Tuesday, September 30, 2008

Why Not To Enter Orders To Buy "At Market"

Ever wondered whether to place an order at market, or at a limit? Go with the limit. If not ....

Pay special attention to the high and the low of the daily range in this Google Finance quote for Claymore Capital US (UBD) exchange-traded fund:

Imagine explaining that buy to your family.

Naked Shorts Alive and Well

For an up-to-date listing of failed-to-deliver stocks whose (short) sellers have failed to deliver securities to buyers to such an extent that they meet the requirements for enhanced enforcement, have a look at the Regulation SHO list promulgated by NASDAQ. ACAS is still on this list, interestingly. Over 18% of ACAS is shorted, and the shorts apparently can't find (or haven't bothered to find) ACAS certificates to borrow in order to deliver them.

As I feared, the SEC isn't prosecuting failure to deliver. It's business as usual at the federal agency that Congress has charged with regulating the securities markets. If I were buying tires and they weren't delivered, I'd have a good suit under Texas law for deceptive trade practices, and I could get treble damages and my attorney's fees. It's a case so good that attorneys might take it on contingency -- exactly as the legislature intended with it passed the Deceptive Trade Practices Act decades ago. In Texas when you buy things, you can expect them to be delivered.

The fact that federal securities regulators can't be bothered to enforce something like the requirement to deliver securities is so bizarre that it passes understanding. It enables blatant price manipulation; cautious investors frequently place good-'till-cancelled limit sell orders to "protect" gains in a stock, or to limit losses, and short-term price movements caused by naked short positions' creation can trigger real sales by genuine investors unaware of the nature of the market activity in their stocks. (There are still market participants who make investments on the basis of balance sheets, and not geometric images superimposed on price charts. The SEC needs to go talk to some retail investors.) Once a cascade of real sales is underway, the selling pressure quickly exceeds the selling pressure created by normal exit interest: in addition to ordinary liquidation interest, and the liquidations of investors whose price thresholds have been reached, the market must absorb all the phantom shares "created" when the short-sellers entered the market.

In a simple exercise of market mechanics, it is possible to demonstrate that as immediate-term supply becomes infinite, the immediate-term price one can get for a marginal unit offered for sale will approach zero. Limitless cost-free shorting can destroy markets in any security in which there is a serious short effort: as price declines trigger legitimate sales, the resulting equity erosion will create liquidity emergencies in the accounts of investors who expect markets to enjoy the regulation set forth in the Rules. (It's not as if Google (GOOG) displayed some sudden shortage of cash during the last minutes of trading on September 30.)

If sellers were simply required -- as the rules purport -- to deliver securities they offered for sale, short-sellers would be forced to undertake effort to borrow shares, and the shares' loan would not be cost-free. In a regulated market, demand by shorts to borrow would act to create value: shorts required to borrow from a finite pool of share certificates would be forced to compete with each other to borrow the shares, and would bid up share rental fees commensurate with borrowing demand. The shorted shares would not be free, and the cost to maintain a short position would increase with the unavailability of certificates. If the delivery rules had any real meaning, the market would regulate itself.

Contrast the current situation, in which it is possible for two individuals to purchase more than 110% of a publicly-traded company's total outstanding shares, when short-sellers so swamp the market with phantom stock that share prices don't even change noticeably even immediately following a 350-1 reverse stock split. Share price and market capitalization can impact companies' ability to borrow (and trigger prepayment obligations and credit termination), owners' ability to maintain consistent management in the face of raiders, and investors' life savings. The problem doesn't exist because of some evil cabal of nefarious shorts, it exists because the market isn't doing what it promises: delivering securities to buyers.

As long as regulators facilitate cheating of this kind, the blame for gaming the system must fall back on regulators. If federal law didn't displace state law in the field of interstate securities markets, buyers would sue for common-law fraud when sellers didn't bother to deliver, and they'd win. Instead, Congress vests exclusive power to regulate this market in a tribe of monkeys that expects the forest to rain free bananas forever. We've taken a market that once had the power to regulate itself and, by making a game of the rules requiring delivery, we've made a game of the market itself.

Tell these monkeys you want human rule over the market, with traditional human market expectations like the delivery of what was paid for. The solution is as elegant as it is simple: sellers must identify -- in their own accounts, if they own them, else in an account in which they have permission to borrow the securities in question -- the securities the seller promises for delivery. The identification must be good at the time of the transaction, or the seller has no bona fide intent to deliver and the proposed transaction is a fraud at inception.

This is a rule that could readily be enforced by brokers. A secondary market in securities for loan should materialize quickly for securities in high demand by sellers who don't own the shares, and brokers would benefit from that market as intermediaries. The enforcement of the rule would have the salutary effect of restoring order to a marketplace by simply entering the most basic rule participants expect in markets: sellers mean to deliver whatever is bought.

Is it so hard just to enforce the rules?

Monday, September 29, 2008

Election FUD: About Money

The Jaded Consumer predicted FUD this election season, and it's upon us. Since Obama will win the election (as called here and here), it seems appropriate to focus on the FUD offered by his victorious campaign.

Rather than discuss serious differences the candidates might have, Obama in the first Presidential debate pretended that McCain intended directing tax relief solely to "the rich" and to "corporations". McCain plainly endorses doubling the tax exemption that can be claimed for each child, which has the effect of raising the income at which the lowest-income persons must pay any tax. In a family of four, the taxable income would be reduced $7,000 -- with attendant decreases both in taxes owed and in the tax rate applied to the family's marginal income.

Households that now must pay tax on income starting at $17,700 per year (the married-filing-jointly standard deduction of $10,700 plus two child exemptions at $3500 each) would -- with a doubled child exemption -- face no tax at all until their income reached $24,700 per year. A family of four with a gross income of $45,000 per year -- not a wealthy family -- would have their taxable income reduced from $27,300 to $20,300 per year. The family's income tax reduction (the federal government will still collect a variety of other taxes, which are income taxes, but are not called income taxes -- such Medicare and federal unemployment tax contributions) from $3312.50 to $2262.50 is more than a 31% reduction in income taxes, driving down the household's effective tax rate from 7.3% to 5.0% (excluding Social Security and FUTA). Since the federal government is collecting approximately another 15% in taxes from employees for social security and unemployment taxes (twice that for self-employed people, such as most small businesspersons, due to "self-employment tax" that mimics the employer's federal payroll taxes), these aren't the total tax rates, and many states impose income taxes atop the federal taxes. However, dropping income tax 30% on a working family of four is hardly "doing nothing" for the not-rich.

(Lowering taxable income by $7000 on a super-rich family of four might have more dollar impact due to marginal tax rates increasing with income; the tax on the last $7000 is more at $1,000,000 of income than it is at $45,000 in income. However, the sum involved won't move the needle on the family's effective tax rate for such a family , meaning the break won't materially change their tax rates. The materiality of the impact of the tax break McCain has proposed actually increases with lower incomes. The proportional benefit will simply not be material for the so-called super-rich. By contrast, people whose incomes are low enough the tax reduction amounts to a nearly one-third tax cut will really notice the difference in the amount of disposable income they have. The $1050 savings of the $45,000-earning hypothetical family of four will really be appreciated when the holidays come around. Heck, I'd like some of it myself.)

Obama, by contrast, plans increasing taxes on working people, with special emphasis on the lowest earners: he expressly calls for a new employment tax from which employers offering no health benefits will be unable to find an exemption. (The fact that this will add fuel to population risk segmentation and drive up the cost of health care for people not in employee benefit plans is bad it itself, and requires separate treatment in another article.) The impact on super-low-wage earners will be significant: businesses barely able to meet their payroll will find current payrolls unaffordable, and dump jobs. In an era of raised payroll taxes, manpower requirements couldbe satisfied by self-employed contractors (looking at the economic relationships created with exotic dancers, it's clear anything is possible to avoid employment status) who will either not participate in funding the Obama plan, or who will personally shoulder the payroll tax in the form of an increased self-employment tax. The incentive to hire workers illegally -- and without payroll taxes, and perhaps without status documentation -- will only increase as the cost of lawful employment grows.

Basic economic modeling demonstrates that playing games with the identity of the player the government requires to deliver payment for a new tax does not change the identity of the end-consumers who ultimately bear the tax, or the ultimate behavior of the market participants. If employment's cost is driven up by non-wage components, it will depress wages or (particularly near the minimum wage, where employees' financial situation is most vulnerable) cause job cuts. It is hard to understand how a candidate can, straightfaced, announce a plan to create a new tax on working people -- whether nominally borne by their employers or by someone else -- while saying that he's reducing taxes on working people and it's his opponent who neglects them.

Obama is guilty of tax FUD.

Obama claims that McCain overstates the importance of earmarks. I submit that earmarks are a much larger concern than Obama admits. The fact that earmarks are an epidemic are underscored by the Senate's apparent need to take a bill already commanding 75/25 support for passage and to add pork to it. All this time, I thought pork was horse-trading between members of congress to get votes; apparently, it's not the desert used to lure people to the table at all, but the cocaine they snort coming and going. Or perhaps this is Senate pork to attract House votes, which is a new trade for me to notice, though probably not new to the Beltway Bunch and the heartless desperados with whom they routinely loot the Treasury.

McCain's observation on the topic, that cost-plus contracts must end, offers a portal into a type of federal largesse -- of the sort that constituents imagine is intended to be included in the Congressional overspending represented by the anti-earmark campaign -- that can provide (a) industry-specific, (b) district-specific, and (c) entity-specific funding. Surely this, too, is a type of earmark -- and many DoD systems are vastly expensive and are paid for over decades. Congressional intervention on bidding arrangements decides whether work will be performed in Alabama or Washington. Whether the workers are unionized may become a factor. Whether the entity getting the contract has relationships with non-US defense-industry competitors may be a factor. Politicians sitting on oversight committees have an impact on this kind of thing, and the fact it doesn't show up on Obama's radar as an earmark doesn't mean that it isn't, or that if for some reason technically not an earmark it doesn't raise the exact same constituent concerns about government overspending that are raised by projects widely lampooned as earmarks.

I heard about an Air Force base that built its golf course first, so that it could approach Congress with the need of a barracks, instead of building the barracks first so that it'd be stuck approaching Congress with a request for funding for a golf course. The community where this base was situated got an earmark -- specifically-designated funding for work in a specific Congressional district. Locals got work, much more than if they hadn't gotten to build the barracks and the golf course. The fact that this pork was hiding in a DoD budget doesn't mean it's not just as much an earmark as the money the Senate seems interested in showering on Puerto Rican rum producers.

Without bothering to look, The Jaded Consumer can guess that both Obama and McCain voted for that one. Crazy.

An Aside: Selling Votes Is Good Business
Lobbyists spend a fortune feasting politicians, and it's not because they are such great conversationalists. Lobbyists are buying legislation, and they're spending money with the expectation of a good return. Indeed, they are choosing which legislators' invitations to accept. With legislators advertising for lobbyist contributions, it's no secret what's going on: both parties know how the courting game works and what its currencies are. Sweetheart legislation is part of the currency of this obscene market, and it's a market the public would like see shut down.

Legislation that can't pass without robbing the public to fund favors for politicians' re-election campaigns doesn't deserve to pass. Using the public fisk to conduct public relations among one's constituents should be illegal, but members of Congress have absolute immunity for the votes they make and Congress has no known limit on its spending power.

It might be nice to see a Congress that believes in the limited government provided by the Constitution. Failing that, it might be nice to see an Executive Office official willing to veto measures that threaten the principle of limited government articulated therein.

Simply claiming earmarks aren't important is bogus: they are at the heart of the corruption in the District of Columbia and have an impact vastly beyond that admitted by Obama in the debate.

Corporate Taxes
Corporations (and other legally-created entities) aren't physical things that can be seen or felt; they are legal fictions created to help separate ownership from management, and to enable investment while preventing chaos in business enterprises. None of these creations have life or breath outside that of the people who own them or are paid to make them seem to be doing work. Corporations' (and other created-only-by-law entities') ultimate owners and workers -- human beings -- are subject to taxes.

Obama stated the view that cutting taxes that apply to corporations somehow is a slight to the people who own and run them. The Jaded Consumer has difficulty reaching this view with open eyes. Inverstors and management seek a certain minimum net returns (this means the money that's made after expenses, including taxes, are charged), or they would not bother to enter (or continue) business. Increasing taxes on the entity leaves less money for employees and owners to earn while still allowing the entity to make the after-tax return needed to attract investment. (The same is true of increased payroll taxes; it leaves less on the table with which to increase hourly pay, or freinge benefits, or funding extended vacations or maternity or paternity leave or other things that improve workers' view that they are getting a good deal for their work.) This was exactly McCain's point when he stated that businesses, which are free to legally organize anyplace on the planet and under any jurisdiction they please, may be very attracted to Ireland's 11% rate, causing United States workers to miss out on jobs that weren't created here because the entity's tax rate would be more than three times higher, at 35%.

The Jaded Consumer touched on this point when discussing the relative capacity of banks and regulated business development companies to pay dividends: the entity with the higher tax rate must employ riskier strategies to achieve equivalant dividend-paying capacity. Do we want only high-risk jobs in boom-and-bust industries, or do we want stable employment and high wages? Given that Obama favors raising taxes (at least on anyone whose employer is subject to a payroll tax), one would think he would be excited to see earned incomes (and thus all taxes indexed to earned incomes) bloom. Pretending to "punish" entities that conduct foreign operations and are subject to foreign taxes instead of United States taxes seems like an invitation to repudiate the tax treaties the United States has with the scores of countries with which American firms do business -- treaties that keep them from being taxes in multiple jurisdictions for a combined rate that could in some cases exceed 100%. How Obama imagines that it is possible to sanction entities with foreign job creation in a way that would not simply cause complete departure from creating employment in the United States is one of those mysteries I hope someone will explain.

In this era of REITS, LLCs, LLPs, BDCs, not-for-profit corporations, and so many other entities that lawfully pay no tax at all at the federal level despite carrying on massive interstate and international operations, a vote to reduce entity taxes is not a vote against employees and their retirement savings that are invested in the public markets. If Congress thought that corporations had some moral "need" to be taxed, we'd not have a federal tax structure that enables limited liability partnerships, limited liability companies, corporations that elect to be treated as business development companies, and a host of other entities paying zero tax. The fact is that all the profit of these enterprises -- including the so-called not-for-profit enterprises -- gets taxed as it is pushed to stakeholders in the form of various kinds of income. If we want enterprises' stakeholders to do well, it's not unreasonable to decide not to tax the enterprises' income a second time before the stakeholders get the money; we can just tax the stakeholders.

Obama's claim that lowering entity taxes -- which increases retirement account returns and amplify's liquidity with which to increase jobs and wages -- is a blow against the middle class is pure FUD.

Obama's claim that McCain is raising taxes on the little people when Obama expressly admits doing the same, at a time McCain advocates clear tax cuts for low-income and middle-class families, is the kind of "Republicans Hate Little People" FUD meme we should expect near Election time. If Obama merely advocated eliminating the ceiling on Social Security taxes or Medicare taxes or the like, then he might have some credibility when he preaches against regressive taxation; however, his proposal for new taxes has an obvious and immediate result no-one would like materializing in their lifetimes, much less in the midst of a recession.

Obama's stance on entity taxes suggests he has no idea at all what human beings are the ultimate owners of entities. The Jaded Consumer suggests these ultimate owners include the beneficiaries of pension funds, the owners of 401(k) accounts, individuals with private savings, retirees, and job-creating small businesspersons risking their life savings to employ those in their communities to make an honest return on their labor and innovation. Obama's prescription to raise employment taxes reveals that instead of demonstrating a sophisticated grasp of economic policy he is simply keeping in line with his party's philosophy that a properly-sized government requires higher taxes.

The fact there's no clear math on how many cost-plus contracts are so overpriced they can only be understood as political plums makes it hard to assess the size of the earmarks problem, but since earmarks are one of the keys to the corruption of Congress by special interests, it's clear that they must be addressed before we can have a Congress that works for citizens rather than special interest entities that haven't even the power to vote. Obama's claim during the first debate that McCain was missing the big picture when looking at earmarks may reveal that he himself fails to understand the scope of their damage to the government Americans send to the Discrict of Columbia to govern in their name.

McCain's proposals on restoring accountability in Congress by interfering with the corruption enabled by uncontrolled spending bills isn't so absurd as to be lampooned. A comprehensive plan to end earmarks seems likely to rewire the logic on funding nearly everything Congress wants paid for, and to enable much better transparency (a prerequisite to accountability) than exists. It's much more ambitious than a plan to tax the top 1% or 2% of income-earners a bit more. (Unfortunately, I think accountability is doomed in D.C., but Obama didn't make this claim; he claimed that McCain missed the point, when it's clear McCain has a real problem in his sights, and that it's a problem McCain has some historic interest in addressing.)

Perhaps the most recurring meme that smacks of FUD in this election is the "third Bush term" allegation Obama and Biden have been directing at their opponents. Given NPR's difficulty discerning a difference between the candidates' stated policies, one might turn Biden's comment around: if we don't know the substantial, specific differences between Bush and McCain, or between McCain and Obama, then we may not know the real difference between Obama and Bush. Obama certainly isn't distinguishing himself as yet with bright ideas.

I'll unload on his silly health policy ideas in a later post. The Jaded Consumer gets so frothed and irritated thinking about that stew of sewage that it's hard to type, so the post has been delayed from its originally-promised order. Soon, though. Soon.

Shorts to Market: "I'm Not Dead Yet!"

The shorts who fled financials weren't disappeared to another planet, just another investment. Now that the SEC has put the kibosh (temporarily) on creating any short position in 799 listed financials, short-inclined folks with a pessimistic view on the market and the economy have simply turned to other securities. High-fliers with exposure to contracting disposable income are surely a magnet -- and lo, Apple (AAPL) has plummeted below 110.

ShortSqueeze.com -- whose numbers might be rather outdated -- says short interest in AAPL has increased recently over 24% from under 21 million shares to over 25 million shares. This doesn't result in a particularly crazy fraction of the float (under 3%, though at 110 this might be a bit excessively bearish), but as outdated as ShortSqueeze numbers have appeared in the past, I'm not sure how much further the short interest might have become. (What's a good source for up-to-date short interest?)

Apple, which hasn't demonstrated particularly effective use of cash, could theoretically plow some of its approximately $24 per share of cash into a stock buyback while it was so targeted, and could thus dramatically increase the per-share performance metrics going forward. When Apple lost half its value in a single day in 2001 in the wake of the Cube during the Enron-era panic, Apple was in a different financial position: it had had an unprofitable quarter, and paranoia about solvency was perhaps further warranted. On the other hand, Apple's failure to buy back shares when they traded under $20 irritated some longs when Apple was clearly doing better: Apple should have had more confidence in Apple.

Apple presently is both profitable and rolling in cash, so presumably Apple is in a better position to buy back shares. There's a new financial panic -- caused by subprime mortgages -- but Apple's profitability isn't at issue, only the rate of its growth (a metric that share buyback will improve). I expect Apple's shareholder-hostile management to continue with Great-Depression-survivor-like cash-hoarding instincts (the '90s were long and lean for Jobs, who personally secured the loans that floated NeXT while it was losing money hand over fist, which likely leaves him uninterested in risking inability to tolerate a long cash burn), rather than buttress the value of the shares when shorts have gifted management with a buyback opportunity.

I will wait for general-market malaise and Apple-specific FUD to mature into a share price in the 90s or lower before adding to my current exposure to Apple. Short interest will cause a cascade of sales by those with profits in Apple they hoped to "protect" with trailing limit orders, and will scare folks with long-held positions into rethinking whether they should take their profits while they remain. It will take a while for genuine sales numbers to appear and clarify that Apple's position remains solid, and in that time FUD will have an opportunity to work its magic in eroding confidence in the shares.

Treasury Deal via Podcast

A call held by the Treasury Department from over the weekend has appeared as a podcast. Interesting features of the bailout deal:
  • Participating Banks will face executive compensation restrictions, and Treasury isn't bashful about imposing them, and may impose additional limitations on executive contracts as a condition of participation;
  • Pricing of impaired assets isn't known;
  • Institutions that want to sell over $100 billion in assets to the Treasury-managed fund will have to part with a significant equity stake, to ensure a taxpayer upside -- Treasury repeatedly invoked the huge equity positions taken in Fannie and Freddie to give people an idea what the plan would look like;
  • Treasury's contracts to buy impaired assets will involve one-off negotiations on an institution-by-institution basis;
  • Institutions electing the insurance option rather than the straight-up purchase of impaired assets still face Treasury as a new equity owner, if they cross the $100 billion threshold;
  • Purchases would be delayed a few weeks following legislation while asset managers are hired to conduct valuation and purchase, but it will be prompt;
  • The objective of promoting lending isn't backed by specific language requiring re-lending of funds obtained from the Treasury fund (The Jaded Consumer views this as a potential positive; requiring relending might promote loans being made with a rapidity that exceeds the supply of quality borrower demand, leading to more bad loans).
The big question seems to be how to price the assets. One questioner asked about different institutions' valuation of similar assets, and their relative motivation to participate based on whether the clearing price is above or below the last-reported asset price. This question and its answer illuminate two things: valuation of impaired, illiquid assets remains so speculative that similar assets might appear on the books of different institutions at materially different prices; Treasury doesn't yet have a fixed model for valuing the assets, either.

The fact that the mortgage market is full of hard-to-price assets in the hands of institutions that face significant consequences for trying to sell an excessive amount of poor debt creates a potential buying opportunity for firms with liquidity and patience. Although many firms may have little appetite for home mortgage instruments just now, their fire-sale prices imply a default rate that appears materially worse than the observed default rate, indicating that (a) a buyer might get a good deal, and (b) when Treasury takes an equity stake atop this deal, it stands to do quite well in institutions that are otherwise sound.

I noticed Deutche Bank on the conference call, with a question. I wonder if there's any limitation against investing in non-U.S. institutions that are holding U.S. home mortgage instruments on their books. Might Treasury end up with a large, diversified, global equity portfolio of major lenders?

I ordinarily expect the federal government to squander money at the geratest maximum rate -- hence its appetite to enter cost-plus contracts as the buyer -- but this may be a deal that could work. The interesting thing is that the deal wasn't done last week by the Democratic majorities in both houses of Congress: if the Democrats wanted to do the deal on any particular terms it wanted, they could present a bill to the President for signature or veto -- but they haven't. The conclusion is simple: more important to Congress than getting some specific language in the deal to satisfy policy concerns is avoidance of potentially being alone to catch blame for one's party in a future election cycle lest it go down the toilet. The only reason anyone cares what House Republicans think is that they want House Republicans to share the blame for whatever materializes later.

Of course, with both parties' vote, both parties will clamor to take credit for anything that works, and The Jaded Consumer predicts here that in a few years we will see politicians campaigning with promises of how they will spend Treasury bailout profits. Yes, they will utterly ignore the towering net national debt to pretend there's found-money to spend on some pet project.

Just wait.

Sunday, September 28, 2008

ACAS: Like A Bank, But Different

American Captial Ltd. (ACAS) first appeared on The Jaded Consumer in the context of a post blasting stock analysts' opinions as shallow -- failing to provide more than the most trivial hip-shooting evaluations of companies and, like Yahoo, often telling a misleading story. Rather than tell the story of ACAS in contrast to an entertainer's hip-shot claims, it seemed useful to explain how ACAS differs from other financial institutions more familiar to readers: banks.

As Bush pointed out recently, no depositor in an FDIC-insured bank account has lost a cent in an insured account since the program went live three-quarters of a century ago. What he didn't mention (and that recent events have brought into sharp contrast) is that banks have lost quite a bit of money, have been disassembled for sale in parts like junkyard wrecks, and have been wound down by regulators or seized and sold. (Because creditors such as depositors and bond holders must be paid before anything is left for shareholders, liquidation by regulators is basically lights-out for equity investors.) Protecting creditors (such as depositors) isn't the same as protecting shareholders. What we want to know is what life is like for the equity owners.

The Business Concept
Banks and Business Development Companies (BDCs) like ACAS occupy a similar ecological niche. In the financial world, there are basically two kinds of players. The first has a plan to develop profits from capital, but needs capital. The second has capital but needs good opportunities to turn a profit. Banks and BDCs both occupy a niche that requires skill in matching these needs together: they employ people to allocate managed capital among available opportunities to obtain a suitable risk-adjusted return for their investors.

Where The Money Comes From
ACAS manages permanent equity raised when shareholders bought into the company in an issuance, and it manages any funds borrowed against either this equity or their existing book of business. While lines of credit can be renegotiated at expiration -- which might reduce credit (causing a liquidity issue) or increase the cost of borrowings (narrowing the spread, that is, reducing net returns from equivalent gross profits on investments), these credit-related expirations don't come by surprise and are subject to planning. BDCs like ACAS are regulated in the amount of leverage they can use in making investments; the debt-to-equity ratio of an entity wanting to enjoy tax status as a BDC must be 1:1 or less, a low level of leverage that moderates risk. BDCs don't pay interest on capital contributed by shareholders, and never need pay it back unless they want to conduct a share repurchase.

Banks may open their doors with investor capital -- needed to buy a branch location and fund initial payroll and overhead -- but the funding put to work in a mature bank comes largely from depositors. Depositors are the people who put money into demand accounts -- accounts that are payable on demand like checking and savings accounts -- or accounts payable at a fixed future time like certificates of deposit. Depositors do not contribute permanent capital and banks do not own the contents of depositors' accounts. The other way banks get funds is the way BDCs do, as ordinary creditors: banks issue non-deposit debt instruments such as commercial paper or bonds. Because virtually all a bank's assets under management are in fact borrowings from others -- FDIC-insured deposits are just a form of bank debt whose principal is guaranteed to depositors through a federal agency's guarantee program -- banks are financially precarious by nature, depending strongly on depositor confidence for their immediate-term solvency. Banks are thus stringently regulated with a variety of measurements, such as loan-to-deposit ratios, designed to ensure banks don't over-leverage deposits and find themselves unable to make timely payments that would collapse confidence and cause a run, then trigger runs on other banks, then panic the entire banking system.

As an accounting curiosity, banks' evaluation for solvency under the regulatorily-imposed ratio analysis allows banks to value their outstanding loans at face value regardless their liquidity or market value so long as the loans are performing, as banks are presumed to be in the business of holding loans until maturity for the purpose of receiving contracted-for interest, rather than being in the business of buying and selling securities.

The investment banks we used to have in this country, like Merrill Lynch, levered equity in the neighborhood of 40x to obtain high returns on equity. Investment banks didn't hold depositor funds and were not regulated like retail banks and didn't offer FDIC-insured deposit accounts, and they were not allowed to carry loans at face value while they continued to perform but had to mark them to market values on their financial statements in accordance with FAS-157. Investment banks made money both by brokering big commercial deals and by participating with the firm's own equity in the deals they nurtured (participating often both as debt holders and equity owners).

Unless I'm missing a firm someplace, the United States no longer has investment banks. Still-independent firms like Goldman Sachs are apparently submitting to regulation as commercial banks. These firms may have to restructure to enable their business to continue without impairment in the face of regulation designed in the 1930s for retail banks making home loans. As for firms like Merrill Lynch that became banks through purchase by a bank ... well, the merger committee at Bank of America over its new acquisition Merrill Lynch isn't scheduled to meet until 2010. The Jaded Consumer suggests observers prepare for business as usual for a while yet.

The Relative Risk of Runs
If you've seen It's A Wonderful Life, you understand the idea of a bank run.

A bank run is a special class of liquidity crisis brought on by depositors' unanticipated demand for deposits -- whether by non-renewal of fixed-time deposits in favor of superior investments, or by immediate demand for delivery of demand deposits in cash. In the best case, the bank merely suffers inability to plow expiring loans into new investment, as it is required to pay funds to depositors; in such a mild case -- hardly a run -- the business simply shrinks as the money leaves. As severity worsens, the bank may be unable to meet its own interest payments, payroll, or other overhead ... and in the ultimate extreme has a long line of depositors with outstanding demands, but no cash to meet lawful demands and no way to raise it.

Bank runs exist because banks' investments are not chiefly made with permanent capital contributed by shareholders who cannot make withdrawals, but by funds raised from special creditors called depositors (who can call their debt in without notice) and other creditors holding commercial paper or bonds. A decline in enthusiasm for the bank (or simple cash demand as might be caused by a bad business cycle) will tend to draw out demand deposits, and prevent a bank's replacement of maturing loans with new investment; this kind of withdrawal tends to shrink the bank's funds under management, and thus its capacity to generate returns. The chief problem with this is that banks' obligations to their creditors may have a much longer duration than the obligations of banks' borrowers to the bank.

Changes in interest rate can cause banks' spread -- the money kept by the bank when it lends money for more than its own cost to borrow -- to shrink or go negative. One of the reasons it's so important that a secondary market exist for home mortgages is to get long-lived debts off the books of retail banks so they don't tie up capital sourced from short-term obligations like CDs and commercial paper, or banks would quickly be tapped out of the funds they are willing to invest in long-term risks, and no more such loans would be available. After all, how many are keen to lend their local banks money for thirty years at a fixed rate at single-digit interest?

With A Lever You Can Move The Balance Sheet
Making money on the spread between banks' borrowings and their lendings has two basic possibilities, each with its own risks: huge spreads or high leverage. Huge spreads on something like a home loan would suggest horrific credit, which isn't to the appetite of a well-run bank, as it violates the first and second rules of obtaining acceptable long-term returns. So, the answer most banks turn to is leverage. Banks are often not levering just equity, though, but deposits -- that is, they're using cheap debt like demand deposits and fixed-term certificates of deposit as if it were capital against which to lever other debt like commercial paper and bonds. Yahoo claims that most of the banks I checked out had a "not applicable" debt-to-equity ratio. Deposits might make regulators happy about local confidence in a bank, but it's just debt and leads to crazily high debt-to-equity ratios at banks. I understand a 10:1 ratio of debt to equity is not thought of as particularly remarkable or alarming in a bank.

The risk of leverage is that if liquidity is impaired -- either because of surprise non-performance of debt held by the bank (you can ask Donald Trump's bankers how that's worked) or because of a run by depositors -- insolvency quickly follows. Even avoiding insolvency, the ratios by which the firms are regulated can get crazily out of whack. In the case of a bank, a run would cause loan-to-deposit ratios to push the bank into regulatory takeover. Banks don't have their money in a safe, they have it in various businesses and homes in which they've made loans. If depositors withdrew their money, banks simply couldn't cover it. The only thing that keeps banks running is confidence that banks will keep running.

ACAS: Immune To Runs
BDCs can't accept deposits and can't be subjected to a bank-style depositor run. Firms that have open-ended mutual-fund-like investment pools like Goldman Sachs' Global Alpha might create a liquidity risk by contracting to allow withdrawal of investment from a pool which may be filled with potentially illiquid assets (is there a secondary market for derivative instruments like total return swaps? even during a panic? who are the counterparties?), which could create a run-like environment in which withdrawal demands can outpace liquidity and, in the worst case, bust the fund. If the contracts for investment in the fund are not designed to protect the firm -- for example, fund assets aren't firewalled from firm assets -- the company could theoretically be imperiled by such a 'run' simply because panic-induced fire sales could cause terrible loss realizations and premature exits from performing investments that generate value. Barring terrible asset management plan design, BDCs don't face a run risk because they face no demand deposit risk.

ACAS has pointed out that its funds under management are generally permanent funds, which suggests that a withdrawal crisis as faces open-ended mutual funds is not a risk.

Since BDCs don't face run risks, they're safer from market panics than banks. A bank in a confidence crisis can quickly be turned over to regulators, whose priority is depositors and not general creditors -- and certainly not equity owners who used their shareholders' vote to install management that led to a bank failure. Regulators are interested in protecting the market and in protecting designated classes of creditors (the FDIC loves insured depositors to the extent of their insured principal, and the FHFA loves holders of guaranteed mortgages to the full value of the timely payment of unlimited principal and interest; in insurance-land, policyholders are the most beloved creditor, and enjoy certain protections under state-managed conservatorship and insolvency programs, and under state-run safety-net programs). Bank regulators have no special interest in either general creditors or equity owners. BDCs like ACAS may have share price impacted by panics that involve margin-related liquidations by investors, but the companies themselves are not at special risk and anyone solvent enough to keep their shares in a panic can continue to enjoy the dividends and the long-term returns.

In a panic, banks may be afraid to loan money (or may be too illiquid to loan money) which actually creates a fantastic opportunity for a BDC like ACAS. Not subject to depositor withdrawals, levered less than 1:1 (debt:equity), and enjoying permanent capital to invest, ACAS is in a position to make some of its most attractive purchases when blood is running in the street. Remember what Mr. Buffett said: be fearful when others are greedy and greedy when others are fearful.

Because it doesn't face depositor panics and has remained liquid in the current crisis, ACAS is in a good position to enter investments when others are too afraid or illiquid to enter deals.

How They Make Money
Financial companies of all sorts have the same goal as any other for-profit firm: to make a return that exceeds the cost of capital.

For banks, this is easy to describe: banks loan money for more than they borrow it, and keep the spread less their expenses. Banks also perform services, like those associated with credit cards, that provide some fee income atop any interest income associated with the activity. The basic idea isn't that banks get rich on ATM fees, though -- it's that banks charge more for home loans than they pay in interest to depositors and bond holders. If the loan performs, the bank keeps the spread. If the loan underperforms, the bank is on the hook to the extent of the underperformance. The bank always owes its own creditors what those creditors are due, though, even if its own customers aren't paying.

The story at ACAS is similar. ACAS invests money in applicants' businesses with the plan of obtaining a return that exceeds ACAS' cost of capital and its operating expenses. ACAS also offers services for which it collects regular fees. The difference is that the ACAS, after doing its due diligence on a deal, can tell applicants for its managed funds that the cost of the money will be a series of senior secured notes, a series of senior unsecured notes, a series or two of subordinated debt (some of which might have conversion features), some preferred stock, and a large stake in the common stock of the company. Banks may tell you they are your partner in business, but with ACAS this claim is not puffery but a literal truth; ACAS will send an operational team to tweak performance at portfolio companies, and sit on the board to oversee ACAS' interests. ACAS can afford to risk investment in illiquid non-public investments for an indefinite multi-year time frame because it's got permanent capital that can't be withdrawn. As a holder of high-interest portfolio-company debt, ACAS can get paid without need of liquidation -- and when profits at portfolio companies are good, it can as owner of the common stock pay itself a dividend.

When business is good, ACAS stands to benefit from its' portfolio companies' future financial business (after all, it controls its portfolio companies), so winners will become repeat customers. In the event of failure, ACAS' position as debt holder enables it to get paid first -- and its position as the controlling investor ensures it is in a better position even than a bank to determine how to respond to challenges, how to build or wind down business, and how to derive the best total return from a portfolio company. (Banks with defaulting customers would have to get a United States Trustee in bankruptcy to overtake and turn around operations, and even then the bank would not control operations directly; ACAS just casts a vote and does what it pleases, and need not wait for a federally-recognizeable state of insolvency to intervene to add operational improvements.) In the event of success, ACAS can add to customers' fixed interest payments the benefit of equity upside as high as the equity can go -- and obtain returns far beyond the lawful limits on loan interest. Moreover, because of balance sheet consolidation, ACAS shows portfolio companies' own earnings as ACAS earnings -- something no bank can do, and something that diversifies ACAS' revenues into every business sector and every geography and every currency in which ACAS (or its ECAS subsidiary in Europe) makes investments.

And that's really the bottom line on the business model: Banks and BDCs both stand to lose money if an investment fails, and each stands prepared to use security features and debt-holder status to minimize risk. However, if an investment idea turns out to be spectacularly good a bank is capable of earning no more than the spread on the interest rate in its loan documents. In other words, a bank's return gets better and better as a loan customer's financial position approaches solvency, at which point the bank's return is capped. By contrast, ACAS participates not only in the solvency-enabled contractual debt repayments, but as a controlling equity owner can ride an investment's success its the entire extent.

Even following ACAS' share price plummet from its all-time-high in the high forties, ACAS has offered a double-digit total return and continues to raise its dividend while offering a double-digit dividend.

Getting Paid
Your power to get dividends from an investment is based on both a company's inclination to pay dividends (like Apple doesn't), and the power of its cash flow to sustain dividends. In the current panic, banks have been slashing dividends due to liquidity problems, while ACAS has continued to pay dividends and to increase them according to a pre-announced schedule. Indeed, ACAS anticipates rolling into 2009 approximately $500 million in 2008 profits for payment of future dividends.

The Jaded Consumer realizes that people inclined to make investments often assume the future will be rosy, however, and are not inclined to look at the bad case in making an investment decision. Therefore, a little diversion into tax law is warranted. Most corporations must pay dividends from after-tax profits, if at all. Warren Buffett, who is offended at the tax-inefficiency of paying taxable dividends from profits that have been taxed once already, makes a point to pay no dividend at all from shareholders' profits at Berkshire Hathaway, but to reinvest to avoid double taxation (which is why Berkshire Hathaway's common stock price after Buffett's management of the company since the 1960s looks like this; you don't need a dividend to get an outstanding return). However, banks -- like utility companies -- are often regarded as income stocks. People expect good dividend income from banks, and banks regularly appear (well, before they cut their dividends) on lists of high-dividend stocks.

Enter ACAS. ACAS, as a BDC, has a peculiar tax status that allows it to pay dividends from pretax profits, provided it pays more than ninety percent of its profits to shareholders. Shareholders who want to reinvest can particupate in the DRIP, and those who want periodically to receive income need not liquidate shares as must shareholders of Berkshire Hathaway.

What does this mean? A bank that pays a dividend as high as ACAS is paying it from after-tax profits, meaning that it must make quite a bit more money than ACAS does. Corporate taxes in the United States, after all, are over a third of net profits. A bank paying an ACAS-like dividend is thus required to make about 50% more pretax profit per share in order to have the capacity to keep even with ACAS' dividend, after paying taxes.

Thinking back to high-risk investments and scary leverage levels as the principal magnifiers of returns, do you really want to own a bank stock that offers a dividend yield anything like ACAS' yield? And just how secure would such a dividend be over time, given what is known about the operation, risks, and leverage of banks?

ACAS has paid an increasing dividend every year since going public, and has never missed a quarter or lowered a quarterly dividend. ACAS has permanent capital and need fear no bank run. ACAS has business diversified across continents and currencies, and it doesn't need dangerous levels of debt on its balance sheet to produce the returns it has demonstrated year after year.

Conclusion: ACAS Beats Banks on Safety and Soundness
Unlike a bank, whose return is capped by usury laws and fierce competition for loan business, ACAS need not over-lever its balance sheets to achieve attractive returns. Serious competition for middle-market buyout opportunities is scarce, and ACAS is allowed to achieve significant returns over an investment's life from the complex, multi-tiered debt and equity investment structures through which ACAS protects its interests and oversees the use of its capital. ACAS offers illiquid private companies a single stop for investment needs, leading to an enormous volume of proposed business through which management can cherry-pick the very best deals in the middle market. Illiquidity discounts mean that operating earnings are more cheaply purchased, and ACAS has the patience to enjoy those operating earnings until a reasonable exit opportunity materializes. ACAS offers superior per-deal returns without greater risk than facing a bank (both can lose everything less their security), enabling a lower-leverage and thus liquidity-advantaged solution to achieving reasonable returns on deployed capital.

Why buy common stock in a bank, and hope for levered spreads on interest from a lender's financially sound customers, when you can buy ACAS and enjoy the interest, the quarterly earnings, and the capital gains on the shares of lenders' best customers? And do so without scarily-levered balance sheets?

The case for ACAS may sound like a generalized case for BDCs, but ACAS' position as the largest operating in its market segment places it in the position to invest at all levels up and down a portfolio company's balance sheet, enables it to obtain superior results by acting as the controlling investor, and saves it from being a speciality investment vehicle with interest solely in debt instruments or the like. I'd love to hear from readers about other BCDs situated as ACAS is, but so far ACAS appears sui generis.

I hope the market's current panic makes the DRIP purchase price awfully low, as I plan leaving it running. And the longer the panic continues, the longer ACAS will have to buy the best middle-market opportunities at the most attractive possible prices, enabling the best possible yields. ACAS' willingness to walk away from turkeys assures us that ACAS won't accept lousy deals just to be making deals, even when it causes a short-term black eye. How different this is from banks that churned out terrible loans just to make their quarterly fee numbers!

ACAS is looking out for the long-term, and I love it.

Saturday, September 27, 2008

Houston Getting Power

This week, about a quarter of Houstonians are still without power -- but more are getting power restored daily. Trucks from Pennsylvania and Connecticut have been spotted, and the estimate that ten thousand imported repair workers are in town is probably accurate. One power company, Entergy, boasts that all its Houston-area subscribers are back in power.

The M.D. Anderson Cancer Center offers an example of how this weather-related disaster can wreak havoc on institutions with no material physical losses. Anderson didn't lose power, both because it has generator backup and because the backup wasn't needed: the Texas Medical Center is supplied with power by buried cables, which weren't hit by falling trees. Centerpoint has some 14,500 steel transmission towers, and zero of them were destroyed. The power losses appear to have been caused almost exclusively by lines and connections being severed by falling trees. One wonders how much economic loss might be saved in the future by an investment in increased underground cabling.

Houston hasn't got a hotel shortage, but perhaps a third of the rooms are unavailable due to damage or simple absence of power. With FEMA having bought up all the remaining unoccupied hotel rooms, people coming to Houston for business have a hard time obtaining accommodations. Since a third of M.D. Anderson's patients are out-of-towners -- all of them paying customers, as opposed to storm-turfed nonpayers -- the institution has taken a substantial economic hit.

The problem of storm-turfed nonpayers (non-paying patients "turfed" to Anderson by institutions closing shop for the storm) is vexing because they aren't Texans qualified for coverage under state indigency programs (else their care would not be uncompensated), but are people that other branches of the University of Texas Health Science Center (coughGalveston'sUTMBcough) thought they'd treat on taxpayers' nickel, for fun, despite that they flew into town from other states or countries in order to pose as broke needy locals and are scamming them for free services. Yes, people fly into Houston from Iran and similar places for cancer treatment, and try to avoid paying a nickel for it. No, Texas legislators didn't think they'd opened a worldwide free medical clinic when they funded the University of Texas system during the last legislative cycle.

Some nitwit administrators don't know how to pronounce "no" or "fraud" and just let these folks walk all over them. Maybe they think pissing away taxpayers' money on people who not only don't qualify for indigent care but aren't even Texas or even U.S. taxpayers is somehow a worthy cause. My subtle take is this: being scammed isn't a virtue, and letting people scam you out of resources you are safeguarding for the public is lazy and corrupt.

Sometimes, it's people driving across the Texas border and pretending to be an American cousin to get coverage, and sometimes it's folks flying their known-sick relatives from other continents to the Texas Medical Center to foist them on local hospitals in the hope of winning the medical lottery. I hear someone in the distance crowing about universal health care, and the need for it, as if we should be happy to suffer this indignity. (Nevermind the only reason we now lack it is federal obstruction of state regulation to create universal coverage; let's hear the plea for federal single-payor care and try not to puke.) Even under a universal health care system as exists in Hawaii, Germany, Canada, or the UK you can't just fly into town and demand outrageously expensive treatments for the serious diseases you know you've got. The public feeling of entitlement to health care really creates problems in a place like the M.D. Anderson Cancer Center, where treatments for serious illness routinely cost six and seven figures to provide. The volume of patients at Anderson are quite a bit higher on a daily basis than the emergency rooms that are forced to give uncompensated care to folks who roll in on ambulances, so the losses mount faster. Suddenly absorbing unfunded fraudulent care cases from other branches of the U.T. system (because their administrators don't bother to do the work needed to weed them out) is a serious blow atop the sudden loss of so much regular paying work.

But back to the original point: Houston's power and infrastructure are getting back into shape. Folks with actual physical damage to their power connection to their homes are having the most trouble getting re-connected. I continue to encounter intersections whose traffic signals are dead or flashing, if not laying in the median in pieces.

The Mayor stated that the driveability of Houston roads was mostly restored by citizens responding to his call to take chainsaws and axes to felled trees blockading streets, and was mostly remedied in the first forty-eight hours following the storm. The existence of civil order in Houston appears to have been key to the relatively swift restoration of infrastructure to usability. The existence of a curfew order may have been useful to prevent property crimes, but the number of citations for curfew violation seems to support my thesis regarding the order: it was designed to amplify a show of force by police units, and not to be directly enforced. I strongly suspect selective application on the basis of subjective factors, but I anticipate that officers trained to avoid appearing to conduct profiling "needed" the curfew order as cover for what amounted to a profiling-based enforcement policy.

The intentional use of a curfew order as cover for arbitrary or oppressive enforcement would be very concerning. However, I suspect the order was intended not to support invidious discrimination but to provide cover for hard-to-quantify suspicions regarding vehicles and persons believed by officers not to appear engaged in innocent behavior. The intent of the persons creating the curfew -- that is, if they didn't intend it to be applied uniformly but only selectively against persons bearing undescribed characteristics that would lead police to want to stop and search them -- is a matter that deserves some thought in respect to legality and constitutionality, but that's not this post.

The Bolivar Peninsula appears to have been largely converted into a wasteland, and I expect in time the death toll from the storm will be revised upward as known or suspected non-evacuees are presumed dead.

Tuesday, September 23, 2008

Back in Houston

Houston is up and running. Tens of thousands still struggle without power, but I have seen utility vehicles from as far away as Connecticut working all day restoring utilities. Every day more get power.

The Mayor has decided that the city's landfills don't need to hold tons upon tons of trees, and has started buying wood chippers for the city. The city will have use of wood chips in the parks, and there may be commercial customers. Reduce, reuse, recycle.

I have no Internet connection. Actually, for the price of a Value Meal, I can use a connection at Chick Fil A while I guzzle lemonade (I'm still not sure about the water quality).

I have pics, and more notes on both the evacuation and the vehicle and the food and the iced tea, but these will have to wait until I have a steady connection at home.

More later!

ACAS Opens Asian Office

American Capital (ACAS), which as I write trades above its last-published NAV after trading at a substantial discount for some months, announced today that it is opening an office in Hongkong.

Just to be clear: ACAS isn't announcing the launch of an Asian analog of European Capital. ACAS is announcing that ACAS has opened an Asian office, (a) to help existing portfolio companies access Asia, and (b) to establish relationships with Asian institutions. ACAS is thus targeting Asia with expansion efforts (a) targeted at the businesses of its portfolio companies (which might benefit from better relationships with Asian customers and suppliers), and (b) targeted at growing its funds management business. It's this second thing, growth of funds management business, that will eventually give rise to an Asian subsidiary that does for Asia what European Capital does for Europe. That's not today's announcement, however.

ACAS appears to be executing nicely. ACAS hasn't paid a fortune for an Asian equity boutique, but is building at modest cost using organic growth methods. If and when ACAS develops meaningful Asian funds management business, it will do so at low cost -- to the benefit of existing investors.

Since ACAS is trading above last-published NAV, it is unable to use the stock buyback authorization even if a window opens in which the company isn't barred from making purchases. I have a faint hope that ACAS made some purchases while the stock was in the toilet, but based on past performance I expect most of the quarter has been spent in a trading blackout.

Saturday, September 20, 2008

Heading Back to Houston

Now that half Houston has power and some of the grocery stores seem to operate nearly normally, I'm heading back home.

I don't have an Internet connection there because Comcast hasn't got its stuff together, so I may be out of touch for a while as I get situated and try to get back into business.

I have some half-finished posts I'm dying to get finished, but they'll have to wait.

See you soon!

ACAS: Lazy Man's Diversification

You've heard that you need to diversify. You just don't have the time to know enough about ten or twenty investments to feel like you

American Capital Ltd. -- Overview
American Capital Ltd. (ACAS) has been featured on The Jaded Consumer as an example of how stock analysts don't aid meaningful comprehension of investments, so you might want to consider this recent corporate overview to help you see what ACAS does to earn its money. (Or read the earlier posts here.) American Capital Ltd. is a top-performing Business Development Company (BDC). Unlike Berkshire Hathaway, which pays no dividend because it is tax-inefficient to allow income to be taxed twice, ACAS' tax status enables it to avoid paying taxes on profits paid to shareholders as dividends (so dividends are taxed but once, in the hands of shareholders). Dividends at ACAS have steadily increased since the company went public, so deriving liquidity from the shares doesn't require exit; one can join or drop dividend-reinvestment as one pleases, to suit liquidity needs.

American Capital's 280 portfolio companies across North America and Europe provide diversification across industry, geography, and currency. You've probably worn Riddel sport safety equipment, bought Evenflo products for your kids, and seen Piper aircraft in flight. Unlike a bank, which at best gets paid a fixed loan rate that doesn't violate usury laws, ACAS participates all up and down the balance sheet with various classes of equity and debt -- protecting its investment interest in case of failure, and ensuring good upside in case of success. Control over so many of the companies in its portfolio enables ACAS to direct exit whenever opportune, leading to significant liquidity through routine portfolio turnover. This liquidity assures shareholders of ACAS' continued dividends. Indeed, much of ACAS' 2008 dividend has thus far been paid with 2008 capital gains, and ACAS expects to roll $500 milion in taxable income from 2008 into the future pool from which it will pay 2009 dividends.

Shareholders often view subsequent share issuance with fear: issuances conducted by companies in trouble can be done well below market price, the dilution can cripple future earnings per share, and they can result in management influence by outsiders whose interests are aligned in opposition to the interests of early shareholders. If ACAS has done well in the past, might share issuance dilute owners of the "good" assets by pumping new money into less-attractive investments? Might new shares raise less money than ACAS' existing owners have in equity behind their existing shares? ACAS' share issuance has been conducted at an average of 1.5 times book value, meaning that ACAS' old shareholders ended up with a great boost to NAV after new share issuance.

ACAS offers a way to invest in a broad portfolio of presumably undervalued mid-market companies ordinarily unavailable to the small investor. ACAS is sensitive to the impact of valuation multiples because its assets' values (outside of a few publicly-traded holdings, like ACAS-managed AGNC) are estimated on the basis of such multiples. As multiples expand, ACAS' value follows.

As portfolio companies profit, ACAS is required to pay dividends – investment multiple or no. So buy for the capital appreciation, or buy for the income, but I think it's a buy all around.

Friday, September 19, 2008

American Capital Agency: Really Making Money

Jaded Consumer predicted of American Capital Agency (AGNC), following the 31¢ dividend it paid on the 27-day stub second quarter in which it initiated operations, that its full-quarter dividend looked set to exceed 90¢. Today, AGNC announced a quarterly dividend of $1.00 per share for its first full quarter of operations. At AGNC's IPO price of $20, this would yield an annual dividend return of 20% -- but AGNC hasn't closed at 20 since Monday, September 8. AGNC is likely to continue to exceed a 20% return even if it trades marginally above NAV.

AGNC's performance continues to be understated at Yahoo because it hasn't got twelve trailing months of performance, so AGNC's partial-year results are given as full-year results. The sale on AGNC should continue while AGNC continues to fly under the radar of investors using screening tools that aren't smart enough to notice AGNC's annualized results.

Whether AGNC remains mispriced after that is another question entirely.

ACAS, the SEC, and the Stock Buyback Authorization

There are several theories to offer about ACAS' recent surge from under 20 to past 25.

First, let's simply erase the possibility that people suddenly "get" ACAS and its business. They don't. Understanding ACAS' business would involve reading something more complete than Yahoo's sloppy synopsis and separating the noise from the signal to hear ACAS' story.

Second, it's not the case that ACAS benefitted from the new rule barring until October 3 establishment of short positions in 799 specified financial stocks. The rule doesn't bar maintenance of existing short positions, and the list doesn't include ACAS.

The culprit seems to be the sudden and entertaining interest on the part of the SEC in enforcing rules that have long required actual delivery by short-sellers of certificates to the people who thought they were buying shares of companies rather than a mere promise of shares' delivery. The SEC, after long nodding amiably at "naked" short sellers even as it recognized an epidemic of failure to deliver certificates (see the update at the post bottom), now claims, "the SEC has zero tolerance for abusive naked short selling."


I imagine what the SEC means is that naked short selling, despite being illegal, is still fair game as long as it is not deemed "abusive." I thus expect no serious SEC enforcement. Nevertheless, fear of enforcement -- perhaps by short-sellers' brokers (some activity triggers action by participants of registered clearing agencies) -- has apparently caused long-naked-shorted stocks to be bid up in price (spreadsheet here). The new rule amplifies Regulation SHO (effective sinve January of 2005, for what good it's done) with "enahnced delivery requirements" that allow sellers of securities at least three days, and sometimes more, for securities to be non-delivered before the rule is violated. Anyone engaging in short-term manipulation thus has ample time to hit and run, as the cure for violation is to purchase the non-delivered shares.

When the G-8 Economic Summit came to Houston in 1990, they prettied up the streets by rounding up all the mentally ill homeless that used to be found casting demons from vending machines and preaching heaven or damnation to passersby based on whether they felt generous with their wallets. This doesn't sound like a big deal until you appreciate how ubiquitous the presence of the homeless is in some parts of Houston, such as near downtown and near the Texas Medical Center. Sometimes, it's sporting to try to imagine the kind of command hallucilation would cause a grown man to stand on one foot, opposite fist in the air, and hop in place while yelling incoherently. It was clear as day that these people aren't out on the street exercising their choice to live free of employment or shelter, but are ill. They don't have access (or perhaps, they don't have interest) to pursue ordinary hygenic activities, so they can look and smell and otherwise present a poor impression to visitors. Houston still has episodes of trying to handle "the problem" of the homeless, often in ways that aren't legal. The G-8 Summit served as the high-water-mark for organized anti-homeless activity, though. I don't know whether, with the world looking at Houston for a week, officials jailed these folks for vagrancy, or whether officials found funding to have them psychiatrically evaluated in a county mental health facility until their disinterest in treatment programs could be fully appreciated (after the end of the summit), but they were all back on the street, hard at work casting demons from vending machines, shortly after the Summit was concluded.

I expect this kind of pretend concern for naked shorts' abusive practices will last about as long as naked shorting remains in the headlines. I do not expect to see any offender jail time, just enforcement window-dressing. Just as buying on margin ordinarily forces investors to pay interest, selling short should be expected to cause short-sellers to pay a rental fee to the supplier of the shares sold short. Failure to enforce delivery requirements artificially cheapens the cost of short-selling. Just as getting free margin loans would be considered a frightening risk to drive prices irrationally upward (by adding buying pressure), non-requirement of securities delivery makes it artificially inexpensive to sell shares one doesn't have and elevates the risk that prices will be depressed through the cheapened availability of selling pressure. The SEC's long-running non-enforcement is obnoxious and irrational and fosters unnecessary fear. Foisting enforcement upon clearing houses might cause activity, but the fact the SEC can't be bothered to prosecute offenses is simply boggling. As Mr. Chiarella can tell you from firsthand experience, the SEC was once very active in persecuting -- er, prosecuting -- people suspected of unsportsmanlike behavior even when there was no law broken at all.

The fourth possibility is interesting: ACAS closed 2Q2008 with most of a $500 million share buyback authority uspent, due to lack of non-blackout trading days. Trading at about a third below its NAV and offering a dividend north of twenty percent, I'd think share buybacks would be a solid mechanism to ensure Company benefit from capital available for share buybacks. The downside of the share buyback is that as ACAS loses equity to share retirement, its 1:1 maximum debt:equity ratio deprives ACAS of much more money that it might have invested. In other words, at a 0.7:1 ratio (a ratio ACAS recently kept to avoid running into liquidity problems in the face of NAV risks under FAS-157), a $100 million buyback would cause a $170 million reduction in available capital for investment (because reduction in capital for investment must be matched with a reduction in borrowings for investment, if the debt:equity ratio is to be maintained). If the return on $170 million invested in currently-available deals (net of its interest expense) exceeds the twenty-something percent return on ACAS from dividends, ACAS would rationally prefer to enter deals than to retire shares through a buyback program. Given the state of the deals I expect to be available in this economic environment, I would be entirely unsurprised to discover that ACAS preferred to enter deals.

On the other hand, if ACAS' management expects to return to above-NAV in the medium term, they may view the timeline of the investment in share buybacks as from-purchase-till-reissue and conclude that the total return is not only the twenty-something-percent dividend that isn't paid on retired shares, but the appreciation from >$7 below NAV to whatever premium exists at the next issuance. If ACAS were to sell shares at ACAS' last-reported NAV (over $27) in two years (and there was no NAV improvement in that time), the "exit" might be something like one third (~33%) above recent prices, which atop the >20% dividend would provide an annualized yield easily exceeding 35%. The outlook for a strong risk-adjusted return on a share buyback could be great indeed; without any "exit" ACAS yields the 20%+ dividend return, and need never issue shares again if it's not attractive.

The things to look for in ACAS prices are #3 and #4, I'd think. Shortsqueeze.com claims ACAS' short status is exactly the same as it reported earlier this week:
The short interest is evidently not part of the data ShortSqueeze.com offers with a 20-minute delay, given the short-rule-related price increase observed in ACAS and the unmoving short interest reported at SQ. If undelivered positions were being traded out, and re-initiated with other brokers, for no net reduction in short interest, the price would not have moved as a result of the transactions. The price action and timing suggests short positions' closure, but there's no short interest change reported at ShortSqueeze.

Maybe ShortSqueeze data is no better than Yahoo data. If anyone has a good source for short interest data, please leave a comment!

Blogger Eats Political Comments!

The author of the Enlightened American blog emailed me with irritation:
I replied to your McCain VP post with a long-winded comment but it seems like it was never approved. What gives?
Jaded Consumer never received it :-(.

I notice all the comments Blogger tells me have been offered -- I enabled moderation after getting unreadable posts whose apparent purpose was to create links for commercial products -- and I haven't seen any Palin-related comments. I went back and looked again. I'm not trying to run a political censorship campaign here -- I've even predicted McCain loses the election, though not for the reasons I now suspect will erode interest in the Palin/McCain ticket -- but I didn't get the comment and never got the chance to tell Blogger to put it up.

I think we all benefit from airing the past views and present claims of politicians, and lining these up against genuine analysis of the fields in which they are making claims and policy proposals.
But in any case, I think you do me a disservice by dismissing my viewpointas "partisan" and therefore biased. While I may support Obama, I feel I can still keep some perspective in analyzing the mechanics of the race. As I've mentioned, I used to be a campaign hack (on the local/state level) and so mechanics and tactics are just as interesting as the partisanship of it.
I definitely didn't intend to dismiss the view published EA as illegitimate on the basis of bias. It's the sum of all our biases, after all, that give us an election result we as a culture have claimed is the only source of ligitimacy we have. My comment was specifically about the claim made that Palin's speech was a failure because it was delivered weakly, and failed to persuade Clinton supporters. I took the view that Palin's target audience was not already-committed Obama proponents, and asserted that Palin's speech didn't fail for the reasons outlined at EA. As person with personal experience in politics, EA's author may bring a sophistication or a raised level of expectation that yields a different perspective than might be found in Palin's target audience.
In any case, I don't want to rehash all of my points but just to say ---> I'm not wrong yet!
I definitely wasn't trying to call the election for Palin, and would definitely not try it on the strength of one speech during the first week the nation knew her name. I do think Palin was a net benefit to McCain's campaign, however doomed (the Republicans have serious brand-rebuilding to do in the wake of their failure to deliver the small government Republicans have been preaching for years), and the fact she alone isn't enough to save it doesn't change that she, and her speech, were a net gain for the campaign.
I know you've viewed some of the stock analysis on my site and hopefully, you will notice that I go to great lengths to explore the risks/negatives of my stocks, despite MY BIAS OF HAVING MONEY ON THE LINE.
Having a dog in the fight is very good for one's attention, and this attention hopefully improves the detail-gathering that helps prevent significant things slipping by during analysis. The Jaded Consumer contains scoffing posts railing against service falures at Apple (and things like comical buzz-generation and its seemingly useless cash management, published at a time it was my largest holding. (Currently, it is not: in the aftermath of Ike, and in light of my inability to work from North Texas, and the threat of collapse in the markets, I've lowered my exposure to Apple for the simpe reason that I had lots of capital there at a time I needed to be much more liquid. Unlike EA, I don't try to keep track of my investments publicly, as I have a hard enough time doing it once annually at tax time.) Kicking your own tires is worthwhile, and if you don't appreciate the weakness of a thesis you won't be able to assess it properly.
Also, part of the reason the Palin pick was so risky for McCain is that there are so many fires they have to watch for now. Hence, they put her in a bubble and it's already backfiring.
I don't think anyone believes the choice wasn't risky. But the alternative was to take an arguably worse risk: a runningmate who would not excite anybody, and would leave Obama with all the free celebrity press. The free press Obama has garnered on novelty interest has been worth a fortune, and cannot be bought at any price: genuine buzz yields news stories rather than just paid ads, and the consumers treat these differently. A play to take the "new and different" mantle worked in the near term by putting McCain -- or, rather, Palin -- in the eye of the media.

The fact that politicians can't keep a mantle like "new and different" very long if they do anything -- their action, if any, will line them up with some interest and appear to out them as part of one establishment or another, to the alienation of someone -- ensures that Palin's temporary capture of this buzz can't possibly decide an election as far away as November. However, the Palin announcement has garnered the Republicans some excited free labor from a previously slumbering base (a problem Obama's campaign didn't have) and a great deal of press McCain hasn't been able to obtain for himself (possibly because he's thought to be a known quantity, and therefore unexciting and no good for capturing eyeballs and thus selling advertisements).

I would like to say there's a candidate that makes me optimistic about the next presidential administration, but what I've heard from the campaigns' various mouthpieces has only made my eyes roll. I'm willing to call the election for Obama, but not with any sense of victory. I think the erosion of the Republicans' brand over the last few cycles prevents their victory: the candidates' announced positions are sufficiently similar (with concessions made to the parties' bases) that the marginal votes that decide the election will likely be won not on the basis of prposed policies but mudslinging efforts to depict the opposing candidate as scarier. The idea that candidates "win" by being the lesser of evils is frankly revolting, but in light of the alternatives -- not this election in particular, but generally -- what other basis is plausible?

Elections in this country are so structured that candidates with any hope of really changing things at the national level are long-gone by election day. The behavior of the major parties in advancing their own interests over those of purprted constituents is a betrayal of voters, and there's little at the national level to stop it. The federalization of virtually every field of law has made serious reforms at the local level implausible, as meaningful effort to effect useful change (like universal health coverage in Hawaii and Oregon) is quashed by federal law (Hawaii's program still exists only because of an explicit grandfather clause, the effect of which is to freeze Hawaii's plan in the form in which it existed in 1974, preventing implementation of fixes for decades of observed shortcomings). Frustrated citizens disgusted with the conduct of elected officials can hardly be blamed for concluding that the whole system is so rigged against the public interest that participating in it at all is a surrender to thieves.

However, the solution must come from tha ballot box; the alternative is too terrible to want to imagine. Reform must come. However, like frogs in a slowly warming pot, our fellow-citizens sit still, content to wait until something seems alarming enough to effect systemic improvements. So long as the pot boils slowly enough, the perceived emergency will not be recognized until it is too late to prevent even more serious disaster.

Federal Government To Insure Money Market Funds

I'd like to see the way money market insurance will be priced, and I hope it's not like the federal government priced deposits in FSLIC-insured accounts before the S&L crisis, or like the federal government priced flood risk in the flood insurance program that encourages construction in known flood plains.

Bush, in announcing a halt in short-selling in certain financial stocks, stated:
"Anyone caught in illegal transactions will be caught and persecuted."

Freudian slip?

He also stated that since the federal government began insuring bank deposits seventy-five years ago, no customer has lost a cent in an insured account.  This may be literally true (at least within the $100,000 insured amount limit on insured accounts).  However, the time I recall people waiting for their insured funds to be paid to them under the FSLIC's program when the S&Ls collapsed in the 1980s was much longer than I think anyone's broker is going to give them if a customer with large sums invested in a federally-insured money market account should face a margin call on the basis that the failed fund has ceased to represent funds available in the account.

Thursday, September 18, 2008

Houston at Ike+6

Houston remains a debris field, but more people are getting power restored. Restaurants able to serve customers -- I assume these are restaurants with gas grills, ovens, and stoves -- are doing a brisk business, so brisk in fact that to handle more customers they've in some cases produced special post-storm menus with limited range, so the kitchen can focus on churning out tons of food without having to worry about what people are ordering. At Papasito's on Richmond near Kirby, you can reportedly order three drinks: beer, frozen Margaritas, and water.

Eyewitness reports show that though my home is surrounded by people with functioning electrical power, I seem to have the wrong sort of luck for absentee power restoration: my place is still dark, and the fridge is going to need evacuation. According to CenterPoint Energy, my area sustained significant damage and isn't expected to have power restored until sometime after Monday, September 22.

ACAS Up >29% Today

According to ShortSqueeze.com, today's 29.5% share price increase in American Capital Ltd. (ACAS) wasn't the work of short-sellers covering, as the short interest actually increased from 34.0 million shares to 38.9 million shares, to 19.11% of the float.  Institutional interest stands at 43.5%, down a bit from the 45% observed in May, so it's not as though suddenly pension funds started loading up.

The increased short interest is oddly bullish, in my view:  it represents a pool of shares that must be covered as share prices rationalize.  In essence, shorts taking a position in ACAS bet the dividend won't be paid, or that share price declines will offset paid dividends.  These must be the case for short-sellers to maintain their positions, because the alternative is that short-sellers must pay the dividends to the holders of the shares they've sold short.  Short-sellers' theory requires that past performance not be an indicator of future results, as ACAS' past performance includes the declaration, since a 1997 IPO at $15, of over $29 in dividends

Short-sellers banking on an illiquidity-related collapse are essentially playing chicken with a train that's been building momentum since ACAS' CEO began doing employee-led buyouts in the 1980s.  ACAS' management either has a pipeline full of portfolio comany sale deals in various stages of closing, providing a source of ongoing liquidity without need to access capital markets, or management lied on the last several conference calls.

I don't understand the short play, unless it's a short-term confidence play, or a bet that everything here is a direct lie.