Saturday, November 13, 2010

Time For A Taxi Cab Medallion ETF

. This article was featured at The Reformed Broker, a noted financial blog. The article was subsequently quoted and linked to by the Wall Street Journal.

Half-joking, of course. Let's talk about the ETFization of just about anything. But before we talk about ETFization, we should talk about securitization.

Most people by now have heard of securitization in the mortgage context. It has a bad rep but it does not have to have one, if it is done correctly. Mortgage securitization has been around for many years. But as any business gets standardized and more competitive, the profit margins in these deals decline for the people who put them together. At the same time, these people's steak dinners, condo dues and private school fees do not decline, quite the opposite. So the friendly folks start looking for other things to securitize, and get very creative with it. Toll road revenues. Parking fee revenues. Communication tower rents. Restaurant franchise fees. You might not know but the Dunkin Donuts buyout happened at an untold leverage number precisely due to the "award-winning" finance package put together by people who, in another day and age, would have been designing fuel pumps for diesel locomotives. The theory is simple enough: find predictable enough source of cash flows, tranche them, slap an insurance from the esteemed AAA-rated mortgage insurers, have them rated, and sell them to income-seeking investors. Voila! Oh, the things you can get away with when everyone is chasing yield...

But exotic securitization and mortgage insurers are so 2006. We have ETFization now. The scheme is even simpler. Find an asset class. ETF it. Collect 69-99 bps on AUM. Wash. Rinse. Repeat. Rare earth metals came in the spotlight after an unfortunate fishing trawler incident in Asia and the resultant spat between the Middle Kingdom and the Land of the Rising Sun, that led to claims that the former had stopped exports. The shares of the rare earth miners skyrocketed, and Joe Sixpack could get into the action very quickly with a convenient new ETF, REMX, that debuted just in time for the news that exports have resumed. Then last Wednesday, the CEO of Alcoa, the third largest aluminum producer, said that he'd be very supportive of a physical aluminum ETF and that they'd be more than happy to supply the product. I would like to warn you not to be too surprised when next Wednesday, the CEO of Kraft Foods comes out in full support of the new physical cheese ETF.

What is happening here? ETFs are great. They enable efficient sector exposure and are more liquid that mutual funds. Some invest in geographies or securities (esp. low-priced stocks) that an individual investor might not be able to acquire efficiently. BUT the creation of ETFs brings in new money into the pond without improving the cash flows of the underlying assets. Your risk increases simply because the asset prices are now higher. But the higher prices might result in more interest, new share issuance or whole new ETFs. This might be creating a positive feedback loop.

Let's look at an example of how things evolve. GLD, the major gold ETF, has been around for a few years. A year or two later, we got GDX, gold miners, and SLV, silver ETF. Well, that's not enough for a hot sector. We got palladium and platinum to play with via PALL and PPLT.

You'd think that this is enough for sector exposure? Think again. We got GDXJ, junior gold miners, for people who think that GDX is too staid. Why have five mines in Canada when you can have one in Burkina Faso?

By now we should be done, right? Wrong. There is a better mouse trap. GLD and SLV are favorites for PM market alarmists, so we later got the "physical" gold and silver, PHYS and PSLV. That should wrap it up, this looks like an ETF buffet table. Again, wrong. Why should you limit yourself to gold miners, when you should really be playing the silver miners, SIL. And if having operating mines just does not sound rewarding enough, you can always try to strike gold with GLDX, the "gold explorers" ETF released last week. And, where would we be without the levered gold and silver ETFs, UGL and AGQ.

I am no Soros/reflexivity expert but I can tell you that this looks like market participants really wanting to believe in their investments, and acting it out.

On to my proposal for a NYC cab medallion ETF. For the uninitiated, the cab medallion is the NYC license that allows the operation of the iconic yellow cab with all duties and privileges. The number of licenses has been roughly fixed since the 1930s (yes) which has meant that the price of having one has been increasing steadily as a testament to NYC's foresight, Byzantine politics and anti-entrepreneurial attitude. There are roughly two types of licenses, owner-operator and "corporate". The more expensive corporate (fleet) licenses are rented out. The current price of a corporate license is $825k. The price in October 2004 was $343k. So you have the asset price up 140% in 6 years. It is also cash flowing, and the cash flow is inflation-linked, as rates go up periodically. So, unlike gold, there is the combination of scarcity, desirability AND cash flow. Of course, if a buyer of size enters the market, you know what will happen to prices and yields: the cabs will not be producing more cash just because the medallion prices went up.

And don't get me started on my idea for a pre-paid college tuition ETF with redeemable shares...

Tuesday, November 9, 2010

ZIRP Thoughts: Labor vs. Capital

In many businesses, there is a trade-off between labor and capital. A very simple example is a ditch-digging business (look under “excavation” in the yellow pages). A ditch-digging entrepreneur can hire a few people, hand them out shovels and send them to the job. Alternatively, the same entrepreneur can purchase an excavator and hire an operator and send him to the job. The trade-off capital vs. labor is pretty clear. The racing track can hire people to check the redeemed tickets or it can have machine-readable tickets with the requisite system. The vending machines in the office can be monitored remotely or a guy can come through and check. The landscaper can push a mower or ride one. You get the idea. Now imagine our ditch-digging entrepreneur could have financed the excavator at 25% last year because the banks thought that ditch-digging is not coming back. This year, however, with the recovery and the bank’s own low-cost financing (0% on demand deposits, 1-2% on 3-year CDs for the typical corner bank), our entrepreneur can finance the said piece of equipment at 6%. Clearly, he’s not buying shovels and not hiring. Capital has won.

Looking at the labor part of the equation, is labor getting more competitive or less competitive vs. capital? My bigger picture view is no, even though high unemployment should be lowering labor cost. Why? The big factor is lack of predictability for labor costs: no one really knows what the effect of the healthcare “reform” will be. The other sad factor is that payroll taxes are the most easily collectible taxes for the Treasury. If there are tax increases, one can expect to see them (eventually) there. Then you have a heavily pro-union administration. The capital maintenance costs are generally predictable: depreciation, consumables, insurance, etc. Oh, and there have been accelerated depreciation tax hand-outs. No wonder capital is winning.

Who benefits from this? You see companies like Wal-Mart and McDonald’s issuing fixed-rate debt at record low yields and investing. It would be criminal for them not to. Where is the money going? Wal-Mart just announced a major acquisition in Africa. McDonald’s is continuing their expansion in emerging markets. These companies are building the future first world. Who’s paying for this? It might very well be you: zero-interest is the destruction of prudent behavior and a confiscation of wealth.

There are other beneficiaries that engage in little-to-no value added financial transactions: PE firms. Ridiculously low high yield rates are encouraging PE takeovers and aggressive dividend recaps. Buyouts also often involve “synergies” (read: labor redundancies) to make the projected IRRs, now advertised as “good” if they are in the teens. But the credit wave surfers will surely make it up on volume.

Where are the landmines in the process I describe above? One is that the commodity inflation is getting out of control. I won’t recite the YTD figures here but when there are such one-directional imbalances (everything is up by a lot), there will be winners and there will be losers. There will be margin compression if you’re short cotton (and not charging 10,000% mark-up for your logo). There will be margin compression if you’re short coffee (and not selling the 20 cent cup for $3.49).

Then there are the legacy pension liabilities for a number of companies (not discussing state/local but they should matter to you if you hold munis). Low bond rates make it very hard for pension plans to meet their projected obligations: this means that companies will eventually have to make large contributions to the plans, essentially transferring money from shareholders/bondholders to former employees.

Two For One Book Reviews: “The Greatest Trade Ever” and “The Big Short”

In short, I recommend reading both books to people interested in finding out more about the few investors who were able to make money during the housing meltdown in 2006-2008. The two books track several people, the bets they made, the challenges they faced from their investors, competitors, ill-wishers, families, partners and brokers. There is a certain overlap in two of the characters covered between the books (Michael Burry, Greg Lippmann) but otherwise “the tracks” are separate and yet complementary. Both books are generally “mass market,” that is, neither requires heavy finance background to comprehend and appreciate.

“If you’re not inside, you’re outside”- Gordon Gekko

The overriding (and highly inspiring) theme of both books is that several relative outsiders in the world of high finance (neither character had had a high profile bank/sell-side or fund/buy-side career) were able to see the magnitude of the bubble, and, with the substantial help of the “housing” CDS apostle, Greg Lippmann of Deutsche, were able to short it. Here is a run-down of the characters. If you like stories like Susan Boyle or Paul Potts, these books will inspire you. If you have ever been annoyed by the non-stop optimism types, these books are for you: most main characters are painted as rather somber, dark types.

Lippmann: the odd man out of the group as the only member of the “establishment.” A fixed income trader at Deutsche, Lippmann is instrumental to the creation and proliferation of the CDS contracts linked to the performance of mortgage bonds. He ends up accumulating a large position, making his superiors uncomfortable. Lippmann’s endless proselytizing raises the profile of the new instrument. His is the insight that housing prices just need to level off to see the defaults spike. He’s described as a brash, arrogant, flippant character: how much of that is stereotyping of bond traders, how much of that is a literary embellishment, and how much is the truth, we will never know.

Favorite quote: Deutsche is trying to collect $1.2 bn from Morgan Stanley. MS argues that it should be putting up less because the models indicate that the value of the bonds in question is higher. Lippmann: “Dude, f*ck your model. I’ll make you a market. They are seventy-seventy seven. You have three choices. You can sell them back to me at seventy. You can buy some more at seventy-seven. Or you can give me my f*cking one point two billion dollars.”

Paulson: Paulson is probably the most connected, plugged and conventionally successful fund manager in the group. After enjoying a bon-vivant lifestyle for years, Paulson had moved up to become an M&A MD at Bear Stearns, eventually opening up a merger arb fund. The fund had been “another ham and cheese shop” until the big hit. There is quite a bit of interesting personal details on him in The Greatest Trade, especially his younger years. Otherwise, there is no deviation from the many media stories that have followed his hit.

Pellegrini: Pellegrini had known Paulson since business school and ended up working as a junior analyst at the fund basically as a last chance job substantially below his age. He had suffered setbacks both in his family life (twice divorced) and career (spent seven years as a VP at Lazard). Pellegrini had been the guy behind the housing analysis and the trades that netted Paulson the record wins. The relationship between the two is described as strenuous, mistrusting, and, ultimately, failing. It does not sound like Paulson ever fully trusted Pellegrini with decision-making. Ultimately, Pellegrini leaves the fund.

Burry: a bit of a fairy-tale story. Burry, as a medical resident, starts writing online about value investing at the height of the internet bubble. He ends up being seeded by Joel Greenblatt who had read his writings. Burry, an anti-social guy with one glass eye, ends up figuring out both the bubble and how to short it all by himself. However, he ends up having really hard time keeping his investors on board once they feel that he had shifted from value stock picking to macro. The stress and indignations he goes through are vividly described. Ultimately, he shuts down the fund. Burry’s problems with the banks are also detailed: from “massaging” the marks to outright lies about the contract values once the ball starts rolling to salespeople not even answering their phones, later blaming system problems at their respective banks on the same day.

Eisman: one of the “original” subprime specialists. Eisman had covered many now-bankrupt aggressive consumer finance companies since the early nineties as an analyst at Oppenheimer. He had been known for his too-honest analysis. Eisman had known the sleaze from before so he had been able to recognize it early on in the government-sanctioned expansion of subprime. Post Oppenheimer, he ends up trying to open his own fund only to find that the doors are all closed. Finally, he assembles a good crew of pessimists and some funding from a couple of places. Eisman was recently in the news with his aggressive questioning of Genworth’s management at the last conference call. It really sounds like the character from the book.

Favorite quotes: from his days as an analyst, “The Lomas Financial Corporation is a perfectly hedged financial institution: it loses money in every conceivable interest rate environment.”

Greene: a rich playboy real estate magnate and an acquaintance of Paulson’s ends up stealing the trade idea, and is the only individual able to pull off the CDS trade in size.

Lahde: Andrew Lahde made a splash with his long “good bye” letter. Younger than most, he had started out as a broker, getting his MBA at UCLA after a year of rejections, then working at a third-tier bank and a fund. He starts running his fund out of his apartment, almost runs out of savings before he gets a lucky break with funding. Lahde’s letter is reproduced in full in the book, as he touches on a wide variety of social problems, such as blind credentialism (a class struggle of a different sort) and inane government actions as well as his future plans.

Ledley, Hockett and Mai/Cornwall Capital. Three laid back guys that stumble into the trade somehow after having made outsized wins on a few options trades. Their story is probably the most underreported in the media pieces covering the housing debacle.

There are several other characters in the books that really help flesh out important pieces of the stories. Joe Cassano of AIG is there. CDO managers are there. Subprime industry leaders are there. Family members with various degrees of supportiveness for the main characters are there.

Full disclosure: no connection of any sort to the publishers or the authors of the books. Not that any of them clamor for my views.