DFR and the market

The last several days the fixed income market has experienced what can basically be described as an old fashioned run on the bank except in this case its hedge funds, REITs and other financial companies and those screaming for their money back are not individuals but large institutions that have provided the leverage to the system.

Imagine a game of musical chairs where all kinds of fixed income investment portfolios are looking for a seat -- meaning looking for cash or liquidity to satisfy their lenders. Only so much cash to go around right now and meanwhile the collateral -- the so called assets -- the mortgages and other securities are dropping in value due partly to increased credit losses but mostly due to forced selling -- no liquidity. It all starts because some securities have rising credit risks (subprime for one) and that leads to price declines. Many holders of these securities are highly leveraged and as those securities drop in price, the lenders call and ask for more cash -- a margin call. Some have no additional cash to give and they then lose out -- you may have read about American Home Mortgage or the Sowood hedge fund or the Bear Stearns hedge funds.

The risk to Deerfield is that they operate at 12X equity leverage levels -- similar to most banks -- so all it takes is a small drop in the value of assets and they are technically insolvent. Plus they are supposed to be buying their management company in a deal that requires deerfield to borrow $145 million in cash and pay shares of stock once worth $145 million (now worth $100 mill?) I think the stock has dropped because of liquidity fears -- would they be the next total loss -- and because as it drops the risk the deal falls through goes up.

I think the deal goes through because deerfield's manager is under just as much stress in terms of valuation. I think the liquidity issue blows over eventually -- wouldn't surprise me to see another sharp drop -- we are in the eye of the storm now. The reason is that the mortgage portfolio is fairly conservative and the higher yield portions of the portfolio have borrowed money from long term sources that can't do margin calls. I have relied heavily on David Merkel's analysis over at the Aleph Blog (see link on side) -- he does a far better job than I do of explaining their situation.

The liquidity issues for the market will end sometime soon -- its a snowball and eventually it can't get any bigger without one of two things happening -- the Fed cuts rates or injects liquidity or all the vulnerable companies go under and you are left with the strong that can't be taken down. The question is what impact will there be on either other financial stocks (can you say brokers or money managers!) or on the rest of the economy.

My take would be that the impact will not be as great as many now fear -- why? Some have the idea that private equity has been critical to the bull market and that is simply not true -- it hasn't hurt but rising earnings and low interest rates have played a huge part too. Again, the key to my strategy is to focus on company or industry fundamentals and not worry about macro concerns like the so called debt bubble or even worse the trade deficit.

TSRA's earnings or UEPS' earnings or any number of my holdings are impacted indirectly at most by issues in private equity. That statement makes more sense if you view it in the context of outperformance rather than absolute gains. I am not very good at timing the market -- to me there are always great stories to own that can make you wealthy. The key is selection. In the case of DFR, as I said in a previous note, I focused too much on the rewards and not on the potential risks.

My strategy is usually to identify stocks that are running downhill -- ones that have the wind at their back -- that are benefiting from secular trends while avoiding those that are fighting their way uphill. Now cyclical issues are different -- my ownership in AB suffered some hard times in 2001 -2003 but my cost is $35 and the stock even post pull back is still in the low to mid $80's. Not a bad deal. So there is nothing wrong with waiting out the cyclical issues in a stock that is a great business on a secular basis. I'm still optimistic that DFR will work out; but I wish my position size had been smaller to account for the risks when the credit cycle peaks and liquidity evaporates.