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Harry Newton's In Search of The Perfect Investment Technology Investor. Auction Rate Securities. Auction Rate Preferreds.

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8:30 AM EST Tuesday, March 25, 2008: Prediction is impossible, except after the event. But.... things presently look bad for the economy. Think this way: If the Feds thought so ill of the economy to put out a $117 billion "stimulus" package, they've done a terrible job of ignoring the $360 billion of monies that can't be spent which are locked up in failed auction rate securities. That $360 billion is over three times the size of the "stimulus."

It gets worse: Our capital markets are also locked, with company after company, institution after institution locked out of raising the money they need for their business, their expansion, their day-to-day operations.

Typical news: Brazos Education, the fourth largest holder of bonded student loans has quit providing student loans amid Auction Market Woes. ''We sorrow this determination was necessary,'' Gilbert Murray Watson, president and main executive director military officer of Brazos Higher Education Service, said in a statement today (March 24). ''We hope this state of affairs with the working capital marketplaces alters in the near future to allow us to re-enter student lending.''

Add kids can't go to college, to the houses and businesses that can't be bought or expanded, the shares on Wall Street that can't be bought, the April 15 taxes that can't be paid (and the resulting personal bankruptcies) because of monies locked in failed auction rate securities. Things look glum.

Wall Street is bracing for a massive layoffs, hurting the New York City and State economies. Bear Stearns employs 14,000 people, most paid well. Most will now be fired. Ditto with other investment banks and brokers.

I hate to be negative, but things in the economy do look increasingly awful. John Cassidy has a piece in the latest Conde Nast Portfolio titled, "The Economy of Fear -- Why this recession is going to hit particularly hard--and last longer than you think." He writes:

The economy is most likely spiraling down, with unemployment rising, the stock market tumbling, and corporate losses mounting. In economics, as in quantum physics, nothing is certain, but falling housing prices and slumping consumer confidence point to a deep recession that could last for two or three years. Psychology is critical in economics, and right now it is battered. ...

Unlike some past recessions, which were rooted in inflation problems, this one has been triggered by credit and real estate—both of which have a lot to do with how people perceive their financial well-being and, in response, how they adjust their spending. ... For what is probably the first time since the 1930s, home prices are falling sharply. Nationwide, housing prices have slipped about 10 percent in the past year, and the decline is accelerating, according to the S&P Case-Shiller home-price index. As prices drop, more and more homeowners discover that they owe more than their property is worth, at which point they experience the temptation to hand the keys back to the bank or mortgage company. Jan Hatzius, an economist at Goldman Sachs, estimates that by the end of 2009 up to 15 million households could be in a position of negative equity. If Hatzius is right, the glut in houses for sale will only get larger, and prices will fall a lot further. Just how low they could go is anybody's guess, but a reading of data compiled by Yale economist Robert Shiller, which show the evolution of inflation-adjusted home values since 1890, suggests an overall drop of 30 or even 40 percent.

When property prices fall, homeowners feel poorer, which prompts them to spend less and save more. Gross domestic product falls and unemployment increases. A slide of 25 percent in home prices would wipe out about $5 trillion in household wealth. Coincidentally, this is roughly how much was lost when technology stocks collapsed in 2000 and 2001. Given that some predictions have home values falling even more steeply, the pain could be severe.

In addition, homes are more widely owned than stocks, and they have a bigger effect on spending. Simulations carried out by Frederic Mishkin, one of Bernanke's colleagues at the Fed, imply that the typical American family will cut its spending by up to 7 cents for every dollar in housing wealth it loses. Given a 20 percent fall in prices, this adds up to a nationwide reduction in consumer spending of about $350 billion a year, or 2.5 percent of the U.S.'s gross domestic product. That's a big number—more than big enough to tip the economy into recession. (Harry's comment: Add the $360 billion locked up in failed auction rate securities and you have over 5% of GDP.)

Just as consumers are hitting the panic button, companies also are being squeezed, with many of them unable to access money precisely at a time when they need it. It has been nine months since the subprime crisis began, and it is now affecting virtually all credit products, including two of the safest of all: municipal bonds and corporate bonds issued by blue-chip companies. Now that the credit bubble has burst, even some perfectly reputable and solvent businesses are struggling for access to funds. Unless something happens to reverse these trends, a big drop in G.D.P. is inevitable.

Bernanke and Summers know this, of course. They are relying on the stimulus package signed by President Bush in February and lower interest rates to boost demand. From September through January, the Fed cut the federal funds rate from 5.25 percent to 3 percent. Cheaper borrowing costs make it attractive for families to refinance their mortgages and take out home-equity loans. In the boom years of 2004 to 2006, refis and home-equity cash-outs boosted consumer spending; the Fed is hoping to restart this game. Lower interest rates also bring down the value of the dollar, making American goods such as Boeing airplanes and Apple computers more competitive in world markets. In recent months, the one economic bright spot in the U.S. has been a surge in exports.

I doubt whether these policy changes will be enough to offset the slumping housing market and its psychic multiplier. But a bigger weakness in the optimistic view is its failure to fully address the crisis in the financial system. In the mild recessions of 1990-91 and 2001, we didn't see anything like the dislocation we are now witnessing. In some ways, the current situation more closely resembles the ruinous credit busts of the late 1800s, which shepherded in lengthy periods of economic contraction in that century's last three decades. According to the National Bureau of Economic Research, the U.S. was in recession from October 1873 to March 1879, March 1882 to May 1885, and January 1893 to June 1897 (with a brief respite from June 1894 to December 1895). The slump of the 1870s, which was precipitated by a collapse in the value of railway bonds—the era's subprime securities—and the ruin of banker Jay Cooke, lasted even longer than the Great Depression. ...

We are still looking for market solutions to the credit crisis. First, there was the idea of setting up a privately funded "super" investment vehicle to digest the mess. In that scenario, bailout money would come from the banks themselves. Then came the sovereign wealth funds, with their injections of Middle Eastern and Asian cash into Citigroup and Merrill Lynch, and then a "voluntary" rate freeze on subprime mortgages. Now the big banks and Warren Buffett are vying to "rescue" the municipal-bond insurers. Behind the scenes, the Fed and the Treasury Department have been quietly orchestrating a mortgage bailout, using the Fed's lending facilities and other government-sponsored institutions, such as Fannie Mae and Freddie Mac, but even these efforts are too opaque and indirect to restore confidence, which is their ultimate goal. Lost trust takes a very long time to recover. (Harry's comment: The trust has evaporated. Emails I've received from failed auction rate securities talk plainly about their distrust.)

You can read the entire Portfolio magazine piece by clicking here.

Collapsed capital markets bode ill for redeeming failed ARPs. There is great touchy-feely talk by the ARPs issuers of redeeming their auction rate preferred shares with different financing from capital markets. But I wonder, with these markets largely locked, where will the money come from? I've had several long conversations with Daisy Maxey, financial reporter for Dow Jones Newswires. She's following this mess. Her latest piece from yesterday evening:

Evergreen Investments May Refinance Some Preferred Shares
NEW YORK -(Dow Jones)- Evergreen Investments, the investment management arm of Wachovia Corp. (WB), said it's looking into refinancing "a partial, but material" portion of the preferred shares issued by its closed-end funds through a commercial paper conduit.

Under the scenario being considered, Evergreen would use the proceeds from a commercial paper conduit borrowing to retire a portion of the preferred shares issued by its closed-end funds, and replace the funds' leverage through debt borrowings, Scott Couto, head of global product management for Evergreen, said on a conference call Monday.

Three of Evergreen's five closed-end funds - Income Advantage (EAD), Multi- sector Income (ERC) and Utilities and High Income (ERH) - have issued auction- rate preferred shares, and the firm has about $970 million in outstanding preferred shares.

Couto said he could provide no timeline for a resolution to the liquidity crisis now facing holders of auction-rate preferred shares.

"What we're experiencing is unprecedented," and "very challenging," he told call participants, some of whom sounded quite frustrated by the current lack of liquidity in the auction-rate marketplace. "We're working as quickly as we can through a very complex set of issues."

Many closed-end funds issued preferred shares as a way to boost their returns through the use of leverage. For years, those shares were considered by many investors to be safe, liquid investments, and were routinely sold successfully at auction. In fact, one participant on the Evergreen call said that when purchasing preferred shares, they assumed they were purchasing a money market- like instrument.

In recent months, however, such preferred shareholders have found themselves unable to sell their shares as many potential buyers, including the banks that had for years supported the auctions, stopped buying the shares amid a credit crunch.

When preferred shares fail to sell at auction, the dividend rate paid to the preferred shareholders increases to a maximum rate set by an established formula, but they are essentially locked into the shares.

Evergreen's management has received authorization from the fund's board of trustees to proceed with negotiations on the "possible near-term" solution of a partial refinancing, and to implement it subject to the trustees' review and approval, said Couto.

But he cautioned that there remains "much work to be done," and cited necessarily negotiations, legal and regulatory requirements and any necessary shareholder approvals as some of the hurdles remaining.

Evergreen will continue to work on this as well as other possible solutions, Couto said.

Karen McColl, managing director of investment product management at Evergreen, said the firm, in an effort to show its commitment to the closed-end fund business, will combine the refinancing it is considering with advisory fee waivers to keep costs down for the affected funds' common shareholders. If the borrowing on any commercial paper funding exceeds the maximum rate being paid to the preferred shareholders at that point, Evergreen will waive its advisory fees to the level where the common shareholder would never pay more than the maximum rate at that time less five basis points, she said.

Evergreen will also continue to explore the issuance of preferred shares with a conditional put, which would be eligible for purchase by money-market funds, as a possible solution, McColl said. It's something that several other closed- end fund companies have also said they are considering.

But Couto said that Evergreen doesn't believe the notion of money-market eligible preferred shares has the "the near-term" possibilities that the refinancing option offers. "We are aware of several different parties exploring" such a possible solution, he said, but "I'm not sure anyone has solved all of the outstanding issues at this point."

Evergreen has been working with financial intermediaries, large securities exchanges, trade groups, ratings agencies and its competitors, among others, in an effort to identify possible solutions, Couto said.

Whatever solution the firm pursues, McColl said, it will seek to preserve common shareholders' ability to earn consistent yield through leverage, while also seeking to provide liquidity for preferred shareholders.

The firm is operating in "uncharted waters," and can offer no concrete timeframe for any of the possibilities it's considering, but will provide periodic updates as it progresses, she said.

Couto, in response to a question, said "We regret that we will not be able to provide liquidity by tax time."

There was no equivocating about the state of the auction-rate securities market, however.

Said McColl, "We are not likely to see successful auctions any time soon, if ever."

-By Daisy Maxey, Dow Jones Newswires; 201-938-4048;

12b-1 fees are paid on failed auction rate securities. It might be fun asking your broker if he and/or his firm is being paid a 12b-1 fee by the issuer of your failed auction rate security. Apparently, some (including Nuveen) are. I'm guessing the issuers are paying this fee so your broker can more easily withstand your complaints at having your money locked up indefinitely. You could ask for the money to be transferred into your account. Good luck.

Land in Arizona plummets: Picture a large piece of land containing 225 finished lots, ready for home building. A year ago, that land would have sold for $100,000 a lot. It just went for $18,500. That's an 81.5% reduction in one year. What's impressive about this reduction is that it costs at least $25,000 to finish the lot, to make it ready for selling as a home site. That $25,000 would include the roads, the electricity, gas, water, etc. Even at $18,500 it's unlikely anything will be built. It will be sat upon for five years, as the new owner prays for a return in new home demand.

Friends of mine are nibbling at selective western properties, seeking bargains. Curiously, they're not that easy to find, since many present owners are unwilling to part with their properties. Stick around. Many are having difficulty paying for them and will sell them soon.

Meanwhile the developers of western properties are having their own problems. One I know had a certified net worth of $100 million two years ago. Today he is broke, teetering on the edge of personal bankruptcy -- his personal guarantees now completely and utterly worthless.

Wondering where all our Iraqi reconstruction money went? Basically it went into the hands of Iraq's present crooked politicians and the insurgents we're fighting. The latest issue of the ultra-respectable Conde Nast Portfolio magazine has the story "The Betrayal of Judge Radhi." His job was to figure where the money the U.S. had spent for Iraq's reconstruction had gone. According to Portfolio, "billions of dollars were being wasted or stolen outright in Iraq, including $8.3 billion that went unaccounted for in 2003 and 2004. Many of Iraq's leaders were either directly participating in the thievery or quietly supporting it through hired guns, who later waged sectarian wars in the streets. Radhi was supposed to track down the criminals, stanch the hemorrhaging of money, and put an end to the corruption that was dubbed the 'second insurgency' by Stuart Bowen (the U.S. special inspector general for Iraq reconstruction) and considered a principal source of funding for the terrorist groups that the U.S. military was trying to crush."

IN the end, Judge Radhi was hounded out of Iraq and his investigations curtailed. If you're ready to be thoroughly depressed as to just how badly the war in Iraq has been handled, read this article. I can't find it on Portfolio's web site. Pick up the April issue on your local newsstand. Or better, get yourself a subscription -- Click here.

Better than ARPs
Shamus and Murphy fancied a pint or two but didn't have a lot of money between them, they could only raise one Euro.

Murphy said "I have an idea." He went next door to the butcher's shop and came out with one large sausage.

Shamus said "Are you crazy? Now we don't have any money left at all!"

Murphy replied, "Don't worry - just follow me."

He went into the pub where he immediately ordered two pints of Guinness and two glasses of Jamieson Whisky.

Shamus said "Now you've lost it. Do you know how much trouble we will be in? We haven't got any money!!"

Murphy replied, with a smile. "Don't worry, I have a plan, Cheers!"

They downed their Drinks. Murphy said, "OK, I'll stick the sausage through my zipper and you go on your knees and put it in your mouth."

The barman noticed them, went berserk, and threw them out.

They continued this, pub after pub, with Murphy and Shamus getting more and more drunk, all for free.

At the tenth pub Shamus said "Murphy - I don't think I can do any more of this. I'm drunk and me knees are killin' me!"

Murphy said, "How do you think I feel? I lost the sausage in the third pub."

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 is . You can't click on my email address. You have to re-type it . This protects me from software scanning the Internet for email addresses to spam. I have no role in choosing the Google ads on this site. Thus I cannot endorse, though some look interesting. If you click on a link, Google may send me money. Please note I'm not suggesting you do. That money, if there is any, may help pay Michael's business school tuition. Read more about Google AdSense, click here and here.

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