More Madoff Victims: Kevin Bacon and Kyra Sedgwik

I know it sounds like a funny headline but I am not trying to be facetious here. It is a tragedy anytime someone loses most of their life savings to a lying con artist, and this situation with Bacon and Madoff is no exception.

We'd heard that along with Hollywood boldfacers Jeffrey Katzenberg and Steven Spielberg, Bacon and his wife, Kyra Sedgwick, lost money in Madoff's devastating $50 billion Ponzi scheme, and Bacon's rep, Allen Eichorn, confirmed it for us. "Unfortunately, your report is true," he wrote. He wouldn't elaborate on whether, as we'd heard, they'd lost everything except for their checking accounts and the land they own. "I can confirm that they had investments with Mr. Madoff — no further specifics or comment beyond that," he said, adding: "Please, let's not speculate or rely on hearsay."

But we can't help but speculate! Just think about it: Footloose money: gone. Wild Things residuals: gone. The Singles stash: obliterated. If there's anyone in Hollywood who didn't deserve this, it's Kevin Bacon and Kyra Sedgwick. Those two have worked. It sincerely pains us. At least they have The Closer to fall back on.

Trading idea for oil: a weird kinda pair trade

It's clear that OPEC, geo-political risk, loose Fed and a resulting sh*ty US dollar will not let oil stay below $40 a barrel for all of 2009. However, given the global recession underway, it is clear that WTIC will not exceed $60 a barrel in 2009 (fyi Brazil and OPEC say they need about $75 a barrel for additional investment/supply...good luck with that).

The point is that crude will rise in 2009 but not enough to help oil producers/drillers who's business models require much higher prices. So how will I play this anticipated situation of rising crude but suffering oil producers?

*I will buy and hold the DXO (The 2x long oil ETN) and swing trade the DUG (2x short oil ETF) *

At first glance this trade might look pointless since the two trades would just cancel eachother out, but here's why that won't happen:

1) The DXO is an ETN (exchange traded note), which does not suffer from the same daily resets and time decay issues as the options in the DUG and all the other Proshares leveraged ETF's. A simple look a the DXO and DUG charts shows that the DXO is safe to "buy and hold" if you expect crude to stabilize somewhere higher between $40 and $60 (ie there is no need to market time this ETN).

2) The DUG is a play on the oil producers/drillers and not directly on crude oil spot prices like the DXO. The DUG tracks the Dow Jone U.S. Oil and Gas Index so it is more correlated to the daily stock movements of Exxon, Chevron and Conoco Phillips (those three combined make up more than 45% of the NAV of the index). Granted those three producers are linked to oil prices, but recently there has been a notable divergence in price action between oil prices as seen in the graph below (note the USO is an index that tracks WTIC prices):

The chart shows that despite crude oil's crash, the producer stocks have held up relatively well (aside from COP). Nevertheless, EVEN IF CRUDE OIL RISES TO $45, $55 or even $60 a barrel, XOM and its peers cannot be viable investments (OPEC, Brazil, Russia, etc. have said that $70 is support for them).

So the way I will play the inevitable demise of oil producer stocks in 2009 is with the DUG and I will hedge myself with any rise in oil prices by going long the DXO. Please note that because of the time decay issues associated with the options in the DUG, I must swing trade the ETF and market time the SOB, but the DXO is a pure buy and hold. Now I haven't implemented the trade yet, but when I do I will certainly let you know.

Israel Palestine Conflict added to the "Wall of Worry"

The carnage in the Middle East is absolutely horrific. If this continues, the current conflict might begin to rival the Six Days War(let's pray it doesn't for both sides sake).


Nevertheless, this war is just another problem Obama will inherit from Bush (ironic considering Bush expected therewould be peace in the Middle East by 2005...whoops). Now, putting aside my political bias, as Obama's "to do list" grows by the hour it will become clear to Wall Street that Obama cannot save them from the graves they have dug themselves (economically, environmentally, socially, politically, etc.)

I am optimistic that Obama can restore global confidence over two terms, but certainly not in the next 12 months. I say 12 months because that is what Wall Street and Main Street is currently expecting (2nd half 09 recovery)...they assume the cavalry will show up just in time to save the day...big mistake!

Conclusion: Black Swan events like these will certainly accelerate an end to the "Obama honeymoon."

Late night thought...

The Fed's attempts to lower the cost of capital for American consumers and banks won't work in 2009. THE PROBLEM ISN'T that we can't get access to cheap credit. If you have a good credit history and solid personal balance sheet then you can get a sub 6% mortgage (super cheap). Of course, you're probably saying: "But given our cultural proclivity for debt most of us can't get this loan because most don't have solid personal balance sheets."- AH-HA! There's the rub my friends.

THE PROBLEM IS REALLY that we already have too much debt and CAN'T AFFORD to add any more, even if the Fed drives interest rates down to 0%. America has hit its debt ceiling and is now in the process of paying it off, not taking on more. Besides, who will borrow $300k to buy a house or borrow $20k for a business venture when more than 30% of Americans polled are worried about losing their jobs and the housing market it not stabilizing? Rather than encouraging Americans to "fatten" up and eat more from the debt trough, the government should use the money to provide debt/principal reductions and lowering interest payments on existing loans (not new ones).

So regarding credit in 2009, the Fed will find itself in the same position it has been in since 2007: Pushing on a string.


Time for some music. Have a good night.

Future credit cycle scenarios: Ayers Rock or Matterhorn?

Put simply, Bank of America is debating the depth — and structure — of the credit cycle. Specifically, whether we’ll see a ‘classical’ version of accelerating defaults followed by rapid improvement (the Matterhorn) or an Ayers Rock scenario, in which government intervention to stave off bankruptcy ends up prolonging the credit adjustment.

Despite its headline figure of 30% cumulative default rates across 09-11, the “Matterhorn” scenario should be hoped for as the economic implication of “Ayers Rock” increases cumulative defaults to 50%.

The historical perspective suggests that Matterhorns are much more likely than Ayers Rocks — but, then again, we’ve never seen government intervention on this scale before. We’d also note that a prime criticism of quantitative easing in Japan was that it ended up postponing the structural change that many argued was necessary for the country’s banking system. That the US is embarking on something similar could end up tilting the balance in favour of an Ayers Rock situation.

Given the government's efforts to prop up an overleveraged financial system (a system that will inevitably succumb to massive defaults and consumer retrenchment) I believe we are in store for an Ayers rock credit cycle. Thx Greenspan, Paulson, Bernanke, and Bush!!!

Hat tip to FT Alphaville for the find.

2009: The Fallout

2008 saw the collapse of Wall Street and Global Financial Markets at the hands of the deflating international real estate bubble (with the largest bubble obviously residing in the US). The failure of world renowned institutions like Bear Sterns, Lehman Brothers, Fannie Mae, Freddie Mac, and others destroyed all confidence in the financial credit and equity markets. Slow and ineffective action from governments and central banks precipitated the "crisis of confidence" amongst investors. The level of fear, anxiety, and volatility witnessed in 2008 reached comparable levels seen only during the 1930's with the Great Depression. After everything that has transpired in 2008, it is safe to assume that modern capital markets will NEVER be the same again (much needed rules and updated regulations will ensure that).


With that said, if 2008 was about Wall Street's crisis and subsequent collapse, then 2009 will be about the collapse of "Main Street" and the International Economy. The evaporation of trillions of dollars in imaginary wealth and credit lines will destroy any chance of economic growth in the next 12-18 months. Over the long run, governments and central banks will work around the clock to re-inflate the financial system by lowering the cost of capital for banks and consumers, but in 2009 the level of capital destruction from defaults and bankruptcies (individual, corporate, and governmental) will overwhelm policy makers. Furthermore, the psyche of credit markets, banks, and consumers heading into the new year is far too fragile and uncertain meaning an "L" shaped economic recovery (much like Japan's lost decade) is the best case scenario investors (not to mention human beings) can hope for in 2009.

In a few days, I will post some specific forecasts and predictions for 2009 regarding unemployment, real estate, credit writedowns, government intervention, alternative energy, and a few other subjects I deeply care about.

Children avert your eyes!

Roubini's 2009 forecast

How much has Harvard's endowment really lost?

And we thought Madoff was the only liar on Wall Street..puhlease ;-)

Harvard University's admission that it lost $8 billion from its $36 billion endowment fund, as staggering as it sounds, may grossly underestimate the true magnitude of the loss between from July 1 through Oct. 31 2008. According to a source close the Harvard Management Corporation (HMC), which runs the fund for Harvard, the loss is closer to $18 billion if the losses on the fund's illiquid investment are realistically appraised. (Harvard's PR team is very smooth for convincing us it was "only" $8 billion)

From 2000 to 2008, the notional value of Harvard's wealth quadrupled through a strategy that involved shifting the lion's share of Harvard's money from American stocks, bonds and cash to to highly esoteric investment...by the time the bubble burst in the fall of 2008, less than a fifth of Harvard's endowment fund was invested in exchange-listed stocks and bonds. (WHAT??? Less than 20% of porfolio was in stocks and bonds?)

Where was the rest of Harvard's money?

-Nearly 28% of Harvard Endowment fund was in what the fund manager's called "real assets," a category comprised of timber forest and arable land in remote areas, commercial real estate participators, and huge stockpiles of oil and other physical commodities (NOTICE HOW MUCH ALL THESE "REAL ASSETS" HAVE DECLINED IN VALUE).
-Another huge chunk of the endowment was in private equity placements and hedge funds (UH-OH!) which imposed restrictions on withdrawals.
-Another 11 percent of Harvard's money had been sunk in volatile emerging markets. Here the investments took a double hit: First, the local stock markets collapsed in most of these countries, with, for example, Russian stocks, losing 80%, of their value. Second, on top of these losses. the local currencies lost much of their value against the dollar, with the Brazilian Real, for example losing 40% of its value.

My knowledgeable source finds the claim by Harvard's money managers that the fund only lost 22 percent not only "purely pollyannaish" but self-serving (they got increased bonuses for 2008).

Harvard University, relies on the interest from its endowment fund for one-third its budget, needs to be more realistic. As its President, Drew Faust, noted in letter to the Harvard faculty, "We need to be prepared to absorb unprecedented endowment losses and plan for a period of greater financial constrain,"
(This "thrifty/conservative mindset" should be prevailing in America right now! But we are all too busy shopping.)

The collateral damage goes far beyond the ivy-covered walls of Harvard. Money managers at other non-profit institutions plunged their funds into the murky get-rich-fast universe of illiquid investments.

California Public Employees' Retirement System, heavily invested in the same sort of "real assets" as Harvard. Leveraging its own funds, It bought so much undeveloped real acreage, that by 2008 it became the largest private land owner in America. (FUBAR....this is retirement money...FUBAR!)

Then came the subprime debacle, and the real estate bubble imploded, leaving Calpers with unsalable land and, because of its borrowed funds, a 103% loss. Together with other losses in hedge fund and conventional investments, Calpers found that it had lost nearly 40% of the value of its entire pension fund.


Speechless

An Xmas postcard from a friend...

Thx Brian.

My gift to my readers (all 5 of you): scenes from the best Christmas Movie EVER!







I wish everyone Happy Holidays and a kickass New Year!!!

California is f*d....

Full disclosure: I work part time on campus at a CSU (Cal Poly San Luis Obispo), so I am a little anxious about all the budget cuts. I know it sounds stupid to fret over a part time job on campus, but life is expensive (this job helps with that); besides you never know what stupid politicians and state university boards will decide to do.

The point of these excerpts from an article I read, is to show how much municipal governments (like CA) are"in over their heads." If our states are already f'd, I don't want to see them in 8-12 months from now.

A loss of nearly 42,000 jobs last month pushed California's unemployment rate to 8.4%, a 14-year high and the third-highest jobless rate in the country.

California's November unemployment figure lagged behind only Michigan with its crippled automobile industry at 9.6% and Rhode Island at 9.3% after job cuts this year in retail, manufacturing and services.

Even once-strong hiring in healthcare and government is showing signs of weakening next year. A projected $41.2-billion state budget deficit could lead to involuntary furloughs and wholesale firings of workers at state and local government agencies, school districts, community colleges and public universities.

California's real unemployment picture is darker than the state's 8.4% unemployment rate indicates, economists caution. "People believe there are no jobs to be had, and they are simply dropping out of the labor force and don't get counted," said economist Sung Won Sohn of Cal State Channel Islands. California's real or "effective" unemployment rate is probably twice the official number, Sohn said, meaning "the pain in the marketplace is much greater than 8.4% would show."


The city of Vallejo, Calif., gained national attention earlier this year by filing for Chapter 9 bankruptcy protection. Now, two neighbors are fighting to avoid the same fate, as the state's economic crisis spreads.Isleton and Rio Vista, small towns roughly 50 miles northeast of San Francisco, say they have begun consulting with bankruptcy lawyers as they draw up plans to deal with their mounting budget crises. The towns' leaders say they hope to avoid bankruptcy, but concede the move may eventually be their only option.Vallejo instantly became the nightmare scenario for towns across the state facing a similar toxic mix of foreclosures, debts, pension obligations and the inability to raise money on bond markets.

I've been super busy with Xmas shopping. I've also been doing a lotta soul searching lately on account of this Global Economic Meltdown. This is largely on account of my impending graduation in 6 months (arguably the worst time ever to be entering the job market) so I need to lock up work ASAP. Hint, hint...my blogging responsibilities might have to take a back seat for the next few months. Doesn't mean I will stop blogging altogether, but I gotta prioritize.

Private Equity 101...

a very interesting Money Morning article about how Private Equity firms (aka Leveraged Buyout Firms) operate. The part about "covenant-lite" and "reverse convenants" is especially eye-opening since it means controlling PE firms don't have to answer to stakeholders or act in the company's best interest (two seemingly antiquated notions nowadays).

PE's current push into assisting (aka purchasing) distressed banks is also very disturbing since they would then be playing with our bank accounts/deposits and would also be backed by the bailout machine known as the U.S. government...moral hazard anyone?



The once booming business of private equity faces an uncertain future. What’s not uncertain, however, is that many private equity deals are imploding from the weight of leveraged debt and greed. Inevitable bankruptcies will result in higher unemployment and a deeper recession.

Private equity firms are the debutante sisters of hedge funds. They raise huge pools of capital from pension funds, endowment funds, sovereign wealth funds, institutional investors and wealthy entrepreneurs. But while hedge funds buy and sell the stocks of companies they hope to profit from, private equity shops buy whole companies.

The trick of the deal is to pay for the target by using as little equity capital as possible, and raising the remainder by actually having the target company borrow the required funds. (I assume the author is referring to the use of tax shields here to maximize overall firm CF's) Except for the private equity firm’s initial equity investment, the target company is essentially buying itself (More likely burdening itself with massive, crippling debt).

And if that isn’t enough of a trick, very often when the target is privatized, their new masters have the company borrow even more money so they can then pay themselves a dividend as a bonus for the good job they did in leveraging the company to the hilt so they can streamline it.

There are two elements that made massive borrowing possible.

The first was a ready supply of capital courtesy of the U.S. Federal Reserve’s easy money policy and low interest rates. The second was the ability of banks that lend money to acquired companies to pool those loans into securities called collateralized loan obligations, or CLOs, and sell them off to investors. Banks and investors refer to this asset class as “leveraged loans.”

Banks and non-bank lenders attach covenants to the loans they make. Typically, covenants dictate to borrowers what specific balance sheet requirements must be met and include debt-to-cash flow leverage ratios, limitations on the total amount of debt a company can carry, minimum equity provisions and other dictates that serve to secure collateral that is relied upon by lenders.
But, banks were so flush with money and so eager to lend that privately acquired companies, driven by their new private equity masters, proposed that the money they borrowed should not be encumbered by the protective covenants lenders are used to demanding. Hence the birth of “covenant-lite” loans.

Covenant-lite loans included insane “reverse covenants” that benefited the borrowers not the lenders. (unbe-f**king-lievable! How backwards is that?)

Among other things, some borrowers demanded and got rights to:
-Increase debt-to-EBITDA levels to 10:1.
-Freely substitute collateral.
-Issue unsecured debt equal to the total amount of existing debt (if they hedged or effected swaps.
-Employ PIK (payment-in-kind) options, where instead of paying interest in cash they could substitute more debt.
-Employ PIK toggles**, sometimes called “extendibles.”
**PIK toggles...like an option ARM mortgage, where borrowers can choose whether to pay the interest due, some part of it, or none of it, and roll unpaid interest into principal.

Eventually, investors simply stopped buying leveraged loans. And the net result is that banks may be sitting on over $150 billion of junk leveraged loans that they can’t place. They are taking hits to their balance sheets as they have to mark down these loans....they are terrified that the recession will drive more of these leveraged companies into bankruptcy.

Thomson Reuters recently reported that 40 private equity companies have sought bankruptcy this year. According to Standard & Poor’s, of 86 S&P rated companies that defaulted this year, 53 of them were private equity related transactions. Linens ‘n Things which was taken private by Apollo Group Inc. went bankrupt. Sharper Image, Wickes Furniture and catalogue company Lillian Vernon, were all taken private by Sun Capital Partners Inc., all of them are bankrupt. Mervyn’s which was taken private by Sun Capital and Cerberus Capital Management LP. is bankrupt.

Then, of course, there’s the pure genius of PE firms coming to the rescue of troubled banks. But, TPG Capital (formerly Texas Pacific Group) doesn’t look so genius with its $7 billion investment in Washington Mutual Inc. (OTC: WAMUQ) which was wiped out in a matter of five months. ($7 billion lost in 5 months...lmao...what a bunch of idiots).

There’s a lot of pressure on banks to raise capital and there’s a lot of pressure being exerted by the private equity guys to lean on the Fed and U.S. Treasury to bend the rules to let them play in that sandbox. (I AM NOT EASILY FRIGHTENED BUT THIS SCARES THE SH*T OUT OF ME!) Pushing hard from the private equity camp are Randall Quarles, Managing Director of Carlyle Group Ltd. and a former senior Treasury official and none other than the former Treasury Secretary himself, Chairman of Cerberus Capital Management, John Snow.

What the private equity guys want is the ability to buy into banks and control them. If they get their hands on the low cost deposit-based capital at commercial banks, they’ll be unstoppable. How about having the piggy-bank, backed by taxpayers to leverage at will?

Right now there’s a limitation imposed on investors in Federal Deposit Insurance Company insured commercial banks. Once an investment exceeds 9.9% there must be an agreement with regulators to not “control or influence” management. If an investment exceeds 24.9% the investing entity must register as a Bank Holding Company, and subject itself to all necessary transparencies called for by regulators and the Fed. Private equity guys do not want any part of either of those restrictions. They don’t want their business looked through nor do they want their capital encumbered. (Not surpised...only 28 days until Hank Paulson and Bush Co. are gone! They are the only ones who would be stupid enough to let this go PE "assistance" go through).

Some good news, but more bad news

Diane Garnick, investment strategist at Invesco says "I'm more bullish short-term — valuations have been knocked down."

The strategist also cited falling commodity prices, which reduces companies' input costs (and she's not worried about deflation), as well as mass layoffs, which can boost the bottom line. (yeah, but higher unemployment means fewer potential customers and lower future sales).

Having said that, Garnick is restrained in her enthusiasm for stocks in the short term because of still elevated levels of volatility (as measured by the VIX) and in the longer term because of what she calls "the next two crises":

1) Municipalities facing budget shortfalls because of reduced tax revenues.
2) Social Security funds being depleted even before Baby Boomers start to retire en masse.

Regarding volatility, Garnick notes that if the S&P is at 900 and the VIX at 50 (current levels are 899 and 54, respectively), the market is pricing in a two-thirds chance the index will trade between 770-1,029 over the next 30 days.

"Now is one of the most difficult times to make a commitment" to stocks, but "it's a good time for active managers who can handpick the winners and losers," she said. (I agree...you can't be a long term investor in this market when you have 10% intraday market swings. You have to take profits and cut losses when you can.)