Archive for the 'Hedge Funds' Category

Bad News & Good News On Wall Street

Kurt Brouwer September 15th, 2008

The action on Wall Street is wild and woolly today.  Actually, it’s been that way all year long it seems.  But, this is particularly crazy.  The major stock indexes have fallen sharply today.  This was preceded by declines on the European exchanges before our markets opened.  Today’s market action was triggered by some wild scrambling (see The Mother of all Mondays) over the weekend as Wall Street executives and U.S. Treasury representatives met to figure out what to do with several troubled and tottering financial services firms.

The problems at these firms could probably be resolved with time. Unfortunately, owing to the negative climate, time is in short supply. Compounding the problem is leverage — that is borrowed money. Many of these institutions are operating on very high leverage and that puts them under the gun.

The outcome of all the activity had some bad news and good news in it for investors along with some good news for U.S. taxpayers.

Lehman Files For Bankruptcy Protection

First, Lehman Brothers, a 14-year-old firm with a 158-year-old name filed for bankruptcy protection.  Most of the media is talking about how this old firm weathered multiple crises over the past 158 years and now has finally succumbed.  But, Lehman Brothers was bought by American Express in 1984 and only became an independent company again in 1994. The demise of a 14-year-old firm is not as good a story, but it does have the charm of being accurate.  For more on this, see this piece by our friend Allen Sloan at Fortune magazine.

One piece of news is that Lehman’s share price actually hit 19 cents today.  That’s good.  The shareholders were invested in a highly-leveraged company that made enormous bets in a wide variety of real estate related deals.  Those deals soured and the company’s shareholders paid the price.  That’s how it should work.  The market giveth and the market taketh away.

Bank of America Buys Merrill Lynch

Second, Merrill Lynch was snapped up for $50 billion by Bank of America.  The $50 billion figure is a bit fluid as the deal was originally announced as $44 billion. Nonetheless, that number represents a healthy premium from the recent price of its shares.  And, that’s pretty good news because in this extreme environment, Bank of America actually is offering a substantial premium for Merrill.

As an alum of Merrill, I have to say that this outcome is probably good for Merrill and its customers and, ultimately, should be pretty good for Bank of America. If you are keeping score, BA is going to come out of this mess as the holder of two diverse and yet dominant franchises — Countrywide Mortgage and Merrill Lynch (see Bank of America Snaps Up Countrywide).

Insurance Giant AIG Wants Bailout

Three, American International Group, an enormous insurance company, is also in deep trouble.  It is seeking a very large loan from the Feds after having turned down several buyout offers.  No telling how it will work out, but given the events of the past week, I suspect it will end in tears for its shareholders.

And, that’s the news — both good and bad — for investors.

The good news for taxpayers is that the Feds let Lehman Brothers go under.  As we saw earlier this year, the Treasury helped J.P. Morgan purchase Bear Stearns and it did so by backing a pretty big pool of Bear Stearns’ obligations (JP Morgan, Fed Move To Bail Out Bear Stearns).

Then, there was the takeover of Fannie Mae and Freddie Mac (Bill Gross Was Correct — Treasury To Take Over Fannie & Freddie).

Finally, the Feds decided they could not take over every troubled financial services firm so they told the assembled mass of Wall Street CEOs — who were lined up in their limos over the weekend — the bailout window is closed.  And, that is good for taxpayers.

After the government takeovers of Fannie and Freddie, we were getting perilously close to an absolutely untenable position in which Wall Street firms could make enormous bets and when those bets paid off, they made oodles of money.  But, when those bets lost huge amounts of money, Wall Street turned to the government for a bailout.  That’s not the way it is supposed to work and I’m happy the U.S. Treasury finally got the message.

Here is what happened over the weekend as told by Bloomberg [emphasis added]:

Lehman Files for Record Bankruptcy, Victim of Meltdown Firm Helped Create  (Bloomberg, September 15, 2008, Yalman Onaran and Christopher Scinta)

Lehman Brothers Holdings Inc., the fourth-largest U.S. investment bank, succumbed to the subprime mortgage crisis it helped create in the biggest bankruptcy filing in history.

…Lehman was forced into bankruptcy after Barclays Plc and Bank of America Corp. abandoned takeover talks yesterday and the company lost 94 percent of its market value this year. Chief Executive Officer Richard Fuld, who turned the New York-based firm into the biggest underwriter of mortgage-backed securities at the top of the U.S. real estate market, joins his counterparts at Bear Stearns Cos., Merrill Lynch & Co. and more than 10 banks that couldn’t survive this year’s credit crunch.

…Lehman shares plunged 95 percent at 11 a.m. in New York trading to 19 cents from their $3.65 close on Sept. 12.

…Since the collapse of the subprime home-loan market last year, the world’s biggest banks and brokerages have reported more than $510 billion of writedowns and credit losses on securities tied to mortgages. Lehman still had a $50 billion stockpile of the investment at the end of August. Falling housing prices and fear of a U.S. recession have eroded prices for the holdings.

Lehman’s leverage — the ratio of total assets to shareholders’ equity — was 31 last year when the mortgage market collapsed. That compares with 33 at Morgan Stanley and 32 at Merrill Lynch. Only Goldman Sachs had a lower ratio, at 22..

In other words, Lehman made a two-part bet.  First, it put many billions into risky real estate deals and real estate-related securities.  Second, it did so by using enormous leverage, which is illustrated by its ratio of assets to equity of 31.

Bank of America Will Buy Merrill for $50 Billion as Credit Crisis Broadens (Bloomberg, September 15, 2008, David Mildenberg and Bradley Keoun)

Bank of America Corp., the biggest U.S. consumer bank, agreed to acquire Merrill Lynch & Co. for about $50 billion as the credit crisis claimed another of America’s oldest financial companies.

Bank of America will pay $29 a share for New York-based Merrill in stock, 70 percent more than the Sept. 12 closing price, the company said in a statement today. Merrill, battered by $52.2 billion in losses and writedowns from subprime- mortgage-contaminated securities, has plunged more than 80 percent from its peak of $97.53 at the start of last year.

The takeover ends 94 years of independence for Merrill and gives Charlotte, North Carolina-based Bank of America a sales force with 16,690 brokers who manage $1.6 trillion for customers. Merrill, led by Chief Executive Officer John Thain, was in danger of becoming the next subprime casualty after Lehman Brothers Holdings Inc. filed for bankruptcy court protection earlier today.

…Merrill is the second bargain picked up this year by Bank of America Chief Executive Officer Kenneth Lewis tied to the collapse of the mortgage markets. The bank bought Countrywide Financial Corp. for $2.5 billion in stock last July to become the nation’s biggest home lender. As recently as Sept. 12, Bank of America was considering making a bid for New York-based Lehman…

AIG Slumps After Insurer Rejects Buyout Offers, Seeks $40 Billion Fed Loan  (Bloomberg, September 15, 2008, Hugh Son)

American International Group Inc., the largest U.S. insurer by assets, fell by almost half in New York trading as the company failed to present a plan to raise capital and stave off credit downgrades.

AIG, seeking to raise $20 billion in capital and sell $20 billion of assets, rejected investments from buyout firms KKR & Co., TPG Inc. and J.C. Flowers & Co., people familiar with the talks said. AIG instead sought $40 billion from the Federal Reserve, the New York Times reported, citing an unnamed person. Warren Buffett is said to be in talks with AIG as well, Insurance Insider reported today citing unidentified people.

“People are afraid of what they are not hearing from the company,” Robert Bolton, managing director at Mendon Capital Advisors Corp., said today in a Bloomberg Television interview. “The only thing people have to trade on right now are the rumors, and they are coming up with their own conclusions.”

So, what are we to make of all this.  First, I’ve been paying attention to Wall Street for over 30 years now and, quite frankly, Wall Street firms have always been over-leveraged and undercapitalized.  Many Wall Street firms failed in the late 1960s and early 1970s due to a variety of factors, primarily mismanagement and undercapitalization.  Then, we had the stock market crash in 1987 (see The Crash of 1987).  In fact, the last big Wall Street crisis we had, the collapse of Long-Term Capital Management in 1998, was also triggered by a highly-leveraged entity — in that case, a hedge fund.

Second, though it generates lots of scary headlines, this financial panic on Wall Street may not have that much impact on Main Street.  Back in October of 1987, when the stock market fell 22% in one day, there were widespread predictions of another depression.  Never happened though.  Though this crisis will certainly impact the stock and bond and mortgage markets — real estate too — it will blow over as have all the other ones.  Congress will call for hearings and proposals for increased regulations. Pundits will claim that over regulation or under regulation led to this outcome.  And, the country will survive.

As investors, the events of this year are a reminder that there are no sure things.  Real estate, stocks, corporate bonds, commodities and even government-backed bonds have all taken hits this year.  That is why as investors we need to be well-diversified. And, as downturns such as this one demonstrate, we have to be patient as well.

Stocks Soar — Climbing a Wall of Worry

Kurt Brouwer July 29th, 2008

U.S. stocks soared today despite a long list of negatives.  There is an old term on Wall Street term that applies in this situation — that stocks are ‘climbing a wall of worry’ as they rose today despite plenty of potential problems.  Actually, though we can’t really make this claim unless and until stocks enter a protracted upturn.  So, maybe we’ll just say that investors have been whipsawed over the past couple of days as this stock market tries to figure out what it wants to be when it grows up.

The DJ Industrials rose 266.48 points, which is +2.39%

The S&P 500 rose 28.82 points, which is +2.33%

The Nasdaq Composite rose 55.40 points, which is +2.45%

There were plenty of negative stories such as the continued decline of home prices, a huge writeoff of assets at Merrill Lynch, news of bankruptcies at retailer Mervyns and restaurant chain Bennigan’s Steak and Ale.  And, finally, even Starbucks is hurting as it announced the layoff of 1,000 employees.

In other words, there was plenty of negative news such as that which triggered yesterday’s market decline. Yet, stocks went up.  What’s going on?

  • First, there has been a significant pullback in commodity pricing, particularly in oil. Oil prices fell again today and are off roughly $25 per barrel from the high point of $147.
  • Second, there was a bit of strengthening in the dollar. These two pieces are connected and for much of the year, a declining dollar has exacerbated the soaring price for oil.

Assuming this trend — falling oil prices and a stronger dollar — continues, we will see the reverse situation as we pay a lower price for oil because of strength in the dollar.  This is a big if though, so I’m not making too much of this trend.  If you want to dig deeper, see Declining the Dollar and Oil Prices — Too Low For Too Long.

  • Another factor that has clearly helped stocks is that corporate earnings are growing at many companies. Obviously, financial stocks and housing-related companies are spewing red ink, but many publicly-traded companies have announced surprisingly strong earnings. Earnings or corporate profits drive valuations of publicly-traded companies and these announcements are - well - a bit of a surprise for many who focused on all the bad stuff that is happening in financial stocks.
  • A related point to the earnings picture at non-financial companies is that valuations are pretty darn good. In fact, some portfolio managers seem to be pretty excited about these valuations.

For example, in a recent interview in Barron’s, hedge fund manager, Lee Cooperman, said this:

…[Barron’s]: Are there any particular pockets of the market where you have been finding opportunities?

Cooperman: To some degree, I feel like a kid in a candy store. We find a tremendous number of values in the stock market. Consider that Anheuser-Busch [ticker: BUD] was trading at 47 when it got acquired by InBev [INBVF.Belgium] for $70 a share in cash, or 22.4 times 2008 earnings. That’s about a 45% premium. Hercules [HPC] was selling at $16 when earlier this month it agreed to be acquired by Ashland [ASH] for $23, or 14.1 times earnings — a 40% premium. Rohm & Haas [ROH] is getting acquired by Dow Chemical [DOW] for 21 times earnings, a 74% premium. These are cash deals, so there is plenty of money around. We have two markets, one being the financials, where companies are losing tens of billions of dollars that they are equitizing to replace their losses. And you have the industrial economy, which has done fairly well; its assets are selling at well below replacement cost…

I have heard similar statements from other smart, savvy portfolio managers.  However, we are still in a bear market for stocks (real estate too obviously).  Good days like this one are nice, but they do not mean the trouble is behind us.

For a more in-depth treatment on the state of stocks, see The Kitchen Sink Stock Market.

The Other Real Estate Disaster

Kurt Brouwer July 11th, 2008

This is a very long article from Forbes on state pension funds and the leveraged real estate investments they have made. For years, those looked very good, but now problems have arisen [emphasis added]. The tone of the piece leans toward impending doom, which is no doubt overdone because state pension plans have placed modest percentages of their assets in these leveraged real estate funds. However, the downturn in real estate is real and it appears as if pension plans are going to take a few lumps along with the rest of us.

The Other Real Estate Disaster (Forbes, July 21, 2008, Stephane Fitch)

Your state’s employee pension fund is probably (a) doing badly with recent real estate pools and (b) working very hard with the private equity operators of these pools to keep you in the dark.

Scott Lawlor and the managers at Pennsylvania Public Schools’ $63 billion pension fund had a beautiful relationship. From an office on New York’s Park Avenue Lawlor and his firm, Broadway Partners, ran real estate “opportunity funds,” fat with capital from the teachers’ pension and other institutions. He had invested the funds in a $10 billion pool of glamorous office properties like Boston’s John Hancock Tower. Lawlor delivered profits–or so the Pennsylvania fund managers reported–of up to 40% a year. The state fund managers kept capital flowing, both to his funds and to his pocket, in the form of fees.

Everything was private. No Wall Street analysts, no regulators, no outsiders and no interference. No ordinary Pennsylvania pensioner got to see Lawlor’s quarterly financial reports. The managers in their pension plan’s Harrisburg headquarters had all signed nondisclosure agreements with Lawlor.

The picture turned grim by March. Lawlor was struggling to keep his buildings, purchased with as much as 90% debt, from falling into the hands of lenders. He owed $1.2 billion of short-term “mezzanine” debt to New York investment bank Lehman Brothers (nyse: LEH) and other lenders. (The debt has since been extended.) The funds’ previous gains? Mostly, if not entirely, gone. It will be months before Pennsylvania’s 500,000-plus public school employees and retirees know how much of their $196 million in principal in Lawlor’s funds is left.

The retirement plan “has seen some decline in value this past quarter,” says Charles Spiller, head of private equity and real estate investments at the Pennsylvania teachers’ fund. But he refuses to comment on Broadway. Last September he valued positions in 58 private real estate investment funds at a total $3.6 billion. What’s this pot of money worth now? That’s a secret for a few more months, and Spiller isn’t releasing any of the communications he’s had from the fund operators about their recent results.

Enticing investors with the lure of returns exceeding 20%, opportunity funds are the slickest deal in real estate. They account for one-sixth of $2 trillion in total net assets in private equity, says the London firm Private Equity Intelligence, which tracks the industry. A year ago the most closely studied funds in the U.S. were holding $213 billion in commercial real estate equity, leveraged 70% on average. Traders of swaps contracts on the leading commercial property index were recently betting on a correction of up to 15% in values–which would result in $100 billion in writedowns.

This is the other meltdown–the one you haven’t heard much about. It’s not part of the real estate and credit contagion that started with the subprime calamity, then spread to all corners of the debt market. This misadventure has its own origins in hubris, battered further by dumb mistakes and bad timing. The catastrophe may not stack up quite as high as the $350 billion in writedowns that investment funds and banks have registered in the bond markets, but for small investors all across America whose retirement pools poured 1% to 5% of their assets into opp funds, heavy losses–only beginning to surface–could be a sizable blow. If the setbacks for pension funds are severe enough, it could force state governments to raise taxes to cover shortfalls and induce companies to cut back on dividend payments to shareholders in order to set aside additional money for their private workforce pensions.

Many opportunity funds are black boxes. What these investments are worth is often anybody’s guess until they’re liquidated, typically seven to ten years after they finish raising capital. They’re virtually unregulated–a recent statement by the Financial Accounting Standards Board leaves it to the funds to address fair value–and private equity groups don’t have to file regularly to the Securities & Exchange Commission. When they do give out internal rates of return, they’re usually expressed as a rough percentage of money originally invested. Rarely are they adjusted for leverage.

The failure to account for leverage is what makes these private equity pools so popular. In a rising market, which real estate enjoyed until a year ago, leverage turns average performers into seeming geniuses. In an up market a mediocre real estate manager enjoys million-dollar paydays, according to the customary formula that gives operators of private equity pools up to 20% of gains.

Say the manager buys a building for $100 million, putting down $30 million of your money and borrowing the rest. Over the next three years it appreciates to $150 million. Interest on the mortgage adds up to 20%, or $14 million. Before fees, you have made $36 million, a 120% return. That comes to 30% a year. But the unleveraged return was only 14.5%. Which return number, 30% or 14.5%, is the one most likely to be talked about?

In a down market, of course, leverage turns average performance into a disaster. But the operators of the pools are not expected to share 20% of the losses. No, the losses belong 100% to the providers of the equity capital. That would be you, if you’re a taxpayer…

See California Public Employees Take Big Hit On Real Estate for more on real estate investments in state retirement plans.

Paul Krugman — The Worst May Be Over

Kurt Brouwer May 5th, 2008

Princeton economist and New York Times columnist Paul Krugman has been very bearish on this financial crisis — until now. In this column, he actually exudes a whiff of confidence in Federal Reserve Chairman Ben Bernanke and in our financial system [emphasis added]:

Success Breeds Failure (New York Times, May 5, 2008, Paul Krugman)

Cross your fingers, knock on wood: it’s possible, though by no means certain, that the worst of the financial crisis is over. That’s the good news.

…Last August, as investors began to realize the scope of the mortgage mess, confidence in the financial system collapsed.

I believe we’ve been lucky to have Ben Bernanke as Federal Reserve chairman during these trying times. He may lack Mr. Greenspan’s talent for impersonating the Wizard of Oz, but he’s an economist who has thought long and hard about both the Great Depression and Japan’s lost decade in the 1990s, and he understands what’s at stake.

Mr. Bernanke recognized, more quickly than others might have, that we were in a situation bearing a family resemblance to the great banking crisis of 1930-31. His first priority, overriding every other concern, had to be preventing a cascade of financial failures that would cripple the economy.

The Fed’s efforts these past nine months remind me of the old TV series “MacGyver,” whose ingenious hero would always get out of difficult situations by assembling clever devices out of household objects and duct tape.

Because the institutions in trouble weren’t called banks, the Fed’s usual tools for dealing with financial trouble, designed for a system centered on traditional banks, were largely useless. So the Fed has cobbled together makeshift arrangements to save the day. There was the TAF and the TSLF (don’t ask), there were credit lines to investment banks, and the whole thing culminated in March’s unprecedented, barely legal Bear Stearns rescue — a rescue not of Bear itself, but of its “counterparties,” those who were on the other side of its financial bets.

It’s still far from certain whether all this improvisation has resolved the crisis. But it was the right thing to do, and for the moment things seem to be calming down…

Professor Krugman’s columns often have an overt political tone to them and I generally ignore those. However, he is an excellent economist, so I do pay attention to his economic opinions. He has been quite bearish and negative for the past year or so. For example, in an interview in Fortune magazine on March 17, 2008, Krugman opined that the economic downturn could last into 2010 or even 2011 [Identification added in brackets below and emphasis added]:

How Bad Is The Mortgage Crisis Going To Get? (Fortune, March 17, 2008, Jia Lin Yang)

…[Fortune]:Can you compare this to other economic crises the U.S. has faced?

[Paul Krugman]: The financial stuff looks like a combination of 1990 and 2001, and probably bigger than both combined. You’ve got the financial disruption, which is probably bigger than the savings and loan crisis. And you’ve got the loss of wealth from the housing bust, which is bigger than the dot-com bust. So this looks fairly nasty. And then everybody who’s paying attention is worrying about the Japan analogy. Japan never had a really severe recession. It just started with a recession and never really had a recovery for a whole decade. And that’s the kind of thing we’re afraid of.

[Fortune]: You’ve been saying 2010 is when we get out of this recession. How did you arrive at that date?

[Paul Krugman]: The last recession officially ended after eight months, but employment didn’t start to recover until 30 months later, so I think we go at least that long this time. If the recession started in January 2008, then that would mean July 2010 is the first month we have anything that feels like a recovery. But I wouldn’t be surprised if it goes longer than that - maybe into 2011…

Given how negative Professor Krugman has been — even as recently as March of this year — today’s column struck me as a sea change in his thinking. What do you think?

Via: Larry Kudlow and Donald Luskin

California Public Employees Take Big Hit On Real Estate

Kurt Brouwer April 26th, 2008

CALPERS or the California Public Employees Retirement System has $241 billion in assets, so the struggles it is having with real estate have to be taken in context. Nonetheless, the potential loss of a billion here or a billion there — after a while it adds up to real money. This piece documents how a deal that included lots of smart people just blew up [emphasis added]:

Calpers-Linked Land Partnership Gets Default Notice (Wall Street Journal, April 26, 2008, Michael Corkery)

A large California land partnership involving one of the largest U.S. pension funds has received a notice of default on a $1 billion loan after failing to meet certain terms of its lenders.

LandSource Communities Development LLC, a partnership that involves the California Public Employees’ Retirement System, received the default notice Tuesday, amid talks to restructure $1.24 billion of debt. The partnership, which owns 15,000 acres in Southern California, had received an extension to meet its current loan terms, including a required payment, but the deadline expired on April 16. The default notice applies to about $1 billlion of the total debt.

…Partnerships such as LandSource were a common way to own and develop land during the housing boom. They provided high returns to investors and lenders and a way for builders to keep highly leveraged land off their books. But the ventures have run into trouble as the value of undeveloped land has plummeted and as demand for new homes has eroded.

MW Housing Partners, which includes Calpers, took a 68% financial stake in LandSource in early 2007 amid the slowing housing market. Cerberus Capital Management’s LNR Property Corp. unit has a 16% stake, and home builder Lennar Corp. has a 16% stake. Lennar and LNR operate the management of LandSource. None of these equity partners is liable for the debt if LandSource defaults. Calpers and Cerberus representatives declined to comment.

…LandSource’s trouble followed mounting stress at two large joint ventures in Las Vegas, called Kyle Canyon Gateway and Inspirada, involving many of the nation’s largest home builders. One partner in these ventures said Friday that it is unlikely that it will meet its obligations to the deals. The partner, home builder Kimball Hill Homes, announced Wednesday that it had filed for Chapter 11 bankruptcy protection…

The part I like most about this is that the joint venture partners seem to be ready to take the loss very quickly. Instead of hanging on for years and years, these investors are taking the hit and moving on. Assuming this trend continues in other real estate ventures that are struggling, we will be able to move much more quickly through the down cycle.

If you are one of the 1.5 million public employees or retirees who gets retirement and healthcare benefits from CalPERS, no doubt you hate to see this sort of thing. But, CalPERS has done very well with real estate over the years and this is just the flip side of those good years. It comes with the territory.

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