A debt bell tinkles Borrow to plow

®
Vol. 34, No. 5
Two Wall Street, New York, New York 10005 • www.grantspub.com
MARCH 11, 2016
A debt bell tinkles
The Skopos Auto Receivables Trust
2015-2 came into the world on Nov. 9. It
is in trouble today, just four months later. Casting about for someone or something to blame, we blame “liquidity.”
Subprime auto loans stock the Skopos
trust. There are $154 millions’ worth of
those IOUs, and they are not to be confused with Treasury bills. The weighted
average FICO score of the trust’s obligors is 543 (the national average is 695).
The weighted average interest cost is
20.79%, and the average vehicle vintage
is the 2012 model year. The Kroll Bond
Rating Agency, passing judgment on
the Skopos Trust, reckoned that “base
case” losses would reach 21% to 23%.
Losses, in fact, have exceeded those
estimates, which threaten what adepts call a “cumulative net loss trigger
event.” Should the trigger be squeezed,
Irving, Tex.-based Skopos would be
obliged to redirect its corporate cash
flows to the bondholders.
Bondholders do, for now, seem amply
protected. Not so clear are the terms
on which America’s subprime auto buyers will continue to be accommodated.
Such a trigger event, relates AssetBacked Alert, “would make it difficult for
[Skopos] to continue doing business as
usual—and would make it virtually impossible for Skopos to raise additional
capital through securitization. Sources
said other deep-subprime lenders, including Go Financial and United Auto
Credit, face similar pressures due to
rising losses among the loans underpinning their securitizations.”
There was a great hurrah in the immediate wake of last week’s employment
report; 242,000 new jobs and a headline
unemployment rate of 4.9% seemed to
connote the thing once called prosperity. Sober second thoughts followed.
“When, however, most of the growth is
in lower-paying jobs,” observed Steve
Blitz, director and chief economist at
ITG Investment Research, “the topline numbers do not likely translate
into the kind of spending most models
would forecast, including the ones running at the FOMC.” Trudges—still—
the nation’s business.
The story with Skopos has perhaps
less to do with the rate of the growth
in national output than with the rate
of production of dollars. On this score,
truer words were never spoken than
the ones lately uttered to this publication by Christopher L. Gillock, CEO of
Colonnade Securities, Chicago. “Everything is improving in the economy
at large but not quickly enough for the
flood of liquidity that is seeking out
yield,” says Gillock. “Just because there
is much more liquidity available doesn’t
mean there will be good loans to make.
When there are no good loans to make,
people make bad ones.”
Chair Yellen, please copy.
•
“Well, Mr. Trump ain’t calling balls and strikes.”
Borrow to plow
A farmer was asked what he got
for his crop. “I got to grow it,” he
replied. So went the dark joke from
a long-ago agricultural depression.
Now under way is the story about
the current difficulties of American
farming. Deere & Co. (DE on the
New York Stock Exchange) is the focus; bearish is the thesis.
Today’s farmer toils under a pair
of problems that history would
judge to be blessings. No. 1, there
is too much food; global stockpiles
of grains (excluding rice) are projected to reach 465 million tons at
the end of the 2015–16 crop year,
the highest in 29 years, according
to the International Grain Council. No. 2, there is too much machinery; farmers and dealers have
over-borrowed and manufacturers
have over-produced. What looks
like a tax- and commodity-priceinduced bubble in tractors, combines, harvesters, etc. is visibly
deflating—visibly, so far, except
to the stock market.
The Deere story has a little
something for everyone. The dollar is up and exports are down (the
macro angle), farm incomes and
grain prices are down by half from
their respective peaks (the micro
angle) and the federal tax code has
subsidized excessive capital investment in farm machinery (the political economy aspect). Encumbered
farmers are starting to squirm under the debt they incurred to buy
the heavy equipment for which, at
$3-per-bushel corn, they no longer
(Continued on page 2)
2 GRANT’S / MARCH 11, 2016
(Continued from page 1)
Don’t look down
$120
Deere & Co.’s share price
3/8/16:
$83.85
100
100
80
80
60
60
40
40
20
20
0
1/6/06
1/4/08
1/1/10
1/6/12
1/3/14
1/1/16
share price
share price
$120
0
source: The Bloomberg
have such urgent need. The Deere story turns out to be a credit story.
It’s a story that bears faint resemblance to the visitation of plagues in
the 1980s, when low crop prices were
overlaid on high interest rates, punitive
levels of debt and the Carter administration’s embargo of grain exports to Soviet
Russia. Thirty-six years later, low crop
prices and ultra-low interest rates have
sown another kind of debt problem.
While the aggregate farm balance sheet
appears sound enough, the very aggregation masks emergent difficulties.
“The amount of debt is concentrated
into a smaller percent of people this
time,” Jim Farrell, president and CEO of
Omaha-based Farmers National Co., tells
colleague Evan Lorenz. “The amount of
concern is in a smaller percent of people,
but they are larger. The impact is going
to be bigger when someone goes under.
We had an operator who was unable to
get financed. He had eight farms that he
leased from us. That is more of what we
will see. Back in 1982 or 1983, it might
have been one or two farms. A big operator might have had three to four farms
with you. Scale is different.”
Other things remain the same—the
seasons, for instance. Now is the season
to secure an operating loan. The applicants who present themselves to Farm
Credit Services of America, in Omaha,
Neb., say they expect to break even,
tops, this year, according to Bill Davis,
the company’s chief credit officer. Seven years of exceptionally rich incomes
stopped cold in 2013, Davis relates: “In
the past two years, we’ve seen working-
capital positions decline and a lot of
break-even P&L statements and some
losses. On average, our customers are
breaking even to losing a little money
this year on the crop side.”
In such circumstances, equipment
purchases take a backseat to husbanding cash and reducing costs. Davis goes
on: “We also have done some restructuring of debt to help them restore working capital in some cases. Our producers
are working hard to reduce their operating cost structure. Their operating cost
structure went up when grain prices and
profits were strong over the past five
to seven years. All their inputs—seed,
fertilizer—all went up as well as cash
rent, which was a large part of their cash
expenses, when crop prices went up.
Those cost components haven’t come
back down yet.”
Deere & Co. was a credit story from
its inception. In the panic year of 1837,
the eponymous John Deere, in flight
from his creditors in Rutland, Vt., moved
his blacksmith shop to Grand Detour,
Ill., which is where the company remains
to this day. Deere divides its manufacturing operations into agriculture and
turf (75% of net equipment sales in the
quarter ending Jan. 31) and construction and forestry (the remaining 25%).
North American sales predominate both
in volume and profitability, margins on
big farm equipment being the widest.
Though Deere’s leaping yellow stag
trademark is affixed to backhoe loaders,
combines, excavators, articulated dump
trucks and lawn mowers the world over,
the home market is where the money is.
The one-time blacksmith shop has
become a kind of bank—at least, operating income from the Deere captive
finance unit, John Deere Capital Corp.,
has grown to eclipse the earnings from
shrinking equipment sales. Of overall
operating income in the three months
to Jan. 31, ag and turf sales chipped in
$144 million, or 35%; financing activity,
$194 million, or 48%. As recently as fiscal 2013, the respective contributions to
operating income were 79% and 15%.
The bank of Deere shows assets of
$39.4 billion and equity of $4.3 billion. As
of Oct. 31, the loan book was tilted 85%
to ag and lawn, 15% to construction and
forestry. North American assets account
for 87% of the whole. Europe (5%), Latin
America (5%), Australia (2%) and Asia
(1%) fill out the portfolio. By type of loan,
the breakdown was as follows: installment loans and finance leases, 59%; operating leases, 13%; wholesale floor-plan, or
dealer, lending, 21%; revolving loans, 7%.
More on operating leases in a moment.
For the boom that was, the stockholders of Deere & Co. may thank, in part,
their elected representatives in Washington. Section 179 of the U.S. tax code
allows businesses to deduct the full cost
of new or used equipment, up to a certain threshold, in the year in which it
was purchased. After a 2010 doubling,
that threshold stands at $500,000. From
Deere’s point of view, it was a most propitious boost. Farm income itself was on
its way to doubling between 2006 and
2013, and farmers needed a tax shield.
Over those same seven fat years, Deere’s
North American sales jumped to $21.8
billion from $13.9 billion.
The lean years are here, though they
are not—yet—so very skinny (Deere’s
12-month rolling North American sales
are still almost $2 billion higher than
fiscal 2006’s grand total). One marker
of emerging distress is the inventory of
used equipment that crowds the dealers’
lots. Gary Eklund, a salesman at a Deere
dealer in Brimfield, Ill., tells Lorenz that
outsize inventories of late-model used
equipment have crimped the demand
for new merchandise. “It doesn’t matter
whether it is Case or John Deere, everyone has plenty of inventory on the lot,”
says Eklund. “It has totally slowed down
for the used buyer as well.”
Jon Hoffman grows beans and corn
and raises cows on a six-section—which
is to say, a six-square-mile—farm in
South Dakota. Lorenz asked him to
describe the replacement demand for
Copyright ©2016 by Grant’s Financial Publishing, Inc. Reproduction or retransmission in any form, without written permission, is a violation of Federal Statute.
GRANT’S / MARCH 11, 2016 3
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4 GRANT’S / MARCH 11, 2016
$4,000
Value at risk?
Residual values underlying Deere & Co.’s operating leases
3,500
2015:
$3,603
3,000
3,000
2,500
2,500
2,000
2,000
1,500
1,500
1,000
1,000
500
500
0
2002
2004
2006
2008
2010
2012
2014
in $ millions
in $ millions
3,500
$4,000
0
source: company reports
large equipment. “There is none,” Hoffman replied. “That’s what is happening.
These guys have bought all the equipment they needed during the good years.
They got up to a $500,000 write-off on
their machinery in one year. In other
words, if they bought $500,000 of machinery, they would write off $500,000
from their income tax. If they had a tax
problem, some of these guys went a little
crazy with the iron. They probably created other problems because now this
machinery is worth a lot less than it used
to be and they are still making payments
on the machinery when they don’t quite
have the income. That’s a big factor.
“These guys have replaced their fleets
and now times are tough,” Hoffman continued. “The guys who are very solid have
all the machinery they need, and they
don’t need to replace them for quite a
bit of time. The dealers are really struggling right now. Their sales are way down.
Some of them are just dead. This will balance out as the market clears itself.”
“The glut of late-model inventory
on dealer lots has led to a collapse in
used-equipment pricing,” Lorenz relates. “According to MachineryPete.
com, used-equipment prices dropped
by 32% between the first quarter 2013
and the fourth quarter 2015. Most unusually, used-equipment prices actually
fell between the third and fourth quarters of 2015. ‘The fourth-quarter values
had gone up in the previous 12 years and
usually up big, because of section 179,’
Greg Peterson, the ‘Pete’ behind Machinery Pete, tells me. ‘Farmers at the
end of the year with money looking for
deductions and trying to get that last
minute deduction. Last year was the
first time I hadn’t seen that since 2002.
That’s evidence that the current reality
is different now. It’s just different. That
would be a pullback and the story line
that is unfolding.’”
Deere runs—certainly, has run—a
squeaky clean financing operation. In
the quarter ended Jan. 31, accrued annualized loss provisions came in at just
eight basis points. “The financial forecast for 2016 contemplates a loss provision of about 19 basis points,” Joshua Jepsen, Deere’s head of investor relations,
said on the company’s Feb. 19 earnings
call. “Even so, this would put the year’s
losses below the 10-year average of 26
basis points, and well below the 15-year
average of 39 basis points.”
Past results are not invariably indicative of future returns. They were not in
the famous case of American residential
real-estate lending. Between 1990 and
2007, net charge-offs on loans backed by
one-to-four family residential properties
averaged 14 basis points. By the fourth
quarter of 2009, those charge-offs had
surged to 247 basis points. Even allowing that Deere’s loans to farmers remain
money-good, there remains the company’s exposure to its dealers, which,
as mentioned, constitute 22% of the
finance subsidiary’s portfolio.
“In order to boost sales,” Lorenz relates, “Deere has increasingly offered to
finance customers with operating leases.
In an operating lease, Deere finances a
customer’s use of equipment for a period of time—say, three years—and then
takes back the equipment at the end of
the lease’s term. This leaves the risk of
falling residual values squarely on Deere’s
balance sheet. Operating leases funded
15% of net equipment sales in the first
quarter of 2016, an increase from 6%, 8%
and 12% of equipment sales in fiscal years
2013, 2014 and 2015, respectively.
“At the end of fiscal 2015, Deere estimated that equipment under operating
lease would be worth $3.6 billion when
the leases all expired. If that estimate—no
small thing in comparison to the $4.3 billion in finance-company equity—proves
to be too high, Deere would have to take
a loss on the eventual sale of its used tractors, combines, corn planters, etc. And
let’s not forget that, with the downturn
in agricultural-equipment sales, Deere’s
operating profit is largely generated by its
financial-services division.”
How much can residual value fall
if a manufacturer is forced to sell used
equipment at a bad time? Hoffman tells
Lorenz that he recently went online to
bid on a used corn planter. It traded for
$47,000. “Four years ago,” says Hoffman,
“that same planter would have sold for
$75,000 to $80,000. . . . There are real
bargains out there. Guys who have money can afford them.” The flip side of the
bargain coin is the risk of falling residual
values to Deere’s balance sheet.
At $83.85 per share, Deere trades at
20.5 times the fiscal 2016 estimate, 15.2
times trailing net income and 9.0 times
peak earnings, which were registered in
2013. Of the 24 analysts on the case, six
say buy, six say sell and a dozen say just
stand around, holding. Short interest
amounts to 13% of Deere’s equity float.
Over the past 12 months, insiders have
net sold 98,454 shares for $9.4 million
in proceeds. As far as the out-years are
concerned, the consensus of analytical
opinion holds that (to summarize) everything will be OK.
Barring a snapback in grain prices and
agricultural incomes, we think, everything will not be OK. Deere, in the absence of those improvements, will face
mounting stress both in credit losses and
write-downs in the residual values of the
machinery it’s leased.
Joe O’Dea and Felix Xu, analysts at
Vertical Research Partners, neatly summarize the bearish case, thus:
“U.S. and Canada 100-plus horsepower tractor unit sales peaked in 2013, were
down 14% in 2014, another 25% in 2015
GRANT’S / MARCH 11, 2016 5
and are expected to fall another 15–20%
in 2016. Still, given the magnitude of the
upcycle, rolling 10-year sales will actually
grow in 2016. If we take 2017 down another 10% and run flat at those levels,
the rolling 10-year fleet doesn’t get to
prior trough until 2024. Ethanol, permanent section 179 and favorable farm-bill
programs can all contribute to keep volumes above prior trough. Nonetheless,
strength of the upcycle means there’s
no near-term or even medium-term
need for demand to improve, and we
anticipate a protracted period of softer
volumes. Still inflated used-inventory
levels despite OEM efforts to underproduce in 2015 adds risk of even more
severe declines than anticipated.”
Last word goes to the Pete of Machinery Pete: “One thing we are watching is
the number of machinery auctions as an
X factor. It has been . . . seven to eight
years since we’ve seen this many machinery auctions. The old data used to
show that the auction values would get
softer from St. Patrick’s Day into early
fall. The question is whether it will be
a glide lower, or are we going to take another jump?”
Watch this space.
have all confirmed under no uncertain
terms that they have no leverage to
press Chinese issuers for a reason, if
they choose not to.”
Yes, America is an exceptional
country. So is China.
•
For the un-meek
If something can’t go on forever, it
won’t. To that famous axiom, we append a corollary. In a financial context,
the definition of “forever” depends
on the quality of a capital structure.
Load up a balance sheet with debt, and
forever can be over in a flash.
Now under way is a bullish speculation on a bearish set of circumstances.
We focus on a pair of bruised offshore
oil-drilling businesses: Atwood Oceanics, Inc. (ATW) and Transocean Ltd.
(RIG). Each is listed on the New York
Stock Exchange, each is leveraged and
each could yet—in an adverse debt
and oil-price situation—blow up in the
face of a hopeful punter.
In a Feb. 29 blanket downgrade of a
half-dozen offshore drillers, Atwood and
•
Chinese exceptionalism
You cast your ballot for shareholder
proposals as your interests and conscience direct. You return the proxy to
the company. And the company returns
the proxy to you. It is marked “rejected.” Come again?
This actually happened last month.
China International Travel Service
Corp. Ltd. is the paragon of corporate
democracy that spurned the proxy.
Management had put five proposals up
for a vote. The offending shareholder
had voted yes on two of them, as management had recommended, and no on
the rest (the items that our informant
opposed were described in the proxy as
“investment plan,” “financial budget report” and “guarantee plan”).
The incredulous investor asked his
custodian for an explanation. “In the
market for China only,” came the reply,
“the market guidelines provide issuers
complete discretion to reject votes for
no given reason. This is something that
we have attempted to escalate with
several subs retained by our global custodian clients over time; however, they
Transocean among them, Moody’s collapsed the bearish argument into two
sentences: “Significantly reduced upstream capital spending and the declining creditworthiness of upstream customers coupled with a steady supply of
newbuild rigs entering an already oversupplied rig market will keep day rates
under heavy pressure. Leverage and
cash-flow metrics are expected to deteriorate sharply as current drilling contracts roll off or are replaced by contracts
with lower day rates.” Thus, Atwood
was demoted to Caa1 from Ba3 (with a
negative outlook) and Transocean to B2
from Ba2 (with a stable outlook).
The shrunken oil price is the besetting problem, the absence of demand
for drilling services the deflating consequence. The capital goods that shone so
brightly with oil at $107 a barrel—the
deepwater semi-submersible rigs, jackup rigs, drillships, harsh-environment
semi-submersibles, midwater semi-submersibles, high-specification jackups—
have come to look a lot like rusted steel
with oil at $36 a barrel.
Of course, the eye focuses most on
the rust, physical and financial, at the
(Continued on page 8)
Still standing
Financial summary for year ending Dec. 31, 2015
(in millions of dollars)
Atwood Oceanics
Cash
Debt
Net debt
Transocean
$116
1,608
1,493
$2,339
8,490
6,151
EBITDA
Net debt/EBITDA
685
2.2
2,328
2.6
Operating income
Interest expense
Operating income/interest exp.
507
50.8
10.0
1,380
432
3.2
Total debt
Equity
Total debt/equity
1,608
2,984
53.9
8,490
14,816
57.3
Scheduled maturities
2016
2017
2018
2019
2020
Thereafter
Debt-related balances, net
Total debt:
960
648
1,608
1,089
686
1,095
32
935
4,672
-19
8,490
_________________________________
sources: The Bloomberg, company reports
6 GRANT’S / MARCH 11, 2016
Credit Creation •
$740
720
retail money fund balances in $ billions
Federal Reserve Balance Sheet
(in millions of dollars)
March 2,
2016
The Fed buys and sells securities…
$4,244,303
Securities held outright
0
Held under repurchase agreements
and lends…
34
Borrowings—net
and expands or contracts its other assets…
194,871
Maiden Lane, float and other assets
The grand total of all its assets is:
$4,439,208
Federal Reserve Bank credit
Foreign central banks also buy,
or monetize, governments:
Foreign central-bank holdings of Treasurys
$3,251,037
and agencies
Feb. 24,
2016
March 4,
2015
$4,250,938
0
$4,237,182
0
17
19
196,727
211,499
$4,447,682
$4,448,700
$3,254,251
$3,255,573
Jan. 2015
Rmb 27,794
237
233
67
Claims on domestic economy
7,404
4,867
4,896
Other assets
1,529
1,534
1,130
Rmb 33,704
Rmb 31,784
Rmb 33,887
MOVEMENT OF THE YIELD CURVE
4.0%
4.0%
3.5
3.5
2.5
2.0
2.0
1.5
1.5
1.0
1.0
0.5
0.5
0.0
3 month
6 month
source: The Bloomberg
2 year
5 year
10 year
30 year
0.0
yields
yields
3.0
3/8/16
12/9/15
3/9/15
2.5
640
620
12/13
19 yuge ba
Dec. 2015
Rmb 25,150
3.0
660
sources: The Bloomberg, Federal Reserve Bank o
Jan. 2016
Rmb 24,534
Its assets total:
680
12/12
(in billions of renminbi)
Gold
Retail money fund balances
vs. Crane 100 Money Fund Index 7
700
600
People’s Bank of China Balance Sheet
Foreign exchange and other foreign assets
Savers get a (small) raise
Observe that the narrowly defined
money supply, M1, has declined at the
annual rate of 0.7% over the past three
months (the data are to your right).
Yes, monetary conditions have tightened, but not in the old familiar way.
The single driver of the slight
shrinkage in transactions balances is a
plunge in demand deposits—down at
an annual rate of 7.3% over the same
three months. It used to be said that
5% would pull money from the moon.
One small fraction of 1% is pulling billions from banks today.
Money-market mutual funds are the
new destination for savings. In the past
90 days, cash held at retail money funds
has soared by $104.2 billion to $718.2
billion; over the same stretch, demand
deposits have fallen by $22.4 billion, to
$1.2 trillion.
As recently as year-end 2007, excess
bank reserves totaled a mere $1.8 billion, with a “b.” After successive rounds
of bond- and mortgage-buying, a.k.a.,
QE, those balances stand today at $2.3
trillion, with a “t.” As banks no longer
need to borrow reserves from one another, the Fed funds market has receded
to insignificance. To raise the cost of
borrowing, the Fed lifts the rate it pays
money funds via its reverse repo facility,
a.k.a. RRP (see Grant’s, May 2, 2014).
And how is this rate quoted today? At 25 lordly basis points, which
GRANT’S / MARCH 11, 2016 7
• Cause &
Effect
0.21%
7-day current yield
Annualized Rates of Growth
0.18
(latest data, weekly or monthly, in percent)
0.15
0.06
0.03
0.00
12/14
2/22/16
of St. Louis
asis points
•
Reflation/Deflation Watch
FTSE Xinhua 600 Banks Index
Moody’s Industrial Metals Index
Silver
Oil
Soybeans
Rogers Int’l Commodity Index
Gold (London p.m. fix)
CRB raw industrial spot index
ECRI Future Inflation Gauge
Factory capacity utilization rate
CUSIP requests
Fed’s reverse repo facility (billions)
Grant’s Story Stock Index*
*Index=100 as of 7/31/2013
Grant’s Never-Never Index*
**Index=100 as of 1/4/2013
6 months
0.0%
-5.3
-3.0
9.8
7.7
32.2
7.2
0.1
6.1
4.4
12 months
-0.3%
0.0
0.2
10.7
7.5
21.0
5.8
3.0
5.5
5.5
Latest week
Prior week
12,420.51
1,421.68
$15.69
$35.92
$8.79
1,930.56
$1,277.50
426.51
(Feb.) 105.1
(Jan.) 77.1
(Jan.) 1,133
51.4
90.22
11,516.25
1,393.46
$14.69
$32.78
$8.55
1,905.32
$1,226.50
421.74
(Jan.) 103.4
(Dec.) 76.5
(Dec.) 1,289
56.9
86.78
Year ago
11,444.35
1,707.25
$16.16
$50.76
$9.86
2,673.75
$1,202.00
471.56
(Feb.) 101.8
(Jan.) 79.4
(Jan.) 1,479
80.9
116.62
174.99
169.20
201.62
EFFECTIVENESS OF THE MONETARY POLICY
M-2 and the monetary base (left scale) vs. the money multiplier (right scale)
$16
10x
12
8
8
6
4
4
0
1/05
M-2
1/07
1/09
monetary base
1/11
1/13
money multiplier
2
1/15 1/16
money multiplier
means that money-fund investors
earn 19 basis points, up from a mere
three basis points in July. Demand
deposits pay nothing.
“The RRP is uncapped, i.e., money
funds can park unlimited funds at the
Fed’s borrowing facility,” as colleague
Evan Lorenz explains. “This has led to
two concerns: one, that in a financial
crisis the RRP would accelerate a run
on short-term funding; and, two, that
when the Fed raised rates, deposits
would decamp to higher-paying money
funds, which have unlimited access to
a risk-free creditor, and to tighter bank
liquidity. There is no sign yet of a run
on the short-term financing markets,
but we may be witnessing the start of
savers moving deposits in order to get
higher yields.
“The Fed next meets on March
16,” Lorenz proceeds. “The move out
of demand deposits and into money
funds is another datum indicating that
the funding markets have tightened
perhaps more than the 25 basis-point
hike in December would indicate (see
also the CLO and CMBS markets
in the Jan. 29 and Feb. 26 issues of
Grant’s). At the same time, inflation
does, indeed, seem to be hotting up.
In January, the CPI rose by 1.4% yearover-year; excluding food and energy,
it leapt by 2.2%.”
Federal Reserve Bank credit
Foreign central-bank holdings of gov’ts
People’s Bank of China
Commercial and industrial loans (Jan.)
Commercial bank credit (Jan.)
Asset-backed commercial paper
Currency
M-1
M-2
Money zero maturity
in $ trillions
0.09
yield in percent
0.12
3 months
-0.3%
-6.8
-0.04
11.1
10.1
21.6
5.4
-0.7
7.2
3.3
8 GRANT’S / MARCH 11, 2016
(Continued from page 5)
bottom of the cycle. Let us take this opportunity to say that we do not know if
this is the bottom of the cycle. We stand
by our hopeful working hypothesis of
Jan. 29, which is that low prices are doing their painful, constructive, bullish
work. In the offshore-drilling industry,
old rigs are being mothballed or turned
to scrap. New rigs, with which Atwood is
especially well-stocked, will be the first
to find work, come the cyclical turn.
“The intensity of the current downturn,” P. Cary Lowe, chief operating officer of Ensco Plc., told dialers-in on the
fourth-quarter conference call, “while
very challenging in the near term, will
also be the catalyst to drive out excess
supply through the scrapping of older
rigs and cancellation of certain new
builds, which in the mid-to-long term
will be positive for our sector.”
®
James Grant, Editor
Katherine Messenger, Copy Editor
Evan Lorenz, CFA, Analyst
Harrison Waddill, Analyst
David Peligal, Contributor
Hank Blaustein, Illustrator
John McCarthy, Art Director
Eric I. Whitehead, Controller
Delzoria Coleman, Circulation Manager
John D’Alberto, Sales & Marketing
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We judge that Atwood and Transocean are reasonable candidates for
survival. Atwood boasts a modern fleet;
Transocean, the deepest backlog of
work in the business. The respective
quoted yields on the companies’ publicly traded debt are the visible measures
of uncertainty. Both companies happen
to have floated issues of 6½% notes maturing in 2020. Atwood’s are quoted at
50.37 to yield 28.35%, Transocean’s at
70 to yield 15.8%.
“The biggest risk for Atwood,” Sajjad Alam, an analyst at Moody’s, tells
colleague Harrison Waddill, “is re-contracting risk. For all their rigs—other
than the two new drillships—contracts
end this year. So, unless they find work
for those rigs, they’ll have to depend on
cash flows from those two drillships to
support debt. They also have some remaining payments they have to make
on two additional ships under construction through 2018, so they need to have
access to some sort of external funding, and the credit facility that they’re
relying on has a covenant attached to it
which they’ll probably blow through in
the earlier part of 2017.”
Atwood, which declined to come to
the phone when Waddill called, has issued projections of cash flow, cash on
hand, capital spending and other vital
signs that point to survival through
2018 (though we are unaware of the
oil-price assumptions that accompanied this guidance). If the oil-price recovery accelerates, worry will be moot.
Otherwise, the No. 1 concern will be
the bank line, which topic Atwood’s
CEO, Robert J. Saltiel, addressed on
the Feb. 3 earnings call. “Given the
uncertain timing of our industry’s recovery,” said Saltiel, “we recognize
that there’s a risk that the covenants
on our revolving credit facility could be
stressed at a lower point in the cycle in
late fiscal 2017, potentially limiting our
access to these funds.” The CEO was
referring to the covenant that caps the
maximum allowable ratio of net debt
to EBITDA at 4.5:1, compared with a
Dec. 31 reading of 2.2:1.
Saltiel wanted his auditors to know
that the company wasn’t just wishing
and hoping: “We’re in discussions with
our lead bankers now . . . and recent
discussions are signaling a growing
flexibility regarding covenant modifications as this issue becomes more
widespread across the industry.” Not a
few encumbered oil and gas business-
es have achieved such modifications in
recent months. The list includes C&J
Energy Services, Ltd., Chesapeake
Energy Corp., Energy XXI Gulf Coast,
Inc., Premier Oil Plc. and EnQuest
Plc. Constant readers will recall that
NOW, Inc. (Grant’s, Jan. 29), a kind
of universal hardware store for energy
producers, has managed to eliminate
its interest-coverage-ratio covenant.
Then, too, concerning Atwood’s negotiating position, Christine Besset,
associate director of commodities,
materials and real estate at Standard
& Poor’s, observes: “They have highquality assets, and two of their new
drillships are unencumbered, so they
could potentially add those to collateral in exchange for relaxed covenants.”
On last month’s earnings call, the
Transocean front office dodged a question about oil prices. There is no one
restorative, break-even price, came the
non-reply; observe, for instance, the
company said, that Statoil ASA is penciling in $30 per barrel or less for the
immense Johan Sverdrup oil field in
Norway, now in the planning stage. As
for the price of oil that would balance
incremental supply and demand over
the long term, Transocean (like many
another observer) reckons that $90 is
the minimum.
The risk to Transocean, Ben Tsocanos, an oil- and gas-ratings director at
S&P, tells Waddill, “is a combination
of low utilization, committed capital
spending and significant debt maturities.” Then he offered a caveat, to wit: “I
think they are deferring capital spending as much as possible. The dividend
has been reduced, but they have very
large debt maturities looming. They
have a lot of cash [$2,339 million] and
an undrawn credit facility [$3,000 million]. So that’s why they are a BB-plus
and not lower, because they have all that
cash. If they can’t refinance, they could
still pay off the maturities.”
One of these days, some genius will
take his oil-drilling company into a cyclical downturn debt-free. He or, for
that matter, she will borrow at the bottom of the market to buy up cheap assets. That time is not now, as far as we
know. Certainly, Transocean does not
currently resemble that shrewdly managed enterprise. At least, though, it is
repaying the debt it probably ought not
to have incurred. After retiring $1 billion
this year, says Philip Adams, an analyst
at GimmeCredit, it stands to close 2016
GRANT’S / MARCH 11, 2016 9
with a cash balance of $1.9 billion. “As
it concerns their credit facility,” our informant adds, “the revolver has a typical investment-grade covenant package
consisting of one ratio: a consolidatedindebtedness-to-total-tangible-capitalization limit of 60%. Transocean says it
is currently below 40%; my raw GAAP
ratio is 36%.”
Not the least of the appeals of
ATW and RIG is that they have so
few friends. Concerning Transocean,
the consensus of analysts surveyed by
Bloomberg is one lonely buy, 15 holds
and 22 sells. For Atwood, the analytical
skew is 6, 20 and 6. Shares sold short
as a percentage of each company’s float
coincidentally total 38%.
Since our Jan. 29 story on National
Oilwell Varco (NOV) and NOW, Inc.
(DNOW), the former share price has
declined by 3.2%, the latter increased
by 33.6%. The difference, we think, is
attributable to the fact that DNOW was
closer to the brink than NOV. Certainly,
ATW is financially weaker than RIG,
therefore riskier, and—therefore—more
susceptible to the joyous relief imparted
by the lifting of bankruptcy fears. Each
remains a speculation.
•
Trade closed
The Nov. 27 issue of Grant’s featured
a bearish analysis of the four Oil Patch
banks enumerated nearby. Each had
outsize exposure to oil-and-gas borrowers, and none—so we judged—had been
properly valued for that risk. “While the
banks may yet take additional marks on
their respective books,” comments colleague Evan Lorenz, who identified the
short-sale opportunity, “the market has
performed its revaluation, even as we
have become friendlier to the energy
markets. We accordingly lift our fatwa.”
•
Not quite parity
A great debate was scheduled to be
held at the Crosby Hotel in New York
City on Wed., March 9, the day after
Grant’s went to press. It was to pit
Greg Jensen, co-chief executive officer of Bridgewater Associates, against
the editor of Grant’s. The topic was
risk parity, the Bridgewater-conceived
investment strategy that came in for
criticism in the issue of Grant’s dated
May 29, 2015. Following is the text of
your editor’s opening remarks.
I stand before you as the manager
of 154 billion fewer dollars of financial
assets than Bridgewater has under its
wide-spreading wings. You may wonder why I’m here. I hope to prove that
writing men have a contribution to
make to financial topics even as difficult and consequential as the one on
today’s agenda.
In 1940, a half-century before the
apple of risk parity dropped on Ray
Dalio’s head, an early glimmer of the All
Weather investment strategy emerged
from the pages of Fred Schwed’s wise
and witty book Where are the Customers’
Yachts? You may recognize the spirit
of risk parity, a.k.a. All Weather, in
Schwed’s lighthearted sentences:
“When there is a stock-market boom,
and everyone is scrambling for common
stocks, take all your common stocks
and sell them. Take the proceeds and
buy conservative bonds. No doubt the
stocks you sold will go higher. Pay no
attention to this—just wait for the
depression which will come sooner or
later. When this depression—or panic—becomes a national catastrophe,
sell out the bonds (perhaps at a loss)
and buy back the stocks. No doubt
the stocks will go still lower. Again pay
no attention. Wait for the next boom.
Continue to repeat this operation as
Oil Patch banks revisted
BOK Financial Corp.
Texas Capital Bancshares, Inc.
Cullen/Frost Bankers, Inc.
Hancock Holding Co.
WTI crude ($/bbl)
11/27/15
3/8/16
$68.92
59.53
69.83
29.14
$54.84
36.85
54.99
24.96
41.71
36.24
_________________________________
source: The Bloomberg
% chg.
-20.4%
-38.1
-21.3
-14.3
-13.1
long as you live, and you’ll have the
pleasure of dying rich.”
The brilliant founder of Bridgewater Associates could be sure he would
die rich. What troubled him was the
hereafter. Who would make the big
asset-allocation decisions after he
was gone? The ideal designate turned
out not to be a person but a process.
Which is where, if I read Bridgewater’s Sept. 16 manifesto correctly,
risk parity comes in.
“Because Ray believed that he could
not trust his trustees and the people
they picked to make those asset allocations well,” this document relates,
“and because he believed that the
basic laws of investing were timeless
and universal, he set out to create a
timeless and universal strategic assetallocation mix—i.e., one that would
have worked well going back 100 years
or more and that would have worked
in all economic environments including the most extreme ones, such as the
U.S. Great Depression (deflationary)
of the 1930s and Germany’s hyperinflationary depression of the 1920s.”
That asset-allocation mix is the one
we’re here to debate. Stocks and bonds
fill a risk-parity portfolio, as they do
myriad others. For Bridgewater, the
art is in the balancing. Weigh assets by
risk, they say, not by dollar value. And
then, having turned the key to start the
semi-autonomous risk-parity vehicle,
do not attempt to override the internal
steering mechanism. At the very least,
theory has it, a risk-parity portfolio is
trustee-proof.
Schwed, like Dalio, aspired to devise an automatic system (though the
Schwed method requires someone to
make the periodic buy-sell determinations). Like risk parity, the Schwed
plan proceeds from the observation
that the world is cyclical. And, like risk
parity, the Schwed approach makes
no representations about short-term
success. Its purpose is long-term, allseason compounding.
As Fred Schwed has long since gone
to his reward, I’ll have to speak for the
two of us. To begin with, a query: What
is risk? To my absent friend it meant—
and to me it means—the permanent
loss of principal. For Bridgewater, risk
means something else: volatility and,
again to quote from last fall’s manifesto,
the chance that “our assumptions are
wrong.” As there’s no one correct definition of risk, I don’t say that Schwed and
10 GRANT’S / MARCH 11, 2016
10,000
The best of times
18%
S&P 500 Index log scale vs. 10-year Treasury yield
1,000
12
yield in percent
S&P 500 Index level (log scale)
S&P 500:
1,979.26
10-year yield:
1.83%
100
10
6
1/62
1/72
1/82
1/92
1/02
0
1/12 3/8/16
source: The Bloomberg
I are right and that my immensely accomplished sparring partner and his cochief executive officer are wrong. What
I do say is that our differing approaches
to risk may account for our fundamental
disagreement about risk parity.
Leverage is inherent in All Weather
portfolios. You buy stocks and you buy
bonds, but you don’t stop there. You
borrow the cash with which to buy more
bonds. You do this because a 50%–50%
split between bonds and stocks would
provide no real diversification. Why?
Because stocks are riskier than bonds,
the argument goes. They are inherently
riskier because they are more volatile
than bonds. The extra increment of
bonds achieves a rough parity of risk—
meaning volatility—between stocks and
bonds. Besides, it isn’t much leverage,
adherents say: just two turns, which is
less than the average S&P 500 company
uses and one-tenth of what the average
American bank employs. Then, too, proponents insist, it’s debt in the service of
balance—debt, in Bridgewater’s words,
“to create volatility in lower-risk assets
which creates better diversification than
would be possible without leverage.”
No need to guess, I think, why leverage plays no part in the Schwed plan.
The author lived through the 1929
Crash, the ensuing Great Depression
and that financial and emotional coup
de grâce, the bear market-cum-depression of 1937. I suspect that he was prone
to what another risk-parity shop today
chooses to call, a little disparagingly,
“leverage aversion.”
It’s an aversion I share—and you
should, too, if the asset you’re leveraging is as grotesquely mis-priced as government securities are today. As you
know, more than one-quarter of sovereign debt in the so-called advanced
countries is trading to deliver a yield of
less than zero. Nor is the risk-reward
proposition exactly irresistible in the
bonds that yield something greater than
zero. Ponder, for example, the German
government’s ½s of Feb. 15, 2026, now
priced to deliver a yield of 0.18%. If that
security were to suffer a markdown in
price to such an extent that it yielded all
of 2%, the loss of principal would represent 33.1 years of lost coupon income (a
staggering feat on a 10-year obligation).
Or consider that Himalayan highyielder, the U.S. Treasury 2½s of 2046.
At a 2.6% yield to maturity, a rise in
yield of one percentage point would
mean a drop in price of 18%. That is the
unleveraged sensitivity. The leveraged
one I leave to your imagination.
I am well aware of the excellent results that risk parity has delivered in
real time, including in 2008, and of the
strong showing which it has made in
various back tests. I do wonder, though,
whether All Weather will turn out to be,
equally, all climate.
I have in mind the monetary climate.
A bond is a promise to pay money. Have
you ever stopped to ask what is money?
Wall Street people, famously contentious, will debate the nature of risk at
the drop of a hat. We dispute like the
Medieval Schoolmen over the constitu-
tion of a proper bond index. But as to
money—the thing that most of us spend
most of our working lives trying to accumulate—we are strangely incurious.
Next to nothing is ever really new
under the sun of investing. Savers and
speculators have been casting their
bread on the waters of risk since the
dawn of time. What is relatively new—
new in the slow-moving clock of monetary history—is the coming of universal
paper money in 1971 and, as a concomitant of universal paper money, the advent of discretionary central banking by
former academic economists. Once we
had the gold standard. Today, we have
the Ph.D. standard.
You’ll recall that the Bridgewater position paper defined risk as both volatility and the chance that “our assumptions are wrong.” I would invite a closer
look at the house assumptions concerning the effects of post-2008 monetary
policy. Bridgewater sees central banks
as saviors. Not I.
The risk-parity strategy makes losses when a diversified portfolio of assets produces a lower return than cash.
“While any one asset might underperform cash for a while,” to quote, again,
the Bridgewater broadside, “it is rare
that a well-diversified portfolio of assets
will underperform cash for long because
it is intolerable for the economy, which
leads central banks to ease monetary
policy and fix things. That is because
the world economic system depends
on central banks making cash available
at interest rates that people can borrow
at so they can use the cash to do things
that produce higher returns than the
cost of the cash that they’re borrowing.
“That is not just a theoretical statement,” the document proceeds:
“throughout history, the times in which
a well-diversified portfolio of assets underperformed cash for any significant period of time were times of depression and
were always followed by central banks
doing all in their power to rectify that.”
“Throughout history” is a mighty
big phrase, and it happens not to be
entirely accurate. Throughout the 19th
century and the first three decades of
the 20th century, according to Homer
and Sylla’s History of Interest Rates, the
dollar-denominated yield curve was
persistently negatively sloped. That
is, a well-diversified portfolio of bonds
did, in fact, underperform cash. Bond
yields were lower than commercial paper rates, and lower than call-loan rates.
GRANT’S / MARCH 11, 2016 11
20%
Old school: persistent negative carry
Long-term yield curve
18
U.S. governments 1800–30, 1840–80
New England municipals 1800–1914
Commercial paper 1830–1914
18
16
14
14
12
12
10
10
8
8
6
6
4
4
2
2
0
1800
1820
1840
1860
1880
1900
yield
yield
16
20%
0
1914
source: A History of Interest Rates, New Third Edition
“Similarly,” as those historians relate,
“the yield curves of prime corporate
bonds tended to be negative (long-term
yields below short-term yields) most of
the time from 1900 until 1930.”
According to the British economist
Charles Goodhart, in his monograph The
New York Money Market and the Finance of
Trade, 1900–1913, it was the very volatility of short-term rates that kept financial
order in the decade and a half before the
coming of the Federal Reserve in 1914.
As short rates dwarfed bond yields, financial leverage was prohibitively costly. Of
this era, Goodhart concludes, “On the
basis of its record, the financial system as
constituted in the years 1900–1913 must
be considered to have been successful to
an extent rarely equaled in the United
States. The almost complete absence
of bank failures, the growth of banks, or
bank capital and of bank profits was conspicuous.” Of course, the era that Goodhart describes encompassed the Panic of
1907; it shines nevertheless.
The fantastic success of Bridgewater
Associates speaks for itself. So does the
success to date of the risk-parity investment technique. As for the future, I
ask you to let your imagination run. To
our forebears, it would have seemed inconceivable that today’s central banks
would do what they are doing—10 short
years ago, it might have seemed inconceivable to us. Yet radical monetary
policy has not only been implemented.
It has also entered the mainstream,
another so-called tool in the monetary
“toolbox.” As for the consequences of
these interesting experiments, they remain to be seen.
The central premise of risk parity, as
I understand it, holds that highly valued
promises to pay fiat currency constitute
a low-risk category of investment asset;
as it is ostensibly low-risk, it is an allegedly suitable candidate for leverage,
which leverage will be available to a riskparity portfolio manager in all settings at
a reasonable cost. My reading of financial history casts doubt on those suppositions and, therefore, on the long-term
viability of risk parity.
I have not yet attempted to solve the
problem that Ray and Greg and others at
Bridgewater have addressed with their All
Weather portfolios. Knowing, as I do, a little about the financial past, and knowing
nothing at all about the financial future,
I believe that no asset-allocation protocol
can give dependable service under any set
of future contingencies. Perhaps science
may yet come to the rescue. Clone Ray,
clone Greg and let those genetic holographs apply their formidable brainpower
to whatever opportunities and difficulties
tomorrow may hold. They will surely be
different from today’s.
•
Valeant’s fine print
It’s not easy keeping up with Valeant Pharmaceuticals International, Inc.
(VRX on the Big Board; March 7, 2014
in Grant’s). On Feb. 28, the company
welcomed CEO J. Michael Pearson back
from medical leave while disclosing a
list of horribles that might have been
drawn up by the short interest. Among
these revelations: Management would
not be meeting the Feb. 29 deadline for
filing its 10-K report, and a competitor
had filed a generic drug application for
Xifaxan, a product that had garnered 8%
of Valeant’s third-quarter sales.
“With all that going on,” observes colleague Evan Lorenz, “few—I bet—have
taken the time to read the fine print
in Valeant’s various bond and credit facilities. We hadn’t, until John Hempton,
chief investment officer of Sydney-based
Bronte Capital Management, pointed
to section 4.3 of the VRX Escrow Corp.
bond indenture. Some $10.2 billion of
these securities had financed Valeant’s
2015 purchase of Salix Pharmaceuticals,
Ltd. Failure to file timely financial statements with the SEC constitutes an event
of default, the contractual language says.
Such a default could be cured by meeting a second filing deadline for audited
financials, this one on April 29.
“If Valeant does not file by April 29,”
Lorenz relates, “holders of 25% of any of
the escrow securities can demand immediate payment of principal and accrued
interest. The smallest of these issues is
the euro-denominated senior unsecured
4½s of May 15, 2023, of which €1.5 billion ($1.7 billion) are outstanding at par
value. As the bonds trade at 79.50 to yield
8.4%, an investor (or a group of investors)
would need to buy €298 million ($328
million) to amass the 25% stake required
to demand the acceleration in payments.
As of Sept. 30, Valeant had $1.4 billion in
cash, an amount that probably declined
in the wake of the costs involved with
shutting Philidor Rx Services and starting a new distribution agreement with
Walgreens Boots Alliance, Inc. ‘Of course
there are people who know this—and
they only need buy 25% of one series—
and can load themselves with offsetting
and larger positions in the CDS and the
debt,’ Hempton observes by email.”
You’d know it if Valeant defaulted.
One of the top issuers in the institutional loan market, Hillary Clinton’s favorite
drug company was the most widely held
obligor late last year in post-crisis-vintage collateralized loan obligations.
On Monday, Valeant promised to
host a call on March 15 to discuss preliminary—not final audited—results
for the fourth quarter of 2015. The
clock is ticking.
•
®
Vol. 34, No. 05h-ctr
MARCH 11, 2016
Two Wall Street, New York, New York 10005 • www.grantspub.com
We have broken out the centerfold story for your reading comfort.
No broken headlines across pages any longer.
19 yuge basis points
“The RRP is uncapped, i.e., money
funds can park unlimited funds at the
Fed’s borrowing facility,” as colleague
Evan Lorenz explains. “This has led to
two concerns: one, that in a financial
crisis the RRP would accelerate a run
on short-term funding; and, two, that
when the Fed raised rates, deposits
would decamp to higher-paying money
funds, which have unlimited access to
a risk-free creditor, and to tighter bank
liquidity. There is no sign yet of a run
on the short-term financing markets,
but we may be witnessing the start of
savers moving deposits in order to get
higher yields.
$740
retail money fund balances in $ billions
720
“The Fed next meets on March 16,”
Lorenz proceeds. “The move out of demand deposits and into money funds
is another datum indicating that the
funding markets have tightened perhaps more than the 25 basis-point hike
in December would indicate (see also
the CLO and CMBS markets in the
Jan. 29 and Feb. 26 issues of Grant’s).
At the same time, inflation does, indeed, seem to be hotting up. In January, the CPI rose by 1.4% year-overyear; excluding food and energy, it
leapt by 2.2%.”
•
Savers get a (small) raise
Retail money fund balances
vs. Crane 100 Money Fund Index 7-day current yield
0.21%
0.18
700
0.15
680
0.12
660
0.09
640
0.06
620
0.03
600
12/12
12/13
12/14
sources: The Bloomberg, Federal Reserve Bank of St. Louis
0.00
2/22/16
yield in percent
Observe that the narrowly defined
money supply, M1, has declined at the
annual rate of 0.7% over the past three
months (the data are to your right).
Yes, monetary conditions have tightened, but not in the old familiar way.
The single driver of the slight
shrinkage in transactions balances is a
plunge in demand deposits—down at
an annual rate of 7.3% over the same
three months. It used to be said that
5% would pull money from the moon.
One small fraction of 1% is pulling billions from banks today.
Money-market mutual funds are the
new destination for savings. In the past
90 days, cash held at retail money funds
has soared by $104.2 billion to $718.2
billion; over the same stretch, demand
deposits have fallen by $22.4 billion, to
$1.2 trillion.
As recently as year-end 2007, excess
bank reserves totaled a mere $1.8 billion, with a “b.” After successive rounds
of bond- and mortgage-buying, a.k.a.,
QE, those balances stand today at $2.3
trillion, with a “t.” As banks no longer
need to borrow reserves from one another, the Fed funds market has receded
to insignificance. To raise the cost of
borrowing, the Fed lifts the rate it pays
money funds via its reverse repo facility,
a.k.a. RRP (see Grant’s, May 2, 2014).
And how is this rate quoted today? At 25 lordly basis points, which
means that money-fund investors
earn 19 basis points, up from a mere
three basis points in July. Demand
deposits pay nothing.
Grant’s is Webcasting the
Spring 2015 Conference live on April 13.
On-demand available April 14.
Of course, nothing’s better than being at the Plaza Hotel yourself. (Who are
you going to meet while staring at your iPhone?) Next best thing is our
day-long Webcast—live. And if you should happen to miss the live event,
on-demand viewing is yours, too.
In person: $2,150, includes breakfast, lunch and cocktail reception.
Webcast: $1,750 gets you the complete virtual experience, the ability
to participate in a live Q&A and on-demand viewing.
Register now at www.grantspub.com/conferences.
“Cheer up, Herbert!
Grant’s is Webcasting the Spring Conference!”
Questions? Please call 212-809-7994 or email conferences@grantspub.com