Schwab YieldPlus Funds Tank

For years, Charles Schwab marketed the YieldPlus funds as "a safe alternative to money market funds that preserve principal while being designed with your income needs in mind." Charles Schwab also represented that its YieldPlus funds were designed to provide "high current income with minimal changes in share price."

The Schwab YieldPlus Fund Investor Shares (SWYPX), and Schwab YieldPlus Fund Select Shares (SWYSX) have declined over 30% since July of 2007. Unfortunately for investors these funds had large investments in risky mortgage-backed securities. Morningstar now ranks these two funds as last among ultra-short-term bond funds. So much for the Schwab claim in the marketing literature, “The [YieldPlus] funds provide higher yields on your cash with only marginally higher risk [and therefore] could be a smart alternative.”

An earlier HingeFire article from October (see Grandma’s Money Market Fund feels the SIV pinch) outlined the risks of brokerage money market funds, and why investors should be wary of these instruments.

Now Schwab is offering investors a mere 5 to 12 cents on the dollar of their losses, and demanding that the account holders quickly take the offer. This, of course, drove investors to contact law firms to launch class action suits on their behalf.

The Subprime Mess Explained

A very funny skit that gets to the heart of the subprime crisis....

http://it.youtube.com/watch?v=SJ_qK4g6ntM

The Derivative House of Cards: The “Shadow Banking” System falters

Traditionally banking was collecting cash, making loans, and selling low-risk bonds. The old-world apparently was run over by the freight train of modern derivative banking. The brave new world of banking is focused on derivative structures, generating fees, and passing risk down the chain. However the recent credit crisis has proven that eventually someone will be left holding the bag as the house of cards crumbles.

The new modern banking system has operated in “the shadows” according to many. The recent credit crisis has exposed the monstrosity as a multi-headed dreaded hydra. Is it time to properly apply regulatory structure to tame this beast?

A recent article in the Financial Times discusses the system of opaque institutions, non-existent regulation, and derivative vehicles which has led to the credit market turmoil.

Out of the shadows: How banking's secret system broke down
http://biz.yahoo.com/ft/071216/fto121620071354448683.html?.v=1

"What we are witnessing is essentially the breakdown of our modern-day banking system, a complex of leveraged lending [that is] so hard to understand," Bill Gross, head of Pimco asset management group recently wrote. "Colleagues call it the 'shadow banking system' because it has lain hidden for years, untouched by regulation yet free to magically and mystically create and then package subprime loans in [ways] that only Wall Street wizards could explain."

Will State SIV Funds bankrupt local communities?

Many states are hiding a deep dark secret; they have been running investment funds that have bet heavily on mortgage-backed derivatives. Hiding behind financial confidentiality; many government officials loath to discuss the impending crisis. Significant portions of the money placed in these state funds comes from local governments who have been urged to allocate money in these vehicles in order to earn higher returns. Now the wheels are coming off.

The recent situation in Florida is a standard run on the “bank”. Very jittery local governments basically rushed the gate to remove money from the state fund over several days until officials shut down withdrawals on January 29th. Today the fund re-opened up to limited withdrawals of up to 13% of assets limited to $2 million. Action was described as brisk as many communities sought to recover something from the pending fiasco.

The local governments have every right to be nervous; currently many of these state funds are probably only worth only 30% of their “face-value”, as a continual cycle of downgrades hit their mortgage-backed SIV investments. Many local communities rely on these funds to pay pensions and operating expenses. A crisis in these state funds would leave many government retirees out in the cold and communities unable to meet payroll.

States such as Connecticut, Maine and Montana are experiencing similar scenarios with local governments rushing the gate for withdrawals, the quarantining of troubled fund components, and more than 20% of some funds being declared as defaulted SIV investments. The state government officials have moved to the defensive in recent days making statements that they expect the funds to “recover” and that state reserve funds can cover any contingent shortfalls.

So much for proper stewardship, most of these vehicles were sold to the state financial oversight boards as “safe” investments that would earn higher interest. Of course, Wall Street reaped exceptional fees for their involvement in these entities while hiding the actual risk involved from these government entities.

At this point, it is simply a question of how deep and painful the fallout for local governments will be rather then a question of if the downside SIV scenario will occur.


Reference:
Fund Crisis in Florida Worrisome to States
http://www.nytimes.com/2007/12/05/business/05invest.html

Should Citi Pay for its Mistakes

There is one point of view that deems that the creation of the M-LEC to bail-out Citi and other banks from their SIV crisis is a concept that interferes with the free market. The other side of the argument promotes the need for stability in the market place to avoid a string of cascading failures underlines the need for the creation of the SIV Superfund.

From a risk tolerance perspective, why should banks such as Citi be bailed out for their own mistakes? Shouldn’t the shareholders and the company pay the price in a free market economy? Isn’t the SIV bailout effectively a form of capital-based socialism; where firms avoid the consequences of their decisions? Certainly, the financial market would not offer group bailouts for individual who can not meet their financial obligations; why should it be any different for a large bank.

Allan Sloan of Fortune takes Citi to the task in his recent article:

Citigroup: 'Gimme shelter'
http://money.cnn.com/2007/10/26/magazines/fortune/citishelter.fortune/index.htm?postversion=2007102914

Grandma’s Money Market Fund feels the SIV pinch

The SIV panic did not really set in among regulators until “supposedly-safe” money market mutual funds started to take losses. The federal regulators are now calling foul.

‘Securities regulations state that money market funds can only buy short-term, very safe securities. In particular, rule 2a-7, part of the Investment Company Act of 1940, says that money market funds can only hold securities that have "minimal credit risks."’

Impacted money market funds include offerings from industrial giants such as Bank of America, who watched $640M of customer funds get flushed down the tubes when Cheyne Finance went under, to smaller brokerages. The list of firms, whose money market funds are holding SIV paper, includes major players such as JP Morgan, Fidelity and Federated.

It is now obvious that SIVs never merited AAA ratings, which would imply these securitized products had the strength to weather any storm. The defense made by some funds that the debt was “ultra-safe” because it was highly rated, does not really hold up when performing any type of basic risk analysis of these instruments.

Money market funds are supposed to be the safest investment; something that a retired grandmother can feel safe in. The financial manipulations of Wall Street in building derivatives have now destroyed this trust. Money market funds offered by most brokerages are not covered under FDIC protection so retail customers will take the hit. No wonder steam is rising from the brows of regulators. The question remains will they implement the necessary reforms to eliminate future occurrences, or stand frozen like a deer in the headlights.

A recent article in Fortune discusses SIV impact on money market funds in more detail.

Risky money market fund bets may be illegal
Money market funds may have broken a law dictating a conservative investment profile by investing in SIVs, reports Fortune's Peter Eavis.
http://money.cnn.com/2007/10/25/magazines/fortune/funds_sivs.fortune/index.htm?postversion=2007102605

Quants meet Reality

The Quants on Wall Street this summer received a harsh introduction to reality and the impact of multi-sigma events in the market. Traditionally, significant dislocations that tear apart the fabric of mathematically driven funds occur about every 18 years based on historical analysis. Most quants ignore history and focus on short term back-testing studies; blindly confident in their belief that these events have been arbitraged out of the market by superior math and will never occur again. Akin to the railroad engineer holding his hands over his eyes while driving the train over the cliff.

In earlier posts, the phenomena of quants was touched on:
Will Someone tell the Financial Whiz Kids that their House is Built of Cards
http://hingefire.blogspot.com/2007/10/will-someone-tell-financial-whiz-kids.html

A number of recent articles put the role of quantitative analysis and algorithmic trading in the limelight as the driver of recent market disruptions. The losses from in-house algorithmic trading desks have been extreme over the past couple of months as volatility spiked and pricing diverged from historic patterns. Morgan Stanley reported a $480 million loss in the third quarter from the bank's in-house equities trading desk that employed computer generated models to drive returns. Many other investment banks demonstrated similar issues while a number of hedge funds closed up shop.

Volatility puts algo trading under pressure
http://www.reuters.com/article/reutersEdge/idUSL2648150020071026

Nassim Nicholas Taleb discussed the impact of multi-sigma events on the market in his recent book “The Black Swan: The Impact of the Highly Improbable” “The term black swan comes from the ancient Western conception that all swans were white. In that context, a black swan was a metaphor for something that could not exist.” A Black Swan is a large-impact event that greatly deviates from the ordinary and is difficult to avoid. Taleb’s embedded thesis is that financial engineers are lulled into false complacency, not planning for the worst case and are never prepared for events that rip the fabric of their models.

The MIT Technology Review recently posted a pair of excellent articles about the role of financial engineers in the implosion of the derivatives market this past August; a crisis that is still unfolding. There finally appears to be a glimmering of understanding that the structured derivative market is a house of cards that can be crumbled by multi-sigma events, and it is just a matter of time until the Black Swan visits any leveraged market sector. The brick wall of reality trumps math every time… or in just a matter of time.

The Blow-Up: Part 1
In Wall Street's summer of scary numbers, all eyes were on the mathematically trained financial engineers known as "quants."
http://www.technologyreview.com/Biztech/19530/?a=f

The Blow-Up: Part 2
How the financial engineers known as "quants" contributed to Wall Street's summer of scary numbers.
http://www.technologyreview.com/Biztech/19531/?a=f


References:
Black Swan
http://www.investopedia.com/terms/b/blackswan.asp

Black swan theory
http://en.wikipedia.org/wiki/Black_swan_theory

Nassim Nicholas Taleb’s book can be found at:
http://www.amazon.com/Black-Swan-Impact-Highly-Improbable/dp/1400063515

There is an Elephant in the Room – SIVs

Minyanville had some good topical commentary on SIVs. The recent creation of a Super-SIV fund, backed by banks and coordinated by the Fed, is effectively a bailout of Citi. Peering ahead like a sloth caught in the headlights, Citi was facing a situation with their SIVs that had the potential to sink the entire firm; which would cause a confidence crisis across all investment banks. This drove the creation of the Master Liquidity Enhancement Conduit in an attempt to calm the waters. Another unmentioned concern is that the financial engineering in the banking system is not merely limited to the SIVs associated with commercial paper, any sector of the leveraged derivative market has the potential to be a poorly constructed house of cards which can come crashing down in a matter of weeks.

The Problem with SIVs
Due to years and years of increased leverage we effectively have a banking system that is not functioning.
http://www.minyanville.com/articles/C/index/a/14597/from/yahoo

Increasing Risk: Headwinds

The headwinds facing the stock market have increased from a mellow breeze to a near gale over the past three months. It will be difficult for the market to continue an upward trend when facing these gusts; in fact is increasingly likely that the market will rollover and dive.

These factors are likely to put the brakes on the U.S. economy increasing the probability of a recession. While any individual factor is not enough to swamp the boat, the combination of all the factors puts a severe dampening on forward progress. The market is tacking against the prevailing wind and will have difficulty in maintaining headway.

It is apt that this commentary is being provided in late October, a period in which the market historically faces calamity, keep in mind 1929 and 1987. It is not clear if the headwinds will spark a loss of confidence that will lead to an immediate tumble, or if the events will play out over a period of months with the indexes washed over by the general economic conditions. Many times the market acts as a leading indicator of a broader economic slowdown. It is more apparent each week that the storm is brewing, and the factors outlined below will have an impact on your portfolio.

Lower earnings and increased warnings

Every earnings season sees a mix of hits and misses. The trend in the current season shows an increasing number of companies guiding down and a larger number missing their original estimates, while barely exceeding their revised numbers. This trend is likely to continue during the course of this fall earnings season; underneath the covers it provides a tale of a U.S economy that is effectively slowing despite the financial engineering used by a number of firms to make their numbers appear better.

The warnings are not confined to any single sector; it varies from candy suppliers such as Hershey to Investment Banks such as Citi whose net tumbled 57% in their report this week. The forecasted earnings growth for the S&P500 have fell from 6.2% to -0.2% between July 12th and October 16th.

Earnings Expectations Shrink Among Wall Street Analysts
http://www.schaeffersresearch.com/commentary/observations.aspx?ID=20581&c=obsfeed

Retail Sales Dropping

While a broader September retail sales report this week came in higher then expected. It is difficult to spotlight any good news contained in the report except that automobiles are still selling.

The spotlight on individual stores is less promising. Many retailers have issued warnings about dropping sales or are coming in at the lower end of their forecasts. Wal-Mart, the world's largest retailer, posted a 1.4 percent gain in September same-store sales, at the lower end of its forecast. Macy's Inc. and J.C. Penney Co. said sales declined. Nordstrom, among the few chains to post a gain, fell short of analysts' estimates. Specialty retailers at malls also posted declines. This drop is driven by the fact that consumers are in many ways tapped out, and are facing higher monthly expenditures for needed items such as gas and food. Driven by fuel costs, consumer prices have risen sharply at a 0.3% rate in September, for an overall increase of 3.6% in 2007 which is above the 2.5% rate recorded for all of 2006.

Home Prices Dropping

The news from the housing front continues to become gloomier. It is difficult to find a word of encouragement anywhere when the word “housing” is included in the conversation. The reports this week show that home building has hit a 14 year low, while unsold inventory is near record highs. Recent surveys have indicated housing price drops in the majority of metro area markets in the U.S.

Home building at 14-year low
http://news.yahoo.com/s/nm/20071017/bs_nm/usa_economy_dc_7

The Foreclosure Crisis

The foreclosure situation in the U.S. has reached a level where Washington is paying attention, over 1 million plus stand to lose their homes over the next two years. This increasing number of foreclosures weakens consumer confidence, reduces consumer spending, and wreaks havoc on the financial sector. Most of these foreclosures are associated with subprime debt and ARMs resetting.

Washington has put a number of bipartisan measures in place, but most of this legislation will do little to minimize the crisis. It is more likely that the federal government’s prompting of banks to take steps to alleviate the pressure on homeowners by not adjusting the rates upward will have greater impact in reducing the number of homes on the foreclosure register.

Congress takes action on home loan crisis
http://www.wthr.com/global/story.asp?s=7170592

The Credit Crimp

As foreclosures are soaring, most homeowners are finding it difficult to get Alt-A, subprime, or jumbo loans. The mindset that these homeowners had in which they planned to simply refinance to a lower rate as their ARMs reset has caught them in a trap. The problem being that no bank will extend them a new mortgage.

Mortgages are not the only consumer debt impacted by the credit crunch. Many homeowners are finding that their HELOCs are being cancelled with little explanation. Credit card holders being hit with higher rates and having their cards cancelled if they late on paying any of their debt.

An earlier post from August 3rd discussed the Credit Crunch and the associated scenarios for the economy. It appears that we are solidly in midst of the “middle case”.
Credit Crunch – Increasing Risk
http://hingefire.blogspot.com/2007/08/credit-crunch-increasing-risk.html

Consumers Tapped Out

So what happens when the majority of homeowners have used their houses as ATM machines to purchase other stuff, and suddenly they have gone back to the bank and the ATM spigot is cut-off. Well, first of all they stop buying stuff. No more big SUVs, fancy boats, exotic vacations, and vanity items.

This is readily apparent in reports on big ticket items and non-essential retail. Coupled with falling home prices, rising prices of necessary items, job losses, and dropping consumer confidence; there is an expectation of continued erosion in consumer spending. Simply because from a big-picture perspective consumers no longer have the cash to spend.

The consumer buying binge is over
http://money.cnn.com/2007/10/15/news/economy/colvin_buyingbinge.fortune/index.htm?postversion=2007101609

Lower consumer confidence

With debt piled on their backs, their home values dropping, banks not giving loans, and their neighbors losing jobs; consumer confidence is hugging all time recent lows. There is no expectation that the situation will improve after the upcoming fourth quarter with the associated holiday spending. While consumer spending always spikes during this time of year; it is still likely to be below most retailer’s expectations.

One recent article provided this description - “Consumer confidence continues to hover in negative double digits, above its recent lows but below its recent average.”

Confidence Is Low and Steady
http://abcnews.go.com/Business/story?id=3737552&page=1&Business=true

Corporate credit market jitters

The recent creation of a Super-SIV fund by major banks to stem credit losses associated with commercial paper is symbolic of the fear regarding corporate market rather then a cure for the ills. The concept that a complete segment of the corporate credit market has ground to a halt and most firms can not even define the pricing of the instruments should cause a gut-wrenching moment for all investors. The situation may work itself out over time, or implode into a large-scale bailout situation that makes the subprime crisis appear to be a minor side-show.

An earlier post discussed the formation of the Super-SIV fund.
Credit Market with the Jitters
http://hingefire.blogspot.com/2007/10/credit-market-with-jitters.html

Increasing oil prices

The recent spike in oil prices acts as a drag on the entire economy. Transporting goods costs more, small businesses are crimped with fuel costs, families spend more fuel, and homes cost more to heat. Fuel costs show up in the prices of everyday necessary items that all households need; the cost of everything from milk to shampoo goes up.

The increasing oil price rises, which is likely to drive gas at the pump to over $4 per gallon, is one of the most detrimental items to the overall economy. Shortly the fuel costs will be hitting a point where everyone feels the pinch and it will not be ignored by most families in their planning.

Oil jumps above $90 a barrel
http://news.yahoo.com/s/ft/20071019/bs_ft/fto101920070736179330

Mixed Manufacturing reports

Te recent manufacturing reports demonstrate a mix trend. Some areas such as New York increased while neighboring areas such as Philadelphia sunk. The lack of correlation in the reports and the slide in national surveys over the past three months, does not spell out a promising trend in regards to U.S. manufacturing.

Philadelphia Fed's Factory Index Dropped to 6.8
http://www.bloomberg.com/apps/news?pid=20601087&sid=ahCdurYvWGHA&refer=worldwide

U.S. Economy: New York Fed Factory Index Unexpectedly Rises
http://www.bloomberg.com/apps/news?pid=20601068&sid=aOCTmTf6mcsU&refer=economy

Increasing Job Losses

The job losses are not simply associated with the mortgage and home building sectors. Recent reports have shown the shedding of jobs across all industries in the U.S.

A good number of larger employers have recently announced significant reductions their workforces. This week, both AOL and Boston Scientific were at the top of the headlines for their sizeable job cuts.

The general trend in each week’s unemployment report is an increasing number of claims.

U.S. Jobless Claims Rose 28,000 to 337,000 Last Week
http://www.bloomberg.com/apps/news?pid=20601068&sid=agxmWCYcodl0&refer=economy

The increasing job losses erode consumer confidence and spending; thereby impacting the earnings of corporations associated with this activity. Consumer spending represents nearly two thirds of the U.S economy, therefore all factors that impact it must be considered from a broader perspective.

Falling Dollar

The falling dollar is a mixed situation. A lower dollar makes imports more expensive, and slows U.S. consumer spending. However a falling dollar also increases exports and makes American products more competitive overseas.

Dollar Falls to Record Low Against Euro on Growth, Fed Outlook
http://www.bloomberg.com/apps/news?pid=20601087&sid=atTi8soeh.KM&refer=worldwide

Another primary concern of a falling dollar is that it will drive investors outside the U.S. to take their money out of the American markets. This outgoing money flow will normally lead to a reduction of the indexes.

The Rush to Downgrade

Credit agencies are nearly stumbling over themselves to downgrade mortgage-backed securities and other derivative instruments. S&P appears to add another batch representing billions every week. This is one of the factors defining the existence of increasing risk of recession as outlined in the 'middle case' in the earlier 'Credit Crunch' post from August 3rd.

“S&P two days ago lowered ratings on $23.4 billion of subprime and Alternative-A securities that were created as recently as June, its swiftest downgrade of mortgage bonds. Investors and U.S. lawmakers have criticized S&P and other credit-rating companies, saying the firms downplayed the risk of bonds backed by loans to homeowners with poor credit.”

S&P Cuts $22 Billion of Subprime Mortgage Securities
http://quote.bloomberg.com/apps/news?pid=20601087&sid=a47IJsAZLTZQ

The Good News

Is there any good news about the American economy and stock markets? There are some positive points that investors should keep in mind.

Historically low interest rates – The interest rates in the U.S. are still near historical lows. This acts as a very positive driver in terms of borrowing costs for businesses, homes, and consumer items despite the credit market issues.

Low unemployment rate – The U.S unemployment rate is still near traditional lows showing that Americans are nearly fully employed. This however ignores the trend from high paying professional and manufacturing jobs to lower paying service sector jobs that has beset the economy.

Increased exports due to lower dollar – The exporting of products from the U.S has climbed and is helping to close the still-significant trade gap over the past couple of months. This is driven by the lower dollar.

Return to traditional lending standards – There is a positive side to the stop of irrational loans in the U.S., it removes energy from the bubble. The return to sane and traditional lending standards is long overdue; however there will be economic pain as the country struggles through the aftermath.

Summary

The headwinds are increasing for the economy and market. While any individual factor is not enough to sink the ship; the combination of all the factors will impede the situation. Earnings growth and other fundamental drivers of the stock prices are under pressure.

It would be wise at this point for investors to adopt a defensive stance for their portfolio. They should underweight sectors in turmoil such as housing, mortgages, and banks while seeking to reduce overall risk. This does not mean that an investor should dump all of their stocks and go to cash; it simply implies that it is time to pay attention to what sectors within the stock market your money is allocated to and take steps to reduce the risk.

Traditionally areas such as consumer staples, tobacco, alcohol, and movies tend to do well during a recession. Investors should take a close look at stocks in these sectors and consider overweighting. Other areas that are ripe for gains in the current economic environment are commodities. The demand for raw materials, crops, and energy are increasing world wide; this will likely fuel the continued price gain in these items.

From a broader portfolio perspective, the percentage allocations that you have to stocks, bonds, commodities, and cash should remain the same based on your age and objectives; there is no need for drastic action in your 401K plan. Think long term!

A $100B Super-SIV Fund will not plug the Dyke

Barron’s takes the creation of the recent Master-Liquidity Enhancement Conduit, or MLEC fund to task… stating that it will not stop the flood while called the size of the fund “a spit in the bucket” compared to the mountain of existing bad debt.

I discussed the formation of the Super SIV in an earlier post, observing that the credit market still has a bad case of the shakes:
Credit Market with the Jitters
http://hingefire.blogspot.com/2007/10/credit-market-with-jitters.html

The Barron’s article expands upon this with some interesting commentary.
$100 Billion Won't Plug the Leaky SIVs
http://online.barrons.com/article/SB119244948063659074.html

Credit Market with the Jitters

The corporate credit market still appears to have a bad case of the shakes, to the point that investment banks coordinated by the Fed are preparing for a bail-out.

The sales of commercial corporate paper have suffered over the past few weeks due to the fear wrought by the subprime sector. Despite the contagion, commercial paper sales have increased during the past few weeks giving some the perspective that the possible crisis is in the rear view mirror.

However the rather large Structured Investment Vehicle (SIV) market, that is generally associated with lower quality corporate debt, appears to have come to a complete halt. These derivatives are backed by commercial paper, and are similar to the CDOs that have provided excessive angst in the subprime market. Generally the SIVs used short-term commercial paper with low interest rates to purchase longer-term mortgage-backed securities and other instruments with higher rates of return. A market arbitrage that bears resemblance to international interest-rate carry trades, but tends to blow up spectacularly when one of the underlying tenets alters

The banks would create a Super-SIV fund (Master Liquidity Enhancement Conduit or M-LEC) that would provide emergency financing to bail out SIV entities in order to prevent sell-offs. The Fed and Treasury hope that this will reassure investors in these vehicles and kick some life back into the commercial paper market.

The key question remains regarding how much impact this event should bear over the broader stock market. Deteriorating credit conditions are normally very bad news for investors. Should the implementation of this SIV fund from the banks be taken as fair weather news to calm the seas or with a dose of fear?

Banks May Pool Billions to Avert Securities Sell-Off
http://www.nytimes.com/2007/10/14/business/14bank.html?_r=1&oref=slogin

Banks set plan to revive credit market
http://news.yahoo.com/s/ap/20071015/ap_on_bi_ge/banks_credit