The $18 Billion Writeoff

Sometimes you just have to MICROMANAGE EVERYTHING. Chuck Prince let a few idiots load up several dozen trainfuls of sub-prime loans while he had his back turned, and it came back to bite him hard. $18 billion is a lot of money for one mistake. 10% of the countries on this planet don't have an annual GNP that large. Fewer than twenty guys in the world are worth that much. That's like feeding $574 into a woodchipper, every second, for an entire year. Ok, you get the point. Probably fewer than 50 guys at Citi screwed the other 350,000 employees out of any sort of real bonus in 2007, as well as making their options worthless and their dividend checks a lot smaller.

It's funny how the firms that have aspired to be the financial supermarkets (like Citi, B of A, and Merrill) are the ones who are being hit the hardest. Managing that many pieces of the financial puzzle is tricky during the best of times; being the buyer of last resort for other firms' sewage is sheer stupidity. Hey, I'll hook a hose up to the bottom of my toilet and send whatever comes down the pipe over to those firms too.

There will be a point in time, however, where buying Citi will be a smart investment choice. I've met with Vikram Pandit one-on-one a couple of times back in the 1990s. He is as smart as they come, and he will not allow Citi to make a mistake of this size again. Breaking up the company is the best option for most CEOs. Sandy Weill was able to hold it all together, and Pandit also has that ability, especially as a manager of risk.

But for the moment, Citi needs all the Vaseline you can send them.

Bank of America Buying More Manure

If you put down a $2 bet in poker and then back it up with another $4 on the next betting round, spectators might think you have a good hand. But if you put down $2 billion and then back it up with $4 billion in an attempt to buy the pot, you had better know exactly what you are doing. Countrywide may be a good fit for Bank of America in name only, since the financial behemoth is the country's only true coast-to-coast bank.

The bank has a long, sad history of overpaying for institutions that ultimately deliver less than promised. Over the years, B of A has acquired many firms that were meant to shore up areas in which it was weak. Each time, it succeeded in bringing in more deposits from the customers of those firms, but alienated the core members of the acquiree. As a result, Ken Lewis has been forced to admit over and over that the expected results in the weak areas have not materialized.

Well no kidding, Ken. When you try to force a bank culture down the throat of another industry like investment banking, mortgages, insurance, hedge funds, wealth management, etc, it will never work. The only way to make it work is to let them run things under their own brand, business as usual. When you get bank people out of their element, you wind up with trouble.

Countrywide is a steaming pile of dung fresh from the bowels of the American consumer. It is what is left over from a series of poor decisions on credit (meaning millions of poor decisions, really). There may be a few diamonds in the rough there for B of A to scoop up. But it will get its hands very dirty in the process.

Bloomberg

You might be thinking this is a political post. Not at all - we will be getting our first Bloomberg financial terminal within a month. If you are a financial newbie and don't know what that is, maybe you will understand this analogy. No Bloomberg:Bloomberg::abacus:Cray supercomputer. While it probably won't change our thought process at all, it will save us a great deal of time and effort. At that time we can crank up our strategy into full-throttle mode. We can definitely make money without a Bloomberg, but it is a lot easier and faster to make money with it. Our initial positions are working out well. Normally I don't like to do short-term trades (less than a month), but in this case it absolutely makes sense. Starting off the year up while the market is getting its ass kicked can only help us. Soon we will unleash the power of this fully armed and operational Death Star - wait, bad analogy, the Empire lost in the end. Never mind. Let's just say we are optimistic about our prospects this year.

A random rant: I freak out every morning when I look at our position reports. Even though we are perfectly hedged, I always see a small loss in the mornings. Why? Because options market makers remove their bids/asks after trading ends for the day. So I see things like: Bid = $.05, Ask = $6.70 every morning on the options positions, and of course we are always seeing the worst case when the positions are "marked to market", which in this case is really "marked to insanity". Once trading starts, things brighten up and the true value is reflected and I am happy again. Using the last price of the day is a good idea; using a spread that Evel Knievel couldn't clear on a 600hp Harley is not.

Group Meeting

A quick update - Today we had our first group pow-wow of the new year. We discussed likely trends for 2008 and ate massive amounts of cheeseburgers. The iced tea was flowing as well, all the way through. I know, more detail than you needed. But hey, you will never get anything less than full disclosure from me.

The good news is this - we are on track to have a very good year. The bad news is that not everyone will share our good fortune. Funds that are biased in certain sectors or directions are going to get hammered, unless they see it coming and are able to make some very quick adjustments.

Market Falls Flat On Face

Well, the market has had its worst start to a new calendar year in as long as I can remember. Three trading days into 2008 and the S&P 500 is down nearly 4%. These three days have wiped out ALL of the S&P gains from 2007.

The Fed will certainly cut interest rates this time around, but it probably won't be enough to reverse the market and send it shooting upwards. What the market needs is a real catalyst, and I don't see one lurking around the corner. Many economists are saying that we are probably in a recession, and I agree with them. All indications are that business is slowing down a little bit. That means all of the up and down movements in the market are just noise.

However, that noise helps our strategy a great deal. We are pointing towards an up month so far. What we don't need now is for the S&P to blow through 1400 and head straight for 1300. While our strategy would do fine, it could potentially scare off other investors from the market.

There will come a time when the big financial institutions that have been getting crushed for months will be a slam dunk buy. But there is probably more blood running in the streets before we get to that point

Initial Market Strategy

I mentioned at the beginning of this blog that I wouldn't be going into any detail on individual positions. However, I think it makes a lot of sense to talk in more general terms about the market. We had one of our investment team pow-wows yesterday morning and we agreed unanimously that the market would probably go sideways for a while. I think we are going to see a range of 1400-1550 for the S&P for quite a long time, probably for more than half of 2008.

There is no real catalyst in the near term to move the market out of this range either way. On the downside, the specter of the credit crunch still weighs heavily, as does the likelihood that we are already in an economic recession. Most of that is already priced into stocks in many sectors. On the upside, there are many companies that are growing like gangbusters right now, but their access to capital is tightening more every day. That growth will inevitably slow in a more pronounced fashion because of the aforementioned pressures.

So we are starting out exactly market neutral. We have built the portfolio so that movement in equity prices should have little to know effect on portfolio value. Volatility remains high, however, and we should be able to do very well with our use of options. With portfolio risk essentially removed, the real risk now is simply opportunity cost, which we are more than willing to accept for the time being. The ability to crank out medium-sized (but consistently positive) returns for awhile is not a bad thing.

10 bips a day

That is one of the targets we are shooting for, anyway. Doing that would mean a gross return of about 25%. Naturally, we want to do better. Of course, with a carefully constructed portfolio such as ours, we are just as focused on having low volatility, so a Sharpe ratio in the 2-3 range would be nice.

Apparently, there was another investment group years ago with a name similar to ours. Although they are long gone, they still owe the NYSE some money. How do I know all this? Because the NYSE put a temporary freeze on our ability to trade until they were sure we weren't the same folks. So our initial trades haven't taken place yet. There's always something. At least yesterday we were in cash while the market was down 220 points, so we already look good on a relative basis.

I'm also doing an interview today or tomorrow for an online group; I'll post more on that after it happens.