Worse than Enron?

Friday, December 4th, 2009

Nomi Prins, former Managing Director at Goldman Sachs and former head of international analytics for Bear Stearns in London, says that after poring  over thousands of pages of SEC filings of the biggest banks, she is concerned that the Enron scandal could be made trivial by the banks’ scandal that is in the making.

The nation’s biggest banks, plumped up on government capital and risk-infused trading profits, have been moving stuff around their balance sheets like a multi-billion dollar musical chairs game.

I was trying to answer the simple question that you’d think regulators should want to know: how much of each bank’s revenue is derived from trading (taking risk) vs. other businesses? And how can you compare it across the industry—so you can contain all that systemic risk? Only, there’s no uniformity across books. And, given the complexity of these mega-merged firms, those questions aren’t easy to answer.

Goldman Sachs and Morgan Stanley, for example, altered their year-end reporting dates, orphaning the month of December, thus making comparison to past quarterly statements more difficult. In the cases of Bank of America, Citigroup and Wells Fargo, the preferred tactic is re-classification and opaqueness. These moves make it virtually impossible to get an accurate, or consistent picture of banks ‘real money’ (from commercial or customer services) vs. their ‘play money’ (used for trading purposes, and most risky to the overall financial system, particularly since much of the required trading capital was federally subsidized).

Source: The Daily Beast, December 3, 2009
*Nomi Prins is author of It Takes a Pillage: Behind the Bailouts, Bonuses, and Backroom Deals from Washington to Wall Street (Wiley, September, 2009). Before becoming a journalist, she worked on Wall Street as a managing director at Goldman Sachs, and running the international analytics group at Bear Stearns in London.

Tags: Analytics, Backroom Deals, Balance Sheets, Bank Of America, Bear Stearns, Becoming A Journalist, Biggest Banks, Citigroup, Enron Scandal, Gold, Goldman Sachs, Government Capital, Morgan Stanley, Musical Chairs, Nomi, Pillage, Play Money, Quarterly Statements, Real Money, Systemic Risk, Wells Fargo
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Bill Gross: Investment Outlook (December 2009)

Friday, November 20th, 2009

Bill Gross, Co-Chief at PIMCO has just released his latest investment outlook, titled Anything but 0.1%. Gross reveals that he is worried that bubbles are forming as a result of zero interest rate policy. This is a must read issue.

Listen to the newsletter, read by Bill Gross:

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On one hand Gross says it is prohibitive to stay for too long in money market instruments yielding next to nothing. On the other hand Gross says that zero interest rates are forcing investors back out on to the risk spectrum.

Ah, but this is not a vindictive diatribe, although to me, money changers resemble Mammon more than archangels, and they all make too much money, including PIMCO. My point is to recognize, and to hope that you recognize, that an effective zero percent interest rate, as a price for hiding in a foxhole, is prohibitive. Like the American doughboys near France’s future Maginot line in WWI – slumping day after day in a muddy, rat-infested pit – when the battalion commander finally blew his whistle to charge the enemy lines, it probably was accompanied by some sense of relief; anything, anything but this! Anything but .01%!

Recently, approximately $20 billion a week has been exiting those payless, seemingly godless funds in search of a higher-yielding Nirvana. Yet, as Will Rogers knew, and Lehman Brothers demonstrated to another generation, the pain of the foxhole can immediately transition to the dodging of real bullets on the investment battlefield. Moving out on the risk asset spectrum has worked wonders since March of this year, but it comes with the risk of principal loss – failing to receive the return of your money. When viewed from 30,000 feet, there is even a systemic risk that new asset bubbles are in the formative stages – perhaps because of the .01%. Gold at $1,130 an ounce, global equity markets up 60-70% from their 2009 lows, a cascading dollar now 15% lower against a basket of global currencies just 12 months ago, oil at 80 bucks, mortgage rates at 4% thanks to a $1 trillion dollar credit card from the Fed; the list goes on. The legitimate question of the day is, “Is a 0% funds rate creating the next financial bubble, and if so, will the Fed and other central banks raise rates proactively – even in the face of double-digit unemployment?” As Chicago Fed President Charles Evans said in a recent speech, “This notion is often described as an imperative to ‘lean against a bubble,’ meaning that a central bank should act to lower asset prices that by historical standards seem unusually high.”

Gross makes the interesting point, that in the “New Normal,” of lower growth, with companies transforming into low-growth utilities-like businesses, rather than looking like Boardwalk and Park Place, why not simply opt for the utilities? Buffett, for example, has taken down all of Burlington Northern.

In a low growth environment, it seems to me that a company’s stock should yield more than its less risky debt, and many utilities provide just that opportunity. Utilities and even quasi-utility telecommunication companies now yield between 5 and 6%, whereas their 10- and 30-year bond yield less and at a higher tax rate to you the investor.

Read the whole letter here, download the PDF here.

Tags: Archangels, Battalion Commander, Bill Gross, Doughboys, Formative Stages, Foxhole, Global Currencies, Global Equity Markets, Gold, Gross Co, Gross Investment, Interest Rate Policy, Investment Outlook, Lehman Brothers, Maginot Line, Money Market Instruments, oil, PIMCO, Risk Spectrum, Systemic Risk, Will Rogers, Zero Percent
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Buttonwood Summit Yields Sharp Criticism

Monday, October 19th, 2009

The Economist’s Buttonwood Gathering, a conference bringing together global regulators and bankers to discuss and debate new ideas and develop a new set of guidelines moving forward, has just taken place in New York. Michael Panzer, was in attendance and has kindly shared some of the more interesting quotes on his blog, as reported below.

Secretary Tim Geithner, United States Department of the Treasury:

“Generally, we did not do enough.” (Referring to the failure to address growing concerns over excessive risk-taking in the period leading up to the financial crisis.) [Editor's note: understatement of the year?]

Stephen Roach, Chairman, Morgan Stanley Asia:

Those who are looking for a “V”-shaped recovery are in for “a rude awakening.”

“The imbalances going into the crisis were large to begin with. Now, they are bigger than ever.”

George Soros, Chairman, Soros Fund Management:

“Bankers have too much power.” (Referring to the hold that Wall Street has over Washington.)

The “globalization of financial markets is built on false premises: namely, that markets can be left to their own devices.”

Sheila C. Bair, Chairman, Federal Deposit Insurance Corporation:

“Insured deposits are being used in ways that I don’t like to see.”

Wilbur L. Ross Jr., Chairman and Chief Executive Officer, WL Ross & Co.:

People were focused on “risk-ignoring rates of return.” (Describing one of the things that went helped bring about the financial crisis.)

If regulators had taken the time to visit a Countrywide Lending office, they would have seen something akin to “a Wall Street boiler room,” rather than a bank branch. (Referring to regulator’s unwillingness to go out into the field and see what was really going on during the housing boom.)

“Government is its own systemic risk in the mortgage market.”

Lawrence H. Summers, Director of the National Economic Council, The White House:

The root of most financial errors is “when you try to do today what you wished you had done yesterday.”

“I can assure you that on Main Street, it is a very different conversation.” (Referring to the contrast between the optimism on Wall Street and the more pessimistic mood of those struggling to get by in other parts of the country.)

“It is not the administrations’s view to bribe those who have been part of the problems we have experienced to do what is in the national interest.” (Referring to the suggestion that banks and other financial institutions need financial incentives to support proposed regulatory changes.)

Jeffrey D. Sachs, Director of The Earth Institute, Quetelet Professor of Sustainable Development, and Professor of Health Policy and Management, Columbia University:

“It was grotesque.” (Referring to fact that, despite its extraordinary size, the $62 trillion credit default swap market was essentially unregulated.)

“This was a crisis made in the U.S.” (Referring to the suggestion that China’s export policies played a key role in creating the credit bubble.)

Niall Ferguson, Laurence A. Tisch Professor of History, Harvard University, William Ziegler Professor of Business Administration, Harvard Business School:

“We are living though a gradual shift away from a dollar-centric system.”

“Is China the Germany of our time?” (Referring to the combination of economic dynamism and growing nationalism that stoked the aggressive ambitions of Nazi Germany.)

“The problem of being a declining empire doesn’t have a solution.” (Referring to the suggestion that a great many, if not all, of America’s problems are fixable.)

Robert J. Shiller, Arthur M. Okun Professor of Economics, Yale University:

“Look up ‘bubble’ in an economic textbook and it’s not there.” (Referring to the shortcomings of the traditional economic curriculum.).

People “are living in a ‘pretend-and-extend’ environment, waiting  for the economy to recover.” (Referring to the precarious state of the commercial real estate market and the wave of resets coming due between 2011 and 2013.)

Elizabeth Warren, Chair, TARP Congressional Oversight Panel:

“The reason banks lost confidence in each other is because they looked at their own books.” (Referring to the loss of confidence that roiled markets during the darkest days of the crisis.)

Source: Michael Panzer, October 16, 2009.

Tags: Boiler Room, Chief Executive Officer, China, Department Of The Treasury, Deposit Insurance Corporation, Emerging Markets, Excessive Risk, False Premises, Federal Deposit Insurance, Federal Deposit Insurance Corporation, George Soros, Lawrence H Summers, Michael Panzer, Morgan Stanley, Mortgage Market, National Economic Council, oil, Soros Fund Management, Stephen Roach, Systemic Risk, Tim Geithner, Understatement Of The Year, United States Department, United States Department Of The Treasury
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The Road to Depression

Monday, December 1st, 2008

Brad DeLong says two big mistakes made the crisis worse:

James Bradford DeLong (b. June 24, 1960, Boston) commonly known as Brad DeLong, is a professor of economics at the University of California, Berkeley and a former Deputy Assistant Secretary of the United States Department of the Treasury in the Clinton Administration. He is also a research associate of the National Bureau of Economic Research, and is a visiting scholar at the Federal Reserve Bank of San Francisco.

The Road to Depression, by Brad DeLong, Project Syndicate: For 15 months, the United States Federal Reserve, assisted by the financial regulators of the US Treasury, have been trying…,

above all, to avoid a deep depression.

They have also had three subsidiary objectives:

• Keep as much economic activity as possible under private-sector control, in order to ensure that what is produced is what consumers really want.
• Prevent the princes of Wall Street … from profiting from the systemic risk that they created.
• Ensure that homeowners and small investors do not absorb too much loss, for their only “crime” was to accept bad risks, which they would not have done in a world of properly diversified portfolios.

Now it is clear that the Fed and the Treasury have lost the game. If a depression is to be avoided, it will have to be the work of other arms of the government, with other tools and powers.

The failure to contain the crisis will ultimately be traced, I think, to excessive concern with the first two subsidiary objectives: reining in Wall Street princes and keeping economic decision-making private. Had the Fed and the Treasury given those two objectives their proper - subsidiary - weight, I suspect that we would not now be in this mess…

The desire to prevent the princes of Wall Street from profiting from the crisis was reflected in the Fed-Treasury decision to let Lehman Brothers collapse… The logic behind that decision was that, previously in the crisis, equity shareholders had been severely punished…

But this was not true of bondholders and counterparties, who were paid in full. The Fed and Treasury feared that the lesson being taught in the last half of 2007 and the first half of 2008 was that the US government guaranteed all the debt and transactions of every bank and bank-like entity that was regarded as too big to fail. That, the Fed and the Treasury believed, could not be healthy.

Lenders to very large overleveraged institutions had to have some incentive to calculate the risks. But that required, at some point, allowing some bank to fail…

In retrospect, this was a major mistake. … With that guarantee broken by Lehman Brothers’ collapse, every financial institution immediately sought to acquire a much greater capital cushion…,

but found it impossible to do so.

The Lehman Brothers bankruptcy created an extraordinary and immediate demand for additional bank capital, which the private sector could not supply.

It was at this point that the Treasury made the second mistake. Because it tried to keep the private sector private, it sought to avoid partial or full nationalization of the components of the banking system deemed too big to fail. In retrospect, the Treasury should have identified all such entities and started buying common stock in them - whether they liked it or not - until the crisis passed.

Yes, this is what might be called “lemon socialism,” creating grave dangers for corporate control, posing a threat of large-scale corruption, and establishing a precedent for intervention that could be very dangerous down the road.

But would that have been worse than what we face now? The failure to sacrifice the subsidiary objective of keeping the private sector private meant that the Fed and the Treasury lost their opportunity to attain the principal objective of avoiding depression.

Of course, hindsight is always easy. But if depression is to be avoided, it will be through old-fashioned Keynesian fiscal policy: the government must take a direct hand in boosting spending and deciding what goods and services will be in demand.

Go to Source

Tags: Array, Banking System, Bondholders, Br, Brad Delong, Collapse, Counterparties, Department Of The Treasury, Deputy Assistant Secretary, Diversified Portfolios, Dow, Eco, Economic Activity, Economic Decision, Economics, Economist, Economists, Economy, Excessive Concern, Failure, Fed, Federal Reserve, Federal Reserve Bank, Federal Reserve Bank Of San Francisco, Financial Regulators, Health, Img, Investors, James Bradford, Lehman Brothers, Leverage, Loc, National Bureau Of Economic Research, Princes, Private Sector Control, Project Syndicate, risk, Shareholders, Systemic Risk, United States, United States Department, United States Department Of The Treasury, United States Federal Reserve, University Of California Berkeley, Us Government, Us Treasury, Visiting Scholar, Wall Street
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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

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