The Ponderings of Woodrow

Why today mattered...

Today I am struck by the complexity of our lives.

This morning, my wife gave birth to our 3rd son; and both mommy and son are healthy and happy as I write this. As I sat holding my newborn son, most likely our last, I was overwhelmed by a feeling of gratification. Gratification that I have a wife who supports and understands me, and who so beautifully and intelligently serves as the foundation of our family. Gratification for three healthy children. Gratification that I'm fortunate enough to have the means to support them in a way that will provide them with every opportunity. Gratification for the overwhelming support my colleagues and friends show me every single day.

My personal gratification was counterbalanced by the historic nature of today's inaugural festivities. To see millions of Americans descend upon the Capitol to show support for President Obama, to see the hope for great change physically manifested in a wave of citizens as diverse in ethnicity, age, sexual orientation and personal beliefs, was a powerful thing. And certainly President Obama delivered a speech worthy of his standing as an accomplished orator.

...So let us mark this day with remembrance, of who we are and how far we have traveled. In the year of America's birth, in the coldest of months, a small band of patriots huddled by dying campfires on the shores of an icy river. The capital was abandoned. The enemy was advancing. The snow was stained with blood. At a moment when the outcome of our revolution was most in doubt, the father of our nation ordered these words be read to the people:

"Let it be told to the future world...that in the depth of winter, when nothing but hope and virtue could survive ... that the city and the country, alarmed at one common danger, came forth to meet [it]."

America. In the face of our common dangers, in this winter of our hardship, let us remember these timeless words. With hope and virtue, let us brave once more the icy currents, and endure what storms may come. Let it be said by our children's children that when we were tested we refused to let this journey end, that we did not turn back nor did we falter; and with eyes fixed on the horizon and God's grace upon us, we carried forth that great gift of freedom and delivered it safely to future generations.

But I couldn't help and think about the exorbitant costs being incurred, well north of $150mm according to the latest tally. Was today historically significant? Yes. Did we deserve a day to celebrate all that's still great about our nation? Certainly. But isn't there something obscene about spending $150mm on pomp and circumstance at a time when our nation is at its most precarious in generations? My friend Howard Lindzon said it best:

It would have been a great idea to therefore cancel the first, biggest and dumbest party of the administration for an "America has a surplus party" one or two years out if all goes well.

We are the Capital One Society. Pleasure now.

I have seen zilch that shows me we are willing to push off the "pleasure now" philosophy from our new President. Even if he talks about it tonight, he sure wont be taken seriously buy me.

Color me skeptical.

And then on top of all that, I see the market by which I make my living completely give up the goat. I've never before felt so unhappy to be right about the way things are going, and where I fear they're continuing to head. Today's market action was negative on many levels, another day of indiscriminate selling across all sectors, caps, valuations and relative fundamentals. We broke key technical support levels and saw the financials lead the way down. Even the most balanced market prognosticators understand that financials need to find their bottom before the market can begin to heal; and yet we saw carnage in the sector today: Bank of America (BAC) down 29%, Citigroup (C) down 20%, J.P. Morgan (JPM) down 21%, Wells Fargo (WFC) down 24%. Even State Street (STT), thought to be a relative safe haven in the sector, lost almost 60% of its value as problems in its commercial paper business may necessitate a capital infusion. With each passing day more people realize the crutches and cliches that helped make their investing careers are just that, crutches and cliches that fail to support Mr. Market when we're in unprecedented times.

So as I get ready to call it a night I'm left thinking about the complexity of perspective, and wonder if tomorrow will prove any less conflicting.

Disclaimer: At the time of writing, neither the author nor the firms affiliated with the author maintained a position, long or short, in the publicly traded companies mentioned or any related instruments. The author and the firm reserve the right to alter their investment positions at any time in the future. The content on this site is provided as general information only and should not be taken as investment advice. Content should not serve in any way as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of firms affiliated with the author. Any action taken as a result of information or analysis on this blog is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Valuation isn't a catalyst to move markets

I've been hearing a lot of people argue that "stocks are cheap" as we continue to see bourses around the world plummet. As an investor, I'm acutely aware of valuation and its role in investment selection and subsequent performance. But I'm also mindful of how valuation loses significance at times of great velocity.

Link provided by CNNMoney.com

Are stocks cheap? By some measures, they certainly appear to be; at least relative to where they've traded over the last decade. But here's the rub...the de-leveraging we're seeing and the financial crisis we're dealing with is unlike anything this world has seen in generations, much less the last ten years. The daily moves we're seeing are comparable to what we saw in the 20s and 30s folks. So whether our equity markets are cheap compared to the last ten years hardly seems relevant.

But at the end of the day, if you're a fundamental investor [as I and my partners are], you have to remember that valuation doesn't supersede fundamentals. It can be tempting to look at a stock and see that it's trading at valuations we've not seen in our careers, but that can be a painful crutch. It gets back to my assertion last week that stocks aren't as effective at "pricing in" downward estimate revisions as we would like to think.

Remember the Nasdaq Bubble...the inverse can be true, too

At the peak of the Nasdaq bubble, very few investors could make a credible argument that stocks weren't obscenely valued. Blue chips were trading at 10x-20x-30x REVENUES. Triple digit P/Es were the norm. Companies with almost no revenues were coming public and trading at 100x projected sales, or higher. The idea of valuing companies on their future cash flows was resoundingly discredited as "out of date." Sell-side analysts turned to the "relative valuation" game, i.e., "ABC Corp trades at 80x revenue and XYZ is growing faster, so it should trade AT LEAST 80x revenues or more." And buy-siders played the game because you would've been slaughtered on an absolute basis if you didn't.

There were plenty of fund managers waiting for the inevitable crash to happen at the start of this decade. And yet I can tell you that many of them went out of business waiting for that crash to happen. Stocks were expensive, insanely so. And they continued to get more expensive.

The Nasdaq Bubble didn't burst because of valuation. It was only after the fundamental problems became unmistakable that investors began a rampant and unapologetic DE-LEVERAGING of their equity investments. And stocks went from insanely expensive to, in many cases, inordinately inexpensive. How many optical networking stocks went from 80x sales to trading a below net cash? More than you and I care to remember.

So again I'll say...the inverse can be true

Stocks can also become INSANELY cheap. And they can stay that way for years IF the underlying fundamentals that drive the market remain weak. I sure hope that doesn't happen. And I've seen a lot of aggressive action by the world's governments to prevent that from happening. There's a truism that says, "Don't Fight the Fed." Well right now the stock markets are "Fighting the FedS." And we're all not going to magically wake up one day and say, "OK, that's it...stocks are TOO CHEAP and I'm buying." Nope.

Valuations aren't an impediment to a new bull market, and that's a good thing. But for stocks to turn, and sustain an upward trajectory, it's got to come from improvements [or anticipation of said improvements] in the fundamentals. And right now that's as much about watching the TED spread, the Baltic Dry Shipping Index, and what specific investments (and when) TARP will be undertake.

As my friend Howard Lindzon has been saying, this is dangerous market. Guys like Steve Cohen, Israel Englander and John Paulson aren't sitting on billions in cash right now at market lows because they're scared. They are some of the most aggressive, accomplished investors on the planet and yet see too much uncertainty to put the majority of their partners' capital to work. Take note, I certainly am.

Disclaimer: At the time of writing, neither the author nor the firms affiliated with the author maintained an position, long or short, in the publicly traded companies mentioned or any related instruments. The author and the firm reserve the right to alter their investment positions at any time in the future. The content on this site is provided as general information only and should not be taken as investment advice. Content should not serve in any way as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of firms affiliated with the author. Any action taken as a result of information or analysis on this blog is ultimately your responsibility. Consult your investment adviser before making any investment decisions. 

Buffett invests in GE...should we smile or frown?

You've got to hand it to him, Warren Buffett knows how to make a splash.

Last week, the world's greatest value investor stepped into the maelstrom and invested $5B in Goldman Sachs. At the time, a lot of us wondered whether Buffett's move would calm the markets -- it hasn't. Tomorrow we'll get another chance to see if the Oracle of Omaha's confidence in bellwether U.S. equities will help stem the tide of investor uncertainty.

That's because today Warren Buffett invested $3B in General Electric. The terms were similar to those he received from Goldman Sachs:

• Berkshire will invest $3B in exchange for perpetual preferred stock that pays a 10% annual dividend
• Berkshire will receive rights to purchase an additional $3B in common stock at $22.25 per share, exercisable for the next 5 years
• GE will raise an additional $12B in common stock through a spot secondary [pricing tonight]
• GE can call in the preferred stock at any time over the next three years for a 10% premium

In discussing the deal, Buffett spoke of the opportunities he's seeing in the equity markets as well as GE's stature as an American institution:

"Frankly these markets are offering opportunities that weren't available six months or a year ago," Buffett said in an interview on CNBC. "So we're putting money to work."

"GE is the symbol of American business to the world. I am confident that GE will continue to be successful in the years to come."

So should investors look at Buffett's actions enthusiastically as a sign that it's safe to get back in the water OR are his investments actually cause for concern and indicative of just how serious the credit crisis has become?

The Bull Case -- Buffett is putting money to work

Buffett has invested $8B in the last week in two respected U.S. domiciled companies. Both are on the SEC's no-short list and both have suffered difficult times and lagging stock prices. Many people have made a career out of following in Buffett's footsteps, and there is unquestionably a symbolic component to seeing him put Berkshire's capital to work at a time when so few investors are willing to commit.

Mike O'Rourke, the Chief Market Strategist for Baypoint Trading (BTIG) summed up the bullish side of Buffett's actions in his nightly newsletter:

Once again, we find the cynicism surrounding another Buffett investment stunning.  For twenty years, market participants clamored to follow Buffett into any transaction, and now that he is finally putting money to work, the common response is that companies are giving him too much. In a capital constrained world, if you can get Buffett’s capital, you are well ahead of the competition.

The Bear Case -- Buffett is naming his terms, and they're not cheap

10% perpetual preferred plus warrants = hardly the same as going out and buying common shares in the open market. Buffett is no altruist, he and his investors expect him to act aggressively when opportunity arises. He's getting extremely attractive terms because GE and Goldman Sachs feel those terms are warranted; and there's the rub. GE is an American institution and carries a AAA credit rating. The fact a AAA-rated firm of GE's caliber would feel compelled to offer a senior perpetual preferred to any investor, even Warren Buffett, is a testament to just how tight liquidity remains throughout the system. To take a page out of my friend Roger's book...companies are paying a premium for option liquidity.

So is Buffett signaling a market bottom? Impossible to say. Buffett doesn't need the equity markets to rally for his investments to pay off. He just needs GE and Goldman Sachs to stay solvent and pay him 10% dividends year in, year out. Furthermore, Buffett is telling anyone who listens just how tenuous a situation the capital markets are in and the necessity of a bail out and then a lot of hard, smart decisions to follow.

One last point...To be a truly great value investor you have to zig while others zag. You have to be willing to put capital to work in an area where most won't. That's why great value investors pounce during periods of extreme sentiment. Buffett has the benefit of hindsight, great instincts and, most importantly, an ability to be patient in a market that, by definition, favors impatience. Stock prices are quoted in the blink of an eye, returns are followed in real time, funds are put to work and redeemed based on what happens over the course of days, weeks and months. To make money the Buffett way, you have to be willing to forgo all of that and treat equity stakes as though they were private investments with long-term horizons. That's MUCH easier said than done. Most public equity investors, particularly those running hedge fund money, are compensated [and rebuked] based on what they do in shorter time intervals. Buffett doesn't need to worry about that; if Berkshire Hathaway's stock were to meander for years, it wouldn't change his functional wealth, his buying power, or his reputation.

Disclaimer: At the time of writing, neither the author nor the firms affiliated with the author maintained an position, long or short, in the publicly traded companies mentioned or any related instruments. The author and the firm reserve the right to alter their investment positions at any time in the future. The content on this site is provided as general information only and should not be taken as investment advice. Content should not serve in any way as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of firms affiliated with the author. Any action taken as a result of information or analysis on this blog is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Why there MUST be a debate tonight

Should they, or shouldn't they?

As news broke last night that the potential $700B bail out was falling apart thanks, in part, to John McCain's involvement in urging for an alternative proposal, it seemed we were very close to postponing, if not outright canceling, the first of the scheduled Presidential Debates.

McCain had already signaled his intention of skipping the debate earlier in the week:

"I am calling on the President to convene a meeting with the leadership from both houses of Congress, including Senator Obama and myself," Mr. McCain said in New York on Wednesday afternoon. "It is time for both parties to come together to solve this problem."

McCain's critics immediately cried foul, implying that he was using the dire financial crisis to his political advantage. Obama's critics were equally offended by his retort that the debate should go on, complaining that he was using McCain's bipartisan overture against him.

The Argument Against Debating Tonight

I was having a conversation this morning with one of my partners, Monty, who is - by far - one of the sharpest and most reasoned minds I have the pleasure of associating with. Were it not for him, we wouldn't have been half as defensively positioned as we've been in the face of this crisis. And, for the most part, we see eye to eye on life's big issues. I say all that because he and I appear far apart in our view of the debate.

His view is that neither Presidential hopeful should take the stage tonight. He reasons that regardless of whether McCain's overtures were politically motivated, it was the right decision because the future leader of the free world [whether it be Obama or McCain] needs to have a direct hand in shaping the solution to our current crisis. I can't disagree with his logic, McCain and Obama are acting U.S. Senators and one of them will be the POTUS. To not have input on what's transpiring now would be a disgrace.

Another good friend of mine [who wants to remain anonymous] reminded me that "elections aren't won or lost on debates, they're just dog and pony shows to help the media get some ratings points." While I don't entirely agree with his jaded premise, I do understand his point that debates, in and of themselves, aren't always the most important variables in the election equation.

Why I Disagree and Think We MUST Have a Debate Tonight

Despite the very rational arguments against having a televised debate tonight, I'm strongly in favor of the debate forging ahead as scheduled.

Reasons for forging ahead:

1. It's the largest audience the candidates will have prior to the election -- History shows that the first debate is always the most watched. Furthermore, 70-80 million Americans will be watching tonight's events which is, inarguably, the widest reach either candidate will have to stake his claim to the highest office in the land
2. Debates HAVE played an enormous role in close elections -- The polling numbers indicate an incredibly close race. Many voters remain undecided. History has shown that televised debates CAN be major factors in tight races. Let's not forget that Ronald Reagan and Jimmy Carter were neck and neck in the polls until the debates.
3. The American people deserve a place at the table -- Putting off or canceling a debate at a time of crisis would send the wrong message to an American voting populace that feels underrepresented already. What kind of message would it send if our candidates held off addressing the American people in order to solve a financial crisis that most voters view as a "Wall Street" problem? Misguided or not, a LOT of Americans feel that way, and we can't ignore the will of the people.
4. Oration and debate are critical skills for a competent world leader [or at least SHOULD be] -- Call me an idealist, but I still believe that the POTUS should be able to convey a strength of character and ideals on the largest of stages. He should be able to stand before the world and evoke a sense of calm, a sense of trust and, most importantly, a sense that he's a leader of men. I would never hire someone that couldn't articulate their views clearly and concisely, why should it be okay for the most powerful elected official in our country to lack those skills? As I type this, I'm staring at copy of Abraham Lincoln's Speeches and Writings sitting on my bookshelf, is it unreasonable to think we could again have a leader as eloquent?
5. We may actually see our candidates go off script, for once -- Tonight's debate is supposed to focus on foreign policy and national security. That said,  I would be shocked if Jim Lehrer [tonight's moderator] doesn't find a way to make our financial problems a central issue. Debate preparation is a science unto itself these days, I realize. But if there's going to be a moment when Obama and McCain have to think on their feet and speak off the cuff, it's tonight. We're in the midst of a historic financial crisis and neither man has all the answers [because there are no answers, yet]. Let's see how they handle themselves at a time when there is one central issue that most voters care about, and no stump speech or party line with which to stand behind.
6. Postponing under the guise of dealing with the financial crisis is disingenuous [or would at least be perceived that way] -- The idea that debating would take either Senator out of the ongoing financial bail out discussions rings hollow, in my view. It would be one thing if both Obama and McCain were busy handling their Senatorial duties in lieu of other campaign obligations, but how many days (and votes) have they missed on the campaign trail? It's reasonable for them to hit pancake breakfasts, church socials, and rallies in key electoral blocks day in, day out, but not reasonable to address the key issues on the grand stage? Non sequitur.
7. Debating doesn't preclude the candidates from being involved in the process -- These men are used to appearing in three or four states in a single day and how many countless appearances? How many people on staff do they have? Is there a chance they're not connected 20 different ways to what's happening back in Washington? Realistically, they could bury their heads back into this bail out discussion the second they're off the podium, while flying in their planes back to D.C. and as they're being chauffeured back to the Congressional offices.

I realize I may be coming across as an idealist [when I genuinely pride myself on being a realist]. But I've always felt that the office of President of the United States should be held by someone capable of greatness. I find it impossible to reconcile the notion that the leader of the United States can't be both a person of character and a polished orator. Why can't we have it all? Has it gotten to that point where it's no longer reasonable to expect our POTUS to be more intelligent, more articulate, more inspiring than most? I certainly hope not. Could tonight's debates end up an unmemorable blip on the long election trail? Perhaps. But given the uncertainty surrounding our economy, the myriad questions [many without answers] facing us in the days and weeks ahead, wouldn't it be fantastic to be blown away tonight by one of these men? To be shown that, in fact, one of them really is capable of greatness? I'll be watching, and I'll continue to hope until the last of those 90 minutes.

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. Content should not serve in any way as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of firms affiliated with the author. Any action taken as a result of information or analysis on this blog is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

The Necessity of Blame

The search for someone to blame is always successful -- Robert Half

Blame Game for Financial Crisis

Created using http://wordle.net/. Images of Wordles are licensed .

Blame is EASY. Especially in a situation as grave as our nation is facing right now. I say this because I'm overwhelmed by the pervasiveness of blame in the process. Congressional hearings where the only bipartisan action is finding someone, other than Congress, to blame for our financial crisis. Investment banks crying afoul of short-sellers. Homeowners blaming predatory lenders for making it too easy to overextend themselves. People decrying future tax burdens because their neighbors took out huge mortgages with low teaser rates. Debt holders blaming the ratings agencies for rating things AAA when they were Toxic FFF. And so on and so on...

BUT IS THERE A POINT? Is BLAME productive?

When I was in college, I was involved in a car accident. I was in the back seat of my friend's beaten down clunker; and we were driving on the shoulder with our hazards on trying to get off the turnpike and find a hotel for the night since there were no mechanics open at that hour. It was a cloudy, rainy night and unbeknownst to us there was an 18-wheeler coming up behind us. The driver of that 18-wheeler was dozing off. Long story short, the 18-wheeler slammed into the back of the car and I woke up in an ambulance, unsure of what happened. I learned during that process the concept of COMPARATIVE NEGLIGENCE. Essentially the courts try to determine who to blame, and assign a percentage of blame to each participant. I was apparently 10% to blame; for failing to have a seatbelt on [despite it being legal since I was in the back seat]. The truck driver was 60% to blame; apparently falling asleep at the wheel and slamming into another vehicle works that way. And my buddy, the driver, picked up the rest of the blame for being on the road in a broken down car rather than stopping and awaiting emergency service. The courts used the percentages to determine the amount of damages awarded to the injured parties.

While comparative negligence may work for disability tort litigation, it has absolutely no place in stemming the tide of this financial crisis. If we're really on the precipice, as the Treasury Secretary, Fed Chairman and even the Oracle of Omaha believe, isn't assigning blame right now a suboptimal way of spending our time?

Howard Lindzon said, "I am not a fan of witchhunts, but they generally get shit done." His point is well taken, even if I wish it weren't.

Sometimes there are legitimate reasons for assigning blame, for figuring out WHOSE FAULT IT IS. But there will be time for that later. Our country is facing the most severe financial crisis since the Great Depression and there are no easy answers. Paulson and Bernanke haven't done a credible job of articulating the losers in this crisis. Yes, Wall Street stands to lose jobs and a lot of wealth. But Main Street stands to lose much more. The inability for small businesses to stock shelves and make payroll because lines of credit are drying up. The inability to refinance mortgages. Students unable to pay for tuition because student loan programs have evaporated. Retirees unable to pay their bills because their portfolios are pressured. We are already in recession territory, how many of us truly understand what it would mean to be in a Depression? Are we really prepared for double digit unemployment? Unfunded pensions? Municipal bankruptcies? Further devaluation of our currency? Reflation?

If not, we all need to get past our personal biases, our anger, and our desire for a pound of flesh. Can we do it? Or will we worry about making sure those most culpable aren't disproportionately benefited by a bail out effort? You decide.

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. Content should not serve in any way as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of firms affiliated with the author. Any action taken as a result of information or analysis on this blog is ultimately your responsibility. Consult your investment adviser before making any investment decisions. 

Can Buffett do what Paulson and Bernanke couldn't?

It's hard not to appreciate the symmetry of today's events.

Less than a week ago, Treasury Secretary Hank Paulson and Fed Chairman Ben Bernanke met with Congressional leaders and painted such a bleak picture of our financial system that they compelled the legislators into action, signaling initial support for a $700 blank check mechanism meant to overpower all the fear, uncertainty and doubt freezing up the liquidity of our capital markets. For good measure, SEC Chairman Cox piled on an ill conceived ban on select short sales.

The impact on the equity markets was short-lived, to say the least, as was the pledge of bipartisan support for getting something done in a timely fashion. As we braced for today's hearings, the equity markets staged a powerful sell off yesterday and many began to question the Paulson plan from seemingly every angle.

Having watched much of the hearings today, I was absolutely stunned at how unconvincing Paulson and Bernanke were in conveying their message of financial Armageddon to the Congressional committee. Let's hearken back to comments made by Senators Dodds and Schumer following last week's late night emergency session:

Congressional Leaders Stunned by Warnings [NY Times]

“When you listened to him describe it you gulped," said Senator Charles E. Schumer, Democrat of New York.

As Senator Christopher J. Dodd, Democrat of Connecticut and chairman of the Banking, Housing and Urban Affairs Committee, put it Friday morning on the ABC program “Good Morning America,” the congressional leaders were told “that we’re literally maybe days away from a complete meltdown of our financial system, with all the implications here at home and globally.”

Mr. Schumer added, “History was sort of hanging over it, like this was a moment.”

When Mr. Schumer described the meeting as “somber,” Mr. Dodd cut in. “Somber doesn’t begin to justify the words,” he said. “We have never heard language like this.”

For those of you who listened to the hearings today, you heard those very same Senators (and their fellow committee members) paint a decidedly different picture. Where was the sense of urgency? Where was the "something must be done right now, and it's not about partisan politics" mantra?

More importantly, where was the eloquent, descriptive state of the financial union that so many of us expected to hear from Paulson and Bernanke today?

Today, Bernanke and Paulson HAD to be better than they were. Realistically, these men were asking for a $700 billion bail out package with a broad, sweeping expansion of their powers and had, to date, offered up a 3-page (or 6-page in the revised version) memorandum in defense of the maneuver. They needed to scare the American people with the severity of the realities facing them.

They had to know that the American people had spoken loud and clear to their elected officials in the preceding days. "Main Street" just wasn't seeing how the Paulson Plan helped them. And in an election year, particularly September of said election year, if you can't get "Main Street" to see the validity of the proposal you have ABSOLUTELY NO HOPE of getting Congress to sign on the dotted line. But didn't Bernanke and Paulson know that before sitting down to testify today?

I assumed they did. Which means either they a) simply failed on the grandest of public stages to convey the actual severity of the situation or b) made a calculated bet against coming across as the heavies to the American people; knowing that a significantly reduced version of the bail out plan was a best case scenario to begin with.

The Markets Didn't Seem to Put Much Faith in the Paulson Plan

The U.S. indices finished at the lows of the day today, following a dramatic sell off on Monday; signaling to many that investors simply weren't putting much credence in the state of the Paulson Plan to stem the bleeding in a timely and optimal manner.

Enter the Berkshire Call Option: Buffett Announces Investment in Goldman Sachs

Berkshire Hathaway has agreed to invest in Goldman Sachs, Buffett's first investment in a Wall Street firm since his much ballyhooed involvement with Salomon Brothers in the early 90s. The terms of today's agreement:

• Berkshire will invest $5B in exchange for perpetual preferred stock that pays a 10% annual dividend
• Berkshire will receive rights to purchase an additional $5B in common stock at $115 per share, exercisable for the next 5 years
• Goldman will raise an additional $2.5B in common stock through a secondary [it's first equity issuance since 2000]
• Goldman can call in the preferred stock at any time for a 10% premium

The Perceived Value of Buffett's Endorsement

As I type this, shares of GS are trading at $134.75 [up 7.9% after hours]; signaling the market's enthusiasm for Buffett's investment. Broadly, equity futures are up on this news. There are plenty of rational reasons for the market's enthusiasm tonight:

• Buffett is, without question, one of the best investors walking the Earth
• He's heretofore avoided stepping into the Wall Street malaise; his willingness now will be perceived as a signal of bottoming
• A lot of investors are more than happy to follow Buffett's lead
• This move puts Goldman on sounder financial footing and signals that the government's moves last week to stem the fire sale are working
• We're collectively (and justifiably) more impressed by the actions of a private free market participant than we are by the bazooka of forced socialism

But Let's Not Confuse Buffett's Investment in Goldman with What the Paulson Plan is Trying to Solve

The market is beaten up. Conviction is low. Volatility is (relatively) high. Buffett will make people feel better. Whether it's a temporary tonic or the siphon that gets the investment pump churning again very much remains to be seen. But I remain skeptical of this move as a harbinger of a broader fix for several reasons.

• This is a move to invest in a storied financial entity, Buffett's investment does NOTHING to help set a fair market price for the toxic assets the Treasury is trying to get $700B to acquire
• Buffett is just the latest investor willing to invest in a Wall Street firm under attractive terms; he's not blazing the trail here. For example, it was announced just a day ago that Mitsubishi UFJ is buying 20% of Morgan Stanley
• Buffett is getting extremely attractive terms; Goldman didn't provide Buffett with a $500mm annual dividend in perpetuity plus call options for 7% of the company's equity because it had offers pouring in. Few firms will be able to ask for, and get, those kinds of terms

It's not about this investment, it's about whether Buffett can convince the market of reasonable marks for all the toxic assets in the system. The market is tired and frustrated. A lot of people have been looking for "the sign" of a bottom in the financial sector and whether this helps spark the private sector to put money to work remains to be seen. One would hope that Buffett's willingness to get involved will also signal his willingness to actively vocalize thoughts on the appropriate way to value and dispose of the toxic assets which plague the system. If he can convince private buyers to start taking troubled assets off the banks' balance sheets, he may actually accomplish more with $5B than Paulson and Bernanke can with $700B. A scary thought to be sure, but one that's not out of the realm of possibility.

Disclaimer: At the time of writing, neither the author nor the firms affiliated with the author maintained an position, long or short, in the publicly traded companies mentioned or any related instruments. The author and the firm reserve the right to alter their investment positions at any time in the future. The content on this site is provided as general information only and should not be taken as investment advice. Content should not serve in any way as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of firms affiliated with the author. Any action taken as a result of information or analysis on this blog is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Hedge Fund fallout just getting started?

Nouriel Roubini, not too long ago considered an alarmist by many, has been so right (while so many were wrong) that his missives are quickly becoming must reads by anyone even tangentially involved in the capital markets.

In today's Financial Times, Roubini discusses what he sees as the "next step" [free registration required] in the global unraveling of the "shadow banking system":

...The next stage will be a run on thousands of highly leveraged hedge funds. After a brief lock-up period, investors in such funds can redeem their investments on a quarterly basis; thus a bank-like run on hedge funds is highly possible. Hundreds of smaller, younger funds that have taken excessive risks with high leverage and are poorly managed may collapse. A massive shake-out of the bloated hedge fund industry is likely in the next two years.

A Global Process of Deleveraging

Easy money. At the heart of our current financial crisis is a systemic disregard for risk which in turn fueled an asinine bubble in worldwide liquidity. The availability of easy money stemmed every rung of the economic ladder. Consumers got easy car loans, homeowners got easy mortgages, corporations fueled M&A and buybacks with easy debt, MEW was plentiful, historic LBOs, unprecedented money growth in emerging and developed sovereign nations. You name it, the liquidity was there. The notion of "what goes up must come down" is more than a truism in this case. While we're beginning to understand the significance of the mess we've collectively made, anyone that thinks the Paulson Plan magically gets us through the normalization process needs to revisit their statistics textbooks from university.

Felix Zulauf explained the situation succinctly in this week's Barron's [sub required]:

The leveraging-up in this cycle is reversing, and we are now deleveraging. When a huge system -- that is, the global credit system dominated by the investment-bank giants that have been the major creators of credit in the last cycle -- turns down, the fallout is going to be terrible. Deleveraging is a very painful process, and will run longer and deeper than anybody can imagine.

Quantifying Hedge Fund Leverage

The hedge fund industry has grown up during the liquidity bubble. That's no coincidence. I've had a number of people ask me what the "typical" leverage profile is within the industry. A recent study by the ECB puts the average hedge fund leverage at 1.4x-1.5x in its most recent analysis; with the caveat that leverage was declining in the face of tighter credit conditions. Unfortunately, even if this number proved accurate, knowing the Mean for our industry isn't very helpful in estimating the potential fallout that Roubini predicts.

1. Hedge funds are fluid instruments and a snapshot is just that, a snapshot. Industry leverage can change dramatically in a matter of weeks. Quarter to quarter is anyone's guess
2. The mean isn't predictive given the dispersion of styles and risk characteristics within our industry. There are funds that use little to no leverage, and there are firms that use 10-12x leverage [think Bear Stearns Enhanced Leverage Fund]
3. The majority of funds are unregistered and unregulated, creating an opacity of disclosure

But Wait, There's More...

1.5x leverage doesn't seem as bad as you thought, right? Well that only accounts for a component of the unwinding Roubini is hinting at. A good chunk of hedge fund capital comes from fund of funds; which use leverage to generate their returns. Still not enough for you? Then remember that lots of hedge funds used that capital to invest in highly leveraged debt instruments (i.e., CDOs).

Way back in January 2007, Gillian Tett of the Financial Times [sub required] relayed a story from an anonymous emailer who expressed disbelief at the ease by which hedge funds have been able to lever up as much at 50:1 [admittedly an extreme example]:

He then relates the case of a typical hedge fund, two times levered. That looks modest until you realise it is partly backed by fund of funds' money (which is three times levered) and investing in deeply subordinated tranches of collateralised debt obligations, which are nine times levered. "Thus every €1m of CDO bonds [acquired] is effectively supported by less than €20,000 of end investors' capital - a 2% price decline in the CDO paper wipes out the capital supporting it.

"The degree of leverage at work . . . is quite frankly frightening," he concludes. "Very few hedge funds I talk to have got a prayer in the next downturn. Even more worryingly, most of them don't even expect one."

Don't Cry for Me Argentina

Right now the "Main Street vs. Wall Street" sentiment is at a fever pitch and, for as little sympathy the average citzen has for the travails of Lehman, AIG, Goldman, Morgan Stanley, et al...you can be sure they have less sympathy for the hedge fund industry. We're big boys (and girls) and the rational among us can't reasonably expect the kind of blank check bail outs being afforded the investment banks, insurers and traditional lenders.

• Unregulated = Unprotected -- The pound of flesh the government is demanding for this monster bail out is HEAVY REGULATION; and as an industry we've fought continuously against oversight. Ironically, if the HF fallout is severe enough, we're probably facing increased regulation when all is said and done anyway.
• Easy Political Targets -- The blame game is already underway. While I personally think it's counter productive to spend cycles figuring out who to blame [especially b/c just about everyone is culpable in a mess of this magnitude], it's an ELECTION YEAR and politicians need someone to rally against. Since they can't blame over-leveraged consumers [they need those votes] and assuredly won't blame themselves [how can they win re-election that way?], hedge funds are an easy target.
• Short-selling criticism is a harbinger -- I've already said my piece on the silliness of the short-selling ban; but that isn't stopping the politicians from beating the "short selling = evil" drum.

Drowning in High Water

Deleveraging and public criticism are just two of the issues at play right now. The proverbial other shoe to drop is the incentive allocation model. For those who aren't familiar with how hedge funds are structured, typically we collect a management fee (based on a percentage of assets under management) and a performance fee (based on a defined percentage of the net profits during a given fiscal period). But what happens when a fund manager fails to generate a positive return? We're subject to a high water mark:

EurekaHedge FAQ:
What is a high water mark?

Where a hedge fund applies a high water mark to an investor's money, this means that the manager will only receive performance fees, on that particular pool of invested money, when its value is greater than its previous greatest value. Should the investment drop in value then the manager must bring it back above the previous greatest value before they can receive performance fees again.

In other words, if a fund loses 10% in Year N, it has to make back that 10% in Year N+1 before it can begin accruing performance fees.

Nine of out Ten Hedge Funds are Under Water

According to a recent survey by EurekaHedge, 97% of the 4,000 funds it surveyed were under their high water mark as of July 31st. That shouldn't be a surprise given where the equity indices currently sit, but it does raise the question of what the resulting impact will be. Barring a major turnaround in the capital markets between now and year end, the majority of the world's hedge funds won't receive performance fees.

Thoughts on the potential fallout:

• Large, multi-strategy mega funds will weather the storm better than most -- The mega funds are diversified and well capitalized to weather a down year or two. Presuming the aggrerate returns aren't significantly below the high water mark, the potential to quickly get back above water in 2009 will be incentive. Furthermore, top performers at smaller funds will likely look upon the relative safety of working for a mega firm in a new light
• Hundreds, if not thousands of funds will shut down, merge or recapitalize -- Some fund managers will simply close their doors and move onto other initiatives; returning capital to LPs and living off their past proceeds. Others will look to "get big quickly." Expect many funds that fall significantly under water to lose top performers who would have otherwise generated performance fees on their own portion of the portfolio
• Capital raising will become more difficult -- This is already happening but capital raising will become more difficult; particularly as fund of funds and large institutions struggle to justify past investments in toxic CDOs and other leveraged, non-performing assets
• Investors will demand more transparency -- This is self explanatory, and inevitable
• Aggregate returns will moderate -- Systemic deleveraging means more muted aggregate returns. For funds that have made their way using little to no leverage [full disclosure: we are one of those entities], this hopefully brings opportunity

Tumultuous times are ahead, for every portion of the financial world. Roubini's prediction that hedge funds have a period of rationalization ahead is both logical and highly likely. There will be pain; much of it necessary. But those who stay focused on the task at hand, execute within their stated investment parameters, and balance the need for absolute returns with the need to service and protect their partners against undue risk will not only survive, but flourish. Changes are inevitable, but I for one don't necessarily think that's a bad thing -- longer term, of course.

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. Content should not serve in any way as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of firms affiliated with the author. Any action taken as a result of information or analysis on this blog is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Is this what Nero felt like as Rome burned?

Last night we got the incredulous news that the SEC was planning some kind of ban on all short-selling. I, and many others weighed in on the matter but understood that details were sketchy at best and our initial reactions could be premised on false assumptions.

Well, it's now official and - frankly - is somehow even more stultifying than I could have imagined.

Banning short-selling made no sense. But the SEC has done one better (or worse depending on your perspective). The SEC has, effective immediately, banned short-selling on financial stocks. For official details, read here:

• SEC temporarily bans short-selling in financial equities

Here are a few of the key bullet points:

• 799 financial stocks protected from short-selling
• Order is effective immediately save for market makers through quad witching
• Order lasts until October 2nd if not further extended beyond that

On the surface, I'm sure some people are looking at this as a more rational decision than an outright ban on short-selling any equity. I disagree, for two reasons:

1. Financials are, fundamentally, one of the most troubled sectors -- Short-selling is a bet against the performance of an equity. Generally the decision to short is premised out of some belief/analysis that the underlying fundamentals (or technicals in some cases) of a company are impaired or on the precipice of difficulty. Why then does it make sense to prevent shorting in one of the, if not THE, most fundamentally impaired sectors? The inverse of this would be like preventing investors from buying commodity stocks globally over the last few years.
2. This artificially creates added short-sale pressure on other sectors -- A ban on short-selling would've probably caused an artificial rally in equities and, yes, probably an equally painful sell-off once the ban was eventually lifted. By limiting the ban to the financial sector, the SEC is all but guaranteeing that billions of dollars of short book are going to be reallocated to other sectors. Hedge funds aren't going to stop running net neutral books just because the SEC wants financial firms to feel warm and fuzzy until the start of October. So that means any other sector is now going to have enormous pressure shifted to it by those who either want to, or have to run short exposure.

Disclaimer:The content on this site is provided as general information only and should not be taken as investment advice. Content should not serve in any way as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of firms affiliated with the author. Any action taken as a result of information or analysis on this blog is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Who needs arteries when you have veins?...Cox allegedly wants to ban short-selling

It's been a crazy week to say the least. A day after the biggest sell-off since the Nasdaq bubble burst, we looked set for another volatile, yet down day until late day news that the Treasury Secretary Paulson was lobbying Congress for the creation of an entity that would buy bad loans from troubled financial institutions. The market rallied to one of its biggest gains since 2002.

 

As if that wasn't enough mania for one day, after hours comes word that SEC Chairman Cox has proposed a temporary ban on short-selling:

SEC Chairman Christopher Cox briefed Congress late Thursday of the agency's plans to take the extraordinary step of interfering with the market's regular functioning. Short-selling is a trading strategy of selling borrowed stock in hopes it falls and can be repurchased at a lower price. 

The details of the SEC's measures are unclear. The ban must be approved by the commissioners, and there's no word on which stocks are covered or for how long it will be in 
effect.

Now, to be fair, details are completely unclear right now. We have no idea of the magnitude of what's been proposed, and whether Congress would entertain such an idea. That said, the mere fact a discussion is even being had boggles my mind.

Who needs arteries when we have veins?

So what does this bloody analogy have to do with today's craziness? Any closed system only works if a) the constituent parts are functional and b) each of those constituent parts play a key role. I would argue (as most rational people would) that short-selling is an integral part of the securities industry.

Let's not confuse abusive, naked short-selling with what Cox is allegedly trying to curtail tonight. Short-selling is an essential component of a free market. How ironic is it that, at a time when liquidity is evaporating throughout the system, we're talking about removing a major component of the most liquid part of the capital markets (daily trading in listed equities).

Paul Kedrosky sums it up succinctly:

But even if we dismiss price efficiency, consider the practical consequences of making it impossible to short financials (and don't even get me started about disallowing all shorting): What happens, for example, if you're running a long/short quant fund with billions of dollars and hundreds of positions? Do you give the money back now that you can't trade the short side of your fund? Do you push all the short trades through ETFs? Do you abandon the entire financial sector? And who do you sue when your fund blows up because you're not sector neutral? Short-only funds are, of course, now, turned into commercial real estate companies.

An outright ban of short selling, even for a temporary time, makes so little sense I would normally be loathe to even acknowledge this kind of rumor. But based on what we've seen over the last week, nothing appears out of the realm of possibility.

Michael "Mish" Shedlock termed this the peak of insanity:

...Apologies offered for the séance prediction. At least I considered the options. Most did not. With that in mind, I cannot predict (nor can anyone else) when this manipulated rally will fizzle out, one can only state that it will.

Those looking for a global equities crash are likely to get it if this resolution passes, and in fact may get one whether it does or not. Such is the nature of intervention into the no longer free markets in light of the fact there is simply no such construct as "peak insanity".

So who needs arteries when we have veins? Anyone that wants to live another day.

Disclaimer:The content on this site is provided as general information only and should not be taken as investment advice. Content should not serve in any way as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of firms affiliated with the author. Any action taken as a result of information or analysis on this blog is ultimately your responsibility. Consult your investment adviser before making any investment decisions.