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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, i.e. fallen:

The 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."

My 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."

So how crazy is my "deep value" money manager? I instance this piece in this weekend's Economist magazine (my favorite magazine):

Cracks in the edifice

The world's biggest bank loses its boss, and a few billion

ON REFLECTION, 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-downs—the first big, the second enormous—has 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 7th.

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.

Citi's exposure 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 exposed—to the tune of more than $80 billion—to 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.

These headaches, 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.

The mortgage 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 elusive—hence the regular calls for the group to break itself up. The main operating units—global consumer, capital markets, wealth management and alternative investments—still “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 least four.

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.

Moreover, like 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.

Compounding the difficulty, the new boss may have to spend much of his time fighting off legal attacks and smoothing regulators' feathers—just 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 vehicles.

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 dividend.

But markets, 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 knight—perhaps a sovereign wealth fund—if 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.

CDOh no!

With trades 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 figures—and 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 banks—not 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.

The uncertainty 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 worse—at a mere 10 cents on the dollar.

Most banks 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 clean—even 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 of capital.

European banks 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 states—much of it held by retired people through funds—might have to be downgraded. Public-private partnerships in Britain, which are also customers, would also be affected.

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.

How life has changed:

The 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 Middle School:

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 that opportunity.

Sincerely, Edna

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 on this site. Thus I cannot endorse, though some look 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 Michael's business school tuition. Read more about Google AdSense, click here and here.
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