The financial markets have dealt with a cascade of bad news during the past
month. Two large government-sponsored enterprises, Fannie Mae and Freddie Mac,
were placed under conservatorship by the Federal Government. American
International Group (AIG) announced that it received a two-year $85 billion
secured revolving credit facility by the Federal Reserve Bank of New York to
“meet its liquidity needs.” AIG is now in the process of selling business
units. Lehman Brothers filed for bankruptcy. Merrill Lynch is in the process
of merging into Bank of America. Wachovia is in the process of merging with
Citigroup or Wells Fargo. Goldman Sachs and Morgan Stanley agreed with the
Federal Reserve to seek bank charters, which will result in more oversight and
higher capital requirements.
On September 16, the Reserve
Primary Fund, one of the largest money market funds, reported a decline in net
asset value below $1 per share due to losses on the commercial paper of Lehman
Brothers and other issuers. In response to concerns about other money market
funds, the US Treasury announced a Temporary Guarantee Program for Money Market
Funds on September 29. Under the program, the U.S. Treasury will guarantee the
share price of any publicly offered eligible money market mutual fund – both
retail and institutional – that applies for and pays a fee to participate in the
program. Like several European countries, the US Government may soon provide a
blanket guarantee on all bank deposits in order to avoid a mass transfer of
uninsured deposits at the banks to money market funds. Uninsured bank deposits
above the new $250,000 FDIC limit on deposit insurance totaled $1.9 trillion or
27% of US bank deposits at the end of the second quarter of 2008, according to
the FDIC.
On Saturday, October 4,
President Bush signed HR 1424 into law. Division A of the law is titled the
“Emergency Economic Stabilization Act of 2008” and authorizes the Treasury
Secretary to purchase “troubled assets” from financial institutions. The Act
provides initial authorization for $250 billion but an additional $450 billion
can be authorized when the President submits a written report to Congress
detailing the plan of the Treasury Secretary. The Act came at a time when the
short-term interbank lending and the commercial paper markets were seizing up.
One little-noticed feature of the law authorizes the Treasury Secretary to
designate “financial institutions as financial agents of the Federal Government,
and such institutions shall perform all reasonable duties related to this Act as
financial agents of the Federal Government as may be required.” How this
provision of the law will be used remains to be seen.
Nouriel Roubini, a NYU
professor and founder of Roubini Global Economics, now thinks that credit losses
in the US will surpass $2 trillion. He offered his opinion on the bailout: “The
Treasury plan is a disgrace: a bailout of reckless bankers, lenders and
investors that provides little direct debt relief to borrowers and financially
stressed households and that will come at a very high cost to the US taxpayer.
And the plan does nothing to resolve the severe stress in money markets and
interbank markets (by raising capital at banks) that are now close to a systemic
meltdown.”
Peter Schiff, President of
Euro Pacific Capital, believes that the bailout plan will raise concerns about
inflation in the United States: “Where’s the tax increase to fund this bailout?
Where is the cut in programs? The government’s not doing either – They’re just
going to print money. And if you think inflation is the answer, take a trip to
Zimbabwe and see how it’s working for them.”
Many aspects of the global
financial system do not have a productive activity associated with them. Credit
default swaps (CDS), which brought down AIG, are a prime example. The notional
value of over-the counter derivatives worldwide amounted to $596 trillion at the
end of 2007, according to the Bank for International Settlements. This far
exceeds any legitimate hedging purpose associated with companies that are
producing real goods and services. Unfortunately, the widespread participation
in speculative instruments throughout the financial system - what some refer to
as the “casino economy” - has impacted the real economy. Hopefully, government
policies will change to increase capital requirements and eliminate speculative
activities at financial institutions that put depositors’ funds and taxpayer
money at risk. In the meantime, industrial production and employment are now in
the process of declining in many countries simultaneously.
Risk premiums, the
additional expected return on investments above the risk-free rate (the US
T-bill rate is normally used as a proxy), are at very high levels for a variety
of assets. The descriptions of some securities added below will illustrate the
point. The discounts to net asset value on many closed-end funds are at
historically high levels. On September 19, Abhijit Chakrabortti and Jason Todd
of Morgan Stanley offered this opinion:
We believe the equity market has become dominated
by fear and that the risk/reward profile has shifted sufficiently to expect a
sizeable rally. We are not convinced that the longer-term bear market has ended
or even that we have seen the lows in the current cycle, particularly given the
risks that remain in relation to the financial system and the growth outlook.
However, a number of our ‘markers’ for signaling a tactical buy have now been
satisfied. We have become increasingly confident that at around 1200 on the S&P
500, the benefits from a normalization in the risk premium from extreme levels –
which mainly reflect deep concerns about the fate of the financial system – will
outweigh the downgrades to the cyclical earnings outlook. Once risk premiums
normalize, the market should refocus on earnings.
The key questions now are:
1) How long will it take the financial system to regain some sense of stability?
2) What will be the impact of the financial system on the real production of
goods and services? 3) When will risk premiums on assets begin reverting
towards normal levels?
Additions
Gramercy Capital Corp. (GKK)
is a real estate investment trust that invests in commercial office buildings
and commercial mortgages. At the time of purchase, GKK sold at approximately 3X
estimated funds from operations (net earnings + depreciation) or 31% of book
value. After GKK acquired American Financial Realty Trust in April 2008,
leverage increased and the stock price declined. GKK has sold properties during
the second and third quarter and has used the proceeds to buy some of its own
collateralized debt obligations and mortgage-backed securities in the secondary
market at a substantial discount. On July 24, GKK reduced its guidance for 2008
funds from operations to $2.25 to $2.40 per share, due primarily to an increase
in nonperforming loans and provisions for possible loan losses. At midyear, GKK
owned 798 bank branches, 347 office buildings, and 11 parcels of land. The
occupancy rate was 87.6%. Its top tenants are Bank of America and Wachovia,
which account for 45% and 19% of leased space, respectively. At the current
price of $2.27, GKK sells for approximately 1X 2008 estimated funds from
operations. The last quarterly dividend of $0.63 was paid in July but the
dividend is expected by many to be reduced or eliminated. Given the low price
of its debt and preferred stock, the best use of funds now is to repurchase both
in the secondary market.
The John Hancock Patriot
Dividend Fund (PDT) was purchased at a 17% discount to net asset value. The
closed-end fund invests in preferred and common stocks with high dividend
yields. The two largest sectors are utilities and financials, which account for
59% and 24% of the portfolio, respectively. PDT has extended its self-tender
offer to October 23. PDT has a policy of offering to purchase up to 5% of
shares outstanding at a 2% discount to net asset value, provided the Fund sells
at an average discount of 10% or greater during a 12-week measurement period.
The measurement periods occur during the second and fourth quarter of the year.
PDT currently sells at a 24% discount to net asset value and all shares that
were purchased for clients have been tendered to the Fund. The current dividend
yield based upon the market price is 8.4%.
Idearc Inc. (IAR) senior
notes (8% due 11/15/2016) were purchased at a large discount to par value and a
yield-to-maturity of approximately 23%. IAR is a spinoff of Verizon and its
products include yellow and white page directories, Superpages.com, Superpages
Mobile, Switchboard.com, and LocalSearch.com. IAR recently hired a new CEO and
CFO and appears on track to meet its target of reducing costs by 10%. The notes
are rated B3/B- by Moody’s and S&P, respectively. The ratio of EBITDA/interest
expense was 1.9X during the second quarter of 2008. The company appears to be
able to make its interest payments and meet its debt covenants for the
foreseeable future.
Qiao Xing Universal
Telephone, Inc. (XING) manufactures and distributes telecommunications products
in China. It owns 69.9% of Qiao Xing Mobile Communications Co. Ltd (QXM), whose
results are included in the consolidated financial statements. Second quarter
sales declined due to the May earthquake. The company is introducing several
new high-margin products in the third and fourth quarters. Two of the models
will operate using the CDMA protocol and some of the new products will have
features similar to the Iphone. XING’s management expects 40% revenue growth in
2009 due to the new products and the continuance of local Chinese brands gaining
market share at the expense of foreign competitors. At the end of 2007, XING
had $416 million of unrestricted cash. One measure of liquidation value which
assigns a value of zero to noncurrent assets is net current assets (current
assets – total liabilities). At the end of 2007, XING had net current assets of
$513 million, compared to a current market capitalization of $72 million. XING
sells for approximately 3.3X our conservative estimate of 2008 earnings.
Bunge Limited (BG) is a
leading global agribusiness and food company headquartered in White Plains, New
York. BG originates, transports and processes oilseeds, grains and other
agricultural commodities worldwide, supplies fertilizer to farmers in South
America, and produces food products for commercial customers and consumers.
BG currently sells for 4.5X estimated 2008
earnings.
ASA Limited (ASA), a
closed-end fund company that invests primarily in
stocks of companies engaged in the exploration, mining or processing of gold,
silver, platinum, diamonds or other precious minerals. It may also invest in
gold, silver and platinum bullion or securities that seek to replicate the price
movement of gold, silver or platinum bullion. During a period of rapid monetary
expansion that is likely, ASA is expected to maintain purchasing power.
At the time of purchase, ASA sold at a 12% discount to net asset value.
First Trust Aberdeen Global
Opportunity Income Fund (FAM) is a closed-end fund that invests in sovereign and
corporate debt of various countries. 52% of the portfolio holdings are
denominated in US dollars and the remainder in foreign currencies. FAM
currently sells at a 21% discount to net asset value and the current dividend
yield is 12.9%.
The Western Asset Emerging
Market Debt Fund (ESD) was purchased. At the time of purchase, ESD was trading
at a 14% discount to net asset value. ESD invests in the debt of countries
that are considered “emerging markets,” a distinction that is increasingly
difficult to define. 66% of portfolio holdings are denominated in US dollars.
The largest country concentrations are Russia, Brazil and Mexico, which
represent 20%, 15%, and 11% of the portfolio, respectively. ESD currently sells
at a discount of 23% to net asset value and has a dividend yield of 12.6%.
The Morgan Stanley Emerging
Markets Domestic Debt Fund (EDD) is a closed-end fund that invests primarily in
sovereign debt securities denominated in the local currencies of emerging market
countries. The four largest holdings by country are: Brazil 25%, Hungary 18%,
Mexico 17%, and South Africa 13%. At the time of purchase, EDD sold at a 20%
discount to net asset value. EDD now sells at a 25% discount to net asset value
and has a current dividend yield of 16.9%.
Deletions
Insured Muni Income Fund (PIF)
was sold at a 7% discount to net asset value. The fund was under pressure from
a dissident shareholder group that wanted to open-end the fund but management
resisted their efforts. When management does not support such changes, they
usually fail and discounts to net asset value widen again.
SK Telecom (SKM) and Huaneng
Power International (HNP) were sold due to reduced earnings estimates.
Ocean Power Technologies,
Inc. (OPTT) was sold. Based upon discussions with a consultant to a competing
company, Renewable Energy Holdings (REH on the London Exchange), there appears
to be an alternative technology for wave power that has a lower capital cost and
is more likely to be permitted in coastal areas due to its reduced impact on the
environment.
Australian Government bonds
were sold. The Australian currency has a high correlation to commodity prices.
The proceeds were used for the purchase of global closed-end funds which are
currently selling at unusually large discounts to net asset value.
If you have any questions
regarding your accounts, please contact me.
Sincerely,
Robert G. Kahl
CFA, CPA, MBA
Sabino
Investment Management, L.L.C.