Financial Hippie's  Instablog

Not an investment... Any time someone is trying to pitch gold to you as an "investment", he is probably trying to sell you commemorative coins for 2x the intrinsic value. Gold doesn't make sense from a fundamental investing point of view.

• It can't create value on its own
• It currently trades at more than 50% of replacement cost
   
• Demand comes from the eyes of the beholder. Industrial use is barely over 10% of total demand. Annual mining of gold only contributes to 1.5% of total above ground stock. We have a few hundred years of above ground supply for industrial use. Just the scrapping of gold every year covers industrial demand by 2x. Why are we even mining this stuff?
   

click here if you need a simple primer on gold

Buffett shies away from gold, because he's bullish on America long term and doesn't feel he needs such an insurance policy, right or wrong.

... but a much needed insurance policy against the establishment. Scary and unprecedented numbers coming out of both fiscal and monetary policies worldwide are increasing demand for protection of wealth. But hold on, just like buying any insurance product, you have to think about how much premium you are paying vs. the coverage you are receiving.

Let's first take a look at how much premium the coverage costs. I'm going to triangulate the premium in 3 ways.

1) The eyeball regression method. If I draw a fitted line through the graph, the predicted value is probably $500ish 2000 dollars or $550 today. Premium = $400.

click here for a chart

2) The comparable method. The CRB Commodity Index is down 40% since last June. Gold? roughly flat. Premium = $400 to $500.

3) The inductive method. If inflation expectations since 5/31/09 has been cut in half, shouldn't the price of gold also be cut in half? Premium = $400 to $500.

Let's call it $450.

Different payout scenarios under the coverage. If you believe inflation expectations will go beyond the scenarios that I have outlined below by year end 2012, then you should vote for Ron Paul.

Scenario 1. Bernanke surprises pundits, tightens earlier than expected. Inflation expectation remains at 2-3% range. Trend line value of gold increases to $600 through 3 years of 2.5% inflation. You lose $350 in premium for the coverage, but you are ecstatic because your mortgage rates will not come close to your parents' rates in the 80s. Jim Grant loses half of his writing material.

Scenario 2. Bernanke leaves the gas pedal down a little longer than necessary, openly admits inflation is a threat, sounds super hawkish and tightens a little just to show he means business. 5-6% inflation expectations in 2012 = $800 in real price of gold (using PCE deflator, 2000 = 100), or $1100 nominal at year end 2012. You don't know if you should collect your insurance for a small gain or roll it over. Jim Grant advises you to roll it over of course.

Scenario 3. Bernanke can't tighten because fiscal deficit is severely crowding out private investment. Interest rates are already high while the economy is still weak. Bernanke refuses or is not independent enough to mimic Volcker, ie. squash inflation but create a recession while doing it. Inflation expectation is +10%, highest it has ever been since the University of Michigan survey first started asking the question in the late 70s. Gold is $2000 in 2000 dollars, or +$2500 nominal. Your policy has paid off, but you're not sure how good you feel about your future prospects. You turn on the TV, Jim Grant is running for office.

These are the outcome and payouts as I see them. You can assign odds to each scenario yourself, or disagree with my scenarios all together. For now, I'm in between scenarios 1 and 2 and carry no gold position. Whatever you decide, please don't call gold an investment. Successful investments make you feel good when you make money, while insurance gives you a bitter taste in your mouth when collected.

But what I really want to know is... what is Greenspan telling Paulson? It is public knowledge that Greenspan is on Paulson's payroll. I wonder what Greenspan has said to Paulson that would make him put on such a large gold position. Could the conversation be something like this?

Paulson: "Alan, you got us into this mess, what do you think? You think Bernanke has any chance of steering the country out of this situation in one piece?"
Greenspan: "Dude... no way... I messed things up really bad... he's got no chance. Buy all the gold you can get your hands on."


Disclosure: no position in anything gold related
 

It's hard to find value these days in the market. However, I believe the whole agency REIT space is still attractively valued. I think CIM is a special case where it will provide the same yield as agencies but with an optionality on returning leverage.

IPOed at the worst possible time. When Chimera first IPOed on 11/15/07, the vehicle was supposed to achieve ROE in the low teens by investing in non-agency RMBS and other loans, while funding purchases with repos and lines of credit, resulting in a ROE model that looks something like:

Asset yield             6.5%
Cost of funds         5.0%
Spread                  1.5%

Leverage               7x
Levered yield        10.5%
Equity yield            6.5%
Mgmt Fees,G&A    3%

ROE                      14%

CIM raised 500mm in IPO. They were supposed to build the portfolio over a period of six months.

Then, the world fell apart... CIM's leverage got as high as 4x by 08Q1, but they had to sell some securities to mitigate funding risk and ended the quarter with 3.4x leverage. As the credit markets blew up in the next few quarters, non-agency paper continued to lose value, while funding them with repos became harder and harder as institutions tightened their quality of acceptable collateral (non-agencies weren't making the cut). Furthermore, banks were also reluctant to lend as many uncommitted lines of credit became useless. It was the perfect storm to coerce Chimera to sell assets at a huge loss. Book value declined by about 80% as they realized close to $150mm in losses from investments sold from Q1-Q3 and received low marks on the rest of the portfolio... stock went from $20 to $2.

The bottom? No leverage = no margin calls. For most of 09Q1 and 09Q2, according to several publicly traded mortgage REITs, non-agency paper could be bought on an UNLEVERED basis for yield-to-maturity of mid-to-high teens after adjusting for loss provisions. This means if these RMBS PMs have done their modeling correctly (and that's a big if, which I will address later), shareholders would be able to "clip" 15%+ percentage coupons. I put "clip" in quotes because a good portion of the return will be from amortization of discount, which will complicate cash flow around dividend payments. CIM said on their 09Q1 call that it wasn't an issue yet, but the non-agency book has tripled since then. CIM will probably need to further tap the Annaly repo line.

The stock went from $20 to $2. How can you trust management? Look, they got caught in a vice because of macro conditions; many people did during 2008. T-bills were trading at negative yields for crying out loud; I don't think anybody expected that. CIM's paper, of course, is on the polar opposite side of the risk spectrum. So if chances are that I will never see in my life time appreciation of t-bills like that again, then chances are that I will never see destruction in structured products like that again either. For that reason, I'm willing to give them a pass.

Mike Farrell's (CEO of Annaly) conservatism and recent macro data makes me sleep better at night. Although low, delinquencies are rising in the portfolio. Since Mike Farrell is staunchly in the "no greenshoots" camp, you would think PMs at Chimera model loss assumptions very conservatively. Against his bearish outlook, the stabilization of median home price and employment data in recent months might give CIM's portfolio more margin of safety and possible upside.

Barney Frank is the wild card. Cramdown, according to CIM, will not "increase the cumulative losses", but "alter the way losses are distributed throughout the capital structure" (08Q4 earnings call). To read about recent cramdown threats by Frank, click here. I hate politics. It gives me a headache. Please help me monitor this risk if you get involved.

How does the stock double or triple? This is the hard part. The company needs to leverage a teens ROA a few times; the problem is funding. Borrowing a poker term, your outs for possible funding sources are 1) repo 2) re-REMIC 3) TALF II. None of them looks that good for now. For that reason, until the company can show it can increase leverage, it's probably not worth more than $4 (slight under 15% yield on 2010 dividends). Their best chance for re-leverage currently is to do a re-REMIC, which is hard to sell right now. However, I do believe people's appetite for structured products will return if the yields are attractive enough, which will result in a higher funding cost to CIM. But if CIM can continue to purchase assets with such attractive yields, there will be plenty of spread left for CIM despite the higher cost. And if they can't buy assets at attractive yields, then that means their owns assets have appreciated. Book value will jump and you will make money either way.

Disclosure: long
 

 We all know the foot race that is going on in the solar industry - companies are trying to achieve the lowest per megawatt cost for an installed system. Until the next leapfrogging technology comes along, the most important factor to drive down cost is scale*. Here is where the US solar companies will have serious problems competing against the Chinese solar companies because the US solar companies lack cheap, indiscriminate access to capital like their Chinese cohorts.

 

Let's take First Solar (FSLR) for example. FSLR is funded by private money. Even though the US government is offering tax incentives for installing solar projects, they are not however involved in the funding of the company in any way. Why would they? FSLR has one plant in the US, the rest of the plants are mostly in "low cost locations" - ie. Malaysia. Have you ever heard of the "United Solar Workers"? I would guess a few hundred out of the 3,500 FSLR employees are Americans. My point is... if they closed shop tomorrow, there will be plenty of companies to fill the supply void. I wonder if the Malaysian government has the capacity or the desire to step up and lend.

The Chinese solar manufacturers are a different story. Remember, the number one goal of the Chinese government is to maintain social stability. Suntech Power (STP) employs close to 10k employees by itself, and these are "high quality" jobs that are looked upon favorably by the Chinese Government. If I include all of STP's peers in China, their upstream suppliers such as LDK Solar (LDK) and the downstream system installers, I would guess the Chinese solar industry employs probably a few hundred thousand people throughout the value chain.

Now let's look at the banking relationships. Many of these loans are unsecured and covenant lite and represent roughly on average 25% of total capital. Top 3 Chinese solar related company by market capitalization and their respective government backers are:

• Suntech Power (STP) : China Construction Bank,  Bank of Communication.
• Yingli Green Energy (YGE) : Export-Import Bank of China, China Development Bank
• LDK Solar (LDK) : China Construction Bank, China Development Bank, Bank of China, Agricultural Bank of China, Export-Import Bank of China. (wow, so many backers, this company really needs help)

I'm not going to bore you with the detailed capital expenditures budget and liquidity position for each US and Chinese solar company. But in times like these, where both US and Chinese solar companies are using their own money to set up an off-balance sheet entity to buy their own products to show "earnings" (A recent Barron's article eluded to Enron, but I think its more like Boston Chicken), who do you think is going to win that battle? Especially when the Chinese government can, just like recently, press "the lend button" indiscriminately with little regards to the creditworthy or the investment merit of these projects?

If scale is the most important deciding factor of cost reduction in the long run... until a new breakthrough comes along, how are US solar companies supposed to compete with their Chinese counterparts when they don't have access to cheap capital? I believe they must come up with a breakthrough in technology. I'm confident the US will be at the forefront of that leapfrogging breakthrough, but I'm not sure if the current publicly traded US names will be the companies to provide it.

* Study done by Gregory Nemet at the University of Wisconsin - Madison. On page 15 of the document, Nemet breaks down the drivers of cost reduction very nicely for us. 

Click here for slides

First Solar investor day from earlier this year - the "Cost Reduction Roadmap" slides. As you can see, First Solar will want you to believe "efficiency" or their continuing technology innovation will be the leading factor for cost reduction. I'm not saying it isn't an important factor, but if you add up the rest of the "Plant size" related items, "Low cost location" and "throughput", you would come up with 22-24% or a 1.35 : 1 ratio of plant size to efficiency (23% / 17%), roughly inline with Nemet's research of 1.4 : 1 (43% / 30%). Plant size is still the biggest factor.

Disclosure: short FSLR