Inflation — the arch nemesis not just of the fixed-income market, but potentially of a nation’s entire economy (see Zimbabwe).  There has been increased talk of potential inflation in the U.S. as the federal government debt zooms past $11 trillion with ubiquitous predictions of multi-trillion dollar deficits exacerbating the problem.

Obviously, a rising federal government debt has negative implications for future inflation.  However, this is far from the only debt threatening to storm the gates.  State and local governments are facing some of their most trying times ever in balancing their budgets — taxes are being raised and services are being cut — yet bankruptcy is a looming possibility for more and more municipalities.  Add to this the frightening situation over unfunded pension liabilities and you have a recipe for disaster.

Already, fears of governments not being able to fund their growing liabilities are spooking investors.  Just last week, Great Britain was unable to sell 1.75 billion pounds of 40-year gilts (British Treasury bonds).  The hegemony of the U.S. dollar has made it highly doubtful that the U.S. would default on its debt, though by running the printing presses overtime, the government may simply “monetize” its debt, rendering the value of the currency in which the debt is paid all but useless.

Recently, both Russia and China have made noises regarding the risks (to all countries without the initials USA) of maintaining the U.S. dollar’s place at the top of the global currency pecking order.  Last Thursday, China’s mere suggestion of introducing a global reserve currency caused a vicious selloff in the dollar on world currency markets.  Later, a United Nations panel ran with the same idea.  Clearly, a pattern of nervousness is growing in the guts of some of our country’s biggest debtholders (China currently holds a $700 billion-plus IOU with Uncle Sam’s autograph at the bottom of it).

Inflation hasn’t been a huge problem in the U.S. in a generation.  But the days of 18% mortgage rates and WIN (Whip Inflation Now) buttons could be just around the corner.  When inflation strikes, the cost of protection will be prohibitive.  What follows can be thought of as the personification of The Lamb’s Rule #7 — “If you’re gonna panic, make sure you’re the first.”

There are several ways to protect oneself from the dangers of inflation.  While some are simpler than others, each carries varying degrees of difficulty and liquidity built into it.

*TIPS — An acronym for Treasury Inflation-Protected Securities, these are U.S. Treasury notes that pay a fixed coupon plus the rate of inflation.  For example, the current 10YR TIP carries a real yield of approximately 1.25%.  That means that, if bought and held to maturity, an investor would earn 1.25% plus the rate of inflation as measured by the U.S. Consumer Price Index (CPI).  TIPS can be bought from myriad securities dealers and from Treasury Direct. 

However, while the coupon on TIPS moves in step with inflation (via adjustments to the bond’s principal), TIPS do not protect investors from increases in market interest rates.  In other words, as real yields rise, the value of TIPS will fall, often precipitously given their very high durations.  Only by concurrently shorting nominal Treasury securities against a long position in TIPS (somewhat difficult from a practical standpoint) can an investor protect himself against an increase in real rates.  As a final caveat, the CPI figure’s components are determined and calculated by the very entity paying the coupon (the U.S. government), creating somewhat of a conflict of interest.

*Rate ETFs — Exchange-traded funds (ETFs) have been around for several years.  They are relatively liquid and trade very much like stocks.  They were created to enable investors to participate in strategies or to purchase combinations of stocks (similar to mutual funds) in which they would otherwise be unable to.  The PST and TBT ETFs offer a leveraged view on Treasury Note performance.  Their performance is intended to correlate closely with double the inverse total return of different segments of the Treasury curve.

One downside to these ETFs is that rates must increase by enough to cover the coupons earned by the underlying securities.  In other words, unless rates rise by a large amount, an investor would still see her investment decline in value should the rate move be less than the coupon payments.

*Foreign Exchange ETFs –  These ETFs offer investors the opportunity to profit from a decline in the value of the U.S. dollar in relation to other currencies, without the difficulty of trading foreign exchange directly with a currency dealer.  If/when inflation becomes more pronounced as both capital account and current account deficits overwhelm the U.S. economy, the value of the dollar could fall.  These ETFs offer some measure of protection.  The CYB and UDN ETFs offer a short position in the U.S. dollar versus the Chinese Yuan and a basket of currencies (British Pound, Canadian Dollar, Euro, Japanese Yen, Swedish Korona, and Swiss Franc), respectively.

Of course, as inflation rises and the Federal Reserve attempts to fight it, the Fed could raise short-term interest rates (as Chairman Paul Volcker did in the late 1970s).  This could squeeze U.S. dollar shorts as the cost of financing those positions increases.

*Commodity ETFs — Like other ETFs, these funds make it easier for investors to gain exposure to a given asset class, in this case — commodities.  Precious metals such as gold are often considered the “classic” inflation hedge.  However, any commodity denominated in U.S. dollars can serve as an effective inflation hedge.  There are a variety of commodity ETFs available, including ones for gold (GLD), oil (USO), and grains (DBA).  There are also more generic commodity ETFs that cover a more diverse set products, such as the GSG ETF.  Essentially, in purchasing these ETFs, an investor is wagering on the relative value of these products against the U.S. dollar.  In a sense, buying equities accomplishes much the same thing.

*”Hard” Assets — Vacant land, a farm, even the house in which you live (if you own rather than rent) can serve as an effective inflation hedge.  This is perhaps the simplest and easiest way to hedge against inflation.  Simply by owning a home, one can protect against the ravages of inflation.  Owning a home can have a dual benefit, depending on how it is financed.  This leads to the next inflation hedge…

*Financing — As long as payments are affordable, financing a large (80%?) portion of any purchase on a fixed-rate basis, particularly one as large as a home, has several (inflation fighting) advantages.  For example, take a homebuyer who borrows money at, say, 6%.  If inflation and interest rates skyrocket, as occurred some thirty years ago (remember those 18% mortgage rates), not only has the borrower saved himself a huge opportunity cost, but he can essentially monetize his debt to the bank by investing any current savings/income in higher interest bearing instruments, effectively arbitraging the remainder of his loan.  Fixed-rate financing brings with it another built-in advantage — if mortgage rates drop, the homeowner can refinance (assuming adequate equity) at a lower rate, decreasing his monthly payments.  This exemplifies positive convexity, a key benefit of a mortgage’s refinancing option.

*Payer Swaption — This is The Lamb’s preferred means of inflation protection.  As a background note, The Lamb is a HUGE fan of insurance.  You name the insurance, The Lamb owns it —  health, property, life, long-term care — The Lamb’s got it all.  He likes the safety, the protection, and most of all, the peace of mind.  So, it should come as no surprise that The Lamb likes “payers” as inflation protection.  Like other insurance, a payer swaption can be thought of as an “option premium”, or the cost of buying insurance.  Your “downside” is that nothing happens, and all you’ve lost is the premium you paid for the insurance. 

While most insurance doesn’t pay off, and is viewed by some as a waste of money, try buying hurricane insurance in Miami when a Category 5 monster is in the Florida Straits — you may find it a tad expensive.  It’s the same with inflation.  Buying protection is cheapest before you see the whites of its eyes.

So, back to payer swaptions.  Essentially, payer swaptions give the buyer, in exchange for an upfront premium (just like insurance), the right (but not the obligation) to pay a pre-determined fixed interest rate for a certain period of time beginning at a certain time in the future.  Think of them as puts on interest rates.  For example, if you own a payer swaption struck at 6% and rates are at 8% when the put expires, you would exercise the option and pay a 6% interest rate when market rates are at 8% (as a practical matter, you would “cash settle” the trade, pocketing the present value of the difference between the two rates).

Payer swaptions can be utilized to garner inflation protection while only risking a small cash outlay.  As an example, a payer swaption giving the buyer the right to pay a 5.50% fixed rate (versus a series of floating three-month rates equal to LIBOR) for ten years, beginning in ten years, can be purchased for roughly 3% of the notional amount (e.g. — $30,000 for a $1,000,000 swaption).  A relatively small premium, an investor can lose 3% in just one day of stock market moves. 

If, in ten years, inflation and interest rates are higher, say even at just 7% (just above the average over the past 20 years, and far below the 10% in 1989, and the mid-teens reached a decade before that), the swaption would be worth approximately $100,000 — more than triple the initial premium.  What’s more, unlike other types of insurance, this insurance provides ten years worth of protection.

Via The Bloomberg (click on image for better view):

Historic 10YR Swap Rates

It has been nearly two years since the beginnings of the current economic crisis.  And while many culprits have been put forth to assume the mantle of blame, the most critical item now on the agenda is the jumpstarting of the U.S. and global economies.

With equity prices down over 50% from their highs and residential/commercial real estate not far behind, asset price deflation is the most visible symptom of today’s economic malaise.  While dismal unemployment statistics certainly play an integral role in consumer confidence and spending, the public is bombarded with daily report cards on the nation’s (world’s) economic health by way of asset price reports, particularly those of equities.

Whether it has been the ubiquitously mentioned Troubled Asset Relief Program (TARP), the Commercial Paper Funding Facility (CPFF), or any other government-led attempt to kickstart the economy, the major flaw in each has been the lack of capital to purchase assets which serve as the backbone for so much of this nation’s daily lending — securitized products.  Knocking down this one pin, the theory goes, will raise asset prices, stimulate consumer and business confidence, and grease the country’s economic gears.

Arguably, a big enough pool of capital aimed squarely at these assets would be sufficient to break the financial logjam and get capital flowing again.  Up to this point, the problem hasn’t been that assets were not cheap enough for investors to buy, but that funding was not available to lend to those who wanted to purchase these assets at current market prices.

Now, the Fed and Treasury have launched the Term Asset-Backed Securites Loan Facility (TALF) to provide as much as $1 trillion in funding for specific, highly-rated asset-backed securities (ABS).  The program certainly has holes — funding will only be available for newly issued securities (not secondary paper), and only for securities rated AAA.

However, as the Fed provides investors with advantageous funding for ABS, prices for these securities should rise, potentially dragging the prices for other similar assets higher as well.  While the TALF is far from a sure thing, its success could represent the knocking down of that one all-important economic pin.

Come on, Rodney!

How many athletes/personalities can you identify in this commercial from the 1980s?  Click here for a list, and contact The Lamb if you recognize others.

“Remember, anyone can do it.  Not everyone will.  The only question is:  Will you?” — Gary Keller, The Millionaire Real Estate Investor

Yesterday, President Obama pledged $75 billion to help alleviate the financial hardships caused by the decreasing value of a single asset class — residential real estate.  The goal is to ameliorate the unfortunate burden of homeowners having to pay monthly mortgage payments that the government says could cause them “financial ruin.”

Among other things, the scheme calls for allocating this $75 billion to as many as 9 million homeowners (less than $139 per family per month, spread over five years – the length of time this program is scheduled to remain in effect).  Call The Lamb naive (he’s been called worse), but does this really do anything to solve the long-term dilemma that home prices remain far above their long-term average of two-and-a-half times median household income?

Quoting a summary of the plan:

“This initiative is intended to reach millions of responsible homeowners who are struggling to afford their mortgage payments because of the current recession, yet cannot sell their homes because prices have fallen so significantly” (emphasis added).

Responsible?  Many of these borrowers purchased an asset, real estate, at a price that was three to four times the amount of their gross annual incomes!  Exacerbating their financial risk (which is now being dispersed to more responsible taxpayers to foot the bill for them), many of these borrowers were leveraged more than the usual four to one (via a 20% down payment).  In fact, some (euphamistically described) “brave” souls even went with the then-ubiquitous (for 2005-2007) no-money-down or negatively amortizing mortgages. 

Responsible, indeed.

Can it really be that surprising to these borrowers that they can no longer afford the payments on that asset?  Several of the bobble heads on CNN and CNBC have posited that banks and other mortgage lenders bear the brunt of the responsibility for homeowners taking on such large debt burdens — if the money wasn’t offered to them, these homeowners would not have borrowed it.

The Lamb calls B.S. here.  That argument is akin to a policy holder blaming a life insurance company for costing him money because he didn’t die in a timely manner!

As long as money is being transferred from the responsible to the irresponsible (or from the economically fortunate to the economically unfortunate, if that is more tasteful), why not give taxpayer money to those that suffered losses in other markets?  Raise your hand if you lost money in the stock market in the past few years.  At least these investments were not nearly as highly levered.  And why stop with equity investments?  How about those that were burned in corporate bonds, commodities, or even art?

Why is real estate being held out above all others as a sacrosanct investment in which people are insulated against loss?  Do we really want a system in which the most leveraged investment opportunity available to most people is insured against loss by other taxpayers?  Is this not the very definition of moral hazard?

Many argue that “you gotta live somewhere.”  Fair enough.  But despite its spelling, RENT is not a four-letter word.  Let’s look at renters for a moment.  Here is a group of people that, for whatever reason, chooses not to purchase a home.  Maybe they can’t afford the down payment (although that certainly was not the issue earlier this decade when a down payment was apparently only for suckers).  Maybe they don’t want to take the risk of fixed monthly payments for thirty years.  It doesn’t really matter why.

What matters is that by not targeting real estate prices as they zoomed skyward for a decade, and then unilaterally attempting to stop their rational descent, government is essentially punishing renters for making what in hindsight was the correct economic decision.  Renters who did not chase irrational (or “unaffordable” if that term is friendlier) prices earlier and could otherwise afford to purchase a home today, are being unfairly kept from doing so by government’s artificial price floor.

“Everyone wants a piece of land.  It’s the only sure investment.  It can never depreciate like a car or a washing machine.  Land will double its value in ten years.  In less than that.  Land is going up every day.” — Sam Shepard, Curse of the Starving Class

In the early 1990s, when The Lamb first began trading, his boss gave him a piece of advice that he has kept in the forefront of his mind ever since:  hope is not a hedge.  The message was simple — if you want to protect a position, then take specific action.  Don’t just hope and pray that things will work out — they usually don’t.

As has been mentioned ad infinitum by the ubiquitous talking heads, today is a historic day for the United States.  A new administration takes the reins of a shaky economy and an equally optimistic constituency.  Comparisons of Barack Obama to FDR and Ronald Reagan have been tossed about as if to signify that all is about to be right in the world.

But despite revisionist history, let us recall that economic difficulties continued or worsened during the first few years of each of the above two administrations.  In fact, economic conditions deteriorated significantly during FDR’s second term in office as Americans came to realize that his alphabet soup public works programs were an ineffectual short-term bandaid for a lethal long-term wound.

Regardless of your political affiliation in general or opinion of Obama specifically, we are all rooting for this administration’s success.  The multi-trillion dollar question, however, is what steps will be taken and, more importantly, what will be the ramifications?

Will we have tax cuts (individual and corporate) or tax increases?  Increased government spending or less?  (OK, I think we all know the answer to that one).  What will the Federal Reserve and the Treasury Department do if/when the dollar begins to slide as short-term interest rates remain near zero while budget deficits and the cost of entitlement programs soar?  Remember, the Fed can control either the price or the supply of money — not both.

As we leave a trying 2008 and enter a (perhaps) riskier 2009, take the time to review your finances.  Remember The Lamb’s Rule #2 — Know and understand what you own, and what you owe.  Determine what can hurt you and actively take steps to protect yourself.  Don’t look back a year from now and regret that you had too much money in equities, inadequate protection from higher interest rates or a weaker dollar, or too much/little fixed-income credit exposure.

Remember, hope is not a hedge.

Last November, The Lamb wrote that Uncle Sam should eschew saving General Motors.  He argued that the attempt would be tantamount to keeping alive a terminal patient, with the suffering borne by the American taxpayer.

Fast forward nearly two months.  While The Lamb’s opinion on rescuing GM hasn’t changed, the status of the company’s finances has.  Last week, GM “received $4 billion in initial rescue loans from the U.S. Treasury to help it avoid collapse.”  Many more billions of dollars in loans and other financial assistance is likely forthcoming.  As the Treasury said last week in explaining its current and future assistance to the auto industry (via Bloomberg.com):

“Treasury may consider, among other things, the importance of the institution to production by, or financing of, the American automotive industry.”  The government will weigh “whether a major disruption of the institution’s operations would likely have a materially adverse effect on employment and thereby produce negative spillover effects on economic performance” or on credit markets.

Well, if that doesn’t telegraph that more aid to General Motors is in the cards, The Lamb doesn’t know what does; add to this a newly-inaugurated President Obama’s likely aversion to having one of the most iconic American companies go toes-up on his watch, and you have the makings of an open-ended rescue program.

Just as in the case of the AIG bailout, which carried an initial $85 billion price tag, Uncle Sam has a nasty habit of throwing good money after old money.  He hates to take a loss, especially one that would receive such loud press coverage.  Rather than lose a few billion of taxpayer dollars, he habitually continues to bolster old investments with new money.  With AIG, for instance, over $67 billion (now a total of $152 billion, if you’re keeping score at home) has thus far been promised to the beleagured insurer to protect/bolster/insure the original $85 billion.

Now recall last month that The Lamb advocated investing money in certain institutions that had received money from Uncle Sam in return for preferred stock.  The idea is that owning senior debt of companies that had issued preferred stock to the government was a good risk/reward trade in that Uncle Sam could not recoup any of his principal unless and until you received yours, as senior debt is ahead of preferred stock in a company’s capital structure.

As The Lamb said then and still fervently believes today, “Uncle Sam is gonna get his money back.  You will, too.”

The loan(s) that Uncle Sam provides GM will, in all likelihood, be senior to any senior debt of GM and will not obviate the risk of GM’s defaulting on its senior debt.  However, The Lamb believes that there is a better than decent chance, similar to that of the AIG situation, that Uncle Sam will be loathe to let a company to which it has lent billions of dollars go bankrupt.

Now, it is certainly possible that there will eventually be a (coerced) debt-for-equity exchange, a shotgun merger, or even a pre-packaged bankruptcy.  Each of these could easily result in a significant haircut for GM bondholders.  However, the recovery value for GM debt is likely to be around 10 cents on the dollar, somewhat mitigating any loss.  GM bonds are unquestionably very risky — both Moody’s and S&P have them rated well into the nether regions of junk status.

However, with all this in mind, one interesting and admittedly very risky investment idea is to purchase relatively short-dated senior debt of General Motors.  Though only for investors with the greatest predilection for pushing the risk/reward envelope, 2-year maturity senior debt of GM currently carries a tantalizing yield-to-maturity of over 100%.  Translation:  if the bonds mature at par (100 cents on the dollar), an investor will quadruple his money over a two-year period, including coupon payments.

The GM 7.20s of 1-15-2011 are currently (as of Friday) priced at a dollar price of 25.03, according to the bond market’s Financial Industry Regulatory Authority’s (FINRA) pricing service.  This equates to a yield of 100.46%, and is a low enough dollar price that even a 10 cent recovery value brought about by bankruptcy will not completely wipe out the investment.

As a final caveat, before making this or any other investment, The Lamb strongly urges you to repeat Rule #2 at least three times while standing in front of a mirror:  “Know and understand what you own.”

Disclosure:  The Lamb currently has a small amount of the above-mentioned GM 7.20s tucked neatly into a dark little corner of his portfolio.

“Seek advice, but use your own common sense.”  This Yiddish proverb seems particularly apropos in the wake of the ongoing Bernard Madoff scandal.  For years, even decades, investors in Madoff-associated funds basked not only in the comfort of 10%-plus returns, but also in an incredible lack of variance in those returns.  All this despite a market that endured several years of roller-coaster-like ups and downs.

The list of investors in Madoff’s funds reads like a “who’s who” of banks, funds, foundations, and ultra-wealthy individuals.  Many (if not most) of these investors are far smarter than The Lamb would claim to be.  However, where was their due diligence?  Where was their questioning, their skepticism?  Where was their interrogation:  “How are you able to do this?”

When people with the gall to question or challenge his returns did ask him for explanations, most were greeted with the refrain, “It’s too complicated, you wouldn’t understand.”  While that may have been true (doubtbul, but possible), The Lamb prefers to cling tightly to Rule #2:  “Know and understand what you own (and what you owe).”  If it’s too complicated for The Lamb to understand, he passes.

(Madoff did respond to more persistent inquiry by saying that he employed a “split-strike conversion strategy.”  This fancy sounding tactic involves selling out-of-the-money call options on one’s positions to generate extra income.  It also utilizes some of this option premia to purchase downside protection in the form of out-of-the-money put options.  However, even with this modus operandi, it would be nearly impossible to generate the consistently high returns that Madoff claimed.)

A few months ago, The Lamb had a significant portion of his cash position invested in GE Interest Plus (GEIP).  After reading the prospectus, he believed that this investment, described on the GEIP website as “a AAA-rated unsecured and unsubordinated debt obligation of GECC (General Electric Capital Corporation),” was simply a retail-targeted short-term IOU of GECC, one of the largest and historically safest companies in the world.  In other words, this was tantamount to floating-rate (the rate would change as short-term market interest rates changed) commercial paper.  The Lamb invested.

However, several months ago as the financial crisis worsened and short-term rates almost universally fell, the yield on The Lamb’s GE Interest Plus account actually rose.  In fact, the rate was now quoted at a level far in excess of what GECC was offering on its institutional commercial paper.  Something was off.  Either there was a problem with something related to GE Interest Plus or The Lamb was too dumb to figure out why he was earning such a (relatively) high rate.  He needed answers.

The Lamb exchanged several emails and phone calls with GE Interest Plus, but was graced only with vague and seemingly pre-formed responses.  Now, to be clear, The Lamb is not insinuating that there was or is anything untoward occuring at any entity of General Electric.  (In fact, he still owns a sociable-sized position in senior unsecureed GECC floating-rate notes maturing in 2012).  However, without a satisfactory explanation, he did not (and still does not) feel comfortable having anything more than a token amount of money invested in GEIP, and has yanked over 99% of his investment.

————————————————–

Several years ago, The Lamb was charged with investing his grandmother’s savings.  Thankfully, she had an ample nest egg and really didn’t need anything except for the safe return of her principal in order to pay for her lifestyle.  That lifestyle consisted almost entirely of having lunch at “The Club,” playing Mahjong with the girls, and making the 40-minute drive to the (legal) casinos in South Florida for some Hold ‘Em poker. 

Therefore, The Lamb kept all of her money in cash, yielding next to nothing.  Her returns would be minimal, but she would be able to play Mahjong and poker for decades, and could lunch at The Club whenever she desired, sending back all the too-fishy crab cakes and cold coffee she wanted to.

The Lamb’s Rule #1 was paramount here:  “With “can’t lose” money, return on capital is far less important than return OF capital.”

Despite her advancing age, Grandma Lamb maintained a competitive streak.  Besides wanting to win at Mahjong and poker, she wanted to be sure that she was earning all she could on her life savings.  Many of her friends at The Club had been investing for years with a nice man from New York who had provided them with returns north of 10% — “Guaranteed!” 

She shrugged off as cynical her obstinate grandson’s arguments that guaranteed 10% returns were either impossible, illegal, or both.  All she knew was that her friends were earning 10%, and she was stuck with only a tiny fraction of that return.  But as the years went on, she (thankfully) fixated more on her poker game and less on her bank statement’s puny investment performance.  Eventually, she even learned to tune out her friends’ boasts of their lucrative investments with that nice man from New York; her money stayed in cash.

Grandma Lamb passed away on Halloween evening, 2007.  She played her final game of poker just one week before she died — a joyful five-hour session she shared with her grandson.  Despite years of low returns on her money, Grandma Lamb still had more than enough of it to cover her grandson’s $45 loss that day.

Oh, and that nice man from New York?  You may have heard of him.  His name is Bernie Madoff.

With apologies to Dire Straits, The Lamb can think of no better description than the title of this post for describing the investment opportunities currently available courtesy of Uncle Sam.  No, he’s not talking about the zero (or negative) yields available from U.S. Treasury Bills.

The Lamb is speaking about some good, old-fashioned, generic corporate bonds.  As a refresher, corporate bonds are simply IOUs from corporations — you lend them money, they agree to pay you back that money on a pre-set date in the future, as well as paying you interest along the way.  Of course, the risk is that the company goes bankrupt, defaults on its promise, and you’re left fighting for recovery value (the amount ultimately received in a bankruptcy proceeding).

As the economy has headed south recently, default rates have crept up and are expected to continue to rise.  And certainly, debt of many financial companies carries with it at least the same amount of risk as non-financial debt.  Or does it?

As mentioned in several earlier posts (Fannie, Freddie, and Sam; John Smiles, Milton Cries, The Lamb Sighs; and Uncle Sam vs. Uncle Sam) the “Bailout Binge” has been in full force for many months now.  The time has come for investors to take advantage of this government insurance/subsidy.  After all, your tax dollars are what’s bolstering these guarantees.  Shouldn’t you be compensated for your generosity?

Let’s take a small step back.  On October 13th, the FDIC (these are the same good people who insure the deposits, with certain restrictions, at most of your local banks) adopted the Temporary Liquidity Guarantee Program (TLGP).  Essentially, this program puts Uncle Sam’s good name behind some newly issued financial debt that matures on or before June 30, 2012.

The TLGP is in addition to Uncle Sam’s buying (again, with your money) preferred stock (which must remain outstanding for a minimum of three years) in these very same financial institutions.  Currently, these investments are (mostly) under water.  But hey, what’s $8 billion or so between friends?

Now, before we get to the good stuff, let’s review what happens in the event that a corporation goes bust and (in the unlikely event) its assets and liabilities are not assumed by another institution.  The first ones to get their money back are secured creditors.  These are the ones that lent money to the company, but only in exchange for receiving an unfettered claim on certain assets of the borrower.  Next (remember this part, this is what we care about) are the debt holders (senior, than junior, etc.).  Then come the preferred stock holders, followed last in line by common stock holders.

The Lamb’s view is this:  Uncle Sam is going to be loathe to let any institution in which it has invested taxpayer money actually NOT pay that money back.  The public relations black eye, not to mention the financial fallout, would be just too great to bear.

However, Uncle Sam would not be first in line to get paid back if a company went toes up.  Before Uncle Sam, as a preferred stock holder, received dime one, the senior debt holders would have to get every single penny of their money back, including accrued interest.

Now freely available for your investing pleasure are the senior debt of the very same financial institutions that have sold preferred stock to Uncle Sam.  For a not-necessarily exhaustive list of these firms, click here.

Many of these institutions have senior debt trading in the market which matures before the preferred stock can be retired.  And, it’s yielding as much as five percentage points or higher than its corresponding TLGP counterparts, some at yields around 10%.  Granted, this debt does not carry the expressed FDIC guarantee behind it.  But do you really think that Uncle Sam, in the unlikely event that one of these banks goes under, will be willing to face Ma and Pa taxpayer and tell them that the hundreds of billions of dollars they spent on preferred stock is not going to be repaid?

Neither does The Lamb.  He recemmends buying the short-term (less than three years) senior debt of companies that have sold preferred stock to Uncle Sam.  Uncle Sam is gonna get his money back.  You will, too.

Disclosure:  The Lamb owns senior (non-TLGP) debt of Merrill Lynch (soon to be Bank of America), Goldman Sachs, Morgan Stanley, and AIG.  He is looking to purchase more.

As a parent, one would not reward a child with extra dessert for throwing his dinner against the wall.  As a boss, one would not lavishly remunerate an employee who has negligently cost the company money.  Poor behavior should be punished, or at the very least, not encouraged.

Unfortunately, Uncle Sam continuously insists on not only rewarding, but actually encouraging bad behavior on the part of consumer borrowers.  The Lamb has been a vocal critic of the American Mortgagor as the prime suspect in the current financial impasse.  While others certainly share the mantle of culpability, the American homebuyer stands atop the pedestal of guilt.  His inability/unwillingness to repay debts he assumed voluntarily is at the crux of the current crisis.

So, what should be done?  Well, what should NOT be done is what the Treasury is currently considering.  From The Wall Street Journal:

“The plan, which is in the development stages, would use mortgage giants Fannie Mae and Freddie Mac to bring loan rates down as low as 4.5%, a full percentage point lower than the prevailing rates for 30-year fixed mortgages.”

Let’s see.  Easy credit over the past few years encouraged borrowers to take on more debt than they could afford to pay back.  This led to a wave of defaults, causing lenders to go bankrupt, which threatened to destabilize the financial system.  This led to bailout after bailout, which coincided with historic downdrafts in asset prices in everything from equities to commodities, and from high-yield debt to Triple-A asset-backed securities.

Now that asset prices are beginning to show signs of stabilizing, what should the next step be?  Hmmm… that’s a tough question…  Wait!!!  Why don’t we use artificial means to make credit easy again?  Yes, that’s a great idea!  In fact, let’s just go ahead and use taxpayer money (which, by definition, is money paid by those who acted prudently by NOT borrowing over their heads and are still paying taxes) to encourage even further bad behavior (i.e. — more borrowing).

In fact, that is exactly what is being proposed (again, via The WSJ):

“Under the plan, Treasury would buy securities underpinning loans guaranteed by the two mortgage giants, which are temporarily under the control of the government, as well as those guaranteed by the Federal Housing Administration.”

Already, the New York Fed is planning on purchasing Fannie and Freddie (GSE) debt.  The first purchases are slated for this Friday.  From the New York Fed’s website:

“What is the policy objective of the Federal Reserve’s program to purchase direct obligations of the housing-related GSEs?
The goal of these debt purchases, combined with the purchases of mortgage-backed securities (MBS) backed by Fannie Mae, Freddie Mac and Ginnie Mae announced on November 25, 2008, is to reduce the cost and increase the availability of credit for the purchase of houses.”

Sounds like giving your kid more messy food to throw against the wall.

The Lamb is cynical by nature.  He is a paid-up subscriber to the axioms “If it sounds too good to be true, it probably is,” and “Where there’s smoke, there’s arson.”

Recently, a friend of The Lamb, Adam (name changed to protect the imprudent), told him about a new website called OneSeason.com.  Adam is a willing, though very suspicious, participant in the OneSeason market.  Essentially, this site allows “investors” to buy and sell shares in their favorite players and teams from the world of sports.  There are both primary and secondary markets.

In the primary market, OneSeason conducts initial public offerings (IPOs) of shares for both teams and players (with a price set at $5 per share) via an allocation algorithm.  These shares are then traded in the secondary market, splitting if/when the price reaches $20 per share.  The company makes money by charging commissions of 5% on IPOs and 1% on secondary trades.  Presumably, fixed and variable costs are de minimus. 

Now for the fun part.  Unlike traditional shares of company stock which entitle the holder to a fractional ownership of that company’s net profits, holders of OneSeason shares simply own the bragging rights to a given player or team.  Unfortunately, bragging rights, much like gold and vacant land, are not positive carry investments.  Then again, land and gold are both tangible assets and offer at least the potential of capital appreciation.

Of course, OneSeason shares can go up in value.  An investor simply has to find someone to pay a higher price than he paid — the so-called “greater fool theory.”  The Lamb certainly feels that OneSeason participants are entitled to purchase shares as they wish – (The Lamb’s Rule #5 — “You pay your money, you take your choice.”)  However, he feels that OneSeason has essentially created a somewhat mitigated pyramid scheme.  This “venture” differs only slightly from the early 20th century Ponzi Scheme. 

Charles Ponzi's Mugshot

The product (service?) OneSeason sells has no intrinsic value save for the aforementioned bragging rights of player/team cyber-ownership.  This may be a good time for potential OneSeason participants to repeat to themselves The Lamb’s Rule #2 — “Know and understand what you own.”

One may ask how this is any different from owning a baseball card or even a work of art.  The difference is that in owning one of these two types of positional goods, an investor has possession of a tangible item, and more importantly, one which is of finite supply– 

Pablo Picasso is not going to be composing many more paintings, and the American Tobacco Company threw away the mold for the T206 Honus Wagner baseball card nearly a century ago.

As amazing as it seems to The Lamb that this market exists, more incredible still is that it has actually spawned websites for OneSeason investors (again, the term “investors” is used extremely loosely here) to exchange opinions and information about share prices of players and teams, much like websites devoted to fantasy football/baseball enthusiasts.  Sites like OneSeasonNation.com and OneSeasonTrader.com garner far more hits than does your editor’s humble corner of the blogosphere.

Trade shares at OneSeason.com if you wish.  But keep The Lamb’s Rule #4 (An asset is only worth what someone else is ready, willing, and able to pay for it) safely in the front of your mind. 

Right now, Adam is wishing he had remembered it…

Note:  This post is in no way meant to endorse, oppose, compliment, or impugn any person or political party.

Monday, January 28th, 2013

President Palin sat alone in the Oval Office wondering if the plan she had developed with her financial S.W.A.T. Team would be enough to extricate the country from its latest economic crisis.  She was barely one week into her first 100 days in office, and things were going from bad to worse.  She thought back to her predecessor and the challenges he faced during his four years in her position.

It was late summer 2009 and the previous year’s credit crisis already seemed like a distant memory.  The 0.125% federal funds rate and enormous federal bailout programs appeared to have stabilized the financial markets.  The Dow had clawed and scratched its way back above the 11,000 mark and there had been a nearly one year absence of major corporate failures. 

However, the easy monetary policy masked a deeper dilemma.  With memories of 2008 still fresh in their minds, financial institutions remained fearful of committing capital for longer-term projects.  As many banks began facing maturities on their debt, rollovers became a looming problem.  The 2008 guarantee of bank debt issuance had failed to lower term funding costs significantly as investors had grown leery of just what that U.S. government guarantee was really worth.

With small and large banks alike experiencing growing funding difficulties, President Obama called on Treasury Secretary Lawrence Summers to find a solution.  Working with Fed Chairman Robert Rubin, who had reluctantly assumed his position after Ben Bernanke had been “asked” to leave by the President, Summers embarked on a bold solution. 

Loathe to face the specter of another large bank failure, the duo ordered (the official stance was “strongly encouraged”) the marriages of the country’s few remaining “super” banks.  Goldman Sachs was sent kicking and screaming into the arms of Citigroup, and Morgan Stanley was reunited with its ex-spouse JP Morgan.  The restriction on any institution holding more than 10% of total U.S. deposits was conveniently repealed.

Unfortunately, this failed to stem the rising tide of consumer bankruptcies.  Credit card debt was now crippling the country.  By late 2010, credit card debt in the United States had skyrocketed from $27 billion in 2007, past the 2009 level of $96 billion (estimated by NBC News), to a staggering $200 billion, as households tapped any possible source to pay for day-to-day living expenses.

Faced with a public outcry and using the 2008 bank bailout as precedent, President Obama ordered Secretary Summers and Chairman Rubin to enact a freeze on all credit card interest charges effective as of December 1st, 2010.  To mollify the credit card companies, the Treasury would begin making the interest payments on all balances as of this date, though at a rate of just 9%.  Though this was below what they were currently slated to earn from consumer balances, the credit card companies acceded to the plan as it dramatically reduced their allowances for bad debts and strengthened their deteriorating balance sheets.

Financial blows continued to batter the global economy.  South American nations, borrowing more and more money in an effort to grow their own economies out of the three year recession, faced spiraling inflation.  Playing their trump card, they threatened an oil embargo against the U.S.  With oil already having soared above $350 per barrel after the June 2011 Israel-Iran War and the American public demanding a reprieve from crippling gas prices, the United States approved low-interest loans to Brazil, Venezuela, and Argentina in exchange for their promise to maintain the flow of oil.

The dire financial straits of consumers and declining property values culminated in much lower tax receipts for municipalities, just when this money was most badly needed.  California, already buckling under huge fiscal strains and unwilling/unable to repeal Proposition 13, in early 2012 became the largest municipal bankruptcy on record, easily eclipsing Orange County in 1994, Alabama’s Jefferson County in 2009, and even the 2011 State of Arizona filing.

In an effort to forestall cascading municipal failures which threatened to paralyze essential state and local services from education to police and fire departments, in the summer of 2012 Congress passed the Municipal Assistance Rescue Program (MARP).  The MARP allowed state and local governments to borrow money interest free from Uncle Sam for up to three years.

However, as the conga line of municipalities lining up to take MARP funds grew, the national debt soared, as did interest rates on everything from U.S. Treasury securities to home mortgages.  Inflation, that scourge not seen since the late 1970s, skyrocketed past 12% and the U.S. Dollar, already battered by the proliferation of government bailouts the past four years, sank like a stone. 

Many banks were now unwilling to make loans in dollars, fearful of the currency’s continued depreciation and unable to effectively hedge themselves in the increasingly illiquid foreign exchange markets.

As summer turned to fall with the economic and financial landscape looking increasingly bleak, the nation elected its first female president — Senator Sarah Palin of Texas.

Sitting in the Oval Office, President Palin greeted newly appointed Fed Chairman Timothy Geithner.  The President wanted reassurance that her campaign pledge of lowering inflation and crippling interest rates could be accomplished.  The Chairman, taking a page from one of his predecessors, Paul Volcker (who had raised the federal funds rate to as high as 20%), reiterated faith in their plan to raise the funds rate from the current 10% all the way to 18%.

In response to the President’s hesitancy to increase rates, Chairman Geithner explained its necessity in wringing inflation out of the system.  The Chairman admitted that he had learned his lessons from the ill-planned bailout binge that he had helped orchestrate and sustain as President of the Federal Reserve Bank of New York during the presidencies of George Bush and Barack Obama.  He said that the country now needed to take its financial medicine, no matter how bad the taste, in order to cure the disease of inflation.

Besides, he elaborated, raising short-term rates might be enough to reverse the outflow of foreign capital that had been occurring for most of the past year.  China and Japan, for example, had sold nearly $1.5 trillion of dollar-denominated debt, mostly U.S. Treasury and Agency securities.  America’s runaway inflation had shaken their faith in its ability to service its debt, now owned predominantly by foreign governments.

If this did not work, Geithner worried, the country might be forced to return to some version of the gold standard, not seen in the United States since President Nixon abandoned it in 1971.

As February turned to March and March to April, the economic climate began to improve.  Data showed that foreign capital was returning to the U.S., taking advantage of higher short-term yields.  As inflation fears abated, fixed-rate mortgage rates dropped precipitously, falling below the psychologically important 10% level.  Even the Dow had closed above the 5,000 mark for the first time since late 2011.

The country was learning (forced?) to live within its means after an arduous period of stagflation.  Long-gone were the days of easy credit and government safety nets.  But a more disciplined and realistic debtor-creditor relationship had emerged, one which held the promise of stable prices and moderate long-term growth.