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Investment Process
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  by Dennis M.
 •Brae Head Total
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Past Commentaries

Current Commentary, Review and Outlook
January 1, 2008

To My Clients, Friends & Observers:

Apparently I’m not the only one feeling a little squeamish. You have to be optimistic, yes, but realistic too, and it’s hard not to think about things like, oh, a war with no end, the price of gas and food, the dollars that are rotting in my pocket, the cost of my kids’ educations, the price of my health insurance, and the chronic, systemic corruption of our political economy. Why am I not relieved watching our presidential candidates address little or none of the above? Sure, I’m all for “hope” and “change” but could I maybe see a few of the details?

There is a small bust of George Washington in my office. What would he think, this president who had to be begged to serve, who did so without pay or vanity, and who retired so gracefully? How would he react to this election burlesque today, overweighted in greedy, pandering, vain ideologues winking and nodding, talking in code, saying everything and saying nothing? The challenges for the next president are so enormous that I’m frankly suspicious of any candidate who wants it badly. They say that Fred Thompson “doesn’t want it badly enough.” Who would?

The politically savvy will always deflect responsibility for any action with an uncertain outcome. Best to have someone to blame in place at all times. One would think from watching the news that the Federal Reserve chairman is solely responsible for the economy and the stock market of the United States. The executive branch is a lame duck shackled to its crusade 150 degrees around the globe, waiting for relief that only history will bring. I recommend Sun Tsu’s “Art of War” for everyone’s reading list. The legislative branch seems to do as little as possible and I suppose we should be grateful. It probably pays better. Why risk alienating lobbyists and donors by doing something? In any case we have the judicial branch to make the laws.

Our most recently retired Fed chairman fell in love with this arrangement - and with himself apparently, although I’m not certain of the sequence. Now, with a press agent and a book deal, he won’t shut up, despite the inarguable fact that it was his easy money policies which let the party get out of hand to the extent of the hangover we suffer today. As recently as ’05 it was his testimony that there was “no housing bubble.”

Our dollar has lost 50% of its value against the Euro, 40% against the pound and over 20% against a basket of Asian currencies since 2002. The price of oil has tripled in dollars, doubled in Euros and remained the same in gold. We have inflation: rising prices, falling currency and diminished purchasing power. Whatever happened to the objective of price stability? Moody’s Investor Services has announced that the U.S. Treasury Bond could lose its AAA credit rating within ten years. Our standard of living, let alone our retirement plan, is at great risk.

The producer price index was up 6.3% in 2007, consumer prices up 4.1%. Cost of food increased nearly 25%; oil and gas energy an additional 18%. Inventories rose .4% in December. Leading indicators are down three months in a row. The Philadelphia Manufacturing Index dropped precipitously to -20.9 in January from -1.6 in December. Yes, the signals of recession or slowdown are multiplying. The Fed will cut rates further – at the further expense of dollar value – to keep the party going. I would rather suffer the slowdown – we all would – rather than sacrifice our purchasing power! We are quietly being legally robbed and none of the presidential candidates addresses it, other than Rep. Ron Paul, M.D., who has been glibly marginalized as a dope.

I watched Chairman Bernanke address Congress this morning and many of the questions put to him were about the type of “short-term stimulus” that Congress might pass to help the economy. Here we go again: the Fed’s going cut rates, Congress is going to mail everybody a check, the president is going to come up with some temporary business spending incentives. Same ol’ same ‘ol ‘til next time, and the next times are coming harder and faster.

Here are the best things Congress could do short-term: stop pasting band-aids on an economic slowdown and start fixing the long-term, structural problems, starting with the moral hazards of its own behaviors, like taking money from foreign interests. Pass H.R. 2600, which has been stuck in committee since June. That is the Border Tax Equity Act of 2007, co-sponsored by 14 Reps from both parties. It would tax imports to the same degree that their Value Added Taxes are exempted by their countries of origin. It would start to level the playing field for our manufacturers. Start exporting our health and safety standards to countries that are exporting the products of almost slave-labor at clearly predatory prices. Fine and imprison the personnel of companies hiring undocumented aliens. (That would end the illegal alien problem in 6 months.) Boycott and sanction OPEC countries. (That’s another bill that can’t seem to get started, NOPEC, sponsored by Arlen Spector.) Open ANWR, the Gulf of Mexico and the Santa Barbara channel to oil drilling. Make the tax cuts permanent and stop the pork barrel spending.

Here’s the best thing the Fed could do short-term: cut the Funds rate to 2.5% to get it in line with the rest of the yield curve, which would then be positive, and then leave it alone. Stop printing excess money. Stop talking to the Street. Start talking up the dollar. Though open-market actions are generally ineffectual, political campaigns and jawboning have had results at stabilizing the currency. Start talking, loudly, about the cost of war and the effects on the economy.

Here’s the best thing the administration could do: end this war in Iraq as quickly and systematically as possible. Apart from the deaths of over 4,000 heroic young Americans and the tens of thousands of Iraqis, this has been phenomenally expensive. It is an economic disaster. We experienced sharp inflation shocks after WWI, WWII and Vietnam. Does anyone care to mention the fathomless stupidity of the policy called “Guns and Butter” during the Johnson administration? We paid the price for over ten years and the Social Security system has never recovered. The Fed is printing money to finance a war. Let us recall Eisenhower’s warning about the military industrial complex. Get out of the Middle East, NATO and Korea entirely; we have no allies there that can’t take care of themselves. Start using diplomacy and economic weight instead of the military. There is no need to put missiles in Eastern Europe other than to recreate a Russian enemy. There is a rationale for trade sanctions and tariffs; start suggesting them to beneficial effect. Talk softly and carry a big stick. Ask for Congressional support for global trade policies.

 The CMO: A Personal Memoir

 Though it seems that “subprime” is the culprit for everything housing related, in fact there are structural problems with the securitization of the mortgage industry, inherent problems left unaddressed since the creation of mortgage-backed securities in the 1980’s. The problems with pricing collateralized mortgage obligations have surfaced repeatedly over the last twenty years. They simply can’t be priced like bonds.

I bought my first CMO for clients on May 25, 1988. It was CMO MLT 31C, with an indicated annual yield of 11% to final maturity on 5/8/2009. I bought my second CMO for clients on June 22, 1988. It was CMO MLT 32B, with a yield of 10.01% to final maturity on 8/1/2008. I read the prospectus for each thoroughly. These were pools of mortgages, grouped into proportions of principal and interest repayment called “tranches.” Tranch A would pay all principal first and a little bit of interest last; tranch G would pay nothing but interest to start and principal only at the end; tranches B and C paid some combination of principal and interest in different proportions between A and G. CMO’s appeared attractive to certain institutions which wanted some predictability of duration and return.

Bear in mind that all mortgages must carry some prepayment assumptions and with a pool of mortgages these assumptions can only estimate an average life of the securitized debt. The average life of a CMO is critical to its duration. Duration is the formula used to accurately price a fixed income security as market interest rates (yields) change. This is not a straight-line relationship, in fact the change of price/yield is convex. The convexity of bond prices to interest rate changes (or the volatility of bond prices) is as much a function of the expectation of interest rate changes as it is to actual market interest rates.

Here’s the bottom line: the best calculations we can make for the duration and convexity of a specific bond – with a fixed maturity and interest rate – are approximations. For a pool of a thousand different mortgages the estimates and assumptions are magnified. So is the margin of error or unpredictability. The only certainty is that the results will be somewhere in a range.

Those early CMO’s were the only ones I have ever positioned. I liked the product. They were, quite literally, “plain vanilla,” which is the term given to those first generation CMO’s. At those rates my clients were doubling their money in less than seven years. (They lasted about 5 or 6 years before being completely paid out.) But subsequent CMO offerings were not plain vanilla. The prospecti had become impenetrable documents 80 pages or longer, with litanies of estimates and assumptions spread across 30 or 40 exchangeable tranches, some with floaters and/or inverse floaters. They were full of smoke and mirrors to me. Because of inaccurate prepayment assumptions CMO’s eventually could only be grouped according to “original average life.” 

Not too long afterwards, in 1989, I sold a client a “joint and survivor” life insurance policy. This policy replaced an existing policy on which the client was still paying annual premiums and actually seeing declining cash values. This new policy required one payment, a single premium of $140,000, and would pay close to a million dollars, to be used for estate taxes, upon the second death of the married couple. Internal rate of return was greater than 7%. If they died within 20 years it was a very good investment. If they lived longer than that it still wasn’t a bad investment. One of the things I always insisted on from insurance underwriters was an illustration of the lowest interest rate possible for the policy, the “worst case scenario.” The insurance company in this case had an A+ claims-paying rating, the highest given by A.M. Best, the rating agency.

When I reviewed the first annual policy statement with my client I was shocked. The value of the policy was much less than originally illustrated despite the fact that interest rates hadn’t changed much. I called the company and got a revised “in-force” illustration along with some reassurances. OK. In year two, the problem had gotten worse: in addition to deteriorating valuations the policy was now showing premium payments taken out of dividends. I called the company again. This time I needed an explanation for why a “vanishing premium” option was being exercised when neither I nor the client had authorized it. I also wanted to know precisely what the underlying portfolio of securities was that funded the policy. The policy was performing worse than the “worst case interest rate scenario” they had illustrated and interest rates had not changed. They wouldn’t reveal the investments.

So I sent a three page letter with attachments to the Commissioner of Insurance here in Massachusetts. Her completely unsympathetic response was that I had most likely misrepresented the policy I sold and that I should be prepared to make a full accounting to the underwriter and prepare for some potential regulatory censure. She was undoubtedly very popular with the insurance industry and probably considered me “off the reservation.” I don’t respond well to this type of bullying. So back I went to the underwriter in Toronto, telling them explicitly what they had done wrong and what I wanted them to do to make my client whole. Their response was another threat letter. Sandbagged for the last time, I asked my clients if they would allow me to help them litigate. They consented.

Two weeks later I sat in the offices of Millberg, Weiss, Hines, Bershad, & Lerach in New York, stating the facts on behalf of my clients, who became leaders of a class action suit against the insurance company. It resulted in a settlement, almost nine years later, of over $500 million to the plaintiff’s class. My clients were made whole and finally, the mystery of the underlying investments was solved. They were CMO’s, packaged and sold by the investment bankers of my former firm. There were many class action suits in the 90’s against insurance companies with policies featuring “vanishing premiums” that never vanished. Most were invested in CMO-type products.

So why then, if these things can’t be priced properly, are they still being sold? Why, to make matters worse, do these structured products contain sub-prime (junk and worse) debt obligations? Well, in the interest of either diversification or deception many bankers buried measures of sub-prime junk in large pools of mortgage backed product to be distributed to other institutions around the world. This neither mitigated any risk nor hid the nature of these sub-prime bombs. It’s kind of like having “a touch of ebola” or “a little HIV.” These things have been continually written and sold for the easy money they’ve generated. They have been sold and subsequently relied on as loan collateral by institutions large and small around the world. What a disgraceful export. If no laws have been broken, then we need some new laws.

 Despite the mayhem it has created – globally – Wall Street had a record year in 2007 for bonuses. This includes Merrill Lynch, which took $12 billion in losses in the last two quarters and yet paid out compensation that exceeded revenues. It also includes Jeffries Group, which we own, and which recorded $140 million in net earnings for the year, but which took a $24 million loss in the 4th quarter because of bonuses and compensation costs paid to keep executives from going to competitors. This is absurd. Where are the stockholders bonuses?

 Maxed Out

Throughout history morality sometimes gets ignored when it comes to making money. Such times can be perilous. I am reminded of the remark made to me by my manager at my first brokerage firm which refused to pay me an investment banking fee I had earned. He said, “Nobody lied, the truth changed.” I left a month later. That firm, and perhaps too much of the industry, became overpopulated with “wise guys” in management. They are paying the price now. It seems today it is immoral not to make money and those that don’t are punished.

Maxed Out is the name of a current documentary DVD that I recently rented from Blockbuster. I was so impressed by it that I bought two copies for my lending library. I urge everyone to watch this movie. The credit card industry, as this movie shows, preys on those least able to pay: the infirm, the young and naïve, the irresponsible, the poor and the ignorant. The industry lobbied hard for the discard of usury laws, and won. Not too long ago they scored with Congress again, changing the bankruptcy laws so that creditors can own their debtors for life.

This is not hyperbole, given the fact that an average person maxed out on their credit cards and making minimum monthly payments will likely die before the principal is repaid. Some card companies often deliberately hold payment checks or not cash them at all in order to provoke late fees, penalties and higher interest rates. Total costs can exceed 40% annually. The profits are too obscene to quibble about the price in human misery. Welcome to Pottersville!

Such a corporate culture obviously found its way to the mortgage business. The term “sub-prime” was no less respectable than “junk bond” until very recently, and there is a good market for junk. Funny thing is, in the corporate world, a “prime” borrower is something less than best credit risk. Junk bonds are traded in the light of day; sub-prime loans have been hidden in pools of other debts.

This is not a one-way ticket

 A global economic meltdown is in no one’s best interest. If we can avoid a world war, economic growth of the developing nations will accrue to our benefit and we will all be wealthier. There will be many multilateral trade agreements and compromises along the way. The best defense against circumstances beyond our control is to own the participating companies. There is no other place to go. Better an owner than a borrower. There is little return for lenders in the fixed income markets. The markdown in the equity markets so far this year is the largest since 2002. Bearish sentiment reached 70% last week. The highest I can recall was 65% in 1995 after which the market returned 23% in the following 12 months. To sell into the present panic would be a big mistake; better to hedge. However, this sell-off could accelerate if credit default swaps fail. These swaps are derivatives designed to mitigate defaults - to an extent.

Perhaps a moratorium on the dismantling of the securities regulations created during the Great Depression is in order. I question whether voiding Glass-Steagall was a good idea. I regret that the uptick rule for short sales was eliminated last year. Clearly, the production and distribution of derivatives needs oversight. Hedge funds need more transparency. The costs of mistakes or malfeasance extend far beyond the participation of the “accredited investors” in the funds.

You have to be optimistic. Things do change when they have to change. Right now there may be a consensus forming that trade and finance have got to change. It is in neither the best interest of the U.S. nor the rest of the world to lose the dollar as the reserve currency. The dollar has to be defended with sound monetary and fiscal policies and fair trading agreements. Whole chunks of American capital infrastructure are being traded for oil. This is like selling off parcels of the family farm for pizza and beer. Communicate with your representatives.

The correction in real estate is creating great opportunities for those capable of buying. Right now there are million dollar properties auctioning for $400,000 in San Diego County. Many of the untouchable real estate markets are accessible again. Keep your powder dry and your eyes peeled. Even better opportunities are ahead into 2009.

Best regards,
Dennis M. O'Connor

Dennis O'Connor