Up, up and away

Inflation cuts the purchasing power of your dollars. It can destroy certain types of savings so we want to keep an eye out for it so we can make adjustments in where we keep our money. Most vulnerable are fixed rate investments that seem the safest such as CDs, annuities and bonds.

I tell students in my Basic Investing class at Yavapai College that when someone says “safe” the first thing you should ask is “safe from what”. In this case, investments that seem safe from default may not be enough to buy the car or groceries you were planning on for your old age.

The Consumer Price Index officially pegged inflation at 4.1% for 2007. If you are like me I am still basking in the afterglow of the friendly 1 or 2% inflation from a few years back. To see inflation above 4% again is sort of a shocker. With gas prices and food rising like it has, this shouldn’t be a surprise, but it is.

Will it get worse before it gets better? I think so.

Although it may seem that I am getting off topic, I’m going to bring this train of thought back around to inflation, I promise. Keep reading . . .

Last week I sent out an email mentioning the strange happenings in the stock markets and suggesting you all fasten your seat belts. With the perspective of 6 more days we now know that the strangeness was caused by French Bank Societe General which had just discovered $2.2 billion dollars (yes, that is with a “B”) of losses created in a period of just a few weeks by a “rogue” trader.

Incidentally, an aggressive trader whose compulsions make money is treated like a rock star on Wall Street. One who loses money is branded a “rogue”.

Now, a really big bank like SocGen can absorb a $2 billion loss. But what they did is immediately sell the entire batch of assets involved, driving the market down so fast that in 2 more days the losses totaled a staggering $7.1 billion. And some people think bankers are smart.

SocGen’s losses were focused on European stock indexes, so they did not directly influence our markets, but indirect influence can be significant too. In this case, fearing that crashing European stock prices were going to spill over into our markets, the Federal Reserve Board of Governors met in an emergency holiday session on Martin Luther King day.

I imagine the minutes of that Fed meeting to read something like “Holy ____! We already have massive problems with mortgage and other credit problems. We can’t afford to have a stock market melt-down, too. We have to lower interest rates. A Lot!” So they did.

What had the Fed so on edge is the steadily increasing scope of the defaulting debt problems. For months now, there has been much talk of “sub-prime” loan losses, but the problems just keep spreading from there. As I said a few weeks ago, “there is never just one cockroach.”

The “cockroach” of the day is bond insurance companies. These firms insure bonds, including many municipal bonds, against default, and in doing so can lift a bond’s ratings to AAA. For a municipality that has a lower credit rating on it’s own merits, a AAA rating can save them a bunch of interest…millions of dollars of interest. But the insurers first need to be AAA rated themselves. The problem is that they also insured some of the mortgage backed bonds and in doing so, they blew it. Those losses are now causing the bond insurers themselves to be downgraded from AAA to something lower. The repercussions may be wide ranging.

Many mutual funds advertize they will only hold “insured” or “AAA” bonds and when a bond is longer qualified, first it will lose resale value and cause share values of that mutual fund to drop. Those bonds will then need to be sold off to keep the AAA purity of the portfolio as advertized. A glut of supply as the no-longer-AAA bonds are sold will depress prices even further, causing even more losses.

My guess is these insurers are in much worse shape than is now widely known. Downgrades would cast doubt on the credit quality of $2.4 trillion of bonds the industry guarantees. That is a lot of bonds. Just 10% losses equals $240 billion gone, “poof”.

This calls into question the banks, brokerage firms and insurers whose net worth can be wiped out by this type of markdown in market prices of bonds they hold. The bonds may still be paying interest as expected, but the loss of market value still causes a ripple effect. When a firm’s net worth drops too low, they need to find a cash investor or the government will shut them down.

When you hear of big firms getting “cash infusions” these are actually new investors showing up. In the past few months, Morgan Stanley received $5 billion from a Chinese government owned fund, Citigroup sold a portion of their bank for $7.5 billion to the Abu Dhabi government's investment arm and UBS revealed that it had received a $9.7 billion injection of funds from the Government of Singapore Investment Corporation. All were needed to cover massive losses in the bond/mortgage markets or the companies might have had to shut down.

A year or so ago in this newsletter, I commented that all of our trade deficits for purchases of foreign oil, cars and electronics were putting billions and trillions of our dollars in foreign hands, and those folks want to be able spend their dollars just like you would with yours. The problem is that the numbers are so big that those folks aren’t going to be satisfied with doo-dads from Wal-Mart, they will want to buy the whole company. And that is exactly what they are doing, buying chunks of Citibank, Morgan Stanley and UBS.

In my readings I have seen some very serious suggestions that several of the largest banks (and not just in the US), of the "too big to be allowed to fail" size, have negative net worth. Technically they are broke. With each announcement of new massive losses, we will see yet another large capital investment announced as well.

I think there is quickly rising risk that taxpayer money is going to have to be spent on shoring up some of these big banks. The alternative is to see them become foreign banks. Politics being what they are, that would look very bad, so probably will not be allowed to happen. There will be a lot of finger pointing, shouting and blame all around, but it is quite possible that the government will step in and print some more money to keep the situation from getting out of hand.

A few years back, Fed Chairman Ben Bernanke said he “would drop money from helicopters before he would let deflation get a foothold in the US”. It looks like the big banks may be one of the first stops for Ben’s helicopter.

One helicopter the Fed uses is to lower interest rates. However lower interest rates can also fuel inflation. Last week as our stock markets appeared poised to crash, the Fed lowered interest rates by 3/4%, and my guess is that we have more rate decreases in our future.

Ben appears to not be enjoying his recent testimony before Congress. Perhaps being caught between the hard spot of deflating asset prices and the rock of rising inflation is causing his angst. In any event, the Fed voted last week to fight deflation. This means that for the foreseeable future you and I should not expect a lot of help from the Fed fighting inflation. They are more worried about deflation.

The Fed will “jaw bone” about fighting inflation, but actions speak louder than words.

So now we have one more force to push inflation a little higher. The cost of oil, food and bailing our banks is all going up. Get ready for more inflation.

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Commissions? Nope.

A few months ago I mentioned that I was going to begin using more “Exchange Traded Funds” or ETFs for our managed accounts. These investments work like mutual funds, each share representing a basket of underlying stocks or bonds. But the internal costs of ETFs offer large savings over traditional mutual funds.

Offsetting these savings are $24 “ticket charges” that appear as commission on your confirmations of buys and sells. These are not true commissions, but rather are charges imposed by National Financial, the account custodian. I receive no part of them.

In 1994 when I started managing money for clients, I absorbed the cost of these ticket charges. After my business had grown some, I found myseP hesitating to do trades because a single transaction could cost me $1,000 or more out of my pocket for ticket charges.

Your interests are best served if I can make my decisions with the least conflict of interest. It is not good for you if I hesitate to move your money out of harm’s way because protecting you will cost me a chunk.

Passing these costs through to you while offsetting them with lower fund expenses does provide the best level of efficiency for your account, so that is why I am doing it.

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Uncertainty Is Our Friend

“(The) argument is made that there are just too many (investment) question marks about the near future; wouldn’t it be better to wait (to invest) until things clear up a bit? You know the prose: “Maintain buying reserves until current uncertainties are resolved,” etc. Before reaching for that crutch, face up to two unpleasant facts: The future is never clear and you pay a high price in the stock market for a cheery consensus. Uncertainty actually is the friend of the buyer . ..”

Warren Buffett, Forbes Magazine, August 6,1979