Grants Interest Rate Observer 2009W-Break

8/14/2019 Grants Interest Rate Observer 2009W-Break

1/33

Vol. 27, Wint Bak decemBer 23, 2009Two Wall Street, New York, New York 10005 www.grantspub.com

(December 12, 2008) Credit is what

we are bullish oncast-off residen-tial mortgage-backed securities, seniorbank loans, convertible bonds andcorporate debentures, high-rated andmiddling. And its credit that fills thenew Grants model portfolio. Expec-tantly, we call it our Supermodel Port-folio. May it deliver superior returnsfor 2009 and beyond. No guarantees,of course. However, at the least, weexpect it will outearn the correspond-ing portfolio control group, an assort-ment of long-dated, super-safe (asa certain newspaper habitually callsthem) U.S. Treasurys. Whoever coinedthe phrase return-free risk to ap-ply to government securities at theseground-hugging yields was a sage aswell as an aphorist. Barring a deflation-ary collapse, the Treasury market willsurely have its comeuppance.

The investments that stock theSupermodel Portfolio have had theircomeuppance already. They deservedit. Credit had a heart attack last year onaccount of its scandalously loose livingduring the bubble years. Still remorse-ful and weak as a kitten, the institutionof lending and borrowing is gatheringstrength for the next cycle. A not-badtime to invest, we think.

The portfolio, in the hypotheticalsum of $10 million, is apportionedamong RMBS, secured bank loans,investment-grade corporates, convert-ibles and junk (or should we say high-yield?) bonds. We set aside no cashreserve. This is not to say, however,that we refuse to entertain the possi-bility that even better credit opportu-nities will present themselves in 2009.

these. The fact is that, at this point in

the cycle, junk is hugely speculative.The iShares iBoxx $ High Yield Cor-porate Bond Fund (HYG on the BigBoard), our junk-bond trading vehicle,holds a position in 51 liquid issues. Ata price of $64.81, the fund pays month-ly dividends to produce a current yieldof 13.5%; indicated yield to maturity is18.7%. Its market cap is $1.02 billion.Given the risks, we assign to high yieldan allocation of just 5%. We view it as aportfolio seasoning, an herb.

A little less speculative is the invest-ment-grade component of our Super-model Portfolio, though investment-grade yields in relation to governmentyields imply a looming deflationarydisaster even for better-rated debt. At616 basis points, the spread between

They well might. If they do, well just

have to raise some more imaginarymillions to scoop them up.

No need to say much on high-yield(see the prior issue ofGrants), exceptto explain its presence in what is in-tended to be a safe and cheap port-folio. Rarely, if ever, has junk been

junkier, to judge by the ratings mix ofthe bond crop or the likely sky-highprospective default rates. Then, again,we believe, never have yields to ma-turity been so high22% on the Mer-rill Lynch Master II Index. Come thecyclical turn, junk bonds will shine.The question is, from what level willthey begin to glimmer? There can beno assurance, to steal a phrase fromthe junk-bond prospectuses, that itwont be from prices much below even

Introducing the Grants Supermodel Credit Portfolio

Treasury portfoliosecurity price investment4 1/2s of May 2038 128-06 $2.0 million4 3/8s of February 2038 125-03 2.05s of May 2037 135-15 2.04 3/4s of February 2037 130-08 2.04 1/2s of May 2036 123-27 2.0

Cash* 0.0Total $10.0

Grants Supermodel Credit Portfolio

iShares iBoxx $ High Yield (HYG) 63.75 $ 0.5iShares iBoxx $ Investment Grade (LQD) 92.14 2.0Nuveen Floating Rate Income Fund (JFR) 5.03 2.5Calamos Convertible Fund, Class B (CALBX) 15.69 2.5GSAA 2005-12, Class AF-3 50 1.25Popular 2007-A, Class A-3 32 1.25Cash * 0.0Total $10.0 million

*cash earns 1%.


2/33

Winter Break-GRANTS/DECEMBER 23, 2009 2SUBSCRIBE!- go to www.grantspub.com or call 212-809-7994

the Moodys Baa-rated corporate indexand the 10-year Treasury is the high-est since at least 1962. Indeed, accord-ing to Deutsche Bank data recentlyquoted in these pages, the gap is prob-ably wider than at any point since theGreat Depression (whenlet us not

forgetthe nominal GDP was sawedin half). Moodys relates that theinvestment-grade default rate nevertopped 1.6% in any Depression year,while the average annual default ratefor investment-grade bonds from 1920to 2006 was just 0.146%; the high was1.55%, recorded in the recession year1938. For what its worth, the MoodysBaa index has actually been rallyingthese past few weeks, trading to 8.75%from 9.5%, yet such high-quality issu-ers as Caterpillar and Hewlett-Packardhad to dangle 100 basis-point conces-

sions (in relation to the yields assignedto their own outstanding issues) in or-der to place new securities last week.

Senior loans, in the shape of a $2.5million allocation to the Nuveen Float-ing Rate Income Fund (JFR on theBig Board), are the third item in theportfolio. Leveraged loans is whatthe adepts call these instruments.They are secured claimstradablebank loanson leveraged companies.True, such leverage was typically ex-cessive, but the senior secured lendersstand to come out of the experience ina relatively strong position. The trou-ble is that leveraged loans attractedleveraged buyers; they yielded a pit-tance over Libor. To enhance the re-turn, loan investorse.g., hedge fundsand collateralized loan obligationsborrowed liberally against the lever-aged collateral. Come the great margincall, they sold (and continue to sell)

just as liberally. All told, accord-ing to the definitive chronicler of theloan market, Standard & Poors LCD,the [loan] index is down 25.5% overthe past three months, leaving returnsfor the first 11 months of the year at asoul-destroying negative 27%, all butensuring that 2008 will produce thefirst annual loss for the index, whichdates to 1997.

Soul-destroying? An editing er-ror, probably; LCD must have meantwealth-destroying and, therefore,opportunity-creating, though theopportunity thereby created seemsnot yet to be widely perceived. Supplykeeps coming out of the woodwork,and the public continues to yank its

money from loan mutual funds. Mo-tivated sellers put out calls for bids,i.e., bids wanted in competition,and they are the bane of the market.BWICs in the sum of $3.3 billion seta monthly record in October. Anoth-er $1.3 billion of BWICs rattled themarket in November. (These days,OWICs, i.e., offerings wanted incompetition, are only a dim, gauzymemory.) While these figures aretiny in relationship to the institutionalloan universe of $595 billion, LCDobserves, they are daunting in theabsence of any new funding sources.Loan funds have suffered net outflowsin 16 of the past 17 weeks, for a year-to-date total of $4.5 billion. Assets un-der management have dropped to $7.5billion from $15.9 billion.

There are, according to the Bar-rons Weekly Closed-End Fundsroundup, 19 loan-participation funds.As you know, closed-end funds issuea fixed number of shares, and withthe proceeds from the sale of thoseshares, they acquire assets. The fundsare exchange-listed and the prices atwhich they trade may or may not mir-ror the value of the underlying assets.The universe of listed loan-participa-tion funds trades at a large discountto NAVat last report, an average of17.2%.

Investors are getting a double dis-count, colleague Dan Gertner pointsout. The price of the loans held in theportfolios has fallen below par value.And the funds are selling at a discount

to the underlying NAV because somany investors are selling. Elliot Her-skowitz, president of ReGen Capital,has studied the discounts at which theclosed-end funds are trading. He findsthat the funds are trading between 30and 60 cents on the dollar of the un-derlying par value of the loans. Her-skowitz told me, It really points outthat, based on the way these thingsare trading, you can buy into loans at50 cents on the dollarI mean thesenior loans. And I think its just anunbelievable opportunity out there.Herskowitz cautions that the marketis thin and prices can move erratically.But if youre careful about getting inor out, its just an unbelievable oppor-tunity. It is very rare for the retail in-vestor to actually get a better deal thanthat which exists for the institutionalclients, he says. But in this particulararea, at this particular time, given theway these things are trading, its just aglaring example.

We chose the Nuveen Float-ing Rate Income Fund to carry theleveraged-loan flag for a number ofreasons. For one thing, JFR has re-deemed 59% of its auction-rate pre-ferred securities ($235 million outof $400 million), and Nuveen says itintends to redeem the balance. Foranother, 93.6% of the funds portfoliois allocated to variable-rate loans andshort-term investments (many fundshave heavy junk-bond exposures).Finally, the fund is quoted at a dis-count to a discount. Thus, as of July

0

100

200

300

400

500

600

700

0

100

200

300

400

500

600

700

1/071/021/971/921/871/821/771/721/671/62

Priced for Roubini

spread between yields of Baa corporate bonds and 10-year Treasurys

source: The Bloomberg

inb

asispoints

inbasispoints

Dec. 9, 2008:616 bp

Dec. 9, 2008:616 bp


3/33


31, the portfolio encompassed $954million of loans and bonds. Assumingno change since the reporting date,the underlying assets are trading at47 cents on the dollar, based on thedecline in the disclosed NAV. Then,too, at the current price of $5.03 a

share, the fund is trading at an 18.7%discount to its $6.19 NAV. Multiplyone discount by the other, and a new

JFR investor winds up owning theassets at 38 cents on the dollar. Thefund shows these characteristics ofdiversification by industry: media,18%; hotels, restaurants and leisure,7.3%; health care, 6.4%; and chemi-cals, 4.8%. Typically for the group,

JFR is leveraged 42%, with preferredstock and borrowings. The currentyield is 14%. In order for JFR to paya common dividend, the value of its

assets must be 200% greater thanthe value of the leverage-providingpreferred stock and borrowings. Asof November 28, the ratio stood at239%, comparedfor referenceto 243% in January. (Consult www.etfconnect.com for current informa-tion on closed-end funds.) Open-endfunds provide unleveraged access tothe bank loan market. Among threeof the largest are Fidelity FloatingRate High Income, Eaton VanceFloating-Rate Fund and FranklinFloating Rate Daily Access Fund.

As to convertibles, we laid out thestory line in the previous issue ofGrants; suffice it to say that they arestill not the fixed-income markets fa-

vorite flavor. We choose the Class Bshares of the open-end Calamos Con-vertible Bond Fund (CALBX) for theSupermodel Portfolio. The B stock hasa deferred sales charge that shrinks bya percentage point in every year thatan investor chooses not to redeem

from 5% in year one to zero percent inyear six. The funds annual operatingexpenses are 1.88%, and the averagecredit quality is triple-B. Assets total$462 million. Information technologyis the top sector weighting (24.4%),followed by health care (20.3%) andconsumer discretionary (13.2%). TheCalamos fund, founded in 1985, hadbeen closed to new investors sinceApril 2003. It reopened on October7, with John P. Calamos Sr., co-chiefinvestment officer, recalling the per-sistent knocking on its door by some

would-be investors. [O]ur responsehas always been not until we identifya significant opportunity that may beadvantageous for both new and ex-isting investors, he said. Well, wethink we have found one. Nick P.Calamos, co-CIO, added, Accordingto our research, we believe the globalconvertible market is significantly un-dervalued today. So do we.

Last but not least come residentialmortgage-backed securities, the hard-est of the credit markets hard cases.In particular, we tap for inclusion inthe Supermodel Portfolio a pair ofstructures we first reviewed in ourSeptember 19 issue. They are theGSAA Home Equity Trust 2005-12

and the Popular ABS Mortgage Pass-Through Trust 2007-A. At the time,the slices on which we particularlyfocusedClass AF-3 of GSAA andClass A-3 of Populartraded at 69and 59, respectively. Todays pricesare 50 and 32.

At inception, the GSAA Home Eq-uity Trust was stocked with Alt-A resi-dential mortgages, 2,919 of them. Allwere fixed-rate and first-lien and allhad maturities of 30 years or less. Theaverage FICO score, LTV and loansize were 690, 79.1% and $194,740, re-spectively. Thirty-nine percent of thedollar value of the mortgages was se-cured by houses in California, Floridaand New York.

Oddly enough, the deal hasnt per-formed badly. The principal balancehas been reduced by 43% and the

number of loans by 39%. Troubledloans (60 days or more delinquent)stand at 13.8% of the outstanding bal-ance, and cumulative losses amount to

just 0.85% of the original balance. Wethought that the Class AF-3 was cheapat 69. We like it moreexactly 28%moreat 50. AF-3 pays a fixed couponof 5.07%, and its credit enhancementhas grown to 12.3% from 7.4% as thetop of the structure has melted away.It is the third-pay bond, i.e., third inline to receive principal payments. Butit might as well be second, becausethe first bond in the structure has paiddown 95.8% of its original balance.

In our post-Labor Day review of theRMBS field, Gertner spoke to BryanWhalen, managing director of Met-ropolitan West Asset Management.Whalen obligingly came to the phoneagain last week. He told Gertner that,in a base case, the AF-3 bond wouldyield 29% to a five-year maturity. Evena modified Nouriel Roubini disasterscenario would permit a 14% yield,he said. In such a setting, the condi-tional (i.e., steady-state) prepaymentrate would slow to 3% from the cur-rent 8.2%, 84% of the remaining poolwould default (compared to 13.8% ofthe deal that is currently troubled) andloss severities would reach 70% (upfrom 50% at present, which is ghastlyenough).

And if interest rates should happento rise, what then? Not much, prob-ably. At 50 cents on the dollar, theAF-3 is trading on credit quality andliquidity, not on interest rates. I havea hard time believing that this bond

0

100

200

300

400

500

600

700

800

0

100

200

300

400

500

600

700

800

12/0712/0212/9712/9212/87

Buyers, please call your office

Merrill Lynch U.S. Convertible Bond Index(excludes mandatory convertibles)


index

level in

dex

level

Dec. 9, 2008:462

Dec. 9, 2008:462


4/33


would sell off even with a few hun-dred-basis-point Treasury sell-off,Whalen told Gertner. In fact, pricesmay go up in that scenario if the mar-ket is indicating that credit is improv-ing and the economy may be improv-ing and reinflating.

Our final investment, the PopularABS Mortgage Pass-Through Trust,will absorb our last imaginary $1.25 mil-lion. Your hand may quaver when youwrite the check (if you are followingalong at home), as the Popular bondtriple-A-rated Class A-3houses sub-prime mortgages. The wrinkle is thatthe mortgages are overachieving ones,though priced as if they were slugs.For one thing, adjustable-rate loansconstitute just 49% of the 2,779 mort-gages in the pool, the rest being fixed-rate. Usually, ARMs occupy a much

bigger share of a subprime RMBS. Foranother thing, the collateral is widelydistributed, with just one bubble mar-ketFloridain the top five.

On the face of it, our Popular in-vestment will win no quality-assur-ance awards. Its troubled loans standat 21.6% of the outstanding balance,while cumulative losses total 1.5%of the original balance. But it shinesin comparison to an especially rottenfield. In the 07-2 portion of the trad-able ABX subprime mortgage index,for instance, troubled loans amountto 35.7% of the outstanding balance,while cumulative losses foot to 4.9%.That ABX subindex last traded at33.6, a slight premium to the plainlysuperior Popular bond.

Though the Popular deal referenc-es slightly more fixed-rate mortgagesthan it does ARMs, the Class A-3 bondpays a floating-rate coupon: Libor plus31 basis points. That fact, of course,makes it more sensitive to interest-rate movements than the precedingAF-3 model, but only to a degree. At32 cents on the dollar, the market isplainly more worried about solvencythan about Libor. Whalens base casewould produce a yield to maturity of21% and an average life of eight years.The stress casea 3% prepayment vs.an observed 14.7% rate, and 93% ofthe remaining loans defaulting with aloss severity of 70%still results in a14% yield to maturity.

The mark to market over the pastcouple of months has been brutal,Whalen tells Gertner, but if you canput the emotions aside and keep your

eyes on the horizon, and not on short-term volatility, investors should bedrooling over todays prices.

Pass the napkins and reach for thebuy tickets. May the GrantsSupermod-el Credit Portfolio be worthy of its name.

Horrible? Certainly.Bearish? Not necessarily.

(June 12, 2009) Not even rising job-lessness, plunging Treasury prices andthe widening prevalence of negativeequity entirely exhaust the list of rea-sons to despair for American residen-tial real estate. A third wave of losses,set to soak the heretofore high-and-dryprime borrower, is supposedly crash-

ing over the market. Were right inthe middle of this third wave, MarkZandi, chief economist at MoodysEconomy.com, told The New York Timeslast month, and its intensifying. Thatloss of jobs and loss of overtime hoursand being forced from a full-time topart-time job is resulting in defaults.Theyre coast to coast.

Residential mortgages and houseprices are the subjects at hand. In pre-view, we are selectively bullish on thefirst and expectant toward the second.Regrettably, the easily accessible pub-lic plays on recovery in toxic mort-gage-backed securities have movedout of bargain-hunting range. Mr. Mar-ket, reliably fickle, may just decide to

move them back again, though wewould not spin out the following essayon that hope alone. Rather, we reap-praise the state of American residen-tial mortgage finance because so muchseems to depend on it.

Bullish, admittedly, isnt the

first word that springs to the mindsof readers of the everyday mortgagenews. For instance, first-quarter de-linquency rates climbed across theboard, even for prime borrowers. Se-quentially, they were up by 19.8%(to 6.06% from 5.06%) and by 63.3%from the year-ago level (to 6.06% from3.71%). The inventory of foreclosedhouses financed by prime mortgagesclimbed by 32.5% sequentially (to2.49% of prime mortgages surveyedfrom 1.88%) and by 104.1% from theyear-ago level (to 2.49% of that mort-

gage universe from 1.22%).The all-in cost of foreclosure pro-

ceedings to creditors has also taken aleap. According to new data compiledby Fitch Ratings, loss severities acrossthe credit gamut accelerated between

June 2007 and April 2009for sub-prime mortgages, to 73% from 40%;for Alt-A mortgages, to 55% from19%; and for prime mortgages, to 43%from 14%.

In Street parlance, houses are theunderlying in the residential mort-gage market, and they are lying lowerall the time. As of March, the S&P/Case-Shiller 20-city composite indexwas down by 18.7% in a year and by32.2% since July 2006. Phoenix, with a

0

1

2

3

4

5

6

7

8

9%

0

1

2

3

4

5

6

7

8

9%

2Q082Q062Q042Q022Q002Q98

Not so prime

troubled prime mortgages as of 2009 first quarter

source: Mortgage Bankers Association

distress

rates

distress

rates

foreclosures

delinquencies

foreclosures

delinquencies


5/33


peak-to-present decline of 53%, lostthe most; Dallas, off by only 11.1%, theleast. Not surprisingly, transaction vol-umes have plunged with house prices,while inventories have traced a coursein the opposite direction. In April, ac-cording to the U.S. Census Bureau,

new homes sold at a seasonally adjust-ed annual rate of 352,000, 0.3% higherthan in March but 34% below the year-ago reading and 74.7% below the July2005 peak of 1.4 million. The invento-ry of unsold, unlived-in houses stood,at last report, at 10.1 months (i.e., itwould take 10.1 months to get rid of ahouse at the current sales pace), downfrom 12.4 months in January.

If you detected a small shaft of sun-light in the previous sentence, it wasntyour imagination. Falling prices areparting the clouds. Distressed proper-

ty sales accounted for fully 45% of allused-house transactions in April, ac-cording to the National Association ofRealtors. After mostly retreating fromthe housing market after the bubbleburst, The Wall Street Journalreportedon May 20, investors are returning indroves, hoping to take advantage ofthe distress. In many cases, realtorssay, investors also are outbidding first-time home buyers and other would-beoccupants because they often come tothe table with all-cash offerings.

Colleague Dan Gertner, our firstvice president for the mortgage mess,relates that house prices, having fa-mously overshot to the upside, nowseem to be overdoing it in the oppo-site direction. The basis for his conclu-sion is, in the first place, the analyti-cal test developed by reader R. KingBurch: Multiply the average houseprice (new and used) by the number ofsales and divide by GDP to arrive at anintuitively attractive bubble-o-meterfor residential real estate. Since 1970,the Burch Index, as it will henceforthbe known, has averaged 9.8%, with astandard deviation of 2.9. It peaked at18.3% in 2005, just shy of a three stan-dard deviation from trend. The latestreading, 7.5% at the end of the firstquarter, is a 0.8 standard deviation be-low the post-1970 mean. The BurchIndex, Gertner observes, indicatesthat the housing correction has over-shot to the downside.

Gertner invokes a second test ofhouse-price value, the rent-to-priceratio monitored by Morris A. Davisof the University of Wisconsin-Madi-

son School of Business. For donkeysyears, houses returned an average of5%. The yield declined from 5.5% in1960 to slightly less than 5% in 1999.Then it plunged to 3.1% in the firstquarter of 2006. But now look: Owingto rising rents and falling house prices,the ratio is back to 5.1%. Let us say,muses Gertner, that 5% is the correctyield for a house and that the price-to-rent ratio overshoots by one standarddeviation to 5.7%. Assume, too, thatrents stay the same. In that case, theCase-Shiller index would have to reg-ister an additional decline of 9.9%, fora total drop, peak-to-trough, of 38.9%.

A third test of house prices, Gert-ner proceeds, is the National Associa-tion of Realtors index of affordability.The index is set so that a reading of100 means a family earning the me-dian income would be able to afford ahouse offered at the median price. Anindex of 150 would mean that the fam-ilys income is 150% of the minimumamount required to afford a median-priced house (assuming a 20% downpayment and principal and interestpayment no greater than 25% of in-come). As of March, the index stood ata record 172.5, more than three stan-dard deviations above its long-termaverage of 125.

Of course, things are never so badthat they cant get worse, and the bearmarket that follows a truly bubbly bullmarket often surprises the pure ratio-nalist by how low it goes. So let us pos-it, suggests Gertner, that house prices

overshoot to the downside by the samethree standard deviations as they over-shot to the upside (as measured by therent-to-price ratio). In that case, theywould register a further drop of 26.9%for an overall decline of 50.4%.

Nobody knows the future, but allcan observe how markets discount it.In the case of the residential mortgage-backed securities market, collectiveexpectations are as dire as the knownfacts. A mortgage investor I know (heprefers to remain anonymous), Gert-ner relates, has built a data base ofliquidated loans. In the past month,the average liquidated prime loan hadan original loan-to-value ratio of 75%on a house priced at $750,000. So theloan was in the amount of $562,500.Notably, the price of the house atthe time of liquidation had fallen not

just by the Case-Shiller 20-city aver-age (32.2% from the bull-market peakto date), but by 45%, to $412,500.Its notable but not surprising, inas-much as foreclosures tend to clusterin weaker neighborhoods. Anyway,subtract the written-down value fromthe par amount of the loan, and yousee that the creditors are in the hole by$150,000, or 26.7% of face. But the all-in loss severity is another 12 percent-age points higher than that, such arethe burdensome costs of foreclosure.

Daunting as these numbers are, theyare nobodys secret. How is the RMBSmarket discounting them? In the caseof a particular senior-most tranche of acertain prime RMBS, the market is fig-

4/091/081/071/061/051/041/031/02

Creditors losses soar

mortgage loss severities

source: Fitch Ratings

loss

levels o

ss

eve

s

0

10

20

30

40

50

60

70

80%

0

10

20

30

40

50

60

70

80%

Alt-A:55%

subprime:73%

prime:43%

Alt-A:55%

subprime:73%

prime:43%


6/33


uratively laying in candles and cannedgoods. Beneath the tranche in ques-tion are five layers of credit protectionamounting to 7.8% of the principalsum of the structure. This, the pent-house tranche, is quoted at 74 cents onthe dollar to return an expected 10.3%over the life of the deal.

Our anonymous investorit is hewho expects the 10.3%has modeledthree sets of total-return outcomescorresponding to three different setsof assumptions. The most importantof these assumptions are prepaymentspeeds, default rates and loss severi-ties. Our investors base case featuresprepayments decelerating to 4% fromthe 14% actually registered over thepast three months, default rates ac-celerating to 3% annually from thecurrent 1%, and loss severities imme-diately rising to 50%.

Even under a future as bleak as thisone, our tranche, to repeat, is expectedto deliver an annual return of 10.3%.Under a less severe set of assumptions(e.g., prepayment speeds doubling to8%, default rates at 2% and loss severi-ties of 40%), an investor would earn12.2% a year. Of some comfort to usis the finding that even under a trulygruesome set of assumptions (e.g., pre-payment speeds falling to 2% a year,defaults rising to 8% and loss severitiesclimbing to 75%), an investor wouldearn a projected 2.8% per annum.Incidentally, at a 75% loss severity, a$750,000 house would be hammereddown to $195,000.

We know of only two avenues bywhich a retail investor can participatein the residential mortgage-salvagemovement. The first is Redwood Trust(RWT on the Big Board), featured inthese pages on February 6. Redwoodsmanagement was lately out buying2004 and earlier vintages of seniorAlt-A RMBS and 2005 vintages of se-nior prime RMBS and junk-rated Alt-ARMBS. Studying the most recent 10-Qreports, we venture that managementis paying 65 cents on the dollar for as-sets it regards as money-good. Impres-sive enough, but Redwood commonis quoted at 1.6 times book and yields6.6%. Perhaps Mr. Market would beso obliging as to mark it back downto book, or, say, to 1.2 times book at aminimum, in order to afford the value-minded investor a margin of safety?

Then there is Chimera InvestmentCorp. (CIM on the Big Board), a spe-cialty finance company managed bya wholly owned subsidiary of AnnalyCapital (to disclose an interest, Gert-ner and your editor are both Annalyinvestors). Chimera invests in RMBS,residential mortgage loans and otherreal estate-related securities. Its man-agement is partial to Alt-A securitiesof 2006 and 2007 vintage, a part of themarket that Redwood has avoided. Acharacteristic Chimera strategy is topay 50 to 55 cents on the dollar for se-nior Alt-A bonds that, down the road,it expects to sell for 70 to 80 cents onthe dollar, allowing for write-downsof 20 to 25 cents. Gertner asked Wel-

lington Denahan-Norris, chief invest-ment officer of Chimera, if the lat-est mortgage data on delinquencieshad her spooked. We expected it tobe bad, and it continues to be bad. .. , she replied. We run some prettydraconian scenarios, and none of this

is unexpected, and the bonds that webuy can withstand increases of muchgreater magnitude than weve experi-enced so far.

At 1.4 times book value and with ayield of 9.1%, Chimera, like Redwood,trades as if the market were confidentof a happy outcome. We, too, expectgood things, but we would be morecomfortable investing if the marketexpected bad things. It will, too, soon-er or later. Just wait.

Early bird specials

(June 12, 2009) The trouble withlong-anticipated disasters is not thatthey never happen. The trouble, rather,is that they rarely unfold according to awell-thumbed script. Bearing this truismin mind, we return to commercial realestate, a disaster in fact as well as in themaking. Or is it?

Not precisely, according to J. BruceFlatt, senior managing partner andCEO of Brookfield Asset Manage-ment (BAM on the New York StockExchange), manager of $80 billion ofproperty, power and infrastructure as-sets and the 51% owner of a separatelytraded commercial real estate subsid-iary, about which you soon will hearmore. Its helpful to make distinctions,Flatt reasonably cautions. Real estateis the largest business in the world,he says, and saying real estate is badis a dangerous thing, or real estate isgood is a dangerous thing.

Skirting generalizations, therefore,we get down to cases. The first is CBRichard Ellis Group (CBG on theNYSE), the worlds No. 1 commercialreal estate broker. Brookfield Proper-ties (BPO on the NYSE), owner of 75million square feet of office space in108 buildings in the United States andCanada, is No. 2.

Constant readers will remember thenames. Grants was bullish on Brook-field Asset Management, owner of51% of BPO, in the issue of Jan. 13,2006, and bearish on Ellis in the issue

4

6

8

10

12

14

16

18

20%

4

6

8

10

12

14

16

18

20%

200920052000199519901985198019751970

Excess, now, to the downside

calculated transaction value as a percentage of GDP

sources: Bureau of Economic Analysis, Census Bureau, National Assn. of Realtors

percentofGDP

percentofGDP

2 standard deviations

1 standard deviations

Mean

two standard deviations

one standard deviation

minus one standard deviationminus one standard deviation

mean

three standard deviations


7/33


of June 29, 2007. Today, we are bullishon BPO and CBG alike, though we ap-pend a single, four-letter caveat.

In past cycles, Flatt reflects, realestate caused issues for banking. Thebanks got in trouble because they hadbig portfolios of real estate. . . . This

time aroundand Im talking aboutcommercial real estate, not residen-tialbanking issues caused problemsfor real estate.

So debt is our caveat. Research fromEllis itself shows that $200 billion ofsecured debt, and perhaps $200 bil-lion more of the unsecured kind, fallsdue this year, mainly in the secondhalf. Although loan extensions haveoften been negotiated, the firm adds,there is a growing likelihood thatmore forced property sales will occurlater in the year. Even before this par-

ticular rug gets pulled out from underthe commercial real estate market, theMoodys/REAL Commercial PropertyPrice Index has fallen by 22.8% fromits October 2007 peak.

Ellis has not only kept track of thedebt drama, but it has also participatedin it, borrowing heavily to buy Tram-mell Crow in 2006. Though it reck-ons the acquisition a success, the ac-quirer almost died in financing it. Thewherewithal for debt service dwindledalarmingly with the collapse in real es-tate activity. In the first quarter, leas-ing revenue was down by 32%, salesrevenue by 66%. It could have broughtonly so much joy to Ellis headquartersthat the Crow building-services busi-

ness was the companywide best per-former, down a mere 4% in revenueand now accounting for 44% of over-all revenue. As the CBG share priceplunged almost to nothingness, man-agement sat down with its lenders toseek covenant relief on its $2.4 billionin mostly acquisition-related debt.And it has won at least some tempo-rary breathing room.

As Ellis knows about debt at firsthand, so does it understand distress,and management has declared itselfbullish on the opportunities in salvage.Of course, colleague Ian McCulleynotes, such a surge in distressed op-

portunities would benefit not only theinvestment division, which has $2 bil-lion in fallow capital, but also the salesbrokers. Sales might benefit from aslew of impending distressed salesas overleveraged owners are forcedto dispose of real estate, and leasingactivity might improve as companiesbegin to regain more confidence aboutthe future. Its also a business thatis relatively capital un-intensiveagood thing during our imagined fu-ture inflationand should generatesubstantial cash flow that, come theturn, could be used to pay down debt.Even in the March quarter, one of theworst in living memory for real estatedealing, Ellis managed to generatepositive operating income, and man-agement has completed three-quartersof a major cost-cutting drive. All in all,as an option on recovery in real estatesales and leasing activity, if not on realestate prices, CB Richard Ellis offersfantastic leveragewith all the associ-ated thrills and chills.

Brookfield Properties, our next can-didate, is a company with a set of vitalsigns youd swear were typographicalerrors. Take the average rent on itsoffice buildings, which include theWorld Financial Center, 245 Park Ave.and 300 Madison Ave., all in New York,as well as properties in Boston, Wash-ington, D.C., Houston, Los Angeles,Denver, Minneapolis, Toronto, Cal-gary and Vancouver. Its average in-place rent is just $22.69 a square foot,well below the $29 per-square-foot av-

80

100

120

140

160

180

200

80

100

120

140

160

180

200

4Q084Q064Q044Q024Q00

Bear market in progress

Moodys/Real CPPI, Office


index

level

index

level

1Q09:123.921Q09:123.92

0

5

10

15

20

25

30

35

40

$45

0

5

10

15

20

25

30

35

40

$45

6/51/2/097/41/4/087/61/4/07

Double ugly

CB Richard Ellis vs. Brookfield Properties


price

pershare

price

pershare

CBG:$7.89

BPO:$7.56

CBG:$8.14

BPO:$7.92


8/33


of which BPO owns just 45%, is con-solidated on the BPO balance sheet.

As we do the numbers, the marketis valuing BPO at a discount to bookvalue, stated and hypothetical alike.Cash net operating income from di-rectly owned property in the first quar-

ter was roughly $170 million; timesfour equals $680 million. (The home-building segment, which broke even,is a non-factor in the calculation.) As-sume a 7.5% cap rate. At the projectedlevel of cash net operating income andat the assumed cap rate, BPOs directlyowned property would be worth nearly$2 billion more than its current bookvalue of $7.1 billion. After taking intoaccount property-level minority inter-ests, the mark-to-market value couldbe $4 or $5 higher than stated bookvalue of $8.65 a share. For evidence

in support of the notion that book isunderstated, consider the refinancingof Petro-Canada Centre, announcedTuesday afternoon, which allowedBPO to pull $70 million in equity outof the property. Given that the sharesare trading at below $8, McCulley ob-serves, the market is discounting theproperty at an even higher cap rate.Maybe the market is worried aboutMerrill Lynchor about the U.S. Of-fice Fund.

The Office Fund, a portfolio of 58buildings with 28 million square feetof leasable space (including, in NewYork, the Grace Building and One NewYork Plaza) is, as noted, 45%-ownedby BPO. In real estate circles, the fundis better known as the Trizec portfo-lio, Trizec Properties Inc. being theseller, in 2006, to BPO, Blackstone andother third-party investors. Thoughthe fund is leveraged, the debt is re-course only to the funds properties,not to BPO. Performing the same kindof calculation as described above (withcash net operating income and an as-sumed cap rate), one finds that thevalue of the Office Fund portfolio isperilously close to the amount of debtit carries. So while on the books it isheld at a loan-to-value ratio of 78%,McCulley relates, in real life, it mightbe closer to 100%. Then, again, accord-ing to Brookfield, there are contractualincreases in net cash operating incomecoming down the pike, which wouldserve to enhance value even at higherassumed cap rates. As for the debt, itdoesnt fall due until October 2011,and Flatt, in an e-mail to me, writes

ration (as an independent company) ofthe tenant. The current ward of KenLewis and Tim Geithner represents7.7% of BPOs total square footage,McCulley notes, and about 10% ofrevenues. As Merrill has been movingpeople to the new Bank of America

building on Sixth Avenue and 42ndStreet, Brookfield confronts the dis-agreeable necessity of marketing a bigspace in a down market. And Merrillis currently paying about $35 a squarefoot in net rent, above the $30 marketrent. Howeverand with BrookfieldProperty there is usually a redeeminghoweverthe debt on the two Mer-rill-occupied buildings is self-amortiz-ing and will be gone by 2013, and inthe next four years, Brookfield oughtto be able to find replacement tenants.Continued delays on the World Trade

Center site, pushing the completion (ifthey even get started) of the plannedadditional office towers well past 2013,will also make it easier to lease spaceacross the street.

A look at the balance sheet of Brook-field Properties shows $19.4 billion inassets, of which $14.8 billion is bricksand mortar, $1.2 billion is property indevelopment, $1.2 billion is home-building lots and inventory and $221million is cash. The assets are financedby $11.6 billion in debt (of which 93%is nonrecourse), $1.5 billion in subor-dinated capital securities, $348 millionin preferred equity and $3.33 billion incommon equity. The totals are over-stated because the U.S. Office Fund,

erage market rent in those cities. NewYorkers, who during the bubble kepthearing about triple-digit leases beinginked in the very A-quality kind ofspace in which Brookfield specializes,will wonder what pulls down the com-panywide average. They should be a

little less provincial, in our opinion. InHouston, in-place rents are $12.72 asquare foot, in Los Angeles, $19.95.

Another thing: Though the U.S. of-fice vacancy rate climbed to 14.7% inthe first quarter, just 5.7% of Brook-fields space was empty. So, in the firstquarter, BPO managed the feat thathas eluded so many other public realestate companies: It earned no less infunds from operations in 2009 than ithad in the corresponding 2008 period.

All real estate is not the same,Flatt reminds McCulley. When I talk

about real estate, what we buy andwhat we own today, [it] largely is high-quality, long-leased office buildings ingreat markets which have a chance oflong-term growth in rents over the next50 years, because they are good placesto be and people want to occupy spacein them. You look at the portfolio andthe cities that we are in and they are allmoney-center places.

All to the good, but Brookfield Prop-erties does business on the same trou-bled planet as everybody else. Thecompanys biggest tenant is MerrillLynch, lessee of 4.9 million square feetin the World Financial Center in lowerManhattan. The lease expires in 2013,some years following the recent expi-

-600

-400

-200

0

200

400

600

800

1,000

1,200

-600

-400

-200

0

200

400

600

800

1,000

1,200

5/085/035/985/935/885/835/785/73

Crisis over?

spread between REIT yields and 10-year Treasury yields


inb

asispoints in

basispoints

May 31, 2009:325.9 bp

May 31, 2009:325.9 bp


9/33


inverted. Long bonds yield 4.36%, junk bonds 13.6%. That 616 basispoint spread between Baa corporatesand 10-year governments has tight-ened to 361 basis points. Convertiblebonds are back in style with investors.. . , to quote from The Wall Street Jour-

nal of June 3, while leveraged loanshave left their previously desolatedfans bedazzled. Through June 22, ac-cording to Standard & Poors LCD,the market has returned 31.4% thisyear. Not quite every department ofcredit has participated in the run-up.Commercial real estate mortgages arestill stamped toxic, while the afore-mentioned ABX 07-2 index has sunkto 25.6. We continue to troll for oppor-tunities in RMBS. The CMBS market,too, will eventually serve up bargains,though we believe it is early, yet, to go

looking for them.For the record, the Supermodel

Portfolios standout performer wasthe leveraged-loan entry, the NuveenFloating Rate Income Fund (JFR),up 31.8% in 10 weeks (we sold it onFebruary 20 after a deep discount toNAV turned into a small premium).Close behind, at 30%, is one of our twoRMBS allocations, the GSAA ClassAF-3. Our junk-bond fund was up by21.2%, our convertible fund by 15.4%(a five percentage-point back-end loadwould, however, take a bite out of thatgain; therefore, let that gain be 10%).Bringing up the rear was our second

ter than a default-proof long bond ap-preciating by 50 basis points a week?

Certainly not the credit instrumentsto which we had taken a shine. Invest-ment-grade corporates were in badenough odorthe spread between theMoodys Baa index and 10-year Trea-

surys was 616 basis points, the widestin decades. Speculative-grade claimswere candidates for burial at some Su-perfund site. Rarely, if ever, has junkbeen junkier, we noted about thehigh-yield market, to judge by the rat-ings mix of the bond crop or the likelysky-high prospective default rates.Then, again, we believe, never haveyields to maturity been so high22%on the Merrill Lynch Master II Index.Senior loans to leveraged businesses(leveraged loans, theyre called),supposedly armored against the kind

of default risk and volatility that comewith the territory in junk bonds andpreferred, had delivered a total returnof minus 27% for the first 11 months ofthe year, while the average closed-endleveraged loan fund traded at a 17.2%discount to net asset value. Convertiblebonds were priced for a triple disaster inequities, credit and optionality. As forresidential mortgage-backed securities,a representative indexthe ABX 07-2penultimate AAAchanged hands at33.6 cents on the dollar. Professionalinvestors (they know who they are) hadloved it at par.

As we go to press, the story line is

that if some equity will be required toeffect this [refinancing]. . . , Brookfieldand its partners will contribute shouldit be necessary. But what if worse didcome to worse and the value of thefunds assets were written down tozero? BPOs book value would drop to

$6.51 a share from $8.65 a share. Andthat book would be understated byperhaps $4 or $5 a share, if you con-sider the previously mentioned gainon the rest of the Brookfield Proper-ties assets.

For perspectiveand for the re-cordBPO traded at close to five timesbook in the not-so-long-ago boom.

Goodnight, sweet Supermodel

Credit is what we are bullish oncast-off residential mortgage-backedsecurities, senior bank loans, convert-ible bonds and corporate debentures,high-rated and middling, led off thepage-one story in the December 12 is-sue ofGrants. And its credit that fillsthe new Grants model portfolio. Ex-pectantly, we call it our SupermodelPortfolio. May it deliver superior re-turns for 2009 and beyond.

Pretty fair returns the SupermodelPortfolio has, in fact, delivered: Up21.7% through June 23, compared to aloss of 17.4% on the corresponding con-trol group of long-dated, super-safeTreasurys. But as fast as the profitshave come, so has the opportunity re-ceded. In early December, credit wasfriendless while commerce stoppedcold. No yield was too low or durationtoo long for the Treasury bulls. Nowits the obligations of the U.S. govern-ment that people are running awayfrom. So well pay the theoretical taxeson our conceptual winnings. SecretaryGeithner can do what he likes with ourimaginary check.

What turned an investment into atrade was, in good part, the snap re-versal of investment sentiment. Whenour Supermodel first emerged fromher dressing room, the 30-year Trea-sury passed for the ultimate in safety,soundness and certainty. Its yield was3%, on the way to 2.52% (at whichpoint it arrived on December 18, justsix days after the cover date on the is-sue ofGrants that roundly disparagedreturn-free risk). What could be bet-

0 100 200 300 400 500 600 700 800

current

2008: credit collapse

2002: Enron/WorldCom crisis

2001: 9/11 attacks

2001: tech wreck

1998: LTCM crisis

1997: Asian crisis

1995: tequila crisis

1990-91: recession/real estate crisis1987: stock market collapse

1982: Penn Square Bank failure

1980-81: recession/LatAm crisis

1975: recession/inflation scare

1973: OPEC embargo

1970: recession

1962: Cuban missile crisis

1937-38 relapse

1932: Great Depression

Crises and credit: a survey

Baa corporate spreads, in basis points

source: Gluskin Sheff + Associates


10/33


top reflation campaign for helping toclose the panic-induced gulf betweenTreasury obligations and everythingelse. One of these days, however, thegovernment will bear the blame forlifting the yields on all fixed-incomesecurities as a benign reflation gives

way to a malignant inflation. Whenthat red-letter day will come, we dontknow, but neither does anyone else.

High-yield equity

(July 24, 2009) In the long-ago erapreceding the great credit cascade, ahedge fund went courting a biotechcompany. Said the fund to the manage-ment: Do something for the share-

holders, or else. Management resist-ed, then succumbed. In August 2007,when the front office said uncle, thetargets market cap was $2.8 billion.Not quite two years later, the remnantsof the company have a combined mar-ket cap of $1.15 billion. Dividends paidalong the way raise that value to $1.7billion, for an overall loss of $1.1 billionfrom the moment the drive for share-holder value got properly under way.Long live shareholder value.

Now unfolding is a bullish analy-sis on PDL BioPharma (PDLI on theNasdaq), one of the two successors ofthe company that came under the fiercegaze of Daniel Loeb and Third PointLLC. PDLI, as we will henceforth callit, collects royalty checks for a living.The royalties spring from seven patents(collectively known as Queen et al.) thatexpire in 2013 and 2014. By the time thepatents go away, we contend, the valueof the payments earned from royaltieswill far exceed todays share price.

Advocates of the efficient markethypothesis will be rolling their eyes bynow. What can explain the presence ofsuch unharvested value? The very tech-nique of the corporate spin-off can, tostart with. Whereas, pre-Third Point,there was one company, now there aretwo: Facet Biotech Corp. (FACT, alsoon the Nasdaq) and PDLI. Transactionslike these create selling pressure, dislo-cations and change of analytical focus.From confusion comes opportunity.

Third Point is long goneit an-nounced liquidation of its stake in No-vember 2007but to listen to PDLImanagement, PDLI is, in fact, all for

ing but growing. For another, creditis knitting. Junk-bond issuance inthe United States last month reached$23.2 billion, the highest since Octo-ber 2007, reports Thomson Financial.On the other side of the Atlantic, ac-cording to a June 19 dispatch from The

Wall Street Journal Europe, Inflows ofnew money into credit funds have ex-ceeded outflows by the greatest evermargin in the past three months, ac-cording to new research, demonstrat-ing investors eagerness for exposure tonew corporate and bank bonds. Sometime ago, George Soros popularizedthe three-dollar word reflexivity toevoke the power of market action tochange economic reality. Surely, thereis something to the idea. In 1991-92,it was the lift-off in stock and bondprices (the starting pistol popped as al-

lied troops poured over the berms andinto Kuwait to begin the first Gulf war)that helped to close the books on the

junk-bond and commercial real-estatetroubles of 1989-90. Maybe this yearsrally in speculative-grade credit willmake its own contribution to econom-ic convalescence.

Credit the governments over-the-

RMBS pick, the Popular 2007-A, ClassA-3, up by 3.1%. It should have donebetter, and probably will.

Popular, colleague Dan Gertnerrelates, is a subprime deal consum-mated in one of the worst years forsubprime deals, 2007. Despite that

lineage, the structure continues to per-form admirably compared to its peers.Overcollateralization on the triple-Astack continues to build. It was 32.1%at last count, up from 25.9% originally.Subordinate tranches remain intactdown to the Baa3/BBB-minus-ratedM-8 tranche, while delinquencies of60 days or more constitute only 30.4%of the total. The comparable ABX07-2 index has not been so lucky, withcredit enhancement amounting to just25.4%, while losses have eaten awayat a number of subordinated tranches.

Delinquencies have reached 45%.A little further on in this issue, we

speculate on how Americas newfoundreluctance to lend and borrow may,or may not, stunt the long-awaitedrecovery. Its a worthy speculation,though we wonder if the problem isquite what it seems. To start with, asyou will read, overall debt isnt shrink-

Low yield or high?(data as of June 23, 2009)

Treasury portfolio

current original current changesecurity price value value from cost4 1/2s of May 2038 $102.20 $2,000,000 $1,594,588 -20.27%

4 3/8s of February 2038 99.91 2,000,000 1,597,302 -20.13

5s of May 2037 110.11 2,000,000 1,625,606 -18.72

4 3/4s of February 2037 106.13 2,000,000 1,629,559 -18.52

4 1/2s of February 2036 102.03 2,000,000 1,634,543 -18.27

Cash* 0 179,501

Total $10,000,000 $8,261,098 -17.39%

Grants Supermodel Credit Portfolio

iShares iBoxx $ High Yield [HYG] $77.25 $ 500,000 $ 605,882 21.18%

Calamos Convert. Fund, Cl. B [CALBX] 18.71 2,500,000 2,885,564 15.42

GSAA 2005-12, Class AF-3 65.00 1,250,000 1,625,000 30.00

Popular 2007-A, Class A-3 33.00 1,250,000 1,289,063 3.13

MetWest Low Duration [MWLDX] 7.26 2,000,000 2,050,847 2.54

Cash* ___ 0 3,716,654

Total $10,000,000 $12,173,011 21.73%

*cash earns 1%**includes original investments in LQD and JFRsources: The Bloomberg, Grants staff calculations


11/33


Synagis, which prevents infectiousdiseases, is another big revenue genera-tor for PDLI, although the payer of theroyalties on that product has unilaterallydecided it has paid enough. MedIm-mune, which makes Synagis and hasbeen paying royalties for the privilege

for 10 years, sued PDLI in December.Theyve been paying, as you observe,for over 10 years, about $250 million,McLaughlin remarked on the confer-ence call. Its a little interesting whena licensee wakes up 10 years later andgoes, Gee, I dont think I infringe any-more, or, I dont think your patents aregood anymore. Such appears to be thebiggest risk on the horizon for PDLI.

Gertner, let the record show, is anowner of the stock. He built a valuationmodel, as follows:

The major inputs are royalties/li-

cense agreement revenues, general andadministrative expenses, interest ex-pense, taxes and dividends.

Royalties and license-agreementrevenues have been growing rapidly andconsistently in recent years (30.8% in2008 and 36.6% annually between 2004and 2008). This growth rate is the mainvariable that drives PDLIs worth.

General and administrative ex-penses, excluding depreciation, were$3.8 million in the first quarter. Onthe first-quarter call, the company ex-pected G&A expenses of $12 million to$15 million. To be conservative, I an-nualized the first-quarter numbers andinflated them by 5% a year. In reality, Iwould expect this expense to decline aspatent expiration approaches.

Interest expense is incurred from apair of $250 million convertible bondissues, the 2s of 2012 and the 2.75s of2023. The 2.75s have a put right at paron Aug. 16, 2010. Annual interest ex-pense for the two issues is $11.9 mil-lion. In each case, the conversion priceis higher than todays share price (i.e.,$8.08 for the 2.75s and $11.22 for the2s). I ran expected returns based onthe 2.75s being redeemed in 2010 andconverting at the current conversionratio. To be conservative, I assumedno earned interest on PDLIs cashbalance, which footed to $193 millionon March 31.

The federal tax rate is 35%. Nevadahas no income tax. At the end of 2008,PDLI had $219 million in net operatinglosses and expected to use $173 millionof them in 2009, reducing taxes by $61million. I taxed the company at 35% af-

covering, developing and commercial-izing innovative therapies for severe orlife-threatening illnesses. The sevenaforementioned patents, which were is-sued between 1996 and 2006, cover thehumanization of antibodies (of whichmore in a moment). PDLI licenses thepatents to biotech and pharmaceuticalcompanies in exchange for royalties.

About antibodies: They are pro-teins, relates colleague Dan Gertner,found in the blood and bodily fluidsthat protect us from foreign invad-ers (i.e., bacteria and viruses). When abacterium invades our body, antibod-ies are produced by plasma cells to killthe intruder. Specific antibodies canbe made to target antigens on specificcells, including cancer cells. To createantibodies that target antigens on cancercells in humans, tumor cells are injectedinto mice. The mice produce anti-tumorantibodies, which are extracted. PDLIstechnology is the process whereby themouse-produced antibodies are human-izedto be acceptable by humans.

Nine humanized antibody productsare paying royalties to PDLI today.Eight are approved by the FDA andby regulatory agencies outside theUnited States. One of these productsis Avastin, which treats metastaticcancer of the colon, rectum, lungs andbreasts. Avastin, which is sold by Ge-nentech, accounted for 22% of PDLIsfirst-quarter revenues. Its sales arebudgeted to grow by 29% this year.

the stockholders. Our main focus,CEO John McLaughlin said on thefourth-quarter conference call, is toenhance shareholder return. To thatend, we have been working with ourfinancial advisors and our board of di-rectors to determine the best means ofmaximizing value for our shareholders.Our board has approved the paymentof a semiannual dividend of $0.50. .. . Second, we are exploring means ofmonetizing our royalties so that we canbring future cash flow forward in timeand pay to our stockholders sooner. Asyoull recall, this effort was terminatedin November 2008, due to the deterio-rating conditions in the financial mar-kets. We are ascertaining whether con-ditions warrant restarting those efforts,and we look forward to discussing ourprogress with you in future calls.

PDLI is not your everyday operat-ing company. For one thing, its lifespanis no longer than the remaining life ofits patents; like a gold mine, its a wast-ing asset. Also atypically, the companyhas a full-time head count of just six,and just to save the shareholders a fewdollars, management last year movedthe office to Nevada from California.Andandin the past four months,the not-so-numerous insiders havebought 13,000 shares in the open mar-ket without selling one.

PDLI first saw the light of day in1986 as Protein Design Labs, a biop-harmaceutical company focused on dis-

50

0

100

150

200

250

$300

50

0

100

150

200

250

$300

2000 2001 2002 2003 2004 2005 2006 2007 2008

Antibody cash cows

PDL royalties by product

source: PDL BioPharma

inmillionsofdollars

inmillionsofdollars

Herceptin

Avastin

Lucentis

Synagis

Tysabri

other


12/33


MedImmunes lawsuit is successful). Ifgrowth continues in the next five yearsas it has in the past five, investors canexpect close to 30% annual returns.

Green light for recovery

(September 4, 2009) According to ev-ery known publicly disseminated fore-cast but one, no near-boom will followthis near-depression. The exception tothe predictive consensus points to thestrongest snapback since the slump of1981-82, a recovery with more than twicethe zip of those stuttering rebounds thatfollowed the half-hearted downturns of1990-91 and 2001 (each, coincidentally,

just eight months long, hardly worth the

bother). Following is an investigationinto the merits and implications of thismost contrary opinion.

Value investors know that the eco-nomic future is unfathomable; not leastare its mysteries withheld from econo-mists. One might as well chart the S&P500 or present the SEC with irrefutableevidence of the Madoff fraud as to hazarda guess on the starting point or strengthof the next cyclical upturn. So contendsthe tribe of Graham and Dodd.

bonds are converted. If immediatelyand if revenues grow by only 10% untilthe patents expire in 2014an investortoday could expect to earn 6% a year. If,however, revenues grow by 30% a year,an investor could earn 23% a year.

Then, again, Gertner goes on,

there are potential catalysts forgrowth rates to accelerate beyond thehistorically observed 30%. Avastin, forinstance, is in more than 10 Phase IIItrials. Other therapies on which PDLIwould earn royalty income are also inadvanced trials. The source of anotherpossible hidden asset is that human-ized antibodies are made in batches,stored for up to two years and thensold as needed. Larson told me thatdrug companies produce an antibodyover about a six-month period andthen shut down production, clean the

facilities and restart to begin makinganother antibody. The good news forPDLI is that any antibodies made priorto patent expiration require paymentsto PDLI no matter when they are sold.It follows that PDLIs revenues maycontinue into 2016 and not, after all,come to an abrupt end in 2014.

From my simple analysis, Gertnerconcludes, the downside on PDLI isa pretty attractive high single-digit re-turn over the next five years (that is, if

ter 2009, because there is some doubtwhether or not it will be able to use theremaining NOLs in future years.

I paid dividends with two goals inmind: to build up enough cash to paydown the two convertibles as they comedue and to return cash to the sharehold-

ers in a timely manner. Actually, thetiming of the dividends has a minimaleffect on the annualized return.

Of the five inputsrevenues, G&Aexpenses, interest expense/convertibleconversion, taxes and dividendsreve-nue growth and convertible conversion(or repayment) drive the returns for in-vestors. On the call, management forecastapproximately 10% revenue growth for2009. This is much less than the annualgrowth rate of 30% to 37% registered inthe past few years. The reason its so lowis that management is not counting on

anything from MedImmunes Synagis.While MedImmune continues to payus royalties . . . [w]e remain confident inour legal position that Synagis infringeson our Queen et al. patents and we areowed royalties on those sales, CFO CrisLarson told dialers-in on the call, and wehave chosen to be conservative with re-gard to our financial guidance.

Gertner has come up with a numberof different return scenarios, depending,for example, on when the convertible

Those devilish Cartoons.Everyone has a favoriteorder yours!

Own a print of a Hank Blaustein masterpiece.

Find your favorite in the Grants cartoon treasury: www.grantspub.com/cartoon

4x4 cartoon size, signed by Hank, matted and suitable for framing, $150.


13/33


on certain sequences of cyclical events,sequences anticipated in the leading in-dicators that Moore devised under theguiding influence of Mitchell and ArthurBurns (Richard Nixons Fed chairman,the scholar-who-went-wrong). ECRIsLong Leading Index, which points to a

Reagan-strength GDP lift-off, was de-veloped by Moore in the 1980s, based onwork performed by himself and his men-tors 50 years previously.

In the 1930s, Banerji relates, whenMitchell had already put in more than aquarter century of research in his career,the then-Treasury Secretary, [Henry]Morgenthau, asked Mitchell to come upwith early indicators of economic recov-ery. And you can imagine why he wouldwant that. . . . Mitchell, joined by Burnsat that time, came up with the very firstwhat they called the leading indicators

of cyclical recovery. And just around thetime they finished their work is whenMoore started his career and joinedthem, in the late 1930s.

In 1950, Moore constructed his lead-ing indicators of recession and recov-ery. No more for him than for Mitchelldid U.S. cyclical history begin in 1946;in putting his theories to the empiricaltest, Moore began in the administrationof U.S. Grant. Having done that, Ba-nerji goes on, he moved on and createdthe original Index of Leading EconomicIndicators, the Leading Inflation Index,the Future Inflation Gauge, leading in-flation gauge for many countries, the firstinternational application of the leadingindex, all of that. But then in the early1990s, he went back and asked a very im-portant question. He said, OK, we knowthat the first-ever index of leading indi-cators that I put together in 1950 workedin the 19th century, early 20th century.What have they done for us lately? Andthat was the most interesting part. Whathe found was that the same indicatorshad worked just as well in the secondhalf of the 20th century. Which bringsus to the 21st.

Details of the composition of ECRIsindices are proprietary. There are abouta dozen inputs, Banerji admits underclose questioning. Stock prices are surelyone of themno secret thereas ECRIhas been harping since January on thestrong link between cyclical upturns inthe growth [rate] of the U.S. Long Lead-ing Index . . . and stock price recoveriesduring business cycle recessions. InMarch, the month the market scrapedbottom, ECRI went forth with the ta-

lysts, Banerji and Achuthan continue,ECRIs objective leading indexes havecontinued to shoot up in anticipation of arelatively robust revival in U.S. econom-ic activity. Specifically, the U.S. LongLeading Index skyrocketed to an all-timehigh in July, while its growth rate ramped

up to just under a 26-year high. By earlyAugust, growth in the Weekly LeadingIndex had also hit a 26-year high.

Following a report on the institutesvarious up-trending subindicesfor fi-nancial and nonfinancial services, con-struction and manufacturing, each at atwo- or three-year highthe text contin-ues: Faced with the undeniable realitythat the economys output has alreadybegun to increase in the current quarter,more pessimistic forecasters who, untilrecently, were predicting an L-shapedrecovery whenever it arrived, have

been forced to scrunch their L into aW and predict a double dip back tonegative growth in the fourth quarter.This is wishful thinking: the messagefrom every one of our leading indexesis unambiguousthere is no double dipanywhere on the horizon.

Unambiguous is one of those wordsthat reveal a professional personality. Forour part, almost everything about mar-kets is ambiguous. There are few fixedand certain causal relationships, only ten-dencies. God intended it so, lest the richbecome even richer and more overbear-ing. ECRI, in contrast, takes the viewthat cycles in market economies proceedin much the same fashion at all timesand in all places. You can, in fact, bank

And there is wisdom in that line ofthinking. However, there is also wis-dom in identifying the precious value ofa well-founded idea set in opposition toa hardened consensus of belief. Whichis, we think, what we have in the pre-diction that the recovery will shock by

its strength and that government bondbulls and the Federal Reserve are on thewrong macroeconomic scent.

The authors of the forecast, AnirvanBanerji and Lakshman Achuthan, arethe principals of the Economic CycleResearch Institute in New York. Accom-plished though they are, they would beeaten alive on Wall Street. Pick up thecurrent edition of U.S. Cyclical Outlookand look for their names. You wont findthem until you get to page 22, and in atype size so diffidently tiny as to leadyou to conclude that the only reason

they identify themselves on page 22 isbecause there is no page 23. The namebroadcast at the top of page one is thatof a dead man, the institutes founder,Geoffrey H. Moore, on whom the greatWesley C. Mitchell (1874-1948), authorof A History of the Greenbacks andBusiness Cycles: The Problem and ItsSetting, among other seminal works,laid hands. Moore, who died in 2000at the age of 86, developed the leadingindices that form the intellectual under-pinning of ECRIs forecasts.

Leading Indexes Soar: No DoubleDip In Sight, the headline over theAugust installment of the Outlook assertswith characteristic certitude. Undaunt-ed by widespread misgivings among ana-

0

100

200

300

400

500

600

700

800

900

0

100

200

300

400

500

600

700

800

900

8/097/09

6/095/09

4/093/09

2/091/09

12/0811/08

10/089/08

8/08

All together, now

usage of double dip in periodicals

source: Factiva

numberofappearances nu

mberofappearances

802


14/33


fice, fretting about a long-lingering gapbetween output and potential outputon the order of 7%, forecasts real GDPgrowth of 2.8% in 2010 and 3.8% in 2011(andsome out-year guesswork4.5%in 2012 and 2013). At that, the CBO isa far sight more bullish than Wall Street.Economists polled by Bloomberg Newspredict 2.3% growth in 2010, with a lowand high range of 0.5% and 4%. TheFeds forecast is implicit in its zero-percent funds rate and in its chairmansoft-repeated pledge not to tighten foran extended period. Taking him at hisword, speculators in the futures marketsare assigning just a 4.1% chance of a rateincrease at the December meeting of theFederal Open Market Committee, downfrom 28% a month ago. If, as McCul-ley notes, GDP growth does surprisesignificantly to the upside in the nextseveral quarters, those Eurodollar futureswill look very mispriced.

They look perfectly priced to a marketpreoccupied with its own regrets. The21st-century investor is out of practiceat dealing with adversity, the lucky dog.He or she listens with knocking knees tocomparisons of our present troubles withthose of distant days, though, as often asnot, the comparisons are overdrawn.

Deflation is the Feds bogeyman. It is,in fact, the Brad Pitt of bogeymen. Year-over-year, the CPI has fallen by 2.1%.Yetfor historical perspectivein thefirst year of the depression of 1920-21, itdropped by 10.8%. In the Great Depres-sion of 1929-33, it fell by a cumulative26%. Maybe its a measure of the ad-

Following the undernourished re-cession of 1990-91, quarterly GDP ad-vanced at the annual rates of just 2.7%,1.7% and 1.6%. Only in calendar 1992did quarterly growth begin to top 4%.Recovery from the 2001 downturn waseven slower-paced, measuringbythe quarter, at annual ratesjust 1.4%,3.5%, 2.1%, 2.0%, 0.1% and 1.6%. Wor-ried about everyday low prices, whichit was pleased to style deflation, theFed pushed the funds rate to 1%, a 40-year low, and held it there for a full 12months, until June 2004.

As a rule, ECRI holds, the deeper theslump, the snappier the recovery, thoughBanerji observes that the service-inten-sive, government-managed contempo-rary economy is less prone than earliermodels to drastic movements in eitherdirection. Its as if, he says, you drop aball and it has a very big drop, then it alsoshows a big bounce, but its the bounci-ness of the ball that has been going downover the decades since World War II. Inother words, sureits less bouncy, buta big drop in economic activity still isfollowed by a relatively large rebound.What these leading indexes are sayingis notthat following the worst recessionsince the Great Depression you will getthe biggest rebound since the Great De-pression, merely that, at least based onthe evidence so far, its going to be stron-ger than the last two recoveries. In thatcontext, he says of the house forecast,it is not that audacious.

Let us then call it highly unconven-tional. The Congressional Budget Of-

ble-pounding historical observation thatonce a growth rate cycle upturn hasstarted, a business cycle upturn beganin zero to four months. The implicationcould not have been clearer that a mar-ket rally, when it started, would be nosuckers affair but the real McCoy.

Banerji has a cautionary word on whatthe ECRI indicators dont predict. Theymake no representation, he says, that astrong recovery will deliver a strong andsustained expansion. On this score, he hashis doubts, as do we. Then, again, whyhave an opinion? The expansion, as dis-tinct from the recovery, might be a yeardown the road. If ECRI is right about thesoon-to-bloom recovery, Wall Street andthe Fed will be agog, and share prices,commodity prices and interest rates willbe making furious adjustments for theunscripted strength.

For a thought experiment aboutwhat a recovery much stronger than theprevious two might look like, colleagueIan McCulley proposes, lets considerthe early 1980s. The 1981-82 recession,pre-Great Moderation and pre-Green-span, was notable for its sheer violence.It began in July 1981, two months be-fore long-dated Treasury yields put intheir 20th-century top of nearly 15%. Inthe worst quarter of the slump, the firstquarter of 1982, real GDP contracted atan annual rate of 6.4%, neatly matchingthe worst print in the current recession,which was registered in the first quarterof 2009. Likewise, the recovery was no-table for its volatility to the upside. Start-ing in the first quarter of 1983, quarterlyreal GDP growth tripped along as fol-lows: 5.1%, 9.3%, 8.1%, 8.5%, 8.0% and7.1%. Not until the third quarter of 1984did real GDP growth drop below 5%. Inannual terms, inflation-adjusted GDPgrew by 4.5% in 1983, 7.2% in 1984 and4.1% in 1985.

This was a quarter-century ago, historyas ancient to most professional investorsas the Panic of 1873. Volatility seemed togo out of the GDP in the mid-1980s. Andas the expansions became more muted,so did the downturns. When economicgrowth is slow and calm, adjured theFrench economist Clement Juglar in1889, crises are less noticeable and veryshort; when it is rapid or feverish, violentand deep depressions upset all businessfor a time. Experiencevery pleasantand profitable experience, at thathadtaught a generation of investors and pol-icy makers to prepare for the slow andcalm outcome.

-8

-6

-4

-2

0

2

4

6

8

10%

-8

-6

-4

-2

0

2

4

6

8

10%

6543210-1-2-3-4

Down hard, up fast

real GDP growth inpast four recessions

source: Bureau of Economic Analysisquarters from business cycle trough

growthrate

growthrate

1981-82

1990-91

2001

2007-09


15/33


derive their unhedged confidence. Therest of us, revering though we mightthe intellectual provenance of the LongLeading Index and its offshoots, are like-ly to require other sources of support be-fore we go buying puts on money-marketinterest-rate futures and speculating in

moderately valued steel stocks (see be-low). Geoffrey H. Moores original 1950leading indicator list comprises businessfailures, industrial stock prices, new du-rable goods orders, residential housingstarts, commercial real estate starts, theaverage manufacturing workweek, newbusiness incorporations and the whole-sale price index for commodities. Therewas not so much as a nod to money sup-ply or bank credit. Of that original list, asapplied to 2009, five components havelikely bottomed and are rising, two arestill falling (business failures as proxied

by bankruptcies and default rates, andcommercial construction starts), whiledata for new-business formations are notavailable in real time.

Moore pioneered in leading indices,but he didnt patent them. The Confer-ence Board compiles its own LeadingEconomic Index by which many swear,including such highly regarded forecast-ers as Paul Kasriel at the Northern TrustCo. The LEIs components include av-erage weekly manufacturing hours, ini-tial unemployment claims, manufactur-ers new orders for consumer goods andmaterials, vendor performance, manufac-turers new orders for non-defense capi-tal goods, new private-housing buildingpermits, stock prices, M-2 money supply,

and 7.2% of GDP, respectively; thatfor 2007-08 was on the order of 30% ofGDP. Is 30% the new baseline? In a pa-per delivered at the central bankers pic-nic at Jackson Hole, Wyo., last month,C.A.E. Goodhart of the London Schoolof Economics pointed out that monetary

authorities the world over have crossed akind of Rubicon of intervention: Dur-ing this crisis, said Goodhart, mostcentral banks have been steadily drivenfrom their comfort zone of only provid-ing liquidity to a limited set of (core)banks by lending against top-quality as-sets for short periods, towards lendingto a widening range of financial institu-tions against almost any grade collateralat ever longer maturities. The genie can-not be put back in the bottle.

Whether the genie, thereby sprung,is bullish or bearish for the GDP in the

short run is a matter for guesswork. Pos-sibly, it makes no difference. So, too,with the perils just enumerated; mostmay not bear at all on the timing andpower of the next recovery. As to thefuture of capitalism, to name one suchdistant imponderable, it looks no darkertoday than it did in 1933, when the U.S.economy was blasting out of the GreatDepression. The error of optimismdies in the crisis, but in dying it givesbirth to an error of pessimism, Banerjiis fond of quoting the French economistA.C. Pigou. This new error is born, notan infant, but a giant.

Only Banerji and Achuthan are privyto the ingredients of the secret sauce ofthe various indicators from which they

vance of civilization that a minor declinein prices calls forth an enormous gust ofcredit creation. Then, again, maybe its ameasure of financial hypochondria.

Having come to understand how hol-low was the debt boom, the bear mar-kets victims reproach themselves for

missing the danger signals (all too obvi-ous in retrospect) and for ever having lis-tened to the establishments paid bulls.Resolving not to be duped again, theyhave compiled a long list of reasons whythe recovery will be subpar.

Thus, for instance, Americans havesaved too little. Ergo, they will now savemuch more, a new secular drag on growth.China has stuffed itself with bank credit.When its banking system goes the wayof all overleveraged banking systems, thebid will go out of the commodity markets(Grants, July 10). The growing number

of U.S. problem banks is another item onthe worry list. Also, swine flu, the end ofcash-for-clunkers (or, alternatively, thefact that the subsidy was ever conceived),the risk presented to 20th-century busi-ness models by the Internet, the de-struction of wealth in the residential realestate bear market, the incomplete com-mercial real estate bear market, etc. Be-sides, the argument goes, the great workof de-leveraging has hardly begun. Itmay well be, Bill ODonnell, strategistat RBS Securities, was quoted as sayingin the Financial Times last week, thatmore [bond] investors are signing on[to] the sugar high from [the] stimulusthesis and [are] worried about what crashlies beyond the boost from homeownertax credits, cash-for-clunkers and othertemporary/transitory props for the U.S.economy. In July, former Fed governorLaurence Meyer told a Bloomberg radioaudience that the United States will notreturn to full employment for six years.

Maybe, too, in the back of the mar-kets mind is the fear that this great re-cession is no mere cyclical disturbancebut rather a ringing-down of the curtainon an era of relatively free enterprise andrelatively light taxation. The immensefederal money-printing project begs thequestion of what our central bankersand politicians will dream up the nexttime growth sputters. The combinedfederal fiscal and monetary response tothe 1981-82 recession measured 3.8% ofGDP. That is, the increase in the fed-eral deficit combined with the growthin the Feds balance sheet amounted to3.8% of GDP at the cyclical peak. Read-ings for 1990-91 and 2001 were 2.8%

-30

-25

-20

-15

-10

-5

0

5

10

15

20

25

30%

-30

-25

-20

-15

-10

-5

0

5

10

15

20

25

30%

8/1/088/7/988/5/888/4/788/9/68

Leading Index in orbit

change in ECRI Weekly Leading Index


growthrate

August 21, 2009:19.6%

Aug. 21, 2009:19.6%


16/33


of revenue that management soughtto pretty up, even to the point of em-ploying, as the SEC puts it, devices,schemes or artifices to defraud. Atthe macro level, it was the ups anddowns of the economy itself that theFederal Open Market Committee

worked to flatten. The Great Mod-eration is what economists call the20 or so years in which these effortsseemed to bear fruit. It was a goldentime of shallow recessions, measuredexpansions and high visibility. Asto the visibility, the case of the Secu-rities and Exchange Commission v. Gen-eral Electric Company is a reminder ofhow little we ever really know.

The eye that the stock market turnsto history is dim enough. The one ituses to see, but yet not to see, the trans-gressions of the great and good is

actuallylegally blind, at least duringthe bull portion of the cycle. So it wasthat, [b]eginning in 1995 and continu-ing through the filing of form 10-K forthe period ended December 31, 2004,GE met or exceeded final consensusanalyst earnings per share expectationsevery quarter, as the SEC describes it.In a better world, investors would col-lectively face federal charges for beingso gullible as to fall for such a thing.

Its a fine irony that GE, the bluest-blooded of American blue chips, triple-A-rated from 1956 until 2009, the lastof the original Dow stocks still in theDow, wound up funding itself throughsuch public assistance programs as theCommercial Paper Funding Facility(CPFF) and the Temporary LiquidityGuarantee Program (TLGP). Its aneven finer irony that the governmentwas succoring GE even as it was inves-tigating it. [W]e believe, commentthe equity analysts at J.P. Morgan ina September 8 research report, GEwill go down as the least publicizedtoo big to fail story in the crisis.

The Morgan report, incidentally,takes a guardedly bullish line towardthe stock, calling it one of the laststocks for which a little good news canstill go a long way. And the analysts,with C. Stephen Tusa Jr. in the lead,add that, [i]n the look for non-con-sensus, catch-up stories, GE stands outas the last, in our view. Not disagree-ing with this judgment, we hereby liftour own fatwa on GE (e.g., Grants,Sept. 5, 2008), now quoted at 10.3times trailing net income, half of thepost-1990 average of 22 times, a fifth

in 2009, compared to $11 billion in thefull 12 months of 2008 (and $91 billionin 2007), have lately shown signs of life.REITs have led the equitization parade,selling more than $15 billion of shares toinvestors this year.

The rallies in tradable bank debt and

junk bonds have likewise advanced thecause of a strong recovery. Cemex, forinstance, the Mexican-domiciled globalcement maker, was a member of thatnonexclusive corporate club that over-borrowed in order to overexpand. Acredit crisis overlaid on a slowdown inconstruction put it at the mercy of itscreditors, and a failed bond auction inMarch pitched it into crisis. But Cemexwas able last month to refinance $15 bil-lion of bank debt and to extend its repay-ment obligations as far forward as 2014.Since the March lows, the stock has ral-

lied to $12 from $4.To reiterate, ECRI is forecasting and

we are guessing. The future is unfathom-able. Still, we are bullish on the GDP.

Under the cloak ofrespectability

(September 18, 2009) Wall Street wasaway from its desk when the Securi-ties and Exchange Commission andGeneral Electric Co. came to termson August 4. To settle charges ofbook-cooking and earnings manipu-lation, Thomas A. Edisons corporatebrainchild neither admitted nor de-nied guilt, but paid a $50 million fineand vowed never again to commit thesins to which it had not confessed. Asell-side analyst obliged a reporter atThe Wall Street Journalwith the com-ment that, really, the revelationsdidnt matter. While the accountingpractices at issue might have beenfrustrating, he claimed, they werenever material.

They were and are materialandentertaining, too, in a shabby kindof waywe are about to contendon this, the first anniversary of thegreat troubles of 2008. The crimes towhich GE allegedly stooped reveal amanagement besotted with its ownshare price. More broadly, the SECcomplaint invites reconsideration ofan era in which powerful people didtheir all to smooth out the bumps. AtGE, it was the untidy ebb and flow

the shape of the yield curve and an indexof consumer expectations. Though theLEI rose by 0.6% sequentially in July, itsfourth straight monthly increase, the rateof climb has set off no such bullish sirensat the Conference Board as the LongLeading Index has done at ECRI.

So one must choose, though to lis-ten to Banerji or Achuthan, there is nochoice. Thus, Acuthan: Our statisticalmethodology is different (new and im-proved), and more importantly the entirestructure of the approach has evolved towhere we have a large array of leadingindexes for inflation, employment andgrowth, andwithin growthleadingindexes for major sectors, like services,manufacturing and construction. Fur-thermore, for overall cycles in growth weuse a sequence of Long Leading, Week-ly Leading and Short Leading indexes

to home in on upcoming turning points.All of this is to say that the forces driv-ing the economic cycle are too complexto be forecast reliably by any one leadingindex. In a way, this makes sense, no?

For ourselves, in this cycle, well lineup with ECRI. A forecast so seeminglyimpossible, yet so eminently logical,must have some claim on the truth. Wedraw confidence from the wise Pigou.Fear colors decisions in the bust just assurely as faith did in the boom. It wasntpure reason that led American manufac-turers to cut inventories and their cus-tomers to slash purchases in June at thefastest rates since World War II (down,year-over-year, by 9.8% and 18%, respec-tively). The manufacturers were as shell-shocked as their customersand as thecentral bankers. In one way or another,all fell victim to the boom-time error ofoptimism. Now, in atonement, theyrecommitting the symmetrical error ofpessimism. The money that our distin-guished policy makers are printing andspending in such profusion will almostcertainly fail to boost American enter-prise in the long run. But it may stokecurrent-dollar GDP in the short run.

In the meantime, Mr. Market is doinghis part. Going up, stocks are said to dis-count a recovery, but their rising consti-tutes its own healing balm. Companieshave taken advantage of a lately buoyantstock market to sell equity in order to de-lever, McCulley notes. Through July,U.S. companies had sold $130 billion ofcommon equity, up 38% year-over-year.Secondary offerings were up 50% year-over-year. Even IPOs, which remainmoribund with only $4.3 billion so far


17/33


enue recognition. A member of GEscorporate accounting group approvedthe accounting for these transactionsdespite learning that GE maintainedsignificant obligations that (1) sug-gested that the risks of ownership forthe locomotives had not passed and

(2) should have precluded revenuerecognition under GAAP.

To convey some size of the scopeof this apparent fiction, the locomo-tive bridge financing transactions inthe fourth quarter of 2002 accountedfor 131 of the 191 engines ostensiblysold in that period. Inclusion of thesetransactions significantly overstatedthe performance of the GE Transpor-tation Systems, according to the com-plaint, significantly overstated theperformance of the GETS business inthe fourth quarter of 2002, with GETS

revenues and profits being overstatedby 45.1% and 39.6%, respectively.And again in the waning months of2003: bridge-financed locomotivesales represented 42.8% of the quar-ters locomotive unit sales, overstatingfourth-quarter revenues and earnings,according to the commission, by 22.6%and 16.7%, respectively.

Enron was crashing and burning in2001, but not until 2003 did the im-port of that fraud seem to register ei-ther on GE or its Wall Street enablers.Thus, the complaint relates, In De-cember 2003, the [GE] business teaminformed the senior accountant thatthe financial intermediaries had re-quested GE represent that the railtransactions had been disclosed toGEs outside auditor and accountedfor in accordance with GAAP. Whenhe asked why the financial intermedi-aries were seeking the representation,the senior accountant wa

Documents

Grants Interest Rate Observer 2009W-Break