The Leverage Game

As a relatively new Hedge Fund manager, I tend to get calls from vendors and assorted financial types trying to sell me services or systems. I got a call the other day from an organization whose name I will withhold that offered to lever up my assets under management (AUM) by ten times.

So here is how the deal works. They lend you ten times your AUM and in return the payoff is split as follows:

First 10% return - they get 90%, you get 10%.
Second 10% return - they get 50%, you get 50%.
Third 10% return - they get 10%, you get 90%.

Sound too good to be true. Well it is. Here is how the downside is split:

First (-10%) return - you lose 100%, they lose nothing.

The payoff is asymmetrical, as you probably figured out. So in effect, after a ten percent decline, your capital is wiped out. What happens if you go down more than 10%? Well you can't because they monitor the portfolio daily and will pull their money out once you hit a negative 10%.

Also, if you assume that you achieve a 10% return for the year on the borrowed money, you are no better off than if you hadn't borrowed. Let's say that you started with a million and borrowed $9 million (just to keep the numbers even).

After a year, your have a ten percent return, or $1 million. You have to hand over $900 K of that and you keep $100 K. That's the same $100 K return you would have earned if you had just invested your $ 1 million by itself and earned 10%.

I keep wondering how many of my fellow managers are levered up like this. I read about a Warburg fund that was levered up 20 to 1.

Thrift Report

The Office of Thrift Supervision (OTS) just released its third quarter report on the state of the thrift industry. While the market and the media have been focused on the travails of the large cap banks and brokers, the thrift industry is just as important to our financial system as it has $1.57 trillion in assets and originated 30% of all mortgages in the most recent quarter. The full report is available here:

Thrift Industry

Highlights include:

1) Loan loss provisions increased to 0.92 percent of average assets in the third quarter, an increase from 0.22 percent in the third quarter one year ago and from 0.38 percent in the prior quarter.

2) Troubled assets (noncurrent loans and repossessed assets) were 1.19 percent of assets, up from 0.95 percent in the prior quarter and 0.64 percent a year ago.

Loan loss provisions as a percent of average assets are now at the highest level as far back as the report goes (1991).

Although these metrics are high, it can get a lot worse. If you look at page 11 of this report, entitled troubled assets, you can look at the peak back in the early 1990's.

Also, as the report notes, if you exclude the top ten thrifts who are active in originating loans for sale, the industry return on assets would have been much higher.

Highly Recommended

I just found a blog that is probably one of the best I have seen on Homebuilders and the related mess that is going on in that area. It is written by Reggie Middleton and is located here:

Reggie Middleton's Boom, Bust & Bling Blog

He brings a lot of insight into an area that is usually full of hyperbole. I would recommend subscribing to his feed.

How Many Shoes Can We Handle?

Everyone is waiting for the next "shoe to drop" in the financial markets. No one knows when or what it will be but the market spends an inordinate amount of time thinking and speculating about it. Here is another scenario:

Citigroup, Inc., under pressure from the financial markets and shareholders decides to reduce its balance sheet risk, just in case. A memo goes out from the office of the new CEO. Long time commercial bankers call their customers. The conversation goes something like this:

Banker: Hey John. How are things going?

Customer: Oh good. How's the bank?

Banker: Pretty good. The reason I am calling is that the loan that is due next month. We're not going to be able to roll it over this time.

Customer: What?

Banker: Yeah, I'm sorry but I wanted to give you some notice so you can make other arrangements.

Customer: But we have always paid on time. I've had that loan with you for years. That bank was called First National City Bank when I first took it out. You can't do that.

Banker: Well I've got to go. I have some other customers to call. Bye John.

John decides then not to open that new store, or build that building, or expand into that new line of business.

The credit crunch spreads to Main Street.

Scary Chart of the Day

From a presentation at a conference yesterday in New York City.

Wilbur Ross Speaks and You Damn Well Better Listen

I just listened to a great interview with Wilbur Ross on Bloomberg which was brought to my attention by the people at Vinvesting


Wilbur Ross Bloomberg Interview

The interview is 25 minutes long and goes into good detail on the issues of the day, including the sub prime lending fall out, brokerage earnings, the growth of the hedge fund industry and the inherent weakness of quantitative "black box" investing.

Wilbur Ross - Words of Wisdom

Can someone please get this guy to run for president?

Wilbur Ross sums it all up

Another Leg Falls

How many legs do we have propping up the Stock Market? I've lost count. We all know that the Private Equity buyout "leg" is history. The latest one to collapse is the buyback stock craze, which has reduced the supply of stock the last few years. Once again a chart from The Wall Street Journal says it all:



Public companies have been levering up to buy back stock, most of them due to pressure from idiotic hedge fund managers who have apparently never lived through a business cycle. I have this picture in my head of the typical company in a meeting with its bankers to renegotiate its covenants during the next business cycle contraction. The CEO says something like this: "We don't know what happened, our largest shareholder told us this was the ideal capital structure." The bankers just stare back at them, their mouths open, unable to formulate a response to this stupidity.

This is now coming to an end as lenders tighten standards and credit rating agencies actually start doing their jobs. Now many legs does a table need to stay standing?

When Numbers Lie

"We will follow developments in the subprime market closely. However, fundamental factors--including solid growth in incomes and relatively low mortgage rates--should ultimately support the demand for housing, and at this point, the troubles in the subprime sector seem unlikely to seriously spill over to the broader economy or the financial system."

Chairman Ben S. Bernanke
June 5, 2007

American Home Mortgage Undertakes Substantial Reduction of Employee Base and Operations Aug. 2, 2007

American Home Mortgage Investment Corp. (NYSE:AHM) today reported that, in light of the liquidity issues resulting from extraordinary disruptions occurring in the secondary mortgage market, the Company has determined to significantly reduce its operating structure as it seeks the most appropriate course of resolution to preserve the value of its remaining assets.


From AHM 10-K for period ending 12/31/2006:

Mortgage-backed securities owned

$9.3 billion- Total Portfolio
$8.5 billion - AAA Rated
91.6% AAA

Loan Origination Summary

Prime Loans - 91.1% of all loans originated
Alt-A - 8.9%
Non-Prime - 0%


Cumulative 5 year GAAP Net Income

$682.1 million


Return on Equity

12/31/2006 - 22.74%
12/31/2005 - 28.05%


Book Value

$1.27 billion
$25.19 per Share

Schadenfreude

I confess that I am one of those people who sometimes take a perverse pleasure in the misfortune of others.

Schadenfreude

The latest bunch of smart guys to have their asses handed to them are the people at Sowood Capital Management, a hedge fund started a couple of years ago by alumni of the Harvard Endowment. It was reported today that funds they run have lost 50% of its value in a month. This is getting to be a commonplace event lately but the news with Sowood is that they didn't invest in sub prime paper but in regular corporate debt.

How does such a thing happen? Major hedge funds have entire departments dedicated to risk management.

Was it a fatal combination of leverage, lack of liquidity and hubris? Was it a reliance on impenetrable mathematical black boxes that tell you the pricing relationship between different securities but that never seems to work in times of market crisis?

We'll never know. The principals at Sowood will no doubt move on and start another hedge fund with an equally impressive sounding name and raise another billion from people who are supposed to know better.

Conundrum Solved?

Has the great Wall Street conundrum been solved? I wrote 2 days ago about the disconnect between deal fever and the viability of financing those deals, and the decline in the market yesterday may have validated my words. The market was down 447 points at one point in the afternoon and it was a little unsettling to watch such a free fall.

Is it over? Wall Street is notorious for having a selective memory so maybe the buy on the dips investor will drive things back up. But remember 300 points is not what it used to be. The market is down 4.8% from the high reached a week ago but that statistic is deceptive since it is from the intra day high of 14,121.04. The market closed that day at 14,000.41, giving us a correction of 3.9% from that close.

I had some serious flashbacks yesterday to the late 1980's, when Wall Street was riding high. It was the age that gave us "Bonfire of The Vanities" by Tom Wolfe, and the movie "Wall Street" directed by Oliver Stone. Everyone remembers the famous "greed is good" line from that film but the one I remember was spoken by Martin Sheen who played the father of Bud Fox.

"Stop going for the easy buck and start producing something with your life. Create, instead of living off the buying and selling of others."

We thought it was the age of excess but now 20 years later we know it is nothing compared to today.

I remember sitting at my desk when the news came out that Michael Milken had earned $550 million in one year heading up Drexel's junk bond unit. Today that might not even get you a table during the evening rush at the 21 Club. And then one day in October 1989 it came to an inglorious end when the leveraged buyout of United Airlines fell through. It was a watershed event that precipitated a 7% drop in the Dow in one day.

Does Chrysler equal United Airlines? With hindsight it just might be.

The Conundrum

The Conundrum is simple and is this - the market continues to climb based on a "buy on the dips" mentality fed, at least in part, on continued takeover speculation that is embedded in the value of equities. Every time the market declines significantly, it bounces right back as investors jump into names they have been stalking. I think that at every buy side shop there is an investment thesis template that reads "potential buyout candidate" and all the analyst has to do is fill in the name and symbol, and give it to his Portfolio Manager.

However, the financing that supports that takeover activity is starting to undergo a repricing by investors based on a reevaluation of the perceived risk. Many investors have stopped investing at all here or have paused, while other investors are rejecting covenant lite and toggle or pay in kind bonds while demanding higher yields. Higher yields mean less of a return on these deals which will shrink the universe of potential buyout candidates.

There are at least 6 "hung up" bridge loans held by investment banks where Wall Street firms provided interim financing to buyout shops, in anticipation of replacing the bridge loan with permanent financing. Until this pipeline clears or the investment banks feel that conditions in the credit market are returning to normal (I hate to even use the word normal) this type of stop gap financing will be harder to come by.

The latest deal financing to fall through was reported today by The Wall Street Journal - the buyout of Allison Transmission, a unit of General Motors. Investment banks postponed an offering of $3.1 billion in loans.

We have a conundrum here. The stock market cannot continue to be propped up by the private equity buyout frenzy if the financing that supports that frenzy is no longer viable. There are a number of possibilities here:

1) The market is seeing through the current turmoil in the credit markets and expects the financing to return. If true, this would be extraordinary considering the market usually has a one-week time horizon.

2) The market believes that even if risk reprices at a higher level - the internal rate of return (IRR) on private equity deals will still be sufficient enough that the buyouts will continue.

3) There are other things that are pushing the market higher besides the buyout frenzy. This could be a number of things, perhaps even the dreaded "liquidity" excuse that I hate so much as OPEC and the Chinese have so much money they have to put it somewhere.

4) I am completely wrong and have no idea what I am talking about and shouldn't be writing an investment blog much less running a hedge fund. If this is true please send me an e-mail privately and tell me.

5) The investors who are propping the market up don't fully understand the reasons supporting valuation that I described earlier in this post so therefore they cannot stop investing when these reasons end.

6) There is a lag time before the financing problems impact the stock market.

7) Investors believe that private equity shops have so much money that they will spend it no matter what. If they make bad deals it will be years before the limited partners who invest in these funds feel it.

If I had to make a bet, it would be on reasons 2 and 7 (I hope it's not #4). Interest rates are still low historically, some marginal deals may fall through, but many would still work at least on paper based on a spreadsheet with optimistic projections of future cash flow growth and EBITDA exit multiples.

High-Grade Bonds ?

Definition - A bond with a rating of AAA or AA, the two highest ratings.

Bear Stearns dropped the bombshell today on investors in its two sub prime hedge funds. The company stated in a letter to investors that "the preliminary estimates show there is effectively no value left for the investors in the High-Grade Structured Credit Strategies Enhanced Leverage Fund and very little value left for the investors in High-Grade Structured Credit Strategies Fund as of June 30, 2007."

The real stunner, at least for me, was this line in the letter, where they gave the cause of the loss in the value of the fund,

“Unprecedented declines in the valuations of a number of highly-rated (AA and AAA) securities.”

Well, I’m sorry but AA and AAA securities don’t go from par to effectively nothing in a couple of weeks. Well maybe if you lever up 5 to 1 they do but someone at the ratings agency or Bear didn’t do their job.

So just imagine the meeting where Bear salesmen were pushing this fund on its clients.

“Well isn’t this a little risky?” said the client.

“Oh no, don’t worry, we only buy AA and AAA rated bonds,” said the smiling salesman.

“Oh, OK,” said the client

“We even put the words – High Grade – in the name of the fund to make you feel safe,” said the smiling salesman.

“Yes, but what about the word – leverage – that’s in there also?” said the client.
“Oh, don’t worry about it, we know what we are doing here. We are experts at this type of thing,” said the smiling salesman.

I even had to sit my wife down this morning and explain to her why this would never happen to the Hedge Fund where we have all of our life savings invested.

"I don't buy crap like this," I said.

"Well make sure you don't. I don't want to be working for a living when I am 70 years old," she said.

Homebuilder Debt to Capital Ratio - Be Careful Out There

Lennar Inc. (LNR) just released its quarterly earnings report and highlighted what it considers its low debt to total capitalization of 31.6%. Investors should note, however, that the numerator of this calculation only includes the on balance sheet debt and Equity of Lennar. Lennar has not filed its 10-Q for the May quarter as of the day I wrote this, but the company has the following debt according to its 10-Q from the previous quarter (ended 2/28/07).

$ 278,232 - 7 5/8% senior notes due 2009
$ 299,766 - 5.125% senior notes due 2010
$ 249,461 - 5.95% senior notes due 2011
$ 345,719 - 5.95% senior notes due 2013
$ 247,559 - 5.50% senior notes due 2014
$ 501,851 - 5.60% senior notes due 2015
$ 249,694 - 6.50% senior notes due 2016
$ 300,000 - senior floating-rate notes due 2009
$ 109,212 - Mortgage notes on land and other debt

$ 2,581,494

This total debt number is close to the number in Lennar's press release of $2,585,286,000 for the May quarter, which when divided by total debt and equity of $8,168,841,000 gives us the 31.6% number. However, if you dig into the 10-Q for February you will see that Lennar calculates the debt to total capital of its unconsolidated entities as follows:

Debt of Unconsolidated Entities $5,619,394,000
Total Equity of Unconsolidated Entities $3,299,991,000
Total Capital $8,919,385,000

Debt to total capital of Unconsolidated Entities 63%

To be fair to Lennar, there is a footnote that says the Equity is carried at book value and the market value is $1.3 billion higher than book.

If you do a weighted average of the on balance sheet debt to capital and then the unconsolidated entities, then you get

Debt $8,200,888,000
Equity $9,074,972,000

Total Capital $17,275,860,000

Debt to Capital 47.47%

I believe that Lennar has a reputation as one of the more open and transparent Homebuilders so it may not be possible to calculate this for the other publicly traded Homebuilders, but investors should look twice at the official number that come out in press releases.

Now when I contacted investor relations to get the company opinion on this matter they said that:

"it would not be accurate to add the equity and debt from our JVs. Most of this debt is non-recourse to Lennar or has recourse via maintenance guaranties."

Well, now I am even more confused and need to do a little more work on the entire concept of these structures. I will come back to this at a later time. If anyone has encountered these structures before and has a more complete understanding of them, please comment.