Monday, October 5, 2009

10 Year TIP Auction/More on GJS/Ground Beef & Coal Ash-Profits Over Public Safety/ Goldman Upgrades View of Large U.S. Banks/

1. GJS Current Yield Differential Compared to the Other Goldman Sachs' Floaters: A reader disagreed with my assessment of just a .1% penalty per year over the next 25 years for GJS. After all, the current yield difference is close to 3%. This issue relates to the my analysis of the GS floaters in the prior post. Analysis of Prior Question about Goldman Sach's Floaters I did not explain why I assessed such a small penalty and I sent him an email explaining my rationale which I will quote in my blog in pertinent part:

" Maybe GJS needs a larger penalty for the yield difference now. But I will stick with my .1% assessment for the following reasons. My reason for assessing it just .1% is that I would expect it to be earning about the same or more, most of the time, than the current guarantees of the others based on their respective prices. The others are earning now about 5 to 5.25 % based on their guaranteed rates at their current market prices. My purpose in assessing this fee is to determine how the current yield difference between GJS and the other GS floaters may impact overall return over a 25 year future period. To answer that question, I wanted to make an effort to guess at the duration of that yield difference by looking at historical periods. At a 2% 3 month T Bill rate, GJS would have an effective yield of 5.5% at a $13 cost, greater than the guarantees of all of the other GS floaters at their current prices. I then looked at the table for the monthly T Bill rates since 1982 published by the Federal Reserve. From 1982 to 2001, there was not a single month less than 2%. Then Greenspan took the rates down below 2% starting in November 2001 and the rates stayed below 2% until November 2004. Then the rate stayed above 2% until the current crisis falling below 2% in March 2008 until now. I then eliminated all of the low months above 1.7% T Bill rates, since at that rate GJS has a yield similar to the other floaters now at 5.0%. I then eliminated 11 more months at below 2%. So roughly speaking, over the past 27 years, I was left with about 3 1/2 years of yield difference and during those years the yield difference fluctuated with some readings in the 1 to 1.7% range that would narrow the difference. Due to the low price of GJS in relation to its par value, compared to the other floaters, it does not take much of a T Bill rate to narrow the difference."

So given the relatively short duration of the low T Bill rates that penalizes GJS in a unique fashion, I thought that a .1% penalty applied every year, including those years when the difference would not be present, to be a reasonable guess. Moreover, we are already deep into a low interest rate period at the time of my last buy of GJS last Friday, about 1 1/2 years, so we may be closer to the end of the current unfavorable period for this security than the beginning already. But, in the last analysis, this kind of issue does not lend itself to anything remotely resembling certainty, since I am trying to gaze 25 years into the future. I personally feel more comfortable predicting trends over 25 years than I would over the next five, others may be less comfortable. When assessing the penalties and rewards, there are no right or wrong answers, just a series of hunches about the future.

Another point to always keep in mind is that the coupon rate is paid on par value. As the discount to par widens, that juices the value of the T Bill or Libor float provision. So, while I said that a float of .85% over 3 month Libor rate is a better float than one that floats .9% over the 3 month T bill, that would be true only if the two securities were selling at precisely the same discount to par value. It would not be true if the one with the T bill float was selling at $13 with a $25 par value compared to the other at $16 say. You can do the calculations assuming a 4.5% T Bill rate at the same time the 3 month Libor is at 5% just to see for yourself.

Another issue is the time frame for capturing most if not all of the discount to par value, currently at $12 for GJS. If GS survives to 2033, when the underlying bond matures, then the profit of $12 would be captured then of course. But, I would suspect that the will be two possible alternatives when the discount can be captured sooner. The first is a period of high Treasury bill rates, at a time when GS looks prosperous and a good credit. I would expect the discount to par value to narrow substantially under those circumstances. For example at a 6% T Bill rate, the yield at a $13 cost for GJS would be 13.27%. I would expect a narrowing of the discount under those type of circumstances. The other would be in a five year period before maturity, when the discount could disappear at times, assuming GS is still prosperous.

I am putting the synthetic floaters into retirement accounts to avoid dealing with the tax issue associated with the swap agreement that is discussed in the prospectuses for these securities. The float is created by the swap agreement. I initially did not read that part of the prospectus and did not understand it when I read it. So, I sold all of the synthetic floaters that I bought in a taxable account and transitioned those holdings to the retirement accounts. I hate thinking about tax issues, particularly complex ones. I did receive a few interest payments in the taxable account for some of the synthetic floaters before I sold them. I looked at my brokerage account over the weekend, in the 2009 tax summary section, and could not find any of the interest payments listed for those synthetics. I then discovered the brokerage had reduced my cost basis by the amount of the interest payments received by each of those securities. I have no idea whether that is correct or not, but it would not impact by tax liability in any event. The short term gain would be tax the same way for me as the interest payment. Now, I have no idea what would happen if I still owned those securities at the end of the year and had not sold them. Would by tax basis still be reduced or would those payments show up on the 1099 as interest payments. Again, I would not venture a guess. I just got rid of the issue by selling them in the taxable account so I have to deal with this tax issue only for this year and no other.

2. Ground Beef: The article in the NYT on Sunday about the ground beef industry is just another exhibit that safety of the food supply has never been a priority of the government. Meat packers can legally refuse to sell to anyone who tests their product. Better not to test for deadly pathogens otherwise you might have to do an expensive recall. The assertions by meat packers about their desire and efforts to protect the public from deadly pathogens is just a bunch of PR. I did not know until I read that article the lengths that firms who package the beef will go to earn an additional few cents a pound, by mixing different grades of beef from several slaughterhouses. Possibly, one could argue in good faith that some progress has been made since Upton Sinclair published "The Jungle" in 1906. But, after reading the NYT article about the ground beef industry, it would be impossible to argue that the FDA is protecting the food supply in any meaningful way. The emphasis is not on safety of the food supply but protecting the profits of the food suppliers. In that sense, the seal of approval by the FDA (“U.S. Inspected and Passed by the Department of Agriculture”) is just another part of the PR spiel by the food industry.

3. Goldman and Large U.S. Banks: GS raised its opinion on large U.S. banks to attractive from neutral.

4. "Intellectuals" & Crimes Against Women: The French "intellectual" Bernard Levy referred to Roman Polanski's admitted act of having sex with a 13 year old girl, after drugging her with a Quaalude and some champagne to be a "youthful" error by a 43 year old man. Harvey Weinstein referred to that criminal act as a "so called crime" An article in the NYT on Sunday places that kind of comment in an appropriate context. The European intellectuals rallied around a French Marxist philosopher who strangled his wife to death, later claiming that it was an accident. He was just giving her a neck massage. Another man deemed to be an artist by the intelligentsia beat his girlfriend to death, and he claimed that was an accident too. Needless to say, the "Les People" or crypto-intelligentsia rallied around him too. I would suggest that the comments of Harvey Weinstein, Levy, and their ilk have nothing to do with intelligence, just a lack of a moral compass and a less than enlightened view of appropriate behavior towards women, call it a medieval or middle eastern male attitude.

5. Coal Ash in School Carpet/ Water Supply: Another failure of the government to make any effort to safeguard public health was revealed in a 60 Minutes story about coal ash.

6. Ten Year TIP Auction: I will start to be more aggressive in buying the 10 year TIP at the auction when the coupon moves closer to 2.5%. The coupon for the TIP is commonly referred to as the real yield. I would agree with the commentator who wrote the article in Seeking Alpha that the attractiveness of the TIP improves significantly at that yield compared to where it is now. The real yield rose late last year because the breakeven number went to around zero, as the market priced no inflation over 10 years in late 2008 when I bought the TIP ETF at $93. That was not exactly rational in my book. I discussed my opinion of other factors that may impact the pricing of the TIP, both the real yield and the breakeven spread, in a prior post: Advantages and Disadvantages of Treasury Inflation Protected Securities: I now have about a $80 profit in the 2 TIP bonds bought at the last 10 year auction in the ROTH, and I am just buying 1 bond at today's auction. I will discuss the results of that auction tomorrow.

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