Change Alley

Deal of The Decade

2009-05-28T06:31:00.000-07:00

A short video with interesting commentary on possibly the most value-destroying deal ever.

Schwarzman at Yale

2009-03-28T21:12:00.000-07:00

Always a fascinating and self-deprecating guy...

Icahn at Yale

2009-03-28T21:00:00.000-07:00

Soros on Commercial Real Estate and Inflation

2009-03-26T12:49:00.000-07:00

From Bloomberg News:

Billionaire investor George Soros said U.S. commercial real estate will probably drop at least 30 percent in value, causing further strains on banks.

“Commercial real estate has not yet fallen in value,” Soros, 78, speaking at a forum in Washington, said. “It is inevitable, it is written, everybody knows it, there are already some transactions which reflect and anticipate it, so we know, they will drop at least 30 percent.”

Soros said the risk of further declines in property prices is reason for the administration of President Barack Obama to move quickly to recapitalize banks. Soros said Obama acted too slowly on a banking overhaul and should have moved immediately upon taking office.

“At that moment of enthusiasm, fresh out of the gate, he would have gotten that money, and then we could have recapitalized the banks the right way, which would be to draw a line over the existing past accumulated bad assets and create new banks on top of these old banks,” Soros said.

Soros also said that the U.S. may face a new round of inflation should the flow of credit recover because of the large increase in the money supply stemming from the Federal Reserve’s purchases of Treasury securities.

“In order to make up for the collapse of credit, we are effectively creating money,” Soros said. That creates “an incredibly swollen monetary base, which, if it were leveraged, you would have an explosion of inflation.”

A Collection of George Soros Interviews

2009-03-20T20:36:00.000-07:00

Here is an interesting collection of interviews with George Soros.

George Soros Interviews A giant collection of interviews with George Soros

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Jim Rogers: Depression and Crude Oil

2009-03-16T23:07:00.000-07:00

From Bloomberg News:

The U.S. risks sending the world into a depression as its bailouts of failed companies rob healthy businesses of capital, investor Jim Rogers said.

“The U.S. is taking assets from competent people and giving them to incompetent people,” said Rogers, chairman of Singapore-based Rogers Holdings and the author of books including “Investment Biker” and “Adventure Capitalist.” “That’s bad economics.”

The U.S. government should let American International Group Inc., whose fourth-quarter loss was the worst in corporate history, go bankrupt, Rogers added in a Bloomberg Television interview today. Congress approved a $700 billion bank bailout package in October, and President Barack Obama’s administration has suggested it may need an additional $750 billion.

The U.S. is repeating the mistakes made by Japan in the 1990s and risks creating “zombie banks” by rescuing failed financial services companies that should have been allowed to go under, Rogers said.

New York-based AIG has received $173 billion in government aid, and had earmarked $1 billion in retention pay for about 4,600 of the company’s 116,000 employees so they won’t leave.

The Treasury this week intends to provide more information about a $1 trillion plan to remove distressed mortgage assets from banks’ balance sheets. The Federal Reserve is also scheduled this week to start the first phase of a $1 trillion program to revive the market for securities backed by consumer and business loans.

Oil Prices

Oil prices may rise to record levels in the future because of depleting reserves and a lack of major field discoveries, Rogers said. Crude oil in New York hit a record $147.27 a barrel in July and traded at $46.98 at 12:13 p.m. Singapore time.

“Reserves of oil are going down all over the world,” Rogers said. “The price of oil has to go much, much higher. I don’t know if the oil price will go up to record level in three years or five years. I don’t know when but I know it is.”

People should be prepared for inflation as governments worldwide are printing money to prop up economies at a time when commodities supply is under pressure, Rogers said.

“We’re going to have serious, serious inflation down the road,” said Rogers, who owns gold and silver. “I wish I knew when.”

Calls to return to the gold standard, when currencies were backed by bullion owned by governments, are flawed because it is “not going to solve our problems,” he also said.

Goldman Betting On Distressed Debt

2009-03-16T18:19:00.000-07:00

It is clear that huge fortunes will be made in distressed debt, when the smoke clears and the economy recovers. But, as the following article mentions, timing is critically important. It will be interesting to see when John Paulson begins buying debt and financials, given his impeccable performance throughout this crisis.

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From The Financial Times:

Goldman Sachs is asking investors in its $15bn private equity fund for approval to shift much of its remaining uninvested money into distressed debt in a stark indication of just how dysfunctional the buy-out business has become amid the meltdown in credit markets.

In recent months, many private equity firms have quietly shifted their focus to buying debt at a discount as they are unable to pay for acquisitions with cheap flexible debt as they could during the boom years. Goldman is now seeking to do likewise.

“Given the dislocation we are facing in the credit markets, we believe the ability to achieve private equity-like returns at an even more senior position in the capital structure provides a significant opportunity for the fund,” the bank told investors.

TPG, for example, plans to dedicate $2.5bn of its $18.8bn buy-out fund to distressed debt, and has hired Alan Waxman from Goldman Sachs to run it.

GSO, Blackstone’s debt specialist, has also been buying debt at a discount and plans to step up such purchases of the debt in its own deals.

For example, it has told investors in its funds that it and Bain Capital now control $500m of the debt of portfolio company Michaels Stores, bought from a hedge fund at cents on the dollar.

But such a shift in strategy can be perilous. On its earnings call in early March, Steve Schwarzman, Blackstone’s founder, noted that the firm lost money by wading into the corporate debt market too early. Blackstone also marked a multibillion dollar portfolio of debt purchased from Deutsche Bank to zero at its year-end.

For Goldman, there are also other issues. In some cases, Goldman will potentially be pitting itself and its investors against some of its best clients, the private equity firms controlling these highly indebted companies. Often, the goal of buyers of distressed debt is to ultimately control the issuing company when it cannot meet all its obligations.

However, one person familiar with the thinking at Goldman said: “Goldman will never go hostile against our clients. We will come to agreement and not push companies to file for Chapter 11 bankruptcy protection.”

Of the $9bn remaining in the fund, Goldman plans to allocate $4.5bn to stressed and distressed investments and increase open market purchases of both debt and equity securities from 10 to 25 per cent of total commitments.

Another $1.5bn will go to firms Goldman already owns in part to help them buy their own debt. Only $3bn will go to buy-outs, originally the only mission of the fund. Goldman has invested $2bn in the fund, including an additional $500m injected recently.

Alan Blinder: Origins of the Financial Mess

2009-03-14T14:01:00.000-07:00

Alan Blinder of Princeton University gives an excellent lecture on and analysis of the financial crisis:

Where Are We?

2009-03-09T21:42:00.001-07:00

Some interesting charts...

Buffett on Banking

2009-03-09T18:49:00.000-07:00

From today's CNBC interview:

Banking has never been better in one sense. I mean, the banks are getting their money very cheaply, deposits are coming in, spreads have never been wider, all the new business they're doing is terrific. They will earn their way out of it, in most cases, overwhelming number of cases. And they should not be spooked by the idea they're going to have to issue tons of stock at some very low price under the circumstances where the very actions of—that that may be coming keep pushing down the price. So that's spooking, you know, people in the banking business. But the banks can earn their way out of this. I mean, the average cost of funds for Wells Fargo, for example, the fourth quarter last year, was 1.44 percent. I can earn money with money at 1.44 percent. I mean, it's cheap. It's abundant and the spreads are terrific.

Jim Rogers on China and Macro

2009-03-08T18:00:00.000-07:00

From Bloomberg News:

China’s stimulus spending will help its economy overcome the global recession sooner than the U.S. and other countries, investor Jim Rogers said.

China’s reserves allow the government to spend on projects that will make the nation more efficient and competitive as the global economy recovers, said Rogers, the author of “A Bull in China: Investing Profitably in the World’s Greatest Market.” Signs China is taking steps to liberalize its currency will also benefit the country, he added.

“I certainly expect China to come out of it sooner than the U.S.,” Rogers, chairman of Singapore-based Rogers Holdings, said in a Bloomberg TV interview in the city-state. “They seem to be spending the money on the right things. China is doing a far better job than the others.”

Premier Wen Jiabao reiterated last week the government’s pledge to “significantly increase” investment in 2009 to help counter the slowest growth in seven years. He didn’t specify new stimulus spending in addition to a 4 trillion yuan ($585 billion) plan announced in November.

The People’s Bank of China cut interest rates five times in the final four months of last year, including the biggest single reduction since the 1997-98 Asian financial crisis. The government is targeting growth of 8 percent in 2009, after the economy slowed to a 6.8 percent gain in the fourth quarter.

Yuan, Yen, Dollar

China will allow trade settlement in yuan with Hong Kong soon, central bank Governor Zhou Xiaochuan said at a briefing in Beijing on March 6. President Li Lihui of Bank of China Ltd., the nation’s largest foreign-exchange lender, said yesterday in Beijing the bank is already conducting trial international yuan settlements in Shanghai and Hong Kong.

“I’m glad to see they’re taking yet another step towards convertibility,” said Rogers, who in April 2006 accurately predicted oil would reach $100 a barrel and gold $1,000 an ounce. He said he owns Japanese yen as he expects more of the money to “come home.”

Rogers added he plans to sell his remaining U.S. dollar holdings later this year because the world’s largest economy isn’t a “safe haven” for investors.

“I plan later this year to get out of the rest of my U.S. dollars,” he said. “It’s had an artificial rally too but it’s a terribly flawed currency. The U.S. is printing money as fast as it can and that’s always throughout history led to currency problems down the road.”

Rogers on June 30 advised investors to avoid the dollar “at all costs” as the U.S. economy slows, and favored commodities. The dollar has risen against nine of the Group of 10 currencies since then, according to data tracked by Bloomberg.

Rogers added he remains bullish on agriculture and that commodities are “the only area of the world economy I know which is benefiting.” He said he owns “some” gold and silver, and regards silver as “cheaper.”

Water, power and other infrastructure companies’ shares are favored because their earnings are less vulnerable during the global slowdown, Rogers said.

Vince Stanzione: Commodities Presentation

2009-03-06T19:21:00.000-08:00

Many commodities and gold investors will find this presentation to be interesting. For full disclosure, I am a commodities investor with positions in base metals, agriculture, and energy. Yet a question that I would offer to Vince Stanzione regarding his statement about an ounce of gold in 1928 being the same ounce of gold that it is today, is what would an equally-sized investment in the Dow Jones index be worth over this same time period? What would the performance be relative to gold?

Bad News Bears

2009-03-05T18:46:00.001-08:00

Here is an interesting chart of the current bear market superimposed over other historic financial nightmares. In our current crisis, the speed with which the markets collapsed is close to unprecedented. We can only hope that September of 2008 wasn't October of 1929.

Jim Rogers on Gold

2009-03-05T15:53:00.000-08:00

Here is Jim Rogers' assessment of gold. It's pretty bad when the biggest commodity bulls have this view...

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From TradingMarkets:

“Gold is a commodity but gold is one of my least favorite commodities. There are other commodities that are going to do a whole lot better. Supply and demand are completely out of whack for nearly all commodities, and the inventories – they've run down the inventories of nearly every commodity in the world. The exception, of course, is gold.

Gold exploration has continued to expand for the past 20 years, gold mining production has continued to expand – it certainly hasn't declined in the past 25 years even though gold is down, and gold inventories are at the highest in the history of the world. I mean all the gold that's ever been mined is still out there. The Central Banks own it. The Central Banks want to sell it. I'm not saying they're right or wrong, mind you, don't get me wrong. I'm not making a value judgment here. I'm just dealing with facts. So I own gold. It's in my index. I own a couple of gold-mining shares but I am less optimistic on gold than I am on most other commodities. But I do own it. For centuries, people have tried to figure out how to turn lead into gold – do you know that alchemist's quest: "If we could figure out how to turn lead into gold, we'd all be rich." I would submit to you that you should figure out a way to turn gold into lead and you'd make a lot more in the next few years because lead would go up more, percentage wise.”

Resorts Take the Big Vacation into Chapter 11

2009-03-04T13:21:00.000-08:00

Resorts and luxury entertainment are now feeling the same pain as retailers and mortgage lenders, with MGM Mirage saying in today's news that it might default on its debt. But, as was the case with the retail and financial industries, it is extremely risky to attempt to catch a falling knife here. Japan's "Lost Decade" offers a valuable lesson for investors. Goldman Sachs made a fortune investing in Japanese golf clubs during the 2000s, which you can read about here and here. But! Goldman began buying a full decade after the real estate market crashed in Japan. Caveat emptor!

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From The Deal:

One thing you can be sure of in an economic downturn is that industries that thrive on extreme material excess will go through their own market correction. The resort and destination club sector is a case in point.

We're not talking about the summer resorts in the mountains or down at the beach, but the high-end stuff. Places you have to fly to, places where you are part of a big-bucks set.

What's so incredible is how many of these resorts and destination clubs exist, which really speaks to just how decadent the spending on vacations and pleasure had become.

And now those resorts and destination clubs are failing as fast as the economy is tanking.

The trend may have started innocently enough on July 18 with the bankruptcy filing of Rothbury, Mich.-based Double JJ Ranch Inc., a resort operator founded in 1937 that attracted blue-collar families with its indoor water park and horseback riding activities. But since then, tonier resorts have started visiting the bankruptcy court.

For example, there was the Nov. 11 filing of Yellowstone Mountain Club, which reportedly counts billionaire Bill Gates among its clientele. Established by Edra and Tim Blixseth in 2000, Big Sky, Mont.-based Yellowstone owns a high-class private ski and golf community on 13,600 acres of land located about 20 miles from Yellowstone National Park (the couple is now divorced, with Edra owning Yellowstone). The property includes ski trails, a golf course, lodges, residences, restaurants and other resort facilities.

Others have tumbled every month since. On Dec. 9, Minnetonka, Minn.-based VREP LLP, which operates an international destination club under the name Lusso Collection, entered bankruptcy, claiming its wealthy clientele evaporated "almost overnight." Denver-based High Country Club, a luxury destination resort company, filed for Chapter 7 liquidation on Jan. 27.

On Monday, March 2, came the latest victim: Sedona, Ariz.-based ILX Resorts Inc., an operator of timeshare resorts. ILX owns and operates eight resorts in Arizona, Indiana and Colorado, as well as in Mexico. It also owns additional undeveloped land in Arizona and Mexico that it had acquired to build additional resorts. The company blamed its need to file bankruptcy on unstable credit markets.

The credit markets have become the convenient excuse for bankruptcy filings these days. But for resorts and destination clubs, the inference is that it's the folks who once worked in those credit markets moving the money around that have disappeared. They aren't throwing the bucks around to sip cocktails on the veranda. Or maybe corporations finally got embarrassed by the American International Group Inc. (NYSE:IAG) executives who, fresh off receiving an $85 billion government bailout, were found to be attending a conference at a posh resort.

How many of these resorts are there? We'll likely find out soon when they trudge into Chapter 11 or Chapter 7. So many sprung up when everyone this decade really believed that they could live the life of the rich and the famous. Problem is, even the rich and the famous have maxed out their credit cards, so you can only imagine what kind of shape the pretenders are in.

Jim Rogers: "The Destruction of America"

2009-03-03T15:03:00.000-08:00

Jim Rogers is looking at farmland and gold...

Something's Funny With Gold And Money

2009-03-02T22:51:00.000-08:00

Something that gold investors often fail to realize is that the aboveground supply of gold can increase just as fast as – or much faster than – the supply of money. This is an important part of why the view of gold as a “solid currency” is a fallacy.

Gold inventories are currently the highest they've been in the history of the world. And throughout the twenty-year bear market in base metals, gold exploration skyrocketed. Even in 2003, 75% of mining exploration was allocated to gold, up from 50% only three years earlier.

I do not have the current CRB Commodity Yearbook figures, but it is without a doubt that gold exploration has dramatically increased since then, with new mines coming on stream, in response to high market prices.

In other words, the supply of gold is huge and expanding, especially relative to that of every other commodity. And since gold is an element, it cannot be destroyed. Compare this with a commodity such as crude oil, which gets used up and can't be renewed.

Here is a graph of gold production:

As you can see, production skyrocketed after 1980, even when prices went into a multi-decade bear market. The current numbers are probably substantially higher than what is reported there, possibly going right through the top of the chart, in response to such high market prices.

As for the demand side, the demand for gold used in jewelry – the commodity's staple use – is so small that the CRB Commodity Yearbook doesn't even bother to report the figures anymore. All demand for gold has been falling – except for use by financial speculators.

I have no idea where the gold price will go, but with the market at a thirty-year high, today's buyers have no margin of safety. And in terms of supply and demand, I can hardly see why gold investors would be concerned about the money supply: unlike the supply of gold, the money supply has not increased by several hundred percent.

If we look at M2, the monetary aggregate used to forecast inflation, it has only expanded by about 10% from where it was a year ago:

Individual money market accounts are included in M2, but wider measures of the money market – like commercial paper and repurchase agreements – are included in M3.

The Fed discontinued its reporting for most of the components of this latter aggregate, but my guess is that the extreme stress in the credit markets probably would have shown M3 sharply contracting, hence the need for a massive liquidity injection.

While the Federal Reserve can print money, so can the giant mining companies ramp up gold exploration and production. And the facts show that the latter have been much more successful in supplying the market.

While this may be a vote of confidence for the free enterprise system, it presents an ugly picture for today's buyers of gold.

Warren Buffett's 2008 Letter to Shareholders

2009-02-28T11:14:00.000-08:00

“By the fourth quarter, the credit crisis, coupled with tumbling home and stock prices, had produced a paralyzing fear that engulfed the country. A freefall in business activity ensued, accelerating at a pace that I have never before witnessed. The U.S. – and much of the world – became trapped in a vicious negative-feedback cycle. Fear led to business contraction, and that in turn led to even greater fear.”

Berkshire 2008

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Jim Rogers: Civil Unrest in the U.S.

2009-02-27T13:07:00.000-08:00

The co-founder of the Quantum Fund is extremely pessimistic on the stock market.

Eddie Lampert's Letter to Shareholders

2009-02-26T13:03:00.000-08:00

This is far and away the best Sears Holdings shareholder letter to date. Eddie Lampert gives a fascinating analysis of the current economy, the financial crisis, short selling, mark-to-market accounting, and economic theory. Recall that Eddie Lampert, a summa cum laude graduate of Yale, studied under Nobel laureate economist James Tobin during his tenure there. In this letter, Lampert makes his financial and economic brilliance abundantly clear. During such trying economic times, I am sure that large Sears shareholders like Bruce Berkowitz practically fell out of their chairs when they saw this.

Eddie Lampert's 2009 Letter to Shareholders

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John Paulson: Distressed Opportunities

2009-02-25T23:33:00.000-08:00

From Bloomberg News:

Distressed assets offer the best investment opportunities this year as the global recession deepens, billionaire hedge-fund manager John Paulson said.

“The decline in the market has created a very good buying opportunity,” Paulson, 53, whose New York-based Paulson & Co. oversees about $30 billion, said in a speech at a hedge-fund seminar hosted by Societe Generale and Lyxor Asset Management in Tokyo today. “Distressed opportunity in the U.S. is shaping up to be the best opportunity in a lifetime.”

Paulson said he’s focused on assets such as mortgages and debt from bankrupt companies, while in the equities markets he cited the utilities, consumer staples and pharmaceutical industries. Financial stocks remain risky, Paulson said.

In the 15 years since starting its first funds, Paulson & Co.’s one down year was 1998. All his funds were profitable in 2008, with the flagship fund returning about 38 percent, compared with a loss of 19 percent for hedge funds worldwide on average. The 2008 returns came after his funds made more than $3 billion for the firm in 2007 by anticipating the collapse of the U.S. housing market and subprime mortgages.

Investors are chasing distressed assets after more than $1.1 trillion in losses at financial firms globally and frozen credit markets helped drag the U.S., Europe and Japan into their first simultaneous recessions since World War II.

Deep Recession

“In 2009, we expect this recession is going to be deeper and longer than consensus estimates,” Paulson said. “We don’t think we’re through the banking crisis yet. We think that in many cases, losses the banks will experience will exceed their common equities.”

Hedge funds are private, largely unregulated pools of capital whose managers can buy or sell any assets, bet on falling as well as rising asset prices, and participate substantially in profits from money invested. Managers typically charge fees equal to 2 percent of client assets and 20 percent of investment profits.

“We’re bearish on the economy, but very bullish on opportunities in front of us,” Paulson said.

Merger Trainwrecks

2009-02-24T21:55:00.000-08:00

It turns out that the Zell-Blackstone deal, as well as the Blackstone IPO, marked almost the exact top of their respective markets:

http://www.nytimes.com/2009/02/07/business/07properties.html?_r=1&em=&pagewanted=all

As a general rule, mega M&A deals will always tend to mark the top of a market. We saw this in the 1980s with Merger Mania, culminating in the historic $30 billion RJR Nabisco LBO – right in front of the 1990 recession.

And then we saw it hugely in early 2000, with the $164 billion AOL-Time Warner deal, one of the greatest value-destroying transactions of all time. The merger agreement was filed in February of 2000, at the market's apex. By 2002, the value of AOL was written down by $100 billion.

Looking over commodity producers and industrial companies, we clearly saw a lot of M&A at the top of the current market.

And of course, the financials: the $47 billion merger between Fleet and Bank of America took place in 2004; MBNA and Bank of America in 2006; Bank of New York and Mellon in summer of 2007; and then Bank of America buying Countrywide Financial in January of 2008, to name a few.

However, the worst of all was RBS and Fortis' colossal $100 billion acquisition of ABN AMRO in October of 2007 – again the absolute top of the market. Fortis is now defunct and RBS is being propped up by the British government.

By contrast, heavy bankruptcies and deep-value industry consolidation are positive signs. And sharply-reduced capacity and inventories, especially when they have been depressed for long periods of time and appear to be improving, are signs of a market bottom.

This is probably where the agriculture markets are right now. It continues to appear that agriculture may well be the biggest bull market over the next ten years or so.

Fed Looks to Manipulate Treasury Market

2009-02-23T16:58:00.000-08:00

The Federal Reserve is now considering manipulation of the market for long-term Treasuries. While Richard Fisher says the Fed should not try to "peg" long-term rates, this is exactly what they would be doing: creating a de facto peg.

Over the coming years, when the thirty-year-long bull market in bonds begins to reverse itself, and inflation is discounted into the yield curve (making long-term rates rise sharply), short-selling 30-year Treasuries will be an excellent trade. In fact, it is a one-way bet.

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From MarketWatch.com:

The Federal Reserve should start buying long-term Treasury securities, Richard Fisher, the president of the Dallas Federal Reserve, said Monday.

"The Federal Reserve must, of course, be very careful to avoid any perception that it stands ready to monetize exploding federal deficits as this would undermine confidence in our independence and raise serious doubts about our commitment to long-term price stability," Fisher said in a speech at Harvard University.

"These concerns certainly do not preclude some Treasurys purchases, however, as we seek to strengthen the economy in a time of crisis," Fisher said.

Buying longer-term Treasurys is "not a sharp departure from past practice," Fisher said. The Fed often buys longer-term securities to maintain a well-balanced portfolio, he said.

Fisher said the Fed just shouldn't try to "peg" long-term rates.

"Past efforts to do so soon have led to costly credit-market distortions and inevitably ended in tears," Fisher said.

Fisher is not a voting member of the Federal Open Market Committee this year.

Fed watchers are split over where the Fed now stands on the idea of buying Treasuries.

Although the issue has been a championed by Fed chief Ben Bernanke in theory, many think the Fed is actively backing away from the idea in practice.

In the minutes of the Fed's latest meeting, all but one of the Fed members agreed to defer the issue at least until there was more evidence about existing Fed innovative programs. Richmond Fed President Jeffery Lacker dissented from the FOMC's statement in January, saying he preferred that the Fed buy Treasurys rather than providing liquidity through targeted credit programs.

Some Fed-watchers are adamantly opposed to the idea of the central bank purchasing Treasurys. They believe it could do damage to the market for Treasurys, just as the government is ramping up issuance to over $1 trillion in net new securities to counter the downturn.

"We believe this is one of the worst monetary policy ideas to surface in years," wrote Lou Crandall, chief economist at Wrightson ICAP.

"If the Fed commits itself to a policy of artificially depressing the returns on Treasury securities for an extended period, it will force investment committees around the world to reconsider their portfolio allocations to the U.S. Treasury market as an asset class," Crandall wrote recently.

"There is no guarantee that the international investors who dominate the Treasury market will move into other dollar-denominated assets if the Fed manages to make Treasury securities unattractive to them.

Given the Treasury's massive borrowing needs, any attempt to rig the market in this environment could backfire – with serious long-term consequences for the public finances of the United States," Crandall said.

But the idea has its supporters on the Fed in addition to Bernanke, Fisher and Lacker. Some Fed bank presidents want the Fed to target the growth rate of money. They would support purchases of long-term Treasurys if that were the best way to achieve that objective.

Agriculture Crisis

2009-02-21T12:20:00.000-08:00

It looks as if agriculture futures might be in for a ride sooner than I had expected:

http://www.nytimes.com/2009/02/22/us/22mendota.html?hp=&pagewanted=all

Talk about an absolutely killer case of stagflation.

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MENDOTA, Calif. — The country’s biggest agricultural engine, California’s sprawling Central Valley, is being battered by the recession like farmland most everywhere. But in an unlucky strike of nature, the downturn is being deepened by a severe drought that threatens to drive up joblessness, increase food prices and cripple farms and towns.

Across the valley, towns are already seeing some of the worst unemployment in the country, with rates three and four times the national average, as well as reported increases in all manner of social ills: drug use, excessive drinking and rises in hunger and domestic violence.

With fewer checks to cash, even check-cashing businesses have failed, as have thrift stores, ice cream parlors and hardware shops. The state has put the 2008 drought losses at more than $300 million, and economists predict that this year’s losses could swell past $2 billion, with as many as 80,000 jobs lost.

“People are saying, ‘Are you a third world country?’ ” said Robert Silva, the mayor of Mendota, which has a 35 percent unemployment rate, up from the more typical seasonal average of about 20 percent. “My community is dying on the vine.”

Even as rains have washed across some of the state this month, greening some arid rangeland, agriculture officials say the lack of rain and the prospect of minimal state and federal water supplies have already led many farmers to fallow fields and retreat into survival mode with low-maintenance and low-labor crops.

Last year, during the second year of the drought, more than 100,000 acres of the 4.7 million in the valley were left unplanted, and experts predict that number could soar to nearly 850,000 acres this year.

All of which could mean shorter supplies and higher prices in produce aisles — California is the nation’s biggest producer of tomatoes, almonds, avocados, grapes, artichokes, onions, lettuce, olives and dozens of other crops — and increased desperation for people like Agustin Martinez, a 20-year veteran of the fields who generally makes $8 an hour picking fruit and pruning.

“If I don’t have work, I don’t live,” said Mr. Martinez, a 39-year-old father of three who was waiting in a food line in Selma, southeast of Fresno. “And all the work is gone.”

In Mendota, the self-described cantaloupe center of the world, a walk through town reveals young men in cowboy hats loitering, awaiting the vans that take workers to the fields. None arrive.

The city’s main drag has a few quiet businesses — a boxing gym, a liquor store — and tellingly, two busy pool halls. The owner of one hall, Joseph R. Riofrio, said that his family had also long owned a grocery and check-cashing business in town, but that he had just converted to renting movies, figuring that people would rather stay at home in hard times.

“We’re not going to give up,” Mr. Riofrio said. “But people are doing bad.”

Just down the highway in Firebaugh, José A. Ramírez, the city manager, said a half-dozen businesses in its commercial core had closed, decimating the tax base and leaving him to “tell the Little League they’d have to paint their own lines” on the local diamond.

The situation is particularly acute in towns along the valley’s western side, where farmers learned on Friday that federal officials anticipate a “zero allocation” of water from the Central Valley Project, the huge New Deal system of canals and reservoirs that irrigates three million acres of farmland. If the estimate holds and springtime remains dry, it would be first time ever that farmers faced a season-long cutoff from federal waters.

“Farmers are very resilient, we make things happen, but we’ve never had a zero allocation,” said Stephen Patricio, president of Westside Produce, a melon handler and harvester. “And I might not be very good at math, but zero means zero.”

While California has suffered severe dry spells before, including a three-year stint ending in 1977 and a five-year drought in the late ’80s and early ’90s, the ill effects now are compounded by the recession and other factors.

Federal, state and local officials paint a grim picture of a system taxed as it has never been before by a growing population, environmental concerns and a labyrinth of water supply contracts and agreements, some dating to the early 20th century. In addition to the federal water supplies, farmers can irrigate with water provided by the state authorities, drawn from wells and bought or transferred from other farmers. Such water may not always be the best quality, said Mark Borba, a fourth-generation farmer in Huron, Calif.

“But it’s wet,” he said.

Richard Howitt, the chairman of the agricultural and resource economics department at the University of California, Davis, estimates that 60,000 to 80,000 jobs could be lost — including in ancillary businesses — and that as much as $2.2 billion in crop and other losses could be caused by restrictions on water and the drought, which he called “hydrologically as bad as 1977 and economically as bad as 1991.”

“You’re talking about field workers, processing handlers, people packing melons, trucking hay, sprayers, people selling tractors, people selling lunches to people selling tractors,” Mr. Howitt said. “And in some of these small west-side towns, it’s going to hit the people who are least able to adapt to it.”

One of the hardest hit areas is the farmland served by the Westlands Water District, which receives water exclusively from the Central Valley Project and distributes it to 600,000 acres in Fresno and Kings Counties. Sarah Woolf, a spokeswoman for the district, said that her 700 members expected to leave 300,000 to 400,000 acres fallow and that some might not come back to farm at all.

“Everyone’s trying to go down fighting,” Ms. Woolf said. “But there will be significant companies that will go out of business, as well as families that have been farming for generations, if it doesn’t get better.”

The outlook for things getting better quickly is dim, despite forecasts of rain this week. Last month, California officials estimated the snowpack in the Sierra, a primary source of water for the state when it melts in the spring, at 61 percent of normal. On Friday, the State Department of Water Resources said it would deliver just 15 percent of its promised contracts, a level it was able to maintain only because of the recent spate of rain. “It’s pathetic,” said Lester A. Snow, the department’s director.

Lynette Wirth, a spokeswoman for the United States Bureau of Reclamation, said water levels in all federally managed reservoirs in California were well below normal, with “abysmal” carryover from the previous year.

“There’s been no meaningful precipitation since last March,” Ms. Wirth said.

Farmers, of course, are also dealing with issues unrelated to rain, including tight credit from banks and recent court decisions meant to protect fish that have limited the transfer of water through the Sacramento-San Joaquin Delta, which feeds snowmelt to farmbound canals. Many farmers refer to a “man-made drought” caused by restrictions.

At the same time, environmental groups say they also fear a range of potential problems, including depletion of the valley aquifer from well pumping, possible dust-bowl conditions in areas of large patches of fallow ground and concern about salmon and other species. “It’s a tough year for the environment, and people,” said Doug Obegi, a lawyer with the Natural Resources Defense Council.

George Soros: Bottomless Market

2009-02-20T20:50:00.000-08:00

From Reuters:

Renowned investor George Soros said on Friday the world financial system has effectively disintegrated, adding that there is yet no prospect of a near-term resolution to the crisis.

Soros said the turbulence is actually more severe than during the Great Depression, comparing the current situation to the demise of the Soviet Union.

He said the bankruptcy of Lehman Brothers in September marked a turning point in the functioning of the market system.

"We witnessed the collapse of the financial system," Soros said at a Columbia University dinner. "It was placed on life support, and it's still on life support. There's no sign that we are anywhere near a bottom."

His comments echoed those made earlier at the same conference by Paul Volcker, a former Federal Reserve chairman who is now a top adviser to President Barack Obama.

Volcker said industrial production around the world was declining even more rapidly than in the United States, which is itself under severe strain.

"I don't remember any time, maybe even in the Great Depression, when things went down quite so fast, quite so uniformly around the world," Volcker said.

Wilbur Ross: Buying Financials

2009-02-19T12:29:00.000-08:00

Here is an extensive interview with billionaire financier Wilbur Ross. Evidently he is now rolling up a huge financial institution, similar to his past moves in steel and auto parts. Ross is generally supportive of the Obama administration's plan and Secretary Geithner, and he holds a huge cash position ready to deploy throughout this crisis.

Jim Rogers: The Financial Rescue Plan

2009-02-19T12:17:00.000-08:00

Jim Rogers on the bailout plan. He says that Tim Geithner essentially caused the crisis and that he's now shorting big companies like IBM, General Electric, and JPMorgan...

David Einhorn's Greenlight Capital Annual Report

2009-02-18T21:38:00.000-08:00

Here is Greenlight Capital's 2008 annual report.

I am a tremendous admirer of Greenlight Capital and their success, and had a great experience last year with Dan Roitman, Greenlight's Chief Operating Officer, who offered me straightforward and generous advice about a company I was researching, when he clearly did not have to help me at all. In fact, 99% of executives in a similar position wouldn't have been so generous.

It really is difficult to overstate how phenomenal these guys are, as investors as well as personally. And, of course, they are Cornell alums who are extremely philanthropic, which is always a winning bet.

Greenlight Capital 2008 Annual Report

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Soros on Oil and Agriculture

2009-02-17T21:35:00.000-08:00

From Bloomberg News:

George Soros’ $21 billion fund returned 8% last year, which is incredible not only in light of the global crisis, but also given his fund’s size. As you can see, Soros is now betting big on oil and agriculture, outside of the United States.

...

Billionaire investor George Soros’s hedge-fund firm bought more shares of Petroleo Brasileiro SA and Potash Corp. of Saskatchewan Inc. in the fourth quarter, almost doubling its holdings.

Soros Fund Management LLC bought 16 million shares of the Petrobras’ U.S. traded shares, bringing its stake to 1.45 percent, according to a filing yesterday with the U.S. Securities and Exchange Commission. The New York-based firm increased its holdings in Potash by 2.6 million shares to 2 percent in the fourth quarter. Petrobras and Potash are now the firm’s two biggest reported U.S. stocks.

“As long as you see through the current crisis there are a few compelling reasons to buy,” Hernan Ladeuix, the head of oil and gas research at CLSA Ltd. in Singapore, said in an e-mail. “Oil prices should go up, probably strongly in coming years. Petrobras is the only large international company where you can have confidence that production can grow 5 percent per annum.”

The purchases made Soros the second-biggest shareholder in the U.S.-traded shares of Petrobras, Brazil’s state-controlled oil company. Petrobras preferred shares fell 5.4 percent in Sao Paulo yesterday, the most since Jan. 12, driven by a drop in oil prices to below $35 a barrel.

Potash, the biggest maker of crop nutrients, also fell by the most since Jan. 12, declining 7.4 percent yesterday. Soros Fund is the eighth-biggest holder in shares of the Saskatoon, Saskatchewan-based company.

Best Buy, Wal-Mart

Soros Fund added 9 million shares of Best Buy Co., bringing its stake to 2.3 percent of the electronics retailer. The firm also started a new position in Desarrolladora Homex SA de C.V., the Mexican homebuilder, bringing its holdings to 4.9 percent of U.S.-traded shares, according to data compiled by Bloomberg. The firm bought 5 million shares of R.R. Donnelley & Sons Co., North America’s largest printer, representing a 2.4 percent stake.

Soros’s hedge-fund firm sold 3 million shares of Wal-Mart Inc., bringing its stake in the discount retailer to 0.01 percent. The firm also sold all of its 2 million shares in Research In Motion Ltd., the maker of the Blackberry phone.

Money managers who oversee more than $100 million of equities or more must file, within 45 days of the end of each quarter, a Form 13F with the SEC that lists their U.S. exchange- traded stocks, options and convertible bonds. The filings don’t show non-U.S. securities or how much cash the firms hold.

Soros’s firm oversees $21 billion. Its Quantum Endowment Fund returned 8 percent last year. That compared with an average loss of 18 percent by hedge funds, according to data compiled by Hedge Fund Research Inc. of Chicago.

Michael Reyen: Are You Bullish on The Bear?

2009-02-16T19:59:00.000-08:00

Recently, I heard a commentator on CNBC say that he is bullish about Russia, which he claimed to be one of the few countries poised for positive growth in 2009. As a member of one of the ‘BRIC’ countries, Russia has experienced an economic resurgence within the past decade. But is the specter of positive growth enough? There are several alarming trends that demand attention when considering an investment within Russia.

1.) Falling oil prices pose a serious risk to Russia’s ability to balance its budget, prop up the ruble, and maintain complacency among the people. Russia was able to build up a cushion of cash to guard against falling oil prices, estimated in October of 2008 to be the third largest in the world.[1] However, as the economic crisis intensified, Russia has burned through more than 30% of its currency reserves within the past six months while the ruble has tumbled in value by more than a third.[2] Additionally, inflation stands at 13% a year.[3] Although Russia is better poised to resist a repeat of the 1998 default with $388 billion in cash remaining, a defense of the ruble at the promised 41 ruble to euro/dollar basket of currencies may prove unsustainable, with the ultimate devaluation coming at the expense of confidence in the government and its ability to manage the economy.[4]

2.) Government corruption and general disregard of the rule of law are serious problems within Russia. The ruling party of former members of the KGB and state security services, collectively known as siloviki, or hard men, is strategically placed to accelerate the transfer of wealth and assets from the private sector to their control. The nationalization of successful private companies within Russia is not a new phenomenon, with the most glaring example being the nationalization of the petroleum company Yukos and the imprisonment of its owner Mikhail Khodorkovsky. However, the current economic crisis provides a perfect opportunity for the intensification of this type of nationalization under the guise of government aid to distressed firms. These actions could result in the emergence of a “corporatist state” within Russia, consisting of a “highly monopolistic system, based on a peculiar state-private partnership in which the profits are privatised by Kremlin friends and debts are nationalised.”[5]

Unfortunately, the courts offer little recourse for private investors. The Russian legal system is ineffective and fails to provide adequate protection over property rights, which is a pre-requisite for private investment. Judges serve at the mercy of the President and the ruling siloviki. Corruption also permeates the judicial system and society as a whole. Openly acknowledged as a part of doing business in Russia, the country received a 2.1 out of 10 rating on the corruption index (with 10 being a low rate of corruption) while the corruption market is valued at $300 billion or 20% of GDP.[6] Many large Russian companies seek justice in London and the European Court of Human Rights is flooded with Russian cases.[7] Apart from the ineffectiveness of the legal system and the prevalence of corruption, it is also dangerous to be a high profile legal operator within Russia.

3.) Russia has recently seen a rise in ultra-nationalism that has undercurrents of neo-fascism and xenophobia. The most glaring example of the danger of this ultra-nationalism is the recent murder of prominent human rights lawyer Stanislav Markelov. Mr. Markelov was gunned down in broad daylight in central Moscow along with a freelance journalist working for Novaya Gazeta, a Russian newspaper highly critical of the government. Speculation is that he was gunned down by ultra-nationalists for announcing that he would fight against the release of a Russian tank commander who was imprisoned for murdering an 18 year old Chechen woman. The journalist is the fourth Novaya Gazeta reporter to be murdered or die under mysterious circumstances since 2000.[8]

The rise in ultra-nationalism is due in part to the influx of immigrants during Russia’s decade of prosperity, with the number of migrant workers estimated at over 10 million – making Russia second to only the U.S. in immigrant population.[9] These migrants, primarily Muslim and hailing from the former Soviet Republics of Central Asia, live in squalid conditions and endure both attacks from ultra-nationalists (667 attacks and 86 murders motivated by racism last year) and police harassment.[10] Although the migrants are crucial to Russia’s economy and dwindling native workforce (Russia’s population of 142 million is decreasing by 700,000 a year),[11] the economic crisis is likely to exacerbate their hardship while increasing the frequency of attacks against them as the general populace begins to feel economically desperate and resentful of these low-wage workers. Unfortunately, the Russian government’s recent rhetoric has fanned the flames of ultra-nationalism.

4.) Aside from nationalistic rhetoric, the Russian government also uses the economy to further its political goals, specifically its power within the international energy markets. President Putin is highly involved within the country’s energy industry, and has been active in using politics to prevent Central Asia from building a pipeline to Europe that bypasses Russian territory.[12] These actions, involving Russia’s most attractive industry, are likely to come at the expense of private business. The most recent example is the government’s shutdown of a natural gas pipeline to Ukraine that distributes heating fuel to homes throughout Europe. For three cold weeks much of Southeastern Europe was without heat as Russia renegotiated natural gas contracts with Ukraine. Although it superficially involved natural gas pricing, the undertones of this disagreement are Ukraine’s overtures to the West, contemplation of NATO membership, and weapons sales to Georgia.[13]

The Ukrainian episode along with the war in Georgia is part of a larger pattern of increasingly frosty relations with the West. Other concerns include Russia’s recent arms sales to anti-American governments such as Venezuela and Iran, and the use of the promise of aid and loans to Kyrgyzstan as enticement to force the closure of a U.S. airbase crucial to the mission in Afghanistan.[14] Although the base closure is not an explicit condition of the $2.5 billion in Russian aid to Kyrgyzstan, it is suspicious that the Kyrgyzstan parliament is delaying the vote on whether to expel U.S. troops until after it receives the $450 million down payment from Russia.[15]

It is not a foregone conclusion that any of these trends will hurt GDP growth or hinder returns on investments in Russia (the same cannot be said for the global economic downturn). However, these trends do indicate that any investment in Russia should be carefully considered and an appropriate risk premium factored into any expected return.

Michael Reyen is a former bank auditor and graduate of Colgate University. He is currently pursuing his law degree and Masters in Economics at the University at Buffalo.

[1] The anti-West: An Axis in Need of Oiling, The Economist, Oct. 26, 2008, at 72.

[2] Down in the Dumps: The rouble, a symbol of the Kremlin’s power, is looking sickly, Economist.com: Finance & Economics, Feb. 5^th 2009, available at http://www.economist.com/finance/.

[3] Id.

[4] Id.

[5] Russia: The Long Arm of the State, The Economist.com: Special Report, Nov. 27, 2008, available at http://www.economist.com/specialreports/displaystory.cfm?story_id=12627970.

[6] Russia: Grease My Palm, The Economist.com: Special Report, Nov. 27, 2008, available at http://www.economist.com/specialreports/displaystory.cfm?story_id=12628030.

[7] Russia: A Matter of Judgment, The Economist.com: Special Report, Nov. 27, 2008, available at http://www.economist.com/specialreports/displaystory.cfm?story_id=12628022.

[8] Michael Schwirtz, Leading Russian Rights Lawyer Shot to Death in Moscow, Along With a Journalist, New York Times, Jan. 19, 2009.

[9] Michael Schwirtz, For Russia’s Migrants, Economic Despair Douses Flickers of Hope, New York Times, Feb. 10, 2009, at A11.

[10] Russia: The Incredible Shrinking People, The Economist.com: Special Report, Nov. 27, 2008, available at http://www.economist.com/specialreports/displaystory.cfm?story_id=12627956.

[11] Id.

[12] Andrew E. Kramer, Russia and Ukraine Sign Agreement on Gas, New York Times, Jan. 20, 2009, at A11.

[13] Id.

[14] The anti-West: An Axis in Need of Oiling, The Economist, Oct. 26, 2008, at 71; Associated Press, Krygyzstan: Vote to Close U.S. Base Is Delayed, New York Times, Feb. 10, 2009, at A11.

[15] Id.

Buffett on Hyperinflation

2009-02-15T18:14:00.000-08:00

As you can see, Warren Buffett has been loading up on bonds:

http://www.bloomberg.com/apps/news?pid=20601103&sid=ajshQre7kVYw&refer=us

"Buffett agreed to buy a combined $750 million in debt from wallboard manufacturer USG Corp., motorcycle-maker Harley- Davidson Inc. and Sealed Air Corp., the maker of Bubble Wrap shipping products, in the past three months paying between 10 and 15 percent.

"Buffett also agreed in September and October to spend $8 billion on preferred shares of General Electric Co. and Goldman Sachs Group Inc. that pay 10 percent annual interest. This month, he agreed to buy convertible notes from Swiss Reinsurance Co. worth 3 billion Swiss francs ($2.6 billion) that pay 12 percent annually."

While Buffett’s bond investments might be mandated because he is using insurance float, it stands to reason that if he was overly concerned about very high rates of inflation, he would not be doing most of these transactions.

If Buffett was concerned about high inflation or a deteriorating dollar, he would simply do what he did before: forget about yield and invest in foreign currencies. For example, he could simply buy yen forwards or yen bonds if he thought the U.S. currency faced imminent destruction.

Granted, Buffett’s recent Swiss Re position has this dollar-hedge effect. But if Buffett expected hyperinflation, he would be making very different investments. He would be investing in hard assets or securities related to them.

With high domestic inflation, anything interest-bearing or financial is rat poison – yet Buffett has been investing heavily in dollar-based, fixed-income securities. Evidently he isn’t overly concerned about high inflation.

CDO Hell

2009-02-13T15:17:00.000-08:00

Here is a chronology of the CDO meltdown, laying bare what true junk ABS-CDOs actually were. Yet, with over 76% of these instruments that were issued at the market's peak currently in default, it stands to reason that we're pretty close to being done with this, or at least that the most intense phase of the crisis is behind us.

From the Financial Times:

Almost half of all the complex credit products ever built out of slices of other securitised bonds have now defaulted, according to analysts, and the proportion rises to more than two-thirds among deals created at the peak of the cycle.

The defaults have affected more than $300bn worth of these collateralised debt obligations, which were built from bits of other asset backed securities (ABS) such as mortgage bonds, other CDOs and structured bonds, or derivatives of any of these, according to analysts at Wachovia and Morgan Stanley.

So-called CDOs of ABS caused huge losses to banks such as Merrill Lynch, UBS and Citigroup, which held large amounts of the supposedly safest, top-rated chunks of them. They have since been damned by bodies such as the Bank for International Settlements as being too complex to risk manage effectively.

CDOs of ABS were used increasingly at the peak of the credit bubble to keep the securitisation machine moving by recycling hard to sell bits of subprime mortgage bonds and other risky tranches into new structures with top-notch credit ratings.

However, the ratings of these deals proved unsustainable, as evidenced by the fact they have accounted for 92.9 per cent of all 16,587 ratings downgrades globally from all rating agencies since the beginning of last year, according to Morgan Stanley.

The way these complex and risky transactions were exploited at the peak of the bubble can be seen in data from analysts at Wachovia, who reckon that 47.6 per cent of all CDOs of ABS by volume issued since the market substantively began in 2002 have now hit an event of default.

By their records, the first three years of the market saw less than 100 deals sold per year and less than 10 per cent of those have defaulted. The number of deals done rose to 133 in 2005, less than 20 per cent of which defaulted, and 89 in just the first half of 2006, about one-third of which have defaulted.

However, the real peak of the market saw 147 deals done in the second half of 2006 and 172 done in the first half of 2007 – of which 68 per cent and 76.2 per cent, respectively, have now defaulted.

The way these CDOs have performed has especially hurt the new wave of specialist credit hedge funds, which sprang up in recent years and became heavily dependent from creating and managing such deals. They were drawn to such business by a belief in the sustainability and predictability of the fees it would generate.

However, about one-third of the CDOs of ABS that have defaulted, or almost $105bn worth, have been or are being liquidated – often leading to losses for investors and putting further pressure on market prices of the bits of mortgage bonds and other CDOs they are selling.

Milton Friedman on Inflation

2009-02-11T14:07:00.000-08:00

Given that inflation has come on the radar lately, it is no shock that many armchair economists have come out of the woodwork, making all types of nonsense claims. And given that inflation is a controversial issue among different schools of economics, here is one of the best series that I've seen, with Milton Friedman explaining inflation and how to cure it.

Milton Friedman: The Purpose of the Federal Reserve

2009-02-10T21:19:00.000-08:00

By Friedman's standard, and what we are seeing in the economy, it looks as if the Federal Reserve has pursued exactly the right approach. The idea of not supporting banks and reigning in the money supply is outrageously foolish at this point.

Government-Sponsored Trainwrecks

2009-02-10T18:07:00.000-08:00

Here are the chilling statistics on Fannie and Freddie, the housing market, and what the U.S. government is on the hook for.

From Bloomberg News:

Fannie Mae and Freddie Mac, the mortgage-finance companies seized by regulators, may need more than the $200 billion in funding pledged by the U.S. government if the housing market continues to deteriorate, Federal Housing Finance Agency Director James Lockhart said.

The companies’ needs will depend largely on the direction of home prices, Lockhart said in an interview in Las Vegas yesterday. His comments followed statements from Fannie Mae in November and Freddie Mac Chairman John Koskinen last week that the government’s funding commitment through 2009 may fall short of what the companies need to make good on their obligations.

“When we sized the amount in September, we obviously looked at stress tests and what was happening in the marketplace,” Lockhart said. “There’s been some significant events since then that weren’t in our forecast.”

The U.S. housing market lost $3.3 trillion in value last year and almost one in six owners with mortgages owed more than their homes were worth, according to a Feb. 3 report from Zillow.com. Following a record boom, home prices are down 25 percent on average since mid-2006 amid a tightening of lending standards and an economic recession, the S&P/Case-Shiller Composite 20-city price index shows.

Freddie Mac and Fannie Mae are the largest U.S. mortgage- finance companies, owning or guaranteeing $5.2 trillion of the $12 trillion home-loan market. The government seized control of Fannie Mae and Freddie Mac after their losses threatened to further disrupt the housing market, and pledged to invest as much as $100 billion into each company as needed if the value of their assets drops below the amount they owe on obligations.

A ‘Hard Look’

Fannie Mae said in a November regulatory filing that “this commitment may not be sufficient to keep us in solvent condition or from being placed into receivership.” Freddie Mac is taking a “hard look” at whether it will need more than $100 billion, Koskinen said last week.

“It’s going to be a close question,” Koskinen said in an interview on Bloomberg Television’s “Conversations with Judy Woodruff.”

McLean, Virginia-based Freddie Mac has taken $13.8 billion in federal aid and said it will need as much as $35 billion more by the end of this month. Washington-based Fannie Mae said it may tap as much as $16 billion in funding.

Lockhart, who was in Las Vegas yesterday to speak before the American Securitization Forum’s annual conference, said Fannie Mae and Freddie Mac’s most recent requests for aid, which were larger than some expected, were driven by temporary market disruptions that may not translate into permanent losses.

“There were some temporary imbalances that made their numbers pretty dramatic,” he said.

Government Demands

Federal officials are now leaning on the government- sponsored enterprises to help stabilize the housing market. House Financial Services Committee Chairman Barney Frank said last week that the companies will be used “very aggressively” to help reduce record foreclosures.

Lockhart said Fannie Mae and Freddie Mac aren’t expected to take a loss “under any program” that requires their involvement. “We would expect them to be writing business that’s profitable at this point, not a large profit,” he said yesterday. “But we would not expect them to be writing business at a loss under any program.”

The Treasury, not the companies, would bear the cost under proposals to use the companies to drive down mortgage rates to about 4.5 percent, Lockhart said. That proposal was under consideration as part of a comprehensive housing-recovery plan being developed by the Treasury.

‘A Hot Idea’

“That was a hot idea for a while: It’s cooled off,” Lockhart said. “But Fannie and Freddie wouldn’t be asked to eat the difference. If it happened, that would be the U.S. Treasury.”

Fannie Mae and Freddie Mac may also be used to provide direct financing to single-family and multifamily residential mortgage lenders, Lockhart said. Currently Fannie Mae and Freddie Mac provide financing by either buying loans from lenders or helping them package the debt as bonds for sale to investors, thus freeing up cash to make more mortgages.

The FHFA is reviewing whether the companies’ congressional charters, which generally prohibit lending directly to the public, would restrict expanding into so-called warehouse financing.

Credit Standards

Mortgage bankers and other companies that have seen their sources of credit dry up in the past year have been pushing for the change, according to Lockhart.

“The problem is that unfortunately bankers have tightened their credit standards and withdrawn from some markets,” Lockhart said. “And as interest rates fall, if we have relatively large refinancings, we’re going to need to have mortgage bankers be able to provide mortgages in the interim before they sell them to Fannie and Freddie.”

Missing the Bull's-Eye at Target

2009-02-09T19:42:00.000-08:00

Given that I have commented on Bill Ackman and Pershing Square lately, I've included this letter to Pershing Square IV investors, who have now lost 90% of their invested capital.

As I wrote before, Pershing's TIP REIT transaction with Target was nothing more than a highly sophisticated attempt to immediately lift the stock price, and place Pershing's call options and total return swaps in the money.

But the main question that I have is, with stock prices where they are, would Bill Ackman now choose to buy Target stock, among all the other opportunities? In other words, is Target the most superior opportunity currently available?

To be clear, this is not an attack on Pershing Square or Bill Ackman, but a criticism of short-term-oriented investment strategies. With the benefit of hindsight, Ackman's leveraged Target investment appears to have been a mistake, made at the top of the market, caused by impatience.

Pershing Square IV Letter to Investors

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Jim Rogers: A Retrospective

2009-02-07T17:28:00.000-08:00

After thinking this morning about commodities and inflationary prospects, I watched a Jim Rogers interview from 1995, which I have included below. You will have to fast forward a bit, because he appears toward the end. Here are a few of his predictions from 1995:

“Next year and the year after, I don’t think we’re going to have good times in the American stock market.”

“Inflation is coming.”

“Commodity prices are going through the roof.”

Best country to invest in right now: “Iran.”

“Everything in life comes down to timing.”

Well, it looks as if Jim's timing was profoundly wrong.

In fact, much of this flies in the face of what he said in Hot Commodities, published a decade later, which was to the effect of “if you went through the 1990s and didn't touch shares in technology companies then you missed out on massive gains," essentially meaning that it was a mistake caused by not being open to new things.

But, as you can see, he was saying the exact same stuff back then as he is today. And he certainly wasn't talking about technology.

Anyone who continues saying that inflation will come or commodities will rise is bound to be proven right at some point. This not to single out Rogers as being wrong, but to emphasize my stance on how difficult it is to predict macro events – unless, that is, you only have one perennial prediction.

What history shows is that, aside from short-term macro shocks, the best asset class to own, by far, is stocks. And if you can buy those stocks at depressed prices or in periods of intense fear, then your total return can be magnified significantly.

Land, labor, capital and commodities are combined to create businesses that increase productivity. And while any one of those factors may become relatively attractive during a boom, owning excellent businesses – or fractional interests, called stocks – is the best investment over the long haul.

Keynes predicted that the great financial fortunes – paper fortunes, such as the Rothschilds in his day – would be destroyed by long-run inflation. Clearly, this has not happened.

Quite the contrary: the countries with the most developed financial systems have always been the most prosperous, whether the Medicis in Renaissance Italy, the Rothschilds in 19th-century London, or today's commanding skyscraper in Lower Manhattan that reads, simply: "85".

Thus, while the gloom and doom is persuasive nowadays, I remain highly skeptical that the world – financial or otherwise – is coming to an end. I lean more towards John Paulson's prediction that massive returns will accrue to buyers of solid, yet beaten-down financial stocks, as the smoke clears and we emerge from this crisis.

Macro Musings

2009-02-06T16:35:00.000-08:00

Here is an interesting article on macro funds and hedge funds in general:

http://bloomberg.com/apps/news?pid=20601109&sid=ay.jqGduLoH8&refer=home

Of course, if people do “flock to global macro” as the article says, it will bankrupt the strategy.

A problem with macro over the long term is that it often comes to resemble rank gambling. Managers can make billions on each trade – or lose billions. They sell the strategy with historic bets like George Soros and sterling in 1992. But I am sure they fail to mention the innumerable historic blow-outs.

Also, the catch is that global macro is usually way more difficult than it has been lately. Over the past few years, the strategy was insanely simple: long commodities, long BRICs, short the dollar, short financials. These were one-way bets with every manager on one side of the trade.

The interesting thing is, each time this happens, everyone says that funds can’t move the market. The markets that these managers operate in are too big to be influenced – like crude oil, last summer. And then the market collapses and in hindsight we find that everyone was on one side of the trade and it created a bubble. It is important to maintain a healthy degree of skepticism with virtually everything along these lines.

A current example might be oil production and supply. I’ve heard many people make claims that production is down and supply is down, as if we’re back in 2003. So after a decade of skyrocketing prices and activity in the energy sector, production and supply are down?

This is a complete lie, no matter what the numbers say. The government or the central bank or whoever else will diligently present figures showing a certain case; but you’ll always do better using common sense. The people producing the data are backwards-looking by definition, and always way behind the curve.

Bill Ackman's Pershing Square Annual Report

2009-02-05T14:34:00.000-08:00

The benefits of Bill Ackman's strategy are relatively obvious and outlined in the following report. But to address the opposite, the downsides, a few of my criticisms are how shortsighted – meaning short-term – and market-obsessed this approach is.

I have explained some of these criticisms before, and the charts included in the presentation show how Pershing is essentially pursuing a classic trading strategy, as opposed to a value investing strategy of intense patience and being unconcerned with whether the stock exchange is open or closed.

Mr. Ackman and Mr. Market appear to take each other very seriously. And this approach works – just look at George Soros or Steven A. Cohen or whichever successful trading operation. But it probably isn't replicable by individual investors, even if they're attempting to buy the same securities.

One example is Borders Group, where Pershing intervened in a potential liquidity crisis and became a creditor, obtained valuable warrants, as well as an agreement to potentially buy Borders' high-quality Paperchase business at an undervalued price. This delivered substantial value to Pershing at the expense of common shareholders. (Why would shareholders benefit from selling Paperchase to Pershing for half price? Would Warren Buffett make this move?)

That said, Ackman makes it clear that Borders is exactly as I noted – a very cheap call option – and also makes clear that a mere 1% of his portfolio is at risk. Yet, another distinction between Pershing and common shareholders is that the former began accumulating Borders shares at above $20 each, whereas the latter can now accumulate them for about 50 cents.

I strongly believe that shareholders are best served by owner-operators, who make disciplined decisions – often unpopular decisions, when short-term fixes are available – to deliver excess returns over the long term, and to build great businesses.

By this standard, I believe that the business Bill Ackman sold this year – Sears Holdings – has a superior operating philosophy. And while Ackman might be able to extort a small profit through his Sears Canada stake, my view is that Eddie Lampert is a vastly superior investor, and will create more value for all stakeholders over the long term.

Pershing Square 2008 Annual Report

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Soros at MIT

2009-02-04T11:51:00.000-08:00

Here is George Soros giving a fascinating theoretical discussion of financial markets at MIT. Also, I include an article of mine, from the Expert Voices archive of the National Science Digital Library, which expands Soros' theory into a more robust and rigorous theory of financial markets. My article was published in April 2008, where I described the largest bankruptcy of this crisis as Bear Stearns, using the term "bankruptcy" in the figurative sense. You can now substitute this with the literal example, Lehman Brothers.

Coffee Talk

2009-02-03T20:10:00.001-08:00

Here is a look at rising coffee demand in Asia. Coffee is a commodity that may well prove to be a better investment than the typical crude oil and gold.

From Bloomberg News:

Coffee demand in China, the fastest-growing major economy, may keep expanding by 20 percent a year if roasters offer products suited to local consumer budgets and tastes, Japanese trading company Marubeni Corp. said.

The number of coffee roasting companies in China has increased to 30 from 25 a year earlier as sales rise to consumers in Shanghai and other coastal cities, Kazuyuki Kajiwara, general manager in Marubeni’s coffee section, said in an interview in Tokyo yesterday.

Starbucks Corp., the world’s largest coffee-shop chain, said last year China had the potential to become its largest market outside the U.S. as the number of middle-class consumers rises. Japanese roasters such as Tokyo-based Unicafe Inc. are targeting sales in the country as opportunities decrease in a mature home market with a gradually declining population.

“We estimate coffee consumption in China is growing by 20 percent on year, or at the same pace of increase in roasters,” Kajiwara said. The Chinese market will probably keep expanding at a similar pace as potential coffee drinkers in China are as many as 200 million people, he added.

China’s coffee consumption is probably 30,000 metric tons a year, about 7.5 percent of Japanese demand of more than 400,000 tons, Kajiwara estimated. Marubeni established a coffee-roasting subsidiary in Shanghai in 2006.

Aroma Coffee (Shanghai) Co. started production in October 2007 with roasting capacity of 300 tons a year. Marubeni aims to boost sales in China after gaining a 15 percent share in South Korea’s coffee market of 100,000 tons a year, Kajiwara said.

Flavor Preference

“We believe the Chinese market has a potential to grow depending on the quality and price of coffee products,” Kajiwara said. Coffee at some upmarket stores costs 40 yuan ($5.85) in China, as expensive as in Tokyo, while Chinese roasters also failed to meet local preferences for a strong flavor, he said.

Aroma Coffee roasts imported and domestic beans, Kajiwara said. China produces 25,000 tons of beans a year, of which 5,000 tons are the robusta variety, grown in Hainan and mainly used in instant coffee, and the rest are arabica beans produced in Yunnan and preferred by coffee house operators.

China sells about 60 percent of its coffee output overseas, and half of the exports are directed to Japan for production of soluble coffee, Kajiwara said. China also imports about 15,000 tons of coffee a year, including instant coffee, he added.

Japan, the world’s third-largest coffee importer, purchased 387,538 tons of green coffee beans in 2008, down 0.6 percent from a year earlier, according to the Ministry of Finance. The country also imported 6,652 tons of roasted coffee beans last year, up 14 percent from 2007, the ministry said in its Web site.

Japan’s Imports

Japanese imports, including soluble and liquid coffee, peaked at 458,507 tons in 2006 and then retreated to 425,778 tons in 2007 because of rising international prices, according to All Japan Coffee Association, a roasters’ organization.

Of the total imports, one-third is used for production of canned coffee, Kajiwara said. Half of the remaining volume is used to produce instant coffee, he added.

“I don’t see Japan’s recession hurting domestic coffee consumption,” Kajiwara said. “Consumers may be drinking less coffee at shops, but they should be brewing it at home or having cheaper instant coffee.”

Marubeni is Japan’s largest coffee importer with a 25 percent share in the domestic market. The company aims to boost sales by increasing shipments of roasted coffee or processed products to end-users, Kajiwara said. Globally Marubeni sells 3 million bags of coffee a year. One bag weighs 60 kilograms (132 pounds).

Paulson Funds Annual Report

2009-02-03T13:44:00.000-08:00

Paulson's merger arbitrage commentary is particularly interesting, in the sense that buying Anheuser-Busch stock would have been an incredibly risk-averse investment over anything but the short-term; and the upside was a 90% return when calculated on an annualized basis. This is a strategy that almost anyone could have implemented.

Also, Paulson explains the reasoning and analysis behind his historic bet against subprime and financials, which is extremely valuable reading. Paulson states that we are halfway through the crisis; yet he has liquidated his bets against subprime and is beginning to make select investments in distressed debt and other long positions within the credit and financial space.

Going forward, he makes it very clear that being a long investor in financials will generate immense returns when the markets rebound, throughout either 2009 or 2010.

Paulson Funds Annual Report

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Jeremy Grantham on China

2009-02-02T16:07:00.000-08:00

I encourage you to read the entire Grantham interview; yet his specific views on China are below.

Last year, a friend and I sat in on a lecture given by Eswar Prasad at Cornell University, on the renminbi and China's banking system. It began to dawn on us that the emergence of China as a dominant economic power is quite possibly the greatest dogma in all of finance and economics, and anyone who says otherwise is labeled not a skeptic, but a heretic. (Or at least an idiot!)

Lawrence Summers, an economist, Presidential advisor and former president of Harvard University, remarked that “[China's] economic significance dwarfs the Industrial Revolution or the Renaissance.”

We will see whether or not Summers is correct. Either way, I have no entrenched view or vested interest. But there is no doubt that when it comes to global-macro speculation – whether stock markets, currencies, commodities, or the wealth of nations – China is still the biggest game in town.

What is your bold prediction for the future?

Keying off the word "bold," my prediction is that China will be a substantial disappointment. The reason I say "keying off" is that this is far from being a certain prediction. But I have a strong hunch China will disappoint, and maybe even bitterly disappoint.

That's the nature of the hunch, I look at everything and my stomach tells me they've been extraordinarily lucky in the last 15 years. It's hard to separate good luck from talent. I have a suspicion that a lot of what other people see as skill was good luck. And that they have a difficult job, and under this stress their modest talent will be revealed. The modesty of their talent.

What are some ways they got lucky?

They got lucky that the U.S. decided to run a huge trade deficit when they needed to run a huge surplus for political reasons. And it balanced out, as long as we ran an equal deficit. They were presented with the strongest global economy in history in which to sell their cheaper products.

Everyone else seems to be quite happy [with China]; maybe they're right. That's why it's a bold prediction rather than a high-confidence near certainty.

You had mentioned that the Chinese are new to capitalism, so their bench is not very deep.

Are they really so much better that they can handle an economy growing at four times the speed of the U.S. with a lack of experience? It doesn't compute, but we will find out.

You Can't Predict Who Will Change the World

2009-02-01T07:57:00.000-08:00

Possibly the best article I've seen by Nassim Nicholas Taleb, which discusses the comparative advantages of the United States. One of his most important points is our culture of risk-taking and creativity, as he addresses the most common criticisms of America as a declining power in the age of globalization.

...

Before the discovery of Australia, Europeans thought that all swans were white, and it would have been considered completely unreasonable to imagine swans of any other color. The first sighting of a black swan in Australia, where black swans are, in fact, rather common, shattered that notion. The moral of this story is that there are exceptions out there, hidden away from our eyes and imagination, waiting to be discovered by complete accident. What I call a "Black Swan" is an exceptional unpredictable event that, unlike the bird, carries a huge impact.

It's impossible for the editors of Forbes.com to predict who will change the world, because major changes are Black Swans, the result of accidents and luck. But we do know who society's winners will be: those who are prepared to face Black Swans, to be exposed to them, to recognize them when they show up and to rigorously exploit them.

Things, it turns out, are all too often discovered by accident--but we don't see that when we look at history in our rear-view mirrors. The technologies that run the world today (like the Internet, the computer and the laser) are not used in the way intended by those who invented them. Even academics are starting to realize that a considerable component of medical discovery comes from the fringes, where people find what they are not exactly looking for. It is not just that hypertension drugs led to Viagra or that angiogenesis drugs led to the treatment of macular degeneration, but that even discoveries we claim come from research are themselves highly accidental. They are the result of undirected tinkering narrated after the fact, when it is dressed up as controlled research. The high rate of failure in scientific research should be sufficient to convince us of the lack of effectiveness in its design.

If the success rate of directed research is very low, though, it is true that the more we search, the more likely we are to find things "by accident," outside the original plan. Only a disproportionately minute number of discoveries traditionally came from directed academic research. What academia seems more masterful at is public relations and fundraising.

This is good news--for some. Ignore what you were told by your college economics professor and consider the following puzzle. Whenever you hear a snotty European presenting his stereotypes about Americans, he will often describe them as "unintellectual," "uneducated," and "poor in math," because, unlike European schooling, American education is not based on equation drills and memorization.

Yet the person making these statements will likely be addicted to his iPod, wearing a T-shirt and blue jeans, and using Microsoft Word to jot down his "cultural" statements on his Intel-based PC, with some Google searches on the Internet here and there interrupting his composition. If old enough, he might also be using Viagra.

America's primary export, it appears, is trial-and-error, and the innovative knowledge attained in such a way. Trial-and-error has error in it; and most top-down traditional rational and academic environments do not like the fallibility of "error" and the embarrassment of not quite knowing where they're going. The U.S. fosters entrepreneurs and creators, not exam-takers, bureaucrats or, worse, deluded economists. So the perceived weakness of the American pupil in conventional studies is where his or her very strength may lie. The American system of trial and error produces doers: Black Swan-hunting, dream-chasing entrepreneurs, with a tolerance for a certain class of risk-taking and for making plenty of small errors on the road to success or knowledge. This environment also attracts aggressive tinkering foreigners like this author.

Globalization allowed the U.S. to specialize in the creative aspect of things, the risk-taking production of concepts and ideas--that is, the scalable part of production, in which more income can be generated from the same fixed assets through innovation. By exporting jobs, the U.S. has outsourced the less scalable and more linear components of production, assigning them to the citizens of more mathematical and culturally rigid states, who are happy to be paid by the hour to work on other people's ideas.

Let us go one step further. It is high time to recognize that we humans are far better at doing than understanding, and better at tinkering than inventing. But we don't know it. We truly live under the illusion of order believing that planning and forecasting are possible. We are scared of the random, yet we live from its fruits. We are so scared of the random that we create disciplines that try to make sense of the past--but we ultimately fail to understand it, just as we fail to see the future.

The current discourse in economics, for example, is antiquated. American undirected free-enterprise works because it aggressively allows us to capture the randomness of the environment--the cheap Black Swans. This works not just because of competition, and even less because of material incentives. Neither the followers of Adam Smith nor those of Karl Marx seem to be conscious of the prevalence and effect of wild randomness. They are too bathed in enlightenment-style cause-and-effect and cannot accept that skills and payoffs may have nothing to do with one another. Nor can they swallow the argument that it is not necessarily the better technology that wins, but rather, the luckiest one. And, sadly, even those who accept this fundamental uncertainty often fail to see that it is a good thing.

Random tinkering is the path to success. And fortunately, we are increasingly learning to practice it without knowing it--thanks to overconfident entrepreneurs, naive investors, greedy investment bankers, confused scientists and aggressive venture capitalists brought together by the free-market system.

We need more tinkering: Uninhibited, aggressive, proud tinkering. We need to make our own luck. We can be scared and worried about the future, or we can look at it as a collection of happy surprises that lie outside the path of our imagination.

Nassim Nicholas Taleb is an applied statistician and derivatives trader-turned-philosopher, and author of The Black Swan: The Impact of the Highly Improbable.

Crashology 101

2009-01-31T12:30:00.000-08:00

In the 2000 stock crash, which began to accelerate in fall of that year, the market bottomed in late 2002. That's about two full years, peak to trough. For the 1973 crash, the market began its slide in January and bottomed out in December of 1974. Again, about two years.

Here is a great Wall Street Journal page on stock crashes in general:

http://online.wsj.com/public/resources/documents/info-StockCrash_0710-14.html

Overall, stock crashes in the United States always seem to last about two years, peak to trough, even in the Great Depression. As Warren Buffett described that episode: “During the Depression, the Dow hit its low, 41, on July 8, 1932. Economic conditions, though, kept deteriorating until Franklin D. Roosevelt took office in March 1933. By that time, the market had already advanced 30 percent.”

By this crude, two-year yardstick, the current market peaked in October of 2007, and we can expect it to recover sometime in the late 2009 or early 2010.

Throughout this crash, I have realized why so many smart investors often end up with inferior results. The reason is two-fold: when the market is richly-valued, they accept small or nonexistent discounts in price relative to value. And then they become fearful or unable to purchase deep value securities when the market is in a state of chaos. It seems ridiculously obvious to say this, but we see distinguished investors falling into such traps nearly every day.

We’ve seen many examples of the first reason; there was no shortage of aggressive buyers in the markets for stocks, commercial real estate, and private equity in 2006 and 2007. And now, with investors fearful of macroeconomic disaster, they’re making decisions to do things like pile into gold at a thirty-year high.

Interestingly, if we compare this to what, say, Warren Buffett has done in metals, here is a fascinating old article about when he amassed the largest silver position in the world:

http://www.time.com/time/printout/0,8816,138593,00.html

That was when silver prices were at a multi-decade low. It is what I wrote in one of my favorite articles for the National Science Digital Library, when agricultural prices were at their peak: the smart investors in commodities were buying in the late 1990s and early 2000s, when prices were at rock bottom and supply and demand were incredibly out of whack. The commodities bull market hadn’t even started yet.

As for the current stock market, Buffett also wrote:

“Over the long term, the stock market news will be good. In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a flu epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497.

“You might think it would have been impossible for an investor to lose money during a century marked by such an extraordinary gain. But some investors did. The hapless ones bought stocks only when they felt comfort in doing so and then proceeded to sell when the headlines made them queasy.”

While I do believe that sharp macroeconomic vicissitudes will continue over the coming years – and, for that matter, throughout our lives – many stocks probably have already bottomed. And, as Buffett says, we will probably see a sharp advance in the market before the economy improves.

When I look over all the potential global-macro trades – commodities, currencies, fixed income, whatever – the best opportunities that I see, in terms of risk and reward, are currently in the stock market.

We’ll see what happens.

Jim Rogers on How to Invest

2009-01-30T18:12:00.000-08:00

"Do your homework."

Jim Rogers Biggest Investment Mistake @ Yahoo! Video

Jim Rogers on Global Finance

2009-01-30T14:49:00.000-08:00

Here is an interesting presentation given by Jim Rogers. My only criticism is that Rogers repeats many of the same points lately, yet his logic is beginning to sound more dogmatic and convoluted than was the case five or ten years ago. For example, he presented a rock-solid case for commodities investment at that time. Yet, with his current criticisms of letting the banks fail as opposed to bailing them out, Rogers doesn't provide much reasoning for critics, especially those who've cited contrary examples such as Lehman Brothers. Additionally, you have to question what biases he's currently bringing to the table. In light of his commodities index, asking what asset class in which to invest is like asking the barber if you need a haircut.

Einhorn on Inflation

2009-01-29T15:05:00.000-08:00

David Einhorn is now buying gold, the yen, and calls on long-term interest rates. In fact, he sounds a lot like Jim Rogers nowadays – the Fed is going to debase the currency, Ben Bernanke is obsessed with money printing, and so on.

http://www.businessweek.com/print/investor/content/jan2009/pi20090128_208724.htm

But there are a couple of problems with this line of reasoning.

First, it’s not at all what we’re seeing. The risk of a depression is higher than the risk of hyperinflation, at least right now, so to a large degree the Federal Reserve is doing the right thing. They contracted the money supply and didn’t support banks after 1929, and the result is well known.

Second, gold is an horrendous investment under all other scenarios except for high inflation. The supply of gold is massive – there is more gold available now than ever before in history – and demand has dwindled to basically nothing more than use as an inflation hedge. It is one of the most inferior commodities in terms of fundamentals.

If inflation does not occur as predicted, you have no margin of safety. You are left holding a nonproductive lump of metal. In buying gold at current prices, roughly the highest in thirty years, there is not much room for error.

Yet it sounds much more reasonable to tell your investors that you’re holding gold, as opposed to sugar futures or lead futures or whatever else. The fact is that Einhorn’s investors would probably be better served if he simply held the Rogers Index instead.

Third, higher inflation appears to be turning into a consensus view, and the consensus view is rarely correct. You have to question why investors like Einhorn would even get into these big macro questions, and what competitive advantage they have there. Is David Einhorn really within his circle of competence in predicting the fall of Western Civilization?

Incidentally, here are some of my views on inflation. I have held similar views to what Einhorn is currently expressing, since early 2006. But now I am playing the devil’s advocate even with my own reasoning.

The interest rate trade definitely makes sense: coming out of this crisis, rates must rise. Moreover, the yen will continue to strengthen as the carry trade continues to unwind; but it seems that Einhorn is a little late to this party as well, as the yen was probably a better trade in 2008 than it will be in 2009.

I am with Buffett in saying that you’re going to do a lot better with picking great businesses than you will in trading macro events. The latter are just way too difficult to predict, at least for anyone who has tried to predict them before.

From everything I’ve seen, David Einhorn has a fantastic track record in short-selling weak financial companies over the past decade; but he is new to global macro. You know the saying about if you’re at the poker table and can’t pick out the patsy...

Einhorn on Stocks

2009-01-28T17:50:00.000-08:00

David Einhorn's Greenlight Capital Reinsurance, a new venture, recently reported results:

http://www.reuters.com/article/marketsNews/idUSN0526607620081105

It is interesting to note that Einhorn is still very bearish on financials. Moreover, he appears to be interested in European markets recently, both stocks and fixed-income, which may be rooted in skepticism about the U.S. dollar.

...

Reinsurance company Greenlight Capital Re (GLRE.O) is betting that some large financial companies' shares will fall further even though its portfolio is now more conservatively positioned than it was a few weeks ago, its chairman said on Wednesday.

"The portfolio is more net long than it was at the beginning of October," said David Einhorn, Greenlight Capital Re's chairman of the board. Einhorn also runs a New York-based hedge fund called Greenlight Capital and is well known for having questioned the health of investment bank Lehman Brothers before it filed for bankruptcy in September.

Einhorn told Greenlight Capital Re's shareholders on a conference call that mistakes in the portfolio have hurt the company.

Greenlight Capital Re reported on Tuesday a net loss of $117.8 million, or $3.29 per share loss, in the third quarter. Its share price was up 7.7 percent in morning trading on Wednesday to $13.45, curbing its year-to-date stock losses to around 40 percent.

Einhorn reminded shareholders that he never reveals his exact trading strategies but said the portfolio is still short large financial companies whose balance sheets remain exposed to the fallout from the current financial crisis.

The hedge fund manager also said the company is betting against companies that rely on consumers spending a lot of money, a trend researchers say is changing as growth slows and unemployment rises.

Looking back, Einhorn said the company miscalculated on how short positions would protect the protect the portfolio. "We should have been more conservatively positioned," Einhorn said, adding that the long side of the portfolio also suffered from "analytical errors in a few names."

Einhorn said the company's portfolio was hurt by a bet that carmaker Volkswagen AG's (VOWG.DE) shares would sink while they rose dramatically.

People who are familiar with Einhorn's hedge fund portfolio and the reinsurance company's portfolio say they are often very similar.

Bill Ackman's Great Expectations

2009-01-27T15:06:00.000-08:00

In Bill Ackman's Q3 letter to investors, he laid out his approach to investing in high-risk, high-reward scenarios:

"We occasionally are willing to invest a small amount of fund capital in situations which offer the potential for a many-fold profit at the risk of a large or near-total loss of capital invested. I typically call these investments mispriced options."

Not long ago, while discussing credit default swaps in an interview, Ackman explained how an investment in these instruments presented such an opportunity before the credit crisis hit, where 2% of your portfolio could return "ten times — the portfolio." Ackman went on to say that John Paulson "made a fortune this way," with his historic bet against subprime MBS and other weak credits.

What Ackman is really saying is to make investments where you have a high expected value. This means analyzing the size of potential gains and losses, adjusted for the respective probabilities that such gains or losses will be realized. Here is how to define it, in the language of elementary statistics:

In words, it is the sum of all possible gains and losses multiplied by their relative probabilities. This type of reasoning is commonly used by skilled gamblers, and you can look over some basic examples on this gambling webpage.

This is the essence of what Ackman is talking about with "mispriced options"; a small position that will either expire worthless or be worth a fortune. In fact, with stock prices devastated by panic selling, Ackman appears to be using this logic quite often nowadays.

One current example might be General Growth Properties (NYSE: GGP), a beleaguered REIT facing bankruptcy. But whatever the case is with General Growth, it seems that another Ackman holding, Borders Group (NYSE: BGP), might be a safer bet.

This month, Pershing Square installed both a new CEO and non-executive chairman, which you can read about here, essentially giving Pershing full control of the company. At the very least, it is clear that Ackman is committed to Borders as a going concern.

And while the probabilities inherent in a potential General Growth bankruptcy filing are anyone's guess, Pershing Square's ongoing commitment to Borders can be interpreted that the odds are tilted in stockholders' favor.

Borders' current share price is roughly 53 cents. This is down from over $20 before the credit crisis began. Given that Ackman started buying at the latter price, we might assume that he believes the company is worth much more.

Indeed, going by what Ackman said at the time, in late 2006, the shares might be worth about $36 each. But since then, we must also assume that value has been destroyed, from the economic malaise as well as a dilutive emergency financing, which granted Ackman warrants to purchase additional shares at $7 each.

Let us assume that Borders' intrinsic value is $10.60 for our example, or twenty times the current market price. This is less than a third of Ackman's original estimate, but a price that puts his warrants in the money. Thus, we have a possible gain of $10.07 and a possible loss of $0.53, on a per share basis. But what is the probability of such a gain or loss?

Setting up the expected value problem the same way as before, but using these new assumptions, we find that Borders' current market price implies a 5% probability that Borders will survive and return to our $10.60 price. For the mathematically inclined, this probability is derived as follows: ($10.07x) - ($0.53)(1-x) = 0, and thus x = ($0.53)/($10.60) = 5%.

But, given Pershing Square's continued commitment to Borders, you might assess that the market is mispricing these odds and there is a greater than 5% chance that Borders will survive and return to our $10.60 stock price.

By Ackman's definition of a "mispriced option," as set forth above, Borders fits the bill. This is an opportunity that could provide a tremendously outsize return, if one is willing to accept the chance of a total loss of capital invested.

Let me be clear: this is an illustration, not a recommendation. Borders' stock does not trade for 53 cents because it is a risk-free proposition. The company faces an onerous debt burden and, depending what happens with the economy, still might not make it through these hard times.

Moreover, such a situation is clearly inappropriate for investment of more than even a few percent of one's portfolio. This is not a situation analogous to Warren Buffett's famous 1964 investment in American Express, where he bet roughly 40% of his partnership's capital on the stock. In that case, Buffett had high confidence that his chance of loss was near zero, with a company that is immensely stronger than Borders is.

This illustrates a current opportunity cost that investors must weigh: Should you accept a relatively lower gain, although still handsome by most standards, with near certainty? Or should you shoot for truly eye-popping gains, but with a risk of permanent loss?

Moreover, how do you gauge your confidence level and accuracy in assessing such risks? Should you attempt to create a portfolio across the risk spectrum, with a small amount of capital in Borders-type stocks and a larger amount in American Express-type stocks?

These are questions that only you can answer.

Short-Term Capital Mismanagement

2009-01-26T16:22:00.000-08:00

It almost strikes me that Ken Lewis is trying to make it appear as if he's taking aggressive action, to make his own botched deals look better – first Countrywide Financial, now Merrill Lynch. I particularly love this line: “Recent reports that Mr. Thain had spent $1.2 million to redecorate his office caused Mr. Lewis to further question Mr. Thain's judgment, according to a person close to Mr. Lewis.”

Do you think that Warren Buffett does his questioning about managers after the fact? Wouldn't you want to be sure of a person's judgment before closing a larger-than-life deal?

The fact with John Thain, like Stan O'Neal before him, is that he's a product of the past era on Wall Street, of egregiously-high wage labor. They've built their lives around receiving flagrant "bonus" checks, so even in a time of total crisis, it almost appears bizarre how desperate they are to get them.

The alignment of interests is all-important. John Thain has a gold-standard résumé – Harvard MBA, Goldman Sachs executive, CEO of the NYSE – and it would be very easy to talk up his abilities. In fact, he is probably an extremely smart, excellent manager. The only problem is that John Thain's interests are aligned with John Thain, and not shareholders.

Even more, he probably has no sense of attachment that comes from building anything, aside from his résumé or some loose loyalties to Goldman Sachs. This makes a huge difference in terms of how someone manages a business.

This type of manager will make decisions to do acquisitions at high prices, or sell assets (like the CDO portfolio) at rock-bottom prices – to appease Wall Street or manage the share price – and work to build a corporate empire at the expense of shareholder value. And, of course, they will pay themselves outrageous compensation packages, also at the expense of shareholders.

I believe that the BAC-Merrill deal supports my theory of management determinism. I would bet that Ken Lewis' prime reason for this deal was the “Merrill Lynch franchise” – one of the most storied Wall Street names, and “the thundering herd” (no pun intended, that's really what they call their brokers).

But Ken Lewis flat-out admits to placing no emphasis on management, as if it didn't matter at all and he fully expected Thain to be gone within a short period of time. It appears that he made a $50 billion purchase with the same standards that other people would use for a $50 purchase.

Lo and behold, it is already looking like another trainwreck deal. It's looking like AOL-Time Warner, which was announced in January of 2000 – at the apex of the tech bubble – and then merged a year later. This was one of the most value-destroying transactions ever undertaken. My favorite line from the deal was: “One of the creative breakthroughs was in the valuation.”

The experience with an owner-operated business, where the CEO has huge economic and emotional interests – Steve Jobs at Apple, Buffett at Berkshire – will almost always be a superior investment, relative to some bureaucratic behemoth run by hired MBA operators. It is the difference between night and day.