Shark attack

Regular readers will know that I am a surf lifesaver at North Bondi and later at Bronte Beach.

I am stunned as anyone by the shark attack. 

I was not at Bondi yesterday evening - but I was the evening before - but at the North end - teaching my son to surf.  The conditions were very similar - dusk, extremely low tide, overcast, weeds washing into the beach.

John

Tapes and films – the data-point from hell

Think of Nitto Denko as Japanese 3M.  Indeed it is the company in the world that most resembles 3M.  It does tapes, films, laminates – the usual 3M product set.  Like 3M a large part of sales winds up in automotive uses.

Now just how bad are their sales?  Here is the monthly sales report:

Compared with January 2008 , Nitto Denko's total consolidated sales revenue was down 51% (Y-o-Y) and decreased 9% from December 2008. LCD-related product sales was also down 57%(Y-o-Y) and decreased 1% from December 2008.

Ok – is it a recession or a depression?  

Private equity involvement in the bailout and leverage

I don’t know what Mr Geithner’s plan is. The stuff out there is so vague you can drive a truck through it.

But the smarties all seem to have one trade on – which is long distressed loans short financial institutions.

That is at least the broad position in the Paulson letter.

And far from me to encourage you onto a crowded trade – the position makes sense.

There are plenty of assets trading at 60-70c on the dollar that sit on bank balance sheets at much higher prices. If you force the banks to recognise the assets at 70c on the dollar they are amazingly insolvent.

So either

(a) the assets are underpriced, or

(b) the banks are overpriced or

(c) both.

Long junky loans short financial institutions is just an old fashioned arbitrage – and the few unimpaired arb funds (eg Paulson) are making hay...

Are the junky assets really underpriced in the market?

There are plenty of assets trading at 60 cents on the dollar. Diversified pools of mortgages (admittedly less-than-prime pools) often seem to trade at this level.  AAA strips against those pools are often 70c in the dollar and where 12 percent of the assets need to go bad before you bear any loss. Implicitly there needs to be 40 percent losses before you lose money on these investments.

I know it is bad out there – but 40 percent losses imply worse than 60 percent defaults with 60 percent loss given default. It is simply not going to happen on a widespread basis (though I can show you individual securitisations that are worse than this).

So why don’t people bid up the price of the junky assets? Well some are – see the Paulson letter – and he has made good money doing things like that.

But there is a return problem. Some of these assets are quite long dated – you might get paid over ten years. And meanwhile you get say 10/7 times the AAA yield (the stuff is trading at 70c in the dollar) and it might pay 85 cents in another 10 years – so you get nearly another 2% per annum in carry.

Well 10/7 times treasuries isn’t very much – less than 4% and nearly 2% carry – and whoa you have an asset on which you won’t lose money indeed on which you probably will make five percent.

That really excites me. Asset prices are way down – this crash might be the investment opportunity of a lifetime – and I have a smorgasboard of assets to chose from on which I will not lose money over the long term – indeed on which I might make 5% per annum.

I am just thrilled.

So how are those assets really?  Underpriced but hardly exciting. To be exciting they have to be insanely underpriced. There are a few insanely underpriced assets out there, but John Paulson (Paulson funds) won’t tell you what they are. And even then they are not that exciting.

No – to be exciting you need to borrow against them. You need to be able to use leverage. Cheap leverage. Lots of leverage. And it can’t be margin loans or the like – because the asset prices are so volatile that your funding might go away.

But – with permanent cheap funding at government rates it should be profitable to buy those assets. Seven to one levered at government rates (which are a couple of percent) the returns will be spectacular.

So if the Geithner plan is to attract say one hundred and fifty billion of private risk capital and allow it permanent and secure access to say a trillion dollars of government money at a government rates then hey – I am in. (I would require the interest rate risk be matched too.)

It would be a pretty big gift from the government – as nobody – a good bank or a bad bank – can borrow at the same (extraordinarily low) rate as the US Treasury. But as a plan it might just work. And because 150 billion of real private spondulicks is at risk there are some pretty strong incentives for the private sector manager to get it right.

Well who should be the private sector manager?

I don’t know. Most of them won’t work for a $500 thousand dollar salary. And that is problematic.

But – hey its my civic duty. I will do it.

Yes – you heard me, I would do it for a $500K salary. And no base fees – and a very small performance fee. Admittedly the very small performance fee will be on a very large amount of money – and with all that cheap government leverage it might leave me as rich as Croesus – say Bob Rubin rich. Indeed as the underpriced assets are common and the only problem is the inability to lever them – I should make an absolute killing if Mr Geithner will give me enough cheap, matched and permanent funding.

Indeed I would never bother with this fund I am setting up. I would get my original clients together and raise a few hundred million of private money to start the bail out fund. I will even put in most my own net worth.

Oh, and I wouldn't hide the motive either.  Its greed.     

How about it Tim? You game?

Don’t believe what they say

Calculated Risk points us towards a slide in the presentation that JP Morgan made when it purchased Washington Mutual.  Calculated risk (falsely I think) indicates that it is relatively easy to quickly put up a stress test scenario as to end losses for various types of loan.

Anyway – back to the slide which you can find here.  It presented three scenarios up to and including a “severe recession”.  It is now clear that the unemployment rate will exceed the severe recession scenario in the slide.  However home price appreciation (well really depreciation) from peak to trough is still considerably less than the severe recession scenario in the slide and it is still not clear we will get outcomes that bad.

When that slide was presented I thought it overly – indeed insanely bearish on housing losses – and I still do.  WaMu had loan balances of 176 billion and JPM was predicting a loss over the history of those loans of 54 billion in its severe recession scenario. 

To get that loss more than half the loans WaMu made had to default.  If you assume any reasonable recovery the default rate probably had to be north of sixty percent.  

Even in a severe recession that seemed unlikely to me.  I know a few WaMu customers (middle class, northern California, financially stressed) and whilst some might default it seemed unlikely that half would.

There is – in America – a core group of people who believe that you should pay your home loan.  It is bad out there – but WaMu did have some old loans in its book – which even with 40 percent house price depreciation were going to have positive equity.  Also WaMu’s book was at least in part diversified by states.

If you believed in $54 billion in losses (and I don’t) then it is right that WaMu equity was worthless or near worthless even if Sheila Bair had granted some forebearance.

Why financial institutions lie

Most the time problematic banks have an incentive to spin their position as better than it is.  Banks lie about the quality of the assets on their book.  They do it all the time because if their capital appears adequate their cost of funds will be lower and the availability of funds will be higher.  Having funds available at low cost is central to bank profitability.

Most banks have huge and responsive investor relations functions – because continuously convincing the market of their credit worthiness is a core operating function.  The guys staffing these IR departments are usually nice enough – but unless you can piece together their statements over a period of years then you are probably best advised not to believe much they tell you.

Bank IR and financial management are very practiced at spin.  

They will really get to lying if the Government chooses to buy bad assets from them.  I can just imagine the scene – lying bankers (there is no other kind) on one side – and suckers – also known as taxpayers – on the other.  

There are exceptions to the rule that financial institutions spin the positive.  Ambac (a credit insurance company) is a company that is brutally bearish with you if you go do an investor relations meeting.  I have done that – and you come out wanting to slash your wrists.  Ambac is writing no business.  It is trying to settle old claims presumably for less than the present value of the claims that they will have to pay.  If they can convince people that there is a high probability they will not be around in six years to pay the claim then claimants might settle for 60 cents on the dollar now.  Indeed the only reason why you wouldn’t settle for 60c on the dollar now on an Ambac claim is that you haven’t taken the hit in your own balance sheet.  [Barclays is an offender here.  It will not settle some claims because it does not want to recognise its own losses.  Oh, and there is a high possibility that Ambac will not be around to pay the claims which will be problematic for some...]

Anyway because Ambac is trying to settle claims they have an incentive to make their credit look worse than it really is – that way you get to settle the claims cheaper.  [Funnily MBIA is not playing that game.  My view is that MBIA is worse than Ambac – but is pretending it is better.]

The incentives on JP Morgan

Consider the situation that JP Morgan was in when they were negotiating with Sheila Bair to convince her to confiscate WaMu and to hand it to them.  JP Morgan had previously been willing to buy WaMu for $8 a share.  They had done due diligence on it twice.  But here was the opportunity to buy it for less-than-nothing – if you could get it confiscated first. 

Bluntly JP Morgan had an incentive that few banks actually have – which is to high-ball the loss estimates.  Their job was convince Sheila Bair to confiscate the bank.  How do you do that?  Well you tell bad stories.  You have to make it seem that even in modest recessions (their severe recession case was a modest recession by current standards) that the losses would be enormous.

So – consistent with incentives – they high-balled the losses to Sheila Bair – and then – to be consistent – they highballed the losses in the public presentation.  They were of course doing what bankers do – which is lying when they have the incentive to lie.

Calculated Risk swallowed that lie.  They know better than to swallow overly bullish lies.  They should also know better than to swallow overly bearish ones.

General rule: believe nothing bankers say when their incentive is to lie.  Verify everything you can.  If you can’t verify then discount veracity appropriately.  If they are investment bankers they lie more convincingly than regional bankers – though both are pretty convincing.

John

PS.  This was a situation where a banker (Jamie Dimon) was buying something (WaMu) from the government (Sheila Bair).  The lying banker got the better end of the deal.  

It won't be any different if banks sell things to government.  The lying banker will get the better end of the deal.  If the private sector is in for 10% of the equity it will help but not solve the problem...

PPS.  I suspect I am meant to comment on the plan.  I don't think there is a plan.  Stress test everything is not a plan.  Indeed I think the stress tests have the same lies built into them that everything else does.  Third party assessments is a plan - but it requires an openness that banks are not familiar with - and perhaps a billion dollars in accounting bills (which is I guess stimulus).  

Not ordinary fires

I do not want to say much about the Australian fires - but this photo of molten metal from burnt cars gives you some idea of their intensity.

For the record - apparently these were aluminium alloy wheels.  The melting point is just under 1000 kelvin.   Way hotter than lead (600 kelvin).  Iron melting point is 1800 kelvin - furnace temperature.  There are incidents of iron being serious impaired (eg children swing sets that collapsed with heat damage) but I have not seen plausible photos of iron melting like this...

J

How good is the Wall Street Journal?

Or alternatively how bad is the New York Times?

The Wall Street Journal was the only major American paper to increase its circulation last year.  Given the malaise of newspapers its a miracle that any paper increased circulation.

However they did it after increasing their cover price as this old Seeking Alpha article reminds us.   

It is hard to find any business anywhere (let alone a newspaper) that managed to increase prices and custom last year.  Now part of it was that the financial crisis made financial news interesting.

But at least part of it has to be the demise of the once-great New York Times.  

I guess Ben Stein is the Sulzberger family gift to Rupert Murdoch.

For competitors the failed editorial of the New York Times (Krugman excepted) is the gift that keeps on giving... 

John

Weekend edition: The conspiracy to keep you poor and stupid

First- a brief book review:  Nontechnical Guide to Petroleum Geology, Exploration, Drilling and Production – Norman J Hyne.

This is a good but dull book - a handbook of upstream oil process – how a drill works, all the processes involved in guiding drills, essentially a technical manual aimed at scientists and engineers who want to get up to speed (and hence useful) in the management of upstream oil and gas.  If that is what you want I highly recommend this book.

I do not believe in investing in any industry until you understand it – and this will give you a very good understanding of the oil and gas industry.  If your fund manager doesn’t read stuff like this then find a different fund manager.  (This book is about widening your circle of competence.  I am hardly recommending it for general reading – but we found it useful.)  

The real purpose of this post

Norman Hyne is very matter-of-fact.  For instance – without reference to whether such a thing should exist – or without reference to the vast scientific revolution that was required even to say such a thing – Hyne talks about 14 thousand feet of sediment.  Sometimes he talks about 20 thousand feet of sediment.  And it goes without saying that the world must be very old for this sediment to exist.  The author won’t even bother entertaining the idea that the world is 6000 years old (and that the sediment was all laid down in some biblical flood).  That notion is of no use whatsoever to a field petroleum engineer.  

Likewise there is a chapter on analysing drill core samples.  This is done by analysing micro-fossils – weeds and seeds.  The organising principal of the theory is evolutionary biology.  Creation Science is not entertained.  Norman Hyne is a practical guy – and he wouldn’t mention such “theories” because they are no use in drilling for oil.  Indeed you will find no worthwhile petroleum geologists who view creation science as a useful theory in finding oil.  

We have just had a US President whose fortune was built on oil.  We had a VP who was CEO of Haliburton – a major upstream oil contractor and technology provider.  These people know that Creation Science is useless – that it will not help you find oil or make money.

Yet – admittedly with political considerations at heart – they were active or passive supporters of creation science crap.  They knew it would keep the constituents poor or stupid – and yet – for understandable political reasons they backed it.

One of the more famous conservative blogs is called the Conspiracy to Keep you Poor and Stupid – but I have only once found such a conspiracy.  And that was on the conservative side of politics.

I have said on this blog that conservatives sometimes have a better grasp of reality than liberals.  They tend to have a more realistic view of the human condition than many starry-eyed liberals.  However this is another example of conservatives becoming the anti-science reactionaries of American politics.  Lots of real reform (eg greenhouse) will not be done well until conservatives engage properly with the reality.  This is yet another plea for American conservatism to get back its intellectual strength.  It really is time...  

John Hempton

I have been criticised in the email and in the comments for a political sermon - the belief that creationism is a straw man to beat the political drum on.  

I wish it were true.  Over half the US population in some surveys believe this crap.  I have seen high profiles conservatives describe evolution as "the liberal creation myth".

These are the same conservatives who have anti-science belief elsewhere.  Everytime I mention greenhouse the blog goes wild.   The temperatures of over 120 farenheit that my parents in law (rural southern Australia) experienced on the weekend  may not be driven at all by the greenhouse effect - but my feeling is that the burden of proof is now totally on the climate-change-deniers.  A couple of hundred dead (in the resulting fires) tends to focus the mind - and my mother in law - usually a tough old woman - spent most of Sunday crying...

Once Maggie Thatcher argued (indeed demonstrated) that lots could be achieved if you appealed to individualism.  She was right.  She had a decent understanding of the human condition.  I might not agree with all she aimed for - and ultimately I think there are non-market goals.  But the position had strengths and we should keep the good bits of it.

But the Maggie Thatcher view that financial markets could regulate themselves is now a smouldering ruin called the Royal Bank of Scotland.  

How we get a facts-and-circumstances driven politics is something that regularly makes me ponder.  Its is also the central political question of the next ten years - how we keep the good bits of the Thatcher/Reagan revolution (a general belief in markets and the worth of the individual) whilst tossing the bad bits (lack of environmental responsiveness, failed financial market regulation etc).  

If I sound like I am giving a sermon I apologise in advance.  But my guess is that the same people who believe in creation science are the people who believe that climate is the realm of god - not the realm of human ingenuity and destructiveness...

J

Finally - the real issue with greenhouse for this blog is the notion that it is real and it will effect investments.  For instance if heat-waves of the kind experienced in southern Australia are common then fruit trees in the Goulburn Valley are not worth what they used to be.  (You have a hard time growing peaches when the temperature is 120 farenheit.)  

Likewise governemnts will do things and that will change the value of all sorts of assets (coal, nuclear, hybrid cars and lots of things I can't think of).  All of that is worthy of consideration.  

How to guarantee your job in a Spanish bank

The Spanish banks always looked vulnerable to me.  I have criticised Santander several times on this blog.  

But this story deserves more coverage.  Ibex Salad – a blog about the Spanish stock market and olive oil business – is reporting that banks are taking the property they are repossessing from bankrupt property developers and selling it to their own staff at a 35 percent discount and with 100% percent financing.  

This is called loss deferral.  That is what distressed banks do.

But Ibex Salad makes the obvious point.  For employees this has one side benefit – staff who borrow from the bank are more likely to keep their job.  Probably a good deal for the bank staff – even if they are paying slightly over the odds.

John

Those wonderful shops

I been looking at retailers lately – not something I know a lot about.  I know enough to know I can hurt myself if I get these wrong – as my post about being a fuddy-duddy old guy reveals.

However I have come across this retailer in relatively good categories with a very low valuation and acceptable looking – though economically cyclic - run of same store sales increases.  Here are the numbers:

Fiscal year	Same store sales
1992	1%
1993	7%
1994	8%
1995	15%
1996	5%
1997	-8%
1998	-1%
1999	8%
2000	8%
2001	-4%
2002	-10%
2003	4%
2004	-3%
2005	1%
2006	8%
2007	6%
2008	-8%

The same store sales were up 50 percent over the period 1992 to 2007 – not a great 15 years – but not diabolical.  They were down 8% in 2008 – which – given the economy looks bad – but again not pinch yourself bad.  

And this stock looks cheap.  Really cheap.  Breathtakingly cheap.

I am going to leave a few spaces before the rest of this post….

More space…

And more…

So it’s a bait-and-switch – the company is Circuit City – and whilst the same store sales look sort of acceptable they were anything but acceptable when compared to the competitor.  Here are Circuit City’s same store sales compared to Best Buy:

Fiscal year	Circuit City	Best Buy
1992	1%	14%
1993	7%	19%
1994	8%	27%
1995	15%	20%
1996	5%	6%
1997	-8%	-5%
1998	-1%	2%
1999	8%	13%
2000	8%	11%
2001	-4%	5%
2002	-10%	2%
2003	4%	2.4%
2004	-3%	7.1%
2005	1%	4.3%
2006	8%	4.9%
2007	6%	5.0%
2008	-8%	2.9%

And now you can see what happened.  Circuit City just got crushed.  Best Buy had superior sales per-square-foot or sales per unit of cost structure – and that difference got bigger and bigger and bigger.

As it did they could cut price – so whilst Circuit City’s same store sales sort of kept up with the costs their gross margin per unit of costs most certainly did not.

It is impossible to analyse the stock except in the context of its competition.  Circuit City’s problems are not it sales per-se – but its sales relative to its competitors.  Underperform by that much for that long and – despite your glorious past – there is nothing left.  Every investor should have emblazoned on their forehead that “competition is a wealth hazard” and anyone that tries to sell you a stock without analysing the competition should be sacked.  [Simple but blunt.]

I visited Circuit City headquarters once.  In those days it had a billion dollars of unencumbered cash on its balance sheet.  That cash represented past profits.  Past glories of which there were many.  Circuit City was a fantastic company once…

Circuit City it seemed tried many things to get the sales up (and match Best Buy).  The above mentioned cash disappeared when CC had a bad experiment in credit cards.  It should be easy enough to drive sales if you lent to people who had no intention of paying you back.  Given that, it is surprisingly hard to find the credit card boost in CC’s numbers.  

Also about just before I visited them they (finally) got rid of whitegoods – and tried to match the software (music, DVDs etc) offering at Best Buy.  They had to refurb all the shops.  Lots of cost – and only a few years of interesting same store sales growth.  

People seemed to be down on Circuit City sacking its expensive sales staff and rehiring cheap ones a few years before insolvency.  But the expensive sales staff hardly helped the sales keep up with Best Buy and would have been sacked anyway when the company was liquidated.  The problem lay elsewhere and being sacked two years ago was a relative blessing (the new hires will be hunting for work in this labour market).

Consider this an open thread.  What is it that Circuit City did worse than Best Buy?  I have my ideas – and will jot them in the comments where appropriate – but I really want yours.

Also – if anyone has a good memory – can they tell me why both companies had lousy sales in 1997?

John

Smashed up old fuddy-duddy guys

When I was about 22 my dream date and I ended making love on the balcony of a friend’s beach house on a balmy evening with a very high end stereo playing Van Morrison’s Astral Weeks at reasonable volume.

It even happened a few times.

My dream material goods were not fast cars (never been a rev-head) or an iphone (they didn’t exist) or even a mobile phone.  No – it was a high-end stereo – probably a beautiful Scottish turntable like a Linn - and a beautiful pair of Italian speakers (I still own my Sonus Fabers – and they cost a couple of thousand dollars then – probably five thousand in today’s money).  

That was a long time ago.  

Today’s 22 year old wants 5000 songs in his pocket (or 20 thousand), has probably never heard of Astral Weeks, can’t possibly afford a beach shack on the New South Wales coast (they used to be the playthings of the middle class – they now cost millions and are the play things for the super-rich) and wouldn’t give a damn about my Sonus Faber speakers.

Small, portable.  Who would have thought that Bob Dylan (of all people!) would wind up squealing about the declining sound quality of modern music.  He is right: the sound quality that made Astral Weeks so special is gone.  Even the sound of Bob Dylan howling out a pre-Animals version of House of the Rising Sun) is just missing on an iPod.  

Which leads me to how much you can stuff up an investment thesis.  

If you had told me in 1998 that (a) houses would get bigger, (b) the upper middle class would grow like topsy, (c) the middle class would borrow to finance houses and lifestyles like the upper middle class then I would have thought that high-end stereos would just have a great time.

I would have thought the middle class would continue to have such dreams – and that music – especially at high fidelity (and possibly high volume) would remain key to social lives (or even making love on the balcony).  

If I had known how the macroeconomic outcomes were going to look I would purchased Tweeter stock with glee.  Tweeter was a chain of big-box stores that sold at a price/quality point above Best-Buy or Circuit City.  It was a place where I could fantasize about my favourite consumer goods.  Ok – my Sonus Faber speakers might have been a step above Tweeter – but that was sort of the idea.

Well the world that I dreamed about has been smashed up – and I am just another smashed up fuddy-duddy middle aged guy.  (Get used to it John.) 

Tweeter is being liquidated.  John, say goodbye to your once dreams of material goods.

But for the moment I want to leave you with a promo from Tweeter’s liquidation sale.

I guess it tells you what to short.  All of this is so yesterday.  Like your blogger.

John

PS.  The Animals ruined House of the Rising Sun forever.  The first person in the song that Bob Dylan sung was a woman – and it wasn’t her father that was the gambling man – it was her sweetheart.  The pain in the lyrics is far more intense that way.  I gather the Dylan version is quite close to a version sung by Leadbelly – but I have never heard the Leadbelly version.

Anyway - even if you loathe Bob Dylan (and plenty of people do) listen to this gem.  Then buy the CD next time you see it in the discount bin - but only if you too are a fuddy-duddy like me.

PPS.  If you are really interested in the anticedents of the house of the rising sun - here is a Joan Baez version from 1960.  Obviously this pre-dates either Dylan or the Animals.  Baez has a truly stunning voice but Bob Dylan changes the lyrics for the better (much better).  If anyone can fine the version of the lyrics either Woodie Guthrie or Leadbelly sung I would be interested.  

I think the lyrics were refined to sheer elegance by Bob Dylan and stuffed by the animals.