Thursday, January 1, 2009

Deleveraging is still in process

Happy New Year!

Things are relatively quiet during this holiday break. But don't be fooled by the lull in the action.

The Fed has nationalized the credit card securitization market (AXP, COF), the commercial paper market, the auto industry (GE, GJM), the world's largest insurance company (AIG), and the world's largest bank by assets managed (C) within the last three months.

My point: The credit crisis is not over. The bank system still are deteriorating. Short the financials across the board.

Transparency: The author purchased SKF July $100 Call contracts on 12/31 at $36/contract.

The Treasury is handing out naked puts on behalf of the taxpayer

US Bancorp acquires Downey Savings & Loan and agrees to take the first $1.6B in losses and the FDIC will take any additional losses.

JP Morgan acquires WaMu in a deal that requires JP Morgan to take the first 30B in losses and the FDIC will take any additional losses.

Now IndyMac is acquired by a private equity group for $13.9B in a deal where they liable for the first 20% of losses, and the FDIC is liable for the remaining amount. No quantification of what that 20% is a percentage of. I am looking for the details.

What kind of deals are these? A free put contract for an asset already purchased at a severe discounted asset? The capitalization of the FDIC is not designed to recapitalize distressed mortgage asset portfolios. Thus the bill for these extended losses will be a virtual pass through to the taxpayer.

WaMu, Downey, and other deals like these all potential exposures much bigger than "first loss" amount describe above. My question is why can't the acquirer at least endure some of the extended downside. Maybe 100% first loss, then 25% after a certain threshold? But the current policy gives the companies no incentive to resolve deterioration of the underlying assets after a certain loss level. In fact, it may just make a great extended tax break subsidized by the general public.

In a year of panic and half baked ideas, this was one of the worst ideas to come out of the Treasury and I plan to write my Congressmen to communicate that.

Goldman Sachs Pair Trade: Long and Short

Due to the credit crisis, the investment banking model is broken. Current stand alone investment banks are racing against the clock to find reliable funding source for their outsized portfolios. That being said, investment banks are voracious capitalist market makers with tremendously talented people. Goldman Sachs, the highest class of the bunch, has produced many powerful government officials and has led the world in financial innovation and ability to make profits facilitating markets.

What is an investor to do?

Recently Warren Buffett, at a pivotal time for GS, invested $5B in perpetual preferred shares of Goldman Sachs yielding 10% at par. If I were to read the tea leaves of why Warren Buffett made this investment, I would say Warren believes that despite all of the problems that Goldman Sachs has, it's track record as a profit machine will attract a white knight. Thus even if the credit crisis were to continue relentlessly and deplete all on hand resources for GS, at some point prior to any default event, a buyer will take the company private, making all preferred shareholders whole in the process.

What examples do I have for this thesis? Think about Warren Buffett and Salomon Brothers. That position started with an initial investment in preferred shares of the investment bank also. Second, look at the arrangement that PIMCO holds with Allianz as an independent subsidiary of Allianz insurance conglomerate. PIMCO has no liquidity problems despite having just as many leveraged positions.

This being said, no one can predict when the white knight will appear. In the process, Goldman could lose another 25%, or 50% or even 75% or more of it's stock price prior to being rescued. The common stock holds the greatest risk in this case, even though all classes of securities in the capital structure would suffer greatly.

Thus the position proposed is the following:

Long - Goldman Sachs A Series - Non-Cumulative Preferred Securities - Floating Rate
Short - Goldman Sachs - JAN 10 $55 put contract
(Or if you do not use options then short GS common shares directly at above $84/share)

Buy 1 put contract for every 100 preferred shares purchased
(Or short 100 shares of common for every 100 shares of preferred purchased)

Any investor should "leg" into this position. Buy puts at below $9 and buy the A series at $9/share or below.

Lockstep Investing - 2008 Performance Results

Performance is calculated with the assumption that equal weight is given to every investment put forth on this blog.

Portfolio Performance

UBS Long 850 1900 123.53% Closed
Citi Short 27 16 40.74% Closed
COF Long 10 14 40.00% Closed
BAC-PJ Long 16 17.4 8.75% Closed
PAC Long 21.5 23.39 8.79% Open
FRE-Y Long 9 0.3 -96.67% Closed
BAC Short 26 12 53.85% Closed
AXP Long 3 3.8 26.67% Open
COF Long 5.58 4.9 -12.19% Open
SKF Long 2.4 2.85 18.75% Closed
HBC Long 6.3 5 -20.63% Open
JBI Long 21 23.45 11.67% Open
BAC-PE Long 8.1 8.71 7.53% Closed
TLK Long 20.12 24 19.28% Open

Final 2008 Return 16.43% Total

All open positions marked to market as of 12/31 close. PAC position includes a single divident payment incurred of $.37.