Friday, February 29, 2008

Investing 101 From Buffett

Buffett gets better at explaining investing every year. This is a comprehensive description from this year's Berkshire shareholder letter.

Businesses – The Great, the Good and the Gruesome
Let’s take a look at what kind of businesses turn us on. And while we’re at it, let’s also discuss what we wish to avoid.

Charlie and I look for companies that have a) a business we understand; b) favorable long-term economics; c) able and trustworthy management; and d) a sensible price tag. We like to buy the whole business or, if management is our partner, at least 80%. When control-type purchases of quality aren’t available, though, we are also happy to simply buy small portions of great businesses by way of stockmarket purchases. It’s better to have a part interest in the Hope Diamond than to own all of a rhinestone.

A truly great business must have an enduring “moat” that protects excellent returns on invested capital. The dynamics of capitalism guarantee that competitors will repeatedly assault any business “castle” that is earning high returns. Therefore a formidable barrier such as a company’s being the lowcost producer (GEICO, Costco) or possessing a powerful world-wide brand (Coca-Cola, Gillette, American Express) is essential for sustained success. Business history is filled with “Roman Candles,” companies whose moats proved illusory and were soon crossed.

Our criterion of “enduring” causes us to rule out companies in industries prone to rapid and continuous change. Though capitalism’s “creative destruction” is highly beneficial for society, it precludes investment certainty. A moat that must be continuously rebuilt will eventually be no moat at all.

Additionally, this criterion eliminates the business whose success depends on having a great manager. Of course, a terrific CEO is a huge asset for any enterprise, and at Berkshire we have an abundance of these managers. Their abilities have created billions of dollars of value that would never have materialized if typical CEOs had been running their businesses.

But if a business requires a superstar to produce great results, the business itself cannot be deemed great. A medical partnership led by your area’s premier brain surgeon may enjoy outsized and growing earnings, but that tells little about its future. The partnership’s moat will go when the surgeon goes. You can count, though, on the moat of the Mayo Clinic to endure, even though you can’t name its CEO.

Long-term competitive advantage in a stable industry is what we seek in a business. If that comes with rapid organic growth, great. But even without organic growth, such a business is rewarding. We will simply take the lush earnings of the business and use them to buy similar businesses elsewhere. There’s no rule that you have to invest money where you’ve earned it. Indeed, it’s often a mistake to do so: Truly great businesses, earning huge returns on tangible assets, can’t for any extended period reinvest a large portion of their earnings internally at high rates of return.

Let’s look at the prototype of a dream business, our own See’s Candy. The boxed-chocolates industry in which it operates is unexciting: Per-capita consumption in the U.S. is extremely low and doesn’t grow. Many once-important brands have disappeared, and only three companies have earned more than token profits over the last forty years. Indeed, I believe that See’s, though it obtains the bulk of its revenues from only a few states, accounts for nearly half of the entire industry’s earnings.

At See’s, annual sales were 16 million pounds of candy when Blue Chip Stamps purchased the company in 1972. (Charlie and I controlled Blue Chip at the time and later merged it into Berkshire.) Last year See’s sold 31 million pounds, a growth rate of only 2% annually. Yet its durable competitive advantage, built by the See’s family over a 50-year period, and strengthened subsequently by Chuck Huggins and Brad Kinstler, has produced extraordinary results for Berkshire.

We bought See’s for $25 million when its sales were $30 million and pre-tax earnings were less than $5 million. The capital then required to conduct the business was $8 million. (Modest seasonal debt was also needed for a few months each year.) Consequently, the company was earning 60% pre-tax on invested capital. Two factors helped to minimize the funds required for operations. First, the product was sold for cash, and that eliminated accounts receivable. Second, the production and distribution cycle was short, which minimized inventories.

Last year See’s sales were $383 million, and pre-tax profits were $82 million. The capital now required to run the business is $40 million. This means we have had to reinvest only $32 million since 1972 to handle the modest physical growth – and somewhat immodest financial growth – of the business. In the meantime pre-tax earnings have totaled $1.35 billion. All of that, except for the $32 million, has been sent to Berkshire (or, in the early years, to Blue Chip). After paying corporate taxes on the profits, we have used the rest to buy other attractive businesses. Just as Adam and Eve kick-started an activity that led to six billion humans, See’s has given birth to multiple new streams of cash for us. (The biblical command to “be fruitful and multiply” is one we take seriously at Berkshire.)

There aren’t many See’s in Corporate America. Typically, companies that increase their earnings from $5 million to $82 million require, say, $400 million or so of capital investment to finance their growth. That’s because growing businesses have both working capital needs that increase in proportion to sales growth and significant requirements for fixed asset investments.

A company that needs large increases in capital to engender its growth may well prove to be a satisfactory investment. There is, to follow through on our example, nothing shabby about earning $82 million pre-tax on $400 million of net tangible assets. But that equation for the owner is vastly different from the See’s situation. It’s far better to have an ever-increasing stream of earnings with virtually no major capital requirements. Ask Microsoft or Google.

One example of good, but far from sensational, business economics is our own FlightSafety. This company delivers benefits to its customers that are the equal of those delivered by any business that I know of. It also possesses a durable competitive advantage: Going to any other flight-training provider than the best is like taking the low bid on a surgical procedure.

Nevertheless, this business requires a significant reinvestment of earnings if it is to grow. When we purchased FlightSafety in 1996, its pre-tax operating earnings were $111 million, and its net investment in fixed assets was $570 million. Since our purchase, depreciation charges have totaled $923 million. But capital expenditures have totaled $1.635 billion, most of that for simulators to match the new airplane models that are constantly being introduced. (A simulator can cost us more than $12 million, and we have 273 of them.) Our fixed assets, after depreciation, now amount to $1.079 billion. Pre-tax operating earnings in 2007 were $270 million, a gain of $159 million since 1996. That gain gave us a good, but far from See’s-like, return on our incremental investment of $509 million.

Consequently, if measured only by economic returns, FlightSafety is an excellent but not extraordinary business. Its put-up-more-to-earn-more experience is that faced by most corporations. For example, our large investment in regulated utilities falls squarely in this category. We will earn considerably more money in this business ten years from now, but we will invest many billions to make it.

Now let’s move to the gruesome. The worst sort of business is one that grows rapidly, requires significant capital to engender the growth, and then earns little or no money. Think airlines. Here a durable competitive advantage has proven elusive ever since the days of the Wright Brothers. Indeed, if a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favor by shooting Orville down.

The airline industry’s demand for capital ever since that first flight has been insatiable. Investors have poured money into a bottomless pit, attracted by growth when they should have been repelled by it. And I, to my shame, participated in this foolishness when I had Berkshire buy U.S. Air preferred stock in 1989. As the ink was drying on our check, the company went into a tailspin, and before long our preferred dividend was no longer being paid. But we then got very lucky. In one of the recurrent, but always misguided, bursts of optimism for airlines, we were actually able to sell our shares in 1998 for a hefty gain. In the decade following our sale, the company went bankrupt. Twice.

To sum up, think of three types of “savings accounts.” The great one pays an extraordinarily high interest rate that will rise as the years pass. The good one pays an attractive rate of interest that will be earned also on deposits that are added. Finally, the gruesome account both pays an inadequate interest rate and requires you to keep adding money at those disappointing returns.

Buffett Quotables

CNBC's Michelle Caruso-Cabrera takes a look at the wit and wisdom of billionaire investor Warren Buffett.

Roubini's Testimony to House of Rep.

This letter is a little bit technical, but it does a terrific job outlining the possibility of a vicious cycle/serious recession.

Start first with the recession that is now enveloping the US economy. Let us assume – as likely - that this recession – that already started in December 2007 - will be worse than the mild ones – that lasted 8 months – that occurred in 1990-91 and 2001. The recession of 2008 will be more severe for several reasons: first, we have the biggest housing bust in US history with home prices likely to eventually fall 20 to 30%; second, because of a credit bubble that went beyond mortgages and because of reckless financial innovation and securitization the ongoing credit bust will lead to a severe credit crunch; third, US households – whose consumption is over 70% of GDP - have spent well beyond their means for years now piling up a massive amount of debt, both mortgage and otherwise; now that home prices are falling and a severe credit crunch is emerging the retrenchment of private consumption will be serious and protracted. So let us suppose that the recession of 2008 will last at least four quarters and, possibly, up to six quarters. What will be the consequences of it?

Here are the twelve steps or stages of a scenario of systemic financial meltdown associated with this severe economic recession.

First, this is the worst housing recession in US history and there is no sign it will bottom out any time soon. At this point it is clear that US home prices will fall between 20% and 30% from their bubbly peak; that would wipe out between $4 trillion and $6 trillion of household wealth. While the subprime meltdown is likely to cause about 2.2 million foreclosures, a 30% fall in home values would imply that over 10 million households would have negative equity in their homes and would have a big incentive to use “jingle mail” (i.e. default, put the home keys in an envelope and send it to their mortgage bank). Moreover, soon enough a few very large home builders will go bankrupt and join the dozens of other small ones that have already gone bankrupt thus leading to another free fall in home builders’ stock prices that have irrationally rallied in the last few weeks in spite of a worsening housing recession.

Second, losses for the financial system from the subprime disaster are now estimated to be as high as $250 to $300 billion. But the financial losses will not be only in subprime mortgages and the related RMBS and CDOs. They are now spreading to near prime and prime mortgages as the same reckless lending practices in subprime (no down-payment, no verification of income, jobs and assets (i.e. NINJA or LIAR loans), interest rate only, negative amortization, teaser rates, etc.) were occurring across the entire spectrum of mortgages; about 60% of all mortgage origination since 2005 through 2007 had these reckless and toxic features. So this is a generalized mortgage crisis and meltdown, not just a subprime one. And losses among all sorts of mortgages will sharply increase as home prices fall sharply and the economy spins into a serious recession. Goldman Sachs now estimates total mortgage credit losses of about $400 billion; but the eventual figures could be much larger if home prices fall more than 20%. Also, the RMBS and CDO markets for securitization of mortgages – already dead for subprime and frozen for other mortgages - remain in a severe credit crunch, thus reducing further the ability of banks to originate mortgages. The mortgage credit crunch will become even more severe.

Also add to the woes and losses of the financial institutions the meltdown of hundreds of billions of off balance SIVs and conduits; this meltdown and the roll-off of the ABCP market has forced banks to bring back on balance sheet these toxic off balance sheet vehicles adding to the capital and liquidity crunch of the financial institutions and adding to their on balance sheet losses. And because of securitization the securitized toxic waste has been spread from banks to capital markets and their investors in the US and abroad, thus increasing – rather than reducing systemic risk – and making the credit crunch global.

Third, the recession will lead – as it is already doing – to a sharp increase in defaults on other forms of unsecured consumer debt: credit cards, auto loans, student loans. There are dozens of millions of subprime credit cards and subprime auto loans in the US. And again defaults in these consumer debt categories will not be limited to subprime borrowers. So add these losses to the financial losses of banks and of other financial institutions (as also these debts were securitized in ABS products), thus leading to a more severe credit crunch. As the Fed loan officers survey suggest the credit crunch is spreading throughout the mortgage market and from mortgages to consumer credit, and from large banks to smaller banks.

Fourth, while there is serious uncertainty about the losses that monolines will undertake on their insurance of RMBS, CDO and other toxic ABS products, it is now clear that such losses are much higher than the $10-15 billion rescue package that regulators are trying to patch up. Some monolines are actually borderline insolvent and none of them deserves at this point a AAA rating regardless of how much realistic recapitalization is provided. Any business that required an AAA rating to stay in business is a business that does not deserve such a rating in the first place. The monolines should be downgraded as no private rescue package – short of an unlikely public bailout – is realistic or feasible given the deep losses of the monolines on their insurance of toxic ABS products.

Next, the downgrade of the monolines will lead to another $150 of writedowns on ABS portfolios for financial institutions that have already massive losses. It will also lead to additional losses on their portfolio of muni bonds. The downgrade of the monolines will also lead to large losses – and potential runs – on the money market funds that invested in some of these toxic products. The money market funds that are backed by banks or that bought liquidity protection from banks against the risk of a fall in the NAV may avoid a run but such a rescue will exacerbate the capital and liquidity problems of their underwriters. The monolines’ downgrade will then also lead to another sharp drop in US equity markets that are already shaken by the risk of a severe recession and large losses in the financial system.

Fifth, the commercial real estate loan market will soon enter into a meltdown similar to the subprime one. Lending practices in commercial real estate were as reckless as those in residential real estate. The housing crisis will lead – with a short lag – to a bust in non-residential construction as no one will want to build offices, stores, shopping malls/centers in ghost towns. The CMBX index is already pricing a massive increase in credit spreads for non-residential mortgages/loans. And new origination of commercial real estate mortgages is already semi-frozen today; the commercial real estate mortgage market is already seizing up today.

Sixth, it is possible that some large regional or even national bank that is very exposed to mortgages, residential and commercial, will go bankrupt. Thus some big banks may join the 200 plus subprime lenders that have gone bankrupt. This, like in the case of Northern Rock, will lead to depositors’ panic and concerns about deposit insurance. The Fed will have to reaffirm the implicit doctrine that some banks are too big to be allowed to fail. But these bank bankruptcies will lead to severe fiscal losses of bank bailout and effective nationalization of the affected institutions. Already Countrywide – an institution that was more likely insolvent than illiquid – has been bailed out with public money via a $55 billion loan from the FHLB system, a semi-public system of funding of mortgage lenders. Banks’ bankruptcies will add to an already severe credit crunch.

Seventh, the banks losses on their portfolio of leveraged loans are already large and growing. The ability of financial institutions to syndicate and securitize their leveraged loans – a good chunk of which were issued to finance very risky and reckless LBOs – is now at serious risk. And hundreds of billions of dollars of leveraged loans are now stuck on the balance sheet of financial institutions at values well below par (currently about 90 cents on the dollar but soon much lower). Add to this that many reckless LBOs (as senseless LBOs with debt to earnings ratio of seven or eight had become the norm during the go-go days of the credit bubble) have now been postponed, restructured or cancelled. And add to this problem the fact that some actual large LBOs will end up into bankruptcy as some of these corporations taken private are effectively bankrupt in a recession and given the repricing of risk; convenant-lite and PIK toggles may only postpone – not avoid – such bankruptcies and make them uglier when they do eventually occur. The leveraged loans mess is already leading to a freezing up of the CLO market and to growing losses for financial institutions.

Eighth, once a severe recession is underway a massive wave of corporate defaults will take place. In a typical year US corporate default rates are about 3.8% (average for 1971-2007); in 2006 and 2007 this figure was a puny 0.6%. And in a typical US recession such default rates surge above 10%. Also during such distressed periods the RGD – or recovery given default – rates are much lower, thus adding to the total losses from a default. Default rates were very low in the last two years because of a slosh of liquidity, easy credit conditions and very low spreads (with junk bond yields being only 260bps above Treasuries until mid June 2007). But now the repricing of risk has been massive: junk bond spreads close to 700bps, iTraxx and CDX indices pricing massive corporate default rates and the junk bond yield issuance market is now semi-frozen. While on average the US and European corporations are in better shape – in terms of profitability and debt burden – than in 2001 there is a large fat tail of corporations with very low profitability and that have piled up a mass of junk bond debt that will soon come to refinancing at much higher spreads. Corporate default rates will surge during the 2008 recession and peak well above 10% based on recent studies. And once defaults are higher and credit spreads higher massive losses will occur among the credit default swaps (CDS) that provided protection against corporate defaults. Estimates of the losses on a notional value of $50 trillion CDS against a bond base of $5 trillion are varied (from $20 billion to $250 billion with a number closer to the latter figure more likely). Losses on CDS do not represent only a transfer of wealth from those who sold protection to those who bought it. If losses are large some of the counterparties who sold protection – possibly large institutions such as monolines, some hedge funds or a large broker dealer – may go bankrupt leading to even greater systemic risk as those who bought protection may face counterparties who cannot pay.

Ninth, the “shadow banking system” (as defined by the PIMCO folks) or more precisely the “shadow financial system” (as it is composed by non-bank financial institutions) will soon get into serious trouble. This shadow financial system is composed of financial institutions that – like banks – borrow short and in liquid forms and lend or invest long in more illiquid assets. This system includes: SIVs, conduits, money market funds, monolines, investment banks, hedge funds and other non-bank financial institutions. All these institutions are subject to market risk, credit risk (given their risky investments) and especially liquidity/rollover risk as their short term liquid liabilities can be rolled off easily while their assets are more long term and illiquid. Unlike banks these non-bank financial institutions don’t have direct or indirect access to the central bank’s lender of last resort support as they are not depository institutions. Thus, in the case of financial distress and/or illiquidity they may go bankrupt because of both insolvency and/or lack of liquidity and inability to roll over or refinance their short term liabilities. Deepening problems in the economy and in the financial markets and poor risk managements will lead some of these institutions to go belly up: a few large hedge funds, a few money market funds, the entire SIV system and, possibly, one or two large and systemically important broker dealers. Dealing with the distress of this shadow financial system will be very problematic as this system – stressed by credit and liquidity problems - cannot be directly rescued by the central banks in the way that banks can.

Tenth, stock markets in the US and abroad will start pricing a severe US recession – rather than a mild recession – and a sharp global economic slowdown. The fall in stock markets – after the late January 2008 rally fizzles out – will resume as investors will soon realize that the economic downturn is more severe, that the monolines will not be rescued, that financial losses will mount, and that earnings will sharply drop in a recession not just among financial firms but also non financial ones. A few long equity hedge funds will go belly up in 2008 after the massive losses of many hedge funds in August, November and, again, January 2008. Large margin calls will be triggered for long equity investors and another round of massive equity shorting will take place. Long covering and margin calls will lead to a cascading fall in equity markets in the US and a transmission to global equity markets. US and global equity markets will enter into a persistent bear market as in a typical US recession the S&P500 falls by about 28%.

Eleventh, the worsening credit crunch that is affecting most credit markets and credit derivative markets will lead to a dry-up of liquidity in a variety of financial markets, including otherwise very liquid derivatives markets. Another round of credit crunch in interbank markets will ensue triggered by counterparty risk, lack of trust, liquidity premia and credit risk. A variety of interbank rates – TED spreads, BOR-OIS spreads, BOT – Tbill spreads, interbank-policy rate spreads, swap spreads, VIX and other gauges of investors’ risk aversion – will massively widen again. Even the easing of the liquidity crunch after massive central banks’ actions in December and January will reverse as credit concerns keep interbank spread wide in spite of further injections of liquidity by central banks.

Twelfth, a vicious circle of losses, capital reduction, credit contraction, forced liquidation and fire sales of assets at below fundamental prices will ensue leading to a cascading and mounting cycle of losses and further credit contraction. In illiquid market actual market prices are now even lower than the lower fundamental value that they now have given the credit problems in the economy. Market prices include a large illiquidity discount on top of the discount due to the credit and fundamental problems of the underlying assets that are backing the distressed financial assets. Capital losses will lead to margin calls and further reduction of risk taking by a variety of financial institutions that are now forced to mark to market their positions. Such a forced fire sale of assets in illiquid markets will lead to further losses that will further contract credit and trigger further margin calls and disintermediation of credit. The triggering event for the next round of this cascade is the downgrade of the monolines and the ensuing sharp drop in equity markets; both will trigger margin calls and further credit disintermediation.

Thursday, February 28, 2008

Sears Holdings Letter to Shareholders

Eddie Lampert, Chairman of Sears Holding, published his annual letter to shareholders today describing the results and the future for the company. In the letter, he publishes a chart showing market capitalization, sales and capital expenditures for retail companies worth more than 5 billion. (excerpt of the chart reproduced below) The chart shows the often neglected fact that Sears is a giant in the retail world, ranked 8th in terms of sales. Second, the company's stock is trading at less than 30% of annual sales, which is much lower than its peers. The reason for the discrepancy is in part due to negative bias, but mostly it is because Sears is much less profitable than its competitors. Eddie Lampert's goal going forward is to use the company's scale , size, and unique assets to increase efficiency and squeeze out extra value for Sears shareholders. It seems like a very plausible outcome and at its current price, the stock is worth keeping an eye on.

Tuesday, February 26, 2008

Correction: Fairfax's ICP Lawsuit

After a lengthy discussion regarding the last post, as well as more research, I have to issue a correction. And unfortunately, things have become much more confusing. I'm assuming in this that people have already read the last post.

First, the initial mistake. I had assumed that the convertible option on the debt would result in newly issued shares. But since it is Fairfax's holding company level which is holding the debt, this is actually not the case. The exchange option into Odyssey Re("ORH") shares must come from Fairfax itself, meaning it would be equivalent to giving back a portion of the shares it had purchased.

At first, I thought that would have still been fine. Based on what Fairfax announced, the first transaction involved the purchase of 4.3 million ORH shares for 78 million in debt and the option to convert into 2.15 million shares. In such transaction, ORH's stock would have had to rise 75% for the convertible feature to even be worthwhile, meaning that it was a legitimate transaction (the reasons for which were spelled out in the previous post).

However, I then ran across conflicting reports. On the one hand, I had the Fairfax press release, which stated that:
Fairfax Financial Holdings Limited, through a subsidiary, has purchased 4,300,000 outstanding common shares of Odyssey Re Holdings Corp. in a private transaction. As a result of this purchase, Fairfax beneficially owns 52,364,400 (80.6%) of the 65,003,963 outstanding common shares of Odyssey Re. As consideration, the subsidiary issued US$78,045,000 principal amount of 3.15% Exchangeable Notes due February 28, 2010 which are exchangeable into 2,150,000 Odyssey Re common shares for two week periods commencing on each of November 19, 2004 and February 16, 2005.
But then I found the SEC documents relating to this transaction, which can be found here and here. They state:
Amendment No. 1 to the Schedule 13D related to the purchase by Fairfax, through a subsidiary, pursuant to a master note purchase agreement, dated as of March 3, 2003, of 4,300,000 outstanding Shares (the "2003 Purchased Shares") in a private transaction. As consideration for the Purchased Shares, a subsidiary of Fairfax issued $78,045,000 aggregate principal amount of 3.15% Exchangeable Notes due February 28, 2010 (the "Old Exchangeable Notes"), exchangeable into 4,300,000 Shares.
In addition, two other passages which stuck out:
WHEREAS, the Issuer and the Guarantor intend that the transactions contemplated hereby result in the Guarantor being able to treat members of the consolidated group (within the meaning of U.S. Treasury Regulations section 1.1502-1(h)), of which Fairfax, Inc., a wholly-owned subsidiary of the Guarantor, is the common parent, as owning at least 80 percent of the outstanding Shares (as defined below) and therefore treat Odyssey (as defined below) as a member of such group for U.S. federal income tax purposes;
(Note: this is one of the first lines in the master purchase agreement)
And also:
it is acting for its own account, and has made its own independent decision to enter into this Agreement and each other Transaction Document and as to whether this Agreement and the other Transaction Documents are appropriate or proper for it based upon its own judgment and upon advice of such advisors as it deems necessary; each of the Issuer and the Guarantor acknowledges and agrees that it is not relying, and has not relied, upon any communication (written or oral) of the Purchaser or any affiliate of the Purchaser with respect to the or any other Transaction Document and that it has conducted its own analyses of the legal, accounting, tax and other implications hereof and thereof (it being understood that information and explanations related to the terms and conditions of this Agreement or any other Transaction Document shall not be considered investment advice or a recommendation to enter into this Agreement or any such Transaction Document); it further acknowledges and confirms that it has taken independent tax advice with respect to this Agreement and each other Transaction Document;legal, accounting, tax or other implications of this Agreement.
The combination of all of this leaves me scratching my head. I want to go with my trust in Prem, but as someone in the comments said: In this instance, Prem may have been "a bit too clever." So, the lawsuit remains a risk and I will have to settle for a "wait and see" approach. That is unfortunate too, because Odyssey Re is trading at a very discounted price on concerns over this lawsuit.

Saturday, February 23, 2008

Fairfax: Any Merit in the ICP Counter-Suit?

As many of you are probably well aware, Fairfax reported its 4th Quarter earnings the other day. Since the CDS gains were expected and well covered earlier on this site, I do not think there is much more I can add over their own release on that matter. But what I wanted to talk about was the ICP press release released right before earnings, entitled:

Fairfax Financial is Asked to Answer Disclosure Questions on Conference Call

Essentially, ICP is counter-suing Fairfax, alleging that the transaction Fairfax entered into with Bank of America in 2003 was improper. In the transaction, Fairfax purchased 4.3 million shares of its subsidiary Odyssey Re's stock("ORH") in exchange for 78 million in debt that was also exchangeable into Odyssey shares. ICP is challenging two things with regards to this transaction. The first is that Bank of America did not really borrow the 4.3 million shares it sold short to Odyssey. The second is that the transaction's structure had no business purpose, but was executed for the sole reason of saving money on taxes. (Something which is not allowed)

Again, remember that I am no legal expert- I am just using common sense. But in this situation I think that is enough. I can throw out the first argument about the borrowed shares right away. There are several major banks who have been involved in naked short selling, so Bank of America was not doing something unheard of. And I can not see how Fairfax can be faulted because Bank of America did not uphold its responsibility to borrow the shares.

What about the merits to the second argument- that the transaction had no business purpose, and was commenced just to save money on taxes? Fairfax definitely did save on taxes from this transaction, because the purchase of the shares allowed it to consolidate Odyssey, and so use the holding company's past losses to offset Odyssey's profits. Well first, we have got to break the transaction down into two parts, because Fairfax first made the transaction in March of 2003, and then refinanced it in November of 2004 with different terms.

1. March 2003: Fairfax purchased 4.3 million ORH shares for $78 million in debt at 3.15% interest and exchangeable into 2.15 million ORH shares.

2. November 2004: Fairfax refinances the debt for 101 million in debt at 3.15% interest and exchangeable to 4.3 million ORH shares.

So let's begin with the first transaction. Hypothetically, if Fairfax was taking out a loan and buying ORH shares, there would be no problem whatsoever to that. And, if Fairfax wanted to save interest costs by adding a convertible feature, that would also be fine. Since the exchange feature involves only 2.15 million shares, there does not appear to be any doubt- Fairfax has ownership of these shares, profiting from any gain in price and suffering from any losses.

But when Fairfax refinanced the debt in November of 2004, the transaction appears to have some questionable features. If Fairfax bought 4.3 million ORH shares in exchange for debt that is also exchangeable to 4.3 million shares, has a proper transaction actually commenced? Will Fairfax really gain if the price goes up, or is it just paying a small interest fee so they can temporarily claim "rights" to the shares and save on its taxes?

My understanding is that it is a proper transaction. Let's look at a few hypothetical examples to see. First, if the stock price went down to $10, Fairfax does face a loss. This is because the value of it's 4.3 million shares are now much lower, but it still owes the 101 million in debt, which Bank of America would have no reason to convert. So, the transaction satisfies the risk of loss requirement.

Now, if the share price increased to $40 per share, would Fairfax profit? The 4.3 million ORH shares are worth 172 million. The Bank of America debt of 101 million would also be converted, meaning Bank of America also ends up with 172 million worth of stock- and Fairfax no longer owes 101 million in debt. Now, this is where ICP says that the two of these cancel out and none of them are better off. But that is not really correct. Fairfax's shares are now worth 172 million and they do not owe the debt, so they did receive the profits. In return they had to issue 4.3 million shares, giving up a piece of their ownership. The company's financial and capital position is clearly different than it would have been if the transaction did not occur.

Economically, Fairfax is also still better off. Before the transaction, Odyssey Re had 65.142 million shares outstanding, which Fairfax owned 73.6% of. When the transaction first completed, Fairfax's stake increased to 80.4%, satisfying the 80% ownership level for tax purposes. At the end of our $40 example when Bank of America converts, Odyssey would have 69.442 shares outstanding, and Fairfax would own 75.3%. So Fairfax can clearly say it benefited by doing this transaction because it ended up with a larger ownership of Odyssey Re without needing to lay out any capital up-front.

So overall, this leads me to believe that there is little risk to Fairfax from this ICP lawsuit. Of course I was never really worried because I trust Prem and there was this excerpt below from the conference call, but I felt it would be right to understand the transaction myself.

Q: Bill began, from ICP capital. I have submitted some very detailed and comprehensive questions related to your 2003 tax consolidation. First question is do you plan on responding to those in written form?

A: Yes, good morning, William. You put a press release out, so let me put this into perspective in relation ship to your press release. The press release was issued late yesterday afternoon by a company. This is for our shareholders just so that they know a little bit about the perspective on it called institutional credit partners or ICP and by William Gayen [ph] ICP employee accusing Fairfax from profiting from an improper tax transaction. ICP and Gayen [ph] had dependents in a lawsuit brought by Fairfax in which Fairfax alleges that they and others engaged in a racketeering conspiracy to harm Fairfax by disseminating information about Fairfax so that short sellers could profit. I just wanted to make two points. First we took great care and obtained expert advice before entering into the transactions raised in the release. We have reviewed the accusations in the press release and we are confident they are baseless and misleading. Second, when Fairfax first learned in October 2006 that GAyen was alleging fraud by Fairfax, our counsel requested that Gayen [ph] to provide any information he had about this alleged fraud and to meet to discuss this information. But he never responded to that request. Because these accusations have also been raised by ICP and Mr. Gayen [pn] in their response to the racketeering lawsuit brought by Fairfax, it would be improper to address these accusations now in any further details. So thank you for asking that, and Jane next question

Saturday, February 16, 2008

Wheat Prices Skyrocketing

Here is a multi-year chart of wheat prices:

That can not be good for inflation...

Wednesday, February 13, 2008

Pulp News

Three pulp producers reported earnings today- Mercer, Catalyst Paper and Tembec. Here are some excerpts from each regarding pulp fundamentals:

Pulp markets continued to strengthen in the final quarter
of 2007, ending a year of continual price increases resulting
from both strong demand and a weakening U.S. dollar. Based
upon the current demand levels we are seeing in the market
and historically low inventory levels, we believe that there
will be continued upward pressure on pricing into the first
part of 2008.
Pulp markets were strong throughout 2007 with global pulp
shipments up 3% year-over-year and low world producer and
consumer inventories during the year.
Demand for NBSK pulp is expected to remain steady during
the first half of 2008, with the expectation that benchmark
prices will increase modestly in early 2008 followed by
potentially softer pulp prices in the second half of the year.
Higher consumption by China is expected to be offset by
weaker demand from markets in the U.S. and Europe, which
is expected to limit overall growth in demand in 2008.
Looking ahead, pulp markets should remain strong and price increases have already been announced for the March quarter.
The March price increase is another good sign. I am hoping to do an updated write-up on SFK Pulp Fund as soon as I can get a few questions answered.

Tuesday, February 12, 2008

Berkshire's Letter to MBIA

(hat tip to David)

February 6, 2008

Mr. Gary Parr
Deputy Chairman

Dear Gary:

As you know, many constituencies in the financial markets have been increasingly focused on the emerging issues in the financial guaranty industry for several weeks now. In fact, we ourselves have had several meetings with the New York Insurance Department to explore whether there is something we can do under the current circumstances that would be helpful in addressing the growing concerns in the financial marketplace. Unfortunately, the structured finance "side" of the business, with its many moving pieces and interdependent variables, has proven to be beyond our ability to adequately analyze. Nonetheless, we are ready and willing to lend our reinsurance support to the municipal side of the house, and in fact had set out in a letter to the New York Superintendent of Insurance a concept that we believe would address the needs and concerns of main street America's municipalities. The Superintendent has no objection to our approaching you with this proposal. We would like to meet with you and your client, MBIA, to discuss whether MBIA would have any interest in the proposal .

The key elements of the proposal we described to the Superintendent were: (1) we would raise the capital level in our monoline insurer, Berkshire Hathaway Assurance Corporation (BHAC), to $5 billion; (2) we would assume by reinsurance the muni bond portfolio of several of the monoline companies for a premium of 150% of the existing unearned premium reserves of the companies (with respect to two of the leading companies this would result in a combined unearned premium reserve of $6 billion, plus $3 billion for a total premium of $9 billion which, with the increased capital contribution to BHAC would result in approximately $14 billion of assets available to meet the combined $600 billion or so of total principal value of municipal bonds insured by these two companies); (3) we would undertake not to reduce BHAC's assets by dividends, fees, etc., for a minimum period of ten years; and (4) we had furthermore proposed that, if the companies found a preferable solution during the first 30 days of our cover, they could have a no-questions-asked walk-away option in consideration of a break-up fee that would be paid to us.

The gist of our proposal to you is that we would reinsure MBIA's current municipal bond insurance portfolio in consideration of a premium payment to us of an amount equal to 150% of the existing unearned premium reserves. Like many potential reinsurance buyers, I recognize that your first reaction may be that this is an excessive premium, and I want to offer you upfront the thought processes that led me to conclude that this is in fact a fair proposal that achieves important objectives for both parties.

We priced this proposed reinsurance cover to reflect the significant opportunity cost from our perspective in providing this type of bulk reinsurance cover. In the current market environment, we are able to command premium levels double (or higher) your client's prior rates to insure the risks that in addition have the benefit of your client's AAA insurance cover. Given our conservative use of capital (for example, the capital ratios in our monoline insurer would be higher than other insurers and would not be subject to reduction by dividends, fees, etc. for a minimum of ten years under the concept we presented to the Department), by offering this cover we forgo these direct opportunities to wrap already wrapped bonds. Despite this, there is an obvious appeal to a bulk transaction like this given the low overhead costs which would be involved.

Taking all these factors into account, we came down in favor of making the proposal and are prepared to pursue it with you directly. It is efficient as both a bulk transaction and a transaction that we believe will help stabilize the currently unstable marketplace conditions for the municipal business. In that sense, this approach also has the appeal of serving the greater public good, not an unimportant consideration for us, both as a matter of principle and as a company with a vested interest in national economic conditions.

From your perspective, I would respectfully suggest that this proposal would allow MBIA to release substantial capital from the municipal bond side of the house that can be deployed to support other obligations. I would submit that our proposal at the pricing levels we require is actually a cheap way for MBIA to raise capital as compared to other alternatives and is therefore of great benefit to MBIA's owners and their municipal bond policyholders.

Should this proposal prove to be of interest to you, and I sincerely hope that it is, we would ask for the courtesy of a reply as soon as possible. We would be prepared to complete this transaction within the next five days.


Ajit Jain,

Buffett Bids on Bond Insurance?

Bloomberg reported today: Buffett Bids for MBIA, Ambac Municipal Bonds
Billionaire investor Warren Buffett said he offered to shore up $800 billion of municipal bonds guaranteed by troubled MBIA Inc., Ambac Financial Group Inc. and FGIC Corp. in a bid to gain 33 percent of the debt insurance market.

Buffett's Omaha, Nebraska-based Berkshire Hathaway Inc. would assume the risk of the debt, he told CNBC television. The offer excludes the bond insurers' subprime-related obligations. One company has already rebuffed the proposal and the two others haven't responded, Buffett said.
Berkshire would put up $5 billion as capital for the plan and is offering to insure the municipal debt for 1.5 times the premium charged by the bond insurers to take on the guarantee. The insurers could accept the offer and back out within 30 days for a fee, Buffett said.

We know already that the structured product obligations of the bond insurers have and will continue to lead to large losses. Buffett's new proposal would mean that the bond insurers would have to accept losses on their municipal business as well. We can conclude that likely has two things in mind. One, Buffett is trying to take advantage of the bond insurer's liquidity problems to make a good investment. Second, Buffett thinks that they may have under-priced their municipal risk too. That would be real bad news for the bond insurers.

AIG Discloses Weakness in Derivative Accounting

Another company which Fairfax has bought credit protection against has visited the confessional:
American International Group Inc., the world's largest insurer by assets, said auditors found a ``material weakness'' in how the company values its credit- default swap portfolio. The stock fell the most in 20 years.

The contracts declined by about $4.88 billion in October and November, according to data in a regulatory filing today. The drop was confirmed by company spokesman Chris Winans. AIG had said in December that the value of the ``super senior credit derivatives'' fell by about $1.1 billion in those two months. The stock retreated 11 percent to $45.16 as of 10:19 a.m. in New York Stock Exchange composite trading...

And from another article:

Credit-default swaps tied to AIG's bonds soared 37 basis points to a record 207 basis points, according to CMA Datavision.
For those unfamiliar with Fairfax's CDS portfolio, see the previous post.

Saturday, February 09, 2008

A Small Update on Fairfax's CDS Portfolio

As I was glancing back at the list of companies Fairfax held Credit Default Swaps on, I had to note how amazing this investment has turned out to be.

Readers might first need a quick tutorial: A credit default swap(CDS) is an agreement between two parties that deals with the credit risk on a third-party bond. One party buy protection by offering an up-front fee to the seller. In return, the buyer's principal is protected by the seller in case of default or some other adverse event. When such event happens, the seller usually pays face value on the bond to the buyer, and he assumes the defaulted bond withe the hopes of recovering at least some of his losses.

Now it is important to note two things about this transaction. First, the counter-party you deal with is very important (for the buyer of protection). If the bond you bought protection for defaults but the other party in your trade can not afford to pay you, then you still lose money. So, this counter-party risk must also be managed for.

Second, you do not need a default to occur to start making money on a purchased CDS. If the perception of risk in a bond starts to increase, then the cost of insurance will rise and your purchased protection would be worth more in the market.

Now, the funny thing about Fairfax's CDS investment is that they did not own the underlying bonds they bought protection for. So Fairfax's intent was clear- they thought the companies they bought protection against would default in the near future. And so far, their prediction seems to be coming to fruition. For example, Fairfax held swaps against all the major bond insurers- MBIA, Ambac, PMI Group, and MGIC. Their share prices have plummeted as their survival has come under doubt. (see chart)

Fairfax also bought swaps against other major sub-prime players like Countrywide, Washington Mutual, and Societe Generale. The last one has been all over the news recently as the company reported a major loss:
AN OLD line of Hank Paulson's has been dusted off since news broke of a €4.9 billion ($7.2 billion) trading loss at Société Générale, France's second-largest bank. “We will never eliminate people doing bad things,” the former head of Goldman Sachs, now America's treasury secretary, once said. “In a town of 20,000 people, there's a jail.” The question now being asked of SocGen is: shouldn't there also be a police force?
The future of the bank itself is also in doubt. Its shares have slumped since the start of the year (see chart) and its credibility has been shredded, not just by the trading loss but also by write-downs of subprime-related investments.
Fairfax picked their targets correctly, but they were also careful about which counter-parties they dealt with- Deutsche Bank, Barclays, and Citigroup. As an example, Calculated Risk reports:
Deutsche Bank ... reported no write-downs related to structured products and less than EUR50 million net write-downs in leveraged finance. ... The bank also reiterated its EUR8.4 billion pretax profit goal for 2008, even though it said it expects "conditions to remain challenging in 2008."
All this leaves me excited about Fairfax's 4th Quarter earnings report on February 22. Around that time they should also be making their annual filings with regulators, which will mean I can find updated information on Fairfax's swaps and investment portfolio.

Thursday, February 07, 2008

Predictions '08

Let me begin this with a quote from Robert Reich's Work of Nations:
The predictable failure of all prediction notwithstanding, the public continues to pay attention to stock analysts, trend spotters, futurologists, weather forecasters, astrologers, and economists. Presumably such respect is due less to the accuracy of their prophecies than to the certainty with which they are delivered. The reader of these pages is duly warned...
That being said, I think we can observe certain facts to get a feel for where things stand in our economy today. Let me begin by introducing you a concept I picked up from the economist Hyman Minsky. Minsky came up with three classifications for debt relationships.

The first and safest class was hedge financing; In these arrangements, the borrower's income could cover both the interest payments and the principal balance.
The second stage was speculative finance, in which the borrower could afford the interest payments, but for principal the borrower needed to either sell assets or refinance.
Finally, the riskiest stage was Ponzi finance, defined as the borrower's income being insufficient for even the interest payments.

The reason this is relevant is that this concept can be applied to all sorts of investing relationships. Take stock investing for an example. The goal in stock picking is to buy an enterprise for less than the discounted future cash flow of the business. Stated another way, it is equivalent to buying a security where its income stream can cover both our interest(discounting) and our principal payments. Ponzi units, which deal with the other extreme, can be seen during a stock market bubble. For example, during the tech bubble many companies were trading at P/E ratios of over 30. That meant that the earnings yield on a stock investment was likely much lower than the prevailing risk-free interest rates. What this meant was that stocks were in Ponzi territory- the only way these investments could be justified were if you could assume significant earnings growth. When that did not materialize, the prices of stocks plummeted.

So that brings us to where we are at today. The most obvious source of economic uncertainty today is from residential housing. Here was another example of a Ponzi. Since 2004, many loans were made to borrower's who could not even afford their interest payments. There are many reasons for why things got out of hand, but the idea of an adjustable-rate mortgage was certainly one factor in promoting the excesses. I mentioned earlier in the stock example that the only way a Ponzi situation could be justified was if income was expected to grow rapidly. But with residential housing, our "earnings" is simply nationwide household incomes. To make the assumption that national income would rise significantly seems foolish and calls into question the worth of many of these loans. It is clear that residential investment became very imbalanced, and going into this year we will probably see things continue to languish.

Now without being an expert in commercial real estate, I have to gauge from information like this that things got out of hand here, too.
Mr. Macklowe and his son Billy paid $6.8 billion to buy seven New York buildings from Equity Office Properties Trust. ... Macklowe Properties put in only $50 million of equity and borrowed $7.6 billion, according to the documents. (Mr. Macklowe borrowed more than the purchase price to cover closing costs and other fees.) The deal also had "negative debt service," meaning that the rents from the buildings weren't expected to cover the debt payments for five years..
Again, here we see another example of a Ponzi relationship in the commercial real estate market, characterized by extreme leverage and an inability to service the interest on the deal. As the post goes on to say:
Troubled New York real estate titan Harry Macklowe has reached a tentative agreement with his lender to turn over effective control of seven Manhattan office buildings he triumphantly acquired less than a year ago for $7.2 billion ...
So there is likely to be additional losses in wealth and economic headwinds from the decline in the commercial real estate market. We are beginning to see signs of this here.

Moving on to the corporate world, we have the issue of corporate profits as a percent of GDP. Here's what Warren Buffett had to say on the issue:
You know, someone once told me that New York has more lawyers than people. I think that's the same fellow who thinks profits will become larger than GDP. When you begin to expect the growth of a component factor to forever outpace that of the aggregate, you get into certain mathematical problems. In my opinion, you have to be wildly optimistic to believe that corporate profits as a percent of GDP can, for any sustained period, hold much above 6%.

Currently, the figure stands at a relatively high 8.24%. (The chart isn't fully updated) With the nation coming off a period of excess consumption, profits are likely to come down. This means two things. One, stock wealth will disappear as valuations are discovered to be expensive. Two, corporate debt from last year's M&A surge will run into trouble. We've already begun to see signs of this here.

This is a lot of wealth disappearance and this has secondary effects on spending and employment- the exact extent of which is difficult to tell. I personally feel the consequences might be more painful than most are imagining. And if I had to make a few more bold predictions, I would say:

-International wealth and profits will not be spared.
-there will be more derivative losses and more counter-party problems.

The nation as an average needs to expel the expectation of double-digit investment returns over the next few years- Profits are at cyclical highs, valuations are rich, and the 10-year treasury is at 3.77%. But in the end I yield to the idea that 10 years from now we will all be better off than we are today, and that individual opportunities do exist. So it is with a cautious mindset that I proceed with investing this year.