Agora Financial’s Rude Awakening

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Laguna Beach, California

• Brazil vs. Merrill: the greater hazard will surprise you,
• Giselle abandons the dollar, Prince abandons caution,
• Which investor nailed the risk assessment model? And plenty more…

Eric Fry, reporting from Laguna Beach, California…

Which individual possesses superior financial acumen? This Brazilian super-
model?…

Or this American CEO, formerly known as “Prince?”

Here at the Rude Awakening, we’d give the nod to the Brazilian super-model,
Gisele Bundchen, and not merely because she knows how to maximize her
portfolio. She also knows how to avoid obvious risks – a talent that
Citigroup’s CEO, Chuck Prince, seems to lack.
 
Some risks are so obvious, you’d have to be the CEO of a bank or brokerage
firm to miss them. Lending money to people who cannot repay a loan is –
obviously – a bad idea. And yet, most of America’s largest finance companies
spent the last several years issuing obviously bad loans. Other finance
companies merely purchased the obviously bad loans or, better yet, issued
insurance policies against obviously idiotic mortgage-backed securities.

Why did all these well-educated bankers and investors issue and/or buy all
these stupid loans? Because they thought they would get away with it. They
thought they would get away with assuming enormous risks in exchange for a
few extra basis points. But the well-educated bankers were wrong; they did
not get away with it…and their shareholders are just beginning to pay the
price.

“I never understood,” your California editor’s French friend remarked last
weekend, “how so many of my colleagues at work were able to buy houses. They
were just university scientists making $45,000 per year, but they were buying
$450,000 homes. I just kept asking myself, ‘How is this possible?’…It does
not work like that in France, you know.”

“I know,” your editor replied, “and it never should have worked like that in
the U.S. either. But the structure of mortgage-lending industry became so
messed up here in America that everybody wanted to make stupid loans.”

“I don’t see why,” the friend replied. “Why would the banks want to make bad
loans?”

“Because the banks would sell the bad loans to some other sucker immediately
after making them. The banks did not KEEP the loans, they just issued them,”
your editor explained, “and they made a lot of money doing that. So a very
perverse situation developed. Neither the borrowers nor the lenders cared
very much about prudence…or about the truth; they just cared about creating
a new loan. In effect, the borrowers and the lenders were on the same side of
the fence. The lenders didn’t really care how bad a loan might be, as long as
they could sell it to someone else.”

“Ohhhhhh! Maintenant je comprends!” the friend nodded.

Of course, the perversity of America’s late-boom mortgage lending industry
did not merely consist of issuing stupid loans, the perversity also consisted
of issuing hundreds of billions of dollars worth of idiotic mortgage-backed
securities (MBS). Eventually, the REALLY smart bankers began to believe that
they could convert toxic waste into treasure. These folks convinced
themselves that subprime loans could produce AAA securities, just by slicing
and dicing them into various pieces. Eventually, therefore, the REALLY smart
bankers started keeping for themselves some of the stupid loans and idiotic
MBS they should have been selling to someone else.

Thanks to the collective stupidity of these really smart folks, dozens of
mortgage lenders have perished, while dozens more struggle for survival. Even
the massive, too-big-to-fail institutions like Merrill Lynch and Citigroup
are doing their darnedest to fail anyway. Probably, they will not fail…but
not for lack of trying.

On Monday, Citigroup admitted that its private collection of mortgage-backed
exotica might be worth $11 billion LESS than previously imagined. This
massive write-down edges the financial world much closer toward reality.
Unfortunately, as Citigroup, Merrill Lynch and other finance companies mark
their distressed mortgage assets to market, they also shave billions of
dollars off of their capital bases, which incites investor
anxiety…legitimate investor anxiety.

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Super-Models and Super-Investors
By Eric J. Fry

Most of us pay more attention to Brazilian supermodels than to Brazilian
government bonds. But both of these homegrown assets possess stunning
profiles…and both have important messages to share. One says to avoid the
dollar; the other says to avoid American financial stocks. We are inclined to
listen to them both.

“Giselle Bundchen wants to remain the world’s richest model,” Bloomberg News
reports, “and is insisting that she be paid in almost any currency but the
U.S. dollar…When Bundchen, 27, signed a contract in August to represent
Pantene hair products for Cincinnati-based Proctor & Gamble Co., she demanded
payment in euros.”

The Brazilian super-model might not be a super-investor, but several super-
investors share her dollar-phobic perspective. Warren Buffett and Bill Gross,
for example, both suggest selling dollars. “We’ve told all of our clients
that if you only had one idea, one investment, it would be to buy an
investment in a non-dollar currency,” said Gross, the manager of the world’s
biggest bond fund. “That should be on top of the list.”

Warren Buffett concurs. Just a few days ago, the Oracle of Omaha remarked,
“We still are negative on the dollar relative to most major currencies, so we
bought stocks in companies that earn their money in other currencies.”

Super-investor, Jimmy Rogers, is even more blunt: “The dollar is collapsing.”

Of course, Rogers, Buffett and Gross may all be wrong about the dollar’s
plight…which would mean that Giselle would also be wrong. But at least she
would be wrong for good reason. All of these investors are responding to
obvious risks for the U.S. dollar and taking evasive action.

Avoiding obvious risks does not always produce investment success, but it
usually prevents disaster. Giselle understands this principal; Citigroup CEO,
Chuck Prince is learning it.

Despite the obvious onslaught of disastrous trends for the U.S. housing and
mortgage industries during the last two years, Prince thrust his bank’s
balance sheet full-steam ahead into the treacherous mortgage-backed
securities market. What was he thinking? Or more accurately, what was he NOT
thinking?

We may never know. But we know that the recent missteps of Prince, Stan
O’Neal and other star-crossed CEOs have radically rearranged the global
financial hierarchy…Which brings us back to sexy Brazilians – not Gisele,
but the dazzling Brazilian economy.

After several years of robust economic growth, the Brazilian economy has all-
but-erased its reputation as an economic basket-case. Gone are the memories
of chronic corruption and crippling devaluations. The once-pathetic Brazilian
currency is now a paragon of strength and respectability – so much so that
Brazilians prefer their “reis” to our dollars.

Meanwhile, here in the world’s richest country, our multibillion-dollar
credit contagion expands from press release to press release. We would stop
the presses if only it would halt the contagion. But the financial world is
not so configured.

For the first time ever, therefore, investors consider Brazilian government
bonds safer than Merrill Lynch bonds. According to the relative pricing of
credit default swaps (CDS) on Brazilian government debt versus Merrill Lynch
debt, the reeling American brokerage firm is a riskier credit that the
resurgent Latin American economy.

[CDS are a kind of insurance policy against a bond default. The greater the
perceived risk of default, the more expensive the insurance - i.e. the CDS -
would become. Declining CDS prices, therefore, would indicate declining
anxiety about a potential default, whereas rising CDS prices would indicate
rising anxiety about a potential default.]

Buying five years of protection against a Brazilian default used to cost much
more than buying five years of protection against a Merrill Lynch default.

But now that Brazil has become as crisis-free as the U.S. financial sector
has become crisis-prone, CDS prices have flip-flopped. Merrill CDS prices
have jumped above those for Brazilian government debt! In other words, CDS
buyers consider a Merrill Lynch default more likely that a Brazilian default.

Maybe CDS investors have got it all wrong…or maybe the U.S. finance sector
is in much deeper doo-doo than most investors believe. The “doo-doo”
interpretation seems more plausible.

CDS pricing is not necessarily indicative of future trends, but neither is it
NOT indicative. For example, after presenting the following chart in the
March 14, 2007 edition of the Rude Awakening (”Credit Default Swaps…and
You”), we advised, “Sell the mortgage lenders…Finally, investors are
beginning to recognize that the unfolding mortgage-lending crisis might be
something more than a fleeting annoyance…

“Now that companies like New Century are perishing,” we concluded, “and the
nation’s largest banks and brokerage firms are warning of possible ‘mortgage-
related charge-offs’ demand for CDS protection is rife. Demand for put
options on mortgage-lending stocks is also very robust. As a result,
insurance ain’t cheap. Then again, how often do you get the chance to buy
fire insurance when you’re house is already ablaze? If the bond market is as
smart as she usually is, this inferno might blaze for a while longer still.”

And indeed it has. The mortgage-lending conflagration has consumed hundreds
of billions of dollars worth of asset values, both in the real estate market
and in the mortgage-backed securities market. At the same time, the
conflagration has scorched the careers of a few finance-company CEOs, torched
the U.S. dollar and threatened the viability of numerous enterprises.

An updated version of CDS pricing for Pulte Homes, Washington Mutual and the
Russian government shows that the market has become even more anxious about
homebuilders and mortgage-lenders. Pulte Home CDS cost five times more than
Brazil CDS. A contrarian investor might infer from these pricing extremes
that the time has come to buy Pulte and sell Brazil. Perhaps the contrarian
would be correct.

But a chicken investor would conclude that the time has come to accept the
verdict of the CDS market and avoid stocks like Merrill Lynch and
Pulte…even though they have already suffered mightily. A chicken would
infer that the time has come to avoid obvious risks and play it safe.

Cluck…Cluck.

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Rude Endnote: We apologize to all those readers who receive their emails in
text and were therefore unable to view the aptly illustrative picture
featured in the column above. For a look at an extensive catalogue of Chuck
Prince images, click here.

Cheers,

Joel Bowman
Rude Awakening