In honor of Edward Hugh – Part 1

Edward Hugh writes A Fistful-of-Euros – one of my favorite blogs. I always thought of Edward as some second-tier economics academic who was right about several key issues and had an obsession which left his faculty members nonplussed. Academic rigor was not the key – and almost everything on Hugh's blog could have been fined-up by someone who had a decent understanding of Paul Krugman's book on currency and crises. (Of course fine technical detail did not detract from Mr Hugh being right – and on the key issues he was and remains emphatically right.)

I have in the past referred to him as Professor Hugh – and whilst someone corrected me in the comments it never occurred to me he was some disheveled amateur economist living a low-key life in Catalonia. He was way better than that – indeed way better than most economics professors.  Besides he had some help from Claus Visteen – an uber-nerd macroeconomics grad student who writes the very competent alpha-sources blog. [I would have incorrectly guessed that Ed was Claus's PhD supervisor or something like that..  Still I only once seriously thought about doing a PhD in economics and Brad Delong did not answer my emails... I guess I am not knowledgeable about the ways of the academy.]

Edward Hugh is having his day in the sun and the New York Times has honored him with an article. An in celebration I thought of further (and trivially) honoring him with a blog post – about how a post-crisis Europe might look and the path to getting there.

Alas I found that I could not write a single post to cover the ground – and so I will write a couple which will wind up longer and more complicated than I envisaged.

The first post – tomorrow I hope – will cover a bank right at the center of the storm – the surprisingly well-run National Bank of Greece.  NBG is however a small part of the big problems of Europe.  I think the best way of explaining macroeconomics to non-economists is to work from specific and concrete examples and NBG is an excellent example.  (Krugman’s book tends to stand real-world examples – but is hardly light reading…)

And so, at least for tonight, I will raise another glass of Spanish wine to Edward Hugh and settle down to drafting some serious bank analysis.

 

 

John

PS.  For completeness I should disclose several positions here. 

1.  National Bank of Greece has preference shares listed on the New York Stock Exchange where there is no restriction on shorting them.  They were priced at about 80c in the dollar until quite late into the crisis – indeed they traded at a premium to the sovereign and they were a good short.  We remain short them – but the bet is not as delicious as it was when we first put it on and we have covered almost all of the position.

2.  We remain substantially short the Spanish banks.  Again it is illegal to short them in Spain (except via derivatives).  It remains legal to short their ADRs.  At one stage in the fund the Spanish bank shorts were (collectively) our largest losing position.  We increased them – and increased them again on the way down and they are now (collectively) our second largest winning position.  We are also slowly covering the position.  I have blogged about BBVA and I thought (and still think) they are fudging the accounts of their US subsidiary – though that is not the reason we are short these stocks. 

3.  We have minor positions – long and short – in various European banks.  Generally smaller banks in solvent countries (especially France) are OK – and bigger banks tend to have cross-border exposures.  In 2003 or 2004 I went to a banking conference in London where the theme was cross-border banking consolidation in Europe.  That was not a good idea but plenty of investment bankers made a career on it.  [In investment banking you can make extra-good money promoting bad mergers.]

4.  I have not run this series through Edward Hugh.  I hope he appreciates the attention and does not resent my intrusion onto turf he covers so well.  I am closer to Claus than Edward Hugh (emails number over a dozen from Claus and very few from Mr Hugh – though none are close).  However I have met none of these people and chatted to Claus only a couple of times.

The Fannie Mae and Freddie Mac reform proposal from Goldman Sachs

Donald Marron and Phil Swagel have written a paper which proposes a reform structure for Fannie Mae and Freddie Mac.  It should not be taken seriously – and indeed it should disqualify this pair from serious debate – a larger gift to Wall Street that does not solve the problems of the GSEs is hard to envisage.  But – as the Washington Post takes it seriously and this pair are not lightweights I thought I should have a go at explaining what is wrong with it.

Fannie and Freddie (collectively the GSEs) did a few things some of which wound up hurting them and some of which did not. 

a.  They guaranteed mortgages – taking credit risk.  Some of these mortgages were well secured first mortgages with significant downpayments.  Some were more funky including 95 percent loan to valuation mortgages with odd payment features but supplementary credit insurance.  They insured substantial portfolios of what is now widely known as Alt-A.

b.  They purchased mortgages for their own book – usually, but not exclusively, the mortgages that they insured anyway.

c.  They purchased securitization strips including the (originally rate AAA strips) of private label mortgage securitisations including some truly atrocious mortgages.

In doing this they took credit risk (the risk the mortgages would default), interest rate risk (the risk that interest rates would change sharply causing loss of value of the mortgages or loss of spread on funding mortgages) and refinance risk (being the risk one day they would find they could not borrow money even if they were solvent).

You can take credit risk by guaranteeing mortgages or owning them.  But it is only by owning mortgages that you take interest rate risk and refinance risk.  If all you have done is guarantee the mortgage you don’t have to finance it or refinance it – so there is no refinance risk.  And you don’t care what the coupon on the mortgage is because you are not collecting the coupon.

I should not need to say at this point that the problems of Fannie and Freddie were entirely credit related.  They lost money guaranteeing mortgages and owning AAA strips of securitizations but they did not lose money on interest rate risk.  Interest rates have not been sufficiently volatile to do them great harm.

Alas every solution around for the GSEs that is in the public domain – ranging from the original (Hank) Paulson GSE conservatorship agreement down, force the companies to reduce their interest rate risk (by shrinking their portfolios) and do nothing at all about the credit risk (by allowing them to grow their guarantee business). 

The Swagel/Marron proposal is this taken to its logical extreme – it wants to allow multiple private entities with an explicit government backstop to compete in issuing guarantees – presumably driving the market price of the guarantee down.  They do not state this – but this will allow Wall Street to lay credit risk off to the government at minimum cost to them.  These entities however will not be allowed to own or finance mortgages or take interest rate risk – in other words they will be prevented only from doing the thing that is (a) profitable and (b) did not actually hurt Fannie and Freddie.  The profitable business that did not hurt the GSEs will of course be taken up by the banks – especially the investment banks.

Swagel and Marron are not completely stupid – they want to restrict the type of mortgages the competitive entities can guarantee to limit the risk to the government – with maybe a more strict definition of “qualifying mortgages”.  However one lesson of the crisis is that private sector entities competing with thin capital are more-than-keen to sell the trashiest mortgages and pretend they are golden.  If private sector institutions can do that to other private sector institutions (proven by observation) then it is absolutely assured that competitive private sector GSEs will do that to their regulator. 

The Swagel/Marron proposal is all the credit risk (proven nasty) to the Government and all the rest (so far looking pretty benign) to Wall Street.  It is the proposal from Goldman Sachs and – I presume that Wall Street could not be happier.

Serious and non-serious contributions to the economic debate

I like to think you know people who are not serious when they always have the same solution – no matter what the problem.  For instance there is a faction in the Republican party who think that whatever the problem the solution is to cut taxes.  If you are running too big a surplus the solution is to cut taxes. If you are running a deficit the solution is to cut taxes.  If you are fighting a war the solution is to cut taxes.  If you face global warming the solution is to cut taxes.  These people can be effective political operators but are useless at furthering the intellectual debate.  There are similar groups who think the solution is always more government regulation.  Puerile arguments exist on all sides of politics.

If you go back to the anti-Fannie-Mae debate as it was about the year 2001 the argument was always that Fannie and Freddie were taking too much interest rate risk – and that the interest rate risk would eventually blow them up.  You can see that in Greenspan’s 2005 views on how to reform the GSEs.  Greenspan stated that the GSEs posed  a threat to the system.  However the risk he focuses on exclusively comes from the owned portfolio – from interest rate risk.  I believed Greenspan’s views when he stated them in 2005 – and I was short many stocks based on interest rate risk.  [I got that wrong as I have detailed before on this blog.]

Greenspan proposed solutions to the interest rate risk problems posed by the GSEs.  Incidentally they are the right solutions if you think interest rate risk is the problem – they are the wrong solutions if you think credit risk is the problem.  Greenspan (and other GSE critics) would have handed the whole financing issue – including interest rate risk management to the banks (including the investment banks).  I thought that was right because they could manage that better.  Sure it would have been good for Goldman Sachs but the standard analysis of the risks said you wanted to put that risk in Goldies hands anyway.  I would have supported the gift to Goldies because I thought it was the right thing to do.

The GSEs blew up – but they blew-up entirely on credit risk.  The risk Greenspan and all the bulk of anti-GSE thought (including me) identified was the dog-that-did-not-bark.  The GSE critics (including myself) got the analysis wrong.  The solution we proposed was not the right solution to the problem that actually occurred (but it remains the right solution if you are Goldman Sachs).  Moreover post crisis there is little evidence that the banks could handle the derivatives exposure embedded in hedging Fannies and Freddie’s book any better than the GSEs (the other pre-crisis assumption I made). 

Alas the bulk of the GSE critics want to enact the solution for the problem that did not occur.  Like Swagel and Marron they want the solution that maximises government exposure to credit risk and minimizes government exposure to (and revenue from) all the other risks in the mortgage business.  They want the solution from Goldman Sachs despite it being the solution to the wrong problem.

I was wrong on the facts.  I changed my mind.  Most of the other critics were wrong too.  They did not change their mind.  That might make them effective political operators but it makes them useless at furthering the public debate.

Marron and Swagel however are (usually) far better than that.  They are amongst the best that the Republican Party has to offer on economic policy – thoughtful and knowledgeable.  I ran my criticism of their proposal past them and they stated that they just assumed that the “American Public” wanted the government to absorb mortgage market credit risk.  That may be their view (and they should state it up front) – but for “American Public” here I think you should substitute “Goldman Sachs” and you will have a more accurate picture of the politics.

That said – I hope serious commentators less in love with Wall Street come up with some decent solutions – because if they don’t what we will get is the solution from Goldman Sachs because no other proposal is on the table.  Mike Konczal – I am laying out a challenge for you.

Nigerian spam email of the week

From: Dudley Caruthers Esq (Barrister at Law)

Subject: BP Related Agreement Entitlement

E-mail:

Dear Friend

I am the private solicitor for Mr Tony Hayward, the esteemed Chairman and Chief executive of British Petroleum.  My client has various personal and family related holdings of BP stock and options. Due to his faithful long standing service to BP the total value of his holdings amounts to in excess of 100m pounds sterling.  Mr Heywood is a British citizen but it has been my sorrowful duty to advise him that his personal and family wealth is at great risk of being wrongfully confiscated by US authorities acting extra-territorially under special powers authorised by the US government and with the secret consent of a supine UK political and legal establishment. 

Mr Heywood is also at great risk of losing his personal liberty and becoming another victim of the long reach of the politicised USA legal system in the same way that was meted out to other British subjects including, most egregiously, the 3 bankers from Natwest (see  http://en.wikipedia.org/wiki/NatWest_Three).  Unfortunately I am not able to advise or assist him in this regard as my expertise lies in the structuring of executive compensation schemes and the management of private endowments; but I am horrified at the witch hunt being perpetrated on my client by the Obama administration and its agencies and I will do all that I can to safeguard my client's financial position.

I am reaching out to you as it has become clear that Mr Hayward's holdings must be liquidated and held in trust for the benefit of himself and his family beyond USA or UK legal jurisdiction. Exercise of his options and liquidation of his stock is now complete but it has proven necessary to assign title to the ensuing 100m pounds of cash to a person such as yourself who resides in a non recognised tax haven country and where there is a sound basis for UK and USA authorities to recognise the legal validity of local agreements.  The taxation and legal recognition agreements between your jurisdiction of Australia and those of UK and USA present a unique opportunity to protect these assets whilst providing you with a benefit in accordance with your key role.  I am a keen reader of your blog and greatly admire your economic and political acumen.  I immediately recognised that, at this hour of great urgency and risk to my client, you are the man who is capable of securing protection of the Hayward estate.

It is with this in mind that I wish you to consider the possibility that you and I (as Mr. Hayward's agent) have previously entered into verbal agreements providing for you to become the beneficiary of all Mr Hayward's BP stock and stock option benefits upon their occurring a significant "force majeure" event affecting my client and British Petroleum.  It is my legal interpretation that such an event occurred with the sinking of Deepwater Horizon and that title to Mr Hayward's rights and holdings transferred at that time.

If you do recollect our agreement then it is now necessary to transfer the 80m pounds of  cash proceeds to yourself which are after payment of  a 20m pound advisory and arrangement fee for the services rendered by my firm. Transfer of the cash will only occur to you upon you executing the correct documents which are (i) the force majeure beneficiary transfer agreement  (ii) a statutory declaration that the force majeure beneficiary transfer agreement was properly entered into as a verbal agreement in January 2002  and (iii) details of your Australian bank account including account name, password and account number and most critically an agreement between yourself and myself as trustee for Hayward related entities granting the trustee the right to claw back  50% (40m pounds) of the transfer at any time and requiring you to escrow the 40m pounds in a separate account.

I sincerely trust that you will search your memory and recollect that we met in Sydney in 2002 and recollect the nature of our agreement.

Please contact me at my firm's Nigerian subsidiary's offices at the address below such that we can act with the speed required of us.

Weekend edition: In the tradition of Yves Smith’s – antidote du jour

I went to a free concert on the Opera House steps on the weekend.  The billing was very strange: Laurie Anderson (and possibly her partner Lou Reed) were giving a concert on the opera house steps for dogs.  Thousands of dogs.  It was billed as inaudible to the owners – and I could not tell whether Lou Reed was having us on.  After Lou Reed brushed off the Metal Machine Trio for an impressively loud show in the concert hall (earplugs supplied) – and he was going from something you could not listen to to something you could not hear.
I was pleasantly surprised. Dogs and family loved it.  Lou Reed did not appear but milled around the audience allowing this ridiculous photo of your blogger and his designer mongrel:


Lets call it a Walk on the Wild Side. 
Seriously though – how could I resist a connection – any connection – with the Velvet Underground and one of my favorite albums. 

What is it with Carlo Civelli and George Soros?

Carlo Civelli is nothing if not controversial.  His name alone gets Canadian securities regulators into a lather as he was a major investor and a major seller (in advance of the crunch) of some of the most egregious stock promotes of all time.  Delgratia is the most-cited example - where Civelli was allegedly the main backer of a company which had a major gold find.  The stock plummeted on revelations that drill samples had been salted - or as the court documents sum up the engineering reports, "any [gold] detected had been introduced after drilling."  The salting was done by persons unknown and the chief geologist won a defamation suit when the Canadian press suggested he did it. 

Civelli was a backer of another over-hyped resource stock - Pinewood Resources – a stock which announced large finds and collapsed to pennies.  There was also Arakis Energy.  Arakis sums up what is good-and-bad about Civelli.  Arakis - through dealings with warlords - got prospective acreage in Sudan on which they found oil.  The quality of the finds was however grotesquely overhyped leading to a run-up and collapse.  The company was eventually sold to Talisman for roughly 15 percent of peak price.  The CEO - a longtime Civelli associated - agreed many of the nasty facts and settled for a twenty year ban from the Canadian securities industry.  The good bit was that there were real resources there - value was created.  The bad bit was that - as per many Civelli stocks - it was overhyped.

Note that Carlo Civelli was not charged – and only management received bans.  Overhyping is epidemic in the stock market.  Moreover there were plenty of good bits in Arakis.  There was real oil - and in commercial quantity.  Carlo Civelli has - contrary to what his critics have said - backed some valuable resource projects.  That Carlo Civelli has backed frauds does not imply that if Carlo Civelli backs it is a fraud.  Nor does it imply that Carlo Civelli was involved in the fraud.  Both of those are much more dubious propositions.

The most controversial current Civelli stock is Interoil - a company with real gas finds in remote Papua New Guinea and with well researched allegations that the finds are overhyped.

Still the Interoil bears (and there are plenty) were dealt a body-blow when Soros funds management purchased a large stake in the controversial company presumably after competent due-diligence.  Interoil is one of Soros's largest holdings.  Sure Buffett buying would confer even more credibility to Interoil - but Soros is a pretty good second best. 

This blog however does not want to comment on Interoil - it wants to raise the latest association of Carlo Civelli and Soros funds management.  Dear readers - I give you Manas Petroleum and its subsidiary Petromanas into which Soros has invested just over $40 million.

Manas/Petromanas is an unlikely candidate for a large Soros investment.  The parent trades on the over-the-counter bulletin board and has used paid stock promoters. It maintains its website in Vancouver rather than in its home base of Switzerland.  Petromanas (a listed subsidiary) trades on the Canadian venture exchange and their website is maintained in New York not where their business operations are.  Petromanas owns the Albanian prospects of Manas and it is that which Soros is investing in.

These companies are slickly promoted.  Here are three You-Tube videos detailing Manas Petroleum's prospects and management.  Money has been spent on them.

 

 

 

 

 

The use of paid promoters has been widespread - for instance a 34 page stock report by report by Cohen Independent Research Group (a penny-stock promoter) has the following disclaimer:

Cohen Independent Research Group Inc. (CIRG) distributes research and other information purchased and compiled from outside sources and analysts. This report/release/advertisement is an advertisement and is for general information purposes only. Do not base any investment decision on information in this report. All information herein should be viewed as a commercial advertisement and is not intended to be used for investment advice.  [Emphasis added.]

This is not the only example of paid-promoters shilling Manas though is by far the most prominent.

Penny-stock shills have - as many have noted - a poor record.  Paid penny-stock promoters poorer still.

But hey - this is Soros - so there is always the possibility that Mr Soros and his organization have found the promote that someone thought was worth advertising with Mr Cohen (presumably so they could sell it) - but in fact represents a fantastic investment.

I see three possibilities:

• 1.  Soros has found the well promoted penny stock that really is worth your hard earned cash or
• 2.  The Soros organization have become active participants in penny stock schemes or
• 3.  That Soros organization has a rogue analyst/fund manager who is (knowingly or unknowingly) involved in stealing large licks of money by investing in dodgy promotes run by Civelli and his agents.

Stuffed if I know.  I have no position.  But I would be very wary shorting Manas – Civelli stocks have often gone for enormous runs before blowing up and Civelli has backed real finds like Arakis (even if they were excessively hyped). 

 

 

John

People like me in Thailand

This post is motivated by my local dead-tree (the Sydney Morning Herald) wasting good column-inches on Kriangsak Kittichaisaree – the Thai Ambassador to Australia.

Once upon a time I unfortunately purchased a stake in Bangkok Bank. The bank – a survivor from the Asia Crisis – is a run really well by a Thai-Chinese family. Its loan book was conservative – and was working through the last of the Asia-crisis problems.

Bangkok Bank’s biggest problem was that Siam Commercial Bank (a bank controlled by the Thai Royal Family) was trying to grow like topsy especially in consumer loans after bringing in some McKinsey consultants who thought that American style consumer lending was exactly what was needed in Thailand. Siam Commercial had imbibed the banking philosophy that was to lead the world to ruin. Bangkok bank was actually run by sensible people who behaved as owners. I never met them – but I suspect I would really like them.

As part of the research I chatted to the investor relations or CFO of every reasonably sized Thai bank. I also chatted to some people at GE Finance who had been involved in the purchase of Bank of Ayudhya.

My problem was that I failed to heed the elephant in the room. Every Thai person I spoke to identified what they saw as the risk - Thaksin Shinawatra. Thaksin was a populist and popularly elected politician who was modestly corrupt (at least by the standard of developing countries) but who had a patronage network outside Bangkok (especially outside the Bangkok elite). Stylistically the comparison (made by many and I do not think too unfairly) was to Mussolini. More fairly he was in the mold of Berlusconi – the richest guy in the country using his power as such to win elections and rig the game in his favor.

Every single person I spoke to hated Thaksin. These were the educated finance professionals and managerial class – people like me. Many of them were liberal-democrats in the soft-liberal sense – really like me. Sometimes the hatred stretched to loopy conspiracy theories – but generally they just thought it was something worth ear-bashing a foreigner for about twenty minutes on. Everybody had an opinion – and it was the same opinion.

The elephant in the room of course was not Thaksin – it was the views of the elite about him. It was a view tainted a little with racism or at least regionalism – with the Bangkok elite looking down on people from the provinces (especially those from Issan whose first language was sometimes Khmer but more often a dialect of Lao and who they would suggest had darker skin though I never noticed the skin tone). [For those who study these things young women from Issan dominate the sex-tourism industry in Thailand reflecting their origin from poor and less educated rural areas. These are not the Bangkok elite.  Rural lightly educated or uneducated poor were the core supporters for Mussolini too.]

Still – as a keen observer of the United States I was getting used to seriously polarized politics. There were plenty of liberals (sometimes liberal-elites) who hated George Bush with similar vehemence. There are plenty in America who hold similar ill-will towards Obama. The big difference was that in Thailand I could not find a single Thaksin supporter amongst the people like me whereas there are many conservative (or more commonly libertarian) people in the American financial elite.

When the coup happened I was not particularly surprised – and (foolish me) not particularly alarmed. After all the people who supported the coup – at least tacitly – were people like me. The military decorated their tanks with yellow ribbons – signifying their loyalty to the King (and hence – as someone who comes hails from a democratic-constitutional monarcy) to some loyalty to the framework of democratic-monarchy. 

When the Thaksin’s party (the Peoples Power Party) won the post-coup election I suspected we would just get back the same politics minus some of the corruption.

Alas it was not to be. The Orwellian named People’s Alliance for Democracy - the Yellow Shirts who don’t want to accept that Berlusconi (sorry Thaksin) was democratically elected – set out to make Thailand ungovernable if elections were fair. [Remember the occupation of Bangkok airport which did not end with snipers and hail of government bullets.]

But be clear what people like me have done in Thailand now. They have subverted democracy with a military coup and a refusal to accept the result of the subsequent election. And they have shot people that have disagreed with them.

An American equivalent would be if (say) the Tea Party (displacing its predecessor Republican Party) won the US Presidential elections and – like many demagogues – turned out to be modestly corrupt. In response a coup was organised by the displaced elites (Democrats and non-Tea Party Republicans) and Tea Party protestors were subsequently shot in the street.

In most civilised countries the actions of the past-elites would be called Treason. In America the military leaders of any such attempted coup would be court-martialled and receive the death penalty. What is more – even as someone who opposes the death penalty I would shed no tears... the alternatives are Hobbsian.

And that is where people like me have got to in Thailand which is a rather sobering thought indeed.

 

 

John

PS.  If you do not think the Government looks like a collection of liberal-elite then look at on Kriangsak Kittichaisaree’s CV which lists amongst other things a specialisation in law of international human rights at Harvard.  I wonder where they taught him that it was acceptable to be the Ambassador for a Government that shoot in the streets people who want the re-establishment of a popularly elected (albeit corrupt) democratic government.  I look forward to his resignation on principle. 

Post script:  many people have complained about my analogy of Thaksin to various Italian leaders.  This analogy is often used by the Thai elite – and is not mine.  The fair comparison I think is Berlusconi – who used his control of the main media to get elected – whereas Thaksin used methods more akin to vote buying.  [My Italian friends – again people like me – hate Berlusconi with a similar vehemence but they would not have condoned a coup.]  That said the Thai Foreign Minister just the other day was using the Mussolini comparison.  I do not want to get into direct analogies of policies – because – frankly they fall down.

From the perspective of the Japanese household

Japanese bonds – yielding close enough to zero – have been a fantastic investment for about twenty years. 

After all seven year JGBs were yielding above 1 when I was (unfortunately) short them.  Nominal prices were dropping more than three percent per year.

So the return on owning JGBs was over 4 percent real per year.  Tax only applied to the nominal part of the return – so the post tax return was about 4 percent per year REAL.

Now how long did you need to hold stocks to get a 4 percent post-tax real return? 

Mrs Watanabe with her large JGB holding has seemingly done OK.

Just saying…

 

 

John

First Solar – a follow-up post the result

Such is the life of a short-seller.  The biggest short in our fund (First Solar) came out last night (Australian time) and – again to use the Australian vernacular – hit us around the head with a bit of 4 by 2. 

It was ugly.  The stock was up almost 18 percent and was the best performed stock in the S&P.  Moreover it has been up for a few days prior to the result.  This has not been a profitable position.

On the plus side we run a portfolio – and somewhat unbelievably the customers performed about with market despite this blow.  Obviously Bank of America – our biggest long – was up 5 percent – and that position is more than double the size of our First Solar short.  Also – and less obviously – our next biggest short (which I will refrain from naming) was down hard.  Those two more than offset First Solar and the rest of the portfolio was merely OK.  [Even the Spanish bank short – also a largish position – did not hurt us despite Santander’s blowout results.] 

If you just looked at the aggregate you would not even notice the “First Solar Pain” – but I don’t look at the aggregate – and I am hurting – if only via wounded pride.  So it is time to have a re-examination – a look at what went wrong or did not go wrong.  After all I need to know whether to persist in this loss-making position.  As I introduced you (dear reader) to my initial thoughts I will introduce you to my continuing thoughts.

When to persist with a loss making short

There are three reasons for covering a short – and only one of them is a happy reason. 

The first reason is that the thesis has played out and you have made your profit. 

The second reason is that your thesis is wrong.  At Bronte Capital we have a strict “no broken thesis” rule.*

The third reason for covering a short – one that happens all-too-often – is that the short poses too much risk and must be reduced for risk control.  This happens with shorts but not longs because when a long goes against you (that is down) it gets smaller and hence does not threaten the fund.  When a short goes against you (up) it gets larger and hence often must be reduced for risk control reasons.  This is the main practical difference between shorting and traditional long investing.  Positions on which you are wrong shorting hurt a lot because they get larger and you wind up wrong on larger positions.  (Leveraged long investing – which we do not do – requires risk management similar to shorting.) 

Anyway – there are only two reasons I will cover the First Solar short after this beating.  One is risk control – and that is more-or-less automatic.  If the position is too large we will trim it.  The other is that our thesis is wrong.

I am not going to tell you about the risk control process (unless you want to become a client).  I will tell you about the thesis.

Our thesis – and the the First Solar results

Our thesis for First Solar – run through in detail in the two earlier posts [here and here] has a few parts.

Part A - is that crystal silicon modules (c-Si) are becoming cheaper to manufacture because the Chinese are getting good at producing them and that the most expensive ingredient (polysilicon ingot) is becoming substantially cheaper as the market has become competitive and glutted.

Part B – is that the Chinese c-Si producers are competitive and that over time the price of modules will come – through normal competitive pressure – down to near the cost of c-Si cells – that is costs will determine prices.

Part C – is that the lower price of c-Si modules will compress First Solar’s margins (First Solar uses a thin-film CdTe technology) and competes almost entirely with c-Si manufacturers.  Moreover First Solar will not be able to reduce its costs because it is so efficient already – essentially that FSLR’s “roadmap” to lower costs is nonsense.

Bluntly – it is Part B above that I am wrong on.  The price of modules received by FSLR was very good and margins remained fat (and indeed got fatter).  In the original thesis Part B was the bit without a time-frame – and I might be right or might be wrong on it in the long run – but I am most certainly wrong on the basis of the last quarter.

Lets deal with the bits I am right on so far -

Part A:  There is no doubt that c-Si cells are becoming cheaper to produce.  First Solar said “the low end of guidance has resilience to $40/kg poly and c-Si processing cost of 75c/watt by Q4 for non captive demand”.  (See p23 of the results presentation.) 

I am going to come back to that sentence because I think it is central to what has happened – but for the moment note that these are assumptions about competitor costs that were unthinkable only 18 months ago. 

The cheapest of the competitors (say YingLi) will be below 75c/watt by Q4 – but it is unlikely the average Chinese manufacturer can get to that target.  As for the poly price I think it will be below $40/kg – but it is not there yet.  That said – it is obvious that they need to deal with competitors with much lower cost structures than previously.  The first part of my thesis is not broken. 

Part C: The company has an aggressive plan (“the roadmap”) for reducing their costs per watt by the end of 2014.  This plan was illustrated in the following (not to scale) picture:

 

Note – the vast bulk of the cost-saving (18-25 percent) was to come from “efficiency”.  Well the conversion efficiency of the cells remained unchanged at 11.1 percent (see p.28 of the results presentation).  They need – as my last post explained – to improve the conversion efficiency by approximately 15bps per quarter over four years to meet their target.  They are behind schedule.

The company states its cost per watt each quarter.  Usually they cite “core costs” (that is not including “stock compensation” and “ramp up penalty”).  Those costs were stable at 80c/watt.  This quarter they cited “total costs” in the conference call as those dropped 3c/watt to 81c/watt. 

They can’t meet their targets by dropping non-core costs to zero – they have to improve their core costs – and the main way that they plan to do that is via increasing conversion efficiency – and they are not on target.  The third part of my thesis is thus not broken.

The problem part of my thesis

The problem part of my thesis is pricing.  And boy is that broken. 

In the fourth quarter of 2009 – a quarter that disappointed – First Solar had operating profit of roughly 145 million and production of 311 MW.  Some of the profit is for their development business – but – at a first approximation it is reasonable to think of this as operating profit of 47c/watt.

In the first quarter they had operating profit of 191 million and (nicely increased) production of 322 MW.  This is – at a first cut – operating profit of 59c/watt. 

Now operating costs per watt only changed 3c/watt (and all of that was “non core”).  Operating profit changed 12c/watt.  The company shot-the-lights out on price received.

Unless there is something peculiar about First Solar this will probably apply to every solar producer – including the marginal Chinese.  But whatever – competition has not driven down prices at least yet. 

Competition and prices

It is a core part of my world view that competition tends to squeeze margins – but it has not happened here.  There are short-term reasons that are easily identified.  The most obvious is that Germany has a concessionary feed-in-tariff regime which will be adjusted (down) from the end of June.  There is massive demand in Germany for panels to be installed by the end of the second quarter.  First Solar is sold out. 

That sort of demand pressure (sudden, urgent) is enough to delay what (I hope) is the inevitable reduction of prices to reflect lower Chinese costs. 

However whilst it is part of my world-view that competition tends to squeeze margins it is not universal.  Some things just don’t have much competition – I never notice margin squeeze at Microsoft.  Also some things that are ostensibly competitive (beverages) seem to maintain fat margins for very long times (for example Coca Cola).   I don’t see any particular reason why the third part of my thesis won’t be right eventually but I am open to persuasion otherwise. 

The prices received

I said I would get back to the mathematics of the guidance – in particular the comment that: the low end of guidance has resilience to $40/kg poly and c-Si processing cost of 75c/watt by Q4 for non captive demand.

Now c-Si cells use about 6.5 grams of poly per watt (a number that is reducing).  This means that the guidance is resilient until the c-Si makers have costs of (75c plus 0.0065*40c)/watt = $1.01 per watt.

Now c-Si cells should (and do) sell for more per watt than other cells (such as amorphous silicon) because c-Si cells are cheaper to install due their higher efficiency.   I thought that difference should be about 15c/watt – but I have seen numbers as low as 9c/watt and as high as 30c/watt.  The usually accepted number is about 25c/watt – but – to make the case as favorable to FSLR as possible I will chose a low (10c/watt) penalty. 

If we get to prices being set by C-Si costs at $1.01/watt (plus say 8c/watt profit for the Chinese producers) then we should get to 99c/watt (including profit) for FSLR.  FSLR’s costs are at 80c (core costs) and for the moment look pinned.  This implies margin at FSLR at 18c.  This could be higher if FSLR reduces costs – but is unlikely to be dramatically higher.

FSLR’s margin in the first quarter was 59c/watt.  Bluntly – if the Chinese get to the costs on which the FSLR’s guidance is based then FSLR’s profit crashes if FSLR has to match the Chinese prices. 

It would be hard to see how FSLR can maintain its guidance under these conditions.  Except that FSLR gives us an out – they say that they are resilient “for the non-captive demand”.  FSLR can maintain higher selling prices because it has “captive demand”.

FSLR has captive demand because it is also a project developer and it purchased another project developer (Next Light Renewable Power) very recently. 

The question is – is it sustainable to be selling to internal or captive power developers at prices substantially above Chinese costs?  Obviously it is in the short term because the solar panel market is “sold out”.  It is not so obvious in the long term.

In the long term either (a) the prices at which First Solar sells to “captive demand” has to match the Chinese prices or (b) First Solar is investing its balance sheet in high cost (and hence uncompetitive) captive projects. 

Obviously this can continue for a while – whilst prices remain high for solar panels.  But I think it will end – and FSLR’s earnings will crash when it ends.  I think Part B of my thesis is only temporarily wrong.  So I will (subject to risk management) keep my position. 

The market of course has a different view – and that difference is painful.  Having a short go up almost 20 percent on a result is – to put it mildly – unpleasant. 

 

 

 

John

 

*The no-broken thesis rule was detailed in David Einhorn’s book on Allied Capital.  Its funny but in a book about a more-than-average difficult short the thing I most benefited on was some (very) wise words on portfolio management.   

The arithmetic of bank solvency – part 1

This is a post driven by Krugman’s many debates on  bank profitability.  In particular, a post from Krugman – about why banks are suddenly profitable – and the debates it engendered amongst my friends is the origin of this post.  Long-time readers of my blog will know I have explored these ideas before.

First observation: at zero interest rates almost any bank can recapitalize and become solvent if it has enough time. 

Imagine a bank which has 100 in assets and 90 in liabilities.  Shareholder equity is 10. The only problem with this bank is that 30 percent of its assets are actually worthless and will never yield a penny.  [This is considerably worse than any major US bank got or for that matter any major Japanese bank in their crisis.]

Now what the bank really has is 70 in assets, 90 in liabilities and a shareholder deficit of 20.  However that is not what is shown in their accounts – they are playing the game of “extend and pretend”.

Now suppose the cost of borrowing is 0 percent and the yield on the assets is 2 percent.  [We will ignore operating costs here though we could reintroduce them and make the spread wider.]

This bank will earn 1.4 in interest (2 percent of 70) and pay 0 in funding cost (0 percent of 90).  It will be cash-flow-positive to the tune of 1.4 per annum and in will slowly recapitalize.  Moreover provided it can maintain even the existing level of funding it will be cash-flow-positive and will have no liquidity event.  (It does however need to be protected from runs by a credible government guarantee.)

Now lets put the same bank in a high interest rate environment.  Assume funding costs are 10 percent and loans yield 12 percent.

In this case the bank earns 8.4 per year in interest (12 percent of 70) and pays 9 per year in funding (10 percent of 90).  The same bank with the same spread is cash flow negative.  

This is an important observation – because – absent another wave of credit losses – a marginally insolvent bank with a government guarantee will certainly recapitalize over time provided its funding costs are pinned somewhere near zero.  The pinning of the funding costs near zero is not a subsidy (except in-as-much-as the government guarantee is a subsidy).  Both these banks have the same spread and have the same profitability.  The answer depends criticially on whether you can pin the funding to a low interest rate. 

Banks and sovereign solvency

All banks more or less anywhere get their finances entwined with the finances of the sovereign.  No sovereign will (or in my opinion should) allow a mass run on banks but they can only stop such a run if their own credit is good.  But this link between sovereign solvency and bank-system solvency means that bank funding costs at a minimum are bounded at the lower end by sovereign borrowing costs.

It was pretty clear in the crisis where the US Sovereign borrowing costs were pinned.  I barely cared whether BofA was solvent when I purchased it (but I was pretty sure it was).  I cared that the US government was going to pin its funding costs.  Buying BofA at low single digits was – in the end – a bet on US Government solvency.

On the same token Spanish banks may go the way of Greek banks.  They can’t control their funding costs because the Spanish sovereign cannot control their funding costs.  The idea that European sovereigns can default is now front-and-center.  And the Spanish banks can’t control that either.

Extend-and-pretend (what Felix Salmon crudely deigned to be the Hempton plan) worked well in America.  It won’t work in Spain because you can’t pin rates at zero even with a government guarantee.  The scale of financial restraint needed to solve this problem is enormous.  But the alternatives are worse.

 

 

 

John

Quote of the day: Bess Levin on the Goldman hearings…

Bess Levin is truly wonderful:

Apparently Goldman didn’t just hurt its clients, it hurt everyone in the world. Take a moment right now to show us on the doll where Goldman touched you.