Agora Financial’s Rude Awakening

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Laguna Beach, California

· A look back at the ongoing catastrophe that was, is and will most likely be,
· One spooky-clear forecasts from this year’s Value Investing Conference,
· Merry Christmas Holidays from Team Rude and plenty more…

Eric Fry, with visions of sugarplums dancing through his head, reports…

Steven Romick called it!…and we were there.

During a May 7th presentation to the Value Investing Congress in Pasadena, California, Romick cited chapter and verse of the bearish case against brokerage stocks…and presented an impassioned and compelling argument for selling them short.

Romick warned about “a potential Financial Armageddon from even a partial unwinding of hundreds of trillions of dollars of off-balance sheet of derivatives,” while also singling out Lehman Bros. as a particularly vulnerable institution.

But your editors did not select this particular “Best of Rude” column just because Romick “told us so,” but rather because Romick’s analysis is a timeless example of the investment skepticism that breeds success, especially in tough markets.

So please enjoy the “Best of” column below. Alternatively, please enjoy the rest of your Christmas Day.

Merry Christmas from the team at the Rude Awakening!

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Eric Fry, reporting from Laguna Beach, California…

Many generations of investors have trusted in Moody’s infallibility. One generation of short-sellers has scoffed at the notion. The financial markets have settled the dispute: Moody’s is fallible.

Throughout the illustrious 99-year history of Moody’s Investor Service, the esteemed rating agency has enjoyed a Pope-like reputation for infallibility. Moody’s dispensed its ratings like so many papal bulls, thereby establishing a sacred canon for generations of fixed-income investors.

“Moody’s said it. We believe it. That settles it,” served as the approximate due diligence process that vetted trillions of dollars worth of bonds throughout the entire 20th century and the first seven years of the 21st.

But this dubious underpinning of the American capital markets began to crumble sometime around mid-2006, when American home prices finally stopped going up, and actually started going down. At that very moment, the benign macro-economic trends that had served Moody’s rating “system” so well began to degrade.

You see, dear investor, during robust economic times, even a CCC credit will perform like a AAA credit. But when times are tough, only a true AAA credit behaves like a AAA credit – all the imposters slide down the rating scale toward mere junk.

Alas, times are tough…very tough. In fact, times are particularly tough for any investor who trusted a AAA rating from Moody’s. Tens of billions of dollars worth of formerly AAA mortgage-backed securities have slipped into the murky depths of “non-investment grade” paper. Moody’s reputation and share price have followed a similar trajectory.

This downward trajectory gained fresh momentum Wednesday when Moody’s disclosed that a “computer glitch” may have caused the company to award AAA ratings to as much as $4 billion worth of securities that deserved much lower ratings.

Oops!

This revelation begs a follow-up question: “What sort of glitch cause Moody’s to award AAA ratings to hundreds of billions of dollars worth of mortgage-backed securities that deserved much lower ratings?”

News of the ratings snafu at Moody’s produced a stampede of would-be litigants, hoping to tear a bit of flesh from Moody’s hide. Shortly thereafter, Moody’s main competitor, Standard & Poor’s, downgraded Moody’s credit rating. Moody’s might survive these slings and arrows and atomic bombs of outrageous fortune. It might not.

Either way, weep not for Moody’s. It has lived a rich and prosperous corporate life. Weep, instead, for the innocents who trusted in Moody’s and who failed to recognize the hubris of awarding a AAA rating to a collection of junk credits, just because a computer-generated risk calculation assigns a low probability of disaster. A low probability, we now understand, is not the same thing as impossible. And being right a lot of the time, we now understand, is not the same thing as being infallible.

The analysts at Moody’s, despite their advanced degrees and high-powered computers, were never any more capable of predicting next year’s default rate on a AAA subprime CDO than a monkey with an abacus.

We do not fault Moody’s for trying to know the unknowable; we merely wince at the idea that highly complex, utterly unknowable, financial creations could ever garner a AAA rating.

Shun complexity, dear investor, and crave simplicity.

And if you’d like to get a better feel for the sort of complexity you might like to shun, please read the second and final portion of Steven Romick’s May 7th speech to the Value Investing Congress. Steven Romick, Senior Vice-President of First Pacific Advisors, Inc., is the portfolio manager of FPA Crescent Fund, FPA Hawkeye Fund, FPA Multi-Advisor Fund, and various separate accounts. He was previously Chairman of Crescent Management. http://www.fpafunds.com/mutualfundinvestors.asp

For those of you who may have missed the first half of Romick’s speech, please click on the following link: http://www.agorafinancial.com/afrude/2008/05/22/the-raw-deal/

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The Raw Deal, Part II
By Steven Romick

We expect that the market will likely show us a number of head fakes as 2008 continues. Beachgoers have seen a Great White Shark and they aren’t going to enter the water until they’re sure that it’s safe to swim. Their confidence level will increase commensurate with the time that has passed since the sighting; however, just because a dorsal fin has not been seen for a period of time, that does not mean the shark has left the area. We believe that this shark will be trolling our local beaches for some time to come.

Commercial and investment banks, insurance companies and other mortgage lenders and investors have taken cumulative write-downs in excess of $300 billion, to date. We do not believe that all such companies have come clean and, until then, we will neither hit bottom, nor have the capability to fully assess the damage to our financial system, and its economic impact. The International Monetary Fund estimates that the total worldwide losses in the financial sector will be just shy of $1 trillion, but that’s with subprime losses at $45 billion –and we’ve certainly surpassed that. The Sovereign Wealth Funds have been kind enough to inject tens of billions of dollars in equity in order to keep the wheels on the bus, but we can’t count on them. And, if they continue to “befriend” us, we accelerate the transfer of our national wealth to our children’s detriment.

The markets applauded JPMorgan Chase’s recent acquisition of Bear Stearns. We can only agree, as letting Bear fail could easily have led to a daisy chain of negative consequences to our currently fragile financial system. However, the cynic in us has concern (but no evidence) that JPMorgan Chase’s actions were nothing more than playing defense. Bear Stearns was reported to have roughly $14 trillion of derivative exposure, an amount approximately equal to our Gross Domestic Product. Who lies on the other side of those trades? In other words, what counterparties would have been harmed had Bear been allowed to fail? Did JPMorgan Chase buy Bear because they were getting a great deal, or did they buy them to avoid an impairment of their own off-balance sheet derivative transactions? Oh, and how did they get a comfort level with what they were actually buying when they had just a couple of days to perform their due diligence?

JPMorgan has assets of $1.6 trillion and equity of $126 billion. They seem reasonably well-capitalized at 7.6%. We just hope that there’s no problems in their almost $92 trillion derivative exposure that is more than 50x their assets and, more importantly, greater than 700x their equity. We hope them to be well-matched, but if they are even the tiniest bit wrong, their equity could be wiped out as their equity represents just 0.13% of their gross derivative exposure.

We surmise that additional bank failures will make headlines in the months to come. Financial institutions have been taking on greater risk over the last few decades, both in leverage and complexity of investment, with a veritable alphabet soup of inexplicable (at least to us) investment products – that were made worse by the capital they control both on and off-balance sheet, where the total dollar amount has increased geometrically to the point where our GDP is now dwarfed by such exposure. At the same time, the U.S. government’s regulatory oversight of many such institutions has been increasingly poor, but that hasn’t stopped Congress from passing 1999’s Gramm-Leach-Bliley Act, allowing banks to engage in both commercial and investment banking, prohibited since 1933’s Glass-Steagall Act. We would argue the division between commercial and investment banking holds greater importance today, given the greater regulatory challenge in the increasingly complex world of global finance.

We just pray for well-matched books and solvent counter-parties. In the interim, we continue to avoid investments in the financial arena, despite our contrarian nature and what appears to be huge upside potential. We believe the downside for such investments to be just as great as the upside, and believe that future portfolio returns will be dictated by as much of what you do not own, as by what you do.

We keep Japan’s lost decade of the 1990s in mind as we wrestle with what might transpire in the United States, both with respect to its economy and markets. From 1989 to 2003, Japan’s benchmark Nikkei index declined 80%. On the way down, Japanese investors saw eight rallies of more than 20%. In three of those instances, the Nikkei increased more than 40%. And yet, thirteen years later, the Nikkei sat at just 20% of its peak value. We are not projecting such a prospective decline in U.S. stocks. The Nasdaq is already more than 40% off its all-time high. The Nikkei experience of the last decade certainly reflects what a bumpy, secular bear market can look like. We do expect to see some dramatic, but ultimately ephemeral rallies in U.S. stock indices over the next few years but believe that U.S. market returns will end up in the mid-single digit range over the next decade.

It may seem easy to just let recent events guide us to our statement that we have yet to see the nadir, but we do not see how we can have hit bottom when companies still haven’t come clean. Take Lehman Brothers persistently generous interpretation of GAAP accounting standards as an example.

Lehman’s first quarter announcement looked good on the surface. In a press release on March 18, they reported $0.81, beating consensus expectations. The Wall Street Journal attributed the 4.2% rise in stock prices that day, in part, to Lehman’s earnings release, printing the following headline the next day: “Goldman, Lehman Lift Markets.” However, their reported pre-tax income of $663 million benefited from a $600 million revaluation of their debt. Lehman, under recent FASB pronouncements, has the ability to reduce their debt under certain circumstances, e.g., if their borrowing cost rises. The marked down amount will be made up by higher interest expense until either maturity, or subsequent revaluation. So without this “benefit,” Lehman would have reported earnings that were barely break-even.

Although some analysts mentioned the debt revaluation, none (that we saw) pointed out that they would have missed their earnings wildly without it. With additional information from the 10Q that was filed a few weeks later, we realized that their earnings were even worse than we thought. Level III assets (assets that are marked to model, rather than marked to market) were revalued upwards by $700 million and Mortgage Servicing Rights were revalued upwards by $364 million, or 31%. To our way of thinking, pre-tax income was therefore actually a pre-tax loss of $996 million, but we hold a minority viewpoint. Although our short position in Lehman was reduced in the $20s, we have recently increased our stake at current levels.

We’re looking carefully and selectively for companies in which to invest, especially in light of:

A) A potential Financial Armageddon from even a partial unwinding of hundreds of trillions of dollars of off-balance sheet of derivatives.
B) International economies that are more coupled with our own than many people realize.
C) Recent complacency regarding risk and prospective market returns.
D) Macro risks that can disrupt 2008 and/or 2009 estimated earnings such that substantial buying opportunities will materialize.

Nevertheless, we are not 100% in cash. Here are a few investments we consider attractive.
I spoke last year about our large investment in Energy, and spoke specifically about ConocoPhillips. We have maintained our investment in Conoco and the sector as a whole.

Those investments range in size from 17 – 24% of our portfolios. We continue to believe an investment in the space is justified given the global supply constraints in the face of increasing demand, as well as it providing both an inflation and U.S. dollar hedge. Although, Conoco has increased nicely in price, it has clearly disconnected from the price of oil and we remain optimistic regarding its prospects…

Any Questions?

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[Rude Endnote: Your managing editor managed to get himself cast as an extra in a Bollywood film shoot tomorrow morning. With a bit of luck, we won’t be left on the cutting room floor. We’ll let you know.

Happy Holidays and, as always…

Cheers!

Joel Bowman

The Rude Awakening
aussiejoel@the-rude-awakening.com