Technology Investor 

Harry Newton's In Search of The Perfect Investment Newton's In Search Of The Perfect Investment. Technology Investor.

Previous Columns
8:30 AM EST, Friday, August 10, 2007:
"Father," the son asked, "Is there a guaranteed way to make a small fortune?"

"Yes," replied the father, "start with a large one."

Today we all have a small fortune. Ultimately, the markets will recover. They always do. Here's what happened earlier this year when we had another big day fall:

The biggest problem facing markets today is no longer the billions lost on bad, stupid, foolish loans to deadbeats to buy houses they couldn't afford -- . 10% to 20% of whom never made even one payment on their home loan. (I kid you not.) It's what else is wrong. And there are three other BIG things that might be wrong:

1. Easy money loans to other places. When the Fed dropped rates to almost nothing, it made money cheap and plentiful. Investment bankers organized loans to everybody and their uncle for not just subprime home mortage loans. Credit requirements were loose. Which ones have gone wrong? And who is still holding the bag? Loans these days are moved around, sold like hot potatoes from one institution to another. Companies now holding these loans are in big trouble. Right now we don't know who they all are, nor the full extent of the damage. Not knowing is not good for stockmarkets. They get fearful. Fear drives them downward, viz. yesterday.

2. Loans to hedge funds to buy equities. Many, many hedge funds borrowed cheap money to finance the purchase of equities. They did because it increases their return -- if the stocks go up. For example I own a stock that goes from $100 to $10. Hence I made 10% on my money. But if I borrow $50 to finance my buy, then my return had risen to nearly 20% (i.e. $10 divided by $50 less the interest on the loan). Let's say I borrow $90. Suddenly I've made nearly 100% on my money (i.e. $10 divided by $10 less the interest on the loan). If the stock rises to $120, my returns start to look really interesting. What happens, however, when the stock falls by $11? The bank calls me in a panic. They're about to lose money. I know own collateral that's worth less than the loan. They insist I sell the stock before it gets worse. I do and it gets worse. Selling creates panic and more selling. Hence yesterday's drop.

The sad part we simply don't know the full extent of the hedge fund disaster. Many hedge funds actually borrowed from several places, i.e. they had severla prime brokers. Many are leveraged up huge amounts -- like 100 to one. They borrow $99 to buy $100 stock. (I kid you not.) It takes only a small hiccup in the stockmarket to wipe out their net asset value (the value of their stocks less their debt obligations). Yesterday was not a small hiccup. It was a large one.

3. Many private equity deals are about to south. Private equity funds have been buying big public companies and taking them private. This has driven up the value of all companes, since many investors expect their favorite companies to be bought at a price higher than what it is currently trading at. Private equity funds borrow money to help pay for these takeovers. Many people call these takeovers LBOs -- leveraged buyouts. There'll be less money around for these deals. Hence, there will be fewer LBOs.

In these columns recently, I have been predicting exactly what happened yesterday. And I can see further big falls. Will we now flop into a recession? It's possble. It is clear that it will take time for this mess to unravel. But it will unravel. It always has. Stick with my rules. But remember the BIGGEST rule of them all, "When in doubt, get out" -- i.e. examine each stock you own. Dump the ones that might be harboring upcoming problems. That includes all financials.

In the long-run? My friend, Dan Good, a successful (now retired) investment banker, forecasted this morning, "The world economy is strong and after we give back the gains for 2007 and the credit markets stabilize, we'll be back to normal markets, probably in the late fall." I suspect he may be right.

Now, let's do some reading. The Wall Street Journal posted this piece early this morning, "Typhoon of Anxiety Roils Global Markets"

As questions grow about the extent of potential fallout from the mortgage crisis, the wave of anxiety that swept European and U.S. markets yesterday kept its momentum overnight, with asset prices dropping across Asia and a handful of central banks pumping extra liquidity into their local markets.

Central banks in Japan, Australia and Singapore injected cash into their local money markets in an echo of yesterday's moves by the European Central Bank and the Federal Reserve to keep lending rates at targeted levels, Dow Jones Newswires reports. Meanwhile, authorities in Malaysia, the Philippines and Indonesia stepped into the foreign-exchange markets, selling dollars to support their currencies. In Tokyo, the Bank of Japan injected a trillion yen, or $8.4 billion, after lending rates rose above its policy rate, while the Reserve Bank of Australia coughed up about $3.2 billion, twice the liquidity required, Dow Jones says. Traders told the news agency that the Monetary Authority of Singapore injected nearly $1 billion into that market, although shortly after, the city-state's overnight deposit rate was a stubborn 2.75%, well above 2.25% a day before. Other central bankers around the region, including in South Korea, stepped forward to say they would inject funds if short-term lending rates became volatile. The events in Asia are particularly startling because central bankers in the region have kept a steady focus on containing liquidity to fight inflation, as The Wall Street Journal notes; both the Australian and Korean central banks raised interest rates this week.

Barclays Capital analyst Masuhisa Kobayashi wrote in a research note that Friday's moves either mean the credit market has destabilized so much that central banks had to act, or the action was merely meant to prevent such a situation, Dow Jones reports. "The market seems to have taken the former, more pessimistic view," he said. Indeed, Asian stocks slumped the most in more than a year, with benchmarks in the region's eight biggest markets all sliding as much as 2%, Bloomberg reports. South Korea's Kospi index plunged 4.2%, the most in three years; Australian shares lost 3.7%, their biggest decline since September 2001, and in Singapore, investors ignored news that the economy grew at its fastest pace in two years last quarter and sold off shares to the tune of 3.2%. In Europe this morning, the ECB also injected cash for the second straight day, adding nearly $84 billion to money markets as stock indexes around the region slumped again. "There are indiscriminate sell orders from panicked investors,'' Liu Juming, a fund manager at Ta Chong Investment Trust Corp., which manages $1.1 billion of assets, told Bloomberg. "The old saying in the investment world that 'cash is king' came about because of days like today."

As on both sides of the Atlantic yesterday, the big question, as Businessweek puts it, is whether the large but isolated problem -- liquidity shrinkage prompted by the subprime crash -- metastasizes into something harder to contain. "It's a question of confidence," Businessweek cites Charles Diebel, head of interest-rate strategy for Nomura Securities in London, as saying. "There's plenty of cash out there, but there are a lot of small fires burning." Where those fires are burning is the next question: The Journal reports that the Securities and Exchange Commission is checking the books at top brokerage firms and banks, including Goldman Sachs and Merrill Lynch, to make sure they aren't hiding losses from the mortgage meltdown. People familiar with the matter tell the Journal that the regulator wants to know whether Wall Street brokers are using consistent methods to calculate the value of subprime-mortgage assets in their own inventory and that held for customers like hedge funds. The Journal writes that fund managers have broad discretion in attaching a value to suprime assets, and it is hard to establish an accurate price for them because, unlike stocks or bonds listed on an exchange, they can't be readily bought or sold. "I don't think any of the regulators have a handle on where the net exposure of subprime is," Christopher Whalen, managing director of Institutional Risk Analytics, which builds risk systems for regulators and auditors, told the New York Times.

Mr. Whalen said the situation is worse in Europe, where even less public data is available, the Times writes. And U.S. subprime assets that found their way to Europe apparently may show up in unexpected places. An affiliate of IKB Deutsche Industriebank, which is currently being bailed out by German private and government-backed banks, bought bonds backed by U.S. mortgage payments and, to fund such purchases, sold commercial paper to Robbinsdale Area Schools district in a northwestern suburb of Minneapolis, to the city of Oakland, Calif., and the Montana Board of Investments, the Journal reports. The buyers evidently weren't aware of the potential perils of their investments. "We don't take risks," Katano Kasaine.

"LBO shops circle ravaged loan desks" came from The Deal last night: This piece shows how our ills are already beginning to work themselves out..

Sensing opportunity amid the credit markets' woes, several private equity firms are angling to purchase buyout-related loans and bonds at steep discounts from banks' trading desks, sources said.

Ironically, these are often the same private equity firms that have forced the banks to honor loan and bridge financing commitments that the banks now seek to unload by selling them at a discount.

According to several market sources, firms such as Apollo Management LP, Bain Capital LLC, Blackstone Group LP, Carlyle Group, Kohlberg Kravis Roberts & Co., Thomas H. Lee Partners LP and TPG have been mulling moves to step into the loan and bond secondary markets to buy bank debt and profit from fire sale prices.

"We're all trying to get this off the ground," said one professional at a private equity firm.

One head of trading at a major investment bank tacitly confirmed that conversations with the private equity firms are taking place. "We're talking to everybody," the trader said. He noted that his firm was not willing to unload its debt at any price but would sit on it if it had to. "We're a very patient firm," the trader said.

Making this trend particularly interesting is the fact that private equity firms are looking at buying debt in deals that have just been completed, and that banks have been unable to syndicate, which has led to a freezing up of lending markets that had hitherto been fueling the most active LBO environment in history.

Sources indicate that Apollo has been particularly active, buying a large chunk of the debt of Thomson Learning, a company that was bought by Apax Partners and Omers Capital Partners for $7.75 billion. Thomson's lenders, led by Royal Bank of Scotland plc, were only able to syndicate the deal after adding covenants and raising interest on the debt.

Sources also contend that much of Dollar General Corp.'s subordinated debt has been bought by one of the bidders who lost out to KKR on the auction for the company. Although the buyer couldn't be identified, reports have indicated that Blackstone Group, Bain Capital and TPG were among the bidders for the company in March. KKR bought discount retailer Dollar General for $7.3 billion, then financed the deal with an aggressive covenant-lite loan and payment-in-kind bonds that the lending banks, led by Goldman, Sachs & Co., were unable to syndicate last month, helping precipitate the current credit-market crunch.

The private equity firms either didn't return calls or declined to comment.

The buyout shops are attracted to the secondary markets because much of the debt is trading below par, pushing yields up to double-digit levels. The LCDX index of bank loans, for example, hit an all-time low of 90 (par value is 100) at the end of July due to the expectation that the majority of a $240 billion backlog of bank loans will get hung up in coming months and the simultaneous withdrawal of collateralized loan obligation funds from the market. High-yield bond prices have fallen as well, and, although both loans and bonds have stabilized in recent days, Thursday, Aug. 9, saw a fall-off in prices prompted by news that Paris-based BNP Paribas SA had suspended redemptions in three hedge funds, citing problems in the U.S. subprime market.

These falling prices are forcing the private equity firms to consider bank loans a viable investment opportunity, because few expect to be able to complete traditional buyouts in the coming months due to a credit crunch that many see extending well into the fall.

"They're all looking to get into the asset class because it's dramatically oversold," said one leveraged finance banker.

One partner at a major private equity firm, however, notes that while the investment opportunity is good in theory, several firms are struggling to find leverage to finance the strategy. Ironically, it is the very same banks that are holding the paper that will have to lend money to leverage the deals, which is becoming a difficult proposition in the current environment, where banks are reluctant to lend.

"This is a great idea, but it depends on the tooth fairy giving me leverage," the partner said.

One banker noted that the issue of private equity firms swooping in to buy discounted debt in the very same deals they've forced the banks to carry may be irksome, but many desks will do whatever they have to do to sell the debt at the highest price they can.

"If that's your best bid, you're going to sell it to them," the banker said.

Take this message to the moon
When NASA was preparing for the Apollo Project, it took the astronauts to a Navajo reservation in Arizona for training.

One day, a Navajo elder and his son came across the space crew walking among the rocks. The elder, who spoke only Navajo, asked a question. His son translated for the NASA people: "What are these guys in the big suits doing?"

One of the astronauts said that they were practicing for a trip to the moon. When his son relayed this comment the Navajo elder got all excited and asked if it would be possible to give to the astronauts a message to deliver to the moon.

Recognizing a promotional opportunity when he saw one, a NASA official accompanying the astronauts said, "Why certainly!" and told an underling to get a tape recorder. The Navajo elder's comments into the microphone were brief.

The NASA official asked the son if he would translate what his father had said. The son listened to the recording and laughed uproariously.
But he refused to translate. So the NASA people took the tape to a nearby Navajo village and played it for other members of the tribe. They too laughed long and loudly but also refused to translate the elder's message to the moon.

Finally, an official government translator was summoned. After he finally stopped laughing the translator relayed the message: "Watch out for these assholes. They have come to steal your land."

This column is about my personal search for the perfect investment. I don't give investment advice. For that you have to be registered with regulatory authorities, which I am not. I am a reporter and an investor. I make my daily column -- Monday through Friday -- freely available for three reasons: Writing is good for sorting things out in my brain. Second, the column is research for a book I'm writing called "In Search of the Perfect Investment." Third, I encourage my readers to send me their ideas, concerns and experiences. That way we can all learn together. My email address is . You can't click on my email address. You have to re-type it . This protects me from software scanning the Internet for email addresses to spam. I have no role in choosing the Google ads. Thus I cannot endorse any, though some look mighty interesting. If you click on a link, Google may send me money. Please note I'm not suggesting you do. That money, if there is any, may help pay Claire's law school tuition. Read more about Google AdSense, click here and here.
Go back.