In a previous article we reviewed the main Brazilian Retail banks to give investors in EWZ some background on MSCI Brazil Index’s 25% exposure to the Brazilian financial sector.  This article will focus on the domestic investment banks.

Santander and HSBC occupy the #6 and #7 spots in the Top 10 Brazilian Banks by assets, with shares of 8% and 3% respectively.  Other major foreign banks such as Citi, J.P. Morgan, Credit Suisse and Deustche Bank are small market players in the retail banking arena, each with shares between 0.5% and 1% of the total banking assets.

While most of these banks are not leaders in the Brazilian retail banking landscape, all these foreign banks are part of the top 10 banks by investment banks by fees for Latin America (consisting mainly of Brazil and Mexico).  This classification includes fees for M&A (merger and acquisitions advisory), loans (credit lending), DCM (debt capital markets, i.e., bonds) and ECM (Equity Capital Markets, i.e. stock issuance).

The local Brazilian investment banks

The only local banks within the top 10 investment banks are BTG Pactual (leading the table), Itau BBA, and Santander BBI.  The table below shows the league table rankings as of Aug 2012:

BTG Pactual has an interesting story and has been referred to by some as the Goldman Sachs of Latin American or its “tropical version”.  The bank was sold by Brazilian investment banker Andre Esteves to UBS in 2006 for US$3.1bn when he was just 37 years old.  Three years later he bought it back for USD2.5bn when UBS hit a rough patch during the financial crisis.  Pactual currently has a joint venture with Caixa Economica Federal that jointly owns Banco PanAmericano.  This is BTG Pactual’s first acquisition of a retail bank.

Itau BBA, the investment bank arm of Itau Unibanco Holding, was created in 2002 when Itau acquired Banco BBA-Creditanstalt in 2002.  In 2011 it achieved third place in the Top 10 Brazilian Investment Banks table; as of August it was placing fourth for 2012.  Earlier this year it received the Best Investment Bank for Brazil 2012 Award by Euromoney.

Bradesco BBI was #7 in the Top 10 table for 2011 and so far this year its holding the #8 spot, followed closely by foreign banks Santander and HSBC.  Earlier this year it also received the Best Investment Bank – Brazil 2012 Award, this one was awarded by Global Finance.

For more information, please visit Market Realist’s emerging market section: Emerging Markets

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The MSCI Emerging Markets Index covers the performance of 817 emerging market stocks across 21 emerging markets. The index covers 85% of each country’s free float adjusted market cap, meaning it takes into account only the publicly available shares, as opposed to the total issued shares. In emerging markets it is common for companies to have low free-float percentages (e.g., in Latin American values as low as 10-15% are observable) as many family owners own a large portion of the outstanding stock, making it unavailable to the general public. Naturally countries with larger more and developed stock markets have larger market capitalizations and larger free-float percentages, and therefore end up having the lion’s share of the index.

The chart below shows the concentration for the top 5 countries in the index. China, South Korea and Taiwan account for 44% of the index. Approximately 10% more is accounted by the remaining Asian countries: Malaysia, Indonesia, Thailand and Philippines. Latin America accounts for c. 20% (driven by Brazil) and Africa for less than 10%. The two main ETFs tracking this index, Vanguard’s Emerging Markets ETF (VMO) and iShares Emerging Markets ETF (EEM) suffer from the same bias.

MSCI states that it frequently revises the composition of the index based “extensive discussions with the investment community”, though South Korea is still part of the index despite it is considered an “advanced economy” by the IMF and CIA, a “high income economy” by the World Bank, and a “developed market” by Dow Jones, FTSE and S&P. Additionally, Taiwan is considered an advanced economy by the IMF. Coincidentally, South Korea and Taiwan make up over 26% of the index.

The graph below shows the share by country grouped by regions for VMO, which closely tracks the MSCI EM Index:

For more information please see the full article link: Emerging market ETFs are over 50% concentrated in Asian equities

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Commodity ETFs like USO and UNG often do not track the performance of the underlying indices due to contango, or the market state where the price of an energy futures contract trades above the expect spot price at maturity. Since commodity ETFs purchase commodity futures contracts to mimic spot performance, they fall victim to contango as they roll their futures positions from one month to the next.

For example, an investor should be able to see clearly that during West Texas intermediate (WTI) crude oil’s recovery from January 2009 to April 2011, from $35/barrel to $112/barrel (+320%), USO, the United States Oil Fund LP ETF, only rose from $24 to $45 (87.5%).

The worst commodity performer in terms of contango is natural gas, represented by the UNG ETF. The roll cost for UNG can be greater than 8% per year, which can cause steep losses for the retail investor, despite a price appreciation in the underlying commodity. In the graph below, you can see that the value of the ETF has fallen 96.4% in 4 years, while natural gas prices have only fallen about 79%. This has been terrible for investors trying to capture the price movements of natural gas.

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Several Latin America oriented ETFs such as MSCI Brazil Index Fund (EWZ) or Global X InterBolsa FTSE Colombia 20 ETF (GXG) have a larger proportion of their holdings concentrated in the financial sector. These holdings are usually concentrated in nature, with a few large cap securities accounting for most of the sector exposure. While the increased concentration may be seen as a negative by most investors, the keen investor may be able modify his or her exposure to the sector accordingly.

An example of an ETF with too much financial exposure is GXG. A quick glance at its fact sheet will reveal that the ETF’s financial sector exposure is almost 25%. First of all, investors need to avoid being mislead by the category titles. For example, GXG’s exposure to the Financials sector seems to be only 17%, but there is an additional 7.5% within a  category called Financial Services. Reviewing the Top 10 Holdings in the fact sheet will show that Bancolombia, Grupo Aval and Banco Davivienda are the main financial stocks in the portfolio, and that they account for c. 22% of holdings. Investors not familiar with the emerging market companies highlighted in fact sheets can perform a quick Google Finance search to define the industry classifications for unknown tickers.

Below we illustrate how to neutralize the exposure to the financial sector by selectively shorting the ETF holdings. The process is as follows:

1. Find the ETF portfolio holdings for which exposure is to be eliminated.
2. Calculate the weight of those companies within the ETF and get the equivalent dollar value for the investment in the ETF.
3. Divide the dollar share of each company by its price to get the number of shares to short.

For example, Bancolombia is currently trading at COP27,600, equivalent to $15.19.  Bancolombia has a weight of 12.1% in GXG, so assuming a $1,000 investment in GXG, the dollar share of Bancolombia would be $121.In order to eliminate the exposure to Bancolombia, one would have to  sell short the equivalent amount of shares, which is obtained by dividing the dollar exposure by the share price: $121.00 / $15.19 = 8 shares. The 8 shares sold short would cancel out the $121 of exposure to Bancolombia. The same could be done for the other three banks, as shown below. Note that the number of shares may not be a whole number, in which case one can round to the closest whole number, keeping in mind the hedge will not be perfect.

To see the entire article and table, please see the following Market Realist link: Reducing Financial Exposure in Brazilian ETFs

©2013 Leverage Academy Forum. All Rights Reserved.

As the S&P 500 index approaches new highs not seen since 2007, the current market’s P/E is some 2 multiple points lower than in ’07 which means that stocks are not as expensive despite being close to making new highs. In concert with this more favorable valuation currently for stocks, we point out there is still ample cash on the sidelines that could be invested which could fuel even further gains for equities.

As the stock market approaches the all-time high for the S&P 500 of 1,565 which was hit on October 10th, 2007, we note that the current valuation of the S&P 500 in early 2013 is substantially cheaper than that high level made in ’07. This could mean further gains for stocks as investors continue to adjust their asset allocation. The current day’s market level of 1,507 represents $108 in all S&P 500′s company’s earnings per share (EPS) resulting in a price to earning’s ratio of just 13.9x. This $108 in EPS for the index currently is a much improved number from the earnings level expected in 2007 which was only $95 per share. This valued the market at 16.5x earnings at the time in 2007, or over 2 multiple points higher than the current valuation now.

For the full article, please follow the link below: Market Realist S&P500 P/E Ratio Below Long Run Average

©2013 Leverage Academy Forum. All Rights Reserved.

In this investor letter, Ackman discusses the idea of time arbitrage, which is taking advantage of forced sellers for the benefit of long term profit. This is because stocks are often more volatile than their underlying businesses, and few firms and individuals can stomach volatility.

He also discusses that private equity portfolio companies, because of their higher implied leverage, have much more volatile returns, but unfortunately, you do not see a mark-to-market as you do in publicly traded equities.

Enjoy the letter below:

Pershing-Square-Q1-2012

©2013 Leverage Academy Forum. All Rights Reserved.

The video is also below:

Banking & Fiscal Issues

• “There is an interrelated problem of the banking system and the excessive risk premium on sovereign debt – they are Siamese twins, tied together and you have to tackle both.”
• Soros summarizes the forthcoming Eurozone Summit ‘fiasco’ as fatal if the fiscal disagreements are not resolved in 3 days.
• There is no union without a transfer.
• Europe needs banking union.
  • Germany will only succumb if Italy and Spain really push it to the edge (Germany can live in the present situation; the others cannot)
  • Europe needs a fiscal means of strengthening growth through Treasury type entity
    • What is needed is a European fiscal authority that will be composed of the finance ministers, but would be in charge of the various rescue mechanisms, the European Stability Mechanism, and would combine issuing treasury bills.
      • Those treasury bills would yield 1% or less and that would be the relief that those countries need in order to finance their debt.
      • Bill would be sold on a competitive basis.
      • Right now there are something like over €700bn euros are kept on deposit at the European Central Bank earning a 0.25% because the interbank market has broken down, so then you have €700bn of capital that would be very happy to earn 0.75% instead of 0.25%, and the treasury bills by being truly riskless and guaranteed by the entire community, would yield in current conditions less than 1%.
      • Governments should start a European unemployment scheme, paid on a European level instead of national level.
      • Soros’ solutions, however, are unlikely to prove tenable in the short-term as he notes “Merkel has emerged as a strong leader”, but “unfortunately, she has been leading Europe in the wrong direction”.
        • “Euro bonds are not possible because Germany would not consider euro bonds until there is a political union, and it should come at the end of the process not at the beginning.
        • This would be a temporary measure, limited both in time and in size, and thereby it could be authorized according to the German constitution as long as the Bundestag approves it, so it could be legal under the German constitution and under the existing treaties.
        • The political will by Germany to put it into effect and that would create a level playing field so that Italy and Spain could actually refinance debt on reasonable terms.

        
        

Scenario Discussion

• LTRO would be less effective now
• At 6%, 7% of Italy’s GDP goes towards paying interest, which is completely unsustainable
• Spain may need a full bailout if summit is not successful
  • Financial markets have the ability to push countries into default
  • Because Spain cannot print money itself
  • Even if we manage to avoid, let’s say an ‘accident’ similar to what you had in 2008 with the bankruptcy of Lehman Brothers, the euro system that would emerge would actually perpetuate the divergence between creditors and debtors and would create a Europe which is very different from open society.
  • It would transform it into a hierarchical system where the division between creditors and debtors would become permanent…It would lead to Germany being in permanent domination.
    • It would become like a German empire, and the periphery would become permanently depressed areas.

On Greece

• Greece will leave the Eurozone
  • It’s very hard to see how Greece can actually meet the conditions that have been set for Greece, and the Germans are determined not to modify those conditions seriously, so medium term risk
  • Greece leaving the euro zone is now a real expectation, and this is what is necessary to strengthen the rest of the euro zone, since Greece can’t print money
  • By printing money, a country can devalue the currency and people can lose money by buying devalued debt, but there is no danger of default.
    • The fact that the individual members don’t now control the right to print money has created this situation.
    • A European country that could actually default. and that is the risk that the financial markets price into the market and that is why say Italian ten-year bonds yield 6% whereas British 10-year bonds yield only 1.25%.
• That difference is due to the fact that these countries have surrendered their right to print their own money and they can be pushed into default by speculation in the financial markets.

On Angela Merkel

• Angela Merkel has been leading Europe in the wrong direction. I think she is acting in good faith and that is what makes the whole situation so tragic and that is a big problem that we have in financial markets generally – she is supporting a false idea, a false ideology, a false interpretation which is reinforced by reality.
• In other words, Merkel’s method works for a while until it stops working, and that is what is called a financial bubble
  • Financial bubbles look very good while they are being formed and everyone believes in it and then it turns out to be unsustainable…
  • The European Union could turn out to have been a bubble of this kind unless we realize there is this problem and we solve it and the solution is there.
  • I think everybody can see it, all we need to do is act on it, and put on a united front, and I think that if the rest of  Europe is united, I think that Germany will actually recognize it and adjust to it.

On Investing

• Stay in cash
• German yields are too low
• If summit turns out well, purchase industrial shares, but avoid everything else (consumer, banks)

Conclusion: We are facing conditions reminiscent to the 1930s because of policy mistakes, forgetting what we should have learned from John Maynard Keynes.

©2013 Leverage Academy Forum. All Rights Reserved.

Click here to view the embedded video.

Burry left work as a Stanford Hospital neurology resident to become a full-time investor and start his own hedge fund. He had already developed a reputation as an investor by demonstrating astounding success in “value investing,” which he wrote about on a message board beginning in 1996. He was so successful with his stock picks that he attracted the interest of such companies as Vanguard, White Mountains Insurance Group and such prominent investors as Joel Greenblatt.After shutting down his web site in November 2000, Burry started Scion Capital, funded by a small inheritance and loans from his family. The company was named after The Scions of Shannara, a favorite childhood book.

Burry quickly earned extraordinary profits for his investors. According to Lewis, “in his first full year, 2001, the S&P 500 fell 11.88 percent. Scion was up 55 percent. The next year, the S&P 500 fell again, by 22.1 percent, and yet Scion was up again: 16 percent. The next year, 2003, the stock market finally turned around and rose 28.69 percent, but Mike Burry beat it again—his investments rose by 50 percent. By the end of 2004, Mike Burry was managing $600 million and turning money away.” In 2005, he veered from value investing to focus on the subprime market. Through his analysis of mortgage lending practices in 2003 and 2004, he correctly forecast a bubble would collapse as early as 2007.

Burry’s research on the runaway values of residential real estate convinced him that subprime mortgages, especially those with “teaser” rates, and the bonds based on these mortgages would begin losing value when the original rates reset, often in as little as two years after initiation. This conclusion led Burry to short the market by persuading Goldman Sachs to sell him credit default swaps against subprime deals he saw as vulnerable. This analysis proved correct, and Burry profited accordingly. Ironically Burry’s since said, “I don’t go out looking for good shorts. I’m spending my time looking for good longs. I shorted mortgages because I had to. Every bit of logic I had led me to this trade and I had to do it”. Though he suffered an investor revolt before his predictions came true, he earned a personal profit of $100 million and a profit for his remaining investors of more than $700 million. Scion Capital ultimately recorded returns of 489.34 percent (net of fees and expenses) between its November 1, 2000 inception and June 2008.

The S&P 500 returned just over two percent over the same period. According to his website, he liquidated his credit default swap short positions by April 2008 and did not benefit from the taxpayer-funded bailouts of 2008 and 2009. He subsequently liquidated his company to focus on his personal investment portfolio. In a April 3, 2010, op-ed for the New York Times, Burry argued that anyone who studied the financial markets carefully in 2003, 2004, and 2005 could have recognized the growing risk in the subprime markets. He faulted federal regulators for failing to listen to warnings from outside a closed circle of advisors. In April 2011, he suggests: (1) Open a bank account in Canada, (2) there are opportunities in small cap stocks, and (3) blue chips may be less attractive than their price-earnings suggests.

©2013 Leverage Academy Forum. All Rights Reserved.

We have seen the dire economic consequences of excessive consumer, corporate, financial, and sovereign leverage of the past 5 years. Our global economy has been a punching bag for corporate greed, political incompetency, and poor central bank planning. From shadow banking and derivatives (“weapons of mass destruction” according to Mr. Buffet) in the United States to Greece’s fraudulent attempt to the enter the Eurozone, world markets have been whipsawed every year since 2007. I cannot help but feel deep remorse after witnessing multiple occasions of the VIX above 40, sovereign CDS making multi-year highs, and political uprising. Five years later, we have yet to learn that leverage is the primary cause of our pain.

Despite an Icelandic bankruptcy, 2 Greek bailouts, a Portuguese bailout, and Irish bailout, and a U.S. bank bailout, 35% of U.S. homes underwater, and 20%+ unemployment rates in certain Western nations, student loans have emerged as yet another bubble, the U.S. consumer savings rate remains below 4%, European banks are levered 26x on average, and countries continue to borrow at astronomical rates. Are we doomed to repeat our mistakes? Sadly, the answer seems to be yes.

Every 2 generations (70-80 years), individuals tend to forget the pain that their forefathers felt in a deep economic contraction. The Great Depression certainly did its job. Maybe we need a constant painful reminder to reign in our tendency to express “irrational exuberance?” Luckily, for learning purposes, a global debt deleveraging cycle is the most painful type of contraction. Hopefully, our children and grandchildren can learn from our mistakes.

Until then, I have started this series to explain the BANKRUPTCY process, specifically the U.S. Ch. 11 process, as I continue to do my part to clean up the riff-raff, the banksters, the incompetent politicians, and the corrupt corporate bureaucrats holding back true capitalism.

• Bankruptcy is governed by federal statute (11 U.S.C., Section 101):
  • For the equitable distribution among creditors and shareholders of a debtor’s estate in accordance with either the principle of absolute priorities or the vote of bankruptcy majorities of holders of claims
  • To provide a reasonable opportunity, under Chapter 11, to effect a reorganization of business
  • For the opportunity to make a “fresh start” through, among other things, the discharge of debts

• The goals of bankruptcy are:
  • To afford the greatest possibility of resolution for the estate as a whole, while maintaining the balance of power as between all creditors and the debtor as of the petition date

• Debtor’s rights and protections include:
  • Automatic stay: an automatic injunction to halt action by creditors
  • Exclusivity to formulate/propose plan of reorganization
  • Continued control and management of the Company
  • Assumption/rejection of executor contracts and unexpired leases
  • Asset sale decisions
  • Avoidance actions
  • Discharge of claims

• Secured creditor’s rights and protections:
  • Secured to extent of value of collateral
  • Limitations on debtor’s ability to use proceeds/profits of collateral (“cash collateral”)
  • Entitled to “adequate protection” for use of collateral or diminution thereof
  • Entitled to relief from automatic stay for cause shown
  • Entitled to interest and reasonable legal fees when collateral value exceeds debt
  • Entitled to be paid in full in cash or to retain lien to the extent of its allowed claim and receive deferred cash payments totaling at least the allowed amount of such claim

• Unsecured creditors’ rights and protections include:
  • Majority voting controls
  • Improved and mandated disclosure by debtor
  • Committee representation at debtor’s expense
  • Ability to challenge business judgment of debtor
  • Absolute priority rule generally ensures payment before distribution to existing equity security holders
  • Ability to examine/challenge validity and enforceability of liens and, if debtor refuses, to obtain authority to bring fraudulent conveyance, preference and other actions
  • May continue to exercise corporate governance subject to limitations
  • Valuation as the fulcrum and equalizer of debt and creditor powers

• Equity may also seek committee representation under certain circumstances and thereby obtain leverage similar to that of creditors’ committee

~Xavier, Leverage Academy Instructor

(All similar entries are in LA’s “Bankruptcy” folder on the right of the blog.)

©2013 Leverage Academy Forum. All Rights Reserved.

According to ZeroHedge, the Bank of Spain has recently nationalized Bankia, the first of many nationalizations that have to occur in Spain because of poor underwriting by the cajas (regional banks/savings and loan institutions) and falling real estate prices. The Spanish housing price graph above shows how much further the property bubble went in Spain, where at one point, more than 15% of the labor force was working in construction.

With a government debt to GDP ratio of 70%, and another 30%+ of municipal debt, where is Spain getting the money to accomplish these bailouts?

By Alexander Lemming, Leverage Academy Associate

Statement on BFA-Bankia

The Board of Finance and Savings Bank (BFA) announced today the Bank of Spain its decision not to buy in the terms and conditions agreed to the securities issued in the amount of € 4.465m who signed the FROB (Bank Restructuring Fund). BFA has concluded that the most desirable to strengthen the soundness of the business project that began with the appointment of Jose Ignacio Goirigolzarri as president is to request the conversion of these titles in stock ordinary. This conversion must be authorized by the Bank of Spain and the other authorities Spanish authorities and community and will be conducted in accordance with the valuation process established in the indenture securities.

The Bank of Spain has worked hard in recent months with the group address BFA-Bankia to specify the measures to ensure compliance with the provisions of the RD-l 2/2012 for the sanitation Spanish financial system. BFA-Bankia late March presented a restructuring plan and restructuring that included measures that would comply with the RD-l, and standardize its financial  position.

After analyzing this reorganization plan, the Bank of Spain also ordered the entity measures complementary to streamline and strengthen management structures and management, increasing professionalization and a divestment program. These additional actions should serve to enhance the soundness of the institution and restore market confidence. The events of the past weeks and the growing uncertainty about the future of the company has made it advisable to go further and raise the providing resources to accelerate and increase public sanitation.

The changes in the presidency of BFA-Bankia is precisely oriented in the direction shown in professional management and allow the group to boost its restructuring program. The new address of the entity must submit in the shortest possible plan of reorganization strengthened that places BFA-Bankia able to cope with a full guarantee its future.

In any case, BFA-Bankia is a solvent entity that continues to function quite normally and customers and depositors should have no concern. (ZHedge)

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