I, along with 7 other investment colleagues, are forming a new investment website which was launched last week. It is called: http://www.investorwalk.com/
Please refer to our new site for all my future blogs and articles, including my ten predictions for 2009. I will also post some public ones here from time to time. Thank you very much.
Thursday, January 1, 2009
Wednesday, December 10, 2008
Why Wall Street Needed Credit Default Swaps
This article was published at various websites in April 2008, the response and feedback have been overwhelming. I decided to re-post it here at my blog site.
We have all heard about CDOs (collateralized debt obligations) and probably about the insurance of CDOs through CDSs (credit default swaps), which transfer the credit risks of CDOs between two parties (financial institutions).
The CDS is a bet between two parties on whether or not a company or a financial product will default. It is third party speculation on the outcome of the CDO. The CDS provides insurance to cover a fixed income product in case of its default. If a company declares bankruptcy or a debt is downgraded, a claim is triggered.
Currently, the outstanding notional amount of all credit default swaps is about $65 trillion, more than half of the entire asset base of the global banking system. Why are financial institutions are so interested in them? Why have they created so many of them to make this market so big and out of control?
There are many incentives, some of them are larger, and some smaller. I will discuss the three major reasons.
Transference of Risk
First, credit default swaps are not normal insurance policies; each side can trade them to make a quick profit (spread) if there is a willing counterparty. Commonly, after the original CDS contract is engaged, each of the original two parties will try to engage another party to further hedge their risk and earn a small spread. Pretty soon there are layers and layers of counterparties involved, with the total notional amount increasing several fold, until no one knows who they are really dealing with anymore.
You can't monitor this risk since you don't know your counterparty down the CDS chain, and whether they are able to pay in the event of a default. If you throw the counterparty risk out the window, you can always find a sucker to do the trade with you and earn a small spread.
This kind of entanglement has never been seen before in the usually highly-regulated insurance industry. This is why CDSs are traded on OTC (over the counter) derivative markets which bypass all government regulations.
This entanglement creates a chain reaction. If something happens - even a downgrade but not a default - the claim will trigger a domino effect of many claims cascading down through various parties. It will break at the weakest joint (counterparty), probably a highly leveraged hedge fund, and will ripple through all parties involved and likely break the whole chain. It amplifies counterparty risk to the hilt, beyond the default risk of the CDO itself.
Let us use the analogy of new type of car insurance: Car insurance company A trades our car insurance policy costing us $1,000 per year (or $1,000 revenue for them) for another $1,100 similar policy from another company B, and pockets a $100 quick profit. Or we trade our $1,000 policy (company A) with $900 policy from another company C. If we find cheap auto insurance, we just simply cut A out and make a switch to C. Our relationship with the insurance company is always one on one.
However, imagine what happens if both parties trade the policy with a third party. If an accident occurs, company A will not want to pay us, since we engaged company C, and company C will not want to pay either, since it did not issue the original policy. And if company A pays us eventually, they will have to file a claim against company B, who will most likely deny such claim.
This is what happened to the insurance company AON in a story that surfaced last year from a lawsuit. In this real story, Bear Stearns loaned $10M to an entity in Philippines. To hedge this default risk, Bear purchased a protection contract from AON for $0.4M. To hedge this risk, AON purchased protection from Societe Generale for $0.3M. AON thought they were geniuses, offsetting the risk and at the same time earning an easy quick $0.1M profit. Who says there is no free lunch on Wall St.? Think again!
You guessed it - the loan went bust as expected. Bear sued AON for $10M based on the first CDS contract. AON lost the case and paid. Of course, AON sued Societe Generale. Due to some legal technicalities, a different court and judge had a different opinion.
The judgment was that the first and second CDS contracts were two separate contracts. Legally, the resolution of first CDS lawsuit did not automatically grant the similar status to the second CDS. The first judgment can't be referenced in the second lawsuit. As a result, the risk can't automatically be transferred and offset each time.
AON lost the case, and the $0.1M "profit" turned into $10M loss in principal. It was an expensive lunch. This sets an important legal precedent for future CDS lawsuits. A small $10M default in the Philippines impacted three parties. Maybe this is an unexpected downside of globalization?
The market cap of GM is about $11Bn. However, based on estimates in the CDS market, there are about $1 trillion (notional amount) in CDSs betting on GM and their bonds. Any change in GM's situation will create a ripple effect in this $1Tn CDS community of GM.
There are obviously not $1Tn of GM assets to serve as collateral, so you have to trust all parties involved in this wild casino betting that they won't go under water. As a matter of fact, you better pray, because if one goes under, which is a high probability, it will throw a monkey wrench in the whole community, as everyone is trying to unwind and get out at the same time. It becomes a "no way out situation."
Bill Gross at PIMCO did a simple calculation in January in his famous article "Pyramid Crumbling." The total amount of CDS contracts was $45 trillion at that time. The historical default rate is 1.25%, so $500Bn CDS contracts are likely to default. Assuming a recovery rate of 50%, the resulting loss is $250Bn alone.
In the case of CDOs created from sub-prime mortgages, Gross’ assumptions are too optimistic. The assumed default rate is far too low. His recovery rate assumption is probably also too high if you consider the long process of home foreclosure in a deteriorating real estate market with no buyers and legal maneuvers which can be implemented by homeowners (refer to my early articles on foreclosure). I expect to see real losses doubling his estimate, or approximately $500Bn in the sub-prime market.
Using CDS to Smooth Earnings
Second, and more importantly, besides the quick profit earned through a small spread, there is a big incentive to use credit default swaps to smooth earnings from quarter to quarter and to hide losses.
If a CDO is rated AAA by rating agency (almost as good as US Treasuries) why would Wall St. want to buy insurance for protection? At the same time, assume a AAA CDO enjoys a 50 basis point spread above US Treasury rates. It is almost as good as a free lunch. Why would Wall Street firms want to eat into the 50 bp spread (and their profit) to buy CDS insurance?
The answer lies in different accounting treatments. Wall Street firms are not stupid, and they are smart enough to know their CDOs are not US Treasuries, even if their structured product groups and sales people claim they are, with the backing of the rating agencies. It is similar to the promotion of internet stocks in late 1990s, when Wall Street put out a "strong buy" ratings on supposedly great internet companies with unbelievable growth stories, while their internal memos referred to them as "pieces of garbage".
Due to GAAP (generally accepted accounting principles) requirements, investment banks need to mark their CDO products to market if they do not carry CDS insurance. This creates a problem, since both interest rates and credit spreads fluctuate, making it harder to manage earnings. What happens if investors or regulators suddenly realize they are really a piece of garbage? They don't want earnings volatility and surprises, especially at the time when their bonuses are at stake. Banks want to defer paper losses due to write-downs until they actually sell their CDOs, which would mean real bonus reductions for executives and structured finance groups.
By purchasing CDS insurance, according to GAAP regulations, there is no need to mark-to-market, Investment banks need to declare losses only if the CDO is permanently damaged and a claim will have to be paid. No more quarter to quarter fear of marking to market.
This effectively transfers the price risk to a counterparty, who in turn dumps it to another party, and so forth. By the time it comes back full circle, no one needs to worry about marking to market and earning surprises. If a paper loss happens, they can point to the insurance and claim it is only temporary. Financial statements will not be impacted.
CDS provide a vehicle to allow participants to hide any losses to a point where they really can't hide them anymore. They act as an earnings smoother and, worse, they hide the actual risk of investment bank holdings from the public. This is a reason why so many strange things have happened on Wall Street over the last several years.
For example, for a AAA rated CDO with a 50 basis point spread, investment banks would buy insurance from a small second tier bond insurer (such as ACA) whose rating was only single A as a firm (now at junk triple C). If they believed a rating agency with AAA rating on this CDO, why would they want to cover it with a lower rated policy which eating into their profits?
In the example earlier, GM has an $11Bn market cap with $1Tn in CDS outstanding. Use home insurance as an analogy here. If your house is only worth $200k, why would there be policies on your home with a combined notional amount of $20 million?
Using CDS to Accelerate Earnings Recognition
The third and most important use of CDSs concerns the strong incentive to book the next ten years' profit today.
CDSs offer investment banks something called a “negative-basis trade,” which is another accounting loophole like the earnings smoothing discussed above. Using the same example of a CDO with a 50 basis point spread over US Treasures, banks will buy a CDS, costing 20 basis points. By doing so, even though they seem to make less profit (50 vs. 30 basis point spread), banks can book the difference in spread for the whole life of this CDO instantly, through the magic of a negative-basis trade.
If the life of the CDO is ten years, banks can book the whole ten years of phantom profits this year, even if the CDO defaults sometime in the future. This has obvious implications for the bonuses of the structured product groups at Wall Street firms.
Who cares whether this CDO defaults next year? Let’s realize the next ten years’ of bonuses today! There is a common secret at Wall Street - it doesn't matter whether a product is good or bad; the only thing that matters is how you structure it. As former Secretary of the Treasury, John Connally, said to European central bankers in the 1970s' "It might be our currency (the US dollar), but it is your problem." The same thing applies here. If a CDO defaults, investment bankers have already bumped up their stock price, cashed out their stock options and their vested shares, and collected their year end bonuses. Now it is the shareholders’ problem.
This kind of accounting manipulation can fool people for a few years, but not forever, since the well of CDOs gets sucked dry very quickly when every single firm on Wall Street has found out about this and is doing it. A firm owning a mortgage originator has a competitive advantage since it guarantees the source for the well. This is why Stanley O'Neal at Merrill Lynch wanted to buy First Franklin (a mortgage loan originator) so badly, because for every loan First Franklin originates, Merrill Lynch executives and their structured product groups could accelerate ten years of their firm's earnings and future bonuses.
Wall Street wants to package and collateralize everything from residential to commercial mortgages, from credit card to auto loan debt, resulting in a major shift and increase from traditional M&A fees to the so-called trading "profit" in recent years "earned" by investment banks.
How real were the past earnings reported by both Wall Street firms and hedge funds with large CDO profits? If managers can trade a minor reduction in profit (from 50 to 30 basis points) for an immediate bonus of 10 times (by accelerating ten years of earnings to the current year) what would they choose?
If a CDO defaults next year and take a hedge fund under their high water mark, it's no a big deal. The fund already collected a 20% fee from the "profit" the year before. The manager can close the fund and open a new one, raising money probably from the same pool of investors. If you want to see a pyramid scheme, there is none more vivid than this.
How about those unbelievable earnings reported by Wall Street investment banks over the last several years?
Frankly and openly, early this decade, investment banks had repeatedly expressed their dissatisfaction about relying mainly on the traditional banking fees from M&A and IPOs. There was very little room for manipulation since they only got paid when a banking deal or IPO was completed. By discovering the CDO and CDS markets, they suddenly found their Holy Grail, with profit becoming more and more skewed toward the asset "structuring" (or manipulation?) and the trading side now representing the majority of their "earnings."
This kind of accounting abuse is not unusual. It happens in the option ARM (adjustable-rate mortgages) market too. Homeowners (borrowers) for the first year or two pay a teaser rate of 2%. However, in their financial statements, banks (lenders) report the full amount of interest, say 6%, as "profit," while they actually only collect 2%. The net 4% shortfall is added to the borrower's balance. Banks have nothing to lose, but homeowners see their balance increasing and home prices dropping.
WaMu reported $1.4B profit from this kind of ARM last year, while Countrywide earned approximately $600M from them in 2007. How much of those earnings were real? How much real cash have they actually collected or will collect? They would be lucky to collect one third, and the rest they may never see. ARM default rate jumped from 1.5% from last summer to 5% by end of 2007. There are two big waves of ARM rate resets coming - one this summer and another in October this year. By the end of this year, I forecast ARM default in double digits. The total outstanding ARM loans are estimated to be approximately $4-5 trillion. A 10% default will put $400Bn of loans in default.
There are many other accounting manipulations and abuses in the mortgage market. For example, when MBS (mortgage-backed securities) are sold to investors, banks will record the cash flow from interest and servicing rights over the whole life of this bond up front, as something called a "gain on sale". In another example, since mortgages classified as "loans held for sale" on the balance sheet must be marked to market, banks move them to another category called "loans held for investment," which has no such requirement. Only when banks believe their losses are not temporary, but permanent, must they mark to market. Banks can always argue the current real estate plummet is only temporary, if you think long term.
If you are using the last several years' earnings as a reference point, banks don't look very expensive today (setting aside the risk associated with all the off-balance items in their long footnotes). But do you think those trading profits will return in the future? I really doubt it.
Accounting and legal loopholes will get closed by new regulations, and the CDO market will dry up for the foreseeable future. Banks will not be able to return to their previous earning power without their trading "profit" from accounting loopholes. Even if the economy comes back soon with lots of M&A and IPO deals, which is very unlikely, the good old days of trading "profit" are likely gone forever.
I don't see why all the sovereign wealth funds (SWFs) are rushing to invest in Wall Street banks. There is not much upside - only a lot of downside. It is also very interesting to note the stated investment strategy of many SWFs is to seek a 5% stable annual return in very safe financial products.
SWFs are investing in financial institutions like Blackstone and investment banks which are anything but safe and stable. This totally contradicts their investment strategy. Nothing they have invested in can be regarded as safe and stable, let alone yielding a 5% annual return. Perhaps they will see a 5% fluctuation weekly if not daily.
No SWF has factored in currency risk, which may be 5% in US dollar terms, but could result in a negative 25% return in their own currency (if the US dollar depreciates 30% in the next several years, as I believe is likely). Their investments could not be further from their stated investment strategy, and this raises a credibility issue with regard to everything else SWFs have claimed.
Of the outstanding $45 trillion CDO credit default swaps at the end of last year, JP Morgan owned about $15 trillion, or one third of the whole market. This is may be the reason for the Bear Stearns' acquisition by JPM. Even though Bear Stearns' CDS position was “only” around $2.5 trillion, the default of Bear would bring a shock wave of counterparty risk across the whole CDS market and would inevitably expose JPM, with its huge CDS risk, to the global financial market. Who can afford to pay for this? Who has a large enough capital base to absorb such a loss, especially since these contracts are concentrated in only a few CDS derivative dealers like JPM? No one.
It always comes down to the deep pockets, as in any liability litigation, where litigators will skip all the smaller players but will jump on whoever has the deepest pockets and largest exposure and position. JPM currently seems to fit the picture. When such a time comes, all the other weaker and smaller players will try to dump their risk to JPM to unwind their positions. By buying Bear Stearns, JPM can postpone the CDS debacle for another year, but not forever. I expect JPM will eventually suffer very large losses in this area - bigger than one third of their market share. Bernanke and Paulson better get their helicopter and $500Bn of cash ready for their Wall Street friends.
Early this decade, Warren Buffett publicly turned against derivatives. "When Charlie [Munger] and I finished reading the long footnotes detailing the derivatives activities of major banks, the only thing we understand is that we don't understand how much risk the institution is taking," he told investors. He said "Derivatives are financial weapons of mass destruction [WMD], carrying dangers that, while now latent, are potentially lethal."
I believe what he was referring to at that time were not CDSs, but other derivatives such as interest rate swaps. The day will come when investors become aware of the OTC CDS scheme, which has no footnote in annual reports, no market, is not regulated, leaves no trace whatsoever, has no clearing house, and where everything depends on the credit and liquidity of the weakest player in the CDS chain. If an interest rate swap can be called a WMD by Warren Buffett, I can't come up with a name for the CDS. Just as Paul Volcker said last week, the current crisis is "the mother of all crises." The CDS is the mother of the current credit crisis.
The CDS is a Wall Street vehicle used to manipulate loopholes in accounting and legal regulations in order to move and hide losses, to record future profits today, to manipulate, realize and increase reported earnings in today's financial statements to accelerate bonus payments, all done with the help of willing and eager accomplices, in both bond insurers and rating agencies.
At the same time, it is the same old game of quick profits, phantom earnings, rip-offs, manipulation, distortion and cover-up, played on Wall Street since its inception. Only this time it is greatly exacerbated by the financial deregulations enacted during the Greenspan era.
Thomas Tan, CFA, MBA
Thomast2@optonline.net
We have all heard about CDOs (collateralized debt obligations) and probably about the insurance of CDOs through CDSs (credit default swaps), which transfer the credit risks of CDOs between two parties (financial institutions).
The CDS is a bet between two parties on whether or not a company or a financial product will default. It is third party speculation on the outcome of the CDO. The CDS provides insurance to cover a fixed income product in case of its default. If a company declares bankruptcy or a debt is downgraded, a claim is triggered.
Currently, the outstanding notional amount of all credit default swaps is about $65 trillion, more than half of the entire asset base of the global banking system. Why are financial institutions are so interested in them? Why have they created so many of them to make this market so big and out of control?
There are many incentives, some of them are larger, and some smaller. I will discuss the three major reasons.
Transference of Risk
First, credit default swaps are not normal insurance policies; each side can trade them to make a quick profit (spread) if there is a willing counterparty. Commonly, after the original CDS contract is engaged, each of the original two parties will try to engage another party to further hedge their risk and earn a small spread. Pretty soon there are layers and layers of counterparties involved, with the total notional amount increasing several fold, until no one knows who they are really dealing with anymore.
You can't monitor this risk since you don't know your counterparty down the CDS chain, and whether they are able to pay in the event of a default. If you throw the counterparty risk out the window, you can always find a sucker to do the trade with you and earn a small spread.
This kind of entanglement has never been seen before in the usually highly-regulated insurance industry. This is why CDSs are traded on OTC (over the counter) derivative markets which bypass all government regulations.
This entanglement creates a chain reaction. If something happens - even a downgrade but not a default - the claim will trigger a domino effect of many claims cascading down through various parties. It will break at the weakest joint (counterparty), probably a highly leveraged hedge fund, and will ripple through all parties involved and likely break the whole chain. It amplifies counterparty risk to the hilt, beyond the default risk of the CDO itself.
Let us use the analogy of new type of car insurance: Car insurance company A trades our car insurance policy costing us $1,000 per year (or $1,000 revenue for them) for another $1,100 similar policy from another company B, and pockets a $100 quick profit. Or we trade our $1,000 policy (company A) with $900 policy from another company C. If we find cheap auto insurance, we just simply cut A out and make a switch to C. Our relationship with the insurance company is always one on one.
However, imagine what happens if both parties trade the policy with a third party. If an accident occurs, company A will not want to pay us, since we engaged company C, and company C will not want to pay either, since it did not issue the original policy. And if company A pays us eventually, they will have to file a claim against company B, who will most likely deny such claim.
This is what happened to the insurance company AON in a story that surfaced last year from a lawsuit. In this real story, Bear Stearns loaned $10M to an entity in Philippines. To hedge this default risk, Bear purchased a protection contract from AON for $0.4M. To hedge this risk, AON purchased protection from Societe Generale for $0.3M. AON thought they were geniuses, offsetting the risk and at the same time earning an easy quick $0.1M profit. Who says there is no free lunch on Wall St.? Think again!
You guessed it - the loan went bust as expected. Bear sued AON for $10M based on the first CDS contract. AON lost the case and paid. Of course, AON sued Societe Generale. Due to some legal technicalities, a different court and judge had a different opinion.
The judgment was that the first and second CDS contracts were two separate contracts. Legally, the resolution of first CDS lawsuit did not automatically grant the similar status to the second CDS. The first judgment can't be referenced in the second lawsuit. As a result, the risk can't automatically be transferred and offset each time.
AON lost the case, and the $0.1M "profit" turned into $10M loss in principal. It was an expensive lunch. This sets an important legal precedent for future CDS lawsuits. A small $10M default in the Philippines impacted three parties. Maybe this is an unexpected downside of globalization?
The market cap of GM is about $11Bn. However, based on estimates in the CDS market, there are about $1 trillion (notional amount) in CDSs betting on GM and their bonds. Any change in GM's situation will create a ripple effect in this $1Tn CDS community of GM.
There are obviously not $1Tn of GM assets to serve as collateral, so you have to trust all parties involved in this wild casino betting that they won't go under water. As a matter of fact, you better pray, because if one goes under, which is a high probability, it will throw a monkey wrench in the whole community, as everyone is trying to unwind and get out at the same time. It becomes a "no way out situation."
Bill Gross at PIMCO did a simple calculation in January in his famous article "Pyramid Crumbling." The total amount of CDS contracts was $45 trillion at that time. The historical default rate is 1.25%, so $500Bn CDS contracts are likely to default. Assuming a recovery rate of 50%, the resulting loss is $250Bn alone.
In the case of CDOs created from sub-prime mortgages, Gross’ assumptions are too optimistic. The assumed default rate is far too low. His recovery rate assumption is probably also too high if you consider the long process of home foreclosure in a deteriorating real estate market with no buyers and legal maneuvers which can be implemented by homeowners (refer to my early articles on foreclosure). I expect to see real losses doubling his estimate, or approximately $500Bn in the sub-prime market.
Using CDS to Smooth Earnings
Second, and more importantly, besides the quick profit earned through a small spread, there is a big incentive to use credit default swaps to smooth earnings from quarter to quarter and to hide losses.
If a CDO is rated AAA by rating agency (almost as good as US Treasuries) why would Wall St. want to buy insurance for protection? At the same time, assume a AAA CDO enjoys a 50 basis point spread above US Treasury rates. It is almost as good as a free lunch. Why would Wall Street firms want to eat into the 50 bp spread (and their profit) to buy CDS insurance?
The answer lies in different accounting treatments. Wall Street firms are not stupid, and they are smart enough to know their CDOs are not US Treasuries, even if their structured product groups and sales people claim they are, with the backing of the rating agencies. It is similar to the promotion of internet stocks in late 1990s, when Wall Street put out a "strong buy" ratings on supposedly great internet companies with unbelievable growth stories, while their internal memos referred to them as "pieces of garbage".
Due to GAAP (generally accepted accounting principles) requirements, investment banks need to mark their CDO products to market if they do not carry CDS insurance. This creates a problem, since both interest rates and credit spreads fluctuate, making it harder to manage earnings. What happens if investors or regulators suddenly realize they are really a piece of garbage? They don't want earnings volatility and surprises, especially at the time when their bonuses are at stake. Banks want to defer paper losses due to write-downs until they actually sell their CDOs, which would mean real bonus reductions for executives and structured finance groups.
By purchasing CDS insurance, according to GAAP regulations, there is no need to mark-to-market, Investment banks need to declare losses only if the CDO is permanently damaged and a claim will have to be paid. No more quarter to quarter fear of marking to market.
This effectively transfers the price risk to a counterparty, who in turn dumps it to another party, and so forth. By the time it comes back full circle, no one needs to worry about marking to market and earning surprises. If a paper loss happens, they can point to the insurance and claim it is only temporary. Financial statements will not be impacted.
CDS provide a vehicle to allow participants to hide any losses to a point where they really can't hide them anymore. They act as an earnings smoother and, worse, they hide the actual risk of investment bank holdings from the public. This is a reason why so many strange things have happened on Wall Street over the last several years.
For example, for a AAA rated CDO with a 50 basis point spread, investment banks would buy insurance from a small second tier bond insurer (such as ACA) whose rating was only single A as a firm (now at junk triple C). If they believed a rating agency with AAA rating on this CDO, why would they want to cover it with a lower rated policy which eating into their profits?
In the example earlier, GM has an $11Bn market cap with $1Tn in CDS outstanding. Use home insurance as an analogy here. If your house is only worth $200k, why would there be policies on your home with a combined notional amount of $20 million?
Using CDS to Accelerate Earnings Recognition
The third and most important use of CDSs concerns the strong incentive to book the next ten years' profit today.
CDSs offer investment banks something called a “negative-basis trade,” which is another accounting loophole like the earnings smoothing discussed above. Using the same example of a CDO with a 50 basis point spread over US Treasures, banks will buy a CDS, costing 20 basis points. By doing so, even though they seem to make less profit (50 vs. 30 basis point spread), banks can book the difference in spread for the whole life of this CDO instantly, through the magic of a negative-basis trade.
If the life of the CDO is ten years, banks can book the whole ten years of phantom profits this year, even if the CDO defaults sometime in the future. This has obvious implications for the bonuses of the structured product groups at Wall Street firms.
Who cares whether this CDO defaults next year? Let’s realize the next ten years’ of bonuses today! There is a common secret at Wall Street - it doesn't matter whether a product is good or bad; the only thing that matters is how you structure it. As former Secretary of the Treasury, John Connally, said to European central bankers in the 1970s' "It might be our currency (the US dollar), but it is your problem." The same thing applies here. If a CDO defaults, investment bankers have already bumped up their stock price, cashed out their stock options and their vested shares, and collected their year end bonuses. Now it is the shareholders’ problem.
This kind of accounting manipulation can fool people for a few years, but not forever, since the well of CDOs gets sucked dry very quickly when every single firm on Wall Street has found out about this and is doing it. A firm owning a mortgage originator has a competitive advantage since it guarantees the source for the well. This is why Stanley O'Neal at Merrill Lynch wanted to buy First Franklin (a mortgage loan originator) so badly, because for every loan First Franklin originates, Merrill Lynch executives and their structured product groups could accelerate ten years of their firm's earnings and future bonuses.
Wall Street wants to package and collateralize everything from residential to commercial mortgages, from credit card to auto loan debt, resulting in a major shift and increase from traditional M&A fees to the so-called trading "profit" in recent years "earned" by investment banks.
How real were the past earnings reported by both Wall Street firms and hedge funds with large CDO profits? If managers can trade a minor reduction in profit (from 50 to 30 basis points) for an immediate bonus of 10 times (by accelerating ten years of earnings to the current year) what would they choose?
If a CDO defaults next year and take a hedge fund under their high water mark, it's no a big deal. The fund already collected a 20% fee from the "profit" the year before. The manager can close the fund and open a new one, raising money probably from the same pool of investors. If you want to see a pyramid scheme, there is none more vivid than this.
How about those unbelievable earnings reported by Wall Street investment banks over the last several years?
Frankly and openly, early this decade, investment banks had repeatedly expressed their dissatisfaction about relying mainly on the traditional banking fees from M&A and IPOs. There was very little room for manipulation since they only got paid when a banking deal or IPO was completed. By discovering the CDO and CDS markets, they suddenly found their Holy Grail, with profit becoming more and more skewed toward the asset "structuring" (or manipulation?) and the trading side now representing the majority of their "earnings."
This kind of accounting abuse is not unusual. It happens in the option ARM (adjustable-rate mortgages) market too. Homeowners (borrowers) for the first year or two pay a teaser rate of 2%. However, in their financial statements, banks (lenders) report the full amount of interest, say 6%, as "profit," while they actually only collect 2%. The net 4% shortfall is added to the borrower's balance. Banks have nothing to lose, but homeowners see their balance increasing and home prices dropping.
WaMu reported $1.4B profit from this kind of ARM last year, while Countrywide earned approximately $600M from them in 2007. How much of those earnings were real? How much real cash have they actually collected or will collect? They would be lucky to collect one third, and the rest they may never see. ARM default rate jumped from 1.5% from last summer to 5% by end of 2007. There are two big waves of ARM rate resets coming - one this summer and another in October this year. By the end of this year, I forecast ARM default in double digits. The total outstanding ARM loans are estimated to be approximately $4-5 trillion. A 10% default will put $400Bn of loans in default.
There are many other accounting manipulations and abuses in the mortgage market. For example, when MBS (mortgage-backed securities) are sold to investors, banks will record the cash flow from interest and servicing rights over the whole life of this bond up front, as something called a "gain on sale". In another example, since mortgages classified as "loans held for sale" on the balance sheet must be marked to market, banks move them to another category called "loans held for investment," which has no such requirement. Only when banks believe their losses are not temporary, but permanent, must they mark to market. Banks can always argue the current real estate plummet is only temporary, if you think long term.
If you are using the last several years' earnings as a reference point, banks don't look very expensive today (setting aside the risk associated with all the off-balance items in their long footnotes). But do you think those trading profits will return in the future? I really doubt it.
Accounting and legal loopholes will get closed by new regulations, and the CDO market will dry up for the foreseeable future. Banks will not be able to return to their previous earning power without their trading "profit" from accounting loopholes. Even if the economy comes back soon with lots of M&A and IPO deals, which is very unlikely, the good old days of trading "profit" are likely gone forever.
I don't see why all the sovereign wealth funds (SWFs) are rushing to invest in Wall Street banks. There is not much upside - only a lot of downside. It is also very interesting to note the stated investment strategy of many SWFs is to seek a 5% stable annual return in very safe financial products.
SWFs are investing in financial institutions like Blackstone and investment banks which are anything but safe and stable. This totally contradicts their investment strategy. Nothing they have invested in can be regarded as safe and stable, let alone yielding a 5% annual return. Perhaps they will see a 5% fluctuation weekly if not daily.
No SWF has factored in currency risk, which may be 5% in US dollar terms, but could result in a negative 25% return in their own currency (if the US dollar depreciates 30% in the next several years, as I believe is likely). Their investments could not be further from their stated investment strategy, and this raises a credibility issue with regard to everything else SWFs have claimed.
Of the outstanding $45 trillion CDO credit default swaps at the end of last year, JP Morgan owned about $15 trillion, or one third of the whole market. This is may be the reason for the Bear Stearns' acquisition by JPM. Even though Bear Stearns' CDS position was “only” around $2.5 trillion, the default of Bear would bring a shock wave of counterparty risk across the whole CDS market and would inevitably expose JPM, with its huge CDS risk, to the global financial market. Who can afford to pay for this? Who has a large enough capital base to absorb such a loss, especially since these contracts are concentrated in only a few CDS derivative dealers like JPM? No one.
It always comes down to the deep pockets, as in any liability litigation, where litigators will skip all the smaller players but will jump on whoever has the deepest pockets and largest exposure and position. JPM currently seems to fit the picture. When such a time comes, all the other weaker and smaller players will try to dump their risk to JPM to unwind their positions. By buying Bear Stearns, JPM can postpone the CDS debacle for another year, but not forever. I expect JPM will eventually suffer very large losses in this area - bigger than one third of their market share. Bernanke and Paulson better get their helicopter and $500Bn of cash ready for their Wall Street friends.
Early this decade, Warren Buffett publicly turned against derivatives. "When Charlie [Munger] and I finished reading the long footnotes detailing the derivatives activities of major banks, the only thing we understand is that we don't understand how much risk the institution is taking," he told investors. He said "Derivatives are financial weapons of mass destruction [WMD], carrying dangers that, while now latent, are potentially lethal."
I believe what he was referring to at that time were not CDSs, but other derivatives such as interest rate swaps. The day will come when investors become aware of the OTC CDS scheme, which has no footnote in annual reports, no market, is not regulated, leaves no trace whatsoever, has no clearing house, and where everything depends on the credit and liquidity of the weakest player in the CDS chain. If an interest rate swap can be called a WMD by Warren Buffett, I can't come up with a name for the CDS. Just as Paul Volcker said last week, the current crisis is "the mother of all crises." The CDS is the mother of the current credit crisis.
The CDS is a Wall Street vehicle used to manipulate loopholes in accounting and legal regulations in order to move and hide losses, to record future profits today, to manipulate, realize and increase reported earnings in today's financial statements to accelerate bonus payments, all done with the help of willing and eager accomplices, in both bond insurers and rating agencies.
At the same time, it is the same old game of quick profits, phantom earnings, rip-offs, manipulation, distortion and cover-up, played on Wall Street since its inception. Only this time it is greatly exacerbated by the financial deregulations enacted during the Greenspan era.
Thomas Tan, CFA, MBA
Thomast2@optonline.net
Friday, December 5, 2008
Western Goldfields – Strong Net Cashflow from Operations
Everyone remembers the California gold rush a century ago, but few know a large gold mine is currently under operations in the southeast corner of California near the Arizona and Mexican borders. This is the mining operations known as the Mesquite Mine managed by Western Goldfields (Amex: WGW).
This mine was actually operated from 1985 to 2001 by several mining companies including Newmont, but was suspended in 2001 when gold prices fell to the bottom. However, Western Goldfields acquired the mine in 2003, and production re-started in January of this year, the timing of which couldn’t have been better since the current turmoil in the credit market makes any financing very difficult if not impossible for some other cash stripped mining companies.
Western Goldfields (WGW) is headquartered in Toronto, Ontario. I met their President and CEO Mr. Raymond Threlkeld and Director of IR and Corp Development Mr. Hannes Portmann on November 20 in New York City. They discussed the details of the compelling value and low risk that their Company offered in comparison to their current low stock price.
Their major project, the Mesquite Mine, has 4.3 million resource ounces of gold including 2.8 million ounces in reserves. They are continuing drilling to find additional gold resources that could add 1 to 2 years of additional mine life beyond the current 14 years. Since it is a open pit operation, WGW can produce gold in a relatively cheap cost, with 2008 cost of sales averaging around $500 per oz. With the planned increasing production from 2009 and beyond, the cost of sales is expected to average around $420 per oz for the life of the mine.
This low cost is important during today’s gold correction and high production cost environment, comparing to many other mining companies. It enables WGW to make decent profit and generate substantial cashflow from operations. Even with today’s gold price, and expected 150,000 oz or more of annual production starting 2009, they can generate about $50 to $60 million in cashflow per year from operations. As a matter of fact, their current 3rd quarter 2008 has gold sales of 47K ounces at the cost of $390 only, with cashflow from operating activities at $16.5 million. Their stock price was trading at a ridiculous low level and temporary dipped below $0.50 per share late last month when the whole mining industry got hammered. However, it has since recovered nicely to $1.34 as of last Friday (11/28).
WGW has a very strong cash position of $45 million on hand including $7.5 million of restricted cash due to their loan covenants. At the same time, they are adding cash from their operations each quarter. This is why when their stock price dropped last month, they announced on Nov. 8 that they will buy back their shares up to 12.8 million shares, or 10% of their public float, maximum allowable by TSX. As Raymond said at NYC that in the current environment, cash is king and they definitely have the luxury of their vast cash position to do it. WGW does have $86 million loan outstanding, but since they will be generating strong cash, they are planning to pay it back in about 2 to 2.5 year’s time. By my rough calculation above, with today’s gold price, they should have no problem to pay $30 million toward their debt each year from their operations. Unlike many juniors, they don’t need to do any financing without pursuing any strategic acquisitions. Their management team seems to be very financially conservative in their business operations.
More importantly, if we believe the recent gold price is depressed and not supported by the dire macroeconomic situation and monetary inflation, we should see substantially higher gold price for many years into the future. The operating leverage provided by the Mesquite project will substantially increase the value of Western Goldfields. It won’t surprise me that WGW doubles or even triples from the current $1.34 price level to somewhere in the $3-4 range, which only brings them back to the price level this time of last year.
Disclosure: I don’t own Western Goldfields, but I believe WGW is currently undervalued and provides a good risk/reward opportunity for a diversified mining portfolio for long term capital gain.
This mine was actually operated from 1985 to 2001 by several mining companies including Newmont, but was suspended in 2001 when gold prices fell to the bottom. However, Western Goldfields acquired the mine in 2003, and production re-started in January of this year, the timing of which couldn’t have been better since the current turmoil in the credit market makes any financing very difficult if not impossible for some other cash stripped mining companies.
Western Goldfields (WGW) is headquartered in Toronto, Ontario. I met their President and CEO Mr. Raymond Threlkeld and Director of IR and Corp Development Mr. Hannes Portmann on November 20 in New York City. They discussed the details of the compelling value and low risk that their Company offered in comparison to their current low stock price.
Their major project, the Mesquite Mine, has 4.3 million resource ounces of gold including 2.8 million ounces in reserves. They are continuing drilling to find additional gold resources that could add 1 to 2 years of additional mine life beyond the current 14 years. Since it is a open pit operation, WGW can produce gold in a relatively cheap cost, with 2008 cost of sales averaging around $500 per oz. With the planned increasing production from 2009 and beyond, the cost of sales is expected to average around $420 per oz for the life of the mine.
This low cost is important during today’s gold correction and high production cost environment, comparing to many other mining companies. It enables WGW to make decent profit and generate substantial cashflow from operations. Even with today’s gold price, and expected 150,000 oz or more of annual production starting 2009, they can generate about $50 to $60 million in cashflow per year from operations. As a matter of fact, their current 3rd quarter 2008 has gold sales of 47K ounces at the cost of $390 only, with cashflow from operating activities at $16.5 million. Their stock price was trading at a ridiculous low level and temporary dipped below $0.50 per share late last month when the whole mining industry got hammered. However, it has since recovered nicely to $1.34 as of last Friday (11/28).
WGW has a very strong cash position of $45 million on hand including $7.5 million of restricted cash due to their loan covenants. At the same time, they are adding cash from their operations each quarter. This is why when their stock price dropped last month, they announced on Nov. 8 that they will buy back their shares up to 12.8 million shares, or 10% of their public float, maximum allowable by TSX. As Raymond said at NYC that in the current environment, cash is king and they definitely have the luxury of their vast cash position to do it. WGW does have $86 million loan outstanding, but since they will be generating strong cash, they are planning to pay it back in about 2 to 2.5 year’s time. By my rough calculation above, with today’s gold price, they should have no problem to pay $30 million toward their debt each year from their operations. Unlike many juniors, they don’t need to do any financing without pursuing any strategic acquisitions. Their management team seems to be very financially conservative in their business operations.
More importantly, if we believe the recent gold price is depressed and not supported by the dire macroeconomic situation and monetary inflation, we should see substantially higher gold price for many years into the future. The operating leverage provided by the Mesquite project will substantially increase the value of Western Goldfields. It won’t surprise me that WGW doubles or even triples from the current $1.34 price level to somewhere in the $3-4 range, which only brings them back to the price level this time of last year.
Disclosure: I don’t own Western Goldfields, but I believe WGW is currently undervalued and provides a good risk/reward opportunity for a diversified mining portfolio for long term capital gain.
Sunday, November 30, 2008
My Overview of a Special Year 2008
What a year. It has been 11 months since I put out “My Ten Predictions for 2008”. In general, I think my predictions have luckily turned out to be about right, but I underestimated the severity of both the up and down movement.
Former Goldman Chairman John Whitehead said on Nov 12th that the current crisis is worse than the great depression in 1930s. For the past year, I have been saying all along that this crisis is a repeat of the 1930s and 1970s, but I didn’t expect it would be worse than the 1930s, probably only a repeat of the 1970s. However, like Mr. Whitehead, I am beginning to feel that he may be right. I hope we both are proved wrong, but I will likely take that view into consideration for my upcoming 2009 predictions. Perhaps Mr. Whitehead has been aware of the situation for a long time, but felt he was unable to say it freely to the public due to his position, until now.
Gold, HUI and US Dollar
In my ten predictions from last year, I correctly predicted that gold would hit $1,000, silver would hit $20 in 2008. Also, the US dollar index almost hit my target of 70 (71 to be exact). HUI didn’t hit my target of $600, and only reached around $520 at peak before crashing. I didn’t foresee the severity of the precious metal correction, especially the PM mining industry due to the deleveraging process when commodity hedge funds have been dumping everything for margin calls, for cash, and for redemption. I correctly predicted the volatility of $50 movement in gold which has occurred many times so far this year, including the almost $100 rebound within 24 hours back in September.
During the 1970s, gold underwent 2 years of severe correction, falling 40% between 1974 and 1976. This year, gold has dropped 34% from $1,030 to as low as $680 twice in the last two months. Hopefully, this is the final correction. Even the current correction is more than I originally anticipated, I am still holding my view, as discussed in previous articles, that $700 provides a strong support on a monthly close chart, even on a daily (three times) and weekly (not yet) close chart that gold dipped below this level for a short time. After the current correction, gold should start several years of its inevitable rise, which will lift all other boats such as silver, HUI companies and many financially strong PM mining juniors, just like the 2nd half of 1970s.
Banking Crisis and Citigroup
No one can reasonably discuss 2008 without talking about banks and the banking crisis, so I will spend more time in this area. My best call in this sector was that Citigroup would fall to the teens (below $20). This call was made when Citi was trading at $30 after already falling from $60, and 3 months before Meredith Whitney from Oppenheimer gave her famously bearish view on Citi and her price target of $15 when many people were highly doubtful of her prediction at that time.
Why did I pick Citi out of so many banks in the entire banking industry? My view on the financial industry has been heavily influenced by Jeremy Grantham of GMO when he predicted in the summer of 2007 (not 2008) that a major US bank would fail, and half of the hedge funds and private equity firms would get wiped out by 2010. I was trying to pick a major bank as a candidate of failure to reflect both of our bearish views on Wall St. I didn’t name Bear Stearns or Lehman since they were small, AIG and WaMu were not even real banks, Merrill was a possible candidate, but more of a brokerage house, Wachovia was a bank, but not quite a major one and not on my radar screen.
In order to fulfill Jeremy’s prophecy, the only candidate, a symbol for the US banking industry and financial dominance, a financially weak but a major bank, had to be Citi. In February, when Whitney put out her report after she studied in detail Citi’s balance sheet and especially off-balance sheet (pages of footnotes), I immediately knew that my target was too conservative (too high), I should have said in single digits instead of teens. The timing of 2010 by Jeremy was also too late, it could happen even this year. Usually, analysts from institutions are hesitant to state bearish views on the firms they cover (even for the indomitable Whitney); they would rather stop their coverage than give out potentially financially damaging ratings and targets, such as a share target in single digits. For banks to be in single digits, especially if below $5, it means it can be out of business anytime, when trading partners stop transactions with the bank and customers withdraw their funds. This is what collapsed Bear Stearns.
For many years, since the old Sandy Weill days, I have never thought Citi’s business model would work. Putting all the financial services under one umbrella, the so-called financial power house to leverage the scale and customer base, was only a fantasy even during the good old days. During bad times like now, this model is only leveraging viruses of toxic structured products, contagious OTC derivatives and amplifying losses. In addition, I have always voiced strong disagreement when Citi’s board picked the current CEO. I predicted that he wouldn’t last until the end of 2009, now he will be lucky to survive this year. Asking a salesman selling toxic structured products from Morgan Stanley, and a money losing hedge fund manager, to lead a banking conglomerate is similar to asking a used car salesman to fix all the problems at GM.
At the same time, Citi’s problems have been developing for many years, from his predecessors beginning with Sandy Weill. There has been wide speculation that Mr. Prince was just a scapegoat for someone else still there. Since during his CEO tenure, he was not the one behind the scene to aggressively push Citi into holding huge positions in CDOs, OTC derivatives and off-balance-sheet financing to chase phantom “profit”, which is what has brought down the house. The only solution for shareholders to recoup some value is to break up Citi into 8 to 10 pieces of small financial service firms, with some eventually going out of business. This is still better than the entire firm going out of business.
The 2nd bailout of $20 billion for Citi this week (11/24) came only a month after the 1st one of $25 billion. More importantly, the government will guarantee Citi’s losses up to $306 billion. But Citi is not Lehman which had only $600 billion in assets. How could the government know that the loss on Citi’s $3.3 trillion assets ($2 trillion on its balance sheet and $1.3 trillion on its off-balance sheet), was 5 times bigger than Lehman’s, would maximize at $306 billion? What would happen if the loss turns out to be $600 billion? Will the government put up the difference? Where is the limit? Will government only cover the balance sheet assets, not the more questionable off-balance-sheet ones? How about the estimated $700 billion toxic assets under the $1.3 trillion off-balance sheet, the loss of which can wipe out Citi’s equity not only once but 10 times? What happens to other smaller banks? Should government let them fail like Lehman just because they are small?
There has been four phases of bank rescue by the Fed and the Treasury Dept so far. The 1st one was to let a large bank to rescue a small one, represented by the famous $2 initial offer from JP Morgan to Bear Stearns. Pretty soon, no one wanted to be the white knight or the sucker anymore. Then the 2nd phase was just to let them fail, as in the case of Lehman. It had caused more trouble of leading other investment banks to fail. So that didn’t work. The 3rd phase was to get the $700 billion capital to buy MBS, CDOs and OTC derivatives, except no one knows how to value them and whether they are still worth anything at all. At the same time, it will also force banks to realize and accelerate losses, especially for their off-balance sheet items. So it didn’t work either. Finally, it has entered the 4th phase of injecting capital by buying preferred shares of only the large banks. I think this phase will only buy time for a quarter or two, then another capital injection, then…until the government eventually owns and nationalizes all the major banks in the US, as British government now owns RBS.
The best decision I have seen recently is the $50 billion deal of selling Merrill to BOA. How much was Merrill worth? Maybe at 0.5 of its tangible book value (around $14 billion) based on the share prices of many banks trading these days (PNC bought National City only at 0.3 of its BV), but BOA paid 1.8 of tangible BV. Kudos to Mr. Thain, cash out whenever you still can and if you are lucky, find a sucker to pay a high price. A great deal for Merrill’s shareholders (and bondholders), but really bad news for BOA shareholders. This is actually the 2nd time BOA took the bait and acted as a sucker: the 1st time was with the purchase of Countrywide at an unbelievably over-inflated price, resulting Angelo Mozilo happily cashing out and dumping all his troubles to BOA. Did they forget the “fool me once…and fool me twice….” saying?
Apparently, BOA wants to be another Citigroup by following Citi’s business model, i.e., by becoming another financial power house to offer all kinds of financial services under one roof, only to watch Citi collapse. It didn’t work for Citi, neither will it for BOA. BOA hopes cost cutting will do the trick; just look at how many jobs Citigroup has cut in the last year or so. The more people they cut, the lower their share price. It is inevitable that BOA will follow the same path.
OTC Derivatives and GE
My other calls on OTC derivatives (credit default swaps or CDS) being land mines, skyrocketing numbers of lawsuits (among rating agencies, bond insurers, banks, state/local governments and investors), credit card losses, sovereign wealth funds stopping investing in US banks, etc., have unfortunately all turned out to be true. Early this year, I have followed up with another article specifically discussing CDS: “Why Wall St. Needed Credit Default Swaps?”, the main points of which can be summarized as: Wall St. had used CDS for,
1) quick profits;
2) earning manipulation on financial statements; and
3) taking advantage of the accounting loophole “negative basis trading” in order to pay themselves huge bonuses based on phantom earnings.
Let us look at GE. GE had been buying back stocks around $35 for the 1st 9 months of this year, but had to issue new dilutive shares to Warren Buffet and others at much lower prices last month (October), in a unusual buy-high-sell-low act of pure shareholder equity destruction. All their business units are solid and still making money except no one knows what is going on at GE Capital, which is one of the largest OTC derivative dealers and holders of many structured products such as ABS through securitization. GE is never transparent about what is in their portfolio to investors, unlike investment banks, so their stock price has been heavily punished to around $15. Maybe all other GE business units are worth $15, but what happens if GE Capital, like many banks these days is, without a government bailout capital injection, a negative worth of ($5)?
GE has assured public that they only use OTC derivatives for hedging, and are very careful and conservative in their usage (whatever that means). Sure, that is exactly what Lehman said a few days before filing for bankruptcy (Lehman’s derivative positions were all fully hedged), so was AIG. AIG said they had only used CDS very carefully and conservatively, until one day out of blue people suddenly found out that a 300 people small AIG subsidiary in London wiped out the whole firm by selling $450 billion undisclosed “insurance” in the form of CDS? When counterparties are being wiped out one after another, where would GE get their “hedges” from? In addition, when AIG’s rating was downgraded from AAA, the liability of its CDS shot up exponentially, a fate GE will face soon.
Another risk about GE is its dependence on the commercial paper (CP) market to constantly refinance their large $80 billion liquidity needs. The CP market is too big and too complex for the US government to support on a daily basis. The government can save it for a few days, maybe even a few weeks, but not forever. If the CP market freezes up again or worse shuts down eventually, GE immediately faces liquidity problem which can put them out of business. GE has many good and viable industrial operations, and the only solution for them is to shut down GE Capital, even at the price of losing half of their earning power and a vital tool for all their past earning manipulations to deliver quarterly targets that Wall St. had wanted, and to sell assets and business units to raise a lot more cash in order to stop reliance on the CP market.
Commodities and Energy
I was correct about the inflation concern, the booming of agricultural commodities and crude oil, but only for a half year. Inflation expectation has given way suddenly to scary deflation worries and because of that, commodity prices have collapsed in the 2nd half. Is inflation dead? I don’t think so, especially in the eye of recent unprecedented monetary inflation by the Fed. There is usually a lag between monetary inflation and real price (CPI) inflation.
While the US dollar is temporarily experiencing a slight reprieve from its decline in purchasing power, its future, due to the lag time (velocity of circulation) which is somewhat retarded when an economy is in recession, should not be expected to continue in this trend. However, once inflation is out of cage, it is impossible to put it back in. The current debate about deflation vs. inflation could turn out to be both right. In other words, it seems more and more likely that we will face the worst nightmare of inflationary depression. No wonder Mr. Whitehead said this is worse than 1930s.
When I wrote “My Ten Predictions for 2008”, crude oil was traded around $90. I only gave out a target of $100 since oil had been doubled in 2007 from $50 to almost $100 and I expected that there should be a correction in 2008. But oil had a good run in late December and at the 1st trading day of 2008, it already hit $100. I knew then that I set the target too low, and I should’ve predicted $125. Well, even so, it was still too low since oil went all the way to $147.
However, I don’t think the current collapse of crude to $50 has anything to do with demand and supply, nor did the $147 oil. The high was purely greed out of speculation and now the low is purely fear that people will go back and live in caves again to stop using energy. The reality is demand will grow more slowly than previously anticipated, but it will still remain at least flat, if not up, especially with the larger population from emerging market countries demanding more energy. In addition, peak oil is a fact, and it is always a big question whether fast economic growth and higher living standards, especially in emerging market, will be able to accommodate the fast growing population on mother earth.
I also believe that alternative energy: solar, wind, biofuel, etc., is more of a fantasy than reality, more driven by political correctness and sloganeering than by economic sense. Alternative energy, e.g., solar and wind, is too small to make any appreciable difference in the larger energy consumption picture. And if they were economically feasible, people would have used them at large scale centuries ago. Biofuel makes little economic sense without government subsidies. It always takes energy to produce energy. When you see it has to waste 80-90% of one form of energy to make incremental 10-20% of another form of energy, you know something is not right and it is not sustainable. The meltdown in alternative energy stocks such as solar this year has indicated that people are abandoning hype and returning to reality.
Other Markets and GM
My other good call was the October 2007 peak being the peak of the past bull market, from which we entered a long lasting bear market and in which we witnessed many severe corrections. However, I didn’t expect such a washout so quickly. Originally I thought it was more likely in 2009 and 2010 to see a freefall like that of today’s.
My prediction of yield curve getting steep was correct also. However again, I didn’t anticipate the severity and the mess in the fixed income market, and who would’ve expected the short end of the yield curve hitting zero as it did in Japan! The current steep spread between the short and long end is not a good sign. I disagree with some economists who predict a quick economic recovery due to the steep yield curve. Instead, I think the short end shows people dumping anything and everything for cash, and the long end with high yield indicates no confidence in holding US dollars for the long haul. The historical record high spread between corporate bonds, munis and treasuries also indicates big troubles lie ahead. At the same time, I also correctly predicted the double digit fall in the real estate market, as reflected by the national S&P/Case-Schiller Index, which is now common knowledge.
It is hard not to mention GM this year, especially the option of bankruptcy vs. bailout. It is a very tricky and difficult situation for both the government and public. In theory, the auto industry needs to be in bankruptcy before it can rise from the ashes. Auto industry is now paying the price of what they have done in the long past, especially dumping tons of gas-guzzling SUVs onto the public lately--only because they could make 5 times more profit by selling a SUV than a compact car. The environmental damage caused by SUVs will not be reflected in the auto industry’s balance sheet, or even any government statistics, but it is a real liability for the whole of society, and someday it may prove to be catastrophic. Even with the strong SUV sales, they were still only able to break even. Now with SUV sales crashed, how will they be able to sell 5 times the number of compact cars to replace all of the SUVs?
For the three big automakers, bankruptcy is the only way to wipe out all their debts, their pension and healthcare obligations, existing union contracts, their ridiculous large dealer network across the country, and their incompetent management which should have been cleaned up long ago. However, the government’s bailout on the banking industry makes the auto-maker’s bankruptcy option socially dangerous, extremely difficult, ethically wrong, and with many politically incorrect. If the government can spend $5 to 7 trillion to guarantee financially toxic structured loans and products, $300 billion to buy preferred shares of banks which are then used in part to pay bonuses to the already super rich bankers, how can the government not spend what initially appears to be mere pocket change of those sums to rescue the auto industry in order to save millions of jobs and healthcare/pensions for the retirees?
The speculation that bankruptcy in big three could cost 3 million jobs might be a little exaggerated. But we also should realize that the auto industry is not like the airline industry. When all major airlines were in bankruptcy, people still bought tickets for their flight services and there was no competition for domestic routes from foreign airlines, unlikely the auto industry. The consequence of paying bankers while letting even 1 million workers lose jobs and more retirees to lose pensions/healthcare coverage could cause wide-spread social unrest, too much a risk for the government to bear.
At the same time, a “pocket change” of $25 billion doesn’t sound like a lot of money (comparing to the banking bailout). But the three big automakers will burn through that in less than a year, then they will come back next year to ask for more, just like Citigroup getting $25 billion last month then asking for more this month. Pretty soon, the US government will own not only the banking industry, but also the auto industry. To be fair to all, maybe they should own the airlines and any other industry in trouble down the road. How can they favor and save one industry but discriminate and dump the others? Where is the end of this?
Year 2008 will definitely go down in the history book as a very special year. It is a year marking the start of the 3rd depression after the 1930s and 1970s. It is the end of the 20 year Greenspan era of financial manipulation, distortion, rip-off and cover-up by Wall St. This resulted in high profits for the few on Wall St. and a huge burden on the mass of taxpayers from trillions in bailout capital, to destroy the political justification and honorable orientation of our free market society. It is also the beginning of a new, real and honest era for money: the gold era!
Some related stocks and indices: GLD, ^HUI, C, GE, GM, ^GSPC, SPY, USO.
Former Goldman Chairman John Whitehead said on Nov 12th that the current crisis is worse than the great depression in 1930s. For the past year, I have been saying all along that this crisis is a repeat of the 1930s and 1970s, but I didn’t expect it would be worse than the 1930s, probably only a repeat of the 1970s. However, like Mr. Whitehead, I am beginning to feel that he may be right. I hope we both are proved wrong, but I will likely take that view into consideration for my upcoming 2009 predictions. Perhaps Mr. Whitehead has been aware of the situation for a long time, but felt he was unable to say it freely to the public due to his position, until now.
Gold, HUI and US Dollar
In my ten predictions from last year, I correctly predicted that gold would hit $1,000, silver would hit $20 in 2008. Also, the US dollar index almost hit my target of 70 (71 to be exact). HUI didn’t hit my target of $600, and only reached around $520 at peak before crashing. I didn’t foresee the severity of the precious metal correction, especially the PM mining industry due to the deleveraging process when commodity hedge funds have been dumping everything for margin calls, for cash, and for redemption. I correctly predicted the volatility of $50 movement in gold which has occurred many times so far this year, including the almost $100 rebound within 24 hours back in September.
During the 1970s, gold underwent 2 years of severe correction, falling 40% between 1974 and 1976. This year, gold has dropped 34% from $1,030 to as low as $680 twice in the last two months. Hopefully, this is the final correction. Even the current correction is more than I originally anticipated, I am still holding my view, as discussed in previous articles, that $700 provides a strong support on a monthly close chart, even on a daily (three times) and weekly (not yet) close chart that gold dipped below this level for a short time. After the current correction, gold should start several years of its inevitable rise, which will lift all other boats such as silver, HUI companies and many financially strong PM mining juniors, just like the 2nd half of 1970s.
Banking Crisis and Citigroup
No one can reasonably discuss 2008 without talking about banks and the banking crisis, so I will spend more time in this area. My best call in this sector was that Citigroup would fall to the teens (below $20). This call was made when Citi was trading at $30 after already falling from $60, and 3 months before Meredith Whitney from Oppenheimer gave her famously bearish view on Citi and her price target of $15 when many people were highly doubtful of her prediction at that time.
Why did I pick Citi out of so many banks in the entire banking industry? My view on the financial industry has been heavily influenced by Jeremy Grantham of GMO when he predicted in the summer of 2007 (not 2008) that a major US bank would fail, and half of the hedge funds and private equity firms would get wiped out by 2010. I was trying to pick a major bank as a candidate of failure to reflect both of our bearish views on Wall St. I didn’t name Bear Stearns or Lehman since they were small, AIG and WaMu were not even real banks, Merrill was a possible candidate, but more of a brokerage house, Wachovia was a bank, but not quite a major one and not on my radar screen.
In order to fulfill Jeremy’s prophecy, the only candidate, a symbol for the US banking industry and financial dominance, a financially weak but a major bank, had to be Citi. In February, when Whitney put out her report after she studied in detail Citi’s balance sheet and especially off-balance sheet (pages of footnotes), I immediately knew that my target was too conservative (too high), I should have said in single digits instead of teens. The timing of 2010 by Jeremy was also too late, it could happen even this year. Usually, analysts from institutions are hesitant to state bearish views on the firms they cover (even for the indomitable Whitney); they would rather stop their coverage than give out potentially financially damaging ratings and targets, such as a share target in single digits. For banks to be in single digits, especially if below $5, it means it can be out of business anytime, when trading partners stop transactions with the bank and customers withdraw their funds. This is what collapsed Bear Stearns.
For many years, since the old Sandy Weill days, I have never thought Citi’s business model would work. Putting all the financial services under one umbrella, the so-called financial power house to leverage the scale and customer base, was only a fantasy even during the good old days. During bad times like now, this model is only leveraging viruses of toxic structured products, contagious OTC derivatives and amplifying losses. In addition, I have always voiced strong disagreement when Citi’s board picked the current CEO. I predicted that he wouldn’t last until the end of 2009, now he will be lucky to survive this year. Asking a salesman selling toxic structured products from Morgan Stanley, and a money losing hedge fund manager, to lead a banking conglomerate is similar to asking a used car salesman to fix all the problems at GM.
At the same time, Citi’s problems have been developing for many years, from his predecessors beginning with Sandy Weill. There has been wide speculation that Mr. Prince was just a scapegoat for someone else still there. Since during his CEO tenure, he was not the one behind the scene to aggressively push Citi into holding huge positions in CDOs, OTC derivatives and off-balance-sheet financing to chase phantom “profit”, which is what has brought down the house. The only solution for shareholders to recoup some value is to break up Citi into 8 to 10 pieces of small financial service firms, with some eventually going out of business. This is still better than the entire firm going out of business.
The 2nd bailout of $20 billion for Citi this week (11/24) came only a month after the 1st one of $25 billion. More importantly, the government will guarantee Citi’s losses up to $306 billion. But Citi is not Lehman which had only $600 billion in assets. How could the government know that the loss on Citi’s $3.3 trillion assets ($2 trillion on its balance sheet and $1.3 trillion on its off-balance sheet), was 5 times bigger than Lehman’s, would maximize at $306 billion? What would happen if the loss turns out to be $600 billion? Will the government put up the difference? Where is the limit? Will government only cover the balance sheet assets, not the more questionable off-balance-sheet ones? How about the estimated $700 billion toxic assets under the $1.3 trillion off-balance sheet, the loss of which can wipe out Citi’s equity not only once but 10 times? What happens to other smaller banks? Should government let them fail like Lehman just because they are small?
There has been four phases of bank rescue by the Fed and the Treasury Dept so far. The 1st one was to let a large bank to rescue a small one, represented by the famous $2 initial offer from JP Morgan to Bear Stearns. Pretty soon, no one wanted to be the white knight or the sucker anymore. Then the 2nd phase was just to let them fail, as in the case of Lehman. It had caused more trouble of leading other investment banks to fail. So that didn’t work. The 3rd phase was to get the $700 billion capital to buy MBS, CDOs and OTC derivatives, except no one knows how to value them and whether they are still worth anything at all. At the same time, it will also force banks to realize and accelerate losses, especially for their off-balance sheet items. So it didn’t work either. Finally, it has entered the 4th phase of injecting capital by buying preferred shares of only the large banks. I think this phase will only buy time for a quarter or two, then another capital injection, then…until the government eventually owns and nationalizes all the major banks in the US, as British government now owns RBS.
The best decision I have seen recently is the $50 billion deal of selling Merrill to BOA. How much was Merrill worth? Maybe at 0.5 of its tangible book value (around $14 billion) based on the share prices of many banks trading these days (PNC bought National City only at 0.3 of its BV), but BOA paid 1.8 of tangible BV. Kudos to Mr. Thain, cash out whenever you still can and if you are lucky, find a sucker to pay a high price. A great deal for Merrill’s shareholders (and bondholders), but really bad news for BOA shareholders. This is actually the 2nd time BOA took the bait and acted as a sucker: the 1st time was with the purchase of Countrywide at an unbelievably over-inflated price, resulting Angelo Mozilo happily cashing out and dumping all his troubles to BOA. Did they forget the “fool me once…and fool me twice….” saying?
Apparently, BOA wants to be another Citigroup by following Citi’s business model, i.e., by becoming another financial power house to offer all kinds of financial services under one roof, only to watch Citi collapse. It didn’t work for Citi, neither will it for BOA. BOA hopes cost cutting will do the trick; just look at how many jobs Citigroup has cut in the last year or so. The more people they cut, the lower their share price. It is inevitable that BOA will follow the same path.
OTC Derivatives and GE
My other calls on OTC derivatives (credit default swaps or CDS) being land mines, skyrocketing numbers of lawsuits (among rating agencies, bond insurers, banks, state/local governments and investors), credit card losses, sovereign wealth funds stopping investing in US banks, etc., have unfortunately all turned out to be true. Early this year, I have followed up with another article specifically discussing CDS: “Why Wall St. Needed Credit Default Swaps?”, the main points of which can be summarized as: Wall St. had used CDS for,
1) quick profits;
2) earning manipulation on financial statements; and
3) taking advantage of the accounting loophole “negative basis trading” in order to pay themselves huge bonuses based on phantom earnings.
Let us look at GE. GE had been buying back stocks around $35 for the 1st 9 months of this year, but had to issue new dilutive shares to Warren Buffet and others at much lower prices last month (October), in a unusual buy-high-sell-low act of pure shareholder equity destruction. All their business units are solid and still making money except no one knows what is going on at GE Capital, which is one of the largest OTC derivative dealers and holders of many structured products such as ABS through securitization. GE is never transparent about what is in their portfolio to investors, unlike investment banks, so their stock price has been heavily punished to around $15. Maybe all other GE business units are worth $15, but what happens if GE Capital, like many banks these days is, without a government bailout capital injection, a negative worth of ($5)?
GE has assured public that they only use OTC derivatives for hedging, and are very careful and conservative in their usage (whatever that means). Sure, that is exactly what Lehman said a few days before filing for bankruptcy (Lehman’s derivative positions were all fully hedged), so was AIG. AIG said they had only used CDS very carefully and conservatively, until one day out of blue people suddenly found out that a 300 people small AIG subsidiary in London wiped out the whole firm by selling $450 billion undisclosed “insurance” in the form of CDS? When counterparties are being wiped out one after another, where would GE get their “hedges” from? In addition, when AIG’s rating was downgraded from AAA, the liability of its CDS shot up exponentially, a fate GE will face soon.
Another risk about GE is its dependence on the commercial paper (CP) market to constantly refinance their large $80 billion liquidity needs. The CP market is too big and too complex for the US government to support on a daily basis. The government can save it for a few days, maybe even a few weeks, but not forever. If the CP market freezes up again or worse shuts down eventually, GE immediately faces liquidity problem which can put them out of business. GE has many good and viable industrial operations, and the only solution for them is to shut down GE Capital, even at the price of losing half of their earning power and a vital tool for all their past earning manipulations to deliver quarterly targets that Wall St. had wanted, and to sell assets and business units to raise a lot more cash in order to stop reliance on the CP market.
Commodities and Energy
I was correct about the inflation concern, the booming of agricultural commodities and crude oil, but only for a half year. Inflation expectation has given way suddenly to scary deflation worries and because of that, commodity prices have collapsed in the 2nd half. Is inflation dead? I don’t think so, especially in the eye of recent unprecedented monetary inflation by the Fed. There is usually a lag between monetary inflation and real price (CPI) inflation.
While the US dollar is temporarily experiencing a slight reprieve from its decline in purchasing power, its future, due to the lag time (velocity of circulation) which is somewhat retarded when an economy is in recession, should not be expected to continue in this trend. However, once inflation is out of cage, it is impossible to put it back in. The current debate about deflation vs. inflation could turn out to be both right. In other words, it seems more and more likely that we will face the worst nightmare of inflationary depression. No wonder Mr. Whitehead said this is worse than 1930s.
When I wrote “My Ten Predictions for 2008”, crude oil was traded around $90. I only gave out a target of $100 since oil had been doubled in 2007 from $50 to almost $100 and I expected that there should be a correction in 2008. But oil had a good run in late December and at the 1st trading day of 2008, it already hit $100. I knew then that I set the target too low, and I should’ve predicted $125. Well, even so, it was still too low since oil went all the way to $147.
However, I don’t think the current collapse of crude to $50 has anything to do with demand and supply, nor did the $147 oil. The high was purely greed out of speculation and now the low is purely fear that people will go back and live in caves again to stop using energy. The reality is demand will grow more slowly than previously anticipated, but it will still remain at least flat, if not up, especially with the larger population from emerging market countries demanding more energy. In addition, peak oil is a fact, and it is always a big question whether fast economic growth and higher living standards, especially in emerging market, will be able to accommodate the fast growing population on mother earth.
I also believe that alternative energy: solar, wind, biofuel, etc., is more of a fantasy than reality, more driven by political correctness and sloganeering than by economic sense. Alternative energy, e.g., solar and wind, is too small to make any appreciable difference in the larger energy consumption picture. And if they were economically feasible, people would have used them at large scale centuries ago. Biofuel makes little economic sense without government subsidies. It always takes energy to produce energy. When you see it has to waste 80-90% of one form of energy to make incremental 10-20% of another form of energy, you know something is not right and it is not sustainable. The meltdown in alternative energy stocks such as solar this year has indicated that people are abandoning hype and returning to reality.
Other Markets and GM
My other good call was the October 2007 peak being the peak of the past bull market, from which we entered a long lasting bear market and in which we witnessed many severe corrections. However, I didn’t expect such a washout so quickly. Originally I thought it was more likely in 2009 and 2010 to see a freefall like that of today’s.
My prediction of yield curve getting steep was correct also. However again, I didn’t anticipate the severity and the mess in the fixed income market, and who would’ve expected the short end of the yield curve hitting zero as it did in Japan! The current steep spread between the short and long end is not a good sign. I disagree with some economists who predict a quick economic recovery due to the steep yield curve. Instead, I think the short end shows people dumping anything and everything for cash, and the long end with high yield indicates no confidence in holding US dollars for the long haul. The historical record high spread between corporate bonds, munis and treasuries also indicates big troubles lie ahead. At the same time, I also correctly predicted the double digit fall in the real estate market, as reflected by the national S&P/Case-Schiller Index, which is now common knowledge.
It is hard not to mention GM this year, especially the option of bankruptcy vs. bailout. It is a very tricky and difficult situation for both the government and public. In theory, the auto industry needs to be in bankruptcy before it can rise from the ashes. Auto industry is now paying the price of what they have done in the long past, especially dumping tons of gas-guzzling SUVs onto the public lately--only because they could make 5 times more profit by selling a SUV than a compact car. The environmental damage caused by SUVs will not be reflected in the auto industry’s balance sheet, or even any government statistics, but it is a real liability for the whole of society, and someday it may prove to be catastrophic. Even with the strong SUV sales, they were still only able to break even. Now with SUV sales crashed, how will they be able to sell 5 times the number of compact cars to replace all of the SUVs?
For the three big automakers, bankruptcy is the only way to wipe out all their debts, their pension and healthcare obligations, existing union contracts, their ridiculous large dealer network across the country, and their incompetent management which should have been cleaned up long ago. However, the government’s bailout on the banking industry makes the auto-maker’s bankruptcy option socially dangerous, extremely difficult, ethically wrong, and with many politically incorrect. If the government can spend $5 to 7 trillion to guarantee financially toxic structured loans and products, $300 billion to buy preferred shares of banks which are then used in part to pay bonuses to the already super rich bankers, how can the government not spend what initially appears to be mere pocket change of those sums to rescue the auto industry in order to save millions of jobs and healthcare/pensions for the retirees?
The speculation that bankruptcy in big three could cost 3 million jobs might be a little exaggerated. But we also should realize that the auto industry is not like the airline industry. When all major airlines were in bankruptcy, people still bought tickets for their flight services and there was no competition for domestic routes from foreign airlines, unlikely the auto industry. The consequence of paying bankers while letting even 1 million workers lose jobs and more retirees to lose pensions/healthcare coverage could cause wide-spread social unrest, too much a risk for the government to bear.
At the same time, a “pocket change” of $25 billion doesn’t sound like a lot of money (comparing to the banking bailout). But the three big automakers will burn through that in less than a year, then they will come back next year to ask for more, just like Citigroup getting $25 billion last month then asking for more this month. Pretty soon, the US government will own not only the banking industry, but also the auto industry. To be fair to all, maybe they should own the airlines and any other industry in trouble down the road. How can they favor and save one industry but discriminate and dump the others? Where is the end of this?
Year 2008 will definitely go down in the history book as a very special year. It is a year marking the start of the 3rd depression after the 1930s and 1970s. It is the end of the 20 year Greenspan era of financial manipulation, distortion, rip-off and cover-up by Wall St. This resulted in high profits for the few on Wall St. and a huge burden on the mass of taxpayers from trillions in bailout capital, to destroy the political justification and honorable orientation of our free market society. It is also the beginning of a new, real and honest era for money: the gold era!
Some related stocks and indices: GLD, ^HUI, C, GE, GM, ^GSPC, SPY, USO.
Wednesday, November 5, 2008
Augusta – Focus on Advancing Copper Rich Deposit in Arizona
Augusta Resources (AZC) is primarily focused on the Rosemont Copper deposit near Tucson, Arizona, one of the largest copper mines currently in development in the North America. Augusta is headquartered in Denver, Colorado, and their Rosemont property is 50 km southeast of Tucson, conveniently located for mining operations via highway, a network of unpaved roads, and proximity from major transmission line and main rail lines to key ports. Their President & CEO, Mr. Gil Clausen, was in New York City on October 29th to discuss their strategy and growth potential of their resources.
In the past week or so, Augusta has two important announcements. They first announced on October 31st that a silver off-take financing arrangement with Silver Wheaton is to be re-structured upon completion of the Updated bankable feasibility study which is expected to be complete by yearend. My expectation is that the term will be likely more favorable than the previous agreement elected back in April, 2008, due to higher resource estimates and thus better economic value. Then this Monday (Nov 3rd), they announced that they have received significant strategic interest regarding their 100% owned Rosemont Copper/Moly project.
The Rosemont Copper project for Augusta is a very large low cost open-pit copper deposit. The total resources (M&I and Inferred) are estimated to be 7.7 billion lbs of copper, 190 million lbs of moly and 80 million ounces of silver, which turns into about 11 billion lbs of copper equivalent. The cost estimate is expected to be in the neighborhood of $0.5 per lb of copper, net of by-product credits (the net by-product credit is calculated based on very conservative long term $12 moly and $8 silver). Even without including the by-product credit, the cash cost is still only $0.9 per lb of copper. With today’s depressed commodity prices across the board, there is still a good profit margin due to its high grade and low cost. This puts Augusta well below other median and marginal cost producers and give them a large competitive advantage. Strategically, the major U.S. copper producer Freeport-McMoRan is also operating near Augusta’s property, and this location, the low-risk jurisdiction and its copper/moly rich mines make Augusta well situated for future options.
The production is expected to start in the 2nd half of 2011, assuming permitting and construction on schedule, with average annual planned production of about 230 million lbs of copper, 5 million lbs of moly and over 3 million ounces of silver which ties to the silver-backed financing deal with Silver Wheaton mentioned above. This level of output will account for 10% of US copper output once in production, and propel Augusta to become a solid mid-tier copper producer, probably the 3rd largest in the US.
The capital expenditure of their Rosemont project costs about $800 million total, with 40% of the capital committed under fixed price contracts. According to the last bankable feasibility study (BFS) back in 2007, which will be updated by yearend, with conservative assumptions on commodity prices for the whole life of this mine: $1.5 for copper, $15 for moly, and $10 for silver, and with a discount rate at 10%, the net present value (NPV) is still around $460 million, more than 4 times higher than the current Augusta’s market cap of $96 million. The payback period is also impressive with less than 3 years. The upcoming BFS is likely to be more favorable due to increased level of resources.
Even with the recent reduced forecast of copper demand, the copper mine supply still falls short for foreseeable future years. No doubt that the current slump in commodities has depressed the stock prices of many developmental mining firms like Augusta. But financially Augusta is strong, and had $15 million cash at the last Q2 report. The previous April Silver Wheaton deal has satisfied about 20% of total capital requirements for the Rosemont project by only sacrificing 2% of the total future project revenue. Then on June 17 this year, Augusta has secured another $40 million loan with Sumitomo. Both deals have minimized equity dilution for existing shareholders. What might happen in the near future, maybe Q1 next year when an updated BFS is available, it is very typical for a junior to sell partial interest in its project to a major in exchange for financing to continue the construction of their mining operations. The latest press release indicates the possibility of such joint venture potential.
More importantly, if we believe the recent copper price was oversold and has reached the bottom, and will stay above $2 on average for many years into the future, the operating leverage provided by Augusta will substantially increase the value of its Rosemont project. It won’t surprise me that Augusta would triple or even quadruple from the current $1 price level to somewhere in the $3-4 range, which only brings them back to the price level this time last year.
Disclosure: I don’t own Augusta Resources, but I believe AZC is currently undervalued and provides a good opportunity for a diversified mining portfolio for long term capital gain.
Thomas Tan, CFA, MBA
Thomast2@optonline.net
Disclaimer: The contents of this article represent the opinion and analysis of Thomas Tan, who cannot accept responsibility for any trading losses you may incur as a result of your reliance on this opinion and analysis and will not be held liable for the consequence of reliance upon any opinion or statement contained herein or any omission. Individuals should consult with their broker and personal financial advisors before engaging in any trading activities. Do your own due diligence regarding personal investment decisions.
In the past week or so, Augusta has two important announcements. They first announced on October 31st that a silver off-take financing arrangement with Silver Wheaton is to be re-structured upon completion of the Updated bankable feasibility study which is expected to be complete by yearend. My expectation is that the term will be likely more favorable than the previous agreement elected back in April, 2008, due to higher resource estimates and thus better economic value. Then this Monday (Nov 3rd), they announced that they have received significant strategic interest regarding their 100% owned Rosemont Copper/Moly project.
The Rosemont Copper project for Augusta is a very large low cost open-pit copper deposit. The total resources (M&I and Inferred) are estimated to be 7.7 billion lbs of copper, 190 million lbs of moly and 80 million ounces of silver, which turns into about 11 billion lbs of copper equivalent. The cost estimate is expected to be in the neighborhood of $0.5 per lb of copper, net of by-product credits (the net by-product credit is calculated based on very conservative long term $12 moly and $8 silver). Even without including the by-product credit, the cash cost is still only $0.9 per lb of copper. With today’s depressed commodity prices across the board, there is still a good profit margin due to its high grade and low cost. This puts Augusta well below other median and marginal cost producers and give them a large competitive advantage. Strategically, the major U.S. copper producer Freeport-McMoRan is also operating near Augusta’s property, and this location, the low-risk jurisdiction and its copper/moly rich mines make Augusta well situated for future options.
The production is expected to start in the 2nd half of 2011, assuming permitting and construction on schedule, with average annual planned production of about 230 million lbs of copper, 5 million lbs of moly and over 3 million ounces of silver which ties to the silver-backed financing deal with Silver Wheaton mentioned above. This level of output will account for 10% of US copper output once in production, and propel Augusta to become a solid mid-tier copper producer, probably the 3rd largest in the US.
The capital expenditure of their Rosemont project costs about $800 million total, with 40% of the capital committed under fixed price contracts. According to the last bankable feasibility study (BFS) back in 2007, which will be updated by yearend, with conservative assumptions on commodity prices for the whole life of this mine: $1.5 for copper, $15 for moly, and $10 for silver, and with a discount rate at 10%, the net present value (NPV) is still around $460 million, more than 4 times higher than the current Augusta’s market cap of $96 million. The payback period is also impressive with less than 3 years. The upcoming BFS is likely to be more favorable due to increased level of resources.
Even with the recent reduced forecast of copper demand, the copper mine supply still falls short for foreseeable future years. No doubt that the current slump in commodities has depressed the stock prices of many developmental mining firms like Augusta. But financially Augusta is strong, and had $15 million cash at the last Q2 report. The previous April Silver Wheaton deal has satisfied about 20% of total capital requirements for the Rosemont project by only sacrificing 2% of the total future project revenue. Then on June 17 this year, Augusta has secured another $40 million loan with Sumitomo. Both deals have minimized equity dilution for existing shareholders. What might happen in the near future, maybe Q1 next year when an updated BFS is available, it is very typical for a junior to sell partial interest in its project to a major in exchange for financing to continue the construction of their mining operations. The latest press release indicates the possibility of such joint venture potential.
More importantly, if we believe the recent copper price was oversold and has reached the bottom, and will stay above $2 on average for many years into the future, the operating leverage provided by Augusta will substantially increase the value of its Rosemont project. It won’t surprise me that Augusta would triple or even quadruple from the current $1 price level to somewhere in the $3-4 range, which only brings them back to the price level this time last year.
Disclosure: I don’t own Augusta Resources, but I believe AZC is currently undervalued and provides a good opportunity for a diversified mining portfolio for long term capital gain.
Thomas Tan, CFA, MBA
Thomast2@optonline.net
Disclaimer: The contents of this article represent the opinion and analysis of Thomas Tan, who cannot accept responsibility for any trading losses you may incur as a result of your reliance on this opinion and analysis and will not be held liable for the consequence of reliance upon any opinion or statement contained herein or any omission. Individuals should consult with their broker and personal financial advisors before engaging in any trading activities. Do your own due diligence regarding personal investment decisions.
Sunday, October 12, 2008
The Survival of the Longest
A specter is haunting the world — the specter of gold, while the old fiat money has lost all its powers. Gold is now the only safe and sensible asset, because only gold will survive apocalyptic scenario that is about to unfold. Those who thought “this time will be different” are about to be proven right. Only a few of the most respected authorities of the market predicted elements of the unfolding demise. As, one after another, these predictions come true, we will see the financial markets gradually unravel.
In August of last year I forecast a target of 800 for the S&P, which is about to be tested. This was an easy target to establish, since it represented the low of the 2001-2003 bear market. Last week’s heroic performance – what traders call a “dead cat bounce” - was a temporary respite from the market’s downward spiral. I now doubt 800 will be the bottom for this bear market. There may be more dead cat bounces, but there is no support in sight once 800 is decisively broken. My ultimate target is 400-500 for the S&P (or 4,000-5,000 for the Dow) which will be reached by the end of 2010. The timing of the 2010 bottom is consistent with what was given by Wharton professors Andrew Abel and Jeremy Siegel in 2001 in their “baby boomer cashing out” scenario discussed below.
My pessimism is based on my belief that neither government actions nor unnatural market mechanisms, such as circuit breakers and banning short sales, are capable of arresting this bear market. Many believe this bear market will recover quickly, like it did in 1987. This will not happen. After the one-day 20% drop in the market in 1987, circuit breakers were introduced to limit daily declines. But the market has adapted and selling pressure is distributed over longer time intervals, and the net effect is the same. Regulators could install additional market holidays, like they did in the 1930s, but the market will continue to adapt.
Jeremy Grantham’s Predictions
Earlier this year, Jeremy Grantham of GMO predicted in an interview with Barron’s that the S&P 500 would drop to 1,100 by end of 2010. A lot of people just laughed at him. Was this crazy old man out of his mind? Now, to quote Hamlet, “All the rest is silence.” We always should listen to an old man who experienced the so-called “Nifty Fifty” losing 80% of their market value in 1970s and has extensively studied the Great Depression of the 1930s. He probably regrets now that his 1,100 target was too conservative.
Jeremy derived his 1,100 prediction with a P/E of 11-12 as a norm for a long-term capital market. With a more representative bear market P/E value of 6-7, the forecast comes out in the 600-700 range. At the extreme of this bear market a few years down the road, the S&P 500 might very well overshoot and drop all the way to 4-500. That was the launch pad for last leg of the bull market that followed the recession of the early 1990s. Everything could go back to square one, while 20 years of bull market returns turn out to be in vain.
How long will this bear market last? Well, the Great Depression caused a bear market lasting over two decades, from 1929 to 1952. Only in 1958 did that market come back to the old 1929 peak, nearly three decades later. The 1970s were not much better—the bear market lasted 14-16 years from 1966 or 1968 to 1982. Even though that bear market ended more quickly, it still took until 1992 — 24 years later — to return to the markets’ 1968 peak.
My most optimistic forecast is this bear market will last another 4-5 years, which is overall actually about 12 years if we count 2000 as the starting point. If we use Jim Rogers’ commodity super-cycle, which usually runs opposite to the general equity market, this will be the latest two-decade bear market for equities, he predicts, lasting until 2020. When will the S&P 500 be back to last October’s peak? No sooner than 2024.
Another reason this bear market differs from 1987 is that, in 1987, the fundamentals were strong, stocks were trending upward, and the market didn’t have its economic lifeline of credit severed. There is another fundamental factor now suggesting we face a longer-lasting bear market than the 1970s. It is demographic. Baby boomers are not comfortable with the market turmoil of the past year, and they want to lock in their nest eggs and cash out. Their withdrawals have in turn caused more baby boomers to do the same. They don't want to take the risk of sitting through this credit crisis and bear market, since no one knows how long it will last.
What happens if it lasts as long as two decades? Time is not on boomers’ side. How can we blame them? With the real estate market freefalling with no bottom in sight, it is only natural for them to protect their only remaining nest eggs. And they will likely never get back into the stock market again once they cash out, since profiles grow more risk-averse with increasing age. Their overriding concern is to protect their cash. This is why you see US Treasuries, the so-called safe haven vehicle, with infinitesimally low yields. Boomers will not be tempted by equities even if they reach “undervalued” levels of 50% of book value, 70% of intrinsic value, P/E ratios of 6, etc. Inflation will gradually eat their money away with negative real interest rates, and they will worry about that later when inflation reaches double digits.
The above discussion about baby boomers is not new. In 2001, Abel and Siegel voiced concern about the potential herd behavior of the baby boomer generation — that their cashing out simultaneously could cause a stock market meltdown around 2010.. What an accurate prediction that is. They only missed by two years! Who wants to get caught holding the bag as the last one to cash out at the lowest price in 2010?
Good for Buffett but Bad for Common Shareholders
As the market dives, Warren Buffett’s investment in both GE and Goldman Sachs deserve discussion. Perpetual preferred stocks are usually a good way to invest in good businesses, as long as the firms survive, and obviously Buffett thinks both will. I tend to agree. But even if both GE and Goldman survive, such investments come at a large cost to the existing common shareholders.
In GE’s case, GE is using Buffett’s name and investment to raise $12 billion in a separate public offering, diluting their common shares. That’s not counting on the $3 billion of GE warrants, which could potentially cause more dilution. Almost all GE industrial units are doing fine since they are usually #1 or #2 in their respective sectors and have some monopoly pricing power. The biggest risk for GE is their GE capital unit, which never reveals the illiquid assets through loan and mortgage securitization and OTC derivatives in its portfolio, as is also the case with investment banks. And, unfortunately, it accounts for half of GE’s earning power. If GE Capital is in the same trouble as Wall Street investment banks, GE will likely have to shut down this division, write down large losses for its portfolio, and they will lose half of their earning power and an important vehicle to smooth their earnings every quarter. But as a conglomerate, they will still survive. The problem is that in an economic depression, with decreasing revenue and a shrinking profit margin, GE’s earnings will be depressed substantially. But it will still have to honor its large interest payment to Buffett on the new preferreds before common shareholders see any dividends.
Goldman is a much riskier investment than GE. The largest expense for investment banks is compensation, and they always issue many new shares, on top of cash bonuses, to retain talent every year as part of their incentive program. In an economic depression, there are likely no banking deals, not much trading activity, and especially no more highly profitable structured products like before. Goldman’s net income could be running less than $1 billion in its worst years (like Morgan Stanley is today). But they have to pay Buffett $500 million —10% interest on his $5 billion investment — every year. What is left for common shareholders with Buffett’s annual payout and increasingly diluted shares? The incentive program becomes demoralizing. Both deals are really bad for common shareholders.
Bailouts and the Unraveling of Private Equity
There are many angry investors around the country, causing the House to defeat the $700 billion bail out plan initially. Without Wall St.’s innovations on structured products, the subprime crisis could have been easily contained, even in the face of widespread abusive lending practices. The problem is for every $1 of subprime mortgages, Wall St. created $10 CDO products, then the math geeks at structured product groups used those to create another $100 of OTC derivatives out of thin air (for more on this, refer to my previous article Why Wall St. Needed Credit Default Swaps?). Now, suddenly, a $700 billion default of subprime loans would cause a $7 trillion default in CDOs and $70 trillion in CDS losses, a crisis 100 times larger than it should be. Now you know why Wall St. is so profitable, because in the past 5-10 years, they have already sucked the blood and “profit” of not only this generation but the next. If Washington is serious about a bailout, its size will need to measured in tens of trillions instead of trillions.
Not long ago, with a market for CDOs virtually nonexistent, Merrill was forced to sell CDOs at 20 cents on the dollar. That alone sounds bad enough, but Merrill had to finance 15 cents out of the 20 itself, suggesting that those CDOs may really only have been worth 5 cents. In response, banks devalued CDOs in their portfolios, but the markdown was to 20 cents, not 5. The clear implication is that their portfolios are still shored up to more than they are really worth. But any asset writedown has to be matched by equity, and even with the CDOs propped up at 20 cents on the dollar, there is really no more equity to write down for many banks, and no way to raise new equity, leaving liquidation of the firm as the only option. Since debt stays the same, debt-to-equity ratios have to be reduced in the current deleveraging process. As a result, each writedown causes more writedowns, and it becomes a death spiral and a “no way out” situation.
In the summer of 2007, Jeremy Grantham predicted half of hedge funds will get wiped out, and more than half of all private equity firms will vanish. Let us just look at the private equity sector, which, in boom years, can achieve a 50% return easily.
Let us look at a hypothetical deal: PE Firm A, with a 2+20 fee structure, purchased Company B for $4 billion. It did so by borrowing $2 billion at 6% interest, netting $1 billion in 2 years by IPO — a very typical deal in the good old days. It yields a 50% return ($1 billion on a $2 billion investment) for the PE firm (partners only). But for you as a PE investor, your share of that return is: $1B profit - $0.08B fee (2%*$2B*2 yr) - $0.2B PE profit cut - $0.24B interest ($2B*6%*2 yr) = $0.48B, or 24% return ($0.48B/$2B). The same deal that seems to achieve a 50% return (for the firm partners) has a real return for its clients that is only half that.
Now let us use the same example above, but let us say the equity market enters a couple of years of bear market like we are facing now. The same deal now takes 5 years instead of 2 years to spin off in an IPO. What would the return for PE clients be?
The answer is zero. It is: $1B profit - $0.2B fee (2%*$2B*5 yr) - $0.2B PE profit cut - $0.6B interest ($2B*6%*5 yr) = zero. Five years for nothing. The extra 3 years of interest payments and the excessive 2+20 fee structure eat all of the remaining profit. For all corporate pension funds, state and local government retirement funds, endowment funds and foundations rushing to invest 10-20% of their resources in private equities: Do they realize investing in 5%-per-year US treasury bonds (27% over 5 years compounding) would actually offer better return and carry no risk at all (except the risk of holding the US dollar)?
In the above calculation, I didn’t even factor in a long recession with a decade long bear market, the reduced revenues and deteriorating profit margins that would result, or potentially large losses for businesses the PE firm may have purchased. This is why Jeremy was so confident about his prediction, even though he was still in the middle of the bull market last year — predicting only half of them dead was conservative. Now, with the clock ticking, no credit for financing, and no equity market for IPOs to cash out and dump the risk to the public, it’s likely that the whole private equity sector will get wiped out by the end of 2010, just like the investment bank sector.
Diminished Returns Across US Industries
For a decade-long recession and likely depression, the only firms that will survive are those preserving cash by cutting their workforce; stopping capital expenditures, R&D and IT investments; cutting dividends, including preferred dividends; and discontinuing stock buybacks. Things will get very nasty. Only firms that can still manage to generate net cashflow during a depression will emerge as survivors, as in 1930s and 1970s. Newer companies with experimental technologies will be vulnerable and regarded as nonessential, and undercapitalized private firms will be in trouble since the IPO window will be shut for the unforeseeable future. Venture capital firms will have to hold on to their investments forever, at least another decade, without any IPOs in sight, until all their cash is burnt out. Many firms relying on bank financing will not survive. The only businesses that will thrive will be cashflow-positive energy firms and mining producers.
Pretty soon, people will realize holding cash in US dollars is also unwise, due to its quick deterioration. The current rise in the US dollar is due to short-term disappearance of the money supply, since banks don’t want to lend money. Once the government socializes the banking industry and floods the system with worthless paper, people will downgrade US Treasuries, since the US government is buying and holding the worst quality mortgages and CDOs dumped by the banks.
In a normal bankruptcy process for investment banks, common stocks, preferreds and subordinated debts get wiped out. Bondholders act as a cushion and suffer some losses, but usually customers and trade partners are protected. The current bailout plan, the previous Bear Stearns bailout, and the AIG bailout all use taxpayer money to bail out the bondholders and the perferreds, which are held mostly by institutions. The bailouts basically wipe out individual investors, then use taxpayers’ money to protect large institutions.
The next thing that will happen is all investors, including foreign central banks, will dump US treasuries and buy the ultimate asset everyone around the world trusts — gold. People will realize this is worse than the 1930s — at least then fiat money was backed by gold. Now the US dollar is backed by the $10 trillion national debt and the larger unfunded obligations of Medicare, Medicaid, Social Security, pensions, and the GSEs. Failures in the banking, auto, and airline industries loom on the horizon. Government can’t socialize only the money losing sectors, and taxpayers and lawmakers have only so much patience. They can’t tolerate this forever. Pretty soon, the government will need to take over a profitable sector, like energy firms, to offset some of its losses. The US is moving down the slippery path of socialism quickly.
There will be a nuclear winter for many years to come. It’s no wonder that many years ago George Soros correctly predicted that there would be the end of globalization and the death of capitalism. This is the payback time for all the abuses select elites have committed against our whole society, but now that it’s here, the public is footing their bills. If the G-7 is serious about bailing out the global economy, the only way to do it is to have double-digit hyperinflation to inflate the whole world out of depression at any cost. And they have to do it now. It can’t be half-hearted either; otherwise it will end up being the worst nightmare of hyperinflation coupled with an immense depression. This means all commodities will skyrocket and currently slumping commodities would provide the best buying opportunity before oil goes to $150 and gold to $2,000. When people lose faith in fiat money, the next thing to happen is barter like in the Weimar Republic, where only commodities, especially gold, are treated as money.
This is the end of an era, one characterized by financial engineering and alchemy, capital distortion, rip-off and cover-up, the flooding of worthless fiat currencies, and the deluge of manipulated paper assets like stocks, bonds and derivatives. It is the beginning of a new, honest and real money era: the gold era.
In this difficult period, do nothing and hold nothing but gold. Only gold, the ultimate asset that has survived the longest in human history, can save us now.
In August of last year I forecast a target of 800 for the S&P, which is about to be tested. This was an easy target to establish, since it represented the low of the 2001-2003 bear market. Last week’s heroic performance – what traders call a “dead cat bounce” - was a temporary respite from the market’s downward spiral. I now doubt 800 will be the bottom for this bear market. There may be more dead cat bounces, but there is no support in sight once 800 is decisively broken. My ultimate target is 400-500 for the S&P (or 4,000-5,000 for the Dow) which will be reached by the end of 2010. The timing of the 2010 bottom is consistent with what was given by Wharton professors Andrew Abel and Jeremy Siegel in 2001 in their “baby boomer cashing out” scenario discussed below.
My pessimism is based on my belief that neither government actions nor unnatural market mechanisms, such as circuit breakers and banning short sales, are capable of arresting this bear market. Many believe this bear market will recover quickly, like it did in 1987. This will not happen. After the one-day 20% drop in the market in 1987, circuit breakers were introduced to limit daily declines. But the market has adapted and selling pressure is distributed over longer time intervals, and the net effect is the same. Regulators could install additional market holidays, like they did in the 1930s, but the market will continue to adapt.
Jeremy Grantham’s Predictions
Earlier this year, Jeremy Grantham of GMO predicted in an interview with Barron’s that the S&P 500 would drop to 1,100 by end of 2010. A lot of people just laughed at him. Was this crazy old man out of his mind? Now, to quote Hamlet, “All the rest is silence.” We always should listen to an old man who experienced the so-called “Nifty Fifty” losing 80% of their market value in 1970s and has extensively studied the Great Depression of the 1930s. He probably regrets now that his 1,100 target was too conservative.
Jeremy derived his 1,100 prediction with a P/E of 11-12 as a norm for a long-term capital market. With a more representative bear market P/E value of 6-7, the forecast comes out in the 600-700 range. At the extreme of this bear market a few years down the road, the S&P 500 might very well overshoot and drop all the way to 4-500. That was the launch pad for last leg of the bull market that followed the recession of the early 1990s. Everything could go back to square one, while 20 years of bull market returns turn out to be in vain.
How long will this bear market last? Well, the Great Depression caused a bear market lasting over two decades, from 1929 to 1952. Only in 1958 did that market come back to the old 1929 peak, nearly three decades later. The 1970s were not much better—the bear market lasted 14-16 years from 1966 or 1968 to 1982. Even though that bear market ended more quickly, it still took until 1992 — 24 years later — to return to the markets’ 1968 peak.
My most optimistic forecast is this bear market will last another 4-5 years, which is overall actually about 12 years if we count 2000 as the starting point. If we use Jim Rogers’ commodity super-cycle, which usually runs opposite to the general equity market, this will be the latest two-decade bear market for equities, he predicts, lasting until 2020. When will the S&P 500 be back to last October’s peak? No sooner than 2024.
Another reason this bear market differs from 1987 is that, in 1987, the fundamentals were strong, stocks were trending upward, and the market didn’t have its economic lifeline of credit severed. There is another fundamental factor now suggesting we face a longer-lasting bear market than the 1970s. It is demographic. Baby boomers are not comfortable with the market turmoil of the past year, and they want to lock in their nest eggs and cash out. Their withdrawals have in turn caused more baby boomers to do the same. They don't want to take the risk of sitting through this credit crisis and bear market, since no one knows how long it will last.
What happens if it lasts as long as two decades? Time is not on boomers’ side. How can we blame them? With the real estate market freefalling with no bottom in sight, it is only natural for them to protect their only remaining nest eggs. And they will likely never get back into the stock market again once they cash out, since profiles grow more risk-averse with increasing age. Their overriding concern is to protect their cash. This is why you see US Treasuries, the so-called safe haven vehicle, with infinitesimally low yields. Boomers will not be tempted by equities even if they reach “undervalued” levels of 50% of book value, 70% of intrinsic value, P/E ratios of 6, etc. Inflation will gradually eat their money away with negative real interest rates, and they will worry about that later when inflation reaches double digits.
The above discussion about baby boomers is not new. In 2001, Abel and Siegel voiced concern about the potential herd behavior of the baby boomer generation — that their cashing out simultaneously could cause a stock market meltdown around 2010.. What an accurate prediction that is. They only missed by two years! Who wants to get caught holding the bag as the last one to cash out at the lowest price in 2010?
Good for Buffett but Bad for Common Shareholders
As the market dives, Warren Buffett’s investment in both GE and Goldman Sachs deserve discussion. Perpetual preferred stocks are usually a good way to invest in good businesses, as long as the firms survive, and obviously Buffett thinks both will. I tend to agree. But even if both GE and Goldman survive, such investments come at a large cost to the existing common shareholders.
In GE’s case, GE is using Buffett’s name and investment to raise $12 billion in a separate public offering, diluting their common shares. That’s not counting on the $3 billion of GE warrants, which could potentially cause more dilution. Almost all GE industrial units are doing fine since they are usually #1 or #2 in their respective sectors and have some monopoly pricing power. The biggest risk for GE is their GE capital unit, which never reveals the illiquid assets through loan and mortgage securitization and OTC derivatives in its portfolio, as is also the case with investment banks. And, unfortunately, it accounts for half of GE’s earning power. If GE Capital is in the same trouble as Wall Street investment banks, GE will likely have to shut down this division, write down large losses for its portfolio, and they will lose half of their earning power and an important vehicle to smooth their earnings every quarter. But as a conglomerate, they will still survive. The problem is that in an economic depression, with decreasing revenue and a shrinking profit margin, GE’s earnings will be depressed substantially. But it will still have to honor its large interest payment to Buffett on the new preferreds before common shareholders see any dividends.
Goldman is a much riskier investment than GE. The largest expense for investment banks is compensation, and they always issue many new shares, on top of cash bonuses, to retain talent every year as part of their incentive program. In an economic depression, there are likely no banking deals, not much trading activity, and especially no more highly profitable structured products like before. Goldman’s net income could be running less than $1 billion in its worst years (like Morgan Stanley is today). But they have to pay Buffett $500 million —10% interest on his $5 billion investment — every year. What is left for common shareholders with Buffett’s annual payout and increasingly diluted shares? The incentive program becomes demoralizing. Both deals are really bad for common shareholders.
Bailouts and the Unraveling of Private Equity
There are many angry investors around the country, causing the House to defeat the $700 billion bail out plan initially. Without Wall St.’s innovations on structured products, the subprime crisis could have been easily contained, even in the face of widespread abusive lending practices. The problem is for every $1 of subprime mortgages, Wall St. created $10 CDO products, then the math geeks at structured product groups used those to create another $100 of OTC derivatives out of thin air (for more on this, refer to my previous article Why Wall St. Needed Credit Default Swaps?). Now, suddenly, a $700 billion default of subprime loans would cause a $7 trillion default in CDOs and $70 trillion in CDS losses, a crisis 100 times larger than it should be. Now you know why Wall St. is so profitable, because in the past 5-10 years, they have already sucked the blood and “profit” of not only this generation but the next. If Washington is serious about a bailout, its size will need to measured in tens of trillions instead of trillions.
Not long ago, with a market for CDOs virtually nonexistent, Merrill was forced to sell CDOs at 20 cents on the dollar. That alone sounds bad enough, but Merrill had to finance 15 cents out of the 20 itself, suggesting that those CDOs may really only have been worth 5 cents. In response, banks devalued CDOs in their portfolios, but the markdown was to 20 cents, not 5. The clear implication is that their portfolios are still shored up to more than they are really worth. But any asset writedown has to be matched by equity, and even with the CDOs propped up at 20 cents on the dollar, there is really no more equity to write down for many banks, and no way to raise new equity, leaving liquidation of the firm as the only option. Since debt stays the same, debt-to-equity ratios have to be reduced in the current deleveraging process. As a result, each writedown causes more writedowns, and it becomes a death spiral and a “no way out” situation.
In the summer of 2007, Jeremy Grantham predicted half of hedge funds will get wiped out, and more than half of all private equity firms will vanish. Let us just look at the private equity sector, which, in boom years, can achieve a 50% return easily.
Let us look at a hypothetical deal: PE Firm A, with a 2+20 fee structure, purchased Company B for $4 billion. It did so by borrowing $2 billion at 6% interest, netting $1 billion in 2 years by IPO — a very typical deal in the good old days. It yields a 50% return ($1 billion on a $2 billion investment) for the PE firm (partners only). But for you as a PE investor, your share of that return is: $1B profit - $0.08B fee (2%*$2B*2 yr) - $0.2B PE profit cut - $0.24B interest ($2B*6%*2 yr) = $0.48B, or 24% return ($0.48B/$2B). The same deal that seems to achieve a 50% return (for the firm partners) has a real return for its clients that is only half that.
Now let us use the same example above, but let us say the equity market enters a couple of years of bear market like we are facing now. The same deal now takes 5 years instead of 2 years to spin off in an IPO. What would the return for PE clients be?
The answer is zero. It is: $1B profit - $0.2B fee (2%*$2B*5 yr) - $0.2B PE profit cut - $0.6B interest ($2B*6%*5 yr) = zero. Five years for nothing. The extra 3 years of interest payments and the excessive 2+20 fee structure eat all of the remaining profit. For all corporate pension funds, state and local government retirement funds, endowment funds and foundations rushing to invest 10-20% of their resources in private equities: Do they realize investing in 5%-per-year US treasury bonds (27% over 5 years compounding) would actually offer better return and carry no risk at all (except the risk of holding the US dollar)?
In the above calculation, I didn’t even factor in a long recession with a decade long bear market, the reduced revenues and deteriorating profit margins that would result, or potentially large losses for businesses the PE firm may have purchased. This is why Jeremy was so confident about his prediction, even though he was still in the middle of the bull market last year — predicting only half of them dead was conservative. Now, with the clock ticking, no credit for financing, and no equity market for IPOs to cash out and dump the risk to the public, it’s likely that the whole private equity sector will get wiped out by the end of 2010, just like the investment bank sector.
Diminished Returns Across US Industries
For a decade-long recession and likely depression, the only firms that will survive are those preserving cash by cutting their workforce; stopping capital expenditures, R&D and IT investments; cutting dividends, including preferred dividends; and discontinuing stock buybacks. Things will get very nasty. Only firms that can still manage to generate net cashflow during a depression will emerge as survivors, as in 1930s and 1970s. Newer companies with experimental technologies will be vulnerable and regarded as nonessential, and undercapitalized private firms will be in trouble since the IPO window will be shut for the unforeseeable future. Venture capital firms will have to hold on to their investments forever, at least another decade, without any IPOs in sight, until all their cash is burnt out. Many firms relying on bank financing will not survive. The only businesses that will thrive will be cashflow-positive energy firms and mining producers.
Pretty soon, people will realize holding cash in US dollars is also unwise, due to its quick deterioration. The current rise in the US dollar is due to short-term disappearance of the money supply, since banks don’t want to lend money. Once the government socializes the banking industry and floods the system with worthless paper, people will downgrade US Treasuries, since the US government is buying and holding the worst quality mortgages and CDOs dumped by the banks.
In a normal bankruptcy process for investment banks, common stocks, preferreds and subordinated debts get wiped out. Bondholders act as a cushion and suffer some losses, but usually customers and trade partners are protected. The current bailout plan, the previous Bear Stearns bailout, and the AIG bailout all use taxpayer money to bail out the bondholders and the perferreds, which are held mostly by institutions. The bailouts basically wipe out individual investors, then use taxpayers’ money to protect large institutions.
The next thing that will happen is all investors, including foreign central banks, will dump US treasuries and buy the ultimate asset everyone around the world trusts — gold. People will realize this is worse than the 1930s — at least then fiat money was backed by gold. Now the US dollar is backed by the $10 trillion national debt and the larger unfunded obligations of Medicare, Medicaid, Social Security, pensions, and the GSEs. Failures in the banking, auto, and airline industries loom on the horizon. Government can’t socialize only the money losing sectors, and taxpayers and lawmakers have only so much patience. They can’t tolerate this forever. Pretty soon, the government will need to take over a profitable sector, like energy firms, to offset some of its losses. The US is moving down the slippery path of socialism quickly.
There will be a nuclear winter for many years to come. It’s no wonder that many years ago George Soros correctly predicted that there would be the end of globalization and the death of capitalism. This is the payback time for all the abuses select elites have committed against our whole society, but now that it’s here, the public is footing their bills. If the G-7 is serious about bailing out the global economy, the only way to do it is to have double-digit hyperinflation to inflate the whole world out of depression at any cost. And they have to do it now. It can’t be half-hearted either; otherwise it will end up being the worst nightmare of hyperinflation coupled with an immense depression. This means all commodities will skyrocket and currently slumping commodities would provide the best buying opportunity before oil goes to $150 and gold to $2,000. When people lose faith in fiat money, the next thing to happen is barter like in the Weimar Republic, where only commodities, especially gold, are treated as money.
This is the end of an era, one characterized by financial engineering and alchemy, capital distortion, rip-off and cover-up, the flooding of worthless fiat currencies, and the deluge of manipulated paper assets like stocks, bonds and derivatives. It is the beginning of a new, honest and real money era: the gold era.
In this difficult period, do nothing and hold nothing but gold. Only gold, the ultimate asset that has survived the longest in human history, can save us now.
Friday, September 12, 2008
Agnico Eagle – Focus on per Share Value Creation for Shareholders
Agnico-Eagle (AEM) is an international gold producer, headquartered in Toronto, Ontario of Canada, with advanced-stage projects and opportunities in Canada, Mexico and Finland. The CEO, Mr. Sean Boyd, was in New York City on August 29th to talk about their strategy and growth potential at the Yale Club. There are six major 100% owned gold mines in AEM’s portfolio, all in low geopolitical risk regions:
1) LaRonde mine in Quebec is Canada's largest gold deposit in terms of reserves, with P&P (proven and probable) gold reserves of 5 million ounces, which has generated strong earnings and cash flows for AEM. Current production is about 200,000 ounces of gold but in 5 years it is expected to ramp up to 400,000 ounces.
2) Gold production will begin in this quarter at AEM’s Goldex mine near LaRonde, which holds more than 1.6 million ounces of gold and is expected to produce more than 150,000 ounces of gold next year.
3) In Finland, construction of the Kittila gold mine commenced in the summer of 2006, with initial production expected in the fourth quarter of 2008. This mine has probable reserves of 3 million ounces and is expected to produce 150,000 ounces of gold next year for AEM.
4) Shaft sinking is complete and level development underway at the Lapa deposit, also in Quebec, Canada, with probabe gold reserves of 1.1 million ounces. Production is expected in mid-year 2009 with average annual production of 125,000 ounces.
5) The Meadowbank project in the Nunavut Territory in northern Canada is advancing towards initial gold production in the 1st quarter, 2010, which has probable gold reserves of 3.5 million ounces and is expected to add 360,000 ounces of gold production per year to AEM.
6) Initial gold and silver production at AEM’s Pinos Altos project in Mexico is expected in third quarter 2009. It has probable gold reserves of 2.5 million ounces, 73.1 million ounces of silver from 24.7 million tonnes at 3.2 g/t gold and 92.2 g/t silver. Full annual production is estimated to be around 150,000 to 200,000 ounces of gold.
In general, AEM is estimated to produce around 300,000 ounces of gold this year, about 2/3 from LaRonde mine and the rest from Glodex and Kitila. However, we should see explosive increase in gold production for AEM in the next 2-3 years. Overall, Gold production is estimated to be over 600,000 ounces next year due to contributions from Goldex, Lapa, Kittila and Pinos Altos. In 2010 and beyond, we should see Meadowbank make a big splash by producing likely 360,000 ounces of gold per year alone. The whole gold production for AEM should reach close to 1.4 million ounces of gold at that time, more than quadruple from this year’s estimate of 300,000.
AEM has been careful not to dilute their shares even at the same time they have done several strategic acquisitions. From 1998 to today, period of 10 years, their number of shares outstanding has been up by 2.6 times, but their gold reserves have been growing 12.8 times, preserving and increasing shareholder’s value substantially. With the six mines discussed above, AEM continues to target potential several 5 million oz gold deposits, and strives to grow its reserves further by expanding the mines they currently 100% own and investing early in high quality gold deposits via strategic acquisitions. AEM is spending $65 million on exploration this year, the largest budget in AEM history. AEM has also made strategic investments in Gold Eagle (GEA.TO) and Comaplex Minerals (CMF.TO).
Agnico-Eagle's operating history includes more than 30 years of continuous gold production primarily from underground operations. Since 1972, Agnico-Eagle has produced over 4 million ounces of gold, at the same time as one of the lowest total cash cost producers in the North American gold mining industry. It currently has $7.5 billion market cap, a mid-tier gold producer with ramp-up production in the near future. Agnico-Eagle has traditionally sold all of its production at the spot price of gold, having a policy of not selling forward future gold production, enabling shareholders to participate fully in rising precious metal prices, once this gold bull market resumes. Agnico-Eagle has also paid a cash dividend for 26 consecutive years with current yield around 0.3%.
AEM’s current 2nd quarter earning decreased substantially due to the crash of zinc price resulting less by-product credit thus higher cash cost, and the delay of the Goldex mine production. AEM is capital heavy in 2008, planning to spend $800 million, but will decrease probably 50% every year afterwards. Majority of the financing for this capital expenditure is coming from their cashflow from operations, expanding bank credit facility and cash position.
Overall, with the additional mines into production, AEM is expected to double then double again their gold output in the next 3 years from 2008. With their by-product credits of zinc, silver and copper, the cash cost of gold production is very low, probably around $80 per ounce for 2008. Even if we don’t count those credits, AEM can still produce at less than $300 cash cost per ounce of gold, in the lowest quartile of cash cost producers but with high gross profit margin for a mid-tier gold producer in the industry. More importantly, when gold resumes its bull market, the operating leverage from AEM will provide explosive increase in both revenue and earnings for investors. It won’t surprise me that AEM can double from the current $50 price level to be in 3 digit territory in the next 24 months.
Disclosure: I have been long Agnico-Eagle since November 2007, and I believe Agnico-Eagle is currently undervalued and provides a good opportunity for a diversified mining portfolio for long term capital gain.
Thomas Tan, CFA, MBA
Those interested in discovering more about me, my trading strategy and reading many of my other blogs can visit my blog site: http://tzt-investment.blogspot.com
1) LaRonde mine in Quebec is Canada's largest gold deposit in terms of reserves, with P&P (proven and probable) gold reserves of 5 million ounces, which has generated strong earnings and cash flows for AEM. Current production is about 200,000 ounces of gold but in 5 years it is expected to ramp up to 400,000 ounces.
2) Gold production will begin in this quarter at AEM’s Goldex mine near LaRonde, which holds more than 1.6 million ounces of gold and is expected to produce more than 150,000 ounces of gold next year.
3) In Finland, construction of the Kittila gold mine commenced in the summer of 2006, with initial production expected in the fourth quarter of 2008. This mine has probable reserves of 3 million ounces and is expected to produce 150,000 ounces of gold next year for AEM.
4) Shaft sinking is complete and level development underway at the Lapa deposit, also in Quebec, Canada, with probabe gold reserves of 1.1 million ounces. Production is expected in mid-year 2009 with average annual production of 125,000 ounces.
5) The Meadowbank project in the Nunavut Territory in northern Canada is advancing towards initial gold production in the 1st quarter, 2010, which has probable gold reserves of 3.5 million ounces and is expected to add 360,000 ounces of gold production per year to AEM.
6) Initial gold and silver production at AEM’s Pinos Altos project in Mexico is expected in third quarter 2009. It has probable gold reserves of 2.5 million ounces, 73.1 million ounces of silver from 24.7 million tonnes at 3.2 g/t gold and 92.2 g/t silver. Full annual production is estimated to be around 150,000 to 200,000 ounces of gold.
In general, AEM is estimated to produce around 300,000 ounces of gold this year, about 2/3 from LaRonde mine and the rest from Glodex and Kitila. However, we should see explosive increase in gold production for AEM in the next 2-3 years. Overall, Gold production is estimated to be over 600,000 ounces next year due to contributions from Goldex, Lapa, Kittila and Pinos Altos. In 2010 and beyond, we should see Meadowbank make a big splash by producing likely 360,000 ounces of gold per year alone. The whole gold production for AEM should reach close to 1.4 million ounces of gold at that time, more than quadruple from this year’s estimate of 300,000.
AEM has been careful not to dilute their shares even at the same time they have done several strategic acquisitions. From 1998 to today, period of 10 years, their number of shares outstanding has been up by 2.6 times, but their gold reserves have been growing 12.8 times, preserving and increasing shareholder’s value substantially. With the six mines discussed above, AEM continues to target potential several 5 million oz gold deposits, and strives to grow its reserves further by expanding the mines they currently 100% own and investing early in high quality gold deposits via strategic acquisitions. AEM is spending $65 million on exploration this year, the largest budget in AEM history. AEM has also made strategic investments in Gold Eagle (GEA.TO) and Comaplex Minerals (CMF.TO).
Agnico-Eagle's operating history includes more than 30 years of continuous gold production primarily from underground operations. Since 1972, Agnico-Eagle has produced over 4 million ounces of gold, at the same time as one of the lowest total cash cost producers in the North American gold mining industry. It currently has $7.5 billion market cap, a mid-tier gold producer with ramp-up production in the near future. Agnico-Eagle has traditionally sold all of its production at the spot price of gold, having a policy of not selling forward future gold production, enabling shareholders to participate fully in rising precious metal prices, once this gold bull market resumes. Agnico-Eagle has also paid a cash dividend for 26 consecutive years with current yield around 0.3%.
AEM’s current 2nd quarter earning decreased substantially due to the crash of zinc price resulting less by-product credit thus higher cash cost, and the delay of the Goldex mine production. AEM is capital heavy in 2008, planning to spend $800 million, but will decrease probably 50% every year afterwards. Majority of the financing for this capital expenditure is coming from their cashflow from operations, expanding bank credit facility and cash position.
Overall, with the additional mines into production, AEM is expected to double then double again their gold output in the next 3 years from 2008. With their by-product credits of zinc, silver and copper, the cash cost of gold production is very low, probably around $80 per ounce for 2008. Even if we don’t count those credits, AEM can still produce at less than $300 cash cost per ounce of gold, in the lowest quartile of cash cost producers but with high gross profit margin for a mid-tier gold producer in the industry. More importantly, when gold resumes its bull market, the operating leverage from AEM will provide explosive increase in both revenue and earnings for investors. It won’t surprise me that AEM can double from the current $50 price level to be in 3 digit territory in the next 24 months.
Disclosure: I have been long Agnico-Eagle since November 2007, and I believe Agnico-Eagle is currently undervalued and provides a good opportunity for a diversified mining portfolio for long term capital gain.
Thomas Tan, CFA, MBA
Those interested in discovering more about me, my trading strategy and reading many of my other blogs can visit my blog site: http://tzt-investment.blogspot.com
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