Safety First

So what makes a muni bond safe?

Safety isn’t in the eye of the beholder. It’s an aspect of credit. And credit is simple: either the borrower pays you back or he doesn’t. That’s why I like studying credit: it’s like a pass-fail course where you’re always graded at the end. And if you do your work right, you should pass the course.

Since credit has been around as long as people have been getting loans, what are the characteristics of sound credit? As I’ve studied the bond market I’ve learned that credit comes down to five factors:

First is liquidity—how much cash you have on hand, and how quickly you can raise cash. If you have cash, you’re more likely to pay your debts. Second is solvency—how indebted you are relative to your assets and earning power. For muni bonds, we look at how much debt is outstanding relative to the size of the economy. Third is efficiency. If you do your work with a minimum of expense, you can probably save your way back to solvency. The fourth factor is credibility. If the government is seen as responsible and legitimate, it’s more likely to be able to raise fresh cash when it needs to. The final factor is growth. If an economy is growing well, it can often grow its way out of a fiscal problem.

These five factors all bear on whether a town or a school district or a water system will be able to pay its debts. As we know, not all of them do. But most of them do. In the past 40 years bonds have been issued by almost 100 thousand different creditors. Only 54 of them have defaulted.

The vast majority of muni bonds are safe. By examining their liquidity, solvency, efficiency, credibility and growth we make them even safer.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Sunshine

“Sunshine on my shoulder makes me happy.”

John Denver recorded that hit over 30 years ago. Whatever he meant, I’m pretty sure he did NOT intend it as a commentary on the municipal bond market. But that’s what’s needed in muni bond land: sunshine.

By sunshine, I mean transparent disclosure of current financial conditions. The kind of disclosure we get in the stock market. The kind of information we get on the general economy. Because US companies have to report their revenues, expenses, and earnings every quarter, there are very few genuine surprises. Yes, you get the occasional fraudulent Enron, but in general, in the equity market the best surprise is no surprise.

There are some areas of the muni market where this is the case. In California, for example, the State Controller provides monthly updates (about 10 days after each month-end) regarding the State’s revenues and disbursements. Contrary to what you might read in the media, that State’s credit rating is still A1 and is not close to junk.

But there are many places where disclosure is sadly lacking. Not every issuer has tens of millions of dollars to spend on financial analysis, and accrual accounting in the public sector can be tricky. Nevertheless, if small companies with around 300 employees can produce financials 90 days after the quarter closes, cities like Chicago or Miami ought to be able to come up with preliminary numbers on a regular basis. The problem is, the current political leadership may not want to.

There are problems in the muni market. But they’re problems that can be fixed. In order to fix them, we need to see them. And in order to see them, we need sunlight.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Becoming One

Back in October, another major leap was taken.

The French President helped the German Prime minister with an intractable European problem. Their Dauville plan called for investor losses on bonds of “bailed out” countries. This was risky, but it has created a closer European Union.

Originally, Germany wanted countries with excessive deficits to face automatic penalties. This would instill fiscal discipline. But only Finland and The Netherlands supported them. As a compromise, they offered the notion of investors taking a haircut on the bonds of supported countries. In a private conversation, the French agreed to this halfway measure.

When the deal was circulated, it caused a fracas. The notion of haircuts on sovereign debt had been unthinkable. But such a measure enforces market discipline on profligate spenders. It has always been the hallmark of sound finance. The market’s reaction was swift: sell the bonds of the lower-rated countries, because now they posed de-facto, rather than theoretical, credit risk.

But there’s a compromise: a permanent bailout fund that makes every euro-zone country partly responsible for its free-spending brethren. This will involve countries more deeply than ever in each other’s finances. The details are still being worked out.

Amid the planning and compromise, the pull of independence will continue to face the push of coordination. But the result will be a more perfect European Union.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Blowing Bubbles

So, was it all just a bad dream?

With the stock market ending at its high for the year and at levels not seen since the Lehman bankruptcy, it’s reasonable to ask: have we learned anything? Should we just go back to business-as-usual?

Clearly, there are some obvious lessons. For one thing, we know that markets are not perfectly efficient and that prices can be misstated for years. Ever since Gene Fama started looking at the behavior of stock market prices in the ’60s, people have wondered how accurately the market evaluates asset prices.

Well, the results are in. Markets can be fabulously, spectacularly wrong. Lehman, Bear, and Merrill were insolvent in 2008 even though the market thought they were worth billions. But that doesn’t mean that betting against the market is an easy thing. Markets can remain irrational longer than many investors can remain solvent.

But some of the derivative implications of the efficient-market hypothesis have taken a justified drubbing. For example, the belief that market-clearing prices are always and everywhere the best indication of an asset’s value is clearly wrong. In early 2009 FASB recognized this, albeit under some pressure. (It always seemed to me that the academics who lead that body have more faith on markets than most practitioners, but that’s another story.)

In any case, one lesson is clear: the market, like “Father,” doesn’t always know best.

Douglas R. Tengdin, CFA
Chief Investment Officer
Hit reply if you have any questions—I read them all!

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Peer to Pauper

It’s Christmastime. And what would Christmas be without a thick slice of financial fraud.

Amid the cash-wires from Nigeria and offers of an inheritance from a Yemeni fourth cousin comes a new scam candidate: peer-to-peer lending, or P2P for short.

The concept seems simple: make loans directly to the borrower with some of your investment capital, and earn a much higher return than you could with a bank CD. By cutting out the middleman, everybody wins. Or not.

Sites like prosper.com or lendingclub.com claim that they can match investors and borrowers and cut out the bank, with its 3% lending margin and its management, bureaucracy, and offices. But the sites don’t mention things like losses, deposit insurance, regulatory compliance, or other similar items. In fact, they are the kind of things that the 3% margin goes to pay.

But there’s another caveat about P2P lending that the web sites don’t mention: fraud. Because the lenders and borrowers don’t know each other, the chances for chicanery are legion. If this lending medium takes off, the scam artists will set up fake web sites and lending networks in order to pocket the investors’ cash. And with the anonymity of the internet, such cons will be easier than ever.

There’s are reasons why banks are regulated. Controlling fraud is one of them.

Douglas Tengdin, CFA

Charter Trust Company

Muni Blues

Meredith Whitney says hundreds of billions of dollars will be lost. Are the Chicken Little’s right this time?

Meredith Whitney is famous for going short Citibank stock in October of 2007 while Chuck Prince was still dancing. She was right on that call, and has since been one of Wall Street’s most powerful analysts. In September she published a 600-page report on municipal finance that she says took two years to produce. Recently she said that she expects 50-100 significant municipal defaults next year totaling hundreds of billions of dollars.

That’s a big number. Let’s leave the states out of it—even California and Illinois. There is no legal framework for a State to file for bankruptcy. Even Whitney doesn’t think they’ll go bust. She’s concerned about the cities, counties, and school districts that receive state aid. If that’s cut, they might try to save money by suspending debt payments.

But why would they bother? Debt service is typically less than 10% of their budget. Shafting the bondholders doesn’t save enough to make a difference. In the short run, it actually increases expenses: filing for bankruptcy is expensive. And the muni market is highly diverse: general obligations, water and power revenue bonds, housing bonds, and more. Saying that muni credit is in trouble is like saying there’s water in the basement. The particulars matter.

Shouting fire in a crowded theater is a great way to get noticed. But this time, it sounds more like a cry for attention from someone used to being in the spotlight. Perhaps she would have done better to stick to banking.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Naughty or Nice

Why are people nice to each other?

A recent study offers some clues. A group of subjects were divided up into pairs, with an “allocator” and a “receiver” in each. The allocator had the authority to divide $10 between the two of them. The receiver had no control over the split.

In one set of experiments, the allocators just divided the money and the exercise was over. Interestingly, on average only 15% of the money was given to the receivers under these conditions. Then the researchers added communication. When the allocators were allowed to explain their decisions, giving fell to only 6%. Then the communication became two-way. When the receivers were allowed to communicate with the allocators, either before or after the division, 25% of the cash was donated.

Asking is powerful. Knowing you can explain your decision, though, and the recipient can’t talk back actually encourages more selfishness. When the conversation is one-sided, people are more self-serving. But when communication is a two-way street a more equitable division is likely. Accountability can lead to a more just outcome.

Amid all the celebration and gifts and family gatherings it’s good to know that there are people who love and care for us. And some of the most caring actions are to hold us accountable for how we share the gifts that we have been given.

Something to think about during this holiday season.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Doing Nothing

In Pooh’s Little Instruction Book Piglet comments, “Don’t underestimate the value of Doing Nothing.” There are many investors who should heed his advice.

Of the many temptations in investing, the temptation to act too soon is among the worst. If something unexpected happens, people want to know what what you are doing about it–as if your doing something will change the underlying problem. By contrast, if something expected happens, it is inviting to execute your plan right away, even though it is likely that the best values will be had down the road a ways.

In this way, investing is a lot like baseball. Ted Williams used to comment that he would divide the strike zone into 77 different cells, each the size of a ball. He would then only swing at the pitches that were in his favorite cells–the ones he knew he could hit. If a ball didn’t enter his sweet spot he would simply wait for the next one. His patience helped him build a career .344 batting average over 20-years.

Consider the recent financial crisis: many investors thought that the crisis was overblown, and that the Fed’s decision to supply the necessary liquidity would keep the economy out of a full-fledged panic. Nevertheless, the best time to buy wasn’t right after the Lehman bankruptcy or the AIG meltdown or even the WaMu debacle. It was months later.

Piglet was right: it’s easy to underestimate the value of doing nothing. Waiting can be uncomfortable–but it’s not as uncomfortable as doing something dumb.

Douglas R. Tengdin, CFA
Chief Investment Officer
Hit reply if you have any questions—I read them all!

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Out of Hibernation

Are the bond market vigilantes coming back to the US?

We saw the bond markets in Greece and Ireland fall prey to the bond vigilantes. These are institutional investors who aren’t afraid to sell sovereign credits. In the early ’80s we had bond vigilantes in this country. They weren’t as concerned about credit risk as they were about interest rate risk. With Paul Volker running the Fed, interest rates doubled from 7% to 14% in a short period.

The Treasury Bond contract moved down the intranet-day limit on three successive days. There were rumors that a prominent bond trader had been caught on the wrong side of the move and had cut his own wrists.

In 1994 bond market investors sold Treasury Notes so that their yields went from 5% to 8% over 12 months. President Clinton expressed significant frustration that his policy initiatives were held hostage by a bunch of bond traders. Those were bond vigilantes, presiding over 20%-30% moves in the market.

By contrast, the current sell-off, while significant, seems tame by comparison. Yields have risen by 1% the past six weeks which is serious, but it doesn’t impair any of the Administration’s policy goals, which is the real test of a vigilante.

Bond vigilantes have been with us a long time. But the latest interest rate move seem more like a minor skirmish, rather than real vigilante action.

Douglas R. Tengdin, CFA
Chief Investment Officer
Hit reply if you have any questions—I read them all!

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Mathworld

Mathworld

There is a place, a wondrous, magical place, filled with transformations and amazing discoveries. It’s not Narnia or El Dorado. No, this place is real. This is Mathworld.

Mathworld is the place where math people live. They eat and breath in the everyday world, but their thoughts and notes are filled with x’s and y’s and other strange symbols. What they do can be very useful–email and blogs couldn’t happen without Mathworld–but it seems like another place.

Truth be told, I live in Mathworld a lot of the time. Investments and earnings and bond markets are filled with such calculations. But recently I was exposed to some Higher Math: a place of modular arithmetic and topology and fractals. I felt like a trespasser on forbidden ground. It was clear that I only live on the border. The true mysteries of Mathworld lay somewhere to the interior.

All kidding aside, advances in Mathematics have given us abundant food, inexpensive travel, and ubiquitous communications. But these advances seem to rely upon a Faustian bargain with Mathworld’s citizens: give us our toys and you can have your tools.

I’m just glad that Mathworld doesn’t depend on me. Another fruit of a diversified economy.

Douglas R. Tengdin, CFA
Chief Investment Officer
Hit reply if you have any questions—I read them all!

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