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As returns began to dwindle in the early 2000s, many of the professionals turned to leverage (borrowing money) to juice returns. Now, with a greater aversion to debt, professionals have largely relied on traditionally riskier assets such as lower rated bonds and alternative assets.

QE3, Municipals and You

October 10th, 2012 by Kurt L. Smith
  • Federal Reserve Chairman Ben Bernanke kicked off Year Six of the Financial Crisis by announcing a mortgage bond buyback scheme dubbed historic as the Fed is now focused on the employment woes of the nation.  Will it work?  One only need look as far as a Federal Reserve Bank president, Charles Plosser, to find a cogent critic.  Thank goodness this is America and one can voice dissent.

    Buyback Ben’s announcement, dubbed QE3, was announced September 13th.  Fed action was highly anticipated, a nickname already granted and all that remained was the details of how fast and furious action might come.  Buyback Ben is aware of the issues: he is targeting Bonds (debt is an issue) and he is targeting housing, so he has decided to buyback mortgages.

    Charles Plosser, President of the Philadelphia Federal Reserve Bank, is a critic of the plan.  You already knew I’d be critical so I appreciate Charles stepping up to add credibility to the critic’s side.  As the name implies, QE3 is but another attempt to reflate the economy.  Yet after already inflating the Fed’s balance sheet by some $2 trillion and the Obama administration’s profligate spending of some additional trillion dollars each year, we have little to show the middle class for our efforts.

    Actually we do have a lot to show for Fed and fiscal policy looseness.  Large corporations, with their access to record low interest rates are raking in tremendous profits.  Cutting costs (I mean people) and keeping prices high (there will be inflation) has been a winning combination in the short run.  Municipal governments, states included, are following the same formula of cutting costs (people and interest payments) while jacking up fees and taxes.

    So where is all this short-run emphasis getting us?  Down the road, yes, but at what cost?  The implications of cutting costs, particularly people, may better the Income Statement of the corporation and the municipality but it continues to weaken the economy as a whole.  Buyback Ben is right to focus on employment but with the tools of monetary policy?

    The implications of the Fed’s zero (low) interest rate environment also cuts both ways.  You, the saver, know this firsthand as this low interest rate environment has been Fed policy for the past four years but seemingly is stretched out as far as the eye can see.  Zero rates should entice us to borrow now and spend now, thus adding to economic activity.  But today is not 2005!  The world spent twenty some-odd years borrowing and borrowing and borrowing (pushing prices, primarily housing prices, higher and higher) until it no longer makes sense to borrow.  The benefits (higher home prices) no longer justify the costs of borrowing more.

    So who is borrowing in this environment?  I believe it is desperate who are borrowing and that spells trouble.  Students are among the desperate as Buyback Ben now knows employment is an issue.  Read the terms and conditions (risks) of a student loan and desperate would seem to accurately describe anyone who signs it.  Issuance of student loans has skyrocket by hundreds of billions of dollars the past several years and now tops $1 trillion, more than credit card debt.

    Also, leading the list of the desperate are governments and their Central Banks.  QE3 in the US and European bond buybacks are financial attempts of desperation to try and stem the tide of the effects of deleveraging.  The more we talk about this subject the more we recognize it for what it is: more of the same.

    Municipalities have benefitted by the lower rates forever mantra.  Last week, worst rated state in the union, California, was able to borrow at record low long-term interest rates.  Many municipalities have joined the US Treasury in issuing more debt.  Some municipal issuance simply refinances older, higher cost debt, but many are simply taking the opportunity to borrow more.

    We are not investing in these new bonds.  We are avoiding issuers of new, additional debt.  This is our prerogative and judging by the amounts of uninvested Cash you have, you can easily attest to this.

    Professionals in the markets, most that is, do not exercise this prerogative for Cash.  We have seen the financial markets become dominated over the years by the professionals (mutual funds, ETFs, asset managers, banks, hedge funds, pension funds and insurance companies) and these investors are largely all in the same boat: remain invested!  As returns began to dwindle in the early 2000s, many of the professionals turned to leverage (borrowing money) to juice returns.  Now, with a greater aversion to debt, professionals have largely relied on traditionally riskier assets such as lower rated bonds and alternative assets.

    As time marches (crawls) on and the professionals are pushed further and further into a box, I am reminded of my friend in the housing industry in the early 2000s.  A lifelong homebuilder, my friend had to build more and more houses in order to continue to make a profit.  Business was great (it had been for seemingly ever) and this allowed him to rationalize the rewards as greater than the costs.  Yet overnight, seemingly overnight, his business was bankrupt.  The question he now knows he missed was “should I even be in this business?”

    We are seeing a few (very few) examples of this decision as some of our best and brightest hedge fund managers have exited the business voluntarily.  These are exceptional moves as almost every other financial professional continues to try and play the game, especially the new game of focusing on high risk assets.

    Like Bernanke’s Fed, doing something today may look worthwhile at the moment, but Plosser is right to put the question of costs and risks on the table.  I continue to believe these risks are huge, because, once again, the professionals are largely on the same side of the boat.  Our strategy is Cash and near-Cash hasn’t hit us the home runs that buying long-term bonds might have generated for us these past several years.  Just look at the charts below.  But as the Fed continues to expand it’s balance sheet and as the Obama administration continues its deficit spending, I believe the risks are greater than several years ago.  I kept out of the trade because I continue to believe the trade is but temporary.  Higher prices today do not tell me we are in a low interest rate environment for seemingly ever; high prices tell me the risks are higher because the complacency of the professionals is greater.

    Investing is all about risks and rewards.  Unfortunately too many professionals (like homebuilders of old) have entered the picture and focus solely on today instead of tomorrow.  No wonder so much of today’s trading is high frequency trading and day trading.  The time horizon of professionals is skewed.  At this stage of the financial crisis we know the reward.  Thanks to Big Bill at PIMCO we all know the possible rewards in the marketplace are quite low.  But what about the costs and the risks?  In year six, after trillions have been spent and leveraged I believe the risks are greater and therefore my threshold of safety and return are even higher today than previously.


    Laredo TX Waterworks & Sewer System Revenue
    Moody’s: Aa3 (A1 Underlying) S&P: AA- (AA- Underlying)
    Fitch AA- (AA- Underlying) AGM Insured
    DUE 3/1 DATED 10/1/12 MATURITY: 3/1/2042
    SALE AMOUNT: $41,120,000

    1 2013 2.00% 0.54%
    2 2014 2.00% 0.70%
    3 2015 3.00% 0.80%
    4 2016 4.00% 0.92%
    5 2017 2.00% 1.15%
    6 2018 4.00% 1.34%
    7 2019 4.00% 1.60%
    8 2020 4.00% 1.95%
    9 2021 5.00% 2.20%
    10 2022 4.00% 2.41%
    11 2023** 4.00% 2.54%
    12 2024** 5.00% 2.59%
    13 2025** 5.00% 2.68%
    14 2026** 5.00% 2.75%
    15 2027** 5.00% 2.84%
    16 2028** 3.00% 3.08%
    17 2029** 3.00% 3.13%
    18 2030** 3.10% 3.20%
    19 2031** 3.15% 3.27%
    20 2032** 3.20% 3.34%
    25 2037** 3.50% 3.64%
    30 2042** 3.625% 3.71%

    *Yield to Worst (Call or Maturity) **Par Call: 3/1/2022
    Source: Bloomberg This is an example of a new issue priced the week of   10/1/12 Prices, yields and availability subject to change


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