Harry Newton's In Search of The Perfect Investment
Newton's In Search Of The Perfect Investment. Technology Investor.
8:30 AM EST Thursday, February 14, 2008: St
Valentine's Day. For years muni bond floaters worked. I've been in them for
years. As you know from yesterday's column, these things have now blown up.
As I wrote yesterday,
Every day on
Wall Street there are auctions which sell off short-term paper. For years
I have bought paper in the auctions for seven and 28-day packages of (triple
tax-free) muni bonds. I have used these bonds as a way to earn extra money
on cash. You can call these things by different names. I call them floaters.
for the first time in at least 20 years (not true it turns out -- it happened
after September 11) -- a variable rate preferred muni bond auction failed.
Not sufficient buyers showed up. Normally when this happens, the seller, in
this case Citibank the firm that sponsored the auction, would step in and
buy the unsold floaters. But they didn't.
Last night, Mike
O'Rourke, Chief Market Strategist of BTG, wrote to his investors:
The newest headliners
are Auction Rate Securities (ARS). Its time to jump back into the alphabet
soup. Auction Rate Securities are bonds whose interest rates reset through
an auction every 7, 28 or 35 days. Holders and new bidders enter the rate
they are seeking for each auction. So if you are seeking 5% and the auction
comes in at 4.8%, you missed the issue. If an auction does not attract enough
bidders, it fails. When it fails, the current holders remain locked in and
must continue to hold the position until a successful auction. It sounds very
similar to the Asset Backed Commercial Paper Market, where you can get trapped
in short term money market type investments. At that point, the locked-in
holders receive a premium rate for a failed issue. Bloomberg news reported
a glaring example of a failed issue - a Port Authority of NY and NJ bond is
yielding 20% this week. Historically, auctions have not failed because
the banks and brokers running the book bid on the excess supply to keep this
normally short term market liquid.
The first notable
problem in ARSs was disclosed in Bristol Myers (BMY) earnings report.
BMY announced that their original $811 million investment was worth $419 million,
which is a 49% loss. The company said they expected to recover $117
million, or 1/3 of the loss, when the market recovers. The other 2/3s was
written off. BMY reported The companys investments in ARS represent
interests in collateralized debt obligations supported by pools of residential
and commercial mortgages or credit cards, insurance securitizations and other
structured credits, including corporate bonds. Some of the underlying collateral
for the ARS held by the company consists of sub-prime mortgages. Moodys
estimates the ARS market has somewhere between $325 and $360 Billion outstanding.
While BMY was caught in the toxic end of the market, a good portion of
the market is AAA rated municipals. Port Authority of NY & NJ and
many of their peers should have pretty solid collateral. Another interesting
fact in this story is that there is an Auction Rate Securities Preferred market
in which closed end mutual funds borrow, usually up to 35% of their NAV, in
order to leverage their book. The kicker here is that if the book were to
be liquidated, the ARS holder is first in line to get paid. Therefore, 65%-70%
of the value of the closed end would need to be wiped out before the ARS holder
incurred principal losses. Closed End Municipal Bond funds are believed to
make up approximately 1/3 of this portion of the market. For closed end munis
to lose 70% of their value appears highly unlikely, even in this credit crunch.
if not most, of these bonds are supported by excellent collateral, this
entire market is locked up across the board as auctions fail at a record rate.
What happened? It probably started with BMY. It is more common than one might
think that corporations own these instruments as short term investments. As
CFOs realized that they hold paper with the same acronym that cost BMY several
hundred million dollars, they probably began liquidating at a healthy pace.
Just like many other areas of this credit crunch, buyers became sellers. The
other factor is that the banks and brokers have stopped providing the liquidity
by bidding on the excess supply. This has occurred Street-wide. This begs
the question, why would brokers stop the standard operating procedure of buying
this short term credit backed by good collateral? Perhaps the banks and brokers
believe the bond insurer downgrade is coming. Banks and brokers, who are already
strapped for capital, cannot afford to have their excess cash tied up potentially
indefinitely if the downgrade prompts aggressive selling and failed auctions.
Moodys said they would complete their review of the bond insurers in
mid to late February. Well, it is mid February. Buffetts bond insurance
business is up and running. Rumor has it Eric Dinallo (Superintendent of the
New York State Insurance Department) will be making his first public statements
tomorrow. The ducks are certainly lining up nicely. The brokers counterparty
risk is still there, which probably explains the notable weakness. The quicker
this situation is brought to a climax, the better off the market is.
I have $4.5 million
of these things. I spent hours on the phone yesterday. Things I learned:
1. I'm scared.
These things have worked flawlessly for years. I could buy and sell them when
I wanted. Now I'm stuck with them. I put my holdings up for sale yesterday.
No one wanted to buy them. I'll do the same today. No one will probably buy
2. My holdings,
which are issued by Nuveen, are allegedly backed by high quality muni bonds.
I have three-to-one coverage, allegedly. Those bonds are allegedly more than
sufficient to pay me off, eventually. "Allegedly" and "eventually"
are the key words.
3. ARSs backed
by muni bonds are safer than ARSs backed by residential and commercial mortgages
or credit cards,
4. Everybody and
their uncle -- including Cohen & Spears, Scudder, Nuveen, Blackrock, Citibank,
Morgan Stanley, Neuberger Berman, van Kampen, Eaton Vance, Goldman Sachs, John
Hancock and Deutsche Bank -- have put their highest net worth (and most valuable)
clients in these things. If they don't fix this mess quickly, there'll be mass
hysteria, a major loss of confidence in the financial community and more lawsuits
than you can ever imagine. If you want to be really depressed, read this piece
in today's Wall Street Journal called Debt
Crisis Hits a Dynasty. To quote from the article,
(a family who recently sold their business) rank among the earliest victims
of "auction rate" securities, a once-obscure type of bond now sending
shock waves through broad swaths of the U.S. economy. Auction-rate securities
-- an unusual type of long-term bond that behaves like a short-term bond --
have become a keystone of modern finance. They are routinely used to fund
everything from college student-loan programs to municipal road-and-bridge
5. Don't give
your money to Wall Street unthinking. Assume the worst. They're just as stupid,
if not more stupid, than you are. Remember it's not their money. They
don't care. Re-read the Journal's article.
6. The only person
you should trust is yourself. Remember what Mae West said, "I've been rich
and I've been poor. Rich is better."
7. When doing
due diligence, you have to focus on the absolute worst thing that could ever
happen. The Black Swan event. Once you know what it is, you can go from there.
8. I'll learn
more today, allegedly.
Is a book on voyeurism a peeping tome?
Does the name
Pavlov ring a bell?
A man's home is
his castle, in a manor of speaking.
When two egotists
meet, it's an I for an I.
A chicken crossing
the road is poultry in motion.
If you don't pay
your exorcist, you get repossessed.
Once you've seen
one shopping center, you've seen a mall.
A boiled egg in
the morning is hard to beat.
A grenade thrown
into a French kitchen would result in Linoleum Blownapart.
This column is about my personal search for the perfect
investment. I don't give investment advice. For that you have to be registered
with regulatory authorities, which I am not. I am a reporter and an investor.
I make my daily column -- Monday through Friday -- freely available for three
reasons: Writing is good for sorting things out in my brain. Second, the column
is research for a book I'm writing called "In Search of the Perfect
Investment." Third, I encourage my readers to send me their ideas,
concerns and experiences. That way we can all learn together. My email address
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