Thursday, March 21, 2013

Based on the facts alone, Cyprus is not Lehman... unless everyone believes that it is.

Greek Islands have a history of hiding monsters in labyrinths: first minotaurs in mazes, now creditors in balance sheets. 

In trying to explain the world, particularly the European world, I often find myself drawn to the works of Alan Furst. In his novel, Red Gold one of his characters is trying to explain why something that seems obvious may not be: "It should, logically it should. But the world doesn't run on logic, it runs on the seven deadly sins and the weather." This is how I feel about the question of whether Cyprus is a catalyst for the reignition of the Euozone crisis or not.

On Monday I wrote that Cyprus was not a big deal, that because of the unique scope and purpose of the Cypriot financial system the decision to require the, largely non-EU, depositors to contribute to the rescue of the financial system was indeed a one off and that this treatment could not be generalized to the depositors in Spain and Italy. Initially the markets seemed to agree with me and during the day on Monday the markets made back all their losses from Sunday night and monday morning.

But, with the typical Mediterranean flair for the dramatic, the Cypriots decided not to depart center stage of the Eurozone financial crisis. No, no and they really wanted their 15 minutes of fame. No more playing second fiddle to Greece or red-headed stepchild to Turkey. This is their moment to shine. So, rather than knuckling under to the Germans and their troika henchmen and henchwomen they sent the bill authorizing the depositor levy down in flames. I'm sure that felt awesome... for about fifteen minutes.

And that's because while it's one thing to tell the Germans and their henchpersons that you refuse to be a party to their nefarious scheme to raise the 15.6 billion Euros necessary to stave off the collapse of the Cypriot financial system it is another thing entirely to raise 15.6 billion Euros all by your lonesome, or even the 5.6 billion you need to unlock the troika 10. Especially if the total value of all the goods and services produced in your economy is only 18 billion Euros per year, and your government only takes in 7.4 billion Euros per year of which it has already committed to spend 8.2 billion Euros meaning it already has to borrow 800 million Euros just to stay in business. Add to this the fact that the government is already in debt to the tune of 14.4 billion Euros. Then ask yourself, given all the excitement in Greece last year, what are the chances that someone is going to lend them another 6 billion EUR so that they can rescue their depositors? By Monday? I feel pretty comfortable answering that one: zero.

Still, they need the money and I think it makes some sense to discuss the how and the why of that. As a person I do not like AT ALL has nonetheless correctly pointed out, Cyprus has a variety of problems. First of all, as mentioned it has a relatively high debt to GDP ratio of 80% and an annual budget deficit of 4% meaning the finances of the state are a bit complicated. Second, as mentioned in my previous blog post, that has a banking system about six times the size of it's economy owing to the fact that it serves as a banking center for Russian companies which are domiciled there on account of the tax treaty with Russia.

It is important to keep in mind what I mean by this. I do not mean to say that this is some kind of illicit haven, the vast majority of the Russia related financial activity is simply to take advantage of the fact that Cyprus has a tax advantaged status within Russia, is withing the Eurozone, and has a robust rule of law. The way in which the banks in Cyprus are related to Russia is not even that they primarily lend to Russia, though they do, but rather that they provide banking services to the many many Russian companies and special purpose entities which are incorporated there. For example Mark Kurtser, is a Russian doctor whose medical company is incorporated in Cyprus, listed on the London Stock Exchange, and does all it's business in Russia. When it needs to do business in Cyprus, it has a bank account there for the purpose.

So simply because the economy of Russia is so large the businesses which do business in Russia but are incorporated in Cyprus have a lot of need for banking services and there are two important implications of that. First of all is that when you are looking at the official records of the Cypriot banking system a lot of what appears to be a Eurozone deposit is in fact a Russian deposit. Dr. Kurtsers company is an EU entity incorporated in Cyprus doing business in Russia. For regulatory purposes, it's accounts are counted among those of EU residents. So when the EU officials are trying to figure out who is who among the depositors in these banks, it's not so easy to do and is probably why they came up with the broad levy in the first place.

The other implication of this is that since most of what the Russian entities in Cyprus need the banks to do in Cyprus is simple cash management the Cypriot banks have a lot of deposits and therefore haven't really needed to issue other forms of capital and so in the event of an insolvency there isn't much of a capital cushion before you hit the depositors. Have a look at the balance sheet of the Cypriot banking system as a whole . You can see that there are 126 billion EUR in assets. Of those, deposits of Euro area residents (which includes locally incorporated Russian entities) are 72 billion, or 57% of assets and external liabilites, that is deposits that are from outside the Eurozone are 34.7 billion or 27% of assets so 84% of the balance sheet is deposits. To give you some perspective, JP Morgan funds only 49% of its balance sheet with deposits.

So here we have situation in which the entire banking system has only 1.7 billion Euros of bonds outstanding. While there is an item on the balance sheet that says the capital and reserves of the banking system are 15 billion EUR I think the fact that the market cap of the Bank of Cyprus, the largest in the country with a 38 billion balance sheet, has a market cap of 371 Million EUR I think we can say that the equity part of the capital structure is 1 billion EUR tops. So we have 1.7 billion in debt, 1 billion in equity and a 120 billion balance sheet. So in the event that asset prices drop 2% the entire non-depositor capital structure is wiped out. This is why the EU/IMF/ECB demanded that the depositors be part of the mix: there isn't anyone else.

And that includes the Cypriot state. We don't know how big the hole in the banking balance sheet is but given the fact that a 15.6 billion number has been discussed we can assume that it is at least that much and is probably more. Let's call it 20 billion. Now let's imagine that the Cypriot state decides to nationalize the banking system. They step in wipe out the stockholders and the bondholders, they're still in waaay over their heads.  They take over assets worth 100 billion (120-20) but owe the depositors 117.3 billion, or they're 17.3 billion in the hole. So the simple act of nationalizing the banks cannot be done without clipping the depositors for more than they would have lost in the levy. That vote isn't looking so smart now is it?

Thus when the Cypriot parliament, themselves in the hole for 14 billion EUR, told the troika where to go with their 10 billion EUR rescue package, they set themselves a real problem of where to get the money. Their first idea was Russia, and you can see why, the folks who stand to lose the most in a depositor levy are the Russian depositors. The thing the Cypriots forgot about is that the Russians don't feel bad at all about their people going broke and sometimes they even lend a hand.The other thing to know about the Russians is that if there are assets to be had, they wait until AFTER the fiasco to snap them up on the cheap. What's more, as anyone who has ever owned a GKO can tell you the Russians know a thing or two about putting the creditors against the wall and they probably think the Cypriots are cowards for even asking for help before an actual default. So as you might imagine, the Cypriot emissaries to the Kremlin have got bubkus.

Well, as I write this the Cypriot parliamentarians are probably rocking out of bed to go legislate their newest plan which is to carve the banking system in two: a good bank and a bad bank. They'll put the insured deposits and the performing assets in the good bank and hope it keeps trundling along. Then they'll put the uninsured deposits and the sketchy assets in the bad bank and slowly wind it down. The key word here is slowly. As you can see from my favorite document, 80 billion of the 120 billion are loans, there are only 10 billion in securities. So the bad bank is going to have to liquidate a loan book which will probably take a lot of time. For this reason the parliamentarians are going to have to limit the capacity of people to remove their money from the bad bank since it will be instantly highly illiquid. Capital controls in an Eurozone state, even if temporary, are a serious source of concern and might make people think that the 10% one time levy might have been better. Yep, that vote looks less smart by the minute.

So then there's the question of whether this is a "Lehman Event" for the Eurozone. I don't think so, even in a worst case scenario where the good-bank/bad-bank thing doesn't work out and you have a sovereign default and Euro exit by Cyprus. I believe this for three reasons.

1.) Scale-- when Lehman went bankrupt it's balance sheet was $639 billion, that's five times the size of the entire Cypriot banking system. The CDS auction to determine the likely recovery rate yielded $0.08 on the dollar implying over $500 billion in losses. This is not even remotely that large. Even a Cypriot sovereign default would not be the end of the world, it's total debt is only 14 billion Euros and at this point I doubt very highly that there are any highly concentrated holders of Cypriot paper outside of Cyprus who would be pushed to the edge by taking a loss on it.

2.) No transmission mechanism-- Lehman Brothers, and with it AIG were major players in the global financial system and had massive counterparty exposure to virtually every other bank in the world. The speed and the potential breadth of the contagion were massive. What's more there were a lot of securities on the Lehman and AIG balance sheets that might be dumped into illiquid markets which were nonetheless used to mark the books of all the other banks in the world which could cause a chain reaction simply through mark to market losses. None of that is possible in this case. Not only are the notional amounts low since almost the whole asset side of the balance sheet is loans just working out of them to pay off the uninsured depositors is probably going to provide lifetime employment for the 8,000 finance sector workers in Cyprus. Unlike a real player like Italy or Spain the scale of the sovereign debts of Cyprus are not large enough to take down any of the European banking system.

3.) Cyprus is a unique case-- as I have repeatedly argued in this and my previous post, there are many things that set the Cypriot banking system, balance sheet, fiscal situation and political circumstances apart from the rest of the Eurozone. I think the ECB, EU and IMF are serious when they say that the solution they proposed in this case was uniquely tailored to the circumstances that prevail in Cyprus and that they are not likely to be used in the case of Spain or Italy. It is disturbing to set the precedent of harming the insured depositors but it was the least bad of most options for the depositors themselves. I think that it's possible that the markets think this if this weeks auctions were any indication.

So though I think this is a special case and I continue to think that this is not even remotely as dangerous as the Lehman/AIG fiasco in September 2008, if enough big investors just read the headlines and don't pore over the balance sheets of the banking system, if they refuse to take the ECB and the EU at their word and decide that a Spanish depositor is just as at risk as a Cypriot then whether I've made a logical argument or not won't matter at all. Market psychology has a logic all it's own and in the event that the markets decide to punish the troika for this then there's no argument anyone can make. If only a few investors panic, then this could be a great buying opportunity. That said if the panic becomes general then, as in 2008, there's no telling where it ends.

Logically, this should be a minor event but, the world doesn't run on logic. It runs on the seven deadly sins and the weather. Thanks for your time.

Monday, March 18, 2013

Why Cyprus Doesn't Matter

Shhhh!!! Don't let them hear your Russian Accent...

So yesterday the Eurozone member states, the ECB and the IMF shocked the world with their demands that depositors in Cypriot banks take a haircut in order to help pay for the rescue of the country's financial system. The shock comes because the nature of what was asked was that uninsured depositors take a 9.9% haircut and, and this is the main point, the INSURED depositors should take a 6.75% haircut. This is unprecedented, the whole point of having deposit insurance is that insured deposits are supposed to be the safest assets there are, you literally cannot lose money because in the event that the bank folds the government is supposed to make you whole.

In a piece of excellent reporting the FT described how this came to pass: it was essentially a coordinated ultimatum from Germany, the power behind the EU since it is the largest contributor to any rescue, the ECB, and the IMF.  The decision produced instant outrage and, to some extent, unreasoning fear in the markets. The Euro dropped a big figure and the Yen rallied 2% as money fled the Eurozone and headed for "safe havens." Pundits in the twitter-sphere high fived each other for beating the Wall Street sell side analysts to the punch in declaring this a terrible precedent that could well push the Euro-zone back into crisis. When the S&P futures opened Sunday night, they were down a percent before Asia even opened. It was a panic.

At the same time as the news was coming out so was a lot of punditry that drove the panic. Various financial journalists were appalled that the Germans, the ECB, and the IMF would collude to destroy the small depositors in Cypriot banks. Not only that, they were demanding that the Cypriot depositors pay up before the bank bondholders and shareholders would have to pay. This seemed like an outrage. What's more, if you imagined that this was going to be the modus opperandi for future rescue packages from the European Stabilization Mechanism then the odds that other countries would choose to apply for them, and thus receive massive speculator destroying ECB bond purchases would decline thus increasing the probability of a reignited speculative attack on the solvency of the Eurozone countries. Pandemonium was on the way and this is why the markets crashed last night and early this morning.

The trouble is, and I pointed this out on twitter yesterday afternoon, Cyprus is a VERY VERY special case and the troika went after the depositors in Cypriot banks for very specific reasons that do not apply to any other country in the Eurozone. Everyone in power knows this but the general reader and the average financial journalist does not. So I will spell it out for you.

The first thing to know about Cyprus is that since the 1990s it has had a very special tax treaty with Russia. The original purpose of this tax treaty was to prevent double taxation of income from investments in Russia which originated in Cyprus, it has had the effect however of making Cyprus an offshore tax haven for Russians both to invest in Russia and to have their money technically outside the Russian legal system. As you might imagine this has had a profound impact on the financial system in Cyprus. Remember that the economy of Cyprus is small. It has a population of 1.1 million, a labor force of about 450,000, and a GDP of about 16 billion EUR. This tiny country has a banking system with 107.8 billion EUR in deposits or 660% of GDP. In the US, bank deposits are about 83% of GDP. So here you have a massive financial system, which actually employs 7% of the working population in Cyprus, funding Russia and providing safe haven for Russian depositors in its banks. What's more E35 billion of the deposits on the Cypriot banking system are in amounts under 100,000 EUR which means they are insured by the Cypriot state.

Now since the financial crisis in 2008 Cyprus has had many of the same problems as Greece with regard to it's solvency and some of the problems of Iceland and Ireland with regard to it's banks. This past weekend those problems came to a head and Cyprus was forced to seek help from other Eurozone members. This presented the IMF, the ECB and the Eurozone member states with a very serious problem. Is the Cypriot state deeply mired in debt? Yes. Will it need to be rescued? Most likely. Is the Cypriot banking system insolvent? Yes, the largest bank in Cyprus is in such bad shape it no longer qualifies for the ECB emergency funding program established in December 2011. Is the Cypriot government capable of making whole the $35 billion of deposits under $100,000 in it's banking system? Not even remotely, Cypriot central government revenues are about $10 billion and it's expenditures are already $11 billion. So what we have here is a collapse in the banking system which, through the deposit insurance scheme will lead to a collapse of the central government finances, which will in turn lead either to a government default or a Eurozone exit either of which may very well result in the reignition of the general Eurozone panic. Time to call in the cavalry: the IMF, the ECB, and the ESM (primarily Germany.)

 It might be tempting to draw a comparison with Greece, which the ESM (nee EFSF) did rescue. There are two differences with that which make Cyprus more complicated. First of all, the main problem in Greece was that the day to day operation of the Greek government was unsustainable. In the case of Cyprus, which does have fiscal issues, there is an acute crisis in the banking system which is forcing the hand of the government early. Second of all, the primary beneficiaries of a rescue of the Cypriot state, and with it the Cypriot banking system aren't even Cypriots, they're not even Eurozone members, hell, they're not even members of the European Union. They're Russians.

According to the ECB, 35EUR billion of the 108EUR billion deposits are from outside the Eurozone, ie Russia. Of the remaining, it's pretty hard to know because Russian money may well be behind an EU incorporated SPV. To come up with an estimate, lets imagine for a moment that the amount on deposit in Cypriot banks by actual Cypriots is similar to that in the Germany which has a 130% bank deposits to GDP ratio, that would mean that something like 80 billion EUR is on deposit in Cypriot banks from Russian account holders much of that is probably decomposed into several accounts below the 100k EUR insurance level to take advantage of the insurance.

I can see the Germans connecting the dots and thinking: "Hold on just one second here. In order for us to defend the Euro and prevent a Cypriot default and potential exit we have to make a bunch of Russians whole on 80billion Euros? What kind of interest rate have they been making on these Cypriot deposits the past few years? 8%? Meanwhile back in Germany depositors in our domestic banks earn next to nothing. And we are going to tax them to rescue these guys? Oh HELL NO! I've got a better idea, why don't we make them pay for their own bailout by confiscating about 10% of their deposits? They'll never miss it, I mean what is that? 5 quarters of interest? To hell with them, let's charge 'em." And that's why they did what they did.

"But wait!" You can hear the financial press exclaim. "What about the retail Cypriot depositor? What about them?" Well, let's look for a second at that. If there are 35 billion EUR in "retail deposits" and 450,000 working age Cypriots that would mean that the average Cypriot has about 78,000 EUR or 5 times the percapita GDP of the country in the bank. Is this likely? Not at all, in fact it's impossible. It is by far more likely that a majority of the accounts under the 100,000 EUR threshold are not retail Cypriot accounts at all but, as mentioned, are Russian accounts purposefully trying to take advantage of Cypriot deposit insurance. So by going after the "small depositors" the Germans are actually going after the more clever Russians.

It is also important to keep in mind that no one can say that this is what is being done. Still less can the implement a policy which specifically targets Russians. There is some effort being made to make the tax 0% on deposits under 20,000 EUR which would probably protect most Cypriots, but the troika had to appear to be addressing everyone equally. Remember, Europe still depends on the goodwill of Russia for it's gas supplies and Russia has many ways of making life difficult for the Eurozone generally.

So what can you take away from this? Well first of all, Cyprus is very much a special case because in its rescue the Germans are being asked to save an EU member state by rescuing depositors in an EU banking system who are themselves based outside the EU and they are saying no. This is not at all an equivalent to what would happen in the event that something similar were to happen in Spain or Italy, both contributors to the ESM, Eurozone members, and EU members. So I don't think anyone should worry about this decision being used as a precedent for other Eurozone states and as people begin to understand that more fully I think the markets will recover. The other lesson is that when the banking system is too large for the government itself to rescue, terrible things happen and as I have written, that is the case in pretty much every state in the Eurozone. So while this will blow over, the larger storm is still coming.

Monday, February 25, 2013

Italian Voters Sack Markets in the Rest of the World

The markets today were blindsided by events in the Italy. The Italians had an election yesterday that has returned a split between the lower and the upper houses such that a government cannot be formed. Not all the results are in but it looks as though Silvio Berlusconi is going to win a blocking plurality of the Senate and the centrist Bersani is going to win the lower house. This is something of an upset. Originally Bersani was favored to win but a last minute surge for a Beppe Grillo, a comedian turned anti-corruption and anti-austerity activist, pulled votes away from him and left Berlusconi with a majority in the Senate. Due to the nature of the Italian Constitution there is some ambiguity as to who will be invited to form a government and if there is not enough clarity new elections in May might be needed. What is clear is that the Italian electorate is not a big fan of government austerity nor by implication the broader strategy of the EU in handling the Eurozone crisis.

So what was the reaction to all this? Well, it was something close to panic. Markets which had been up decently in the morning fell and then more or less crashed. The S&P touched a high of 1525 this morning then pretty much fell all day to close on its lows of 1488, down about 1.8%. European markets got totally destroyed. Why is this? Well, if you recall, the main story in world markets for most of the last three years has been a series of near death experiences of the Eurozone. First Greece went through a near death experience and then, for the private sector bondholders at least, an actual death experience. Then for most of 2011 and the first half of 2012 Italy and Spain were in something of a race to see who would be pushed into bankruptcy first and these bankruptcies were in a race with the EU officials and the European Central Bank to see who, if anyone could put the pieces back together again.

In Italy there was a lot of concern that the country would fold and since its economy is very large that it could take the whole EU down with it. So great were these fears that in November 2011 Silvio Berlusconi was forced from office and replaced by Mario Monti who then enacted a number of unpopular but necessary reforms and began to calm the Italian markets but the panic then moved to Spain.  Then about six months or so ago Mario Draghi the president of the ECB basically said that he would do everything in his power to ensure that the Eurozone did not break up including, conditional on a troubled country taking a rescue from the ESM and imposing its conditions, buying outright the bonds of that country similar to what the Fed is doing in the US with its quantitative easing. Since then the markets have breathed much much easier, Spanish and Italian bond yields have fallen and people have begun to think that the worst was behind us.

Yesterdays election, by showing that the people of Italy are somewhat less inclined to support the continuation of the Monti reforms, much less the draconian policies that would be required under the terms of an ESM rescue package that would trigger ECB bond buying just let the air out of the Draghi hope balloon and resurrected the spectre of a voluntary default or Euro-exit by a major European economy. Either a default or a Euro-exit (which, since the debt is denominated in Euros, would be swiftly followed by a default) would almost certainly destroy the European banking system and with it the European Economy and with that the stability of the world economy. Ergo: mass-hysteria in the worlds equity, currency, and bond markets. Now keep in mind we are in fact a long long way from any of these negative outcomes actually happening and it may well be that cooler Italian heads will prevail (in the event that cool headed Italian is not a contradiction in terms.)

Something that is worth pondering though, if you are an avid reader of Paul Krugman or pretty much any of the people decrying the coming sequester battle you might just ask yourself, "gosh, if the Italians are voting down austerity, shouldn't that be a GOOD thing? I mean, Krugman says that what is destroying Europe is austerity, surely a step away from this would be good. And also didn't President Obama just go on TV today and say that these budget cuts would be bad for the economy?" The trouble with the views of Krugman, and less so Obama is that once you have enough debt you can't just vote your way out of austerity. Stimulus can only be paid for in so many ways: taxation, borrowing and money printing. Italy can't print it's own money. It doesn't want to pay taxes or cut spending. OK fine but what do the bondholders have to say? Well, until Monti arrived on the scene and Draghi announced his intentions to buy the bonds of countries that imposed austerity they were saying, "that's all well and good but we would prefer to not buy your bonds. Actually, not only that, we're prefer to sell the ones we already have. What's more, once we're done selling all our Italian bonds, we'll take it a step further and sell the hell out of Italian banks that we know are loaded to the gills with Italian bonds and can't sell them. 

So even if the voters try to vote "No!" to austerity their vote is not the final one cast. The final one is cast by the bondholders and their vote is probably going to be "Ciao!"

By the way my fellow American Generation Xers and Millenials, this kind of thing is coming within our lifetimes to a Republic near you.

Friday, February 22, 2013

Ackman, Icahn and Herbalife: no longer a blitzkrieg, now a siege

So by now now most people are familiar with key events in the Herbalife drama: The conference call questions by David Einhorn, The massive Ackman powerpoint, The entry of Dan Loeb, the televised Ackman/Icahncatfight, the Icahn 13D, the Ichan CNBC interview, the HLF earnings and the HLF conference call at which Pershing Square may or may not have been prevented from asking questions David Einhorn style.

The drama of the personalities has been so intense I think that many investors who watch this stock, think that there will be some kind of quick dramatic resolution. In this post I will argue that there will not be. I do think that the odds favor one side over the other but I think that we are a very very long way from a resolution, and when it comes most people who trade the name will not be part of it.

First, let's have a look at Ackmans position. He has done 18 months of research and has made a massive presentation outlining it. When the company responded that he simply didn't understand their business he sent them a list of 284 follow up questions and dared them to answer them. In summary, the Ackman thesis is that Herbalife is nothing more than a pyramid scheme. An extremely well managed one, but a pyramid scheme nonetheless.

He claims that the primary rewards to distributors are generated not by actual sales but by recruiting new distributors. In support of this thesis he points out that the company does not really track sales to end users and accuses the company of overstating the value of its sales by recording them generally at the suggested retail price when in reality many of these products are available on the internet not only below the SRP but also below the levels implied by the distributor discounts. 

He also makes the following additional arguments if I may paraphrase his executive summary: 1.) the company exaggerates the chances of success as a distributor, 2.) the company exaggerates the rewards of being a distributor, 3.) there is a high failure rate for distributors, 4.) Herbalife has been the subject of litigation on this issue 5.) the company targets the poor, 6.) the company hides its true nature through obfuscating its compensation scheme, 7.) Herbalife distributors quickly saturate their markets, and 8.) the top 1% of distributors earn almost 90% of all rewards.

Of course, as is well known, Ackman did more than just claim this was a pyramid scheme. He announced his belief that all pyramid schemes are ultimately destroyed, either by running out of new suckers to become distributors or by legal action on the part of the regulatory authorities. Ackman expressed his belief that one or both of these outcomes was likely in the near future. As a result he decided to short 20% of the float of the company, about $1 billion worth. He announced that his target price was zero. As you might imagine the shares of the company cratered, falling from the $40s to the $20s in short order but then began a rather miraculous levitation and have whipsawed around $35 with all the recent news.

Ackman is an excellent dramatist and clearly his firm is thorough. The presentation is well made and has a good narrative arc. It is very long but it doesn't feel like it takes a long time to read and at first glance it seems pretty convincing. There are a number of factors, aside from his research and presentation skills, which help Ackman in this case. 

First of all is the way that the regulatory authorities work with regard to pyramid schemes. They never come out and say “this company is NOT a pyramid scheme.” This is quite logical because there would be nothing to stop someone from then turning such an officially sanctioned firm into a pyramid scheme. So the only proof that the authorities will not intervene in HLF is that that are not intervening, which they may do at any time. Thus there is no way for them to definitively disprove Ackman. 

Second there are a great many regulators involved. The FTC and the SEC at the federal level and all 50 state Attorneys General, so Ackman has 52 bullets and as he has said, all it takes is one. This is quite true. Ackmans publicity campaign, if successful enough, also has the capacity to materially harm Herbalifes ability to recruit new distributors or frighten old ones thereby hastening the effect that Ackman claims is already underway. Ackman is also helped to some extent by the company itself. Whether it is a pyramid scheme or not it certainly does not keep records clearly enough to instantly demonstrate that it is not one. So, Ackman talked a good game and once you read the presentation you can see why the stock went over a cliff after it.

That said, there are a few very important weaknesses to Ackmans case, some of which were pointed out in the Loeb letter. Loeb pointed out that no pyramid scheme has ever survived for more than 10 years and that the majority of those that the FTC shuts down are exposed in less than 5 years. HLF has been in business for 30 years, that's quite a lot of time for a pyramid scheme to survive. While the Loeb letter makes some interesting points I think he is remarkably silent about some of the other weaknesses of Ackmans position.

The first weakness I think is the most glaring: the size of the position itself. HLF has about 108 million shares outstanding. Ackman is short 20 million of them. Now remember before HLF became the darling of the daytraders it traded about 1.5 million shares a day, and let me assure you that once it's known that Ackman is a buyer that's the same side the day traders will be on, so that 1.5 million shares is a good estimate for the real interest in the name. That means that in order for Ackman to close his position he would have to be, under normal circumstances, 100% of the buyside volume for an entire month. Even in the event that he was able to do that in secret, he would almost certainly drive the price much higher. In the event that he was not able to keep it a secret so many people would try to front run him he would soon have to seek an off exchange accommodation with someone who happened to have a lot of shares. I think his price target is zero for a very good reason: short of the company going to zero he can't get out. 

Then there is the issue of the catalysts which would send the stock to zero, remember: it is not enough that Ackman be correct that HLF is a pyramid scheme, it must be a pyramid scheme that comes undone on a time horizon that rewards him and his investors. If HLF keeps the thing going for another 30 years he's in big trouble.

There are basically two things that could kill HLF and Ackman correctly identifies them: regulatory intervention or total market saturation and/or a depleted supply of idiots/distributors. It's true that Ackman gets 52 bites of the regulatory apple but lets look at that a little more closely. He correctly points out that HLF targets the hispanic community. The company has something like 360,000 “distributors” and 90,000 “sales leaders” there's some confusion as to what this means but these people believe that Herbalife is a business they own. Let's imagine for a moment that you are a state AG, how eager are you to shut down a business which has millions of end users and tens of thousands of micro-entrepreneurs, who just happen to be members of an extremely important voting bloc? What's more, even though Ackman has promised to give his share of the spoils to charity, whoever kills HLF will be seen to have done the bidding of a New York billionaire hedge fund manager. You'll need an alchemist like Axelrod to live that down but Axelrod probably won't take your calls. 

“But wait!” our hypothetical AG might exclaim, “I'll be a hero if I shut this thing down because obviously it is victimizing these people.” Will he? Is it? HLF has 90,000 sales leaders, around and a 50% "retention rate" meaning 45,000 of them fail every year but that 90,000 number is pretty consistent so they are also replaced by another 45,000, every year. Yet the FTC has received only 210 complaints over the past several years. How can that be? In the past 5 years hundreds of thousands of these micro-entrepreneurs have failed but generated only a handful of complaints. Not a powerful motivator for our hypothetical AG. “But wait!” he might think, “Even though the damage may not be material, this company is giving them false Hope! We have to stop that.” Now hold on a second, what was the slogan of perhaps the most persuasive political candidate in the adult lifetime of most people reading this? What was his campaign slogan? Hope. Let me assure you, if there is one thing the American political system is not prepared to deny the voters, it's hope.

Well what about the possibiltiy of HLF running out of "suckers" to peddle their products? Well, the trouble for Ackman is that, as far as suckers go, there's another one born every minute. Not only that, though we may have more than our fair share, they make suckers outside the US as well and HLF is all over them. The company operates in 88 countries and though their main growth is in established markets they're not going to run out of people who are concerned about their waistlines or want to be millionaires any time soon. This is borne out by the earnings of the company which have been remarkably consistent as you can see.

So where does that leave Ackman? Well, he has a massive position that is cost prohibitive to close in the open market, he may have seriously misunderstood the incentive structure in which the regulatory authorities operate, and he may have to wait for HLF to run out of countries to open in before the economics start affecting the stock price. This isn't a great position to be in, but it's actually worse than that.

If I had to bet, I'd say that what drew Loeb into this wasn't the economics of HLF but the size of the Ackman short. As Kyle Bass mentioned, being on the other side of Dan Loeb is bad enough, but then Carl Icahn hopped into the mix and now everyone is talking about a “short squeeze.” For a discussion of this and why I think it's unlikely I need to talk a little about what precisely a short squeeze is, so bear with me. 

Short selling is where you borrow the shares of a company from someone and sell them in the open market. Then at a later date you buy them back, hopefully at a lower price, and return them to the person from whom you borrowed them, keeping the difference in price. The lender of the shares is paid a small fee for this called “the borrow cost” which varies with the supply of shares that can be lent and the demand for borrowing them. The way the market generally works is that as part of the custody agreement that an investor will sign with his custodian the investor gives the custodian the right to lend out his shares an the custodian might share some of the proceeds with the client.

It was probably quite easy for Ackman to borrow the shares as the vast majority of the shares of HLF are held by institutions who are more than happy to lend out the shares for a little more edge or lower custody fees. There are, however, a few technical issues that the short seller faces. First of all, the rate at which he borrows the shares can only be fixed for a certain amount of time maybe overnight or maybe Ackman negotiated longer terms with his prime broker but it's not forever and so it is possible that the cost to him over time might increase. Ackman might have to pay higher costs if borrow gets tight but he's well enough financed that increased costs alone will not be able to force me out of the trade.

The more serious threat is that the HLF shareholders from whom Ackman borrowed might want their shares back in a hurry.  In that case Ackman would have to go out and buy them at whatever price he could get or make a off exchange arrangement to get them from a large holder. There are two  ways in which Ackman might be forced to close his short at what would be, given the lack of liquidity, ruinous prices. 

The first is one where all the shareholders needed to have their shares in their physical possession, such as in the case of a tender offer. In the event of a take-private transaction, someone would make a tender offer for the shares, say at $55 a share and everyone who wanted to get $55 would have to get possession of the shares and tender them to the buyer. So when Fidelity or some other company goes to their custodian to get the shares, the custodian would turn around to Ackman and say, “OK, games over, give us the shares back, we have to turn them over to their original owners.” Then Ackman has to go get them at whatever price he can which, as discussed, might be quite high indeed. 

Interestingly the tender offer doesn't even have to be for the whole company, even a partial tender would destroy Ackman. Imagine the following scenario: the company says, “OK, we've got $787 million left on our buyback. Here's what we're going to do. We're going to take $750 million of that and offer to buy 15 million shares at a price of $50 from anyone who tenders their shares to us on March 31st. In the event of an oversubscription shares will be bought on a pro-rata basis from those who tender their shares.” 

That is let's say you have 1,000 shares of HLF. You tender them to the company and let's say that they get a total of 30 million shares tendered to them, twice what they are offering to buy. What happens is this: they send you a check for $25,000 and your other 500 shares back. With the stock trading at $37, I think quite a few people would tender their shares at $50 even if they knew the tender would be oversubscribed. As mentioned, they would need actual possession of the shares to submit them to the tender. Thus their custodians would have to deliver them to the company which means they would have to get them back from whomever they lent them. So you see, a partial tender is just as dangerous for Ackman as a full take-private transaction. 

That said, I don't think either a partial or full tender are likely to happen. From their recent 10Q, the company only has $350 million in cash. Sure they could borrow the money from Icahn, but it might be hard to justify in subsequent lawsuits why you spent the shareholders money buying back shares for $50 though a tender when the shares are out there in the market offered at $37. I also don't think that Icahn is likely to tender for the whole company. Even in the event that it's actually worth $70 a share or more, that doesn't provide nearly the margin of safety required to handle the additional debt the company would have to take on in order to buy back the shares.

The second thing that might force Ackman to close is if enough holders simply refused to let their custodians lend the shares drying up the pool from which Ackman is borrowing. This is the theory that people who are rooting for a squeeze post the Icahn options exercise believe. It's true that Icahn will probably withdraw his shares from the borrow pool once he exercises his options, but I don't think that will decisively affect Ackman's borrow cost.

First of all, while it's true that institutions are probably selling HLF and hedge funds who think the stock is cheap and/or subject to a squeeze are buying them, you would need an awful lot of people to cooperate in order to lock up enough stock to force Ackman to close. Even at it's zenith the short interest in HLF was 37 million shares leaving more than 60 million out there. At the time, you could still borrow it, it was expensive, but it could still be done. So even if Ackman and Lobe both locked up their shares and as many people piggy backed Ackman as in late December, there are still more than enough shares for Ackman and let me assure you he is getting better terms than any of the other shorts so he'll be the last guy to get forced out. 
What's more is that engineering a short squeeze is a non-trivial undertaking and it requires a high level of trust among the participants. Imagine the following. You're a hedge fund manager and you've been following this whole thing. Then one day you get a call from Icahn who says that he's putting together a team to run up the stock price of HLF and try to squeeze Ackman. He asks for you to participate by buying some shares of HLF and locking them up, preventing Ackman from borrowing them. Let's say you do this and sure enough the stock starts floating, then leaping, then screaming higher.

This presents everyone involved in the short squeeze with a dilemma: do I close out, take the money and run, or do I stick around and wait till Ackman folds? The trouble for the squeezers is that if enough of them close out, the squeeze is over before Ackman gets pushed out and the stock crashes back to Earth burning them all. This isn't even the worst case scenario. Imagine a world in which Ackman is able to negotiate with a few of the squeezers in order to safe himself and he does an off exchange transaction to close his position. Everyone who is not in on it is holding the bag when it is announced that the squeeze is over because Ackman is out. Then remember that the leader of the anti-Ackman faction is Carl Icahn, is he the kind of guy you would have to be worried about cutting a separate deal for himself with Ackman? Yes he is. Thus I think it will be very very hard to engineer a squeeze. 

The last thing that might force Ackman to close out is that he just runs out of money to maintain the position. Recently there was a  bizarre Reuters article that claimed that since Ackman put up cash to fund his short position in HLF that he was not vulnerable to a short squeeze. This is preposterous. It's true that he's not borrowing money, but it is also true that he IS borrowing shares and therefore there is a price at which he may have to buy back those shares which would exceed his capacity to do so. His prime broker is well aware of this fact and so in the event that the shares go higher he is going to have to put up more cash in order to maintain the position.

The thing is, for Ackman, it doesn't even have to be losses on HLF itself that force him out. Ackman is the head of Pershing Square Capital, a hedge fund that has concentrated positions in a number of companies. Even in the event that he fully funded the HLF short with cash as Reuters alleges, it is important to remember that Ackman's positions are almost certainly is cross margined.Thus the exposure of the entire firm needs to be taken into consideration. If a reversal in the fortunes of JCP, or Canadian Pacific depletes the capital of his firm, his prime broker may force him to trim his risk in HLF and as discussed, once the hype dies down and it's only trading 1.5 million shares a day, that could take some doing.  Personally I don't think this is likely to happen any time soon but it is a possibility and it is an issue that Icahn does not face. Icahn has the money, and it's his money.

So where does that leave us? Basically it leaves us in a waiting game between Ackman and Icahn, something totally different than the exciting clash of wills that is being portrayed in the press. Whether HLF is a pyramid scheme or not is only cosmetically the central issue. For Ackman to win it is necessary condition that HLF is a pyramid scheme but it is not a sufficient condition. Either the company must be investigated and destroyed by the authorities or they have to be destroyed by the economics of being a pyramid. And one of those things has to happen before 1.) someone decides to initiate a tender or partial tender offer. 2.) either losses in HLF or elsehwere or redemptions from his fund force Ackman to close the position. Since none of these events is likely to happen in the near term, by far the most likely outcome is that the company continues to operate as it has for the preceding 30 years, and the stock grinds higher albeit with a lot of volatility as all the weak hands piggybacking Ackman and Icahn are shaken out with each new announcement of positive or negative news.

So what's Icahns game in all this? I'll tell you. Icahn doesn't need to actually cause Ackman to be forced out, he just needs to be there when it happens. You see, if and when Ackman goes to the wall, for whatever reason, it will not be possible for him to close out his position in the open market. It's simply too big and the market is too thin. He's going to have to negotiate a private transaction with someone who can give him the shares he needs and he'll have to pay whatever price that guy wants. Icahn wants to be that guy. Doing off market transactions in size with a highly motivated counter-party is what made Icahn famous back in the 1980s. I'll tell you what though, you don't want long HLF when that happens because once the drama is over, the stock will crater the next day. The retail daytraders may help Icahn run up the stock, but for the same reasons other hedge fund managers will hesitate to get involved in a squeeze, they won't be part of the payoff. In the meantime Icahn gets to buy a large stake in a company that is growing at double digit rates for about a 9 PE and when Ackman needs him, he knows how to find him.