Harry Newton's In Search of The Perfect Investment
Newton's In Search Of The Perfect Investment. Technology Investor.
8:30 AM EST Monday, February 25, 2008: The
good news is that it was wonderful seeing the kids over the weekend. The bad
news is that life looks increasingly glum for us idiot holders of muni bond
auction rate preferreds. The moral of our disaster is obvious: Never, ever,
ever believe anything anyone on Wall Street tells you. Their motivation is twofold:
Sell you something, anything now. Do as little work as possible.
broker emails me this morning this "will work itself out." Fact is,
it may not. He is using long-time Wall Street sales "logic" -- the
same "logic" as the girl who rubs vanishing cream on her stomach,
hoping her pregnancy will disappear. Fact is this "logic" causes losses.
If you and I believed it, we wouldn't believe in portfolio diversification and
stop loss orders.
said, everybody who's reading this and who owns these Auction Rate Securities
must send me an email. Or, if you know someone, who has these things,
ask them to send me an email. Obviously I'll keep everything ultra-confidential.
We need to get together to share research and resources. Over the weekend I
spent much time speaking to a gentleman whose family owns over $60 million of
these things -- which is, sadly, a lot more than my $4.5 million. So far our
"strategy" -- call it The Non-Vanishing Cream Strategy -- is
In particular, find docs/evidence where Wall Street said they were selling us
cash equivalents. Find evidence of lies e.g. these auctions have
everything we hear and read.
3. Noise. Make
lots of it.
4. Stay in
5. Force the
funds' hand. We need to force the the Nuveens, Eaton Vances, etc. of this
world to "de-lever." That's their fancy word for selling some of the
bonds backing up our securities and paying us off.
Since there is
absolutely no incentive on their part to do this -- in fact there is a substantial
incentive not to do this, we need to bring pressure. Elements of our
Pressure Strategy possibly include:
1. A publicity
campaign involving full-page advertisements in The Wall Street Journal
headed in huge bold letters, "Why no one should ever deal with Nuveen,
Eaton Vance, etc. .. again."
2. Force a regulatory
decision / legal settlement, the key element of which would be to insulate the
companies from lawsuits from their common stockholders.
3. Collect material
preparatory to major class action and individual lawsuits. Personally, I believe
this has a huge element of fraud. We were told it was a "cash equivalent."
In fact, on brokerage statements these holdings were listed as "cash and
cash equivalents." They were never listed as auction rate preferred. We
were not told about the "auctions." We certainly were never told these
auctions had never failed. They had actually failed many times. We were being
sold a 7-day cash-equivalent "floater." We were not told that we were
being sold a long-term security with zero liquidity -- i.e. we could never sell
it. Which is where we stand today.
In many ways,
this mess is exactly what Wall Street wanted. In fact, if it was planned it
was brilliant. Going forward, Wall Street will earn huge fees from loaning us
money against our now-illiquid securities. They'll also earn huge fees from
raising new bonds for owners of the bonds that failed -- the hospitals, the
highway authorities, the local municipal authorities, etc. Their friends, the
lawyers, will do handsomely, also.
If you own these
things, you should be aware of a story that ran last week on Dow Jones Newswires.
I've bolded the important parts:
NEW YORK -(Dow
Jones)- Eaton Vance Corp. (EV) said the current liquidity crunch in the auction-rate
preferred securities market is unprecedented, was unanticipated, and will
have no quick fix.
an extraordinary environment which none of us anticipated," said Payson
Swaffield, chief income investment officer at Eaton Vance, in regard to recent
failed sales of auction-rate preferred shares that have left some shareholders
of its closed-end fund preferred shares holding shares they'd like to sell.
He made the comments Wednesday on a conference call to update broker- dealers
and others on the issues.
the firm must balance its responsibilities to both its common and preferred
shareholders, Swaffield said the firm is working diligently to consider
its options to restoring liquidity. In addition to working to better educate
broker-dealers and investors, the firm is considering certain refinancing
options for holders of the auction-rate preferreds through capital markets
methods as well as possibly talking with broker-dealers about approaching
the Fed about borrowing, Swaffield said.
can borrow at the Fed cheaper than these max rates, the Fed could provide
liquidity for the shareholder of these" auction-rate preferred securities,
Swaffield said, "there's not likely to be a quick fix, as much as
we would like one."
One call participant
noted that "Eaton Vance's name is at risk here regardless of who has
"We understand the pain. We're working as diligently as we can."
But he also
noted, that the firm has no legal obligation to provide liquidity.
we have to do is figure out a way to get the holders of auction-rate preferreds
liquidity although there's no legal obligation because that's not what the
security is," he said. In attempting to restore liquidity for the preferred
shareholders, Eaton Vance has an obligation to make ensure that it doesn't
increase costs for the common shareholders, Swaffield said.
difficult position. We're going to work on it," he said. "I don't
have a lot of confidence that the ARP (auction-rate preferred) market will
come back soon. We're not relying on that."
market will come back "in a partial way," coupled with other refinancing
options, he said, "but we're not pretending to think it will come back."
noted that though the cost of borrowing has increased for the holders of the
closed-end fund's common shares as interest rates have increased due to the
failed auctions, the maximum rate is not that much higher than it had been,
"maybe 20 (basis points) or 30 basis points" higher. "It continues
to make sense to employ the leverage, given the relatively low cost of leverage,"
he said. Short-term rates have been declining, and if rates continue to fall,
that will benefit common shareholders, he noted.
are currently trading at very large discounts "because it's a flight
to quality - it's really a fright" to quality, Swaffield said. Investors
are "almost afraid of quality," he said, noting that the funds'
underlying loans are highly rated and collateralized.
a very interesting buying opportunity," he said. "We think when
the message gets out, investors will take advantage of this opportunity."
One stock broker
on the call who said he was from Wachovia Securities LLC, suggested that the
auction-rate securities market in its present form is dead. " You're
in a position now of keeping your reputation or leaving these things to start
trading at 85 cents on the dollar or whatever it may be which I think would
be a terrible situation," the broker said.
To that, Duncan
Richardson , chief equity investment officer and portfolio manager at Eaton
Vance, said, "I think it's early to call the death of the ARP ( auction-rate
preferred) market." ...
participant who said he was from Morgan Stanley, said the issue has to be
resolved quickly. Firms won't be able to bring out another closed-end leveraged
fund if investors aren't able to redeem their preferred securities, he said.
Eaton Vance could either deleverage by, for example, going to 15% leverage
rather than 30% and redeeming some of the auction-rate preferred securities
or allow higher rates until demand meets supply, he suggested.
As to the future of leveraged closed-end funds in general, Swaffield said,
" We're not too worried about that now. We're dealing with the issue
we have in the market -- to resolve the liquidity issue; that's what we're
focused on right now."
bond insurers -- MBIA, Ambac, etc. are bankrupt. William Ackman founded
a hedge fund called Pershing Square Capital in 2003. Today it manages over $1.6
billion. He has shorted the monoline insurers, MBIA and others. He believes
they are effectively bankrupt and will never be able to raise the money they
need to replenish their lost capital. I recommend that you watch this interview
TV. In essence, he's saying that the people who are putting their money
into saving Ambac and MBIA are wasting their money, since virtually no amount
of money they can raise can ever cover the monolines' upcoming gargantuan losses
-- many of which they have not yet recognized.
It gets better.
You Buy a Bridge From Warren Buffett? First I have to admit that
the new business magazine from Conde Nast called Portfolio
is simply getting better, issue by issue. The March 08 issue talks about Buffett
getting into municipal bond insurance. It's an eye-opener. Here are key excerpts
famed investor is getting into municipal-bond insurance. Too bad the industry
is a racket.
In a crisis,
the guy with the cash gets the call. Late last year, Eric Dinallo, New York
State's top insurance regulator, picked up the phone and persuaded Warren
Buffett's company to rescue the municipal-bond world.
staid business of municipal bonds was on the verge of panic. Dinallo hoped
that Buffett and his gold-plated name could calm things down. The credit crunch
that has consumed the real estate and banking worlds is now threatening $2.6
trillion worth of municipal bonds, which help pay for everything from bridges
and tunnels to hospitals and schools. ... Two-thirds of those bonds are owned
by retail investors, many of whom want and need the sort of safety that's
supposed to go along with investing in government debt. Regulators like Dinallo
fear that a panic would crimp the ability of state and local governments to
raise money, leading to service cutbacks and canceled community-improvement
isn't with the muni bonds themselves but with the insurance companies that
guarantee them. These bond insurerssuch companies as MBIA and Ambacare
supposed to ensure that the bonds are safe. Trouble is, the insurers themselves
are in crisis. This makes it clear that the entire business of muni-bond insurance
is a giant taxpayer rip-off.
In theory, bond
insurance lowers the cost of borrowing money. It's not unlike having your
mother-in-law co-sign your mortgage: With her good credit alongside yours,
the interest rate you pay will most likely drop. Let's say that Walla Walla,
Washington, wants to build a dam. The rating agencies Moody's, Standard
& Poor's, and Fitch assign Walla Walla a credit rating that determines
how risky an investment the city is and, therefore, how high its interest
rate should be. Assume Walla Walla's rating corresponds to a 5 percent interest
rate in the market. If the city buys bond insurance, however, its bond becomes
triple-A, reducing its interest rate to 4.75 percent good for Walla
Walla, which can keep its water at bay, and good for local taxpayers, who
won't have to pay as much to protect themselves from it.
has also been very good for insurers. Until last year, bond insurers ranked
among the most profitable companies in the world, with Ambac having the
highest operating profit margins of any firm in the S&P 500. But then
competition rushed in. In an effort to make more money, bond insurers made
a terrible mistake. They branched out beyond their core business to invest
in all sorts of exotic mortgage securities and other structured finance products.
This has turned out to be the equivalent of insuring your brother-in-law Robbie
for his sure thing involving that email from Nigerian royalty. As the bond
insurers' deals have inevitably soured, the companies and their credit ratings
have come under pressure and their stock prices have been tanking. Indeed,
in January, Fitch stripped Ambac of its triple-A rating, which is tantamount
to crushing its business model. If the bond insurers go out of business, it
could cause widespread devastation. On the other side of these firms' trades
are banks, which could suffer losses if the insurers don't make good.
Hence the call
to Buffett's Berkshire Hathaway, with its Himalayan mountains of cash and
unassailable triple-A rating. Who wouldn't want Buffett as their insurer?
It's a great break for a brilliant investor who managed to be in a strong
position when others were weak and now may reap the rewards. Other savvy investors,
such as Wilbur Ross, have contemplated joining Buffett in jumping in.
The reason the
business can be so rewarding is that government bonds are intrinsically safe:
Municipalities almost never default. From 1970 through 2006, only slightly
more than 0.1 percent of all muni bonds went bad, according to a large
Moody's study. By comparison, corporate bonds in the same period had a 9.7
percent default rate. In other words, corporate bonds are 94 times
as likely to fail as muni bonds are.
I asked David
Schultz, a professor at the Graduate School of Management at Hamline University,
in St. Paul, Minnesota, what he made of Buffett's entry into the muni-bond-insurance
business. "First off, I would say it's still a useless product,"
Schultz said. "Buffett's decision demonstrates that it's probably very
profitable. What a great market to get into. Since I think you don't need
the insurance, it becomes almost pure profit."
How is it that
municipalities almost never default on their debt? When communities face trouble
and consider filing a claim on their bond insurance, they think twice. They
don't want to risk being downgraded or shut out of the capital markets for
future bond sales. It's the same rationale that might keep you from filing
an insurance claim if you have a fender bender. You could figure that it's
better to eat the cost of the repair than risk having your premium go up.
But bond insurers
have it even better than your car insurance company. If you totaled your car,
you'd have to submit the claim, future premium increase or not, because you
couldn't afford to shoulder the cost of a whole new car. But when municipalities
are hit with a disaster or a bridge collapse, they can always get the money
from taxpayers. They raise taxes or find other, often draconian ways to stave
off default through service cutbacks. The high-finance term for this type
of insurance is the free lunch.
So why do the
governments buy bond insurance in the first place? Mainly to get the higher
credit rating, which lowers the interest rate and reassures investors. The
rub, though, is that they should have received lower rates anyway. The municipalities'
credit ratings are too low. If rating agencies properly assessed them according
to investors' true risk of loss, muni bonds would have lower interest rates
without the expense of insurance.
We know this
because Moody's has been conducting an epic research project over the past
decade to figure it out. The result is a secret decoder ring, provided by
Moody's, into which an investor can plug a muni-bond rating. Out pops what
the corporate rating would be. According to Moody's table, almost every
muni bond would get a higher rating. About two-thirds would probably be triple-A
if they were rated with the same criteria used to rate corporate bonds.
conclusion is that Moody's, as the most influential of the credit-rating agencies,
should simply start lifting its ratings on municipalities. But Moody's doesn't
have any plans to do that. Why it won't is one of the great mysteries of the
muni-bond world. Is it merely a historical artifact? Are the rating agencies
plagued by memories of government debacles like the Orange County, California,
derivatives blowup or the strike-riddled and garbage-strewn streets of New
York during the 1970s budget crisis? According to Moody's, investors and issuers
like the system the way it is. But that's not credible. Why would issuers
want to pay more than they should? More likely, the system remains unchanged
because bond insurance is good for everyone in the marketexcept for
municipalities, that is, but they have no choice except to go along with it.
companies, which love the current setup in the relatively risk-free muni business
for obvious reasons, happen to be among the rating agencies' best customers.
You have to wonder whether the agencies have a conflict of interest
that prevents muni-bond-rating reform.
Attorney General Richard Blumenthal is starting to investigate this very question,
issuing subpoenas over the past few months. "The question is why there
are two standards for ratings and why Connecticut towns and cities should
be required to obtain bond insurance when the likelihood of default is virtually
zero," Blumenthal told me. "Is there conduct that violates the antitrust
laws in terms of anticompetitive practices or collusion among rating agencies
or the bond insurers?"
muni bonds like insurance because it lets them buy bonds based on their triple-A
rating rather than having to pick and choose from an immense universe of offerings.
"Bond insurance provides a way to commoditize the market rather than
doing credit analysis and checking each credit," explains UBS muni strategist
And Wall Street
firms like insurance, McNamara adds, for essentially the same reason: They
don't have to employ lots of people to check a place's creditworthiness before
selling a muni to investors. "It lowers the marketing expenses of the
bond when the issuer goes to tap the capital markets," she says. In other
words, investors and Wall Street outsource credit analysis to rating agenciesnot
always the best move, as we've seen elsewhere. Credit-rating agencies have
blown the analysis on bond insurers, which is why the market is in crisis
in the first place. Well, you win some, you lose some.
How the rating
agencies handle municipalities really ought to be a bigger scandal. Think
about it: Credit-rating agencies screwed up the mortgage-securities business
because they were too lax in their ratings. They're screwing up munis
because they are too punitive. In both cases, they manage to benefit
from their "mistaken" ratings.
be commended for bringing Buffett in, but it's a Band-Aid. It would be better
to eliminate muni-bond insurance for good. That's what makes his January efforts
to broker a bailout of the bond insurers ill-advised. The financial guarantors
got into this mess by making bad bets on structured finance. They shouldn't
be helped simply because they are perceived as vital to an entirely separate
market. Regulators should let things play out. If bond insurers go under,
so be it. If banks traded with them imprudently, let the banks take their
lumps. Instead, regulators should force the rating agencies to bring their
muni-bond ratings in line with the rest of their ratings. And they could create
a governmental mechanism to back muni bonds in the event of default. Municipalities
are effectively the insurers of muni bonds already. Why not make it explicit?
is that some municipalities are finally figuring this out. In recent months,
the states of Wisconsin and California, as well as New York City and 300 other
issuers, have sold bonds without buying insurance, according to Bloomberg
News, which has been on top of the muni-bond scandal. Cities and states would
save billions if they didn't buy insurance but received proper ratings.
So Warren Buffett
may not reap his windfall after all. What good news for taxpayers that would
charm of passwords:
I watched my four-year old daughter enter the
password -- she typed "minniemickydonaldpluto."
I said, "Wow,
darling, that's a really big password!"
She replied, "Well,
they said it had to be at least four characters..."
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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