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HEWING TO HIGH-QUALITY JUNK
Winning fund manager still sees value in high-yield corporate bonds, even after an impressive run.
High-yield corporate bonds have had an impressive rally since early March. So is it time to get off the train? Not yet, says J. Matthew Philo, a veteran high-yield manager at MacKay Shields, an asset manager based in New York with about $30 billion under management.
While Philo, 49 years old, still sees value in this sector, he is focusing on the higher-quality end of the junk-bond spectrum. He and his colleagues are not convinced a sustained economic recovery is at hand, based on their analysis of individual companies. Philo’'s duties include subadvising the Mainstay High Yield Corporate Bond Fund [ticker: MHCAX], which has gained 15.2% this year – testament to the big rally in high-yield credits. Its 5- and 10-year annual returns are a more muted 2.64% and 4.34%, respectively. But the fund has bested 75% of its Morningstar peers over those periods. To learn more about what is going on in the high-yield market, Barron's caught up with Philo last week.
Barron’s: Let us start with your overview of high-yield investing.
Philo: The high-yield market got to its cheapest level ever in the middle of December. At that time, the Merrill Lynch High Yield Master II Index, which is a reasonable representation of the broad high-yield bond market, was at an average bond price of 55% of par. Its spread over Treasuries was a record 21.68 percentage points. As of May 1, that same index was at 71% of par, and the spread had narrowed to 13.36 percentage points. So value is still attractive for high yield, but it is in the midst of a powerful rally that began March 9, along with the rally in equities. In terms of dollars, the high-yield index is up about 20% since the rally began. That is a powerful move that has accelerated somewhat recently.
High-yield investing is not for everyone, particularly not individual investors. Could you talk about the risks?
It is important to understand that in high yield, any new issue at par has asymmetric risk reward. Because we are investing in bonds, not stocks, our upside is capped.
If you buy a bond at par, or 100, and it gets tendered for a small premium to Treasuries, which is a high-yield home run, you can think about 20% or 25% of upside. Conversely, if a high-yield bond defaults, it has historically traded down to 40% of par – although in the current environment, it is much lower than that.
We think recoveries from defaults during this high-default cycle will be at record lows. So you can think of about as much as 90% downside from par when you make a serious high-yield mistake. As a result, you quickly come to understand that high yield is all about risk control – and the primary enemies are defaults and the recovery level on defaults. We emphasize having a margin of safety, which we analyze by looking at asset coverage and free cash flow.
Explain those concepts, starting with asset coverage.
It is the real-world value of a company’s assets in a less-than-ideal environment, relative to a company’s fully drawn debt, including credit facilities and various covenants. For a margin of safety we are comfortable with, we want a company’s asset coverage to be two times debt, fully drawn. The inverse of asset coverage is loan-to-value. We want to feel that the real-world value of our assets is worth twice the debt for most of the companies in our portfolio. Sometimes, we will go to 1.5 times asset coverage, depending on the situation. The other metric that protects you against defaults is true free cash flow. That is cash from operations, minus what a company needs to reinvest in its business in order to keep that cash-flow stream intact.
How have cash flows been holding up?
There are not a lot of industries generating strong operating results. Right now, peak free cash flow in health care and cable TV are the exceptions. But most companies exposed to any meaningful cyclicality are not generating peak levels of free cash flow.
We also favor strategic companies, meaning companies with big market shares and barriers to entry. They are the companies whose assets people will line up to bid on in a restructuring. All of this boils down to controlling defaults and striving to have recoveries better than the market average.
How else do you go about generating returns?
We also look for bonds whose prices improve, as measured by tightening spreads, and we have three primary catalysts, one being whether a company has enough free cash flow to retire a significant amount of the debt over the next five years. Second, if a company intends to raise money below you in the capital structure, commonly through a public or private-equity offering, that is always an improving credit. The third catalyst is an operational turnaround that a company has begun to implement successfully.
You divide your investing universe up into four groups, from least risky to most risky. Talk about that a little.
We do not move from relative safety to relative risk unless we are being fully compensated or overcompensated for the additional default risk. And what defines safety or relative risk in high yield to us has nothing to do with the credit-rating agencies. It has to do with our measure of asset coverage and our judgment of the volatility of cash flow.
What is your overall take on the high-yield market in light of the recent rally?
We like the high-yield market, even after the recent rally, but it does not make sense to have a full weighting in the riskier part of that market. So we are underweight credit risk.
Why is that?
It is not clear to us that there is high confidence that an identifiable economic rebound is in the works. The jury is very much still out. What we ultimately care about is what we hear from the companies we talk to. Not only are we seeing soft operating results for companies with meaningful cyclicality – but we also are not hearing that they have any clear visibility on demand improvement in their markets. That makes us cautious on near-to-intermediate-term earnings prospects, and that is not the environment where you want to have a full weighting in the riskiest part of high yield.
And there are a couple of other factors, one being that the environment for restructuring unsecured debt is the worst it has been in modern history, in our opinion. In other words, it is easier for unsecured debt to get wiped in court proceedings.
Are you avoiding unsecured credits?
No, we own lots of unsecured credits, which are the largest segment of the high-yield market. What we are avoiding, though, are unsecured credits with a meaningful probability of default.
Where do you see the default rate going?
Default rates have picked up in the high-yield market, and we see that most likely heading to double-digit annualized rates for a year or two. The current trailing 12-month default rate is about 8%. So a spike in default rates is the bad news. The good news is that the market's valuation reflects that kind of default pain.
Besides the faltering economy and the lack of credit availability, why is the default rate going so high?
It is also the [leveraged buyouts] of the previous cycle, particularly the ones financed in 2006 and 2007. They will play a large role in future defaults, but they will be somewhat slow to default relative to historic norms, because the covenants were so lax on the financing. So a lot of those defaults may not occur until 2010.
Before we hear about a few individual companies, let's talk about your portfolio in terms of sectors.
We are avoiding consumer exposure in a lot of ways. We do not own any home builders. We are extremely underweight retail. We have just begun to buy one credit in the restaurant industry, and we have been sellers of some consumer-discretionary bets over the last few weeks, including gaming. There, we made a significant bet on gaming companies focused on markets other than Las Vegas, which we think is overbuilt. We felt that secondary [gaming] markets all over the country will hold up much better, and the bonds of those companies have reflected that.
What is your biggest sector weighting?
For some time, it has been health care, both service providers and medical-product companies. That was a bottom-up analysis, which includes how earnings will look in the near to intermediate term. In health care, we actually see positive operating momentum, which really separates this group from the average industry. And at the same time, valuation is attractive and remains attractive for a lot of those credits, relative to their default risk.
We have been modestly overweight in energy, with an emphasis on higher-quality credits within high yield – and, in general, we prefer natural gas over oil, although we do own both. We also have a modest overweighting in financials, mainly in areas like insurance brokerage and property-and-casualty insurance.
Let’s move on and talk about a few companies that look interesting to you.
One is Hanger Orthopedic , which is the largest operator of orthotic and prosthetic patient-care centers in the U.S. It is a public company [ticker: HGR]. They do manufacture and distribute, but they primarily service braces and artificial limbs. This business has very favorable demographics, and they have a recurring revenue component, as there is a replacement cycle for these products. The regulatory environment looks pretty favorable, and they have gotten price increases. On a net-debt basis, which is debt minus cash, it is 3.6 times leveraged. Its public enterprise value trades at 7.75 times EBITDA [earnings before interest, taxes, depreciation and amortization]. On an annual basis, the company generates 8% of its net debt in free cash.
Most important to us is that the 3.6 times leverage, in our judgment, represents two times asset coverage, and this company is a dependable free-cash-flow generator. When these bonds, which mature in June 2014, were issued, they yielded 10.25%. Now they are priced at 103 and yield 9.1%, which is 7.62 percentage points over [comparable] Treasuries. We consider it to be a solid Group II credit – in our language, middle-of-the-road risk, at two times asset coverage – but it does not have the lowest cash-flow volatility.
What is your next pick?
Another area of opportunity in high yield is what we call the crossover market. These are investment-grade credits that are trading like high-yield bonds or have been downgraded recently to below investment grade. That includes an issue by Tyson Foods [TSN] in Arkansas.
Where is the upside?
Tyson Foods is the world’s 2nd largest food-production company, with annual revenues of roughly $27 billion. It has a [very strong] market share in beef, chicken and pork. It also has a prepared-food business that is profitable and worth a lot. Beef is its largest business, and they had a 22% share of the U.S. market at the end of last year.
Tyson had weak years in 2007 and 2008, accounting for the downgrade of this particular issue to below investment grade. They faced a lot of pressure on commodity prices. Their chicken business was particularly weak, although that looks like it is turning the corner, and they have had some relief from corn prices.
Their largest competitor in the chicken business, Pilgrim’s Pride – which actually has a slightly larger market share – was a recent high-yield bankruptcy, and is shuttering some of its chicken production. That should create a better environment for Tyson. We are also encouraged that Tyson has improved its liquidity, in part, with a $274 million equity offering last September.
What about the issue you mentioned that is now trading like a junk bond?
These bonds, which mature in April 2016, had a coupon of 6.6%. But because of the downgrade, the coupon is now 7.85%. They are trading at 92 cents on the dollar, which is yielding 9.5% – or 6.73 percentage points over Treasuries. Their net debt is about $2.8 billion and the market cap is roughly $4 billion. Under the worst-case scenario, this year's EBITDA could come in at $600 million, which would mean a very modest cash burn. But we think they are on the road to recovery, and normalized cash flow is $1-billion-plus. Our view is that the asset coverage exceeds two times.
Let’s move on.
Another so-called crossover credit was issued by Harley Davidson [HOG], specifically its bonds that mature in June 2018 with a coupon of 6.8%. The bonds are now trading at 79 on the dollar. The yield is 10.4%, roughly 735 basis points over Treasuries.
What is to recommend this company?
Most people know Harley Davidson as the world’s leading heavyweight motorcycle manufacturer. They have a 50% market share in the U.S. And they have an independent-dealer network that is 82% exclusive to Harley Davidson, so it gives them a lot of control over the distribution channel. And they have taken care of liquidity needs very recently, including a one-year, $625 million credit facility.
So it sounds like Harley has enough cash on hand?
Yes, they do. We own bonds issued by the company's finance subsidiary, which is called Harley Davidson Financial Services. Unencumbered financial-subsidiary assets, primarily accounts receivable, are 120% of its unsecured debt, which is very high for a finance company.
Even if loan originations slow down a lot, a well-run finance company throws off a ton of free cash, and the credit performance has held up quite well. Our analysis is that it will continue to do so.
IF YOU BELIEVE BANKS ARE RECOVERING ...
... then I have a bridge in Brooklyn I would like to sell you.
Economics analyst James Quinn says the U.S. banking system in insolvent as a whole, and that all attempts to represent otherwise are a blatent lie: “President Obama and his cronies at Treasury and the Federal Reserve are trying to mislead the public regarding the health of our banking system. ... They are perpetrating the greatest fraud in the history of the world. The conspirators are Barack Obama, Timothy Geithner and the Treasury Department, Ben Bernanke and the Fed, Sheila Baer and the FDIC, and Barney Frank and the Democratic Congress. ... They have colluded to commit taxpayer funds to enrich bankers that brought down the financial system, without getting congressional approval.”
How about telling us what you really think, Mr. Quinn. No need to hold back.
The conspiracy theorists of the world believe the U.S. government faked the landing of Apollo 11 on the moon. They also believe 9/11 was an inside job, ordered by operatives within the government. The rationale of these acts was to distract the masses from the disastrous Vietnam War and the plummeting stock market, while escalating their control over the American people.
I believe I have uncovered the largest conspiracy in history. The government wants you to believe that banks are recovering, housing has bottomed, stimulus works, borrowing leads to prosperity and war leads to peace. President Obama and his cronies at Treasury and the Federal Reserve are trying to mislead the public regarding the health of our banking system. If you believe their spin on these issues, I have a structurally deficient bridge in Brooklyn I would like to sell you.
The government has something up its sleeve this time. They are perpetrating the greatest fraud in the history of the world. The conspirators are Barack Obama, Timothy Geithner and the Treasury Department, Ben Bernanke and the Fed, Sheila Baer and the FDIC, and Barney Frank and the Democratic Congress.
They have colluded to commit taxpayer funds to enrich bankers that brought down the financial system, without getting congressional approval. They have delayed foreclosures and have tried to artificially prop up the housing market. They have poured billions of stimulus pork into the states praying for some of it not to be wasted. They have confiscated billions in taxpayer funds, bestowed them on reckless banks and forced them to lend it to anyone with a pulse, again.
The outrage from the public during the Trouble Asset Relief Program (TARP) confiscation made it crystal clear to courageous congressmen they did not want to vote on something requiring fortitude and bravery again. They have outsourced their obligation to safeguard their citizen’s tax dollars to unelected bureaucrats at Treasury and the Federal Reserve. They have already sacrificed their obligation to declare war to the Presidential branch. What is the point of having a Congress?
Nothing up their sleeve
Barack Obama and his henchmen in Treasury and the Fed have chosen to play for time, pretend the banking system is solvent, and hope that the average American does not care. As long as the ATM still spits out $20 bills, everything is OK. The International Monetary Fund has estimated total credit write-downs of $4.1 trillion, with $2.7 trillion in U.S. institutions. McKinsey has concluded that there are still $2 trillion of toxic assets sitting on the books of U.S. banks. Economist Nouriel Roubini, who has been correct from the beginning, estimates total losses on loans made by U.S. financial firms and the fall in the market value of the assets they are holding will reach $3.6 trillion ($1.6 trillion for loans and $2 trillion for securities). The U.S. banks and broker dealers are exposed to half of this figure, or $1.8 trillion; the rest is borne by other financial institutions in the U.S. and abroad. With $2 trillion of write-offs to go, how could Treasury Secretary Geithner make the following statement to a Congressional panel late last month, “Currently, the vast majority of banks have more capital than they need to be considered well capitalized by their regulators.”? Is he lying or shading the truth? Does it matter?
The U.S. banking system is effectively insolvent, or at least the the “Too Big To Fail” boys are.
Roubini’s estimate of $1.8 trillion more losses for U.S. banks will cause a slight problem for the U.S. banking system. The entire U.S. banking system has only $1.4 trillion of capital. Therefore, the U.S. banking system is effectively insolvent. Mr. Geithner would contend that he was not lying. There are 8,500 banks in the United States. The top 19 banks control 45% of all the deposits in the country. These are the banks that are insolvent.
Mom & Pop Bank in Louisville, Kentucky, did not create toxic loan instruments that infected the worldwide economic system. The vast majority of the 8,500 banks in the country are in good shape. Citigroup, Bank of America, Wells Fargo and the other “Too Big To Fail” banks destroyed the economic system. The Fed, Treasury, and FDIC are already backstopping or supplying 70% of the entire banking system balance sheet. It is time to allow the well-run banks to take the deposits of the horribly run banks. The $1.8 billion of future losses do not include the commercial real estate losses, credit card losses and losses from the next wave of mortgage resets in 2010 that will wash over these banks.
Of course we all know that the “Too Big To Fail” banks all reported profits better than expected in recent weeks. CNBC said so. Let us examine these tremendous profits at one of the banks, Bank of America. It reported profits of $4.2 billion. This included: $1.9 billion came from the gain on sale of CCB shares; $2.2 billion came from marking to market adjustments of Merrill Lynch notes; and non-performing assets that were $25.7 billion compared to $7.8 billion one year ago, a 329% increase in one year. Without these convenient accounting adjustments, Bank of America would have lost money.
Andrew Ross Sorkin pointed out in a recent New York Times article: “With Goldman Sachs, the disappearing month of December did not quite disappear (it changed its reporting calendar, effectively erasing the impact of a $1.5 billion loss that month); JP Morgan Chase reported a dazzling profit partly because the price of its bonds dropped (theoretically, they could retire them and buy them back at a cheaper price; that is sort of like saying you are richer because the value of your home has dropped); Citigroup pulled the same trick.”
In other words, the first-quarter bank profits were faked. They were manufactured as a public relations effort to convince the country that the big banks are in fine shape.
If the banks are in such good shape, why has the government had to use taxpayer funds to rollout the two dozen rescue plans? And now we breathlessly await the results of the stress tests. The FSP (Financial Stability Plan for those not in the know) rolled out by Geithner was supposed to save our banking system. The plan was described by Treasury as:
Increased Transparency and Disclosure: Increased transparency will facilitate a more effective use of market discipline in financial markets. The Treasury Department will work with bank supervisors and the Securities and Exchange Commission and accounting standard setters in their efforts to improve public disclosure by banks. This effort will include measures to improve the disclosure of the exposures on bank balance sheets. In conducting these exercises, supervisors recognize the need not to adopt an overly conservative posture or take steps that could inappropriately constrain lending.
Coordinated, Accurate, and Realistic Assessment: All relevant financial regulators – the Federal Reserve, FDIC, OCC, and OTS – will work together in a coordinated way to bring more consistent, realistic and forward looking assessment of exposures on the balance sheet of financial institutions.
Forward Looking Assessment – Stress Test: A key component of the Capital Assistance Program is a forward looking comprehensive “stress test” that requires an assessment of whether major financial institutions have the capital necessary to continue lending and to absorb the potential losses that could result from a more severe decline in the economy than projected.
It is fascinating that in the first paragraph they specifically state they do not want to be overly conservative. Which of the top 19 banks in the country have run their businesses in an overly conservative manner in the last 10 years? Has the Federal Reserve been overly conservative in the last 10 years? Have the SEC and FDIC been overly conservative in the last 10 years? Have consumers, homebuilders, credit card companies and retailers been overly conservative for the last 10 years? If there was ever a time to be overly conservative, it is now.
It is also nice to know Treasury wants accuracy and better disclosure, but then twists the arm of the Financial Accounting Standards Board to relax mark-to-market rules, so banks can continue to lie about the value of “assets” on their books. They allow Goldman Sachs to bury the fact that they left December out of their financial results deep in their footnotes. Shockingly, Goldman lost $1.5 billion in December. They continue to allow banks to report one time gains as part of ongoing operations, but billions in losses that are recorded quarter after quarter are not from ongoing operations. The folks at CNBC report whatever the banks say, no questions asked.
This brings us to the stress tests for the 19 biggest banks in the land. The most stressful conditions are supposed to be 10% unemployment and a 20% further fall in home prices. That does not sound too stressful to me. Considering the government reported figures are a manipulated lie, we already have unemployment between 15% and 20% in the real world. A 20% further decline in home prices is a given. The Case Shiller futures index forecasts that the New York Metro area will fall by 31% by the end of 2010. The massive overhang of housing inventory, the coming onslaught of mortgage resets in 2010, and the millions of foreclosures in the pipeline guarantee at least 20% further downside in housing prices. I have a feeling these 19 banks are going to need to study a little harder for their test. Professor Geithner is giving them an open book take home exam and gave them the answers. They will still flunk.
William Black is a former senior bank regulator. He is currently an associate professor of economics and law at the University of Missouri. Mr. Black held a variety of senior regulatory positions during the S&L crisis. He managed investigations with teams of examiners reporting to him, redesigned how exams were conducted, and trained examiners. He calls the stress tests conducted on the 19 biggest banks in the country a complete sham. In his own words:
On Thursday, we will see how much transparency and disclosure the Treasury and Fed will provide regarding the not-so-stressful tests. Obama’s minions have been hinting that six banks have failed. Sheila Baer stated that the $110 billion left in the TARP kitty should be enough to cover the capital shortfalls. This is a lie.
- “You cannot conduct a meaningful stress test without reviewing (sampling) the underlying loan files and it seems likely that the purchasers of securitized instruments (not just mortgages) do not even have the loan file data. Moreover, loss ratios vary enormously depending on the issuer, so even a bank that originates (or has purchased a bank that originates) similar product cannot simply take its own loss rate and extrapolate it to the measure the risk on the value of securitized credit instruments.”
- “It is vastly more difficult to examine a bank that is engaged in accounting control fraud. You cannot rely on the bank’s books and records. It does not simply take more, far more [employees]. It takes examiners with experience, care, courage, and investigative instincts and abilities. Very few folks earning $60,000 are willing to get in the face of the CEO and CFO making $25 million annually and tell them that they are running a fraudulent bank and they are liars. FYI, this is one of the reasons why having ‘resident examiners’ never works.”
- “Examiners certainly cannot do the stress testing that Geithner describes or evaluate the reliability of a large bank’s proprietary stress test. If they were serious about constructing reliable stress tests, which they are not, you would require their analytics to be made public. You would have the industry fund independent investigations by rocket scientists chosen by a committee selected by the regulators of the soundness of the analytics. You would also have the industry fund competitions to rip them apart (a bit like we hire legit hackers to test security by trying to defeat it) and show where they produce absurd results. The concept that there are 100 examiners with these skills, suddenly freed up from all other duties, assigned to CONDUCT stress tests is a lie.”
As we saw previously, the U.S. banking system will need close to $1 trillion more capital to stay viable. If the Fed was so keen on disclosure and transparency, why has it not released the names of the banks that have borrowed from them, and the collateral provided for the loans? Because the Fed has taken worthless toxic paper onto their books and loaned newly printed dollars against the worthless paper. The taxpayers are on the hook.
Catastrophic to Awful! – The Banking Spin Cycle
There seems to be a patent unwillingness to admit to and confront the problems facing the industry.
Risk consultant and author (Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives) Satyajit Das administers some further well-deserved kickings to the banking industry while it is down. Clearly a big cover-up job is being admiminstered. Recent reported profits stem from Enron-style accounting. The banking system is insolvent. Full stop. End of story. Nothing else to see here folks ... move along. Until the problem is admitted there can be no talk of a cure.
The recent rally in equity markets – the largest for decades – was predicated, in part, on the improving fortune of banks.
Banks reported better than expected profits. U.S. banks seem likely to pass the “stress” test. Repayment of taxpayers’ funds by some institutions, at least, seemed imminent. Scrutiny suggests that the episode reflected Adlai Stevenson’s logic: “These are conclusions on which I base my facts.”
Banks beat “well managed” low-ball expectations. In the last quarter of 2008, publicly traded banks lost $52 billion. Despite a return to profitability for some institutions, in the first quarter of 2009, banks are still expected to lose around $34 billion. For example, UBS and Morgan Stanley recorded losses.
The quality of earnings was questionable. Core businesses declined 20% to 30%. Trading revenue, especially fixed income, rose sharply at most big banks, reflecting high volumes of bond issuance, especially investment grade corporate issues and government guaranteed bank debt.
Corporate issuance was the result of the continued tightening in credit availability as banks reduced balance sheet. The issuance of government guaranteed bank debt provided underwriters with a “double subsidy” – the government guaranteed the debt but then allowed the banks to earn generous fees from underwriting government guaranteed debt.
High volatility generated strong trading revenues. Key factors were increased client flows and increases in bid-offer spreads (by up to 300% in some products). High trading revenues also reflect principal position taking and trading. It will be interesting to see if trading revenues are sustainable.
Questions remain about the impact of payments by AIG to major banks including Goldman Sachs ($12.9 billion), Merrill Lynch ($6.8 billion), Bank of America ($5.2 billion), Citigroup ($2.3 billion) and Wachovia ($1.5 billion). Non-U.S. banks also received substantial payments including Société Générale ($12 billion), Deutsche Bank ($12 billion), Barclays ($8.5 billion) and UBS ($5 billion). Conspiracy theories notwithstanding, it seems likely that these were collateral amounts due to the counterparty or settlement of positions that were terminated. At a minimum, the banks benefited from a one-time increase in trading volume and, reflecting the distressed condition of AIG, larger than normal bid-offer spreads on these closeouts.
The banks also benefited from revaluing their own debt where credit spreads widened. The theory is that the bank could currently purchase the debt at a value lower than face values and retire it to recognize the gain. Unfortunately, banks are not in position to realize this “paper” gain and ultimately if the debt is repaid at maturity, then the “gain” disappears.
Earning also were helped by a series of one-time factors. Bank of America realized a large gain on the sale of its stake in China Construction Bank and also revalued some acquired assets as part of the closing of its Merrill Lynch acquisition. Goldman Sachs changed it balance date, reporting results to the end of March rather than February. Given that its last financials were for the year to the end of November 2008, Goldman separately reported a loss for December 2008. It is not clear how much Goldmans Sachs profit benefited from the change in the reporting dates.
Barclays Bank recently sold its iShares unit (a profitable unit which contributed around 50% of the earnings of Barclays Global Investors) to a private equity firm for $4.2 billion, allowing the bank to book a gain of $2.2 billion that boosted capital ratios. CVC Capital only paid $1.05 billion with the rest ($3.1 billion) being borrowed from Barclays itself. The loan was for 5 years and Barclays is required to keep the majority of the debt on balance sheet for at least 5 years. In effect, the gain and capital increase is lower than the cash received (in effect, Barclays is treating part of its loan as profit and capital!). In addition, senior executives of Barclays received substantial gains from the sale under a compensation scheme where Barclays Global employees received shares and options up to 10.3 % of the division’s equity.
Effects of changes in mark-to-market accounting standards, which arguably reflected political and industry pressure, are also not clear. New guidance permits banks to exclude losses deemed “temporary” and also allows significant subjectivity in valuing positions. This may improve the financial position and overstate both earnings and capital. Some commentators believe that the changes could increase earnings by up to 10% to 15% and capital by up to 20%.
The market ignored continuing increases in bad debts and provisions. After all, “that is so yesterday!” Further losses are likely in consumer lending (e.g., mortgages, credit cards and auto loans), corporate and commercial lending.
In recent years, it has become an article of accepted faith that corporate debt levels have fallen. In aggregate, that is perfectly true. However, the debt has become concentrated in a number of sectors – commercial property, merger financing, private equity/leveraged finance and infrastructure and resource financing.
The overall quality of debt has deteriorated significantly. In 2008, more than 70% of all rated debt was non-investment grade (“junk”). This is an increase from less than 30% in 1980 and around 50% in 1990. The debt is also heavily reliant on collateral; the loans are secured against financial assets (shares and property). Reduced ability to service the debt and falling collateral values may prove problematic. For example, the recent distressed sale of the John Hancock Tower produced about half the value paid a few years earlier.
In April 2009, the International Monetary Fund (IMF) estimated that banks and other financial institutions face aggregate losses of $4.1 trillion, an increase from $2.2 trillion in January 2009, and $1.4 trillion in October, 2008. Around $2.7 trillion of the losses are expected to be borne by banks. The IMF estimated that in the United States, banks had reported $510 billion in write-downs to date and face additional write-downs of $550 billion. Eurozone banks had reported $154 billion in write-downs and face a further $750 billion in losses. British banks had written down $110 billion and face an additional $200 billion in write-offs.
Banks may not be properly provisioned for these further write-downs. Recent accounting standards made it difficult for banks to dynamically provision, whereby banks provided in low-loss years for any eventual increase in loan losses when the economic cycle turns. Criticisms regarding income smoothing led to this practice being discontinued. Increasing bad debt will flow directly into bank earnings as credit losses increase as the real economy slows.
Banks may also face write-downs in intangible assets (goodwill or surplus on acquisition) and future income tax benefits. The values of businesses purchased in a more favorable environment will need to be progressively reassessed. The tax benefits of losses can only be carried as an asset where there is a reasonable prospect of utilization in the near future.
In one of his raves on TV, James Cramer, the notorious American commentator, referred to bank accounts as “fiction.” He referred to them as the work of Somerset Maugham, William Faulkner or Joseph Conrad. In reality, they are the works of lesser writers – “pulp fiction” or “romantic potboilers.”
The stress tests do not provide comfort regarding the health of the banks. As Nouriel Roubini, chairperson of RGE Monitor, has pointed out, the likely macro-economic environment is likely to be significantly worse than the adverse scenarios used. The Federal Reserve hinted that banks – even banks that passed the “stress test” – would be required to hold extra capital. This is puzzling as surely a bank is appropriately capitalized or it is not. Given that the test is the basis for setting solvency capital requirements, this is hardly reassuring or a guarantee that further taxpayer funded recapitalization of the banking system is not going to be needed.
The proposal floated by some banks to return taxpayer capital misses an essential point. The banks did not offer to waive the government/FDIC guarantees, which have allowed them to fund in the capital markets. The suspicion is that the proposal had more to do with avoiding close public scrutiny of compensation and hiring practices. Goldman’s compensation costs increased 18% in the first quarter while employee numbers were down around 7%, translating into a 27% increase in employee costs.
The reality is that the global economic system is deleveraging and levels of debt must be reduced. As result, asset values are declining and sustainable growth levels have fallen significantly. In this environment, banks are likely to continue to suffer losses on assets (bad debts and further write-offs) and earnings will remain sluggish (lower loan demand and lower levels of financial transactions). Higher funding costs and the need to raise capital compound the difficulties. For the banks currently: “On the liability side, some things are not right and on the asset side, nothing is left.”
Many major global bank shares are still, on average, trading at levels 70% to 90% below their highs. Following the collapse of the “bubble” economy, Japanese banks staged a number of significant recoveries in share price before falling sharply, necessitating government intervention to recapitalize and consolidate the banking system.
Analysis of recent financial performance does not also take into account the underlying favorable current dynamics of the banking industry. Banks are currently beneficiaries of very low and, in some cases, zero cost of deposits. Banks also benefit from a sharply upward sloping yield curve that allows them to generate significant earnings from borrowing short and lending long. Banks have also benefited from subsidies and support from governments, favorable changes in the fair value accounting treatment of securities, and sharply lower competition in most market segments. Adjusting for these factors, it is surprising that banks have not actually performed better.
The truth is that banks remain in the ICU (intensive care unit). Even after around $900 billion in new capital, the global banking system remains short of capital by $1 trillion to $2 trillion. This translates into an effective reduction in available credit of around 20% to 30% from previous levels. Bank earnings and balance sheets remain under pressure.
The financial system will need continued government support for some time to come, even though the performance of governments trying to rehabilitate the financial system has been problematic. In April 2009, Elizabeth Warren, chairperson of the Troubled Asset Relief Program (TARP) Oversight Panel, questioned the very approach to resolving the problems of the financial system: “Six months into the existence of TARP, evidence of success or failure is mixed. One key assumption that underlies Treasury’s Public-Private Investment Program (PPIP) approach is its belief that the system-wide deleveraging resulting from the decline in asset values” – thus leading to an accompanying drop in net wealth across the country – “is in large part the product of temporary liquidity constraints [that are a consequence of] non-functioning markets for troubled assets. On the other hand, it is possible that Treasury’s approach fails to acknowledge the depth of the current downturn and the degree to which the low valuation of troubled assets accurately reflects their worth.”
Two other panel members, New York State Superintendent of Banks Richard Neiman and former New Hampshire Senator John Sununun, issued dissenting findings, noting: “We are concerned that the prominence of alternate approaches presented in the report, particularly reorganization through nationalization, could incorrectly imply both that the banking system is insolvent and that the new administration does not have a workable plan.” Many would question the selection of the words “incorrectly imply.”
Constant changes in tack in the dealing with financial system problems do not suggest a consistent and well thought out strategy in dealing with the problem. Less than rigorous stress tests, using the PPIP to leverage FDIC funding into a lopsided subsidy for private investors or converting the preferred stock into shares to avoid having to seek additional congressional mandates also suggest political constraints in resolving the issues.
Evidence of political influence and a palpable lack of transparency in dealing with the problems are emerging. There are allegations that the Treasury may have “pushed” Bank of America to consummate its controversial acquisition of Merrill Lynch when it sought to withdraw after additional losses came to light. The Treasury secretary at the time, Henry Paulson, is alleged to have suggested that Bank of America’s management and board could be removed if it did not proceed. There are also suggestions that both the Treasury and Bank of America decided to avoid public disclosure of these events.
In his books The Logic of Collective Action and The Rise and Decline of Nations, American economist Mancur Olson speculated that small distributional coalitions tend to form over time in developed nations and influence policies in their favor through intensive, well-funded lobbying. The policies result in benefits for the coalitions and its members but large costs borne by the rest of population. Over time, the incentive structure means that more distributional coalitions accumulate, burdening and ultimately paralyzing the economic system, causing inevitable and irretrievable economic decline.
Government attempts to deal with the problems of the financial system, especially in the U.S., Great Britain and other countries, illustrates Olson’s thesis. Active well-funded lobbying efforts and “regulatory capture” is impeding necessary actions to make needed changes in the financial system. Urgent steps are necessary to accurately recognize losses on assets, remove toxic assets from balance sheets, recapitalize the banks and allow normal financial transactions to resume. If such actions are not taken then the broader economy and sustainable growth levels will be adversely affected. There seems to be a patent unwillingness to admit to and confront the problems facing the industry. Recognition of the problem is generally a prerequisite to working towards a solution.
Amusingly, Peter Hahn, a former managing director of CitiGroup and now a fellow at London’s Cass Business School, was reported by Bloomberg as saying: “When you look at the income numbers that have been put out by banks recently, they contain so much fudge and financial manipulation. You could say that the automobile industry has a clearer future at the moment.”
Banks have gone from catastrophic to just awful. By most standards, that condition does not constitute a necessary and sufficient condition for a recovery in the global economy.
THE DYNAMICALLY-HEDGED ECONOMY II
Credit Bubble Bulletin editor Doug Noland sees a “Government Finance Bubble” as the latest bubble driving the financial markets. He believes, or concedes, that the real economy may in turn be dragged up to some degree by the return of liquidity and securities market inflation.
The Government Finance Bubble features the wholesale transfer of risk from the private sector to the public sector as the U.S. government and Federal Reserve buy or otherwise guarantee just about every risky asset under the sun. So far, although there are signs this will not continue forever, the market has been willing to absorb all the government-related debt issued to cover this massive transfer. But surely at some point investors will note that in effect the quality of government debt has been dragged down to that of those being bailed out rather that the quality of the later raised to the government’s level. At this point the artificial and fleeting recovery will be revealed in all its fakery.
All attention this week was focused on the bank stress tests. Importantly, market perceptions have shifted dramatically to the view that banking system problems are manageable and that policymakers have found the right balance in their approach. The reported total capital shortfall was nowhere near as dire as, not long ago, many had feared. Indeed, several weeks back no one would have even contemplated Wells Fargo and Morgan Stanley on the same morning tapping the market for a combined $11 billion of common equity capital. And with markets having somewhat recovered – and even the impaired financial players having regained access to the capital markets – the marketplace has now largely taken the cataclysmic market “tail” risk scenario off the table. The equities VIX index dropped this week to the lowest level (31) since before the failure of Lehman, mirroring the ongoing collapse in credit spreads.
My obsession with the credit system began in the early ‘90s, as I studied the complex process of impaired banking system rejuvenation. Beginning early in that decade, innovation and rapid expansion propelled Wall Street finance into a major force of system credit creation. Securitizations, the GSEs, and derivatives markets in particular – contemporary Wall Street risk intermediation – combined to play a momentous role in system reliquefication/reflation. This was much to the delight of the traditional banks – first promoting their recovery and later spurring incredible growth in earnings, stock prices and compensation. This new credit system structure developed into the historic Wall Street finance and mortgage finance bubbles.
Today, myriad forms of government risk intermediation and market intervention are spurring system credit creation and reliquefication. I have labeled the most recent phase of risk intermediation distortions and credit excess the “Government Finance Bubble.” One will miss important dynamics by focusing on bank credit.
It is worth noting first quarter bond issuance data from the Securities Industry and Financial Markets Association (SIFMA). Total bond issuance (muni, Treasury, mortgage-related, corporate, agency, and ABS) jumped to $1.420 trillion during the period. This was a notable 71% increase from a dismal 4th quarter to the strongest issuance since Q2 2008 ($1.598 trillion). If the first quarter’s pace is maintained, total 2009 issuance of $5.680 trillion would trail only 2003 and 2007.
First quarter bond sales were actually up 3.2% from Q1 2008, led by a 60% y-o-y increase in Treasury issuance ($326.8 billion). On a quarter-over-quarter basis, Agency issuance was up 332% to $413.7 billion; Mortgage-Related issuance increased 69% to $364.8 billion; and Corporate issuance surged 188% to $215.1 billion. Exemplifying the scope of the unfolding Government Finance Bubble, Treasury and Agency debt issuance combined for an incredible $740.5 billion during the first quarter, up 59% y-o-y to a record annual pace of $2.962 trillion.
This morning Fannie Mae reported a worse-than-expected first quarter loss of $23.2 billion. In just three quarters, Fannie has reported losses totaling $77.4 billion. No worries, however. Fannie’s debt spreads this week tightened another 12 to 31 basis points (down from November’s 159 bps) and Fannie MBS spreads narrowed an additional 9 to 83 (down from November’s 232 bps). Despite unprecedented losses and massive capital shortfalls, the GSEs have nonetheless become major players in the unfolding Government Finance Bubble. An insolvent Fannie requested an additional $19 billion of government assistance this morning.
Today from Fannie: “In March, Fannie Mae provided $93.3 billion in liquidity to the market through Net Retained Commitments of $5.4 billion and $87.8 billion in MBS Issuance ... March refinance volume increased to $77 billion, nearly twice the refinancing volume reported in February and our largest refinance month since 2003. We expect that our refinance volumes will remain above historical norms in the near future ... Fannie Mae began accepting deliveries of refinance mortgage originations under the Making Home Affordable program in April 2009.”
Fannie’s “Book of Business” (retained mortgages and MBS guarantees) expanded at a 12.3% rate during March to $3.144 trillion (largest increase since February 2008). Fannie MBS guarantees grew at a 15.4% annualized pace during March to $2.640 trillion. The $31.4 billion increase in guarantees was the largest in 13 months. The company’s “New Business Acquisitions” jumped to $92.8 billion from February’s $53.8 billion and January’s $28.8 billion.
The wholesale transfer of various private sector risks to “Washington” is a key facet of the Government Finance Bubble.
The current wave of mortgage refinancings is the strongest since the powerful – and system reliquefying – 2002/3 refi boom. The few analysts that even care are generally discounting the systematic impact of refinancings. They argue that there is today dramatically less equity available to extract and spend. From an economic perspective, I do not have a big issue with this analysis. But from a systemic risk perspective, the unfolding refi boom is anything but inconsequential.
By the end of the year, I would not be surprised to see upwards of $1.0 trillion of “private” mortgage exposure having been shifted to the various government-related agencies (Fannie, Freddie, Ginnie, FHA, and FHLB). The wholesale transfer of various private sector risks to “Washington” is a key facet of the Government Finance Bubble. Nowhere is such redistribution accomplished as effectively and surreptitiously as when the mortgage marketplace is incited to refinance by (Fed-induced) collapsing yields. Think in terms of our government placing its stamp of guarantee on hundreds of billions of risky, illiquid and unappealing mortgage securities – transforming them into coveted “money”-like agency securities. Such dynamics work wonders. ... Previous holders of these mortgages receive cash, while the entire marketplace benefits from higher mortgage/MBS prices.
Some years back I titled a Bulletin “The Dynamically-Hedged Economy.” The gist of the analysis was that the Financial Sphere was the driving force for the Economic Sphere – and not vice-versa. Derivatives and leveraged speculation “ruled the world.” Credit system and speculative bubble dynamics had nurtured powerful and self-reinforcing dynamics. A financial sector embracing risk and leverage was spurring liquidity excess, higher asset prices, a more robust economic expansion, buoyant confidence, animal spirits, and an only greater degree of self-reinforcing credit and speculative excess.
As we witnessed last autumn, an abrupt reversal of these dynamics fomented system illiquidity and near systemic breakdown. Selling begat more selling – especially from the expansive derivatives marketplace. There was absolutely no way that system liquidity could absorb the combined selling pressure associated with speculative deleveraging and the hedging (and associated “dynamic” trend-following selling) of systemic risks.
The system is again rocked by yet another bubble-related convulsion: These days, it is the self-reinforcing unwind of bearish bets and systemic risk hedges. Washington’s unprecedented measures to intermediate risk and boost marketplace liquidity have spurred a self-reinforcing wave of bearish position liquidations and a reversal of hedging strategies. This dynamic has had a major impact in the credit, equities and, seemingly, more recently in the currency and commodities markets. I would add that this unwinding process tends to generate liquidity throughout the marketplace. And, let’s face it, there is nothing like a big short squeeze to get the animal spirits flowing on the long side. Most will interpret these dynamics bullishly. I would caution that we are witnessing only the latest variant of Acute Monetary Disorder and destabilized markets.
The more bearish analysts argue that current economic underpinnings do not support surging stock and debt prices. Of course they don’t, but that is not really the key issue. Rather, the question is whether the return of liquidity and securities market inflation will stoke sufficient confidence (from both spenders and lenders) to spur sustainable economic recovery. Here I must lean heavily on my analytical framework.
In the short-run, I have to presume that major financial sector and market developments will work to stimulate the real economy (as they have repeatedly in the past). At the same time, it is my view that the economy today is unusually susceptible to an artificial and fleeting recovery. The unwind of bearish hedges will at some point have run its course, concluding a period of major artificial liquidity generation. Moreover, I question the sustainability of the Government Finance Bubble (fiscal and monetary) overall.
The markets are setting themselves up for disappointment. I would posit that the more energized the markets and economy the greater the amount of credit issuance that will need to be absorbed by the markets (debt and currency). So far, it is mainly Treasury yields that are rising. Government Finance Bubble dynamics would seem to dictate, however, that agency debt and MBS yields could provide the key to both artificial economic recovery and inevitable disappointment. And I would not expect a sinking dollar to support the markets for agency securities or Treasuries.
THE WRECK OF MODERN FINANCE
What has been enormously profitable for the financial services sector has proved pretty well disastrous for the global economy as a whole.
Martin Hutchinson delivers an entertaining “the prosecution rests its case” summary evisceration of modern finance theory. The problem with the body of theory is that it is, well, wrong. Where? Pretty much from top to bottom, as Hutchinson goes over in detail.
This would all be pretentious but harmless academic folderal but for the fact that, in a nonfictional analog to Dr. Frankenstein and his creation, modern finance’s ideas have been brought to life, and become thoroughly incorporated into real live financial markets over the last 35 or so years. The consequences will feel more familiar to Mary Shelley’s readers than Mel Brooks’s viewers. Everything worked out just fine for the financial services industry and its coterie of consultants, service providers, etc., and for Doug Noland’s leveraged speculators (see piece immediately above). Everyone else got trashed, with a potentially catastrophic denouement still in the offing.
Over the last 30 years, the capital markets have been restructured through the tenets of modern finance in its various forms, which together have gained six Nobel Prizes (Modigliani, Sharpe, Markowitz, Miller, Merton, Scholes) and might have generated a couple more (Fama and Black.) This has been enormously profitable for the financial services sector, which has doubled its share of U.S. economic output. As we are only now coming to see, it has proved pretty well disastrous for the global economy as a whole.
The most fundamental error of the modern financial edifice was its assumption of randomness in market movements, without a true understanding of the conditions necessary for randomness to hold. The laws of probability and the idea of randomness were generated by the 17th century French mathematician Blaise Pascal, who used them to help in winning card games, roulette and other activities in which tiny physical variations cause a discrete change in results. Since tiny physical variations are themselves unpredictable, their results are truly random.
This true randomness almost never holds for economic activities. Some of them are governed by complex underlying equations, impossible for mediocre mathematicians to solve, which produce pseudo-random “chaotic” behavior, in which prices or other variables appear to move randomly but are in reality mostly determinate. The interaction between economic variables is partly random (itself partly caused by inadequacies in our ability to measure economic quantities quickly) and partly determined by these kinds of complex non-linearities.
Other economic variables are also not random, and may not be governed by discoverable laws; they are simply unknown. Next year’s Gross Domestic Product, for example, is theoretically determinable from factors we could already know (plus a few random elements). But it is mostly not random. We simply do not know what it will be.
Pretending that deterministic (but chaotic) quantities or unknown quantities are random is a huge category error. If such quantities are not random, they will not obey the laws of randomness. In particular calculations that depend on the properties of randomness, such as Monte Carlo simulation, the Value at Risk methodology or the Black-Scholes options model will be quite simply wrong, often very badly wrong.
For non-random quantities, one of the most important properties of truly random quantities, the tendency of their distributions’ “tails” to disappear at around three standard deviations from the mean, will not hold. In probability, the chance of four [independent] events happening is the product of their four probabilities. In fuzzy logic, the alternative analytical system for the unknown, the “belief” of four events is the minimum of their beliefs. If each event has a probability/belief of 1 in 10, it is the difference between 1 in 10,000 (random) and 1 in 10 (unknown).
Nassim Taleb in his best seller criticized Wall Street for being Fooled by Randomess. He had it precisely wrong. In reality, Wall Street and the economists and “mathematicians” (mostly not very good ones, or good ones who figured out there was a problem but stayed around for the money) have been fooled by assuming randomness where it does not exist.
That assumption makes the equations easier to solve. Random quantities tend to be linear, exponential or normal, the three types of equations economists know how to deal with. Chaotic quantities generally obey power-series equations, or even nastier ones, while unknown quantities by definition do not obey any equations at all.
Financial quantities, mostly a mixture of the chaotic and the unknown, are thus frightfully hard to model. One has some sympathy. Even Benoit Mandelbrot, a truly superior mathematician who invented fractal geometry, made devastating criticisms of others’ models in his 2004 The Misbehavior of Markets, but was unable to come up with a better alternative.
The invention of PCs, together with the intellectual “advances” of modern financial theory, from around 1980 caused an explosion of mathematical modeling on Wall Street. Models were used to price options, to value complex packages of securitized debt, to manage investments and above all, to manage risk, even being incorporated into the “Basel II” bank capital requirements.
In the “Value at Risk” risk management system, for example, the model calculates the maximum possible loss in 99% of periods covered. Even if the model worked, that would be a foolish way to manage risk for an entire bank when the periods are as short as a day or a month; 100 trading days is only five months and even 100 months is only eight years. While the 200 year life expectancies of the old merchant banks may have been excessively conservative, eight years is surely rather too short a life expectancy for banks if the market is to function soundly.
The VAR assumption, that even in the other 1% of periods the model would not be too far wrong, is completely and dangerously false. When David Vinear, chief financial officer of Goldman Sachs, said in August 2007, “We were seeing things that were 25-standard-deviation events, several days in a row,” he was condemning his risk management out of his own mouth. In a truly random system, 25-standard-deviation events would not just be rare, they would be literally impossible, of infinitesimal probability during the entire history of the universe.
Not only are price movements not random, the market is not “efficient.” It is subject to bubbles and periods of depression – indeed one of the most profitable strategies during the latter, employed by the late Sir John Templeton and others, is to buy small out-of-the-way stocks at random, since analysts stop covering the lesser names when business is bad, and their prices drift down arbitrarily far. (Conversely, that is why many of the best investment managers, mostly invested in small stocks, did so badly in 2008, down 70% or 80% when the market overall was down only 40%; the market was de-arbitraging as the financial system fell apart.) As innumerable behavioral finance professors have demonstrated, expectations are not rational.
The Capital Asset Pricing Model also does not work, as many have found to their cost. On the corporate side, it combined with the tax-deductibility of debt interest and short-term oriented compensation systems to leave banks and corporations excessively leveraged. Lehman Brothers shareholders have lost more through bankruptcy than they previously gained through leverage. Business failure is in itself an extremely expensive process. Of course, bailouts here, there and everywhere have mitigated the costs of owning, say, AIG or Citigroup shares, but on the other hand, being a debt-holder in Chrysler or General Motors has proved unexpectedly expensive, as the Obama administration has reallocated resources to its union friends. In the last six months, the resource allocation process has become almost entirely political, and will remain so until the U.S. government runs out of money, which fortunately should not take too long.
On the investment side, the CAPM has led to the development of innumerable phony asset classes, whose returns were supposed to be uncorrelated to the stock market, but which were mostly notable for the hugely greater fees they provided to their sponsors. Hedge funds depend on excessive leverage and the continuance of misguided financial engineering. Private equity funds depend on the existence of a thriving public market for takeout. And emerging markets funds depend on the health and liquidity of the world economy. None of them diversify risk more than marginally and all of them add huge new layers of cost. The Yale Model of investment management does not work – except for the lavishly rewarded investment managers who developed it.
Securitization appeared to be a mechanism that allowed banks to remove assets from their balance sheets, while providing relatively low-risk, liquid assets for investors. It also did not work. First, banks were left with most of the residual risk, so allowing them to remove the assets from their balance sheets merely encouraged excessive leverage. Second, the ratings agencies assumed randomness of outcome in, say, pools of subprime mortgage assets, an assumption that proved to be laughably wrong. When mortgage underwriting standards deteriorated, they deteriorated everywhere, so all pools ended up with their share of almost-worthless “liar loans.” Even when underwriting standards were maintained, real estate mortgage losses were not probabilistically independent, since a nationwide housing-price decline caused an ever-increasing cascade of losses, far beyond past experience. Housing and credit card loans are not probabilistically independent, because the business cycle is not random; in a down cycle they all go wrong at once.
The largest nirvana for mathematically-generated profits was the derivatives markets. Here the “vanilla” markets were relatively sound, with risks manageable and finite. They were, however, almost infinitely arbitrageable, so became a trading desk heaven, with far too much volume for the contracts’ real uses, endless speculative games played, and infinitesimal margins. Most important, they produced an explosion of counterparty risks so that even the dodgiest bank or broker active in the markets could not be allowed to go bust. That problem can largely be solved by President Obama’s proposed legislation forcing standard derivatives to trade over recognized exchanges, eliminating most of the counterparty risk and concentrating the rest in one place.
In order to increase profits, traders devised more and more complex derivatives types, the management of which required dangerously false assumptions about randomness. These more complex contracts up-fronted most of their profit, leading to bonus bonanzas, while leaving their risks ticking like a time-bomb through their entire duration of several years – so we may not yet have seen all the loss explosions this business will produce.
Finally, there were credit default swaps (CDS). As derivatives, these were poorly designed, because their settlement rested on a primitive auction procedure that is itself gamed by the major dealers, who use it to extract rent from the U.S. government and any companies unfortunate enough to near bankruptcy. As we have recently seen in two cases, Abitibi-Price and General Growth Properties, CDS deviate even further than most derivatives from the theoretical efficient-market modern finance ideal in that they allow debt-holders to “game” the default process itself.
In essence, CDS holders, who if they are also bondholders can vote in the bankruptcy process, act like spectators at a suicide, yelling, “Jump! Jump!” and pushing companies into default in order to reap bonanza profits from their CDS. This is particularly attractive if the CDS were issued by AIG and so effectively guaranteed by taxpayers.
CDS also act as highly efficient vehicles for short selling. Their cost is so low in relation to their potential profit and their volume so large that they can provide huge incentives to unscrupulous speculators to drive viable companies over the edge – this was part of the problem at Lehman Brothers, for example.
In summary, the dangers of CDS are so out of proportion to their modest advantages as risk management tools that it seems wisest for the authorities to ban them altogether, not something I would normally recommend.
We gave poor Jeff Skilling of Enron 24 years in jail for inventing a new trading platform that turned out to be unsound. As we peer out from the wreckage that modern finance has left, one cannot help thinking that there are a number of Nobelists who more deserve such Draconian punishment.
TOOTHLESS WATCHDOGS? AUDITING THE AUDIT FIRMS
Investors beware: Financial audits can go only so far in detecting fraud.
Accounting frauds have been with us ever since investors started delegating business management responsibilities to those over whom they had no direct oversight. In some very real sense, the integrity of the reported numbers in any country’s financial assets market is the basis for everything else. If the numbers are untrustworthy any analysis of the numbers becomes a case of garbage in/garbage out. The collapsed mortgage finance bubble involved massive sins of omission (we are being charitable here) as mortgage backed securities were systematically and massively overvalued. When this became apparent the crash ensued.
Any reasonable person will admit that a determined, intelligent and patient set of crooks can create a fraud which can evade detection by even a careful auditor for a good long time. (See, e.g., the Tino De Angelis Salad Oil Scandal story.) The real world question is then just how much diligence and perspicacity do investors have a right to expect from the nominally independent financial accounting firms on whose reports they depend? “There is, in fact, some murkiness about auditors’ responsibilities for detecting fraud,” notes Barron’s. An accounting firm wants to be rehired by the company it is auditing, so there is some tendency for a “cozy interdependence” to show up over time.
During bull markets accounting frauds can proliferate in an environment of overall lack of investor skepticism. Now with the financial markets collapse and the Bernard Madoff scandal it is inevitable that the spotlight will turn on those accountants who failed to save investors from themselves. For example, BDO Seidman, the 7th-largest U.S. auditor, has been linked indirectly to Madoff, while #5 McGladrey & Pullen is being criticized for its failure to detect a $3 billion Ponzi scheme purportedly masterminded by one Thomas J. Petters (who once owned Polaroid).
There were, in fact, countless non-fraudulent alternatives to Madoff’s fund. Plenty exercised a modicum of due diligence looking at the Madoff opportunity and said no thanks. Enron was fundamentally impossible to understand without making a full-time job of it. No one forced anyone to buy a stock they did not understand. A lot of earnings stories which end up falling apart when accounting that falls on either side of the fraud line is revealed never looked attractive in the first place when cash flow analysis was used.
So what are good defenses against fraud? Diversification, delegation of investment decisions to professionals when you are not going to do your own careful checking, confining oneself to investments one understands, and – most importantly – cultivating skepticism about everything you are told.
A quote attributed to Josiah Stamp, a British banker and statistician is: “The government are very keen on amassing statistics. They collect them, add them, raise them to the nth power, take the cube root and prepare wonderful diagrams. But you must never forget that every one of these figures comes in the first instance from the village watchman, who just puts down what he damn pleases.” We would not accuse the average corporation with that level of arbitrariness, but beware that numbers are a representation of reality – not reality itself.
The Big Four accounting firms are used to embarrassing headlines about their purported misdeeds. After all, the past decade has seen one business catastrophe after another at companies audited by the major firms. Witness the scandals at Tyco, WorldCom and Xerox. [Ed: Not to mention Enron – see piece immediately above.]
These days of Ponzimania have put the glare on two smaller auditing firms. BDO Seidman, the 7th-largest U.S. auditor in terms of net revenue, has been linked to disgraced financier J. Ezra Merkin and so, indirectly, to the ubiquitous Bernard Madoff. McGladrey & Pullen, the 5th-largest in the field, is under fire for its connection to a $3 billion Ponzi scheme purportedly masterminded by Minnesota entrepreneur Thomas J. Petters.
In investor lawsuits filed in recent months, BDO Seidman and McGladrey & Pullen stand accused of shoddy audits and signing off on the books of fraud-ridden businesses and investment funds. The cases, together with a string of earlier ones involving the two firms, raise unsettling questions about the level of confidence investors can put in financial audits.
There is, in fact, some murkiness about auditors’ responsibilities for detecting fraud.
The two audit firms say they stand by their work, and there is, in fact, some murkiness about auditors’ responsibilities for detecting fraud. The firms are supposed to “obtain reasonable assurance about whether the financial statements are free from material misstatement, including misstatements caused by fraud,” according to the Public Company Accounting Oversight Board, the federal entity that supervises auditors of public companies. The gray area centers on what is reasonable, an issue that often plays out in the courts because accounting firms can be one of the only solvent players left when a company goes down.
Before Madoff came along, there was E.S. Bankest LLC. The Florida factoring company went bust after its executives allegedly carried out an elaborate 9-year scheme to steal roughly $170 million from the business while fabricating false financial statements; 9 Bankest insiders were convicted of criminal charges in a Florida federal court. BDO Seidman had audited the company and concluded its books were free from material error.
“Auditors are supposed to have professional skepticism, and that is just inconsistent with the client relationships that they try to preserve to keep the money flowing.”
California attorney Steven Thomas, who in 2007 won a $522 million jury award against BDO Seidman stemming from its Bankest audits, says the case reflects the kind of cozy interdependence that helped sink Enron and Arthur Andersen. “Auditors are supposed to have professional skepticism, and that is just inconsistent with the client relationships that they try to preserve to keep the money flowing,” Thomas says.
BDO Seidman spokesman Jerry Walsh says the firm is appealing the Bankest verdict and remains “extremely confident that this jury’s findings will be overturned.”
The firm also is contesting a civil lawsuit from the collapse of Le-Nature’s Inc., a Pennsylvania iced-tea producer shuttered in 2006 after allegedly faking $240 million in revenue, according to forensic accounting undertaken by a bankruptcy court. BDO Seidman auditors had certified that Le-Nature’s financial statements were free from material error.
“There is a difference between being fooled and putting your head in the sand so you don’t see things,” says Robert Loigman, a New York lawyer representing Le-Nature’s investors who sued. A tour of the company’s Latrobe, Pennsylvania, warehouse would have made clear Le-Nature’s was not selling $300 million worth of bottled drinks a year as claimed, he says.
Walsh says his firm “was one of many victims of a collusive fraud at Le-Nature’s.”
For McGladrey & Pullen, some tough questions have come from Frederick J. Grede, a Chicago bankruptcy trustee who claims the firm’s auditors actively participated in the “looting” of Sentinel Management Group, a $1.4 billion investment fund that failed in August 2007.
A lawsuit filed by Grede accuses McGladrey & Pullen auditors of “preparing false footnotes to Sentinel’s financial statements,” certifying bogus financial statements to federal regulators, “consciously ignoring” serious problems “clearly shown” in the firm’s work papers.
The Securities and Exchange Commission and the Commodity Futures Trading Commission are pursuing top Sentinel executives in court, saying they siphoned hundreds of millions of dollars. McGladrey & Pullen declined to comment on the case.
The recent Ponzi schemes have touched off another round of litigation. Take the case of J. Ezra Merkin.
According to New York Attorney General Andrew Cuomo, Merkin repeatedly lied to his customers about what he was doing with the $2.4 billion they had given him. In a 54-page civil fraud complaint, Cuomo accuses Merkin, who ran a trio of investment funds, of giving his investors “false” offering documents and quarterly statements. Merkin, according to the suit, consistently deceived investors about the fact that he had entrusted Madoff with their cash, which vanished. Merkin has denied any wrongdoing.
The Merkin funds were audited by BDO Seidman, which attested that the books were free of material error. New York Law School, which lost $3 million it placed with Merkin’s Ascot fund, claims BDO Seidman failed to “maintain an appropriate degree of skepticism” or collect sufficient evidence to support its conclusions.
In a lawsuit, the school blames BDO Seidman for not telling investors about Merkin’s alleged sleights of hand. Exhibit A: the 2007 audit of Ascot, which lists the fund’s assets on a week-to-week basis, but does not mention that just one broker, Madoff, held nearly all those assets.
Nancy Kaboolian, an attorney for New York Law School, declined to comment. But New Jersey lawyer Alan Wasserman, who is preparing another case against BDO Seidman on behalf of Merkin investors, says Merkin’s heavy reliance on Madoff is a “red flag any accounting firm should have seen” and noted.
Says Walsh: “It is unfortunate that these investors would bring legal action before all of the facts are known and seek to blame others for their own investment decisions.”
McGladrey & Pullen, meanwhile, has been targeted in the case involving Petters, who once owned Polaroid.
Before his arrest by federal agents in October 2008, Petters allegedly convinced investment funds to pump billions into a nonexistent TV-wholesaling business. McGladrey & Pullen audited three of those funds, which made a steady stream of high-interest loans to the Petters Company. All three funds were wiped out, and investors are suing McGladrey & Pullen, saying the firm should have noticed that the funds were shoveling vast sums into a business with no real customers.
Petters pleaded not guilty in December to charges of mail fraud, wire fraud, money laundering and conspiracy.
“McGladrey & Pullen stands by the quality of its audits, which are conducted with due care while conforming to professional standards,” company spokeswoman Betsy Weinberger says.
In the view of Richard L. Kaplan, a law professor at the University of Illinois, a diligent auditor should go to source documents to verify the financial statements it is scrutinizing. If a fund claims it has cash in a bank account, auditors should get records directly from the bank, he said.
Kaplan has advocated tougher oversight of accounting firms. Still, he acknowledged there are limits. “A very determined crook,” he said, “will deceive virtually any auditor.”
A CLASSIC SOUP STOCK LOOKS TASTY
Campbell Soup lacks the buzz of Monster energy-drink maker Hansen Natural. But its proven staying power makes it the better stock bet.
Campbell Soup is selling at 12 1/2 times earnings and sports a dividend yield of 3.8% -- the highest in 20 years. With a long-term growth rate of only 5-7% the stock is not the last of the all-time bargains, but given the stability of its sales and earnings it strikes us a very reasonably priced.
When Campbell Soup and Hansen Natural showed up on opposite ends of the 52-week high and low list recently, it was a stark reminder of changing Wall Street sentiments: The once-defensive stock of Campbell Soup [ticker: CPB] has quickly become passé, replaced by high-growth stories like Hansen Natural [HANS], whose caffeinated beverages are again jolting shares. The maker of energy drinks and organic soda is up 70% over the last six months, versus a 30% decline for comfort-food specialist Campbell.
Hansen now fetches 19 times forward earnings-per-share estimates versus a stingy 12 times for Campbell. Needless to say, Barrons.com prefers shares of the latter.
Of course, Hansen has enviable growth prospects, assuming that energy drinks continue to win share over traditional carbonated beverages. But it is fair to wonder whether Hansen's highly caffeinated Monster drinks have the staying power of condensed soup.
Fund manager Don Wordell views the current rally, led by stocks like Hansen, as unsustainable. “All the stocks we thought were going to be dead earlier this year are now rallying,” says Wordell, who runs the RidgeWorth Mid-Cap Value Equity Fund [SMVTX] for RidgeWorth Investments. “We think the market is going to come back and focus on the companies that have strong balance sheets, strong business models and long histories of paying dividends."
Shares of 140-year-old Campbell should still fit the bill. The soup maker has raised its dividend for six straight years, and, at 3.8%, Campbell sports its highest yield in at least 20 years. Over the last five years, Campbell's shares have posted a total return of 12%, versus a 6% decline for the Standard & Poor's 500 index.
Barrons.com wrote favorably about Campbell late last year (“A New Taste for Campbell,” December 30, 2008). Much of the positive argument remains, particularly with shares at a decade-low valuation.
Campbell continues to forecast long-term sales growth of 3% to 4% and earnings-per-share growth of 5% to 7%. While condensed soups are still a large component of Campbell's revenue, new products like the health-conscious Select Harvest and V8 soups are gaining traction. In the November-to-January period, they helped drive up sales in Campbell's ready-to-serve category by 7%.
Meanwhile, with 12% of Hansen shares held short, the stock has its skeptics. To be fair, Hansen has performed far better than Campbell over the last five years, with its shares up some 1,400%. According to Canaccord Adams analyst Scott Van Winkle, investors have been further encouraged of late by a new agreement in which Coca-Cola bottlers will distribute Hansen products throughout the U.S., Canada and Europe.
[Hansen] reported first-quarter earnings of 44 cents a share, beating expectations and sending shares to a fresh 52-week high of 43.39 ... Analysts surveyed by Thomson Reuters had foreseen EPS of 37 cents, up from a 2008 figure of 29 cents.
But Hansen shares look topped out once again. At the very least, they are well above the average 12-month target of 37.25 held by analysts. “There is not a lot of margin for error in this market environment with that valuation,” Van Winkle says. He adds that a takeout premium has likely been embedded into Hansen shares, with many anticipating that Coca-Cola [KO] could make a bid for the entire company.
The company said its market share in energy drinks continued to rise in the quarter. Hansen now controls about 28% of the category. Despite the recent momentum, Mark Astrachan, an analyst at Stifel Nicolaus, downgraded Hansen shares in late March to Hold from Buy. “There is a lot of good news out there,” he says. “But we think the shares are reflecting that.”
Campbell shares should have an easier path to long-term gains. Soleil Securities analyst Edgar Roesch notes that recent data points from food makers portend better results for Campbell, which reports fiscal third-quarter earnings later this month.
Shares of Kraft Foods [KFT] rose 4% last Tuesday, after the packaged-foods maker beat first-quarter expectations, largely because retailers reduced inventories less than feared. “Destocking” has hurt Campbell lately. If the inventory trend that helped Kraft pans out for Campbell, too, the soup maker likely will report improved shipments to retailers as part of its third-quarter results. It could also benefit from broader catalysts. Packaged-foods stocks have lagged in the recent rally – especially Campbell. On a forward price-to-earnings basis, it trades at a 12% discount to the group.
“At some point, there is going to be bargain-hunting, and people are going to look at what has been left behind,” says Roesch.
Cue the revving of shopping carts.
HESS: A BOLD EXPLORER WITH BIG, UNDERVALUED ASSETS
With its heavy emphasis on exploration and a recent history of drilling successes, Hess is arguably the best major energy stock for anyone betting on an eventual recovery in crude oil.
We recall once seeing a decomposition of the constituents of a stock’s return. Most important was the direction of the stock market itself. Second most important was the industry the stock was in. The specific company only came in at #3.
This Barron’s piece makes a good case for energy company Hess vs. its peers, based on factors such as the value the market is placing on its oil and gas reserves (low) and its finding and development costs (also low). But make no mistake about it, the most important factor behind the sucess of failure or of an investment in Hess will be how the energy sector of the stock market performs. And, as one might imagine, besides the performance of the stock market itself the direction of oil prices will be of primary importance.
The New York-based concern (ticker: HES), with a stock-market value close to $20 billion, has the equivalent of 1.43 billion barrels of energy reserves, 68% of it oil, the rest, natural gas.
Like other energy companies, it is scaling back capital spending this year, to $3.2 billion. But it still is allocating $800 million for exploration – a smart move, given Hess’s discoveries in Australia, Libya, Egypt and elsewhere last year.
Overall, Hess devotes 80% of its capital spending to exploration and production. Other names, such as industry giant ExxonMobil (XOM), might offer more stability, and smaller rival Murphy Oil (MUR) is growing faster. But Hess could enjoy the biggest pop, relative to its size, from an oil rebound.
While being willing to spend big in the hope of discovering yet more oil and gas, Hess is bolstering its finances. Its debt-to-capital ratio, which was at 52% seven years ago, has been halved to 26.3% as of the end of the first quarter, and management plans to cut $200 million in costs this year. Hess had net debt of $3.2 billion and $1.1 billion of cash at the end of the quarter, during which it raised $1.25 billion through a debt offering.
Management, led by John Hess – son of Leon Hess, who began running the company in the 1930s – has assembled a portfolio of projects that bulls think will boost reserves and long-term output and lift shares to $70 over the next year and a half, versus their recent 61. Says Oppenheimer analyst Fadel Gheit, “Hess has one of the highest exploration potentials in the sector, and any of their major exploration plays could have significant impact on its valuation.” Gheit rates the shares Outperform.
If crude prices rebound strongly – they are off by about $100 a barrel versus levels early last summer – Hess could easily exceed that target. But the ride will likely be bumpy. Hess stock soared 104% in 2007 and hit an all-time high of 137 last summer when oil jumped above $145 a barrel. But the stock sank to 36 in December, as profits plummeted along with crude prices, which have been ranging in the mid-$40s to mid-$50s in recent months, and management’s hedges did not work out. With petroleum prices still far from their peak, earnings per share could tumble 97% this year, to 18 cents, while revenue could be down by almost a third, to $28.6 billion from $41 billion.
But profits could jump next year, if the global economy and crude stabilize. Some analysts expect Hess to earn $750 million, or $2.55 a share, in 2010, and most are basing their estimates on relatively modest expectations for oil and gas. Standard & Poor’s, for example, sees oil averaging $54 a barrel next year, up from an estimated $45 average in 2009, and gas hitting $6.21 per million British thermal units in 2010, versus an average $4.45 per MMBtu this year.
Natural gas is still down more than 25% for the year, at $4 per MMBtu, but anticipation of an easing of the recession has pushed oil above $50. That is helped Hess to jump by 20% since April, aided by better-than-expected first-quarter results reported late last month. In the quarter, Hess lost nine cents a share, but oil and gas output, at 390,000 barrels a day, topped expectations.
Over the long term, Hess is a solid bet to outrun the overall market amid a pickup in crude pricing.
To be sure, the stock has advanced a lot in a short time and could fall back just as quickly. In fact, anyone who does not own the stock but wants it would be well-advised to wait for a pullback, which is likely to be temporary. But over the long term, Hess is a solid bet to outrun the overall market amid a pickup in crude pricing, a likelihood as OPEC cuts production further.
Last year, Hess increased its energy reserves 8%. Exploration and production generated 24% of revenue and 90% of net income. Marketing and refining chipped in the balance.
Hess goes for big scores, taking significant positions in potentially high-impact wildcat and other wells. Its largest holding, the JDA Phase 2 natural-gas project in the Gulf of Thailand, pumps out 800 million cubic feet of gas a day. But what really has captured the imagination of investors is the company’s 40% stake in an area off Brazil called BM-S-22, located south of a major discovery by that country’s oil giant, Petrobras (PBR).
Brazil project a potential “game-changer” for Hess.
Project operator ExxonMobil announced in January that it had discovered traces of oil at its first well there. Hess will not speculate on the potential size of the find; drilling under about six miles of water and rock poses major challenges. But Ariel Capital Investment analyst Ken Kuhrt calls the Brazil project a potential “game-changer” for Hess. Barclays Capital analyst Paul Cheng, pricing oil at $80 a barrel long term, pegs Hess’s total exploration potential at $777 million to as much as $13 billion, or $2 to $40 a share. Hitting the midpoint of that range, or $5.2 billion, would be significant.
One key factor: John O’Connor, who led Hess’s worldwide exploration effort for seven years, is now retired. He was replaced by Greg Hill, a well-regarded former Shell executive. Skeptics worry that Hill will not be able to repeat his predecessor’s success. That is one reason that Deutsche Bank analyst Paul Sankey has a Hold rating on the stock, which he thinks is worth 46.
Hess’s reserves at $15.73 a barrel, versus $21.29 for Murphy.
Investors are betting that bears like Sankey are wrong. The stock now fetches 24 times its expected earnings of $2.55 next year, versus ExxonMobil’s 12 times. But Hess is appealing when you divide its enterprise value (market value plus net debt) by proved reserves. On that basis, the market values Hess’s reserves at $15.73 a barrel, versus $21.29 for Murphy, for example.
Hess’s 3-year finding and developing costs average $19.86 per BoE, compared with $23.23 for its peers.
Based mainly on projects already online, S&P analyst Tina Vital expects Hess to raise production 2% this year and 3% in 2010. Hess boosted production 1% last year, to 381,000 barrels of oil equivalent. Peer Marathon Oil (MRO) is growing faster, but Hess is a lower-cost producer. Its 3-year finding and developing costs average $19.86 per BoE, compared with $23.23 for its peers. “Hess offers better return prospects than some of the others,” says Vital, who raised her rating on it to Buy from Hold recently, with a 67 target.
For anyone who thinks the long-term direction of energy prices is up, the company looks well worth a wager.
Hyperinflation May Be Overhyped
As inflation fears wax and wane, tangible assets get whipsawed.
The specter of inflation that was supposed to scare investors back into commodities has so far stayed in the shadows.
Oil and gold were touted as havens from price creep, after the Federal Reserve in March said it would, in effect, print money to resuscitate credit markets. Yet $1.5 billion poured out of energy exchange-traded funds and notes in March, while fresh flows into precious metals stalled, reports Barclays Capital. In April, the large crude ETF U.S. Oil [ticker: USO] saw marginal inflows, while SPDR Gold [GLD] bled $628 million in outflows, National Stock Exchange data show.
While the Fed now seems more worried about inflation's opposite – a vortex of falling prices and shrinking asset values -- commodity true-believers still warn of inflation ahead. In these times of unprecedented turmoil in the credit markets, however, how far ahead is tough to predict.
Says Michael Magers, a managing director of Gresham Investment Management, “There is concern an inflationary environment might be forthcoming. If that is the case, hard assets are something you want to have as part of your portfolio. But it is hard to tell what the time horizon is."
Tangible assets are popular hedges against inflation, since they retain real value even as paper money loses it. Some commodities, such as oil, are also key factors in the price of materials and goods. As crude neared $150 a barrel last July, U.S. consumer prices were up 5.6% annually.
But now Americans are paying less than they once did for common things. Consumer prices in March fell 0.4% from a year ago – the first annual decline since 1955. That has led many analysts to suggest that while commodities make sense as inflation protection, the inflation threat is not imminent. Michael Lewis, Deutsche Bank’s global head of commodities research, believes that “if you are buying commodities for a pickup in inflation, that is really not the main threat over the next three years. We still see a disinflationary environment."
At the $165 billion California Public Employees’ Retirement System, the largest U.S. public pension fund, commodities are a small piece of its inflation-linked asset program. While its target is to hold 1.5% of its market value as commodities, Calpers' commodity portfolio is less than $500 million, or 0.3%. “Throughout, we have remained at the lower end of the range as we gain experience in this sector,” spokesman Clark McKinley says.
Eventually, Fed experimentation could send too many dollars coursing through the economy, setting off a nightmare scenario of rocketing, uncontrolled prices. Yet economist Ed McKelvey of Goldman Sachs argues that is highly unlikely, and besides, the U.S. central bank has ways to shut the monetary spigot, too – for instance, by shelving plans to buy mortgage-backed and other securities, or by raising interest rates.
Writes McKelvey in a recent note, “They are clearly aware of those options and prepared to use them should such a situation develop. We therefore think it is time to stop hyperventilating about hyperinflation.”
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