Archive for January, 2010

Changes to distressed investing

Saturday, January 30th, 2010

Here is a situation:  Hedge fund A has a long concentrated position in a unsecured bond with a small issue size.  This bond does not trade very often.  The hedge fund feels this company could go into bankruptcy or hit a rough patch.  If they sell the bond, it could tip the hand of the market or cause a large decrease in the bond price because of such a large sell order.  Subsequently they purchase a CDS (basically a bond option) in an amount less than, equal to, or greater than the notional value of their bond position.  A few months later, the company declares it is entering bankruptcy.

On 1/9/10, a bankruptcy judge in Delaware ruled in the bankruptcy case of Six Flags (re: Premier International Holdings, Inc. Case No. 09-12019 Bankr.D. Del. Jan.9, 2010) that the ”members of an ad hoc committee of note-holders are not required to comply with the disclosure requirements of Bankruptcy Rule 2019.   This ruling is different than two other bankruptcy cases involving Northwest Airlines Corp (Southern District of NY 2007) and Washington Mutual (District of Delaware 12/2/09).

Bankruptcy Rule 2019 states that any committee representing more than one creditor should list each creditor’s claim, date of acquisition, price of acquisition and other claims or interests.  Normally, these committees list each of the creditors and the aggregate holdings of the committee.   Bankruptcy workout groups such as Alvarez & Marsal assume they will never learn which unsecured creditor owns what as the creditors are likely to have constant movement of their holdings (e.g. derivatives, options, equities, swaps).

In the situation of our hedge fund, if they own more CDS exposure than their underlying bond exposure, they want the company to be worthless and will vote as such.  There is an industry movement to enforce CDS restrictions so that the interests of the company will match the interests of unsecured bond holders.

Bottom line:  If you make an allocation to a junk bond manager or a distressed bond manager, ask how Bankruptcy Rule 2019 and the current disparity of rulings from bankruptcy courts will affect his/her strategy.  As an aside, Deutsche Bank just downgraded FTI from a buy to a hold as they expect corporate bankruptcies to hit a plateau and decrease after 2010.  Analysts are sometimes right and sometimes not.

Always Asking, Never Assuming™

Christopher Holtby

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K&R insurance

Friday, January 29th, 2010

There is a type of insurance which, in concept, is rather bleak – kidnap and ransom – which is commonly referred to as K&R insurance.  According to Clayton Consultants and International Maritime Bureau, Mexico, Venezuela, Nigeria, Somalia, Pakistan, Iraq and Afghanistan ranked as the top countries for kidnapping in 2008.  Insurance companies such as Chubb, Charitis (formerly AIG), and other insurers provide K&R insurance.  They contract with firms such as Clayton Consultants, G4S, Control Risks and others to provide the service of bringing the kidnapped individual back safely.

These firms use force as a last resort.  According to these consultants, out of every 100 kidnappings about three or four hostages are killed (excludes Iraq numbers).  Most kidnappings are essentially a form of business.  For example, last year, off the coast of Somalia, the Saudi Arabian ship, Sirius Star, paid a $3 million ransom.  Last week a similar situation resulted in a $7 million ransom being paid to the Somalian pirates.  Insurance companies do not advertise, discuss, disclose, etc. what is paid to the kidnappers.  It results in the kidnappers seeing foreigners as human ATMs (see examples in Nigeria).

Those most at risk are very wealthy families and politicians in the high risk areas.  Consultants mention that high profile Americans in high risk areas (celebrities, politicians, business people or related family members) are most at risk. 

Bottom line: Sometimes it pays to be a nobody.  If you are thinking of purchasing or do purchase K&R insurance, DO NOT TELL ANYBODY except as instructed by the security consultants who will brief you before your departure.     

Always Asking, Never Assuming™

Christopher Holtby

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Inflation debate information

Friday, January 15th, 2010

As you probably aware, by March 31, 2010, the US Federal Reserve will have completed the purchase of $1.25 trillion of federal agency mortgage paper from Fannie, Freddie and broker-dealers.  The mechanics of this process starts with the Fed printing money and paying this newly minted money to the sellers of the mortgage paper.  When the sellers are private companies, such as banks, this can cause the money supply and monetary base in the US to rise significantly.  The banks can choose to invest, lend or deposit the funds at the Federal Reserve in an interest bearing account.  Because the velocity of money has not increased (as of 1/15/10), this means that, so far, the banks, constrained by current or future loan problems, have deposited the sales proceeds at the Federal Reserve.  Currently, analysts do not know exactly how much of the mortgage paper was sold by banks versus Fannie and Freddie, which makes the analysis more difficult.  These details will not be available for another few months.

As long as these deposited reserves remain at the Fed, the monetary base has increased, but the money multiplier has not started ($1 of reserves can be leveraged around 10x).  The worry for all investors is: when and why will the banks move money from their Fed interest bearing accounts and lend and/or invest the money for a higher rate of return?  This would increase the money multiplier and eventually cause inflation. Right now, the largest part of the Fed’s balance sheet is comprised of GSE-based residential mortgages.  The great debate centers around the how to “unwind” or “exit” the program of holding GSE-based residential mortgages.  If the Fed signals they will begin to sell, these securities will drop in value very quickly in anticipation of the largest owner of these securities coming to market.  That is not a good option.  The Fed could just hold the mortgages until maturity, but that would cause another set of problems.  The Fed could completely stop purchasing mortgage bonds from Fannie and Freddie.  In essence, the Fed is trapped, as all options have less than perfect outcomes.

The Fed can increase the reserve deposit rates offered to banks holding deposits there at any time.  The Fed could raise those reserve deposit rates if they feel banks are beginning to loan or invest those original mortgage paper proceeds.  They can also engage in term deposit auctions of bank’s deposits at the Fed, thus “locking in” money and avoiding this money leaking into the economy.  These actions do not withdraw liquidity from the banking system as asset sales would; they only temporarily limit the effects of the money multiplier.  It appears likely the Fed can manipulate and extend this system for quite some time.

Bottom line:  This is a complicated topic.  Investors should pay attention to the reserve deposit rate, as well as other policy interest rates.  The inflation debate centers on more than just the increase of the Fed’s balance sheet.

Always Asking, Never Assuming™

Christopher Holtby

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China Inc. acquisition philosophy

Monday, January 4th, 2010

As a partially central-planned and partially market-based economy, China’s approach to acquiring non-Chinese assets is not understandable through a CNN headline.  Through various agencies (e.g. National Development and Reform Commission), Beijing has promoted a type of “going out” policy which encourages China’s companies to invest abroad.  Those investments have included natural resources, finance, technology, consumer brands and distribution channels.  The general areas of China’s private and state-owned companies’ acquisitions are: 1) natural resources, 2) prestige deals, 3) acquisitions of foreign firms whose brand or technology can assist Chinese companies’ domestic positions, 4) bargain hunting, and 5) desperation deals for Chinese companies needing growth/distribution channels abroad because of tight margins at home (source: Dragonomics).

The big state-owned companies use the first two approaches.  Private and/or entrepreneurial local state-owned companies use the last three approaches.  The private and entrepreneurial companies have their own narrow interests.  They have raised the flag of national interests only when it assists them individually and not on the direction of Beijing.  In 2009, state-owned companies were big purchasers of resource assets, driven by Beijing wanting to control the states needs for economic growth.  As commodity prices were low, this made sense.  Australian veterans believe resource assets sold to Chinese companies were overvalued.  Time will tell.

As China transitions into a mature, industrialized country, many acquisitions will be driven based on industrial policy (driven partly by the China investment Corp).  For example, since January 2009, Beijing has released plans for 11 industries to be consolidated to smooth-out economic growth and increase domestic demand.  Domestic companies will continue to acquire international assets to protect them or to provide more leverage during this consolidation phase (e.g. they will be the acquirer not the acquiree, such as Beijing Auto making bids for Opel and Saab). 

Bottom line:  In order to make a decision regarding the investment merits of China, investors should understand the internal and external investment strategies of Chinese companies and how they are spending shareholder capital.  Their success or failure depends, in part, on internal party politics.

Always Asking, Never Assuming™

Christopher Holtby

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