Ugly Employment Report

The US shed 533,000 jobs last month and the unemployment rate hit 6.7%.  This is the worst employment report I have ever witnessed and indeed the US hasn't lost jobs at this pace in over 30 years.  163,000 of the job losses came from the goods-producing industries, with manufacturing firms cutting 85,000 jobs.  Construction employment was down 82,000 and the service-sector lost 370,000 jobs.  If that weren't enough, the prior month was revised down from 240,000 to 320,000 job losses.  Unsurprisingly, the market is unhappy with these numbers as it confirms that the current recession we are in will be incredibly painful.  Hopefully, our lawmakers are paying attention and can find a way to keep the US auto industry out of Chapter 11 (unless it is a government financed pre-pack) as the loss of our manufacturing sector would be devastating.     

Treasury Working on Another Mortgage Scheme

The Treasury Department tested out another mortgage scheme, concocted in a panic, by leaking it to the press.  The plan is aimed at "revitalizing the US home market."  Details are sketchy, but it has something to do with lowering mortgage rates to 4.5% for buyers who can qualify for a conforming loan from Fannie and Freddie.  Only those who can document their income, and afford the monthly payments will qualify.  The fact that the Treasury has to make the clarification that people who cannot afford a mortgage will be excluded from the plan, gets to the heart of the Treasury's problem.  It is why, so far, no program that lawmakers have initiated has accomplished much more than averting a total collapse of the financial system.  In every speech I have heard Mr. Paulson deliver, he continues to stress that the root of the credit crisis is the correction in the housing market.  Sure, the correction in home values has caused significant damage, but it is merely a symptom of the real disease, which Mr. Paulson has completely misdiagnosed.  The root of the credit crisis was a period of lax lending and stupidity by the credit markets, where standards for lending versus all sorts of assets were lowered to unsustainable levels.  Easy lending led to inflated asset values which were not supportable by fundamentals.  This is precisely why the commercial real estate market is also collapsing, because buying properties for a 2.5% cap rate, which was customary in heated parts of the country, is moronic.  It does not make financial sense when you are borrowing at 6.5% to finance the purchase and putting in little equity.  Asset values are now in a free-fall and they aren't going to stop declining until the fundamentals make sense for buyers.  Sure credit is tight right now, but a credit-worthy person who can put 20% down and can afford the monthly payments can get a mortgage.  Maybe the government should stop trying to prop up housing values with crazy financing schemes, and just start buying houses in bulk at huge discounts from banks's REO departments, do slight renovations, and convert them into housing for veterans, or poor people.  Sounds crazy, but possibly not any crazier than anything else that has been proposed.     

Hedge Funds Overwhelmed by Redemption Requests, Uh Oh

Speculation has mounted in the past month about the number of hedge funds that would be forced to close their doors due to poor performance.  Hedge funds were supposedly bracing themselves for record redemption requests from investors by hoarding cash.  Noted hedge fund managers, such as George Soros, were making dire predictions about the industry shrinking drastically.  Now that the year-end is upon is, it appears as if the shrinkage may have been understated.  The past couple of days have been littered with headlines announcing that large hedge funds had halted redemptions due to an overwhelming amount of requests for capital withdrawals.  What's even more curious is that hedge funds with relatively decent performance have had to act to halt redemptions in order to keep from penalizing the investors that wish to stay in the fund.  Yesterday's announcement by Tudor Investments of its intent to halt redemptions was a bit of a surprise.  Tudor investments was only down 5% so far, a screaming outperformance of just about every single asset class with the exception of John Paulson (Paulson is his own asset class.)  Redemptions in Tudor Investments were halted so that the firm could avoid having to dump all of its liquid assets and leave its loyal investors holding a bunch of illiquid crap.  Perhaps the securities were liquid at some point, but not anymore, which begs the follow-up question: Is the fund really only down 5%?  

Today brought a string of similar headlines from hedge funds.  Fortress halted withdrawals from its global macro fund after it received requests for $3.51 billion, or nearly 50% in withdrawals.  The Fortress Global Macro Fund might ring a bell to my regular readers.  Back in August, I wrote about the manager of that fund receiving a $300 million share grant from Fortress, to keep him from leaving when the fund was already down 12% on the year.  Equity holders in FIG who may have been irritated at being so heavily diluted just to keep someone "motivated" can at least take some comfort in the fact that his $300 million grant is worth a heck of alot less today.

Dealbreaker had post after post today of funds posting lousy performance numbers and announcing halting of redemption requests, names including Farrallon and Highbridge, two of the largest and most well-respected funds in the hedge fund community.  I shudder to think of what we're going to hear in the redemption department from Citadel, which was already down nearly 40% on the year.  

All of this frantic pleading for a return of capital makes me ponder who wants their money back and why?  In particular, why all the redemption requests from funds that have performed reasonably well?  The obvious suspects are the pensions and endowments that have contributed to the hedge fund boom of recent years by increasing allocations towards alternative investments.  Clearly they are getting killed and need to raise cash to meet obligations as the value of all of their investments has fallen across the board.  If that is the case, then really, the hedge fund redemption frenzy will probably be over by year end.  Lots of shops will close, and those that are still standing will be able to buy assets on the cheap.  What concerns me is that the answer is far more ominous.  It's possible that many of the redemption requests are coming from rich people who are blowing out.  One of the things about this downturn that has been somewhat interesting is the number of very wealthy people that have been forced to liquidate stock holdings because of excessive personal leverage (Sumner Redstone and the CEO of Chesapeake to name two that come to mind.)  While it may be the case that wealthy investors are pulling money from hedge funds because they are worried about the market and the economy, it may also be the case that they really need the money.  Perhaps they got a little over extended, they have loans to repay, can't sell any one of their houses, have watched their stocks crater, have contemplated selling the family jewels, and frankly, they just NEED SOME CASH.  I suspect that a nice Fannie Mae conforming loan with a 4.5% interest rate is not even going to begin to solve their problems.          

       

Merrill Lynch Has Trouble With Math

A Bloomberg story this morning claims that Merrill Lynch is said to be cutting bonuses by 50% this year.  I'm sure that headline was meant to be eye-catching, so that readers are shocked by the huge haircut Merrill's bankers will be forced to stomach.  What caught my eye, however, was the fact that Merrill's revenues dropped 96% in the nine months ended September 2008 from a year earlier.  Investment banks generally pay out 50% of revenues as compensation.  Something about the math here doesn't really add up.  Revenues shrink by 96%, the firm loses over $20 billion, nearly fails, and is forced to merge and get various bailouts from the government.  Yet somehow, Merrill is only reducing bonuses by 50% from last year, which was a record year for pay?  The article clarifies that bonuses account for the bulk of a year's pay for most traders and investment bankers.  While that is certainly true, we are talking about people who have base salaries of $150,000 or so, and then receive bonuses of like $650,000.  Let's not be mistaken that anyone here is working for commissions alone.  So while our lawmakers argue over putting GM out of business, the recipient of $10 billion in cash from Mr. Paulson and multiple billions in loans via Mr. Bernanke, is busy handing out bonuses.  Nice.    

AutoMakers Plead For Government Funds: Take Two

Today was a very good day to make a case that the US auto industry needs a government bailout. November car sales were flat-out horrendous.  Even Toyota had a year-over-year decline in sales of 34%.  Ford outperformed the competition with a mere 31% drop.  GM saw sales plunge 41% and Chrysler won the prize for worst sales performance by an automaker with a wrenching decline of 47%.  Overall, the industry sold about 34%, or 400,000 fewer vehicles, in November 2008 than it did a year ago.

Both GM and Ford presented turnaround plans to Congress today.  GM requested a total of $18 billion in federal loans, stressing that it needed an immediate injection of $4 billion to stay afloat until the end of the year.  GM's situation is the most precarious as it will likely be forced into a Chapter 11 bankruptcy filing before Christmas without government funds.  The automaker began discussions with bondholders in an attempt to cut its debt load by $30 billion by swapping debt for equity in GM.  GM will also attempt to restructure obligations to a UAW health-care trust set to begin paying benefits to retirees in 2010.  Nevertheless, the company stated that it didn't have a "Plan B," and was depending on help from Congress.

Ford is in much better shape, primarily due to the fact that it borrowed every penny it could raise in 2006 before the credit markets fell apart.  Ford is only asking for a $9 billion credit line, in the event that the recession is longer and deeper than expected.  Ford estimated that it would return to profitability by 2011 and planned to accelerate the development of new hybrid and batter-powered vehicles.  Of course, with the price of gas plummeting every day due to the commodity rout, by the time the vehicles are completed, everyone is going to want to buy a Hummer again.  Because when you're living underground in a bunker with your canned goods, and your bars of gold (wondering what the hell they're good for) and you have to go out for groceries, it's going to help to have a Hummer handy.  You'll be using the electric car as a toaster.  

Weak Earnings, Economic Data Haunt Market

Although equity futures are higher in pre-market trading, most of the earnings releases this morning are marginal, at best.  Yesterday was a brutal day for the market, with all indices down sharply.  The day began with China reporting a steep decline in manufacturing and ended with Bernanke admitting he was ready to initiate Japanese-style monetary policy.  As a quick aside, is anyone else perplexed by the Fed's announcement to purchase long term treasuries during a period when it needs to be issuing all kinds of treasuries to finance these purchases?  I'm not an economist, but perhaps someone can explain how this makes sense.  Why not purchase corporate debt and fund it with treasuries?  Aren't widening spreads and risk aversion the real problem?  But I digress.  Back to the headlines:   

• Sears swung to a larger than expected loss of $146 million.  Revenue declined 7.8% to $10.7 billion.  The company will close more stores and continue buying back stock. Great idea!  Because all of that stock that Sears paid $135 for last year in its buyback program has worked out really well for them.
  
• Staples third-quarter profit fell 43% on costs to acquire Corporate Express.  Revenue rose 34% to $6.95 billion, but declined excluding the acquisition.
• GE announced that profits at its GE Capital finance unit will decline to $8 billion this year, and $5 billion in 2009, lower than previous guidance.  Profit excluding charges at GE Capital will be around $9 billion, as forecast.  The company plans to keep the $1.24 dividend in 2009 and protect its AAA credit rating.  It seems highly unlikely to me that it can do both and I suspect that the dividend will have to be cut at some point down the line.
• Beazer Homes posted yet another loss and a sharp decline in revenues.  The company wrote down deferred tax assets by $398.6 million, indicating that it had no plans to ever make money again.  The builder reported a net loss of $473.9 million or $12.29 a share.  Revenue decreased 35% to $712.6 million.

With news like this, it seems hard to imagine that the indexes can muster more than a anemic rally.  Although, in a crazy volatile market such as the one we're stuck with, anything is possible.

Exotic Illiquid Investments Losing Luster With Pensions, Endowments

According to the Wall Street Journal, The Pennsylvania state employees' pension fund may be forced to make cash payments of $2.5 billion or more to Wall Street trading partners, due to investments in a "complicated" strategy referred to as "portable alpha."  Portable alpha is basically a leveraged bet on hedge fund performance.  An investor buys derivatives to match the market's return (the beta) and then uses the excess cash to invest in hedge funds (the alpha.)  According to the Wall Street Journal, an estimated $75 billion or more has been invested using portable alpha, with pension funds being eager players.  This strategy worked brilliantly from 2003-2006, as did pretty much any investment in anything during the bull market.  Leverage in a bull market is fantabulous.  Those who weren't around during the Long Term Capital kerfuffle in 1998 just recently learned: leverage in a bear market is deadly.  What has contributed to the deadliness of this credit market blow-out is the use of leverage to enhance returns on illiquid investments.  It's one thing to borrow a bunch of money to buy stocks or plain vanilla bonds.  The market goes down, you are forced to sell your stocks and bonds to repay your debt and it's over.  You're out of business but it's a pretty quick hit to the market.  However, stocks and bonds are fairly liquid.  What happens when you are leveraged and invested in illiquid assets, such as private equity funds, hedge funds, land, and oh, I don't know, timber?  Now you have a big problem.  Maybe you thought your hedge fund was liquid, but, um, no, now that it has frozen all redemptions due to the fact that it is down 65% for the year, and it was invested in all kinds of crap you never understood; not so liquid.  Your private equity fund?  Oh yeah, those guys have been in the business for years, everyone is clamoring to get into that fund because it's so prestigious.  I'm sure I can just sell my stake in the fund to someone else who really really believes in the Chrysler, GMAC, Freescale [insert name of highly cyclical company taken private at the peak of the economic cycle and loaded up with debt] turnaround story.  Except that, um, maybe not.  Because, you see, Harvard and a host of other investors who used to have a long investment horizon are now rushing to sell those stakes too at discounts of over 50%.  Also in line to punt private equity stakes are AIG (must repay government loan) and Lehman (must finish liquidating to complete bankruptcy process.)  The problem is; too many people rushing for the exits, and far too few lined up to buy either because they can't or because they believe that even a 70% discount is a crappy deal.

Investors have learned a very hard lesson in the past year.  The common refrain pitched by Wall Street to investors with supposedly long time horizons was that the extra yield offered by less liquid investments was worth the risk of tying up your money in assets that weren't easily redeemable.  Unfortunately, investors didn't demand enough of a premium for liquidity risk.  Now that they need the money, they are paying the price by having to sell their stakes at huge discounts.  What this has created is a yawning divide in the price between liquid and illiquid assets that, frankly, should've always existed.  Sure stocks are down around 40% on the year.  But many hedge funds are down more, and if they've frozen redemptions, good luck ever getting your money back.  Hedge funds have turned out not to be liquid investments.  Private equity funds don't have to mark to market, but given the lack of an exit strategy for most of their investments, they are facing a much longer time horizon than expected to reap any returns.  The time horizons, of course, will be shortened when a host of firms that were recent leveraged buy-outs go bankrupt because they were terrible investments. 

Given the horrible returns that pensions and endowments are certain to post this year, there will be a huge backlash towards the alternative investing that has been the rage for the past several years.  Risk premiums will return to more realistic levels without everyone chasing after the same investment strategies.  Ultimately, extraordinary investment opportunities will abound for those willing to take the risk.  Investors who have patiently sat on the sidelines for years because they didn't believe all the hype, will be in a position to cherry pick from a variety of investment options offering significant returns.  Fees for hedge funds and private equity funds will be reassessed and reduced significantly.  The alternative investment party is finally over.