Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.
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Continuing on our hypothecation theme, David Stockman, former Director of the White House Office of Management and Budget during the Reagan Administration penned the following to Mrs Lee Adler of the Wall Street Examiner. Stockman is currently writing a book on the financial crisis and some of the thoughts he expresses in his exchanges with Adler relate to the ideas he is developing in the book.
Those you hoping for a quick end to the ructions in Europe and a return to normal levels of volatility may wish to ponder Mr Stockman’s thoughts on why European Banks are on the verge of collapse:
“The real story of the present is the shadow banking system, the unstable and massive repo market, and the apparent daisy chain of hyper-rehypothecated collateral. It looks like the sound bite version amounts to the fact that the European banking system is on the leading edge of collapse for the whole system. These institutions are by all evidence now badly deficient of the three hallmarks of real banks—deposits, capital and collateral.
BNP-Paribas is the classic example: $2.5 trillion of asset footings vs. $80 billion of tangible common equity (TCE) or 31x leverage; it has only $730 billion of deposits or just 29% of its asset footings compared to about 50% at big U.S. banks like JPMorgan; is teetering on $500 billion of mostly unsecured long-term debt that will have to be rolled at higher and higher rates; and all the rest of its funding is from the wholesale money market , which is fast drying up, and from repo where it is obviously running out of collateral.
Looked at another way, the three big French banks have combined footings of about $6 trillion compared to France’s GDP of $2.2 trillion. So the Big Three [F]rench banks are 3x their dirigisme-ridden GDP. Good luck with that! No wonder Sarkozy is retreating on France’s AAA and was trying so hard to get Euro bonds. He already knows he is going to be the French Nixon, and be forced to nationalize the French banks in order to save his re-election.
By contrast, the top three U.S. banks which are no paragon of financial virtue—JPM, Bank of America, and Citigroup—have combined footings of $6 trillion or 40% of GDP. The French equivalent of that number would be $45 trillion. Can you say train wreck!
It is only a matter of time before these French and other European banks, which are stuffed with sovereign debt backed by no capital due to the zero risk weighting of the Basel lunacy, topple into the abyss of the shadow banking system where they have funded their elephantine balance sheets. And that includes Germany, too. The German banks are as bad or worse than the French. Did you know that Deutsche Bank is levered 60:1 on a TCE/assets basis, and that its Basel “risk-weighted” assets are only $450 billion, but actual balance sheet assets are $3 trillion? In other words, due to the Basel standards, which count sovereign and other AAA assets as risk free, DB has $2.5 trillion of assets with zero capital backing!
This is all a product of the deformation of central banking and monetary policy over the last four decades and the destruction of honest capital markets by the monetary central planners who run the printing presses. Furthermore, this has fostered monumental fiscal profligacy among politicians who have been told for years now that the carry cost of public debt is negligible and that there would always be a central bank bid for government paper. Perhaps we are now hearing the sound of some chickens coming home to roost.”
Posted by Roger Montgomery, Value.able author and Fund Manager, 16 December 2011.
Investors should keep a close watch on Monadelphous and Fleetwood. If their premiums to intrinsic value decline, they may present attractive opportunities. Read Roger’s article at www.eurekareport.com.au.
How many of you have heard the financial term ‘Hypothecation’? Microsoft word hasn’t – the bug-prone program constantly tells me to check the spelling. If it’s also new to you, take note because you may be hearing a lot more about it and it could impact your portfolio.
Prior to the collapse of MF Global, it’s unlikely that many in the investment world would have ever heard of the terms; ‘hypothecation’ or ‘re-hypothecation. If you hold any dollars in an international brokerage / trading account, especially one where your funds are dispatched to somewhere in the UK, hypothecation may be the canary in the mine.
MF Global was allegedly using client-segregated monies for its own trading activities – a practice that is for obvious reasons, not practiced in most countries. The trading brought a 230-year old firm to its knees in a matter of weeks and resulted in the freezing of client funds. Funds thought to be ‘segregated’ and separate from the working capital of the firm, weren’t. But is MF Global an isolated case or is a practice that levers clients funds widely practiced and one that could undermine the financial system?
What the MF Global collapse has uncovered is that laws designed to prevent to access to ‘segregated’ accounts are being circumvented. Some firms may have also shifted accounts to countries where it is legal to access client’s funds for the firms trading activities. When you thought the only risk was that of your trade or investment selection going wrong, think again.
Hypothecation is, in simple terms, the practice of a borrower putting up collateral to secure a debt. An example of this is the typical purchase of a house. The buyer puts down a 20% deposit and borrows the remaining 80%. In this case the borrower has put up some cash and the house (at an agreed value) as collateral to cover the debt until the mortgage is paid off. Until such the borrower retains ownership of the collateral. Thus the collateral (both the deposit and the house) remains “hypothetically” controlled by the creditor, usually a bank. If the borrower can’t afford to meet agreed repayments (default), the creditor can take possession of the collateral and sell it to recover its assets. That’s Hypothecation – hypothetically the borrower owns the house, but in fact, they don’t until all loans are paid off. The same goes for securities purchased on margin.
With the basics out of the way we return to MF Global. Surprisingly hypothecation occurs when an investor puts their capital into a trading account to buy and sell securities such as CFD’s, Futures, Options, Commodities, etc.
And that should be that. Your money sits in your segregated trading account as collateral covering your positions – margined or not – until such as a time that you suffer an inability to pay back your debt to your broker (creditor) – if you ever do. And that is as we know it in Australia. MF Global here in Australia appears to have followed that procedure. But has it done so in the UK and the US? And how do others behave?
The practice and rules regulating hypothecation vary depending on the jurisdiction in which the trading account exists. In the US for example, the legal right for the creditor to ONLY take FULL ownership of the collateral if the debtor defaults is classified as a lien – a form of security interest granted over an item of property to secure the payment of a debt or performance of some other obligation.
In the UK however, these rules are more than a little different. In the US there are some breaks, re-hypothecation is capped at 140% of a client’s debit balance. In the UK however, there is no limit on the amount of a clients funds that can be re-hypothecated, except if the client has negotiated an agreement with their broker that includes a limit or prohibition. UK brokers can ‘REUSE’ collateral put up by clients to secure their own trading activities and borrowings through a little unknown process called Re-hypothecation! While you may think that your ‘segregated’ capital is being used only as collateral for your own trading activities and borrowings / margin, a firm such as MF Global who operates out of the UK, can re-use their clients collateral to back their own trades and borrowings! Are you thinking credit card on credit card, gearing on gearing, leverage on leverage? And how do excessively leveraged position usually work out? Not well generally.
In the industry it’s referred to as “fractional reserve” synthetic liquidity creation by Prime Brokers. The IMF in their 2010 paper The (sizable) Role of Rehypothecation in the Shadow Banking System” Manmohan Singh and James Aitken state: “Mathematically, the cumulative ‘collateral creation’ can be infinite in the United Kingdom”. They add that courtesy of no re-hypothecation haircuts one can achieve infinite “shadow” leverage and the creation of a large shadow banking system.
Gary Gorton in his 2009 paper “Haircuts” about systemic risk in the repo market (something I used to teach for the Securities Institiute of Australia) suggests that banks’ reliance on the repo market constitutes a systemic fragility which renders the entire banking system prone to runs: “Gorton predicts the crisis was not a one-off event and it could happen again”.
He also addresses the relationship between confidence and liquidity suggesting when “confidence” is lost, “liquidity dries up” and concludes the financial crisis was a manifestation of an age-old problem with private money creation, banking panics. ‘Haircuts’ are the functional equivalent of information arbitrage: “When all investors act in the run and the haircuts become high enough, the securitized banking system cannot finance itself and is forced to sell assets, driving down asset prices. The assets become information-sensitive; liquidity dries up. As with the panics of the nineteenth and early twentieth centuries, the system is insolvent.” “Liquidity requires symmetric information, which is easiest to achieve when everyone is ignorant. This determines the design of many securities, including the design of debt and securitization.”
What Gorton says is that the increasing complexity of banks and the securities they issue is motivated by the need to obfuscate the masses and distract them from what is really occurring.
Let’s say a hedge fund (who is managing your money) puts up $100,000 collateral to support a leveraged position of $1,000,000. If the broker then re-hypothecates that $100,000 and uses this to support the same level of leverage, the firm is in a position where just $100,000 in collateral (not theirs) is supporting $2,000,000 in leveraged market positions.
A move of just 5% on $2,000,000 equates to $100,000 in profit and both you and your broker make $50,000 each. A move however of 5% against a $2,000,000 position can however wipe most of the collateral – and such moves are not uncommon today. While a single trade will unlikely bring down a broker’s diversified trading book, if all trades move in unison (remember US house prices were never expected to all decline at once), as was the case when MF Global traded European bonds, you can see how quickly everything can unravel.
And remember, while the broking firm enjoys all of the trading profits and fees, the clients bear the risk. If the broker loses, they file for bankruptcy, leaving clients holding an empty can. This appears to be what transpired at MF Global. It’s the ultimate privatization of profits and socialization of losses. And according to an increasingly vocal group of experts it could all happen again if a sovereign defaults.
And now you also have the reason why Central Banks around the world are applying a policy of ‘price stability’ or ‘price support’ in asset markets like the stock market – everyone is leveraged to the hilt.
It has been estimated that in 2007, re-hypothecation accounted 50% of the worlds Shadow banking system and the IMF estimated that US banks received $4 trillion of funding from the UK from re-hypothecation using just $1 trillion in clients funds, funds being levered several times over. In this light, don’t think for a moment that MF Global is alone in using client’s funds to trade and borrow for their own trading activities.
It appears in the current market environment that the first question you should ask is not whether or not your investment idea will work out correctly, it’s more a question of whether the money you put into your broker sponsored account will ever come back.
And now that re-hypothecation is exposed, I wonder how many assets have been double, tripled and quadruple-counted. An expose on this subject by Reuters about this subject following the collapse of MF Global, revealed that “Engaging in hyper-hypothecation have been Goldman Sachs ($28.17 billion re-hypothecated in 2011), Canadian Imperial Bank of Commerce (re-pledged $72 billion in client assets), Royal Bank of Canada (re-pledged $53.8 billion of $126.7 billion available for re-pledging), Oppenheimer Holdings ($15.3 million), Credit Suisse (CHF 332 billion), Knight Capital Group ($1.17 billion), Interactive Brokers ($14.5 billion), Wells Fargo ($19.6 billion), JP Morgan($546.2 billion) and Morgan Stanley ($410 billion).”
And if you are wondering what the implications are, it may not be what you think. Initially there will be the denials and then, if Prime Brokers have to recall all the stock they lent out, imagine the global short covering rally?
And meanwhile the Euro crisis related elimination of deficit spending could force banks into administration or liquidation, which in turn causes assets to be marked down to market and pressure on equities. We invest in interesting times…but don’t forget highest quality stocks at substantial discounts to intrinsic value.
Posted by Roger Montgomery, Value.able author and Fund Manager, 12 December 2011.
In 2010 here at the Insights Blog I wrote:
“a bubble guaranteed to burst is debt fuelled asset inflation; buyers debt fund most or all of the purchase price of an asset whose cash flows are unable to support the interest and debt obligations. Equity speculation alone is different to a bubble that an investor can short sell with high confidence of making money.
The bubbles to short are those where monthly repayments have to be made. While this is NOT the case in the acquisitions and sales being made in the coal space right now, it IS the case in the macroeconomic environment that is the justification for the purchases in the coal space.
China.
If you are not already aware, China runs its economy a little differently to us. They set themselves a GDP target – say 8% or 9%, and then they determine to reach it and as proved last week, exceed it. They do it with a range of incentives and central or command planning of infrastructure spending.
Fixed asset investment (infrastructure) amounts to more than 55% of GDP in China and is projected to hit 60%. Compare this to the spending in developed economies, which typically amounts to circa 15%. The money is going into roads, shopping malls and even entire towns. Check out the city of Ordos in Mongolia – an entire town or suburb has been constructed, fully complete down to the last detail. But it’s empty. Not a single person lives there. And this is not an isolated example. Skyscrapers and shopping malls lie idle and roads have been built for journeys that nobody takes.
The ‘world’s economic growth engine’ has been putting our resources into projects for which a rational economic argument cannot be made.
Historically, one is able to observe two phases of growth in a country’s development. The first phase is the early growth and command economies such as China have been very good at this – arguably better than western economies, simply because they are able to marshal resources perhaps using techniques that democracies are loath to employ. China’s employment of capital, its education and migration policies reflect this early phase growth. This early phase of growth is characterised by expansion of inputs. The next stage however only occurs when people start to work smarter and innovate, becoming more productive. Think Germany or Japan. This is growth fuelled by outputs and China has not yet reached this stage.
China’s economic growth is thus based on the expansion of inputs rather than the growth of outputs, and as Paul Krugman wrote in his 1994 essay ‘The Myth of Asia’s Miracle’, such growth is subject to diminishing returns.
So how sustainable is it? The short answer; it is not.
Overlay the input-driven economic growth of China with a debt-fuelled property mania, and you have sown the seeds of a correction in the resource stocks of the West that the earnings per share projections of resource analysts simply cannot factor in.
In the last year and a half, property speculation has reached epic proportions in China and much like Australia in the early part of this decade, the most popular shows on TV are related to property investing and speculation. I was told that a program about the hardships the property bubble has provoked was the single most popular, but has been pulled.
Middle and upper middle class people are buying two, three and four apartments at a time. And unlike Australia, these investments are not tenanted. The culture in China is to keep them new. I saw this first hand when I traveled to China a while back. Row upon row of apartment block. Empty. Zero return and purchased on nothing other than the hope that prices will continue to climb.
It was John Kenneth Galbraith who, in his book The Great Crash, wrote that it is when all aspects of asset ownership such as income, future value and enjoyment of its use are thrown out the window and replaced with the base expectation that prices will rise next week and next month, as they did last week and last month, that the final stage of a bubble is reached.
On top of that, there is, as I have written previously, 30 billion square feet of commercial real estate under debt-funded construction, on top of what already exists. To put that into perspective, that’s 23 square feet of office space for every man, woman and child in China. Commercial vacancy rates are already at 20% and there’s another 30 billion square feet to be supplied! Additionally, 2009 has already seen rents fall 26% in Shanghai and 22% in Beijing.
Everywhere you turn, China’s miracle is based on investing in assets that cannot be justified on economic grounds. As James Chanos referred to the situation; ‘zombie towns and zombie buildings’. Backing it all – the six largest banks increased their loan book by 50% in 2009. ‘Zombie banks’.
Conventional wisdom amongst my peers in funds management and the analyst fraternity is that China’s foreign currency reserves are an indication of how rich it is and will smooth over any short term hiccups. This confidence is also fuelled by economic hubris eminating from China as the western world stumbles. But pride does indeed always come before a fall. Conventional wisdom also says that China’s problems and bubbles are limited to real estate, not the wider economy. It seems the flat earth society is alive and well! As I observed in Malaysia in 1996, Japan almost a decade before that, Dubai and Florida more recently, never have the problems been contained to one sector. Drop a pebble in a pond and its ripples eventually impact the entire pond.
The problem is that China’s banking system is subject to growing bad and doubtful debts as returns diminish from investments made at increasing prices in assets that produce no income. These bad debts may overwhelm the foreign currency reserves China now has.”
I now wonder whether we are seeing the bubble slip over the precipice? Falling property prices (10 per cent of the Chinese economy) leads to lower construction activity, leads to declining demand for Australian commodities, leads to falling commodity prices, leads to bigs drops in margins for a sizeable portion of the market index…
Watch this video and decide for yourself.
Posted by Roger Montgomery, Value.able author and Fund Manager, 8 December 2011.
Buying shares in the right businesses will help investors avoid being caught in an index that is going nowhere. Read Roger’s article at www.eurekareport.com.au.
This is a retail business that I’ve known for a long time, indeed in a past life I influenced one of its largest shareholdings.
At that time the company was leveraging its 90% brand awareness; increasing its return on equity every year, from 40% to ultimately more than 70%, without any debt; it was rolling out stores; it appeared to have perfected its buying strategy; and the share price had risen from $2.40 to a high of $18.60.
More than a year since I wrote that The Reject Shop shares were among the most expensive retail stocks and they touched their high, the performance has been somewhat unsurprising: declining to a closing low of $9 recently – a fall of just over 50%.
For those of you who have been fortunate enough to have been following us since 2009, you may recall in September 2009 when I wrote about the reasons why I decided to sell The Reject Shop:
“I can’t stop thinking that the value of the business just cannot rise at a fast enough clip to justify the current price. I really don’t like trading things that I have bought but I don’t think the value of the business can continue to rise indefinitely. With a share price of $13.45 (intraday today) and a valuation of $11.27, the shares are 24% above their intrinsic value. This combination of factors tells me we are safer in cash.”
Today the shares trade at about my current estimate for intrinsic value (see graph) of $9.22 and in anticipation of a possible big discount being presented, it’s worth reviewing our stance to determine whether we need to change it for this company.
Since I last wrote about the Reject Shop, a number of events have served to deliver sufficient concerns to market participants – analysts as well as investors – that they have turned their back on this once market darling.
First, the Queensland floods closed the Queensland distribution centre, seriously denting any supply chain efficiencies the company had built. Second, the company has doubled its equity base since 2006, from $26.6 million to $53 million, and this has been entirely due to the retention of earnings rather than less-desirable capital raisings. In the absence of an equivalent increase in profits, return on equity would be expected to decline. One way to stave off a decline in the all-important return on equity measure of performance is to increase leverage. The problem for the Reject Shop’s intrinsic value is that leverage has indeed increased – 34-fold – and yet return on equity next year is forecast to be lower next year than in 2006.
The Reject Shop still enjoys its high brand awareness but, as is typical in many store roll out stories, as the offer matures the later sites are less profitable than the early sites.
This doesn’t fully explain the fact that during a period in the economy where one would expect a bargain offering to shine, it hasn’t. Eighty percent of Australians still know the brand but I believe consumer experience and mismanagement has done it some damage.
According to one report, 20% of the population believe the company offers rubbish – cheap Chinese junk that quickly breaks after use and fills our tips. It’s the very reputation China itself is trying, but frequently failing, to shake off.
The other reason for damage to the brand is confusion brought on by mismanagement. Several years ago the average unit price was about $9 and basket size was $11, but over the years one cannot help but have noticed many higher-priced items creeping into the stores.
The Reject Shop was originally the place you went to for discounted seconds and end-of-line items. Under lauded retailer and merchant Barry Saunders, The Reject Shop successfully transitioned to a discount variety retailer, offering everyday lines at cheaper prices than the incumbents. Grey market (“parallel import”) Colgate toothpaste for $2 a tube and toilet paper for a few cents a roll ensured repeat business, higher inventory turnover and higher margins from consumers filling their baskets with other higher-margin items.
The company had successfully implemented the Walmart and Woolworths profit loop. Adding more expensive items, some in the $30, $40 and $50 bracket, confuses the offer and damages the brand. Simultaneously, inventory turnover falls and working capital costs increase.
Higher-priced items should at least partly explain why the company has not been performing well in the two-speed economy (I prefer to call it the one-cylinder economy) that would normally lend itself to the “bargain” offer. The other reason for the declining performance, including declining same-store sales growth, is the enthusiastic emergence of competitors. It’s really a second wave: The Reject Shop had put an end to Millers and the Warehouse Group previously. But now BIG W, Kmart, Target, Bunnings, a reinvigorated Mitre 10 and Masters will compete directly with The Reject Shop; you may have already seen some of their aggressive Christmas advertising.
If The Reject Shop’s offering had not been confused by the inclusion of higher-priced items, the company would have been in a much better position to defend its turf. The misguided product mix, however, appears to have left the gate open and the well-funded competitors have rushed in, as have Crazy Clarke’s, Sams Warehouse, Chicken Feed, GO-LO and more than 35 others. Of course these competitors will also compete for sites, potentially relegating The Reject Shop to less preferred sites or having to pay more for the best of the remaining locations.
That, and the possibility of a fall in the Australian dollar, represents the bad news. The good news is that The Reject Shop still has terrific brand awareness, many more stores to open, a reinvigorated marketing campaign and the reopening of the Queensland Distribution Centre ahead of the Christmas peak selling period.
On balance, if the company can hit its targets it could increase its intrinsic value by more than 15% per annum over the next three years and many believe the bad news and bearish case is factored into the share price. But I would like to see a decline in debt or a greater margin of safety or both, before buying its shares.
Rest assured that a rising tide (a rally in the stock market) will lift the price of the company’s shares. To be certain of a good return rather than be hopeful of an excellent one, we simply need a bigger discount, as the graph illustrates.
Posted by Roger Montgomery, Value.able author and Fund Manager, 3 December 2011.
Roger Montgomery discusses why Embelton (EMB) is one of his stocks to watch in 2012 in this article published in the December 2011 issue of Money Magazine. Read here.
In 1979, just like today, many thought equities were finished. Investors in Credit Corp, Flight Centre, Northern Star and many more top stocks would disagree. Read Roger’s article at www.eurekareport.com.au.
A good friend who lives and works in the UK recently sent me an allegory that succinctly describes, for those who haven’t read Michael Lewis, the growth of sub-prime loans, the collateralised debt obligations into which they were securitised and the credit default swaps which were the tradable insurance contracts on the CDO’s. It then goes on to neatly leave us with the consequences.
If you have seen it before or believe you have a solid understanding of the events, you are many steps ahead of most. For the rest of us,
Heidi provides an explanation;
Heidi is the proprietor of a bar … She realises that virtually all of her customers are unemployed alcoholics and, as such, can no longer afford to patronise her bar. To solve this problem, she comes up with a new marketing plan that allows her customers to drink now, but pay later.
Heidi keeps track of the drinks consumed on a ledger (thereby granting the customers loans). Word gets around about Heidi’s “drink now, pay later” marketing strategy and, as a result, increasing numbers of customers flood into Heidi’s bar. Soon she has the largest sales volume for any bar in Manchester…
By providing her customers freedom from immediate payment demands, Heidi gets no resistance when, at regular intervals, she substantially increases her prices for wine and beer, the most consumed beverages. Consequently, Heidi’s gross sales volume increases massively.
A young and dynamic manager at the local bank recognizes that these customer debts constitute valuable future assets and increases Heidi’s borrowing limit. He sees no reason for any undue concern because he has the debts of the unemployed alcoholics as collateral!
At the bank’s corporate headquarters, expert traders figure a way to make huge commissions, and transform these customer loans into DRINKBONDS. These “securities” then are bundled and traded on international securities markets.
Naive investors don’t really understand that the securities being sold to them as ‘AAA Secured Bonds’ really are debts of unemployed alcoholics. Nevertheless, the bond prices continuously climb – and the securities soon become the hottest-selling items for some of the nation’s leading brokerage houses.
One day, even though the bond prices still are climbing, a risk manager at the original local bank decides that the time has come to demand payment on the debts incurred by the drinkers at Heidi’s bar. He so informs Heidi. Heidi then demands payment from her alcoholic patrons. But, being unemployed alcoholics they cannot pay back their drinking debts. Since Heidi cannot fulfil her loan obligations she is forced into bankruptcy. The bar closes and Heidi’s 11 employees lose their jobs.
Overnight, DRINKBOND prices drop by 90%. The collapsed bond asset value destroys the bank’s liquidity and prevents it from issuing new loans, thus freezing credit and economic activity in the community. The suppliers of Heidi’s bar had granted her generous payment extensions and had invested their firms’ pension funds in the BOND securities. They find they are now faced with having to write off her bad debt and with losing over 90% of the presumed value of the bonds. Her wine supplier also claims bankruptcy, closing the doors on a family business that had endured for three generations, her beer supplier is taken over by a competitor, who immediately closes the local plant and lays off 150 workers.
Fortunately though, the bank, the brokerage houses and their respective executives are saved and bailed out by a multibillion dollar no-strings attached cash infusion from the government. The funds required for this bailout are obtained by new taxes levied on employed, middle-class, non-drinkers who have never been in Heidi’s bar.
Its nicely articulated don’t you think? Fortunately the problem is contained to…Earth. But where too next?
Postscript: This week, China’s vice-premier and head of finance, Wang Qishan, predicted that the global economy has commenced a long-term recession. He observed: “Now the global economic situation is extremely serious and in such a time of uncertainty the only thing we can be sure of is that the world economic recession caused by the international crisis will last a long time.”
Posted by Roger Montgomery, Value.able author and Fund Manager, 25 November 2011.
The Reject Shop is cheap but not good value. Read Roger’s article at www.eurekareport.com.au.
