Let’s Play “Where’s Your Money Now”

This game is to be played only after following Alice down the rabbit hole to Wonderland.  It’s really the only way to digest the unbelievably creative financing schemes and still have any sanity.   I want to make clear that not all funds are managed the same way.  Some money managers have actually avoided mortgage-backed investments.  Where’s your money?  You worked hard for it, you saved it, you need to know where it is.

Montana, Connecticut Hold Downgraded by Moody’s (Update2)

By David Evans

Dec. 3 (Bloomberg) — Montana and Connecticut state-run investment pools hold debt tainted by the subprime mortgage collapse whose ratings were cut or put under review by Moody’s Investors Service, the latest examples of downgraded holdings leaving local-government investors vulnerable to losses.

In Florida, disclosures that a state-run pool for schools and cities held $1.5 billion of downgraded and defaulted debt prompted governments to pull out almost half of the fund’s $27 billion in assets.

Moody’s lowered its rating on commercial paper issued by the Orion Finance structured investment vehicle, or SIV, to “Not Prime” on Nov. 30, saying its net asset value is inconsistent with Orion’s former Prime-1 rating. Montana owns $50 million of the paper. Moody’s put another $105 billion of SIVs on review for a possible downgrade, of which Montana holds $55 million and Connecticut holds $300 million, records show.

“This just reinforces the fact that we have a serious issue,” said State Senator Dave Lewis, of Helena, Montana, a member of the Legislative Audit Committee.

Schools, fire departments and towns across the U.S. that use state- and county-run funds like a bank account are seeing the far-ranging effects of the housing slump, as complex investments once sold as high-yielding, safe havens are now backed by collateral investors don’t want. Modeled after private money-market funds, the investment pools are supposed to hold safe, liquid, short-term debt.

Florida Halt

Florida officials halted further withdrawals on Nov. 29 as they consider options to address the crisis. The State Board of Administration’s three trustees, Governor Charlie Crist, state Chief Financial Officer Alex Sink and Attorney General Bill McCollum are to meet tomorrow to consider the crisis.

Montana’s $2.2 billion fund has already had $250 million of withdrawals since the fund’s $90 million holding of Axon Financial was cut to “D,” or default, by Standard & Poor’s last week. It was lowered to “Not Prime” by Moody’s on Oct. 23.

The Montana pool, managed by the Montana Board of Investments, has almost 24 percent, or $525 million, invested in SIVs, all of which carried top investment ratings when purchased.

The city of Billings withdrew $26 million from the pool last week along with Yellowstone County, which pulled $59.5 million. Richland County took out $51.3 million and the Lockwood school district withdrew $12.1 million, while the city of Bozeman pulled $39 million.

Falling Values

SIVs are typically offshore companies created by banks and other firms to sell short-term debt to buy mortgage securities and finance company bonds with higher yields. They profit on the spread between the two. Moody’s last week said it may lower ratings on $105 billion of debt sold by SIVs after the average net asset values of those sponsored by firms including New York- based Citigroup Inc. declined to 55 percent from 71 percent a month ago. The assets were valued at 102 percent in June.

Connecticut’s Short-Term Investment Fund, which invests cash for state agencies and municipalities, is holding $300 million in debt issued by SIVs that may be downgraded by Moody’s. The state’s $5.8 billion fund held notes issued by SIVs affiliated with Citigroup as of Sept. 30: Beta Finance, Dorada Finance and Five Finance, according to its most recent quarterly report.

Connecticut also holds $100 million in defaulted SIV notes issued by Cheyne Finance. The fund has a $52 million reserve to absorb losses.

Gary Conrad, chief financial officer of New Canaan, Connecticut, said he’s withdrawn $20 million of the town’s short-term cash from the state’s investment fund in the last three weeks. “We’re taking as conservative an approach as possible.”

Greenwich Decision

Kathleen Murphy, the treasurer in Greenwich, said she won’t deposit $150 million in tax receipts and proceeds from a bond issue into the Connecticut fund until she gets a better handle on the valuations of its debt holdings.

“We want to have options,” Murphy said. “Any kind of downgrades of their securities could end up blowing through their reserve. That needs to be clarified before we put new monies in there.”

Lewis, a member of the Legislative Audit Committee in Montana, questioned whether the state board’s policy of allowing pool participants to remove their money at full value, which concentrates the risk among those with money still entrusted to the pool. The majority of the money in the pool belongs to state agencies.

Legislative Action

“I think we may need a special session of the state Legislature,” he said.

Carroll South, executive director of the Montana Board of Investments, said Nov. 30 he will have enough cash to address any further withdrawals.

South said he participated in a conference call for investors in Axon Financial on Nov. 30 and still has no idea how much can be recovered from its collateral.

Placed on review by Moody’s were Zela Finance, of which the pool owned $25 million until it matured Nov. 14, Hudson Thames Capital, in which the fund invested $25 million, and Premier Asset Collateralized Entity, of which the pool owns $30 million.

Back in August, it had already started:

Sentinel Trustee Blames Collapse on Excessive Leverage (from the Chicago Sentinel)

By Ann Saphir

(Crain’s) — Sentinel Management Group, Inc.,  imploded because of over-borrowing, unconventional accounting and a compensation structure that encouraged its head trader to make risky trades that backfired as credit markets tightened, Sentinel’s bankruptcy trustee said Monday.

The statements by trustee Fred Grede were the first to lay out what happened at the Northbrook cash-management business in the days leading up to its Aug. 13 bankruptcy filing.

Regulators have said they thought there was as much as $500 million in securities missing from Sentinel’s coffers. Not so, the trustee said.

“We do not think this is a case of missing securities,” Mr. Grede said in a preliminary report to creditors at a meeting Monday. “What this case is really about is leverage, and excessive leverage, if you will.”

Sentinel’s business was to take cash deposits from futures brokers and hedge funds and generate a return for its customers. Instead of keeping that money safely liquid, it used it to buy securities. It then obtained loans against those securities.

It used the proceeds from the loans to buy more securities, Mr. Grede said.

At its height, Sentinel had about $700 million in loans and had borrowed against $4 billion in securities, Mr. Grede said. “All of this for a company that maybe, maybe had $3 million in capital,” he said.

As credit markets began to tighten over the summer, the securities against which Sentinel had borrowed began to lose value, and those holding the securities began to demand more collateral, he said. “As a result, the whole thing begins to implode.”

The compensation structure for Sentinel’s head trader, whom the trustee didn’t name but in court papers is identified as Charles Moseley, made matters worse, Mr. Grede said. Mr. Moseley, who was fired shortly before bankruptcy filing, was paid based on the profitability of the house account.

“He began to buy riskier securities, more high-yield securities, as a result of trying to improve his compensation,” Mr. Grede said.

Today, the shortfall of assets to liabilities is between $391.5 million and $491.5 million, the trustee said. The range is wide because about 35% of the securities are rarely traded, making them difficult to value.

Sentinel had kept track of the value of its securities on a “cost-plus-interest” basis, a method that can overstate the value of securities when markets are in decline, Mr. Grede said.

The trustee said he has his work cut out for him. “The objective is to maximize the return for the creditors,” Mr. Grede said. “We’ll do everything we can to maximize returns for the benefit of creditors.”

Market Close

I heard a comment that watching the market the past couple of days has been as exciting as watching glue dry.  The indices drift a bit lower, but nothing earth-shattering.  On a day with no economic reports or major news, the market just wafted around like a feather in the wind. 

Some equities did OK, mostly the “usual suspect” groups in tech and solar.  Retail is having a last fling, as well.  No, I’m not very positive on retail.  Retail needs consumer money and that’s drying up, like it or not.  I’ve seen that some analysts are recommending retail stocks right now and I wonder what their investing time frame might be.  Buy retail stocks now and hold a week or two?  Or buy now and hold for years?  It would be nice if they would specify that time frame.

Just heard that Senator Dodd is calling for Treasury Secretary Paulson to clear up questions about his former employer’s role in originating securities related to subprime mortgages.  Apparently, a story in the New York Times raises questions about the activities of Goldman Sachs reportedly selling collateralized mortgage obligations (CMOs) while Paulson led the Wall Street firm.  The article says GS was selling short the very securities they were underwriting.  GS doesn’t deny this and says they disclosed that fact. The article says that if GS was “aggressively pushing subprime mortgages that they knew to be of concern while simultaneously shorting collateralized mortgage obligations”, then it could raise suspicions of why the Bush administration’s waited until recently to begin initiating a plan to help homeowners who took out subprime mortgages.  Sen. Dodd says that Paulson’s failure to address these concerns may lead to a formal investigation.

All I can say about this right now is, what a dog and pony show.  Sen. Dodd is a presidential contender, so take that for what it’s worth.  I’m totally unbiased concerning political parties, though. I don’t trust either side of the aisle these days.  The finger-pointing and the blame games haven’t even begun in earnest.  Lawyers are going to be having a field day, suing everyone in site for the losses suffered by investors. Attorney’s General in every state will be filing complaints on behalf of pension funds.  The news will be filled with one sad story after another about people who have lost everything.  Government officials will be calling for hearings.  Prepare yourself for a lot of righteous indignation by the accused, “categorically deny”-ing everything.  Hmm… I think I’ve read this book before….in the ’80’s (LTCM scandal)…..Enron…..yep, starting to see a pattern here.  This is just the beginning, not the end, of the financial fall out.  Fasten your seat belts, it’s going to be a bumpy year.

Mid-day Update

Choppy is the word for today.  No economic catalysts and the news, good or bad, isn’t really registering on anybody’s radar.  Preservation of capital is the main goal is this environment.  The popular stocks are maintaining fairly positive territory, but do not become complacent.  I see this up/down chop lasting all day.

Pre Market - December 4th 2007

Overnight the markets got more shots across the bow which warn of additional problems to the economy. The Redbook Retail data was released for the weak ending December 1st. It shows the sales growth has indeed pulled back and was only 2.2% when compared to the same time last year. This would confirm the expectations that retail sales are going to be hurting this year, especially the holiday shopping season. The data also shows that the all important ‘black Friday’ shopping weekend growth was only 0.3% (November sales growth).

For those of our readers that are invested in alternative energy stock, such as solar companies. We would caution you and perhaps you would want to consider taking any profits off of the table. It is being reported that President Bush may veto the energy bill, which includes tax benefits for the alternative energy sector. A veto of the bill would be very negative for the alternative energy sector.

Multiple downgrades overnight on the financial sector have added to the pre market deterioration of the futures.

The Bank of Canada has cut their interest rate by 25 basis points, this cut was a surprise to the market, and so far the impact to our markets are mixed.

And For Our Next Trick, The Sun Will Rise In The West

The news on the financial front is bad.  Period.  It doesn’t matter how many times some analyst, CEO, Fed Chairman, or the President says the economy is robust or the “subprime” problem is contained, the news is bad.  From all of the research I’ve been able to do on the financial debacle, I could write a proper horror novel.  For anyone who thinks the financial problems have already been priced in the market, here are a few observations:

Corporate profits are going down.  Prices companies pay for materials are increasing (same for individuals) and their margins are shrinking.  We’ve written before about all of those share buy-backs being an ominous sign.  The reason is this:  A company has 2 million shares and earns .10 per share in year one, then buys back 1 million shares.  In year two the company reports they earned .12 per share.  Did they have a good year?  No.  They actually earned less, but in year two they just don’t have as many shares.  Yes, I made this simplistic, but keep it in mind the next time you simply scan the headlines of an earnings report.  Be sure to dig a little deeper, see if you can find their year-over-year revenues and profit margins.  And right now, expect any company to project a rosy outlook for their sector, unless it is a sector that feels it needs an interest rate cut to survive.  Then you will be hearing wailing and gnashing of teeth.  But, that’s OK, you say, because at least they aren’t involved in this credit crunch thing, right? Do you know how many companies are actually involved in financing activities?  Would you be surprised to learn that Caterpillar (CAT) and Deere (DE) and Pitney Bowes (PBI) derive 12% of their earnings from financing activities? And what about all those store credit cards?  No big deal because people are paying their debt?  Think again.

Loan repayments are defaulting at an increasing rate, and it’s not just subprime, but all loan types.  Construction and industrial (commercial) loans, credit card loans and personal  loans defaults are on the rise.  Why is this happening?  All of this credit was a house of cards.  The following scenario starts with the fact that housing was overbuilt and overpriced. And the more complicated financial schemes and relaxing of financial rules to continue expanding credit are not accounted for, but only makes it worse. 

Bank A loans Fred $1,000, with interest, for a house. The hope of Fred being able to repay, is the risk that Bank A is taking, and if Fred can’t repay it, Bank A will take the house.  Joe finds he needs $2,000 to buy a house.  So, he goes to Bank B and borrows the money, with the same deal as Fred.  Bank A and Bank B sell those mortgages to Bank C, thereby ridding themselves of the risk if Fred or Joe can’t pay the loans.  Bank C doesn’t really want the risk, even though it is making money from the servicing of those loans and collecting the interest.  So, Bank C bundles those loans, calls them an investment vehicle and sells them to Investor A and Bank D.  Why does Investor A and Bank D buy this debt?  Because it’s value should go up as home prices appreciate.  Bank D wants to use it as collateral to borrow money and Investor A expects to make a nice return, since real estate only goes up.  Until it doesn’t.

When the housing prices drop, the collateral supporting the price of those loans drops as well.  Investor A wants to sell these loans now and take his cash out of the market.  But, the problem is that suddenly everyone figures out that housing is in a slump and doesn’t want to pay Investor A’s or Bank D’s asking price.  So they have two choices.  Hang on to the loans (debt) and wait/hope that real estate prices go back up, or sell at a loss. 

Ok, that’s the simple version of what’s going on.  Banks are losing money, broker/banks are losing money, other’s involved in finance are losing money.  And they are all pinning their hopes on real estate values rising.   

Bloomberg article on U.S. Profits  

Forbes Magazine article on corporate financing

Article on mortgage meltdown, not just sub prime