Wednesday, March 30, 2016

"Window Dressing"....part deux (Subtitle: 1.6 Quadrillion things I don't Understand)

Here's another little situation I stumbled across when I was reading a few articles on Yahoo! and Google finance. This bullish article on Alibaba pointed me to the Baron Family of funds. A related article described how Baron sold an Alibaba position to "harvest a tax loss" and subsequently jumped right back in. Based on that decision alone, I felt compelled to take a look at the filings. Judgement like that from professional money managers always piques my curiosity. Here's the quote from the 12/31/15 QE Financial Report.

Alibaba Group Holding Ltd. is the largest e-commerce company in China
with over 75% of the market. Alibaba owns and operates the two largest
online shopping platforms in China, Taobao and Tmall. It also participates in
the profits of Ant Financial, which owns Alipay, the largest third-party online
payment provider in China. Alibaba focuses on an asset-lite platform
business model which generates both high margins and high returns on
capital. We believe the company is well positioned going forward with
substantial growth in Chinese e-commerce combined with improving
monetization across mobile channels, as consumer adoption of mobile
purchases continues to grow rapidly. Alibaba has also made considerable
investment in cloud computing and health care that we believe will be
longer-term drivers of growth. We believe large growth potential and
current valuation make it a compelling investment going forward. We sold
Alibaba during the third quarter to harvest a tax loss in the investment, and
repurchased it in the fourth quarter.

http://www.baronfunds.com/BaronFunds/media/Quarterly-Reports/Baron-Funds-Quarterly-123115.pdf

By way of background, Baron is a nice little business. They've been around for a while, since 1982, and have about $19 Billion Invested and Under Management. According to their annual shareholder letter their compound annual rate of return has been about 12% compared to 9% for the S&P 500 since inception. Impressive. They manage thirteen separate funds with about about 15% of Net Asset Value (NAV) in Energy and Emerging Markets right now.

Of note, they also throw great parties with lots of celebrity appearances. At their recent annual Investor Conference Lady Gaga, Tony Bennett, Alicia Keys, Steve Martin, Martin Short and Michael Bublé provided the entertainment. Elon Musk was a surprise "electrifying" speaker. Heavy hitters of Financial Media (Chris Dodds. Andrew Ross Sorkin) presented, and/or moderated panel discussions at the event. To his credit, Ron Baron made it clear that no investor money was spent on this event....it was all out of his own pocket as a Thank You to all of the investors who've continued to invest in his business. Actually, I might consider putting some money into a Baron Fund just to finagle a spot on the guest list for next year's meeting. This event sounds like it's amazing. (Prior year entertainers listed below, include Barbara Streisand, Billy Joel, Jerry Seinfeld, Elton John, Rod Stewart, Sting, ect.) I wonder if there's a minimum investment required to get on the guest list?

The mantra for this year's event was "Question Everything". (Authors Note: As an aside I'm not sure how diligent Baron might be with their "questioning" given their infatuation and positions in Alibaba. From their Financial Report it looks like they simply retyped content from Alibaba press releases and put it in the financials. To me, "questioning" would start with actually reading the filings, but hey, that's just me.)

After thinking through of all of the above, I thought I'd dig in and take a look at how well the individual funds did last year. As per my discussion in Window Dressing, I also took a look at how many Repos these funds might have had on hand as of 12/31/15. Remember Window Dressing?....it's where mutual funds take all of their il-liquid junk assets and ship them off for Treasuries overnight (Repos) in order to get the junk off the books and "dress up" their quarter and year-end Financial Statements. Feel free to go back and re-read the Window Dressing post if you think you need a quick brush-up on the concept. Everything below is taken from the 12/312015 & 6/30/2014 Financial Reports. Here are the results.




Not exactly a stellar year, but hey, it was tough on everyone.  So after thirty-plus years of solid returns we can give the Baron Funds a pass, right?  Well, that would normally be true, "It's always best to dance with the girl that brung ya to the prom", but a few things just leap off the pages when we look at the numbers.

The first thing we notice, is that the funds lost 4% in 2015, as compared to the S&P 500 which gained 1.4% (including dividends) for the same period.  The second thing we notice is that the NAV has actually declined from $22 Billion down to $19.6 Billion (11%).  Not only are the funds losing money, Baron is experiencing significant cash outflow.  Investors are not putting cash into the fund, they are pulling it out.

After paging through their gigantic report something else popped out at me.  They do a lot of business with a company by the name of Fixed Income Clearing Corp. (FICC), purchasing significant volumes of overnight Treasury Repos.  Here are a couple of the footnotes.

$ 69,761,323 Repurchase Agreement with Fixed Income Clearing Corp., dated 12/31/2015, 0.03% due 1/4/2016; Proceeds at maturity - $69,761,555; (Fully collateralized by $25,360,000 U.S. Treasury Note, 2.25% due 11/15/2024; Market value - $25,423,400) and $44,730,000 U.S. Treasury Note, 2.50% due 5/15/2024; Market value - $45,736,425)

$57,532,192 Repurchase Agreement with Fixed Income Clearing Corp., dated 12/31/2015, 0.03%  due 1/4/2016; Proceeds at maturity - $57,532,384; (Fully collateralized by $30,530,000 U.S. Treasury Bond, 7.625% due 2/15/2025; Market value - $45,069,913 and $13,580,000 U.S. Treasury Note, 2.25% due 11/15/2024; Market value - $13,613,950) 

There are eleven (11) similar footnotes. Total Repos as of 12/31/15 were $462 Million (2.4% of Assets), up from $335 Million (1.5% of Assets) as of 6/30/2014.

Since we have no way of knowing the terms of these Repos, or what assets were exchanged for the privilege of putting these "One Night Only" Treasury Securities on the books, we have to ask:  "Exactly why are these Repos there?"  Did they pay cash  for the Treasuries?....or perhaps they traded a stack of securities they didn't want anyone to see?  Baron might be judiciously managing their money, balancing fees with interest earned and eking out every last basis point for their investors.  Or perhaps, and I'm just speculating here, they might just be enthusiastically participating in what could be a  good-old-fashioned Christmas at Macy's style  "Window Dressing" scheme.  If the latter is correct, by my guesstimate/count, they could have as much as $462 million "Window Dressed" bad assets on the books as of 12/31/15.  As far as I can tell from the report they also have no Level 3 Assets, which I find curious.  Most of the funds I review have at least some il-liquid assets (Level 3 Assets) on the books.  They admit their mistakes, write them down and move on.

The breakdown by fund tells us something as well.  The poorer performing funds generally have higher levels of Repos.  Relevant Repos are 7.6% of the Focused Growth Fund NAV, 4% of the International Growth Fund NAV, 10.4% of the Emerging Markets Fund NAV, 17.7% of the Energy and Resources Fund NAV and 5.1% of the Discovery Fund NAV.

Why?  Well, generally, there's no need to Window Dress funds where there are no problems.  On the other hand, poor performing funds have a significant incentive to monkey around with the numbers in order to stave off redemptions.  Simply put, Mutual Funds are not like Banks.  Once Mutual Fund Investors smell trouble, they bolt. They can take their money anywhere immediately, and they do. Unlike a bank, with Mutual funds there's nobody (like the FED) waiting in the wings to provide liquidity, stepping in to bail investors out.  The fund managers just have to keep selling until they can't sell anymore, or like Third Avenue, they go to the SEC with a "please make it stop" letter and all of the post-run retirees like Margret (who are always the last ones to the redemption party) become what I call Financial "Firemen"  (i.e. -  They actually provide the "free" liquidity to facilitate the wind-down and put out the fire. In layman's terms, they are hosed).

For example, in the case of Baron, the Energy & Resources Fund declined by 32% in the last year and had 18% or it's assets deployed in Overnight Treasury Repos.  The Emerging Markets Fund had a one year loss of 11% with 10% of the Fund's Assets in Repos.  Therefore, if the Repos are really "bad assets" and they should be written off, the Energy & Resources Fund actually lost 50% and the Emerging Markets fund lost 21%. Makes sense?

The other thing that's very common practice with Mutual Funds is to compare your performance to some Index that's actually worse than what you did.  If you didn't beat the S&P this year, for the love of God don't compare your fund to the S&P....compare it to some obscure Index that nobody tracks.  This "Mental Accounting" game tells the Investors "Yes, it's true our performance sucked this year....but we didn't suck nearly as much as this Index which we found that's designed to mirror the sucky-ness of the sector we have invested your money in!...so we sucked much less than everyone else who chose to put their money this crap!"  Of course, money is portable.  There is no "Growth Money", "Tech Money" or "Emerging Markets Money". Investors can put their money anywhere they think is best.  Money is money.  The only way to evaluate a money manager is to determine "did they beat the market"?  If they do, on a consistent basis, they are adding tremendous value.  If not, as an investor, you can just put your money in an S&P Index Fund, assume the risk of the market (if you choose...or keep it in cash if you don't want the risk) and get on with your life.  As you can see, our friends at Baron had a tough time when compared with the market this year.  .

This is the odd courtship ritual that scores of  fund managers continue to preform when times get tough. They need to hold on their current investors, by whatever means necessary, and sign up new investors to provide liquidity and feed the beast.  There's a tremendous incentive to make the numbers "suck less". That's really what window dressing is all about.  Money managers are very much like the brave young pioneer shouting to his fellow pioneer friend as they are frantically trying to outrun a grizzly bear....."I don't have to run faster than the bear" he yells..."I just have to run faster than you!" Such is the life of a money manager when there's a liquidity event or valuation reset.

As an alternative to trying to outrun other fund managers, some of them might just throw a big party.

Who is FICC?

Well, the simple answer is that Fixed Income Clearing Corporation (FICC) is a wholly owned subsidiary of  The Depository Trust & Clearing Corporation (DTCC) of course!  I presume most of you have never heard of these business.  DTCC provides trust, custodial and clearing services for financial institutions (Banks, Mutual Funds, Hedge Funds, Exchanges, etc.) The headline from their 2014 Annual Report Dashboard says it all.
Total Value of Securities Processed in 2014 - $1.6 Quadrillion
To my somewhat foggy recollection, I believe this is the only time I've ever seen the word "quadrillion" in an annual report.

Yes, that's right, this relatively unknown, behind-the-curtain business handles:

 $1,600,000,000,000,000

...worth of securities transactions every year.  Although I might sound naive, I'd like to ask: What does "processing $1.6 Quadrillion in securities" even mean?  Is that a good or bad thing?  Is 23 pairs of chromosomes the right number?  Who's to know?  It just "is what it is".  To put this in perspective, according to the most recent FED report I could find, US "Non-Cash" transactions (Debit, Credit & Prepaid cards, ACH Transactions and Checks) in 2012 totaled  122.8 billion transactions, with a value of $79.0 Trillion.

Simply put, DTCC processes roughly the dollar value equivalent of twenty times (20x) ALL US Non-Cash transactions every year.  Or, to describe it another way, this figure represents roughly 90x the GDP of the United States cleared/processes/traded through DTCC every year.

DTCC is an industry owned and governed "market utility".  Interestingly, it's a relatively tiny little business given the role that is seems to have carved out in the global economy. There are four primary operating units, Global Trade Repository (GTR), National Securities Clearing Corporation (NSCC),Fixed Income Clearing Corporation (FICC) and The Depository Trust Company(DTC) .  Total assets are roughly $25 Billion with Shareholder Equity of $1 Billion. (24:1 Leverage). Revenue came in at $1.4 Billion and they generated a net income of only $32 Million. I suppose this lack of profits is understandable since the business is run as an industry funded quazi-non-profit utility. Transactions processed are 64,000 times assets and they pay themselves the equivalent of minimum wage to do it.

The annual financial report lists like a Who's-Who of US Bankers. Nearly every Major Bank and Exchange (JPM, Citi, Morgan Stanley, FINRA, ICE, Bank of America, State Street, UBS, Ameritrade, Wells Fargo, PIMCO, Goldman, etc.) has executive representation on the board. These folks are the best and brightest. Everyone of them dedicated to relentlessly knocking down the roadblocks which might be an impediment to growth. Their motto, right in their annual report is: "Protecting Safety and Soundness". Fortunately, I'm sure their full time jobs at their primary employers don't interfere, or take time away from their responsibilities at DTCC. What could possibly go wrong?

For some of my readers who might not be much older than my nicest pair of dress shoes I'll go through a one paragraph history lesson on why DTCC exists today.

When I was a young pup making my way in finance I remember some of the wily old gray-beards talking about how things were way back in an era that they used to refer to as "the1960's". The NYSE only cleared a few million shares a day, mortgage backed securities, derivatives, synthetics and the NASDAQ didn't exist. I know this sounds prehistoric to you youngsters reading this, but at the time, securities laws required the physical delivery of stock certificates to the actual owners (or the broker by proxy) of the stock. That's right, when you bought 100 shares of IBM the stock certificates actually showed up in the mail the next week (or two). As trading volume grew, physical limitations became apparent. Stacks of stock certificates piled up on filing cabinets, desks and every open table space in every empty conference room, Files and certificates were mailed to the wrong place, mis-delivered and often lost. Some brokerages even closed mid-week when they got too far behind. Mail rooms were humming. As volume grew, nobody could keep up. Wall Street needed to do something, so they hatched a plan to "computerize" everything. They needed to change the state securities laws to eliminate the requirement for actual delivery of stock/security certificates, create an escrow/depository and record ownership of the securities in name only (book-entry form) at the brokerage. Theoretically, every brokerage account could be reconciled to the actual stock certificates and securities on file at the Depository. Thus, in 1973 the Depository Trust & Clearing Corporation (DTCC) was born. Overhead, paper, mailing costs and staffing were reduced and eliminated. Efficiency increased and the foundation for the expansion of financial markets was firmly in place.

Fast forward forty years. Here's a potentially prophetic, ominous quote from the DTCC shareholder letter:


Our role is so essential to the functioning of the financial system that a disruption in the clearance and settlement of trading activity could grind the markets to a halt. We continued our track record of functioning at the highest levels, powered by battle-tested and robust processing engines that handled nearly $1.6 quadrillion in securities transactions in 2014 – an average of about $6.4 trillion per business day.

I have to say, that I really hate it when I see words like "grind markets to a halt" in a financial statement. Moreover, maybe it's just coincidence, but whenever I hear an IT guy use the word "robust" or "battle tested" I can be rest assured that the system he's referring to is the one that's going to blow up next.

In 2014, according to the World Bank, US Stock Market turnover was about $41 Trillion, so we can assume that the rest of DTCC's $1.6 Quadrillion cleared ($1.559 quadrillion) is comprised of financial assets other than stocks. (i.e. Bonds, Derivatives, Synthetics, MBS's, CDO's, Futures, Swaps, etc.) give or take a Trillion dollars or two. (Authors Note: I had never believed, until now, that at any point in my financial career, that I would be rounding any financial metric to a "trillion or two".)

Moreover, the processing/outage/collateral risk is primarily concentrated in DTCC and two other similar businesses, Euroclear  (Brussels - $770 Trillion) and Clearstream  (Deutsche Borse Frankfort - $225 Trillion). These three (3) relatively small businesses clear $2.6 Quadrillion in securities transactions, with volume growing significantly every year.


Theoretically, every Stock Certificate, Bond, Derivative and trade-able Contract (Exchange Traded or OTC) has specific requirements/form and physically exists somewhere, either at DTCC, Euroclear, Clearstream or a custodial bank/trust (State Street, JPM, etc.) or a broker/dealer. The contract stays in one place, but the ownership changes constantly in a flurry of daily electronic, book-entry activity. As an old-school bookkeeper, I can't help but wonder if and how the book entry ever gets reconciled with the physical contracts. (Remember the mess with trying to figure out which mortgages were bundled with which Mortgage Backed Securities? The "show me my mortgage defense?"...."what? you can't produce my mortgage? I guess I don't owe you anything!...") By way of confession, I know that when my little insurance business is audited, every once in a while we have a hard time coming up with the signed policy contracts requested by the auditor....and I'm embarrassed to say, we have far less than $2.6 Quadrillion in annual transactions to monitor/manage.


Next, lets examine where all of these assets came from and how all of this value was created. Obviously, the assets aren't "real". They are leveraged promises. The economy has only been growing at 2%. None of the $2.6 Quadrillion in annual leveraged promise transaction volume existed in 1970. Back then, investors bought stocks and bonds. That was it. Generally, all of these contracts take the form of "I'll promise to give you something now....and you promise to give me something later." The "something" can be cash, currency, a commodity, stock/bond, basket of securities or just about anything. The "later" can be tomorrow, a month from now, a year from now or "whenever". Each of these transactions has the possibility of a gain or loss, i.e.) the "something" I gave you today will be worth less (gain) or more (loss) than the value of what you are going to give me later. Now, since all of these "somethings" and "laters" are relatively well defined and stable, we can deploy "leverage" to each of the contracts. This is how we create these huge notional values ($2.6 Quadrillion for example). If I need to buy $100 million worth stocks, bonds, commodities or a currency from you next year at today's quoted price, since the relationships have been historically stable, I don't need to give you $100 million now, I can post $1 million in collateral today and promise you that if the value of the stock/bond or currency decreases, I'll post more collateral (margin call) to cover the decline. Moreover, do you remember my discussion on Rehypothecation?  The practice where large institutions actually use customer collateral to fund margins? As you might recall this funding mechanism provides virtually unlimited leverage.

Notional Contract values become enormous, The values eventually exceed, sometimes by a wide margin, the actual availability of the underlying asset. They have to be netted and closed out. The most current figure I have for the Notional Value of open Derivative Contracts comes from the Bank of International Settlements.  For example, the notional value of OTC derivatives contracts outstanding at end-2014 was $630 trillion, which was eight times greater than global output and 6.5 times larger than all outstanding global debt securities. Exchange Traded Derivatives are an additional $127 Trillion as of 12/31/15. Of course, a substantial portion of the assets represented by these contracts won't/can't be physically delivered. Yet, in my little example case, I want/need the $100 million asset my counter-party has promised to deliver. I'm entitled to my stock/bond/ commodity or currency. I've kept my end of the deal. But, there's a point at which the contracts can't be fulfilled, yet I still need my asset....then what? How can I get something that physically doesn't exist? I'll be forced to deal with a counter-party in default. It's not unreasonable to believe that at some point , the wind-down and settlement of these far-a-flung contracts simply can't work out without a few bumps in the road.

Back to "Window Dressing" 


Now, let's go back to Baron and the other 1,574 customers of FICC.  The FICC customer list includes virtually every household fund name, Nuveen, Hancock, TIAA-CREF, Aberdeen, PIMCO, Royce, Schwab, TransAmerica, Value-Line, etc. Many of the funds sampled list FICC Repos on their balance sheet as of the most recent year end. Again, these Repos represent Treasury securities, possibly exchanged for il-liquid collateral, the most conservative, yet nearly invisible form of window dressing I know of. Yet, it truly is, because of the lack of disclosure requirements, impossible to tell which assets the Repos replaced. As I suggested in my prior post, when you review your struggling mutual fund's financial statements, and you see a large, overnight Treasury Repo value, you might just want to think about why that transaction is really on the books in the first place. Again, is it because the fund manager astutely contacted FICC to collect a few more crumbs of interest income for the quarter rather than let cash sit idle? Or could it be that FICC might just be the Christian Dior' of Window Dressing helping your pioneer fund manager outrun a financial grizzly bear.

So what do we have.....

We've got three relatively small businesses providing custodial clearing and matching services for the lions share of the worlds financial assets. These businesses have demonstrated that they are fully capable of providing services which, intentional or not, could be used to hide "bad assets" and potentially materially mis-state (Window Dress) the assets of mutual funds, ETF's and any other business which may want to "improve" their financial results at year/quarter end.

The volume and integration of these transactions has become, at least for me, mind boggling. As the DTCC annual report mentioned, if something goes haywire "any disruption could grind the markets markets to a halt". I need only recall the Knight Capital debacle as a harbinger of things to come. Knight Capital was handling a third of the NYSE volume one day, and out of business the next. No matter how "battle-tested" and "robust" these systems are, we are only one "computer dude uploading the wrong software" away from another flash crash....next time it might be much more "crash" and not so much "flash".

Given the above, and I want to be clear here, I'm not some Luddite. I get it. Technology is important and valuable. Tech has changed our lives for the better in heretofore unimaginable ways. Vastly improved communication, safety, efficiency, health, transportation, security, etc are just the tip of the ice-berg. That said, I also now have a virtually unlimited supply of cat videos, porn, spam and website/email fraud dumped on my electronic doorstep every day. Pardon my rant, but do I really need a super computer in my toaster to send continuous updates to my smart phone letting me know the real-time status of my toast? God forbid that something goes wrong with the application either setting my house on fire or causing me to spend thousands of dollars on diagnostics and threat detection to determine whether my toaster has been hacked and if so what precautions I need to take to better secure my toaster from rouge toast-hackers. I just want a %$#*!! piece of toast! What I'm saying is that tech, simply for the sake of more tech doesn't help anyone.

The world's financial markets aren't Facebook or Twitter.....this is real money. If something or someone goes berserk we don't get unFriended or have our embarrassment re-Tweeted. We go broke. This whole mess started 40 years ago with a simple concept "hey, maybe we can streamline the process and save some postage" ....and now look where we are.

Finally, my wife and I were in Italy a few years ago, wonderful trip. On the train to Sorrento we rode through Pompeii. I couldn't help but feel sorry for the poor Pompeii charcoal people timelessly preserved in the ash. Very sad. They were instantly baked to a crisp, just like little Cannoli shells left in the oven a smidge too long. They never knew what hit them. In my mind's eye I can visualize them occasionally glancing up at Vesuvius and thinking "Hey....I wonder what that smoke is?....does it feel warm to you?....kind of hot for this time of year.....don't you think?......did you feel that rumbling?....what was that?....I've never heard that before......the water from the well is really hot...what's up with that?....oh well.....seems like a nice day....let's go to the beach...."

Anyway, I hope everything with the global financial markets turns out OK.......It's kind of cold in Cleveland right now, but I'm looking forward to the Summer....maybe we'll go to the beach.




Other Recommended Reading

DTC - 2014 Annual report
http://www.dtcc.com/annuals/2014/index.php

Stock Turnover - $41 T - 2014
http://data.worldbank.org/indicator/CM.MKT.TRAD.CD



DTCC Financial Statements
http://dtcc.com/annuals/2014/pdfs/DTCC_Consolidated_Financial_Statements_2014.pdf
http://dtcc.com/annuals/2014/performance-dashboard/index.php

Baron - Alibaba
http://www.gurufocus.com/news/392537/baron-funds-comments-on-alibaba-group-holding-ltd#.VsPFN6IAJoo.email

DTCC
https://en.wikipedia.org/wiki/Depository_Trust_%26_Clearing_Corporation

Baron Financial Reeport - 12/31/15
http://www.baronfunds.com/BaronFunds/media/Quarterly-Reports/Baron-Funds-Quarterly-123115.pdf

Baron Financial Report - 6/30/14
http://baronfunds.com/getattachment/dd6db42b-8b30-40b7-a524-2341b9d0fc78//

Baron - 2013 Annual report -
http://baronfunds.com/getattachment/4f7068f3-cf03-494f-bf3d-d29e8db97e4d//

DTCC
http://www.afr.com/business/banking-and-finance/quadrillion-dollar-corporation-at-the-heart-of-the-financial-system-20150707-gi6w7b

Euroclear - USD 770T in 2014 - Brussels
https://www.euroclear.com/investorrelations/financials/annual-report/annual-report-2014.html
https://www.euroclear.com/dam/PDFs/Corporate/Euroclear-Credentials.pdf

Clearstream - EU 200 T in 2015 - Luxembourg
http://www.clearstream.com/blob/11370/5631f715ef77eac6c9e86637747717eb/gdb-annual-report-data.pdf
http://corporatereport2015.deutsche-boerse.com/deutscheboerse/annual/2015/gb/English/pdf/Financial_report_2015_e_FINAL_20160316.pdf

DTCC

https://en.wikipedia.org/wiki/Depository_Trust_%26_Clearing_Corporation


Goldman wrong on 5 of 6 trades
http://www.bloomberg.com/news/articles/2016-02-09/goldman-sachs-abandons-five-of-six-top-trade-calls-for-2016?cmpid=yhoo.hosted

The estimated number of noncash payments, excluding wire transfers, was 122.8 billion in
2012, with a value of $79.0 trillion.  (Includes, Debit, Credit & Prepaid cards, ACH Transactions and Checks)
https://www.frbservices.org/files/communications/pdf/research/2013_payments_study_summary.pdf

Ron Baron - Forbes Profile
http://www.forbes.com/profile/ron-baron/

Flash Crash - May 6, 2010
http://www.nytimes.com/2010/05/07/business/07markets.html?action=click&contentCollection=DealBook&module=RelatedCoverage&region=EndOfArticle&pgtype=article&_r=0

DTCC - FICC Clearing Members - 146 - State Street Sponsored Funds - 1,574 (Including Baron Funds) - look at Nuveen/Hancock/etc.
http://dtcc.com/client-center/ficc-gov-directories#/

Knight Capital
http://www.forbes.com/sites/steveschaefer/2012/08/02/knight-capital-trading-disaster-carries-440-million-price-tag/#3a228aae14c4


Alibaba Investors
http://www.sfhfm.org/boston-partners-buys-386493-shares-of-alibaba-group-holding-ltd-baba/


List of entertainers at Baron Shareholder Conferences
https://en.wikipedia.org/wiki/List_of_Ron_Baron_Investment_Conference_Entertainment

List of Ron Baron Investment Conference Entertainment
From Wikipedia, the free encyclopedia
Year
Main Performance
Lunch
Lunch
Lunch
2015
2014
2013
2012
2011
2010
2009
2008
2007
2006
2005
2004
2003
2002
Mona Lisa Sound (Rock String Quartet)
2001
2000
Mona Lisa Sound (Rock String Quartet)
1999




Monday, March 14, 2016

Monopoly Money

Let's take a few minutes to talk about how Chinese businesses are buying US$ and Euro denominated assets, as well as why they might be doing it.

Today's Thesis:

Think of it this way, if, by some magic, some invisible force in the financial universe allowed me to convert “monopoly money” to US$ and I knew that relatively soon, the clock would strike midnight and my monopoly money would become worthless again, I’d be buying up every dollar denominated asset I could get my hands on.  The asset price would be irrelevant.  Of course, in my fairy tale, the RMB is the monopoly money and the invisible force is the currency markets.  Money for nuthin' ...US$ denominated assets for free.

Let's start with how we got here

I won't bother recapping the odyssey of the Renminbi over the last half decade.  If you feel so inclined, please refer to the post I did eleven months ago, China's Dream.....Defying Financial Gravity. To refresh your memory.  Here's the thumbnail of what I said:

"Even though the "supply" of RMB has increased four fold since 2007 the RMB per US$ exchange rate has remained rock solid in a range of about 6.5 +/- RMB to the US$.  You'd expect a significant decline in the exchange rate with a money supply increase of this magnitude, yet it hasn't happened.  The RMB is a miracle of modern economics."


"If I were a betting man, once the PBoC starts to exhaust it's Great Wall of Currency after trying to support an unsupportable Renminbi, I'd think the value would settle in much closer to a nickel than fifteen cents.  Once this value is reestablished, the value of China's assets, including all of those US$ denominated ADRs & Bonds will also be re-priced, and that's not going to end well for anyone.  China's Dream will soon become the world's Nightmare."

There are also a couple of excellent, recent articles, one by Kevin Dougherty on Forbes on the expected depreciation of the currency and the history/role/effectiveness of currency/capital controls, and  another by Christopher Balding, picked up by Gordon Chang, discussing the probability of China's Trade Surplus being faked for years, even suggesting that a current surplus may not exist at all.  Both articles pave the way, to at least to a preliminary understanding of how the Alice-through-the-looking-glass NBS numbers and the actions of the PBoC are seemingly becoming more divorced from reality by the day.   Moreover, hard, or even anecdotal evidence of a fudged trade surplus and/or overstated currency reserves would tend to accelerate the decline toward the Renminbi's true, intrinsic value (IMO ...a nickel), further explaining why it's currently under such pressure.

The New York Times also published a wonderful Keith Bradsher piece on how the Chinese People are Losing Confidence in their Currency.  When people are paying other people to stuff currency in their  underwear to get it out of the country, I'd think that's a pretty obvious warning bell that there's a problem.  The article is a worthwhile, fun read.

Finally, I've never heard (until now) of a Central Bank (PBoC) issuing a statement warning a Hedge Fund (Soros) of the repercussions of shorting a currency (RMB) before.  I guess, it's a brave new world out there now.  Things are clearly different.

So, now for the recap.  We've got a large Central Bank (PBoC) making monetary policy decisions based on "fake" metrics, driven by fiscal policies which require it to support what I, along with many, would argue are un-achievable, unproductive, capital deployment directives in pursuit of an unrealistic real GDP growth target in the current economic environment.  That's where we are today.

If you have a moment, please take a few minutes to read through the above referenced articles.  They are very well done and help describe the puzzle pieces I'm referring to in this post.  I'm sure Kevin, Chris, Keith and Gordon, as I always do, would appreciate the page views.

Now, let's examine where we are...

As described above, it seems that everyone on the planet wants to get out of the RMB.  The clock is about to strike midnight and they want to convert as much monopoly money to real assets as possible.

We need to only look at the unwinding of the carry trade and the parade of Chinese acquisitions of US assets that have taken place or are contemplated over the last few months to see what's going on.  Whether it's Syngenta ($43 Billion), GE Appliances ($5.4 Billion), Blackstone Luxury Hotel Portfolio ($5.9 Billion in two transactions) Deutsche Bank China Assets ($3.8 Billion), Sharp Electronics ($5.9 Billion), Chicago Stock Exchange, AGTech ($300 Million), IBM Credit ($550 Million), SAB Miller ($1.6 Billion), Carmike Cinemas ($1.1 Billion),Soccer Teams, Real Estate, the establishment of China's $30 Billion Electronics Industry Acquisition Fund , China's State owned $338 Billion VC Fund,or even Alibaba's US$ debt fueled spending spree, etc., etc.  (Links Below), it's clear that the China's demand for US assets is accelerating.  Alibaba's IPO alone facilitated the thinly disguised off shore transfer of more than US$20 Billion to Shell Companies in the Caymans and BVI.

Moreover, US Barristers and banks are only too happy to facilitate the spending spree.  Both the New York Times and 60 Minutes did great work describing the "enthusiasm"  Real Estate Developers/Managers, brokers and NYC law firms have for laundering (allegedly) illegal overseas money into "clean" US assets.  I can just imagine the effort and fervor these firms would put forth, and the relative ease which the transactions might be accomplished, if the money were actually provided from a seemingly legitimate source.

As an aside, especially with Alibaba's acquisition spree, am I the only financial person out there who thinks that the lack of participation by Chinese Banks in these deals is odd?  In Alibaba's case, 97% of all revenue is derived from China operations, yet, according to their filings, not one Chinese Bank participated in the IPO, (US$23B) Bond Issue (US$8 Billion) or Credit Facilities (US$5 Billion and proposed $3 Billion).  All financing is provided by US & EU Investment Banks?  Really?

Finally, I also find it curious that Chinese acquirers are routinely willing to pay much more for a target than other suitors. In some cases, nearly double competing offers, presumably to make sure the deal gets done. Again, am I the only financial person who finds this phenomenon peculiar?



GE Appliance Sale to Haier

Now, let's look at one of the deals mentioned in the long list above.  I bring up GE for two reasons; First, I've followed GE for years (full disclosure, I own some shares) and know a little bit about the business.   Second, this deal is a poster-child for my Monopoly Money thesis.  Here are a few relevant bullets on GE's direction.

1.) Ever since the GE Capital debacle almost wrecked the company back in 2009, Jeff Immelt has been on a mission to focus on "core industrial business".
2.) GE operating businesses rarely, if ever, lose money or have negative cash flow.  If they do, they are either  quickly fixed, sold or (metaphorically of course) taken out back and shot.  GE Managers are really smart people who understand their businesses.  GE managers are committed to understanding and using financial metrics/data to improve the business, as opposed to the alternative, yet increasingly more popular management style which emphasizes using accounting gimmicks to fix the metrics/data while leaving the underlying business unaffected and/or languishing.  
3.) GE has been transitioning for a few years.  Non-Core businesses have been sold or are up for sale. NBC Universal, GE Capital Business Segments and now GE Appliances, etc.

Brief chronology of the GE Appliance Sale to Qingdao Haier Co., Ltd. (Haier) per the GE 10K:

During the third quarter of 2014, GE signed an agreement to sell its Appliances business to Electrolux AB for $3.3 billion. On July 1, 2015, GE was notified that the Department of Justice had initiated court proceedings seeking to enjoin the sale of Appliances to Electrolux AB. On December 7, 2015, GE announced that it had terminated its agreement to sell its Appliances business to Electrolux AB and would pursue other options to sell the Appliances business. GE received a break-up fee of $175 million from Electrolux AB.
On January 15, 2016, GE announced the signing of a definitive agreement to sell its Appliances business to Qingdao Haier Co., Ltd. (Haier) for $5.4 billion. The transaction has been approved by the board of directors of GE and of Haier, and remains subject to customary closing conditions, including Haier shareholder approval, and regulatory approvals. The transaction is targeted to close in mid-2016. 

Everyone wins!....Right?.....The DOJ was focused on protecting the American consumer from a presumed monopoly pricing, effectively killing the Electrolux purchase.  A month after killing the deal, GE announced a new agreement to sell the same business to Haier for $2.1 Billion more (A 63% premium to the Electrolux AB offer).   Everyone did their job flawlessly.  The DOJ protected the American Consumer.  GE generated a quick, additional $2.1 Billion for their shareholders and Haier gained a valuable foothold in the lucrative US Consumer Market and a respected US Brand.  Just like in our pre-financial crisis markets, the "invisible hand" seems to be operating perfectly.

The frequency and size of these transactions is increasing.   The game plan is always a variation on the following theme:  The Chinese Acquirer looks for a target business, using a US, Swiss or EU Investment Banks (USIB). The deal is structured and advised by a USIB and funding is provided (and usually syndicated) in US$ by USIB's.  The USIB sells off the risk and collects significant fees for doing the deal. The resulting securities are rated AAA and eventually find their way into Mutual Funds, Pension Funds and ETF's.

What We're Really Dealing With....

I believe it was Ronald Reagan, addressing a concern that Japanese Investors were buying up US Real Estate, specifically when he was told that a consortium had agreed to buy the Pebble Beach Golf Course, he quipped.... "Well...at least they think America is a good investment..."

Let me be clear.  "This is not that".  What's happening today is nothing like the market driven free flow of capital that began in the 80's, when freely-traded, floating, unrestricted currency had begun to find its way around the globe establishing a global, rather than local equilibrium for asset and business valuations.

As Ronald Reagan put it, America was, and has (almost) always been, because of our legal system, regulation, free markets and financial system, a preferred destination for global capital and a "good investment".

The following quote, is dubiously attributed to Mark Twain in the opening minutes of "The Big Short". For the purpose of this post, it's a perfect illustration of what's going on in global currency markets. The quote's origin is irrelevant.

"It ain't what you don't know that gets you into trouble. It's what you know for sure that just ain't so."

When you are a financial manager, doing a deal virtually guaranteed to make a ton of money, it's difficult to see or even look for things that "just ain't so". US Businesses believe that they are taking the Chinese Investors to the cleaners when they accept an offer double what competing buyers are willing to pay.  Are Chinese business-people somehow able to generate synergies that no other potential bidder is able to realize?  Are they that much smarter than US Managers in a market they have no experience in?  Are US businesses somehow suddenly worth double simply because of who owns them?  Do these new Chinese acquisitions and their economic prospects skyrocket overnight? Would the SEC/DOJ step in and stop an arms length sale of a business when there are no apparent Anti-Trust or restraint of trade implications?  Of course not.

So why are these deals taking place at these prices?  For more than a year I've discussed the ramifications of China's facade economy, fake, nonsensical NBS Data and the steady stream of (allegedly) fraudulent IPOs and Bond Issues fueled by an artificially pegged "Monopoly Money" RMB which bears no resemblance to economic reality.  All of the aforementioned windfall sales of US Assets are happily facilitated by complicit US Investment Bankers, for size-able fees, of course.

Winners and Losers

Hypothetically, let's just say I'm right.  Let's say that at some point in the near future, market forces somehow bust the Renminbi peg and that the real value of the Renminbi , unsupported by intervention (or threatened intervention) of the PBOC is really closer to a nickel than fifteen cents. Of course, it's impossible to predict with precise accuracy the implications and timing of the fall of the Renminbi,  I can't do it.  Nobody can.  99% of the time, market behavior is rational and steady, and the other 1% or less (i.e. during crashes) it's a complex adaptive nonlinear system with sometimes unexpected, perverse feedback loops.  Things begin to move in very unpredictable ways.  Yet, I feel that this is a worthwhile exercise.  So....let's make some guesses.  Who wins and who loses?

Hypothetical Big Winners:

1.) China's elite.  They've been able to buy "real" assets at a net discount. If they can "get the hell out of Dodge" they'll be able to live a wonderful life in San Francisco, NYC or the Caymans.
2.) US & EU businesses who have goods manufactured in (Apple) and import goods (Walmart)  from China.
3.) Travelers allowed to visit China.  (presumably after the RMB is revalued there will be a new normal re: travel and financial transactions)......US$50 hotel rooms in Beijing and Shanghai would be wonderful if you're fortunate enough to get a visa!
4.) Hedge funds who understand what's happening.  They've made huge leveraged bets on the outcome of this scenario,  We just don't know who they are.
5.) That's about it.


Hypothetical Big Losers (This list is a little longer):

1.)  The hard working Chinese people.  Their work and effort will be worth a third of what it should be worth had China's financial architects not taken the path they did.
2.) US Investors.  Exchange traded assets will be revalued.  ADRs will be repriced.  Bond issues will be repriced and/or default.  The direct effect will be roughly $2 Trillion.  The liquidity effect multiplier could be virtually any number depending on how rapidly the revaluation takes place.
3.) Holders of Renminbi denominated collateral, specifically HK & EU banks (HSBC, Deutsche, Credit Suisse, Standard Chartered) who have significant interests in Mainland Real Estate Collateral.  When 90% of a project is financed and the underlying collateral takes a 66% haircut, the math no longer works.  
4.) Chinese Retail Investors.  Capital inflow will dry up.  Equity markets will collapse.  Loans will default, real estate values will be reset and life savings will be lost.  Tienanmen Square II?
5.) Hedge Funds.  There are huge leveraged Bets out there going the wrong way.  We just don't know who's swimming naked.   We'll find out only after it's too late to do anything about it.
6.)  The US retail Investor.  Those of you who continue to blindly plow a percentage of your paychecks into Index funds and Mutuals in the mistaken belief that US Stocks, like real estate, will always go up "for the long run".
7.)  The FED.  Once everything is revalued we'll need a TARP II (maybe even a three and four) to hold all of the troubled assets generated by yet another mess brought to us by the US Banking System.  Moreover, if all of this carnage takes place in a zero-interest rate environment, all bets are off as to what the FED might be able to do to support capital formation and keep the economy out of a recession/depression.  Quadruple M2, to keep up with the EU and China?  Negative 10% Interest Rates?
8.) US Investment Banks.  There will be a populist uprising (Bernie, Hilliary, Donald) to "break 'em up"...."close the borders"...."build a wall"...."get 'em outa here".  This time, someone might actually be going to jail.  Money will flow out of Wallstreet and back to Main street.  Capital formation will be crippled for years, perhaps decades to come.
9.) International Trade - There will be a political "Anti-China-Anti-Trade" backlash the likes of which we've never seen.  Like mortgages today, the cost of trade may actually drop....but try to get a mortgage (or a trade deal) done.  Similarly, the cost of Chinese goods will be next to nothing (plus freight), but the probable administrative, political, compliance and tariff costs and red-tape would likely increase geometrically.
10.) New York City, Bay Area and Silicon Valley Real Estate prices will correct/collapse.  Foreign money would dry up with a Renminbi revaluation.   No more vacations and second homes in America for rich Chinese. Alibaba, Yahoo and Softbank will all be gone, along with many of the Unicorns in the pipeline..  Bankers will have to find jobs  and move to the country's new financial centers, Chicago, Omaha, Denver, Atlanta and Cleveland (Ok....I admit Cleveland is a bit of a reach...but you get the drift).  $5 Million condos with a view of the Bay or the River will become a thing of the past and banks will be writing off/down mortgages at a pace that will make 2010 look like a walk in the park.
11.) The PBOC.  After loosing control of the currency and the Chinese economy, Chinese bankers will no longer be allowed unrestricted playtime in the global financial sandbox.

Well, that's it for today.  Of course, the above is all hypothetical based on myriad assumptions and best guesses.  As always, the above is not investment advice.  As an Investor, you should always do what you think best.  As for me. I'm going to hunker down and keep out of the fray, at least until I can confirm I'm wrong.  Obviously, I hope I am indeed dead wrong on all of this....but sadly, my track record on these impending disasters doesn't often, if ever, coincide with my hopes.





Syngenta - $43 Billion
http://in.reuters.com/article/syngenta-m-a-chemchina-idINKCN0VC19V

GE Appliance $5.4 Billion
http://money.cnn.com/2016/01/15/investing/ge-haier-appliances-sale/index.html

China Electronics Industry Fund - $30 Billion
http://www.nytimes.com/2016/01/09/technology/china-setting-up-fund-for-its-electronics-industry.html?_r=0

Deutsche Bank Assets - $3.8 Billion
http://www.nytimes.com/2015/12/30/business/dealbook/deutsche-bank-joins-retreat-from-china.html

Sharp Electronics to FOXCONN - $5.9 Billion  (As you read this you might think "Hey Foxconn is a Taiwanese company.  Please think it through.)
http://www.reuters.com/article/us-sharp-restructuring-idUSKCN0VD0CN?xid=nl_daily

Chicago Stock exchange - No Terms disclosed
http://www.chicagotribune.com/business/ct-chinese-investor-group-buying-chicago-stock-exchange-20160205-story.html

http://www.bloomberg.com/news/articles/2016-02-05/obscure-chinese-firm-dives-into-22-trillion-u-s-stock-market


Casin Group's offer comes amid an unprecedented overseas shopping spree by Chinese companies. Businesses from Asia's largest economy have announced $70 billion of cross-border acquisitions and investments this year, on track to break last year's record of $123 billion, according to data compiled by Bloomberg.

Alibaba Buys AGTech - $300 Million
http://www.bloomberg.com/news/articles/2016-03-07/alibaba-finance-affiliate-buy-h-k-firm-for-china-lotteries?cmpid=yhoo.headline

China Life buying CITI China Loan Business US$3 Billion  & IBM Credit for $550 Million
http://finance.yahoo.com/news/citigroup-raise-3-bln-guangfa-stake-sale-china-125045870--sector.html

Alibaba mulling over buying Yahoo! and Groupon
http://www.forbes.com/sites/dougyoung/2016/02/29/alibaba-raises-more-cash-yahoo-stake-in-sight/?utm_campaign=yahootix&partner=yahootix#57da60be24fd

Alibaba seeks $4 Billion Loan to fund acquisitions
http://finance.yahoo.com/news/alibaba-talks-several-banks-4-130713373.html
https://finance.yahoo.com/news/chinas-alibaba-says-agrees-3-000649613.html

Alibaba SEC Filing re: $B Loan Syndication
http://www.sec.gov/Archives/edgar/data/1577552/000110465916103882/0001104659-16-103882-index.htm

Alibaba.....spending spree on acquisitions
http://www.bloomberg.com/gadfly/articles/2016-03-10/too-much-cash-not-for-alibaba?cmpid=yhoo.headline


China Resources buying INBEV $105B & SABMiller $1.6B


Alibaba spends $12 Billion on Investments in 2015
http://finance.yahoo.com/news/jack-ma-expensive-lowkey-strategy-200423126.html

Dalian Wanda buying Carmike Cinemas - $1.1 Billion
(Dalian Wanda already owns AMC Cinemas making DW the largest theater operator in the US)
http://fortune.com/2016/03/03/amc-entertainment-to-buy-carmike-cinemas-for-1-1b/?iid=leftrail&xid=nl_daily

China's Shopping Spree - Ken Rapoza
http://www.forbes.com/sites/kenrapoza/2016/03/10/china-deal-makers-increase-spending-in-u-s/?utm_source=followingweekly&utm_medium=email&utm_campaign=20160314#4607a77ed816

China's State Owned $338 Billion VC Fund
http://www.bloomberg.com/news/articles/2016-03-08/china-state-backed-venture-funds-tripled-to-338-billion-in-2015

60 Minutes - Lawyers, Guns & Money - the US legal system is only too happy to facilitate the acquisition of US assets anonymously.....for a fee of course.
http://www.cbsnews.com/news/anonymous-inc-60-minutes-steve-kroft-investigation/

New York Times - Anonymous Ownership of high end real estate gone wild....
http://www.nytimes.com/2015/02/08/nyregion/stream-of-foreign-wealth-flows-to-time-warner-condos.html?_r=0

Forbes - Sports Teams - Football/Soccer
http://www.forbes.com/sites/ywang/2016/02/04/chinese-billionaires-invest-in-football-is-it-worth-it/?utm_source=followingweekly&utm_medium=email&utm_campaign=20160208#6035411b2181

Blackstone sells Hotel Portfolio to AnBang Insurance - $6.5 Billion
http://www.usatoday.com/story/money/2016/03/13/blackstone-selling-strategic-hotels-to-anbang-for-65b/81726894/

Where is all that Chinese Money Really Going?
http://www.forbes.com/sites/kenrapoza/2016/01/31/this-is-where-all-that-chinese-money-is-really-going/?utm_source=alertscalledoutcomment&utm_medium=email&utm_campaign=20160209#8e991017c649

Why China Doesn't Have a Trade Surplus
http://www.baldingsworld.com/2016/02/23/why-china-does-not-have-a-trade-surplus/

Gordon Chang - Commentary on Balding's World
http://www.forbes.com/sites/gordonchang/2016/02/28/china-ran-a-36-billion-trade-deficit-in-2015-says-peking-u-prof/?utm_source=followingimmediate&utm_medium=email&utm_campaign=20160228#d8258377cf04

Kevin Dougherty - Capital Contrils
http://www.forbes.com/sites/realspin/2016/02/25/china-capital-controls-confusion/#1d5d78742417

Chinese Losing Faith in their Currency - New York Times
http://www.nytimes.com/2016/02/14/business/dealbook/chinese-start-to-lose-confidence-in-their-currency.html?_r=0

PBOC Warns the Hedgies against shorting the RMB
https://larouchepac.com/20160215/pboc-warns-soros-gang-again

GE 10K
http://www.sec.gov/Archives/edgar/data/40545/000004054516000145/ge10k2015.htm

Towers of Secrecy - Time Warner Center & Foreign Shell Companies
http://www.nytimes.com/2015/02/08/nyregion/stream-of-foreign-wealth-flows-to-time-warner-condos.html?rref=collection%2Fnewseventcollection%2Fshell-company-towers-of-secrecy-real-estate&action=click&contentCollection=us&region=rank&module=package&version=highlights&contentPlacement=1&pgtype=collection&_r=0