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The Bank Credit Analyst Sounds Alarm Bells

FORECASTS & TRENDS E-LETTER
by Gary D. Halbert
December 4, 2007

IN THIS ISSUE:

1.   BCA Calls On The Fed To Cut Rates

2.   A Plan To Rescue The Subprime Market

3.   More Storm Clouds On The Horizon?

4.   Conclusions - What You Should Do

5.   Hg Capital Advisors Long/Short Government Bond Program

Introduction

It is rare for The Bank Credit Analyst to shout a message directly to the Federal Reserve, and central banks around the world, to take immediate action to avoid a potential financial crisis.  But this is in effect what Martin Barnes and his fellow editors at BCA have just done.  The credit crunch created by the subprime meltdown has not gone away, and is now estimated to be considerably worse than originally projected.   This is leading to additional strains on the financial system, including the major money center banks.

As a result, BCA is calling on the Fed and central banks around the world to cut interest rates repeatedly over the next year in order to avoid a recession and even greater financial market disruptions.  BCA’s primary concern is that the Fed and foreign central bankers are still too fixated on inflation, at the very time that the credit crunch could lead to a recession and deflation.  BCA’s latest reports for December urge the central bankers to change their focus, cut rates and add liquidity before it’s too late.

Having been a continuous reader of BCA for 30 years now, I know when they are very concerned about a financial meltdown and a recession that would almost certainly follow.  Based on their latest reports, I think it is safe to say that Martin Barnes and his fellow editors at BCA are becoming worried.  Among other things, they recommended taking profits in stocks and moving to a neutral position.  They do believe that if monetary authorities act decisively in the months just ahead, a financial meltdown and a recession can be avoided.  I will discuss their latest views in the pages that follow.

And speaking of the subprime debacle, I’m sure you’ve heard by now that Treasury Secretary Henry Paulson has floated a major new proposal to help fix the subprime mortgage problem – a freeze on interest rate resets on subprime mortgages.  He hopes that he can cobble together a deal that major banks, mortgage servicers and the securities industry can agree on before another wave of adjustable mortgage rates reset.  It is feared that these resets will spark a wave of defaults that could threaten the health of the US economy.  All of the details of his plan have not yet been released, but I’ll discuss the major goals of his proposal, as well as some possible drawbacks.

Unfortunately, the subprime crisis has also revealed that there may be another shoe to drop in the credit markets, that being in the world of corporate debt, including credit swaps, an array of credit derivatives and junk bonds.  The world of corporate debt has become vastly more complicated over the last 15 years or so, with dozens of sophisticated strategies and credit vehicles which are actively traded in the secondary market.  Many of these credit strategies are highly leveraged. 

This corporate credit market dwarfs the subprime market.  There are fears that we could be facing yet another, even larger, credit market event over the next several months.  However, unlike many subprime mortgages that were peddled to homebuyers with no credit history (or even bad credit), corporate borrowers must demonstrate reasonable creditworthiness and collateral.  Hopefully, this market will not unravel in the months ahead as some predict.

Fortunately, not all the news is bad.  The economy surged ahead at a 4.9% annual rate in GDP in the 3Q according to the latest Commerce Department report.  While 4Q growth is sure to be considerably lower, we are nowhere near a recession.  As this is written, the Fed is giving signals that it will cut rates again on December 11, as it should.  And the stock markets have rebounded strongly over the last few days.  As you can see, we have a lot to cover this week.

BCA Calls On The Fed To Cut Rates

In their December report, the editors at BCA issue a clear warning to the Fed and central bankers around the developed world: they need to cut interest rates repeatedly to reflate the credit markets, or risk a more serious credit crunch and a recession.  They begin by saying:

“It is an ugly picture: the U.S. is in the midst of the worst housing downturn since the 1930s; the subprime mortgage crisis has spread through the credit markets like a virus, causing  spiraling losses for lenders and borrowers; leading indicators for the developed economies are looking increasingly sick; and the major stock markets are struggling.  It is clear that significant monetary reflation is needed.”

Those are dire words from the usually upbeat editors at BCA.  But at various times over the years, BCA has felt it necessary to rifle a shot across the bows of monetary leaders, some of whom are thought to read BCA on a regular basis.  This is one of those times. 

I did trade e-mails with BCA editor Martin Barnes last week, and he and his fellow editors still believe that the technology-led “long-wave upturn” is still intact for the US economy, at least for a few more years.  However, as BCA has maintained ever since they predicted the long-wave upturn in the early 1980s, there will be times when the economy slows down and mild recessions will occur.  In light of worsening conditions in the credit markets, BCA believes that swift action on the part of the Fed and central bankers around the world is now key to avoiding a serious economic downturn and a possible recession next year.

I believe BCA’s concerns began to mount with the Fed’s policy statement following the last rate cut on October 31 when the FOMC wrote:

“The Committee judges that, after this action, the upside risks to inflation roughly balance the downside risks to growth.”

This was “Fed-speak” for don’t expect any more rate cuts.  It took a few days for that statement to soak in, and the equity markets plunged thereafter.  Several Fed officials echoed the statement, and suggested there would be no further rate cuts, in their remarks during November, and each time it weighed on the equity markets.  Fortunately, Fed chairman Ben Bernanke changed his tune last week and hinted that there may well be another rate cut on December 11.

There are several theories regarding why the Fed may be reluctant to cut rates further, but as BCA points out, credit conditions have worsened significantly since the Fed met at the end of October.  Specifically, estimates of the losses from the subprime and credit market meltdown have surged from around $150 billion to $500 billion in recent weeks. 

Without additional rate cuts and injections of liquidity from the Fed, the credit markets could seize up again and threaten not only the economy and the stock markets, but also the major banks.  It is still uncertain just what the major banks’ exposure is to subprime and other bad debt, and the housing downturn continues to worsen.  Sales of existing homes fell 1.2% in October to a new record low.  There are now 4.5 million existing homes for sale on the market, raising the unsold inventory to a 10.8-month supply at the current rate of sales.  The median home price fell to $207,800, down 5.1% from a year ago.

While the housing downturn has further to run, BCA does not believe this trend, alone, will cause a recession.  Only if the credit crunch worsens does BCA see a recession, and the editors believe there is still time to avoid another seize-up in the credit markets if the Fed moves aggressively by adding liquidity and lowering rates in the months just ahead.  They urge officials at the Fed to realize that they have already fallen behind the curve, and to get serious about cutting rates.  The next FOMC meeting is on December 11.

In addition to aggressive action on the part of the Fed, BCA believes the major banks and lending institutions should accelerate their efforts to identify and write off bad debt, even if they have to issue equity to shore up their capital ratios.  BCA believes this is necessary to restore confidence and allow inter-bank transactions and the commercial paper market to return to more normal conditions. 

A Plan To Rescue The Subprime Market

The Federal Reserve estimates that there are roughly two million adjustable rate subprime mortgages that face resets to higher interest rate levels in 2008.  The Fed also projects that at least 500,000 of those subprime mortgages will go into default next year, and the number could be much higher.

Mortgage industry executives and major banks, in conjunction with the Treasury Department, worked last week to hammer out details of a homeowner rescue plan that would freeze interest rates on many US subprime mortgages for several years, but questions remain over how to avoid investor lawsuits and other legal challenges.

One of the biggest potential problems is the threat of lawsuits from investors who bought securities backed by these troubled mortgages. These investors were promised a certain yield, based on the expected hikes in interest rates, and an automatic freeze could give them grounds to sue mortgage servicers.

Yet, with an estimated $250 billion or more in mortgage defaults expected in 2008, should interest resets kick in, a plan to freeze rates may be the only answer.  Treasury Secretary Henry Paulson held a press conference on Monday morning wherein he announced a framework for the new government/industry reset freeze plan, called the “Hope Now Alliance.”  Paulson said the plan is aimed at helping save the homes of subprime borrowers with adjustable-rate mortgages who cannot afford higher payments as their interest rates reset in coming months, but who otherwise could afford to stay in their homes.

According to the Treasury Secretary, over 50% of all mortgage defaults occur without the borrower ever contacting the mortgage lender.  So a big part of the new rescue plan is to get the word out to homeowners that they can either stay in their existing mortgage with no interest rate resets for the next several years, or they can refinance into a new mortgage with different terms.  They have established a new mortgage hotline: 1-888-995-HOPE.

The Treasury Secretary also announced plans to form a new government agency to regulate FANNIE MAE and FREDDIE MAC, the two quasi-government mortgage lending institutions.  The Treasury Secretary also called on Congress to appropriate the funding for this new agency, as well as the money to finance the Hope Now Alliance.  Of course, the Secretary did not say how much this mortgage freeze plan will cost.  Details will follow later this week, we are told.

Above all, it is clear that the subprime meltdown is still a major threat to the financial system.  There are those who will conclude that the Hope Now Alliance program is nothing more than a government bailout of the mortgage and banking industries, and that a new government agency to regulate FANNIE and FREDDIE is unnecessary and will be too expensive.  Others will argue that this massive bailout program does not solve the problem, but merely pushes the ultimate mortgage crisis out into the future.

In my view, it is too early to tell.  We don’t have the details yet.  My guess is that the editors at BCA will be in favor of the government’s newly announced rescue plan.  In their December report, BCA argued that more US states should follow California’s lead in freezing subprime mortgage resets in 2008.

Whatever you may think about the government’s latest mortgage freeze plan, one thing is clear.  The mortgage problems are very large and could pose a serious threat to the economy.

More Storm Clouds On The Horizon?

I recently read an alarming article written by Ted Seides, CFA.  Mr. Seides is the Director of Investments at a hedge “fund of funds,” so he’s very familiar with the complex world in which sophisticated hedge funds play.  While this article does not present a hand-wringing, gloom-and-doom scenario, it does call attention to what might be the next shoe to drop in the credit markets.

Specifically, Mr. Seides writes that the junk bond and counterparty risk markets have experienced some of the same recent “innovations” that the subprime mortgage market did.  In other words, they have been packaged into securitized debt offerings and had a liberal dose of leverage thrown in.  This, in his opinion, makes the corporate credit markets potentially vulnerable to the same type of negative market reaction that occurred when everyone figured out that their investment-grade bonds were backed by very risky subprime mortgage loans.

Trying to describe the junk bond and counterparty risk markets would require far more space than I can dedicate to it here.  The main thing to know is that all bonds carry some level of risk of default.  Junk bonds are considered the most risky, but also carry a higher rate of interest to compensate the lender for taking additional risk.  The counterparty risk comes in when a lender transfers the risk of default on a credit instrument to another party.  In essence, this transaction amounts to the other party insuring the lender against the credit risk. 

The enhanced risk in these transactions occurs as a result of the same kind of Wall Street financial alchemy that turned subprime mortgages into triple A rated bonds.  The bottom line is that these transactions gain several degrees of separation between the actual debtor and the investor holding the bag if default occurs.  Thus, it’s likely that there are bond investors out there that may be holding far more risky investments than they think they are.

Of course, it’s significant to note that the subprime mortgage market and corporate credit markets are two very different beasts.  While Mr. Seides observes that lending standards in the corporate world have relaxed over the last few years, I don’t think they ever got to the point of the “no-doc” mortgage loans that were granted by mortgage originators.  Plus, not all corporate credit carries a “junk bond” rating.  Much of it is “investment grade” paper issued by some of the most stable corporations in existence.

Even so, the application of leverage might amplify any relaxation of credit standards that occurred, in addition to the normal increased credit risk found in high-yield (junk) bonds.  In the very nervous financial markets world in which we live, it’s often true that the perception of risk is a greater problem than the real story.  The subprime mortgage debacle is a good example.  It’s not practical to assume that every subprime mortgage will end up in default, but the uncertainty as to the value of any bond supported by such mortgages caused pretty much all of them to become toxic waste.

The result is that those holding bonds backed by subprime mortgages have discovered that they now have an asset that is of far less value (if it can be valued at all) and of far lower quality.  This causes the deterioration of balance sheets across a broad spectrum of bondholders, but especially those institutional investors that are required to hold only assets of a certain quality.

If the same thing happens in the wider corporate credit markets, Mr. Seides says that the repercussions could dwarf the subprime mortgage problems we recently experienced.  That’s because the total outstanding value of these derivative investments is actually greater than the amount of underlying cash bonds.  Plus, the corporate credit markets are many times the size of the subprime mortgage market – as much as $45 trillion (yes, that’s with a “t”), or five times the total US national debt.

This last statistic brings up an interesting thought.  I mentioned earlier that a subprime bailout has been proposed by Treasury Secretary Paulson.  If the corporate credit markets experience similar problems, don’t look for a similar bailout.  With a potential liability equal to five times the national debt, it will be far beyond the government’s power to do anything about it.

Gloom and doom?  Maybe.  A situation to watch carefully?  Definitely! 

I ran across a show on the Discovery Channel the other day about storm chasers.  These intrepid individuals go out looking for tornados in an effort to film, measure and then possibly be better able to predict their behavior.  On the show, they chased many storm clouds in an effort to find a tornado.  However, even with all of their sophisticated equipment, they could not tell ahead of time which storm would produce a tornado and which would not.  All they knew was that the potential for one existed.

There’s an economic parallel here.  We have a number of storm clouds on the economic horizon, with potential problems in the corporate credit markets being one of them.  Unfortunately, even with all of our sophisticated economic analytical tools, we have no way of knowing which of the various economic threats will actually wreak economic havoc, and which ones will not.

Conclusions - What You Should Do

The last thing the stock and bond markets need right now is more uncertainty.  I have read volumes of material and talked to many money managers who have described the markets’ action in 2007 as “crazy” or “weird” or some other highly technical jargon indicating that they have been very unpredictable. 

I personally believe that the market is acting the way it is because of emotional trading.  I think we can all agree that the daily news often drives the direction of the stock market, even when the fundamentals indicate it should go the opposite direction.  I heard someone say the other day that when the news is driving the markets, the best place to be is in the parking lot.  In other words, cash is king when the markets are acting this crazy.

That may be true, but cash doesn’t always provide the return necessary to meet your financial goals.  For a long time, I have advocated the use of professional money managers who have proprietary strategies for moving into and out of the markets in order to minimize losses and have the potential to produce “absolute returns.” 

For the more aggressive investor, an investment program that offers the ability to go “long” or “short” in the market may be appropriate.  If a long/short system is accurate, you have the potential to make money even when the market declines.  Of course, there are never any guarantees that any Advisor’s system will be right all of the time, or that positive gains can be maintained in all years.

I recently introduced one such long/short program to you from Hg Capital Advisors in Houston.  I won’t go into all of the same detail as I did in my earlier description, but a thumbnail description is that Hg offers a long/short program that trades 30-year Treasury Bond mutual funds.  Just recently, the Hg Long/Short Government Bond Program reached the 3-year actual track record milestone.  Since its inception, this program has produced average annualized returns of 20.46%, with a maximum drawdown of -8.76%.  Past performance is not necessarily indicative of future results.

However, the investment business is often a case of “what have you done for me lately?”  And 2007 is certainly no exception, with even many risk-managed investments encountering difficulty.  Thus, I’m very pleased to be able to tell you that the Hg Long/Short Government Bond Program has produced a year-to-date gain of 15.36%, which compares very favorably with both the S&P 500 Index YTD gain of 5.99% and the Lehman Long Government Bond Index YTD gain of 10.76%.

As you consider the impressive performance numbers above, keep in mind that past results are not necessarily indicative of future returns.  Also, be advised that the Hg Long/Short Government Bond Program is an aggressive strategy that is not suitable for all investors.

For a more detailed discussion of Hg’s Long/Short Government Bond Program, click HERE to go to our Advisor Profile for this program.  You can also obtain additional information on this program by calling one of our Investment Consultants at 800-348-3601, via e-mail at info@halbertwealth.com, or by completing one of our online request forms.  Also be sure to read the Important Notes and disclosures about the Hg Capital Long/Short Bond Program following the Special Articles below.

Best regards,

 

Gary D. Halbert

SPECIAL ARTICLES

Paulson Urges Congress To Act On [Mortgage] Loan Woes
http://online.wsj.com/article/SB119669624800711876.html?mod=hpp_us_whats_news

Democracy is about letting people say ‘no.’
http://www.telegraph.co.uk/opinion/main.jhtml;jsessionid=LG3GK3U3TAH35QFIQMGSFGGAVCBQWIV0?xml=/opinion/2007/12/04/dl0401.xml

Hillary versus the “Oprah Factor”
http://www.opinionjournal.com/editorial/feature.html?id=110010937

IMPORTANT NOTES:  Halbert Wealth Management, Inc. (HWM), Hg Capital Advisors, LLC, and Purcell Advisory Services, LLC (PAS) are Investment Advisors registered with the SEC and/or their respective states.  Information in this report is taken from sources believed reliable but its accuracy cannot be guaranteed. Any opinions stated are intended as general observations, not specific or personal investment advice.  Please consult a competent professional and the appropriate disclosure documents before making any investment decisions. There is no foolproof way of selecting an Investment Advisor. Investments mentioned involve risk, and not all investments mentioned herein are appropriate for all investors.  HWM receives compensation from PAS in exchange for introducing client accounts to the Advisors.  For more information on HWM or PAS, please consult Form ADV Part II, available at no charge upon request. Any offer or solicitation can only be made by way of the Form ADV Part II.  Officers, employees, and affiliates of HWM may have investments managed by the Advisors discussed herein or others.

As benchmarks for comparison, the Standard & Poor’s 500 Stock Index (which includes dividends) and the Lehman Long Government Bond Index represent an unmanaged, passive buy-and-hold approach.  The volatility and investment characteristics of these benchmarks cited may differ materially (more or less) from that of the Advisor.  The performance of the S & P 500 Stock Index and the Lehman Long Government Bond Index is not meant to imply that investors should consider an investment in the Hg Capital Long/Short Government Bond (LSGB) trading program as comparable to an investment in the “blue chip” stocks that comprise the S & P 500 Stock Index or the Treasuries that comprise the Lehman Long Government Bond Index.  Historical performance data represents an actual account in a program named Hg Capital 199Hg-TYX, custodied at Rydex Series Trust, and verified by Theta Investment Research, LLC.   Since all accounts in the program are managed similarly, the results shown are representative of the majority of participants in the Program.  Purcell Advisory Services utilizes research signals purchased from Hg Capital Advisors, an unaffiliated investment advisor.  The signals are generated by the use of proprietary software developed by Hg Capital Advisors.  Statistics for “Worst Drawdown” are calculated as of month-end.  Drawdowns within a month may have been greater. PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.  Mutual funds carry their own expenses which are outlined in the fund’s prospectus.  An account with any Advisor is not a bank account and is not guaranteed by FDIC or any other governmental agency.

When reviewing past performance records, it is important to note that different accounts, even though they are traded pursuant to the same strategy, can have varying results.  The reasons for this include: i) the period of time in which the accounts are active; ii) the timing of contributions and withdrawals; iii) the account size; iv) the minimum investment requirements and/or withdrawal restrictions; and v) the rate of brokerage commissions and transaction fees charged to an account. There can be no assurance that an account opened by any person will achieve performance returns similar to those provided herein for accounts traded pursuant to the Hg Capital LSGB trading program.

In addition, you should be aware that (i) the Hg Capital LSGB trading program is speculative and involves a high degree of risk; (ii) the Hg Capital LSGB trading program’s performance may be volatile; (iii) an investor could lose all or a substantial amount of his or her investment in the program; (iv) Hg Capital will have trading authority over an investor’s account and the use of a single advisor could mean lack of diversification and consequently higher risk; and (v) Hg Capital LSGB trading  program’s fees and expenses (if any) will reduce an investor’s trading profits, or increase any trading losses.

Returns illustrated are net of the maximum management fees, custodial fees, underlying mutual fund management fees, and other fund expenses such as 12b-1 fees.  They do not include the effect of annual IRA fees or mutual fund sales charges, if applicable. No adjustment has been made for income tax liability.  Money market funds are not bank accounts, do not carry deposit insurance, and do involve risk of loss.  The results shown are for a limited time period and may not be representative of the results that would be achieved over a full market cycle or in different economic and market environments.


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Forecasts & Trends E-Letter is published by ProFutures, Inc. Gary D. Halbert is the president and CEO of ProFutures, Inc. and is the editor of this publication. Information contained herein is taken from sources believed to be reliable but cannot be guaranteed as to its accuracy. Opinions and recommendations herein generally reflect the judgement of Gary D. Halbert (or another named author) and may change at any time without written notice. Market opinions contained herein are intended as general observations and are not intended as specific investment advice. Readers are urged to check with their investment counselors before making any investment decisions. This electronic newsletter does not constitute an offer of sale of any securities. Gary D. Halbert, ProFutures, Inc., and its affiliated companies, its officers, directors and/or employees may or may not have investments in markets or programs mentioned herein. Past results are not necessarily indicative of future results. Reprinting for family or friends is allowed with proper credit. However, republishing (written or electronically) in its entirety or through the use of extensive quotes is prohibited without prior written consent.

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