Unintended Consequences

"The difference between death and taxes is death doesn't get worse every time congress meets"

Boy do I have a lot f things to talk about, so please spare me the diagnosis of A.D.D., lets begin:

-Congress just knows how to screw things up, hence the reason for starting this blog with the above quote. I don't know how anyone could forget their last great move; well if you forgot it had "unintended consequences" of making foreclosures easier than defaulting on your credit card. The most interesting part is that for 10 years banks started picking up credit card companies for "synergy" purposes. I still remember when Citi made a bid for Sears Credit Card. So, after the banks made all these acquisitions, they decided to lobby congress to make it harder for credit card bills to be "written off" when users filed for bankruptcy.

Unintended Consequence: When the mortgage/housing meltdown happened, consumers found it easier to default on their house payments than their credit card payments. Why is this bad? Well if you are a bank, a house is an illiquid asset on your balance sheet, a bank can't do what it is supposed to do (lend) when their reserves are homes. There lies the problem of Congress and their "unintended consequences."

-Congress and the Federal Deserve this week were casted for the remake of "Dumb and Dumber" this week with their respective decisions. Congress passed the tax rebate program and the Fed lowered interest rates by 75 basis points to stabilize the equity markets as if that was their job. Mark it down because I don't think you will see two groups try to outrun each-other to the equivalence of financial hell faster than Dumb and Dumber.

Unintended Consequence: The Federal Reserve has lost credibility, there are negative yields all over, check the 10 year out (-61 bp's). The Fed is not there to stabilize the equity markets. And Congress taking on more debt to help people out, never mind that we have the lowest savings rate of all time. The unintended consequence is that instead of the consumer using the rebate to consume, the opposite will happen. They will payoff their debt, hopefully.


Mortgage Insurers, Insurance Market, and Shrinkage?
Anyways, over the past year there has been a battle brewing between two value investors, well not really a battle but rather a disagreement on one sector. Basically, Marty Whitman thinks the mortgage insurers can make it and Bill Ackman thinks otherwise. I have been following their views during this time and I am somewhere in between.
-I don't have position in any of the mortgage insurers.
-I do think there is a reason for their existence as businesses
-I don't think they have inherent moats, but rather their moats are dependent on rating agencies classification of AAA.
-I do think their underwriting was lax.
-I don't think they deserved their AAA ratings.
-Lastly, I know Mr. Dinalo is a politician, and if Mr. Spitzer proved anything, it was that you can get a lot of face time and job promotion if you use your badge. That's exactly what I think Mr. Dinalo has on his diner table, and he has a lot! Investment banks, mortgage brokers, mortgage insurers, etc..
-This effects the line of business that I help underwrite, but I know that a lot of municipalities are in the middle of some of the biggest construction/infrastructure projects for the past 50 years. Pipes, our highway's, sewers, utilities, etc. are old and municipalities issue bonds for these projects and use tax payments to payoff these bonds.
-Going back, Mr. Dinalo called Sir Buffett to "start" a bond insurer not to tip him off or to help one of the most brilliant sets of minds but because when there is not a mono-liner that can insure against defaults, you would have a complete shutdown in government projects. I think this is one of the reasons why there is a great arbitrage opportunity in Municipal Bonds, some closed-end funs are selling at 10% discounts and yielding over 5%. Bill Gross hinted this great opportunity at the most recent Barrons Round Table. The yields should normalize, but we have learned that markets can remain indistinguishable in the short-term.
-So, I think some will survive, others will die, and Berkshire will Thrive!

-Banks are also heavily dependent on not seeing these bond/mortgage insurers fail because then they would be left with 100% exposure to (un)structured finance proxies, which are usually levered. How are they levered? well if you have to pay for a default, you have shrunken your capital structure allow for what banks should be doing: LEND.

-This is where it gets interesting, well it's pretty obvious that the insurance market is pretty soft right now, I know that for a fact because of my job. It is soft because of too much capital capacity, but when you have Berkshire which has made some insurance purchases over the past month (ING, Swiss Re, starting the mortgage insurer) you have to ask yourself if he sees a turn. Instead of soft to softer, it could simply maintain this level of softness and still be very profitable. Thankfully, the only two businesses I have been purchasing over the past month has been ORH and FFH, safe and cheap. Further, because this is a credit/liquidity crunch, in the end it is those who stayed away from financial engineering/shenanigans that will profit.



Some say that this most recent quarters write-offs are the last, I'd like to play devils advocate for a second. If you are a bank and write off too much you have just destroyed your capital base/reserve and now can't lend. That is why there have been so many injections of capital within some of the most widely known banks. I think the winners in this whole mess are actually the small regional banks who were to small to mess around with a lot of the structured finance products. We have heard the phrase "Too Big to Fail" over and over referring to Citi, Bank of America, etc. and I'm not going to be bold and say they will fail, but I think the sweet spot is the midget regional banks because they are in fact "too small to fail."

So I guess you know where I am looking for Value: small regional banks and I don't think a soul is watching these, the majority are preoccupied with the big banks trying to pick out who is "too big to fail," I will be looking for the midget banks that are "too small to fail." Moving on...

Businesses I've Talked AboutIn this post, I briefly mentioned some businesses that I was look at, sometimes I like to make updates and revisions so lets begin today with PETS, PFE, SNS.

-PFE- this week they reported earnings, the price is virtually unchanged, and I will stick by what I said:

Interesting yield, very non-cyclical, they say that they will revive their product flow. P/E at depressed levels and if you live in Canada, it makes even more sense because of the currency situation.

-PETS- reported outstanding numbers this, is an outstanding business and I admire this company very much even though I don't hold a position, again I will stick with what I said:

I think this is one of the more interesting businesses out there. Certainly a niche market, ROE above 30%, P/E reasonable relative to growth. They are buying back shares from their 20 million dollar charter. I can't stress how much I like this business, people are married to their spouse and pets. This will never become a 50 billion dollar market cap business, but they have somewhat of a monopoly. No debt, 50 million in cash and will continue to add to it. Definitely has a moat.

-SNS- I had some really negative things to say about this company's management. I do hold an indirect position through my WSZL holding and had considered taking a position to leverage returns, however I'm closer to throwing because of management more than I'm closer in taking a position. They also reported their earnings and I did listen to the conference call and was absolutely appalled by the tone and direction. There is a difference between being stupid and choosing to be stupid while being oblivious to all the facts. Mr. Sardar Biglari wrote a great piece here and management was oblivious to all of his improvements not to mention the analysts. I just don't understand and for that reason I now have two piles: 1)Too hard to understand, and 2)Too ignorant to understand.

I wish Mr. Biglari best of luck and hope he gets his wish for the two seats because SNS obviously doesn't understand what they are doing. I think SNS is in need of an efficient capital allocator and that is exactly what they will get with Mr. Biglari!

I will be flying to St. Paul on Monday until Thursday for business, not pleasure meaning that I probably will not be able to write this week.

Until next time, take care,

S.K.

Shoot First, Ask Second

Busy activity this week.

For anyone that has any "chips" or a vested interest in the market of businesses, there was disappointment this week. I can't say all, but the majority of asset classes had a downward revaluation of business value, some warranted and others unwarranted. When it was unwarranted, it was "recession" issues. Now, I am not surprised with the downward revaluation of some businesses because I have expressed my worries for the past six months and made subsequent purchases of cheap insurance ("puts") on the financials, S&P 500 (because of the 20% weighing from the financials) and the Russell 2000.

This week, I sold to close the puts on the Financials (+750%) and the S&P 500 (+290%) and immediately placed the proceeds in the "pick of the year" ORH. Friday was a great day for this transfer because what I sold was up and what I bought was down. This is as ideal a situation becomes and very thankful the market allowed for this opportunity. When I first mentioned ORH, I stated my intentions to increase the position size from the 12% to somewhere in the 20% range. Because my account is down a little over 4% for the year and the purchases this week, ORH is now my largest holding and represents 25% of my portfolio of business.

Realized to Unrealized

I sold the puts because I believe there was a little too much pessimism. Also, we still have not heard the realized genius moves from the ORH portfolio of CDS. So this move makes a lot of sense to me, especially because ORh has had a downward revaluation recently. At 36.56 you are buying at the same price that management has repurchased shares at, and with $87 million left from their $200 million dollar buyback, I can't imagine why they wouldn't be buying at these prices. In fact, this is utterly unbelievable! So I realized profits and placed proceeds in a business with unbelievable unrealized profit potential. I think you understand by now why I am so intrigued with this offer.

Finally, about two weeks ago I ran into a quote from my primary inside info in the banking industry, CEO of Wells Fargo, Richard Kovacevich who stated "We're buying with both hands" on acquiring triple A rated jumbo mortgages, as the spread they are paying over smaller home loans quadrupled since July to 1.1%. Now I glanced at this quote everyday for the past two weeks and looked at the market action on the sidelines. Could I have been wrong in my action of selling the financials puts, or is it the market that is over-reacting? That is utterly unknowable, but I am happy to have a guy like Mr. Kovacevich's rational as opposed to the now famed "shoot first, ask second" analyst momentum. Where were you 6 months ago?

In my very first post on this blog titled "Cancer and Random Gleanings" I ended with a Mr. Kovacevich quote when he said, "I am not a forecaster of the future; I'm a historian. And history says this will blow up. It always has. And there will be some blood on the street." That was June 2007, this is now, and when he says "We are buying with both hands" he has more credibility!

Thank you and have a great long weekend, unfortunately the insurance industry or my company don't recognize tomorrow as a holiday, so that's it for today.

Take care,

S.K.