Broken Contracts – October 2008

October 21, 2008

Dow Jones Average: 9,034
S & P 500 Index: 955


Broken Contracts

Financial markets worldwide went into panic mode in recent weeks as fallout from the mortgage crisis spread from the financial sector to all corners of the market. Taxpayer financed rescue packages totaling well over a trillion dollars were announced by governments around the globe. The largest banks in Europe and the United States were closed, forced to merge, or partially nationalized. The Bush administration made banks an offer they couldn’t refuse forcing partial nationalization on institutions that in some cases did not request or want public money. The world has been turned upside down in ways few thought possible.

The financial markets are gripped by a fear that obligations and guarantees will not be honored, particularly with respect to agreements called credit default swaps. Credit default swaps are really insurance contracts bought by investors to protect against the potential default of bonds owned by the investor. While traditional insurance companies are tightly regulated by State insurance commissioners and regulators, the swap market is completely unregulated. The size of the credit default swap market is enormous, totaling tens of trillions of dollars. The bankruptcy of Lehman Brothers in September was a watershed moment in that it exposed the magnitude of the losses on credit default swaps. After Lehman slashed the carrying value of their swap contracts, AIG, the largest insurer in the world, was forced to do the same, touching off a full blown panic in the markets.

The real estate boom of recent years, and the loose lending practices that accompanied that boom, fueled the demand for credit default swaps. The chain of events leading to the current national predicament is quite logical in retrospect. Real estate prices accelerated after Alan Greenspan cut rates to the historically low rate of one percent in 2002. The relentless climb in real estate prices created a wave of people wanting to refinance, cash out some home equity, buy a bigger home, or speculate in the market. Banks, mortgage brokers, and investment firms saw an opportunity to make billions in fees marketing mortgages, packaging those mortgages into pools, and then quickly selling the packages called CDO’s (collateralized debt obligations) to investors hungry for high yield investments. There was no shortage of money ready to buy the pools of mortgages. Investors from overseas poured money earned from foreign trade back into U.S. assets. Investment firms and hedge funds also bought into the pools on behalf of their clients. Mortgage pools paying out nine percent certainly seemed better than the one percent Treasury yields available in 2002-2004. The buyers of these multi-billion dollar pools were justifiably nervous about default as many mortgages had been issued without the usual credit checks, income verification, or any down payment. Investors sought protection in the form of credit default swaps. There were plenty of parties willing to offer credit default protection. The premiums received for signing the contract were substantial and the risk of loss was considered remote.

The financial system imploded when it became apparent that the issuers of credit default protection had neither the ability, nor in certain cases the intention to make good on the insurance. Investors who assumed that the bond pools were covered by insurance discovered that the insurance company had gone out of business. The situation was comparable to a house burning down and the owner finding out that the fire insurance policy was not going to be honored. Because the “house” encompassed much of the U.S. financial system, the government felt it had to restore confidence in the integrity of financial agreements by becoming the ultimate guarantor. On September 19th the government took the unprecedented step of guaranteeing all deposits in money market funds. After the bailout bill passed, the government guaranteed all loans between banks, announced a plan to buy up to 540 billion in paper from money market funds, and another plan to lend directly to companies. The financial system has been temporarily socialized in an attempt to avoid an even more catastrophic meltdown.

The Election

A number of clients have asked what my thoughts are on the election and its implications for the financial markets. With less than two weeks to election day, I will address the question in this update even though my conclusion may not please all readers. Given the fragile state of the economy the election in two weeks takes on even greater psychological importance. While the initial reaction to the election will be more emotional, by next year investors will be reacting to actual policy prescriptions. After following the campaign closely from both a policy and political perspective, it is my opinion that the markets will react more positively in the short term and the longer term to an Obama-Biden victory than to a McCain-Palin win. The public is alarmed by the lack of oversight and foresight coming from leaders in Washington. In a time of economic crisis there is little patience for gridlock and partisan battles. These sentiments work in Obama’s favor which partially explains his consistent lead in the polls.

Investors should be reassured by the foresight Senator Obama has demonstrated with regard to economic matters. Almost two years ago he said that the economy was “living on borrowed time and borrowed money”, that it was on an unsustainable path propelled by ballooning debt. Obama’s economic outlook has been shaped in part by supporter/advisors such as Warren Buffett and Paul Volcker, two men who are universally respected for their economic judgment. Investors prefer clarity of direction to uncertainty. Hopefully the end of this long election campaign will remove one element of uncertainty, and allow investors to focus with greater optimism in the future.

Current Strategy

The stock market declined by almost twenty percent in the first three quarters of 2008 and then fell off a cliff in October, losing another twenty percent in the process. Unless the market stages a significant year end rebound, 2008 could go down as the worst year since the 35 percent drop in 1937. Huge declines in stock prices create buying opportunities for those with cash reserves and the nerve to deploy those reserves. We bought a number of positions in January 2008 at the very bottom of this year’s first big pullback in prices. We took short term gains on several of those buys. We bought a few more positions in July and September as individual sectors of the market retreated. The buys made during that period have gone lower in the October collapse. For clients with limited equity exposure, we made a third foray into the market on Friday, October 10th, the final day of the worst week in Wall Street history. We bought in at very low prices that day and have seen those positions move to a profitable position.

We have heard from a number of clients who feel that buying stocks in the midst of panic is a scary proposition. We welcome such feedback as it gives us a chance to explain our strategy, and to point out that even though we have calculated the probabilities of success no one knows the future for sure. It does take some courage to buy when everyone else is panicking, but in our opinion it is far scarier to buy into a sharp market rally at higher prices. Buys made during rallies are the ones that often come back to haunt an investor. We are not sure that October 10th was the final bottom of this dramatic market slide, but it did provide some good, low entry prices for those willing to buy. About a week after our October 10th buy, Warren Buffett wrote an op-ed piece in the NY Times saying that he was buying at a similar level. It turns out that we may have been in good company when we stepped into the breach on the 10th of October.

The fixed income portion of client accounts is becoming somewhat smaller as we move more money into stocks. The best values in the fixed income market can be found in the tax-exempt municipal bonds, and once again in the TIPS (Treasury Inflation Protected Securities) market. Yields on tax-exempt bonds have zoomed to over five percent, which is the highest rate in about eight years. The yield on municipals has increased because investors have grown concerned about budget shortfalls at the state and local level. While we may buy some municipals, our enthusiasm is tempered by longer term inflation concerns. TIPS continue to be one of the most predictable bonds as they are fully backed by the U.S. Treasury, rise in value each year at the rate of inflation, and have a current yield of about three percent. We already have a lot of TIPS in client accounts, but may buy more for those who are underweighted in this type of bond.

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