Bill Ackman, Joseph Stiglitz on Charlie Rose

Tuesday, April 28th, 2009

A fascinating, enlightening conversation and debate about the economy with Bill Ackman, major investor and hedge fund manager of Pershing Square Capital Management LP, Kate Kelly of The Wall Street Journal, Andrew Ross Sorkin of The New York Times and Joseph Stiglitz, economist and a member of Columbia University faculty.

Here is the complete transcript:

CHARLIE ROSE: The Obama administration today took the latest step in
its efforts to repair the nation’s banking system. The Federal Reserve
began releasing information about its stress test on major banks. The Fed
reported that while reserves had substantially reduced in some banks, most
had capital well in excess of government standards. The 19 banks examined
hold two-thirds of the assets and more than half the loans in the U.S.
banking system. The government privately told bank executives their test
results this afternoon. The Fed also released its methodology ahead of an
announcement of the results in two weeks.

We want to talk about the financial sector, the stress test, all of
this, with a very interesting group of people. Bill Ackman of Pershing
Square Capital management, a hedge fund here in New York. Joseph Stiglitz
of Columbia University, co-winner of the 2001 Nobel Prize in economics.
Andrew Ross Sorkin of “The New York Times,” a reporter and columnist. And
Kate Kelly of “The Wall Street Journal.” I am pleased to have all of them
here at this table.

I will begin with you. Tell me where we are in terms of — what do we
know about the stress test? What do we know about the results? What are
they telling us and who cares?

KATE KELLY: Well, there are precious few details that have been
released so far. We’re going to know more I think on May 4th. But what
happened is, the banks underwent these stress tests. They had certain
parameters they were supposed to run their models against, run their
portfolios against — assumptions about unemployment and how severe it
would get this year, for example; assumptions about losses on the value of
certain holdings that were approximately close to what you saw last year
with the Lehman Brothers failure. And the Fed met individually with the
bank management today. I think it was CEO, CFO, other senior people, risk
officers, to discuss where they stood, how strong they were — I think they
had three buckets from strong to weak — and whether they would need to
raise capital.

So what’s interesting is, there has been much back and forth about how
much to disclose, and I don’t think we fully know what they are going to
disclose yet. But what they do will have a major impact on public
perception. And even if they don’t give us all the details, based on who’s
raising capital, we’re going to be able to make some assumptions.

CHARLIE ROSE: Yes.

KATE KELLY: So the government is in a bit of a box.

CHARLIE ROSE: All right, Andrew, add to that.

ANDREW ROSS SORKIN: Well, so the issue this afternoon — I talked to
a number of the executives who have been briefed on their status, if you
will — and the question right now is what assumption the government used
for their revenue, right? They did all these other assumptions which they
used for everybody across the aboard, but what they didn’t do — they
actually for each bank individually said what is their revenue going to be
for the next two years. And that’s the most fungible, if you will, of all
of these, because every bank thinks they’re going to have higher revenue
than the government seems to think. And so what we’re going to be seeing
over the next week is a debate privately, that hopefully will come out in
public at some level, over what those revenue judgments are, and — and
that’s– that’s what we’re going to find out. And that to me will tell us
in the end who’s strong and who’s not, and who we can actually believe.

CHARLIE ROSE: OK, but it will tell us that, and then what will
happen?

WILLIAM ACKMAN: It depends.

(LAUGHTER)

WILLIAM ACKMAN: The answer is, the banks that need more capital,
where does the money come from?

CHARLIE ROSE: Exactly.

WILLIAM ACKMAN: And the last six months, the money has come from the
taxpayer, and the question is if that is going to continue. And there are
some alternatives in the taxpayer.

And this past weekend, Larry Summers was on “Meet the Press,” and he
talked about asset liability swaps as alternative means to raise capital
for banks. I translate asset liability swap for debt-for-equity swap,
junior debt-for-equity swap, preferred stock for equity swap.

Basically, what’s interesting is that the banks in this country have
all the capital they need. The problem is too much of that capital is in
the form of debt, not enough is in the form of equity. The way we solve
that problem typically in America is through a reorganization process,
where a judge adjudicates a bankruptcy or some other form of
conservatorship or reorganization. They figure out the value of the firm.
They figure out how much equity needs to be raised, and they compromise
with the bond holders until the bond holders end up owning the firm.

What you can do instead is Bill the bond holder has to convert $50
billion of his debt into equity, and that magically raises $100 billion of
capital, because for each dollar of debt that becomes equity, you’re
canceling a dollar of debt, you’re creating a dollar of equity. And the
system is really set up for this. This is a classic restructuring
approach.

CHARLIE ROSE: OK, why haven’t we tried this before? Is this — do
you think this idea has merit? This idea of Ackman and Larry Summers
talking about it publicly?

JOSEPH STIGLITZ: It’s what I said they should have been doing all
along.

CHARLIE ROSE: Oh, this was your idea?

JOSEPH STIGLITZ: No, what I’m saying is, it is what we have done. We
did it in Continental Illinois, we’ve done it in — what they’ve confused
is the notion of too big to fail with the notion of too big to be
financially reorganized. And this is just a simple process of financial
reorganization. We do it all the time.

The bond holders don’t like it, because they would prefer the
taxpayers giving them money. It’s perfectly understandable. And the bond
holders have been — their voice has been heard very clearly, but it’s not
in our national interest. The banks would be stronger after they do this
kind of financial reorganization. They don’t have to pay out every month
all the interest payments that they had to pay before. They now have all
the capital that — you know, the leverage right now is huge. So small
change in the value of the assets means that the capital is all wiped out.
So now you have more capital, less debt. They’re in a better position to
go forward. It’s basically the notion that we call a fresh start.

CHARLIE ROSE: Right, so what does Mr. Geithner think of this?

JOSEPH STIGLITZ: Well, they’ve been resisting this.

CHARLIE ROSE: Because?

JOSEPH STIGLITZ: Well, the only reason I think is because the — a
lot of influence from the bond holders, financial sector bond holders don’t
like it. You don’t have to be a genius to figure out why they don’t like
it.

CHARLIE ROSE: Exactly right. Andrew.

ANDREW ROSS SORKIN: Well, no, I mean, it’s funny, you said Bill the
bond holder. I should say Bill Gross the bond holder from Pimco, and he is
someone who has had a lot of influence, as have other bond holders, who
have suggested that the moment that you effectively force these bond
holders to take a haircut or to swap out into equity, you are going to
undermine the entire bond market and we’re going to see some kind of
cataclysmic disaster.

Now, I’m not sure that’s the case, and as you’ve seen in other
bankruptcies, we’ve gotten through that. So at the end of the day, yes,
this would instill more confidence, but there is other people on the other
side saying that it would kill confidence.

WILLIAM ACKMAN: There is also a lot of misunderstandings. I mean, I
think that if the taxpayer really understood that their capital was going
in — if you think about a bank that took in $25 billion of TARP funds.
Let’s assume they have $400 billion of debt — that’s a round number for a
systemically important bank — $25 billion is enough to pay interest on
$400 billion of debt for a year. So banks won’t lend money because they
need that capital to pay interest on their debts.

I read a study by a guy by the name of Professor David Scharfstein of
Harvard Business School where he said of the $350 billion that was infused
into bank actually didn’t go into banks. Went into.

CHARLIE ROSE: This is the original TARP money?

WILLIAM ACKMAN: Right. It went into bank holding companies. Only
something like $17 billion went into the actual banks. And I know this is
a little technical perhaps for your audience, but I think it’s important.

The companies that trade on the stock exchange are called holding
companies, and they’re shells. They have debt. They have equity. And
they own the systemically important institutions. So the thing that we’re
worried about, that we want to protect, the deposit-taking institution, is
actually the subsidiary of the holding company. And that’s why these –
that’s why systemically important institutions are structured this way, so
that there’s the investor entity — I call it the holding company — can be
compromised. You know, the debt for equity then can be converted without
an impact at all on the subsidiaries. So the thing that guarantees
derivatives, the entity that lends money, you don’t want — when Lehman
failed, what happened was construction stopped, derivative counterparties
tore up contracts. If they had been a deposit-taking institution, there
would have been a risk.

The beauty here is you can simply just walk your way through the
capital structure of the holding company and create enormous amounts of
capital. Let me just follow it through for what it can do. Imagine if we
did this across the 19 — let’s not do it– you don’t convert all the debt
into equity. What you do is you set a standard. You say, look, we need
these banks to be extremely well capitalized, which means they need to have
a certain amount of capital. We now have all the data we collected from
the stress tests. So each bank needs to have — call it 10 percent common
equity to total assets, and we convert sufficient amount of debt — you
know, if JP Morgan has a better balance sheet, you convert some. Less for
JP Morgan, then you pick another institution and (INAUDIBLE) balance sheet.
It’s a very fair process.

Once you do that, if the banks are now overcapitalized and you
restrict dividends and you restrict stock buybacks, the only way the bank
can earn an adequate return on its capital is by increasing assets. And
what does that mean? It means making loans.

Now you’ve got 19 banks competing to make loans, and it has a huge
impact on the economy, because the average businessman says, I can’t spend
money today because I have a debt maturity and I can’t refinance. But if
he has three bankers knocking on the door, or 19 saying, “I’m going to lend
you money,” they can start spending again, and the economy can recover.

CHARLIE ROSE: Go ahead.

JOSEPH STIGLITZ: Exactly right. I mean, and in a way, it’s so
interesting, because we’ve been spending our money dealing with what
they’re now euphemistically call legacy assets. They used to first call
them toxic waste, toxic assets, then they called them troubled assets, and
now the official term is legacy assets. But that’s backward-looking. And
it hasn’t.

CHARLIE ROSE: Why is that backward-looking?

JOSEPH STIGLITZ: Because it’s looking at the loans that were made in
the past.

CHARLIE ROSE: As long as those loans are there, those assets are
there, those toxic assets are there, these banks have a very bad balance
sheet.

JOSEPH STIGLITZ: Yes, but there’s another way of dealing with that
problem.

CHARLIE ROSE: Which you can’t — you don’t quite know how to
evaluate.

JOSEPH STIGLITZ: Which is to convert the debt — convert the debt
into equity. No one knows how to value those risky assets. And what
they’re doing is very simple. They want to take all that trash and dump it
on the U.S. taxpayer. And it doesn’t make it disappear.

CHARLIE ROSE: The original idea, we buy all the toxic assets.

JOSEPH STIGLITZ: That’s right.

CHARLIE ROSE: Under the Paulson plan, the first Paulson plan.

JOSEPH STIGLITZ: Exactly. And then they went into buying it in bulk,
and then they — the current program is to use the private sector as the
garbage collector and dump it on our backs, but it’s all basically the same
idea.

CHARLIE ROSE: From the beginning, the toxic assets have been a huge
problem. So what should we do about them now?

KATE KELLY: I just think there’s a fundamental debate going on here
about valuation, and I’m not sure what the answer is. But there is
certainly a countervailing view to what you were saying, that indeed these
toxic assets can be marked, and they should be marked lower than where the
banks think they should be, and that’s why the banks don’t want to sell
them.

CHARLIE ROSE: But that raises the question, if they do that, what
will that mean to the balance sheets of the banks if they have to mark them
lower, and how many banks will we find are in fact at that evaluation
insolvent?

KATE KELLY: Probably quite a few, which is a scary prospect.

CHARLIE ROSE: And so what do you do then?

JOSEPH STIGLITZ: And that’s why you need to convert the debt into
equity. So that — it’s the only way you can do it. If it turns out then
that the banks are right and the toxic assets are worth a lot more, then
the equity of the banks will go up automatically, and they get fully
compensated. So the issue here is who’s going to bear the risk of the
uncertain valuation? And is it the people who gave the money to the bank
or is it the U.S. taxpayer? And it’s really simple as that.

CHARLIE ROSE: Andrew.

ANDREW ROSS SORKIN: This all points, though, to the issue of
confidence and what the goal of the stress test was supposed to do, which
was supposed to be to instill confidence. We were supposed to have this
stress test. We were supposed to get the results and we were supposed to
say, ah, this is all going to work out.

CHARLIE ROSE: Meaning they had enough capital to do what they need
(ph) to do.

ANDREW ROSS SORKIN: They had enough capital or we knew which ones
were in trouble and which ones weren’t, and we were all supposed to feel
very good about it. Instead, what I worry about now is that we’re going to
look at the results of the stress test, and it’s almost a lose-lose.
Either you are going to be very realistic, perhaps even too realistic for
many people, and you’re going to suggest that some of these banks really
are either insolvent or in so much trouble that they are going to need
either additional tax dollars, beyond by the way taking preferred shares
and swapping them for common, or you’re going to decide.

WILLIAM ACKMAN: How about bonds…

ANDREW ROSS SORKIN: Or bonds.

WILLIAM ACKMAN: … into equity.

ANDREW ROSS SORKIN: Or you’re going to decide that the entire process
is a whitewash and you’re going to have no confidence in the test to begin
with.

KATE KELLY: I think you’re right about that quandary, because
initially, I think people were excited about getting real results. Then
the word leaked out that nobody was going to fail the stress test.
Everybody was more or less in good shape.

(LAUGHTER)

(CROSSTALK)

KATE KELLY: Right. And then the public reaction was, well, are these
stress tests worth the paper they’re written on?

CHARLIE ROSE: And what is their methodology is another question about
it.

KATE KELLY: How can that be? How can — this is just going to hurt
confidence.

JOSEPH STIGLITZ: And you look at the numbers when they come out, and
they certainly are not the worst numbers that one could imagine. I mean,
they’re sort of median. But stress is stress. It’s not where the average
is. It’s what happens if.

ANDREW ROSS SORKIN: I mean, they’re thinking worst case is
unemployment at 10.3 percent. Housing prices are down.

CHARLIE ROSE: You mean.

ANDREW ROSS SORKIN: The government.

CHARLIE ROSE: The assumption.

ANDREW ROSS SORKIN: The assumptions built into the stress test assume
three major things. One, that unemployment is at 10.3 percent.
KATE KELLY: In the worst-case scenario.

ANDREW ROSS SORKIN: In the worst-case scenario.

(CROSSTALK)

KATE KELLY: 8.8 is (INAUDIBLE).

ANDREW ROSS SORKIN: So this is median already in some cases.
Unemployment — unemployment is at 10.3. We go to.

WILLIAM ACKMAN: House prices.

ANDREW ROSS SORKIN: . house prices at 22 percent. Thank you, I
apologize. And finally, the economy contracts by 3.3 percent. All of
those are right down the middle. Nobody would argue, I think, that that is
true stress, worst-case scenario.

CHARLIE ROSE: Right. What would true stress be?

ANDREW ROSS SORKIN: Probably 11 or 12 percent unemployment.
Absolutely.

WILLIAM ACKMAN: I think an analogy that I think will help understand
this. Think of a bridge that a truck had driven over. The bridge
collapses, the truck falls down, kills a thousand people who happen to be
walking under the bridge. When something like that happens, when they go
to rebuild the bridge, that bridge had a 10,000-pound capacity; the truck
weighed 9,800 pounds, but stress and otherwise, the bridge collapsed.

What you need to do is — we don’t need well-capitalized banks under a
historic definition. What we need is extraordinarily well-capitalized
banks. And you have to ask yourself, what is the downside if the U.S.
banking system was the best capitalized banking system in the world? So
imagine a world — and using this debt for equity — the beauty of
converting debt for equity is it’s not a taking from taxpayer and it’s not
a taking from the bond holder. The bond holder is getting exactly what
they own. Right? A bond holder is an owner of a company in the same way
an equity investor. The equity investor.

ANDREW ROSS SORKIN: Except that most bond holders don’t want to do
this.

(CROSSTALK)

ANDREW ROSS SORKIN: Most shareholders don’t want their stock to go
down.

Tags: 2001 Nobel Prize In Economics, Andrew Ross Sorkin, Bank Executives, Banking System, Bill Ackman, Charlie Rose, Columbia University Faculty, Financial Sector, Government Standards, Hedge Fund Manager, Joseph Stiglitz, Kate Kelly, Nobel Prize In Economics, Pershing Square, Pershing Square Capital, Pershing Square Capital Management, Pershing Square Capital Management Lp, Stress Test, Stress Tests, Wall Street Journal
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Bill Ackman: Pershing Square Q3 2008 Letter

Thursday, November 27th, 2008

Pershing Square Q3 2008 Investor Letter
by Bill Ackman, November 15, 2008 at 11:44 pm

These are extraordinary times particularly for active participants in the capital markets. While I do not normally choose to write about macro and regulatory events, I thought it would be useful for you to understand how we think about recent events and their impact on our portfolio.

We are currently witnessing the greatest deleveraging event in history. What began as a credit bubble bursting has now spread to the equity markets as banks, investment banks, hedge funds, structured products, mutual funds, pension funds, endowments and other leveraged and unleveraged market participants have been forced to liquidate assets by their counterparties, leverage providers, redeeming clients, and as a result of downgrades, other debts or other commitments that need to be funded.

These actions have led to forced and indiscriminate selling in security markets around the world, which in turn has caused other investors to panic or simply to sell, to get out of the way of other forced sellers.

As a fund which is generally substantially more long than short, we have also suffered large mark-to-market declines in our long investments. Year to date, however, our performance has substantially exceeded that of the broader equity markets, which at this writing have seen a more than 34% decline. Our outperformance is largely due to large gains on our investments in Longs Drugs and Wachovia Corporation as well as profits on our credit default swap and other short exposures. Our market losses have been further mitigated because we operate unleveraged and have substantial cash balances. Currently, we have cash and near-cash (Longs Drugs and Wachovia/Wells Fargo long/short) equal to approximately 39% of our capital.

When, you might ask, will the selling end? While I don’t proclaim to be a market prognosticator, I will make a few observations. Unlike the deleveraging that takes place when banks and other financial institutions sell assets to meet regulatory requirements, which is typically a longer term process, the forced deleveraging that is now taking place in the equity markets is being implemented largely by the prime brokerage firms and margin account managers at broker dealers around the world. Prime brokers are not known to be laggardly in their approach to liquidating an account that no longer meets margin requirements. This is likely to be even more true in the current environment. As such, it may be reasonable to conclude that the forced liquidation that is now taking place may not be a prolonged process.

Security prices around the world have come down tremendously. In the larger capitalization U.S. markets, which are the focus of our strategy, the reductions have been substantial. As of the market close on October 31st, the S&P 500 is down 34.0%, year to date, and down by 37.5% from its high on October 31, 2007; and this is after last week’s rally in which the S&P 500 rose more than 12% from the lows. Unlike the bear market of 1973 and 1974, in which stocks declined by 45% from the highs, this bear market was not preceded by the “Nifty 50″ bubble in which large capitalization growth stocks traded at extraordinary valuations. While valuations were not cheap one year ago, in a long-term historical context, the market as a whole (particularly if one were to exclude financials) was not particularly expensive either.

As such, in today’s market, we are finding extraordinary bargains, the kinds of opportunities that are normally associated with market bottoms. While there are still weak and poorly capitalized businesses that are likely still overvalued, the high quality, well-capitalized, larger capitalization businesses which are the focus of our strategy look very cheap to us.

While this means that now is likely to be a much better time to be a buyer rather than a seller, it does not mean that the market will not continue to decline, even substantially, from current levels, particularly in the short term. In fact, because of tax-loss selling over the next 60 or so days, there will likely be additional selling pressure. At some point, however, the forced selling will come to an end. Large amounts of cash are sitting on the sidelines waiting to be deployed when investors feel the coast is clear. In the event the market were to start to rise again, it would not be a surprise to see institutional, retail, and hedge fund investors rapidly deploy capital so as not to miss a, perhaps, explosive market rally.

What does this all mean for Pershing Square? Despite the fact that we occasionally have an opinion, we spend little time trying to outguess market prognosticators about the short-term future of the markets or the economy for the purpose of deciding whether or not to invest. Since we believe that short-term market and economic prognostication is largely a fool’s errand, we invest according to a strategy that makes the need to rely on short-term market or economic assessments largely irrelevant.

Our strategy is to seek to identify businesses and occasionally collections of assets which trade in the public markets for which we can predict with a high degree of confidence their future cash flows - not precisely, but within a reasonable band of outcomes. We seek to identify companies which offer a high degree of predictability in their businesses and are relatively immune to extrinsic factors like fluctuations in commodity prices, interest rates, and the economic cycle. Often, we are not capable of predicting a business’ earnings power over an extended period of time. These investments typically end up in the “Don’t Know” pile.

Because we cannot predict the economic cycles with precision, we look for businesses which are capitalized to withstand difficult economic times or even the normal ups and downs of any business. If we can find such a business and it trades at a deep discount to our estimate of fair value, we have found a potential investment for the portfolio. Next we look for the factors that have led to the business’ undervaluation, and judge - based on our assessment of the company’s governance structure, management team, ownership, and other factors - whether we can effectuate change in order to unlock value. When the price is right, the business is high quality, the management is excellent, and there are no changes to be made, we are willing to make a passive investment.

Our assessment of the short-term supply and demand for securities plays almost no role in our determining whether to invest capital, long or short. If we believed that it was possible to accurately predict short-term market or individual stock price movements and we had the capability to do so ourselves, we might have a different approach. Below I quote Warren Buffett in his 1994 Letter to shareholders where he perhaps says it best:

We will continue to ignore political and economic forecasts, which are an expensive distraction for many investors and businessmen. Thirty years ago, no one could have foreseen the huge expansion of the Vietnam War, wage and price controls, two oil shocks, the resignation of a president, the dissolution of the Soviet Union, a one-day drop in the Dow of 508 points, or treasury bill yields fluctuating between 2.8% and 17.4%.

But, surprise - none of these blockbuster events made the slightest dent in Ben Graham’s investment principles. Nor did they render unsound the negotiated purchases of fine businesses at sensible prices. Imagine the cost to us, then, if we had let a fear of unknowns cause us to defer or alter the deployment of capital. Indeed, we have usually made our best purchases when apprehensions about some macro event were at a peak. Fear is the foe of the faddist, but the friend of the fundamentalist.

A different set of major shocks is sure to occur in the next 30 years. We will neither try to predict these nor to profit from them. If we can identify businesses similar to those we have purchased in the past, external surprises will have little effect on our long-term results…

Stock prices will continue to fluctuate - sometimes sharply - and the economy will have its ups and down. Over time, however, we believe it is highly probable that the sort of businesses we own will continue to increase in value at a satisfactory rate.

I believe we will look at the current U.S. stock market valuations for high quality mid and large capitalization businesses as presenting perhaps the best investment opportunities of our lifetimes.

Portfolio Update

The last quarter and, in particular, the last few weeks have been an extraordinarily busy and productive time for Pershing Square. During this time, we have made considerably more buy and sell decisions than usual, taking advantage of the liquidity of our holdings, the enormous volatility of the market, and new opportunities that have presented themselves in recent weeks.

In the third quarter, we disposed of our investments Cadbury PLC, Canadian Tire, and Austrian Post at prices generally higher than current levels. We also disposed of the substantial majority of our investment in Sears Holdings. We hold a residual interest in Sears (which represents approximately 1.5% of fund capital) as its price declined to a level at which it made no sense to continue to sell. We redeployed the capital from these sales into Wachovia Corporation, which I will discuss further below, as well as a new investment in which we are in the process of accumulating a position.

We sold these positions not because we thought they would be poor investments, but rather because we believed that we could redeploy the capital in investments that offered a more attractive risk-reward profile. As we have often stated, we are always willing to sell an existing holding at a profit or a loss, if we can find a better use for the funds. For our taxable investors, sales at a loss have the additional benefit of offsetting taxable gains.

Our sales were also motivated by the fact that three of the above companies - Sears, Canadian Tire, and Austrian Post - each have a controlling shareholder. Because we believe that one of our important competitive advantages is our ability to effectuate change at companies in our portfolio, other than in special circumstances, we do not expect to make investments in controlled companies in the future.

As a result of recent changes in the portfolio and strategic developments with respect to Longs Drugs and Wachovia Corporation, our long portfolio is now comprised of higher quality, more economically resilient businesses, companies for which we can be a catalyst to create value, and a large amount of cash and soon-to-be cash that we can redeploy in new opportunities.

On the short side of the portfolio, we have been opportunistic in unwinding single-name credit default swaps in cases where spreads have increased significantly, and have covered certain short positions where stocks have declined substantially as a result of company-specific as well as market-related events. We recently repurchased CDS on the investment grade credit index as certain technical factors have made this investment/hedge attractive once again.

Longs Drugs

In last quarter’s letter, I alluded to a new position on which we expected to file a Schedule 13D shortly. That position was Longs Drugs, a West Coast based drugstore retailer. While Longs’ was valued in the market as an underperforming drug store retailer, we valued the business based on its component parts which included: (1) owned and long-term, below-market, leasehold real estate, (2) RxAmerica, a rapidly growing pharmacy benefit manager (”PBM”) which generated more than 20% of the company’s trailing operating income, and (3) an underperforming, low-margin drugstore retailer. At our cost, we believed that Longs real estate value alone more than covered our purchase price and we were getting the PBM and the retailer for less than free. We estimated the fair market value of the company to be $85 to $95 per share assuming each of the company’s assets was sold to the buyer who could pay the highest price.

Unlike many of our previous active investments, we concluded that Longs had reached the end of its strategic life and should be sold to one of its larger competitors, namely CVS or Walgreens. While it has been rare for us to buy a stake in the company with a view that a strategic sale was the right exit opportunity, we have done so in the past. For example, our original investment in Sears Roebuck & Company was predicated on a strategic outcome at the company which was ultimately achieved when it was acquired by Kmart.

In the current weak (to use a euphemism) credit environment, we are particularly wary of investments which are predicated on a sale. However, in this case, we were comforted by the fact that Longs Drugs would be a must-have acquisition for CVS and Walgreens and that both companies, which are many times the size of Longs, could easily finance the acquisition. Even in the event a sale did not go through, we had purchased Longs at an attractive price which offered a substantial margin of safety against a permanent loss of capital.

Within one week of our 13D filing, Longs announced that it had entered into a transaction to be sold to CVS for $71.50 per share in a cash tender offer, an approximately 44% premium to our average cost. While we were happy with the deal, we were somewhat unhappy with the purchase price, particularly when we learned that the company had not run a competitive auction. Thereafter, we hired the Blackstone Group with whom we have worked successfully in past transactions in an attempt to achieve a better outcome for all shareholders.

We and Blackstone were successful in attracting a bid of $75 per share from Walgreens; however, the greater regulatory risk and potential time delay in a transaction with Walgreens led Longs’ board to reject the transaction in favor of the CVS offer. Walgreens subsequently withdrew its offer citing market conditions, and a day later, the CEO of Walgreens stepped down. We anticipate that we will be fully cashed out of our investment in Longs’ by the close of trading today.

Wachovia Corporation

Wachovia is a good example of the types of opportunities that have emerged in the current highly volatile environment. On Monday morning September 29th, Wachovia Corporation announced that it had entered into an agreement in principle to sell its banking subsidiaries to Citigroup. The transaction was structured in an unusual manner. In the deal, Citi was paying $2.1 billion of its own stock to Wachovia Corporation (the publicly traded holding company for the Wachovia banking subsidiaries) and assuming $53 billion of senior and subordinate holding company debt in addition to the debt and other liabilities of the Wachovia banking subsidiaries. The description of the transaction was limited to a several paragraph press release and a conference call presentation by Citigroup that morning. Wachovia stock opened later Monday afternoon at approximately $1.80 per share, down 82% from Friday’s close.

The market’s reaction to the Citi transaction was severe, particularly as the transaction was announced only four days after Washington Mutual’s subsidiary banks were seized by regulators and sold to J.P. Morgan. In that transaction, WaMu’s holding company filed for bankruptcy, wiping out shareholders and materially impairing holding company creditors.

The Wachovia transaction, however, was structured in a materially different manner from the WaMu seizure. It appears that the government, in order to protect bank holding company bondholders from losing their investment and perhaps to avoid triggering a CDS credit event, structured this deal so that Citi would assume the holding company debts. Interestingly, as part of the Citi transaction the government provided an excess-of-loss guarantee on Wachovia mortgages to protect Citi, which the government could likely have avoided if it had not required Citi to assume $53 billion of holding company debt. It appears that the government had concluded that additional bank holding company debt defaults would create systemic risk or reduce the ability for bank holding companies to access this important source of capital, and therefore chose to protect the Wachovia banking subsidiary and the holding company bondholders.

The unusual structure of the transaction created an interesting investment opportunity. By removing the holding company debts, Wachovia Corporation, now orphaned from its bank subsidiaries was left with some very attractive assets. Based on our reading of the public filings, conference call transcripts, and internet research over the course of Monday morning and afternoon, we estimated that Wachovia was left with the following assets: approximately $2 billion or more of cash, $2.1 billion of Citigroup Stock, the Wachovia Securities wealth management operation, A.G. Edwards (which had been purchased one year ago for approximately $7 billion), Evergreen Asset Management (a mutual fund manager with $245 billion in assets under management), Wachovia Insurance Services, and other ancillary assets.

In light of the Citi debt assumption, the only material liability of Wachovia Corporation was $9.8 billion of non-cumulative, perpetual preferred stock. Because this preferred is both non-cumulative and perpetual, Wachovia has no obligation to ever pay a dividend on these securities making these liabilities effectively a free form of equity financing. These types of preferred securities are typically structured to qualify as an attractive form of bank holding company equity which gets favorable regulatory and rating agency treatment. Now that they were orphaned by the transaction, at best these liabilities were worth less than 50 cents on the dollar.

We also determined that the structure of the transaction would create a large tax asset for the holding company. By selling the bank subsidiaries for less than their net tangible asset value, we estimated that a $26 billion tax loss would be created. This tax loss could by carried back two years enabling the holding company to recover approximately $7.5 billion of cash taxes that had previously been paid.

Our conservative estimate of value of New Wachovia was in excess of $8 per share even assuming that the preferred stock was redeemed or valued at par. We began buying the stock shortly after it opened on Monday afternoon. My instructions to our traders Ramy Saad and Erika Kreyssig were to buy every share we possibly could, including pre- and post-market trading. They did a superb job.

Between Monday afternoon and late Thursday we acquired 178 million shares, or approximately 8.3% of the company, at an average price of $3.15. On Friday morning before the open, Wells Fargo announced a definitive agreement to acquire Wachovia for 0.1991 shares of Wells common stock, or more than $7.00 per share based on Friday’s trading price. We began selling our Wachovia stock on Friday. We could not, however, hedge the Wells Fargo stock price because the short selling ban was still in effect.

Citi, which thought it had an exclusive to complete the transaction with Wachovia, brought litigation later that Friday to enjoin the Wells Fargo deal. By late the following week, Citi, likely as a result of pressure from the government, had agreed to allow the Wells transaction to go forward while retaining their lawsuit for damages against Wells Fargo.

As of this date, we have hedged 100% of our exposure to Wells Fargo shares, and have been opportunistic in unwinding a substantial portion of the position. Assuming we waited until transaction closure and taking into consideration Wachovia shares already sold, we have locked in a 67% profit on this $560 million investment.

The government and all of the parties appear to be doing everything they can to consummate the transaction promptly. The transaction received HSR approval in one day and the Treasury and banking authority approvals over the following weekend. Wells has been issued 39% of the voting stock of Wachovia and transaction closure is anticipated by year end. The transaction requires the recently filed form S-4 to be approved by the SEC and the completion of the mechanics of the shareholder meeting in order to be consummated. It is an excellent deal for Wells Fargo and for Pershing Square.

A Mistake

While most of our long investments are comprised of great businesses or assets at fair prices with a catalyst to create value, we occasionally are willing to invest a small amount of fund capital in situations which offer the potential for a many-fold profit at the risk of a large or near-total loss of capital invested. I typically call these investments mispriced options. Our CDS investments fit this profile. While not all mispriced options will be profitable for the funds, I expect our collective experience in these commitments to be quite favorable over time.

We purchased stock in American International Group, Inc. (AIG) after the announcement of the government bailout. In summary, we did so because at the price paid, we purchased AIG at a substantial discount to book value, and we believed that book value was a conservative estimation of the value of AIG’s underlying businesses net of derivative losses. We also believed that there was the potential for a renegotiation of the government’s extremely harsh financing commitment to AIG which provided for 80% dilution, enormous commitment fees, and a high interest rate.

In particular, we believed that if AIG could pay back the government promptly through a combination of asset sales, termination of certain CDS contracts at potentially less than fair market value, and equity investments from existing and potentially other investors, that there was a chance to renegotiate the 80% zero-strike warrant package to the government. If the warrant dilution could be mitigated, it would be possible for AIG shareholders to make a many-fold return on investment. Initially, we believed that the potential for return outweighed the risk of loss. Because of the inherent leverage of AIG, the risk of a permanent loss of capital on this investment was material. As such, we limited the size of our investment to 2.5% of fund capital.

After acquiring our position, we met with other large holders, policymakers and contacted Berkshire Hathaway and other potential investors about a proposed recapitalization of AIG. Unfortunately, the collection of shareholders that were attempting to restructure the government deal was exceedingly disorganized and some large holders were conflicted by a desire to buy certain assets from the company.

We ultimately concluded that the return on invested brain damage from this investment exceeded the probability-weighted opportunity for profit, and we decided to fold the tent. We sold our stock and incurred a modest loss to the funds.

Our Business Model

In order to achieve long-term success, Pershing Square must make good investments and operate with a robust business model. With much media attention focused on hedge fund failures, I thought it would be worthwhile reviewing the characteristics of our business model and explaining why we will withstand industry-specific and overall environmental threats to the investment and hedge fund businesses. The principle factors which contribute to the robustness of our business model are as follows:

* Our portfolio management approach is inherently low risk (where risk is defined as the probability of a permanent loss of capital), particularly when compared with other hedge fund business models. An important distinguishing factor about Pershing Square compared to most other hedge funds is that we do not generally use margin leverage in our investment strategy. The lawyers prefer that I put in the word “generally” to give us the flexibility to use margin to manage short-term capital flows, but, to-date, we have not used any but an immaterial amount of margin, and only for a brief period of time, and we have no intention of changing this approach,
* We generally invest in higher quality businesses with dominant and defensive market positions that generate predictable free cash flow streams and that have modestly or negatively leveraged (cash in excess of debt) balance sheets. We buy these businesses at deep discounts to our estimate of intrinsic value giving us a margin of safety against a permanent impairment of capital. I say “generally” again here because we do make exceptions in certain limited circumstances; that is, we may buy a more leveraged or lower quality business if we believe the price paid sufficiently discounts the risk.
* We often seek investments where we can effectuate positive change to catalyze the realization of value. This serves to accelerate the recognition of value, helps us avoid “dead money” situations, and protects us somewhat from managerial actions which can destroy value.
* We are diversified to an adequate but not excessive extent. This has further benefits for risk and operational management which I will discuss below.
* There is an inherent balance to our long/short investment approach. Historically, when equity or credit markets weaken, our shorts become more valuable, and occasionally materially more valuable, offsetting somewhat the mark-to-market declines in our long portfolio. If we choose to unwind these short positions during market downturns, we can generate capital to invest in a now less expensive market. These short investments generally stand on their own in that they do not typically require a stock market or credit market decline to be successful. That said, they have served as a useful hedging tool during periods of dramatic market declines.
* We have been paranoid about counterparty risk since the inception of the firm. First, we trade with counterparties which we believe to be creditworthy. Second, we have negotiated ISDA agreements which provide us with daily mark-to-market cash and U.S. Treasurys equal to the previous day’s market value of our derivative contracts. In cases where we are required to post initial margin and therefore have some exposure beyond the market value of our derivative contracts, we have typically purchased CDS on our counterparties to further mitigate counterparty risk. While our approach to counterparty risk has protected us from any counterparty losses to date, please be forewarned there is no perfect approach to avoiding counterparty risk.

Our simple approach to investing also allows us to avoid complicated approaches to risk management. Our investment strategy does not require us to open offices all over the globe. As such, we don’t need traders working around the clock. We can go to sleep at night and sleep. Our weekends are largely our own (Ok. I admit it. I am writing this letter in the office on Sunday.) Our risk management approach is to: (1) put our eggs in a few very sturdy baskets, (2) store those baskets in very safe places where they cannot be taken away from us and sold at precisely the wrong time due to margin calls, and (3) to know and track those baskets and their contents very carefully. We call this approach the sleep-at-night approach to risk management. If I can’t, we won’t.

I am extremely skeptical of more automated, algorithmic, Value at Risk, and other business school sanctioned approaches to risk management. None of these approaches saved Lehman, Bear Stearns, Fannie, Freddie, AIG, WaMu, Wachovia or any of the other institutions that used these and other ostensibly more sophisticated risk management strategies.

Our investment strategy and approach to counterparty risk serves to limit the risks inherent in our individual investment selections, our counterparty risk, and the portfolio as a whole. There are, however, other important risks to our business, principally operational, reputational, and regulatory risk.

Operational Risk

Our investment approach is largely straightforward and relatively simple. This, coupled with the concentrated nature of the portfolio, allows us to run our business with a limited number of personnel. We have five senior investment professionals including myself. Shane Dinneen, still officially a junior investment professional, is fast earning his stripes as an eventual senior member of the team.

We could manage our portfolio with less human talent than we have. For members of the investment team reading this letter, don’t be concerned because I have no intention of shrinking the team, but I make the point nonetheless. Simplicity in our investment approach allows for a simpler back office and a smaller overall staff. We have 31 people total at Pershing Square. It could be fewer, but one of Tim Barefield’s (our COO) important risk management principles provides for back-up talent for every role in the firm.

Our Noah’s Ark approach to personnel duplication makes for a good analogy for the ship we have designed. We have worked hard to build a business that can withstand the Great Deluge, and this goes beyond counterparty risk. For example, it is not yet clear this year whether there will be any incentive allocation to be shared at the firm. That said, whether or not the funds’ finish the year in the black, it will be extremely unlikely that a member of our team leaves by choice, and I have no intentions of letting anyone go. This is due to several factors:

* Pershing Square’s large amount of assets under management per investment principal and per overall employee are important ratios to consider when evaluating the sustainability of Pershing Square or any hedge fund for that matter. The economics of a high Asset per Employee ratio attract and allow for the retention of top talent. Our team can be compensated appropriately even in times of short-term underperformance. Hedge funds which barely (or don’t even) cover their costs with management fees are inherently unstable enterprises because in an unprofitable year they cannot pay their people and are likely to lose their most talented professionals to other firms.
* Pershing Square is a nice place to work. While this sounds like an obvious approach to retaining talent, many and perhaps most hedge funds don’t fit this description. We are big believers in taking care of our team not just financially and with attractive benefits, and we have those in spades. We consider every employee at the firm a member of our extended family, and we treat and care for them appropriately. We do this not for business reasons, but it has important long-term business benefits.
* Pershing Square is an extremely exciting place to work. We believe our work creates value beyond the profits we historically have generated for our investors. Our approach to value creation at businesses has created enormous value for investors who happened to own companies to which we contributed to the creation of value. Similarly, investors and counterparties who listened to our views on the bond insurers, Fannie Mae and Freddie Mac, etc. saved themselves from large losses or perhaps profited by short sales. The fact that our work creates value for the markets as a whole provides additional motivation to the team.

Bottom line, we are built to last, and we will continue to work hard to deserve your continued support.

Reputational and Regulatory Risk

Reputational risk is one of the key risk factors for a business that is subject to a high degree of regulatory scrutiny in an industry that seems to generate considerable public scorn. Our approach to assessing reputational risk is to apply the New York Times test. We ask ourselves whether we would be comfortable having our family and friends read a front page New York Times story about actions taken by Pershing Square written by a knowledgeable and intelligent reporter who has access to all of the facts. If we are comfortable with such an article being read by our close friends, our families, and the public at large, our action passes the test. If not, we reconsider our potential action.

More recently, I have decided to participate in the public dialogue about hedge funds, agreeing to occasional appearances on television or otherwise talking to the press, speaking at industry events, meeting with Congressman, Senators, and other officials. I do so not for any desire for public recognition, but rather because I believe that it is important for the hedge fund industry to come out of the shadows and defend the importance of our work. If we and others (that includes hedge fund investors in addition to the managers) don’t do so, the industry, in my view, is at even greater risk of further regulatory, tax, and other legal changes that will materially harm our business models and industry.

One does not need to look further than the recent short selling ban which was an extremely ill-advised regulatory change that contributed to market turmoil and the recent market decline. By imposing a ban on an investment approach that has been legal for generations with no warning or opportunity for public debate, the SEC caused a short squeeze and subsequent market disarray that wiped out large amounts of hedge fund capital, caused forced selling as long/short, market neutral, quantitative, and other managers had to sell long positions to rebalance their books. More significantly, it cost the U.S. capital markets its highly respected position as an exemplar free marketplace where the rule of law prevailed. It also contributed to hedge fund underperformance, thereby leading to investor redemptions, further reducing industry capital.

I believe the short selling ban also contributed to continued market declines since the ban was put into place. In that hedge funds are among the most opportunistic investors in the world, destroying large amounts of hedge fund capital likely contributed to market declines because of a dearth of opportunistic hedge fund buyers who would normally step in and purchase the compelling values created by falling markets.

Even though the restriction on short selling has been eliminated, the longer-term consequences of populist regulatory actions will continue to be felt by the markets and its participants until such time as our securities regulator makes clear that the U.S. will never again change the rules of the game mid play.

Specifically, the short selling ban was harmful to Pershing Square because we lost the opportunity to lock in even greater gains on our Wachovia investment by not initially being able to hedge our Wells Fargo exposure. I estimate this loss at approximately 3% to 4% of fund performance. This loss was somewhat offset by our ability to sell certain investments into the short squeeze at higher than anticipated prices. We were otherwise not materially affected because short selling equities has not been a material part of our investment program, although we did cover one large equity short at a loss which is now trading at a more than 40% lower price, another 4% to 5% potential loss of profit assuming we had not covered at higher prices.

Hedge fund investors - the pension funds, state plans, charitable, healthcare and other institutions and the individuals who invest in hedge funds - are a much more appealing constituency to defend the industry than the managers themselves. I encourage you to consider becoming part of the public debate on the industry. We collectively need one another’s support.

Investor Risk

The stability of a hedge fund’s capital base is critical to its long-term success. We have endeavored to attract high quality investors who have a deep understanding of our investment approach. We do our best to continually inform you of the progress of our holdings and business, and remind you of the inherently volatile nature of our concentrated strategy. Our investment strategy is also transparent. The nature of our approach requires most of our holdings to eventually be disclosed publicly. As such, it is easier for you to understand how we have made and lost money over the years, and to assess our ability to replicate our historic strategy and performance.

Over the last nearly five years, we have delivered very little of the volatility that investors are concerned about, that is, downward volatility. As such and with strong historical performance, we have not “tested” our investor base. We hope never to “test” our investor base.

While we have considered a longer-term lock-up structure, we chose not to modify our existing liquidity terms because we did not want our terms to be overly burdensome to investors and to present a hurdle to the reinvestment of capital, particularly during a period of temporary underperformance. Year to date, we have had minimal redemptions. New commitments have exceeded our redemption requests by approximately 3 to 1. We have a pipeline of new prospects that are in the process of completing their due diligence. That said, the continuity of our investor base is a long-term success factor for the funds and for this we are relying on you.

Is Now a Good Time to Invest in Pershing Square?

I have never before suggested that one time or another would be a better time to invest in Pershing Square. I am going to take the risk of doing so now. At the risk of sounding promotional, I believe that now is perhaps the best time in our history to increase your investment in Pershing Square. A few thoughts to consider:

When one invests in Pershing Square today, with respect to our current portfolio and potential opportunities in the market, the spread between price and value is the widest it has been since the inception of Pershing Square and likely over the last 30 or more years in our opinion. Investments like Target Corporation which we purchased initially in the mid to high $50s per share now sell at approximately $40 per share and there has been no meaningful diminution in the per-share value of Target since our initial purchase 18 months ago. In fact, the probability of Target and other Pershing Square holdings implementing a value-creating transaction are higher today than before because of management and shareholder frustration with current share price levels. Consider that Target management options are nearly all out of the money, and a meaningful number of vested options will soon likely expire worthless if there is no change in the status quo.

An additional investment in Pershing Square today also purchases a pro rata interest in our cash and near-cash investments. While purchasing cash indirectly is not an inherently attractive proposition, we are currently analyzing a number of long and short investments that appear extremely interesting, and subject to completion of our due diligence, may become large new commitments. While for the first nearly five years of our business, we found only a limited number of interesting opportunities, albeit a sufficient number to generate attractive returns, we are now presented with tens of intriguing situations that are worthy of careful review. One could reasonably conclude that the greater spread between price and value and a wider selection of attractively priced opportunities will lead to higher rates of return on these commitments than during previous periods of greater market efficiency which characterized the first four years of the funds’ existence.

While many have portrayed the current environment as a highly risky time to invest, these individuals are likely confusing risk with volatility. We believe risk should be determined based on the probability that an investor will incur a permanent loss of capital. As market values have declined substantially, this risk has actually diminished rather than increased. Risk is high now for the leveraged short-term investor, but actually much lower for the unleveraged, long-term investor in high quality, mid and large capitalization, modestly leveraged businesses.

Unlike levered hedge funds whose risk increases as NAV declines, Pershing Square’s risk has declined with the recent decline in the value of our portfolio. Why? This is due to the fact that a leveraged manager’s probability of being sold out by its prime broker increases as its portfolio’s equity declines. Many hedge fund strategies are confidence and credit sensitive because they require continued access to low-cost financing. Recent declines may also require leveraged hedge funds to post additional collateral on trades which did not require an initial down payment. Because our investment strategy does not require leverage to operate, recent increases in financing costs and reductions in leverage afforded to hedge funds have no impact on our current or future prospects. In our case, the margin of safety of our investments actually increases, the greater the decline in our holdings’ share prices. We, of course, also have no margin leverage creating the risk of a forced sale. So yes, I believe now is a good time.

Pershing Square Advisory Board Addition

Matt Paull joined the Pershing Square Advisory Board on September 1st. For some of you, Matt’s name may be familiar for he was formerly the CFO of McDonald’s Corporation before his retirement earlier this year. I have known Matt for about 10 years, and interacted with him intensively in mid to late 2005 and in early 2006 when Pershing was advocating for change at McDonald’s.

As CFO of McDonald’s, Matt was one of the most highly regarded public company CFOs in the country. Shareholders were the beneficiaries of superb capital allocation and strong share price appreciation during his tenure as CFO. I consider it one of Pershing Square’s greatest accomplishments that we were able to garner Matt’s respect and friendship even though there were occasionally contentious moments during our engagement with McDonald’s.

Matt has already proved enormously helpful in our interactions with Target Corporation. As a former CFO, particularly one that has been on the other side of one of Pershing Square’s most significant engagements, Matt brings a uniquely valuable perspective to the firm and to the management teams of our portfolio companies.

In addition to his Pershing Square advisory role, Matt is currently serving on the business school faculty of University of San Diego.

Organizational Update

We completed our move to the 42nd floor of 888 Seventh Avenue in August. The second time round, we really got it right. The space is beautiful, promotes communication, and is extraordinarily well organized and efficient.

After the move, we made several additions to the team. Courtney Leonardo and David Robinson joined the IR team in administrative roles, roles which had previously been filled by temporary employees. Alex Song joined us from Goldman Sachs as the newest junior member of the investment team. Amy Stern joined the Finance and Accounting team from Tiger Global, and will focus her efforts on management company accounting. Amy is also attending the NYU Stern School of Business where she is working on a business school degree. Jill Skousen replaced Whitney Stodtmeister as the administrative assistant for the investment team after Whitney moved to Santa Barbara. Helena Tunner joined us to work with Dianna Baitinger at front desk reception.

On other news, Alex Kaufmann of our IR team will be attending Columbia University’s Executive MBA program on Fridays and weekends. We are big believers in continuing education for our personnel.

As always, we are extremely appreciative of your support, particularly during uncertain times. If there are any questions I have failed to answer above, please call Doreen, Alex, Ashley or myself.

Sincerely,
William A. Ackman

Tags: 10 Years, Analogy, Array, Bailout, Banks, Bear Market, Bear Stearns, Bill Ackman, Blackstone, Bondholders, Br, Brokers, Canada, Cash Balances, CDS, Cement, Citigroup, Columbia University, Commitments, Commodity, Commodity Prices, Counterparties, Credit, Credit Bubble, Credit Default Swap, Credit Market, Credit Markets, Current, Desc, Diffe, Dollar, Earnings, Economics, Economy, Extraordinary Times, Failure, Fannie Mae, Financials, Focus, Freddie Mac, Gold, Health, Hedge Fund, Hedge Funds, Img, interest rates, International, Investment, Investment Banks, Investment Strategy, Investor Letter, Investors, Letter To Shareholders, Leverage, Liquidation, liquidity, Loc, Longs Drugs, Market Declines, Market Losses, Market Participants, Markets, Mining, Money, Mortgage, Mutual Funds, New York Times, Ny Times, oil, Outperformance, Pershing Square, Portfolio Management, Prognosticator, Rally, Real Estate, Redemptions, Regulatory Events, REW, risk, S&P 500, saa, Security Markets, Shareholders, Short Selling, Short squeeze, spreads, Squeeze, Stock Market, Stock Prices, Stocks, Structured Products, Substantial Cash, Systemic Risk, Target, Trading, Treasury Bill, Valuations, Value, Volatility, Wachovia, Wachovia Corporation, Warren Buffett, Wells Fargo
Posted in Bonds, Credit Markets, Economy, Gold, Markets, Oil and Gas | No Comments »

Bill Ackman on Charlie Rose

Thursday, November 20th, 2008

Bill Ackman, founder and CEO, Pershing Square Capital Management, and now infamous and highly successful activist hedge fund manager of nearly $6-billion in assets, appeared on Charlie Rose, November 11, 2008.

In 2002, Ackman started a public campaign questioning America’s bond insurers, in particular MBIA. that work uncovered among other things the possibility of a looming systemic problem in the credit market. In September he wrote a letter to the Treasury Secretary Henry Paulson, suggesting ideas for reforming Fannie Mae and Freddie Mac.

Click the play button viewer to see the interview in its entirety:

Tags: Bill Ackman, Credit, Credit Market, Fannie Mae, Freddie Mac, Hedge Fund, interview, Paulson, Pershing Square, Video
Posted in Bonds, Credit Markets, Markets | No Comments »

Is There a Bull Market Somewhere?

Wednesday, September 24th, 2008

Not likely, according to PIMCO’s Bill Gross. In his most recent Investment Outlook, Gross, reasons and opposes (for now) the idea that in the very different worlds of Louis Rukeyser, Jim Cramer, and Jim Grant, “There’s always a bull market somewhere!”

While he does agree that there are always stocks, bonds, and currencies that can be found to be going up, while markets are going down, Gross cautions:

So the lesson must be to go forth and find the bull market, wherever it is. Almost always – but NOT NOW, because in a global financial marketplace in the process of delevering, assets that go up in price are rare diamonds as opposed to grains of sand. For the past several months our PIMCO Investment Committee blackboard has continued to display the following lesson plan:

What Happens During Delevering

1. Risk spreads, liquidity spreads, volatility, term premiums – they all go up.
2. Delevering slows/stops when assets have been liquidated and/or sufficient capital has been raised to produce an equilibrium.
3. The raising of sufficient capital now depends on the entrance of new balance sheets. Absent that, prices of almost all assets will go down.

Essentially, Gross’ thesis is that as the GSEs, banks, investment banks and global hedge funds delever their balance sheets, they also lower the prices of all securities that can be arbitraged within the marketplace. 

The 10% year over year decline in prices has not been witnessed since the great depression, and that is a red flag.

a 10% aggregate asset price decline does more than make us all 10% less wealthy. Because many of these assets are leveraged and margined, the more they decline, the more frequent and frenzied the margin calls, and if the additional cash flow is not provided, not only an asset liquidation but a debt liquidation follows. It is the debt liquidation that potentially turns a stagnant/recessionary economy into something much worse.

This rare event of systematic debt liquidation is the central issue in both the US and globally. If central bankers are unable to take effective measures, the campfire could turn into a forest fire, and a mild asset bear market could turn into a destructive financial tsunami. Gross points out that even they and their SWF and central bank counterparts who have been doing their part to stem the tide, and in some cases bought into debt issues too early, only to see those issues now priced “underwater,” are now reluctant to make additional commitments.

Paulson and Bernanke have consulted PIMCO regularly throughout the credit market debacle, and have apparently acted on some of that advice as well as that of others like Pershing Square’s Bill Ackman, who floated a Frannie bailout plan prior to the Fed’s that was eerily similar.

Paul McCulley stated in late July, that the only thing that was viable given the delevering of the market that was well underway, was for government to lever up its balance sheet, much the way it is proposing to this week, with the $700-billion TARP plan.

Tags: Bailout, Banks, Bear Market, Bernanke, Bill Ackman, Bill Gross, Blog, Chart, Credit, Credit Market, Economy, Fed, Grain, GSE, Hedge Fund, Hedge Funds, Investment Banks, liquidity, Markets, Paul McCulley, Paulson, Pershing Square, PIMCO, Recession, risk, spreads, Thesis, UK, Water
Posted in Bonds, Credit Markets, Economy, Markets, Outlook | No Comments »

Few Gain, Many Lose from Frannie Bailout

Monday, September 8th, 2008

UK bank shares are having a huge day (above are the 9:20 a.m. (Eastern Time) prices of UK bank stocks, September 8, 2008), following this weekends Frannie bailout announcement.

It appears that the short squeeze in bank stocks is in this morning’s trading.

Here are some excerpts from the saavy folks at DealBook.

Over the years, Fannie Mae and Freddie Mac showered riches on many winners: their executives, Wall Street bankers and Washington lobbyists. Now the foundering mortgage giants are leaving some losers in their wake, notably their shareholders, rank-and-file employees and, in the worst case, American taxpayers.

Golden Parachutes all around:

Daniel H. Mudd, the departing head of Fannie Mae, stands to collect $9.3 million in severance pay…

Richard F. Syron, the departing chief executive of Freddie Mac, could receive an exit package of at least $14.1 million

Its not clear that these former Frannie executives will actually get compensated.

But worst of all, long investors in either are getting killed:

The shareholders of Fannie Mae and Freddie Mac, including many employees, will not be so lucky. The companies’ share prices have plunged about 90 percent this year, wiping out about $70 billion of shareholder value. The shares are likely to be worth little or nothing under the government’s rescue plan.

As a result, Wall Street money managers and everyday investors alike stand to lose big. Bill Miller, the star mutual fund manager at Legg Mason, increased his bet on Freddie Mac even as the company’s shares plummeted this year. Last week, when Freddie Mac stock was trading at about $5, Legg Mason disclosed that it had bought an additional 30 million shares. Other value-oriented investors, including Rich Pzena, David Dreman and Martin Whitman, also placed big bets that the mortgage companies would recover. None of these money managers returned calls for comment.

“I am just shocked how they missed this, and why, when it became completely clear that the problem was snowballing, guys like Bill Miller doubled down,” Douglas A. Kass, head of Seabreeze Partners and an outspoken short-seller, told The Times.

And the few investors that gain:

Among the most vocal short-sellers betting against the companies is William A. Ackman, who runs a hedge fund called Pershing Square Capital. Mr. Ackman was among the earliest to warn of the credit crisis, and he is believed to have landed a windfall after shorting both companies, according to The Times, which cited a person with direct knowledge of a recent investment letter.

In the end, American taxpayers have been handed the bill, helping the rest of us around the world sleep a little better at night, now that a great deal of credit risk has been been mitigated.

Thank you Secretary Paulson.

Tags: American Taxpayers, Bailout, Bank stocks, Banks, Blog, Credit, Credit Crisis, Credit Risk, David Dreman, Dealbook, Everyday Investors, Excerpts, Fannie Mae, Fannie Mae And Freddie Mac, Financials, Freddie Mac, Freddie Mac Stock, Gold, Golden Parachutes, GSE, Hedge Fund, Legg Mason, Money Managers, Mortgage, Mortgage Companies, Paulson, Pershing Square, Pzena, risk, S Trading, saa, Severance Pay, Shareholder Value, Shareholders, Short squeeze, Street Money, Syron, Trading, UK, Value, Wall Street, Washington Lobbyists
Posted in Gold, Markets | No Comments »

Pershing Square Capital Management Releases Letter to U.S. Treasury Department Regarding Fannie Mae and Freddie Mac

Sunday, September 7th, 2008

Pershing Square Capital Management, L.P. sent the following letter September 6, 2008 (courtesy: BusinessWire) to the U.S. Treasury Department regarding Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE):

The Honorable Henry M. Paulson, Jr.

Secretary United States Department of the Treasury

1500 Pennsylvania Avenue, N.W.

Washington, D.C. 20220

Re: Fannie Mae/Freddie Mac Restructuring

 

Dear Secretary Paulson:

We understand that a Treasury plan for Fannie/Freddie (”the GSEs”) may be announced this weekend. We thought you might find useful some further thoughts on potential GSE solutions.

 

As you are likely aware, we had previously distributed a proposed restructuring plan for the GSEs. In that plan, under a prepackaged conservatorship, equity interests would be extinguished, subordinated debt would be exchanged for warrants, and senior debt would be exchanged for new senior debt and common equity in the newly recapitalized entities. The government would write a put to the new common equity holders which would expire in three years.

 

It appears, however, that the GSEs may need help more quickly, and conservatorship may not be triggered until the GSEs are formally determined to be undercapitalized. As such, in the event the government needs to inject capital immediately, we suggest you consider the following transaction (”the Transaction”).

 

In order to minimize risk to tax payers while being equitable to other constituents, we suggest that the Treasury consider purchasing senior subordinate debt in the two companies in an amount sufficient to address their capital needs in the short to intermediate term. This senior sub debt would be junior in right of payment to the outstanding senior unsecured debt and senior to the outstanding sub debt, preferred stock, and common equity. We refer to the outstanding sub debt, preferred and common stock as “the Subordinate Securities.”

The issuance of senior sub debt is permitted under the GSE legislation and under the existing terms of the outstanding debt and equity securities of the two entities (please see the attached memo for further details). As a condition of Treasury’s purchase of senior sub debt, the GSEs would defer the interest payments on the outstanding sub debt (which can be deferred for as much as five years), and the dividend payments on preferred and common stock. All of the Subordinate Securities would continue to remain outstanding according to their existing terms.

 

The new senior sub debt should have a market-based coupon and Treasury should receive low-strike price warrants (penny warrants) for a substantial portion, i.e., 49% of the two companies. The coupon and warrant structure should be as close to fair-market-value terms as possible. The ultimate determination of fairness would be the willingness of non-government investors to purchase the Transaction securities on the same basis as Treasury. As part of the Transaction, the GSEs would deleverage their capital structures by paying down senior debt from the free cash flow generated by their core businesses further improving the position of the new senior sub debt.

 

The benefits of the Transaction are as follows:

• The Transaction can be accomplished under the existing terms of the outstanding GSE securities without any required consent other than from the GSEs.
• The new security would be senior in right of payment to the existing sub debt and preferred stock minimizing the risk to tax payers while providing substantial support to the outstanding senior debt that has been deemed implicitly guaranteed by the government.
• The new debt interest payments would be tax deductible, reducing the after-tax cost of capital to the GSEs, particularly when compared with preferred stock.
• In the event the outlook and performance of the GSEs and their assets were to improve dramatically, the senior sub debt could be redeemed, distributions to the Subordinate Securities could resume, and their values would increase accordingly.
• In the event that the GSEs’ fundamentals continued to deteriorate and they became undercapitalized, the GSEs could be placed in conservatorship. In conservatorship, their balance sheets could be restructured along the lines of our original plan or another plan with the Treasury’s senior sub debt treated preferentially to the Subordinate Securities, again minimizing risk to the tax payer.
• The Transaction would be fundamentally fair to all constituents and would respect the existing terms and corporate hierarchy of all outstanding GSE securities.
• The Transaction would minimize moral hazard issues for sub debt, preferred, and common stock investors.

 

Most importantly, we believe there are serious negative implications for other large financial institutions in the event the Treasury were to bail out Subordinate Security holders. The Treasury and OFHEO have done substantial research on the benefits to capital market discipline from large financial institutions’ issuance of subordinate debt, and the destructiveness of the government implicitly or explicitly guaranteeing such obligations.

 

See: Report to Congress “The Feasibility and Desirability of Mandatory Subordinated Debt“, Board of Governors of the Federal Reserve System and United States Department of the Treasury (December 2000), available at: www.federalreserve.gov/boarddocs/rptcongress/debt/subord_debt_2000.pdf

 

“Subordinated Debt Issuance by Fannie Mae and Freddie Mac“, Valerie L. Smith, Office of Federal Housing

Enterprise Oversight, OFHEO WORKING PAPERS, Working Paper 07 – 3 (June 2007), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1000264;

 

“Signals from the Markets for Fannie Mae and Freddie Mac Subordinated Debt“, Robert N. Collender, Samantha Roberts, Valerie L. Smith, Office of Federal Housing Enterprise Oversight, OFHEO WORKING PAPERS, Working Paper 07 – 4 (June 2007), available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1000240&rec=1&src abs=1000264;

(Due to its length, this URL may need to be copied/pasted into your Internet browser’s address field. Remove the extra space if one exists.)

 

“Subordinated Debt and Bank Capital Reform“, Douglas D. Evanoff, Federal Reserve Bank of Chicago, Larry D. Wall, Federal Reserve Bank of Atlanta, FRB Atlanta Working Paper No. 2000-24 (November 2000), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=252754.

 

To the extent the Treasury were to bail out the GSEs’ subordinate debt – which was: (1) never implicitly guaranteed by the government, (2) always rated below Triple A by the rating agencies, and (3) held by investors who knowingly took on the risk of loss in exchange for a substantial credit spread above the GSEs’ senior debt – it would endanger the systemic benefits from subordinate debt issuance for every highly leveraged banking institution in the world and the capital markets at large.

 

Furthermore, we do not believe that the Treasury can purchase GSE sub debt, preferred stock or common stock without incurring an immediate loss to tax payers because of the enormous amount of existing debt senior to these instruments. At a market coupon or dividend yield (to the extent that one were to exist), any debt issued pari passu to the existing sub debt, or preferred stock issued pari passu or even senior to the existing preferred stock would require a yield that would be uneconomic for the GSEs. No third-party investor would purchase these securities regardless of their terms in light of their junior position in the GSEs’ capital structure.

 

Please note that Pershing Square and affiliates own CDS on the subordinate debt of the GSEs. We also note that nearly all participants in the capital market debate on the GSEs are either long or short the outstanding GSE securities.

 

We are contemporaneously releasing this letter to the public in the interest of market transparency.

 

Respectfully,

 

William A. Ackman

 

Contacts

 

Pershing Square Capital Management, L.P.

William A. Ackman, 212-813-3700

Tags: Bail Out, CDS, Credit, Department Of The Treasury, Fannie Mae, Fed, Federal Reserve, Federal Reserve Bank, Fnm, Freddie Mac, GSE, Markets, Paulson, Pershing Square, risk, SMI, strike price, United States Department, United States Department Of The Treasury, Value
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