In an opinion published in
the Wall Street Journal on December 12, Alan Greenspan, former Chairman of the
Federal Reserve Bank, attributed the root of the current mortgage crisis to “the
aftermath of the Cold War, when the economic ruin of the Soviet Bloc was exposed
with the fall of the Berlin Wall.” He writes, “Over the past five years, risk
had become increasingly underpriced as market euphoria, fostered by an
unprecedented global growth rate, gained cumulative traction.”
Dr. Marc Faber, managing
director of Marc Faber Ltd. and publisher of the Gloom, Boom & Doom Report,
offered a different opinion in an October interview with Bloomberg:
If you look at really the source and the origin
of the current problems, they arose from easy monetary policies and rapid credit
inflation over the period…beginning in the 1980s, but more so and at a faster
pace since 2000. We had Y2K – the monetary injection. And then after 2001, the
fed funds rate was cut in January 2001 from six-and-a-half percent to one
percent and kept at one percent until June 2004, when the economic recovery
actually began in November 2001. So, almost three years into the recovery, you
had one percent interest rates, and that led to very strong credit growth. In
the last seven years, nominal GDP has grown by $4.2 trillion and total credit
market debt by over $21 trillion, and it led to a huge leverage. And not only
that, if you have a large debt to GDP or a large debt to equity, that’s one
thing. The other thing is the qualitative distribution. We went into lower and
lower quality credits, and that is the problem now.
Henry Kaufman, President of Henry Kaufman & Company, raises an additional aspect
when he argues that the Federal Reserve and Treasury have failed to keep pace
with a “series of fundamental structural changes that have transformed markets
in recent decades” and that “financial markets have become increasingly
opaque.” He continues, “Compared with a generation or even a decade ago,
financial markets today are much more complex, an order of magnitude larger, and
filigreed with new and often arcane credit instruments.”
There is an ongoing
restructuring of the global financial system. Investors now view with suspicion
business lending models that are based on originating but not necessarily
collecting loans because they are often securitized and sold to somebody else.
As more news surfaces about problems with mortgage-backed securities,
collateralized debt obligations, structured investment vehicles, and other
“financial innovations,” investors are developing a strong preference for
simple, transparent financial instruments. A new accounting standard should
provide additional impetus for simplicity and transparency in the first quarter
of 2008 as financial companies are required to meet a more rigorous standard of
“fair value” and are forced to abandon the “mark-to-model” practices used for
some financial instruments on their balance sheet.
The Financial Accounting
Standards Board issued SFAS 157 to establish more consistency in the methods
used to measure “fair value” and to “expand disclosures about fair value
measurements.” The statement “emphasizes that fair value is a market-based
measurement, not an entity-specific measurement. Therefore, a fair value
measurement should be determined based on the assumptions that market
participants would use in pricing the asset or liability.” The statement became
effective for financial statements beginning after November 15, 2007, and
interim periods within those fiscal years.
SFAS 157 establishes a
hierarchy that prioritizes the inputs for measuring fair value: 1) Level 1
inputs are quoted prices for identical assets in active markets; 2) Level 2
inputs are inputs other than Level 1 quoted prices that are observable for the
asset, either directly or indirectly (e.g. ABX index for mortgage-backed
securities with similar credit ratings); and 3) Level 3 inputs are
“unobservable” (e.g. assumptions from an internal valuation model).
Martin Hutchison, financial
commentator, expressed his concerns about the lack of transparency for Level 3
assets in a recent column:
If Level 3 assets can be valued only by
reference to an internal valuation model, and have been allowed to accrue value
in banks’ financial statements for a decade or more (enabling hefty bonuses to
their progenitors) then how do we know they are really worth anything close to
what the model says, and how do we go about realizing them, in a market where
confidence has vanished? To ask those questions is to answer them. Since every
incentive led bank mathematicians to devise models that maximized the reported
value of the bank’s holdings, and since little or no market existed by which
those values could be checked, it is likely that today those assets’ book values
are highly overstated.
In an apparent maneuver to avoid the use of market quotes (Level 1 or 2 inputs),
some of the major brokers have increased the assets that are valued using
internal models (Level 3). Liz Moyer of Forbes magazine compared the third
quarter of 2007 to the prior quarter. Three major firms had increased their
Level 3 assets significantly: Goldman Sachs by 33% to $72 billion, Morgan
Stanley by 40% to $88 billion, and Lehman Brothers by 57% to $34.6 billion.
Recent “liquidity
injections” into the commercial banking system by the Federal Reserve Bank and
European Central Bank have received attention but Nouriel Roubini, Chairman of
RGE Monitor, believes their efforts will fail. First, the issue is not just
liquidity but solvency and credit problems of many economic agents. Second,
“today’s financial markets are dominated by non-bank institutions – investment
banks, money market funds, hedge funds, mortgage lenders that do not accept
deposits, so-called ‘structured investment vehicles,’ and even states and local
government investment funds – that have no direct or indirect access to the
liquidity support of central banks.” Thus, we have seen banks and brokerage
firms raise additional capital on unfavorable terms from sovereign wealth funds,
while others are denied access to capital altogether.
A recap of some news from
the financial sector for the fourth quarter follows:
October 24, Wall Street
Journal – “Structured investment vehicles, or SIVs – need to find investors for
$100 billion in debt coming due in the next six to nine months, even as ratings
firms continue to come out with reports that lower the ratings of securities in
moves that could further depress the value of SIV holdings. SIVs sell
short-term debt and then use the proceeds to buy longer-term, higher-yielding
securities. But SIVs have had trouble in recent months selling debt, and some
of their roughly $350 billion in assets are backed by U.S. mortgages.”
October 24, Bloomberg –
“Merrill Lynch & Co. reported the biggest quarterly loss in its 93-year history
after taking $8.4 billion of writedowns, almost double the firm’s forecast three
weeks ago.”
November 20, Bloomberg –
Freddie Mac, the second-biggest buyer of U.S. mortgages, posted a third-quarter
loss of $2.0 billion and may cut its dividend and raise capital to weather
“significant deterioration” in the housing market. Chief Financial Officer
Anthony Piszel said, “There is nothing we see right now to be more optimistic
for fourth-quarter performance.”
November 27, Bloomberg –
Writedowns on mortgage-related securities may cost Citigroup $7 billion in the
fourth quarter. Citigroup sold $7.5 billion of convertible shares at 11%
interest to the Abu Dhabi Investment Authority.
December 6, Bloomberg – The
number of Americans who fell behind on their mortgage payments rose to a 20-year
high in the third quarter as borrowers were unable to refinance or sell their
homes. The share of all home loans with payments more than 30 days late,
including prime and fixed-rate loans, rose to a seasonally adjusted 5.59
percent, the highest since 1986, the Mortgage Bankers Association said in a
report today….One in every five adjustable-rate subprime loans had late payments
in the quarter, a number that excludes the one of every 10 already in
foreclosure….Foreclosures started on all types of mortgages rose to an all-time
high of 0.78 percent.”
December 10, Wall Street
Journal – UBS AG, a Swiss bank, announced write-downs of $10 billion on subprime
holdings in the fourth quarter, after a $4.4 billion write-down in the third
quarter. UBS said that it intends to raise $11.5 billion of capital by selling
mandatory convertible notes (subject to shareholder approval) that will pay 9%
interest to the Singapore Investment Corp. and an undisclosed Middle East
country. “Beyond the investments from these two parties, UBS plans to sell
treasury shares and replace its 2007 cash dividend with a stock dividend.”
December 10, Barron’s –
“Fannie Mae disclosed plans to raise $7 billion in new capital in the next
several months…in response to recent losses that shrank the mortgage giant’s
regulatory capital to $41.7 billion, or $2.3 billion above the minimum required
by its federal regulator. The capital-raising was likely prompted by impending
mark-to-market charges that Fannie will have to make in its investment
portfolio, including $42.4 billion of subprime mortgages and securitizations and
$33.8 billion of Alt-A mortgage paper. To match the current prices of these
securities indicated by the ABX index, recent trades and markdowns taken by
various investment banks, Fannie should take an earnings hit in the range of
$6.4 billion to $14 billion, according to one informed source.”
December 14, Telegraph –
“The asset-backed commercial paper market in the US has now shrunk for 17 weeks
in a row, shedding almost $400 billion. Lenders are refusing to roll over
short-term loans as they fall due…”
December 19, Bloomberg –
“Morgan Stanley reported a steeper-than-forecast loss after $9.4 billion of
writedowns on mortgage-related holdings and received a $5 billion cash infusion
from state-controlled China Investment Corp….China Investment, the nation’s
sovereign wealth fund…. is buying securities that convert into Morgan Stanley
shares and pay annual interest of 9 percent.”
December 19, Bloomberg –
“U.S. home foreclosures rose 68 percent in November from a year
earlier…according to data compiled by RealtyTrac Inc. There were 201,950
foreclosure filings in November, including default notices, auction letters and
bank repossessions….Interest rates increased on more than $87 billion of
subprime mortgages in the third quarter, and another $84 billion will reset in
the fourth quarter.” Rick Sharga, executive vice president for marketing at
RealtyTrac, said “I wouldn’t be surprised if we’re at the 230,000 to 250,000
level” for monthly foreclosures in the first quarter of 2008.
December 21, Bloomberg –
“MBIA Inc….disclosed that it guarantees $8.1 billion of collateralized debt
obligations” that include other collateralized debt obligations. “MBIA, Ambac
Financial Group Inc., and other insurers are being reviewed by credit-rating
companies on concern they don't have enough capital to cover potential losses
stemming from mounting downgrades of the securities they guarantee. Fitch
Ratings ratcheted up the pressure on MBIA today, saying it would reassess its
AAA insurance rating for a possible downgrade and gave the company four to six
weeks to raise at least $1 billion. More than $2 trillion of insured securities
would lose their AAA ratings amid mass downgrades of bond guarantors.”
December 21, Associated
Press – “This might have been one of Wall Street’s most dismal years in a
decade, but that hasn’t stopped bonus checks from rising an average of 14
percent.” Four of the biggest U.S. investment banks – Goldman Sachs Group Inc.,
Morgan Stanley, Lehman Brothers Holdings Inc. and Bear Stearns Cos. – will pay
out about $49.6 billion in compensation this year. Of that, bonuses are
traditionally estimated to represent 60 percent, or almost $30 billion.”
December 26, Wall Street
Journal – Merrill Lynch raised $6.2 billion by selling stock to Temasek Holdings
Pte. Ltd., a Singapore state-owned investment company, and Davis Selected
Advisors, LP. The stock was sold at a 12% discount to the previous week’s
market price and “Merrill gave the Singapore fund unusual price protection,
agreeing to reduce its purchase price if Merrill sells its stock at a lower
price during the next year.”
December 26, Bloomberg –
“Billionaire Warren Buffett, the chairman of Berkshire Hathaway Inc., said he
rebuffed U.S. financial firms that approached him recently about buying stakes
in their companies.” He said that “we haven’t seen anything we wanted to move
on.”
December 27, Bloomberg –
William Tanona, a Goldman Sachs analyst raised his fourth quarter write-down
estimates for Citigroup ($18.7 billion), Merrill Lynch ($11.5 billion), and JP
Morgan Chase ($3.4 billion). Tanona estimates that Citigroup will have to raise
an additional $6.2 billion to meet its capital needs.
December 27, Financial
Times – “More than 10 North American banks and fund managers have collectively
injected $3 billion into their money market and cash funds since October to stem
losses….The bailouts, in the form of guarantees, credit lines and the buying out
of troubled securities, are intended to stop funds falling below the $1 a share
promised to investors.”
December 27, Bloomberg –
“ACA Capital Holdings Inc., the bond insurer that lost its investment-grade
credit rating last week, agreed to give control to regulators to avert
bankruptcy…. S&P sliced ACA’s rating 12 levels to CCC, casting doubt on more
than $75 billion of debt the company guarantees, including $69 billion of
securities such as collateralized debt obligations.”
December 28, Bloomberg –
“Assuming that U.S. and European residential property prices fall 5 percent to
10 percent over the next year, investors in non-prime mortgages and securities
linked to them – including banks, hedge funds, asset managers and mortgage
insurers – stand to lose between $350 billion and $500 billion, according to
London-based consultants Independent Strategy. Adding in expected losses from
prime mortgages would lift the tally to more than $650 billion.
Additions
Nuveen Select Maturities
Municipal Fund (NIM) and Nuveen Select Tax-Free Income Portfolio 2 (NXQ) were
purchased during the fourth quarter for some taxable accounts. Both closed-end
funds are unleveraged and currently sell at discounts to net asset value in
excess of 7%. NIM and NXQ have low operating expense ratios and tax-exempt
yields of 4.9% and 4.7%, respectively.
The Delaware Investments
Arizona Municipal Income Fund (VAZ) was purchased for some taxable accounts.
VAZ currently sells at a discount to net asset value of 12% and has a dividend
yield of 5.2%. The fund has investment grade tax-exempt municipal bonds and is
leveraged with 37% of total assets.
The Aberdeen Asia-Pacific
Income Fund (FAX) was purchased for many accounts. FAX invests in government
bonds of Australia and other Southeast Asian countries. The fund currently
sells at a discount to net asset value of 12%, has an average credit rating of
AA and a dividend yield of 7.2%.
The Morgan Stanley Global
Opportunity Bond Fund (MGB) is a relatively small global bond fund with $35
million of net assets, which makes it a candidate for a merger. MGB currently
sells at a discount to net asset value of 12%, has an average credit rating of
BB, and a dividend yield of 6.3%.
Deletions
Telefonos de Mexico (TMX)
was sold at a profit. TMX announced that it will divide the company into two
separate companies through the spin-off of all its Latin American and yellow
page businesses to a new independent holding company to be called Telmex
International. A significant amount of cash will be transferred to Telmex
International for potential acquisitions while TMX will continue to be
responsible for most of the debt. TMX is likely to dedicate more of its cash
flow to reducing debt during the next few years.
ExpressJet Holdings Inc. (XJT)
was sold at a loss. Although XJT has a high level of cash, earnings estimates
have continued to decline further and the consensus estimate for 2008 is now a
loss of $0.80. The company has not yet demonstrated its ability to improve
pricing in the branded segment, which is essential to returning to
profitability.
The United Kingdom
Government bonds were sold during the quarter. The Bank of England lowered its
overnight lending rate in response to a weakening economy. The interest rate
advantage of UK bonds relative to other countries is likely to decline further.
Updates
Since June 15, Methanex
Corp. (MEOH) has been unable to procure natural gas from Argentina, which
supplies 60% of its raw material requirements in Chile. Consequently, three of
the four Chilean plants have not been operating. The three idled plants owned
by Methanex in Chile represent 8% of world methanol production capacity.
Combined with other industry conditions, the constrained supply has led to
record high prices for methanol in December and January. The net impact of
reduced production and higher prices has been positive for MEOH and earnings
estimates have increased steadily during the fourth quarter. MEOH also recently
announced a memorandum of understanding for a joint venture in Egypt that will
produce 200,000 tonnes of dimethyl ether (DME) per year. DME may be blended
with LPG for cooking fuel or other types of fuel for transportation.
The Premier of Alberta, Ed
Stelmach, proposed changes to the Province’s royalty rates for energy resources
to ensure that “Albertans receive their fair share.” The new royalty rates are
likely to be approved by the Provincial Government and should become effective
on 1/1/2009. The simplified royalty formulas for conventional oil and natural
gas will operate on sliding scales that are determined by commodity prices and
well productivity. A sliding scale for royalties on oil sands will depend on
the price of oil. The change will have a negative impact on Canadian Natural
Resources Ltd. (CNQ) because of the higher royalty rates on oil sands and
natural gas from high production wells. As a result, CNQ intends to reduce its
natural gas drilling program and production by 30 to 50% in Alberta. The
Province accounts for 85% of CNQ’s total natural gas production. The change in
royalty rates will have a negligible impact on Penn West Energy Trust (PWE) and
NAL Oil and Gas Trust (NOIGF), according to their investor relations officers,
because they have lower production conventional oil and natural gas wells.
Sonic Technology Solutions
Inc. (SNVFF) announced in October that it had licensed its mobile PCB treatment
technology to Quantum Murray LP for use in Canada. Quantum Murray LP is one of
the largest full-service decommissioning and environmental remediation firms in
Canada and has the ability to obtain performance bonds on large projects.
Phoenix Group Mexico has also notified Sonic that it intends to exercise its
option to license the PCB treatment technology for use in Mexico by January 31,
2008. Both agreements will allow Sonic and its licensees to share equally the
net proceeds from any PCB treatment projects. Sonic will also sell equipment
and maintenance contracts to its licensees. Sonic is currently seeking a
licensee/joint venture partner for the United States.
On November 21, Trina Solar
Limited (TSL) reported $0.29 earnings per share for the third calendar quarter.
The actual earnings were $0.06 less than the consensus estimate and the stock
price declined by 23% for the day but has since fully recovered. On the
earnings conference call, TSL’s management said that they expect to meet their
goal of increasing production capacity to 150MW and 350MW for 12/31/07 and
12/31/08, respectively. TSL has pre-sold 100% of its first half/2008 planned
module production and 50% of its second half/2008 planned production. The
company expects to improve gross margins by reducing its outsourcing ratio of
solar cell production from 75% in the third quarter to 25% in the fourth quarter
and lower it further in subsequent quarters. TSL also intends to construct its
own polysilicon (raw material for solar cells) plant to reduce costs further.
The initial phase of the polysilicon plant is projected to cost $455 million and
will take about two years to construct. After the conference call, the Raymond
James analyst lowered his price target to $66 per share, based on expected
dilution from the financing for the polysilicon plant.
If you have any questions
regarding your accounts, please contact me.
Sincerely,
Robert G. Kahl
CFA, CPA, MBA
Sabino
Investment Management, L.L.C.