20 March 2008

This past week, the stock markets continued their wild ride thanks to the culprit of the week, the banking crisis, which I will explain for you, below.

The good news right now is two-fold:

1. For our managed account clients, all of our model accounts have posted small gains in March, despite the fact that the S&P 500 stock market index² is down 6.5% for the month.  You can relax knowing that Hepburn Capital’s strategies that adapt to changing markets^® are working exactly as we planned them.
2. The average investor in the stock market has lost between 17.6% (S&P 500 Index²) and 23.5% (NASDAQ Index²), but there are increasing signs that the stock market may be bottoming and the worst may be behind us.  At least for a while.

The world is waking up to the fact that many banks are taking big losses, and not just here, but around the world.  You would think that big banks can absorb big losses, but the way banks are set up magnifies the losses.  Let me explain . . .

Banking Crisis 101

Your bank doesn’t just hold your money in a vault full of cash until you come back to get some.  Banks invest your money in loans, some of which are the mortgage loans that have made the news lately.  The many defaults on mortgages caused by declining real estate prices are hitting investors hard, but banks seem to be getting the worst of it because of the way they are structured.

For every one dollar in “capital” (cash from depositors like you and from investors who buy bank stock) a bank can make loans up to ten dollars.  This is called a “fractional reserve” system.   Basically a bank has to have cash reserves at least 1/10th the size of its total loan investments.

As an example, let’s assume that Will’s Bank and Trust has $2 billion in capital, and has invested in $20 billion worth of loans.  The loans I invest in can be auto loans, business loans, mortgages, bonds or almost any other form of IOUs.  At this 10 to 1 ratio we are just fine.

However, these days, loans are defaulting much more frequently that anyone expected.  So, not only is loaned money lost when a default occurs, the rest of the loans lose value too, because few investors will buy them right now fearing even more defaults.  So resale value drops, creating a double whammy for a bank holding mortgage related investments.

If Will’s bank experiences only a 5% loss on its investment in these loans, this means the value of the loan portfolio drops by $1 billion, from $20 to $19 billion.  You would think the loss would be deducted from the loan side of things, right?  Wrong!  Accounting standards require me to “write off” half of my cash because it is needed to reimburse the loan portfolio.

After the write-off what I have left is $1 billion cash and a $20 billion loan portfolio, a 20 to 1 ratio.  This is way over the 10 to 1 limit banks are allowed by the government.

Technically, my bank could be considered insolvent by the government and could be forced to shut down immediately.  My alternatives are to quickly:

Stop making new loans to prevent the ratio from getting any worse.  That is tough on people or businesses that need to borrow.

Call in existing loans, even those with payments being made on time, because I am forced to get my loan ratio back in line.  This one is really tough on businesses that did nothing wrong.

Find investors to take a share of my bank in return for more cash, like the government of Dubai did for Citibank recently.

Find new depositors to put cash into my bank, even if I have to pay high interest to get their money.  Following this logic, banks offering the highest rates of interest may also have the highest risk.

So, this is the spot many banks find themselves in.  The 10:1 leverage allows banks to get fat in good times by earning 10 loans worth of interest while only paying out one CD worth of interest for the privilege. But in hard times the financial leverage greatly increases the risk of the bank going out of business.

How many banks can the government allow to go out of business?  Not many.  This is why the Federal Reserve is so busy finding creative ways to get money into banks.  They call it “injecting liquidity”.  “Bailing out” is a simpler term.

Earlier this month Fed Chairman Ben Bernanke put it bluntly: “There probably will be some bank failures.”  Those kinds of statements bring FDIC to mind, so in my next newsletter I will address FDIC insurance: what it is, what it isn’t, and how to protect yourself, your money and your family in the event of bank failures.

Inside our strategies

Our holdings have changed very little in the past few weeks.  We still have little or no net investment in the US stock market.

Flexible Income¹ accounts are 1/3 in the money market, 1/3 invested in a fund that goes up if the value of the dollar goes down, and 1/3 in one that goes up as the high yield or junk bond market goes down.

Growth¹ oriented accounts still focused on capital preservation with 1/3 in money market and 20% in bond funds.  We hold one or two globally diversified funds, and some accounts have a small investment in the Middle East, an agricultural commodity fund and a consumer staples fund.  This type of fund invests in companies that sell soap, soft drinks, band aids and other things that people still need to buy no matter how bad business gets.  My hedging is calculated to eliminate most of the stock market risk and seems to be working well.

Municipal¹ bonds have bounced back smartly in the past few weeks as I thought they would.  Last year I took steps to move managed accounts holding munis from “high yield” to “high quality” funds.  You should consider doing this now if you hold high yield funds that I do not manage.  Call the office if you would like help.

Although we are not exposed to the US stock market right now, with increasing signs of a bottom at hand, at least a temporary one, this may change over the next few weeks.

I will probably begin by removing our inverse holdings – the ones that go up as a market segment goes down – and then take a hard look at which parts of the markets are responding best to the surge of money the government is sending through our economy.  All of that money has to end up someplace, and part of it will end up in the stock market, sooner or later.

Tired of Junk Mail?

Below is the website referenced in AARP’s recent newsletter which will remove your name from some of the widely distributed lists for credit card offers.  I hope this helps make your life a little simpler.  If you save just one minute per day in handling these junk mail offers, then that amounts to almost 6 hours per year of additional free time for you.

www.optoutprescreen.com.

More rays of sunshine . . .

Although I think it will be a long while before the real estate market bottoms out and turns back up, mortgage rates are staying low and home prices are falling.  This combination makes homes more affordable – an essential prerequisite for a turnaround in the industry.

As mortgage holders refinance into fixed-rate mortgages from ARMs (adjustable rate mortgages) at these attractive levels, their disposable income becomes more stable which should help consumer confidence, another key requirement for economic recovery.

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1. The model accounts mentioned in this article are hypothetical examples of how the strategy may work as designed.   Activity in client accounts may be different from that in the model in amount of each investment, specific timing of trades, and actual security used, which may vary from account to account.  Not all trades are profitable.  It should not be assumed that current or future holdings will be profitable.   A list of all trades in these accounts for the past 12 months will be provided upon written request.
2. *The S&P 500 and Nasdaq Indexes are unmanaged lists of stocks considered representative of the broad stock market.  Investors cannot invest directly in the S&P 500 Index.