Prepare yourselves for a busy autumn

Prepare yourselves for a busy autumn

http://search.ft.com/ftArticle?queryText=I+say+fixed+income+because+the+cash+flows+can+be+more+easily+determined+in+advance+than+with+value+equities%2C+and+you+can+be+paid+to+wait+for+the+prices+to+come+back+-+if+you%27re+right.&aje=true&id=070903000631

By John Dizard, Financial Times
Published: Sep 03, 2007


This is going to be a busy autumn. Snapback rallies will destroy your short positions, and unexpected writedowns will shatter rock-solid value plays turning them into sand.

The conventional wisdom on marketing hedgefunds demonises "strategy drift", which discourages "professional" managers from making any fundamental changes in their methodology.

Too bad, because they're going to have to retool very quickly, or just become machines for turning over their alpha to other investors.

First, a little house cleaning. Along with pouring the sand out of your shoes, there are a few in-the-money positions to get out of now.

One of the riskiest, if most profitable ideas I threw out over the past year was a long position in Nigerian bank stocks. A basket of that paper has more than doubled since then, with some increasing in price (if not value) by more than five times.

Why not be nice and let the Nigerian public own your bank stocks from here on, and let them enjoy the benefit of any future price increases?

Agree with them that you'll just earn the single- digit interest on dollar, euro, or sterling cash deposits, while they have the opportunity for the really big money to come.

Apart from this nod to charity and common courtesy, there may, arguably, be a case for why another rise of 200 per cent to 500 per cent might not be in the cards in the near future.

The reformist central bank governor, Chukwuma Soludo, who pushed through the structural changes that have attracted investors to the banking sector, is under political attack. The government's political base is in the debtor north, and the banking sector and central bank are concentrated in the creditor south.

In a conflict between a government and a central bank, the guys with the guns, rather than the guys in the suits, tend to win. And who knows, it may be the case that the banks have been lending money to people to buy each other's shares. I don't think that goes on for ever.

Then there is the short position I recommended in Argentine GDP warrants. They were 16 at the time I suggested this at the beginning of the summer, and they're down by about a third.

I thought the warrant prices would be driven by electricity supply con- strained growth, and that could still be the case in the future. But I am wary of those sudden short-covering snapbacks, and, as Andre Meyer of Lazard used to say: nobody ever went broke taking a profit.

More generally, a good strategy for the months ahead is to identify forthcoming liquidations of credit securities baskets, do the value analysis in advance as much as possible, and wait for the afflicted institutions to do the dumping.

I say fixed income because the cash flows can be more easily determined in advance than with value equities, and you can be paid to wait for the prices to come back - if you're right. And if you don't have a margin call issue.

Late last week, a credit investor friend of mine was looking at a list of $4bn (face value) of securities being offered by some large fund being liquidated, apparently in London. There were single-A floating rate home equity securities being offered at 37.5 and 20 cents in the dollar. That is, a so-far performing bond, rated at the same level as many banks, being offered with a coupon of 35 per cent.

Nobody was buying it.

Let's say you liked the value of the underlying collateral. Even with a very high, say Depression-level default rate, this bond could well be covered by its collateral.

However, cheap though it is, the problem is that it could get cheaper. So professional credit investors, most of whom depend on bank lines, could be required to mark it down. Then, in a margin-call event, they could be at risk of not meeting the call, which is what happened to the previous owner.

But never mind the banks. What about the nervous limited partners? This is the problem outlined in a 1997 paper, which I once again recommend for your reading list, by Andrei Shleifer and Robert Vishny, called The Limits of Arbitrage.

The two mathematically rigorous economists showed how, at the very moments that an arbitrageur using investors' capital could find the most compelling values, investors would be likely to pull their money back.

Well, people, we are, right now, at the limits of arbitrage in the structured credit markets.

The can opener, in the form of speculative capital, that Bernanke & Co. assume will open up the credit markets, ain't there or ain't big enough. That's why there weren't any bids for that homeless paper .

However, if you are a "real money" person, you can do pretty well in these circumstances. Not every piece of dubious paper will be rescued when the politicians grab the wheel from the economists, but a lot will be.

And at the prices that will be on offer, it looks as if you need to collect just a couple of years' worth of coupons, let alone the principal, to make money.

We're just a month or two away from even bigger forced liquidations.

Even with the Fed's support, the banks don't have the capital to be the buyer of last resort for everything. It'll be raining soup, if you don't mind taking a mark.