Archive for March, 2010

Fishy Fuld Finances – Repo 105

The truth may set you free, or it may just send you to jail. Right now, Anton Valukas’s high profile 2,200 page report has unearthed a reeking stench surrounding a $50 billion fund shuffling scheme. Our legal system will ultimately determine the fate of Dick Fuld, former CEO of Lehman Brothers, and any potential co-conspirators. Anton Valukas, appointed by the U.S. bankruptcy court to get to the root causes of the largest bankruptcy in history (a 158 year old investment banking institution), spearheaded the year-long investigation.

While most observers have not shed a tear over the grilling of Fuld in the media, onlookers shouldn’t feel sorry for Valukas either. His firm, Jenner & Blocker, was paid $38 million for its troubles in researching the report through January of this year.

Completing the report was a Herculean task. Finishing the report involved narrowing down 350 billion pages of documents (spread across 2,600 systems) down to about 40 million pages, which were supplemented by interviews with more than 250 individuals, according to The Financial Times.

Repo 105 Crash Course

At the heart of the Valukas’s report is a unique accounting gimmick used by Lehman Brothers to conveniently shed billions in assets off its books at opportune times. The scheme distorted the firm’s financial position so Lehman Brothers could appear financially leaner than reality. This controversial practice is called Repo 105 (“repo” is short for “repurchase”). Here’s how it works:

a)      The Right Way: In a typical legitimate repurchase transaction, widely used in the banking industry, a financial institution transfers assets (collateral) to a counterparty in exchange for cash. As part of the transaction, the institution that transferred the assets for cash agrees to repurchase the collateral from the counterparty in the future for the original value plus interest. These repurchase agreements are completely valid and function as an excellent short-term liquidity tool for the financial markets. What’s more, the transactions are completely transparent with the associated assets and liabilities in clear view on the publicly distributed financial statements.

b)      The Crooked 105 Way: With toxic real estate values plummeting, and Lehman Brothers’ leverage (debt) ratios rising, Lehman executives became more desperate in hunting out more creative methods of hiding unwanted assets off the balance sheet. To satisfy this need, Lehman travelled across the Atlantic Ocean to court the legal opinion of a preeminent law firm, Linklaters, in order to have them sign off on the imaginative Repo 105 practice. Under Repo 105, Lehman pledged assets equaling 105% of the cash received from a counterparty. Based on the Repo 105 design, the transaction was considered a “sale” and therefore wiped Lehman’s balance sheet clean of the assets. Cash temporarily received by Lehman could then be used to pay down debt. Lehman conveniently used this strategy to pretty up the books (“window dressing”) around critical periods when financial results were shared with the public and investors. Shortly thereafter, Lehman would take back the discarded assets for a cash and interest payment (similar to the previously described repurchase agreement).

In a way, this Repo 105 transaction is like a teenage boy selling a Playboy magazine to his friend for cash right before his mom comes home, then agrees to repurchase the magazine from his friend as soon as the boy’s mom goes back to work. Sneaky, but effective…until you get caught.

Where are the Cops?

With the fresh corporate scandal wounds from the likes of Enron, WorldCom, and Tyco (TYC) still healing, a neutral observer might expect the auditors to more responsibly monitor the behavior of questionable client behavior. The death of accounting giant Arthur Andersen (former Enron auditor) was supposed to serve as a poster-child example of what can happen if irresponsible corporate behavior goes unchecked. Apparently Lehman Brothers’ “Big Four” auditor Ernst & Young didn’t learn a lesson from the carnage left behind by its deceased competitor. Not only did Ernst & Young sign-off on these transactions, but their neglect of whistle-blower allegations also serves to land E&Y in very hot water.

Frustratingly, this outcome wouldn’t be the first time a whistle-blower was ignored – Harry Markopolos the Bernie Madoff sleuth was rebuffed multiple times by the SEC (Securities and Exchange Commission) before Madoff confessed his illegal Ponzi scheme crimes. Although the SEC may feel some more heat relating to Lehman’s Repo 105 accounting fallout, the agency may catch a little break since Lehman surreptitiously neglected to disclose any of this controversial accounting trickery.The SEC and multiple state Attorney Generals may investigate Valukas’ findings further to see if civil or criminal charges against Fuld and other Lehman executives are appropriate.

The Ignorance Defense

Will ignorance be an adequate defense for Lehman executives? So far, this tactic appears to be the leading approach of 40-year Lehman Brothers veteran, Dick Fuld. Fuld’s lawyer claims the CEO had no knowledge of Repo 105 “nor did Lehman’s senior finance officers, legal counsel or Ernst & Young raise any concerns about the use of Repo 105 with Mr. Fuld.” The Lehman chief’s supposed unawareness becomes less credible in the midst of smoking emails such as the following one from a senior trader:

“We have a desperate situation and I need another $2 bn [balance sheet reduction] from you either through Repo 105 or outright sales.”

 

Other executives referred to Repo 105 as a “drug” that they needed to “wean themselves off.” When Bart McDade, a senior Lehman Brothers exec was asked about Fuld’s knowledge regarding the accounting gimmick, McDade had no qualms in explaining Fuld “knew about the accounting of Repo 105.”

The sheer size of these multi-billion dollar off-balance sheet transactions won’t make Fuld’s innocence campaign any easier. I  believe when courts discuss values exceeding $50 billion in size, ignorance will not qualify as an excuse you can hide under – even in the context of a company holding net assets of $328 billion in June 2008.

Valukas doesn’t mince any of his words in the report when the conversation moves to Lehman’s objectives:

“The examiner has investigated Lehman’s use of the Repo 105 transactions and has concluded that the balance sheet manipulation was intentional, for deceptive purposes.”

 

Time will tell how the ultimate judgment will fall upon Dick Fuld and his partnering Lehman Brothers executives, but one need not be a bloodhound to smell the stale fishy odor of Repo 105. Fuld better find some potent breath mints, to quickly fight off the horrible seafood scent, or he might end up as fish bait himself.

Read Financial Times Article on Fuld & Lehman

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper. 

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at time of publishing had no direct position in TYC on any security referenced. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

March 14, 2010 at 11:45 pm 1 comment

Cash Flow Statement: Game of Cat & Mouse

Much like a game of a cat chasing a mouse, analyzing financial statements can be an endless effort of hunting down a company’s true underlying fundamentals. Publicly traded companies have a built in incentive to outmaneuver its investors by maximizing profits (or minimizing expenses). With the help of flexible GAAP (Generally Accepted Accounting Principles) system and loose estimation capabilities, company executives have a fair amount of discretion in reporting financial results in a favorable light. Through the appropriate examination of the cash flow statement, the cat can slow down the clever mouse, or the investor can do a better job in pinning down corporate executives in securing the truth.

Going back to 15th century Italy, users of financial statements have relied upon the balance sheet and income statement*. Subsequently, the almighty cash flow statement was introduced to help investors cut through a lot of the statement shortcomings – especially the oft flimsy income statement.

Beware of the Income Statement Cheaters

Did you ever play the game of Monopoly with that sneaky friend who seemed to win every time he controlled the money as the game’s banker? Well effectively, that’s what companies can do – they can adjust the rules of the game as they play. A few simple examples of how companies can potentially overstate earnings include the following:

  • Extend Depreciation: Depreciation is an expense that is influenced by management’s useful life estimates. If a Chief Financial Officer doubles the useful life of an asset, the associated annual expense is cut in half, thereby possibly inflating earnings.
  • Capitalize Expenses: How convenient? Why not just make an expense disappear by shifting it to the balance sheet? Many companies employ that strategy by converting what many consider a normal expense into an asset, and then slowly recognizing a depreciation expense on the income statement.
  • Stuffing the Channel: This is a technique that forces customers to accept unwanted orders, so the company selling the goods can recognize phantom sales and income. For example, I could theoretically sell a $1 million dollar rubber band to my brother and recognize $1 million in profits (less 1-2 cents for the cost of the rubber band), but no cash will ever be collected. Moreover, as the seller of the rubber band, I will eventually have to fess-up to a $1 million uncollectible expense (“write-off”) on my income statement.

There are plenty more examples of how financial managers implement liberal accounting practices, but there is an equalizer…the cash flow statement.

Cash Flow Statement to the Rescue

Most of the accounting shenanigans and gimmicks used on the income statement (including the ones mentioned above) often have no bearing on the stream of cash payments. In order to better comprehend the fundamental actions behind a business (excluding financial companies), I firmly believe the cash flow statement is the best place to go. One way to think about the cash flow statement is like a cash register (see related cash flow article). Any business evaluated will have cash collected into the register, and cash disbursed out of it. Specifically, the three main components of this statement are Cash Flow from Operations (CFO), Cash Flow from Investing (CFI), and Cash Flow from Financing (CFF). For instance, let us look at XYZ Corporation that sells widgets produced from its manufacturing plant. The cash collected from widget sales flows into CFO, the capital cost of building the plant into CFI, and the debt proceeds to build the plant into CFF. By scrutinizing these components of the cash flow statement, financial statement consumers will gain a much clearer perspective into the pressure points of a business and have an improved understanding of a company’s operations.

Financial Birth Certificate

As an analyst, hired to babysit a particular company, the importance of determining the maturity of the client company is critical. We may know the numerical age of a company in years, however establishing the maturity level is more important (i.e., start-up, emerging growth, established growth, mature phase, declining phase)*. Start-up companies generally have a voracious appetite for cash to kick-start operations, while at the other end of the spectrum, mature companies generally generate healthy amounts of free cash flow, available for disbursement to shareholders in the form of dividends and share buybacks. Of course, some industries reach a point of decline (automobiles come to mind) at which point losses pile up and capital preservation increases in priority as an objective. Clarifying the maturity level of a company can provide tremendous insight into the likely direction of price competition, capital allocation decisions, margin trends, acquisition strategies, and other important facets of a company (see Equity Life Cycle article).

The complex financial markets game can be a hairy game of cat and mouse. Through financial statement analysis – especially reviewing the cash flow statement – investors (like cats) can more slyly evaluate the financial path of target companies (mice).  Rather than have a hissy fit, do yourself a favor and better acquaint yourself with the cash flow statement.

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper. 

*DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing had no direct positions in any security mentioned in this article. References to content in Financial Statement Analysis (Martin Fridson and Fernando Alvarez) was used also. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

March 12, 2010 at 12:46 am 6 comments

Google: The Quiet Steamroller

As Google Inc. (GOOG) has proceeded to steamroll most of its competition on the global advertising roads, they are learning to tread a little more lightly in hopes of avoiding unneeded scrutiny. There are very few places to hide, when your company is on track to achieve more than $20 billion in annual sales and is valued at more than $175 billion in the marketplace.

As Google revenues continue to rise and they look to take over the world (including their position in China), they are enlisting others to assist them in Washington as well. Through three quarters of 2009, the company increased their lobbyist budget by 41% to approximately $3 million, according to the Associated Press (AP).

Google Eating Bite Sized Acquisitions

Ever since the controversy caused by Google’s $3.1 billion takeover of web advertising network company DoubleClick (2007 announcement), and the failed joint search agreement with Yahoo! (YHOO) in 2008 due to government and advertiser concerns, Google has decided to consume smaller bite-sized companies as part of its acquisition strategy. Over the last five months alone, Google has acquired eight different small companies (generally less than $50 million acquisition price), including the following: 1) Picknik (photo editing website); 2) reMail (mobile search applications); 3) Aardvark (social networking focus); and 4) AdMob ($750 million mobile advertising network deal). Eric Schmidt, Google CEO, has stated he would like to do one smaller-sized acquisition per month. Google management also believes they have lowered the inherent risk in these smaller deals because of legacy ties to target companies – all these sought after companies house former Google employees, says Bloomberg.  In addition to remaining below the radar, the string of small deals act as a supplement to Google’s hiring practices, which can become challenging in a scarce qualified engineering hiring environment.

Microsoft Pot Calling Kettle Black

Microsoft (MSFT), the behemoth software giant with monopoly-like market share in the PC operating system market, is now fighting back against growing giant Google. This effectively amounts to the pot calling the kettle black, given Microsoft has already paid about $2.44 billion in fines to EU (European Union) relating to antitrust actions in the past 10 years, according to TechCrunch. Nonetheless, Microsoft CEO Steve Ballmer is not shy about throwing Google under the bus, stating Google is not playing fair in the search market.  Furthermore, Microsoft has filed an antitrust complaint against Google in Europe as it relates to Ciao, an online shopping service powered by Microsoft, and cried foul over an agreement Google made with book publishers and authors on a separate project.

Google is not stupid. They have witnessed massive monopolistic companies like Microsoft and Intel (INTC) butt heads with regulators and pay billions in fines. Needless to say, Google will do everything in its power to avoid additional, unwanted oversight, while quietly driving their steamroller over the competition.

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper. 

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds and GOOG, but at time of publishing had no direct position in MSFT, INTC, YHOO,  or any other security referenced. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

March 9, 2010 at 11:30 pm 1 comment

FX, the Carry Trade, and Arbitrage Vigilantes

What do you think of the Euro? How about the Japanese yen? Are you expecting the Thai baht to depreciate in value versus the Brazilian real? Speculators, central banks, corporations, governments, financial institutions, and other constituencies ask similar types of questions every day. The largely over-the-counter global foreign exchange markets (no central exchange) are ubiquitous, measuring in the trillions – the BIS (Bank for International Settlements) computed the value of traditional foreign exchange markets at $3.2 trillion in April 2007. Thanks to globalization, these numbers are poised to expand even further. Like other futures markets (think oil, gold, or pork bellies), traders can speculate on the direction of one currency versus another. Alternatively, investors and businesses around the world can use currency futures to hedge (protect) or facilitate international trade.

Without getting lost in the minutiae of foreign exchange currency trading, I think it’s helpful to step back and realize regardless of strategy, currency, interest rate, inflation, peg-ratio, deficits, sovereign debt, or other factor, money will eventually migrate to where it is treated best in the long-run. When it comes to currencies, it’s my fundamental belief that economies control their currency destinies based on the collective monetary, fiscal, and political decisions made by each country. If those decisions are determined imprudent by financial market participants, countries open themselves up to speculators and investors exploiting those decisions for profits.

Currency Trading Ice Cream Style

As mentioned previously, currency trading is predominantly conducted over-the-counter, outside an exchange, but there are almost more trading flavors than ice cream choices at Baskin-Robbins. For instance, one can trade currencies by using futures, options, swaps, exchange traded funds (ETFs), or trading on the spot or forward contract markets. Each flavor has its own unique trading aspects, including the all-important amount of leverage employed.

The Carry Trade

Similar to other investment strategies (for example real estate), if profit can be made by betting on the direction of currencies, then why not enhance those returns by adding leverage (debt). A simple example of a carry trade can illustrate how debt is capable of boosting returns. Suppose hedge fund XYZ wants to borrow (sell U.S. dollars) at 0.25% and buy the Swedish krona currency so they can invest that currency in 5.00% Swedish government bonds. Presumably, the hedge fund will eventually realize the spread of +4.75% (5.00% – 0.25%) and with 10x leverage (borrowings) the amplified return could reach +47.5%, assuming the relationship between the U.S. dollar and krona does not change (a significant assumption).

Positive absolute returns can draw large pools of capital and can amplify volatility when a specific trade is unwound. For example, in recent years, the carry trade from borrowing Japanese yen and investing in the Icelandic krona eventually led to a sharp unwinding in the krona currency positions when the Icelandic economy collapsed in 2008. High currency values make exports less competitive and more expensive, thereby dampening GDP (Gross Domestic Product) growth. On the flip side, higher currency values make imported goods and services that much more affordable – a positive factor for consumers. Adding complexity to foreign exchange markets are the countries, like China, that artificially inflate or depress currencies by “pegging” their currency value to a foreign currency (like the U.S. dollar).

Soros & Arbitrage Vigilantes

Hedge funds, proprietary trading desks, speculators and other foreign exchange participants continually comb the globe for dislocations and discrepancies to take advantage of. Traders are constantly on the look out for arbitraging opportunities (simultaneously selling the weakest and buying the strongest). Famous Quantum hedge fund manager, George Soros, took advantage of weak U.K. economy in 1992 when he spent $10 billion in bet against the British pound (see other Soros article). The Bank of England fought hard to defend the value of the pound in an attempt to maintain a pegged value against a basket of European currencies, but in the end, because of the weak financial condition of the British economy, Soros came out victorious with an estimated $1 billion in profits from his bold bet. 

I’m not sure whether the debate over speculator involvement in currency collapses can be resolved? What I do know is the healthier economies making prudent monetary, fiscal, and political decisions will be more resilient in protecting themselves from arbitrage vigilantes.

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper. 

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at time of publishing had no direct position on any security referenced. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

March 8, 2010 at 12:01 am Leave a comment

Digging a Debt Hole

Little did I know when I signed up for a recent “distressed” debt summit (see previous article) that a federal official and state treasurer would be presenting as keynote speakers? After all, this conference was supposed to be catering to those professionals interested in high risk securities. Technically, California and the U.S. government are not classified as distressed yet, but nonetheless government heavy-hitters Matthew Rutherford (Deputy Assistant Secretary, Federal Finance at the U.S. Department of Treasury), and Bill Lockyer (Treasurer for the State of California) shared their perspectives on government debt and associated economic factors.

Why have government officials present at a distressed debt conference? After questioning a few organizers and attendees, I was relieved to discover the keynote speaker selections were made more as a function as a sign of challenging economic times, rather than to panic participants toward debt default expectations. As it turns out, the conference organizers packaged three separate conferences into one event – presumably for cost efficiencies (Distressed Investments Summit + Public Funds Summit + California Municipal Finance Conference).

The U.S. Treasury Balancing Act

Effectively operating as the country’s piggy bank, the Treasury has a very complex job of constantly filling the bank to meet our country’s expenditures. Deputy Assistant Secretary Matthew Rutherford launched the event by speaking to domestic debt levels and deficits along with some the global economic trends impacting the U.S.

  • Task at Hand: Rutherford spoke to the Treasury’s three main goals as part of its debt management strategy, which includes: 1) Cash management (to pay the government bills); 2) Attempt to secure low cost financing; and 3) Promote efficient markets. With more than a few hundred auctions held each year, the Treasury manages an extremely difficult balancing act.
  • Debt Limit Increased: The recent $1.9 trillion ballooning in the U.S. debt ceiling to $14.3 trillion gives the Treasury some flexibility in meeting the country’s near-term funding needs. The Treasury expects to raise another $1.5 trillion in debt in 2010 (from $1.3 trillion in ’09) to fund our government initiatives, but that number is expected to decline to $1.0 – $1.1 trillion in 2011.
  • Funding Trillions at 0.16%: Thanks to abnormally low interest rates, an investor shift to short-term safety (liquidity), and a temporary rush to the dollar, the U.S. Treasury was able to finance their borrowing needs at a mere 16 basis points. Clearly, servicing the U.S.’ massive debt load at these extremely attractive rates is not sustainable forever, and the Treasury is doing its best to move out on the yield curve (extend auctions to lengthier maturities) to lock in lower rates and limit the government’s funding risk should short-term rates spike.
  • Chinese Demand Not Waning: Contrary to recent TIC (Treasury International Capital) data that showed Japan jumping to the #1 spot of U.S. treasury holders, Rutherford firmly asserted that China remains at the top by a significant margin of $140 billion, if you adjust certain appropriate benchmarks. He believes foreign ownership at over 50% (June 2009) remains healthy and steady despite our country’s fiscal problems.
  • TIPS Demand on the Rise: Appetite for Treasury Inflation Protection Securities is on the rise, therefore the Treasury has its eye on expanding its TIP offerings into longer maturities, just last week they handled their first 3-year TIPS auction.

There is no “CA” in Greece

State of California Treasurer Bill Lockyer did not sugarcoat California’s fiscal problems, but he was quick to defend some of the comparisons made between Greece and California. First of all, California’s budget deficit represents less than 1% of the state’s GDP (Gross Domestic Product) versus 13% for Greece. Greece’s accumulated debt stands at 109% of GDP – for California debt only represents 4% of the state’s GDP. What’s more, since 1800 Greece has arguably been in default more than not, where as California has never in its history defaulted on an obligation. 

The current California picture isn’t pretty though. This year’s fiscal budget deficit is estimated at $6 billion, leaping to $12 billion next year, and soaring to $20 billion per year longer term.

Legislative political bickering is at the core of the problem due to the constitutional inflexibility of a 2/3 majority vote requirement to get state laws passed. The vast bulk of states require a simple majority vote (> than 50%) – California holds the unique super-majority honor with only Arkansas and Rhode Island. Beyond mitigating partisan bickering, Lockyer made it clear no real progress would be made in budget cuts until core expenditures like education, healthcare, and prisons are attacked.

On the subject of bloatedness, depending on how you define government spending per capita, California ranks #2 or #4 lowest out of all states. Economies of scale help in a state representing 13% of the U.S.’ GDP, but Lockyer acknowledged the state could just be less fat than the other inefficient states.

Lockyer also tried to defend the state’s 10.5% blended tax rate (versus the national median of 9.8%), saying the disparity is not as severe as characterized by the media. He even implied there could be a little room to creep that rate upwards.

Finishing on an upbeat note, Lockyer recognized the January state revenues came in above expectations, but did not concede victory until a multi-month trend is established.

After filtering through several days of meetings regarding debt, you quickly realize how the debt culture (see D-E-B-T article), thanks to cheap money, led to a glut across federal governments, state governments, corporations, and consumers. Hopefully we have learned our lesson, and we are ready to climb out of this self created hole…before we get buried alive with risky debt.

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper. 

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds (including CMF and TIP), but at time of publishing had no direct position on any security referenced. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

March 4, 2010 at 11:45 pm 2 comments

Getting Distressed can be a Beach

It was just another 65 degree winter day on the sunny shores of Huntington Beach at the 2nd Annual Distressed Investment Summit (March 1st through 3rd) when I entered the conference premises. Before digging into the minutiae of the distressed markets, a broad set of industry experts spoke to a diverse crowd including, pension fund managers, consultants, and hedge fund managers at the Hyatt Regency Huntington Beach Resort and Spa. The tone was somewhat restrained given the gargantuan price rebounds and tightening spreads (the premium paid on credit instruments above government securities) in the credit markets, nonetheless the tenor was fairly upbeat thanks to opportunities emanating from the still larger than average historical spreads.

Topics varied, but several speakers gave their views on the financial crisis, macroeconomic outlooks, general debt/credit trends, and areas of distressed credit opportunity. Like investors across all asset classes, many professionals tried to put the puzzle pieces together over the last few years, in order to provide a clearer outlook for the future of distressed markets. To put the addressable market in context, James Perry, Conference Chair and Investment Officer at the San Bernadino County Employees Retirement Association, described the opportunity set as a $2.5 trillion non-investment grade market, with $250-$400 billion in less liquid securities. Typically distressed securities consist of investments like bonds, bank debt, and/or CLOs (collateralized loan obligations), which frequently carry CCC or lower ratings from agencies such as Standard & Poors, Moodys, and Fitch.

As mentioned previously, since the audience came from a diverse set of constituencies, a broad set of topics and themes were presented:

  • Beta Bounce is Gone:  The collapse of debt prices and massive widening of debt spreads in 2008 and 2009 have improved dramatically over the last twelve months, meaning the low hanging fruit has already been picked for the most part. Last year was the finest hour for distressed investors because price dislocations caused by factors such as forced selling, technical idiosyncracies, and credit downgrades created a large host of compelling prospects. For many companies, long-term business fundamentals were little changed by the liquidity crunch. As anecdotal evidence for the death of the beta bounce, one speaker observed CLOs  trading at  30-35 cents during the March 2009 lows. Those same CLOs are now trading at about 80 cents. Simple math tells us, by definition, there is less upside to par (the bond principal value = 100 cents on dollar).
  • Distressed Defaults: Default rates are expected to rise in the coming months and years because of record credit issuance in the 2006-2007 timeframe. The glut of questionable buy-outs completed at the peak of the financial markets driven by private equity and other entities has created a sizeable inventory of debt that has a higher than average chance of becoming distressed. One panel member explained that CCC credit ratings experience a 40% default within 5 years, meaning the worst is ahead of us. The artificially depressed 4-7% current default rates are now expected to rise, but below the 12% default rate encountered in 2009.
  • Wall of Maturities:  Although the outlook for distressed investments look pretty attractive for the next few years, a majority of professionals speaking on the topic felt a wave of $1 trillion in maturities would roll through the market in the 2012-2014, leading to the escalating default rates mentioned above. CLOs related to many of the previously mentioned ill-timed buyouts will be a significant component of the pending debt wall. Whether the banks will bite the bullet and allow borrowers to extend maturities is still an  open topic of debate.
  • Mid Market Sweet Spot: Larger profitable companies are having little trouble tapping the financial markets to access capital at reasonable rates. With limited capital made available for middle market companies, there are plenty of opportunistic investments to sift through. With the banks generally hoarding capital and not lending, distressed debt investments are currently offering yields in the mid-to-high teens. Borrowers are effectively beggars, so they cannot be choosers. The investor, on the other hand, is currently in a much stronger position to negotiate first lien secured positions on the debt, which allows a “Plan B,” if the underlying company defaults. Theoretically, investors defaulting into an ownership position can potentially generate higher returns due forced restructuring and management of company operations. Of course, managing the day-to-day operations of many companies is much easier said than done.
  • Is Diversification Dead? This question is relevant to all investors but was primarily directed at the fiduciaries responsible for managing and overseeing pension funds. The simultaneous collapse of prices across asset classes during the financial crisis has professionals in a tizzy. Several diversification attacks were directed at David Swensen’s strategy (see Super Swensen article) implemented at Yale’s endowment. Although Swensen’s approach covered a broad swath of alternative investments, the strategy was attacked as merely diversified across illiquid equity asset classes – not a good place to be at the beginning of 2008 and 2009. The basic rebuttal to the “diversification is dead mantra” came in the form of a rhetorical question: “What better alternative is there to diversification?” One other participant was quick to point out that asset allocation drives 85% of portfolio performance.
  • Transparency & Regulation:  In a post-Bernie Madoff world, even attending hedge fund managers conceded a certain amount of adequate transparency is necessary to make informed decisions. Understanding the strategy and where the returns are coming from is critical component of hiring and maintaining an investment manager.  
  • Distressed Real Estate Mixed Bag:   Surprisingly, the prices and cap rates (see my article on real estate and stocks) on quality properties has not dramatically changed from a few years ago, meaning some areas of the real estate market appear to be less appealing . Better opportunities are generally more tenant specific and require a healthy dosage of creativity to make the deal economics work. Adjunct professor from Columbia University, Michael G. Clark, had a sobering view with respect to the residential real estate market home ownership rates, which he continues to see declining from a peak of 70% to 62% (currently 67%) over time. Clark sees a slow digestion process occurring in the housing market as banks use improved profits to shore up reserves and slowly bleed off toxic assets.  He believes job security/mobility, financing, and immigration demographics are a few reasons we will witness a large increase in renters in coming periods. Also driving home ownership down is the increased density of youngsters living at home post-graduation. Clark pointed out the 20% of 26-year olds currently living at home with their parents, a marked increase from times past.

Overall, I found the 2nd Annual Distressed Investment Summit a very informative event, especially from an equity investor’s standpoint, since many stock jocks spend very little time exploring this part of the capital structure. Devoting a few days at the IMN sponsored event taught me that life does not have to be a beach if you mix some distress with a little sun, sand, and fun.

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper. 

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at time of publishing had no direct position on any security referenced. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

March 3, 2010 at 2:14 am 3 comments

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