Detroit Bankruptcy on Munis

Friday’s big news in the markets (outside of the concerns over MSFT and GOOG) was the bankruptcy of the City of Detroit.

This Chapter 9 filing was a long time coming, in my opinion, and should not be a surprise. But some investors might be wondering–will the effects  spill over to the municipal bond sector overall?

In a word, no.

Detroit is a very unique situation (and not in a good sense). It has very little tax revenues, infrastructure is depleted, and its population is near-poverty level. That’s a toxic mix for any municipality.

But it does underscore the importance of due diligence. Investors who own muni bonds must be very selective:

1. pay attention to credit rating

2. think about the macro and micro–economic factors around the country

3. look up the local economy–is business booming? What’s the tax revenue outlook?

4. consider the overall debt load of the municipality

If those are a bit more work than you bargained for, consider a muni bond fund if you’re looking for current income and capital preservation. Some decent ones include SWNTX (Schwab Tax-Free Bond Fund) and PRINX (T. Rowe Price Summit Municipal Income Fund).


Personal Finance: the Housing Question

Legendary hedge fund manager John Paulson had a message on CNBC yesterday: he’s bullish on housing.

Pressed further, Paulson said that one of the best investments a person can get into, right now, is to buy a house. And if one already has a house, buy a second house.

OK, so you may not think that Paulson is to be trusted as his long gold calls are down 30% YTD (although, life-to-date, the gold fund is still up 100%). BUT… does he have a point on housing?

There’s a couple things to consider here (and each person’s situation is different):

1. Assuming the status quo is in place, paying a mortgage makes infinitely more sense than paying rent. Excluding interest, mortgage payments build equity–think of it as a transfer of value from cash to the form of real estate (from the left pocket to the right pocket). On the other hand, paying rent destroys value. It’s cash going into someone else’s pocket.

2. Since mortgage interest rate can be deducted for tax purposes (assuming one itemizes on the tax return), you’re looking at a ~30% savings in dollars paid on a mortgage vs. rent.

3. Right now, mortgage rates are still at historical lows. But that may change in the next year or so. If the Federal Reserve thinks that the economy is growing at a fast-enough pace and feels the need to control inflation, it will raise rates.

4. Congress is considering changing the tax code around mortgage interest deductions, specifically barring the deduction on second homes (e.g. vacation homes) and homes exceeding a certain price.

Conclusion: buy a house, and do it soon.

Investors Dig Morgan Stanley’s Transformation

Morgan Stanley (NYSE: MS) shares are popping on Thursday–up 4.7% in midday trading and reaching 52-week highs.

The New York investment bank announced $980 million in net profits for the quarter, and $8.5 billion in revenues. The profits were just a shade below analysts’ expectations but the revenues were much higher than expected.

Along with the earnings release the firm announced a $500 million share repurchase program, which surely contributed to the stocks surging higher.

Morgan Stanley is in the midst of a transformation right now. For decades, it fought neck-to-neck with Goldman Sachs as the top underwriter and M&A advisor in investment banking. In recent years, however, its star has dimmed a bit.

Now, Morgan Stanley has the country’s biggest retail brokerage business, eclipsing longtime rivals Merrill Lynch and UBS.  And that will serve as the company’s strategy going forward, which is eschewing the volatility of investment banking and focusing more on the stable–but less sexy–business of brokerage and wealth management.

CEO James Gorman has aggressively trimmed costs (including bankers’ pay, for which cash bonus is capped at $125K) to increased return on equity. In fact, he had a message for investment banking employees who may be disgruntled with the pay decreases.

Gorman said on Bloomberg TV, to such bankers: “You’re naive, read the newspaper, No. 1. No. 2, if you put your compensation in a one-year context to define your overall level of happiness, you have a problem which is much bigger than the job. And No. 3, if you’re really unhappy, just leave. I mean, life’s too short.”


Sen. Warren Calls for New ‘Glass-Steagall’

Sandy Weill

Sandy Weill looking jolly (or smug?)

Sen. Elizabeth Warren (D-Mass.) and Sen. John McCain (R-Ariz.) are calling for the revival of certain parts of the Glass-Steagall Act to reform the banking industry. The Glass-Steagall were famously and controversially repealed by the Gramm-Leach-Bliley Act of 1999.

The original Glass-Steagall Act (okay, let’s call it GSA for short because I am tired of typing out Glass-Steagall, which I just did again… D’oh!) was instituted in 1933 and created general guidelines between commercial banks (taking deposits and giving loans) and investment banks (which deal primarily in securities), and segregating the two as a way to protect consumers from the risk-taking of securities firms.

The Gramm-Leach-Bliley Act overturned two main clauses of GSA. Section 20, which stated that federal reserve member banks are banned from being affiliated with firms engaging principally in securities or speculation, and Section 32, which stated that such firms cannot share a common board, were overturned specifically.

Let’s think back to 1999 for a moment. Those were the heady days of Wall Street and the Clinton-Greenspan administration was notoriously lax with its regulations. So much so, in fact, that financier Sanford Weill famously (or brazenly?) orchestrated the merger of CitiCorp (a commercial bank) and Travelers (parent of its namesake insurance company and Salomon Brothers investment bank) in 1998. Now, that merger would have violated the GSA, but Weill (amongst others) were so confident that it would be repealed that he went ahead with it anyways.

A lot has happened since then. We’ve been through a bubble and burst, the wheelin’ and dealin’ mid-aughts, and finally the 2007-2009 financial crisis and stock market crash. The financial crisis led to consolidation in the banking sector, and propelled Bank of America and Merrill Lynch to merge (wouldn’t have been possible under the GSA), and investment banks like Goldman Sachs and Morgan Stanley to convert into bank holding companies (also not possible under the GSA).

The goal of bringing back provisions of the GSA is to get rid of the concept of “Too Big to Fail”. Which brings us to the main question, would bringing back GSA help?

From purely a size perspective, the GSA repeal helped to speed up the process by which banks got too big (and by virtue of that, too big to fail). But we were probably heading to to this direction anyways, it was just a matter of “when” the banks got too big.

But in terms of protecting consumer deposits from risk-taking, there’s some bite. Commercial banks would be barred from engaging in securities trading, issuance, and derivatives, and the chance of them needing a bailout would decrease. Standalone investment banks, on the other hand, would continue as they are.

So yes, I agree with Sen. Warren (despite her past asinine demands for $22 minimum wage) on this one.

Heathrow 787 Fire Denting Boeing Shares

Midday Friday July 12, shares of Boeing Co. dropped 7% on news that an Ethiopian Airlines 787 Dreamliner caught on fire at London’s Heathrow International Airport.

The fire led to suspensions of incoming and outgoing flights at London’s busiest international hub.

It’s the latest hole in Boeing’s armor and the fallout could affect future orders of the much-maligned 787 Dreamliner. From a competitive standpoint, it’s good news for Boeing’s chief rival, Airbus.

Shares of related companies, such as Precision Cast (PCP), are also down on Friday.

Details of the fire are still forthcoming, so I’d say that the 7% drop is perhaps a bit premature. Depending on what caused the fire, it may or may not have long-term consequences for the company. Nevertheless, it’s terrible publicity for Boeing.

Read This Before Investing in Emerging Markets

(This article originally appeared in the Epoch Times)

By Warren Song & Frank Yu

While the phrase “diversify your portfolio” has become a cliché, it holds true in most cases. However, investors should exercise caution when investing in stocks of publicly listed companies based in emerging markets, especially the so-called BRIC nations of Brazil, Russia, India, and China.

In theory, diversification means holding investments from several sectors, types of securities, and geographical locations. But stocks from emerging markets, for the most part, should have lower valuations than those from developed countries, especially compared to U.S. equities. Generally speaking, returns on investments in emerging markets have been largely disappointing.

A few factors should be considered when valuing stock from any emerging market company:

  1. Its home country’s government and legal systems are just, stable, and free of corruption.
  2. The public company’s priority is to work on behalf of the shareholders.
  3. The company is competitive—has value—relative to those in developed markets.

Companies from India and China (including companies listed in Hong Kong) are at a severe disadvantage when measured with rule No. 1 mentioned above. And when factoring in rule No. 2 and 3, most companies from developing countries fall short when measured against competitors from developed nations (of course, there are exceptions).

To illustrate this, we will use China as an extreme example.

In China, corruption is so widespread that among management levels of public companies, there are hundreds of thousands of employees who are the children and relatives of Communist Party and government officials.

Let’s use the U.S.-listed China Petroleum and Chemical Corp., or Sinopec, as an example (NYSE: SNP).

Management typically is appointed by China’s State Council, and this creates a conflict of interest because as a publicly listed company, it should serve the interest of shareholders, not cater to the ruling elite.

In Sinopec’s case, it has a negative reputation within China due to its poor environmental record. Also, because many employees cannot be terminated, productivity is low—far lower than at U.S. competitor Valero Energy (NYSE: VLO). Despite Sinopec’s underinvestment in exploration and research, it still lacks meaningful free cash flow. If China introduces real market-based financial markets, Sinopec would have trouble competing.

While Sinopec was used to illustrate the above points, most other Chinese-based public companies are either state-owned or controlled by local governments in one way or another. As such, the objective is often to increase revenues so the related officials can use such figures (similar to aggregating China’s GDP growth rate) to climb the political ladder to higher-level positions in the government. In addition, they borrow heavily. The end result is industrywide overcapacity, heavy price discounting, vanishing margins, ballooning accounts receivable, and finally stock value destruction and investor disappointment.

Let’s take a look at the price-earnings (P/E) ratios of emerging market firms. Some investors argue that there are quality companies in emerging markets with low P/E ratios, which is an indication of value.

But the P/E ratio alone doesn’t tell the entire story. One thing to remember while investing is that valuations are relative. If you compare the stocks to yields of 10-year government bonds of those countries, the stocks will immediately seem overvalued.

Take Russia for example. Its 10-year government bond yield is almost 8 percent. Move a typical Russian company with a P/E ratio of around 10 to the United States, and its valuation will immediately halve given the fact that the U.S. 10-year Treasury (risk-free) yield is 2.7 percent. This is due to the huge risk difference between the Russian equity and U.S. Treasuries. Conversely, if U.S. Treasury yields suddenly jumped to 8 percent, the U.S. stock market would see a major movement from current levels.

Emerging market firms also typically have lower free cash flow amounts compared to their U.S. counterparts. In China, for example, many public companies have minimal or no free cash flow when applying U.S. accounting standards.

We’ve used China and Russia as general examples. Similarly, Brazilian 10-year government bonds yield more than 11 percent, and for India, the figure stands at more than 10 percent.

Investment of one’s own money is a serious matter. Imagine your portfolio holdings are like your children. You’d want each and every one of them to receive the best education possible, instead of sending three of them to China, Russia, and Brazil just for the sake of diversification.

Warren Song and Frank Yu are contributors to the Epoch Times.

Bernanke Eases Up, Markets Exhale

The Dow Jones Industrial Average and S&P 500 Index rallied to exceed record highs (nominal) on Thursday, July 11.

The Dow’s previous all-time high of 15,409 was reached on May 28, and S&P’s 1,669 was reached on May 21. Today, investors sent stocks higher on remarks by Chairman Ben (Bernanke) that he’s not in a hurry to ease his stimulus measures, or at least not as fast as the market had predicted.

So what led up to this? A recovering housing market and last Friday’s better-than-expected June employment helped. This week so far, stocks have been buoyed by solid corporate earnings.

All of this enthusiasm has some analysts crying foul and predicting a pullback. While others say that the transition from bonds to equities has barely begun.

Right now is probably a time to hold and see. There are still some signs of economic weakness that could thrash U.S. markets–China, Egypt (driving up oil to their highest since May 2012), unemployment, and Greece/Europe. And in addition, avoid emerging markets.