The challenges facing the Euro zone including most recently Italy seem so enormous and intractable that it’s easy to contemplate previously unimaginable outcomes. Der Spiegel reports that the German government is preparing for a possible Greek exit from the Euro. The currency was designed without an exit – it’s unclear how Greece could extricate itself. A weekend nationalization of banks with all deposits converted to drachma? The new currency would immediately collapse from its initial level as unwilling holders of drachma sold, and in any case the days and weeks leading up to such an event would no doubt see a sharp run on deposits from Greek banks. As it is there’s a tax on money leaving the country. And we read every day that supporting Italy will require the IMF and a reinforced EFSF. What will happen if Italy can’t refinance its debt, €250BN of which rolls over in 2012?

But you don’t need to bet on disasters to see downside for the Euro. Just muddling through and avoiding any of the crisis scenarios is going to involve slower growth. The Austerity Solution so favored by the EU and IMF is assuredly lowering GDP growth in the region as well as consumer confidence. The growth differential between the U.S. and the Euro-zone continues to widen. JPMorgan now forecasts +1.7% 2012 GDP growth in the U.S. versus -0.6% in the Euro-zone. Solutions and non-solutions seem to lead to the same place. The next 10% move in the exchange rate looks far more likely to be lower.

The Financial Times notes that Liquid Natural Gas (LNG) tanker ships are experiencing increased demand, one of the very few areas of shipping for which that is true. The rest of the shipping industry has shot itself in both feet as every operator positioned for a 10% increase in market share, which has crushed shipping rates through overcapacity and made the sector even less friendly than U.S. residential construction (if that’s possible). But the virtual shutdown of the Japanese nuclear energy industry following the earthquake has increased Japanese demand for LNG imports and is raising prices. Regrettably, producers of domestic natural gas in the U.S. are not direct beneficiaries because the U.S. currently has no facilities at which natural gas can be compressed for export, but greater global demand is a positive over the long term (i.e. 3-5 years).

Still on the subject of shipping, we continue to be invested in Aegean Marine Petroleum (ANW). They provide bunker fuel to the shipping industry and so operate a very different business model than their customers. Their stock price has been beaten down with their peers, although they continue to generate operating profits and just reported a third quarter of solid margins. If you can believe their book value (assets are ships and fuel inventory) the stock trades at a 40% discount. On their earnings call last week management asserted that market value for their ships was no lower than carrying value – much of the fleet is recently purchased so that ought to be true, although they did take a loss versus book value on the sale of one vessel in the third quarter. Even after rallying on last week’s earnings it still trades at less than 7 X ’12 estimated earings. We continue to hold a modest position in ANW.

Berkshire Hathaway (BRK) remains one of our biggest holdings, for reasons articulated the other day. Warren Buffett’s appearance on CNBC this morning was never boring, and he revealed an investment in IBM which is not a stock we would have bought ourselves. Many large cap U.S. stocks appear attractively priced, and the dividend yield on the S&P500 (SPY) remains more attractive than long-term government or high-grade bonds. The equity risk premium is not as wide as it was but remains nonetheless attractive in favoring equities over fixed income.

Disclosure: Author in Long EUO, BRK, ANW, SPY

At least Italian savers are offered a decent return on their money. 7% on ten-year debt is a bit more like it – at least after taxes and inflation you stand a chance of being ahead of the game, unlike in the U.S. where government policy is hostile to savers and seeks to inflict real losses of purchasing power on anyone desperate enough to invest in government bonds. We could use some Italian yields here in the U.S. However, in Italy there’s just the non-trivial question about ultimate repayment. Meanwhile, Senior loans in the form of two closed end funds, PPR and BHL, yielding around 6% seem a much better bet. Diversified credit risk to leveraged corporate borrowers with short duration, versus concentrated sovereign credit risk with dysfunctional government and long duration. There’s no yield at which we’d invest in Italy; we did buy more of these two funds yesterday.

If the sellers of Italian bonds over the past few days have been banks, it would be wholly understandable. The “voluntary” 50% haircut they agreed to over Greece clearly sets a precedent rather than being unprecedented. Combined with the natural consequence that sovereign credit default swaps have questionable value (since the 50% write-down likely won’t trigger a default event) return of capital is trumping return on capital. Forecasting where the crisis will end remains a complex struggle, but by now we’re becoming trained to contemplate the unthinkable. Markets even seem to have moved beyond the EFSF and that leaves just the IMF to bail out with real money and strings attached, or ultimately the ECB to create money. What a surreal outcome that would be given that the ECB’s constitution was modelled on the Bundesbank’s and more or less dictated by Germany. And of course it may not happen. But with Italy now “in play” so to speak, yet another unthinkable is now a headline. German policymakers will have to wrestle with their deep-seated fear of inflation and their perhaps equally strong desire to maintain the Euro in is present form. We maintain a short € position (through being long EUO) as a hedge on some of our leveraged strategies. We reduced the position yesterday – it’s not that the crisis is over, but obviously everyone gets the joke by now so the $/€ exchange rate provides less protection than it used to.

Disclosure: Author is Long PPR, BHL, EUO

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.

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.

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

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.

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

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 €.

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