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Worse Before Better – An Update

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Our financial markets update to clients (September 17, 2008):

The usual caveats apply. Everyone’s financial situation differs. Consult your own advisor or do your own research. We have been wrong before.

[Formatting problems at the bottom are known issue. Webmaster on the case.]

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Lehman is toast, Merrill’s in a shotgun wedding and AIG is now working for the American government. The right-sizing of the financial industry continues.

We’ll help interpret recent events, then explain why bad news today means (mostly) good news tomorrow and finally go through some action steps.

What happened to Lehman?
Lehman was forced to declare bankruptcy after the government declined to bail it out. For every dollar of real capital it had, Lehman had borrowed another $29 to buy bonds and make loans, some of them really stupid ones. The big losers are the owners of Lehman’s bonds who will get whatever is left over. Lehman had $160 billion worth of debt and losses could be $60 billion. This pain will be widely shared by pension plans, insurance companies, money market funds and bond funds around the globe.

What happened to AIG, formerly one of the world’s leading insurance companies?

Newspapers are calling it a bailout, but in this case the US looks more like an opportunistic investor.

AIG ran aground because it did two stupid things. First, it made a lot of investments in illiquid mortgage backed securities that took a serious turn for the worst. Then, it did something really stupid. Not content to just invest in junk, it made big bets in the form of credit default swaps (CDS). CDS are insurance for bonds. AIG received a small premium over time to guarantee the value of all sorts of bonds, including the same kinds they held in their portfolio. Under the requirement of the CDS agreements, AIG would be required to post a HUGE amount of collateral against these bets if AIG’S credit rating ever declined. Keep in mind that they own mostly illiquid investments and that most likely cause of their credit declining would be losses in their investment portfolio… They really bet the farm — and lost.

The US government (AKA you and I) has extended them a line of credit for $85 billion. In exchange for this line of credit, we get 80% of a company that does have a lot of real (but illiquid) assets and solid lines of business. If AIG borrows money, it must be overcollateralized and the interest rate is LIBOR + 8.5%. We may have gotten a deal, but time will tell.

Why rescue AIG but leave Lehman for the vultures?
Good question. Here is our best guess.

Lehman had also done a lot of CDS but had acted more as a middleman. For example, they would bet that FNMA would go bankrupt with Goldman and then bet that FNMA would stay in business with Merrill Lynch. When it was clear that Lehman would go under, all the swaps traders got in a room and cut Lehman out of the picture. At the end of the day, everyone had the same protection and exposure that they did before. (Please note: this is the theory – the reality is still working itself out).

AIG, on the other hand, had just offered a lot of credit default protection to everyone. If AIG disappeared, there was no one on the other side. There were a lot of financial institutions that were relying on the protection they had bought.

Another factor may have been AIG’s massive presence in the Asian retail life insurance markets. America, as you may recall, is heavily indebted to various Asian central banks and may have been under some pressure to help out.

Is my money market safe?
Maybe. A large money market fund just “broke the buck” because of Lehman bond holdings – meaning that that shareholders will lose some money (3%). If you recall, we went through an exercise about 6 months ago and looked carefully at the holdings of many different money market funds. We were very uncomfortable with what we found and moved most of your cash into the Treasury-only funds.

Fidelity had a conference call later today to tell us their money market fund is fine and Schwab just sent us a note saying they didn’t own any Lehman debt in their money market fund. We are still very uncomfortable with the holdings in typical money market funds. We are comfortable with fairly large holdings in Vanguard funds, some holdings in Fidelity and limited amounts in Schwab. Small money market funds at large institutions are probably insulated – the corporate parent will step in to make up the difference. We worry most about funds with really high expenses — they often take risk to get yields to competitive levels.

Is the crisis almost over?
Absolutely not.

“The crisis” is really several different crises, related but distinct. The first crisis is falling home prices in the United States. A similar crisis is in early days in the UK.

The second crisis is the unwinding of excess leverage. Can you imagine taking your $500,000 in the bank and buying $20 million worth of stocks and risky bonds? $30 million? Investment banks, the mortgage insurers and certain hedge funds (enabled by the investment banks) were doing this on a really large scale. As they lose money, they don’t even have the $500,000 in the bank, so they either need to convince someone to top them up, or start selling assets. The sale of assets is a global phenomenon led by those who have lost money on mortgage-related investments.

The third crisis is the financial stress that the American middle class is going through now with stagnant wages, rising expenses and the demise of home equity lines.

Is this the end of the world?
Absolutely not.

Most importantly, we are not aware of any clients who are now in a financial position because of market declines that will change their day-to-day life one iota. We’ve done our best to get everyone to keep a lot of cash in their investment account.

We have a lot of insight as to the path our economy will follow. We have a lot of insight as to the long run returns from different asset classes. We have little to none as to the path asset prices will follow during the next 1, 2, 3 years. We are continuing to stay focused on the long term fundamentals of various investments and we are very comfortable with the 5-10 year horizon returns offered by a range of investments.

Many of you are still socking away money for retirement. All this money will now have a much higher expected return.

It is the financial industry itself that is at the center of the storm. This will have some knock on effect in the rest of the economy but you will note that two of the three crises listed above are primarily American ones. The rest of the world is growing. It may take a bit of a breather as the US consumer retrenches, but there is no turning back the clock. Jessica just returned from China. There are not just more cars and new buildings in the urban centers but an important change in mindset. People were recycling and reusing. They were focused on the future.

Is there any good to come out of the bad news?

Yes. Unsustainable trends cannot be sustained. The US consumer had stopped saving, enabled by high savings rates abroad.

US Personal Savings Rate in the USThe financial sector had taken over our economy. Over 40% of all profits in the US were made by financial firms, a statistic more befitting a small Caribbean tax haven. Financial regulation in this country was inconsistent and ineffective.

Homebuilders built way more houses than there are families.

Every step we take towards righting these imbalances makes the economy of tomorrow more efficient and resilient. The Commerce Department reports record low housing starts? Great news! The fewer new homes we build today, the faster inventory levels fall back to normal.

We could go on and on.

The best news of all for long term investors is that investment opportunities with excellent risk/reward ratios are now becoming available.

What do we do next?

First, we will rejigger everyone’s short-term cash. We are now finally ready, if you are, to take a little bit of risk. You can earn 5% more by owning a highly diversified portfolio of high-grade short term bonds than by holding Treasury bills. You can earn a higher interest rate that is completely tax exempt by owning a highly diversified portfolio of short term muni bonds than by owning taxable Treasury bonds.

Second, we will start investing everyone’s cash stashes. We won’t go all in yet but our prerequisites of investor panic and attractive asset pricing have been met. Around the globe, there are high quality companies for sale which are available for a 30-40% discount to their liquidation value.

Next, we would encourage everyone to review their mortgages. Rates are plummeting and it may be a great refinancing opportunity. For those of you contemplating taking out money from your home equity lines, we’d encourage you to move fast — they are disappearing.

Who should I vote for in November to fix this mess?

We are not going there. We will make one prediction. Whoever does win will be too busy to spend much time clearing brush at the ranch.

Your messengers,

Elizabeth and Jessica

Topics: Economy, Financial Planning, Housing Bust, Investments | Comments Off on Worse Before Better – An Update

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