Hugh Hendry Sees Opportunities to `Short' Credit in Asia

More brilliance from Hugh Hendry of Eclectica Asset Management:

Eclectica Asset Management, May 2010 Commentary

This is the latest from Eclectica's philosophical and eccentric manager Hugh Hendry. Here is a taste:

Put differently, we believe that central banks in the UK and Europe are likely to keep their monetary tightening powder dry for some time yet. Accordingly, it seems likely that conjecture will remain our preoccupation at least until we receive some resolution to the great speculation of this year. By this we mean an answer to the question of whether we are in the midst of a vigorous yet typical economic recovery, or near the end of an inventory-led and rather short business cycle bearing testimony to an ongoing debt deflation.

Eclectica 05-10 ">

RBS's Janjuah Sees Euro Parity With Dollar `Longer Term'

Bob Janjuah, a voice of reason during a time of insanity. Please click this link to watch the Bloomberg video.

Seth Klarman - Leadership

This video is a guest lecture that was given by Seth Klarman in 2006 to a class at Harvard. The main topic of discussion is leadership. As an investor, there is almost no one that can hold a candle to Seth and Baupost (obviously my opinion). I try to emulate his philosophy of value investing in my own personal investing. I find his views on leadership to be spot-on as well as thought-provoking. This video is definitely worth the 49 minutes. Enjoy!

Bill Gross April 2010 Investment Outlook

The following is the latest Investment Outlook from Bill Gross of PIMCO. I enjoyed this month's letter as it touched on several thematic issues I consider critically important to not only investing but also the overall health and sustainability of the economy.

There once was a family who lived in a fine house on Main Street USA sometime in the 1980s. It was a handsome house with a big yard and a white picket fence, but something always seemed to be missing. There was never enough of this or that – a fancier car, another TV, it didn’t seem to matter – there was never enough. And so, the house came to be haunted by an unspoken phrase, “there must be more money, there must be more money.” The walls seemed to whisper it in the middle of the night, and even during the day everyone heard it although no one dared say it aloud. The chair spoke, the bedroom armoire, and even five-year-old Billie’s toy rocking horse would eerily demand almost in unison, “there must be more money, there must be more money.”

One day, sensing the family’s distress, little Billie asked his father, “What is it that causes you to have money?” “Well, you go to school, get a good job, and get raises,” his Dad said, “but these days there just doesn’t seem to be enough.” But Billie, being just a little boy didn’t understand and so he went off to ride his rocking horse, searching for the “clue” to “more money.” The horse was a special toy because not only did it whisper like the walls and the living room chair, but it seemed to answer questions if you only rode it fast enough. And so Billie would sit on top of his horse when no one was looking, charging madly up and down, back and forth in a frenzied state to a place where only he and his pony could go. “Take me to where there is money,” he would command his steed.

At first, Billie could not make the horse answer the way it had when he asked about Christmas presents or what kind of ice cream Mom would bring home from the store. Finding money seemed too hard of a question for a toy horse, but it made him try even harder. He would mount it again and again, whipping its head with the leather straps, forcing it faster and faster until it seemed its mouth would foam. “Where is the money, where is the money?” Billie would scream, and at last the horse in full gallop cried out, “borrow the money, borrow the money!”

At just that moment Billie’s Mom came around the corner and into his room and his eyes blazed at her as he fell to the floor. She rushed to his side, but he was unconscious now, yet still whispering the horse’s answer. He continued in that condition for the next 25 years, full grown, and confined comatose to his hospital bed. His family would visit, hoping for his revival, and then miraculously one day in 2008 he awoke with his father and mother at his side. “Did I find the money?” he asked, as if it were still the same afternoon. “Did you borrow it?” “We did,” his Dad answered, “but we borrowed too much.” Billie’s eyes seemed to close at that very instant and he died the next night.

Even as he lay dead, his mother heard his father’s voice saying to her, “My God, we became rich – or what we thought was rich – and we thought that was good, yet now we’re poor and a lost soul of a son to the bad. But poor devil, poor devil, he’s best gone out of a life where he rode to his doom in order to find a rocking horse winner.”

Adapted from a short story by D.H. Lawrence
“The Rocking Horse Winner”

For readers lost in the literative metaphor of another of my lengthy introductions to investment markets, let me connect the dots and suggest that it is symbolic of the perversion of American-style capitalism over the past 30 years – a belief that wealth was a function of printing, lending, and of course borrowing money in order to make more money. Our “horse” required more and more money every year in order to feed asset appreciation, its eventual securitisation and the borrowing that both promoted. That horse, like Billie, however, died in 2008 and we face an uncertain and lower growth environment as a result. The uncertainty comes from a number of structural headwinds in PIMCO’s analysis: deleveraging, reregulation, and the forces of deglobalisation – most evident now in the markets’ distrust of marginal sovereign credits such as Iceland, Ireland, Greece and a supporting cast of over-borrowed lookalikes. All of them now force bond and capital market vigilantes to make more measured choices when investing long-term monies. Even though the government’s fist has been successful to date in steadying the destabilising forces of a delevering private market, investors are now questioning the staying power of public monetary and fiscal policies. 2010 promises to be the year of choosing “which government” can most successfully substitute the governments’ fist for Adam Smith’s invisible hand and for how long? Can individual countries escape a debt crisis by creating even more debt and riding another rocking horse winner? Can the global economy?

The answer, from a vigilante’s viewpoint is “yes,” but a conditional “yes.” There are many conditions and they vary from country to country, but basically it comes down to these:

1. Can a country issue its own currency and is it acceptable in global commerce?

2. Are a country’s initial conditions (outstanding debt, structural deficit, growth rate, demographic balance) moderate and can it issue future public debt as a substitute for private credit?

3. Can a country’s central bank be allowed to reflate via low or negative real interest rates without creating a currency crisis?

These three important conditions render an immediate negative answer when viewed from an investor’s lens focused on Greece for instance: 1) Greece can’t issue debt in its own currency, 2) its initial conditions and demographics are abominable, and 3) its central bank – The ECB – believes in positive, not negative, real interest rates. Greece therefore must extend a beggar’s bowl to the European Union or the IMF because the private market vigilantes have simply had enough. Without guarantees or the promise of long-term assistance, Prime Minister Papandreou’s promise of fiscal austerity falls on deaf ears. Similarly, the Southern European PIGS face a difficult future environment as its walls whisper “the house needs more money, the house needs more money.” It will not come easily, and if it does, it will come at increasingly higher cost, either in the form of higher interest rates, fiscal frugality, or both.

Perhaps surprisingly, some of the countries on PIMCO’s “must to avoid” list are decently positioned to escape their individual debt crises. The UK comes immediately to mind. PIMCO would answer “yes” to all of the three primary conditions outlined earlier for the UK in contrast to Greece. We as a firm, however, remain underweight Gilts. The reason is that the debt the UK will increasingly issue in the future should lead to inflationary conditions and a depreciating currency relative to other countries, ultimately lowering the realised return on its bonds. If that view becomes consensus, then at some point the UK may fail to attain escape velocity from its debt trap. For now though, “crisis” does not describe their current predicament, yet that bed of nitroglycerine must be delicately handled. Avoid the UK – there are more attractive choices.

Could one of them be the United States? Well, yes, almost by default to use a poor, but somewhat ironic phrase, because a US Treasury investor must satisfactorily answer “yes” to my three conditions as well, and the US has more favourable demographics and a stronger growth potential than the UK – promising a greater chance at escape velocity. But remember – my three conditions just suggest that a country can get out of a debt crisis by creating more debt – they don’t assert that the bonds will be a good investment. Simply comparing Greek or UK debt to US Treasury bonds is not the golden ticket to alpha generation in investment markets. US bonds may simply be a “less poor” choice of alternatives.

The reason is complicated, but at its core very simple. As a November IMF staff position note aptly pointed out, high fiscal deficits and higher outstanding debt lead to higher real interest rates and ultimately higher inflation, both trends which are bond market unfriendly. In the US in addition to the 10% of GDP deficits and a growing stock of outstanding debt, an investor must be concerned with future unfunded entitlement commitments which portfolio managers almost always neglect, viewing them as so far off in the future that they don’t matter. Yet should it concern an investor in 30-year Treasuries that the Congressional Budget Office estimates that the present value of unfunded future social insurance expenditures (Social Security and Medicare primarily) was $46 trillion as of 2009, a sum four times its current outstanding debt? Of course it should, and that may be a primary reason why 30-year bonds yield 4.6% whereas 2-year debt with the same guarantee yields less than 1%.

The trend promises to get worse, not better. The imminent passage of health care reform represents a continuing litany of entitlement legislation that will add, not subtract, to future deficits and unfunded liabilities. No investment vigilante worth their salt or outrageous annual bonus would dare argue that current legislation is a deficit reducer as asserted by Democrats and in fact the Congressional Budget Office. Common sense alone would suggest that extending health care benefits to 30 million people will cost a lot of money and that it is being “paid for” in the current bill with standard smoke, and all too familiar mirrors that have characterised such entitlement legislation for decades. An article by an ex-CBO director in The New York Times this past Sunday affirms these suspicions. “Fantasy in, fantasy out,” writes Douglas Holtz-Eakin who held the CBO Chair from 2003–2005. Front-end loaded revenues and back-end loaded expenses promote the fiction that a program that will cost $950 billion over the next 10 years actually reduces the deficit by $138 billion. After all the details are analysed, Mr. Holtz-Eakin’s numbers affirm a vigilante’s suspicion – it will add $562 billion to the deficit over the next decade. Long-term bondholders beware.

So I’m on this rocking horse called PIMCO, a “co”-jockey appropriately named Billie, I suppose, and I’m whipping that horse in a frenzy, “The house needs more money, the house needs more money.” Hopefully my fate is not the same as the one created by D.H. Lawrence, nor is the horse’s answer. Billie’s rocking horse was a toy created in the 1980s and abused for two decades thereafter. Today’s chastened pony cannot cry out “borrow money,” but simply the reverse – “lend prudently.” In today’s marketplace, prudent lending must be directed not only towards sovereigns that can escape a debt trap, but ones that can do so with a minimum of reflationary consequences and currency devaluation – whether it be against other sovereigns or hard assets such as gold. Investment strategies should begin to reflect this preservation of capital principal by positioning bond portfolios on front-ends of selected sovereign yield curve subject to successful reflation (US, Brazil) and longer ends of yield curves that can withstand potential debt deflation (Germany, Core Europe). In addition, as increasing debt loads add impetus to higher real interest rates worldwide, a more “unicredit” bond market argues for high quality corporate spread risk as opposed to duration extension. In plain English, that means that a unit of quality credit spread will do better than a unit of duration. Rates face a future bear market as central banks eventually normalise QE policies and 0% yields if global reflation is successful. Spreads in appropriate sovereign and corporate credits are a better bet as long as global contagion is contained. If not, a rush to the safety of Treasury Bills lies ahead.

Above all, however, lend prudently, lend prudently if you want to be a rocking horse winner. And for you would be jockeys: be careful when you put your foot in the stirrups. Riding a thoroughbred can be a thrilling but risky proposition. Just look what happened to Billie – poor devil.

William H. Gross
Managing Director

Hugh Hendry: "I am subject to the harshest possible critic: the market."

Hugh Hendy never ceases to amaze me. Whether it be his macro viewpoints or specific topics, he usually hits the nail right on the head. From yesterday's FT, he issues an open letter to any and all that are willing to listen. Enjoy:

It's time to call the bankers' bluff and let enterprising people flourish, suggests Hugh Hendry.

You don't know me; we've never met. But I fear you are being encouraged to dislike me. Let me explain: I'm a speculator. I manage a hedge fund. Apparently I profit from your misery. Accordingly, our political leaders are keen to see the back of me.

Only yesterday, Germany and France were calling for the "fastest possible" adoption of new rules to put an end to financial speculation. But before you write me off I ask that you listen to my side of the story.

First, and much like the bogeyman of folklore, the size and significance of the hedge-fund industry is vastly over-stated. The best estimate is that people like me control just 2.5 per cent of total global financial assets under management. The ability to move prices and markets resides more with the managers of pension funds, unit trusts and our banking contemporaries; fortunately, for them, they are on much better terms with our political masters.

Second, and much to my regret, I have to correct another misconception. I am not guaranteed success; far from it. I have no certainty or monopoly on making money; that's the nature of risk taking, there is no free lunch. And believe me, I am subject to the harshest possible critic: the market.

Unlike my political adversaries I can't spin this out. If I am wrong in my deliberations, I have to record a loss immediately. So it should come as no surprise that I give great consideration to what I do.

But what about this short-selling business and the allegation that hedge funds seek to profit from the misery of others; are we simply a scourge on society?

I believe not. Let me explain. In short selling, investors borrow shares and sell them, hoping that the price will fall and they can buy the shares later at a lower price, replace them and thereby turn a profit.

Hedge funds are not seeking to dictate economic affairs. Rather we are preoccupied by price. A market-based economy like ours requires a pricing mechanism to allocate resources and ensure that we all prosper. Get it wrong and we endure the calamity of the technology bubble and the sleazy debacle of the American mortgage crisis.

It's not that hedge fund managers are bitter and seek to wreak havoc. It's just that we believe that recurring and periodic recessions reveal the economy's winners and losers. And through our endeavours, hedge funds attempt to discover the identity and inadequacies of the poor businesses. During hard times, such businesses typically go bust, allowing us to make an investment profit by betting on that eventuality, and ensuring that successful and prudently managed businesses prosper.

Or rather that was how it was supposed to work. But our political leaders have gone to considerable cost to avert this normal business cycle.

Fearing that the huge scale of reckless bets within the banking system threatened another depression, our politicians have used public funds to bail out the economy's losers. And in doing so they run the danger of creating a plutocracy: a society ruled by the wealthy. Consider that fact that in Latvia school teachers have had to take a 35 per cent pay cut so that the Swedish banks who funded the real-estate bubble are repaid their imprudent mortgages.

We need to stop this socialisation of risk taking: heads I win, tails you lose. Consider the American government's enormous bail out of the failed insurer, AIG. According to the world's largest bond fund manager, Bill Gross, it is perfectly acceptable for the taxpayer to subsidise his returns. As he explained it to the investment magazine Barons: "All I'm saying is the government would lose almost $50 billion if it decides AIG no longer is worth supporting. It is a game of chicken. You either call the government's bluff or you don't."

I would recommend a different course of action. It is the same one recommended in 1930 by then US Treasury Secretary Andrew Mellon. I would call the bankers' bluff and seek to purge the rottenness out of the system. All of us will work harder, prices will adjust, and enterprising people will flourish. Of course, this is a minority view. Instead, those in power would rather use the subterfuge of inflation to hide the enormous public subsidy.

The politicians' problem is that free and independent capital markets tend to be anti-inflationary. As we have seen, attempts at quantitative easing immediately depress the value of existing government bonds in addition to the value of sterling. And then you have the problem presented by my little industry. But we are intelligent, well-funded and willing to vociferously challenge public decisions. Most importantly, we are on your side.

Baupost's 20 Investment Lessons of 2008 (and 10 False Lessons)

The following is taken from Baupost's annual investor letter (via Value Investor Insight via My Investing Notebook). Baupost is of course Seth Klarman's shop and what he says, in my eyes, should be taken as near religion. Seth is an investing legend whose track record is rivaled by almost no one. He is one of the greatest value investor's of all-time and has been practicing his craft since co-founding Baupost in 1982. Enjoy!:

One might have expected that the near-death experience of most investors in 2008 would generate valuable lessons for the future. We all know about the “depression mentality” of our parents and grandparents who lived through the Great Depression. Memories of tough times colored their behavior for more than a generation, leading to limited risk taking and a sustainable base for healthy growth. Yet one year after the 2008 collapse, investors have returned to shockingly speculative behavior. One state investment board recently adopted a plan to leverage its portfolio – specifically its government and high-grade bond holdings – in an amount that could grow to 20% of its assets over the next three years. No one who was paying attention in 2008 would possibly think this is a good idea.

Below, we highlight the lessons that we believe could and should have been learned from the turmoil of 2008. Some of them are unique to the 2008 melt- down; others, which could have been drawn from general market observation over the past several decades, were certainly reinforced last year. Shockingly, virtually all of these lessons were either never learned or else were immediately forgotten by most market participants.

Twenty Investment Lessons of 2008

1. Things that have never happened before are bound to occur with some regularity. You must always be prepared for the unexpected, including sudden, sharp downward swings in markets and the economy. Whatever adverse scenario you can contemplate, reality can be far worse.

2. When excesses such as lax lending standards become widespread and persist for some time, people are lulled into a false sense of security, creating an even more dangerous situation. In some cases, excesses migrate beyond regional or national borders, raising the ante for investors and governments. These excesses will eventually end, triggering a crisis at least in proportion to the degree of the excesses. Correlations between asset classes may be surprisingly high when leverage rapidly unwinds.

3. Nowhere does it say that investors should strive to make every last dollar of potential profit; consideration of risk must never take a backseat to return. Conservative positioning entering a crisis is crucial: it enables one to maintain long-term oriented, clear thinking, and to focus on new opportunities while others are distracted or even forced to sell. Portfolio hedges must be in place before a crisis hits. One cannot reliably or affordably increase or replace hedges that are rolling off during a financial crisis.

4. Risk is not inherent in an investment; it is always relative to the price paid. Uncertainty is not the same as risk. Indeed, when great uncertainty – such as in the fall of 2008 – drives securities prices to especially low levels, they often become less risky investments.

5. Do not trust financial market risk models. Reality is always too complex to be accurately modeled. Attention to risk must be a 24/7/365 obsession, with people – not computers – assessing and reassessing the risk environment in real time. Despite the predilection of some analysts to model the financial markets using sophisticated mathematics, the markets are governed by behavioral science, not physical science.

6. Do not accept principal risk while investing short-term cash: the greedy effort to earn a few extra basis points of yield inevitably leads to the incurrence of greater risk, which increases the likelihood of losses and severe illiquidity at precisely the moment when cash is needed to cover expenses, to meet commitments, or to make compelling long-term investments.

7. The latest trade of a security creates a dangerous illusion that its market price approximates its true value. This mirage is especially dangerous during periods of market exuberance. The concept of “private market value” as an anchor to the proper valuation of a business can also be greatly skewed during ebullient times and should always be considered with a healthy degree of skepticism.

8. A broad and flexible investment approach is essential during a crisis. Opportunities can be vast, ephemeral, and dispersed through various sectors and markets. Rigid silos can be an enormous disadvantage at such times.

9. You must buy on the way down. There is far more volume on the way down than on the way back up, and far less competition among buyers. It is almost always better to be too early than too late, but you must be prepared for price markdowns on what you buy.

10. Financial innovation can be highly dangerous, though almost no one will tell you this. New financial products are typically created for sunny days and are almost never stress-tested for stormy weather. Securitization is an area that almost perfectly fits this description; markets for securitized assets such as subprime mortgages completely collapsed in 2008 and have not fully recovered. Ironically, the government is eager to restore the securitization markets back to their pre-collapse stature.

11. Ratings agencies are highly conflicted, unimaginative dupes. They are blissfully unaware of adverse selection and moral hazard. Investors should never trust them.

12. Be sure that you are well compensated for illiquidity – especially illiquidity without control – because it can create particularly high opportunity costs.

13. At equal returns, public investments are generally superior to private investments not only because they are more liquid but also because amidst distress, public markets are more likely than private ones to offer attractive opportunities to average down.

14. Beware leverage in all its forms. Borrowers – individual, corporate, or government – should always match fund their liabilities against the duration of their assets. Borrowers must always remember that capital markets can be extremely fickle, and that it is never safe to assume a maturing loan can be rolled over. Even if you are unleveraged, the leverage employed by others can drive dramatic price and valuation swings; sudden unavailability of leverage in the economy may trigger an economic downturn.

15. Many LBOs are man-made disasters. When the price paid is excessive, the equity portion of an LBO is really an out-of-the-money call option. Many fiduciaries placed large amounts of the capital under their stewardship into such options in 2006 and 2007.

16. Financial stocks are particularly risky. Banking, in particular, is a highly leveraged, extremely competitive, and challenging business. A major European bank recently announced the goal of achieving a 20% return on equity (ROE) within several years. Unfortunately, ROE is highly dependent on absolute yields, yield spreads, maintaining adequate loan loss reserves, and the amount of leverage used. What is the bank’s management to do if it cannot readily get to 20%? Leverage up? Hold riskier assets? Ignore the risk of loss? In some ways, for a major fin-ancial institution even to have a ROE goal is to court disaster.

17. Having clients with a long-term orientation is crucial. Nothing else is as important to the success of an investment firm.

18. When a government official says a problem has been “contained,” pay no attention.

19. The government – the ultimate short- term-oriented player – cannot withstand much pain in the economy or the financial markets. Bailouts and rescues are likely to occur, though not with sufficient predictability for investors to comfortably take advantage. The government will take enormous risks in such interventions, especially if the expenses can be conveniently deferred to the future. Some of the price-tag is in the form of back- stops and guarantees, whose cost is almost impossible to determine.

20. Almost no one will accept responsibility for his or her role in precipitating a crisis: not leveraged speculators, not willfully blind leaders of financial institutions, and certainly not regulators, government officials, ratings agencies or politicians.

Below, we itemize some of the quite different lessons investors seem to have learned as of late 2009 – false lessons, we believe. To not only learn but also effectively implement investment lessons requires a disciplined, often contrary, and long-term-oriented investment approach. It requires a resolute focus on risk aversion rather than maximizing immediate returns, as well as an understanding of history, a sense of financial market cycles, and, at times, extraordinary patience.

False Lessons

1. There are no long-term lessons – ever.

2. Bad things happen, but really bad things do not. Do buy the dips, especially the lowest quality securities when they come under pressure, because declines will quickly be reversed.

3. There is no amount of bad news that the markets cannot see past.

4. If you’ve just stared into the abyss, quickly forget it: the lessons of history can only hold you back.

5. Excess capacity in people, machines, or property will be quickly absorbed.

6. Markets need not be in sync with one another. Simultaneously, the bond market can be priced for sustained tough times, the equity market for a strong recovery, and gold for high inflation. Such an apparent disconnect is indefinitely sustainable.

7. In a crisis, stocks of financial companies are great investments, because the tide is bound to turn. Massive losses on bad loans and soured investments are irrelevant to value; improving trends and future prospects are what matter, regardless of whether profits will have to be used to cover loan losses and equity shortfalls for years to come.

8. The government can reasonably rely on debt ratings when it forms programs to lend money to buyers of otherwise unattractive debt instruments.

9. The government can indefinitely control both short-term and long-term interest rates.

10. The government can always rescue the markets or interfere with contract law whenever it deems convenient with little or no apparent cost. (Investors believe this now and, worse still, the government believes it as well. We are probably doomed to a lasting legacy of government tampering with financial markets and the economy, which is likely to create the mother of all moral hazards. The government is blissfully unaware of the wisdom of Friedrich Hayek: “The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.”)

The Big Short

This is an excerpt from Michael Lewis' upcoming book, The Big Short: Inside the Doomsday Machine. It is from Vanity Fair's April issue. The entire piece is worth the read but I want to highlight a small part that details the ridiculousness of the sell-side, especially when it comes to marking positions for month-end (from personal experience, this is one of the most frustrating things to deal with when you are on the other side of the trade and you have a know-nothing sell-side trader trying to make his monthly P&L look better for his boss):

In the spring of 2007, something changed—though at first it was hard to see what it was. On June 14, the pair of subprime-mortgage-bond hedge funds effectively owned by Bear Stearns were in freefall. In the ensuing two weeks, the publicly traded index of triple-B-rated subprime-mortgage bonds fell by nearly 20 percent. Just then Goldman Sachs appeared to Burry to be experiencing a nervous breakdown. His biggest positions were with Goldman, and Goldman was newly unable, or unwilling, to determine the value of those positions, and so could not say how much collateral should be shifted back and forth. On Friday, June 15, Burry’s Goldman Sachs saleswoman, Veronica Grinstein, vanished. He called and e-mailed her, but she didn’t respond until late the following Monday—to tell him that she was “out for the day.”

“This is a recurrent theme whenever the market moves our way,” wrote Burry. “People get sick, people are off for unspecified reasons.”

On June 20, Grinstein finally returned to tell him that Goldman Sachs had experienced “systems failure.”

That was funny, Burry replied, because Morgan Stanley had said more or less the same thing. And his salesman at Bank of America claimed they’d had a “power outage.”

“I viewed these ‘systems problems’ as excuses for buying time to sort out a mess behind the scenes,” he said. The Goldman saleswoman made a weak effort to claim that, even as the index of subprime-mortgage bonds collapsed, the market for insuring them hadn’t budged. But she did it from her cell phone, rather than the office line. (Grinstein didn’t respond to e-mail and phone requests for comment.)

They were caving. All of them. At the end of every month, for nearly two years, Burry had watched Wall Street traders mark his positions against him. That is, at the end of every month his bets against subprime bonds were mysteriously less valuable. The end of every month also happened to be when Wall Street traders sent their profit-and-loss statements to their managers and risk managers. On June 29, Burry received a note from his Morgan Stanley salesman, Art Ringness, saying that Morgan Stanley now wanted to make sure that “the marks are fair.” The next day, Goldman followed suit. It was the first time in two years that Goldman Sachs had not moved the trade against him at the end of the month. “That was the first time they moved our marks accurately,” he notes, “because they were getting in on the trade themselves.” The market was finally accepting the diagnosis of its own disorder.

It was precisely the moment he had told his investors, back in the summer of 2005, that they only needed to wait for. Crappy mortgages worth nearly $400 billion were resetting from their teaser rates to new, higher rates. By the end of July his marks were moving rapidly in his favor—and he was reading about the genius of people like John Paulson, who had come to the trade a year after he had. The Bloomberg News service ran an article about the few people who appeared to have seen the catastrophe coming. Only one worked as a bond trader inside a big Wall Street firm: a formerly obscure asset-backed-bond trader at Deutsche Bank named Greg Lippmann. The investor most conspicuously absent from the Bloomberg News article—one who had made $100 million for himself and $725 million for his investors—sat alone in his office, in Cupertino, California. By June 30, 2008, any investor who had stuck with Scion Capital from its beginning, on November 1, 2000, had a gain, after fees and expenses, of 489.34 percent. (The gross gain of the fund had been 726 percent.) Over the same period the S&P 500 returned just a bit more than 2 percent.

Michael Burry clipped the Bloomberg article and e-mailed it around the office with a note: “Lippmann is the guy that essentially took my idea and ran with it. To his credit.” His own investors, whose money he was doubling and more, said little. There came no apologies, and no gratitude. “Nobody came back and said, ‘Yeah, you were right,’” he said. “It was very quiet. It was extremely quiet.”

A New Start

Almost 5 months to the day since my last post. Obviously I have failed in staying up-to-date with posts. I have been busy with life, busy with investing, and the all the other usual excuses for being absent. I will be jumping ship from my current hedge fund and this will most likely allow me to post more frequently. Hopefully the best is yet to come.

Hayman Advisors New Letter

More fantastic commentary out of hedge fund firm Hayman Advisors. You may recall Hayman as one of the few to recognize the oncoming crisis. The difference between Hayman and other "Doomsayers" is their ability to implement strategies to profit (nothing against Nouriel Roubini and others but I have far more respect to those who put their skin in the game and actually have risk riding on their calls). Without further delay, happy reading:

Hayman Advisors 10-09

Prepare for the next leg in the Ice Age journey into deflation

Deep deflation thoughts from SocGen's Albert Edwards:

"While there can be no doubt that survey evidence is pointing to a more robust second half, equity markets should be far more nervous than they currently are. We heartily concur with GMO’s Jeremy Grantham who remarked recently that after 20 years of more or less permanent overvaluation of US equities, we saw just five months of under-pricing through the March trough. Do bursting global equity valuation bubbles really end like this? Of course they don’t.

One of the lessons from Japan was that, in a post-bubble world, equities were subject to far more violent swings. We expect to see an exact replica event play out in the west. The Great Moderation - where the 1980’s debt super-cycle filled in troughs of recessions - will now give way to far more violent swings in the economic cycle more usually seen in the pre-war years and the 19th century. Meanwhile, as we saw in Japan, each economic downswing will sink us deeper and deeper into the deflationary mire."

Eclectica August Letter

Here is the August letter from Eclectica, the hedge fund managed by Hugh Hendry. For those of you unfamiliar with Hugh, he stands firmly in the "deflation" camp. He appears from time to time on CNBC Europe. He brings up many though provoking topics that often aren't discussed or even contemplated, especially in the age of Quantitative Easing. This is a must read for any contrarian investors and I would make the argument is necessary for all investors. As we have all seen over the past 2 years, no scenario should be considered impossible anymore.

Eclectica 08-09

Audit the Federal Reserve

91 co-sponsors on the bill...let's hope the number keeps growing.

Ron Paul Speaks The Truth...Again

To quote the Wizard of Oz:

Pay no attention to the man behind the curtain.

1/2 Trillion Loss? Just Another Day at the Office

Seeing stories like this make me incredibly upset. Not just the sticker shock of the size of the loss, but also the amount of money made by those who ran the entire global financial system into the 7th level of hell.

ABC News is reporting that a London office of AIG might have lost up to $500 billion dollars:

Ground zero for AIG's spectacular implosion, which has soaked up more federal bailout money than any other entity, appears to have been a small London branch office that may have lost nearly half a trillion dollars in bad deals.

The disastrous deals were built up in a decade and, when the crisis hit, the man who ran the unit for the last eight years retired after making $280 million for himself and leaving with a $1 million-a-month consulting contract.

So who was the genius who deserved to be so well compensated? A man by the name of Joseph Cassano.


In the article, ABC News claims they have a tape of Cassano speaking to investors. This is a quote that will live in infamy for many, many years to come:

It is hard for us with, and without being flippant, to even see a scenario within any kind of realm of reason that would see us losing $1 in any of those transactions.

Brilliant. And now we, the taxpayers, are subsidizing his $1 million a month salary for "consulting services" (I'm sure its work that adds loads of value to AIG). This is one of the more infuriating things I have heard or seen so far during this collapse. Forget Madoff, forget Jerome Kerviel, forget Brian Hunter, forget Nick Leeson...if you roll up every "Rogue Trader" into one, they don't even come close to this man.

Hayman Advisors Letter

This is a very good letter from Hayman Advisors. Hayman is a firm managed by Kyle Bass. They made huge gains in 2007 using similar trades to Paulson in the mortgage market. What I took away as important highlights:

*In the past, I have stated my belief that there is not enough money in the world to soak up the tens of trillions of dollars of deleveraging that must occur over the next few years. This could not be truer than it is today. While I do not have a solution (and maybe it does not exist) to the problems facing us today, what I do know is that attempting to re‐lever a massively over‐leveraged system is clearly NOT the answer.

*If the U.S. were a public company, not even Ken Lewis would consider purchasing us (at a premium no doubt).

*The silver lining in our research is that the U.S. is one of the least levered countries in the world! Just saying that puts a bit of fear into me, but it is true. The U.S. is less levered and less exposed to radical economic deterioration than Western Europe. It is also far less dependent than East Asia on worldwide trade that is a byproduct of the net aggregate demand that previously emanated from the U.S. and other parts of the developed world. East Asia is quickly catching up to Central and Eastern Europe as the most afflicted region of the global economy.

*To be clear, we believe that the U.S. (and in fact, the world) is in an ongoing debt deflationary spiral that will likely continue for some time (possibly years). The rampant printing of currencies around the globe is not, in our opinion, likely to be immediately “inflationary” (in the common understanding of the term) as leverage comes out of the private sector and asset values continue to decline. The greater concern is the potential inflationary time bomb that grows as governments continue to borrow, print and “stimulate.” What happens to inflation when the velocity of money goes from zero to 100?

*Given all of the above, we are very confident in two predictions: 1. The U.S. is in relatively better shape than the rest of the world, and the dollar will be a safer currency than virtually any other (and yes, that includes the Yen). 2. Uncertainty and fear are rampant. Confidence in governmental and central bank leadership (are the two really that separate?) is plummeting worldwide. As a result, we believe people will look to “old-fashioned” stores of value – those which represented money long before green pieces of paper backed by a promise existed. Indeed, investors have already begun moving into precious metals. We expect this will continue.

*Once you have a deep understanding of how the U.S. and world banking systems work, it gives you a sense of how bad things really are and may become. So far, the Federal Reserve and the Treasury's “best and brightest” have decided that the best way to get through this is to add more leverage to an over-levered economy. The TALF program is attempting to re‐start the securitization market. Wait a minute! Did we not just get here through the disintermediation of risk? Shouldn't institutions that are actually making loans be required to keep some or all of those loans on their balance sheets? It looks like we are trying to head right back to where we just came from. The problem is that they have already taken all of the “suckers'” money in the securitization marketplace. Re‐levering will not work, in my opinion. We need to let the weak fail and the strong survive. Bernanke needs to take some cues from Von Mises and the Austrians.

*For your wealth, you must think about the enormity of this problem around the world, and what the likely governmental responses will be. I believe they only have two paths to walk down eventually. One is to print money in an attempt to paper over their losses (pardon the pun). This path can only lead to massive debasement of the fiat currency in our wallets and bank accounts, which is akin to them stealing it from savers. The second path is to move all of the “bad” private assets to the government or public balance sheets and then default on their sovereign debt. The world needs a “do‐over” and this would be the cleanest way to rebuilding the world's financial system. As much as I would like to think there is another path to salvation that does not include enormous pain, there is just no other way when you look at all of the numbers.


Hayman Capital

Publish at Scribd or explore others: Engineering Research business social

Mark of the Beast

You have it here first folks, the anti-christ may have just arrived.

The Doom Bunker

Absolutely brilliant Colbert from Thursday night. Here is Part I:

The Colbert ReportMon - Thurs 11:30pm / 10:30c

Glenn Beck's War Room

Colbert Report Full Episodes
Political Humor

Rap Battle
Joke of the Day

Now, prepare to enter the Doom Bunker!!!!!!!!

The Colbert ReportMon - Thurs 11:30pm / 10:30c

Doom Bunker - Jack Jacobs and Stephen Moore

Colbert Report Full Episodes
Political Humor

Rap Battle
Joke of the Day

Europe on the Ropes

If the following letter from Niels Jensen, head of UK-based Absolute Return Partners, doesn't scare the shit out of you...I suggest you get your head checked. Eastern Europe represnets a potentially massive systemic risk and I don't see how anyone thinks stocks can sustain any rally. Yes we are oversold, yes there is significant cash sitting on the sidelines, yes every government worldwide is throwing everything they can think of at this crisis. Despite all of this, I am staying out. Enjoy!



Europe On the Ropes
The Absolute Return Letter March 2009

"Many of today's policy proposals start from the view that "greed" and "incompetence" and "poor risk assessment" are the ultimate source of what went wrong. In fact, they were not the true cause at all. Moreover, even if they had been, it is fatuous to think that we will now create a post-crash generation of bankers and traders who are not greedy, much less a new generation of quants who will be able to assess and manage risks much better than "the idiots" who have brought us to the current abyss. Greed cannot be exorcised. Nor can the inherent inability of any quants to determine the "true" probability distributions of all-important events whose true probabilities of occurrence can never be assessed in the first place."

Woody Brock, SED Profile, December 2008

Policy mistakes 'en masse'

The last few weeks have had a profound effect on my view of politicians (as if it wasn't already dented). All this talk about capping salaries for senior bank executives is quite frankly ridiculous. It is Neanderthal politics performed by populist leaders. That Gordon Brown has fallen for it is hardly surprising but I am disappointed to see that Barack Obama couldn't resist the temptation. The mob wants blood and our leaders are delivering in spades. The stark reality is that we are all guilty of the mess we are now in. For a while we were allowed to live out our dreams and who was there to stop us? Policy mistakes – very grave mistakes – permitted the situation to spin out of control. From the U.S. Federal Reserve Bank under the stewardship of Alan Greenspan being far too generous on interest rates to the British Chancellor of the Exchequer -who now happens to be our Prime Minister - advocating 'Regulation Light'.

Policing must improve

If you really want to prevent a banking crisis of this magnitude from ever happening again, the focus should be on the way banks operate and not on how much they pay their staff. And, within that context, any discussion must start and end with how much leverage should be permitted. The French have actually caught onto that, but their narrow-mindedness has driven them to focus on hedge funds' use of leverage which is only a tiny part of the problem. It is the gung ho strategy of banks which brought us down and which must be better policed. And guess what; if banks were better policed - and leverage restricted - then profits, even at the best of times, would be much smaller and there would be no need to regulate bankers' compensation packages.

It is pathetic to watch our prime minister attacking the bonus arrangements of our banks when the UK Treasury, on his watch, spent £27 million pounds on bonuses last year as reward for delivering a public spending deficit of 4.5% of GDP at the peak of the economic cycle. Even my old mother understands that governments must deliver budget surpluses in good times, allowing them more flexibility to stimulate when the economy hits the wall. What Gordon Brown has done to UK public finances in recent years is nothing short of criminal.

So, with that in mind, let's take a closer look at the European banking industry. The following is not pretty reading. I have rarely, if ever, felt this apprehensive about the outlook. So, if the crisis has made you depressed already, don't read any further. What is about to come, will make your heart sink.

More leverage in Europe

Let's begin our journey by pointing out a regulatory 'anomaly' which has allowed European banks to take on much more leverage than their American colleagues and which now makes them far more vulnerable. In Europe, unlike in the US, it is only risk-weighted assets which matter to the regulators, not the total leverage ratio. European banks can therefore apply a lot more leverage than their US counterparties, provided they load their balance sheets with higher rated assets, and that is precisely what they have been doing.

That is fine as long as you buy what it says on the tin. But AAA is not always AAA as we have learned over the past 18 months. Asset securitisations such as CLOs proved very popular amongst European banks, partly because they offered very attractive returns and partly because Standard & Poors and Moodys were kind enough to rate many of them AAA despite the questionable quality of the underlying assets.

Now, as long as the economy chugs along, everything is dandy and the AAA-rated assets turn out to be precisely that. But we are not in dandy territory. Many asset securitisation programmes are in horse manure to their necks, so don't be at all surprised if European banks have to swallow further losses once the full effect of the recession is felt across Europe. The two largest sources of asset securitisation programmes are corporate loans and credit cards. Senior secured loans are still marked at or close to par on many balance sheets despite the fact they trade around 70 in the markets. The credit card cycle is only beginning to turn now with significant losses expected later this year and in 2010-11.

Not much of a cushion left

Citibank has calculated that it would only take a cumulative increase in bad debts of 3.8% in 2009-10 to take the core equity tier 1 ratio of the European banking industry down to the bare minimum of 4.5%1. By comparison, bad debts rose by a cumulative 7% in Japan in 1997-98. One can only conclude that European banks are very poorly equipped to withstand a severe recession. Seeing the writing on the wall, they are left with no option but to shrink their balance sheets. Despite talking the talk, banks will use every trick at their disposal to reduce the loan book. No prize for guessing what that will do to economic activity.

The wheels are coming off
But that is not the whole story. It is not even the most worrying part of the story. For the true horror to emerge, we need to turn to Eastern Europe for a minute or two. Nowhere has the credit boom been more pronounced than in Eastern Europe. And nowhere is the pain felt more now that credit has all but dried up. One measure of the credit fuelled bonanza is the deterioration of the current account across the region. Credit Suisse has calculated that in four short years, from 2004 to 2008, Eastern Europe's current account went from +6% to -6% of GDP2. That is a frightening development and is likely to cause all sorts of problems over the next few years.

Meanwhile Western European banks, eager to milk the opportunities in the East after the iron curtain came down, have acquired many of the region's banks (see chart 1). Now, with many Eastern European countries in free fall, ownership could prove disastrous for an already weakened banking industry in the West.



The problem is widespread

To make matters worse, the problems in the East are beginning to look systemic. Credit Suisse has produced an interesting scorecard where they rank a number of countries around the world on factors usually taken into consideration when assessing the credit quality of sovereign debt (see chart 2). At the top of the tree (i.e. the worst credit score) you find Iceland – hardly surprising considering their current predicament. More importantly though, of the next 14 countries on the list, 8 are Eastern European – not what you want to hear if you are an already undercapitalised European bank with huge exposure to Eastern Europe.

Swedish banks are already reeling from their exposure to the Baltic countries. Austrian banks are in even worse shape, having been the most acquisitive of any European banks. Some Italian banks could be dragged under by their Eastern European exposure and even the conservative banking sector in Switzerland doesn't look like it can escape the mayhem.

Worst of all, the problems in the East are just about to unfold at a point in time where the European banking industry is bleeding heavily from massive losses already incurred in other areas. With no access to private funding, banks find it virtually impossible to re-build their capital base with anything but tax payers' money.

US banks are better off

US banks are in less of a pickle. Unlike the subprime debacle which hit both the US and the European banks hard, US banks have little exposure to Eastern Europe. To prove my point, according to the IMF, European banks have 75% as much exposure to US toxic debt as American banks, but 90% of all cross border loans to Eastern Europe originate from Western European banks. And, to add insult to injury, European banks have been much slower than US banks in terms of recognising their losses. Write-offs now total about $750 billion in the US and only about $325 billion in Europe.



The great mortgage show

The problems in Eastern Europe begin and end with their large external debts. In recent years, ordinary people all over the region have converted their traditional mortgages to EUR- or CHF-denominated mortgages. Some have even switched to JPY mortgages. Who can possibly resist 3% mortgages? Didn't anyone inform them of the risk? As currencies across the region have fallen out of bed in recent months, these mortgages have suddenly become 30-50% more expensive. No wonder the local economy is suddenly tanking.



Credit Suisse has calculated that net foreign liabilities (as a % of GDP) have risen from 47% to 65% in recent months as a direct result of the loss of local currency values (see chart 3 – and don't ask me why Credit Suisse has included South Africa in Eastern Europe!).

Chart 4: Eastern European vs. Asian Crisis



Source: Wall Street Journal

Back in 1997-98 Asia went through a similar currency crisis. However, as you can see from chart 4, Asian current account deficits were much smaller than Eastern European deficits are now. So were debt levels. Despite that, the Asian crisis did enormous damage to the local economy. Eventually Asia came good, primarily because the devalued currencies allowed the Asian countries to export more. Eastern Europe does not share this luxury. With over 90% of the world's GDP in recession, who are they going to export to anytime soon?

Austria is in greatest trouble

According to the latest estimates from BIS, Eastern European countries currently borrow $1,656 billion from abroad, three times more than in 2005 and mostly denominated in foreign currencies (ouch!). 90% of that can be traced to Western European banks. About $350 billion must be repaid or rolled over this year. Not an easy task in these markets. Austrian banks alone have lent about $300 billion to the region, equivalent to 68% of its GDP according to the Financial Times. A default rate of 10% on its Eastern European loans is considered enough to wipe out the entire Austrian banking system. EBRD has gone on record stating that defaults in Eastern Europe could end up as high as 20%3.

An extra $250bn to the IMF

Hungary, Latvia and Ukraine have already received emergency loans from the IMF and both Serbia and Romania are reportedly considering asking for help. Meanwhile the IMF's coffers are draining quickly and it has asked leading industrial nations for new funding. At their summit a week ago, EU leaders coughed up an extra $250 billion but nobody said where the money is going to come from. Even if they find the money, it is likely to prove hopelessly inadequate. Our leaders must grow up. Measuring everything in billions is so yesterday. Trillions are the new billions, like it or not.

Conspiracy or...?

On the 11th February the Daily Telegraph's Brussels correspondent Bruno Waterfield wrote an article under the header: "European banks may need £16.3 trillion bail out, EC document warns." In the article, the reporter revealed that he has seen a secret document produced by the EU Commission which briefed the union's finance ministers on the true extent of the banking crisis. Less than 24 hours later, the article's header was changed to "European bank bail-out could push EU into crisis" and two paragraphs had mysteriously disappeared. Here they are:

"European Commission officials have estimated that "impaired assets" may amount to 44pc of EU bank balance sheets. The Commission estimates that so-called financial instruments in the 'trading book' total £12.3 trillion (13.7 trillion euros), equivalent to about 33pc of EU bank balance sheets.

In addition, so-called 'available for sale instruments' worth £4trillion (4.5 trillion euros), or 11pc of balance sheets, are also added by the Commission to arrive at the headline figure of £16.3 trillion."

Do yourself a favour - read those two paragraphs again. Newspaper editors do not change content light-heartedly. Did the Telegraph editor receive a call from Downing Street? Or Brussels? Did he have second thoughts about the avalanche that he could possibly instigate? I don't know and I probably never will. But one thing is certain. If the EU Commission's estimate of £16.3 trillion of impaired assets is correct, then the crisis is far worse than any of us could ever imagine. Not only would we have to get used to the prospects of a systemic meltdown of our banking system, but entire nations may go down as well.

Public debt to rise and rise

Even if actual losses prove to be much, much smaller (and I sincerely hope so), the banking sector cannot, in the current environment at least, raise sufficient capital to stay afloat, so more, possibly a lot more, tax payers' money will have to be put forward. This can only mean one thing. Public debt will rise and rise. The official estimate for the UK for next year is already approaching 10% of GDP, an estimate which will almost certainly rise further. We probably have to get used to running 10-15% deficits for a few years, a fact which seriously undermines the notion of government bonds being next to risk-free.

BCA Research has calculated the effect on public debt in a number of countries, as a result of further bank losses being underwritten by tax payers. Obviously, those countries with the largest banking industries (as a % of GDP) will be hit the hardest (see charts 5a and 5b).



For that very reason, and as pointed out in last month's Absolute Return Letter, there is a real risk that investors will demand much higher risk premiums on government debt. Only a few days ago, Ireland issued 3-year bonds at almost 250 basis points over corresponding Bunds. As more and more debt is transferred to sovereign balance sheets, we will likely see the spreads between good and bad paper rise further but we will also witness increasingly desperate measures being applied by the men in power. If they could prohibit short-selling of banks on the stock exchange (which didn't work), why wouldn't they consider prohibiting short-selling of government bonds? Not that it would necessarily work any better, but desperate people do desperate things.

Can Germany rescue us?

Most investors remain convinced that Germany will come to the rescue - in my opinion not as simple a solution as widely perceived given the enormity of the crisis. One possible solution which has been mentioned frequently in recent weeks is for all the eurozone nations to get together and start issuing joint bonds. This would undoubtedly help the weaker nations, but the idea was shot down by the German Finance Minister only a few days ago when he said that closer economic harmony across the eurozone would be needed before Germany would be prepared to entertain such an idea.

The most obvious trick left in the book, therefore, is to inflate us out of this mess. With the enormous amounts of public debt being created at the moment, years of deflation a la Japan would be catastrophic. You will never get a central banker to admit to it, but a healthy dose of inflation is probably our best prospect of surviving this crisis.

Given this outlook, do you really want to be long euros?

Niels C. Jensen

Quote of the day

The top five U.K. banks have $10 trillion of assets and their GDP is only $2.13 trillion. The whole country could fall into the ocean. The top five U.S. banks represent only about 60 percent of GDP by comparison.