We're with AIG!

Some of you might recall the commercial where a little boy shows up at his parents’ bedroom door. The mom asks, “what’s wrong, did you have a nightmare?”, and the boy responds by saying “No, I’m concerned about this family’s financial future”, and he rattles off a variety of issues facing all of us: retirement plan predictability; supplemental health insurance; estate planning; and car insurance. Finally, the father responds, “Buddy, we’re with AIG!”, and the boy says ‘Oh, don’t get up, I’ll tuck myself in.’ (Watch Video)

Well, that poor little boy IS having nightmares and the term “We’re with AIG!” took on a whole new meaning this week. The market value of one of the world’s largest companies plummeted this week as AIG sought to raise capital to post additional collateral on their outstanding obligations.

AIG is one of the largest insurers for the obligations of other companies. The instruments are called Credit Default Swaps and many investors, including hedge funds, buy these CDS’s as insurance against a company defaulting on any of their debt. With the housing and credit crisis causing many firms to collapse or otherwise default on their payments, AIG has been on the hook as the insurer, causing both S&P and Moody’s to downgrade AIG.

Once a company is downgraded, many of the creditors can ask the company to post additional collateral and in the case of AIG, that additional collateral was initially estimated to be $15 billion or higher. With a lower credit rating and a stock price approaching zero, AIG has been left with very few options to raise the needed capital. That is why the FED, the Governor of NY, and several others were scrambling to figure out how to resolve the issue. Meanwhile, the share price for AIG continues to spiral downward. Without a resolution, AIG will be forced to file for bankruptcy and the potential of a systemic shock across the globe would be imminent.

The fear arises from the fact that AIG equity and debt is very widely held by institutions all over the world. It has operations in over 130 countries and if these securities are deemed worthless, there is the possibility of more writedowns, additional downgrades, and mounting liquidity issues.

So in order to reduce the probability of a global meltdown and asset writedowns for many of the money market mutual funds that hold AIG debt, the verdict is that AIG will receive an $85 billion loan from you, me, and every other person that pays taxes, and the US government will own 79.9% of AIG. The result is an extension of a wedding between two mortgage giants, consummated earlier this month, and includes a diversified insurance company to boot (kind of like a mother-in-law that you weren’t counting on!) A much more exotic combination, for sure! Can you say ménage ‘a trios?

Don’t get up, I’ll tuck myself in!!

The Economy Still Coughing

The beige book released by the FED today showed signs of weakening across all US regions. The lone bright spot in the economy, exports, may even begin to slow down as foreign demand slows further. There were a few data points that gave the markets optimism, but the bad news was far more dominating.

Rollercoaster

When the markets opened today, all the indexes shot through the roof and it looked like it was going to be a positive day. With oil down 5% on the day after Gustav slowed down, it looked like a typical reaction by the equities. But at the end of the day, the Dow, S&P, and Nasdaq all ended in negative territory, while oil prices remained at 5-month lows. Huh?

What is a Hedge Fund?

Hedge funds and mutual funds have many similarities. A mutual fund is a pool of assets made up of investments from many different individuals and institutions. They invest in mutual funds because mutual funds provide diversification and there is a person or team of people that manage the investments of that mutual fund, usually under an investment mandate explicitly stated in the fund’s prospectus. (So what are the differences?)

A hedge fund is very similar in that it is a pool of assets from many individuals or institutions. In the case of hedge funds, however, they are limited in the number of investors they can have and the types of investors they can accept. The number of investors depends on whether the fund is a 3c1 (100) or 3c7 fund. For the most part, only accredited investors can invest in hedge funds. An accredited investor is one that has $1 million in investable assets and has made over $200,000 a year in two of the preceding three years. If a couple is being considered together, the requirement increases to $300K.

Both hedge funds and mutual funds can invest in the same securities. At least in most cases. The difference is that hedge funds can enter into combinations of investments not available to mutual funds and they can also apply leverage to their portfolios. There are probably as many unique hedge fund investment strategies as there are hedge funds so for simplification we try to categorize the different strategies to make comparisons. The process is similar to grouping large cap managers with large cap managers, or growth managers with growth managers.

Some of the hedge fund strategies include: long/short, convertible arbitrage, merger arbitrage, relative value arbitrage, global macro, commodity trading advisor, fixed income arbitrage, and several others. There are a handful of hedge fund indices that have their own set of indices and similar but distinct categories. For the time being, I’ll describe a very simple long/short strategy.

When a mutual fund manager thinks a stock will appreciate from $50 to $100, they will buy the stock. A hedge fund will do the same. However, if a mutual fund manager thinks a stock’s price will go from $100 to $50, there is nothing they can do. A hedge fund however, can borrow the stock from someone else, sell it in the market for $100, and hope they can buy it back in the future for $50. If they are right and the stock drops to $50, they can buy it in the market and return the borrowed stock plus interest. The net result to the hedge fund manager is a profit of $50 minus interest to borrow the share. This is called short-selling, and long/short hedge funds enter into a diversified set of transactions on both stocks expected to appreciate (long) and stocks expected to depreciate (short).

We should also consider that many hedge funds are managed by some of the most talented fund managers. Lured by the thought of 2% management fee and 20% incentive fees, many good managers may leave the larger mutual fund firms or brokerage houses to start their own hedge fund. There is a drawback, however, which is that the 2/20 fees also attract poor managers and now that there are close to 10,000 funds, by some estimates, it gets harder to uncover good managers.

Within a portfolio, hedge funds can provide good diversification and either enhance returns or reduce volatility. There are hedge funds that are designed to generate very high returns, sometimes reaching 30% or more. These hedge funds carry with them a great deal of risk, however. It’s the only way to generate such high returns and although risky, can enhance returns to a well diversified portfolio. There are other hedge funds that use very conservative strategies that can be used as substitutes to fixed income, particularly now that interest rates are so low. These funds provide stability to a well diversified portfolio and uncorrelated returns to both stock and bond markets.

Don’t believe all the hype that hedge funds are bad. The only ones that make the news are those that blow up. We never hear about the ones who quietly generate 12% per year with low volatility. That would be too boring for CNBC to cover. That’s OK, we’ll cover them here!!

The Consumer Grows Weary

The economy seems to be struggling along and you wonder if it might not be better for the thing to finally collapse than to torture us through this never-ending drip drip drip of stagnation. Economic data continues to have huge impacts on the movements of markets but for every ounce of good news, there is an equal if not greater amount of bad news.

Gross Domestic Product was revised upward to 3.3% from an expected 2.9%. Taken alone, that is not a bad level of growth for our economy. However, dissecting the parts reveals that the majority of that growth was driven by the growth in exports due to the weaker dollar, and the contraction in imports due to slower US demand for foreign goods. The overall impact of the export/import affect is estimated to be 3.1%. For those of you who don’t remember, GDP is made up of government spending, consumer spending, business investment, and exports minus imports. If the exports minus imports portion was 3.1%, the remaining drivers contributed a measly 0.2%. That is why it feels like we are in a recession even though the GDP numbers are coming in strong.

Consumer spending, which had been kept afloat by the federal stimulus package during the second quarter, seems to finally be weakening amidst higher unemployment and higher prices. In July, personal income declined by 0.7% from the prior month and consumption measured in real terms (accounting for inflation) fell by 0.4%. It looks like the consumer is starting to reach for the white towel. There is some hope however, in that consumer confidence had increased from prior month levels, but the index is still at recessionary levels and much of the improvement in confidence came from lower prices at the pump.

Even though the weak dollar should continue to benefit US exporters, the slowing growth in foreign markets will serve as a counterforce and should mute the affect of currency advantages. The real question looking forward to the rest of 2008 and into 2009 is how well the manufacturing sector holds up and how the consumer will react. The manufacturing sector has held up well as revealed by an unexpected rise in durable goods orders. Month over month, durable goods increased by 1.3% but a closer look shows that when adjusted for inflation, the increase was only 0.3%.

As for the consumer, the tax rebate impact is now gone and estimates are that only 30% of the rebates were spent. The rest of the money was used to either pay down debt or is being saved for a rainy day. With so many hurricanes swirling around, this may not be such a bad idea.

We should expect slower growth in Q3 and Q4 as issues continue to be shaken out and those less affected wait and see. There was a time not long ago when economists were insistent about the world economies ‘decoupling’ from the US. Either they were completely wrong or it just happens to be a coincidence that the world is now starting to slow considerably.

The Biggest Wedding of the Year?

The latest word is that perhaps the best way to solve the problems of two separate but similar entities is to have them joined. With Minister Paulson as the master of design, it’s quite possible that Freddie Mac and Fannie Mae will be united in what may be the biggest wedding of all time.

As foster mother, OFHEO failed to live up to her motherly obligations and now we have Freddie and Fannie running rampant and causing all types of havoc. With plans to have the ceremony at the White House, the reception on Capitol Hill, and the honeymoon at the Treasury, you would think the two crazy kids would have gotten hooked a long time ago. The Treasury, after all, does print the money you know! (See Below)

There has been talk about the possibility of merging Fannie Mae and Freddie Mac. How and when that would happen is still a mystery. But one thing is certain. The failure of one or both of these Government Sponsored Entities (GSE) would be disastrous. If one of these GSE’s fails, we could assume that the same forces will cause the other GSE to fail, in essence, making the mortgage market all but shut down in the near term.

Fannie Mae and Freddie Mac were established to make homes more affordable for lower and middle income Americans. They are both ‘sponsored’ by the US government but the implications of that have become dubious at best. Neither provides home loans, but each one stands ready to buy mortgages from banks in order to take them off the banks’s books and provide the bank with capital to make additional loans. In some cases, the GSE’s don’t buy the mortgages, but provide a guarantee in the event of default. They currently hold or guarantee roughly half of the $12 trillion market in mortgages making it clear that their failure would be much worse than the failure of Bear Stearns would have been.

For many years, critics of the two firms pointed to their sheer size and business practices and felt that they were both too big and unregulated. They were both extremely risky, some said. Their size didn’t happen by mistake, however. Over the years, both firms lobbied hard to pass legislation that allowed them to remain independent, grow rapidly, and remain unregulated. As the connection between the GSE’s, Wall street, mortgage bankers, real estate agents, and lawmakers became tighter, both Fannie and Freddie became profit drivers for the above-mentioned constituents, which made sure that the status quo held firm. Both firms had members of their board who were tied to political power-players and they hired well connected lobbyists to protect their interests. In the early 90’s the Office of Federal Housing Enterprise Oversight (OFHEO) was made regulator for both Fannie and Freddie, but we now know that OFHEO was a weak regulator.

So what went wrong? Since Fannie and Freddie owned or guaranteed roughly half of all outstanding mortgages, the subprime meltdown and subsequent effects has had a detrimental effect on the value of the assets they hold. As foreclosure rates rise, they are on the hook for those mortgages and the mortgages they hold, and which are now trading at much lower levels. It moves them closer to violating their minimum capital requirements and making them look insolvent. As a matter of fact, by general accounting standards, if their assets were marked-to-market (priced at what current buyers are willing to pay), some economists say they are already worthless!!

Since banks and other lenders rely on Fannie and Freddie to buy their mortgages in order to free up capital and make more mortgages, the elimination of either or both of the GSE’s will freeze up the housing market through ever tightening bank standards. Already, even the most qualified borrowers are facing less favorable loan terms.

Now, Treasury Secretary Hank Paulson is considering all possible options, along with Ben Bernanke and a few others. One possible scenario was a merger of the two to form one larger, more stable firm, but this would be highly unlikely. Besides the uncertainty of whether a merged firm will emerge stronger than the sum of it’s parts, it doesn’t address the risks inherent in the business model. Risks that are surfacing now: that perhaps these agencies got too big!

There is also the possibility of further regulation, in the form of higher capital requirements or limits to lending standards. For some, this would be a natural step since both Freddie and Fannie have always been free-wheeling children of the US Government. The least that the US government could do is give the agencies a curfew.

Finally, one or both agencies can be placed in a conservatorship. In this scenario, their shares would be worthless and you, me, and the rest of the taxpayers will pick up the tab. A conservatorship has quite a bit of flexibility to overhaul the agencies but cannot close them. What will come out of this will surely be some form of consolidation and distribution. Perhaps a smaller, combined entity can fulfill it’s purpose within a system that will eventually shift risk to the private sector. It would be a huge undertaking and could take a decade or longer to complete.

When it’s all said and done, we should end up with a structure that on the surface looks less risky. But rest assured that financial innovation will someday challenge the limits of even the most well thought out solution.

More Housing Data

And yet again it came in mixed. The Case-Shiller Home Price Index decreased yet again but in what some economists termed, 'Some regions are struggling to turn things around', some regions actually showed flattening trends. Even nationally, the rate of decline seems to be slowing somewhat. Now the focus turns to buyers and the forces pulling in opposite directions. As home prices have fallen to make homes more affordable, bank lending standards have tightened and mortgage rates have risen, making it more difficult for buyers to obtain financing. Even if prices stop falling, it will be awhile before they begin to rise again and it would require a resolution of Fannie and Freddie issues to give banks enough confidence to lend again. But speaking of confidence, consumer confidence ticked higher for the second month in a row. No, that doesn't mean consumers think the economy is better. Actually, the survey showed that consumers opinion of the current situation is still bleak. However, their assessment of the economy over the next 6 months improved in some categories. A sign of things to come? Perhaps.

Mixed Up Housing Data...

Causes even more confusion and speculation. The National Association of Realtors reported that home resales last month rose 3.1% to an annual rate of five million units. It was higher than expectations which under normal circumstances would be a good thing. But, as we have seen time and time again, bad news is never too far from good news. While home resales increased, it came at a steep price, or rather, a steeply declining price. The median home price decreased another 7.1% to $212,400 from a year earlier and the number of homes on sale increased to a record-high of 4.67 million. My interpretation: there is still a whole lotta supply out there and more homes may be put up for sale, but I think we are finally seeing some buying activity. For months, prices kept declining and buyers kept staying away. But I don’t have a crystal ball anymore (I had to pawn it!) so I won’t even try to predict a bottom for housing.

The Russian Oil Mob and US Housing

As the Olympics come to an end and the final medal counts are tabulated, someone not paying attention may be surprised to see that Russia is third on the list of total medals won. The world has shone a light on China and their flamboyance has lived up to and even surpassed expectations. Some estimates reach $50 billion in total spending by the Chinese in preparation for the Olympics and their desire to showcase this rapidly waking giant has been nothing short of magnificent.

But quietly sitting at third place in total medals is Russia, and the Georgian conflict aside, I think many of us have forgotten that Russia is the second largest oil exporter in the world. Many traders blamed the Georgian conflict for the huge upswing in oil prices this week, which dropped just as quickly by the end of the week when Russian forces began to pull back. While some economists started calling a bottom on oil, Goldman Sachs and others reiterated their $150 price target for oil by the end of the year. If that’s the case, consumers should expect only a temporary reduction in gas prices, if any.

The moral of this story, however, is that perhaps there is too much focus on OPEC and geopolitical tensions in the Middle East with little regard for the impact that Russia has on world oil markets. On a CNBC interview, one trader, when asked about Thursday’s huge price increase (several days after the Georgia conflict began)went so far as to say, “I don’t think many traders realized that Russia is the second largest exporter behind Saudi Arabia.” And these are people that trade oil on a daily basis??

Back at home, the data from the housing sector continues to disappoint although by now at least the results are no longer surprising. The National Association of Homebuilders pending home sales index remained at an all-time low of 16. (At least it didn’t fall further) and housing starts dropped another 11% to a level not seen since March 1991.

The talk now is that interest rates may fall further before rising again and that it will take until 2Q 2009 to begin to see an economic recovery.

This week, watch for additional economic data that may shed some light on the state of the economy and whether it’s nearing a bottom. The GDP number should be revised upward, but it will be interesting to see how personal income has been affected in light of the increase in the unemployment rate.

The Slippery Dollar

Once again we saw oil prices and the dollar moving in opposite directions. Since oil and other commodities are priced in dollars, it would make sense that the weaker the US dollar, the more it costs to buy a barrel of oil priced in US dollars. At some point, however, this relationship, called correlation, will ‘decouple’. Not completely, but the relationship will not be as strong. For example, PPI, a measure of wholesale prices, was reported today well above expectations, which indicates that the inflation issue is still prevalent. If it persists, the FED may have to raise interest rates, resulting in an adverse affect on an already fragile economy, but causing a strengthening of the US dollar. Sure, this may put downward pressure on oil, but global demand, although slowing, is still strong, and many economists are expecting a pick up in demand after the olympics. To hedge our positions, we have exposure to both oil prices as well as dollar strengthening. If they continue to be negatively correlated, the result of our positions will be muted as they move opposite each other. However, as I have mentioned in previous posts, I’m bullish on oil and I am also bullish on the dollar. It’s just a matter of time.

Diving, Housing, and Fay

Well, it’s fitting that I am awake at 1AM watching Olympic diving on TV. As Hurricane Fay heads NNW away from Miami, she has left behind a wonderfully choreagraphed onslaught of wind and rain worthy of a medal. In the financial markets, there wasn’t a whole lot of economic data but the markets, led by financials, sold off heavily. We did get a bit of good news from the housing area. Although the National Association of Home Builders held steady at an all-time low, two out three components improved. The expectations of sales in the next 6 months improved and so did the index of present sales, although the latter improved only slightly. The one component holding steady was the traffic of prospective buyers. If we can get some more buyers out shopping, we might really get the ball rolling in the right direction. Note to foreigners: the dollar won’t stay weak forever…buy now.

Michael Phelps Wins Seventh Depreciating Metal

Congratulations Michael! You just won seven gold medals now worth 10% less than they were worth at the beginning of the Olympic Games. However, it’s better than having won silver medals now worth 20% less than just over one week ago.

According to the Ishares Silver Trust (SLV) and the SPDR Gold Trust (GLD), silver and gold prices have dropped considerably over the last week and even more so over the last month. So one might wonder, what’s the big deal of winning a gold medal? Well, I’m being facetious of course as we all know, or at least can imagine, the glory that comes from being the top athlete in your sport.

With the global economy showing signs of slowing, commodity prices across the board have come down considerably from many of their all-time highs. Where they go from here is a tricky question to answer since some commodities have indeed been driven by global demand, while others are often viewed as a safe haven during economic uncertainty.

Short of hanging it from one’s neck, there really isn’t much use for gold as a raw material, so oftentimes, the price of gold is being driven by what I call, a residual affect of everything else. If you’re not sure about the economy, invest in gold. If you’re worried about inflation, invest in gold. If you don’t have any confidence in the dollar, invest in gold. Ah, and it is perhaps this last comment that has driven gold prices down recently, as the dollar has shown signs of strengthening, and the European Union has shown signs of slowing. If the EU lowers rates to help spur growth, it will weaken the Euro relative to the dollar and give even more momentum to the recent trend.

Overall, I still like the overall commodity trend. Demand for oil, gas, metals, and some agricultural products will not disappear overnight. Perhaps there was some speculation in these markets and the price is returning to a supply/demand balance, but I think the days of $1 gallon gas prices are long gone, and the world as we know it now is more likely to persist than what the world was just a few years ago.

I am not a market-timer so I would never suggest when to get in or out of a particular investment to take advantage of short-term fluctuations. However, the long-term fundamental trend as I see it is to have some exposure to commodities. And, if you can swim 100 meters in less than 50 seconds and someone is willing to give you gold for doing it, don’t worry that it’s worth less than what it was worth at the beginning of the race. Bow down so they can drape it over your head, sing the national anthem, and smile!!

Europe Slows

The european economies may be nearing recession, as the European Union’s statistics agency said GDP for the second quarter contracted 0.2%, increasing the likelihood that interest rates will be lowered in the near future. The implications are that the dollar will continue to strengthen, potentially having a negative effect on one of the few brightspots of the US economy. Although the stronger dollar will increase the purchasing power of US consumers for goods imported from foreign countries, consumers are likely to restrain their spending until the housing and credit crisis subsides. So the likelihood that the stronger dollar will jumpstart consumer spending is minimal. But even worse, export growth, one of the largest contributors to GDP growth, will be driven down by a combination of lower demand from foreigners and higher prices in US dollar terms. It could hurt the US large caps that have fared so well with the weak dollar and expanding overseas markets.

Georgia on My Mind

Well, it's not only Georgia, and the hostilities between them and Russia. I am uncomfortable with the muted affect that this violence has had on the price of oil. It went up slightly today, but the geopolitical landscape in that area of the world is very fragile. We still have a position in commodities with a good portion of it in Oil and Natural Gas.

Export Ambiguity

US export data came in much higher than expected, causing many economists to increase their estimate of 2Q growth to 3%. The weak US dollar has benefitted many US companies with global markets, but exports aren't the 'feel good' driver that most consumers can feel, well, good about!! The higher than expected net exports will be the key driver for GDP growth in the second quarter, but employment weakness is still prescient in the minds of most Americans. For this reason, you still might hear the now-common response to the question, "How are you?", "Well, fine considering the economy!". Sure, it feels bad, but the increase in exports more than likely means that large US companies are still generating sales and will continue to do so if the dollar stays weak. The dollar has strengthened over the last few weeks but it is coming off an all-time low versus the Euro so US goods are still cheap to foreigners. Within portfolios, make sure there is some exposure to the large cap space with international markets. The dollar should continue to strengthen, but it won't happen quickly!

The $50 Trillion Investment

It’s not alternative energy but may alleviate some of our reliance on oil over the long-term. It may also help jumpstart the US economy at a time when many construction workers are being laid off from positions in housing and related sectors. The fastest growing economies are relying on these investments to facilitate and maintain their growth, while developed countries are more concerned with improving productivity, maintaining their standard of living, and keeping their citizens safe.

While US politicians have increased their focus on this segment, the majority of the investments will be made outside the US and the types of investments will vary by geographic region. Nevertheless, a $50 trillion dollar investment got my attention and in the rest of this article, I’ll share some of the details of what I found. (Read More)