Looking to Put Money to Work? Here Are Some Thoughts.

I've gotten a number of questions regarding places to put money. Stocks are beaten down, so are bond yields. What's an investor looking to put money to work for 2-3 years to do?

1. Calpine (CPN)
- This utility trades at a HUGE discount to its enterprise value, likely due to investors attempting to front run expected liquidations by CPNs HUGE hedge fund/ private equity holders.

2. Shaw Group (SGR)
- This Jim Cramer favorite has a great backlog (a few BILLION), yet trades near its cash holdings of a bit above ONE billion. This stock, likely beaten down due to its major hedge fund holders, has a diversified group of businesses and will be a TOP rebound candidate once markets turn.

3. Agency Capital Corp. (AGNC)
- This American Capital Strategies (ACAS) affiliate invests in Freddie, Fannie and Ginnee Mae paper which, due to recent government guarantees, should trade like treasuries. Dislocations in the market, however, have created shocking opportunities to invest in guaranteed securities, which AGNC does on a leveraged basis. Huge >20%+ yield.

4. Mosaic (MOS)
- This ag favorite is trading at the same price it was in early 2007 when sales AND prices were lower. At this price, growth expectations make this stock hard to pass.


If you're in it for the long run, it's going to be hard to bet against these plays.

How far we've come.

“Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate … purge the rottenness out of the system”

- Andrew Mellon, Treasury Secretary under President Herbert Hoover

Citigroup: RFP for Lunesta

Justin Killion: You know what Citi needs?
Evan Plisner: Money and a reverse stock split?
JK: Nope
JK: Sleep.
JK: Otherwise their insomnia is going to turn into a dirt nap.

Overshot Pt. 2

Those who think oil prices are sustainable in the $40s are just as crazy as those who thought oil was worth buying at $150 (Goldman Sachs). If I may introduce the concept of economics and the "invisible hand of the free market": As oil prices decline, fewer pipelines are filled to capacity, rigs are taken offline for maintenance, and overall production decreases, reducing supply and moving prices back up. This is, of course, without the eventual return to global growth vis-a-vis EVERY COUNTRY IN THE WORLD. Ladies and gents, while oil may trade as low as $40 before year's end, don't expect it to stay that way for long...better fill up now.

EP

Yield Curve, Quantitative Easing and CMBS

Last Thursday, the treasury had quite a poor auction of 30-year bonds. Yet over the past few days, we have seen an unprecedented spike in the price of the very same long-term treasuries. I have read some speculation that this could not occur and is largely short-term for various spurious reasons. I contend that this is a result of the Feds recent admission about the reality of quantitative easing despite the fact that informed speculators have claimed this as the only inevitable policy for quite some time. Besides the fact that the Fed seems to have completely lost control over the fed funds rate (see image, blue is target FF, red is effective FF), it appears to have decided to embark on a path of quantitative easing. This is precisely what Japan had to resort to after its asset-bubble burst. The fundamental idea is that with short-term interest rates so low, any further reductions have very little, if any, affect as stimulus. Accordingly, the central bank rapidly increases the money supply to prop up asset prices (avoiding deflation) and aims to decrease long-term interest rates (to effectively avoid a liquidity trap). Also, under a policy of quant easing the Central Bank tries to grow its balance sheet by increasing the amount of bank reserves held with it. (Interestingly, some Fed papers have concluded that quant easing largely failed in Japan.)

This is all in favor of a flattening yield curve. But wait...theres more! As the Treasury shifted its TARP investment away from ABS, they (even investment-grade CMBS) have simply collaped in price. Accordingly, Dresdner (via FT Alphaville for us non-Dresdner clients) notes the possibility of increasing use of +10 year treasuries in convexity hedging for MBS. Since most mortgages are ~30 year it seems to me that even later maturity treasuries would be used, particularly since most of this securitization came from the hay-day of the 2000s. (I know very little about convexity hedging, any help with this is appreciated!).

Being as I'm not an expert on any of these subjects, all comments, questions, and criticisms are welcome. If you're reading this, stay tuned for a post on the USD sometime soon. Think third-world-style devaluation.

Disclosure: As of this writing, I intend (though may not) take a position in long-term maturity treasury bonds.

The Market Remedy

The major indexes were down at least 5% today bring them down to the lowest level we have seen in many years. No one is really sure what is going to happen next. Personally I thought we would see more resistance when the Dow broke below 8000, but the selling continued throughout the day. If we are to get out of this mess we need to start fixing the problem areas of the economy. Housing, housing, housing! I get sick of all this talk about the auto industry when we need to consider solving the problem of foreclosures. This is trickling down to the banks which is freezing financing which leads to higher loan rates for consumers which leads to less spending on things like autos. Liquidity in the market for MBS related products is non-existent which is causing distress in the financial sector. TARP was signed into law to hopefully combat this liquidity problem but now it has been announced that TARP is on hold. Why make all the fuss for the bill and then not follow through? I just don't get it and now we have Congress basically just waiting until the next year when they will be able to pass legislature to their liking. Market intervention is the preferred avenue to correcting the economy, but maybe we should just sit back and pass the steering wheel to the Adam Smith.

Mark Cuban

If you haven't already heard, Mark Cuban has been accused of insider trading by the SEC. It is alleged that he sold approximately 6% of Mamma.com back in June 2004 after getting some information from the CEO about a PIPE (private investment in private entity) financing. The company announced the financing in order to raise capital but through this financing existing shareholders are diluted which is why Cuban wanted to sell in the first place. He apparently sold the day before the announcement and saved some $750,000 in losses.

He also runs a Web site called Sharesleuth.com, which bills itself as providing "independent Web-based reporting aimed at exposing securities fraud and corporate chicanery." -CNBC

That is pretty ironic. Cuban obviously denies the charges brought against him, but the evidence seems pretty clear. If it took 4 years to discover this I am going to bet that they spent a good deal investigating the case. No matter what happens, I just hope that his legacy isn't ruined. I mean, he's been ejected from more NBA basketball games than Joe Dumars, and who could forget his Dancing With the Stars performance.

Citigroup Cuts 53,000 Jobs!

It was announced officially this morning that Citigroup is going to cut its labor force 20% from its peak of 375,000 employees in 2007. In October, there was an initial round of job cuts and more were expected given the market in the last 3 months. But I don't think anyone expected this many people. The hard line stance from Vikrum Pandit is bold, but it may pay off. Citigroup needs to reevaluate the way they do business as many bets against mortgage related securities have soured. Stronger competitors have emerged and will begin to take market share away from Citigroup if they don't make changes. I think this is a step in the right direction (Yes it sucks for the people losing their jobs). In hard times, firms need to be agile and adaptable in order to emerge a better company. With less employees they will be focusing better on the areas of business that have the best margins. Also I think we will start seeing the other banks (JP Morgan, Wells Fargo, B of A) do the same. It's impossible to maintain employment levels from an economy growing at 3-5% when currently there is negative GDP growth. If production levels are down then less labor will be needed to provide the goods and services.

TRS: Bad News

The Total Return Swap, or TRS, allows an investor to gain exposure to the economic return of an asset without actually holding the underlying security. The swaps, often used by activist investors, allow funds to gain economic control of a large number of shares in a company without largely disclosing their stake, as they do not technically own the shares, simply an investment tied to them. The flip side of this is that the bank with which they enter into the swap agreement hedges their exposure to the swap by purchasing the underlying shares.

My thoughts, however, are that TRS's tied to leveraged loans are actually artificially depressing loan prices. Because the banks issuing the swaps linked to the loans already have huge inventories of the securities on their own balance sheets, it's simple for the bank to simply set up an entity to purchase the loans on behalf of the swap-issuer from the bank (yes, a bank subsidiary purchasing loans from its parent). By doing this, there is no need for purchases to take place on the open market, therefore preventing large buyers from stepping into the market and providing bids.

How did AIG get stuck with all these CDSs

A question a lot of people are asking themselves is why such a strong (?) company like AIG gets stuck with so many CDS contracts. Well, here is a great post by Blogonomics explaining that AIG was essentially collecting free money by writing protection on CDOs that they assumed would never loose their value.

You don't need to know about CPDOs or about the spread between CDS and bond yields in order to answer this question. It's much, much simpler than that. The fact is that AIG didn't use "shareholders' and policyholders' cash to write protection against debt instruments". If it wanted to buy bonds, then it would have needed to come up with some cash to do so. But writing protection, by contrast, was a way of receiving money, not spending it.

When AIG wrote protection on CDOs and the like, it got insurance premiums in return, and considered those premiums to essentially be free money, since (according to AIG's own models, and those of the ratings agencies) the chances of those CDOs defaulting were essentially zero.

Now, of course, it's clear that those insurance contracts constitute an enormous contingent liability for AIG -- one so big that without government help the company would have gone bust. But at the time, no one at AIG was worried about that, so busy were they raking in the dollars insuring CDOs which they were positive would never suffer any losses.

AIG's biggest mistake was in failing to realize that this business couldn't scale in the way that most insurance does scale. Most insurance does scale: if you insure a house against fire, for instance, it's easy to lose much more money than was paid in insurance premiums. But if you insure houses across the country against fire, you'd need a nationwide conflagration in order to lose lots of money.

The CDO market doesn't work like that, however. The reason AIG's models said the CDOs couldn't suffer any losses was that house prices don't fall in all areas of the country simultaneously. Since AIG was only insuring the last-loss CDO tranches, investors with lower-rated tranches took the risk that prices in Florida, or Arizona, or California might fall. AIG would only lose money if prices fell in all those states at once -- which is, of course, exactly what happened.

But AIG never stopped to think that the event which would precipitate a payout on one CDO was exactly the same event which would precipitate a payout on all the other CDOs as well. AIG could easily afford any given CDS contract. What it couldn't afford was lots of CDS contracts -- because with CDS, unlike with most insurance, there was no safety in numbers, only more danger.

The investors in CPDOs, at least, put their money up front, and looked to make their relatively modest profits slowly, over time. They lost their money, but at least they had their money before they lost it. At AIG, the financial products group booked its profits immediately, without spending any money at all. When their losses arrived, the firm had to scramble to find the cash, since it had never allocated much in the way of capital to the group.

Insurers are always happy to take your money. But spending money on insurance is always fraught. You've spent your money up front, and now you hope that if the thing you're insuring against comes to pass, the insurance company will do the right thing and pay out. Your big fear is that they won't, either because they think they've found a reason to reject the claim, or because they've gone bust.

That's why insurers need to be very highly regulated. If they weren't, anybody could set themselves up as an insurer, take in lots of premiums, and then simply disappear. But that's also why AIG was writing protection on bonds rather than buying bonds outright. Under the insurance model, you can rake in your premiums and provision very little capital against them, so long as you wow your regulator with enough whiz-bang models saying that you'll never need to pay out on those policies. If you buy a bond, by contrast, the seller wants cash up front. And where's the fun in that?