LBO's Gone Wild

From The Economist:

To understand how private equity reached this position, consider the long-term prospects of leveraged buy-outs (LBOs), its core business. In 2006-07 the industry binged, buying companies with an enterprise value of $1.4 trillion. After adjusting for inflation, that is the equivalent to one-third of all the LBOs ever. Denial and rose-tinted accounting mean that losses on these investments have yet to be fully recognised. But the shares of listed buy-out funds are trading far below their book value and some clients, anticipating losses, are reportedly considering off-loading their interests in LBO funds.

Another corner of lending that I would be worried about, especially as profits begin to decline. Not to make it sound like a golden rule, but you should always be weary when activity surges in any financial corner. After all, remember that the final returns of all financial activity boils down to the underlying profits of American business. Market participants are constantly jockeying for a greater piece of the profit pie, and some do better than others. But we are dealing with 1.4 trillion dollars here. That means LBO firms found 1.4 trillion worth of securities that they thought that Wall Street was evaluating wrong-very wrong. Wrong enough where they could offer shareholders a 30% premium and still make out on top in the deal. I find it more likely that they were a little too optimistic in their projections.

No Shortage of Regulators

From Three Hours With Warren- Live from Omaha:

QUICK: If you imagine where things will go with Fannie and Freddie, and you think about the regulators, where were the regulators for what was happening, and can something like this be prevented from happening again?

BUFFETT: Well, it's really an incredible case study in regulation because something called OFHEO was set up in 1992 by Congress, and the sole job of OFHEO was to watch over Fannie and Freddie, someone to watch over them. And they were there to evaluate the soundness and the accounting and all of that. Two companies were all they had to regulate. OFHEO has over 200 employees now. They have a budget now that's $65 million a year, and all they have to do is look at two companies. I mean, you know, I look at more than two companies.

QUICK: Mm-hmm.

BUFFETT: And they sat there, made reports to the Congress, you can get them on the Internet, every year. And, in fact, they reported to Sarbanes and Oxley every year. And they went--wrote 100 page reports, and they said, `We've looked at these people and their standards are fine and their directors are fine and everything was fine.' And then all of a sudden you had two of the greatest accounting misstatements in history. You had all kinds of management malfeasance, and it all came out. And, of course, the classic thing was that after it all came out, OFHEO wrote a 350--340 page report examining what went wrong, and they blamed the management, they blamed the directors, they blamed the audit committee. They didn't have a word in there about themselves, and they're the ones that 200 people were going to work every day with just two companies to think about. It just shows the problems of regulation.

Quote Of The Day

A trader discusses his reason for purchasing Fannie Mae today on CNBC: (Video Link)

Pisani : …What fool would buy Fannie Mae now when everyone knows the equity is worthless? Here’s a fool who just bought Fannie Mae this morning. Now, what’s going on, why would you buy Fannie Mae right after the open, what price did you buy it at, what price did you get out at, and why?

Redler: Well as active traders we look for over-emotion. Everyone on TV was saying Fannie and Freddie are zeros. They might as well be zeros, but it doesn’t have to be a zero tomorrow…

It's kind of like musical chairs. As long as the music is playing, everyone can keep dancing around, and some will profit at other people's expense. But at some point reality will hit on the entire game and the music will stop for Fannie/Freddie Mac shares. And at that point, someone will be left holding the bag (or in this case, the worthless equity certificate).

Lessons from a "Lost Decade"

There's a great article in this week's The Economist drawing similarities between America's crisis and the Japan's experience with 10 years of stagnation.

...
By learning from Japan’s mistakes, America can avoid a dismal decade. However, it would be arrogant for those in Washington, DC, to assume that Japan’s troubles simply reflected its macroeconomic incompetence. Experience in other countries shows that serious asset-price busts often lead to economic downturns lasting several years. Only a wild optimist would believe that the worst is over in America.

Quote It

Charlie Rose: You can clearly say General Motors will not go bankrupt.
Wagoner, CEO of GM: Absolutely.
...

Hypothetical Scenario For The Mortgage Nuts....

Something has always bugged me about credit default swaps and mortgage/bond insurers. Imagine a community with one bank, and that bank has 10 million in loans. Now the usual rules dictate that the bank should have at least a 1 million in equity as a cushion because, face it, lending has a tendency to have its bad cycles. The other 9 million is financed by deposits.

Now let's say another party comes to the bank and offers to take the credit risk on all 10 million of the bank's loans, in what is essentially a blanket credit default swap on their loans. The bank now views its operation as essentially risk-free (ignoring liquidity risk), so their equity cushion doesn't matter. But shouldn't the new counter-party now be required to have a 1 million equity cushion in case things go bad, since they are supposed to be the first and only line of defense? I think the answer to that is yes.

The problem is I haven't seen that. Look at Fannie Mae. At September 30, 2007, they had 2.8 trillion in total mortgage assets and guarantees. But their balance sheet had total capital of only 49 billion, or 1.75% of total obligations. If it were looked at like a bank, that would be an asset-equity ratio of over 50-1. That doesn't leave much margin of safety at all.

Am I missing something?

Josh Waitzkin @ Google

"Chess champion Josh Waitzkin visits Google's Mountain View, CA headquarters to discuss his book "The Art of Learning: A Journey in the Pursuit of Excellence." This event took place on April 10, 2008, as part of the Authors@Google series.

Josh Waitzkin is an 8-time National Chess Champion, 13-time Tai Chi Chuan Push Hands National Champion, and Two-time Tai Chi Chuan Push Hands World Champion. In 1993 Paramount Pictures released the film Searching for Bobby Fischer, based on the highly acclaimed book of the same title written by Fred Waitzkin, documenting Josh's journey to winning his first National Championship."

Helpful Advice from Bruce Berkowitz

What is your strategy for the fund? If I was to build a stock screen like Bruce Berkowitz, what would it look like?

We start with this basis: The only thing you can spend is cash. We want companies that generate significant cash in most times. That is how we start. We don't care much about what they make, but we have to understand it. The balance sheet has to be strong; we want to make sure there are no tricks in the accounting. Then we try and kill the company. We think of all the ways the company can die, whether it's stupid management or overleveraged balance sheets. If we can't figure out a way to kill the company, and its generating good cash even in difficult times, then you have the beginning of a good investment.

The link to the full interview is here.

A Personal View of The Crisis

They are called risk managers, and collectively, their job is to monitor their bank's transactions for signs of trouble. So where were they in the midst of the current tragedy that is among us? This week's The Economist gives a rare treat by allowing a risk manager at a large global bank to share his view of the current credit crisis. It unfortunately conveys the message that even in the banks, the heart of the financial system, serious misunderstandings exist about the nature of finance and their fiduciary duties.

IN JANUARY 2007 the world looked almost riskless. At the beginning of that year I gathered my team for an off-site meeting to identify our top five risks for the coming 12 months. We were paid to think about the downsides but it was hard to see where the problems would come from. Four years of falling credit spreads, low interest rates, virtually no defaults in our loan portfolio and historically low volatility levels: it was the most benign risk environment we had seen in 20 years
....

The possibility that liquidity could suddenly dry up was always a topic high on our list but we could only see more liquidity coming into the market—not going out of it. Institutional investors, hedge funds, private-equity firms and sovereign-wealth funds were all looking to invest in assets. This was why credit spreads were narrowing, especially in emerging markets, and debt-to-earnings ratios on private-equity financings were increasing. “Where is the liquidity crisis supposed to come from?” somebody asked in the meeting. No one could give a good answer.

Let me begin with an elementary lesson on financial bubbles. Let us imagine a perfect world where the future was clear and I could tell you all the future payments of an asset to an exact number- let us say $1 per year. And let us say I want my investment to give me 10% a year, and using that rate, I calculate that this asset is worth $10 to me. Now, Joe comes along and offers me $12, and I say sure. That $12 to me today is worth more than the $10 I calculated that asset to be worth. And whether Joe knows it or not, by paying $12 for that asset, he is now accepting a lower return for that asset- 8.3% to be exact. But Joe doesn't deal with things like that. Joe knows Bill will pay him 15 dollars for that, so he immediately flips it, books a very nice gain, and rids the asset to Bill. Bill, being the clueless investor he is, crosses his fingers and waits. And sure enough, Bob (whose financial understanding leaves room for improvement) says, "Look, this asset has already gone from $10 to $15, I'm sure I can dump it for $20." And you know what, maybe he is right.

Unfortunately, something is missed along this way. That is, that ultimately someone has to hold on to that asset, and the money they will get for it is that original income stream- that $1 per year. So "Johnny Ultimate Bagholder", who has seen this great run-up of this asset from $10 to $30 thinks the trend is his friend, and he can make big bucks by buying it today. Unfortunately, he is then stuck with a product making him only 3.3% a year. And although maybe that doesn't sound bad and Johnny can reconcile himself with that fact, the rest of the world can't- they still want their 10%. Reality comes crashing back in, and Johnny now sees a huge loss.

This sound far-fetched? Well, it has happened to us in the last ten years- twice. In 2000 when stocks were trading at 40x earnings (or worse), those stockholders were looking at returns near 2.5% a year on their asset- and that assumed the business would be around forever and competition didn't erode those earnings. And recently during the housing boom, investors flocked into the market on the belief that house prices could only go up. And people actually invested their money in an asset that was generating negative underlying returns, as the cost of interest was well above the money they could make renting the house out. And anyone with just a common understanding of the above financial concept could have seen how this was going to lead to disaster.

So let me return to the original quote:

...but it was hard to see where the problems would come from. Four years of falling credit spreads, low interest rates, virtually no defaults in our loan portfolio and historically low volatility levels: it was the most benign risk environment we had seen in 20 years.
...
The possibility that liquidity could suddenly dry up was always a topic high on our list...

My problem is these are not ways risk is supposed to be found. Every indicator he mentions there is actually more of a signal of a bubble than anything else, but I am not advocating contrarianism either. What these guys should of been doing was asking if these transactions made sense. Did it make sense for house prices to keep going up when the underlying payment (rent, or working income) could not afford it? Was any actual wealth created when the value attributed to nationwide homes was doubled? Did it make sense to let people subsequently draw money out of their homes to use to spend? The answer to all of these is no. And I regret to say that the harsh reality is that is the only way to do finance. You have to look at what makes sense and make reasonable expectations for the future. And unfortunately, it seems risk managers of banks worldwide have been clueless to that.

My gripe doesn't end there.

Our business and risk strategy was to buy pools of assets, mainly bonds; warehouse them on our own balance-sheet and structure them into CDOs; and finally distribute them to end investors. We were most eager to sell the non-investment-grade tranches, and our risk approvals were conditional on reducing these to zero. We would allow positions of the top-rated AAA and super-senior (even better than AAA) tranches to be held on our own balance-sheet as the default risk was deemed to be well protected by all the lower tranches, which would have to absorb any prior losses.

Let me rephrase it another way- "Our business was to pool assets, mainly bonds. We would then split them up into different groups, one which was safe and one which would take heavy losses. We made it a point to make sure our customers would buy the losses. We may not be too good at understanding risk, but you should see our customers. Boy, did we make money off of them!" Nowhere in that statement do I see any ideals of fiduciary duty, of doing whats mutually beneficial for both yourself and the customer. And I hate to break the news to you, but:

That mini-liquidity crisis was to be replayed on a very big scale in the summer of 2007. But we had failed to draw the correct conclusions. As risk managers we should have insisted that all structured tranches, not just the non-investment-grade ones, be sold.

THAT is not the right conclusion.

A Conversation with Peter Chernin

Charlie Rose recently conducted a conversation with Peter Chernin, Chief Operating Officer of News Corp. Investors looking to get some insight on the future of the media industry will find this very helpful.




Highlights:
- In today's media, you need to do something great. Why would you go to mediocre content in a world with infinite choices?
-Why is media undervalued by Wall Street? Wall Street likes predictability, and right now they are uncertain about the future of old media.

Myspace and the Internet
- Revenue sources on the internet are being found. MySpace reached 1 billion of sales in 5 years, faster than Google. It represents 10 - 12% of all page views on the internet.
- They are excited about hyper-target technology they are developing for the internet, and believe advertisers will begin to embrace the internet more.

- Over 2.5 billion mobile phones worldwide, representing a huge potential. News Corp is trying to be ahead of the curve on future mobile distribution market.

How has this change affected the creation of content?
- There have been resilient forms of content, such as movies, hour dramas, half hour comedies. People will begin to create very short forms of entertainment.
- You don't know what the world will want in a few years- but you do know what you like. You have to trust your own opinions.

What do you like most about Rupert Murdoch?
1, his curiosity and love of the world around him. Second his will, his phenomenal determination and dedication.

Black Box Insurers

From The Economist:

AFTER watching bank shares drop by almost a third this year, most European investors probably consider the idea of buying insurance stocks a sick joke. Banks’ balance-sheets may be difficult to understand but insurers can be mind-bogglingly complex too.
...

The alternative is the industry’s home-grown accounting standard, which is called Embedded Value (EV). A life company’s EV represents its shareholders’ funds plus the value of future profits it expects to generate from its existing book of business, after adjusting for risk. This is a concept most investors can get their heads around. But individual companies can pick their own assumptions on things like investment returns. Furthermore, diversified firms often report EV only for their life divisions, making it harder still to compare companies on a consistent basis. The result is that many investors view EV as just another type of black-box reporting.

The good news is that the industry is taking note. In June, a forum of Europe’s biggest insurers agreed to implement new Market Consistent Embedded Value (MCEV) rules in 2009. These require companies to make uniform assumptions about investment returns and apply the reporting standard across the entire company. In addition it will no longer be possible to book at once the profit expected from holding risky assets. Mr Crean argues that MCEV standards make it easier to see how much cash is being generated by the “back book” of existing business and how much of this is being reinvested in new business, rather than being handed to shareholders as dividends.

This is something I've never looked into, but I know Fairfax holds credit-default positions against several European insurers- a bet signifying their belief in increased credit troubles for these companies. If these companies have been allowed to book immediate profits on risky assets, that could be a source of large write-downs in this current market turmoil.