Saturday, March 22, 2008

Risk Of Failing U.S. Highway System: Deadly To Drivers

According to the American Society Of Civil Engineers’ (ASCE) Report Card for America’s Infrastructure, an estimated $1.6 trillion is required over a five-year period to fix our failing infrastructure to bring them to a good condition. Of this, $210.3 billion a year is required just to keep the surface transportation system working[i].

Here is an excerpt of their most recent report card as of 2005: (2008 update from ASCE)

What Is The Risk?
New York Times reported today that another Minnesota bridge was closed due to bent bridge joint reinforcements (‘gusset’ plates), a problem similar to the Minneapolis I-35 (westbound) bridge that collapsed on August 1, 2007. In the I-35 (westbound) bridge collapse, 13 people died and 45 people were injured. Aside from the human and litigation costs, which are still not quantified, Minnesota Department of Transportation estimates the lost revenue of detouring nearly 140,000 vehicles that used to go over the I-35W bridge is approximately $400,000 a day. Moreover, it estimates impact to local economy to total $60 million. Based on the estimated completion date of the bridge of December 24, 2008, direct and indirect lost revenues totals approximately $264.4 million.

Adding in the cost of building the bridge of approximately $234 million to $264.4 million in lost revenue, we arrive at a total cost of lost revenue and construction of approximately $498.4 million. One can figure that the litigation cost associated with the bridge collapse to be several multiples of this figure.

What Is The Cost of Mitigating The Risk?
According to the American Society Of Civil Engineers’ (ASCE) 2005 report card, updated to 2008, estimated cost to maintain our surface transportation infrastructure is $155.5 billion annually. Currently, only about $60 billion is allocated, leaving $95.5 billion gap.

Even to a non-risk manager, this would be an obvious gap that requires closure. If one believes the American Society Of Civil Engineers’ (ASCE) cost to repair / maintain our transportation systems (air, road, bridge, rail, transit, and water), then the annual cost is approximately $210.3 billion. ($150.3 billion, if one nets out the $60 billion currently spent.) ASCE also estimates that our failing transportation infrastructure is costing Americans approximately $145.2 billion in additional travel time, operating cost and repairs, about $722 per motorist a year.[ii]

Fact Tidbit: We’ve spent more than $510 billion (or $1,700 for every American) in the Iraq War and are still spending $200 million a day. Economists are projecting that by the time we add up all of the cost of the war, including veteran health care and benefits, the total cost would exceed $1 trillion and perhaps reach $2 trillion. Perhaps this money could have been allocated to our transportation infrastructure, making this a better nation.

13 dead and 45 people injured. 140,000 vehicles adversely affected daily, resulting in $400,000 per day in lost revenue to the local economy from an I-35W Bridge collapse. All because the gusset plates in the I-35W Bridge were assumed to be sufficient and therefore not inspected. If they were inspected as part of a normal inspection process, they would have found what the NTSB (National Transportation Safety Board) declared in their January 2008 preliminary report[iii]:

“The investigation discovered that the original design process led to a serious error in sizing of some of the gusset plates in the main trusses. …results indicate that some of the gusset plates were undersized and did not provide the margin of safety expected in a properly designed bridge. These undersized gusset plates were found at 8 (of the 112) nodes on the main trusses of the bridge… These gusset plates were roughly half the thickness required."

In looking at the actual engineering calculation of the gusset sizing[iv], it is clearly obvious that the failed gusset plates in sections U10 and L11 were only 1/2 inch thick while gusset plates on U6 and L5, the mirror opposite of the failed gusset plates, were 1 inch thick and 5/8 inch thick, respectively. So, for a lack of half-inch thickness at each of these two support joints (U10 and L11), the bridge collapsed.

As for the NTSB’s preliminary comment that asserts:

“Bridge inspections would also not have identified the error in the design of the gusset plates.” And
“The error in the design of the gusset plates would not have been identified by routine load rating calculations because gusset plate stresses are not normally part of these calculations.”

I can’t buy that. Click here to see an actual picture of the I-35W Bridge gusset, taken in 2005. Now, tell me that a bridge engineer could not have inspected the gussets and figured out that there might have been a potential problem.

I hope the I-35W bridge tragedy would be the wake-up call for the Federal Government to work closely with the States to ensure that a similar tragedy is not repeated.

Ed Kim
Practical Risk Manager
[i] 2005 Report Card For America’s Infrastructure, updated to 2008

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Risk Of Growing Consumer Debt: When Will It Pop?

The Philadelphia Federal Reserve’s Winter 2007 Payment Card Center report notes that total household debt exceeded $13 trillion in 2006. This means that an average household had $11,647 in debt as of 2006 (this is based on a total of 111,617,402 household). The report goes on to further state that banks sold an estimated $128 billion in non-performing consumer debt, of which approximately $88 billion was in defaulted credit card debt, to collection agencies in 2005. If this figure holds true, then 9.85% of all outstanding household debt may default in 2008.

Currently, according to the Federal Reserve Charge-off and Delinquency Rates for 4Q 2007, seasonally adjusted, the total consumer loan charge-off rate is 2.55% (Credit Cards charge-off was 4.17%). Total consumer loan delinquency rate was 3.39% (Credit Cards delinquency rate was 4.55%) for the same period.

That means that the 4Q 2007 total consumer loan delinquency and charge-off rates as reported in the Federal Reserve report of 5.26% is far below the level in 2005. Given the declining economic condition, this is difficult to believe. Most economic reports coming out all indicate a slowing economy with increasing potential for increasing consumer debt defaults.

Based on the current economic trend of a slowing economy, the likelihood that consumer default rate will increase is more plausible. If the Philadelphia Federal Reserve’s Winter 2007 Payment Card Center report’s estimation of 9.85% in non-performing consumer debt in 2005 is extrapolated to 2008, then expect an additional 4.59% increase in consumer loan delinquency to occur. The only question is when.

What The Charts Tell Us
Perhaps the following charts will provide an understanding of when (source of the charts: St. Louis Federal Reserve, National Economic Trend, February, 2008).

Consumer Consumption makes up 65% of GDP. Knowing this, it is important to gauge the financial health of the American consumer. However, the American consumer has not been frugal. Since 1992, American households have been taking up more debt with corresponding higher debt service. Household debt service went from approximately 10% of their disposable income in 1992 to approximately 14.25% in 2007. Given that CPI has increased 4% from February 2007 to February 2008 while consumer sentiment has been dropping, the consumers would probably look to cut back on most purchases going forward.

The reason why the consumers will cut back on consumption is clearly evident in the following set of four charts. Real disposable income has been decreasing with steep drops in November and December 2007, precisely the months that one would not want to see disposable income drop. Correspondingly, personal savings rate went negative in the same months. That does this mean? It means that consumers went into debt to buy holiday cheers in November and December 2007. Quite an expensive holiday; a holiday that consumers will be paying for sometime.

So the consumers went into debt in November and December 2007. So, what did they buy? My guess is: just the basics. The next two charts, both labeled “Real consumption” by the Fed. The bottom left Real Consumption chart indicates that real consumption is declining from 2006. What is more revealing is the lower right chart of Real Consumption, which indicates that for the first two months of 2008, the real consumption was close to 0%. Look real close because the lower right chart is for the first two months of 2008. Any guesses on what the third month will show? How about “stays the same around 0%?”

What is driving the consumers to really slow down on their consumption? Ah, well, people have to have income to pay for their consumptions. However, if you look at the historical trend of compensation, it does not look pretty. In fact, it looks pretty grim. The gray bars on the charts correspond to the recession periods of 1982, 1990-91, and 2001. Except for the 2001 recession, all previous recessions had, either prior to or immediately after, a period negative compensation growth. Well, we have entered into that period once again.

People are consuming less and selectively because of a simple fact: their real incomes have been dropping and are lower now than a year ago.

What Can You Do?
One can console oneself by knowing that all through the recession periods, companies have been able to generate profit (see below). Even in the worse recessions of 1982 and 1990-91, the corporate profit did not take a major hit. Yes, there were pockets of industries that got hit harder than other but overall, corporate profit has been steadily climbing. Hopefully, you are one of those who are benefiting from the increasing corporate profits.

If not, then join the growing line at an unemployment office because the employment picture does not look bright. In fact, employment trend is once again dipping down, close to zero growth. This means that unemployment rate will increase. If 1990-91 recession is any indication, we may be headed toward 7% to 8% unemployment rate:

So knowing that consumer debt default rate will increase further, perhaps as much as 4.59% over the current level. Perhaps even more. The consumers, who make up 65% of the GDP, are unable to spend because, as we have seen above, they are making less while their overall debt service has increased. Moreover, there are indications that the slowing economy will lead to higher unemployment. So, with increasing prices coupled with lower income and negative savings rate, it is abundantly clear that the consumers will have to resort to borrowing. Be it in credit cards, home equity loans, or other debts, they will borrow more until the debts overwhelm them.

That’s when the consumer debt bubble will pop, taking down a lot of banks that are under capitalized. My guess as to exactly when? I am sort of marking mid-January 2009 as my guess. That way, Mr. Bush can declare “Mission Accomplished” while leaving office.

May your trading be profitable!
Ed Kim

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Thursday, March 20, 2008

We Are In A Recession But What Type? A Comparison To Two Recent Recessions

Yes we are in a recession. However, It will be several more months before National Bureau of Economic Research is ready to declare it, so take this time to do a bit of comparison of this recession with two recent recessions.

Data Sources: U.S. Bureau Of Economic Analysis, Federal Reserve, and Wikipedia.
Factors To Think About
The significant factor at play right now in determining where the U.S. economy will go from here is the Consumer. With Consumer purchases making up about 65% of GDP (Investment is 17% and Govt. is 19%), any change in spending will have a direct effect on the economy. Moreover, personal savings is now negative, which means that people are now more dependent on the credit cards to pay for staples and necessities. As of January 2008, the total consumer debt outstanding was $2.5 trillion. If the consumer loan default rate goes up, as I think it will, then we will see some dark months ahead.

Fact tidbits:
1. Average credit card charge off rate is approximately 4.15% and growing.
2. Conference Board Consumer Confidence Index (1985=100) is now 75.0, down from 87.3 in January and 99.5 in September. Even during the 2001 recession, the confidence was above 100. On January 1991, it was as low as 55.1.

Can Anything Be Done To Revive The Economy?
Short of a major and direct government intervention of giving every American family a large check, say $50,000, there really isn’t much that anyone can do to get the consumer back into the market and kick-start the economy. Current administration is using a classic Keynesian and Monetary economic attempt at forestalling a recession by lowering rates and injecting liquidity into the financial institutions. Unfortunately, this is not going to work as the financial institutions themselves are afraid of being short of liquidity and are not lending sufficiently to restart the economy, a classic liquidity trap.

In a grand scheme of things, if one follows the Austrian economic theory of minimal interference in the market and letting the natural course of action take place then, I think, this recession shall too pass in eight to 14 months.

Fact Tidbit: We’ve spent more than $510 billion (or $1,700 for every American) in the Iraq War and are still spending $200 million a day. Economists are projecting that by the time we add up all of the cost of the war, including veteran health care and benefits, the total cost would exceed $1 trillion and perhaps reach $2 trillion. If this money had been instead invested in public works projects to fix our failing highway infrastructure ($1.6 trillion over 5 years required), or even build a coast-to-coast bullet train (according to NYT, China is building an 807-mile high-speed link between Beijing and Shanghai, which could cost $12 billion by 2008), then this economy would have been vastly different. Perhaps, we would be worrying about the end to the era of prosperity.

There are many confusing signs out there, especially from the ‘experts’ who recommend that you buy or sell based on what they ‘think’ the market will do. Filter these noises out and seek your investment path that is looking out longer than the next three months. After all, everything reverts back to the Mean. This means that if the market goes down, then it will trend back up and vice versa. Knowing this, look at the data from reliable, primary sources to help you make your investment decision rather than data that have been filtered through someone else, even if that filter is this one.

May Your Trading Be Profitable

Ed Kim

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Wednesday, March 19, 2008

Fannie And Freddie Reduces Capital Reserve: Risk Of Taxpayer Bailout Just Increased

With the news out today that Fannie Mae (FNMA) and Freddie Mac (FRE) have been allowed to reduce their capital reserve by $3.2 billion and $2.6 billion, respectively, it is now abundantly clear that the Federal Government is willing to pick up the check, yet again, for the mess that the banks have made.

According to their joint press release, the Office of Federal Housing Enterprise Oversight (OFHEO), the regulatory body that monitors Fannie and Freddie (collectively, GES), the official reason for allowing Fannie and Freddie to reduce their capital reserve is “To support growth and further restore market liquidity.”

How This Action Will Not Support Growth
Firstly, there is no growth in real estate. According to the National Association of Realtor’s current forecast, existing home sales is projected to drop by 4.8% and new home sales is projected to drop by 23.7% in 2008.

Secondly, the Banks are still holding a vast amount of real estate loans that they were unable to offload as mortgage back securities (MBS) when the market collapsed in mid 2007. According to the FDIC, the real estate loan holdings by FDIC insured financial institutions more than doubled from 0.82% of total asset in December 2006 to 1.71% in December 2007. As of December 2007, this translates into $135.2 billion in real estate loans on the books, based on a total of $7.9 trillion in all loans.

Thirdly, it will not benefit the homeowners since they will have to go through a complete refinance procedure. For those with conventional adjustable rate mortgages with low loan-to-value (LTV) ratio, this is an option. However, for those homeowners who have taken out a ‘NINJA’ loan (No Income, No Job/Asset verification loan), the recent tightening up of mortgage approval process has closed the door on their ability to refinance since NINJA loans are not offered.

Fourthly, many homeowners with good credit and verifiable income are at high risk of defaulting on their mortgage since they had obtained 90% or more LTV, no-money down financing that included a ‘piggy-back’ second mortgage. While they desire to refinance out of ever increasing mortgage payment, they cannot since they do not have the money to pay off the difference between the refinanced amount (typically 80% LTV) and the current mortgage balance (still about the original loan amount).

Finally, for those that can afford to refinance, there is now a more stringent standard that they will have to meet, resulting in higher rate of rejection (see chart, courtesy of AM Best 2007 Special Report).

So Who Does This Fed Action Support?
In the press release, the answer becomes very clear [bold and italics added for emphasis]:

“OFHEO, Fannie Mae and Freddie Mac today announced a major initiative to increase liquidity in support of the U.S. mortgage market. The initiative is expected to provide up to $200 billion of immediate liquidity to the mortgage-backed securities market.

Once again this is not an attempt to help the homeowners but rather a way to get the banks out of trouble that they gotten themselves in the first place. Now, helping the banks to restart the economy is something I am all for. However, this latest ploy does not do anything to restart our economy.

Risk Of Federal Government Bailout Of The GSE
As capital reserves of Fannie and Freddie decline by a third from 30% to 20%, they are going to take on additional risk on their books by investing in MBS. This creates a thinner cushion against write-downs. New York Times report highlights the issue:

“At the end of 2007, Fannie Mae had $45 billion in capital and Freddie Mac had $37 billion, for a total of $82 billion between them. That cushion supports more than $1 trillion of combined debt.”

Now, with the Fed action, the total reserve between the GSE will be reduced by $5.8 billion while taking on an additional $200 billion in MBS. So, Fannie and Freddie will have $76.2 billion in reserve to cushion potential losses from $1.2 trillion in MBS, or a tier-1capital reserve ratio of 6.35%, which is lower than most banks, including Citigroup, which was above 8% in 4Q 2007. This scenario increases the potential of the taxpayer needing to bailout Fannie and Freddie. If expected default rate and loss given expected default, as detailed in my previous article “Risk of Irrational Fear”, are applied to the GSE, then expected losses will be:

$1.2 trillion x 4.2% junk bond default rate x 40 cent/$1 loss = $20.6 billion in losses, nearly 27% of the reserve capital, resulting in a capital reserve ratio of 4.6%.

Should losses in the 4% to 5% range occur, Fannie and Freddie will require immediate capital injection. Moreover, this would cause substantial losses in the market. After all, if Fannie and Freddie, the two truly “can’t fail” companies begin teetering, then the entire market will begin free falling.

The probability of this risk event unfolding is high given the continuing deterioration in the real estate market and with nearly $700 billion in ARM mortgage interest rate resets to occur in 2008. If the projected defaults increase substantially over the historic average, then the Federal Government will be forced to step in with tens of billions dollars in capitalization. And guess where that money is coming from.

May Your Trading Be Profitable

Ed Kim

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Random Musing: Parallels To The Panic Of 1907

Notice: The Random Musing is meant to amuse, pique curiosity, and add a bit of controversy by looking at issue from a completely different perspective. If you emote after reading the Random Musing, then it is working.
I just happened to be reading about the Panic of 1907 when I noticed three very striking parallels to what happened in 1907 and what is happening now. They say that history doesn’t repeat itself but comes back in a similar form. I guess this is true since it seems that the issues that rocked the financial industry and the nation in 1907 is back again, this time in a slightly different guise.

What happened in 1907?
Here is an excerpt from the Wikipedia on the subject [bold and italics added for emphasis]:

“The Panic of 1907, also known as the 1907 Bankers' Panic, was a financial crisis in the United States. The stock market fell nearly 50% from its peak in 1906, the economy was in recession, and there were numerous runs on banks and trust companies. Its primary cause was a retraction of loans by some banks that began in New York and soon spread across the nation, leading to the closings of banks and businesses.

In March 1907, over-expansion and poor speculation led to a stock market crash. Money became extremely tight. A second crash occurred in October 1907. On October 21, the National Bank of Commerce ceased to honor checks of Knickerbocker Trust, causing a run on the Knickerbocker Trust. By the end of October 22, the National Bank of North America had failed and runs were sparked on nearly every trust in New York.

To bring relief to the situation, United States Secretary of the Treasury George B. Cortelyou earmarked $35 million of Federal money to quell the storm. Complete ruin of the national economy was averted when J.P. Morgan stepped in to meet the crisis. Morgan organized a team of bank and trust executives. The team redirected money between banks, secured further international lines of credit, and bought plummeting stocks of healthy corporations. Within a few weeks the panic passed, with only minimal effects on the country.

By February 1908, confidence in the economy was restored.”

What grabbed my attention immediately was the fact that the original J. P. Morgan was the one who came to the rescue, with the full cooperation and involvement of the United States Secretary of the Treasury George B. Cortelyou. How eerie is this? Compare this with the New York Times report on the Bear Stearns Bailout:

“Hoping to avoid a systemic meltdown in financial markets, the Federal Reserve on Sunday approved a $30 billion credit line to engineer the takeover of Bear Stearns and announced an open-ended lending program for the biggest investment firms on Wall Street.

After a weekend of intense negotiations, the Federal Reserve approved a $30 billion credit line to help JPMorgan Chase acquire Bear Stearns, one of the biggest firms on Wall Street, which had been teetering near collapse because of its deepening losses in the mortgage market.”

The other parallel is the complete lack of confidence in the counterparty that shook the stock market as noted in EH.Net Encyclopedia [bold and italics added for emphasis]:

“Meanwhile, by Thursday, October 24, call money on the New York Stock Exchange was nearly unobtainable. Call money was money lent for the purchase of stock equity, with the stock itself serving as collateral for the loans. Call loans could be called in at any time. The opening rate for call money was 6 percent, but exchange president Ransom H. Thomas noticed a serious scarcity of money. At one point that morning a bid of 60 percent went out for call money. Yet, even at that exorbitant rate, no money was offered. The last recorded transaction of the day was at the opening rate of 6 percent. Fearing a total collapse of the stock market, Thomas called Stillman for aid. Stillman referred Thomas to Morgan, who was in control of most of the available funds. While Thomas traveled to Morgan's office, the call money rate on the exchange reached 100 percent.”

Now, for the final parallel, the one that most people would say is IRONIC:

“In 1913, the commission recommended the adoption of the Federal Reserve Act, which mandated the creation of a central banking system to dampen the effects of future panics.”

I guess we came around a full circle. Now, after nearly 100 years, the report card for the Federal Reserve can be handed out. I will not be the one to grade them but I can guess what the final grades is going to be; and it ain’t going to be pretty…it most likely will rhyme with sail, mail, dale, pail…

May Your Trading Be Profitable

Ed Kim
DISCLOSURE: The author holds long positions in JPM at this time.

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Tuesday, March 18, 2008

Risks Of Irrational Fear In The Market

As the credit confidence crunch takes a major victim in Bear Sterns, there are a growing group of investors and financial advisors that are talking about the next bank to fail. The current speculation is on Leman Brothers, with some still talking about Citigroup, Merrill Lynch, and the other usual suspects. While recent events do lend credence to the worrywarts, the level of negativism has sunk too far into the nadir of pessimism. It is the growing strength of the negative sentiment that is driving the market right now and causing significant loss in market value of many firms, especially the financial institutions.

What can an informed investor do? First take note of historic data, below, which indicates that the losses, while large, will be easily absorbed by the market correction. Second, know that the fear factor is driving the market right now. And it is this driving fear that is causing the irrational moves that can easily lead investors to substantially losses.[i]

So, let’s take a look at the facts, then figure out the potential losses, and conclude with why all of that really doesn’t matter in the current market.

A Look At Past Major Economic Events
One thing that investors need to realize and understand is that the fear of losing money created the actual losses to the creditors. While some of the Alt-A loans securities and high-yield bonds are going to default, the default rate will not be in the range that begets a run on the bank.

Junk Bonds: According to Moody’s, historic default rate of corporate bonds, from 1920 to 1999, have been below 2%. However, there have been periods of high default rates:

1. 1932, the historic peak during the Great Depression: peak of 9.2% in July
2. 1970, due to default of Penn Central Railroad and affiliates: approximately 3% (>8% for junk bonds)
3. 1991: 4.1% (5.71% default rate for junk bonds)
4. 1999, after the Russian financial crisis: 2.19% (5.51% default rate for junk bonds)
5. 2000: 2.28% (5.71% default rate for junk bonds)[ii]
6. 2002, post dot-combust: 10.9% default rate for junk bonds[iii]

Additionally, from S&P, via the way of Sterns Business School, is a chart of the recent junk bond default rate from 1998 to 2006:

Mortgage-back Securities: According to Fitch Rating, the average annual default rate of Fitch-rated
MBS and CMBS, from 1994 to 2005, were 0.231% and 0.268%, respectively.

Rational View Of Potential Defaults And Losses In 2008-2009
Moody’s report notes that the average recovery was 43%[iv]. This means that if a bond defaults, an investor received, on average, 43 cents back for every $1 invested.

So the doom and gloom forecast of near total collapse by fly-by-night blogging charlatans seem way too pessimistic and unreal, when put into historic perspective.

Junk Bonds: Moody’s is now projecting the global junk bond default rate to rise to 4.2% in 2008 and reach 4.7% by November 2009.[v] Moreover, Professor Edward Altman, the New York University professor who created the Z-score mathematical formula for measuring a company's bankruptcy risk, stated that the junk bond default rate would go to 4.64% in 2008[vi]. So there is a range of 4.2% to 4.7% rate of probable default out of the $1.1 trillion junk bonds currently outstanding.

Assuming that this range is correct, we can arrive at a loss potential of $46.3 billion to $51.7 billion in junk bonds will default. Using a recovery rate of 43 cents on a dollar, the net loss to investors is expected to range, approximately, from $31 to $34.6 billion.

Mortgage-back Securities: As for MBS, which had $6.1 trillion outstanding as of 1Q 2006, the historic default rate is lower than the junk bond default rate. Even if we apply the Moody’s 2008-2009 default rate projections for junk bonds to the MBS, the total loss potential ranges from $256.2 billion to $286.7 billion.

Applying a recovery of 60cents on a dollar, which conservatively assumes that the value of the real estate securing the loans will drop by a total of 40%, the net loss to investors is expected to range, approximately, from $102.5 billion to $114.8 billion.

The Future Looks Bad But Is Not All That Bleak
While a potential loss to investors of $133.5 billion to $149.4 billion in 2008-2009 is a large sum, most of the projected losses has been baked into the market already. In their paper "Leveraged Losses: Lessons from the Mortgage Meltdown," by David Greenlaw, Jan Hatzius, Anil Kashyap, and Hyun Song Shin, the total credit loss from the mortgage melt down is expected to be $400 billion with U.S. leveraged financial institutions experiencing about $200 billion of this loss[vii].

However, Pessimism Runs Deep
So, while the reality is not that bleak, as Fed Governor Miskin had said in his February 2008 speech:

“…relatively small losses in one sector of the credit market can have an outsized impact on aggregate economic activity if they cause a disruption to the financial system that leads to an amplified impact on lending.”

“It is not just the impact on leveraged financial institutions that matter, but on the overall ability of the financial system to channel funds to those institutions with productive investment opportunities.”

For a Fed Governor to come out and clearly articulate that there is a major disruption to the financial and investment industries is, given the current nervousness of the market, a clear indication of how pervasive this irrational fear is gripping our economy.

So, informed investor take note that, due to the currently high level of irrational fear in the market, the slow down in the U.S. economy will be more severe that if this was a simple case of the market correcting itself, as was the case after the dot-com bubble popped. Even if the facts are indicating the slow down may not be that severe, the market is now being driven lower by a collective movement built around irrational fear that things will get worse than it is already. While the facts indicate otherwise, it is not a wise move to fight the market when it is stampeding. And right now, the market is stampeding right over a cliff.

May Your Trading Be Profitable

Ed Kim
[ii] Default Risk.Com

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Unwitting Victims Of The Bear Sterns Collapse - Its Employees

Ironically, if one goes into the Bear Sterns Investor Relations page, the page banner reads: “EIGHTY-THREE YEARS OF PROFITABILITY” and “TWENTY FIVE YEARS AS A PUBLIC COMPANY”. While a cynic may find this to be amusing, to me, this is a sad testament of complete mismanagement and failure at the C-level that ultimately will cost the hard working folks their retirement money.

Bear Sterns employees hold approximately 1/3 of the company stock, and of this, according to their 2007 Proxy Statement, the executives at the C-level hold 9%. So, the regular working folks at Bear Sterns hold approximately 24% of the common stock.

Now, for those folks who have not or do not work for a Wall Street Brokerage or a major investment bank, here is a reality check: most of the workers work in the part of the bank that is known as the “Middle Office and Back Office” (MO/BO). These folks do not make the six-figure bonuses that one reads/sees/hears in the media. A typical MO/BO worker makes less than $100,000 a year.[i] Now, one would say that this is still a lot of money.

Granted, when compared with the median household income in the U.S. of $48, 201, this seems like a lot. However, the MO/BO workers are also mostly composed of “exempt workers” who make a fixed annual salary. This means that they do not qualify for overtime pay even though they will work overtime; a lot of overtime. The end result is that the MO/BO workers annual pay, when calculated on an hourly rate, is not that much different from any other job. An interesting read from on this very subject.

So, having normalized the pay rate, one can begin to appreciate the magnitude of the loss suffered by the employees who saw the stock price go from $165 in January 2007 to $5.50 at today's open. With most of their stock holding in 401k or other retirement vehicles, such as BEAR STEARNS COMPANIES INC. 2008 TRUST, which held 27,316,339 shares as of February 14, the employees of Bear Sterns have seen their retirement money go up in smoke.

Perhaps the employee shareholders of Enron could provide some measure of comfort to these folks.

May Your Trading Be Profitable

Ed Kim
DISCLOSURE: The author holds no long or short positions in BSC at this time.

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Monday, March 17, 2008

Now The U.S. Dollar is the Carry Trade Vehicle

The combined effect, of the current credit crisis and the continual lowering of the Federal discount rate, now at 3.25% from 3.50%, has lowered the value of the Dollar against major currencies. While this is the dark cloud facing U.S. economy, there is a silver lining: Carry Trade.

Benefits Of the Current U.S. Economy
FX Exchange: For U.S. Business with major global presence: since their sales are occurring in stronger currencies, they will realize a positive FX exchange, which will help their revenue figures.


Borrowing Cost Lower In The U.S.: While people are bemoaning the rising cost of borrowing, some citing GE, which sold the 4.875% 5-year bonds last week at a yield 1.29% higher than similar-maturity government rates, they are forgetting that the overall borrowing cost is still lower than other major countries[i]:

For example, according to Bloomberg, the current bank rate in Germany is at 4%, in the UK it is at 5.25%, and in Australia it is at 7.25%. Japan is the only major economy country with lower interest rate than the U.S. However, the cost of the Yen has risen dramatically.

The Silver Lining
So, credit worthy companies seeking lower borrowing cost can still tap into the U.S. banks to borrow at a lower overall rate than in other major economy countries. Additionally, if the company is U.S. based, then there is the added boost of reporting revenue in dollars. Therefore, all earnings in Yen, Euros, and Pounds will show higher revenue when converted to dollars.

The banks are not lending you say? Not true. Banks are still lending. However, their lending parameters have tightened substantially. But, if you are a credit rated company with solid balance sheet, the lending spigot has not been turned off.

While the mood in the U.S. is dark and gloomy, look forward to the days when the U.S. companies begin to report higher revenue and profit driven by the lower cost of borrowing and the declining value of the dollar.

Ed Kim

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Sunday, March 16, 2008

Will The Unwinding Yen Carry Trade Save GM Or Ford?

On Monday, March 10, I wrote an article entitled, “Will GM Or Ford Survive The Current Economic Crisis?” about the survivability of GM and Ford due to the current economic condition. In that article, I questioned the likelihood of GM and Ford being able to return to profitability in 2008. Since then, the Yen-Dollar exchange rate dropped to ¥98.9 to $1, the highest level in 12 years. With stronger Yen, resulting from the Yen Carry Trade unwind, comes the question of whether this will mean hardship for Japanese cars manufacturers like Toyota, Lexus, Honda, Acura, Nissan, and et al. and a bit of a breathing room for GM and Ford.

The Answer: May Be A Little But Not Really Material
Here is why. While Japanese automobile companies exported 2.2 million cars and trucks to the U.S. in 2007, 23.2% of their total production of 9.8 million cars [i], the Japanese car manufacturers have been diversifying their production out of Japan for sometime now and have established manufacturing and assembly plants in North America as well as in Europe, India, Australia, and China.

Overall, in 2007, the three major Japanese car manufacturers imported only 13.4% of their cars produced in Japan to the U.S. In fact, of the 5.3 million cars and light trucks sold in the U.S. in 2007, the three major Japanese car manufacturers produced majority of their cars sold in the U.S. from their assembly plants in North America. In 2007, the import of their Japanese production was 10.5% for Toyota, 29.3% for Honda, and 3.9% for Nissan. And, majority of the imports from Japan were their specialty divisions vehicles: Lexus, Acura, and Infinity, respectively.

Data Sources: , Toyota, Honda,, JAMA.OR.JP, JAMA.CA/jamastats

Japanese Car Manufacturers Have Large Foot Print In the U.S.
According to the Japanese Automobile Manufacturers Association (JAMA), 63% of all Japanese cars sold in the U.S. in 2006 Japanese cars were made in the U.S. Overall, the number of Japanese cars being imported dropped from approximately 3.4 million vehicles in 1986 to fewer than 2.3 million cars in 2006, a reduction of approximately 1.2 million cars.

Source: Japanese Automobile Manufacturers Association

Individually, the top three Japanese car manufactures have the following presence in the U.S.:



If A Japanese Car Is Made In the U.S.A., Then Is It An American Car?
According to a September 2007 survey done for JAMA, 70% of the people polled agreed that a car made in America by Americans is a U.S. product regardless of the make of the car. (28% of the people polled disagreed.)

Japanese car manufacturers have invested $30.9 billion in building new plants in the U.S., employ 425,000 workers, and purchase $48.8 billion in auto parts from U.S. parts manufacturers. With that much U.S. based investment, employment, and spending, aren’t they better for the U.S. economy than GM or Ford?

While the unwinding Yen Carry trade may hurt the Japanese car manufacturers a bit, they have diversified out of Japan and historically were well hedged against FX risks. Therefore, the stronger Yen may dent the Japanese car manufacturers a bit but will not do anything to help GM or Ford. What bedevils GM and Ford are Profitability and Liquidity. According to their respective financial statements, here is a comparison of Toyota, Honda, and Nissan with GM and Ford on the key metrics:

Source: Yahoo Finance

Japanese car manufacturers have managed to remain profitable, despite carrying more debt that equity (except for Honda). On the other hand, GM and Ford have crushing debt load while generating losses.

In layman’s terms: if GM and Ford were two families, then these two families’ income don’t cover their living expenses so they wind up using their credit cards to make ends meet, resulting in increasing debt load that will be difficult to pay off. Like a family that finally succumbs to the mounting debt, there is a point where GM or Ford may decide to file for bankruptcy protection.

May your trading be profitable!

Ed Kim

DISCLOSURE: The author holds long positions in GM or F at this time

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