Investing Ideas

Within the last few months the US Federal reserve has cut interest rates from 5.25% to 2.25%.

How the dollar decline helps.
A decrease in the value of the dollar will make US exports cheaper and imports into the US more expensive. This should significantly reduce the trade deficit. US Multinationals which make a lot of their money overseas will do great. Financial companies will have access to cheaper money which will increase liquidity and profits for financial companies. Interest rates on housing loans should decline and Adjustable rate mortgages which reset will have a smaller increase for the time being. Here is an article on how to make money off the dollar decline.

The big question. Whats next?
Based on the reasons i stated above the market seems to think this is positive but I disagree. The reason the fed is reducing interest rates is because they see a major recession looming. The fed cites that “core inflation is under 3%”. Core inflation is also known as CPI excluding food and energy. If you can find people that do not eat, do not drink, do not drive or use electricity then by all means core inflation can be used. Personally I eat, drink, drive and use electricity so for me the Consumer Price Index is the real measure of inflation. Interest rates are supposed to be higher than inflation. The Inflation rate is currently over 4%. With interest rates at 2.25% people that hold Cash in savings accounts, CDs or money market accounts are losing money.

Here is a chart from the Cleveland Fed. Click the chart for a better image.

As you can see at the end of the chart, while Core CPI remains low the actual CPI has shot above 4%. So what protects your investment when there is high inflation? Treasury Inflation protected securities. If inflation remains at this level for a significant period the fed will be forced to increase interest rates dramatically to combat inflation. If the fed delays controlling inflation we may have a bigger problem. Lets just hope we don’t need to bring back Paul Volcker who had to boost interest rates to 20% and put the economy into a recession to combat inflation and end the stagflation of the 70s.

The easiest way to invest in TIPS is to buy the exchange traded fund TIP
Another new exchange traded fund WIP has recently started trading. WIP is a global TIPS fund with exposure to 18 Countries and 15 Currencies.

Disclosure: I do not own TIPS, WIP.

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The first step to understanding deleveraing is to understand leveraging.

What is Margin?

Margin buying is buying securities with cash borrowed from a broker, using other securities as collateral. This has the effect of magnifying any profit or loss made on the securities. The securities serve as collateral for the loan. The net value, i.e. the difference between the value of the securities and the loan, is initially equal to the amount of one’s own cash used. This difference has to stay above a minimum margin requirement. This is to protect the broker against a fall in the value of the securities to the point that they no longer cover the loan.

Example: Universal XYZ trades at $10 per share and John has $200.

If the shares rise to $12
Without Margin: John can buy 20 shares of the company. If the shares rise to $12. John can sell his shares for $240 and make a profit of $40 with an investment of $200.
With Margin: John can buy 100 shares of Universal XYZ for $1000, using $200 of his own money, and $800 borrowed from his broker. The net value (share - loan) is $200. The broker wants a minimum margin requirement of $100. If the shares rise to $12 he can sell for $1200 and make a profit of $200 with an investment of $200. Five times what he made without margin. (He will have to pay some interest on the loan)

If the share price drops to $8

Without Margin: John can buy 20 shares of the company. If the shares fall to $8. John can hold his shares or sell for $160 for a loss of $40 on an investment of $200.
With Margin: John can buy 100 shares of Universal XYZ for $1000, using $200 of his own money, and $800 borrowed from his broker. The net value (share - loan) is $200. The broker wants a minimum margin requirement of $100. If the shares fall to $8, the net value is now zero, and John will either have to sell the shares or repay part of the loan (so that the net value of his position is again above $100).

So whats happening in the markets?
Margin is used by companies, private equity and hedge funds the same way that it is used by individuals, but on a much larger scale. There are companies which have taken on leverage to buy large amount of mortgage debt. They borrowed money from Citigroup, JP Morgan, Goldman Sachs and other such companies. They bought mortgage debt that paid a higher percentage of interest than what they would pay to the companies they borrowed from.  As housing prices have declined so has the value of the mortgages held by these entities. The companies that lent them the money are now issuing margin calls to increase the net value or they will sell off the assets. The problem is that mortgage debt is considered toxic by the street and no one wants to buy it unless they can buy it at a huge discount.  If the motgage sells at a discount (which is the only way it would sell in this market), the lower sale decreases the market value of debt held by other institutions which in turn get a margin call and might in turn get liquidated and it continues. A deleveraging domino effect.

Fallout
In my opinion the the dominoes effect can cause closure/redemptions at a lot of funds that hold mortgage debt. It can also affect entities that hold mortgage debt along with other securities. These entities may try to stay afloat by selling stocks and bonds they hold instead of selling their mortgage debt at depressed prices. This will result in  spillover into other markets.

So whats the opportunity?
The only opportuniy for individuals with cash will be to buy stocks/bonds at lower prices if there is a fallout into other markets. The big opportunity exists for companies that are sitting on tons of cash and can buy this debt at very cheap rates. Companies like Berkshire Hathaway which has 40Billion in cash and a ton more in bonds could get very good deals. In a recent Q&A session on CNBC Warren Buffett mentioned that he had made a bid on a 3.5 Billion Municipal Bonds portfolio and had offered 75cents on the dollar. I’m sure he would pay a lot less for mortgage debt. Cash rich companies like this could make a lot of money buying mortgage debt at depressed prices, and investors could make good money buying the companies which get great deals on the mortgage debt.

Full Disclosure: I own shares of Berkshire Hathaway, I am not invested or short  Citigroup, JP Morgan, Goldman Sachs.

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An amazing piece of research done by Whitney Tilson of T2 partners was released on March 7th. This is a must read for anyone who plans to buy Financial’s, Brokers, Asset Managers, Monolines, Insurers, Banks or Housing related companies.

The main things he covers

• Why we had a housing bubble
• How the Bubble formed
• The consequences and why he feels it has much lower to go.
• Details on Loan Origination volume
• Default rates
• Mortgage Loses for companies/industries.
• Securitization, Asset Backed Securities, CDOs.

The first chart on page 3 of the presentation tells a lot about the Bubble. It points out that from 1995 to 2005 the pretax income in the US went from $30,000 to $40,400 an increase of 35% while the borrowing power of the people went from 90,000 to 360,000 an increase of 300%. Simply put in 1995 homebuyers would be lent 3 times their annual income while in 2006 it had risen to 9 times their annual income.

You can read the presentation here. You will need to give your Email and Name.

Full Disclosure: I am not invested in or short of MBIA, Ambac, Moodys, McGrawHill(S&P) or Any of the companies listed on page 50 of the presentation. I used to own shares of Washington Mutual and D. R. Horton. I do own shares of USG. After reading this presentation I am considering a position in Whitney Tilson’s fund (TILFX).

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Background
Municipal Bonds also known as Munis’ are Bonds issued by State and Local Governments who use the money to finance projects. The payments for these Munis are made from the taxes they collect. It is extremely unlikely (but not totally unheard of) for a Municipality/City/State to go Bankrupt and stop making payments on their Bonds. Most municipalities have credit rating that are relatively low. If they had a higher credit rating they would have to pay lower interest rates on the money they borrow. To get a higher credit rating for their bonds the government entity issuing the bonds can insure them with a AAA credit insurer aka a Monoline insurer. Once insured with a AAA credit insurer the bonds receive a AAA credit rating and have to pay much lower interest rates.

How the subprime mess has affected Muni’s
Most of the companies that provided insurance of Munis also started insuring CDO’s (Collateralized Debt Obligations). The companies have to pay the mortgage companies if the homeowner fails to pay and the house sells for less than the cost of the loan. As everyone has read/heard, there are an unprecedented number of people who are unable to make payments on their house. House prices are down and the mortgage companies are losing money. This in turn means that when they cant recover the original loan the Monoline insurers have to make payments. The market feels that the amount of payments that some of these companies need to make to cover the CDO obligations will leave little capital left to cover the obligations of the Insured Munis. Since the feel that the Monolines wont have money left to pay for insured Munis they are treating the Munis as if they are uninsured.

Whats the opportunity
As I mentioned earlier it is very rare for a government entity issuing Munis to go bankrupt. Another thing is that the interest from Munis is not taxable at the Federal level. If you buy Munis that are issued by entities in the state you live in the income is exempt from state taxes as well. Because the income is not taxed at Federal level and sometimes not taxed at state level, Munis usually have lower yields than US Treasury’s. The reason being that after tax a Muni yield of 6% is similar to a 8% yield that gets taxed at 25% income tax rate.

Here are some examples based on data when i wrote this

US Treasury Yields - 6 Month - 1.56%; 2 Year - 1.55%; 5 year - 2.49%; 10 year - 3.6%
Pimco California Municipal Income Fund - PCQ: 6%
Pimco New York Municipal Income Fund - PNF: 5.4%
Pimco Municipal income Fund - PMF: 6.4%
Individual California Muni Bonds with maturity in the next 5 years

Note : With Managed Funds or Closed End Funds the value of the Fund can go down. Some funds are only allowed to hold bonds with a specific rating eg: A or higher. If the monoline insurers have their credit rating downgraded the rating of some of the bonds the mutual funds hold will also be downgraded and the fund manager may have to sell the Munis at a loss. It may be safer to buy individual Muni Bonds because you can decide to Hold till Maturity. This is not an option when you buy a fund since the fund manager makes the decisions to buy or sell.

Disclosure: I do not hold any Munis but I am considering buying PCQ or individual California Bonds.

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