Monday, October 6, 2008


1.  European Central Bank & Inverted Yield Curve:  Earlier this month, the European Central Bank kept its short rate at 4.25% creating an inverted yield curve where the yield on  short maturity paper is greater than the yield on longer dated maturities in an economic environment that is clearly deflationary and in desperate need of an interest rate cut.  The problems in Europe, similar to those in the United States, have become much worse since that decision.  The ECB  is fighting a risk of inflation when deflation is the only meaningful risk in the European economies.  I have previously discussed the problems at Fortis  & Dexia that have just spiraled Europe Plus, the recent 50 billion euro bailout of Hypo Real Estate Holding AG after an earlier bailout Worldwide  Then you have the European governments appearing to be in disarray and unable to develop a coordinated response but each government acted individually to guarantee deposits in their local banks.   All of this is just adding to the anxiety.
This story which will published in tomorrow's Washington Post is worth reading, relating to emergency actions being contemplated by Germany.

2.  Marsha Blackburn Disagrees with Warren Buffett: Whose Opinion is Worth Listening to: Possibly people will pay attention to Warren Buffett next time he says that we are on the precipice.   I heard my congressional representative, Marsha Blackburn, disagree with Warren and say there was plenty of time to avert disaster.  Jack Welch is another one that knows less than Marsha on credit issues and the economyJack Welch says U.S. faces deep downturn | Reuters  This is from Marsha's interview with the Tennessean: "No, I don't think it's an emergency situation. I think it's a situation knowing that Congress is about to end the session. The 110th Congress will come to an end. People are going to leave and go for the election, which is 34 days away. I think it is an imperative situation that we do some action, I don't think it's an emergency situation… | The Tennessean  One of her solutions, as mentioned yesterday was to sale insurance on assets that had already gone bad, sort of like someone offering to sell fire insurance at a "reasonable" price that a homeowner could afford after the uninsured home just burned to the ground.   It is hard to see how that would work.  We  already know that AIG, the largest insurance company in the world, had to be bailed out a few weeks ago because it was a private insurer of these mortgage securities. I know Marsha does not read the New York Times but there is a recent article discussing at length how credit insurance destroyed  How would you price insurance, Marsha, on assets that have already gone bad and worse, how could anyone charge a premium that the holder of these assets could afford to pay?  Of course, none of her solutions actually address the main problems, a lack of liquidity and a loss of confidence.  Just a few sensible questions that someone more alert than a Tennessean reporter may want to ask at some point.  

3.  Democrats and the FANNIE/Freddie Implosion:  I have been asked about the Democrats involvement in the Fannie and Freddie debacle.  For as long as I can remember, I have been reading stories about the risks posed by these GSCs to the financial system, with over 5 trillion of mortgage assets owned or guaranteed.  The leverage on their balance sheets was just enormous, especially when you considered their guarantees.    The model may have worked for more decades to come except for the risky assets acquired in the past three or four years in an effort to boost their profits and under pressure from their private investors to take on more risk.  A substantial part of this additional and irresponsible risk taking had nothing to do with any government program to make loans available to minorities as claimed by Marsha, Coulter and Limbaugh.  It was part of the GSEs response to take on more risk in response to their investors' pressure as shown in the recent article in the NYT.
The Democrats were far more supportive of Fannie and Freddie than the Republicans and the Democrats were relunctant to say the least in controlling their excesses, including excessive leverage where risk was socialized and benefits were privatized.  As shown in this story, Congress this year with the support of the White House and GSEs regulator James B. Lockhart 
adjusted the companies lending standards to enable them to purchase 50 billion more of subprime mortgages, and this was viewed by Democrat Barney Frank then as part of the solution.“I’m not worried about Fannie and Freddie’s health, I’m worried that they won’t do enough to help out the economy,” the chairman of the House Financial Services Committee, Barney Frank, Democrat of Massachusetts, said at the time.  I have always viewed Congress as using the GSCs as some kind of piggy bank to further their political agendas and the Democrats need to plead guilty to that charge.  But the problem with the GSCs was far more of their own making, attempting to capitalize on the bull market in real estate by assuming more risk buying funky mortgage securities like Option ARMs and interest only mortgages that  has just recently resulted in the seizure of Washington Mutual, the largest savings and loan, and the forced sale of Wachovia, the fourth largest commercial bank in the United States in terms of assets.   

4.  Trust Certificates Containing the Same Junior Bond Issued by Aon: The following discussion of the Trust Certificate (TC) containing an Aon bond assumes familiarity with the prior blog’s discussion of TCs.  The common stock symbol for AON is AOC.  It is an insurance broker.  The underlying bond in this TC, KTN, is an AON  junior subordinated debenture  maturing on 1/1/2027.   The coupon on the trust certificate is 8.205%. Interest is payable in January and July. Today, this bond for no reason fell 14.21% to 16. The TC has a $25 par value.   The effective yield at a $16 per share cost would be 12.875%. If held to maturity in 2027, and assuming AON was able to redeem at par value, this would be another $900 profit for a 100 share purchase.  A straight line amortization of that $900 over 19 years would equal $47 per year on 100 shares or an additional 2.9375% per annum. While this can be complicated there are other TCs which contain AON bonds, such as KVF and KVW, that have the same maturity as the KTN discussed above but all of these TCs have different maturities. Because the market in TCs is so inefficient and irrational, the effective yields on these AON TCs will vary substantially even though all should be the same. They all are from the same issuer with the same maturity date.   KVF has a 7.75% coupon and KVW has a 8% coupon.  But that is not important when you buy the security on an exchange after it IPO or original listing.  The issue now  is  solely  the yield based on your purchased cost.  It would not be unusual during a trading day to find these securities to  have a 2% effective yield differential based on their respective market prices of the three TCs. So, I will just buy whatever is the best one on a particular day, choosing to buy the highest yielding one and normally selling the lowest yielding one if it is carried in inventory.   I came close to making that switch today. Aon is a lower tier investment grade credit.  Two of the downsides are the normal enemies of any long term bond, an increase in inflation and default by the issuer.  I do not see now any concern over the near or intermediate term for a default but the AON bonds are junior which carries more risk. I do have an intermediate term concern about inflation, looking out two or more years.  The TC market is also highly erratic and volatile, not because the prices of the underlying bond price are volatile in the institutional bond market, but because the market in TCs is dominated by individual investors that are currently subject to wild swings in fear, anxiety and a host of other emotions.  If anything, the value of this TC, KTN, should be stable or ticking slightly up in a volatile market for common stocks.  The fact that it is acting more volatile than a bank stock is, in my opinion, due solely to the limited number of individual investors trading them which presents more of an opportunity now than a risk. Limit orders need to be used in the TC market due to the wide bid/ask spreads and low volumes.   These three TCs are Smith Barney originated.

 In full disclosure, I own shares of KVW and will continue to buy additional shares of other AON TCs at or below the current price, or even slightly above.   I have bought and sold KTN and KVF several times already this year. This is not a recommendation to buy or to sell.  Trade at your own risk, and perform research about this security by reading the prospectus at and further studying the financial health of AON (symbol AOC at yahoo finance) before making any investment. Consult with your financial advisor prior to making any purchase. In this blog, I am merely describing my reasons for purchasing this security and the potential pitfalls that I identified prior to purchase.  This security may not be suitable for others based on their unique financial position and risk profile.  THE PROSPECTUS ON THIS TC CAN BE FOUND AT SEC.GOV and the appropriate search term is structured products,

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