Debt, Dilution, Default and Denial

May 21, 2008

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This article’s by Bennet Sedacca , courtesy of Minyanville.

Debt, Dilution, Default and Denial

Risk comes from not knowing what you are doing – Warren Buffett

Debt is like a drug. When used properly, it can help the sick or enhance the life of a healthy individual. If abused, both can result in addiction and despair. But now, the use of debt has become so widespread and has been so incredibly abused that we now find ourselves in quite a nasty predicament.

When in debt, the borrower has only a few options. Debt can be serviced (by simply paying the minimum payment each month), repaid, refinanced or defaulted on. A reasonable amount of debt, though, is actually a healthy thing. Prudent levels of borrowing can help businesses grow, individuals buy a home, teenagers attend college, and allow the U.S. government and state and local municipalities to provide essential services.

When a person is given a small dose of a painkiller for a sports related injury, that dose, if abused, can result in addiction and eventual rehabilitation: Just like any entity that becomes too addicted to debt, only to see their debt service overtake their ability to grow.

Further, when debt is used to turn a relatively simple instrument like a residential or commercial mortgage into a leveraged financial Frankenstein (Mary Shelley would have loved some of these instruments!), problems can and have arisen. Wall Street’s alchemists have turned relatively simple mortgages (sub-prime, prime and Alt-A) into CDO’s, CLO’s and the like.

Think of the alchemy in the following way; A CDO with multiple layers of safety (equity, mezzanine and everything from BBB to AAA rated tranches) that are hard to analyze, hard to price, impossible to sell in many cases, and result in the holder of these esoteric securities being forced to write the values down, which results in:

Dilution

I have written quite a bit about Level 2 Assets (hard to price, "marked to model" assets) of late. To be perfectly honest, I have never seen a list of Level 2 Assets out for the bid, nor has anyone at any bank or brokerage firm ever volunteered to show me what any of these securities actually are. What disturbs me the most is the trend in the sheer amount of Level 2 Assets on the books of not only banks and brokers, but public companies in general. This also goes for Level 3 Assets (those that are "marked to management’s best guess"). I did a quick study on Bloomberg today that allowed me to come the following conclusions:

535 publicly traded companies in the United States have some Level 3 Assets on their balance sheet.
Level 1 Assets (those that are ‘marked to market’) are only $1.5 trillion.
Level 2 Assets have swollen to $10.5 trillion.
Level 3 Assets have increased to $1.3 trillion.
Cumulative Shareholder’s Equity is only $2.3 trillion.

And none of this includes Freddie Mac’s (FRE) most recent confession in its May 14th earnings release that it now has $155 billion of Level 3 Assets (mostly non-Agency sub-prime assets according to the company) on their books. $155 billion is 5.5 times Freddie’s shareholder equity and 23% of Total Assets according to the company. I have to admit that as a holder of Freddie Mac and Fannie Mae (FNM) preferred shares, I was, to say the least, more than slightly aghast. I have shed many of my holdings there and likely will continue down that path until our position hits zero.

Am I being alarmist with this analysis? Perhaps, but better safe than sorry, and even if I have to take a small loss (in some cases I may) I have found that the best traders/investors are the ones that know how/when to take a loss, rather than hoping the investment will perform as they had originally planned. As they say, "Hope is a poor roadmap to success in the markets."

As a result of their own greed, banks and brokers have been forced, on a global scale, to write down more than $315 billion since the crisis began last summer. Most of the write-downs have been confined to the sub-prime sector to date, but I’m highly uncomfortable that the crisis, in the end, will be confined to sub-prime.

In fact, we’re already beginning to see strains on other parts of the credit markets. The problems stretch all the way from credit card receivables, Alt-A loans, prime loans, auto loans and motorcycle loans. The problem is not at all contained, as many analysts, economists, TV commentators and other "hopers" would like us to believe. Unfortunately, contagion is here, perhaps for a while. To make matters worse, when we add exploding commodity prices and a rising unemployment rate to the picture, the takeaway is far from optimistic.

As such, I’ve now pared my long only equity portfolios to my lowest level since 2001 and continue to shun credit risk. I continue to live by the following adage—"If you are not being properly compensated to take risk, particularly credit risk, do not take risk."

There is no doubt in my mind that while I’m in "extreme caution mode" I can very easily be wrong. What I mean is that credit spreads may tighten further and stocks could continue to rally, my firm, Atlantic Advisors, operates under the assumption that it isn’t possible to be "too cautious with someone else’s money."

As a result of all the write-downs that have occurred, many financial institutions have been forced to come to market with common equity, convertible preferred and straight preferred deals. Companies on this list include the likes of Merrill Lynch (MER), Fannie Mae, Freddie Mac, National City (NCC), Regions (RF), Fifth Third Bancorp (FITB), MBIA (MBI), AMBAC (SBK), J.P. Morgan (JPM), Lehman Brothers (LEH), Citigroup (C) and so on.

Some of the companies, like National City, have diluted existing shareholders by 50% just to stay in business. The same, sadly, can be said for MBIA and AMBAC, two municipal insurers that got burned when they entered the vague world of Credit Default Swaps and CDO’s.

For what it is worth, I highly doubt that AMBAC and MBIA will survive this crisis as they now have nearly three times their shareholder equity in "deferred tax assets." Even Freddie Mac disclosed it now has deferred tax assets on its books, a potential sign of financial stress.

It is clear to me that what many of the aforementioned companies should be doing is not what they are actually doing. Take Merrill Lynch, for example. Merrill has said on several occasions that it doesn’t need to raise capital, only to raise billions of capital a week later, paying as much as 8 5/8% for preferred stock.

It then went on to state (just last week) that it wrote down an additional $5+ billion in assets since March 31st. This brings their write-downs to a staggering $37 billion since last July on a base of just $31 billion of shareholder equity. The part that bugs me is that Merrill now has nearly 3 times its shareholder equity in Level 3 Assets, and at the same time it states that it can produce a 20% return on shareholder equity. All I can say to the company is "Lotsa luck."

What it should be doing, in my opinion, is cutting its common dividend and issue as much common and convertible stock as it can while the capital raising window remains open, which I expect to shut abruptly as we approach 2009.

Think of it this way: If you owned your own company, business was slowing, your cost of capital was rising, profits disappeared, you were writing down the value of your net worth and assets, employees were leaving and you were levered up to your eyeballs, what would you do? A prudent investor would cut dividends to shareholders, reduce headcount, try to cut leverage and find a way to raise equity even if you dilute your own holdings just so you can fight to live another day.

Those companies that resist these measures will live to regret it, in my opinion, even to the extent that their stubbornness to please Wall Street and investors over the near term could result in insolvency. Unlike Bear Stearns (BSC), the rest of the system cannot be simultaneously bailed out—the math just doesn’t add up. Over the next few months, my firm expects, in its Harbor Pilot Fund, to very specifically identify credits and companies that it expects to have trouble in the next round of credit problems (these bets could be in the credit or equity/equity options market or both). It had similar positions leading up to the Bear Stearns bailout, but closed those positions around the time of the bailout.

Defaults

As I stated at the beginning of this piece, one of the potential outcomes for over-indebted entities is default. Note that on the balance sheets of banks in this country, according to the FDIC, that "other real estate assets" have risen by 100% over the past year. I wonder what "other real estate" could be?

I’m sure it’s foreclosed homes on top of the 4.5 million unsold homes spread across the United States, 2 million of which are vacant. Can one expect a quick turn housing given all of this? I don’t believe so.

What exactly is a CDO that Wall Street alchemists cooked up? It’s nothing more than a derivative of the original loan itself! Whether the loan was prime, sub-prime, Alt-A, credit card backed, or backed by commercial real estate, if the loan itself does not perform as expected, which many are not, the CDO holder feels the pain. The more delinquencies, the more defaults. Now that so many of these assets reside on the balance sheets of brokers and banks, not to mention levered up hedge funds, it seems to me that we have a little game of "chicken" going on.

Let’s say that you’re part of the risk management team of an investment bank or commercial bank and you hold a particular Type 3 (or even something not as bad as Type 3) and your buddy at another firm owns the same or a similar security. If you trade your bonds, the magical three words to make an asset qualify for Type 3, "no observable input," go away. When the bonds trade, there is now a market. I imagine that you may not like the market price, especially if your balance sheet is levered 25:1, but you would then have that magical input, otherwise known as the price.

This new price makes you mark your bonds down. Eventually, those that are marking a lot of esoteric securities "to myth" as Warren Buffett likes to say, will have to mark the bonds to market: Margin calls, anyone?

Much of the data I’ve presented is not at all positive, but to ignore the facts is to bury one’s head in the sand and burying one’s head in the sand isn’t any better at producing exceptional investment results than hoping.

Why wouldn’t someone mark their bonds to the real price where they would trade if they were to be forced to sell? Why would so many firms lever up and pay dividends they can’t afford instead of simply raising capital to bolster a weak balance sheet while they can? I can sum up the answer to that question, which is also the answer to "Why are so many investors again embracing all sorts of risk – credit risk, structure risk, etc.?"

Denial

Every day, including weekends, I awaken wondering what the markets might have in store for me. When I was younger, before absolute return investing took hold, I would sometimes suffer from "performance anxiety," the feeling that I was under-performing others that were taking more risk than I.

A perfect example would be in 1999 when I was told "It’s different this time," and "This is a new paradigm: Why don’t you get with the program?" As time went on, absolute return investing took on more importance for me. The money that is entrusted to my firm is capital that many have taken quite a bit of risk to accumulate and that they don’t care to lose. It’s not that my firm doesn’t take risk: In fact, we are nearly fully invested at all times, but the risk we take is measured, or what you might call "defined risk."

The question that always comes up on my firm’s trading desk is "In the absence of a benchmark, what would you buy?" This is a relatively simple question and one that we ask ourselves every time we initiate a position, because as absolute return investors, the only benchmark, or "bogey," is to avoid red numbers, or in laymen’s terms, to not lose money. When I look at the macro-economic picture, the ruins that used to be the balance sheets of financial institutions, the battered consumer and an indebted country and populace, I wonder how so many people can take so much risk without proper compensation.

For example, the junkiest of junk bond deals are now getting done daily (CCC rated Hovnanian Enterprises floated a $600 million 11 ½% 5 year deal on Friday and the price went directly from 100 to 103 ½). Similar deals are getting done in the financial space as the Federal Reserve has the Moral Hazard Card back in play again.

When I began worrying about credit way back in 2004 (my credit concerns actually date all the way back to 2001), I actually hoped that my analysis would be wrong. The cards were laid out in a very organized fashion and the odds of being wrong about credit were not likely. Where are we now? Now that even more debt has been created, more structured financial vehicles have been created than I could have ever imagined and the write-offs have begun to occur, I am afraid that the next waive of delinquencies and bankruptcies will be more widespread from the corporate boardroom, to Main Street and Wall Street, and to living rooms across America and, more likely, the whole world. If one thinks that the only place greed and avarice exists is within the confines of the U.S.’ borders, they will likely be mistaken.

I have been asked for an outlook for what I think might occur over the next six to 12 months. Considering this is an election year with a lot at stake and with many voters in both parties (at least the ones I talk to) going to vote for the candidate they dislike the least, this could further pressure the dollar, as will reckless money creation and other fiscal and monetary policies. It seems to me that the only way out of this mass is for a series of Bear Stearns-like events, and other events, like National City of Cleveland, which was at the brink of losing the chance to raise capital.

All I can say is that I think whichever Presidential candidate is voted into office in November will be "one and done" as no matter who wins, they will be facing a problem that started a couple of decades before.

I think a "Perfect Storm" has formed and that if you want to use a hurricane as an analogy, the outer bands of the storm hit the U.S.’ shores in the August 2007-March 2008 timeframe. The real issues are closer to the eye of the storm, which is likely an early 2009 event.

I continue to be cautious (not bearish) and to scour the landscape for opportunities in both my long only and hedged strategies. If I’m wrong, I’ll still earn a modest rate of return, but if I’m correct, and have my capital intact as the eye of the storm hits, that’s where the real money will be made.