Weekend edition: A daft funds of hedge funds

I might start a hedge fund one day. So maybe I shouldn’t spend my time tearing into funds-of-funds.

But I got a problem. I get a kick out of pulling wings off butterflies.

One of my earliest posts (and still in the top five accessed on this site) was a post about New World Capital Management – a fraudulent hedge fund in Santa Fe. The fund was a blatant and obvious fraud.

My first email from New World was 17 Jan 2008 – and I smelt a rat immediately.

But obviously not everyone did. Here is a fund-of-funds suing New World Capital Management and Greg Duran. This fund was still promoting New World several weeks after I smelt a rat.

This fills me with amazement. There is only one real reason for investing in a fund of hedge funds – and that is that the fund-of-funds do the due diligence for you. If a fund-of-funds got suckered by something as simple as New World Capital Management then they got no right to be in the business. And their clients should all pull their money now. Go on. Do it now. You should.

So with wonder and amazement I link you (again) to a small court case. It’s the fund of funds (not the management company) suing. It’s only for 750 thousand dollars but you would think the management company would wear it.

Let us review what these people are saying:

• We are a fund of hedge funds.
• We invest your money with frauds.
• We can’t do our job.
• Invest with us.

John

PS. Now if any funds of hedge fund want more simple due diligence – I have an email. Just contact.

Dell and warranty issues

Dell has a terrible reputation for customer performance – and that reputation has been the biggest driver of the stock price. Jeff Matthews has blogged about it here.

The big Kahuna (Dell himself) came back to Dell to fix quality – and presumably warranty and customer service issues.

I can assure you that the customer service fix has not reached Australia. I have a problem with an XPS1330. It’s a cooling problem – and I admit I probably triggered it by lying in bed with a laptop working. I guess that is what a laptop is for – but the machine got too hot. The motherboard fried around the video card.

The problem is the common problem with the XPS1330. There are several on-internet solutions improving the cooling system. These apparently work – but are not exactly how I want to spend my time.

Dell is a favourite amongst value investors. And maybe it will be a great stock if the service issues turn properly.

And I know that this is just an anecdote – but when I have to approach the Australian Consumer Commission to enforce my repair rights for equipment sold knowingly faulty I suspect there is a fair way to go.

Now is there anyone out there from Dell customer service?

John

The Dick Bove problem and an investment idea

Dick Bove is an analyst I do not know. He is a regular talking head on Bubblevision. I won’t hold that against him. (If Dick Bove wants a friend – please get in contact.)

Background

These days Mr Bove seems best known for a report released after the Indy Mac failure in which he asked “Who is next?” Next was BankAtlantic (NYSE:BBX).

BankAtlantic has sued him. That is a move which is astoundingly stupid and reflects terribly on BBX management. The record for companies that sue critics is not exactly good.

However this is not the Dick Bove I want to talk about. Dick Bove gave an interview on Fox Business which is well worth a watch. Go on - watch it. In it he decries the bear case for banks. In particular he notes:

• In 1990 when the troubles were occurring with banks non performing assets (NPAs) were about 5% of the industry when it is now about 3%.
• He looked at NPAs compared to bank capital – and noted it was about 40% during the last crisis (a danger zone) and he notes it is now at 17%.
• He thinks that big banks (like Bank of America) consist of more than their construction portfolio and their home equity loan portfolio. He notes that net interest income is going up. They are also a huge money management firm, huge data processing firm etc and these are all doing OK.

He is very annoyed at what the government is doing to smaller thrifts:

• Government officials have said that they will allow banks to fail – and they have said many banks will go under – but they seem to save the larger banks.
• It thus makes people move to Bank of America, JP Morgaan, Wells Fargo etc at the cost of smaller banks.

Anyway it is obvious that bank bad loans in American banks are nothing like as high as in the early 1990s. There is plenty of bad credit out there – but it is mostly not in American banks. In my history of the US Financial Market I wrote early last year I indicated that I thought the credit risk was in the securitisation market and mortgage insurers and by-and-large not in the (US) banks – and funnily enough that is what is happening – the huge losses realised by banks notwithstanding. [I underestimated bank credit problems – but that does not change the fact that the problems outside the US banks are much worse than the problems inside American banks. The credit problems at Natixis and UBS dwarf anything in America except maybe Citigroup.]

Moreover when I start trying to bash up banks there are many I can’t make them go bust including banks trading at 0.6 of book and where their subordinated debt is trading very distressed. One example: I think Fifth Third Bank is fairly clearly solvent – and the pricing of the equity and (particularly) the debt indicate that the market at least thinks insolvency is a realistic possibility. [Often the debt is a better buy than the equity – though as Bill Gross will point out in this video anyone who has purchased debt-like bank equity instruments is not very happy with themselves…]

I will assert that trading unrealistically depressed for the subordinated debt is commonplace. Even the (very problematic) Washington Mutual is probably solvent – though its biggest problem – which I think makes the stock unable to be owned – is the death-spiral financing it took with TPG. [TPG have an anti-dilution clause which makes raising any additional equity outrageously expensive.]

The Dick Bove problem

Let me phrase the Dick Bove problem this way: if bank credit is substantially better than the last cycle (even if non-bank credit is appalling) then why do the banks look so toxic?

Dick Bove asserts that they are just not so toxic. He made that call a couple of months ago – and anyone that followed his advice has been smashed. I will give him credit though – he has stuck to his guns.

I have another take.

My answer to Dick Bove

My answer to Dick Bove is as follows: despite all appearances to the contrary this is not a credit driven crisis. It’s a funding driven crisis. It is much worse than last time not because the losses are worse than last time (they are the for the whole system but they are not for the banks). It is worse than last time because the funding situation is diabolical.

What has happened is that American banks and investment banks have sold lots of toxic waste to Europeans and Asians and their credibility – both individually and collectively is impaired. The same banks have to sell their own debt and subordinated equity to the same Europeans and Asians that they ripped off only two year ago. To put it mildly that makes it harder for banks to fund themselves.

It’s the lack of credibility that is the major problem for many financial institutions.

Washington Mutual as an extreme example

Washington Mutual sold dross to the market. Mish follows a particularly bad WaMu deal. This deal is really toxic. WaMu simply didn’t care what it originated if it originated stuff like this. It didn’t care because it sold the risk. WaMu was in the business of ripping off the people funding its mortgage originations.

But what is left in WaMu is not actually that awful. I am not saying WaMu is pristine. That would be stupid. WaMu is a mess – but you need to make some pretty extreme assumptions to model it as insolvent. It has just over 20 billion dollars of tangible capital left (admittedly after a huge raise). It has 240 billion of loans with 8.5 of provisions already against them. It makes about 8 billion a year in pre-provision income and the net interest margin is rising as are low cost deposit volumes.

If you assume that WaMu takes 30 billion in cash losses on the loans (mostly mortgages) over the next two years it should be survivable. The pre-provision profit will cover 16 – the provisions another 8 and the capital ratio starts in the 7s. Tangible capital of 20ish would drop to 16 less any new provisions – and given the capital ratios at the moment would wind up at say 5. It would be difficult for management – but solvency should be OK. At 30 billion in cash losses the stock is probably OK long term provided the losses can be stretched out and WaMu is not forced into a capital raising. If the losses are closer to 10-15 billion the stock would be a big winner.

30 billion in losses is a number way larger than guidance or indicated in the delinquency. However nobody (including myself) believes WaMu because their credibility is stuffed. Remind yourself again about Mish’s bad deal.

The internet is full of stories about WaMu being insolvent – and those stories are credible precisely because WaMu has no credibility.

If WaMu were to take 45 billion of cash losses over four years the subordinated debt (trading just over 30%) should wind up worth par. [The stock of course would be awful.] It is not plausible to me that the cash losses on the portfolio will be that high.

The problem for WaMu is that they need to take their hit over three years. If they took it all at once WaMu would hit the wall very hard. They need to maintain their funding continuously to remain liquid.

Funding is a real problem (actually the problem) for WaMu. WaMu has net loans of 231 billion and a bundle of other assets. The core funding is deposits of 182 billion. There is a bunch of FHLB funding (secured) adding up to most the difference – but there are also “other borrowings” of 30 billion.

How much credibility does WaMu have to support those “other borrowings”? Short answer: not much. And if you look you will see the “other borrowings” are falling quarter by quarter reflecting the real problems that WaMu has maintaining those borrowings. WaMu has no choice but to shrink its way out of the “other borrowings”.

The very fine women who run Gimme Credit (possibly the best and most savvy independent credit analysis firm) have note that unsecured creditors are “pulling funds” from WaMu. They don’t want to use the phrase “run on the bank” – but it is probably a “walk on the bank”.

The difficulty maintaining wholesale funding is not caused by current balance sheet problems. (They are just not that bad.) The problem is caused by WaMu’s lack of credibility. If WaMu hadn’t sold a whole lot of toxic dross marketed as AAA the capital markets might trust them.

Cost of not being believed

The cost of not being believed as a financial institution is high.

Washington Mutual says that it has no need to raise capital – but the cynics argue that the truth is that they can’t raise capital. Certainly when the preferred shares yield 24% and they have an anti-dilution clause on the common –any capital raised would be enormously expensive.

I don’t think they need regulatory capital at the moment (see the calculation above). But the amount of capital you need is not a regulatory function – you need capital if the financial markets won’t lend to you. Capital gives you credibility – and because WaMu has no credibility it needs considerably more capital than its regulatory standard or its unsecured creditors will “walk”. So hang the regulatory standard – WaMu is short capital because it is short credibility.

If WaMu shortage of credibility (capital) turns into a liquidity crisis they will need to sell the whole shebang. Anyone say Wells Fargo, $1 per share?

If you don’t believe me think of Bear Stearns. There is a lot of dross around (most visibly the Vanity Fair article) which argues shorts bought down Bear Stearns.

I argue otherwise: Ambac insured a Bear Stearns home equity line of credit deal where Ambac has already provisioned over 80% of outstandings. Almost every loan made in that deal will default.

Bear told people things about that deal to get it sold and to get Ambac to write the insurance. Those things were lies, pure unadulterated lies.

If you tell lies for too long nobody will believe you any more and you will not be able to roll your own funding. And as a financial institution if you can’t roll your own funding you are going down.

It is entirely possible that Bear Stearns had adequate capital and inadequate funding (though I express no opinion). But the story that shorts told lies that bought down bear doesn’t hold water. Bear told the lies that bought down Bear. The fault resides totally with Bear’s management.

An investment idea

I have no strong opinion on whether you should be long Washington Mutual common or not. I think the problem with being long the common is the death spiral equity (with the non-dilute clause) that WaMu sold TPG is probably enough to decide against the common. Besides if the “walk on the bank continues” WaMu will need to sell itself in distress. The common is very cheap and very dangerous.

But if this is a credibility crisis and not a solvency crisis – and I can’t count it any other way – then the WaMu subordinated debt should be money good. There is a preferred instrument (the K class preferred) which is trading in the 6s against a face value of 25 – implying almost a three quarter chance of insolvency.

If – like me – you think that is overblown – then this is a buy.

You will lose 100% if WaMu if there is an FDIC takeover of WaMu. But if WaMu sells itself at $1 per share to Wells Fargo (or similar) you make a triple or more as the instrument returns to near par. And if WaMu is solvent independently you also make a triple. Meanwhile – as it is a 7.25% yield on face – you get a 26.6% running yield on the current price. That is sweet enough for me.

I purchased quite a few – and despite the 10% fall in their price yesterday I am still showing a profit...

But I can’t say this is a low risk position – and – in the tradition of this blog – I am looking for people to tell me I am wrong. I need plausible arguments as to why WaMu is not only illiquid – but is not worth Wells Fargo rescuing at $1 a share.

I will publish decent arguments explaining why I am wrong if the senders want that. (I am the arbiter of decent here – but if the arguments make me worried about a position I will publish…)

Thanks in advance. This is another position that scares the s--t out of me...

John

PS. I retain only two positions that scare the c--p out of me. You dear readers know both of them.

Selling volatility in the sports betting market

I have always been intrigued by what “risk control” really means in banking. I know a lot about banking – but the level of sophistication by which I would control most risks is the “smell test”. Does this seem sensible of itself (and it is not sensible just because everyone else is doing it). If I get it wrong how much does it hurt? All very much the way Warren Buffett claims to judge insurance risks.

But financial mathematics has an attraction. It brings an appearance of precision to some very imprecise arts.

But my test as to whether you really understand financial mathematics is whether you can meaningfully apply it to simple real world problems. If you can get maths to do that it is not wasted and can add something to your risk management.

So – in this line – think of this post as a second year university financial mathematics course without the maths.

David – the financial salesperson extrovert and his sports betting junkie

David (not his real name) was financial sales guy I knew kind of well. Like most financial sales guys he was an extrovert. He worked with analysts – and they were all introverts. If you put him in a bus with his colleagues on the way back from some Christmas function he would try to get everyone singing Scottish football songs. This was amusing but usually unsuccessful. To the extent it was successful I blame alcohol and not David’s out-of-tune lead. [Dave – if you are reading this – your singing wasn’t bad – it was just memorable.]

Anyway Dave had fifty bucks left in an old sports betting account. He reckoned that he could bet the entire sum every week for six months and end up with more money than he started with.

This sounded impossible – and I was prepared to fund the experiment if I was wrong.

David may have been a sales guy – but he was no fool. He divided his stake into five equal amounts and bet on five near certainties. A typical sort of bet might be for Roger Federer to win the second round at Wimbledon. Like a good sales guy and sports fanatic he could find five such events somewhere in the world most weeks.

He wouldn’t get great odds – the bets often paid only 1.05 times the sum wagered. But he would win all five bets most weeks.

The odd week he would lose one – and the four winners would wind up losing 16% (=1-4*1.05/5). It would take him a few weeks to recover – but he recovered – and little harm was done.

I lost track of how David was going – but you can see what is going to happen. Week in, week out the David will make a profit. He might have a setback – but it would be manageable. He looked like a consistent winner.

Of course if he did it for long enough his number would be up – and he would bet on five losers. It is highly unlikely to happen in any particular week – but done for long enough it was inevitable.

The strategy will have the property of making regular seemingly-consistent profits – but taking irregular large losses. Off six months of data it was almost impossible to tell if he was adding value with his wagering – but my guess is he probably wasn’t.

So what has this got to do with financial mathematics?

Well what David was doing was betting on likely outcomes. If you bet on likely outcomes you make money most the time but when you lose you lose big.

I call this selling volatility in the sports betting market. You can model it just like selling volatility in the finance market (but hey – I am saving you doing a financial maths course).

Selling volatility in financial markets is just betting on the world staying within likely parameters. I can design you a hedge fund that would make a profit almost all the time –and has fantastic consistent returns.

Maybe I could even convince rating agencies I am a genius. But the only strategies I know that are consistent have a blow-up risk. That is what selling volatility is all about. I know several Australian funds (and there were many more) which blew up precisely this way late last year.

If you watch for long enough it is amazing how often you see people selling volatility. And they often don’t even know they are doing it. Over times I hope to point a few out. But that is subject matter for later posts.

CINFIN admits defeat on Fifth Third

In my first post on Fifth Third I noted that Cincinnati Financial (a well run insurance company) had a massive holding in 53 during its great run up. They retained the holding as the stock fell from $60 to $10.

Guess what - they sold half today - and the explanation makes no sense. They want to reduce their exposure to low-dividend stocks.

What is remarkable about the sale is that they are selling 480 million in stock after the price collapse - and they still have to pay 120 million in capital gains tax. That is reflective of how good a stock 53 was before it became bad...

And having to pay 120 million in capital gains tax is a high quality problem - but it would have been a higher quality problem to have paid 600 million in tax a few years ago!

It's the economy stupid

If you have not seen Jon Stewart's take on the mortgage crisis watch it now by clicking here. I laughed myself silly.

Whoa – here come the Japanese

Tokio Marine is a shockingly overcapitalised Japanese insurer. It consists of a vast excess of Japanese bonds and equities writing a fair bit of profitable Japanese business and some not so profitable business whenever it leaves Japan. (In that light it is oh-so-typical Japanese.)

It is buying Philidelphia Consolidated Holdings for an absurd price.

Philly is one of the best run companies I have ever seen. It has family ownership and control – with an old guy with too many heirs. It is a better risk selector than any in the business – and (despite a little bit of legerdemain with reinsurance) has generally written extraordinarily profitably. [For those with a memory – the legerdemain had to do with their Katrina losses. Herb Greenberg wrote about it…]

I have at various times been short the stock (and consistently lost money). This was not a management short – just a valuation story. Philly wrote at a combined ratio of 80 or so - in other words unsustainably well. And despite that it traded at one of the highest multiples in the industry. If they even reverted slightly towards normal the stock probably would have halved.

I am (thankfully) not short it now (plenty of other fish-to-fry). But you got to admire the family getting out now and finding a buyer.

Insurance rates are falling continuously – and so it is almost inevitable that they will not continue to underwrite at such super-profitable ratios. The right valation is probably $20 a share - not the $61 being paid...

The exit also solves the inheritance problem for the many heirs.

Lessons

First lesson: Valuation shorts are pretty difficult. Look for structural shorts instead.

Second lesson: The Japanese are willing to pay big prices for non-problematic businesses and reasonable prices for problematic ones. We should not be surprised at the big Japanese banks injecting capital into the highly problematic Barclays.

There will eventually be a Japanese exit for many American financials. Maybe the Japs will be tempted by the weak USD.

Warning

I have never noticed these Japanese financials being particularly well managed – but they are wealthy – and in the acquisition battle wealth beats smarts – at least for the next couple of years.

I would be far more excited if a Japanese insurer were to buy back 400 billion yen of one of its own shares… but hope doesn’t help you pick stocks.

The Oops Slide

Yesterday I noted that Ambac’s paid claims are running about 20 million a month – which is somewhat less than the 150 million a month that say MGIC is paying. I also noted that their claims paying capacity was a fair multiple of MGIC.

I didn’t include the real big Ambac problem. They insured a whole lot of CDO exposures which are currently non-defaulted but whose credit profile is deteriorating and on which the end losses will be large but are uncertain.

Here is what I refer to as the oops slide from Ambac’s last fixed income presentation. It breaks up the CDO exposure by original rating and Ambac’s current (self estimated) rating:

This slide alone explains why Ambac is so much more damaged than MBIA. It’s the reason why I might be mad with my Ambac holding.

Nothing much else in Ambac’s insurance company alarms me… but this is petrifying.

If someone has some granularity on the deals – both likely default rate and likely loss given default I would love to see it.

Please...

Whose definition of subprime?

There is no standard definition of subprime. I used to think of the world in terms of “Household International Subprime” and “Conseco Financial Subprime”. The guys at Household didn’t think you could ever write loans at the Conseco level profitably over a cycle (discussion in year 2000). The HI credit modellers I talked to were well aware of the risks of the business – but thought it was unlikely that there would be severe stress on it outside periods of large unemployment. (They were wrong!)

Nonetheless the year 2000 distinction between Household and Conseco could be given with FICO scores:

· Household Subprime was FICO620 to 680, and

· Conseco subprime was below 620.

I think the guys at HI were more-or-less right. The HI business might be profitable on average over long periods and the Conseco business was hopeless at the outset. [Profitable over long periods does not make it a good business.]

After that conversation the world changed and everyone started doing Conseco subprime. There were plenty of issuers who worked with FICOs of 575 and below. I was short several – not because I thought a blow-up was inevitable –just that that sort of business cannot be profitable over a cycle.

High FICO defaults – or why FICOs were misleading

FICOs have proved not to be a great indicator of default.

There are deals done with a weighted average FICO of 710 which are defaulting very badly – see the FICO in Mish’s bad deal for instance. These deals consisted almost entirely of refinances – often cash-out refinances. A person with very poor credit could show as having good credit if they always repaid their last loan. They can achieve this by sequential cash-out-refinances. (A rolling loan gathers no loss.)

Deals with average FICOs above 700 that are behaving that way usually contain a very large number of cash-out-refis.

Why I mention

One of my games is to look at the definition of subprime that people were using (particularly prior to the recent credit crisis). Lots of companies wanted to deny they did subprime loans – so all they did was define subprime to be a credit notch below where they were. Defining the loan as Alt-A doesn’t make the bad credit go away – but it made you look safe. [See IndyMac for a company that denied doing bad credit by defining good as what they did.]

Anyway here are two definitions that stand out for me. The first is from MGIC – a mortgage insurer. The second from Ambac.

Here is MGIC’s definition (2006 annual report):

A-minus and subprime credit loans are written through the bulk channel. A-minus loans have FICO scores of 575-619, as reported to MGIC at the time a commitment to insure is issued, and subprime loans have FICO scores of less than 575. [MGIC defined prime loans as having a FICO above 620.]

To me this definition was astounding. The whole of Households year 2000 business would be prime by MGIC’s definition.

Ambac drank the poison too. It drank less poison but was less aware that it was doing it. The word FICO never appears in the 2006 annual which is full of soothing words about how they had reduced their underwritings in the subprime area. By the 2007 annual report they included a FICO definition:

FICO scores range from 300 to 850. Though there are no industry standard definitions, generally FICO scores are as follows: prime (FICO score over 710), mid-prime (FICO score between 640 and 710) and sub-prime (FICO score below 640).

The entire MGIC midprime business and some prime business is subprime by Ambac’s definition.

I knew in advance that MGIC’s underwriting standards were worse than Ambac. Much much worse. I was short MGIC and had sold out of Ambac. [I always wanted to be long Ambac as much as anything because I liked the CEO. I just did not like the credit cycle and some deals they were underwriting - so I sold my position well before the top.]

MGIC will pay almost 2 billion in claims this year. They are paying less claims than they anticipated – but not for any good reason – it is just that state legislatures are passing bills to slow down foreclosure and the courts are jammed and there are delays.

Ambac pays about 20 million in claims a month (admittedly rising).

Ambac has many times the claims paying capacity of MGIC and a small fraction of the claims rate.

But MGIC is still writing business and Ambac has almost ceased.

They might both be bust – indeed I express no opinion about the insurance companies. But if MGIC remains solvent and Ambac fails then the world is a very strange place indeed. [I will explore MGIC in more detail in a future post. Suffice to say I have no position long or short and the world might indeed be strange.]

Changing tone on MBIA

I have just sold my small holding of MBIA. I have been convinced - following a careful examination of documents issued for GICs - that this post is incorrect in several important ways. In particular the GICs at MBIA have a larger effect on parent company liquidity than GICs at Ambac.

I still have no opinion whatsoever on the solvency of the insurance company. [I intend to do that work - and if I form an opinion that is worth having then I will again take a position in the stock.] I now however take the view that if the insurance company is bad the parent company is likely bad.

And that the statement by Jay Brown about parent company liquidity in a recent letter to shareholders is actively misleading.

I have retained my holding in Ambac.

I make plenty of mistakes. This sort of mistake I enjoy. I made a profit.