Investment Journal

Landmark Case Possibilities With Detroit Chapter 9

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Today, the trial begins to determine if Detroit can enter chapter 9 bankruptcy. I have been trying to read a lot about what this means for the muni bond markets. As of right now, not much. But in the future, possibly a lot.

Here is a great piece on the subject and one that I will refer to through this post. It is written by the Chicago Fed, and explains what is going on, and how the Emergency Manager, Kevyn Orr, is going about trying to right the ship. The document is short, but somewhat dense. I had to read it three times and making some notes helped me understand it better.

After making this diagram, I joked to myself that this is probably a better flow chart understanding of the City of Detroit’s debt than any sort of financial documents the city of Detroit had prior to the EM taking over. But I digress.

After the issue of letting Detroit go Chapter 9 is resolved (I guess I don’t really see any other option) there are several interesting issues that may affect the muni bond market moving forward.

The debt looks like this, in simplified form:

Water and sewer debt – $6bb

General Obligation debt (limited tax backed and unlimited tax backed) – $1bb

Pension Obligation Certificates and associated swaps – $2.3bb

Pensions – $3.5bb

Other Post Employment Benefit Obligations – $5.7bb

First, Orr has decided that the only things that he will be treating as secured debt will be the water and sewer system bonds (backed by a pledge of revenues from the utility system) and the “double barreled” UTGO (unlimited tax general obligation) and LTGO (limited tax general obligation) bonds. Double barreled means that these certain bonds have separate income streams derived from the State of Michigan. This is significant because no General Obligation bond in the muni universe in any Chapter 9 filing has ever been impaired (with the exception of the disastrous Jefferson County, Alabama filing in 2011). Basically, Orr is offering ten cents on the dollar to EVERYONE that is not secured. This includes pensions, OPEB (other post employment benefit) plans, pension obligation certificates, swaps, and all the rest. In the middle of this, the fact that Orr treated the UTGO debt (which can be funded by unlimited property tax levies) just like all of the other debt is a first. This will also be settled in court, and will affect the perception of a lot of other cities’ GO debt as relates to the backing by property tax levies.

The next Big Deal to the muni bond universe is that there is a conflict between state and federal law as to if Orr can pound down the pensions and OPEBs. Law in the State of Michigan says he can’t but federal law has no issue with it. There is no law on record that addresses this and I am sure it will be a bitter battle to the end. If there is some sort of sweeping Tenth Amendment ruling that says that you can’t touch the pensions, this will affect the debt of a LOT of large cities that have similar state laws in place, such as Chicago, LA and others that have giant unfunded pension obligations. But to me, winning this in court is one thing for the pensions, actually getting the money out of the city of Detroit, that has none, is quite another. I am sure that they would at that time try to get preferred secure status over the utility bonds, but I don’t think that will really happen.

So far, the markets have just shrugged their shoulders at this whole affair, with the small exception of punishing the bonds slightly from places in the State of Michigan. I am sure that as this disaster winds its way through the courts, that this may change. Being an investor in the muni market, I will be keeping a close eye on how this plays out, as well as the soon to be crisis in Puerto Rico.

Cross posted at LITGM.

Customer Protection in Brokerage Accounts

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The Wall Street Journal has an article in their November 24, 2012 issue titled “Protecting a Small Account” with the tagline “What the Spate of Brokerage Blowups Means for Investors”.

The article discussed some recent events where brokerages went bankrupt or ran into financial troubles, specifically smaller or regional firms. They give some generic advice, such as research your firm or and carefully check your brokerage statements each month for evidence of unauthorized trades.

The overall risk is that if a firm goes bankrupt while holding your money, The Federal Securities Investor Protection Corporation (SIPC) provides the following guarantees:

The Securities Investor Protection Corporation protects customers against the loss of missing cash and/or securities in their customer accounts when a SIPC member broker-dealer fails financially. SIPC either acts as a trustee or works with an independent court-appointed trustee in a brokerage insolvency case to recover funds.

The statute that created SIPC provides that customers of a failed brokerage firm receive all non-negotiable securities such as stocks or bonds that are already registered in their names or in the process of being registered. At the same time, funds from the SIPC reserve are available to satisfy the remaining claims for customer cash and/or securities custodied with the broker for up to a maximum of $500,000 per customer. This figure includes a maximum of $250,000 on claims for cash.

The simplest answer to this potential risk is to split up your assets so that you don’t have more than $500,000 with a single brokerage firm.

However, there are downsides to doing this. For one thing, larger firms give bigger discounts as you consolidate assets. Vanguard, for example, gives a large number of free trades and provides lower cost mutual funds, along with other services. In order to get certain types of brokerage services at other firms it helps to be a larger scale customer, as well.

Based on a review of Vanguard, Fidelity and eTrade, the major firms also take out insurance with Lloyds of London for additional coverage beyond the SIPC minimums. Per Vanguard’s web site:

To offer greater protection and security, Vanguard Marketing Corporation has secured additional coverage from certain insurers at Lloyd’s of London and London Company Insurers for eligible customers with an aggregate limit of $250 million, incorporating a customer limit of $49.5 million for securities and $1.75 million for cash. Coverage provided by SIPC and certain Lloyd’s of London and London Company Insurers does not protect against loss of market value of securities. The policy provided by certain Lloyd’s of London and London Company Insurers is subject to its own terms and conditions.

In addition to a Lloyds policy, Fidelity describes additional protections available to investors at their site here. Key additional items:

Broker CDs, which are issued by an FDIC-insured institution and held in Fidelity brokerage accounts, are also eligible for FDIC insurance. The coverage maximum for IRAs and brokerage accounts is $250,000 per bank. All FDIC insurance coverage is in accordance with FDIC rules.

I inadvertently tested this over and over during the 2008-9 crash as CD’s I bought from high yielding bank through my brokerage account repeatedly failed and the cash investment, plus accrued interest to date, was transferred back into my cash account with every failure. I certainly wish that I had those high yielding CD’s back today, since interest rates are now below 2% even for 5 year CD’s, but I digress…

There are important exceptions to the coverage, including stocks bought on margin and futures contracts. If you are using these sorts of instruments then you need to do additional research.

Cross posted at Trust Funds For Kids

Vanguard and BlackRock (iShares)

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About ETFs

ETFs (Exchange Traded Funds) are an alternative to traditional active or passive mutual funds that trade on exchanges.  There are many advantages to ETFs over mutual fees including:

1) tax efficiency – mutual funds deliver you capital gains (and losses) even when you don’t make any trades due to internal fund activity.  These gains and losses are avoided (in the vast majority of cases) for ETFs, UNTIL YOU SELL

2) liquidity and stock-like features – ETFs are often more liquid and you can buy and sell them on the exchange immediately, and you can see their prices transparently.  Trading like stocks also allows you to do things like use leverage, etc… which you can’t do with mutual funds

3) lower prices – historically ETFs have had lower prices than mutual funds, and did not have origination fees or “loads” like many funds did

The primary disadvantage that used to be levied against ETFs was that you had to pay brokerage fees each time you made a trade, and if you invested regularly (i.e. payroll deductions) these costs added up over time.  This argument has been diminished by lower trading costs across the board and changes in investor behavior.

Vanguard and ETFs

Vanguard was originally slow to adopt ETFs, despite their advantages, because Vanguard thought that ETFs enabled rapid trading which was against their business model of supporting long term investors.  However, over time, Vanguard has gotten into the ETF business and as brought their low-fee ethos to the ETF arena.  Vanguard ETFs are now among the most popular offerings and have been gaining in market share.

Note that Vanguard has a unique ownership structure.  Vanguard is owned by its mutual funds and charges at cost to the mutual funds, and does not make a “corporate” profit.  This is in contrast to competitors that not only charge the cost of doing business but also must make a profit to pay to the corporate parent.  Many of these companies have grown large and very profitable over the years (as funds under management increase) while Vanguard has been able to  turn its increasing scale into cost reductions for its products (i.e. if there are more customers and more fees, the fee that they need to charge per unit of dollar under management goes down assuming their costs are not completely variable).

BlackRock

BlackRock bought iShares, who were one of the pioneers in the ETF space.  While iShare ETF fees were not high by industry standards (in general), the arrival of Vanguard has put pressure on iShare products and they began losing market share.  As a result, iShare products reduced fees and are now in a sort of “price war” with Vanguard.

A Wall Street Journal article titled “BlackRock Wages Reluctant Fee Fight” describes a recent earnings call where the CEO (Fink) of BlackRock talked with analysts:

Mr. Find railed against competitors that sell investment products to certain clients “at cost”, or without profit.

You can call that fee pressure, Mr. Fink said.  But he had another term for it: “stupidity”… Although Mr. Fink didn’t single out any rivals in his comments, observers took the barbs to be aimed at Vanguard.

What is interesting about Mr. Fink is that he did not offer a reason for WHY his company was better for investors than Vanguard.  This is analogous to the famous line of “Where are the Customer’s Yachts?” about how Wall Street always seems to makes money while their customers (investors) don’t always fare as well.

Fink had an opportunity to explain why the profits that iShare pays to BlackRock (beyond the fees necessary to run the ETFs) result in superior products for customers and investors, and he didn’t take that bait.  The reason, of course, is that there isn’t any reason why his products should cost more than Vanguards’ to the end customer, because they are essentially interchangeable (where they have equivalent products) which means that they have no extra value.

Fink seemed to be saying that it was “stupid” for Vanguard to be in business where they weren’t making any corporate profit, and just using their economies of scale to reduce prices (rather than paying that money to shareholders).  It is certainly true that Bogle, the founder of Vanguard, could have been a billionaire if he had monetized his inventions (the index fund), but instead he started the one company on Wall Street that definitely does NOT provide yachts for its’ employees.  Whether or not the average investor wins or loses on Vanguard products is up to the product mix, market activity, and customer activity, but it isn’t due to Vanguard taking off an inordinate share of fees to pay a corporate parent in the form of profits.

Mr. Fink didn’t offer a defense because there isn’t one.

Cross posted at Trust Funds For Kids

Faith vs. Experience for Investing

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A recent Wall Street Journal titled “The Young and the Riskless” details how “twentysomethings” are not investing in stocks, but instead are putting their savings into less risky investments. The tag line on the article is:

Twentysomethings are seeking safety from market volatility at precisely the wrong moment in their investing lives. Here’s how to get back on track.

From the outset I was struck by the author’s presumptuous and scolding tone. I also like their strategic use of the word “volatility” instead of the more appropriate term of “losses” when describing market events over the twentysomething’s financially sentient lifetime, which would be something like the last 10-15 years.

Per the charts in the article

The percentage of young investors who say they’re willing to take above-average or substantial risk has declined from 52% in 1998 to 31% in 2011. 52% of investors in their 20’s who say they will “never feel comfortable in the stock market”. 33% of 20-somethings’ non-401(k) portfolios held in cash, versus 27% for all investors.

It is important to understand how “faith” in the market is typically defined in the popular financial press. Faith usually means putting your money in an index fund (or ETF), with low fees, continuing to do so regardless of market conditions, and relying on the belief that “in the long run” it will all turn out alright and you will be able to retire rich. The “financial calculators” have an assumed rate of return that you receive on your money, similar to the same calculators that public pension funds use, and they are typically “set” between 6% and 10%. Due to the “miracle of compounding returns” you can amass large sums of money in the future.

The problem with this mantra is that NO ONE has been winning with this strategy for a LONG time. What you see, instead, is that money put into the market is often battered immediately by volatility and is worth a fraction of what you put in only months prior. If you change jobs regularly (once every 2-3 years, as younger people often do) and are an avid 401(k) saver (which is recommended), many times when you pull out your money it will be valued far less than what you put in, or about even when the company match is taken into effect (depending on vesting). This can be demoralizing. I know that when I left companies in the late nineties and after the dot-com collapse I started putting more of my money into cash-like investment selections (despite warnings from my employers’ 401(k) educational materials) just because I hated moving balances worth a fraction of what I held back out of my pay when I left to start with a new company.

Also, in order to win “in the long run”, you have to stay with it in the short run. This means that when stocks plummet, you need to stay in the market and keep investing. If you decide to cut your losses and run, or stop putting new money in during market troughs, you don’t get the same benefits when the stocks rise later. This post I wrote basically said that no matter what you did in 2007, it turned out to be a loser, but if you bought during the trough in 2008 (or held throughout) you saw big gains later as the market turned back around (to where it was before). BUT if you didn’t stick with the markets, you didn’t benefit from these gains and ended up as a net loser. It is VERY HARD mentally to keep investing when markets are going down, but if you don’t buy low there is no way you can even conceptually win in the “long run”. If you bail, for sure you are going to fail, assuming you are following the mantra (which is what the WSJ article’s author was lamenting).

Kids see their parents’ struggles. Their parents have been believers in the markets, since the bear markets of the 70’s were replaced by the bull markets of the 80’s and 90’s. If you retired in the 90’s, after years of investing in the doldrums, you not only benefited from high interest rates which appeared to “goose” the compounding effect, but you also essentially did some great “market timing”, buying low and selling high. But the parents of today’s twentysomethings didn’t retire in the early 90’s, they kept working, and watched their investments suffer along. Now the parents’ are in a bind.

Not only did the markets get hit, but there isn’t really an underlying foundation of belief in WHY the market should do so great “in the long term”. In the past you could look at the track record of the US and show how we weathered recessions, panics and depressions, wars whether declared or un-declared, and always came out ahead. But today everything seems to be static or declining; our unemployment rate is high, we have high “real” inflation from commodity price increases (oil, food), and the cost of services like a college education or health care (if you can get insurance at all) is very difficult to bear. In order for the market to rise, the country needs to be productive, well run, and growing – does this seem to be today’s perception of American performance? This lack of an underlying narrative in why markets should rise of the long term (other than it has happened in the past), combined with the miserable ACTUAL performance during the last decade and a half, is killing confidence in the “long run” hypothesis that markets go up.

Another element of caution is that not only did stocks crater (or stay flat), but everything else fell apart too, in defiance of what the typical financial media said would occur. Housing became a miserable investment, rather than the guaranteed path to wealth that was painted in the press. Can’t you remember people saying that renting was “throwing your money away”? I remember having many, many people look at me in a dumbfounded fashion when I told them that I rented for over a decade when I could have easily bought. This thinking has obviously changed radically, despite record low interest rates (high rates would have made the housing problems unimaginably worse, at least in the short and medium term).

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Downgrade

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So S and P downgraded Fannie Mae and Freddie Mac today. You don’t say? Well done guys – I wish I could miss super obvious things like that for a half decade or more and still have a job.