The turmoil in the credit
markets during late July and early August resulted in significant re-pricing of
risk and changes to financial sourcing. There were three key credit markets
that experienced dislocations: 1) the non-agency mortgage-backed securities (MBS)
market, 2) the asset-backed commercial paper (ABCP) market, and 3) the offshore
LIBOR (London Interbank Offered Rate) funding market.
After problems in the
subprime mortgage loan market emerged in July, several hedge funds and banks
around the world reported surprisingly large losses. Bids from potential buyers
for various types of securities that included subprime loans or non-agency MBSs
became scarce to nonexistent.
Issuers in the ABCP market
found that they were unable to rollover maturing debt and called on their bank
sponsors who had provided backup lines of credit. Buyers in the financial
markets have demonstrated an increased aversion to complex financial instruments
that lack transparency. As a result, banks are gaining market share but they
are raising the cost of financing.
In spite of central bank
liquidity injections during the third calendar quarter, risk premiums rose on
interbank loans quoted in London. Today, the LIBOR rate for 3-month euro loans
remains at 76 basis points over the ECB benchmark rate, compared to 17 basis
points at the beginning of July. The LIBOR rate for 3 month US dollar loans is
at 48 basis points over the Fed funds target rate, compared to 11 basis points
at the beginning of July.
On September 18, the
Federal Reserve reduced its target level for the Fed funds rate, the short-term
interbank lending rate, by 0.5% to 4.75%. The Federal Open Market Committee (FOMC)
said in a statement that the action was taken to “help forestall some of the
adverse effects on the broader economy that might otherwise arise from the
disruptions in the financial markets.” Doug Noland of PrudentBear.com describes
the action as aggressive because the financial markets were anticipating a
decrease of only 25 basis points and several economic indicators suggest that an
interest rate cut was not required. Noland writes:
This decision was made with the US employment
rate at 4.6%. August’s personal income was up 6.8% y-o-y (year over year).
Both the ISM Manufacturing and Non-manufacturing indices were firmly above 50
(indicating economic expansion); monthly trade deficits having settled
stubbornly at around $60 billion (per month); and with nominal Q2 GDP growth
having accelerated to 6.6% (3.8% real GDP) annualized, the highest in five
quarters. Crude was trading at about $80 and gold above $700, as the Goldman
Sachs Commodities index broke out to record highs.
The financial markets
anticipate additional cuts in the Fed funds rate. The current yield on the 2
year US Treasury note is only 4.08%. The consensus opinion appears to be that
the Fed’s primary goal is to support the US housing market and they are
relatively unconcerned about further devaluation of the US dollar or commodity
price inflation. Jim Rogers, co-founder of the Quantum hedge fund in the 1970s,
described the Fed funds rate cut as a mistake and bluntly opined that the
“clowns in Washington” have “signaled to the world they don’t care about the US
dollar.”
On several occasions, we
have seen disappointing US economic news accompanied by a rise in the stock
market. Gary Dorsch, editor of Global Money Trends, argues that some of the
FOMC’s actions appear to be designed to counter the impact of any negative
economic news on the financial markets. For example, on September 27 the Fed
provided a liquidity injection of $38 billion through repurchase agreements
within minutes after the Commerce Department reported that sales of new
single-family homes fell 8.3% and the median price of a new home fell 8.3% for
the month of August. Other Fed liquidity injections have accompanied negative
economic news on job losses, retail sales and home foreclosures. According to
Dorsch, since US Treasury Secretary Henry Paulson began to direct the Working
Group on Financial Markets (aka Plunge Protection Team), “Wall Street dealers
have been given the green light to buy DJI-30 index futures” to provide a safety
net for the stock market.
On October 4, the European
Central Bank (ECB) and Bank of England both left their benchmark financing rates
unchanged at 4.0% and 5.75%, respectively. The ECB was widely expected to raise
its benchmark rate in September to counter inflationary pressures but delayed
any increase due to the credit market dislocations during the quarter.
Australia and Canada appear to be the only countries likely to raise benchmark
lending rates in the near future as their economies remain strong due to
commodity exports.
Gary Dorsch believes that
the inflationary monetary policies of the world’s central banks are the key to
understanding the commodity and stock markets. 18 of the top 20 economies in
the world have been growing their money supply at double digit rates.
The two exceptions have
been Switzerland and Japan. Dorsch writes:
Nowadays, central banks are heavily managing
currency exchange rates in a game of competitive devaluations. To illustrate,
the Federal Reserve is inflating the US M3 money supply by 14% per year, and the
Reserve Bank of Australia is inflating its M3 supply by 18% per year, to keep
the Aussie dollar within close boundaries. So while central banks are able to
guide exchange rates in moderate ranges, the net result is explosive growth of
the world’s money supply, which in turn, leads to massive inflation in commodity
and stock markets. This is the basic theme of the global marketplace today.
There is an ongoing policy
debate about the role of government in avoiding or at least easing the pain of a
credit contraction. Mervyn King, Governor of the Bank of England, warned in a
written statement to the Commons Treasury select committee, “The provision of
large liquidity facilities penalizes those financial institutions that sat out
the dance, encourages herd behaviour and increases the intensity of future
crises.” Alistair Darling, Chancellor of the Exchequer, echoed his remarks by
calling for a return to “good old-fashioned banking.”
The United States appears
to be taking a different approach. On August 31, President Bush announced that
he will let the Federal Housing Administration begin a new program called FHA
Secure to provide refinancing on 80,000 homes that “will help people who have
good credit but who have not made all of their payments on time because of
rising mortgage payments.” Bush said in a statement at the White House, “The
Government’s got a role to play….It’s not the government’s job to bail out
speculators, or those who made the decision to buy a home they knew they could
never afford.” Thomas Donlan, in a Barron’s editorial, called the announcement
a “masterpiece of contradiction and confabulation.” Senator Clinton, on the
other hand, praised Bush for “finally beginning to grasp the seriousness of the
foreclosure crisis” and Senator Chuck Schumer praised him for “starting to sound
like a Democrat.”
I’ll allow Peter Schiff,
President of Euro Pacific Capital, the last word regarding the solution to the
housing bubble:
With the ugly truth laid bare, many now prod
Bernanke and Bush for solutions. Unfortunately there are none. Based on absurd
assumptions about real estate, we simply borrowed more money than we can ever
hope to pay back. There is no magic elixir we can swallow to cure what ails
us. The free market is the only force that can fix this mess. Unfortunately,
the fix won’t be pretty.
Prudent lending standards will return, guaranteeing that real estate prices
collapse…..The financial institutions that are calling most loudly for a bailout
claim the Government must act to protect homeowners. However, the most severe
losses will not be born by homeowners but by those who loaned them the money.
Therefore any bailouts will ultimately go to lenders not borrowers. Homeowners
who offered no down payment and who have no equity in their homes will in
reality lose nothing in foreclosure, except perhaps a debt burden on an
overpriced house. In addition, even those homeowners who made down payments
likely extracted larger sums in subsequent refinancings or home equity loans.
With plenty of available foreclosed homes on the market to rent it is unlikely
that these former homeowners will become homeless.
Additions
The American Century
International Bond Fund (BEGBX), Aberdeen Asia-Pacific Income Fund (FAX), and
some Canadian Government bonds were purchased early in the quarter. I expect
further depreciation of the US dollar and will maintain significant positions
denominated in foreign currencies.
ExpressJet Holdings Inc. (XJT)
was purchased during the quarter. XJT operations include capacity purchase
agreements with Continental Airlines (CAL) and Delta Airlines (DAL), as well as
its own branded regional and charter service through its subsidiary, ExpressJet
Airlines. XJT started its branded service in April 2007. The low passenger
load factor of 39% for its branded segment during the second quarter reflected
the lack of consumer awareness as service was initiated in several cities. The
passenger load factor for the branded segment improved to 65% and 64% for July
and August, respectively. Some nonrecurring expenses were incurred during the
first three quarters as aircraft were painted and modified prior to being placed
into service under the ExpressJet brand name. I expect XJT to return to
profitability by the fourth quarter of this year. Book value is $5.32 per share
and the company has a strong balance sheet with $294 million of cash and
equivalents as of June 30.
NAL Oil and Gas Trust (NOIGF)
is a Canadian investment trust that develops and produces oil, natural gas, and
natural gas liquids. The Trust distributes approximately 70% of its cash flow
to shareholders and invests about 30% of its cash flow to replace reserves. The
current dividend yield is 15.4%.
Tele Norte Leste
Participacoes S.A. (TNE) is a Brazilian telecommunications company that provides
fixed-line, mobile, data and internet services. TNE sells for 10X 2007
estimated earnings of $2.18 but free cash flow is approximately $1.50 higher per
ADR.
US Treasury bills were
purchased during the quarter to maintain high credit quality and a relatively
short average maturity in portfolios. Expectations for higher inflation are
increasing as the US dollar declines and the Federal Reserve maintains high
money supply growth.
Deletions
Endurance Specialty
Holdings Ltd. (ENH) was sold as a precaution. ENH has a significant position in
mortgage-backed securities (MBS) and agency bonds. Although most securities in
the company’s fixed income portfolio have AAA credit ratings, many MBS were
being priced lower in the financial markets. ENH also has a currency mismatch
between assets and estimated liabilities on insurance written that is likely to
lower earnings if the US dollar declines.
The Macquarie Global Total
Return Fund (MGU) and Cohen and Steers Select Utility Fund (UTF) were sold
during the quarter. Both funds are leveraged to some extent and I thought that
a combination of higher interest rates and higher risk premiums for all sectors
could cause a decline in net asset values.
SK Telecom Ltd. (SKM) was
sold during the quarter to provide a source of cash for other purchases.
iShares Silver Trust (SLV)
was bought and sold during the quarter at a loss. Commodities such as silver
should maintain their purchasing power as the Federal Reserve and other central
banks increase their money supplies at high rates. SLV was not responding as I
had expected and I decided to sell.
The Investment Grade
Municipal Income Fund (PPM) was sold. The fund had increased its leverage to
41% of assets and I wanted to reduce holdings of leveraged municipal closed-end
funds and replace them with non-leveraged individual municipal bonds with
shorter maturities.
Equity Inns (ENN) Series B
preferred shares were sold at a loss. The Board of ENN approved a buyout offer
from a group of private equity entities controlled by Goldman Sachs. When the
terms of the acquisition were published, it stated that the Series B preferred
stock would be converted into preferred stock of the acquiring corporation and
the shares would no longer be publicly traded. In addition, there would be no
public financial information available for the acquiring corporation. As a
result, the price of the preferred shares declined more than 20% from its
trading range prior to the acquisition announcement. In my opinion, management
ignored its fiduciary duty to the preferred shareholders. A class action
lawsuit has since been filed on behalf of the preferred shareholders.
Some higher cost tax lots
of Sonic Technology Solutions Inc. (SNVFF) were sold for taxable accounts to
realize losses and offset some realized gains on other securities. New contract
announcements for PCB remediation have been slower than expected and I will
continue to monitor the company’s progress.
Updates
Sonic Technology Solutions
Inc. (SNVFF) announced in August that it had entered into an agreement with
Shell Canada Energy to develop oil sand process innovations that will improve
the economics of oil sands processing. Any intellectual property created will
be owned jointly by Shell Canada and Sonic.
Methanex Corp. (MEOH)
purchased a 20% interest in a dimethyl ether (DME) production and marketing
company from China’s XinAo Group for $5.4 million. DME, which is produced from
methanol, can be used as a clean substitute for diesel fuel in transportation or
power generation, or it can be blended with liquefied petroleum gas and used for
household cooking and heating. MEOH will supply up to 300,000 tonnes per annum
of methanol for the first phase of production of DME at the Chinese plant.
Industry analysts estimate significant incremental increases in methanol demand
from China for DME and fuel blending during the next five years.
Trina Solar Limited (TSL)
announced several contract wins in the third quarter to supply solar
photovoltaic (PV) modules. IBC Solar in Germany agreed to buy 40MW of solar PV
module capacity during the next two years, extendable to a higher volume. Four
different companies in Italy (Enerpoint, Tecnospot, Enereco and EniPower) agreed
to buy a combined minimum of 49M of solar PV module capacity during the next
three years. UBS analyst Stephen Chin said that the Italian Government has a
goal of increasing solar production capacity from less than 100MW in 2007 to
3,000MW by 2015.
Sinovac Biotech Co., Ltd. (SVA)
announced financial results for the first half of 2007. Sales increased 189%
from the prior year to $13.5 million. Operating income and net income were $6.1
and $3.5 million, respectively. SVA had earnings per share of $0.09 for the
first six months of 2007. SVA has a market leading position in China with its
inactivated Hepatitis A vaccine, Healive. In August, SVA announced an exclusive
promotion agreement with GlaxoSmithKline China to market the adult formulation
of its influenza vaccine in China.
If you have any questions
regarding your accounts, please contact me.
Sincerely,
Robert G. Kahl
CFA, CPA, MBA
Sabino
Investment Management, L.L.C.