Thursday, 15 November 2012

Beware of the prospectus and always know what you want from an investment . . .

It was a busy day yesterday and I didn't get time to add to the blog. One thing that mesmerised me yesterday was the JPY sell-off, it's been a long time coming and interestingly was precipitated by negotiations surrounding Japan's own fiscal cliff. The Japanese have to borrow $480bn to make the current budget work and the only way of doing that was by having the government promise to call an election after the bill gets passed. Failure of course would have effectively decapitated Japanese banks who hold huge portfolios of government bonds and are already struggling with the equities they hold and should have long ago divested. Combined losses from "mega-bank" (Mitsubishi UFJ, Sumitomo Mitsui and Mizuho) shareholdings have more than tripled in the six months ended Sept. 30 from Y170bn to Y540bn. So you can imagine the amount of equity that would have be raised to keep these banks as going concerns if they were forced to take a hit from a JGB collapse!

Japan is kind of like a huge ponzi scheme, with the banks owning everything. The idea you see of ultra low rates since the early 90's was that the ease of credit would allow the economy to grow and therefore make up the gap between real tangible assets and paper value allowing the ponzi to be traded out. Of course all that was a bit like the US government telling Bernie Madoff that they were going to inject funds into his firm so he could try and make enough to return money to investors . . . not likely to work. Of course as an investor you can still make money trading the market, you just have to look for the right instrument. For many in the late 90's and early 21st century this was the Japanees bank's convertible preference shares. These shares had diabolic terms attached to them both for the banks and the investor. The vast majority had were resettable, meaning that at various points in time the conversion price of the preference shares reset to the prevailing stock price and therefore also increasing the number of shares you received in order to preserve your face value. The problem of course was that there is a floor to the reset and when you hit the floor the investor in the prefs doesn't getting any more shares at a lowe price and therefore starts to suffer a real slide in value because up until that point in time investors might consider themselves somewhat hedged. What really happened was that foreign investment banks started to offer to buy prefs directly from the banks and they in turn would not notionally hedge, but in fact actually hedge, treating the resets as barrier options and pricing accordingly. I could go on, but suffice to say Goldman Sachs was the prime beneficiary of this type of play by dominating the trading, pricing and distribution (when they liked you) especially in the prefs issued by SMFG. Maybe that's enough of Japan for one day . . . all you need to know is that the Nikkei was up nearly 2% when the rest of the world was going down.

Australian banks have recently been issuing convertible preference shares. They're not in the same toxic category of some of the Japanese prefs in their construction. I think the main reason that the Aussie's issued these hybrids was because they needed to onshore funding as they were and are too exposed to offshore bond markets which in 2008 basically closed down and put the bank's mortgage books in real peril.

I was speaking to a firm this week about a possible position. They asked me about my short-lived hedge fund and what our investing strategy was. I always give the same example that we built the fund predicated on protected investments. The best example of this was during the BP oil spill in the Gulf of Mexico. At the time the BP share price collapsed and as a professional investor in commodities and related infrastructure you had to make a choice of whether you trusted the BP reserves and oil price enough to cover the costs of various legal actions and still make a good return. The alternative we looked at was a capital structure arbitrage scenario. Basically we built a table of scenarios and then considered what BP would have left in order to repay their various stakeholders. To cut a long story short we realised that with the most senior debt trading in the high 70's as opposed to pre-crisis high 90's and with the 90%+ likelihood that even in the most extreme cases that the bond holders would get their money back there was a quick low risk 20%+ to be made. Of course you then went further down the capital structure and via modification via a risk-weighted model built a position in BP that maximised returns while minimising potential capital losses. The argument that you had to go all-in on the equity alone didn't fit in with our philosophy. If we had been a high volatility type hedge fund whose investors understood boom or bust bets then yes you go for the shares, but that of course comes down to horses for courses.

With a light rain falling here in Sydney I'm probably going to get out my Tacx trainer and head up the virtual Pyrenees:


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