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Vol. 27, Summer Break Two Wall Street, New York, New York 10005 • www.grantspub. AUGUST 21, 2009

Opportunists apply here

(November 28, 2008) In the 30 days market cap of $33.2 billion, total debt of value of the various options embedded
to November 20, the Dow Jones Con- $7.1 billion and total assets of $22.7 bil- in any convert, notably the opportunity
vertible Arbitrage Hedge Fund Index lion, of which $1.7 billion consists of cash to exchange the bond for common stock
executed a power dive remarkable even and short-term investments. In the past at the stipulated rate, in this case at a
in this season of nose-down price ac- 12 months, EBITDA (earnings before price of $55.96 a share. Given that the
tion: It fell at the annual rate of 93.7%. interest, taxes, depreciation and amorti- stock trades in the high 20s, the con-
De-leveraging and deflation explain zation) covered interest expense by 19.2 version feature is, for the time being,
the general tenor of things in convert- times ($5.02 billion over $261 million). nugatory. But, observes Barton, 10%
ible bonds. But another, more particu- Debt is 1.4 times EBITDA. Altogether, was the wrong yield on a double-A-rat-
lar source of distress is at work in that Medtronic is a strong candidate for not ed bond, straight or convertible. At 80,
specialized market. Convertible arbi- going out of business. the Medtronic 1 1/ s were not just cheap,

trageurs own convertible bonds—they Yet, on October 28, the aforemen- he says, or “stupid cheap.” They were
and almost nobody else. From which it tioned Medtronic convert traded at “absurd”—Barton’s highest value acco-
follows, observes John Barton, himself 80.75, a price to yield 10.6%. It didn’t lade—indeed, absurd enough to have
a convertibles practitioner, that if one stay there for long, though, and is quot- collected a new constituency of buyers
such investor is “looking for the exit and ed today at 90, a price to yield 6.1%. At to replace the retreating convertible arbs.
in pain, they’re all looking for the exit, the October low, the adjusted spread of The story of the redemption of the con-
and they’re all in pain.” To say nothing the Medtronic issue to Treasurys was vertible market, when it’s written, will
of their investors. 1,600 basis points—i.e., adjusted for the be the story of the handoff of one bond
What manner of prices and yields the
hastily exiting arbs are leaving behind
Arbs in distress
them is the subject at hand, and Barton 160 160
is our tour guide. Every market save the Convertible Arbitrage Hedge Fund Index
Treasury market is on sale (or lately has 140 140
been), of course. But we are going to ven-
ture that none is so cheap—nor so disor-
120 120
ganized nor demoralized—as the one in
convertible bonds. Anomalies abound.
Converts that present a better risk-reward 100 100
proposition than junk bonds constitute
index level

index level

one such example. Converts that stack up 80 71.18 80

more favorably than the equity into which
they are convertible make another. 60 60
As an introduction into the oddities
of the convertible world, consider, first,
40 40
the Medtronic 1.5s of April 2011 (Cusip
585055AL0). The borrowing company,
founded in 1949, is the world’s leading 20 20
manufacturer of medical devices for
the treatment of heart disease, spinal 0 0
injuries and diabetes. The debt is rated 12/01 12/02 12/03 12/04 12/05 12/06 12/07 11/18/08
A1/AA-minus. Medtronic has an equity source: The Bloomberg
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Priced for a three-point landing total assets of $1.8 billion. In the last 12
90% 90% months, $300 million of EBITDA cov-
AMR 4 1/2s of February 2024 ered $3 million of interest expense 100
80 80
times over. The only debt happens to
70 70 be a convertible issue, the 1s of Decem-
Nov. 25, 2008:
60 35.3%
58.2% 60 ber 2033 (00971TAE1), convertible into
64.7249 shares, or at a price of $15.45 a
50 50 share. Down by 69% this year, the stock
40 40 last traded at $11.35 a share.
yield to put

yield to put
Now, then, Barton mused, look at
30 30 things as an equity holder might. The
20 20 share price has collapsed. It is wonder-
fully volatile. At today’s quotation, you’re
10 10 in the enterprise at 2.4 times sales, 6.0
0 0 times EBITDA. Buy the bond, on the
other hand, and your valuation drastical-
-10 -10 ly improves: You’re in at 0.25 times sales
-20 -20 and 0.66 times EBITDA. “And what am
I sacrificing for that?” Barton reflects.
-30 -30 “Basically nothing. Conversion price
10/1/04 4/1/05 10/7/05 4/7/06 10/6/06 4/6/07 10/5/07 4/4/08 10/3/08 is 15.45, but I’m paying 93.5, a yield to
source: The Bloomberg the December 2010 put of 4.4%. So I’m
participating 100% in the appreciation of
after another to buyers outside the con- buyer is paying only 66.5 cents on the dol- Akamai at prices greater than 14.45. Basi-
vertible universe—or, at least, outside lar, about two-thirds of face. Shave a third cally, I’m giving up the first three points
that portion of the convertible universe off the $12.02 conversion price, and you of any stock-price upside. So for me to
that is suffering massive redemptions. come up with $8. Above $8 a share, if Mr. say that I want to own this stock and not
Another thing, adds Barton, you have to Market has his wits about him, the Law- this convertible bond, I need to make the
pay cash. Leverage, which was there for son convertible holder would participate argument that I want those three points
the asking before the bust, is today un- tick for tick in share-price appreciation. “I relative to a stock that’s down 50% in
available. No mystery, then, that prices would just look at it as a high-yield bond the past three months. And I want those
have fallen, or continue to fall. that happens to have a call that is not three points so badly that I’ll walk out
Though the Medtronic issue has unreasonable,” Barton comments. “The from the safety of that bond to invest at
found a new home, the orphanage of un- company’s been spoken of in the past as six times EBITDA and over two times
placed and unwanted converts is filled a take-out candidate. You have a change- sales, rather than at 0.25 times sales and
to overflowing. Barton mentioned, for in-control put, so that would be a home at 0.66 times EBITDA.”
instance, the Lawson Software 2 1/ s of 2
run. And whatever the return on this The more Barton thought about it, the
April 2012 (52078PAA0), quoted at 66.5 thing really is going to be, it’s not going to more incredulous he became. “That’s an
for a yield to maturity of 15.7% and an be 15%. It’s going to be better. It’s going insane relationship between the two,” he
option-adjusted spread to Treasurys of to be better because you’re not going to went on. “Nobody owning those shares
2,050 basis points. Lawson originates ride a 15% curve all the way out into 2012. should not make the switch to the con-
and sells the kind of software that a busi- At some point, either this will trade for a vert. Not to do it, you’re taking on a huge
ness customer would need to harmonize lower yield, or they’ll get sold, or they’ll amount of downside. In this market, can
such administrative functions as billing, recover, or something. And given the val- the shares still get cut in half? Sure.”
procurement, distribution and person- uations you’re coming in at, I think this In Barton’s mind—and, as we listen to
nel. With a market cap of $612 million, compares really well to a lot of the stuff him talk, in ours, too—the 2008-model
total debt of $248 million and assets of I am seeing in high yield. Certainly less convert is as versatile as it is cheap. Why,
$1.3 billion, of which $362 million con- leveraged. . . . If I were a high-yield guy, he proceeds, some give good service as
sists of cash and equivalents, Lawson, I would look at this and say, ‘These guys high-yield cash equivalents. “There are
too, seems a likely survivor. In the last have a variable cost structure; I’m coming a bunch of short-dated converts with
12 months, EBITDA covered interest in at a fraction of a reliable cash stream.’” very high yields to maturity that are cer-
expense 11.6 times ($95.7 million over Or put yourself in the shoes of a stock tainties. And the reason they trade where
$8.3 million); total debt to EBITDA investor, Barton proceeds, turning to they do is because the yield is a function
stands at 2.5 times. Akamai Technologies, which claims of very few points to the maturity. You’re
Like Medtronic’s convertible issue, to own and deploy “the world’s larg- not getting a whole lot of points to the
the Lawson bonds are priced as if they est distributed computing platform.” upside. If you need to raise cash, you
were straight debt. They are convertible Akamai, in Hawaiian, means “smart,” don’t care that you are selling something
into 83.2293 shares, or at a price of $12.02 and Akamai is smart enough to do the at a 20% to 30% yield that’s a certainty if,
a share—a far cry from the current quo- things it does without much debt; it in fact, you just need the cash.”
tation of $3.76 a share. However, Barton has just $200 million vs. $301 million of Comverse Technology, a globe-gir-
points out, the cry is not quite so far as it cash and marketable securities, a stock- dling software development company
seems, because the Lawson convertible market capitalization of $1.9 billion and that got caught with its hand in the op-
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tions-backdating cookie jar a few years Buy one, sell the other
back, is the issuer of one such attractive 150 150
Smithfield Foods high-yield and convertible bond issues
short-dated security. The issue, in the 140 140
sum of $418 million, is the 0s of May
2023 (205862AM7), quoted at 94 and 130 130
convertible into 55.6347 shares. The
conversion price is $17.97, while the 120 120
stock is quoted at $5.91. What lends 110 110
sizzle to the situation is that the bond
is putable on May 15, 2009, at par for 100 100


a yield to put of 14%. Cash and cash
90 90
equivalents of $1.3 billion (not count-
ing $200 million of currently frozen high-yield bond
80 of 2017: 80
auction-rate securities) could redeem 53
the issue three times over. “It’s incon- 70 70
ceivable to me that they could burn
60 60
through that much cash between now
and May,” Barton says. “This is virtu- convertible bond
50 of 2013: 50
ally a T-bill. The reason you can get 50.9
14% essentially on cash here is that the 40 40
guy who’s selling it at 94 needs that 7/4/08 8/1 9/5 10/3 11/7 11/21
cash and doesn’t care that it’s only six source: The Bloomberg
points til May. ‘So what that I’m giving
someone 12% to 13% total,’ you say, ‘I things right because the arbs’ loyal in- convert,” Barton explains. “You are
need the money.’” vestors have suddenly decided that the profiting also from the prospective con-
AMR Corp.’s 4 1/ s of February 2024
business of nickel selling and dime buy- vergence to a similar yield between the
(001765BB1) is another junk-grade T-bill ing is a little too risky for their blood. two. You’ve got a 220 basis-point higher
surrogate. Whether airline traffic is falling In the convertible market, one can yield to maturity in a pari passu bond in
even faster than the price of oil is a good buy converts and sell high-yield bonds the convert. So Smithfield Foods doesn’t
question. But it may not be as pertinent of the same legal standing—they are have to do anything. The stock can stay
as it seems at first glance. The AMR pari passu with the converts—and, in the right where it is. If the convert yield
converts, all $324 million of them, are process, pick up points up front, increase falls and the straight yield rises, the arb
putable in February. Quoted at 90, they one’s yield to maturity and shorten one’s is ahead of the game. And, also, you’re
yield 58.2% to the put. It’s true that AMR duration. “The amount of money in the picking up the put on the enterprise. If
is loss-making ($1.8 billion in the past 12 hands of guys who tie different markets things really got bleak at Smithfield—
months) and highly leveraged. It is also together is usually pretty small, and right they don’t export pigs any more and the
true that the 4 1/ s are the second maturing
now those are the guys who aren’t in a prior debt maturities have covenants that
debt issue and that, as of September 30, position to put capital into anything,” trip it up, any kind of bear scenario for
there was $4.6 billion of cash and short- Barton says. “So there have been some Smithfield—in that case, these are pari
term investments on the balance sheet, real disconnects between markets. And passu claims and they would converge to
14.3 times the principal to be redeemed. convert vs. high yield, or U.S. high yield the same percent of claim on the enter-
AMR does have the option to redeem the vs. European high yield are where you prise, and you’re long the convert at 51
bonds in stock, but it must give the bond- see that.” and short the high yield at 53.”
holders 20 days notice (a convertible hold- Smithfield Foods, the nation’s top So much for exotica. What about out-
er so informed could presumably hedge pork producer, is the name behind one right purchases? “What would I look for
away some or all of the equity risk). of these anomalies. One could, as Bar- in convertible longs?” Barton mused. “I
One casualty of the credit collapse is ton suggests, buy the Smithfield con- would look for convert longs where they
the art of capital-structure arbitrage. Its vertible 4s of June 2013 (832248AR9) are the only ones in the capital structure,
practitioners are in the business of obser- while shorting the Smithfield straight the company is not likely to need the cap-
vation and inference. When the logical 7 3/ s of July 2017 (832248AQ1). Both is-
ital markets, I am being given a nice yield
and legally defined relationship among sues are rated BB-minus. The converts and a call that I might like, and I have got
various corporate obligations moves out last traded at 50.9, a price to yield 21.3%, plenty of time to sit on it and not worry
of line, they buy or sell to restore it to the straights at 53, a price to yield 19.1%. about it and wait for either the yield to di-
coherence. It is a sign of the times that The trade delivers a pickup in points minish or the equity call to come through.
so many of these relationships are bro- (2.1 up front) and in yield to maturity But one way or another, it is going to be
ken and seemingly irreparable. The arbs (220 basis points) and a shortening in money good. . . . What I wouldn’t want to
watch in amazement as the debt mar- duration compared to that of the straight own is convert behind high yield, behind
kets randomly attach a higher value to issue alone. There is, however, negative bank debt in a high fixed-cost business
a junior nickel than they do to a senior carry of 375 basis points—the straights that could turn into a cash user and might
dime. Amazement turns to horror, how- pay 7.75%, current, the converts 4%. need the capital markets. Because that is
ever, when the anomaly persists—or “Long the convert, short the high a formula for a zero.”
when they are rendered powerless to set yield, you’re capturing the call in the •
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Triple-A upgrade the upper tranches, padding them with

lower-rated mezzanine tranches. Let the
other (or, choosing to rent, for none at
all), they cause such structures as this
junior slices absorb the first blows. Let one to shrink. As often as not, the shrink-
(March 6, 2009) “They don’t upgrade the senior ones have first claim on cash age leaves the senior securities stronger
triple-As,” a promoter quipped way back flow. Insulate the bottom of the struc- than they were on Day 1.
when. They may not, but we are about to. ture with equity ($11.5 million would do, ACE today is reminiscent of a
The top layers of ACE Securities Corp. they decided). Thus fitted and armored, Thanksgiving turkey on the Friday af-
Home Equity Trust, Series 2005-HE5, the good ship ACE set sail. ter the Thursday, with just 1,597 loans,
a subprime-mortgage-backed securi- Soon it was shipping water, for more down from 7,712. Of the four original
ties structure of boom-time vintage, we than four-fifths of its mortgages were triple-A-rated tranches, only two re-
hereby crown quadruple-A, one notch adjustable-rate and thus susceptible main, and they are melting away; the
better than the best. to what has come to be known as reset other two were paid down. Thus, the
Unlicensed by the SEC, Grant’s shock. Furthermore, 45.5% of the port- A-1 tranche stands at $24.4 million,
doesn’t rate often, but we rate with con- folio was sourced in the bubble states down from $549 million, and the A-2C
fidence when the urge comes over us. of California and Florida. By June 2007, tranche at $27.7 million, down from
The A-1 and A-2C layers, or tranches, a fifth of the loans were in trouble—60 $68.8 million. Smaller, the top-rated
of the aforementioned contraption we days or more delinquent, in foreclosure specimens are also safer.
make bold to liken to Treasury bills— or in repossession. Today, 53% are so As of the February remittance re-
T-bills, that is, priced to yield 9.9% and dinged. The lower-rated tranches have port, what remains of the ACE flotation
11.3%, respectively, to fairly short ma- taken the beating for which they were looked like this:
turities. It would be nice to buy them, intended. Not counting the excess-
or others like them, but the structured interest reserve, four have been erased —$328.2 million in balance-sheet
finance market is broadly off limits to and a fifth is almost gone. footings;
us civilians (though a mutual fund we But give the engineers their due. No —$188.2 million of delinquent or oth-
name below has exposure to mortgage harm has yet come to the triple-A-rated erwise damaged mortgages;
matter of this kind). Thus, we write not tranches, and none is likely to. Ameri- —$140 million of current mortgages;
principally in the how-to vein but in the cans are a restless people, even in bear —$52.1 million of triple-A-rated liabil-
gee-whiz vein. The story of the ACE markets. They refinance and pull up ities, supported, or protected, by $276.1
structure is the story of the credit cycle stakes, and more than a few go broke. million in subordinated liabilities.
in miniature. The bad news, you know And as they swap one mortgage for an-
about. Now comes a kind of good news.
Truer words were never spoken
than the trader’s adage, “There are no Better than the best
bad bonds, only bad prices.” The ACE ACE S­eries 2005-HE5 performance
RMBS was a bad bond when it came
into the world in August 2005. It never
—principal balance— ——————rating——————
had a chance; society made it what it
was. Yet it—specifically, in its pent- initial current initial current Grant’s
house strata—is a good bond today.
A-1 $549,265,000 $24,367,853 Aaa/AAA Aaa*/AAA AAAA**
At inception, in the foam of the credit A-2A 333,119,000 paid off Aaa/AAA NR/WR
bubble, it was priced too rich. Today, A-2B 135,251,000 paid off Aaa/AAA NR/WR
so we contend, it’s too cheap. A-2C 68,780,000 27,713,617 Aaa/AAA Aaa*/AAA AAAA**
Dan Gertner of this staff has been M-1 57,482,000 57,482,000 Aa1/AA+ Aa1*/AA+ BBB
keeping tabs on the ACE structure M-2 53,171,000 53,171,000 Aa2/AA Aa2*/AA BBB
since 2006, but new readers may need a M-3 31,615,000 31,615,000 Aa3/AA A2*/A BBB
primer. You may think of structures like M-4 28,023,000 28,023,000 A1/AA- A2*/A BBB
this as banks without walls. On the asset M-5 25,149,000 25,149,000 A2/A+ Ba2*/CCC BB
side are mortgages, on the liability side, M-6 23,711,000 23,711,000 A3/A Caa2*/CCC CCC
notes. The notes finance the mortgages. M-7 19,400,000 19,400,000 Baa1/A- C/CC CC
In typical asset-backed security fashion, M-8 17,963,000 17,963,000 Baa2/BBB+ C/CC CC
the notes are clumped into tranches, of M-9 15,808,000 15,808,000 Baa3/BBB C/CC CC
which there were 20. ACE came into the M-10 12,215,000 3,793,127 Ba1/BBB- C/D D
world in 2005 with assets and liabilities B-1 14,371,000 - Ba2/BB+ C/D D
footing to $1.4 billion. Though the as- B-2 25,149,000 - NR/BB+ NR/D D
sets overwhelmingly were subprime, no B-3 15,089,000 - NR/BB NR/D D
CE 11,496,688 -
less than 76% of the liabilities were rated
P 100 100
R 0 0
The financial engineers assumed that Total $1,437,057,788 $328,196,697
house prices would never fall as they
have, in fact, fallen. But that is not to say * downgrade watch
that the wunderkinder made no allowanc- ** as of March 2009
es for adversity. They overcollateralized source: The Bloomberg
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“Yes,” Gertner allows, “the deal has Worse yet better

performed horrendously. But it did what 90% 90%
overcollateralization of ACE Securities Series 2005-HE5
it was designed to do. It has protected
the senior securities at the expense of 80 80
the junior ones. The February bulletin
contains the usual quotient of miserable 70 70
news. But there is also the unexpected,
positive fact that more principal was re- 60 60
paid to the top of the structure than was

credit support

credit support
lost at the bottom. Specifically, the se- 50 50
nior holders got $5.8 million, while the
pawns lost $1.8 million.” 40 40
Which brings us, at last, to our rat-
ings decision. “Let us say,” Gertner 30 30
muses, “that 100% of the structure
went through the complete liquidation 20 20
cycle—from delinquency to foreclosure
to repossession to the sheriff’s auction. 10 10
In order to impair the remaining triple-A
(quadruple-A, by our lights) obligations, 0 0
the loss severities would have to hit 84%. 0 7 14 21 28 35 42
In the case of a $100,000 mortgage, just months of seasoning
$16,000 would be salvaged at the hypo- source: The Bloomberg
thetical auction. The fact is, over the past
12 months realized loss severities have are repaid faster than the lower-rated an argument.
averaged 50.3%. I would say that the ones are erased, credit quality at the top Now unfolding is an exploration into
likelihood of the triple-A stack surviving improves. The thicker the wall of pro- the crisis-related investment oppor-
without a loss is extremely high. Indeed, tection around the senior-most claims, tunity. We write, we hope, with a due
it’s as close to certain as anything could the more creditworthy those claims be- sense of the gravity of the times. It’s not
be in these interesting times.” come—at the extreme, more creditwor- just every cycle in which a certain Ayn
Prompting our unofficial upgrade was thy than triple-A. Rand disciple and former Fed chair-
an official move in the opposite direction. Just how many quadruple-A tranches man plumps for nationalizing American
Moody’s last week placed the aforemen- there might be is a matter of guesswork. banks. Then again, the bad news is not
tioned tranches under surveillance for Gertner has heard estimates, stemming exactly news anymore. From its peak,
possible downgrade. They were caught from pay-downs in the 2005 and 2006 the Keefe, Bruyette & Woods bank-
in the dragnet of a much broader prob- vintages, of between $25 billion and $50 stock index (BKX) has fallen by 82%,
able re-rating of 7,942 tranches of 2005- billion. Metropolitan West Low Dura- while the financial-stock component of
07-vintage RMBS with an original face tion Bond Fund (MWLDX) is a likely the Standard & Poor’s 500 Index weighs
value of $680 billion. Prompting the ac- beneficiary of the quadruple-A phe- in at just 9.5% these days, down from
tion, said Moody’s, was its own upward nomenon. Senior non-agency RMBS 22.3% as recently as September 2006.
revision of the ultimate likely loss on constitute 40% of the fund’s assets (cor- Yet, your editor is here to attest, if
these securities. For instance, in the case porate bonds make up 33% and agency there is anything scarier than owning
of the class of 2006, it says it believes RMBS 22%). In the past 12 months, the the stocks of banks, brokers and insur-
that 30% will be wiped out, double its fund has lost 16% of its value, a fact we ance companies during a credit liquida-
estimate of January 2008. ascribe not to managerial error but to tion, it’s being short them during the
Maybe, in the case of the ACE deal, Mr. Market’s imperfect understanding post-crisis moon shot. Citi, for example,
Moody’s simply lumped in the strong- of the better-than-best non-agency op- was an $8.50 stock in December 1991.
as-steel triple-A-rated tranches with the portunity. We expect the old gentleman Within two years, it was a $40 stock.
rest. Perhaps, following close study, it will see the light. Within six years, it was earning—al-
will forgo downgrading them. Not much • most—its intraday-low 1991 share price.
chance, however, of an upgrade to bet- The Bank of New Hampshire traded at
ter-than-triple-A. $3.50 a share in September 1991, two
Quadruple-A securities aren’t born. Options on recovery weeks before the FDIC seized seven
Rather, they are made. What makes other Granite State institutions. In April
them is the natural pay-down of senior (March 6, 2009) As to whether the 1996, it fetched $43.50.
tranches. Recall that, in an asset-backed world will survive, opinion is mixed. Maybe today’s basket cases will pro-
security, income and principal trickle Some say yes and some say no, and oth- duce per-share earnings equal to today’s
down from the top. When the trickling ers are on the fence. Neither is there share prices at some not-too-distant
fills the pockets of a senior tranche, that any firm consensus concerning the na- date. We don’t rule it out. Neither do
tranche is retired, as were two of the tion’s banks. Will even one remain in we dismiss the possibility that Sheila
original four triple-A tranches of the the private economy on the day the Bair will wind up controlling every bank
ACE security. If the top-rated tranches Great Recession expires? You can get in the BKX. But, born optimists, we at-
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fills the bill of a Ward 1 candidate. The

Springtime for delinquencies 12th-largest financial-services hold-
8% 8%
delinquency rates of U.S. commercial banks, seasonally adjusted ing company, Winston-Salem-based
BB&T conducts a diversified busi-
7 all loans 7 ness—brokerage, capital markets and
insurance, besides basic banking—in
C&I loans
5.78% the American southeast, including for-
6 real estate-secured loans 6
merly bubbly Florida. Nonperforming
consumer loans loans, at 1.34% of total assets, are, so far,
delinquency rates

delinquency rates
4.59% manageable, though $8 billion of home
5 5
builders’ loans (“residential acquisition,
development and construction loans”)
4 4 and $11.5 billion in commercial real-
2.58% estate loans may yet break out in hives.
3 3 BB&T performed the astounding
trick of turning a fourth-quarter and full-
year 2008 profit (of 51 cents and $2.71
2 2 cents per share, respectively). It lent
more in the fourth quarter than it did in
the third, and more in 2008 than it did in
1 1
1Q85 1Q90 1Q95 1Q00 1Q05 4Q08 2007. Net cash interest margins fattened
source: Federal Reserve
by two basis points in the fourth quarter
compared to the third, and by 22 basis
points compared to the fourth quarter of
tach a higher probability to the former hallelujah as they go. 2007. Net interest income, before pro-
outcome than we do to the latter. Clairvoyants, seeing into the future, visions for bad debts, jumped by 7.5%
“High expenses for loan-loss provi- naturally do their bank-stock investing from the 2007 fourth quarter. BB&T
sions, sizable losses in trading accounts at the bottom. Fearless because they did issue $3.1 billion of preferred stock
and large writedowns of goodwill and are all-knowing, they buy the junior- to the U.S. Treasury toward the end of
other assets all contributed to the in- most security of the shakiest survivors, last year in connection with the TARP,
dustry’s net loss,” noted the FDIC in the stocks that go up the fastest and far- but it seems that it didn’t have to. With
reporting that, in the final three months thest. For the rest of us, lacking perfect $8 billion of tangible common equity
of 2008, insured financial institutions foresight, we might consider options on against $152 billion in assets, the bank
suffered their first quarterly loss since the shares of a cross-section of finan- is sitting in the capitalization catbird’s
1990. No surprise, then, that, despite cials, three or so, let us say, from each of seat—barring, of course, another year or
the highest ratio of reserves to loans in the three departments of the financial two worth of seismic jolts in credit and
14 years, coverage ratios stand at 16- triage ward: ambulatory, salvageable business activity.
year lows, or that nonperforming loans and doubtful. But, one must consider, what about
climbed by 107% last year to reach BB&T Corp. (BBT on the Big Board) the other possibility? How would it be
2.93% of overall loans, the highest in 17
years. Also came the report that the top-
Incredible shrinking bank stocks
secret FDIC list of “problem” banks 24% 24%
comprised 252 institutions controlling weighting of financial-stock component of S&P 500
$159 billion of assets, compared to the 22 22
year-earlier tally of 76 institutions con-
trolling $22 billion of assets. Evidently,
20 20
Citi is beyond problematical; it alone
controls $1.9 trillion of assets. So what
is the bullish-bearish-hopeful-confused 18 18
investor to do?


An options strategy, perhaps. Pick an 16 16

assortment of banks of varying degrees
of survivability. Buy call options at strike 14 14
prices double the current price, with ma-
turities clustered in early to mid-2011.
12 12
The reason not to do any such thing is
that options tick like time bombs. The March
Feb. 20,
3, 2009:
reason to stop one’s ears to the ticking 10 9.22%
9.54% 10
is the likelihood that the cycle will turn
within 24 months and financial stocks 8 8
will lead the way up, with the book-en- 5/19/00 5/17/02 5/14/04 5/19/06 5/16/08
try share certificates themselves crying source: The Bloomberg
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Option basket
(in $ billions)

allw. for price to
mkt. total 5-yr. comp. non-perf. to loan losses to tgbl. comm. tgbl. book
ticker cap assets asset growth total assets nonperf. loans equity-to-assets value
PNC Financial PNC $10.6 $291 33.67% 0.74% 236% 2.90% 1.23x
BB&T Corp. BBT 8.6 152 10.94 1.34 110 5.30 1.07
Goldman Sachs GS 41.6 885 16.99 na na 4.82 0.97
Morgan Stanley MS 19.5 659 1.80 na na 4.33 0.68
Key Bank KEY 3.2 104 4.24 1.41 147 5.95 0.52
Comerica CMA 2.1 68 5.11 1.46 84 7.21 0.43
Regions Financial RF 2.4 146 24.66 1.18 141 5.23 0.33

source: company filings

for BB&T if all this World War II-grade in the fourth quarter—and we place it, many others on Wall Street, mistook
fiscal stimulus and Weimar-caliber side by side with BB&T, in the first a calamity for a business cycle. As the
credit creation “succeeded”? Even as department of the Grant’s triage clinic. regulators count capital, PNC is amply
it is, according to CEO Kelly S. King, On the February earnings call, James covered, with a so-called Tier 1 ratio of
speaking on the fourth-quarter confer- E. Rohr, PNC’s chairman and CEO, capital (equity and preferred) to assets
ence call, the market is coming BB&T’s sounded as cheerful as Barack Obama of 9.7%. But the market puts no more
way. Customers have come knocking, used to before he took office. “We’ve stock in the bank regulators these days
for one thing. They seem to like a sol- been open for business throughout than it does in the ratings agencies, and
vent bank. “[I]f you see something that this period by adhering to our business the market is focused on tangible com-
says they can’t get a loan, give them my model and leveraging our success at mon equity. Preferred doesn’t count.
number,” King invited the listeners-in. building long-term relationships with “Owing to the National City acquisi-
Then, too, King went on, the col- our clients, and by allocating capi- tion,” colleague Ian McCulley observes,
lapse of the shadow banking system has tal based upon risk-adjusted returns, “PNC has a tangible common equity ra-
done a world of good. “I’m very, very we’ve delivered significant value to the tio of just 2.9%. Asked on last month’s
pleased with what is going on with re- shareholders over time.” call if another capital raise is in the off-
gard to restoring pricing discipline,” the So far as the dividend is concerned, ing, management was noncommittal.
CEO stated. “We had an interesting there will be 85% less of it, PNC dis- (PNC is one of the few banks that could
thing for the last 20, 25 years. We dis- closed on Monday, suggesting it was raise private capital.)” Rohr reaffirmed
intermediated the banking industry as a the regulators’ idea. Up til then, the at a conference on Tuesday that there is
huge amount of loans left the banking Pittsburgh-based super-regional had no plan to raise common equity.
system and went through securitization been on the offensive. At the end of The Grant’s triage ward sorts its pa-
into various conduits and other invest- December, it doubled its customer base tients by price-to-book ratios. Goldman
ment areas, which caused two things by swallowing Cleveland’s National Sachs (GS) and Morgan Stanley (MS),
to happen. One is we lost the volume City Bank for $5.6 billion of stock and unloved though they may be in Wash-
and put enormous pricing pressure on an odd lot of cash. The combined entity ington, D.C., are welcome here, in
loans, because a lot of these investors shows $291 billion in assets, $175 billion Ward 2, the salvageables, reserved for
didn’t have the capital and reserve re- in loans and $193 billion in deposits. It shares quoted at a discount, though not
quirements that we do. And so I started has a 33% ownership stake in Black- a gaping one, to book. The Fed’s open-
making loans 36 years ago, and over that Rock, a capital-markets business and a handed lending has quieted fears about
period of time, we’ve lost about 300 custody business. Nonperformers stand the pair’s liquidity, and disaster has
basis points on the same kind of loans. at 74 basis points of total assets, and the thinned out the competition. In 2008,
We haven’t gotten it all back yet. It will allowance for bad loans covers 236% of each shed some of the excess pounds
take a little while, but on the larger-size known duds. National City was chok- accumulated during the bubble years.
credits, we’ve already seen a 100-plus ing on bad loans, home-equity credits Morgan Stanley, for instance, shrank
basis-point improvement just in the last among others, and PNC was able to its balance sheet by 37%, to $659 bil-
three or four months. We’re beginning mark some of these assets as low as 42 lion. True, for the time being, neither
to install floors on credits because abso- cents on the dollar. will be raking in billions from highly
lute rates are so low, and there is a lot of Come the turn, shareholders will leveraged proprietary trading. But wid-
receptivity to that in the market.” thank CEO Rohr for his courage and er spreads will allow for profitable deal-
PNC, too, is the kind of bank to foresight in buying low. Pending that ing even on lower leverage. Though
which nervous, safety-seeking custom- happy event, however, they will have the equity advisory business is likely
ers have been flying—transaction de- to live with the possibility that Rohr did to be as quiet this year as a 2009 off-
posits climbed by $5.9 billion, or 10%, not, in fact, buy low, but rather, like so site, there’s work to be had in restruc-
SUBSCRIBE! - go to or call 212-809-7994 Summer Break-GRANT’S/AUGUST 21, 2009  8

turing and debt underwriting—and in gressive than most at charging off bad equivalent to 8.3% of gross domestic
asset management. In the 12 months loans, and nonperforming assets actu- product (i.e., GDP for 1933, the year
to November 30, Goldman’s asset- ally ticked lower in the fourth quarter. the Depression officially ended). To
management business, which includes Then, again, the loan book would be banish the demons of 2008-9, succes-
prime brokerage, generated $3 billion worth $15 billion less than the value at sive administrations have spent, or
in pretax earnings on period-end assets which it is carried if it were marked to encouraged to be printed, the equiva-
of $779 billion, down just 10%. Morgan market, the recently filed 10-K report lent to 28.9% of GDP. A macroecono-
Stanley’s asset arm performed no such discloses. True, under U.S. generally mist from Mars, judging by these data
feat, showing a $1.8 billion pretax loss accepted accounting principles, the loan alone, would never guess how much
after write-downs. The wealth-man- book is not marked to market, but the more severe was that depression than
agement business did generate $1.2 common stock is. On Tuesday, it was this recession. The decline in real
billion in pretax earnings, however, quoted at a ratio to tangible book value GDP from August 1929 to March
and the Morgan Stanley-Smith Barney of just 0.33%. It seems fair to conclude 1933 amounted to 27%; that from De-
merger holds promise for the next up that good news is not exactly built in. cember 2007 to date, just 1.8% (“just
cycle. Before it took Smith Barney off Alternatively, rather than buying calls 1.8%” is the phrase to use if one is
the trembling hands of Citigroup, Mor- on a self-selected basket of potential cri- still employed). So for a slump 1/15th
gan had 8,400 brokers superintending sis survivors, McCulley points out, one as severe as the Depression, our 21st
$546 billion in client assets. Bigger now could use the Financial Select Sector century economy doctors have admin-
than Bank of America, which famously SPDR Fund (XLF). “You can buy call istered a course of treatment more
bought Merrill Lynch, the new Morgan options that expire in January 2011 with than three times as costly.
Stanley will field 20,000 brokers over- a strike of $15 for 65 cents a piece,” he Since John Maynard Keynes walked
seeing $1.7 trillion in client assets. winds up. “XLF was last quoted at $7, the earth, economists have plumped
So much for Ward 2. We now come and come the turn, the sector could eas- for deficit spending and money print-
to the institutions about which Mr. ily double. It’s happened before.” ing to combat recessions. Different
Market entertains a reasonable doubt. • schools of thought have recommend-
The likes of Comerica (CMA), Key ed more of one and less of the other,
Bank (KEY) and Regions Financial but only the most radical prescribed
(RF), among many others, trade at Sold to you, Uncle Sam anything like today’s mega-dose: a
steep discounts to book. They are offi- combination of fiscal and monetary
cially doubtful. Yet, despite their well- (April 3, 2009) What marks our stimulus equivalent to more than a
aired troubles, each shows a relatively Great Recession for greatness is nei- quarter of GDP, not counting whole-
high amount of tangible equity and ther the loss of jobs nor the shrink- sale federal guarantees of money-
reserves in relation to nonperforming age in GDP, but the immensity of the market mutual funds, bank deposits,
loans. A word about Regions: With federal response to those afflictions. bank bonds and sundry direct guar-
its shrinking net interest income, its The scale of the government’s inter- antees of the balance sheets of such
immense 2008 net loss ($5.8 billion, vention is much more than unprec- begging behemoths as Citigroup and
owing to a $6 billion write-down of edented. Before 2008, it was unimagi- Bank of America.
goodwill) and its heavy exposure to nable. “This crisis did not come about be-
residential real estate and construc- Now unfolding is an examination cause we issued too little money but
tion loans in Georgia and Florida, the of the chain of events that has taken because we created economic growth
bank would appear to have what the us to this, the kitchen-sink phase with too much money, and it was not
early Americans called a churchyard of U.S. counter-cyclical policy. The sustainable,” Angela Merkel, the Ger-
cough. But the insiders, or some of narrative prompts a question: If it’s man chancellor, was quoted as saying
them, seem deaf to it. Over the past taking this much to revive today’s in last weekend’s Financial Times.
six months, they have bought 227,000 economy (which, as of now, remains And she added, seeming to address
shares and sold none. unrevived), what kind of a jolt might Barack Obama and Timothy Geith-
A glance at the balance sheet conveys be necessary to succor tomorrow’s? ner directly, “If we want to learn from
no sense of the depth of the bank’s ad- An even bigger shock, we surmise, that, the answer is not to repeat the
mitted problems. Assets foot to $146 if tomorrow’s economy is no less en- mistakes of the past.” We would go
billion and shareholders’ equity to $16.8 cumbered than today’s. But it is al- further than Merkel by misquoting
billion, of which $7.3 billion is tangible. most certain to be more encumbered, Santayana, to wit, “Those who cannot
Nonperforming assets account for 1.2% since the active ingredient of the remember the past are condemned to
of total assets, and loan-loss reserves Bush-Obama palliative is credit for- keep piling on the ‘stimulus’ and the
represent 141% of nonperforming loans. mation, the very hair of the dog that ‘quantitative easing’ and the ‘TARPs’
However, on the January call, manage- bit us. Skipping down to the bottom and the ‘TALFs’ and the like un-
ment warned that 9% of the loan portfo- line, we renew our doubts as to the til the dollars thereby expended are
lio was “distressed.” Residential home- staying power of paper currencies worth only the cost of producing
builder loans amount to $4.4 billion, and to the creditworthiness of the them, which is just about nothing.”
home-equity loans to $16.1 billion and governments that print them. To make sense of the outpour-
a portfolio of third-party-originated con- To try to exorcise the Great De- ing of federal stimulus initiatives, an
sumer loans (RVs, autos, boats) to $3.9 pression, President Herbert Hoover observer requires a scorecard and a
billion. Management has been more ag- deployed fiscal and monetary stimulus primer. You are now reading a primer
SUBSCRIBE! - go to or call 212-809-7994 Summer Break-GRANT’S/AUGUST 21, 2009  9

on the modern precedents. The Na- not so different from today’s. Since swing to deficit from surplus, the
tional Bureau of Economic Research the Depression and its aftermath combined fiscal and monetary stimu-
identifies 10 postwar recessions be- were still fresh in memory, lenders lus amounted to 3.3% of GDP.
fore this one. On average, from peak and borrowers walked on eggshells. We hold in our hands an archaeo-
to trough, they lasted for 10 months As for the Truman recession, the logical relic, a Washington Post edi-
and registered a 1.8% decline in infla- administration attacked it with fis- torial taking Truman to task for his
tion-adjusted GDP. The government cal policy. Federal outlays had been “advocacy of deficit financing as a
attacked the average slump with an on a steep decline since the end of method of overcoming the downturn
average fiscal stimulus of 2.6% of World War II. In 1945, the final year in economic activity.” The needful
GDP and an average monetary stimu- of conflict, government had spent thing, declares The Post, is “a revival
lus of 0.3% of GDP, for a combined $93 billion. In 1948, it spent just $30 of business and banker enterprise,”
countercyclical lift of 2.9%. As the ta- billion, which generated a budget not the shoring up of already-ade-
ble shows, this recession of ours is not surplus equivalent to 4.5% of GDP. quate consumer purchasing power.
so severe by GDP shrinkage alone. Counter-cyclical spending revved up “A Government spending program
It is, however, off the postwar charts in 1949 and again in 1950, the year of that will add to the size of an already
in financial dislocation as well as in the outbreak of war in Korea, when huge Federal debt and tend to shake
federal intervention. And we expect the budget was in deficit to the tune confidence in the credit standing of
that, some day, it will prove to be a of 1% of GDP. This swing to deficit the Government is not the way to
record-setter in the unintended con- from surplus represented a 5.5% shift provide investment initiative,” this
sequences of the government policies in the fiscal balance. astounding document continues. “It
it called forth. And what did the Fed contribute to is the way, on the contrary, to retard
A word on method: We measure fis- the anti-recession cause? Remarkably, it. We do not believe that Congress,
cal policy by the cumulative change it tightened. Interest rates stayed low or for that matter the American peo-
in what is known as the fiscal bal- but did not go lower (in fact, in 1948, ple, can be converted to a belief in
ance, i.e., in the federal budget deficit the Fed raised its discount rate to 2% deficit financing as an easy road to
as a percentage of GDP. We measure from 1.5% and did not see any reason future prosperity and full employ-
monetary policy by the cumulative for lowering it, slump or no slump). ment.” The date was July 12, 1949.
change in the Federal Reserve’s bal- M1, consisting of currency and check- The Post changed and so did the
ance sheet. For an index number of ing accounts, peaked at $113.4 billion world, but not immediately. In 1954,
the government’s overall exertions in January 1948 and steadily dwindled a slump of moderate severity ran its
over the course of a recession, we add to $110.9 billion by October 1949, the course with no federal assistance
the fiscal and monetary changes. The month of the trough. Reserve Bank whatsoever. Miraculously, the econ-
measurements are indicative only, credit, i.e., the Fed’s earning assets, omy recovered all by itself. Nomi-
but then, again, they have the virtue fell by a quarter, to $18 billion, over nal GDP peaked at $382 billion in
of simplicity. the course of the downturn. Yet— the second quarter of 1953 and fell
The first postwar slump, Novem- Ben S. Bernanke, please copy—the to $375.3 billion in the first quarter
ber 1948 through October 1949, must republic survived and the recession of 1954, a 1.7% decline, or 2.7% in
have gratified the Truman admin- ended. Altogether, giving effect to real terms. Half way into the reces-
istration with its brevity and meek- the Fed’s tightening and the budget’s sion, the Fed did reduce its discount
ness. It lasted for 11 months and dug
a 1.7% hole in real GDP. In Ameri-
can experience, deflationary depres- What government did­—and didn’t do
sions had followed major wars. The
post-Appomattox slump measured 32 length decline in –—stimulus as % of GDP—–
months, a pair of post-World War I peak trough (months) real GDP monetary fiscal combined
depressions a total of 25 months. The
August-29 March-33 43 27.0% 3.4% 4.9% 8.3%
1946 Employment Act had made it
May-37 June-38 13 3.4 0.0 2.2 2.2
the government’s business to foster
the circumstances in which all could November-48 October-49 11 1.7 -2.2 5.5 3.3
find work. Mass unemployment was July-53 May-54 10 2.7 0.0 -1.4 -1.4
a thing of the past, President Harry S. August-57 April-58 8 3.2 0.0 3.2 3.2
Truman vowed as he signed the leg- April-60 February-61 10 1.0 0.7 1.0 1.7
islation into law. December-69 November-70 11 0.2 0.3 2.4 2.7
Nowadays, no edition of The Wall November-73 March-75 16 3.1 0.9 3.1 4.0
Street Journal is complete without January-80 July-80 6 2.2 0.4 1.1 1.5
news of some new federal initiative July-81 November-82 16 2.6 0.3 3.5 2.8
to control, suppress, humiliate or rein July-90 March-91 8 1.3 1.0 1.8 2.8
in Wall Street. Finance was still more March-01 November-01 8 0.2 1.3 5.9 7.2
comprehensively regimented in Tru- December-07 15 1.8 18.0* 11.9* 29.9*
man’s term. The Federal Reserve,
subordinated to the Treasury, pegged *estimated
the government yield curve at levels sources: Federal Reserve, Congressional Budget Office
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rate by one-quarter of 1%, to 1.75%; Deeper shade of red

and two months later, it lopped off 3% 3%
another 25 basis points. But so far Federal budget deficit as a percentage of GDP
from “quantitative easing” was the 2 2
policy of that time that Reserve Bank
credit stood stock still. If monetary 1 1
policy was neutral, fiscal policy was
positively contractionary, though war 0 0

percentage of GDP

percentage of GDP
and peace confuse the question of
intent. A falloff in federal spending -1 -1
followed the truce in Korea, with the
budget deficit narrowing from 1.7% -2 -2
of GDP in 1953 to 0.3% in 1954. The
combined fiscal and monetary stimu- -3 -3
lus was therefore minus 1.4%. The
Eisenhower administration, taxed -4 -4
by its critics for inaction in the face -5.8% as of
of a 5% unemployment rate, insisted -5 Dec. 31, 2008 -5
it was doing everything it could and
should do. “[The administration],” -6 -6
The Washington Post judged in August 12/68 12/73 12/78 12/83 12/88 12/93 12/98 12/03 12/08
1954, “has genuflected to an exces- source: The Bloomberg
sive degree before the idol of the bal-
anced budget. . . .” Maybe Ike took was then showing a year-over-year Roosevelt’s time. The transformation
his cue from the 1949 editorials. rise of 3.5%), the government was worked magic. The number of dollars
What accounts for the regenerative nonetheless “firmly committed to in the world proliferated wonderfully,
qualities of the economy of yesteryear? the principle that the Federal Gov- just as Chancellor Merkel noted to
Favorable demographics might explain ernment must take whatever action the Financial Times.
part of the resiliency—the baby boom is necessary to stop the economic Taboos kept falling, for instance,
was then bouncing. Financial conser- downturn and stimulate the recovery the convention that big banks should
vatism, too, might have contributed to of the recession.” set a good example for little banks by
the capacity for self-healing—overall Little did the then-vice president not going broke, and that the world’s
indebtedness amounted to just 142% know how much action would prove reserve-currency issuer should set a
of GDP in 1954, compared to 370% to- to be “necessary” within a few short good example for lesser nations by
day. So distant was that time that Gen- decades—or how critical a part he being a net creditor, as Britain had
eral Motors was still a member in good himself would play in making it so. been during the long reign of the
standing of the American private sector, What greased the ways for radical pound. In 1984, the FDIC forestalled
and its debt was rated triple-A. “Wall federal action was the breakdown of the bankruptcy of the Continental
Street,” in the early 1950s, was still lick- age-old inhibitions in the early 1970s. Illinois National Bank & Trust Co.,
ing its wounds from the early 1930s. It First to fall was the partnership form the nation’s eighth-largest bank, and
could not have crashed because, doing of organization on Wall Street. Sec- so doing established the principle
a dull business at sea level, it couldn’t ond was the gold-anchored dollar. that some banks were “too big to
have hurt itself very much even if it had Over the general partner of every fail.” In 1988, Thomas Gale Moore,
jumped out a window. partnership hangs a sword of Damo- a member of the President’s Council
The Eisenhower economy did, cles. Let the partnership fail, and the of Economic Advisers under Ronald
however, absorb one hard knock. The GP is at risk for everything he or she Reagan, shrugged off the news that
eight-month recession beginning in owns. When Donaldson, Lufkin & the United States had become a net
August 1957 featured a 3.2% drop in Jenrette went public in 1970, exchang- debtor. “We can pay off anybody by
real GDP, one of the steepest of the ing limited liability for the unlimited running a printing press, frankly,”
postwar era. To cure the patient, the kind, a new chapter in financial risk Moore was quoted by the Dow Jones
administration allowed the budget taking was opened. Would that it had newswires as saying in reference to
to swing from a 1957 surplus equiva- quickly closed. With a little more fear America’s privileged status as the
lent to 0.7% of GDP to a 1959 defi- of God, and a little less “value at risk” only official fabricator of dollar bills,
cit equivalent to 2.5% of GDP. The (as one of the failed gods of quantita- “so it’s not clear to me how bad [the
Federal Reserve cut its discount rate, tive risk management is known), the transition to net debtor status] is.”
in four steps to 2 1/4%, at economic debt bubble might not have become But we run ahead of our story. The
low ebb in April 1958, but it allowed the blob that ate the world economy. recession of the mid-1970s was scary
no growth in the size of its balance As for the dollar, the Nixon admin- enough to elicit the now-familiar
sheet. In mid-recession, Vice Presi- istration redefined it, on Aug. 15, phrase “not since the Great Depres-
dent Richard M. Nixon pledged that, 1971, as a piece of paper of no intrin- sion. . . . ” In one critical particular,
while the administration was mind- sic value instead of the 1/35th of an at least, however, the comparison was
ful of the risks of inflation (the CPI ounce of fine gold it had been since inapt, for nominal GDP kept climb-
SUBSCRIBE! - go to or call 212-809-7994 Summer Break-GRANT’S/AUGUST 21, 2009  11

ing from the peak of the cycle, in No- How the world changed
400% 400%
vember 1973, to the trough, in March
1975. Of course, the inflated dollars ratio of total U.S. debt to GDP 370%
in which nominal GDP was counted 350 350
flattered the true state of things.
In real terms, from peak to trough, 300 300
GDP dropped by 3.1%. “[T]he out- Aug. 15, 1971:
look is approaching a situation that 250
Nixon closes
the gold window
is somewhat desperate. . . ,” George
Perry, a Brookings Institution econ-

200 200
omist, warned the House Budget
Committee at what turned out to the
trough. “We are now staring at what 150 150
is likely to be called the first postwar
depression.” And what should the 100 100
government do about it? “For the
near term, we should be pulling out 50 50
all the stops. . . . It is hard to put a
limit on what we could do [to stimu-
0 0
late the economy] and still be help-
1920 1930 1940 1950 1960 1970 1980 1990 2000 2008
ful.” So the Federal Reserve printed
sources: Federal Reserve, Bureau of Economic Analysis, Bureau of the Census
money, lifting Reserve Bank credit
by 17% over the course of the cycle,
while administration spent money. 1.8% of GDP—but not ill-founded. latter recession was much milder than
In 1975, federal outlays jumped by The Federal Reserve fretted that the former and did not come with the
an astonishing 23.4%. The combined monetary stimulus was losing its po- unwelcome baggage of a banking cri-
fiscal and monetary stimulus was tency. Elderly readers will recall that sis.” In a November 2002 meeting of
equivalent to 4% of GDP. the policymakers of the early 1990s the FOMC, Chairman Alan Green-
The recessions beginning in 1980, dealt with many of the same prob- span, then in his clairvoyant phase,
1982 and 1990 called forth the conven- lems that bedevil today’s mandarins, urged that the committee not stint on
tional fiscal and monetary medicines from a big-city banking crisis to a the money printing. It would always
in the more-or-less standard postwar real-estate slump (though, back then, be possible to tighten, he said, but “I
dosages, but the decade featured a the blight was mainly concentrated in don’t think we could adjust all that
novel upswing in lending and borrow- commercial structures). To put things easily if we were to fail to move and
ing. When Ronald Reagan took the right, the Greenspan Fed reduced the the economy began to deteriorate and
oath of office in January 1981, debt funds rate to 3%. Many gasped twice: we were looking into a deep defla-
summed to 169% of GDP. On the oc- Not only at how low it was but also tionary hole.”
casion of George H.W. Bush’s inaugu- at what little effect this remarkably “All the stops,” George Perry’s
ration in January 1989, the ratio stood stimulating rate of interest seemed to policy prescription for the 1973-75
at 233%. At the start of Bill Clinton’s have. What was going on? Governor recession, seemed exactly to charac-
first and second terms, it was 240% Wayne Angell demanded of his col- terize the federal exertions during
and 253%, respectively. And by the leagues on the Federal Open Market the eight-month downturn beginning
time that George W. Bush gave way Committee. “Since we have watched in March 2001. Fiscal and monetary
to Barack Obama, it had reached the the Fed funds rate come down from intervention in the combined sum of
aforementioned 370%. 9.9% to 3%—that’s 690 basis points— 7.2% of GDP, was the most muscular
As early as the 1990-91 recession, and it has had less than the intended since the Great Depression. Insofar as
economists wondered if the nation effect upon credit and upon spending, that 1% funds rate was instrumental
were not too heavily indebted to al- then it seems very appropriate for us in blowing up the debt bubble, how-
low full scope to federal anti-reces- to look again at this model.” ever, the intervention only postponed
sion projects. “Since the government This was in October 1992. A decade the evil day.
failed during the prosperous 1980s to later, in the throes of the first reces- Its coming, in 2007, found the fed-
run budget surpluses, or even achieve sion of the 21st century, the central eral budget in deficit in the amount of
balance,” Robert D. Hershey Jr. of bankers were pushing even harder, 1.2% of GDP, the smallest since 2001.
The New York Times wrote in Janu- with still less evident effect, though Next year came the flood. Outlays
ary 1991, “it lacks the wherewithal all too few had the wit to wonder grew by 9.1%, fastest since 1990, while
to pump up a deflated economy. A what was wrong with their approach. receipts plunged by 1.7%, yielding a
long-feared prospect is thus at hand: a “While it took a 3% funds rate in 1992 shortfall equivalent to 3.2% of GDP.
recession that hits when fiscal policy to resolve the banking crisis and spur It was only temporarily shocking. In
is already immobilized.” Hershey’s economic growth,” colleague Ian 2009, federal spending is expected to
concerns were premature—the Bush McCulley points out, “in the millen- jump by as much as 34% and receipts
administration succeeded in produc- nial recession, the funds rate got all to tumble by 14.5%. On the basis of
ing a fiscal pick-me-up equivalent to the way down to 1%, even though the the Obama administration’s proposed
SUBSCRIBE! - go to or call 212-809-7994 Summer Break-GRANT’S/AUGUST 21, 2009  12

budget—not the most pessimistic lays, the federal response to the Great share price, no stock-market miracle is
document in Washington—the CBO Recession would be 12 times greater necessary, only a snapback in corporate
projects a deficit of 13.1% of GDP in than that to the Great Depression. “It operating margins.
2009 and 9.6% of GDP in 2010. is utterly impossible to keep up with We focus here on Legg, the nation’s
As for the Fed, since December the things that happen in Washing- No. 2 publicly traded, freestanding as-
2007 it has conjured more than one ton,” Frank Kent, a political colum- set manager by assets, but our bigger
trillion new dollars into existence. nist for the Baltimore Sun, wrote in interest is the investment-management
“Quantitative easing,” the three-dol- March 1934, one year into the New business. Is the mutual-fund business
lar phrase for heavy money printing, Deal. “One project follows another model kaput? Not yet, we judge. One
promises at least two trillions more. so rapidly that they baffle the hardi- of the bear arguments against com-
At this writing, the Fed’s balance est mind. . . . . The whole business panies like Legg is that management
sheet foots to $2.1 trillion. As recent- has become fantastic. The activities fees will fall. Well, they have been fall-
ly as December 2007, it totaled $874 are on so many fronts, the experi- ing since the early 1980s and may well
billion. Inasmuch as the Fed has the ments so numerous, varied and vast continue to fall, but it won’t be news if
authority to absorb $1.25 trillion more that confusion reigns and many on they do. The bears say that assets won’t
of agency-issued mortgage-backed the inside are as perplexed as those come back after this terrible bear mar-
securities, $200 billion more of agen- looking on.” ket, not much of which was anticipated
cy debentures and $300 billion more It’s strange to reflect how relatively by Legg’s storied investment profes-
of Treasurys, not to mention as much small was the intervention that occa- sionals. But inflows and outflows for-
as $1 trillion for the new Term Asset- sioned so much bafflement, confusion ever follow investment performance.
Backed Securities Loan Facility, or and perplexity. Maybe Kent won- Come the next bull market, the money
TALF, the balance sheet of the very dered what the government would will be flowing back again, with no hard
near future will easily top $3 trillion. ever do for an encore. So do we. feelings. ETFs? They stand to garner
“Just counting the projected decline • more investable assets, but the threat to
in the U.S. fiscal balance and the ac- mutual funds from that quarter seems
tions the Fed has already taken,” Mc- overblown. For all the talk and trum-
Culley points out, “you get interven- ‘Solid across the void’ pets, ETFs constitute only 5.5% of mu-
tion equivalent to between 18.7% and tual fund assets. In the year-to-date, the
19.9% of GDP. Adding the authorized (May 15, 2009) Legg Mason Inc. is average technology mutual fund has re-
increase in the size of the Fed’s bal- the city of Buffalo, or maybe the Bal- turned 18.3%, twice the rise in the Nas-
ance sheet over the next year gets you timore Orioles, or perhaps The New daq, while the average large-cap-blend
to 28% to 30% of GDP.” York Times of the asset-management mutual fund has returned 3.1%, nearly
However, this heretofore unimag- industry, a once-thriving enterprise twice the rise in the S&P 500. Are not
ined 28% to 30% of GDP is just for now fallen on evil days. Since 2007, quite five months of exceptional re-
starters. One must also consider the the year Legg management found turns proof that active managers have
new federal guarantees, including: all about structured investment ve- finally found a way to earn their keep?
$1.8 trillion to backstop the com- hicles and—and—decided to sign a No such belief is priced into the rel-
mercial paper market, $540 billion 15-year lease on its very own 24-story evant share prices.
for the Money Market Investor Baltimore office tower, assets under the Especially is it not priced into the
Funding Facility, $3 trillion for the company’s management have fallen by slumped-over Legg Mason share price.
soon-to-expire blanket guarantee of 34.7% and its share price by 80%. We The outlier among investor-owned as-
money-market mutual funds, $700 hold no view on the recuperative pow- set managers, Legg is quoted, on an
billion for expansion of deposit guar- ers of Buffalo, the Orioles, or the Times, enterprise value-to-AUM basis, at 77
antee coverage to $250,000 per de- but we are bullish on Legg, now free basis points, compared to 116 for Al-
positor, $1 trillion for ensuring the and clear of its SIV difficulties and lianceBernstein, 138 for Blackrock,
debt of sundry financial institutions delivered from the near-term threat 175 for Invesco, 288 for Eaton Vance,
and a further $450 billion for addi- of insolvency. For a much higher LM 289 for Franklin Resources and 348 for
tional guarantees. Nor must one for-
get the Fed’s thoughtful guarantee
of more than $400 billion of assets Asset-manager comps
on the overstretched balance sheets (in $ millions)
of Citigroup and Bank of America.
The new Public-Private Investment
mkt. P/E P/B oper. assets AUM EV/
Program could add an additional $1
trillion. All told, such guarantees cap ratio ratio margin under mgt. y/y chg. AUM
and backstops sum to $8.9 trillion at Blackrock $18,650 29.6x 1.6x 27% $1,283,000 -6% 1.38%
face value, representing an addition- Legg Mason 2,741 NM 0.6 -7 632,000 -33 0.77
al 63% of GDP. “So in total dollars,” AllianceBernstein 5,319 7.0 3.3 6 435,000 -44 1.16
McCulley winds up, “the govern- Franklin Resources 14,472 15.7 2.1 24 421,000 -34 2.89
ment’s response to this crisis could Invesco 5,843 12.2 1.0 11 367,600 -26 1.75
be equivalent to GDP—all of it.” T. Rowe Price 9,963 25.7 4.0 29 268,800 -29 3.48
Counting these hypothetical out- Eaton Vance 3,209 19.6 12.1 25 119,300 -21 2.88
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Legg’s Baltimore neighbor, T. Rowe So cost cutting is de rigueur through- since September. Such data, however,
Price. What ails Legg is a thrice-told out the Legg Mason organization: at the elicited no “great quarter, guys!” huz-
tale. The company absorbed a $2.9 fixed-income shop, Western Asset Man- zahs from the dialers-in. With revenues
billion loss on the $10 billion of SIV- agement, which manages $472 billion down by 42%, realized cost savings of
issued commercial paper that found a of the company’s $632 billion of assets; 22% impress only so much.
host in its money-market mutual funds. at ClearBridge, the second-largest divi- No more calculated to raise inves-
Investment assets fled—$77 billion in sion, which manages the equity funds tors’ spirits was the loss, in the March
the December quarter, $44 billion in in the Legg Mason Partners-branded period, of another $44 billion of AUM.
the three months to March 31—and op- fund family; and at Brandywine, Per- As one analyst put it, the outflows were
erating margins collapsed. Legg calcu- mal Group, Royce & Associates and the “worst in the group in the quarter
lates that, excluding the items it trusts Batterymarch. It’s the equity side that despite performance that was in line
are unusual, it generated $69 million of gets the attention—especially, in recent with the group, especially on the equity
operating income in the March quarter, years, the brickbats—but stocks consti- side.” Indeed, the lately derided (for-
good for a pro forma operating margin tute just 20% of the asset mix. It’s 57% merly celebrated) Bill Miller has the
of 11.2%. In the boom, based on gen- bonds and 23% money markets. Legg Mason Value Trust up by 9.06%
erally accepted accounting principles, On the May earnings call—Legg, in the year-to-date, which is good for
Legg consistently produced operat- Japan-style, has a March 31 fiscal year- 76th percentile performance honors.
ing margins in the mid-20s (the GAAP end—the new CEO was expound- Western Asset’s numbers, notably ter-
figure for March was minus 7%). For ing on cost control. Management had rible in 2008, are also on the upswing.
Legg’s top management, it is either a sliced 22% from its operating budget, “While it may take time for the pipe-
goad to effort or a cause to drink that and it had identified enough additional line for some of their flagship strategies
some of its peers, even in this bear fat to lop off 27% “on a run-rate basis” to grow meaningfully again,” the Legg
market, are still earning operating mar- by September 30, related Mark R. Fet- Mason IR department advises colleague
gins in the mid-20s. ting. Head count was down by 13% Ian McCulley, “we continue to see new
mandates in those and other strategies,
such as Western’s TIPS product and
Legg Mason Inc. some international products.”
(in $ millions, except per-share data) Time does fly. Legg went public
only in 1983 with a $27 million IPO
that doubled shareholders’ equity.
12 mos. to
Miller’s fund, pre-Miller, had assets
12/31/08 3/31/08 3/31/07 3/31/06 3/31/05 of less than $30 million. Today, after a
Operating revenues $ 3,809 $ 4,634 $ 4,344 $ 2,645 $ 1,571 mediocre year in 2007 and a debacle in
Operating expenses 4,296 3,584 3,315 1,965 1,082 2008, it has $3.5 billion. By any reason-
Operating income (487) 1,050 1,028 680 489 able standard, what’s amazing about
Other income (expense) (2,379) (606) 15 36 (18) Legg is not how much it has lost, but
Tax provision (986) 176 398 276 175 how far it’s come.
Minority interests ­ — — — (6) — And management, oblivious to
Income from cont. operations (1,879) 267 646 434 295 the gathering debt storm, almost lost
Net gain on sale — — 1 710 113 it all. That the $10 billion SIV prob-
Net income (1,879) 267 647 1,144 408 lem did not, after all, sink a company
Earnings per share (13.36) 1.86 4.58 9.50 3.95 with March 31 equity of $4.45 billion
speaks as much to good fortune as it
Cash 1,563 1,464 1,184 1,023 795 does to managerial acuity. After laying
Current assets 4,199 4,686 2,392 2,127 6,552 the SIV crisis to rest, Legg has $1.1 bil-
Goodwill and intangibles 5,259 6,646 6,858 6,797 1,447 lion of cash (an expected tax refund
Total assets 10,136 11,830 9,604 9,302 8,219 will add $500 million more), $3.2 bil-
Short-term debt 509 932 5 120 103
lion in debt and $9.32 billion in total
assets. The debt consists of a $550
Current liabilities 2,030 2,739 1,312 1,598 4,939
million term loan, $1.25 billion in 2.5%
Long-term debt 2,967 1,826 1,108 1,166 708
convertible notes and $1.125 billion in
Total liabilities 5,315 5,210 3,063 3,452 5,926
equity unit hybrids. The nearest debt
Shareholders’ equity 4,821 6,620 6,541 5,850 2,293 maturity is 2011.
Having passed through the shadow
Cash from operations 571 964 905 545 366 of the valley of death, management
Assets under mgt. (billions) 698 950 969 868 375 seems determined to find the sun-
shine of safety. Last week, it chopped
Shares outstanding (millions) 141 the quarterly dividend to three cents a
Price per share $19.20 share from 24 cents, its $1.1 billion of
Market capitalization 2,741 cash notwithstanding. An analyst on
Price/earnings nm the call asked why. “[T]he market may
Price/book 0.62x be a leading indicator,” Fetting replied,
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“and it may or may not be a bear-mar- perous peers, say, a price equivalent to wrong with the asset-management
ket bounce, or whatever. But we want 60 to 100 basis points of AUM. Anyway, business model and that, when the
to be solid across the void and preserv- these indications of interest suggest bear market ends, the company should
ing cash for that, I think, is actually the that the public markets are prepared to benefit. The same is true for the entire
right thing for the long-term interest of value asset managers more highly than group, but Legg is particularly beaten
the shareholders. It could be, if we are the private market does.” down. Analysts expect the company
pleasantly surprised, that we’d have an With Charles Schwab’s recent an- to produce operating margins of 13.4%
opportunity to revisit and take a look at nouncement that it plans to create its and earn 95 cents a share in the fis-
other ways we could bring capital back own line of ETFs, inquiring minds will cal year to March 2010. It wouldn’t
to the shareholders.” Fetting added that wonder if actively managed mutual take much in the way of better-than-
the bear market had served up some funds, like the rotary-dial telephone, expected asset growth or margin im-
“interesting” acquisition possibilities. are not one of the great ideas of yes- provement to earn closer to $1.50 or
“The trend toward consolidation and teryear. In the year to March 31, ETF $2 a share in the next couple of years.
increased size in the business is long assets fell by 15.6%, to $482 billion, With the same business mix, the com-
running,” McCulley observes. “The while mutual fund assets fell by 21.2%, pany earned $4.58 a share in the year
Investment Co. Institute calculates to $9.25 trillion ($5.4 trillion excluding to March 2007. Make no mistake, this
that the number of firms in the fund money market funds). Equity mutual stock is something of a warrant on bet-
business shrank by 12% during this de- funds, which manage a grand total of ter financial-asset returns in the future.
cade. But the need for wounded global $3.3 trillion, relinquished 43% of their More likely, however, after a quarter
banks to improve capital ratios should assets in 2008, and redemptions from or two of positive earnings, the market
lead to a new wave of asset-manager those funds are on track to shrink AUM will realize that Legg should not be val-
transactions. Thus, Barclays is sell- by 30% in 2009. ued like a distressed bank but, rather,
ing iShares, the ETF operator, for £3 As noted above, however, ETFs still like its asset-manager peers.”
billion to CVC Capital Partners, or— claim just 5.5% of total mutual fund •
perhaps—to a higher bidder. iShares assets, while ETF costs are starting
generated £658 million of revenue and to rise. Whereas the management fee
£288 million of operating profit in 2008, on the plain-vanilla SPY is just 9.5 ba- Horrible? Certainly.
providing a 43.7% operating margin. sis points, the investment-grade bond
The business manages £226 billion in fund, LQD, charges 15 basis points, Bearish? Not necessarily.
assets, indicating that CVC’s bid val- and the junk bond fund, HYG, gets 50.
ues the business at 132 basis points of EWZ, the iShares Brazil fund, will set (June 12, 2009) Not even rising job-
AUM, about the same as AllianceBern- you back 63 basis points, while some lessness, plunging Treasury prices and
stein (and, of course, much higher than of the new double- and triple-levered the widening prevalence of negative
Legg’s 77 basis points). According to ETFs—a brand new way to lose mon- equity entirely exhaust the list of rea-
Bloomberg News, Bank of America’s ey—get nearly 100 basis points. sons to despair for American residen-
Columbia Management fund business “Ultimately,” McCulley winds up, tial real estate. A third wave of losses,
has attracted bids that value it closer to “the Legg Mason investment thesis set to soak the heretofore high-and-dry
Legg Mason than to Legg’s more pros- is that there is nothing fundamentally prime borrower, is supposedly crash-
ing over the market. “We’re right in
the middle of this third wave,” Mark
ETFs shrink, too Zandi, chief economist at Moody’s
120% 120%
growth in assets under management, told The New York Times
100 100
last month, “and it’s intensifying. That
loss of jobs and loss of overtime hours
and being forced from a full-time to
80 80 part-time job is resulting in defaults.
They’re coast to coast.”
60 60 Residential mortgages and house
rate of increase

rate of increase

prices are the subjects at hand. In pre-

40 exchange-traded,
exchange-traded 40 view, we are selectively bullish on the
funds: first and expectant toward the second.
20 20
Regrettably, the easily accessible pub-
lic plays on recovery in “toxic” mort-
gage-backed securities have moved
0 0 out of bargain-hunting range. Mr. Mar-
ket, reliably fickle, may just decide to
-20 mutual funds,
mutual funds -20 move them back again, though we
-21% would not spin out the following essay
-40 -40 on that hope alone. Rather, we reap-
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009* praise the state of American residen-
*year-over-year through March 2009 tial mortgage finance because so much
source: Investment Co. Institute seems to depend on it.
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“Bullish,” admittedly, isn’t the the distress. In many cases, realtors to rising rents and falling house prices,
first word that springs to the minds say, investors also are outbidding first- the ratio is back to 5.1%. “Let us say,”
of readers of the everyday mortgage time home buyers and other would-be muses Gertner, “that 5% is the correct
news. For instance, first-quarter de- occupants because they often come to yield for a house and that the price-to-
linquency rates climbed across the the table with all-cash offerings.” rent ratio overshoots by one standard
board, even for prime borrowers. Se- Colleague Dan Gertner, our first deviation to 5.7%. Assume, too, that
quentially, they were up by 19.8% vice president for the mortgage mess, rents stay the same. In that case, the
(to 6.06% from 5.06%) and by 63.3% relates that house prices, having fa- Case-Shiller index would have to reg-
from the year-ago level (to 6.06% from mously overshot to the upside, now ister an additional decline of 9.9%, for
3.71%). The inventory of foreclosed seem to be overdoing it in the oppo- a total drop, peak-to-trough, of 38.9%.
houses financed by prime mortgages site direction. The basis for his conclu- “A third test of house prices,” Gert-
climbed by 32.5% sequentially (to sion is, in the first place, the analyti- ner proceeds, “is the National Associa-
2.49% of prime mortgages surveyed cal test developed by reader R. King tion of Realtors’ index of affordability.
from 1.88%) and by 104.1% from the Burch: Multiply the average house The index is set so that a reading of
year-ago level (to 2.49% of that mort- price (new and used) by the number of 100 means a family earning the me-
gage universe from 1.22%). sales and divide by GDP to arrive at an dian income would be able to afford a
The all-in cost of foreclosure pro- intuitively attractive bubble-o-meter house offered at the median price. An
ceedings to creditors has also taken a for residential real estate. Since 1970, index of 150 would mean that the fam-
leap. According to new data compiled the Burch Index, as it will henceforth ily’s income is 150% of the minimum
by Fitch Ratings, loss severities across be known, has averaged 9.8%, with a amount required to afford a median-
the credit gamut accelerated between standard deviation of 2.9. It peaked at priced house (assuming a 20% down
June 2007 and April 2009—for sub- 18.3% in 2005, just shy of a three stan- payment and principal and interest
prime mortgages, to 73% from 40%; dard deviation from trend. The latest payment no greater than 25% of in-
for Alt-A mortgages, to 55% from reading, 7.5% at the end of the first come). As of March, the index stood at
19%; and for prime mortgages, to 43% quarter, is a 0.8 standard deviation be- a record 172.5, more than three stan-
from 14%. low the post-1970 mean. “The Burch dard deviations above its long-term
In Street parlance, houses are the Index,” Gertner observes, “indicates average of 125.”
“underlying” in the residential mort- that the housing correction has over- Of course, things are never so bad
gage market, and they are lying lower shot to the downside.” that they can’t get worse, and the bear
all the time. As of March, the S&P/ Gertner invokes a second test of market that follows a truly bubbly bull
Case-Shiller 20-city composite index house-price value, the rent-to-price market often surprises the pure ratio-
was down by 18.7% in a year and by ratio monitored by Morris A. Davis nalist by how low it goes. So let us pos-
32.2% since July 2006. Phoenix, with of the University of Wisconsin-Madi- it, suggests Gertner, that house prices
a peak-to-present decline of 53%, lost son School of Business. For donkeys’ overshoot to the downside by the same
the most; Dallas, off by only 11.1%, the years, houses returned an average of three standard deviations as they over-
least. Not surprisingly, transaction vol- 5%. The yield declined from 5.5% in shot to the upside (as measured by the
umes have plunged with house prices, 1960 to slightly less than 5% in 1999. rent-to-price ratio). In that case, they
while inventories have traced a course Then it plunged to 3.1% in the first would register a further drop of 26.9%
in the opposite direction. In April, ac- quarter of 2006. But now look: Owing for an overall decline of 50.4%.
cording to the U.S. Census Bureau,
new homes sold at a seasonally adjust-
Not so prime
ed annual rate of 352,000, 0.3% higher 9% 9%
than in March but 34% below the year- troubled prime mortgages as of 2009 first quarter
ago reading and 74.7% below the July 8 8
2005 peak of 1.4 million. The invento-
ry of unsold, unlived-in houses stood, 7 foreclosures 7
at last report, at 10.1 months (i.e., it
would take 10.1 months to get rid of a 6 6
house at the current sales pace), down
distress rates

distress rates

from 12.4 months in January. 5 delinquencies 5

If you detected a small shaft of sun-
light in the previous sentence, it wasn’t 4 4
your imagination. Falling prices are
parting the clouds. Distressed proper- 3 3
ty sales accounted for fully 45% of all
used-house transactions in April, ac- 2 2
cording to the National Association of
Realtors. “After mostly retreating from 1 1
the housing market after the bubble
burst,” The Wall Street Journal reported 0 0
on May 20, “investors are returning in 2Q98 2Q00 2Q02 2Q04 2Q06 2Q08
droves, hoping to take advantage of source: Mortgage Bankers Association
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Creditors’ losses soar Even under a future as bleak as this

80% 80% one, our tranche, to repeat, is expected
mortgage loss severities to deliver an annual return of 10.3%.
subprime: Under a less severe set of assumptions
70 73% 70
(e.g., prepayment speeds doubling to
Alt-A: 8%, default rates at 2% and loss severi-
60 60
55% ties of 40%), an investor would earn
12.2% a year. Of some comfort to us
50 50 is the finding that even under a truly
gruesome set of assumptions (e.g., pre-
loss levels

loss levels
40 40 payment speeds falling to 2% a year,
defaults rising to 8% and loss severities
30 30 climbing to 75%), an investor would
earn a projected 2.8% per annum.
Incidentally, at a 75% loss severity, a
20 prime: 20
43% $750,000 house would be hammered
down to $195,000.
10 10 We know of only two avenues by
which a retail investor can participate
0 0 in the residential mortgage-salvage
1/02 1/03 1/04 1/05 1/06 1/07 1/08 4/09 movement. The first is Redwood
source: Fitch Ratings Trust (RWT on the Big Board), fea-
tured in these pages on February 6.
Nobody knows the future, but all the dollar to return an expected 10.3% Redwood’s management was lately
can observe how markets discount it. over the life of the deal. out buying 2004 and earlier vintages
In the case of the residential mortgage- Our anonymous investor—it is he of senior Alt-A RMBS and 2005 vin-
backed securities market, collective who expects the 10.3%—has modeled tages of senior prime RMBS and
expectations are as dire as the known three sets of total-return outcomes junk-rated Alt-A RMBS. Studying the
facts. “A mortgage investor I know (he corresponding to three different sets most recent 10-Q reports, we venture
prefers to remain anonymous),” Gert- of assumptions. The most important that management is paying 65 cents
ner relates, “has built a data base of of these assumptions are prepayment on the dollar for assets it regards as
liquidated loans. In the past month, speeds, default rates and loss severi- money-good. Impressive enough, but
the average liquidated prime loan had ties. Our investor’s base case features Redwood common is quoted at 1.6
an original loan-to-value ratio of 75% prepayments decelerating to 4% from times book and yields 6.6%. Perhaps
on a house priced at $750,000. So the the 14% actually registered over the Mr. Market would be so obliging as to
loan was in the amount of $562,500. past three months, default rates ac- mark it back down to book, or, say, to
Notably, the price of the house at celerating to 3% annually from the 1.2 times book at a minimum, in order
the time of liquidation had fallen not current 1%, and loss severities imme- to afford the value-minded investor a
just by the Case-Shiller 20-city aver- diately rising to 50%. margin of safety?
age (32.2% from the bull-market peak
to date), but by 45%, to $412,500. Excess, now, to the downside
It’s notable but not surprising, inas- 20% 20%
much as foreclosures tend to cluster calculated transaction value as a percentage of GDP
in weaker neighborhoods. Anyway, 18 18
subtract the written-down value from three standard deviations
the par amount of the loan, and you
16 16
see that the creditors are in the hole by
$150,000, or 26.7% of face. But the all- 2 standard
two standard
in loss severity is another 12 percent- 14 14
percent of GDP

percent of GDP

age points higher than that, such are 1 standard

one deviations
standard deviation
the burdensome costs of foreclosure.” 12 12
Daunting as these numbers are, they
are nobody’s secret. How is the RMBS mean
10 10
market discounting them? In the case
of a particular senior-most tranche of a
8 8
certain prime RMBS, the market is fig-
uratively laying in candles and canned minus one standard deviation
goods. Beneath the tranche in ques- 6 6
tion are five layers of credit protection
amounting to 7.8% of the principal 4 4
sum of the structure. This, the pent- 1970 1975 1980 1985 1990 1995 2000 2005 2009
house tranche, is quoted at 74 cents on sources: Bureau of Economic Analysis, Census Bureau, National Assn. of Realtors
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Then there is Chimera Investment Talking points

Corp. (CIM on the Big Board), a spe- 200 200
mobile-phone penetration in six Asian locales
cialty finance company managed by
a wholly owned subsidiary of Annaly Hong Kong Thailand
Capital (to disclose an interest, Gert- Sri Lanka
ner and your editor are both Annaly 150 150
Macau Vietnam
investors). Chimera invests in RMBS,
residential mortgage loans and other

phones per 100 people

phones per 100 people

real estate-related securities. Its man-
agement is partial to Alt-A securities
of 2006 and 2007 vintage, a part of the 100 100
market that Redwood has avoided. A
characteristic Chimera strategy is to
pay 50 to 55 cents on the dollar for se-
nior Alt-A bonds that, down the road, 50 50
it expects to sell for 70 to 80 cents on
the dollar, allowing for write-downs
of 20 to 25 cents. Gertner asked Wel-
lington Denahan-Norris, chief invest-
ment officer of Chimera, if the lat- 0 0
12/04 12/05 12/06 12/07
est mortgage data on delinquencies
source: The Bloomberg
had her spooked. “We expected it to
be bad, and it continues to be bad. .
. ,” she replied. “We run some pretty vices in Hong Kong and Macau, a land- by Li changes hands in Hong Kong
draconian scenarios, and none of this line service in Hong Kong and mobile under the ticker 215 HK. U.S. holders
is unexpected, and the bonds that we operations in Indonesia, Thailand, Sri of Hutchison Telecom received Amer-
buy can withstand increases of much Lanka, Vietnam and Israel. Once upon ican Depository Receipts for their in-
greater magnitude than we’ve experi- a time, there was a crown jewel in In- terest in HTHKH, and these ADRs
enced so far.” dia, too. Selling the Indian subsidiary trade—intermittently—under the tick-
At 1.4 times book value and with a to Vodafone in 2007 for the fanciest er HTHKY. Volume in the American
yield of 9.1%, Chimera, like Redwood, of prices—the equivalent of $860 per scrip is less than $500,000 a day.
trades as if the market were confident subscriber—management pleased the We wonder if Dennis Lui’s capsule
of a happy outcome. We, too, expect followers of Graham and Dodd at the summary of the differences between
good things, but we would be more cost of alienating the members of the Hutchison and its spin-off does the
comfortable investing if the market cult of growth. You know which sect spin-off full justice. HTHKH controls
expected bad things. It will, too, soon- has more adherents. 47% of the 3G market in Hong Kong
er or later. Just wait. So the track of the share price flat- and 33% of the overall wireless market
tened. Paying a fat, special dividend in Macao. It has an advanced fiber-to-
• in December didn’t help it. Would the the-building network in Hong Kong
spin-off of the dowager, dividend-pay- and the largest fiber capacity into
Cheaper talk ing Hong Kong and Macau operations mainland China. Its fixed-line busi-
do the trick? We’ll soon see. Manage- ness is on the move, too. “Growth has
(May 29, 2009) If barely breaking ment effected this very dismember- actually been pretty robust for what is
even is the new hitting ’em out of the ment on May 14. So Hutchison Tele- supposed to be a boring company,” col-
park, Hutchison Telecommunications com International today comprises the league Ian McCulley observes (let the
International is almost a home run. volatile, growth-targeting, emerging- record show that he owns Hutchison
Thanks to a surge this very week, the markets businesses, while the spin-off, and its spin-off as well as other cell-
stock has returned a grand total of 7.1% called Hutchison Telecommunications phone names), “with the top line ex-
since the bullish analysis so cunningly Hong Kong Holdings, consists of the panding at a compound rate of 10.9%
published in these pages on the eve of aforementioned Hong Kong and Ma- from 2006 through 2008 and operating
the plunge in global equities 19 months cao assets. “Hutchison Telecom is a income at a 22.1% compound rate over
ago (Grant’s, Oct. 19, 2007). We count growth stock, and HTHKH is a yield- the same period. That’s even more im-
ourselves lucky. driven security,” Dennis Lui, CEO of pressive given that the market is what
Now unfolding is a reappraisal of Hutchison Telecom, told dialers-in to the analysts call ‘saturated’; there are
Hutchison and its new spin-off in the the March earnings call. 1.6 and 1.7 cell phones per capita in
broader context of the emerging-mar- Before delving deeper into the in- Hong Kong and Macao, respectively.”
kets telecom business. In preview, we vestment questions, a word on the Of course, growth will be harder
believe we see opportunity. family tree. Hutchison Wampoa, the to come by now that Hong Kong is
You may recall that Hutchison Tele- shipping, ports and real estate con- confronting what the analysts call
com International (HTX on the Big glomerate controlled by Li Ka-shing, “challenges.” With real wage growth
Board) was a kind of telephone omelet. owns 60.4% of both companies. That stalled, GDP shrinking (perhaps by
Its ingredients consisted of mobile ser- portion of the spin-off not controlled 3.5% this year) and property prices
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Selected emerging-markets mobile phone operators

(in $ millions)
mkt. enterprise est. millions of EV per
name symbol cap. value P/E subscribers subscriber
MTN Group MTN SJ $28,155 $34,929 11.9x 98 $356
Bharti Airtel BHARTI IN 30,550 31,617 14.9 100 316
Orascom Telecom ORTE EY 5,713 10,918 12.1 78 140
Turkcell TCELL TI 11,303 9,049 7.8 36 251
Millicom International MICC 6,211 7,660 10.6 34 221
PT Excelcomindo Pratama EXCL IJ 900 2,787 13.5 25 107
Hutchison Telecommunications Int’l HTX 1,020 1,870* 73.6 10 186

*pro forma the spin-off
sources: The Bloomberg, company filings

falling, consumers may think long amount to as much as 75% of net in- expect the Indonesian operation to
and hard before splurging on that new come, the shares this year may yield be EBITDA positive within 2010 and
iPhone. Some such adversity must be 6% to 7%. Then, too, HTHKH is a our Vietnamese operation is ready to
discounted in the HTHKH share price spin-off, therefore an analytical or- launch its new GSM service [it began
already. Larger and slower-growing phan. Who knows what good things in April].”
PCCW, Hong Kong’s old monopoly might happen to the valuation if and Hutchison Telecom International is
fixed-line and mobile provider, is when the brokers discover the com- not, in fact, a pure play on emerging-
the relevant HTHKH comp. PCCW pany’s existence? markets telephony. Remaining after
trades at 12 times trailing net income, The previously quoted CEO of the Hong Kong and Macao spin-off is
HTHKH at 11 times. PCCW shows Hutchison Telecom International the 51% stake in Partner Communica-
a ratio of debt to earnings before in- calls the emerging-markets business, tions of Israel. “As a developed mar-
terest, taxes, depreciation and amor- the one he now leads, the “growth” ket company,” McCulley observes,
tization of 4.2:1, HTHKH of 1.9:1. If, telecom company. “Our operations in “the No. 2 mobile company in Israel,
as the management of HTHKH has Indonesia and Vietnam,” Lui has said, with a 31% market share, Partner
indicated, the dividend payout will “form the key impetus for growth. We would almost seem to fit better with

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the spun-off Hong Kong and Macao stake, which, as noted, is publicly trad- 2007. Nor does Millicom’s valuation
assets than with the high-risk/high- ed and worth about $1.3 billion, and fall far outside the emerging-markets
growth emerging-markets assets. Any- allocate subscribers on a pro-rata basis telecom norm.
way, you don’t have to wonder about (i.e., Hutchison owns 65% of the Indo- “If you believe,” McCulley winds
Partner’s operations or valuation. A nesian operation, so it gets 65% of the up, that for many emerging markets
stub interest representing the minor- subs). Do this exercise, and you find this is a severe recession—that and
ity interest not owned by Hutchison that the market is valuing the custom- not an endless debt crisis—then mo-
Telecom trades in Israel and on the ers outside Israel at a little under $28 bile phone operators are a way to get
New York Stock Exchange (where it each—but on the way to $213 each exposure to growth in domestic de-
takes the form of ADRs). The shares once that $900 million is borrowed. mand in the developing world. As for
are valued at nine times earnings with “The valuations of emerging-mar- the Hutchison properties, the reason-
a 9% dividend yield and with a free- kets telecoms have collapsed, and not ably valued and cash-generative Hong
cash-flow yield in excess of 10%. It without reason,” McCulley notes. “In Kong and Macao business seems more
would not be surprising if Hutchison the first quarter, according to Reuters, attractive than the rump HTX busi-
decided to monetize the Partner stake worldwide cell-phone sales contracted ness. While there is nice optionality
if and when Vietnam and Indonesia at the fastest rate in the industry’s in monetizing the public Partner stake
begin to come into their own.” brief history, showing a year-over-year embedded in the latter, you can cur-
At a glance, one might suppose that decline in volumes of between 13% rently buy competitors like Millicom
Hutchison Telecom is a bargain within and 16%. There is also the issue of that have better market shares and are
a bargain. Its enterprise value amounts how much low-hanging fruit has been actually profitable at what are histori-
to $1.475 billion ($1.02 billion in eq- picked. The International Telecom- cally cheap valuations.”
uity market cap plus net debt of $455 munications Union estimates that, at •
million, ignoring the minority inter- the end of 2008, there were 4.1 bil-
est), while the 51% stake in Partner lion mobile-phone subscribers world-
Communications alone is worth $1.341 wide (one individual with two phones China channels
billion. Evidently, the investor gets an is counted as two subscribers). In this
option on the Indonesian, Vietnamese, decade, the customer count has grown ‘Monkeybrains’
Thai and Sri Lankan businesses for a by no less than 24% a year. The 4.1 bil-
mere $134 million. However, though it lion grand total compares to 1.3 billion (July 10, 2009) Too much debt got
is cheap, it is not quite that cheap. As fixed-line telephones and 1.5 billion us into this mess, and too much debt
McCulley observes, another $900 mil- Internet users. Even some of the poor- will see us out of it. Socialize the risk
lion of debt is about to be incurred to est countries in Africa have penetra- of a new cycle of open-throttle lending
finance cap-ex in Vietnam and Indone- tion rates over 40%.” and cling to the monetary system that
sia. “So on a forward basis, enterprise Millicom, one of the great Paul Isaac assures a repeat crisis. Such, approxi-
value is going to be significantly high- stocks (Grant’s, March 12, 2004), is a mately, is the global policy-making
er,” he relates. “On the other hand, case in point. The Luxembourg-based consensus. Central bankers and finance
if any of the operations in emerging company (MICC on the Nasdaq), ministers have achieved an uncommon
countries turn into the kind of home fetched $125 a share in December meeting of the minds. The cure for
run that the famed Indian business 2007. After rallying by 27% to date what ails us is the hair of the dog that
did, or, perhaps more accurately, if a this year, the price is $57. As recently bit us, they prescribe, though not in ex-
wide-eyed buyer appears, there could as early 2008, subscriber growth was actly those words.
be substantial upside in the shares.” trucking along at almost 60% per an- It’s no small thing that China is es-
Enterprise value per subscriber is num. In the first quarter, it was a mere pecially enamored of the shot-and-a-
another way to look at cell-phone busi- 29%. Analysts expect flat earnings in beer-for-breakfast approach. Nothing
nesses like these. Hutchison Telecom 2009, with growth resuming in 2010. about China is small or insignificant
has a close comp in PT Excelcomindo The balance sheet shows $729 million nowadays, since the Chinese economy
Pratama, the No. 3 Indonesian car- in cash against $2.219 billion in debt, is actually growing. It might, indeed,
rier with 25 million customers. Having and the ratio of net debt to run-rate account for 74% of worldwide GDP
registered a first-quarter loss and dis- EBITDA is less than one. Thanks to growth in the three years to 2010, the
closed plans to finance cap-ex with a rising EBITDA margins (and rising International Monetary Fund esti-
new share sale, Excelcomindo trades EBITDA) coupled with a reduction in mates. Since 2005, China has gener-
at an enterprise value of $107 per sub- cap-ex, Millicom has reached a mile- ated 73% of the global growth in oil
scriber, half or less than half of the stone of sorts: This year, for the first consumption and 77% of the global
typical emerging-markets valuation. time ever, it expects to generate free growth in coal consumption. By the
Millicom International, which has 33.6 cash flow. looks of things, it accounts for a fair
million subscribers in 16 countries in If you haven’t looked in a while, share of the growth in worldwide lux-
Latin America, Africa and Asia, com- you wouldn’t recognize today’s tele- ury-car consumption, too:
mands $221 per subscriber, while the com valuations. Millicom trades at 11
MTN Group, with 98 million custom- times, far higher than the 5.5 times at FRANKFURT (Dow Jones)—
ers throughout Africa and the Middle which it was quoted in the autumnal BMW AG said Monday that sales at
East, trades at $356 per subscriber. And panic but worlds away from the 40 its core BMW brand in China were up
Hutchison? Back out the 51% Partner times it fetched at the beginning of 46% on the year in June at 8,033 cars,
SUBSCRIBE! - go to or call 212-809-7994 Summer Break-GRANT’S/AUGUST 21, 2009  20

fueled by strong demand for its X5 Indispensable country?

and X6 models. 80% 80%
China’s actual and projected contributions to global GDP growth;
Sales in China for both the BMW
three-year moving average (PPP basis)
and the compact Mini brand rose 44% 70 70
on the year at 8,506 cars, a company three
spokesman said. 60 60

Now unfolding is a preview of the

50 50

GDP growth share

GDP growth share

next, the future, credit collapse. Such
methods as China is employing—a
borrowing binge centrally planned 40 40
and directed—will eventually come to
grief, as the readers of Grant’s know full 30 30
well. Indeed, in money matters, nearly
everything seems to come to grief 20 20
sooner or later. However, it is equally
true that, before the grief, comes the
10 10
laughter and levitation. Massive injec-
tions of money and credit are always
unsound. But for stocks, commodities 0 0
and credit, they are bullish before they 1970 1975 1980 1985 1990 1995 2000 2005 2010 2014
are bearish. In the fad for “quantitative source: International Monetary Fund
easing,” when might the laughter turn
to tears? How to prepare for that inflec- tapered off a bit in April and May but ly prayers of thanksgiving, and their
tion point? How to see it coming? appears to have roared back in June.” gratitude would truly be incalculable if
China is not alone in seeding bad Complementary roars have issued only they knew how long the Chinese
loans right on top of the previous from China’s manufacturing indus- could keep it going. Absent Chinese
cycle’s only partially harvested crop tries and world commodity pits. Last stockpiling, where would commodity
of desperate debts. Loan guarantees, week, the People’s Republic purchas- prices be? Without a functioning Chi-
commercial paper purchases and other ing managers’ survey registered 53.2, nese banking system, where would
forms of financial artificial respiration its fourth consecutive month over the the world economy be?
by the governments of the G-20 na- 50% mark that indicates economy- A superb primer on the risks of
tions sum to the equivalent of 32% of wide growth. The Shanghai A-share China’s go-for-broke lending drive
last year’s combined G-20 gross do- market jumped by 65% in the first was published by Fitch Ratings on
mestic product, the IMF estimates. half, to a level that fixes its value at 31 May 20. Is it not passing strange, the
That is on top of average fiscal stimu- times trailing net income, up from 12.8 agency asks, that Chinese lending is
lus equivalent to 5.5% of GDP. So the times at the October lows. Chinese accelerating even as Chinese corpo-
United States, implementing fiscal M-2 was 25.7% larger in May than it rate profits are shrinking? “Ordinar-
and monetary stimulus worth nearly was a year before. Chinese officialdom ily, falling corporate earnings are met
30% of GDP (Grant’s, April 3), is not is targeting 8% GDP growth this year, with tightened lending, but in China,
far out of the interventionist main- while the World Bank predicts 7.2%, precisely the reverse is evident. . . .”
stream. China is in a class by itself. of which, the organization says, six full You would expect—and Fitch does
In the 1930s, Western intellectuals percentage points owe their existence anticipate—that the borrowers of
persuaded themselves that the Soviet to government stimulus. As between these trillions of renminbi are not so
economic model was depression-proof. the 8% government forecast and the profitable as they were in the boom,
Today, not a few investors marvel 7.2% non-government forecast, our and some will therefore struggle to
at the vigor of the modified commu- money is on the government. Not only service their debts.
nist economic model of the People’s do the cadres print the money, but Reading Fitch on China, we think
Republic. Credit may contract in the they also calculate the GDP. So, fall- of the author Mark Singer on Okla-
United States, but it expands—nay, ing in with the Communist Party, we, homa. In China, Fitch explains, credit
explodes—in China. “If the rumored too, predict 8% growth for 2009—bar- losses don’t surface promptly on ac-
new lending figures for June are ac- ring an early explosion in the Chinese count of “pervasive rolling over and
curate (for more, see Michael Pettis’s banking system. maturity extension of loans when they
blog at,” observes col- New directives to Fannie Mae and fall due. This not only leads to under-
league Ian McCulley, “Chinese banks Freddie Mac to refinance certain capturing of NPLs and delayed credit
will have lent 7 trillion renminbi, or a mortgages at up to 125% of appraised costs, but also, by extension, inflated
little more than $1 trillion, in the first home value reaffirm the U.S. govern- capital. Consequently, in the short to
half of 2009, compared to Rmb4.9 ment’s membership in the hair-of- medium run, Chinese banks’ perfor-
trillion in all of 2008, Rmb3.6 trillion the-dog bloc. But no credit-market mance may continue to hold up well
in 2007 and Rmb3.2 trillion in 2006. intervention approaches the one be- as rapid loan growth drives up the de-
New lending was exceptionally strong ing mounted in Beijing. For it, the nominator of NPL ratios and boosts
in the first three months of this year. It world’s commodity producers say dai- profits via high volumes, but the me-
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dium-term risk of a deterioration in finally pick up the pieces may or may sponsored drive to lend their way to
corporate portfolios is rising.” not drive the typical mid-size American prosperity. So loan officers push all
Neither did credit losses surface bank to risk-taking from which it would the harder. “For example,” as Fitch
right away at the Penn Square Bank, otherwise shrink. In China, however, explains, “a branch manager is given
Singer related in his 1985 tour de there appears to be no doubt. “Prior to an annual profit target of Rmb35 mil-
force, “Funny Money.” Penn Square the global crisis,” according to Fitch, lion. If the average loan margin is
originated oil-patch loans at its head- “domestic [Chinese] credit conditions 3.5%, he needs to lend Rmb1 billion
quarters in an Oklahoma City shop- had been fairly tight; strict loan quo- to meet this goal. However, if the av-
ping center during the boom of the tas had been put in place at the start erage margin declines to 2%, he now
late 1970s and early 1980s. Interests of 2008 amid concerns about inflation, needs Rmb1.75 billion to meet the
in these credits it syndicated far and and [corporations] and banks were in- same objective. This is not the first
wide. An alert loan buyer might have creasingly employing off-balance-sheet time Chinese banks have faced a mar-
taken a cautionary hint from Penn transactions to complete deals. How- gin squeeze, but in the past the abil-
Square’s super-fast growth and evi- ever, since the rollout of the stimulus ity to raise credit volume was limited
dent undercapitalization, if not from package [last November], the climate by quotas [i.e., central-bank-imposed
the nickname of its chief energy- has dramatically changed. Projects that quotas to restrict lending to combat
lending officer—they called him had been sidelined when quotas were inflation]. Now, in a quota-less envi-
“Monkeybrains.” But the Continental tight have been put into action with the ronment, that restraint is gone.”
Illinois National Bank & Trust Co., assumption that if problems arise, Bei- China has its Sheila Bair as well
of Chicago, one of Penn Square’s top jing will likely step in with assistance.” as its Ben Bernanke, and the safety-
loan participants, seemingly suspect- If problems arise? As Fitch itself im- and-soundness bureaucracy in March
ed nothing until the Oklahoma bank plies, the only question is when: Non- urged banks to set aside in reserve
failed in 1982. When Continental Illi- performing loans at foreign banks in 150% of the par value of their bad
nois itself became insolvent in 1984— China, “which are generally believed debts, up from 120%. But the direc-
pulled down, in part, by its Penn to have stricter risk management and tive seems more in the way of a sug-
Square participations—a new chapter oversight and are less willing to roll gestion than a ukase. Certainly, the
in the socialization of credit risk was over delinquent loans,” are already on stock market does not believe that the
opened. To save the Federal Deposit the rise. Chinese loan officers work evil end to the new credit boom is yet
Insurance Fund, the government na- to a quota. They take their direction in sight. In Hong Kong, the big three
tionalized Continental, then the na- from their branch managers, who re- Chinese banks—Industrial & Com-
tion’s seventh-largest bank, with as- port to the senior management, which mercial Bank of China, Bank of China
sets of $41 billion. Pure and simple, it answers to the board of directors—and and China Construction Bank—trade
was too big to fail. Indeed, Comptrol- the directors hang on the words of the at price-to-book multiples of 2.5, 1.7
ler of the Currency C. Todd Conover People’s Bank. and 2.5, respectively.
subsequently hinted, the 11 largest The trouble these days is that too We are as bearish on the multiples
banks in the country were systemi- many motivated loan officers are as we are on the stated book values.
cally irreplaceable. And so was born chasing too few creditworthy borrow- On the other hand, the stock market
the too-big-to-fail doctrine. Whether ers. Net interest margins at Chinese is as sanguine about Chinese bank
or not it was an American invention, banks are tightening on account of stocks as economists are complacent
the policy today belongs to the world. the recession and the governmentally about Chinese inflation. The late Mil-
China, in particular, has taken the
idea and run with it. 10,000
Preview of tomorrow’s crisis 10,000
Examining, first, the track of Chi- Chinese bank lending; rolling 12-month sums Rmb8.62 trillion
nese bank lending and, second, the
trend in Chinese nonperforming
loans, the seasoned reader will re- 8,000 8,000
member not only Monkeybrains but
also Drexel Burnham Lambert. In the
in billions of renminbi

in billions of renminbi

mid-to-late 1980s, the American junk- 6,000 6,000

bond market combined breakneck
growth with muted default rates. The
secret, fully revealed during the sub-
sequent bear market, was that the de- 4,000 4,000
fault rates were a direct product of the
issuance rates. Borrowers didn’t de-
fault because of—to adapt the Fitch
2,000 2,000
formulation to that earlier time—the
“pervasive rolling over and maturity
extension of bonds as they fell due.”
Drexel failed when the junk market 0 0
did. 3/01 4/03 4/05 3/07 5/09
The idea that the government will source: The Bloomberg
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ton Friedman handed us not so much a but too much money, period. What thwart the designs of the entrepre-
postulate as a divine law when he said the fatal, redundant increment of cash neurs who would, if they could, build
that “[i]nflation is always and every- chooses to pursue varies from cycle something better. There’s no end of
where a monetary phenomenon.” But to cycle. In pursuit, however, it never mischief in quantitative easing. On the
a new generation of central bankers fails to distort something. Lately, the other hand, it’s an ill monetary wind
and economists is having its doubts. money has been chasing investment that blows no portfolio any good. Bei-
“Some worry that the rapid growth assets rather than goods and services. jing has been lifting prices in resource
of money and credit will lead to infla- In Shanghai, it is chasing A-shares. markets. “The round of oil-field auc-
tion,” the Beijing office of the World Globally, this year, it has pushed up, tions in Baghdad last week,” McCul-
Bank advises in its June Quarterly Up- or contributed to the pushing, of the ley points out, “is a sign of things to
date. “However, with a lot of [spare] prices of lead, copper and nickel by come, as China National Petroleum
capacity in China and world-wide 75%, 71% and 50%, respectively. Who Co. was part of a winning BP-led bid,
putting downward pressure on raw knows? Maybe the central banks have while most other Western majors
material prices unlikely to soar soon, prevented some prices from falling walked away complaining of unfair
substantial generalized price pres- further than they otherwise would terms. (China National has a separate
sures seem unlikely any time soon.” have done. Central bankers, however, deal to develop other Iraqi fields.)
An asterisk at the end of that sentence to generalize across the profession, re- Sinopec is buying Addax Petroleum,
leads the reader to a footnote in which fuse even to imagine the problem in with reserves in West Africa and Iraq,
the World Bank economists finish the these terms. They are content rather in an $8.8 billion deal, and, according
argument: “The relationship between to assert that, owing to the prodigious to The Wall Street Journal, is paying $16
monetary aggregates and inflation is gap between output and potential per barrel of proven and probable re-
complex. That is why central banks in output in recession-wracked econo- serves, more than triple the valuation
mature market economies have large- mies, their actions have instigated no of other deals in the region.” Western
ly abandoned using money as a guid- inflation but have forestalled defla- companies may answer to their share-
ing variable for inflation projections, tion. Self-congratulations ringing in holders, but as an energy consultant
giving priority to output gaps.” their ears, they are prepared to crank put it to the Financial Times last week,
So the economists give intellectual the presses even faster when duty “The Chinese companies are answer-
cover to the money printing. For the next calls. What’s the harm in it? they ing to politicians who have an aggres-
“mature market economies,” we ad- seem to ask. sive strategy of resource capture.”
vise a return to the basics, starting In fact, by cutting off interest rates at The properly skeptical observer is
with the very definitional threshold the knees, central banks punish thrift. in a quandary. China holds perhaps
of the problem. Inflation is not “too Prolonging the lives of businesses that $1.5 trillion of low-yielding Treasurys
much money chasing too few goods,” deserve to go out of business, they and U.S. agency securities. You’d ex-

Those devilish Cartoons.

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pect it to be edging out of two-year Bad debt comes later

notes and Fannies and Freddies into 20% 20%
resource investments, even if it had Chinese nonperforming-loan ratio
no doubts about the dollar. But it
does have doubts, which it has taken 16 16
to expressing in deeds as well as in
words. On Monday, a Shanghai mu-
nicipal government finance official

percent of total loans

percent of total loans

called a press conference to announce 12 12
the decision of three local companies
to begin settling import and export
contracts in renminbi rather than dol-
8 all banks: 2.04% 8
lars. From offstage, a Singapore cur-
rency analyst declared, according to
Bloomberg, “This is a first step on the
long road towards that target of mak- 4 foreign banks: 1.09% 4
ing the [renminbi] a global reserve
currency. That’s probably going to
take five years or more.”
It could be a long, hard road if China’s 0 0
Monkeybrains banking system follows 3/04 3/05 3/06 3/07 3/08 3/09
the Penn Square-type trajectory, as we source: The Bloomberg
expect it will. Besides, Bloomberg News,
in the very same dispatch, relates that ment. Note, please, that the dollars spite a year-over-year drop in exports
the dollar’s share of official vault space might as well have never left home. of 26.4%,” McCulley notes, “and the
climbed to 65%, or $2.6 trillion, up 100 Note also that their transit insti- American consumer’s newfound taste
basis points on an admittedly incomplete gates credit creation in China, some for thrift, China has posted an $89 bil-
sample set, in the first three months of of which, though not all, may be lion cumulative trade surplus through
the year. And it quotes He Yafei, China’s neutralized, or “sterilized,” by the May, which is actually ahead of last
deputy foreign minister, speaking in People’s Bank. Under a proper gold year’s record-setting pace.”
Rome on Sunday: “The dollar will main- standard, creditor countries gain re- A good-size portion of the Treasurys
tain its role for ‘many years to come.’” serves while debtor countries lose and agencies that America’s creditor
So saying, He came to the root them. Built into that system is a nations accumulate is held for safe-
of the problem. The dollar’s “role” balancing mechanism. New under keeping at the Federal Reserve Bank
in the world—its exalted status as the paper-money arrangements of of New York. We track these custody
a reserve currency—is what has fa- recent decades is a kind of intrinsic holdings on pages six and seven of
cilitated the piling up of debts on imbalance. The major debtor coun- Grant’s; the Fed discloses them every
one side of the Pacific and U.S. try loses no reserves even as the Thursday. Strange to relate, they have
Treasury assets on the other. It is debtor countries gain them. grown, not shrunk, in the past three
the dollar’s role that has allowed Our Great Recession has restored a months, at an annual rate of 27%.
the United States to consume much small measure of balance to the inter- All in all, the world is reverting to
more than it produces and to fi- national financial traffic. U.S. imports pre-crisis form. Central banks are
nance the difference in the curren- have fallen further than U.S. exports, monetizing dollars, subsidizing credit
cy that it alone may lawfully print. thus reducing the U.S. current-account and socializing risks, and the People’s
China ships merchandise to us; we deficit for the first quarter to $101.5 bil- Bank is outdoing all others in this
ship dollars to China. These dollars lion vs. the year-ago reading of $179 bil- direction. Certain it is that these un-
wind up at the doorstep of the Peo- lion. The second-quarter shortfall was precedented monetary maneuvers
ple’s Bank, which creates the ren- the smallest in absolute terms since the will come to a sorry and dramatic end.
minbi with which to absorb them. fourth quarter of 2001, and the small- What we are struggling to divine is the
And what does the bank do with its est as a percentage of GDP—2.9%— timeline. Watch this space.
greenbacks? Why, it invests them since the first quarter of 1999. Yet, still, •
in the securities of the U.S. govern- China accumulates dollar bills. “De-

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To the re n
aders of G
T h is c o m
Beachhe p il a t io n
a d is s u e , of recen
is t a r t ic le s
c li e n t s , c for you. , t h e f ir s
la s s m a t e A n d it ’s t annual
too. Plea s , s h ip m a f or your f G r a n t ’s
se pass it tes, brot r ie n d s , c
members along, wit h e r s - in - la w o-worker
of the gre h our tha a n d m a id s,
ater Gran n k s, to any s -of-hono
t’s family and all p r,
We return . rospectiv
two week e
s from tod
ay with V
ol. 27, No
. 17.
cerely you


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