Issue 60- April 01, 2010

Grand Isle to Lincoln

The longest straight stretch of the entire U.S. interstate highway system runs along I-80 in Nebraska, from Grand Isle to Lincoln. While it is only 72 miles or just about an hour of travel time, it is not like the rest of this particular road provides much in the way of variety or distractions. Much the same could be said about the current investing backdrop. Restoring liquidity and stabilizing the markets was job number one. Now, the long road to a lasting recovery is only just beginning.

Mile Post 312

The Federal Reserve in their March 16th meeting once again reiterated their commitment and expectation to maintaining a low benchmark rate for the foreseeable future.

The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period.

What they don’t say explicitly is that this policy allows the needed healing process to continue within the banking and real estate markets. This is no accident. Bank failures picked up in 2010 right where they left off at year end and with a steady pace of 41 institutions closed thus far in the first quarter. This painful process comes on top of the closing of 140 in 2009 and is absolutely a required element of the credit cleanup. Until such time as local lending markets are in a position to go back on offense and actively market credit to small businesses, job creation will continue to remain impaired. Even though that time will not come fast enough, we are able to see a path to the ultimate resolution. If we consider that as of year end the FDIC had identified 702 institutions on their “problem list” and we are cleaning up around 150 banks per year…. It could potentially take another 4.5 years to chew through the list. While this process no doubt has the look and feel of driving through Nebraska, it does provide a tangible map on which to make decisions and anything that provides clarity is a welcome development.

Continuing in that vain, the Federal Reserve has now testified on numerous occasions as to the tools it will employ to remove the excess liquidity and accommodation from the system. There are those who have taken this outline to mean that the board of governors has plans to imminently raise rates. Good luck with that. With 10% unemployment, hundreds of failed banks still operating within the system, residential real estate sales slowing, and the official wind down of the Quantitative Easing mortgage purchasing program set for March 31st, the last thing they need is to create speed bumps in their own plans.

Mile Post 353

Commercial real estate problems are accelerating. A number of high profile properties have recently either missed interest payments or were foreclosed upon. These would include our own hometown Columbia Tower which was purchased in 2007 for $621mm by Beacon Capital Partners. The principal balance on the $480mm mortgage now exceeds the assessed value of the building of $380mm. The equity is gone and junior debt holders may also be wiped out. With vacancies rising and rents dropping, the income on the property no longer is sufficient to cover the $1.65mm monthly interest payment. Adding complication, this loan is just one of a dozen others which were packaged into a commercial mortgage backed security (cmbs) now owned by numerous institutional investors. The government has established the “Legacy Securities Public Private Partnership” or PPIP in an effort to create a functioning market for these securities. There are 8 private sector fund managers who have competed to participate in its establishment and we are reviewing the opportunities that might be available for our clients.

It is not just office buildings that can’t meet their debt service; 2010 has also featured the foreclosure of other types of commercial properties including high profile hotels and golf courses. The Stone Eagle Club in Palm Desert was forced to cease operations just last month. These more discretionary projects will be extremely difficult to evaluate and will require even more creative ownership solutions. While each of these cases provides the opportunity for a strategic purchase, the challenge remains one of timing and resources. Can the analysis and purchase plans keep pace with the ever growing wave of defaults and what is the potential capital pool available to absorb not only the defaulted properties but also the $1.3 Trillion in current commercial debt maturing over the coming few years?

Mile Post 399

Equity markets posted a solid positive quarter on modest volume and without much in the way of net new cash flows as measured by mutual funds. This phenomenon has been frequently referred to as a “melting up” of stock prices and worries many pundits as simply a speculative phase. But if net new cash into mutual funds is not the driver of demand then what is the source? We suspect that just as we have seen tremendous reallocations into liquid fixed income markets by the institutional community, it also seems clear that they are also putting more money back to work into traditional, liquid, long only equity strategies.

Bond funds continued to enjoy the torrid pace of contributions across a variety of taxable and tax exempt sectors. Rates remained fairly stable throughout the quarter and this in a period where we have begun to see a transformation in the US Treasury market auctions to include substantial purchases by domestic accounts. Initial reports of diminished foreign central bank appetite were met with widespread concern, but we would argue that healthy domestic demand is at least as positive an offset considering years of under allocations to the asset class. Corporate, mortgage, and municipal bonds all enjoyed strong demand again offsetting slightly higher US Treasury rates.

P.I.G.S. are a Problem

The ECB dealing (or the lack thereof) with the Greece debt problem was perhaps the single biggest financial development of the first quarter. Concerns about the credit worthiness of a member of the confederation, exposed a long nagging worry that a single policy which floated such disparate credits as Germany and Greece was destined for abuse.

While the absolute size of the problem associated with Greek debt is relatively small, it is still an intractable problem. The fact that the most credit worthy member, Germany, is either unable or unwilling to step in speaks volumes. The EU by charter can’t force out a member nor can they take over their debts. Instead, they are looking to craft a solution in conjunction with the International Monetary Fund. This is a stunning failure of will.

The IMF was established at the end of World War II to help promote exchange rate stability and trade. In the modern era, they are most frequently involved in smaller, emerging market countries that do not have the wherewithal to establish or maintain credit on their own. Their terms are typically stark and currency devaluation is a primary tool. But Greece has already rejected these types of terms when suggested by Germany and there will be no mandated devaluation of the Euro. Greece simply can’t go back to the Drachma. The ECB can neither live with Greece in their current form, nor can they seem to cajole them into something more financially sober. This unpleasant episode will likely be repeated to somewhat lesser degrees in the coming months with regards to the other P.I.G.S. nations. Needless to say this has put downward pressure on the Euro and is likely to continue to do so until such time as an acceptable solution presents itself. Meanwhile, the ECB has done the one thing that it can to support its weakest relative, it will continue to accept Greek bonds as collateral at their main borrowing facility albeit with a bigger discount than in the past.

None of the first quarter’s themes is likely to dissipate in the second. For example, while we may see some pressure on rates, demand is likely to stay strong. Economic results will be muddled and depending on the argument one wishes to put forward, there will be something to “prove” your point. As investors, we will remain vigilant against deflation and continue to emphasize quality throughout asset classes.

Best Wishes,

Patsy and Jen

• Grand Isle to Lincoln
• Mile Post 312
• Mile Post 353
• Mile Post 399
• P.I.G.S. are a Problem