Tom A's Stock Picks

Fixing Fannie and Freddie

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Citing persons familiar with the matter, the WSJ says Paulson is near to determining the fate of FNM and FRE - an announcement could come as early as this weekend. Bill Gross has chimed in with his recommendations. Bill Ackman has been heard from too. The universal conclusion is that the ends of justice will be served by wiping out the common shareholders and maybe even the preferred shareholders should take a big haircut. But Bill Gross should be covered OK on the bonds, says Bill. I don't know what Ackman says, but I imagine it favors some sort of short position or something he did with credit default swaps or puts. Good old BIll. Anyway, here is my opninion:

I am not a shareholder, but I have trouble with the idea that the government should wipe out their interests. Fannie and Freddie were supposedly private businesses with a public interest duty to support affordable housing. The government set capital requirements for the business, and both companies are in compliance. So to me the idea that the government should exert some sort of financial eminant domain and dispossess shareholders seems unfair.

In point of fact there is no immediate danger of insolvency, both FNM and FRE can go on idefinitely as long as they can turn over their debt. Much of the crisis has been created by a carefully orchestrated series of attacks, with the article in Barron's providing what very nearly proved to be the coup de grace. Never hesitant to invoke conspiracy theory, I see a scheme by the far right to discredit FNM as a relic of the New Deal. By their reasoning, we could use a man like Herbert Hoover again.

I advocate a rights offering backed by the US Government. Existing shareholders would recieve rights to buy shares at below market value, sufficent to raise the required capital. The rights trade on the open market and the shareholders could sell them if they didn't want to exercise. Any rights that are not exercised would revert to the Federal Government, which would then be an owner to the extent existing shareholders and other market participants passed on the deal. That would achieve fairness for shareholders by allowing them to dilute themselves if they have the courage. In Freddies's case the amount to raise would be the 5.5 billion they told their regulator they would raise. FNM could aslo do a raise in due course.

Eventually the panic will subside and the Government will be able to sell any shares they might own at a profit. FRE and FNM have a virtual monopoly and with interest rates so low they have a good margin on new business, so they would become profitabe as housing recovers. The usual short memories would set in and the stocks would go back up to where they came down from.

Bear in mind that a lot of the shares are held by institutions, many of whom are long term believers in the stock and will be glad to salvage their investments.

Finally, the enabling legislation reads as follows:

"(A) GENERAL AUTHORITY -- In addition to the authority under subsection (c) of this section, the Secretary of the Treasury is authorized to purchase any obligations and other securities issued by the corporation under any section of this Act, on such terms and conditions as the Secretary may determine and in such amounts as the Secretary may determine. Nothing in this subsection requires the corporation to issue obligations or securities to the Secretary without mutual agreement between the Secretary and the corporation. Nothing in this subsection permits or authorizes the Secretary, without the agreement of the corporation, to engage in open market purchases of the common securities of the corporation.

"(B) EMERGENCY DETERMINATION REQUIRED -- In connection with any use of this authority, the Secretary must determine that such actions are necessary to --

"(i) provide stability to the financial markets;

"(ii) prevent disruptions in the availability of mortgage finance; and

"(iii) protect the taxpayer.

"(C) CONSIDERATIONS -- To protect the taxpayers, the Secretary of the Treasury shall take into consideration the following in connection with exercising the authority contained in this paragraph:

"(i) The need for preferences or priorities regarding payments to the Government.

"(ii) Limits on maturity or disposition of obligations or securities to be purchased.

"(iii) The corporation's plan for the orderly resumption of private market funding or capital market access.

"(iv) The probability of the corporation fulfilling the terms of any such obligation or other security, including repayment.

"(v) The need to maintain the corporation's status as a private shareholder-owned company.

"(vi) Restrictions on the use of corporation resources, including limitations on the payment of dividends and executive compensation and any such other terms and conditions as appropriate for those purposes."

Where I would hang my hat is "the need to maintain the corporation's status as a private shareholder-owned company." That does seem to limit Paulson's options. The phrase "obligations or securites" seems broad enough to include a rights offering. Finally, note the use of the terms "mutual agreement" and "agreement." Paulson does not have unilateral authority to make a determination as to where in the capital structure he comes in: he needs to secure a mutual agreement.

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Toll Brothers - well-positioned for the housing recovery

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Toll Brothers (TOL) is sitting on top of a horde of cash, actively looking for opportunities to pick up land at fire sale prices, well-prepared to capitalize on the financial difficulites of smaller, weaker builders and the banks who made bad construction loans. Bob Toll is an industry veteran, with a long record of success, and understands the housing cycle as well as anyone. TOL caters to the luxury home segment and will lead the housing recovery, which may occurr sooner than most analysts expect.

My first investment experience with TOL was not a happy one. I had been doing well with options, thought TOL was over-priced, and sold some naked calls on it. Quite a few naked calls, as a matter of fact. Of course the stock promptly rallied while I watched in horror. After the daily pain got to be more than I could endure, I cut the position in half and sold some puts under the theory the stock couldn't go both directions at once. That at least proved to be true and I eventually closed the remainder of the position with a manageable loss. In due course homebuilders tanked: if I had stuck to my guns, I would have made a profit. I have not sold any naked calls since.

So I learned to respect Toll Brothers.

I added TOL to my SLOport in September last year and have added to the postion on a few days when the market, the homebuilding index, and the stock were all down. I have a 17% profit and expect to make 50% or more when the housing recovery gets going.

I did a longish blog on Homebuilders, to include TOL, KBH and RYL, on 8/15: rather than erhash it, here is a link http://www.investorplaceblogs.com/users/toma47/2008/08/homebuilders_survival_of_the_f.php.

The recent bailout of Fannie and Freddie may very well spark a rally in the homebuilders, on the gorunds that the availablility and cost of mortgages will be improved, preventing further deterioration in the housing market. That may be temporary, but based on the strong balance sheet and the ability and opportunity to refill their pipeline with new land at bargain prices, I now plan to hold TOL, currently at 24.20, for a target of 32.

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MBIA - a high-demand security

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I want to tell you how pleased I was to receive a UPS Express Envelope from Charles Schwab, my broker. Inside was another UPS Express Envelope - for my convenience in replaying - together with a high quality folder, a letter, a contract, and a brochure. It seems that Schwab would like to borrow my shares of MBI - they are "high-demand securities."

Schwab is always looking for new opportunites to help their clients get the most out of their investments. In this case, they can get me another 1.5% per year by borrowing my shares. I called Howie Kennedy, the author of the letter, to see what it was about. If (for example) Goldman Sachs would like to borrow some shares to be sold short, for a customer or perhaps for their own account, they would naturally contact the Securities Lending departments of anyone who might have the shares available. Schwab cannot lend my shares without my permission, unless I'm on margin, which I don't use. But, with my permission, they will borrow my shares and lend them out, paying me interest and posting collateral. I declined the offer.

I asked Howie if my shares of ABK (with another broker) would also be "high-demand." Yes, they are. As a matter of fact there is a list of high-demand securites which they like to have access to. So using the list, they check the customer accounts and helpfully approach anyone who owns the target shares.

Think about it a minute: if there is a list of shares that are high-demand, everyone involved in the operation has to know what shares are on the list. Well any brokerage employee with a normal level of intelligence who becomes aware of what stocks are in hgh demand would naturally to the right thing, which would be to short as much of the target stocks as he dared. Anyone invovled in the operation of locating the shares, sending out the letters, and making the follow up phone calls would be well aware of what stocks are to be shorted.

The letter was dated September 4th. Surprise, surprise, today MBI is down 15% on high volume. By further coincidence tonight my Financial Consultant, a helpful fellow named Matt Teeporeten, called "just to follow up" on the letter. So helpful, to ask to borrow my shares so they can be sold short and drive the stock price down. Or used to cover some naked short-seller's tracks. In the best case scenario, I have a panic attack, sell the shares as they tank, and the borrower Schwab is representing covers by buying my shares. A sweet deal.

You don't need a formal conspiracy - just business as usual, a list of high-demand securities, a group of people whose normal job dutes expose them to working to round up the shares to be sold short, and human nature to look out for number one. Result, stocks mysteriously head south, as if by common consent. Remember, there a host of people involved in tracking down and lending the shares. The whole operation is well-orgainzed and efficient - but, that's what it is, an operation.

Wall Street is a crooked and manipulative place. It strikes me as a strange coincidence that I receive a fancy mailing and a follow-up call about borrowing may shares, which have been there for 6 months or more, just before the shares tank.

There is a list. BSC is no longer on it, neither are FRE and FNM. AIG is on it. LEH is at the head of the list. MBI and ABK are in perpetual demand: however, they are made of tougher stuff than BSC, FRE or FNM or they would long since be gone. The whole process, even if done according to the forms of legality, is inherently manipulative.

The present financial crisis will not abate until the uptick rule is restored and laws against naked short-selling and stock manipulation are enforced by our servants at the SEC.

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AIG - in the crosshairs

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In my Wednesday post, I mentioned that AIG was on "the list" of high-demand securities. That observation proved to be correct, as AIG tanked Friday and its CDS spreads went into orbit. For those who are not familiar with how the operation works, there is a primer on the front page of the Money and Investing section of the WSJ today, headlined "Uncaged Bears Hit Lehman Stock Hard." Their analysis yields 4 steps:

"1. Hedge funds short shares of companies like Lehman, Merrill Lynch and AIG.

2. The funds buy up credit default swaps on the compnaies, sending those prices higher.

3. Investors worried that the CDS market is signaling bad news sell the stock

4. Hedge funds book profits on their short sales as share prices fall."

Other signs of this type of operation include biased and one-sided news coverage and blogs - the rule is, the writer finds the largest possible negative number by reading the company's financial statements and press releases and then presents it without any of its related context. For AIG, the number would be the 26 billion in mark to market losses on their insured portfolio of Super Senior CDOs. Another number would be the 12 or 13 billion of collateral AIG might need to post in the event of a downgrade by S&P or Moody's.

TV journalists, in an effort to prove they are where it's at, echo the negative, out of context numbers.

I have ample experience investing in front of operations of this kind, inadvertently earned while owning shares of Ambac (ABK) and MBIA (MBI). Both victims survived, and my portfolio survived, by dint of averaging in at the bottom. Now, with that experience in mind, I am starting to enlarge my very small position in AIG, in accordance with a set of tactics I have developed for cases of this kind. The steps:

1) Important - find strong support for the necessary thesis - that the victim can survive the attack.

2) Determine the total amount of money you are willing to risk

3) Develop a metric for the company's value - you need this as a starting point.

a) Tangible Book Value per Share, or other estimates of book value per share

b) Smart money or prior capital raise entry points

i.) example, Warburg Pincus invested in MBI at 31 per share

ii.) ecxample, MBI raised additional capital at 12.75 per share

4) Make more or less equal dollar investments of 10% of your max at the following points:

1/2 your metric
1/3 your metric
1/4 your metric
1/5 your metric
etc.

5) Sell in due course when sanity returns to the market

For AIG, I had previously prepared a loss estimate for the Super Senior CDOs, using disclosures on their website and an elaborate 11 page Excel workbook. I got losses of 4 billion, not the 26 billion mark to market. As far as posting collateral due to a downgrade, MBI and ABK both went through that exercise and survived. So, I think AIG can survive the attack.

I am willing to risk 7% of my portfolio, or 70,000 for my Marketocracy account.

Instiutional investors participated in a capital raise earlier this year at 38. So, my first entry point would be at 19, 1/'2 of this metric. The next buy point would be at 12.66 (1/3 of the metric), then would come 9.50, etc. In actual practice I bought 500 shares in my SLOport at 14.03, roughly 7,000. I was busy on my personal portfolio, and missed the next buy point under 12.66. There is no need for numerical precision, but it is definitely important to start small so you have enough cash to keep buying at the scary points.

This is a crazy sounding system. But bear in mind it is an insane market. As an example, my last SLOport buy on ABK was at 1.26, 1/12 of the adjusted book value, 15.75 at the time.

A similar approach to WM in my personal portfolio netted a pre-market buy at 1.75, which was 1/5 of where the smart money (TPG) came in at 8.75. On WM the survival thesis is not really all that strong, so I elected to exit on the rumor (of course it was unfounded) that JPM would buy them out, selling as high as 3.23, day-trading.

I personally prefer a more conservative, value strategy, rather than dancing around picking up shares in front of these manipulative operations. I have written to my senators and congressmen and the SEC complaining about the manipulation inherent in CDS, options, and naked short-selling, to no avail. The SEC is absolutely determined to keep their head in the sand. While I personally regret the devastation of wide swaths of our economy by these anit-social acts, I believe the best way to earn money unde present market conditions, is to buy the shares of companies that are being attacked but will survive the ordeal.

PS. 9/17/08

Slight problem here, the Treasury comes in and takes 80% of the company. This strategy will not work in this market - even solvent companies can be beaten down to zero, the government completes the job.

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Moral Hazard - a Danger to our Financial System

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Lately Hank Paulson has drawn a line in the sand - no more bailouts - no more "moral hazard." The reasoning is, if market participants think the government will bail them out of their mistakes, they will become reckless, which is moral hazard. I disagree. The true moral hazard is created by a financial system that permits a small band of manipulators to make leveraged bets in favor negative outcomes in situations where they have no other stake in the matter.

To introduce my argument: the term "moral hazard" originated in the insurance business, to describe a situation in which the presence of insurance creates an active desire for a loss to occur. As an example consider what would happen if someone were able to buy fire insurance on a house he didn't own, or to purchase life insurance on an enemy or a complete stranger. Moral hazard is created by the lack of an insurable interest in the life or property insured. Someone who buys fire insurance on a building he does not own wants the building to burn down: that's why he buys the policy. The motivation is arson for profit. Because of this, life insurance, as well as fire insurance, cannot be legally purchased if there is no insurable interest.

The relevance to the current market difficulties is this: credit default swaps are a kind of insurance, created to permit protection by those who are exposed to loss because of an interest in a debt or bond.. For example, someone who owns a bond issued by MBIA (MBI) can protect himself from loss by buying a credit default swap on that company. But there is no requirement of an insurable interest. The problem this creates is that speculators buy CDS protection on a company's debt and then put out rumors or distortions while shorting the stock. The results lately have been devastating. I regard it as the financial equivalent of arson for profit.

I first became aware of this phenomenon as a shareholder of MBI. William Ackman, of Pershing Square, sold the stock short and also bought CDS protection on the company. He owned none of their debt: the only reason to buy the CDS was to make a profit when its value increased, or best of all, to collect on it if he could engineer an insolvency. To that end, he and others spread grossly exaggerated estimates of possible losses arising from MBI's business of providing insurance on structured finance products.

Ackman's persistence and tenacity were extraordinary. When doubts about MBI's survival became sufficiently grave to draw regulatory attention, he had the gall to introduce himself into the debate, writing to NY Insurance Department Superintendent Eric Dinallo and proposing a solution that would have the effect of creating a loss on MBI's bonds. In point of fact, he was motivated by a vendetta arising from an incident in a previous life: he had tried the same trick before, while a principal at hedge fund Gotham Partners. Gotham Partners was liquidated, in part because of losses incurred while shorting MBI. How sweet, to get revenge and make a profit too.

In my previous blog on this topic, in December last year, I issued the following warning: " A determined group of negativists can short a companies stock, go long credit default swaps on the same company, and create the appearance of a disaster in progress, meanwhile lining their own pockets at the expense of legitimate investors... Perhaps speculators will succeed in destroying the economy - in effect, burning down the house we all live in. That is the true moral hazard."

Recent events - the demise of Lehman (LEH), Bear Stearns (BSC), Fannie Mae (FNM) and Freddie Mac (FRE) - provide a chilling chronicle of moral hazard run rampant. In each and every case, huge profits were made by causing business failures that may have been preventable. The recent episode involving American International Group (AIG) which has not been resolved as I type this, is only the latest chapter.

General Electric (GE) credit default swaps have been trading at increasing spreads. GE is an industrial, perhaps, but has a very large financial services business. Perhaps the studious financial arsonists have identified a chink in the armor, a flaw which can be exploited to bring down another icon of American business. I saw a graph of their CDS spreads on TV yesterday, it was stunningly familiar.

At this point I am sad enough to wish that I was wrong.

To talk of moral hazard as emanating from the shareholders of a legitimate business, as if they were stupidly oblivious to the danger of attack by financial murderers, is stunningly inappropriate. In a law abiding society, most of us walk around unarmed. Most of us sleep at night in frame dwellings, secure in the belief that we will not be incinerated by an arson attack. However, in the financial arena, that is no longer the case. Any business that is not armored and fire resistive is an instance of moral hazard, a victim looking to be the target of attack, and culpable in its own demise.

As Warren Buffet noted, derivatives are a weapon of financial mass destruction. These weapons are trained at the heart of American business.

Our regulators have been stunningly inept. The up-tick rule has been abolished. Niggling distinctions between "abusive" naked short-selling and acceptable naked short-selling become the basis for a tentative approach to possible regulation. A state official, Eric Dinallo of the NY Insurance Department, was the only regulator to come to the defense of MBI, when he finally wrote an article in the Financial Times, noting the illegality of Ackman's defamatory attacks.

Meanwhile, the huge credit default swap industry, a totally unregulated business of insurance, continues as an arena of toxic machinations. Here, in total obscurity, bets are placed: which of the remaining financial companies should be the next victim? Would you be comfortable if strangers could legally place bets on your longevity? Or on whether your house would burn down?

Paulson has been cleaning up the best he can, conducting the last rites and finalizing the effect of the short-sellers attacks. He administers the coup de grace, placing the shareholders of FRE and FNM in a position where the short-sellers will never have to cover, and legitimate shareholder's losses become permanent. This actually creates further moral hazard, as short-sellers can rely on Paulson to complete their work and make the damage permanent and fatal.

I have been writing to my congressmen, as well as the appropriate regulatory bodies, and suggest you do the same.

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Redefining "toxic waste"

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As the financial crisis has deepened, the use of the phrase "toxic waste" has come up as a convenient and descriptive term to cover MBS, CDO, CDO^2, RMBS, the whole alphabet soup of Structured Finance. The questionable ingredient in these securities has been residential mortgages, extending from sub-prime through Alt-A all the way to prime and jumbo. Let's remember what the underlying collateral is: it's the American Dream - home ownership.

Many of our ancestors lived as slaves, serfs or tenants on the estates of a privileged few, subject to the arrogant whims of a ruling elite, landless and powerless. Over a period of centuries, and at the expense of the self-sacrifice of many brave men, we have forged a nation that is freer, more equal, and more just than any other. To own one's own home in such a nation is a valuable privilege, beyond the means of most if it were not for the institution of mortgage financing. A home is the one acquisition for which borrowed money is normally a necessity: a mortgage can lay the foundation for a steady increase in personal net worth, enriching homeowners and society as a whole.

So let's not call residential mortgages, as an integral part of the American Dream, toxic waste.

In a previous existence, I was an insurance agent and wrote and serviced homeowners insurance on a good many houses. I inspected them all: went out and took a picture, and either measured them myself or secured a copy of the Assessor's field card, which included the dimensions. Using the dimensions and information provided by the insurance companies, I estimated the replacement cost of all of them and provided insurance in appropriate amounts. I lost a few customers because I would not insure the house itself for more than its replacement cost: remember, the land can't burn. I also lost some customers because I wouldn't under-insure in order to reduce cost. That was OK with me.

Across the hall from my office there was a mortgage broker, who seemed very prosperous. One of my clients, I'll call him Tommy because that was his name, used their services. I asked him why he didn't just go down to the bank and get a loan for himself. Tommy's response was straightforward: "He tells my lies for me." I supposed at the time that this was reasonable given Tommy was self-employed and couldn't document his income. But I used to ask myself whether telling people's lies for them didn't pay better than what I was doing.

It has become distressingly evident that there was a great deal of dishonesty involved by many parties to real estate transactions leading up to the bursting of the bubble. Some home-buyers overstated their incomes or claimed they would owner-occupy houses that were intended for flipping or rental. Some up-raisers submitted inflated appraisals, whether on their own or under encouragement from mortgage issuers. Some mortgage issuers knowingly accepted fraudulent or inflated transactions, secure in the knowledge they could pass the risk on down the line. Those who packaged the resulting transactions at times failed to do due diligence in verifying the quality. The rating agencies at times ignored their own duty of due diligence. Some underwriters at my bond insurers no doubt used a studied carelessness to avoid verifying the quality of the business they wrote. Those who sold the resulting structured finance product at times recommended the investments as safe when they knew otherwise. And so on and so forth, up and down the line.

The toxic waste here is greed and dishonesty.

Plans are being developed to permit the Treasury to buy these transactions. I believe it is necessary, support it, and look forward to the resulting improvement in the economy and the financial sector.

But I hope Treasury does not lose sight of the root cause of this evil. The individual transactions should be examined, bean by bean, and pushed back down the feeding chain to the responsible party. If there has been fraud, misrepresentation, or breach of warranty, let the perpetrators bear the consequences of their own actions. I don't mind contributing as a taxpayer to the support of the privilege of homeownership for as many as possible: what I do mind is paying for losses caused by greed and dishonesty.

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NY State to Regulate CDS as Insurance

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Finally! A start to solving the CDS problem. New York Governor Paterson, together with Insurance Superintendent Dinallo, announced that the state will regulate credit default swaps as insurance when there is an insurable interest underlying the transaction. Here is a link: http://www.ins.state.ny.us/press/2008/p0809224.pdf. The announcement is well worth reading in its entirety: it provides a great deal of clarity about the serious issues that remain for the SEC to address.

This is another serious embarrassment to the SEC, as a state regulator has been forced to extend his own jurisdiction in order to compensate as much as possible for the serious omissions of Federal oversight. The announcement encourages the SEC to step up to the plate and regulate credit default swaps that are not insurance - ie., "naked swaps."

The purchase of a credit default swap, when the buyer does not own the referenced debt, is in point of fact euivalent to a naked short sale of the bond. The announcement explains: "... just as with short selling of stock, most swaps are now used by speculators who do not own the bonds and the value of swaps outstanding are generally much more than the value of a company's debt. Swaps bought by speculators are known as "naked swaps" because the swap purchasers do not own the underlying bond. Speculation in a company's bonds can under some
circumstances hurt that company's ability to borrow."

To quote Dinallo: "The severity of this crisis was substantially increased by what the government chose not to regulate, principally credit default swaps.This is primarily a credit crisis, not an equity crisis, and that is where the focus should be now."

The point is, the SEC needs to halt the sale of naked swaps immediately, as they are causing far more of the problem than the activities of legitimate short-sellers. Thes is the same issue I have been referring to as the moral hazard caused by credit default swaps.

This will be good news for Ambac (ABK) and MBIA (MBI), as they will now be able to provide insurance on corporate bonds without competition from unliclensed, unregulated and potentially irresponsible market participants.

Watch for an announcement from the SEC. When that appears, the crisis is over.

PS After this was posted SEC Chairman Cox asked Congress for authority to regulate CDS. It turns out that Congress blew the call in 2000 with the Commodity Futures Modernization Act, which barred the CFTC from regulating credit-default swaps. Already smart lawyers are asserting Cox has no authority even to investigate fraud or manipulation in connection with CDS.

Cox was very careful in his testimony at the Senate hearing today to point out that the buying of "naked swaps," those that are not supported by an insurable interest, is in point of fact a naked short sale of the underlying bond. It has huge leverage and very little downside risk. Cox further notes that the amount of CDS purchased frequently is greater than the total amount of bonds outstanding.

So now what is needed to to write your congressman to pass a law to enable the SEC to regulate these contracts. I now think that naked swaps are gambling contracts, and as such illegal per se.

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Bailout - Why the Big Rush?

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The question that has been coming up again and again is why this has to be done by Friday, by early next week, why can't we take our time and do it right?

One answer Hank and Ben didn't volunteer was that the quarter ends on 9/30 and all of these mark to market values on MBS need to be pegged to the prices as of Tuesday. If as we have been told none of these things have been trading, and it is not possible to get reasonable quotes, what are they going to be marked to?

I suppose you could set the mark to market values by checking out the spreads on CDS. Maybe that wouldn't work real well because the things are thinly traded and widely used to hedge long bond positions. Nobody wants to sell any of the precious protection while the end of the financial system as we know it hangs in the balance.

It might have been simpler to have strangled the mark to market concept before it got out into GAAP and played its part in creating the crisis. That part of the system wasn't broke: there was no need to fix it. If Congress can't agree on a bailout I think the people at the Financial Accounting Standards Board should pull an all-nighter Monday night and change the rules back to what they were. Otherwise those who regulate banks and insurance companies are going to have to change their capital standards to work around the problem.

Even the talk and potential for action has been driving the ABX upward - a nice bailout plan, all signed, sealed and delivered would at least push it up long enough to get past Tuesday.

Another question that isn't getting answered is why this plan? Why not go back to the basics, fix the regulatory system and allow the market to correct itself over time?

There is one part of the regulatory system that doesn't need fixing because it doesn't exist. That would be the part where Credit Default Swaps are regulated, the selling of "naked swaps" is outlawed or severely reduced, where there is a central clearing house and transparecy about this 62 trillion dollar high stakes casino in the middle of the financial system.

Neither Paulson nor Bernanke dares to precipitate the great unwind that will end the CDS debacle. They are hoping to slowly ease the CDS market back to reality by exerting force on the underlying bonds, allowing all the players to unwind gradually without taking each other down in a massive counterparty crisis.

Have a nice day.

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Garden Party II

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This post extends an allegorical tale I started in March, the first five paragraphs date from then:

Here we are, guests at a Stock-picker's party. At a country estate, on the carefully landscaped grounds of a newly built mansion, we are enjoying a pleasant gathering, chatting with old friends, sipping a drink, munching on various delicacies, strolling through the spacious formal gardens. I forget who our host is, it doesn't really matter, there's plenty of good food and a truly wonderful spirit of companionship and camaraderie among all concerned. Day Traders, Active Traders, Swing Traders, Investors, Speculators, Brokers, Analysts, Gurus and Guru wannabees - everybody is having a good time.

Suddenly a cloud comes over the sun, the day grows noticeably darker, and we hear a whispered rumor: "unwelcome guests, uninvited, they are crashing the party." The first to appear is Risk, perhaps you have seen him on TV lately, bleary-eyed and with a sallow complexion, he keeps sneaking around, insinuating himself into the conversation, slyly sabotaging all the arrangements. He saunters over to the punchbowl and surreptitiously spikes it from a small flask he carries in his pocket. Soon his cousin Volatility arrives, built and dressed like a professional wrestler, he drains the bowl in one long swallow and then starts picking fights and tipping over the tables, smashing glassware, hurling plates and saucers at everyone.

Then comes Call, not the pleasant fellow who always hangs around with Put, but Dr. Margin Call. When Margin calls, people listen - they have no choice. With a rueful grimace he informs his victims of the precarious state of their financial health, and prescribes his remedies - purging and bleeding. The last unwelcome guest is Loss, mournful and lugubrious, like an undertaker come to lay to rest our fondest hopes of quick profit, not to mention our legitimate aspirations to financial security.

Can't we do anything about this? Where is our host, surely he can have this riffraff evicted - he can call the authorities and restore order. We will send them back to where they came from and continue with our party, none the worse for the temporary interruption. Alas, our host is the renowned architect of financial disaster, Professor Leverage. A gifted man, incredibly inventive, but he sometimes overreaches himself. Some even question his sanity. Our unwelcome guests are his offspring, and he is powerless to make them leave. As we look on in horror, his mansion, in reality nothing more than an elaborate house of cards, collapses in a cloud of smoke, which billows upward and eclipses the sun...a flock of financial vultures circles overhead...

But wait! Isn't that a helicopter I hear? Perhaps Ben will come to the rescue.

Note from the author: this is where I dropped the narrative in March 2008. Now I will resume the tale.

The sun shone for a minute or two, a helicopter hovered aloft, baskets of greenbacks showered down on the guests, and the party picked up where it left off.

But then terrible, horrible, ghastly misfortunes started to strike various guests. Bear Stearns turned pale, pirouetted, and fell. The coroner appeared, as if out of nowhere, Dr. Paulson pronounced him dead of natural causes, and promptly sold the corpse to J.P. Morgan. Then Freddie and Fannie turned pale and started making weird gurgling noises. Paulson's diagnosis was grim - terminal capital inadequacy. He called in Lockhart, who reversed his previous finding of good health. Fannie and Freddie were both bled and purged of 80% of their shareholder interest, then resuscitated with the promise of a transfusion.

Somewhere in there the Lehman Brothers were attacked by mysterious forces and fell to the ground. Paulson's diagnosis, instant triage, "not too big to fail, let them bleed to death, moral hazard must be prevented, at all costs."

Goldman Sachs and Morgan Stanley started to look weak and woozy, but they hustled over to Dr. Paulson who examined them briefly and declared they needed nothing more than a change of climate. He wrote them out a prescription - move to commercial bank-land, the asset valuations are better there. Warren Buffett very generously donated some of the precious green blood to strengthen Goldman.

Soon a gasp of horror went up from the guests. "They're here, the executioners, the agency executioners!" A squad of stooped, monk-like figures appeared, hooded and cowled, toting AK-47s, the dread minions of S&P and Moody's sprayed an indiscriminate fusillade of downgrades at anyone and everyone, before picking out their special victims: Ambac, MBIA, and American International. Lining them up, they opened a devastating fire of multi-notch downgrades. MBIA and Ambac flinched but stayed on their feet. AIG started bleeding profusely, gushing and hemorrhaging green blood, he fell, gravely wounded. Dr. Paulson appeared: the diagnosis, terminal lack of capital, the prognosis, grim. The cure: a liberal purging and bleeding, 80% of shareholder interest, followed by a prompt resuscitation with a transfusion of government backed promises. A crowd of onlookers screamed in protest: "moral hazard, moral hazard, you'll teach all shareholders to expect a bailout." The shareholder muttered among themselves, complaining their board gave them the run-around.

Moody's executioners paused to reload with new assumptions and projections, more deadly than before. MBIA stood there stoically, "I've got a bullet proof vest." I looked, and sure enough, there it was, direct from AAAcme Manufacturing Company. "I am not dependent on capital markets," intoned MBIA, "go ahead and shoot me." Ambac called on his congressman - "please don't let them shoot me, I can't stand the loss of any more blood. The cavalry is on their way, please make them wait, five minutes, ten minutes, I beg of you. By the way, if you made insurance part of the solution I could do some wonderful things."

Then the Mighty WaMu fell, a pernicious run of deposit withdrawals had weakened him. OTS pronounced the diagnosis, death of natural causes, and then FDIC ripped his heart out and handed it to JPM as a trophy. The crowd watched in utter amazement, shocked and awed by the spectacle.

Finally Professor Leverage appeared, accompanied by his friend, George. Calling for silence, George proposed a solution: "Rebuild Professor Leverage's mansion," he said, "restore it as it stood before, and the party can go on." Paulson and Bernanke outlined the plan: using a 700 billion lever, and applying immense forces at certain strategic points, they claimed they could raise the mansion in a matter of days. Some doubted the need for that much leverage, suggesting lesser sums, as little as a niggardly 150 billion. "That won't do it," wheedled Paulson," we need a big bundle of bucks to raise this sucker back up." The onlookers debated furiously: some thought a policy of insurance on the mansion would be a better solution. Others thought depriving offending CEOs of their golden parachutes would be a an improvement, guys like Willumstad and Freeman, prime offenders. Or more purging and bleeding of shareholders, 80% is too little. The debate raged on as darkness fell.

At the outskirts of the crowd, a superannuated bean-counter watched in wonder. "Maybe if they can prop that thing back up again, even for five minutes, it would be a good time to leave the party."

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Hartford Financial Group Takes a Dive

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Today as the market and financials in particular were bouncing back from yesterday's plunge, Hartford Financial Group (HIG) declined from 51.25 to as low as 31.26, apparently on Fitch's announcement changing their outlook to negative. I have a small starter position and spent some time trying to figure out how to respond to the sudden movement.

I looked at options activity and saw October puts at 30 and 35 trading at what I considered to be expensive prices. Often that kind of activity is a sign that "someone knows something," and reason for concern. With Hartford on the list of stocks that can't be shorted I don't have short-sellers to blame.

When reviewing the stock before I bought, I noted that it would normally trade at a P/B of greater than 1.5 at some point during the year and buying in the area of book value I expected to do well. Possible issues included a large amount of MBS, creating a riski of being forced to liquidate at market prices rather than holding to maturity, a DAC unlock for the 3rd quarter, and the exposure common to any financial of a rating agency downgrade. DAC stands for deferred acquisition costs and is a timing issue as I understand it - the company has to recognize the agent's commissions on Life and Annuity as an expense, but the exact timing is variable.

Double checking, I searched the 10-K to see if HIG has any exposure to the collateral type liquidity issues that created AIG's problems and did not find any.

My experience has been that these financial stocks, once they start trading well below book value, can just keep going down - often to mere fractions of that metric. HIG does not appear to have any Achilles heel of the sort that sank AIG so I am at a loss to see why that should happen here.

It is the last day of the quarter, so maybe somebody is dumping a position to take it off the books before they report.

Taking all of this together my big decision is to do nothing. I will consider adding to the position if and when it trades at well under half the book value, because in the past that has permitted me to average in at favorable prices. I will not reduce the position until I have more information - such as whether a bailout will be passed and a look at 3rd quarter earnings.

P.S 10/1 Located an article that cited exposures to WaMu, AIG and Lehman totalling 655 million. that would be 3.2% of Book Value or $2.08 per share. That number would compare with a capital cushion of 1.5 billion Hatford estimated they had on the strictest rating agency requirments as of 6/30/08. With the stock already trading under book the declines of $10-20 per share are over-reactions. Earnings will be out in late this month

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