Financials

By now almost everybody probably has heard of how California will issue IOU's to pay its bills and how these will yeild 3.75%. As Joe Weisenthal at Clusterstock pointed out, this puts and end to the key difference between the Federal Government and California- that California couldn't print money when in a pinch. Because soon thousands of companies and individuals will be receivng California funny money in lieu of greenbacks.

Thousands of businesses and individuals will now get issued a note promising to be paid by October for everything from tax refunds to services and goods. California, a state with the eighth-largest economy in the world, was forced to issue the IOUs after Schwarzenegger and lawmakers failed to produce an agreement before the state’s fiscal year began yesterday.

Joe even had some fun at Clusterstock and offered $500 in real dollars for $1000 in face value of California IOU.

We think $.50 on the dollar is a fair price, and we'd love to buy more, but we don't want to be overwhelmed by you desperate Californians looking to unload your worthless paper for our valuable paper

But are California IOU's really worth anything as low as only 50 cents on the dollar? We realize Clusterstock was just having fun, but stay with me for a moment... Might IOU's actually be worth something pretty close to 100 cents on the dollar? Banks are already on board. Bank of America says they will accept IOU's and Well's Fargo as well. I bet most other banks probably will too, if they haven't already made a statement. Great... so now California could potentially take down Bank of America... and thousands of Californians... no wait that's impossible. Let's think about what if California really couldn't honor these IOU's. Would the federal gvernment allow such a thing to happen when thousands of ordinary people were pretty much forced to receive them? Or can we assume that there is actually an implicit guarantee of this paper. I mean look who is receiving these things... (hat tip Mr. Salmon)... the aged, the blind, disabled persons, people needing basic family needs, people with development disabilities, in mental health treatment... will these people be left with worthless paper? What about the too-big-to-fail banks?

This is not a valuation call, merely a supply/demand observation. As highlighted by Dealbook and an analyst at Fox-Pitt, the conversion of Citi's preferred shares (remember the first round of Citi life support provided by Singapore, Kuwait, Sandy Weill himself, and Prince Alwaleed?) could lead to massive selling of newly converted shares. Preferred owners may not want shares of Citi. The preferred paid nice dividends, the shares have a much different profile. Given that the conversion of Citi's preferreds will dilute existing shareholder by 76%, there will obviously be a lot of new share supply coming onto the market.  Most preferred holders might not sell immediately, but even if a minority decide to sell it could be a lot of selling in a short period of time.

After watching their US$3bn investment in the Blackstone (BX) IPO shrink by nearly two-thirds. (from $29.605 to $12), China Investment Corp is reported to be investing $500mn in Blackstone funds (not directly in the stock this time) in an attempt to get into markets while prices are cheap. Fair enough on the market call, but I guess there aren't any hard feelings regarding the overvalued price CIC was given previously for Blackstone shares ($29.605).

Let's just say that Blackstone wasn't lying on their roadshows when they said they were the smart money... unfortunately CIC and later Blackstone IPO buyers probably didn't realize the implications this has when it's the smart money you are buying shares from.

But hey, that was two years ago, and I guess if you're going to pay management and, hopefully, performance fees on your investments, mind as well pay them to the company you already own 12.5% of. Maybe the investment can even boost the value of CIC's BX shares... but I wouldn't go this far:

The entrance of a deep-pocketed investor like CIC would be a dream come true for the hedge fund industry, which has been ravaged by negative portfolio returns and investor withdrawals. Not only could CIC replenish the capital for some hedge funds, but it could help the wider industry by signaling that it's a smart place to put capital again.

While surely good news, until Blackstone shares break $29.605, let's not expect the market to be taking it's cues from CIC investments.

I've seen two sites attacking "Reverse Convertibles" after a WSJ piece by Larry Light which called them "Nest Egg Slashers", those two sites being The Baseline Scenario and Felix Salmon at Reuters. First a brief description of these products... while investors should be extremely skeptical of any products like this foisted on them by their brokers, the negative reaction towards them has strayed from the path of logic.

In a reverse convertible, you give $100 to a bank for some period, like a year; it pays you a relatively high rate of interest, say 10%. The $100 is virtually invested (no one actually has to buy the stock) in some underlying stock, like Apple. If at the end of the period the stock is above a threshold, like $80, you get your $100 back; if it is below the threshold, you get the stock instead.

Larry Light's WSJ piece is right to point out that these products make juicy fees for banks that sell them. And one can imagine that a lot of people lost money in 2008 on them given the collapse in markets. But Felix Salmon and The Baseline Scenario take it a step further and air the idea that such products should be banned and make no sense. Felix Salmon:

This is the kind of thing that a Financial Product Safety Commission should exist to regulate — and, frankly, to outlaw entirely. The number of people buying these notes who are qualified to price them is exactly zero. Reverse converts are a scam, and it’s high time US regulators put an end to them.

Frequently, a lot of professionals can't even price stocks, so I don't think we should be banning products just because we ourselves believe that others are fools for buying them. Rather, I think it's healthier if we encourage a culture of skepticism towards any investment opportunity rather than banning cherry-picked products completely and implying that the approved products are "safe". We trust almost anyone to have the brains to drive a car at deadly (upon impact) speeds, yet not to do a little homework towards a financial product?

Also, you need to know the terms of each one before you call them a scam. Actually, if priced right they could make sense. If priced right. Which I bet a lot of them aren't. But the key point is that you can't ban the entire concept, at the right price such a product might be a good buy. I'll explain further below.