Wealth International, Limited

Finance Digest for Week of August 20, 2007

Note:  This week’s Offshore News Digest may be found here.


“William Poole, president of the St. Louis Federal Reserve Bank, said the subprime mortgage rout doesn’t threaten U.S. economic growth, and only a ‘calamity’ would justify an interest-rate cut now,” reported Bloomberg on August 15. “‘It’s premature to say this upset in the market is changing the course of the economy in any fundamental way,’ Poole, 70, said in the interview. ‘If the Federal Reserve were to act when it turns out there is no impact, then clearly the market would say these guys really don’t have the intelligence they need to have a policy actually based on solid evidence.’”

“The Federal Reserve took emergency steps to limit the damage to the U.S. economy from the crisis in global credit markets on Friday by cutting the discount rate at which it makes loans to banks,” reported the Financial Times on Friday, August 17. “The central bank cut the rate by half a percentage point to 5.75%, while keeping the main federal funds rate on hold at 5.25%. The surprise move, which was agreed during an emergency conference call on Thursday night, makes it more likely the Fed will cut its main rate next month and may help ease liquidity in financial markets and limit the blow to financial institutions from the deterioration in assets exposed to the meltdown in the U.S. subprime mortgage sector.”

I was as mystified as anyone with Dr. Poole’s Wednesday evening comments. U.S. and global Credit systems were succumbing to extraordinary stress, with overt negative ramifications for economic activity – especially for the U.S. Bubble Economy. Poole, “who confers regularly with regional business contacts,” must not have many friends on Wall Street. The Board of Governors in Washington, the Federal Reserve Bank of New York, the Treasury and Administration do.

Friday’s 50 basis point reduction in the discount rate vaunted Dr. Bernanke, as a CNBC commentator put it, “to rock star status.” Others referred ecstatically to “the new maestro.” Whether it was merely coincidence that the surprise cut came one hour before trading opened for a key option-expiration session in U.S. equity markets, we can only speculate. But the relieved bulls took the move as a signal that the Bernanke Fed would maintain a “sophisticated” approach to market support operations. For an increasingly desperate Wall Street, it was pure genius.

It is Wall Street’s hope that Fed rate cuts will, once again, work their magic to restore confidence and incite a renewed appetite for risk. I have little doubt that Fed comments and cuts will have dramatic and immediate effects on a terribly distorted stock market, along with highly unstable financial markets generally. Yet this week’s wild gyrations will do little to remedy the faltering “quant” funds. And this week’s currency and emerging market tumult created only further stress in the leveraged speculating community and derivatives marketplace.

Bear market rallies are notoriously the most ferocious. And with the massive shorting that features prominently in today’s marketplace – most related to the problematic proliferation of various hedging programs and leveraged “market neutral” strategies – the Fed maintains extraordinary power to incite stock market panic buying ... on demand.

The more paramount issue is whether the Fed and global central bankers have the capacity to maintain the necessary credit creation to sustain inflated asset markets and bubble economies over the intermediate term. More specifically and immediately, will Fed rate cuts halt a rapidly unfolding mortgage credit collapse? I actually believe the acute crisis unfolding throughout the commercial paper market can likely be ameliorated through aggressive lending at the Fed’s discount window. But the tattered MBS marketplace is a whole different story.

With a liquidity crisis forcing even national lending powerhouse Countrywide to dramatically tighten lending standards, the dearth of credit availability for subprime, Alt-A, and jumbo mortgage finance – virtually everything outside of GSE-related “conventional” mortgages – has reached crisis proportions. Today, holders of MBS face a confluence of extraordinary uncertainty regarding MBS illiquidity, the further direction of interest rates, general economic prospects, and prospective credit losses – along with systemic liquidity uncertainties. There will be evolving fears of a California bust and the viability of the mortgage insurance industry. It will not be long before the marketplace recognizes the devastating ramifications of the jumbo mortgage freeze – especially for home prices throughout California and elsewhere across the country.

Late-cycle credit bubble excesses were having a major, yet unappreciated, stimulating impact on upper-end incomes. From California real estate to Wall Street securities markets, unprecedented credit-induced asset inflation has been feeding both directly and indirectly into the paychecks of a wide-ranging number of industries and “service” sectors – from biotech, to alternative energy, to Hollywood, to professional sports and the media/advertising, and to finance. With the bursting of the credit bubble and the accompanied dramatic downturn in credit availability and marketplace liquidity, expect a snowball-like surge in the number of layoffs of highly-compensated employees and spending cutbacks (marketing and capital investment).

It is also my view that the bubble-related boom at the “upper end” has played an instrumental role in the U.S. economy’s vaunted “resiliency”. This is actually a typical bubble economy attribute, one that creates unrecognized susceptibility to what eventually becomes an abrupt and radical change in monetary conditions (the bursting of the credit bubble). Mr. Poole’s contacts in business may report that everything appears just fine today, but apparently little do they appreciate that Financial Sphere tumult is in the process of pulling the rug out from beneath the Economic Sphere.

The fundamental problem with Wall Street finance is that the proliferation of speculating, leveraging and hedging strategies ensures an eventual liquidity crisis. As well as derivatives function for individual firms seeking to shift or hedge risk, they are a smoldering disaster when an entire marketplace perceives it can lay off market risk. There will simply be no one take the other side of the trade.

Similar dynamics are in play for credit “insurance”. Credit derivatives and “arbitrage” appear to work too well during the boom, ensuring Credit excesses and wholesale risk distortions that expand over the life of the boom. However, this “market” will inevitably prove unviable during the downside of the credit cycle. Again, there will be unmanageable losses – in this case mushrooming credit losses – and few with the wherewithal to make good on their obligations.

Contemporary Wall Street finance is terribly flawed because of its ability to avoid adjustments and corrections – for its capacity, dogmatism, and its determination to finance history’s most spectacular credit and economic bubbles. The Fed may succeed in slowing at least temporarily the unwind process. I do not, however, believe central bankers can resuscitate the bursting U.S. credit bubble. Confidence has been broken and some of the incredible nonsense of it all has been revealed. This, unlike 1998, is not simply a case of reversing the deleveraging process and inciting animal spirits. It is also not 2000-2002, when the credit system maintained a strong expansionary bias that would reflate the tech sector and the mildly recessionary U.S. economy.

Reiterating previously expounded views, the dilemma today is that it requires enormous credit growth and risk intermediation to sustain what has become a global proliferation of myriad bubbles. The amount of required ongoing credit creation is unprecedented, at the same time that bursting speculative bubbles spur unparalleled deleveraging (forced selling of previously leveraged securities holdings). GSE balance sheets are not available to absorb any deleveraging, placing the entire role on global central bankers. Central banks have great capacity to create liquidity. But their ability to manage the unfolding breakdown in private-sector risk intermediation is much more ambiguous.

Link here (scroll down).
Even Fed may not save our bacon this time – link.
Bernanke using “all tools” to calm markets, Senator Dodd says – link.
Wanted: Central bank with new answer to old problem – link.


Credit markets have changed since the middle of July. The great 6 year over-extension of global credit, complete with declining risk premia, generous terms and low rates, is over. We have begun a long journey back toward normalcy. Readjustment will be painful and take months. So many shares, bonds, vehicles and funds are bloated with leverage that fall-out will be significant. The harder central banks, politicians and pundits fight, the longer and more volatile the adjustment. Continued large central bank cash infusions and rate cuts are in the offing. Hundreds of billions have already been infused. Policy choices will attempt – with some success – to determine winners and losers according to the interests, whims and errors of those intervening.

The regulated core of the present international financial structure has shrunk radically as a percentage of financial activity. Thus, the sheer size of the lightly regulated, nimble and elastic market periphery is too large to quickly and easily offset. This bodes poorly for the ultimate effect of intervention. Already we see the Fed and ECB injecting liquidity to core institutions while peripheral and specialty firms fail. We are over $400 billion into central bank cash injections. Investment funds, mortgage lenders and other key components of the non-core financial structure continue to struggle, or worse. Commercial paper liquidity, inter-bank lending, and broad accommodation are painfully inadequate.

Discussing subprime as the cause of asset repricing has become ubiquitous. I would liken this line of explanation to the way that American urban violence is often discussed as “gang related” or “drug related”. In short, it is a lazy catchall employed to avoid scratching below the surface. Subprime mortgages are in trouble. About 15% are in various stages of the default pipeline with 5% in final stage default. This is truly alarming and merits some serious mortgage-backed securities (MBS) repricing. $2 trillion in mortgages without any government guarantee face valuation, liquidity and repayment risks. This is only one strong gust in the storm roiling global asset markets. Housing distress is now and will continue to drag down the U.S. economy. We are increasingly confident that the drag from housing will pull the U.S. into recession by late 2007 or early 2008.

The global bubble has many other sub-component bubblettes. The internationalization, integration and expansion of finance extended and distributed the effects of overly cheap and easy credit. Innovation of new products, thin opaque markets in credit vehicles and voracious appetite for leveraged yield have transformed balance sheets and portfolios. This mountain of gas-soaked rags was ignited by the credit concerns in subprime.

Cheap and easy debt was taken on to buy houses, currencies, bonds, equities, mortgages, leveraged loans, credit default swaps, real goods and services. Credit burdens were taken lightly, rolled over, bundled and sold. As long as lenders, buyers, ratings agencies and faith held, bubbles formed and swelled. The size, volatility and interconnectedness of international asset inflation was unprecedented. The downturn has been similarly correlated. Subprime was the match, but the fire is never really caused simply or exclusively by the match that lights it.

Global asset markets are now being redefined by risk aversion, illiquidity and credit backwash. Individuals and institutions that rely on (1) roll over financing, (2) liquid (always open) credit markets, or (3) investor faith are in trouble. Subprime borrowers are less unique than ahead of the curve. As house prices fall further and adjustable rates rise, others will join them. This matters suddenly because subprime problems are now driving market psychology. The present turmoil is just as psychology-driven as the hyperextension of gains we saw in April-July 2007. Subprime went into serious difficulty in April, but the markets soared in response. What is different today is that fear has spread to the entire “originate to distribute” financial universe.

U.S. Treasury, Federal Reserve and expert testimony promised this would not happen. It did. Ratings agencies and researchers recommended and applauded the safety and wisdom of the new structured debt products. They got it wrong. Questions started getting asked about the true value and risk of these innovative, engineered products in mid-July. Many still await answer. Investors no longer wait patiently and liquidity has dried up.

Each round of risky “originate to distribute” lending was used to fund the next round. Thus, the risks multiplied systemically. So much air was pumped into these instruments that ever more daring capital structures, pricing demands and raw debt material were sought. What many folks forgot was that the quality of the underlying assets should never be lost sight of. Suddenly everyone is realizing this. Thus, a scramble to reduce leverage and raise cash is underway. Hedge funds heavily into CDOs, CLOs and equity tranche mortgage-backed debt are going bust and selling assets. Insurance companies, global banks, and pension funds are combing complex books. This creates downward pressure on assets and spreads distress and loss. Raising cash means selling. Hiding loss and surviving means selling into strength to raise maximum cash and minimum suspicion.

Finance companies, banks, and investment managers relied on liquid markets. Valuations have been generous and have been driven by models employed by the firms creating the vehicles. Ratings agencies certified new products based on historically accurate assumptions about the probability of various events. They failed to adjust their models for the brave new world of structured products that they were helping to create. Rapid declines in high profile quantitative hedge funds now offer further evidence of modeling problems. Investors and managers are trying to determine the true value of their assets and the size of their losses. Many subprime mortgage securities retained investment grade ratings weeks into punishing price declines. In the midst of this stress test, faith in the models, ratings agencies and regulators is at low ebb.

Leverage has been a cheap, easy, always-available yield booster – until recently. Now debt vehicle creation has stalled. Originators are stuck with unsold inventory. Liquidity and demand have dried up. Market prices for credit vehicles are much, much lower than the models predicted. Demand is absent and discounts demanded are huge. Sudden interest in the underlying asset quality is raising dangerous and unnerving questions.

This raises the specter of further declines as assets over-correct looking for accurate valuation. Until recently, regulators spun increasingly absurd reassuring yarns. Now, late in the game, they will have to spend more money and rebuild trust. So far they are busy injecting liquidity in the wrong areas and offering the absurd assurance that losses are contained.

Link here.
Banks ready for “the old way” of business – link.


Capital One’s shuttered GreenPoint Mortgage is the latest mortgage banking implosion to bump Wall Street’s panic meter up a notch, and industry insiders say it is just another indicator that retail banks will be stung by the credit mess they helped create. “Banks are not going to want to be in the mortgage business after all this is over,” says Richard Wilkes, a mortgage industry veteran who ran First Nationwide Mortgage before it became a part of Citigroup. “It happened to the insurance companies in the 1980s when players like Travelers and Prudential owned mortgage banking operations. They just couldn’t stand the cyclicality and the banks won’t be able to either.”

But big names in retail banking like Capital One have become deeply entwined in the mortgage lending industry, particularly since the beginning of the decade. Loan originators made boatloads of cash selling mortgages to investment banks that turned them into the asset-backed bonds. The game ended when the mortgage-backed bonds turned out to be toxic waste for investors, and high-profile write-downs on their value sparked the credit crunch that is strangling the markets. However, it will be so easy for banks to get out of mortgage lending altogether. Capital One shuttered GreenPoint, but it will still retain a $12.5 billion mortgage portfolio and make new loans through its Home Loans unit and its bank branches.

“The banks dominate the mortgage banking industry now. Other than Countrywide, the large banks are really the main originators,” says Tom LaMalfa, managing director of mortgage research company Wholesale Access. “Mortgage lending is a trillion dollar market, and they can’t leave people with nowhere to turn. [We have lived through] the S&L crisis of the 1990s, and I think regulators would preclude banks from exiting this business and leaving us in a lurch.”

It is difficult to imagine who could step in and fill the gap should consumer banks like Capital One or Wells Fargo exit mortgage lending operations altogether, particularly given how badly the business has suffered. Nearly 120 mortgage lenders in the past nine months have closed their doors, declared bankruptcy or been sold off to the highest bidder. Not only have companies closed, thousands of layoffs now dot the country where booming economies once stood. “A severe economic slowdown is unavoidable given the seizure we’ve had in the financial markets,” says LaMalfa. “As providers become fewer, it will increase the cost of mortgage financing until you get to the point where no one can get a loan.”

What does it all mean for the retail banks? Losses, earnings hits, and, inevitably, falling stock prices, whether or not their mortgage units dealt in subprime loans. Capital One downgraded its 2007 earnings estimate by about 30% and said it could not predict future performance despite the fact that its other business lines are healthy. Be on the lookout for similar problems at banks like Wachovia, Bank of America, and Wells Fargo, which all have mortgage banking and servicing units. “We’re right on the front end of problems for the mortgage banking business,” says LaMalfa.

Link here.
Housing woes hit high end – link.
Mortgages lead biggest rise in late loans since 1990 – link.
Moratorium on foreclosures urged in California – link.
Fitch to review $92.1 billion of subprime securities – link.


An analysis of the largest 20 banks and thrifts shows that four institutions are under-reserved for possible credit losses, a red flag as the economy slows and mortgage defaults rise. Perhaps more troubling, the numbers show that one of those institutions – Washington Mutual – could face serious liquidity problems as worries about the housing and mortgage markets multiply. Meanwhile, another big lender, National City, could see its earnings and dividend come under pressure as a result of its low reserve levels.

The findings come as investors confront a rising tide of bad news in the U.S. credit markets. Foreclosures nearly doubled last month from a year ago. Shares in bank and brokerage stocks have dropped sharply this summer. With the financial sector under increasing stress, we checked two key ratios to measure the strength of big banks’ balance sheets: loan-loss reserves as a percentage of nonperforming loans, and nonperforming assets as a proportion of core capital and reserves.

Banks and thrifts walk a fine line in setting their quarterly loan-loss provisions, which add to their reserves against future losses. If they reserve too little, they can be seen as taking on more risk in the event of a decline in credit quality and padding their earnings for the current quarter (since additions to the loan-loss reserves lowers net income). If they reserve too much, investors, analysts and regulators may see the institution as attempting to manage earnings by being able to under-reserve in the future when earnings would otherwise weaken.

A good benchmark for loan-loss reserve coverage is 100% of nonperforming loans, which are loans past due 90 days or more. If a bank is forced to charge off loans totaling more than its loan-loss reserves, the losses eat into capital. That can hurt earnings if loan quality continues to deteriorate. Another thing to consider is headline risk. As we have seen with Countrywide, any bad news in this environment can cause depositors to flee – every bank’s worst nightmare. Looking at the largest 20 banks and thrifts, it is clear that four are under-reserved and two have an alarming level of capital exposure to nonperforming loans. Here is a look at the four cases ...

Link here.


Day traders in the spring of 2000, shoeshine boys in 1929, the “meaner rabble” in 1720s London ... Glancing at the history of speculative bubbles, as we do all too often here, we find the ordinary sort, in fact, acts as the very pin itself.

The one thing needful at the top of each bubble, the rabble also takes on the role of greatest sucker, too. Piling in as the smart money runs for the exits, the common or garden investor pays top price. He or she is then left holding the “asset” as its price collapses ... and by that time, the Lear jets have long since cleared the tarmac, taking the money with them.

Think of it as the classic “life cycle” pitch from your financial adviser, only with a sidesplitting twist. There, you will find a retirement wannabe moving from “accumulation” to “distribution” and then “legacy”. In a market-wide bubble, by contrast, the smart money first accumulates an asset, before distributing it to the dumb money, which is then left holding a legacy of wipeout losses and debt. Ha! It’s a laugh a minute when the poor schmucks find the “wealth” they have gathered is evaporating in the sell-off.

But something is amiss with the pattern of the latest financial bubble to burst – the bubble inflated by cheap home loans worldwide. Yes, “Every fool aspired to be a knave,” as a broadside noted of the South Sea Bubble nearly 300 years earlier. No-doc and low-doc loans are not known as “liar’s loans” for nothing.

But rather than the fools merely failing to turn knave now that they are losing their homes, they have also succeeded in pushing the foolishness far higher up the food chain. The greatest excesses have come at the top, up in the marble-topped kitchen of haute finance – where the mortgage-backed securities, credit default swaps, and collateralized debt obligations still cannot be served, mercifully, to ordinary investors calling their broker directly. Driven by the “liar’s loans” of 2003-2006, in fact, this last gasp of air into the U.S. housing boom saw the mortgage lenders and their creditors – the investment banks – playing the fools every chance they got.

Mortgage lenders happily played the fool, apparently safe in the knowledge that the magic of securitization – of packaging home loan assets for sale to other financial institutions – would get them “off risk” quickly. Why worry about risk when appraising a new loan? The chance of default by the wannabe homeowner was set to become somebody else’s concern. Investment banks also simply passed on the risk ... letting it trickle through their fingers in return for a fat fee. Bundling higher-risk securities into a CDO with enough boxes ticked to qualify for a AAA rating, managers could earn up to 0.75% of the sum total. One asset manager says he would expect a payout of $2.5 million each and every year until maturity on a $500 million CDO.

With the moneymen playing the fools so gladly, therefore, it is no surprise to find mortgage underwriting changed beyond recognition between 1998 and 2006. The U.S. mortgage market switched from cautious fixed-rate borrowing to head-in-the-sand ARMs, while the underlying debt was left untouched or actually grew larger, as borrowers struggled to meet just the interest alone after fudging the numbers to bag a loan they could never repay. Robert Rodriguez of First Pacific Advisors noted, “the origination volumes for the last two years, when the most egregious deterioration in underwriting standards occurred, total more than the previous seven years of originations combined.”

In short – and just as in every bubble before it – the value of cash taken out by the smart money at the top of the U.S. home loans scandal was greater than the entire accumulation preceding it. Who this smart money was, however, remains a real mystery. For the dumb money pumped in at the top actually came from hedge funds and Wall Street insiders, rather than flowing to them! This time around, it was the smartest guys in the room who played sucker.

A victory for us poor fools at the bottom, perhaps? Trouble is for the “meaner rabble”, of course, the knaves and the fools at Bear Stearns and everywhere else were using our retirement savings to inflate that last gasp. Put mortgage-backed tomfoolery aside, in fact, and you will find the same problem – professional investors neglecting the concept of risk in search of easy returns – right across the developed world’s pension portfolio right now.

“24% of all the hyperleveraged assets managed by large hedge funds ($1 billion or more) internationally belong to pension funds and endowments,” says a report from Greenwich Associates, as quoted by Paul Gallagher in the Executive Intelligence Review. Pension funds have also stumped up one-fifth of the money held in “hedge funds of funds”, the aggregating superfunds run by many large banks. In the first half of 2007, around 40% of current flows into the hedge fund industry have come from pension funds. And “As pension fund money is coming in,” says Gallagher, “it has allowing ‘smart’ money to get out.”

Or rather, the flood of pension fund money was allowing the smarties to get out before the start of August. Now even the dimmest pension fund trustee ... sitting on even the farthest flung beach for his vacation ... will know just how foolish buying mortgage-backed bonds and derivatives would make him today. How the so-called smart money now plans to exit the high-leverage debt markets is anyone’s guess. “The overall flow of capital into hedge funds has dropped dramatically ...,” Gallagher goes on. “Numerous reports ... have shown ‘high net worth individuals’ reducing their net hedge fund investments by half between 2006-2007 – investing instead into real property and stocks.”

Instead of high net worth billionaires, it is now Joe Public left holding this junk, thanks, of course, to his well-paid retirement fund managers. As late as May, Jean Fleischhacker – a senior managing director at Bear Stearns – was telling fund managers gathered in a Vegas ballroom that they could generate 20% annual returns from unrated mortgage-backed credit derivatives. Citigroup recently sold $140 million in just this kind of unrated junk to the California Public Employees’ Retirement System. Members of the CalPERS scheme have just got to wonder, along with the rest of us: How much is that $140 million worth today?

The “meaner rabble” really did climb on board this mega-geared bubble in liars’ loans. It is just that in this money bubble, most people had no idea they were even involved – let alone put at risk. Giving control of your money to a financial “expert” might indeed prove the most foolish decision of all.

Link here.
Bonuses on Wall Street threatened by credit crunch – link.


Switzerland’s top banker has warned of massive losses from the unfolding credit crisis, describing the collapse in U.S. lending standards as “unbelievable”. Jean-Pierre Roth, president of the Swiss National Bank, said market turmoil was far from over as tremors from the subprime debacle continued to rock the world.

“We are certainly not at the end of the story. There are question marks surrounding the development of the American economy,” he said. “Something unbelievable happened. People who had neither income nor capital got credit with very attractive conditions. Now reality is striking back.”

In Germany, the state bank SachsenLB admitted that it had received a €17.3 billion bail-out after its investment arm racked up huge losses on U.S. subprime debt. It had previously denied holding direct exposure to subprime. The revelation came as traders braced themselves for another turbulent week, with mounting expectations that central banks may soon cut rates to prevent market mayhem leading to an economic downturn.

While the surprise 0.5% cut in the U.S. discount rate to 5.75% last Friday helped settle markets and launch a relief rally on Wall Street and European bourses, investors remain wary until it becomes clearer who is holding the main losses on US mortgage debt. Stockmarket historian David Schwartz warned investors not be fooled by signs of recovery. “The truth is no one knows how serious the financial problem in the U.S. is, nor how it will unfold. We do know central banks are scared out of their minds,” he said.

Link here.


The Garden of Eden began to look like a perfect storm until the Fed acted last Friday. We experienced a host of “Black Swans” that spooked the equity markets. We are now experiencing a temporary reprieve that will enable the deleveraging of credit to continue. Christopher Wood, emerging markets analyst at CLSA (an affiliate of Crédit Lyonnais), predicted that “the world is nowhere yet near the peak of the fear that will be generated by the unwinding of the credit bubble.”

Mark well the shocking events that led to a panic in credit markets that triggered a panic in the stock market. Bear Stearns hedge funds froze up. Goldman Sachs had to inject $2 billion of its own money into its hedge fund to maintain solvency. BNP Paribas, the sixth-largest bank in the world, refused to honor redemption obligations because it could not properly value its holdings. And so on. In just several trading sessions, shares of the Powers That Be of Higher Finance – Morgan Stanley, JPMorgan Chase, Citigroup, Goldman Sachs, Merrill Lynch, and Lehman Brothers – lost over 20% of their value in the stock market. Until Friday’s partial bailout, that is a bear market in financial stocks by any definition. But beware: The repricing of risk is not finished.

A hodgepodge of foreign investors – banks in Asia and Europe – own various species of subprime debt, and as the rating agencies downgrade this paper, they will have to mark it to market. J. Kyle Bass, managing partner of Hayman Capital in Dallas, predicted the highly leveraged mezzanine paper of the CDO (collateralized debt obligations) structures will fetch bids of around 10 cents on the dollar, creating what he calls an “ensuing horror show.” This “horror show” will take time to work its way through the financial system. Expect to see huge losses taken by banks and other investors around the globe that will underscore the excesses of the past few years of reaching for yield without a clear understanding of what they were buying.

Then there is the troubling symbiosis of hedge funds and investment banks. The banks have lent billions to hedge funds that hold illiquid and highly leveraged assets and need to raise money to meet the demands of banks for more collateral. Second, the banks are still warehousing loans to private equity houses for multibillion-dollar leveraged buyout deals that are stymied for the moment. As Wood put it last week in Greed and Fear, his investment letter, “It is crucial that market discipline is reasserted in the profligate behavior that had become commonplace in the credit world.”

There is blame all around for this “profligate behavior”. First, there is the mortgage banks that lent 100% of the purchase price of a home without demanding income and net worth statements from the buyer. Then there are the naive buyers who believed they would get an easy ride on easy credit conditions. Thirdly, there are the investment banks and commercial banks that gathered the lousy mortgages together and sold packages of them indiscriminately to investors. Finally, there are the rating agencies that were paid scads of money to give credit ratings without truly understanding the paper they were valuing.

Now, for some predictions by Croesus: The Fed will continue to ease credit conditions due to the disappearance of liquidity. The Eurodollar futures market is discounting a full percentage point cut in the federal funds rate from 5.25% to 4.25% by March 2008. Whether that will save the U.S. economy from recession is anyone’s guess. As John Plender, the thoughtful Financial Times columnist, put it over the weekend, “If an economy is robust but unsoundly financed, it will not stay robust for long.” Well, the robust days are over for the time being.

The rating agencies and the world of structured finance will get a black eye and require investigation by Congress. A horde of investors will pull their money from a horde of hedge funds, and some of the worst hit will close their doors. A portion of the private equity deals will be delayed, at minimum, and some will never be done.

The markets will continue to be volatile, especially the stock market in the U.S., where the requirement for an uptick on a stock before it can be shorted has been removed by the deregulators, who have enabled sharp, violent downdrafts in the market by hedge funds and other professional bears. A terrible mistake.

In the credit markets, credit derivative swap indexes will continue to offer brilliant ways to price murky markets, to hedge risk and disperse around the globe. These indexes will give derivatives a good name as they serve as benchmarks for pricing debt markets, in the same manner as the S&P 500 is an index for pricing the stock market.

Watch the debt markets for signs of what to expect in the stock market. The debt markets are twice as large as global equity markets – over $100 trillion. They are an early warning sign of troubles ahead. If deleveraging in the credit markets has a long way to go – and I believe it does – then expect more downdrafts in the equity markets. The Bernanke reprieve may be a way to lighten up exposure if the updraft continues. This Monday the so-called TED spread, between T-bills and the London Interbank Offered Rate, soared to 300 basis points, up from its usual 20 basis points. This is an indication that the market is still worried about the financial condition of the world’s largest banks (see chart).

Link here.


The current weakness in domestic markets has recently been magnified overseas as panic spread to foreign investors with exposure to U.S. asset-backed debt. Some commentators point to this reaction in an attempt to disprove the belief that foreign assets offer protection from falling U.S. stocks. I believe such conclusions are premature. Global stock markets will soon decouple from ours, and strong returns overseas will occur even as U.S. stocks slump.

I believe that the recent sell off in global stocks is liquidity-driven and will likely be short-lived. Many of our foreign creditors, particularly those using leverage, were forced to meet margin calls by selling assets to raise cash. Since the assets causing the problems had little, if any, value, they were forced to sell other assets instead, causing prices to fall sharply. In addition, the increased risk aversion that followed led to deleveraging of other speculative positions, particular yen carry trades, putting additional downward pressure on many of the foreign assets that had been purchased with borrowed yen.

In contrast to the recent declines in U.S. stocks, which are driven by deteriorating fundamentals and a poor outlook for corporate earnings and the U.S. economy, the steep drops in many foreign stocks do not stem from financial distress in the companies themselves, but simply from the short-term distress of their highly leveraged shareholders. Remember, the root of the problem lies in the inability of American borrowers to repay their debts. While foreign lenders may be getting stung a bit, they will take their losses and move on. On the other hand, American borrowers will face much bleaker futures.

In a mortgage crisis, such as the one we are currently experiencing, lenders typically get hit first. Today, America’s lenders usually carry foreign passports. Although foreign creditors may be the first to take it on the chin, American borrowers will ultimately be knocked out by the combination punch of much higher interest rates and vanishing home equity. Foreigners are suffering now because they loaned money to Americans who could not repay. However, as we are the ones who are broke, we are the ones who are in real trouble.

Furnished with a greater appreciation of the risks, foreigners will now buy fewer dollar-denominated bonds collateralized by U.S. real estate, automobiles, receivables, credit card debt, etc. Americans will then find it increasingly difficult to buy consumer goods or real estate on credit. As discretionary consumer spending grinds to a halt, real estate prices plunge and our economy falls into a protracted recession, the developing bear market in U.S. stocks will continue. However, as foreign consumers and businesses enjoy the benefits of additional goods and credit previously provided to Americans, overseas economies will grow faster, extending the lives of what are very powerful bull markets.

On a similar note, the recent global rout in stocks produced similar declines in both gold and gold stocks. Again, I believe we are witnessing liquidity events that will likely reverse as the true nature of our problems become apparent. As Fed officials continue to talk tough on inflation and deny the obvious threats to our economy from the growing credit crunch and collapsing real estate market, gold is being sold in favor of treasuries. Soon however, the markets will see through this charade and gold will shine more brightly than it did in 1980. The key for those of us holding the yellow metal or other non-dollar assets in anticipation of a major economic crisis in the U.S. is not to panic out of our positions. I am confident that we are holding the winning hand. All we need do is not throw it away.

Link here.


Has the financial reckoning day arrived?

The Old Testament recounts how, in 600 B.C. Babylon, one ounce of gold bought 350 loaves of bread. As of today, one ounce will still buy 350 loaves of bread in the U.S. Yet despite the sudden worldwide aversion to all things “risky”, investors seem to prefer U.S. government promises (bonds) in place of gold.

To some, this makes little long-term sense. The dollar has consistently moved in one direction over the past 60+ years. A 1940s dollar is only worth roughly five cents today. Regardless, the global economy still depends on the fact that the dollar acts as the standard world currency. And the U.S., exclusive to what any other truly sovereign nation may deem prudent, has the right to create as many dollars as the U.S. deems fit. We print a currency backed by only the worldwide confidence in our economy, its resources and our innate ability to successfully manage the subtle intricacies of Keynesian economics. Perhaps, one day, the world will call our bluff.

If traditional havens such as gold are deemed “too risky” in this climate, where do we turn? I am not so sure. But I am sure of one thing: You would be hard pressed to find another group of financial analysts more attuned to the heavenly virtue of hard money than the motley crew here at Agora Financial. By hard money, I mean gold. J.P. Morgan once said: “Gold is money, and nothing else.” And he should know.

Morgan saved the government from financial distress on more than one occasion. For instance, during the 1890s he stepped in and orchestrating a deal to purchase $65 million in gold after federal reserves became dangerously low. He went on to form J.P. Morgan and Co. in 1895. By 1912, the investment-banking house held assets whose aggregate value was compared to all the property in the then-22 states west of the Mississippi River.

Even though Morgan saved the American government on more than one occasion, his remarkable influence on American business had Congress scared. They feared that one individual held more concentrated power than the entire American government. President Theodore Roosevelt and Congress forced J.P. Morgan & Co. to decentralize. The hearings led to the foundation of the Federal Reserve in 1913, giving birth to America’s financial printing press. Since then, we have shunned gold for paper. Since then, we have spent more than we have earned. Since then, we have dilluted the value of the dollar. As we said, a 1940s dollar is only worth roughly five cents today.

I do believe we are in an era of silent inflation. Many analysts would have you believe that gold is the only answer. It is one of the best ways to protect your wealth from the nasty ravages of inflation, but gold has some drawbacks. Let us take a cue from Morgan Stanley’s Barton Biggs. As an investment, Biggs has shunned gold for some very sound reasons. He cites the negative yield associated with storing the actual metal. He also points out that gold does not enhance the purchasing power of its owners. He deems gold to be apocalypse insurance, not much more. I tend to agree. And I do not believe we are anywhere near an apocalypse.

There is still a tremendous amount of liquidity chasing deployment. According to The Economist, the top sovereign wealth funds combined will control $2.5 trillion by the end of this year alone (in contrast, hedge funds are thought to have a mere $1.6 trillion). And assuming forex coffers keep growing at this remarkable pace, the amount could balloon to $12 trillion by 2015. Consequently, we firmly believe the era of asset appreciation, especially in the arena of international equities, will maintain a very, very bright future.

It never hurts to own some gold. But I would not start stocking the cinderblock bunker if I were you – not yet, at least.

Link here.


The future of the City as a premier financial center looks dim.

According to (pervasive but possibly apocryphal) legend, Chinese prime minister Zhou Enlai, when asked in the 1970s what he thought of the French Revolution, responded “It’s too early to tell.” As for London’s Big Bang of 1986, it is also “too early to tell” whether it was beneficial. However if the current unpleasantness turns into a full fledged credit crunch and stock market crash, we will not have to wait until 2170 to find the answer. Contrary to unanimous media gloating at the time of last year’s 20th anniversary of the event, that answer is likely to be negative.

For those too young or non-British to remember, Big Bang was the package of legislation, legal activity and Bank of England rulings, culminating in 1986, that opened the City of London to foreign competition and abolished most of what had made its financial services business unique. On the broking side, the sales function (brokers) was no longer separated from trading (jobbers.) On the banking side, all aspects of the issues and mergers business were opened to foreign competitors, with no privileges remaining for local houses. The Stock Exchange became first primarily electronic and then entirely so; the trading floor was abolished. The Bank of England’s historic regulatory function was abandoned and a statutory system similar to the U.S. SEC was introduced. Ownership of all institutions was opened to foreigners, as was membership of the Stock Exchange, while the acceptance discounting privilege that had protected major merchant banks against financial disaster was abolished.

Much to the surprise of all concerned (at least in Britain) the result of Big Bang was to wipe out the merchant banking community and reduce London to the status of a “branch plant” city, in which ownership and control of essentially all leading participants lay overseas. This was not inevitable. Foreign banks have always been allowed into the New York market, and serve mainly as enthusiastic buyers of the various scams that New York financiers are so expert at developing. On the positive side (at least as far as the City’s workforce were concerned) incomes at the top end of the financial services industry soared, while those senior practitioners who were unable to compete in the new world were consoled by generous buyout terms for their partnership interests.

Before 1986, London had two periods of preeminence in international finance. The first, as is well known, was between 1694 and 1914. The second was the 1960s, when after reaching a very low ebb around World War II, the City pioneered the Eurobond and Euroloan markets. Thus by 1972 most of the London merchant banks had regained a considerable international standing, and new more entrepreneurial institutions had grown up that appeared to be taking the City into new areas, particularly international private equity. The one thing missing was international equity trading. Because of the appallingly prolonged exchange control regime, which did not end until 1979, London brokers had lost their pre-war expertise in international share trading and investment./

Then came the credit crunch of 1973-74, an episode almost forgotten today, judging by coverage of recent events. When followed by near hyperinflation over the next five years, this had two effects. First, it wiped out every major entrepreneur in Britain’s financial services business. Second, it halved the capital base of the merchant banks in dollar terms, making them too small to compete effectively against larger foreign institutions. By 1980 Salomon Brothers, among the most aggressive forces on Wall Street, alone made $500 million in profits in 1982, more than the entire banking and broking City of London.

In retrospect therefore, the early 1980s was an appallingly bad time to “level the playing field” and allow aggressive foreign houses into the London market. Had the market been opened in the 1960s, the U.S. investment banks would have had capital bases no larger than the London merchant banks. London houses would have proved formidable adversaries for foreign predators from the U.S. or Europe. It is most unlikely that foreign banks would ever have achieved more than a modest position

Conversely, had London been left to grow organically until the late 1990s, the merchant banks and brokers would have rebuilt their international equities businesses on the back of two decades of high profitability and booming stock markets, with the British-designed product of privatization universally popular. By the time London was fully opened it is likely that they would once again have been competitive. In the 1980s, hobbled by small size, lack of experience with London’s new financial system and lack of expertise in international equities, the London houses were piranha fodder.

Even so, more could have been done to ensure that some protections were retained, and it is a stinging criticism of the ideologically blinkered Thatcher government and two feeble Bank of England Governors that it was not. Moving to electronic trading removed the advantage of experience from established traders, and allowed the young, foreign and well capitalized to seize control of the market. Switching to U.S. modes of dealing and regulation automatically gave an advantage to the Wall Street houses experienced in such methods against the London houses accustomed to a different system. The disappearance of the merchant banks was probably inevitable, given the timing and details of the 1980s changes. In any case, nothing significant was done to save them. On the one occasion in which the government and Bank of England could have been helpful, the 1995 Barings collapse, they notoriously failed to assist in any way, allowing London’s oldest merchant bank to be absorbed by an inept Dutch behemoth.

Currently, the new system has been blessed with 20 years of favorable conditions, with only moderate downturns in 1990-92 and 2000-02. It has produced enormous wealth for participants, and even the effect of foreign ownership has been mitigated by the usual investment banker tactic of siphoning off most of the profits before they reach the shareholders. To an even greater extent than in New York, the financial services business has enormously increased its share of output and earnings. While it remains questionable how much of its additional output represents real value and how much successful rent-seeking, even that consideration should not unduly deter Britons, since a high percentage of the rents are being extracted from foreign companies and institutions.

It now remains to be seen what will happen in a serious downturn, which we may or may not be entering but will undoubtedly experience soon. Hedge funds, particularly those with misguided quantitative strategies, will be the first to go. They have been achieving sub-par investment returns for a number of years now, the sector being sustained only by the aggressive salesmanship of their managers. Without profits, their investors will start trying to recapture the remnants of the invested money.

Private equity, too, is likely to go into a prolonged downturn. Here the extraction of the “carried interest” by the managers before companies are sold will leave many funds in a hopelessly illiquid position, unable to pay the staff. This in turn will produce a glut of private equity positions to be sold, which will produce a catastrophic drop in their value. Except for the most long-term oriented funds specializing in the more arcane emerging markets, it is likely that following a downturn private equity investment will be correctly perceived as an activity that adds little or no economic value. Employment levels and remunerations in the sector will thus be decimated.

Trading desks will make large losses. They have been sustained by an ever-increasing proliferation of derivative products that fail to offer the security they pretend, and are highly illiquid in a downturn. In a bear market, there will be no buyers for such products. Consequently there will be few trader jobs other than in the most mundane sectors.

Judging by past patterns, a downturn in London’s “investment banking” business will last at least 2-3 years, producing huge and unanticipated losses in each year, followed by a drastic decline in activity. It will also no doubt result in the arrest, conviction and imprisonment of a number of leading practitioners. Ethical standards in the new City have slipped to those of Wall Street and it will be no surprise if Wall Street-style prosecutions, spurred on by a vengeful investing public, bring some big names low.

At that point, the foreign shareholders who control today’s London houses will have three choices. They can keep the London houses going, in the hope that in a mass desertion of the business by others they can pick up market share. They can bring the businesses back to their head offices, recognizing that in a trader’s world such businesses require little specialist expertise that is not readily internationally available, and that bringing the business closer to its controllers is more important with today’s communications than its physical proximity to the markets. Or they can close the businesses down altogether.

If sufficient players choose either of the second or third options, London will cease to be a top tier financial center. At that point the only beneficiaries of the special foreigners’ tax deal, so obnoxious to those of the British public who know about it, will be the Russian mafia. Since attracting yet more of the Russian mafia is probably not a British objective, the tax deal will then go.

After the 2000 peak, I believed that a lengthy bear market would lead to the recreation of something like the London merchant banks, as foreigners pulled back from the market. But at this point, the opportunity has probably gone. By 2012, when new merchant banks could successfully be established as the market begins to recover, it will have been 25 years since Big Bang and the senior potential participants would all be 60 plus.

For those not subject to the penal British taxation that will be exacted after the financial behemoths depart, it may be thought fairly unimportant that London ceases to be a premier financial center. Florence and Amsterdam both lost their top tier status, yet both cities remain prosperous, their attractions increased by the houses left to posterity by their bankers. Regrettably, the Luftwaffe and the developers destroyed most of the best bankers’ architecture in London. It seems unlikely that in 2200 tourists will be visiting to see the post-1950 rubbish. Even as a museum, therefore, the City’s future appears limited.

Link here.


Just a few weeks ago, Fortune magazine pronounced the world to be in “the greatest economic boom ever.” This may be, but the turmoil in stock and bond markets poses some unnerving questions. Is the global economy stable? Or might its periodic crises someday lead to a calamity?

Go back a century, to when the world enjoyed another fabulous boom. From 1896 to 1913, trade roughly doubled. Declining steamship and telegraph costs were melding countries together. “There was something close to an integrated world market for most goods,” Harvard political scientist Jeffry Frieden writes in his book Global Capitalism. In 1870, wheat prices in Liverpool were about 60% higher than in Chicago. By 1913, the gap was 16%. European investors eagerly bought bonds of then-developing societies – Argentina, Australia, the U.S.

Compared with this earlier extravaganza, today’s boom still impresses. From 1990 to 2005, trade rose 133%. Supply chains are increasingly global. Since 1985, imported components as a share of worldwide manufacturing output have doubled, to almost 30%. Cross-border money flows (for stocks, bonds, loans, real estate, entire companies) are huge. Finally, the boom has reduced acute poverty. The share of the world’s population living on $1 a day or less has dropped from 40% in 1981 to 18% in 2004, the World Bank estimates.

The vast flows of goods, services, technology and money have clearly done much good. But there is a less reassuring comparison with the past. The world economy collapsed during World War I and could not be successfully reconstructed in the 1920s. Britain, which had stabilized the old trading and financial system, was too weak to resume its leading role. The failure to find an alternative abetted the Great Depression of the 1930s.

Today’s global economy undeniably faces some big, potentially destabilizing threats, oil being the most obvious. The rise of new trading powers, particularly China, has altered global politics. Conflicts may grow. Cooperation may be harder. Global finance also belongs on the list. Anyone claiming to understand today’s world financial system is either delusional or dishonest. Although subprime U.S. mortgages are the center of attention, they are not the real problem. The real problem is the unanticipated nature of the losses, which has triggered a broad reappraisal of risk. Investors do not know who holds the bad subprime loans. Some European banks and funds turned out unexpectedly to have suffered large losses. Nor do investors know whether subprime losses foretell other bad credits. So investors are retreating from risk. Many are shunning loans and securities that only recently were considered routine.

The result: a “credit crunch”. Last week, outstanding U.S. commercial paper fell a huge $91 billion. “It was an eye-opener,” says economist John Lonski of Moody’s. Global capitalism, Frieden writes, survived earlier only until it stopped producing widespread prosperity. No problem, say many economists. The U.S. economy may slow (housing remains a drag), but Europe, Japan and many “emerging market” countries have strengthened. Global Insight, a forecasting firm, predicts world economic growth of 3.6% this year and next, down only slightly from 3.9% in 2006.

Well, maybe. But there is another view. Economist Joseph Mason of Drexel University argues that the basic financial threat today is “overborrowing” by investors to buy risky securities. That implies more losses as investors scramble for safety by dumping weak bonds and loans. Given today’s global money bazaar – losses in one market may spill over into others – the danger would be a worsening “credit crunch” that corrodes confidence and dooms the world boom. As history suggests, there are no guarantees.

Link here.


Last week’s stock market slide was fueled by hedge funds’ indiscriminate selling to raise cash. But as these players rushed to unload anything liquid in their portfolios, some mutual funds have been scooping up the resulting bargains. “I think most managers have been buyers in this correction,” says Larry Puglia, the portfolio manager of the $11 billion T. Rowe Price Blue Chip Growth Fund. “Earnings growth prospects for many companies are still quite sound, and the valuations have gotten more attractive.”

Few mutual fund managers have the leeway to sell all of their holdings and move into cash, so their stock-picking skills really come to the fore during market crises like this. Here is a look at where four fund managers see bargains.

Puglia looks for companies with free cash flow growth, leading market position, seasoned management and strong fundamentals, especially a high return on invested capital. If a company’s fundamentals remain strong, he is willing to keep buying on the way down. The manager has been buying a mix of industrials, technology and consumer staples stocks, including General Electric, Microsoft, PepsiCo, Procter & Gamble and Google. He has also been buying financials, including Goldman Sachs. That is right, Goldman Sachs, the investment bank that injected $2 billion into a hedge fund that lost 30% of its value in a week. The company’s stock is down more than 20% from its 52-week high, but Puglia believes it will perform well over the next two years.

Financial services companies in general have led the market’s selloff as more subprime borrowers find they cannot make their mortgage payments. The mortgage lenders who make these loans, the investment banks that repackaged them into securities, and the hedge funds and other investors who buy them have all been hit by a credit crunch as the market struggles to determine what they are worth. Puglia has unloaded some financial services stocks, but not all. In addition to Goldman Sachs, he also likes American Express, Morgan Stanley and Charles Schwab. Puglia has sold energy stocks, and thinks natural resources shares are only now beginning to look cheap.

Colin Glinsman, manager of the $1.86 billion Allianz OCC Value Fund, says investors need to look at individual stocks and determine if the market has overreacted to the mortgage crisis. Like Puglia, Glinsman thinks some – but not all – financials were oversold last week. In general, “if it doesn’t have exposure to the credit crunch, it’s cheap,” he says. “We look for companies where the stock overshoots on the downside because of fear, but is fundamentally sound. These are the ones that will go up after this period.”

Of course, he has to sell something to free up cash first. So he scans his portfolio for stocks that are trading at levels close to their long-term fundamental value and have less upside potential. Glinsman especially likes MBIA and Ambac Financial.

Clark Winslow, manager of the $900 million MainStay Large Cap Growth Fund, is adding to his holdings of some stocks while aggressively selling those that no longer fit his investment criteria. While some commentators believe the U.S. economy is headed into a recession, Winslow believes growth will merely slow. He expects that a rise in unemployment and a reduction in capacity utilizations will lower inflationary pressures, allowing the Fed to drop interest rates. That should help the stock market recover next year.

With the S&P trading at a reasonable 15 times next year’s earnings, the fund manager believes this is a good time to look for companies with weak valuations and good growth prospects. Among his top picks are Cisco. Winslow expects the maker of network equipment to be a “major beneficiary of world economic growth,” with rising revenue growth and profits climbing 20% a year. Another pick is pharmacy manager Medco Health Solutions, which is capitalizing on the trend of generics replacing high-priced proprietary drugs, says Winslow, predicting 20% earnings growth.

“Everyone is worried about the next shoe to drop, but these periods of volatility give us a chances at stocks that were not available a couple of months ago,” says Russell Croft, co-manager of the $24 million Croft Value Fund. “Our goal is to beat the market with reduced risk.” A long-term value-oriented investor, Croft’s time horizon is one to three years and he invests in companies of any size in any sector. Right now, he likes industrial adhesive company 3M and timber firm Weyerhaeuser.

William Nasgovitz, co-manager of the $350 million Heartland Select Value Fund, has been looking to buy stocks of companies of any size that trade at low valuations, such as 13 times next year’s earnings. But he will not touch a company at any price unless he has a clear understanding of how much exposure it has to subprime mortgage crisis. “We’re focused on businesses with good balance sheets,” Nasgovitz says. “[We] don’t want companies that are significantly leveraged. Those are not your friends now.” He especially likes railroad company Union Pacific, which is down 17% from its 52-week high in July.

Link here.


Robert Olstein has plenty of advice for turning around underperformers. Companies will not admit it, but many end up doing what he says.

Now in this summer of market discontent, Robert Olstein is out to find troubled companies that show potential for turning around. And the perennial gadfly has plenty of ideas to help them, if only they would listen. Will they? It appears that plenty of problem-plagued outfits have paid heed to his vociferously expressed nostrums in the past – although many are loath to admit it.

This guy is an accounting sleuth, someone who makes his living delving through footnotes in financial statements and unearthing hidden weaknesses, or strengths. Olstein, 66, makes his opinions very clear in tv appearances and in person. He is eager to call various Wall Street pundits morons, lunatics or stupid. Olstein, who once had a newsletter called the Quality of Earnings Report, puts little stock in reported net income. Earnings are too easily manipulated, he warns. And he sticks to financial reports in lieu of interviewing management: “Why talk to the ministers of propaganda when I can get the truth from their financials?”

Now a money manager in Purchase, New York, the former analyst runs mutual funds that focus on finding companies whose stocks are at least at a 30% discount to their “intrinsic value” – what he calculates companies would be worth to an acquirer. He eyeballs a host of metrics, looking for strong free cash flows and how surplus cash is used, and the possibility of cleaning up their balance sheets. Based on what the numbers tell him, Olstein then looks for how they deploy capital, which often calls for him to make operational judgments. Thus, he urges limping Home Depot, whose stock he owns, to halt store expansion and concentrate on what it already has.

The record at his flagship Olstein All Cap Value fund (assets: $1.8 billion) suggests he is onto something. Since its 1995 founding the fund has scored an annual total return of 15.7%, versus 10.2% for the S&P 500 through June 30. You might think twice about about buying All Cap Value in light of its stiff expenses, 2.2% of assets yearly. Buy its stocks instead.

Olstein loves to fire off indignant letters to executives and directors of errant companies in hopes they will follow his wisdom. One case where this worked was RadioShack (NYSE: RSH). He was attracted by the electronics chain’s well-known brand and its big domestic coverage, with 4,470 company-operated stores. Still, he was incensed that it cluttered shelves with low-margin products like radio-controlled toys and TV antennas. Offerings in MP3 players and flat-screen TVs were meager. RadioShack’s CEO, David Edmondson, was forced to resign for lying about his academic record. Olstein, who had invested before this fracas appeared, blasted RadioShack’s board for initially supporting Edmondson. “The board, as constituted, is no longer an effective steward of shareholders’ interests,” he wrote. He took the company to task for sins ranging from declining margins to frittering away its great geographic distribution.

The company finally listened, and its directors then talked with him several times. A new chief executive, retail veteran Julian Day, proceeded to implement many of Olstein’s suggestions, and the stock moved up. Since Day’s July 2006 arrival the company has returned to the black and amassed an enviable cash kitty. The turnaround is still a work in progress, with second-quarter sales a letdown, which sent the stock skidding again. Nonetheless, RadioShack shares are still higher than when Day started, and Olstein recently sold two-thirds of his stake for a 47% return.

One of the newer companies on Olstein’s makeover list is Boston Scientific (NYSE: BSX), which has taken a beating over its acquisition of Guidant, the cardiac device maker, and is now under regulatory scrutiny for product recalls for its pacemakers and defibrillators. Boston Scientific also has problems with defective stents. And it just took a $360 million aftertax charge to partly back out of another acquisition. Thanks to the Guidant buyout, long-term debt quadrupled from 2005 to $8.3 billion. From $3.4 billion, at the end of 2005, retained earnings (the cumulative total of earnings less dividends) have shrunk to $33 million.

But half of Boston Scientific’s business has steady growth products, such as feeding tubes and catheters for endoscopic surgery. The market for coronary stents is also stabilizing. The next step, Olstein says, should be to sell some divisions and use the money to lop debt. The company has considered selling part of its endosurgery unit to the public, although it seems to have backed away from the idea lately.

Similarly, Olstein has hopes for clothing retailer Gap (NYSE: GPS), another iconic name, which owns Banana Republic and Old Navy stores, with 3,000 locations worldwide. Its stock has lagged in recent years on the heels of earnings disappointments stemming from product fashion misses, overexpansion and willy-nilly markdowns. Olstein agitated for Gap to hire a well-regarded chief exec with financial and merchandising experience. The company just hired Glenn Murphy, former head of a Canadian drugstore chain. The biggest change Olstein wants to see is for Gap to halt new store openings and close underperformers. That should allow it to bring fashion ideas quickly to market. Gap has good brands, high insider ownership and $3 per share in net cash. If a private equity group acquired the retailer, Olstein says, fixing it would be easier – adopting his remedies, of course. Then Gap could be sold back to the public at a nice markup.

As for Hewitt Associates (NYSE: HEW), the consulting and outsourcing firm, Olstein calls for a reduction in its loser personnel department outsourcing arm. He calculates this line of business penalizes annual earnings per share by 75 cents. The last four quarters totaled $1.30 EPS. He is encouraged that it is a solid free-cash-flow generator.

Link here.


Mutual funds that have been longtime Berkshire Hathaway investors are decamping.

Warren Buffett draws as many gee-whiz headlines as ever these days. But the Berkshire Hathaway (NYSE: BRKA) mystique may be wearing thin among longtime devotees who know the company best. Several solid mutual funds that have held its stock for ages.

One is the sterling Sequoia Fund, bound in a tight relationship with Buffett for four decades. Since the start of 2005 Sequoia has unloaded $650 million of Berkshire shares, shrinking their weight in Sequoia’s portfolio from 35% to 26%. Wallace Weitz shares a hometown with Buffett and runs Weitz Value and Weitz Partners Value funds. He has had a long-standing appetite for the Wizard of Omaha’s stock, which had been making up 7.6% of his two funds. Weitz lightened up on the stock last fall. The reduction in the holding, to 7.4% of assets for Value and 7.2% for Partners Value, is small, yet it is equivalent to a devout Muslim deciding to skip some of the required daily prayers. Weitz says he still loves Berkshire but trimmed it to buy other holdings.

Another Buffett acolyte, Christopher Davis and his Davis Advisors, has exited from Berkshire entirely in Davis Financial Fund. It recently reported selling $49 million worth of Berkshire A shares for a $20 million profit. Three other Davis-run funds have thus far maintained their levels of Berkshire stock.

Sequoia did not get around to alerting its investors until earlier this year that it has been easing out of Berkshire lately. The stated reasons for reducing its Berkshire load were its desire for better diversification and Buffett’s age. Buffett, 77 on August 30, has assured shareholders that a change in management (he has not publicly named a successor yet) and a possible shift in control to the Bill & Melinda Gates Foundation (he is donating most of his shares to it) will have no impact on Berkshire’s fortunes.

The extraordinary rise in Berkshire’s share price during Buffett’s tenure (2,533-fold so far) is not necessarily over, yet it seems to be tapering off. Over the past five years the share price growth has lagged behind the S&P 500’s.

Link here.


Money manager Judith Saryan used to be bored by electric power. She covered the sector as an analyst and then chucked it in the mid-1990s to focus on telecom. The best that could be said about electric utilities, she thought, was that they paid nice dividends. Ho-hum. As she saw things back then, electric companies were hidebound dependents of state regulatory commissions, which decreed how much they could charge and how they should do business. Then came deregulation.

A series of congressional and regulatory moves in the 1990s allowed utilities to split off their generating plants from their distribution business. That meant new private companies could buy power plants from utilities, then sell the juice back to the utilities. It also meant that utilities could set up their own unregulated subsidiaries to own power plants. State regulators had less sway over the new entities than they did over the distribution companies. The new entities were free to peddle power to the highest bidder.

So Saryan, who had been working at State Street Global Advisors, decamped in 1999 to run Eaton Vance Utilities, albeit with some lingering misgivings about the area. She figured that a long snubbed stock group where big reforms were under way meant an opportunity. She was betting that electricity prices were about to climb, and her bet panned out. The fans of deregulation, in Congress and in several state capitals, promised that increased competition would lead to lower rates for consumers. Sorry. Higher energy prices in recent years and higher electricity demand scotched that dream. The upside for investors: The higher rates have done a swell job jazzing up the profits of a once sleepy business.

The industry’s stocks – after weathering a storm early in this decade, courtesy of the Enron scandal and the stink over price gouging in California – have done well. Over the past five years the S&P 500 Utilities Index has generated a 17.1% average annual total return, vs. 9.8% for the broad S&P 500. Saryan’s portfolio has fared even better – 22.6%. Dividend growth and cash flow are the main impetuses for these stock prices, Saryan contends.

While the bull market has brought down the industry’s average yield from 5.5% five years ago to 3.5% lately, she thinks that good buys still exist there, since the companies – some of them, anyway – have a penchant toward raising payouts regularly. We have culled holdings in her fund that show a 5-year dividend growth rate better than 10% per year (see table). Their yields range from 2% to 3.5%. That may be shy of the 10-year Treasury’s 4.8%, but it outshines the S&P 500’s average dividend of 1.8%. And for the time being dividends are still taxed at just 15% federally.

Despite the sector’s run-up (the market’s recent troubles have not really hurt utilities), these names are still not very expensive. To be sure, Saryan also believes that dividend growth will slow a tad among energy transmission and distribution companies, as they divert more capital to building new plants and power lines needed to meet the surging demand. Hence she is gradually shifting her fund’s concentration from utilities, currently 80% of the portfolio, to 50% over the next two years, renaming the fund Eaton Vance Dividend Builder.

Some of Saryan’s best performers, like Exelon and Entergy, bought up nuclear plants at distressed prices in recent years. Exelon, a combo of Philadelphia Electric and Commonwealth Edison, purchased a unit of the infamous Three Mile Island nuclear plant for $23 million, excluding fuel costs, when its book value was $600 million. Big opportunities exist in Europe, too, where large state-owned companies have been privatized. Dominant operators like Germany’s RWE and the U.K.’s Scottish & Southern have been winners for Saryan’s portfolio. Their dividends are growing faster than those of U.S. counterparts.

If you want to concentrate on utilities without owning individual stocks, look at some of the other utility funds that have done well over the past five years (see table). While expenses are reasonable, most of these funds carry a load. (Saryan’s fund charges 1.06% of assets yearly, and has a 5.75% load.)

Link here.


Like most advertising agencies, the Brooklyn Brothers, a tiny (2006 revenue: $4 million), 4-year-old New York outfit, gets most of its business the usual way: in fees for making TV, print, online and outdoor ads for clients like the New York Rangers and the History Channel. But last summer the firm decided to take a flier. In exchange for sweat equity – product R&D, branding, packaging and, of course, an ad campaign – it is taking a 20% slice (and an undisclosed sales royalty) of a bottled coconut water called Oco. “A lot of traditional, old-fashioned ad agencies, they are really in the business of producing ads,” says Paul Parton, a Brooklyn Brothers partner. “We’re in the business of producing profits.”

He should be so lucky. The agency has not yet found a manufacturer or distributor. It does not plan to put the drink on store shelves until early next year. And it must contend with established coconut-water brands like Zico. But Parton cannot shake the idea that a big payday lies just around the bend. He hopes to replicate the head-smacking success of Vitaminwater. Coca-Cola recently picked up the vendor of that silly liquid for $4.1 billion.

In pursuit of such dreams many agencies, big and small, are investing in the brands they push on behalf of others. No longer content with hourly fees, which by many accounts are shrinking, firms are taking ownership stakes in new products in lieu of some or all payment. Others are investing their own capital to launch an idea. In some cases they are sidling up to private equity firms to help find brands to acquire and, in others, trying to get a piece of the action.

Why should LBO firms have all the fun? New York’s Kirshenbaum Bond & Partners, now majority-owned by MDC Partners, pulled in just $2 million to $5 million in annual fees putting Snapple on the map in the 1990s, while its client, Thomas H. Lee Partners, bought it for $140 million, then sold the tea company two years later to Quaker Oats for $1.7 billion. Crispin Porter & Bogusky did not share in the bounty when a group of private equity partners last year sold the public 19% of Burger King – a lagging brand the agency had boosted with its offbeat King campaign. Given what a 19% stake fetched in a 2006 public offering, the private equity players nearly doubled their investment over four years. “I wish when we had gone to work for Burger King pre-IPO we had said, ‘Don’t give us any money, just give us two points,’” admits Charles Porter, chairman at the Miami agency.

They are learning. Richard Kirshenbaum and Jonathan Bond, the two principals of Kirshenbaum Bond, invested $50,000 apiece after landing the Meow Mix account in 2002 and made out nicely after the cat food maker was sold twice in the space of four years. Crispin Porter took undisclosed minority stakes in Haggar (sportswear) and Method (eco-friendly detergents) in partial payment for advertising and design work. Cozying up to private equity firms is another way to score. Kirshenbaum Bond recently got the assignment to research the marketing efforts of two retailers that Thomas H. Lee was looking at.

This month London’s Bartle Bogle Hegarty (2006 revenue: $150 million) plans to start a Web site to sell stylish clothes for pets. The agency will handle all design, logo creation and advertising. It will also outsource apparel manufacturing, owning 100% of the site. Neil Munn, picked off last year from Unilever, says such ventures should bring in $25 million in revenue and 25% of the agency’s profits by 2011. Anomaly, a 3-year-old $15 million (revenue) shop in New York City, has sunk $1.5 million of its own money to help launch five brands. In each case, Anomaly owns about 30% of the ventures. To focus on them, says Carl Johnson, the agency’s founder, the agency has dropped out of 30 pitches for big clients. “The old agency business model is broken,” he says.

But the new model has its downside. Kirshenbaum and Bond have personally invested $300,000 each in five clients, making money once, breaking even once and losing it all three times. The idiosyncratic Saatchi brothers, Maurice and Charles, and four colleagues paid H.J. Heinz at least $10 million for a 51% stake in Complan meal-replacement drinks and Casilan protein supplements five years ago. Sales have since been anemic, says Andrew Leek, the head of investment group Saatchinvest. And big plans to buy five or six brands in sports apparel or distilled spirits have not yet panned out. “It takes longer to turn around a brand than we previously thought,” Leek admits.

There are boosters, who view investing in brands as a survival strategy. “Private equity will beat out ad agencies if the agencies don’t do it,” insists Andrew Berlin, who runs a collection of small ad shops owned by the WPP Group. Berlin’s WPP contract is up in December. But he is trying to talk Martin Sorrell, WPP’s chief and a skeptic, into partnering on a brand investment group. “Adding equity causes all sorts of stresses and strains,” writes Sorrell in an e-mail. Such ownership, Berlin reasons, is the best way to go. “Trying to make money in advertising,” he says, “is like climbing a telephone pole covered in grease.”

Link here.


One of the biggest scientific discoveries since electricity is here. It is a subject which is covered by thousands of academic and scientific journals every year. The discovery is called carbon nanotubes (CNTs). CNTs were actually discovered years ago, but have been virtually impossible to study and manipulate until recently.

CNTs are exactly what they sound like, tubes of graphitic carbon molecules with a diameter of 1-2 nanometers. But for as small these things are, the have some absolutely mind-blowing properties. CNTs have 50 times the strength of steel and are lighter than aluminum. They have among the highest thermal conductivity of any known material and can transmit twice as much heat as pure diamond. They also are able to conduct 1,000 times more current than copper, which is the leading material in electricity conducting. They are also better semiconductors with electron mobility 70 times larger than silicon.

The applications for these characteristics are infinite. This technology can be used in touch screens, Liquid Crystal Display screens, thin-film transistors, solar panels, and even fuel cells – CNTs solve the current problems with kinetic, resistive and mass-transfer losses in today’s fuel cells.

This is just the start. Think about this: CNTs have 50 times the strength of steel and are lighter than aluminum even when they are diluted with water and sprayed on various things. The result of covering things with this solution is like clear coating whatever you want with basically clear steel at a thickness of one nanometer.

As you can imagine, there are many companies looking into exploiting this technology, but only one with the intellectual properties and resources to get it off the ground. This company just signed a licensing agreement that will get these CNTs out of the lab and into everyday life. What make this company an interesting play are the recent mergers and partnerships. They signed an agreement in April of this year to start perfecting this technology for use on Nintendo products. The company also recently merged with another carbon nanotube industry leader. The merger combines hundreds of nanotube patents, which sets the new company apart from all of the competition. Finally, about a month and a half ago, the company signed a strategic alliance with the biggest R&D firm in the world, which has a budget of $3.8 billion. [Ed: A little search engine sleuthing turns up Unidym, Inc., a majority-owned subsidiary of Arrowhead Research Corporation (NASDAQ: ARWR) as the most likely company being referred to here.]

In times of erratic markets, ideas like this one are going to save the smart investor. Many people are afraid of tech companies when other stocks are volatile, but smart investors know that surrounding circumstances do not have an impact on innovations like this. In fact, some of the best investments are made when the market is unstable.

Link here.


An actual cure for cancer has been found, at least in mice. There is encouraging preliminary evidence that it may also work for humans. The LA Times reports that researchers have taken white blood cells from mice with natural immunity to cancer and implanted them in normal mice. This single transplant gives the normal mice permanent immunity to all forms of cancer. Especially interesting is the fact a brand-new biological process appears to be at work. The scientists are assuming the process is somehow genetic in nature.

The studies, led by Dr. Zhen Cui, have been repeated at Wake Forest University School of Medicine but not at other laboratories. There have not been enough of the naturally resistant mice been bred to supply other laboratories. (An aggressive breeding program is changing all that.) Nevertheless, the results were good enough to be published in the Proceedings of the National Academy of Science. Other laboratories are eager to replicate them, and the supply of immune mice is rapidly being increased. The immune mice were an accidental discovery made in 1999.

In these mice, any tumors that develop are killed within two days. The mice are otherwise normal in every respect. There is no harm to normal tissues. It works for every type of cancer tested. Researchers are optimistic that the fact that the immunity lasts for a lifetime and transfers between strains of mice when crossbred mean it will work in humans as well. Scientists at The Cancer Research Institute, Scripps Research Institute and Washington University School of Medicine have agreed to collaborate in efforts to isolate the gene.

This is not merely a laboratory curiosity, as the limited evidence to date indicates the same mechanism may exist in humans as well. When white blood cells from mice with the immunity are mixed with tumor cells, they surround the tumor cells and then rupture them. Cells taken from people who never get cancer have been found to behave in the same fashion. There are a few caveats: Humans are more prone to reject cells from other humans, so matching of types would have to be carefully considered and developed. In addition, the cells would need to be free of viruses.

The bottom line is that something has been discovered with earth-shaking significance. I expect that it will be found not only effective in controlling cancers, but also to offer other benefits. Assuming the white blood cells that are transferred are not themselves immortal, then it would appear this process must work by the mutant cells training all of the recipient body’s white blood cells to “think” differently – and sustaining that memory for life. It is almost as if the “smarter” white blood cells have an ability to recognize not only viruses and bacteria as invaders, but any kind of cell that is aberrant, at least in the manner of a cancer.

The notion of cells having memory is well established in science. It is the basic mechanism by which white blood cells recognize invaders. In his groundbreaking book The Biology of Belief, cell biologist Dr. Bruce Lipton explores this phenomenon in detail. I will be watching closely to see which companies are licensed to develop and market this new process. It should be worth a fortune.

Link here.


The solar market has been one of the fastest growing markets, and we have seen companies in this sector jumping 60%, 80% and even 100% in just a couple of short months. Renewable energy has been a hot political topic, but it has been just as hot as an investment. We have seen tremendous growth in wind, hydro and geothermal energy production, but one of the more recent markets to catch fire has been solar. To see just how explosive this market really is, there is no need to look any further than a couple of solar module producers, Trina Solar (TSL: NYSE) and First Solar (FSLR: NASDAQ). These two companies have recently signed some major deals, and it has shown in their stock prices.

I have reason to believe there is an even better way to play this market than these companies. Trina Solar recently signed contracts with a German company and three Italian companies that have TSL set to deliver solar modules that will produce approximately 88-99 megawatts of power over the next three years. Just on the news of these contracts, TSL stock jumped 16%, but this company was hot before these contracts even came out. The story for First Solar is even more impressive. First Solar also produces solar modules. With the signing of its recent contracts, FSLR is set to manufacture and sell enough solar modules to create 658 megawatts of power by 2012. The total amount of solar energy produced in the U.S. amounts to approximately 400 megawatts. After the news release of its most recent contracts, First Solar jumped 24%, but even more impressive is that it has more than doubled in price since the beginning of May.

These are two great stories in the solar market, and I can just see you sitting in front of your monitor saying to yourself, “Woulda, shoulda, coulda.” But instead we can learn from what has happened and use that knowledge to make profitable decisions in the future. I know that the solar market is still young, and there are still some amazing gains to be had. In fact, I have a totally different way to play this market and experience what might turn out to be the greatest gains of the solar market yet to come.

Commodities and solar energy.

My passion in life happens to be commodities investing. It is what I do because I love to do it. I invest in commodities for two main reasons. The first is that I am a simple guy who likes to read the supply-and-demand fundamentals of a market. What you see is what you get. The second reason I prefer commodities investments is that I believe in holding tangible assets with M3 money supply growing at around 13% per annum. I loved the market for solar energy, but I really wanted a way to play it with a commodities investment, because that is what I do. It did not take much digging before I came across what traders were calling “gray gold”.

Gray gold, or silicon, is the base semiconductor used in the production of over 85% of solar cells. Rapid growth in the use of solar energy has led to a very large increase in the demand for silicon. The problem is that refiners are really having a hard time in keeping up with this sudden increase in demand.

There is no reasonable substitue for silicon. [Ed: Yet. See article above on carbon nanotubes.] It is this reason that silicon-based semiconductors make up over 85% of the solar cell market. The preferred form of integrated circuit is called a complementary metal-oxide semiconductor (CMOS) logic circuit. This circuit has a much lower level of energy consumption than any other form of integrated circuit used in the solar industry. It becomes much more economical in the production of electricity when the integrated circuit consumes less energy. Silicon-based semiconductors are the only way you can make a CMOS logic circuit.

Silicon is the second most abundant metal on Earth. 25.7% of the earth’s crust is made of silicon. But the process of refining silicon is rather expensive. First, all impurities must be purged. To make semiconductor-grade silicon, the metal needs to still undergo more processing. Not only is this process itself very expensive, it is also very expensive to increase refiner capacity. German silicon refiner Wacker Chemie, for example, has undertaken a project to expand its refining capacity from 5,500 tonnes to 9,000 tonnes. The price tag on this project? Over $270 million. It would take a large demand shock to push the prices of silicon to high enough levels to make it economical for refiners to bring more capacity online.

This is the fundamental idea behind a commodity supercycle. Getting additional supply online to meet growing demand takes time and money. The market needs to be assessed, funds need to be raised, permits need to be obtained, and finally, the project needs to be started and finished. The time lag consists of a supply shortage met by higher prices. The shortage and price increase can also be judged or predicted by the size of the demand shock. And this particular demand shock is one of great significance.

As proven with ethanol, government money can make a bull market out of nothing. But what happens when the market is actually economical on its own, but is then combined with taxpayer money? You get a huge, stinking demand shock. California has recently announced the largest solar energy potential program in U.S. history. There are many other similar forms of legislation that are either already passed or in the process right now. We are seeing the green wave take hold around the globe.

Silicon is used in cell phones, computers, and MP3 players, but its greatest use is definitely in the solar market. Solar energy currently makes up approximately 50% of the demand for silicon, and that number is rapidly increasing. From 2000-2004, the number of annual photovoltaic installations nearly quadrupled. In that same period, the price of silicon went from $9 per kilogram to nearly $30 per kilogram. The market for solar-grade silicon currently is estimated to be around $2.3 billion. By 2010, PV installations are expected to quadruple again and the market for solar-grade silicon is expected to rise to $10.4 billion. With solar taking up an increasing percentage of the silicon market, you can expect to see an even stronger correlation between the growth in the solar market and the price increase in silicon.

PV installations quadrupled from 2000-2004. The price increase in silicon over that same period was 230%. In 2000, there was excess refiner capacity. The increase in demand was met by spare refiner capacity, and still a 230% increase in price followed. What happens when PV installations quadruple again, but this time spare refiner capacity is not there to meet the growing demand? Your guess is as good as mine as to what the actual price will bring. But I can promise that the shortage in silicon due to a skyrocketing demand in the solar market and a refining capacity with minimum wiggle room will result in some spectacular price action in the silicon market.

It is my opinion that silicon refiners are set to experience the greatest gains in the solar market. PV producers will be forced to pay higher input costs to produce their modules because of silicon shortages. With government subsidies and tax breaks, they will be more than willing to pay these higher prices, allowing for the price of silicon to continue its bull run. Although the profit for solar producers will be hurt by higher silicon prices, the refiners will be in a position to experience tremendous gains. Playing the solar market from a commodities perspective is the best and safest way to profit off the solar energy boom.

One of the refiners producing solar-grade silicon that I think is set to profit off the coming bull market for silicon is Tokuyama. Tokuyama is mainly traded on foreign exchanges, but you can also trade it here in the U.S. (TKYMF: Other OTC). These guys have experienced increased revenue from their sales of silicon, and as the price of gray gold continues to push up, look for Tokuyama’s stock price to also experience large gains. But it is not the only one set to profit from this market.

Link here.


Bank of China Ltd. had its biggest drop since going public last year after the nation’s 2nd-biggest bank said it holds almost $9.7 billion of securities backed by U.S. subprime loans, the most of any Asian company. The 5.4% decline in Hong Kong erased $10 billion of Bank of China’s market value. Almost 1.5 billion shares were traded, more than four times the daily average over the previous six months.

“Bank of China disclosed numbers that no stockholders wanted to hear,” Warren Blight, a Hong Kong-based analyst at Fox-Pitt Kelton (Asia) Ltd., said in a research note. “The market is likely to be very surprised by the scale of the exposure.”

The collapse in securities backed by subprime mortgages has caused losses at lenders around the world, helping send Asian banking stocks lower in the past month. Industrial & Commercial Bank of China Ltd., the world’s largest bank by market value, disclosed this week that it had $1.2 billion of subprime-related securities. Losses related to subprime loans damped enthusiasm for Bank of China even after it reported a 51% increase in first half profit. The shares have fallen 10% in Hong Kong this year, the 4th-worst performance among companies on the benchmark Hang Seng index. Bank of China raised $11.2 billion in an IPO in June 2006.

Link here.
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