taxes. Expenses for running a large fund are small. A team of 20 hot-shot hedge fund guys might run a fund with $10B of capital taking on $100B in assets making $40B on profits per year. They might pay themselves 2% of assets and 20% of profits which is $2B/year + $8B = $10B/year leaving $30B/year in pretax profits for the investors which is a 30% return. The 20 hedge fund guys each make half a billion per year if it is divided equally. If something goes horribly wrong and these credit instruments result in massive losses, the investors lose all of their invested capital but are not on the hook for the losses. The Fed (or maybe the taxpayer) is on the hook for the losses. If the hedge fund makes their expected profit for say three years before the shit hits the fan, they still make $1.5B each and then need to look for new jobs.

Some would say that the cause of the crisis was too much borrowing, too much leverage and too much greed. The Fed's solution appears to be more borrowing, more leverage and more greed. Somehow, I don't think the American people are going to like that plan.

Who owes who what

2009-02-20T18:08:00.000-08:00

The Federal Reserve publishes their quarterly flow of funds report. It is a fascinating document with all kinds of interesting figures.

One table shows the assets and liabilities in the US credit markets. So it shows you who owes who what.

Here are some statistics. Everything is in Trillions of dollars.

The total credit markets $51.80T. The following table shows who owes the debt and who owns those same credit market instruments as assets. Categories less than $1T are not shown.

Liabilities
Borrower	2009	2004
Household and Non-profit	$13.92T	$9.50T
Non-farm, non-financial, corporate	$7.01T	$4.97T
Federal Government	$5.80T	$4.03T
Issuers of asset-backed securities	$4.21T	2.21T
Government Sponsored Enterprises	$3.15T	$2.60T
Non-farm, non-corporate, business	$3.75T	$2.20T
State and local government	$2.22T	$1.57T
Rest of World	$1.96T	$1.25T
Commercial Banks	$1.46T	$0.66T
Fianance Companies	$1.28T	$1.00T
Total US credit market debt	$51.80T	$34.60T
Assets
Rest of world	$7.85T	$3.84
Commercial banks	$7.85T	$5.99
Domestic non-financial sectors	$6.15T	$4.79
US Agency and GSEs total mortgages	$4.89T	$3.32
Issuers of asset-backed securities	$4.11T	2.12T
Households and Non-profits	$4.09T	$3.04
Insurance companies	$3.79T	$3.11
GSE credit and equity instruments	$3.02T	$2.56
State and local governments	$1.48T	$1.12
Pension funds	$2.37T	1.51T
Mutual funds	$2.37T	$1.51
Finance companies	$1.621T	1.201T
Savings Institutions	$1.32T	$1.29

One thing that is trivially true but also something that most people don't think about is that debt nets to zero. All debts or liabilities are someone else's assets. The net debt of the world is zero. This table above shows that the net debt in the US is $7.85T-$1.96T = $5.89T. This is the difference in the gross amount that we lend to them minus what we owe to them. The rest, $45.9T, is debt that we owe to ourselves. That is it nets out to zero inside America. But who are the borrowers and who are the savers?

Basically it breaks up into three groups. There are the net debtors: households, non-financial businesses and government. Then there are the net savers, banks, pension funds, insurance companies and mutual funds. You can also include "rest of world" here. Then there are what you can call arbitrageurs. These are entities that have large gross debt but little net debt. That is, they borrow from the capital markets but invest in other debt instruments. These are: GSEs, issuers of asset backed securities and finance companies. This would also include hedge funds, investment banks and the like.

So do we have too much debt? Remember debt is a gross measure. Much of this debt is just due to the rise of the arbitrageurs. Whether that is good or bad is hard to say. All of this extra leverage helps with liquidity. It makes it easier to borrow and therefore probably lowers interest rates and lubricates the wheels of industry. Whether or not it does anything else useful is hard to say. It also of course adds complication to everything and we have been paying the price for this over he past few years.

There is clearly too much household debt. As you can see from the table above, household debt grew from $9.50T to 13.92T from 2004 to 2009. Most of that is mortgage debt but is also made up of credit card debt, home equity loans, student loans, auto loans etc. During that time, average salaries did not increase. People simply over-consumed. Now their assets, homes and stocks, are falling in value and so they are getting poorer and they will have great difficulty servicing this large debt load.

Businesses also borrowed heavily. Corporate and non-corporate together increased their borrowing from $7.17T to $10.76T. Earnings may have increased over that period but they are now dropping at the fastest pace since ... well maybe ever. They won't be able to service this debt either. According to Standard & Poor’s, nearly 66% of nonfinancial companies have below investment grade ratings. They are predicting a default rate for this group of about 14% in 2009.

We may have about $7T of unserviceable debt which is roughly the increase from 2004. Much of that will be restructured, foreclosed on etc. Maybe only 30% of that will becomes losses. But even still that is $2.1T. We can see above where those losses will show up - with the savers: banks, pension funds, insurance companies and mutual funds and the "rest of world".

So in total, it looks like this. Savers who wanted to accumulate more wealth loaned money to people who bought either consumables (e.g. steak dinners), over-priced assets (e.g. houses) or unproductive capital assets (e.g. steak house restaurants). These tuned out to be bad loans. All that principal will not come back to the savers. But the wealth that was lost by the savers didn't all go up in smoke. All the extra steak dinners might be gone but the houses and commercial real estate and businesses are not. They might have less value than everyone thought but they are not valueless. So part of the loss in wealth is just a realization that it wasn't real wealth to begin with. We as a country are really no poorer than in 2002. We just thought we got rich in between. There has of course been a transfer of wealth between many individuals but not much in the way of real net loss.

This isn't quite right though. We did increase our US net debt by about $3.3T since 2004. That works out to be about $33,000 per american family. We have assets in return however even if we might have over-paid for some of them (like houses). With our assets falling in value and wages falling due to unemployment we have to spend much less. We need to save more. This will be the main dynamic of the next few years. The world will have to adjust to a US consumer which is spending a lot less. This adjustment is likely to be very painful. Our economy is out of balance. We have too many of somethings like restaurants and retail stores and too little of other things like factories for exporting goods. Since the economy is out of balance much of the investment will be required to restructure it to the new reality. This is likely to sop up any actual economic growth for a few years.

There are some groups that are likely to benefit. Poorer people who had no or negative equity to begin with may now have large negative equity especially if they bought a house with no money down that has plummeted in value. If they walk away and declare bankruptcy, their net worth goes from a large negative number to zero. It has increased. Since they will no longer have to service this debt, they will have more discretionary income. They will be richer. Their creditors however will take the loss. This is a rather direct transfer of wealth from rich to poor. This commonly happens in depressions.

It is official: Obama is a tool

2009-02-15T09:14:00.000-08:00

Ok, I was admittedly excited when Obama was elected. Finally, there was someone who would help reverse the plight of the middle class in America. It has taken less than a month for me to decide that his presidency will be a failure. It is not that he lacks good intensions. It is that he is not a strong leader. He is another Jimmy Carter. He is too impressionable, too willing to keep the status quo, too willing to try to please everyone. What we need right now is someone willing to be confrontational and make hard decisions. He is not that person.

Foremost is his handling of the economic crisis. For a while there was some hope when he hired Paul Volcker. The hard nosed former Fed chairman is exactly the kind of person that should be leading the handling of banking crisis. Unfortunately Paul seems to be losing favor in the administration. Larry Summer seems to be in charge. Summers, the protege of Robert Rubin was one of the chief proponents of deregulation and free markets. In other words, he is one of the people that caused all the mess to begin with. The foxes are guarding the hen house. Goldman Sachs in firmly in control.

We are already seeing some of the bad policies that will come out of this administration. The right thing to do is to nationalize the insolvent banking systems like Sweden did in the 90s when they had a financial collapse. However, that is not the Obama plan. He said in an interview that this would not be possible due to the "different culture" in the US. Different culture? What does culture have to do with whether a bank is insolvent? I assume that he is saying that Swedes are pinkos and that we in America believe in capitalism. But taking over the banks is not socialism. It is capitalism. In a capitalistic system, when a company becomes insolvent, it's equity is wiped out and ownership is transferred to it creditors. Usually this is what happens in bankruptcy court. The banks are insolvent and they should be handed over to their creditors which are the depositors. Propping up banks with government money is socialism, not the other way around. For banks, this is done by putting them into receivership. This is what needs to be done.

Today in the Wall Street Journal there is an article saying that Obama's aid David Axelrod says Obama has a solid plan on housing. His plans will prevent foreclosures and "put a floor under house prices". Now preventing some foreclosures makes sense. It is in the interest of both the homeowner and the banks. However "putting a floor under house prices" is absurd. House prices like everything else are set by supply and demand. Houses are still over-valued which is why people are not buying them. They were in a bubble. The huge demand for houses was primarily due to two things 1) Speculators hoping to flip houses for a profit and 2) a huge group of people that got fooled into believing that they could afford a house when the really could not. Clearly neither of these two sources of excess demand are coming back and there is more supply than ever. Houses prices will continue to go down regardless of what Obama does. But the fact that he is trying to prop up housing prices shows that he is an imbecile. When house prices have fallen to the point where the price-to-income ratio is normal, people will buy them and they will have more money left over to spend in the economy. It does not do any good if we keep house prices unaffordable. High house prices is one of the reasons why people could only afford to live by running up lots of consumer and home equity debt. The sooner house prices fall to normal levels, the sooner we can come out of this recession. If the government tries to manipulate house prices upward, it will only prolong the pain.

Credit problems ahead

2009-02-12T21:21:00.000-08:00

Here is a nice slide from a great (but scary)

presentation by T2 partners.

If you go through and apply reasonable loss rates to these categories, it isn't hard to get $3 trillion dollars in total credit losses.
(note: agency double counts prime loans). Maybe half of that is concentrated in US banks. The total capital of the US banking system is roughly $1 trillion which basically makes the banking system insolvent.

HERE is another estimate from Nouriel Roubini.

A theory of boom bust

2009-02-01T10:13:00.001-08:00

Anti-progressive policies allow wealth to accumulate more quickly at the top of the economic spectrum.
The wealthy save most of the money and much of the wealth gets lent to the middle classes keeping interest rates low.
The middle classes have less income but are able to borrow cheaply to support the same standard of living.
Higher amounts of leverage, profit growth and more capital accumulation pushes asset prices higher leading people to believe their wealth is higher than it really is. This creates a wealth effect which supports debt-supported spending.
Eventually, the debt cannot be serviced and the process goes into reverse. Asset prices fall. Debt goes bad. The middle classes stop consuming beyond their income.
Ultimately the wealth accumulation reverse as social unrest forces the government to adopt more progressive policies and wealth redistributes more equally.

The Graham and Dodd formula versus DCF

2009-01-06T20:20:00.000-08:00

The Graham and Dodd formula for the Price-to-earnings ratio is given by

PE = (4.4/Y) * [8.5+2*G]

where Y is the discount rate or, as they put it, the AAA corporate bond rate. G is the expected growth rate, both expressed in percent. The formula is not really derived from anything. It is more of a "rule of thumb" than anything else.

I thought it would be interesting to see if I could try to derive it (or something like it) from the discounted cash flow (DCF) analysis.

DCF, first popularized by John Burr Williams, posits that the value of a stock or any security is the sum of the discounted cash flows that it is expected to produce for the owner. When I do DCF calculations, I usually choose a growth rate and some number of year that it will grow at that rate. Then I assume that it stop growing for 20 years and vanishes after that. Usually, I use 6 years for the number of growth years. So this DCF PE estimate will depend on the two variables G and the discount rate Y and we can compare these to the Graham and Dodd formula above. I calculated both of these on a grid of Y and G. Here are the results.

The first figure shows the PE versus the growth rate for fiver different values of the discount rate in five different colors. The solid lines are the DCF calculations and the triangles are the Graham and Dodd formula. Note that the Graham and Dodd formula is linear in the growth rate so those lines are straight. The DCF is non-linear in G so they don't match up perfectly. Nonetheless, the basics trends are the same. The Graham and Dodd formula is not that far off of DCF although it is worse for low discount rates.

This plot shows PE plotted versus the discount rate for five different values of the growth rate in five different colors. As before the lines are the DCF and triangles Graham and Dodd. The Graham and Dodd curves are too steep at small discount rates. One can see from the formula that it scales directly with 1/Y so goes to infinity as Y goes to zero. The DCF does not have that feature if you truncate it after some number of years like I have done. Note also that the very low growth rates (the green curve) are off by quite a bit.

So Graham and Dodd seems to be a quick and dirty way of giving PE results similar to DCF but it by no means exact. In the days before computers, that might have been helpful but now it seems the formula is somewhat obsolete.

There is also the exact DCF result when you assume a small constant growth rate into eternity and a discount rate. The DCF simply becomes a geometric series which can be summed if G is less than Y. The well known result is
PE = 100% / (Y-G) which is different in form from the Graham and Dodd formula. Note also that they differ greatly at G=0. The DCF perpetuity gives PE = 100%/Y and Graham and Dodd gives PE=37.4% / Y; they are off by almost a factor of three The difference could be explained easily by saying that a stock is not guaranteed to produce a stream of earnings forever and should not be valued as if it is. Or one could say that unless the earnings are actually payed out in full, you should not value them at full value. Some combination of these two arguments can easily explain the uselessness of the perpetuity formula.

What does US debt imply about the future?

2008-12-27T22:07:00.000-08:00

Here is a not so lovely plot showing the total US debt as a fraction of GDP from the early 1920s to the present.

Yves, at nakedcapitalism has a nice post on this here (the origin of the plot).

The debt is now roughly $54T with a rough breakdown household debt $14T, non-financial businesses $11T, state and local government, $2T and US federal government $10T, financial businesses $17T.

Another source of various charts and figures is
here .

One should keep in mind that it is not really the total amount of debt that matters but rather the carrying cost of that debt. For example, if interest rates are zero, then it doesn't really matter how much debt you have since your interest payments are practically negligible. Interest rates have been dropping steadily since the Volcker recession in the early 1980s and are now essentially at zero.

Now have have clearly reached one of those great turning points in economic history. What is to happen next?

Well, if the US were not the powerful economic and military superpower and holder of the reserve currency the outcome would be fairly obvious. We would suffer the same fate as Iceland or Argentina. Other countries would stop lending to us and refrain from investing in our country. Our currency would plummet and interest rates on our debt would sky rocket. Since a lot of our debt would be in other currencies, devaluing our currency would only alleviate our problem to a limited extent. We would go begging to the IMF for a bailout and would receive it only by accepting their terms which would include higher taxes and in effect a lower standard of living.

However, the US is not Iceland. The US debts are almost entirely in US dollars. The US dollar is also the reserve currency of most central banks. The US is not only the sole military superpower, it is the largest source of consumer demand in the world economy. If any central bank or ALL central banks decide to sell off their dollar denominated holdings and give up the US dollar as reserve currency, the dollar will drop and there will be major economic as well as political consequences.

Loss of competitiveness in exports as US exporters benefit

Loss in the value of US dollar reserves

Major restructuring costs as the world economy rebalances

US power decreases as it can no longer run large deficits

Power shifts eastward, the consequences of which are uncertain

The politicians of Asian countries (China in particular) might not be able to withstand a large loss of jobs in exports. For this reason they might not be too keen in allowing the dollar to weaken. This is not a question of whether it is better for them in the long run. It is a question of whether they can throw a lot of people out of work and still remain in office. The European's might not like the monetary situation which empowers the US but probably prefer it to one in which Asia hold more power. They after all share a common culture and are military allies. Likewise Japan and Saudi Arabia (among others) depend on the US military and so have reason to sustain the current situation. So it seems that it is unlikely that any drastic change in the US dollar as reserve currency will be precipitated from abroad. It doesn't appear to be in the best interests of these countries. Asia is too dependent on exports to the US and if Asia does not dump the dollar it is unlikely that anyone else will since that would just allow for a further loss in competitiveness to Asia.

But, one way or the other, the US needs to restructure its debt. Fortunately, there is a way. The Federal Reserve can simply print money and monetize the debt. It could if it wished, simply buy every outstanding loan and then restructure the loan any way it wished. It could simply forgive all the debt and in doing so reduce the debt to zero. This is of course the extreme case but there is nothing in principle stopping the Fed from devaluing the dollar and reducing the real value of this debt load. Some people have a knee jerk response that this is preposterous and would never work. They say, it would cause our foreign debt holders to immediately sell their Treasuries which would cause yields to spike. But this is incorrect. The Fed has unlimited amounts of dollars and could choose to buy every US treasury at 0% yield if they wished. This would effectively make Treasuries and dollars exactly equivalent. If our foreign debt holders wish to sell them, they would simply end up with dollars. They would have to spend those dollars in the US boosting US exports or buy US assets like stocks and real estate.

Now of course this is highly inflationary. The US money supply is roughly $10T. If the Fed converted $50T in debt to $50T in dollars, this would increase the money supply roughly by a factor of six. Every real asset would be about 6 times more expensive. That would be the cost of eliminating all of our debt. However, even in this extreme scenario, this is not really hyperinflation. A devaluation by a factor of six is roughly the same as was experienced in the US between 1960 and the present. It is not like Zimbabwe whose currency has an inflation rate (Dec 2008) of 516 quintillion percent (516 followed by 18 zeros).

Now, the Fed need not erase all of the debt. It would be enough to reduce household debt by $5T which would put the US household back to where it was in the late 90s. It could also do things like buy up all the credit card debt from the US banking system (there is about $2.6T) and refinance it at a fixed 5% interest rate. Keep in mind that the average interest rate on credit cards is about 17%. This would greatly reduce the interest payments for US consumers and keep the debt from growing too quickly. They may even be able to pay it off. It could also offer to buy any outstanding mortgages at face value (or some reasonable discount to that) and refinance them at a lower principal to reflect the lower home price. This would keep many of these people in their homes and repair the balance sheet of the American homeowner. It would also be a giant bailout for the US banking system. Businesses then would also want some kind of bailout. Where this stops is hard to know. The point is, that the Fed has almost unlimited power in terms of printing dollars and spending them wherever they want. If they lack certain powers, the congress can vote to give them new ones. But the US itself has the power to determine the real value of their debt since it is entirely in their own currency.

Foreigners can gripe out how we have duped them. They have traded real assets for pieces of paper and then we devalued those pieces of paper. But they can't simply blame us. They knew what they were getting into. They never expected us to act in any other way then what was in our own best interest. The situation is akin to a bank who makes loans to people unable to pay them back. They deserve to share the pain. There is really no other way. They may be harmed even more if the US does not prevent deflation from setting in. Deflation in the US will simply spread to every other country.

What will result from this however is that we will have to give up forever the idea that we operate under a capitalistic system. We will have to admit the role of the Federal Reserve as massive central planner. What looks like capitalism is really play-capitalism and when the play gets too rough, mommy comes in and breaks it up.

The result of all of this is likely to be a more balanced world economy. The world will be a lot more reluctant to lend money to the US. But the US will have less need to borrow since its debt load will be reduced. Perhaps the dollar will remain devalued and the US can export more and erase the trade deficit. Of course lots of things can go wrong. But one should keep in mind the tremendous power of the Federal Reserve in being able to create as many dollars as it wishes. The outcome will not be determined simply by economic factors. Political factors are at least as important for an economy with a fiat monetary system.

Would printing by the Fed be fair? Well, if your attitude is that anyone who borrows is morally obliged to pay it back then the answer is no. But the world isn't fair. Countries all act in their own best interest. That should not surprise anyone who is a realist. Paying back our debt in full value is not in the best interest of the United States and might not even be in the best interests of our debtors. Likewise, since bankruptcy is always an option, it benefits banks to restructure the loans to consumers so that they can service them. Obviously, some ways of restructuring the debt are more fair than others. It is uncertain how far the Fed would go or how far they would need to go.

So what are the investment implications? Well, the Fed probably won't be able to act too aggressively until the situation has worsened further. They need political cover in order to convince the US and foreign politicians that there is no other way. So stocks will likely fall further as earnings vanish. The weaker businesses will fail and other banks will be brought down. Panic is likely to rise as the world economy approaches the brink of complete meltdown. The near term outlook then is for deflation. At some point however there will be no more deflation plays. Yields on treasuries will have approached zero. Stocks will have fallen to extremely low valuations. Bonds will be in a bubble. At this point, the Fed will act aggressively to reflate the economy. So stocks will be a good bet here and also commodities. Gold should do well as there will be great uncertainty of the future monetary system and the dollar is likely to end up devalued. Stocks that may do the best are those with low debt and plenty of foreign currency exposure. In particular, ones with less exposure to bad, or at least uncertain, economic conditions. JNJ, CL, KO come to mind. Times of economic and political turmoil will likely be good for the consulting agency ACN. Energy companies should do fairly well though probably less well than the past few years. I will revisit this in more detail in the future.

Nikkei back to 1984 prices

2008-10-07T22:17:00.000-07:00

The 1980s were an incredible decade for Japan. From 1984 to 1990 the Nikkei rose fourfold from 10000 to 40000. Today it is at 9444. It has gone up and down and 24 years later it is right back where it started. Pretty depressing. Is it time to look at some Japanese stocks?

Over the same time the Dow went from about 1100, peaked around 14,000 and is now about 9447. The Dow and Nikkei are almost exactly at the same level. But in the case of the Dow it is up by a factor of 8.6.

Notes on valuation of AIG

2008-10-05T15:08:00.001-07:00

This post is to collect various notes on valuing AIG.

This story attempts to estimate a break-up value for AIG.

"CreditSights estimates that the company's general insurance business is worth $95.2 billion, its life insurance and retirement services business is worth $147.7 billion, its financial services business, including its aircraft leasing unit, is worth $9 billion and its asset management operations are worth $3.6 billion, said Haines. That valuation, which assumes limited stress in the financing markets, comes to a total of $255.5 billion."

That works out to $19/share after the 80% dilution. That seems much higher than any other estimate. I am also not sure of they are including the mark-to-market losses. Probably not. If we take out another say $30B for CDS losses, that would still be $16/share. The book value as of last 10-Q was $5.80/share including the dilution.

Recently (after the bailout) Bill Ackman, the hedge fund manager of the Pershing Square, bought AIG. I think he paid around $3.50. He
estimates book value to be around $6. This estimate takes into account the mark-to-market losses and the 80% government dilution. He also thinks there is a chance that some of the dilution can be reversed if AIG pays the loan back very soon. I agree.

The real valuation of AIG would have to include the following:

1) Figure out what they are going to sell and what they will get for it and how long it will take them to pay off the loan. Also consider the interest on this toxic loan.

2) Figure out what the real losses will be on the CDSs. Also consider the fact that the mark-to-market losses could get worse. They could also reverse if the TARP bailout moves these MBS priced higher. This will have some effect on liquidity and might effect how much of the company they have to sell.

3) Then figure out the earnings and earnings growth of whatever is left over and model it in the usual way with a DCF.

4) Estimate the actual dilution that the government will demand. Will they take the full 80% or something less.

5) Think of anything else that could go wrong.

################# UPDATE ###############

They are reworking the deal. This info comes from the Wall Street Journal.

Lets go over the details. They are scrapping the original deal. Now the are giving AIG a 5-year loan for $60B at LIBOR plus 3% which comes to about 6% given that LIBOR is about 3%. That is much better than the original 14% loan. They are also giving them $40B in preferred stock with 10% dividend yield. Not sure if it is cumulative. In addition they are injecting $50B in common capital. The government still will keep a 79.9% equity stake. I assume that means common equity but I am not sure.

First of all this is pretty good so far. Instead of paying 14% on $85B or $11.9B pretax per year, they will pay $3.6B pretax in loan interest and $4B aftertax for preferred dividend. At 40% tax rates that saves them about $1B per year after tax. Not a big difference but it helps. The real advantage is that this increases total capital by $90B which will greatly improve the capitalization of AIG and should raise their credit rating. Also it increases common capital by $50B. So instead of giving away 79.9% of the company in exchange for just a loan, common shareholders get $50B common capital in return. This seems a lot more fair to me. At least it is better than before. Now they will have to sell roughly $40B worth of assets over the next 5 years to pay back the loan. That is only half of the $85B in asset sales that was required by the first deal. Plus, they get 3 extra years in which to get it done.

Then the story gets a bit more complicated. The government is setting up one "vehicle" to handle AIG's CDSs on CDOs and another to handle the securities lending business. The first one will be capitalized with $30B from the government and $5B from AIG. That would take on the $70B CDS porfolio on the CDOs. As of last credit presentation, they has $57.8B net exposure to multi-sector CDOs including subprime and $22.5B in multi-sector CDOs without subprime for a total of $80.3B. This may have shrank down the $70B quoted in the journal. It is not clear if this capital is in addition to the other capital injected into AIG. I think almost certainly not. So this would be setting aside $30B out of the total $90B in new capital and $5B of current AIG capital. In addition it says that AIG (or presumably this new vehicle) will attempt to buy the insured CDOs from their counterparties for 50 cents on the dollar so that it can tear up the CDS contracts. The notional exposure (before AIG's subordination) was $112.6B as of last presentation. So 50 cents on the dollar would be $56.3B. If it buys the CDOs back, it gets the collateral back that it had to post.

I can't say I understand this bit. There are 112 different transactions. What makes them think that the counter parties want to take a 50% hit on these if they can make AIG pay anything over the subordination level. AIG's average subordination on the CDSs including subprime is 23.9%. The subordination on CDSs without subprime is 16.3%. So if we just take the ones with subprime, those counterparties can only take a 23.9% hit before AIG covers them. So why sell it back to AIG for a 50% hit? Is it because they don't think AIG could actually pay them off? Perhaps it has more to do with asset reduction. This is confusing.

The other vehicle would be set up to handle the problems in the securities lending facility. AIG lent out securities to short sellers and took in collateral. It used this collateral to buy mortgage backed securities collateralized by subprime loans. Pretty dumb move. When the short sellers closed their shorts (presumably because of the short selling ban and/or deleveraging), they wanted their money back and AIG couldn't sell the RMBSs. So they borrowed money from the Fed to pay back the shorts. The new vehicle would take $20B from the government and $1B from AIG and buy the illiquid RMBSs from AIG at 50 cents on the dollar. So does that mean that AIG will realize a $21B loss on those or is some of that money simply for liquidity?

So the first part of this is good news. The second part concerning these two vehicles is confusing. It sounds like this will improve AIG's liquidity, solve the securities lending problem and protect them from future CDS losses. But what is the cost to AIG? It isn't clear to me what this unwind will cost them. They have already written down about $30B to cover these losses. Will this result in losses above that?

Lets do a rough calculation. Lets say that this unwind results in a $50B total loss. That is $20B on top of what was already written down. Last 10-Q showed $78B in equity. So after the unwind that would be $20B pretax and maybe $12B after tax so that would make equity $66B before the equity infusion. They added $90B but appear to putting $35B on this into the first vehicle. So that leaves $55B of equity left in AIG. Total equity is now $121B including the $40B preferred stock leaving $81B in common equity. Original shareholders own only 20% of that which is $16.2B. There are 2.7 billion original shares so book value per share would be $6/share.

If this is correct (a big if), the stock should be worth at least book value and so should go roughly to $6/share but probably not right away. If the break up value by CreditSights is correct, then it should be worth even more.

A worst case scenario might look like this. Assume the $70B in CDSs are completely worthless and are written off entirely. This is $40B in additional write-downs pretax and $24B after tax. Even this leaves book value per share at $5.11/share. Seem like the stock is a good investment at less than $3/share. I expect it will trade above $3 tomorrow morning.

There are other stories out now saying that if the securities purchased at 50 cents on the dollar result in profits, the government will share them with AIG but keep 2/3 of them. This adds a little more value to AIG.

Time for America to refinance their debt

2008-10-05T08:56:00.001-07:00

Why should the US go on a borrow and spending spree?

The US consumer is in debt in a major way. The typical american has a mortgage at say 6% interest. Most have credit card debt at say 14%. Many have a home equity loan at 9%. I don't know the weighted average interest being paid but it is probably about 10%. So why don't we all just refinance? The government can borrow at 4% and send us all a "stimulus package" to pay down their higher interest debt. Sounds good to me. This is a kind of arbitrage of refinancing. It works as long as people are willing to buy treasuries at these low rates.

This is actually not a bad idea. After all, the stimulus package can be structured to give fixed amounts to American middle class families. The bill that gets stuck with the taxpayers gets payed in the normal progressive fashion. That is, rich people pay more of it. So this acts to redistribute wealth from the rich to the middle class which is exactly what is needed. This is inevitable anyway if the economy is to survive. The only other option is mass bankruptcy which effectively does the same wealth redistribution. If someone who is underwater by $100K declares bankruptcy, he becomes richer by $100K and his creditor becomes poorer by the same amount. If we use tax policy or inflation to reduce their debt load we can fine tune the wealth redistribution more gradually.

The dollar must die

2008-09-29T00:54:00.000-07:00

What is the inevitable conclusion to this world financial crisis?

1) The US dollar must drop but it will drop slowly over the next decade or so. It will not be caused by a sell off in Asia.
2) This will increase US exports and decrease the US trade deficit.
3) This will slow global growth and so most commodity prices will not increase much in dollar term despite the dollars weakness.
4) US nominal wages will rise and US denominated debts will shrink in real terms.
5) Gold should increase in dollar terms as it becomes a more stable source of money.
6) China will suffer as it needs to decrease exports and increase consumer spending as a percent of GDP.
7) US treasury yields will increase but not very much. The Federal reserve will absorb more and more treasuries and allow the dollar to weaken as it needs to do.
8) A long period of slow growth and poor returns to capital will prevail.
9) The best sectors will be US exports with foreign currency exposure and recession resistant business models, healthcare companies should do the best, JNJ, PFE, MDT etc.
10) US military spending will decrease. US will rely more on its allies for security.

The wrong-headed media coverage of AIG

2008-09-27T09:26:00.000-07:00

The media has been writing all kinds of garbage about the fall of AIG. The general themes are that 1) AIG didn't know how to handle risk. 2) They should not have stepped outside of their familiar territory, insurance, and ventured into credit derivatives and 3) They were brought down by massive CDS losses related to mortgages.

Lets start with the first one that AIG does not know how to handle risk. These CDS derivatives that everyone is blaming for the collapse in not what brought them down. They have experienced very little actual losses on these instruments. What brought AIG down was the confluence of mark-to-market accounting with overly aggressive credit rating agencies combined with a panicked credit market leading to a liquidity crisis. I will get back to this later.

Now on to the second one, that AIG should not have ventured into the market for these credit default swap, CDSs, that were the specialty of investment banks like Goldman Sachs. People say, they should have stuck with what they know, insurance. The reason this is absurd is that CDS ARE insurance contracts. The opposite conclusion should be reached that ONLY insurance companies should be writing these instruments NOT banks. CDS are contracts where the writer agrees to make a payout when some event of default occurs. This is no different from when an insurance company agrees to make a payout when a fire occurs. They just need to estimate the chance of such an event and be sure that they are adequately capitalized to handle the losses. In fact, Eric Dinallo, the New York, Superintendent of Insurance is now pushing for CDSs to be classified as insurance and demanding that anyone writing such contracts get an insurance license.

Now let me explain why CDS losses did not bring down AIG.

AIG had $441B worth of CDSs as of last quarter, June 30, 2008. $307B (3/4 of the portfolio) of these are "regulatory capital" related. These are not risky by any means. In short AIG agreed to accept some of the risk of bank loans in order to allow banks (about half of them European banks) more room to lend until the new Basel II regulatory capital changes go into effect in about a year. Generally speaking, AIG will start to suffer losses on this portfolio when loss rates on these loan portfolios hit 23%. This is for bank loan portfolios. Since banks are generally leveraged about 10 to 1, a 10% loss on a portfolio are usually fatal for banks. Losses like this generally only happen during major depressions like the Asian financial crisis or the Great Depression and have never happened all over the world at the same time. Losses as large as 23% are that much rarer. It has never happened and short of nuclear armageddon, never will. Losses to date on this $307B regulatory capital portfolio is $125 million or 0.04% of the portfolio. To put this in perspective, AIG makes about $10B/year from insurance and probably more than a billion dollars from the premiums on these very contracts.

So that takes care of 3/4 of their CDS portfolio. There are three other parts of this CDS portfolio that I will discuss, corporate credits, CDOs with subprime and CDOs without subprime.

CDSs on corporate credits of which they have $54B of exposure. These are CDSs which will pay out in case certain companies go bankrupt. Losses to date have been about $1B or less than 2% of the exposure, which is about the same as losses experienced on a typical corporate bond portfolio. This can easily be made up by having yields 2% higher than risk-free treasuries. So far these have likely been very profitable just like the regulatory capital related CDSs discussed above.

Then there is the CDSs on the multi-sector CDOs which can be broke up into subprime related and not subprime related. The exposure of the part not related to subprime is $22B. The "losses" to date have been $3.5B. The CDSs related to subprime have an exposure of $57B with "losses" to date of $21B.

Now I will discuss these "losses" and explain why I put this in quotes. One needs to understand a bit about how these losses are calculated. I will also explain a bit about how these CDSs work. The CDSs are insurance contracts against defaults in things called CDOs. The CDOs are the instruments which receives the cash flows from underlying mortgage backed securities which are pools of mortgages. I won't go into the details here but the key thing to understand is this. If the CDOs start producing losses then the writer of the CDS, that is AIG, has to pay the CDO holder the cash that was not received. So far, hardly any of these CDOs have defaulted. That has to do with the fact that these are "super-senior" CDO tranches. This means basically that there are other less senior tranches that need to be wiped out completely before they lose any money at all. That is the issue of subordination. It is like being in the 10th row of the British army. If you get attacked, the people in front of you will get the bullets and you won't get shot at until all of them are dead. It affords protection.

So if the CDOs have not defaulted, then why do they have "losses". This is due to so called mark-to-market accounting. Basically this is because the CDOs are marketable. Parties occasionally, but rarely, sell them. The accounting rule FAS 157 requires that the CDOs be marked to the market prices. The CDS writer needs to assume that these prices are correct in predicting what the losses will be in the future. So regardless of what the losses actually will be, the CDS writer can be brought down simply by the market panicking and selling off these CDOs which is exactly what happened to AIG. So the trouble is not really that AIG underestimated the risk of losses on these instruments. It is that they did not foresee the effect of market panic of the value of their insurance contracts because usually this has no bearing. For example, if there is a major hurricane like Katrina, people often and irrationally get more risk averse to hurricanes. They think that maybe global warming will result in more dangerous and more frequent hurricanes. This may be true but the event of a hurricane does not change the truth of it.
If insurance contacts traded on the market, you would find that they would increase in value and that the writers would experience large losses. But they don't trade on the market and insurers do not account for hurricane insurance contracts in this way. Insurance companies are allows to estimate their own losses and keep reserves for what they think they will be. This has been the way insurers have accounted for losses as long as there has been insurance and accounting. So far, it has worked pretty well as long as they are regulated by insurance commissions.

If CDSs were only written by insurers, they would likely be accounted for in the same way. If they were accounted for like insurance contracts then AIG would not have taken large losses, not yet anyway. AIG has estimates that their losses from CDSs related to subprime loans would be less than $8B even in extreme circumstances. They have been forced to mark down $25B due to the market panic and sell off in CDOs. I won't even get into all of the facts that explain why AIG's losses will be much smaller than people think.

What happened to AIG was this. Due to mark-to-market accounting, they have to write down their CDS portfolio to unrealistic levels. Because of this, they had to raise capital to avoid credit rating downgrades from companies like Moody's and Standard and Poor's and Fitch. These companies being accountants cared only about the numbers and the rules and not the reality of the situation. Credit rating downgrades would force AIG to come up with cash collateral to give to those holding the CDS contracts, mostly New York investment banks like Goldman Sachs and Morgan Stanley. The credit ratings agencies realized that AIG might not be able to raise the cash to do this. Because of this, they saw this as a major business risk. A downgrade and a collateral call would cause a default which would cause a bankruptcy event at AIG. Because of this new risk, they felt AIG needed to be downgraded anyway. It was a catch-22 of sorts. If they were vulnerable to a liquidity run, then they were not deserving of their current rating. Because of this the downgrade the liquidity run was assured. So the credit agencies gave AIG a short amount of time to find the cash. Once the markets became aware of AIG's situation, AIG because radioactive. No one would be first to put in any cash if they were not sure that others would join in. If you put in cash and it wasn't enough, then your money might get locked up in bankruptcy and you might not even get it back. So the liquidity run began on AIG. S&P gave AIG just three days to sell off some of their subsidiaries to raise the cash to avoid a downgrade. AIG was not able to do this in time and as a last resort went to the Federal reserve. The rest is history as the Fed seized 79.9% of the common shares in return for a high interest collateralized loan. Such was the fate of AIG.

So in summary, the media is reporting all kinds of non-sense about AIGs fall. The reality is that AIG did not anticipate the difference that mark-to-market accounting would have on their CDS insurance contracts as opposed to their typical insurance contracts. They did not underestimate the risk of losses. They underestimated how a market panic could create fictitious losses that would have real effects, ultimately fatal ones, on their business.

AIG, is there any hope?

2008-09-26T21:16:00.000-07:00

The credit agreement on AIG's toxic government loan is now out . It is spelled out clearly that the treasury is going to own and control 79.9% of the company. I don't see any way around this. So must we give up our last bit of hope that this massive dilution can be undone?

Let us quote Lady Galadriel from Tolkiens's "The Lord of the Rings".

"Even now there is hope left... But this I will say to you: your quest stands upon the edge of a knife. Stray but a little and it will fail, to the ruin of all. Yet hope remains while all the company is true."

There are a few options left. These are 1) The practical option 2) The political option 3) The legal option

The practical option: a capital injection.

The first of these options is that the shareholders can still try to find an alternative source of capital to inject into the company. If they are able to find say $100B of capital (say from Sovereign Wealth Funds) they might try to buy out the company. Obviously, if they are going to do this, they will need the government to take back their loan money, and give back their 79.9% equity position. So they need to have enough capital so that the government has no worries that AIG will need further cash. Now you need to think of the Fed and Treasury's incentives. They don't really want to be lending AIG money, nor do they want ownership of an insurance company. I think they will feel that the taxpayers would rather get AIG off the government books since this will be the minimum risk position for taxpayers. Taxpayers don't want a high risk, high return opportunity. That is not what the Treasury is for. I think if the shareholders can find such a group willing to invest such a large sum of money, the deal will probably happen. However, I think the chance of this happening is no better than 5%. Even if it does happen, the current shareholders are not likely to get more than 30% of the company. So this is not much better than the current situation. The chance of us getting 100% of the company back through this kind of deal is basically zero.

The political option.

There is a chance that the powerful shareholders of AIG can exert pressure on politicians to act to reverse some of this deal. Remember the Treasury is subservient to Congress and the President. If it turns out that AIG's losses on CDSs are minimal and that we find that its demise was caused by some conspiracy of hedge funds attacking the stock and CDS market to create a panic, there might be some sympathy for AIG shareholders. It would seem somewhat unfair, I think, if AIG comes out of this with massive dilution and other companies like Goldman get saved by some kind of bailout. This might seem kind of arbitrary and there is a chance that politicians will act to correct some of the things that were done. Perhaps they would reduce the government stake from 79.9% to 50%. Again, I think the chances are small, maybe 3% that this will happens.

The legal option
This might be our best option since there are so many ways to go about it. Clearly the shareholders are going to sue a lot of people, the management, the BOD, the Fed, the government, etc. They might even be able to sue certain hedge funds for manipulating the stock. Who knows how this could turn out? I think it is very likely that they will win some judgements. How much this will produce for shareholders is hard to say. The chance of getting the credit agreement pronounced invalid is probably very small but could be maybe 2%.

Overall, I would say there is still maybe a 10% chance of some kind of upside coming out of the various possible ways to undo some (probably not all) of the dilution. This should be factored into the price of the AIG stock. However the most likely situation is that the dilution will stick. So one needs to try to value the company as it is and then divide by 5 to come up with a price for the diluted common stock.

I won't go into detail here abut this. It depends on many things. If this bailout goes through where the government buys up illiquid MBSs, then the CDS marks that we have now will probably reverse. We will end up paying out some cash losses on the CDSs but they may be smaller than it would be if the government stayed out of the housing market completely.

I think it is fairly conservative to say that the CDS and MBS losses will be less than $30B. That is only another $5B mark from last Q which leaves total tangible equity around $60B or $4.40/share. However this is probably not the right way to value AIG. People have estimated the breakup value of AIG from $150B-$180B. Lets use $130B due to the loss of brand value from all of this and the illiquid marketplace. Lets take off another $30B for mortgage related losses and another $10B for interest payments on their toxic government loan. So leaves about $90B or $6.60 per diluted share.

The current price is about $3 and so it seems relatively attractive. However there are still risks to this. How valuable is AIG as a company controlled by the government? How much damage will be done to the brand? Will a credit crunch result in mostly fire-sale prices for their subsidiary assets? Are the CDS losses really greater than we think? All of these worries should keep the price of AIG well below the "rational" value of the company for some time. I think what really needs to be done is that these CDS contracts get unwound. But what price will AIG have to pay to do this? Does the government have the incentive to act in the interests of shareholders or will they act more in the interests of the financial system as a whole? That is a scary question.

Given all of these uncertainties, the stock looks fairly priced at $3.

The Rape of AIG: Open Letter to Mr. Paulson

2008-09-24T19:39:00.000-07:00

To Mr. Henry Paulson, Treasurer of the United States,

A few days ago, the nation's largest insurance company, AIG, came to New York Fed and said, "We need help. We are having a liquidity crisis. If we are not given a loan, we are going to default on our collateral calls to Goldman Sachs, Morgan Stanley and other investment banks and declare bankruptcy". The company and the Fed knew that this would be the fatal blow to Wall Street and, in fact, the world financial system. If AIG had chosen to file for Chapter 11 bankruptcy (reorganization not liquidation), their $400B+ in credit default swaps (CDSs), a guarantee of sorts, would have been declared not-secure. The counter-parties to these would then have to mark these instruments down as the guarantee would no longer have firm backing. Three quarters of this CDS portfolio was for "regulatory capital relief" for banks all over the world; half of it from European banks. These banks offloaded much of the risk on their own loans to AIG so they could grow their asset base faster than their capital base while waiting for the new Basel II capital accords which will allow for higher leverage ratios. These banks would instantly be undercapitalized and unable to loan.

But even more pressing would be the crisis that would hit Goldman Sachs. Goldman has survived, unlike Bear Stearns and Lehman Brothers, because they have effectively hedged their exposure to subprime lending by buying this insurance from AIG. Many people, including myself, Ben Bernanke and yourself have claimed that the "fire-sale" prices for mortgage backed securities is not indicative of the true value of these securities. However it is these "fire-sale" prices, combined with mark-to-market accounting that have damaged the balance sheet of companies like AIG and the investment banks. The difference, however, between AIG and Goldman is that Goldman has been able to hedge its exposure. That is, it's mortgage backed securities may have been marked DOWN to unrealistic levels but its CDSs with AIG have been marked UP to unrealistic levels. In other words AIGs pain has been Goldman's gain. If AIG had instead chose the protection of Chapter 11 bankruptcy, then Goldman would be instantly insolvent and the last two of the New York Bulge Bracket firms would have failed.

What did AIG get in return for agreeing to the Fed's offer of a loan and saving Wall Street and the world financial system? It got 80% of its equity stolen and handed to the Fed. AIG did not have a solvency problem. They had a liquidity problem. AIG's breakup or liquidation value has been estimates at $180B after paying off its liabilities. That would have corresponded to roughly $66/share. Maybe we would have only received half of that, $33/share, in a bankruptcy auction and restructuring. Instead our shares trade at $4/share now that the government owns 80% of the company and effectively controls it. Whose interest was it really to enter into this deal?

Lets compare this to the way Goldman Sachs, the company you led as CEO from 1998 to 2006, was treated when they ran into a liquidity crisis earlier in the year. Goldman along with the other investment banks normally raise their funds through commercial paper and relatively short terms bonds. That is because, despite the names, they are not banks. They do not pay FDIC insurance premiums, cannot raise deposits and do not normally have access to the Fed's discount window. They are regulated by the SEC not the Fed, FDIC or OTS that regulate real banks. In fact, they are no more real banks than the subprime mortgage lenders who went bankrupt from a liquidity run earlier in the year. These, you might recall, were thrown to the wolves by the investment banks when the IBs decided that the business model would no longer be profitable. "Well, that's capitalism!", I guess you can say. No one ever promised them a guaranteed line of credit. I guess it was their fault for not securing longer term lines of credit.

So when Goldman Sachs and the other IBs (with 30-40 times leverage) discovered that the commercial paper market was effectively shut off for them, what might one expect to happen to them? Bankruptcy? Perhaps the Fed, to protect the financial system from freezing up would give them a toxic loan, like AIGs, at 11% and take 80% of their equity? Is that what happened? No. Instead the Fed and treasury made unprecedented changes to the entire Federal Reserve System in order to accommodate these companies. They created the Primary Dealer Credit Facility (PDCF) so that the IBs could borrow funds at the discount rate 2.25% (lower than the commercial paper rate they were issuing before) against "good collateral". Eventually the "good" part was removed and any collateral was OK, even common stocks. Then they were given access to the discount window. Then, the Term Auction Facility was created where you just auctioned off money at rates not far above the discount rate to these "banks". because the "banks" said that going to the discount window created a stigma for these "banks".

So instead of punishing these companies for their greed, poor management and investing mistakes, you did everything in your power to bail them out. Despite the fact that they are not real banks you let them borrow directly from the Fed at lower rates than real banks (who pay into the FDIC) can get on their certificate of deposits. When Bear Stearns and Lehman brothers actually became "insolvent" (and who can tell anyway at 40 times leverage), they were allowed to fail but not Goldman and Morgan Stanley. They just had a liquidity crisis. They are solvent and so deserve your protection, right? And AIG? You claimed that because they are just an insurance company, they don't deserve the same protection. After all, they don't pay into the FDIC. They might look like a bank, but they are not really a bank. So you gave them a toxic loan and took 80% of their equity so that they would not declare bankruptcy and destroy the remaining members of the Wall Street money club. You derisively called AIG a "hedge fund on top of an insurance company". Well what is Goldman? It is a giant hedge fund on top of nothing and has four times the leverage of AIG. The difference in treatment between AIG and Goldman is no doubt due to your giant conflict of interest as a Goldman lifer and former CEO and now the secretary of the treasury.

Now you ask for a $700B bailout from the taxpayers so that Goldman can dump mortgage assets worth maybe five times their equity at "hold-to-maturity" (read: wishful thinking) prices. I think the tax payers are going to want a few terms with that. How about 80% equity in Goldman Sachs and Morgan Stanley. They have been already been bailed once by completely restructuring the Federal Reserve System. Then they were bailout out again by convincing AIG to avoid bankruptcy. Now you want another $700B handout? Not without 80% of Goldman. If you don't like those terms, well, that is what bankruptcy protection is for.

Signed,
David Johnston
An AIG shareholder and a taxpayer

AIGs bailout and what it means for investors

2008-09-19T00:45:00.000-07:00

As an AIG shareholder, I was shocked an dismayed at the crisis at AIG and bailout from the Fed. Now I sit here with an enormous loss on my hands and an AIG stock worth only $2. So what to do now? Sell or hold? How much is this ghost of AIG worth?

I have no idea nor does anyone else. The reason why is that there has been no clarification of what really happened and what this deal with the Federal Reserve really entails. Nor do we know what really caused the liquidity crisis and whether the bailout has helped or hurt their cash problems. AIG is now a laughing stock and people appear to be pulling their money out as fast as they can.

So let me try a few scenarios to try at a valuation. First the simplest one. Before the liquidity crisis, I had estimated the stock to be worth about $40/share. So if the shareholders get to keep only 20% then the stock should be worth about $8. Of course everything has changed. AIGs reputation has been severely damaged. They may still face a liquidity problem. On the flip side, they may be liquidating a lot of their subsidiaries and so the AIG reputation may not matter as much. Also the break up value of AIG may be even higher than my estimated fair value. People have estimated the break value at $150B. Others say $180B. There are $2.7B shares so that is $11/share even with the 80% dilution, using $150B for the total. Of course all of this depends on the final losses from the CDS portfolio. Still, I have estimated these to be less than $20B. Certainly not $100B that would be required to come up with the current price.

So even with the 80% dilution, there is a chance that the company is worth substantially more.

However the real reason that people might consider investing in this cigarette butt of a stock is that this deal with the NY Fed may not stand. If AIG can liquidate assets quickly or find the money somewhere else, they may be able to get back that 80% equity stake.

Before I discuss how this is possible, let me comment on the deal. We don't really know the facts since there is no term sheet or anything in the public domain. From press releases from the Fed and AIG we know that the loan is 8% above LIBOR and has a 2-year term. There are some loan covenants but they are not disclosed other than that the Fed reserves the right to prevent dividends to shareholders. There is also some vaguely worded mention that the taxpayers will get "up to" a 79.9% equity stake. There was an 8-k from AIG saying that they issues a warrant to the Fed and that this required a shareholder vote. Then another 8-k came out to correct this and simply said that shareholder action would depend on the form of the equity. In other words it is not clear at all and the deal is likely still being formed.

There has been some
discussion from corporate lawyers on whether any of this is legal. It is possible that the Fed will screw it up and create an illegal contract which can be thrown out in court later on. There isn't exactly a lot of precedence on this kind of thing.

There is talk that some major shareholders led by Hank Greenberg are trying to come up with an alternative plan. Greenberg mentioned on the Charlie Rose Show that they could raise capital in various ways: from sovereign wealth funds, from selling assets, from current shareholders etc.

So lets looks at this and try to game how it is likely to work.

First of all lets look at the incentives of shareholders. Anyone holding AIG shares likely believes that the CDS losses are manageable. If not, they would probably not still be holding shares. So they likely believe that the company is worth at least $60B and so losing 80% to the government would be a major and avoidable loss. They would likely want to do everything they can to undo this deal including investing more of their own capital.

Same with SWFs and other PE investors. They likely see the value in AIG as long as they can provide the needed liquidity. With a recession looming and the $700B federal bailout coming, an insurance company with 60% of sales overseas looks like a great place to invest long term.

The main thing to look at is the incentives of the NY Fed and the US government. This is much harder to figure out.

They clearly didn't want to give this loan. If someone else could come in and take over they might be happy about it. However, they need to be sure that this party provides enough liquidity so that failure is not possible. That is because they don't ever want to be in this same situation again. So this might require something like $150B. It needs to be an overwhelming amount of money so that AIGs credit worthiness is completely secured.

There is the issue of the warrant (if it exists). Naturally the Fed does not want to give up an asset that may be worth $50-80B. An assets is an asset after all and nobody gives them up for nothing in return. However this asset might be more trouble than it is worth. There could be all kinds of legal action on the part of AIG shareholders. There is the issue of liability. A warrant does not usually mean ownership however the marketplace is not likely to see it this way. As long as the Fed has this loan outstanding and the warrant in place, the world will expect the Fed to keep AIG functioning.

There is the issue of making an example of AIG. People (i.e. taxpayers and homeowners) are mad and want blood. It looks good for Paulson to say that he was hard nosed with AIG just like he was with Lehman and FNM and FRE. However there are problems with this as well. A couple of days after AIG they announced the mother of all bailouts. Coincidentally, this was when the fires had reached the gates of Goldman Sachs where Paulson was CEO. That doesn't exactly look hard nosed. It looks rather self serving and inconsistent. Why is it OK to save Wamu, Goldman, Morgan Stanley and others but take 80% of AIG? AIG is actually the only one of these that is probably solvent. Their problem was liquidity not solvency. If they were a small company they likely would have gone into Chapter 11 until they could obtain financing and come out unharmed. Avoiding Chapter 11 likely had more to do with systemic issues.

If the party led by Greenberg can present an alternative plan that gets some or all of this equity back, then Paulson and company might go for it. It would relieve the government of the problem and might help them in a couple of ways. It would show the world that private capital still exists and is still willing to invest in US companies. It would likely be good PR for Paulson as it would be a step away from the socialist tactics that they have been forced to apply. Although the loan to AIG probably has no real risk (since it is a senior loan with a company that has a trillion in assets), the public probably doesn't understand this.

If the Fed refuses to give up their equity stake, can AIG shareholders play hardball? Perhaps. Remember that the executives at AIG are also large shareholders. What if they all threaten to quit? What would happen to AIG then? They may figure that they have lost 90% of their value now. What is another 10%? I think that if they acted with solidarity, they could exert enormous pressure on the government. How could the Fed run AIG if everyone knowledgeable quit and refused to give them any information. They could also threaten to refuse the loan and take the company into Chapter 11. It is possible that they can get foreign governments to put pressure on the US government. Do foreign leaders want AIG controlled by the NY Fed? I doubt it. How powerful is Greenberg really? He used to be the worlds most powerful businessman. Does he still have this kind of power? Is he as shrewd as he used to be? I am betting that Greenberg will play hardball if needed.

So overall, I think there are many reasons to be hopeful that the AIG stock will recover. It is far from a certainty but even with a 20% chance of success, this adds enough speculative value to the stock to make it worth far higher than $4 where it is trading now.

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New valuation

Ok, so lets assume that the government gives in and lets this group of investors replace the loan with capital. What kind of deal might be expected from new investors? Well, probably not a very good deal. Lets do a new valuation assuming this deal happens.

First we need to value the company as is. The equity of the company as of last Q was $78B. The real equity is probably somewhat higher. Lets just say $80B as a round number. There are 2.7B common shares. The normalized earnings for AIGs core company is about $4/share or $11B/year after ignoring the financial products group fluctuations. That is a ROE of 13.5% which is about average for the company (using $80B for equity).

Such a company is generally worth about 1.5 book value. That is about $120B. Valuing it on 9 x earnings would put it at $97B. A DCF would be much higher since the interest rates (i.e. discount rate) is so small. Lets say it is valued somewhere between these as $100B. This of course assumes that they become essentially an insurance company again with plenty of capital. Lets call this valuation V so we can some up with a formula.

So lets say the investors want to put in C=$60B of new capital. Then it would be worth about V+C=$160B. Let say they demand some haircut, H, on the value. Perhaps they will pay only H=60% of the value of the total company. This determines the percentage of the company that they get to own, P. The present owners get to keep 1-P. The haircut is given by

H= C/((C+V)*P) and so P=C/((C+V)*H). Using H=60% and C=$60B and V=$100B, this is P=62.5%. Current shareholder would keep 37.5%.

That would mean that our share of the company should be worth $160B*0.375=$60B or $22/share.

The full formula for the value of the share price is given by

PPS = (1-C/((C+V)*H))*(C+V)/2.7 = [V+ (1-1/H)*C]/2.7
where C and V are expressed in billions of dollars.

A more extreme case would be a that they only pay H=40% for the value they get back. What a deal! That would be PPS=$3.70/share. That is below the current price. This shows how sensitive the PPS formula is to H. You can see that P=1 when H=C/(C+V). So current shareholders have no incentive to do this deal when H is greater than or equal to this.

Probably the most likely haircut would be H=50% which gives PPS=$14.8. This would be a great deal for the new investors and still a pretty good deal for the current investors given that the current share price is about $4.

The alternative to this would be just leaving the deal with the government as is. In that case the shares might be worth $8 or so depending on how the deal goes. That value should be considered a floor for the stock. Assuming that the government deal has a 80% probability of sticking and therefore the buyout deal has a 20% chance of going through, I come up with a weighted average PPS of $9.36. That is about twice the current share price which not coincidentally is about the same haircut demanded for the new investors. It may take a couple of years to reach this price since the company may see a lot of trouble in the year ahead.

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Other info about the governments stake (both positive and negative)

First the good news. There has been lots of contradictory information on the form of the governments stake. Reading between the lines and interpreting all of this leads me to conclude that the 79.9% equity stake is a worst case scenario, not the most likely scenario. They might not yet even have the deal completed. I think they have structured this so that the company has the incentive to raise capital, sell assets and pay off the loan as quickly as possible. For example the WSJ mentioned that the form is an equity participation note . Today the new CEO said on CNBC that the government has convertible preferred shares. Obviously, I have no idea. But the CEO also said that IF they can't pay off the loan, the government will get 79.9%. So I don't know what to think but it appears that the 79.9% stake is a threat and not a certainty.

There is however something I am quite afraid of. There is the possibility that Paulson and company will decide to use AIG as the sacrificial lamb. Paulson is after all the former CEO of Goldman Sachs. Goldman is probably the biggest counterparty to AIG's CDS contracts. The New York Times has just reported on this meeting of shareholders today to discuss an alternative to the Fed's plan. Here is a quote:

"One person involved in the planning, who spoke on condition he not be identified, said that in the worst case, winding down the unit’s affairs could consume the Fed’s entire $85 billion loan."

So basically, the Fed could decide to make AIG pay off the counterparties in return for cancellation of the contracts. This could easily erase all of the equity of AIG. This would be great for Wall Street, great for the economy and terrible for AIG. AIG is much better off holding their subprime CDSs to maturity and paying them off as defaults happen.

Martin+Osa

2008-09-10T18:58:00.000-07:00

Martin+Osa is a new retail concept by the teen retailer American Eagle Outfitters (AEO)

The M+O concept is aimed instead at an older demographic 25-40. The theme of the clothing is "refined casual". The design of the clothes by San Francisco designer Deborah Hampton are clean and simple but with subtle detailing and fine tailoring. The clothes use luxurious fabrics such as silk, organic cotton and cashmere but are priced reasonably, about the same as J-Crew.

My wife and I are big fans of M+O and we also are AEO shareholders. I have personally visited 4 of the 28 M+O stores. The store designs themselves are quite impressive. The store is made of hard wood and the front is simply a wall of wood with a minimalist blue glass stripe running through it. The store (and the clothes) smell of freshly chopped wood.

The changing rooms which are about as big as my old college dorm room (to allow for baby strollers) have high ceilings and a button where you can call the extremely helpful sales staff. The customer service at M+O is similar to what you would receive in a luxury boutique. They give out free Fiji Waters just for visiting the store. (Recently J-Crew has copied this tactic.)

I have mentioned that I love the store and the clothes. But how is the brand being received by other customers. To answer this question, I went through a lot of the reviews at www.yelp.com . This was slightly painful since Yelp divides their reviews by store (in some particular city) and not by brand. So I had to go through and search for each store. I managed to find 13 stores that had at least one review. There are 65 reviews in all and 33 of them are from the San Francisco Store. I think this is where Yelp originated. The reviewers choose a star rating from 1-5 and then submit a written review. I have constructed a table below showing the average rating for each store and the number of reviews. The weighted average review is shown at the bottom and is 4.24 stars out of 5. That is excellent, I think, for a still developing brand. Consider that some reviewers hate the store for whatever reason and give it 1 star. Most people love the store and give it the highest rating. To really get a feel for the customer response to M+O, I suggest you click on the store link and read the reviews yourself.

To summarize the reviews, everyone loves the stores and appreciates the excellent service. Most people like the clothing. Most appreciate the quality of the clothing. It is not cheap but you get good value for your money. Some people feel the clothes are a little boring, the opposite of flashier J-Crew. However the store concentrates on basics and casual clothing. You won't find glittery golden dresses or animal print shirts at M+O. If you are looking for clothes to build a solid wardrobe, M+O does this very well.

Store	Number of stars (out of 5)	Number of reviews
San Francisco Store	4.3	33
West Los Angeles Store	4.5	6
Glendale CA Store	4.0	4
Newport Beach, CA Store	3.5	4
Burlington, MA Store	4.5	4
Skokie, IL Store	4.5	3
McLean, VA Store	4.0	3
Schaumberg, IL Store	4.5	2
Santa Clara, CA Store	3.5	2
Raleigh, NC Store	4.0	1
Las Vegas Store	4.0	1
Austin, TX Store	4.0	1
Dallas, TX Store	5.0	1
Total Number of Reviews		65
Weighted average	4.24

Ok, so this sounds great so far. Beautiful stores, great service, high quality, fashionable clothing at a reasonable price. But are these stores going to be profitable? This is after-all an investment blog not a fashion blog. These stores are expensive to build and those large dressing rooms increase rental costs. High quality salespeople must be paid better than the teenagers they hire to run AEO stores.

Well, they are getting there. Like any startup, the brand stumbled a bit at first. The first few clothing lines were a little dull and underwhelmed most shoppers. Naturally, its started with no brand recognition and the opaque store-front keeps many from seeing inside. Some people think it is a spa or something. The retail sector of course is terrible right now and this demographic in particular has been hit very hard from the housing bust. So sales per square foot (the key gauge of success for a retailer) was pretty low at first. This caused many on Wall Street to declare the brand a failure. Few people on Wall Street think this brand is going to succeed and many have been calling for AEO to write it off and be done with it.

However not all is lost for M+O. Each clothing line has gotten better since the first one. Same store sales have been growing at 21% (last quarter) and 55% (the quarter before that) from this low base last year. I think they are starting to hit their stride.

There are a few reason why SSS are improving so quickly. First, as I mentioned, the clothing lines continue to improve steadily. The other main reason is that customers who purchase clothing are happy with their purchases and return to the store even as new customers come in. Making customers happy and getting them to make repeat purchases is the crucial thing for any retailer. Since I am a regular M+O customer I know why people come back. First of all the clothing is of excellent quality. As a guy, I'll admit that when shopping, I didn't always inspect the stitching on pants, marvel over the fabrics, or note the quality of the seams. But when you take your M+O clothes home, you notice these things over time. I'll bet women notice this even quicker. You notice not only the quality of construction but the subtle design details. You begin to appreciate the difference between this brand and the mass produced junk that is sold at most places at slightly lower prices. For example a pair of shorts that I bought at Target the other day split at the seams, the first day I wore them. They cost $15. I can buy M+O shorts on clearance for about the same price. J-Crew and Banana Republic produces some good quality clothing at similar prices but M+O offers a different aesthetic. They do their niche, "refined casual" better than either of the other two in my opinion. But what really sets them apart is the quality of the shopping experience. Try going to the tiny J-Crew stores with a baby stroller. It is not very fun. I think over time M+O will retain their customers and slowly build up a loyal following.

American Eagle Outfitters CEO Jim O'Donnell says that their goal is to reach four-wall break-even by the fourth quarter of this year, 2008. He says that this will occur at sales of $375 per square foot. Last quarter he said that they were basically on track for somewhere between $350 and $375. Four-wall break-even means breaking even when you exclude the overhead of clothing design and brand development costs. O'Donnell has said that they intend for the brand to fully break-even by 2010.

So it appears that if things go as planned that the investment in M+O will take a long time to pay off. The good news however is that this could be a very durable brand. The clothing styles are classy and classic and are not likely to go out of style. Polos and denim have attained a permanent stature in American fashion. So they might have a long period of profitable growth ahead of them fueled by steady cash flows from the now saturated AE brand. It is said that there is little barrier to entry in retail. While that is true, it will be difficult to replicate something like M+O without a lot of capital and a lot of patience, two things that are in short supply right now in the business world.

M+O is starting to advertise heavily in a few cities: Chicago, San Francisco and LA. I have seen the first billboard here in Chicago. This should have the effect of driving higher traffic to the stores and if the product is right, this should lead to higher sales even in this miserable retail environment. I will be watching this closely.

The Inyx forgeries

2008-07-22T16:03:00.000-07:00

Jay Green of Inyx submitted to Westernbank a letter of credit allegedly from Pareto Securities which provided a $300MM short-term bridge financing for a buyout of Inyx. The letter was signed H. Suain, International Operations. Green identified him as Harald Suain.

The CFO of Pareto in an affidavit claimed that 1) There has never been any H. Suain or Harald Suain. 2) The letter is not authentic and not even on authentic Pareto letterhead. 3) Pareto never offered any such letter of credit to Inyx.

In other words, the letter is a forgery. This would be the third accusation of forgey against Kachkar. Apparently he submitted similar letters of credit from Countrywide Bank and also Mellon Bank in the UK. Countrywide has also called the letter a complete forgery.

Who is Harald Suain? The only record that I can find for that name is a guy in Europe who is an agent for a Norwegian Soccer Coach, Trond Sollied. Well Kachkar is a big soccer fan as he tried to buy the Marseille Soccer with the forged Countrywide letter.

The forged Pareto document is online so we can have a look at this signature and see if it resembles the handwriting from the usual suspects, Kachkar, Green or Benkovitch.

Growth and reversion to the mean

2008-07-21T06:48:00.000-07:00

Here is an update of the previous post on whether a high 5-year growth rate predicts the next 5-year growth rate. The answer is still No but now with more statistical significance.

I have collected more data. Now I am using every stock on the NYSE, NASDAQ and AMEX.

I require that there is 10 years of data and that in each 5-year period, there is at most one year with earnings data not available or earnings that are negative. If earnings are negative (or unavailable) that one year, I ignore it and fit the growth rate to the remaining four data points. So there is a slight bias towards higher growth rates but this bias is the same in both periods so this should not cause any correlation. Growth rates above 50% or less than -50% are discarded. The results are insensitive to increasing this number 50% to 80%.

There are 2206 stocks that meet these requirements. Here is the result. (Click for higher resolution)

The top panel just shows the last 5-year growth rate versus the growth rate 5-years previously. As before there appears to be little if any correlation. The red dashed lines show the median growth for each period which is 10.5% for the last five years and 7.1% the five years before that. This higher growth in the latest period is probably real and is expected since the period 1998 to 2002, the internet bubble, went from a boom period to a recessionary one and the last five years 2003-2008 included the recovery and housing bubble. It looks like we are now going into another recessionary period due to the housing bust. The Pearson's correlation coefficient is -0.0953. This slight negative correlation is explained below.

The lower panel is even more informative. The stocks are sorted by the growth rate in the previous period and divided into 19 percentile groups. That is, each group has equal number of stocks and has similar previous 5-year growth rate. For each group, I calculate the median of the previous 5-year growth rates and the corresponding median of the last 5-year growth rates. These two median growth rates are plotted versus one another with error bars indicating the error due to having a finite sample. Clearly, there is no indication that the median growth rate in the next period has anything to do with the median growth rate in the previous one. The blue line shows the y=x relation that would be expected if the best predictor of future growth rate was the past growth rate. Clearly this is NOT a good fit to the data. The red horizontal line just shows the median growth rate in the last 5-year period. This fits the data points quite well. This would indicate that the hypothesis that "Future growth rates are independent of past growth rates" is consistent with the data. There is one deviant point which has the lowest growth rate in the previous period and in fact the highest growth rate in the more recent period. I haven't yet looked into this in detail but these may be highly cyclical companies such as oil, energy etc. This point probably is the cause of the slightly negative Pearson's correlation coefficient.

Overall, this study points toward mean reversion. Companies that are growing at higher or lower than average rates will most likely revert to average growth rates in the future.

The application to investing also seems to support the "value investing" method rather than the "growth method" at least in their simplest incarnations. That is, stocks that have grown rapidly and (usually) sport a high valuation on earning probably will not grow any faster than the stocks that have grown only slowly or even had negative growth. So paying a higher valuation for "growth stocks" does not appear to be logical. I will investigate this in more detail in future posts.

Does past growth correlate with future growth?

2008-07-14T20:38:00.000-07:00

I did a little test to see if the past 5-year growth rate correlates with the "future" 5-year growth rate. Since I don't have access to the future data, I will use the earnings data from the past 10 years split into two parts. I have a list of stocks whose earnings I have looked at over the past few years. This is not a random sample by any means but should not be terribly biased. If there is any bias it might be that I typically look for companies with consistent results which might bias things in the direction of positive correlation.

Here is the list of tickers. There are 157 stocks. All have been pruned to have at least 9 years of data.

aa aame abk adp aeo afl ahm aig ajg all anf apol appb axp azn ba bac bax bbby bbt bcs bdx bmy bni bpop brl bro bud c cat cc cfc chc cinf cl cle clx cors crft csco ctas ctx dd dell deo dhi dis drl e educ eth expd faf fast fbp fdc fdx fitb fnm gd ge gfr ggg gm gsk hasx hban hd hsy ibm intc intu ir jnj jpm k kbh kcli key ko ksws leco lfg liz mbi mcd mdt mer mhp mlea mmc mmm mo mrk msex msft mtb mtg mth mxim ncc nke nsec nte nwlia ofg orcl ori pep pfe pg phm plxs pmi ras rdn rf rgf ri rt ryl sbux sial snn stc sti stj strt swm syy t tbl tgic tma tmk tol tsn tss tues ug uhco unh ups usb ust utmd utx vz wat wb wdfc wfc wfmi whi wmt wwy xom

For each of these I calculate the 5-year (annualized) growth rate of earnings in the most recent five year period (years 5 to 9) and in the more distant 5-year period (years 0-5). The growth rate is calculated by using all of the points and fitting an exponential curve to these points. I throw away growth rates greater than 50% or less than -50% to avoid have large numbers skew the averages.

Here are the results:

The mean annualized growth rate in the first 5-year period is M1=11.9% and the standard deviation is S1=15.2%.
The mean annualized growth rate in the second 5-year period is M2=13.9% and the standard deviation is S2=13.9%.

The Pearson correlation coefficient R is -0.0329.

R = 1/(N-1) * Sum_i (G1_i-M1)/S1 * (G2_i-M2)/S2
with N=157

So there is a small (and probably negligible) NEGATIVE correlation. Thus, there is no evidence at all that the 5-year growth rate is useful in predicting the growth rate of the next five years.

This study does not claim to be conclusive by any means but it shows that if there is such correlation, it is not very strong.

See scatter plot below of the growth rates plotted versus one another. No correlation is apparent.

Bank profitability at WHI

2008-05-05T13:10:00.000-07:00

My last post on banking profitability can be readily applied to W Holding (WHI).

WHI has a leverage ratio assets/equity of about 14.6. In addition it has preferred equity nearly equal to common equity. So equity/common-equity is about 2.

So to build value for common shareholders and pay a small dividend we want to have return-on-common-equity at least 5%. If we cannot reach at least ROCE=5% then we can't really claim even to be worth common book value. The borrowing cost, BC, of preferred shares originally was about 6.7%. We can use the following formula (the the last post) to figure out the ROE that is required.
ROCE = ROE * (EQ/CEQ) - BC (EQ/CEQ-1)
Using the above numbers, the required ROE is 5.85%. Lets call it 6% for simplicity. Using the above leverage ratio, this requires ROA of 0.4%.

Now 0.4% might seem like a pretty easy target for a bank. Normally a good bank can generate ROA of 1% or so. However WHI has some serious problems that are difficult to overcome. Lets try to see why. We will look at our ROA profitability formula.

ROA = (1-T) * [ (1 - ER + NII) * NIM - L]

T = Tax rate = 40% for WHI
revenue = Net Interest Income + Non-interest income = 260MM (4x the first quarter)
ER = efficiency ratio = Non-interest expense divided by revenue = 67% for WHI (last quarter)
NII = Non-interest income divided by revenue = 10% for WHI (last quarter)
NIM = Net interest margin = net interest income divided by total earning assets = 1.3% for WHI (last quarter)
L = provisions for loan losses divided by total earning assets = 0.72% for WHI (assumes 30MM provisions per quarter)

Current ROA = -0.1%
Given, these number the bank is unprofitable. The only reason it booked a profit in the first quarter was because it had a tax benefit from carrying back losses to previous years earnings. However because it has to pay out preferred dividends, it is even worse. The common equity is going to shrink if it can improve profitability.

What went wrong for WHI over the last few years when it had ROA > 1%? Basically everything that can go wrong. The tax rates went up, efficiency got worse, NIM went down and loan losses went up. WHI never was a high NIM bank but it was very efficient and had excellent underwriting and it made use of lots of leverage. This leverage was great when it was profitable but now acts like an anchor slowing their recovery.

If we go back just a couple of years we have ER=33% and L=0.005 and NIM=2% and T=30%. This gives ROA=0.73%. In 2001, NIM was 2.7% and ROA was almost 1%.

The tax rates went up when they changed the Puerto Rican laws on the taxability of the securities portfolio. This was previously tax free but is now partially taxed. They have also increased the tax rates. This may improve in the future but there is no guarantee. Effective tax rates were also lower because a higher percentage of earnings was coming from the tax-free (or at least tax-efficient) securities portfolio. Now it generates negative earnings as borrowing costs have risen against these fixed rate securities. Only loans are profitable and they are taxed at the full rate.

Their main problems are poor NIM and high loan losses. Loan losses will likely be high for the remainder of the year but should improve in 2009. The poor NIM is probably temporarily low due to loans resetting before deposits. However the deposit scenario is poor for WHI since they rely on brokered deposits and Repos. Even though the Fed has cut rates, brokered CD rates are still high. Much of their Repos are locked in for a year or more at nearly 5% rates.

NIM may get back to 2% by years end but likely will not improve beyond that for quite a while. If they keep their securities portfolio small, it will be higher than previously and they will be a more normal looking bank: less leverage, less reliance on Repos for funding. Expenses will also stay high due to legal expenses and restatement expenses. They should probably improve ER to 50% by years end and improve by a little beyond that.

So by years end, if we adopt these numbers, NIM=2%, L=0.7%, ER=50%, that would bring us to ROA=0.1%. This is still poor and will not lead to a profitable year. However there may be enough in tax benefits from charge offs to make the tax rate temporarily about zero. This would result in a temporary ROA of 0.16% which is slightly better but still might result in shrinkage of equity.

If 2009 is much better, we may see NIM=2.2%, L=0.5%, ER=42% and that would be ROA=0.6% which would be good enough to build value and send the stock back above book value. However it is unlikely to result in rapid growth. Their days of 25%+ growth rates are probably over.

Banking profitability and leverage

2008-05-05T00:28:00.000-07:00

There is a fairly simple formula for banking profitability. Return-on-assets, ROA, given by

ROA = (1-T) * [ (1 - ER + NII) * NIM - L]

where

T = Tax rate
revenue = Net Interest Income + Non-interest income
ER = efficiency ratio = Non-interest expense divided by revenue
NII = Non-interest income divided by revenue
NIM = Net interest margin = net interest income divided by total earning assets
L = provisions for loan losses divided by total earning assets

So the general strategy for banking is always to try to increase non-interest income if it doesn't increase non-interest expense too much. You want to keep your non-interest expenses as low as possible. Then you want to have a high NIM which usually means low deposit costs. Then you want good underwriting i.e. low loan losses. You usually can't do much about taxes. That is really about all there is to banking. The devil of course is in the details of how you actually do this better than your competitors.

Return-on-equity, ROE, is just
ROE = ROA*(assets/equity)
where (assets/equity) is the leverage factor. This leverage factor is limited by banking regulators. It must be less than 25 and is usually required to be less than 20 to be consider "Well capitalized". Most banks try to get it around 12-15. If a bank is profitable, i.e. ROA > 0, then they usually benefit from more leverage. However this can be more dangerous because if things turn bad, the bank may become unprofitable and this leverage will magnify losses to equity. If the bank pays no dividend and retains earnings it can grow at a growth rate equal to ROE, if all of these ratios above stay fixed. It is pays out a fraction PR of earnings as a dividend, then it can grow at (1-PR)*ROE while continuing to pay the dividend at the same payout ratio.

It is also possible to leverage up the shareholders equity by raising other forms of equity such as preferred shares. This requires a fixed dividend payout to preferred shareholders which comes after tax. This involved another leverage factor
EQ/CEQ = (equity/common-equity).
The preferred equity, PE, is the difference between equity and common-equity, PE =EQ-CEQ. If the bank goes bust, the preferred share holders are paid back this preferred equity before common shareholders get anything.

The return-on-common-equity ROCE is given by

ROCE = ROE * (EQ/CEQ) - BC (EQ/CEQ-1)
where BC = the borrowing cost or the dividend yield of the preferred shares.

If you set this to zero you you can solve for the condition where the bank's total equity stays the same size (before payment of any common dividend). That is
ROE = BC (PE/EQ). For example of PE/EQ is 1/2, then the bank's common equity and total equity stay the same when the ROE is half the borrowing cost. When this is true the bank stays the same every year. If you want it to stay the same size after paying a dividend, you replace ROE with (1-PR)*ROE.

When can the common shareholders grow their common-equity faster by issuing preferred shared? Just set ROCE equal to ROE and solve and you find this is equal when ROE =BC. So your ROE had better be higher than your borrowing cost or issuing preferred shares is not worthwhile.

If you want to know the growth rate of common equity, this is equal to ROCE. If there is a common dividend, just replace the ROE with (1-PR)*ROE. That tells you the growth rate of retained common equity. If you keep issuing preferred shares to keep the ratio EQ/CEQ the same, and the other ratios remain the same, you can grow the whole bank at this faster rate. Like the usual leverage ratio, banking regulators put limits on this leverage factor. Usually they want at least half the equity to be common equity.

Ok, lets do an example. Lets assume:
NIM = 3%
ER= 50%
NII=10%
T=40%
L=0.5%

This results in ROA = (1-T) * [ (1 - ER + NII) * NIM - L] = 0.78%. Now lets assume assets/equity =15. This results in ROE = 11.7%. Now lets suppose the bank pays a dividend at a payout ratio of PR=25% of earnings. Then it can grow at G=(1-0.25)*11.7 = 8.78%. Mid to high single digit growth rates are fairly typical for banks. Now, what about issuing preferred shares? Lets suppose it can sell preferred shares at a yield of 6%. Since ROE > 6%, this sounds promising. Lets say that it raises total equity to twice common equity EQ/CEQ=2

ROCE = ROE * (EQ/CEQ) - BC (EQ/CEQ-1) = 17%
The growth rate after paying preferred and common dividends will be
G = (1-PR)*ROE * (EQ/CEQ) - BC (EQ/CEQ-1) = 11.6%. So as long as they continue to issue preferred shares to keep EQ/CEQ=2, and everything else stays the same, then they can grow at this faster rate. In reality, of course, nothing stays the same but that is a different matter.

Now what if the economy goes into recession and the loss ratio, L, goes to 2%? Now ROA=-0.12%. It is now slightly unprofitable. ROE=-1.8%. Equity of the bank has contracted by -1.8% before payment of preferred and common dividends. ROCE=-9.6%. The leverage due to the preferred shares has magnified this loss. Common equity has dropped by -9.6%. That is a pretty big hit for just 2% loan losses. The bank will likely cancel the common dividend payment and if this goes on for another couple of years, it will have to raise common capital and dilute the interest of current shareholders in order to keep the leverage ratio below the regulatory limit.

W Holding - Analysis of the 1Q 2008 Call Report

2008-05-03T14:41:00.000-07:00

Ok, I finally got some time to go over this. Here is what I see, starting with the income statement. (all numbers in millions, rounded)

Loans rates have reset lower by about 100 bps (from 2007 1Q) but deposits rates have increased by about 26 bps. This is squeezing net interest income. NIM is only 1.28% down from 1.915% 2007 1Q and down from 1.656% last quarter. Net interest income is down 20 from last quarter. This will likely improve next couple two quarters. We would like to see NIM closer to 2%. Expenses are higher by 10 due mostly to legal/FDIC/advisory expenses. I am glad this isn't higher. We lost 7.7 before the tax benefit of 47 but 39.7 after taxes benefit. Additional loss in comprehensive income (i.e. doesn't flow through income statement) of 9.6 probably due to balance sheet restructuring.

Total equity capital is 1097 versus 1072 or a gain of 25. This is $3.43/share of book value.

Securities were completely restructured. It appears that they simply sold most of them and bought some shorter term securities to match their remaining liabilities. Total is 5342 down from 6542 last Q. In addition, they now have 2135 expiring in 3 months or less and another 1025 expiring in one year or less. They also sold or retired all of their structured notes 170.

This reduces assets and combined with the gain in capital, the capital requirement ratios are much improved. The tightest one is still Tot Risk based cap = Tot_risk_based_capital/Tot_Risk_weighted_assets which is now 11.33%. This is above the 10% Well-capitalized level by 146 and 366 above minimum. If after next quarter they do not replace their retiring securities they will be 189 above Well cap. if there is no change in capital. If they make about 30 next quarter,as I expect, they will be 219 above well capitalized. If so they might actually be able to buy back shares. I think they only need a buffer of about 160-180 above Well cap.

Now, Past due and non-accrual. This is actually not looking good. Non-accruals dropped from 481 to 467 but 30 days late increased to 215 from 31. Thus total NPAs increased to 682 from 512. Now some of these will probably be cured but much of it will go into non-accrual. Part of the reduction of Non-farm non-res non-accrual was El Legado. But what about Pueblo, Syroco and others? I was hoping for a larger reduction. Are these loans still in non-accrual or have they been replaced by others? 55 of C&I loans are 30 days late. That is worrisome because they could be ABL loans and could lead to large losses. Construction loans 30 days late increased from 1 to 11. Provisions for the quarter was 30 which is close to what I expected. Overall, it looks like there could be a second wave of losses coming next few quarters as the US recession affects Puerto Rico. Is this what we are seeing in the 30 day lates?

Overall, the report is mixed. The bad news is non-accruals still being higher and 30 day lates increasing sharply. Also the poor NIM due to loans resetting faster is slowing our recovery.

The good news is that we are much better capitalized and this will only get better next quarter. We are still profitable. This is partly due to the tax benefits from our charge-offs offsetting high provisions. Allowance for loan losses is still 217 which will allow for more tax benefits as some of this is charged off. Interest income should improve as deposit costs come down as long as non-accruals do not increase by a lot. We might actually be able to buy back stock. Given that the stock price is 1/3 of book value, this can greatly increase BV/share.

So to conclude, it is a decent report and bolsters my case for holding this stock. We are on track to make 150 for the year which is what Stipes said he expects to do. That would put BV/share at $4.1 and EPS at $0.91 (or 0.7 after subtracting preferred dividends). If so and we get current with the SEC we should sell at around $5/share.

----------------UPDATE--------------

See my posts on profitability. After reviewing this further I no longer think they will make much in 2008. They are being hit on profitability on all fronts: NIM, expenses and loan losses and I don't see these improving much for a few quarters at least. The tax benefit from first quarter is likely much larger than what they will book in the quarters to come. I think it may take them until 2009 to improve substantially. I think they will probably linger around $1 until they get current with the SEC. After that, they will still probably stay around $2 until profitability improves after which they will return to book value. It may take them a few years to get back to $5. Still, this would make them a good long term investment. I think the chance of them buying back any stock is small. Still, they should consider it as long as they can foresee improvements in the future. Even 30MM of buybacks near $1 would increase shareholder value by a lot and probably not endanger capital ratios.

The New Bernanke Dollar

2008-03-14T22:41:00.000-07:00

Houses for the banks

2008-02-29T22:25:00.000-08:00

What will be the result of this whole housing bubble blow up? I will try to describe the whole thing is very broad terms.

Around 2000, the demand for real estate started to increase rapidly. Demand for real estate comes from three different sources. First of all, a population increase can cause this. There can also be demand from people who want to own more than one house. There can also be a change in preference between renting and buying. The first reason, population increase, has been fairly steady over US history and are not the main driver of the recent housing bubble.

The demand for second homes certainly increased. People, in recent times, think of second homes as an investment. After the stock market crash of 2000, the dot-com blowup, people looked for alternatives to stocks. They noted the wonderful returns that they or their parents may have received by buying during or before the inflationary 1970s. This current demand was aided by the very low interest rates following the stock market crash. The two sources of this were Greenspan's Federal Reserve as well as the "vendor financing" resulting from the rise of the US trade deficit. In short, China sends us products, we send them dollars and they buy US financial assets such as US mortgages and US Treasuries. This helped keep interest rates down leading to a refinancing boom and a boom in first home purchases.

This was the first stage of the housing bubble. The number of homes of course didn't change as rapidly. This change in the supply-demand balance lead to the beginning of the price appreciation bubble. This of course feeds back and enticed more people to think of housing as a good investment which led to more buying.

The next stage of the bubble came from converting more renters into buyers. Traditionally people would rent while they were young and save money for a down payment on a home. This is what I learned when I was young. Typically this would be 20% of a house price. This was demanded from banks to create an equity cushion. Mortgages are non-recourse loans that allow the buyer to simply stop paying the mortgage and giving the bank the right, in turn, to foreclose or take back the collateral. The equity cushion provides the incentive for the buyer to do whatever it takes to avoid default. It also allows the bank to suffer as much as a 20% loss on resale without suffering a net loss.

Due to this dramatic run-up in house prices, the banks relaxed their lending standards to allow for lower down-payments. In addition, since house prices were rising rapidly, they were not too concerned about suffering any loss on the value of the collateral. There was no need for a 20% down payment if the house would be worth 20% more next year. Many of these loans were resold to investors anyway. So it would not be the problem of the originating bank or mortgage originator once it was sold off, if the payments were not made.

The worst of this was the subprime lending industry. Fueled by short-term loans from Wall Street banks, these lenders would give loans to just about anybody capable of fogging a mirror. The lenders were extremely profitable because they could sell off the loans very quickly. A 1% gain on a home loan isn't that great if it takes you a year to do it but if you can turn-over 10 such transactions in a year, that is a 10% annual gain on your capital. Better yet, if you can leverage up your assets to 10 times capital, that is a 100% return on capital. What a business model? So faster turnover from the buying mania and leverage created this wonderful business opportunity. However it depended on insatiable demand for houses as well as a plentiful supply of borrowed money from Wall Street and finally demand for these securitized mortgage products in the secondary market.

All this time, the homebuilders were ramping up their building. There was more demand for homes and so this resulted in higher profit margins. These profits created more capital that could be used to buy more land and build more homes. The end result would of course be a much larger supply of houses.

Home prices rose. Economic activity was vibrant with all this building and buying and selling. There were profits all around. Builders made a killing. Banks made a killing. Even the buyers made a killing if you counted the capital gains on the houses. All of these were extremely leveraged. The buyer bough with little or no money down. Putting down 5% (1/20th of the house) and getting a one-year appreciation of 20% meant a 400% return on invested capital. Who needs to work when you can get returns like that just by signing on the dotted line? Bank loans are always leveraged transactions. They are allowed to leverage their capital by about a factor of 10%. Builders were leveraged as well by borrowing from the banks.

Of course this all had to come to an end. Eventually prices got so high that most people simply could not pay the mortgage payment. They could not even pretend anymore. Monthly payments were as much as twice what it would cost to rent the same house. This was almost 50% of the average persons take home wages. The supply of people that could be converted from renters to buyers or single home owners to second home owners began to dwindle. The excess supply of new homes relieved some of the pressure on home prices.

So eventually home price appreciation stopped. Then the whole process which depended on rising home prices would come apart in dramatic fashion. Now we are in a period of falling prices. Now the total supply of houses is much larger than before. The supply of people willing to speculate on house prices has evaporated. The supply of banks willing to make low down payment loans has contracted. The fact that prices are clearly dropping removes any incentive to buy now. The deflationary mindset sets in. Why buy now when you can buy cheaper next year? The supply of houses for sale is even larger due to a massive wave of foreclosures.

What is the endgame for all of this? House prices will eventually bottom. They will do so when it becomes cheaper to buy then to rent. It will do so when a person can buy a home and rent it out for a profit. The trouble is that this break even point between buying and renting seems quite a ways off.

So who is the winner and loser from all of this? Like all bubbles, this has resulted in a miss-allocation of resources. This results in a inefficiency and so a decrease in GDP. Basically, houses will end up on the balance sheet of banks who will have to auction them off at a loss. So banks will have lost money which will easily erase all of the profits from the proceeding years. People who owned before the bubble will have seen their house value go up and down. Many of these will not be impacted. However, some of these may have borrowed against their home and now find themselves with a much higher debt/equity ratio. They may now have to work longer than they had planned in order to retire and so may spend less in the coming years. Again , this will reduce GDP.

Some people with good credit and secure jobs who bought near the peak will have to pay higher than normal mortgage payments for the rest of the life of the mortgage. Some people may have lost all of their net worth by having bought at the wrong time and now have to sell for whatever reason.

Who are the winners? For every losing speculator there is a winning speculator. Some people who bought and sold at the right time made a small fortune.

Young people and renters are winners. They will in the future be able to buy houses much cheaper. There are a lot more houses now and not that many more people.

A good Zen koan for investing

2008-01-13T00:49:00.000-08:00

Joshu asked Nansen, “What is the Way?”
“Ordinary mind is the Way,” Nansen replied.
“Shall I try to seek after it?” Joshu asked.
“If you try for it, you will become separated from it,” responded Nansen.
“How can I know the Way unless I try for it?” persisted Joshu. Nansen said, “The Way is not a matter of knowing or not knowing. Knowing is delusion; not knowing is confusion. When you have really reached the true Way beyond doubt, you will find it vast and boundless as outer space. How can it be talked about on the level of right and wrong?”
With these words, Joshu came to a sudden realization.

—“Ordinary Mind is the Way,” translated by Katsuki Sekida

This is one of my favorite koans. It also has an investing parallel. I have rewritten it as:

Joshu asked Nansen, “What is the way the make money in stocks?”
“Don't try to make money in stocks. Just invest wisely,” Nansen replied.
“Shall I try to seek after great returns?” Joshu asked.
“If you try for it, you will become separated from it,” responded Nansen.
“How can I get rich investing unless I try for it?” persisted Joshu. Nansen said, “The Way to riches is not a matter of trying to get rich or trying to keep from losing money. If you do that you will be bound with fear watching your daily net worth fluctuate wildly. Just invest wisely keeping true to your principles. If you do that you will be rich."
With these words, Joshu came to a sudden realization.

Why people lose money on fast growing companies.

2007-11-03T00:28:00.000-07:00

Most people pick stocks like this. First they find what looks to be a "good company". A company that qualifies as a "good company" usually has a high growth rate.

For example people who call themselves "growth investors" will look for a company growing at 40% or so. Maybe it has only been around for two years but grew earnings at 40% both years. They say to themselves. "If it keeps growing at 40% for two more years (and why shouldn't it?) and retains the same valuation, then I will have doubled my money in two years."

Other people who would call themselves value investors or Warren Buffett inspired investors have read all the Buffett books. They take a variation on this. First of all, they look for high and stable return-on-equity, low debt, and a fairly high growth rate, say 20%. Then they look at valuation. They might be willing to pay P/E = 18 for a company growing at 20% and ROE=20% and no dividend. They might use DCF to get the "right" valuation.

Most of these "growth investors" and "value investors" don't beat the market.

The growth investor gets it wrong because they never really trust these growth predictions. They need to diversify into 25 growth companies because they have little faith in each one. Because of this, they do not know the companies very well. Sometimes there is not much to know. They may be speculative at best to begin with. Some do very well and keep growing quickly. Some slow down and lose their high valuation and some simply go bust. They get an average return over long time periods.

The "Buffett investor" gets it wrong as well. They also do not beat the market by much if anything. They may not get big losses because they avoid the speculative bubbles but may have some real dogs. Many of their "good companies" stop being good, drop in value and are sold. What went wrong? They read all the Buffett books. They made sure all had high ROE and therefore probably an economic moat.

What is wrong with the intrepid value investor? I first discovered it by reading this article over at Tweedy Brown, called "Great 10-year record = Great Future, Right?
(You might need to click around for it under research reports). It is a great article, a real eye opener for me. Many of these Tweedy Brown articles are great reads.

The gist of the story is that the earnings growth of companies over the proceeding 5-year period is uncorrelated with the earnings growth the preceeding 10 years. Similarly, the ROE is also uncorrelated. Companies with high ROEs over the 10-year period do not grow faster than the average company. And stock returns are not better for these high ROE companies.

What??!! You mean you can't turn Warren Buffett's performance into a simple formula based on high ROE? Sorry but no. Maybe that isn't surprising to you. After all, there are not many Warren Buffetts around despite everyone reading the books on how to emulate him.

Of course Warren never said it was that simple. He talks about many things including mangement, strong brands or economic moats. He talks a lot about fully understanding the business and being able to predict earnings. He talks about buying only cheap companies which he defines as companies selling below their intrinsic value.

I don't really think there is any great mystery to how Buffett does it. It is simply that he does it better than everyone else. When he says "really understand a business", he sets a higher threshold than most people. That is, he understands their competitors. He understands, whether their costs will likely rise or fall. He only buys companies for which he thinks he can undertstand what the demand for their products/services will be. He looks for companies that have little risk of underperforming his goals. It is these rare companies that he fully understands for which he can predict where they are going to be in 10 years. Once he knows this, he knows the value of the company and if it sells well below this value, it is a buy.

The bottom line is that Warren is hard to emulate because he does a lot of hard work that most people do not or will not do. It takes a long time to analyse an entire industry. Also, he has that rare constitution for investing. He doesn't get spooked out. He has confidence in what he is doing because he knows everything he needs to know. He doesn't get distracted. He doesn't violate his principles. He is of course the complete package, as Michael Jordan was the complete package in basketball. You can read books on how to be like Mike but that won't get you that far without talent.

One last thing about Buffett that I should point out. A rare quality he has is incredible patience. I see dozens of companies that I like and would invest in (and have invested in). Buffett aparently sees none. He has been sitting on $40B for several years and has invested very little of it. Clearly, his standards are much higher than most people. That kind of patience is incredibly rare among investors.

The Global Housing Crash

2007-10-29T00:19:00.000-07:00

I am a believer in the global housing crash scenario. Normally, I don't put much faith in economic forecasts. I think it is almost impossible to do it well. Alan Greenspan agrees by the way. He recently said on the John Stewert Show (of all places) that he hadn't seen any improvement in economic forecasting over his entire life. However, the housing situation is different. It is a matter of common sense. Logically, real housing prices should not change very much. Houses and the land they sit on are stagnant things like commodities. They do not produce cashflows other than by renting them out. But renting them out for an amount that doesn't cover the mortgage payment is a negative carry. They are clearly overvalued and must come down one way or the other. I won't go over the argument why they are overpriced and why they must come down. Rather, I want to focus on the consequences.

Lets assume that the following dire scenario happens:

House sales and prices continue to drop over the next two years. The subprime buyers cannot be kept in their houses despite much government interference. It simply isn't in their interest to stay. They foreclose and/or declare bankruptcy. However they aren't the only ones. Other "prime" homeowners with negative equity, negative net worth but otherwise good credit realize that they also have no incentive to stay in their homes. Many of them also join the subprime crowd. The negative feedback is obvious. More foreclosures lead to more inventory which puts more pressure on prices. The deflationary psychology sets in. People put off buying because prices are dropping so quickly. The Fed will do its best but can't force people to buy houses. Washington will do its best to pass legislation with incentives to slow the crash but with only mild effects. Prices drop by 10% per year for four years, a total of 35% and then start to decline another 2% for the next six years. The total 10 year decline is 42%. With 2% inflation, real prices have dropped by a factor of 2.

What would the consequences be?

I don't really know. But I think this would lead to many different crises, certainly a long recession if not a depression. Some of the milestones would probably include

~~Lender failures~~
~~Home builder bankruptcies~~
~~Financial company impairments~~
~~Credit crunch~~
~~Failure of leveraged speculators~~
Major bank balance sheet impairments
Recession in countries with housing crashes
Recession spreads to most other countries
Failure of mortgage insurance companies requiring Government bailout
Near or complete insolvency of Fannie Mae, Freddy mac requiring Government bailout
Investment bank failures
Major bank failures
Currency devaluation arms race
Rise of protectionism
Major inventory/capacity overhang in manufacturing/export countries like China
Deflation in all major asset classes
Flight to safety, US dollar?, blue-chips, health care, high cash-flow, recession resistant companies, Treasuries
International goverment intervention in mortgage market and banking
Panic, crises, unforseeable events and eventually resolution and recovery

In the end (whenever that is), houses are no longer sexy "investments". They become more affordable and necessary "expenses". They are just the place where you live.

As I mention above. I don't know how it will end or what will go right or wrong along the way but many of these things could happen. Many will only happen if house price declines cross certain thresholds. A 10% decline will be manageable. A 20% decline will be major pain. Beyond that, my above scenario is (I think) quite likely and I don't see what could cause prices to stop decling at only 20%. They will still be very expensive for most people and still a negative carry for renting out in most markets. I don't think most companies have a plan for 30% price declines.

Westernbank versus Inyx Timeline

2007-10-10T22:10:00.000-07:00

This is a timeline to keep track of developments concerning the Inyx , Westernbank interaction

Feb 2005, Irish High Court bars Kachkar and Carrigan from investment and directorship positions in Ireland. (source: Carrigan testimony doc 191)

March 31, 2005, Inyx and its wholly-owned subsidiary, Inyx USA Ltd. (“Inyx USA”), entered into a Loan and Security Agreement (as amended, the “USA Loan Agreement”) (attached Exhibit 1) with Westernbank. Fraud guarantees signed by "Inyx Operators" (source: RICO complaint)

May, 2005, Inyx Pharma Ltd. (“Inyx Pharma”), which is also a wholly owned subsidiary of Inyx, signed an amendment to the USA Loan Agreement (attached Exhibit 2), and became a co-borrower under that Agreement. Inyx, Inyx Pharma and Inyx USA are referred to hereinafter as the “USA Borrowers.” loan $46M ($10M revolving and $36M in 4 term loans) secured by all assets (source: RICO complaint).

July 2005 Jose Biaggi appointed CEO and President of Westernbank.

August 30, 2005, Kachkar, Green and Goldshmidt each executed similar guarantees covering fraud, deceit or criminal acts by Inyx, the EU Borrowers, or any officer, employee or agent of Inyx or the EU Borrowers. (source: RICO complaint).

On August 31, 2005, Inyx Europe Limited (“Inyx EU”) and Ashton Pharmaceuticals Limited, f/k/a Celltech Manufacturing Services Limited (“Ashton”), entered into a Loan and Security Agreement (as amended, the “EU Loan Agreement”) with Westernbank (attached Exhibit 9). Inyx EU and Ashton are referred to hereinafter as the “EU Borrowers.” Under the EU Loan Agreement, Westernbank agreed to lend up to $35.5 million, consisting of a revolving credit line of up to $11.7 million and term loans to Inyx EU in the aggregate amount of $24.8 million, pursuant to four promissory notes. Loans are now about $82M (source: RICO complaint also Montanez testimony).

October 24, 2005, Inyx sought and received a $5 million Secured Over Formula Advance Loan from WBC for working capital to purchase new inventory. The loan was to be guaranteed by inventory one of the Inyx Companies was to purchase pursuant to existing purchase orders. The Inyx Companies, however, never reported such inventory to WBC, and the underlying purchase orders were fraudulent. In addition, while the loan has long since been due and owing, the loan has never been repaid. Loans now $87M (source: RICO complaint).

Nov 2005, Another $10M in loans for revolver at Inyx Pharama Loans now $97.5M (source: Montanez).

On or about August 1, 2006, a conference call was conducted among Westernbank employees and Handley and Hunter. During this call, Handley and/or Hunter falsely represented to Westernbank that most of the Inyx past due accounts receivable discussed on the call would be collected over the coming months even though they knew that most of these
accounts receivable were fraudulent. This conference call took place over international wires (source: RICO complaint).

On or about August 11, 2006, Kachkar, Green, Goldshmidt and other Inyx Companies employees traveled to Puerto Rico to meet in person with Westernbank employees. Among the topics discussed were Inyx’s aging accounts receivable. Kachkar, Green and/or Goldshmidt told the Westernbank employees that they should direct their questions to Handley
and Hunter because they were the ones knowledgeable about the accounts receivable (source: RICO complaint).

Sep 2006, Loans are up to $110M. Accounts receivables increasing, need more working capital. Added to revolver (source: Montanez).

Starting in September 2006 and continuing through at least May 2007, the Inyx Operators repeatedly, misled Westernbank by advising it that the Inyx Companies and/or the Inyx Operators were finalizing arrangements with other sources of funding either to buy out or significantly pay down the Inyx Companies’ debt to Westernbank (source: RICO complaint).

Oct 2006, Auditors cannot complete audit in UK.

November, 10 2006 Jay Green says final stages of due dilligence with Goldman Sachs, Wachovia, Credit Suisse. Jay Green requests a waiver of financial covenants. They are writing off $37M in receivables and that they are pre-billings. "Raised a red flag". Contacted Kachkar who claims this is only GAAP accounting and that receivable are good (source: Montanez)

November 17, 2006 personal guarantee from Kachkar and Benkovitch in the amount of $10 million (source: RICO complaint).

November 20, 2006 Mike Vasquez sends letter acknowledging the $37M in pre-billings. (source: Montanez)

Jan 2007 Last WHI Conference call. Stipes says Inyx is current and that it is not a bad loan. Might be acquired.

Jan 17, 2007 Jack Kachkar offers $148.6 million to buy Marseille soccer team.

Feb 21, 2007, Skepticism grows over Kachkar's funds
Money laundering worries. . French Press says
he has 386M Euros (same link).

Mar 2, 2007
Jay Green sends Westernbank a letter of commitment for financing from Pareto Securities. The letter turns out to be a forgery.

Mar 5, 2007
French Paper reveals that
TRACFIN, the French agency that investigates money laudering is investigating Kachkar and Benkovitch.

March 7, 2007 personal guarantee from Kachkar and Benkovitch in the amount of $8 million (source: RICO complaint).
Loans at $120M (source: Montanez).

Mar 14, 2007 Kachkar's claims to have purchased Grimaldi Castle exposed in
Provence Paper .

Mar 24, 2007 Robert Louis-Dreyfus decided not to extend a payment deadline for Kachkar to buy Marseille team.

Apr 11, 2007 Jose Biaggi tenders his resignation as CEO and President of Westernbank and member of the BOD.

In May 2007, Westernbank learned of a collateral deficiency under the Loan Agreements in excess of $80 million because of uncollectible accounts receivable. Various Inyx officers, including Kachkar, Green and Goldshmidt, thereafter gave false assurances to Case 3:07-cv-01606-ADC Document 3 Filed 08/23/2007 Page 32 of 54 33 Westernbank in June 2006 that the collateral deficiency was substantially less than this sum, the accounts receivable identified as uncollectible were in fact collectible, and/or that the collateral deficiency would be covered by other assets (source: RICO complaint).

May 2007, David Zinn says receivables probably not collectable (source Montanez).

May 14, 2007, Sahara Bank replies by SWIFT saying that it has no letter of credit from Qadahfi for Westernbank.

May 31, 2007 Meeting with Kachkar. He says receivables are good (source Montanez).

June 7, 2007, Kachkar and Benkovitch executed an Amended and Restated Limited Guarantee (the “First Personal Guarantee”) (attached Exhibit 14) guaranteeing, with certain limits as detailed in the First Personal Guarantee, all obligations of the USA Borrowers and the EU Borrowers to Westernbank under both the USA and EU Loan Agreements (collectively, the “Loan Agreements”), up to $30.1 million. The First Personal Guarantee was given “in substitution” of earlier guarantees (source: RICO complaint).

June 19, 2007 According to 8-K filed June 25, 2007, WB decides that the Inyx loan is impaired.

June 20, 2007, Kachkar and Benkovitch executed an additional Limited Guarantee (the “Second Personal Guarantee”) (attached Exhibit 15) guaranteeing, with certain limits as detailed in the Second Personal Guarantee, all obligations of the USA and EU Borrowers to Westernbank under the Loan Agreements in an amount equal to the sum of $70 million plus the amount that the repayment obligations under the Loan Agreements exceeded $142.4 million. This Guarantee was “in addition to and not in substitution of” the First Personal Guarantee for $30.1 million, which remained “continuously in effect.” (source: RICO complaint).

June 20, 2007, Kachkar and Benkovitch executed a Collateral Deficiency Letter (attached Exhibit 16), through which Kachkar and Benkovitch agreed to Case 3:07-cv-01606-ADC Document 3 Filed 08/23/2007 Page 12 of 54 13 provide certain collateral (the “Mining Collateral,” as defined in the Collateral Deficiency Letter) sufficient to cover the amount of the collateral deficiency under the Loan Agreements (source: RICO complaint).

June 22, 2007 Montanez says "We became concerned on approximately June 22nd." because David Zinn reports missing $4.1M in receivables at Inyx USA and 28M sterling missing at Inyx Pharma and 51M sterling missing at Ashton. They contact Zinn who says they will never be collected. Zinn also says $14M in funds have been diverted from lock box (source: Montanez).

June 25,2007 WB files the
8-K reporting the impairment. WHI stock falls.

As of June 28, 2007, Westernbank had made loans to the USA and EU Borrowers in the amount of $142,778,299.77 under the Loan Agreements. As of that date, numerous Events of Default under the Loan Agreements had occurred (source: RICO complaint).

June 28, 2007, administrators were appointed for Inyx Pharma and the EU Borrowers (source: RICO complaint).

June 29, 2007, Westernbank sent a demand letter to the USA Borrowers (attached Exhibit 17). In that demand letter, Westernbank informed the USA Borrowers that (i) the amount of the outstanding loans exceeded the amounts available under the lending formulas and (ii) Westernbank was demanding, as entitled under the Loan Agreements and the Cross-Default Agreement, for the immediate payment of such excess amounts, totaling $87,282,422. The demand letter also informed the USA Borrowers that all other “Obligations” as defined under the Loan Agreements had become due and payable (source: RICO complaint).

June 29, 2007, Westernbank sent a separate demand letter to Inyx Pharma and the EU Borrowers making the same demand as in the demand letter sent to the USA Borrowers but referring to the Obligations under the EU Loan Agreement that had become due and payable as a result of Event of Defaults under the EU Loan Agreement (attached Exhibit 18) (source: RICO complaint).

July 2, 2007, Inyx USA, as well as another Inyx subsidiary named Exearis, Inc., filed voluntary petitions for relief under chapter 11 of title 11 of the United States Code in the United States Bankruptcy Court for the District of Delaware (source: RICO complaint).

On or about July 3, 2007, Westernbank sent to Inyx, Inyx Pharma, Inyx EU and Ashton a “Notice of Default and Demand” (attached Exhibit 19). The Notice of Default and Demand stated that numerous defaults had occurred under the Loan Agreements (source: RICO complaint).

On or about July 3, 2007, Westernbank also issued letters to the Inyx Operators demanding payment under the Fraud Guarantees (attached Exhibit 20). By these letters, Westernbank demanded payment from the Inyx Operators of at least $80 million (source: RICO complaint).

On or about July 3, 2007 and on or about July 10, 2007, Westernbanki ssued letters to Kachkar and Benkovitch demanding payment under the Personal Guarantees and the furnishing of the Mining Collateral under the Collateral Deficiency Letter (attached Exhibits 21 and 22). Westernbank demanded from Kachkar and Benkovitch (a) payment in the amount of $30.1 million under the First Personal Guarantee, (b) payment in the amount of and $70,378,299.77 under the Second Personal Guarantee, (c) the furnishing of the Mining Collateral sufficient to cover the collateral deficiency under the Loan Agreements, and (d) compliance with and performance of their covenants under the Collateral Deficiency Letter (source: RICO complaint).

July 26,2007 The

Stipes Fights Back article published in Caribbean Business

A house is NOT an investment

2007-10-07T13:48:00.001-07:00

People often get caught up in prevailing myths which provide a basis of belief which leads them to make poor financial decsisions. One of the biggest myths is the idea that buying a house is an investment. The way we talk about things often dictates the decisions we make. Investing money always seems more prudent than simply buying. Often it is said that buying a house is an investment. Is this true? That of course depends on what we mean by investment.

I think the best definition of investing is using ones savings to buy an asset which will provide real future returns in excess of the invested capital.

For example buying a factory with which you will produce marketable products is an investment. Even if you borrow most of the capital, you can pay the interest payments with the operating cash flows. If it is a good investment, you will have profits left over which you can put into savings. Over the long term, it is likely that you can pay off the mortgage and collect these cash profits. After say 30 years, you will have paid off the loan so that you own the factory, the cash flows that were produced as well as the future cash flows that will come in the future. If the real value of these things are greater than the real value of the invested capital, you have made a profitable investment.

I will use the term real value to mean inflation adjusted value. We can compare dollar amounts at different times by discounting them by the risk free return.

Other examples of investments are buying stock in a company, buying CDs from a bank, buying an apartment building which is producing cash flows in excess of the mortgage payment interest rates.

So, what about buying a house? Well, we all need a place to live. Our main choices are renting an apartment or buying a house (or condo). A similar decision to this is choosing what to eat. We all need food but we seldom talk about investing in our food. We consider it a necessary purchase not an investment. Buying a house should be considered the same.

It is possible to think of buying houses as investing. For example, if you buy a house for the purpose of renting it out, it can be an investment. If the rental payments are large enough to pay for the mortgage and also build equity in the house, this can be an investment. However this shows that it is only possible to make housing an investment if mortgage payments to rent are a low enough ratio. In fact this is the best way to value the price of houses. The price to rent ratio is similar to the price to earnings ratio for a stock.

During times of a speculative housing mania, the price of houses will be increasing. People buy houses with borrowed money and hope to make money simply from the increase in house price. If the house price is increasing faster than the interest rate of the borrowed funds then it may be the case that the rent is below the required mortgage payment but the appreciation of the house makes up for this negative cashflow.

However, this situation is unstable and cannot last for long. Eventually the house price will stop appreciating at these high rates and may even start deceasing. These people with negative cashflow will have to sell. This wave of selling will lead to higher inventories of houses for sale which will lower prices further. This kind of "investing" is better thought of as speculation. The profits depend on price appreciation and not positive cashflow. It is no different than speculating on the prices of gold, currencies or pork bellies.

Whether or not such housing speculators make money depends on when they got into the game. People who started early may come out with a profit. Those who started late will come out with a loss.

The housing industry is constantly promoting the idea that buying a house is an investment when this usually is not true. When you are buying a house to live in, this is simply a purchase to satisfy your housing needs. It is the main alternative to renting and often makes sense for people. If the payments on a traditional 30-year fixed mortgage are comparable to the payments that you would pay to rent the same house, then buying is probably a good idea. That is because you are paying a similar amount and are building equity in the house.

The housing prices in Los Angeles these days are so high that buying a house can only be thought of as irrational. Prices are way above any amount that is justifiable by rental cash flows. You will pay more on a interest only mortgage than you would pay to rent the same place. With an interest only mortgage, you are building no equity in the house. The no-money-down, interest-only-loan, which was so common these past few years can be thought of as renting money to speculate with infinite leverage on house prices. Most people would never borrow $20K and then buy pork belly futures but they actually undertaking something even riskier when they use these interest-only motgage products to buy a house. They are not actually buying a house- i.e they don't build equity-they are merely speculating on rates of appreciation. The only benefit over renting is that you get to profit from any appreciation of the house. However in a climate of falling home prices, this can only be a negative. Plus you need to pay all of the expenses associated with buying such as taxes, repairs and insurance. In such an environment prices have to go down since there is practically no financial incentive to buy at current prices. People who got in late may forclose and these forclosed homes will add to the inventory driving prices down further.

Valuation of W Holding (WHI)

2007-09-16T15:24:00.000-07:00

I have constructed a model for valuation of the W Holding company, a Puerto Rican bank (ticker: WHI). They are likely to suffer a one time loss over one or more bad loans this year. This model will assume that they have a fixed return-on-assets (ROA) over the immediate future. It assumes a fixed leverage, Assets/Equity. They have preferred shares and so pay a fixed dividend to preferred share holders. They also pay a common dividend. I will assume that this common dividend is a fixed percentage of net earnings (prior to preferred payments, common dividend and one time loss). I assume that common shareholders compound their dividends in a money market account. The following tables show the constants, the key variables, the expected yearly data and finally the results which include a valuation. We discount this to the present to get a Net Present Value which we can compare to today's stock price. All dollar amounts and share counts are in Millions.

Enjoy.

Fixed Constants
Name	Value	Description
NSHARES	164.897	Number of shares
ASSETS	17894.0	Beginning Assets
EQUITY	1147.00	Beginning Equity
PREF	36.9120	Annual preferred payments
LEVERAGE	15.6000	Leverage ratio, Assets/Equity
PREF_EQ	530.800	Preferred Equity
PRICE_NOW	2.11000	Today's Price per share
PE	10.0000	Price-to-earnings ratio for final valuation
PCB	1.50000	Price-to-common-book-value ratio for final valuation
DISC_RATE	0.100000	Discount rate to convert final value to present value

Variables
Name	Value	Description
ROA	0.00800000	Return on Assets
DIV_PAYR	0.200000	Dividend Payout Ratio, fraction of Net Income before one time loss and dividends
LOSS1	170.000	One time after tax loss due to this years bad loans
BB_EQ	50.0000	Equity used to buy back stock in first year
PRICE_BB	2.60000	Average stock price for buy-back

Per Year Data
Year	Earnings	E. Growth %	Dividend	Assets (end)	Equity	Com. Eq. /share	ROE	ROCE
2007	-26.8480	-126.848	28.6304	15671.9	1004.61	3.25271	-2.34071	-4.35703
2008	125.375	NA	25.0751	16660.8	1068.00	3.68787	12.4800	26.4611
2009	133.286	6.30974	26.6572	17748.3	1137.71	4.16648	12.4800	24.8114
2010	141.987	6.52782	28.3974	18944.5	1214.39	4.69287	12.4800	23.3949
2011	151.556	6.73962	30.3112	20260.1	1298.73	5.27181	12.4800	22.1706
2012	162.081	6.94444	32.4162	21707.1	1391.48	5.90856	12.4800	21.1063

Results
Description	Value
Final number of shares	145.666
Ending common equity per share	5.90856
Total dividends received per share	1.17726
Total dividends compounded per share	1.32790
Price based on PE = 10.0000	11.1269
Price based on PCB = 1.50000	8.86284
Final Value/share = Av. Price + Total comp. dividend	11.3228
Net Present Value (discounted at rate = 10.0000%)	7.03054

The key variable is ROA. I have assumed 0.8% in the example above which is quite conservative. The average ROA for W Holding since 1996 is 1.15%. The max was 1.147% (in 1997) and the min is 0.59% (in 2006). A more optimistic value for ROA would be 1% which would increase the Net Present Value to $9.5/share.

The main thing that I left out was share dilution from stock options which may be considerable. I would guess that there may be about 10 million shares created for management. This would lead to a dillution of 6%.

W Holding and the Yield Curve

2007-07-07T14:48:00.000-07:00

Here I will explain a bit about the yield curve and how it affects the profitability of banks with the focus on Puerto Rican banks and W Holding in particular.

The long term rates such as the 10 year or 30 year yields are determined by SUPPLY of savings and the DEMAND for long term loans. Essentially this is determined by the bond market and essentially is affected by everything that goes on in the world including the growth of the world economy, the savings rates, the inflationary expectations and world politics (i.e everything).

The curve defined by the yield of similar secutites (say US Treasuries) as a function of maturity is called the yield curve. Here is a webpage which will show you the shape of the yield curve at various points of time. You can check it daily as well as get some of the most insightful bond market commentary from PIMCO .

I won't go into the gory details of the yield curve and what it means in detail. It is quite a fascinating creature actually. It not only tells you about the present supply versus demand of loanable funds of various maturities but also tells you about the future expectation of changes in itself. In short, if you want to borrow (or lend) money for 10 years, you can do it in several different ways: one fixed 10-year loan or two 5-year loans or five 2-year loans. Global arbitrage will result in making the expected cost the same. This will presume the market assumption of what the 5-year yield will be in five years from now or what the 2-year will be at various points in the future. I like the quote from financial writer and former derivatives trader Frank Partnoy, "If you don't understand the forward yield curve, you're probably losing money to someone who does". Pardon the digression.

Generally banks borrow short term funds. For example they receive checking and savings deposits or issue CDs. They also borrow from each other at the Fed funds rate and if necessary can roll over these short term loans. Similar short term loans between banks are called repurchase agreements or repos. These are loans where the borrowing bank sends some collateral to the other bank such as bonds or some financial security. Funds from checking and savings accounts are the preferable way to borrow money since the interest expected on these is minimal. CD rates and in general the short term lending rates are largely determined by the Federal reserve. The Fed directly controls the overnight lending rate, the Fed funds rate, and all other short term instruments compete with this rate and so do not differ much from the Fed funds rate.

The difference between the long end (say 10-year yield) and the short end (the 3-month yield) is called the yield curve spread or simply the spread. This number is crucially important to the profitability of banks. This is because they typically borrow short and lend long. For example they issue CDs and take these funds and offer mortgages or business loans. When this spread is large, they can make a lot more money than when the spread is small. When the spread is negative, they are actually losing money by lending. This is one reason why the spread is typically positive. There is no incentive for banks to lend at rates that are lower than their borrowing costs. So they will refrain from doing so which will reduce the supply of loans and drive up the interest rate. Like all market rates, it is all determined by supply and demand. There is also the issue of risk spreads. Riskier loans require higher interest rates over the risk-free US treasuries. When these risk spreads are higher banks make more money. When they are tight (like now), banks have to take on risk without as much compensating profitability. These periods of low risk premiums do not usually last very long and frequently end in turmoil. As Greenspan put it, "...history has not dealt kindly with the aftermath of protracted periods of low risk premiums." Often they end in too many bad loans and not enough profit on the surviving loans to make up for it. In short, there is too much money and not enough good investments to make with it.

Let's get back to our bank in question, W Holding (ticker WHI), parent holding company to Westernbank of Puerto Rico. The defining feature of Puerto Rican banks is the lack of low cost deposits. Puerto Rico is quite poor. Although part of the US, they are as about as poor as Mississippi, the poorest US state. There is not a lot of money hanging around in checking and savings accounts. Instead these banks mostly rely on brokered deposits. In essense they have to buy their funds in the money market through CDs and repos and other similar short term instruments. Although this is usualy thought of as a dissadvantage, they have other advantages that can make up for it. The main one is the low tax rates. PR banks can register as an International Banking Entity (IBE). Because PR is not a state and doesn't have full representation, they are not taxed by the US government. Remember the whole "No taxation with representation" thing?. We take that pretty serious in the US (except for Washington DC). PR banks thus have lower tax rates and can offer slightly higher rate CDs and repos because they can earn slightly higher after tax returns by investing in US treasury securities.

These IBEs are typically divisions within the bank and when the yield curve spread is positive they become incredible cash machines with very little risk involved. The only risk is that the yield curve will flatten or invert, making them unprofitable or even loss producing. However these periods are usually not long lasting. If the flattening is due to rising treasury prices (falling yields) then they have made a capital gain on those bonds which make up for the fact that yields going forward are smaller. Rising Fed funds however are simply bad for IBEs and make this business difficult. Happily, these times do not last forever. The natural state for the yield curve is to have positive slope and so the natural state of IBEs is profitability.
There can be maturity mismatch. Much of this can be handled with derivative instruments such as interest rate swaps. Generally speaking, there are short term risks but over the long term they are great businesses. They can be run with very few employees and so are extremely efficient. WHI is one of the most efficient banks in the US.

This brings us to a rather simple point. The profitability of WHI is affected by the spread. The stock price is also affected by their profitability and so one would expect a correlation between the spread and the stock price. Lets look at a chart

The red is the yield curve spread with the scale on the left. The black is the stock price (scaled arbitrarily). One can see that there is a pretty good correlation. The stock price has a bit of a lag as investors don't seem to react until reported earinngs begin to decline. You don't want to be in WHI when the spread is huge (say 2004), profitability is large and investors think this will go on forever. However buying in the 2000 recession, before the fed cut, would have made you a four-bagger in three years. You want to be contrarian. You want to get in when things are bleak and the bank is simply skating by with low profit margins. The market is short term oriented. They won't wait for things to change. However a long term investor can simply buy in here and wait. Someday, things will change. The Fed will lower rates and the yield curve will steepen. The IBEs of Puerto Rican banks will become cash machines again and the banks will grow at growth rates of 20%+. The stock price will rise and continue to rise for years as the economy recovers until the Fed decides that it is time for a slowdown. You want to get out while the gettin' is good before a new crop of investors learn their lesson about the yield curve the hard way.

Where I get financial data

2007-06-02T20:42:00.000-07:00

If I had lots of money I would pay Standard and Poor lots of money and I would get their Compustat database with some visualization software. However I don't so I have rolled my own. Here is a brain dump.

Where do you get financial data? Here is where I get mine.

1) Yahoo finance. http://finance.yahoo.com/
This is a pretty good site. I won't go into it in detail but you can find lots of financial data here as well as stock price charts and a message board (alas with too much spam). The problem with yahoo is that you can't get much for financial data from more than two year ago. It is good for short term info but not so good if your looking for 10 years worth of earnings data. You can also look up historical prices here. Other info you can find here are short ratios, EV/EBITA, Analyst estimates etc.

2) MSN Money
A good place for a 10-year history of profitability is MSN Money. For example, go here to get the 10 year profile for IBM.
The key things to note on here are the 10-year, net profit margins, return on equiy and assets.
http://moneycentral.msn.com/investor/invsub/results/compare.asp?Page=TenYearSummary&Symbol=IBM
When I want to look into a company that I know nothing about, I go here first. One glance at this table and I can see whether the company is profitable and stable or otherwise.

3) Morningstar
http://www.morningstar.com/
This is a great site for info about stocks. I pay $9/month or so for the premium membership. Here you can find loads of info about the companies. One of the best things are the analyst reports where you can learn a lot about the companies. They also gives recommendations for whatever that is worth as well as rate the management and tell you whether they believe the company has an economic moat (i.e. barrier to entry). Unlike bank analysts, they don't have conflicted interests. The other great thing is the stock screener. This is the best that I have seen. There are hundreds of parameters to screen on. You can even screene on things like their Morningstar management grade. You can also get 10-year financial data from the three financial statements. Highly recommended.

4) Scottrade
www.scottrade.com
This is the discount broker that I use. One of the things that I like about it is the access to Standard & Poor Stock Reports which are similar to Value Line reports. You can also buy these in book format from your bookstore . Obviously, I prefer the electronic PDF format. I can also save these to my laptop and use them as a database. They have 10 financial data and in a more useful format then most other places. Again, if I were more savy (or had more time), I would write some software to extract the data from the PSF files and store them in a more structured way. What I have been able to do is write a piece of code which prompts the user to highlight the table of 10-year financial data and cut and paste it into a file. Then it stores this into a simple text file and makes the following plot using Bed Bath and Beyond (BBBY) as an example.

I know that is a lot to take in at once but by looking at this, I get to see every financial aspect of a company in a single glance. Every box shows a 10 year history of some financial quantity. The top three (left to right) book value per share, earnings per share and cahsflow per share. In the sixth row you see the Returns on : assets, equity, invested capital, total capital, capital and tangible capital. I won't go into the details here about what the differences are. The three on the left of the bottom row are P/E, pretax earnings yield and free-cash flow yield. I can click on any box to see the growth rate calculations. I can also see the number of shares to see if the company has been buying back shares or diluting. This is extremely useful. I don't know of any other way to visualize this data without paying someone a lot of money to write some kind of software to do this. S&P also gives the stocks a rating 1-5 stars and over the past decade, this has proven to be market beating advice. Whether that will continue is anyone's guess.

5) National Association of Investment Clubs
http://www.better-investing.org
I decided to pony up $49/year to join this. I haven't explored here too much. I joined only to get a hold off their compustat database. You don't get the whole data base but you can search by ticker and get a complete financial history of a company. For example I can get the earnings for JNJ or GE all the way back to 1950. Pretty cool. I can save these html files with a simply keystroke. I wrote some software which then reads these html files. That way I can make a little database of companies that I haved looked up. If I were a bit more savy, I would be able to write a program which fetches this info without having to use a web browser. Maybe in the future. I also have written some code which makes plots of this data and calculates growth trends. For example this is one for JNJ.

This is very useful when you want to know the long term picture of the company. Unfortunately, this only gives you the long term picture of the PAST. The version which calculates the future earnings is still in development ;)

6) Insider trades.
You will want to keep track of insider trading (the legal kind). This is especially important with small obscure, out of favor or ignored companies.
http://www.secform4.com/top-lists.htm

7) SEC Edgar
Sometimes you need to get your hands dirty and read through anual reports like 10-K or the quarterly 10-Qs or other SEC filings. Go directly to the SEC page and search by ticker.
http://www.sec.gov/edgar/searchedgar/companysearch.html

8) Answers.com
Enough with financial data. There is more about companies than the numbers. I have mentioned two places already to get qualitative info. The morningstar and S&P analyst reports. But what if you want to read about the history of a company. You can find these at www.answers.com. They are written by Hoovers.com. I find these excellent places to read about the long term history of a company especially if they are not too well know. For example if the company is Bank of America, then there are many places to get info. For a company like this, you will find multiple books written on the company. However, for a less well know company like Graco (GGG) answers.com might be the best place to go. Wikipedia usally just has the same Hoover's histories.

9) Guru Focus
http://www.gurufocus.com/
This is a good site to find out where some of the world's best investors are putting their money. For example you might find out that Warren Buffet and Bill Miller both bought some stock which is now 20% lower than they paid. This may not lead you directly to riches but is still very useful info. If I am casually looking at a stock and I find out that a couple of these guys is buying it, then I might look into it in more detail. For example, seven of these value investing guru's have bough UPS. About 10 have bought Wal-Mart.

Valuation of RGFC.PK

2007-05-30T20:41:00.000-07:00

The valuation of R&G Financial (RGFC.PK) which just sold its Florida Bank to Fifth-Third bancorp. I estimate it is selling at half its value and will probably double if/when it return to the NYSE from the pinksheets.

----------------
Shares
------------------------------------
21,559,584 Class A
29,561,190 Class B
-----------------------
51,120,774 Common shares

Liquidation value of Preferred stock

Series A 50,000,000
Series B 25,000,000
Series C 69,000,000
Series D 69,000,000
------------------------
total 213,000,000

------------------------------------
Equity (based on Bank Holding Company data, after restatement)
http://www.chicagofed.org/economic_research_and_data/bhc_data_2001_2006.cfm
-----------------------------------
544,945,000 As stated on BHC form
- 213,000,000 Preferred
---------------------
331,945,000 Equity for Common shares
- 118,569,000 Non-tangible servicing asset (though not worthless)
---------------------
213,376,000 Tangible Book Value

6.49335 Book value per share
4.17396 Tangible book value per share
3.02 Cohen (former analyst) estimate of Tangible book value per share

211,685,000 Other assets, probably mostly derivatives included in book value
Interest rate derivatives, probably OK

723,721,000 Listed on BHC as intangible and other assets
255,816,000 Listed on BHC as other liabilities
--------------------------
467,905,000 Diff between these two

------------------Changes with sale of Crown bank--------
Price payed
288,000,000 For crown bank
50,000,000 Paying off preferred shares
16,000,000 Real estate
-----------------------------
354,000,000 total payed

226,000,000 tangible assets of Crown bank
--------------------------
128,000,000 Gain in tangible assets for RGF common stock holders

213,376,000 Old Tangible Book Value
+128,000,000 Gain in tangible BV
---------------------------
341,376,000 New tangible BV

6.67783 New Tangible BV per share

----------------------------------
If Cohen's number is right
285,451,984 New tangible BV
5.58387 New tangible BV per share
----------------------------------

3.90 Price per share on May 30
69.84% Fraction of tangible BV
-------------------------------------

-------------Valuation----------------
Even a poor bank is worth about 1.5x tangible book value per share
Using TBV=5.58387
This is
Value = 8.3758
which is over twice the current price

Other scenarios:
The deal falls through. It needs to sell out like Doral to obtain cash. Value = 1.5 /share. Probability 10%
The deal goes through but tangible equity declines by $50M. Value = 6.0/share Probability 10%
The deal falls through and they fail. Value =0 Probability 5%
--------------------------------
Value = 0.75*8.4 + 0.1*1.5+ 0.1*6 = $7.05/share

I will take as my value 7.0/share which makes it a buy at 3.90 however with the risk involved I can only put a small amout of my money into it.

############## UPDATE #####################
RGF announces that the think the restatement will be about $240 million after taxes. They had figured $185-$200M previously. On their BHC form they listed -$264,637,000 as accounting restatement which is probably pretax.

So I think we subtract about $50M which gives us about 230-280 of tangible book or $4.5-$5.5/share. It is selling at
$3.95/share today. Still pretty cheap but worth the risk? Investors did seem to like Doral once it got an infusion. Maybe RGFC.PK is worth a few bucks. I think the chance of doubling is still very good and chance of failure small.

Also the $16M is not for RGF sharholders

8-K about FHA license being taken away. Hopefully temporary.

Price on July 23, $2.60/share WOW!!!

##################### Update ###########################

12/2007 Holding company report out

Common book value down to $125MM. There is $523MM in either 30 days late or non-accrual. They have recently said that they are probably not going to pay any more preferred dividends. They are now deteriorating quickly. It could be the end for RGF. They will likely need to sell the bank in order to avoid being seized by regulators. Yikes.

Home builder earnings

2007-05-18T22:19:00.000-07:00

I made this plot of earnings and book value for two of the oldest buiders Pulte Homes (PHM) and Centex (CTX). Black is PHM and red is CTX. The solid lines are book value per share (BV) and the dashed line is earnings (E), multiplied by 10.

They have grown BV by a factor of about 1000 since 1968. Pretty impressive. That is a 19.9% annualized growth rate for PHM and 17.8% for CTX.

You can also see how volatile the earnings are. Earnings are the change in BV from year to year: the derivative of the BV curve. The ratio of the two E/BV is the return on equity (ROE). You can see that the average ROE is roughly 10%. For the past 10 years, the ROE has been much higher. The dotted lines are about twice the solid so ROE is about 20% similar to the late 1970s.

You can also see the major recessions in 1973-1974 (the OPEC oil crisis) , 1980-1981 (Volcker's recession), and the 1991 Bush recession. The 1973-1974 recession appears to have been the worst for these builders. PHM nearly lost all of its earnings but still managed to avoid a loss. For both companies, BV has never declined in nearly 40 years. They have never had a loss.

Despite these terrible recessions, builders have managed to recover after a couple of bad one or two years. I think they will do likewise after this recession. Will the profitability of builders return to ROE=10 like they did in the 80s? Perhaps. However, the future may not resemble the past. What really matters in terms of growth for the builders is population growth. It appears that the government is passing immigration "reform" which should allow not only higher than average population growth but also plenty of cheap labor which will add to builder profitability. I think it is true that the long term picture is still rosey for home building in the US. However in the shorter term, we are likely to see a recession and the housing slump is likely to get worse before it gets better. There are still lots of uncertainty over how this will all play out. I think we are likely to see massive intervention on the part of the government aided by the Fed to prevent a full blown deflationary collapse. As an investor, my job is to decide whether builders will survive, whether they will grow thereafter and to decide when all this bad news is sufficiently priced in to create a good entry point in the stocks. I like Meritage Homes (MTH) best at this point although they are probably not the most conservative pick. Still, they seem to have the most long term potential and seem to be most feared by market participants presumeably because they only build in the southwest. They are trading at 0.88 BV and may go a bit lower. I have some shares, purchased at around this valuation and may acquire more if they drift lower towards half book and I see a rise on the Fear Meter which is now registering only Medium-High.

Of course one should be prepared for some volatility in prices. In the 1973-1974 recession, CTX tumbled in price from 2.78 to 0.3 (split corrected) which is a factor of 9.3,Yikes! Of course, they started off that priced 4.8 times book (way overvalued)and bottomed at half book (way undervalued). It seems half book is about the maximum fear point. MTH may not be there yet.

Stirring up trouble

2007-03-29T05:10:00.000-07:00

I love to pick fights

On Craigslist

On Mankiw's blog

The Chinese problem

2007-03-26T23:17:00.001-07:00

Everyone in the investing world needs to have a basic understanding of our trade situation with China. It boils down to this. We buy stuff from Walmart,Target etc who buys their inventory largely from China. So essentially China is sending us stuff and we are sending them dollars. What can a manufacturer in China do with dollars? Well, they can buy US imports, they can buy US financial assets (stocks and bonds or real estate) or they can trade them for Yuan or other currency on the Forex market. As most people know, we have a significant trade deficit with China which means that the Chinese typically do not use their dollars to buy US goods and services. They typically buy US treasury bonds which is essentially saving in the US dollar currency.

This dollar build-up should have a natural brake on itself. Eventually, the excess amount of dollars should cause the dollar to drop (via supply and demand). This makes Chinese goods more expensive to Americans and so should decrease their buying. However, it hasn't exactly worked out that way. The Chinese central banks has been inflating their currency by printing as many Yuan and trading them for dollars as it takes to keep the Yuan from appreciating so that Americans do not stop buying and the Chinese can grow their export-led economy at a very fast pace.

Can this go on forever? Can the Chinese keep growing their factory base at 10% if US consumption only grows at 4%? Not unless the Chinese or someone picks up their consumption. It is unlikely that the Chinese and the rest of the world are going to change that quickly. The Chinese are new to this capitalism thing. They still lack basic property rights, a solid sytem of business law, a strong financial system. Most importantly, the Chinese lack a basic sense of political and economic security. Without this security, they will opt to save rather than consume.

This should lead to dire consequences for China. Eventually they will develop excess capacity. This means they will have too many factories making too many products and not enough Americans or anyone else to buy them. This is the classic economic problem which leads to recession. When the excess is large enough, it leads to a depression. Whether or not this is a mild to medium recession or a more severe depression (like the Great Depression) may depend on the stability of the Chinese financial system. I don't have much knowledge about this but the general concensus is that the Chinese banks are plagued by corruption and nearly insolvent. So you can easily see what could go wrong for the Chinese. They need to support their growing economy with growing consumption but don't seem to be able to do so.

What can the Chinese do to prevent this? I would argue very little. I think it is enevitable that they undergo a recession. They can further inflate their currency which lowers prices for Americans. However this doesn't work out as planned. They still need to buy oil, energy and commodities from outside of China. Cheapening the currency just makes these more expensive. That is, inflation is never a solution. It can add a temporary stimulus but cannot really benefit the real economy.

A better way to look at all of this is without the use of currencies. Currencies can add another layer of complexity that act to obscure the real issues. Basically the real issue is this. As global markets have opened up over the last few decaded, poor people (like the Chinese) have been able to get jobs servicing the people in the more developed nations (like the US). Since they were poor, and had little access to jobs, they were willing to work for less pay. It is just supply and demand. There are lots of skilled but jobless Chinese willing to work all day to pay for their rent and dinners and the global economy has found a way to allow these people to service the richer American people. As long as there are more Chinese people (or in general poor people anywhere) than jobs, their wages will remain low. They simply have no bargaining power to ask for higher wages if their employers (ultimately the rich consumers) can go elsewhere for work.

This will end when we run out of poor unemployed people. Once that happens, they will demand higher wages and they will get them. This will cause higher prices for the rich Americans. In the mean time, the poor will have been saving their money and will be less poor. Ultimately, they will be as rich as the Americans. Overall, this is good for everybody. That is the whole point of the field of Economics. Trade is good for everybody. Isn't this great how trade solves all problems? Well...

Fab Five

2007-03-23T10:08:00.000-07:00

Sometimes when we are diligently searching for wonderful ideas, we miss what is right in front of our noses. There are times when the best investment ideas are not found by digging through the 10-Ks of obscure pinksheet companies but rather are found right out in the open among the largest, most prominant companies. This may be one of those times.

Which five Dow stocks have negative returns over the last year as well as the last five years?

Ticker	Full Name	PE	10-y Ann. Growth	Div. Yield	Div. Growth
JNJ	Johnson & Johnson	16.2	13%	2.5%	16.5
PFE	Pfizer	10.0	9%	4.5%	14.4
WMT	Wal-Mart	17.8	17%	1.8%	24.6
AIG	AIG	12.7	12%	1.0%	24.7
HD	Home Depot	13.7	21%	2.3%	23.7
	Average	14.1	14.4%	2.42%	20.8

All five are considered to be among the highest quality companies in the world (nearly all Dow stocks are). Companies like this are what the financial writer George Goodman (aka "Adam Smith") has termed super-currency. They are more reliable than any currency, resistant to inflation and accepted everywhere as a store of value. When the world is caught up in panic over the next crisis, these kind of stocks hold up the best. JNJ PFE and AIG are practically recession proof and this five stock portfolio is fairly well diversified across a few major industries: health care, retail and insurance/financials.

Their growing dividends are very attractive to income investors (i.e. the massive wave of retiring boomers) and their recognition factor will be attractive to all the new foreign investors (like in Asia) looking for an alternative to their less established stocks and overall turbulent markets. They have little real downside risk from here. All should have a sustainable long term growth rate above 10% (for at least 15 years). All of these are suffering from the fact that they were incredibly over-valued when the 90's bull market came to an end.

What would the expected return be over the next ten years for this five stock portfolio?

Let's assume the average growth rate slows from the 10 year average of 14.4% to G=12.0%. The average dividend yield is 2.42%. We will assume that dividend grows at the same rate as earnings (despite the fact that dividends are growing a lot faster at 20.8%). The annual return will then be R=G+Y = 14.42% assuming that the valuations don't change. That is a pretty good return for no-hastle investing. If the valuation grows from the average PE of 14.1 to 17.0. This might be expected as they become more favored. This is ΔV =20% expansion of valuation. If it comes over ten years that adds another 2% to the annual return. For the mathematically challenged, the annual change is ΔVA = [1+&DeltaV]^(1/N) -1 where N is the number of years it takes to expand.

This gives us a ten-year expected return of R=G + Y + ΔVA = 16.4%. If this valuation expansion happens faster; say in three years (not unrealistic) , then the return is R(3-year) = 21% which would be spectacular. You can fiddle with the numbers and get different results either better or worse. However, It seems almost impossible (short of a depression happening) that this portfolio wouldn't return at least 9% over 5-10 year times scales. Since dividends are growing at 20.8% and these stocks are buying back shares, it would not be surprising for these stocks to return more like 25%.

I own the first three JNJ PFE WMT and may soon buy the other two. I have a few other good investing ideas but feel that there aren't too many good places to invest in this market. In the meantime I will put money into the Fab Five and keep some cash around in case things change.

Mortgage Insurers

2007-03-20T17:31:00.000-07:00

I am completely convinced that we have a housing bubble in the US that will bust and cause havov for the US economy. Still, I would like to keep my cool and invest somewhere at some time in the real estate sector when fear of the crash is overdone. So where to invest? The usual places would be homebuilders, banks, furniture makers, home furnhing like Home Depot etc or title insurance.

Another place is private mortgage insurance (PMI). Mortgage insurance is an interesting business. Basically they insure against banks losses for the top 10-20% or so of loans for people who don't pay a full down payment. Some notable mortgage insurers are (tickers) MTG, RDN, PMI and TGIC. All of these are down somewhat and hovering near book value. These companies have typically grown about 15% over the past decade or so and investors have had good returns despite significant volatility. Buying them at the right time typically gave you a 40% one year return.

The bussiness model is fairly simple. They get paid a premium by the borrower. If they forclose and the bank takes a loss, they pass on this loss to the PMI which either pays the bank or takes over the title. Like any insurance company, it makes sense to talk about the loss ratio (losses over revenue) and expense ratio (operating expenses over revenue) and the sum of the two which is called the combined ratio. When the combined ratio is less than 100%, the PMI makes an underwriting profit. It can also invest the float for investment income. The net operating income is the sum of the underwriting profit (or loss) and the investment income. Most regular insurance companies have a combined ratio near 100%, usually a few points higher. Thus they take a small loss to be able to invest the float at a higher return (mostly in bonds). They make a profit on the spread. A combined ratio of 100% means they are getting an interest free loan which they can invest at say 5% in bonds. There is generally a limit of float-to-equity which is considered safe but they can thus leverage their return on assets by this ratio to make a reasonably high return-on-equity of 12-20% or so for a good insurance company. Generally they grow at about the same rate as ROE.

Mortgage insurance is quite different. In good years the combined ratio is very small. For example MTG (company name is MGIC) has a combined ratio of between 45% and 70% for the past 5 years. Wow! What a bonanza! Even if it just buried their money in the backyard they are making a net profit margin between 30-50% just for signing pieces of paper. Unlike most insurance companies, they make more money from underwriting profits (in good years) than they do from investments.

Figuring out the future of this industry is complicated and requires a good understanding of the whole mortgage industry. (I don't claim to understand it well enough but I am working on it).

For example these companies are at the mercy of :
1) the Federal government which competes with them through the FHA.
2) Fannie Mae and Freddie Mac who make a lot of the rules of what is conforming etc.
3) Strengthening/consolidating lenders who siphoning off premiums through captive reinsurance.
4) Lenders offering piggyback loans and other PMI alternatives.

I won't go into the details of the these issues. Another important things is the shape of the yield curve, the persistenacy of premiums, tax deductability, pricing pressures etc.

What I want to focus on is loss ratios. I have mentioned above that combined ratios over the past 5 years are in the range 45-70%. Expense ratios are typically in the range 20-30% which leaves loss ratios in the range 20-40%. Are these typical numbers? Are there typical numbers? Would we expect losses to increase significantly?

That is difficult for me to estimate. Surely they will rise, but will they rise enough to make combined ratios much above 100% where the PMIs would start reporting losses and decreasing book value? I don't think anybody knows for sure which makes it quite a gamble.

Lets look at the past for examples. First of all there is the Great Depression. There were actually PMI around during the 1920s. None of them survived. All went bankrupt in the collapse of the financial system. MGIC (MTG) started up in 1957 to compete against the FHA which was a "New Deal" program to restart the mortgage market during the Depresssion. You can read about the history of MGIC HERE .

Ok, well you might not want to count the Great Depression. Hopefully that won't happen any time soon. What about more recent history.

Here is a plot that I made of Book Value Per share (BV), Earnings (E), Dividends (D) and Return on Equity (ROE) since 1990.

Basically BV has grown at 20% and you can now get a 2% dividend yield. On top of that they are selling for P/B of about 1 which very low. If they continue growing at this rate and get back to P/B of say 1.5 in 3 years, your getting a return of 36% anualized for the next three years, maybe even better. Sounds great right?

I have my doubts. Let look further back into the 80s. The 2002
10-K
for PMI group shows the loss ratios back to 1981.

The bottom line is that loss ratios in the 1980s were terrible. They attributed these to the real estate decline in the oil patch. When inflation was reigned in by Paul Volker's Fed, oil prices collapsed and so did all the business in Texas and other oil patch locations. Loss ratios were in the range 200-265% for contracts written in years 1981 and 1982 and these losses carried on for twenty years for contracts written in those two years. That is PMI was still paying out losses (probably small ones) in 2002 for bad decisions made in 1981. I am not sure how all of this works its ways into yearly earnings. I would like to see a chart of common equity for PMI through all of these years. I am guessing it decreased significantly in the mid 80s but don't know sure since PMI was not a public company then.

How does this relate to today? Surely the oil-patch real estate bust was more acute than todays national/international housing bubble. However todays bubble is more wide spread and I don't see any reason why losses couldn't be worse than the 1980-1983 debaucle. Will these companies even survive? I don't know. Hopefully they are reinsured well enough to handle a national housing crash but I don't have the expertise to figure that out. I have seen a quote in the 10-K of MTG that says that because they are regionally diversified, they don't expect major losses. However that seems to rely on the idea that house prices can't crash everywhere at once. What if they do? Are they still prepared to weather the storm if house prices decline by 20-30% nationally like some bears (i.e. Gary Shilling, Jim Rogers) are predicting?

I don't want to make that bet. I am staying away from investing in these companies until I start seeing them handling severe losses gracefully. Which means I might miss them entirely. That's fine. I will stick to more transparent businesses. I think that if hell gets cut loose on these companies the stock prices will collapse to something like 1/4 of book (see for example the subprime lenders). In that situation you might be getting the right odds to make a bet on these companies. In fact, you might be better off to invest through LEAPS (long term options) since they would either go bankrupt or survive and prosper. If they go bankrupt you lose it all with either common stock or LEAPS but with LEAPS you get more leverage on the upside. I don't think your getting good odds to invest in the common stock now.

The LA Housing Bubble

2007-03-18T23:39:00.000-07:00

This is an example of a house in my neighborhood, the Silverlake neighborhood of Los Angeles. This plot is from Zillow. Can anyone really believe that this rediculous price expansion is not a price asset bubble? In 1997 this was worth $115K. By 2004 it had appeciated to about $200K. That is an 8% annualized price appeciation which is pretty good, about 6% more than the inflation rate of 2%. Then things went crazy. The bubble mentality set in. People decided that prices in this neighborhood were going to accelerate. They were right. Over the next three years the price would increase from $200K to $900K at a 65% annulaized rate. During this time houses became not places to live but things to invest in for short term gains. Failed traders from the dot-com days decided that real estate was the place to be. This house below was traded three times in these three years. The original owner sold in in 2005 for $450K and probably walked away with $350K in profit. It was bought by someone looking for a short term profit. They probably invested no more $10K by buying with an interest only, low or no down payment loan. It would go from $450K to $650K in two months. That is, they multiplied their $10K investment by 20 in two months. That annulized rate of return is over 6 billion percent!!!! By this standard the next owner was down right conservative. This person held it for a whole year and only made a $150K profit. The poor sucker that bought next for $800K may have watched this zillow chart and seen $100K of equity appear about thin air. Unfortunately it is clear to all that this bubble is busting. The poor owner probably has this house sitting on the market at inflated prices and has to bear the horror of watching the prices drop like the hapless NASDAQ in 2000.

Now consider the effects of all of this home equity appearing out of nowhere for millions of people in Los Angeles. How much money was created? Well if there are one million households in LA and if each house recieved $300K of new equity, that is 300 billion dollars. The total amount of new equity created in the US is a few trillion dollars. The effects of a few trillion dollars introduced into the economy can't be ignored. Many of people would pull money out of their homes though a home equity loan. They would use this money for home repairs, new expansions, to buy cars or pay off loans or credit card debt to free up these cards for new purchases. All this new money flooded into the economy. Much of it ended up in bank accounts which helped fuel new lending. As prices rose further and further, houses became unaffordable to most with traditional loans. But banks would not allow the party to stop. New products were dreamed up that allowed anyone to buy a house regardless of credit quality or lack of down payment. These were the interest only loans, the adjustible rate mortgage (ARMs), the negative amortization loans, the option ARM, stated income loans etc. As long as prices were rising, even poor credit buyers could sell at a profit if they couldn't keep up with payments. Banks themselves were not at risk as long as prices rose even if they put their own capital at risk through second mortgages (piggyback loans). Non-bank subprime lenders would originate multitudes of loans to poor credit buyers and sell these loans off to Wall Street banks who would send them along to hedge funds looking for high yield products where they could could make huge profits by buying these with large amounts of leverage, some of which was generated by borrowing yen at near zero rates, selling yen for dollars and buying high yield US mortgage loans. When the bust started, the Wall Street banks stopped providing capital to these risky subprime lenders who collapsed due to this liquidity crisis. This reluctance of banks and non-bank lenders to lend would further add pressure to the collapsing housing market. The end game is now obvious. This housing collapse will be the worst since the 1930s. The bubble is bigger than previous bubbles in the 70s,80s and 90s. The collapse will therefore be worse. Some people still hope that Washington or the Fed can still save housing and save the economy. Unfortunately, the only solution is for prices to come way down. In the meantime this will lead to a miserable economy, higher unemployment and probably a severe banking crisis. The Fed can probably bail out banks if it chooses to to prevent a deflation like the 1930s by lowering rates close to zero which would allow banks to make large enough profits on the spread to cover real estate losses. However it can't make people spend like they did before. It can't restart the boom. It is time finally to face the music and deal with the fact that our economy cannot grow at these unsustainable rates of past years.

The mystery of mean reversion

2007-02-15T01:25:00.000-08:00

One of the things I find fascinating about markets and the economy is the tendency towards mean reversion. Rather than taking a random-walk, markets seem to shuffle back in forth, contained within a tight range of possibilities. One of the places you see this is with the stock market averages. In Jeremy Siegel's book, "Stocks for the Long Run", he shows a plot (need a link) of the stock market average from 1830 to the present. Amazingly, it is nearly a straight line (on a log-axis) when corrected for inflation which indicates a steady 6.9% return over long periods of 30 years or so. In the shorter term, there are "wiggles" like the great crash of 1929 and the great bull market of the 1990s but over long periods you see it return to the trend. Other investments like bonds or real estate or gold do not show any kind of regularity. Stocks do not behave as a random walk, where the next move is simply random. Even though the country has changed dramatically from a agricultural economy to an industrial economy and then finally a service economy, the stock market returns have not changed a bit. Over 30 year periods, you simply get a 6.9% real return just like you always have.

Well, this isn't a history class. What does this mean for investors? There are a number of useful things to take away from this. Lets stick with the stock market averages for now. For one, it means that the current prices of stocks are not really the best predictor of where they will likely be in the future. This contradicts the Efficient Market Hypothesis (EMH) which says that the current price of stocks is really the best predictor: the price tells you everything and the trend tells you nothing. Mean reversion says the best predictor is really the trend itself. If your below trend, then your most likely to move upward back to the trend. If your above the trend then the opposite is more likely to happen. The long term data clearly indicates that mean reversion and not random walks is a better description of the stock market averages. In other words, in times like 1980 when stocks were well below the trend, we should have known better and simply loaded up on stocks. It should have been a no brainer and of course it is in hindsight. We were way below trend and they were practically giving stocks away. Of course most people hated stocks then. Business Week had their famous "Death of Equities" cover. In the opposite extreme was 1929 and 1999 when we were way above trend but crazy about equities. Using the insight of mean reversion should have convinced people to pull out and ignore stocks for a while. Of course we know what happened. The bubble bursted and we heading back to the trend. Surprise, surprise.

Other places that you see mean reversion is with whole industries. Banking for example goes through periods of high profits and periods of low profits. Same with insurance companies. Real estate also has these cycles. By understanding that these cycles are temporary and actually acting on this insight, you can out-perform the indices. Of course, not everyone can do this anymore than everyone can be taller than average. There seems to be some principle that keeps the average person at a 6.9% return. The goal of the stock picker to be better than average. But clearly only a few of us can do this. Others need to underperform and most will simply cling to the average by buying index funds.

The value investor is someone who tries to appreciate this principle of mean reversion. They seek to buy things that are out of favor and probably performing below average. The hope is that, as usual, things will change and this company's fortunes will change for the better. If the company is selling for a cheap enough price, then it will appreciate quickly when things begin to change. In my opinion, the best places to do this are with older companies that have survived many such cycles. For example, buy high quality and conservative insurance companies when profits are lower than usual. This is usually when there is a soft market and many companies are jumping into insurance and fighting for market share and so lowering prices. This eventaully will change when there is a crisis and these new companies become unprofitable and start to pull their capital from the insurance business. This allows prices to rise and the old stalwart insurance company becomes more profitable again. Other examples. Buy home builders during a housing crash (like now). Buy industrials during a recession.

The key is that you may have to wait a a while to get good returns. It is very difficult to forcast accurately when things will change. In fact it is probably almost useless to try to guess since the Market is a great discounting machine that is trying to determine this before you do. Marty Whitman has said that you should try to buy at the point of maximum fear. Of course you never know that you have reached this point. Buffett has said to "be feraful when others are greedy and greedy when others are fearful". However getting the timing right is difficult at best. Buffett has made the point that what you really do is simply try to figure out how much the company is worth as the total discounted cash flow (DCF) over its lifetime. This is the long view and to do this you need to assume that things will revert to the mean. You should not simply extrapolate the present situation because that is what the Market does. To beat the market, you should use the principle of mean reversion.

Why do things revert to the mean? That is the great mystery and we will leave that one to the philosophers and the social scientists. What an investor needs to know is that for whatever reason it is simply a proprerty of the markets. To beat the market averages you should work it into your investment scheme. If everyone did this and we had a market of DCF robots then maybe this wouldn't work. But Markets are controlled by people and people are afraid to lose money and get more afraid as security prices drop. This makes them ignore mean reversion and miss opportunities that value investors take advantage of. This is unlikely to change anytime soon as it appears to be simply a part if human nature. If we can resist these human emotions and invest more objectively, we have a chance at above average returns.

Road to Serfdom - cartoon version

2007-01-27T16:51:00.000-08:00

Great Cartoon for your socialist friends

Two value strategies

2006-12-22T23:44:00.000-08:00

I believe that all good investing involves buying something below it real value. Up until now I have been concentrating on what may be called a Buffett strategy. This is essentially investing in good business at prices below their value. For example you can buy companies with high return on equity (ROE) and low P/E. You can make guesses about their probable future growth and so estimate their fair value P/E and buy if the market P/E is below that.

There is another way where you buy companies at low price to book value, P/B, regardless of whether they are good or bad. These strategies are connected because of the identity

P/B = P/E * ROE

This is true simply because ROE = E/B. So you can't really have low P/E , low P/B AND high ROE. You need to choose whether you want to go with high ROE and low P/E or low ROE and low P/B. With good companies like Coke or Walmart your going to get stable and predictable earnings, high ROE and high P/B. Generally you care about getting them at low P/E.

The other strategy is buying companies with low P/B. In the extreme you want to get things where the Current Assets - Liabilities is less than the market cap. This is tangible book value and is what you would get (hopefully) if the company was liquidated right away.

The main difference is that for the growth companies, you are valuing the companies based on the earnings that will come in the future. For the low P/B companies you are simply looking at what is there already. In some ways these low P/B companies are a more conservative bet. You don't need to project far in the future. You just look at what is there. The trick for these is to figure out whether your actually going to be able to extract that value.

Things can go wrong. The management can piss away stockholder value by trying to save the company with hair-brained schemes or outright fraud. When tangible book value is substantially more than market cap, the stockholders would usually be happy if the company simply liquidated and paid out a final dividend. However often this doesn't happen. If the CEO is getting a high salary he is often happy bleeding the company for years and simply collecting salary. He need to look for management with interests alligned with shareholders. You also need to look out for other liabilities that may arise such as pending lawsuits or other fishy things on the balance sheet or 10Qs.

Combining these two strategies is probably a good idea since they should be uncorrelated. In fact the low P/B stocks themselves should have practically no correlation and so is good for diversification. The diversification thing is more than just reducing volatility. Value investors shouldn't fear that. It has more to do with the fact that some of these companies will blow up and could cost you everything you put in. However most will return above book value. Some of these will more than triple in a few years and should make up for the occasional loss. It is not short term volatility that matters but rather volatility of long term portfolio growth. If you lose it all your done. This relates to the Kelly formula from gambling theory. Never bet your whole payroll on one bet. Figure out the right amount to bet on each based in your edge and the odds your getting.

Also with these low P/B companies you have low expectations of earnings growth. Generally you just want them to quit losing money, stablize their business and generate postive earnings with below average ROE. Then they return to above book value and you sell them. This could be considered more conservative than expecting an already good company to get even better and grow even faster. It is these low expectations that make them a reasonably good investment.

Concord Camera (LENS)

2006-12-21T01:47:00.000-08:00

This company is terrible. Their stock is abysmal. I just bought $2K of shares. Basically they sell single use cameras, traditional 35mm cameras and digital cameras. They are losing money not gaining it. However what makes them a buy is that they have little debt and lots of cash and they are selling for less than the cash on the books. Somewhere around half the tangible book value.

A company like this should be liquidated for its assets. Unfortunately that isn't going to happen. They may get bought out but probably will attempt to return to profitability. That might happen. I am just hoping that they will stop burning cash and stabilize so that the market starts to value them at something close to book value.

I think there is a decent chance of that happening. They are ditching the digital camera sales which is good because they had negative gross margins. They also must have required more R&D to keep up with the trends. They will be left with one time use cameras and traditionals which should be fairly easy to produce for a profit. Lets hope. I don't need to large profit to make me a profit. I just need them to stop bleeding cash. I think that is happening now. Last quarter they had break even cash flow.

Another positive is that the terrible CEO is buying shares. He seems like a greedy bastard but at least I can count on him to look out for himself. If he is buying he probably sees good times ahead or at least sees the company as being undervalued. With all of their assets, that is not hard to believe.

Then there is their new product, the OnGuard Kids Safety Watches.
http://www.onguardkids.com/
Basically they are watches for which kids can set off an alarm if they are grabbed by a stranger. These will sell for $39 and probably will make a decent gross margin. Sounds rediculous but then again so are paranoid american mothers. I think these will augment the operating margins and so I see this as a good thing.

If all goes well this company may double within the year. If all goes to hell, I think the major holders will force the company to liquidate while it still has assets. I don't think the downside is so bad and it has quite a bit of upside. Overall I think this is a good bet.

The psychology of investing

2006-12-14T12:41:00.000-08:00

Picking stocks can be a very frustrating experience. I think different people have different psychological problems when it comes to investing. Some example are

1) Getting caught up in a bull market

When stock are going up you feel your getting left behind. If you don't buy now, you might not get the chance to buy at all.
This is a dangerous one. I have learned to look out for it. My first experience was gold as it started to accelerate to $700/oz. Naturally I rushed into this one and bought at the top and then panicked when it crashed and sold at the bottom. I only lost $100 or so but enough to learn a lesson. The lesson there was mostly to avoid speculation. Gold is always a speculation. I can value stock fairly well but commodies? I am going to leave that one to other people and concentrate on what I can do well. I don't think I will get too caught up in this in the future but will be on the outlook.

2) Indecision on when to buy

This is always hard. Do I buy now or wait for it to go down further. I need to develop some kind of method for making this decision. This can be stressful since you tend to go back and forth everyday depending on how you feel about the economy and which article/webpage you happen to have read last.

3) Which to choose from?

Usually I can boil things down to a few candidates. For example right now some candidates on my list are JNJ, Walmart, K-Swiss, Meritage Homes, Home Depot. All are clearly undervalued but by how much? There is also the timeliness issue. Even if K-Swiss is undervalued, it is going to go down in a hurry if we have a consumer pull back. So maybe I should wait on those kind of stocks and buy stocks like JNJ which I only expect to go up. Of course you can be dead wrong on the short term direction of the stocks. I could always just buy all of them. The problem there is that I don't want to have a portfolio of 50 stocks since I don't have the time to cover all of them. If I am going to start buying so many stocks I might as well just buy the Dow. I want to keep my portfolio focused but feel afraid of missing a good opportunity.

4) Fear in a falling market

I haven't really experienced this too much except (as mentioned) with gold. I think if you have enough confidence in your stocks, you can avoid this. The trick is knowing your companies and knowing how much they are worth. Only then can you be confident that the market is wrong and you are right.

CRFT - How a drop in the dollar can kill it

2006-12-11T20:50:00.000-08:00

I like this little company Craftmade International INC (CRFT) which makes ceiling fans and outdoor lighting accesories. They make good returns on equity (fairly steady ROE= 25%). They have been growing earnings at about 20% over the last 10 years. They are still tiny (market cap $96M) so have plenty of room to grow.

I even called around and and asked all kinds of people about their fans. Apparantly they are top notch. Based on the usual valuations they are quite cheap EBIT/EV = 17%. They even have an 8% Free cash flow yield (on EV). On top of that thet have a dividend yield of 2.6%.

So what is wrong with this company? Two things.

First of all they sell half of their product to the new home market. Housing starts are down 20% and will probably fall another 20%. So they may see a 20% revenue drop from that. But that is simply a cyclical phenomenon, not a problem with the business. Starts will rise again someday and the market will improve.

What will kill their business? A dollar decline could. To see this, we need to understand how this business works. Basically they are very light on assets. They design the fans, outsource manufacturing to China and Taiwan and sell them to US new home builders and home refurbishers. This company has fairly steady 6% net margins. This means that any change in their cost of goods and sales (CG&S) is magnified by a factor of 100/6=16.7 in net income.

They are very up front about this in their annual report
http://www.sec.gov/Archives/edgar/data/856250/000095013406017675/d39626e10vk.htm

They say that a 1% drop in the dollar will decrease annual net income by $1.15M. Net income is $7.1M so this is 16.2% which agrees with my 1/(Net Margin) calculation for the degree of magnification. In other words a 6.2% decline in the dollar versus these currencies will result in the entire loss of income. In fact a 26.3% decline in the dollar wipes out all $30.3M of stockholder equity.

Here is the dollar versus the Taiwanese dollar and the Yuan.
http://finance.yahoo.com/q/bc?s=USDTWD=X&t=2y&l=on&z=m&q=l&c=usdcny=x

The USD to TWD has lots of flucuation but has declined about 3% in a two months (this is Dec 11 2006). The dollar has been falling versus the Yuan since they unpegged it a little over a year ago. It is down almost 6%. If this continues then CRFT is history. It's entire business model is based cheap goods and sales from Asia and sold to the insatiable US consumer. How could it survive? It would have to raise prices to compensate. Can CRFT raise prices on ceiling fans amid a severe housing contraction? No way. In fact their will probably be a supply glut and prices will probably fall. CRFT may in fact be a good short opportunity.

I think this is an excellent micro example of a larger macro phenomenon. Most people think that if the dollar declines by 5% it means that their trip to Europe becomes 5% more expensive. They wouldn't think about a company going bankrupt because of it. The concept of leverage is clearly displayed here. However the dollar might not decline. Maybe globalization has created so much foreign labor that companies like CRFT will be able to keep lowering labor prices by shopping around. In fact I think this is why they have been moving away from Taiwan to China. Maybe they will be OK after all? Or maybe not. I think they began this move before the Yuan was unpegged and before the Secretary of the Treasury was going around asking the Chinese to lower their currency.

The moral of the story is (I think) to stick to companies with much higher net profit margins like JNJ (20%), KO (21%) and MSFT (28.5%) and stay away from little speculative companies that are highly leveraged to things like exchange rates. This is another reason to prefer old companies who have survived many such currency/economic cycles.

The other vaulation method - EGM

2006-12-09T14:11:00.000-08:00

There is another way to value stocks besides DCF that isn't too bad. I don't know what its name is but we can call it the explicit growth method (EGM).

It is fairly well based in reality. How do you make money on a stock? You buy it, hold it for some time and then sell it. The profit (or loss) is the dividends that you have collected plus the capital gains (or loss).

So lets assume that we have an initial valuation metric P/E. One could use any of them such as P/B or P/D P/CF etc.

Lets ignore dividends first off. If the stock grows at G for N years then the earnings will be E_0 * (1+G)^N. If the valuation P/E stays the same you will have obtained a anulaized return of G. That pretty easy. If the valuation changes then the price of the stock will be P=(P/E) * E_0 * (1+G)^N

Your anualized return will be R=[r^(1/N)*(1+G)] -1 where r is the ratio of the final valuation to the initial. Example. The stock grows earnings at 10% for 5 years. The P/E goes down from 20 to 15 so that r=0.75. That is a 4% return. If the vaulation went the other way from 15 to 20 it would be a 16.5% return. If the valuation stays the same it is a 10% return.

You also have to add in dividends. We want to assume that the dividend payout ratio stays the same so that the dividend grows with earnings. With no change in valuation this is simple. You just add the dividend yield (which stays constant) to the annualized return from capital gains. So for example if G=10% and the yeield Y=2% then the return is R=12%.

But what if the valuation changes? This now depends on when and how the valuation changes and whether or not you reinvest the dividends or whether you invest them somewhere else at some other rate (ie the discount rate). Lets assume a constant change in valuation (linear in time) and reinvested dividends. In this case the dividends help more in the beginning if the stock valuation rises and help more in the end if the valuation drops. Thus, dividends have been called a bear market protection device. If Altria groups has a 4% dividend yield and the P/E drops by 50% you may have lost in capital gains but are now getting a dividend yield of 8% as long as they keep the dividend at the same rate. Not bad.

I believe you can just take the geometric mean of 1+Y which means that the average number of shares that you gain each years is AY = Y* (1 + (1-r)/2)

So your annulized return R is (keeping first oder in yield)
1+ R = r^(1/n) * (1 + G + AY) with the adjusted yield, AY = Y* (1 + (1-r)/2)

Example r=0.75 as before, Y=0.02 G=0.1 you get R =0.06. A 6% gain is not bad for a stock that declines in P/E by 25%.

The trick is that you need to reinvest those dividens when it declines and not sell out low. ideally you want to benefit from all three things. Growth in earnings, growth in valuations and also reinvesting dividends.

Lets look at a plot. We are going to run a Monte Carlo simulation and make a random distribution of P/E expansion factor r. Lets assume this is log-normally distributed and has a mean of 1 and sigma(log)= 0.15. We want to generate the distribution of returns for the two cases when we have only growth and when we have growth and a dividend yield. We will assume in eaither case that the sum of growth and yield are equal. For example in the middle panel we have Y= 3% so that black is G=10% Y=3% and the red is for only growth G=13%. The lower panel is for a higher Y=6%. One can see that the mean return is the same. The effect of having a dividend yield is that it reduced the variance of return. However this reduction is not very large even for rather large yields of 6%. This is for 10 years periods. The variance reduction is even smaller for shorter periods where capital gains becomes more important. I think this makes the case fairly well that dividends don't really protect you much in bear markets. However it could well be the case that stock which pay a dividend will not fluctuate as much. That is probably true and so you should expect less variation in returns due to this. However you do much better in reducing volitility just by buying another few uncorrleated stocks. I don't think one should discriminate against non-dividend paying stocks. It seems that adding the dividend yield to the growth rate is a pretty good estimate of return as long as you expect the valuation to stay about the same.

One could argue that this isn't really a fundamental valuation method since you have just postponed the question of what the correct valuation should be. That is true and DCF is probably better in this way. However this method has its merits. It is actually better related to how one actually makes money in stocks. Your not going to hold a stock forever. Valuations are affected by demand as well as supply and demographics have an effect on valuations. This can be input into this model but not really in DCF (unless you raise the discount rate). It seems a better way of treating dividends. We have a long historical record of what the market has been willing to pay for earnings. The average P/E of the market is about 15. I would say that for most mature companies, the P/E should be somewhere in the range 10-20 depending on their profitability and other factors.

PEG is a rediculous valuation metric

2006-12-09T13:30:00.000-08:00

I have never understood why people use PEG (PE ratio divided by the growth rate) as a valuation metric. It really makes no sense. Here are a few reasons.

First of all, if you knew what the future earnings were going to be, you could value the company with discounted cash flow (DCF). That's the real way to value stocks. Lets give a few examples. We will assume a discount rate of 10% and assume that earnings are to be thought of as free cash flow.

First example. G=30% for 10 years followed by 20 years of 4% growth. The correct DCF PE is 90 and so the correct PEG is 3.
Now if instead we had only 5 years of 30% growth followed by 25 years of 4% growth the correct PE is 38.6 and so the correct PEG is 1.3. Finally lets consider two years of 30%, 8 years of 10% and then 20 years of 4%. That gives PE = 30.1 and so PEG=1.

So obviously the right PEG has everything to do with how long the company will grow its earnings at that initial rate. In most cases the recommendation of buying stocks with PEG < 1 is actually too conservative. In retrospect buying Walmart with PE=100 would have been a very profitable thing to do since it grew quickly for 2 decades.

But there are other things wrong with PEG. It ignores things like return on equity (ROE) and quality of earnings. Maybe companies can grow earnings but will never develop into very profitable companies. Maybe they are growing earnings so quickly only because their initial earnings are so tiny (compared to say invested capital or total assets). For companies that have positive equity and fast growing earnings but very low ROE, it is useless to look at PEG. You should instead analyse the business model and figure out what ROE they will eventually obtain and how long it will take to get there.

Another reason to hate PEG. For slow growth companies, it makes no sense either. Perpetually slow growing companies can be valued with P/E = 1/(DR-G) where DR is the discount rate and G the perpetual growth rate. This requires G < DR.

inverting this E/P = DR -G or DR = E/P + G

Your expected return will be the discount rate DR = E/P + G. So you can see that what matters is E/P + G not PEG=(P/E)/G. You could choose to write this DR = E/P * (1+ G/(E/P)) for your expected return. Now you see that what matters is the
valuation E/P and the ratio of growth to E/P not its inverse P/E. In other words the right PEG is 1/(G*(DR-G)) which still obviously depends on G and DR.

So PEG makes no sense for slow growers and for fast growers it depends critically on how long the fast growth will continue. So why it is used at all?

Best 50-year stocks

2006-11-27T21:05:00.000-08:00

From Jeremy Siegels "The Future for Investors"

These are the best survivor firms from the past 50 years. Top 10 with annual return.

Stock	Annual Return
Phillip Morris	19.75%
Abbot Labs	16.51%
Bristol Myers	16.36%
Tootsie Roll	16.11%
Pfizer	16.03%
Coca Cola	16.02%
Merk	15.90%
PepsiCo	15.54%
Colgate Palmolive	15.22%
Crane	15.14%
Heinz	14.78%
Wrigley	14.65%
Fortune Brands	14.55%
Kroger	14.41%
Schering-Plough	14.36%
Proctor & Gamble	14.26%
Hershey Foods	14.22%
Wyeth	13.99%
Royal Dutch Shell	13.64%
General Mills	13.58%

Note that all are either consumer brand names or pharmaceutical with the exception of Royal Dutch Shell and Crane. There are no tech stocks with the exception of Crane (industrial products). None of these obtained a 20% return by themself. If you wanted to beat Buffett's 22% you needed to buy and sell.

Stock Valuation

2006-11-27T18:53:00.000-08:00

I have been trying to figure out a good method for stock valuation. There are of course many models for valuation mostly based on discounted cash flow models DCF. The idea is that a company is worth the sum of all future cash flows to the owners between now and infinity, discounted by some discount rate. This discounting is because money now is worth more than money in the future. If I had money now I could invest it and get about 10% per year so that in 7 years it will double. The discounting of future cash flows accounts for this simple fact.

Here is a good link to an overload of information on variations of DCF.

However for stock picking I think these complex models are not required. If you knew the inputs precisely (i.e. growth rates etc) then it might be good to include all of these details such as changes in working capital and changes in payout ratio. However you don't. I am looking for a good proxy to use for the whole class of stock that I like to invest in. I want a generally useful tool: a jacknife of sorts that I can quickly use to compare all stocks.

So a simple N-stage DCF model should suffice. I have written one in the IDL computer laguage. Of course, you need to pick a discount rate. This is always difficult. They way I figure it, you you simply fix the discount rate and keep it constant for all stocks. This is possible because I am only going to invest in one kind of company: companies with stable earnings and somewhat predictable growth rates. I don't need a variable risk premium, I don't need to work out the correct WACC etc.
I just use 10%. This of course specifies the relative weight I give to earnings now versus earnings in the future. However 10% seems reasonable because it is approximately the average stock return, is not far from the average bond rate (plus a constant risk premium). It is also the number of fingers that I have. This gives a fair value P/E of 10 for a perpetually zero growth company and a fair P/E of 20 for a perpetual growth rate of 4.8% which is about the long term bond rate. The way I figure one most needs a discount rate to decide whether to buy stock at all. Once you have chosen one, just use DCF to decide between stocks. Buy the cheapest relative to the DCF value with a few caveats.

Next choice: which earnings to use. Some just use accounting earnings. The Usual E. Others use DCF with the dividend D in which case P/E becomes P/D or inverse of dividend yield. There is the handy formula for the dividend discount model for constant growth.
Y= D/P = DR-G
where Y is dividend yield (D/P) and DR is the discount rate and G is the dividend growth. This is called the Gordon Growth Model and is easy to derive (it is just a geometric series). This only works for DR > G so that you don't get infinite value D/P = 0. I find this equation useful in that it tells you what the correct discount rate should be. DR= Y + G. If you buy the stock and sell in the future, after dividends and earnings have grown by G, and the valuation D/P stays the same then your anualized return will be R=Y+G which is the discount rate. In other words, the discount rate is your expected return. You want to buy things that give you a rate equal to or better than you expected return. This is somewhat circular but really gives you an idea of what the discount rate should be. 10% is not so bad of a return. Naturally I would like a higher return so if I use DR=10% in my N-stage DCF and find things that are selling for a significant discount to this rate, then I will buy them.

There are still other choices for earnings. I think using free cash flow (FCF) is probably the best. Buffett calls this Owner Earnings and in my code I use OE as FCF per share. This is cashflow-capital expenditure. The trick here is knowing whether the capital expenditure is really different from expenses and different from real investment. I don't have a good feel for this. Should I simply just trust the accounting line "Capital Expenditure" and subtract that off? If you do that you see that Home Depot has significant OE but Walmart does not. I doubt these two companies are that different so I am not sure if this is just differences in accounting.

So for a company reinvesting all of its money, use OE as earnings and look at growth in OE for the growth rates, G. For price I use enterprise value (EV). This is what you use if you were going to buy the whole company for market value and I think this is the right way to think about buying stocks. You get whatever cash and cash equivilents that the company owns and are stuck their debt as well. So EV = P - Debt + Cash. So now OE/EV is the measure of valuation that I estimate with DCF.

What about dividends? I still need to figure how to include these properly. I think you can simply augment the growth rate by
the dividend yield. This is because you can just buy more shares which is equivilent to having a faster growth rate. If a stock is growing OE at 12% with a dividend yield of 2% then use 14% for G. Not sure if this is entirely correct but will do for now.

The final question is how many stages. You clearly need at least two since most companies that I look at grow at something close to or greater than DR=10%. There is no point in getting carried away and having more than four. For a stable company like JNJ I use 2 or 3. Sometimes I get creative with stocks like homebuilders which should see a decline in earnings and then a turn around. You can still use DCF for this.

The hard part of DCF of course are the growth rates. Garbage In = garbage out as they say. Here, you don't want to over estimate growth or you could end up paying way too much. I think the best way to do this is to use the historic growth rates over 10 years. I get these from S&P though my scottrade account. I think a good thing to do is to take the ten year pattern and divide into 2 five-year segments and get the growth rate for each. Use the lower of thr two and take off 2 percent to be conservative. By doing this you aren't assuming it can grow any faster than it already has. Avoid new companies that have grown quickly because they had no earnings to begin with. Avoid cyclicals that have just come off a huge bull market. Don't ever input very high growth rates like G=40% since they are not sustainable. In fact I want to find companies with high ROE since this tells you the sustainable growth rate. G = ROE (1-p) where p is the payout ratio. That is I will avoid the Googles and the unproven internet stocks etc with huge growth rates and low ROE. I would rather buy a company with G=10% and low valuations since these kind of growth rates are likely to persist and getting the growth rate correct as well as the period of growth is less important.

Finally an example. Johnson & Johnson (JNJ). A perfect company for me (see "My rules for investing" post).

Annual growth in OE over the past 10 years is 13.4% (by exponential fitting) and 14.8% (point to point). The two five year periods are
G=13.5% (first) and G= 17.6% (most recent) as determined by exponential fitting. The lesser is 13.5%. The dividend yield is
Y=2.3%. So I will use G=13.5+2.3-2=13.8%. I will use a 3-stage model with
---------------
N Years | Growth
-------------
10 13.8%
10 8.0%
20 4.0%

In IDL I simply type:
IDL> dcf,[10,13.8,10,8.0,20,4]
Using default DR 10.0000
12.1112 12.7136 13.6629
total V/E = 38.4878

This reports that the Value to Earnings of 38.5. That pretty high but I think reasonable for a great company like JNJ. Over the next 40 years that predicts a growth in earnings (dividend adjusted) of 17 or 7.7 adjusted for 2% inflation. Taking out the dividends it says that the company must grow by a factor of 6 or so in 40 years which I think is very reasonable considering that the developing world is getting richer and will desire the same level of health care as the developed world and also the developed world is ageing rapidly. The key to trusting high valuations that come out of DCF is to ask whether the company is truely great and is likely to remain a strong company in the extreme distant future. I am fairly certain Coke, JNJ and Budweiser will be around in 100 years unless they are bought by another company. I have no idea what will happen to Google or Yahoo.

So how much does JNJ cost? Since we are working with owner earnings, it is EV/OE that we look at for valuation. The inverse of this I call free yield FY=OE/EV. JNJ has FY = 5.43% or OE/EV=18.41. This is not too different from the usual P/E which for JNJ is 17.29.

So according to DCF it is underpriced by 50%. Quite a steal!

What will my return be? Over the next 20 years this is a rise of about 7.75 in earnings. If valuation stays the same that is an 11% annulaized return. Not bad. However as I mentioned, I think the right valuation is twice as high. So if it takes 10 years to obtain the right valuation this will be a 13% return. If it takes 10 years it is 19%. If it only takes 3 years, it is a 37% annualized return although over a shorter period. I figure this is a sure thing to obtain a 10% annulized return over some future interval and possibly as high as 30% as long as I hold on through any ups and downs. I will buy now and sell whenever it becomes overpriced. I would probably sell if P/E > 35 but may sell after a year if there are even better opportunities.

Of course the growth rates could be wrong. Lets try a simple 2-stage with 10% initial growth.
IDL> dcf,[10,7,20,5],val,e,de
Using default DR 10.0000
8.61628 9.64537
total V/E = 18.2617

That comes closer to the price but requires 10 years of only 7% growth followed by 20 years of 5%. I don't see anyone could think that JNJ would see such terrible growth rates especially with the demographics that we have. JNJ is definitely underpriced. A definite BUY. The only question is whether there are better buys out there which is always the source of all my stress.

My rules for investing

2006-11-27T15:41:00.000-08:00

Here is my list of rules for buying stocks. These will probably evolve with time. I will refrain from investing in any company which fails ANY of these rules. If a company passes these tests then I will buy it if it well priced compared to my personal valuation models.

1) I understand the business reasonably well. I know where profits come from and what drives earnings growth.

2) The company has little to no risk of failure.

3) The company has stable postive earnings and decent earnings growth over long periods of time, say 10 years.

4) The company's earnings growth is sustainable. It's growth is fed by high returns on equity. ROE > 15, minimum, preferably much higher.

5) This high ROE is maintained by some apparent competitive advantage.

6) The company has low or no debt or at least high interest coverage for it's level of earnings volatility. This should be reflected in low leverage and high ROA and ROIC. Shows strong financial strength.

7) The company produces free cash flow and/or dividends.

8) The company is well managed. Management hold shares in the comany and act rationaly as owners.

9) The company returns excess cash to shareholders though dividends or buybacks. Exceptions are when company can reinvest in the business as very high ROIC.

10) The company has a good long term outlook. There is no chance of becoming obsolete by new technology or fundamental changes is the world economy. It is poised to benefit from important megatrends of our time: ie globalization, demographics. Macro ideas may enter here but should not dominate other factors.

11) The company is not burdened by organized labor or unfunded pension liabilities or any other off balance sheet items
including major lawsuits.

12) The company's earnings are not heavily regulated by the government.

13) Insiders are buying or some Superinvestor is buying or I am just VERY confident about the stock.

14) The company can be purchased at a good price (see "Stock Valuation" post).

The tug of war - inflation versus deflation

2006-11-27T05:43:00.000-08:00

I find it best to think of the monetary environment as a great tug of war. On one side is inflation which threatens to blow price asset bubbles, raise worker wages as well as prices and set in place an expectation of further inflation. Unchecked, this leads to hyperinflaton, destruction of the currency and eventually economic collapse. Think Weimar Germany of the 1920 or more recently Argentina. Pulling against inflation is deflation, a dropping of prices due to either excess supply or deficient demand. This leads to industry shutdowns, unemployment, lower wages and also loss of corporate profits. Think the Great Depression.

While many people tend to concentrate on warning of one or the other, I like the tug of war analogy. There are plenty of inflationary as well as deflationary forces in the world. The key is whether or not they are balancing each other or whether one is getting the upper hand. Usually there is a back and forth as one side begins to gain ground and the other gives it followed by a reversal as the losing side pulls back. The great fear of the bears on either side is that one side will win, dragging the losers through the mud and causing an economic collapse.

The great deflationary force today (perhaps a better term is disinflationary force) is globalization. This introduces more and more workers into the world economy and keeps wages down, prices down and corporate profits up. Against this is the greater demand for commodities as the world develops and the high profits spawning price asset bubbles. The US trade deficit and growing national debt seems to require a dollar decline which would lead to inflating prices for the US consumer. For the most part, these forces act to cancel each other out. Despite the fact that each team is pulling harder than before, things haven't moved much. The last two decades have seen low and stable inflation.

There are the gold bugs who think that paper money is the root of all evil and that the promoters of this great evil are the Federal Reserve and other central banks who aim at positive inflation. Their prediction is always hyperinflation where gold will soar in dollar value and the gold bugs themselves will become imensely rich. So far these gold bugs have had miserable returns as they missed the great bull market in stocks from 1982 to 2000 even considering the rather impressive gain in gold of the past few years.

On the other hand are the deflationists. Gary Shilling comes to mind as their chief proponent. At least with Gary Shilling we find someone who has made some excellent returns with his predictions. Gary made the excellent decision to buy zero coupon 30 years treasuries at their yield peak in 1980 and keep buying them (even on margin) through all of the great bond 25 year bull market. His return has been over 20% anualized since bond yields have fallen due to the change from the high inflation 70s to the low inflation 80s and 90s. Shilling still predicts that the disinflationary forces of globalization will dominate and cause outright deflation. He predicts a popping of the housing bubble and a decline of US house prices by as much as 30%.

Who is right? I tend to side with Shilling who makes some excellent arguments. However I also wonder if there is something else at work which makes the inflation/deflation distinction, the wrong way to look at things. Certainly I see the housing bubble deflating. This is clearly deflationary and will lead to a US recession. But what of the rest of the world. I think they are unlikely to decouple and will follow the US into a world recession. But what of the dollar? It does seem that the trade deficit cannot get much larger and that foreign holders will eventually dump dollars driving up interest rates. So can one be a dollar bear and still a deflationist? Shilling is not a dollar bear as far I understand. How can he deny the dollar weakness? Can't the Fed simply inflate the currency and reflate asset prices if they choose. This seems to be what PIMCO bond guru, Bill Gross predicts. Of course this can cause inflation just as the Fed bailed out the NASDAQ crash in 2000. But then again, if a world recession hits, no country will want too strong a currency. So perhaps the Fed can ease significantly without the world dumping dollars. Perhaps investors will pull out sharply from foreign investments to buy safer US assets which will prop up the dollar. I think this is Shillings idea. The US dollar is a safe haven. Asian currencies are not. So how does this all work out? I find this quite perplexing. I see great danger in financial markets but am unsure of how to avoid it.

My solution so far is to buy some safe, large multinational US stocks like JNJ, KO, MO concentrating on the less economically-dependent areas like health care and consumer staples. I figure that these seem rather hedged against either senario and are
reasonably priced. About 60% of my money is still collecting 5% in the money market due to indecision and fear of these threatening global imbalances.

The macro environment

2006-11-25T13:05:00.000-08:00

I try to select stocks without making too many asumptions about the economy. However, I wonder if one can't ignore the economy for certain sectors. For example, you cannot just buy homebuilders without some feel for how the economy is going to behave. Well, I suppose you could but really the earnings of home builders for the next five years will be greatly affected by whether or not the US sinks into a recession and whether this pulls the rest of the world along. Even more so for banking which is more highly leveraged.

Buffett always claims to ignore the economy but I am not sure that I believe him. He seems to have avoided many of the past recessions. I suppose he would claim that it was simply over-valuation that tipped him off and not the economic outlook. Recently he has been outspoken about the fact that the US dollar must decline. That is pretty macro for Buffett.

Perhaps it is best to go against the prevailing view of the economy. For example it is probably true that people overestimate economists ability to predict the direction of the economy. If so then the prevailing view will have biased valuations in that particular direction. If so, then then market is not exactly macro-efficient but rather macro-biased. There must be money to be made simply by ignoring the popular economic view and insisting that we know nothing of the where the economy is going. Just use prior information not posterior information (in Bayesian language). I think the same principle applies to microeconomics. Ignore the analysts and just look at past earnings, histoic ROE and use common sense. If analysts are pessimistic then you have a buying opportunity because the market will discount their bogus information. This is probably the guts of contrarian stock picking. But is it right?