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Monday, 23 June 2008

Don’t Buy What Wall Street Is Selling

by: Martin Hutchinson posted on: June 18, 2008

Imagine that you’re the investment director for one of the new sovereign wealth funds (SWFs). A very important guy - you get to invest several hundred billion dollars, with far fewer committees and shareholder interest groups harassing you than if you're the head of U.S. institutions such as CalPERS or TIAA-CREF.

Last winter, you had delegations from all the big banks in New York explaining that they’d just had this teensy weensy hiccup in subprime mortgages and so were giving you an unparalleled opportunity to buy shares - or convertible bonds - at a modest discount to the market price. You bit and you bought - a few billion dollars in each of two or three of them maybe, a fleabite in terms of your overall funds to invest but real money for ordinary mortals.

Now you open The Wall Street Journal handed you by a flunky to see how your investment is doing….

And find it’s down an average of 15%. And that’s in dollars, which themselves appear to be turning into some kind of peso.

The Politburo will not be happy (if yours is the Chinese fund). You may even find yourself minus a hand (if it’s one of the Middle East funds). Worst of all, if you’re from Singapore’s Temasek Holdings, you may have to explain your poor investment decision to the razor-sharp intellect of the 84-year-old island patriarch Lee Kuan-Yew!

The reality is, according to a Financial Times calculation, the sovereign wealth funds, institutions and other investors who have poured $65 billion into cash-starved U.S. financial services companies since last October have lost $9.7 billion, or 15% of their initial investment. In some cases, like the monoline insurers, investors have lost 65% to 70% of their money in less than six months. Yes, that’s a small number compared to the cost of the War in Iraq or Barack Obama’s health plan, but if you’re running a large fund that made several of these investments, it could play merry hell with your job security.

So, when the financial services companies discover their next set of disasters, which they will, and come round for another emergency injection of equity capital, where are they going to find the buyers?

Make no mistake, there will be more disasters - we’re nowhere near through the woods yet. Lehman Brothers Holdings Inc. (LEH), which had previously avoided writeoffs, just declared a $2.8 billion second-quarter loss and is now fighting desperately for survival. American International Group Inc. (AIG), the insurance and finance giant, has written off more than $20 billion and fired its top management, but nobody thinks they’ve found all the problems hidden in their books yet.

Even Goldman Sachs Group Inc. (GS), which has so far been snootily superior about its lack of major write-offs and quarterly losses, now has $96 billion in “Level ” assets, three times its capital. “Level ” assets, for those who haven’t been following the bizarre accounting sub-plot to this saga, are those for which no meaningful market price can be found, so instead they are valued by in-house mathematical models. I hate to be cynical, but if I had borrowed twice my net worth and invested it all in assets for which there was no market price, I might be just a tad worried in a financial storm as big as this one.

There are two forces that make me believe Wall Street investment houses will report another round of unexpected losses.

The first is the continuing decline in house prices. The $300 billion that has been written off Wall Street balance sheets so far represents the worst paper - subprime mortgages that weren’t justified in the first place. Almost certainly that $300 billion figure is still too low, but there might be the hope of an end to the losses if not for the continuing decline of house prices, at a rate of about 2% per month nationwide.

Those declines are exposing huge new tranches of mortgages that were previously in good standing. If the principal amount of even a prime mortgage becomes substantially above the value of the home, and the borrower gets into difficulties, the odds of default increase. The large bumps in property taxes that municipalities are beginning to levy, to cover unexpected gaps in their tax receipts, exacerbate the problem. Future mortgage losses will probably greatly exceed those already written off financial sector balance sheets.

The second force causing further write-downs on Wall Street is all the other lending the banks did during the boom years that is now also turning out to be rubbish. To the extent mortgages default, credit card loans cannot be far behind, and indeed we are already seeing a sharp rise in credit card delinquency ratios, which particularly affects the regional banking sector. Then there are the acquisition loans, and lending in general to overleveraged companies that are turning out not to have the cash flow they had projected.

Finally, there is the new and terrifying area of credit default swaps, now with a total volume of an extraordinary $62 trillion, ten times the size of the U.S. corporate bond market. Theoretically, for every loser on a credit default swap there is a winner. But in practice, many of the losers will turn out to be hedge funds and other non-creditworthy riffraff, and the financial system will be left holding the bag.

The losses investors have suffered on past equity investment in U.S. financial institutions are now probably sufficient enough to deter further investment in such institutions. Thus the market may well be shut out from raising future capital. We are already seeing this problem in Britain, where a $600 million rights issue for the home mortgage lender Bradford & Bingley PLC (BDBYF.PK) was withdrawn, even after it had been underwritten, an extraordinary event that did not happen, for example, during the crash of 1987.

Sovereign wealth funds may be stupid, but they’re not THAT stupid. And nor is the equity market as a whole.

For the financial system, this is likely to bring further bankruptcies or emergency bailouts - except that the Federal Reserve may not be able to find banks to conduct a bailout, as JPMorgan Chase & Co. (JPM) did for Bear Stearns Cos. Inc. (BSC) When JPMorgan Chairman James Dimon says, as he did last week, that he believes the financial crisis is almost over, he may be indulging in desperate wish-fulfillment rather than cold hard analysis - Bear Stearns seems likely to cost Morgan even more money than previously feared.

So if your broker comes to you with a great deal for a U.S. financial institution, I would advise you to hang up. Don’t be lured by the promise of big dividends - soon the banks will be too cash-poor to pay. We’ve already seen dividend cuts from the likes of Citigroup Inc. (C) and Washington Mutual Inc. (WM). More cuts are on the way.

What can investors do about it? Simple - avoid fashionable companies involved in “symbol manipulation” and look for makers of actual PRODUCTS - things you can drop on your foot (possibly crushing it, if we’re talking about Deere & Co.’s (DE) John Deere 3510 sugar cane harvester). Just make sure the companies you invest in won’t need to go to their banks for extra money anytime soon, because the banks won’t have any to give.

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