Francis Chou Semi-annual Letter – Observations From a Man Who Identified Early the Opportunity In Credit Default Swaps
Over the past 15 years his US$ Chou Associates fund is up 13.2% vs 6.2% for the S&P 500. I remember vividly reading the following from Mr. Chou in 2007 in reference to his 2006 letter which was well prior to the credit collapse:
“Credit default swaps (CDS)
In last year’s letter, we informed investors of our interest in CDS. We wrote, “In terms of investment ideas in derivatives, we believe that CDS are selling at prices that are compelling. At recent prices, they offer the cheapest form of insurance against market disruptions. In CDS, one party sells credit protection and the other party buys credit protection. Put another way, one party is selling insurance and the counterparty is buying insurance against the default of the third party’s debt. The Chou Funds would be interested in buying this type of insurance…. To give you some sense of perspective, in October 2002, the 5 year CDS of General Electric Company was quoted at an annual price of 110 basis points. Recently, it was quoted at an annual price of 8 basis points. To make money in CDS, you don’t need a default of the third party’s debt. If there is any hiccup in the economy, the CDS price will rise from these low levels. The negative aspect is that, like insurance, the premium paid for the protection erodes over time and may expire worthless.”
Subsequent to that letter it took until mid September 2007 for all of our compliance and regulatory approvals to be put into place and by then the prices of CDSs had moved appreciably. In accordance with our prospectus we could invest no more than 5% of the net assets of the Fund, at the time of purchase, in CDSs.
We missed the low hanging fruit, but the good thing is we now have these approvals in place and can exploit the situation next time. The current price of General Electric’s 5 year CDS is at 168 basis points, and shows the potential for gain.”
“General Comments on the Market
NON-INVESTMENT GRADE AND INVESTMENT GRADE BONDS ARE NOW FULLY PRICED: Non-investment grade bonds have rallied tremendously from their lows in March 2009, and at current prices we believe they are close to fully priced. For example, three and a half years ago the spread between U.S. corporate high yield debt and U.S. treasuries was 311 basis points. Currently, it is about 696 basis points, down from its peak of over 1,900 basis points in December
Similarly, we believe that investment grade bonds are now close to fully priced. However, when compared to corporate bonds, U.S. treasuries are in bubble territory. In our opinion, this is the worst time to hold cash and short-term treasuries unless you believe we are headed into a 1930s style depression. And if you believe that you should redeem all your Fund units. In equities, we believe the financial, retail and pharmaceutical sectors are undervalued. REVISITING THE BANKS: In the 2006 annual report, we noted our alarm at the cavalier approach of financial institutions with regard to their lending standards, particularly to subprime borrowers. We also expressed concern with the widespread use of derivatives by financial institutions. In the annual letter to unitholders, dated March 2, 2007, I wrote:
Derivatives and financial institutions We remain a keen and interested observer of derivative instruments. Derivative instruments are financial instruments created by market participants so that they can trade and/or manage more easily the asset upon which these instruments are based. Derivatives are not asset classes unto themselves. Their values are derived solely from an underlying interest, which may be a commodity such as wheat or a financial product such as a bond or stock, a foreign currency, or an economic/stock index.
According to the Bank for International Settlements, contracts outstanding worldwide for derivatives at the end of June 30, 2006 rose to $370 trillion. We are alarmed by the exponential rise in the use of derivatives. No one knows how dangerous these instruments can be. They have not been stress tested. However we cannot remain complacent. We believe the risk embedded in derivative instruments is pervasive and most likely not limited or localized to a particular industry. Financial institutions are most vulnerable when (not if) surprises occur – and when they occur they are almost always negative.
As a result, we have not invested heavily in financial institutions although at times their stock prices have come down to buy levels. Some 30 years ago, when an investor looked at a bank, he or she knew what the items on the balance sheet meant. The investor understood what criteria the bankers used to loan out money, how to interpret the loss reserving history, and how to assess the quality and sustainability of revenue streams and expenses of the bank to generate reasonable earnings. That was 30 years ago and you can see how easy it was to evaluate a bank. …. Now, when an investor examines a bank’s financials, he or she is subjected to reams of information and numbers but has no way of ascertaining with a high degree of certainty how solid the assets are, or whether the liabilities are all disclosed, or even known, much less properly priced. As the investor digs deeper into the footnotes, instead of becoming enlightened, more doubts may surface about the true riskiness of the bank’s liabilities. Those liabilities could be securitized, hidden in derivative instruments or morphed into any number of other instruments that barely resemble the original loans. It is meant to show just how creative participants have been in producing new derivative products, with little regard for a sound understanding of their leverage and true risk characteristics. We may be witnessing a ‘tragedy of the commons’ where the search for quick individual profits is causing a system-wide increase in risk and reckless behaviour. Sub-prime mortgage lenders
Some of the greatest excesses of easy credit were committed by sub-prime mortgage lenders. Credit standards were so lax and liberal that homeowners didn’t even need to produce proof of ownership to be able to borrow up to 100% or more of the appraised value of their houses.
Companies with the most liberal lending practices have started to report serious, even crippling, financial problems. Some optimists believe that the worst is over. However, they may be in for a surprise. Instead of it being the darkest hour before the dawn, it could be the darkest hour before pitch black. It will take a while (and maybe a long while) for the excesses to wring themselves out of the system. Well, starting in 2007, financial institutions went through a cataclysm. Directly or indirectly, almost all of them had to be bailed out by the U.S. government. Looking back at the crisis, this is what we have observed:
1) The U.S. government will not let major financial institutions fail. 2) The financial institutions that survive will be the ultimate beneficiaries of any recovery in the economy.
3) Interest rates will be kept at artificially low levels for the foreseeable future. The spreads between what the banks are paying for deposits and borrowings in the market (like FDIC insured), and what they can lend at is enormous. After being severely burned, they have tightened their lending criteria and have been extremely cautious with their lending practices. In general, the quality of loans now being made are quite high and for the first time in many years, banks are being paid handsomely according to the risks they are taking.
4) Financial institutions in general are hoarding capital. This will provide them with ample cushion to absorb losses if a double dip recession were to occur. 5) The books of financial institutions were carefully examined by all kinds of government agencies, including regulators, before the government allowed them to repay the U.S. Treasury under the Troubled Asset Relief Program (TARP). 6) Most of the big banks are selling below 10 times their potential earning power in the future.”
Interesting reading. Francis seems more optimistic than his friend Prem Watsa of Fairfax, and actually quite similar in positioning to Bruce Berkowitz of Fairholme.
I wrote an article comparing the recent actions of Berkowitz and Watsa.
Francis Chou is fascinating individual. He has only a grade 12 education and worked at Bell Canada as a repairman after coming to Canada from India in 1976. He learned investing be reading Ben Graham and Warren Buffett and obviously took to it naturally. 10 years ago he was virtually unknown and had a tiny amount of money under management. Today he is a must read.