A last hurrah for the rational markets hypothesis - Biota Holdings redux

You know we should all give this game away – at least when it comes to short term trading.  Rationality doesn’t work and I am not a good gut instinct trader.

I have posted on Biota (see here and here) – a stock very unlike my usual stock market picks.  I purchased it after it had risen 60 percent on swine flu.  It is clearly a big beneficiary of the flu as it is entitled to a 7% royalty on sales of Relenza – one of only two drugs that is likely to be effective against swine flu and one of two drugs that governments stockpile to deal with events like this.

I figured that if you believed the movement in Glaxo’s share price on the swine flu outbreak then you should believe that Biota would triple in Tuesday’s trading.  I also suggested that that was not going to happen.  The stock was up pennies.  However I observed that the relative movements was proof – if any more was needed – that markets are (at least medium term) irrational.  

Now there is a reason I was willing to speculate in Biota – which is that it simply is not that expensive.  I mentioned that Biota’s cash holdings were about AUD60 million.  Well I understated it.  It was 60 million before recent cash inflows.  

It is receiving a fairly big royalty payment on sales of Relenza before the swine flu outbreak.  Here was Biota’s last press release.  The company is not promotional – and there has not been a single release since the swine flu outbreak (if anything the CEO has talked down the stock).  

For Immediate Release

Melbourne, Australia — 23 April 2009

Relenza Royalty for March 2009 quarter $32.3 million

Biota Holdings Limited (ASX:BTA) today announced that it had received notification from GlaxoSmithKline (GSK) that Relenza sales were $462 million and indicative royalties were $32.3 million, for the three months ended 31 March 2009.

Indicative royalties for the nine months to 31 March 2009 total $36.1 million.

Biota CEO Peter Cook attributed the performance to recent significant orders for pandemic stockpiling from the UK and Japanese Governments.

After that cash inflow the cash holdings of Biota are closer to 100 million.

Now does anyone seriously believe that Swine Flu won’t cause a substantial increase in pandemic ordering of Relenza?  

I have no idea how big that that inflow will be – but five times the most recent quarter is hardly implausible.  (Though I am more than happy to say that it was just a guess...)

In that case Biota would have cash backing almost equal to its market cap.  And it could be bigger.  You would guess on a small possibility of very big Relenza ordering and massive and repeated stockpiling of the drug.

More to the point – the emergence of reports of psychological and resistance problems with Tamiflu will probably shift the market towards Relenza.  And Biota has a second generation flu product which should be out before Relenza runs out of patent.

Of course the dear stock market can price up the 93% of Relenza revenue for Glaxo by 6 billion and ignore the 7% owned by Biota.  In fact I frankly expect them to do so.  Rational markets don’t exist – and don’t consider this to be a stock tip because the insane relative movements can exist quite a long time and I figure the rise in market cap for Glaxo is probably wrong too.  But if you ever wanted a clear rational markets counter-example then this is it.

J

PS.  To me the strongest reason for buying the stock is that Biota is by far the cheapest financial protection against a very nasty global pandemic.  That ultimately is why I purchased it.  Though I admit - if the stock is super-strong I will take some profits...

Can the stock market count?

The title is a rhetorical because I have been long enough in the market gain to know that the stock market does not come close to counting accurately.  The rational expectations hypothesis is just nonsense. 

That said I have a single highly topical example.  

I purchased Biota Holdings yesterday.  Biota is a one-product company – a biotech with a line in influenza drugs.  It is also a small cap company listed in Australia.

Biota invented Relenza – one of two drugs that are effective against swine flu – and one of two drugs stockpiled by governments in anticipation of an event like this influenza outbreak.

More precisely Biota is entitled to a royalty of 7 percent of Relenza sales.  Glaxo funded Biota’s development and much research and as a result Relenza is essentially a Glaxo drug.  (Incidentally Gilead is to Roche as Biota is to Glaxo.  Gilead developed Tamiflu.)

Glaxo’s stock price went up by 7.5 percent in a sharply down market on the news of swine flu.  It was quite specifically a swine flu reaction in that pretty well only the companies that would benefit from swine flu (Glaxo, Roche, Gilead etc) went up.  

7.5 percent on Glaxo’s huge market cap is a lot.  Indeed as Glaxo’s market cap at the end of the day was USD79.8 billion the rise in Glaxo’s market cap of about USD6 billion.

Now Biota is entitled to 7% of the sales of Relenza – without any expenses – just a pure royalty – so whilst it is entitled to 7% of the sales – at a minimum it should be entitled to say 8% of the economics.

Now if Glaxo’s market cap rose by USD6 billion then Biota’s market cap should rise by 8% of USD6 billion or USD480 million.  USD480 million is AUD676 million.  

I do not expect it to happen.  Biota’s market cap at close of business yesterday (and after a 80% rise) was AUD276 million.  

If the market could count then Biota would approximately triple today on the open.

I doubt it will happen because (a) the market can’t count and (b) fund managers would rather speculate a lot on Glaxo for small gains than a little on Biota for big gains because.  Well frankly nobody was ever sacked for buying Glaxo/IBM.  

The effect of swine flu is hard to calculate.  But the stock market effect of swine flu on Glaxo is highly visible and it should be reflected in Biota’s share price.  But even when things are easy to calculate (as this post demonstrates) the market does not price consistently.  At least one of the Biota/Glaxo stock price moves is demonstrably wrong.

When things are hard to calculate – eg losses in the financial system – is it any surprise that the market is entirely schizoid?

John

Post script... the extent to which the stock market can not count is indicated by the fact that Biota opened a penny down albeit still above my midday yesterday purchase.

Now I do not think the move in Glaxo was necessarily rational... but one of the Biota or Glaxo moves is clearly wrong.

Biota - a wild speculation

Biota is an Australian listed company.  It has a share in a drug that cures influenza and almost certainly works on swine flu.  The stock went about 60% today.

The drug (Relenza) is a true wonder except that it has several features that make it very difficult to market.

First – and foremost – it must be taken very early in an influenza infection.  Indeed it is most effective if taken at the first sniffle.

The problem is that influenza – which can be debilitating and is sometimes fatal – starts life with about the implied threat of a common cold.  There is absolutely no way you would be crawling to the doctor to get some Relenza when you have the slightest sniffle.

By the time the influenza has taken hold – and you are running fevers and have joint pain and feel near death then the drug is ineffective.

The second problem is that the drug is inhaled through a turbo-inhaler.  Taking it is somewhat more pleasant than having an injection – but certainly less palatable than a tablet.

The third problem is that there is a competitor drug (Tamiflu) which is taken orally and is a little more consumer palatable.  Against this there are some links to psychological problems (especially in Japan) with Tamiflu.  More importantly there are resistance problems with Tamiflu that appear absent with Relenza.  

The main market for Relenza is stockpiles by government health authorities who are holding it as protection against bird flu going super-contagious.  Some governments tend to prefer Relenza stockpiles because of the lesser resistance problems.  The German Government stockpiles Relenza because they believe it more effective than Tamiflu.  That said the market is dominated by Tamiflu.

Biota is a company that has been living on very little money – the moneys made almost entirely from selling to Government stockpiles.  Needless to say governments are reliable if parsimonious payers.

Still Biota has AUD60 million cash (and equivalents) on hand and a market cap of AUD250 million.  

If Swine flu is the real deal then Biota will be a huge stock.  And if not – then maybe the fear will encourage more government stockpiling.

I speculatively purchased Biota today.  It is unusual that I purchase anything after a rapid 60% rise… and I may do some dough.  But this looked to me to be a sensible speculation – and not a bad hedge against global catastrophe.  Now I guess I have to be prepared to do my dough.

ANZAC Day edition

The original ANZACs were the Australian and New Zealand Army Corps.  They landed on 25 April 1915 at Galipoli in the Dardenelles for what was to become a protracted and punishing military defeat.

Australians (and New Zealanders) still commemorate Anzac Day as their national day of remembrance and with numerous dawn services, remembrance parades followed by war stories, stories about the (great) grandkids and drinking with your mates.  It’s a day that is both sombre and joyous, reverential and light-hearted.  We remember our dead in a peculiarly Australian fashion.  

Today I was privileged to go to the ceremony with Alice.  Alice looked after me as a child and I return the favour in her old age.

Alice served as a nurse in the Second World War.  Her first husband served in Palestine, Tobruk and possibly El Alamein – but paid with his life at the true battle for Australia – at Kokoda.  (The reason I am not sure he fought at El Alamein is timeline.  He may have been at El Alamein and he was certainly in Egypt but the main battle was fought at El Alamein in late 1942 and the Kokoda battles were already happening by then.)  

Alice’s family sacrifice did not end there – her second husband had what I suspect were continued psychological problems after New Guinea.  Alice’s son (Richard) served in Vietnam.  (It is possible however that Alice's second husband fought at El Alamein - and she confuses which battles they fought in.)  

I pushed Alice in her wheelchair at the Legacy War Widows Service in Sydney.  The ranks of World War II War Widows are getting thinner – and Alice may have been amongst the oldest.  She is the youngest (and one of only two surviving) of more than a dozen children.  Being the youngest of many her father was not young when she was born – and – possibly uniquely – she was wearing her father’s Boer War medals.  The medals proudly were issued under Queen Victoria and Edward VII and showed their heads – reminding us that Australia has always fought under the auspices of the British Crown.

The ceremony was short and moving – and whilst I was pushing a wheelchair I did not feel that I belonged in the march.  Other people had sacrificed much and I was a beneficiary not a victim.  Still many tears were shed.

It was about an hour till the main march went through.  Richard disappeared to march with his Vietnam buddies.  I was left chatting with a bunch of mostly spritely women in their 80s whose husbands had died when they were 18-20.  Most did not remarry though one did and the second husband died in the Korean War.

Their husbands mostly died in campaigns against the Japanese after fighting the Germans.  The woman who sat next to me told me her husband served on HMAS Australia and was killed by a kamikaze at the Battle of the Coral Sea.  I was surprised as I did not know that kamikazes had been used as early as the Battle of the Coral Sea (1942).  Moreover it did not gel with her age as she was 18 married and pregnant when the war ended (1945) so it was unlikely that he was killed in 1942.  But HMAS Australia was the victim of a kamikaze – possibly the first kamikaze and there were many dead.  The date of that attack (January 1945) matched the age of her child.  Not to quibble.  She bought up a very well adjusted child as a very young widow – and she never remarried.  It does talk however to how inaccurate memory is – even of very important things.  Her mixed up memory matched Alice's doubt about which husband (if any) fought at El Alamein.  

The march itself was charming, lighthearted, sad and poignant.  And most of those things all at once.

It was led by a group of horses in full nineteenth century military regalia.  After a decent interval came a man with a wheelie bin and a shovel who – to cheers from the crowd – cleaned up the horse dung.

Then came a riderless horse called Galant in lieu of any surviving veterans from the Boer War.  Another riderless horse represented the First World War which was dated 1914-1918.  Flags representing all Australian divisions that fought in that war were carried by serving military officers.

There was no horse and no other representation for Australia’s (minor) involvement in the Russian Civil War (1919).  Australia played a very small role in that war – and there were few Australian dead – but the parade did not honour them.  The Australians fought in British units – though – according to this minor history at the Australian War Memorial web site Australia did send naval ships for reconnaissance.  

After a decent interval came a formal precession led by Professor Marie Bashir.  Marie Bashir is the Governor of New South Wales – and hence the representative of Her Majesty the Queen of Australia.  Governor Bashir is I think 78 years old – but my spritely war-widow companions thought she looked young and fantastic.  

Then came a large number of divisions of Second World War veterans.  Some were carried in taxis, some in military vehicles, some in wheel chairs – but most marched.  A few dropped out of the march to flirt with the war widows which I found hilarious and the widows found flattering.  Many saluted as they went past us.

The women tended to look a little better than the men (which is not atypical amongst 85 year olds).  Most colourful were the women who served in field hospitals who were dressed to the nines and all wearing gleaming (and elegant) white gloves.  Interspersed were marching bands mostly provided by various high schools including my high school.  My old high school (Sydney High) is an academically selective school with a history of taking the upwardly mobile children of the latest generation of immigrants.  In the days that Jim Wolfenson went there it was full of Jews and other children of Eastern European refugees.  It now is the children of Indians and Middle Eastern Muslims as well as South East Asians.  The band filled me with hope for Australia – and the racial mix of the students in it differed dramatically from the all-white Second World War returned soldiers.  

The troops went past largely in order of the campaigns they fought.  Most of the campaigns I knew Australians were involved in – but there were groups that fought with Americans and other services (usually in specialised roles) that I did not know about.  One example were the Polar Bears – a naval group covering arctic supply lines.  

There were contingents from Korea, the Malaya Emergency and extensive Vietnam Veterans.  There were small groups from the first Gulf War, East Timor, Iraq and Afghanistan.  

Finally there were groups representing allies we fought with in various wars.  There were for instance a small group of Dutch soldiers who were assigned to Australian Divisions after Dunkirk.  There were Americans (mostly from Vietnam), Ghurkhas and other assorted South Asians.  The largest group were Vietnamese who fought for the South and later settled in Australia as refugees.

To me though one of the most moving parts of the whole parade happened by fluke.  We tried to find a bathroom for Alice – and a woman who worked for Legacy led us to a disabled toilet.  Legacy is a charity for families of war dead – and it was Legacy who had organised the War Widows special ceremony.  They have a group for the children of war dead – and – for the first time – she had organised them a place in the parade.  They were led by a military truck and in the back was their oldest member – a son of a soldier who died in the Great War – and their youngest member – a son of a soldier who died in Afghanistan.  I would not have understood the significance of that baby had I not met the organiser.  

And whilst I am sad for the child – if I judge it by the children of the war widows I sat with then the boy will turn out OK, and in sixty five years he will still be honouring his father’s sacrifice.

John

PS.  I have to repeat one of the comments.

My mother was raised in an orphanage in Brisbane run by Legacy. As far as I know, she doesn't go to A.N.Z.A.C. Day parades, but does go to the Dawn Service. The "Legacy Kids"/orphans have their own get-togethers. Every August for the past 26 years, the orphans have a re-union on the birthday of the woman who ran the orphanage. She was a Legacy employee who had lost her husband on the Kokoda Track. One of her brothers was a Rat of Tobrook (9th Division) and El Alemein veteran, who later lost an arm at Milne Bay in Papua New Guinea. Another of her brothers is buried in France, killed while flying for the RAF. After her husband died, she lost her only child. She later gave back by running the orphanage for Legacy. She touched hundreds of orphan's lives. They never forgot her. She was also my Godmother.

My Grandfather was killed in Sydney during WWII while serving in the Australian Army. My mother has never visited his grave - its just too painful, even after all these years. My father has an uncle buried in northern France, a casualty of WWI's Battle of the Somme. No one from our family has ever visited his grave to pay our respects. There are many families like ours in Australia with similar stories to tell. 

Lest We Forget.

PPS.  I have been a little perplexed by the stories told by the War Widows.  They are sometimes embellished, sometimes the stories are compressed.  I gather Alice's first husband fought with the 7th division.  He could not have fought at El Alamein as he would have been in New Guinea by that time.  Here is a history from the 7th's website.  Almost all of what Alice told me (and the medals she wore) are consistent with this history - though she mixes her two husband's campaigns up.  

The 7th Division left Australia in October 1940 for the Middle East.  Over the next two months, the 7th was concentrated in Palestine.  It was slotted for a move to Greece to help in the defence against Axis invasion, but instead moved into defensive positions in the Western Desert.  Parts of the Division under the command of Maj General Allen crossed into Syria and fought a hard won victory in the campaign against the Vichy French .  18th Brigade excelled itself as part of the defence of Tobruk.   With Japanese invasion of Australia imminent, the Division was recalled home.  Elements of the Division (2/3rd Machine Gun Battalion, 2/2 Pioneer Battalion, 2/2 CCS,2/6 Fld Pk Coy and 105 Gen Tpt Coy)were diverted to Java. They fought a defensive campaign against overwhelming Japanese odds and were only forced to surrender after an early capitulation by the Dutch forces there.  

The Division moved to New Guinea and established headquarters in Port Moresby.  The timely arrival of the Division in New Guinea helped to halt the Japanese advance..  21st Brigade fought a bitter campaign of attrition on the Kokoda Track,until replaced by 25th Brigade who slowly forced the Japanese northwards.  18th Brigade and other Australian units inflicted the first decisive defeat of the Japanese on land in World War 11 at Milne Bay and then at Buna and Sanananda in January 1943.   21st Brigade and the militia 39tth Battalion won a costly victory at Gona in December 1942.    George Vasey took over command of the Division in October 1942, until his death in a plane crash in 1945.  Major General Milford then took over command until the end of the war.    In 1943, the Division was airlifted from Port Moresby to Nadzab in the Markham Valley.  After an advance on Lae, the Markham and Ramu Valleys were soon swept clear of Japanese troops.  A bloody campaign in the mountains of the Finisterre Ranges followed. 

Liquidity and banks – a primer

Several of the responses to the last post (about bank excess liquidity) seemed to confuse liquidity and solvency.  Indeed several confused “cash reserves” with “loan loss reserves” and the like.

Aaron Krowne – a fairly sophisticated guy and the proprietor of the Mortgage Implode-O-Meter for instance suggested that the 170 billion in cash is necessary to meet loan losses.

Let’s get this right.  A bank’s liquidity goes down when they lend money.  They lend their liquidity.

A bank’s liquidity does not go down when there are loan losses.  You do not need cash to deal with loan losses.  You need net worth to deal with loan losses.

A bank really needs liquidity to deal with people being unwilling to leave their funds either on deposit to a bank or on loan to a bank.  If a bank gets a run on deposits (even a small run) it needs liquidity and it needs it bad.  This is essentially unpredictable.  If it cannot roll its own funding it needs liquidity and it needs it bad however this is more predictable because there will be a known debt maturity schedule they need to meet.

Bank of America carries 170 billion in cash rather than the more normal 30-40 billion because it is scared of runs (both retail and wholesale).

The wholesale run is happening and has been happening ever since that fateful week in September when bank creditors realised that – on the say-so of Sheila Bair – they could lose their assets entirely.  [Washington Mutual as originally confiscated left the senior debt holders essentially nothing.]

Still fear – and fear alone – can run a big bank out of liquidity.  You do not need to be insolvent as a bank to become illiquid.  Pretty well the entire Norwegian banking system was illiquid and confiscated during the 1992 Norwegian banking crisis.  Capital was constrained but the government made a profit on the bank-bail-out suggesting (ex-poste) that the problem was a liquidity crisis and not a solvency crisis.  [Unfortunately nobody, government or private sector, knew for certain whether the issue was solvency or liquidity during 1992 though plenty of people expressed very strong opinions many of which were wrong.]

But get this – and remember it well.  In traditional banking cash held by the bank beyond simple transactional balances exists solely to deal with fear.  If there is no fear then banks have no liquidity problem.  And they will have no liquidity problem even if they are staggeringly insolvent.  Indeed many Japanese banks had no fear, staggering insolvency and operated for more than a decade.  Closer to home Conseco Finance was almost certainly insolvent a few years before it collapsed.

I got at least a dozen emails that thought that liquidity at Bank of America was to do with losses.  All of them misunderstood this simple and key point.  

Now investment bank liquidity is much more complicated.  The most controversial example is credit default swaps – especially margined credit default swaps.

Writing a credit default swap is in many respects very similar to making a loan.  The credit risk – the key risk – is almost identical.

But when you make loans cash walks out the door immediately.  You have to have cash to make loans.  If you have only limited cash then you cannot make unlimited loans and so you will tend to be selective about the loans you make (choosing better credits).  If you have to raise cash in order to finance lending then you need to go to market (issue bonds etc) and that imposes some discipline and costs on you.

When you write a credit default swap you just need someone to have faith that you are good for the exposure.

No cash walks out the door.  

Lending imposes the discipline of being required to have cash.  Writing CDS does not.

Felix Salmon (and others) have had long arguments about whether CDS caused or exacerbated the crisis.  In most this argument I agree with Felix, but the ability to write vast amounts of CDS without needing cash was important in some parts of the crisis.  Plain old lending has more discipline.  This was certainly a large part of the problem at AIG, MBIA and Ambac.  

But CDS have another property.  CDS (unlike loans) do not require cash when they are written.  But CDS (also unlike loans) cause a cash drain when they default.

A bank which writes CDS needs cash to deal with credit losses.  A bank which does traditional lending does not.

Unfortunately CDS cash requirements go up in a financial crisis.  That is when the cash gets called.  

And that is also precisely the time when banks have most fear surrounding them and hence most difficulty raising cash.  CDS give financial institutions a cash call at precisely the wrong time.  That is why – if anything – they exacerbated the crisis.  

Lines of credit written by banks (Citigroup and JP Morgan were huge writers) also require cash precisely in times of crisis.  Most the time you write the line of credit and there is no cash drain on the bank.  But when the customer is stressed the lines of credit will be drawn.  That also – by usual correlation – tends to be the time that bank liquidity is most difficult.

Still – and this is my reaction from picking apart Bank of America – most of the huge cash balance of bank of America is to deal with fear in the funding markets – and very little is required to deal with loan losses.

Capital – that is net assets – is what is required to deal with loan losses.  Cash on hand is frankly irrelevant for that.  Whether Bank of America has sufficient net assets to deal with their (large) loan losses is a matter of widespread disputes.  Many strong and differing opinions exist – and inevitably some of them will be wrong.

Mixed up policy responses and liquidity preference

I frequently get emails suggesting that governments should force banks to lend and that would solve the recession.  I tend to agree but it would be difficult – and the government actions to date have exacerbated the lack of lending.

As it is, there is little to no balance sheet growth at any major bank in America and aggregate bank lending is falling.  Excess cash at the Federal Reserve is building up fast.  The economy is still sour (and getting more so) and bank credit losses are continuing to rise.  

Meanwhile banks sit on cash.  

Bank of America (for recent and topical example) is carrying $173 billion in cash and cash equivalents – a number which immunises them against many but not all ills and is about $140 billion higher than normal.

This excess cash inhibits BofA profitability by maybe 5-7 billion per annum (pre-tax).  They don’t really want that profit drain – but – in a telling comment – they thought it was worth it to have that negative carry because the cost to running short of liquidity was too high.  

The excess cash across the entire banking system probably exceeds a trillion dollars.  If only it could be spent – then we would have the stimulus we need.  

Alas – that is what is meant by being at the zero constraint of monetary policy.  We have banks with a seemingly endless liquidity preference.  It is not that there is no demand for loans (though demand is much ameliorated).  Banks are rapidly tightening lending criteria too and indeed some banks are just not lending to new customers.

Now lending standards needed to tighten.  2006 was insane.  But early 2009 is also insane– and if it were a perfect world lending would have moderated much slower so as to displace maybe 200 thousand workers per month.  (The economy can usually generate new jobs that fast.)  Indeed the whole idea of stimulus is to slow the rate of job loss in the economy down to a level where normal functioning of the labour market can deal with it.

That is not where we are.  We have an extraordinarily rapid change in liquidity preference for banks, an extraordinary tightening of standards and an extraordinary recession.  

Now some people are into forcing the banks to lend.  Willem Buiter (who is often clever and sometimes wrong) suggests confiscating banks that will not lend.  Useless as tits on a bull he says.

That would be fine if he did not want to confiscate marginally insolvent banks too.  A bank that is stretched for capital or liquidity would usually preserve both by restricting lending.  You restrict lending so as not to be confiscated – except in Willem Buiter’s world where you lend to avoid being confiscated.  

Now I thought that the confiscation of Washington Mutual was perhaps the single most destructive government action of this cycle.  That was a minority view – and remains one.  Felix Salmon thinks I am alone – but a paper from the New York Fed makes it clear that the confiscation of WaMu very rapidly increased the liquidity preference of mainstream banks and hence spread the crisis from the Wall Street Banks to Main Street.  

The lesson of Washington Mutual – learned hard – was that you could have adequate capital but a minor run and be confiscated.  The only way to cope was to have massive excess liquidity.  

And so we are in an unusual liquidity trap.  In the Japanese liquidity trap the general populace had massive excess cash savings.  The liquidity preference was the preference of the legendary Mrs Watanabe who liked sitting – in cash – on three years of Mr Watanabe’s salary.  

In America the liquidity preference belongs to banks.  Mr and Mrs Middle America are not swimming in cash.  Indeed all the evidence suggests that they are over-indebted.  It’s the banks that are swimming in cash.  And it is the bank’s excess demand for liquidity that makes monetary policy ineffective.

Now Paul Krugman has argued that it doesn’t really matter why we are at the zero bound in monetary policy – but I think it does.  If we are at the zero bound because Mrs Watanabe wants to save to excess then we should target Mrs Watanabe.  If we are at the zero bound because Bank of America is scared of arbitrary government action (as evidenced in the confiscation of WaMu) then we should address Bank of America’s concern.

The first way to address Bank of America’s concern is for Sheila Bair to fall on her sword.  She should resign because – through confiscating Washington Mutual – she spread the crisis to Main Street.  But regular readers should know I have a very low opinion of her and will not be surprised by that comment.

But I have a second proposal.  It is floated for discussion only as it is obviously risky.  The idea is that the bank capital adequacy requirements be dropped a couple of percentage points – but only if their genuine third party loans fully owned on the balance sheet are growing by more than say five percent per annum.

Welcome to the 21st Century

An AIG business that did not lose (much) money

AIG has sold 21st Century to Zurich.  21st Century is not a bad personal lines insurance company.  I blogged about it here (arguing that the CEO of that unit deserved his bonus).  

Anyway 21st Century was always partly owned by AIG but they took it private in 2007 buying the 39 percent they did not own for 813 million.  That valued 21st Century at just shy of $2.1 billion.

They just sold it to Zurich for $1.9 billion.  Zurich also assumed unit debt.

Hell – they are down less than ten percent.  

It’s a record for AIG.  Much rejoicing was had by taxpayers everywhere.  $2 billion down – 178 billion to go.

Now it is time to watch Zurich.  21st Century – despite (or maybe because) of its AIG pedigree is a far better run institution than Zurich’s Farmers business.  If Zurich is halfway competent they will merge Farmers into the (much smaller) 21st Century and not the reverse.

However there is no sign they are going to do that.  Competence and insurance seldom go together.

-----------

Post script.  Zurich is saying that they purchased more than the old 21st century operation.  

This makes the pricing element of the post wrong.

The old 21st century operation was MUCH better than either Zurich or any prior AIG operation - so it should remain the bulk of the value.

The reserving of Zurich's personal lines business did not make any sense in the 1999 year and adjacent periods.  Nor did anyone esle.  

If you go back and look even Berkshire (GEICO) mis-estimated their profits in 1998 and 1999 and had huge true ups in 2000.  So did Progressive and Mercury General.  In both MCY and PGR the stocks got hammered into 2000.  So - from memory - did the old 21st century stock.

However the degree of mis-statement was MUCH MUCH higher at Farmers.  Farmers true results were 5 percentage points worse than 21st in those days.  Farmers caused big problems.  State farm was (operationally) worse than any but it had (much) more capital.

PPS.  Just to remind those without very long memories.  The old 21st century was a very fine auto insurer and an average household insurer.  (I do not believe that it is possible to create enough difference as a household insurer to be a fine business.  GEICO is a fine auto insurer and does not do household.  Ditto Progressive.)

The auto business once a fine competitor to Mercury (MCY) in California.  MCY however does not sell household insurance.

Both were from California.

With earthquakes.

What was then called 20th Century hurt themselves bad on the Northridge Quake.   From memory that is how AIG got its initial stake.  

On that initial stake AIG made good money.  Better money than on their own business.

J

Bramdean did reply

My last post about Bramdean Asset Management observed that Bramdean had sent money to an un-named fund and received it back the same day.  This was done for "regulatory purposes".

I presume that there must be a legitimate reason for doing this - but to date I have not found one and nobody has identified one.  I still seek assistance.

Several people in comments have suggested nefarious regulatory purposes are possible - with the best example being a lawyer who transferred considerable trust funds to his own account for one hour (and returned them in full) so as to qualify for better credit at a casino.  

I presume that the fund in question is better than a Casino - but maybe private equity funds from 2007 are in fact glorified casinos and someone just needed to maintain credit.

Anyway I would love somebody to identify a respectable regulatory purpose as I have not been able to do so.

I did ask this question of Bramdean.  And (contrary to what I said in the last post) there has been a reply.

  

I repeat it here in full for your benefit.

Dear Mr Hempton

Thank you for your email and for your interest in Bramdean Alternatives Limited.

With regards to your query, private equity funds are structured and governed within the terms of their stated mandates.

Regards,

Loretta Murphy

Head of Investor Relations and Communications

For and on behalf of Bramdean Asset Management LLP

35 Park Lane

London W1K 1RB

Tel:    +44 20 7052 9272

DDI:  +44 20 7590 2001

Fax:   +44 20 7052 9273

E:mail:-lmurphy@bramdean.com

I am not picking on Bramdean here.  The unnamed fund probably sent the same request to almost all of their investors and the investors all sent money for a "regulatory purpose" and received it back later.  The activity is widespread and almost certainly legitmate.  

I just don't know what it is and a fairly direct email to Bramdean did not produce a helpful reply.  If they do reply I will let you know again.

John

PS.  One of my favourite bloggers - on seeing the Bramdean letter said "regulatory arbitrage is so 2006".  Maybe we are just caught in a timewarp.

Goldman’s Orphan Month

Goldman Sachs just put out pretty good results and did a big capital raising.

Here is a table for Goldman Sach’s revenue for the three months ended Feb 2008, Nov 2008 and March 2009 respectively.  The table comes from the 8K dated 13 April 09 – essentially the 8K in which they announced results to raise money.

(click for detail)

Now the observant amongst you will notice that these three month periods are not contiguous.  Indeed the three months to November 2008 and the three months to March 2009 conveniently forget the month of December 2008.

That is right.  Goldman Sachs changed its balance date – and there is a one month period not reported in the usual quarterlies.  An “orphan month”.

Now December 2008 was a pretty bad month.  Probably the worst on record.

Here – also from the same 8K is Goldman Sach’s revenue during the orphan month.

It is hardly linear.  Total revenue for the three months ended March 2009 was 9425 million.  For the one month it was 183 million.  Of course this revenue was offset by some very large charges rammed into the orphan month.  If you click on the attached table you will find that Fixed Income Commodities and Currency (FICC) revenue refers to Note 19.  Note 19 says blandly that it “includes the writedowns of approximately $1 billion related to non-investment-grade credit origination activities and approximately $625 million (excluding hedges) related to commercial mortgage loans and securities”

Ah – that explains it.

There is also another billion in losses labelled as "other corporate and real estate gains and losses".  That line doesn't even occur in the March accounts.

The costs are also non-linear – but not as non-linear as the revenue.  

The net loss applicable to common shareholders for the orphan month was just over a billion dollars.  The four month period was just profitable.

Am I surprised that Goldies had an “orphan month” and stuffed the bad news in it?  No.  If you were – then obviously you are new to investment banking.

But I am surprised at the credulity of the press.  Most stories about the quarterly result simply omitted the December month.  This story though at the WSJ Deal Blog was considerably better – noting that December was really ugly but not understanding why.

They even note that December is seemingly omitted from the official records – but doubt it is deliberate.

The Deal Blog is more observant than most.  

But perhaps they too are new to investment banking.  Note 19 explains about half of it.  The mysterious "other corporate and real estate gains and losses" explains most the rest.

Post script:  The excellent Floyd Norris (New York Times) also picked this up.   There are some journalists way better than average.  

Further postscript:  Krugman has also commented.

Farewell Greg Newton

I only spoke to Greg Newton (of the Naked Shorts blog) twice and my email box has about a dozen emails. 

He died suddenly recently.

I want to second Nihon Cassandra's fitting obit.  

http://nihoncassandra.blogspot.com/2009/04/farewell-greg-newton.html

---------

Post script:  I have rejected several anonymous comments along the lines that he was (a) crooked, (b) revolting, (c) better dead.

I have always seen him - even in the title of his blog - as poking fun at people who deserved fun poked at them.  He was a little more vicious at the people who were bent.

The people who are picking arguments with him I am happy to publish in the comments - so long as the posts are not anonymous and the arguments are detailed.

My view- the nasty(but not rationally argued) comments about a dead guy tend to show he was onto something good.

J