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JAMES GRANT EDITOR

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Vol. 29 Winter Break Two Wall Street, New York, New York 10005 • www.grantspub.com December 30, 2011

Ready-mixed short sale

(October 21, 2011) China’s empty to invest, and how not, capitalists de- shovels of the modern infrastructure in- apartment towers, redundant bridges pend on interest rates, the prices that dustry. Concrete-making equipment is and untraversed highways wouldn’t balance the supply of savings with the Zoomlion’s forte, contributing 46% of exist without concrete—or without demand for savings. Capitalism being first-half 2011 sales. Cranes come next, the concrete pumps, concrete mix- honored more in the breach than in the at 34%, followed by sanitation equip- ing plants and concrete placing booms observance, however, the free play of ment, 5%, road-working gear, 4%, and that deliver the ready mix where, in so interest rates is frequently subordinat- earth-moving, material-handling and many instances, it actually isn’t needed. ed to government directives. On this other miscellany, plus 3% from “financ- Changsha Zoomlion Heavy Industry score, distortions abound even in the ing activities.” Domestic sales contrib- Science & Technology Development nominally free-market United States. uted all but 5% of 2010 corporate rev- Co., the No. 2 maker of concrete-relat- In the People’s Republic, where the enue; Zoomlion is mainly a homebody. ed and general construction machinery government fixes interest rates, sets At a glance, you wonder what the in the People’s Republic, is the subject lending quotas and directs capital to bears are talking about. Zoomlion under discussion. In preview, Grant’s is politically favored economic sectors, grows like a Chinese skyline, and its bearish on it. it’s often unclear which are the distor- balance sheet shows Rmb 1.3 billion in You, gentle reader, may doubt you tions and which is the reality. net cash. Its shares change hands at just need a short-sale candidate situated Zoomlion, which is 20.6% state- 7.8 times the 2011 earnings estimate. 7,649 miles west of the New York owned, can be said to operate in the None of this displeases the sell side. Of Stock Exchange, especially one whose service of distorted reality. Beijing’s the 22 analysts who have an opinion, 16 price has the ill grace to tumble before hell-bent-for-election drive to build, say “buy,” six “hold” and none “sell.” Grant’s goes to press. However, you modernize and grow has created an For 2012, the analytical consensus an- won’t regret knowing more about what insatiable demand for the picks and ticipates 24% growth in net income on makes the world’s No. 2 economy tick, a 26% jump in sales. or—as we see the situation—not tick. We rest our bearish case on the fact Zoomlion (1157 on the Hong Kong that the bullish story is coming apart Stock Exchange) is more than a major at the seams. Final demand is wilting corporation and a large and liquid stock. and real estate prices are falling, yet It is also a kind of macroeconomic labo- Zoomlion continues to report break- ratory specimen. neck growth. The key to this mystery Founded in 1992, the company has seems to lie with the Zoomlion balance boomed in tandem with the invest- sheet and with management’s approach ment-charged Chinese economy, its to revenue recognition. The company sales climbing at the compound an- is financing more and more of what nual rate of 65% since the word go. As its customers buy, and inventories are seen from Capitol Hill in Washington, crowding dealers’ lots. D.C., the People’s Republic is a mer- Bulls, needless to say, have a differ- cantilist export machine, but the 2010 ent take on the subject. Consider, just GDP data tell a different story. Fixed- for instance, they say, the inspiring asset investment contributed 49%, prospects of building-site mechaniza- net exports 4%. tion. In 2009, just 40% of Chinese con- Investment may be necessary, but it crete was machine-mixed, as opposed isn’t always productive. To decide how “But Daddy, you were so smart yesterday.” to 78% in Japan and 84% in the United SUBSCRIBE! - go to www.grantspub.com or call 212-809-7994 Winter Break-GRANT’S/december 30, 2011 2

States. Certainly, the bulls contend, Vendor finance the difference will narrow, fattening 35,000 60% Zoomlion’s revenues as it does. How- Zoomlion sales (left scale) and ever, observes our own analyst, Evan percent backed by company 30,000 (right scale) 55 Lorenz: “Much of the narrowing has (right scale) already occurred, and some won’t hap- pen for years. Thus, revenues of Zoom- 25,000 sales 50 percentage backed lion’s concrete-related business soared percent with backing by 97% in 2010 and by 58% in the first half of 2011. Adding in the rest of the 20,000 45 industry’s sales and those expected for the balance of the year, you see that 15,000 40 the 2011 concrete-mechanization rate in China may be closer to 64% than the in Rmb millions 40% reckoned for 2009. Yes, it’s below 10,000 35 the American rate, but it should be. China’s per-capita GDP is one-ninth 5,000 30 the size of America’s.” Undebatable is the slowdown in Zoomlion’s end markets. The CEO of 0 25 Caterpillar gave testament to this fact 2007 2008 2009 2010 2010* 2011* in July, the president and chief operat- *first-half results ing officer of Cummins Inc. on Sept. sources: company reports, Grant’s estimates 13. “In China,” the man from Cum- mins, Norman Thomas Linebarger, end markets are stagnant or shrink- “In addition to underwriting loans told visiting analysts, “truck and con- ing? The answer takes this form: In with its own balance sheet,” Lorenz struction markets have clearly come 2007, just 4% of Zoomlion’s sales were continues, “Zoomlion guarantees its off as a result of the end of stimulus company-financed. Through the first customers’ loans and leases with third- spending that the Chinese govern- nine months of 2010, 32% were so as- party lenders. Such off-balance-sheet ment put in back in ’08 and the tight sisted. On June 30, finance receivables guarantees have climbed to Rmb 10.4 money policy they’ve been imple- totaled Rmb 18.4 billion, up 28% in billion as of June 30 from Rmb 7.3 menting.” Concerning the monetary the previous 12 months. “Zoomlion’s billion at year-end 2010 and Rmb 3.4 situation, it’s a pretty good sign that competitors also discovered the rocket billion at year-end 2009. Combining money is tight when corporate debt- fuel of customer financing,” Lorenz company-financed sales and leases ors go into hiding to escape their un- relates. “Their trade receivables, too, with sales under financial guarantees, licensed creditors, as hundreds of Chi- are bulging, albeit from a smaller base. Zoomlion backstopped 52% of sales in nese executives have done, according As of June 30, XCMG Construction the first nine months of 2010, up from to reports from Reuters, Bloomberg Machinery Co. posted receivables of 31% in 2007. The company no longer and Caixin. Rmb 9.8 billion, up 187% year-over- breaks out how its customers fund pur- “Since about March this year,” year; Sany Heavy Industry Co. showed chases. As for June 30, total company Frank Manfredi, the publisher of receivables of Rmb 13.4 billion, up exposure to customer loans and guar- Machinery Outlook, tells Lorenz, “the 65% year-over-year.” antees amounted to Rmb 28.8 billion, machinery markets in China have Then, too, we conjecture, Zoomlion compared to stated cash and equiva- dropped pretty rapidly—they’re down is stretching the maturities of its leases, lents of Rmb 20 billion.” about 30% to 40% compared to a year perhaps to 72 months from the 24 or 48 Zoomlion isn’t alone in continuing ago. And most people think that the months it vaguely acknowledges. We to grow in contravention of bearish numbers that were reported in 2010 do not conjecture lightly. The longer reports on the ground. Compared to were unsustainable anyway.” Another the lease, the more uncertain the re- Zoomlion’s 50% rise in sales in the first expert source, OTR Global, concurs, sidual value of the machine at expiry. six months, XCMG reported a bump of in shorthand style: “Sources said 3Q11 An inflated residual value in a lease 48%, Sany a spurt of 79%. We suspect sales decreased an average of 18%- document means easier terms for the that the protocols of revenue recogni- 23% yy, marking the first time new lessee, and the likelihood of a future tion go some way to explain the fire- equipment sales were down yy since loss for the lessor. Because Zoomlion works. Zoomlion, like its competitors, OTR Global initiated coverage in did not crank up its leasing effort until books the sale of a machine when a Sept. 2009,” the firm said in a Sept. 29 2008, management has not yet had the dealer takes it into inventory. Over- bulletin. To move metal in hard times, educational experience of managing a crowded dealer lots therefore point to the research shops agree, Chinese lease book through a full credit cycle. a problem in economic coordination. manufacturers are cutting prices and (Aside from inexact indications of the And, indeed, OTR Global, reporting lowering the financing bar. lease durations, the front office disclos- high and rising dealer stocks, quotes Which raises the question previ- es no information about underwriting an unnamed Zoomlion dealer in cor- ously posed: How can Zoomlion con- assumptions. Nor did it return our tele- roboration of this suspicion: “Zoomlion tinue to report zooming sales when its phone calls and e-mails.) is also doing OK because of its financ- SUBSCRIBE! - go to www.grantspub.com or call 212-809-7994 Winter Break-GRANT’S/december 30, 2011 3 ing policy. They allow customers to Lorenz goes on. “After disclosing how ticker 1157. You’ll find many links that get equipment with only 100,000 yuan customers paid through sales for the simply say, ‘An announcement has just [$15,600] down payment.” The quota- first three quarters of 2010, the com- been published by the issuer in the tion calls to mind a report last month in pany suddenly ceased reporting those Chinese section of this website, a cor- the Peoria Journal Star that Caterpillar data altogether. Maybe the inconsis- responding version of which may or dealers in China are raffling off Mer- tency has something to do with a May may not be published in this section.’ cedes-Benzes. Buy an excavator, win a 2010 change in auditors (in came Baker To save you, the readers of Grant’s, the car, the pitch goes. Gamblers, however, Tilly China, out went Beijing ZhongXi trouble, the corresponding English ver- not getting into the spirit of the promo- Certified Public Accountants Co.). Or sion is, in fact, not published. You know tion, have been buying excavators only take such seemingly simple items as that the Chinese investor has been told to return them when they don’t win the change in earnings per share. In something, but not quite what. the car. Maybe this year’s big machin- full-year annual reports, that figure “Possibly, the most puzzling lines on ery sales are only the cutting edge of is sometimes calculated before other the company’s financials are those indi- next year’s poor machinery sales. comprehensive income (change in fair cating that, while days inventory stood “Zoomlion publishes a most eccen- value of securities, exchange differenc- at 118 days, days payable amounted to tric set of financials,” relates Lorenz, es, etc.). In other years, it is calculated 260 days. In other words, this company who has been poring through them. after. Some important information, like that appears to flatter its own top line “The company reports many line items the geographic breakout of sales, is with aggressive vendor-finance tech- down to the penny, a level of preci- disclosed only on an annual basis. In- niques is itself the beneficiary of indul- sion unparalleled in the West. But just ternational sales are, in large part, from gences from its own vendors. Compare as important is what it doesn’t report. Zoomlion’s September 2008 purchase and contrast Zoomlion’s larger rival, Caterpillar, Volvo and other household of Compagnia Italiana Forme Acciaio Sany,” Lorenz winds up, “which shows corporate names segregate, for report- SpA (CIFA). Curiously, international days payable at 75 at year-end 2010. ing purposes, finance operations from sales declined by 14% in 2010, which Should Zoomlion’s days payable fall to manufacturing ones. Not Zoomlion. It may show problems at CIFA—Zoom- 75, the aforementioned net cash bal- lumps them together, reducing the cu- lion still holds Rmb 1.7 billion in good- ance would shrink by Rmb 16.4 billion rious analyst to conjecture. As for us, we will from this acquisition. If sales do not to net debt of Rmb 15.1 billion.” conjecture that the finance operations pick up, Zoomlion may have to write If all else fails, the real estate and are likely running at a loss, thus subsi- down goodwill. construction-equipment bulls allow dizing the manufacturing business— “Not to complain,” Lorenz con- themselves to hope that the govern- though for how long, we can’t tell. tinues his complaint, “but English- ment will ride to the rescue. How “Important line items that help in- speaking investors may feel especially would China hum without them? As vestors determine the health of the shortchanged. Scroll through the Hong we read the news, however, it sounds company flit into and out of existence,” Kong Stock Exchange news sector for as if the government is not inclined to

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Our speakers are as provocative, stimulating and unexpected as an issue of Grant’s. To find out about our next conference—or to read about prior events—go to www.grantspub.com/conferences or email us at [email protected] SUBSCRIBE! - go to www.grantspub.com or call 212-809-7994 Winter Break-GRANT’S/december 30, 2011 4 saddle up this time. Thus, from the for which the promoters expressed their another, we believe that the rewards Sept. 29 FT: “In interviews with the gratitude with a specially discounted outweigh the risks. Financial Times, two officials said that price of just $29.61 a share. BX today Strategically, Blackstone seems to tightening measures over the past trades at $11.91. be in the right place at the right time. year had been aimed at choking off All along, Blackstone has suffered Institutional investors are huffing and credit flows to poorly managed devel- from what the investor-relations profes- puffing to deliver the returns they rashly opers in China’s unruly housing mar- sion would call a problem of perception. promised the actuaries. Eight percent ket.” Quoth one of the higher-ups: “If For instance, contrary to supposition, seemed a modest enough hurdle rate a couple of real estate companies fail the firm is not mainly a private-equity in 2007. Today, it looks well-nigh unat- because of bad management practic- shop. Of its almost $160 billion of assets tainable, hence the stampede to alterna- es, then they should fail. The banks under management, private equity ac- tives—i.e., alternatives to depreciating who lent to them should be punished counts for not quite 30%. The rest is ap- equities and manic Treasurys. Credit through higher non-performing loans. portioned among hedge funds, credit in- is one such alternative. Blackstone, in As long as that doesn’t become a big vestments and—the crown jewel—real these post-Dodd-Frank times, is an al- systemic crisis, that’s fine.” estate. Then, too, Blackstone is neither ternative bank, lending against the kind If that is, indeed, the new party line, highly leveraged nor habitually unprofit- of collateral that others won’t touch— much would be different for Zoomlion, able, appearances of its GAAP financials CLOs, whole loans, etc.—though they the most levered of the equipment notwithstanding. In fact, there’s net cash were happy enough to accept it during makers in China’s infrastructure mar- on the balance sheet, and the second the credit bubble. kets. Perhaps the head office is already quarter showed strong earnings, even Blackstone is the beneficiary of a re- trying to tamp down expectations. An according to GAAP. lated mass movement to investment- Oct. 11 press release projected third- Still, it’s no misperception that management simplicity. The CalPERS quarter earnings of Rmb 0.16 to 0.18 Blackstone has its hands full. Its marks of the world have many general-part- per share, up 7% to 20% from Rmb 0.15 to market are plunging, and the presi- nership relationships to attend to. They per share in the third quarter of 2010. dent of the United States has a tax- want fewer. Here, too, the advantage It was a marked deceleration from the reform agenda. Facing off against the goes to Blackstone, which, like other big 74% increase to Rmb 0.60 posted in the hedge-fund population of Greenwich, publicly traded alternative managers, of- first half of 2011. No estimate of sales Conn., the administration is demand- fers a kind of one-stop shopping. or operating earnings was forthcoming. ing an end to the favorable treatment “Look at Blackstone,” says a man Chinese- and English-language speak- of carried interest in the federal tax who, preferring anonymity, has done ers found themselves on an equal infor- code. Such a revision would hit the more than look—he’s bought the mational footing. Not for the first time, taxable Blackstone investor, to be sure, stock. “Pre-recession, they had $70 both were in the dark. though not Blackstone’s reported net billion of assets under management. • income. Neither would it touch Black- Today, it’s about $160 billion of AUM. stone’s dividend. Recession presents And this has been a horrendous fund- yet another business risk, but Black- raising environment for your typical Opportunism Inc. stone, at the end of the second quar- fund. It’s not just Blackstone—most of ter, had $31.4 billion of uninvested these guys, the public alternative asset (October 7, 2011) It’s not much of a cash to deploy. Taking one thing with managers, have taken in additional world, but it’s the only world we have. And if it doesn’t end—let’s just sup- Private enterprise pose—it will pay to own something be- $300 $300 sides U.S. Treasurys again. We write in assets under management anticipation. of private equity firms Blackstone (BX on the New York 250 250 Stock Exchange), the fast-growing purveyor of so-called alternative

assets, is a dividend play with an 200 200 in billions of dollars embedded call on prosperity. Pros- perity being a distant memory, BX trades where other financial stocks 150 150 do, i.e., lower. Yet, though Mr. Market seems to hate the firm that

Stephen A. Schwarzman built, the in billions of dollars 100 100 Blackstone clientele keep throwing money at it. Apollo Founded in 1985, Blackstone went 50 KKR 50 public in June 2007 at the very top of Blackstone the market. The price was $31 a share. It was a Chinese investor—Beijing 0 0 Wonderful Investments—that took 12/08 6/09 12/09 6/10 12/10 6/11 down the largest portion of the equity, source: company reports SUBSCRIBE! - go to www.grantspub.com or call 212-809-7994 Winter Break-GRANT’S/december 30, 2011 5 money. Apollo and KKR have grown million gain in 2009. Last year brought a “Potential” is the word, as “carried in- as well. $1.58 billion gain, which the first half of terest” is pay for results. It’s contingent. “This is an unloved category, for sure. this year—up by $1.47 billion—almost “Currently,” Peligal explains, “Black- They basically debuted at the top. They matched. A glance at the Bloomberg stone has fee-earning assets under man- created the top. They disappointed peo- terminal, however, suggests that no such agement of $35.8 billion in private equi- ple right out of the box. They fell under repeat performance is indicated for the ty and $27.9 billion in real estate, and it’s their high-water marks and, basically, second half of 2011. raising more in both categories. Some of because of the recession, the economics “From a bottoms-up standpoint,” our the existing funds are below their high- of the business have been obscured ever friend, the Blackstone bull, says, “we water marks—no incentive fee is pay- since. But, in addition, they’re compli- see $4 a share of cash and co-invest- able until values return to the stipulated cated entities. They’re limited partner- ments. The stock today is at $11.91 a minimum marks. Nevertheless, let’s fig- ships—and GAAP accounting requires share [it was at $12.50 when we spoke to ure out what the company could earn in two things that make them a particularly him]. It’s a long way from the IPO price, a proper bull market. tough read.” even though AUM and, presumably, “Once the newest real-estate fund is Indeed, chimes in David Peligal, the the earnings’ power of the business has closed,” Peligal continues, “fee-earning Grant’s analyst on the case, “You read more than doubled since the IPO.” So, assets under private equity and real es- the SEC, GAAP-compliant financials of the analysis proceeds, subtract $4 of net tate might total $75 billion. Assume that Blackstone and its peers, and you have cash and co-investments from the share Blackstone generated gross returns of the sudden urge to read something else. price. What do you get for the residual 30% on that $75 billion. And assume that For instance, to quote from the Black- $7 and change, i.e., the portion of the incentive fees averaged 20%. Subtract stone 10-K, ‘We expect to record signifi- share price representing a claim on the the firm’s performance compensation cant net losses for a number of years as a business itself? You get a dividend—to of 40%. The pretax payout would reach result of the amortization of finite-lived start with, 50 cents a share in annual $2.7 billion, or $2.45 a share. These are intangible assets and non-cash equity- distributable income after all expenses big assumptions, of course. And it might based compensation.’ Translation: The at the current rate. This is the income just be that there is no bull market in our pre-IPO partners in Blackstone got stock stream derived from Blackstone’s man- immediate future. But because Black- in the IPO. The stock is vested over a agement fees, which are drawn on capi- stone is raising money, the top end of period of five or so years. Ergo, the value tal contractually committed for 10 years. the earnings range could be as high, or of those awards are recognized year by “It’s not at the whim of the market,” even higher than, our supposed $2.45 a year. But this is an accounting fiction. our informant points out. “It’s actually share. And if the markets don’t recover The partners owned the business before a much better anchored flow. We could and performance fees add up to zero, it went public. They own 60% of the arguably justify the price based on the you still earn the 50 to perhaps 60 cents shares today. In the IPO, they just ex- way other money-management firms— a share in dividend income.” changed private shares for public ones. like T. Rowe Price or Eaton Vance or Certainly, the Blackstone front of- “Then,” Peligal goes on, “there’s the Franklin—are valued. But then, in addi- fice knows the arithmetic. Schwarzman GAAP mandate to consolidate, or partial- tion to this sector, and with Blackstone himself earns no bonus; his cash com- ly consolidate, the debt of the companies in particular, you have an enormous car- pensation is $350,000 a year. He already in which Blackstone invests on Black- ried interest potential.” has his name on the New York Public stone’s own balance sheet. Let’s say that Blackstone has a 1% equity holding in a Economically profitable collateralized loan obligation. Onto the $3.0 $3.0 Blackstone balance sheet goes 100% Blackstone’s economic net income before taxes of the economics of that CLO, debt in- 2.5 2.5 cluded. Pick up the latest Blackstone 10-Q and you may conclude that loans 2.0 2.0 payable total $9.3 billion. In fact—sub- 1.5 1.5

stantively—they total only $1.03 billion. in billions of dollars Run a screen, as a short seller might, for 1.0 1.0 companies both leveraged and unprofit- able. There’s Blackstone.” 0.5 0.5 To remove these GAAP-induced dis- tortions, Blackstone reports “economic 0.0 0.0

net income,” i.e., pretax income exclud- in billions of dollars ing IPO-related amortization charges -0.5 -0.5 and both revenues and expenses from -1.0 -1.0 Blackstone-managed funds. However, be warned: Not even this favored met- -1.5 -1.5 ric traces the neat upward progression so beloved by institutional investors. -2.0 -2.0 Blackstone earned $2.42 billion of ENI 2006 2007 2008 2009 2010 2010* 2011* in its coming-out year of 2007. It showed *first-half results a $1.33 billion loss in 2008 and a $723.8 source: company reports SUBSCRIBE! - go to www.grantspub.com or call 212-809-7994 Winter Break-GRANT’S/december 30, 2011 6

Library. To be able to bestow another Clients keep sending money $30 $170 benefaction of that grand scale, he’ll Blackstone share price (left scale) have to make the shareholders rich, too, vs. assets under management (right scale) as he goes along. 25 assets: 155 Naturally, the firm requires no small $158.7 billion degree of cooperation from the gods. Possibly, the gods will be uncooperative. The latest private-equity fund to get 20 140 in billions of dollars fully invested, BCP V (December 2005 to January 2011) has delivered a net in- ternal rate of return to date of only 2%, 15 125 a far cry from the 20% to 40% returns achieved earlier. Then, again, Black- price per share stone is already busy funding private-eq- 10 110 uity number VI, a giant, as Schwarzman share price told dialers-in on the July 21 earnings as of Oct. 4: call. “The fund is now over $16 billion 5 $11.91 95 in size,” the CEO said, “making it the largest fund raised in the industry over the last three years and likely will be the 0 80 largest for the next year or two or three 7/07 1/08 7/08 1/09 7/09 1/10 7/10 1/11 9/30 years, as well.” source: The Bloomberg Blackstone’s hedge-fund segment shows what kind of growth the firm has worse than the current conditions, be- exception, fled. Today, in a market enjoyed and what may yet be possible. cause it means anybody with a pulse pocked with opportunity—which is to The division managed just $500 mil- can take out money, and they tend to say, fear and distress—Blackstone has lion in 2001, while today it has $40.6 bid things up aggressively and that money to act. billion—$5 billion came in during the creates bubbles. So today’s conditions It’s a buyer’s market all right. Valua- first half of 2011 alone. Out of the rest are actually much better for Black- tion disparities between so-called core of the $158.7 billion under management stone than the white-hot credit market and non-core assets are some of the wid- on June 30, private equity accounted that was prevailing.” est in memory. Banks are shrinking (and for $46.7 billion, real estate $37.6 bil- For a case study in the uses of adver- quaking), the commercial mortgage- lion, credit $33.8 billion, while—as not- sity, look no further than the Blackstone backed securities market is largely shut ed—$31.4 billion lay fallow. real-estate group. You may remember and, to top it all off, the Europeans are “We bought it last year at 10 bucks shaking your head at its $39 billion coming. Only now are the European and we were selling at 19 when the sky purchase of Equity Office Properties banks starting to sell their real estate as- was pretty blue earlier this year,” our early in 2007—a top, surely, you might sets, according to a Peligal informant. friend, the bull, relates of his BX in- have sensed (as indeed it was). Black- As in the bond and stock markets, vestment. “Now we’ve loaded all the stone, too, seemed to agree, as it nimbly “safety”—without much regard to price way back up again—it’s a lot cheaper peeled off salable pieces of Sam Zell’s or value—is the watchword in real es- at 12 today than it was a year ago, just portfolio before the cycle turned. To- tate. The properties in greatest demand on the basis of the increase in earn- day, in similarly contra-cyclical fashion, are the ones that most closely resemble ings power from the AUM raise. But Blackstone’s managers are buying what the risk-reward characteristics of U.S. we sort of wonder to ourselves: ‘Where others are selling—earlier this year, for Treasury securities, say, a long-leased are we wrong on this?’ I think, to some instance, the U.S. shopping centers of Washington, D.C., office building priced extent, the risks are clearly present Melbourne-based Centro Properties to a 4.5% cap rate. Dented assets, never with the economy. Secondarily, it’s ex- Group for $9 billion. mind broken ones, go begging. posed to the equity markets, because With just 23.7% of firm-wide assets, On Sept. 26, Equity One, a Florida- a lot of people look at this entity and the Blackstone real-estate division based property owner and developer, an- say, ‘The only way you’re going to dis- delivered 55.6% of first-half economic nounced the sale of 36 shopping centers, pose of your investments and get any net income. Beyond its own skill and comprising 3.9 million square feet and value is from the equity-market IPOs.’ resources—perhaps, in money terms, situated mainly in Atlanta, Tampa and And that’s true for the private-equity three to four times’ greater than that Orlando, to a Blackstone real-estate part- business. It’s not true for the other of the next largest entrant—the com- nership. In the 12 months through June two-thirds of the business, so we think pany owes a shout-out to its van- 30, the centers generated net operating that’s one material misperception. But quished competitors. In the early and income of $35.4 million, the press re- another exposure is the health of the mid-2000s, no big bank could seem lease said. Divided by the $473.1 million credit markets. If the credit markets to hold up its facade unless it em- purchase price, you get a net operating are rocky, they can’t always line up ployed maximum leverage to buy real yield of 7.5% before leverage, not bad credit for their investments. Our view estate at the minimum available cap for this low-return world. Says a party to on that would be actually [that] white- rate. Come the Great Recession, the the transaction: “And they’re grocery-an- hot credit markets are terrible, in fact bank funds sold and, almost without chored shopping centers—so it’s hard to SUBSCRIBE! - go to www.grantspub.com or call 212-809-7994 Winter Break-GRANT’S/december 30, 2011 7 disintermediate either the supermarket Not-so-real returns or the pizza guy through the Internet.” 3.0% 3.0% In the 12 months through June 30, real 10-year yields for U.S., Switzerland, Singapore and Germany Swiss Blackstone expanded its assets under 2.0 2.0 management by 43%, whereas, in the 12 months through Tuesday, the share price has fallen by 5%. From these facts, 1.0 1.0 we conjecture that the customers are satisfied but the market is out of sorts. 0 real yield Maybe the customers know best. 0 • German -1.0 -1.0 real yield

U.S. The pending dollar rally -2.0 -2.0 (July 15, 2011) Against the Swiss franc on Monday, the euro made an -3.0 -3.0 all-time low. Against the U.S. dol- Singapore lar, however, it scored a 17-week— mind you, not a 17–month—low. -4.0 -4.0 All the world knows what’s wrong 7/1/10 9/1 11/1 1/3/11 3/1 5/2 7/12 with the euro. But what’s wrong source: The Bloomberg with the dollar? The flight to the dollar that hasn’t Only a year ago, the greenback Evan Lorenz observes. “Since the occurred is the subject at hand. You’d jumped when the world sneezed. In start of 2011, the Dollar Index has fall- think that monied Europeans—fol- the seven months to early June 2010, en by 4% and is down by 14% from its lowing along with us in America as EU the U.S. Dollar Index climbed by 19%. June 7, 2010, high. Other safe-haven functionaries try to explain away the It was a period during which the world currencies have continued to appreci- inevitable Greek default, or to squelch awoke to the problems of post-classical ate, the Swiss franc and the Singapore the ratings agencies for having the te- Greece—as five-year Greek credit de- dollar rising 13% and 5%, respectively, merity to downgrade Portugal, or to fault swaps bulged to 801 basis points against the greenback this year, each “stress-test” the European banks— from 193 basis points—and came to setting record highs. Remarkably— would be doing enough precaution- terms with the passing, on March 31, amazingly—the euro itself has rallied ary dollar buying to push down the of QE1. The springtime air was pres- by 4.3% against the dollar.” euro-dollar exchange rate well below ently rent with anxious talk about a Markets sometimes get a bee in $1.40. They have not so far, but noth- new recession. The dollar was a port in their bonnets. So frazzled, they fix ing would surprise us less. “If not now, that squall, just as it had been during on one consideration in the deter- when?” to borrow a phrase from the the post-Lehman storm. mination of a clearing price to the federal-debt-crisis-negotiator-in-chief. “Not lately, though,” as colleague exclusion of others seemingly just as relevant. In the foreign exchange Greenbacks in the dust markets, interest rate differentials 135 135 are one such preoccupation; national euro, Singapore dollar, Swiss franc and gold price gold indexed to U.S. dollar (July 1, 2010=100) debt, purchasing power, GDP growth 130 130 and geopolitics are others. Geopoli- tics, at least, we can eliminate from 125 125 consideration as a factor in explain- ing the absence of a monetary flight Swiss to the dollar from the euro. Switzer- 120 franc 120

index level land and Singapore, to which capital is flying, don’t have the H-bomb. 115 115 Gold is a pacifist. Interest-rate differentials, then? index level 110 110 These days, in developed economies, SGD they are differentials without differ- 105 105 ences. The negative real yield on the euro Singapore government’s 10-year bond is, in fact, greater than that on the U.S. 100 100 10-year note (minus 2.4% vs. minus 72 basis points). You can earn a 1% real 95 95 yield by venturing 10 years out on the 7/1/10 9/1 11/1 1/3/11 3/1 5/2 7/12 Swiss yield curve, at which rate you source: The Bloomberg would double your money in 70 years, SUBSCRIBE! - go to www.grantspub.com or call 212-809-7994 Winter Break-GRANT’S/december 30, 2011 8 but you’d probably lose patience. Gold the American form of error to the Eu- riod.” These facts are inconsequen- yields not much less than Libor. ropean kind. The talks in Washington, tial. All you have to know, they say, A Graham and Dodd devotee might D.C., over the federal debt ceiling, for is that Greece is on the verge of a home in on value, or “purchasing instance, we regard as political postur- more-than-technical default, that the power parity,” as it’s known in the cur- ing. The underlying fiscal problem is euro is more precarious than the dol- rency markets. Again, not much help. real enough, and worrying, too, but the lar, and that the so-called global refla- According to The Economist’s Big Mac crisis is artificial. Not so the flailing ef- tion trade hangs by the thin thread Index, which calculates PPP for ex- forts of the once and future chieftains of the People’s Republic of China. actly one basket of goods, the Swissie of the European Central Bank, Jean- Thus, the argument goes, the 10-year was 83% overvalued and the euro 29% Claude Trichet and Mario Draghi, to Treasury—quoted at all of 2.8% on overvalued vs. the dollar at year-end beat back the European banking-cum- Monday morning—is just as rich as it 2010. So the euro, though objectively fiscal-cum monetary contagion. Now ought to be. overvalued and possibly doomed, is up there is a crisis. Now begins a comparison of the marginally on the year against the dol- Gold is our favorite monetary me- government bond yield with the lar. It makes you think. dium. As between the dollar and the Wal-Mart dividend yield, and more. What about debt? Singapore has a euro, we prefer the dollar. If the dollar We compare things that grow—e.g., strong dollar with a 97% ratio of debt should execute a crisis-induced U-turn the Wal-Mart dividend—with things to GDP; the United States has a weak against the single currency, we expect that don’t—e.g., the coupon attached 1 dollar with a 92% ratio of debt to that gold would shudder, buckle and to the U.S. 3 /8s of May 15, 2021. GDP. Switzerland has a strong franc then recover to make new highs. The We appraise the investment merit with a 55% ratio of debt to GDP. As barbarous relic, at least, is mute. The of Wal-Mart alongside the retailer’s for the Netherlands, with a 64% debt- central bankers and finance minis- majority-owned Mexican subsidiary, to-GDP ratio, and Italy, with a 119% ters and banking regulators can never and we size up both of those entities debt-to-GDP ratio, they belong to a seem to stop talking. in relation to Costco, America’s No. confederation of nations that shows a • 2 retailer by market cap. In preview, raio of debt to GDP of 75%. Still, Italy we’re partial to Wal-Mart. has a fiscal problem. Comparing the enterprise that Perhaps the reserve-currency curse Phil Fisher meets Sam Walton founded with the enter- is finally catching up with the green- prise that Sam Adams, John Adams back, as it did so long ago with the Benjamin Graham and Thomas Jefferson founded isn’t pound sterling. Not promptly settling so farfetched as it might first appear. accounts with its Asian creditors, this (July 1, 2011) To the bond bulls, it Though each is a wonder of the age country has built up stupendous defi- matters not that the U.S. government and each is a cornucopia, each hap- cits, fiscal and otherwise. The IMF is on the cusp of technical default, pens to be stuck in a growth slump. compares the nations of the world in that the CPI has risen by 3.6% over America is looking over her shoulder terms of their external financial po- the past 12 months or that—the ele- at the fast-rising Asian economies, sitions. Its criterion is “the current vated pace of inflation notwithstand- Wal-Mart at Costco. Happily, how- account balance,” which is the sum ing—the zero-percent funds rate is ever, there is nothing to compare in of the trade account, the income ac- likely to persist “for an extended pe- the matter of fiscal rectitude. The count (i.e., income from loans and in- vestments) and the secondary income Wal-Mart’s bottom line account (i.e., transfer payments). By $18.5 4.6 this standard, the dollar is making net income (left scale) vs. diluted shares (right scale) heavy weather of it. Thus, in 2010, ac- cording to the IMF, the United States net income ran a current account balance deficit 16.0 4.4 equivalent to 3.2% of GDP. In con- trast, Switzerland ran a 14.2% CAB shares in billions surplus, Singapore a 22.2% CAB sur- 13.5 4.2 plus. The European Monetary Union countries essentially broke even, with Luxembourg, for instance, earning a 7.7% surplus and Greece logging a 11.0 4.0 10.4% deficit. This publication, which stands for net income in billions the gold standard, is perennially bear- 8.5 diluted shares 3.8 ish on the monetary and banking ar- rangements of the modern world. Yet, climbing down from that lofty perch of disapproval, we try to distinguish be- 6.0 3.6 tween one variant on unsound practice 1/01 1/02 1/03 1/04 1/05 1/06 1/07 1/08 1/09 1/10 1/11 and another. In that vein, we prefer source: The Bloomberg SUBSCRIBE! - go to www.grantspub.com or call 212-809-7994 Winter Break-GRANT’S/december 30, 2011 9 famously cash flow-negative U.S. Picture of the American middle 15% 15% government may command (for now) Wal-Mart and Dollar General growth in U.S. same-store sales a triple-A credit rating, but the fa- mously cash flow-positive retailer earns its double-A. At the three- 12 12 year point on the yield curve, the DG Treasury is paying 0.67% to borrow, WMT (U.S. stores) 5 9 9 Wal-Mart 1 /8%. Objectively, the

Treasury is the weaker credit, but growth rate Wal-Mart has no Bernanke. Chartered Financial Analysts may 6 6 object that there can be no true com- parison between the apple of a gov- growth rate ernment bond and the orange of a 3 3 common stock, and the two assets are, indeed, dissimilar. But all life is choice, and all investment is arbi- 0 0 trage. Professional asset managers may find themselves slotted in a one- asset career specialty, but, ultimately, -3 -3 1/09 4/09 7/09 10/09 1/10 4/10 7/10 10/10 1/11 even they must choose between one kind of claim and another. Will it be source: company reports bonds or stocks, Secretary Timothy Geithner or CEO Mike Duke? is growth? Do you count the raw dol- ry’s five-and-dime. Last year, Dol- Wal-Mart was a $50 stock, more or lars of sales and earnings? Or the raw lar General generated $13 billion in less, when Grant’s last addressed it dollars divided by the share count? sales and same-store sales growth of in the issue dated Dec. 10. In truth, By the first method, Wal-Mart looks 4.9% by selling a quarter of its mer- Wal-Mart has been a $50 stock for as if it were sleepwalking. By the sec- chandise for $1 or less. Compared to the past 10 years. Earnings have ond, it almost resembles Apple. Con- Dollar General, Wal-Mart fairly blots gone up but the multiple at which cerning the per-share WMT, Phil out the sun with 2.1 million em- the earnings are capitalized has col- Fisher, the growth-stock guru, could ployees and fiscal 2011 revenues of lapsed. Management has made its find common ground with Benjamin $421.8 billion. Net sales at the Ben- share of mistakes—including, re- Graham, the value guru. tonville, Ark., giant grew by 3.4% cently, a failed attempt at rewriting Tom Gayner, chief investment of- last year, but in the 50 states, same- the merchandising strategy—but the ficer of Markel Corp. and a sizable store sales actually shrank by 0.6% share price isn’t its fault. Mr. Market holder of Wal-Mart, quips that during (and have shrunk for eight consecu- has got it into his head that Wal-Mart the 2007-09 bear market, the typical tive quarters). Fiscal year 2009, with can’t and won’t grow, that it will con- money manager went through three its 7.3% top-line growth and domes- tinue to lose market share and that— phases in his Wal-Mart experience. tic same-store sales growth of 3.5%, if share repurchases continue at the First, he invested in Wal-Mart, then seems, for the Wal-Mart shareholder, current torrid rate—the Walton fam- he shopped at Wal-Mart and finally like a long lost golden era. ily, returning to majority ownership, he worked for Wal-Mart. In 2011, So Wal-Mart goes for growth will somehow freeze out the public. however, it’s the Wal-Mart customer outside the 50 states. With last On each point, we demur. base that’s down on its luck. month’s $2.4 billion purchase of a The story of Wal-Mart’s lost de- “American consumers are in the 51% stake in South African-based cade in the stock market is easily early stages of an unprecedented re- Massmart Holdings, sub-Saharan told. In the fiscal year ended Jan. trenchment,” Stephen Roach, the Africa moved into the corporate 31, 2001, earnings per share were Morgan Stanley economist turned sphere of influence. Of Wal-Mart’s $1.40 on sales of $42.67 per share, Yale professor, wrote in the Financial 9,198 stores, 4,774 are situated and there were 4.48 billion shares Times a couple of weeks ago. “In the outside the United States, includ- outstanding. Ten years later, in the 13 quarters since the beginning of ing 1,773 in Mexico. Wal-Mart de fiscal year ended Jan. 31, 2011, earn- 2008, inflation-adjusted annualized Mexico SAB de CV, the 65%-owned ings per share were $4.47 on sales growth in consumption has averaged Mexican subsidiary (Bloomberg per share of $114.95, and there were just 0.5%. Never before in the post- ticker: WALMEXV MM), shot the 3.67 billion shares outstanding. A war era have U.S. consumers been this lights out in the 2000s, even in un- decade ago, Wal-Mart commanded a weak for this long.” Monday brought prosperous 2009, when same-store trailing P/E multiple as high as 41.7 news of a second consecutive drop in sales climbed by 3% despite a 2.2% times; today it trades at 11.7 times. inflation-adjusted personal consump- fall in nominal Mexican GDP. In Granted, growth is all to the good; no tion expenditures. the 10 years to 2010, Walmex sales value investor is against it. What are The tale is told in the very pros- and earnings per share sped along you willing to pay for it is, rather, the perity of Dollar General Corp. (DG at compound annual rates of 16.7% question before the house. And what on the Big Board), the 21st centu- and 19.1%, respectively. But Mexi- SUBSCRIBE! - go to www.grantspub.com or call 212-809-7994 Winter Break-GRANT’S/december 30, 2011 10

want in the size you can actually use, can growth, too, has decelerated. In its statistical advantages, even on a go to Wal-Mart. the first five months of 2011, Wal- per-share basis; in 2010, its sales per Admittedly, Costco has the sizzle mex sales were ahead by 9.1%, com- share, at $175, were more than 50% (and at lunchtime, the denser popu- parable-store sales by 2.3%. In the higher than Wal-Mart’s. But in the lation of shoppers). To us, it seemed first five months of 2010, by con- past 10 years, Wal-Mart has boosted a little sad that Wal-Mart had to hire trast, the company logged growth of its dividend by 18% a year. Costco, Will Smith, the comic actor, to be its 20.6% and 3.3%, respectively. which initiated a payout in 2004, has paid friend and facilitator at the June What has not subsided so far is the boosted its dividend by 13% a year.” 3 annual meeting. In fact, the actual Walmex price-earnings ratio. At 26.6 Costco is a magnificent merchan- star of that proceeding was the Wal- times the current year’s estimate, it dising machine, to be sure. But is it Mart board of directors, which autho- is double the parent’s multiple and so much more magnificent than Wal- rized the repurchase of $15 billion of only slightly higher than the lordly Mart? Grant’s set out on a voyage of stock, renewing the prior year’s au- 24.1 times at which Costco trades. discovery to New Jersey’s big-box thorization of $15 billion, of which all Is growth—measured in dollars or country. We inspected a Wal-Mart but $2 billion was spent. pesos without reference to the share in Secaucus at 11 a.m. and a Costco The aforementioned Gayner re- count—so precious as that? Is Costco in Clifton at lunchtime. We talked to flected on the implication of these so superior to Wal-Mart in what is customers and gaped at the stagger- buybacks in which Wal-Mart has nowadays known as the customer ex- ing mounds of golf clubs, automatic bought in 445 million shares over the perience? Let’s find out. garage-door installation gear, en- past eight quarters. “Today,” he ob- Please note, observes colleague gagement rings, hamburger meat and served, “the market cap is roughly David Peligal, that Wal-Mart has de- sunscreen (the piles being especially $190 billion. So we’re saying that the livered the goods that equity inves- notable at Costco, which eschews whole pie, steady state, is worth $190 tors would seem most to prize. Thus, the nicer forms of presentation). We billion. So my joking math is that, in in the 10 years to Jan. 31, 2011, Wal- talked to Wal-Mart fans and Costco 15 years at the current rate, the share Mart’s sales and earnings per share fans, and satisfied ourselves of the count will be one. Instead of cutting compounded by 10.4% and 12.3% essential truth of the proposition that pie into roughly 3.5 billion shares per annum, respectively. “You look (sworn to by Eric Whitehead, your outstanding, $190 billion will be cut at the Costco stock chart,” Peligal editor’s right-hand man) that you re- into one slice. So that one slice will goes on, “and you assume that COST ally can’t get out of Costco without be worth $190 billion. If we’re going generated much faster growth, but spending at least $100. So it’s Costco to make 20% on our money between not so. In the 10 years through 2010, for sheer volume—you can find what now and then, what is the net pres- Costco’s sales and earnings per share you need in quantities three times ent value of $190 billion for 15 years? compounded by 10% and 8% per an- larger than you need—but for the I think it’s about $12 billion. I kept num, respectively. Costco does have targeted purchase of the item you doing the math to make sure it was really right—to make sure the zeroes were right—and it is. It appears that the price chart is going to be 50, 50, 50, 50, etc., and then $12 billion—if Show everyone how smart you are... the stock does nothing. I suspect that Own a print of a Hank Blaustein masterpiece. we will not reach that end point, but we don’t really have to. You can cut it in half, cut it in half again, then cut 5”x 5” cartoon size. it in half again—whatever margin of Signed by Hank, safety you want—but it sure seems like it’s worth a lot more than $50 on matted and suitable that path.” for framing, $150. As for the United States of Amer- ica on the eve of the Fourth of July weekend, we love this country. As to Find your favorite its securities, however, someone else in the Grant’s can have them. cartoon treasury! •

Go to The risk down under www.grantspub.com (June 3, 2011) There was “fake cash to order. recorded on the books,” the chairman of Longtop Financial Technologies, the WWW.GRANTSPUB.COM/CARTOONBANK New York Stock Exchange-listed Chi- SUBSCRIBE! - go to www.grantspub.com or call 212-809-7994 Winter Break-GRANT’S/december 30, 2011 11 nese financial software company, belat- implications of his bearishness. The Australian hedge fund that was fore- edly admitted to a partner of Deloitte cessation of Chinese growth would handedly short Longtop shares, “the Touche Tohmatsu, because there had turn down the economic and financial Chinese banks were in on the fraud, at been “fake revenue in the past.” Scales lights in places as geographically far least on the branch level. This is no lon- fell from the auditor’s eyes as Deloitte removed from the People’s Repub- ger a story about Longtop, and it is not Touche’s attempts to confirm the exis- lic as the United States, Brazil, New a story about Deloitte. Given the cen- tence of Longtop’s bank deposits met Zealand and—as noted—Australia. It trality of Chinese banks to the global with resistance, then with obstruction would deflate the so-called reflation economy, it’s a story much bigger than and, finally, with threats to the Deloitte trade, the dimensions of which would Deloitte or Longtop.” auditing staff. Trusting investors were become fully apparent only after it The infernal machine of the world gobstopped. For six years running, De- ended. China’s Ponzi-like banking monetary system we take to be that loitte had blessed Longtop’s financials system, sustained by the misbegotten bigger story. It’s the reserve currency with a clean opinion. As recently as No- reserve currency system, is the reed on system in toto. The word “reserve” con- vember, the market had valued the com- which leans a fair portion of world en- notes the dollar’s role as a favored as- pany—with its comforting Big Board terprise—including, for instance, the set on the balance sheets of America’s ticker, LFT—at $2.4 billion. Fidelity, art world, as illustrated in the March Asian creditors, especially China. What Putnam and Janus owned the shares, sale of a Chinese vase for $18 million does the dollar have to do with China’s trading in which was suspended on May that Sotheby’s had conservatively ap- falling-down banks? The connective 16 at a closing price of $18.93. When trad- praised at $800 to $1,200. tissue is familiar enough to constant ing resumes, the opening price will likely Because we are bearish on China, readers. Recall, please, that we Ameri- be closer to the funds rate. we are bearish on the Australian dollar, cans send dollars west to finance our Now under way is an investigation quoted near a 30-year high against the perpetual trade deficit. These dollars, into the relationship between finan- greenback. Reciprocally, we are bull- the Asian central banks buy with their cial misinformation and the modern ish on an Australian winemaker that very own currency, printed specially for monetary system—and between Aus- would thrive with a cheaper currency. the purpose. Having bought the George tralia and its No. 1 trading partner, the You may say that if China steps in Washingtons, the portfolio managers do People’s Republic of China. Arithme- front of a bus, people will be drinking not bury them but, rather, invest them tic is the point of contention between water, not wine, but we say they will in dollar-denominated assets. So the dol- ourselves and Beijing. Grant’s supports be drinking wine, and lots of it. lars fly home again. We Americans can plain, unvarnished numbers. We like It caught our eye, in reading Floyd have our cake and eat it, too. our interest rates straight and unma- Norris’s account of the Longtop scan- In times past, a deficit country like nipulated (not the kind the Federal Re- dal in The New York Times on Friday, the United States lost real monetary serve serves up, to be sure). Likewise, that Deloitte didn’t just take Longtop’s wealth, e.g., gold, to its creditors. The we prefer authentic inflation rates, ex- word on the size of its liquid assets, loss set in train a deflation of prices and change rates, coal prices and electricity but tried to verify the deposits with wages and thereby an improved com- tariffs. The Chinese Communist Party Longtop’s bankers. It seems the bank- petitive position. By the same token, a takes an alternative approach. It shows ers were in the habit of fibbing. If so, surplus country like China gained real a distinct aversion to unprocessed facts. as Norris quoted John Hempton, chief monetary wealth. The acquisition pro- In the People’s Republic, the price sys- investment officer at Bronte Capital, an duced an inflation of prices and wages tem is subordinated to party rule. We are bearish on China. The wages of money printing In 2011, that is a large and compre- $3,500 10.0% China’s foreign exchange reserves (left scale) forex hensive announcement. To be proper- vs. year-over-year change in inflation rate (right scale) ly bearish on China, one must be simi- reserves larly bearish on the things connected 3,000 8.0 with the vast Chinese enterprise. Re- cently, Jeremy Grantham, the public 2,500 6.0 brain of GMO in Boston, compiled a list of commodities for which China change in CPI accounts for an outsize share of global 2,000 4.0 demand. The world’s No. 2 economy, generating 9.4% of world GDP, buys 1,500 2.0 53.2% of the world’s cement, 47.7% of

its iron ore, 46.9% of its coal, 45.4% of in billions of dollars CPI its steel and so on down the line, with 1,000 0 receding but still substantial shares of lead, zinc, aluminum, copper and 500 -2.0 nickel. Among edible items, according to Grantham, China buys 46.4% of the pork, 37.2% of the eggs, 28.1% of the 0 -4.0 rice and 24.6% of the soybeans. 1/00 1/01 1/02 1/03 1/04 1/05 1/06 1/07 1/08 1/09 1/10 3/31/11 So a bear on China must confront the source: The Bloomberg SUBSCRIBE! - go to www.grantspub.com or call 212-809-7994 Winter Break-GRANT’S/december 30, 2011 12 and thereby a diminished competitive Borrowing like Americans position. Something like balance in in- 170% 154 ternational accounts was thus achieved Australian household debt (left scale) house price vs. home prices (right scale) index and maintained. Prosperity there was, 160 142 too, in that faraway time (the true-blue gold standard didn’t survive World War I). The central banks didn’t directly aim 150 130

at it. Growth and employment were, debt to house price index rather, the co-products of sound money. income ratio 140 118 Today’s transpacific monetary traffic achieves nothing like balance. On the contrary, deficits pile up on one side, 130 106 surpluses on the other. Economists and central bankers may pour out their de- nunciations of this lopsidedness—you 120 94 can see it, with respect to China, in the debt to disposable-income ratio accompanying graph of Chinese reserve 110 82 accumulation—but the criticisms fall on deaf ears. Asian mercantilists like their piles of Treasurys, American consumers 100 70 their mounds of stuff. It’s a curious thing 3/02 3/03 3/04 3/05 3/06 3/07 3/08 3/09 3/10 12/10 about 21st-century monetary policy, but sources: Reserve Bank of Australia, Australian Bureau of Statistics its practitioners follow no hard-and-fast rules. Some do target inflation—the ers, but officials see that as no great in- its bankers might have done what they European Central Bank and the Bank convenience. Bankers pack up the slow allegedly did even in the golden age of of England, for example—meaning loans in so-called asset management hard money and solvent banking, but the they aim to achieve it (just a little, mind companies. Time—and growth—will monetary and financial arrangements in you). But most shoot for prosperity, the cure all is the party mantra. place in China would tempt a saint. thing itself. To fire up growth, they push The United States wasn’t born rich, We believe they are debauching around interest rates, crank the presses the China bulls never miss an opportu- Australia, which, in your editor’s opin- and raise up stock prices. To the millen- nity to interject. During the formative ion, doesn’t deserve it. Australian house nial sensibility, it seems the obvious ap- years of American industrial growth, prices may be bubbly, and the Austra- proach; if we want something, let us go European creditors despaired at Ameri- lian consumer overleveraged, and the after it hammer and tongs. ca’s penchant for bankruptcy, fraud and high Australian dollar starving innocent However, achieving better living outright theft. In the 1870s, observing Australian exporters, but the world’s through monetary means is harder the corrupt financing of the first trans- No. 13 economy has achieved feats that than it looks. Capital misallocation is continental railroad and listening to should leave American policymakers a common unintended consequence U.S. Grant arraign his good-govern- wide-eyed. We are not now referring of modern-day monetary policy. Press ment critics—“morbidly honest,” the to the astounding fact that Australia has interest rates to the floor and house president called them—the foreigners borne not one year of GDP shrinkage prices, for instance, may reach the sky probably wondered what they had got since 1991. The odd slump is salutary, before they tumble back to earth. And themselves into. we believe. Without it, cyclical excesses to mitigate the busts that are part and But not even in that time of industrial go uncorrected. Nothing is so unstable parcel of the booms, central banks in- growing pains did Washington, D.C., as stability, as Hyman Minsky approxi- advertently give cover to scoundrels. take command of the banking system to mately postulated. To applaud a 20- Bear markets unmask imposters; oth- funnel credit to state-owned enterprises year recession drought is to subscribe to erwise, Ponzi schemes can grow to in order to achieve the planners’ goal of the unlikely proposition that Australia systemic proportions. In China, in the 8% GDP growth. Neither did Gilded has gone 20 years without overdoing it. matter of Longtop and Deloitte, we Age politicians resort to exchange-rate However, our admiration for Austra- wonder if we are seeing the tip of a gi- suppression to boost American exports lian interest rates is unbounded. In the gantic Madoffian iceberg. (though they did not scruple to lay on first place, you can actually see them with The Chinese credit system, as heavy tariffs to stymie imports). We are the naked eye. In the second place, they described in the prior two issues of bearish on China not because many com- go up as well as down. To ward off the Grant’s, is only a blunter variant on the panies are corrupt—17 state-owned en- demons of 2008-09, the Reserve Bank now orthodox monetary policy tech- terprises have lately misreported finan- dropped its cash target rate to 3% from 1 niques of the capitalist West. As you cial data, China’s National Audit Office 7 /4% between March 2008 and April will recall, the Chinese Communist disclosed last week—but because many 2009. In America, monetary experts can’t Party treats the state-owned banks not prices are. Manipulate enough prices and seem to stop wringing their hands over as commercial enterprises but as instru- before you know it, the bullet trains, sans the Fed’s projected “exit strategy.” In ments of national policy. The centrally passengers, are streaking from empty city Australia, the Reserve Bank simply raised 3 directed lending sprees inevitably yield to empty city past idle steel mills and un- the rate, to the current level of 4 /4%. up undigestible masses of nonperform- tenanted shopping malls. Longtop and Looking at Australia’s economy, SUBSCRIBE! - go to www.grantspub.com or call 212-809-7994 Winter Break-GRANT’S/december 30, 2011 13

you couldn’t tell there was a world- actual export dependency on China Not to worry, bulls counsel. Yes, they wide recession. In the plague years of may actually be greater. Japan, which acknowledge, commodity prices and 2008 and 2009, Australian real GDP accounts for 18.9% of Australia’s ex- investment in commodity extraction grew by 2.6% and 1.3%, respectively, ports, and South Korea, which takes stand at 100-year highs as a percent- thanks in no small part to its proximity 8.8%, are also large exporters to China. age of Australian GDP. And, yes, in the to China. It was a most favorable com- You would expect that Australia, with next two years, Australia will record the parison to rates of growth of zero per- its huge mineral resources, would be highest rate of investment, measured as cent and minus 2.6% registered in the an export-dependent economy. But a percentage of GDP, in at least a half United States. Neither—looking at the net exports contributed a mere 1.1% century. But even if China should hit Reserve Bank’s balance sheet—could to GDP in 2010. In fact, Australia ran a cyclical speed bump, much of that you tell that the world almost came to trade deficits in 77% of the calendar investment would go forward. Lique- an end. For reference, the Federal Re- quarters since 2000.” fied natural gas projects are conceived serve has bloated its footings by 211% In the Texas real estate boom of the on a 20- to 40-year time horizon. Cal- since year-end 2007. Over the same late 1980s, buildings went up to house culations for iron ore investment are period, the Reserve Bank’s assets de- the real estate appraisers, developers, similarly farsighted. The big mining clined by 9.4%. The Australian central architects, engineers and bankers, the companies have committed billions of bank did, in fact, expand aggressively people who—as the visionaries reck- dollars—Aussie or U.S., it doesn’t make in 2008, but it subsequently took out oned—would be required to construct much difference at current exchange what it had put in—and then some. still more shiny new office towers in rates—to these investments, and they Since November 2008, it has sawed its Dallas and Houston to accommodate will not be easily discouraged. balance sheet in half. Striking, too, is the projected marvelous growth that At the end of April, 94 projects were the nature and quality of the Reserve the real estate boom had set in mo- in an advanced stage of development, Bank’s assets. Fully half consists of gold tion. Not until the great comeuppance with a record outlay of A$173.5 billion, and foreign exchange, with the balance did the survivors realize they had been or 13% of 2010 GDP, up from 9% in in Australian government debt (11%), capitalizing a boom on a boom. 2009, finds the Australian Bureau of other Australian dollar-denominated So, too, today—it seems to us and oth- Agricultural and Resources Econom- securities (37%) and other assets (2%). ers—in Australia. “The two key export ics and Sciences in a May report. “This On the down side, Australia is a di- earners for Australia are iron ore and coal, represents a 31% increase from October rect beneficiary of the corrupting sym- and the prices of these commodities have 2010,” the agency says. “New capital biosis of America’s dollar and China’s increased tremendously because of China expenditure in the mining industry is renminbi. China is booming not solely over the past five years,” Brian Redican, estimated to be $55.5 billion in 2010- on account of the suppressed renminbi senior economist at Macquarie Group, 11, 53% higher than 2009-10. Based on exchange rate, but it’s the cheap cur- advises Lorenz. “The way that this is industry intentions from the December rency, perhaps, that imparts the manic impacting the economy is not exports quarter 2010, Australian Bureau of Sta- and inflationary cast to China’s growth per se, but, rather, in mining investment. tistics survey data indicate capital ex- spurt. Whatever the case may be, Aus- BHP and Rio Tinto are flush with funds penditure in the mining sector in 2011- tralia is—for now—most profitably sit- and are expanding facilities, and this has 12 may be around $73.7 billion.” uated in the Chinese vortex. been a major impact on the economy. If China is setting universal records “China,” relates colleague Evan you look at mining investment as a share in the investment intensity of its eco- Lorenz, “accounted for 25.3% of Aus- of GDP, it has increased from 1% to 3%, nomic growth. In 2009, fixed-asset in- tralian exports in 2010. But Australia’s and companies plan for that to double.” vestment amounted to 48% of GDP, up from 35% in 2000. In the United States, fixed-asset investment was just 12% Advanced mineral and energy of GDP in 2010 (a more current figure capital expenditure projects than China’s), a decline from 18% in (in A$ billions) 2000. With respect to investment in- tensity, the No. 13 economy looks more value of projects* GDP value as % of GDP like China than the United States. In 2010, Australia registered fixed-asset investment worth 27.4% of GDP, up 2002 A$17 billion A$784 billion 2% from 24.7% in 2000. 2003 21 833 3 Sitting where the Aussies sit, noth- 2004 23 895 3 ing could seem more reasonable. Un- 2005 34 966 4 reasonable to them is the skepticism 2006 43 1,041 4 of the people on the other side of the 2007 71 1,137 6 world who fail to grasp the significance 2008 80 1,241 6 of the transformation of India and 2009 110 1,248 9 China. Suddenly, two billion people 2010 174 1,344 13 demand—and have the wherewithal to buy—the coal and iron ore in which the *April of following year West so signally failed to invest in the sources: Australian Bureau of Agricultural and Resource Economics and Sciences, IMF decade of the 1990s. SUBSCRIBE! - go to www.grantspub.com or call 212-809-7994 Winter Break-GRANT’S/december 30, 2011 14

The boom of all booms year stem mainly from a failure of gov- 120 $1.10 Australian dollar (right scale) ernment-controlled electricity rates to vs. indexes of mining and manufacturing production (left scale) keep pace with costs paid by utilities for the coal that fuels about three-quarters 110 mining 1.00 of the country’s electrical generation.” manufacturing “According to the power plants,” re- 100 Australian dollar 0.90 lates a May 26 dispatch from Xinhua AUD in U.S. dollars News Agency, the government’s own, 90 0.80 “the cost of generating one [kilowatt hour] of electricity has already exceeded the price they sell to grid companies, so 80 0.70 the more electricity they generate, the more money they lose.” Might that ex- 70 0.60 plain why China Southern Power Grid Co., the People’s Republic’s No. 2 elec- mining and manufacturing indices tricity distributor, turned up at the top 60 0.50 of the list of 17 state-owned enterprises that the government’s own auditor last 50 0.40 week charged with cooking the books? 3/90 3/95 3/00 3/05 12/10 Meanwhile, Global Sticks is coming sources: The Bloomberg, Australian Bureau of Statistics home. The Canadian maker of wooden ice-pop sticks is moving to Thunder Bay, Ontario, from Dalian, China. Chi- “[I]f,” Reserve Bank Gov. Glenn Ste- tralia removed those obstacles to the na may have lower wage costs, notes The vens told a Victoria University audience workings of the price mechanism with- Toronto Globe & Mail, which broke the in February, “China and India maintain, out a social or economic breakdown. story last week, but “[w]hen the power on average, their recent rates of ‘catch-up’ Concerning China, we are dead cer- goes off, it suddenly doesn’t matter if to the productivity and living standards tain of its errors, highly uncertain as to your labor is expensive. . . . Chinese of the high income countries, and if they when the consequences of those errors power prices have gone up as little as follow roughly the same pattern of steel might validate a short sale of China 1/10 of the rise in world oil prices.” intensity of production as seen in the past or its myriad proxies. Michael Pet- Heavy-duty money printing, wild and in other economies, a strong pace of in- tis, professor of finance at the Guan- wooly lending, exchange-rate suppres- crease in demand for resources will likely ghua School of Management, Peking sion, a closed capital account and price persist for some time yet.” Booms do go University, who has done so much control—not the ideal combination of boom, Stevens acknowledged, but he to expose the weaknesses in China’s macroeconomic policies for a healthy noted that “[t]he current boom looks big- banking and credit structure, posed a and growing economy. They are, how- ger than any other since [the founding of question in the May 23 edition of his ever, the policies dear to the heart of the Commonwealth of Australia in 1901] newsletter: “[A]re debt levels in China the Chinese overlords. Nemeses there at least.” It would, Stevens added, “be currently unsustainable?” he asks, then will surely be, though on the gods’ own rather extreme to assume that the rise of answers: “Probably not. I think China timetable. How to prepare for what may China and India is a short-run flash-in- has at least four or five more years of prove to be more than a bump in the the-pan phenomenon.” this kind of debt build-up before it hits road of China’s long economic march? Amen, says Warren Hogan, chief the debt limit. Why do I think this? Un- Of short-sale candidates, there is no economist of the Australia & New Zea- fortunately, I have no reason beyond shortage. One could pick on Vale, Rio land Banking Group: “Cyclical issues in intuition, especially since neither I nor Tinto or BHP. One could sell the pub- China I don’t get too concerned about, anyone else truly knows the amount of lic seaborne shippers, the commodity because the amount of capital commit- debt in the system.” of your choice (not gold, however, we ted by large miners won’t stop if China What Pettis doesn’t know, neither do think), or even Sotheby’s. Alternative- slows down for a year or two, which I we. As for our intuition, we see an omi- ly, one could sell the Australian dollar. think is a low probability event.” nous near-term convergence of events As things stand, admittedly, it’s fairly There is, too, in Australia a shrug of in China’s developing power crisis. For valued. The value of Australia’s ex- the shoulders regarding the calculated an electricity shortage that is crimping ports in relation to the value of Austra- misinformation of China’s state-manip- production, drought gets the blame, but lia’s imports stands at a 140-year high. ulated prices. Australia’s own economy price control is the real cause. Though The economy is near full employment. in the 1960s and 1970s was a model of the Chinese government fixes electrici- An epic investment boom is under way. resource misallocation, you will hear. ty rates, the world sets coal prices. “Fast- The $1.07-to-the-greenback exchange The exchange rate was fixed, wages growing China has long experienced rate is, therefore, the Reserve Bank’s were inflexible, tariffs were high, the periodic power shortages, especially in best friend. A much lower exchange financial sector was bound hand and winter and summer when weather de- rate would present the central bank foot. In short, the argument goes, it was mands boost demand for heating and with the necessity of raising Australian a system that anticipated China’s. No- cooling,” the Associated Press reports interest rates, which—in conjunction tice, however, say the bulls, that Aus- from Shanghai. “But the problems this with elevated Australian house pric- SUBSCRIBE! - go to www.grantspub.com or call 212-809-7994 Winter Break-GRANT’S/december 30, 2011 15 es—are high enough to hold down the has arguably acted as a ‘poison pill’ for es, depreciation and amortization. This percentage of first-time home buyers to parties potentially interested in acquir- year, with the Australian unit com- 16% as of the April report, down from ing the Beer business, while parties manding 105 U.S. cents, the company 21.7% of total buyers in the decade interested only in the Wine business is expected to generate no more than of the 1990s and 28.5% in May 2009 would be unlikely to contemplate an ac- A$258 million in EBITDA. (when the government was bending quisition of all of Foster’s.” According to a sampling of Wine Spec- over backwards to help). Lindeman’s, Penfolds, Rosemount, tator reviews (no wine tastings allowed in The forex picture would, we believe, Wolf Blass and Beringer are Treasury’s the office during business hours), there’s change in a flash if China tripped or five main brands. To build them, and nothing wrong with Treasury Wine Es- if Australia took an autonomous spill. 45 others, BofA’s Errington relates, tate’s vintages that a more forgiving ex- “Australia,” as Lorenz observes, “is an Foster’s spent more than A$8 billion change rate wouldn’t fix. If we’re right open economy, its $1.4 trillion GDP over the past 10 years, “sparing no real about China, help is on the way. on a par with that of Texas. The rapid cost to create a world leading asset • movement of capital in and out of the base.” Call it A$10 billion to A$12 bil- country registers strongly on the ex- lion in today’s money, Errington goes change rate. You don’t have to turn on, as against the winemaker’s current Raining REITs over many pages of history to see dra- enterprise value of not much more than matic movement. For example, the A$2 billion. TWE shows A$140 million (April 22, 2011) The previous is- Australian unit fell by 39% against the in net debt vs. BofA’s 2011 estimates of sue of Grant’s took note of a coming greenback between July 15 and Oct. 27, A$2.89 billion in equity and A$258 mil- wave of mortgage real estate invest- 2008, a period during which the Com- lion in earnings before interest, taxes, ment trust IPOs. The issue you hold modity Research Bureau/Reuters U.S. depreciation and amortization. in your hands (or that glows on your Spot Raw Industrials Index plunged by For Treasury, which conducts 34% screen) takes stock of the newcomers 26%, Lehman Brothers filed for bank- of its bottling operations outside the while pausing to remember the RE- ruptcy protection and world credit mar- mother country (California, with 32%, ITs that came a cropper. In preview, kets stopped in their tracks.” is far and away the busiest foreign out- the mortgage REIT Class of 2011 has Of course, not every dislocation in fi- post), the Aussie dollar exchange rate much to learn. Someone must pay the nance is apocalyptic. Life goes on, the is the villain of the piece. China is well tuition, but it doesn’t have to be you, reserve currency system notwithstand- and good as a wine market—manage- gentle reader. ing (though we sometimes wonder ment has high hopes for the Chinese Reasons for the crowded IPO cal- how). Maybe the Chinese mandarins palate—but the magnetic tug of the endar are many and obvious. The will suffer not a proper depression but China trade on the Aussie dollar is the yield curve is steep, investors want only a steep correction. Maybe the Aus- killer. In 2007, when the Australian cur- income, mortgage managers want sie dollar will correct but not crash. But rency was quoted at 78.7 cents to the fees—and the administration wants even such a marginal markdown in the greenback, TWE generated A$484.9 out. The Treasury’s February white Australian exchange rate would be as million in earnings before interest, tax- paper on Fannie Mae and Freddie manna to the desperate Aussie export- ers—for instance, the wine exporters. Treasury Wine Estates (TWE on the Sydney bourse) bears the stigma of be- Made for sharing: Grant’s reprints. ing “probably the most AUD-sensitive stock on the Australian market,” accord- Grant’s articles and cartoons ing to a May 24 Bank of America Mer- rill Lynch research bulletin by David —prepared to order. Errington and team. Treasury is a new stock—it began trading on May 10—but Have you found a Grant’s article not a new company. Before acquiring its very own ticker, it was the wine group of particular interest? within Foster’s (Foster’s, as no Ameri- can sports fan needs reminding, being Would your presentation benefit “Australian for beer”). In explaining the from a Grant’s cartoon? spin-off to shareholders, Foster’s gin- gerly touched on the wine business’s Share a reprint with colleagues and lamentable earnings: “A formal sale pro- clients. Articles are reformatted to cess might result in the sale of TWE at a price that does not appropriately reflect include your company name. its underlying value and future pros- Cartoons are sent in whatever pects,” management said. Then, too, as format you require. independent investment adviser Grant Samuel & Associates observed in the One-time reprint rights are available. Call Grant’s at 212-809-7994 for details. March de-merger statement of TWE, “[t]he presence of the Wine business WWW.GRANTSPUB.COM SUBSCRIBE! - go to www.grantspub.com or call 212-809-7994 Winter Break-GRANT’S/december 30, 2011 16

Class of 2011 (in $ millions) name sponsor date filed fees max. offer AG Mortgage Investment Trust Angelo, Gordon & Co. 4/5/11 1.5% $345 mil. American Capital Mortgage Investment American Capital, LLC 3/31/11 1.5 500 Putnam Mortgage Opportunities Putnam Investments, LLC 4/11/11 1.5 300 Apollo Residential Mortgage Apollo Global Management, LLC 3/21/11 na 300 Pimco REIT Pimco 4/5/11 1.5* 600 Provident Mortgage Capital Associates Provident Funding Associates, LP 3/8/11 1.5 300 TMAC Mortgage TCW Investment Management 3/11/11 1.5 300 Western Asset Mortgage Capital Legg Mason/Western Asset Mortgage 3/24/11 1.5 300

*20% incentive with 8% hurdle

Mac announced the government’s in- “Neither has it been lost on the “All new filers will be externally tention to reduce its commanding role filers or their investment bankers,” managed,” Lorenz observes. “The in mortgage finance. There’s hardly Lorenz continues, “that running a business acumen running each REIT room to enlarge it. Over the past three mortgage REIT is highly remunera- will sit in a larger fund, e.g., TCW or years, according to Redwood Trust, a tive. Nearly all the newcomers pro- Apollo, and that fund will collect the REIT that is trying to reinstitute free pose to charge a management fee of management fee. Externally managed enterprise in the mortgage field, the 1.5% of equity each year, well in ex- REITs add another layer of potential government has guaranteed nearly cess of what a mutual fund typically misalignment between shareholders’ 90% of mortgage originations. Over commands. There are some honorable and management’s interests. And that the past 25 years, it has guaranteed an exceptions. Hatteras Financial (HTS is only one problem. The largest extant average of 51%. on the NYSE), for example, is notable REITs change hands at an average of To make the transition from all for scaling down its fees as its equity only 110% of net asset value. Investors government to less government, the pool grows. The pending Pimco trust in a new REIT give up a portion of the Treasury proposed that Fannie and is notable in another way: It proposes freshly raised funds to compensate the Freddie raise the cost of the mortgage a 20% performance fee for returns in underwriters. That is, the public pays insurance they write, reduce the size excess of 8% on top of the 1.5% man- a premium for the privilege of invest- of the loans they insure and shrink agement fee.” ing in a blind pool on which accrues a their portfolios by 10% per year. Just As noted here two weeks ago, the management fee. ‘If we are all trading the raising of this immense trial bal- REITs have never had it so good. at book value,’ an executive at one loon brought cheers from civilian The two-year to 10-year portion of of the established REITs remarks, ‘I mortgage managers. The removal— the yield curve measures 271 basis don’t know how these deals are going or, at least, reduction—of govern- points steep, more than double the to get done.’” We know. Money-mar- ment subsidies promises more ratio- 1.12% post-1990 average. Mortgages ket interest rates hovering near zero nal pricing, therefore better returns are devilishly hard assets to man- will smooth the way. on invested capital. age, loaded as they are with what the Some deals are done, others Of course, the contemplated changes CFAs are pleased to call “optionali- are undone. Carlyle Capital came may be a long time coming—if, indeed, ty.” The steepness of the yield curve, undone in March 2008 when its they ever arrive. But the promoters of however, constitutes an almost irre- lenders refused to continue to ex- the new REITs don’t intend to wait. sistible temptation to give the mort- tend financing to a portfolio that Eight new prospectuses are on file, gage business a try. was leveraged 32:1. (Memo to the and colleague Evan Lorenz has made a In the first quarter alone, the five Class of 2011: No leverage ratio over survey of them. largest mortgage REITs raised $5.3 31:1.) In mortgages, as in stocks or “The new REITs,” Lorenz reports, billion in new capital via secondary commodities or anything else, price “are adopting a hybrid model, which offerings. The eight pending IPOs is all important. While MFA and allows them to invest both in agency seek an initial $2.9 billion. The Chimera Investment Corp. (CIM on and non-agency securities. This makes truth of the matter is that mortgage the NYSE) have made hay by invest- sense if the future of the mortgage mar- REITs are insatiable. They issue ing in the private-label RMBS shak- ket will involve a reduced role for the stock to go public. Then they issue en loose by the Great Recession, the government-sponsored enterprises. In stock to “gain scale.” Then—scale REITs that bought that paper at par, this respect, the new offerings take after attained—they issue more stock to e.g., New Century and Novastar Fi- MFA Financial (MFA on the NYSE). rake in additional management fees. nancial, didn’t survive the crisis to American Capital Mortgage Investment The reason the REITs, as an indus- buy the dips. Corp., Putnam and Pimco raise the hy- try, trade not much higher than book While it’s clear sailing, high cotton brid ante by drawing commercial mort- is because book-plus-a-little is where and full speed ahead today, it was not gage-backed securities into their poten- they tend to issue more stock—and always thus. For instance, on June tial universe of investments. still more stock. 30, 2004, the Fed began to tighten SUBSCRIBE! - go to www.grantspub.com or call 212-809-7994 Winter Break-GRANT’S/december 30, 2011 17

Missing in action we need the $8 now. And if we can’t get the $8 now, we will liquidate your name inception fail date reason for disappearance collateral pool in support of our loan.’ You can actually go bankrupt on that Luminent Mortgage Dec. ’03 Sept. ’08 Chapter 11 in the REIT market. That’s not hap- Thornburg Mortgage June ’93 May ’09 Chapter 11 pening now, but that did happen in Bimini Capital Sept. ’04 Oct. ’07 NYSE suspends 2002-03, and that happened a little KKR Financial Holdings June ’05 May ’07 de-REIT, convert to LLC bit in 1998. Deerfield Capital June ’05 Nov. ’08 de-REIT, convert to C corp. “Most of these mortgage REITs that are starting, these ‘newcos,’ by Laser Mortgage Management Nov. ’97 May ’02 NYSE suspends their own prospectuses, disclose that Apex Mortgage Capital Dec. ’97 July ’03 merged with AHM they have no experience running a American Home Feb. ’04 Aug. ’07 Chapter 11 mortgage REIT,” Gundlach winds Anthracite Capital March ’98 March ’10 Chapter 7 up. “[T]hose that have no experience New Century Financial June ’97 April ’07 Chapter 11 running a leveraged portfolio…will learn how to do it over the course of Carlyle Capital July ’07 March ’08 defaulted on $16.6B a couple of years, but you are going Novastar Financial Oct. ’97 Jan. ’08 NYSE suspends to make a couple of mistakes as you Sunset Financial Dec. ’03 April ’06 merged with Alesco learn how to do it.” HomeBanc March ’04 Aug. ’07 Chapter 11 And therein lies the germ of a trade: Crystal River Capital July ’06 Aug. ’10 acq. by Brookfield Asset Mgt. long an existing REIT (e.g., MFA, Hatteras, Annaly), short a newco prom- ising, but not yet delivering, a strategy MortgageIT Holdings July ’04 Jan. ’07 acquired by Deutsche Bank comparable to that of the paired long. Fieldstone Investment Feb. ’05 July ’07 acquired by multiple entities The fledglings labor under not one Hanover Capital Mortgage June ’97 Oct. ’08 reverse takeover disadvantage but two. They bear the aforementioned underwriting fee, and sources: The Bloomberg, company filings they need time to put money to work to produce a dividend. Then, too, the policy, raising the then 1% funds rate ingful leverage that have really sur- management, being human, must be by 25 basis points. By year-end 2005, vived over a full cycle.” allowed to make some rookie mis- the yield curve began to invert. An- Prepayment risk is but one of the takes. We forgive them in advance. naly Capital Management (NLY on mortgage land mines. “Because,” Gund- • the NYSE), the largest and one of the lach explains, “you have a payment de- best-run REITs, suffered a decline in lay in getting your principal. They an- book value per share to $9.48 in the nounce the prepayment the evening of Nutmeg State conversion second quarter of 2006 from $13.45 in the fourth business day of the month. the 2004 first quarter. But you don’t actually get the money, in “I can’t remember anything close,” the case of Fannie Mae, until the 25th. (February 22, 2011) Mutual thrifts says Jeffrey Gundlach, CEO of Double- And that gap in the middle is incredibly keep changing their spots. According Line Capital and former world-beating difficult to manage for a REIT because to the February SNL ThriftInvestor, 24 fixed-income manager at Trust Co. of even though you have a receivable com- savings institutions converted to in- the West, concerning the queue of pro- ing in on, say, the 25th, the margin clerk vestor ownership in 2010. Not since jected mortgage REITs. “In the past, if calls you on the fifth business day and. . 1999 have so many depositor-owned there were three it was an event. Eight . says, ‘We need more collateral, because banks and S&Ls gone public. At year- is unbelievable. I’m sitting here getting the factor on all of these securities has end, 18 more candidates came forward phone calls all the time from invest- dropped with the prepay numbers that to convert, while 52 were in an earlier ment banks saying we should launch a just came out.’ He no longer has, say, stage of IPO latency. The 52 are mu- REIT fund for you. The market’s wide $100 of collateral (under high prepay tual holding companies. Having par- open. With reputation and the Double- environments, you can get even 8% [of tially switched to investor ownership, Line brand, you could raise billions of the underlying principal] paying off in a they are laying plans to complete the dollars. What’s wrong with you? My month; it can be that high). What they transition. Twenty-two mutual hold- answer is that I am too old to raise bil- do is, they say, ‘We have $92 in collat- ing companies change hands on ma- lions of dollars and go around the world eral, please send us the $8.’ jor exchanges, another 30 in the pink saying ‘I’m sorry,’ which is what I think “‘I’ll be happy to send it to you sheets. would end up happening.” when I get it on the 25th,’ you say. ‘So Grant’s welcomes them (see the is- The trouble boils down to the na- I’ll pledge you this IOU that comes sues of Oct. 29, Nov. 12, Nov. 26 and ture of the risks required to generate wrapped in a government guarantee Jan. 14). The typical mutual-to-stock a competitive dividend yield—14% that comes due on the 25th.’ The mar- candidate is under-managed—at least, and up constitute today’s benchmark. gin clerks do not accept that. What from the profit-maximization point of “Few, indeed,” Gundlach goes on, they say is, ‘That’s great, be happy to view—and overcapitalized. It survived “are the REITs that have done mean- take that money when you get it, but the debt disaster and sees opportuni- SUBSCRIBE! - go to www.grantspub.com or call 212-809-7994 Winter Break-GRANT’S/december 30, 2011 18

Depositors sell to investors tate is what it lends against. Its loan 30 30 portfolio is secured by residential real mutual-to-stock conversions estate (41% of the total), commercial real estate (28%), construction liens 25 25 (4%) and time-share interests (9%). Commercial loans and home-equity lines of credit constitute 10% and 7% number of conversions 20 20 of the portfolio, respectively. “Other” is the name of the residual. At the December 2007 start of the 15 15 big recession, Farmington had lots of tangible equity (equal to 9.4% of as- sets) and few nonperformers (0.39% of 10 10 total loans). Capitalizing on that posi- number of conversions tion of strength, management made hay. From the 12th month of 2007 to 5 5 the ninth month of 2010, the balance sheet grew by 59%, to $1.5 billion. In March 2008, the current CEO, John J. 0 0 Patrick Jr., joined the company, having 1999 2001 2003 2005 2007 2009 2011e previously headed the Connecticut op- source: SNL ThriftInvestor erations of the former TD Banknorth. “I came from an organization where ties in the post-disaster marketplace, tween 55.8% and 68.8% of tangible we took it from the 17th-largest bank including those implicit in the winding book. Day traders will be interested to in the state to the fifth-largest bank,” down of Fannie and Freddie. In some know that, according to SNL, 16 prior Patrick tells colleague Evan Lorenz. cases, a gray and long-serving manage- comparable thrift conversions—i.e., “And so, there was an opportunity to ment looks forward to monetizing the uncomplicated, “single-step” affairs— be part of a growth story here.” value of its stewardship by selling out enjoyed average share price apprecia- Growth doesn’t just happen, of when the time and price are right. tion of 10% on the first day of trading. course, and Farmington has been First Connecticut Bancorp, hold- Farmington was founded with ini- spending money on new systems, new ing company for Farmington Savings tial deposits of $88.70 during the ad- people and new branches. Among Bank, broadly conforms to demutu- ministration of Millard Fillmore. One the new hires is the former CFO of alization type, and we therefore look hundred and sixty years later, under Rockville Financial (Grant’s, Jan. 14). kindly on it. To “look kindly” is an the administration of Barack Obama, “We’ve built a platform here that’s intermediate kind of investment pos- the bank shows $1.2 billion in depos- very scalable,” Patrick says. “We’ve ture, stronger than “hold” but weaker its and $1.5 billion in assets. It serves made investments in this company than “buy.” In ardor, it resembles a kiss Hartford County with 15 branches and that you don’t see in other mutuals.” on the cheek. We go no further with four limited-service offices. Real es- You do see them, however, in the in- Farmington because its problem loans have been growing faster than its loan portfolio. “The Year of Yes” was the ‘Yes’ to growth $1,600 90% theme of its 2009 annual report, which First Connecticut’s asset growth (left scale) assets proudly flagged “record asset growth vs. efficiency ratio (right scale) of $160.8 million.” “Yes to growth,” as the bank puts it, is laudable, especially when others are shrinking. But growth 1,400 80 for the sake of growth is anathema for

even a well-capitalized financial in- efficiency ratio stitution. What we don’t know about First Connecticut—and won’t be able 1,200 70 to find out until the IPO has come and efficiency gone—is whether asset quality is, or is not, a problem with a capital “P.” If, as expected, between 9.8 mil- assets in millions of dollars lion and 15.2 million shares come to 1,000 60 market next quarter at $10 apiece, you’ll find them on Nasdaq under the ticker FBNK. The company would then command a market cap of be- 800 50 tween $102 million and $158 million, 12/05 12/06 12/07 12/08 12/09 9/10 and the stock would be valued at be- source: company reports SUBSCRIBE! - go to www.grantspub.com or call 212-809-7994 Winter Break-GRANT’S/december 30, 2011 19 come statement. On a trailing 12-month that we will continue organic growth • basis, non-interest expense has ballooned as we continue to move forward,’ he to $40.8 million from $24.2 million in says. ‘We don’t expect to do anything Also from the vault... 2007. In consequence, Farmington’s ef- to dilute tangible book value.’ While ficiency ratio, a measure of non-interest Patrick, age 51, has stated no inten- expense to net-interest income plus tion to buy, he may have an incentive In the “everything old non-interest income, has moved in the to sell. His contract entitles him to a wrong direction, to as high as 85.6% in $5.5 million payout should the bank is new” category, we’d 2008 from 63.5% in 2005 (lower is better). be acquired. like to point a finger Then, again, as Farmington has gained “Rapid growth in any financial scale, the efficiency ratio has begun to raises red flags,” Lorenz concludes. back six years to. . . come down, reaching 73.8% in the nine “Farmington has grown assets at a months ended Sept. 30. compounded rate of 18% per year “As part and parcel of rapid growth since December 2007. While non- plus depressed earnings,” Lorenz performers, at 1.8% of total loans, are points out, “capital has not grown no reason for alarm per se, they sit commensurately with assets. Today, dramatically higher than the 0.39% Farmington’s tangible equity totals level in 2007. Reserves, which amount Inside baseball in Europe just 6.5% of assets. A key reason the to 1.57% of gross loans, may not be bank is flipping to a public charter is to enough to cover losses if delinquen- (June 3, 2005) Since we proph- raise the capital required for continued cies continue to mount.” esied that European sovereign debt growth. Post the IPO, the bank will be “Our whole management team yields would begin to de-converge comfortably capitalized with between has lived through the late 1980s and (Grant’s, March 11 and 25), Portu- 11.4% and 14% tangible equity to as- early 1990s with what happened here gal has owned up to a shockingly big sets, opening it to the greatest invest- in New England,” says Patrick in re- fiscal deficit, the Organization for ment risk for ex-mutuals: A cheap val- sponse to this observation. “None of Economic Cooperation and Devel- uation and excess capital can lead even us ever want to live through that again. opment has revised upward its 2005 the most well-intentioned manage- . . . To grow for the sake of growth is deficit forecasts for Greece and Italy ment teams to destroy value via acqui- not right for us. It has got to be the (as well as for Portugal), and French sitions and empire building. Patrick is right kind of growth with the right as- voters have rejected the European cognizant of the threat. ‘We’ve had an set quality.” Constitution. But spreads between organic growth strategy. We anticipate Here’s hoping. the strongest and weakest European national borrowers have widened only a little. Following is a progress report on an admittedly exotic speculation. Why wait around? Not just anyone can call up the Mor- gan Stanley derivatives desk and buy himself a basket of credit default swaps (CDS) on—for instance— Italy, Greece and Portugal, the so- called Club Med of the euro zone. But for those with the will and the way, no sweeter risk-reward proposi- tion is available in all the credit mar- kets, we judge. Before monetary union, European governments borrowed each accord- ing to its ability, the weaker paying significantly more than Germany or France. For example, in 1995, Span- ish and Italian 10-year notes fetched a yield premium of 525 and 600 ba- sis points, respectively, over German bunds. Today, they’re quoted at spreads of zero and 21 basis points, respectively. Call today for group and bulk rates to Grant’s. Theory had it that, in a unified European economy, every sovereign 212-809-7994 borrower would be equally credit- worthy. Each would be subject to the strictures of the stability and growth SUBSCRIBE! - go to www.grantspub.com or call 212-809-7994 Winter Break-GRANT’S/december 30, 2011 20 pact. All would share in the cohe- Club dead sive power of the single currency. 6% 6% And theory was borne out. Conver- real GDP growth in three European countries, measured year-over-year gence—one of the longest-running 5 Greece, 5 and most lucrative fixed-income 3.6% trades in years—came to pass. 4 4 But centrifugal forces have over- taken unifying ones, and neither 3 3 stability nor growth appears to be in GDP growth Europe’s immediate future. De-con- Italy, 2 -0.2% 2 vergence may already be under way. Thus, since March 8, the premium 1 1 of Italian to German 10-year yields GDP growth has widened to the aforementioned 0 0 21 basis points from 10. Over the same span of weeks, the premium Portugal, of Greek to German 10-year yields -1 0.6% -1 at December 2004 has widened to 24 basis points from at December 2004 seven. Portugal has no on-the-run -2 -2 10-year note; but the premium of the 3 -3 -3 Portuguese 4 /8s of 2014 to the equiv- 3/99 3/00 3/01 3/02 3/03 3/04 3/05 alent German bund has expanded to source: The Bloomberg 10 basis points from five. In 1994, the occasion of another Portuguese vestors are assuming the ECB will Europe with indissoluble ties. This fiscal crisis (though one less severe continue to shield Club Med debt is now being put to the test. The than today’s), Lisbon was borrowing by treating it as identical to German high point of the European ‘Project’ at a yield of 11.5%, 385 basis points debt in their refinancing activities,” may have passed when a clutch of over the German rate. the Telegraph noted on May 28, “but ex-communist states joined the EU What price should the market already the Bank of England refuses on May 1, 2004, each jealous of their exact on the free-riding profligates to accept Greek bonds at par, and this newly won sovereignty.” of western Europe? The Daily Tele- political gamble overlooks the hard- As an aid to clear investment graph, London, offers perspective. It ening mood in Paris, Berlin, Madrid thinking, it sometimes helps to imag- points out that the sovereign credit and the Hague. [European Monetary ine selling the thing you plan to buy, spreads in Europe are smaller than Union’s] architects always expected or vice versa. We asked colleague Ian the differences prevailing between trouble, but counted on a ‘beneficial McCulley to paint us a picture of the the members of another federation, crisis’ that would help push Europe re-convergence trade: What forces one much longer established than further towards full economic fed- of politics or finance would make the EU (it contains 50 states and its eralism. Jacques Delors even spoke it profitable to sell credit insurance capital is in Washington, D.C.). “In- of an inevitable ‘debt union’ binding on Italy, Greece and Portugal? A weakened euro exchange rate might Rumors of de-convergence help, he ventured; it could help to 30 30 yield spread between Greek, Italian and Portugese 10-year notes stimulate export growth, therefore and German bunds GDP growth, even in such econo- Greece: 24 bps mies as Italy’s (which is shrinking), 25 25 Portugal’s (which is stagnating) or Greece’s (which is growing, thanks Italy: to the stimulus afforded by the non- 21 bps 20 20 recurring 2004 Olympics). A political in basis points backlash might hasten real economic reform and thereby institute a more 15 15 prosperous Continental economy, McCulley goes on. And bond yields in basis points might continue to fall, “which would 10 10 tend to compress the spread differ- ences between the various sover- eigns,” he notes. “Investors could 5 Portugal* 5 also become more sanguine about credit risk and push CDS spreads lower in all credit markets.” 0 0 More likely, however, he and 1/3/03 7/4 1/2/04 7/2 1/7/05 5/31 his editor judge, is that the weaker *Portugal has no current 10-year bond economies will get weaker, and that source: The Bloomberg SUBSCRIBE! - go to www.grantspub.com or call 212-809-7994 Winter Break-GRANT’S/december 30, 2011 21 still-narrow credit spreads will wid- Value, Italian style en. According to Viktor Hjort, Mor- 22bp 22bp gan Stanley credit derivatives and Italian 10-year credit-default swaps structured credit strategist, London, 21.14 bp buying credit protection is much like 20 20 buying a put. The most liquid con- tracts typically run for five years—if the cost of protection against default 18 18 were 10 basis points, the CDS buyer in basis points would put up $10,000 a year on each $10 million face amount of CDS he 16 16 bought. Some of these contracts trade

more frequently than others, Hjort in basis points cautions. You can think of them as 14 14 a deep, deep out-of-the-money op- tion. Not so deep, we believe. • 12 12

Bring back the lira 10 10 2/1/05 3/31/05 4/29/05 5/31/05 6/14/05 (June 17, 2005) On June 8, the gov- source: The Bloomberg ernment of Italy issued €E2 billion of floating-rate, 15-year debt at an ini- tial yield of only 2.75%, an interest gled out for official condemnation). details on June 19. rate worthy of the proverbially triple- What to do? The solution pro- The odds on the recommission- A-rated Roman Empire under Caesar posed by a trio of ministers in the ing of the lira do seem long. Berlus- Augustus. Except, today’s Italy is in government of Silvio Berlusconi is to coni himself rejects the idea (even as recession, the only economy in the trade in the euro for the previously he winks at it), and a poll released G-7 so blighted. And the European unlamented lira. “Does sterling have Saturday shows that nine out of 10 Union last week began procedures no economic foundation because it is Italians are opposed to it. On the to discipline the Italian government outside the euro?” demanded one of other hand, in a November poll, 64% for exceeding EU and euro-zone the ministerial champions of the dis- of Italians said they had either “a limits on budgetary deficits. In this carded Italian currency. “Is Denmark lot” or “some” trouble “handling” respect, too, Italy stands alone (not living in absolute poverty because it the euro, according to the Finan- in its open flaunting of the EU fiscal is outside the euro? Are Swedes poor cial Times, “the highest level in the rules, for it is only doing what France because they are outside the euro?” 12-nation eurozone.” (If the euro has and Germany do, but in being sin- The politicians promise to fill in the taken some getting used to in Italy, it might be because the single cur- rency lacks the garlands of commas Euro-denominated gold price jumps $480 360 and zeros that had bedecked the de- price of gold in dollars (left scale) vs. in euros (right scale) 354.48 valuation-prone lira.) To mainstream Italian politicians, 450 350 the lira-restoration project is an em- barrassment and an abomination. In anguish, they cry out to their coun- trymen: Are you nostalgic for the old

420 340 gold price in euros sky-high inflation rates? For the old towering interest rates? For the se- 390 330 rial monetary and fiscal crises? It is not to be taken seriously. “Talk of an implosion of the eurozone has . .

gold price in dollars . left most serious analysts cold,” the 360 320 $427.05 FT recently pronounced. “Goldman Sachs, for example, put the likeli- hood of the collapse of monetary 330 310 union this decade at 1%.” The bond market is priced for ap- proximately those odds. Thus, on 300 300 May 30, the day after the French 1/3/03 7/4 1/2/04 7/2 1/7/05 6/14 voted down the proposed European source: The Bloomberg Constitution, the government of SUBSCRIBE! - go to www.grantspub.com or call 212-809-7994 Winter Break-GRANT’S/december 30, 2011 22

Italy was able to sell E2.5 billion of according to a new poll, 56% of Ger- in the liberated Eastern European three-year notes at a yield of 2.3%, mans want their beloved deutsche state. The strategy: Swap a fixed- and another€E2.5 billion of 10-year marks back. In Germany nowadays, rate cash flow for a floating-rate cash notes at a yield of 3.5%. Whatever relates our German-speaking col- flow. Specifically, lock in the two- else was running through inves- league, Susan Lhota, people say year Czech swap rate, at 2.24%, and tors’ heads as they reached for their “teuro,” not euro. The “t” signifies receive the six-month Czech money checkbooks to trade today’s euros for teuer, meaning expensive. rate (the Prague interbank overnight tomorrow’s presumptive euros (and We judge that Europe wants rate, or Pribor) at 1.75%. The fixed- at such fancy yields), it was not: “We cheaper money. And, we predict, it rate side of the swap pays annually, investors require a margin of safety will get it. the floating-rate side, semiannually. not only against the known risks but • So positioned, a trader initially suf- also against the increasingly worri- fers 49 basis points of negative carry. some possibility that the real risks However, a 50 basis-point tightening we face are today unknown, at least Unthinkable euro thoughts by the Czech National Bank would to ‘serious’ analysts.” propel him or her (slightly) into the For last month’s 14.5% drawdown (July 29, 2005) From across the black. To listen to our unnamed ad- in its Credit Fund, GLG Partners, Atlantic come new and unsanc- viser, that half percentage point would Europe’s biggest hedge-fund man- tioned notions about European fi- be only the start. Czech interest rates agement company, has blamed the nance. First is that interest rates have no business being as low as they downgrades of General Motors and are too low, especially in the Czech are, and would not be except for a 2002 Ford, events so improbable that Republic. Second is that seemingly deflation scare. And though no inflation their occurrence produced an “eight comical calls to reinstate the lira in scare is in the immediate offing, expec- 1 standard deviation move,” as GLG fact point to a serious risk of the tations center around a 2% or 2 /2% rate put it. Yet, is it only our imagina- euro zone breaking up into its 12 of rise in consumer prices. “Retail sales tion or do outlying events not seem quarrelsome components and cut- growth keeps surprising on the up- to occur most frequently and devas- ting short the grand experiment of side,” our man winds up. “Which is not tatingly to leveraged investors oper- the single currency. surprising considering this is a country ating without a margin of safety in Interest rates first. Did you know where people didn’t have everything. overvalued markets? that the Czech overnight rate is just Now they are getting a color television, In the euro zone, bond prices are 1.75%? That it is 25 basis points be- a car, a refrigerator.” But the existing, driven these days mainly by expec- low the European Central Bank’s too-low, unsustainable and fluky 1.75% tations of easier monetary policy policy rate, even though Czech mort- overnight rate was expected to stand and weaker business activity. The gage growth is ripping along at 56%? following a July 28 meeting of Czech results are as noted: generationally That the Czech stock market is up by monetary policy makers. low yields, even for the fiscally un- 21% this year and that Czech GDP is One of the many oddities about repentant government of Italy. And growing by 4.5%? All true, observes Czech crown-denominated interest because Italy is still a member of the an anonymous European reader, rates is that the Czech Republic is euro zone, and because its bonds are who suggests a trade to profit from expected to enter the euro zone in still in the relevant bond indices, fi- a return to normal-size interest rates 2010 (along with Poland, Hungary duciaries invest in Italian debt mere- ly because it exists. Czech money: too cheap to last All the while, the price of cred- 7% 7% it insurance on Italian sovereign Prague interbank overnight rate debt continues to widen, even as the euro-dollar exchange rate con- 6 6 tinues to weaken (Grant’s, March 11). We deem the Italian credit-de- fault swaps, at 21 basis points and 5 5 change, to represent good value,

still (alas, these instruments are Pribor available only to institutional-size 4 4 investors). And we deem Italian Pribor sovereign debt—and that of Greece and Portugal—to represent rare and 3 July 26, 3 extreme anti-value. 1.751.75%% “Serious” analysts will rue the day they discounted the centrifugal forc- 2 2 es now unleashed in Europe, in our opinion. On the cover of the June 2 issue of the German magazine Stern 1 1 is the headline, “Have we choked 7/14/00 7/6/01 7/5/02 7/4/03 7/2/04 7/1/05 on the euro?” Inside is a report that, source: The Bloomberg SUBSCRIBE! - go to www.grantspub.com or call 212-809-7994 Winter Break-GRANT’S/december 30, 2011 23 and Slovakia). You might suppose Interchangeable credits? that, in view of the risks associated 300 300 spread between yields on Czech and German 10-year bonds with any complex human endeavor, the market would not be assigning 250 250 this one a zero-percent probability of misfiring. But it is: Czech inter- est rates are pitched below euro- 200 200 denominated ones all the way out to five years. in basis points 150 7/22/05,July 26, 150 Which brings us to the future of 2922.13 bp the single currency. A new report from Smithers & Co., London, con- 100 100

cludes that it might not have one, in basis points or, at least, not a very long one. This radically bearish prognosis is the 50 50 fruit of a carefully reasoned argu- ment. “The fate of the Eurozone will 0 0 be decided by the performance of its weakest link,” the report proposes. Let one nation secede and devalue, -50 -50 and others would, by force of com- 4/7/00 4/6/01 4/5/02 4/4/03 4/2/04 4/1/05 petitive pressure, be led to do the source: The Bloomberg same. Before you know it, the world would be back to lira, francs, marks, ed together to resist the devaluation 1933 onwards, the Gold Bloc lost punts, etc. of the British pound and the U.S. ground to the devaluing countries. Why might a nation, even a weak dollar. These countries—the so- Belgium, in particular, found it hard one, leave the fold of a peaceful and called Gold Bloc, including France, to compete against the prices quot- united Europe? An inability to adapt Italy, Belgium, The Netherlands ed in cheap pounds, and it left the and an incapacity to innovate are two and Switzerland—left it to the An- bloc in 1935. “[T]he Belgian defec- good reasons. Imagine a country with glo Saxons to destroy themselves tion weakened the credibility of the an aging population, an uncompeti- with paper money. They would Bloc as a whole,” write Smithers and tive manufacturing sector, an inef- stay the course with gold. At first, Grant, “and in turn exposed other fective government and an inflexible the Gold Bloc flourished, write the members to competition from Bel- labor market. Imagine Italy. eponymous Andrew Smithers and gian exports which were now cheap- The Smithers argument stands on his colleague Oliver Grant, a fellow er. Further defections followed and logic, it seems to us. What doubles of St. Anthony’s College, Oxford. the Bloc effectively came to an end its power is that it equally stands on For the member countries, the De- in 1936.” historical precedent. In the 1930s, a pression was not so devastating as All of which bears on the seem- group of European countries band- for their neighbors. However, from ingly mirthful speculation about a return of the lira. “In the case of the Deflation? Never mind. Eurozone,” the report warns, “the 7% 7% defection of even a single member Czech consumer price index, year-over-year change is likely to be fatal for the system. If 6 6 Italy, for example, were to withdraw, this would expose other countries to Italian competition, especially as this 5 5 would almost certainly be accompa- nied by a large devaluation of the re- 4 June 30, 4 instated lira. Other vulnerable econ- 1.8% Czech CPI omies would come under pressure; 3 3 perhaps Spain or Portugal would be the next to go. And so on, until the Czech CPI 2 2 whole system had crumbled.” Italy entered the euro zone at what some now regard as an adversely high 1 1 exchange rate. The Czech Republic is determined to enter at an advan- 0 0 tageously low one. Hence the 1.75% overnight central bank rate—the ar- -1 -1 tificial, inflationary and unsustain- 1/31/00 1/31/01 1/31/02 1/31/03 1/31/04 1/31/05 able 1.75% overnight central bank source: The Bloomberg rate, we would say. It’s here.

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