At least hockey's back

It's incredibly ugly out there. So much happens in any given day, that it's almost impossible to keep track of what's going on. Hundred point swings happen almost in an instant. Today was one of the worst days yet on the Dow - down 679 points. That's the 6th consecutive day of triple-digit losses. The market is trading on fear now. No one wants to lend to anyone simply because they don't know if they will get their money back. We can only hope that this crisis of confidence is somewhere near a bottom. At some point, this will stabilize. The only problem is, no one knows how long it will take to get there, or what type of intervention or lack thereof is required in order to get there.

The Fed and several other central banks around the world cut interest rates by 50 basis points yesterday. It helped, for about an hour or so. Then the markets resumed their downward trajectory. The central banks acted in an attempt to spur banks to lend again. They made money cheaper, which, ironically, helped us get into this mess in the first place. Although the action will take months to feed through, it was intended to bolster confidence. The Fed Funds rate is now 1.5%. The overnight rate in Canada is 2.5%. This will help provide some confidence and slightly more liquidity, but concerns of a massive recession are not going away with a rate cut.

Interestingly, in Canada, the banks refused for the first time since the Asian crisis, to fully pass along the interest rate to consumers. They only cut their prime rate by 25 basis points. They argue that the cost of funding their business is simply too high to reasonably warrant the full 50 basis point reduction. This has not sat well with a bunch of folks.

So the rate cut is undoubtedly better than the lack of a rate cut. This I think we can agree on. But, the rate cut didn't really help stop the selling. Neither did the Treasury's plan to act as a buyer-of-last resort in the commercial paper market. Commercial paper, you'll remember, is a form of short-term debt companies sell to fund their day-to-day operations. The cash raised from the commercial paper is often what funds payroll and inventory purchase. This market has essentially frozen up. This was not a good thing at all. The Fed made a very astute move in attempting to get this market moving again. Liquidity in this market is key. In essence, the Fed has become a private investor directly in companies with this move. They will collect interest and fees from their investment in what essentially amounts to IOUs from companies. As I said this will help create a more liquid market as private investors (read: pension funds, money market funds, hedge funds to a certain extent) have become too nervous to buy the paper.

As I mentioned in an earlier posting, one of the key measures that has been used to gauge liquidity and confidence in the market has been LIBOR. 3-month LIBOR for dollars was 4.75% on Thursday. A month ago, it was around 2.8%. A high LIBOR indicates that banks are unwilling to lend to each other. When banks are unwilling to lend, the financial system starts to sputter. Liquidity dries up. Credit freezes. It's harder/more expensive for companies to fund their operations. Furthermore, many mortgages and consumer loans are directly tied to LIBOR. LIBOR goes up, you (the consumer/homeowner) pay more. That's not a good thing, Martha.

Also making news today was the potential downgrading of GM and Ford. Remember that posting I wrote a few months ago on Ford and GM. Yeah... things haven't gotten better. Sure, oil is down, that's fine and dandy. You know what's worse than consumers switching from buying SUVs to buying compacts? Consumers not buying cars at all because they can't get a loan from their bank to do so. Consumers so scared about the economy that they are unwilling to spend. Will one of these companies fall over? Maybe not within the next few months, as they should have adequate liquidity and cash to fund operations. But things look a lot worse for 2009.

What's happening in Canada? Well, the TSX is getting smoked. Simple as that. A very weak global economy means a lot less people using commodities. Oil is down to about $87 a barrel. Worse yet, a lot of these small companies out west can't get access to credit to fund their considerable investments. In case you didn't realize, it costs serious investments in order to get stuff out of the ground and into your car. It doesn't help when you have no money to get the stuff out of the ground. Further impacting the sector is that many funds are liquidating their positions in these companies as they seek to fund redemptions.

Where do we go from here? Probably more losses. It will probably get uglier. There is some rumour of the Treasury stepping in and directly investing in the financial sector, most likely via preferred shares. That's pretty much what's happened in the UK. A move of this magnitude would likely help calm markets, but that's what we said about the bailout, the commercial paper backstop, and the rate cut. Maybe a better measure would be to temporarily suspend mark-to-market accounting. Maybe the government could suspend the capital gains tax for two years. Maybe the government could cut income taxes, or start some public works projects. Some stimulus is needed. Rates can't go much lower. The government can't bail out everyone. This will require innovation and patience. Hopefully we reach a bottom soon, but with Asia dropping 11% this evening, tomorrow could be another rough day.

What does this all mean for the QCTC? We started the competition on Monday. Maybe you shorted some financials as I suggested in our first meeting. You can still do that in the game, and, actually, as of today, you can do it in real-life again. Maybe you invest in a gold ETF. Maybe you take a flier and hope we've hit a bottom, and invest in a Canadian bank. Or maybe it's so bad out there, you've given up hope like a bunch of investors, and you really only care about how well the Leafs played tonight against the Wings, and you're holding your hypothetical cash under your hypothetical mattress.

Happy Thanksgiving.

There's A Hole In My Bucket

Dear Liza, dear Liza, there's a hole in my bucket, dear Liza, a hole. The bucket is the U.S. financial system, soon to be the U.S. economy. Let's face it. This is the worst financial crisis since the Great Depression. It has the potential to get much, much worse. Something needs to be done in order to at least stop the bleeding. Hank Paulson and Co. can't wave a magic wand and fix everything by buying up $700 billion in toxic debt. They can however, start Fixing A Hole (The Beatles - Sgt. Pepper's). The plan will help. There is no doubt about that. There is also no doubt about the fact that nobody wanted it to come to this. The government should always remain as far out of the markets as possible. Yes, there is a role for government in basic regulation, but excessive intervention serves to privatize rewards and socialize losses.

Now you might say, well, "hey, wasn't it a lack of regulation that got us into this in the first place?" Yes, it partially was. It was also partially the fault of the government who enacted legislation in the 1970s, and again in the 1990s that encouraged lenders to give out mortgages and loans to people who couldn't necessarily afford to pay them back. This legislation really took effect as soon as interest rates plummeted in the early 2000s.

Have you ever seen the commercials that say "BAD CREDIT, LOW CREDIT... NO MONEY DOWN!!" or "NO CREDIT, NO MONEY,NO PROBLEM"? Yeah, you saw them. You don't see them much anymore. Basically, credit was extended to people who could not afford to keep up with the payments in the long-run. Sure they could pay for it when the overnight rate was 1%, and money was basically free, but rates went up 17 times to 5.25% for overnight borrowing. That feeds through to the rates on mortgages in a big way. Most of these mortgages were ARMs. They reset to the higher rate after a few years. So all of a sudden, instead of paying say $10 in interest, you're paying $30. If you're income is $60, that's a big problem. Now, it was made a lot better by the fact that home prices were rising. So, you at least had some more equity in your house. Then the value of homes started dropping. The bubble burst. So now what do you do? Well, in some cases, the value of the mortgage was worth more than the home - negative equity. So what do you do? You default. You don't pay.

That feeds through. The lender that gave you the $200,000 mortgage can maybe now expect to recover $100,000. In some areas where home prices have fallen by as much as 30%, maybe you expect to receive less. So, why isn't this a localized problem? Why isn't it just the lenders in California, and Florida (or wherever) that are feeling the pain? Well. This is where we can put some blame on the banks, the financial engineers. There are these things called structured products. They take many forms. Some are Collateralized Debt Obligations (CDO), some are Collateralized Loan Obligations (CLO), some are Mortgage-Backed Securities (MBS). In their most basic form, they take a payment from here, a payment from there, throw it in a nice blender, and you have a new security to sell around the world.

The ratings agencies didn't really know how to deal with this. Some of these products had pretty reliable characteristics (AAA). But some of the other tranches (think, different "levels" of the debt) were super risky. Sometimes a lot of the product was made up of super risky cashflows. They added the juiced up yield that investors were starved for.

So what happened? Well, these loans started to go sour. People started missing payments. People started defaulting. The cash flows that were expected to occur now won't occur. The major banks invested in these assets. Over the past year, they have had to continually write the value of these assets down. They banks have to mark them to market. As noted in an earlier post, Merrill recently wrote down the value of some of its holdings to 22 cents on the dollar. Many other banks have followed suit, although potentially not quite as drastically. So these writedowns have resulted in big-time losses.

The big-time losses are bad, but it's made worse when many of the financial institutions were levered at 30 to 1. That means for every dollar of equity, there was 30 dollars of debt on the balance sheet. It's all fine and good to juice up returns through leverage (debt costs less than equity), but when the losses start piling up, the equity cushion disappears quickly. So the banks have had to raise collectively hundreds of billions of capital to cushion the losses.

But what happens when everyone is holding these assets, but no one really knows what the other guy is holding. All the banks trade with each other, and they are all exposed to counterparty risk - the risk that the guy you trade with or lend to today won't be around tomorrow. Traditionally, the risk was fairly low between the big-name institutions. Lehman would have no problems trading, lending, or borrowing with Bear. Things changed. Borrowing between banks became risky. The London Interbank Offered Rate (LIBOR) hit its all time high on Tuesday at 6.88%. What's worse, thousands of companies have their cost of borrowing directly tied to LIBOR. BANG! The cost of funding business just skyrocketed. Not good at all.

After the nationalization of Fannie and Freddie, the outright collapse at Lehman, the near-collapse at Merrill (thank-you B of A), and the rescue of AIG, there was a general panic in the markets. It was more a crisis of confidence than anything else. Institutions that had largely avoided the heart of the disaster (Morgan Stanley and Goldman Sachs), were now the target of the short-sellers. People had zero confidence in the companies, and zero confidence in the business model. If you didn't have a large base of deposits to draw upon, you were dead meat. So down went Lehman and Merrill, and with them, the business model of the pure investment bank. Morgan and Goldman two Monday's ago applied to be bank holding companies. The end of an era.

Where do we stand now? Well, this crisis will reach mainstreet. The American public might change it's tune about not bailing out the "fat cats" once they realize that they can't get their student loan, a mortgage, or a new line of credit. If a few more institutions the size of WaMu fail, then the FDIC probably will run out of money to cover the losses. Then it will hit mainstreet. Hopefully the bailout is passed. Personally, I'm a big-free market guy. I dislike the government greatly. However, if ever there were a time for the government to step in and try to stop the bleeding, it is right now. There is no liquidity out there. Look at what happened with Xstrata and Lomnin today. No financing for the deal, the deal falls through - lots of value erased. This will continue to happen if liquidity doesn't return. It will get worse if we have to keep on going institution by institution, trying to determine which ones we can save, which ones can be acquired, and which ones will fail.

The bailout bill needs to pass. The Democrats and the Republicans need to come together and get it done. Nancy Pelosi needs NOT to make a highly partisan speech moments before voting. Hopefully, in due course, if the deal goes through, the asset values will rise again, and the government make end up making money. The government needs to step in and fix the hole in the bucket. Until the leaking stops, the financial institutions won't be able to deliver the water (loans) to the public. We need to stop the bucket from completely bursting. It will be disaster for Wall Street, and yes, Main Street will feel it in a big, big way.

The Certainty of Life: Death and Taxes

This week, the Liberal Party of Canada announced that they would reverse the Conservative Party's plan to tax income trusts. Clearly, our nation’s largest political parties don’t see eye to eye on this issue. So what ever happened to income trusts following the Conservative’s initial announcement to tax income trusts in the first place?

On October 31, 2006, Jim Flaherty proclaimed to Canadians that the government would be implementing new taxes on income trusts in 2011. In essence, the income tax structure benefits which allowed trusts to distribute a very high percentage of their cash flow – in some cases, nearly 100% – would end. The following day, income trusts in Canada lost roughly one-fifth of their market capitalization – a huge loss for a company in one or two years, let alone one day. As the clock starting ticking, the management and directors of income trusts had to start contemplating what move was best for the funds. Should they cut distributions when they ran out of cash? Should they restructure? Should they refinance? Should they convert into an entirely new entity? Should they sell off some or all of the trust?

Two of these options become the most widely feasible for most income trusts: either cut distributions to the extent of the proposed tax increases, or convert into a corporate structure.

The logic for converting to a corporation (from a trust) is generally “short-term pain for long-term gain.” A conversion would:
a) Reduce the distribution expectations – many corporations have no dividend or one below 3%; and
b) Allow management to re-allocate funds to invest in growth opportunities.

The immediate reaction to the distribution cut would be for existing unitholders – aka “yield pigs” (investors who are looking for trusts distributing cash for a 10% or higher yield) – to sell off their units in large blocks (short-term pain). Many Canadian income trusts followed this route: Aeroplan Income Fund, TransForce Income Fund, Fairborne Energy Trust, High Arctic Energy Services, Trinidad Energy Service Income Trust, and Keystone North America. 90-days following the announcement that they would convert, these trusts traded on average down 17%.

The second option available in income trusts is to cut distributions to unitholders. Two Canadian trusts have taken this route: Primary Energy Recycling Corporation and Boralex Power Income Fund, which cut distributions by 31% and 22%, respectively. 90-days following the announcements they would cut distributions, they traded on average down 24%.

What can we learn from this? Firstly, the fundamental reason why people invest in any income trust is for its stability: predictable cash flows, tangible assets with easy-to-understand valuation procedures, tax benefits, and steady distributions. Income trusts also have significantly higher yields than bonds, bank dividends, preferred shares, and almost all other securities that one could name. Thus, when income trusts announce distribution cuts – especially when the market does not expect them – the unit price is at risk.

And yet, it would seem that management is stuck between a rock and a hard place: converting to a corporation results in a negative outcome for shareholders, as evidenced from their double-digit decline since conversion. Moreover, one’s entire shareholder base will be replaced with more aggressive, growth-focused investors which could take a more active role in their growth-development phase.

The conventional wisdom suggests that there are two certainties in life: death and taxes. But, if it’s up to Liberal leader Stephane Dion, perhaps income trusts will get a tax break after all. How unconventional.

Into the Abyss

No one knows where this market is heading or what it is currently doing. CFOs are perplexed at the relentless downward pressure on their share prices, even though their balance sheets may be in relatively good shape (I emphasize relatively). One of the main problems right now is market liquidity and borrowing costs. It simply costs a lot more money to borrow now than it did a week ago, a month ago, or a year ago. This is due to a complete lack of confidence in what banks are holding on their balance sheets, and how those assets are valued, in addition to a growing perception that perhaps the broker-dealer business model of Goldman, Morgan, and three of the casualties of the crunch - Bear, Lehman and Merrill.

Banks simply don't want to lend to each other because they have no idea of who might be next to fail. This has easily been one of the craziest two weeks ever. That's a pretty powerful statement. Consider this fact, one that I found truly outrageous and unbelievable when I first read it today on the WSJ website. For a brief period, investors actually bid more than par for 1 month T-bills. Think about that for a second. That's like me saying to you, "Hey, here is $101. In one month, can you give me back $100?". Investors, as the Journal noted, were thus saying to themselves, well, I'm going to go right ahead and take a loss on this, but at least the loss will be small and I'll know what it is. This is mindblowing. It has never happened before ever.

The game has completely changed for investors and traders. A year ago, heck, even a few months ago, there were people calling bottoms in the financials. Often, this was accompanied by an adage that basically said, "hey, these companies are big, safe, and they'll be around in 10 years, 20 years... so they are a solid long-run investment". You can't say that with any certainty anymore. Will Morgan Stanley be around in its current form in 1, 2, 5 or 10 years? Who knows. The company has a much stronger balance sheet than those that have failed. They have liquidity, but you never know what can happen once traders pummel the stock and capital providers lose confidence.

When will this all end? No one knows. It's going to be a long and painful process. Banks have to delever. Companies around the world bought complicated assets largely linked to the U.S. housing market for years. They did this by borrowing money. This borrowed money was for a period of time "cheap". Now the value of these assets are falling faster than a fan of the Ottawa Senators hopes during April. These assets need to be written down to appropriate levels - something many CEOs have been extremely reluctant to do due to the huge, huge losses that would be sustained. Once companies clean up their balance sheets, they need to repair them by rebuilding their capital base. The capital cushions have been diluted and eroded due to the aforementioned losses. Many banks were levered near 30 times. This has simply proven to be too much. Getting rid of all this debt will be long and painful, and will cost a lot of money. Consumers will be hit. Borrowing costs will rise. Hedge funds will be smoked. They rely heavily on leverage to amplify returns. Now debt is much more expensive, the returns won't be as rosy. The ripple effects will soon reach Main Street.

The philosopher George Santayana once opined that those who cannot remember the past are condemned to repeat it. The market must learn the hard way that too much leverage and risk that is hard to measure and quantify can engender great danger and many losses. One thing remains certain however, this is a tremendous learning experience for the market, and for observers of it.

Another One Bites The Dust

I promise I won't break out in song, but am I the only one that hears Queen's song playing constantly in their heads? Let's be honest folks, it's a killing field out there. As I write this, Lehman Brothers appears as if it won't make it past the next few days, let alone the next few hours. Barclay's just pulled out of the bidding for the distressed bank. It was basically the last bidder available for Lehman. The Journal reported that Barclay's walked away from the bidding for a variety of reasons which will be determined in the coming hours and days. One can assume that no agreement could be reached on what would be done with the billions of dollars of toxic assets that Lehman holds. It is an end similar to that of Bear Stearns, save for the fact that it wasn't directly a liquidity issue that caused Lehman to fail, but rather a lack of confidence in the bank's ability to continue its operations. Lehman didn't face the cash crunch that Bear did, as Lehman was and is able to borrow from the Fed's emergency discount window, unlike Bear. It's more a question of what the value of Lehman's $50-odd billion of illiquid assets is worth. In the summer, Merrill unloaded about $31 billion of notional debt at 22 cents on the dollar. At some price, there is a buyer for the illiquid Lehman debt. The thing is, at that price, Lehman is probably bankrupt anyway.

One of the main reasons that Barclay's likely walked away was the fact that the government lead by Treasury Secretary Hank Paulson was completely unwilling to bail out Lehman as it did with Bear, Fannie and Freddie. They refused to provide a backstop for the risky mortgages that a potential buyer would have had to assume. The moral hazard is simply too great. The coming failure of Lehman sends a powerful message to those who seek and take excessive risks. The government isn't (and shouldn't) be there to wipe up the mess that private companies take. Although the government did largely bail out Bear and Fannie and Freddie, in those cases, the shareholders were almost completely wiped out. Nevertheless, the government did enter into a catch-22 situation, in that they almost created an expectation with their previous bailouts that they would continue to bail out firms. Lehman however, seems to have been the final straw.

So what's next for Lehman? Well, it appears as if (barring some new development) the firm will file for Chapter 7 bankruptcy, and will likely be liquidated. There was an emergency trading session called today in order to unwind the credit default swaps that Lehman had entered into. It's extremely complex and will take quite a while to sort out. With respect to Lehman directly, it will probably be broken up and its assets auctioned to the highest bidder. Distressed-debt funds, private equity funds, sovereign wealth funds - these will be the types of buyers of Lehman's assets. It won't be pretty for the markets. Tomorrow will be a manic Monday for sure.

In other news, Merrill - a firm that could be potentially be next on the credit-crunch casualty list - is apparently in advanced talks to merge with Bank of America, one of the suitors rumoured to have been interested in Lehman. According to the Journal, the price for Merrill has been pegged at around $25 to $29 per share. Over the past week, Merrill's share price has fallen by 36%. This will, in my opinion, at least help stabilize the storm that is about to descend this week in the wake of Lehman's likely collapse.

UAL rides the rollercoaster

Dearest traders,

Hope you (all five of you that read this) took my Sunday night advice with the mid-day put options. Probably could have made an easy 50 percent there. For all of you who did not listen to my prophetic words, maybe you will learn for next time I dare predict the future.

Enough of the self-praise for today. An interesting anecdote for you that reveals a lot about the psychology (re: fear) of the markets right now. Early yesterday into the trading day, Bloomberg terminals flashed with the headline that United Airlines had filed for bankruptcy protection. No one dared to do any real fact check, just the word “bankrupt” was enough to send the shares plunging to $3.00 from a $12.16 open -destroying about a billion dollars of market value in the process. The internet allowed for all of this to happen within 13 minutes of the story being accessible. Lucky for UAL, management sorted things out; by the end of the day shares had rebounded, and were off only 11 percent.

One of the reasons I found this situation so amusing was how it was juxtaposed with a recent job description I was looking at. It was for a trading floor position (i.e. the guys who believed that UAL was worthless yesterday). Attention to detail and ability to verify/process information were listed as numbers one and two in attributes required for the position. It surely would seem that way. At the information session for this position, I asked one of the traders how could this kind of mistake could ever happen on a trading floor –supposedly where the best and the brightest go to work. He said that sometimes things are flying so fast out there, mixed with the recent scares from the banking sector, it might be safer to pull the trigger and ask questions later than to get caught in the bloodbath.

The point here is that the markets are still a little jittery. Today, the entire potash industry seems to be taking a beating. I dare say that this is a good time to get in, but this is more a long-term play, as opposed to the one-day like play I recommended Sunday. Soon to follow, a post on why I am bullish on potash.

Fannie/Freddie and their Chilean Parallel

My response to a comment made by Mr. Ballard under the “Fannie and Freddie” post: well, they should begin to stabilize or they "should" begin to cost taxpayers some serious cash.

I had the opportunity to do a course on Latin American banking systems while on exchange in Buenos Aires. There are many interesting parallels between the Chilean banking situation in the late 1970s early 1980s and what is happening right now in the US. In the 70s as a response to a major banking crisis, the Chilean government gave what amounted to a full guarantee to a major Chilean mortgage bank. This created an unlimited liability for the Chilean taxpayer. Chilean banks, incentivized to take on significant risk given that they were guaranteed in the case of default, exploited this opportunity and developed mortgage portfolios that were exceedingly risky. Eventually, due to an outside shock, the system collapsed and the Chilean economy was sent into a two-year depression, accompanied by all the social costs that this entailed.

Anyone who analyses the situation recognises the central failure here: regulation. If a government is to accept an unlimited liability of this kind, prudential regulation must accompany it to keep banks’ portfolio risk in check. The US government needs to follow up this move with a proper policy for prudential regulation on the mortgage front, or risk a fate similar to that of the Chilean banking system in the 1980s.

I commend the US government’s initiative to scale back the size of Freddie and Fannie, opening up the door for competition in this market. When it comes to banks, larger institutions are less likely to fail –but the old adage “the bigger they are, the harder they fall” is quite poignant here.

How do we as traders profit off this? It certainly scares away the bears who thought there might be some kind of eminent disaster in the wings due to the failure of either Freddie or Fannie. The US government eliminated the uncertainty associated with the worst-case scenario in this action. Treasury bills are down, now that the government has an exposure to these risky mortgage assets. This all has bad implications for the value of the dollar. Of course, all this will already be priced in by the time we normal people get to the markets tomorrow.

I am going to bet holders of bank stocks are breathing a sigh of relief right now. All I can say is that I wish I had listened to Scott Taylor last week and made that bank play... What I am going to do: play volatilities at mid-day with a few put options on bank stocks, after the excitement has subsided. I'm still pessimistic about this whole situation.

When Do The Airbags Deploy?

Once again, not the best title, but work with me here. This entry will be about the wreck that is the automotive industry. It is truly one of the most fascinating stories right now in the markets, and if you haven’t been following, hopefully I can get you up to speed.

It’s actually fairly simple and quite intuitive in terms of what’s been happening in the automotive sector. High oil prices (fuelled by supply concerns, emerging markets demand, geopolitical instability, and a certain degree of speculation) have translated into over $4 a gallon gas in the U.S., and higher gas prices in the rest of the world (in Europe, the cost of gas can be double that of the U.S.). In case you haven’t noticed, North Americans tend to love their giant SUVs. The soccer mom in downtown Toronto driving her 4 kids to school in a Suburban, and the beer-drinking gun-slinging all-American badass driving his Ford F-150 in Alabama all of a sudden is paying $100 for a single tank of gas.

In any type of economy, a $100 tank of gas is going to hit the bottom-line of basically everyone. Joe Sixpack feels it, and I’m sure whoever is funding Al Gore is feeling the pain too, as he jetsets around the world burning up sweet, sweet fuel. Couple the high cost of gas with the steep drop in house prices (some estimates now indicate an 18% to 20% drop in prices peak-to-trough), and you’ve got a bit of a problem. All of a sudden, people aren’t able to tap the equity in their homes for cash. All of a sudden, people are having more trouble keeping up with their mortgages as the rates on their ARMs readjusted. All of a sudden, that gas-guzzling SUV looks a lot less attractive.

This is a double-whammy for automakers. They are selling fewer autos overall due to the economic slowdown (consumers have less money to spend) and they are selling lower-margin cars, as opposed to trucks and SUVs. Now, automakers literally cannot move fast enough to shift production towards smaller, more compact cars. Many top level executives and industry observers have noted that they have never seen a demand shift occur so rapidly.

The automakers are getting smoked on other fronts as well. One of the key reasons why losses at the automakers have been so stunning is the sheer size of writedowns they are incurring. Now, you may say, “wait a tick-tock, these automakers aren’t banks, and they don’t have all these toxic subprime loans sitting on their balance sheets, so what’s the dealio?” Then I’d say, “dealio… really?” I’d also then tell you that in fact it makes perfect sense for automakers to take writedowns, and in more than one way. First off, leasing vehicles is a considerable part of their business model (or at least used to be). At the end of the lease, they get the automobile back. Unfortunately, the residual value of these autos has fallen off the map, and the companies are being forced to mark them to market. Secondly, each of these companies has financing units (GMAC & Ford Motor Credit Co.). The writedowns here are just common sense – fewer people are able to keep up with car payments, more bad loans, thus, more writeoffs. (As an aside, these financing arms also made some forays into residential housing mortgages a few years back when they were going gangbusters – looks like a big mistake now).Chrysler actually just announced that they will be leaving the leasing business all together.

The shift in the automotive market has resulted in some truly mind-blowing 2Q numbers from automakers. Last week, GM reported a $15.5 billion loss for just the second quarter. A week earlier, Ford posted an $8.7 billion loss for the same period. Lord only knows what happened at Chrysler when Bob Nardelli realized the amount of red ink on his P&L this past quarter (Chrysler is now a private company owned by PE firm Cerberus). The only real question now is liquidity. Simply put, do these companies have the liquidity to keep them going through the next few years, let alone the next few quarters? They are burning cash at an unprecedented rate. GM is expected to burn about $12 billion in cash this year, $2 billion in 2009, and $5 billion in 2010 according to some analyst’s estimates. Ford’s going through cash faster than Michael Moore goes through cheeseburgers. It’s estimated that they will burn about $13 billion in cash this year alone. Both companies seem to have some liquidity, but it certainly won’t last for long. Ford currently has about $26 billion in cash on the balance sheet, while GM is at about $21 billion.

Management at GM recently indicated that the “minimum required cash” needed to function properly is $11 to $14 billion. It’s pretty simple math to see that at the current rate, GM will reach this level pretty soon without substantive action. GM plans close four truck plants in coming years and raise $15 billion more in liquidity by the end of 2009, through cost cuts, asset sales and asset-backed financing. While this plan was generally well received by investors, GM’s market cap remains at $6 billion – it’s lowest point in about five decades.

When you’re burning cash at the rate at which these companies are, liquidity does become an obvious concern. However, both of these companies still have a range of options to boost liquidity. They are both engaging in rapid cost-cutting measures, and are downsizing and streamlining their operations. They both have the option of selling assets to boost cash if needed, and possible equity injections. There aren’t too many people out there predicting either of these companies will roll over; however, investors are certainly spooked. As of Thursday, the 5 year mid-price on GMs CDS was 2686 bps (200bps off the all-time high set on Monday) while Ford 5 year CDS was trading at 1801 bps mid (also 200bps off the all-time high). To refresh you all, a Credit Default Swap is a heavily traded type of contract that in essence measures the cost to insure a company’s debt.

These companies clearly face serious issues, but with every bad, there is some good. Both companies have realized that they face a new market. They are taking drastic measures to bolster liquidity, and to turn their ships around. They will burn a great deal of cash in 2008, but most analysts expect the cash burn to slow down through 2010. Moreover, there is always the potential for a stabilization of US sales volumes, a recovering consumer, and a potential fall in oil prices. GM and Ford both still have strong international operations, which have helped to partially mitigate the substantial losses in North America.

This problem is not limited to the Big Three. Even Toyota has felt the impact of high gas prices and a shift in consumer sentiment. On Thursday, the company reported a 28% drop in 2Q08 profit, due mainly to weak U.S. sales and a stronger yen. Last month, Toyota cut its 2008 global production and sales forecast, and scrapped plans to develop the Tundra in North America. In terms of residuals, Toyota booked provisions for losses of 9 billion yen (lower than Nissan’s 42 billion yen and Honda’s near $20 billion yen in provisions.

In Europe, both BMW and Daimler have warned of lower annual earnings. These companies have also relied on bigger, less fuel-efficient cars to drive profitability. The cars where BMW and Daimler make their margins, for instance, the 5 and 7 Series, have seen volume declines. 7 Series sales were down 12% from a year earlier. Mercedes’ Smart car sales rose 27% in July, while sales of Daimler SUV’s fell 19%.

It's not a pretty picutre out there. The prices of the automakers are severely depressed. Does it make them a good trade in the market? Well, it's not for me to tell you that, but clearly, if you think that these companies can rebound in the long-term and can keep ample liquidity in the short-term, then yes, maybe the automakers look attractive. Value investors (such as Warren Buffett) often suggest looking at the long-term staying power of a company. For instance, Buffett owns a large portion of Coke (KO). That company will be here tomorrow, and it's a good chance it will be here in 20 years. Most people used to say that about Ford and GM, especiallly GM. Clearly, that isn't the best statement to make these days. Will they go bellyup? Frankly, in my humble opinion, I don't think the U.S. government would let a GM go bust, but then again, who knows.

Fannie and Freddie

The title need not be too clever on this one. In case you have been under a rock for the last week, on vacation, or at the Calgary Stampede taking in some sweet country tunes, this has been an incredible week on the markets. We've seen oil drop from record highs by more than $10 a barrel, only to shoot up again to new records (thanks a bunch Iran and Nigerian rebels). We've seen incredible volatility in both the credit markets (see London on Tuesday for further reference), and astounding drops in equity values across the board in financials, consumer cyclicals, and well, anything with any exposure to the rapidly souring economy. It hasn't been too positive. The sentiment on the street is almost universally bearish.

By far, the biggest story of the week, and potentially one of the bigger stories of the year is the rapid and almost unbelievable fall in the share prices of Fannie Mae and Freddie Mac. The Federal National Mortgage Association (FNMA) and the Federal Home Loan Mortgage Corporation (FHLMC) have seen their share prices plunge this week. Fannie closed at $9.96 on Friday, while Freddie closed at $7.75. They opened the week at 19.76 and 15.08 respectively. Their 52 week highs have been $70.57 and $67.20 - an unbelievable erosion of shareholder value. These are the lowest values seen in 16 years.

Fannie and Freddie have been mortgage industry stalwarts since 1968 and 1970 (when the became private corporations - Fannie had been around since 1938 as a government-owned entity). Fannie and Freddie have the unique distinction of having the implicit backing of the U.S. government, and hence, have been thought to be immune to the more wild swings in the market. As a result of this backing, they have been historically able to borrow at very low rates over the benchmark Treasury (about a 1/8th spread over Treasuries). Fannie and Freddie's bonds now yield about .78% over Treasuries - the spread has doubled since last summer. The CDS on Fannie and Freddie has jumped about 20% this week alone. The 5 years now trade at about 78 bp a piece. That is, it costs $78,000 to insure $10m of notional per year.

Fannie and Freddie were created to ensure easy access to home mortgages. The Congressionally-chartered institutions have become critical pegs in the financial system, and currently own or guarantee about $5.2 trillion worth of U.S. home mortgages. That is actually half of all US mortgages currently outstanding. Now, as has been well documented, the subprime and housing crisis that has hit the U.S. in the past year has reduced the much of the value of the assets on Fannie and Freddie's balance sheets. Simply put, many Americans are not keeping up on their mortgage payments, and Fannie and Freddie are starting to see less inflow of cash. To make matters worse, the value of the homes if seized in foreclosure has fallen dramatically from a few years ago. So the two companies are getting hammered at both ends. It's not a pretty picture to say the least.

Thus, with the value of assets on the balance sheet rapidly eroding, it's become clear that FNM and FRE will have to raise more capital. They have already recorded combined losses of about $11 billion this year. That includes losses realized on the sale of foreclosed homes, provisions for future loan losses, as well as the downward revision of the value of mortgages and related securities. These losses will most definitely be added to in the future. Fannie has already issued capital to the tune of $7.4 billion in April, while Freddie is in the process of raising about $5.5 billion. One major problem facing the two companies right now is that they have not been required to hold much capital in the past due to the fact that regulators never fathomed a situation of widespread defaults (like this) occurring. With every massive drop in the value of the common shares, it becomes harder and harder to issue new shares, due to the effect of dilution.

There are a number of possibilities for Fannie and Freddie. One is that the Fed might purchase a bunch of the mortgages from the company, thereby alleviating some of the immediate pain, and shifting the burden to taxpayers. Another, more drastic option, would be to the firms into conservatorship, which would transfer ownership directly to the government. Still another option includes an infusion of private equity capital; however, this is less likely given the huge exposure FRE and FNM have to the housing market, and the tight regulations by which they must abide. Although these options would be explored as a last resort, it's becoming increasingly likely that there will need to be some form of government intervention. The downside risk of these two behemoths failing is stunning, and regulators, politicians, and pundits have all agreed that the government cannot let Fannie and Freddie fail.

One thing that Hank Paulson and the government does not want to do is incentive risk-taking. They do not want to create a moral hazard as they arguably did in the case of Bear Stearns (although Bear shareholders lost so much money, it can be argued that no moral hazard was really created). The implicit guarantee by the government has created an awkward situation, as shareholders have long believed that the companies will be rescued in a crisis, which has allowed the two companies to borrow at very favourable rates. Many would argue that it is these same profit-oriented investors who should feel the brunt of the pain now, as they for years have enjoyed steady dividends and capital appreciation provided by Fannie and Freddie.

In other the-world-might-or-might-not-be-ending news, the government on Friday announced that it was seizing IndyMac Bank. It is the 3rd largest bank failure in U.S. history. The collapse is expected to result about $4 to $8 billion in costs for the FDIC (Federal Deposit Insurance Corp). This could constitute about 10% of the fund's $53 billion deposit-insurance fun. Funny/sad story on this one. A few days ago, Democrat Chuck Schumer sent a letter to the Office of Thrift Supervision (the regulator) questioning the solvency of the bank. Of course, that's not the wisest thing to do in a situation like this, and investors promptly withdrew $1.3 billion in deposits from the bank. Schumer's comments, though, were only the large straw that broke the camel's back. IndyMac has been in trouble for months. The bank specialized in Alt-A mortgages, which are given to people who don't need to fully document their incomes or assets. Surprise, surprise, this didn't turn out so well for them. The bank will be reopen on Monday. The FDIC will provide about $100,000 per depositor. About $1 billion of the deposits were uninsured, so about 10,000 investors will get the shaft. Long story short, add IndyMac to the list of institutions to get absolutely smoked as a result of the subprime crisis. There will be more to come.

Credit Default Swaps

To this point, this blog has focused largely on the stock market and on stock-related things. However, the stock market pales in comparison to the fixed-income market. As of 2006, the fixed income market's size was an estimated $45 trillion. The vast majority of this market trades OTC (over the counter). That is, bonds and fixed income securities are not generally traded on an exchange as stocks are. They are instead carried out by market makers, using inter-dealer trading programs. Thus, the fixed income market doesn't often get much recognition in the financial press (except for when the assets underlying a structured product - like a subprime asset-backed security - blowup), as it is not as visible to the average Joe Public.

So this market is not as visible to you or me, unless you are working on the credit trading floor of an investment bank (in which case, you can probably skip the rest of this blog, and go wait for the rain delay in the Wimbledon finals to end). So, if it's not as visible, what is it all about? Well, basically, banks create a market for these securities by matching buyers and sellers. They make their cut on the bid-offer spread. Think of this as the commission the dealers make in return for providing liquidity. What are they trading you ask? Well, they are trading everything. Some desks trade corporate bonds, while others government bonds, or municipal bonds, etc. Often times though, a company will issue many bonds. Each of these bonds is subject to a variety of risks: credit risk, interest rate risk, and foreign exchange risk.

So with all these different types of debt floating around, how do we isolate the credit risk (the risk of default) for a certain company? Well, in 1994, in London, a JP Morgan employee formulated an answer in the credit default swap (CDS). The CDS is essentially a form of insurance on a company's credit (read: debt). It is an OTC contract between two parties, and it allows you to go long or short on the risk that the company has a credit event (bankruptcy, default, restructuring). The basic structure of a CDS is as follows. Party A buys protection from Party B on a reference entity (call this reference entity a bond issued by Company TML). Party A pays party B a periodic payments (say every year) in return for the guarantee that if there is a credit event on TML Co's debt, Party B will return the full face/par value to Party A. In other words, Party A is selling risk, and Party B is buying it. If no credit event occurs during the life of the contract (typically 5 years), then Party B will have to do nothing, and will have received a nice yield. If TML Co's defaults on its debt (because it can't sell enough tickets now that Mats Sundin is gone, and it can't pay the interest on its debt), then Party A delivers the defaulted company's debt and gets 100 cents on the dollar from Party B (i.e., par value). One of the beautiful aspects of the CDS is that neither company needs to actually own TML's debt. That is, you don't need to own the underlying in order to buy or sell credit risk on said entity.

The payment that Party A (the buyer of protection a.k.a the seller of risk) makes to Party B (the seller of protection a.k.a. the buyer of risk) is measured in basis points. This premium is often referred to as the spread. The spread is, as mentioned, paid in basis points per annum and is usually paid quarterly. For instance, if 5-year protection for AT&T bonds are trading at 200 basis points, in order to protect a $10 million notional exposure to AT&T bonds, you'd have to pay 50 bps every quarter, or $50,000 each quarter on the $10 million notional.

If you're a keen observer, you'll have said, "hey, wait a minute here chief, why the hell are you calling this a spread, it's not at all like the yield spread of a corporate bond over a government bond". To which I would respond, "yes, that is correct, thank you for your concern." CDS spreads, as you can see from the example above, are not based on any risk-free bonds or benchmark interest rates. They are simply the annual price of protection on a reference entity, quoted in basis points (bps).

If it helps, try to think of a CDS as a put option written on a corporate bond. The protection buyer is protected from losses resulting from a decrease in value of the bond resulting from a credit event. Therefore, you can look at the CDS spread as the premium on the put option. This premium is spread out over the life of the contract.

As I mentioned earlier, the CDS allows for the isolation of credit risk. The CDS also provides liquidity to the markets, as the contracts are standardized, and concentrated around certain maturities (5-year being the most common). These two factors have helped make the CDS market worth about $45 trillion in 2007. The explosion of CDS-related instruments in the past few years has been helped by the creation of CDS-indices around the world. In Europe, the main index is iTraxx. The iTraxx Europe CDS index is used as a benchmark, and is composed of 125 equally weighted names as selected by a poll of financial dealers (the dealers select the CDSs based on volume traded over the last 6 months). Each 6 months, a new series is issued.

There are 1, 3, 5, 7, and 10 year maturities. Put them all together, and you get a nice little curve. If the curve flattens (that is, the premium paid on 1-year CDSs is roughly similar to that paid on 7 or 10 year CDSs), it is a bearish scenario, as investors believe that there will be more defaults in the short term. This is quite bizarre if you think about it, as it means that investors are worried about credit events in the immediate term. Naturally, you'd think that given a long time frame, there'd be more probability of a negative credit event. So when the curve flattens, or even inverts, it's not a great sign.

One of the other interesting aspects of credit default swaps alluded to earlier is that leverage can very easily be utilized. This is because a CDS does not require funding initially. In other words, you have to only commit a portion of the capital of the notional. As all good finance students know, leverage can be both good and bad, so it's important to be careful with credit default swaps. In order to reduce your risk, you can hedge by buying protection at a certain level on a reference entity, and sell protection on the same reference entity, at either a different spread, or a different maturity.

So basically, you now know how credit default swaps work. If tomorrow Ford comes out with an announcement about how bad U.S. auto sales are, you can be darn sure that the CDS spread on its debt will increase, as there is a greater chance of default. That is, it will cost you more to buy protection on it, as the risk of default is higher.

CDSs are incredibly useful tools for hedging risk, and a great deal of money can be made using these derivatives. With the market in its current state, the volatility of CDS contracts is extremely high, which makes for an incredibly fascinating time. Keep a close eye on credit default swaps, as I guarantee you'll be hearing more of them.

Cash Flow is King

When the O'Jays sang For The Love of Money way back in 1974, they made a point of emphasizing they were crooning about cash money. They weren't talking about post-depreciation, after interest-deductibility, after-tax earnings. They were "talkin' bout cash money... dollar bills y'all - come on now". Now I'm not sure what kind of investors the O'Jays were, but if they had simply followed their own mantra, they might have been gosh-darned good ones. Why, you ask? Well, it's pretty simple: cash is King.

When you evaluate and value a company, you want to be able to look at the money it is actually generating. We don't want this figure to be clouded by accounting tricks, or other financial maneuvers that can skew the true picture. Basically, you want to know that you're getting what you pay for. Cash is especially important in turbulent, uncertain times such as these. Now, the true cash flow of a company, for full disclosure, can be subject to some interesting tricks, but - on the whole - it provides a much cleaner picture of the health of a company.

Having a healthy cash flow, especially in turbulent periods, can be a great thing. It can give you the flexibility to alter your dividend, or initiate a stock buyback. Moreover, when markets turn sour, it can give you a nice little cushion to maintain your capital ratios if you're a financial institution. This extra little bit of cash may even allow you to avoid having to go to the markets to raise additional capital.

So how do we find the cash flow, more specifically, the free cash flow? (Free cash flow is cash not required for operating or reinvestment deemed necessary to keep your business in the exact same condition as last year). To get it: take EBIT (a.k.a the operating earnings) and multiply by (1-Tc). This yields the after-tax earnings of the firm as if it were financed entirely by equity - the EBIAT (Earnings before Interest and After Tax). It is the flow to both equity and debt holders. Now we add back the non-cash depreciation expense, subtract the capital expenditures (CAPEX, earlier noted as the reinvested deemed necessary to keep the business the same, that is, it is the value that makes the book value at the beginning of the year the same at the end of the year after taking the depreciation of the plant, equipment etc. into account - BV1 = BV0 + CAPEX - DEP). We also subtract any investments in net working capital (NWC).

We now have Free Cash Flow. But wait, there's more! What I didn't tell you, and maybe you picked up on it, but we just calculated unlevered free cash flow. This is generally what is used, because in most cases, we'd like to disregard leverage (for the purposes of comparing two companies fairly). There is actually also levered free cash flow. This is calculated in the same way, except interest payments or debt repayments are taken into account. (So to be clear, you'd take EBIT + Interest Payments in the first step.) Unlevered FCF is usually the metric used, especially for potential buyers, who are interested in changing the capital structure (read: debt levels) of the target company. That is, the current capital structure isn't very important. Levered FCF measures the flow to just the equity holders.

Now, we have the unlevered free cash flows, what do we do with them? Well, we can do a number of things. First off, we can plug them into a little model know as the Discounted Cash Flow (DCF) Model. Now, there are a lot of things to discuss about the DCF. In fact, it can be the topic of many lectures in higher finance courses. But I'll try to give a quick run down. Basically, in order to value the company, we look at all the cash flows that it creates indefinitely into the future. We want to convert future money into today's terms. Sounds easy right? Well, it's a little more complicated than that. Money has a time-value to it. There is an opportunity cost associated with it. So, we have to discount the cash flows by a rate that is deemed to be appropriate to the providers of capital. This discount rate is known in this situation as the Weighted Average Cost of Capital (WACC). The WACC accounts for the time value of money, and the risk premium associated with the cash flows.

Now, many people you talk to within the financial industry will tell you that the DCF model is highly academic, and that it's not really used in the 'real-world'. Let's just assume for a minute that this is 100% true (which it isn't); how else can we use cash flow to get a value of the company? Well, the answer lies in multiples. For instance, the Price to Cash Flow (P/CF) metric is often used for companies where the earnings number reported isn't very valuable. For instance, consider two oil and gas companies in different jurisdictions. The different tax regimes, accounting regulations can vary differently between jurisdictions. P/CF gives you a clearer picture of the true worth of the company.

The Free Cash Flow Yield can also be a handy little tool in relative valuation. Ceteris paribus, you'd like a company with a higher free cash flow yield, as the metric is the FCF per share a company is expected to earn against its price per share. That is, investors want a higher yield because investors want to pay as little as possible for as much as possible. They want to get the best deal.

So there's a little introduction to cash flow and the DCF. There is of course a lot more to discuss. Remember though, with the downturn here or coming soon depending on to whom you listen, earnings quality will once again come to the forefront, and cash will remain king.

News and Notes for April and May

So, first off, I'd like to apologize for the lack of activity on the blog over the last few months. As I've mentioned numerous times, all of us have been on exchange, and we're now just finishing up. (For those actually at Queen's, which I hope is most of our readers, I highly, highly recommend going on exchange - easily the best decision you can make). We were literally traveling for 1.5 months straight, so little time to sit down and update this blog. Regardless, we've all kept one eye on the markets over the last few months, and a lot of things have happened in that time.

Now, getting to the markets. Way back in March, Bear Stearns was purchased by JPM in what some describe at the watershed moment of the Credit Crisis of 2007/2008. It was the denouement of the saga that has wreaked havoc on the markets since July and August of last year. With two month's hindsight, it appears to have been the bottom of the market. The Fed acted pretty quickly and swiftly, and really calmed both retail and institutional investors. Moreover, the economic stimulus package that was authorized by President Bush and Congress has just begun to kick in. This package is intended to kickstart the U.S. consumer, which makes up about 70% of the U.S. economy. This is all done in order to avoid or mitigate the consequences of the first-consumer led recession since 1991.

Many economists and analysts believe that we are already in a recession. Others believe that we will narrowly avoid one. Whichever view is correct, it's pretty clear that the road ahead is anything but smooth. Over the last two months, we've seen: more writedowns from banks, a decrease in consumer confidence (a 28-year low), a huge spike in oil prices, the fall in the U.S. dollar, rumours of ratings downgrades at major insurers, layoffs and weak job growth, a continuing slump in the U.S. housing market, and rising commodity prices and food shortages around the world. However, in the most recent earnings season, we've also seen some companies at the very least meet and, in a handful of cases, exceed analyst's expectations.

We've also seen some investors jump into the market in a big way in order to take advantage of low valuations. For instance, Warren Buffet bought a giant heap of candy, Nelson Peltz bought some burgers, Steve Ballmer and Carl Icahn have each made runs at Yahoo, and HP purchased EDS for $13 billion. Moreover, in another sign of increasing investor confidence, equity markets have rallied since Bear was bailed out in March. Turning to the credit markets, in another positive sign, yields on junk bonds have rallied since March. The Merrill Lynch Junk Bond Index now yields about 7 points more than low-risk treasuries, which is better than the 8.6% high the day after Bear collapsed. (As investors become less risk-averse, yields on junk bonds falls). Although it must be pointed out the spread was around 2% before stuff hit the fan in July '07. So, there is good and bad in the market. Have we rebounded from the lowest of the lows? Most likely. Are we out of the woods? Most definitely not. In the interim, the market will continue to digest data on a piecemeal basis.

Just getting back to the Competition for a second. We are currently working on determining an outright and risk-adjusted winner. You will get an e-mail as soon as we have the final results. The winners can claim their prize at our first meeting for the next school year in September.

VISA's Initial Public Offering

One day after the financial markets were shaken by the announcement that Bear Stearns would be bought by JP Morgan for $2 per share (this has subsequently been quintupled to $10 per share), another momentous event took place: VISA Inc. had its initial public offering (IPO). An IPO is the first offer of a private company’s shares on the public market. When securities are issued publicly, underwriters are usually involved primarily to price and sell the issue (the lead underwriters for VISA were none other than JP Morgan and Goldman Sachs).

On March 18, 2008, VISA sold 406 million shares at $44 – raising nearly $18 billion. Why is this so significant, you ask? Firstly, this is the largest IPO in history (the next largest was the AT&T offering which collected $11 billion in 2000); secondly, and arguably more important, it comes at a time when consumer confidence is low, credit markets are illiquid, and all the general “health” of the US economy is in question.

Many market commentators are viewing the VISA IPO as a test of investor sentiment in these new equities. One of the major concerns for any IPO, in the short-term, is establishing a stable share price – senior management is particularly conscious of this, as well as investors. An IPO underwriter (the banking group selling the issue) must engage in a careful balancing act: price the IPO too low and the company will fail to raise the most capital (and it effectively leaves profit to investors); price the IPO too high, and shareholder return will be low as share prices fall to reflect the true value of the company.

With all the hype surrounding the offering, it is not surprising that VISA stock opened at $60 per share (this would suggest that the offering was underpriced, leaving [$60 – $44 x $406M shares] $6.5 billion “on the table”)! Since last week, China Life has invested $300M in VISA, giving further legitimacy to VISA as a worthwhile investment.

To invest in a company whose primary business is lending credit – especially in light of the current subprime fallout – is risky, to say the least. In the coming months, consumers will likely be spending less money and charging less to their credit cards, even with the Federal Reserve slashing interest rates. Yet, one need only look at the performance of VISA’s major competitor for a hint of what may await gutsy investors.

MasterCard went public in May of 2006 at $36 per share. Since then, the stock has returned over 500%, trading over $200 per share. With such high barriers to entry for the industry, coupled with VISA’s brand-name reputation and a base of customers which is double MasterCard’s, VISA may indeed be a stock worth keeping an eye on.

A Beary (Stearns) Wild Market

Ok, so it was either this title, or "Lions, Tigers, and Bear Stearns (oh my)". I couldn't really figure out what I'd do with the Lions and Tigers bit though. Regardless, the subject of this post won't change - the mammoth collapse of the 5th-largest U.S. bank. Before I start however, I wanted to point out that there is only 1 week left in the competition. With the unbelievable swings in the markets in the last couple weeks, a large bet one one or two stocks could catapult you to victory or decimate your hard work over the last several months. Be very (beary?) weary.

So what the heck happened to Bear Stearns? Well, to sum it up in a few words: it took on way too much risk, and got hammered in the subprime fiasco. It was so highly exposed to subprime that it's bottom-line was negative for the first time in 83 years. It's credit rating dropped from AA to A. Investors sold it off en-masse. From a trading high of near $160, to around $5 today. A startling drop of Titanic proportions. Here was a firm that survived the Depression and WW2, and all of a sudden a few bad bets and a souring market leads to its collapse. How this happened is a fascinating story.

Last Friday, Bear Stearns stock dropped 47%, from around $60 to around $28 bucks. The collapse was preceded by that of its close affiliate Carlyle Capital (the mortgage investment fund of Carlyle Group). There was basically a run on this fund after investors started asking for their money back. This really unnerved the market, and raised questions about Bear Stearns. Rumours began circulating that Bear was facing a cash crunch, which newly-minted CEO Alan Schwartz decried as ridiculous. He noted Bear's strong balance sheet and abundance of cash - investors didn't believe him. From Wednesday to Friday, Bear's clients and lenders (a.k.a Bear's counterparties - counterparties are just the parties a financial firm trades with) began moving their money out of the firm. Essentially, it was a classic run on the bank (Jimmy Stewart was nowhere to be found - if you don't know what I'm talking about, you probably haven't seen the 2nd best Christmas movie ever... Alastair Sim in the 1951 version of Scrooge takes the cake). So , there was a liquidity crisis at the bank. Securities firms were demanding cash from Bear, as opposed to accepting collateral. This required, in a rather extraordinary step, the Fed to step in with J.P. Morgan (JPM) to keep Bear afloat. The Fed acted in order to preserve the confidence of the financial markets. Basically, if Bear had completely collapsed, the shit would have hit the fan (excuse the crudeness).

Basically, Bear got access to cash for 28 days. The way it works is as follows: JPM borrows money from the Fed and relends this money to Bear, providing it with liquidity. The amount that Bear could borrow was limited by the amount of collateral that Bear could supply. The Fed was to assume all the risk here. The Wall Street Journal pointed out that, "it was the first time since the Great Depression that the Fed has lent in this fashion to any entity other than a bank".

So why did Bear collapse? Well, Bear has historically had a reputation of being a strong risk manager. However, in recent years, its mortgage business grew rapidly. It became basically the highlight of Bear Stearns recent success; that is, until a bunch of subprime mortgages went sour and home prices started falling. You'll remember from our first meeting the discussion of the two Bear hedge funds that collapsed in July. This was essentially the first major trigger in the subprime disaster. It all built up into last weeks loss of confidence in Bear Stearns. Investors wanted their money back, Bear had to give it to them.

So why did the Fed act? Well, that's an excellent question with a very interesting answer. Here's how the WSJ put it (paraphrased): The Fed had to act because Bear risked defaulting on its "repo" loans (short-term loans from the government - usually overnight - that influence the level of interest rates). In order to get these loans, Bear (and the other 20 "primary" dealers) had to pledge high-quality collateral, which was in short supply. If Bear defaulted, the other dealers would see access to repo loans become more restrictive. As a result, the pledged securities behind these loans could be sold in what amounts to a fire sale. This would aggravate the drop in securities prices.

On Sunday, J.P. Morgan announced in what some might term a bombshell (only because of its terms) announcement that it would buy Bear Stearns for $2 per share. That was the value hundreds of investment bankers working on basically no sleep for the weekend determined was fair. The market seems to disagree, with Bear trading at around $5 per share currently. This disparity is due to the fact that the market feels there could be a higher bidder, and that shareholders won't accept the deal.

There are other reasons for the stocks higher price. First off, bondholders are eager to get the deal done, because upon completion of the deal, Bear bonds will be converted into JPM bonds. There creditors are buying shares so they can vote. Other investors are shorting Bear bonds and CDS's (credit-default swaps). They are buying shares to vote "no", hoping that Bear goes into bankruptcy.

So, this has been a pretty fascinating story, and I hope this entry has been enough to get you up to speed on what's gone on in case you were enjoying St. Patty's Day a little too much. There is so, so much more to talk about and so many interesting subplots to this story. One really interesting one: billionaire investor Joseph Lewis, who has lost $1 billion on his investment in BSC is going to try to challenge JPM's $2 per share offer. This will develop over the coming days and weeks.

Just a final reminder the competition ends March 28th. Here's a tip, if you want to make or lose your shirt in one day, buy or short one of the financials. With volatility like we've witnessed in the last week (some days up 15%, some days down 30%), you could make a big move in the competition, and win the prize.

Happy Easter to all!

Stock Buybacks

So today IBM announced that it was going to be buying back $15 billion worth of stock. In response, IBM rose nearly 4.5% (markets still haven't closed at this point, but it's getting late here in Europe). Moreover, the news actually helped boost the market amid worries of falling consumer sentiment and rising core wholesale prices (warning: stagflation).

So why is the IBM buyback important? Well, many saw it as a ray of hope in an increasingly troubled market. The news thus far has been pretty grim, and any sort of positive news is being put on a pedestal the market. However, there is a more fundamental reason behind why this news is positive, which I'll get to shortly.

A stock buyback is just that. The company buys back its own stock/shares. Just like a dividend, it's a way of returning wealth to the shareholders of the company. So, that's pretty good, but if that's all it is, why is there such a generally positive, sustained reaction to the announcement of a share repurchase. Well, think of it this way. In a stock buyback, the company takes spare cash it has lying around (or even sometimes issues new debt to raise cash to buyback shares) and reinvests this cash in itself, by buying back shares. This action essentially reduces the number of shares outstanding. Since there are fewer claims against the company's assets, each investor holds a greater proportion of the total shares. This is good news for the shareholders as it juices up the EPS.

There is another reason why stock buybacks are often so positively received. In essence, as mentioned earlier, the company is investing in itself. Now, a rational investor would only make an investment if they saw a large potential upside; that is, they believed the shares of the investment were undervalued. Thus, a share buyback has a signaling effect. Clearly, one would think that the management of a company would have better information about the prospects of a company compared to some analyst sitting in New York. It's only logical. The managers live and breathe the company, they know it inside and out. If they choose to pump money into its shares, logically, there should be some sort of reason for that. So investors recognize the information asymmetry and take this buyback as a cue to invest in the company.

In theory, this all sounds pretty dandy. However, there can be two flaws with this thinking, maybe you've already recognized them. First off, managers know about this signaling effect, and may try to fool investors into thinking their shares are undervalued. That is, they may make a sub-optimal investment in their companies' shares in order to reap the short-term benefits of a price boost. This short-term price boost could lead a sneaky manager to large profits, as he (or she) could then exercise his stock options. The problem with this is, in the long-run, investors will find out, and they will really punish the firm. The second flaw with the reasoning is that managers often have a biased, overly optimistic view of the firm's prospects. It's sort of a rah-rah-sis-boom-bah attitude that pervades the top management of many firms. The management's hubris is such that they feel that the market has really undervalued their shares, and that surely the prospects are much brighter than currently reflected in the share price. This can be dangerous, and actually does happen in real life, especially in smaller, family-run firms.

Another dubious reason for management issuing a stock buyback is to improve the financial ratios. For instance, a stock buyback reduces the number of outstanding shares. Fewer shares, same return, higher return on equity (ROE). A buyback also reduces cash. Fewer assets, same return, higher return on assets (ROA). ROA and ROE go up, everything is roses, right? Well, technically, yes. However, if this is the only reason why a company has initiated a buyback, then all those roses suddenly have a lot more thorns (yes, that was a veiled reference to Poison). Moving on, if you were paying attention earlier, you'd remember that I said that a buyback juices up your EPS, due to the fewer number of outstanding shares. This becomes important when considering the P/E ratio. Follow me here... fewer shares, higher EPS; higher EPS (ceteris
paribus), lower P/E. Many investors tend to think a lower P/E ratio is indicative of better 'value'. So the company is now cheaper, even though it has the same earnings.

There is another brief considerations regarding share buybacks. Many companies have buyback programs in place already, so why is there such a big hubbub when they announce more buybacks. These extra buybacks are usually above and beyond the baseline buybacks, which are in place to reduce the massive diluting effect of stock options. Each time someone exercises their options, the company mints some new shares. Thus, there is dilution. This dilution is usually eliminated through company buyback programs. Investors like this.

So, in summary, buybacks are pretty interesting things. They are generally viewed very favourably by investors for the reasons outlined above. When looking at a company in which to invest, take a look-see and find out if there is a share repurchase plan in place, or if there are rumours of one coming up. A company with lots of cash on the balance sheet, and not many strategic acquisition prospects on the table is a prime candidate for a share buyback, or a dividend*. So keep a look out for these companies, they could give a nice boost to your portfolio.

Note: Dividends are now taxed at an equal rate to share buybacks (capital gains tax). In 2003, President Bush signed a law which equalized the rate, leading to a huge boom in dividends, which were not as historically popular as buybacks.

A brief note on dividends

Dividends, dividends, dividends. Even if you're new to the investing world, one of the first things you'll hear about is dividends, the importance of them, or the lack thereof. Investors often fall into two camps: those that seek a moderately high dividend yield (too high is not usually considered good), and those that do not feel dividends add value.

Basically, dividends are payments of cash or stock (usually cash) that a company makes to its shareholders. In essence, if a company earns a profit, it can either re-invest this money in the business, or pay it out to shareholders. Usually, the nature of the company's business and industry will be the main determinant of the size or existence of a dividend. If a company can earn a higher return than its shareholders (r > k), this company will generally not pay out a dividend, or its dividend will be small. This is just common sense. The company can do more with $1 of earnings than the shareholders can. The shareholders, therefore, would rather have the company put that money to work. This type of company is known as a growth company. A prime example would be Google.

If the shareholders can do more with $1 of earnings than the company, then they will seek a high payout ratio. In a perfect world, they would want a 100% payout ratio. Now, this obviously never happens; nevertheless, the point stands. A declining company should seek to return more of its earnings to the shareholders. Now, it's always hard to explicitly identify companies that are said to be declining (because no CEO would ever want to admit that their industry is dying or shrinking). However, take a look at BCE.TO or ROC.TO (Bell - 4.1% yield and Rothman's 5.5% yield), both companies are in semi-declining industries, and their payout ratio is on the higher end of the scale.

"Normal" companies with r = k will generally have an ambiguous policy towards dividend payouts. Many companies would rather try to claim they are a growth firm (note: there is a difference between growth and growing - earnings can be growing, but that doesn't mean it's a growth firm), and they will not pay out a dividend. Other companies will pay out a dividend for several reasons. One main reason is related to clientele theory. Some theorists believe that investors are attracted to a company because of its dividend payout ratio. For instance, some older investors seek current income, and thus, would want to invest in companies that have a high payout ratio. This was a major factor in the rise of income trusts over the last few years, and why so many grumpy old men went ballistic after the governments decision to implement a new tax scheme on the income trusts (more on that in another post to come).

Another key reason why investors prefer companies that pay dividends is that they impose a form of discipline on management. Sometimes, there is a lot of spare cash lying around. If a company doesn't pay out dividends, managers and executives could be tempted to try to put this money to work. This would lead to accepting projects that perhaps have a negative NPV or earn less than the IRR.

Another benefit of dividends is their ability to dampen fluctuations in return. For instance, many REITs have lost a lot of money over the last year. For example, say a stock lost 15% of their value over the past year, this stock however, has successfully paid out a dividend 4 times over the year. This guaranteed return lessens the overall loss on the stock, to say 8%. Furthermore, dividends allow investors to dollar-cost average, by taking the payouts and re-investing them at prices lower than the original purchase price. In the long-run, this can prove to be very enticing, and reinvesting dividends can yield significant returns.

This post has been intended to give a brief overview and introduction to dividends. Clearly, though, it's from a 50,000 foot level. There is a lot more to be discussed, and I suggest reading through your textbooks or taking a look at some sites online. For the purposes of the competition, it might be interesting to take a look at a site like www.thestreet.com, which often has a list of companies that have hiked their dividends. This is usually a very positive sign in the market, and something that investors typically look for. On the flip side, companies that cut their dividends are usually in a lot of trouble. Citigroup, for instance, recently had to cut its dividend in order to free up cash to preserve their capital ratios. So generally, in the short-run, if you see a company cut its dividend, it is usually a sign of bad times ahead in the immediate future. For a foundationally solid company like Citigroup, it could signal something close to a bottom.