Thursday, November 6, 2008

End of An Era

One minute I held the key
Next the walls were closed on me
And I discovered my castles stand
Upon pillars of salt and pillars of sand
Coldplay

Everyone ought to bear patiently the results of his own conduct.
Shakespeare

It has been over two months of financial turmoil. For over 25 years I have been studying banks, monetary policy, credit markets and financial crises. So following these events for me has been fascinating and appalling. I have been saying in my newsletters and presentations for well over a year that we were facing serious problems. I have ranted and raved that risk wasn’t priced into the market, how the misuse of derivatives was going to lead to trouble and that unless the U.S. housing market was resuscitated that things were going to keep getting worse. I just didn’t think that it would mutate to such an extreme outcome. Things are moving so fast that I will not be able to talk about everything that has happened. I will try to hit the main highlights of the last seven weeks. It is like watching dominoes fall knocking each other haphazardly. It has been unclear what impact each falling domino would have on other dominoes. I will try to walk you through the chain of falling dominoes and what the impacts have been.

As we have previously discussed, financial institutions had taken huge bets using derivatives which were not properly reflected on their balance sheets or understood by management. These derivatives amplified the impact of the collapsing housing market. It was as though an atomic bomb was detonated in the credit markets flattening many institutions in its wake.

This current episode started when the Treasury nationalized Fannie Mae and Freddie Mac on September 8th in response to the failing housing markets and shriveling of the credit markets. The combined assets of Fannie and Freddie are over $5 trillion. These entities had been set up to support the housing market. Their job was to help guarantee most of the mortgages in the United States (provided they met certain standards), and were able to fund these guarantees by issuing their own debt, which was in turn tacitly backed by the government. The government guarantees allowed Fannie and Freddie to take on far more debt than a normal company. In principle, they were also supposed to use the government guarantee to reduce the mortgage cost to the homeowners, but the Fed and others have argued that this rarely occurred. Instead, they appear to have used the funding advantage to rack up huge profits and squeeze the private sector out of the “conforming” mortgage market. Regardless, many firms and foreign governments considered the debt of Fannie and Freddie as a substitute for U.S. Treasury securities, and snapped it up eagerly.

Fannie and Freddie were weakly supervised, and strayed from their core mission. They began using their subsidized financing to buy mortgage-backed securities, which were backed by pools of mortgages that did not meet their usual standards. Over the last year, it became clear that their thin capital was not enough to cover the losses on these subprime mortgages. The massive amount of diffusely held debt would have caused collapses everywhere if it was defaulted upon; so the Treasury announced that it would explicitly guarantee the debt.

But once the debt was guaranteed to be secure (and the government wiped out shareholders both preferred and common shares), no self-interested investor was willing to supply more equity to help buffer the losses. Hence, the Treasury ended up taking them over. The Treasury only got authority from Congress to take this action in July, and in seeking the authority had insisted that no intervention would be needed. The opposite has happened. The Treasury has replaced the management of both companies and will presumably oversee their operation. This decision marked an acknowledgment by the government that the mortgage market and the institutions to make it operate in the U.S. are broken.

It is now clear that the government should not have wiped out the preferred shareholders. These shares were extensively held by financial institutions, foundations, school districts, and municipalities and were seen as ultra safe. The impact was percussive and reverberated through the market. It has taken weeks to see the full impact, but it is clear now that this was one of the reasons the credit markets completely seized up.

The following Monday the largest bankruptcy filing in U.S. history was made by Lehman Brothers. Lehman had over $600 billion in assets and 25,000 employees. (The largest previous filing was WorldCom, whose assets just prior to bankruptcy were just over $100 billion.) Lehman’s demise came when it could not even keep borrowing. Lehman was rolling over at least $100 billion a month to finance its investments in real estate, bonds, stocks, and financial assets. This may sound like a crazy way to run a business, but this is how all the investment banks were operating financing long term needs with short term debt.

Basically, when it is hard for lenders to monitor their investments and borrowers can rapidly change the risk on their balance sheets, lenders opt for short-term lending. Compared to legal or other channels, their threat to refuse to roll over funding is the most effective option to keep the borrower in line. This was especially relevant for Lehman, because as an investment bank, it could transform its risk characteristics very easily by using derivatives and/or by churning its trading portfolio. So for Lehman (and all investment banks), the short-term financing is not an accident; it is inevitable.

Why did the financing dry up? For months, short-sellers were convinced that Lehman’s real-estate losses were bigger than it had acknowledged. As more bad news about the real estate market emerged, including the losses at Freddie Mac and Fannie Mae, this view spread.
Lehman’s costs of borrowing rose and its share price fell. With an impending downgrade to its credit rating looming, legal restrictions were going to prevent certain firms from continuing to lend to Lehman. Other counterparties that might have been able to lend, even if Lehman’s credit rating was impaired, simply decided that the chance of default in the near future was too high, partly because they feared that future credit conditions would get even tighter and force Lehman and others to default at that time.

The failure of Lehman rippled through the market causing havoc. Its assets were sold in a chaotic fashion, causing stable assets to plummet in value. Lehman’s business units that made markets for many bonds and derivatives were not operating. The results were disastrous. First, the short term commercial paper market froze, which then caused some money market funds to fail (or they broke the buck). Banks stopped lending to other banks and started to hoard cash. The blood (cash) was no longer circulating and the patient (economy) went into cardiac arrest. In retrospect, allowing Lehman to fail was the worst mistake the U.S. government made. A plan to liquidate Lehman in a controlled way would have avoided much of the turmoil that followed. From this point on, fear escalated and the herd began to stampede for the exits.

The next day (Sept 16th), the Federal Reserve made a bridge loan to A.I.G., the largest insurance company in the world with over $1 trillion of assets and over 100,000 employees worldwide. The loan is for two years at 850 basis points (8.5%) over Libor (the rate that banks in Europe lend to each other). The Fed has the option to purchase up to 80 percent of the shares of A.I.G., is replacing A.I.G.’s management, and is nearly wiping out A.I.G.’s existing shareholders. A.I.G. is to be wound down by selling its assets over the next two years. The Fed has never asserted its authority to intervene on this scale, in this form, or in a firm so far removed from its own supervisory authority.

A.I.G. had to raise money because it had written $57 billion of insurance contracts whose payouts depended on the losses incurred on subprime real estate related investments. While its core insurance businesses and other subsidiaries (such as its large aircraft-leasing operation) were doing fine, these contracts, called credit default swaps (C.D.S.’s), were hemorrhaging.
Furthermore, the possibility of further losses loomed if the housing market continued to deteriorate. The credit-rating agencies looking at the potential losses downgraded A.I.G.’s debt on Monday, Sept. 15th. With its lower credit ratings, A.I.G.’s insurance contracts required A.I.G. to demonstrate that it had collateral to service the contracts; estimates suggested that it needed roughly $15 billion in immediate collateral.

A second problem A.I.G. faced is that if it failed to post the collateral, it would be considered to have defaulted on the C.D.S.’s. Were A.I.G. to default on C.D.S.’s, some other A.I.G. contracts (tied to losses on other financial securities) contain clauses saying that its other contractual partners could insist on prepayment of their claims. These cross-default clauses are present so that resources from one part of the business do not get diverted to plug a hole in another part. A.I.G. had another $380 billion of these other insurance contracts outstanding. No private investors were willing to step into this situation and loan A.I.G. the money it needed to post the collateral.

In the scramble to make good on the C.D.S.’s, A.I.G.’s ability to service its own debt would come into question. A.I.G. had $160 billion in bonds that were held all over the world - nowhere near as widely as the Fannie and Freddie bonds, but still dispersed widely. In addition, other large healthy financial firms had guaranteed A.I.G.’s bonds by writing C.D.S. contracts. A failure by A.I.G. would have taken some of these institutions down. Given the huge size of the contracts and the number of parties intertwined, the Federal Reserve decided that a default by A.I.G. would wreak havoc on the financial system and cause contagious failures. There was an immediate need to get A.I.G. the collateral to honor its contracts, so the Fed loaned A.I.G. $85 billion. Since then A.I.G. has had to borrow even more from the government to stay afloat. Its board of directors is analyzing which divisions to sell off first to start repaying the loans.

Then Merrill sold itself to Bank of America. This is the type acquisition that would normally take months to negotiate. Instead, it was thrown together over one weekend. Merrill Lynch knew it could not weather the storm created by Lehman’s failure. B of A has always wanted to own Merrill Lynch’s retail brokerage business. Merrill knew that if it did not find safe harbor (a willing buyer) before Monday morning, that it would be dead before the end of the week. So it was a shot-gun wedding. Now the dominoes fall even faster.

By Wednesday the credit markets (this is where bonds are bought and sold and funds are lent from one firm to another) has ceased to function. Investors fled the credit markets and ran to Treasuries. The price was bid up so high on Treasuries that they had no yield and investors were paying the government to hold their money for free (see chart). On the flip side, the cost of borrowing for companies soared. This stunning flight to safety started to cause serious damage to an already compromised economy. The last remaining large Wall Street firms, Goldman Sachs and Morgan Stanley, which just weeks before were considered relatively strong, came under assault. Their stock prices plummeted and no one would loan them money. Remember how devastating this was for Lehman.

Now it’s Thursday, and the Treasury and Federal Reserve begin discussions on what would become the largest financial bailout in U.S. history. The plan was to authorize the government to buy distressed mortgages at deep discounts from banks and other institutions. The program would be run by the Treasury and use $700 billion of taxpayer’s money to fund the program. The goal was to inject liquidity into the banking system and jump start the market in the mortgage-backed-bond market back to life. The markets rallied on the news. Discussions between Congress, the Treasury and the Federal Reserve continued through the weekend on TARP (Troubled Asset Relief Program). Everyone assumed Congress would pass the bill on Monday. Congress did vote on Monday but failed to approve the bill. Fear gripped the markets resulting in the worst one day decline in the U.S. stock markets in two decades. Congress did not pass the bill because many representatives do not understand the financial markets. They saw this as a bailout of greedy investment bankers. Over a week later, the Senate passed the bill followed by Congress but the administration had to compromise on several fronts, such as pay caps for executives. The delay caused more market turmoil and the markets fell further.

In the meantime, the last two independent investment banks on Wall St., Goldman Sachs and Merrill Lynch, transformed themselves into bank holding companies. Now they will be subject to greater regulation. Instead of reporting to the relatively “hands-off” SEC, Goldman and Morgan Stanley will have much closer supervision by bank examiners from several government agencies. The firms will look more like commercial banks, with more disclosure, higher capital reserves and less risk-taking. In exchange, the firms get access to the Federal Reserve’s lending facilities, which should help them avoid the fate of Lehman Bros.

As officials in Washington were still negotiating TARP, Washington Mutual was seized by the FDIC and sold to JPMorgan Chase. The FDIC then pressured the weakened Wachovia into a deal with Citigroup. Four days later Wells Fargo made a richer offer for Wachovia and the legal wrangling started. In the end they decided to split the baby in half so Citicorp and Wells Fargo split Wachovia. Throughout the turmoil the FDIC has done a tremendous job of handling failing banks so there is as little turmoil in the financial system for consumers and businesses as possible.

During the week, the crisis became increasingly global. Many financial institutions and banks overseas had purchased some of our more toxic securities and derivatives. In addition, these firms had adopted the Wall Street model of high leverage and imprudent use of derivatives. They had also extended risky real estate loans in their own countries. In Europe, the week was punctuated with one state intervention after another to rescue faltering banks in Germany, Belgium, the Netherlands and Britain.

Over the weekend of Oct. 4th many of the leaders of the European Union met to try to come up with a coordinated effort, but failed. Separately, the German government said on Sunday that it would guarantee all private savings accounts in the country in an effort to reinforce increasingly shaky confidence in the financial system. The rest of the European nations followed suit on Monday. If they had not guaranteed deposits each country faced a run on their banks. European leaders still could not agree on any coordinated response to the crisis, leaving the markets in disarray. Further away in Iceland, the country’s financial system completely collapsed. The government intervened and now owns all five of Iceland’s banks. The cost of intervention in Iceland was greater than the country’s annual GDP (value of all goods and services produced in a year). The European stock markets fell precipitously.

On the same day, emerging markets took one of their biggest collective tumbles in a decade as stock markets from Mexico to Indonesia to Russia were gripped by fears of a collapse of Europe’s banking system, and concern that a global recession could drag down the price of commodities, forcing a steep slowdown in emerging-market growth. Many of the world’s fastest-growing economies thought they had insulated themselves from problems in the developed world. But economists said that simultaneous turmoil in Europe and the United States was too much for these markets to bear.

On Tuesday, Britain and Spain moved to shore up their failing banks. The violent fallout in the housing market in both countries was causing their banks to fail. Both countries stepped up to inject liquidity into the system.

At this point the markets fell further. The technical term for it is “negative feedback loop.” I just call it a panic. The Federal Reserve and European Union announced a coordinated interest rate cut. In response stocks ignored the good news and declined again. Credit markets remained frozen, with banks still hoarding cash. These declines were free falls caused by very low trading volume. The price of stocks was declining on very few trades. So there are only a few panicky sellers that are willing to sell at any price to a few brave buyers while the majority of investors sat on the sidelines watching the carnage. Once the madness starts it is difficult to stop. The market falls out of fear like a freight train and no one wants to get in front of it.

What finally calmed the markets was a direct injection of capital by the Treasury into nine of the nation’s top banks. In other words, the government is guaranteeing the basic plumbing of the financial markets. Treasury Secretary Paulson asked the nation’s top bank executives to a meeting in Washington on Monday October 13th. At 3PM Treasury Secretary Henry Paulson, flanked by Federal Reserve Chairman Ben Bernanke and Federal Deposit Insurance Corp. Chairman Sheila Bair welcomed the executives to one of the most important bank gatherings in history.

For an hour, the nine executives listened to the Paulson and Bernanke paint a dire portrait of the U.S. economy and the unfolding financial crisis and how the government intended to buy a stake in each of their firms. Each banker was handed a term sheet detailing how the government would take stakes valued at a combined $125 billion in their banks in the form of preferred stock, and impose new restrictions on executive pay and dividend policies. The participants, among the nation's best deal makers, were in a peculiar position: they weren't allowed to negotiate. Mr. Paulson requested that each of them sign the deal and described it starkly. He told them that they could accept the government's money or risk going without the infusion. If their companies found they needed capital later and couldn't raise money privately, Mr. Paulson promised the government wouldn't be so generous the second time around. Paulson argued the plan represented a good deal for the banks: The government would be buying preferred shares, and thus wouldn't dilute their common shareholders. And the banks would pay a relatively modest 5% in annual dividend payments. Each bank was asked to participate so that no bank would look weak by accepting the capital infusion. The meeting ended at about 4 p.m. By 6:30 p.m., all of the sheets had been turned in and signed by the CEOs.

The magnitude of the infusion into the banking system calmed the stock markets and allowed the credit markets to thaw. Banks have begun lending to other banks and businesses again. The panic and fear that had gripped the markets has abated, but the de-leveraging process is now reverberating through the Main Street economy.

Tuesday, September 16, 2008

Umbrellas, Dinosaurs and the U.S. Financial System

“A banker is a fellow who lends you his umbrella when the sun is shining, but wants it back the minute it rains.”
Bradley’s Bromide

It is storming in the financial markets and the banks want their umbrellas back and in some cases are they are then closing their doors. This is the complete restructuring of the U.S. financial system and everyone is hoarding umbrellas.

Sunday night was surreal. I was folding laundry and watching a Discovery Channel program about the lives and extinction of dinosaurs with my family. During ads I was allowed to switch the channel to the financial stations (CNBC) and hear about the extinction of the U.S. Investment Banks. In my 30 years in the financial industry I have seen restructures, consolidation and failures before but this was a mass extinction. On Sunday it somehow seemed apropos to be learning about the extinction of both dinosaurs and investment banks.

Someday I may be telling my children the story of the five investment banks that like the three little pigs built their homes of sticks and straw. Only in this case none of the five investment banks built a house of bricks. So no one was saved from the big bad wolf.

Why is this such a significant event that the press is now calling it Black Sunday? The failure of our banking system is the equivalent of a heart attack for the U.S. markets. It will take a complete heart transplant to revitalize our capital system. The flow of credit is the blood that keeps our economy humming. When banks fail, lending contracts, business can’t grow and the economy contracts. What might save us this time is the globalization of the banking system that has occurred over the last 15 years. We no longer supply the entire world’s capital needs. In fact, the funds used to prop up most of the financial system this year has come from Europe and the Emerging Markets.

It is this new global banking system that will help to resuscitate us. Our financial system will emerge more humble and more conservative (not as leveraged). We will re-emerge but gone will be the high flying dare devil acts that were so common on the street. Profit margins and growth rates for financial stocks will be much lower than the steroid pumped returns we had grown use to. Our stature in the world as financial power will shrink as well. Our economy will be contending with the fallout from this implosion for years to come. The good news is that we are dealing with our problems unlike the Japanese that just left their banks on life support and never operated.

In the long run our economy will be fine. It is important to view your investments as long run commitments. Would you buy a house and then a few days later sell it in a panic? No, so why would you treat your portfolio that way? In the short run the markets will continue to be down right frightening. Volatility is at a thirty year high. This is exactly the wrong time to be selling. In fact, this is the point when you start buying. No one can call the market bottom, so this is the time when smart investors start cherry picking.

Friday, August 15, 2008

Is your Money FDIC Insured?

Three banks failed last month and some 90 more are on regulators' troubled list. Could you lose your deposits if your bank fails? Yes, you can even if you are covered by FDIC insurance. The reason, depositors don't realize that they have to obey all the FDIC's rules.

In general, you'll be O.K. if you have less than $100,000 in any one bank and up to $200,000 in joint accounts. Some retirement accounts may be covered up to $250,000 as long as they are not brokerage accounts. But just to be sure, go to the FDIC's web site shown below and plug in your account information into its calculator, the electronic deposit insurance estimator. If that exercise informs you that some of your money lacks insurance, the first step is to try changing your accounts' ownership status. For example, by titling one account in your name, one in your spouse's name and one jointly, you can insure as much as $400,000 in deposits at that one bank.

FDIC Calculator

Or you can spread your money among banks and insure an unlimited total amount, as long as you keep under the limits discussed above for each institution.

If you have so much in the bank that this seems like a lot of trouble, check out the certificate of deposit account registry service, known by its acronym CDARS. It lets you keep up to $50 million in CDs with one home bank. That bank then parcels out your holdings among other banks, so that you stay fully insured. Interest rates will be lower than you could get on your own, but then again you won't lose your money if your financial institution fails. Check out the website for more information on CDARS.

CDARS

Tuesday, July 22, 2008

Investment Discipline

“History is merely a list of surprises. It can only prepare us to be surprised yet again.”
Kurt Vonnegut
Having experienced a multitude of market crises, I realize that history never repeats itself exactly, so I’d be arrogant not to admit that almost anything can happen from here. It is a distinct possibility that things will get worse before they get better in the stock market. Even if the economy holds up, fear and pessimism could cause of investors to panic and send the market down further than justified by long-term economic fundamentals.














































At times like this, it is essential to have a sense of perspective and rely on sound long-term investment disciplines when making decisions. It is important to avoid panicking because of short-term market concerns and uncertainty. It is easy to put too much weight on negative scenarios when all you hear is bad. Inevitably, investors always flee the stock market at just the most inopportune moment, when the tremendous bargain basement deals are obtainable. I love the chart above because it shows how the average equity investor underperforms the markets. He has only earned 4.5% per year over the last twenty years due to emotional trading. Over the same 20 year period, the S&P 500 domestic stock index earned 11.9% per year and the bond market earned 7.9%. The average equity investor missed out on these returns by fleeing the market at the low and re-entering when it has already recovered. Dalbar Inc. calculated the average investor’s performance using net aggregate mutual fund sales, redemptions and exchanges by month for twenty years.
Bubbles lead investors to make errors in judgment, thereby mispricing assets on the way up. Investors do not understand the risks they are taking and what could happen. On the flip side, riskier assets often fall to bargain prices on the way down when investors are frightened. The risks become clear: investors panic when losses start to accumulate and flee the market. This pattern of overzealousness-followed-by-panic repeats throughout the history of mankind.
While the perspective gained from years of experience is useful, humbleness is just as important. It is crucial to always be open to market signals and stay intellectually honest about factors you can and cannot assess. Or else you will miss when the market is warning you that it isn’t the normal boom-bust cycle but a full scale melt down. I spend hours assessing risk, global economies and investment markets. I try to communicate what I have learned to you through my blog, newsletters, phone calls and meetings. At this point, this is a normal bear market. Fleeing the markets now would be a big mistake since stocks are priced to outperform bonds over the next five-years. Second, big market downturns invariably present opportunities - you just have to have conviction.
Since 1946, there have been nine bear market declines of 20% or more. The average drop was 32.5% over 14 months. The average bull-run lasted 70 months, with average returns over 185%. While this does not guarantee future results, it certainly provides food for thought. With major indices down about 20% from their October 2007 peaks, it would not be surprising to see the markets fall another 10%, at least from the perspective of history. Many traders are now referring to 2008 as the Year of Capitulation.
It has been a tough first half, and even some legendary money managers have taken a hit. GuruFocus.com follows the trades of legendary money managers and keeps track of their results over 6-month and 12- month time periods. If you think your portfolios performance has been dismal, you may take some consolation in seeing how many Managers of the Year and other top-notch investors have been (Marty Whitman down 43%). Even Warren Buffett is now in negative territory for both the 6 and 12-month periods just ended. Warren has a great perspective on market down turns. He said at his recent shareholder meeting, “If a stock [I own] goes down 50%, I’d look forward to it. In fact, I would offer you a significant sum of money if you could give me the opportunity for all my stocks to go down 50% over the next month.” Mr. Buffett wants the price to decline so he can buy more cheaply. I wouldn't bet against any of these guys rebounding in a big way once the market picks up in the future.

Monday, July 21, 2008

Week in Review

As a result of good news last week, stocks were able to break their multi week losing streak. A combination of stronger than expected earnings announcements, introduction of the governement's plan to save Fannie Mae and Freddie Mac, short covering and outright buying in the financial sector and a sharp correction in oil prices. The S&P 500 rose 1.7% to 1,261, the Nasdaq climbed 2% to 2,283 and the DJIA increased 3.6% to 3.6% to close at 11,497. Financial stocks led the way, advancing over 11% while energy, utilities and materials all declined. Inflation worries still pursist but falling oil prices will add some stability to the stock and credit markets.

Bonds - Why do we own them?

Bonds are worth owning. Yes, the credit markets are a mess and bonds did fall in value during the Second Quarter 2008 but bonds offer stability. Bonds are much less volatile then commodities, stocks and residential real estate. See the adjacent chart. Bonds have a standard deviation of only 1.1% while oil's is over 9%. Standard deviation measures how scattered the returns are from the average. The more variation the higher the standard deviation. The down side is bonds earn less than stocks. So even though stocks are more risky in the long run they generate a higher return.
I view bonds as an insurance policy. How much long term return do you want to give up to gain stability? You are essentially buying an insurance policy for your portfolio the way you would for your home. In the case of property insurance, the question is how much current income are you willing to spend to protect you home from a catastrophic event. You are never going to make as much money invested in bonds instead of stocks. So how much do you need to invest in bonds to protect your portfolio from a catastrophic event? That depends on whether you need the money now or are years away from retirement. It depends on how well you can handle short term market swings. It depends on how much money you have and how much money you'll need and when. So the answer is it depends on your needs and your money personality. In other words, there is no magic formula. So it is important to carefully address all these issues when determining your allocation to bonds.

Friday, July 18, 2008

Short Selling

In order to bring more stability to the stock market the SEC acted this week to retrict naked short selling. Here are three good stories on NPR (National Public Radio) that discuss who, what and why of it all.

Short-selling-profiting-from others misery

What-is-naked-short-selling

SEC Cracks down on naked short selling

Thursday, July 17, 2008

Global Focus is Now Chic

Look whose going global! First it was California Public Employees Retirement System (CalPERS) and now it is California's other big pension fund California State Teacher's Retiriement System (CalSTRS).

The proposal by CalSTRS' staff reflects a greater interest by institutional investors to move from a home-country bias and have their equity portfolio reflect the broader global market. CalSTRS could move some $15 billion to overseas equities from domestic stocks if its investment committee approves.

At Altamont Wealth Management, we have been actively shedding our home country bias and moving towards a global allocation for two years. It is great to hear that the large institutional pension funds are catching up.

Going-Global

Wednesday, July 16, 2008

Second Quarter Market Review

"You make most of your money during a bear market; you just don’t realize it at the time." Shelby Cullom Davis

The first half of the year had all the thrills and chills of a bad horror flick. There were nauseating triple digit declines in the U.S. market, warnings of collapse among players in the global financial system and the subprime-mortgage-housing foreclosure crisis debacle. Then we had a rally in early spring and investors breathed a sigh of relief as many believed that the subprime monster had been tamed and the worst was behind us.

Ah, but never underestimate a bad horror movie. There was more than just one monster in this picture. The oil monster was on the rise and he scared consumers out of their SUVs. His pal, the inflation monster, also caused fear as he caused food prices and healthcare costs to rise. In response, the markets ran scared and fell hard again. These last two monsters, oil prices and inflation, delivered a one-two psychological blow to the markets. Investors had been lulled into feeling safe by the early spring rally that had pushed the market averages into positive territory for the year. Of course, everyone knows that you can never be safe until the hero, Obama or McCain, captures the monsters and saves the economy. But I am getting ahead of myself; let’s first talk about the second quarter.

So a sharply negative first quarter was followed by two months of positive returns, but the selloff resumed with a vengeance in June, with large-cap stocks dropping over 8%, resulting in a 3% decline for the second quarter. Surprisingly, Mid Caps and Small Caps hung on to have a positive quarter with the S&P400 Mid Caps rising 8.7% and the S&P 600 Small Caps up 3.5%.

Value stocks fell across the board, which is not surprising since the financial, mortgage and housing stocks are all in bad shape. Conversely, Growth stocks were positive across all market caps. Domestic high-quality bonds were down just over 1% for the second quarter and up just 1% for the year. Though not a good return in a normal environment, bonds did provide balanced investors with a modicum of protection from stock-market losses, which is part of their role.

Being diversified outside of U.S. stock market didn’t help much. Developed international markets fell 2.3% for the quarter and are down almost 11% year-to-date. Emerging markets were positive for the quarter earning 2.2% but are still down almost 10% for the year.

Interestingly, international bonds have performed well this year. They are one of the least risky ways to profit from the declining dollar. Emerging market debt has performed admirably, reflecting the rise in third world countries on the economic world stage. PIMCO Developing Local Markets was up 3.3% over the quarter and 5.8% year-to-date. PIMCO Foreign Unhedged that invests in developed countries was down 5% for the quarter but still up 5% for the year.
The only relief domestically was in the commodities markets which have profited from rising food, metal and oil prices. Unfortunately, commodities look like a speculative bubble that is going to pop.

Monday, July 14, 2008

Last Week in Review, Market Shorts at Bearish Levels

Another icky week and more worries. Once again stocks declined last week in the face of credit concerns, recession worries, high oil prices and inflation fears. The S&P 500 fell 1.8% during the week to 1239. we are firmly in Bear territory now.

As we have discussed before the Fed is between a rock and a hard place. It cannot serve dual mistresses of low inflation and economic growth. So in order to keep the peace it will have to keep the Fed funds rate at 2%. It will continue to aggressively use what ever tools it has at its disposal to create liquidity and fight off market instability. We will continue to see the Fed step in as necessary as it did this weekend to provide liquidity to Fannie Mae and Freddie Mac.

The next chart highlights the amount of short interest in the market today. This measure depicts the percentage of trading volume that is betting the market will go down. Historically, levels this bearish have been fore bearers of future market rallies.

So what is the outlook from here? Presently, the U.S. equity market is in the process of making its third bottom (the first occurring in mid-January and the second in mid-March). The next notable move will probably be up as fears begins to abate.
As long as oil prices keep rising, stocks will remain under pressure, central banks will be unable to act and the risk of recession will grow. In the long term, for the markets to recover will require oil prices to abate which means the demand for oil must subside. Demand pressures should subside as the global economy continues to slow. It will become ever more difficult for oil prices to continue their unprecedented drive higher as demand pressures abate. The bottom line is that a correction in oil prices is a necessary if the world economy is to avoid a major slump, for inflation to decline and for equity markets to enjoy a sustained rally. At this point oil prices haven't shown any weakness so it is unclear when things will begin to get better.

Monday, July 7, 2008

Credit Reporting Agencies: Errors, Impacts and Problems

If this can happen to a well known reporter on NPR then it can happen to you!

Terry Gross and her husband recently had a tusssle with credit rating agencies when they assigned credit problems inadvertently to her husband. They had to hire an attorney to help straighten out the mess with the rating agencies.

Terry discusses the impact of credit agencies on our lives with Prof. Elizabeth Warren, a specialist in bankruptcy and contract law at Harvard Law School. It is a very informative discussion.

http://www.npr.org/templates/story/story.php?storyId=92049490

Thursday, July 3, 2008

Bruce Berkowitz, Manager of Fairholme

Here are some comments made by Bruce Berkowitz, Manager of Fairhome at the 2008 Morningstar Conference in Chicago last week. He addresses potentially closing his fund, the recent change in the fund's charter and the future of his fund. These remarks were made after he had spoken on a panel.

Monday, June 30, 2008

Pimco's Mohamed El-Erian at Morningstar Conference 2008

I am attended the 2008 Morningstar Conference in Chicago. I am trying something unusual. I am going to try and post my notes on the most compelling speakers and publish them. The opening address was given by Mohamed El-Erian from Pimco. He presented his current Investment Outlook. Here are my notes:

Notes Morningstar Conference 2008
June 25, 2008
Mohamed El-Erian, Pimco
Investment Outlook

New book
When Markets Collide
Co CEO and co CIO of Pimco

Objective is to share my thought about opportunities in the markets. It is a very fluid and uncertain environment. I will use a simple framework which speaks to what is happening and sheds light on opportunities and risks that we are facing.

It is hard to believe what has happened over the last year. The unthinkable has become thinkable. This is not noise, this is a signal. Understanding these signals is the key to managing money well.

A year ago, none of us would have predicted that the next crisis would occur here and not a third world country. That bank runs would occur here in the US and United Kingdom versus the rest of world. That our banking system would raise $350 billion of new capital to replace a similar amount it had to write-off. What is even more significant is that this recapitalization is from the poorer third world countries and not from traditional money centers. I could not have made these predictions a year ago.

I would submit that the markets are trying to tell us something.

If you were in the FOMC meeting, you would hear the members discuss how worried they are about inflation, employment, and the dollar. The issue: the Federal Reserve cannot fix these all of these problems simultaneously. They must pick between growth and inflation. Unlike the European central banks, whose mandate is to focus on inflation, the US Federal Reserve must respond to multiple factors.

There were signals early on of the problems to come. They cropped up as conundrums, puzzles, and anomalies. We have gone from serial inconsistencies (or sequential) to all-together simultaneous inconsistencies.

It is important to understand these changes and navigate thru portfolio asset allocation and rebalancing. These represent great opportunities but great risk. Retooling is critical but don’t fall in love with answers.

#1. Disruptions this time are taking place in the heart of the US financial system. This system is crucial to our economy. It is like the oil in your car - without it the car grinds to a halt. (Additional Explaination from Libby - Restructuring the Financial sector is the equivalent of the U.S. economy getting a heart transplant).

This is a story about systemic risk and how the banking system itself mispriced the risk.
As the market looks at risk it currently is re-pricing it through the market. Currently the market is saying through pricing that Citigroup and Goldman are riskier then Brazil and Mexico. So the contamination is very different this time. Our impact on the world is different this time.
In 2000, the breaking of the technology bubble had a greater impact on the global markets than the US. This time the origins and the impacts of this crisis are different.

The Casualties:
1. The Credibility of the most sophisticated financial system of world
2. Effectiveness of policy and the credibility of our policies
3. Highly leveraged institutions and transactions have been hurt the most
4. Just-in-time risk management system has been debunked, due to lack of confidence
5. Comfort with the “originate and distribution” model

On the whole the rest of world didn’t get hurt by this but has to deal with consequences.
Imagine a horse race. In February 2007 three horses started running a race.
“Deleveraging Process” was first out of the starting gate
“Capital Raising” – the most hesitant horse until it saw how far ahead the deleveraging horse was, then started galloping
“Policy” was the sleepiest and saw the race was long. It started only in August

The distance between horses is shrinking. You must be cautious when the distance between horses is lengthening. What counts is the distance between horses for each asset class.

We have had a sequential re-capitalization process for a while.
In the early 90s, it was the Emerging Markets.
In the early 00s and mid 00s, it was corporations like Enron.
Today it is the re-capitalization of our financial sector.
This is inherently risky to do because it is at the center of the capitalist system. (Like heart surgery – you’ve got to keep the patient alive).
Tomorrow it is the US Consumer due to the housing market and consumer debt levels.
We will end up with a stronger system after it is all over. We are very lucky these things have all happened sequentially versus simultaneously.

But the implications go beyond this. There are drivers of global change. The markets of yesterday are colliding with the markets of tomorrow. There are handoffs. The developed countries are handing off to the developing economies.

The growth handoff – the gradual realignment of global powers, has now reached critical mass. No longer will the handoff be slow. We think in linear terms like markets and infrastructure but development is now non-linear. We are use to nothing happening for a long time, but change is speeding up and now it will happen all at once. (Change in these growing markets overseas will be exponential.)

Next is the Wealth handoff. Wealth will shift to Asia, the Middle East and other Emerging Economies. There has been a turnaround in inflationary dynamics from global dis-inflation to inflationary pressures, which helps these countries.

Last:
There has been a change in the barriers of entry to markets. Emerging economies are now driving global growth. A trillion dollars of accumulation and consumption has now moved out of our economy.

The US Consumer market has hit a harsh head wind. Consumers can’t access house equity – the ATM card is gone.
It is near the time when people en masse will walk away from their homes. It has already begun - people are falling behind in their mortgage payments before falling behind in other things. Historically, this has never happened before.

There is a trader in a hot air balloon floating in the sky. He spots a man on the ground. He asks where am I? The man answers: You are in a hot air balloon floating above the ground. The trader is disgusted. This does not help him at all determine where he is. The trader yells back – Are you an analyst? The gentleman on the ground says, Yes how did you know. The trader responds, you gave me accurate information that is totally useless. The Analyst yells back, Oh you must be a trader. The trader says how did you know? The analyst responds, You don’t know where you are, how you got there and where you are going, and you are still blaming the analyst.

There are going to be opportunities and risks, and if you are like the poor trader you will not survive.

You need to have total clarity about return expectation and risk tolerance. Revisiting asset allocation for secular robustness is crucial for success. The choice of investment management vehicles in the context of this new configuration of risk will make all the difference. Portfolio and manager must reconcile challenges. You must ask yourself - What mistakes do I usually make and what could happen? Then analyze what the outcomes could be of these mistakes in this new world. Your risk management analysis should include “fat tail” protection. It is essential to set up proper procedures and structure, so don’t fall victim to human nature.

You must have a mentality of constructive paranoia. Openness to appropriate re-invention and internal mechanisms will avoid second guessing. You must have Secular and cyclical anchoring.
Understand the pitfalls of “rational fools.”

A sociologist and animal behaviorist created a test. They took a starving donkey and set up a situation where the donkey had to pick between the same amount of hay spread out or concentrated in a pile. The donkey saw no difference between the piles and refused to pick, thereby starving to death.

The moral, if we get paralyzed and do not change then we lose. Doing nothing is not a choice.

Don’t treat this as a one-time disruption. This is going to be a bumpy journey. Don’t think we are ever going back to business as usual (or the way it was before the sleeping emerging markets woke up). Don’t forget that this crisis involves opportunity and a new capital structure.

We are living through a bumpy secular transformation. Old and new markets are colliding. New opportunities are wrapped in new and complex configurations. Re-tooling is necessary for survival.

Soft decoupling process. In the past, when our economy hit the skids we took the world with us. Now we are in a process of slowly decoupling our economy from the rest of the world. Now when we slow by one unit the rest of the world will still slow, but by less. So world will outgrow moving along with us.

We will continue to experience demand shocks to commodities because the Emerging economies are driving growth. They are making new and bigger demands. They are inefficient users of commodities. Conservation is not a word they know. Commodities are now expensive and more volatile and will stay this way. The very shift in prices itself signals a new and different volatility.

Question: What will it take for the market to recover?
The key to our recovery lies in the housing market and consumer.

Monday, June 23, 2008

Last Week in Review

Last week in every market segment was down including energy, materials and utilities. Overall, it was a tough week with the S&P500 down 3.1%, Nasdaq fell 2% and the Dow Jones Industrial declined 3.8%. Year-to-date the S&P500 is now down 9.3%. Small caps continue to outperform large (less negative) and growth is trouncing value investing. Market jitters continue and the bears are winning.
Oil troubles continue with prices rising to new highs. Increasing energy prices have stoked inflation fears. The numbers of speculators in the commodity markets is growing rapidly only adding to the feeding frenzy. In addition, escalating tensions between Israel and Iran is adding instability to an already rocky oil market. The scuttlebutt is that Israel will bomb Iran with assistance from the U.S. in the next six months. Oil prices will soar to over $200 a barrel if Iran is attacked. Baring an attack, the energy markets look very frothy and should retrench from these lofty levels.
Problems in the financial sector persist. Banks have only written off one-third of their bad investments and the housing market is rapidly disintegrating. These problems will not be fixed overnight. Until the housing market begins to recover the economy and markets will stay in turmoil.
Inflationary forces continue in the developed and developing world is reaching the choking point. Many economists feel inflation is not that bad because it has not spread to workers. Rising unemployment is keeping wages down. So in economist-speak inflation is not so bad.
In the real world the problem is that the collapsing housing market in conjunction with rising food, energy and healthcare costs have taken the consumer out of the market. I know I write this all the time but two thirds of our Gross Domestic Product (GDP) is generated by consumer spending. Consumers aren’t spending (look at the recent performance of retailers and automobile manufacturers). Consumer lead recessions (vs. business lead recessions) are always deeper and take longer to recover. It takes more time to build up consumer sentiment and get consumers spending again. This is not going to be an easy and quick V-shaped recovery. It will probably resemble a very wobbly wide W-shape.
The Fed is talking hard ball and many of its members want to raise the Fed Funds Rate when they meet. It will be difficult for them to raise rates any time soon because it would bring this fragile economy to a screeching halt. Instead, they will have to keep rates where they are and if things get worse they may have to lower rates again.
In the short run, the market will remain choppy with equities swinging significantly down on bad news and moderately up on good news.
I will be in Chicago this week at the Morningstar Conference. I hope to meet with numerous portfolio managers of mutual funds. I will be reporting back my findings and interviews.

Monday, June 16, 2008

Last Week in Review

Concerns over energy prices, weakening consumer confidence, a mixed inflation report and some increased activity in the merger-and-acquisition calendar caused U.S. stocks to experienced mixed performance for the week. The S&P500 Index was basically flat, falling one point to 1,360. After last week, the index was down just over 6.5% for the year. Large value stocks are the worst performing for the week and the year, down 7.8% year-to-date. Small and Mid Cap stocks are still out performing Large Caps.

Data last week pointed to continued weakness in consumer confidence, which acted as a drag on stock market performance. Historically, extremely low levels of consumer confidence have often presage market rallies. In fact, in the 12 months following the 10 lowest readings of consumer confidence over the last 30 years, stocks were up an average of 20%.

The big news last week was inflation. The CPI (Consumer Price Index) for May posted its largest monthly increase since last November, primarily due to energy prices. Core CPI inflation (which excludes energy and food prices) remained low. I do not believe that inflation is low even if you exclude food and energy. The government’s method of calculating inflation is flawed. It manipulates the calculation, substitute’s goods and then under estimates the price of improved goods. Inflation is a political hot potato and the incentive is to keep it low. The government has to increase social security benefits by the rte of inflation so low inflation equates to low benefit payout increases. Broad-based inflation in the U.S. is picking up and if our inflation is the same as most of the developed world then our inflation rate is around 7% which would mean we really are in a recession.

This leaves the Federal Reserve between a rock and a hard place. Deteriorating economic growth combined with the credit market issues has forced the Fed to keep dropping interest rates. On the other hand, the Fed is feeling pressure to increase rates due to rising inflation, the weak U.S. dollar and high oil prices. At this point, the Fed is talking tough (saying they plan to raise interest rates and that the dollar should strengthen) which is helping to bolster the equity markets. However, the Fed is unlikely to raise interest rates any time soon, given ongoing credit market problems. In fact it is entirely probable that the Fed may have to lower interest rates despite their hawkish rhetoric. The near term will continue to be bumpy in the equity and credit markets. The deteriorating economic climate here and abroad coupled with the worsening energy crisis will cause the markets to struggle for the next few months.

Tuesday, June 10, 2008

Commodities: Short Term Bubble

In January 2007 oil was $60 a barrel and this morning it is approximately $137 a barrel. It is a mind boggling rise in prices that has hurt consumers and attracted significant media attention.
Speculators are widely blamed for this rise. See the attached graph by JPMorgan which shows the marked increase in speculators participation. Speculators are partially to blame for this run up but there are sound fundamental reasons for this rise. There is more demand for oil (think emerging countries like China) and a tight supply. The third impetuous is rising political risks in the Middle East. It is very likely the U.S. and/or Israel will bomb Iran before Pres. Bush leaves office. This will destabilize the supply of oil causing the price to escalate further.
Goldman Sachs sees crude rising to $141 a barrel and possibly $200 a barrel in 2009. As with all bubbles it is hard to see where and when we will reach the top and how far and swiftly we will fall when it bursts. The bubble will burst as demand begins to wane (as growth in China continues to slow and demand in the developed country contineus to drop) and supplies stabilize. Speculators will leave the market like rats off a sinking ship. This might not happen for at least a year but it will happen. I do think long term that a 3% allocation to commodity futures is a good diversifying investment if you are using futures and the DJ AIG Commodity Index. The road will be pretty bumpy and beware of any erosion in the oil futures market.


Monday, June 9, 2008

Last Week in Review

The U.S. stock market fell sharply last week. The market consistently fell during the week with only positive trading day mid week. The bulk of the decline occurred on Friday due to new unemployment data for May and another dramatic rise in oil prices.
For the week the S&P 500 declined 2.8% and is down 6.5% year-to-date. Mid and Small Cap stocks held up better than the Large Caps last week and for the year. A trend not predicted by most market prognosticators, including myself.

Last Friday’s unemployment report showed greater weakness in the labor market than expected in May. The drop was significant, with payrolls declined by 49,000 and unemployment surged to 5.5%. Some economists postulate that this spike in unemployment may be a one-month aberration; however the labor market clearly has been weakening in 2008.

The negative side of the economic story is clear, with headlines focusing on housing and higher commodity prices. The primary main story rolling forward is going to be inflation, and its impact on consumers, interest rates and the markets. Inflation and tightening credit have restrained consumption in recent months and are likely to remain headwinds for some time to come.

Tuesday, May 27, 2008

Last Week in Review

Last week was brutal. The market traded down in front of the three day Memorial Day weekend. It is not unusual for the market to decline in front of a long holiday weekend. Many investment banks and market makers do not want to sit on a large inventory of stocks over a long weekend. What is unusual is the magnitude of that fall. The S&P 500 fell 3.5% over last week and has fallen 5.5% year-to-date. The pain was evenly spread between growth and value but Large Cap domestic stocks have fallen more than Small caps for the week and the year. No one is more surprised by these results then me. I truly thought that Small Caps would take it on the chin this year and Large Caps with their international exposure would outperform.

All major sectors of the market were negative last week and year-to-date only energy and materials sector are positive. It is not a surprise that financials are the hardest hit sector. The chart below is a pictorial summary of last weeks market action and was produced by JPMorgan.

Manage Your Credit Card Debt Away

Every once in a while you find a great website that is truly helpful and not gimmicky. I ran across one such website the other day. It was created by the cooperative efforts of Utah State University Extension and WebAIM.org. The website primarily helps consumers gain control of their consumer debt. It has a great calculator that lets you enter your specific debt information for each obligation. The site then calculates how long, at that rate, it will take you to pay it off and how much it will cost you in interest. You can also see the impact of making additional monthly payments to each credit card or loan.

It will also help you establish an Emergency Fund plan so you are prepared if you lose your job or the unexpected happens. It also has a calculator that helps you determine how much debt you must pay off to qualify for a mortgage.

There is also a section that helps individuals develop a spending plan. It helps you allocate your take home pay and makes suggestions for different expense categories (i.e. food usually comprises 18% to 25% of your income).

The Educational Center has dozens of helpful how to articles on topics as diverse as selecting a credit card to how to protect your self from insurance fraud. These are pithy articles just chocked full of good tips.

You will need to setup a profile with username and password to start exploring this site but it is totally worth it.

Please pass this site on to anyone who has is having trouble managing their debts. It is also a great site for educating teenagers or kids about money. I always wonder how many kids would run up credit card debt if they knew how much it costs. There is a great article offering helpful suggestions for parents on managing allowances.

Powerpay

Friday, May 23, 2008

The Fed at Work: A Play-by-Play Commentary

Relying on both conventional and unconventional means, the Federal Reserve (Fed) has been attempting to break the credit crisis’ stranglehold on the economy. It has been extraordinary to watch the Fed take actions that have not been used since the Great Depression, and a few actions that have never been used.
The Fed needs to be aggressive because the current liquidity crunch in the credit and mortgage markets is creating a negative feedback loop between the financial markets and the U.S. economy. The strain in the credit markets is putting pressure on the broader economy, leading to further weakness in the housing market, which then creates further dislocations in the credit markets, etc., etc., etc. Additional aggressive policy action by the Fed will be essential to break this self actuating spiral.
Since September the Fed has slashed its overnight lending target to 2.25% from 5.25%. It has also injected $200 billion into the credit markets by opening the Fed’s borrowing window to non-banks (such as investment banks), and has loosened collateral standards for these short term loans and now accepts lower rated asset-backed securities. In other words, an institution can pledge riskier bonds as collateral and receive Treasuries from the Fed. The Treasuries can easily be sold to generate the cash needed by the firm to meet its obligations. These loans are short term and will have to be paid back but in the mean time liquidity has been improved which will prop the credit markets up and keep the asset-backed bonds and lower credit quality bonds from falling further.
The Federal Reserve has now committed approximately half of the Fed’s portfolio to the fight and has pledged to commit more if necessary. Essentially, the Fed is using its own balance sheet as a tool to inject funds into the market right where it needs it the most. It is this type of creative aggressive action that is requisite if the Fed hopes to break the negative spiral between the economy and the credit markets.
The Fed also stepped in to ensure that Bear Stearns did not go under. Bear Stearns found itself in trouble because Wall Street began to question whether the investment bank had the necessary capital to back all its trades and bets. The firm was the highest levered investment bank (least assets to greatest debt) on the Street by a significant amount. Bear Stearns was not a very popular investment bank with its compatriots due to its aggressive brass-knuckle tactics. The combination of its bad rap and the high leverage ultimately set the stage for its demise. The firm began to go under as investors pulled their money on rumors of illiquidity and lenders called their loans and refused to extend additional credit. It was a classic run on a bank, the kind we saw Jimmy Stewart stave off in “It’s a Wonderful Life.” It was the old one-two punch. I feel no sympathy for the executives at Bear Stearns. If you swim with sharks, you do business with sharks, you act like a shark, then you are a shark and may be attacked, killed and eaten by other sharks.
The Fed stepped in and helped negotiate the purchase of Bear Stearn’s by JPMorgan for $1.2 billion in stock. In addition, JPMorgan will also absorb any losses on the first billion dollars of $30 billion of Bear’s riskiest assets. Those assets will be managed independently by BlackRock. The Federal Reserve Bank of New York is guaranteeing the remaining $29 billion, and in return, will reap any gains from that portfolio.
Why bail out Bear Stearns? After years of never allowing any of our financial institutions to fail, these banks have become so interwoven and enormous that nobody can be allowed to sink beneath the waves. Otherwise, a tsunami would swamp the hedge funds, banks and other brokerage firms that remain afloat. If Bear Stearns failed, for example, it would result in a wholesale dumping of mortgage securities and other assets onto a market that is frozen and where buyers are in hiding. This fire sale would force surviving institutions carrying the same types of securities on their books to mark down their positions, generating more margin calls and creating more failures, further hurting the economy and the housing market (the spiral). This bailout is less about saving Bear Stearns and more about shoring up the financial markets, housing markets and the economy.
On the flip side, this deal does not pass the sniff test. Why hasn’t there been another bidder? I find it difficult to believe that no one else was interested. It couldn’t have been that unstable because if the situation were so precarious, why wouldn’t shareholder ownership position be completely wiped out. Instead, a week later the bid is raised from $2 to $10 a share (a $1 billion increase in value). Is JPMorgan manipulating the situation to protect its $91.7 trillion dollar derivative exposure (per Office of Comptroller of the Currency September 2007 reported data) which is backed by only $123 billion of equity? How much of this counter party exposure did JPMorgan have with Bear Stearns? I can only surmise that JPMorgan made a sweet heart deal with the Fed and other governmental agencies. The deal would require JPMorgan to commit whatever resources would be necessary to prop up and acquire Bear Stearns. In return the Fed would not allow other suitors to bid up the price and they would not disclose JPMorgan’s full exposure to Bear Stearns. In essence, the Fed propped up both JPMorgan and Bear Stearns. One bank ate another and won. The game goes on.
The government has also reduced capital holding requirements for Fannie Mae and Freddie Mac from 30% to 20%. This frees up more money that Freddie Mae and Freddie Mac can use to purchase mortgages, thereby shoring up the mortgage-backed securities market. This increase in funds will help add liquidity and hopefully begin to break the gridlock that is crippling the credit markets. The regulatory body that oversees Fannie Mae and Freddie Mac has said they would lower the capital requirement even more if needed.
Congress has begun to do its part to break the spiral. As part of an economic stimulus package enacted last month, the cap on standard mortgages was temporarily increased from $417,000 to $729,750 in high-cost markets through the end of the year. Standard mortgages usually have lower interest rates than jumbos because they can be purchased or guaranteed by Fannie Mae or Freddie Mac. This is a great idea and could have made lower cost mortgages available in some of the most hard-pressed expensive housing markets. Unfortunately, this has just created an intermediate tier to the mortgage market. These tweener-loans are less expensive then the jumbo mortgages but the interest rates are not as low as a standard mortgage under $417,000. The loan originators are pricing the loans to reflect the additional risk they are taking with these tweener-loans because Freddie Man and Fannie Mae could decide to not purchase or guarantee them. So this part of the stimulus plan has been a bust.
Despite the efforts of the Fed, credit markets are not functioning properly. Sizable losses on subprime loans have lowered the capital base of many financial institutions. The situation is exacerbated by a financial system that has, over a period of years, become intertwined in a spaghetti-like fashion through the spread of complex financial products (CDOs, CLOs, CDSs, and the like). This complexity makes it difficult to clearly understand what assets may be at risk, how big those risks may be, and also who is at risk. This uncertainty has led financial institutions to retrench, which in turn makes credit (loans) more expensive and less available—even while the Fed tries to make credit less expensive and more available. If there are any more major disruptions in the credit, the Fed will have a very difficult time restoring equilibrium. According to Bill Gross at Pimco, what Washington really needs to do is get off its “high moral-hazard horse and move(s) to support housing prices… Authorities must act quickly, with a shot of adrenalin straight to the heart of the problem: housing prices…The decline needs to be stopped quickly in order to avert additional crises.”

Thursday, May 22, 2008

PIMCO's Mohamed El-Erian, co-CEO Interviewed on NBR

It is a pleasure to hear such clarity of thought after experiencing the daily onslaught of garbage media. Mohamed has it right. The dual threats of inflation and slow growth mixed with an ailing housing market are causing dislocations in the equity and credit markets. PIMCO is right on the money. The economy won't recover until the housing market does. Let's hope that Washington gets it right with its new housing legislation.

Here's the interview.

Wednesday, May 21, 2008

What teens should know about managing money!

One of the last taboos is money. We will frequently teach our kids about the birds and the bees before we teach them anything about fiscal responsibility and money management.

If you have teenagers here is a nifty website with some great educational material. Read through the lesson plans and student resource guide for ideas on teaching your teenagers about money management. Spend a little time each week discussing how to manage money properly. After all it is a necessary life skill. Don’t let them learn the hard way. Teach them now how to manage their money so it doesn’t manage them.

Link to Guide and Lesson plans

Tuesday, May 20, 2008

Recession, Yes or No?

Does it really matter whether we meet the economist’s technical standards for defining a recession or not? I think the answer is yes! It is clear to just about everyone that the economy is in trouble. Even our Federal Reserve Chairman, Ben Bernanke admits that it is highly likely that we are in recession. He actually used the R word.
The downward slopes of most of the graphs below speak for themselves, but here are a few highlights. Jobless claims are beginning to rise. This past week monthly job losses hit a five year record high. The consumer doesn’t need an economist to tell him that the job market is getting increasingly dicey, just look at consumer sentiment. It is not just the job market that has consumers running scared. The combination of declining house prices, skyrocketing oil and food costs, a major credit crunch as well as rising job layoffs have brought consumer confidence to its lowest point in five years. Let’s face it -we are in a recession or at least flirting with one.

Wednesday, March 26, 2008

How Did a Few Bad Mortgages Humble Wall Street?


That was the topic this morning of a persentation I gave to a retired group of seniors interested in investments. Their name is the $ums in Retirement. A great group of guys in Walnut Creek that are retired but actively involved in improving and maintaining their financial health. I really enjoyed talking to them. I promised to post this slide which was orignally a full page article in the New York Times. It shows how mortgages were packaged and sold. If you read this and then my previous posting on Shadow banking you will have better understanding of how a few bad loans could humble Wall Street. To clearly read this graphic just click on it and it will appear full size in a seperate window. Pay careful attention how the BBB rated mortgages in step 3 are miraculously turned into AAA rated securities in step 4. Happy reading!

Tuesday, February 26, 2008

Shadow Banking

Shadow banking system is comprised of a plethora of opaque institutions and vehicles that have sprung up in American and European markets over the last decade. They have come to play an important role in providing credit across the financial system. These institutions, moreover, have never been part of the “official” banking system; they are unable, for example, to participate in Fed Treasury auctions. But as the credit crisis enters its sixth month, it has become clear that one of the key causes of the turmoil is that parts of this hidden world are imploding, sparked by the failure in mortgage-backed bonds. This in turn is creating huge instability for “real” banks, partially because regulators and bankers alike have been badly surprised by the degree to which the two (official and shadow banks) are entwined. Financial derivatives of all descriptions are involved, including SIVs, CDOs, and the most egregious CDSs. If you want to understand the shadow banking world you must learn this new alphabet soup of entities and investment vehicles. So follow along as we trace our way through the rubble.
Until this summer, structured investment vehicles (SIVs), collateralized debt obligations (CDOs), and credit default swaps (CDS) attracted little attention outside specialist financial circles. Though often affiliated with major banks, they were not always fully recognized on a bank’s balance sheets.
Structured investment vehicles, or SIVs, are bank-linked funds. In a way, they are a virtual bank. The SIVs issued short-term debt at relatively low interest rates and used the proceeds to buy longer-term debt carrying higher rates, including debt backed by mortgages. They have an open-ended structure which could stay open forever as long as they keep buying long term assets and selling short term debt. Why do this? Banks profited by setting up these structures because they pocketed the difference between the short term and long term rates, and they did not have to hold reserves for these loans that were placed off balance sheet. At their peak, SIVs held some $340 billion in assets, a figure that fell to a still whopping $265 billion by early December as they sold off some holdings.
When debt markets froze up in August the fear was that the SIVs would be forced to unload their assets in a panic. That would create big losses, the theory went, and set artificially low market prices for the assets -- forcing financial institutions to take huge write-downs. A government effort to stabilize the markets with the help of three major banks ultimately failed, but it did ward off a complete meltdown. The banks claim they are not responsible for the losses caused by these SIVs. Interestingly, despite their protestations, they are stepping up and taking the write-downs associated with these shadow entities they created.
CDOs are actually bonds, unlike SIVs which are entities which that hold assets. These collateralized debt obligations are structured products backed by an asset that has a cash flow, like a pool of mortgages. Other assets that collateralized these products are corporate bonds in various forms. Here’s were it gets really complicated; there are synthetic CDOs that never owned the asset backed bonds or loans. They gained exposure to these asset-backed loans through the use of credit default swaps. Many SIVs purchased CDOs and synthetic CDOs.
So what is a credit default swap (CDS) and why are these contracts a problem? Brace yourselves, this is a mind bender. This is a vast, barely regulated market in which banks, hedge funds and others trade insurance against debt defaults. This isn't like life insurance or homeowners' insurance, which states regulate closely. It consists of financial contracts called credit default swaps (CDS) in which one party, for a price, assumes the risk that a bond or loan will go bad. This market is vast - about $45 trillion, a number comparable to all of the deposits in banks around the world.
Originally, these contracts were intended to protect Wall Street firms from losses on mortgage securities and other debt they own. However, not everyone who buys one of these contracts has bonds to insure. Some players bought them just to speculate on market movements. These investors were basically betting on which direction the value of an insurance contract would rise or fall, which they did daily based on the market’s perception of risk. In much the same way gamblers make side bets on football games, a financial institution, hedge fund or other player can make unlimited bets on whether corporate loans or mortgage-backed securities will either strengthen or go sour.
If they default, everyone is supposed to settle up with each other, the way gamblers settle up with their bookies after a game. Even if there isn't a default, if the market value of the debt changes, parties in a swap may be required to make large payments to each other (just the way an investor would have to put in more capital if the stock he bought on margin fell). Of course, Wall Street investors often use heavy borrowing to magnify their wagers. Recently, the ability of institutions to make good on their many trades with one another is beginning to falter. The turmoil on Wall Street could rock the foundations of the financial system around the globe if the major insurers of these contracts go under.
“What we are witnessing is essentially the breakdown of our modern-day banking system, a complex [or composite] of leveraged lending [that is] so hard to understand,” Bill Gross, head of Pimco Asset Management Group recently wrote. “Colleagues call it the ‘shadow banking system’ because it has lain hidden for years, untouched by regulation yet free to magically and mystically create and then package subprime loans in [ways] that only Wall Street wizards could explain.” By any standards, the activities of this shadow realm have become startling. Traditionally, the main source of credit in the financial world was the official banks, which typically forged businesses by making loans to companies or consumers. They retained this credit risk on their books, meaning that they were on the hook if loans turned sour.
Why has the financial model changed so radically in the last few decades? Why did the shadow banking system develop? Banks began to increasingly sell their credit risk to other investment groups, either via direct loan sales or by repackaging loans into bonds. This was made possible by new regulatory reforms, which have permitted the banks to reduce the amount of capital that they need to hold against the danger that borrowers default. They did this by passing their loans to new vehicles (SIVs) either by creating these themselves or by sponsoring outside fund managers to run them. This was a huge incentive because it allowed banks to make many more loans without having to raise more capital. These new entities have been instrumental in vastly increasing credit over the past three years. Paul Tucker, head of markets at the Bank of England, has described this as the age of “vehicular finance”.
Bob Janjuah, credit analyst at Royal Bank of Scotland, estimates that these shadow banks could have accounted for half of all net new credit creation in the past two years. Because these vehicles typically borrow heavily to finance their activities, they have also been a key reason why leverage (or debt levels) across the financial world has risen so fast without regulators or ordinary investors being fully aware of this boom.
Hedge funds have had an oversized impact on the increase in the supply of credit. Satyajit Das, author and derivatives industry expert, cites an example where just $10 million of real (non-leveraged) hedge fund money supports one $850 million mortgage-backed deal. This means $1 of real money is being used to create $85 of mortgage lending. This is a level of credit creation that is far beyond the wildest dreams of any banker.
Since SIVs and CDOs have never been in the business of gathering deposits from customers, their significance to the economic and financial system has not been widely recognized by regulators and policymakers. The problem now is that the business model behind parts of this shadow banking world looks increasingly shaky. Essentially, the role of regulators in this world was replaced by the credit rating agencies, which awarded high, ultra-safe ratings to the debt issued by SIVs and other vehicles on the basis of historical analysis of the probabilities of defaults and losses across the shadow banking system. Now these vehicles’ credit ratings are being downgraded. As the credit market absorbs this debt, it is contracting. The holders of these synthetic CDOs and SIVs are having the equivalent of a margin call, hence the large write downs
Jan Hatzius of Goldman Sachs estimates that mortgage related losses of $200-400 billion alone might lead to a pullback of $2 trillion of aggregate lending. Even if this occurs gradually, he writes, "The drag on economic activity could be substantial. Add to that my $250 billion loss estimate from CDS, as well as prospective losses in commercial real estate and credit cards in 2008 and you have a recipe for a contraction in credit leading to a recession.” (I have to thank Bill Gross from PIMCO for this quote).
The problem is that it is difficult to quantify the losses and impossible to confidently forecast how restrictive credit will be and for how long. There is also fear that credit problems will spread to other areas, such as credit cards which have also had permissive underwriting standards. At this point, it seems pretty clear that banks will have more write-offs over the next few months or quarters and that structured investments (pools of debt that have been turned into securities), which are often highly leveraged, will suffer through more ratings downgrades as collateral values decline further. This suggests that the current trend of less credit and higher costs probably has a way to go. This is true not just in the mortgage market (subprime and prime) but in the consumer and small-business loan market as well.
Problems like these do not get fixed overnight. They take months and sometimes years to unravel. It is obvious that whole parts of this economy (automotive industry) as well as whole regions of the country (Detriot with almost 8% unemployment) are in recession. The temporary fiscal plan proposed by Bush can’t plug this breach. It will, at best, be a small levee holding back a briskly flowing river.
The housing market will still fall, lenders’ underwriting criteria will tighten, consumers will spend less and the economy will slow to a crawl. Why? Because borrowing will no longer be cheap. The Fed can lower the interest rate to 1% but it won’t take the 30 year mortgage rate past 5%. The mortgage lenders aren’t offering teaser loans based on short term rates anymore. Only the 30 year mortgages are primarily available. So now you’ll need to put down a 10% deposit to buy a house and can only borrow at the higher 30 year rates. Fewer consumers will now qualify for homes, cars, and credit card debt. So the consumer is out of the picture. Businesses won’t be able to attain loans as liquidity continues to dry up. As I said before that just leaves the government and its stimulus package is a joke.
This is a mess that will be cleaned up by the next administration. Until then, the economy will bungle along. It will neither recover nor fall precipitously. The economy will be in a coma. The U.S. market should bumble along in the same trading range. As long as the stock market doesn’t get an unexpected big shock (i.e. terrorist attack), we should weather the storm, a little care worn but a good deal wiser. The best scenario for 2008 is nothing happens. This is not very inspiring, but it’s unfortunately realistic. Holding the course will be this year’s mantra.

Thursday, February 21, 2008

Mortgage-Backed Securities and the Housing Market

Most mortgages are not held by the lender who made them to you. They are pooled with others and sold to investors such as insurance companies, mutual funds, foreign banks and pension funds. A different company processes your loan payments. Yet another company represents the investors as the trustee.

The very innovation that made mortgages so easily available, an assembly line process known on Wall Street as securitization, has caused our current problems.

The idea of pooling loans and selling them to investors dates back to 1970, but the practice has exploded in recent years. At the end of last year, $6.5 trillion of securitized mortgage debt was outstanding. In the last few years, securitization led to this explosion of bad loans because the agents writing the loans didn’t care if they would ever be paid back. They made a fee by originating the loan and then sold the mortgage (passed on the risk) to another middleman who then passed it on to some anonymous investor. The incentive was to originate loans and to heck with proper underwriting (screening the borrowers to see if they qualified).
The process begins with the entity that originates the loan, either a mortgage broker or lender. The loan is assigned to a company that will service it (collecting borrowers’ payments and distributing them to investors). A Wall Street firm then pools thousands of loans to be sold to investors who want a steady stream of cash from loan payments. The underwriters separate them into segments based on risk called tranches.

Once a pool of mortgages (trust) is sold, a trustee bank oversees its operations on behalf of investors. The trustee makes sure that the terms of the pooling and servicing agreement are met; this document determines what a servicer can do to help distressed borrowers.
By its nature, the complex design of mortgage securities creates unwanted difficulties, which are written to ensure that the middlemen make their profit with little to no risk. Almost nothing in this process is done in favor of the borrowers’ interests. In fact, the agreements require that any modifications to loans in or near default should be “in the best interests” of those who hold the securities. Loan modifications are restricted which explains why many borrowers are having difficulty renegotiating their loans.

Fifteen years ago, the last time the housing market ran into stiff trouble, government-sponsored enterprises like Fannie Mae did most of the work pooling and selling mortgage securities. These enterprises readily agreed to loan modifications, but not so this time. In fact, it is in many cases impossible to determine who really is holding the title.
This is a mess, and many more home owners will lose their homes, keeping the housing market depressed until well into 2009. Why has the implosion of mortgage-backed securities been so destructive to the financial markets? The failure of mortgage-backed bonds has rippled through the markets, hurting financial institutions and the newer non-traditional banking system. This unregulated shadow banking system is comprised of a plethora of opaque institutions and vehicles that have sprung up in American and European markets over the last decade. They have come to play an important role in providing credit across the financial system. In the next few days I'll post more information about this sahdow banking system as well as credit swaps, SIVs and more.

Tuesday, February 19, 2008

The Math: Economy Less Consumer Equals Recession

Without a doubt, investors will remember 2007 as the year that the housing market collapsed and triggered a credit crunch. The earnings of just about any company that was involved in homebuilding or lending were crushed, and resulting economic worries triggered stock declines for many consumer goods companies. Simultaneously, U.S. exports boomed, reaching an all-time high of 12.1% of GDP. Not surprisingly, companies with significant foreign-based earnings did well. Overseas stocks also delivered great returns, and as these economies continued to grow so did their demand for energy and raw materials commodities from China and other high-growth developing countries.
The last four months have been difficult for stocks as prices have declined substantially from their highs in October 2007. The markets have broken through many technical support levels -- this is true for every major index (Dow Jones, Russell, Nasdaq and S&P), which means that technical damage has been done.
The good news is that the Federal Reserve has finally woken up to the severity of the situation and is working diligently to respond to escalating economic concerns. On January 22, 2008, the Fed unexpectedly cut the fed funds rate by 75 basis points (0.75%) from 4.25% to 3.50% in advance of its policy meeting. The Fed has not cut rates in one stroke by such a large amount since 1982. In making the cut, the Fed cited the “weakening of the economic outlook and increasing downside risks to growth.” This move was desperately needed to ensure market stability and sooth investor fears. Sinc then, the Fed has continued to cut rates and has stated its willingness to cut rates further to shore up the markets.
It appears that the combined impact of the housing implosion and the fallout from the structured finance debacle has pushed the U.S. into recession - or at least whole sectors of the economy are now in recession. How protracted the economic weakness will be and what its full impact on the markets are the new questions to be answered.
The key to an economic turnaround is consumer spending because it accounts for 70% of our economy (Gross Domestic Product—GDP). The falling housing market and the resulting tightening of mortgage lending have hit consumers hard, causing them to spend significantly less. Consumers who are more and more worried about the overall economy have triggered stock declines for many consumer goods companies.
A volatile stock market does not help consumer sentiment either. When you add rising unemployment to the mix, it is obvious that the U.S. consumer isn’t going to go on a spending spree anytime soon. It will be tough to entice the consumer to start spending when it is difficult to borrow, and many are already heavily in debt. Until credit markets are repaired, the consumer won’t start spending enough to cause a recovery, and businesses will curtail spending. If consumers and businesses aren’t spending, that only leaves the federal government, a scary thought. Even the proposed fiscal stimulus plan by the President won’t be enough to turn the tide. When credit becomes this tight, a recession is almost inevitable.
How did credit get so tight? Why are funds more scarce and underwriting criteria toughening? It all started with the mortgage-backed securities and how they are packaged and sold through our unregulated shadow banking system.