|11-07-2007, 02:03 AM||#26|
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Join Date: May 2001
How many of you have stepped up to the plate in recent trading sessions and bought shares of Citigroup?
You say you don't follow the crowd. You say that your favorite quotation is Nathan Rothschild's famous phrase that the time to buy is when the blood is running in the streets.
Well, now may be just such a time.
At least that is what I conclude by reviewing the advice of several of the contrarian newsletters that I monitor.
The blood of Citigroup Inc. (C:Citigroup, Inc
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C 35.08, -0.82, -2.3%) has definitely been running on Wall Street over the past few days. A brokerage downgrade of the company was blamed for the 362-point plunge in the Dow Jones Industrial Average ($INDUow Jones Industrial Average
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$INDU 13,660.94, +117.54, +0.9%) last Thursday, for example. And the stock fell another 5% on Monday, following the resignation over the weekend by CEO Chuck Prince and the company's announcement that it would take at least $8 billion in new mortgage debt-related write-downs. ( Read full story.)
One newsletter editor who definitely is buying in the wake of Citigroup's blood running in the streets is John Dessauer, editor of the Investor's World newsletter. In his most recent hotline, written last Friday night, Dessauer had this to say about the company: "The fact is that Citigroup is one of the most profitable companies in the world, earning $21.2 billion last yea r... Earnings estimates for 2008 have been reduced but are still ... well above (what is) needed to restore capital ratios and eliminate speculation about a dividend cut ... Take advantage of the negative speculation. Citigroup is a Buy."
Kelley Wright, editor of Investment Quality Trends, agrees. In his most recent issue, he draws an analogy between Citigroup's current travails and those that plagued Altria Group (formerly Philip Morris) earlier this decade. Wright reminds us that, in 2003, Altria Group Inc. (MO:altria group inc com
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MO 72.94, +0.58, +0.8%) "was deeply undervalued ... because of a $10 billion judgment against the company. The judgment, which could have effectively put the company into bankruptcy, was eventually overturned but not before the stock slid to $28 a share with a dividend yield of 10%! We initiated our largest position ever in Altria and today the stock trades in excess of $73 with a $3 dividend and a current yield of over 4.0%."
Wright acknowledges that the crisis in which Citigroup currently finds itself might prove to be different than the one from which Altria was able to recover. After all, he points out, "the Wall of Worry is a constant Wall Street companion." But, like previous crises, Wright is betting that, "this too shall pass."
These two editors turn out to be in good company in endorsing Citigroup's prospects. Among the investment newsletters monitored by the Hulbert Financial Digest that have beaten a buy-and-hold in the stock market over the last decade on a risk-adjusted basis, Citigroup is tied for 14th most popular.
Mark Hulbert is the founder of Hulbert Financial Digest in Annandale, Va. He has been tracking the advice of more than 160 financial newsletters since 1980.
|11-07-2007, 03:48 AM||#27|
Join Date: Oct 2003
Here read this...read between the lines
lot better things to invest in than Citi.regulators will becoming down on the banks especially after the elections
When JPMorgan Chase, Citigroup and Bank of America last month announced a plan to bail out the structured investment vehicles that are at the core of the credit freeze, one might have expected the markets to take heart. After all, the 400 billion in SIV assets are possibly the biggest weight on the credit markets. If the banks weren't forced to sell these assets into the secondary market or write them down substantially, could life return to normal?
But almost as soon as the plan was leaked, the limits of this latest bit of financial engineering became obvious. "As several leading hedge funds have halted investor transactions because assets of this type cannot be valued by anyone, how can these SIVs fairly transfer assets to this new vehicle?" asks John Taylor Jr., chief investment officer of 12 billion hedge fund FX Concepts, noting that the plan is also "fraught with issues of self-dealing and conflicts of interest."
So the problem remains. No one really knows what things are worth in the structured credit market - and the fear is that many of these products are worth a lot less than anybody wants to admit. "The cynics among us are still worrying if the investment banks are properly valuing, or marking, the falling value of their loans and loan commitments. And in conjunction with this, many investors are still trying to ascertain what they actually own and how to value it," wrote Chad Yonker of Litchfield Capital Management, a 140 million equity long/short shop, in the firm's Sept letter to investors.
The current valuation issues are so serious that they are being addressed by high-level groups of hedge fund managers and investors at the behest of the U.S. Treasury and the President's Working Group on Financial Markets. Some of the biggest names in the industry will be involved in the asset managers' committee, including Eton Park Capital Management's Eric Mindich (who heads the group) and executives from D.E. Shaw Group, Och-Ziff Capital Management, Avenue Capital Group, Highfields Capital Management, Ellington Management, Cantillon Capital Mangement, Silver Point Capital and Reservoir Capital Group.
This is not the first time that valuation has been a source of problems at hedge funds. Improper pricing has often been at the heart of hedge fund frauds and meltdowns. Valuation of illiquid securities, which have become a bigger and bigger portion of the investment universe, has long been suspect. But as long as the buying frenzy continued, there was no problem: It was easy to mark these securities to market when buyers continued to bid them up. But if there is no market - that is, nothing is trading - then it becomes more difficult. Is the halt in trading or refusal to mark to market just an unwillingness to avoid the bitter truth?
Some hedge fund managers argue that there is a market, at least in certain kinds of structured credit, and that that's how they are valuing their holdings. "Just like in corporate CDS [credit default swaps], every dealer sends you daily marks [for asset-backed credit default swaps]," says J. Kyle Bass, manager of Hayman Capital Partners, whose fund has profited handsomely from shorting the subprime market. But it's certainly convenient not to mark to market for those who are long mortgage-backed securities (MBS) or collateralized debt obligations (CDOs). Bridgewater Associates estimates that the assets banks are hard-pressed to get rid of are down 15% or more, "which would make taking these losses harder to stomach."
"There are prices to all these securities," says one hedge fund manager. "What people are saying is, 'We don't like the price.'"
The alternative to marking to market is to "mark to model," but there is much debate over how close to reality such models might be in the structured credit market, given that the models are based on historical assumptions for a market that is only a few years old and has never been tested in such a troubled environment. They're also subject to individual interpretation. Warren Buffett, chairman and chief executive of Berkshire Hathaway, has referred to "marking to model" to value structured credit in the current environment as "marking to myth." Adds one manager: "If the model says something is worth 96 and the best price is 86, then the price is 86."
If managers are throwing up their hands and refusing to value their portfolios, marking to model or smoothing returns by fiddling with the numbers, investors can get a raw deal. A new accounting standard for pricing illiquids that goes into effect in January could help matters somewhat. But there's no assurance the worst is over. The looming resets on adjustable-rate mortgages are causing concern about delinquencies and defaults, and some managers are anticipating a large-scale downgrading of asset-backed collateralized debt obligations - both of which are expected to cause forced selling. In truth, nobody really knows just how bad it will get. Ultimately, current valuations could prove meaningless.
The poster child for valuation woes this cycle is 5.5 billion Ellington, which in late September told investors it was suspending redemptions and subscriptions for two of its funds holding subprime mortgage securities. The reason? Pricing difficulties. Mortgage powerhouse Ellington took that action in New Ellington Credit Partners (NECP) and New Ellington Credit Overseas (NECO), which together have around 1.9 billion in assets. In a letter to investors, the firm explained that its inability to determine the net asset values for certain subprime mortgage securities was due to little or no trading in these securities, particularly those with low credit ratings or no ratings at all.
Such valuation difficulties mean that Ellington's marks in July and August, as well as the dealer marks it will be receiving for September, may not differ from each other and may fail to reflect actual transaction prices once normal trading resumes. As a result, losses could be greater or less than reported. In August, Ellington's composite returns for NECP and NECO were -6.41% in July and -2.47% in August, taking the composite to -6.74% for the year.
THE PIG IN THE PYTHON: MAJORITY OF SUBPRIME RESETS CONCENTRATED OVER NEXT 18 MONTHS
Source: Barclays Capital Research
Pricing problems such as those encountered by Ellington make it difficult to ensure that investors - new ones, departing ones, and those who remain in the fund - don't get burned. Subscriptions and redemptions are based on a fund's net asset value at the time. If, for example, a fund's net asset value is inflated due to gains of 5% being reported for the month, rather than 5% losses, a new investor would be overcharged while one liquidating his position would take more off the table than he's entitled. Meanwhile, investors who stay in the fund would be left with less. That creates an incentive for investors to leave.
Hedge fund performance and management fees also are based on the fund's valuation, creating a conflict of interest for managers pricing their own portfolios. Any overstatement of returns, intentional or not, is likely to affect investor perception of future performance as well.
Hedge funds that invest in structured credit may be the most prone to subjective valuations and most at risk of manipulation by managers, according to risk management solutions provider Riskdata. In fact, the firm found that 30% of the 1,000 hedge funds it surveyed that trade these illiquid securities are smoothing returns and, therefore, lowering perceived volatility. Investors using simplistic measures of valuation to decide whether to invest or to remain invested, such as Sharpe ratios or simple volatility measures, would view the fund as less risky than it is, says Olivier Le Marois, Riskdata's chief executive.
Uncertainties about valuation can cause a financing squeeze - as happened at Bear Stearns in July. "For those [repo] financings that involve subprime positions, the pricing uncertainties and volatility could lead to sudden margin calls," said Ellington in its third-quarter earnings' letter to investors, but it assured investors that "for the time being, dealers have generally been renewing our existing repo financings."
Ellington is the first U.S. fund to throw up its arms and say there is just no way to price structured credit referencing subprime mortgages reliably in the current environment. The firm says it reaches its "estimates of fair value by taking into account a number of factors including: extrapolation from quarter-end valuations using our models, dealer indications when we have them, observable transactions, and ABX index values" to determine NAV on off-quarter months. "The values of our funds are determined at each quarter-end based, in large part, on independent third-party dealer marks."
In Europe, BNP Paribas Investment Partners briefly suspended the calculation of net asset values for three of its asset-backed money market investment funds in August, along with subscriptions and redemptions. "The complete evaporation of liquidity in certain market segments of the U.S. securitization market has made it impossible to value certain assets fairly, regardless of their quality or credit rating," said the firm in a statement. At the end of August, the firm reopened the three funds, despite continuing difficulty in obtaining market prices, as a result of having developed a pricing mechanism that combined several valuation methods, according to Absolute Return's sister publication EuroHedge.
So what are other managers doing? A recent survey by Greenwich Associates found that 80% of investors around the globe who are active in asset-backed securities and CDOs have found it more difficult than usual to get dealer price quotes. Investors in mortgage-backed securities found it slightly easier to get quotes than investors in collateralized loan obligations. Nearly two-thirds of those active in MBS struggled to obtain dealer quotes versus nearly 80% of CLO investors. While there are designated market makers for these securities, "they can always say 'no price' or give some indicative level," says one CDO trader.
In contrast to Ellington, a number of hedge funds - particularly those that have profited from short positions - still believe it's possible to mark certain structured credit positions to market and are committed to running their portfolios based on these valuations. One example is Hayman, which runs a global special situations fund and jointly manages a subprime fund with Corriente Capital Management. Both have large gains on short U.S. subprime residential mortgage-backed securities bets through CDS positions. "Our entire portfolio is marked by the dealer that we have the most positions on with," says Hayman's Bass. He says that every month Goldman Sachs marks every position, including those with other counterparties. In addition, "there's a screen market for a lot of this stuff [that is, ABS CDS for managers to use when marking to market], even if spreads are wide," he says. Hayman's special situations fund gained 0.46% in September, which means it is up 156.98% for the year (Bass declined to comment on performance).
Structured Portfolio Management is another beneficiary of subprime short strategies. The 700 million hedge fund began shorting the market in February and uses market prices obtained from dealers to mark its MBS portfolios. "We go to the dealer and live with what they tell us, and we always have," says Chief Executive Donald Brownstein. He admits these prices are of limited value in some cases. "A lot of dealers have no idea where they [certain structured credits] trade because they [certain securities] are not trading, but that does not release us from the responsibility of using dealer marks." SPM's MBS Composite Fund, with $130 million in assets, gained an estimated 2.5% in September, taking it up to about 20% for the year. The subprime MBS fund, launched in February, has $25 million in assets and was up an estimated 7% in September and more than 120% for the year through the third quarter.
While marking MBS to market can be difficult, marking asset-backed CDOs to market is almost impossible, according to some managers. "For CDOs and CDOs squared, you have to lick your finger and stick it in the air because nothing is trading," says Hayman's Bass. One billion-dollar multistrategy shop admits it's steering clear of CDOs altogether because it's "almost impossible to value a CDO. Until defaults run through the CDO structure, you don't know exactly what's in them."
The only party that knows precisely what's in a CDO is the originator, who is not obligated to help managers mark their positions or provide liquidity for the security once they've bought it.
There is also a lack of appetite and potential conflict of interest for dealers holding similar assets on their books. Many of the large broker-dealers already have written down their structured credit holdings. For example, Merrill Lynch announced in October that it would write down about $7.9 billion in its fixed-income trading business for the third quarter due to the depressed value of CDOs and subprime mortgages. Citigroup, Deutsche Bank and UBS also took credit-related hits.
As such, many dealers are not interested in trading these securities. Why? If the dealer bought them at a discount to the price at which it has marked the securities it already holds, it would be forced to write down its entire portfolio, say market participants.
Some dealers are now asking whether a pricing request is for an actual asset sale or merely for portfolio valuation purposes. This seems to indicate that the dealer would provide only a somewhat hypothetical price for valuation purposes when the price may be lower if he intended to buy it.
When it's difficult to get a market price, managers resort to "marking to model." That's fraught with difficulty too, as such an action may reflect what the manager believes its assets are worth but not necessarily what the market is willing to pay for them. These models vary from shop to shop, and valuations are based on assumptions, such as expected future cash flows and the probability of default, that are at the discretion of managers and thus leave room for manipulation. "If you're marking to model, you're making everything up," says Bass. "We don't mark our portfolio on our expectations."
Others take a more flexible approach. Charles Smithson, CEO of risk management consultant Rutter Associates, believes it is better to use a blend of market and model to mark positions when dealer quotes are unavailable or unreliable. "If you have a transaction price in an illiquid market - that is, the market is somewhat stale - you'd probably still prefer the market price to a model price, but it depends on how stale the prices are," he says. "If it's one day, it's okay, but if it's six months, then it's probably not."
One thing that might help is a new accounting rule, FAS 157, which must be adopted by hedge funds by January. FAS 157 requires managers to provide a greater degree of transparency about the way in which securities are being valued and demands that valuations be based on each security's market, or "exit," value rather the historical cost of the security to reflect the realities of market behavior.
Under the new rule, hedge funds have to report the fair value of their holdings using a hierarchy that enables investors to distinguish between assets marked to market and those valued using models and market-based assumptions. Assets that can be valued using unadjusted, quoted prices for identical assets in active markets, such as equities and government and agency bonds, will be classed as "level one." Securities such as certain MBS, which can be priced using observable market data in less liquid markets, would fall in "level two" under FAS 157. "Level three" securities are those for which there is little or no observable market data, such as for certain CDOs, which are valued using models and best judgment about the assumptions that marketplace participants would use to value the same securities.
While FAS 157 will provide a greater degree of disclosure and transparency for investors about the pricing of a fund's securities, market participants note that it won't prevent managers from using a degree of discretion when it comes to pricing illiquid securities.
That's why many managers and investors say that independent valuation - by a party other than the hedge fund firm itself - is the best insurance against manipulation of returns. In a recent study of 4,286 hedge funds, researchers found that some managers fudge returns to avoid reporting losses when possible. "Using one proxy...we estimate that 10% of hedge fund monthly returns are distorted," says Nicholas Bollen, a professor at Vanderbilt University who co-authored the study. But this is mitigated when returns are closely monitored by an independent party. That is, embellishment was not detected in returns when they were audited.
This is not something all hedge funds do on a regular basis. "From my conversations with managers and investors, there's a large degree of variability in terms of the frequency of audits," says Bollen. "From the data that are available, there are some funds for which it is unclear whether they are ever audited," he adds.
Another way to get an indication of price levels is to look at repo financings. "If it's a recent transaction, it shows what people are willing to lend at," says Art Tully, co-head of the global hedge fund practice at Ernst & Young.
Managers who have profited from being on the right side of the subprime bet also believe that the controversy over valuation boils down to this: the market just refusing to price in the additional mortgage-related carnage that lies ahead. "The market, in my opinion, has not settled on an appropriate price level for different bonds," says SPM's Brownstein.
In fact, this is precisely what some funds are banking on. A number of firms that launched distressed funds in recent months have yet to deploy their capital in anticipation of a forthcoming fire sale. "I still think there's a lot of inefficient pricing in the marketplace," says Bass. "There's plenty to do."
One of the key uncertainties currently affecting pricing is the number of home mortgage holders - and not just subprime borrowers - who will be able to make repayments, especially with a potential recession and adjustable-rate resets looming. At the end of 2005 and the beginning of 2006, house prices peaked and the largest volume of subprime mortgages were issued with the lowest underwriting standards. These are due to begin resetting this quarter, with the bulk due to reset over the next 18 months. "Approximately $414 billion of ARMs are scheduled to reset through 2009, with the monthly dollar volume through 2008 averaging about $19 billion," according to the securitization research team at Barclays Capital. In addition, there is a question whether the defaults and delinquencies will be so significant that investors holding senior tranches will be affected.
Managers who have done well in subprime investments so far believe that there will be a large-scale downgrading of mezzanine CDOs in addition to the MBS downgrades already happening. If senior tranches are hit, it would lead to the forced selling of these tranches by investors, such as pension funds and central banks around the globe, which can only hold highly-rated paper. "I predict that these tranches of mezzanine CDOs will fetch bids of around 10 cents on the dollar," says Bass in a recent letter to investors. "The ensuing horror show will be worth the price of admission and some popcorn."