Today's WSJ featured a column titled "A Fund Behind Astronomical Losses" which is worthy of close study. Magnetar Capital is a $9 billion hedge fund established in 2005 by a 41-year old trader Alec Litowitz who had been a trader for Citadel Investment Group.
Magnetar facilitated the creation of $30 billion of CDOs named after various constellations. These CDOs starred Magnetar as the anchoring investor which would provide the all-important critical highest risk tranche of funding. Knowing this and recent history, one might guess that Magnetar had become a black hole. Not so.
In a version of "head I win, tails you lose," Magnetar lived up to the name "hedge" fund, profiting whether the subprime market held up or collapsed. Magnetar did this by purchasing credit default swaps, which essentially insure against the AAA tranches - possibly in the same CDO as it bought the riskiest tranches. Because investors were so bullish about the highest tranches (and risk in general), the highest tranches were overpriced. The resulting losses in these tranches provided Magnetar more return than total losses in the riskiest tranches.
A resulting question is who sold Magnetar these credit default swaps. Certainly these five year swaps are continuing to be held be Magnetor and "marked to market" for investment results for Magnetar investments. Are the swaps, which are less than liquid, being marked equally on the other side? Me thinks not.
Monday, January 14, 2008
Sunday, January 13, 2008
What Kind Of CRAP Is This?
One of my cochamim (wise ones) in the investment arena is Francis Chou. Recently, he taught a class in Toronto and outlined the principles for investing in CRAP companies. CRAP is an acronym for Cannot Realize A Profit. His investment results have been excellent and I was interested in how they were generated.
The beauty of CRAP companies is that they are so inexpensive. For anyone with a bargain mentality, these companies have an overwhelming allure. However, it doesn't take long to lose money in one of these investments and that is no fun. Chou states that losing money in some of these investments is part of the process. The purchase of CRAP companies involves "a shotgun approach rather than a rifle approach."
Chou screens through thousands of companies, looking for the companies with the highest drop in price. In the course of this process, Chou believes that he can only value about 20% of the companies. These are only valued in a general way. He quotes Buffett as saying that guessing the exact weight is not necessary; just knowing they're fat is enough. The valuation of the other 80% he describes as "inconclusive."
Within these conclusive companies, he "shotguns" for 60% accuracy. But, he does so with at least a certainty of 80%, not a 60% level. Because of the accepted limitations in accuracy, he avoids purchasing more shares in a company when it drops in value. He simply accounts these drops as likely to be in the 40% where he missed it, often takes the loss and moves on.
The beauty of CRAP companies is that they are so inexpensive. For anyone with a bargain mentality, these companies have an overwhelming allure. However, it doesn't take long to lose money in one of these investments and that is no fun. Chou states that losing money in some of these investments is part of the process. The purchase of CRAP companies involves "a shotgun approach rather than a rifle approach."
Chou screens through thousands of companies, looking for the companies with the highest drop in price. In the course of this process, Chou believes that he can only value about 20% of the companies. These are only valued in a general way. He quotes Buffett as saying that guessing the exact weight is not necessary; just knowing they're fat is enough. The valuation of the other 80% he describes as "inconclusive."
Within these conclusive companies, he "shotguns" for 60% accuracy. But, he does so with at least a certainty of 80%, not a 60% level. Because of the accepted limitations in accuracy, he avoids purchasing more shares in a company when it drops in value. He simply accounts these drops as likely to be in the 40% where he missed it, often takes the loss and moves on.
Wednesday, January 9, 2008
Borrowin' Themselves Rich at MBIA
As a former shareholder of MBIA, I remain interested in the company's progress - if that's what you call the price move from $67 per share in October to today's $13 per share. Today, MBIA announced that it would be raising $1 billion in new capital, cutting its annual dividend by about 62%, to 52 cents a share, and doing an insurance deal that will effectively free up additional money for the firm.
I assumed that the $1 billion would be equity capital, much like the recent one by Warburg Pincus and was curious to see the terms. A close friend of mine told me that the capital infusion would be debt. I told him that was impossible, as increased equity capital was needed to maintain MBIA's AAA rating.
Then I read this in the WSJ: "The $1 billion in new capital will be raised by issuing a kind of debt known as surplus notes." I had never heard of surplus notes. Having been trained by my children, I turned to Wikipedia. It defined surplus notes as "a bond issued by an insurance company."
"These securities are subordinated obligations, and fall at the very bottom of the operating insurance company's capital structure. Surplus notes are debt-like in that they pay a coupon and have a finite maturity. However, in many cases, state insurance regulators have allowed insurance companies to classify the capital raised via surplus notes as “surplus” (which is the statutory equivalent of equity), because surplus note holders are last in line to make a claim on the company's assets in a default scenario, much like where equity holders reside in a public company. While surplus note holders have last claim on the assets of the operating insurance company, it is important to realize that this claim is at the operating company level, which is still ahead of holding company obligations."
Essentially, these surplus notes are equity capital with a coupon. However, unlike a preferred stock, the interest payment would be fully taxable to the purchaser as ordinary income and fully deductible to MBIA. The advantages here accrue to MBIA. So what kind of deal would incent an investor to purchase the surplus notes? I can only imagine an extraordinarily high interest rate accompanied by a conversion privilege.
I assumed that the $1 billion would be equity capital, much like the recent one by Warburg Pincus and was curious to see the terms. A close friend of mine told me that the capital infusion would be debt. I told him that was impossible, as increased equity capital was needed to maintain MBIA's AAA rating.
Then I read this in the WSJ: "The $1 billion in new capital will be raised by issuing a kind of debt known as surplus notes." I had never heard of surplus notes. Having been trained by my children, I turned to Wikipedia. It defined surplus notes as "a bond issued by an insurance company."
"These securities are subordinated obligations, and fall at the very bottom of the operating insurance company's capital structure. Surplus notes are debt-like in that they pay a coupon and have a finite maturity. However, in many cases, state insurance regulators have allowed insurance companies to classify the capital raised via surplus notes as “surplus” (which is the statutory equivalent of equity), because surplus note holders are last in line to make a claim on the company's assets in a default scenario, much like where equity holders reside in a public company. While surplus note holders have last claim on the assets of the operating insurance company, it is important to realize that this claim is at the operating company level, which is still ahead of holding company obligations."
Essentially, these surplus notes are equity capital with a coupon. However, unlike a preferred stock, the interest payment would be fully taxable to the purchaser as ordinary income and fully deductible to MBIA. The advantages here accrue to MBIA. So what kind of deal would incent an investor to purchase the surplus notes? I can only imagine an extraordinarily high interest rate accompanied by a conversion privilege.
Tuesday, January 8, 2008
If Recession's Here, What To Do?
Many of the headlines lately concern themselves with the likelihood of a recession. The following graph describes to me a very high likelihood that we are already in the throes of a recession:
But while looking over these articles, I am reminded of Warren Buffett's cautionary words: "We will continue to ignore political and economic forecasts, which are an expensive distraction for many investors and businessmen...We will neither try to predict these nor to profit from them."
So what are we to do? This morning I learned some wisdom from a local businessman (who is a residential realtor, by the way): "no habits are neutral." Combining these two individuals' advice, my "to do" list means: DO NOT waste time reading, discussing or contemplating issues related to political discussions (like Obama, Osama, et al.) and economic discussions (like recession, recovery, et c.) - without, of course, being rude to others. These are not constructive discussions, roughly translating to "ain't no bank deposit here."
But while looking over these articles, I am reminded of Warren Buffett's cautionary words: "We will continue to ignore political and economic forecasts, which are an expensive distraction for many investors and businessmen...We will neither try to predict these nor to profit from them."
So what are we to do? This morning I learned some wisdom from a local businessman (who is a residential realtor, by the way): "no habits are neutral." Combining these two individuals' advice, my "to do" list means: DO NOT waste time reading, discussing or contemplating issues related to political discussions (like Obama, Osama, et al.) and economic discussions (like recession, recovery, et c.) - without, of course, being rude to others. These are not constructive discussions, roughly translating to "ain't no bank deposit here."
Monday, January 7, 2008
American Express Feeling Good?
At the Merrill Lynch conference on November 13, 2007, American Express (AXP) CEO Kenneth Chenault discussed the third quarter results (which included the Visa settlement of $2.25 billion) and an outlook of how poor economic conditions would likely impact AXP's results.
As a shareowner and card user, I am not one to contend with AXP's powerful business positioning. AXP is global, vertically integrated and has a "spend-centric" model with a rewards program that is difficult to match. AXP reports that now over 90% of cardholders are in a rewards program. This is in itself a powerful incentive for cardholders to stay current on payments, as these rewards are forfeited if payments do not meet certain standards.
All that said, I was still disturbed by the following graph:
This graph depicts the Billed Business as a function of a change in Cards In Force and change in Basic Cardmember Spending. The increase of 16% is an excellent rate of growth and compares favorably to other credit card companies. My concern is the higher growth rate of loans. It seems unlikely that higher income individuals would be accumulating debt on credit cards simply out of convenience; credit card interest rates are not low.
Later in the presentation, CEO Chenault focused more specifically on these rapid rates of debt growth in comparison to competitors, reviewing a slide titled "U.S. Managed Loan Growth vs. Competitors: Q3’07 vs. Q3’06." His comment, comparing AXP's 24% rate to the low single digits of others, was "Now, I know that when I look at this slide, I feel good about it." To me, it seems like the wrong time to increase debt levels. If the default rates hit 1991 levels of nearly 10%, AXP would not be crippled, but it would be "easy come, easy go" on those Visa monies.
As a shareowner and card user, I am not one to contend with AXP's powerful business positioning. AXP is global, vertically integrated and has a "spend-centric" model with a rewards program that is difficult to match. AXP reports that now over 90% of cardholders are in a rewards program. This is in itself a powerful incentive for cardholders to stay current on payments, as these rewards are forfeited if payments do not meet certain standards.
All that said, I was still disturbed by the following graph:
This graph depicts the Billed Business as a function of a change in Cards In Force and change in Basic Cardmember Spending. The increase of 16% is an excellent rate of growth and compares favorably to other credit card companies. My concern is the higher growth rate of loans. It seems unlikely that higher income individuals would be accumulating debt on credit cards simply out of convenience; credit card interest rates are not low.
Later in the presentation, CEO Chenault focused more specifically on these rapid rates of debt growth in comparison to competitors, reviewing a slide titled "U.S. Managed Loan Growth vs. Competitors: Q3’07 vs. Q3’06." His comment, comparing AXP's 24% rate to the low single digits of others, was "Now, I know that when I look at this slide, I feel good about it." To me, it seems like the wrong time to increase debt levels. If the default rates hit 1991 levels of nearly 10%, AXP would not be crippled, but it would be "easy come, easy go" on those Visa monies.
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