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Debt, Dilution, Default and Denial


Four D's that spell economic trouble.


"Risk comes from not knowing what you are doing."
- Warren Buffett


Debt is like a drug. When used properly, it can help the sick or enhance the life of a healthy individual. If abused, both can result in addiction and despair. But now, the use of debt has become so widespread and has been so incredibly abused that we now find ourselves in quite a nasty predicament.

When in debt, the borrower has only a few options. Debt can be serviced (by simply paying the minimum payment each month), repaid, refinanced or defaulted on. A reasonable amount of debt, though, is actually a healthy thing. Prudent levels of borrowing can help businesses grow, individuals buy a home, teenagers attend college, and allow the U.S. government and state and local municipalities to provide essential services.

When a person is given a small dose of a painkiller for a sports related injury, that dose, if abused, can result in addiction and eventual rehabilitation: Just like any entity that becomes too addicted to debt, only to see their debt service overtake their ability to grow.

Further, when debt is used to turn a relatively simple instrument like a residential or commercial mortgage into a leveraged financial Frankenstein (Mary Shelley would have loved some of these instruments!), problems can and have arisen. Wall Street's alchemists have turned relatively simple mortgages (sub-prime, prime and Alt-A) into CDO's, CLO's and the like.

Think of the alchemy in the following way; A CDO with multiple layers of safety (equity, mezzanine and everything from BBB to AAA rated tranches) that are hard to analyze, hard to price, impossible to sell in many cases, and result in the holder of these esoteric securities being forced to write the values down, which results in:


I have written quite a bit about Level 2 Assets (hard to price, "marked to model" assets) of late. To be perfectly honest, I have never seen a list of Level 2 Assets out for the bid, nor has anyone at any bank or brokerage firm ever volunteered to show me what any of these securities actually are. What disturbs me the most is the trend in the sheer amount of Level 2 Assets on the books of not only banks and brokers, but public companies in general. This also goes for Level 3 Assets (those that are "marked to management's best guess"). I did a quick study on Bloomberg today that allowed me to come the following conclusions:

  • 535 publicly traded companies in the United States have some Level 3 Assets on their balance sheet.
  • Level 1 Assets (those that are 'marked to market') are only $1.5 trillion.
  • Level 2 Assets have swollen to $10.5 trillion.
  • Level 3 Assets have increased to $1.3 trillion.
  • Cumulative Shareholder's Equity is only $2.3 trillion.

And none of this includes Freddie Mac's (FRE) most recent confession in its May 14th earnings release that it now has $155 billion of Level 3 Assets (mostly non-Agency sub-prime assets according to the company) on their books. $155 billion is 5.5 times Freddie's shareholder equity and 23% of Total Assets according to the company. I have to admit that as a holder of Freddie Mac and Fannie Mae (FNM) preferred shares, I was, to say the least, more than slightly aghast. I have shed many of my holdings there and likely will continue down that path until our position hits zero.

Am I being alarmist with this analysis? Perhaps, but better safe than sorry, and even if I have to take a small loss (in some cases I may) I have found that the best traders/investors are the ones that know how/when to take a loss, rather than hoping the investment will perform as they had originally planned. As they say, "Hope is a poor roadmap to success in the markets."

As a result of their own greed, banks and brokers have been forced, on a global scale, to write down more than $315 billion since the crisis began last summer. Most of the write-downs have been confined to the sub-prime sector to date, but I'm highly uncomfortable that the crisis, in the end, will be confined to sub-prime.

In fact, we're already beginning to see strains on other parts of the credit markets. The problems stretch all the way from credit card receivables, Alt-A loans, prime loans, auto loans and motorcycle loans. The problem is not at all contained, as many analysts, economists, TV commentators and other "hopers" would like us to believe. Unfortunately, contagion is here, perhaps for a while. To make matters worse, when we add exploding commodity prices and a rising unemployment rate to the picture, the takeaway is far from optimistic.

As such, I've now pared my long only equity portfolios to my lowest level since 2001 and continue to shun credit risk. I continue to live by the following adage-"If you are not being properly compensated to take risk, particularly credit risk, do not take risk."

There is no doubt in my mind that while I'm in "extreme caution mode" I can very easily be wrong. What I mean is that credit spreads may tighten further and stocks could continue to rally, my firm, Atlantic Advisors, operates under the assumption that it isn't possible to be "too cautious with someone else's money."

As a result of all the write-downs that have occurred, many financial institutions have been forced to come to market with common equity, convertible preferred and straight preferred deals. Companies on this list include the likes of Merrill Lynch (MER), Fannie Mae, Freddie Mac, National City (NCC), Regions (RF), Fifth Third Bancorp (FITB), MBIA (MBI), AMBAC (SBK), J.P. Morgan (JPM), Lehman Brothers (LEH), Citigroup (C) and so on.

Some of the companies, like National City, have diluted existing shareholders by 50% just to stay in business. The same, sadly, can be said for MBIA and AMBAC, two municipal insurers that got burned when they entered the vague world of Credit Default Swaps and CDO's.

For what it is worth, I highly doubt that AMBAC and MBIA will survive this crisis as they now have nearly three times their shareholder equity in "deferred tax assets." Even Freddie Mac disclosed it now has deferred tax assets on its books, a potential sign of financial stress.

It is clear to me that what many of the aforementioned companies should be doing is not what they are actually doing. Take Merrill Lynch, for example. Merrill has said on several occasions that it doesn't need to raise capital, only to raise billions of capital a week later, paying as much as 8 5/8% for preferred stock.

It then went on to state (just last week) that it wrote down an additional $5+ billion in assets since March 31st. This brings their write-downs to a staggering $37 billion since last July on a base of just $31 billion of shareholder equity. The part that bugs me is that Merrill now has nearly 3 times its shareholder equity in Level 3 Assets, and at the same time it states that it can produce a 20% return on shareholder equity. All I can say to the company is "Lotsa luck."

What it should be doing, in my opinion, is cutting its common dividend and issue as much common and convertible stock as it can while the capital raising window remains open, which I expect to shut abruptly as we approach 2009.

Think of it this way: If you owned your own company, business was slowing, your cost of capital was rising, profits disappeared, you were writing down the value of your net worth and assets, employees were leaving and you were levered up to your eyeballs, what would you do? A prudent investor would cut dividends to shareholders, reduce headcount, try to cut leverage and find a way to raise equity even if you dilute your own holdings just so you can fight to live another day.

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No positions in stocks mentioned.

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