Harry Newton's In Search of The Perfect Investment
Newton's In Search Of The Perfect Investment. Technology Investor.
8:30 AM EST, Monday , November 12, 2007: The
good thing about hedge funds is they can hedge. When things looks awry, they
can short a bad sector and/or bad stocks. My favorite hedge fund's favorite
short is an ETF called XLF. It is an index fund that tracks financials.
Its top 10 holdings read like a rogues' gallery of recent bad loans -- Citigroup.
Bank of America, AIG, JPMorgan Chase, Wells Fargo, Wachovia, Goldman Sachs,
American Express, Morgan Stanley and Merrill Lynch. It has recently done well,
big disaster -- so far -- in bad loans is Citigroup.
Why this all concerns
me is that one of my money managers (who actually has done well in the past)
bought a slew of financials for me -- including AIG, Citigroup, Bank of America,
Countrywide Financial, JPMorgan Chase, Merrill Lynch, Travellers, , . As I wrote
on Friday, My money manager says he's figured "the
worst case scenario" and he reckons a 50% gain in 18 months on these
financials. It's a "deep value" play. He says it's worked in the past,
thought he admits he might be "a little early."
hedge fund manager, who's short financials, thinks my money manager (who doesn't
go short) is "insane." My hedge fund manager: "Let
me clarify. Your money manager will be right, eventually. I think that trying
to time the bottom when we have no real idea what the exposure is to bad loans
is premature and way too risky."
how crazy is my "deep value" money manager? I instance this piece
in this weekend's Economist magazine (my favorite magazine):
followed this Citigroup piece with another one on credit markets.
biggest bank loses its boss, and a few billion
it was not the best of metaphors. In an interview in August, as the first
wave of subprime woe was crashing over markets, Chuck Prince explained that
customers flocked to Citigroup in such trying times because we are a
pillar of strength. Less than three months later, that depiction looks
almost comically awry. A double dose of mortgage-related write-downsthe
first big, the second enormoushas made a mockery of risk models and
controls at the world's largest bank. On November 4th, as the scale of the
second write-down was revealed, Mr Prince took the only honourable course
and resigned. The troubles of Citi and other big banks helped push down the
Dow Jones Industrial Average to its lowest level since mid-September on November
It is no coincidence
that Mr Prince's departure came less than a week after the ignominious exit
of his counterpart at Merrill Lynch, Stan O'Neal. Both banks had ploughed
gleefully into collateralised-debt obligations (CDOs), which pool mortgage-backed
securities and other credit instruments, becoming the top two underwriters
in the business. Poorly understood (even by their creators, it seems), these
are now souring at an alarming rate.
to CDOs came as a shock: it had kept $43 billion-worth on its own books. Most
of this was highly rated, but so rapidly have subprime-mortgage defaults risen
that even this super-senior paper is now being downgraded by rating
agencies. In the light of this, Citi thinks it will have to take an extra
hit of $8 billion-11 billion in the fourth quarter. This has filled other
firms that stacked up on CDOs with trepidation (see article).
This is not
an isolated slip-up for Citi, which has already had to swallow $1.4 billion
of losses stemming from over-exuberance in leveraged buy-outs. It is also
heavily exposedto the tune of more than $80 billionto some of
the so-called structured investment vehicles (SIVs) that have struggled to
roll over their debt in commercial-paper markets. On November 7th Moody's,
a rating agency, put SIV debt, including Citi's, on review for a downgrade.
combined with $26 billion-worth of acquisitions over the past year, have deflated
the bank's capital cushion (see chart). The tier-one ratio could fall to a
dangerously low 6% or less if it had to absorb and write down SIV assets,
estimates CreditSights, a research firm. Citi's shares fell by 7% in a single
day last week, an extraordinary drop for a bank with $2.3 trillion in assets,
on fears that it would be forced to cut its dividend.
Mr Prince was
struggling to get a grip on Citi long before the housing crisis. The bank
was bloated, its revenues flat. Only when calls for draconian action came
last year from the largest shareholder, Saudi Arabia's Prince Alwaleed bin
Talal, did the streamlining take on urgency.
mess will ensure that Mr Prince is remembered as a failure. But he deserves
credit on other fronts. He pushed Citi into fast-growing emerging markets.
He also invested heavily in branches and technology to bring colour to its
anaemic American retail operations. Most importantly, says Dick Bove, a banking
analyst with Punk Ziegel, an investment bank, he restored senior managers'
faith in their ability to bring about organic growth. His predecessor, Sandy
Weill, supercharged the share price with a never-ending string of bold acquisitions.
But in order to find the money for those deals, Mr Weill stripped operating
divisions of much-needed capital. Wall Street never quite appreciated the
problems this posed for his anointed successor.
Some of Mr Prince's
efforts are just starting to bear fruit. Internal growth has picked up dramatically,
helped by a renewed push to channel capital to the most deserving businesses,
not to the pushiest. Group revenues in the first nine months were 14% higher
than a year before. If they hadn't got their head taken off because
they knew nothing about risk management in mortgages, earnings would have
been impressive, says Mr Bove.
Even so, the
blow-up has rekindled worries that Citi may have grown too large and complex
to manage. For all Mr Prince's efforts to bring coherence to a dysfunctional
family with more than 300,000 employees in over 100 countries, synergies have
proved elusivehence the regular calls for the group to break itself
up. The main operating unitsglobal consumer, capital markets, wealth
management and alternative investmentsstill move to their own
beat, says one Citi banker. Mr Prince used to joke that Citi didn't
have a good culture in Mr Weill's day; it had five or six. It still has at
That may explain
why there is hardly a stampede to apply for what should be the best job in
banking. Several possible candidates seem happy to stay where they are, among
them Jamie Dimon, Mr Weill's former heir-apparent. He now runs JPMorgan Chase,
where he has, so far, made a better fist of creating an efficient financial
conglomerate than his midtown rival. Robert Rubin, a former treasury secretary
and Goldman Sachs chairman, appears to have spurned the chance, though he
did agree to step in as chairman. Hence the appointment of an interim chief
executive, Sir Win Bischoff, who has run Citi's European business since 2000.
The new man
(or woman: Citi's wealth-management head, Sallie Krawchek, may be in the running)
faces a daunting to-do list. The priority is to calm twitchy investors by
showing that the bank is on top of its losses. Analysts still want to know
how a pile of CDOs that warranted barely a mention a few weeks ago can now
be inflicting so much damage. To be fair to Citi, transparency is improving:
this week's 10-Q filing contained previously undisclosed information
about its SIVs, for instance. But Michael Mayo of Deutsche Bank worries that
Citi may be entering an information and management vacuum: its
newly installed fixed-income heads are untested, its temporary boss is an
unknown quantity (in America, at least) and it is not planning to offer another
financial update before mid-January.
other banks, it is finding that valuing its $135 billion of illiquid assets
is more art than science. This week Gary Crittenden, Citi's chief financial
officer, told analysts none too reassuringly that the latest valuation of
CDOs was merely a reasonable stab. He confessed to viewing the
mark-downs as no more indicative of where we are going to come out at
the end of the quarter than where we would be two weeks from now. Further
write-downs, beyond the estimated 20% haircut already taken, look probable.
In a sign of how grave the problem is, Citi has picked the man who co-ordinated
its role in the rescue of Long-Term Capital Management, a hedge fund that
collapsed in 1998, to run its new subprime unit.
the difficulty, the new boss may have to spend much of his time fighting off
legal attacks and smoothing regulators' feathersjust as Mr Prince did
in his first year. Trial lawyers acting on behalf of shareholders have already
taken aim at Merrill and, more recently, Citi. Meanwhile, market watchdogs
are scrutinising the bank's accounting treatment of its off-balance-sheet
Even if no further
horrors are lurking in the shadows (a big if), getting Citi back on track
is likely to take the best part of a year. Mr Crittenden is hopeful that its
capital adequacy can be brought back to comfortable levels by mid-2008. On
numerous key financial measures, including free cash flow (of over $20 billion),
the bank still looks reasonably healthy. It says there is no need to cut the
twice bitten in less than a month, are understandably shy. Citi is now seven
times more likely to default on its debt than it was in June, according to
derivatives markets. There is even talk of the need for a white knightperhaps
a sovereign wealth fundif Citi's mortgage losses continue to mount.
If that seems far-fetched, bear in mind that so did the past week's events
only a few months ago.
scarce and losses mounting, it is going to be a harsh winter
IT WAS not a
good omen. This week Lewis Ranieri, a pioneer of mortgage securitisation in
his Liar's Poker days at Salomon Brothers, sold his property-financing
firm because the subprime crisis had cut it off from fresh debt. If the industry's
godfather can't navigate the storm-tossed markets, what hope its greedy children?
Banks that a
few months ago were falling over each other to underwrite mortgage-backed
securities and the labyrinthine pooling structures, known as collateralised-debt
obligations (CDOs), that sit atop them, have admitted to more than $30 billion
in losses. That figure is set to rise sharply as mortgage defaults in America
climb. Citigroup estimates that big banks may be facing $64 billion in write-downs,
excluding its own figuresand it was one of the top two underwriters
of CDOs. Banks will be dealing with the pain for a lot longer than anyone
imagined only a couple of months ago.
Most CDOs were
engineered to provide both yield and safety, with a thick band of each rated
AAA or even better, super-senior. Lower-rated tranches have been
in trouble for months. But the prospect of a collapse in the value of the
supposedly safe portions terrifies the banksnot surprisingly, since
there is at least $350 billion-worth of such CDOs outstanding.
This looks all
too possible now that rating agencies have started to downgrade AAA-rated
CDOs, some of them by several notches (14 in the case of one notorious tranche).
The agencies have given warning in the past month that they might downgrade
another $50 billion-worth of top-rated CDOs, and that looks like the tip of
the iceberg. One fear is that this leads to a wave of hurried sales, because
many institutional investors are allowed to hold only AAA-rated paper. In
addition, default notices have been issued on more than $5 billion-worth of
CDOs, as senior investors try to grab what they can.
is compounded by the difficulty of finding a fair value for these
complex instruments. The fall-back method recommended in a recent paper by
the Centre for Audit Quality, an industry research body, is to employ assumptions
that market participants would use, a technique known as Level
3, which becomes subject to strict accounting regulations in America
on November 15th. But Level 3 is not that useful, confesses a
risk controller at a big European bank. Banks have tended to use it as a bucket
into which they throw any securities they find hard to value and then make
an educated guess at the price. Among Wall Street firms, the soaring amounts
of Level 3 securities now exceed their shareholder equity.
Finding a better
indicator of market prices is no easy task, however. One measure, though an
imperfect one, especially for CDOs, is the ABX family of indices. These relate
to derivatives linked to subprime, which are traded even when the underlying
bonds are not. The ABX indices are near record lows, having fallen precipitously
in October. Even the top tranches are well below par value (see chart). According
to Citi, some AAA-rated CDO tranches are faring even worseat a mere
10 cents on the dollar.
are probably reluctant to mark down their assets that far. Citi and Merrill
Lynch lead the list of shame, with combined write-downs of more than $22 billion.
But others may just be slower in coming cleaneven the teflon traders
at Goldman Sachs. CreditSights, a research firm, estimates Goldman's potential
CDO-related charges at $5.1 billion, for instance. On November 7th Morgan
Stanley said it would write down its assets linked to subprime by $3.7 billion.
For the first time, there is serious talk of banking giants running short
can expect more grief, too. UBS, a Swiss bank, has reportedly been criticised
for booking its mid-quality paper at twice the level implied by the ABX index.
Marcel Ospel, its chairman, faces mounting pressure to resign after the bank
reported big losses on fixed-income securities in the third quarter.
Banks are not
the only ones who need to worry. Hedge funds hold more than 45% of all CDO
assets, according to the IMF. Insurers are exposed, too; American International
Group, the world's largest insurer, this week fell far short of earnings targets
because of mortgage-related problems. In addition, one obscure but important
corner of the industry faces a fight for survival over its subprime exposure:
the specialist bond insurers.
In return for
a premium, bond insurers guarantee repayment of interest on a variety of debt
securities in case of default. Their mainstay used to be municipal bonds,
but over the past decade they moved aggressively into structured finance.
Before October, it was thought that the two biggest, MBIA and Ambac, would
get away with losses in the low hundreds of millions. But the rating agencies'
assault on high-grade CDOs, the bread and butter of the insurers' structured
business, raises the prospect that they could run low on capital. Analysts
at Morgan Stanley forecast combined losses for the two firms of up to $18.7
billion. Even the minimum expected loss, a much lower $3.3 billion, would
be a huge blow for companies with combined equity capital of just $12 billion.
Some think the
rating agencies will eventually have to strip the bond insurers of their cherished
AAA ratings. They are loth to do this because it would wreak havoc,
not only in structured products but across financial markets, says Andre Cappon,
a consultant. New issues of municipal bonds could slow dramatically, since
many borrowers rely on the insurers' top rating to enhance their own creditworthiness.
Over $1 trillion of debt issued by American cities and statesmuch of
it held by retired people through fundsmight have to be downgraded.
Public-private partnerships in Britain, which are also customers, would also
For those holding
CDOs, things could get worse before they get better. Tim Bond of Barclays
Capital points out that defaults on subprime loans are still accelerating
in America, particularly on mortgages made since 2006. This will take time
to feed through to CDOs, via mortgage-backed bonds, but feed through it will.
A consumer-credit slump, which looks increasingly likely, would clobber securities
backed by credit-card and car loans, which are also pooled in CDOs. That would
be all the beleaguered banks need.
life has changed:
Radio --- Just when you have lost all faith in human kindness.
The letter was
sent to a school principal's office after the school had sponsored a luncheon
for the elderly. An old lady received a new radio at the lunch as a door prize
and was writing to say thank you. This story is a credit to all humankind. Forward
to anyone you know who might need a lift today.
Dear Safety Harbor
God bless you
for the beautiful radio I won at your recent senior citizens luncheon. I am
84 years old and live at the Safety Harbor Assisted Home for the aged. All of
my family has passed away. I am all alone and I want to thank you for your kindness
to an old forgotten lady.
My roommate is
95 and has always had her own radio, but before I received one, she would never
let me listen to hers, even when she was napping. The other day her radio fell
off the nightstand and broke into a lot of pieces. It was awful, and she was
in tears.She asked if she could listen to mine, and I told her to kiss my ass.
Thank you for
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
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