Tuesday, May 25, 2010

NYB/S/Government Entitlements/Principal Protected Notes/Build America Bonds/Rand Paul-Reactionary Not Conservative//

I did not place any orders yesterday. I am hibernating. Yesterday was unusual in that the VIX fell 4.44% to close at 38.32 and the S & P 500 declined 1.29%. Still, the recent spikes in the VIX, discussed in this earlier post have made the LB more cautious than usual. RB could not resist saying that volatility is a friend that needs to be embraced by Mama's Boy. Besides, the RB added for good measure, that stinking VIX Asset Allocation model promulgated by the NERD is simply capturing a market experiencing post traumatic stress disorder with flashbacks to September 2008. The problems in Europe are nothing like the sovereign debt problems confronting the emerging long term secular bull market in 1982, as the Old Geezer started to reminisce about the good old days, when most of the Latin American countries actually defaulted on their debts. Latin American debt crisis

Wherever Europe may be headed, the market certainly needs less hyperbole from business and political leaders. Yesterday, I read excerpts from a speech by Jeff Immelt that Europe may be "teetering" on the edge of economic disaster: Reuters CNBC

The announcement by the ECB of its tepid purchases of government and corporate debt during the second week of its buying program was not reassuring to the market: NYT RBS is saying that the ECB needs to pick up the pace to prevent a "complete collapse in confidence" BusinessWeek The currency ETF for the Euro (FXE) fell $1.94 or 1.55% in trading yesterday.

1. Build America Bonds: Bill Gross recommended Build America Bonds (BABS) in this interview with CNBC, based on their yield being about 2% over treasuries. BABS are taxable municipal bonds. More information about these bonds can be found at the SIFMA site. Powershares has an ETF devoted primarily to Build America Bonds (BAB). The expense ratio is .35%, and this ETF had 193 holdings as of 5/24/2010: Build America Bond Portfolio | BAB A list of its holdings can be found at Holdings. A waiver brings the expense fee down to .28% until it is revoked. Looking through the list of holdings, most are rated A or better with a number of AA rated municipal bonds. Distributions are paid monthly.

SPDR has also recently launched a similar fund with the symbol BABS. The expense ratio is .35% and this ETF has 39 holdings: SPDR Nuveen Barclays Capital Build America Bond ETF

Both of these funds' holdings will be similar in credit quality to investment grade corporate bonds. The average yield to maturity would be long term for both funds, giving them a lot more interest rate risk than an intermediate term bond fund with an average maturity of 7 to 10 years.

I do not have a position but may buy one of these ETFs at some point.

2. Principal Protected Notes: I really do feel sorry for individuals who bought principal protected notes issued by Lehman. There is no doubt in my mind that many individuals did not fully understand what they were buying and were not fully informed about the risks inherent in these products. Unfortunately, many individuals rely on brokers to act in their best interests and are not inclined to make any meaningful effort to protect themselves.

If an investor takes the time to read a prospectus, or just the opening paragraph of one, it would be apparent that the Lehman principal protected note was in fact a senior obligation of Lehman Brothers, subject to the credit risk of the issuer. If Lehman failed, then the owner of the note would be an unsecured creditor in Lehman's bankruptcy. I would never expect to recover more than 20 cents on the dollar in that eventuality, and would not be surprised that the "principal protected note" would be worth only a few cents. I view that as nothing more or less than common sense that does not require much if any financial sophistication. It does require some effort to learn about the security before making the investment.

In her column in the NYT on Sunday, Gretchen Morgenson takes on the role of an advocate for those unfortunate individuals who bought Lehman notes. She mentions a couple who invested half of their savings in one at the urging of a UBS broker. This is just awful advice which was made worse by the timing of it, just a few months before Lehman's collapse. I am not questioning the facts as recounted by Ms. Morgenson. I find it easy to believe that the broker did not fully inform this couple about the risks and gave the couple extremely bad advice.

But, it is also clear the couple made no meaningful effort to assess the risk themselves, and I view that as negligent too. They claim the broker did not send them a prospectus. Okay, if they did not receive one, why did they not ask for a copy or just go online and find it? The couple claims that they did not understand the product or even know Lehman was the issuer. Okay, if that is true, the broker sounds like a cad, but why would anyone invest so much money in something that they do not fully understand or have no meaningful grasp of the product being purchased? This comes back to individual responsibility and an unwillingness among millions to accept any responsibility for their own actions or their failures to take even rudimentary precautions to protect themselves.

Morgenson quotes a lawyer for the aggrieved individuals, Jacob Zamansky, who says that these products are not capable of being understood by individuals. And, he adds for good measure that no investor would buy one if the risks were honestly disclosed. That is self-serving hogwash and garbage. Some of them are somewhat complex and do require a few minutes to grasp, but they are not that difficult to understand. These kind of instruments can play a role in a conservative investors portfolio, but I would not buy one that is not publicly traded. If I become concerned about credit risk, I at least want the option of bailing by selling the security just like I would a stock.

Recently, I have invested in several exchange traded notes, issued by Citigroup and Bank of America, that are similar to the ones described by Ms. Morgenson. I took the time to read each prospectus and to understand exactly what I was buying before investing $1000 in the first one. It is obvious after reading a few lines that these notes are senior obligations of the issuer which exposes me to credit risk. For the ones issued by Citigroup funding, I am principal protected at maturity provided Citigroup survives to pay me the $10 par value. I am not principle protected in the event Citigroup is seized by the FDIC or files for bankruptcy. In that eventuality, I am just screwed. This is not a difficult concept to grasp or for a broker to explain to a client.

When I initially decided to buy some exchange traded principal protected notes issued by Citigroup Funding, my first decision was to limit my exposure to a specific dollar amount given the credit risk connected to holding senior note obligations of Citigroup. Some investors could rationally conclude that they do not want any exposure based on their tolerance to risk and their personal situational risks. The credit risk is the same as buying a fixed coupon senior bond from the issuer. The difference is that the distributions are tied to the performance of an index for the principal protected notes. After making the decision on the dollar amount of risk, I proceeded to select a few to buy. On one, I have already received an annual interest payment of $180 on a $10 note, based on the percentage gain in a commodity index. MKN & MKZ

Some of the discussions on the Citigroup exchange traded notes that I have purchased this year can be found in these posts:

Bought 100 MKN at 9.85- Tied to Commodity Index
100 MKZ bought at 9.96 Bought 100 MKZ at 9.91 in the Roth IRA -Tied to Commodity Index (100 of the 200 shares have already been sold)
Bought 100 MYP at $10.12 -Tied to the S & P 500
Bought 100 MHC at 9.8 Tied to the S & P 500
Bought 100 MOU at $10.12 -Tied to the Russell 2000
Bought 100 MBC at 9.84 -Tied to the Russell 2000

MBC is ex dividend today for its 3% guarantee ($30 on 100 shares). ( referenced in today's WSJ.com under "initial")

Each of those notes have a $10 par value and mature in 2014. Distributions are paid annually at the greater of a guarantee or a percentage gain in an index, provided the index does not gain too much as explained in the foregoing linked posts in greater detail and in the relevant prospectuses. There is no excuse for anyone who buys these securities to refrain from reviewing the prospectus or refusing to take the time to understand exactly what they are buying. If they do not take the time, then they have no one to blame but themselves.

The similar products that were issued by Bank of America do not guarantee the return of the $10 par value below a certain level in the index, and are more risky in that respect. I am more comfortable with a BAC note than one from Citigroup, but there is obviously risk in owning notes from either of them. The BAC notes are discussed in these posts:


Bought 200 SFH at 10.18- Tied to S & P 500

Bought 100 SDA at $9.8/-Tied to S & P 500 and matures in 2015.

Bought 100 SJV at 9.67 -Tied to the S & P 500

I am not likely to invest in more than 100 shares of another BAC special investment product, since I own other types of BAC securities, including trust preferred issues and common stock. I will not exceed $10,000 in exposure to any firm after combining the purchase cost of all securities issues by it, including the common stock, preferred stock, junior bonds, and senior notes. In addition to over 200 shares of the common, I also own the following junior bonds: Buy of 50 MJH at $7.51; Bought 50 BACPRW at 22.62 in the ROTH; Bought 50 of the TC CPP at $24.2.

3. Rand Paul Is a Reactionary-Not A True Conservative: Rand Paul is not a conservative. His supporters are not true conservatives. I am glad to see him win the republican nomination for the Kentucky Senate race since some of the prevailing views of the Tea Party can be aired to a nationwide audience. Ultimately it is up to the people whether or not to accept his reactionary views.

Paul's beliefs have many similarities to the European anarchists, though I am sure that he would be offended by that comparison. He views government as the source of evil and wishes to eliminate virtually all activities of the federal government except for defense of our shores. When Rachel Maddow asked Paul whether he approved of the 1964 Civil Rights legislation (YouTube), Paul tried to obscure his core beliefs but they managed to shine through anyway: Coward If a white businessman wants to refuse to serve a black patron at a lunch counter, or to provide them lodging in a hotel, then Paul believes that is their right. The federal government has no role to play whatsoever in regulating anyone on anything. He views any such effort to be an infringement of the citizen's freedom, which means to him that individuals have a right to do whatever they please free from federal government interference. The states can regulate activity within their borders that are a proper exercise of police power in Paul's ideology but the federal government should be constitutionally prohibited from any similar type of regulation.

So, without a a state law, a meat packer could mix rat meat with the ground beef; BP would be free to pollute the waters of the gulf; there could be no Federal Reserve Bank; no Food & Drug Administration; No Environmental Protection Agency; and so on. In short, just to keep this brief, all of the laws passed by the Federal government that most people take for granted now as necessary to protect the public's health, safety and welfare should be repealed according to Mr. Paul and the Tea Party crowd. This philosophy is not new. It is the same platform previously known by the name "States' rights" reincarnated with a different white face than Strom Thurmond, Lestor Maddox or George Wallace. What is the Appropriate Political Label While those advocating the core belief of State's Rights wish to call themselves conservatives, they are in reality reactionaries, desiring to turn back the clock to the 19th Century in order to protect what they view as their freedoms: freedom to discriminate, freedom to pollute, freedom to have an unsafe workplace, freedom to sell unsafe drugs and food, freedom to sell harmful products, and generally the freedom to cause whatever harm so desired by them. It is not surprising that this movement has a found a home in the modern day GOP.

I discussed in two earlier posts the desire of these reactionaries to overturn the Supreme Court decision in Wilkard v. Filburn. Most people would not have any idea about the full scope of this controversy. Conservative or Delusional Reactionaries? the 10th Amendment & the Commerce Clause They view this decision as a primary source of where America went wrong. Why? The Supreme Court's interpretation of the Commerce Power in that case extended the federal government's regulatory power to private activity, and this was the jurisdictional source of all the subsequent legislation that the reactionary forces in America do not like. This would include the Civil Rights Act of 1964, environmental protection, minimum wage, occupational safety legislation, food and drug laws, and any other progressive legislation adopted in the past 100 years. It is why Glen Beck views the republican President Theodore Roosevelt with such hostility, since he advocated federal legislation regulating the safety of food and drugs. Item # 3 Conservative or Delusional Reactionaries?

Some of Paul's core beliefs are discussed in two recent Wall Street Journal articles: Republicans Are Peppered Over Paul's Remarks - WSJ.com Paul Remarks Have Deep Roots - WSJ.com His true colors are on display for all to read in a letter he wrote in 2002: Rand Paul POLITICO.com The core of his philosophy is considerably broader than opposition to federal civil rights legislation as applied to private citizens or to the ADA requirements for private business. A lot of the commentary misses the mark entirely on the true scope and implications of his beliefs.

It is also not surprising that Paul and the Tea Party crowd will forever fail to learn anything from history or the consequences of what happens in a society free from federal regulation. And, they will never understand how their core philosophy was the key contributing cause to the Great Depression in the 1930s and to the recent Near Depression. Instead, as shown in their recent successful effort to defeat the real conservative GOP Senator from Utah, Robert Bennett ( USATODAY.com), they are angry about the actions necessary to save the financial system from collapse largely caused by allowing people to do what they want in a vacuum of meaningful federal regulation. POLITICO Ignorance can be a form of bliss.

4. Unsustainable Government Entitlements: The sovereign debt woes of Greece, and to a lesser extent Spain and Portugal, are the first major warning shots that western governments have promised more than they will be able to deliver. There is not a bottomless pit of money that can be borrowed and spent on entitlements.

True conservatives and the tea party crowd share some common views on the direction of government spending.

The article on Sunday in the NYT discusses the growing gap between the liberal benefits promised by European governments and the ability of those governments to pay for them. The problem has just hit the weakest of the EU members first. And how do they plan to support these liberal retirement benefits when the ratio of active workers to retirees falls to 1.3 to 1 from 7 to 1 in the 1950s.

Greece is allegedly tightening its belt some by extending the retirement age of civil servants. When there are already more than 500,000 union members of the Greek civil service, out of a population of just 11 million, extending the retirement age is not exactly an attack on the root cause of too much government spending.

This article from Morningstar highlights the differences between European sovereign and corporate debt. There is at least one ETF that is devoted to worldwide corporate bonds: SPDR Barclays Capital International Corporate Bond ETF That ETF has some exposure to U.S. corporate bonds, at around 18.75% of the portfolio, followed by Germany at 16.15%, the U.K. at 12.51%, and France at 11.28%. Given the large percentage of foreign corporate bonds, this fund would have a considerable amount of currency risk for a U.S. investor. I would anticipate that the changes in the currency valuations to be far more significant than the modest dividends paid by this kind of ETF, so any purchase by me would primarily be a "bet" against the U.S. dollar, just like BWX and WIP, and consequently not something that I would want to own during a period of dollar strength as now. I will key off the US Dollar Index Future (DXY) as a key consideration in buying and selling these foreign bond ETFs. The Dollar Index & Foreign Government Bond ETFs WIP & BWX

5. New York Community Bank (owned-regional bank strategy): NYB was upgraded to outperform by BMO Capital Markets yesterday. The analyst, Peter Winter, believes that the dividend is secure and the bank will not likely be impacted by regulatory changes. He raised the price target to $20. My shares were bought in 4 fifty share lots with an average cost of around $11, with the position divided between the taxable and regular IRA account. NYB is the only stock owned in the regular IRA. Bought 50 NYB at $11.3 50 NYB at 10.9 50 NYB at $11 Added 50 NYB at $10.57

6. Sprint (own bonds): GS upgraded Sprint to buy and raised the price target to $6 from $3.5. Citigroup reiterated its buy rating. MarketWatch

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