Market Flash Commentary

And Then There Were Two

2008 will undoubtedly be remembered as the year the face of the U.S. financial system was redrawn. With the failure of Lehman Brothers and the acquisition of Merrill Lynch by Bank of America, only two independent investment banks remain in this country – Morgan Stanley and Goldman Sachs.

What began last year as a housing market collapse has spread into every corner of the global financial system. We have previously written about the trickling of housing troubles into the credit market, and the events of this summer are just a continuation of that process. But now, the magnitude of the fallout is a new development.

This month alone we have seen the failure and subsequent takeover of Fannie Mae and Freddie Mac, the bankruptcy of Lehman Brothers, the sale of Merrill Lynch to Bank of America, and the Treasury bailout of AIG. The ripple effects continue to raise questions about the solvency of Washington Mutual and the viability of Morgan Stanley’s independence.

As much as these events make the world seem to be spinning out of control, the underlying problems can really be distilled down to three areas: complexity, leverage and counterparty confidence. We believe that the housing meltdown was the primary contributor to this crisis, but it was also the catalyst that exposed the weaknesses in the overall credit system.

Over the past decade, the once obscure world of derivatives and hedging has grown to dominate the credit market. Years ago credit default swaps (CDS) were used to insure against financial losses when one company lent money to another. CDS’s gave large lenders the ability to off-load credit risks from their balance sheets. With those risks gone, lenders then had the ability and willingness to make more loans. CDS’s were simply an insurance policy. And like most insurance policies, they were hugely profitable to the issuers because defaults rarely happened.

These profits quickly caught the attention of other financial institutions and the number of contracts grew. In addition, a notional market for these contracts developed so that participants were able to trade these instruments with one another. This created a strong environment of financial interdependence among various institutions. Basically, this is how the credit default swaps market works:

Imagine company A loans money to company B. Company A buys a CDS from company C to off-load the risk that company B will default. C sells this packaged credit risk (or CDS) to company D who buys many other CDS’s thinking that the economy will expand, which will improve the overall default rates and increase the general value of CDS’s. Maybe company D borrows the money to buy these and more CDS’s are created by more companies as a result.

You can quickly see how the fate of everyone involved is connected. Not only do you have to worry about doing business with company D but also anyone else that does business with company D. Company A supposedly offloaded their risk of company B defaulting, but what if the owner of that CDS can’t make good on the contract? Company A, B, C, and D are all in trouble.

Furthermore, when these contracts are created the guarantees must be backed by capital. This capital is used as a backstop should a default occur, and thus the value of this capital is an important component in the transaction. This capital is not cash sitting around. Instead, companies often hold capital in other investments such as bonds.

While this is a relatively simple example, it is easy to see how all these firms become dependent on one another. It also gives some insight as to why the market reacts so violently when one of these participants fail. We have now seen several very large participants in this market go under, which has led to a real and justified lack of confidence in the financial system.

Magnify all of these relationships with leverage, and you have nothing but a recipe for volatility. In many cases these firms’ leverage ratio exceeded 30 to 1. This means that for every $1 in capital a firm controlled $30 of securities. With that level of leverage and interconnectivity in the system, troubles with a limited number of institutions can quickly cascade into a systemic problem.

To be clear, the CDS market does play an important role in an efficient credit system. It is an effective mechanism by which the market can collectively render an opinion on the credit worthiness of companies beyond the traditional credit rating agencies. However, it is a largely unregulated and opaque market with no central exchange.

Fortunately, there is one financial institution which has the full confidence and sheer size to make a difference, and that’s the Treasury. The US Treasury has been called to the rescue more than once for this very reason. Whether the term “bailout” accurately applies in all of these situations, the Treasury has been very effective in putting out the fires over the course of this year starting back in the first quarter when it orchestrated the merger of JP Morgan and troubled Bear Sterns.

The Plan

While fighting fires is important, the Treasury has not addressed the fundamental problems that have kept the markets on edge. Knowing this, the Treasury has announced a plan to essentially remove many of the riskiest securities from the market place.

The details have yet to be finalized, but in general the Treasury will create a fund that will buy these securities at some price to unfreeze the market in these instruments. In essence they will make a market where one no longer exists for an estimated $700 billion in securities. So with this giant group of securities removed from the balance sheets of so many companies, faith will be restored in the capital level and solvency of each counterparty.

The debate over this plan is currently in full swing and as such there is a lot of information being reported that is wrong, incomplete, or misleading. It is also obvious that all but a few politicians, including both presidential candidates, have very little understanding of what is going on. The Fed and Treasury, however, have a very good understanding of the situation.

Let there be no doubt that the numbers being thrown about are extremely large. That being said, it is wrong to say that the government is going to “spend” $700 billion. They are in fact going to purchase several hundred billion dollars of bonds. While a lot of these bonds have bad loans wrapped inside them, the vast majority of these securities are currently performing as expected. No one knows what these things are worth or what the government is going to pay for them, but one thing is for sure; the government will be buying these securities at a steep discount.

This actually presents an interesting situation. Through the treasury market, the federal government has access to the cheapest money in the world. They are going to use those funds to buy income producing securities that are surely yielding higher than the government’s borrowing cost. Ultimately, the level of defaults realized in the future will determine the actual cash flows. But it is very hard to imagine how the Treasury can’t profit from this plan.

The high likelihood that the Treasury will make money on this plan has been downplayed because it is a politically sensitive issue, but it is worth noting that this is the same business model that has made huge profits on Wall Street. The difference is that unlike Wall Street, the Treasury can not get squeezed on the short end and forced to sell. There is a saying on Wall Street that goes, "The market can stay irrational longer than you can stay solvent." That does not apply to the Federal government.

The Blame Game

Plenty of people are plenty mad. Shareholders are angry over diminished portfolio values. Politicians are unhappy about the state of the economy. Homeowners are upset over their declining property values and foreclosures. Now tax payers are being told the deficit is going to skyrocket because “Main Street” is having to bailout “Wall Street”.

This is a huge mess for sure and it has done a lot of harm to the image of our country in the eyes of the global financial community. But there is plenty of blame to go around.

Let’s start with Wall Street. There is blame on two fronts. First, Wall Street has spent years inventing ever more complex financial instruments without fully vetting them in a stressful environment. Not only did companies sell these securities to others but they then held them on their books. Secondly, the risk management department in all but a few investment banking firms had become complacent and incompetent. We suspect the brightest minds are working in private equity and hedge fund firms and not the major brokerage houses.

Next, let’s not forget who took out all of those bad loans and drove up property values to insane levels. You are going to hear a lot of talk in this election year about poor victimized “Main Street.” Actually, this started on Main Street. The mortgage industry merely gave these folks the rope with which to hang themselves. Flipping houses became the new career path for many. Television was full of “flip this house” programming and no money down real estate schemes. Loans were taken out by Joe-next-door lying about his income. To debunk the “poor mistreated Main Street” idea, the increase in foreclosures is in new purchases where the person taking out the loan never could afford the house long-term, the person knew this but did not care, and instead planned on flipping it before they ran out of money.

Finally let’s look at the role of government. This crisis has not been due to a failure to regulate. There are major regulatory changes that need to be made, but mostly the changes need to promote standardization and transparency in new markets. If this mess was due to a regulatory failure, then why is it that the least regulated firms (private equity and hedge fund firms) seem to be holding up the best? On the other hand, the center of the storm is within the much regulated banking, brokerage and insurance industry.

Then there is the issue of home ownership. Politicians have for years been pushing home ownership to the masses, and they have been using their influence to force the lending industry to comply. In hindsight it is becoming clear that there is a group of people out there that is really meant to be renters. Homeownership is not in the Bill of Rights and maybe requiring a substantial down payment and healthy credit is a good idea after all.

I came across a good article in the Wall Street Journal written by Mr. Calomiris, a professor of finance and economics at Columbia Business School. I wanted to share it here because it does a good job of enlightening us as to the government’s role in this mess. Try to remember this when our elected officials express their rage to the media.

Many monumental errors and misjudgments contributed to the acute financial turmoil in which we now find ourselves. Nevertheless, the vast accumulation of toxic mortgage debt that poisoned the global financial system was driven by the aggressive buying of subprime and Alt-A mortgages, and mortgage-backed securities, by Fannie Mae and Freddie Mac. The poor choices of these two government-sponsored enterprises (GSEs) -- and their sponsors in Washington -- are largely to blame for our current mess.

How did we get here? Let's review: In order to curry congressional support after their accounting scandals in 2003 and 2004, Fannie Mae and Freddie Mac committed to increased financing of "affordable housing." They became the largest buyers of subprime and Alt-A mortgages between 2004 and 2007, with total GSE exposure eventually exceeding $1 trillion. In doing so, they stimulated the growth of the subpar mortgage market and substantially magnified the costs of its collapse.

It is important to understand that, as GSEs, Fannie and Freddie were viewed in the capital markets as government-backed buyers (a belief that has now been reduced to fact). Thus they were able to borrow as much as they wanted for the purpose of buying mortgages and mortgage-backed securities. Their buying patterns and interests were followed closely in the markets. If Fannie and Freddie wanted subprime or Alt-A loans, the mortgage markets would produce them. By late 2004, Fannie and Freddie very much wanted subprime and Alt-A loans. Their accounting had just been revealed as fraudulent, and they were under pressure from Congress to demonstrate that they deserved their considerable privileges. Among other problems, economists at the Federal Reserve and Congressional Budget Office had begun to study them in detail, and found that -- despite their subsidized borrowing rates -- they did not significantly reduce mortgage interest rates. In the wake of Freddie's 2003 accounting scandal, Fed Chairman Alan Greenspan became a powerful opponent, and began to call for stricter regulation of the GSEs and limitations on the growth of their highly profitable, but risky, retained portfolios.

If they were not making mortgages cheaper and were creating risks for the taxpayers and the economy, what value were they providing? The answer was their affordable-housing mission. So it was that, beginning in 2004, their portfolios of subprime and Alt-A loans and securities began to grow. Subprime and Alt-A originations in the U.S. rose from less than 8% of all mortgages in 2003 to over 20% in 2006. During this period the quality of subprime loans also declined, going from fixed rate, long-term amortizing loans to loans with low down payments and low (but adjustable) initial rates, indicating that originators were scraping the bottom of the barrel to find product for buyers like the GSEs.

The strategy of presenting themselves to Congress as the champions of affordable housing appears to have worked. Fannie and Freddie retained the support of many in Congress, particularly Democrats, and they were allowed to continue unrestrained. Rep. Barney Frank (D., Mass), for example, now the chair of the House Financial Services Committee, openly described the "arrangement" with the GSEs at a committee hearing on GSE reform in 2003: "Fannie Mae and Freddie Mac have played a very useful role in helping to make housing more affordable . . . a mission that this Congress has given them in return for some of the arrangements which are of some benefit to them to focus on affordable housing." The hint to Fannie and Freddie was obvious: Concentrate on affordable housing and, despite your problems, your congressional support is secure.

In light of the collapse of Fannie and Freddie, both John McCain and Barack Obama now criticize the risk-tolerant regulatory regime that produced the current crisis. But Sen. McCain's criticisms are at least credible, since he has been pointing to systemic risks in the mortgage market and trying to do something about them for years. In contrast, Sen. Obama's conversion as a financial reformer marks a reversal from his actions in previous years, when he did nothing to disturb the status quo. The first head of Mr. Obama's vice-presidential search committee, Jim Johnson, a former chairman of Fannie Mae, was the one who announced Fannie's original affordable-housing program in 1991 -- just as Congress was taking up the first GSE regulatory legislation.
In 2005, the Senate Banking Committee, then under Republican control, adopted a strong reform bill, introduced by Republican Sens. Elizabeth Dole, John Sununu and Chuck Hagel, and supported by then chairman Richard Shelby. The bill prohibited the GSEs from holding portfolios, and gave their regulator prudential authority (such as setting capital requirements) roughly equivalent to a bank regulator. In light of the current financial crisis, this bill was probably the most important piece of financial regulation before Congress in 2005 and 2006. All the Republicans on the Committee supported the bill, and all the Democrats voted against it. Mr. McCain endorsed the legislation in a speech on the Senate floor. Mr. Obama, like all other Democrats, remained silent.

Now the Democrats are blaming the financial crisis on "deregulation." This is a canard. There has indeed been deregulation in our economy -- in long-distance telephone rates, airline fares, securities brokerage and trucking, to name just a few -- and this has produced much innovation and lower consumer prices. But the primary "deregulation" in the financial world in the last 30 years permitted banks to diversify their risks geographically and across different products, which is one of the things that has kept banks relatively stable in this storm.

As a result, U.S. commercial banks have been able to attract more than $100 billion of new capital in the past year to replace most of their subprime-related write-downs. Deregulation of branching restrictions and limitations on bank product offerings also made possible bank acquisition of Bear Stearns and Merrill Lynch, saving billions in likely resolution costs for taxpayers.

If the Democrats had let the 2005 legislation come to a vote, the huge growth in the subprime and Alt-A loan portfolios of Fannie and Freddie could not have occurred, and the scale of the financial meltdown would have been substantially less. The same politicians who today decry the lack of intervention to stop excess risk taking in 2005-2006 were the ones who blocked the only legislative effort that could have stopped it.

Market News

Investing in Turbulent Times

As everyone knows, investors have faced an extremely challenging investment environment over the last twelve months. The confluence of higher inflation driven by energy costs, the still unresolved credit crisis, and election year politics has left many wondering “where to from here?” If you compare the global financial markets today to the financial environment ten years ago, today’s markets are substantially more interconnected and complex, which means that situations change at an amazing and sometimes alarming rate.

“Where to from here?” is a question with an answer somewhere in the tangle of hedge funds, leverage, swaps, CDO’s, quantitative finance and the like. But anyone who says that they have the answer to this question is kidding themselves.

As most people now know, the investment community’s capacity to anticipate the timing and triggers of financial shocks is virtually nonexistent. The last nine months has further supported that reality. Attempting to avoid a market downturn is just as risky as missing out on the gains. The only game in town is to ride it out.

To be sure, contemporary finance has become incredibly complex and there is no safe asset class. Admittedly, there are asset classes that do have stable values. But in a world of properly priced risk, good luck maintaining your purchasing power with their meager returns. This is a tangible problem. For example, go to the gas station or the grocery store and imagine the adjustment that you would have to make on a static income. This is especially true as we live longer in retirement. Prefer a CD? Then you must consider the long-term solvency of your bank. Risk is everywhere in life and it’s unavoidable. The trick is to find the right risk for you.

Risk is an interesting word that means different things to different people. For some, it refers to the potential of losing money. For others it means risk of not meeting goals, and still to others it could mean variability of returns. The classic definition of risk generally refers to the latter. But like you, we live in the real world and realize that it means all of the above. In times like these, risk assessment is very important and we take it very seriously. Be assured that we are always looking for ways to minimize any of the risk your portfolio might face.

The Lost Decade

We have all been told that stocks provide the best long-term investment returns. This is not an academic argument but in fact a historical truth. The only problem with this statement is that the definition of “long-term” is poorly defined.

A case in point is the last ten years. The approximate return of the S&P 500, which is widely viewed as a proxy for the U.S. market, is roughly 1.5% per year for the last decade. That’s right. Over the past ten years stocks have returned roughly half of money market rates. Adjust this for inflation and the true return is just short of zero.

So when does this faith in the equity market payoff? How long is “Long-Term”?

Rules of the Road

The current turbulence serves to remind us to expect the unexpected. The economy, both domestic and global, is always changing and with that goes the investment landscape. Such changes require that an investor live by a set of rules to help guide investment decisions during the occasional and inevitable market downturns. As a firm, we are no different. While we may not have a rigid and inflexible doctrine, we do follow certain standards when we invest your money. During these unusual times, we think it to be wise and useful for you to take note of some of the rules we think are important.

Market Timing
History has shown us that it is difficult at best to correctly guess market movements over the long run. Therefore, it is best to have a plan and stick with it.

Stay Invested
In turbulent markets it is critical to remain calm. One must avoid the temptation to panic and sell in such times. The goal is to “buy low and sell high,” not the other way around. Patience is a key attribute to have in volatile markets. If you have faith in the resiliency of the economy, the fundamentals will eventually present themselves and you will be successful.

Diversify
Diversification is a time tested rule. Live by the old saying: “Do not put all of your eggs in one basket.” This concept is a key risk reducer. By spreading investments into many companies, countries, and sectors, you effectively spread your risk. This is what asset allocation accomplishes. As you know, for each client we maintain a unique allocation to various asset classes such as domestic stocks, international stocks, large and small caps, fixed income bonds, preferred stocks, and cash. The goal is to invest in different markets, thus reducing the chance that all of your investments will go down at the same time.

Re-allocate
This concept is tied to asset allocation. Once your mix of assets is established, you must periodically rebalance the portfolio to get the asset allocation levels back in line. Different assets will grow at different rates. Therefore, by re-allocating your investments you are in effect selling this year’s higher performers (selling high) and buying the lower performers (buying low). Historically, these actions result in long term success.

“Cash and Cash Flow is king”
Having readily available cash is more important than ever during times like these. For those in the accumulation phase, having cash available when the market is going down gives us a chance to invest at lower prices. This is very similar to going to a department store and feeling excited when you bought something that was on sale rather than at full price. For those in the distribution phase, i.e. retirees, we always have a certain amount of cash available for everyday needs. Having additional cash available prevents selling assets at the wrong times to cover any cash needs that may arise.

Our clients should be accustomed to our talking points about cash flow. For any investor, maintaining investments that produce cash flow is critical. If our goal is the growth and protection of wealth then the production of cash flow should be paramount to success.

Controlling the Controllables
We feel it is smart to avoid worrying about those variables you cannot directly control, such as market movements. Instead, we focus energy on those issues we can control, namely expenses and taxes. We employ strategies that give our investors the ability to influence each of those variables. By using low cost index funds and individual securities, we keep a tight lid on ongoing investment expenses and control the timing of taxes. Additionally, we utilize loss-harvesting strategies to minimize the taxes on future realized gains.

In Summary

We want everyone to take a deep breath and relax. We have to put these markets into historical perspective. A long term investor must expect troubled markets to occur every so often. It is perfectly natural to feel both nervous and cautious. In fact, in good times and bad, we are always cautious in our investment decisions. The main point we want to stress is that it is unwise and unhealthy to worry too much about everything. Leave the worrying to us. We will always do what we think is best for your accounts.

Market News

The Third Rewrite

It seems that every time we’ve tried to get our newsletter out this month we’ve had to rewrite it because there has been yet another major event to rattle the markets. Although these events have involved different institutions and markets, they’ve all been rooted in the subprime mortgage crisis that began this summer. If nothing else, these past few months have been an important lesson in the interdependency of the global financial markets. From a broad perspective, the scenario playing out right now looks like this:

The real estate markets soften, putting pressure on property owners who can’t afford the mortgage payments long-term and were hoping to flip their property in the shot-term.
Rising foreclosures and higher interest rates further depress housing prices, making it increasingly difficult for property owners to escape from the high debt load.

More and more people are forced or willing to walk away from their properties, leading to alarmingly high default rates in the mortgage backed bonds that now own these loans.
As the losses mount, bondholders become aware of the disturbingly high number of bad loans wrapped inside their bonds due to appallingly poor underwriting practices that have been prevalent in the mortgage industry for several years.

Unable to ascertain the magnitude of this problem, buyers of private-label mortgage backed bonds or anything associated with them vanish from the market in a matter of weeks. Prices of these securities plummet.

Owners of these securities that have used them to collateralize loans get margin calls as the much lower bond process no longer supports the debt levels. Hedge funds are the first to get hit.

Forced liquidations from margin calls further drive prices of these securities down, creating a cycle of more margin calls.

The Fed, European Central Bank, fund sponsors and money center banks have to step in and act as counterparty for the forced sales of these securities.

Commercial and investment banks make huge write-downs in the value of their portfolios to reflect the lower prices of their own securities as well as the massive amount of capital contributions made to their leveraged subsidiaries.

Shocked by their loss of capital and the known losses of their peers, financial institutions severely cut back on their lending activities, curtailing economic activity.
Additionally, consumers’ lack of available credit further pressures GDP down. Unemployment rises as a result of this slowdown.

The Fed steps in and lowers short-term interest rates hoping to keep the economy from slipping into a recession. The value of the dollar against other currencies drops due to our lower rates. Oil gets more expensive in dollar terms.

The Fed is slow to aggressively lower rates because of the inflation fears brought on by the already weak dollar.

Recession fears are magnified by the Fed’s slow response and seemingly unending data showing a slowing economy. The stock market drops 10-12% in the first 3 weeks this year.
Counterparties to credit default swaps are finding it difficult to fulfill their contractual obligations due to higher than anticipated default rates.

Major monoline insurers Ambac and MBIA have trouble raising needed capital to shore up their balance sheets leaving in question the quality of their bond insurance contracts.

That’s “B” as in Billion

On the surface, it’s hard to believe that the residential mortgage market could lead to a recession in an economy our size or the global liquidity squeeze we saw this fall. But these are really big numbers we’re dealing with here. To be sure, the bond market is by far the largest financial market in the world and the mortgage market comprises roughly 60% of the U.S. credit market. Furthermore, according to the FDIC, real estate related holdings for U.S. banks accounted for 58% of total assets. This is up from 45% in 2000.

Since May, specific losses reported by the world's biggest banks have climbed to more than $100 billion as a result of U.S. subprime mortgages. Hardest hit, Citigroup Inc. posted its largest loss in the bank's 196-year history this past week, driven by $18 billion of write-downs on its mortgage and other fixed-income investments. On the brokerage side, Merrill Lynch had write-downs of $14 billion.

It’s still uncertain if the worst of the write-downs are over. Citigroup, for example, ended the fourth quarter still exposed to $37 billion of subprime mortgages, and $43 billion of corporate-loan commitments for leveraged buyouts remain on its balance sheet. Still, losses from the current credit crunch (nearly equivalent to 0.7% of U.S. gross domestic product) haven't reached the level seen in the savings-and-loan collapse in the late 1980s, when losses reached $189 billion, or 3.2% of average GDP.

Globally, foreign banks have been hit by these write-downs as well. Analysts estimate that state-owned Bank of China, traditionally the most international of the country's big banks, may have to write off a fourth of the nearly $8 billion it holds in securities backed by U.S. subprime mortgages.

Similar situations have been seen across the European Union banking sector. German bank IKE Deutsche Industriebank nearly collapsed in August under the weight of its subprime investments. Multibillion Euro write-downs have been taken by French and British banks as well.

The “R” Word

The credit crunch that was sparked by problems with residential mortgages is spreading to the broader economy with banks making it harder and more expensive for some small and midsize businesses to borrow.

While companies with strong balance sheets still can borrow what they need at good rates, others are beginning to feel the chill. In particular, start-up and smaller companies are finding that banks are setting higher rates, seeking more collateral or lending smaller amounts.

This is the way it often unfolds when there is a squeeze on lending. The last significant credit crunch, which ran from about 1989 to 1992, began with a pullback on lending for commercial real estate that then spread to business lending. This time, the problems spread from residential real estate and are being felt by everyone from commercial farmers to makers of heavy machinery.

With other indicators pointing toward a possible recession (including falling stock prices and rising unemployment,) a widening credit crunch doesn't bode well for the economy. Start-ups and small businesses are generally the companies that create jobs in a downturn. But tighter credit could curb business investment and hiring as companies recalculate the costs of investing in new machines, marketing campaigns or ventures. This could magnify the current slowdown in growth.

These scenarios have a wider economic implication than just in the United States. Because the U.S. comprises over a fifth of world-wide GDP, a meaningful slump in growth domestically would surely be felt around the globe.

Equity prices are already pricing in the expectation of slow or negative growth around the world. In addition to U.S. stock prices being down somewhere in the neighborhood of 15% in a few short weeks, European and Asian markets are down significantly as well. This pessimistic outlook is being echoed in the bond market too. While the risk spreads have increased the yields on many corporate issues, the core risk free rate has declined, reflecting the view of slower growth going forward. The ten year treasury yield is now down over 50 basis points since this summer.

Looking Forward

It seems unavoidable that this is going to be a rocky road for all financial markets for, at least, the first half of the year. Stocks will have to mount a healthy rebound to overcome January’s double digit declines. That would be difficult, to say the least, in an unhealthy economy.

In our opinion, the biggest impediment to any recovery is the continued default worry in the credit market. The most recent scare and possibly hardest to quantify is in the credit-default swap market. These are complex financial arrangements where one entity contractually sheds its portfolio default risk to someone else for a fee. This is essentially buying default insurance for particular securities in a portfolio.

Many financial institutions have been using these contracts to hedge much of the risk in their portfolios. Now, due to the elevated default rates, the ability of these counterparties to actually make good on these swaps have come into question.

This month, bond insurer ACA Capital Holdings requested a one month grace period to unwind $60b of credit-default swap contracts it can’t pay. Standard & Poor’s cut ACA’s rate 12 levels to CCC, casting doubts on the company’s guarantees. ACA is an important case to follow because it shows how the banks react to fast-deteriorating counterparty creditworthiness.

Because most of those guarantees are in the form of derivatives, these contracts are required to be valued at market rates. Those valuations are now highly suspect and may require further write-down’s in the banking industry, further depressing earnings and capital.

These problems will get sorted out. It’s just a matter of how long and at what price. In the meantime, the question remains as to where to hide. U.S. stocks clearly aren’t the place. International equities offer no relief. Last year every category of bonds posted negative returns except treasuries. There were even worries with money market funds.

Short of liquidating everything in your portfolio and putting the cash in treasuries, there is probably little that can be done to sidestep the expected price volatility. That being said, there is a saying that in crisis there is opportunity. We believe the opportunity in this market is income.

Through all of this, yields on dividends and interest have risen considerably. We now have the opportunity to pick up as much as 2% higher income returns than we’ve seen as recently as last summer. Our focus now is to lock in these higher long-term yields. In addition, U.S. Based firms with large international revenues will greatly benefit from the weak dollar. We just need to keep an eye on their credit worthiness.

Market Flash Commentary

Perspective on the Last Few Trading Days

The nation's stock market did an amazing 600 point about-face, rising from its morning low to finish deep in positive territory yesterday. The rally, which followed two days in which anxious investors drove stocks sharply lower around the globe, culminated in a 30-minute buying frenzy that left the Dow Jones Industrial Average at 12,270.17, up 298.98 points. The Dow's 631.86 point intraday swing was its biggest since July 2002, one of the low points of the last bear market. There have been just nine days with 500-plus point swings since 1995, many of which occurred at major market turning points.

Yesterday’s trading was important not just because of the point gains but because of the reason for these gains. The rally was supercharged late in the day by news that insurance regulators met with major Wall Street firms to discuss ways to stabilize and potentially bail out big bond insurers. These insurers have taken a hit because of their exposure to securities tied to subprime mortgages, and their instability threatens the wider financial system because they insure tens of billions of dollars in bonds, many of them held by Wall Street firms. Together, this insurer bailout, talk in Washington of creating a fund to buy troubled mortgages, and the hope for continuing Federal Reserve interest-rate cuts was the perfect combination to address the largest concerns in the market.

Understanding Credit Default Swaps

Credit default swaps (CDS) have become an increasingly popular way for financial institutions to insure potential default losses in their portfolios. Speculators such as hedge funds use CDS’s to potentially profit from the changing credit outlook in the economy. The technical definition of a CDS is a bilateral contract under which two counterparties agree to isolate and separately trade the credit risk of at least one third-party reference entity. Under a credit default swap agreement, a protection buyer pays a periodic fee to a protection seller in exchange for a contingent payment by the seller upon a credit event (such as a default or failure to pay) happening in the reference entity. When a credit event is triggered, the protection seller either takes delivery of the defaulted bond for the par value (physical settlement) or pays the protection buyer the difference between the par value and recovery value of the bond (cash settlement).

The popularity of CDS’s has leaded them to become the most widely traded credit derivative in the international financial marketplace. Outstanding CDS’s totaled $28.8 trillion in December 2006, up 107% from the year before. The market for credit derivatives is now so large that in many instances the amount of credit derivatives outstanding for an individual name are vastly greater than the bonds outstanding. For instance, company X may have $1 billion of outstanding debt and $10 billion of CDS contracts outstanding. If such a company was to default, and recovery is 40 cents on the dollar, then the loss to investors holding the bonds would be $600 million. However the loss to credit default swap sellers would be $6 billion. In addition to spreading risk, credit derivatives in this case also amplify it considerably. This is a huge and meaningful market. As such, more and more entities are becoming involved in trading these securities.

With any CDS there are two parties. The buyer wishes to reduce his exposure to risk and the seller who is willing to increase his exposure to risk for a fee. The buyers are typically banks, pension funds, insurance companies and the like. The sellers have traditionally been speculators such as hedge funds. However, bond insurers like Ambac and MBIA have become increasingly active in this market place over the last few years. This is at the heart of the credit crisis today.
Because mortgage backed bonds comprise approximately 60% of the bond markets, it is easy to see how the CDS market has been impacted by the massive default rate of sub-prime loans, and thus sellers of these derivatives have experienced loss rates that had never been imagined.
One of the biggest criticisms of the CDS market is that these contracts are not collateralized. Their ultimate value depends on the creditworthiness of the counterparty. This counterparty risk is at the core of the latest round of fear that has struck the financial markets and was partially addressed yesterday.

A recent survey found that 26% of investors were worried about counterparty risk. These fears are not unfounded. Two days ago ACA Financial Guaranty Corp. asked its trading partners for more time as it scrambles to unwind more than $60 billion of swaps it sold but can’t fully pay off. The contracts were intended to protect Wall Street firms from losses on mortgage securities and other debt they own. As a result, Merrill Lynch had to write down $3.1 billion on debt securities it hedged through ACA. Citigroup has set aside $935 million to cover the likelihood that trading partners won't make good on trades in this market. These write-downs are in addition to the actual un-hedged losses that these banks have already taken. This has been taking place all over Wall Street.

Wider Implications

What happens when your insurance company goes broke? That’s what many have been asking themselves about Ambac and MBIA. These two monoline insurers are by far the largest insurers of municipal bonds. Most municipal bonds that trade today carry the highest credit rating of AAA. In a great many cases, that rating has been granted based on the bond insurance issued by one of these two firms. In fact, most small municipal governments have no credit rating at all. They find it cheaper to buy the insurance than pay to have a full audit performed and rating assigned.

Thanks to the huge losses incurred at Ambac and MBIA on their CDS business, their capital base has dwindled dangerously low. Forced to raise capital, MBIA issued $1 billion in bonds to shore up its balance sheet. To attract buyers, these bonds had to carry a 14% coupon. Even so, a week later these bonds were trading down 10-15%. Keep in mind that a typical investment grade bond (BBB or higher) would trade in the mid-5%. Not only was the 14% coupon indicative of a junk bond rate, but the fact that they traded so much lower immediately after issuance says that the marketplace feels bankruptcy is extremely likely. The next week, Ambac followed up with attempting to float its own issue. With the MBIA issuance fresh in investor’s minds, they had no takers. That day, credit agencies cut Ambac’s rating to AA (still very generous in our opinion) and stocks in both companies tanked.

The obvious question to ask is how can all of these bond issues trade with AAA ratings if the underlying insurance is perceived as no good? Shouldn’t the value of these bonds be marked down as well to reflect the riskier nature of their credit? How does this impact the cost of borrowing for municipalities that depend on those ratings? The cascading effect of this becomes obvious. Further write-downs lead to a further reduction in portfolio values which in turn puts more pressure on required capital levels which then limits banks’ ability to lend.

Pending Recession

Financial institutions, especially in the U.S. but also globally, have lost a tremendous amount of capital in the last few months. Faced with the prospects of another wave of write-downs that could be larger than the first, it’s apparent how economic growth is threatened. Modern economies run on credit. Whether it be consumer credit or business liquidity needs, access to capital is essential. The current situation is that most banks are either limited or unwilling to make major loan commitments at this time. All of the current data clearly points to a slowing economy and stock prices have come down to reflect this. There are only two events that will bring us out of this downturn, which are a stabilization of asset values and a massive injection of liquidity into the economy.

The Fed’s Role

Tuesday morning we were greeted by a surprise announcement that the Fed was cutting a key interest rate by 75 basis points. The size and timing of this announcement was a complete surprise that helped stem massive losses in stocks. The Fed’s move helped pair the opening declines on the Dow by roughly 350 points. The next day we were told that a bailout of the bond insurers was being orchestrated, which fueled a 600 point rally. It’s clear what the financial markets perceive as important. This is beginning to resemble the Fed’s orchestrated bailout of Long Term Capital Management in 1998. That too was centered on counterparty risk that threatened capital liquidity. We’re hopeful that all the cards are on the table now and it’s just a matter of accounting for all the losses.