Evergreen Virtual Advisor – Investment Newsletter by David Hay

Incredibly, tax-free bonds now yield 20% more than taxable Treasury bonds. And in another sign of how topsy-turvy the credit markets are, A-rated bonds now yield more than BBB-rated issues.

Points to Ponder

Incredibly, tax-free bonds now yield 20% more than taxable Treasury bonds. And in another sign of how topsy-turvy the credit markets are, A-rated bonds now yield more than BBB-rated issues.

The Fed has been busy selling Treasury bonds out of its portfolio and replacing them with lower quality but much higher yielding mortgages and corporate debt. Some have wondered if it might run out of assets, but it holds $11 billion in gold valued at just $40 an ounce. Based on current market prices, the true value is roughly $230 billion.

US nonfinancial corporations have a record amount of cash on their balance sheets, roughly $650 billion. This allows them to weather the economic and financial storm as well as buy back stock, such as with Microsoft’s recent $40 billion repurchase announcement.

The SEC recently banned short-selling on hundreds of stocks, including most large financial issues. A quick glance at the chart below indicates the immense level of the short position on bank stocks.

Again illustrating the enormous asset base within the US, and contrary to beliefs that we are a nation of chronic spenders, the total assets at registered investment advisers (like Evergreen Capital) recently hit $42 trillion.

EVAluating the Environment

Tarpedoed. In no small measure due to the efforts of some of the talking (screaming) heads on CNBC, and the other merchants of misinformation in the media, the so-called TARP failed to pass Congress. Thanks to their rantings, millions of Americans were convinced this was a Wall Street bailout, with the $700 billion disappearing into a sewer somewhere in lower Manhattan. Thus, whipped into hysteria, irate legions screamed at their representatives to vote it down. Of course, the day it flopped, investors (i.e., most Americans) lost $1 trillion in market value. Given the media frenzy, as well as Mr. Paulson’s and Bernanke’s timid presentation on its benefits before Congress, it’s no surprise that lawmakers showed all the courage of the Italian infantry in front of Stalingrad. After a harrowing week in the financial markets, with the destruction of even more taxpayer wealth, Congress finally approved a revised bill. It might have passed with much less drama—and trauma—if we’d let a certain Nebraskan do the selling.

Understandable doubts. As expected, I did receive some skeptical feedback on my view that the government could make money on a properly conceived and executed (I know, two big “ifs” when politicians get involved) mortgage stabilization program. But I’m far from alone in my belief. The living legend, Warren Buffett, was interviewed on CNBC last week and it was a gem, particularly on this topic.

Here’s my slightly paraphrased summary:

• If we don’t do something like TARP, our financial system is at risk of falling off a cliff.
• The real economy and the financial markets are joined at the hip, so the American people need to realize “this isn’t the time to vent your spleen … this is the time to do something that gets the country back on the right track.”
• Since the huge institutions are deleveraging en masse, you need an entity with enormous resources and a very low cost of capital (i.e., the Treasury) to counterbalance that.
• If the government does it right (and he admitted it wouldn’t do it perfectly), he believes “they’ll make a lot of money.” Notice that he didn’t say taxpayers would come out on the short end or even make just a little on this—he thinks they will make lots of money (more on this in a bit).
• When asked why he wasn’t doing this, he said that to really make it work well, you would need to use huge leverage and borrow very cheaply—basically, something only the government can do but that the government should earn double-digit returns on its investments. Then, there’s another member of the investing royal class who agrees with him…

Gross estimates. Bill Gross is the chief investment officer of the gargantuan money management firm Pimco and is often referred to as the “Bond King.” His opinions and the capital he controls can literally move even the multi-trillion fixed-income markets. Therefore, it was particularly meaningful when he made a passionate case both on CNBC and in a Washington Post op-ed piece that something like TARP, if properly managed, should actually generate significant profits to the taxpayers. His calculus is that the average price of depressed mortgage debt right now is 65% of face value and that the yield to the Treasury at that price level would be between 10% and 15%. Similar to what I was noting last week, this distressed pricing creates tremendous opportunity.

Capitalizing on the spread. The Bond King assumes a cost of 3% to 4% to the government on the debt sold to finance the mortgage purchases, creating a 7% to 8% net annual spread or profit on the 12% or so the government should earn. That’s about $50 billion per year if the entire $700 billion is deployed. Of course, as he points out, this will accrue over several years and it’s clearly just a ballpark calculation. But it is consistent with nearly all the analysis that I’ve seen that mortgages are currently being valued at levels far below what they are worth based on both cash flows and default rates, even using extremely negative assumptions. Gross has further offered to help manage the valuation and acquisition process for no fee to him or his firm. Many are cynical about his motives, but his math about how cheap these securities are is persuasive. In reality, this extreme overdiscounting goes far beyond mortgage debt.

The wages of fear. While the stock market has been in a typical recession-related bear market, falling about 30% from its peak, the devastation wreaked in the nongovernment credit markets (corporate bonds, mortgages, bank loans, preferred stocks—basically anything that trades on a yield basis) has been unprecedented, at least since WWII. Commercial real estate-backed bonds rated AAA are pricing in a 19% loss, even though in the past the worst experience was an 8% loss. Additionally, prices of junk bonds and home equity loans are consistent with an unemployment rate of 20%, according to Deutsche Bank. What has been even more toxic to the system is the pricing in the esoteric world of credit default swaps (CDSs). I realize most people don’t understand these things (and, based on the staggering losses being reported, neither did the big institutions); therefore, a quick overview might be in order.

A very good question. One of my best clients, with whom I’ve had the pleasure of doing business for 25 years, recently asked me how so many old-line and once-powerful financial institutions can come apart at the seams almost overnight? I suspect many of you have been wondering the same thing, and I admit that I have been stunned to see a massive and immensely profitable company like AIG forced onto the ropes in little over a week. (Confession time: We’ve been stung on a couple of these, including AIG debentures, though I believe these will ultimately recover.) Increasing reserve requirements, as mortgages were downgraded, played a big role in this calamity, but the CDS market was the real accelerant, at least for AIG. These vehicles are basically insurance policies taken out to protect bond holdings from default. They are often sold by the largest financial firms with the best credit ratings. In normal times they are a nice source of income, but in a period of sheer panic they have proven disastrous.

Credit Default Spiral. Selling insurance on a corporate bond has about the same result as buying a corporate bond. You receive cash flow, but in this case it is in the form of a premium payment received from the purchaser of the default insurance rather than an interest check from the bond issuer itself. The amount you receive for a weaker company is higher than what you receive for a stronger company, much like in the real bond market where the interest rate is elevated for riskier borrowers. Thus, it was not unreasonable for a bank or insurance company to believe that it was virtually buying corporate bonds and, as long as it did effective credit analysis, it was a fairly conventional strategy. But due to the extreme nature of this panic, it backfired horribly. CDS spreads have, in many instances, been surged out to far wider levels (indicating much higher default probability) than would rationally be expected. This then unleashed a virulent chain reaction.

A very vicious circle. Like so many things in this panic, CDS spreads exploding to irrationally high levels creates a self-perpetuating cycle: The more the spreads increase, the more write-downs the financial institutions are required to take; the increase in write-downs cause rating downgrades, a desperate hunt for more capital, and, frequently, forced selling of bonds or purchasing of CDS coverage, which further elevates the CDS spread, requiring even more markdowns. The prestigious Lex column in the Financial Times recently summarized the problem concisely: “…the pressure to hedge has led the most liquid (CDS) contracts to overshoot, in effect pricing in absurd default risks and recovery rates. These same prices are then used as supposedly objective indicators to value the securities the CDS contracts are designed to hedge—hence the spiral of over-hedging and overstated marked-to-market losses.” The key question is: When will this nauseating nosedive stop?

Let them fail! There are those who feel we should let the mortgage market find its own floor and if that means most financial institutions collapse, so be it. It will cleanse the system, ridding our country of our debt overhang, and properly punish all those greedy Wall Street leeches. While this might work eventually, the reality is that it would almost assuredly cause enormous economic pain and human suffering. There is no reason we need to subject our system and ourselves to such agony when markets are in full panic mode, aggressive government buying can decisively turn the tide. And there’s a surprising precedent that decisive intervention can turn the tide…

The muck stops here. Hong Kong has long been considered the ultimate laissez-faire, capitalism-in-the-raw economy. During the Asian crisis of the late 1990s, when the stock exchange of Hong Kong collapsed, the government stepped in and bought a massive amount of shares. It was criticized at the time, but guess what? It worked. The market stabilized and a few years later the Hong Kong government sold out for a tidy profit. In our current situation, this might even be more lucrative as these mortgages throw off high levels of cash flow, and private investors are likely to piggyback onto the government once prices begin to turn up. Encouragingly, other measures are also likely to be implemented, such as raising deposit insurance and suspending the disastrous (at least during a panic) mark-tomarket accounting rules. In other words, our bumbling, stumbling government may now have at least caught up with the curve, if not quite gotten ahead of it. Therefore, maybe, just maybe, this unbelievable nightmare might be finally chased away by the dawn’s early light of intelligent intervention

Evergreen Capital Management
500 108th Avenue, Suite 720
Bellevue, WA 98004
Phone: (425) 467-4600
www.evergreencapital.net