Ken Kam's Best Ideas Blog

When I was in college, Paul Volcker, who was then the Chairman of the Federal Reserve, pushed money market interest rates up to around 13%. I remember thinking that if you could lock up that kind of return why would anyone bother with stocks.

After all, the long-run return of the S&P 500 is about 11%. But stocks don’t deliver 11% every year. As we’ve seen, they can go for long stretches of time with lower and even negative returns.

If I could lock in a rate of return above 11% I know I would sleep better at night.

Money market accounts are nothing to get excited about right now. But the commercial paper market is having a fire sale and the yields have soared.

Take the Managed High Yield Plus Fund (HYF) for example. This is a closed end bond fund that invests in a diversified portfolio of commercial paper. On Tuesday it closed at $1.56 per share. The fund pays a monthly dividend that works out to $0.48 per year – an annual yield of over 30%!

What’s the catch? The bonds are not of the highest quality so there is risk that some will default. But the bonds are already trading at a big discount to reflect this risk and it would take a lot of defaults to bring your overall yield below 11%.

If the market gets worse, I’ll be happy to hold on for the 30% yield. If the market gets better, the yield should come down and the price should rise.

A month ago the yield was just under 20% and the price was about $2.50. This means that if commercial paper market eased enough to bring the yield back to 20%, these shares could go back to $2.50 for a potential 57% gain.

If the Federal Reserve’s plan to buy commercial paper succeeds in restarting this important part of the credit market, HYF could be a big beneficiary.

Chris Rees, the mFOLIO Master who brought this stock to my attention, had this to say about HYF.

“In times like this, it is natural for people to experience fear and contemplate safety. However, it is my belief, especially right now, that the safety investors may
be seeking, may not be found in a money market fund making 3%. A couple of MM funds recently broke the dollar peg, one losing 10% of its value. And that's cash!  I'd rather be invested in hard tangible assets purchased at a healthy discount and producing good income than be sitting in cash. And it's important to note these returns are not just while the crisis is on, but for years to come.”

In addition to HYF, Chris has found 2 other stocks with similar characteristics. We are buying all three of them for our managed account clients who are mirroring Chris Rees’ mFOLIO.

Posted by Ken Kam at 3:13 PM | Permalink

This morning Europe announced a rescue package totaling more than $2 trillion. I am impressed with the speed at which they have adopted this rescue plan. If they had not agreed on a plan and backed it with serious money, I was afraid that we would see the market completely break down this week. That is why I bought SKF and TWM last week. Now that the governments of the world have made it clear that there will not let another big bank fail, SKF is no longer a good hedge for the portfolio.

TWM on the other hand is a different story. So far, government has done nothing to assist the smaller companies that make up the Russell 2000 and that TWM provides the inverse return of.  A lot of healthy companies have suffered as banks refused to extend their credit lines. In the next few weeks, as earnings season gets into full swing, we’ll find out just how much damage has occurred. That’s why I’m keeping the TWM position for now.

In contrast to Europe's rescue plan, our government is taking a long time to start putting our $700 billion rescue package to work.

It is now clear that our government's decision to let Lehman Brothers fail was a big mistake. By letting Lehman fail, the Federal Reserve and the Treasury accomplished two things that they did not want to do.

First, they showed banks that it was risky to lend to other banks if there is any doubt about their solvency. This is usually a good lesson, but coming as it did in the midst of a credit crisis, it caused banks to stop lending to each other and made the crisis worse.

Second, because $400 billion of Lehman’s debt was covered by a type of insurance called a credit default swap, the firms that sold the insurance needed to raise a lot of money to settle their contracts. In order to do this they sold a lot of stock and that selling was a big reason the market has been falling nearly every day since Lehman failed.

Posted by Ken Kam at 4:19 PM | Permalink

The price that will determine the settlement value of $400 billion of credit default swaps related to Lehman bonds was set today at 8.625 cents on the dollar. We were expecting the number to be between 10 and 18 cents. Right after the results were announced the market reached its low point of the day.

The big question now is whether the companies that sold these swaps will be able to make payments that will total about $366 billion. They have until October 21 to do so. That seems like a long time to wait to find out which banks, if any, did not get the payment they expected.

This weekend, I suspect that the banks that are owed money will be seeking assurances that they will be paid. If they get those assurances, they will feel less need to hoard cash and perhaps even start lending again. If so, the credit markets may start to recover next week. That would be the best case.

If those assurances are not forthcoming, I suspect we will hear nothing about it from the banks. Instead, we will hear from the leaders of the G7 nations about the need to have a coordinated plan to deal with additional bank failures. Treasury Secretary Paulson has already announced that he is prepared to use some of the $700 billion rescue package to inject capital into troubled banks. The British have already approved a similar plan. However, the rest of Europe doesn't seem to be on the same page.

I hope that the worldwide stock market crash we've seen this week has convinced the G7 leaders that no single country can protect itself on its own. If so, perhaps the world's governments will be more effective next week than they were this week.

The first indication that things are getting better will be when the interest rate banks charge each other starts to come down. The interest rate I'm watching is called LIBOR (London Interbank Offered Rate).  The LIBOR rate went up everyday this week which tells me that all of the extraordinary things that governments did this week failed to restore confidence.

I think that news that the Lehman bond CDS settlements are being paid would do more strengthen bank capital and restore confidence than anything else. Lets hope we hear some positive news about this over the weekend.

Posted by Ken Kam at 8:19 PM | Permalink

I want to let you know that I've recently put a hedge into my Kam Family blend. This is the reason I’m doing it.

In spite of all of the things the Federal Reserve, Congress and the Treasury Department are doing, the credit crisis seems to be getting worse. And, there is an event coming this Friday, that I think could be pivotal.

An auction being held that day will determine the price at which about $400 billion of credit default swaps (CDS) will settle.  These CDSs are related to bonds issued by Lehman Brothers. Currently the Lehman bonds are worth about 10 cents on the dollar, so the companies that sold these "insurance policies" owe about $360 billion to the firms that bought them

In the past couple of weeks, the firms that know they will have to pay have been selling everything they can to raise the money taking the whole market down.

To the extent that the buyers of these CDS were banks, Friday could be a turning point in the credit crisis. You see, a bank that purchased a CDS probably has already written down the value of the Lehman bond, but it probably has also booked a corresponding gain from the CDS.

If the banks get paid on settlement day, there is no problem. But if they don’t get paid, the banks may have to book sizable losses. There could be bank failures and we hope our Government has the capacity to handle them.

The prospect of some banks failing over the weekend because their insurance policies did not pay off may be a big reason banks are unwilling to lend to each other right now.

The good news is that hopefully banks will be more willing to lend to each other again once we get past this settlement and it becomes known who had to absorb this $360 billion loss.

Right now I am concerned that the credit crisis could get a lot worse over the weekend. That is why I added two inverse ETFs to my Kam Family Blend.

These ETFs are designed to move in the opposite direction of a market benchmark. The Ultrashort Russell 2000 (TWM), is designed to give us twice the inverse return of the Russell 2000. So, if the Russell 2000 goes down 5%, TWM should go up 10%. The Ultrashort Financials (SKF) is designed to move twice the inverse of the S&P financial sector index.

If the worst case happens, these positions will increase in value and enable us to take advantage of the many bargains that will be available so we can recover quickly from the downturn.

Posted by Ken Kam at 9:23 PM | Permalink

Put $700 billion in the bag and no one gets hurt.

That's pretty much what I'm hearing as the reason for pushing through a $700 billion bailout for the financial industry. We are told that the situation is so dire that we must accept Henry Paulson's plan or face financial Armageddon.

Of course, when Ben Bernanke was asked what would happen if Paulson's plan was not approved, he said car loans and student loans would be more difficult to get, and businesses would find it harder to borrow money. Perhaps he was trying to downplay the consequences so as not to start a panic, but that doesn't sound like Armageddon to me.

In fact, it doesn't sound like it's worth spending $700 billion to avoid.

Using $700 billion of taxpayer money is a huge decision, or at least it ought to be. It's more than $2,000 for every man, woman, and child in the U.S. It makes me angry to think that they want my 4 year old daughter to contribute $2,000 to a plan which, at least, originally, would have allowed bank executives to keep their compensation packages and their golden parachutes.

It looks like Congress will fairly quickly agree to use $700 billion of taxpayer's money to implement Henry Paulson's plan to resolve the credit crisis.

As details of the plan have emerged, however, I have become less confident that this will in fact be the end of the crisis. Nevertheless, I expect that the news will send the market up, at least for a few days.

As I've listened to Paulson and Bernanke explain their proposal, I am left with the impression that protecting taxpayers is a lower priority for them than protecting banks. This is the only way I can make sense of their proposal to use taxpayer money to buy mortgage securities from banks at a higher price than anyone else would pay, without even asking for an equity kicker -- part of the company -- to offset the risk.

Then there's the claims put forward by Wall Street insiders including Andy Kessler, a hedge fund manager, who writes in the Wall Street Journal that this is going to be a great deal for the Treasury -- akin to the purchase of Alaska for $7 million in 1867. Those billions of bad loans we're buying will be money makers soon enough.

If that's so, I want to know why Mr. Kessler's hedge fund, or any other hedge fund, is not willing to do the same deal? I've never know them to turn down easy money.

Why is it a good deal for my daughter's money, but not a good deal for his money?

A better alternative

If the primary objective is to recapitalize the banking system, as Bernanke testified to Congress, it seems to me that there might be a better way to use $700 billion to accomplish this.

Morgan Stanley (MS) was said to be looking at a good bank/bad bank structure when it was considering a merger with Wachovia (WB). As I understand it, Morgan Stanley would have bought the "good bank" from Wachovia's shareholders, leaving Wachovia's shareholders with cash and all the bad loans -- the "bad bank."

Why couldn't the Treasury use the $700 billion to do something similar -- splitting out the "good banks" from the banking system while paying cash and leaving the bad loans to existing shareholders. I suspect that using the money to set up a number of "good banks" will do more to restart the flow of credit than Paulson's plan to buy the bad loans at favorable prices. This plan would save the part of the banking system that is healthy and empower it to continue making good loans. In contrast, Paulson's plan rewards the part of the banking system that made the worst loans.

To my knowledge such a plan has not been considered, and that feeds my impression that the taxpayers' interests are a low priority.

Getting our goat

The situation reminds me of a portion of the "Hitchhikers Guide to the Galaxy", by Douglas Adams, in which the leaders of the planet Golgafrincham decided to get rid of the least useful third of their population. This was accomplished by making up a story about a giant space goat coming to eat their planet and convincing all of the people they wanted to get rid of to board Ark-B, the first of three giant spaceships that would take them all to a new planet. The other two-thirds of the population, of course, did not follow.

The way that Paulson and Bernanke have described the problem, I cannot shake the feeling that my wife, daughter, and I are being told to board Ark-B. Tell me again what the problem is that is so severe that it justifies taking $2,000 from every man, woman, and child in the country?

Nevertheless, this train has left the station. No matter what we think, Paulson is going to have $700 billion to fix the credit crisis as he sees fit.It's a lot of power to give one man, especially one who was not elected and who has the gall to tell us he doesn't want there to be any oversight.

I am insulted that they think they can scare the money out of me without offering a good explanation. Maybe there are good reasons why each of us should give them $2,000, but I haven't heard them yet.

There is only one thing that politicians respond to more than money -- your votes. Whether you agree with me or not, I hope this makes you angry enough to vote. If the politicians who did this are returned to office, at least I'll feel that they really did represent their constituents instead of the interests of a very small group that thinks they can scare us out of $700 billion.

Thank goodness there is an election coming up.

Posted by Ken Kam at 10:45 PM | Permalink

Paulson's Bazooka

In July, U.S. Treasury Secretary, Hank Paulson, asked Congress for the authority to lend and inject capital into Fannie Mae and Freddie Mac. At the time, Mr. Paulson said that he did not plan to use the authority because as he put it, "if you have a bazooka in your pocket and people know it, you probably won't have to use it."

Well, Mr. Paulson used his bazooka. Over the weekend he announced that the government was taking over both firms and injecting fresh capital. In hindsight, it was inevitable because the threat of Mr. Paulson using his bazooka and wiping out the equity holders prevented both firms from raising capital from anyone else. But it was the discovery by Morgan Stanley's team, brought in to investigate Fannie/Freddie's books, that aggressive accounting approaches made the firms look stronger than they really were, triggered the need to move now. Already leveraged at 40 to 1, far beyond normal banks, restatement of their balance sheets would have made it worse, possibly moving them towards bankruptcy. That would have not only wiped out the equity holders, but would have hurt the bond holders too.

Mr. Paulson's decision led to a huge windfall for the banks, institutions, and even central banks that own the debt securities of both Fannie and Freddie. The yield on those instruments were higher than U.S. Treasuries because they were riskier and those bonds clearly stated that they were NOT guaranteed by the U.S. Government. Now they are and since the yield on Treasuries are lower, the VALUE of those securities just jumped higher. That's good news for the institutions holding them and the banks trying to improve their capital position.

The Credit Crunch

The billions of dollars of losses that the banking industry has been hit by come at the expense of reductions in bank capital. Banks must maintain a minimum level of capital for every dollar they lend out.

The problem is that the losses have been so severe that many banks don't have enough capital remaining to lend more money. In fact, they don't have enough capital to support the amount of loans they have already made. So they have to either raise new capital or sell and reduce their loan portfolios. That's what Merrill Lynch, Lehman Brothers, Washington Mutual, Citibank, and many, many others are trying to do right now. In today's market, raising capital is difficult, especially when nobody knows how extensive the losses will be.

Until a few months ago, investment banks would buy mortgages to create structured securities that were then sold all over the world to bond buyers looking for higher yields. The major rating agencies played along, issuing their highest ratings to these complex securities and giving bond holders a false sense of security.

But as the bond holders suffered significant losses the industry that securitized these loans collapsed. Bond holders no longer could trust the rating agencies that said the bonds were safe, the insurance companies that guaranteed the loans, the investment banks that packaged the loans, the banks that originated the loans, and the home owner that borrowed the money. As a result, banks have been unable to sell loans to free up their capital to make new loans.

To break the logjam, a way must be found to create securities out of these loans that bond buyers will trust and purchase. That's where Fannie and Freddie come in. I think it's going to take nothing less than a government guarantee to bring them back to the market.

Before Treasury's takeover, both Fannie and Freddie had little capacity to purchase mortgages from banks because of their own lack of capital. Paulson's "bazooka" made it possible for both firms to borrow money at favorable rates, but it also made it impossible to raise the capital needed to buy enough mortgages for banks to start lending again.

When it took over the firms, Paulson committed the U.S. Treasury to injecting up to $200 billion in capital as needed. Since both firms have been leveraged as much as 40 to 1, an additional $200 billion in capital could potentially support the purchase of up to trillions of dollars worth of mortgages. That's enough to free up credit capacity in the banking system and break the lending logjam.

If its done well, banks will be able to make new loans that conform to Fannie Mae and Freddie Mac standards secure in the knowledge that they will be able to sell them. If this is the case, the ultimate cost to the taxpayers may be smaller than many expect.

However, it could be done poorly, if banks are able to sell all the bad loans they made when investment banks were setting such very low lending standards. Let's hope that is not the case, otherwise, the cost to the taxpayer will be much higher.

In short, the plan should accomplish its intended effect: first, of stabilizing and increasing the value of $Trillions of Fannie/Freddie bonds because the U.S. Government has taken responsibility to guarantee payment. That should shore up the balance sheet of lots of financial institutions around the world. Next, the injection of capital by the U.S Government should enable Fannie/Freddie to start buying loans from banks again. Finally, it will give breathing room for banks to write-off their bad loans and clean up their balance sheets so that new capital can be raised.

The hope is that that will get the banking system to start lending again so that the credit worthy parts of the economy are not starved. It could take awhile to work its way through the banking system, but I think real progress has been made.

Investment Banks

The move to takeover Fannie/Freddie does not help the investment banks. Their capital is even thinner - leveraged 2 or 4 times more than the banks: from 24 or 33 to 1. So, the write-downs and losses have quickly eroded their thin capital base. Their ability to survive, let alone their capacity to conduct business, is dependent upon their ability to attract new capital.

The investment banks convinced the world that housing prices would continue to rise and couldn't or wouldn't fall. They created mortgaged-backed securities to capitalize on this belief and co-opted the credit rating agencies and default risk insurance companies to believe this too. Then they convinced their customers there was very little risk. They believed their own sales pitch so much that they decided to go in even deeper by loaning to hedge funds (and sometimes even creating the hedge funds themselves) 30 to 1 so that the hedge funds could buy their mortgaged-backed securities.

They took big risks on the bet that housing prices would not fall. While prices rose, they made huge bonuses. When they were wrong, they bankrupted their firms.

This segment of the industry will be recapitalized to the level of activity that makes sense; but at a reduced leverage rate. 30 to 1 leverage is excessive, perhaps even reckless. More due diligence will be required. Ratings and insurance will cost more and mean less.

The net result? Less credit capacity, less money available, especially to dumb projects that don't create real value, and higher cost of capital. The last point is significant. It means that future earnings will be discounted at a higher rate and maket values will be lower.

Posted by Ken Kam at 1:48 PM | Permalink

Perhaps the biggest risk investors are facing right now is the credit crisis. I've been conferring with the top investors at Marketocracy, pooling our insights and data, to understand the causes of the crisis and to know what to look for to tell us when the worst of the crisis is behind us.

Through these discussions, a possible solution to the credit crisis has emerged. It's one that could help both banks and homeowners much more than another big government bailout or another big bankruptcy.

Here’s the idea. The government should require banks to tell homeowners the value at which the bank is carrying their mortgage on their books, and give homeowners a chance to buy their mortgage from the bank at that value.

I think the idea has merit because it would provide a good reason for the banks to value these mortgages realistically. Price them too low, and the bank gives homeowners a bargain. Price them too high, and the bank would be unable to sell them and would have to keep them on their books. In short, it would encourage the reassessment of mortgage and home values that's necessary to bring the system back to reality.

Instead of a continued wave of foreclosures, struggling homeowners could end up keeping their homes with realistic mortgages. And, banks would have realistic prices to value their mortgage portfolios and give us all a better picture of the health of the financial system.

Here's the way it currently works

The capital base of the entire financial system is highly sensitive to the estimated value of mortgage securities -- basically, packages of mortgages traded by institutions. Right now there is a bias to undervalue these securities because it is viewed as prudent and conservative. However, undervaluing these securities also reduces a bank's capital and makes the bank look more precarious.

Accounting standards require banks to value their portfolios of these securities at the lower of cost or market. However, as this crisis has worsened, the market for these securities has dried up. So the only prices you can get are from brokers who don't really want to buy so they quote prices that are so low that banks don't want to sell. The problem is that using these lowball prices to value a bank's mortgage portfolio can cause a severe enough reduction in capital to bring a bank down.

To get a true picture of the health of the financial system, we need a realistic valuation for mortgage securities, not a conservative one.

How low are the prices?

A few weeks ago, Merrill Lynch sold $30 billion of mortgage backed securities for 22 cents on the dollar, or a 78% discount.  Many banks have not marked down the value of their mortgage securities as aggressively as Merrill. Lehman Brothers, for example, said that they had marked down their Alt-A mortgages to 39% of face value. But, all banks have already taken some markdowns. The big question is whether they have been marked-down far enough.

The best way to answer that question is to see whether anyone would be willing to buy these mortgages at the discounts the banks have already taken.

Let the homeowner in the deal

Merrill sold their mortgages for just 22 cents on the dollar. Was that a realistic price, or a consequence of there being only one buyer, a private equity firm.  If so, why not let the homeowners in on the opportunity? Homeowners who want to stay in their homes would be motivated buyers, so its easy to see why they may even be willing to pay more than a private equity firm.

The bigger the markdowns that are already on the books, the more room there is to work out deals that make both the homeowner and the bank better off than they are now.

It may help to work through an example. Consider the situation of a homeowner who paid $500,000 for a home and borrowed 100% of the purchase price. After several years, the home is only worth $400,000 and the homeowner is under water by $100,000. If the homeowner had the opportunity to pay off the $500,000 mortgage for $110,000 -- a 78% discount --  would he do it?

Since the house is worth $400,000 today, by taking advantage of the offer, the homeowner would go from being $100,000 underwater to being $290,000 ahead. I think that is a tremendous incentive for the homeowner to move heaven and earth to marshal the funds needed to accept the offer.

The homeowner should even be able to get a bank to finance a new $110,000 mortgage because the new mortgage would represent only 27.5% of the current value of the home.

The bigger the markdowns that are already on the books, the more room there is to work out deals that make both the homeowner and the bank better off than they are now.

No matter where prices settle out, they will be a more accurate assessment of the market value of the mortgages than we have now. This is exactly the information we need to assess the health of the financial system.

If it turns out that homeowners in general would be willing to buy back their mortgages at a 40% discount, and banks in general have already written off more than 40%, it seems to me that the markdowns have been carried too far and the worst of credit crisis could be put behind us.

If homeowners were able to buy back their mortgages at the prices that banks list them on their books, banks could get better prices for their mortgages, the financial system would be better capitalized, and homeowners could get a better deal for their homes.

Posted by Ken Kam at 5:17 PM | Permalink

On July 28, Merrill Lynch (MER) agreed to sell $30.6 billion worth of securities they described as “U.S. Super senior ABS CDOs”  for a fire-sale price of $6.7 billion or about $0.22 on the dollar. Was this a good deal for Merrill Lynch's shareholders?

John Thain, Merrill’s new CEO, must think so. But I think there was an alternative that may have been much better for Merrill’s shareholders and for the homeowners whose mortgages were the underlying collateral for these securities.

To illustrate my thinking, lets consider the situation of a homeowner who paid $500,000 for a home and borrowed 100% of the purchase price. After several years, the home is only worth $400,000 so the homeowner is underwater by $100,000.

If this represents the typical mortgage holder in the pool of mortgages that made up the collateral for Merrill’s CDOs, its easy to understand why the securities have lost value. After all, when a homeowner’s mortgage exceeds the value of the home, there is a strong incentive for the homeowner to stop paying and walk away. 

When this happens, the mortgage holder has to foreclose on the home and sell it. In the above example, the home has a current value of $400,000. Since you often don’t get full value in a foreclosure sale, lets suppose you can only net $250,000. That means you would get back $0.50 on the dollar which is terrible unless you are comparing it to a deal which will only give you $0.22.

Perhaps an even better alternative would be to offer the homeowner the opportunity to pay off the $500,000 mortgage for $300,000 ($0.60 on the dollar). If the house is worth $400,000, the homeowner would go from being $100,000 underwater to being $100,000 ahead thereby providing a tremendous incentive to marshall the funds needed to accept the offer.

The homeowner may even be able to get a new $300,000 mortgage because the new mortgage would represent only 75% of the $400,000 value of the home.

Are these kinds of deals possible? No one can say for certain except for Merrill. But, when you are willing to take $0.22 on the dollar, you must believe that the collateral has lost 78% of its value. Property values have come down, but I don’t think they have come down anywhere near that much. Seems to me that there was a lot of room for Merrill to have negotiated a better solution for the homeowners and for their shareholders.

Posted by Ken Kam at 5:20 PM | Permalink