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Saturday, September 01, 2007

Market vultures await more blood

Market vultures await more blood
By John Authers
Copyright The Financial Times Limited 2007
Published: August 31 2007 18:40 | Last updated: August 31 2007 18:40

World markets have been in crisis for weeks. That should mean rich pickings for someone. One of the oldest, but truest, aphorisms in investment is that you should “buy when there’s blood in the streets”.

There is speculation that the legendary investor Warren Buffett, who is sitting on a huge cash pile, is about to start spending it. And hedge funds started buying up stricken subprime lenders earlier this year, to a flurry of publicity. But the history of those deals is problematic.

For example Lone Star, a private equity group, on Friday offered to buy Accredited Home Lenders, troubled by bad subprime debts for months, for about $225m. But this was only after it pulled out of a planned $400m purchase announced earlier this year. The message for other circling vultures is that there may not yet be enough blood in the streets.

Another deal hailed as a masterstroke, Bank of America’s purchase of a $2bn stake in Countrywide, the biggest US mortgage lender, also needs to be proven. Countrywide’s stock has drifted down since the deal was announced. The market is still unconvinced either that Countrywide is a bargain, or that the BofA investment will be enough to propel the company back to safety.

Value investors, such as Mr Buffett, are not gamblers. Part of their creed is that by buying cheap they buy a “margin of safety”. Even if a company goes bust, for example, they want to know that its break-up value is bigger than the price at which they buy.

At first glance, it looks as though financial stocks represent a good value opportunity. They are usually valued by their multiple of book value (the total value of the assets on their books, minus their liabilities). On this basis, they are their cheapest in more than a decade.

But there is no margin of safety in financial stocks. The low multiple to book value is not – as would usually be the case – because of pessimism about future earnings prospects.

Rather, it is because nobody quite believes the current stated book values. With subprime defaults running high, and with financial services groups around the world discovering they cannot put a value on assets they had thought were safe, many may have to mark down the assets on their balance sheets. That generates uncertainty and it does not offer much margin of safety.

But if the bargain-hunters are not yet finding opportunities to make money, others are. Sadly, they are betting on things to get worse.

They can do this with great comfort, because the market’s previous ridiculously low estimate of risk allowed them to place their bets at what now seem to be insanely cheap prices. Bargains were to be found when the credit market was at its peak – but it is now too late to get in and profit to the same extent.

One of the most successful investors to bet on a credit crunch was Jim Melcher, who has run Balestra Capital, a small New York hedge fund, for almost a decade. It has doubled so far this year. He did this by exploiting the complex new debt instruments that are now exploding in the faces of their inventors.

For example, he bought credit default swaps (CDSs) against a range of 30 collateralised debt obligations (CDOs) that were rated AA. Translated into English, he bought insurance against default by packages of loans that were not the highest quality, but were not junk either.

The cost to him, the effective premium, was 0.6 per cent per year. This was the most he could possibly lose from the strategy. The potential profit, if all the bonds issued by the CDOs were to default, was 100 per cent. He now expects to make this on about 20 of the CDOs for which he bought protection. “I’ve never seen a cheaper play to make where you could take less risk with more return than I was offered in this market,” he says. That was a classic value investor’s investment – tiny risks to the downside, with potentially huge profits. He is not waiting for the CDOs to go to zero and has taken profits on a third of these bets. In one case this involved taking $7m for an investment that had cost about $50,000 some months earlier.

Other bets also took advantage of new esoteric instruments and paid off handsomely. He sold short the ABX index of subprime mortgage bonds, a manoeuvre that made money when the price of these bonds shot down.

He also sold short high-yield, or “junk” bonds while buying Treasury bonds. That paid off when there was a sharp increase in the extra yield that junk companies had to pay. And he bought the Japanese yen, which has risen during the market mayhem.

The risk was that someone on the other side of the transactions had to pay up. These counterparties are usually investment banks and Mr Melcher thought some might go under. As insurance he bought “put” options – giving the right to sell stock for a given price – in investment banks. These were cheap because they were “out of the money” – meaning that they conferred the right to sell for a price far below the price at which the companies were trading.

That trade also proved lucrative, as the fall in investment banks’ share prices has pushed up the price of the options. Even his insurance policy is making money.

The true bargains, then, were when the credit market was at its peak. There will be chances to pick up undervalued securities when this crisis has played itself out. But for now, the discouraging news is that value investors remain on the sidelines – while Mr Melcher is still betting on things to get worse.

The writer is FT investment editor


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