Thursday, May 27, 2010

FrontPoint's Steve Eisman's Speech And Presentation From Ira Sohn Conference

This is Steve Eisman's excellent presentation and speech from the May 2010 Ira Sohn Conference on why much of the for profit education space is a short. He specifically talks about ITT Education, APOL, WPO and COCO. He makes the analogy between these business models and the subprime debacle. The first 40 or so pages are the actual presentation and the last several pages are the text of his speech. We recommend reading the speech first, then digging through the presentation. Our notes on Eisman's talk are here.

You may know Eisman from his fame calling the financial collapse and shorting subprime securities as well as many of the links into subprime (e.g., originators, banks, etc.). Michael Lewis profiled Eisman (and Burry and others) in his new book The Big Short.

This whole industry is so dirty, it's easy to see how government regulation is the only way that it is sustained. Munger and others often talk about buying businesses that are good for their whole ecosystem (suppliers, employees, customers, and owners). Much of the for profit education system is actually a shitshow for huge portions of its ecosystem, most importantly its customers. Typically those sorts of businesses can only exist and thrive with the help of government's Visible Fist.

Anyway, read the speech first (near the end of the slide deck) then review the slides. Eisman's speech is titled, "Subprime Goes to College."
Steve Eisman - Ira Sohn Conference - May 2010

David Einhorn Complete Ira Sohn Conference Speech

As we discussed here and here, at yesterday's Ira Sohn Conference, David Einhorn gave a speech entitled "Good News for the Grandchildren" about why sovereign debts, huge structural budget deficits, and debt monetization/QE/quantitative easing will matter for our generation and will have to be dealt with well before our grandkids' time.

It was an excellent speech. Below is the unabridged version. Enjoy. Think gold.

David Einhorn - Greenlight Capital - Ira Sohn Conference Speech 2010 - Good News For The Grandchildren

David Einhorn OpEd: NY Times - Easy Money, Hard Truths

TILB friends know that we have followed Greenlight Capital's David Einhorn for years. A year and a half ago, when he first began to publicly disclose his position in gold, we took note.

As we reported from yesterday's Ira Sohn Conference, Einhorn gave a presentation called "Good News for the Grandchildren" (implying that the debt crisis will manifest itself in our generation, not theirs). In today's NY Times, he basically provided them with a slightly modified version of the speech as an OpEd.

Here is the OpEd from the NY Times. Because it's basically the transcript of a speech he gave yesterday, we provide it below in its entirety. Please support the NY Times, one of TILB's favorite newspaper.
Op-Ed Contributor
NY times
Easy Money, Hard Truths
Published: May 26, 2010

Before this recession it appeared that absent action, the government’s long-term commitments would become a problem in a few decades. I believe the government response to the recession has created budgetary stress sufficient to bring about the crisis much sooner. Our generation — not our grandchildren’s — will have to deal with the consequences.

According to the Bank for International Settlements, the United States’ structural deficit — the amount of our deficit adjusted for the economic cycle — has increased from 3.1 percent of gross domestic product in 2007 to 9.2 percent in 2010. This does not take into account the very large liabilities the government has taken on by socializing losses in the housing market. We have not seen the bills for bailing out Fannie Mae and Freddie Mac and even more so the Federal Housing Administration, which is issuing government-guaranteed loans to non-creditworthy borrowers on terms easier than anything offered during the housing bubble. Government accounting is done on a cash basis, so promises to pay in the future — whether Social Security benefits or loan guarantees — do not count in the budget until the money goes out the door.

A good percentage of the structural increase in the deficit is because last year’s “stimulus” was not stimulus in the traditional sense. Rather than a one-time injection of spending to replace a cyclical reduction in private demand, the vast majority of the stimulus has been a permanent increase in the base level of government spending — including spending on federal jobs. How different is the government today from what General Motors was a decade ago? Government employees are expensive and difficult to fire. Bloomberg News reported that from the last peak businesses have let go 8.5 million people, or 7.4 percent of the work force, while local governments have cut only 141,000 workers, or less than 1 percent.

Public sector jobs used to offer greater job security but lower pay. Not anymore. In 2008, according to the Cato Institute, the average federal civilian salary with benefits was $119,982, compared with $59,909 for the average private sector worker; the disparity has grown enormously over the last decade.

The question we need to ask is this: If we don’t change direction, how long can we travel down this path without having a crisis? The answer lies in two critical issues. First, how long will the capital markets continue to finance government borrowings that may be refinanced but never repaid on reasonable terms? And second, to what extent can obligations that are not financed through traditional fiscal means be satisfied through central bank monetization of debts — that is, by the printing of money?

The recent United States credit crisis was attributable in large measure to capital requirements and risk models that incorrectly assumed AAA-rated securities were exempt from default risk. We learned the hard way that when the market ignores credit risk, the behavior of borrowers and lenders becomes distorted.

It was once unthinkable that “risk-free” institutions could fail — so unthinkable that the chief executives of the companies that recently did fail probably didn’t realize when they crossed the line from highly creditworthy to eventually insolvent. Surely, had they seen the line, they would, to a man, have stopped on the solvent side.

Our government leaders are faced with the same risk today. At what level of government debt and future commitments does government default go from being unthinkable to inevitable, and how does our government think about that risk?

I recently posed this question to one of the president’s senior economic advisers. He answered that the government is different from financial institutions because it can print money, and statistically the United States is not as bad off as some other countries. For an investor, these responses do not inspire confidence.

He went on to say that the government needs to focus on jobs now, because without an economic recovery, the rest does not matter. It’s a valid point, but an insufficient excuse for holding off on addressing the long-term structural deficit. If we are going to spend more now, it is imperative that we lay out a credible plan to avoid falling into a debt trap. Even using the administration’s optimistic 10-year forecast, it is clear that we will have problematic deficits for the next decade, which ends just as our commitments to baby boomers accelerate.

Modern Keynesianism works great until it doesn’t. No one really knows where the line is. One obvious lesson from the economic crisis is that we should get rid of the official credit ratings that inspire false confidence and, worse, are pro-cyclical, aggravating slowdowns and inflating booms. Congress has a rare opportunity in the current regulatory reform effort to eliminate the rating system. For now, it does not appear interested in taking sufficiently aggressive action. The big banks and bond buyers have told Congress they want to continue the current system.

As William Gross, the managing director of the bond management company Pimco, put it in his last newsletter, “Firms such as Pimco with large credit staffs of their own can bypass, anticipate and front run all three [rating agencies], benefiting from their timidity and lack of common sense.”

Given how sophisticated bond buyers use the credit rating system to take advantage of more passive market participants, it is no wonder they stress the continued need to preserve the status quo.

It would be better to have each investor individually assess credit-seeking entities. Certainly, the creditworthiness of governments should not be determined by a couple of rating agency committees.

Consider this: When Treasury Secretary Timothy Geithner promises that the United States will never lose its AAA rating, he chooses to become dependent on the whims of the Standard & Poor’s ratings committee rather than the diverse views of the many participants in the capital markets. It is not hard to imagine a crisis where just as the Treasury secretary seeks buyers of government debt in the face of deteriorating market confidence, a rating agency issues an untimely downgrade, setting off a rush of sales by existing bondholders. This has been the experience of many troubled corporations, where downgrades served as the coup de grĂ¢ce.

The current upset in the European sovereign debt market is a prequel to what might happen here. Banks can hold government debt with a so-called zero-risk weighting, which means zero capital requirements. As a result, European banks stocked up on Greek debt, and sold sovereign credit default swaps, and now need to be bailed out to avoid another banking crisis.

As we saw first in Dubai and now in Greece, it appears that governments’ response to the failure of Lehman Brothers is to use any means necessary to avoid another Lehman-like event. This policy transfers risk from the weak to the strong — or at least the less weak — setting up the possibility of the crisis ultimately spreading from the “too small to fails,” like Greece, to “too big to bails,” like members of the Group of 7 industrialized nations.

We should have learned by now that each credit — no matter how unthinkable its failure would be — has risk and requires capital. Just as trivial capital charges encouraged lenders and borrowers to overdo it with AAA-rated collateral debt obligations, the same flawed structure in the government debt market encourages and therefore practically ensures a repeat of this behavior — leading to an even larger crisis.

I don’t believe a United States debt default is inevitable. On the other hand, I don’t see the political will to steer the country away from crisis. If we wait until the markets force action, as they have in Greece, we might find ourselves negotiating austerity programs with foreign creditors.

Some believe this could be avoided by printing money. Despite the promises by the Federal Reserve chairman, Ben Bernanke, not to print money or “monetize” the debt, when push comes to shove, there is a good chance the Fed will do so, at least to the point where significant inflation shows up even in government statistics.

That the recent round of money printing has not led to headline inflation may give central bankers the confidence that they can pursue this course without inflationary consequences. However, printing money can go only so far without creating inflation.

Government statistics are about the last place one should look to find inflation, as they are designed to not show much. Over the last 35 years the government has changed the way it calculates inflation several times. According to the Web site Shadow Government Statistics, using the pre-1980 method, the Consumer Price Index would be over 9 percent, compared with about 2 percent in the official statistics today.

While the truth probably lies somewhere in the middle, this doesn’t even take into account inflation we ignore by using a basket of goods that don’t match the real-world cost of living. (For example, health care costs are one-sixth of G.D.P. but only one-sixteenth of the price index, and rising income and payroll taxes do not count as inflation at all.)

Why does the government understate rising costs? Low official inflation benefits the government by reducing inflation-indexed payments, including Social Security. Lower official inflation means higher reported real G.D.P., higher reported real income and higher reported productivity.

Subdued reported inflation also enables the Fed to rationalize easy money. The Fed wants to have low interest rates to fight unemployment, which, in a new version of the trickle-down theory, it believes can be addressed through higher stock prices. The Fed hopes that by denying savers an adequate return in risk-free assets like savings deposits, it will force them to speculate in stocks and other “risky assets.” This speculation drives stock prices higher, which creates a “wealth effect” when the lucky speculators spend some of their gains on goods and services. The purchases increase aggregate demand and lead to job creation.

Easy money also aids the banks, helping them earn back their still unacknowledged losses. This has the perverse effect of discouraging banks from making new loans. If banks can lend to the government, with no capital charge and no perceived risk and earn an adequate spread, then they have little incentive to lend to small businesses or consumers. (For this reason, higher short-term rates could very well stimulate additional lending to the private sector.)

Easy money also helps the fiscal position of the government. Lower borrowing costs mean lower deficits. In effect, negative real interest rates are indirect debt monetization. Allowing borrowers, including the government, to get addicted to unsustainably low rates creates enormous solvency risks when rates eventually rise.

While one can debate where we are in the recovery, one thing is clear — the worst of the last crisis has passed. Nominal G.D.P. growth is running in the mid-single digits. The emergency has passed and yet the Fed continues with an emergency zero-interest rate policy. Perhaps easy money is still appropriate — but a zero-rate policy creates enormous distortions in incentives and increases the likelihood of a significant crisis later. It was not lost on the market that during this month’s sell-off, with rates around zero, there is no room for further cuts should the economy roll over.

EASY money has negative consequences in addition to the risk of inflation and devaluing the dollar. It can also feed asset bubbles. In recent years, we have gone from one bubble and bailout to the next. Each bailout has rewarded those who acted imprudently. This has encouraged additional risky behavior, feeding the creation of new, larger bubbles.

The Fed bailed out the equity markets after the crash of 1987, which fed a boom ending with the Mexican crisis and bailout. That Treasury-financed bailout started a bubble in emerging market debt, which ended with the Asian currency crisis and Russian default. The resulting organized rescue of Long-Term Capital Management’s counterparties spurred the Internet bubble. After that popped, the rescue led to the housing and credit bubble. The deflationary aspects of that bubble popping created a bubble in sovereign debt, despite the fiscal strains created by the bailouts. The Greek crisis may be the first sign of the sovereign debt bubble bursting.

Though we don’t know what’s going to happen next, the good news for our grandchildren is that we will have to face our own debts. If we realize that our own future is at risk, we might be more serious about changing course. If we don’t, Mr. Geithner and others might regret having never said never about America’s rating.

David Einhorn is the president of Greenlight Capital, a hedge fund, and the author of “Fooling Some of the People All of the Time.” Investment accounts managed by Greenlight may have a position (long or short) in the securities discussed in this article.

A version of this op-ed appeared in print on May 27, 2010, on page A35 of the New York edition

Ira Sohn Recap

We attended the Ira Sohn conference yesterday for the Tomorrow's Children's Fund. Klarman, Tepper, Arbess, Einhorn, Ackman, Dinan, Robbins, Zell, Eisman, Jacobson, S-Ratt, Grantham, and Niall Ferguson. In summary, this was by far the most macro oriented conference we've ever seen from a bunch of largely "bottoms up" investors.

Below are two sets of notes. One from your intrepid TILB author and the other from BTIG's Mike O'Rourke. O'Rourke writes BTIG's must read "Bedtime with BTIG" every night. While we are not much for technical trading, he provides technical insights and recaps that give a concise, useful review of the day past and preview of the day ahead. In any case, here are the notes. In both cases, these are not exact transcriptions. Also, sadly TILB had to leave in the middle of S-Ratt's brutal pack of lies, causing us to miss Larry Robbins, Bill Ackman, and Seth Klarman. Fortunately for you, O'rourke didn't leave and has complete notes. O'Rourke's notes are first, our's follow.

BTIG Notes - Ira Sohn
Posted on Thu, May 27th, 2010 at 7:17 am
by Mike O'Rourke

This is a summary of ideas expressed at the 15th Annual Ira W. Sohn Investment Research Conference.
The Ira Sohn Research Conference Foundation is dedicated to the treatment and cure of pediatric cancer and other childhood diseases.
NOTE: The notes below were taken in real time, but we apologize in advance for any transcription errors. THESE ARE THE OPINIONS OF THE SPEAKERS, BTIG DOES NOT AGREE OR DISAGREE WITH ANY OF THE STATEMENTS.

Jonathon Jacobson, Highfields Capital Management
Highfields is a long term value investor. Jacobson is worried about the current investment environment. Despite all of the looming macro headwinds the biggest threat is the “Clowns & Climate in Washington D.C.” Several states are hovering on the edge of bankruptcy and we the taxpayers will wind up paying for those losses. The administration has embarked upon a process of rolling vilification of industry after industry, Health Care, financial Services, Energy, Cable, Soft Drink, etc. The perception in Washington is that if someone has done well in this country, it was done at someone else’s expense. Rather than address the issues politicians will continue to “kick the can down the road.” Fundamentals are hard to handicap when the rules are constantly changing.

Jacobson is bullish on Sallie Mae (SLM). The company is currently misunderstood by the market because it is in transition from being a lending based company to a fee based company. The key point is if Sallie Mae were strictly in a run off mode as the government ends cuts back the FFELP program (which they are not) it would be worth $15, even with a conservative 12% discount rate. It currently has a $5 Billion market capitalization and is trading 2x pre-tax, pre-provision earnings and is trading 4x pre-tax earnings. Most competitors have gone out of business or in the process of exiting the business. Jacobson believes Sallie Mae is worth somewhere between $15-$25 per share. In 2011 he is forecasting $0.80 -$1.00 in earnings power. Additionally the company is well positioned to acquire additional servicing rights as competitors exit the business. Sallie Mae is larger than the 3 other government approved student loan servicers combined. Management is acquiring stock and aligning their interests with shareholders. 87% of the balance sheet is funded to term. Credit losses peaked in Q3 2009. Main risk is regulatory, but if management believes the best move for shareholders is to liquidate the company, they will.

Sam Zell
The theme of the election was change. A major change has occurred within the American economy. One party political dominance is changing how investors will act in the future. It is an environment of survival of the fittest. Zell presented a music video that was an ode to Charles Darwin. Extinction is for those who do not adapt and evolve. The winner is the one who builds the better boat, not the one who rearranges the deck chairs. He who adapts succeeds.

Dan Arbess, Perella Weinberg Partners
The foundations of the global economy are shifting. Fiscal imbalance and sovereign risk are only symptoms of the problems that will fuels this change. The trend of deficit spending over-consumption in the west and the export driven production of the east needs to reverse. Consumption in the east must rise and the west must exercise restraint to bring a semblance of balance back. Macro squalls can wreak havoc on a portfolio, so effective hedging strategies are important. The key them Arbess proposed was “Shaking hands with China.” The way to play the theme is to be long those companies who sell China what it needs and short those who make products that the Emerging Markets can make better. Consumption is only 35% of GDP in China, half of what it is here and the Chinese save half of what they make. China alone will increase its urbanization rate from 46% to 58%, adding 210 million urban residents in 70 million households. They need a lot of stuff to urbanize 20 million people a year, and Arbess wants to be long the guys who will be selling it to them.
Arbess believes weaker currencies and weaker sovereign credits should be sold. He is bearish on the Euro and on EU sovereign debt. This is the endgame of the debt supercycle and confidence in fiat currencies will erode, as such he likes Gold. The deflationary economic environment will lead to monetary debasement. The irony today is post-Maoist China has no entitlements and needs to create some to boost domestic consumptions and the U.S. more entitlements than ever.

He likes commodities and the commodity nations in the G-20 and even Africa, both fundamentally and as a currency debasement hedge. He says own junior mining companies that own big assets close to their customers. These will often start out trading at discounts as much as 90% to their cash flow potential, and often show less downside beta than large caps.

Arbess likes Ivanhoe mines (IVN). Its vast copper and other mineral deposits in Mongolia are close to the same size as Manhattan. Noncore assets are worth half of the current market capitalization of the company. Rio Tinto is a key partner of Ivanhoe, and its presence reduces the risk for the investor. Rio recently purchased shares above the current price levels Backing out the coal business and other peripheral assets, the stock at its current price around $13 creates the copper mine at less than $2.5 billion, which is less than half of what it’s worth on an NPV basis, and a tiny fraction of inground metal value, assuming $2.50 long term copper and $1000 gold. At recent commodity prices, Arbess thinks the stock could be worth up to $30 to Rio.

Arbess also noted Solution (SOA) and Celanese (CE) as other ways to play his theme and believes both have 50% upside from current levels. Another name he likes is YUM Brands (YUM) who had 37% growth in China last year. China’s successes of the last 30 years are real and the country is fiscally strong with $2.5 Trillion in reserves and fiscal responsibility. Another play on his theme is shorting the Japanese Yen versus the Canadian Dollar. Japan is shrinking while its debt is growing, exactly the opposite of the urbanizing emerging markets. Canada, by contrast, has arguably the soundest economy in the G-7. No coincidence, they really don’t like leverage up there. And the country is rich in Shake Hands With China resources. This is the end of the buy now and pay later mentality. The global rebalancing process will be messy, but it will also be rife with opportunity.

David Tepper, Appaloosa ManagementTepper started with an anecdote about the horse “output” problem in 19th century New York City and forecast that city would be buried under horse excrement . The moral of his story was “don’t listen to the crap.” Tepper was highlighting that the world changes and evolves and people and societies adapt. Tepper noted that everyone of the “PIIGS” has instituted austerity programs, something many would not have believed would happen. He mentioned the ECB buying debt despite its conservative Bundesbank roots and the Spanish Government shutting down the largest Caja run by the Roman Catholic church. All of these things at one point seemed unthinkable, but this is society adapting to the situation.

Tepper likes the AIG-8.175% Junior Subordinated Debt. It is trading at $0.72 on the dollar giving it a current yield of 11%. Right now there is $73 Billion of capital structure below it $49 Billion in Preferred and $24 Billion in equity. He thinks those two combined are really only worth $40 Billion. He warned that this did not mean the equity is worth zero, there is some option value and a conversion of government preferred into common could distort a capital structure arbitrage if set up. Tepper says AIG has $9 Billion of EBIT and other assets worth $45 Billion.
Tepper noted there are opportunities in the CMBS market. He said what you should really care about in the CMBS market is “Can they make the coupon?” These are 10 year securities and if they can make the coupon you should ask what will the environment be in 2016? You should not be looking at today, you should be looking at the future.

Tepper still likes Bank of America (BAC). He believes normalized earnings are $2.65-$2.70 per share and has a $27 price target. He also likes Banco Santander (STD). it is one of a handful AA rated banks in the world (no major U.S. bank is as high as AA). Only 30% of the banks exposures are to Spain, it is really an Emerging Market/Global play. They will earn $1.50 and that has the potential to double. Tepper concluded noting that 2000 was the beginning of the end and that today we are at the end of the beginning.

Niall Ferguson, Harvard University
Ferguson proposed being “Long virtue.” Focusing on nations with good fiscal situations as opposed to the overly indebted Western governments. Citing Bank of International Settlements long term forecasts Ferguson highlighted Pigs “R” Us. Which means that the U.S. and the U.K. are in equally precarious fiscal situations as the “PIIGS.” Ferguson noted that 40% of U.S. Debt is short term and that type of duration leaves one open to roll risk. “U.S. Debt is a safe haven similar to the way Pearl Harbor was.” Ferguson highlighted the “good boys, ” nations with better fiscal situations. Topping the list was Norway with net debt of -140% of GDP due to the nations effective management of its oil reserves. Other good boys were Sweden, Denmark and Switzerland. The U.S. leaves itself at risk by being highly reliant upon foreign capital.

Steve Eisman, Frontpoint
Eisman’s theme was “Subprime goes to College.” After what transpired in the subprime mortgage market a few years ago, Eisman though he would never see a business with the capability to prey upon the underprivileged to those extremes again. Then he came across the For Profit Education industry. Despite only having 10% of the students these schools get 25% of the government aid. The industry is in bed with Washington due to serious lobbying efforts and the back and forth of executives from the companies to Government positions and back. Title IV loans offered by government programs comprise 90% of for profit education revenues.

ITT Educational (ESI) has higher margins than Apple (AAPL), and margins in the for profit education industry are 3-4 times those in other industries that deal with the government. For profit schools target poorer people, often leading them towards degrees that won’t get them jobs. The companies also maneuver to acquire small failing schools in order to get their accreditation. The loans the students take out for profit education have high default rates. ESI and Corinthian (COCO) often provision 50%-60% for the loans they privately offer, so the default rates overall are likely 50%. The companies in the industry are Education Management (EDMC), COCO, Apollo Group (APOL) and Washington Post (WPO). WPO, more than 100% of its EBITDA comes from for profit education. Eisman calculates there could be $300 Billion in defaults over the next 10 years. The key catalyst going forward is that the government will publish a rule for gainful employment , that threatens the companies. The government is also seeking to fix the accreditation process.

Jeremy Grantham, GMO
IN GMO’s 7 year forecast U.S. High quality names are aberrantly cheap and should provide 7.6% real return per year. In constructing a portfolio Grantham said it should be 40% U.S. Blue Chips, 20% Emerging Markets and 30% EAFE Blue chips. Grantham notes that bonds are “grotesquely” overpriced predicted to post a real return 1.7% per year. Grantham’s 3 choices or recommendations are Timber which has 7.5% forecasted real annual return. Then Grantham likes Emerging Markets which he believes will go to a premium P/E to the rest of the world. Finally he likes high quality U.S. blue chaps. They are trading at a 17% discount to fair value and 55% of earnings come from around the world.

The bedrock of Grantham’s thinking is that “Things regress to the mean.” Of the 34 bubbles GMO has identified it takes about 3.5 years for the bubble to run up and it comes back down to the trendline nearly as quickly. All bubbles reverse. Grantham believes both the U.K. and Australia are in housing bubbles. The risks to betting against bubbles are career risk and business risk. Grantham believes debt has nothing to do with growth, and debt has less influence than most think. Grantham concluded by noting the importance of the upward bias in the third year of the presidential cycle.

David Einhorn, Greenlight Capital
Einhorn’s theme was “Good news for the Grandchildren.” In essence the fiscal challenges of the United States are so severe that they will need to be dealt with before our grandchildren inherit them. Our own future is at risk. Average public sector pay is nearly double that of private sector pay. Public sector workers “Retire to rehire,” and fuel a system that is heading in the same direction as Greece. Einhorn wonders how long will the capital markets continue to let the U.S. keep borrowing. Nobody knows where the line is, not the Government nor the ratings agencies. A credible plan to avoid the debt trap is necessary. Europe is a prequel to what will happen here.

Einhorn is short the ratings agencies Moody’s (MCO) and McGraw-Hill (MHP). Credit rating agencies provide a false sense of security and are pro-cyclical. Einhorn also questioned the validity of the Government CPI data . Citing Shadowstats, Einhorn noted inflation calculated under the 1980 methodology would be 9%, as opposed to the less the 2% it is today. The lower real rates will fuel inflation and bad behavior and create bubbles. This easy policy of bubble bailouts is an unhealthy cycle.
He believe the lower real rates tempts the central bank to monetize debt. As a hedge against this Einhorn is long Gold as well as African Barrick (ABG LN) . ABG LN trades at ½ the value of its peers, 6x Ebitda and with a 10% free cash flow yield.

James Dinan, York CapitalDinan commenced by noting people adapt, markets adapt and animal spirits prevail. Dinan believes large companies are in good shape. Dinan likes Coca Cola Enterprises (CCE). The company is going through restructuring in which Coca Cola (KO) is giving CCE $10 per share and some European bottling assets in exchange for U.S. bottling assets. Dinan stated Europe is a better place than the U.S. for the bottling business, due to less competition. The deal also gives CCE the option to expand its European footprint. After the deal and receiving the $10 per share new CCE will be $15 and trade 10x earnings and 6x EBITDA. New CCE will have 20% gross upside.

Dinan’s next long idea was ING Groep (ING). ING has a global presence as a bank and insurance company. As part of the bailout the company received during the crisis the company must split its banking and insurance businesses by 2013. The company is currently trading at €6.25 which is .6x book value. Dinan believes it can go to 1x book which would make it worth €8.50-€9.20 per share. The life insurance divestiture could be used to pay back the Government bailout, or it could spin out the insurance business. An 8x-10x P/E multiple on the combined bank and insurance company would make it worth €14-€18.

Dinan also sees opportunity in post bankruptcy equities. Currently one he is investing in is Lyondell (LALLF). Currently the stock is trading below its reorganization plan value. Q1 earnings tracked well ahead of expectations especially in the companies commodity business. A sum of the parts valuation gives Dinan a $22-$28 price target.

Steve Rattner
The former advisor to Treasury on the Auto industry restructuring provided a defense for the Obama Administration’s handling of TARP, the Stimulus (EESA), the Stress Test (SCAP) and the Auto rescue. Rattner said the Administration sought the middle ground on most issues and gave examples of the extreme views in each case.
Regarding the Auto industry restructuring Rattner addressed the question of whether the UAW received more than it deserved. Rattner said that Labor was a critical creditor and all stakeholders received more than they would have in an outright liquidation. Rattner noted that in the Chrysler plan the UAW’s VEBA received 40%-50% of what they were owed. In the GM plan VEBA received 84%-92% of what it was owed. In both cases warranty holders, dealers and trade/suppliers all received 100 cents on the dollar. Rattner used this as an example that the plans sought to protect as much franchise value as possible.

Rattner offered what to expect from the Administration going forward. He said the government will remain involved in the Financial sector. He noted taxes are going up. The Administration has avoided protectionism and is leaving business in the industrial and manufacturing sector alone.

Larry Robbins, Glenview Capital Management
Robbins started asking the question of why is the market’s P/E so low. The 3 potential explanations he offered were the “E” is wrong and estimates could be too high, or “the bigger the D.C. the smaller the P/E.”The last reason and one he highlighted was that it is not a math problem, but it is a psychology problem. He note market participants are suffering from Post Traumatic Stress Disorder.
Robbins noted that individual stocks were one of the best ways to tackle an uncertain environment. He looks for stable earnings growth, potential for multiple expansion and positive optionality. Robbins likes McKesson (MCK). He notes earnings are growing at 18% and it is trading under 11x forward earnings. The company proved it is acyclical by posting growth in Q1 2009. Robbins highlighted he expects MCK to have $5.2 Billion of “Dry Powder.” This is a combination of cash and Free Cash Flow expected to be thrown off over the next 18 months. Robbins also likes Express Scripts (ESRX). Earnings are growing 35% and although that won’t be sustainable it will still continue fast growth. Management has been superior over the past decade in retiring stock. The company is trading 14x 2011 earnings and under 13x Free Cash Flow. Robbins next pick was Life Technologies (LIFE) which is in a consolidating and over capitalized industry. The company has a 80% consumable product mix and is trading 11.5x 2011 earnings. Robbins last pick was Fidelity National Information. The company rebuffed private equity takeover attempt because the price was not high enough and figured they could do the same thing Private Equity planned by doing a leveraged recapitalization. The company is tendering to buy $2.5 Billion of shares , or 22% of the outstanding. Robbins thinks they could have done $3.5 Billion but were being conservative. Earnings grow this 15%-23% and the company is trading under 12x 2011 and 10x Free Cash Flow.

Bill Ackman, Pershing Square
Ackman started by outlining how he believed the credit ratings business should be reformed. The short version is NRSRO’s should not be allowed to rate an issue until 60 days after it comes. That would create a buyside environment that would attempt to handicap what the rating should be using market forces. The underwriter would also need the instrument to hold up in the secondary market and therefore is incentivized to make sure it is a quality product. All relevant information should be disclosed to the market and the ratings agency should disclose its model.
From there Ackman went into GGP part two. GGP will be split into two companies GGP and GGO. GGP will have 200 regional malls. It will have a competitive advantage because 80% of the properties will be single property non-recourse financing . Company owns 31% of Aliansce (ALSC3 BZ) in Brazil. GGP is benefitting from the economic recovery. GGO is where GGP’s noncore assets will go. They include housing development land, land in Hawaii, land on the Las Vegas strip and South Street Seaport. Ackman referred to GGO, that he hopes it to be a mini Berkshire Hathaway. Ackman thinks new GGP will be worth $15 and new GGO will be worth $5. He finished by saying he bought 150 million Citigroup shares but did not give his thesis.

Seth Klarman, Baupost Group
Klarman delivered what would be his opening statement if ever called before Congress. Klarman noted that most people on Wall Street operate honestly, ethically and provide good service. It is the land of caveat emptor and transactions should be entered skeptically. When it comes to the complexity of derivatives, the purchaser should know they will wind up overpaying. There is a culture of compliance. He guides his firm with two rules. The Wall Street Journal Rule, don’t do anything you would not be willing to read about in the WSJ the next day. The second is the football field rule, if run to close to the sideline you increase the risk of running out of bounds, instead cut to the middle. Financial Transactions among consenting adults are an important part of the capitalist system. He has a fiduciary obligation to his clients, not his counterparties. Short sellers are the policemen of the financial markets.

TILB Notes - Ira Sohn - these are in reverse order because we were emailing them one by one and I'm too lazy to cut and paste to reorder them.

Steve Rattner - ex Quadrangle, Treasury Car Czar, Lazard.

Reflections on crisis. Necessary and appropriate response to crisis. TARP was critically important. Stimulus package - not perfect but good. Stress Test for banks - restored confidence. Auto rescues (detail to come).

Believes Administration deserves credit for finding the middle ground.

Autos: no private capital available. Would have been chpt 9, not chpt 11. Labor was a critical creditor to these companies. Nothing abnormal about different stakeholders getting different recoveries. Believes every creditor received more than they would have in a liquidation. Doesn't believe they abrogated or changed law.

Put $50B into GM and believe it's investment worth $40B today on paper. Deems that 20% loss a success. [TILB: Conveniently left Chrysler out of that analysis]

I can't stand listening to him any further. No more notes on S-Ratt.

Jamie Dinon - York Capital
Don't think end is near. People adapt, societies adapt, etc. Equities are a good place to be if you're worried about that. Flexible, long duration, inflation resistant (albeit perhaps lagged).

Event driven:
CCE (Coke Bottling) - KO buying domestic bottling assets for $10/share. Left with European assets plus KO's Swedish and Norwegian bottlers. European macro for KO better than US - faster growing due to low penetration, better comptttv position vis a vie Pepsi and other bottling competitio, option to buy KO's Germany business as well as potential for other European assets. 6x EBITDA and <10x earnings for the stub. Comps trade at 8x ebitda and 13-15x. Stub at $15 vs comps implied $20-25. Dual listing catalyst. Safe business.

ING - Netherlands global bank. (All numbers in euro). Had Alt-A problems in crisis. Received Dutch bailout. Forced by EU to split insurance from banking. Sum of Parts: insurance - 30% in developed Europe (assume 0.7x bk in developed markets and 1-2x bk in EM, so overall 1x bk assume). Backing out insurance, €9.30 tangible book for bank. Trades today at €6. Deserves better than book, decent bank. Decent banks should trade > book.

Like post-bk equities. "Resurgence" phase.
Lyondell-Basel - ticker: LALLF came out of bk in April. $9.5B mrkt cap. Below plant value and below rejected bid from Reliance. Bk plan calls for 1.8B ebitda in 2010. Did $0.6B in Q1. Specialities business is rock solid and does 1B ebitda like clockwork and was on track in Q1. So the non-specialty business is crushing it if you back into the projections for that business. Apollo is biggest owner. Sum of Parts is $18-22B. Normalized ebitda $3.5B. Put 5-6x multiple on that and big upside.

Liquidation Play: Icelandic bank Keupthenk (spelling sorry). Claims trade at 23c. 25% Yield to Recovery. Base case 39c. Downside 22c. Upside mid 50s. 7th largest bk in history. 27% market price in cash. Most of the balance is performing loans.

David Einhorn: Greenlight
Title "Good News for the Grandchildren" [referring to passing budget debts to grandkids]

Obama knows what he wants to do on every issue in advance, but he wants to start a blue ribbon commission for dealing with debt w/o promising to actually do anything about it.

This won't be our grandchildrens' problem - it will be our generation's problem. The mount of debt is mind-numbing. Gov't acctng is done on a cash basis, so future promises (unfunded mandates/entitlements) aren't even counted yet.

Rails on average public sector worker situation vs private sector. Ridiculous skew of compensation and job security. Amount of gov't workers has now made them a critical voting block.

Questions: 1) how long will capital markets accept this? 2) how much liability can we pay via central bank monetization?

AAA financial instttns collapsed and nobody saw it coming, even as it became inevitable in retrospect. Think of the implication to gov't.

Using The Administration's 10 year forecast which assumes low rates and robust economic growth shows structural deficits through the whole period (just in time for unfunded mandate costs to kick in).

Should get rid of ratings agencies entirely or at least rid of their govt legislated position. Made fun of ratings agencies using their own quotes (especially the sovereign analysts).

Procyclical ratings agencies will cause problems at the worst moment. Ill-timed (from borrower's perspective) downgrade can serve as a coup de gras.

Zero risk weighting for banks to buy gov't debt will massively exacerbate the problem. Practically ensures the problem will spread fast.

Greenlight still short Moody's and McGraw Hill (S+P).

Monetization likely. May even show up in gov't statistics (sarcastically delivered). Recent bout of of QE not showing CPI ramp may have provided central bankers false confidence.

Shadow Stats says pre-1980 methodology would show 9% CPI today vs 2% govt reported. Lots of other stats on bad govt CPI stats.

[Summary from TILB so far - buy gold]

Low rates drives "wealth effect" by driving up capital market asset prices. This is fake.

Failed banks balance sheets most recent financial statements show solvency despite the huge losses fdic takes upon failure. This is almost certainly also true in "solvent" banks. Easy money policy used to bail them out.

Low rates creating an addiction. Japan can't even accept normalization.

If the emergency has passed, why still have 0% rate emergency policy? Negative consequences in addition to debasement/inflation: bubble inflation [malinvestment risk]. Rips Bernanke, etc.

Fed seems to want to create a new bubble. [Goes through history of Greenspan's bubble machine and into Bernanke's sov debt bubble...]

Gold, African Barrick Gold (ABG). ABG trades at half value on nearly every metric (6x ebitda). Believe catalysts include major index inclusion.

Patrick Wolfe (the guy that plays five people blindfolded simultaneously in chess at Berkshire). Announced the new Ira Sohn San Francisco Excellence in Investing in the Fall. Will be an annual event.

Next up, Einhorn

Jeremy Grantham - GMO
Got out of intense company analysis 20 years ago and into the bullshitting business. So here I am.

7 year forecast updated through May 21. S+P 1.5% pa real, high quality is "aborrently" cheap. Small cap expected return negative. [Long quality/short small crap anyone?]

Bonds grotesquely overpriced. EM 6.1% pa.

Timber is his top pick at 6% real. Didn't lose money through great depression. EM is his second place pick. US quality third. Combination "would make quite an interesting portfolio, I think".

US large high quality at cheapest value ever. "And right when we need them!"

Bubbles always make it back to trend. When you see one, it's time to cash in on some of your Career Risk chips. Avg bubble take 3.5 years to form and slightly faster to return to trends.

Took some time to taunt French and Fama. Made fun of Bernanke.

When you find a bubble, fighting it is incredible pain.

Today's bubble? UK Housing bubble is incredibly massive being supported by variable rate financing (Aussie too). UK housing needs to fall nationwide in price by 33%. Aussie needs to fall 42% to trend.

[TILB - Overall, one of most entertaining speakers]

Steve Eisman - Frontpoint
Subprime Goes to College (for profit education shorting)

Basic short thesis on for profit education. Bad companies, gov't in bed with for profit education, nasty selling habits, etc.

Often gov't grants/loans are 90% of revenue. ITT - 40% op mrgn vs 7-12% for typical gov't contractors. Title 4 has accntd for more than 100% of rev growth. Same for Apollo (growth more than 100% from gov't).
Historically, lower means families seek lower cost instttns. Title 4 inverts this needed relationship - hence the subprime analogy.

Further, the industry doesn't successfully educate their students (on average). Calls out CoCo, Apollo and ESI (ITT). Drop out rates 50-100% per year. Quite alarming, particulalry given student debt that accompanies this. Defaults of gov't guaranteed loans skyrocketing, despite industry obfuscation. When industry makes private loans, they provision 50-60% up front.

None of this matters until gov't cuts them off. Unregulated (loosely regulated) sales practices. Also, schools battle being cut-off by controlling accreditation process (akin to ratings agencies) to stay eligible for govt guarantee loans. BPI example shows how for-profits acquire distressed not for profit schools to get their accreditation.

Gov't looking at instituting new requirements. In particular, a Gainful Employment measurement for grads. Will crush APOL even if cut costs by 15% (40% hit to profit in two years), ESI 50%, COCO 40%, EDMC lose massive money due to debt, Washington Post would go from very profitable to overall loss making.

Believes if nothing is done, on the cusp of social disaster.

Niall Ferguson (Harvard).
No investment experience. Pure academic. Kept accidentally referring to David Tepper (prior speaker) as "Steve." Was an KC yesterday at a Kauffman Conference about Expeditionary Economics. Was hopeful it meant sending Paul Krugman to Somalia.

Believe we should be long "virtue". Even if PIGS cut to austere levels, still will be >100% debt to gdp. Guess what: same analysis shows worse for US and UK. PIGS R US.

Metrics of Doom. Shows cyclically adjusted primary balance: US, UK, Greece and Japan are absymal. Lots of other analysis that keeps showing US is "Out-pigging the PIGS" on all sorts of metrics. All his charts basically show is what won't happen. Problems will explode before them.

40% of US federal debt rolls in next 12 months. Treasuries are a safe haven in the same way Pearl Harbor was. Don't expect to hold a 10 year to maturity.

Shows a list of the Good Boys. Switzerland, Australia, NZ, Denmark, Czech, Australia, Canada, Sweden, Norway, etc.

Good way to diversify away from EM. Some of the same concepts but perhaps less China risk.

Don't argue with nasty fiscal arithmitic. Predicts US has Greece problem by 2012-13.

David Tepper: Appaloosa - 30%+ annualized since 1992.

Spoke at conf in 1998 to 75 people.

Was $13B of AUM last month. Now $12B. Oh well.

Wrote a song but not going to sing it.
Story from 1800s: tells story of horseshit problem that Hance also occasionally shares. Crisis from urban horse "output." Crisis happens, markets adapt, people adapt. Most likely won't be hyperinflation or deflation. The ECB bought govt bonds - the Bundesbank - "holy Christ. it's like the chastity belt is off and the girl is starting to play." The world adapts.

Investment ideas:
AIG - small insurance company (har, har). 8.175 jr sub debt. $4B issue. $24B of common equity. $12B of preferred. $9B of EBIT. Has another $40B of jr debt to his bonds which trade at 72c on dollar. So $70+B of jr securities. Maybe not worth $70B, but probably positive value. Govt owns 80% equity. Do your own work.
CMBS: started investing in late-08. Typical: 30% equity in a property (or 10 eq and 20 mezz). In the mortgage AAA 70%, jr AAAs 10% and then another 8% jr AAAs. Cap rate's not the thing. It's "can they make the payment"? No building going on. Bought an AJ the other day near 20% YTM likely to retire at par. Not looking at today, looking at future.

Equity Market: in 98, talked about Kospi and Samsung and Posco. Not bad ideas at that time period. If you want to make a lot of $ today, financials. BAC will make normalized $2.70. We say worth $27. Santandar (we know people hate it). One of 5-6 banks in world still AA. 30% Spain, majority EM, rest US. Double from here.

Thoughts on the world: thinking back to 97-98 period. History rhymes. Initial sov debt crisis. Lagged by Russia default. Then LTCM. Then Fed eased like crazy and market +50% (begining of end of bull mrkt). Maybe today is the end of the beginning. We know what our troubles are and we can attack them. Won't be that bad either way. Somewhere in the middle.

Sings a quick ditty then says, "I'm done."

Dan Arbess - Perella Weinberg Xerion (restructuring expert - (youngest partner ever at White and Case - led their restructuring group)).
Introduced his son who is a Leukemia survivor (6yrs ago). Loud applause.

Unsustainable global growth model of East lending to West for consumption of its production. World must rebalance. No quick fix. East must consume and West must save. This is bigger than 2008. Fear we and our politicians might not be up to the task. Placid macro backdrop may be gone for balance of our careers (he's probably 45). Success demands we be on the right side of global themes and hedged against dark side of those themes.

Themes we like: shake hands with China (buy what China needs). Short overleveraged Western producers. Hedge debasement (precious metals). Used an example of the West as a boiling frog.

Our nation alone owes China a trillion and a half dollars. Gov't taking over private debts through balance sheet contamination process. Every scenario bad for Euro. Bearish on Euro and Euro sov debt. US Treasuries perhaps short term safe haven, but beware. Confidence in fiat paper will erode. Gold and other precious metals. Prepare for stag-asset inflation.

We need to buy less, eat less and study more. Post Mao'ist China has no social entitlements and we have more than we can afford - it's ironic. Prepare for East to rise up and West to shrink down.

Gov't intervention growing and growing (took an explicit swipe at Rattner who is a speaker later in the day - referncing S-Ratt's pressure when Xerion led the Chrysler Holdouts [as a personal aside, hard to brlieve that was only a year ago]).

Like commodity rich nations (including Africa and jr miners).

Ivanhoe Mines ($13/sh). Owns largest undeveloped copper mine and huge met coal assets. Met coal and other non-core assets worth half market cap. Rio Tinto strategic partner that will own 47% of company. Has bought from $10-16. Down 30% this month. Believe copper mine is implied at half NPV value.

Look for good downstream businesses with big mrkt shares and EM presence. Solutia. Like it a lot.

Even further downstream - EM consumer businesses. YUM Brands. Explosive growth in China.

70% of all products sold in WMT made in China [TILB - wow]. Short high cost leveraged balance sheet G-7 producers.

Doesn't believe in China bubble. Formidable competitive advantage and resource base. True that latest stimulus is inefficient but believe urbanization trend and fiscal situation will drive them through that.

Short Yen vs CAD. Summary: Japan is totally f'd. Canada best G-7 economy.

2008 learned banks aren't safe. 2010 even sovereigns may not be. What's next? American innovation and EM globalization will drive the rest of our careers. Rebalancing will be messy and restorative. Loaded with invstmnt opps.

Sam Zell
No particular stock pitch. Here to tell you thoughts on the environment.
Post election theme of change. We have real change. No doubt. We are going to extremes that will impact investors in the future.
Every year since 1976, I've sent/issued an annual gift that has my thoughts on the next year. Here's what I sent this year:
The Survival of the Fittest (played
Extinction from inabikity to adapt. Shakes out weaker and benefits stronger. Ability to look around the corner and see what's coming. "Charlie...Charlie Darwin...sumpin' smells like fear" [autos, tbtf, swaps, etc. all addressed] "the pie got smaller, who will eat, who will be eaten". "The DNA that will endure is the DNA of the entrepreneur."

"So I guess the message, in less than subtle terms is 'he who adapts will succeed, he who doesn't adapt may not be here next year.'"

Short and to the point. Basically a video of his last music box and the song.

Jon Jacobson (Highfields) Went first because Sam Zell wasn't there yet.
20-30 core positions.
Very worried today. Primarily about the "clowns and the climate" in Washington. 50% of those filing tax returns in 2010 will not pay tax. We will be on the hook for state's liabilities. Administration that is fundamentally anti-business with a rolling antagonism and villification of business. There seems to be something wrong with earning acceptable returns and being successful. Worried about class warfare and social unrest down the road.

As excited about the discounts available today in good businesses as ever. But how do you trust the environment when the rules constantly change.

That said, talking about Sallie Mae. Good underlying biz fundamentals and we understand why it's disliked.

2x pre tax, pre provision earnings. 4x pre tax earnings.
6x net income.

Dealt with refinance concerns. Congress eliminated FFELP in the health care reform bill. Despite that loss, still #1 by far.

Worth $15-25/share. Liquidation/runoff vale $15. By 2011, $0.8 - $1 per share earnings. Potential to acquire servicing rights and improve balance sheet $0-$2+/share ($1/share of earnings power is possible). Biggest, most efficient student loan servicer. Dept of Education has SLM as one of four servicers for Fed direct student loans. Bigger than next 3 combined.

Dominates private student loans. Parents co-sign more than 80% of priv student loans.

Most effective collector of defaulted loans. Biggest mngr of 529 plans.

As FFELP goes away, many smaller student lenders will need to shed servicing as they lose scale. SLM well positioned to buy them.

Mgmt totally aligned. Love mgmt. Co. has retired $6B of unsecured debt at attractive prices in last 12 months. CEO buying with his own money, etc.
87% of balance sheet is term funded. Can easily retire maturities as needed. Appropriately capitalized.

SLM legislation risk. Hard to assess. Every company under attack.
Bank Tax risk. Bankruptcy reform. CFPA could become a regulator. Believe mgmt would literally liquidate if that's the best value per share opportunity.

Monday, May 24, 2010

Inflation Nation - Prepare For The Coming Hyperinflationary Dollar Collapse


TILB has been trying to post less frequently and to have those infrequent posts avoid frustrating topics such as the destruction of our economic and social future. You can understand that.

I've established many times over that nobody cares, so why even keep banging the gong...particularly when it seems I'm banging it with my forehead instead of a mallet?

As an aside, friend of TILB and thief (before I invented it) of the phrase Tooth Fairy Economics Tom Woods makes several appearances in this video as do several other TILB mancrushes like Ron Paul, Peter Schiff, Mark Faber, and Uncle Jimmy Rogers.

This is the best video I've seen since Chris Martenson's Crash Course collection (someday I'll post about that video collection - if you haven't watched it yet, you must stop everything you're doing and spend a few hours watching immediately - link here).

I've been meaning to sit down and write more about the value of money, why price deflation is the natural course of the world (a good thing, btw!), and why not all GDP is created equal, but honestly, it's an emotional drain to reflect on and write about these ideas and it requires more of my head banging the gong. But I'll get to it, because while I'm sure nobody reads this, much less cares, I find the anguish and process of putting myself through it strangely beneficial.

In any case, watch this video and watch the Crash Course. As the great Cypress Hill has warned us so many times, "when the shit goes down, you better be ready...YOU BETTER BE READY!!" Indeed

PS: Please do me a favor and buy some actual, physical gold. It's for your own good.

Tuesday, May 11, 2010

Hayman Advisor's Kyle Bass: The Pattern Is Set

As we've said many times, we hate us some dollar and we hate us some yen even more than the dollar. The euro is an enigma. Other fiat currencies are subject - long-term - to the same issues. That leaves us with gold. Apparently Hayman's Kyle Bass agrees with us. This should come as no surprise to long-time TILB readers as we've highlighted Kyle's work/talks several times.

Below is the text of Hayman's most recent letter to its clients following the European debacle this weekend. TILB's immediate reaction was "holy shit, I don't want to own the euro", in spite of most Wall Street participants claiming this was a great showing of support for the euro. Our view was this "show of support" was more akin to a roadmap for self destruction. The euro's rally than recent retrenchment seems to support our initial take.

We lifted the below text it from First Adaptor's blog (click here for First Adaptor). Make sure to follow First Adaptor on Twitter.

The Pattern is Set - Betting the Bank on a Keynesian Free Lunch by Kyle Bass


Dear Investors:

With the avalanche of announcements over the weekend out of Europe and the IMF (and even the US Federal Reserve), I think it is important to communicate our views. The Lisbon Treaty explicitly prohibits direct monetization of fiscal deficits (i.e. printing money out of thin air in order to perpetuate deficit spending) because central bankers are (or I guess at least "were") aware it is the path to severe inflation or even hyperinflation. Just as the Romans did time and time again, the EU has now decided to change from the rule of law to the rule of man when it suits them. With none of the sixteen members of the currency union forecasted to be in compliance with the Maastricht Treaty (the foundation on which the EMU is built) in 2010, today's actions further attempt to eliminate the natural policing role that markets play with respect to egregious economic behavior. It looks like there will be no consequences for fiscal profligacy... no negative implications for continuing to spend far beyond one’s means... there will be nothing but moral hazard for running massive deficits as member countries can now hold hostage the entire EU (as Greece has done).

The ECB’s monetary policy action simply adds to the moral hazard that was originally created on the fiscal side of the problem. The pattern is now set. This is exactly how very smart people meeting together in order to "solve" a debt crisis frequently (and now permanently, it appears) mistake a solvency crisis for a liquidity crisis. From now on, it seems everything will be deemed to be a liquidity crisis that will be met with more "bail-outs" and debt financed spending. This will eventually break traction in a violent way and facilitate severe inflation or even hyperinflation. The one thing the EU taught us this weekend is that paper money will be worth less (maybe much less) in the future.

Germany weakened itself as it has now abandoned the core bargain of the Euro (which was that they would never be responsible for another country’s debt) by opting to be the largest guarantor of a new loan program that essentially makes European countries joint and severally liable for emergency funds for the worst fiscal offenders in the EU. It has begun a process of ceding its fiscal sovereignty to the over-indulgent countries. I still cannot believe Germany has done this. No wonder Merkel’s government is so unpopular. Meanwhile, I guess that Trichet must have decided on the lesser of two disastrous outcomes for fear that the very existence of their European Union was being called into question. He must have believed this to be the case as it would be the only rational reason to agree to such drastic measures – despite his blanket opposition to such policies just days ago and against the explicit wishes of the Bundesbank, Germany’s central bank.

We believe that there is a “Keynesian End” to the policy du jour that governments can solve all their fiscal and economic problems with more debt and more cross guarantees (aided and abetted by desperate central bankers). We at Hayman believe this theoretical endpoint is reached when debt service exceeds government revenues. Of course, any particular country has certain fixed expenses beyond debt service; therefore, the real endpoint occurs significantly in front of our definition. Outside of Greece and “Club Med” countries, Japan will begin to grace the front pages of newspapers very shortly. Japan has already reached a point where its central government tax revenues are eclipsed by debt service and social security payments alone. Coupled with its debt and demography problems, the world's second largest economy is about to enter a real bond crisis.

Attached is a Bank of International Settlements working paper that I highly suggest you read [TILB - link to referenced working paper here]. Please pay particular attention to the chart on the top of page 11 and remember the numbers you are seeing are as a percentage of GDP and NOT government revenue. This paper takes a very conservative view of interest rates (it essentially assumes they stay flat from the low levels of a few months ago – regardless of changes to debt levels or savings rates) and extrapolates current fiscal projections and even assumes pretty robust global growth. Even in this somewhat utopian scenario, the Keynesian End arrives in many of the world's countries much sooner than is popularly believed.

The competitive devaluation will begin in full force with Japan needing a weaker Yen to grow exports, the US needing a weaker dollar in order to double our exports (under the current Obama plan), and the EU really needing a weaker euro in order to grow their own exports. It is no wonder that Bretton Woods failed so miserably in prohibiting “cheating” via currency weakening. It is also no wonder that the IMF and World Bank were created at that very same meeting in 1944.

We have also attached a chart showing total IMF commitments to member countries as a percentage of each respective country’s IMF quota. The magnitude of the initial EUR 30 billion commitment to Greece trumps all other commitments made throughout this crisis by multiples. This does not even include the EUR 250 billion announced for the broader Eurozone this weekend. By granting Greece more than 30x their quota, they are making a mockery of their own rulebook.

This weekend, the EU and the IMF effectively went all-in with a bad hand in the highest stakes game of financial poker ever played with the world. We believe the agreement released was nothing more than a Potemkin agreement in order to placate bond investors. In the end (and there will be a reckoning for many countries) nations, including the United States, need to dramatically cut spending and get their fiscal balances in order. Unfortunately, our elected officials are on the hamster wheel of electoral cycles and are not able to make tough decisions like this as they would likely not be re-elected without a “sea change” in public opinion towards government spending and deficits. We are therefore on the path to significant currency devaluation around the world that will likely result in significant inflation. We increased our holdings of gold on Monday morning as well as taking other steps to position ourselves for the most likely outcome over the next few years. Interestingly enough, based upon the market reaction in the last 36 hours, it seems the law of diminishing returns applies to bailouts as well.


J. Kyle Bass
Managing Partner
Kyle is clearly cut from the Austrian cloth.

Visualizing President Obama's Budget Cuts

An oldie but a goodie. Lord, I hate our government.