Repricing Risk & Recession

Quality is King in a financial and credit crisis. Now is the time to have your guard up and defense on the field.   Look at the risk and reward; you should be well compensated for taking risk in a credit crisis.  Let’s take a look at the fixed income market, there are two things happening at the present time.  There is a huge repricing of risk by investors as those investors have now realized that they were taking on too much risk for too little reward.   This repricing of risk has led to an unwinding of the credit leverage bubble at the worse possible time as the economy goes into a recession.  In order to unwind the leverage and borrowing in the financial system investors are forced to sell assets.  As the economy heads into a recession investors are now demanding more safety and return on their investments so they want to buy at lower prices.  We now have a vicious circle of financial institutions forced to sell assets at the same time investors are demanding better pricing and are concerned about safety.  This is leading to ever lower prices and higher yields in the debt markets.

The following is a list of problems we see in the financial system any of which would not be that big of a cause for concern.  When reviewed together it paints a more disconcerting picture.

The Perfect Financial Storm

We are now seeing severe financial problems in the following markets:

Auction-rate Debt markets $343 billion market

Investment Bank and Broker Debt plus $1 trillion debt

CDOs Collateralized Debt Obligations

Unsold LBO Bonds held by Banks $148 billion

CMOs Collateralized Mortgage Obligations

Sub-Prime Mortgages $300-400 potential billion losses

SIV Commercial Paper $400 billion down to $100 billion

Monoline Insurers Downgrade AMBAC, FIGC, MBIA etc….. $800 billion muni/$580 billion ABS Asset Backed Securities

Credit Default Swaps    $ 43 Trillion  (that is not a misprint)

Derivatives Markets $500 Trillion.

Declining Real Estate Market Nationwide

Overleveraged Consumer

We believe that the combination of the all of the above has created the Perfect Financial Storm during this Credit Crisis in the debt markets.  We have stated for almost eight months that we would exercise extreme caution in these investment markets.  Remember the castle analogy in our last report?  During this “Perfect Financial Storm” it is very important to understand the investments you are in, particularly in the fixed income markets.  If you do not understand the bond or preferred stock you are in ask your broker advisor.

Collapse of the Auction-Rate Bond Market

In our most recent MaxOut Savings Report titled “The Next Phase” we stated the fixed income markets would be next to decline as the investment banks with overleveraged balance sheets would be forced into selling bonds.  We have now seen the first major casualty of this as the brokers pulled back on supporting the auction-rate debt markets with bids.  This has led the auction-rate market to freeze up and trap investors in their auction rate bonds and preferred stock.  In the auction-rate debt markets the coupon or interest paid is adjusted every week, month or at a set time frame.  The theory being that the price will remain at par and the interest rate will rise and fall as needed.   The positive is that once the auction fails, they receive the highest rate at which the debt can be set.  In some cases investors have gotten 20% tax free. A failure in the auction-rate debt market happens when there are more sellers than buyers in the market. In the past the brokerage firm would step up and buy some of the debt and the yield would be set at where they bought it yield wise.  The market failed because Merrill Lynch, Citigroup, Goldman Sachs and UBS are no longer supporting the markets due to troubles of their own.   We hear that there have been conference calls to the brokers at some of these firms explaining to them why the firm is leaving the clients to fend for themselves in this situation.

If you have some of these investments, the key is to look at the yield you are getting and the assets backing them.  In many cases if the investment auction fails you will get a very high return, so you are foregoing liquidity for yield; not a bad trade off if you do not need the money.  The safety of the issue is a key concern.  Most money market preferred stocks from closed-end bond funds are backed by quality assets at 2-3 times the value of the outstanding preferred stock.  This very high quality asset backing makes these auction-rate preferred stocks a very good investment.  If the backing of the auction-rate preferred stock or bonds is anything less than an asset to debt ratio of 1.3 to 1, then we would sell the investment.

CDS Credit Default Swaps

I can hear our readers now: Ted I do not know what a credit default swap (CDS) is nor do I care.  A Credit Default Swap is simply a contract that will pay off if a creditor or company defaults on their debt.  They were used to buy protection on less that AAA rated debt and thereby converting it to AAA in some cases.  The Credit Default Swaps are also used to speculate in the debt markets with companies in financial trouble.  This is why you should be concerned because there is $43 trillion dollars worth of credit default swaps out there right now.  Here is what Bill Gross head of the Pimco Real Return Fund the largest bond fund in the world wrote recently about credit default swaps or CDSs in a paper titled Pyramids Crumbling:

Pyramids Crumbling

“While the exact amount of reserves supporting the Bank of Shadows is undeterminable, let’s go back to the $45 trillion BIS estimate of outstanding CDS for more insight. If total investment grade and junk bond defaults approach historical norms of 1¼% in 2008 (Moody’s and S&P forecast something close) then $500 billion of these default contracts will be triggered resulting in losses of $250 billion or more to the "protection selling" party once recoveries are inserted into the equation. To put that number in perspective, many street estimates ascribe similar losses to subprime mortgages, a derivative category substantially distinct from CDS insurance. Of course, "buyers of protection" will be on the other "winning" side, but the point is that as capital gains and capital losses slosh from one side of the shadow system’s boat to the other, casualties and shipwrecks are the inevitable consequence. Goldman Sachs wins? Fine, but the losers in many cases will not be back for a return match. Much like casinos depend upon a constant stream of willing gamblers believing that this is their day, so too does Wall Street. But a trillion dollars of SIVs with their asset-backed commercial paper may be a dinosaur relic of yesterday’s shadow system. They will likely not be back. And the New Century mortgage originators? The Bear Stearns hedge funds? The chastened Freddie Macs and Fannie Maes, and all of the banks and investment banks requiring fresh capital through the sale of stock? They’ll be back but not in risk taking, fighting form. Throw in an embarrassed regulatory network consisting of the Fed and Congressional watchdogs asleep at their post, but are now more than willing to display their prowess, and you have a recipe for credit contraction, a run on the shadow banking system that would give Mr. Stewart shivers aplenty. The unfairly "Ben Stein pilloried" Jan Hatzius of Goldman Sachs estimates that mortgage related losses of $200-400 billion alone might lead to a pullback of $2 trillion of aggregate lending. Even if this occurs gradually, he writes, "The drag on economic activity could be substantial." Add to that my $250 billion loss estimate from CDS, as well as prospective losses in commercial real estate and credit cards in 2008 and you have a recipe for a contraction in credit leading to a recession.”

Derivatives Markets

Some estimates place the amount of derivatives at $200 trillion; this number is somewhat deceptive because it includes all types of contracts for debt, stocks and commodities.  Warren Buffet has called derivatives weapons of “mass financial destruction.”  Derivatives make it very hard to value the financials because you could go over the books of a company for months then open a drawer and there is $10 billion of liabilities.  This is what happened to Societe Generale when they had a $7 billion loss from private trading contracts.  There will be more derivative losses from trading and fixed income problems during the year.

How do we solve this Problem? Lower Rates & Stimulus Spending

This will all result in a recession in the United States later this year as the Credit Crisis works its way through the economy.  The Credit Crisis will hurt the indebted consumer and cause further cuts in consumer spending.  The extent of the financial problems will take more than just lower interest rates from the Federal Reserve.  We expect it will take a combination of lower short term rates, tax cuts and very heavy government spending to stabilize the economy.  In the past we have stimulated the economy with tax cuts. This has gotten more difficult because taxes have been cut so much over the last 20 years that it is harder to find places to further reduce taxes. The Congress and President just passed a $150 billion stimulus plan that includes about $100 billion of tax credits for consumers. This could be just the start for this year and next if the economy weakens as we suspect it will.  We have now seen US Government budget deficit estimates for 2009 and forward of over $700 billion.  This will be done to support domestic demand in the economy; hopefully we will see better targeted spending than the ‘China Relief Program” of tax credits just passed by Congress and the President that will just be spent at Wal-Mart on imported Chinese goods.  At MaxOut Savings Advisors we believe it will take all of the above actions plus creative programs from industry and the government to get us out of this problem.  The one thing that should be avoided is a bailout program for Wall Street and speculators.  In addition any loans from government agencies or the Federal Reserve should come with equity participation.  That is if we lend money to the company to save it we should get part ownership of the company plus loan repayment.

Liquidity not Foreclosures

The interesting thing so far is the majority of the problems have been in the fixed income or debt markets as a result of excess leverage rather than defaults.  To put it another way, the problems are due to forced selling not actual failure or default of the bonds.  Look at the mortgage markets, well over 95% of the mortgage loans are fine and paying on time.  We expect this to change in the future as the economy continues to slowdown into a recession; but for now this has been a problem with liquidity in the fixed income markets.

Huge Money Supply Growth/Inflation

To combat the liquidity problem the Federal Reserve has been pumping money in the financial system.  Over the last 4 weeks the M2 money supply has increased by $139 billion.  Over the last month the M2 has grown at a 25% annualized growth rate.  This is the fastest rate since 9/11 2001.  We believe this will be inflationary in the future and could put further pressure on the US dollar.  It will be very bullish for gold and silver stocks and appears to have triggered the next bull move up in these stocks.  It will also move long-term rates higher.  The positive is that it is acting to stabilize the stock and bond markets and this is the reason for the liquidity injections from the Federal Reserve.

The Final Phase

The final phase of all this should be a marked decline in the stock market as the economy slows and earnings estimates are cut for 2008 and 2009.   We do not believe that the total earnings decline of a recession has been factored into the stock markets.  We would continue to look at large capitalization companies with good quality balance sheets.  Stay away from companies that have listened to Wall Street and “restructured”.  These “restructured” companies have sold divisions and taken on debt to buy back stock.   Now with the economy slowing, all that debt will slowly strangle the company.  The stock they shrewdly purchased at 40% higher prices with the additional new debt is not as useful either.   As we have continued to see inflation and high government spending the gold & silver stocks should continue to outperform.  At MaxOut Savings Advisors we have maintained high levels of cash patiently waiting for what we believe will be great investment opportunities later this year.  We are particularly watching the credit markets for opportunities that we think will soon develop.  Remember in a Wall Street Land of over-leverage, cash is King!

Next Report: 401K Mistakes and Ideas

For our next MaxOut Savings Report we will try to make things a little more basic and write about 401K mistakes, ideas and help.  If you have a qualified retirement plan it is a MaxOut Savings Report you do not want to miss!

Need Help Managing Your Retirement Investments?

In these volatile times, investing your retirement funds can be difficult and time consuming.  Why not hire the MaxOut Savings Advisors team to manage your money?  If you would like MaxOut Savings Advisors to manage your retirement investments using our value methodology, I would be happy to meet with you.  To schedule an appointment please give us a call at 713-627-0400 or email me at ted@maxoutsavings.com.

Remember Save Aggressively and Invest Conservatively!

Did you know that the MaxOut Savings Advisors money managers can now manage your IRA Rollover at Fidelity Investments?  At MaxOut Savings Advisors we use Fidelity Investments to handle our investments for our clients.  We invest in stocks, bonds and Fidelity and non-Fidelity no-load mutual funds. If you would like to sit down with us at MaxOut Savings Advisors and discuss your IRA Rollover or 401-k or just review your retirement plan give us a call at 713-627-0400 or email me at ted@maxoutsavings.com

Ted K Geoca

President

MaxOut Savings Advisors, LLC

Houston, Texas

ted@maxoutsavings.com                                 713-627-0400

Remember to catch:

The MaxOut Savings Show with Ted Geoca on Saturday at 11:00am on KNTH 1070AM!

The MaxOut Savings Show and Report do not give out financial advice.  Any recommendation idea may not be suitable for all investors.  Moreover although information contained herein is believed to be reliable, its accuracy cannot be guaranteed.  MaxOut Savings Advisors, LLC may or may not have positions mentioned herein. MaxOut Savings is a Registered Investment Advisor registered with the SEC. You should always make investment decisions based on your own financial situation.

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