Democracy Returns to Greece

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

The Elusive CDS Payoff

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;

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.

Savour the Moment

Sometimes you feel as if you’d like the world to stop right where it is. For most investors, arriving at work and checking their portfolios over coffee this morning should be one of the most pleasant beverages they’ve consumed in many months. After the misery of the third quarter culminating in September’s testing of every reasonable investment thesis, sanity is finally returning. The Europeans have avoided disaster; the Germans have crammed voluntary losses on the banks (who have only themselves to blame for owning so much Greek debt in the first place). The banks say they will recapitalize through retained earnings rather than dilutive secondary offerings. The EFSF will be stretched as needed (although details are still sketchy). Life as we knew it can resume, and risk assets are cheap. Enjoy the view, like gazing across a beautiful vista on a sunny day. Touch the moment and savour it. Of course there are problems, and the moment won’t last. But for now, just look and let September’s nightmare recede.

So having done that, what’s next? Well, having engineered a voluntary loss of 50% on holders of Greek debt and thereby avoiding an actual default, the market for sovereign credit default swaps (CDS) appears superfluous. Cautious buyers of Greek debt (were there ever any?) who bought credit insurance (i.e. CDS) have found it a waste of money. Sovereign defaults are at the end of the day as much political as credit events. Rating agency assessments of countries are political judgments, and maybe we’re witnessing the end of one corner of the CDS market. Bankers have warned that reduced hedging opportunities will reduce the appetite of banks to extend credit – that may not be a wholly bad outcome given the amount of poorly conceived credit they’ve extended in the past. But reduced credit in the near term combined with Europe-wide fiscal retrenchment will stifle growth.

For our part, the main challenge to investors remains finding a fair alternative to the paltry yields offered in fixed income. Senior loans continue to be an attractive sector. The ING Prime Rate Fund (PPR) yields close to 6% and closed at a  7% discount to its NAV. When I spoke to one of the co-PMs a couple of weeks ago he felt fairly sanguine about defaults barring a European disaster which, at that time couldn’t be ruled out. Meanwhile, high-grade corporate bonds at around 4% with no growth require conditions close to but just short of deflation to turn out well. The gap between the 8% earnings yield on the S&P500 and 2.25% ten-year treasury bonds is somewhat narrower than a month ago but still historically wide. Today is probably not the day to jump into equities, but at a calmer moment they still look like a more attractive long-term investment than bonds. The after-tax return on $100 in ten year treasuries can be beaten by a combination of $80 in 0% cash and only $20 in 2.2% dividend yielding stocks assuming as little as 4% dividend growth. Bonds are at yields that only a QE emboldened government could love.

In equities we remain fully invested. Natural gas E&P names continue to represent the more volatile sector of our Deep Value Equity portfolio. Devon Energy (DVN) is barely above the value of its proved reserves. We continue to believe Gannett (GCI) is very cheap at 6X earnings or less than five times free cashflow. And Microsoft (MSFT) remains attractive at less than 7X earnings net of cash (less debt) on balance sheet. MSFT has been cheap for many, many months. It’s not exciting to be an investor – far from it. But it continues to be reliably profitable.

Disclosure: Author is Long PPR, DVN, GCI, MSFT

If you had more money than you knew what to do with…

So says Don Sturm, owner of two community banks in Colorado. And Mr. Sturm’s complaint is not that he’s been amply paid (although he may have), but that depositors are flooding in at a rate that outstrips his banks’ ability to usefully redeploy the money. This is QE2 at ground level. Investors fleeing the treacherous equity markets are selecting safe bank deposits, but are receiving nothing in return. In some cases banks are actually charging large clients for the privelige of being depositors.

Banks are still struggling to find enough good places to put the money they have. Although the system is awash with liquidity that other necessary component of inflation which is velocity (in other words, how quickly money gets recycled) is notably absent. Hence the ballooning money supply is not yet translating into inflation. But M2 is growing at an increasing pace – according to figures from the Federal Reserve its annualized growth has quickened from 10% over the past year to 24% over the past three months. Still no sign of a problem, and yet ten year treasury notes yielding 2.25% or high grade corporate debt at just over 4% provide scant protection should money velocity reappear and link up with already ample money creation.

On a different topic, how exactly does an investor in Greek debt get comfortable with a “voluntary” 60% loss? To accept any negotiated settlement there needs to exist a worse alternative, and it’s hard to imagine what that might be. Since the purpose of a voluntary loss is to avoid triggering a payoff on CDS contracts, it’s a stretch to see why any holder of Greek debt who also owned such CDS insurance would accept an uninsured 60% loss rather than endure a bankruptcy and so retain the ability to claim on their insurance coverage. Maybe there are very few holders of CDS who use it to insure against risks they already have. It increasingly appears as if most buyers of CDS protection were smart enough to avoid actually needing the insurance. It’s as if most homeowners insurance was owned by people on their neighbour’s house rather than their own.

We continue to be short the Euro through a long position in EUO. Although Europe’s leaders are clearly focused on the issues at hand, the latest recapitalization needs are being dismissed by analysts as simply covering the loss from a mark-to-market of existing bond holdings at current levels rather than simulating a more stressful scenario than currently exists. The EU’s leaders are getting there but at a painfully slow rate, and southern Europe is most likely already in a recesson. As is often the case, it looks as if the economic cycle in  the U.S. will be ahead of Europe’s, which should provide support for the $ against the €.

Monday Morning Thoughts, October 24th

There’s an interesting article in the Wall Street Journal highlighting that banks are increasingly the first source of funds for takeovers – providing more funds that the high yield bond market. Kinder Morgan’s recent acquisition of El Paso is cited as an example, but there’s increasing evidence that banks are increasing their risk appetite. The Fed’s confiscatory interest rate policies are steadily squeezing people out of riskless assets where there’s no return to be made. In our Fixed Income strategy we continue to own senior loan closed end funds such as Blackrock Defined opportunity Fund (BHL) and ING Prime Rate Trust (PPR). The prices on this sector had dropped more than 20% over the past six months, through lower NAVs and prices shifting from a premium to a discount.

Hedge funds are nervously waiting – not for the publication of my book, The Hedge Fund Mirage, but instead to see how big redemptions are going in to the end of the year. The WSJ has an article noting poor performance by some very large funds (Paulson, Maverick and Kingdon amongst others). Hedge fund investors are apparently maintaining their strategy of momentum investing even though it has served them so poorly over the years. Adding to winners and redeeming from losers. There aren’t many hedge fund investors who seek out under-performing managers.

We invested in Transocean (RIG) on Friday in our Deep Value Equity strategy. We had previously owned the largest owner of offshore oil rigs last year following the Gulf of Mexico oil spill when its stock traded down substantially on fears of enormous legal liability. Such fears were unfounded and the stock recovered. We exited although well before its high. In recent months concerns of economic slowdown as well as BP’s lawsuit have depressed the stock price which is now trading more than 30% below the market value of its rigs (according to research from JPMorgan). There’s considerable room for error around such estimates, but this provides a greater margin of safety than on other names in its peer group. In addition with consensus estimates for $5.26 per share in earnings next year it appears attractively priced. BP’s lawsuit will no doubt continue to be a cloud over them for some time, but with $17BN in market cap and $25BN in enterprise value they’re big enough to handle even a $1BN legal settlement. It also pays a $3.16 dividend which gives it a yield of almost 6%.

We continue to own Gannett Co (GCI). It has been an unrewarding experience so far. It’s true they’re in the hated newspaper business which continues to shrink every quarter, but they also own broadcasting and digital franchises which look much more attractive. The problem is their publishing division is their biggest, notably the newspaper USA Today. But they are consistently profitable and trade at less than 6X earnings which are expected to grow modestly next year (helped by election-related TV advertising and continued double-digit growth in their online businesses). We’d like to see them buy back more stock but cashflow from operations regularly exceeds $700 million per year (compared with their market cap of 2.7BN), and with minimal capex needs they’ve been paying down debt. Perhaps the improved lending climate noted above will induce a private equity buyer to acquire what we think is a very cheap company.

Disvlosure: Author is Long BHL, PPR, RIG, GCI

Reining in the Rating Agencies

Through the ongoing and mind-numbing complexity of the European sovereign debt crisis, the bureaucrats in Brussels can be relied upon to introduce some absurdity into their deliberations. The latest is a report in the FT that under certain circumstances  the EU will suspend the ability of rating agencies to evaluate sovereign credits. Now it’s true that markets are generally too reliant on credit ratings issued by S&P, Moody’s and Fitch. The basic business model of charging the issuer for the rating is fraught with conflict, as catastrophically revealed during the sub-prime crisis. However, alternative models are hard to identify – increased competition among rating agencies would likely cause a “race to the bottom” in which issuers would flock to those with the most forgiving standards. And charging investors, the actual users of the ratings, is regarded by many as unworkable.

But the downgrade of U.S. debt that occurred in the Summer highlighted the absurdity of the rating agencies evaluating sovereign debt. Unlike a corporate issuer where a detailed financial analysis encompasses most of the necessary work, sovereign credit analysis incorporates a political judgment as well. The U.S. downgrade in the Summer illustrates the rating agencies straying beyond their expertise. U.S. creditworthiness is based to a large degree on a willingness to repay debt, and an opinion on which is as much political as it is financial. The rating agencies have no more insight on the politics than many other informed observers, and as such their opinions ought to be irrelevant except for the fact that so much bond investing is rules-based driven by the ratings that these agencies issue. Many bond investors are required to hold issues with minimum ratings from the three Nationally Recognized Statistical Rating Organizations (NRSROs), otherwise known as S&P, Moody’s and Fitch.  But really, since sovereign issuers have the ability to tax, their credit ratings are by nature not simply financial. The ratings frankly shouldn’t carry any more weight than other sell-side research on bonds.

As sensible as it might seem to ditch the legal support for NRSRO-issued sovereign credit ratings, the EU bureaucrats in Brussels have revealed their own muddled thinking in the latest proposal. No doubt France’s impending loss of its AAA rating, a possibility the French regard with horror but which financial markets have already moved past, is the catalyst. The FT reports that under proposed EU regulations ratings will be suspended during times of financial stress. So good ratings are fine, but bad ones are not. And presumably the EU’s credit experts will anticipate trouble by suspending ratings prior to a downgrade, therefore providing an eloquent and informed signal to investors that perhaps those bonds are not quite as safe as previously thought.

In the U.S. we can be grateful that we don’t subsidize such entertaining idiocy with our tax dollars. It must be more frustrating for those sitting in Europe.

The IMF Will Need to Bail Out Europe

The FT has a very good summary of the current state of play in the European debt crisis. Yet another weekend summit critical to the survival of the Euro is upon us. Once again, bottom-up analysis of investments is held hostage to the macro issues at play.

The EU is designed to seek consensus and is antithetical to the type of strong leadership now required. Since no single leader will be held responsible if the whole edifice crashes down, all the political calculations are based on domestic politics. It’s democratic, but ill-suited to the problems they’re facing.

The FT article highlights some important points regarding the European Financial Stability Facility (EFSF). Although €440 billion sounds like enough money, particularly if used as a first loss guarantee (theoretically increasing its firepower by 4-5 times) that’s not what’s really available. Prior bailouts of Greece, Portugal and Ireland have reduced this to  €250BN – and unsurprisingly these countries have withdrawn their pledges to the EFSF. In addition,  €230BN comes from Spain and Italy, and since Spain is quite possibly one of the future recipients of bailout funds the ultimate available funds shrink further.

For many months it’s been clear that German taxpayers would be writing a check – either to Greece or to their bondholders. But even that is looking less clear without sufficient bailout funds available. So it appears that the IMF will ultimately ride to the rescue. They’ve apparently already been asked, but the U.S. and U.K. both opposed such a move. One can only imagine the outcry in Congress at such a move. So making such support politically acceptable will no doubt require another round of robust risk reduction, since only when voters are poorer will they accept the need for U.S. money to bail out Europe.

But of course the U.S. is a net debtor as well. Things will work out – they invariably do when there’s no alternative. But the stage is set for macro issues to overwhelm everything else.

Force-feeding Capital to European Banks

There can be little doubt that the European sovereign debt crisis has finally drawn the full attention of Europe’s leaders. After following events from a more than discrete distance, it is starting to look as if a consensus is evolving around three principles:

1) Greater write-down of Greek debt

2) More realistic stress tests of Europe’s banks with a view to requiring them to reach 9-10% equity capital to risk-weighted assets over a fairly short period of time

3) Using the EFSF as a guarantor of first loss on sovereign debt, in effect increasing its firepower to €2 trillion or more.

The European Banking Authority’s (EBA) last stress tests identified only €2.5 billion in capital shortfall for the entire region, a ludicrously low figure that lost them great credibility. Mike Cembalest, JPMorgan’s Private Bank CIO, memorably commented that the number was so low he thought the results were being released by country alphabetically starting with Andorra. At the same time the IMF’s estimate of the needed additional capital was €100-200 billion.

However, there is a problem with forcing banks to raise additional capital. They may instead decide to shrink their balance sheets instead, a prospect noted in the FT today. Issuing equity at 0.5 X book value is scarcely an attractive proposition and selling assets must be a realistic alternative. But that could well lead to a sharp slowdown in lending, further hampering the EU region’s efforts to avoid (or emerge from) recession.

George Soros floats an interesting suggestion that governments should first unconditionally guarantee their banks to stabilize them, following up with recapitalization later when their share prices have presumably recovered.

While it’s positive that constructive solutions are now receiving consideration, holders of risky assets can still benefit from being short the Euro. The € continues to be the focal point of the global slowdown. We are long ProShares UltraShort Euro (EUO) as a hedge against other types of long equity risk in our hedge fund. The risk of a complete disaster is receding, but the solutions don’t look to be positive for European growth.


Disclosure: Author is long EUO

The Principal Agent Problem in Private Equity

Peter Morris has written an interesting article noting the principal-agent problem as it relates to investors in private equity. Peter spent 25 years working in financial services and is the author of a report written for the Center for the Study of Financial Innovation (CSFI) called Private Equity, Public Loss? Peter and others have pointed out the disparity between low returns earned by private equity investors and the ample compensation earned by the managers of those investments. The principal-agent problem Peter notes is not unique to private equity of course, but he makes a good case for much greater transparency around results for such investors and challenges the notion that “sophisticated” investors are well equipped to make well informed decisions in this arena. Investors in hedge funds have suffered through similarly poor results as Peter also notes, and he kindly refers to a book I have written called The Hedge Fund Mirage which explores this issue.

There are interesting public policy issues surrounding this entire area, in that public pension funds are increasingly allocating capital to alternative investment strategies in the hopes of reaching the 7-8% return targets they need to meet their obligations. Ultimately, a failure to meet those goals will have consequences for taxpayers throughout the developed world as workers retire if pension plan returns fail to met expectations.

How UBS mismanaged its way to a profit

The good news from UBS today is that they expect to post a modest profit for the third quarter.  This is in spite of losing $2.3 billion through the unauthorized trading of Kweku Adoboli. On top of that, the woefully inadequate risk oversight that Mr. Adoboli so painfully exposed has forced UBS to hasten the shrinking of their investment bank, incurring restructuring charges. However, in spite of these twin blows to their results, UBS expects to include a $1.5 billion Swiss franc profit from widening credit spreads on their debt. That’s right, because the company’s self-inflicted wound has soured investors on the bank’s prospects and therefore raised the yield on their debt, in the topsy-turvy world of accounting this is counted towards their profit. The green eye-shade logic is that because UBS owes money (on the bonds they’ve issued) the lower price for the bonds implies the value of what UBS owes has gone down. It’s the same as if the investors in those bonds just decided to forgive 5% of the face value.

Of course, UBS still owes the same amount of money, and borrowing just became more expensive for them. But the Looking Glass world of liability accounting regards this differently. So when UBS announces a profit for the third quarter, remember that it came about through the market’s recognition of their weak risk management structure.