WAVETECH ENTERPRISES, LLC
Private Account Wealth Management Services
Newsletter Issued 07-10-07:
By: John T. Moir
Chief Editor: Clare Mc Kendrick
Position overview . . .
Our previous newsletter, dated June 14th, stated that there are an increasing number of technical divergences appearing within the major stock indices, confirming our belief that we are close to resuming a stock market decline. We forecasted a DOW trading range for the month between 12,750 and 13,700, with the anticipation of this forthcoming decline. This projection proved to be partially accurate, but with a narrower-than-expected trading range for the month, between DOW 13,251 and 13,692.
The US treasuries were forecasted to see higher yields, as inflation fears reemerged, resulting in the 10-year note yield piercing the formidable interest rate level of 5.25%. This proved to be fairly accurate, as the 10-year note yield did reach an intra-day high yield of 5.30%, before closing at 5.24%. The lack of a close above the key 5.25% interest rate yield, caused the US 10-year note to rally in price and inversely decline in yield, as it remained within a range for the month between 4.93% and 5.24%.
The US dollar was anticipated to attract continued interest, due to rising yield of the various US treasuries, and we had a forecasted trading range for the month between euro fx equivalent of $1.31 and $1.36. This projected trading range proved to be larger than anticipated, with the actual euro fx equivalent range for the month being between $1.3315 and $1.3572. There still remains a number of uncertainties that are preventing to the US dollar from mounting any type of formidable rally, which led to narrow trading range for the month.
Looking forward . . .
There were mortgage-backed securities, in the beginning, that turned ordinary home loans into bonds. Then came collateralized mortgage obligations (CMO’s), which divided and distributed the mortgage securities according to when they would get paid off. This payoff period has always remained uncertain, especially given homeowners’ agenda to refinance when it suited them.
The next phase was the collateralized debt obligation (CDO’s) and it close relative, the collateralized loan obligation (CLO’s). Both the CDO’s and the CLO’s represent pools of corporate bonds or other loans — including subprime mortgages — that are split up into groups of varying risk and return. The first in line to get paid and receive the highest credit rating and the lowest yield, and so on down the line.
Here is where the real problem begins: The top tier of CDO’s and CLO’s can be backed by a pool of junky credits and still get a triple-A rating. The pawns at lower tiers absorb the losses to protect the major obligations in the top tier. The financial derivative markets have exploded, in just a few years, to as much as $1 trillion, by some estimates.
It appears that the ratings agencies were convinced into giving triple-A ratings to these fancy derivatives by their glossy first-impressions. Many of these trashy assets, in prim and proper attire, are trying to be passed off as having a justifiable triple-A rating, but without any form of pedigree for such a rating.
Bloomberg estimates that 65% of the bonds in the indexes that track subprime-mortgage debt do not meet the rating criteria at the time they were issued. That means Moody’s, Standard & Poor’s and Fitch are all masking mounting losses by failing to downgrade these securities. There could be forced-selling that would further roil the subprime and CDO’s, if those downgrades actually took place.
CDO’s are traded rarely, if at all, in a thin market. As a result, these exoticas are not “marked to the market,” like most securities, but “marked to a model.” Various reports indicate the high-quality CDO’s that a Hedge fund going-out-of-business tried to sell, fetched bids as low as 85 cents on the dollar.
A whole parade of leveraged financing’s have been recently either postponed, restructured or left on underwriters’ shelves, since they now lack the support of the derivatives market.
We may have reached a turning point in leveraged financing. Dealers reportedly are cutting back on making markets in high-yield paper, because of the capital they have tied up in bridge loans and problematic mortgage paper. Also, securities in the secondary market may face markdowns, if new issues have to be priced at a discount to draw buyers.
Private-equity firms have been slow to face up to the deterioration in the financing environment for leveraged buyouts. Dealers who have been unable to persuade deal sponsors to adjust terms to the new reality are instead leaning on investors.
These dealers are warning portfolio managers who refuse to “take their fair share” of the troubled offerings will be faced with reduced allocations on more desirable securities in the future. These are similar tactics that were employed by Drexel Burnham Lambert in the latter days of the reign over the junk bond market in 1989.
A pickup in default rates could slow the creation of CLO’s, cutting off the key financing source for new leverage buyouts (LBO’s). All of these capital-market mechanisms will ultimately cut back on financing various deals, reducing aggressiveness by private-equity firms. This could remove the buyout premium from stock prices, which may be an understatement.
An array of factors has conspired to produce at least a short-term turning point in the perceptions of risk, which are as follows: The already-discuss subprime-mortgage and CDO woes hitting hedge funds, the overextended carry bets on the Japanese yen by naive investors, the hawkish comments on monetary policy, and emerging-market central banks shifting assets from US dollar bonds, which has pushed volatility higher.
Central banks have been tamping down volatility by flooding the global financial system with liquidity, since the bursting of the dot-com bubble in March 2000. China’s currency peg has added to the flood by printing a massive amount of yuan to buy up US dollars that are recycled into US assets, keeping a lid on American interest rates and providing cheap financing for US home buyers. Japan, by holding its interest rates at just 0.5%, has provided fuel for global speculation in high-yielding assets via the “yen carry trade.”
This cycle, in essence, has seen a massive arbitrage, using cheap debt financing to buy up equity and property assets all over the globe.
The key question now is when, not if, the credit flow will end. This would mean the other processes could go into reverse, notably the “yen carry trade,” and have a profound impact on equities as well.
The carry traders will have to buy back the Japanese currency they sold in exchange for higher-yielding assets, as borrowings in cheap yen are paid back to meet margin calls. This has not happened so far, but when the yen carry trade unwinds, the global margin call will be on.
The addition of China and India to the global economy is recent years brought a wave of disinflation, as millions of workers added to the global labor pool, producing low-cost goods and providing cheaper services. However, this disinflation wave is waning, and the development of China and India has been pushing up the prices of many commodities.
We are now seeing a lessening in the level of liquidity, not only in the US, but around the world. Liquidity is still positive, but the trend is toward less-favorable conditions. This means risk levels are rising for equity investors around the world, especially in Brazil, Russia, India, and China.
More than 90% of all new money invested in mutual funds by US investors in April 2007 went into international funds. We have not seen mutual fund flows so lopsided since early 2000, just prior to a major stock market decline.
Long-term conclusions and current month expectations . . .
The subprime market awaits a far greater problem in the next two years, when homeowners will face increases of as much as 50% in their monthly payments, after their two-year teaser rates expire and convert to materially higher floating interest rates. This two-year period will see an estimated $800 billion in subprime loans reset to much higher interest rates.
For many subprime borrowers, default will be the only viable option, as tighter lending standards close the refinancing window shut for them. Dwindling or negative equity in homes mean these homeowners would not be able to roll into a 30-year fixed mortgage, even assuming that they can handle the higher monthly payments. Therefore, we are expecting foreclosures to surge in the months and years ahead.
It is becoming increasingly apparent that the credit-rating agencies made some fundamental mistakes in determining triple-A status to so much subprime-CDO debt, and their models assumed the US housing market is regional, not national. They reasoned that large CDO pools, composed of mortgage slices from all over the US, would provide sufficient diversification to sustain localized meltdowns.
Subprime problems appear to be growing exponentially, with sloppy loan underwriting in the past two years and the looming reset problem are now national in scope. Many subprime CDO’s are synthetic creations that reference the performance of the same mortgage-backed securities.
The coming crisis in subprime CDO’s is reminiscent of the Savings & Loan (S&L) collapse of the early 1990’s; both involved improper lending and will be enormously costly. The bill for the earlier S&L mess totaled more than $150 billion, but this current house of cards is already costing over $200 billion today, and could exceed $800 billion, depending upon the percentage of equity recovered through the liquidation process. This conservative estimate is based upon existing home values declining by less than 15%, but it is highly likely that values will decline even further.
This time around the burden will fall on both global and US investors, and the repercussions are likely to be felt on Wall Street as well. The DOW, along with the other major stock indices, continue their topping-in-price process, and are close to resuming either a correction or a major stock market decline. Therefore, we are forecasted a DOW trading range for the month between 12,700 and 13,675.
The US dollar is struggling to maintain global support, and is anticipated to resume its decline in value, with a euro fx equivalent trading range for the month between $1.35 and $1.39. This deteriorating support could propel the US dollar to new lows, even if interest rate yields, offered by US treasuries, move higher.
The US treasuries are forecasted to remain within a large yield range for the month, as global investors continue to decide if they will purchase additional US treasuries in the coming months. The US 10-year note is projected to a yield range for the month between 4.75% and 5.20%. Last month’s attempt to pierce the key 5.25% yield on the 10-year note may still be achieved in the near future, as rising inflation concerns continue to grow, with increasing wage pressures and elevated inflation-related commodity prices.
SUGGESTED INVESTMENT ALLOCATIONS:
1. A 75% to 85% allocation of their taxable ordinary funds and/or tax-deferred funds into a conservative as well as flexible investment strategy using various no-load index mutual funds and exchange traded funds (ETF’s) offered through our Wavetech Enterprises’ Private Account Wealth Management Services. The minimum investment criteria are determined after reviewing the investor’s current assets and fund allocations. These services are ideal for individuals, trusts, foundations and privately held corporations that have large stock, bond and/or real estate holdings and are seeking an active management service to generate a long-term average rate of return on investment between 15% to 20% per year (after fees) through either a rising or declining stock, bond or real estate market.
2. A 15% to 25% allocation toward cash, Treasury bills, CDs or money market funds with short maturities which will allow investors to rollover these instruments and obtain a higher level of return as interest rates move higher.
If there are any questions regarding the information discussed within this newsletter, the investment allocations mentioned above or our unique management service, please call the number provided below or e-mail us and we would be happy to provide further clarification.
John T. Moir
Worldwide Investment Manager
Wavetech Enterprises, LLC
Phone: (775) 841-9400
Acknowledgements: Federal Data, Bloomberg, Bill Gross with Pimco, Barry Ritholtz with Ritholtz Research & Analytics, Leverage World Letter by Martin Fridson, Bridgewater Associates’ Daily Observations by Bob Prince and Fred Post, Deutsche Bank, MacroMavens by Stephanie Pomboy, Financial Commentator by James Welsh.
Note: These newsletters have no regard to the specific investment objectives, financial situation or particular needs of any specific recipient. These newsletters are issued for informational purposes and are not to be construed as a solicitation or an offer to buy or sell any securities or related financial instruments. These newsletters are based on information obtained from sources believed to be reliable, but are not guaranteed to be accurate, nor are they a complete statement or summary of the securities, markets or developments referred to in the various newsletters. Recipients should not regard these newsletters as a substitute for the exercise of their own judgment. Any options or opinions expressed in these newsletters are subject to change without any notice and the Wavetech Enterprises, LLC newsletters are not under any obligation to update or keep current the information contained within. Past performance is not necessarily indicative of future results. Wavetech Enterprises, LLC and its newsletters accept no liability for any loss or damage of any kind arising out of the use of any or all parts of these newsletters.