Time to Cut Links to the Leveraged Lending Economy

Monday, at about 10AM, I sold my holdings in Deerfield (DFR), Deutsche Bank (DB), and Royal Bank of Scotland (RBS). I did it bloodlessly, realizing that Deerfield is the largest loss I have ever taken. With the proceeds, I bought two placeholder assets that I will hold until the next reshaping (coming in a month), the Industrial (XLI) and Technology (XLK) Spiders. By doing that, I cut the majority of the links that I had to the leveraged lending economy, which is collapsing at present. When I saw that haircuts on repo for prime agency collateral had been raised for the second time, I threw in the towel, because too many things have broken that even I did not expect would break. (Even the haircuts on Treasuries have risen.)

With Deerfield, I made the error that if the collateral was very high quality, it could survive, even at high levels of leverage. In a true panic, that does not matter. All that matters is whether your leverage is low enough to allow you to survive the credit bust, and that you can do that over your financing horizon.

Financing horizon? By that I mean how often your solvency gets measured. For many mortgage REITs, that is a daily, weekly, or monthly phenomenon. The longer the period, the better the odds of survival. Short repo financing is by its nature is a weak financing method in a crisis. The day you cross the line (margin inadequate) the brokers move to liquidate. Given that some other managers may have been more aggressive, your excess capital can disappear, as more aggressive mangers miss margin calls, and the pressure of their liquidations forces your more conservative positions down, and you have to liquidate also.

Now, think of a life insurance company, a long-tailed casualty insurer or a defined benefit pension plan. If they buy AAA whole loans, or prime mortgage collateral, they can hold that position for 3+ years without worry. Their liabilities aren’t going anywhere. They know what they will be able to hold the investment through the panic period. There are still questions over what the best time to buy is, but with many large companies or plans, the optimal thing to do is to suck in a little bit each day, quietly, when the bonds are cheap. You won’t get the exact bottom; no one does, but you will do well. My own example is buying floating rate trust preferreds back in late 2002. I bought a 2% position over two months for my life insurance client without disturbing the markets. My client cleared a minimum of 10% on those investment grade bonds within a year as the panic lifted.

Comments

[MW]

So what I'm reading from your articles is that you are a short term investor selling at near bottom's.....Please come back and read your articles six months from now and let us know your thoughts as a long term view would not have you selling low, but rather buying there if you believe these companies are viable over the medium to long term.

Maybe you end up being right, however history shows that selling after quick downward jumps is not the best way to make money long term. Good luck.

[dhruv]

DFR: Currently leverage ratio is 5-to-1. 500 Million in agency RMBS + some interest rate swaps and nearly 110 million is capital. I arrived at this number by reading the latest news related to DFR.

So even if margin haircut is 5% it is still safe. Now fed will prop us RMBS by buying them. This should be good news for DFR.

Bears was leveraged 32-to-1 and so is lehman brother.

[User 131764]

Wow! This article really tells me that you have no idea what you are talking about. You know absolutely nothing of DFR's operating structure, and you've obviously been burnt by your inability to read the market. If you were any kind of investor, you would have been out of these stocks long before 3/3/08 (when DFR burst).

I can tell you that DFR probably isnt going anywhere as they have boxed their liquidity issues in order to survive this credit bust. The losses were heavy on their non-agency rated paper and we're forced to sell their holdings at a deep discount to create liquidity. However, those issues are long gone, and shall not be returning any time soon. DFR/DCM is now operating within a much safer realm (mostly corporate bank loans) and has little to no sub-prime exposure at this point in time.

What would I say to a new investor to DFR?
BUY BUY BUY!!!
This stock is never going to be this cheap again, and returns will be hefty for those of us who have leveraged down during this market phenom.

[User 131764]

What do you think today tough guy? Hows a 60%+ gain in 1 day for ya? And its only gonna get better from here. Now I bet you wish you had just hung on a little bit. Good riddance to those investors who bailed out. No faith at all.