Friday, February 27, 2009

Yen/Dollar Rate Above 98, Good For Stocks?

Readers would be familiar with my yen-rate theory. I expected the weaker yen to signal less risk aversion, and hence a potential to move funds back into equities. The flight-to-safety play in 2008 didn't include gold. In fact, it was mostly concentrated in U.S. treasuries, the U.S. dollar and the Japanese yen.

The Japanese yen is down more than 10% since it peaked mid-December of last year. The yen has actually fallen below the levels seen at the height of credit anxiety during the October and November low points. However equities have not jumped as I expected. The yen typically rose with risk aversion as it did at the start of the collapse in mid-September of last year.The yen-dollar rate has scaled above 98 yen as write this.

Japan is more dependent on its exports for economic success than nearly any other nation. The global recession and the strengthening of Japan's currency has made it terribly difficult for its multinationals to sell products to the world. It does not seem that the Japanese government has done anything concerte to weaken the yen.

I believe that investors are beginning to take more risk with their money again. It's likely that the risk being taken is far more incremental. I see the initial move out of yen going to high-grade corporate bonds and maybe gold. It is still early days but its a good scenario for the willingness to move out of yen alone. There is a lot of liquidity on the sidelines, and there is only so much TIPs you can buy. Further improvements in the buying of corporate bonds will necessarily cause an inflow into equities.

Besides, Japan needs a weaker yen if the economy is going to be able to do its bit to improve its export-let economy. We don't need a paralysed Japanese economy. Sticking to the yen rate theory and gradually increasing equity weighting. Risk aversion may be abating, but the flow back into equities will be gradual and more gingerly in nature owing to uncertain markets.

p/s photo: Chen Kuang Yi

Thursday, February 26, 2009

The Formula That Brought On This Crisis

I blame the ratings agencies for the bulk of the credit mess we are in, the Wall Street firms are not far behind. Ironically, both parties relied on a simple formula devised by a math wizard. He is David Li, and you can find him now as the Head of Risk management at the China sovereign wealth fund, CIC. Below was the exceptionally revealing article from the magazine Wired (of all places).

A year ago, it was hardly unthinkable that a math wizard like David X. Li might someday earn a Nobel Prize. After all, financial economists—even Wall Street quants—have received the Nobel in economics before, and Li's work on measuring risk has had more impact, more quickly, than previous Nobel Prize-winning contributions to the field. Today, though, as dazed bankers, politicians, regulators, and investors survey the wreckage of the biggest financial meltdown since the Great Depression, Li is probably thankful he still has a job in finance at all. Not that his achievement should be dismissed. He took a notoriously tough nut—determining correlation, or how seemingly disparate events are related—and cracked it wide open with a simple and elegant mathematical formula, one that would become ubiquitous in finance worldwide.

For five years, Li's formula, known as a Gaussian copula function, looked like an unambiguously positive breakthrough, a piece of financial technology that allowed hugely complex risks to be modeled with more ease and accuracy than ever before. With his brilliant spark of mathematical legerdemain, Li made it possible for traders to sell vast quantities of new securities, expanding financial markets to unimaginable levels.

His method was adopted by everybody from bond investors and Wall Street banks to ratings agencies and regulators. And it became so deeply entrenched—and was making people so much money—that warnings about its limitations were largely ignored.
Then the model fell apart.

Cracks started appearing early on, when financial markets began behaving in ways that users of Li's formula hadn't expected. The cracks became full-fledged canyons in 2008—when ruptures in the financial system's foundation swallowed up trillions of dollars and put the survival of the global banking system in serious peril.
David X. Li, it's safe to say, won't be getting that Nobel anytime soon.

One result of the collapse has been the end of financial economics as something to be celebrated rather than feared. And Li's Gaussian copula formula will go down in history as instrumental in causing the unfathomable losses that brought the world financial system to its knees.
How could one formula pack such a devastating punch? The answer lies in the bond market, the multi trillion-dollar system that allows pension funds, insurance companies, and hedge funds to lend trillions of dollars to companies, countries, and home buyers.

A bond, of course, is just an IOU, a promise to pay back money with interest by certain dates. If a company—say, IBM—borrows money by issuing a bond, investors will look very closely over its accounts to make sure it has the wherewithal to repay them. The higher the perceived risk—and there's always some risk—the higher the interest rate the bond must carry.
Bond investors are very comfortable with the concept of probability. If there's a 1 percent chance of default but they get an extra two percentage points in interest, they're ahead of the game overall—like a casino, which is happy to lose big sums every so often in return for profits most of the time.

Bond investors also invest in pools of hundreds or even thousands of mortgages. The potential sums involved are staggering: Americans now owe more than $11 trillion on their homes. But mortgage pools are messier than most bonds. There's no guaranteed interest rate, since the amount of money homeowners collectively pay back every month is a function of how many have refinanced and how many have defaulted. There's certainly no fixed maturity date: Money shows up in irregular chunks as people pay down their mortgages at unpredictable times—for instance, when they decide to sell their house. And most problematic, there's no easy way to assign a single probability to the chance of default.
Wall Street solved many of these problems through a process called tranching, which divides a pool and allows for the creation of safe bonds with a risk-free triple-A credit rating.

Investors in the first tranche, or slice, are first in line to be paid off. Those next in line might get only a double-A credit rating on their tranche of bonds but will be able to charge a higher interest rate for bearing the slightly higher chance of default. And so on.
"...correlation is charlatanism"

The reason that ratings agencies and investors felt so safe with the triple-A tranches was that they believed there was no way hundreds of homeowners would all default on their loans at the same time. One person might lose his job, another might fall ill. But those are individual calamities that don't affect the mortgage pool much as a whole: Everybody else is still making their payments on time. But not all calamities are individual, and tranching still hadn't solved all the problems of mortgage-pool risk. Some things, like falling house prices, affect a large number of people at once. If home values in your neighborhood decline and you lose some of your equity, there's a good chance your neighbors will lose theirs as well. If, as a result, you default on your mortgage, there's a higher probability they will default, too. That's called correlation—the degree to which one variable moves in line with another—and measuring it is an important part of determining how risky mortgage bonds are.

Investors like risk, as long as they can price it. What they hate is uncertainty—not knowing how big the risk is. As a result, bond investors and mortgage lenders desperately want to be able to measure, model, and price correlation.

Before quantitative models came along, the only time investors were comfortable putting their money in mortgage pools was when there was no risk whatsoever—in other words, when the bonds were guaranteed implicitly by the federal government through Fannie Mae or Freddie Mac.
Yet during the '90s, as global markets expanded, there were trillions of new dollars waiting to be put to use lending to borrowers around the world—not just mortgage seekers but also corporations and car buyers and anybody running a balance on their credit card—if only investors could put a number on the correlations between them. The problem is excruciatingly hard, especially when you're talking about thousands of moving parts. Whoever solved it would earn the eternal gratitude of Wall Street and quite possibly the attention of the Nobel committee as well.

To understand the mathematics of correlation better, consider something simple, like a kid in an elementary school: Let's call her Alice. The probability that her parents will get divorced this year is about 5 percent, the risk of her getting head lice is about 5 percent, the chance of her seeing a teacher slip on a banana peel is about 5 percent, and the likelihood of her winning the class spelling bee is about 5 percent. If investors were trading securities based on the chances of those things happening only to Alice, they would all trade at more or less the same price.
But something important happens when we start looking at two kids rather than one—not just Alice but also the girl she sits next to, Britney. If Britney's parents get divorced, what are the chances that Alice's parents will get divorced, too? Still about 5 percent: The correlation there is close to zero. But if Britney gets head lice, the chance that Alice will get head lice is much higher, about 50 percent—which means the correlation is probably up in the 0.5 range. If Britney sees a teacher slip on a banana peel, what is the chance that Alice will see it, too? Very high indeed, since they sit next to each other: It could be as much as 95 percent, which means the correlation is close to 1. And if Britney wins the class spelling bee, the chance of Alice winning it is zero, which means the correlation is negative: -1.

If investors were trading securities based on the chances of these things happening to both Alice and Britney, the prices would be all over the place, because the correlations vary so much.
But it's a very inexact science. Just measuring those initial 5 percent probabilities involves collecting lots of disparate data points and subjecting them to all manner of statistical and error analysis. Trying to assess the conditional probabilities—the chance that Alice will get head lice if Britney gets head lice—is an order of magnitude harder, since those data points are much rarer. As a result of the scarcity of historical data, the errors there are likely to be much greater. In the world of mortgages, it's harder still.

What is the chance that any given home will decline in value? You can look at the past history of housing prices to give you an idea, but surely the nation's macroeconomic situation also plays an important role. And what is the chance that if a home in one state falls in value, a similar home in another state will fall in value as well?

Here's what killed your 401(k) David X. Li's Gaussian copula function as first published in 2000. Investors exploited it as a quick—and fatally flawed—way to assess risk. A shorter version appears on this month's cover of Wired.
Probability Specifically, this is a joint default probability—the likelihood that any two members of the pool (A and B) will both default. It's what investors are looking for, and the rest of the formula provides the answer.

Survival times
- The amount of time between now and when A and B can be expected to default. Li took the idea from a concept in actuarial science that charts what happens to someone's life expectancy when their spouse dies. Equality - A dangerously precise concept, since it leaves no room for error. Clean equations help both quants and their managers forget that the real world contains a surprising amount of uncertainty, fuzziness, and precariousness. Copula - This couples (hence the Latinate term copula) the individual probabilities associated with A and B to come up with a single number. Errors here massively increase the risk of the whole equation blowing up. Distribution functions The probabilities of how long A and B are likely to survive.

Since these are not certainties, they can be dangerous: Small miscalculations may leave you facing much more risk than the formula indicates.
Gamma - The all-powerful correlation parameter, which reduces correlation to a single constant—something that should be highly improbable, if not impossible. This is the magic number that made Li's copula function irresistible.

Enter Li, a star mathematician who grew up in rural China in the 1960s. He excelled in school and eventually got a master's degree in economics from Nankai University before leaving the country to get an MBA from Laval University in Quebec. That was followed by two more degrees: a master's in actuarial science and a PhD in statistics, both from Ontario's University of Waterloo. In 1997 he landed at Canadian Imperial Bank of Commerce, where his financial career began in earnest; he later moved to Barclays Capital and by 2004 was charged with rebuilding its quantitative analytics team.
Li's trajectory is typical of the quant era, which began in the mid-1980s.

Academia could never compete with the enormous salaries that banks and hedge funds were offering. At the same time, legions of math and physics PhDs were required to create, price, and arbitrage Wall Street's ever more complex investment structures.
In 2000, while working at JPMorgan Chase, Li published a paper in The Journal of Fixed Income titled "On Default Correlation: A Copula Function Approach." (In statistics, a copula is used to couple the behavior of two or more variables.) Using some relatively simple math—by Wall Street standards, anyway—Li came up with an ingenious way to model default correlation without even looking at historical default data. Instead, he used market data about the prices of instruments known as credit default swaps. If you're an investor, you have a choice these days: You can either lend directly to borrowers or sell investors credit default swaps, insurance against those same borrowers defaulting. Either way, you get a regular income stream—interest payments or insurance payments—and either way, if the borrower defaults, you lose a lot of money. The returns on both strategies are nearly identical, but because an unlimited number of credit default swaps can be sold against each borrower, the supply of swaps isn't constrained the way the supply of bonds is, so the CDS market managed to grow extremely rapidly.

Though credit default swaps were relatively new when Li's paper came out, they soon became a bigger and more liquid market than the bonds on which they were based.
When the price of a credit default swap goes up, that indicates that default risk has risen. Li's breakthrough was that instead of waiting to assemble enough historical data about actual defaults, which are rare in the real world, he used historical prices from the CDS market. It's hard to build a historical model to predict Alice's or Britney's behavior, but anybody could see whether the price of credit default swaps on Britney tended to move in the same direction as that on Alice. If it did, then there was a strong correlation between Alice's and Britney's default risks, as priced by the market. Li wrote a model that used price rather than real-world default data as a shortcut (making an implicit assumption that financial markets in general, and CDS markets in particular, can price default risk correctly).

It was a brilliant simplification of an intractable problem. And Li didn't just radically dumb down the difficulty of working out correlations; he decided not to even bother trying to map and calculate all the nearly infinite relationships between the various loans that made up a pool. What happens when the number of pool members increases or when you mix negative correlations with positive ones? Never mind all that, he said. The only thing that matters is the final correlation number—one clean, simple, all-sufficient figure that sums up everything.

The effect on the securitization market was electric.
Armed with Li's formula, Wall Street's quants saw a new world of possibilities. And the first thing they did was start creating a huge number of brand-new triple-A securities. Using Li's copula approach meant that ratings agencies like Moody's—or anybody wanting to model the risk of a tranche—no longer needed to puzzle over the underlying securities. All they needed was that correlation number, and out would come a rating telling them how safe or risky the tranche was.
As a result, just about anything could be bundled and turned into a triple-A bond—corporate bonds, bank loans, mortgage-backed securities, whatever you liked. The consequent pools were often known as collateralized debt obligations, or CDOs. You could tranche that pool and create a triple-A security even if none of the components were themselves triple-A.

You could even take lower-rated tranches of other CDOs, put them in a pool, and tranche them—an instrument known as a CDO-squared, which at that point was so far removed from any actual underlying bond or loan or mortgage that no one really had a clue what it included. But it didn't matter. All you needed was Li's copula function.

The CDS and CDO markets grew together, feeding on each other. At the end of 2001, there was $920 billion in credit default swaps outstanding. By the end of 2007, that number had skyrocketed to more than $62 trillion. The CDO market, which stood at $275 billion in 2000, grew to $4.7 trillion by 2006.

At the heart of it all was Li's formula. When you talk to market participants, they use words like beautiful, simple, and, most commonly, tractable. It could be applied anywhere, for anything, and was quickly adopted not only by banks packaging new bonds but also by traders and hedge funds dreaming up complex trades between those bonds.

"The corporate CDO world relied almost exclusively on this copula-based correlation model," says Darrell Duffie, a Stanford University finance professor who served on Moody's Academic Advisory Research Committee. The Gaussian copula soon became such a universally accepted part of the world's financial vocabulary that brokers started quoting prices for bond tranches based on their correlations. "Correlation trading has spread through the psyche of the financial markets like a highly infectious thought virus," wrote derivatives guru Janet Tavakoli in 2006.
The damage was foreseeable and, in fact, foreseen.

In 1998, before Li had even invented his copula function, Paul Wilmott wrote that "the correlations between financial quantities are notoriously unstable." Wilmott, a quantitative-finance consultant and lecturer, argued that no theory should be built on such unpredictable parameters. And he wasn't alone.

During the boom years, everybody could reel off reasons why the Gaussian copula function wasn't perfect. Li's approach made no allowance for unpredictability: It assumed that correlation was a constant rather than something mercurial. Investment banks would regularly phone Stanford's Duffie and ask him to come in and talk to them about exactly what Li's copula was. Every time, he would warn them that it was not suitable for use in risk management or valuation.

In hindsight, ignoring those warnings looks foolhardy. But at the time, it was easy. Banks dismissed them, partly because the managers empowered to apply the brakes didn't understand the arguments between various arms of the quant universe. Besides, they were making too much money to stop. In finance, you can never reduce risk outright; you can only try to set up a market in which people who don't want risk sell it to those who do. But in the CDO market, people used the Gaussian copula model to convince themselves they didn't have any risk at all, when in fact they just didn't have any risk 99 percent of the time. The other 1 percent of the time they blew up. Those explosions may have been rare, but they could destroy all previous gains, and then some.

Li's copula function was used to price hundreds of billions of dollars' worth of CDOs filled with mortgages. And because the copula function used CDS prices to calculate correlation, it was forced to confine itself to looking at the period of time when those credit default swaps had been in existence: less than a decade, a period when house prices soared.

Naturally, default correlations were very low in those years. But when the mortgage boom ended abruptly and home values started falling across the country, correlations soared.
Bankers securitizing mortgages knew that their models were highly sensitive to house-price appreciation. If it ever turned negative on a national scale, a lot of bonds that had been rated triple-A, or risk-free, by copula-powered computer models would blow up. But no one was willing to stop the creation of CDOs, and the big investment banks happily kept on building more, drawing their correlation data from a period when real estate only went up.

"Everyone was pinning their hopes on house prices continuing to rise," says Kai Gilkes of the credit research firm CreditSights, who spent 10 years working at ratings agencies. "When they stopped rising, pretty much everyone was caught on the wrong side, because the sensitivity to house prices was huge. And there was just no getting around it. Why didn't rating agencies build in some cushion for this sensitivity to a house-price-depreciation scenario? Because if they had, they would have never rated a single mortgage-backed CDO."

Bankers should have noted that very small changes in their underlying assumptions could result in very large changes in the correlation number. They also should have noticed that the results they were seeing were much less volatile than they should have been—which implied that the risk was being moved elsewhere. Where had the risk gone?
They didn't know, or didn't ask.

One reason was that the outputs came from "black box" computer models and were hard to subject to a commonsense smell test. Another was that the quants, who should have been more aware of the copula's weaknesses, weren't the ones making the big asset-allocation decisions. Their managers, who made the actual calls, lacked the math skills to understand what the models were doing or how they worked. They could, however, understand something as simple as a single correlation number. That was the problem.

"The relationship between two assets can never be captured by a single scalar quantity," Wilmott says. For instance, consider the share prices of two sneaker manufacturers: When the market for sneakers is growing, both companies do well and the correlation between them is high. But when one company gets a lot of celebrity endorsements and starts stealing market share from the other, the stock prices diverge and the correlation between them turns negative. And when the nation morphs into a land of flip-flop-wearing couch potatoes, both companies decline and the correlation becomes positive again. It's impossible to sum up such a history in one correlation number, but CDOs were invariably sold on the premise that correlation was more of a constant than a variable.

No one knew all of this better than David X. Li: "Very few people understand the essence of the model," he told The Wall Street Journal way back in fall 2005.
"Li can't be blamed," says Gilkes of CreditSights. After all, he just invented the model. Instead, we should blame the bankers who misinterpreted it. And even then, the real danger was created not because any given trader adopted it but because every trader did.

In financial markets, everybody doing the same thing is the classic recipe for a bubble and inevitable bust.
Nassim Nicholas Taleb, hedge fund manager and author of The Black Swan, is particularly harsh when it comes to the copula. "People got very excited about the Gaussian copula because of its mathematical elegance, but the thing never worked," he says. "Co-association between securities is not measurable using correlation," because past history can never prepare you for that one day when everything goes south. "Anything that relies on correlation is charlatanism."

Li has been notably absent from the current debate over the causes of the crash. In fact, he is no longer even in the US. Last year, he moved to Beijing to head up the risk-management department of China International Capital Corporation. In a recent conversation, he seemed reluctant to discuss his paper and said he couldn't talk without permission from the PR department. In response to a subsequent request, CICC's press office sent an email saying that Li was no longer doing the kind of work he did in his previous job and, therefore, would not be speaking to the media. In the world of finance, too many quants see only the numbers before them and forget about the concrete reality the figures are supposed to represent. They think they can model just a few years' worth of data and come up with probabilities for things that may happen only once every 10,000 years. Then people invest on the basis of those probabilities, without stopping to wonder whether the numbers make any sense at all.

As Li himself said of his own model: "The most dangerous part is when people believe everything coming out of it."

— Felix Salmon ( writes the Market Movers financial blog at

p/s photos: Yu Hasebe

Tuesday, February 24, 2009

European Union Financial System Might Be Even Worse Off

The media tend to focus on the credit crisis too much on just the US and maybe the UK. Even the secondary focus was largely on how China would figure in being a catalyst for recovery. There are pockets of the world that are facing the crisis with more devastation, and urgency for help. In a sense for them, its should be called a debt crisis rather than a credit crisis. We are talking of Eastern Europe, Western Europe, Russia and Ukraine... hey, basically the EU. Most of what's written below was taken from The Telegraph, UK.

In much of Western Europe, things are nearing boiling point. Austria's finance minister Josef Pröll made frantic efforts last week to put together a €150bn rescue for the ex-Soviet bloc. Well he might. His banks have lent €230bn to the region, equal to 70pc of Austria's GDP.

"A failure rate of 10pc would lead to the collapse of the Austrian financial sector," reported Der Standard in Vienna. Unfortunately, that is about to happen.

The European Bank for Reconstruction and Development (EBRD) says bad debts will top 10pc and may reach 20pc. The Vienna press said Bank Austria and its Italian owner Unicredit face a "monetary Stalingrad" in the East. Mr Pröll tried to drum up support for his rescue package from EU finance ministers in Brussels last week. The idea was scotched by Germany's Peer Steinbrück. Not our problem, he said. We'll see about that.

Eastern Europe has borrowed $1.7 trillion abroad, much on short-term maturities. It must repay – or roll over – $400bn this year, equal to a third of the region's GDP. Good luck. The credit window has slammed shut.

Not even Russia can easily cover the $500bn dollar debts of its oligarchs while oil remains near $33 a barrel. The budget is based on Urals crude at $95. Russia has bled 36pc of its foreign reserves since August defending the rouble.

In Poland, 60pc of mortgages are in Swiss francs. The zloty has just halved against the franc. Hungary, the Balkans, the Baltics, and Ukraine are all suffering variants of this story. As an act of collective folly – by lenders and borrowers – it matches America's sub-prime debacle. There is a crucial difference, however. European banks are on the hook for both. US banks are not.

Almost all Eastern bloc debts are owed to West Europe, especially Austrian, Swedish, Greek, Italian, and Belgian banks. En plus, Europeans account for an astonishing 74pc of the entire $4.9 trillion portfolio of loans to emerging markets. They are five times more exposed to this latest bust than American or Japanese banks, and they are 50pc more leveraged (IMF data).

Spain is up to its neck in Latin America, which has belatedly joined the slump (Mexico's car output fell 51pc in January, and Brazil lost 650,000 jobs in one month). Britain and Switzerland are up to their necks in Asia.

Whether it takes months, or just weeks, the world is going to discover that Europe's financial system is sunk, and that there is no EU Federal Reserve yet ready to act as a lender of last resort or to flood the markets with emergency stimulus. The European Central Bank already needs to cut rates to zero and then purchase bonds and Pfandbriefe on a huge scale. It is constrained by geopolitics – a German-Dutch veto – and the Maastricht Treaty.

It is East Europe that is blowing up right now. Erik Berglof, EBRD's chief economist, said that the region may need €400bn in help to cover loans and prop up the credit system. Europe's governments are making matters worse. Some are pressuring their banks to pull back, undercutting subsidiaries in East Europe. Athens has ordered Greek banks to pull out of the Balkans.

The sums needed are beyond the limits of the IMF, which has already bailed out Hungary, Ukraine, Latvia, Belarus, Iceland, and Pakistan – and Turkey next – and is fast exhausting its own $200bn (€155bn) reserve. We are nearing the point where the IMF may have to print money for the world, using arcane powers to issue Special Drawing Rights. Its $16bn rescue of Ukraine has unravelled. The country – facing a 12pc contraction in GDP after the collapse of steel prices – is hurtling towards default, leaving Unicredit, Raffeisen and ING in the lurch. Pakistan wants another $7.6bn. Latvia's central bank governor has declared his economy "clinically dead" after it shrank 10.5pc in the fourth quarter. Protesters have smashed the treasury and stormed parliament.

In almost every way, this is much worse than the Asian financial crisis in the late 1990s, as indicated by the table below. There are accidents waiting to happen across the region, but the EU institutions don't have any framework for dealing with this. The day they decide not to save one of these one countries will be the trigger for a massive crisis with contagion spreading into the EU. The governments and ECB cannot risk NOT saving any one country or banking institution, but that strategy is drawing almost all the reserves and ammunition these institutions have.

[eastern europe economy]

Europe is already in deeper trouble than the ECB or EU leaders ever expected. Germany contracted at an annual rate of 8.4pc in the fourth quarter. Germany will have shrunk by nearly 9pc before the end of this year. This is the sort of level that stokes popular revolt. The implications are obvious. Berlin is not going to rescue Ireland, Spain, Greece and Portugal as the collapse of their credit bubbles leads to rising defaults, or rescue Italy by accepting plans for EU "union bonds" should the debt markets take fright at the rocketing trajectory of Italy's public debt (hitting 112pc of GDP next year, just revised up from 101pc – big change), or rescue Austria from its Habsburg adventurism.

Hungary’s forint fell to an all-time low in recent days, and Poland’s zloty slumped to the lowest in five years on plunging industrial output. Half of all loans to the private sector in Poland are in foreign currencies so borrowers face a severe debt shock after the 40pc fall of the zloty against the euro since August.

There are contagion worries for Western banks that have lent $1.74 trillion (£1.22bn) to the ex-Soviet bloc -- split between $1 trillion in foreign loans and $700bn in local currency debt through subsidiaries. Austria’s banks are the most exposed with the share of risk-weighted assets tied to the region reaching 54pc for Raffeisen and 38pc for Erste Bank. The exposure of Germany’s Bayern Bank is 48pc, Italy’s UniCredit is 45pc, and Swedbank is 29pc.

The region needs to roll over $400bn in foreign debts this year, equivalent to a third of total GDP, raising concerns that it may need a massive rescue programme from the International Monetary Fund and the European institutions.

p/s photos: Elva Hsiao

Monday, February 23, 2009

Ideologies, Financial Markets & Personal Values

Which camp do you belong to? Republicans or Democrats, Socialist or Capitalist... many in the Western world often know what they are or what they stand for ... e.g. "he is a left leaning republican ... blah-blah..." People in Asia do not usually ponder these matters, the most important political consideration is whether you are a Communist, and as long as you are against Communism, you are ok. Now here is a case which caught fire over the weekend. If you are honest and admit whose side you are on - it basically tells a lot about how you view the world and people around you.

On CNBC, Rick Santelli complained and ranted that the president’s housing plan rewarded “bad behavior” and suggested creating an Internet Web site to allow Americans to vote on whether they wanted to subsidize “losers’ mortgages.” The rant captured many's attention, some for and some against. Over the weekend, the notable and fiery Robert Gibbs, Obama's press secretary, launched a strong rebuttal against Santelli.

Mr. Gibbs decried Mr. Santelli for what he called a rant and made these observations:

“I’m not entirely sure where Mr. Santelli lives or in what house he lives but the American people are struggling every day to meet their mortgage, stay in their job, pay their bills, send their kids to school. You can’t stay in this program unless you continue to make mortgage payments. That’s important for Mr. Santelli and millions of Americans to understand. Mr. Santelli has argued, I think quite wrongly, that this plan won’t work for everyone. Now every day when I come out here I spend a little time, reading studying the issues, asking people who are smarter than I am questions about those issues. I would encourage him to read the presidents plan and understand that it will help millions of people many of whom he knows. I would be more than happy to have him come here and read it. I’d be happy to buy him a cup of coffee — decaf.”

Before you read on, which camp do you think you are in. Decide now, it should strike a chord in you immediately. Are the things Santelli said always at the back of your mind?

All things being equal, Santelli's diatribe is quite Republican, let the markets correct itself. You made a bad decision, you should have to pay for it yourself. Surprisingly, or rather, unsurprisingly, Santelli did not make the same rant when funds were doled out to banks via TARP!!! That is so Republican, the corporations and businesses are supreme, not the masses.

The key phrase in Santelli's rant was "losers' mortgages". That implies that if you were not smart enough, you deserve to rot in hell. Anyone who ends up on the losing side will be called "losers", not when the bet is still on. That camp always believe investments and funds should go to the deserving, not the needy, hence they are generally against "crutches" and "safety nets"... try pushing through a bill to give single mothers' benefits, and you would have big problem persuading the Santelli's camp.

What is a government but a collection of people under one nation, entrusted to take care of the economy, social infrastructure and prosperity of those people. Its not a business. You cannot lay off your own citizens when the going gets tough.

The assumption that an individual is entirely responsible for their own decisions and actions is false and flawed. You can be a hard working individual with normal commitments, who ends getting caught up in the credit implosion tidal wave that is greater than you can fight off or predict. If you have a mortgage, a car loan, and is supporting two kids in college, and find that your property is now in negative equity, and your job no longer exists - is that entirely your fault? I am not making excuses for those who have lost their jobs and/or in negative equity property loans - some may have taken on more risk than they can or should shoulder. Some have taken on mortgages greater than their ability to pay, but its hard to decipher one from the other.

Most individuals are not "specialised or informed enough" to read prospectuses, to understand the actual make up of CDOs, or what credit default swaps are, many are not aware the regulators are not doing their job well, many have been relying on those fucked up credit rating agencies that put a AAA stamp on those CDOs, many more are deluded that they can afford a$500,000 loan when their monthly salary is only $5,000 by mortgage finance companies, ...

People have government to put in place specialised regulators, laws and enforcement officials to "protect individuals" from excessive mania or maniac behaviour. When you keep offering huge loans to people with little capital and affordability, it is very difficult for the individuals not to be caught up in the spiral. Governments and responsible officers in industry are there to "not allow" these things to get out of hand - they did not do their jobs.

Individuals also have to share their burden of their follies, its not all one sided, but to trash Obama's mortgage renegotiation plan as taxpayers funding those "losers' mortgages" is plain irresponsible and cruel.

CNBC has taken the place of Fox (Republican) network. CNBC is so biased towards the ancient Republican policies that it is ridiculous. Michelle Caruso-Cabrera is the female Rush Limbaugh as some would say. Gasparino is not far behind. Somehow those people in the Santelli camp tends to be owning more than a couple of paid off houses - coincidence? To be fair, there are rich people who are Democrats too, so you need to differentiate. Just that Democrats, even when they are rich, still feel a bigger need to have a fairer society; while a Republican thinks that you need to be pro-business so that the rich can employ the poor.

The housing bill, stimulus bill and TARP are not perfect, but they are a starting point to pull together. Santelli stated something like “you can’t spend your way to prosperity” to which his audience of traders applauded and whistled approvingly. Well, Santelli and his band of traders had no problem leveraging themselves to prosperity over the past 5 years.

No prizes for guessing which camp I belong to.

p/s photos: Aum Patacharapa Chaichua

Saturday, February 21, 2009

Credit Crisis 101 - Leverage

Pick up any business magazine or paper, or watch the business channels, you will find a plethora of information on the credit crisis. Sometimes, too much information overload will distract from the real issues and when we talk about the crisis, we have too many angles on the problem. Unless we zero in on the root cause (not not ascribing blame), we won't be able to get a handle on the crisis and its effects.

Let's get the blame out of the way. I have blogged about the blame game: mainly its the ratings agency, followed by Greenspan and then the Wall Street firms. If you have to describe the root of the current crisis in one word, that word has to be "leverage". If you take leverage out of the equation, if we didn't have the many new fangled acronyms, which were basically packaged loans supported by derivatives like capital platform, we would have a very mild recession. This recession is the severest we have seen since the Depression because of the leverage i.e. derivatives. Leverage implies very little capital outlay for a certain contract of service or product. If we have derivatives and leverage during the 1920s, the whole world might have collapse even more brutally.

Yes, we have more knowledge since then, we have a better understanding of fiscal and monetary policy, and some say better laws and regulation (well, there are regulators but they did not do a good job at all). Its the leverage which brought about such a recession that is much worse than any we have seen in modern times.
If you want to take an account of the mess, the more reliant you were on that leverage, the more you fell as the values were nothing but book entries. The investment banks would not have been in so much trouble if they did not get greedy themselves and bought most of the instruments.

Naturally, the front line got hit the worst, the investment banks that parlayed capital up to 20x-30x leverage to issue these papers, and when they collapsed it very easy to see capital totally vanishing with just a minor drop in values. Now we are talking of properties (which these papers were based on) losing 30%-50%, hence the negative equity.
Those who bought properties using these kind of easy and unchecked loans were the first to be foreclosed. Even if you did not participate in those loans, you might have benefited via rising housing values, and refinanced, you would have got hit as well. Generally the affected banks lost about 90% or more in share price while most of the broader equities lost about 50% and counting.

The rest of the world got hit because they got a corresponding inflow of liquidity emanating from these gains. Liquidity was ample.
Related areas which practiced excessive leverage were hedge funds. If these funds bought emerging market shares and commodity, those prices got inflated as well, hence when it came time to de-leverage, the outflow was very severe. In particular commodity prices. Its not just a bull cycle, it was the leveraged funding which went looking for "liquid assets" to move into. Hence the very sharp rise in commodity prices in 2004-2008, and they came down just as fast. Related to commodities were the commodity ETFs which were coming out like fresh donuts. Every commodity ETF basically just fueled the rise and trend even further, causing many pension funds to specifically target a substantial weighting in commodity as a critical portfolio composition.

Unfortunately, the US consumers represents a significant engine for global demand. They are key to the US economy, and they need to buy crap from the rest of the world, so that the rest of the world have the funds to buy crap from other countries. The wealth destruction from falling share prices and more importantly, the losses from property, have caused the US consumers to tighten their consumption patterns. That has severe ramifications for the flow on effects to the rest of the world relying on exports for growth. Yes, it may not be the rest of the world that is at fault, but you still get swept up in the tsunami.

The curtailment of credit and loss in wealth from the deleveraging is what is bringing global demand to its knees. Every country has attempted to reflate, whether the sums are big enough is still debatable, I think it is, but more than just reflating you need to address the root problem. Has the deleveraging stopped? Well, banks are still holding the toxic assets, refusing to write down to a fairer market value, say twenty cents to the dollar, as that would wipe out the bank's equity. Hence NATIONALISATION is the best solution going forward. You are not going to do it, let the government do it. Nationalisation of banks = forced sale of these assets = investors have a good idea of the losses = shareholders will be wiped out but its necessary.

As big as the TARP is, it is insufficient to replace the writedowns. You want a bad bank, you need $2 trillion minimum. Already the lawmakers are balking over the TARP's $780bn, the amount for bad bank is humongous. By nationalising, you basically close a few big banks that shouldn't be allowed to continue. By propping them up, you will eventually have to pump close to $2 trillion anyway to get them on even keel.

The other major contention is that property has to stop falling in price because as it keeps down trending, investors have no idea how to put a fair value on those toxic asset losses. A better plan Obama should have included is to put a stop to the slide - put up an incentive for new home owners to buy, e.g. $25,000 for new homeowners that qualify. Its pointless to renegotiate mortgages if prices keep falling. You need genuine long term buying.

As for auto sector in the US, the crisis basically hasten their demise. Their business model does not work and is inflated. They must be bankrupted so that they can negotiate a reasonable business model with a very much reduced pension/healthcare liability overhanging the car makers. But the US auto sector is the least of global concerns.

Things are coming to a head, falling share prices will force the government's hand. Keep an eye on developments on these two front:

a) how they deal with the toxic assets properly

b) how to stop property prices from sliding further

To that end, the markets looks oversold as a lot of liquidity is on the sidelines. To activate the flow back, we need to see catalysts that would trigger (a) and (b) in the right way. Bank nationalisation would be one. Bad bank is still OK but the hurdles on raising $2 trillion will not be easy.

Things are so bleak now that it gives me room to be optimistic that certain things will happen when you are forced into a corner. These are very difficult decisions, do you have the political will to nationalise banks.

Another potential positive catalyst will be Geithner roping in private equity and hedge funds to start buying up the toxic assets. Pricing will be an issue but the government is keen to get these funds to take off some of these assets via special funding, which may be hard to come by for hedge funds and private equity funds now. Geithner has a strong hand now, by forcing banks to sell the toxic assets to these funds or else face nationalisation. Geithner has seen his credibility being eroded quickly with his conceptual plan that lacked details and a pricing mechanism for the toxic assets. He can restore much of it by moving fast to move the toxic assets. Yes, banks will have to do massive writedowns, and many may be barely solvent, but that's part and parcel of what needs to be done.

Despite all the bad news, I am more hopeful than most as things are coming to a head - and tough decisions are forthcoming, which will be good for the markets.

p/s photos: Natasha Hudson

Friday, February 20, 2009

Rebalancing The Twins - Update (Oil & Gold)

Well, the psychological $1,000 for gold has been struck. Time to reassess the situation. Still not time to sell as I mentioned that being long gold is absolutely necessary if you are going to play some shares in current times.

The sad part was that I got out of oil futures short position too soon and did not short them again. Fair enough, cannot win everything, but I have been looking to go long on oil futures for the last few weeks and am now comfortable with the level. Hence gold position stays the same, rollover as usual.

Double long new position now:

NYMEX miNY Light Sweet Crude Oil April 2009 $38.575


Initial long gold position $802

Went double long at $900.6

Average long position: $851.3

Justification: Going long on gold is one of the safest plays for as long as I have argued since August last year because there are those doomsday scenarios playing out, whereby all assets are worthless, hence gold. I don't subscribe fully to that theory but it makes gold move up for those who buy on that premise. My stronger conviction is the amount of money being printed that is not backed by anything, particularly in the US and Europe. Technically they can absorb back the liquidity when things fare better but that is not going to happen the moment we see recovery. The slump is so bad that it is likely that all central banks and governments will keep ample liquidity in the financial systems for as long as they can - long reflationary play and a long way for players to get out profitably before we bump into the next reflationary bubble. Those on the deflationary camp might as well put more money to Madoff funds.

As for oil, I wished I had ridden it down all the way but it was too volatile for my liking. I like crude oil futures very much, one the current price is below production cost in general, thus OPEC cuts and lower investments into new oilfields. Decimation of demand is overblown if you look at consumption per day figures from IEA in December and January. If you look at crude oil futures 6 -9 months down the road, its more than $55-$60, that may be speculation or hedging, but it also points to where the trend is headed. Oil prices will rise, not so much on pure demand recovery but more on a reflationary play.

p/s photos: Lee Hyori

Regulators Need To Fix Dividend & Share Buyback Schemes

Possibly my most important posting this year.... This is not the crux of the problem we are facing but is part and parcel of navigating the "compensation culture" of Wall Street and high-falutin' CEOs. Excessive risk taking has been the center of what brought the credit markets to its knees. The compensation culture is one where the base salary is only a fraction of these people's compensation packages, even though for many of them the base salary is already more than $1m. In Wall street, the culture is even more evident in that analysts and bankers get between $100,000-300,000 as their base salaries but there is a tacit understanding that their overall compensation will be in multiples of their base salary - and not in number of months like the rest of us. Hence many of them argue that the compensation cap by Obama will not work. Its like saying "don't throw us in prison as there are too many of us"...

An article by David Reilly, Bloomberg news columnist, wrote recently that there need to be a revamp of the way companies pay dividends and do share buybacks. I totally agree. Dividends that are steady, predictable and "high-ish" will always attract the longer term funds as solid shareholders, thus propping up share prices. As the CEO, your destiny is tied to the share price, thanks to the finance literature over the last 20 years which says that the CEO and senior management's goals, objectives and compensation must be tied to the share price performance - which indirectly implies that shareholders interest are served. BUT ARE SHAREHOLDERS INTERESTS BEING SERVED PROPERLY?

The compensation maniac rise over the last 10 years and the current crisis basically reinforced to us that shareholders interests are not best served under current system of tying in share prices to compensation.

The current system will make almost all CEOs to aggressively pay out strong dividends or have a strong dividend policy, and worse still, engage in frequent and at times excessive share buybacks. Share buybacks in the US are usually then canceled (unlike in Malaysia, which defeats the purpose) and that will improve the EPS by a corresponding amount, which will then move share prices higher if forward PER ratings and valuations stay the same. That is because the bulk of the CEOs and Wall Street compensation rides on share options.

The danger with Obama's pay cap is that much of the additional compensation will be paid via shares, although they will only vest after TARP money has been fully repaid. Thus, I can already predict what the CEOs will be doing once they get profits rolling again:
a) pay down TARP
b) improve dividends
c) buyback shares
The only difference is that they will pay down TARP as a new priority. It does not change the compensation culture. Especially in times like this any free cash flow should be used to shore up balance sheet and increase your capital standing and sufficiency, not paid back via dividends or doing useless share buybacks.

I can soften the blow for dividends, its good and essential to encourage long term shareholders to hold onto good stocks for a long time. I do agree that if a company can, they should pay good dividends, above the company's capital requirements for normal growth strategy. It would be prudent to have a proper dividend policy (e.g. percentage of profits that goes into dividend pool; or targeting a dividend yield year in year out). But do not do haphazard dividend payments one year from the next, it is unprofessional and unpredictable, and will cause valuations to be marked down.

Here is where we need more bite from the board of directors, especially the independent ones. New guidelines by the SEC should be furnished to the directors to ensure that dividends and share buybacks are backed by a solid grasp of business fundamentals and industry trends.

Share buybacks are only OK if shares are subsequently canceled, otherwise the CEOs have no fucking idea what share buybacks are supposed to do. Trashing share buybacks was my very first article for this blog, so its ranks very high on my list of piss-me-off-silly issues. However, owing to the compensation culture in Wall Street and among CEOs in the US, the share price is like their religion. Thus they will engage in excessive and frequent share buybacks, EVEN when they are not necessary - this will lead to a depletion of capital, and hello... what are really troubling the banks nowadays.... They have pushing a lot of free cash flow into share buybacks, depleting capital, pushing up EPS... and yet leveraged up even more on their remaining lesser capital.

Now, oops, they need more capital... We need a regulatory body to oversee the amount of shares each company is buying back and reassess them as normal capital requirements for the companies in those industry. For example, between 2003 and 2007, Citigroup paid out $44bn in dividends and spent $22bn buying back stocks. If they had slashed their dividends by half and not do any share buybacks, they would have an additional "capital" of $44bn. But noooo... the compensation culture is such that every time these buggers see some money flowing into the coffers, they will think of ways to use them immediately, always running on the edge, skirting between raindrops... maximising every dollar. Capital is there for a reason, ... to fund growth , AND TO HELP THE COMPANY RIDE OUT BUSINESS CYCLES & MAYBE CATACLYSMIC RECESSIONS.

Is there anybody out there???

p/s photos: JJ

Rating The Top US Banks, Which Are The Zombies?

Came across this very interesting piece by Martin Hutchinson on the current state of the top 12 banks in the US. Which banks are zombies?


Please note that the yen rate has scaled above 94 yen to the dollar, for those who are still following my thesis. Refer to posting on January 16, 2009.


There is a lot of information - both about potential bailout needs and possible investment bargains - which we can gain from the banks’ annual earnings figures. For instance:

  • Banks that made profits in the very difficult fourth quarter of 2008 are probably in good shape, especially if their loan-loss provisions exceeded their charge-offs (the amount actually lost).
  • Even banks that lost money in the fourth quarter - an exceptionally harsh three months - have no immediate need for funding, provided they made money the rest of 2008 and seem likely to resume making money going forward.
  • In this context, management’s dividend policy is a good indicator: If the dividend is maintained, rather than being sharply cut or suspended, management is probably genuinely confident about the bank’s position and outlook.
  • Another good indicator of a bank’s health - at least of the market’s perception - is the ratio of share price to book value. If that’s below 25% or so the market lacks confidence in the bank’s ability to solve its problems.

Using these indicators, we can assess the viability of the leading U.S. banks. Each bank can then be classified with one of our four "official" Money Morning designations. These designations, or labels, consist of:

  • Zombies: Institutions kept alive only by TARP funding. These subtract value from the economy and should be put out of their misery through controlled liquidation, with the healthy parts being salvaged.
  • Walking Wounded: These banks may need a little bit more help, but are currently operating adequately on their own. One caveat: An intensification of economic downturn could push some of them into "zombie" status - or even bankruptcy.
  • Risky but Proud: These banks have relatively high risks, because of acquisitions or their business models, but are operating at full blast and can hold their heads high for their success in dealing with 2008’s enormous difficulties.
  • Hidden gems: These banks have conquered 2008’s difficulties, taken care of their bad debt problems, and still managed to make a substantial profit. Short of a repeat of what U.S. banks had to deal with from 1929-1933 as part of the Great Depression, these financial institutions should continue to operate in the black.

The Envelopes Please …

We listed the 12 largest U.S. banks by assets, as of Dec. 31, ignoring foreign-owned banks, Goldman Sachs Group Inc. and Morgan Stanley (those last two are onetime investment banks that are technically now commercial banks, but still possess a very different business mix. We give you a rundown on the financial stability of each one, and give each institution with the single-most-appropriate of our four official Money Morning designations. The Top 12 banks, biggest first, are as follows:

1. Bank of America Corp. - Zombie: BofA has about $2.8 trillion in assets including Merrill Lynch, and Countrywide Financial Corp., formerly the nation’s No. 1 housing finance bank. It received $45 billion from TARP, plus $118 billion in guarantees against Merrill Lynch’s assets. At Friday’s closing share price of $5.17, the stock was trading at 21% of book value (it closed at $4.90 yesterday). BofA posted a fourth-quarter net loss of $1.55 billion, plus a Merrill Lynch net loss of $15.3 billion, which forced BofA to cut its quarterly dividend to a nominal one cent per share. Judging by other banks’ results, if Bank of America had made no acquisitions in 2008, it would be in solid shape. With the acquisitions, however, it’s a basket case - and may well need even more federal funding.

2. JPMorgan Chase & Co. - Risky but Proud: JPMorgan has $2.175 trillion in assets, and received a $25 billion TARP investment. It’s a major international bank with a large investment banking operation. It bought Bear Stearns, investment bank in March and Washington Mutual in September, both with Federal government help.

JPMorgan booked $702 million in net income in the fourth quarter and $5.6 billion in net income for all of 2008. The company also had a fourth quarter loan-loss provision of $8.5 billion and charge-offs of $4.5 billion. But there were also $2.9 billion worth of securities markdowns in the investment banking operation. Again, this bank is high-risk from an investment standpoint because of its acquisitions, but it appears to be in excellent shape with no immediate need for extra funding. Its Friday closing share price of $24.69 equates to 72% of net asset value, though it closed yesterday at $21.65, down 12.3%. It pays a quarterly dividend of 38 cents per share.

3. Citigroup Inc. - Zombie: Citi remains the nation's third-largest bank, with $1.9 trillion in assets. It received a $45 billion TARP investment, plus guarantees on $301 billion of assets. At Friday’s close of $3.49, it was trading at 25% of book value. Citi lost $8.3 billion in the fourth quarter of 2008 and $18.7 billion for the whole year. It was finally forced to sell control over its Smith Barney brokerage operation to Morgan Stanley in January, and has reduced its dividend to a nominal penny a share. Citi has been a serial flirter with bankruptcy over the past 30 years and remains a basket case. There are a few good assets buried within the rubble - chiefly because the company is so large and diverse.

4. Wells Fargo & Co. - Risky but Proud: Wells Fargo has $1.3 trillion in assets, and garnered a $25 billion TARP investment. Originally a small bank based in San Francisco, Wells Fargo came into the big leagues when it merged with Wachovia, late last year. Its Friday closing price of $15.76 equated to 104% of its book value, though it closed yesterday at $13.69. Wells Fargo’s stock pays a quarterly dividend of 34 cents. The company posted a fourth-quarter net loss of $2.55 billion, not including an $11 billion net loss at Wachovia. Wells Fargo’s full-year earnings totaled $2.84 billion. It had a fourth-quarter loan-loss provision of $8.4 billion, compared with actual charge-offs of $2.8 billion. Wachovia’s 2006 acquisition of the California mortgage bank Golden West Financial puts Wells Fargo at risk, but the company’s operations appear solid and it has no immediate need for extra funding.

5. PNC Financial Services - Risky but Proud: The Pittsburgh-based PNC has $291 billion in assets, after buying the slightly larger National City Corp in October. It also received a $7.6 billion TARP investment. At Friday’s closing price of $28.20, PNC’s shares were trading at 79% of book value. The company pays a quarterly dividend of 66 cents per common share, and posted a fourth-quarter net loss of $248 million (excluding costs associated with its acquisition of National City, the company had a fourth-quarter profit of $132 million). PNC had provision for credit losses of $990 million, compared with net charge-offs of $207 million. This is one of the riskier banks because of the difficulties in integrating National City and possible problems in National City’s loan portfolio. But it appears to have no immediate need for funding and is currently profitable, and its stock is selling close to book value and paying a solid dividend. One final point: PNC’s shares fell only 6.1% yesterday, a day when the shares of most major banks fell by more than twice that amount, perhaps hinting that investors perceive less risk in PNC’s shares.

6. U.S. Bancorp - Hidden Gem: U.S. Bancorp has $266 billion in assets, and received $6.6 billion in TARP funding. This regional banking firm is based in Minneapolis, and the company operates primarily in the upper Midwest and Northwest. With a closing price of $12.40 on Friday, USB shares were trading at 131% of book value (the shares closed yesterday at $10.73, down 13.47%). The company also pays a quarterly dividend of 42.5 cents per common share. U.S. Bancorp posted a fourth-quarter profit of $260 million, and a profit of $2.94 billion for all of 2008. It also had a credit-loss provision $1.3 billion in the fourth quarter, compared with actual charge-offs of $627 million. U.S. Bancorp is in good shape, with no apparent need for extra money.

7. The Bank of New York Mellon Corp. - Hidden Gem: New York Mellon has $237 billion in assets, mostly through its operations in New York and Pennsylvania. It received $3 billion in TARP funding. With closing price Friday at $25.26, Bank of New York Mellon was trading at 125% of its book value (the shares closed yesterday at $23.13, down 8.4%). The bank posted a fourth-quarter profit of $28 million, and net income of $1.39 billion for all of 2008. The fourth quarter was tough as for everybody, but Bank of New York Mellon appears to have no near-term need for funding.

8. SunTrust Banks Inc. - Walking Wounded: Sun Trust has $189 billion in assets, and received $4.9 billion in TARP financing. Based in Atlanta, the bank has operations in the Mid-Atlantic and the Southeast. Its Friday closing price of $8.72 meant that SunTrust shares were trading at only 19% of their book value. The company posted a fourth-quarter loss of $379 million, but a profit of $747 million for all of 2008. It also had loan-loss provisions $962 million in the fourth quarter, compared with $552 million in charge-offs. SunTrust has reduced its quarterly dividend sharply to 10 cents per share, but it appears to be in no immediate trouble. However, if the economy deteriorates, the bank’s exposure to the Florida housing market could be an Achilles' heel. Investors are clearly concerned: SunTrust shares was down 18% yesterday and is down 88% in the past year. The Atlanta Journal-Constitution reported yesterday.

9. State Street Corp. - Hidden Gem: State Street had $174 billion in assets, and received $2 billion in TARP funding. It’s a Boston-based bank, but serves institutional investors throughout the world. At Friday’s closing price of $27, the shares were trading at 111% of their book value. State Street posted fourth-quarter earnings of $65 million, and 2008 earnings per share of $3.89, up 13% from the year before. With a global business, conservative leverage and Boston management, State Street could gather strength when the financial crisis finally ends.

10. Capital One Financial Corp. - Walking Wounded: Capital One has $161 billion in assets, and received a $3.6 billion TARP investment. It’s primarily a credit card company, headquartered in McLean VA. At Friday’s close of $12.11, it is trading at just 20% of book value. Capital One lost $1.4 billion in the fourth quarter of 2008, and was just below break-even for the full year, but made $895 million from continuing operations. Its stock pays a quarterly dividend of 37.5 cents per share. Capital One is in dangerous waters and could soon succumb to a zombie if credit-card problems really escalate.

11. BB&T Corp. - Hidden Gem: BB&T has $152 billion in assets, and accepted a $3.1 billion TARP investment. It’s a regional bank, headquartered in Winston-Salem NC, with its primary operations in the Mid-Atlantic region. At Friday’s closing price of $15.33 a share, the stock was trading at about 58% of its book value. The company posted net earnings of $284 million in the fourth quarter, after loan write-offs of $528 million. It posted a profit of $1.5 billion for all of 2008, and pays a quarterly dividend of 47 cents a share. I’m sure it would gladly take more taxpayer money, but it certainly doesn’t appear to need it.

12. Regions Financial Corp. - Walking Wounded: Regions has $146 billion in assets, and received $3.5 billion in TARP financing. It’s a regional bank, headquartered in Birmingham, AL, with operations primarily in the Southeast. At Friday’s closing price of $3.38 a share, Regions’ stock was trading at about 18% of book value, and the bank has suspended its dividend. The company lost $5.6 billion in 2008, and its tangible net worth is only $10.5 billion. However, on an operating basis, it made a profit of about $300 million. Regions had a fourth-quarter loan-loss provision of $1.15 billion, and charge-offs of $796 million. I’m classifying it as "walking wounded," but think it’s more likely to revive itself than to accept a toe-tag. In fact, it’s likely to need only a modest amount of additional funding to see its health improve.

p/s photos: Keiko Kitagawa

Thursday, February 19, 2009

Wall Street & Auto Bailouts According To Calvin & Hobbes

The genius of Calvin & Hobbes is still relevant today as it was 15 years ago. The cartoon strip above probably described the current Wall Street bailout excesses precisely. Some would say it applies to the current auto bailouts as well. Click to enlarge.

Wednesday, February 18, 2009

Market Valuations, Market Bottom & Short Positions

As things get more uncertain, it is useful to look at things that would help us understand the pulse of the market better. The first is the relative market valuations within various sectors or category of stocks. A look at the table below would allow us to form a good idea of the themes and plays in the markets now. Interestingly, the fundamentals indicate that investors have an appetite for risk. Tech stocks and small caps are being rewarded with the highest P/E ratios and these stocks deliver the lowest yields. Investors are pricing large cap stocks with higher yields more conservatively, possibly indicative of the uncertainty. Merrill Lynch analyst David Rosenberg recently revised his earnings forecast for S&P 500 stocks down to $28 in 2009. That puts the P/E for the S&P 500 at 29.5. He also projects operating earnings of $55 for 2010. Applying a classic recession-trough multiple of 12x against a forward EPS estimate of $55 would imply an ultimate low of 666 on the S&P 500, likely by October if our estimate of the timing for the end of the official downturn is accurate. That is easily another 20% down from present levels. If only things were that simple and straight forward. There is a theoretical valuation and projection, and there are things we cannot really project fully. In my view, the S&P 500 will not even dip below

Table 1: data as of market close, Feb 13, 2009 source: Yahoo! Finance

700 because of sellers' exhaustion. It all has to do with relative yield and returns analysis. Michael Carr noted correctly that by applying Rosenberg’s estimate to a different valuation model offers a slightly more bullish scenario. The “Fed model” uses the interest rate on the ten-year Treasury note to develop a market forecast. The current yield of 2.88% implies that the market can support a P/E ratio of 34.7 for 2009 earnings. This gives a fair value of 971 on the S&P 500, or more than 17% higher than the current level. However, there is an average 16% risk premium priced into stocks according to this model, which places the current level of the S&P 500 at fair market value. I would still side with the bulls on the current market tussle.


Now onto short positions in the US markets. This to me gives me a better feel on the volatility and negativity than say the VIX indicator. You get to see what real players are betting against and how the flow of positions are moving.

COMPANY / JAN 30, 2009 / JAN 15, 2009 / NET CHANGE / PCT CHANGE -----------------------------------------------------------------------------


  • General Electric Co / 167,972,565 / 142,508,373 / 25,464,192 / 17.87%
  • Citigroup Inc / 180,983,983 / 162,793,089 / 18,190,894 / 11.17%
  • Banco Santander S.A./ 32,658,235 / 19,383,491 / 13,274,744 / 68.48%
  • Pfizer Inc / 89,402,555 / 78,153,592 / 11,248,963 / 14.39%
  • New York Community / 28,781,736 / 18,439,584 / 10,342,152 / 56.09%

General Electric continues to be betted against - nobody really thinks that GE will collapsed but that margins and their financial side will drag the company share price lower with each quarterly earnings - good to short. Citigroup despite having losses guaranteed, are still a firm favourite for shorties. The company is not out of the woods yet. Surprisingly Bank of America is not here, I think it could be that the share price of BoA has gone too low for shorts to be interested.


  • Nokia Corp / 18,552,903 / 38,313,687 / -19,760,784 / -51.58%
  • Wells Fargo & Co / 111,677,537 / 125,872,995 / -14,195,458 / -11.28%
  • Wal-Mart Stores / 40,345,362 / 50,760,650 / -10,415,288 / -20.52%
  • Johnson & Johnson / 25,595,022 / 33,671,605 / -8,076,583 / -23.99%
  • EMC Corp / 45,809,727 / 53,372,969 / -7,563,242 / -14.17%

Well this group is the one you want to be in. It shows the companies that have seen most short positions being covered, generally meaning the stocks are more than likely to go up from hereon. Surprise to see Wal-Mart there, I think it was due to some betting that the recent quarterly results will surprise on the downside - nah, they did well, thus scaring the shorts to cover. Johnson & Johnson is thought to be a solid stock, but to the shorts, even good companies are good candidates to short because too much buying or too much good news means the company is priced to react nagatively to any slight hint of bad news.


  • Ford Motor Co / 273,286,779 / 270,453,510 / 2,833,269 / 1.05%
  • Citigroup / 180,983,983 / 162,793,089 / 18,190,894 / 11.17%
  • General Electric / 167,972,565 / 142,508,373 / 25,464,192 / 17.87%
  • AIG / 128,659,009 / 131,310,541 / -2,651,532 / -2.02%
  • Wells Fargo & Co / 111,677,537 / 125,872,995 / -14,195,458 / -11.28%

No company wants to be in this group. The longer they are in this category, the more downward pressure on the share price. Unless somehow these companies can engineer a dramatic short covering rally, e.g. beating analysts estimates or positive policy developments.

Generally speaking I don't see any major changes in sentiment from the positions taken by the shorts. They are reasonable plays, and they are plays which are basically betting on a down trending share price rather than looking for a total collapse or that the company's share price is going to zero.

p/s photos: Moe Oshikiri

Goldman Alumni Cannot Simply Do Everything

Goldman Sachs is the only US independent firm left. The rest, Bear Stearns, Merrill lynch and Lehman Brothers - were not so lucky. Or is it luck? For years, you were golden if you hired from Goldman Sachs.

Associated Press: Alumni of the Wall Street firm have advised presidents from both parties, taken high-profile Cabinet posts, run big businesses and been involved in multimillion-dollar philanthropies.

But recent missteps have challenged the notion that Goldman only breeds winners, The Associated Press says.

Henry Paulson, who was criticized for mishandling the first incarnation of the bank bailout, is a Goldman alum. So is John Thain, who rushed billions of dollars in bonuses to Merrill Lynch employees before the investment bank had to be sold. (Henry Paulson did not handle his Treasury role well at all. The TARP program was changed and modified as he was uncertain on how to tackle the crisis. His biggest mistake was allowing Lehman Brothers to fail. Somehow if it was Goldman Sachs in trouble, I'd doubt very much he would have taken that route. As smart as he was at Goldman Sachs, it did not give him the skills and ability to tackle broader macro, monetary and economic policy issues.)

Also a Goldman vet: Robert Rubin, the Clinton treasury secretary who resigned from his senior advisory role at Citigroup last month after being criticized for missing the warning signs of the financial crisis. (As rich as Rubin was, he was mainly a trader, and a very successful trader. He shouldn't have been an economic advisor and probably contributed zilch to Citigroup.)

Those names have lent a rare tarnish to a firm sometimes called the New York Yankees of Wall Street.

”When you become a partner at Goldman, you are supposed to be the master of the universe,” Ed Yardeni, who runs his own investment consulting firm and is a well-known Wall Street economist — and himself was turned down years ago for a Goldman job, told The Associated Press.

”That meant you could run the greatest investment bank on earth, but it turns out that skill set doesn’t always translate to the White House, Treasury or other Wall Street firms.”

Goldman draws its talent from the top students from the best universities and business schools. Those given a chance to embark on Goldman’s recruiting gantlet encounter job interviews in which they are asked not just complex questions about finance but simply why they deserve to be at Goldman.

And just like the Yankees, Goldman employees are well-paid. Its 30,000 employees last year made more than $355,000 on average, including salaries, bonuses and benefits. The average at rival Morgan Stanley was about $250,000.

Those given the coveted title of partner managing director — who are considered partners — can pull in seven figures. But flashing wealth runs against the Goldman culture, and employees, dubbed ”billionaire Boy Scouts,” are expected to give to charity or perform public service.

”Does the firm create exceptional talent, or does exceptional talent create a truly great firm? I think the vast majority of ex-Goldman employees want to believe it’s a little bit of both,” Janet Hanson, a 14-year Goldman veteran who went on to found a money management firm and the global women’s networking group 85 Broads, told the news service.

Teamwork, integrity, accountability and collegiality are other prominent parts of the Goldman ethos, said Charles Ellis, author of ”The Partnership: The Making of Goldman Sachs.” That breeds loyalty not seen at other Wall Street firms.

For instance, the firm uses an evaluation system in which each employee is graded by everyone he or she works with. So low-level workers get to weigh in on their bosses.

Goldman survived the financial meltdown last fall, but not without help. It took $10 billion from the government’s Troubled Asset Relief Program, or TARP. It also received a $5 billion investment from Warren E. Buffett’s Berkshire Hathaway that came with a strong endorsement from Mr. Buffett.

That helped to stabilize Goldman but couldn’t stop the bleeding. From September through November, it lost $2.3 billion — the first quarterly loss since Goldman went public in 1999. Goldman’s chief executive Lloyd C. Blankfein is forgoing a bonus for 2008.

Still, Goldman made it out alive. That’s more than can be said for three of its former fellow investment banks – Lehman Brothers, Bear Stearns and Merrill Lynch — none of which survived the meltdown as an independent firm.

And now that fingers are pointing at top bank executives, Goldman veterans aren’t immune.

When Lehman imploded in September, it was Mr. Thain, a former Goldman president and chief operating officer, who engineered a deal to sell Merrill Lynch to Bank of America. At the time, he looked like one of the smartest guys around.

But Mr. Thain became a poster child for Wall Street greed when news surfaced that he had rushed out billions of dollars in bonuses to Merrill employees just before the Bank of America deal closed.

Then came embarrassing reports that he had spent more than $1 million to redecorate his office at Merrill. Mr. Thain later repaid the money.

”It’s not likely that he sat there and came up with ways to squeeze more for himself or the employees of Merrill Lynch. But he should have known better,” Sydney Finkelstein, a management professor at the Tuck School of Business at Dartmouth and author of the new book ”Think Again: Why Good Leaders Make Bad Decisions,” told The Associated Press. (Why did John Thain end his career by making some of his biggest mistakes towards the end. I could understand why he would ask for his $10m bonus as it was probably pre-agreed. The office refurbishment was silly, but more galling was the audacity to pay out the huge bonuses to Merrill staffers prior to being absorbed by Bank of America.)

Mr. Rubin spent most of his early career at Goldman. He joined the firm in 1966, as an associate in trading and arbitrage, became partner in 1971 and was co-senior partner — C.E.O., in Goldman-speak — from 1990 to 1992.

In 1993, Mr. Rubin left to work in the Clinton White House, and became treasury secretary in 1995. He followed a path into the public sector paved by many past Goldman leaders.

Among them was Sydney Weinberg, the firm’s senior partner from 1930 to 1969, who advised five U.S. presidents. John Whitehead worked in the State Department in the Reagan administration and as chairman of the Federal Reserve Board of New York after he left Goldman, where he was senior partner from 1976 to 1984. And former Goldman head Jon Corzine is governor of New Jersey.

”Goldman Sachs has a long history of people who have chosen to go into public service and we are proud of our alumni who have taken this path,” Goldman spokesman Ed Canaday told The Associated Press.

When Mr. Rubin joined Citigroup in 1999 as a senior adviser, it was considered a coup for the bank.

While he never had an operational role at Citi, the company still took on massive risks that resulted in losses of $18.7 billion in 2008. In early January, Mr. Rubin resigned and said he wouldn’t stand for re-election to the board.

”My great regret is that I and so many of us who have been involved in this industry for so long did not recognize the serious possibility of the extreme circumstances that the financial system faces today,” Mr. Rubin said in a letter to Citi’s chief executive announcing his departure.

Mr. Paulson, too, was drawn to a role in government after leaving Goldman’s helm in 2006, after more than 30 years at the firm. He became treasury secretary in the Bush administration.

His arrival in the public sector came during a booming economy, but what soon emerged was a devastating recession matched with a financial crisis of historic proportion.

Mr. Paulson never seemed to get his hands around it, even with the help of some former Goldman executives he brought to the Treasury Department. Among them was Neel Kashkari, who was appointed to oversee TARP and formerly worked as an executive in Goldman’s San Francisco office.

None of this seriously threatens Goldman’s status on Wall Street, of course. It’s still the place to be — perhaps now more than ever, given the carnage in investment banking.

”The people they recruit have never lost anything,” Mr. Ellis told the news service. ”They have always won. That is the kind of person Goldman wants to hire.”

(Goldman's alumni used to be regarded as very smart people and was welcomed to into important public service positions. Recent history would suggests that that line of thinking could be flawed. A successful investment banker or trader still needs to "prove himself first" before being elevated to critical positions. There are specific skills and the need to have a solid understanding of the broader issues of economic policy, monetary policy and macro-cause-and-effect issues. Its the same situation in politics in many countries, for my life, I cannot appreciate how someone can be Ministry of Tourism one day and step into Ministry of Environment the next day. Yes, they can be surrounded by experienced advisors for each ministry, but positions of importance such as Ministry of Finance, Ministry of Law, Ministry of Housing, Ministry of Foreign Affairs, EPU unit, Foreign Investment unit, etc... must be helmed by people with some relevant experience - and not be divvy up like a barbecued animal after a festival.

People like Louis Gerstner - whom I think is the best manager of businesses over the last 30 years, proving his ability at American Express, RJR Nabisco and then IBM - only come around once in a blue moon.)

p/s photos: Eva Huang Sheng Yi

Margin Valuation Prices As Price Targets

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