Lockstep Investing Newsletter

Ecopetrol: The Petrobras of the future

2012-01-24T09:06:00.000-08:00

Ecopetrol is a buy. The Colombian state owned energy company found massive, easily recoverable reserves. The earnings growth rate is tremendous for this company and it can actually increase as more wells come online.

Moreover, Colombia is a much more attractive place to invest than just a few years ago.

"Per capita GDP in Columbia has doubled since 2002, largely due to increased investor confidence in the country’s political stability. Columbia has seen a 90% drop in kidnappings and a 46% decline in murders over the past ten years."

What better pitch for a company is that?

The author bought at $50.50.

Sherwin Williams: First step of a housing recovery

2012-01-01T16:02:00.000-08:00

When home maintenance is done, the first major improvement to the cosmetic appeal is a can of paint. Thus with the bottoming of housing starts and a spike in remodeling permits (see graph below), it may be time to buy a paint company.

Sherwin Williams is the top paint supplier in the US. The sales at their paint stores are growing at a 7.8% rate and margins are expanding. The dividend is stable and should have room for growth with new sales growth.

The author will buy Sherwin Williams at $87/share.

Turkcell is still a buy: Doubling down

2012-01-01T13:21:00.000-08:00

Turkcell fundamentals and balance sheet are even better than before, and the price even cheaper. Turkcell has seen significant growth in Central Asia and Eastern Europe. Due to a currency collapse, the Belarus subsidiary has been written down to a negligible value. Growth of profits from smart phones has been increasing on track to bring new growth. All of these items make Turkcell more and more attractive.

The Achillies Heel of TKC is the foreign shareholder versus domestic shareholder power struggle that has been ongoing since TeliaSonara bought a controlling share of the company in 2005. Collateral damage to shareholder occurred in 2011 with the foregoing of the dividend payment due to the inability to agree between the two major shareholder factions.

Who knows when these issues will resolve? But the deep value of Turkcell makes this investment worth the wait. Thus the author is doubling down on the Turkcell investment at $11.78.

RusHydro: Consolidating assets

2011-12-23T10:43:00.000-08:00

RusHydro is rolling up power generating assets in Russia. It issued shares at one ruble to RAO ES of East Group for company shares worth 1.65 Rubles.

"On June 30, 2011, the AGM of RusHydro passed a resolution to increase RusHydro's authorized capital by issuing 89,000,000,000 additional ordinary shares with a par value of RUR 1 each. Monetary value of the property transferred to pay for additional shares of RusHydro was determined by an independent appraiser- LLC Institute for Enterprise Issues (the City of Saint Petersburg). In addition, JPMorgan and Morgan Stanley presented their fairness opinions to the Board. The valuations as well as the offering price of shares of in the amount of RUR 1.65 per share were approved by the Board of Directors of RusHydro."

Consolidation provides lots of opportunity for economies of scale for these power generation assets.

"Thus, the first stage of the placement is now complete. As a result, RusHydro consolidated a number of energy assets and became the controlling shareholder of the RAO ES of the East Group and the dominant player in the power sector of the Far East of Russia. This acquisition is fully inline with the development strategy of RusHydro to consolidate undervalued generating assets in Russia to create additional shareholder value through realization of synergies with existing generating, retail, engineering and R&D assets of RusHydro Group.

RusHydro is developing into the preeminent power generation company of Russia with the consolidation of the Far East assets.

"The strategy of RusHydro on development of the Far Eastern power sector shall include substitution of economically inefficient thermal plants with efficient low-cost generation, conclusion of bilateral power-purchasing agreements with consumers both for existing capacities and generation assets under construction, realization of opportunities of electricity export to neighboring countries and carrying out of investment projects using instruments of private-public partnerships and project financing."

Russia Long: Stability obscured by political troubles

2011-12-23T10:11:00.000-08:00

Russia is doing well while Europe suffers. Unemployment has dropped to 6.3% from horrible levels in the previous decade. Inflation is moderating. As long as the oil and gas prices hold up, Russia will continue to maintain a positive current account. Emerging Market Musing notes that Russia foreign currency denominated debt is highly manageable. Fiscal debt is less than 20% of GDP. Russia is currently growing faster than Brazil.

Finally all emerging market investments must be tempered by possible currency gyrations. The ruble is currently at a two year high.

Currently markets are jittery because of recent protests of Putin. But with economic growth at 5% annual rate, I doubt too many waves will be made.

As mentioned before, the authors favorite Russian stock is RusHydro (RSHYY.PK), already owned by the author.

The author has already purchased RSX at $26.87.

Buy Indonesia: Lots of momentum

2011-12-23T10:05:00.000-08:00

Indonesia has tons of demographic momentum and development in progress. As Emerging Market Musing notes, Indonesia is no ugly duckling and holds lots of positive indicators for sustained growth.

This blog is long Indonesia by buying IDX at $27.2.

Following Buffett: BAC preferred shares

2011-12-13T11:12:00.000-08:00

Bank of America is currently facing serious regulatory scrutiny, and therefore the company is selling assets to prove it can make capital ratios under Basel 3 standards.

But the overall solvency of the bank looks intact. Warren Buffett recently purchased cumulative preferred shares of BAC at 6%. While such seniority is not available to the author, this newsletter will purchase BAC H series preferred shares at $22.63 (par $25 / current yield 8.8%).

RusHydro : Tapping Russia's growth

2011-12-05T08:07:00.000-08:00

When looking for an emerging markets stock, utilities reflect the economic health of the country with less volatility than media, tech, commodities, or financials. The Russian index is dominated currently by mining or metals companies. In order to support both industries, the power infrastructure must be developed. This is what led the author to RusHydro.

RusHydro is the worlds second largest hydropower generator, and the largest successor of the former Russian monopoly broken up in 1993. The company was recently privatized by the Russian government (which still owns over 50% of the company) and will complete the privatization of all entities over the next few years.

The company is currently enjoying high paced growth of revenues and earnings. RusHydro has plants all over Russia, and supports many of the fast growing mining interests power needs. But in the future RusHydro also has potential to export it's energy product to China via it's Siberian interests.

"Sayano-Shushenskaya is the fourth-largest hydropower plant in the world by average power generation, with an effective capacity of 3.5 gigawatts and installed capacity of about 6.7 gigawatts. It accounts for roughly a quarter of RusHydro's total capacity, and damages could cost the company about $350 million, analysts estimate."

As recently as 2009 RusHydro faced a devestating setback when the Sayano-Shushenskaya hydroplant blew up and destroyed 9 of the 10 turbines of the facility.

"OAO Power Machines, which made Sayano-Shushenakaya’s turbines, said it’s ready to make at least six units for the station in 2011. It wasn’t asked to service the turbines since 1993 after installing the first and second units in 1978 and 1979, the Moscow-based company said in an e-mailed statement. "

Overall there is tremendous long term upside to RusHydro and major investment banks are taking notice.

"ADRs of OAO RusHydro, Russia’s largest renewable energy producer, jumped 3.4 percent to $3.97, a three-week high, after JPMorgan Chase & Co. reiterated its “overweight” recommendation on the stock while cutting the price target on its Moscow-traded shares by 30 percent to 1.54 rubles. RusHydro’s Micex shares gained 2 percent to 1.22 rubles, or 4 cents. One ADR equals 100 ordinary shares."

The author purchased RSHYY.PK ADRs at $3.42

Bancolombia is a proxy for growth in Colombia

2011-09-21T09:35:00.000-07:00

The demographics, geopolitical, and internal political trends of Colombia are very favorable. Thus I am looking to invest in Bancolombia as a proxy for capturing growth in that country. That said, there is a stock market crisis on the horizon and I believe everything will be on sale when the market panics.

The author is entering an order to buy Bancolombia at $43/share.

The following article quote sums up the opportunity.

Bancolombia gets a lot of Kuczma's attention. The 945-branch, $42 billion-in-assets bank has a leading 21% share of Colombia's loan market, and its stock, at 65, is up nearly 5% so far this year. It also sports a 2.2% dividend yield.

The shares have benefited from improving investor attitudes toward Colombia. In March, Standard & Poor's restored the investment-grade rating of Colombia's sovereign debt, removed in 1999 as the country descended into chaos caused by leftist guerrillas. A decade and $7 billion later—mostly in military aid from the U.S.—the government's stronger hand and the global commodities boom have given the economy new life. Bancolombia's Medellin home might still conjure images of drug-dealing mayhem stirred by the notorious Pablo Escobar, but he died 18 years ago. Although violence hasn't disappeared, murders and kidnappings are down 90% from their peak a decade ago.

For years a pariah, Colombia now attracts a flood of international tourists and foreign direct investment, which at $7 billion through June, was up almost 80% on the year. Oil production is expected to reach one million barrels per day by year end, putting Colombia in the major leagues of global crude producers. The country is also enjoying a windfall from record coffee prices. Less known is that Colombia has become the world's fourth-largest coal exporter.

BRFS: Merger approved - Full steam ahead

2011-07-14T13:07:00.000-07:00

The BRFS merger was approved with concessions.

Overall, only 13% of the merged company will be impacted by the concessions.

Full steam ahead.

"BRASILIA, July 13 (Reuters) - Brazilian antitrust regulators gave their support on Wednesday to a deal that saves the merger that created processed foods company Brasil Foods.

Antitrust watchdog Cade endorsed a plan by which Brasil Foods SA (BRFS3.SA)(BRFS.N) will sell 80 percent of flagship brand Perdigao's production capacity and halts the sale of some of its products for between three and five years.
The agreement averts a forced breakup of Brasil Foods, the Sao Paulo-based processed foods giant spawned from the 2009 takeover of debt-ridden Sadia by smaller rival Perdigao. Cade had threatened to derail the merger, citing Brasil Foods' dominance in several markets."

Brasil Foods : Suffering from turbulence

2011-06-14T10:18:00.000-07:00

Brasil Foods is currently facing two major issues. The first is a rejection of the merger creating the company. The second is the ban of importing of Brazilian chicken into Russia. BRFS currently provids 40% of the chicken imported into Russia, and has a large presence in 40 other markets across the world.

Brasil Foods is currently facing regulator objection to the merger to create the larger company from the combination of Perdigao SA and Sadia SA. Apparently the Brazilian anti-trust regulator has rejected the merger for fear of price fixing in the domestic market do the potential dominance of the new firm on the basis of market share.

But the merger, arranged when Sadia had huge currency derivative contracts blow up on them for a $1B loss, was financed by the Brazilian government. So the same government that put up the money for the merger is now rejecting the combination. There are lots of variables on the motivation of the government, but what is obvious is that this merger is in line with the directive of the Brazilian government to create "national champions".

The regulatory finding is ... a rebuke to Brazil's strategy of using tax-payer money to form "national champion companies" that it hopes will project the country's rising economic power around the globe. Under an explicit strategy to bulk up Brazilian companies for global competition, Brazil's state development bank, BNDES, provided major financing to back the merger.

In fact, JBS, BRFS' main competitor, completed a similar deal last year between JBS SA and Bertin SA to create the world's biggest exporter of beef. The horse has left the barn, why try to close the gate now?

The author believes some compromise will be reached and the merger will go through with various concessions. It would be too painful to keep these companies after so much has been invested.

Regarding the Russian ban, a temporary affair. Russia has, without warning, banned Brazilian meat exports for periods of time on four different occasions in the last ten years. Each time, it has been proven that the "justification" for the ban was without merit. The author feels this will also be the case on this occasion.

The author still long BRFS.

Botox Refresh

2011-06-14T08:31:00.000-07:00

Every time I see a "Real Housewives" episode, I see the future of beauty care and it starts with Botox. I will underscore the attractiveness of Allergan based on the following review.

First of all, Allergan will be able to avoid the dreaded patent cliff for Pharma companies because of the many different indications found for Botox.

"A huge part of Allergan's patent-cliff immunity is its blockbuster Botox, which has helped the company evade the patent problems facing others in the industry in two ways: First, Allergan has continued to discover new applications for it. "Really, Botox is a Russian doll," says Allergan CEO David Pyott, because Allergan keeps discovering new uses stacked inside the original treatment."

Second, Botox is a biologic, rather than small molecule therapy, and thus it is very hard for competitors to replicate without violating their patent defenses.

Third, the newest indication for Botox, prevention of chronic migranes, is the first therapy for prevention of the condition. This is a huge potential market that could lead to an additional $500m in sales for the product. Allergan also makes Latisse, an eyelash extending drug estimated to reach $500m in sales.

Essentially what distingishes Allergan is their innovation in biotech for cosmetic enhancement with mild medical applications. Allergan also has opthamology products and obesity products like the Lap Band. But those areas have not proved as profitable as the biotech area.

Overall, there is tremendous upside to Allergan. As a friend of mine Shawn said tongue in cheek, "It is the Intel of the 21st century". I am sure the "Real Housewives" would agree.

The author changed his previous order and bought AGN at $80.46.

Naspers: The Top Emerging Markets Internet Play

2011-05-31T09:25:00.000-07:00

Naspers originally was South African publishing company and still owns a large portion of the print media market in that country. But since diversifying into internet and media startups, Naspers has become a major force in emerging markets internet growth.

Naspers owns 33% of the most profitable internet company in Russia, Mail.RU. Through this investment, Naspers indirectly owns a small portion of Facebook and also Zynga. Naspers also owns 30% of the most profitable Chinese internet company, TenCent. Naspers owns 30% of the print media leader of Brazil and has been supporting social media start ups to rival Facebook in Latin America.

Overall, if it Naspers continues to cultivate it's niche, it could become a worldwide congolmerate of internet media companies. So far, management has shown great foresight and prudence. I am buying Naspers outright and we will see what the future brings.

Long Naspers at $59/share.

Real Housewives use botox

2011-05-25T15:11:00.000-07:00

As the Real Housewives series has highlighted, beauty enhancing treatments are a "must have" for affluent, attention seeking females (and maybe even a few affluent, attention seeking men too). Allegran holds for the "beauty in a box" Botox treatment worldwide for cosmetic and medical uses. Treatments such as these are an undeniable trend and to own a piece is a must.

Thus the author is going long Allegran (AGN) at $78/share.

Earthquake, Nuclear Crisis, and a perfect buying opportunity

2011-05-20T09:13:00.000-07:00

There is no way to predict an earthquake. It is known that the "Ring of Fire" seismology puts Japan in one of highest risk places in the world for earthquakes. But no one can foresee a 9.0 earthquake or really prepare for all the outcomes. Yet TEPCO, the operator of the nuclear reactors, is currently facing the aftermath of that scenario. The company that provides 35% of the electricity sales in Japan has seen it's stock price fall over 85% from pre-crisis levels due to compensation claims related to the event. In fact, TEPCO is now at risk of bankruptcy due to massive claims and the unwillingness of banks to lend to TEPCO without government guarantees.

WSJ, May 20, 2011

"TOKYO—Tokyo Electric Power Co. said Friday it logged a net loss of ¥1.247 trillion ($15.28 billion) for the fiscal year ended in March—the biggest annual loss in Japanese corporate history outside the financial sector—as it was hammered by massive costs in battling the Fukushima Daiichi nuclear accident.

With compensation liabilities expected to run into trillions of yen (tens of billions of dollars), Tepco also warned that the "significant deterioration" in its financial position "raises substantial doubt about its ability to continue as a going concern."

Given the situation are two alternative paths for Japan to take toward TEPCO...

The negative alternative....

If TEPCO pushed into bankrupt, equityholders of this previously considered "orphans and widows" stock will be wiped out. Insurance companies, stock indexes, pension funds, and other conservative investors will be impacted at a time when Japan's financial system is precarious.

"Ms. Matsumoto is just one of the more than 741,000 individual shareholders
the embattled utility had at the end of March, many of whom had purchased the
stock in hopes of stable and high dividends. While equities are still not the
most popular investment tool in Japan, Tepco was perceived by many Japanese
families as one of the few safe investments to be handed over from one
generation to the next."

Yet these same groups will be responsible for recapitalizing whatever company takes the place of TEPCO, with no certainty of a better outcome for their new investment.

Bloomberg, "Japan to Help Tepco Pay Nuclear Claims; Banks May Have to Write Off Debt" May 13, 2011

“The government should make it clear that consumers will have to shoulder the burden,” said Kazutaka Kirishima, economics professor at Josai University near Tokyo. “Whether through increased electricity rates, tax hikes or government bond issues, the public will eventually have to pay.”

The positive alternative...

On the other hand, if the Japan government provides a financial backstop to TEPCO and returns it to stability, the "orphans and widows" and asset managers will recover and the government will be forgiven for whatever pain was incurred. The breadth of the electric company, TEPCO, that provides electricity to 25% of the nation, cannot be understated. The US nor the UK was willing to force BP into bankruptcy, and it is less likely that a public utility will also suffer such a fate. This is a national champion. As seen by the US financial crisis and how the Fed supported the whole commercial paper market, major industrial countries are top priority for support in financial distress.

In fact, the Japanese government has already established that it is stepping in to support TEPCO, spoken or unspoken.

Bloomberg, "Japan to Help Tepco Pay Nuclear Claims; Banks May Have to Write Off Debt" May 13, 2011

"Japan will create a body to handle claims against Tepco, as the company is called, and will issue bonds to fund them, according to a statement yesterday. As part of the aid, which may include taxpayers’ funds and purchase of shares in Tepco, Chief Cabinet Secretary Yukio Edano said lenders may be required to write off loans to the company."

The writing is on the wall. Japan will stand behind TEPCO and as an investor it is a viable investment opportunity.

Thus this blogger is going long TEPCO (TKECY.PK) at $4.9/share.

Yet to protect the downside, this will be hedged with the Japan index. If there is a nuclear blow up, it should happen sooner rather than later and take the whole Japanese stock market down with it.

Thus this long TEPCO position will be hedged by buying EWJ Dec 2011 $8 Put for .18.

Japan Nuclear Risk Overdone

2011-03-20T12:18:00.000-07:00

After performing extensive research of Japan quake, I read that the risk of any significant lasting impact beyond the local area is very low. The Japanese nuclear crisis is described in the worst case as a Level 6 disaster, but the Level 7 Chernobyl disaster led to the loss of only 31 lives (horrible, but manageable) and increased long term cancer rates.

The Japanese industrial complex is significantly undervalued right now. The nuclear risk is acknowledged, but the stimulative effective of rebuilding will bring about growth over next 6 - 18 months once the rebuilding starts.

The author is long EWJ at $10.30.

Catch the agricultural runup : Long Mosaic

2011-01-12T13:41:00.000-08:00

Roubini has noted that stimulus investment has led to increased commodity prices. That coupled with a poor harvest of corn, wheat, soybeans, cotton, and a few others is leading to higher prices for the core agricultural products. There is a macrotrend that is pointing to significant increases in commodity related assets.

Thus there is basis for the report by the executives of Mosaic when they tell us operating earnings have tripled YOY in Q2 2011, production capacity of potash is running near 100%, the company retired a $455m bond three years early, demand has increased across all markets, demand is set to break record levels, set in 2007, in all market segments.

The author sold Mar 11 $85 puts at $8.50 and Mar 11 $80 puts at $5.50.
The author also initiated a long position in MOS at $79.82.

Brasil Foods long

2010-12-20T17:54:00.000-08:00

Brasil Foods S A is new company formed by Sadia and Perdigão. Peridigao is the second largest protein producer in Brazil and the tenth largest company in the country. Before running into trouble with currency derivative trades, Sadia was a very profitable protein exporter to 110 countries. The combination of the two companies joins to high growth entities in the Brazil domestic market and abroad.

The author sees tremendous upside in BRFS as Brazil expands and the global economy recovers. BRFS is the second largest exporter of meats in the world, and thus will benefit from even a muddling world economy.

The company sells at a 14B USD market cap, in line with 2009 sales. Yet the company reported in 3Q 2010 it is growing at an 8% rate and guided to grow at 10-12% in 2011 due to continuation of the global economic rebound.

Risks to this investment include a rise of the Brazilian Real or fall in the USD. Brazil is also tremendous exporter of commodities so economic deceleration in China or around the world could cause significant problems for BRFS.

But while the world is living on stimulus and papering over economic problems, I am long BRFS.

The author recommends buying BRFS at $15.8.

Netflix: Another position

2010-12-14T23:28:00.000-08:00

Hi,

After discussing the issues facing NFLX with a friend who is an executive in the movie distribution business (DVD sales) with a major studio, I am even more encouraged that there is no upside to NFLX. But since the market can stay irrational longer than any of us can be solvent, I am entering another position of relative safety.

Buy Mar 2011 $290 Call for $.93
Sell Jan 2012 $290 Call for $8.75

Netflix : Viva la overvaluation!

2010-12-13T15:00:00.000-08:00

Is Netflix taking over the world? One movie studio makes a multiyear deal to stream videos for dirt cheap back when no one was getting better than 3mb downsteam from their internet connection, and lives to regret it. Netflix now offers first run movies at $8 with an unlimited subscription. This current deal cuts out DVD sales and other revenue streams for the studios. There is little motivation for the studios to continue the deal in it's current form.

"The relationship between Netflix and the media companies will most likely change drastically, beginning next year when a deal between the company and Starz, the pay-TV channel, to stream movies from Sony and Disney expires.

The original deal from 2008, in which Netflix paid an estimated $25 million annually — a paltry sum, executives say, compared with the hundreds of millions of dollars cable and satellite companies pay Starz for the same movies — is now seen as a major coup for Netflix, and a major mistake by Starz. "(1)

Any major increase cost of content will hit NFLX bottom line hard. The current margins of streaming content is huge, but may not continue to be after the next deal. More importantly, it is diffuclt to see the company sustaining a P/E ratio of 69 with massive increases in costs.

The author will sell NFLX $280 strike Jan 12 calls at $12 and buy NFLX $280 strike Jun 11 calls $4.65

(1) "Time Warner Views Netflix as a Fading Star", Dec 13, 2010, New York Times

Fed Out of Bullets: QE2 will keep the status quo

2010-11-01T16:08:00.000-07:00

Author: The upcoming announcement by the FOMC regarding QE2 will be a non-event. It will chart the course for allocation of huge sums of money toward a policy that will have little effect toward it's goal. It is estimated that the Federal Reserve will print US currency to buy assets to inject money into the financial system.

Regarding the planned purchase of treasury instruments: the only objective, and a noble one, should be to keep rates where they are, and not allow them to rise. At some point if they keep rigging the auctions too long, there will be a run. This is just prolonging the elevated pricing for the treasuries, but cant move the price any higher.

But I do see Fed continuing to buy hefty amounts of mortgage debt. The whole Fed strategy relies upon the mortgage market remaining steady and solvent. During the last few years a drop in long term mortgage rates has enabled a new refinancing binge that helps alleviate the overhang of underwater mortgages. Now that rates are near rock bottom, this trick has more risk of boomerang if the securities are deemed to be low quality at high prices. The implications are too horrendous if mortgage rates rise even a percentage point.

Prediction: Total of $500B USD purchase over six months, including $350B mortgage and $150B treasuries

Not enough to move the market, but enough to scary anyone away from shorting the market.

What does this mean?

1) USD should bounce
2) Emerging markets should correct mildly
3) Treasuries should hold steady for the foreseeable future (I think they will be successful in that)

For a retrospective look at what Helicopter Ben has hinted as options for QE2, refer to the following article from LA Times, July 22: "Federal Reserve gives us insight into Plan B"

"Fed Would Act if Needed, Chairman Says
Ben S. Bernanke, emphasized on Thursday that the central bank was prepared to take action if needed. (July 22)

In his testimony on Thursday, Ben Bernake warned of “unusual uncertainty” in the markets but said the Fed had no immediate plans to deploy additional tools of monetary stimulus.
“We are ready, and we will act, if the economy does not continue to improve, if we don’t see the kinds of improvements in the labor market that we hope for,” Mr. Bernanke told Representative Melvin L. Watt, Democrat of North Carolina, in the second of two days of hearings on monetary policy…."

"First, he said, the Fed could make clear to the markets that it planned to keep the federal funds rate, currently set at zero to 0.25 percent, for even longer than the “extended period” it has been projecting for months."

Author: uhhhh….this is called “do nothing and hope what we have already done eventually works”. Fed Funds rates are already at zero. I have read that the “real interest rate” with deflation counted in is currently 5%. But the nominal interest rate is already at the lower bound.

"Second, the Fed could lower the interest rate it pays on excess reserves — deposits banks hold at the Fed in excess of what they are required to — from its current level of 0.25 percent."

Author: uhhhh….are you kidding me? Is it really going to make that much of a difference to lower the excess reserves rate from .25% to 0%?

"Third, the Fed could expand its balance sheet, which already stands at $2.3 trillion, primarily by purchasing additional assets, whether in the form of additional government debts and mortgage bonds, or in the form of new assets, like municipal bonds."

Author: Ahhh… here we go…. More of the same thing done before…. Maybe something beyond mortgage bonds which can’t drop much lower than the current 5% yield. The Fed can start buying Greek bonds, Dubai debt, Spanish Banks, US auto loans, US credit card loans and everything else put on the market. I would hate to be a shareholder of one of the US Federal Reserve Banks right now. Forced buying does not make for very good return on investment prospects.

QE2 expectations are too big:Long USD

2010-10-29T15:14:00.000-07:00

The USD is oversold. Reports are leaking that the Treasury bond broker dealers are telling Helicopter Ben that additional Fed purchases of Treasury debt may not be productive. Thus the Fed may buy mortgage debt or just reduce the size of the purchases. In any case, the markets have overestimated the interest of the Fed to push rates down further.

Sell UUP Jan 2011 $23 put at .93
Buy UUP Jan 2011 $22 put at .35

.58 upside with .42 downside with technical trends in your favor.

Technical Top - Time to benefit from hype

2010-10-26T17:05:00.000-07:00

After this long bull run, it is time for the market to take a breather. The USD is at a historical support point, fiscal stimulus is peaking. It is enough to take a risk that the SPY (SSO) will not rise another 6% (12%) in the next three months.

The author has entered in the following position.

Sell SSO Jan 2011 $47 Call at $1.22
Buy SSO Jan 2011 $48 Call at $.98

Net credit .24 with $1 risk.

QE2? Be quiet. Long the 30Y bond

2010-10-26T15:05:00.000-07:00

End of stimulus spending and heightened expectations of quantitative easing make treasury bond prices ripe for increases. Also housing is resuming price declines, pushing money to risk adverse areas of the market.

Sell Jan 2011 TLT $93 Put for $1.2
Buy Jan 2011 TLT $91 Put for .81

Net credit of .39 with a $2 risk.

Doubling down: Sallie Mae senior debt

2010-09-17T17:25:00.000-07:00

With the sell off of Student Loan Corp from Citigroup to Discover, the market is finding undervalued assets in private student loans. Sallie Mae, as a third party involved in the deal, purchased a portfolio of $28B portfolio of FFELP, Federal backed student loans, from Student Loan Corp to service. This makes SLM, the 800 pound gorilla, even bigger in the FFELP marketplace. Sallie Mae will be able to use this leverage to support prices and manage supply in this market niche.

"While Sallie Mae will no longer originate FFELP loans, it will still be able to manage its existing $150 billion FFELP portfolio, which generated about $800 million in cash flow in the first quarter, according to analysts." (1)

Sallie Mae has bigger problems. The low interest rate environment hurts earnings because much of the their portfolio floats in a spread to treasuries. Thus the longer the Fed keeps interest rates low the lower the revenue base from the portfolio.

But the real concern is the outstanding debt and whether Sallie Mae will be able to continue to pay it's debt load. Bondholders like us want to know that regardless of the outcome with the company, we are paid what we are owed. A key analyst sees a margin of safety in the current value of the bonds, which are selling at 75cents on the USD.

"For bondholders, the key issue is not the viability of Sallie Mae's business model but the fact that its assets, conservatively valued, more than cover its $27 billion of unsecured borrowings, according to CreditSights. If the company did nothing to restructure, it would have enough value in its current book of business to service its debt, CreditSights analyst Adam Steer said in an interview." (1)

So assuming bonds will pay out at par there is a 25% margin of safety while accumulating a 8% return on investment. Excellent risk reward ratio to the author.

Long SLM again at $19.1 (NYSE: JSM)

(1) Reuters, July 2010

Maybe a weather man would be better

2010-09-05T22:51:00.000-07:00

Everyone knows that the there is no better job than the weather man. Every morning this person checks the lastest satellite images for the latest weather trends without insight to cause and tells the public with the utmost confidence what the day will bring. What sets apart stock market analysts and weathermen is belief in an observable and discernable causality. We don't know what makes the weather. We do know what makes money.

Recent data from the US economy makes the weather man look rather insightful. The mixed influence of a worldwide slowdown and a stimulus has the economy giving strange signals. As recently as July, the technology bellweather, Intel, raised guidance for the year by 10% on high demand. Then just three weeks later the company recanted their upward guidance and stated they will achieve the lower end of their original guidance.

Then on the premise of an upside surprise on the August ISM manufacturing index, the market bounced and gained 5% on renewed optimism. A few days later, when the much larger services sector index underperformed showing only slight growth in the August and the July factory orders index came in below expectations, the market showed no reaction.

It is impossible to tell what is driving the economy right now, or if it is growing or falling off. Many analysts can point to many different data points, but they should defer to a professional who is comfortable with extreme uncertainty. The safest person to ask the direction of the market is to ask the weatherman.

Bernanke, Obama, and Pelosi are in a box: Long volatility again

2010-08-24T15:55:00.001-07:00

For the last year the government and the Federal Reserve has pulled out the stops for financial stability. They have performed every feasible measure to make the system stable and the market secure. Mohammed El-Erian, a voice of the bond vigilante, has expressed that monetary policy will have a neglible effect going future. These measures have only delayed inevitable deleveraging.

As the Q3 starts and stimulus begins to have a negative effect on growth, there will need to be a change in expectations to experience the anemic economic situation that we are currently experiencing. This change in expectations will make the current stock prices look expensive and unsustainable.

Any additional measures will come from fiscal stimulus. But the Republicans think they can take Congress back in November and thus will hamstring any Obama or Peloisi initiative between now and then. Thus if any issues appear, there is significant political risk to any solution. This will create a significant possibility large volatility between now and then.

Why not take advantage of that?

The author is long VXX at $19.

Turkcell: A Demographic play

2010-07-29T14:13:00.001-07:00

"Production depends upon people, not only in the actual process, but because of the final demand that justifies its existence. The more and more consumers, the more and more need for things to be produced. I will go so far as to say that not only growth but capitalism itself may be in part dependent on a growing population."

Bill Gross, PIMCO, August Investment Newsletter

Turkcell is a company that has great prospects from being the #1 wireless provider in Turkey. Turkey has a median age of 27.2 and 25% of the population is under the age of 14. This means that there are huge demographic forces that will increase overall demand for wireless services in the Turkish domestic market.

Add a great balance sheet, significant growth prospects in Eastern Europe, and solid customer satisfaction ratings, and Turkcell is a great long term holding.

Long TKC at $15.

Riding Gold again

2010-07-29T13:51:00.000-07:00

Until the Fed looks to begin raising interest rates, the price of gold will not fall.

Sell $115 Sept GLD put at $3.5
Buy $112 Sept GLD put at $2.6

ECB sends out more propaganda

2010-07-09T14:25:00.000-07:00

The recent news regarding the sovereign debt crisis is not passing the smell test. It seems that the ECB bought right up to their spending limit ($60B euros) and then called the damage control a success. It has been mentioned that Greece has possibly met most of their funding needs for this year. But it is wreeks of a PR campaign to claim victory and hope no one looks as the medicine starts to really take hold and show if it works. Growth is fleeting across the Euro zone, deposits are fleeing Greek private banks. The real test has not even started.

Buy VXX any time it falls below $24. Sell the next time one of the PIIGS needs to refinance when the VXX is above $30 again.

"ECB Signals an End to Aid Program

FRANKFURT—European Central Bank President Jean-Claude Trichet said strains in European financial markets are starting to ease, suggesting the ECB will continue to pare a program to help the region's most-vulnerable countries get back on their financial feet.

The ECB left its key rate unchanged, but all eyes remained fixed on Trichet's press briefing, where the central bank president is expected to soothe concerns over bank liquidity. Dave Kansas, David Weidner and Bob Davis discuss. Also, Ianthe Jeanne Dugan discusses the pain that impacted many hospitals after their derivative bets went bad.
Under the program, which was designed to jump-start dysfunctional segments of the financial markets, the ECB began purchasing government debt in May.
"What is needed in terms of interventions [in government-bond markets] has been progressively diminishing," Mr. Trichet said Thursday after the ECB's monthly meeting.
He rejected concerns that a weaker global economy, and fiscal belt-tightening in Europe, might push the region into another recession, saying investors have been too pessimistic on the currency bloc's economic prospects.

ECB President Trichet dismissed the chances of a double-dip recession.

Mr. Trichet said he is happy with the central bank's monetary stance, suggesting the ECB may keep its main lending rate at a low of 1% for many more months. He said that markets are showing increasing confidence in European officials' ability to manage the crisis.
The ECB has purchased nearly €60 billion ($75.6 billion) in government debt of Greece and other vulnerable countries such as Portugal since the program started on May 10. But the amounts have dwindled after a brisk start, averaging only about €4 billion a week since mid-June. The ECB bought more than €16 billion in bonds in the first week of the program.
"He sort of showed his hand a little bit that they are in the exit" phase, said Erik Nielsen, chief European economist at Goldman Sachs.
Government-debt purchases by central banks had been taboo in Europe, particularly Germany, where the practice stokes fears of a loss of central-bank independence and increases in the money supply, which could lead to inflation. Germany's central-bank chief Axel Weber, a member of the ECB's governing council, has been a vocal opponent of the plan, exposing a rift between the ECB and its largest member country.
Mr. Trichet declined to offer an end date for the program or to specify conditions in markets under which officials would terminate it, suggesting the ECB will continue to buy bonds in small installments for at least a few more weeks, analysts said.

"They may be trying to buy some time" until a €750 billion EU-IMF stabilization fund is operational, said Nick Matthews, an economist at Royal Bank of Scotland. European leaders agreed to set up the fund on May 10,the same day the ECB started buying bonds, in order to prevent Greece's debt crisis from spreading to other countries in Europe's periphery such as Portugal and Spain.
Also Thursday, the Bank of England's Monetary Policy Committee left its key interest rate unchanged at a low of 0.5% to help cushion the economy against the effect of deep cuts in government spending.
The decision was broadly expected, with many economists also predicting the Monetary Policy Committee would maintain its bond purchases, made through its quantitative easing policy, at £200 billion ($303 billion).
Mr. Trichet declined to provide fresh details on bank stress tests, but gave the exercise a nod of support, saying, "We expect that the tests will be confidence-building." The Committee of European Banking Supervision, a London-based body that groups national authorities, said Wednesday that 91 European banks will undergo stress teststo see how their balance sheets would withstand shocks including a double-dip recession and a sovereign shock that generates losses on government bond portfolios.
The ECB president on Thursday continued to warn, as he has for manymonths, that the region's economic recovery will be "uneven." Europe's recovery from the worst recession in decades has been modest so far in comparison with stronger rebounds in the U.S. and in developing countries like China and India.

Rate changes since 2004 in dozens of countries.

Still, after expanding less than 1%, at an annualized rate, in the first quarter, the euro-zone economy should grow around 3% in the April-June period, said Greg Fuzesi, economist at JPMorgan Chase. That's due in large part to a strong pickup in Germany, which accounts for about 30% of the region's gross domestic product. Reports Thursday on exports and factory output point to second-quarter growth of around 6%, at an annualized rate, says Ralph Solveen, economist at Commerzbank.
In a departure from his practice of speaking of the euro zone only in its totality, Mr. Trichet specifically highlighted the German figures Thursday. For the euro zone as a whole, "the second quarter is likely to be much better than the first quarter," Mr. Trichet said. He dismissed the chances of renewed stagnation or a double-dip recession.
Write to Brian Blackstone at brian.blackstone@dowjones.com"

Why you should go long BP - carefully

2010-06-27T14:21:00.000-07:00

The Deepwater Horizon tragedy has been a fiasco. BP will owe billions and will continue to pay materially and in creditibility for many years. But despite all of this, BP will still exist when the noise dies down.

1) Energy security depends on it

BP owns well developed and yet to be developed strategic oil interests all over the world. BP owns interests in Azerbaijian, Angola, Brazil, and Norway. BP has also strategic rights to potential deepwater sites that could hold vast fortunes of oil resources. In bankruptcy, foreign governments may lose faith in US and Britain organization may lose these assets to major competitors from China and Russia. This is much more threatening to the administration than even the clean up effort.

2) BP is as much an American company as it is British

The current form of BP is the result of a merger between legacy BP, and Aramco, the legacy Standard Oil, in 1998, and a purchaser of ARCO, the Atlantic Richfield Co. in 2000, another major American oil producer, and Burmah Oil, PLC. The resulting company is the largest oil producer in the world. But the legacy of the company makes over 40% of the existing shareholders attributable to the Standard Oil and ARCO firms, and thus American interests. Moreover, over 23,000 of 80,000 BP employees are in the US.

So often in the debate about BP there has been accusations that the US government should punish foreign interests for their irresponsibility. Instead, the history of the firm points to a long history of American shareholder interest in BP. The US government has no interest in penalizing the firm to the detriment of US shareholders unless absolutely necessary

What to do?

Although the US government has had blistering criticism and threats to the BP organization, Bloomberg has reported that Obama said on June 16th "BP is a strong and viable company, and it is in all of our interests that it remains so." Thus if the US government has no interest in bankrupting the company through punitive measures, then someone needs to tell that to the bond market. BP bonds are selling at a 10%+ discount to previous prices. This offers a significant opportunity to the prudent speculator. Bill Gross, the founder of PIMCO, has already taken the leap and currently owns millions of subordinated issues.

Long BP Senior Debt "E" Series and Long BP Subordinated Debt

Ally Financial: Fighting the tide

2010-06-24T09:31:00.000-07:00

GMAC Financial, now Ally Financial, is a wonderful example of a company who is making it's best effort to stabilize after a large US bailout.

Ally Financial, with liabilities of over $200B and a significant portion with dubious quality at the time of reckoning, received a total $20B infusion from the US Treasury in March of 2010 through the conversion preferred shares into common equity. With that, the Treasury essentially recapitalized the whole company and at the end of Q1 2010 had $14.8B in cash and cash equivalents. With stimulus across the world, Ally has been able to write up assets and unload risky assets from their balance sheet.

To that end, Ally Financial sold off it's European mortgage assets (1) but has continued exposure to Europe in auto loans and other areas.

This month, Ally Financial has attempted to securitize mortgage securities again by offering a senior not on a $166m mortgage pool with %25 credit enhancement.(2) This means that the pool of low LTV loans and prime borrowers can withstand 25% losses before the senior bond is at risk. The senior note was graded A by Moody's. The auction will not occur until next month.

Overall, Ally Financial is making great strides to reduce risk and return tradtional banking practices. It is still yet to be determined whether the company can stand on it's own. But due to the critical function the company performs in supporting the American auto industry, the implicit support from the US government will provide significant credit protection for all investors.

The author is long GKM until maturity.

(1)"Residential Capital (ResCap), the mortgage subsidiary of GMAC Financial Services, is selling its European mortgage assets and businesses to affiliates of alternative asset manager Fortress Investment Group (FIG: 3.37 -3.44%).

The transaction moves 10% of ResCap's total assets as of year-end 2009 — and 40% of total assets when adjusted for the required Financial Accounting Standard (FAS) 167 treatment of off-balance-sheet securitization — into Fortress ownership.

ResCap said the assets in the transaction are valued at levels established in Q4 2009, and it expects no material gain or loss from the transaction. With this deal, GMAC is essential out of the European market."

(2) "Moody's Investors Service assigned provisional ratings to a senior note issued by GMACM Mortgage Loan Trust Series 2010-1, a new residential mortgage-backed deal.
The securitization is sponsored by General Motors Acceptance Corp. Mortgage (GMACM). According to a source close to the deal, GMACM Mortgage Loan Trust 2010-1 priced on Tuesday.

Moody's has assigned a provisional single-A 2 status to one senior note with an original stated value of $166.35m. This note is supported by a subordinate certificate with an original stated value of $55.45m, which Moody's did not rate.

The transaction is backed by 1,981 loans with a combined unpaid principal balance of $222m originated and serviced by GMAC. Loans insured by the Federal Housing Administration (FHA) make up 97% of the pool, with the remainder insured by the US Department of Veterans Affairs (VA)."

Reiterating - Gold is going higher

2010-06-21T11:40:00.000-07:00

I have taken great interest in the gold debate. Here is what I have found...

There are two major laws to investing in gold.

(1) Gold tracks neither inflation or deflation as a rule, instead gold tracks financial instability

In periods of financial instability, there is a rush to safety to buy treasury bonds and the like. Investors also become skeptical of paper currency. That is a strong bullish case for gold.

(2) Gold consistently increases when short term interest rates are at nominal zero

When the Fed is pumping money into the system to fight whatever financial ill is in the system, this is also a bullish scenario for gold. Right now, the Fed is trying to unemployment and financial instability. Both drivers warrant an extended period of low interest rates. So when will the Fed raise interest rates?

(1 + 2) The Fed historically has only raised rates six months after unemployment starts to fall from peak levels

Based on the current reports regarding the dwindling stimulus and the temporary census jobs boost, unemployment should decline from current levels for the rest of 2010 and early 2011. Thus with the instability in Europe, and these structural problems in the US, the Fed will keep interest rates low as a safe strategy. This is an "all clear" bullish sign for gold for the rest of the year.

Gold is on the rise

2010-05-12T16:04:00.000-07:00

No confidence that more loans will resolve the issue of too many loans in the Euro Zone.

Gold is the play of social instability.

Selling GLD Jul 10 $118 puts for $4.5 and buying $115 GLD Jul 10 puts for $2.9

Ignore the credit raters! Buy GMAC Senior Debt

2010-05-06T09:16:00.000-07:00

The author is adding another safe investment with a US government "put" to support the security. The intent will be to hold until maturity.

The whole investment logic for this one is supported by a quote from Bill Gross, PIMCO, in his May Investment Outlook

“Still, as future bond issuers belly up to the bar with their rating agency seals of approval, it is incumbent on the buying public to treat those IDs with a healthy skepticism. Firms such as PIMCO with large credit staffs of their own can bypass, anticipate and front run all three, benefiting from their timidity and lack of common sense. Take these recent examples for instance: S&P just this past week downgraded Spain “one notch” to AA from AA+, cautioning that they could face another downgrade if they weren’t careful. Oooh – so tough! And believe it or not, Moody’s and Fitch still have them as AAAs. Here’s a country with 20% unemployment, a recent current account deficit of 10%, that has defaulted 13 times in the past two centuries, whose bonds are already trading at Baa levels, and whose fate is increasingly dependent on the kindness of the EU and IMF to bail them out. Some AAA!

Now let’s go the other way. GMAC, that only too recently near-bankrupt finance company, carries recently upgraded B ratings from the rating services. Profiles in courage for all three, I say! I mean the U.S. government has injected $20 billion of capital and owns 65% of the company. It’s the auto industry’s equivalent of FNMA and FHLMC, except those are AAA and GMAC is B with a “positive outlook!” For that, you can buy a GMAC two-year bond at 6½% (8% with what are called “smart notes” that Investment Outlook readers can buy through their broker), while you receive only 1.2% at Fannie and Freddie. Vive la différence!”

The author of this blog has found something comparable to purchase…

NYSE: GKM – GMAC Senior Debt, 7.25% yield at par ($25), currently priced at $20.85 (8.69% yield to maturity) – Callable any time after 2008 and due 2033
NYSE: GJM – GMAC Senior Debt, 7.35% yield at par ($25), currently priced at $21.02 (8.69% yield to maturity) – Callable any time after 2008 and due 2033
I am going to buy a little of both of the above for myself right now. FYI: When they retire the debt, they normally start with the higher yielding one first.

Bought GKM at 20.96 on May 5th and sleeping well.

Stimulus, Strikes, Restructuring and Stability? - Go Long Volatility

2010-04-28T11:13:00.001-07:00

This looks like an absolute no brainer.

We are at the top of the stimulus, 70% of the money will have been spent by September. Stimulus programs are fading out all over the world (except maybe China).

On the other hand, Spain, Portugal, and Greece have all been downgraded and face further market pressures on their debt this year. According to NakedCapitalism, Greece is going to face the most stringent economic constraints ever placed on a sovereign nation to receive their IMF alottment. That will just delay the problem for six months to a year. Once they blow through the first set of conditions, the market will be bigger questions to address.

I don't care if the IMF (a.k.a. US) and it's european friends bailout all of these PIIGS. They won't do it until it is the final option. That guarantees volatility before we get there.

Long VXX at 20.06.

Deleveraging is in effect and it is ugly.

First Marblehead recovers from a bump

2010-04-26T12:12:00.000-07:00

Investing in FMD takes pure guts! (Or just faith in the vampire squid)

FMD has $422m cash ($380m market cap) and a $15m quarterly burn rate. Yet it has no real income because it was forced to stop all banking transactions because of it's capitalization levels and loan guarantees. It continues to take shrinking losses on that previous portfolio. The government lifted the cease and desist order on their bank subsidiary after they sold off their complete student loan portfolio at a sizable loss. So now they can get back into the business in a much better market climate than before.

For me, it is impossible to believe that the private student loan securitization market is permanently impaired. There is plenty of supply of private student loans to be made out there. There is plenty of demand for it from investors due to the strict recovery provisions. FMD servicing capibilities have proven to decrease default rates and increase recovery rates, crucial for student loan securitization investment returns.

A first peek of sunlight is a recent agreement with Sun Trust to perform $200m worth of loan processing, production support, program support and portfolio management, and program administration services. There is no timeframe yet in regards when they will execute this program.

So I think there is a market for them, it just has not reemerged yet. Others have made this bet before, but have yet to realize a return. But with the recent SunTrust deal, real revenues are on the horizon.

Finally, I can say all of these wonderful things, strike them, and still say the fact that Goldman invested $1B in private equity and has a vested interest in seeing a return on that investment is a good enough reason to dabble in FMD. Does anyone have a doubt about Goldman's ability to find a profit, ethical or not? I did not think so.

The author is long at $3.57.

Oil subsides but is still potent for upside

2010-04-22T11:04:00.000-07:00

Oil continues to strength against massive supplies in the US.

"Oil inventories at Cushing reached 34.1 million barrels in the week ended April 16, less than one million barrels shy of a record, the U.S. Energy Information Administration said Wednesday. The extra oil has few outlets, with stockpiles across the Midwest at their highest in at least 20 years and refiners already producing enough fuel to further inflate gasoline and distillate inventories."

Supplies at the highest level in 20 years and oil is still above $80/barrell. Wow.

'"Oil prices have managed to remain above $80 a barrel largely due to strong demand out of China, which has exceeded expectations for economic growth over the last 18 months, even as U.S. oil demand has underperformed.

"The shift in the epicenter for demand continues to shift east of the Suez," wrote analysts with Barclays Capital.'

Yet this may not be the end of it. If the Chinese yuan increases, then oil could go even higher if their stimulus is maintained while the currency appreciates and thus the buying power of China increases.

Short the runt PIIGS

2010-04-22T07:24:00.000-07:00

This will be a drawn out process. But we can be sure that Greece will default in some form or fashion (i.e. restructuring). In the meantime, let's enjoy the instability and make some money shorting the national champions of the most at risk PIIGS.

A few of the facts:

*There is a run on the banks going on in Greece already, official or unofficial. Over 25% of deposits have already left the domestic banks.
* Only six people in Greece claimed income higher than 1m euros in 2008 (pervasive tax evasion)
* Greece has spent over 50 of the last 200 years in default (subprime, always)
* Greece has not had fiscal discipline in the last 10 years, why will that change in a major recession?

As for the short of Portugal Telecom and the national electric company (EDFPY.PK), the performance of the telecom and energy industries are tied to the economic health of the country.

Short NBG at $3.10 entered on 4/22
Short PT at 11.00 (limit order)
Short EDFPY.PK at $37 entered on 4/22

Going to school with Sallie Mae

2010-04-15T15:38:00.000-07:00

Moral hazard is alive and well, why not make some money off of it? A great candidate is Sallie Mae.

Recent policy changes by the Federal government banned the private origination of Federal student loans, Sallie Mae's most profitable activity.

As a result, Sallie Mae has contended that it will need to layoff 2000 workers as it retools to be one of the four designated Federal student loan servicers.

This rebalance in revenue streams pales in comparison to the current liquidity issues facing Sallie Mae. In 2010 and 2011 Sallie Mae is facing a rollover of $11B in debt with only $6B in cash and a hostile credit market. In March Sallie Mae completed a new 1.5B 10-year offering at a horrific 8% fixed. Although this is horrific at first glance in comparison to their current lending rates (5.5% - 6%), since Federal loans often float with interest rates, a rate increase could make this offering cheap in comparison to the discount rate.

Bottom line, the author believes that the Federal Goverment will do whatever it takes to make sure Sallie Mae can rollover their debt. It is not in the interest of the Federal Government to have another major lender fall due to a lack of liquidity, and that has been the minimum criteria for applying moral hazard.

So what do we do? Buy Sallie Mae senior unsecured exchange traded debt (NYSE:JSM) yielding close to 8.3% ($18 price / $25 par) maturing 12/15/2043. Buy at the limit price - $17.50.

Bank inflexibility may lead to government forced writedowns

2010-03-29T10:11:00.000-07:00

Currently there is growing pressure to relieve homeowners by forcing the banks to reduce second mortgages on properties.

From the Wall Street Journal…

“Pressure is growing on U.S. banks to ease terms for distressed homeowners on home-equity loans and other second-lien mortgages. Rep. Barney Frank, chairman of the House Financial Services Committee, last week sent a letter to the four biggest U.S. banks demanding "immediate steps to write down second mortgages."

It appears that the banks enjoy the current lending environment but do not want to concede to rectify the burdens carried by underwater homeowners.

What I read in the bible this morning…

Proverbs 28:8

“ 8 He who increases his wealth by exorbitant interest
amasses it for another, who will be kind to the poor.”

The government may be the instrument that makes the banks recognize their losses and allows the house poor individual to shake free of their debts. But if that is done, the banks could face another major capital problem.

“Most first-lien home loans are held by the government-controlled mortgage companies Fannie Mae and Freddie Mac or by other investors in mortgage securities. By contrast, banks hold most of the seconds and other junior-lien mortgages. About $1.05 trillion of junior-lien home mortgages were outstanding as of Sept. 30, according to the Federal Reserve. Of those, $766.7 billion were held by commercial banks; most of the rest were owned by savings banks and credit unions.
If banks are forced to write down or write off large amounts of those second mortgages, many would suffer major dents in their capital. Laurie Goodman, a senior managing director at mortgage-bond trader Amherst Securities Group LP, said regulators may need to allow banks to recognize losses on second-lien loans over an extended period to avert a disastrous immediate hit to their capital.”

Even though the loss should be recognized immediately, the banks will continue to carry the loans above market prices until forced to do so. But something could go wrong with the bank's plan. This will be an interesting issue to watch over the next few months.

Time to hold your nose and jump into China???

2010-03-12T15:44:00.000-08:00

The China market stinks of government induced economic growth. Since November 2008 I have been highly skeptical of the ability of the world's biggest exporter to sustain economic growth in the face of major declines in import in advanced economies. I was even skeptical that the China stimulus would even be able to solve their problems temporarily. Yet once again I have been proven wrong and see an undeniable trend...

"Chinese exports jumped 46% y/y in February 2010 to US$94.5 billion, after a 21% y/y gain in January. The move suggests that China’s export recovery continues, supported by global demand, but the pace of growth has slowed on a seasonally adjusted basis in early 2010. The 45% y/y climb in imports, reflects in part the revival of the processing trade in which components are imported for re-export as well as the sharp increase in commodity prices."

At the beginning of 2009 exports from China had dropped 20% yoy. With stimulus, exports jumped 45% from 2009 levels but that equates to a 16% increase over 2008 levels. That just returns the country to the growth course it assumed before the crisis began (approximately 7.8% annually).

So is it time to go long China? Probably not. There has been so much positive feedback to the people who have been holding shares of Chinese companies it is hard to see new buyers coming. That said, there has been very little decrease in the stimulative monetary policies of the Chinese government.

As noted in my previous post, oil consumption points to increased economic growth and more upside to the market. But I am not convinced. Nor am I adventurous enough to wade in treacherous waters. I may be missing a huge opportunity, but a penny saved is a penny earned.

Oil: Another China play

2010-02-24T13:22:00.000-08:00

Some said it was the USD holding up the oil price. Now the USD has retraced to pre-crisis levels vs. other major currencies and the price of oil has not fallen.

As it turns out, China imports are a large catalyst in demand for crude oil.

“China’s growing reliance on seaborne crude oil imports will set the tone of the tanker market for the coming decade,” Poten said in a report to clients, quoted by Bloomberg. “China’s expanding middle class, strategic stockpiling and complex refining capacity ensure that it will continue to be a large ship, crude oil story.”

What is strange is that overall world demand is down, but since China is buying, prices are up. This is somewhat understandable because 50% of the oil futures contracts traded are for speculation. So it is a self feeding machine.

In any case, based on this information I will be looking for an acceptable exit point for my SCO position. I cannot invest with 80% confidence when I see I am fighting the Chinese stimulus investment in oil consumption. I will need to wait to see lending decline prior to taking such a position again.

"China’s crude oil imports may reach an all-time high this year as an economic recovery spurs demand for fuels, data from China National Petroleum Corp. showed on Feb. 4. The Chinese economy, which expanded at the fastest pace in the fourth quarter since 2007, will grow four times faster than the U.S. in 2010, the United Nations said in December.

Chinese charterers accounted for about 30 percent of VLCC spot fixture activity this year, up from below 5 percent a decade earlier, Poten said."

Turkcell on sale

2010-02-24T09:17:00.000-08:00

Simple market thesis, find a wide moat, buy and hold. Easier said than done.

Turkcell, the #1 cell phone provider in Turkey is one such company. Beyond the huge domestic market share (57%) and wonderful dividend policy (50% of profits to shareholders), this company holds a huge economic moat. The mobile telecom market naturally requires huge capital investment, and thus the barriers to entry are huge. Also, as in most emerging economies, telecom companies are often partially privatized but still national champions of the current regime. Turkcell is no different. No one in Turkey wants Turkcell to fail.

Purchasing this stock with .79 cent dividend (5.1% yield at $15) does incur currency risk. But economy of Turkey has held up very well in the recent economic crisis and has even been marked for a rating upgrade by the major rating agencies.

Although a large part of Turkcell is already foreign owned, at some point in the future I could see a major multinational moving in and buying Turkcell to extend their geographical footprint. But for now, I am content with the high growth and high yield.

The author is long TKC at $15/share.

What Euro crisis? I smell opportunity. Buy Euro debt

2010-02-23T16:31:00.000-08:00

Headline: Fiscal deficits across Europe threaten to blow apart the Euro.

So what? Who cares.

Let's think about this. Germany is right now benefiting from low budget deficits and artificially lower currency base because they belong the Euro. Exports are recovering because Germany is one of the most competitive exporters of the European Union.

Let's look down the road... worst case, one of the PIIGS default. The euro is abandoned by the European countries and the deutsche mark (DM) is reinstated. The DM soars and exports suffer. Another recession ensues. Painful, not a killer.

More likely...the PIIGS are dragged along without "technically" defaulting. A bailout, backdoor or front door, will just continue to dilute the euro trying to regain competitiveness. The German banks will take some writedowns and move on. Is this bad? Bad for Europeans trying to retire. But not bad for the survivor PIIGS who need to export their way out of their recession.

With this said, what could be on sale during this storm?

Long Credit Suisse Subordinate Debt Notes yielding 7.90% at par ($25 Par), buy at $17/share (NYSE:CRP).

Long Deutsche Bank Subordinated Debt Notes yielding 6.35% at par ($25), buy at $13.5/share (NYSE:DUA).

US Deficit Management: Feeling in the dark

2010-02-17T10:56:00.000-08:00

If there is anything that keeps stomach of the average US investor in a knot, it is the size of the US deficit. For all the story of US growth prospects, with the deficit always looming in the background, there is a feeling that whole system could fall to piece if this issue is neglected. The US deficit is huge. At this time of economic stress, it is important to ask if US at immediate risk? If not, what are some scenarios which could be a tipping point?

Right now, the US is not considered to be a major risk. The US has no problems rolling over their debt at any maturity. We don't know how long that will be so easy. Yet there are other countries with more immediate debt concerns that may be a canary in the coal mine.

Yet as the Economist notes above, the US one of the lowest average duration measures of all heavily indebted countries.

As a course of the recent stimulus financing, the US has been selling heavily into the middle of the medium term of the yield curve. This helps by lowering debt payments on debt rolled over. In fact, the US has actually reduced their interest payments in 2009 recently because of our focus on issuing debt in the 3yr to 7yr range of the yield curve.

Essentially is a leveraged bet on the future economic growth and fiscal management. If there is an econmic shock or significant inflation causing higher interest rates in a 2.5 to 6.5 year period, the rollover of the remaining debt will cause a marked increase in debt servicing payments. This is particularly of concern because the overall US debt schedule will be so focused on the front end of the yield curve causing a massive rollover of debt in just a few years.

Who knows if we will be ready, or just in worse shape from kicking the can down the road, when that time comes?

Scenarios that could cause US debt to become a noose....

1. China decreases consumption of US debt

If China reduces stimulus too fast it's accumulate such massive amounts of foreign currency and becomes a long term net seller of US debt instruments

2. Japan decreases consumption of US debt

If Japan faces a large deflationary spiral or exports do not recover, it must decrease purchases to amortize it's own debt

3. Oil producers decrease consumption of US debt

If a world wide economic slump causes the price of oil to drop, some major oil producers (Middle East, Russia) who also are responsible for purchasing 10% of US Treasury debt, decrease purchases and unload their holdings

Deficit hawks, doves, and peacocks can crow all they want about deficit reduction or increased deficit spending. The looming threat of a debt crisis will remain until there is a cultural transformation regarding fiscal management to reduce short term borrowing needs.

USD bull momentum continues

2010-02-16T10:35:00.000-08:00

Many doubted the USD. Called it dead and buried.

The USD has started to prove a better choice amongst world currencies. Analysts observing the change in the situation have revised estimates of the 2010 value of the USD vs Euro to reflect the trend toward USD strength.

In fact, large amounts of money has also started to point toward continued USD strength.

"According to data compiled by Scotia Capital, traders were net short the euro—meaning on balance they were betting it would decline—by a record $9.9 billion last Tuesday.

That is a 31% increase from the previous record set a week before. Traders were net long U.S. dollars by $7.9 billion, on a par with levels last seen during the financial crisis."

Once again, there are huge deflationary forces taking hold this year....

1. HAMP ends, massive short sales to ensue
2. Agency mortgage purchases by the Fed end (at least for a little while, may restart later)
3. QE using treasury purchases end (again, probably temporary - six months at most)
4. World wide stimulus programs end (South Korea, Brazil, Australia, India, etc)
5. No cash for clunkers
6. Declining influence of the US fiscal stimulus

... and many more

Plus the "flight to the USD" effect from...

1. Euro zone debt crisis
2. Dubai "restructuring" (default at 60 cents on the dollar)
3. Would you put your money in China an export economy with stimulus at 20% of GDP???
4. Massive Japanese QE (Not here yet, but definitely coming by May, no doubt)

Even though the US has huge debt problems, compared to other countries, their issues look reasonable. The Economist ranks the US and UK after the PIIGS for sovereign debt risk.

The flaw the US is the relative short maturity date of the debt. But one crisis at at time. For now, there is no problem rolling over US treasuries in short maturities and thus the USD IMHO is still on a long bull run.

As much as I would like to do it again...

2010-02-15T10:38:00.000-08:00

... it seems the rules of the game have changed.

Back when the world was simple and the banks were audacious enough to mark-to-market, a novice speculator like myself could use news of credit events to short banks before the losses were annouced. But even credit agency reps admit, this is no more...

"The recent credit crisis was over a few trillion in bad, mostly US, mortgage debts, with most of that at US banks. Greek debt is $350 billion, with about $270 billion of that spread among just three European countries and their banks. Make no mistake, a Greek default is another potential credit crisis in the making. As noted above, it is not just the writedown of Greek debt; it is the mark-to-market of other sovereign debt.

That would bankrupt the bulk of the European banking system, which is why it is unlikely to be allowed to happen. Just as the Fed (under Volker!) allowed US banks to mark up Latin American debt that had defaulted to its original loan value (and only slowly did they write it down; it took many years), I think the same thing will happen in Europe. Or the ECB will provide liquidity. Or there may be any of several other measures to keep things moving along. But real mark-to-market? Unlikely. "

So although the Greece bailout, Dubai default, and PIIGS bond auction failures all point to bank losses, a speculator will need to be very careful determining the course of action to protect their financial position.

Short Oil: USD strength will drive oil down

2010-02-12T15:29:00.000-08:00

Over the past six months, the leveraged rise of oil prices has been largely been explained by the drop in the USD despite over two years of continuous slide in demand for oil.

Yet over the last two months the USD has started to shoot up and oil has mildly corrected in kind.

... despite reports of excessive inventory. In fact, some traders are still optimistic regarding oil in the face of these bearish indicators.

Marketwatch reports ...

"The Greek bailout is helping support global markets and the price of oil," [Mike Sander, investment adviser at Sander Capital in Seattle] said. "If Greece was leaning further along to a default, then we would have seen oil break $70 for sure."

The inverse relationship between crude prices and the U.S. dollar has decoupled over the past three sessions, which may continue if the stock market stays strong, said Jim Ritterbusch, president of Ritterbusch & Associates, in a note to investors.

A large build in U.S. oil stockpiles may also be overshadowed by developments regarding the European Union's plan to address Greece's debt issues, he said. "We expect wide price swings in both directions going forward as an unusual crosscurrent of financial guidance will occasionally be butting heads with bearish underlying oil fundamentals."

To think that data from three trading sessions identifies the decoupling of a year long trend is a little far fetched.

But as far as the Greece debt bomb destroying the price of oil, I highly doubt Greece will default either. It is not in the interest of anyone with real money that they do default. But as soon as Greece gets their bailout package, the other PIIGS will come to the trough. The question is not if one can be bailed out, but will all of the countries with debt solvency issues be bailed out. This fear will be enough to drive the market to the USD and put longer term pressure on oil.

Even without a crisis in the making, forecasts for oil consumption are not strong. Whether it is demand fundamentals or technical factors, both provide tremendous demand for the USD that makes the price of oil in USD look very expensive.

This disconnect cannot stand. Oil will correct in correspondence with the new demand for the USD.

The author is short oil by going long SCO April $16 calls purchased at $1.40.

[Oil demand chart in the US]

Roubini right in long run.... but in the long run...

2010-02-09T13:21:00.000-08:00

... were all dead.

Roubini's recent comments that "The USD will devalue by 15% - 20% over the next few years" makes sense, assuming China keeps it's stimulus in place and consequently emerging market commodity providers continue to grow. But in the more visible and short run, the USD looks much more fierce than that long term assessment.

The Greek drama is just the prelude to a string of sovereign financing crisises. The risk premiums will return and the spreads will widen as countries compete with each other for funds to borrow. During these bond auction charades, the US will look safe and secure. Remember, the treasury issued the most debt between the 3yr and 7yr maturities, so the bulk of US massive stimulus funding does not start to come due for a couple more years. Moreover with the unwind of programs for QE using treasuries, mortgage backed securities, asset backed securities, bank debt guarantees, foreclosure moratoriums and whatever else by this March, deflationary forces will come back in force in the US.

So although monetary stimulus has set the stage for inflation when price support is found, the immediate drama in the Eurozone guarantees that the USD will stay strong for a while. In this market, a while is a mighty long time.

Greek drama

2010-02-07T06:25:00.000-08:00

The dramatic events playing out in the press regarding Greek sovereign debt are almost guaranteed to manufacture a happy ending to the final act. But the real outcome will be when the curtains are closed.

It was just a matter of time before all of the global bailouts led sovereign nations to severe debt strains. Unlike the subprime crisis where there was disclosure and mark-to-market accounting for a little while, national fiscal conditions of the PIIGS (Portugal Ireland Italy Greece Spain) are ripe for off balance sheet manipulation. Look at how the US keeps Freddie and Fannie off the official debt tally even though they are now explicitly supported by the US taxpayer.

Moreover, when Iceland's banks were on the brink, the IMF swooped in and recapitalized the country. Who funds the IMF and influences their largesse? The same central bankers (US, Japan, UK, Germany, China) whose banking interests would suffer from any economic shock wave or market turmoil.

"Privately, American officials have said there is next to no chance that Greece will default on its debts. They said European officials were balancing a conviction that the International Monetary Fund should not be involved in solving Greece’s problems with their belief that political pressure was necessary for the Greek political leadership to cut spending and raise revenues."(1)

Greek change of heart? Not even an interesting subplot, Krugman noted that Greece has spent 50 of the last 200 years in default.

But since the issue of sovereign debtors needing forebearence will be a common theme this year, there is lots of interests in not seeming too lenient in the public. Otherwise everyone will want the same sweet deal. Another resolution will be a backdoor bailout by a willing party with an off balance sheet swap deal with funny accounting. If I were to write the script of the conclusion to the third act, it would be "You pay me $100B USD now and I pay you two payments of $75B USD of Yen over the next two years and your government buys only Toyotas for the next ten years." This has been done before.(2)

No matter what monologue of despair or dialogue of conflict plays out in the press, the final act will be a private arrangement where the main actors are major investment banks and quasi government investment vehicles. In fact, Goldman Sachs is at the tip of the spear making sure the conclusion of this drama is a happy one, at least in public. (3)

(1) "Group of 7 Vows to Keep Cash Flowing" New York Times, Feb 6, 2009, by Sewell Chan
(2) "Traders, Guns, and Money", written by Satyajit Das, p. 106-10
(3) "Is Greece’s Debt Trashing the Euro?" New York Times, Feb 6, 2009, by Landon Thomas Jr.

Feb 14, 2009 update

This article confirms my speculation was spot on.

"In Greece, the financial wizardry went even further. In what amounted to a garage sale on a national scale, Greek officials essentially mortgaged the country’s airports and highways to raise much-needed money.
Aeolos, a legal entity created in 2001, helped Greece reduce the debt on its balance sheet that year. As part of the deal, Greece got cash upfront in return for pledging future landing fees at the country’s airports. A similar deal in 2000 called Ariadne devoured the revenue that the government collected from its national lottery. Greece, however, classified those transactions as sales, not loans, despite doubts by many critics."

After this initial deception to get into the euro... there was even more deception to stay in the euro...

"The answer was no. But in 2002, accounting disclosure was required for many entities like Aeolos and Ariadne that did not appear on nations’ balance sheets, prompting governments to restate such deals as loans rather than sales.
Still, as recently as 2008, Eurostat, the European Union’s statistics agency, reported that “in a number of instances, the observed securitization operations seem to have been purportedly designed to achieve a given accounting result, irrespective of the economic merit of the operation.”
While such accounting gimmicks may be beneficial in the short run, over time they can prove disastrous.
George Alogoskoufis, who became Greece’s finance minister in a political party shift after the Goldman deal, criticized the transaction in the Parliament in 2005. The deal, Mr. Alogoskoufis argued, would saddle the government with big payments to Goldman until 2019.
Mr. Alogoskoufis, who stepped down a year ago, said in an e-mail message last week that Goldman later agreed to reconfigure the deal “to restore its good will with the republic.” He said the new design was better for Greece than the old one.
In 2005, Goldman sold the interest rate swap to the National Bank of Greece, the country’s largest bank, according to two people briefed on the transaction.
In 2008, Goldman helped the bank put the swap into a legal entity called Titlos. But the bank retained the bonds that Titlos issued, according to Dealogic, a financial research firm, for use as collateral to borrow even more from the European Central Bank.
Edward Manchester, a senior vice president at the Moody’s credit rating agency, said the deal would ultimately be a money-loser for Greece because of its long-term payment obligations.
Referring to the Titlos swap with the government of Greece, he said: “This swap is always going to be unprofitable for the Greek government.”"

CEG: Credit Crisis Survivor on the Rebound

2010-01-26T12:50:00.000-08:00

Constellation Energy - a company with $21B in sales and $7B market cap. Credit crisis survivor. This company was caught in a debt trap with the bankruptcy of Lehman at height of the credit crisis. CEG made it through as an independent company, but have they solved the problem?

With the completion of the $4.5B sale of 50% of their nuclear energy business to EDF, the company is now on solid footing. This raised $2B in cash to the balance sheet. The company also moved ahead with debt reduction starting with a $1B payoff of debt due in 2012.

But is the company still exposed to another cash shortfall? There are two areas of concern 1) derivatives and 2) debt.

Derivative exposure is still at $1B. Worst case scenario, they use their new cash balance to handle any problems. (CEG 3Q 2009 10-Q)

What about their debt schedule (including BGE)?

Not bad.

Although current earnings are neglible due to deleveraging, this is a temporary circumstance. Overall, earnings should return to $200m per quarter over the next year due to the rebound in energy prices and the economy. This is modest compared to the previous track record which recorded close to $700m+ in earnings per year throughout the last decade.

Bottom Line: CEG looks like it has eliminated it's debt problem has tremondous earnings upside to drive value for investors.

The author is long CEG.

Stimulus Watch: China keeps throwing out the dough

2010-01-21T10:04:00.000-08:00

Apparently China is making a mild attempt to preempt a credit crisis in China...

"Premier Wen Jiabao said yesterday China will “well manage” the pace of credit growth after a record 9.59 trillion yuan of new loans were doled out in 2009, stoking concerns of asset bubbles and worsening credit quality. China’s central bank last week raised the proportion of deposits banks must set aside as reserves for the first time in 18 months."

Lending 9.59 trillion yuan is lending over 25% of GDP in one year. Let's see what they plan for next year...

"China has told some banks to limit lending and will restrict overall credit growth in the nation to 7.5 trillion yuan ($1.1 trillion) this year, banking regulator Liu Mingkang said."

This amount is still over 20% of GDP of nominal loans in one year. Wow.

In addition, the fiscal stimulus keeps rolling...

"...the 4 trillion renminbi multiyear fiscal package, which was announced last year, which is equivalent to 15% to 20% of GDP. ...It's a massive undertaking, all funded internally by the Chinese government plus some private equity participation."

I am not sure when China's fiscal stimulus effect is expected to peak. If someone has found a reference, let me know.

Overall, should you go long China? Can't say. Looks tempting. Despite the huge run up already, i will look into opportunities.

Stimulus Watch: Not more bad is good

2010-01-13T14:19:00.000-08:00

Over the next few months, the receding stimulus will have a negative effect. But what has it done thus far?

According to the rail car stats, nothing but stabilize the situation.

But looking at a bigger picture, things have been less worse.

Understanding what this will mean in the next few quarters is "above my pay grade".

This blog will continue to look for opportunities, long or short, wherever they arise.

GMK: Value south of the border

2010-01-12T12:49:00.000-08:00

Is there a more stable business than having the #1 torilla brand in Mexico?

Has $3B USD in sales and is a market leader in the US, Mexico and a few other countries. They saw a 1% increase in revenue this year (excluding currency issues). Operating margin for the business increased in 2009 to 6.3% from 4.6% last year. Operating profits totaled close to $100m USD for 2009. YAWNN!!!!! Are you bored yet? Let's get to the real questions.

A year ago GMK was caught in a horrible hedging position as corn prices collapsed that caused an $800M+ USD loss for 2008. The GMK was saved by banks (most likely the same banks that sold them the derivatives) and now is liable for a $660m USD note which comes due in 2014. So why invest? Value.

The current market capitalization for GMK is $1B. At the current amortization rate (and assuming they once again refinance to a yet smaller debt position again in 2014) the company should still hold at least a $1.5B market cap. The credit crisis may not be over, but viable businesses like GMK are not likely to remain exposed in the same way as pre-2008. Let's take advantage of this painfully gained wisdom and buy GMK.

The author recommends buying at $8.50.

IMAX changed the movie business

2010-01-12T10:00:00.000-08:00

Did you see Avatar? Everyone did. But did you see Avatar on 3-D IMAX? If so, then you really saw Avatar. The game has changed. Catch the ride.

3-D and IMAX have not only changed the future of the movie business. They have changed the business model of the movie business. IMAX used to be just science documentaries at your local museum. IMAX has made deals with all but one of the major studios to collect 1/3 of the box office take for any feature shown in their theatres. To see Avatar costs $10.50 for a regular adult ticket, but $16.50 for the IMAX experience. Just Avatar alone will put them in the black for 2009.

But the 2010 line up is just as impressive...Alice in Wonderland, Shrek, How to Train Your Dragon, Toy Story 3, and Twilight:Eclipse. It will be a while before a movie like Avatar invests as much in cutting edge graphics. But, as James Cameron has noted, the platform is now there.

"The box office success of “Avatar” boosted analyst estimates for Imax Corp.’s fourth-quarter EBITDA estimate to $20.3 million from $13.7 million and earnings per share to 15 cents from five cents. [EBITDA or earnings before interest, taxes, depreciation and amortization, is a key measure of operating cash flow.] The Firm says IMAX’s share of the box office has risen to the 15%-18% range from the typical 8%-12% from just 3%-4% of the screens, showing the format is a “must-have” for multiplex operators."

International growth is also being initiated due to brand recognition and word of mouth about the IMAX experience. The game has changed worldwide, if an action movie is a must see, then it must be seen on IMAX.

The author recommends buying IMAX at $13.10.

Buy a Warren Buffett throwaway: Constellation Energy

2010-01-02T00:08:00.001-08:00

Constellation Energy is an energy trading holding company with a large regulated utility, Baltimore Gas & Electric, as a subsidiary. In late 2008, the bankruptcy of Lehman Bros caused a massive liquidity crunch for Constellation Energy holding company. The ensuing capital crunch for their positions led them to seek Warren Buffett to provide the capital to allow the holding comapany to stay out of bankruptcy. Warren the White Knight, after staving off creditors sold his position and for his charity received break up fee of $1B from Constellation Energy.

The story was not over. With it's credit rating shot because of the trading mishap, Constellation Energy still needed to secure greater financing. Since the credit markets were closed to risky investments, the company sold half of it's assets to EDF, the French state owned electric utility for $4.5B. The story was still a nail biter because there was political pressure in France not to do the deal. For Constellation Energy, this was a quick end to their liquidity issues or possibly another capital crisis if the deal fell through. On Nov 6th, the deal completed and now CEG is on stable ground.

Reviewing their 3rd quarter statement, the Constellation Energy holding company still holds over $1B in energy trading instrument exposure.

So why touch this dog with bad management? Purely on value. Constellation Energy is a company with annual sales of $19B for 2008 (expected at $16B in 2009) with a market cap of $7B. Now that the EDF joint venture is closed, bankruptcy is absolutely off the table. The company turned profitable again in the 3rd quarter of 2009. Is it sustainable? I don't know. But even if the company breaks even, it is a steal.

Just two years ago, this stock was $60 and had a 3% yield.

I am buying CEG at market. On Jan 4th and it will be the first thing I do in the new year.

Even better than the common shares are the subordinated debt of the Baltimore Gas & Electric (BGE) subsidiary. Thus far, all the problems with CEG have come from the energy trading holding company, the regulated utility has been uneffected other than the fact that they have leaned on the subsidiary for capital during the capital crisis.

As a measure for closing the sale to EDF, CEG committed to recapitalizing BGE.

"The PSC ruled Oct. 30 that Baltimore-based Constellation (NYSE: CEG) could go forward with the EDF deal if it included a handful of concessions. They included:

...

• A $250 million investment into BGE; and,

• A restriction from drawing dividends from BGE if it would drop the utility’s cash reserves below a certain level."

Thus I am also recommending again BGE Capital Trust II (NYSE:BGE-PB). The subordinated debt has a 7.5% yield and is selling 10% below par.

Indicators point to a bounce in the USD

2009-12-11T12:42:00.000-08:00

You say "But EVERYONE is short the US Dollar?"
So what. Is the USD worth zero? We already have lost 20% of the value of our currency in a year. That is a huge move. Let's look forward.

There are fundamental factors that could facilitate a rebound in the USD. A default of Greece, Russia, Hungary, Latvia, Mexico, or a major international bank all might cause a flight back to the USD. Also the completion or ending of the mortgage purchase program, Treasury purchase program, and declining effect of the stimulus all will have a deflationary effect on the USD.

In fact there are market indicators that show the USD could head higher from here in the short term.

The first is the possible break in the USD downward trendline. The euro is foretelling a break of that six month trend.

Second is the options action on the USD Jan 10 Option Chain (expressed through the UUP - USD Bullish ETF). At least one major hedge fund or active market participant has engaged in a bull call spread that will make money as UUP crosses $25.25 or so. Minimal action on the put side of the equation is a bad sign for anyone short the USD.

These positions could be just foolish bets from large accounts dumb money. But sometimes making positions in front of any trend where lots of money is moving in the same direction is the best place to be, smart or dumb.

Time for a makeover!

2009-12-03T17:34:00.001-08:00

Hi, this blog is going to get a makeover. Not just eyebrows and toes either. A whole new look!

If anyone has ideas for a motif, send them my way.

Unemployment peaking in 2011?

2009-12-03T08:44:00.000-08:00

Good morning. I have had lots of family come and go over the past few weeks and it gave me a chance to take a breather from the market. Except for helping a friend out with some questions and stocking some gold, I have been pretty quiet.

News this morning... Goldman has released predictions that give us some food for thought for positions to take now.

"If Goldman Sachs is right, of course. Here is the firm’s 2011 forecast:

The key features of our 2011 outlook: (1) a strengthening in growth from 2.1% on average in 2010 to 2.4% in 2011, with real GDP rising at an above-potential 3½% pace in late 2011; (2) a peaking in unemployment in mid-2011 at about 10¾%; (3) extremely low inflation – close to zero on a core basis during 2011; and (4) a continuation of the Fed’s (near) zero interest rate policy (ZIRP) throughout 2011"

Let's examine each one and comment...

1) GDP growth of 2.1 % through 2010

From such a low base, this is just bouncing along the bottom

2) Unemployment peaking in mid-2011 at 10.75 %

Whoa. CalculatedRisk has noted that the Fed does not raise interest rates until "six months after peak unemployment". So monetary stimulus via the Fed will continue for at least another year. That means more downward pressure on the USD, and thus more upward pressure on commodity prices from domestic sources.

3) Extremely Low Inflation

If you think you can get a 6% yield over the next year with low risk of principal, I think you will have definitely beat S&P index returns and any low risk instrument. This is where you will sleep well.

4) Continuation of the ZIRP

The Fed will continue to create inflation to fight credit related deflation. Money, money, everywhere yet none of it to spend.

This blogger suggests buying Met Life A series at $20.90. Although all big insurers are suffering from investment losses and still holds significant exposures, Met Life must be gaining from the fall of it's biggest competitor in the marketplace.

This security will provide a solid yield while the Fed keeps rates low and includes protection if the Fed must quickly increase rates to address hyperinflation of any sort if it were to occur down the line. If the security is deemed by Met Life in the next few years, then the principal pop will provide an addtional 20%+ return over that time period (annualized rate will be lower).

"Met Life preferred A series securities at MetLife Inc., Floating Rating Non-Cumulative Preferred Stock, Series A, liquidation preference $25 per share, redeemable at the issuer's option on or after 9/15/2010 at $25 per share plus declared and unpaid dividends, with no stated maturity, and with non-cumulative floating rate distributions paid quarterly on 3/15, 6/15, 9/15 & 12/15 to holders of record on the 15th calendar day prior to the payment date or on the date fixed by the board, not more than 60 days or less than 10 days prior to the payment date. The floating rate will be the greater of 4.00% or 1.00% above the three month LIBOR rate. In regards to payment of dividends and upon liquidation, the preferred shares rank equally with other preferreds and senior to the common shares of the company."

Ambac heading for default???

2009-11-05T21:39:00.000-08:00

JP Morgan thinks so, in the near term...

Does anyone remember February 2008 when the monolines were first being reviewed for downgrade and the market went in a frenzy and the CEO of Ambac was on CNBC? Who remembers that and what did you think then?

"We do not agree with the models! We repeat we are at no risk of defaulting. We have over $1B in claims paying resources!" the CEO Callen pleaded over and over again live on CNBC. Two years later and after at least two capital raising activities, Ambac is now at the end of their rope.

Even as recent as this Sept 26, 2008 interview with the CEO Michael Callen shows he is unrepentent about the financial risks to his firm and the system in general. Even in Sept 2008 the CEO claims to have $12B in claims paying resources. Good thing the rating agencies did not allow them to just shirk their responsibilities by moving those assets into a new subsidiary to avoid the existing liabilities (a.k.a. the shell game plan).

Here is the link -> "Ambac Insurance Unit May Be Put in Receivership"

Just a year ago this would have shook the financial sector. But since we started handing out money and the Dow is up, "hey, no problem!"

No recommendations other than encouraging everyone to stay defensive in general.

FHA: Lending with a 20%+ default rate expectation

2009-11-05T12:30:00.001-08:00

This blog has mentioned before that FHA is subprime in sheep's clothing. But how bad is it?

"Although the FHA has tightened credit standards, many of the 2007 and early 2008 mortgages are going bad. The agency expects defaults on 24% of all loans insured in 2007, and 20% of those backed in 2008. "The orders from Congress and us were clear: We want to save as many families as we can, recognizing that a lot of loans people were looking to refinance out of should never have been made in the first place," said Brian Montgomery, who served as the agency's commissioner for four years ending in July."(1)

Although there have been lots of assurances to the contrary, it looks like a bailout is now in the works.

"Two House Republicans warned that growing losses at the Federal Housing Administration could lead to a taxpayer-funded bailout and have asked the Department of Housing and Urban Development for data backing up the FHA’s assertion that it won’t need to ask Congress for any taxpayer money.

“Congress and HUD must take whatever steps are necessary to ensure that this program operates in a manner that does not expose the taxpayer to yet another bailout,” wrote Republicans Darrell Issa of California and Spencer Bachus of Alabama in a letter, dated Monday, to HUD Secretary Shaun Donovan."

Apparently news leaked that the stress tests used in the audit showed FHA is doomed at current capital levels.

Likelihood that a bailout will be avoided, I put it at 10%. But who cares, the DOW is up. Right?

(1) "FHA digs out after loans sour", WSJ, written by Nick Timiraos, Nov 4, 2009

(2) "FHA postpones release of audit as bailout worries mount" WSJ, written by Nick Timiraos, Nov 5, 2009

Is it time for the USD to show some muscle?

2009-11-03T15:17:00.000-08:00

The US dollar has been kicked, spit on, and left for dead in 2009. Gold bugs, fiscal conservatives, and doomsayers all have abandoned the US currency in anticipation of economic meltdown due to the massive amount of debt spending to slow the crisis.

But have USD critics gotten ahead of themselves?

* Oil has overshot against the USD

Since March, USD has fallen less than 20% vs the Euro, but oil futures have increased 40% in anticipation of a collapse in the purchasing power of the USD. Yet that has not happened...

...and as time ticks by, the disparity between the increasing inventory of oil in the market and the demand on the exchanges becomes more and more peculiar.

* Even weaker currencies have gained 30% vs USD

Emerging market currencies such as the Colombian Peso, Brazilian Real, and Turkish Lira all have gained over 25% vs the USD in a just six months. Although their futures are bright, there are still significant political risk to emerging countries that is now disregarded in the purchase price.

* Lots of deflation on the horizon

The market has been bearish on the USD since March. But considering the wind down of stimulus in the next few months (Treasury purchases, MBS purchases, Cash for Clunkers) and also housing programs (HAMP, Housing Tax Credit), the deflation of reduced economic activity should be significantly bullish for the USD.

* USD is reaching historical support levels

Emerging economies need the USD propped up to maintain exports and keep the flow of hard currency into their country. This historical chart underscores the importance of the US economy to the world.

* Traders have moved to a net long position on the USD

In fact, it has been noted recently that traders have switched to a net bullish dollar position.(1)

* USD reversal could cause market mayhem

Many journalists remark on how the investment banks borrow from the Fed for free and invest in other currencies to obtain a spread. This is called a carry trade and it has helped banks such as Goldman Sachs, Morgan Stanley and JP Morgan book billions during this year. Roubini thinks an uptick in the US dollar will lead to a massive carry trade unwind.

“Everybody’s playing the same game and this game is becoming dangerous.”

The dollar has dropped 12 percent in the past year against a basket of six major currencies as the Federal Reserve, led by Chairman Ben S. Bernanke, cut interest rates to near zero in an effort to lift the U.S. economy out of its worst recession since the 1930s. Roubini said the dollar will eventually “bottom out” as the Fed raises borrowing costs and withdraws stimulus measures including purchases of government debt. That may force investors to reverse carry trades and “rush to the exit,” he said.

“The risk is that we are planting the seeds of the next financial crisis,” said Roubini, chairman of New York-based research and advisory service Roubini Global Economics. “This asset bubble is totally inconsistent with a weaker recovery of economic and financial fundamentals.”(2)

The author of this blog thinks it is time for the USD to correct, but that it is too risky to play for a major spike in the USD. In the case there were unforeseen banking issues in Europe or in a significant emerging market, a run to the USD could be damaging to US banks who are leveraging USD.

The author recommends buying SCO under $13 and exiting above $15.5

(1) Forbes.com, "Stronger Buck Threatens Stocks And Commodities", Ryan Campbell, Nov 3, 2009

(2) Bloomberg.com, "Roubini Says Carry Trades Fueling ‘Huge’ Asset Bubble", Michael Patterson, Oct 27, 2009

If this is a recovery...

2009-10-27T15:47:00.001-07:00

If this is a "recovery", then I need to take high school english again. Recovery from an injury means regaining health and mobility. I see little health in the following stats considering the massive stimulus it took us to get there.

First of all, how do job loss trends like this...

...translate into increasing home prices?

It must be this...

...since I don't see a rebound in Buffet's favorit metric...

...or here in US daily oil consumption (even though the reported numbers are only until July)...

Bottom line. All I see is a little prop up, not recovery. Remember, my previous blog mentioned that we are now at the peak effect of the stimulus and that it will wear off from here. At least the headlines have toned down from the cheery "That was easy!" messages of two months ago. Let's see if they turn into "This is kinda hard?" in March when the Treasury stops buying agency debt.

Stimulus Watch: More evidence US at the peak

2009-10-23T13:17:00.000-07:00

Previously this blog noted that not only has the whole world enjoyed a stimulus boost but that US is at the very peak of stimulus spending. To date, this is the amount of funds that have been dispersed.

Now Christina Romer, Chair, Council of Economic Advisers in Testimony before the Joint Economic Committee is confirming suspicions…

“In a report issued on September 10, the Council of Economic Advisers (CEA) provided estimates of the impact of the ARRA (American Recovery and Reinvestment Act) on GDP and employment. ...

These estimates suggest that the ARRA added two to three percentage points to real GDP growth in the second quarter and three to four percentage points to growth in the third quarter. This implies that much of the moderation of the decline in GDP growth in the second quarter and the anticipated rise in the third quarter is directly attributable to the ARRA.”

In fact, Romer’s assessment is that after Q3 2009, the stimulus will provide no boost to GDP growth.

“Fiscal stimulus has its greatest impact on growth around the quarters when it is increasing most strongly. When spending and tax cuts reach their maximum and level off, the contribution to growth returns to roughly zero. This does not mean that stimulus is no longer having an effect. Rather, it means that the effect is to keep GDP above the level it would be at in the absence of stimulus, not to raise growth further. Most analysts predict that the fiscal stimulus will have its greatest impact on growth in the second and third quarters of 2009.”

This might lead to an interesting confluence of events. Bank of America executives have said that there will be a spike in 4th quarter foreclosures as various State and Federal foreclosure moratoriums will wear off and mortgage modification programs are exhausted. “Cash for Clunkers” is now in the past. The home purchase tax credit, a dubious incentive itself, has been applied to maximum effect according to CalculatedRisk. CNNMoney.com also noted that despite extended benefits, 7000 people fall off of unemployment benefits a day.

But who is to say there will not be yet another stimulus program to compensate for this new situation? As long as the debt markets keep buying US debt, it seems that politicians will continue to find temporary solutions to draw out timelines for recapitalization of the financial system and consumers.

Defensive Investing: Preparing for a currency war

2009-10-22T09:40:00.000-07:00

Many people have been talking about how low interest rates and stimulus will devalue the USD. It is more interesting to talk about how long the Fed will apply pressure to the value of the USD and what to do about it.

Historical analysis that says that the Fed usually keeps rates low until 1 year after the peak of unemployment. Since we have not hit the peak of unemployment yet and do not expect it to occur until the beginning of 2010, the Fed will flood us with money until 2011. The USD has already lost 20% of it's value, and could lose another 10-20% more value in the next year.

But the economic policymakers outside the US are not naive. A low USD is like a tariff on imports for America. They know this and like to counteract the problem. On Tuesday Brazil put a 2% tax on all foreign investment into their country to devalue THEIR currency against all other currencies. The next day Turkey announced a similar proposal. Southeast Asian countries (Thailand, Indonesia, Hong Kong, Singapore, Malaysia) have started buying the USD to try to devalue their own currencies against the USD.

So what are we seeing, no one is going to take this lying down. It will turn into a currency war, with everyone racing to the bottom. Southeast Asia and Brazil can put in counter measures, but that only slows the progress. The USD will devalue, but at what price? The US has the biggest pump to flood the world with money, but it does not mean we will benefit the most from the flooding? Likely, but not necessarily.

What to do?: 100% of the known readers of this blog receive income in USD, have debt denominated in USD (if they have debt), and have over 90% of their available cash denominated in USD. A little diversity is a nice defensive measure and never hurt anyone.

As the USD devalues, emerging market currencies become more expensive and stocks in emerging markets equity prices rise. But in this environment owning equities is just like owning a lottery ticket. I think owning emerging market bond fund (EMB) or government debt of other countries (IGOV) in very small portion for a buy and hold scenario is a good step hedging step. Even better is just getting a CD denominated in currency in countries with 1) manageable deficits or no deficit 2) commodity exposure that is an Achilles heal to a devaluing USD (i.e. oil). Two safe choices for the next couple of years will be CDs denominated in the Brazilian Real or the Norwegian krone. Offered at Everbank.com with a minimum $10,000 deposit per CD, the CDs can be rolled every 3 months. The annual interest rate is 4.5% for the Brazilian real and .25% for Norwegian Krone. The money will be there and protected from the degradation of USD and is FDIC insured to boot.

Author recommends opening one rolling 3-month CD denominated in Brazilian Real and 3-month CD denominated in Norwegian Krone.

The Fed: Saving the system by any means necessary

2009-10-20T11:35:00.000-07:00

I am not sure when the US market lost the concept of rule of law. The idea that there are winners and losers is a concept lost during our recent crisis. But whenever it did lose it's way and start rigging the markets so blatantly, it was a sad day.

"Oct. 20 (Bloomberg) -- Bank of America Corp. signed off on its government-assisted purchase of Merrill Lynch & Co. after U.S. regulators said the deal might boost the shares, e-mails from two executives showed. Instead, the stock collapsed.

“The chairman of the Federal Reserve indicated it would be structured in a manner such that BAC stock should go up when announced,” Chief Financial Officer Joe Price said in a Dec. 29 e-mail to executives of the Charlotte, North Carolina-based bank, including Chief Executive Officer Kenneth D. Lewis."

The idea that the Federal Reserve is intervening to create the illusion of value in the purchase of an insolvant corporation strikes as market manipulation and the corruption of free markets. But who cares, the Dow is up, right?

Update on October 23rd: Apparently Mish Shedlock agrees with me...

Emerging Markets: More in line with the US market than first meets the eye

2009-10-15T15:24:00.000-07:00

I buy into the idea that the greatest opportunity for growth in the future will be outside the US. Even more immediately, I will show in this post that the decline of the dollar will make smart emerging market investments even more attractive in the coming deflationary correction.

For example, let's refer to recent history regarding the behavior of the market during the crisis days of Nov 2008. At that time there was a tremendous flight to the USD dollar as investors sought safe investments during the crisis. During that time, the Brazilian Real lost 50% of it's value due to declining commodity purchases and concerns over the world economy.

One of the investments I find attractive in South America is Brazilian bank Banco Bradesco (BBD). I expect that banks will profit from the emergence of a new middle class in Brazil. BBD was trading at $10 in November. As of today the stock closed at $21.50, clearly outpacing the market as a whole. But this is not so simple, because since November the Brazilian Real has recovered 40%, the stock has only appreciated 60% in local currency. This only slightly outperforms the 53% returns of the S&P 500 index from March 2009 bottom. This is occurring not just for Brazil, but for Mexico and many other markets where currency appreciation has occurred against the USD. Many investment magazines and pundits have been pumping emerging markets as outperforming the US. Actually, performance is equivalent, it is just the currency basis that provides the advantage.

What do we gain from this observation?

1) When panic strikes, and there is a flight to the USD, emerging market companies become very cheap

2) If the US, in response to a panic, uses easing methods to address the downturn, this is bullish to US investors interested emerging market stocks simply because of the basis risk (or in this case reward) from monetary easing and a devaluing USD.

I have no positions to recommend at this time. But it is easy to foresee another stage in the crisis due to deflation that is addressed once again with huge floods of dollars. At that point, it will be important to recognize this pattern and take positions in companies like BBD, CETV, TLK, SBS, and GMK to reap benefits from this occasion.

Stimulus Watch: China stimulus effect declining

2009-09-21T20:25:00.001-07:00

Commodities are the key sign for watching the effect of the stimulus program in China. Across the board, signs are starting to show that the largest stimulus program (as a percentage of GDP) is already starting to wane in effect. In the comments, let me know what other factors you are watching to track China's stimulus progress through the system.

(1) Oil consumption

Even though China recently became the #1 consumer of automobiles, oil consumption peaked in July and has been declining. "August seems to have brought a reality check for refiners in China," said Vandana Hari, Asia news director at Platts. "Domestic fuel demand has clearly been lagging their high processing rates, and storage space is finite."

(2) Copper demand

The large state sponsored infrastructure projects drove tremendous demand for copper and semi finished products. There were even reports of pig farmers stockpiling the metal as a speculative investment. But there is cracks in this demand too... "Traders say the market was worried that China, the world'slargest consumer of copper, may have overdone the stock building,which boosted prices in the first half of this year. Chinese copper and semi-fabricated imports fell 20 percent in August from July at just over 325,000 tonnes, and off 30 percent
from a record 476,000 tonnes in June."

(3) Iron Ore

Even iron ore, like copper, linked to China's massive development projects. "Cash prices for iron ore delivered to China from India have fallen 26 percent to $82 a ton since August, according to Metal Bulletin prices for the week ended Sept. 4. Iron ore from Australia has fallen 28 percent since Aug. 13 to $76.1 a ton yesterday, according to the Steel Index. Iron ore inventories at China’s major ports reached 76.5 million tons for the week ended Sept. 4, the highest level this year, according to data provided by Beijing Antaike Information Development Co."

(4) Lending

"The drop in new bank lending -- to an average of 383 billion yuan ($56 billion) in July and August compared with a monthly average of over 1.2 trillion yuan in the first half -- will also pull down transactions in the coming months, said Gao Shanwen, chief economist at Essence Securities."

(5) Constrained Lending -> Real Estate Asset Price Declines by End of Year

Policy tweaks and slower lending will probably be enough for now, analysts say, allowing Beijing to stop short of declaring a full-fledged campaign to stamp out property speculation similar to one in 2007. Ge projected that housing prices would drop toward the end of 2009 or early next year, by about 10 percent, much less than a 20-30 percent fall witnessed last year."

Clearly the world economy would suffer greatly if the program disapated in effect so quickly.

Let me know how you are preparing for the stimulus to wear off and when you expect the timing to occur.

The TARP game is over, next step is an Uber Big "Bad Bank"

2009-09-20T23:08:00.000-07:00

Obama's team came storming into office in the midst of the crisis with all the intent of saving the world financial system. They did it, temporarily at least. As it happened, the crack Obama team handed out cash to failing entities, abandoned accounting scrutiny, and finally provided a little transparency to balance sheets but no accountability for resolution. The markets gained faith in the new system, not because the banks had resolved their problems but because the government was credible and tangible in supporting all major market mechanisms.

This sunlight on the system gave the banks a chance to redeem themselves by opting out of government support by repaying the TARP money. To obtain this freedom, the banks announced their financial health based on increased capital and risk control measures. Was this actually done? No. Now the support programs (agency debt purchases, MBS purchases, T Bond purchases, money market funds(1), home purchase tax credits) are scheduled to lapse. Bloomberg reports "New York Fed President William Dudley, who is vice chairman of the FOMC, has sounded more cautious. "The market expects us to complete these programs,” he said Aug 31. “To contradict that market expectation is a pretty high hurdle.”(2)

What now?

The Obama team remedies addressed the symptoms, but the source was the undercapitalized American consumer and no remedy was found for their plight. As credit cards charge offs, unemployment rates, foreclosure statistics, and many other financial measures all zoom past stress test scenarios, the solvency of the banking system will be in question again by the Spring of 2010. At that point, balance sheets will have to be recapitalized again. Will the banks come back for TARP? No sane bank will risk the public anger of returning to the government as doctor after already claimed to be "cured" and going in for the same penicillin. The credibility of the stress tests will be demolished and the actual health of every bank that took the test will once again be on the table.

What will the government do in that situation? There is no way the Congress will hand out another $750B to the Executive Branch with no strings attached like last time. At least not if they care about holding their jobs come election time. The Executive Branch will have lost their opportunity to single handedly manage the crisis. Instead Congress will take center stage in bringing credibility back to the banking system the only way possible for a government entity. That will require complete nationatization of "bad bank assets" with the taxpayers footing the bill but banks taking a major equity hit in the process.

(1) "Treasury Announces Expiration of Guarantee Program for Money Market Funds" US Treasury Department Press Release, Sept 18, 2009
(2) "Housing Risking Relapse Confronts Bernanke Conundrum"By Kathleen M. Howley, Sept 21, 2009, Bloomberg.com

The author is long SKF at $25.

Stimulus Watch: I hope the Aussies are saving their pennies

2009-09-15T20:49:00.000-07:00

Is Australia about to take shot on the chin? Currently the country is navigating the global downturn with exports of raw commodities to China. Is that about to turn?

Australia, which has benefited greatly from China's increased manufacturing consumption of iron ore. China has gone from consuming less than 20% of Australia's iron ore in 2000 to over 80% in 2008. (1) China has even continued to increase their copper imports during the downturn leading to a scenario where their economy exports less but still increases consumption. For Australia, this situations encourages projections based on artificial demand. For China, this indicates uncorrected inefficiencies in their domestic economies that have been papered over by stimulus plan.

There is evidence that the Chinese binge buying has abated...

"In recent months Chinese demand for iron ore -- the primary material in the manufacture of steel -- has dominated freight market activity while also adding to swings on the main index.Port congestion in China as well as off Australia's coast had previously tied up a large number of Capesize vessels, typically hauling 150,000 tonne cargoes such as iron ore and coal. But queues off China have eased.Brokers said reduced iron ore import activity in China in recent weeks was taking its toll." (2)

Considering the torrid pace of the last six months, this could be a breather or utter exhaustion. We will have to wait and look for more evidence before determining how to address the situation.

(1) "Australia finds fortunes ever more tied to China" Reuters, Aug 19, 2009, by Wayne Cole

(2) "Baltic index drifts lower, cargo enquiry light" Reuters, Sept 16, 2009

Stimulus Watch: China went overboard, do the Math

2009-09-14T16:13:00.000-07:00

Now that the world economic situation has turned up many are looking for a sustainable environment to allocate investment. Yet is it really a meaningful recovery or just a meaningful temporary stimulus?

The total GDP of China $4.3T USD and the amount dispursed through loose credit policies through the first seven months of this year amounted to over $1T USD. This is equivalent to 25% of GDP lent to domestically to increase consumption.

In comparison the US GDP is close to $14T USD and the stimulus program directly related to the federal budget amounted to $1T USD (Stimulus package + Cars for Clunkers + Chrysler Bailout + GM Bailout + TARP + AIG Bailout). This is a total of only 8% of GDP.

IMHO it is obvious that China has created malinvestment and guided resources into frivilous causes in fear. Considering the size of the error, it will only be a matter of time before this causes problems in their financial system.

Now is the time for gold

2009-09-13T15:22:00.000-07:00

This was originally written 9/13/2009

This blogger is now a gold bug. I tried to fight it, but now it makes too much sense. I even think gold is cheap.

Gold has been used as substitute currency at least since rhe Songhai king Mansa Musa flooded Western Civilization with the metal in the 1500s. In the first part of the 20th century, gold was used to back the government currency. The gold standard was abandoned in US but even today central banks and investors use the metal as a hard currency.

It is often stated that gold is an inflation hedge. It is not just sensitive to inflation. The value of gold rose significantly in real terms during The Great Depression, the most severe modern deflationary period. Gold actually rises in value during times of economic or geopolitical stress.(C) So whether it is the realization of trillions of losses by banks or the debasing of the US currency by massive borrowing by the US government, both scenarios contribute to stress and thus justify an increasing price of gold as a de facto currency.

Evidence of the upside of gold can be observed from many different sources.

(1) Miners

The world's largest gold producer, Barrick Gold, abandoned $3B in prices hedges to get long gold, you have to expect there is upside.(B)

(2) Short sellers

Greenlight Capital is long gold and cites due to emerging market central bank purchases. (D)

The author is long gold at $107.50.

(B) "Barrick Eliminates Hedges, Plans Offer", SF Gate, Sept 8, 2009, by Rob Gillies

(C) "Currency Trading and Intermarket Analysis" by Ashraf Laidi

(D) Greenlight Capital 2009 Q4 Newsletter

Green Mountain Coffee Roasters is piping hot!

2009-09-04T16:27:00.000-07:00

The US consumer is currently tightening their belt, losing their jobs, and hunkering down to rebuild their retirement funds. Based on the numbers reported by Green Mountain Coffee Roasters (GMCR), buying a coffee machine seems to be the first step on the road to economic recovery for the American consumer.

As a budding short seller, this stock seemed like a prime candidate to profit from as expectations hit the rocks of reality. At first glance, GMCR holds all the initial signs of a momentum stock out of control. GMCR currently holds a $2.2B market cap and a 47 P/E ratio in a market with declining consumer spending across the board. Yet by the end of the analysis, GMCR looked a momentum stock with a full head of steam with more upside than downside. Here is why....

* GMCR products achieve great customer satisfaction

“During the quarter, we reconfirmed that consumers remained extraordinarily satisfied with the Keurig brewer system. Our quarterly research reconfirmed a top two box satisfaction score that exceeded 92% for all brewer models.”

“Our outlook for fiscal 2010 anticipates a net sales growth rate of 45% to 50%, shipments of system wide K-Cup portion packs to increase in the range of 65% to 70% and fully diluted GAAP EPS to be in the range of $1.70 to $1.80 per share.”(1)

* GMCR has solid organic growth

[Q3 2009]
“It certainly was another outstanding quarter for Green Mountain Coffee Roasters. Net sales totaled $190 million, up 51% over the last year with each business unit contributing strong sales growth. After inter-company elimination, the Keurig business unit net sales were up 97% to $90 million and the Specialty Coffee business unit net sales were up 39% to $100 million. ….
The primary driver of the increase in net sales is the continued growth in K-Cup sales which were up over 79% on a consolidated basis. Sales related to the Tully's brand represented approximately 5.5% of the 61% increase in consolidated net sales and are included in the Specialty Coffee business unit results for the first time.”(1)

* GMCR is rapidly developing new channels for growth and market penetration

“In our third quarter we announced two new licensing initiatives. We licensed Con-Air Corporation to launch a Cuisinart branded Keurig brewed coffee maker during the first half of 2010. We also licensed Jardan to launch a brewer under its Mr. Coffee brand expected during the second half of 2010.

These initiatives are consistent with our fundamental razor blade approach to growing the business which focuses on getting brewers into more households in part by providing consumers with more looks, features, brand choices and price points. Both product lines will be co-branded with Keurig and designed to work with the 200 varieties of gourmet coffee, tea and hot cocoa packaged in Keurig's patented K-Cup portion pack.

With Keurig, Cuisinart, Mr. Coffee all offering Keurig brewed technology, we are seeing to maximize the visibility of Keurig and expand choices for the consumer, thus accelerating the adoption of single cup brewing into homes across North America.”(1)
http://seekingalpha.com/article/159545-lone-pine-challenges-shorts-with-green-mountain-coffee-stake

* GMCR signed deal to sell in Wal-Mart

Wal-Mart is a huge new retail relationship for GMCR to sell the Keurig systems. Although Wal-Mart has a track record of cutting margins on the units it sells, GMCR makes most of their money through the proprietary K-Cup they sell. The Keurig system requires using the K-Cup to function and the owner must keep a supply of cups on hand.

* GMCR has attracted hedge fund interest [Look out for the squeeze, short sellers!]

“In a 13G filed with the SEC, Stephen Mandel's hedge fund Lone Pine Capital has disclosed a brand new position in Green Mountain Coffee Roasters (GMCR). The filing was made due to activity on August 19th, 2009 and Lone Pine now shows an 8.3% ownership stake in the company with 3,603,364 shares.”

Finally, it is very difficult to estimate how much impact all of these new initiatives will have in total. But I am confident that GMCR will have ample opportunity to blow away current sales guidance. That is information that should make any short seller pack up and go home. Or just buy a few shares and go along for the ride.

(1) GMCR, Q3 2009 Results Conf Call Transcript

The author has an order to buy GMCR at $54/share.

FHA is subprime

2009-09-04T09:03:00.001-07:00

When it was discovered that Fannie and Freddie were insolvent due to the poor performance of mortgages, Treasury Secretary Paulson, as a condition of guaranteeing the debt, mandated that Freddie and Fannie shrink their portfolios going forward.

The government need another agency to step into the gap and be the guarantor of mortgages so banks would not stop mortgage lending cold turkey. The agency given that charge was FHA and since then the government has become "the market" in mortgages.

"The FHA now insures $560 billion of mortgages—quadruple the amount in 2006. Among the FHA, Ginnie, Fannie and Freddie, nearly nine of every 10 new mortgages in America now carry a federal taxpayer guarantee."

As a house shopper I have been waiting for the strictest lending environment to achieve the best purchasing deal. Yet in the winter of 2007 my mortgage broker approached me at dinner (at the time he was moonlighting as a waiter) and said "Nothing has changed, FHA is the new subprime".

Since 2007 FHA has gone from single digits market share to providing over 25% of the mortgages in the US market. It was thought that the FHA full doc process would prevent the widespread fraud that underminded the ratings on securitized packages of mortgages. Although fraud has declined, I hear from mortgage brokers is still ways to game the FHA mortgage approval system.

Who will pay for the flaws of FHA? You will.

"Federal law says the FHA must maintain, after expected losses, reserves equal to at least 2% of the loans insured by the agency. The ratio last year was around 3%, down from 6.4% in 2007.
If its reserves fall short, the agency is obliged to notify Congress, which could spark a commotion over the extent to which the government is funding losses in the housing market. Some housing analysts have said losses might lead the FHA to pull back lending, which has helped boost flagging housing demand."(1)

This is a big problem. The agency has been the stop gap in the housing market, but now the stop gap is going insolvent. Officials think it could go insolvent by the end of this year.

...Officials said as recently as May that they didn't expect to fall below the 2% limit, but home-price declines have exceeded those used to model their expected losses. Given the pace of those declines, "there is no way they will make the 2%" if the current study follows last year's methodology, says Mr. Lawler."(1)

Although the problems is obvious, the solution is not. Congressional mid term elections are coming up and the Republicans would so much enjoy yelling "spendthrift" at Democrats for making another federal enterprise insolvent in two years. At the end of the day, another back door bailout including a relaxation of capital standards and additional borrowing capacity will probably occur. But the Republicans and Blue Dog Democrats may be able to extract a higher required down payment requirement for FHA loans going forward, or stricter payment to income ratios for borrowers.

The author purchased SDS at $44.5.

(1) Wall Street Journal, Sept 4, 2009, "Loan Losses Spark Concern Over FHA" by Nick Timiraos

(2) "FHA ready to join Fannie and Freddie"

(3) Wall Street Journal, Aug 11, 2009, "The Next Fannie Mae"

At the top of the hill on the stimulus: What's Next???

2009-09-03T21:13:00.000-07:00

This is the peak of the stimulus...

Whatever money that has been made available has been spent...

* The "quantitative easing" performed with $300B of Fed spending will end in October. Will 10y Treasury Rates (which dictate mortgage rates offered by lenders) stay low???

* Over $800B of the $1.25T of mortgage debt to be bought this year has already been purchased to lubricate the housing market. Has housing bottomed???

* 3/4 of the $232 tax cut of the Obama administration has been doled out to the American consumer. Has retail rebounded???

* 1/2 of the $550B in "shovel ready projects" have been paid out

Banks have made their bed...

* Banks are expected to write off another $1T by the end of 2010

* The accounting rule grace period has ended and banks will need to bring $700B of off balance sheet assets on balance sheet

* The banks have paid back the TARP explaining that they are not in need of assistence. Can they go back to the government for another loan if the writedowns are enforced by conscientious auditors? What do you think the regulators will do this time when they come in for money? I think there will be at least one "accelerated wind down" scenario to play out.

* The banks paid back TARP, not because they want more freedom to lend to business in this difficult economic period, but instead because they wanted to freedom to curtail lending and preserve capital during this tough period.

* A non-TARP company loves to see a TARP trapped bank oblige the government and give out loans to the broader market because it means distressed assets to buy at a discount with less hassle later.

* The foreclosure moratoriums have all expired and all the mortgage modification programs have expended tremendous amounts of effort to offer reprieve to the overextended to minimal effect

* A wall of unprocessed foreclosures are mounting and the forecasted peak of homeowners entering the foreclosure process has not even topped out

Obama is facing a challenge to prove his metal...

* What more can Obama do? Better yet, what more can Obama and Congress push through without a revolt? Obama has already moved the public opinion needle from "Fearless change agent" to "Soft on big business". It would be a popularity killer to let opinion turn even further to point to "In Pocket".

"...mortgage rates are very dependent on the Fed's purchases of $300 billion in Treasury debt that will expire in October and $1.25 trillion in mortgage bond purchases that will expire at year-end. Unless the economy stumbles, we're likely to see higher rates in the fourth quarter."

Government orgs to keep housing afloat are reaching limits

* Fannie and Freddie have a mandate to wind down operations

* FHA has so many deliquent loans that it will not achieve the federally mandated 2% capitalization requirement and thus will require a bailout

In Conclusion...

So what does this mean...

...it is all downhill from here...

The author is long SDS at $44.5.

This really scares me

2009-08-25T15:11:00.000-07:00

Just one year out from a major financial disaster, some of the most leveraged banks that recently lost billions of shareholder value are now looking to expand their trading operations again. What did we learn from the deleveraging debacle? Nothing.

Apparently even more banks than Goldman Sachs and Morgan Stanley want to get into commodities speculation. Soc Gen and Bank of America hardly seem like the type, but the opportunity to squeeze retail investors out of their nickels may be too great. In case, traders know that the place to make big money is where the volatility is. So I guess if you are down tens of billions of dollars you will be tempted to enter a market a lot of zig and zag.

Aug 31 Update: It looks like Citigroup does not want to be left out and is diving in head first too.

Stimulus Watch: Has China closed the spigot already???

2009-08-14T11:25:00.000-07:00

As I have mentioned before, the massive stimulus program in China is driving much of the revival of exports in across the global, particularly in regional partners like Japan and South Korea and commodity producers like Brazil.

But has the Chinese government started to close the spigot of easy money already???

"The benchmark Shanghai Composite Index fell to 3112.72, as data showing a 77% decline in bank lending in July from June raised fears that banks may make fewer loans following record disbursals during the first half. The Shenzhen Composite Index fell 4.4% to 1052.51.

"Even though the Chinese government insists it'll keep a loose monetary policy, the reality may be that some credit tightening measures have already been implemented," said Ben Kwong, chief operating officer at KGI Asia. "The market is worried that a significant slowdown in lending means less liquidity and investors are taking profits."(1)

The evidence of the change might be represented by the recent turn in the Baltic Dry Bulk Index. The index is largely driven by the movement of raw commodities in international trade, and the recent surging demand from China provided a major boost to the index from January's historic lows.

There is still too little data to substantiate a change in the economic climate. But many estimates made by Brazil and even use manufacturers like Alcoa hinge on the sustained growth in China to offset economic stagnation elsewhere. It will be interesting to observe over the next few months if China will be able to maintain it's momentum with or without easy money policies.

(1) "Drop in Bank Lending Spooks Investors; a Fall Back Below 3000?", WSJ, August 14, 2009 by V. Phani Kumar

The whole world is on Viagra

2009-08-02T21:28:00.000-07:00

Last night I heard a story about a friend who looks after his 91 year old grandfather. My friend has a dilemma that even though his grandfather's health is failing because his advanced years, he continues to live the lifestyle of someone younger and more spry. In fact on more than one occasion he has found his dear old grandpa passed out in various areas of the house from overdoses of Viagra.

The global economy is experiencing a similar circumstance.

With US port traffic down...

Retail sales down...

imports and exports are down...

There is little sign of virility to the economic situation. Yet the global markets stay excited over the prospects of a turnaround in the face of this information. Why?

Artificial stimulation from bailouts and stimulus plans, of course.

Only $230B of the $787B US stimulus package has been spent to date. But US is far along ($700B) with the housing market stimulus executed with the 1.25T allocation to purchase agency debt. The US is also stimulating the housing market with $500B in purchases of securitized mortgage debt in the open market at exaggerated prices. Without this support, mortgage rates would rise and provide an additional disincentive for the anemic rate of home sales.

There are auto purchasing incentive programs in the US, South Korea, China, and Brazil. The U.S. , the last to adopt an auto purchase incentive program, "Cars for Clunkers" program has been expended from $1B to $3B in funding. The government rebate will be used in an estimated 500,000 car transactions this year in the US. It has been shown before that such stimulus only pulls forward future purchases. Maybe this time will be different...

In the U.K. the government continues to use quantitative easing to support the yield curve and keep mortgage rates down. The U.K. recently extended their quantitive easing program by authorizing another $50B in funds to attempt artificially depress interest rates.

China also is in the process of executing a $586B spending package to maintain economic growth. But this pales in comparison to the loose monetary policy underwritten by the Chinese government. In the first half of 2009, over a $1T in loans has been made, a 1000% increase over the previous year.

The overall stimulus in China has been massive. “They opted for a very quick fix,” said Stephen Roach, an economist and chairman of Morgan Stanley Asia. “Surging investment, fueled by the most rapid bank lending in history, accounted for nearly 90 percent of China’s G.D.P. growth in the first half of this year. And that is worrisome.”

Overall, with Japan, France, Germany, China and soon the US reporting Q3 growth and no top line growth across the whole bunch, it looks like ailing economy is dependent on special pills to stay in the game. Let's hope we don't over exert ourselves in the process.

Party on! The bill is on China!

2009-07-31T09:36:00.000-07:00

Keep Rockin'!

In the US, Wyeth, JNJ, Time Warner, Conoco Philips, Alcoa, Intel and host of other companies all beat revised earnings with negligible top line growth and extensive spending reductions. So behind the glitter of good earning reports lie a litter of disgarded workers who are victims of CEOs trying to prove they can make their financial targets.

On one hand, employment numbers are being interpreted as showing that unemployment is easing. But it could just as easily be interpreted as not improving because people are falling off the unemployment rolls.

So what is the cause for optimism? The CEO of Alcoa pointed to surprising resilience in the China market driving sales growth in that region. Catepillar also noted an uptick in sales due to large capital expeditures for infrastructure projects in the Middle Kingdom. The world's largest exporter expanding raw material consumption and investment spending in the face of the largest decline in imports across the global economy in decades? Sounds strange.

Based on initiation of the China stimulus package, in the Q1 of 2009 China increased lending 1000%. Within three months, there were more cars sold in China than in the US for the first time ever. Commodity prices took off as manufacturers in China replenished inventories to prepare for the domestic recovery. The optimism is reflected in the Baltic Dry Index chart.

Yet the amount of goods moved within the US declined to 20% YOY levels. It is probable that this indicates a significant decrease in China's exports to the US.

Moreover, the world economy overall is so bad oil demand is very weak and no amount of stimulus has been able to change that.

On the other hand, even domesticly, China's economic strength looks suspect. China claims growth is at nearly 7% annualized. But electrical output, the most reliable measure of industrial capacity utilization, is down 5% annualized and indicates that there is less production occurring.

Better yet, China's new lending spree that is authorized by the central government is executed at the local level and according to reports is carrying up to $4T in debt. I do not dare speculate how that burden come to bear on the markets. But it is bound to have an effect some time.

For now, we can just enjoy the party. In fact the Chinese are opening 4000 retail stock market accounts a day. Over the past month IPOs have been white hot at offering. Sounds like 1999, I like the music, I even might do a jigg or two. But my money is staying on the sideline so this party will not end up left with part of the tab.

Economic recovery around the corner?

2009-07-22T12:52:00.000-07:00

So much talk of a recovery...I decided to check some vital signals to verify the prognosis.

Forward indicators like the Baltic Dry Bulk index definitely show a slight recovery. I was caught short when I was read articles stating that all port traffic into and out of China had virtually stopped and shipping rates to China dropped to zero for the first time. Since then, demand has snapped back and the trend is clearly upward. This is a positive sign regarding international trade, but could just be a bounce due to the artificial support programs being implemented for the credit markets that allowed trade to occur that could not move due lack of supply of Letters of Credit in the market during the 4Q 08 and 1Q 09.

Next I looked at Warren Buffett's favorite indicator, rail car traffic. Across all indicators point to ~20% YOY decrease in traffic with no major upturn in product to be moved in sight. I think we can draw from this consistent 20% margin is that the consumer demand is not returning yet, and that retailers see no need to restock to previous inventory levels. This may also indicate that the upbeat earnings reports were achieved through extended cost reductions rather than top line gains or profit margin increases.

Finally, I looked at Conference Board LEI index to get a broader view of the issue. It seems that there is a significant pick up in economic activity that is not translating to consumer spending. The distorting factor with this index is that two of the leading components are stock market prices and interest rate spreads. Both of these components have been benefiting from significant government intervention in the banking sector and auto sectors. For the sake of the economy let's hope that government facilitation of the credit markets translates into real economic demand to make this uptick sustainable. Normally, those two events happen in the other order.

Overall, there has been a marked change in business environment, even if it is not evidenced in actual economic activity. The alleviation of fear is the first step to moving to a normal economic environment. Yet for Obama and Bernanke, it may serve more to bolster confidence based on perception rather than emphasize the facts and the sober reality.

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

2009-06-25T08:42:00.000-07:00

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.

(1)

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

Commodity prices a "tell" for China's economy

2009-06-24T11:40:00.000-07:00

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

Too early to turn to this TIP

2009-06-18T16:40:00.000-07:00

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 http://www.treasurydirect.gov/ 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.

To anyone who wants to retire soon...

2009-06-08T15:16:00.000-07:00

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)

Arsonists at the restructuring table and GM is burning

2009-05-14T22:29:00.000-07:00

On May 13th Geithner finally put forward a plan to regulate the credit default swap market. Everyone knew it was coming, there was no surprise in the government extending their reach. But what it did not address is the new dynamic created by the CDS industry.

Recently Financial Times has reported that of the 34B USD in GM debt, a large majority of it has been hedged away by the bondholders using CDS and possibly other derivative instruments. Thus, it has been noted, that most bondholders currently feel there is a possibility of higher return collecting on their CDS protection than restructuring and hoping for a turnaround. This is the equivalent of not calling the fire department when your house is on fire because you feel that you can return more on insurance than the value of saving the home. Good math, bad corporate citizenship. There is a lot at stake with many families, corporate partners, and local government entities that rely on this industry to generate commerce. Thus when the government holds debt restructure talks coming later in May to achieve 90% committment from the bondholders, the wrong people will be at the table.

Instead, as a part of the new regulations for CDS, the contracts should also carry the voting privileges of the underlying instrument. Thus if you are a bondholder, and also long CDS to achieve a net short debt position, you should not have the right to vote in any restructuring event regarding the company you will profit from in default. Your debtholder rights should be transferred in percentage allocation to the notional value of your debt position hedged to all of those counterparies that have absorbed the risk of the default of the instrument. This will require a strong regulator body and a more sophisticated clearing system, or just strong legal punitive measures for non-compliance. But providing this transfer of rights is a necessary way to ensure you don't have arsonists buy a seat at the table when you vote whether or not to save a burning house. In this case, the burning house is GM.

OCD Stock Pick #3: TLK

2009-03-31T16:50:00.000-07:00

This is the third in a series of stock picks for the stock pickers suffering from OCD who MUST go long in the world's most dangerous bear market...

As an OCD investor, to protect yourself from your ways, your only chance is purchasing at the correct time. In this time of economic turmoil, for an investor, OCD or otherwise, not to demand a discount due to unforeseen events is reckless.

Thus the author recommends previous pick that can be recycled for the OCD amongst us.

The author previously bought at $20.12 on November 20th, 2008 and recently sold at $26.55. Since that time, there is absolutely no significant news related to the company, positive or negative. The stock has risen and fallen with general market swings.

In the previous analysis the risk factors were the following:

1) Global market conditions
2) Currency risk

Since that time the IDR (Indonesian Rupiah) has actually strengthend 5% versus the USD. The oil prices have stablized, which probably provides a significant amount of support for the IDR.

The author recommends buying TLK again at a value discount of $19/share (9.34B market cap) and 11.1x FY2008 cashflow. (9.34B / .84B = 11.1)

OCD Stock Pick #2: ICE

2009-03-30T16:16:00.001-07:00

This is the second in a series of stock picks for the stock pickers suffering from OCD who MUST go long in the world's most dangerous bear market...

The Intercontinental Exchange is a futures exchange regulated by the New York Federal Reserve that intends to become the premier clearinghouse for credit default swaps. Thus as unregulated insurance contracts decimate the financial landscape, the investor can benefit from the push to bring to transparency to this bidding process. ICE is even owned by a few of the major CDS brokers (i.e. JP Morgan and Goldman Sachs) giving it instant leverage in this new market.

Over the course of the year, there will be steady increase in business as the new regulatory framework is created for this financial instrument. Regardless of the red tape, there are huge market drivers pushing for CDS to be handled in the open market. First of all, no other instrument is available to hedge a fixed income instrument as credit default swaps. Considering the amount of fixed income securities outstanding the need for big banks to mitigate risk, the institution of this marketplace is a win-win for business and government.

With revenue growth near 50% YOY, ICE is benefiting from increased electronic trading. Even at this early stage for the market, ICE produces a free cashflow of $250m annually on 800m in revenue. The company holds net long term debt of only $300m after backing out $12B of cash and $12B of maturing liabilities.

In previous markets, this stock would be evaluated based on it’s growth potential at a high P/E ratio. The OCD investor needs to be defensive in their investment to receive desired feedback loop, thus purchase price needs to be evaluated as a measure of cashflow growth. ICE cashflow growth has been decelerating over the past few years from 60% growth from 2006 to 2007, and 25% from 2007 to 2008. Assuming only a 10% increase in cashflow growth this year, valuing ICE at 11x FY2009 cashflow yields a $3.6B market cap. Based on the market cap today of $5.4B at ($75/share), the OCD investor should place an order for ICE at $50/share. This price is also at technical support point and thus provides a likelihood for being executed and providing immediate positive feedback.

OCD Stock Pick #1: ADP

2009-03-30T14:00:00.000-07:00

This is the first in a series of stock picks for the stock pickers suffering from OCD who MUST go long in the world's most dangerous bear market...

ADP is a payroll processor with long standing relationships and an excellent business track record. With the downgrade of GM, ADP is one of the only four industrial companies retaining AAA credit rating. The company generates $1.2B in annual profit and $1.5B in free cash flow with a $18B market cap ($36/share). Due to the high cashflow, the 3.6% yield is safe assuming no cataclysmic economic events occur.

ADP is a company that can be called “an original outsource outfit”. Companies often hand over their payroll responsibilities to ADP to make sure their employees are paid appropriately and on time. Therefore growth of the payroll business is directly correlated to the amount of people employed across industries. Considering the downside risks to the economy, a healthy margin of safety is necessary to avoid having an autistic tantrum if market turmoil makes this sleepy stock more volatile than what you are looking for.

The author recommends that those suffering from OCD to buy the stock at 12x a deep recession level free cash flow of $1.1B/year, producing a 13.2B market capitalization or $26/share.

Stocks for OCD investors

2009-03-30T13:54:00.000-07:00

Stocks for those with Obsessive-compulsive disorder (OCD).

OCD, according to Wikipedia, is a mental disorder characterized by intrusive thoughts resulting in compulsive behaviors and mental acts that the person feels driven to perform, according to rules that must be applied rigidly, aimed at reducing anxiety by preventing some imagined dreaded event.”

Most people I know who invest in the stock market demonstrate the behaviors of obsessive-compulsive disorder.

The conversation between them and a ‘normal’ person goes something like this…

“Rough Market, eh?”

“Rough market” I reply.

“I bought XYZ at the last dip. I am upset. It went up a little but now it is lower than before I bought it. I am thinking of getting out.”

“Sure, definitely more downside possible.” I say.

“There could be some more downside, what do you think?” clearly nervous about the short term prospects.

“Sure, has been accelerating the unwind of the world’s previously biggest car company, previously biggest bank by assets under management, and biggest private insurer. I think that could cause more downside to the market.”

“What are you looking at buying?” OCD person asks.

Blank stare response.

The financial media, mutual funds, and maybe our mothers have conditioned us as investors to obsessively search for the next buy and hold opportunity. Millions of investors across the globe, like slaves to the financial system, scour the markets for the perfectly controlled positive feedback loop. Their stock purchase may come from a broker report, or a tip, or maybe individual research. They buy 100 shares of stock and if it goes up, then they buy 100 more. Then, if the stock goes up again, they repeat the cycle. If the stock goes down, they panic and exit. No entrance strategy, no exit strategy, and very edgy on the trigger.

Thus it is no wonder why so many people get so angry during bear markets. The behavior of the market is not meeting their expectations for a positive feedback loop, frustrating the desire of the regular fix to satisfy their obsessive compulsive desire for control of their environment.

The author does not recommend going long with a traditional buy and hold at this point. But lots of stock market investors just cannot wrap their mind around shorting or waiting for the demise of the automakers and most of the financials.

So as a community service for those with OCD who have no plans for correcting this portfolio- debilitating disorder, the author has chosen a series of stocks that should best benefit from current market conditions. Thus to address the impaired amongst us, I will recommend a few stocks, if purchased with a measure of discipline, that should provide a controlled positive feedback more often than not over the next year.

Author note: This post is not meant to insult those with Obsessive Compulsive Disorder but intended to insult those without the disorder who still mimic the traits in the stock market.

Author note #2: Stocks chosen for the OCD portfolio will not be included in the authors performance tracking because of the high risk of going long in the current market.

JP Morgan - Counting AIG Bailout Money as a Profit

2009-03-04T17:13:00.000-08:00

If you are worried about where your TARP or any other bailout money is going, this press article on JP Morgan may provide a hint.

The opening of the article leaves out one huge product segment of the Fixed Income Derivatives product group, Credit Default Swaps (CDS). In fact this is a huge oversight, the OCC source shows that banks have a 87T OTC derivative exposure which includes fixed income derivatives and states that of the 16.1T of outstanding credit derivatives 99% are CDS. Why did Bloomberg not come out and be forthright about 20% of the derivatives market?

Moreover, over 40% of reported trading revenues derived from this segment of the derivatives market.

The bailout money for AIG CDS positions no sooner hit AIG's account before it was transferred to AIG's counterparties to settle collateral requirements for it's positions. With AIG posting $60B losses from CDS in the last quarter, there had to be someone on the other side of those trades who would claim a commeasurate gain.

As of Q3 of 2008, according to the Office of the Controller of the Currency (OCC), there are only 5 major CDS brokers amongst the US banks who hold 87% of the outstanding notional credit exposure. JP Morgan is largest one of those five.

Thus when the government provided $60B capital to AIG in order to meet collateral requirements for it’s counterparty positions, one can infer that the ultimate recipient was JP Morgan, and other major CDS dealers. This is the fallacy of the whole market. The government is providing AIG with funds not just to keep AIG afloat, but to support all of AIG’s counterparties from the systemic risk of not getting paid. But in providing this liquidity, the government is allowing JP Morgan to mark profits from bailout money originating at another firm while they hold on to the TARP money they received from the government.

What is to be learned from this? The systemic risk of the “Shadow Banking System” is being balanced by the US taxpayer. But it is not being communicated how many counterparties are also being saved by the single bailout of AIG and other major lenders. What astounds is that the market makers continue to perform solid business in the very instruments that could at any moment cause their demise if the government withdrew it’s support of the losing counterparties. This evidence underscores how dysfunctional the whole banking system is currently and how much more needs to be done to wean the banks with most CDS exposure from government funded settlements.

The author is long puts in JP Morgan.

Lessons from Benjamin Graham, Part #1

2009-02-25T12:57:00.000-08:00

In the classic book, Security Analysis, Benjamin Graham presents an in depth thesis on how the "margin of safety" determines the attractiveness of an investment. Graham wrote the book based on a thorough analysis of one of the most severe investing environments of this country, the Great Depression from 1929 – 1939.

Currently our security market is on a downward trend comparable to that historic time. Looking at the historical data regarding the fall of earnings of the industrial companies during the Great Depression, you can see why there was a 90% drop in market cap from peak to trough.

But the analogy to emphasize is that the market is not near the end of the current cycle. In comparison, over 1929 to 1932, the Dow had equivalent to three consecutive 50% drops in value. The value of the Dow fell from par value of 10, 5, 2.5, 1.2. With this in mind 2009 may not drop by as much points wise, but the percentage loss will be equivalent to last year. In any case, the market is still very much on track to match the largest fall ever recorded.

So what to do?

To learn how to handle a potential future depression, it is wise to learn from the last one. When Benjamin Graham wrote Security Analysis, he did so to provide text to support most secure methods of investing based the test cases of the Great Depression. Benjamin Graham wrote…

The economy today involves faster business cycles due to technology, but still contains industries which hold promise to meet Grahams criteria of a stable enterprise. Using Graham’s profit data over the course of the Great Depression, it is observed that regulated utilities held 66% of their pre-Depression earnings. This is a quite impressive feat compared to 99% reduction of industrial company earnings in aggregate, and 100% loss of earnings for railroad companies on aggregate.

What is wisdom to be passed to the wise retail investor? Whereas the broader industrial sectors suffered seriously from decreased consumer consumption and capital spending associated with major downturns, the earnings of regulated utility industry remained relatively insulated. Although not very attractive for an equity investment where growth of profits is required for returns on a stock, this situation underlines the large "margin of safety" risk-reward propositions for fixed income investors of regulated utilities for the next five to ten years. As profits slide with the general economy, equity holdings for all companies will be comprised. But the debt holder of a regulated utility is not as concerned about a fluctuation in profitability as the ability of the issuer to continue to be current on existing claims. Thus, in these humble times, the prudent will buying securities in preparation for years of lean corporate profits, one place Benjamin Graham has told us this can be found is in debt and preferred shares of regulated utilities. (To be continued in Part #2)

How did we get here? Frontline "Inside the Meltdown"

2009-02-20T17:02:00.001-08:00

This Frontline news program provides a wonderful set of first hand accounts of the credit meltdown.

Confessions of a short seller (and a question "What were you thinking?")

2009-02-20T15:22:00.000-08:00

Originally published as a blog post on Motley Fool CAPS on Oct 21, 2008...

Woo hoo! Mr Paulson, here I am! You banned me for a little while. That hurt. But I weighed my options and decided to stay put. The arrogance of Dick Fuld, the indiscretion of Washington Mutual, and funny people from Iceland nearly made me a gazillionaire. Now I have questions for you and everyone reading this.

Why is it that in winter of 2006 when everyone knew the housing was overleveraged and overpriced that many of you stayed long on financials? But now that the financial stocks are 50% cheaper you are now saying “don’t miss the bottom”. What are you thinking? That is the logic of a lemming. Before you put another dollar in the market, what were you thinking then? What emotion are you listening to now?

Why is it that Bill Nygren made Washington Mutual one of his top five holdings for the next 10 years? Did you “Buy and Hold”? What were you think then? What are you crying about now? http://www.fool.com/news/2004/07/30/5-stocks-for-the-next......

Forget about “in the long run the stock market goes up” stuff because in the long run we are all dead. The fact of the matter is that there was a huge credit bubble supporting growth and it was unsustainable. What is needed is a return to the basic math of investing. Stop thinking about buying low and selling high. Things do not have to go in a specific order. Just think of the more basic concept of receiving more than you invest.

As short seller I long ago realized that markets are like roller coasters driven by fear and greed. They take a slow, deliberate rise toward the peak. But once past the peak, the market drops so fast you will quickly find out what you had for lunch. Moreover, the amount of money made (or lost) in the market is directly propotional to the amount of movement in the stock. The market has never gained 45% in one year, but it definitely has lost it in one year.

The Motley Fool gets you started with Foolish investing based on sound principles. But in IMHO, it is just as intelligent to benefit from the collapse of a house of cards as much as the rise of a dynasty. Is it more dignified to benefit the implosion of Crocs jazzy plastic shoe trend, or the conquest of the Chinese retail market by Wal Mart? Both are successful investing techniques. You can’t have everyone on one side of a trade like you can’t have everyone trying to buy low and sell high.

The best investors I have seen on Motley Fool CAPS or anywhere else focus on a market they know and understand when to buy and sell (and not necessarily in that order). Buffet sold his stake in GEICO once before buying it back later, a synthetic short. Buffett knows insurance, and that is where he plays. So, before you buy another share of Bank of America, please beware I am on the other side of it and realize I will sell you as many as you want because there are so many of you to feed.

Don’t suffer the equities markets, buy XFR

2009-02-17T11:04:00.000-08:00

The equity and debt markets are topsy turvy from the surprises and pressure from the credit crisis. Investors, scared of their own shadow regarding debt, are pricing all debt at a discount to gain safety in their positions. Yet Big Pharma, an industry with incredible cashflow margins on products and strong barriers to entry into their markets, has also seen it's securities priced at a discount. In the panic of the financial system, there are health care companies with products that customers literally cannot live without. Bristol Myers Squibb, the maker of drugs such as PLAVIX, a blockbuster blood clotting therapy, and Abilify, a blockbuster drug for treating the bipolar, is one such company that investors can buy senior debt offered as a preferred shares of a debt trust (NYSE: XFR).

For those not familiar with debt trusts, these shell companies are created for the benefit of the company and the small investor. The company issues standard debt, receiving favorable rates from the debt markets and tax advantages of issuing debt rather than preferred shares, to the trust. The trust, in turn, sells shares like any other stock sold on the NYSE on the open market. This structure allows small investors to invest with the liquidity of the NYSE market and without the large commissions of purchasing from the major brokers over the counter.

This Bristol Myers Squibb debt trust pays the buyer of the trust shares dividends from the notes held in the trust. The total issue is only 25.5m, and thus not attractive to big fish. Yet safety of the issue has to be considered high considering the size of the total debt, $6.1B compared to BMY's current SEPT 30 08 cash position of over $7B in cash on balance sheet and the 43B market cap. Bristol Myers Squibb, although stagnant in revenue growth of the last few years, has maintained consistent profitability, cost reduction, and a strong cashflow position. Many analysts are positive about the BMY pipeline, but that is not the primary concern for an income investor. Since the objective income investing is to not lose money, instead of looking for growth, buying this trust meets some of the highest criteria of safety.

The optimist amongst us may take a look at the common and wonder why take such a conservative approach to very profitable company. Comparing this security to the common shares which as of 2/13 closed at $21.75 and were yielding 5.7%, one might think the opportunity of principal growth is more attractive than the priority given to debt. That may be the case, but in this day of balance sheet surprises, debt holders do not have arbitrary reductions income at the discretion of management. That being said, any jack-in-the-box event should be covered by the cash on hand. Of the debt currently held, the first $2.5B is not due until Oct 2011. Yet there are plenty of areas that have yielded hidden value for BMY. In the 4Q of 2008, BMY generated $582m by selling it's minority stake in ImClone to Eli Lilly when it took over ImClone. In the first IPO of 2009, BMY IPO'd 20% of Mead Johnson, the baby formula subsidiary and the maker of Enfamil, for $680m. The company retained the other 80% of the company and management indicated it would use the cash from the IPO to pay down debt. Moreover, whenever the debt is retired, the shareholders of this debt trust will receive an immediate 11% return on the par value based on the 2/13 closing price.

Bottom line, the debt markets are the safest place to be in this current environment and Big Pharma may be one of the safest industries because in many cases their main payee is government insurance. There is no need to buy a 3.5% Treasury bond for 30 years or suffer principal losses in equities when solid securities like these offer 6.5%+ yield, the highest capital priority, and a shorter time horizon.

The author is long XFR at $22.35 with a 7% current yield.

XFR Description:

SECURITY DESCRIPTION: Lehman ABS Corp., 6.25% Corporate Backed Trust Certificates, Bristol-Myers Squibb Debenture-Backed Series 2002-18, Class A-1, price to the public $25 per certificate. Underlying securities are the 6.875% Debentures due 8/01/2097 issued by Bristol-Myers Squibb Co. (NYSE: BMY). The certificates pay 6.25% ($1.5625) per annum distributions semiannually on 2/1 & 8/1 to holders of record on the day immediately preceding the payment date. Certificates are callable at the option of the call warrant holder on or after 10/31/2007 at $25 per certificate plus accrued and unpaid interest. Certificate ratings at the IPO were AA by S&P and Aa2 by Moody's. Lehman ABS Corp. is an indirect wholly-owned subsidiary of Lehman Brothers Inc. (NYSE: LEH).

Don't fight the Fed, yet

2009-02-16T12:57:00.000-08:00

There has been lots of chatter about the recent drop in the 30 year bond price. The debate is focused on “Is the Fed still in charge of monetary policy?” or “Is there really an deflationary scenario unfolding that justifies this currency debasing through debt?” For investors looking for low risk gains, this great theoretical debate provides ample opportunity to make a profit.

There are lots of solid alarmist reasoning from a theoretical point of view like the overall amount of debt, the increased frequency of Treasury auctions, etc. If we were debating in my college Econ 101 class, the idea of massive stimulous financed by lots of long term debt with the current outstanding account deficit would be considered an instant receipe for disaster in a perfect system. Sure, there is an increasing risk that we will hit a magical limit of borrowing and foreigners will flee and put their money under their mattress. But this is reality and the world does not operate according to models.

First of all, in the world of investment choices for sovereign nations, there are really very limited choices regarding where to put major currency. The Japanese economy is currently declining at a 13% annualize rate and heavily dependent on exports to suffering economies. The European banking system is still unraveling and considered to be insolvent. With this in mind, and a limited amount of canned beans, shotgun ammo, and gold bullion available to buy, the Treasury bond market will still see a thriving business.

The Chicken Littles love to tell stories about how the Chinese, Europeans, and Oil Barons are crazy for buying 30 Year Treasury Bonds at 3.5% and will soon take their money home for domestic investment for higher returns. This logic is flawed for two reasons. 1) A purchase of Treasuries increases in return if a government believes that it’s home currency could possibly devalue versus the USD due to global deflation. In such case, the USD denominated Treasuries provide a highest quality hedge for against any internal stability risk and also against lagging relative performance versus the US economy. 2) The second reason is because of the Federal Reserve's power as a market maker. Besides the Fed Discount rates, the Fed also has the ability to control rates buy choosing where on the yield curve it issues debt, or “paint the tape” as it is called.

From Across the Curve, Feb 4th, 2009 “The Treasury did announce that they will auction $32 billion 3 year notes, $21 billion 10 year notes and $14 billion Long Bonds next week. That package is in line with street estimates.

What was not in line was the profile of the new 7 year note which will be auctioned at the end of this month. Most street analysts had anticipated that there would be a 7 year note and it would be issued quarterly. The Treasury opted for a monthly 7 year note. The private sector Treasury Borrowing Advisory Committee has recommended that the new note should be auctioned for $15 billion at its initial offering at the end of the month.”

So although the amount of debt overall and amount debt sold over the next few years may increase greatly, the notes sold at the shorter maturities will probably be the bulk of the issue, not the 30 year. Thus the Fed will be able to use the proportionately small amount of 30 year Treasuries to request higher bids for the debt.

This is a significant event, and a prudent market move by the Treasury. It is easy to see a sizable profit margin in selling 3-yr, 5-yr, or 7 yr debt when one views the medium term view to present scenarios of zero to even high single digit deflation. For the Chinese, buying up these medium term instruments provides a high degree of safety and a high yield for a negative interest rate environment.

As much as you may not like it, or if it breaks all of the old rules of investing that you have learned, in short term, the Treasury will be able to issue more debt to fund even larger government economic initiatives. Yet we cannot increase or deficits too much or we face a situation where we will debase our currency.

What is an investor to do to profit from this situation?

There are only really two acceptable outcomes on which to base trading positions: 1) The Fed is on the brink and foreigners will flee in the immediate future 2) The Fed still has fighting power, even solid demand, and will have a linearly increasing chance of a day of reckoning in the unforeseeable future (foreseeable meaning a year or less in this chaotic environment).

In the case you are in the #2 camp, then like me, you need to go long TLT. Even with the new stimulus package and the plethora of financial stability programs du jour, the government will only have spent 40% of GDP. This is a comfortable deficit number considering the situation, according to economists like Paul Krugman and Mark Zandi. Thus in the short term the Fed will make purchases and bring the 30 year down to make house prices affordable using 30 year fixed instruments. With all of this uncertainty long term, that is all you need to know. Sure, there will be TARP 2.0, 3.0 and probably 4.0. But this is speculation for the next Federal budget cycle, and can only be addressed through futures or long term options. In the meantime, benefit from the Fed effort to manipulate the long term rates and let the future worry about itself.

Thus the author expects the Fed to bring Treasury 30 year rates down to 2.5% to enable the mortgage market to provide financing at a desired 4.5% 30 year fixed rate.

The author is short TLT $94 JUN 09 puts at $3.3 and long TLT $91 JUN 09 puts at $2.25.

The author is also long TLT $105 SEPT 09 calls at $5.5.

(Each investment will be treated as 50% of the total position)

Deleveraging is still in process

2009-01-01T23:37:00.000-08:00

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

2009-01-01T23:26:00.000-08:00

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

2009-01-01T21:36:00.000-08:00

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

2009-01-01T21:25:00.000-08:00

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.