It is surprising how few people got the joke...

The hedge fund trade was long Porsche, short Volkswagen.  

Porsche after all owns many times its market cap in VW shares so the trade was obvious...

This has been a disastrous trade.  Plenty of hedge funds got hurt bad.  Most of them are still long Porsche.

When I suggested the only responsible trade was short Porshe I was teasing.  A serious tease because Porshe is playing with fire and there are ways that Porsche could go bust.  But it is not a position I would put on.  

Calling it "the only responsible trade" was a tease.  Pure and simple...

Sorry if it did not translate to print.

John Hempton

The only responsible trade...

Warning – I strongly recommend against trading in any security mentioned in this post. The volatility is enormous and the situation fluid. The stocks are not being driven by fundamentals… The recommendations in this post are made in a somewhat humorous manner. They might even be reckless...

I am horrified - despite this warning at least one person has thought that the trade should be placed. Please take this warning seriously. I have no position.

The Stutz Motor Car Company

There was once a fine American sports car company called Stutz. It made beautiful – even legendary cars. The cars had a reputation for dependability, reliability and punishing speed. I know they look antique – but these were really quick for their day – and they won big races like Indianapolis and the Le Mans 24 hour race. Le Mans (at least) is an event that Porsche likes to win. Here is their 1913 Stutz Bearcat – a car that was modified, overpowered etc and won races into the mid 1920s.

Anyway Stutz was controlled by Alan Aloysius Ryan through family holdings. For reasons mostly to do with improved mass production by competitors the company found itself under pressure. Short sellers could smell blood. And they shorted the stock. And shorted some more.

Through this Alan Aloysius Ryan stood firm, buying stock when he could (possibly through options and hidden holding companies so the shorts could not see what he had done). He did this until he declared one day in 1920 that he owned 105 percent of the company and the shorts could settle with him on his terms.

His terms were a price so high that it would bankrupt broker dealers who had stood as intermediaries between the stock exchange and shorts.

Well to put it bluntly the financial market and regulators defended their own. The story is told here and here and here and here in the New York Times – and the amounts of money involved were monstrous for the time. Eventually the New York Stock Exchange –with the threat of criminal proceedings – arbitrarily determined a price to settle the short positions. The shorts even got an officially sanctioned “protective committee”.

That price was way below the top price that Ryan paid – but far more than intrinsic value. The shorts – well – except those that shorted right at the end – lost money. Ryan wound up paying too much for a motor car company which was slowly declining anyway. As he now owned 100 percent of Stutz his debts got intertwined with the car company and both he and the car company went bust. Some family members got a little out but only by suing other family members. The only winners were ordinary longs of Stutz who sold along the way – or even at the final settlement price.

As you might have guessed this looks horribly familiar. Porsche is now firmly in control of Volkswagen – and they did it with non-standard cash settled options and other things they argue that they did not need to disclose. It looks and smells like market manipulation – and Volkswagen – General Motors for Europe – may be - depending on the time of day - the biggest company in the world by market cap. [Yes – its market cap is higher than Microsoft, Exxon or PetroChina.] This is the short-squeeze from hell – the first short-squeeze to infinity since the Stutz corner…

Now I think Porsche is one of the great businesses of the world. They have convinced middle aged richer Americans that they are more attractive – or at least more fun – if they drive that particular fast car. (Viagra is for poorer guys…)

And unlike Ferrari (which spends all of its profits on Formula One) Porsche – like Stutz before it – managed to make its mark with near-production cars in events like Le Mans. In the automobile world there are only two car companies with margins near 10 percent – Porsche and Toyota. And they got there different ways.

Porsche (the business) is having a rough time at the moment because if you haven’t noticed the willingness of middle aged American men to drop 100K on a car is somewhat reduced of late. But that might be temporary.

Porsche is a company I want to love – a very fine consumer brands company masquerading as an automobile company. And it is not expensive at the moment – especially if you back out their holding of Volkswagen. Indeed its holding of Volkswagen is worth many times Porsche’s market cap – making Porsche one of the cheapest stocks in the world.

But if history is a guide the Porsche and its controlling family are going to go the way of the Ryans. Their behaviour doesn’t look any more criminal than Alan Aloysius Ryan – and that wound up with him – and his company bankrupt. The system has a knack of defending itself – and the family that controls Porsche and indeed the Porsche company itself is every bit as expendable as Alan A Ryan.

I started this post with a warning – which was that nobody should play any security involved in this story – and I want to stick with this warning. But if you want to play – and it pains me to say this – the only responsible trade is to short Porsche. Porsche – the company – and possibly the car – like Stutz before it – will likely get confined to the dustbin of history.

This is a sad thing – because Porsche – as I have noted – is a nicely run and profitable company. But the appearance of criminal market manipulation will have consequences – and Porsche will pay the piper. My guess – some hapless European investment bank (say Fortis or UBS) is at risk in this – the greatest squeeze since Stutz – and the European court when forced to decide between a mid-ranking German car company and a bank that is integrated with a European government they will chose the bank at Porsche’s expense.

Porsche lovers can however console themselves if they are going to live another 40 years. Someone made some pug-ugly cars under the name of the “New Stutz Company” in the 1960s. Elvis Presley loved his. A small consolation – but the name lives on well after any family legacy is gone.

John Hempton

PS. Having spent some time the other day slamming the New York Times I would thank them for making available – for free no less – the original newspaper articles about the Stutz Corner.

Is the New York Times giving us a bad read on the newspaper business?

News Corp’s newspaper advert numbers are bad – but they are not catastrophic.  They have got markedly weaker very recently – but until then they were down single digit percentages – and low single digits in most papers.  Some were up - but they were local property papers and the like.  The death of newspapers looked exaggerated if your benchmark was News Corp.

The WSJ is doing OK- not stellar – but OK.  Murdoch clearly has plans to turn it (a) into a national paper, and (b) into the dominant paper in NYC.  In that he is helped by the seeming failures of the New York Times.   

The New York Times is a paper I want to like,  but in fact like less and less.  It is falling into catastrophic disrepair and the stock price shows it.

The New York Times has become the poster boy for the demise of newspapers everywhere.  Revenue and profitability is weak – and the paper looks doomed.

Well is it possible – just possible – that the NYT editorial policies are giving us all a false read about the demise of papers?  

• Why is it that the paper employs Ben Stein despite the regular and ludicrous columns so well criticised by Felix Salmon?
  
  
• Does anybody still read Maureen Dowd?  As far as I can tell the same incoherent column has been repeated for about a decade.  (Maybe I am just insensitive to "gender issues"?)  Is this worth a regular editorial column in what purports to be the world’s greatest paper?
  
  
• Bob Herbert suits my liberal predisposition – but I don’t bother reading him because I learn little new or useful.  He is too predictable.  And he has been that predictable for fifteen years...
  
  
• Friedman seems to know less about foreign affairs (outside Israel and Beirut) than I do.  And I know very little.  He has been spectacularly wrong quite often.  Unlike Friedman though I know I know little about foreign affairs - he has a platform to show off his ignorance twice a week...
  
  
• David Brooks is a poor replacement for the conservative William Safire.  Safire wrote better – and more to the point I had little idea what he was going to say and sometimes I was forced by sheer power of argument to agree with him.  David Brooks has never done that for me.  Safire was a disingenous guy who twisted facts to suit his political views - but he was darn clever about how he did it...
  
  
• In the editorial area all they have is the very clever Krugman.  I agree with Krugman a good proprotion of the time - but I am forced to think.  He drives conservatives to apoplexy for the same reasons that Safire drove liberals to apoplexy.  He is too darn good.  Unlike Safire he doesn't twist the facts - at least in my view.  If only the paper could find five writers the standard of Krugman covering most political persuasons.  But then it would need to sack the others!

And that is when I get to the editorial policy.  Need I repeat that this was the paper that employed Jayson Blair (who just made it up with little consequence for the world) and Judith Miller (whose seemingly made up stories helped propel America to the Iraq war). 

The New York Times is failing – and the newspaper is failing. 

In the past the New York Times would be forgiven their failures – because there were few alternative sources of information.  But now there are plenty… competition is rife.

Competition is seldom good for shareholders.  It hurts well run businesses but competition has a knack of totally disposing of badly run businesses.  Indeed that is the real charm of competition. 

I want to ask a question: how much of the awful results of the New York Times are because of the demise of newspapers generally – and how much are newspaper specific?  How would we know?  

 

 

John Hempton

PS.  Rupert Murdoch would tell you that ultimately content is all that matters.  It suits his business mix to say that.  But maybe there is far more to this than the internet causing destruction...

Buffett by comparison is fairly bearish about the newspaper Berkshire owns.

A new disclosure "Magically" appears

In August – which in this market seems like years ago – I did two posts on MGIC  – the largest mortgage insurer and a company colloquially known as Magic. 

These posts are here and here…

I concluded that I did not believe in Magic – but I outlined the bull case (which was that the companies had something close to positive cash flow) and had a readers who tried to convince me that the bull case was right.  (I was and remain short.) 

In the second post I made an observation about statutory capital and possible shortages thereof. 

My further objection is that statutory capital deficiency happens way earlier than this - and stat capital deficiency will close the business as per TGIC.

It is an innocuous line – but two readers (both of whom I respect) followed me up on it – and one was sure that statutory capital was going to be adequate (he was long).  The other modelled it with brackets for his own uncertainty – and we thought that statutory capital might run short.

Anyway MGIC’s results contained a new disclosure on this issue:

Some states that regulate us have provisions that limit the risk-to-capital ratio of a mortgage guaranty insurance company to 25:1. If an insurance company’s risk-to-capital ratio exceeds the limit applicable in a state, it may be prohibited from writing new business in that state until its risk-to-capital ratio falls below the limit.

We believe that our 2006 and 2007 books of business will continue to generate material incurred and paid losses for a number of years. The ultimate amount of these losses will depend in part on the direction of home prices in California, Florida and other distressed markets, which in turn will be influenced by general economic conditions and other factors. Because we cannot predict future home prices or general economic conditions with confidence, we cannot predict with confidence what our ultimate losses will be on our 2006 and 2007 books. Depending on the extent of future losses, MGIC’s policy holders position could decline and its risk-to-capital could increase beyond the levels necessary to meet these regulatory requirements and this could occur before the end of 2009. As a result, we are considering options to obtain additional capital, which could occur through the sale of equity or debt securities and/or reinsurance.

That is slightly worse than the worst end of the models my readers created for me in August.

In other words it is bad out there.  And if you look its bad not in Magic’s subprime book (where the number of delinquent loans are up only a little in year – because the bad loans have been mostly foreclosed).  It is bad in the prime book (which is really a near-prime book).  Delinquent so called “prime loans” are the problem as they were when I wrote the original posts.  In that category the delinquency (by which they mean edge-of-default delinquency) has nearlydoubled and the loss per claim has also nearly doubled in the last 5 quarters…  [For those interested in actual loans – a year ago they had 11,700 subprime near default loans.  Now they have 12,700.  For “prime loans” the near default pool has risen from 36,700 to 71,100 loans.]

Anyway the disclosure about needing more capital is super-bad.  If the company is forced to stop writing business it will end nastily because the holding company is levered.  And I doubt very much it can raise capital now. 

The stock is down less than 50% in the past two months – so I can’t crow about the short.  (Plenty that is that levered is down more.)  But if the long investors can explain to me why they shouldn’t run for the exits right now I would appreciate it. 

There is also some disclosure that appeared far more prominently.  I looked for it before and it was in footnotes.  I know I should read the footnotes but…

Anyway it says more about Fannie and Freddie than it does about Magic.  It is a definition of “full documentation” that could only exist in the twenty first century mortgage industry:

In accordance with industry practice, loans approved by Government Sponsored Enterprise and other automated underwriting systems under “doc waiver” programs that do not require verification of borrower income are classified by us as “full documentation.”

 

It's about the real economy now

Wal Mart was always a down market retailer.  I feel at home in Target - wide, brightly lit isles, a good collection of kids clothes.  I don't at Wal Mart.

The average household income of people who shop at WalMart and not Target is above what I lived on as a student, but below the income of my (mostly part-time-employed) student household.  

Three years ago Jeff Matthews commented on the difference by saying WalMart had "Target Envy".   This reflected income demographics in the US - where the squeeze was already on lower income households (oil etc) and the middle income demographics were doing middling to OK.  

Target envy might be a thing of the past - but it is clearly getting worse in Wal Mart's demographic.  Paul Kederosky talks about things that WalMart is now seeing.  

Wal Mart has always had a pay-check related shopping spike - with a substantial number of customers living (as I did when a student) from pay stubb to pay stubb.  

But for the first time they are having pay-check driven spikes in the sales of baby formula suggesting the economic pressure is more widespread.  

It is about the real economy now.  

John Hempton

Why Lehman mattered

Read my post on the 1934 Act first… this will not mean much to you unless you have done so… and after that get ready for some seriously wonky stuff…

I was chit-chatting with a very prominent NYC financial journalist the other day and gave him the accepted view – which is that the decision to let Lehman fail was a big mistake. 

He asked quickly and fairly why it was a big mistake. 

I had to confess that I did not know.  Just the facts on the ground since that decision have confirmed that it was a mistake.  That hardly seemed satisfactory to me or to him.

At the time of the decision I thought that whilst the decision was risky Paulson had made the correct call.  Lehman was – he thought and I thought – just not important enough.  I blogged about constructive uncertainty and unfortunately I was wrong.

Krugman (who I admire almost to the point of idol worship even though I think he wrong often) had an editorial in the New York Times which said that Paulson was playing with a loaded gun – but Krugman was not then prepared to call it a mistake (though he has since).   (Score Krugman 1, me 0).

But I now I think I know why letting Lehman fail was a mistake.  It was the absence of suitable broker-dealer regulation in the UK. 

The 1934 Securities Act was written with recent memory of what it means for a major broker-dealer to fail.  Indeed legislators were so scared of this they enacted two pieces of legislation – the first ring fenced the broker deal from all the other business of the broker (the 1934 Act) and the second (Glass Steagall) prohibited combining any of it with a conventional bank. 

It turns out I think that the Great Depression double-separation was overkill – and you could do without the Glass Steagall legislation.  But you could not do without the 1934 Act. 

Anyway Lehman had lots of assets pledged to its European broker dealer which they could in turn repledge to finance client business (as would be possible in the US) and to finance their own business (which would not be possible in the US).  As Lehman’s own business became stretched the UK broker dealer repledged more and more client assets to keep Lehman alive.  This eventually made the UK hedge funds (and the European operations of many US hedge funds) unsecured creditors of Lehman.

Now it turns out that many of the most levered books were resident in the UK.  Why?  Because the UK had eschewed many capital controls of the type favoured in Great Depression legislation.  Lehman’s own UK book was similarly levered.

Lehman UK behaved appallingly pledging pretty well the entire UK client asset base and sending big cheques back to NYC. 

Several hedge funds (notably led by Harbinger) are trying to investigate these transactions and have made requests to the US bankruptcy judge to force Lehman to hand over the details.  I guess the issue is fraudulent conveyance.  Lehman has asked the bankruptcy judge to deny the request for administrative reasons.  The bankruptcy judge should force Lehman to hand over the documents, but being Southern District of NY (the most creditor friendly bankruptcy jurisdiction in the world) Lehman will probably get its way.  A prosecutor looking for indictments should probably look here too…

But let’s see it as it now is.  The assets and liabilities of these highly levered hedge funds became assets and liabilities of Lehman in bankruptcy.  [The entire books effectively were hocked to Lehman creditors…]  The leverage had to come off – and fast.

And so what the Lehman bankruptcy did was trigger waves of delivering – and it did it through the mechanism of UK broker-dealer.

The European trade de-jour – run at high leverage through the UK Broker Dealer was long Porsche, short Volkswagen.  Porsche (a very fine company indeed) owns a very large amount of Volkswagen (read General Motors for Europe).  Indeed Porsche owns several times its market cap in VW stock.   It was a trade everyone had on.  And the more leveraged a player the more they had on – and they had it on in London because it was (a) European, and (b) favoured by people with leverage.

And so – after the Lehman bankruptcy – this trade exploded.  VW went up every day – Porsche went down and the ratios became totally absurd.  Go look – either Porsche is absurdly cheap or VW is absurdly expensive or both.  Anyone that believes in the rational market hypothesis (and there are plenty of them out there) would have a real problem with this data as there is no way the movement is explained by rational valuation… 

Anyway Porsche Volkswagen example of massive deleveraging – but it was perhaps the most spectacular.  It happened across the board – and anyone who was levered to anything that looked like an obvious position had their backsides thrashed following Lehman.  It did not matter if they were housed at Goldman Sachs because enough people would have had the position on at Lehman London to get market prices to administer the thrashing. 

There was a day when high short interest stocks started rising in a falling market for no reason.  Almost all high short interest stocks.  Why?  My guess is because someone at Lehman London was short them and Lehman started covering the positions in bankruptcy.  The move was big enough to destroy some levered players.  But it also happened to stocks into which people were levered long. 

Soon delivering took on its own dynamic because people who were housed way-away from Lehman but were still over-levered got themselves in the vortex. 

Finally the redemptions are coming – and if you were not over-levered before the redemptions you can be over-levered after them.  Redemptions have their own dynamic.

The leverage of course was not only in equity markets – leverage is much more pronounced in debt markets because debt markets typically only have a couple of points of spread and you need to lever that seven to twenty times to get a reasonable ROE.  Moreover Lehman was always primarily a debt house, not an equity house – and the debt-arb funds were far-more-likely to be housed at Lehman than the equity guys…

The deleveraging of debt markets following the Lehman failure left everyone (maybe except Uncle Warren) hoarding cash.  [It also ran the Federal Reserve out of balance sheet in a single day – something that I will come back to in a later post…]

Lehman’s failure cracked this market – and it did so because the UK lacked the basic depression era legislation (the 1934 Act) and had encouraged reckless leverage by reducing capital requirements to low levels. 

It was the failures of London that made Paulson’s decision wrong.  I didn’t see it at the time – and nor did he.  However I have never been CEO of a broker-dealer – and Paulson has.  So one bad mark for me and three for him.  I keep score…

 

 

John

PS.  I should tell you what the German take is on Volkswagen and Porsche… a surprising number think it is reasonable that Porsche trades so cheap because the arb is between a voting stock and a non-voting stock – and being Germans they have seen non-voters ripped off shamelessly in the past – so it is reasonable to discount Porsche massively.  They do think that Volkswagen is over-priced but as there are already so many people on the trade it is an expensive stock to borrow and hence hard to short.  The problem with this argument is that it was just as true when the spreads were a third as attractive as now.  The market remains irrational – but it might be irrational for rational reasons.  

PPS.  This is a good summary of the legal issues as they are now...   http://www.iht.com/articles/ap/2008/10/16/business/NA-US-Lehman-Brothers-Bankruptcy.php

The 1934 Securities Exchange Act and all that

When you sign up to a margin account in almost all cases you pledge your securities to the broker with the ability for them to repledge. 

The reason to broker-dealer must be able to repledge is that it needs to finance the loans to you – and to reduce the cost of that financing it needs to offer collateral. 

So, when I take my million dollars worth of securities to the broker and borrow 100K on my margin account it looks like I have pledged a million dollars to a broker who might be questionable in order to get 100 thousand worth of financing.

There is one word for this.  Dumb.  They can – on face of it – take your assets and pledge them to finance their risky business.

If you do not believe it is dumb have a look at my post on Opes Prime, a small broker-dealer that went down in Australia taking something near a billion in client assets with it.  It involved organised crime, guys that killed hitmen and all sorts of other colourful characters.  There ain’t no way I would want to lend my securities to these guys and wind up an unsecured creditor.

The US had huge problems with broker-dealers in the 1930s.  They folded and lots of people lost their entire fortune by not understanding their credit arrangements. 

Enter the US Securities Exchange Act of 1934.  This is one piece of depression era legislation that survives and thank the Good Lord for that.

What the broker dealer act does is (a) ring fence the US broker dealer and (b) limit the amount that the broker dealer can borrow against your securities and the amount of collateral it may take. 

I am hardly a lawyer – so take the bush lawyer caveat – but the way it works is that the broker dealer may not borrow against your securities to finance their own business, only client business.  So Lehman Brothers US broker dealer could take collateral of securities and if they had 100 million out on client margin loans the most that they could raise using client securities is 100 million and not a brass razoo more.   This is really important because it meant that client assets were not used to finance Lehman’s disastrous commercial real estate and other businesses. 

Moreover when you deposit a million dollars at the broker dealer and give them the right to repledge those securities they can only rehypothecate 140 percent of your outstanding balances.

If you have 1 million deposited and you have 100 thousand borrowed then only 140 thousand can be rehypothecated and the rest must sit in a segregated client account.  [If your broker wants to steal from the segregated client account there are precious few defences – but…]  You can not contract out of this requirement. 

So (provided the broker is not acting criminally) you should get the bulk of your money back if the broker dealer fails.  And provided the capital requirements are adequate (and they mostly are) the broker dealer won’t fail.  Even the Drexel Burnham Broker Dealer did not fail.

Goldman Sachs claims that they can determine the capital requirements of their broker dealer intra-day.  I have no proof of this claim – but in this age of computers that is plausible.

The result.  Whilst Lehman brothers went bust Lehman US broker dealer did not.  This pretty well saved the US hedge fund industry. 

Europe however was a different story.  Lehman Europe failed – and the clients of the European broker dealer (read a good proportion of the London hedge fund community) are now queuing as unsecured creditors of Lehman.  Many funds have folded.  Far more have been nicked.  Whilst the US hedge fund business is currently looking dazed, confused and a little problematic the UK business is on life support. 

In some sense this is the end of the City of London.

I am on record as saying the UK took Maggie Thatcher to heart and deregulated financial activity to such an extent that the whole UK market worked without capital.  That was of course inordinately attractive in a boom where having capital was just a cost.  That attractiveness was one of the reasons why the London market grew and grew – and why UK banks wound up being amongst the biggest in the world.

But now with the biggest bank in the world by balance sheet (Royal Bank of Scotland) effectively nationalised and the and a large part of the UK hedge fund community lying with open veins it looks a little stupid.

This puts in a different light the 8 billion dollars that Lehman London transferred to the US when it was failing.  I stand open to correction – but I would guess that the money was obtained from client accounts from the European/London broker dealer.  It is certainly being investigated by Lehman clients.   This is a scandal of the first order allowed by an insane lassis faire approach to financial regulation. 

So here is a plea for US Depression style financial regulation.  Some of it (such as the Broker Dealer regulation) was well thought out and should be duplicated.   (Some of it was less sensible…)  

If I have a plea to my home country (Australia) after the Opes Prime debacle – a copy of the US 1934 Act would be a good start. 

As for London – I am sorry, but it is a wreck.  Maggie Thatcher you stand condemned.

 

John Hempton

Fred Goodwin hangs tough

Come on Sir Fred

You worked for an inconsequential arm of National Australia Bank.

You walked to an historic but small bank in Scotland.

You went on a binge of overpriced and insane acquisitions and turned your tiny bank into the world's largest by balance sheet.

The bank failed at huge risk to the global economy and required government to bail it out.

And you did not resign and instead hung tough for a golden parachute.

I have said that you are the worst CEO of any major bank anywhere. Vindication I claim.

Resign and waive the right to any package. It is simply indecent to charge a parachute to the taxpayers.


John

Bakkavor Group, an Icelandic follow up...

I got no comments on the Bakkavör Group accounts, see here...

For those that want to know, the balance sheet is written in pounds. It is serious money. Almost 2 billion dollars in debt for a token Icelandic food processing company.

It is the corporates, not the banks that are going to send this around the world. I noted the list of principal bankers contain more usual suspects – they are Barclays, RBOS, Rabobank, Mizuho, Fortis, ABN Amro, Bank of America Securities and HSBC.

The Icelandic confessional has included Erste Bank in Austria (a crash large enough to close the Austrian exchange) and various UK banks and will include others.

But more, still more, will come to the confessional...

J

Iceland denies the airbase link

It did not take long. Iceland has denied the airbase link.

http://www.timesonline.co.uk/tol/comment/columnists/bronwen_maddox/article4916541.ece

But it is clear the Russians have an agenda. What it is is unclear.

Iceland however needs the foreign currency desperately and should take it.

Welcome to the 21st century...