Thursday, June 25, 2009

HSBC: Live by the accounting gimmick, die by the ....

In the first quarter, many banks announced surprised profits in-line with YOY profit returns. Unfortunately, in Q3 accounting tricks will cause sizable losses that will need to be covered by operating profits.

For Q1, HSBC reported ".. a jump in trading income, strong performance in Asia and a $6.6 billion gain on the falling value of the bank's own debt, which helped HSBC earn a pretax profit "well ahead" of the same period last year, the bank said in a trading update."

With the artificial support programs of the Federal Reserve coming online slowly and the credit crisis in full swing, the market value of HSBC debt liabilities dropped $6.6B in the quarter. Accounting rules allow companies with a decrease in value of the debt they issue to claim the decrease in value as a decrease in liabilities and thus claim a paper increase in profit on the decline, and HSBC took full advantage of it.

But did HSBC catch the spirit of this rule when it included is event as earnings? The catch to this rule is that it assumes that the 1) the decrease in the value of the debt does not correlate to the credit impairment and/or possible impairment of the ability of the company to service their debt 2) that the company is able to free the capital to retire the debt in the open market. HSBC generates a huge amount of cashflow, so their ability to service their debt threatened at this point. But considering their effort to maintain capitalization levels in the face of consumer finance losses, whether or not the company is in the position to retire the debt in the open market is entirely debatable.

Since HSBC reported their 1st quarter results, high yield corporate bonds and corporate bonds in general have been on a tear. Some high yield corporate bonds, particularly of financial services companies, have seen increases in value of over 50% since March lows. The junk bond rebound is evidenced by the performance of HYG since March, returning close to 20% return in three months.

In addition, HSBC will face additional losses due to accounting treatment of stockholder gains related to their Q2 rights offering.


Accounting gimmicks are paper gains and losses, but just as they glossed over Q1 pain they may cause additional strain when the losses are reported in unison with the consumer banking problems evidenced by home price declines, and increases in credit card default rates. HSBC should be expected to announce similar losses to the previous quarter in this lending area. But when the overall earnings are measured, accounting strategies will prove to be a double edged sword.

The author is short HBC at this time but has not chosen a short position to recommend.

(1) Breaking Views, July 21, 2009, "Loss in Translation" by John Foley

Wednesday, June 24, 2009

Commodity prices a "tell" for China's economy

Recently China has been viewed as a stand out in a horrible global economic situation. It has been peculiar that the world's biggest exporter has been able 7% rate of growth while other major exporting economies, Taiwan, Japan, Hong Kong, and South Korea, all suffered negative growth rates and negative annual growth targets. In response to this environment, Chinese government has mandated lending in the face of a massive drop in exports revenue.

Unfortunately, in traditional heavy handed approach by the Chinese governmenet, the lending has been indiscrimminately applied. Initial observations suggest that manufacturers have used the additional capital to build up raw material inventories without actual demand to produce for.

"The international media has been following reports of record commodity imports by China. The surge is being portrayed as reflecting China's recovering economy. Indeed, the international financial market is portraying China's perceived recovery as a harbinger for global recovery. It is a major factor pushing up stock prices around the world.

But China's imports are mostly for speculative inventories. Bank loans were so cheap and easy to get that many commodity distributors used financing for speculation. The first wave of purchases was to arbitrage the difference between spot and futures prices. That was smart. But now that price curves have flattened for most commodities, these imports are based on speculation that prices will increase. Demand from China's army of speculators is driving up prices, making their expectations self-fulfilling in the short term...."

Although I do not have the information resources to support this, I would be curious to know if Chinese companies were actually given incentives to borrow money based on their purchases of commodities, and took advantage of the situation to "arbitrage" the purchase domesticly with other market consumers. If anyone has any insight to how the Chinese stimulous package is being administered, chime in. But back to story...

The impact of this rash spending has been evident in the meteoric rise of the Baltic Dry Bulk Index since January even while shipping rates renewed their fall and exports are projected to continue to languish. Chinese firms are importing raw materials, even on decade low export levels. This situation led the CEO of Alcoa to point to China as the demand factor to turnaround abysmal aluminum sales for that company.

But there is evidence that Chinese firms, and foreign firms operating in China, are not planning to import as much as to speculate on the prices.

"And even though foreigners technically can't trade commodity futures in China, some of the world's biggest trading houses have found indirect ways to trade through local brokers. Non-Chinese firms are emerging as influential players on the country's four exchanges, including in soybean futures. "They are trading large volumes," says one bank analyst who follows the sector."

If China is speculating with stimulous money expecting renewed global demand, by the second half of 2009, it may not come. Surveys show that shipping rates could actually decline because of reduced purchases by Chinese manufacturers in late 2009. Moreover, just a technical or market mover related adjustment in commodity prices due to lack of real end user demand could cause significant pain or even unloading of commodity futures contracts if balance sheet issues arise at these speculating firms.

In any case, commodity prices appear to be a solid "tell" over the next six months regarding the effect of the Chinese stimulous and the Chinese economic growth story as scenario to end the global recession.

The author has taken no positions related to this post at this point.

(1) The world market for digging equipment will contract by more than a third in the first half of the business year

Thursday, June 18, 2009

Too early to turn to this TIP

Everybody is screaming about inflation and how it will destroy what little value we have left in our currency. I don't buy it. Unemployment is rising and houses are still only affordable to heavily leveraged or liquid rich guys.

But assuming we are headed for a time when housing bottoms, employment picks up, consumption upticks, and commodities prices come roaring back, are TIPS the best way to prepare ahead of time?

TIPS are treasury debt instruments sold to the public that designed to protect the buyer from problems of owning fixed income securities when inflation is eating away at yield returns. TIPS are just like treasuries, with a fixed yield for a fixed period of time. TIPS protect the owner by providing an adjusted interest payment based on the fixed rate by multiplying the inflation adjusted principal amount by the fixed interest rate. The amount of inflation adjustment is determined by semiannual adjustments (inflation adjusted principal = ((semiannual CPI + 1) * previous principal amount)). Thus as inflation adjusted principal grows, the fixed interest rate coupon paid by the TIPS security increases. (Details here)

How do you get into a TIPS position? There are two easy choices regarding buying TIPS. You can buy them individual issues directly from the Treasury at or buy the iShares Barclays TIP ETF (NYSE: TIP). Current TIPS issues track against the 10 year treasury. The TIP ETF is more attractive because it comprises of all the TIP issues outstanding. This gives a higher yield from the combination of securities than current issues sold from the Treasury. Also, with an average duration of 9.3 years to the TIPS issues held in the fund, investors will see significant protection over the next few years without siginficant volatility due to security rollovers to rebalance the fund.

Should you run out and buy TIPS now? The World Bank indicates that growth should be contracting through 2012. The world's largest container company, Maersk, indicates that the amount of containers moved has dropped tremendously due to decreases in consumer spending and that they do not expect the amount of consumer goods traffic to recover until 2015. With that perspective in mind, the threat of inflation is still a little premature and the need for protection from a security like TIPS may be muted for the next couple of years at least. But when prices start to move upward, it should be a core holding. Since CPI is a lagging indicator, there is an inherent lag in the adjustment of TIPS to the inflation incurred, giving the investor time. This advantage from the lagging indicator might be mitigated by increased demand at the TIPS auction because it is known across the market.

Ultimately, whether or not to buy TIPS depends on when you feel that inflation will become a key driver in the economy. Otherwise, in a deflationary scenario, it might be safer to stick with the paltry returns of the comparable 10-yr Treasury and enjoy the predictable yields.

To view current prices of the most recent TIPS auction results to find out what is available.

The author current does not have any position related to TIPS but expects to go long TIPS sooner rather than later.

Monday, June 8, 2009

To anyone who wants to retire soon...

Dear Uncle, Aunt or any Baby Boomer,

As a amatuer speculator/investor I am often looking for potential investments to suit all different tastes and situations. Since you have begun to transition to retirement I have been looking particularly at conservative, well managed investments that will give you comfort that your money is safe while you focus on service activities and other more actualize pursuits outside of the rat race.

As your unofficial, self appointed portfolio manager, I have two objectives for you.

First, maintain a steady, secure income.

To do this you must find securities with a high margin of safety.

Second, you must prepare for a high probability of massive inflation.

Unfortunately, finding a security that meets the first criteria puts you at risk for the second criteria. So a combination of securities can be assembled in the 20% of your portfolio that is speculative that may put you ahead of the game.

Since the first objective is more important than the second, I have assembled a list of securities that will benefit over the next year from the short term deflation of the asset unwind.

The following securities are all issued by companies with solid fundamentals that could withstand major downturns in the market for an extended period of time.

Ticker List
NYSE:JZL - Kraft debt
NYSE:JZT - Boeing debt
NYSE:KTH - Philadelphia Gas & Electric (Regulated Utility)
NYSE:XFR - Bristol Myers Squib debt
NYSE:JBI - Sempra Energy debt
NYSE:WRS - Westar Electric mortgage debt (Utility)