Wednesday, August 13, 2008

Bill Miller Continues to Boggle Me - Increasing Stake in Freddie Mac (FRE)

For those of you new to the markets, Bill Miller used to be the mutual fund star - beating the S&P 500 for 15 years in a row. He has fallen into tough times the past few years as we outlined in April [Apr 9: Bill Miller is #596! Ouch] As I wrote then

Bill Miller is a mutual fund manager who had an incredible streak of 15 years in a row of beating the S&P 500 (this ended in 2006). He took large contrarian bets in concentrated fashion so hence why I have followed him with interest. I saw an article a few months ago about how he was buying financials, homebuilders, and the like and I just felt bad. Maybe over a 4-6 year time frame, but for the short term.... not so much

Probably his fund has had a few good weeks here on this "buy the junk" rally, but he was piling into those sectors during the winter before multiple legs down. And still (in my mind) a lot of trouble ahead.

While I agree with his recent comments [Aug 5: Bill Miller "Toughest Market I've Seen"] especially for those of us who are not computers and use fundamentals, moves like this boggle me. Talk about throwing gasoline on the fire.
  • SHARES OF Freddie Mac (ticker: FRE) have been in freefall recently but Legg Mason has kicked off a buying spree at the mortgage lender, becoming its largest shareholder. On Monday Legg Mason (LM) disclosed it now owns 79,880,998 shares of Freddie Mac, or a 12.4% stake. At the end of the first quarter, Legg Mason owned 50,244,068 shares of the government-sponsored finance giant. (Adding 30M shares)

  • Baltimore-based Legg Mason filed as a passive shareholder and listed July 31 as the date when it reached the ownership threshold triggering the filing. Previously Legg Mason had been Freddie Mac's second-largest shareholder, edged out by Capital Research Global Investors.

  • Shares dropped to a 52-week intraday low $3.89 on July 11. Since then, the stock has made an incremental recovery, closing at $5.60 on Monday, down 30 cents.

  • "Bill Miller is going to look like the smartest guy in the room or the dumbest," says Lon Juricic, president of, referring to Legg Mason Capital Management's chairman and chief executive. "He's outperformed for so many years, but the credit crunch has him scrambling. Obviously he must still see some value in [Freddie] because he keeps putting shareholder money in it."
  • However, for Juricic, too many questions remain about Freddie Mac's future. "The question is will Freddie Mac be around in six months? When they go to raise capital, who's going to be there?" he says. "It's been trading like it's going to $0, and the Treasury hasn't detailed how they would structure any bailout, so there's concern that there's not going to be anything left over in the plan for common shareholders."
  • Following the report, Friedman, Billings & Ramsey analyst Paul Miller cut his target price to $5 from $7 and maintained an underperform rating on the stock, estimating that Freddie Mac will need to raise $10 billion to $15 billion of capital.

  • Miller’s Value Trust has lost a third of its value over the past year, Fortune’s Eugenia Levenson recently noted, weighed down by bad bets on Citi (C), Aetna (AET) and UnitedHealth (UNH) and hit by $2.4 billion in investor withdrawals.
So that's an interesting situation. A company with under a $5 Billion market cap (well under right now) needing to raise $10 billion... would need to tell its shareholders (if they use stock) we need to dilute you to the tune of 2:1. Meaning for every share you own we are going to issue 2. Is that cool with you? Somehow I think not.

While the equity markets continue its joy ride in the financials, the credit default swaps (a measure of risk) continue to devolve for the financials. Meaning the smart guys who sat in the back of the class with their calculators are increasingly worried while the rowdy jocks (and their computers) have ridden the equity up, up, and up the past month. I'll go with the guys in the back of the room.

Specific to Freddie we've spoken of the potential for these 2 Government Sponsored Entities to go bankrupt (effectively) at least for the common shares (debt will be protected by the printing press of the US government lest we lose all credibility in this world and bring the global financial system to its knees). Mr. Paulson now has his Congressional approved bazooka in which he can use your grandchildren's money to support the stocks (free markets and all).... but my thought is he will use your money to issue preferred stock which while in the interest of "fairness" destroy the common shareholder (read: going to $0). Now, last I checked 50M shares x $0 is no different than 80M shares x $0. But I'll check with those guys with the calculators to make sure my thesis is correct. While I admire Miller for continuing to run a concentrated portfolio this is an abject risk of shareholder money and smacks of desperation (my performance has stunk for years and I need a home run to get back).

I'm not the only one who believes this; none other than Bill Gross has said the same view.
  • Bill Gross, who manages the world's biggest bond fund, said the U.S. Treasury will probably be forced to buy as much as $30 billion of preferred shares in both Fannie Mae and Freddie Mac to help shore up their capital.
  • ``By the end of the third quarter, the preferred stock in Fannie and Freddie will be issued, the Treasury will have bought it,'' Gross, co-chief investment officer at Pacific Investment Management Co., said today in an interview on Bloomberg Television. ``We'll be on our way toward a joint Treasury-agency combination.''
  • Gross adds to a growing chorus of investors and analysts predicting U.S. Treasury Secretary Henry Paulson will need to use his newly won power to prop up Freddie and Fannie.
  • Freddie Chief Executive Officer Richard Syron today told investors the company will wait for its stock to improve before starting its planned $5.5 billion capital raising. (you're going to be waiting a long time....)
  • ``If they're unable to tap the markets to raise capital, we're talking a matter of quarters before the government has to step in,'' said Joshua Rosner, an analyst with independent research firm Graham Fisher & Co. in New York.
This market is without memory and while we are busy partying over the dramatic drop in gasoline from $4.19 to $3.79 (woo hoo, the consumer is back!) not much at all has changed in the financial world, other than a government induced short squeeze of epic proportions [Jul 26: Government Ban on Naked Short Selling in 19 Financials Created the Greatest Short Squeeze of sll Time] and Merrill Lynch essentially paying someone (22 cents on the dollar but we'll finance 75% of the deal and if you lose money, we'll take most of the hit) to get rid of their CDOs [Jul 29: The Bottom is in Financials - Version 23,472]. The seals are clapping all this as good news, but the bond guys are mocking them. The bond guys have consistently been correct - each time the market ran off to a counter trend rally the bond market has stayed consistent and on even keel (read: negative) - both in fall 2007 (all time highs post Federal Reserve emergency cuts) and spring 2008 (post Bear Stearns) ... and now. So we know what followed those periods of disconnect between the bond guys and the equity guys. The equity guys were shown they were "wrong"... again. I continue to believe risk is high, and the Kool Aid consumption is even higher.

Now that the Kool Aid is thick in the air, and we seem to have a failed attempt on the S&P 500 to break back through the 50 day moving average - I've been adding back to Ultrashort Financial (SKF) in scale. Expect the attention sometime in the next 1-6 weeks to return to those financials, especially of the government sponsored type as the attention deficit disorder generation finds something new to fuss about once the oil crisis becomes boring for them to trade. A few more name banks should also be "IndyMac'ing" soon enough to capture the A.D.D. crowd's attention - hi Downey Financial (DSL)

Buy Freddie stock? When it acts like this even with all of King George's Horses and Men flailing to save it? You first. No.... I insist.

Long Ultrashort Financial in fund and personal account

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