Primus Guaranty (PRS) announced yesterday that it entered into a significant credit mitigation deal with one of its counterparties, reworking $1.2 billion in notional value of credit default swaps. According to the press release, $40 million in notional exposure written on a monoline insurer was terminated for $15 million, or 37.5 cents on the dollar. The other billion-plus is being moved to a subsidiary of Primus Financial capitalized with $36 million, which is the maximum exposure (plus future premiums on those swaps) that can be lost.

Working backwards, ring-fencing certain swaps clips the tail risk existing in the portfolio at about 3.1% – a fairly high level that’s about 50% above what I’ve modeled previously. From the press release, my assumption is that the counterparty is willing to do this to minimize credit/counterparty risk related to Primus; it’s not collateral per se, but it functions in the same way.

As for the monoline settlement, well, it speaks volumes about what happens if you aren’t a systemic risk – privately negotiated solutions actually come about, and it means that companies that took risks take losses (or at least agree to accept more uncertainty/variability). One possibly safe extrapolation: if counterparties to a company that doesn’t warrant liquidity concerns like Primus are willing to take substantial haircuts on their CDS transactions, you better believe that Santa Claus came down the chimney for everyone with claims against AIG that were repaid in full. It’s simply a perverse trait of the financial system, and our government, that smaller players are left to deal amongst themselves, whereas larger players are assisted and handed a different set of rules to play by.

More to come after earnings next week…

Lastly, a non-related note. I’ve learned a lot from David Merkel, and he asked those who read them to link to this about the SEC. It’s the least I can do, and I encourage you to read it.

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Disclosure: I own both Primus stock (PRS) and debt (PRD).

This isn’t going to be a typical book review, because my thoughts on the book can be summed up in a concise manner, and I think the real story is much more relevant in regards to current events.

Goldman Sachs: The Culture of Success is written by a former Vice-President at the company, detailing the path taken to the firm’s 1999 IPO. It’s a fairly involved historical work that covers major events and people that made Goldman what it was at the time it went public (the book was published in early 2000, so no vampire squid references). My two complaints:

That said, Goldman Sachs (GS) makes for a good story, albeit one that is not overly colorful – chalk it up to Goldman’s insistence on teamwork, but there are few real characters; the typical biography is a dignified portrayal of top management.

With Goldman’s success, there’s a temptation to view this as a case study in how to great a global financial services company, or manage an organization. I think that’s misleading for two reasons. First, there’s certainly an element of change to surviving as a Wall Street partnership through a tumultuous century-plus. Second, there’s no identifiable hard-and-fast rule beyond “be long-term greedy,” and management’s judgment at various times led the firm to move aggressively into and quickly away from the same business, like asset management.

One theme that runs through the book is the changing culture at Goldman Sachs, and how it became more short-term greedy at times; normally this led to a period of bad results down the line. A central issue: can Goldman (or any investment bank) compete with its clients through proprietary risk-taking, and still play the proper role in serving their clients? Goldman’s actions have indicated they believe it’s possible, or at least beneficial to them to do both. Compounding that issue is the capital structure of the firm, which was a partnership (with unlimited personal liability for members) before the IPO removed that onus.

When Goldman was a partnership, there was significant downside to prop trading and other risky activities – namely, a large failure could bankrupt the individual partners at Goldman. Under the current structure, that isn’t the case, as the classic equity call option exists. Did the reformulation of Wall Street into a corporate world, as opposed to a partnership world, come with the creation of systemic risk? I don’t have any hard evidence, but I can’t imagine that the risks being taken in the middle of this decade would have occurred had personal liability still existed.

Roger Ehrenberg wants to make the compensation of traders more equity-like, which he says is the real story behind Andrew Hall’s potential $100 million payday from Citigroup (C). The partnerships of old risked their own capital to serve customers; the modern quasi-hedge fund risks the capital of others to primarily benefit employees. As unlikely as it might sound, looking back in time to smaller, more focused financial companies based on the partnership model offers a starting point for reframing the debate about Wall Street reach and compensation.

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Editor’s Note: Mike Price sends this list of books on economics and investing he has found helpful.

Economics

Economics in One Lesson
This book by (one time New York Times and The Nation writer) Henry Hazlitt, is widely considered the best intro to free-market economics.

It starts with the simple lesson (from Bastiat) that in economics one must evaluate every outcome for every group of people, then applied this lesson to a multitude of topics, all popular when he wrote the book 50+ years ago, and most still valuable today.

An Introduction to Economic Reasoning
This is a text book, it starts with the simple axiom that humans act and logically concludes economics from there.

Gordon fills the book with humor and easy-to-understand examples, plus, since it’s a textbook it comes with many question each chapter to solidify the knowledge learned.

Economics for Real People
Gene Callahan is one of my favorite thinkers today, this is his intro to Austrian Economics book.

Callahan starts by introducing real economics as an a priori science, one that must deal with real individuals, not aggregates. Then, like Mises & Rothbard, shows how economics logically follows from the action axiom.

I have read a lot of economics books before this one and understood likely outcomes of different situations, but this book is the one that tied it all together logically in my head.

The Politically Incorrect Guide to Capitalism
Bob Murphy is my favorite blogger, and his guide is the best for ending arguments (by winning them).

Like all the books in the PIG series (a couple of which are great, but some are crappy) he goes through the main arguments against his position and then destroys them.

It’s great for when you think you found a weakness in the market or can’t find a good way to show someone with whom you’re arguing why they are wrong.

The Politically Incorrect Guide to American History & 33 Questions About American History You’re Not Supposed to Ask

I own about 7 Tom Woods books and have read all but one of them - he is my favorite modern author. These two are great introductions to revisionist US history, showing how, in the US times of prosperity have always come from times of little government and much free market.

The Concise Guide to Economics
This book is more of an index, it contains 37 chapters, all economics topics, with 1-3 pages on each and 3-4 book recommendations for each.

I use it whenever I need a quick refresher on a topic.

Basic Economics
Sowell has written a litany of good economic books, and has a talent for finding examples for what he is trying to say and making it very easy to understand.

Sowell says economics is a science of scarce resources with alternative resources and show economics in that light. The book is very good, but does have some problems.

What Has Government Done to Our Money? Case for the 100 Percent Gold Dollar
In the best book on money ever written, Murray Rothbard shows that money always starts as a commodity, and that the same laws of supply/demand prevent government from doing any good when money is involved.

Investing

The Warren Buffett Way
This book is probably the most read book about Buffett, Hagstrom has written about 7 books about Buffett, Munger and how they invest and use mental models (a couple of which will be in future articles).

In this book, Hagstrom introduces the tenets Buffett uses to evaluate businesses - he looks at the Business, Management, Financials, and Valuation.

The Little Book That Beats the Market
Greenblatt has two books that are in the top ten investing books of all time. This one introduces earnings yield and return on capital, and shows how a screen of these companies returned 30% a year over an 18-year period.

The book serves as a great introduction to value investing and evaluating businesses.

Financial Fine Print & Quality of Earnings

The next two books serve as great introductions to accounting and starting to dig into the footnotes to gain a better understanding of the business and the integrity of those who run it.

Mosaic: Perspectives on Investing
The last book on this list is by, possibly, the best modern thinker in investing - Mohnish Pabrai. I have been to three of his investor’s meeting and can attest that they live up to the expectations.

This book is a collection of articles on investing, Pabrai has a lot of unorthodox views, he talks a lot about finding a company’s DNA, using a latticework of mental models and using a DCF that has a lot of conservatism built in.

The book starts at $130 on Amazon and is approaching Margin of Safety like prominence, but most of the articles have been archived on the internet and you can find them here.

Conclusion
My public speaking professor showed our class a statistic that claimed humans, on average, retain only about 20% of what they read - so don’t get let down if you’ve read 3-4 of these books and still don’t quite ‘get it,’ I am still not as proficient in economics and investing as I’d like after reading these books and many more, but after each book I read more and more of the whole framework ‘clicks’ in my head and I not only understand that part, but the rest of what I understand seems to make more sense.

Also, I welcome any and all suggestions of different books that also serve as great introductions to investing and economics.

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If you needed something to temper the bullishness that’s gripped the markets, here it is… wallboard maker USG reported second quarter earnings yesterday. From the conference call:

Looking ahead at the remainder of 2009 and into next year, we are not expecting much improvement in our markets. More specifically, we are planning for low levels of residential construction, though some stabilization seems on the horizon, a continuing slowdown in repair and remodel and a fairly significant drop in new non-residential construction.

The new residential construction market has fallen so far that there’s really not much more room for further declines. The market appears to be stabilizing and the June starts figure of 582,000 is somewhat encouraging, but there’s no evidence yet of a meaningful rebound.

Looking down 2009, stability in the new residential and repair and remodel markets will be a welcome relief. The major area of concern right now is non-residential construction. It declined on the second quarter and is likely to continue declining for the next several quarters.
-USG CEO Bill Foote

With USG’s last earnings report, I noted that unit pricing for wallboard was still improving, despite falling demand and a huge amount of excess capacity in the industry. While giving kudos to USG for being able to raise prices, it was a puzzling phenomenon and one that wasn’t sustainable. This quarter, the amazing levitating pricing power came to a halt, and slipped back half a percent, to $120.79/msqft. While far from huge, it snaps a string of four consecutive quarters where average realized price rose, although the streak of consecutive quarters with declining shipments hit five.

USG is also carefully monitoring their liquidity after having to accept $400 million in new capital at a high interest rate and on heavily dilutive (35% or so) terms. CapEx is forecast to be $50 million annually over the next two years, an extremely low figure relative to earlier spending. There’s been too much building in the wallboard industry, USG included, and their plants are on the newer side – this shouldn’t be a problem, but it is an indicator that they don’t expect a material improvement in cash results and are being extremely cautious. Various non-strategic asset sales were also discussed, with the hope of raising an extra $50 to $100 million.

Another exchange of note: commercial demand is expected to be down 20% to 25% year-over-year, but are there pockets of residential real estate that are less bad?

I’m sure it won’t come to any surprise Florida, Arizona, Nevada are still under extreme demand pressure, and the outlook is a pretty tough market. The inner mountain area is a good area. The Midwest area is still fairly solid and pockets in the Northeast.
-USG COO Jim Metcalf

To conclude, a few updated charts relating to various data on USG’s operations and stock performance. First, wallboard prices, the stock price, and the historical price-to-sales (P/S) – even if things look grim, the P/S multiple has been steadily improving, and that’s not because sales are going up.

On to quarterly financial results – again, management deserves credit for controlling what can be controlled. End user markets are terrible, but losses have narrowed and the cost structure is such that a $400 million drop in comparable quarter revenue didn’t move the needle on operating loss.

Finally, a chart of wallboard volumes and how shipment rates have changed. The year-over-year decline was the worst seen at any point in this cycle, and the quarter-over-quarter numbers were marginally worse than last time as well.

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Disclosure: No personal position in USG. Some chart data sourced from Gridstone Research.

This is a long overdue follow-up to a previous post on whether or not the ratings agencies are good candidates to be sold short. CalPERS is suing Moody’s (MCO), S&P, and Fitch, saying that their ratings “proved to be wildly inaccurate and unreasonably high.”

Hindsight is 20/20. Are the ratings agencies legally liable for misjudging the risks to instruments they rated? After all, the lawsuit documents say that CalPERS relied on the “AAA/Aaa” ratings given to the SIVs they purchased. The ratings agencies have the special privilege of a protected franchise, but if CalPERS is truthful that it only invested in SIVs because of the rating, it should have been damn sure that the ratings were appropriate.

CalPERS goes on to say that the assets held by their SIVs were confidential, so there is no way they could have known about the risks of their investment assets. Why were they investing in securities whose value was dependent on something unknowable to them? I’m not an expert on fiduciary responsibilities, but admitting an ignorance of what was owned seems like a pretty clear breach of some basic tenants.

The failings aren’t all on CalPERS. There’s plenty of blame to go around, and the ratings agencies certainly share in that blame. Recovering losses from them, however, crosses a new line and establishes that they have a legal liability for the losses suffered by those whose money they were not managing. Except in cases of fraud, asset managers are not held liable for investment losses; why should the ratings agencies be any different?

Maybe Moody’s looks like an attractive short because it has a negative book value. The value of Moody’s, though, has no relation whatsoever to book value; it’s all about the earnings to be had from acting as a toll between issuers and the debt markets. You can’t put that on a balance sheet, and it’s going to be hard to kill off that advantage for several more years at a minimum – and Moody’s will make a lot of money during that time (this, I assume, is why Buffett owns so much of the stock).

Regulators want to change the relationship between issuers and raters to make it appear more arms-length. As long as the emphasis is on that, and not on explicitly hurting the profitability of the ratings business (as it is with healthcare), I find it hard to believe Moody’s is an attractive short. Right now, the best hope for that is an off-the-wall jury verdict in favor of CalPERS, which looks improbable if not legally impossible.

Court Documents - CalPERS v. Moody’s

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