Saturday, December 22, 2007

Let the MBA's talk to themselves

Too many young MBAs spend more time on the squash court than at the foot of accomplished investors. How else can one expain the herd mentality and foolish investment decisions.

Let’s examine some conventional investing wisdom:
1. New capital, even expensive preferreds, is positive even as it dilutes current shareholders. Therefore push the price up.
2. Taking a large write down on securities that no one can understand is a signal that management, or new management, is on top of the situation and the stock has now bottomed. Therefore, don’t run for the hills or sell short, buy and push the price higher.
3. Agree with the economist fraternity and ignore rising food and energy costs and only concentrate on the “core rate.” People don’t eat or drive so non-core inflation won’t produce the same result as a tax increase. Therefore, keep cheering for lower short term interest rates and push all stocks up as rising prices aren’t as powerful as lower rates.
4.Emerging markets are growing so fast that a slowing American economy will not affect the Third World. Therefore pile into U.S. multinationals and Emerging Market companies and expand their valuations far past what their gowing earnings justify.
5. The list could go on for pages.

The ramblings above lead me to Citicorp. This money center bank hasn’t had good leadership for a number of years, its CEO was a former house counsel! It excelled at following trends and was willing to not only sell, but own securities that it didn’t understand. Its risk manaement was definately NOT crusty.

As I opined early on, the losses will keep coming ala Continental Illinois. The risk culture permeates the institution and it doesn’t only reside in the subprime mortgage portfolio, the CDO portolio, or the SIV that holds lots of asset backed commercial paper. The same management and risk managers that allowed that debt to reside on the balance sheet wasn’t able to discriminate and prevent poor credit from filtering into the LBO and Bridge loan portfolios, the home equity lines, unmonitored credit card portfolio, hedge fund lending, and aggressive merchant banking investments. Now that the auditors and regulators have started looking closer the other cockroaches will come out of the closet.

Selling high coupon preferred to Arabs may keep capital OK for awhile, but it is expensive and ,when converted, is dilutive. That capital won’t be enough to compensate for future losses attributed to the above problem areas that will develop. The dividend will need to be cut or eliminated as it represents billions of dollars of potential capital. Cutting the dividend may hurt shareholders, but so does dilution and both cause a reduction in share price.

I’ve had puts on Citi and think that bet remains a good one. It is likely that the dividend will be cut and the new president will announce losses greater than anticipated so that they are attributed to former management. The housecleaning won’t be enough though and losses will continue and capital will be strained for several years. Owning puts or being short is the place to be as the price will continue downward in 2008.

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