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Reflections
on a turbulent week
Last week the US
stock market delivered the most dramatic losses and gains since
2002. For the week, the S&P
500 gained 0.3%. Substantial
changes have occurred, however, in the fundamental financial system of
the United States.
Timeline
· 2000-2003 - The US Federal Reserve Bank lowers Fed Funds
from 6.5% to 1.0% to boost the US economy following the bursting of the
"tech bubble," aftermath of 9/11 attacks. Rates are kept unusually low, which boosts
consumption of, among other things, residential construction.
· 2000-June 2006 - US housing prices double; millions of new
homes built, many new home-owners, lending standards relaxed or
abandoned, hundreds of billions of mortgage backed securities (MBS)
issued, hundreds of billions of derivative securities issued against MBS.
· July 2006 - August 2008 - housing prices fall 18%,
delinquency and foreclosure rates soar.
· July 2007 - Two hedge funds invested in MBS and managed by
Bear Stearns fail, costing BS 1.6 billion.
· September 2007-May 2008 - after gradually raising rates to
5.25%, the US Fed aggressively drops rates to 2%.
· October 2007 - US stock market makes a new all-time high,
slides 10% by year end.
· February 2008 - Lending limits increased Fannie
Mae/Freddie Mac, which now underwrite 80% of all US mortgages.
· March 2008 - Bear Stearns, the fifth remaining
broker-dealer, faces virtual bankruptcy as clients withdraw assets,
forced into a merger with JP Morgan.
· July 2007 - Stock market hits a one year low as Citigroup,
Merrill Lynch, Morgan Stanley, Bank of America announce additional
write-downs on MBS. IndyMac, a
California mortgage bank, is taken over by the FDIC in the most expensive
bank failure to date.
· August 2008 - Stocks rise modestly, gaining for the first
quarter in four, as the crisis seems to dissipate.
· September 6th, 2008 - Fannie Mae and Freddie
Mac are unexpectedly taken over by the US Treasury as their combined $85
billion in capital proves insufficient to support losses on a $5 trillion
loan portfolio.
· September 12th, 2008 - Lehman Brothers, already
weakened by its own MBS losses, is brought to its knees by short sellers,
client asset withdrawals. Over the
weekend Lehman fails to find a buyer, declares bankruptcy.
· September 15th, 2008 - Merrill Lynch, seeing
the writing on the wall, agrees to merge with Bank of America, leaving
only Goldman Sachs and Morgan Stanley as the two remaining independent
broker dealers.
· September 17th, 2008 - AIG, an otherwise
healthy insurance company, is brought down by exposure to "credit
default swaps" (details below) and is forced to exchange warrants
for 80% of the company in exchange for an $85 billion loan from the US
Treasury. US stocks hit a two year
low, international and emerging stock markets fare even worse.
· September 18th-19th, 2008. US stocks stage an explosive rally as
the SEC prohibits short sales of stock in over 800 banks. US Treasury prepares a plan to purchase
up to $700 billion in MBS through reverse, auctions, taps a $50 billion
fund to back-stop money-market mutual funds.
· September 21st, 2008 - Goldman Sachs, Morgan
Stanley announce their conversion from broker-dealers to banks,
submitting to full regulation by the US Treasury in exchange for
permanent access to the Federal Reserve's discount window (which readily
makes inexpensive funds available on an emergency basis.)
US
financial crisis: an analogy
Freight trains,
which can stretch up to two miles, move slowly but have enormous
momentum. Watching Bear Stearns
fail last March was like watching a freight train crest the hill, roll
down the grade, but wreck on the curve below. Another train crests the hill; the
engineer sees the previous wreck and frantically applies the brakes, but
collides with the debris. Other
trains (Fannie Mae, Freddie Mac, Lehman) pile into the mess. More trains are coming over the hill. Railroad management remains confident
"that market forces will sort out the problems." However, the last train coming over the
hill (AIG) is loaded with nitro-glycerin.
Management throws the switch to shunt AIG off to the side and
incidentally saves Morgan Stanley, Goldman Sachs, WaMu, Wachovia and
dozens of other banks. None the
less, demolished freight cars are scattered everywhere. Cleaning up the mess will take a long,
long time.
Questions from
clients over the past two weeks:
How safe
are my assets at Fidelity, or for that matter at any brokerage?
Client assets at
any brokerage are never co-mingled with the brokerage firm's own
assets. For example, if you had an
account at Lehman Brothers, which went bankrupt last week, you are free
to leave the assets there, or move them to another custodian. Barclay Bank has agreed to buy Lehman's
clearing division, however. In
general, assets at any brokerage are insured for the first $500,000
through the Securities Investors Protection Corp. Custodians may elect to purchase
additional private insurance; Fidelity for example, has an additional
$99.5 million in coverage per account.
One of our reasons
for selecting Fidelity as a custodian is that, compared to Lehman,
Merrill Lynch, Morgan Stanley or Goldman Sachs, Fidelity does no
"proprietary trading" and does not place its own capital at
risk. Furthermore, Fidelity has
been owned for three generations now by the Johnson family, who have
effectively 100% of their net worth tied to the company. As a privately held company, Fidelity
is under no pressure to deliver "earnings" regardless of risks.
Why were
money market accounts considered at risk this past week?
Broker dealers and
custodians operate money market accounts for their clients' cash
balances. These funds are
typically invested in high liquidity, low risk investments including US
Treasury bills, and also bankers acceptances, bank certificates of
deposit and commercial paper issued by banks and also by corporations for
short term financing. These
securities generally mature in 90 days or less, and offer rates of
interest in the 0.5-2.5% range.
Lehman Brothers
was an issuer of commercial paper.
A couple of money market mutual funds had positions in these
securities large enough that, when Lehman filed for bankruptcy and the
paper suddenly was worth 60 cents on the dollar, the money market funds
were no longer redeemable at $1/unit (this is called "breaking the
buck.") In a panic, about
$137 billion was withdrawn primarily from institutional money market
funds over two days last week, with the proceeds spent to purchase
T-bills. Briefly demand was so
great that investors were willing to buy T-bills over face value, which
means that they accrued negative yields (T-bills are sold at a discount
to par, let's say $0.9911 for a bill maturing in three month, pay no
interest, but deliver $1.00 at maturity.)
The US Treasury
made an announcement that they would back up money market funds, but
stability was restored by Monday and the offer was withdrawn. Our clients are invested not only in
Fidelity money market funds, but in short and medium term bond funds from
a number of fund companies. All of
those managers have already provided us with an update of their
positions, and we are satisfied that our clients' exposure to Lehman, AIG
and other at-risk firms is negligible.
What the
heck is a "Credit Default Swap?"
Over the last
decade investment, as margins from traditional lines such as stock
brokerage and securities underwriting became ever thinner , investment
banks and some insurance companies forged into providing structured
products such as "Credit Default Swaps" (CDS) which
"mitigate investment risk."
The pitch was, "Why waste time exploring the credit
worthiness of the companies whose bonds you hold when, for 0.10-0.40%
(10-40 BPS) of face value/year, we'll 'insure' you against the risk of a
bond defaulting." So for a
$10 million issue, the writer of the CDS pockets $10-40K/year in premium.
In the low default
environment of the last 5 years, those premiums fell directly to the
bottom line. Compared to actual
bonds, which have razor thin trading markup's, traders could command
pretty much any spread that they wanted; the swaps exist only in
spreadsheets and faxes, and have no central exchange for reporting and
clearing. However, as the financial
crisis escalated through 2008, the premiums jumped from 10-40 BPS to
400-1000 BPS. Either the writer of
the swap had to post additional collateral to back up their swap, or they
had to buy them back at a loss.
Lehman's problems started with bad investments in commercial
mortgages; however, what killed the firm was the need to post about $20
billion in collateral to cover their CDS exposure. Once Lehman went bankrupt, Lehman
issued bonds fell 40% overnight, triggering additional demands on AIG,
which needed over $80 billion to cover its own exposure.
Essentially, CDS
are naked puts on someone else's bonds.
This strategy has been termed "picking up nickels in front of
a steam roller."
Why did the
SEC limit "short sales?"
Most investors buy
a share of stock, hoping that it can be sold at a higher price
later. However, "short
sellers" borrow a share and sell it, hoping to buy it back later at
a lower price. Short sellers have
some utility in a smoothly functioning market in that their sales prevent
prices from running away to the upside, then crashing. However, if short sellers are the only
market participants (as we have seen in recent weeks) theoretically they
can drive the value of a perfectly healthy company to zero. We discussed a few weeks ago how
elimination of the down tick rule and other structural changes in the
stock market have amplified the power of short sellers.
Not to accuse
anyone of manipulation, but if you have enough capital you could short a
big block of, for example, Lehman, buy a big block of puts on the Lehman
stock as well, then go and bid up the price of a credit default swap on
Lehman's bonds (which as an illiquid non-transparent market is easily
done.) Other investors seeing the
rising prices of the Lehman CDS assume that there's something wrong with
the company that they don't know, panic and start dumping the stock. Then clients of Lehman start pulling
their accounts, and things get worse by the minute. Next thing you know, Lehman is down
from $65 at the start of the year to 18 cents/share. This strategy is too novel to be
illegal, and the SEC is waaaayyy too slow in following up on firms that
might be adversely manipulating the market. The SEC simply banned short sales on
800 banks and some additional firms with large financial operations such
as American Express and General Electric.
What
happens to my homeowner's policy at AIG?
Insurance
companies are regulated at the state level, so AIG has property
subsidiaries in all the states that it does business. The state regulators are very vigilant
(having been burned in the past) that those subsidiaries are adequately
capitalized for the level of policies written each state, and the parent
company has no claim on those assets.
AIG's insurance policies are still in effect and some states offer
additional guarantees through an insurance pool. Ironically, AIG's insurance operations
are very profitable and could be sold to Travelers, Chubb and Aetna.
Why is the
Fed willing to spend $700 billion to bail out "Wall Street" but
not individual homeowners?
First off, nothing
that the Fed has done in the last 6 months can be construed as a bail
out. There are plenty of former
employees of Bear Stearns, Fannie Mae, Freddie Mac and Lehman that have
lost their life savings. In couple
of instances, those losses are in the hundreds of millions to billions of
dollars range. That might be cold
comfort to someone who's losing their house, but the Wall Street folks
aren't getting any special favors.
Every time a
financial institution is forced to sell securities at a loss, all other
banks must revalue their portfolios accordingly. There are plenty of assets trading at
10-15 cents on the dollar, which ultimately might settle at 50-60 cents
on the dollar. The Fed, therefore,
wants to buy up assets to establish a floor price. The Resolution Trust Company provided a
similar function between 1989 and 1995 after the savings and loan crisis,
liquidating the assets of 747 banks with $394 billion in assets in an
orderly fashion. Depending on how
costs are accounted, the RTC may have turned a profit for taxpayers.
Strategy
Investor
confidence took quite a beating last week. A number of our economic indicators,
which were positive in August, have turned negative again. However, stocks outside of financial
services remain at 20 years lows in terms of valuation. Among financial service firms, it's
clear that certain companies such as JP Morgan, Bank of America, and
Wells Fargo will come out of this crisis even stronger. Eliminating short sales helps, but
investors are too shocked to step up and buy just yet. We would aggressively invest all the
cash we have, but we're not willing to step up until other investors get
more invested. This conundrum
should be resolved by the New Year.
Yours sincerely,
David Edwards
President
The Heron Capital Management
client letter is published immediately following month end and when
market conditions require comment. The views expressed in this letter
represent HCMI opinion and strategy as of the date published and can
change at any time upon receipt of new information. Data quoted in this
letter are from sources deemed reliable, but no guarantee of such data is
implied.
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