Citi Slickers

Fancy products cooked up by over-achieving bankers often have unintended consequences. That is because they are designed assuming rational behavior, whereas markets have a nasty tendency to react unpredictably. Take auction-rate securities (ARS), debt instruments or preferred stock that reset through regular auctions. These instruments were widely sold as a way to push up returns without sacrificing much liquidity. Many investors say they were led to believe that they could easily get out because Wall Street would support the auctions in case of a crisis. But when push came to shove in February, the big underwriters stepped back and the $330 billion market collapsed.

Now Citigroup, the largest seller of ARS, has agreed to buy back at par $7.5 billion worth of these frozen instruments from 38,000 retail investors and pay damages to those who have already sold at a loss. The bank has also committed to try to liquidate $12 billion in frozen securities that were sold to institutional investors by the end of 2009. Citigroup will also pay $100 million in penalties to New York and other state securities regulators. The Securities and Exchange Commission is withholding judgment whether to add a federal penalty until the process is complete.

The deal lays down a marker that other underwriters may have to follow. Merrill Lynch will likely face pressure to make investors whole, and UBS, where one of the executives has been accused of insider trading, could face tougher penalties. Industry regulators are also probing other brokers to see if they misled investors about safety and suitability.

It is right to be alarmed by the problems in ARS where long-term bonds are, in effect, transformed into short-term ones by having the interest rate reset in auctions every week or month. The allure for issuers, including hundreds of municipal bodies, is lower interest rates than typical long-term bonds, and the ease of paying down debt if they build up a surplus, by simply taking part in the auction themselves.

But lately dozens of auctions have failed as investors have questioned the quality of the assets on offer. Tens of billions of dollars of bonds have gone unsold, which has come as a shock to corporate treasurers who piled into auction-rate debt assuming it to be safe. Because the interest rate automatically clicks up if the auction is a dud, hospitals, museums, universities and ports have suddenly found their debt-service bills rising sharply. Issuers have scrambled to refinance into proper long-term bonds, or asked banks for letters of credit. The Treasury has even offered to make it easier for issuers to convert to other types of debt. 

The inquiry by regulators is moving much faster than some of the other investigations arising from the credit crunch and the total cost of resolving it could easily dwarf the research analyst settlement that resulted from dubious practices during the technology bubble. That reflects the high priority U.S. regulators place on protecting ordinary people in a country where half of all households own stock. The message from the settlement with Citigroup is clear: when Wall Street shenanigans start hurting main street pocketbooks, the chickens will come home to roost.

Crony capitalism

If Washington ever does decide to buy into Freddie Mac, the government should not expect too much in the way of dividends. The government-sponsored enterprise has slashed its quarterly dividend again – to 5 cents or less, saving roughly $500 million a year. 

Why, though, does Freddie continue to pay even a nickel on its common stock? At this stage in the game, with Washington’s backing having switched from nods and winks to explicit support, the psychological benefits of maintaining even a derisory dividend are moot to say the least.

Similarly muddled thinking was on display in Freddie’s assertion that it stood ready to raise an additional $5.5 billion of equity immediately, but felt this was not the right time to do so for its shareholders’ sakes. That is undoubtedly right, given a market capitalization standing currently at $4.6 billion. However, with Freddie having pulled off the stunning feat of reporting a second-quarter loss of $821 million that was three times greater than even Wall Street’s bombed-out expectations, a capital infusion of some sort is clearly a necessity.

Freddie also opened the box on its mortgage exposure, with a $2.5 billion provision for credit losses. It also took a $1 billion write down, mostly on its pool of Alt-A mortgages – home loans that are less risky than sub-prime but riskier than prime mortgage. This all shows willing in terms of facing up to the crisis in the U.S. housing market. However, alongside Freddie’s deteriorating outlook for house prices and delinquencies, the message is one of battening down ever more hatches as the forecast worsens. Indeed, it has given up trying to project credit losses on its portfolio because it has to keep playing catch-up.

For any mainstream investor, Freddie is a non-starter. Yet its dominant position, alongside Fannie Mae, in the tottering U.S. housing market, makes it indispensable in the eyes of Washington. But if Freddie and Fannie are too important to be allowed to collapse, and the U.S. government is really responsible for their debts, then they should be nationalized. They could then be returned to the private sector when the housing market recovers. Nationalization, followed by speedy, full privatization would be so much better than the new housing bill that does not impose changes in management or approach on Fannie and Freddie and lets shareholders off the hook.

Past efforts to shine a light on Fannie and Freddie have led nowhere. The Office of Federal Housing Enterprise Oversight, the present watchdog, has to grovel annually before Congress for meager funding. Risk-control systems were introduced only in 2002, after years of delay and after Fannie and Freddie had lobbied effectively to gut both proposals. The pair are subject to far weaker disclosure standards than other banks in similar lines of business.

Nor have congressmen had much cause to grumble. Fannie in particular is reputed to be brilliant at defusing political risk. It has spent millions of dollars a year on lobbying, refers deftly to “communities” and “investment”, and often has announced its initiatives under the gaze of a beaming congressman. Both companies have large charitable foundations, with money often going to groups dear to congressmen’s hearts.

The current arrangement cannot be allowed to continue. It allows managers and shareholders to take all the profits and leave the losses to the taxpayer. Private profits, but socialized losses, do not smack of free-market capitalism.

United Natural Foods (Ticker: UNFI)

The rise of Big Organic

“Texas” and “organic” are not words that generally appear in the same sentence. But Wal-Mart is doing its bit to change that. At the company's 24-hour “super center” in Plano, a McMansionized suburb of Dallas, boxes of organic apples, bananas and kiwis nestle close to the entrance, and the meat department is stacked high with “all natural” chicken. You can find spinach-flavored organic baby food and dairy products supplied by Horizon Organic in Colorado.

Wal-Mart opened the Plano store in 2006, as a laboratory for new products. The several hundred organic and “natural” items are a highlight. On the non-organic side, it has a posh coffee shop offering raspberry-truffle lattes, a good wine selection and an excellent sushi bar. Wal-Mart, built on the idea that ordinary folk want good, honest value-for-money, is reaching out for the yuppie dollar.

The firm is hardly alone in embracing organic food. The age of “Big Organic” has dawned. Also in 2006, Supervalu, which owns Albertson's and other grocery stores, started a line of organic apple sauce, canned tomatoes and other delicacies. Safeway, another grocer, has an organic line and McDonald's has heavily promoted its coffee, which is now blended with beans from Newman's Own Organics.

Everyone, it seems, is envious of Whole Foods Market. Yet no one admits to being more surprised by the runaway success of Whole Foods than its boss. “In all my profound wisdom I decreed a maximum of 100 stores, and thought that would saturate the United States,” recalls John Mackey of the time when his company went public in 1992. That in itself was quite a milestone for a grocery retailer that he began in 1978 in a garage in Austin, Texas, when he was living in a vegetarian co-op. At first, hippies and college students were his main customers. But now, with about 270 stores feeding the organic-food-addicted middle class in the U.S., Canada and England, Whole Foods has become firmly established as the world's largest natural-foods chain.

To understand the allure of Whole Foods, look no further than its Austin, Texas, landmark store. Occupying almost 80,000 square feet, it is one of the firm's largest, and features a vast array of treats, from organic enchiladas to an in-house meat smoker. There are sampling stations, cooking demonstrations and café tables galore. Employees, called “team members”, are as enthusiastic as the shoppers, and gladly explain company policy on, say, sustainable fishing (no Chilean sea bass, for instance, as it is seriously over fished). The firm is starting to label its own-brand foods to indicate any genetically modified ingredients.

There are, however, supply problems. At some Whole Foods stores, up to 60% of the produce is organic in the summer – but that number dips in the winter because “natural” food has to respect the seasons. This is also a shortage of organic farms. Step forward $766.14 million (market cap) United Natural Foods (Ticker: UNFI), the largest nationwide distributor of natural, organic, and specialty foods. Whole Foods accounts for more than 30% of UNFI’s sales.

Born from a merger of two leading natural-foods distributors in 1996, UNFI is essentially a roll-up of natural and organic distributors. The company has built unrivaled economies of scale in the distribution of more than 40,000 natural and organic products. The firm is more than twice the size of its nearest competitor, Tree of Life.

As the largest distributor of natural and organic products, UNFI stands to benefit from consumers' increasing appetite for health and wellness products. It will also get a boost from stepped-up store expansion from Whole Foods and higher demand from conventional grocers. Another potential area of growth is expansion into specialty foods such as gourmet, ethnic, and kosher.

To be sure, UNFI has recently had a number of operational setbacks and underestimated the challenges of integrating its first significant acquisition in specialty foods, Millbrook. Even so, UNFI still represents a solid long-term growth story. Certainly Joel Tillinghast’s Fidelity Low-Priced Stock Fund thinks so, having added to its shareholding recently.

At $17.87, on a forward p/e of 12.58. UNFI looks attractive.

Warm and fuzzy

Once a fringe activity of the zealously committed or economically illiterate, “ethical” investing – also known as “socially responsible” – has become a growth industry in its own right, and part of the financial mainstream. But in spite of the recent surge in its popularity, ethical investing is hardly new.

In the 19th century, religious movements such as the Quakers and the Methodists counseled their members to avoid investing in firms that mistreated their workers or made a profit from human frailty. When the Methodist Church itself began to invest in the stock market in the early 20th century it explicitly excluded firms involved in alcohol and gambling from its portfolio. The trend grew and in 1971 the Pax World Fund, an American investment vehicle, was established – initially to avoid investing in companies involved with the war in Vietnam. Pax World now has several funds, all using social as well as financial criteria for investment, and all aiming “to challenge corporations to establish and live up to specific standards of social and environmental responsibility”.

The rapid expansion of ethical investing has coincided with the spread of shareholding, especially in countries like America and Britain and the high profile which environmental and human-rights groups now enjoy and the consequently greater awareness of potential investors. A long campaign against investment in apartheid-governed South Africa persuaded many companies – such as Ford and Coca-Cola – to reduce their business interests there, or pull out altogether.

Many remain skeptical about ethical investing. Ostracizing wicked companies does not reform them, these skeptics say. Besides, what is the moral framework? Is a company which produces drugs that save lives a responsible company, even if it does not slash its prices in poor countries as much as some activists would wish? And is testing its products on animals socially responsible or irresponsible?

The fuzziness of the concept remains a problem, even though funds draw up rules for “screening” companies. Fund managers at Bank Sarasin, a private bank and one of the early ethical investors in Switzerland, shun some sectors, including tobacco and nuclear power, when they select companies for responsible investment. Yet they make exceptions: they have invested in oil companies, for instance, even though fossil fuels are seen as dodgy.

And what to make of pornography? A U.S. coalition of family-focused lobby groups wants hotel companies either to purge their rooms of pornographic TV channels or force lonely travelers to make an embarrassing phone call to “opt in” for such services. Marriott, a perennial target, has said its chain of child-friendly Nickelodeon resorts will be launched porn-free.

For hotel groups, securing a slice of the action from sales of pay-per-view porn is tempting. LodgeNet, an entertainment equipment supplier, serves 1.8 million hotel rooms with movies, not all of them “mature-themed”, and made revenues of $486 million in 2007. Its average monthly per room revenue from movies, including mainstream releases, was $15.80 last quarter.

Such companies negotiate master contracts with hotel chains, or strike separate deals with owners, that see them install the equipment for free for 5-7 years. Franchise fees for hotel groups are driven by room bookings, not extras, and the contribution from movie commissions to an hotelier’s bottom line is seldom transparent. How valuable porn is to them may become clear if it survives in the face of adverse publicity, lawsuits and boycotts by anti-porn campaigners.

Could ethical investors tilt the balance? The Timothy Plan, a “biblically-based” mutual fund group, for example, avoids hotels that offer adult content and companies that install the equipment. But, for the moment, such investors lack muscle. U.S. religious mutual funds manage just $11 billion, according to Morningstar, in a multitrillion-dollar industry.

The Social Investment Forum estimates 11% of US funds under management have some social bent. But socially responsible investing already struggles to define its parameters. The trend is towards assessment across a range of environmental, social and governance criteria rather than exclusion of companies or sectors based on one black mark. Climate change, sustainable development and labor relations are weightier than a businessman’s occasional blue movie.

Coming up short

In the past two months, regulators on both sides of the Atlantic have intervened in the epic struggle between financial companies and the hedge funds that are short-selling their shares. The U.S. Securities and Exchange Commission (SEC) and the U.K. Financial Services Authority (FSA) each scrapped their usual pattern of industry consultation and put out new restrictions so quickly that they were still tinkering with the details as the rules came into effect.

Desperate to prevent more collapses in the financial sector, the SEC on Tuesday extended its ban on “naked shorting” of 17 investment banks, and of Fannie Mae and Freddie Mac, the two mortgage giants. Some argue that such trades, in which investors sell shares they do not yet possess, make it easier to manipulate prices. The SEC has also reportedly issued over 50 subpoenas to banks and hedge funds as part of its investigation into possible abusive trading of shares of Bear Stearns and Lehman Brothers.

The SEC’s moves deserve scrutiny. Investment banks must have a dizzying influence over the regulator to win special protection from short-selling, particularly as they act as prime brokers for almost all short-sellers. There is as yet no evidence that market abuse has driven down financial firms’ share prices – and plenty that their toxic balance sheets and credibility have. Indeed, the SEC’s initiatives are asymmetric. It has not investigated whether bullish investors and executives talked bank share prices up in the good times. Moreover, the SEC’s rule affects only Fannie Mae, Freddie Mac and 17 banks. If the practice is really such a problem, what about the 8,500 other banks?

London’s financial services regulator has as yet failed to provide evidence to justify its decision to tighten the disclosure rules on short-selling of some bank shares. The FSA’s June rule sought to protect companies carrying out rights issues by forcing short-sellers to reveal positions above 0.25% of outstanding shares. But the one-off disclosures do not actually limit shorting and simply supply an unilluminating snapshot of who holds what.

Both the SEC’s and FSA’s rules smack of scapegoating. It is easier to point the finger at hedge funds than address systemic problems. But regulators should not forget their history. Outside short-sellers were blamed for the 1929 crash but the Pecora Commission investigation revealed that the main beneficiaries of the practice were banking insiders such as Albert Wiggin, the Chase president. More recently, Biovail, the Canadian drugs maker, complained vociferously about shorting but has now been sued by the SEC for alleged accounting fraud. In an era of global computerized markets, new rules on shorting may indeed be necessary. But the current regulations seem more like poorly conceived window dressing.