Portfolio Update: September 24,
2008
A Spectacle That Inspires Anything But Confidence
Yesterday we saw Treasury
Secretary Paulson, Federal Reserve President Ben
Bernanke, and SEC Chairman Cox go before the Senate
sub-committee to try and explain why such massive
authority and access to capital is needed. For those in
the financial services industry, they presented their
argument very well. But for those outside that industry
(which means almost all of America), it was gobbly-gook
and looks like the tax payer is once again coming to the
rescue.
The questions of the Senators were
comical and illustrated to me that they really don’t
understand the issue and the importance of getting it
fixed. Granted, in a public hearing they are more
interested in getting sound bites, but when Senator Dodd
ended the meeting with the suggestion that there needs
to be joint hearings with both the House and Senate the
market took a dive. Is Congress really willing to do
nothing or to take a measured step that will fail to
have the needed impact?
Posturing aside, I believe that
they will do something. Do I think the plan is great? Do
I like the power it gives the Treasury secretary? No.
But it’s the best solution that I’ve heard so far. These
are difficult times indeed. The flow of money in our
financial system is coming to a halt. And that’s not
good for America.
Think of it this way. The financial
system of America (and the world) is the plumbing that
allows our economies to function. Imagine if the
plumbing in your house, your neighborhood, your city,
your state, your nation and the world became
‘backed-up’. Think of the disruption that it would have
on our daily life. Think of the impact on business's
ability to make and sell products, to expand and to keep
paying their workers. It would be a situation, that if
not corrected, could have devastating effects. In other
words, it would STINK! (Sorry, I couldn’t help myself.
J )
This is an exaggerated illustration
of what is occurring right now. Fannie and Freddie were
called before Congress and grilled in 2006. In order to
keep from being subject to closer and tighter
regulation, they placated our leaders by saying that
they would start buying mortgages from low income
neighborhoods. That resulted in every Republican
supporting tighter regulation and every Democrat
rejecting it.
Previously, Fannie and Freddie only
bought the highest-quality mortgages which meant there
was very little risk in their loan portfolio. Mortgages
for those with less than stellar credit records were
strictly reviewed by the lenders and mortgage companies
because they knew that they bore risk, whereas all the
risk on high-quality mortgages got transferred to Fannie
and Freddie. Suddenly that changed. Now the risk of
low-quality mortgages could be transferred to Fannie and
Freddie as well. It was off to the races---banks, real
estate agents, appraisers, mortgage companies,
syndicators, etc. all profiting from pushing through
every mortgage possible.
When the economy started to slow
down and interest rates started to rise, guess who
couldn’t make their mortgage payments? That monthly
payment is what flowed through the plumbing and kept the
process from collapsing. If Fannie and Freddie wasn’t
getting that income each month then they can’t buy more
mortgages and the value of the mortgages they own
dropped.
Fannie and Freddie didn’t hang on
to all of those mortgages. They grouped them up and sold
them to investors. Somehow they got a AAA rating! So now
all of these low-quality mortgages are owned by
investment banks, pension funds, your local bank,
401k’s, IRA’s and banks and governments around the
world.
A house with plumbing that doesn’t
work is worth considerably less than the same house
where it works. It’s the same with these mortgages.
Their value plummeted.
Another worm in this can is that
there is an accounting rule that states that companies
have to ‘mark to market’ their investments. All that
means is that if I bought a house that is worth $300,000
and the market now says that house is worth $150,000
then I have to change the value of that house on my
company balance sheet. That’s a $150,000 loss! That’s
what occurred on the balance sheets of companies. That’s
what resulted in their share prices dropping 30% or
more.
The domino effect was started. A
company’s stock price is taken into account when they
receive their credit rating. Just like you and I, a
company’s credit rating determines how much interest
they have to pay to get a loan. Suddenly, sterling
companies couldn’t get loans. If they can’t get loans,
they can’t finance their businesses. They can’t expand.
Anyway, I hope that helps you
understand, in general, what is going on. The current
plan is for the government to step in and provide a
market for all of these bad loans. If the government
offers to buy them it will allow these companies to
exchange those loans for cash. Companies need cash. If
those bad loans are no longer owned by the company then
their credit rating will go up. They will be seen as
more stable and it will be easier for them to get the
money they need to operate.
When the government buys one of
these loans, that money is not gone forever. It’s an
investment where the main problem is there aren’t enough
people willing to buy so the prices are artificially
low. If I own a house that’s dropped in value and no one
wants to buy my house, I’m stuck. That’s what’s
happening.
The home in my example still has
value. It’s an asset. As the economy improves, as the
fear and panic subsides, people are going to start
buying homes. The government offering to buy these bad
loans may also encourage hedge funds and other
opportunists to step up and start buying them. It is
designed to reduce the fear and to get normal buying as
selling (even at a reduced price) happening again. As
more buyers step into the market, the value of my home
(these bad loans) is going to go up.
The nightly news has been
encouraging panic. Why? The viewership of CNBC has risen
dramatically. It’s to NBC’s benefit for Americans to be
scared right now. It improves their ratings and allows
them to charge more for advertising. Is this situation
bad? Absolutely, but not as bad as they make it sound.
There was an isolated case where a
money market fund invested in some bonds of Lehman. When
Lehman went bankrupt, the share value of the money
market fund dropped below $1. That kind of investing is
not something that should occur in a money market fund.
But yet, it caused a panic and everyone started selling
their money market funds. Everyone started pulling money
out of their banks and brokerage accounts. If allowed to
continue, this would have caused the classic run on the
bank. The situation was so bad that at one point,
Treasury Bonds were selling with negative interest. That
meant the buyers were paying the government to hold
their money instead of the government paying the buyer
to loan them money.
That’s why the government has
stepped in and will begin insuring money market
accounts. That’s why, in most cases, you shouldn’t be
concerned about the money in your money market account.
The bottom line is that this is a
multi-faceted issue that cannot be easily explained in
one sentence.
What do I think will happen?
I think that Congress will pass
some sort of a bill this week. My concern is that it
will be too limited and may not have the desired impact.
It might be baby steps when we need to leap forward.
That will result in a muted market reaction.
The Treasury currently has the
ability to buy mortgages on the market and it will begin
to do so. The Federal Reserve is also flooding the
system with money to encourage banks to loan it out.
This will result in more inflation
over the long term. This will mean our dollar will have
less value.
What portfolio action am I taking?
I am remaining defensive. Most
portfolios have very large cash positions. There are
opportunities in these markets to pick up longer-term
holdings that should do well over the next 12-24 months.
I had exited the commodity/hard asset sector about a
month ago. That sector seems to have bottomed and I
anticipate moving some money back into it.
There continues to be opportunities
to buy high-quality bonds at a discount, which results
in a very attractive yield. For instance, there is a
closed-end fund that invests in the government bonds of
emerging markets. These receive the highest credit
rating. Yet, because of the panic in the market, these
bonds can be bought for 20-30% less than their current
market value. That is an opportunity. As the panic
subsides, we will see the share price of that fund go
up—quickly.
History has shown that the best
buying opportunities occur when fear is at its worst. I
believe we are in one of those situations. Therefore, I
anticipate cautiously moving more money into the markets
as they decline. I believe there are attractive
opportunities in financials, in the broad markets and in
small companies.
Regardless of what the evening news
might lead you to believe, this is not the time to
panic. It’s a time to profit from everyone else’s panic.
That’s what Warren Buffet does and is one of the main
reasons he is considered the greatest investor alive. By
the way, he bought $5 Billion of Goldman Sachs last
night. If he’s investing selectively, I want to be too.
A local hotel was built about 10
years ago for $6 million. It was financed mainly with
debt. After 2-3 years it went bankrupt. A disaster, but
not for the group that bought it for $3 million. They
are able to operate it profitably because they aren’t
saddled by all the debt. That is what is going to happen
in our economy. The people that step in and buy the
bargains are going to be the ones that profit. That’s my
intention in the portfolios.
