Monday, August 1, 2011

GDP and Inflation-Worrisome/McConnell and Reid Agree to Framework on Debt Limit Increase/Husky (HSE:CA)/ONFC VLY UBCP/Edison Mission Bonds/Bought 50 of the TC GJR at 19.31

Consumer confidence slipped to the lowest level since early 2009.

The GDP report last Friday was depressing. The government revised the 2011 first quarter GDP growth to .4% from an anemic 1.9%. News Release: Gross Domestic Product The estimate for the second quarter was 1.3%, below the consensus of 1.8%. The government also revised its GDP estimate for the 4th quarter of 2010 to +2.3% from 3.1%. This report was ominous, particularly since government stimulus is already being withdrawn and is likely to be cut further. A decline in government spending at all levels is already contributing to a contraction in GDP.

Output in the Near Depression was also revised down to show a bigger dip. The cumulative decline was revised to 5.1% from 4.1%.  The economy declined by 3.5% in 2009 rather than 2.6%. CNBC

I started to cut back on my stock allocation during the Spring after seeing evidence of a slowdown. I did not expect that the GDP deceleration would be so drastic in the first half, as now estimated by the government.

I had also anticipated a slowdown in the U.S. economy greater than the consensus estimates prior the release of the last GDP report. Some economists have started to revise down their robust growth estimates for the second half, still anticipating nonetheless a sharp bounce in economic activity. I would not be surprised by a slightly positive GDP number for the 3rd quarter.

Some economists believe that the stage is set for "marked acceleration" in the second half:  Deutsche Bank lowered its forecast for the 3rd quarter GDP by one percent to 2.5%, and its 4th quarter estimate by 1.3% to 3%. Still, given the sharp reduction of government spending at all levels, the still over leveraged American consumer, high unemployment, dismal construction activity, and many other negative drags, even the reduced estimates for the next several quarters are too high in my opinion and are based primarily on wishful thinking.

I did mention in a prior post that the current political turmoil has taken investors attention off a slowing economy which would in my opinion cause a correction even with a majority of sane and responsible politicians in Washington.

There is also growing evidence of problematic and incipient inflation that may tie the Fed's hands and cause them to raise rates, even with the economy weak, in an effort to nip inflation from gaining too strong a foothold. Some of these recent data points include the following. The Labor Department reported last Friday that its employment cost index rose .7%, seasonally adjusted, in the 2011 second quarter. Employment Cost Index news release text Based on the last CPI report, inflation has increased at 3.6% rate from June 2010 through June 2011.  Consumer Price Index Summary In the GDP release on Friday, the government estimated that the price index for domestic purchases increased 3.2% in the second quarter.

It is of course deliberately misleading for both Boehner and Cantor to say that an approval of a debt limit without spending cuts gives the President a "blank check". That statement was rated by PolitiFact as False which it is without question.  The same conclusion was reached by an Editorial in USATODAY and at No other conclusion can be drawn given the constitutional powers of the President and the Congress that are well known to both Boehner and Cantor. Only Congress can pass spending bills. The debt limit increase pays for the spending already made by Congress or approved by it. I repeatedly mention these kind of false statements, which are intended to mislead the weak minded and ignorant, since I view them as interfering with sensible solutions to the nation's problems. Ultimately the solution involves the voters to become more informed, far more knowledgeable than they are now.  And I say that recognizing that at least 30% of the voters are hopeless ideologues who create their own reality and do not care about making sound judgments based on reliable factual information.

Suze Orman explains the debt limit issue in terms that most voters can understand.

A republican columnist, Kathleen Parker, has started to call the Tea Party crowd in the House the "The Tea Fragger Party".  The Tea Party crowd has always been with us, going under different names from time to time. They are for the most part the same reactionaries and extremists who listen to the gospel according to Rush and Sean.  They are virulently opposed to Democrats in general and to any social programs that does not benefit them. For many, their opposition to the Democrats and those social programs have racial overtones.

The budget limit increase is still uncertain in my opinion. It is not clear whether the deal announced by the leaders last night can pass the House.

Last Friday, to obtain enough votes, Boehner had to amend his budget plan a way that insures that it would never be approved by the Senate or the President. The amendment would require Congress to approve a balanced budget amendment to the Constitution before the second increase to the debt ceiling. WSJ So under the House plan, in a few months, both the Senate and House would have to approve- by two-thirds vote- a Constitutional Amendment requiring a balanced budget and the spending decreases recommended by yet another commission. This is a link to the roll call vote on Boehner's last plan:  House Vote 677  Some GOP members voted against the revised plan since it was not extreme enough for them including Michelle Bachmann.

Several GOP senators joined all of the Senate Democrats to kill the House bill. The vote was  59 to 41.  Washington Post The extremist Senator from Kentucky, Rand Paul (R-KY) voted against the House bill since the bill was not draconian enough. The two Republican senators from Maine (Collins and Snowe), the vulnerable republican senator from Massachusetts (Scott Brown) and Lisa Murkowski of Alaska also joined the Democrats in opposition for different reasons. Conditioning a debt limit increase on the passage of a Constitutional Amendment is off the charts irresponsible.

The GOP members in the House have shown their willingness to use of the full faith and credit of the United States in an effort to extort changes in spending for ideological reasons. That constitutes an abuse of power. Their intent, as Paul Krugman noted (NYT), is to eviscerate the government's safety nets, by using their political power in the House to condition their approval of a debt limit increase. The balanced budget amendment is not being advanced for legitimate fiscal reasons but to achieve a reactionary agenda. The U.S. does not need to "balance the budget" unless the purpose is to appease ideological extremists. Instead, a sensible balance is required in the amount of money being borrowed and spent, along with a tax policy designed to generate more revenues primarily by closing tax loopholes and minimal increases in taxes on the wealthy.

Those who advocate a balanced budget, which includes all GOP members in the House and Senate, do not recognize their role in creating the current obligations that have to be financed with a debt limit increase. Their view was expressed by Mitch McConnell over the weekend that Obama's policies led to the current problem. As long as substantial parts of the population believe in those kind of delusions, a solution will be hard to achieve.  An accurate statement would be that the serious problem began with President Reagan in the early 1980s, the "deficits do not matter" crowd, and have accelerated by both spending and revenue actions undertaken by both political tribes since that time. A discussion of Reagan's contribution, christened "borrow and spend" as opposed to "tax and spend", is mentioned by historian Richard Reeves in a NYT column.

{During George W. Bush's administration, the gross debt increased from $5.7289 trillion in January 2001 to 10.7 trillion by 12/31/2008, leaving office just prior to the onset of the Near Depression which would dramatically decrease revenue and increase expenses regardless of the party in power. The debt calculations can be performed at the Treasury's web site: Debt to the Penny (Daily History Search Application I was not able to run a similar search for the entire Clinton term, but was able to go from September 1994, when the debt stood at $4.685 trillion, and that number increased to $5.73 trillion by 1/2/2001.  National debt by U.S. presidential terms - Wikipedia}

The two major contributors to the debt problem over the past decade, originating from the GOP, are Bush's IRAQ War on the spending side and the Bush tax cuts on the revenue side.  Over 90% of the nation's 11 trillion in debt, accumulated prior to Obama's Presidency, originated during the Administrations of three recent Republican  Presidents. National debt by U.S. presidential terms  A former Reagan official lays out how the Bush tax cuts contributed to the current debt problem in a NYT opinion column. Those cuts are not set to expire on 12/31/2012, unless extended again. Washington Post The Ryan budget plan would deepen the tax cuts for the rick by reducing their top tax bracket to 25%. Bloomberg

Late last night McConnell and Reid announced that they had agreed to a framework for a deal.  Obama agreed to support it.  NYT  The Washington Post

While the House leaders appear to have accepted the compromise last night, it is impossible to predict what the rank and file will do. I would not make the assumption that the debt limit will be raised based on this compromise until the House vote is taken.  I suspect a large number of liberals who are furious with Obama will vote against this deal, along with a substantial number of GOP House members who are in Maureen Dowd's apt description "adamantine nihilists"  Paul Krugman has already called it a disaster.  NYT The editorial page at the  NYT calls it a terrible deal.

I would not anticipate a problem with the Senate.  The Senate does have the Filibuster and Cloture rules that would require 60 votes to close a filibuster and allow for a vote. A few senators have already announced their opposition to the plan including the two republican senators from Utah, Mike Lee and Orin Hatch. Deseret News

The plan appears to call for $2.417 trillion in spending cuts over 10 years in two stages based on news reports last night.  The first stage of $917 billion would be approved now, including 350 billion in defense cuts.  WSJ. A bipartisan Congressional commission will be formed to find the other $1.5 trillion in cuts. If those additional cuts did not materialize by 12/23/11, there would be automatic cuts of $1.2 trillion over 10 years. One-half of those cuts would come from defense. Washington Post The remaining cuts would come from nondefense spending, including payments to providers of Medicare, but would not affect Social Security or Medicaid.  Unlike the House bill, however, the raise in the debt limit would not be conditioned on both the Senate and House approving the balanced budget amendment.  There would be no revenue increases as part of this deal.

This is a link to the White House's summary of the plan: Fact Sheet: Bipartisan Debt Deal: A Win for the Economy and Budget Discipline | The White House

This is a link to Boehner's powerpoint presentation of the framework to his caucus, which he humorously titled "Two-Step Approach to Hold President Obama Accountable", as if it it was the President that initiated and approved spending bills.  NYT I would just note that both the House and Senate have to approved legislation before the President has the opportunity to sign or to veto it which seems like an introductory comment made by a teacher in a 9th grade civics class that most people must have missed.

Since there has not been enough of downdraft in the market, I am sitting on my cash and did not make a trade last Friday. I suspect that it will take longer to recover from the aftershocks of the Age of Leverage. If the S & P 500 decisively breaks the neckline at 1250, I will likely sit on my hands for longer than I currently anticipate.

1. Earnings Regional Banks (UBCP VLY ONFC FBSS)(own: Regional Bank Stocks' basket strategy):

Valley National Bancorp (VLY) reported net income of 36.9 million or 22 cents in the second quarter, one cent better than the consensus, and up from 20 cents in the second quarter of 2010. VLY is one of my largest positions in this basket. VLY expanded it footprint out of NJ and into NYC with FDIC assisted acquisitions and is in the process now of expanding into Long Island with its proposed acquisition of State Bank and its 17 branch network. As of 6/30/11, the net interest margin was at 3.71%; non-accrual loans tot total loans were at 1.19%; the risk-based total capital ratio was at 13.09%; the efficiency ratio was at 54.95%; and the allowance for losses as a percentage of NPLs was at 105.41%.

Oneida Financial (ONFC), a small savings bank operating in NY, reported net income of $1.7 million or 24 cents, up from 11 cents in the year ago quarter.  Oneida also announced a stock repurchase program of up to 5% of its outstanding stock. As of 6/30/11, the bank had a total risk-based capital ratio of 15.97%; net interest margin was at 3.38%; tangible book value per share was $9.3; the efficiency ratio was at 77.29% (I prefer a much lower number); the tangible equity to tangible assets ratio was at 10.36%; the allowance for loan losses to NPLs was a sturdy 174.43%; and the NPLs to total loans was much better than average at .62%

United Bancorp (UBCP), a small bank operating in Ohio, reported net income for the second quarter of $752 thousand or 15 cents per share, up from 14 cents in the year ago quarter. The quarterly cash dividend is 14 cents per share. The net interest margin is better than average at 4.23%. Non-accrual loans to total loans stood at 1.52% as of 6/30/2011, with the allowance for loan losses to non-accrual loans at 65.97%.

Fauquier Bankshares (FBSS), a small bank operating in two Virginia counties, reported second quarter net income of $1.14 million or 31 cents per share, up from 28 cents in the year ago quarter.  As of 6/30/11, the efficiency ratio was high for banks in this basket at 71.46%; the net interest margin was at 4.06%; NPAs to total assets was at 1.13%; the tangible equity to tangible assets ratio was at 7.7%; and the total risk-based capital ratio was at 13.07%.

2. Husky (own: Canadian Dollar (CAD) Strategy): Husky Energy reported net income of $669 million or 71 cents per share, up from 19 cents int he 2nd quarter of 2010. Production for the 2011 second quarter averaged 311,600 barrels of oil equivalent per day, an increase from 283,900 in the 2010 second quarter.  Cash flow from operations was $1.511 million. All amounts are in Canadian dollars which are worth currently more than USDs. 

3. Impact of EPA Proposed Rules on Owners of Coal Plants-Edison Mission Bonds: The consulting firm ICF International has estimated that up to 20% of the nation's coal fired generation will be shut down this decade due to the EPA's new emission regulations.  Reuters  Those smaller and mostly older coal fired plants would not be able to meet new standards without prohibitive cost retrofits. The EPA estimates that 1.6 billion dollars will have to be spent every year for the next 30 years to comply with the new EPA rule.

This is a link to the EPA's news release on its new rule:  EPA

Duke Power (DUK) has already announced that it will shut one of its Ohio coal plants by 1/1/2015 due to the EPA regulation. Reuters While I own shares of Duke Energy, I am more concerned about the impact of the proposed rules on my Edison Mission senior bonds.

Energy Future Holdings announced that it may have to close 12 coal burning plants in Texas.  Southern Company announced that it would shut two coal stations in Georgia.

As previously discussed, Edison owns a number of coal plants in the 27 states which will be subject to the new rules. These new rules, EM's high leverage and weak margins recently caused Fitch to downgrade the EM senior bonds. Fitch Downgrades Edison Mission Energy & Midwest Generation's IDRs to 'B-'; Outlook Negative I do not know yet whether EM will shut one or more of its coal plants or engage in costly retrofits.  Either choice would be a negative for bondholders.

I intend to sell one or two Edison Mission bonds before the end of this year.

4. Bought 50 GJR at 19.31 on Thursday-ROTH IRA (see Disclaimer):  GJR is a Synthetic Floater in the Trust Certificate legal form of ownership.  The TC GJR represents an undivided interest in  senior Proctor & Gamble bonds owned by a trust and a swap agreement that creates a floating rate. I discuss synthetic floaters, a type of exchange traded bond, in the the Gateway Post for Synthetic Floaters. The reasons for buying this floater in the ROTH IRA are the same as previously discussed in connection with other recent synthetic floater purchases.  Added 50 GYC at $21.60 in Roth IRA;  Bought Back Synthetic Floater GJP at 22.25-ROTH IRABought Back 50 GJT at 18.15-Roth IRA;   Bought Back 50 GJO at 18.55: ROTH IRA. All of those trusts own investment grade senior bonds (AT & T, Dominion Resources, Allstate, Wal-Mart and PG),  the float tied to a short term rate provides some protection against rising rates, and all are selling at discounts to their par value giving me the potential of capital appreciation.  

The main disadvantage for GJR is that there is no minimum payment. For as long as the swap agreement is in force, GJR will pay a monthly interest rate of .7% above the three month treasury bill rate (now very, very close to zero) but no greater than 7.5% based on a $25 par value. In effect and for all practical purposes, the minimum rate is .7% (unless the T Bill yield goes negative) and the maximum rate is 7.5%. The minimum is likely to be paid at least for several more months.

Based on a total cost of $19.31 and a $25 par value, the yield at the maximum rate would be about 9.7% which would be hit when the 3 month T Bill rate exceeds 6.8% during the relevant coupon period. The rate now at that total cost number is close to 1%.

The main advantages of this security is the good credit risk, the possibility of capital appreciation as the spread narrows between my cost and par value, and the float which will make this security more attractive when rates start to rise.

According to FINRA, the underlying PG bond is rated Aa3 by Moody's and AA- by S & P. It matures on 8/15/2034.

GJR Prospectus:
Quote: Synthetic Fixed-Income Securities Inc. Fltg Rate STRATS Series 2006-1 for Procter & Gamble Secs. Seies 2006-1, GJR

I have previously bought and sold GJR:  Bought 100 GJR at 11.29 Sold GJR at $16+

This buy will likely be my last buy for a few days, at least for a long position.

When making this kind of investment, I have to look way into the future. I do not expect much now.