Monday, February 15, 2010

CHINA Greece Dubai/ Financial Innovation: Invitation to be Irresponsible and Reckless/BDCs/Australian Currency

I start my investing decision making process with a big picture opinion. Since I started this blog, I have discussed two big picture themes that have dictated my approach. First, since August 2007, we have been in an Unstable VIX pattern which is viewed as a dangerous market for investors.Vix Asset Allocation Model Explained Simply With as Few Words as Possible Second, I have mentioned that the stock market has been in a long term secular bear market since 1997. An outgrowth of that view is a characterization of the rally off the March 2009 lows as similar to the rally off the October 1974 low, a short term bull cycle correcting the downside excesses of the catastrophic phase of a long term bear market. 1974 or 1982: Start of Cyclical Bull in a Long Term Secular Bear Market or the Start of Secular Bull Market? more on 1982 or 1974 Previously, however, I had been hoping for a rally in the S & 500 to 1250 to 1300 during 2010 before the long term bear market reasserted itself. I now view that as improbable, based on the tightening in China, the slowdown in Europe, and a continuation and possible acceleration of problems caused by excessive debt deleveraging during the Age of Leverage. The current view is that a rally to 1250 and 1300 is less than one in three, though I still believe the worse phase of the bear market is behind us and another three years of the long term bear market are ahead with a new long term secular bull market starting in 2012 or 2013 from the 950 to 1050 level in the S & P 500. The S & P 500 was in the 950 to 1000 range in later part of 1997, so a return to that range after fifteen years could mark the end to the current long term secular bear market.

1. Greece: I read several articles over the past week where the underlying theme was disappointment over the lack of details about what, if anything, the EC was going to do for Greece. Why would there be any details when the Germans really do not want to bail the Greeks out, and Greece has yet to do anything to reduce spending? Two thirds of Germans do not want their government to extend credit to Greece, and a majority want to kick Greece out of the EC as the alternative.

I suspect that Greece will be allowed to default on its debt if it does nothing meaningful to reign in what is clearly out-of-control public sector spending. If Greece does implement wage freezes and other measures to control spending, it may be able to refinance its debt coming due this year without any assistance, though probably at a higher rate than it is accustomed to paying. Until Greece does something, there is nothing for the more prudent EC members to do. Trichet made this clear in an interview over the weekend, the next step is up to Greece who must take "extra measures" to correct its "aberration". EU

A story in the WSJ over the weekend says that the Greeks would prefer a long term loan from the other EC members. Well, sure they do, once they have the money with a maturity date well into the future, they can go back to their old ways, having kicked the can a few years further down the road. Greece faces about 27.5 Euros in maturing debt in April 2010. Reuters has reported recently that Greece plans a 10 year bond in February or March.

Many investors know that the European Union wants its member states to keep annual deficits under 3% of their GDP. One way to cheat is to hide the real debt numbers. Another is just come up with false GDP data. The Greek statistics agency recently revised the GDP numbers. The EC recently released a scathing report on the Greek governments statistics: / _2010_REPORT_GREEK/ .PDF

2. Dubai: Dubai is back in the news. The WSJ reported over the weekend that Dubai World was offering its creditors 60 cents on the dollar for 22 billion in debt, which restructured debt would be backed by the government and paid back over seven years. No coupon would be paid on the restructured debt. And, the cost of insuring Dubai's sovereign debt rose to $636,000 to insure 10 million for five years.

3. China: I read in this article in MarketWatch that the Chinese authorities had targeted bank lending at 7.5 trillion Yuan for 2010 (1.1 trillion U.S.) and that the banks had already lent out 1.4 trillion Yuan during January. This could mean more tightening measures may be necessary.

The Chinese market is closed this week.

4. U.S. Financial Innovation: Mostly An Invitation to be Irresponsible: For the most part, what passes for American financial innovation is simply a means to generate revenue for the Masters of Disaster by tempting individuals, firms and even governments to behave in a reckless and irresponsible manner. Only a few winners emerge from this process, and they are the ridiculously compensated Masters of Disaster themselves, whereas the ultimate losers are everyone else, including millions who had no involvement in any of it.

The story in the NYT on Sunday simply illustrates one example of how Wall Street has assisted Greece to mask the true state of its fiscal affairs, thereby allowing the Greek government and population to engage in a few more years of what one Greek journalist refers to as a "kleptocracy". Brings back memories of how the wizards helped Enron mislead investors, as Floyd Norris noted in his column yesterday. NYT

It is fascinating that Eurostat, the European statistical office, has just asked Greece to explain the currency swap contracts discussed in the New York times article referenced above. This European agency was not aware of what Greece was doing until being informed by an American newspaper.

When I read an article in the WSJ that referenced the Greek God of Wealth, Plutus, it all became clear to me. Plutus wanted only to give riches to the just and the wise. Does that include the Masters of Disaster at AIG's Financial Products unit in London, or to Stan O'Neal or Chuck Prince? Zeus blinded Plutus so that the God of Wealth would shower his favors indiscriminately. That must be how it works. Now, I understand. Plutus must have given special attention to those wizards at AIG's Financial Products unit in London who made between 423 million to 616 million a year. NYT

Another recent example of the perils of financial innovation is the immolation of AIG which was a direct result of the disingenuous financial innovations cooked up by the infamous AIG's Financial Products Unit. The innovations cooked up by those wizards, while making them wealthy, simply added fuel to the expansion of subprime lending in the U.S. by shifting the risk of default to AIG as the seller of credit default swaps. And, many of those unregulated derivatives were bought by banks, particularly in Europe, to get around their own governments' regulatory capital requirements. NYT This is how borrowed U.S. government money eventually found its way to European banks with AIG as a mere funnel.

And, it is certainly clear now that the mortgage "innovations" were simply fuel to keep the transaction gravy train going by allowing people to buy homes that they could not afford, with each party to the transaction taking a cut, from the originator of the mortgage, to the ratings agencies, and to the Wall Street firms which provided the funding and packaged the trash into innovative financial products like the abomination CDO squared. Zuckerman editorial Basically, when boiled down to its essence, the innovations served only one purpose, to generate fees for the Master of Disaster by tempting the gullible, ignorant, and/or greedy to be irresponsible.

If there was any desire to make it more difficult for the Masters to blow up the world's financial system in pursuit of their own narrow self-interest and greed, blind to the consequences and with no consequences visited on them for failure, it could be easily done. If a financial institution wants to be reckless, it has to suffer the consequences. Just by way of example, some regulation over the origination of mortgages could have stopped the housing bubble which was created by excess liquidity in the financial system and the improvident extension of credit. The following is just an example of what I mean. There could be some kind of regulation requiring a mortgage originator to keep any mortgage that did not meet certain conditions, such as a minimum of a 5% down payment and a front end monthly debt service ratio of no more than 30% percent of the borrowers gross monthly income and a back end of no more than 38%. Mortgage Basics (I am being a tad more liberal than the numbers recommended in that linked article from Front end includes the mortgage payment (principal, interest, home insurance and taxes). The back end includes all of that plus all other debt service obligations (e.g. credit card, student & car loans), child support and alimony, etc. So if a mortgage originator wants to give someone a loan with no money down, or in an amount in excess of the front or back end criteria, it is free to do so, but the lender has to keep the loan on its own books and take the entire risk of default.

5. Business Development Corporations (currently own TAXI/PSEC/AINV/HTGC) I thought that this article from Seeking Alpha, written by Nicholas Marshi, was a good summary of the reasons to devote some funds in an income portfolio to BDCs. Personally, I do not devote much capital to them, in spite of their large dividend yields, due to what I perceive to be their risks. Those risks include investing funds in unproven and unseasoned private companies subject to a high failure rate; the possibility of dividend cuts and the impact on the share price when that happens; the need for debt refinancings; the fact that many of them issue stock frequently to raise capital with many of the more recent ones being at prices below net asset value; and the lack of a strong capital cushion given that 90% of the taxable net income has to be paid out as dividends. Many of these type of problems are also found in REITS.

I currently own 200 shares in PSEC, 50 shares of HTGC, 150 of TAXI, and 150 shares of AINV. Given what I view to be their problems, I do not regard them as long term holds but as trades. The objective is straight forward, just hold for several dividend payments and wait to sell the shares at a profit no matter how small. When I am being paid over 10% per annum, I do not need much of a profit on the shares to be satisfied with the investment.

I will use volatility occasionally to manage the position, lower my average cost by selling higher cost shares bought first, and keeping the lower cost shares. This means that I will slice and dice the orders into small increments, say 50 or 100 shares, and will never take a full position in one trade or even two. This post discusses my use of volatility as a risk management tool in equity preferred stocks, and the same technique would be applicable to BDCs or REITs: Embracing Volatility as A Risk Management Tool In the Sub-Asset Class of Equity Preferred Stock

Marshi also published an analysis of Hercules Technology at Seeking Alpha that was had a relatively upbeat though cautious tone to it. The analysis is much more thorough than I would provide in my posts. I do not view the current HTGC yield at last Friday's close to be close to adequate compensation for the risk. At a minimum, I would want 11% to justify even taking another 50 share risk in HTGC. At the current dividend rate of $.20 a quarter, the price would have to fall to around $7.3 for me to add 50 shares. The current yield of HTGC is also not competitive with other BDCs including PSEC and AINV which I also own. Several others have yields in the 10 to 15% range, compared to HTGC at a 8.67% yield at the $9.22 price. HTGC However, I am not so disappointed with the dividend cut, and the underlying caution that it signals about future net investment income, that I will take a loss on my first 50 shares recently bought. I will start to reinvest the dividend which worked the last time I bought and sought Hercules. Item # 5 /Sold HTGC

It is always important to keep in mind the risks in investing in these BDCs, the high yields come with enhanced risk characteristics. One indicia of risk is the percentage of nonaccruing loans to total loans. That number will generally be much higher than any bank.

6. Australia: The Australian dollar has been losing strength over the past several weeks against the U.S. dollar, notwithstanding the improving fundamentals of the Australian economy and Australia's relatively low national debt level as a percentage of its GDP. Last week, Australia reported that its unemployment rate fell to 5.5%: Labour Force, Australia, Jan 2010 The current net debt level as a percentage of GDP is just 10%. Total public debt as a percentage of Australian GDP is 18.2% according to this interactive chart from the Economist. (the estimate for the U.S. this year is 59.8% increasing at a 23.4% rate). I have owned the currency ETF for the Australian dollar, FXA, on several occasions in the past, and do not have a current position after selling out at $91.62. Item # 3 Sold FXA Possibly, the Australian dollar has fallen recently as hedge funds unwound the carry trade. The close last Friday was at $ 88.76 (FXA) I am going to give the newly developed mania for the U.S. dollar some more time to develop and hopefully go parabolic before reinitiating a position in the Aussie currency by buying FXA. This chart reveals that it fell in value against the dollar during the meltdown phase in 2008 and early 2009, bottomed at around $64 in early March, and then started to rally huge before hitting a recent top at $93.5 in November 2009 and another lower top at $92.5 in January 2010: CRRNCYSHR AUS DLR TR ETF Chart

Australia's Central Bank raised its "cash rate" in three 25 basis point increments late last year, with the last increase in December taking the rate to 3.75%. No change was made in the cash rate at the February 2010 meeting (see page 5 / 0210.pdf). Still, 3.75% is much better from a saver's viewpoint than the U.S. Federal Reserves funds rate of 0 to .25%. FXA pays a dividend based on the short rates in Australian dollars after fund expenses, which have been trending up after last year's rate increases: CurrencyShares :: CurrencyShares Australian Dollar Trust Distributions This is a link to FXA's annual report filed with the SEC: Form 10-K

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