Yet their demise hurts anyone trying to manage an investment portfolio in a prudent manner — similar to how Bear Stearns and Lehman Brothers permanently stained the entire investment banking industry. It’s a case of a few bad apples spoiling the whole barrel. Unfortunately, it remains to be seen how regulators and politicians will punish every investor, including those who have acted prudently.

For example, I just read a publicly released copy of a letter dated Oct. 2, sent from the U.S. Congress to Harbinger Capital Partners. It asks Phil Falcone of Harbinger Capital to reveal practically everything that’s confidential about his funds and to testify before a committee. Let’s hope U.S. regulators don’t take action to drive even more investment talent overseas, because we need them here to help keep our markets efficient.

It amazes me how long this environment of panic has lasted. Last Thursday was one of the most violent days I’ve ever experienced in the markets, including the bursting of the tech bubble, and the turmoil continues this week. Quality companies in the oil services, coal, steel, and agriculture sectors were liquidated in violent fashion — many of them down 20% in a day and 50% over the past month. These are real companies performing vital functions necessary to keep the lights on and food on shelves, not speculative Internet stocks.

The list of victims includes companies that are very likely to deliver good earnings over the next few years. The list includes several of the stocks I’ve recommended in past issues of Strategic Investment, and still follow closely. If you’re a long investor, there are some screaming bargains out there — unless, of course, half of the world’s population stops using food, electricity, and oil. I doubt that will happen in a world of unfettered deficits and central banks, but anything’s possible. I’ll have more to say about this in an upcoming issue of Strategic Investment.

For immediate ideas, I strongly recommend considering the long list of bargains that my colleague Chris Mayer has recommended in Capital & Crisis and Mayer’s Special Situations. It’s mind-boggling how cheap some of them have become. Chris is an excellent stock picker. He goes to great lengths to find safe, cheap investments.

Government Inflation vs. Private Deflation

The money managers that survive this environment will probably look to own some of the dirt-cheap stocks in the energy, commodity, and agriculture sectors, rather than expensive stocks that thrived on spending from home equity loans. Once this credit market panic subsides, I expect we’ll see this shift in sector focus. Fund managers will have to start distinguishing between earnings that resulted from fake, bubble-induced consumption, and earnings that resulted from real, sustainable demand. I’m looking forward to earnings season, when analysts and fund managers can finally get some guidance about which companies’ earnings will hold up best during this recession.

Even the best fund managers and stock pickers in the world — several of them listed in this Bloomberg article — are down for the year. A few of these managers saw the credit crisis coming, and made nice profits shorting financial stocks. But the SEC’s totally arbitrary rule changes in recent weeks have created an environment that’s very difficult to navigate.

The SEC’s short selling ban has not changed much, other than taking efficiency and liquidity out of the market. For example, Allied Capital was on the “do not short” list. Yet it crashed earlier this week upon announcing the bankruptcy of Ciena Capital. That was a case of long investors all trying to squeeze out of a narrow door of liquidity.  It was not a “short attack.”

Uncertainty about the banking system is causing this panic in the credit markets. Innocent bystanders are suffering from the fallout from this credit bubble.

For example, I’ve read several accounts of hedge funds whose assets are stuck in the black hole that is Lehman Brothers’ balance sheet. I’m not referring to people who own Lehman bonds, I’m referring to funds that had custodial agreements with Lehman. Custodial agreements are supposed to ensure that Lehman could only execute trades for the pool of assets under its custody — not take actual possession of the assets.

It seems that in the days and hours before declaring bankruptcy, Lehman moved certain assets — many of which it did not own — to its subsidiaries all around the globe. Now, hedge funds with no perceived credit exposure to Lehman are joining the line of creditors, fighting to get their clients’ assets back in bankruptcy court.

This total destruction of confidence in counterparty risk is the reason why credit is drying up. So what has the Federal Reserve been doing as the lender of last resort?

It has nearly doubled the size of its balance sheet in the past few weeks. The Oct. 3 issue of Grant’s Interest Rate Observer describes:

“After a flat-footed start, [the Fed] had shown its ability to degrade its balance sheet by selling off its Treasuries and acquiring dubious mortgages. But it had not really put its back into dollar debasement. The sum total of its earning assets, i.e., Reserve Bank credit, was rising at year-over-year rates of just 3% to 4%. Where was the push to print up enough dollar bills to smother the debt crisis of 2007-8 — assuming the problem was susceptible to smothering through money printing?

“Mystery solved: Reserve Bank credit is suddenly flying. It surged by $203.6 billion, to $1.135 trillion, in the banking week ended Sept. 24. And if Merrill Lynch’s guess is on the mark, it has soared to $1.730 trillion in only the past few days, a near doubling since May 2007 [emphasis added], when the latent crisis became manifest.”

After the panic subsides, the Fed will rein in much of this new money. Right now, banks are “stuffing it under the mattress,” so to speak. Banks and individuals are crowding into the perceived safety of Treasury bonds. That’s why consumer prices aren’t immediately rising; private market credit is contracting as fast as the Fed’s balance sheet is expanding. The Fed will always lend when no one else is willing to do so. “The U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost,” said Fed Chairman Bernanke in November 2002. This means that there will always be paper money available to lend. However, the U.S. dollar is getting debased on an unprecedented scale.

The printing press may be the only way to prevent a self-sustaining credit panic, but it doesn’t come without a price; it lowers the U.S. dollar’s stature even further in the eyes of our foreign creditors.

I’m betting that government inflation will defeat private market deflation. However, when the dust settles, I expect the Treasury and Fed to have its own set of negotiations with foreign creditors. The obligations they are assuming and monetizing are simply too enormous without inciting a potential panic among our generous foreign creditors. Maybe we’ll see a Bretton Woods-type agreement in 2009 — one where the U.S. dollar is devalued by 50% against certain foreign currencies overnight.

Best regards,
Dan Amoss, CFA
October 9, 2008

Strong Resource Companies Will Survive… The Dollar May Not was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

“After advising for weeks there were no huge charges on the horizon, UBS stunned the market on Monday with the massive write-down, saying it had obtained a 13 billion Swiss franc ($11.52 billion) capital injection from the Singapore government and an unnamed Middle East investor…

“UBS said the capital injection would enable it to raise its Tier 1 capital ratio to 12%, despite the hefty write-down of its exposures. Without the recapitalization, the $10 billion charge would have blown a hole in its capital base. Analysts say it is crucial for UBS to keep its Tier 1 capital in double figures in order to secure its franchise as the world’s largest wealth manager…

“‘UBS’ write-downs are large but conservative, and it has managed to find investors to take the risks,’ analysts at Dresdner Kleinwort said in a note to clients on Monday. ‘However, smaller groups may not have this luxury, and there is clear evidence of balance sheet stress emerging.’”

MBIA Receives $1 Billion Private Equity Bailout

Bloomberg reports that, seeking to avert a crippling reduction of its AAA credit rating, “MBIA Gets $1 Billion From Warburg Pincus”:

“Shares of MBIA, the world’s biggest bond insurer, soared as much as 27 percent after the company said it will sell $500 million of common stock to Warburg Pincus. The private equity firm will also backstop a rights offering of up to $500 million next year, Armonk, N.Y.-based MBIA said today. MBIA said it faces ‘significantly’ higher losses from a slump in the value of securities it guarantees.

“The added capital may help ward off a cut in MBIA’s top credit rating, which is under scrutiny by Moody’s Investors Service, Fitch Ratings, and Standard & Poor’s. MBIA’s AAA ranking stands behind $652 billion of state, municipal, and structured finance bonds, and losing the AAA credit rating would endanger those ratings, as well as cut off MBIA’s ability to guarantee debt, its main source of revenue.

“‘It’s a positive for the company,’ said Rob Haines, an analyst at CreditSights Inc. in New York. ‘It staves off the potential for a rating downgrade.’”

My Comment: A problem delayed is not a problem solved.

The insurers, led by MBIA and Ambac, are sitting on $100 billion of collateralized debt obligations backed by subprime mortgage securities. One billion dollars is peanuts, compared with their actual exposure. Bloomberg continues:

“Warburg Pincus, the New York-based firm started in 1971, will initially buy 16.1 million common shares, at $31 each. The firm will also receive seven-year warrants and have the right to appoint two directors… Mark-to-market losses will be more than in the third quarter, and the company will set aside as much as $800 million to cover losses it expects to take on securities backed by home equity loans, MBIA said…

“MBIA, in October, posted a $36.6 million loss because of write-downs on mortgage-related securities and halted stock buybacks to retain capital. So far this quarter, the company ‘has observed a further widening of market spreads and credit ratings downgrades of collateral underlying certain MBIA-insured CDO tranches,’ the company said in [its Dec. 10] statement.

“The fair value of the assets slumped by about $850 million in October, MBIA said. The company will have ‘significantly’ larger mark-to-market losses in the fourth quarter… ‘Given the magnitude of MBIA’s exposures, as demonstrated again this morning with UBS’ write-downs, I don’t see how $1 billion moves the needle,’ said David Einhorn, president of Greenlight Capital LLC in New York, which has a short position on MBIA.”

My Comment: Einhorn is clearly talking his book, but at least he admits it. Furthermore, I happen to agree with him. It took nearly all of that $1 billion, of which MBIA received only half so far, just to cover fourth-quarter losses. What now? The problem sure did not go away.

Bank of America Closes Institutional Fund

Denying a CNBC rumor of an asset freeze, Bank of America is closing its Columbia Strategic Cash Portfolio. Reuters reports:

“Bank of America Corp.’s Columbia asset management unit said on Monday it is closing a privately placed money-market fund for institutional investors.

“The bank’s Columbia Strategic Cash Portfolio fund, which has less than $11 billion in assets, has been closed to new investors, said Columbia spokesman Jon Goldstein.

“Goldstein denied a CNBC report that the fund had been frozen, saying that clients were being offered the option of cash redemptions or of switching their assets into other Columbia-managed funds.”

My Advice: Take the cash and run.

Minyan Peter on Vulture Buying

In response to Quint Tatro’s Minyanville piece on Monday, “Foreign Buyers at the Ready,” Minyan Peter wrote:

“While clearly foreign wealth funds and other offshore money is piling in to ‘bail out’ the capital infirmed, I would make a point about how these capital injections are being structured. Whether it is Citi, E*Trade, or UBS, new capital is coming in as either convertible debt or convertible preferred. Why? Because in liquidation, these new investments rank ahead of common shareholders when it comes to getting paid.

“As I have written previously, on the way down, vulture investors buy converts. At the bottom they go right for the common.”

Note: Peter is a former treasurer at a major U.S. bank.

Smack in the face of enormous losses at MBIA, with even bigger announced losses to come, the market is going giddy because MBIA received a down payment on a potential $1 billion max infusion. However, that infusion does not come close to covering MBIA’s subprime exposure.

The equity markets, in general, are acting as if all these problems are going to be solved by a one-time cash infusion from venture vultures and bailouts from oil producers.

Meanwhile, the credit markets have barely budged. LIBOR is down a mere one basis point from an extremely wide spread. LIBOR is suggesting banks still do not trust lending to each other, not even overnight.

The disconnect between the credit markets and the equity markets is simply staggering. Believe what you want, but the message from the credit markets is that a wave of bank failures is coming, and/or that balance sheet stress is going to get far worse before it gets any better.

Regards,
Mish

December 12, 2007

Balance Sheet Stress and Vulture Buyers was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.