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UNFOLDING CREDIT CRISIS MAKES MAJOR LEAP TOWARD THE HEART OF THE CREDIT SYSTEM
Money is a more ephemeral concept than it might appear from our everyday useage of its various concrete manifestations -- coins, currency, checks, wire transfers, credit cards, etc. Really, whatever is accepted as money is money. If a 6-year-old kid started issuing pieces of paper with "redeemable for 1 gram of gold" scribbled on them, and people accepted them as a medium of exchange, then the scripts would be serving in the capacity of "money" even if the gold was entirely fictitious.
Under a central bank administered regime, most "money" moves into circulation by first appearing as a balance in a bank account. The movements can be obfuscated but, absent Ben Bernanke making good on his threat of dropping currency from helicopters, that is the long and short of the mechanics of the engine. During the credit bubble of this decade, in ways that are not entirely clear to us, the toxic alphabet soup of debt-backed assets (CDOs, SIVs, etc.) originated by Wall Street and money center banks became accepted as a "money".
Doug Nolan, editor of PrudentBear.com's Credit Bubble Bulletin, has been tracking the rise and now fall of the effective monetization of these Wall Street assets -- dubbing the rise part "Wall Street alchemy". Now the fool's gold is turning back into lead. Once the Soviets had repelled the German invasion during World War II, their counter-advance did not stop at the the USSR border but went deep into Germany itself. The question is now is whether the unwinding of "Wall Street alchemy" will stop with the dodgy assets or reach deeper into the core of the monetary system itself, i.e., the banks and supporting government agencies. Nolan sees signs that exactly this is happening.
There have been several key Credit Bubble Bulletin themes for early 2008. (1) Expect credit problem-associated economic weakness to gain momentum. (2) We are witnessing the evolving "breakdown of Wall Street alchemy." (3) Watch for especially atypical Federal Reserve-induced "reflation" dynamics. (4) The year will likely mark the bursting of the "leveraged speculating community" bubble. (5) The unfolding credit crisis will become especially problematic as it converges toward our system's functional "money" supply -- the anchor of our monetary system. This week saw important confirmations with respect to all of the above.
Economic weakness related to faltering availability of credit and marketplace liquidity has been especially prominent in the data of late. This week was no exception. The February reading for the Philadelphia Fed index sank to the lowest level since February 2001. January Housing Starts were reported near the weakest levels since the early '90s recession, while early February auto sales are said to the running 16% below last year's level. ...
Despite the faltering U.S. economy, pricing pressures are accelerating -- a dynamic I have heard referred to as the "new conundrum." January consumer prices were up 4.3% y-o-y. Major commodity price indexes surged to yet new record highs and, if anything, inflationary pressures are broadening. I have suggested that this "reflation" will have consequences divergent from those of the past. With the historic bubble in "Wall Street finance" now bursting, the powerful monetary mechanism linking Fed rate cuts directly to asset price inflation (in particular, real estate, risky debt, and stocks) has been severely impaired if not completely severed. The link between U.S. interest rates, dollar devaluation, faltering confidence in currencies in general, and inflating commodities prices has never been stronger.
During the 2001-2003 "reflation", hedge fund managers were quoted as saying "the Fed wanted me to buy stocks and junk bonds." Today, the Fed would surely hope to send a similar message, while the sophisticated interpret things altogether differently. Today, investors and speculators alike are much keener to buy precious metals, energy, and commodities. And while the U.S. economy is succumbing to powerful recessionary forces, it is no longer the sole global engine of (credit and economic) growth.
It is worth repeating that global credit expansion remains brisk, while bubble dynamics and economic growth remain in place throughout Asia, the Middle East and in the "emerging economies," especially for the powerful boom in Bric countries (Brazil, Russia, India and China). In concert with the bursting of the Wall Street bubble, global inflationary dynamics now strongly favor "things" as opposed to securities. In particular, necessities and stores of value available in relatively limited supply are seeing extraordinary inflationary effects.
Here we see one of the key dynamics (monetary processes) differentiating the current "reflation" from those of the past: Previous "Wall Street finance"-dominated inflationary booms enveloped the securities markets, where the supply of stocks and bonds could be readily expanded to meet booming demand. Today, the world is faced with a very challenging prospect of increasing the supply of crude, natural gas, ethanol, precious metals, industrial metals, wheat, soybeans, grains, coffee, cocoa, tea and literally scores of things now in great demand by end users, investors, and a bloated leveraged speculating community. Keep in mind that foreign official reserves have inflated $1.35 trillion over the past year -- and the U.S. is still on track for yet another year of massive current account deficits. Recognize also that the hedge fund and sovereign wealth fund communities have ballooned to the multi-trillions. U.S. deficits and resulting dollar devalulation continue to spur unwieldy bubbles in China, India, the Middle East and elsewhere.
The bottom line is the world remains awash in dollar liquidity that many are content to exchange for tangible things deemed of greater value than suspect U.S. financial assets. There is no inflation "conundrum," only increased supply constraints and bottlenecks, global hoarding, and an unambiguous speculative fever in markets for many of our economy's basic necessities.
This week provided confirmation of a worsening backdrop for the leveraged speculating community.
February 22 -- Bloomberg (Hamish Risk): "Mathematical models that traders use to calculate prices in the $2 trillion market for collateralized debt obligations don't work anymore, according to UBS AG." ... And the breakdown in models is anything but limited to CDOs and the banking community. Bloomberg today reported that AQR Capital Management, manager of $35 billion of assets, has suffered significant losses to begin the year. Its largest hedge fund is said to be down 15% already, with slightly larger losses for at least one of its smaller funds. This was not supposed to happen, and I will take this development as important confirmation that troubles that hit the "quant" fund community this past summer have worsened significantly so far this year.
August was a terrible month for model-based quantitative strategies, although most funds quickly recovered much of their losses as the markets stabilized in the fall. This time, however, I do not expect the environment to accommodate. Last summer's hope that the situation was a short-term aberration has been replaced with this year's reality of bursting bubbles, credit quagmires, model breakdowns, hopelessly crowded trades, acute marketplace illiquidity and, it would appear, highly problematic fund redemptions. Importantly, the game of leveraged speculation ... works wonderfully only for as long as the industry enjoys (as it had for years) robust inflows.
A steady flow of incoming funds for years ensured ample liquidity to build positions, press bets, increase leverage, and bolster the perception of endless marketplace liquidity, while working to boost industry returns (and overheated expectations). A reversal of flows -- especially when abrupt and significant in scope -- would pose quite a dilemma for individual funds, the industry overall, and the impaired U.S. credit system. It will be interesting to follow how the "quant" types respond to an environment of model breakdown, losses, redemptions, and forced position unwinds. I have a hunch they are not well "programmed" for such a radical change in the environment. We can only speculate at this point as to whether the industry is on the precipice of major redemptions. ...
What is being described here is in essence a Ponzi scheme. In this case the hook was liquidity rather than investment returns. In either case, maintaining the illusion requires a constant inflow of new money. (You could argue that the whole stock market has many of the characteristics of a Ponzi scheme, but we won't go there.)
DB Zwirn ... would provide an interesting case study in fund dynamics. At one point, it was a booming fund group with a stellar reputation, stellar returns, 15 offices worldwide and more than 1,000 employees. It is now suffering catastrophic unwinding, faced with the specter of huge redemptions and illiquid positions (including credit derivatives). Apparently some positions will take up to four years to unwind. Investors that believed they had the option to redeem their interests now confront the likelihood of significant losses and long delays in the return of their capital. I suspect this will be an increasingly common industry predicament.
Throughout the markets, this week provided further confirmation of serious liquidity constraints. The unfolding breakdown in Wall Street alchemy was underscored by further issues with SIVs and the auction-rate securities fiasco. Many individuals, funds, and corporations that believed they had invested in safe and liquid ("money"-like) "cash equivalents" now instead hold illiquid positions in long-term debt instruments of varying quality. ...
February 22 -- Dow Jones (Michael Rapoport): "No one knows for sure who the next Bristol-Myers Squibb Co. might be, but one thing's for sure: There's no shortage of candidates. Dozens of companies have warned of potential problems with their holdings of auction-rate securities, a survey by Dow Jones Newswires has found ... The market for these securities has seized up recently, prompting some companies that hold them, like Bristol-Myers, to write down their value. Beyond those dozens, other companies, including some big names, hold large amounts of these securities ... Without buyers, the securities aren't liquid. ..."
I have in past analysis suggested that the perceived soundness of U.S. corporate balance sheets was extending a "hook" for those of the bullish persuasion. It was, after all, egregious mortgage finance bubble excesses -- and resulting household and financial sector balance sheets loaded with debt -- that were responsible for booming corporate cash-flows and relatively stable balance sheets. Well, these days it is becoming increasingly apparent that a significant portion of corporate America's "cash" hoard is stuck in "auction-rate securities" and various other credit instruments -- today offering little in the way of actual liquidity. This is now a major unfolding issue.
Nolan has consistently noted that in a financial bubble the real goods and services sector gets so conflated with the financial sector that "fundamentals" becomes a nebulous concept. During the dot-com mania, orders from IPO-funny-money flush companies artificially bolstered the reported results of many an equipment producer. When the mania deflated, the IPO funding source disappeared and the results of the dot-com company suppliers fell out of bed. Booms and busts are as old as financial markets, but it seems to take the ability to create money and credit out thin air to create a mania-tail of sufficient magnitude to vigorously wag a whole economy-dog.
In normal times when finance keeps to its role as a lubricant for commerce, relating to company fundamentals as distinct from the machinations of the financial markets is a reasonable first approximation. But when finance becomes a large enough part of the economy to become an end in itself, which comes with the mania territory, that distinction loses its utility.
When bubbles grow to gargantuan proportions another effect enters: Companies engaged in regular commerce look away from their knitting and divert some of their energies to trading the tulip bulbs of the day. The treasurers' offices suddenly become "profit centers". During the 2000's credit mania, Nolan is speculating that more corporate managements than we think decided to invest their excess cash flows -- themselves artificially boosted by the bubble -- back into the credit instruments that fueled the bubble. The value of "cash" on those balance sheets, normally valued at 100 cents on the dollar, no questions asked, is now called into question.
Scores of companies, previously believing they enjoyed easy access to new finance, now face the inability to raise new funds at any cost. At the same time, many companies that thought they were sitting on piles of safe and liquid financial resources now recognize they may instead be facing big losses. Moreover, the recognition of problems on both the asset and liability side of corporate balance sheets comes concurrently with the realization that the so-called sound and resilient U.S. economy is in serious trouble. Simultaneously, confidence in "money" and money-raising is faltering, with negative ramifications for already liquidity-challenged markets and the already weakened real economy.
There is a confluence of factors behind this week's major widening in corporate spreads, especially in the "safest" sectors. Major indices of investment grade credit spreads blew out to record wide levels. ... GSE MBS spreads were this week's eye-opener. Fannie Mae benchmark MBS spreads surged another 17 bps to 192, the widest spreads in eight years. For perspective, this spread has averaged 76 bps since the end of 2002.
I will take the dramatic widening in investment grade and agency spreads as confirmation that the unfolding credit crisis has made a major leap toward the heart of the credit system. I have no way of knowing to what degree widening spreads are being dictated by "technical" hedging-related trading dynamics, as opposed to fundamental issues with respect to the faltering U.S. economy; rapidly deteriorating corporate balance sheets; a highly susceptible leveraged speculating community; the vulnerable GSEs; a distressingly illiquid credit market; and heightened systemic risk more generally. To be sure, a strong case can be made that the current backdrop is quite detrimental to a highly leveraged and speculative credit system.
YOUR MONEY AND YOUR BRAIN
Doug French reviews an interesting new book on investing, Your Money and Your Brain: How The New Science of Neuroeconomics Can Help Make You Rich. The "help make you rich part" really is more along the lines of rule #1 of making money: Don't lose it. (Rule #2 is always remember rule #1.) One of the ways to avoid losing money is to be aware of one's predispositions that would otherwise lead in that direction. This is where the book makes its major contribution ...
The days of defined pension plans are gone, unless you are a government worker. The rest of us are left to manage our own 401k's, IRA's and any other extra money that the government does not grab by overt taxation -- or the stealth variety of inflation. Unfortunately most people's brains are just not equipped for the task. Smart people make stupid financial decisions according to Jason Zweig, who takes us on a tour of the investor's brain in Your Money and Your Brain: How The New Science of Neuroeconomics Can Help Make You Rich.
Of course that "help make you rich" part is the kind of hyperbole that sells books and likely sends a dopamine rush to the brain of a book-buying investor. The brain has 100 billion neurons and only 0.001% produce dopamine, but "this minuscule neural minority wields enormous power over your investing decisions," cautions Zweig. One would think he would be more careful with the titling of Your Money and Your Brain.
Dopamine takes as little as 1/20 of second to reach your decision centers, estimating the value of an expected reward and more importantly propelling you to action to capture that reward. "We have evolved to be that way," explains psychologist Kent Berridge, "because passively knowing about the future is not good enough."
Of course the effect of all this is what Zweig refers to as "the prediction addiction." Humans hate randomness. We want to predict the unpredictable, which originates in the dopamine centers of the reflective brain, according to Zweig, leading humans to see patterns where none really exist. The whole technical analysis field that Wall Street embraces, is based upon the human desire to predict and when seeing two occurrences in repetition, people believe (or want to believe) that a trend is in process that, most importantly, they can profit from.
When Parkinson's disease patients are given drugs to allow their brains to be more receptive to dopamine, they have the insatiable urge to gamble. When these drugs are stopped, the gambling stops immediately. But unfortunately, when we get what we expect, no dopamine rush ensues. "A reward that matches expectations leaves your dopamine neurons in a kind of steady-state hum," writes Zweig, ... "[G]etting exactly what you expected is neurally unexciting."
So, like drug addicts, who need to take increasing amounts to get the same fix, investors must speculate in increasingly riskier investments to achieve the same dopamine kick. And unexpected gains really fire up the dopamine. Neurophysiologist Schultz explains that the "dopamine system is more interested in novel stimuli than familiar ones."
This, of course, explains a lot of risk-seeking behaviors outside of financial speculation.
Zweig also explores how humans are overconfident in their abilities. That our perceptions of investment risk are in a constant state of flux, depending on our memories of past experience, and most of our fears about finances are misdirected.
Okay, so to read Zweig, we are just a bunch of neurotic gambling junkies looking to get high from either playing slots, going to bingo night, or rolling the dice on penny stocks. What is a prudent person to do? You would be surprised. Sure, Zweig counsels us to put our money in mutual funds and forget about picking individual investments. But he goes further, stressing that we should try to find happiness. He says to breath deep to reach an inner calm, turn off the tube to stop envy, surprise someone with an unexpected gift raising both yours and the receivers dopamine levels, and try something new each week even if its just reading a different magazine to gain new perspective, are just some of Zweig's ideas. He also warns the elderly that aging makes us accentuate the positive and eliminate the negative, making old people susceptible to con-men, shysters and their get-rich-quick schemes.
Reading Zweig will not make you rich, but might help make you happy and keep you from going broke.
BUILDERS LOOK FOR THE BOTTOM
Peter Slatin, editor of the Forbes/Slatin Real Estate Report and theslatinreport.com tenders his informed opinion on whether it is time to start bottom-fishing for the home builder stocks. In a word: no -- with one possible exception, and one that would be a buy 10% lower.
Rate cuts and some somewhat relieving news about the economy (lower than expected job losses and an unexpected uptick in retail sales) have inspired investors to peer forward to the end of the housing crash. From a low on January 8 the SNL Financial index of 23 home-builder stocks is up 39%. Should you get on board? For the most part, no. This is a dead-cat bounce. With one or two exceptions I think you should wait a year before buying builder stocks.
The big builders, to be sure, have taken their medicine, and this is a good sign. Between them D.R. Horton (DHI) and Pulte Homes (PHM) have laid off 5,000 workers and written down their inventories of land and houses by $3.8 billion. Publicly traded companies build 80% of this country's single-family houses. The rest of the industry is in the hands of smaller outfits, ranging down in size to a carpenter putting up one speculative house. In this crowd reality has not yet settled in. When it does, you will see another round of price-cutting and another round of writeoffs.
Take a look at the auction market. A spec home can go to auction only if the auctioneer, the builder and the bank come to terms beforehand. The auctioneer wants to see a reserve price low enough that he knows the property will move. The bank is going to release its lien only if it knows that any shortfall between that price and the construction loan will be covered by the builder. The builder may be unwilling or unable to put more money into the investment.
Steven L. Good, chief executive of real estate auctioneer Sheldon Good & Co. in Chicago, tells me his company turns down 40% of smaller builders' requests to auction off their vacant houses. The standoff can continue only so long. At a certain point there will be Chapter 11 filings and sellers who are more motivated.
Home prices have definitely not hit bottom. The S&P/Case-Shiller national index of home prices was down 7.7% year-over-year to November 2007. But the inventory of existing homes for sale in the U.S. is up 13.2% from a year ago, to 3.9 million homes. Not all of the motivated sellers have been heard from.
Can the Federal Reserve save the day? Not easily. There is a limit to what it can do about long-term interest rates. The last cut in overnight rates, January 30, barely budged the rate on long-term Treasurys. People lending money for 30 years correctly perceive that an overnight stimulus from the Fed does not help them. It just means that they are going to be repaid with inflated dollars.
Then there is the congressional stimulus plan, which raises the limits on loans that Fannie Mae and Freddie Mac can handle. Before, the two were barred from buying or guaranteeing home loans larger than $417,000. The bill that was signed February 13 temporarily raises the ceiling to as much as $730,000, depending upon the locale. The point is to reduce interest rates for jumbo loans, which often are a full percentage point higher than smaller ones, and spur home sales. But with the market's low appetite for mortgage-backed securities (into which Fannie and Freddie package the loans they buy), the effect likely will be muted.
Meanwhile, home builders such as KB Home, D.R. Horton, Pulte Homes and Standard Pacific are in danger of breaching the covenants on their bonds because of their financial problems. That may well trigger ruinous requirements to repay investors the face value of the bonds, right away.
What passes for good news in the sector really is not. Beazer reported in late January that its inventory of unsold homes was down 37% year over year, owing not so much to sales as to a halt in building. Pulte Homes is still holding the line on prices despite mothballing 50 developments. It just recorded its first annual loss in its 58-year history. Debt- and land-laden Lennar is rumored to be an acquisition candidate. With some 190, often opaque, joint ventures on its balance sheet, though, that is unlikely. Most of these stocks will give back any recent gains. D.R. Horton and KB Home could fall between 20% and 30%.
Is any home builder worth buying? Washington, D.C.-focused NVR (580, NVR) has very little land -- a good thing -- and a long record of uninterrupted profitability, even in fraught 2007. If you want to buy now, get that one. Luxury home builder Toll Brothers (21, TOL) has pulled itself into a strong cash position. Toll management has been forthright in confronting its challenges, as when it faced up to a 33% slide in contracts signed for 2007's final quarter. It has pruned excess landholdings, and its operations in the New York City area (one of the few not yet suffering) remain relatively healthy. Toll expects further revenue drops -- 22% in the current quarter -- and I suspect the stock will drop another 10%. Buy it then.
TAKE A RISK
Contrarians buy debt when the headlines rail about a debt crisis. Like right now.
Michael Lewitt, cofounder of $1 billion Hegemony Capital, is turning bullish on selected slices of corporate debt. As with the junk bond debacle of 1989-90, the baby is getting thrown out with the bathwater. Lewitt finds interesting the senior level debt -- "junk" bank loans -- secured by assets, of companies not overly exposed to the U.S. consumer sector. Interesting idea, with an attractive contrarian element to it. But the expected returns do not sound that enticing in the instances cited, although we do not claim to understand what a reasonable risk-adjusted expected return for the asset class would be.
From his glass-walled office Michael Lewitt could see the trading floor was getting panicky: One trader fidgeted in his chair, another stared blankly at a stock ticker on the TV overhead, a third clutched his head. By the time the Dow Jones industrial average had fallen 300 points, the veteran fund manager had had enough. He grabbed a pair of dice from his desk, walked onto the floor and jokingly began rolling them. "Google," yelled Lewitt, 50. "Citigroup. Apple."
"You're making me anxious," a 23-year-old analyst burst out, not getting the point that he should calm down.
The market's gyrations can drive even the most dispassionate investors to distraction. So Lewitt has been busy lately reminding his traders to keep their cool -- and to buy into downturns. The cofounder of $1 billion Hegemony Capital of Boca Raton, Florida, once a big short-seller of corporate debt, is turning bullish.
His favorite target is in a once obscure corner of the securities market: floating-rate bank loans (also known as leveraged loans) to outfits also burdened with junk bond debt. Buyout funds used these loans to complete their deals. Leveraged loans are risky, yes, but well worth it, he thinks, with senior secured loans yielding a floating-rate 5.5% of par value and trading at 86 cents to the dollar, down from 101 cents only nine months ago. "I've never seen loans priced this cheaply -- ever," says Lewitt, who has been trafficking in dodgy debt since 1987, when he was an investment banker at the junk shrine of that age, Drexel Burnham Lambert.
Lewitt was once an aspiring scholar doing graduate work at Yale under the curmudgeonly Harold Bloom, whose celebrated book, The Western Canon, slammed faddish literary criticism. Lewitt, who left academia in 1982, writes an investment newsletter sprinkled with references to Ralph Waldo Emerson and Henry David Thoreau, and filled with contempt for investment fads.
The happy result of the credit crisis is that leveraged loans are getting interesting. Which ones? Broad swaths of the American economy not exposed to shaky consumers will do just fine in a recession, he says. So loans to big industrial companies with lots of exports, for instance, will come through the turmoil intact.
All leveraged loans have been trading down because of recession fears. Another factor is technical: selling by investors hit with subprime mortgage losses who need to raise cash fast. The loans are oversold, says Lewitt. He expects defaults on junk bank loans will peak at an annualized 3% rate near the end of the year, up from around 1% today. That is bad, but not bad enough to explain paper selling at a 14% discount to par. These loans, which are senior to bonds and secured by assets, are at the top of the totem pole in a Chapter 11 filing. Investors in such loans typically recover 70% of principal in a bankruptcy, versus 20% for junk bonds.
Individual investors cannot buy into the multimillion-dollar bank loans, but they can get exposure through mutual funds (see table). The 103 bank loan funds followed by mutual funds rater Morningstar are down in total return (price and interest) 7% this year through mid-February but rose 4% annually over the past five years.
Not all these funds are wonderful. Beware of hot hands. Some outperformed by buying the very diciest loans, like second liens (stuff that has made Lewitt bearish until recently). Or by using too much leverage. Example: Van Kampen Senior Loan.
Among the wisest of these players is Fidelity Floating Rate High Income, run by a junk bond analyst turned junk loan trader with a conservative bent. That has held back her performance in the past. But last year when prices began to fall, manager Christine McConnell returned 2.7% versus the industry's 1.1%, according to Morningstar. She began losing money this year. Recent yield: 6.9%. McConnell focuses on loans to big companies like Charter Communications and Georgia-Pacific sporting tight covenants (restrictions on things like debt-equity ratios). Another prudent fund: Eaton Vance Floating Rate, run by an 18-year loan-trading veteran, Scott Page. The fund has lost 3.1% this year but has averaged a 2.9% annual return over the last three years.
These returns do not sound like anything to write home about -- which may not detract from the case for buying the funds now.
Lewitt and his ilk are trolling through the leveraged-loan destruction with care. One intriguing victim: senior secured loans to HCA, a hospital operator with $26 billion in sales. The term B loans, issued when Kohlberg Kravis Roberts helped take it private in 2006, were to yield Libor -- the London Interbank Offered Rate, which is what the sturdiest big banks charge one another for loans -- plus 2.25 percentage points.
The Libor-plus formula computes now to interest of 5.25% (calculated on the par value). But the loans (rated B+) change hands at 91 cents on the dollar. So the effective yield, reflecting both the interest paid and the expected capital gain (if the bonds pay off in three years, as Lewitt expects), is more like 8%. Lewitt is adding to his HCA stake. HCA loans are Fidelity Floating Rate's largest holding.
Junk bank loans are not the only way to buy into risk. There are also junk bonds. Lewitt is wary of them for now, reasoning that their yields still are not fat enough to compensate for default risk. In January junk bond yields climbed one percentage point, to seven points over 10-year Treasurys. (The index showing this yield, Merrill Lynch U.S. High-Yield Master II, has a weighted average credit quality of B+.)
The eclectic-minded Bruce Fund has invested in junk bonds, some of it distressed, in the 25 years since Robert Bruce started the portfolio. The fund, which is on the Forbes Best Buys list, was down 5% last year but has returned an average 24% annually over five years. [Now that sounds interesting.] For a more conservative play on junk, consider T. Rowe Price High Yield. A Morningstar favorite, it has been beating its junk bond rivals of late. Now it is steering away from bonds exposed to consumer spending and, yes, piling into bank loans. The latter are 9% of its holdings.
There is plenty of cheap oil left – if you own the right refinery. Jim Gibbs is enjoying it while it lasts.
The oil refining stocks had a big runup earlier this decade as demand for petroleum products consistently exceeded refinery capacity for the first time since the 1970s. Especially benefiting were those refiners such as Valero Energy which had the capability of processing heavy, sulfur-laden crude stocks. Here is the story behind one of those refiners, Frontier Oil, who has benefited from an outage of a competing heavy oil refiner servicing the same territory. As with any capital intensive commodity producer, the good times will not last forever. We are warned that competing capacity will be arriving in force by 2012. Until then, cracking margins should be good.
When oil hit $100 a barrel in January Frontier Oil (FTO) was paying half that for much of the crude needed to feed its Wyoming and Kansas refineries. The oil, from producers in western Canada, is gooey, acidic and high in sulfur -- harder to refine than benchmark West Texas Intermediate (light, sweet) crude. Frontier's refineries are built tough, with stainless steel catalytic crackers and cokers that cook the crud into gasoline, diesel, jet fuel and $30 a barrel in profit.
This heavy, sour crude is plentiful, but not all refineries in the West and Midwest have innards strong enough to digest it. Without sufficient pipeline capacity to send it down to the megarefineries on the Gulf Coast, producers are beholden to a handful of regional buyers. One big buyer, BP's Whiting, Indiana refinery, was gobbling 170,000 barrels per day until a fire last March and a lightning strike in April knocked its heavy crude processors offline; they are still not back to full speed. Bad for BP, good for Frontier. Canadian heavy has historically sold at a 25% discount to WTI. From 2002 to 2007 Frontier bought 20,000 barrels a day for 30% off. Its current 50% discount off light, sweet crude was, until recently, unheard of.
James Gibbs, Frontier's chief, has no sympathy for Canadian producers that feel they are getting ripped off on the heavy crude his company buys, 50,000 barrels a day (just under a third of its total petroleum consumption). Gibbs, sipping cold beer on a warm winter day at his 13,000-acre South Texas ranch, says of these producers: "They might be crying in their beer right now, but even at these prices the producers are making very attractive rates of return." Just not as attractive as Frontier's. Last year it netted $500 million on revenue of $5 billion, giving rise to an industry-leading 49% return on capital.
For five years oil refiners have been coining money, as capacity fell just a little short of demand. Whatever the price of crude, the gasoline makers were able to tack on a fat refining spread. Frontier's profits peaked last May, when the fuels cooked out of each heavy, sour barrel at its Cheyenne, Wyoming plant sold for $75 more than the cost of the crude.
Helping enrich it were some outages at competitors. Most notably, BP's Whiting and Texas City plants were running at half capacity, as was Valero Energy's (VLO) McKee refinery in West Texas, keeping off the market some 500,000 barrels per day of fuels, about 3% of total U.S. demand.
Such good times were destined not to last. The broken refineries were gradually put back in order at the same time that a weak economy and high pump prices finally induced drivers to consume less. And crude costs climbed so fast that refiners could not push through price increases. In January the business got turned upside down. WTI crude traded above $100 at the same time that a barrel of gasoline fetched only $101 from wholesalers, not enough to cover operating costs. Refiners cut their runs of light crudes to stem losses. Frontier is no longer making the kind of money it was a year ago, but at least it is making money. It helps that Frontier's plants are near Midwest and Rockies states not close to the giant refining centers. ...
The company came close to doubling its size in 2003 after Gibbs agreed to acquire Holly Corp. (HOC), a Dallas refiner with plants in New Mexico and Utah, for $450 million. Their territories meshed perfectly. But the deal unraveled after [a] Beverly Hills oilfield, since sold, returned to haunt Gibbs. In March 2003 Tinseltown darling Erin Brockovich filed a mass toxic tort claiming that drilling on the field had created air contaminants that caused a cancer cluster among students, teachers and residents. ... Though Holly would still make a great partner, there is too much bad blood between the companies for a marriage, says Gibbs.
Frontier has $430 million in cash -- making it a tempting target itself. Its shares jumped 10% to $38 in mid-February on rumors that Valero Energy was mulling a takeover bid. Ridiculous, says a Frontier spokesman. Still, the wonder years will not last forever. "It's not going to be great after 2012," predicts Paul Rolniak of Energy Analysts International. By then many refiners will have expanded and upgraded to take not only heavy crude but also synthetic crude from Canada's oil sands.
Gibbs, 62, expects to survive the down cycle. "We're going to keep right on expanding," he says. "We will consistently be profitable when others aren't."
(GIMME SOME OF THAT OLD TIME) ROCK ‘N’ ROLL
Buy domestic U.S. classic stocks.
Forbes columnist Lisa Hess notes that as badly as U.S. stocks have performed this year, foreign markets have done a lot worse. Since she is finding what she deems values among the universe of U.S. large capitalization stocks, she is wading back in. We question some of her specific choices, but the basic idea is worth entertaining.
The S&P 500 started off the year with the index's worst January performance -- ever. But what is interesting is that foreign bourses did a lot worse. As of mid-February the S&P was down by 7%. The overseas exchanges were off by double digits, both in dollar terms and in their own currencies. Germany's DAX had fallen 14%, China's Hang Seng 17%, Japan's Nikkei 12%.
Bearish on the U.S. since last year, I am finally finding superb American companies at good prices. On a panel at the Columbia Business School's Value Investors conference recently, I said that for the first time in 10 years the U.S. market was more attractive than those in Asia or Europe. The reason: In a global downturn the biggest and most liquid stocks do the best. They are found in the largest abundance in the U.S. Further, the cheap dollar makes our stocks very attractive to offshore investors. ...
Investing styles, like music, change. In complete contrast to 2007, when companies with the highest percentage of foreign sales did the best, domestic exposure is what should be rewarded this year. Herewith, from my personal portfolio, five domestic stocks -- two nonbank lenders, one biotech, one brokerage company and one retailer -- that will only improve with time. They are like Led Zeppelin's 1971 classic, "Stairway to Heaven", perfect for your collection.
My first financial name is Fannie Mae (35, FNM), the mortgage giant. I can hear you screaming: Don't you know there is a depression in housing? Absolutely. But Fannie Mae and Freddie Mac (FRE) are the direct beneficiaries of the chaos, and Fannie is my preferred pick; it is bigger. Of course, its loan-loss reserves and realized losses will rise. Of course, mortgage volumes will slow.
Yet Fannie's market share should expand significantly as other mortgage lenders fall by the wayside. The new increase in loan limits that it can package into securities (to as much as $729,000 in California) is Congress's gift to its lobbyists. Fannie's guarantee fees have increased from 20 to 27 basis points, meaning the annual cost paid by the loan's servicer to Fannie Mae. At 1.1 times book value, a price/earnings ratio of 18 and a low stock price not seen since 1996, I am very happy to own this.
The second financial is Sallie Mae (23, SLM). In a country where education is the ticket to success, the nation's largest provider of government-guaranteed student loans has a good future. ... It was in the red for 2007. Sallie's new chief executive, Anthony Terriciano, has restructured the company and its finances, but the stock is still selling at a level last seen in 2000.
My biotech is Amgen (47, AMGN), the largest and maybe best company in its sector. To buy fine stocks at good prices, you typically must wait for them to stumble. Well, Amgen has stumbled. Two of the firm's largest-selling drugs, Aranesp and Epogen -- they account for just under 40% of sales, or $5.5 billion -- are under attack by federal regulators. The Food & Drug Administration is reviewing claims that the drugs, which fight anemia in cancer patients, may spur tumor growth.
The problem is already embedded in the stock price, off 32% from a year ago. Meanwhile, the market is grossly undervaluing Amgen's $3 billion in annual research and development. A potential blockbuster, Denosumab, used to treat bone density loss, is in late-stage trials. Another unnoticed advantage is that Amgen's genetically engineered drugs, its specialty, are hard to replicate as generics, once they go off patent.
Interactive Brokers Group (35, IBKR) is the world's largest market maker in options, thanks to its skill in using computer programs to price options and match buyers and sellers. While the stock is up 17% since its May public offering, Interactive (P/E: 19) is cheaper than other publicly traded exchanges. I will overlook that management controls 90% of the voting rights, using special Class B shares.
I am also investing in Target (54, TGT), the store with a glint in its eye and broad appeal to both bargain shoppers and style chasers. The stock, down 25% since its high last October, is a bargain as well (P/E: 16). The rap on retailing is that the consumer is supposedly retrenching. Nonsense. In America, when the going gets tough, the tough go shopping.
The question is whether Ms. Hess is falling into some value traps here, where the value is falling faster than the stock's price. Fannie Mae, e.g., is a leading financial stock that is even more leveraged that almost anyone else out there, whose principle assets are under pressure. Nobody really knows what is going on, as the accounting is suspect. We could go further, but the point is that there are lots of opportunities out there if you are inclined to buy, so why gamble?
Target may be cheap, but calling the theory that American consumer will retrench "nonsense" strikes us as fatuous. For a variety of reasons it looks inevitable. The only question is the extent. What will Target's earnings look like if consumers stop spending so much money they do not have? You want to at least have some idea there before jumping in.
Forbes columnist A. Gary Shilling has been bearish on the worldwide economy, and thus on commodities tied into the economic cycle, for quite some time. Now, he warns, it is time to close out your long positions if you still have them.
The long and deep recession I have been forecasting has commenced, even though the statisticians have not called it yet. It was triggered by the subprime mortgage market collapse, as predicted in my June 19, 2006 column. The zeal for high investment returns that was born in the dot-com mania of the late 1990s did not vanish in the 2000-02 stock market bust. It came back to life in the housing bubble. Now we are paying the price.
After the subprime market disintegrated, markets for asset-backed commercial paper and collateralized debt obligations followed. The resulting shortage of credit translates into a crimp in spending. The recession will also be propelled by an extraordinary retrenchment among consumers who were financing their spending sprees on home equity extraction. Refinancings and home equity lines of credit are drying up. House prices are down 10% from their October 2005 peak, and I look for another 16% drop to reach my long-held target of a 25% peak-to-trough slide.
The recession will continue at least until December. It will probably rank with the 1957-58 and 1973-75 declines, the worst of the 10 recessions since World War II. It will be global as exports sold to U.S. consumers shrink, thus slashing the primary growth source for the rest of the world. The decoupling theory said that emerging markets and other foreign economies can keep growing while the U.S. dips. The theory is about to be disproven.
My firm's analysis and my recent two-week trip to China convince me that China does not yet have a big enough middle class of free spenders to sustain growth in the face of weak exports. Define middle income as a family with at least $20,000 a year in the U.S. or $5,000 in China. By that definition 80% of Americans are in the middle or upper classes, but only 8% of Chinese and 5% of Indians.
Do not expect either the recent panicky cut in rates by the Federal Reserve or the hastily enacted tax rebates to save the economy. Interest rates are irrelevant when a scared lender withdraws amidst unknown and perhaps unknowable further writedowns and trading losses. Some of the rebate checks will be spent, but too late -- toward the end of the year when the recession likely will be bottoming. The rest will be saved by chastened consumers or used to reduce debt.
What to do? Sell or short commodities, perhaps via exchange-traded funds, stocks in companies that produce them or futures. Commodity prices, still high, are poised to fall hard as the worldwide recession takes hold.
Chinese demand, terrorism and talk of peak oil drove crude prices. Agricultural prices were hyped by biofuel's popularity, droughts and the prospect of a shift in demand in poorer countries from grain to meat. So institutional investors rushed into commodities, believing they are a relatively stable asset class like stocks and bonds. Individuals bought commodity-backed ETFs. That enthusiasm will soon be history.
With global recession, demand for industrial commodities and oil will fade. It will become clear that much of China's demand for commodities was not primarily to supply its citizens but to supply its export market.
No one will be talking anymore about how oil production is peaking. Look at Petrobras's huge oilfield discovery off Brazil and consider the gigantic energy supplies that will come from tar sands, nuclear, coal liquefaction and maybe shale. More supply equals lower prices. Good weather and weak ethanol prices may knock down ag prices. A recent report in Science magazine has discredited many biofuel schemes as environmental salvations. We are going to stop fueling our cars with taco ingredients.
My favorite commodity to bet against is copper. This is an excellent proxy for global industrial production since it is found in manufactured goods from cars to computers to faucets. The worldwide housing collapse makes copper prices especially vulnerable, as does the shift from copper tubing to plastics in plumbing. Copper's price on the New York Commodities Exchange was $1.90 two years ago. The Comex March 2008 futures contract is $3.56.
Unlike oil, copper has no cartel to prop it up. Because the metal is produced in developed countries and relatively safe emerging lands, no sudden shortage -- as we have seen with rioting in Nigeria's oil-producing area -- will suddenly tighten supplies and spike prices. ... Other industrial commodities are interesting on the downside, too, but copper is my best choice for a swoon.
Left unaddressed is what Shilling thinks about the monetary commodities gold and, to some extent, silver. If central banks succeed in preventing a credit contraction, but banks are unwilling to lend out funds to all the old outlets -- financial assets in their various and sundry manifestations -- will the price of commodities such as gold benefit?
BANKING WITH BUFFETT
Financial stocks have taken a major hit since they topped out early last year. They were the leaders during the preceding stocks bull market, their shares showed excessive valuations concomitant with a bubbly market, and industry managerial practices indicated they had confused brains with a bull market. Given this, normally you would not want to go bottom fishing after the first 20-30% price decline. There is usually more to come.
However, Warren Buffet has been adding to his position in U.S. Bancorp (USB), which looks reasonably priced if current the earnings level hold. It also sports a nice 5%+ yield. Moreover, the bank claims it does not have much in the way of subprime exposure. If that is true, and if that bespeaks a conservative lending culture that has kept them out of other troubled credit areas -- existing and prospective -- then Buffet's interest is understandable. The stock market has certainly treated it nicely compared to its regional bank peers, as shown here.
Jack Adamo, editor of InsidersPlus newsletter, recommends buying shares of Minneapolis-based U.S. Bancorp, the holding company for U.S. Bank, a large commercial and retail bank focused on the Midwest but with 2,518 branches in 24 states nationwide. Adamo selects stocks on fundamental grounds, paying particular attention to insider buying and selling. He also takes into account macroeconomic conditions in assessing a company's value, and whether quality assets may be out of favor temporarily.
He also looks at what the smartest investors are doing. "One of the few people whose work I trust as much as my own is Warren Buffett," says Adamo. "Last week's SEC filings show that Berkshire-Hathaway bought more U.S. Bancorp over the last few months."
Adamo also notes that the stock has been behaving very well in contrast to shares of most financial firms during the maelstrom in the credit markets. "The market is finally starting to believe what the company says about having little subprime exposure," he says. "The 5.2% current dividend yield doesn't hurt either," he adds, noting the bank's strong long-term growth record and steady dividend increases along the way. ...
[A]t $32.70 per share, U.S. Bancorp trades for 13.5 times trailing 12 months' EPS of $2.42. Shares are down 11.7% in the past 12 months but far less bloodied than some larger banks like Citigroup, which is down more than 50% from its high. Adamo calls U.S. Bancorp a "buy" up to $35. "Income investors should take a double position equal to 10% of their income portfolio," he says.
Gary North has previously written about how while everyone thinks the Federal Reserve is in super-inflation mode that the statistics reveal the opposite to be the case. Here he once again with more from where that came from, telling us the Fed is actually deflating.
You have read about the turmoil in international capital markets. It began on August 11. Highly rated packages of mortgages suddenly became unsalable. Their value went into free fall. Banks and brokerage firms have lost well over $150 billion since August. Northern Rock, Great Britain's 5th-largest bank, was nationalized on Sunday, February 17. Otherwise, it would have gone bankrupt on Monday. UBS, the huge Swiss bank, has lost about $10 billion. "Round and round it goes. Where it stops, nobody knows."
The Federal Reserved in mid-August immediately intervened in a series of actions to liquify the American banking system. You have probably read about this, too. The Fed's discount window started taking subprime mortgages as collateral for loans to the banks applying for loans. You have read the headlines about the Federal Reserve's new policy of inflation to solve the credit crisis.
I ask you bluntly: "Have you reallocated your investments so as to hedge against the Fed's wave of fiat money?" Be honest. Have you? I hope not. Why? Because the reports are all wrong. I do not mean a teeny-weeny bit wrong. I mean completely wrong. The Fed has not been inflating. The Fed has been deflating.
Hard to believe? It surely is. I find it difficult to believe myself. I had thought the Fed would inflate ("Reality Check," August 28). So did everyone else. But the data are clear. The Fed has shrunk the money supply since mid-August, 2007. In support of this, I offer evidence from the FED itself. I have assembled the data and the charts. Click the link.
The Fed can reverse itself at any time. What it has been doing is not set in concrete. At some point, the Fed will reverse its current tight-money stance. But until it does, I suggest that you do not "fight the tape." The FED is not printing money to save the economy. It is doing the exact opposite. It is burning money, conceptually speaking.
What is going on here?
Jesus said, regarding charity, do not let one hand know what the other is doing. Bernanke is applying this principle to credit creation. On the one hand, the Fed is making loans to banks based on dodgy collateral. On the other hand, it is selling high-quality credit instruments, primarily Treasury debt. I see no other explanation that is consistent with the data: liquidity for banks coupled with falling monetary base and falling M1.
Why would the FED adopt such a policy? Because it has to choose between two competing goals. Rarely is this the case, but it is today.
First, save the banks. Central banking is the fractional reserve commercial banking system's ace in the hole. The Fed is the lender and therefore stabilizer of last resort. It has only two tools, says Franklin Sanders: fiat money and blarney. These days, it is relying exclusively on blarney.
Second, save the dollar. The Fed receives its monopoly over the money supply from the U.S. government. ... The government expects the FED to maintain a market for the government's debt. In the past, this has meant that the Fed must buy Treasury debt whenever private investors have refused to buy it at interest rates that the Treasury is willing to pay. The Fed has intervened to buy this debt, especially in wartime.
Some people think the Fed holds most of the U.S. government's debt. This is incorrect. ... American investment funds and foreign investors are, especially foreign central banks. The Federal Reserve must now take into consideration foreign demand for Treasury debt. If the rate of interest on Federal debt falls, due to fear over a recession -- the "flight to safety" -- the Fed has a problem. If foreign governments offer higher rates of return than the Treasury, foreign capital may flow into these debt markets. The possibility of a flight from the dollar by foreign central banks and investors becomes a threat.
This would undermine the dollar's position as the world's reserve currency. It is this unique position that has allowed the government to sell its debt to foreigners and inflate at the same time, sticking the buyers with currency losses. It has allowed the Fed to print currency, which is sent home by immigrants living in the United States. This money remains abroad. So, the money is not spent here. It does not drive up prices. This is called "exporting inflation." It does in fact operate with exported currency.
The Fed can inflate in order to forestall a looming recession, or at least mitigate its effects. It can create money. This has the effect of lowering the Federal Funds rate -- the rate at which American banks lend to each other overnight. It can also lend through the discount window, quietly, to keep rumors from spreading about a bank's trouble. It can also lend through a newly created program, the Term Auction Facility (TAF).
The effect of these policies, unless offset by the sale of Treasury debt by the Fed, is to lower interest rates. Lower interest rates send a signal to foreign central banks and investors: more fiat money, higher prices, lower value of the dollar. This message is risky during a period in which there has been a slow but steady shift out of the dollar. The dollar has been falling in value internationally for five years. There is a move away from the dollar as the international reserve currency. It is not a mad dash for the exits by any means. For as long as the commodity futures markets and financial markets are denominated in dollars, the dollar's role will remain strong. But the preliminary signs of a move away from the dollar are becoming obvious.
The Fed normally would have lowered the FedFunds target rate by expanding its holdings of Treasury debt. The monetary base would have risen. M1 would have risen. But both have fallen since mid-August. Something is restraining the Fed. Some concern is keeping the Fed from countering an international credit crunch with a monetary policy to increase liquidity.
The standard effect of such a policy is a reduction in the FedFunds rate. That rate has fallen. But it has not fallen as far as the 90-day T-bill rate has fallen. The T-bill rate went under 2% for one day on January 31 -- a full percentage point below the FedFunds rate. It is now in the 2.2% range, not quite a percentage point below the FedFunds rate. This took place during a period in which the adjusted monetary base declined.
The common interpretation given to this fall in the FedFunds rate has been "Federal Reserve inflation." This interpretation is incorrect. There have been ups and downs in the monetary base since mid-August, but the general trend has been down by 0.4% at an annual rate. This has been a major surprise to me. It has yet to become a surprise to the financial media, which have ignored this unforeseen and unexpected policy.
Bernanke has come, slowly and not surely, to a forecast bordering on "recession ahead." His words are guarded, but we can see a shift in perspective over the last seven months. He dismissed the suggestion before August. He does not dismiss it today. ... He also warned about rising oil prices as part of the "inflation front." This, of course, is economic nonsense. Rising oil prices do not cause price inflation. If oil prices rise, then consumers must cut back elsewhere in their budgets. Cost-plus inflation is a fallacious idea based on ancient fallacies that should have died off after the rise of modern economic theory in the 1870's. But it is still popular, even at Princeton University, I guess. ...
The Fed is still taking appropriate actions against inflation expectations. It is deflating. But Bernanke will not admit this. He continued to provide the standard central banking party line to the Senate. "In the area of monetary policy, the Federal Open Market Committee has moved aggressively ..." He refused to say exactly what the Fed did that was aggressive. Reducing the money supply is not what most people envision when they hear a FED Chairman speak of moving aggressively. The Fed cut the target FedFunds rate. Well, not exactly. The FOMC announced a cut at a time when the T-bill rate was falling. In fact, the Fed was playing catch-up with the T-bill rate. ...
The threat of price inflation is being dealt with properly by the Fed's monetary policy. The FED is contracting the money supply. That is going to put downward pressure on prices. Note: listed prices are not the same as "have I got a deal for you" prices.
Housing prices are headed lower -- much lower in the bubble regions. The Fed's policy is guaranteeing this. Bernanke was wise to admit this possibility. ...
The bullish stance of American investors is being hit hard by a falling stock market and falling real estate prices. The hope of most investors who are long -- and most are long -- is that the Fed will intervene on the side of the bulls. In fact, the Fed has been intervening on the side of the bears.
Because this is so far out of character, the media are blind to the data. They listen to Bernanke's assurances of aggressive monetary policy and think, "stimulus." He even says this magic word. Do what Nixon's Attorney General John Mitchell once said: "Watch what we do, not what we say." They did, and he went to jail.
Watch the statistics of what the FOMC has done, not what Bernanke says they have done. If you don't, you are in for a big surprise.
Certainly interesting, and it has a contrarian appeal that cannot be denied. The big question is whether the monetary base and M1 are the best measures of monetary policy. Total money and credit is some multiplier of these basic measures, and that multiplier could be rising even as those measures of money supply go nowhere. The multiplier could also be falling. In any case there are a lot of cross-currents at work here, so we do not consider Gary North's case an open-and-shut one. But the evidence cannot be dismissed either.
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