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.

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.

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.

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

Wheat Prices Skyrocketing

Here is a multi-year chart of wheat prices:



That can not be good for inflation...

Pulp News

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

Mercer

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.

Catalyst

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.

Tembec

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.

Berkshire's Letter to MBIA

(hat tip to David)

February 6, 2008

Mr. Gary Parr
Deputy Chairman
Lazard

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.

Sincerely,

Ajit Jain,
President

Direct Link

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.

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.

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.

Exchange Bank Sold

One of the nice benefits of owning the small Exchange Bank of Santa Rosa was that I could read through earnings earlier than most shareholders by checking the FDIC Call Thrift Data instead of just waiting for the company to release it. Exchange Bank's 4th Quarter report was published with the FDIC yesterday and it showed that business had deteriorated- rapidly.

Below is what underwriting looked like before the current quarter.

Including the 4th Quarter results...

Within the span of three months, $13 million in loans had to be charged-off, and about $25 million in loans were added to delinquencies, mostly non-performing. One, that makes their total allowance of $24 million look weak. Second, this quarter calls into question whether EXSR's underwriting can be considered much better than average. If we adjust the income statement to take this into account, their earnings power is considerably reduced and the company is no longer very cheap.

Given that things seem poised to get worse in the credit markets and that I was given a golden opportunity, I decided to sell my holding at $113. I wasn't unscathed though, and I had to realize a loss of 16.3%, the first for the site.

Economist: China's Fear of Inflation

From The Economist: China's Fear of Inflation

....

Chinese policymakers are, in a way, victims of their own success. During the past few years China has enjoyed record current-account surpluses, which have allowed the central government to use ballooning foreign-exchange reserves to recapitalise sickly state-owned banks. Flush with cash, the banks have fuelled spectacular rallies in both property and stocks, which have sent even the prices of their own newly listed shares into the stratosphere.

In heated competition with each other to lend money, banks have flouted both basic risk-management practices and government regulations. They looked the other way when borrowers did not have all the paperwork. Since September buyers have had to make a 40% down payment for a second mortgage. But most banks interpreted the rule as applying only to individuals, and not to households. Thus, a large number of borrowers simply had their spouses or children take out mortgages and kept speculating in the property market. In other instances, CBRC officials discovered that local bank branches accepted false documentation showing proper down payments where none existed. Such lax lending has led to a Rmb1trn increase in housing loans in the first ten months of 2007, or nearly one-third of all new bank loans made during that period. Bank regulators have publicly raised alarm about these highly leveraged mortgages, which look uncomfortably like their sub-prime counterparts in the US.

On the stockmarket front, the CBRC has long-standing regulations forbidding the purchase of shares with bank loans. In reality, though, it is all but impossible to enforce how the money is spent once it leaves bank vaults. And in the great Chinese bull market of 2007, it did not really matter anyway because most people were making a killing on stocks and promptly repaying their loans. Indeed, Chinese banks were indulging their own speculative urges by investing in junk US mortgage-backed securities.

....

Reminding us that it wasn't just the U.S. which got out of hand..

Countrywide 4th Quarter Earnings

Remember a few months ago when Countrywide said: (source)

The company expects its earnings per share in the fourth quarter to range between 25 cents and 75 cents. It also anticipates its return on equity for 2008 to range between 10 percent and 15 percent.

Well, that didn't quite work out. Today, the company reported a loss of 422 million, or 79 cents per share. I'll report more about it once they file their FDIC call report.

Robert Cialdini

I am a big fan of Robert Cialdini's work on social influence and persuasion:

Research reveals that there are six basic principles that governs how one person might influence another. Those principles can be labeled as: liking, reciprocity, consistency, scarcity, social validation, and authority.

There is two great articles here and here that covers everything you really need to know about these concepts. (I highly recommend them- they are well worth the time) Essentially though, the principles which Cialdini identifies have an effect on the decisions we make. Some examples:

If you like someone, you are more likely to do something for them.
If you perceive something as scarce, you will assign to it a greater value.
If you are speaking to someone with authority, (say, a police officer) you are more likely to comply with what they say.

And so on. Unfortunately, people can manipulate these principles to their advantage, as the articles above describe. And, if you combine a few of these principles together, you get a 'lollapalooza' effect, as Munger would call it, where people can be convinced to do some real strange things. Over summer I quit working at a financial planning firm after three days because I quickly realized that they were abusing a lot of these tools. (To great success, I may add. Supposedly they are the fastest growing financial planning firm in the country) My job at the firm was based on commission, and my goal was to call up all my friends and relatives and set up a two hour meeting consisting of me, a senior employee, and the prospective client. This brought multiple principles into effect: The liking between me and my friends; the authority from a "senior" employee; consistency for saying they would help me out; commitment for the two hours already spent on the meeting; and reciprocity because the clients felt we were doing them a service.

In reality, the company was offering a terrible proposition. The annual commissions/fees on the mutual funds they sold were about 3.5%, plus there was an upfront commission. This, to invest in a stock market which over the long run generates 12% a year. This means the company was taking nearly one-third of their clients' future annual returns and seriously crippling their compounding of wealth. I felt bad for many of the new workers there, who were probably unaware of what a great disservice they were actually doing to their friends and family.

But these tools are not only meant to deceive. What I found real interesting was when I started asking, "how can I as a person genuinely benefit from these principles in my daily life- how could I be a 'lollapalooza' ?" This is what I came up with:

To benefit from liking, be kind and likable.
To benefit from reciprocity, always try to be helpful.
To benefit from consistency, always speak the truth.
To benefit from scarcity, always be doing something.
To benefit from social validation, treat everyone as a friend.
To benefit from authority, speak with power and conviction.

An Inverted Look At Wells Fargo

Wells Fargo currently has a market capitalization of around 87 billion, and ten year US Treasuries yield 3.44%. Let's say we wanted our investment in Wells Fargo to have worst-case, a 5 percent earnings yield on a very solid franchise. Then Wells Fargo would need to generate a minimum income of 5% x 87 billion, or 4.35 billion. And there is one more thing: We want to work with before-tax numbers, so adjusting for that means we want a minimum of 6.69 billion in operating income per year.

Now we can look at their most recent earnings report and see what level of losses they can handle while still giving us that minimum return. In their most recent quarter, they generated:

(numbers in millions)
9,242 interest income
-3,754 interest expense
= 5,488 net interest

+4,500 non-interest income (rounded down from 4717)
-5,900 non-interest expense


=4,088 quarterly earnings before credit provision and tax

We would need 1,673 million in quarterly operating income, so we can provision 2.4 billion a quarter while still earning a 5% earnings yield on a Wells Fargo common stock.


This means they can provision 9.64 billion a year, which is 2.52% in yearly charge offs. (Remember this is charge-offs, which is after recoveries from the sale of collateral) For comparison, Wells Fargo most recent quarter had an annualized loss rate of 1.28%, and going back to 1988 the worst rate was 1.66%.

So is this a market overreaction? This analysis does assume two things. First, that interest spreads between assets and deposits remain the same. With the recent interest rate cuts, it is likely that net interest margins will contract for financial institutions going forward. Second, it assumes company assets remain constant. Wells Fargo has a very long history of expanding assets, and factoring in future growth would result in a large boost to valuation. But near term a decline seems more likely, as wealth starts to disappear and place considerable stress on economic money supply. If things get really bad, then a sharp drop in assets is plausible from today's levels. These are two things I am still trying to get comfortable with before making my decision, but others might enjoy this fresh look for investing in financials.

Another View on Oil

A few days ago I posted a commentary by FPA Capital regarding why they see future oil supply falling short of demand. Today I came across a different perspective:
World's Oil Fields Declining at 4.5%-CERA

Output from the world's oil fields is declining at 4.5 percent per year -- significantly slower than the 8 percent rate many analysts have assumed, according to a study by Cambridge Energy Research Associates released Thursday.

The study of more than 800 oil fields suggests that theories that global oil production may soon hit a peak due to steep declines at maturing fields may not hold water.

"Some of the more gloomy, pessimistic 'peak oil' views about the future of oil supplies that are current today result from an assumption of high decline rates," said CERA analyst Peter Jackson. "This new analysis provides the basis for more confidence about the future availability of oil."

The 811 fields included in the study account for two-thirds of current global oil production and half the proved and probable conventional oil reserves.

Jackson said world production capacity should reach 112 million barrels per day (bpd) by 2017, while demand will be about 100 million bpd.
...

Peak oil proponents argue its difficult to decipher whether Saudi Arabian oil production might be declining.

Jackson said some Saudi fields were included in the study including the giant Gowar field.

"Gowar does not contribute to the decline stats because it's not declining," he said.

CERA said peak oil theory overestimates decline rates but also underestimates advances in technology.

"The analysis also concludes that decline rates are a function of reservoir physics and investment strategies, and that there is a general historical trend toward lower decline rates in recent years which may be due to better reservoir management practices and the impact of new technology," Jackson said.

Who is right? I can safely say I have no idea. Luckily, I evaluated Harvest using a WTI Crude Oil price of $65.44 and found it was cheap then- today the price is at $90, giving me an additional 37.5% margin of safety in the future price of oil.

Deepwater Oil Production- the Key to the Supply Equation Puzzle

I came across this commentary by Rikard Ekstrand in FPA Capital's 3rd Quarter Shareholder Letter. It makes a nice analysis of future oil supply. (There is also an analysis of Circuit City included in the shareholder letter)

The energy sector is by far our largest investment area. We discussed the rationale for our energy investments in the September 2006 Shareholder Letter.We will expand on that discussion here by providing our thoughts on the deepwater segment, which is vital for future production levels. Before discussing deepwater oil, let’s sum up the current demand and supply equation for oil. Over the last four decades, worldwide oil consumption has virtually doubled from 45 million barrels per day in 1970 to 86 million barrels today. When comparing this to discovered oil volumes, the picture becomes bleak. Harry Longwell, a former Director and Executive President of Exxon Mobil Corporation, backdated discoveries to the time the find was made and built a chart that showed that global discoveries peaked around 1960, or almost five decades ago. This was when we were in the beginning phases of using 2D seismic technology. 3D seismic came a few decades later and now we’re using visualization technologies and real-time data when drilling. The diamond drilling bore technology came in the 1960s and revolutionized the oil drilling industry. Despite these large technological advances, global discoveries have declined from close to 60 billion barrels per year in the peak years of the 1960s to around 10 billion barrels today. Thus, after five decades of significant improvements in technology and understanding of where oil is, we are now finding a fraction of what we found five decades ago.

Due to this declining discovery trend, we are now relying on old fields for the majority of our supply. Eighty percent of global oil production today comes from fields discovered before the 1970s, according to 13D Research. How fast these older fields are depleting is of paramount importance. To appreciate the impact of depletion, the U.S. is one of the best case studies. Depletion of the U.S. oil reserves was first signaled by the drop in yield to exploration in 1940, as measured by barrels per foot drilled. But with enhanced technology, oil production kept growing for another 30 years despite a deceleration in yields. Then the inevitable happened; production peaked in 1970 and it has declined ever since. The decline rate has been slowed by incremental production in new areas such as Alaska and the deepwater Gulf of Mexico, without which the decline would have been much steeper and more serious. The U.S. is a good precursor for what is happening in the global arena. The world is now consuming approximately three times the volume of crude it is finding each year. Put another way, at current levels of oil consumption, we are using up and not replacing two thirds of our daily consumption. This is why we have focused our investment on oil drilling companies. Exploration and thereby drilling for oil must increase to keep production levels from declining over time, and this leads us to deepwater oil.

Deepwater oil is defined as oil found at depths greater than 400 meters, or 1200 feet. Remarkable technological achievements have extended the range of drilling from shallow waters to deep waters over the last decade and a half. This has allowed the mapping of where deepwater oil is in the world. It turns out that there are three main regions where it is prolific, the U.S. and the Mexican Gulf of Mexico, Brazil’s Campos Basin near Rio de Janeiro, and Africa’s Angola and Nigeria. The total proved and probable deepwater and ultra-deepwater resource today is 78 billion barrels according to data from Bank of America, of which 44 billion is proved according to IPC Petroleum Consultants. It is this large resource base that is allowing deepwater production to double from production levels of more than 4 million barrels per day in 2006 to over 8 million barrels by 2011, according to estimates from Bank of America and Wood Mackenzie, a consultant to the global oil industry.

However, by 2011, this data points to a sharply slowing and then flattening deepwater growth profile. The reason for this is that a proven resource base of 44 billion barrels is unable to support peak production in excess of 8 – 10 million barrels per day for any length of time since depletion rates would get too large. For example, 8 – 10 million barrels per day, or 2.9 – 3.6 billion barrels per year, of deepwater production implies a 6.6 – 8.3% depletion rate on a proven resource base of 44 billion barrels. The U.K. for example, an offshore province, has a depletion rate of 7.7% — according to Colin Campbell, a retired petroleum geologist who specializes in depletion — and its production peaked in 1999, or eight years ago, at lower depletion rates than currently.

The only sustainable way to get higher deepwater oil production is to prove up the probable barrels and to make substantial new discoveries. Extrapolating the falling deepwater discovery trend suggests that another 5 – 15 billion barrels of smaller finds can be made, according to Colin Campbell. Adding these possible barrels to the 34- billion-barrel probable reserves gives us 40-50 billion on top of the proven 44 billion. In order to continue growing deepwater production beyond the 2011 forecast, we would need to prove up and bring these barrels to production in the near future. However, the reality is that by the time these potential barrels are brought to production, declines in existing deepwater fields, and onshore fields, will eat up a
lot of these gains. Time will tell if substantially more can be found and economically produced in the deep waters around the world. We believe the impact on oil prices will be significant if we don’t find substantially more than the current discovery trend is suggesting; therefore, we remain of the opinion that, in the next decade, oil prices will likely be substantially higher than they are today.

Of course, this does not take into account the demand side of the equation. The general opinion is that future oil demand will soar as the rest of the world begins to develop. But technology can increase efficiency and reduce our demand for oil, easing the pressure from the lack of new supply. See this video by Amory Lovins- We Must Win the Oil End Game.

Hoisington 4th Quarter Report

Hoisington Investment Management has released their 4th quarter report, in which they discuss their forecast for the upcoming year. They give a great analysis for why they see an upcoming recession lasting longer than most predictions. For the economic buff, this is a must-read. Summary below:

Normally back to back declines in quarterly GDP must occur to constitute a recession. However, in the 2000 recession, alternating quarterly contractions were observed. This pattern could well develop in 2008 since bloated inventories, the typical driver of consecutive quarterly declines, is not present. Also, the relatively stable private service sector constitutes a record share of the U.S. economy. Rather, a slow contraction of credit availability will cause the consumer to feel the impact of declining wealth from falling home prices, fewer employment opportunities, faltering wage gains, and a monstrous debt burden. This should cause the U.S. economy to rotate in a pattern of stagnant economic conditions, recessionary at times, and growth recessionary at others. The growing excess capacity of our capital structure, along with falling profits, will hinder capital spending increases, reinforcing slower consumption. Increases in federal government spending, along with improvement in our trade balance from shrinking imports, will provide stability in the aggregate economic statistics, while the domestic private economy contracts.
In this environment, short-term interest rates will continue to move downward, reinforced by several reductions in the administered Federal funds rate. The long end of the Treasury market will benefit from two factors. First, investor desire for risk-free assets will increase at a time when default rates will be soaring on other fixed income securities. Second, the overall reduction in credit market instruments will mean fewer alternatives for those desiring a fixed rate of return. By the end of 2008 we would expect new record low yields in Treasuries for this cycle.

Three Buffett Stocks Getting Cheaper

Three stocks Buffett has purchased recently have fallen from his purchase prices- USG, WFC, and BNI. All three are great businesses with competitive advantages, and they would be great places to begin doing research.
Regarding Burlington Northern, I've run across two reports in the past. The first is by the Texas Hedge Report and is entitled "Railroads: Following Buffett's Latest Move". This second one was posted on a message board: (hat tip ValueInvestorHaven)

Bottom line is the company has 29000 miles of track which costs about 3 million dollars per mile to "replace" . which totals about 87 billion

Land which is on the book at 1.7 billion dollars has a "conservative"average cost basis of about 50 years ( some of the purcahses are on books pre1900) at a 3% annual appreciation the land is probably worth more than 8 billion and chances are that number is UNDERSTATED.

The terminals probably are worth another 3 billion conservatively and the long term debt which includes leases is about 11 billion .So 100 billion dollars of assets -11 billion of debt is about 89 billion dollars.The whole company can be purchased for under 28 billion at todays closing price.

I can not attest to the validity of that analysis, but if that is accurate that would be an interesting place to start researching. Buffett also mentioned that as fuel costs rise, the comparative advantage of rail vs. trucking widens because fuel makes up less of rail's total costs.

I've been looking into USG recently, and I will post some information on that shortly.

Pope and Talbot Sells Pulp Mills

Pope and Talbot, which filed for bankruptcy a few months ago, announced today the sale of their pulp business for $225 million, which includes $100 million of value from working capital which is not included in the sale. So, their three pulp mills were sold for $125 million. On the one hand, this is slightly disappointing- these are high cost pulp mills and if they were shutdown, it would improve the supply/demand situation in the pulp market. But what is very interesting is the purchase price of $125 million.

Pope and Talbot's Pulp Business
819,000 tonnes NBSK pulp
EBITDA for 6 Months ending June 30, 2007 = $-9,527,000
Value = $125 million

SFK's NBSK Pulp Business
375,000 tonnes NBSK pulp
EBITDA for 9 months ended September 31, 2007 = $+35,940,000
Implied Value = ???

SFK has only 46% of the NBSK production of Pope and Talbot, but it is also significantly more profitable than Pope and Talbot. (Pope and Talbot is currently bleeding money) I had expected their pulp business to be near worthless, but the fact that it received such a large sum is encouraging. I don't know what valuation that implies for SFK's NBSK business, but it would begin with something like this:

SFK Valuation
Current Enterprise Value = 330 million

Working Capital - all other liabilities = 73 million
NBSK Pulp Mills = ???
RBK Pulp Mills = ???

On Moats

Warren Buffett calls them "moats". These are strong, durable advantages which protect the company and its profits from the onslaught of competing firms. Mr. Buffett gives his executives just one goal: "expand the moat". Understanding competitive advantages (or lack thereof) is essential in any valuation of a company.

Of course, spotting a moat isn't always so easy. For a long time, people would tell you Starbucks was an excellent company with a strong moat. But it's moat mostly revolved around its brand image, and the Economist has covered how everything is not so frothy for Starbucks now.

...A tightening of purse strings has increasingly encouraged defection to fast-food chains such as Dunkin’ Donuts or Panera Bread. They sell reasonable coffee for as little as a quarter of the price of the fancy Starbucks brew.

The biggest of all fast-food chains is also about to launch a full frontal attack on Starbucks. This year McDonald’s will help customers to wash down its burgers by installing coffee bars with “baristas” dedicated to turning out the sort of Italian-style coffees that brought Starbucks its success, in nearly 14,000 American restaurants. The addition to its menu is the biggest diversification ever attempted by the burger giant. McDonald’s has already made smaller forays into providing decent coffee, and with some success. Last February Consumer Reports, a trade magazine, rated its filter coffee more highly than the same sort of beverage served up at Starbucks.

For some time, Starbucks managed to earn extraordinary returns because the Starbucks brand meant something to people. But there is often few advantages in retail- anyone can walk into your stores and copy what you are doing. Now that people have seen the great profits to be made in selling coffee, they are devising ways to steal a piece of the lucrative pie. That is bad news for Starbucks.

In contrast, here is a moat I came across while reading the WSJ- LVMH Bottles Up Champagne Market (subscription required-hat tip David Lau)

For revelers who toasted the New Year with champagne, the odds are about one in five that the bubbly was bottled by LVMH Moët Hennessy Louis Vuitton.

The conglomerate, controlled by French billionaire Bernard Arnault, has managed in recent years to lay claim to the largest share by far of the Champagne region's limited grape output. LVMH has done that by cultivating the independent growers who raise most of the grapes -- including by offering them free farming help.

The result is that LVMH, which owns six brands including Veuve Clicquot, Moët & Chandon and Dom Pérignon, dominates the $5.4 billion global champagne market. LVMH doesn't break out its champagne sales, but its wines and champagne revenue in 2006 totaled $2.2 billion. LVMH had 19% of the global market for champagne by volume in 2006, according to Impact Databank, a market-research firm. The company had more than two-thirds of U.S. champagne sales by value and about 62% by volume.

LVMH focused on the needs of independent grape growers, allowing it to secure a long-term supply.

As global demand for bubbly increases, LVMH's strategy leaves it in a unique position. Independent farmers own 90% of the vineyards in France's Champagne region -- the only source of grapes for bona fide bubbly -- and LVMH is the biggest buyer of their grapes. LVMH is also the single largest owner of vineyards in Champagne, possessing 1,650 hectares, or 5%, of the fields available. The French fashion-to-spirits company has achieved a rare agricultural feat: sewing up much of the world's supply of champagne grapes.

...By controlling brands and raw materials, the company is shielded from competition and wields greater control over prices than rivals. Fueled by champagne sales, LVMH's wines and spirits unit is expected to have grown more than 10% in 2007.

...

LVMH's hegemony in the region has met some resistance. By making champagne, a wine with rich tradition, part of one man's industrial portfolio, LVMH is creating a dependency that could undercut farmers' negotiating power in the future, they say.

"It's dangerous for the equilibrium of the champagne industry," vineyard farmers union leader Patrick Le Brun said in an interview during September's harvest. "The growers' hands will be tied." Yet for many in Champagne, LVMH's presence is a win-win situation...

A year ago, he began offering grape farmers a 25-year contract with the champagne house, the longest ever seen in the region until then. He is sweetening the deal with a 7% signing bonus to the grapes price, which is currently around $7.30 a kilo across the region.

Some union leaders, such as Mr. Le Brun, fear the new quarter-century contract will consolidate LVMH's supremacy in Champagne even further. Yet most growers are happy with the security it provides.

Here, we see a company which has control over the limited raw materials for its product-champagne. If LVMH is successful in securing enough 25-year contracts, that will be a very durable and enduring advantage. And if the demand for champagne continues to grow over that period, that will "expand the moat" by making those contracts more valuable. The profits will naturally follow.

Economic Articles of Interest

I ran into two interesting articles on economics today that I thought worthy of re-publishing here. The first is from the folks over at Calculated Risk, who were so kind as to publish their first subscription newsletter on real estate analysis for free. The article can be accessed here. It is kind of lengthy at 14 pages, but it is an absolutely fabulous summary of everything you need to know about the real estate market today.


The second is an (unconfirmed) transcript of a speech made by legendary investor Seth Klarman on leverage and the current credit crisis. (mega hat tip to Lincoln Minor) It was published over at the Motley Fool board, and based on the content appears to be legitimate. It is pasted below.

Some investors target specific returns; a Pension Fund for example might target an 8% annual gain, but if the bundle of asset classes under consideration fails to offer that expected result, they have the choice only to lower the goal, which for most is a non-starter, or invest in something riskier than they would like. The pressure to keep up with a peer group renders decision making even more difficult. That there is no assurance whatsoever that the incurrence of greater risk will actually result in the achievement of higher returns. The best investors don’t target return, they can first focus only on risk and then decide whether the projected return justifies taking each particular risk. When the herd is single-mindedly focused on return, prices are frequently bid up and returns driven down. This is particularly so when leverage is used. Leverage doesn’t have to be dangerous. Non-recourse debt on an asset can certainly make a large purchase more affordable. Taking out a non-recourse loan on an asset you already own can actually reduce risk since the borrowed funds return your capital while the risk of loss is transferred to the lender. But recourse debt, margin debt, is something else entirely. If you purchase some investments and then borrow with recourse debt to buy more, you are now vulnerable to marked to market losses on what you owe. Depending on the precise terms of the debt, the decline of the value of your holdings could force you to either put up more collateral – which you may not have – or to sell off some of the investments you purportedly like to meet margin calls. By borrowing you cease to be the master of your own fate and allow the lender, or actually the market, to be. How ironic to allow the market, which has dished up your current portfolio of opportunity, to dictate to you the need to sell your most attractive holdings in order to survive. The availability and use of margin or recourse debt is especially pernicious. Had you purchased an investment without leverage, which declined in price, you could have used any available cash to buy more. Alternatively you could sell another investment that did not decline or declined less to afford more of the now better bargains. This is in fact a healthy discipline forcing you to choose among investments to own what you like best and necessitates that you carefully decide when to hold onto cash and when to put it to work. Recourse leverage changes this equation as you can seemingly own all the investments you want simply by borrowing to buy them. There is no healthy portfolio discipline enforcing the desire to make new purchases or the anticipation that you may want to. There is also a bit of a slippery slope in the sense that if a little leverage is good, why isn’t more leverage better – when do you stop?

...during our parents’ lifetimes and our own, credit has become increasingly available and standards increasingly lax, to the point where credit cards and checks backed by credit lines arrive unrequested in the mail. Where your house can be used as an ATM, where people with dismal credit histories are eagerly sought after to provide them with loans, where investors flock to buy junk bonds and shady companies seek to issue them, and where investment funds are offered the opportunity to enhance their returns through structured products, derivatives and exotic finances, all of which enable high amounts of leverage. The moral imperative of repaying the banker, your neighbor, who granted you the loan across his imposing desk has been replaced by the moral vacuum of anonymous lenders using credit scoring who quickly resell your loan to someone you’ll never meet, who are actually comfortable with the actuarially determined probability that you may in fact default. Credit rating agencies have embraced the debt or-gy (offensive word detected) with lax standards and naïve models, brewing conflicts of interest and accepting healthy fees to label toxic waste as investment grade. A similar risk exists as a result of the burgeoning increase in capital allocated to alternative investments – venture capital, private equity and hedge funds. While returns start to come down as the pension funds have looked to alternatives to add excess return and diversification, they are hardly a panacea. Some alternative managers have historically added considerable value while for others the jury remains out. For alternatives in their entirety, high performance and management fees truncate upside potential – increased competition has forced many alternative managers to incur greater risk to achieve their accustomed returns. For some this means incurring greater credit risk while for others this means utilizing considerable amounts of leverage.

The pendulum may be starting to turn as recent developments in the mortgage and hedge fund markets suggest. Because the scale of today’s leverage so greatly exceeds historical levels , it seems possible that we are only at the early stages of the credit contraction. Not surprisingly, it may take time to work off these excesses. Intervention by the Fed, as it recently has, seems likely to give license to further speculation, while failing to address and perhaps even exacerbating the underlying problem of lax lending standards, poor credit quality and excessive use of leverage. Indeed, many market participants believe the solution to these problems of over-leverage and bad credit is more debt. Recently many funds have been formed to make leveraged purchases of loans that are expected to trade in the mid to high nineties instead of par, with 5x leverage or more, bringing the yield to a 15% or 20% return. It seems to me incredibly unlikely that the end to the debt crisis can be near at hand when the solution offered – more debt – is in fact what caused the problem in the first place. Many investors lack a strategy that equips them to deal with a rise in volatility in declining markets. Momentum investors become lost when the momentum wanes, growth investors who paid a premium for the fastest growing companies don’t know what to do when expected growth fails to materialize. Highly leveraged investors, like some quant funds in the headlines, were recently forced to sell regardless of value when their methodology produced losses instead of gains. Counting on a government bailout for every crisis seems a dicey proposition, especially when supposedly impossible events happen on Wall Street every few years. By the time the market drops and bad news is on the front pages, it is usually too late for investors to react. It is crucial to have a strategy in place before the problems hit precisely because no one can accurately predict the future direction of the stock market or economy.

Jack Canfield: Decide What You Want

I am currently researching into a company which I hope to post about shortly. In the mean time, I thought this article was fitting as we start a new year. (hat tip to David Lau)

In order to get what you want, you must first decide what you want. Most people really foul up at this crucial first step because they simply can't see how it's possible to get what they want -- so they don't even let themselves want it.

Don't sabotage yourself that way!

What scientists now know about how the brain works is that you must first decide WHAT you want, before your brain can figure out HOW to get it. Once you lock-in your desires, your mind and the universe can step in.

Are you ready to get started?

Be Willing to Dream BIG Dreams
As soon as you commit to a big dream and really go after it, your subconscious creative mind will come up with big ideas to make it happen. You'll start attracting the people, resources, and opportunities you need into your life to make your dream come true. Big dreams not only inspire you, they compel others to want to play big, too.

Set Goals That Will Stretch You
Another value in giving yourself permission to go after the big dreams is that big dreams require you to grow in order to achieve them. In fact, in the long run, that is the greatest benefit you will receive from pursuing your dreams -- not so much the outer trappings of fulfilling the dream (an expensive car, impressive house, loads of money and philanthropic opportunities), but who you become in the process.

As I've seen many times over, the outer symbols of success can all be easily lost. Houses burn down, companies go bankrupt, relationships end, cars get old, bodies age and fame wanes, but who you are, what you have learned, and the new skills you have developed never go away. These are the true prizes of success. Motivational philosopher, Jim Rohn advises that "You should set a goal big enough that in the process of achieving it, you become someone worth becoming."

Service to Others
Something else you'll discover is that when your dreams include service to others -- accomplishing something that contributes to others -- it also accelerates the accomplishment of that goal. People want to be part of something that contributes and makes a difference.

Turn Your Dreams into Goals and Objectives
Once you are clear about what you want, you must turn each item into a measurable objective. By measurable, I mean measurable in space and time -- how much and by when. For instance, if you were to tell me that you wanted more money, I might pull out a dollar and give it to you, but you would probably protest, saying "No, I meant a lot more money -- like $20,000!" Well, how am I supposed to know unless you tell me? Similarly, your boss, your friends, your spouse, your brain -- God, the Universe -- can't figure out what you want unless you tell them specifically what it is. What do you want -- exactly -- and when do you want it by?

Write Your Goals Down
Write your goals down in detail, and read your list of goals every day. This will keep your subconscious mind focused on what you want. For an even more powerful approach, close your eyes and focus on each goal and ask yourself, "What is one thing I could do today to move toward the achievement of this goal?" Write down your answers and take those actions.

I recommend writing down a minimum of 3 goals in each of the following 7 areas:

1. Financial Goals
2. Career/Business Goals
3. Free Time/Family Time
4. Health/Appearance Goals
5. Relationship Goals
6. Personal Growth
7. Making a Difference

To help your reticular activating system begin finding YOUR wants in unexpected places, take time now to decide what you want and start writing!

Tectonic Shift: Jared Diamond's Take

This is part of the ongoing series on the currently ensuing Tectonic Shift. We have been discussing how globalization and technology are leading to a balancing of wages as:

1. competitive pressures push developed world wages down, and
2. people in the developing world are being employed more productively.

The thesis is that this should lead to an increase in demand for basic necessities which are highly valued, such as food and energy. Meanwhile, more conspicuous types of consumption might start coming under pressure.

Robert Reich from The Work of Nations added:

The economic well-being of Americans no longer depends on the profitability of the corporations they own, or the prowess of their industries, but on the value they add to the global economy through their skills and insight. This is because today capital and goods can flow nearly uninhibited. So, corporations seek to invest where the skills they require can be attained for the lowest cost.

So, routine and repetitive labor services will face the most competition, while those who have built up education and human capital will be best able to protect an individual's standard of living.

Today, there has been some added insight on the matter from Jared Diamond, author of Guns, Germs and Steel, in his article - What's Your Consumption Factor? (hat tip Shai)

The estimated one billion people who live in developed countries have a relative per capita consumption rate of 32. Most of the world’s other 5.5 billion people constitute the developing world, with relative per capita consumption rates below 32, mostly down toward 1.

The population especially of the developing world is growing, and some people remain fixated on this. They note that populations of countries like Kenya are growing rapidly, and they say that’s a big problem. Yes, it is a problem for Kenya’s more than 30 million people, but it’s not a burden on the whole world, because Kenyans consume so little. (Their relative per capita rate is 1.) A real problem for the world is that each of us 300 million Americans consumes as much as 32 Kenyans. With 10 times the population, the United States consumes 320 times more resources than Kenya does.
...
Among the developing countries that are seeking to increase per capita consumption rates at home, China stands out. It has the world’s fastest growing economy, and there are 1.3 billion Chinese, four times the United States population. The world is already running out of resources, and it will do so even sooner if China achieves American-level consumption rates. Already, China is competing with us for oil and metals on world markets.
...
The only approach that China and other developing countries will accept is to aim to make consumption rates and living standards more equal around the world. But the world doesn’t have enough resources to allow for raising China’s consumption rates, let alone those of the rest of the world, to our levels. Does this mean we’re headed for disaster?

No, we could have a stable outcome in which all countries converge on consumption rates considerably below the current highest levels. Americans might object: there is no way we would sacrifice our living standards for the benefit of people in the rest of the world. Nevertheless, whether we get there willingly or not, we shall soon have lower consumption rates, because our present rates are unsustainable.

Real sacrifice wouldn’t be required, however, because living standards are not tightly coupled to consumption rates. Much American consumption is wasteful and contributes little or nothing to quality of life. For example, per capita oil consumption in Western Europe is about half of ours, yet Western Europe’s standard of living is higher by any reasonable criterion, including life expectancy, health, infant mortality, access to medical care, financial security after retirement, vacation time, quality of public schools and support for the arts. Ask yourself whether Americans’ wasteful use of gasoline contributes positively to any of those measures.

The world has only so much natural resources and increased demand has already caused the cost of basic commodities to soar (i.e. food, oil, metals, etc.). If the worldwide growth in living standards is going to continue, we need to see a more efficient use of the world's natural resources.

Kurt Vonnegut at Rice University, 1998

So what does this Methuselah have to say to you, since he has lived so long? I'll pass on to you what another Methuselah said to me. He's Joe Heller, author, as you know, of Catch 22. We were at a party thrown by a multi-billionaire out on Long Island, and I said, ''Joe, how does it make you feel to realize that only yesterday our host probably made more money than Catch 22, one of the most popular books of all time, has grossed world-wide over the past forty years?''

Joe said to me, ''I have something he can never have.''

I said, ''What's that, Joe?''

And he said, ''The knowledge that I've got enough.''

His example may be of comfort to many of you Adams and Eves, who in later years will have to admit that something has gone terribly wrong -- and that, despite the education you received here, you have somehow failed to become billionaires.

This can happen to people who are interested in something other than money, other than the bottom line. We call such people saints -- or I do.

Well-dressed people ask me sometimes, with their teeth bared, as though they were about to bite me, if I believe in a redistribution of wealth. I can only reply that it doesn't matter what I think, that wealth is already being redistributed every hour, often in ways which are absolutely fantastic.

Nobel Prizes are peanuts when compared with what a linebacker for the Cowboys makes in a single season nowadays.

For about a hundred years now, the most lucrative prize for a person who made a really meaningful contribution to the culture of the world as a physicist, a chemist, a physiologist, a physician, a writer, or a maker of peace, has been the Nobel Prize. It is about a million dollars now. Those dollars come, incidentally, from a fortune made by a Swede who mixed clay with nitroglycerin and gave us dynamite.

KABOOM!

Alfred Nobel intended that his prizes make the planet's most valuable inhabitants independently wealthy, so that their work could not be inhibited or bent this way or that way by powerful politicians or patrons.

But one million dollars is only a white chip now -- in the worlds of sports and entertainment, on Wall Street, in many lawsuits, as compensation for executives of our larger corporations.

One million dollars in the tabloids and on the evening news is "chump change" in 1998...

Here is a direct link to the entire Rice speech. For those of who are big fans of Kurt Vonnegut (Author of Cat's Cradle, Slaughterhouse-Five, Breakfast of Champions), you can find a complete archive of his speeches, writings, biography and more at Vonnegutweb.com.