Harry Newton's In Search of The Perfect Investment
Newton's In Search Of The Perfect Investment. Technology Investor.
8:30 AM EST, Monday, August 6, 2007:
The party is well and truly over, at least for now. We
are moving into a recession. Share prices will tumble further. Friday's 281
point drop in the Dow was just the beginning.
I am not normally a panic merchant. But this "call" is bleeding obvious.
The only thing that can stop the red ink is immediate action by Bernanke to
pump liquidity into the banking sector and drop the prime rate. I can't call
that one. He's getting a lot of phone calls and feeling a lot of pressure.
Here's the simple
story: Huge losses are appearing in housing loans. A big percentage of those
loans are now worthless. No one knows how many. But the losses have thrown Wall
Street into turmoil. Suddenly no one knows whether the loans they're making
are good or bad. No one knows if the loans they might make are saleable, and
at what price. Since loans are now bundled and sold, no one knows if there'll
be a buyer and at what price. The fear is that loans made today might be sold
tomorrow at a loss.
In this uncertainty,
the human brain makes one "decision." It shuts down, awaiting clarity
and stability. Hence, the banking and investment banking community has essentially
shut down making loans. This has three effects:
1. It kills the
housing business, and hurts all those companies supplying that huge industry.
2. It puts less
money into consumer hands. Remember all those refinancing mortgage loans? Consumers
are 70% of the economy. They have been the mainstay of the economic boom of
the past few years.
3. It puts less money into companies' hands for plant expansion, etc. This is
sad because this area was just beginning to take off.
Now, switch gears.
What would you do if you were a mutual fund, a hedge fund or Warren Buffett?
Buy equities? No way! The outlook for them looks suddenly bleak. They're already
fully priced (or were until late last week). With money drying up, there won't
be anyone around to buy them. Much, much better are bonds and other debt instruments.
are on fire sale. Corporate bonds are way down in price. Some are now yielding
10%+. (Read the cover story in this week's Barron's).
Think earning 10%+ plus the capital appreciation you get when this crisis passes
(a year or two) and the bonds go back to par. Many debt instruments are presently
in limbo. Investment bankers have promised money to corporations, to private
equity funds for buyouts... But no one will buy these instruments -- or at least
not the people who bought them last week. Step in mutual funds. Step in hedge
funds (those surviving). Step in Warren Buffett.
investment bankers are presently feeling will turn into great bargains for mutual
funds, hedge funds and Warren Buffett. While they troll for "bargains"
in bonds, they won't be buying equities. In fact, they'll be selling
equities for two reasons: to finance their bond purchases and to finance their
investor withdrawals. I'm not the only hedge fund investor feeling squeamish
about equities. Thousands of investors are scrambling to get their money out.
As they rush for the door, this can only produce panic selling.
are strong stuff. To check, I sent my comments to my favorite guru. His reply:
The only thing
I would say is that this is a credit crunch, which can, and likely will, be
solved by people stepping in and making markets the way you outline. They
will not completely stop buying equities while they do this. If we can stop
the credit crunch, we can stop the depression. I think the odds actually favor
that outcome dramatically. The markets will be very volatile in the coming
days and weeks, but I would still place my bets against depression and crashes.
My equally favorite
other guru replied:
Why would a
Fed cut help? Subprime borrowers are dead regardless, and corporate borrowers
are being repriced from 200 to 500 bp or more above libor, so a 25 or 50 bp
cut aint going to do much for them either.
But I agree
the party is over, I just dont think the Fed can (or should) try to
keep the party going.
Today is already
tomorrow in Asia. Monday was grim -- in some cases grimmer than Friday 2.2%
drop in the Dow.
You can from this chart on Australia how small stocks are getting hit hardest.
Small stocks are big trouble. When bad things happen, people dump their small
OK. The rest of
today's column consists of articles I read on the weekend, which deal with capital
markets. Sorry there' so much of it. But this is engrossing. And to get a full
picture (not just my biases), you need to read all this stuff:
in America, August 6, 2007: from the Sydney
THE head of
National Australia Bank, John Stewart, said problems in the US subprime housing
mortgage sector would continue to play havoc with the US financial system
but Australia should be largely immune.
Mr Stewart told
ABC television the magnitude of the problem in the US was wide.
serious and it's got a lot further to go, it's about 15 per cent of the mortgage
market in the US," Mr Stewart said.
you an idea, that is about $US1.3 trillion [$1.5 billion]. Right now about
20 per cent of it is in arrears."
US hedge funds
associated with subprime mortgages would feel further pain, he said, possibly
for another two years.
Loan Comes Due by Floyd Norris of the
New York Times, August 5:
its not so easy to borrow.
That is true
for homeowners, and it is true for companies.
Only two months
ago, it seemed as if almost any company could borrow money at low interest
rates. Now loans seem to be drying up everywhere.
What had seemed
like a contained problem, involving home loans to people with poor credit,
has suddenly mushroomed into a rout that threatens to make life difficult
for everyone who needs to borrow money.
are likely to pay more for mortgages, and some with less-than-pristine credit
or an inability to come up with a down payment may find they no longer can
borrow at all.
A German bank
had to be rescued by other banks last week, because it had speculated in securities
backed by American mortgages. One of the biggest mortgage lenders in the United
States collapsed, and another said it would drastically scale back its lending
because it cannot find investors willing to finance the loans it makes.
The volume of
new high-yield bonds also known as junk bonds fell by 89 percent
in July. The market for loans to highly leveraged companies has almost dried
up. Standard & Poors counts $35 billion in corporate loans that
have been delayed or canceled, including loans to finance the leveraged buyout
deal will go through, because banks had promised to lend the money if others
would not take the loans. But from now on there are likely to be fewer corporate
takeovers, and those that do take place are likely to be at lower prices.
This is a classic credit correction, said Jack Malvey, the chief
global fixed income strategist for Lehman Brothers. The magnitude of
risk was significantly underappreciated.
investors have been pulling back rapidly, with more than $1.3 billion coming
out of funds that invest in leveraged loans during recent weeks, and $2.7
billion leaving funds that buy high-yield bonds, according to AMG Data Services.
which had been major buyers of complicated securities that financed leveraged
loans and mortgages, have also pulled back. Some investors have tried to pull
money out of such hedge funds, leading Bear Stearns to stop investors from
making withdrawals from three of its funds.
the core of a financial crisis, when too many people head to the exits simultaneously,
said Robert Bruner, the dean of the business school at the University of Virginia.
Mr. Bruner is
the co-author of a book on the Panic of 1907, to be published next month,
and he sees similarities between then and now. It was a time marked
by the rise of new financial institutions and new financial instruments,
he said. It marked the end of a period of extraordinary growth, from
1895 to 1907.
The credit market
has changed drastically in recent years, as banks grew far less important
and credit rating agencies like Standard & Poors and Moodys
became the essential players in the new financial architecture.
whether mortgages or loans to corporations, were financed by selling securities.
It was the credit agency ratings that determined if those securities could
be sold, and deals were structured to meet the criteria set by the agencies.
turned out to be very generous. The agencies figured that even very risky
loans were unlikely to cause big losses, and so most of the securities backed
by loans to poor credit risks could get AAA ratings the highest available
as long as those securities had first claim on loan payments. Investors
bought the securities thinking they were completely safe, and some did so
with borrowed money.
there is fear even about those securities. The rating agencies are changing
their criteria for the loans, and many investors no longer trust the ratings.
are very panicked and illiquid, said Mike Perry, the chief executive
of IndyMac Bank, the ninth largest mortgage lender in the first half of this
year, as he announced plans last week to curtail lending sharply. It is very
difficult, he said, to find buyers even for the AAA securities.
All this has
happened with few defaults. Mortgage delinquencies are up, particularly on
loans made in 2006 when credit standards were very low, but the real problem
is that lenders and investors fear things will get much worse.This is
what we would characterize as the first correction of the modern neo-credit
market, said Mr. Malvey of Lehman Brothers. Weve never had
a correction with these types of institutions and these types of instruments.
It now seems
likely that the rating agencies, and investors, were lured into a false sense
of security by the lack of defaults. With the value of homes, and companies,
rising, it was usually possible for a borrower in trouble to refinance the
debt or, at worst, sell the home or business. Either way, lenders got paid.
Now, there is
less confidence that rising prices will bail out lenders, and there is doubt
not only about the quality of old loans but also about important parts of
the new financial system.
seem to be expressing concern about the performance and the stability of hedge
funds and, to a lesser extent, private equity funds, said Mr. Bruner.
The credit squeeze
is coming at a time when the American economy seems to be growing, despite
problems in the housing market, and the world economy is strong. The
underlying economy is very healthy, said Henry Paulson, the Treasury
secretary, as he visited China last week. But a good economy in no way precludes
credit problems. In fact, it is during good economic times that credit standards
are most likely to be so lax that bad loans are made.
panics dont happen during depressions, said James Grant, the editor
of Grants Interest Rate Observer. They happen on the brink of
depressions. The claim the world is prosperous is beside the point.
Not all panics
lead to economic downturns, of course, and if this one continues pressure
will grow on the Fed and other central banks to lower the short-term interest
rates they control and thus stimulate the economy.
banks do not always determine what happens in credit markets.
tightened in 2005 and 2006, but creative financing on Wall Street blunted
the impact, said Robert Barbera, the chief economist of ITG, a research
firm. The collapse of that option in the last 90 days means the entirety
of that tightening is arriving now, and there is a violent tightening going
Of course, this
phase will pass. The insurance companies and pension funds that are the traditional
buyers of bonds always have money coming in, from interest payments and bond
maturities, as well as from new business, and they will have to put it to
is that lenders move in great caravans between two extreme points, which we
can call stringency and accommodation, said Mr. Grant, recalling how
hard it was for companies to get loans as recently as 2002.
move back to accommodation one day, he said, but for now it appears that risky
borrowers,whether of the corporate or individual variety, will discover that
its much more difficult to find someone to lend money to them.
good time for a squeeze: From The Economist print edition
of August 2:
Tighter credit conditions are just what the markets need
investors might not agree, but the recent sell-off in financial markets is
good news. It may, at last, have brought people to their senses. For the past
few years, too much money has been lent too cheaply and too easily to too
many people, whether it was speculators trying to make a fast buck in Miami
condominiums or private-equity groups financing their latest multi-billion-dollar
takeover. This wake-up call came too late to save the American housing market
from frenzy and subsequent bust. But it may have arrived in time to stop the
takeover boom getting out of controland when the world economy is strong
enough to cope with the consequences.
Watch out for
the American consumer
The big question
now is how serious those consequences are likely to be. The impact on debt
markets themselves will be big (see article below). As standards are tightened,
many of the reckless practices that have become the norm in corporate lending
will be abandoned. We will now hear a lot less about firms getting covenant
lite loans, under which lenders give up their rights to monitor the
behaviour of borrowers; or payment-in-kind notes, which allow
borrowers to substitute more IOUs for interest payments. As investors steer
clear of riskier debt, the takeover bids that have pumped this year's stockmarket
froth will be curtailed and the most debt-laden borrowers may find it impossible
to raise funds.
But most companies
will be able to shrug off the credit squeeze. That is partly because creditworthy
borrowers still have access to debt (albeit at a higher price), and partly
because many firms don't have to borrow. Across the rich world, firms are
flush with cash. Their profits have been fat for the past five years and,
on average, companies have been funding their capital spending from their
own resources. Credit wobbles by themselves, therefore, need not prompt an
victims also seem well-prepared. Emerging-market bonds and shares, for instance,
may jitter further. That could spell trouble for a few countries, such as
Turkey, which have large current-account deficits (see article). But most
emerging markets are in far better shape than they were during the financial
crises of the late 1990s. They have restructured their borrowing and often
built up vast coffers of foreign-exchange reserves.
risk to the global economy probably lies with debt-laden American consumers.
They have been battered by falling house prices and expensive petrol, and
their spending growth has already slowed sharply. A credit squeeze will aggravate
the housing bust and falling house prices could drag spending down further.
But the rest of the world is growing strongly and unemployment in America
remains low, so a recession there is by no means inevitable. What's more,
if the economy were to head downhill fast, the Fed, despite its public worries
about inflation, has plenty of scope for cutting interest rates.
All told, the
credit wobbles so far are likely to have only modest economic consequences.
But what if they prompt a broader market meltdown? After all, many of the
newfangled instruments that dominate today's debt markets have never been
tested in a serious panic. Credit derivatives have probably improved the stability
of the global economy by dispersing risk, but it is no longer clear where
that risk is being held. And many of the new risk-dispersing instruments are
so illiquid that trouble may not emerge for some time. It was several months
after the subprime mortgage market turned sour before the scale of the losses
at two Bear Stearns hedge funds became clear.
right to worry about more hedge-fund failures. Yet although these highly leveraged
creatures seem to have made credit tremors more sudden and more frequent,
these episodes have not been more calamitous. The past 18 months have seen
two other credit wobbles, albeit on a smaller scale: one in May 2006 when
investors worried about inflation; another in February this year, when fears
about subprime mortgages first surfaced. In each case, the most exposed hedge
funds had to cut their positions quickly. But thanks to the size and diversity
of the hedge-fund industry, others moved in to buy the assets cheaply. The
same dynamic seems to be playing out this time too (see article).
For all the
hand-wringing about hedge funds and complicated derivatives, the real worry
comes from a well-known sourcethe banks. They will face trouble on several
fronts and it is they who could turn a healthy credit squeeze into a nasty
crunch. Many banks have already agreed to underwrite deals and are finding
that they cannot sell the debt on to investors. One estimate suggests that
more than $300 billion of debt is already in the pipeline. Big losses could
Banks will also
suffer from their exposure to failed hedge funds, just as some have already
been hit by their exposure to the subprime mortgage market. Some banks may
have as-yet-undisclosed losses on their own accounts: trading in financial
markets has become an increasingly important source of their profits in recent
years. If banks' profits collapsed, they would become more reluctant to lend.
A bank failure (or the fear thereof) could create a systemic panic.
banks are the biggest worry, their balance sheets look fairly solid. America's
commercial banks bought back $58 billion-worth of their shares in the year
to March, suggesting they have capital to spare. And although banks' shares
have tumbled over the past few weeks, analysts are still forecasting higher
profits for the year ahead. If the solidity of bank finances is to be tested,
the markets have chosen a good time to do so.
are unpredictable creatures. Things could still go badly wrong. So far, though,
the financial wobbles, however unnerving, look like a healthy repricing of
risk. Markets, much like people, sometimes need a good squeeze.
horrors. The effect on financial firms.
From the print edition of the Economist, August 2:
There are losers,
but some winners too
thinking how nice it would be to turn off my computer and not come back until
September, says the head of leveraged-lending at a large bank. As the
spasms in the credit markets claim more casualties, and unsold bonds and loans
for funding leveraged buyouts pile up, wails of pain are echoing across Wall
Street and beyond. But they are interrupted by the occasional hoot of pleasure.
Start with the
victims. For private-equity firms new deals are suddenly harder to do and
existing ones costlier to refinance. Their mega-funds may struggle to deploy
their estimated $300 billion-500 billion of financial muscle. This could scupper
Kohlberg Kravis Roberts's hopes of following Blackstone to the stockmarket.
KKR looks particularly vulnerable because it is less diversified than its
arch-rival in the leveraged-buyout business.
As credit for
buyouts dries up, the biggest losers are the banks left holding hung
bridges. These are loans to buyers that were supposed to be temporary
and for which the banks charged fees. As the price of the loans falls in the
secondary marketto below 85% of their value in some casesa number
of banks could face big losses. To add to their woes, private-equity clients
are also more likely to tap undrawn loan facilities which were negotiated
some time ago on more favourable terms.
Some of these
risks can be hedged in the derivatives markets. But with a backlog of more
than $300 billion, banks may end up selling loans at a discount to make room
on their books for new commitments. According to the head of a hedge fund
that does a lot of business with large banks, their lending desks are now
being stripped of risk-management responsibilities by livid chief executives.
One boss who
is probably more embarrassed than angry is Citigroup's Chuck Prince. His recent
comment that the bank was still dancing in the loan markets has
quickly returned to haunt him. Citi is the most exposed of all banks, having
tried to buy the market at the worst of times, as one competitor
puts it. It was the lead arranger on $25 billion of the roughly $40 billion
of bonds and loans withdrawn in recent weeks. Things may get worse: Citi is
involved in financing some giant buyouts still to come to the market, such
as TXU, a Texas energy-utility, and First Data, which processes credit cards.
be able to take the losses in its stride, given its enormous balance sheet
and low cost of funds (thanks to cheap deposit funding). But most investment
banks do not have the luxury of also being a big universal bank. No longer
happy to act mainly as middlemen, many have wanted a slice of the action themselves.
Wall Street's five big investment banksGoldman Sachs, Morgan Stanley,
Merrill Lynch, Lehman Brothers and Bear Stearnshave piled into potentially
illiquid (and thus risky) assets, from bridge loans to collateralised-debt
obligations (pools of tranched debt), over the past three years. Their lending
commitments rose from around $50 billion in 2002 to over $180 billion in 2006,
according to Moody's, a credit-rating agency. In Merrill Lynch's case, these
commitments far exceed the bank's capital basealthough they also include
safe loans to blue-chip companies.
of an investment bank today is more of a religious experienceone
based on faiththan an investment, says Dick Bove, of Punk Ziegel,
an investment bank. Bear Stearns's shareholders have had their faith severely
tested. Two of the bank's hedge funds have imploded and a third has stopped
investors from withdrawing funds. Even more vulnerable are stand-alone hedge
funds that borrow heavily to dabble in debt. As easy financing evaporates,
investors want their money back and the prime-brokerage units of banks that
lend to them want more collateral, or margin. Credit funds were
up by a mere 0.2% in June, according to Credit Suisse. Returns in July are
expected to be negative.
funds sink quickly in such choppy markets. Witness the demise of Sowood Capital,
a $3 billion fund that lost half its value in short order and this week sold
its credit holdings at a discount to Citadel, another hedge fund. Sowood was
caught out in two ways: it over-borrowed and its hedges failed to neutralise
its risks as expected. The debacle suggests that even the canniest of investors
can slip up: the managers of Harvard's successful endowment have lost $350m
investing in Sowood, according to reports.
of Citadelwhich last year snapped up bits of Amaranth, another troubled
hedge fundis seen by some as encouraging. It suggests that large, diversified
funds will not only survive, but could prosper by swooping on assets they
consider cheap. The top 20 or so funds, including Citadel, have the reputation
(and pay big enough fees) to negotiate hard for more flexible financing arrangements.
So they are less likely to get caught out.
Smaller funds can prosper too. Paulson & Co, a fund based in New York,
has done well from betting early that securities backed by subprime mortgages
would fall in value. The good times may continue for other funds that are
short on subprime.
But there are
signs that the pain is spreading to other countries. Several European banks
and insurers are rumoured to be sitting on mortgage bombstroubled
assets linked to America's subprime mess. IKB Deutsche Industriebank, which
lends money to Germany's middle-sized companies, is being bailed out by a
group of banks including the state-owned bank that partly owns it, thanks
to ill-judged punts on American mortgages. And Australia's Macquarie Bank,
which has been growing rapidly and buying up big infrastructure projects,
has said two of its funds may post losses because of subprime woes.
One German bank,
however, is doing well out of the subprime mess. After one of its analysts
predicted two years ago that a slump was coming, Deutsche Bank piled into
derivatives contracts that gain in value as the housing market sinks. These
bets are thought to have netted the bank at least $250m, perhaps much more.
But it is traders
of distressed corporate debt who are wearing the broadest smiles. After four
years of infuriatingly strong markets, they finally have wads of discounted
bonds and loans to feed on. Goldman Sachs, for one, has upped the size of
a junk debt-fund it is raising, from $12.5 billion to $20 billion.
Though the mood
has clearly darkened, no one really knows if this is the crunch that the markets
have been anticipating. As Stephen Green, boss of HSBC, a global bank with
copious subprime troubles, put it this week: It is too early to tell
if this is a temporary bout of indigestion or whether a whole new pricing
structure will have established itself when people get back from their holidays.
Turn off the computer, head to the beach, and hope.
of All Hedge Funds Gone? by John Mauldin:
Long time readers
know that I am a huge fan of Jeremy Grantham. He is one of the smartest and
most successful investors in the world. In his recent letter, he stated that
"within 5 years I expect that at least one major 'bank' (broadly defined)
will have failed and that up to half the hedge funds and a substantial percentage
of the private equity firms in existence today will have simply ceased to
I have to make
a comment on that. He may be right that 50% of the hedge funds that exist
today will be gone, although I doubt it will be that high. But the demise
of that many hedge funds is entirely predictable and something that we should
expect. Except for the largest funds, the vast majority of hedge funds are
small businesses. Michael Gerber estimates that 80% of all new small businesses
fail with five years of starting up, and 80% of the remainder no longer exist
in the next five years.
When you think
about it, the odds on being a successful hedge fund manager are not all that
high. To charge the fees that they do, they have to deliver the goods consistently.
In these markets, that is tough.
So, while a
lot of hedge funds in the market today will no longer be here in five years,
the real reason is that they simply did not generate enough cash flow for
themselves and their investors to survive. You can actually have a profitable
year and see your assets under management leave. 7% a year for three years
is not all that exciting.
And let me make
a few predictions. There will be thousands more hedge funds in five years
than there are today. And the industry will be twice as large. And that is
a very good thing.
everything is cratering. So this chart has less relevance than it
did when I first published it on Friday. Maybe it will be useful when things
return to normal.
Australian miners and explorers
Services, Banks, mortgage companies,
Oil Services and oil explorers
Real estate syndications**
top performing fund this year is its Emerging Markets Index (VEMAX), which is
up 20.9% so far this year and which I've recommended repeatedly. Sadly on Friday
it fell 2.47%.
** Commercial buildings are now too pricey.
*** Consumers pulled money out of their homes by refinancing mortgages. That
is over. Hence, consumer spending will drop.
loves Pfizer. 4.93% dividend yield and getting its act together,
albeit slowly. To replace Lipitor, which is going generic, I humbly offer some
suggestions for replacement drugs for women:
Take 2 and the rest of the world can go to hell for 8 full hours.
Suppository that eliminates melancholy and loneliness by reminding you of how
awful they were as teenagers and how you couldn't wait till they moved out.
ST. MOMMA'S WORT
Plant extract that treats mom's depression by rendering preschoolers unconscious
for up to two days.
Liquid silicone drink for single women. Two full cups swallowed before an evening
out increases breast size, decreases intelligence, and prevents conception.
When taken with Peptobimbo, can cause dangerously low IQ, resulting in enjoyment
of country music and pickup trucks.
Potent anti-boy-otic for older women. Increases resistance to such lethal lines
as, "You make me want to be a better person. "
Injectable stimulant taken prior to shopping. Increases potency, duration, and
credit limit of spending spree.
Relieves headache caused by a man who can't remember your birthday, anniversary,
phone number, or to lift the toilet seat.
A spray carried in a purse or wallet to be used on anyone eager to share their
life stories with total strangers in elevators.
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 .
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