Foresight Capital Partners

Until recently, the fall out from the collapsing US real estate sector has been limited to parties directly involved in this sector, namely mortgage lenders and builders. This column’s focus on the credit markets is now paying off in that third party effects are now appearing.

This month the aptly named “Bear Stearns High-Grade Structured Credit Strategies Enhanced Leverage Fund” fell into difficulty after losing 23 per cent of its value in the first four months of the year. A fire sale of assets was adverted when Bear Stearns offered to place its own capital on the line to support the fund. These events illustrated that there is no liquidity for this type of Asset Backed Securities and Collateralized Debt Obligations (CDOs) during market stress. Even with numerous other hedge funds, holding similar assets in this instance there were few buyers at prices close to the assets face value. Lombard Street Research said, “We heard buyers were lobbing bids at just 30% [of face value].” Hence, the liquidity assumptions embedded within the pricing and risk management models of such assets are questionable to say the least.

Collateralized Debt Obligations (CDOs) are similar in structure to split-cap investment trusts where differing ‘tranches’ having different rights over the underlying assets. With CDOs, you typical start with a portfolio of mortgage-backed securities, which roughly speaking are pools of similar mortgages, and other loans. The first tranche of the CDO will typically own 5 percent of the portfolio and absorb the first 5 percent of the default loses. The second tranche will own 10 per cent of the portfolio and absorb the next 10 per cent of loses. The third tranche will own 10 per cent of the portfolio and absorb the next 10 percent of loses, and the fourth tranche will own 75 percent of the portfolio and absorbs the residual default loses. The fourth tranche will usually receive a triple A rating by rating agencies and pay a yield corresponding to similarly rated high-grade bonds or highly covered split-cap investment trust zeros.

In a typical CDO transaction, the bank who arranges the loans will retain the first tranche and a very high proportion of the default risk, and sell on the other tranches transferring only the extreme losses to other market participants. The size and yield of the first tranches is largely driven by the average default probability of the securitized assets. These default probabilities in the Bear Sterns case and across the US mortgage backed securities sector appears to have been greatly underestimated. Re-pricing these assets with respect to higher default probabilities, which now seems inevitable, will lead to a mark down of all similar instruments leading to large paper loses.

Web resource:

Queen’s Walk Investment Limited is a LSE listed closed-end fund which invests within the CDO market. Their web site (http://www.queenswalkinv.com/) contains presentations and reports detailing how the fall out from the mortgage markets during Q1 2007 has affected their portfolio.

The yield curve plots the yield of government securities against their respective maturities. Studying the evolution and shape of a currencies yield curve not only details the price of credit available in that currency but also the aggregate interest rate expectations going forward. In the classical Austrian school of economics, one assumes that credit is only available from governments and banks. At present credit is available from just about everywhere, including foreign governments, hedge funds and multinationals. For example, General Motors over recent years has generated more revenue from selling loans to buy its cars than the cars themselves. Such secondary credit markets and their associated curves such as LIBOR/Swap rates are highly relevant to present credit conditions. However, the principle influence in all these markets will still be the underlying currency yield curve with the US Treasury market being by far the most influential and important such market.

Over the past two weeks global equity and bond markets have been over shadowed by a marked and abrupt shift in the level and shape of the US yield curve. The benchmark ten year US Treasury bond has moved from a yield of 4.6 percent, to over 5.25 per cent. With the yield curve evolving from being ‘flat’ and pricing in a cut in US interest rates in the next year, to being ‘normal’ where further interest rate increases are deemed possible than an imminent cut be been completely discounted. Quantitatively driven relative trading strategies ensured that this shift in the USD curve dragged the Uk Gilt and Euro curve higher resulting in immediate loses for global bond portfolios, with an associated sell-off in global equity markets where the DOW has fallen more than 3 per cent from its recent peak.

Higher interest rates will undoubtedly squeeze the real estate sector, reduce the prices offered in private equity buy-outs and ultimately act as a drag on corporate profitability. Pension fund so called liability matching could also see further selling of bonds, as higher yields equates to less bond holdings needed to ensure a given future cash flow. Market prices reflected these developments with obviously targets such as UK mortgage lenders Bradford and Bingley and HBOS in the UK; and house builders and REITs in the US being hardest hit. Regulated utilities where also marked lower as bonds became a more competitive source of stable cash flows.

However you slice it, higher interest rates are not good for equities. One would prefer such moves to result from stronger than expected growth as opposed to inflation expectations, but I for one are not sure that this in the case.

Web Resources:
GBP/USD Yield Curves: http://www.yieldcurve.com/marketyieldcurve.asp
Dow vs USD Yield Curve: http://stockcharts.com/charts/YieldCurve.html
LIBOR/Swap Rates: http://www.swaprates.co.uk

Last week we discussed how ¬the availability of credit has lead to inflationary asset price rises. Here we will continue our discussion and ask how associated credit risk is being distributed amongst market participants.

One sure sign of any asset price bubble is when credit rather than fundamentals (e.g. earnings) is the main support for the prevailing price. The dot com boom (1998-2000), which lead to the dot com bust (2000-2003) was one such instance when the money supply via investors was cut-off and the fundamentals (e.g. earnings) did not support the prevailing prices. It was only when the credit was cut-off, that the risks became clear, or as Warren Buffet would say, “it is only when the tide goes out that you learn who is not wearing trunks”.

The headline “FTSE up with private equity driving top risers” sums up market action this year. All the buy-out targets, with Reuters, Hanson and ICI being the latest on a log line of examples, have all seen sharply higher share prices, with cheap credit being the primary driver behind these buy-out offers. In last week’s Sunday Times business section an article entitled “Will the credit bubble burst?” reported the huge amount of debt being taken on in all these takeovers as $4 of debt for every $1 of equity.

In recent years, leveraged lending in Europe has shifted away from banks towards hedge funds and other non-bank credit investment groups. At the turn of the century according to Standard and Poor’s 95% of all leveraged lending, and lending to firms of non-investment grade status was under-taken by banks. In 2005, banks represented 75% of the market, and in March 2007, this was down to 49.8%. This structural shift moves more than half to leverage credit from a tool in managing corporate relationships to a purely investment asset.

Bloomberg reported the UBS hedge fund lost the company about £150 million in the US sub-prime sector, and then just shut up shop. With RealtyTrac reporting, US Mortgage foreclosures rising 62 percent in April and the number of Americans falling behind on home loans climbing this year, such reversals are only likely to continue. Rise in defaults will lead to rise in defaults in Mortgage Backed Securities, which are generally bundled with credit derivatives and sold as AAA rated securities. These bundles are themselves typically used as collateral in further leveraged activity, which could lead to a domino effect if the AAA rated securities go into default.

This is not happen yet, but it is a possibility, which is being under-priced within credit markets, as illustrated by the existence of “negative basis trades”, which is another story for another time.

Next week, I continue the theme of liquidity and consider the example of China.

Whenever I am asked about property investment I usual suggest that people take a look at the Berlin market. The reason has simply been that I understood it was possible to obtain a 10% rental yield and there was the possibility of a more Anglo-Saxon mortgage market (i.e. prices could get more debt inflated, in addition to the earnings growth inflation). Now firstly it seems you could get a 10% yield but rental yields have been coming down due to investors entering the market and pushing up prices over the past few years, and that now a 6-8% yield is more realistic. What is particularly interesting with this market is that over the past fews years even the smart money, early movers like Morgan Stanley and Blackstone, have found it hard to get a decent return.

Over the past few years there have been a number of trades which have gone through where usually a US Investment Bank or Private Equity Group buys a large block a private residential property in order to reseller it at some point directly within the private market. Now the trade has generally been as follows you buy at the whole sale level (i.e. 300+ flats at once) from Corporations, housing associations etc then resell to owner-occupiers. Apparently the whole sale price at present is around 800 Euro per square meter and the end-user price can be up to 1,000 Euro per square meter. Hence, at least on paper there is something of an arbitrage, at least if you want to get involved in being a real estate agent. However, even with all the investment banking financing tricks people like Morgan Stanley can muster the deals just do not seem to stack up.

Remember JP Morgan is a real business and hence they want 20%+ return on capital, and hence when I say stack up, it means this business does not provide a 20%+ return on capital. Some of the problem’s which such parties have experienced when buying at the wholesale level in order to resell, is that some tenants just do not want to buy, hence you cannot get a clean exit, and you end up having apartment blocks which are partially sold and the ones which are not only provide 6-8% yield. Moreover, if you want to push up the rents in order to try to get the numbers to stack up (or the tenants to leave) then there are municipal rent caps. Hence, you end up being stuck with residential property with a 6-8% rental yield which not really the sort of asset which Morgan Stanley (or people like me) are looking for.

You never make friends (or get customers) by telling people what they do not want to hear and hence the sales people (including sales staff in the financial sector) just tell people what they want to hear. Which is probably the reason why I have always been such a miserable salesman since I always just tell people what I think irrespective of the consequences. Now, just to get my position out in the open, I think property at present is a bad investment and the worst market I know of is the UK. If anyone wants to know my personal rule of thumb with property, it is:

“you take the monthly rent multiply to 100 (maybe 120) to give you a target buying price”

That is, I always think property as an investment should offer a 10%+ rental yield. The reason for this is just that in order to have a 6% real (gross) income, with a 2% vacant/management, and 2% cost of up keep, you need 10%+ gross rental income. To me taking less than 6% income with real inflation around 5%, just does not make much sense. Remember when the property developer programs are not on the TV each night and everyone (and there dog) is not pushing property investments (i.e. when the music stops), it is the rental yield (i.e. the earnings) which will count.

Please, before anyone tells me, I really do not care what the market prices are, or what other persons are doing… what I care about with any investment is entering into positions where I expect to obtain a 25%+ compound return per year on my investment. And even an entry price of 100X rent, the numbers only stack up with gearing.

Making such comments is not going to earn me much popularity but since my no.1 source of income over the past 10 years have been investments, I cannot afford to dilute my approach in the name of popularity. Please also note that this is exactly the line I have been telling family members over the past few years, with differing degrees of success.

Since all my family members know I am involved in investment markets I always get people coming up to me at family gatherings and lettering me know about there latest investment activities. And one can guess this discussion recently often centers around property investments. At one end I have people telling me at such gatherings “I am going to just keep on buying and never sell”, and at the other end I have, “I am glad I sold and now rent”. Guess which one of these two camps made the most money over the past 3 years…. Well its the guy who sold his UK house and invested the monies on the stock market. In fact, in the UK over the last one, two and three year periods, the FTSE index has out-performed the housing index.

With operations like BNP Paribas Arbitrage SNC today buying stakes in closed-end funds like Aurora Investment Trust plc at a discount of under 7%, you really need to ask yourself whether closed-end fund arbitrage is a strategy worth applying anymore. This is not an isolated event and parties such as ‘The Cayenne Trust Plc’ another fund arb are quite happy to build positions in funds such as Perpetual Income and Growth, Electric & General Investment trust at “discounts in excess of 7%” (see September 06 Factsheet). Such parties would have wanted 15-20% (or higher) discount levels 3-5 years ago, and now they are happy on wafer thin margins which seem to the outside observer that in terms of the expected return the entire activity is hardly worth it. In my judgment I would suggest that at discount level under 10%, would render to closed-end fund arbitrage strategy insufficient to justify. Moreover, if you are paying hedge fund/absolute return like fees then the whole strategy becomes a bit of a disaster (at least for the investors in such funds) when the discounts go sub-10%.

As has been widely reported (for example in the FT), the dilution of potential returns from many hedge fund strategies (such as closed-end fund arbitrage) is being diluted by the simple fact that there is too much money chasing the same opportunities. Closed-end fund arbitrage is a clear example of this where parties are deploying capital in trades with ever lower return expectations. This lowering expectation is also very much born out by the figures where according to Credit Suisse Tremont, the hedge funds as a whole have returned 7.64% over the past year, where as five years ago most strategies offered double digit returns. Saying this, even though the performance each year has been getting weaker and now stands at levels not much higher than a bank account, people are still all to keen to throw money at hedge fund strategies. In particular, according to Hedge Fund Research a record $44.5B has flowed into hedge funds over the last quarter, which is only likely to push returns to even lower levels.

In banking big is better, and the European market is sufficiently structurally integrated and de-regulated that the emergence of pan-European banking institution is not only conceivable but also highly likely. The driver (as always) will be competitive pressures since a larger pan-European institutions are in a better position to serve pan-European institutions and benefit from the economies of scale that such a size would bring. From which we formulate our main query:

“What institutions will be involved in the development of pan European banks? Moreover, what is the likely path and drivers for the formation of such institutions?”

My motivation is purely that I see the development of the European banking sector taking a similar development path to the US over the past 10 (or so) years. In the US through end-less mergers over the past decade you now have banking institutions which cover all states and have a global presence sufficient to serve US multi-nationals overseas. Now in order to see the likely effects on profits of an institution moving to a global pan-Euro banking giant, we will consider the example Citigroup which over the period 98 - present, has traveled a similar path in the US. In 1998, you could have purchased Citigroup stock at almost any time that year for around $12.50, with a yield of just over 1%. The present stock price is over $50, and the yield is just under 4%. What that means in that you have got 18.9% capital return compounded over the last 8 years, where the yield on the original purchase is over 14%, meaning that the compound increase in the level of dividend is around 27%. Moreover, this return has not been achieved by the expanding of multiples or excess balance sheet debt, and the evaluation now is reasonable with a PE of 10.38, with the Forward PE of 11.07, and as we mentioned above a yield just under 4%.

Now to just put this performance into perspective the DOW (of which Citigroup) is a 1/30th component has performance as follows:

Open Oct-98: 7,749
Open Oct-06: 11,678
Total Capital Return over the 8 year period: 150.7% (5.26% per year compounded)

Hence, Citigroup has had a capital returned of more than three times the market average. If you take real inflation adjusted returns (assuming average annual inflation of 4% over the period), then Citigroup has an annual real return of 14.9%, against 1.26% for the DOW.

Even if you buy into my theory in order to make any money from it, you still need to be able to predict the likely ‘Citigroup type’ banks in Europe. That is, the banks which will become $250+B market cap giants bringing us back to my original query. At present, there are hundreds of banks in Europe (there is more the 200 just in Italy), and as with any dynamic chaotic process knowing what is going to happen with any certainly is just impossible. However, as a starting point I would expect the emergence of such banking giants to start with the merger of two banks from two of the three main European economies of the UK, France and Germany. For example, a merger between two of the following three banks:

Deutsche Bank: Market Cap (approx): $62.19B USD
Royal Bank of Scotland (RBS): Market Cap (approx): $110B USD
BNP Paribas: Market Cap (approx): $98B USD

Any ideas?