Thursday, February 25, 2010

Structured Products Are Alive And Well, Not Dead, Thanks To "Too Big To Fail"

After the demise of Lehman Brothers I recall reading an article about the end of structured products on Wall Street. The author's premise sounded logical given that the purchasers of Lehman structured products were considered unsecured creditors in Lehman's bankruptcy. Who would line up to "lend" money to a bank without either FDIC insurance or as part of the FDIC's Temporary Liquidity Guarantee Program? Hence, the end of structured finance. The end of a lucrative line of business for banks and, hopefully, less ways to lose money for investors.

Well, wrong. Structured products are alive and well. They may not be quite as daring as a few years back, but they are being sold with abandon and playing to investors quest for a deal too good to be true. Want a 10+ percent return with a relatively short maturity, plus the possibility to earn even more yield if underlying security does well? Would you like it even better if you were given ten percent downside protection? These are the kinds of deals that a proliferating in todays market satisfying investors desire for yield, growth, and safety. But it takes about 170 pages of disclosure to protect the issuer.

The main components of the typical deal aren't terribly complicated. To varying degrees, the bank buys the index or security, sells a call, buys some downside protection, collects their fee and uses the excess, if any, money. An investor could do the same thing for a lot less cost AND WITHOUT ANY CREDIT RISK! Plus, it can be done more tax efficiently than structured as all ordinary income.

What I find offensive is the credit risk. In these structured products you are making an unsecured loan to the issuer! You aren't making an investment in the S&P500 Index or Ford or a commodity. The issuer owns the securities. All the buyer has is the issuer's promise to pay. An investor should substitute Lehman for Bank of America or Citigroup when considering a structured product. Do you want to be an unsecured creditor? If you buy, you are.

Government bailouts have kept these types of investments alive. "Too Big To Fail" takes some of the risk out of making big banks unsecured loans. But government policies can change. There isn't a law that says the government will protect all stakeholders the next time a big bank self destructs. And sales pitches that sound too good to be true, usually are.

Thursday, February 18, 2010

Time To Tax Non-Profits

Politicians will resort to off balance sheet tricks such as Greece's recent admission, celebrate the Fed's "earnings" and dividend to the Treasury, and defer reality until retirement. If they admit that we face problems, more time will be spent blaming someone else than is devoted to solving the dilemma. Serious cost cutting will stay off the table until near the brink.

What can Washington do now that is politically palatable? Raise taxes on the rich is the likely answer. But if taxes are to be raised it should be on the untaxed. I'm not talking about the poor and undocumented immigrants. I'm suggesting the non-profit world. There is a huge swath of American business that isn't taxed due to their form of organization.

Credit Unions used to be mom and pop operations that served factory workers and were manned by volunteers. Now they represent a huge, untaxed portion of our financial system. It's not fair and doesn't generate tax revenue. Bankers would provide cover for the administration on this revenue enhancer. Goodwill Industries does worthy work training the handicapped, but they run an untaxed retail business of significant size. Non-profit hospitals compete with tax paying hospital companies. The list can go on longer than my typing stamina.

If tax increases are required, tax the untaxed. Cuts in spending, not in the rate of growth, are the best idea, but our elected officials don't have the gumption to do what is right. Next best is the tax changes I've proposed.

Tuesday, February 16, 2010

Copper Defies Supply And Demand

The rule of supply and demand states that as a commodity becomes scarser the price should rise. Conversely, as inventories grow, prices should weaken. The rule doesn't say how soon the price should rise or fall. You can go broke waiting for the rule to kick in. But, eventually people won't pay a lot for a commodity that is abundant.

Copper seems to be defying the rule. Inventories have been increasing dramatically and so has price. London Metal Exchange physical inventory has doubled since August!

Now let's look at the rise in copper prices.

Copper versus LME Inventories. Source: Bloomberg, LME

The copper bull market corresponded with a reduction in inventories. But as stocks of copper have grown, the price of copper has decoupled. Instead of going down, price has been rapidly rising. Why and for how long?

China is the reason most often mentioned.That and the weak US Dollar. Many believe that China was hoarding copper as an alternative to buying Treasuries, plus their lending and building boom would make good use of the metal. In fact China did buy over 40% of ALL copper in 2009. It's economy is no where near 40% of the world's economic output. Many feel that the Chinese have a huge inventory in addition to the LME and Shanghai warehoused inventories. Odds are that China will not be a 40% buyer in 2010. And the dollar has been anything but weak lately. Yet copper continues to rocket upward.

If the Chinese have slowed their purchasing and the dollar has strengthened, what keeps copper up? Pure momentum and speculation. Some of the same economic recovery belief that the stock market sees. In fact, copper has been fairly well correlated with the S&P500 lately.

Even speculators can read charts and when you read the inventory chart you should get scared. When producers like FCX say they aren't seeing enough pick up in demand to warrant capital investment that should be a warning that production is exceeding demand. As inventories continue to grow the price of copper will need to adjust downward.

I haven't figured out how, or if, to profit from copper's mis-pricing. Shorting high beta stocks like FCX could get painful as could buying an inverse ETF. I'm going to keep thinking and exploring as I think copper is overblown.

Monday, February 15, 2010

Are Longleaf and Fairfax Visionaries Or Just Stuck?

Years ago, like nearly everyone else who resided in Omaha, Nebraska, I drank the Level3 Kool-Aid. Level3 was an offshoot of Kiewit Construction and everything the Kiewit guys touched turned to gold. They built roads, tunnels, big buildings and mined coal and aggregates. They bought the failed Continental Can Company, stripped it and came out with huge profits. They started a fiber optic company that became the forerunner of MCI and sold it to WorldCom. Level3 was a do-over of a business that they had already made billions in and directed by the same management team that led the former success. Additionally, the managers and accountants of Kiewit would once again make sure the venture was run soundly. But Kiewit was a private company. You could only envy, you couldn't participate unless you worked there.

Level3 eventually went public. We could all get in and become Kiewit millionaires. Omaha did. In the dot-com bubble it hit $158 per share. It became not only the darling of Omaha, but the high tech investing world. It has been all downhill from there. Paper fortunes have been lost and many margined fortunes sunk real fortunes. The devastation has been significant on Omaha Kiewit wannabes. I thank my lucky stars that I wasn't a pig as I often am. I made a few dollars and have watched the saga from the sidelines.

Walter Scott, Level3's Chairman and former Kiewit CEO, has a great business reputation, in spite of Level3's performance. He has an engineers mind, a businessman's nose, and integrity. Those qualities have attracted some quality associates: Warren Buffett, Leucadia Financial, Mason Hawkins of Longleaf, and Prem Watsa of Fairfax Financial Holdings. The first two have done bond financings while the latter two have done both bonds/convertibles and common stock. To the best of my knowledge Berkshire and Leucadia are not involved with Level3 at the present time.

Southeastern Asset Management, Hawkins' company owns 429 million shares and Watsa's Fairfax owns 139 million shares. Both Fairfax and Southeastern each own about a $100 million in a convertible issue paying 15%! I'm not sure if the potential convertible shares are factored into the ownership totals and it really doesn't matter. Included or not, these two guru investors have placed a huge bet on Level3's future. They own approximately 35% of the company, possibly more. While respected value investors, they must be betting on the company's franchise value and moat. LVLT sells at over 4 X Book and has virtually no tangible book value, it's $6 Billion of debt dwarfs it's equity, interest charges gobble up over $1/2 Billion per year, and net earnings have been rare over it's lifespan. It doesn't fare well under almost any value investing metrics. Yet, two guys smarter than me have parked lots of money here. Additionally, both have the bulk of their net worth tied up in their companies, so they aren't some Wall Street hotshot playing with other peoples money while skimming large fees. They must believe.

It's obvious that they too have drunk the LVLT Kool-Aid. Will the result be different from the losses sustained by many of the Omaha faithful? Buffett and Leucadia were attracted by the generous terms offered by LVLT, made a well calculated investment and have exited. Hawkins and Watsa have the bulk of their money at risk in common stock. Their 15% yields on the convertibles is attractive, but the majority of their investment pays no interest. Whether they are under or above water on their positions, they are believers. They still own a ton of LVLT shares.

None of the other security companies are even close in their devotion to Level3, in fact, many other holders are indexers and smaller institutional positions. Analysts aren't impressed. The stock is the province of penny stock speculators and two, well respected value investors. Not the usual bedfellows. When the share price moves it is the result of rumors touting a Google or Sprint acquisition, not any improvement in financial condition. Why do Hawkins and Watsa stay and should I join them?

I think I'm going to keep watching this drama from the sidelines. I had a taste of the Kool-Aid, but have been able to kick the habit. With $6 Billion of junk debt, declining revenue, and poor operating results, I see lots of dilution ahead. LVLT has been masterful at balance sheet management as they have restructured, refunded, converted, and issued securities along their route to telecom survival. But, more of their debt will get turned into equity. Even at a discount, more shares equals dilution.

If Level3 doesn't work out well for Fairfax and Longleaf it won't sink their funds, but individual investors would be better off staying away from dilution prone balance sheets.

Saturday, February 13, 2010

The Pension Bubble

The United States faces a ticking time bomb that needs to be defused. The threat is government pensions, almost all of which are seriously underfunded and poorly designed. Taxpayers are at risk of large tax increases, or significant cuts in services, unless changes are made. The problem exists at the federal, state, county, and city levels. It encompasses the general employee base as well as first responders. It's a large problem given the growth in government employment.

Private business has moved away from defined benefit pension plans about 25 years ago. Defined contribution plans, such as the 401K, have become the norm for business. They need to become the norm for government as well.

The following email was sent to my local newspaper and it's easier to cut and paste it than to re-type and make it fit this post. It serves the purpose nicely. Just transpose your city, county, state, federal government for Mount Dora. The plans are all similiar and almost all in trouble. If they aren't fixed, add a tax increase to the one's we will be getting for the stimulus and bailouts.

Here's my letter:

Lauren, I appreciate your desire to see Mount Dora not only retain it’s charm, but improve as the economy recovers. I share that vision. However, as a resident, and healthy taxpayer, I also expect my city to operate efficiently and show fiscal responsibility.

A major area of fiscal irresponsibility is the pension benefits currently offered to employees in the General Employee Pension Plan. I think it is entirely appropriate that the city council examines the Plan and, after study, makes changes. The current plan is not sustainable, for employees or taxpayers. Employees have not had a raise in pay for two years because the city could not afford it, largely due to an accelerating pension contribution. Not only the absolute dollars contributed to the plan, but the percentage of total payroll have skyrocketed. Additionally, investment performance has been poor. The combination of overly generous benefits and poor investment results has left the Plan in a seriously under funded position. A continued acceleration of this situation will affect all city services, as Plan contributions will take up larger and larger portions of the annual budget.

The goal of pension reform is not to harm employees. Some, however, would not have such a sweet deal. Others, the rank and file, could see paychecks actually increase as they currently pay up to 7% toward their pension plus 6% for social security. And, due to budget constraints, haven’t been receiving pay raises. Some employees may very well welcome a 401K Plan that allows them to keep a few more dollars of net pay and gives the city the flexibility to offer pay increases.

Let’s look at the Plan. It uses a .03 multiplier, and is generous on vesting, early retirement, final year income adjustments, and other components. What that means is that a long-term employee can retire with an income that exceeds his final pay level! For life! Mostly funded by taxpayers. An example: Multiplier [ .03 ] X years of service [30 years] X Final Pay. So, .03 X 30 =. 9 then, .9 X Final Pay, say, 80,000 =$72,000 PLUS Social Security of, lets say $25,000. resulting in a city/employee funded retirement income of $97,000. Remember, both city and employee pay 6% of income into social security. Most plans deduct that benefit from the pension, but the Mount Dora Plan doesn’t!

The over-riding question is should the taxpayer continue an employee’s income for life? Is 30 years of work worthy of that amount of compensation? In the past possibly as government salaries were not as generous as in private business, but for a long time city employees have enjoyed comparable pay scales.

The Council should solve the pension situation and also look at any other areas that affect the fiscal soundness of the city. Luckily for our community, the city isn’t burdened with a large debt load and if the Council acts diligently, it won’t become so.

Thanks for listening. Bill Kabourek

Wednesday, February 10, 2010

Are Central Bankers Throwing Life Preservers or Anchors?

Central banking 101 seems to view "financial rescue" as a virtuous deed. We saw this tenet put into action in the subprime crisis and it is about to emerge again in the coming European sovereign debt bailout. The problems are kicked down the road rather than addressed. CB101 states that it is better for all taxpayers to suffer later, so that creditors and investors don't feel immediate pain. It was put into effect to rescue Fannie and Freddie, and, it appears, the Germans and IMF are about to do an encore with troubled Euro zone borrowers.

Belt tightening is the solution. But, as proven by the recent strikes in Greece, politicians, and their constituants, don't have the stomach for actual solutions. Anchors disguised as life preservers are more palatable. Loan guarantees and public ownership do not solve problems, they only transfer and redistribute the problem. More debt doesn't cure a debt induced ailment. But it does if you are a central banker.

If failure isn't an option and if entitlement cutting isn't viable, what is left in the CB101 playbook. First, defer as long as possible. Put as much lipstick on the debt pig as possible. When she is no longer pretty to anyone, inflate the debt repayment to a manageable level. The bond market is starting to get it "a little" as yields have been moving upward. The Chinese get it "a lot" as they are diversifing their holdings and attempting to minimize the impact of upcoming reflation. There is no other option and smart creditors see the future clearly. The process to protect buying power has begun and will continue.

What might be done to counteract CB101? Equities should do better over time as businessmen tend to be nimble. But, my bet is that markets will offer a much lower entry point prior to reflation in ernest. Midwestern farm ground, even though prices have increased, should hold capital together and produce a modest return. Municipal bonds are going to get very risky as they carry not only interest rate risk, but, increasingly, default risk. Cities, states, and special improvement districts have serious problems, on balance sheet and off. A short term government bond ladder has merit only if one can stomach book losses and hold until maturity. Byron Wein, strategist at Blackstone, opined yesterday that fed funds would go from zero to two percent by yearend 2010. If his view is correct, I'd be patient till later this year and then build that ladder. But, consider quality corporate bonds for additional yield, and if you believe my statement that businessmen are nimble, and safety. Finally, gold, even though it doesn't produce any income and supply never goes away, should gain luster in face of bond inflation.

The next time you see Jean Claude Trichot or Ben Bernancke toss a life preserver, don't get giddy and think good times are here again, get wary and think capital preservation.

Tuesday, February 2, 2010

$30B For Small Business Lending A Boon To Banks

Jobs, Jobs, Jobs is the new mantra. One conventional way to create jobs is t0 foster a healthier small business climate as it is accepted that job growth begins with mom and pop companies. Since the administration has decided that small business job creation will not be encouraged by lower taxes, and instead will let the Bush tax cuts expire, the next best initiative would be to rev up small business lending.

This new program is unlikely to produce the intended results. Whether the funding is doled out directly from government agencies or through bank SBA [ Small Business Administration ] lending, it will help banks more than small business. Why? Because the banks have the collateral already pledged and assigned and stand in a first lien position. Any new lending would be junior to the banker and that would only make the bank loans more secure, thereby helping bank balance sheets and loss reserves. If a bank would agree to additional lending, it would likely be with a government SBA guarantee. That would likely lessen their exposure. Again, that helps the lender. Finally, should another lender appear, government or financial, that wanted the entire business then they would need to payoff the bank's first lien.

We are not going to get a big bang for our bucks here if the goal is job creation. The Administration will get publicity for their claim that they are stoking the engine of growth, small business, but, in reality, they are again helping lenders and taxpayers will be footing the bill through either additional government borrowing or guarantees. The unintended consequence here is not totally bad as the financial firms do need to reduce poorer quality assets if they are going to regain a firm footing for the future.

This $30 Billion will improve bank credit quality, lessen the need for loan loss reserve growth, and future FDIC assessments as the FDIC may end up as the biggest winner since fewer community banks may fail. But don't look for job growth as businesses don't add jobs until they see demand and banks don't release collateral until they see cash or a guarantee.

Monday, February 1, 2010

Shameless Plug Time--Buy Men Who Are Making America

Technology is passing me by. Not only has Amazon's Kindle been very successful, the wife is buying one to avoid touching the lousy newsprint newspapers now use, but Apple has announced the debut of their new ITablet. Holding a book in one's hand will soon be reserved for us dinosauers. I hope assimilation takes awhile as I still have inventory in the basement!

Sales have slowed, so it's time to plug Men Who Are Making America again. The economy may be bad, but that isn't the reason my email inbox,, isn't full of orders. The reason is that the books are downstairs and I rarely think about promoting the book. Apple has now reminded me.

So, if you like real books, order Men Who Are Making America by B.C. Forbes. It's a good read and can be put on a bookshelf. Try that with a Kindle. As always, you can send a personal check after you've received the book. Just send an email and tell me the number you want and the mailing address.

Read about the Business Titans that the book covers, and cost, on the leftmost column of this blog as I don't feel like typing it again.

End of shamless plug. Almost. Let's start a crusade: send a check to Haitian relief and
an order to the crustycreditanalyst for Men Who Are Making America. Now I'm done.
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