August 2, 2011
The FDIC is Funding the Greek Bailout
The Investment View from Prescott, Arizona
Money Market Funds, those accounts that are sooo boring, are really just mutual funds that invest only in very short term bond funds.
The idea is that by holding bonds that mature in a month or two on average, even if interest rates rise, causing principal values on most bonds to fall, the loss on money market investments is expected to be so small that it is less than the interest being earned so it isn’t even noticed. The market risk is just about nil in that type of fund and this is one reason money market funds pay only a small amount of interest.
But as Will Rogers once said, “I am more concerned with the return of my money than the return on my money.” So, what if a bond in a money fund defaults, meaning it does not pay its principal back at maturity? Default risk is very real in these funds.
Money market fund managers now face a squeeze. With rates on Treasury Bills (the shortest term government bonds) held to near zero by the Federal Reserve, managers struggle to provide any yield at all to investors when the funds invest in Treasuries.
As a consequence, managers are forced to look to other markets where they can get higher rates. Right now, high rates are available in Europe on bonds issued by countries like Greece, Portugal, Spain, etc.
In fact, a list of the largest money market funds mentioned on James Grant’s recent interview with Bloomberg.com shows the majority of those money market fund assets are foreign bank bonds and foreign government bonds.
The problem with this approach is that foreign banks have large exposure to government debt of countries like Greece, Portugal, Spain, Ireland and Italy that are all teetering on the brink of bankruptcy. If there is a default, or to use the polite term, a restructuring, principal will be lost to the owners of those bonds, including US money market funds.
A restructuring is a nice way to tell the holder of an IOU – which is all a bond really is – that they will be repaid only a part of the principal value. Under the latest Euro bailout deal, holders of Greek bonds are openly expected to be issued a 21% restructuring loss according, to investment guru John Mauldin. This kind of loss is called a “haircut” in industry terms. Some industry analysts say a 75% to 90% haircut is more likely. Ouch!
That is a big risk to take for a fraction of a percent more yield than a US Treasury, the only money market fund that I recommend to my clients.
Why would a manager take that extra risk? Because the fund manager is not on the hook for a loss, that’s why. US taxpayers are on the hook in FDIC protected money market funds.
Interestingly, US banks with FDIC coverage offer the highest rate of interest of all money market funds. This implies that they also are taking the most risk, too. With FDIC backing they can roll the dice on foreign defaults and if they lose, the FDIC gets to step in and write big checks to make depositors whole.
In effect, a lot of our FDIC insured money is going to Greece, Portugal, Spain and other almost bankrupt countries to prop up their economies.
Ironically, one of the highest money market rates is offered by Ally Bank (per Bankrate.com on July 30, 2011), which not only enjoys FDIC membership, but used to be called GMAC, the financing arm of General Motors, propped up with even more federal bailout money. This feels like a double insult to taxpayers in this country.
There are other abuses of the FDIC guarantee going on, but my blood pressure is already up after writing about this one, so I’ll save the others for another newsletter.
A Slice of Life
Last week, Cathleen and I treated ourselves to a streamlining of our home entertainment system, which required 3 clickers to run, each with different combinations of buttons to push.
Also, when the cat was in her favorite spot on the back of the couch, she blocked my line of sight to the control boxes, so I had to get up from my recliner to change things, which often made me grumble a bit.
Ethan Fisher, who runs a business called HomeSmart Technology came to our house and set us up with a single, really simple clicker that even turns it all on and off with one button from wherever I am, cat or no cat. Now when I want to relax, I can do it easily. I hate having to work to relax – it never made much sense.
Ethan is a licensed contractor, and also does computer support, security systems and alarms. If you would like your home technology organized you can reach him in Prescott Valley at 237-1891 or firstname.lastname@example.org .
I love my new setup!
Q: What are the only two states that have their state name in their capital?
A: Oklahoma City and Indianapolis
What Happens to Interest Rates if The US Defaults?
Lost in a lot of the debt ceiling wrangling has been the likelihood of interest rates rising to compensate bond investors for the rising risk of default. Default on US bonds had been inconceivable until recently. Politics in Washington has put default as a distinct possibility and that is a game changer whether it actually happens or not.
In 2010, the US paid out $413 billion in interest.
That amount is more than the entire budget of the Health and Human Services Department, the Transportation Department, Energy, Veterans Affairs, HUD, Justice, Homeland Security, Agriculture, Commerce, the Treasury and Small Business Administration – combined.
These are the services that many of us think government is supposed to provide. Interest took up more than all those services combined.
And interest is at historic lows. The government has been rolling massive amounts of maturing bonds into short term Treasury Bonds because the interest rates are lower than for longer term bonds. This keeps the annual interest payments artificially low, as well.
If interest rates on new bonds rise to entice bond buyers to keep buying, despite the risk of default, our overall interest costs could easily double. The historic rate of interest averages over 6% but now it is about 3%. A jump back to normal interest levels would add as much as $400 billion a year more to the deficit. What would that do to the next round of budget talks?
Unless Congress grows a spine and deals with this problem now, we will be seeing this discussion over and over as time goes on.
Remember the topic in Washington has been deficit reduction, which does nothing to pay down the debt. It just slows the rate at which we are becoming another Greece. They have yet to tackle the real problem which is paying down the debt.
How’s the Market Doing?
There are often times when picking investments is easy. This is not one of those times. Uncertainty is high, and Congress is not helping with that issue.
As of this writing, on July 30th, there is still no budget deal. After last Wednesday’s 2% drop in the stock markets, I thought Congress would get motivated to pass a debt bill by now, lest they get labeled as the folks who caused the stock market to go into the tank. But the market decline moderated a bit at the end of the week, so Congress still fiddles.
As you read this on August 2nd, the deadline for a debt solution will be upon us. Hopefully things will be a little less uncertain even if both sides howl a bit at what they had to give up to get to that point.
With the normal seasonal summer weakness, coupled with the end of the Fed’s easy money policy, and the dicey track record the stock markets have posted when earlier easings ended, risk is higher than normal right now, even if the debt ceiling issue is settled.
Many of the trend analysis indicators I watch have flattened out, meaning the market direction could go either way from here. It is possible that we may slip back into recession, or the economy could turn back up and strengthen from here.
The good news is that all of this uncertainty has not really caused the market to break below its low points hit in March and June, which would signal a longer-term decline was underway. This could be a sign of underlying strength.
But with things so uncertain at the moment, I think a capital preservation stance makes the most sense.
What’s Going On In Your Portfolio?
Our Flexible Income* accounts continue to be our top performers, with the model account tacking on a little more than 1% gain last month.
The only change in the income portfolios since my last newsletter is the addition of a weak dollar fund – one that goes up as the dollar goes down. We continue to hold a good chunk of the portfolio in gold, along with high yield bond funds, and an energy income fund which holds a lot of energy utility companies – pipelines, terminal facilities, etc. – that pay a nice dividend.
Careful Growth* accounts, despite the stock market’s stumbling around trying to find a direction, also posted a small gain in July. With the major market indexes losing between 2-3% while we posted a gain, it shows the wisdom of being in capital preservation mode.
Growth* portfolios saw the addition of a Japanese stock fund (the Japanese market is surging as they start to rebuild) to our holdings in gold and a hedged growth fund. Until the outlook becomes clearer, only about 25% of our growth portfolios are exposed to the U.S. stock market.
Municipal income* accounts continue to be fully invested in high yield muni funds.
Our Spotlight Strategy
The CAREFUL GROWTH STRATEGY seeks growth of capital with greater consistency of returns than traditional buy-and-hold stock market investing.
* 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.
** 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.
This newsletter may contain forward-looking statements, including, but not limited to, statements as to future events that involve various risks and uncertainties. Forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause actual events or results to differ materially from those that were forecasted. Information in this newsletter may be derived from sources deemed to be reliable, however we cannot guarantee its accuracy. Please discuss any legal or tax matters with your advisors in those areas. Neither the information presented nor any opinions expressed herein constitute a solicitation for the purchase or sale of any security.