Hyman Minsky was an
American economist who died in 1996. His predictions about the relationship
between the financial markets and the economy have been fully realized in recent
years. In his book, Inflation, Recession and Economic Policy, Minsky
wrote:
Innovations in financial practices are a feature
of our economy, especially when things go well. New institutions…and new
instruments… increase in volume and find new uses. But each new instrument and
expanded use of old instruments increase the amount of financing that is
available and can be used for financing activity… Increased availability of
finance bids up the prices of assets relative to the prices of current output…
Lending institutions and
politicians now profess shock that the increased use of “innovative” loan
structures could go so wrong so fast. The potential problems of balloon,
no-documentation, option adjustable rate, piggyback, teaser and stretch loans
now seem obvious after an extended boom period when there seemed to be little
risk for both lenders and borrowers due to ever-rising house prices.
Prime conventional loans
represented only 45% of residential real estate loans originated in 2006.
According to the Mortgage Bankers Association, 13.3% of sub-prime borrowers were
delinquent in the 4th quarter of 2006, while delinquencies on all
types of loans rose to 4.9%. In 2006, 1.2 million homes were lost through
foreclosure. Foreclosure estimates for 2007 now range from 1.5 million to 2.2
million. In some cases, foreclosures may be technically averted by a “mortgage
short sale,” in which the lender agrees to accept a sales price that is less
than the loan balance. This will result in a partial write-off of the loan
balance but avoids the cost and time of a longer foreclosure process. Another
alternative to foreclosure is a transfer in lieu of foreclosure, where the
borrowers simply transfer the deed to the lender.
As lending standards have
tightened, borrowers either qualify for smaller loan amounts or they no longer
qualify at all. On the supply side, foreclosures and forced sales by
financially strapped borrowers will increase the supply of homes for sale,
offset to some extent by a decline in new home construction starts. Changes in
the residential real estate market will have a negative impact on the economy
due to the direct effects on construction and the negative “wealth effect” on
consumer spending.
Washington legislators have
expressed their concerns about real estate lending problems, without offering
any specific solutions. Senator Christopher Dodd said that the government needs
to provide at-risk homeowners “forbearance or something like that to give them a
chance to work through and get a new financial instrument here that they can
manage financially better.” He thought that a few billion dollars of federal
aid “may be a lot less costly” than the lost wealth from foreclosures. Senator
Hillary Clinton also called for lenders to give borrowers who fall behind on
their mortgages a “foreclosure timeout” to allow them time to develop a payment
plan.
In a recent Wall Street
Journal survey of 54 economists, only 11 cited housing as the chief risk to the
economy while 20 cited capital spending. The economists estimated the
probability of a U.S. recession at 26% over the next twelve months, which
contrasts sharply with expectations of most people. A recent Bloomberg/Los
Angeles Times poll found that 60% of Americans expect a recession. The
nonprofessional forecast has been a good indicator in the past. In a December
2000 poll by the Los Angeles Times, 64% of people surveyed correctly predicted
the last recession.
Additions
Penn West Energy Trust (PWE)
was purchased during the quarter. PWE is one of the Canadian income trusts
which dropped in price last October after Canada’s Finance Minister, James
Flaherty, proposed changes to tax trust income distributions at the corporate
level, effective in 2011. In 2006, PWE produced more than 112,000 barrels of
oil equivalent per day of oil and natural gas. The company has a high drilling
success rate and 3.7 million acres of undeveloped lands which are likely to
provide additional reserves in the future. PWE distributes most of its income
to shareholders and plans to maintain its monthly distribution of C$0.34, which
provides a dividend yield of 11.9%.
Endurance Specialty
Holdings Ltd. (ENH) is a Bermuda-based company that underwrites specialty lines
of personal & commercial property insurance, casualty insurance, and reinsurance
worldwide. ENH has a strong balance sheet, with a common shareholders
equity/asset ratio of 30%. ENH currently sells for 6.6X estimated earnings for
2007.
Administradora de Fondos de
Pensiones Provida, S.A. or Provida Pension Fund Administrator (PVD) was
purchased after the end of the first quarter. PVD is Chile’s leader in the
pension fund industry with a 31% market share of assets under management. PVD
currently sells for 7.2X trailing earnings and intends to pay 50% of its
earnings to shareholders in the form of dividends.
Some U.S. Treasury bills
have been purchased during the quarter. T-bills currently offer a higher yield
than longer-term maturities and provide a liquid source of cash for purchases.
MFS Charter Income Trust (MCR)
and MFS Intermediate Income Trust (MIN) were purchased during the quarter for
many retirement accounts. Both MCR and MIN sell at discounts to net asset value
that exceed 10%. Approximately one-third of their portfolios consist of foreign
government bonds and the average credit quality is high.
Insured Municipal Income
Fund (PIF) and Seligman Select Municipal Fund (SEL) were purchased during the
quarter for some taxable accounts. Both funds sold at discounts to net asset
value that exceeded 10% when purchased and the average credit quality is AAA.
The funds use some leverage and the tax-exempt dividend yields for PIF and SEL
are 4.8% and 4.6%, respectively.
Deletions
First Trust Aberdeen Global
Opportunity Income Fund (FAM) was sold. FAM was selling near net asset value
and the proceeds will be used to purchase other closed-end funds that sell at a
discount to net asset value.
Compania Anonima Nacional
Telefonos de Venezuela (VNT) was sold. Although the operating results of the
company have been excellent, there has been considerable political interference
from the Venezuelan Government. Venezuela announced its intention to increase
its ownership of the company at a price that may not reflect its fair value.
There is also a possibility that VNT’s shares may eventually be delisted from
the New York Stock Exchange. An additional dividend of approximately $1 per ADR
should be forthcoming after approval of the currency exchange for the payment by
the Venezuelan government.
Updates
Methanex (MEOH) had record
profits in 2006. Basic earnings per share were $4.43. The price of methanol
was abnormally high during the third quarter of 2006 and the first quarter of
2007 due to operational problems that two competitors experienced last August.
Product prices have now returned to normal levels and the price of MEOH stock
has declined. MEOH now sells for 7.8X the average earnings estimate for 2007
and free cash flow exceeds earnings by about $0.50 per share. During the last
eight years, MEOH has consistently used cash flow to reduce shares outstanding
from 173.1 million to 105.8 million shares as of 12/31/06.
The discounts to net asset
value on many tax-exempt closed-end funds have declined further in recent months
and the funds are usually leveraged. I have maintained a low allocation to
tax-exempt closed-end funds until more of the funds are available at larger
discounts to net asset value, which is likely if there is any significant rise
in interest rates.
If you have any questions
regarding your accounts, please contact me.
Sincerely,
Robert G. Kahl
CFA, CPA, MBA
Sabino
Investment Management, L.L.C.