Knightsbridge Asset Management, LLC
May 11, 2009
Spring Quarterly Commentary
 “Remember, democracy never lasts long. It soon wastes,
exhausts, and murders itself. There was never a democracy that
did not commit suicide.”
John Adams, 1735-1826
Second President of the United
States, 1797-1801
Massachusetts delegate to the
Continental Congress
Constitutional lawyer, Federalist,
Unitarian
In addition to the fragility of democracy, Adams believed in “an
empire of laws, and not of men”, and espoused the independence
of the judiciary from the executive branch. Last year’s HBO
seven part mini-series on John Adams was an exceptional treat
amidst the usual television refuse, and served to remind us that
our nation was founded on extraordinary ideals if not by
extraordinary people as well, some 200 plus years ago.
Certainly we should not dismiss Adams’ thoughts on “laws and not
men” merely because his opinions on “democracy” have yet to
materialize. Sadly, many of the ideas and ideals for which our
nation’s founders fought have been usurped by revisionism in the
name of pragmatism, politics and the modern state.
The current executive branch has demonstrated its conditional
respect for “laws and not men”. Nor should Congress be
excluded. When it comes to capitalism and corporate America,
new sets of rules are being applied, almost daily.
Supposed “bonus payment abuse” resulted in a stupefying piece of
legislation being passed by the House of Representatives that
would have taxed all bonus compensation in excess of $250,000 at
a 90% rate, proving that populist pressures in a democracy are
capable of converting the rule of men into the rule of law by
changing the law.
 After the defenestration of Rick Wagoner as CEO of
General Motors (where was the ratifying shareholder
vote?), the administration attempted to muscle a
bankruptcy settlement without resorting to the
bankruptcy courts where outcomes might be less
predictable. So much for the “nation of laws”. These moves of
desperation ostensibly were well intended, and designed to
prevent the reorganizations from being made to the complete
detriment of employment and labor, particularly in light of the
2 million U.S. jobs lost in the first quarter, a shocking tally.
But the proposed ownership post-reorganization was a bit
imbalanced.
The reorganization proposed by the administration would preempt
the bankruptcy courts, and for Chrysler would give the U.A.W.
fifty-five percent (55%) ownership and 43 cents on the dollar
lent while banks would get no ownership and 29 cents on the
dollar lent. Fiat (Italy) would get 35% for free.
In the case of General Motors, the U.A.W. would get thirty-nine
percent (39%) ownership and $10 billion of future payments for
the $20 billion lent, and banks would get 10% ownership and no
future payments for the $27 billion lent.
This was seen as unduly punitive in the eyes of bondholders and
bankers, and reinforced the notion that the administration was
engaged in a war on capitalism. Earlier excoriations of
corporate, banking and Wall Street leaders from the bully pulpit
had left investors wondering what the next agenda item would
bring. They found out. One administration official (according
to the Wall Street Journal) was quoted as saying “you don’t need
banks and bondholders to make cars”. As libertarian author
James Bovard states, “Democracy must be something more than two
wolves and a sheep voting on what to have for dinner”. In this
case, the senior secured lenders became the sheep. Baaaaaaaaaah.
Mutton anyone?
This raises the question why the present administration,
inundated with a daunting avalanche of problems in its first one
hundred days, would attempt to finesse such a
solution, charges of partiality to labor unions
aside. The answer undoubtedly lies in the  administration’s fear of cascading
unemployment, should both General Motors and
Chrysler go into bankruptcy at the same time,
taking with them a good portion of the entire
auto parts industry. There may also be an element of fear as
regards the further erosion of the American industrial base and
its ability to respond to possible future national defense
challenges. But once again we ask, should the end justify the
means?
In addition, the banking industry is currently at odds with
elements of the administration over capital adequacy issues.
For example, whether Troubled Asset Relief Program (T.A.R.P.)
funds can be repaid and if so under what conditions has yet to
be determined. We find it amusing that Goldman Sachs had
executed a secondary offering of its stock, inflicting
deliberate shareholder dilution, in order to pay back T.A.R.P.
monies and get out from under the damaging compensation
limitations set as preconditions for taking such money. We
surmise dilution is preferable to government whimsy.
The old system of requiring banks to have differing levels of
reserves for Tier 3 (risky), Tier 2 (less risky) and Tier 1
(least risky) assets now appears to be out the same window from
which Mr. Wagoner was thrown, having failed to protect book
equity under today’s economic stresses. In vogue is the “tangible common equity” calculation, which requires a
percentage of assets be maintained as equity, after all assets
have been “marked to market”...a 6% tangible equity to assets
ratio would be good at the nadir of a severe economic cycle.
Regulatory authorities had taken this a step further to look at “what if” scenarios in attempting to determine how much capital
banks should have. Some bankers were complaining that these
stress tests were too draconian, too conservative, would reduce
profitability by requiring overcapitalization, and that extremes
to which an economy could go were unknowable in advance anyway.
Apparently the administration caved-in to this pressure and the
capital-raising calculations resulted in smaller numbers than
investors expected, igniting an explosive rally in many bank
stocks. In two months, Citigroup has gone from “certain to be
nationalized” to “shareholders will be diluted into oblivion” to “they only need $5 billion of additional capital, a pittance!”.
Citigroup CEO Vikram Pandit deserves restitution of his
corporate jet. The stock has rallied from $1 to almost $5.
All is not blue skies just yet. Few can make a case that the
$6.5 trillion commercial real estate market with $3.1 trillion
in loans, has been marked down as severely as it will ultimately
need to be, even if residential mortgages have. With
delinquencies running 2% in commercial real estate, many
estimates are that 8% will be seen before a reversal is
underway, which would mean an additional $180 billion in losses,
much of which would accrue to the banking system whose tangible
equity capital at the moment is about $500 billion excluding
preferred stock equity.
The stock market is divided into two camps at the moment: 1)
those who believe we are seeing a bear market rally and that
banking industry losses, subsequent recapitalizations, and
possible nationalizations will cause new overall stock market
lows down the road, and 2) those who believe the losses taken
and yet to be taken have been discounted in the current price
structure, that dilutive equity raises will be accomplished, and
that the market lows were seen March 9th.
Some of the discrepancy between the two camps has arisen from
the differences between statements made by the more bearish
International Monetary Fund (IMF) and more bullish U.S. Treasury
Secretary Timothy Geithner.
The IMF claims 2007-2010
losses to U.S. banks will be
$1.6 trillion of which
slightly less than $600
billion have been written off
so far. $1 trillion to go.
Tangible capital is slightly
less than $500 billion, and
represents about 3% of $14
trillion in tangible assets
(Citigroup and BankAmerica
account for about 30% of this
asset total). If over the
next two remaining years
earnings of 1% on assets accrued, as well as a 1% loan loss
reserve depletion experienced, then that 4% (2 years X 2%) would
absorb about $600 billion (4% X $14 trillion) of the remaining
$1 trillion mentioned above, leaving $400 billion to be raised
in the equity markets, or to be converted from preferreds into
common equity, or some combination thereof. Therefore, today’s
bank stock prices would on average be anticipating 40% to 50%
dilution from an equity raise, with some, of course, much worse.
Again, if Citigoup and BankAmerica account for about 30% of the
total, they would have to be planning on raising .3 x $400
billion or $120 billion. The fact that the stress tests
required only that they raise $39 billion conjointly shows the
degree to which the current administration changed their tune at
the last minute, after squawking from bankers.
With the equity market up seven of the past eight weeks,
investors are breathing a huge sigh of relief, warranted or not.
After all, it was reported there were 37% fewer millionaires at
the end of 2008 than there were at the end of 2007 in the U.S.
So any glimmers of hope have been welcomed with open arms by
investors. Clearly the mood has made a dramatic shift,
bolstered by economic data showing the rates of economic decline
to be lessening. Risk appetites are returning.
For example, corporate non-investment grade bond offerings in
the first 13 weeks of 2009 have exceeded those in like period
2008 by almost $5 billion or about 65%! This was in spite of a
19-year low in stock offerings for the 13-week period ending
mid-February. But since then, even equity offerings have
returned to levels previously prevailing in the 2000-2008
period.
 Jumbo mortgage spreads have fallen
from over 500 basis points (5%)
above treasuries to almost 300
basis points (3%) above,
indicating banks are lending to
this profitable activity, although
they may still be avoiding other
types of lending.
 The Chicago Board Options Exchange
(CBOE) Volatility Index (VIX) has
dropped from over 80 in November
to almost 30 in April, showing an
abatement of the fear factor.
 There is even a silver lining
to the housing crisis. With
new house prices down 27% nationally, and existing
house prices in California
down a whopping 54%,
affordability is now the best
it has been in over twenty
years relative to household
incomes.
Moreover, first quarter earnings in the aggregate have come in
above analyst estimates. Surprise, surprise!
We remind our readership that the market cycle occurs in four
phases:
- Stock prices are going up, and earnings are still going
down...confused, investors are asking why...
- Stock prices are still going up, and earnings are going
up...because they are in synch, no one asks why
- Stock prices are going down, and earnings are going
up...confused, investors are asking why...
- Stock prices are going down, and earnings are going
down...because they are in synch, no one asks why
So, 1) is the early phase of a bull market, 2) is the later
phase of a bull market, 3) is the early phase of a bear market,
and 4) is the later phase of a bear market. It would appear
that currently we are transitioning from 4) to 1). Maybe.
Recently it has become popular to look at Price/Earnings Ratios
using a ten-year average of earnings in order to smooth out the
dramatic fluctuations that can occur as a result of a single
year of poor earnings. These P/E calculations are referred to
as “cyclically adjusted”. In this chart, one can observe that
the cyclically adjusted P/E reached a level of 12 times earnings
for the market, a level seen only in 1982 and 1932 (when it was
as low as 4.3 times such earnings). Also of interest on this
chart is that this cyclically adjusted P/E got to 47 times
earnings in 2000, so the cyclically adjusted P/E has dropped
almost 75% in the past nine years.
In conclusion, we observe many reasons to become less defensive
but feel the market has come up so fast, the fastest since 1938,
that a period of digestion is in order. We are hopeful that
less severe economic times will allow for the return of “a
nation of laws and not men”, and that the current populist
stridency abates. While we take no issue with the comment that
the financial capital has migrated from New York City to
Washington, we are hopeful this will reverse in the future.
We thank our constituents for their loyalty, support and faith:
most importantly, we have all lived to fight another day.
Very truly yours,
Alan T. Beimfohr John G. Prichard, CFA
Past performance is not indicative of future results. The above information is based
on internal research derived from various sources and does not purport to be a
statement of all material facts relating to the information and markets
mentioned. It should not be construed that the information in this commentary is a
recommendation to purchase or sell any securities. Opinions expressed herein are
subject to change without notice.
(c) Knightsbridge Asset Management, LLC
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