A reader just sent me Human Genome Sciences (HSGI), a $5B market cap biotech company working on a lupus drug, which has a 2 month base built. 

[click to enlarge]

Today, Morgan Stanely upgraded the stock with a price target of $40 which is pushing the price just over the top end of this Nov/Dec base… from a chart perspective my mouth is watering.  I might be a buyer in the last hour here or if the company starts to take off tomorrow.  Any close over $30 would make things very interesting; volume is suspect however.

Let me offer a word of warning; I stay away from biotech stocks as a rule since they are mostly lottery tickets unless you are talking some of the huge names like Amgen (AMGN) or Gilead (GILD) for example.  I will generally make a foray into biotech every 12-18 months when I get very overconfidant, the market is “way too easy” (as it is now – just buy almost anything and you’ll make money sooner or later), or I’m just plain bored and want some spice in the portfolio.  Within a short period of my biotech purchase, invariably either the stock crashes or the market does. So as I am pondering this name, take that into consideration.

Morgan Stanely upgrade:

• Shares of Human Genome Sciences Inc. rose $1.41, or 5 percent, to $29.58 Monday after Morgan Stanley initiated new coverage of the Rockville drug maker with a rating of “overweight.”
• Morgan Stanley set a share-price estimate of $40 on Human Genome Sciences stock, and told clients in a report that “Benlysta is likely to be the first drug approved in lupus in 50 years, and we believe investors underestimate the drug’s pricing power, penetration across various lupus patients, peak sales” and margins, according to Bloomberg News.
• In November, Human Genome Sciences reported its second round of positive results from a late-stage clinical trial of Benlysta, its experimental lupus drug.
• Human Genome Sciences and its development partner GlaxoSmithKline PLC plan to apply to federal regulators in the first half of 2010 to start selling Benlysta on the market, setting up an opportunity to share as much as $6 billion in forecasted peak annual sales from the drug. The companies foresee being able to sell an approved Benlysta in Europe in the first half of 2011.

Human Genome Sciences has spent the past 2 months absorbing these positive results on Benlysta released November 2nd (the stock jumped over 30%)

• The anticipated study data, from a clinical program called Bliss-76, showed a 10-milligram dose of Benlysta, plus therapy with steroids, prompted an improvement in 43 percent of patients, compared with an improvement in only 33 percent of patients on the placebo end of the study.
• Bliss-76 involved 865 patients and took place over 52 weeks. It is the second late-stage study on the potential lupus treatment to meet key goals. Last month, the company reported similar positive results from Bliss-52, which involved more than 860 patients in Asia, South America and Eastern Europe. 

Lottery ticket? Stock of the year?  HGSI was under 50 cents in March… 2009.  Which is why the gambling anonymous type of investor, loves his/her biotech stocks – even if 95 out of 100 flame out in spectacular fashion.

No position…. yet

by Marla Singer and Geoffrey Batt

Buried in the depths of page 26 of the Office of the Special Inspector General for the Troubled Asset Relief Program’s (SIGTARP’s) November 17, 2009 report “Factors Affecting Efforts to Limit Payments to AIG Counterparties” hidden in footnotes 33 and 34 is something of a mystery.  It might be the beginning of an interconnected financial chain involving Dubai, the Federal Reserve, AIG, Basel I, Eastern Europe and even Switzerland and which, even if it doesn’t worry you, probably should.  Or it might be nothing at all.

Consider first “footnote 33,” that reads as follows:

The first Basel Accord, known as Basel I, was issued in 1988; it focused on the capital adequacy of financial institutions. The capital adequacy risk—the risk that a financial institution will be hurt by an unexpected loss—categorizes the assets of financial institution into five risk categories (0 percent, 10 percent, 20 percent, 50 percent, and 100 percent). Banks that operate internationally are required to have a risk weight of 8 percent or less….

The original paragraph that references the footnote reads thus:

As of September 30, 2009, AIG had $172 billion in exposure to swaps in its foreign regulatory capital portfolio.  The portfolio contains swaps purchased by financial institutions, principally in Europe, to provide regulatory capital relief under Basel I. [note 33]  AIGFP’s COO informed SIGTARP in July 2009 that they expect that most of these swaps will be terminated by the end of the first quarter 2010 as most financial institutions complete their transition to Basel II.  Currently, financial institutions are required to hold a certain level of capital against their assets, and one way for a financial institution to reduce the amount of capital is to purchase swap protection on its assets.  However, new requirements decrease the level of capital required for such assets and, in most cases, there will be limited capital benefit to holding on to the existing swaps. Nonetheless, AIG warned in a June 29, 2009, SEC filing that if credit markets deteriorate, the company may recognize unrealized losses in AIGFP’s regulatory capital credit default swap portfolio. [note 34]  AIG could continue to be at risk if the swaps in its regulatory capital portfolio are not terminated by the end of first quarter 2010 as expected. (Emphasis added).

Taken together we read the thrust of this section to mean that a number of European banks, seeking to limit their regulatory capital requirements under Basel I (read: seeking to increase their leverage) bought swap protection on their assets from AIG.  These obligations still sit with AIG and, in the event credit markets sink materially, AIG is likely to take losses on these instruments.  Not just that but:

According to an AIG SEC filing, an ongoing concern for AIGFP is whether it will have to post more collateral if credit markets continue to deteriorate.  The amount of future collateral postings is partly a function of AIG’s credit ratings, which may be affected by any further decline in AIG’s financial condition. (Emphasis added).

Simply put, AIG might also have to post more collateral.  Moreover, though AIG initially expected most of these swaps to “be terminated by the end of the first quarter 2010 as most financial institutions complete their transition to Basel II,” we see from footnote 34 that:

Subsequent to the June filing, European regulators adjusted the implementation timing of Basel II, potentially affecting the holders of AIGFP’s regulatory capital swaps to hold beyond previously anticipated termination dates.

In other words, AIG is still on the hook- and hadn’t planned to be.

This raises a number of questions:

1. If the European banks that bought swap protection from AIG are still relying on this protection to meet their capital requirements, and AIG might be unable to make good on the agreements, are these banks actually out of Basel I compliance as we type this?
2. Are the banks still able to use swap protection to reduce their collateral requirements because of the implicit or explicit backing of AIG by the Federal Reserve?
3. If this situation existed in September-November 2008, as it certainly appears to have, how exactly can the Federal Reserve claim in good faith that it lacked the leverage to negotiate with these banks from a position of strength?  (One assumes that many of the same names collecting payment from AIG were also AIG swap protection buyers of the sort mentioned in the SIGTARP report).  Failure to back up an insolvent AIG would have resulted in near-immediate Basel I non-compliance as the protection offered by these swaps, and on which these banks depended for their reduced capital requirements, evaporated- a near death sentence.
4. Or had these banks somehow, and in the middle of the credit crisis, managed to boost their capital to levels that made the swaps unimportant?
5. If so, why keep them on the books now, instead of unwinding them?
6. Since it doesn’t seem likely that a teetering AIG could make good on these agreements without substantial assistance is the Fed is currently the ultimate backstop for AIG?
7. Does this mean that the Fed is effectively underwriting these swap agreements?
8. Will the Fed post collateral if deteriorating credit conditions at AIG (today’s -$11 billion news suddenly seems especially daunting if the potential insurance shortfall has an effect on credit ratings) or general credit market issues require it?  Or are we missing something significant?  By September 30, 2008 AIG had already posted $974 million in collateral for its “Foreign Regulatory Capital” portfolio.
9. What if European banks are hit with more losses from, oh, we don’t know, say… Dubai?  Deleveraging, risk reduction and credit tightening would have an effect on LIBOR, the Eurobond market and, of course, Eastern Europe.  Might not that sort of contagion easily spread to, say, Switzerland, which enjoyed the other side of the carry trade for years by lending Swiss Franc like mad to any Eastern European mortgage borrower who could sign documents?
10. Could it be that the Fed, once again, might have to bail out the world?

Or maybe we are just missing something obvious.

You might say Dubai what? Greece who? Small peanuts… but they key is contagion risk.  In the late 90s a small economy (Thailand) caused a series of currency disasters which set the world on fire.  Which ironically was the first real use of power by Alan Greenspan to flood the world with US dollars (outside Black Monday 1987)… a now knee jerk reaction to any crisis. 

I know you laugh here saying “only $60 B!” – that’s nothing! Heck that’d 1/3rd of an AIG bailout, or 1/3rd of a Citigroup bailout.  Heck we committed $13 Trillion of US treasure to backstop the global economy. [Mar 31, 2009: Financial Rescue Package Now Totals $12.8 Trillion]  That’s how numb we’ve become to the figures and how epic the use of government/central bank interventions have been in this era… when $60 billion makes many shrug their shoulders.  How far we’ve “advanced” in a decade.

Anyhow, the solution is easy… just have Ben print $60B and hand it to Dubai for the “betterment of the world”… and if it affects any of our financial oligarchs just print more money to give to them as well.  Problem solved…. after all US dollars are akin to toilet paper nowadays.   In fact S&P futures should be up at least 10% because this insures an even more “extended period of” super low rates.  What happened to the party everyone?

• Global financial markets swooned Thursday, with London seeing its most precipitous drop in nearly nine months, a day after Dubai stunned investors with the news that it was asking banks to allow its main investment vehicle, Dubai World, to suspend its debt repayments for six months.Standard & Poor’s 500 Index futures dived 2.2 percent.
• Dubai World, the government investment company burdened by $59 billion of liabilities, sought to delay repayment on much of its debt. 
• The announcement — the global high finance equivalent of a homeowner asking the bank to allow six months of skipped mortgage payments, presumably because the homeowner was out of cash — sowed fear of a contagion of instability that could roil markets that are only now recovering from the near cataclysm of the last year.
  “People are worried about the contagion effect from Dubai,” said Nader Naeimi, a Sydney-based strategist at AMP Capital Investors, which holds $75 billion in assets. “Events like this bring back all the bad memories from the global financial crisis. The market has rallied a long way and is very sensitive to any bad news.”
• Dubai, which borrowed $80 billion in a four-year construction boom to transform its economy into a regional tourism and financial hub, suffered the world’s steepest property slump in the first global recession since World War II. Home prices fell 50 percent from their 2008 peak, according to Deutsche Bank AG.
• Like many Western consumers during the good times, Dubai gorged on debt and borrowed too much to finance a building boom that has gone bust in the downturn. When credit markets froze last year, Dubai, like Iceland, found itself overextended. But Dubai, which has no oil, was backed by its Arab emirate neighbors. At least that is what investors had assumed.
• The cost of insuring Dubai’s debt against default quadrupled Thursday.

This was one of my 2009 Outlier Predictions [Dec 16, 2008: 13 Outlier 2009 Predictions], but I was focusing mostly on Eastern Europe

#12 Wildcard/Europe: Potential defaults on debt arise in a host of smaller countries – especially of the Eastern European variety. I don’t know which ones, but they have been mini U.S.’s, borrowing over and above their head, but unlike the U.S. do not enjoy the fact the entire world rushes into their debt market when a crisis emerges. The opposite will happen – Iceland & Ecuador are just the precursor. Russia, if low oil prices persist, invades another former satellite country both as a nationalistic reason (diversion to the populace from worsening domestic conditions) and to try to light a fire under European natural gas, and/or oil prices.

Keep an eye on Greece for the next one…maybe Ireland too.

• The cost of protecting Greek and Irish government debt against default jumped on Thursday, according to data monitor CMA DataVision, as debt problems in Dubai fuelled risk aversion.

There is one benefit from this… rather than getting the annual CNBC cheerleading about consumer spending from dark mall parking lots across America, we might actually have some useful discussion tomorrow.