Wednesday, July 30, 2008

Solar's Silver Lining

There is not much going on in the stock market these days. It's hard to be bullish on any sector because the fundamentals remain awful, especially in the financial sector where it seems that tons of securitized garbage is still parked in their "off-balance sheet" books. (I must confess that I am not long financials and the only ETF that I will trade is the Ultrashort Financials proshares - the SKF).

But tonight I am not going to write about the miserable state of financials or about pension governance (I can just hear the collective sigh of relief from all those senior pension fund managers!). Instead, I want to focus on renewable energy, paying particular attention to the solar sector.

Let me first direct your attention to Charlie Rose's excellent interview with Amory Lovins, chairman and chief scientist of the Rocky Mountain Institute (click here to see the interview). Lovins has authored 29 books and hundreds of studies addressing alternative energy and the economy. I learned more about alternative energy and U.S. energy policy by listening to this one interview than by reading numerous articles and books on the subject over the past year.

Lovins discusses the fate of the auto industry and how GM's management was complacent and did not take the lead on creating cost-effective energy efficient cars. They had the technical know-how but only recently woke up to the fact that the energy markets have irrevocably changed. He states that one of the big three auto makers will not be around in 18 months.

Lovins hopes to see the next President of the United States adopt a "trans-ideological" approach in developing a sound energy policy. Interestingly, he cites the fact that from 1977 to 1985, the U.S. saved oil at a rate of 5% a year, breaking OPEC's pricing power for over a decade. Then, in 1986, President Reagan reversed the energy efficiency policies that dated back to President Carter and that this was one of the crucial structural changes that increased the U.S.'s dependence on foreign oil.

In terms of alternative energy, Lovins is not in favor of corn ethanol, stating that it makes more sense to make biofuels out of grass or wood chips. Like T. Boone Pickens, he is in favor of natural gas as a substitute to oil. As far as nuclear and coal, Lovins states that they are in real trouble because "it cost too much to build or run or both and their lunch is being eaten by alternatives that we were told would never amount to much." In 2006, "nuclear worldwide added less capacity than what photovoltaics added a tenth of what wind power added or a thirtieth or fortieth or what micropower added". According to Lovins, what this means is that nuclear would make climate change worse and you would get the result a lot slower. Interestingly, Lovins states that China is the world leader in renewable energy (in fact, solar energy will power some of the buildings at Beijing's Olympic village).

Again, it is an excellent interview and it is brief so take the time to listen and make sure you take down notes. There is no doubt in my mind that we are in the early stages of a long structural bull market in renewable energy. Investors should start focusing their attention on renewable energy and fuel cell technology. Wind power and solar power will be the future and there is tremendous growth that is going on in this sector right now.

One sector that has caught my eye is solar. I have been tracking a number of solar stocks and to my surprise, the whole sector suffered collateral damage as the stock market tanked in the last few months. But unlike financials, this pullback creates tremendous opportunities for investors that want to go long renewable energy. Listen to this Tech Ticker interview with Chris Nelder, an editor at and co-author of Profit from the Peak, who maintains that peak oil -- the concept that global oil production will soon decline sharply -- is fact, not theory.

Despite his gloomy scenario, Nelder notes that intensified development of renewable energy sources are inevitable. Nelder is not a big believer in "clean coal" and he is investing in renewable energy stocks, including wind and solar. Importantly, he states that he does not see any reason why solar stocks got whacked given their solid fundamental s and he does not think that solar shares should be coupled with oil prices.

Now, let me give you my take. I believe that hedge funds are playing solar stocks like a fiddle, which explains the extreme volatility in the sector. I have seen shares of many solar companies double, triple or quadruple in a very short period, then fall back hard after they report blow-out earnings and then head right back up. Many of these solar companies are profitable and even the ones that have no earnings yet are growing at such exceptional rates that it is only a matter of time before they become profitable.

The leader in the solar sector is First Solar (FSLR). They reported Q2 earnings after the bell today and they crushed earnings estimates. FSLR posted revenue of $267 million and profits of 85 cents a share; the Street had expected $216.9 million and 58 cents. In late trading, FSLR is up $19.50, or 6.8%, to $304.50. FSLR is considered to be a leader in the sector so barring some unforeseen event, I expect solar stocks to rally tomorrow. (You might want to know that America's richest family - the Waltons - own a huge stake in the company).

But FSLR is hardly cheap. It is currently trading at 130x trailing and 75x forward earnings. If you believe that everything regresses to the mean, either valuation has to come down dramatically or earnings have to increase dramatically so it starts trading at reasonable valuations. Other sector leaders like SunPower (SPWR) are also trading at high valuations. Nevertheless, they are growing exponentially and show no signs of slowing.

The good news for investors is that there are many other solar companies in the sector that are trading at reasonable valuations. One of my favorites is Solarfun (SOLF) but there are many others like LDK Solar (LDK), Renesola (SOL), Yingli Green Energy (YGE), Trina Solar (TSL), Canadian Solar (CSIQ), Suntech (STP), GT Solar (SOLR) and MEMC (WFR). And there are others like Evergreen Solar (ESLR), Hoku Scientific (HOKU) and China Sunergy (CSUN) that do not have earnings yet but are growing at a torrid pace (I particularly like Evergreen Solar's low-cost String Ribbon wafer technology). Here in Canada, I track a few other solar plays like Timminco (TIM.TO), 5N Plus (VNP.TO) and a speculative play on the Venture exchange called Opel International (OPL.V).

Apart from the naked short selling by hedge funds, the sector also got hit because governments are cutting subsidies but the technology has drastically improved, lowering costs so subsidies are not needed to maintain their growth model. If there is one silver lining in this crappy stock market, renewable energy stocks like solar shares are probably it. Keep an eye on this hot sector; despite the short-term headwinds, it is still in the early stages of a structural multi-decade bull market.

Tuesday, July 29, 2008

Merrill Gives Away Its Toxic Waste

The market reacted favorably today to Merrill Lynch's announcement that it is selling its CDOs to Lone Star Funds, a Dallas private equity firm, for the basement-level pricing of 22 cents on the dollar. Most market analysts viewed this move as 'constructive' or a 'watershed for banks' , but investors better scrutinize this deal before jumping to any conclusions.

I read two important articles that critically examined this deal. The first, Merrill’s Latest Misfire, was written by Elizabeth MacDonald of Fox Business News. Ms. MacDonald states the following:

Merrill Lynch’s shocking announcement after the market’s close yesterday that it will book a huge pre-tax $5.7 bn writedown in its upcoming third quarter from its toxic securities and hedges with bond insurers, plus raise another $8.5 bn in new stock, should make investors who piled into the shares just last week at $31 thinking the worst was over after Merrill reported its disastrous second quarter results feel totally blindsided.

It defies reason that Merrill did not know about this massive problem in its book of business, that it didn’t see this freight train of a writedown coming when just last week it disclosed $4.9 bn in second quarter losses due to $9.4 bn in writedowns for the period. Wall Street had expected lesser sums here, $1.8 bn in losses due to $6 bn in writedowns.

At minimum, do you really think it takes only about a week to convince foreigners to invest even more money at a time when the stakes they’ve already bought in Merrill earlier this year are now drastically under water?

Ms. MacDonald goes on to add:

Investors in Merrill should be notably concerned with what is happening at the country’s largest brokerage. Merrill was a repackaging factory for some truly toxic subprime debt, including those pumped out by Countrywide Financial. Countrywide pointed its conveyor belt of nasty loan products at Wall Street, and Merrill was first in line to gin them up into asset-backed securities.

Merrill’s latest writedowns resulted from the sale of a huge $11.1 bn slug of its asset-backed securities, helping to create the latest $5.7 bn pre-tax writedown. It also pulled the plug on hedges with troubled bond insurers, the two white hot zones on many financials’ balance sheets.

Watch how this deal to unload a whopping slug of Merrill’s distressed debt breaks down. Merrill said it sold $30.6 bn worth of distressed debt in the form of super senior asset-backed debt for just $6.7 bn. Merrill had just said at the end of its second quarter these assets were worth $11.1 bn, or just 36 cents on the dollar.

So, being that it has sold this distressed debt, called collateralized debt obligations, for just $6.7 bn to a unit of Lone Star Funds, a Dallas private equity firm, when you do the math, that’s about 22 cents on the dollar. That’s a writedown of 78%. Gasp. That created $4.4 bn of the writedown.

Moreover, Lone Star only has to pony up $1.7 bn to seal the deal, borrowing the rest, or 75%, from Merrill. So Lone Star is effectively putting up just 25% of the deal, about six cents on the dollar, for the gross value of the deal. “That does not sound very good for the about-to-be diluted shareholders, now does it?,” says Jill Schlesinger, executive vice president and chief investment officer for StrategicPoint Investment Advisors.

One of the sharpest minds on Wall Street, Whitney Tilson, points out that Merrill’s announcement said Lone Star ” will not own any assets other than those pursuant to this transaction.” Tilson says that means Lone Star is setting up a special unit to house Merrill’s toxic CDOS, sheltered away from the pension, family trusts, endowment assets and insurance company portfolios Lone Star manages. That means if Lone Star defaults on its loan from Merrill, the only assets Merrill has recourse to are these CDO assets, Tilson notes.

So Tilson asks whether Merrill got to book this deal as a $6.7 bn sale, or as a $1.7 bn deal, with an account receivable on its balance sheet of $5.0 bn.

Does anyone at Merrill or on Wall Street know what these assets are really worth?

Apparently not and keep in mind that these Wall Street "geniuses" are the same people who sold this toxic garbage to institutional pension funds around the world.

The second must read article, Super-Senior Tranches of CDOs are Worth Much Less than 22 Cents on the Dollar: Another Ponzi Scheme of “Selling” Toxic Garbage with More Leverage, comes from Nouriel Roubini's Global Economonitor.

Given its importance, I quote the entire article below:

Nouriel Roubini | Jul 29, 2008

Merrill Lynch decision to “sell” a good chunk of its remaining CDOs at 22 cents to the dollar has been widely praised as the firm finally recognizing the full extent of its losses on these toxic instruments. This batch of $30.6 billion of CDOs was already marked down to $11.1 billion. Now with the “sale” of it to Lone Star at a price of 6.7 billion Merrill Lynch is taking another $4.4 billion writedown and “selling” it at 22% of the original face value.

But is this a market-based “sale”? No way as calling this transaction a “sale” is a joke.

Let me explain next why…

First, note that the secondary market for CDOs is now extremely illiquid and Merrill will provide financing for 75% of the purchase price, or a financing of $5.055 billion. That implies that these CDOs are worth much less than 22 cents of the dollar. These type of “sales” transactions – broker dealers “selling” their toxic waste at a discount and providing hedge funds and private equity funds with heavily subsidized financing for it – has going on for a while. That discounted “sale” price often ends up being much higher than the true value of the assets (and the ensuing writedown of the assets is smaller than the correct one) because of three reasons:

  • the selling broker dealer is providing most of the financing for the transaction as this market is totally illiquid and no one could dump $11.1 billions of toxic and illiquid CDOs in such a market;
  • the interest rate at which the financing occurs is often significantly lower than the appropriate rate at which this risk financing will occur. Merrill has not announced what are the terms of its financing of this deal and this leaves the serious suspicion of a heavily subsidized transaction;
  • the collateral for this risky financing is the same toxic waste that was sold to a fund. In the case of the Merrill transaction if the market value of this $11.1 tranche (now priced at $6.7 billion) falls another 25% the collateral for the 75% financing (that is non-recourse as it is secured only by the collateral) will be worth less than the underlying assets and thus additional losses will be incurred by Merrill. In other terms, as pointed out by Bloomberg since “the financing is secured only by the assets being sold, meaning Merrill would absorb any losses on the CDOs beyond $1.68 billion”. Thus, in a extreme scenario in which the CDOs actually end up being worth zero Merrill will end up having sold them to Lone Star for 5.5 cents on the dollar rather than 22 cents. I.e. leaving aside the first loss of 25% taken by Lone Star all of the remaining credit loss is borne by Merrill.

So, based on the above consideration, is this toxic junk worth 22 cents on the dollar? No way and one would have to assume that the true market value of this garbage is closer to zero than 22 cents. So the street is now arguing that 22 cents on the dollar sets a market benchmark for writing down CDOs (Cit is still carrying them at a value of 53 cents rather than the 22) and many other firms will now have to use this benchmark; but the reality is that this toxic garbage is worth much less than 22 cents. So the charade of pretending to mark down to market the value of this junk will continue for a few quarters with continued bleeding of earnings.

At this point it would be more honest for the financial firms to write down to zero the value of these assets (with possible positive revaluation if they turn out being worth more than zero) and keep them on balance sheet rather than pretending to “sell” them via greater debt that massively adds to the credit risk that these firms are taking at the time when they should be deleveraging rather than releveraging further.

What is the sense of taking on another $5 billion of risky debt that has toxic garbage as collateral? Is this sound financial balance sheet restructuring or another Ponzi scheme of a house of debt-upon-debt cards? Selling worthless junk and providing financing for it is not a “sale”; it is another accounting scam whose purpose is hiding the full extent of the losses on garbage, not coming clean on them. So beware of the cheerleading chorus of banking “analysts” praising Merrill and this transaction.

The entire episode stinks with the Merrill CEO making a series of misleading statements on Q2 earnings and on no need for further capital and now coming out of the blue with this new surprise and a new large capital injection that will massively dilute current shareholders a few days after the dismal Q2 results were reported. Add to this charade the fact that what will be raised in this new round of recapitalization be much less than the announced $8.5 billion once Temasek and other shareholders who participated in the previous recap will be compensated for the massive losses they incurred in that round of recapitalization of Merrill.

If this is the way to run the finances of one of the largest broker dealers in the most advanced financial system in the world it is not wonder that this system is totally broken. The smart and very savvy Mohamed El-Erian (co-CEO of Pimco) put it in polite terms when he recently said while commenting on this financial crisis: “What has suffered most is the credibility of the most sophisticated financial systems in the world." Or as Bill King (a senior financial analyst) put it: "Eventually a critical mass of investors and traders will become cognizant of the obvious scheme and distrust of financial firms’ results, guidance and motives will increase substantially. John Thain’s credibility is now an issue". It is both the credibility and viability of the most sophisticated financial system that is at stake now as most of this financial and banking system is on its way to substantial and formal insolvency and bankruptcy.

Or, as Barry Ritholtz aptly put it in much less polite terms than El-Erian and King in his latest blog:

How Screwed are the Investment Banks?

A brief review of recent Merrill (MER) CEO statements:

1. We don't need capital;

2. We could use some capital, but we won't sell shares, we'll just sell some assets;

3. We need to sell shares and raise capital right away;

Where is Ken* when you need him?

The financial firms obviously think investors are utter fools. And for a while, they were correct. They suckered people into buying into this mess the whole way down. Bottom calls each and every level -- all of which failed. Some analysts even called iBanks a "Generational Buys" -- 30% higher.

Only not so much.

Release earnings. Issue guidance. A few weeks later, lower earnings. A few weeks after that, take more write-downs. Raise more capital. Start it all over again next quarter.

Rinse. Lather. Repeat.

The banks have adopted a Chinese water torture approach -- dribbling out the bad news in small doses over time. Its been working up until now, but I doubt it will keep working much longer. Can they keep fooling people much longer? Merrill issued quarterly earnings on July 17th, and then dropped this bomb shell on July 28th? They must really think we are idiots, and that the SEC is in their backpockets to even attempt getting away with this crap.

What remains to be seen is how these massive writedowns will affect the pricing of illiquid CDOs (and ABCP) at Canadian and global pension funds. If this trend continues into 2009 - and there is no reason to believe it won't - investors can expect more writedowns from banks and pension funds.

(Note: You can read more about Lone Star Funds and its founder, John Grayken, in this New York Times article and this clusterstock article.)

Monday, July 28, 2008

Pension Governance: Risk Management Gone Awry!

Risk management is a cornerstone of sound pension governance yet very few pension funds understand what proper risk management actually entails. I will discuss some important risk management concepts below, highlighting the strengths and weaknesses of risk management using some clear examples.

Let's begin by defining "risk management". The five major risk categories below are taken from CPP Investment Board's site:

  1. Investment risk: The risk inherent in achieving investment goals and objectives, including market, credit and liquidity risk. The operationalization of our Risk/Return Accountability Framework has substantially increased the risk management focus of our investment decision-making. Under this approach, risk decisions are made at the total portfolio level. The board of directors approves an active risk limit, and management strives to maximize active returns within this limit not within individual asset classes.

  2. Strategic risk: The risk that an enterprise or particular business area will make inappropriate strategic choices or be unable to successfully implement selected strategies. The CPP Investment Board's business plans are created annually to operationalize our strategic direction. Progress against the business plans is reviews quarterly by senior management with our board of directors.

  3. Legislative and regulatory risk: The risk of loss due to non-compliance with actual or proposed laws, rules and regulations and prescribed industry practices. Our primary risk management strategy here is our compliance management process, which ensures we have robust practices in place to manage legislative and regulatory risk. It includes oversight by our Legal department and also obtains input from external legal counsel to ensure completeness and accuracy in compliance with all relevant regulations.

  4. Operational risk: The risk of loss from inadequate or failed internal processes, people or systems, or from external factors. Strategies to mitigate operational risk include performing risk and control reviews and continuing our strong hiring practices to ensure that we have the right resources to meet our business challenges. Our operational risk activities also include a business continuity program that defines the best response to any business interruption at the CPP Investment Board.

  5. Reputation risk: Risk of loss of reputation, credibility or image due to internal or external factors. Reputational risk management will continue to be a key focus for our Enterprise Risk and Controls Group in 2008. We will strengthen our approach by building on the solid foundation we currently have in place. The CPP Investment Board has built a culture based on strong ethics which guides all our activities as reflected in our code of conduct. As an example, all employees and directors are required to disclose and personal trading or business interests that might lead to a real potential or perceived conflict of interest or result in personal benefit.

In terms of managing risk, CPPIB states the following:

The board of directors is responsible for ensuring that management has identified the principal risks of the business and has established appropriate policies and internal controls. In turn, management is responsible for recommending policies to the board for its consideration and approval, establishing internal controls and procedures to effectively manage the risks of the organization and providing reports to the board and its committees. Internal auditors, in the course of executing their audit plans, also provide input to management and the board on the effectiveness of the organization’s risk management practices.

We continuously review, assess and manage our risk management concepts and other practices to ensure that risk is managed effectively. For example, the board of directors limits the maximum investment risk that management can assume. The board of directors likewise approves maximum allocations to various investment activities and asset classes.

It also approves credit risk limits, while the president approves the amount of risk that can be taken relative to passive benchmarks (active risk). We also manage cash liquidity risk. Management presents to the board a quarterly report on our compliance with all risk limits, other constraints and the effectiveness of our risk management controls.

It is worth noting that CPPIB happens to have implemented one of the better risk management systems around. They even have a whole division run by John Ilkiw, Senior Vice-President - Portfolio Design and Risk Management, that is responsible for research to support the development of investment policies and value-added strategies including risk management.

Furthermore, CPPIB has a set of policies, guidelines and by-laws that help govern all five risk categories mentioned above. Of these, The Statement of Investment of Objectives, Policies, return expectations and Risk Management for the Investment Portfolio, is the document that explains how investment risk is managed.

On page 7, we see how active risk - the risk taken away from the Policy Portfolio - is managed:

7.1 The Board reviews and approves annually a Fund-level active risk limit relative to the Reference Portfolio within which CPPIB has discretion to make and implement investment decisions with the objective of earning returns above the Reference Portfolio.

7.2 The risk limit is large enough to permit CPPIB the flexibility to achieve the total Fund value-added objectives established by the Board, but not so large as to put Fund assets at undue risk of loss relative to the performance of the Reference Portfolio.

7.3 At no time can the Fund’s active risk exceed the Board-established limit, unless authorized by the Board.

7.4 CPPIB monitors, evaluates and manages active risk exposures relative to Reference Portfolio and allocates risk exposures across investment departments as necessary to maximize the Fund’s active management returns.

7.5 CPPIB reports the active risk exposures to the Board at least quarterly or more frequently as required.

In terms of managing market, credit and other financial risks, CPPIB has implemented the following procedures:

9.1 Market risk is managed by diversifying across different asset classes and investment strategies such that Fund assets are not imprudently exposed to any single unexpected event. In addition, risk budgeting principles and analytical tools are used to measure, monitor and evaluate prospective Fund performance under different market conditions using Value-at-Risk and Capital-at-Risk measures.

9.2 Until credit risk can be reliably incorporated into an integrated market risk model, it will be managed by adhering to credit policies and limits developed by CPPIB, and reviewed and approved by the Board at least annually. Exceptions to Board approved policies or limits can be granted by the President and CEO, but are subject to the review of the Board as soon as is practical.

9.3 Individual private market investments that exceed Board-established dollar limits must be approved by the Board before being implemented. Examples of such private markets investments include private equity, private debt, private infrastructure and private real estate.

9.4 Wherever possible the volatility of private market or non-regularly traded assets is estimated using suitable public market proxies.

9.5 CPPIB reports the Fund’s exposure to market, credit and other financial risks to the Board at least quarterly or more frequently as required.

Now, a couple of my observations. As I have stated in previous posts, the failure of CPPIB to provide clear performance benchmarks for each and every internal and external investment activity is a serious shortcoming. The investment policies should cover all investment activities in detail, providing information on how the benchmarks accurately reflect the risk and return profile of underlying investments. Moreover, CPPIB should clearly state what the approved asset mix weight ranges for each of the major asset classes. CPPIB should also disclose the active risk budget for the total Fund.

In terms of risk management, however, it is clear that CPPIB has implemented a proactive approach by informing its board of directors on a quarterly or more frequent basis of prospective fund performance using Value-at-risk (VaR) and Capital-at-risk (CaR) measures. These measures ensure that any severe investment losses will be brought to the board's attention on a timely basis and the necessary steps will be taken to mitigate any losses that exceed VaR limits (VaR is estimate of the maximum potential change in the value of a portfolio of financial instruments with a given probability over a specified time period).

Why is this important? Well, go back to PSP Investments' 2008 Annual Report and ask yourself how did its board approve CDOs in the first place and what risk measures were undertaken to mitigate the risks of this portfolio? Was the $470 million loss in CDOs marked-to-market and if so, how did PSP's senior management and board allow it to reach such a level without stop losses being triggered or without properly hedging these losses?

I point this out because on page 21 of the Annual Report, we read that in addition to VaR, "PSP Investments uses other investment risk measures including stress testing, scenario analysis and
sensitivity analysis." Surely these measures should have sufficed to mitigate investment losses at a certain dollar amount.

They obviously did not work. The magnitude of the losses exposes some serious shortcomings in the entire risk management process that governs investments at the PSP Fund. (
Was the board of directors properly informed of the risks of these investments and were they made aware of the losses on a timely basis? If so, why weren't stop losses triggered and why wasn't the portfolio adequately hedged? Was there proper segregation of duties between risk management staff and investment staff and between the CIO & CEO functions at the pension fund? Who was ultimately responsible for these losses and more importantly how are they held accountable?)

Moreover, on page 15 of the Annual Report, we read the following:

PSP Investments has an active management strategy designed to add value to the Policy Portfolio, in accordance with a risk budget, approved by the Board, which management allocates to active strategies. Within this framework, management works to optimize its “roster” of active strategies, in order to meet the value-added objectives set out above, under the “Investment Objectives” heading.

Active management involves both internal and external managers and is not limited to the asset classes of the Policy Portfolio. It includes mandates in other spheres such as currency management and tactical asset- allocation across countries and asset classes. Indeed, PSP Investments believes that the best way to achieve its active management target is through the diversification of its return sources. That process continued in fiscal year 2008: we added four new active mandates, using internal and external managers.

Also, in the careers section of PSP Investments' website, under the position of Manager, External Managers Search & Monitoring, we read the following:

Within Public Markets at PSP Investments, the External Manager Search & Monitoring team currently manages a portfolio of approximately $12 billion. These assets are invested with over 20 external managers, in a variety of traditional and alternative strategies. The Manager, External Manager Search & Monitoring will play a crucial role in managing this portion of PSP’s assets.

Given the abysmal performance of active management in Public Markets in FY 2008 (equities underperfomed their benchmark primarily due to public equities' severe underperformance), shouldn't PSP Investments provide a detailed portfolio breakdown of these active internal and external strategies so that stakeholders can understand where losses were concentrated? Shouldn't PSP Investments disclose who is the Vice President responsible for searching and monitoring external managers and how this person and their team are compensated for this activity? (i.e. what is their performance benchmark and does it adequately reflect the beta and the risks of the underlying investment strategies?)

Importantly, if this $12 billion portfolio of external managers swings wildly from one year to the next, then this signals a concentration of beta (market) risk, indicating too many traditional and/or alternative managers that are highly correlated to public indexes. This might also indicate too many external managers are highly correlated to each other. If this is the case, then why bother paying investment management fees for beta when you can just as easily swap into a large cap index
or replicate their main positions through passive derivative instruments for a fraction of the cost?

I am not reinventing anything new here. Leading authorities on risk management like Dr. Frank Sortino have written books and papers about how to properly measure and mitigate against investment risk. One of these, Managing Downside Risks in Financial Markets, has a whole chapter that discusses risks from alpha to omega. For Sortino, it isn't just about risk-adjusted returns but about managing downside risks for each investment activity of a pension fund. (Dr. Sortino founded the Pension Research Institute).

It is worth noting that some pension funds also include explicit discussions on funding risk and operational risk management on their website. For example, the Hospitals of Ontario Pension Plan (HOOPP), states the following for funding risk management:

Living up to its pension obligations, current and future, is HOOPP’s number one priority. But it is by no means our only priority. On the funding side, we’re also committed to:
  • keeping contribution rates at reasonable levels, so the Plan remains affordable
  • keeping contribution rates stable, so that members and participating employers can budget accordingly

To help achieve these important objectives, HOOPP has implemented and advanced a number of funding risk management safeguards. For example:

  • HOOPP conducts a funding valuation each year to gauge the Plan's assets and liabilities (pension obligations). As part of the valuation process, HOOPP works with an independent actuarial advisor to prepare projections of its future funding requirements.
  • HOOPP has established a detailed funding policy that:
    • provides a framework for making informed funding decisions
    • sets “trigger” points that flag potential adjustments to contribution and/or benefit levels

While these are important safeguards, risk management is an ongoing process. HOOPP lowered its long-term investment return assumption in 2007. Adopting a lower, more conservative investment return assumption is consistent with the Plan’s move toward a more risk-averse investment strategy.

We also moved ahead with the implementation of a multi-year funding and risk management program designed to:

  • improve the quality and availability of funding data
  • better measure and manage funding risk
  • bring investment strategies more in line with funding needs
On operational risk management, HOOPP states the following:

In addition to funding and investment risk, HOOPP faces a number of operational risks related to the day-to-day governance and administration of the Plan. While it is impossible to predict let alone preclude every operational risk, HOOPP has – based on industry best practices – taken a number of key steps to protect the Plan and its stakeholders:

HOOPP’s Board conducts an annual review of its governance structure and procedures.

  • The Plan has a number of policies in place designed to minimize operational risk, such as:
    • a code of business conduct
    • a policy governing confidentiality and disclosure of information
    • a whistle-blower protection policy
    • conflicts of interest policies
    • a privacy policy

  • HOOPP has a regularly tested business continuity plan in place. This rigorous plan is designed to ensure that HOOPP can – in the event of a disaster – recover its critical systems at an off-site location and carry on core business functions (including the processing and payment of pensions).

  • During 2007:
    • HOOPP introduced a succession planning strategy to ensure it has the knowledge-based talent it needs going forward
    • moved forward with comprehensive reviews of its internal controls and compliance processes
I highlight whistle-blower protection policy because in my opinion, without proper protection for whistle-blowers, all risk management policies at pension funds are doomed to fail. This is the single most important policy and unfortunately very few public pension funds have implemented whistle-blowing protection policies with any teeth. (They should work with Certified Fraud Examiners to develop these policies and publicly disclose them to all stakeholders. Moreover, whistle-blowers should be protected for having the courage to come forth when they see something that is not in the best interest of beneficiaries and other stakeholders.)

Succession planning is also important and many pension funds do not take the adequate measures to ensure continuity of their investment staff if senior members leave. Of course, any pension fund (or investment fund for that matter) that suffers from a high employee turnover rate is doomed to suffer from low employee morale and succession planning issues. All of these issues need to be addressed by the board of directors and the information needs to be transparent to all stakeholders.

Finally, I urge all board of directors to view this checklist provided by the Japanese Financial Services Agency (press cancel when window pops up and print). Sound pension governance includes a self-assessment questionnaire that asks some tough questions. Given the importance of board of directors at these public pension funds, self-assessments should be carried out on an annual basis.

KKR: Has Private Equity's Death Knell Just Rung?

Private equity giant KKR, which gained fame by taking RJ Reynolds private two decades ago, will go public on the New York Stock Exchange through a takeover of its Amsterdam-listed investment fund KKR Private Equity Investors LP.

This morning David Faber talked about the deal on CNBC's Squawk Box (click here to see discussion). It is worth mentioning that KKR isn't looking to raise new capital, but the arrangement with KKR Private Equity gives it access to the fund's investments at a much cheaper price. And for investors in KKR Private Equity, who have watched shares fall from their initial listing price of $25 to the $10-range, the deal provides assurance that they will recoup some of their losses.

Unlike Blackstone's partners, KKR's partners will not cash out on the deal. At least not for the next six years. Instead, the two founding partners released the following statement:

"For KKR, this transaction provides us with additional capital for our business. Moving forward with a public listing will allow KKR to do what we do best -- grow companies around the world and produce solid returns for our investors from a larger platform and a deeper capital base."

Clearly times are not good for private equity. That closed end fund in Europe was trading at a 50% discount of its net asset value (NAV). KKR's partners were forced to do something to bolster the fund and I think it was a good move on their part (the market seems to agree as the Amsterdam-listed fund jumped 27 percent this morning).

In my opinion, private equity's woes will continue. Last August, Fortune published an article, Why the private equity bubble is bursting, which described the origins of the private equity mania:

The combination of low interest rates, depressed stock prices, and rising corporate profits created ideal conditions for private equity firms to flourish. Using dollops of cash and bushels of debt, they were able to snap up solid companies on the cheap - in 2002 buyout prices averaged just four times cash flow (defined as earnings before interest, taxes, depreciation, and amortization, or Ebitda). In a typical deal a private equity shop would borrow about 70% of the purchase price (those loans go on the acquired company's balance sheet, often doubling or tripling its debt load).

With that kind of leverage, even modest improvements in the company's profits generated huge returns for the private equity firms and their investors. In some cases, they paid themselves dividends that allowed them to recoup their entire investment within a year. And to top it off, they raked in huge fees from the companies for arranging the deals and the financing, as well as for managing the business. (The deals also got a boost from Uncle Sam. The interest on all that debt is tax-deductible, so the companies saw their tax bills drop drastically.) The math made the buyouts bulletproof. "The market was so good that dead people could have made money on LBO deals," says Chris Whalen, a managing director at Institutional Risk Analytics.

The article ends off by stating the following:

For the private equity shops, higher rates reduce the potential value of the companies they hold, since a new buyer will pay more in interest to carry the debt. "If spreads on high-yield debt stay this wide, it's extremely negative for the profitability of private equity firms," says legendary investor Carl Icahn.

The biggest losers, though, are likely to be the swashbuckling hedge funds that gorged on high-yield debt and did it in the most reckless way possible. To amp up their returns, they borrowed heavily to buy the bonds of already highly leveraged companies. That's piling risk on top of risk in a rickety structure that a slight bump can topple. Wall Street firms promoted the practice. Not only did they sell high-yield bonds to the hedge funds, they also lent them money through their prime brokerage arms to buy the bonds on margin. It wasn't uncommon for the funds to borrow 80% of the price of the loans. With that kind of leverage, for example, they could earn 18% or more owning bonds with a nominal interest rate of 10% or so.

The same leverage that magnified their returns will multiply their losses, with potentially dire effects. Here's what the worst-case scenario might look like: As the hedge funds get margin calls from Wall Street, they're forced to dump their holdings of loans and bonds to raise cash. The glut of distressed debt for sale crashes prices and pushes yields to towering levels. Then everyone holding high-yield debt, from Asian banks to small investors with money in junk-bond mutual funds, will take a horrendous pounding.

What we're seeing here is simply sanity returning to the market. And as always in the aftermath of a bubble, sanity returns the hard way.

Sanity has indeed returned the hard way. It's amazing to see how so many "smart" pension funds rushed to diversify their asset mix away from public equities into private markets like private equity, real estate, and infrastructure. It only proves that smart money does do dumb things when they act collectively.

An article from the Boston Globe puts it more succinctly:

Investors stretching for yield are making all kinds of markets do strange things. Look at the subprime mortgage market to see how that practice can end badly. Private equity's debt bubble could become another story with an very ugly ending.

The private equity and real estate party is over. Investors need to carefully monitor their private investments, making sure that they are investing into top quartile distressed debt funds and they need to pay careful attention to their fund's total exposure in private markets to properly manage downside risk.

As far as pension fund managers waiting for an improvement in credit conditions, they might want to remember Keynes' other famous quote that "markets can stay irrational longer than you can stay solvent" and take this opportunity to revisit their redemption policies.

Saturday, July 26, 2008

The Straw That Breaks The Camel's Bank?

Last October, Fortune published an article, The $915B bomb in consumers' wallets, which highlighted the problem of credit card debt in America. The article described the "doomsday scenario" as follows:

Just like CDOs and other asset-backed securities, credit card debt is sliced, diced, and sold off again as packages of securities. Rising delinquencies would hurt not only the banks involved but the securities backed by the credit card receivables. Those securities would decline in value as consumers defaulted, leading to bank losses as well as portfolio losses in the hedge funds, institutions, and pensions that own the securities. If the damage is widespread enough, it could wreak havoc on the economy much as the subprime crisis has done.

Importantly, the article mentions that credit card debt is different from subprime debt in a fundamental way:

Unlike mortgages, credit card debt is unsecured, so a default means a total loss. And while missed payments are at a historical low, they show signs of an uptick: The quarterly delinquency rate for Capital One, Washington Mutual, Citigroup, J.P. Morgan Chase, and Bank of America rose an average of 13% in the third quarter, compared with a 2% drop in the previous quarter.

Keep in mind that was last October. This past week, Harvard Law professor Elizabeth Warren testified before the U.S. Congress' Joint Economic Committee. I quote the following from the CNN article, Middle class: 'On the edge':

Adjusted for inflation, median household income dropped by $1,175 between 2000 and 2007...

At the same time, the average family is spending $4,655 more on basic expenses, such as gas, housing, food and health insurance. Gas alone costs $2,195 more for a family making the same commute in May 2008 as it did eight years earlier.

Families with children saw their child care costs soar. Those with children under age 5 spent an additional $1,508 a month, while after-school costs for older children rose $622.

To cover these soaring expenses, many people have had to turn to credit cards. Nearly 10% of total disposable income in the United States goes to paying off such debt, Warren said.

"There have never been since the Depression so many families standing right on the edge," Warren said. "Families have tightened their belts. They have cut down in every discretionary spending area they possibly can."

"These costs are tearing a hole in the family they simply can't make up," she added. "You can't cut out enough lattes to pay for health insurance in America."

In article posted on ABC News, Credit Cards: The Next Financial Crisis?, Alice Gomstyn reports that to avoid a financial crisis, credit card companies are increasingly raising interest rates, lowering credit limits and canceling inactive accounts. I quote the following:

In the first three months of the year, commercial banks in the U.S. took losses on 4.7 percent of their credit card loans, up from 3.9 percent the year before, according to the Federal Reserve.

In the last two weeks, major credit card players like American Express, Capital One, Citigroup and Bank of America have all reported larger losses from unpaid card bills. American Express saw second-quarter profits from its U.S. credit card business fall a stunning 96 percent from $580 million in the spring of 2007 to $21 million this year. (Overall, the company reported $655 million in second-quarter profits.)

"The credit card companies have really found themselves in a huge, huge hole," said Robert Manning, the director of the Center for Consumer Financial Services at the Rochester Institute of Technology.

Manning argues that banks themselves, not credit card users, should shoulder much of the blame for rising delinquencies and defaults. As the financial slump took hold, he said, banks started relying on their profitable credit card arms to compensate for losses in other divisions such as mortgage lending.

This practice, he said, came at a price -- revenues were being bolstered, in the short term, by drives to offer higher credit limits and more credit cards to higher-risk borrowers.

Credit card lending became "a bit too aggressive," said John Ulzheimer, the president of consumer education for, a credit card information site. "People were getting credit vehicles maybe they should not have been getting. Those bad issuances of cards are, in many cases, coming home to roost right now."

Interestingly, the article goes on to state:

Analysts agree that credit card troubles alone likely won't be enough to topple any one bank in the same spectacular fashion that subprime mortgage losses led to the collapse of Bear Stearns.

But Ron Ianieri, the chief market strategist for the investor education company Options University, said that for banks already suffering from other financial woes, more trouble on the credit card front "could be enough to be the straw that breaks the camel's bank."

"I don't think a credit card crisis would be strong enough to collapse a bank under normal conditions, but these aren't normal conditions," he said. "These banks are teetering right now as it is. One more push -- it doesn't have to be a big push -- and it could knock them off the top."

Analysts like Ulzheimer, however, don't see the need to ring any alarm bells and neither, apparently, do the banks.

"We obviously do not know the extent of the current downturn, but the position of our company today is financially sound and competitively strong," American Express CEO Ken Chenault said in a Monday conference call on the company's earnings.

If you ask me, the slide in American Express' share price is sending an ominous warning to all investors that the credit crisis is far from over. Americans were using their inflated house prices like an ATM machine to extract from their home equity lines of credit, but when house prices started to decline, they switched over to credit cards to make ends meat.

I have been warning my readers that the worst is ahead of us, not behind us. We will experience a prolonged period of debt deflation that will rip through the global financial system. Incidentally, credit card debt is not just an American problem; the United Kingdom and other European nations face similar credit card debt problems. As their economies slow, consumers there are also trying to survive by taking on more debt, including credit card debt.

The end game of all this will likely be a prolonged period of debt deflation. An article in the Asia Times, Debt capitalism self-destructs, correctly points out the following:

The once-dynamic US economy has turned itself into a system in which it is difficult to find any institution, company or individual not over their head in speculative debt. Undercapitalized capitalism, also known as debt capitalism, has been the engine of growth for the US debt bubble in the last two decades. This debt capitalism cancer is caused by a failure of central banking.

In the face of a broad systemic collapse of debt capitalism, where capital has become dangerously inadequate and new capital hazardously and prohibitively scarce, having been crowded out by massive debt collateralized by overblown assets of declining value and with a credit crisis that clearly requires systemic restructuring and comprehensive intensive care, those in the US responsible for the financial well-being of the nation seem to have been reacting tactically from crisis to crisis with a script of adamant denial of obvious facts, symptoms and trends, with no signs of any coherent grand strategy or plan to save the cancerous system from structural self-destruction.

This band-aid short-term approach to artificially pop up share prices in the collapsing equity market and to maintain insolvent financial institutions with technical life-support will lead only to long-term disaster for the whole economy.

But before we get to that point, policymakers should watch William Greider's interview with Bill Moyers (click here to watch interview).

I quote the following from the transcript:

What were you thinking as you saw that report from Cleveland?

WILLIAM GREIDER: Made me angry all over again, even though I know the story. And then I thought, "This is usury." This is a living example of what the Bible prohibited, which is the sin of usury. Most Americans have never heard of it probably.


WILLIAM GREIDER: Usury, to be clear about it, is rich people taking advantage of poor people by lending them money on terms that are sure to make them fail. All three of the great religions, Judaism, Christianity, Islam, had a moral prohibition against usury because they recognized that society can't function like that. People of great wealth and their institutions like banks naturally have the power to overwhelm people of lesser means. And you can't allow that in a decent society. It won't survive.

BILL MOYERS: Where were the gatekeepers? Where were the watchdogs? Why did it take the Fed so long to put an end to-


BILL MOYERS: -predatory practices?

WILLIAM GREIDER: To make the story overly crude, Congress repealed the law against usury. It was done in 1980 by a Democratic Congress, Democratic President. And, of course, the Republicans all piled on and voted for it. And that was the first stroke, only the first of many, in which they stripped away the regulatory laws from the financial system and from banking.

And that allowed the free market modernized gimmicks of one kind or another, all these things we're now reading about, to flourish. And that's where we are. I mean, the gatekeepers said to the banking industry and to the financial industry, "We don't think federal control or regulation is good for you, so we're, therefore, liberating you to do your own thing."


BILL MOYERS: Maybe that's why all the foreign investors rushed in yesterday to buy Fannie Mae and Freddie Mac-

WILLIAM GREIDER: It might have some connection, yes.

BILL MOYERS: -if they know the taxpayers are going to put the money in, they've got a pretty good-

WILLIAM GREIDER: They've got what you might call a no-lose proposition. And the other part of that, and this would be simple. You could pass this in three days. Restore the federal law against usury. That won't have too many details to it at first. But it'll be a general statement that the federal government is prohibiting the kind of outrageous predatory practices, which have become general in this country, of not just banks but other financial firms.

BILL MOYERS: Credit card companies and-

WILLIAM GREIDER: Credit card - yeah, it's a long list. We know those abuses.

BILL MOYERS: Put some limits, some boundaries?

WILLIAM GREIDER: Well, eventually you have to draw very precise boundaries, I think, and restore some structure that says, okay, you can get a return of X on credit cards, but you can't get a return of triple X, right? And that kind of regulation. And that's not easy to draw. It takes a while.

But the first law that would just reassure the public, we're against usury. Muslims are against it. Christians are against it. Jews are against it. And we're going to develop a government laws that prohibited and penalized these institutions when they get caught doing it.

BILL MOYERS: Excessive interest, owned loans.


BILL MOYERS: That's what you mean by usury?

WILLIAM GREIDER: That's the narrowest meaning. But the larger meaning is wealthy people, whether they're banks or individuals, ought not to be able to use their power, their wealth to exploit people who don't have wealth, great wealth. That's not too complicated. And I'm not being utopian here. I'm just saying that you can reestablish legal-slash-moral limits on the behavior of finance and their wealthy patrons. And if they don't want to observe those rules then they need not apply for emergency loans at the Federal Reserve or the Treasury Department.

BILL MOYERS: In other words-

WILLIAM GREIDER: You see what I'm getting at? And-

BILL MOYERS: Yeah, in other words, so-

WILLIAM GREIDER: -and this is a-

BILL MOYERS: -if there's a bailout, certain conditions on that bailout.


I think Mr. Greider is absolutely right on this but I fear that the banking industry will continue to lobby for less regulation to continue their financial rape of U.S. and global consumers. But bankers beware: excessive credit card debt will ensure a prolonged period of economic weakness as consumers get into more debt to pay off their rising bills. If things get really bad, we will witness massive credit card defaults and yet another financial crisis.

Finally, the trailer above comes from the award winning documentary, Maxed Out: Hard Times, Easy Credit and the Era of Predatory Lenders. If you have not seen it, it is well worth renting it to understand the plight of millions of Americans that suffer from the burden of massive credit card debt.

Friday, July 25, 2008

Remembering Randy Pausch

Tonight I want to take a moment to remember an extraordinary human being. Randy Pausch, the Carnegie Mellon University computer scientist whose "last lecture" about facing terminal cancer became an Internet sensation and the basis of a best-selling book, died today. He was 47.

Pausch was diagnosed with incurable pancreatic cancer in September 2006. His popular last lecture at Carnegie Mellon in September 2007 garnered international attention and was viewed by millions on the Internet.

In it, Pausch celebrated living the life he had always dreamed of instead of concentrating on his impending death.

In May, Pausch spoke at Carnegie Mellon's commencement ceremonies, telling graduates that what mattered was he could look back and say, "pretty much any time I got a chance to do something cool, I tried to grab for it, and that's where my solace comes from."

"We don't beat the reaper by living longer; we beat the reaper by living well and living fully," he said.

I couldn't agree more.

Pension Governance: Focus on Alignment of Interests

When I was responsible for analyzing and monitoring hedge fund managers, I would always start by looking at a few basic things like how they are aligning their interests with the interests of the pension fund. Does Mr. or Mrs. XYZ Hedge Fund Manager have skin in the game? If they are not investing in their own fund then why should I invest pension money with them?

Another thing that I would look at is the number of people on the sales staff relative to the number of people on their investment staff. Hedge funds typically charge a 2% management fee and a 20% performance fee. Those that primarily focus on marketing will garner a lot of assets under management in a short period of time. This typically happens after a period of strong performance. Most of these large hedge funds then go on cruise control and forget about the performance fee because they are content collecting 2% on a billion or more dollars (they basically become large asset gatherers).

The main point is that when it comes to investment management, you have to ask yourself how are fund managers and pension fund managers aligning their interests with those of their stakeholders? You will read things like "our bonus scheme is based on a four year rolling return period" but I will tell you right away, that isn't good enough.

When it comes to alignment of interests, the devil is in the details. You need to drill down and conduct a rigorous performance attribution to make sure that the performance of the pension fund manager is measured relative to an appropriate benchmark. If it isn't, then chances are that you are compensating that manager for taking on more risk or for the 'beta' of that investment activity.

Let me give you some brief examples of bogus benchmarks below:

Example #1: Bogus Real Estate benchmarks: In a previous post on Alternative Investments and Bogus Benchmarks, I discussed how for the most part, real estate benchmarks do not reflect the 'beta' of the investments or the risks that are taken by the real estate pension fund managers.

One benchmark that pension funds use is some spread over CPI inflation. The rationale is that real estate is an "inflation-sensitive" asset class and you want to use some spread over inflation as your benchmark. The spreads typically are 400 to 600 basis points (4% to 6%) over the annual inflation rate.

There is nothing wrong with this benchmark if your pension fund's real estate portfolio is primarily made up of core real estate AAA properties. The problem is that many pension funds invest in value added or opportunistic real estate holdings, taking on more risk to beat their benchmark. (You can read more about real estate investments by clicking on this TIAA-CREFF Asset Management paper).

Example #2: Bogus Private Equity benchmarks: Another asset class that typically has easy performance benchmarks is private equity. You can read more about private equity's benchmark blues by clicking here.

Once again, many pension funds use some arbitrary figure based on inflation, but if your pension fund manager is primarily investing in top-quartile buyout funds, then make sure that his or her benchmark accurately reflects this. The key is that you need to understand the composition of the private equity portfolio. Are they primarily investing in large buyout funds or are the returns coming from direct investments and co-investments?

Example #3: Bogus Infrastructure benchmarks: Infrastructure investments also need benchmarks that accurately reflect the 'beta' of the asset class as well as the underlying risks. You can read more about infrastructure index wars in this Pensions & Investments article.

Example #4: Bogus Hedge Fund benchmarks: Many pension funds invest in hedge funds or undertake internal absolute return strategies. Whether they they invest in external hedge fund managers or internal absolute return strategies, make sure you understand the risks of each and every strategy and make sure that the benchmarks used to evaluate these internal or external absolute return managers reflects the risks and the 'beta' of the strategy.

These activities need to be carefully monitored because I can guarantee you that most pension funds do not have a clue about how to properly benchmark these hedge fund strategies. For example, if your pension fund manager is using some spread over T-bills (typically 500 to 700 basis points) and primarily investing in asset based lending hedge funds or other exotic strategies with lock-ups of two to four years, then that benchmark is not reflecting the risk/return profile of those strategies. (Read more about asset based lending here and here).

Some pension funds use commercial indexes like the HFR indexes to gauge the performance of their hedge fund portfolios. Here again, the devil is in the details. For example, if your hedge fund portfolio is made up primarily of top quartile hedge funds that are closed to new investors, then a more appropriate index is the HFR non-investable index.

All these examples highlight the need to drill down into each and every investment activity but to do this, pension funds need to be more transparent by clearly stating who is responsible for these investments and how their benchmark accurately reflect the 'beta' or risks of the investments that make up their portfolio.

As a rule of thumb, if your pension fund manager is easily beating his or her benchmark every year, then you've got a serious benchmark issue which also means that you are overcompensating your pension fund managers for 'beta' or taking undue risks.

The solution to all these benchmark issues is easy: pension fund managers need to be more transparent about each and every investment activity that governs their overall composite benchmark. I would suggest that they follow the lead from Ohio PERS and provide detailed policies on all activities (OPERS' investment policies are not perfect but they are a step in the right direction). Moreover, stakeholders need to know who is responsible for each investment activity and how risk is being managed to hedge against any significant losses.

When it comes to alignment of interests, stakeholders are better served by pension fund managers that continually bolster their governance process by providing as much transparency as possible on the risks and returns of each investment activity.

Wednesday, July 23, 2008

Whither Financial Orgy?

Roughly a week ago, I wrote about how financial stocks were technically oversold and due for a bounce. And boy did they bounce hard off their lows. I track a number of them every day and I was amazed to see the volume and the ferocious moves up. Depending on which financial dog you bought (Fannie and Freddie come to mind), you could have easily doubled or tripled your money in a fews days if you were brave enough to buy those lows.

I couldn't help chuckle watching all the Wall Street cheerleaders parading on CNBC and CNN, telling us that the earnings from banks are positive and that the worst is behind us. One of them cited the increase in Wells Fargo dividend yield to 10% as a "sure sign" that the economy isn't as bad as the media portrays it to be.

I got nothing against Wells Fargo and I know Warren Buffett owns a good stake in that bank. Nevertheless, I can't shake this feeling in my stomach that the Paulson-SEC-Wall Street machine is throwing everything but the kitchen sink to talk up stocks, especially financial stocks.

Before you jump on the buying bandwagon, however, I highly recommend you read John Mauldin's latest Outside the Box comment. Mauldin surveys a few articles from authors that are skeptical of the sustainability of this short covering rally.

I quote from Spencer Jakab's The Mother Of All Short Squeezes May End Badly:

Is it possible though that Cox's actions, however unnecessary, marked the ultimate bottom for banks? They do seem cheap by historical measures, but the widespread euphoria last week looks more like a bear market rally than classic capitulation.

And this editorial from the Economist:

Bear markets often involve bare-knuckle fights, but it is still a shock when the referee starts punching below the belt. The Securities and Exchange Commission (SEC) has intervened in the epic struggle between financial companies and the hedge funds that are short-selling their shares...The SEC's moves deserve scrutiny. Investment banks must have a dizzying influence over the regulator to win special protection from short-selling, particularly as they act as prime brokers for almost all short-sellers...

The SEC's initiatives are asymmetric. It has not investigated whether bullish investors and executives talked bank share prices up in the good times. Application is also inconsistent. The S&P500 companies with the biggest rises in short positions relative to their free floats in recent weeks include Sears, a retailer, and General Motors, a carmaker. Like the Treasury and the Federal Reserve, the SEC is improvising in order to try to protect banks. But when the dust settles, the incoherence of taking a wild swing may become clear for all to see.

And John Mauldin's thoughts:

Deciding to actually enforce a rule already on the book is not going to make the profit picture at banks and other companies any better. They are still going to be shorted as soon as the dust clears. This just gives them (mostly banks) more room to fall. As noted two weeks ago, there may be as much as $1 trillion still to be written off by banks, brokers, insurance companies, pension funds and sovereign wealth funds. This is going to be ugly for at least a year. Those hoping for a bottom should look for it when the quarterly bleeding stops. Bill Gross said today that for Fannie and Freddie to raise capital it will need the help of the government. My side bet is that this will not be good for equity holders of Fannie and Freddie.

I am sitting patiently on the sidelines waiting to jump back into the Ultrashort Financials Proshares (SKF). If it falls near or below its 200 day moving average, I will start buying it back slowly. Why not make money as financial shares head back down?

Finally, you must read Jim Bianco's comment from Naked Capitalism on the possible role of Semgroup's bankruptcy on the oil price drop. I quote the following:

SemGroup, the US physical oil trader, on Tuesday filed for bankruptcy as it acknowledged trading losses of more than $3.2bn in different energy markets after betting this year that crude oil prices would fall. Its collapse came as oil prices plunged to their lowest levels since early June. West Texas Intermediate crude oil fell to an intraday low of $125.63 a barrel, down $5 on the day. Traders sold oil futures as news emerged that tropical storm Dolly was set to miss oil and natural gas installations in the US Gulf of Mexico.

Oil traders said SemGroup could have exacerbated the spike in oil prices this month, when the market experienced unprecedented swings of more than $10 a barrel, as the company was buying back some previous bets on lower prices.
The bankruptcy of SemGroup, which describes itself as the fourteenth largest US private held company, affects approximately $3.1bn of debt, according to court filings.

My advice is to tread carefully in these markets because the only thing that is a "sure thing" is more volatility. Despite the correction in oil prices, I would remain underweight financial shares and even look into initiating outright shorting positions and/or buy the SKF if they rally further from here.

Tuesday, July 22, 2008

Guest Commentary: Diane Urquhart Analyzes PSP Investments' 2008 Results

This blog has given me the opportunity to meet and talk with some very interesting people. One of those is Diane Urquhart who I already favorably alluded to in my very first blog entry on the ABCP's of Pension Governance.

Diane Urquhart is an independent financial analyst and former senior securities industry executive who appeared before the Parliamentary finance committee’s hearings into Canada’s frozen non-bank ABCP.

was one of six witnesses to address the committee and appeared on behalf of a group of retail customers of non-bank ABCP (she also appeared with the support of the National Pensioners and Senior Citizens Federation).

Diane brought to my attention that PSP Investments' 2008 Annual Report failed to highlight significant losses in credit default swaps (click on image above taken from page 60 of the 2008 Annual Report). She went over the financial statements very carefully and shared these comments with me and she allowed me to post them on my blog.

I thank her for this contribution and I hope my readers will take the time to read her comments below. (You can find most of her articles on by clicking here.)

From Diane Urquhart (added emphasis is mine):

PSP Investments has just released its 2008 Annual Report, which has for the first time disclosed the PSP Investments' exposure to Non Bank ABCP at $1,972 million and a writedown taken of -$450 million. PSP Investments is the third largest owner of Non Bank ABCP, behind the Caisse at $12,600 million and the National Bank at $2,250 million. It is inexcusable for a public sector pension plan to have delayed its public disclosure of its exposure to Non Bank ABCP until now. PSP Investments and the Caisse were members of the Montreal Accord and the Pan Canadian Committee, which formulated the ABCP CCAA Restructuring Plan, which is awaiting a decision before the Appeal Court of Ontario.

PSP Investments also owns Collateralized Debt Obligations (CDOs) with a notional exposure of $1.4 billion, where it has taken a writedown of approximately $470 million.

In addition, PSP Investments has marked-to-market losses of -$510 million on $1,351 million notional amount of credit default swaps they have written. Credit default swaps are like insurance contracts since PSP Investments has agreed to pay the credit default damages on reference credit portfolios described in contracts with bank or other financial institution counterparties. These are direct credit default swap contract losses, which are similar to the indirect credit default swap contract losses within the Non Bank ABCP trusts owned by PSP Investments.

In total, the distressed credit losses of the PSP Investments are -$1,430 million, as accounted for in its 2008 Annual Report. The total exposure to the three types of distressed credit is $4,723 million or 12% of the $38,925 million of total pension assets. This level of exposure to high risk credit is far too high for a pension fund, whose fiduciary duty is to ensure assets are invested prudently to fund the defined pension benefits of the Federal public service, RCMP and Canadian Forces.

I would say that the Non Bank ABCP accounting valuation of $1,522 million is far too high, making the unrealized loss of -$450 million far too low. Based on my work as financial advisor to the Ad Hoc ABCP Retail Owners Committee, I would say the likely trading value of the Non Bank ABCP will be $889 million, making the marked-to market loss at about -$1,083 million. The CDO's are likely accounted for at an artificially high valuation as well, but this is not something I can professionally substantiate, since unlike the Non Bank ABCP, there is no public information on the CDO's that PSP Investments owns. The credit default swap contract losses are more visible in the secondary market, so this estimated loss of -$510 may be accurate, compared to the other two types of distressed debt owned.

In fiscal year 2008, the PSP Investment's rate of return was -0.3%, which is 1.5 percentage points below the Policy Benchmark rate of return of 1.2%. The Policy Benchmark methodology is not disclosed. Readers should note that two other non-publicly traded assets classes, real estate and private equity, made strong 2008 contributions of $952 million and $375 million respectively, which offset the writedowns in the distressed credit categories.

The Non Bank ABCP owned by PSP Investments has been the subject of considerable allegations of negligence, and possible fraud, by the banks, securities dealers and DBRS in motions submitted to the Ontario Superior Court of Justice and subsequent appellant filings. This week, Rick Waugh, CEO of Scotiabank and Co-Chairman of the Institute of International Finance Committee on Market Best Practices, admits that banks have made mistakes in structured credit products and that widespread changes in international bank industry practices are in order. PSP Investments makes no admissions about its mistakes in due diligence or undue concentration in structured credit securities. There is no evidence in the 2008 Annual Report that anyone at the PSP Investments has borne any consequences for these mistakes.

My research report, "Another Made-in-Canada Defective Investment Product - ABCP, dated December 17, 2007 can be found at the following web address.

Diane Urquhart
Independent Financial Analyst

***Important Update from Diane Urquhart*** (
added emphasis is mine)

July 24, 2008

I spoke this morning with John Valentini, CFO, and Anne-Marie Laurendeau, Director of Communications and Government Relations,
of PSP Investments. I would like you to place the following follow-up on your website.

John Valentini, CFO of PSP Investments, has advised me that the Collateralized Debt Obligation (CDO) notional amount of $1,400M and 2008 writedown of -$470M is included in the Table of Derivative Financial Instruments found in Note 3(b) of the financial statements under the category of Credit Derivatives Swaps, which shows a notional amount of $1,351M and a fair market value loss of -$510M.

He admits that the terminology of CDO and credit derivatives swaps is not clear in the 2008 Annual Report. John Valentini says that the securities owned that are referred to in the text as CDO's receive premiums and not interest revenue and are considered by PSP Investments to be credit derivatives and not fixed income securities.

As an analyst, I consider the term CDO to apply to different tranches of debt funding a conduit owning securitized assets or synthetic assets associated with credit default swap contracts. The fact that premiums are received and not interest revenue suggests that PSP Investments has written and owns $1,351M of notional amount in credit default swaps, and that these might better have been referred to in the text of the annual report as credit default swaps rather than CDO's.

Perhaps, PSP Investments found the term Collateralized Debt Obligations to be more palatable and simpler to understand for its pension beneficiaries and the general public, but in mind it was the wrong technical term to apply.

The -$510M fair value loss in the Table of Derivative Financial Instruments is a balance sheet fiscal yearend amount, whereas the -$470 million loss in the text is the unrealized loss occurring during the 2008 fiscal year and is part of the income statement. The difference between the -$510M balance sheet fair value loss and the income statement -$470M loss is due to the purchase and sale of positions during the fiscal year giving rise to net losses in the year and long term positions held at the yearend that have accrued fair value loss in the prior year.

My bottom line conclusion from this follow-up discussion with John Valentini is that there are just two classes of distressed credit at the PSP Investments, $1,972M of Non Bank ABCP and $1,351M of written credit default swaps.

The total distressed credit exposure is $3,323M or 8.5% of the $38,925 of total pension assets. The total writedowns on the two distressed credit classes is -$920M or -2.4% impact on the fiscal year performance.

I continue to conclude that there is an unacceptably high concentration of high risk credit securities owned by the PSP Investments, and that these credit securities did not pay a sufficient risk premium at the time of purchase to warrant the risk involved.

Diane Urquhart
Independent Analyst
Mississauga, Ontario
Telephone: (905) 822-7618
Cell: (416) 505-4832