Of the many ways in which Silvio Berlusconi thought he could be forced from power, rising Italian bond yields was probably not high on his list. Even his titillating escapades seemed to have been insufficient to persuade the Italian electorate he should leave. But it turns out 7%+ bond yields, with €300Bn of new borrowing required in 2012, is the the breaking point. Less than a month ago the focus was on Greece and building a secure firewall with the EFSF to prevent contagion spreading to Spain or Italy. Now here we are, and we’re running out of unthinkable developments.

It’s not that Europe doesn’t possess the savings to fund profligate countries while they adopt the German fiscal model. It’s just that the money is in the wrong place – northern Europe not Southern.

So another test of equity investors’ fortitude looms. The S&P 500 (SPY) will once again shift from greed to fear. But it’s always worth looking at the fundamentals of the companies you own. For example, in our Hedged Dividend Capture Stategy, McDonalds (MCD) reported 5.5% Year-on-Year sales growth in restaurants open more than a year. Even in Europe sales grew 4.8%. It yields 3% (more than 1% over ten year U.S. treasuries) and could grow earnings at 10% next year. Kraft (KFT) just revised up their 2011 guidance from $2.25 to $2.27 and continues to exploit synergies from their Cadbury’s acquisition. KFT is also likely to grow at double digits as it prepares to break itself up into two companies and yields 3.3%, more than 1.3% over ten-year U.S. treasuries. The Federal government wants your tax dollars, but really doesn’t want your savings. That’s the message of today’s bond yields.

The near term is usually uncertain, and especially so right now. But the prospects of these and other companies remain solid.

In yesterday’s election the voters of Ohio rejected by 62% to 38% a state law that limited the ability of public sector workers to collectively bargain and to strike. It’s a remarkable reflection of how Ohio voters feel about their government – I mean, who do state employees work for if not the people of the state? Ohio employs 769,000 people in government which represents only 13% of the labor force, substantially less public sector employment than in other states. Union membership as a percentage of the labor force in Ohio is less than 14%, although modestly above the national average of 11.9%.

The law that the Republican-controlled legislature had passed included limits on the ability of public sector workers to collectively bargaining or strike and required greater contributions to their retirement and health plans. The average voter in Ohio must think that all these public sector workers work for some foreign government. I think they’re emulating the Greeks. Perhaps it’s because I grew up in Britain during the 70s when unions periodically held the country to ransom. At times in Europe they still do.

But as an investor you take the world as you find it. I don’t have any plans to invest in Ohio, nor live there. Democracy allows people to vote for concepts that are not obviously good for them. Ohio is adopting some of the values of Europe that have created the current Euro sovereign debt crisis.

Yesterday we lightened up on some of our position in Coeur d’Alene (CDE). We’ve liked this silver mining company for quite some time – it’s been trading at a substantial discount to the NAV of its mining assets and represents a good way to invest in bullion at a discount. Earlier this year there were fears that Bolivia would change the terms under which CDE mines silver at the San Bartolome mine, but even though such fears were unfounded the stock persisted at a wide discount to its underlying assets.

With yesterday’s earnings release the valuation of the stock has largely retraced its steps, and while it remains cheap to its assets we don’t believe it’s as mispriced as it has been. We still own some shares but not as much as before.

We invested the proceeds in McMoran Exploration (MMR). How could you not invest in a company run by someone called Jim Bob? We’ve never met, but he sounds as if he grew up on Walton’s Mountain (a syrupy TV show from the 70s about a Depression-era family). Joking aside, MMR is engaged in drilling for natural gas and oil in the Gulf of Mexico (GOM). Shallow water (as little as 100 feet) but deep wells (up to 32,000 feet so far). The theory is that the geology onshore continues offshore. It’s worth checking out their recent presentation. If you’re not a geologist, it represents a high risk but potentially high return opportunity that will likely resolve itself within the next couple of months when they expect flow test results from Davy Jones No. 1. Jim Bob Moffett, MMR’s CEO, knows a bit about finding valuable minerals having founded Freeport McMoran which is perhaps best known for mining gold and copper at the Grasberg Mine in Indonesia.

The extraordinary depths at which MMR is drilling in the GOM require the development of new technologies to handle the high heat and pressure. There are some interesting and presumably well-informed shareholders, including Plains Exploration (PXP) who owns 23% of MMR’s shares and is restricted from selling until year-end. PXP’s CEO Jim Flores recently stated on a conference call that, “I think you’re going to hear some exciting things out of McMoRan in the next 3 to 6 months, about plans for 2012 that are mind-blowing.”

Admittedly that doesn’t look like detailed financial analysis. Short of having the technical knowledge and information access to independently evaluate MMR’s findings so far, it’s a story stock and not a solid investment. But the different moving parts add up to something interesting, and we have a modest position because we think MMR provides sufficient potential upside for the risk of failure.

Disclosure: author is Long CDE and MMR

If you’re into this kind of thing, which is to say that examining financial statements is a source of stimulating mental gymnastics, figuring out the value of Berkshire Hathaway (BRK) could keep you entertained. BRK released their third quarter’s earnings over the weekend. It’s an insurance company transforming itself into an operating business as Whitney Tilson has pointed out before. It’s true that the acquisition of Burlington Northern has pushed their non-insurance operating earnings to a new level. Breaking the company into its two pieces (insurance and non-insurance) and adding its securities portfolio is an interesting exercise.

Non-insurance businesses generated pre-tax operating income of $5.4BN during the first nine months of the year. There are many moving parts, but assume positive surprises will net out with negatives and you get $7.3BN of full-year pre-tax earnings. Most insurance companies operate an underwriting loss (i.e. they only reach profitability because of investment earnings on the float) but BRK seeks to make a profit on underwriting. Averaging the past two years and annualizing the result generates $765MM in pre-tax operating income. In fact over the past eight years underwriting has produced $17BN, or over $2BN per year.  These two add up to $8BN of pre-tax income, after 35% tax $5.2BN.

Using the S&P500’s trailing P/E multiple of 13 values this at $68BN. This is the value of Berkshire’s insurance underwriting and disparate operating businesses but excluding investment income.

But in addition, BRK has an investment portfolio consisting of marketable securities, non-public investments and cash worth $147 BN. Adding this cash and investment portfolio to the businesses above produces $215BN, compared with BRK’s current market capitalization of $190BN, or in other words the company’s valued at a 12% discount.

Aspen Reinsurance noted that around $95BN of global reinsurance capacity has gone following many events from the earthquakes in Japan and New Zealand to weather-related losses in the U.S. and Australia. Given a harder market (i.e. one of rising premiums given the reduced industry capacity) it’s not unreasonable to expect BRK’s underwriting results to improve next year. If they get back to the eight year average, the company’s worth almost $230BN or is at a 17% discount.

This is a summary of how we look at BRK. It seems to trade at a conglomerate discount. But their underlying businesses are going well, they’re buying back stock and they had their most active quarter of investing in fifteen years, putting almost $21BN to work. We think it remains an attractively priced investment.

Larry Hirshik is both a good friend of mine and our talented trader at SL Advisors. We’ve been friends for over 25 years. Larry and I both spent many years trading interest rate derivatives – eurodollar futures, interest rate swaps and government securities. Interest rate risk has been a topic that consumed much of our intellectual energy for close to three decades. Analyzing economic data, extrapolating growth prospects and assessing the likely path of the Federal Funds rate and interest rates in general was an important part of what we did.

So my friend Larry, who often possesses market insight, noted that there is no longer interest rate risk. Every fixed income analyst is really a credit analyst. As I considered this slap at orthodoxy, I realized Larry was on to something. The Fed has promised zero interest rates through at least 2013, and keeps coming up with new, innovative ways to lower bond yields. Almost every developed country has a policy designed to keep bond yields low enough to shoo away all but the least discriminating investor. The dominant issue affecting the cost of credit for almost the entire world is now its own creditworthiness. European sovereign debt yields are approaching or have already crossed high yield. And so it comes to this – 10 year Italian government bond yields, over 6%, are now competing with si,ilarly yielding leveraged loans. Given the choice between a portfolio of senior debt from non-investment grade corporations, or government debt from an issuer whose yields are now so far above nominal GDP growth as to ensure its debt load is unsustainable, investing in the former seems a wholly more sensible idea. Add this to the “Strange World” list.

I spent an interesting morning yesterday at the AR Symposium, a well-organized get together of hedge fund industry professionals. I had been asked to chair a panel titled “What do investors want and how do they want it”. A year ago I wrote an article pointing out that hedge fund investors in aggregate would have done better investing all their money in t-bills rather than hedge funds. It’s a controversial statement though not hard to prove and to my knowledge no one in the industry has since disputed it. The article was one of the most read on AR’s online site, and it served as the inspiration for my book, The Hedge Fund Mirage, available at the end of the year.

It’s not that I’m against hedge funds. There are many fantastically talented managers, and hedge funds have made enormous amounts of money. It’s just that the money hasn’t really made it through to the clients, in aggregate. I think hedge fund investors ought to do better than they have. I am pro-investor, not anti hedge fund. But not every hedge fund professional initially interprets my message in this way.

So I shared the stage with four charming and well-informed hedge fund investors yesterday. They deftly handled my mildly provocative questions, such as, “Since hedge fund investors have in aggregate not made money, what should they do differently?” Several useful suggestions were offered. I followed up with, “If hedge funds are to meet investors’ 7% return assumptions, this $2 trillion industry needs to generate $140 BN in profits annually, something they’ve never done (apart from the 2009 bounce back following 450 BN in ’08 losses). Why shouldn’t investors be concerned that the industry is overcapitalized?” This one was a little harder but the panel was up to the challenge and offered rebuttals. However, I do think this may continue to be a problem. And 2011 likely represents the 9th consecutive year that hedge funds have failed to outperform a simple blend of 60% stocks/40% bonds. The hedge fund faithful will continue to face such challenges, but most will persevere and new entrants will continue to arrive on the scene.

Another near death experience in equity markets avoided – at least for now. Kevin KAL Kallaugher’s cartoon in last month’s newsletter could scarcely have been better timed (if you missed it October’s letter is available on our website). Stepping back to examine levels of risk seems a reasonable place to start.

There is perhaps no more fundamental a question for bank regulators than knowing how much systemic risk exists, and its trajectory. Although it’s hard to believe looking back over the past few years, there is a well-established trend in the U.S. to increase the amount of equity capital supporting banks. The chart below from the St. Louis Federal Reserve shows that banks have reached 11% equity to assets with only a modest drop during the financial crisis. The numbers exclude companies such as Lehman Brothers (which was not a commercial bank) whose equity: assets was reported to be as low as 3% (i.e. balance sheet leverage of around 30:1) when they filed for bankruptcy in 2008. When Goldman Sachs and Morgan Stanley quickly converted to banks in the aftermath an immediate consequence was that they reduce leverage. But looking at the system as a whole and measuring common equity divided by total assets there is a clearly improving trend upwards. This analysis does not include any risk-weighting of assets, nor does it include any off-balance sheet instruments such as derivatives that might be altering, perhaps substantially, the apparent reduction in risk displayed here.

Systemic banking risk may be lower by one measure, but it’s obviously an imperfect yardstick based on recent history. The chart below shows the standard deviation of GDP (from the U.S. Bureau of Economic Analysis) and the S&P 500. Economic swings have been fairly consistent for most of the past couple of decades while equity market volatility has been at times breathtaking. So is systemic risk really coming down or not?

The now soggy and cold Occupy Wall Street crowd may not yet articulate a coherent set of views, but one might speculate that the financially literate amongst them would favor still less risk rather than more. Measuring equity as a percentage of bank assets is a crude and obviously out-dated tool, in addition to which some of the biggest losses occurred outside the banking system (such as AIG and the Federal housing agencies FNMA and FHMC). The broader socialization of credit risk and a recognition that some banks are too big to fail have been necessary precisely because the banking system is (or at least was found to be in 2008) undercapitalized.  And even with  11% equity: assets, there can be little doubt that banks are in a class of their own when it comes to making their equity capital work hard. No other industry operates with anything like the leverage that banks employ. Companies with far more stable earnings incur far less balance sheet risk. To select a few by way of illustration: Bristol-Myers Squibb (BMY) has 34% equity: assets and Johnson & Johnson (JNJ) 36%. These calculations exclude goodwill from assets and therefore use tangible common equity to be more conservative. As a result no adjustment is made to these and many other companies that own operating assets whose value has increased  substantially since they were acquired but which have not been written up in value on their balance sheets. Financial services companies rarely own assets worth more than their stated value. Loans and bonds are hopefully worth their face amount, but doing much better than getting your money back is hard unless such assets were acquired in distress and while banks often hold distressed assets they rarely acquire them as such. Even within the financial services sector Travellers (TRV) gets by with almost 21% equity. Not coincidentally, these are all holdings in our Hedged Dividend Capture Strategy, which seeks to offer better returns than corporate bonds through a hedged portfolio of equities of steadily growing and prudently managed companies. As regular readers know, outperforming high-grade bonds is not simply a reasonable objective it’s most likely imperative in order to avoid a loss in after-tax real wealth.

Banking leverage is definitely good for banks and is necessary at some safe level in order to allow credit creation and economic growth. While leverage has come down, financial risk has not and there may be a link between increasing compensation and higher levels of risk since the two have grown together. Reducing bankers’ bonuses shouldn’t be an objective of public policy, but further increases in capital would result in a greater share of profits to the providers of capital rather than labor and a safer system too. I’ve long felt banks were much better places to provide labor than capital, which is why I worked for a bank for a long time but have never invested in one beyond the requisite restricted stock employees receive. But since society bears much of the downside of banking catastrophes, it’s reasonable to ask whether society is receiving commensurate benefit. The financial system is measurably riskier over the past twenty years. Who else has this helped beyond the financiers?

It’s a complex question. The global economy has become more linked, and of course there’s only ever one version of history to evaluate. We can’t know how things would have turned out with even lower bank leverage but an otherwise unchanged script. There is no “control experiment” with which to compare, so it’s probably a question that will never have a satisfactory answer. There may be many problems with the Basle III capital guidelines, but directionally the shift towards even greater capitalization seems uncontroversial. If Greek sovereign debt hadn’t been assigned a risk weighting of zero under previous rules, French and German banks who suspended critical thought wouldn’t now hold so much of it. We wouldn’t have a semi-annual Euro crisis. As banks strenuously debate every increase in regulation, their attitude to systemic risk should be part of their response.

What could be more appropriate than Greece delivering a lesson in democracy. The word itself is derived from the Greek language. Democracy began in Greece and is returning there. How very appropriate. The enduring weakness of the EU has been its management by technocrats with often scant regard for popular opinion. The beauty of a referendum is that the Germans and the French, having increasingly taken sovereign decisions over the Greek people will now be in effect negotiating directly with the Greek population itself. Few observers can doubt either the political judgment or the basic fairness of pursuing this route. The French and German banks that recklessly bought so much Greek debt with scant regard for the risks deserve little sympathy. Perhaps they’ll revisit the revised 50% haircut recently agreed on Greek bonds as a smart campaign move as the referendum date moves closer.

It still seems for now that being short the € has many ways to provide a return. Surprises keep cropping up, and in addition there is growing evidence that gap between U.S. and Euro-region GDP growth will widen in favor of the U.S. A cut in short term rates by the ECB seems likely by the end of the year. We are short the € through owning EUO in our hedge fund as protection against falling equities which would hurt other positions. However, the focus of Merkel and Sarkozy on the issues should ensure that the tail risk of a complete disaster will be averted. They will muddle through – it won’t be pretty but that is the most likely outcome. Consequently, we’ll use € weakness to reduce the position.

Senior loans continue to be attractive. The improved GDP outlook in the U.S. should keep a lid on potential defaults among leveraged borrowers. We are invested in PPR and BHL which both have good portfolio management and are attractively priced. Both securities yield close to 6% and are at around a  7% discount to NAV. They represent a solid component of a yield seeking portfolio and are in our Fixed Income Strategy.

Disclosure: Author is Long EUO, PPR, BHL

It’s not just the last decade that’s been harsh on stocks. A report from Jim Bianco’s eponymous research company calculates that for the past thirty years treasury bonds have outperformed stocks. It’s the first thirty year period since 1861 that this has happened according to research on the topic by Jeremy Siegel.

What could be safer than to bet on a continuation of a thirty year trend? Most of the people working on Wall Street have lived the majority of their careers during a time when safe, stodgy investments have been the place to be – though it should be added that the relatively long duration of thirty year bonds makes their price moves more perky than shorter maturities. But the very success of bond investing makes it that much harder to repeat the performance. Just as stocks had impossibly high P/E ratios in the late 90s as the internet bubble climaxed, ten-year treasury notes yielding 2.2% can only return 2.2% over the next ten years. Thirty year bonds returned 11.5% over the past thirty – the yield on thirty year bonds thirty years ago was 14.68% (according to the Federal Reserve’s H-15 report) which accounts for their subsequent return. Today’s thirty year bond yields 3.25%. As mysterious as is the Math of fixed income to some, even Bernie Madoff couldn’t conjure up past returns out of today’s yields.

No doubt for some time to come bonds will be the beneficiary of investors. The world remains a financially risky place, and the latest EU crisis measures increasingly appear to be short of what’s needed. Wilbur Ross was on CNBC this morning noting that a 50% writedown in all EU peripheral sovereign debt (i.e. the GIPSI countries) would require an additional €400BN in bank capital compared with the EBA’s current stress-test estimate of €100BN (of which €30BN is for Greek banks). Other analysts are increasingly finding fault with the absence of detail in the plan. There continues to be plenty for investors to worry about. And yet, stocks don’t require much dividend growth to outdeliver bonds. $20 in 2% yielding stocks with 4% growth provides the same return as $100 in 2% yielding ten year treasuries, leaving $80 to be held in cash or invested elsewhere. Stocks have had a great October and cheaper entry will be available. But the math is compelling.

There have been many times when the ultimate high in the bond market could have occurred – however, one can be certain that past performance will not predict future returns. One can be reasonably sure that future returns will be very low single digits. And there’s a decent chance that today’s bond investors will lose money. Safety comes with a price.

What exactly is a Credit Default Swap (CDS) on Greece worth? It seems likely that the International Swaps Dealers Association (ISDA), the industry body that rules on such things, will soon confirm that the 50% write-down on Greek debt accepted by the banks does not constitute a credit event, because it was accepted voluntarily by the banks and not forced upon them. Although the EMEA Determinations Committee has not yet met, ISDA’s website posts a press release that says, “…it does not appear to be likely that the restructuring will trigger payments under existing CDS contracts.”

Analysts have been predicting as such for weeks. But if a 50% loss doesn’t trigger an insurance pay-off, what does? And if Greek insurance doesn’t pay off, will CDS contracts on Italy, Spain or even France ultimately ever have any value? A sovereign default is a political decision, and quite possibly the insurance contracts owned will ultimately not protect their holders. It reminds me somewhat of the market for perpetual floating rate notes. Many years ago these instruments used to be priced as if they would eventually mature and traded at spreads comparable to finite-lived instruments. Then in 1987 investors realized that these instruments shouldn’t be priced as if one day the issuer would repay them and the market collapsed.

Such may be the fate of developed market sovereign CDS.

To list three credits of note:

Source: ISDA; CNBC.com

The table above takes most recent net and gross CDS outstanding from ISDA, combines them with current CDS prices and assumes four-year average maturity to estimate the approximate net and gross mark-to-market positions among participants from these three names. Although it should be a zero-sum game (i.e. gains for sellers of protections are losses for buyers) the table seeks to estimate the range of P&L swings among participants in the market. The true figures for these three are probably closer to the low end of the two totals above (i.e. $7.3BN) and even that assumes the swaps are worthless which is an extreme outcome. But the same analysis could be applied to other developed sovereigns, perhaps emerging market countries and even corporations deemed too big to fail. Indeed, it appears as if an important element of the negotiation between the banks and the EU was to ensure CDS contracts did not pay off. Avoiding contagion, but perhaps avoiding further losses (if the banks were themselves net sellers of CDS protection) were important consideration. A further step in the socialization of credit risk has been taken.

So buyers of CDS protection are confronting a brave new world. Perhaps selling protection on an EU  sovereign credit is suddenly the easiest money out there.