Thursday, November 17, 2011

In Jefferies we Trust.

With the Euro crisis as a backdrop, as opposed to the housing/mortgage crisis of 2008, this year's Lehman Brothers has been MF Global, a medium sized commodities broker-dealer, spun off from Man Group a few years ago and which had actually purchased the business from REFCO back in 2005.
REFCO, as many may remember was the subject of a famous meltdown of its own. 

MF Global's demise came reportedly due to large leveraged bets on European sovereign debt which didn't pan out.  That's tough for MF's stockholders and bondholders, who are probably looking at steep losses.
Here's the graph for MF's 6.25% 2016 bond, issued in August 2011, which basically fell off a cliff in two months.

Like Lehman, MF Global's debt was "investment grade" (Fitch, S&P and Moody's), right up until the nasty stuff hit the fan in late October. Of course, MF was just a triple B, as opposed to a Lehman's AA at the time of its collapse, so I guess we're getting better in the ratings biz. Off topic, this is why I really don't invest a whole lot in debt of financial companies. Very difficult to analyze and foresee these meltdowns. 

Still, if it were just the stock and bondholders losing, no biggie. The problem is that the issue is affecting customers also. When brokers go down, customers don't normally lose their money or securities, because these assets are (or should be) segregated and separated from the broker's own. It can be a hassle to get everything set up again at new broker/dealer, but competing firms are normally more than happy to bring those customers on board. Sure beats wining and dining them.

The problem with MF is that apparently those customer funds were not well segregated. There is a reported $600 million "missing" from customer accounts. Big problem. 
First off, this isn't supposed to happen. You'd figure that this was a lesson learned from the Madoff scandal (BLMIS was first and foremost, a broker-dealer). Second, this didn't happen with Lehman, where customers were taken over by Barclays and their assets were there. It didn't even happen with Stanford Financial's brokerage arm (other stuff happened there).
So, big black eye for regulators once again. Hopefully the money shows up, but this is kind of like with missing persons. After three weeks, the chances aren't good.

This leads us up to the old crisis equals opportunity adage and the title of this post: Jefferies (JEF). Jefferies is a mid-sized broker-dealer. Not a household name, but well known and regarded in the industry. While checking the company's Sec filings, an analyst at Egan-Jones noticed that the company was long European sovereign debt in an amount equal to close to 80% of JEF's equity and proceeded to downgrade. 
The company said "Whoa, wait a minute. We make markets in those bonds and we're short (as in we have to deliver to clients) pretty much the same amount." (they didn't actually say THAT, but that was the message). JEF even went as far detailing positions and showing how they could change their inventory levels if the wish too. In short, JEF pretty much did everything right to control the damage. (Frankly, if  you used this same yardstick, where does that leave every European bank?)

However, stock and bond traders have not been understanding and much less forgiving lately and JEF's securities have sold off sharply, opening up what appears to be an opportunity. On the very short end,
JEF's 7.75% 2012 bonds (due March 1) are trading below par, for what would look to be nice pickup for less than four months. On the other end, some of the longer dated maturities are yielding at or close to double digits. JEF is still "investment grade" (FWIW, I know).

While the selling could still get worse, I like the odds on this one and am willing (and have) put down some coins on JEF bonds. Drawing on the 2008 parallels, buying Morgan Stanley or Goldman Sachs bonds while Lehman went down in flames, proved to be an excellent investment. We'll see how this one goes. With 2012s, we'll know soon enough. For the long run, the broker-dealer business model is obviously "under review". Bear, Merrill, Lehman and now MF can't all be aberrations. For now, however, "In Jefferies we Trust". 

Monday, August 29, 2011

Sino Forest Epilogue

Since I already did two posts on Sino, might as well make it three and out.

Last Friday, the Ontario Securities Commission suspended trading in Sino Forest stock, alleging that the company may have defrauded investors by exaggerating its profits and assets.
Initially, the order also called for the resignation of the company's CEO Allan Chan and other officers and directors. That portion of the order was then excluded (apparently the OSC doesn't have such authority), but the CEO and several others resigned anyway.

This would appear to be the argument that ends the discussion concerning this case. But you never know, there are always dissenting opinions and conspiracy theorists.  This announcement followed a flurry of news which included a very strange second quarter earnings report in which the company's erst-while rock solid operating margins evaporated, a three-month delay of the "independent review"  and downgrades from the major ratings agencies.

Carson Block is looking like a champ. For his part, John Paulson took his lumps like a man. It was big loss for his fund, but he showed he could recognize when he was wrong.
I do feel for the analysts who came out to support the company. Lesson learned, hopefully. Don't trust everything they tell you, sometimes the numbers are simply a lie. Company officials are NOT your friends.

As for the bond angle, there is a bright spot. On Aug 17, Sino paid its 2011 bonds in full. So whoever took a flier on that trade I mentioned in my previous post, made out like a bandit. I wasn't that brave.

Sino stock may be suspended, but the bonds can be traded OTC, as far as I can make out.
My Bloomberg is indicating a 26 bid on the 2014's (the ones I luckily sold at 72). Ouch!

Wednesday, June 15, 2011

Battle Lines Drawn in the Forest

It’s been almost two weeks since Carson Block's Muddy Waters report on Sino-Forest accusing the company of fraud.

I’ve been following the case even though I no longer have stakes in the game. There has been an interesting back and forth going on in the comment section of this blog and on other message boards. So here’s another post so that discussion can continue.

A few comments on where I think things stand.

1. The MW report

Substance aside, the report is poorly written. It’s self-serving. (Example: “Were Muddy Waters not to have come along, it is likely that this fraud could have continued for a few more years and billions of dollars more” – is this really necessary?). That lowers its value.

There’s information that is irrelevant to the company’s current situation. For example does some deal gone bad in 1994-96 have any bearing on the company’s value today? Probably not, it’s only there to establish a “pattern” of deceit. Lumping all this together in the report is confusing.

But the main elements of the fraud theory are there. The con itself: inflating profits and assets. The mechanism of that fraud: the use of opaque and undisclosed “authorized intermediaries” to fabricate transactions and profits, instead of selling directly (which would leave a paper trail). Finally, the cover up: a convoluted corporate structure to distract the auditors and manipulating the valuation process of its forests.

That’s MW’s theory. It’s not outlandish and certainly we’ve seen bolder scams go undetected for much longer. It could be wrong, of course, as is the case with every theory.

Now a lot of people are asking MW to “prove” their theory. That’s tremendously unfair. To do so, MW would have to have access to all of Sino-Forest’s records and books and be sure they were the “real” ones. That’s not going to happen.
They also can’t ascertain completely the scale of the scam, for the same reason. It could be that MW’s right and billions in assets are missing, or it could be more (or less).
The report says as much (“…without the aid of law enforcement, we will never really know how much money is there or where it went.”). You can’t fault them for that either.

What MW did was look at the evidence and put the pieces together for their theory (feathers, waddle, beak…hmmm).

Mr Block is being “made the villian” by those on the other side of the trade, which again, in my opinion, is unfair. Among other things there is a line of thought, that regardless of the outcome of investigations, Sino-Forest has been “mortally wounded” by his allegations.

Now, frankly the whole idea that you can “destroy” a company by spreading “false” rumors or information is hogwash. If the information turns out to be incorrect, then the company was what it said it was, and the markets will value it accordingly. If the allegations are true, a fraud has been exposed (hard to see the downside in that!). Even financial institutions, which are deemed to be more sensitive to “breaks in trust”, usually bounce back quickly once the air has cleared.
Sino-Forest’s stock has tanked. But lets be clear, a stock price does not a company make. Certainly not in the short run.

2. Company Rebuttal

After initially ignoring the allegations, the company took steps to address the situation. To look into the allegations they appointed an independent committee. That committee is only independent in the sense that it is comprised of “independent” (i.e. not working for the company) board members, but hardly “independent” in a third party sense, since those directors are probably still liable if fraud is present (self-incrimination, anyone?). The committee will be “assisted” by PriceWaterhouseCoopers, which is a good idea since using Ernst & Young, the company’s auditors, who also may be looking at some hot water, would hardly be independent enough.

Still, it’s important that PwC produce and sign off on any report for it to have any kind of credibility. Statements by the company or documents produced by the company without any third party independent (really independent) verification are automatically suspect.
The report is expected to take at least three months to complete.

The company also made some documents and information available to analysts and the public, but kept secret about others, such as its customers’ names and the location of its forests. That’s ok. They have no obligation to disclose this information to analysts or anyone else. When regulators and auditors come knocking, however, that’s a different story.

3. Others Chime in (or not)

The analyst at RBC Capital Markets, Paul Quinn, came out Friday (June 10th) with a very favorable opinion (Outperform – Evidence mounting in Sino’s Favour). Another analyst Richard Kelertas at Dundee (Canadian Firm, recently acquired by Scotiabank) called the MW report “a pile of crap” and was quite adamant in his support of the company (“we believe in the company, we trust the company). Of course, these guys have their reputation at stake since they have been following and recommending the stock for years. Since 2004 in Kelertas’ case and RBC has had an outperform on the stock since May 2009. Both firms reportedly did underwriting for Sino in its 2009 stock offering.

But they are not the only ones who did business with Sino. Credit Suisse, Merrill, Morgan Stanley and others were bookrunners on Sino bond and stock deals. So you can’t really use that as a rationale for the analysts’ positions. No, these guys truly believe what the company is telling them. I can relate. When I worked as an analyst there were some companies I followed for up to ten years and weren’t followed by anyone else. The execs knew me and I knew them. They’d show me the installations, tell me anecdotes and give me certain information that would never be “on the record”. Friends? Maybe. There was a certain empathy. The work’s easier when it’s not confrontational. But let there be no doubt about it, they would lie to my face if that’s what was their interest. And they did. After you get duped a few times, you learn to be a little less trusting and keep some distance.

Other analysts have been somewhat more skeptical. Annisa Lee, an analyst at Nomura Securities had put out a skeptical report already several months ago, well before the MW report. (and was reportedly cut off at today’s conference call). Morgan Stanley’s Vivien Gui also released a note (which didn’t get much press from what I see), which was called “my unanswered questions” and spotlighted doubts about the company’s scale, the location of its forests and the business model.

Then there is the enigmatic presence of Paulson with his large position. He is obviously attentive to what is going on, and reportedly has been supportive of the company. Unfortunately, he is “trapped” in a sense. Here’s why: my first impression was that Paulson should get his hooks in the committee and in the investigative process, to better assess where he stood. Ah, but by doing so, he would become an “insider” with the legal implications that that entails and thereby freeze his position. So, aside from laying blind bets in either direction, Paulson doesn’t really have any option but to wait.

At this point, the only ones who really know the situation are the company insiders. That is probably only a handful of execs. If there is fraud, the outside directors are probably clueless. (I’ve been on boards, the information you get is distilled more than a good scotch whisky). Ernst & Young, the company’s auditors, should know by now if they have been duped. You can bet that the first thing they did when this broke was to call in the Sino audit team and go over every sampling and every piece of independent verification that may be missing or suspicious. If something important got past them before, they now know what it was. Unfortunately since E&Y’s nuts are in the boiler, they won’t utter a word until they have checked and re-checked EVERYTHING. Don’t expect them to talk anytime soon. But they know…already.

4 The Bond Angle

Sino’s stock hit a new low today, but since I like to blog about fixed income and there aren’t a lot of bond blogs out there, I thought I’d chime in on some interesting movements in Sino’s bonds.

The 2014 bonds which my clients held (and the 2017s which they didn’t) have stabilized in the 60-70% range since their initial fall. One could interpret that as players assessing the best case scenario (no fraud full recovery) and the worst (partial recovery even if stock goes to zero) and looking for some middle ground.

2014 Bonds

The 2011 bonds, however, have rebounded sharply from a low in the 60% range to a recent price of around 90%. There would appear to be another dynamic weighing in this case. These bonds are due Aug 17 and there is only $87 million outstanding. Therefore, even if investigations finally reveal that Sino is a fraud, there’s a good chance these bonds could be paid before the results of those inquiries come to light. A play on the lack of expedience of the due diligence, if you will.

2011 Bonds

I’m not recommending it, but there’s is an alternative for Sino bulls to simply going long the stock, if you want to take it.

That’s where the Forest stands (or doesn’t) at this time. The other comment thread was getting too long, so please continue that fine discussion here. Go at it, just keep it civil.

Monday, June 6, 2011

Bitten by a Chinese Duck

Sometimes you see a duck for what it is. Sometimes you take it for what it tells you it is.

The story of the week and perhaps the year is Sino-Forest. This is a Canadian-listed stock, but the company has forestry operations in the Peoples Republic of China.

Last Thursday, a research group called “Muddy Waters” put out a 39-page report on the company, stating in no uncertain terms that the company was a fraud. The company also has no qualms in saying that they are short the stock, and stand to gain financially if their allegations prove true.
Here is their website. You can download the report. Muddy Waters

This case got my attention for an obvious reason: I have stakes in the game. For disclosure purposes, a few of my clients owned some Sino-Forest bonds (10.25% 2014s). Bonds are rated BB by S&P, which makes them junk, but really good quality junk (two steps away from investment grade).

I went back over my notes to see why we bought these bonds back in 2009. Actually we didn’t buy these in particular, but received them in exchange for a shorter maturity paper. Anyway, at the time it looked like a good deal. The company had a very strong balance sheet including a great amount of cash, plus solid and consistent earnings. Those earnings are what struck me as the most positive, because I used to work for a paper company and I know a little about the industry. It’s a tough industry to make money in consistently. But Sino-Forest did and with very strong margins, so more power to them. Financials were audited by Ernst and Young, a big North American firm, so despite being a Canadian Firm born from a "reverse takeover, I thought it was ok. So I laid some coins down for my clients. Not a large bet, by any means. We always diversify a lot. Because stuff happens.

So now this report comes out. The stock plunged (although today it’s on the rebound). Bonds plunged. I downloaded the report and went over it on the weekend. I won’t lie and say I understand every detail. But there is a lot there. Mainly, an explanation of why those profit margins were so generous (they’re false!). Plus there are details about why certain representations that the company makes about its operations, such as size of the plantations, volume of sales, etc. are not realistic. It’s a very complete report.

The company is out today in full denial, offering details about their assets, including the original titles to their plantations. Questions have been raised about the authors of the report and their motivations.

After reading the report and looking over my notes, I fully expected to not being able to unload my clients’ bonds this morning. But lo and behold and bless the market makers souls, there was a market for them this morning, and I managed to unload them at 72%. Facing a possible total wipeout of the investment, this was a windfall for me and my clients. I am very satisfied. Of course, I could have held on and waited for explanations from the company or some sort of recovery in the case of bankruptcy. I preferred to accept that potential "duck bite".

There’s good reasons to give credence to the Muddy Waters report and I’ll give a few. I’ve been sort of in these guys shoes, so I can relate.

  1. These guys are not hiding.

This is not a random anonymous blog or post on a message board. Serious time and money was put into this report and the research to make it happen. Please, let's focus on the “what” and not the “who”. When I was being questioned about that bank report back in 2009, the reporters seemed to be more interested in me than what my report was implying.

The analysts at Muddy Waters have a lot to lose if they are wrong. They face fines, jail time, etc. They are totally in the open on this. They also can't just go and cover their shorts now that they are on the record. They have more than money on the line. They are sure, very sure.

  1. It’s a murky business.

“If it’s so profitable, why isn’t everyone doing it”. There are few competitors in the business, but Sino-Forest is the largest by far. Another company China-Forestry, turned out to be (surprise) a fraud. That said, if the business were so good, there'd be more competition and margins would drop at some point. Hasn't happened (according to the company).

  1. Too good to be true.
Ah. Those profit margins. Yes, there is great demand for materials in China, and I’d assume that’s true for wood chips. But if your margins are this big, it has to be that you worked your forest for several years (grew/planted). But most of Sino’s forests were recently acquired. You can’t have you cake and eat it too. Either you worked the forest and are entitled to those large margins (the time factor, if you will) or you didn’t and the margins should be lower. You shouldn't be able to make this kind of money by just "flipping" a forest.

  1. The Cash, the Cash!
One of the things that drew me to Sino-Forest bonds can also be a great litmus test. The cash. There is supposedly over a billion dollars in cash on the balance sheet. If Sino’s profits are false, that money is going to be missing somewhere. It’s either going to be in the value of the forests or in the cash balances (or both). Of the two, the cash is the easiest to check. If the cash isn’t there, we will know its all a lie. (Have these guys provide certified bank statements? I'd need to see those, ipso facto).

  1. There is more than what is said.
Although the Muddy Waters report is extensive, it probably doesn't contain ALL of the analysts’ suspicions and red flags. That’s usually the case. You only put down on paper enough to drive your point and what has the best documental support. The research is much more extensive and probably includes a ton of anecdotal information which is not in the reports because you can’t really put down things that don’t “seem” or “feel” right or for which the evidence isn’t totally conclusive. Again, I can relate. That whole picture, however, is what allows them to be comfortable with their conclusions.

Of course, I don’t know anything for sure, since I didn’t do the work. You never know for sure. Analyzing from the outside is difficult, because you don’t have access to all the information that goes into putting out the company’s financials. You can’t really go asking the company for access either, as in “would you mind if I checked your books for fraud?”

Nobody likes to accuse anyone else of wrongdoing, even in the face of overwhelming evidence, for many reasons. It’s mean and most good people don’t like to appear being nasty or not giving the “benefit of the doubt” to the offender.

So here’s the question that I ask when a straight one way or another answer is required: “If your loved one’s life depended on your correct (not politically correct) answer, what would you say?”
With that on the line (which fortunately it is not), I’d lean towards calling Sino-Forest a Canadian/Hong Kong duck. If so, it will set a new standard for Asian Fusion fraud cuisine. We shall know soon enough.
This one bit me. Ouch.

Sunday, April 17, 2011

From Russia with Bonds

All investors have their favorite themes or "guilty pleasures". In my case, it's Russian bonds. Despite a troubled past and lots of questions about the future, I seem to feel at ease laying down cash on Russian names and enjoy the pickup over counterparts from other parts of the more "developed" world.

This affinity was only reaffirmed during the credit crunch of 2008-2009. When other countries were scraping for answers and cowering from creditors, the Russians showed some pride and put their reserves where their cojones were. Here's the graph:

During 2008, Russia went through about 40% of its international reserves. And while the financial press was portraying that as a weakness, it was quite the contrary. Russia was telling its local entities and companies: "look, if you need dollars to pay off your international creditors, come and get them". That's
kind of what international reserves are for, after all. They certainly gained the respect of this bond junkie.

The yield nowadays are nowhere near what they were doing the crisis, but I still feel comfortable with Russian bonds and will indulge in my "guilty pleasure" quite often.

For example, in the telecom space, instead of AT&T, Verizon (US) or Vodaphone, I'll take some Vimpelcom or Mobile Telesystems, thank you. With a nice pickup in yield, to boot. (Russians are more cellphone-maniacs than any other country, BTW).

In the energy realm, instead of thinking BP, Exxon or Chevron, how about some Gazprom, which is half owned by the Russian government anyway? Or Lukoil or TNK-BP?

Want something more exotic or risky? How about Alrosa (Diamonds) or Evraz (steel).

Here's a few individual bonds by these issuers.

Finally, here's an excellent clip portraying the history of the soviet union, to the music of Tetris.

Sunday, January 30, 2011

REG S'ed

A couple of months ago, my wife came into the office to look for some files and thought I’d strike up a little conversation.

“Honey, did you know that Jordan is coming out with some bonds?”

I knew she’d be interested since we had visited Jordan in December 2009 and enjoyed the country very much.

“I’d like to buy some” she replied, even though I hadn’t told here what the terms were (not really exciting by the way).

“Sorry, but you can’t” I answered. “It’s REG S”.

It’s usually not a good idea to tell my wife she can’t do something, because she’ll just want to do it more. I knew I had to explain. (So here is kind of what I told her.

What happens is that in order to avoid going through the lengthy, complicated, bureaucratic and unpredictable process of registering a bond with the US SEC, many issuers will do what they call a private placement. They do it under REG S, basically promising that they won’t market or sell the bond to US Persons (citizens and legal residents). So the SEC leaves them alone.

“So I can’t buy it because I’m a US Citizen?” she said.


“That’s not fair” (you knew that was coming). “This is supposed to be the land of freedom” (and the capital of capitalism, I might add).

“Can I never buy these bonds?”

After a year you supposedly can, but good luck finding them or someone willing to sell them to you. Buying in an initial offering is normally a good deal also; the bonds routinely will trade a bit higher right after they’re issued. Sometimes the issuer will register the bonds with the SEC and make them available for trade on US markets, but they don’t have to.

“What about US companies? I can buy their bonds, right?”

No, not really. A lot of those, probably most, are REG S also. Even US companies figured out that it’s a lot easier to go that route and avoid dealing with the SEC.

I added that big US financial institutions could get in on most of these deals, even if my wife couldn’t, through a rule called 144A, which allowed “Qualified Institutional Buyers” or QIBs (not to be confused with Squibs, which are sons and daughters of magical parents who have no magical powers of their own), to participate in private placements also. So my wife needed not feel bad for Goldman Sachs or Morgan Stanley. They weren’t being left out.

By now my wife was very upset, she could do without buying Kingdom of Jordan 2015’s, but she did not like the to see her choices conditioned. In the world of investing, she was a second-class citizen, just for being a US citizen.

“I don’t understand. Why would the SEC do something that discriminates against US citizens?”

They do it to protect you. God forbid that Jordan or Dell Computer or someone else file their forms without all the right disclaimers, provisions and explanations that you are never going to read anyway.

“I’m really sorry I can’t give you a better reason.” I said as she left.

Of course, REG S, is just another example of regulatory patchwork, enacted in the 1990s to deal with exceptions and which ultimately became a rule. Along with security laws dating from the 1930s, which regulate markets and procedures inherited from the 19th century and before, you could think that the whole system was due for revamping.
Maybe we could use something more atoned to a global marketplace where information flows almost instantaneously. Things have changed in the last century or so (you’d think).

Don’t hold your breath. The current system serves the financial industry well. Very well. The recent events concerning Goldman Sachs’ private equity investment in Facebook illustrate the point.

As you may recall, Goldman agreed to invest $500 million in Facebook, through an ad-hoc vehicle. Goldman’s clients would then be allowed to participate in that vehicle and hence invest indirectly in Facebook.

Sounds like something to “like”, right?

The SEC then decided they should look into this deal a bit closer and perhaps force open Facebook’s private “books”. Facebook wasn’t quite ready for that level of information sharing with the world, so Goldman said “REG S”, which translated means “SEC, bug off”.

Vampire Squids 1, Regulators 0. Regular investors: DNP. (Do Not Play).

(The photo is Vampyroteuthis infernalis or the vampire squid from hell. Unofficial mascot of Goldman Sachs).

Saturday, January 15, 2011

State of the Junk

Happy New Year to all. Two-thousand ten was a very good for junk bond investors like myself. Not as fantastic as 2009, but we’ll take this kind of performance any day of the week and twice on Sunday.

The FINRA-Bloomberg High Yield total return index was up 12.2%, for the year, on the heels of a 46% gain in 2009. Not bad.
There are numerous indices out there and this one just happens to be available and free. HERE

The equivalent Investment Grade index did quite well also, yielding 6.5%, even if it did give up some gains towards the end of the year.

For 2011 there are some things to look forward to and some issues to worry about.

Positive for junk: improving economies lowering default rates . Positive for bonds in general: rock-bottom short-term interest rates which continue to force investors to move up in risk to lock in yield.

On the worry side: Big Ben at the FED. Ben’s latest folly, called QE2, as in quantitative easing two or too (take your pick) is a fresh round of dollar printing from your favorite bearded guy.

Jon Stewart analyzed this to perfection last month, but here it is for those who missed it.

The Daily Show With Jon StewartMon - Thurs 11p / 10c
The Big Bank Theory
Daily Show Full EpisodesPolitical Humor & Satire BlogThe Daily Show on Facebook

I know there is a lot of debate over QE2, but I come from the third world, where we have been lectured for decades by first-worlders ad-nauseum that we can’t do this crap and get away with it unscathed.

Now, el Central Banker Numero Uno del Mundo is telling us that he can. Color me skeptical. This is going to come back and bite us and bond investors need to be aware.

When? Not Yet. How? Now sure. Stay tuned.

For now, it looks like us junk collectors will be fine in 2011, although it will be hard to keep up with the equity markets (so don’t try!). After that, it could be plan B time.

As for the photo: a cute little squid of the genus Stoloteuthis from the Indian Ocean.