The QE2 leaving Southhampton

The QE2 leaving Southampton

Today the Federal Reserve launched the highly anticipated QE2, announcing that it will buy $600 million of Treasuries in 2011 ($75 million per month). It will also continue to reinvest payments on its securities holdings which could bring the total capital injection closer to $1 trillion dollars.

I’m still waiting to see any evidence of  “Change You Can Believe In” and for the $8.5 trillion bailout to kick in and create jobs. But since Bernanke seems that it hasn’t been working too well, we’re going to do exactly the same thing that got us in to this mess – keep interest rates low and turn on the liquidity spigots!

One point of interest is these policies seem to benefit banks the most. Here’s an excerpt from an article on Yahoo! News:

Meanwhile, market watchers noted the Fed’s plan is to focus its QE2 purchasing power on the middle of the Treasury curve, i.e. securities from 2.5 years to 10 years. As a result, prices of shorter-term bonds rose while the price of the 30-year bond tumbled, sending its yield sharply higher.

So the real result of the Fed’s action today is a steepening of the yield curve, which most benefits (wait for it)…the banks. The ability to borrow from the Fed at effectively zero and then reinvest in “risk-free” Treasury securities at a higher yield is a huge reason why bank profits rebounded so quickly from the depths of the 2008-09 crisis.

Despite loads of evidence to the contrary (and very little lending) the Fed is effectively doubling down on its bet that boosting the banks’ balance sheets is the best way to revive the economy.

I can’t believe that this is the best policy to revive the economy. However, it definitely makes sense to align yourself with the Federal Reserve’s determined course of action. Seems like there are 2 things you should do:

  1. If you’re currently unemployed, find a job at a bank. Most banks are hiring like crazy. Bank of America has thousands of job postings (I’m not making this up)
  2. If you’re looking to invest, look for companies that benefit by borrowing at zero interest and reinvesting in risk-free Treasury or Treasury-like products.

There are several companies that fall in this category. Not only do they benefit from the current scenario, but they also pay high dividends and enjoy REIT status (meaning there’s no double taxation of profits) without actually investing directly in real estate.

Any guesses? I’ll talk about them in my next post.

angelo-mozilo-head-of-countrywide-financialAngelo Mozilo, former CEO of CountryWide Financial was fined $67.5 million to settle charges of insider trading and civil fraud. Of this, $45 million or 66% will be paid by Bank of America, who acquired the toxic asset and must now indemnify the former head. As I mentioned back in early 2007, CountryWide insiders were dumping stock as fast as they while simultaneously publicly pumping it. Mozillo made about $134 million from insider trading and then another $100 million on the sale of the company to Bank of America. Having profited over $200 million, being fined a mere $22.5 million doesn’t seem like much of a punishment.

Of course, being a CEO of a major US financial institution seems to provide immunity against any wrongdoing.  Now and then, the SEC will prosecute someone to make an example of them, but the most part you can get away with far more than the average white collar criminal.

Meanwhile, Bank of America’s stock has been whacked this year, down 20% year to date. If Bank of America really did buy Countrywide for the tax losses, this investment just got better!

Time Cover: Rethinking Home Ownership

Time Cover: Rethinking Home Ownership

Time magazine recently had an interesting article, The Case Against Home Ownership which explained why the American dream wasn’t all it was cranked up to be. Mainly, because it just doesn’t make economic sense. It prevented people from being able to migrate to where jobs where, resulted in a 49% higher consumption of energy amongst detached-home owners, and cost the government hundreds of billions in lost tax revenue every year. And the often quoted inverse correlation between teenage pregnancy and home ownership is sketchy and inconclusive (apparently the correlation between car ownership is higher than home ownership!).

The article heavily criticizes the role of the government in its efforts to  keep housing affordable by offering tax incentives and artificially lowering the interest rates on mortgages. The result of these policies is that people over-extend themselves in an effort to get a bigger tax break and the average homeowner saves less than $600 a year on their taxes. The major benefit goes to families making over $250,000 a year and who probably wouldn’t have any problems being able to afford a home anyway. The UK removed the tax deductions on homeownership a decade ago and actually has a higher rate of homeownership than the US (which has hovered around 65% over the past two decades).

Interestingly enough, Switzerland, which is one of the wealthiest nations, has a  low ~35% level of homeownership.

I just had a discussion with a young couple that bought a condo during the peak. They felt somewhat trapped as the husband was unable to move to better opportunities elsewhere because they were underwater on their mortgage. He hadn’t considered doing a short sale on the property, mainly since they both had jobs and didn’t really need to, but they were renting out their spare bedroom to help pay their mortgage (they had obviously over-extended themselves).

As I’ve repeated many times before, your own house is not an investment, it’s where you live. You buy a decent place in a decent neighborhood that you can easily afford. You do not buy a house because you need the tax break or because the bank will lend you more money than you can afford (of course, those days are behind us).  We’re still a couple of years away from a bottom in the real estate market. Until then, renting isn’t a bad option.

A UK-based chocolate manufacturer, Hotel Chocolat, has come up with a novel way to raise capital for expansion. Instead of borrowing money from banks or issuing regular corporate debt, it has decided to raise about $7.5 million USD by issuing “chocolate bonds“. Instead of a regular dividend payment (well technically it’s a coupon payment and not a dividend), these bonds will pay dividends in chocolates!

hotel-chocolat-box-of-chocolates

In order to be eligible, you need to be a member of their “Tasting Club”, which already has 100,000 members. For an investment of $2,890 USD or $5,760 USD, you can get a juicy annual dividend of 6.72% or 7.29% delivered to your doorstep every other month.

If you’ve ever been to high-end confectionery, you’ll know they charge a couple of dollars for each piece of candy.  So spending a few thousand quid might not be such a bad investment. Especially since bank yields aren’t very impressive right now. At least it guarantees you won’t have to spring for chocolate for three years, even if the rest of your portfolio tanks!

I wouldn’t be surprised a chain of British gyms are next in line to offer special “weight-loss bonds”, with special dividend rates for people who bought the chocolate bonds!

But the real question is whether Inland Revenue will be accepting their tax payment in chocolate too?

Today the US debt broke the $13 trillion level. Considering that the US GDP or the US economy is $14.2 trillion (according to the World Bank), that makes our debt level just over 91% of the GDP. Greece’s debt-to-GDP ratio is currently at 115%  (or 133% depending on who you ask – I don’t think even the Greeks know for sure!) and look at the trouble it’s facing!

Professor Morici, of the University of Maryland, is critical of excessive government spending. He claims that whenever the debt-to-GDP ratio exceeds 150%, you run the risk of hyperinflation or “the Chinese buying up Wall Street”, a reference to China being the largest foreign lender to the US government. Either way, he claims that we will run the risk of losing our financial standing.

On a brighter note, the UK is trailing right behind us with a debt-to-GDP ratio of 78%.  But the real leader of pack is Japan, with a whopping 227%! Not to worry, we’re nowhere close to Japanese levels yet!

After WWII, our debt stood at 125% of our GDP and we were able to bring it under control. Let’s hope we can do the same thing once again. Meanwhile, we can all watch our share of the federal debt over on http://www.usdebtclock.org, and how the national debt seems to be growing $50,000 every second!

With the passing of the Health Care Bill, there is a slew of tax increases that will go towards paying for it. I don’t think any of them are going towards paying down our ballooning debt. Congress probably feels that inflating it away is the easiest solution! And it is, provided the inflation comes in an orderly fashion. But what if it doesn’t?

Gold closed at a record high today of $1,237/ounce but surged to nearly $1,250/ounce in intraday trading. The gold ETF, GLD, also reported record inflows this week of $2.3 billion dollars. The ETF also disclosed a record 1,185 tons of gold as distrust in global fiat currencies pushed investors to seek more tangible assets. Gold has hit a high against every major currency, with the exception of the Canadian dollar.

gold-record-price-2010-1250-ounce

Buoyed by gold’s action, silver has also seen some price movement. After dropping as low as $15.13 in February 2010, it has jumped nearly 30% to 19.52. (Silver prices hit $19.70 today in intraday trading).

Seems like Marc Faber was right about gold being a bargain at $950/oz! Since that post about 2 years ago, gold prices are up about 29% versus the S&P 500 which is down about 8%.

After hitting a high of $1.51 just six months ago, the euro broke the $1.30 level and is currently trading at $1.28. Greece’s inability to repay its debts has dragged down the euro and proposed austerity measures have led to rioting.

 euro-vs-dollar-may2010

After European Union eventually bails out Spain, Portugal, Ireland and Italy the euro might trade on parity with the dollar!

I wish I hadn’t been so quick to close my long position on the EUO May $21 calls last week!

With the financial crisis and currency devaluation, the long term prospects for gold are still looking good too.

Every few months, someone wants to know if its a good time to buy real estate. A reader asked an interesting question:

Interest rates are artificially low and we won’t see rates this low for a long, long time. What are your thoughts on buying vs renting for a first timer? In my gut I know that housing is still overvalued, but should I jump on low rates and lock in a fixed payment knowing that future inflation will make this payment even smaller?

Most people do not pay cash for their homes, they get a mortgage. And the monthly payment they can afford, along with the current interest rate determines how large a mortgage they can qualify for.

Lets do some back-of-the-envelope calculations. If you can qualify for $2,000 a month (lets  ignore principle, taxes and insurance for now) and rates are 5%, you’ll qualify for approximately $480,000 worth of mortgage. If rates rise to 6%, you only qualify for $400,000 worth of mortgage.

Did you see how a 20% rise in interest rates caused a 17% decline in the amount of mortgage you would able to qualify for?

If your income isn’t going to increase 20% over the next 2 years, but rates might rise 20%, less people will be able to afford homes. So the pool of available buyers for our $480,000 house has become a lot smaller and demand drops off. According to economic principles, as the demand decreases, prices should decrease as well. Thus, the price should drop to $400,000 to match the purchasing power of buyers.

Additionally,  the banks have unsold inventory sitting on their books – in many cases they haven’t even foreclosed on people who stopped making their payments a year ago.

So we have a scenario where the number of homes on the market is likely to increase or stay flat, interest rates are going to increase, and incomes aren’t going anywhere.

The only reasons you should be buying a house right now are

  1. You’re starting a family, don’t want the hassle of moving and can afford a reasonably large house which you will live in for several years
  2. You can afford to pay cash and don’t care where the market is going
  3. You have specialized knowledge of the markets and can get a much better deal than your local home buyer. Real estate investors will be able to take advantage of the current environment to buy cheap homes that generate positive cashflow.
  4. You have a stable job, expect to be in the same place for several years and don’t want your landlord telling you that you can’t paint the living room bright pink

In short, don’t be mesmerized by the tales of real estate agents and Realtors telling you that interest rates will go up and price you out of the market. Only a booming economy with people falling over themselves to buy houses can do that. It may seem like people are out buying homes, but its a temporary phenomena created by all the government to stimulate the housing market. When this stimulus ends, homes prices will probably drift down by the same amount. On a similar note, ZeroHedge has a good article on how dropping homes prices are inversely correlated with rental rates, something I have not been able to verify with my properties!

Only buy a house if you have a good reason to buy one. Don’t get suckered in to it.

At some point we will see inflation, but it’s next to impossible to figure out when.

Last week the internet was buzzing with rumors of Apple coming out with an iPhone that would work on the Verizon Network. If you decide you wanted to trade this rumor what would you do? Would you buy Apple (AAPL) or would you buy Verizon Communications (VZ)? What if I told you Apple didn’t pay a dividend, while Verizon had a 6% dividend yield. Would that make a difference?

As it turns out, I decided I wanted in on this trade. I’ve been wanting to buy an iPhone for a while but the AT&T network is severely congested in major cities and the sound quality for calls is terrible. So I’ve been holding out for the iPhone until it’s available on the Verizon Network.  I did however get myself a 32GB iPod Touch that is simply amazing.

I didn’t buy either of these two companies. Instead I bought Vodafone (VOD) with a dividend yield of approximately 5.3% based on my $23.10 purchase price. It’s not widely known, but Vodafone owns 45% of Verizon Wireless. The remaining 55% of Verizon Wireless is owned by Verizon Communications.

Verizon Wireless borrowed billions of dollars from its parent company to build out its infrastructure and for the $30 billion purchase of Alltel. It’s been generating nearly $10 billion a year in free cashflow and has been paying back the loans. These loans will be completely repaid in a few months. So what will it do with all the money its generating? It’ll start paying dividends to VZ and VOD.

Verizon needs the money for its own dividend payments. In addition to the wireless division, it runs a landline division that isn’t anywhere as profitable as Verizon Wireless. And last week, Vodafone publicly asked Verizon to either spin off Verizon Wireless or to start paying dividends as soon as it was done with the loan repayments.

By itself, Vodafone generates $8 billion a year in free cashflow. It’s 5.3% dividend seems pretty safe and has the potential to see a massive increase if Verizon Wireless decides to pay out a major portion of its cash flows.  In addition to its stake in Verizon Wireless, Vodafone owns a tiny stake in China Mobile and a 44% stake in some French Telecomm company who’s name I can’t pronounce.

This way you get exposure to a global Telecomm player with exposure to the growing US wireless market and no exposure to the US landline market.  You also get a 5%+ dividend yield with exposure outside the the US and the US Dollar. If we do see inflation, this dividend is likely to keep up with it and is probably a better bet than a treasury bond (which would lose value if we saw high inflation).

For the time being, the “Can you hear me now?” dude is a little less annoying!

Disclaimer: I entered a 50% position in VOD. If the price drops from my purchase price I’ll double down.

If you believe the government or the popular press, the economy is out of recession and everything is business as usual again. Last month there was an increase in jobs by 162,000, home sales jumped 8.2%, the Dow is now almost at 11,000 and interest rates are inching upwards  in recognition of the economic recovery. It’s all peaches and cream isn’t it!

Unfortunately, I don’t believe the government or the popular press. I like to look at the facts and draw my own conclusions. First of all, the 162,000 new jobs includes 48,000 temporary census jobs. What happens when these jobs go away? And compared to the millions of jobs lost, 162,000 jobs doesn’t feel like anything to celebrate in the first place.

According the Associated press, in February the pending home sales number jumped 8.2%. This is not year-over-year but rather from January to February. Don’t know if anyone remembers but it was awfully cold in January. Historically home sales slow down during winter, especially when you have pretty bad snowstorms. An 8% increase doesn’t sound like newsworthy at all.  Additionally, the government has been offering a ton of incentives to home buyers, which is probably just cannibalization of future home buying. From the California Association of Realtors:

Californians have a brief window of opportunity to receive up to $18,000 in combined federal and state home buyer tax credits.  To take advantage of both tax credits, a first-time home buyer must enter into a purchase contract for a principal residence before May 1, 2010, and close escrow between May 1, 2010 and June 30, 2010, inclusive.  Buyers who are not first-time home buyers may use the same time frames to receive up to $16,500 in combined tax credits if they are long-time residents of their existing homes as permitted under federal law, and they purchase properties that have never been previously occupied as provided under California law.

And why is the DOW on the verge of breaking 11,000? Is it the fact that the government spent around a trillion dollars propping up the economy or could it be that consumer spending is back? May be its consumer spending. After all, the malls seem full around here. But did you hear that 25% of homes in the US are underwater on the mortgage on 14% of all houses are in some state of default? Being in default means that the monthly mortgage payments are not being made. Doing some back of the envelope calculations, TraderMark was able to put a figure on these numbers. By not paying their mortgage, Americans have an extra $160 billion per year to spend on clothes, cars, vacations and other random stuff.  To see the numbers, check out this post on the hidden stimulus package. No wonder the retailers have been doing well!

And are the interest rates trending higher because the market expects a recovery? Or is it because it expects inflation? If you look at the number of people clamoring for TIPS (Treasury Inflation Protected Securities), the number is trending higher as well. Seems like people aren’t big believers of the US Government’s ability to curb long term inflation.

So what is it – peaches and cream or doom and gloom? The truth is somewhere in the middle. With the government willing to spend money (it doesn’t have) to keep stimulating the economy, it looks like the economy is recovering pretty well. But it cannot come without consequence. At some point someone will have to pay the price of all these bailouts and packages. It might be us, our children or foreign bond holders, but that day will come. Just make sure you invest accordingly.