Barclays recently completed a sale of assets that reminds me about Merrill Lynch’s Lone Star transaction a while back. In the Loan Star transaction, Merrill Lynch sold a CDO portfolio to the private equity firm. It provided non recourse financing for the transaction and effectively received 5.5c in equity for the portfolio. Merrill Lynch maintained most of the downside and retained none of the upside beyond the repayment of the loan.

The Barclays deal seems to leave even more money on the table than Merrill’s. Read their press release here. The balance sheet of the company will look something like …

Assets:

- USD 12.3b of “credit market assets,” mainly ABS CDOs / RMBS / CMBS

- USD 800m of Treasuries

Total: USD 13.1b

Liabilities / Equity:

- USD 12.6b loan from Barclays at Libor +275bp

- USD 450m of additional funding by LPs amortized over 5 years with fixed payment of 7%

There are several extraordinary features of this transaction.

(1) The loan amount is greater than the credit market assets.

(2) “Protium’s cashflow from its assets will be used first to service payment of management fees and distributions to the partners as a priority and subsequently to service payments of interest and principal on the Barclays loan.” Essentially, Barclays loan is subordinated to the “equity” of the partners !!

Barclays claims “The Transaction is part of an ongoing process in Barclays to manage down the quantum and volatility of its credit market exposures as it seeks to protect and enhance the interests of shareholders.” However, it later says “We are not seeking through the Transaction to effect a change to our underlying credit risk profile.” Barclays effectively admits that it is not offloading any risk in this transaction. Instead, they are simply moving assets from their MTM trading book to their accrual loan book. The benefit is “greater predictability of income” as they will no longer have to mark the assets to market, but rather lock in the price of USD 12.3b.

This is quite a price for shareholders to pay for an accounting trick. But damn it must feel good to be a ex Barclays banker at Protium.

Some more commentary …

http://www.guardian.co.uk/business/2009/sep/16/barclays-sells-toxic-assets1

http://www.reuters.com/article/marketsNews/idUSN1628688420090916

http://www.ft.com/cms/s/0/2443b87a-a2ce-11de-ae7e-00144feabdc0.html

http://www.ft.com/cms/s/0/72e03676-a2ff-11de-ba74-00144feabdc0.html

http://ftalphaville.ft.com/blog/2009/09/16/72321/a-definite-transfer-of-value-away-from-barclays/

http://www.businessinsider.com/john-carney-uh-oh-barclays-launches-off-balance-sheet-vehicle-to-buy-toxic-assets-2009-9

http://ftalphaville.ft.com/blog/2009/09/16/72316/the-smart-bit-in-barclays-smart-securitisation/

From the weekly close peak of 380.33 on Aug 26, 1929, the Dow had dropped to 228.73 by Nov 18, 1929, or nearly 40%. By April 21, 1930, it had recovered to 293.43, an increase of almost 30%. After that, it collapsed all the way to 41.63 before bottoming in Jul 1932.

These two articles were pulled from the New York Times in the 1930s. The first one, published on Feb 19, 1930, is flush with signs of improving jobs data. Julius Barnes, chairman of the National Business Survey Conference, proclaimed that “the danger of a long depression [is] apparently ‘fairly over.’” Hindsight is 20/20 and Barnes” foresight was anything but. But given surging business confidence, a rallying stock market, and a big uptick in public works and utilities contracts all pointed upwards.

The second article, from April 1930, the peak of the short lived rally, quotes Benjamin Anderson of Chemical Bank, an economist that is skeptical of the recent recovery. He claims that it is only temporary relief made possible by excessive government spending and cheap money. One must wonder whether the NY Times should rerun this article with some of his more powerful quotes highlighted …

“It is definitely undesirable that we should employ this costly method of buying temporary prosperity again. The world’s business is not a moribund invalid that needs continuous galvanizing by an artificial stimulant.”

“Cheap money will not induce manufacturers and merchants to increase their borrowings in an unsatisfactory business situation. But if merchants and manufacturers will not use cheap money, speculators will. They will use cheap money in buying stocks for the prospect of capital appreciation.”

“Cheap money is a stimulant. It is also an intoxicant. If the dose is large enough, a very substantial temporary effect can be brought about. But headaches follow.”

He goes on to cite figures that show just how many loans are backed by securities and essentially claims that cheap bank financing is holding the stock market up. I won’t restate the obvious cliche here, but those that don’t remember history are doomed to repeat it.

I have created an interesting chart below using data on annual GDP growth in various countries. Over the past 20 years, China, Korea, India and Indonesia are the economies that have doubled in size, with China quadrupling. In the past five years, China, India, Russia and Argentina have shown the fastest growth.

Short term money market rates continue to come down rapidly in the face of improving markets, low central bank rates, and a massive amount of stimulus. USD rates have actually dipped lower than JPY and recently CHF rates. USD 3 month money market rates are now the lowest around. The dollar continues to suffer because of increased appetite for risk and plummeting borrowing costs in USD.

Dollar Is Near Lowest in Almost Year as Borrowing Costs Plunge

Inside the House of Money by Steven Drobny is one of my favorite books on the market because it allows practicioners, as opposed to authors, tell their story. Drobny collects interviews with a few of the best names in global macro fund management and publishes them. One of my favorite interviews is the very first one, on Jim Leitner of Falcon Management. I especially like the interview because Leitner recounts dozens of trades that he’s made and explains where the idea came about. A few are below, some are quotes and some are summarized …

• Long Turkish glass manufacturers. Tragedies can be a buying opportunity. When Turkey had a massive earthquake in 1999, we bought shares of glass manufactureres because we knew everybody was going to have to repalce their windows. Turkish stocks were going down across the board but we bought all the shares of glass manufacturers we could. (page 45)
• Overnight Swiss rates. Price of overnight Swiss franc interest rates, one day in advance. Sensed Swiss franc IR next day were going to be very, very high, so borrowed billions of francs one day forward. Made 1 tick. First successful trade based on knowledge of market. (page 47)
• Long Yugoslavia. We find it interesting from investment because we believe Europe wants to show that they can rebuild countries even if they aren’t good at sending troops. Also, Bosnia is a Muslim country, and with the question of Turkey joining the EU, the Europeans want to show that they don’t have a problem with Muslims, just Turkey. Money is pouring behind this political agenda. However, there is no bond market and currency is difficult, and there are no equity indices. Only way to get exposure is through stocks, so need to sift through and find the appropriate stocks to buy.
• Long Ghana. Ghana is a good example of the value of reading the Economist. There were a few stories about their president, Kufuor, detailing his economic views and policies. He was very impressive.
• Long Guinness Nigeria. A few years ago, the Economist had something on Nigeria, stating that average beer consumption had dropped from 34 liters to 3 and then rebounded to 4. There’s something going on when beer consumption drops 90 percent in a hot country and then starts to rebound. We started buying Guinness of Nigera and it’s gone straight up over the past three years.
• Long gold puts. In 1997, the gold forward curve was upward sloping, which we thought was kind of weird. Spot gold was at $310 and five year forward gold was at $380, and 5y puts at $310 were at $3. Good risk reward. Bought them at $3 and sold them two years later at $18, when gold was at $258, making 2x the money.
• Inflation index linked housing bonds from Iceland. High real yields in an economy with a budget and trade surplus, independent central bank, and inflation and rates coming down. Guaranteed by government and yielding more over inflation than any other inflation linked bond in the world. Good liquidity. Play is that they are to become euro-clearable in the next few months, opening up the door for a huge number of investors. Good carry, fundamentals and technicals.

While the VIX index has recently dropped to levels close or below those prior to the Lehman bankrupcy, the implied correlation index, which was recently launched to measure the correlations between all stocks in the S&P 500, has not dropped as much. The CBOE has published a white paper on the subject, and meat of the discussion is below ..

The significance of implied correlation is that it reflects changes in the relative premium between index options and single-stock options, providing trading signals for a strategy known as volatility dispersion (correlation) trading. Commonly, a long volatility dispersion trade is characterized by selling at-the-money index option straddles and purchasing at-the-money straddles in options on index components. One interpretation of this strategy is that when implied correlation is high, index option premiums are rich relative to single-stock options. Therefore, it may be profitable to sell the rich index options and buy the relatively inexpensive equity options.

So while equity index volatility has come lower and correlation has remained high, the volatility on single stock options hasn’t reduced as much as you would expect by looking at the volatility on the index only. Markets predict that overall volatility will be lower and the outperformance of the winners versus the losers will also be smaller.

Implied correlationImplied volatility

When the financial crisis first started to hit the US subprime mortgage market, there was frequent talk about decoupling — whereby the fast growing emerging markets had sufficient domestic demand and growth to escape relatively unscathed from the collapse in developed nations’ economies. This notion was quickly debunked, as currencies such as KRW and IDR went into freefall as did many emerging stock markets. However, the theory of decoupling may be more relevant on the way out than the way in. The US consumer still seems grossly overleveraged and the US government balance sheet continues to become more and more overstretched.

Going into the crisis, many emerging markets were heavily dependent on exports for their growth. However, coming out, these markets are going to be much more focused inwardly on domestic demand. Coming out of this crisis, we are going to see true decoupling, with the large emerging market countries bolting ahead on domestic, not export driven (at least not to the US), growth.

Debt Burden Quickens Power Shift as G-8 Loses Clout

Asia’s Recovery Highlights China’s Ascendance

There has been a bit of talk about life settlement securities, or death bonds, as the more socialist inclined like to refer to them. These are securitizations of life insurance policies, sold by the individual who has taken them out to a middleman who has in turn sold it to an investment bank that will securitize the same. Below are some links for more information. I would think that should this industry get going, life insurance companies would simply raise the amount at which the policy holder can cancel the plan to the point that it becomes uneconomical for the securitization process to happen.

Life settlement on Wikipedia

Deloitte’s paper on Life Settlement

Wharton’s research on the consumer benefits of a secondary market (2002)

The Economist examines the growth of the market

From the investor perspective

The death bond article

First deal ever in 1995

Class action law suit from 1998

The same geniuses at a venerable investment bank who came up with the acronym BRIC have recently come up with Chindonesia, slightly shuffling the countries that are considered the coming economic powerhouses. The fresh word drops Brazil and Russia in favor of Indonesia. Brazil and Russia, whose growth has been in a large part due to natural resources and the commodities boom, are also similar in that they have previously both had more economic heft, especially in the case of Russia, than they do today. Indonesia fits much better with the stories of China and India — a country with a huge population and a low starting per capita GDP located in Asia. Indonesia is the fourth largest country in the world by population. Its economic growth is only surpassed by India and China amongst large countries, and it has recently found itself much more politically stable than previously.

The Economist recently ran a special feature about Indonesia, and points to four reasons why Indonesia will prosper, which can be summed into two: (1) demographics and (2) government.

From its high of around 56 to its low of about 1, Citi is now trading at 4.85. It’s 30 / 90 / 260 day historical volatilities are 77% / 72% / 162% respectively and the stock has more than tripled from its low. Additionally, many blogs have recently noted that no one knows exactly how to calculate the market cap of Citi, as there are many different ways of calculating the number of shares outstanding. These all contribute to the difficulty in evaluating the the actual value of Citi.

Banks have also recently jumped in value significantly, with much liquidity being pumped into the system and the understanding that it will be difficult for a systematically important financial institution to be allowed to fail. Given this, the possibility that Citi stock doubles or triples from here on out (which will still be well under its peak value) is more than miniscule, especially on a slightly longer timeframe. Citi itself is a highly respected institution and has not been decimated like AIG and has not been as forced of a seller of good assets. It brings a very strong retail network along with great exposure to emerging markets, where a lot of growth in the near future seems to be stemming.

Long dated call options on Citi are priced cheaply, and I’m a buyer of the Jan 2011 5.00 call options.