Jubak's Journal Recent articles: • 3 oddball oil companies primed for profits, 9/28/2005 • A double hit to the Gulf -- and the economy, 9/27/2005 • How the Fed lost the inflation fight, 9/23/2005 More... | Jubak's Journal Airlines and the epidemic of risk Take a look at how broke airlines buy expensive airplanes, and you learn a little about derivatives and the risk that is endangering global markets. By Jim Jubak Like a broken record, Federal Reserve Chairman Alan Greenspan goes on and on about risk. Too many borrowers, lenders, consumers, bankers, bond investors, stock investors, hedge funds and pension funds are taking on more risk than they should. And the end, when it comes, won't be pretty. To understand this epidemic of risk, why it is such a danger to the global financial markets -- and us -- and why the Fed can't do much about it except jawbone, you can try to master the details of the $8.4 trillion market for something called credit derivatives. Or you can answer one simple question about the airline industry. The question: So how do these guys keep buying planes? You'd figure that with four major U.S. airlines in bankruptcy, the two big plane makers would see some drop-off in sales. But no. Even though its customers in the global airline industry are on schedule to lose $8 billion this year, both Boeing The airlines are bleeding red ink, so they don't have the cash to buy planes. And why would anybody in their right minds lend money to an industry that lost billions this year, will lose more next year and, in its history, has lost more money than it has made? (The $40 billion the U.S. airline industry is projected to have lost from 2001 to 2005 more than wipes out the $18 billion it earnings from 1938 through 2000.)
Answer that and you'll be a long way toward understanding why investors who believe the Fed can guarantee the safety of the financial system are fooling themselves. And why so many investors and lenders -- from banks to insurance companies to pension funds to Wall Street investment houses to hedge funds -- are taking on more risk than is good for them. Delta swings the axe Let's get the conventional business-type answers out of the way quickly. Folks aren't lending the airlines -- particularly the U.S. airlines -- money because the carriers have come up with brilliant strategies for cutting costs and making higher profits. Or because they've figured out new sources of long-term profit. Take a look at the plan that Delta Air Lines Related news and commentary on MSN Money Fewer and less-well-paid workers will handle a smaller and simpler route system and fleet. Delta will reduce its domestic seat capacity by 15% to 20%, while adding 25% to its capacity on international routes for a net drop of about 7% to 10% in capacity. And the company will use bankruptcy proceedings to reduce the number of different kinds of planes that it flies to seven from the current 11. Even before its bankruptcy filing, Delta had cut the cost -- excluding fuel -- of flying one seat one mile to the lowest among major carriers. See the problem? Low cost -- if you exclude fuel. Lowest cost among the majors -- when the price competition is coming from new low-cost, few-frills airlines. Fewer types of planes in the fleet -- but still seven, compared to the one in the Southwest Airlines Nothing here is a permanent fix. And if Delta's plan works, AMR Corp.'s Unlikely lessors Here's where the airline bankruptcy story intersects with Alan Greenspan's worries about too much risk-taking by investors. Thanks to the Delta bankruptcy filing (and those of Northwest and UAL and US Airways Group A number of companies that lent money to Delta this way have told investors to expect a hit to earnings if they have to write down the value of these leases. The list includes some surprising names. On Sept. 14, Walt Disney Co. These are old-fashioned leases. Disney's investment dates back to the early 1990s, the company says, and Electronic Data Systems made its investment in 1988. Kind of quaint, actually. These lease deals date back to a time when airlines actually made money, and the companies have had a good ride out of the investments. It's too bad that the leases finally didn't work out. You pays your money and you takes your chances. Risk, sliced and diced Well, at least you used to. Instead of these old-fashioned relatively straightforward leases, airlines these days rely on something called "enhanced equipment trust certificates." These are bonds, backed by pools of aircraft. Any single bond issuance is divided into what are called tranches. Often, individual tranches come with different yields and different risk profiles. Specific investors can pick through the tranches to find one that matches their demand for yield and their tolerance for risk. But the change from something as old-fashioned as a lease on an actual airplane to a derivative that represents a share of a pool of aircraft doesn't stop there. In the old days an investor like Disney was stuck with the risk of the investment it had just made. Today the investor in enhanced equipment trust certificates can sell part of that risk to another investor. That's done with another derivative called a collateralized debt obligation, or CDO. The buyer of a CDO is buying insurance against Delta or any other debtor defaulting on its obligations. The seller of the CDO is hoping that the debtor will not default and that the seller will be able to pocket the price of the CDO. And you can sell a CDO if your risk tolerance changes, then buy another to fit your current needs. Once upon a time, this was a tiny market, with banks arranging these contracts for a large investor such as an insurance company. Now, banks such as JP Morgan Chase Passing the buck What are the takeaways here? Now, thanks to derivatives, investors have a second kind of guarantee: they can buy insurance against the default of the bond issuer. Now that doesn't mean that all companies that buy and sell in the credit derivatives have stopped doing due diligence. But the ability to buy and sell risk is a powerful incentive to stop worrying about the fundamental risk of the original creditor. This is going on right now in the home mortgage and home-equity loan market. Some of the biggest mortgage lenders continue to offer interest-only or other risky mortgages to customers with marginal credit and then shed that risk by packaging the loans and selling them to investors who, in turn, sell their risk in the derivatives market. (More on this in a future column.) The no-worries worry In this system, no one really needs to worry about the risk of the loan they've made, the mortgage they've extended or the bond they've bought. They can lay off that risk on someone else -- for a price -- in the derivatives market. The problem, of course, is that this system only works until it doesn't. Because derivative contracts are frequently bought and sold by the original purchaser, it's hard to tell who is now guaranteeing whom against loss. That's not a minor point if a big debtor goes into default and the guarantor doesn't have deep pockets to pay out on the guarantee. The derivatives market is not very efficient -- in June there was a backlog of 13 days before trades were completed, according to the International Swaps and Derivatives Association. Nor is it transparent -- since derivative contracts are still relatively hand-crafted it is hard to price them. So the market is not very good at detecting and pricing imbalances. The greatest danger is a very human one: complacency. Since the derivatives market lets investors control risk, they stop worrying about taking on more risk. And that, as we all know from experience, creates an accident just waiting to happen. Which is exactly what Alan Greenspan is worried about. Updates Sell Occidental Petroleum For holders of shares of Occidental Petroleum it's Christmas in September. The stock has reached my December price target of $84 a share and then some. I think there's probably some life left in these shares -- especially with winter shortages of heating oil and natural gas a real possibility -- but the stock has been losing momentum relative to the market as a whole, and I think I can find a better candidate (see my buy on Ultra Petroleum Buy Ultra Petroleum Right now I think investors can get more leverage on high oil prices from the shares of what are called "unconventional" oil and gas producers. These are companies that get their oil and natural gas from mining oil sands, drilling into oil shales or tight sand formations, or tapping into coal bed methane. Ultra Petroleum has all its unconventional assets in the tight sands basket. The company controls 93,000 acres in the Jonah natural gas field and the Pinedale Anticline in Wyoming's Green River Basin. Gas was first discovered here in 1939 but the problem has been getting it out at a profit. New completion technology applied only in the 1990s increased the flow to commercially viable rates and high gas prices have done the rest. The company is currently looking to get approval in 2006 from Wyoming to increase the density of its wells on Pinedale to 10- or 20-acres per well from the current 40-acres per well spacing. That will increase production from the Pinedale field. Ultra Petroleum also has a stake in the Bohai Bay oil field in China. As of September 30, 2005, I'm adding these shares to Jubak's Picks with a June price target of $70 a share. I'd set a stop loss at $48. (Full disclosure: I will buy shares of Ultra Petroleum for my personal account three days after this column is posted.) New developments on past columns When will oil run out of gas? As of September 30, I'm raising my target price on Marathon Oil Editor's Note: A new Jubaks Journal is posted every Tuesday and Friday. Please note that Jubak's Picks recommendations are for a 12-to-18 month time horizon. See Jubak's CNBC Picks for shorter six month recommendations. For picks with a truly long-term perspective see Jubak's 50 best stocks in the world or Future Fantastic 50 Portfolio. E-mail Jim Jubak at jjmail@microsoft.com. At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: Marathon Oil and Occidental Petroleum. He doesn't own short positions in any stock mentioned in this column. | |||||||||||||||||
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