Archive for December, 2009

Beschäftigen Sie Besitzrechtsanwalt

Thursday, December 31st, 2009

That is a long title, in German, for estate attorneys in the upcoming year (I spoke German growing up, as my mother and grandparents are Austrian).  The estate planning world is in a state of flux.  On 1/1/2010, the gift tax drops to 35% (it’s currently 45% and increases to 55% on 1/1/2011 based on current law).  The gift tax is calculated on the tax-exclusive basis, making it a more tax-efficient transfer process than waiting to pay the estate tax rate.   For taxpayers living more than 3 years from the date of the taxable gift, only the value of the interest transferred will be used to calculate the deceased’s taxable estate.  For taxpayers living less than 3 years from the date of the taxable gift, the gift tax paid will be included in the deceased’s taxable estate.  In both cases, appreciation in the value of the gift would not be included in the taxpayer’s adjusted taxable estate (source: Leimberg).  There are some additional benefits, subject to the facts and circumstances, such as valuation differences between assets transferred and the value of the interest itself.

As the weeks unfold (Congress reconvenes Jan 5, 2010), clients should be discussing with their estate attorneys how their current wills and wealth transfer strategies align with current rules that take effect 1/1/10 and potential new rules.  Many estate plans written over the last few years had flexibility added to documents using disclaimers, etc.  Clients should discuss the timing of pre-planned taxable gifts, the effects on children and grandchildren, GRATs, QTIPs, and CLATs.
  
Bottom line:  This is going to be a busy year for estate attorneys.
 

Always Asking, Never Assuming™

Christopher Holtby

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Paths for the US ecomony

Tuesday, December 29th, 2009

Much like any long, alcohol-infused party, there is always the painful morning-after hangover.  Over the last 25 years, America had a great credit-infused party (sadly, there was an uneven participation in wealth creation), and now we must deal with and work through our credit hangover.

It is easy to look at old data to make interpretations about what the future could resemble.  The basic tenets of the old data was: low saving rates, high consumer consumption, and low unemployment.  Investors who do not believe that the new economic and financial paradigms will involve these same tenets need to make adjustments.  Economics and history has taught participants that government spending, over the long-term, has a zero multiplier effect on economic growth, whereas tax cuts, over the long-term, have a 3x multiplier effect on economic growth.  Looking at Washington, what are the paths for the US economy? (source: Mauldin)

Argentina – Hyperinflation.  Unlikely.

Austrian school of economics - VERY dramatic spending cuts.  Long and large depression.  Unlikely.

Eastern Europe – structural change (per Niall Ferguson) and restructuring everything.  The current Congress can’t even agree on health reform which they all agree needs to be reformed.  Somewhat likely.

Japanese disease – large deficits, low growth, no net new jobs, no productivity growth, and this can continue for a long-time.  Bond market eventually stops negative feedback loop with higher interest rates.  Somewhat likely.

US glide path option – high unemployment, tax increases, slow growth, eventually leading to spending cuts and current account deficit to GDP at 2-3%.   Somewhat likely.

This means nobody knows for sure the path of the US economy.  We do know that the bond markets will tell Congress (as they are telling the governments of Greece, Spain, Lativa, etc.) when enough debt is too much, requiring an increase in the cost to continue purchasing that debt.  This leads to higher interest costs for a country, which eventually leads to a change.

Bottom line:  Creating and monitoring an investment portfolio that finds the middle route through this credit hangover phase is key.  Investing is part art and part science.  

 

  

 

Always Asking, Never Assuming™

Christopher Holtby

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“Ring-fenced”

Thursday, December 24th, 2009

One of my hobbies is understanding how the “plumbing” of the capital markets works.  How trades settle, how clearing firms work, how exchanges work, how new securities or instruments work into the system, how the system is changing, etc., all provide insight about how the system is working or not working.  Ever since the bankruptcy of Lehman Brothers (LEH) in Sept. 2008, there has been an important operational story brewing.  LEH was a huge prime broker for hedge funds.  A prime broker can provide custodial, trading and financing services.  LEH had prime broker groups based in NY and London.  They were separate legal entities and were regulated by the SEC (NY) and the FSA (London).

LEH’s NY broker-dealer, where the prime broker existed, was bought by Barclays Bank.  LEH’s London broker-dealer went into bankruptcy.  Many US-based hedge funds, in order to increase their leverage levels, used Lehman Brothers International Europe (known as LBIE and based in London) to avoid the leverage limits imposed by the SEC.  Those hedge funds become creditors of LBIE at the bankruptcy.  Recently, hedge funds controlled by Goldman Sachs and GLG won a court case that proved their assets were properly “ring-fenced” from LBIE assets.  They will get their money back.  Most hedge funds were not so detailed and are now unsecured creditors of LBIE.  LBIE fell ”spectacularly short”, ruled Mr. Justice Griff, of ”ensuring client money was not used by the firm for its own account, or that it would be returned to clients in full in the event of an insolvency”.  

Bottom line: How have your hedge funds or funds of hedge funds confirmed/proven that their assets are properly and legally “ring-fenced” from their custodial firm’s assets?  This is just a normal question. 

Always Asking, Never Assuming™

Christopher Holtby

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Internal disagreement with Beijing

Tuesday, December 22nd, 2009

Because of China’s current and future influence on global economics and finance, it seemed wise to spend a few weeks researching China’s operational and structural issues.  The butterfly effects from China have global investment knock-on effects.  There will be a series of forthcoming blogs stemming from my research. 

Any emerging country needs to have an industrial base.  Generally, the steps are: 1) build, 2) organize, and 3) run efficiently.  Over the last 20 years there has been a struggle between the central planners in Beijing and the provincial entrepreneurs over the vision for and implementation of an industrial base.  Beijing wants to create an industrial base that is organized and efficient (e.g. capital and human resources).  The provincial entrepreneur wants to make money without any thought given to the grand schemes coming from Beijing.

Right now, China’s steel industry is the largest in the world.  The excess steel production in China is greater than the total steel production of Japan (world’s 2nd largest producer).  China is the world’s largest producer of cement, plate glass, coal chemicals, crystalline polysilicon, wind power equipment, ships, crushed soybeans and fertilizer (source: Urandaline).  40% of the world’s capacity of crystalline polysilicon, a key ingredient in solar cell production, is in China, with enough production capacity to supply the world 2x over (low-cost solar panel prices have dropped 85% in 9 months).  In 2007, Beijing wanted to close inefficient and polluting small smelters, so they raised the required capacity minimums.  The smelters just produced more, thus thwarting Beijing’s goals.  Private industrialists work closely with local and provincial officials who want tax revenue.  For example, in western China, local governments have welcomed new aluminium and ferroalloy facilities, even though Beijing has warned that excess capacity will lead to bankruptcies.

The ability of China to export their excess capacity from their industrial base requires external demand for that excess capacity.  The Euro zone and America’s demand for China’s excess capacity is slipping rapidly, as those economies re-calibrate to their new deleveraged, slow-growth economies.  Razor-thin margins on China’s overcapacity will lead to bankruptcies and low quality products (remember the lead toys from China?).  Except for a few industries (cement and steel), Beijing has not followed through with punitive action for those provinces supporting over-capacity in a range of industries.  Investors (mostly local banks fed by state banks) do not forsee any penalties and will keep snubbing their nose at Beijing until something changes.  This means that China is creating an industrial base that is fragmented and inefficient.  An inefficient allocation of capital means low returns.  Low returns are not how growth is maximized.  However, Chinese politicians and entrepreneurs are quick learners and will eventually correct this current path.  The timing is the unknown. 

Bottom line:  China’s economy is subject to the same economic rules as all other economies.  

Always Asking, Never Assuming™

Christopher Holtby

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P.I.I.G.S. and European investments

Wednesday, December 16th, 2009

Somebody on Wall Street came up with the politically incorrect term, P.I.I.G.S., which stands for Portugal, Ireland, Italy, Greece and Spain.  This term refers to countries with high current account deficits-to-GDP and political mismanagement of their government’s balance sheet (yes, America should be included in this list as Exhibit A).  There is a key difference between a sovereign borrower, or one that borrow in its own currency from its own people (US, UK, Japan, etc.), and one that can’t (Euro zone, Baltics, etc.).  The European Central Bank controls the currency in which member countries borrow.  The Euro zone countries are much like a state in the US, where they do not control the currency in which they borrow.

Greece is currently experiencing a debt crisis (evidenced by widening CDS country spreads and increase in government yields).  The government has three options: 1) default, 2) reduce the deficit, or 3) become an indefinite recipient of transfer payments from Euro countries that have current account surpluses.  If Greece defaults, Portugal is next, and right after that Spain, which nobody can allow or afford.   If Greece reduces its deficit (following Ireland’s example), it is questionable whether the politicians can withstand the pressure.  If Greece accepts the indefinite transfer payments, it will become similar to southern Italy and the former East Germany.  Southern Italy has been the recipient, for over 50 years, of transfer payments from the north amounting to 7-8% of Italian GDP (source: GaveKal).  This transfer payment is a form of vendor financing similar to the China/US economic relationship (that is slowly being unwound).  Countries such as the Netherlands, Finland and Germany can afford the roughly $300 billion needed in transfer payments to Greece, as these countries have current account surpluses.  The Euro zone has gone from the impossible to probable, bypassing improbable, much like the US did with the Lehman and AIG failures in the fall of 2008.

Bottom line:  Not all sovereign debt is the same, as the source for funding the debt can be very different.  Vendor financing between governments can lead to strong GDP growth (China to US) or low GDP growth (Germany to Italy).  Allocations to European investments need to take into consideration the new paradigms that are forming.       

Always Asking, Never Assuming™

Christopher Holtby

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Iran and you

Tuesday, December 15th, 2009

Financial markets and investors view geopolitical events as odd, almost non-important events.  The number of variables influencing geopolitical outcomes are so numerous that no computer program currently exists that can create a reliable bell-shaped curve of probable outcomes.  As we read about and consider various geopolitical outcomes, our minds hurt thinking about the variations and influencing factors.

Iran is focused on regime survival.  It has learned from North Korea that possessing nuclear weapons almost guarantees regime survival (US does not want to destabilize North Korea).  It is widely believed that Iran is close to nuclear capability, but it is unknown how close they are to a nuclear weapon.  Iran is a Shiite Muslim country, whereas Saudi Arabi is a Sunni Muslim country.  As we have learned in Iraq, these two arms of Islam do not get along (see current fight in Yemen between these two Islamic factions). 

After the summer 2008 election in Iran, which resulted in protests and riots, the Iranian government was able to shut down most modern forms of communication within Iran (Twitter, Facebook, cell phone, etc.).  During one of the protests, there were chants of  ”Death to Russia”.  This was odd, as the normal chants are for the destruction of America, Israel, Great Britain, and sometimes France, but Russia?  Analysis has found that Russian intelligence provided the technology to the Iranian regime to shut-down communication systems during the summer 2008 riots.  Russia has also built rail systems to transport gas to Iran in the event of an embargo from the West.

Israel knows that two nuclear weapons could destroy roughly 70% of their population (source: Stratfor), making an Iranian regime with nuclear weapons untenable.  Russia wants NATO and the US to stop “messing” in their spheres along the old Eastern block.  Russia also wants Western capital.  Some 40% of the world’s oil flows through the Straits of Hormuz (source: Stratfor).  Iran has threatened to mine the Straits of Hormuz if anyone takes military action against it.

The “players” have three options: 1) buy off Russia, 2) carry-out strikes against Iran lead by the US, and 3) buy off Israel.  Nobody knows what Russia’s or Israel’s ”last minute” deal-making would look like.  Nobody knows the outcome.  Obama has promised Israel a 12/31/09 decision, which was extended from an early September 2009 decision deadline.

Bottom line:  For those having agility, geopolitical crises provide great opportunities.  It is not possible to model the various outcomes, with any degree of usefulness, of the current Iranian situation.  The world is a messy place.   

 

Always Asking, Never Assuming™

Christopher Holtby

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The new municipal bond market

Friday, December 11th, 2009

The municipal bond market has made a strong recovery since the November ’08 – March ’09 time frame.  During that period, 10-Year AA rated municipal bonds (underlying credit rating with no insurance wrapper) had yields 150% to 200% of 10-Year US Treasury yields (normal spreads are 80-85%).  The bond market needed liquidity, and those who could provide it (as buyers of municipal bonds) were rewarded. 

Today, the municipal bond market has changed from a rate to a credit market.  Investors need to focus on the underlying credit quality of each bond.  Monoline insurance wrappers (e.g. AMBAC or MBIA) are not relevant.  Municipalities (state and local) are under and will continue to be under financial stresses as their sources of revenue have dropped approximately 7.5% in fiscal year 2009 (source: PIMCO).  Generally, income tax revenues provide 50% of state/local revenue, sales taxes are 30% and corporate income taxes are 10% (remaining 10% comprised of various other sources).  With increased social needs and budget deficits, the next few years will be tough for municipalities.  The problems of city and local municipalities will lag behind state problems, because the former receive the majority of their revenue from property taxes.  As we know, property prices will remain at low levels for the foreseeable future.

Currently, the municipal bond market now prices bonds based on their credit worthiness, which has not happened in over 25 years.  In the past, municipal bond ratings were commoditized by the monoline insurance wrappers.  States such as CA, NV, AZ, FL, NJ, NY and IL are priced very differently compared to states such as SD, TX, and WY.  Credit analysis is the key, just as it has always been with corporate bonds.  It is likely that municipal bonds will have more negative credit surprises, fiscal distress, credit problems and overall bad headline news.

Bottom line:  Credit analysis is the new paradigm for investing and purchasing municipal bonds.  

 

Always Asking, Never Assuming™

Christopher Holtby

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The imperfect future of the US Dollar

Friday, December 4th, 2009

Here are two conflicting facts: 1) the value of the US dollar, relative to other currencies, rests on disturbing fundamentals, and 2) the role of the US dollar, as a means of transaction and unit of account for international trade, is stable.  Predicting short-to-intermediate-term future currency movements is fraught with uncertainty.  Currencies are valued based on their fundamental value or purchasing power parity (PPP) (Big Mac index) relative to another currency.  A currency’s actual value may deviate largely and/or for an extended period over its PPP, but it cannot exist, as such, indefinitely.  PPP is not a fixed number.  This anchor can move higher or lower and is influenced by the inflation differences between currencies.  WITH CURRENCIES, EVERYTHING IS RELATIVE.

The US is currently experiencing the twin deficit syndrome (current account and fiscal).  Textbook economics states that free-floating exchange rates would correct the trade (current account) and financial (fiscal) imbalances.  The academics would argue, correctly, that the US dollar should depreciate very quickly.  A strong portion of these imbalances have been caused by emerging economies artificially keeping their currencies undervalued relative to the US dollar (source: UBS).  These countries have grown their economies and their middle class with export driven policies, with the US consumer being the dominant buyer of their goods (purchases were leveraged and savings were spent to finance these purchases and wage growth was stagnant).  Either exchange rates or relative prices between these countries must change to re-balance trade relationships.  This affects the purchases of our debt by foreigners, the value of foreigner’s assets held in US dollars, etc.  All currencies cannot simultaneously increase and decrease.  Amoungst the developed currencies, the US dollar has been the loser.  

Over the last decade, emerging economies have grown faster relative to the US (to be expected), inflation rates have been steady or declining, and their spread borrow rates in US dollars have dropped dramatically.   The first and second tier emerging countries have independent central banks with inflation targets.  International trade will evolve to include emerging country currencies (e.g. China/Brazil swap trade transactions).  Politically emerging countries are becoming more stable as their middle class grows.

US dollar weakness has limits.  Countries with bulging US dollar reserves do not want those assets to depreciate too quickly.  The US is running a risky strategy of twin deficits to offset the effects of the financial crisis on it’s economy.  As a reserve currency, the US dollar does keep the cost of global transactions low.  These are stabilizers for the US dollar.

Bottom line:  The US dollar will weaken.  The bond and currency markets will provide guidance when investors believe the twin deficits have reached a tipping point.  As politicians re-regulate and partly diffuse globalization, the movements of this long-term trend are murky.  The current popular ABD trade (Anything but the Dollar) is crowded and expensive.  Thinking as a European, whereby over time, investors methodically build-up diversified non-US dollar assets, is a prudent course of action.  

 

Always Asking, Never Assuming™

Christopher Holtby

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Why is it so hard to manage money in these times?

Wednesday, December 2nd, 2009

Anybody who is either younger than 65 or not a student of economic/financial history would find it difficult to remember a time period with these three characteristics: increasing interest rates, decreasing complex financial innovation and tight regulation.  Since 1982, these three characteristics existed in the reverse, leading to consistent US GDP growth somewhere between 5-7% (source: PIMCO).  This consistent growth caused financial assets to appreciate and financial/operational leverage to increase as companies felt comfortable about the consistency US GDP growth.  This situation no longer exists.

Today, the US economy and financial markets are entering a transition period which will eventually lead to decreasing complex financial innovation, increasing regulation and, at some point, increasing interest rates.  The housing market, savings/consumption patterns, and the financial sector are reversing their past trends of the last 25 years or so.  The effect of these new characteristics will be: lower US GDP growth and lower returns on assets.  

Currently, the US financial and economic system is in a transition period.  We are moving from the old paradigm to a new paradigm.  As people from the Midwest and Northeast know, any transition between the main seasons (summer or winter) are a pain in the neck.  The effects of the new paradigm will be dragged out over time, due to our politicians not allowing for true price discovery of all assets (I am agnostic as to who is in power, because I can’t really control that outcome, and like a hand in poker, I am where I am).  Investors must focus on keeping their assets working during this transition period (5 years, 10 years, who knows?), while not forcing their strategies to “fit” into the old paradigm.  That is just plain hard to do.  It takes a lot of patience, reading, learning and thinking.

Bottom line:  Four suggestions: 1) spend less, 2) save more, 3) lower your return expectations on financial assets, 4) focus on matching the maturities of your liabilities to the maturities of your assets, based on suggestions 1-3, and 5) be patient.  Economics and finance, much like nature, will take their course.  Wearing a bathing suit on a NY City beach in January, in the hope of warmer weather, is not a good plan.

  

Always Asking, Never Assuming™

Christopher Holtby

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