December 15, 2008

Global Market Comments for December 15, 2008
Featured trades: (GM), (BAC), (WFC)

1) Yet another weekend of investors furiously paging through IRA's, 401k's, and brokerage statements, struggling to learn if they have been wiped out. The stunning revelations about Bernard L. Madhoff Security Investments, LLC's $50 billion Ponzi scheme, which decimated a good portion of the Jewish charities in New York, is triggering a rebirth of due diligence. It appears that the bulk of the losses were taken by European banks, where that extra bit of distance gave him the cover he needed. One Spanish fund alone, Grupo Santander, took a $3 billion hit.

2) The Madhoff affair highlights the need to spot red flags before making any investment. A short list includes, embellishments on resumes, secretive control systems, inaccessible back office staff, obscure affiliated auditors, subtle conflicts of interest, trades executed only through a captive brokerage subsidiary, mismarked portfolio prices, and too many close relatives in key decision making positions. Another warning is 'mandate creep' whereby managers abandon conservative strategies described in a prospectus in favor of higher risk positions reliant on derivatives. And investors should be alarmed when a track record is too perfect, to the point of statistical impossibility. Madhoff's track record showed only two down quarters out of 214! Madhoff violated all of these principals. Security expert Kroll Fraud Solutions says that investment fraud is up 22% YOY and is rising, and urges more frequent spot checks by regulators. The problem with out of the blue blow ups like this is that they are like cockroaches. There never is just one. They tend to come in waves. Expect more scandals like this as we approach the year end book closing. Twenty twenty hindsight is a wonderful thing.

3) New Mexico governor Bill Richardson has been appointed to the post of Secretary of Commerce. This should be the world's easiest job because there isn't any commerce anymore.

4) The Empire State Manufacturing Index for December came in at a stunning 25%, the lowest on record. But the Baltic Dry Index is rallying, as are secondary resale prices for steel in China. Most importantly, spreads are narrowing across the board in the debt markets, the best leading indicator of future risk taking there is. All good bottom of cycle stuff. This data is not consistent with the world ending. We are in a no man's land now, where the lagging indicators show us still descending into hell, but the leading ones show us at least making it back up to purgatory (I just read Dante's Divine Comedy).

5) Many analysts expect that commercial real estate will be the next shoe to fall. Any deals done in 2005-2007 are particularly suspect, especially those with a high retail exposure and junk financing. Valuations were made based on cap rates as low as 3%.  Move that cap rate back up to 8%, the minimum needed to attract new investment now, and the underlying property drops in value by half. Most REIT's have the cash flows needed to get through this crisis. But if they need to roll over debt in 2009, Heaven help them. Vacancy rates are now 15.7% nationally, and will easily exceed 20% next year. Still, problem loans in this sector are only thought to reach $200 billion, change under the sofa cushion compared to the other disasters out there.

5) The cash tsunami is finally hitting the mortgage market, with 30 year rates hitting a four year low of 5.47%. Bank of America (BAC) is offering a 1-2-3 program where rates start at 3 5/8%, then graduate to 4 5/8% and 5 5/8% in the second and third years. Wells Fargo (WFC) offers borrowers a jumbo rate of 8.5%, but will cut it to 6.5% if you deposit $250,000 with them. These 'compensating balances' use to be illegal, and tell you a lot about the current state of the banking businesses. In the meantime we learn that 50% of the homeowners in Nevada are now underwater on their mortgages.