Weekend edition: having a whale of a time

On Sunday my wife and I walked from Bronte to Maroubra with a coffee at Coogee.

There was about 15 people on the headlands above Maroubra Beach with binoculars and a telescope. They were watching a large group of humpback whales.

The whales were the better part of a mile offshore and if you looked carefully the most that someone with my deficient eyesight could see was spray from their blowhole.

Here is a much magnified photo. It’s a smudge – but hey I am excited!

Mish comments on finance for machine tools

Mish has posted on his blog an email from a friend who is complaining about not being able to finance machine tools:

An emerging trend this year is the sudden scarcity of capital from banks & machine tool finance companies. We planned to purchase two new machine tools this year. It now appears that we can obtain financing for just one, in spite of a spotless corporate credit record and continued sales growth. The lenders seem to be over-tightening because of the recent credit crisis. As I told my banker, “You guys seem frightened of your own shadows!”"

Mish rightly points out that the main problem is not (as the email author suggests) that the banks are "frightened" rather the problem is that the finance companies can't finance themselves.

Now I might be a little dopey - but this looks awful good for a company that (a) makes capital equipment and (b) can afford to finance it.

Did anyone say General Electric?

Time to hide the valuables under the mattress and buy a shotgun

Dana Milbank of the Washington Post asked Phillip Swagel (US Assistant Treasury Secretary) whether it is time to "hide the valuables under the mattress and buy a shotgun". And Swagel did not hit it out of the park.*

At the same time we have the CEOs of major banks saying that they are profitable despite the headwinds.

With due respect - there is plenty of work in Washington for out-of-work CEOs good at spinning BS. Your country needs you.

The full video is here and is worth a watch. (Hat tip to the Big Picture.)

Memo to Phillip Swagel: practice saying the fundamental strengths of the United States are undiminished... even if you don't believe it. Its not good for someone in your position to talk down anything...

*My original wording was "Swagel does not hit it for six". But then I am Australian and therefore a cricket fan.

A not so encouraging dead link

I was doing a little research on Washington Mutual. In particular I was trying to work out whether the entire Long Beach Mortgage portfolio is as toxic as Mish's benchmark deal.

So I go through WAMU investor relations site - and looking for IR for fixed income. I get to this site. I click on the link to WaMu Asset Acceptance Corp (where all the Long Beach stuff resides).

The link is dead.

When major banks can't keep their IR page in order to give you credit data I can't blame people for being skittish.

Memo to WaMu: please fix.

Somthing to say for getting old - or just ignoring survival bias

Getting old is better than the alternative.

But Floyd Norris suggests that it seems to be better for your investing.

As I am getting older at the rate of one year per year Floyd's article should cheer me up. But it doesn't.

An article that suggests that older investors are less likely to be caught up in a bubble has a causality problem at its heart.

If you are likely to get caught up in a bubble you are unlikely to STILL be a professional investor by the time you are 50.

The article seems to suggest that age makes you wise.

But the alternative hypothesis is also possible: wisdom that allows you to grow old (and stay in business).

And if that is the case getting older at the rate of one year per year has fewer benefits than I hoped.

Things I once wrote

In my previous career (that is in May last year) I wrote a brief history of US finance since the 1970s. It explained our positions winning and losing. You can find it on the web here.

Before you read it though – read yesterday’s post on things that I stuffed up. The credit risk/interest rate risk. The conclusions to my article from last year seem wrong in several important ways.

Things I stuffed up – edition one - Interest rate risk versus credit risk

Anybody that trades stocks makes mistakes. I have made plenty. I would prefer sweep those under the carpet but a little bit of healthy self-flagellation is good for the spirit. Besides I hope it will make me a better investor. Besides I just posted that I purchased Ambac - something that could (easily) wind up as the next mistake. So you should know just how much I stuff up.

So this is the first of (almost certainly) many posts detailing things I stuffed up.

The list for the first choice is long. How about these?

(a) Believing that regional banks of Credit Agricole (which are very good) would offset the losses at the investment bank (which is very bad). Stock is down from 36 to 12.

(b) Believing that the mortgage insurers would blow up this cycle but the bond insurers would probably be OK. Ambac is down 90 to 1ish and is no longer writing much business. MTG (which was my favourite short) is down from 60 to 6 but is writing plenty of business. Got the wrong shorts… and didn’t short the bond insurers…

(c) Believing that the (seemingly extreme) valuation difference between News Corp and other media stocks would solve itself by New Corp’s stock price rising. It didn’t as a stock price comparison of Viacom, Time Warner and News Corp will attest. (It was a wash – all the stocks lost a little.)

(d) Buying Origin Energy at under $2 and selling it at about $4 on the basis that the utility parts of the business were fully recognised. I sold it despite loving the management. It is currently under hostile takeover at $15.60 – and the Aussie dollar in which it is priced has almost doubled. I didn’t recognise just how good the gas assets were. This was non-trivial as the fund I worked for owned almost 5% of the company – and left more half a billion dollars on the table and it was my fault.

Against this it should be pretty hard to tell what the worst intellectual error I made in the past five years is. But I have a candidate. I thought that the interest rate risk in US banks would blow up before the credit risk.

Background

The US has a very unusual mortgage market. Most mortgages have the peculiar term of being fixed rate when rates are rising – but being refinanceable if rates fall. This means that customers pay more for their mortgages than most jurisdictions – but that all the interest rate risks fall on the financial sector.

For instance in most markets the difference between central bank fund rate and the average mortgage rate is less (often much less) than 200bps. In the US it is unusual to get a conventional mortgage at under 6 percent – and the feds fund rate is 200bps. Mortgage margins in the US are more than double most countries.

For this however the system as a whole takes an awful lot of interest rate risk. If short rates were to go to say 8 percent there would be 5-7 trillion in mortgages that yield less than that. Individual institutions might say they were hedged – but the system as a whole cannot be hedged.

I spent an awful lot of time looking for banks and other institutions that were particularly levered to interest rate risk. WestAmerica Bancorp (an otherwise pristine bank) stood out. If you look at the balance sheet I linked in my previous post you will see that it contains $1.5 billion in fixed rate securities financed floating. That number is very significant compared to pre-tax income of 120 million or tangible book value of about 270 million. And WABC is by no means the largest offender.

My back of the envelope calculation was that the system had about 400 billion of pre-tax profits. That included all brokers, all banks, all insurance companies, fund managers – the works.

The US system had 7 trillion of interest rate miss-match. Almost half the profits of the entire US financial system could disappear in a 200bps rise in rates across the yield curve. And they would have disappeared without a penny of credit losses. A lot of institutions would lose their profits entirely. They would in my view all try to hedge simultaneously guaranteeing the dynamic hedging strategies that were in place did not work.

And I thought with Alan Greenspan setting the tone of the Fed the stuff up on inflation and hence interest rates was inevitable. Greenspan never saw a problem he could not fix by pumping more liquidity into the system. I thought Helicopter Ben was even more likely to use a little inflation to get the US out of its mess. Indeed that is where the “helicopter” moniker comes from – a speech to that effect. So essentially whilst I thought that credit problems were sort of inevitable – the US would inflate their way out – and hence the real manifestation would be an interest-rate-risk debacle.

So I spent a couple of years getting completely obsessed about interest rate risk. It led to some OK shorts (eg Fannie and Freddie) but meant I underestimated the credit story.

The credit risk I thought had been passed pretty heavily to the non-bank sector. It existed in the Europeans (I sort of knew about UBS). It existed in the investment banks (including Citigroup). It existed in some regional banks (I knew about Bank United). But I was stunned it wound up quite so bad at Fifth Third. Just stunned.

I thus covered a Fifth Third short many years ago. (Ooops.) I was short a bunch of interest rate risk sensitive banks (such as North Fork which was purchased by Capital One) and I didn’t short MBIA and Ambac. Indeed I was tempted to go long (but fortunately I did not). I made money on a few interest rate shorts – but altogether it was not a profitable activity.

A few years ago the short end of the yield curve was at about 1%. The long end in the 4s and quasi-government guaranteed mortgages were in the high 5s. Borrowing short to buy Fannie Mae backed mortgages was the seeming no-lose trade. Everyone was on it. It didn’t even carry much credit risk because everyone knew the government backed Fannie.

However it carried – and still carries – massive interest rate risk. Everyone seemed to ignore that. My usual reaction – if everyone is doing something then it will probably lose you money. I would rather be on the other side.

Still I remain convinced that this is a theme that will play out. Warren Buffett says inflation is heating up – and he doesn’t stretch the duration of his assets.

There are good people who think inflation is highly unlikely. Paul Krugman (who I admire) suggests that Bernanke should ignore the inflation naysayers. Mish writes for ever on how inflation is not likely – see here and here for examples.

I will get back to this shortcoming one day soon.

John

GIGs and Ambac

Warning: Wonkish. Read only if you are interested in Ambac.

The Whitney Tilson post I wrote up on the weekend goes through the issues of GICs and MBIA. The story is that when a municipality raises a bond it doesn’t need all of it straight away. So the bond insurers (using their contacts with the municipalities) sold “guaranteed investment contracts”. These contracts were invested in primarily high-grade instruments (but not Treasuries). A guaranteed return was offered to the municipality. Withdrawal was usually limited to term giving MBIA several opportunities for profit by structuring investments to match total maturity schedules.

The problem for MBIA was that the GICs could be accelerated in the event of a ratings downgrade – either that or the company could be forced to post collateral. The collateral requirements are causing MBIA difficulties.

Ambac has also written GICs and they too can be accelerated. Here is the disclosure in the last annual filing. Note the section bolded by me which says that Ambac has “de-emphasized” this business for reasons primarily related to liquidity needs.

It is clearly a problem in the event of “well defined credit events” (which I presume is a ratings trigger). As to whether this ratings trigger is an issue for the stock: I report – you decide. As to whether these are ultimately parent company liabilities? I will leave that for another post. But if you want to know any earlier than that - read the statutory statements of the insurance subsidiaries.

Financial Services Liquidity. The principal uses of liquidity by Financial Services subsidiaries are payment of investment and payment agreement obligations, net obligations under interest rate, total return and currency swaps, operating expenses and income taxes. Management believes that its Financial Services liquidity needs can be funded from its operating cash flow, the maturity and sale of its invested assets and from time to time, by inter-company loans and repurchase agreement transactions. The principal sources of this segment’s liquidity are proceeds from issuance of investment agreements, net investment income, maturities or sales of securities from its investment portfolio and net receipts from interest rate, currency and total return swaps. The investment objectives with respect to the investment agreement business are preservation of capital by maintaining a minimum average quality rating of AA on invested assets, maximize the net interest rate spread as compared to investment agreements issued and to maintain a liquid floating rate investment portfolio, which includes short term investments, to minimize interest rate and liquidity risk. As of December 31, 2007, the investment agreement business floating rate investment portfolio approximates $6.3 billion or 84% of the investment portfolio related to the investment agreement business. Recently, Ambac decided to de-emphasize the Financial Services businesses. Ambac’s decision to decrease outstanding exposure to the financial services businesses was primarily due to the different liquidity needs of the business compared to the Financial Guarantee business, rating agency views relating to non-core businesses and to allow management to enhance its focus on the financial guarantee business. Ambac believes that this decision should not materially impact the Financial Services business liquidity.

Investment agreements subject Ambac to liquidity risk associated with unanticipated withdrawals of principal as allowed by the terms of the investment agreements. These unanticipated withdrawals could require Ambac to sell investment securities at a loss to the extent other funding sources are unavailable. Ambac utilizes several tools to manage liquidity risk including regular surveillance of the investment agreements for unscheduled withdrawals. In general, Ambac has characterized the portfolio of investment agreements into two broad categories, contingent and fixed withdrawal. As of December 31, 2007, approximately $4.5 billion relates to contingent withdrawal investment agreements. Contingent withdrawal transactions include contractual provisions that allow the investor to withdraw principal and require minimal notice to Ambac. The vast majority of these investment agreements can only be drawn in the event that well-defined, observable events have occurred, primarily credit events. As of December 31, 2007, approximately $3.3 billion relates to fixed withdrawal investment agreements, of which $1.8 billion include provisions where under certain circumstances our counterparty has the ability to withdraw funds during 2008.

Disclosure: I have just purchased a fair size holding in Ambac and a smaller holding in MBIA. I think it is possible (even likely) that both companies go to zero - but I do not think that they do so rapidly. Ambac in particular is trading at out-of-the-money option value only. My expectation of return is high - but I can't eat my expected return and it is entirely possible I will lose 100 percent of my investment. I will sell a fair bit of the position on any big rally. I do not want too many "told you so" emails if I stuff this one up. But then I will not gloat that much if I get it right.

Wachovia and negative amortisation

There is a press story here about how Wachovia is ceasing to orginate mortgages with negative amortisation features.

The headline:

SAN FRANCISCO (MarketWatch) -- Wachovia Corp. said on Monday that it won't offer mortgages with negative amortization features anymore, one of the main types of home loans offered by Golden West, the mortgage giant the bank acquired for $24 billion roughly two years ago.

This is a race: whose head is further in the sand, Wachovia or Barclays?

I wrote here how Fifth Third does not originate neg-am mortgages. Fifth Third (who have now contacted me) have not written such mortgages for years. The IR guy can't actually confirm that they ever wrote them.

Why are Fifth Third and Wachovia even mentioned in the same breath when it comes to difficult (multi) regional banks?

Search me.

Bond insurer – has airport to sell

I wrote about Sydney Airport here. Funnily enough various news source aggregators (such as Wikio) filed the article about a financial crash landing with real airplane crashes. Bronte Capital must have got a few perplexed visitors.

That said – my original post is pretty convincing on the notion that if air traffic in Sydney falls over any sustained period the airport will default.

I have no idea how sharply air-traffic will fall here. Air traffic is one of the most consistent of all variables. It just rises. The reason of course is that the cost of flying in real terms has fallen for decades. When I was a kid people who flew from Sydney to London were regarded with some awe – they were the “jet set”. Now they are “cattle class”. To fly to London cost AUD2000 and average household income was about AUD10000. It costs less in nominal terms to fly to London now...

But if the recent trend in oil prices is permanent and continuing the era of ever-rising air-traffic volumes is over. We will again refer to people who fly long-haul as the jet-set.

There is some listed subordinate debt in Sydney Airport – the so called SKIES (see my last post). Beyond that are a AUD3.7 billion of medium term notes of which AUD2.9 billion is drawn and AUD884 million of inflation indexed bonds with two maturities (2020 and 2030). My sting: all these instruments are insured by Ambac and MBIA.

I see the advert: Bond insurer – selling airport in glitzy long-haul destination.

If oil goes to $400 they will take a loss on this. But otherwise it should be fine.