Private Account Wealth Management Services
Newsletter Issued 09-10-07:
By: John T. Moir
Chief Editor: Clare Mc Kendrick

Position overview . . .

Our previous newsletter, dated August 10th, anticipated the continued downward trend in the major stock indices, with the DOW have a trading range for the month between 12,450 and 13,700. The actual result saw the DOW trend lower, as the share buyback’s and leveraged buy-outs (LBO’s) were postponed and the liquidity spigots was slowly being turned off, with the final trading range for the month between 12,517 and 13,695 — a very accurate forecast.

The US treasuries were projected to rally in price and subsequently cause yield to decline, as the stock market moving lower would produce a safe-haven purchase of various US treasuries. We anticipated that the US 10-year note would have a peak yield for the month of 4.90%. The US treasuries did rally in price, and the actual 10-year note yield range for the month was between 4.51% and 4.86% — a very accurate forecast.

We projected, as least for the near-term, that the US dollar would be supported and anticipated a euro fx equivalent trading range for the month between $1.35 and $1.39. This US dollar anticipated support was for technical reasons, since it could come under significant pressure, if foreign holders of US dollars were to loose confidence in the US monetary policies as whole. The US dollar did rally during the course of the month, resulting in an actual euro fx equivalent trading range between $1.3419 and $1.3841 — a very accurate forecast.

Looking forward . . .

Last Friday’s employment report, released by the Bureau of Labor Statistics (BLS), saw a loss of 4,000 non-farm payroll jobs, when the consensus was for a gain of 110,000 new slots — surprising all of Wall Street. Furthermore, to make things even worse, the job picture was revised lower in June by a whopping 57,000 positions and July by 24,000.

The so-called household data, which bulls used to eagerly parade because it consistently outdid the establishment count, continued this year’s poor performance, shedding 316,000 jobs last month.

What last months dismal employment showing does is pretty much insure the case for a cut in the federal-funds rate and also cinches the case for a recession, later this year or early next.

The current investment landscape and the eruptions that are taking place, courtesy of the subprime disintegration, is similar to when the NASDAQ began to head south in early 2000. The pundits were convinced that we were witnessing only a brief correction. In like manner, in 2005 as the home-building stocks, which had been strong performers, slipped back, the prevailing advice was not to worry, housing was fundamentally sound.

The same complacency, with few exceptions, was the reaction when subprime problems began to emerge last year. The pundits, who failed to recognize the housing and subprime bubbles, are now insisting that problems in collateralized debt obligation (CDO’s) are small in nature and scope. Instead, the problems are anything but insignificant and are apt to cause hurtful losses for financial institutions and their clients when the underlying securities have to be valued at market prices. Several of these institutions will be reporting their third-quarter earnings, from September 18th through the 20th, which should shed more light on the magnitude of their direct monetary involvement in these area.

We estimate that subprime mortgages made up more than half of the $500 billion in CDO’s sold in 2006 and 25% of the face value, or roughly $250 billion, is in jeopardy. This is a significant number, when compared with the $875 billion of capital sported by US commercial banks.

The large losses in the CDO market could have very ugly repercussions, not the least of which would be a pronounced slowdown in financial credit growth, evidences of which are already cropping up now. This, quite obviously, holds very unpleasant implications for the US and global economies. The current credit excesses, both in terms of their quantity and low quality, dwarfs those of the Roaring 20’s — comforting thought.

Real money — US insurance companies and pension funds accounts — actually stopped purchasing mezzanine tranches of US subprime debt in late 2003 and Wall Street needed a mechanism that could enable them to “mark up” these loans, package them attractively, and export the newly composed risk to unwitting buyers in Asia and Central Europe.

The CDO’s were the only way to get rid of the riskiest tranches of subprime debt, and those buyers — mainland Chinese banks, the Chinese Government, Taiwanese banks, Korean banks, German banks, French banks, and U. K. banks — possess the excess pools of liquidity around the globe. These pools are basically derived from two courses: First, massive trade surpluses with the US in US dollars, and, second, petrodollar recyclers. These two pools of excess capital are US dollar-denominated, and have had a virtually insatiable demand for US dollar-denominated debt, until now.

These investors at one time had standing orders on Wall Street desks for any US debt rated triple-A. The CDO managers collected triple-B and triple-B minus subprime and repackaged them so the top tier was paid out first, through the alchemy of CDO’s and the help of the ratings agencies. Wall Street would leverage the lower mezzanine tranches by 10 to 20 times and would magically have 80% of the structure rated ‘AAA’ by rating agencies, despite the underlying collateral being a collection of BBB and BBB- rated assets. This could go down as one of the biggest financial illusions the world has ever seen.


Credit crises have always been painful and unpredictable, and the current one is of no exception, because it is occurring amid the first truly global bubble in asset pricing. It is also accompanied by a number of new and ingenious financial instruments, which are designed overtly to spread risk around and to sell fee-bearing products that are in great demand. They have been inadvertently constructed to hide risk and confuse buyers.

How this credit crisis works out and what price investors end up paying depends on hundreds of interlocking and often novel factors, which also in turn affect animal spirits of “greed and fear.” The management of animal spirits, in the end, is what makes and breaks credit crises.

We are facing some near certainties that should be understood, even if this crisis is contained. First, house prices may move on euphoria in the short-term, but long-term will depend on family income — the ability to pay mortgages and rent.. The market gradually loses first-time buyers until prices break and fall back to affordable normal levels of four times family income. House prices are in genuine bubble territory in the US, Britain and many other markets. In Britain, and in some critical large cities in the US, for example, the multiple of family income has risen to over six times from below four times, and in London last year the percentage of first-time buyers was the lowest since records began being kept. Prices assuredly will fall, from these high levels. They will also further increase mortgage defaults, most of which lies ahead, and lower financial profits as well as overall confidence.

Second, profit margins are at record levels around the world, which have lifted stock prices directly alongside the rising earnings. They have served to raise the price-to-earnings (P/E) multiples as well, as investors on average reward higher margins with higher P/E’s. This may be fine for an individual stock, but for the entire market, multiplying boom-time profits by high P/E’s is horrific double counting and sends markets far too high in good times and far too low in bad times. Higher margins also indirectly raise prices by providing more cash flow for buyback’s and takeovers. So, high profit margins offer multiple supports for the market, but they will eventually decline. They are the most dependably mean-reverting series in finance, since if high margins do not attract greater competition, then a wheel has fallen off the capitalist machine.

Third, and most important, risk will be re-priced. Last year a broad base of risk measures — including volatility, junk and emerging debt spreads, CD rates, high-quality vs. low-quality stock values — reflected the lowest risk premiums in history. On some data investors actually appeared to be paying for the privilege of taking risk. Some spreads, for fixed income, widened slowly at first this year and then widened rapidly in recent weeks. The process for equities, though, has hardly started, as junkier stocks continued to outperform into June, even as the subprime woes spread. High-quality blue chips will sell at normal premiums or better, at the end of the cycle. Investment bubbles and high animal sprits of “greed and fear” do not materialize out of thin air, but need extremely favorable economic fundamentals together with free and easy, cheap credit, and they are required for at least two or three years. Importantly, they also need serial pleasant surprises in such critical variables as in global Gross National Product (GNP) growth, which has all been provided. These conditions always produce excess and are always extrapolated. They, unfortunately, eventually move back to normal, like almost all other investment factors.

Asset prices will be under broad pressure and risky assets will be under extreme pressure, as favorable factors cool off. This adjustment could happen quickly and painfully, if the credit crisis gets out of control. It will still happen slowly, even if all works out well on the credit front.

Long-term conclusions and current month expectations . . .

We think the current problems with the stock market cannot be solved by a liquidity injection. The stock market will likely return to levels where asset prices properly reflect the embedded risk, and the Fed may try everything to prevent this from happening. The risk of deflation concerns the Fed more than the certainty of inflation, which could cause the Fed to aggressively cut interest rates. This type of stimulus could support the stock market briefly, but after the any initial euphoria, we expect asset prices to continue their decline to lower levels. The DOW is anticipated to continue this decline, with a projected trading range for the month between 12,200 and 13,500.

Foreigners were feeling a little queasy about US Corporate’s in June, long before the proverbial “stuff” hit the fan, a catchall category which includes mortgage-backed securities and asset-backed securities. The $46 billion decline in private purchases of high-yield paper — from $68 billion in June to $22 billion — was offset to some degree by central banks, which graciously upped their purchases of US treasuries from $11 billion to $53 billion. One can only imagine what the July and August numbers will reveal. The US treasuries are expected to remain price-supported during the course of the month, as the 10-year note holds yield support above 4.60%, with prices remaining firm and yields subsequently declining.

There are more than $1 trillion of securitized low-grade mortgages outstanding and nearly three-quarters of a trillion dollars worth of mortgages whose adjustable rates are slated to rise over the next year, a majority of them sooner rather than later. These resets, in truth, are not confined to real-estate lending, but affect the overall US economy. Borrowing short has become a raging epidemic, with floating paper now accounting for 54% of the total debt issuance, up from 26% as recently as 2002. That means a startling $540 billion in corporate bonds will need to be rolled over next year.

Financial enterprises are the serial abusers, who will need to replace a tidy $430 billion in debt next year, a third more than this year. In 2008, some $160 billion worth of leveraged loans will mature as well.

Furthermore, these is the $87 trillion interest-rate swaps market, where long-term fixed rate obligations are converted into floating rate short-term notes. Swaps have accounted for more than half of the growth in the $145 trillion derivatives market in the past two years.

These three areas of concern, alone, assures an appreciably larger magnitude of pain in the months ahead for the stock market and US economy as a whole.

The US dollar could be supported near-term, since it is close to long-term price lows. We are anticipating, from a technical prospective, that the US dollar will hold this key support level and have a euro fx equivalent trading range for the month between $1.34 and $1.38. However, the reaction to the upcoming Federal Open Market Committee Meeting (FOMC) on September 18th, where they are expected to cut the prevailing fed funds interest rate of 5.25% by 25 or 50 basis points (0.25% or 0.50%), could cause foreign countries to lose confidence in the US dollar, resulting in its decline even further, to new lows.

The proposal made by President Bush recently to help investors retain ownership of their homes will simply do nothing to change the insolvency of the home buyer. The system is illiquid and that problem was addressed by central banks three weeks ago, but “borrowers” still are insolvent. There is nothing in the proposed plan that will change that fact — nothing.

Softening the tax bite on mortgage write-downs and allowing homeowners who are delinquent by more than three months and who have decent credit history to switch into a Federal Housing Administration (FHA) loan carrying a lower interest rate will effect modest changes. The real questions is how do you get a lender to renegotiate a mortgage when you do not know who the lender is, with some $6 trillion of the $8 trillion in residential mortgage debt having been securitized and sitting who knows where? How do you structure a new deal? One can only imagine the long-distance bill the FHA will have to run up as it tries to arrange a conference call with the Taiwanese banks, German banks, and many others listed earlier, to attempt such an arrangement. This proposed plan is more of a Band-Aid rather than serious relief, given the current condition of housing and the prospect of a huge resetting upwards of adjustable-rate mortgages over the next year, with a big spike in March 2008.

There is something like $300 billion in debt sitting on banks balance sheets pledged to fund the last gasp of merger and acquisitions (M&A) boom, commitments made when junk bonds were priced much more attractively. We can also look forward to the impact of hedge funds dumping assets to meet what could easily prove to be a mighty rush of redemptions. Currently, the secondary cash market is a ghost town, with very little two-way flow, since “The “Street” is full of inventory and really does not want to trade. In comparison, the junk-bond market and asset-backed commercial paper has all virtually shut down.

The fear this month is that there could be a tsunami of some $400 billion of high-quality mortgage-backed bonds that will be dumped by hedge funds and others that have to sell assets to deleverage and want to raise cash to meet growing redemptions.

Also, there is a lot of bond-related supply expected this month that will likely put new pressure on yield margins — the premiums that bonds pay over super-safe US treasuries with comparable maturities. It is simply a matter of time before these issues come to the proverbial surface.


1. A 85% to 95% 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 5% to 10% 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.

Please call the number provided below or e-mail us and we would be happy to provide further clarification, if there are any questions regarding the information discussed within this newsletter, the investment allocations mentioned above or our unique management services.


John T. Moir
Worldwide Investment Manager
Wavetech Enterprises, LLC
Phone: (775) 841-9400

Acknowledgements: Federal Data, Jeremy Grantham with GMO, Gloom, Boom & Doom Report by Marc Faber, Sean Hannon with Epic Advisors, MarcoMavens by Stephanie Pomboy, David Rosenberg, Economist, Barry Ritholtz with Ritholtz Capital Partners, Mirko Mikelic with Fifth Third Asset Management.

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