Is Monetary Policy Too Easy?

Is Monetary Policy Too Easy?

The Fed has been battling deflation since the financial crisis began in 2008.  Negative demographic trends and an over leveraged economy have led to sluggish growth in spite of unprecedented easing by the Fed.  The Fed Funds rate has been near zero for several years and the Fed’s balance sheet has ballooned as the Fed introduced us to Quantitative Easing (QE).  After the first round of QE the Fed moved on to QE2, QE3, and QE “infinity.”  The latest round of QE appears to be drawing to an end as the Fed continues to taper its purchases of UST and Mortgage bonds.  Research has shown QE has diminishing returns and encourages the movement of funds into riskier assets.  It also slows down or drags out the deleveraging process.  We have seen improvement in a very weak labor market, but the economy has been very sluggish.

Inflationary Pressures May Be Building

Inflationary expectations have been well anchored which has allowed the Fed to continue its monetary easing without upsetting the Fixed Income markets.  The bond vigilantes have been silent and are not expressing concern.  However, we are seeing early warning signs that inflation is starting to pick up.  The chart below shows the Core rate of the CPI since January 2008.  The blue line is the year over year rate of inflation and is less sensitive to monthly changes in the index.  It is increasing at a rate of 1.9% annually which is roughly in line with the Fed’s target.  The red line is the annualized rate of the last 3 months of the CPI.  It is more sensitive to recent monthly changes in the index.  This shows a different story, as it is growing at an annualized rate of 2.8%.

 

 

This is the highest this measure has been since early 2008.  We view this as a red flag that inflation may be picking up.  We will be watching this measure closely for further signs that inflationary pressures are building.

 

The Taylor Rule

 

The chart below shows the projected Fed Funds rate using the Taylor Rule Model.  This model uses the Core PCE deflator for the measure of inflation.  The model currently says the Funds rate should be 1.84%.

 

The Model below uses the Core CPI to measure inflation.  Using this measure the model says the Funds rate should be 2.7%.

 

Conclusion

The Taylor Rule model shows the Fed Funds rate is too low for the strength of the economy.  The recent strength in the annualized inflation rate using the last 3 months of Core CPI shows inflation may be picking up.  This is making us more cautious to the rates markets and we will be watching closely for further signs of an inflationary buildup.

 

 

 

 

 

Federal Reserve Forward Guidance

The Fed & Traditional Policy

The Federal Reserve’s traditional monetary policy tool is the federal funds rate.   The Fed encourages economic growth by lowering the federal funds rate and attempts to slow growth by raising the rate.  Since the financial crisis in late 2008, the Funds rate has been between 0.0%-0.25%; this is known as being stuck at the “zero bound.”  Since then, the economy has been in a liquidity trap, the system continues to be overleveraged, and there is a greater desire on the part of borrowers to deleverage rather than increase borrowings.   

The Fed & Extraordinary Policy Measures

The Taylor Rule, a widely followed “rule” regarding interest rate manipulation, called for a negative Funds rate of -2.0% from 2009-2011.  Since it is not possible to create a negative funds rate, the Fed has had to utilize other, less traditional stimulus tools in this environment. 

 

One of these tools, Quantitative Easing (QE), expands the feds balance sheet through asset purchases in the open market. By doing this, the Fed attempts to lower long term interest rates.  The fed has begun to taper these purchases, however, as the continued efficacy of QE has come into question and some argue that the economy is improving.  Another tool used by the fed is called Forward Guidance.  Through Forward Guidance, the Federal Open Market Committee (FOMC) attempts to communicate where they think monetary policy will be in the future.  This is similar to “jawboning,” where the Fed talks down long term rates by giving guidance about potential rate action in the future.

 

A Brief History of Forward Guidance

Below is a brief history of the feds Forward Guidance taken from the Fed’s statements after FOMC meetings. This appeared in the March 14, 2014 MarketWatch from the Wall St Journal:

1.       12/16/2008:  First Mention “Weak economic conditions warrant exceptionally low levels of the fed funds rate for some time.”

2.       8/9/2011: Added Specific Date “are likely to warrant exceptionally low levels for the fed funds rate at least through mid-2013.”

3.       1/25/2012: Extends Date “are likely to warrant exceptionally low levels for the fed funds rate at least through late 2014.”

4.       9/13/2012: Extends Date Further “are likely to be warranted at least through mid-2015.”

5.       12/12/2012: Adds Unemployment Goal “will be appropriate at least as long as the unemployment rate remains above 6.50% and inflation is not more than 2.50%.”

6.       12/18/2013: Continues After End of QE “for a considerable time after the asset purchase program ends.”

7.       3/19/2014: Drops Unemployment Goal  “likely will be appropriate to maintain the current target range for the fed funds rate for a considerable time after the asset purchase program ends.”

The primary lesson to be taken from this history is that the Fed reacts to incoming data concerning the economy, and forward guidance is not set in stone.  They have sought to provide guidance to keep long term rates low, but they have revised their comments and forecasts several times since the financial crisis.  They have consistently overestimated the strength in the economy and the need for monetary stimulus.

 

Connecting The Dots

The chart below shows the federal funds rate forecasts by the 16 members of the FOMC from the March 19, 2014 meeting.  There is consensus to keep rates low through the rest of 2014, but the vast majority sees rates higher by the end of 2015.  Yellen recently commented that rates would stay low through the middle of next year. 

However, when asked about the “dots” moving higher, she said we should not pay too much attention to the dots (even though the Fed is publishing them to give us guidance.) Her dovish comments have created uncertainty in the markets and bring into question the usefulness of Forward Guidance.

 

Forward Guidance Has Limited Value

We are in agreement with Yellen about the value of watching the dots.  The Fed has been providing guidance for the last 5 years.  They have consistently over-estimated the growth rate in the economy and have over-estimated inflation as well.  The dots have alluded to rate increases for the last 2 years, but this has not been the case.  We believe it would be better to focus on the growth rate of the economy and inflation expectations.  The chart below shows projected economic growth by the same 16 members of the FOMC.  They have overestimated growth for this year and show it peaking at the end of next year.  They are forecasting growth in the longer run of 1.8% to 2.4%.  These forecasts of sub-par long term growth and significantly higher short term rates are inconsistent with each other.  During the last few years the Fed has expanded its balance sheet and fought diligently in an attempt to get growth up to trend.  It seems unlikely they will raise rates if growth is even slower in the future.

Taylor Rule Revisited

Considering subdued inflation expectations, relatively high unemployment, and uncertainty regarding the future growth prospects of the economy, many question why the fed would consider raising rates. Perhaps the best explanation for the committee’s higher rate guidance is that the Taylor Rule currently says the Fed Funds rate should be about 1.0%, as shown in the chart below.

 

Conclusion

Future Fed actions are data dependent.  The rate of economic growth and inflation expectations will determine the level of interest rates.  Similar policies in Japan have led to sub-par growth and low interest rates for the last 20 years.  Past and current Fed action has likely drawn out the process of deleveraging in our country and will lead to below trend growth and relatively low rates for a long time.  Fixed Income investors would be wise to monitor the economic data, and pay less attention to forward guidance.

 

 

 

 

 

 

 

Value in Muni Closed End Funds

Closed End Funds (CEF) An Example

The recent spike in rates has provided investors with a unique opportunity to invest at levels that have not been seen in a long time. Nowhere has this become more clear than in the  market for Closed End Funds (CEF’s).  Nuveen Arizona Premium Income Muni Fund (NAZ)  has had a negative return of about  –19.0% during the last year as shown in the chart below.  Part of this poor performance is due to the rise in rates we have seen since the end of April.

 

 

However,  more than half of the poor performance is due to a change in investors’ eagerness to get out of bond funds.  The NAV of the fund is currently $13.44, but the fund is trading at a discount to NAV of –11.46% for a price of $11.90 per share.  This is the biggest discount to NAV for this fund since Lehman Bros. filed for bankruptcy on 9/15/2008. The chart below shows the discount or premium to NAV over the last year.

 During the last year the share price of NAZ topped out on 1/29/2013 at $16.65 per share.  Today the shares are priced at $11.99 per share for a decline of -24.38%.  The chart below shows the move in share price for NAZ during the last year.  The price of NAZ recently took out the Meredith Whitney low of  $11.81 set on 1/18/2011, when investors sold shares after Whitney’s call for numerous high profile muni defaults.  

Opportunity For Income Investors

We believe this drop in share price has created a good entry point for income oriented investors.  The chart below shows the shares at current market price have an indicated yield of about 6.41%.  We believe this monthly dividend is relatively secure.  The fund has Undistributed Investment Income (UNII) of $0.1653 per share.  This is because the fund only pays out, on average, about 93.44% of earnings.  The remaining balance is booked as UNII.  The fund currently earns about $0.0598 per share monthly and pays out $0.064 per share.  There is enough UNII to maintain the current dividend for at least 3 more years.  At 6.41%, the Taxable Equivalent Yield (TEY)  for an Arizona investor in the maximum tax bracket is 11.47%. 

 

 

If you account for the 3.8% surtax for Obamacare for couples who are married and have a modified adjusted gross income of at least $250,000, the TEY is 12.3%.

 
Conclusion

The recent rise in rates combined with selling pressure from retail accounts has created an opportunity for income oriented investors to purchase CEF’s at very attractive TEY’s.

 

 

 

Rising Rates?

Focus on Fed Policy

Recently all eyes have been on Fed policy regarding the possible tapering of bond purchases.  This preoccupation with Fed policy has led investors to liquidate bond mutual funds and ETF’s in record amounts.  This has led to a rapid rise in interest rates to the highest levels of the last two years.  Mortgage rates have soared to 4.5% during the last six weeks.  The chart below shows the rise in 30 year mortgage rates since the Fed announced it might start tapering bond purchases.  We feel investors are currently focused on the wrong thing, and the rise in rates has created a buying opportunity in bonds.

 

 

 What Drives Interest Rates

The two primary drivers of interest rates are the general level of economic growth, and inflationary expectations.  Fed policy is largely driven by these conditions and is very much “data dependent”.  The economy only grew at a 1.8% rate during the 1st Quarter of this year.  This is significantly below the long term economic growth trend.  The Fed has had a history of being overly optimistic about future growth  in the economy.  Forecasts of higher growth rates for the rest of the year strike us as being overly optimistic, considering the recent move higher in interest rates.  We expect higher rates to slow down the housing market and the economy in general during the rest of the year.  It is important to remember that stronger economic conditions for the rest of the year is not a known event.  We feel a continued period of weak growth is more likely.  Higher tax rates, higher mortgage rates, a slowdown in government expenditures, and negative demographics are all headwinds for the economy.  The debt limit ceiling will need to be raised by early fall to keep the government running.  There has been no talk of progress made in Congress regarding the two parties working together to address the budgetary issues facing the country.  Instead, both parties are becoming even more polarized.  It is hard to imagine this changing soon.  The potential for negative noise coming out of Washington concerning budget battles and the debt ceiling  may also be a drag on the economy.

 

The chart below shows the continued decline in inflationary expectations.  This trend is not indicative of rising rates.  In fact, it seems to be providing a green light for the bond market.  Many investors believe the expansion in the Fed’s balance sheet has to be inflationary at some point.  However, the data does not support this argument at this time.

 

 

The Fed’s QE Experiment

The Fed began Quantitative Easing (QE) during the financial crisis in 2008.  Quantitative Easing occurs when the Fed expands it’s balance sheet by purchasing assets such as U.S. Treasuries and Mortgage Backed Securities.  QE is supposed to be a monetary tool which is used when the Fed Funds rate is at or near zero and unemployment is high and the Fed believes more monetary easing is necessary.  QE is a tool to lower long term interest rates to stimulate economic growth. 

 

 

The chart above shows the last two rounds of QE have not been as effective in lowering interest rates as QE1 and QE2.  The diminishing returns of QE3 and QE4 cast a shadow of doubt concerning the effectiveness of continued QE.   Quantitative Easing has been tried in Japan with little success as the Japanese have been engaged in a 20 year battle against deflation. 

 

Stuck In A Liquidity Trap

The velocity of money, as shown in the chart below, has continued its downward trend.  This is a sign we are in a classic liquidity trap, and monetary tools are relatively ineffective in stimulating the economy. 

 

 

This has occurred because there is too much debt in our system, and demographic trends are very negative for the economy.  The Fed’s monetary tools are designed to encourage borrowing to stimulate economic activity.  This does not work well in a highly indebted economy. The large number of baby boomers and longer life expectancies have created a large group of older people in the U.S.  An aging population does not have enough consumers in the accumulation phase of life.  They are not borrowers and spenders.  Instead, there are more consumers who are spending less on things, and more on healthcare.  This is  very negative for economic growth because it dampens the effectiveness of monetary policy.

 

How High Should Rates Be Without Government Manipulation?

The question fixed income investors should be asking is “how high should rates be without the government trying to manipulate the market?”  We believe the current level of rates offers value to investors.  Inflation is running at about 1%.  The Fed has made every effort to get it higher without success.  Japan has been in a similar situation.  The 10 year JGB still yields less than 1% in Japan.  Our 10 year UST yields about 2.55%.  The German bund yields 1.58%, the rate in the UK is 2.34%, and is only 2.2% in France.  Corporate and Muni yields are higher still.  Long Munis for good BBB rated bonds yield over 5%.  This equates to taxable equivalent yields of 8-10%.  These are very attractive rates for retail investors. 

 

Conclusion

Investors should pay attention to the weak trend of economic growth and low inflationary expectations.  The recent selling of bond funds has created a good opportunity for investors to add to their fixed income positions at prices which have not been available for the last 2 years.

 

 

 

 

 

 

 

 

 

 

 

 

Are States The Next Greece?

Recent Events
The recent downturn in our economy has created severe budgetary stress for states, as their revenues have fallen precipitously and the demand for services has increased. The State of California with it’s politically charged budgetary process, high foreclosure rate, and high unemployment rate has received much negative attention in the media. Some are saying “California is the next Greece”. While there is little doubt California is under financial stress we believe these concerns are overblown.

A Sovereign: Greece
Greece is an independent political and financial entity and enjoys “self rule”. It is responsible for it’s budget and has the ability to issue debt and print money. Much of their debt is sold to foreigners and foreign banks. Greece is part of the European Union (EU), and their currency is the euro. The EU requires certain fiscal disciplines for member nations, such as balanced budgets, in order to use the euro as their unit of currency. Recently, it was discovered that Greece created fictitious budgets in order to become part of the EU and their financial circumstances are much weaker than previously thought. The revelation of Greece’s weakened financial state has led to a lack of confidence in their ability to re-pay their debt which has created a “debt crisis” for the country and the EU. The EU has demonstrated a willingness to bail out Greece if certain austerity programs are implemented. Resistance to these austerity measures and violent demonstrations in Greece by it’s citizens have been shown on television. Other EU countries such as Portugal, Spain, and Italy are also experiencing financial problems. Many are questioning the viability of the euro as a currency, and it has been under severe pressure as holders of euro’s look to sell and trade into more secure currencies.

A State: California
The State of California is a political sub-division of the United States. It is responsible for it’s budget, but is required by law to have a balanced budget. It is not able to print money. The U.S. government has helped the States, including California, through various stimulus packages during the last 1.5 years. Most of the debt of the State is held domestically, and is not subject to additional volatility caused by currency risk, which makes them much less volatile than Greek bonds during the last couple of years. Though
the budgetary process is cumbersome and outdated, the financial reports issued by the State comply with legal reporting standards and offer a fair representation of the State’s financial circumstances. The State has the ability to cut expenses and raise revenues to balance the budget. The rapid decline in tax revenues for the last 2 years has caused a great deal of budgetary stress for the State. The ability to make difficult decisions shows the resiliency of the State. These decisions have been made without fiscal discipline being imposed from foreigners, and without rioting in the streets like Greece. The issue of unfunded pension liabilities and healthcare benefits for public employees has not been adequately resolved, and will likely become a major issue during the next 10 years.

Differences
One of the most important differences between Greece and the State of California is the legal framework and rules for reporting. California has had fiscal discipline imposed on it by existing state and federal statutes. These statutes require a balanced budget, and set priorities for paying bills. For example, the highest priority for the State when paying expenses is to first pay those for education, next is debt service on bonds. All other expenses are subordinate to these and are paid after these expenses have been paid. Since Greece is a sovereign, it has been easier for them to avoid fiscal discipline through false reporting and false promises to their citizens. However, this has come to an end as the EU and IMF are dictating austerity measures for Greece.

Another difference is that there is a closer relationship between a State and the U.S. government, than there is between a member nation and the rest of the EU. Imagine being a German citizen and watching reports on television of the rioting in the streets of Greece, while they are expecting you to bail them out. How would you feel when you aren’t even part of the same country?

Sovereigns are also responsible for the banking system and credit conditions within their borders. Many sovereign nations are still reeling from the extensive bailout programs which were required to bail out the banks during the last credit crisis, and to stimulate their economies. In the U.S. the Federal government is responsible for the banking system. This allows the States to focus on other issues, such as education.

Conclusion
There is little doubt that many Sovereigns are riskier credits than States in the U.S. During the last 10 years, the default rate for all Muni bonds has been only 0.1%. There has not been an instance of a State default for over 75 years. The default rate for all Sovereigns during the same time period was 6.0%, which is 60 times greater than the default rate for all Munis.

(Please see chart below for Muni vs. Sovereign comparison.)

Lessons From Vallejo

2008: Vallejo Under Financial Stress

In 2008 the City of Vallejo, CA was suffering from severe financial stress caused by recurring budget deficits in it's general fund. The city found it difficult to bring it's budget into balance because 74% of the budget consisted of expenses for police and firefighter salaries and pension obligations which had been growing out of control. City officials attempted to renegotiate labor contracts and benefits, but were unable to generate enough cuts to balance their budget. The deficit for 2008 was $4.3 million, with a projected deficit for 2009 of $16 million. According to a recent Wall St. Journal article which appeared on March 26, 2010 "salaries for police captains were over $300,000 per year, and firefighters averaged $171,000 a year. These same workers could retire at age 50 with a pension that guaranteed them 90% of their final year's pay."


Vallejo Enters Bankruptcy

On May 23, 2008 the City of Vallejo filed a petition for protection under Chapter 9 of the U.S. Bankruptcy Code. According to the law firm which represented Vallejo, Orrick, Herrington, & Sutcliffe, in order to file bankruptcy a municipality must meet the following criteria:

1. It must be a political subdivision of the state. A state is not allowed to file for bankruptcy.


2. State law must allow a municipality to file for bankruptcy. About half of the states in the U.S. do not allow municipalities to file bankruptcy.


3. The municipality must be insolvent which means they are not able to meet their current obligations or won't be able to meet them in the next year.


4. The municipality must desire to effect a plan to adjust it's debts.


5. The municipality must show it has tried to negotiate unsuccessfully with creditors.

In September 2008 the Bankruptcy Judge Michael McManus determined the City of Vallejo met these conditions, and the Bankruptcy Appellate Panel affirmed his decision on June 26, 2009.

Collective Bargaining Agreement Is Rejected

On March 13, 2009 the judge ruled the City could reject the Collective Bargaining Agreements it had with various city unions, and the City of Vallejo began to renegotiate it’s contracts with public employees including firefighter and police.

Vallejo’s Bankruptcy Workout Plan Affects Bondholders

On December 22, 2009 the City came up with a Bankruptcy Workout Plan which called for no principal or interest payments to be made for three full years beginning January 15, 2011 through January 15, 2014 on outstanding debt. This affects all bonds that are secured by the General Fund. Bonds with dedicated revenue streams are not affected by the moratorium on debt service payments. The bonds that are still paying interest are secured by water revenues, special assessments, and special taxes. Bonds for related entities are also not affected by the Workout Plan. These include Vallejo Sanitation and Flood Control District, Vallejo Redevelopment Agency, and Vallejo Housing Authority. These are all separate legal entities from the City of Vallejo.

Why Vallejo Is Important To Bondholders

During the last 40 years most Muni bond defaults have been for housing and healthcare bonds. There have only been 3 general obligation bonds which were rated by Moody’s that have defaulted during this period. Perhaps the best known case is for Orange Co., CA which defaulted on it’s debt, because of excessive exposure to derivative trades in it’s investment pools by rogue trading by the county treasurer. Bondholders were eventually able to recover 100% of both principal and interest. Jefferson Co., AL defaulted on it’s bonds in April 2008, because of excessive exposure to variable and auction rate securities swaps which caused a large liquidity deficiency for the county when their swaps didn’t work out.

The bankruptcy filing for Vallejo is quite different. It is the result of poor governmental planning with the City lacking the political will to negotiate affordable contracts with public workers, and also making them promises they are not able to keep. Public employees and bondholders alike are watching this case with interest. Numerous municipalities across the country have significant unfunded liabilities for both pensions and healthcare benefits. This case is, thus, important to see if bankruptcy for a municipality is a way to make these liabilities more affordable for it’s taxpayers.

Vallejo: Has Bankruptcy Paid Off?

It is clear bankruptcy has not been a silver bullet for Vallejo, and the costs have been significant. Since filing for bankruptcy, Vallejo’s tax revenues have fallen 20% with further expected declines likely in 2011-2012. The City has not had the political will to reduce existing pension costs. These costs will leave the City
facing projected annual deficits of $23-$27 million once retirement costs are fully recognized. There has been a stigma for residents which makes Vallejo a less desirable place to live. This is reflected in falling property values, reduced services, and a higher crime rate. The City has also been shut out of the credit markets, and will be unable to raise funds for an extended period. The City has made progress in renegotiating labor contracts, but the cost has been high.

We believe other municipalities will look at this case with mixed feelings, and will realize bankruptcy is an option of last resort. It is not a panacea for getting rid of unfunded pension liabilities. Most municipalities are not in the dire straits which Vallejo is in, which means they are not eligible to file for bankruptcy. Fears of widespread use of bankruptcy by municipalities to lower unfunded liabilities are overblown. On a positive note for taxpayers, this case sends a clear message to organized public workers. In a bankruptcy situation their existing contracts are all up for renegotiation. This should make them more willing to negotiate on more favorable terms with municipalities in the future.

Lessons To Be Learned For Bondholders

This case provides several lessons for investors. First, Muni bondholders should realize security selection has never been more important than it is now. Improper security selection can be very punishing to investors. Next, bond investors cannot assume general obligation bonds are more safe than revenue bonds. When a municipality experiences extreme stress and enters bankruptcy, bonds with dedicated revenue streams are superior to claims on the general fund. Also, some municipal entities may lack the political will to make sound financial decisions. Even though municipalities are required to balance their budgets, there may be some situations which make it extremely difficult for them to do so. Many budgetary problems need long term solutions, but politicians are only willing to provide short term fixes. In addition, since states are not able to declare bankruptcy, it is difficult for investors to know which type of bonds have priority over other general fund obligations such as payroll and vendors. Laws will vary from state to state. For example, in California payments for schools have priority over debt service, which has priority over all other general fund expenses. Finally, the Muni market is a fragmented market of over 50,000 different issuers. It is not possible to make general statements re
garding the creditworthiness of all Munis. Pundits which make generalizations about the Muni markets should be treated as suspect. Instead, investors should be more like loan officers who realize that each borrower has different abilities to service their debt. They should consider off balance sheet obligations, wealth levels, and debt per capita before purchasing the issuer’s general obligation securities.

Conclusion

The Muni market is not a good do-it-yourself market. Proper security selection is beyond the scope of most individual investors. We also believe the financial situation of the City of Vallejo shows the danger of blind reliance on default studies, which is not a good policy in today’s environment. These studies cover a time period where most municipalities did not experience the amount of financial stress which they will be facing during the next couple of years. This stress may be caused by declining tax revenues, higher costs of providing healthcare, or unfunded liabilities associated with public employees. Instead, we plan to place more emphasis on revenue bonds with secure revenue streams and less emphasis on some general obligation bonds. This strategy is similar to the one we have used for California Muni bond investors. We will continue to seek out general obligation bonds of high wealth areas, and issuers with low debt per capita levels, and a willingness to make difficult budget decisions. But, we will also place increasing emphasis on essential service revenue bonds where the issuer has a monopoly on the services they provide.

Shared Sacrifice

Turmoil In The Credit Markets
During the last 2 years there has been considerable turmoil in the credit markets due to the rapid decline in the credit quality of borrowers in the corporate, mortgage, and agency markets. The sub-prime mortgage crisis, collapse of Fannie and Freddie, banking and investment banking crises, stress on insurers and guarantors of debt, and collapse of 2 of the 3 largest auto makers are all examples of the deterioration in the credit quality which has taken place. Even the credit quality of the U.S. Government (the heretofore standard for a riskless borrower) has been called into question.

Fixed Income Credit Analysis and Risk
This decline in credit quality has made credit analysis more important than ever. Fixed Income money managers who were able to avoid major problems with credit issues have achieved superior performance to those who were unable to foresee potential credit problems. The penalty for being “wrong” on the credit of an issuer has been harsh as credit spreads blew out to very wide levels. A good credit analyst is able to identify and understand the risks in any given security. Most investors lose money because they grossly underestimate the amount of risk they are taking. The other mistake they make is “reaching for yield”. This leads to creating portfolios that consist of all the weakest credits, because they are the ones that yield the most. These portfolios do not perform well in stressful times for the markets. A good credit analyst is also able to determine what the “worst case” is for any security he owns. This is extremely important when things “go bad” for a credit. There are different layers of security for a bondholder. These include debt service coverage, the issuers ability to pay, and where the bondholder stands as a creditor in bankruptcy. In bankruptcy, there are long established rules that apply to secured and unsecured creditors, as well as to equity holders. These rules provide comfort to secured bondholders when things “go bad” for one of their borrowers. The current economic cycle has allowed the government to become involved in the economy to an unprecedented extent, which has revealed a new level of risk a good credit analyst needs to consider. We will call this ‘political risk”, which is the risk of confiscation of secured creditor assets for the benefit of a junior class of creditors. This is a risk that is more prevalent in unstable less developed countries, and was unthinkable in the U.S. until Chrysler.



The Chrysler Bankruptcy
The auto industry was particularly hard hit in the recent economic slide with both Chrysler and GM going into bankruptcy. The actions taken by the government in the Chrysler bankruptcy were unprecedented. The President introduced the concept of “Shared Sacrifice” in the media as he called upon secured creditors to take less than they were entitled to legally so that one of his political supporters, the UAW (a junior creditor), could get a larger share of the new firm. TARP participants who represented the majority of senior secured creditors were then coerced into voting for a government sponsored cram down which gave the secured creditors only 30% of the company while the junior class of creditors (UAW) received 50% of the firm. The secured creditors who did not vote for the plan were labeled as speculators and were portrayed as all around bad guys to the public. This creates an enormous amount of uncertainty for investors in fixed income securities in the U.S., because laws which were deemed sacrosanct have been rendered meaningless as assets are confiscated from one class of creditor and given to another class of creditor based on political whim instead of rule of law.

Bankruptcy Law
Existing bankruptcy law is designed to protect debtors from creditors seizing their assets without giving them time to come up with a plan to pay creditors in a fair and equitable manner. When bankruptcy is declared an estate is created, similar to when a person dies. The assets of the estate are then valued, and creditor claims are processed and organized into order of their priority. Some claims are secured, and have a priority over junior claims. A first mortgage claim is entitled to receive full payment before the second mortgage holder receives any funds. Priority of claims is a well established principle of bankruptcy law. Debtors are not allowed to pay some creditors to the detriment of others immediately prior to or during bankruptcy. The debtor in possession of the assets is allowed to form a plan which is equitable to it’s creditors, and the creditors can then vote on the plan. If a majority of the creditors vote for the plan, the dissenters will suffer what is caused a cram down, as the plan is approved over their objections. In the Chrysler case there are problems with the asset valuation process, priority of claims issues, and the nature of the government’s cram down. The concept of “shared sacrifice” violates bankruptcy law and discourages lending, particularly to weaker credits.


Conclusion
We believe the government has now re-written bankruptcy law in this country. Since the Chrysler case, GM has been put into bankruptcy. A similar approach to a rushed asset valuation process has been taken in GM as well. Virtually every secured creditor in the country has now found their position in bankruptcy lowered, as the government ignores the established rules of bankruptcy law. We were fortunate that we did not own any bonds for the auto companies, because our credit analysis deemed them too risky. We also avoid high yield bonds, because they are very highly correlated to equities, and don’t offer enough diversification to the investor’s overall portfolio. However, even though we dodged the Chrysler bullet, we are still very concerned by the government’s actions and our level of “trust” for our system has been shaken. Why would any investor want to invest in high yield fixed income with the additional risk of confiscation in bankruptcy? Without the established priority of claims in bankruptcy there is now no such thing as a secured or priority claim. “Shared sacrifice” does considerable harm to encouraging lending during these difficult times, because it makes it nearly impossible to determine the lender’s worse case. It makes more sense for the lender to avoid lending to riskier firms, because a secured loan to a struggling creditor suddenly has become much riskier.