The Dangers of Investing In Muni Funds

Ulli Uncategorized Contact

For over a year I have warned against investing in municipal bond funds, because I believed that there would be some fallout from the credit crisis affecting this market segment as well, which turned out to be correct.

The weekly table in section 7 of my StatSheet (see table above) clearly showed that most of the muni funds I track have lost sharply. To me, it has never made much sense to invest for a good yield yet at the same time lose big on the principal side.

On that subject, Bloomberg reports that “Pimco Muni Funds Down as Much as 60% to Buy Auction Shares:”

Pacific Investment Management Co. plans to redeem preferred shares from six closed-end municipal bond funds that lost as much as 60 percent this year.

The Pimco funds, which plummeted after suspending dividend payments to common shareholders, said yesterday they will redeem $407 million in auction-rate shares next month, after declines in the municipal market drove their holdings below minimums relative to the amount of money they’ve borrowed.

Plunging debt prices have pushed closed-end funds to defer dividends and reduce borrowing to comply with U.S. securities law. Funds that issue preferred shares are required to maintain net assets of at least 200 percent of the amount of leverage. Municipal-fund investors are likely to show little patience for those that miss dividend payments, said Jeff Laverty, a closed- end fund analyst at Oscar Gruss & Son Inc. in New York.

“That’s the reason they’re in these things: to provide current income,” Laverty said.

The funds are Pimco New York Municipal Income, Municipal Income Fund II, California Municipal Income Fund II, Municipal Income Fund III, California Municipal Income Fund III and New York Municipal Income Fund III.

Closed-end funds, unlike the open-end variety, issue only a fixed number of common shares that trade on an exchange like stocks. Investors in the funds have suffered a series of blows this year that have pushed share prices to record discounts. In February, the auction-rate market collapsed, eliminating a source of new financing and leaving holders of preferred shares unable to sell. In recent months, falling prices on the bonds in their portfolios have forced the funds to cut their borrowing.

Pimco, a unit of Munich-based Allianz SE, announced the dividend suspension on its municipal funds Dec. 1.

“When Pimco suspended their dividends on six of their municipal funds because of asset coverage issues, their share prices tumbled,” Cecilia Gondor, a closed-end fund analyst at Thomas J. Herzfeld Advisors Inc. in Miami, said in an e-mail earlier this week.

The average return this year for municipal bond mutual funds tracked by Bloomberg has been a 14 percent drop. The six Pimco closed-end funds were down about 49 percent to 60 percent this year, placing them among the nine worst-performing funds in their class, data compiled by Bloomberg show.

Investors have shunned lower-rated securities in recent months, making it harder for municipal funds to find buyers for higher-yielding tax-exempt debt in the secondary market. Among the Pimco funds’ top holdings were securities backed by U.S. states’ and counties’ tobacco-settlement revenue, according to Bloomberg data.

Merrill Lynch & Co.’s total-return index of municipal tobacco bonds has lost 17.3 percent this year, the worst since the 1998 settlement with cigarette makers opened the door for the securities.

[emphasis added]

Those investors who mistakenly assumed that tax-free investing in Muni Funds, or any income funds for that matter, carries less risk than equities, have been bitterly disappointed by seeing their portfolios slashed in half. The lesson simply is that there is no investment in existence that you can assume to be safe from severe market declines.

So, let me play that same old song again to “never, ever invest in anything without an exit strategy.” I have been harping on this since the last bear market wiped out fortunes; unfortunately, I still have not been able to get the message across to everybody on Main Street America. If you’re reading this, and agree with it, please pass this blog and newsletter on to family, friends and co-workers.

Sunday Musings: The Next Mortgage Shock

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Wall Street, along with many investors, seems to long have forgotten Subprime mortgages, which ignited the economic crisis we’re currently in.

However, there are other dangers lurking which most people are not aware of. I am talking about the upcoming recasts of Alt-A (liar loans) and Pay-Option ARM mortgages (less than interest only loans).

The more recent focus has been on lower interest rates, and how they will actually help home owners lower their payments as their mortgages get reset. While this is true, the more important fact that has not been mentioned is what happens when their mortgages get recast.

So what’s the difference between reset and recast?

Most mortgage of the past are of the adjustable kind where the interest rates are adjusted (reset) once a year. With lower rates, that has benefited many homeowners. The problem is that just about all mortgages have a 5-year term, after which they are recast. It simply means that any negative amortization is added to the loan balance, which is then amortized over the remaining 25 years.

In that case, low interest rates won’t help much, because an amortized loan has higher payments than an interest only loan.

How much higher?

One reader wrote in and said that his payment went from $2,137 to $3,730 per month, which is an increase of almost 75%. It’s pretty clear that most people with these types of loans have not gotten a similar raise recently to absorb the difference in payments. This now has become no longer a matter of lower interest rates, but a matter of cash flow.

There are over $600 billions of these types of mortgage in the market with the majority having been placed in California and Florida.

CBS featured a video on the subject titled “A Second Mortgage Disaster On The Horizon.” It pretty much explains the upcoming mortgage resets over the next 2 years.

Why bring it up?

I am not trying to focus on the negatives here, but I am trying to realistically assess what is on the economic menu for the next couple of years. These mortgage recasts will certainly not contribute anything positive, so be prepared that there will be some kind of a fallout effect on the stock market as well.

Just because we are seeing a rebound rally off the lows right now does not mean all is well. To protect yourself, if you invest in the markets, always have an exit strategy, because it will save your bacon if you’re wrong or if unforeseen events suddenly reverse market direction.

This year has confirmed that simply holding on to investments no matter what is nothing more than gambling and/or unnecessary risk taking. If you lost because of it, don’t make the same mistake in the future again.

Looking At The Big Picture

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It’s easy to get caught up in the day-to-day news barrage and meaningless market fluctuations on Wall Street. Additionally, endless discussions as to whether we have hit a permanent bottom or not add to the confusion.

My point has always been that it’s far more important to focus on the bigger picture, which is why I look at major trends via my Trend Tracking Indexes and not minor ones, which may serve the day trader but not the long term investor.

Sometimes it is useful to look at current market activity in historical context to see if there are any parallels to give us some indication as to what might be in store in terms of market direction. Calculated Risk pointed to an excellent chart, which was first featured at dshort.com.

Take a look (double click to enlarge):



It shows the drops of the worst four bear markets in history. What immediately caught my attention was the fact how similar the Crash of 1929 was (left arrow) compared to this year’s drop of the S&P; 500 (right arrow).

Even though the measurement of the 1929 bear was done via the Dow Jones, while this year’s data represent the S&P; 500, there are uncanny parallels. I can now see where many forecasters have come up with the fact that we possibly could be in a bull market for a year or so, before the bottom slowly and surely drops out again in a similar fashion like in the 1929 crash. This is most likely were predictions of a low for the S&P; 500 of 450 to 650 have come from.

I have no idea, if the markets will play out a similar scenario as in 1929 although current economic conditions clearly support that possibility. However, I am sure of one thing. Many investors will be drawn back into the market if the bullish trend continues for some time. The assumption will be that happy times are here again and maybe they will be.

My view is that far more downside risk remains. However, by the time bearish tendencies become obvious to the public, the lessons of 2008 will be long forgotten, and most buy-and-hold investors will again take another serious portfolio hit as the markets slowly deteriorate.

As time goes on, I will review this chart occasionally to see if the similarities continue or if we in fact challenge history with a new bull market.

No Load Fund/ETF Tracker updated through 12/18/2008

Ulli Uncategorized Contact

My latest No Load Fund/ETF Tracker has been posted at:

http://www.successful-investment.com/newsletter-archive.php

Despite a celebratory rally, caused by the lowest interest rates ever, the major indexes made no noticeable headway this week.

Our Trend Tracking Index (TTI) for domestic funds/ETFs remains below its trend line (red) by -8.51% thereby confirming the current bear market trend.



The international index now remains -21.01% below its own trend line, keeping us on the sidelines.

For more details, and the latest market commentary, as well as the updated No load Fund/ETF StatSheet, please see the above link.

Who’s Responsible?

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Many readers have complained about the poor handling of the credit crisis by the government along with the bailout orgy involving many industries at tax payer’s expense.

Who is really at fault for the problems that plague this country? To get closer to the truth, the following was sent in by a reader referencing an article written by Charlie Reese, a former columnist for the Orlando Sentinel Newspaper (sorry, no link):

Politicians are the only people in the world who create problems and then campaign against them.

Have you ever wondered why, if both the Democrats and the Republicans are against deficits, we have deficits?

Have you ever wondered why, if all the politicians are against inflation and high taxes, we have inflation and high taxes?

You and I don’t propose a federal budget. The president does.

You and I don’t have the Constitutional authority to vote on appropriations.

The House of Representatives does.

You and I don’t write the tax code, Congress does.

You and I don’t set fiscal policy, Congress does.

You and I don’t control monetary policy, the Federal Reserve Bank does.

One hundred senators, 435 congressmen, one president, and nine Supreme Court justices 545 human beings out of the 300 million are directly, legally, morally, and individually responsible for the domestic problems that plague this country.

I excluded the members of the Federal Reserve Board because that problem was created by the Congress. In 1913, Congress delegated its Constitutional duty to provide a sound currency to a federally chartered, but private, central bank.

I excluded all the special interests and lobbyists for a sound reason. They have no legal authority. They have no ability to coerce a senator, a congressman, or a president to do one cotton-picking thing. I don’t care if they offer a politician $1 million dollars in cash. The politician has the power to accept or reject it. No matter what the lobbyist promises, it is the legislator’s responsibility to determine how he votes.

Those 545 human beings spend much of their energy convincing you that what they did is not their fault. They cooperate in this common con regardless of party.

What separates a politician from a normal human being is an excessive amount of gall. No normal human being would have the gall of a Speaker, who stood up and criticized the President for creating deficits. The president can only propose a budget. He cannot force the Congress to accept it.

The Constitution, which is the supreme law of the land, gives sole responsibility to the House of Representatives for originating and approving appropriations and taxes. Who is the speaker of the House? She is the leader of the majority party. She and fellow House members, not the president, can approve any budget they want. If the president vetoes it, they can pass it over his veto if they agree to.

It seems inconceivable to me that a nation of 300 million can not replace 545 people who stand convicted — by present facts — of incompetence and irresponsibility. I can’t think of a single domestic problem that is not traceable directly to those 545 people. When you fully grasp the plain truth that 545 people exercise the power of the federal government, then it must follow that what exists is what they want to exist.

If the tax code is unfair, it’s because they want it unfair.

If the budget is in the red, it’s because they want it in the red.

If the Marines are in IRAQ , it’s because they want them in IRAQ .

If they do not receive social security but are on a n elite retirement plan not available to the people, it’s because they want it that way.

There are no insoluble government problems.

Do not let these 545 people shift the blame to bureaucrats, whom they hire and whose jobs they can abolish; to lobbyists, whose gifts and advice they can reject; to regulators, to whom they give the power to regulate and from whom they can take this power. Above all, do not let them con you into the belief that there exist disembodied mystical forces like ‘the economy,’ ‘inflation,’ or ‘politics’ that prevent them from doing what they take an oath to do.

Those 545 people, and they alone, are responsible.

They, and they alone, have the power.

They, and they alone, should be held accountable 100% by the people who are their bosses provided the voters have the gumption to manage their own employees.

We should vote all of them out of office and clean up their mess!

It’s hard to argue with his viewpoints; however, I would add that changes will never happen because I don’t see any way where you could get 545 people to agree on anything. Even if they were all replaced, pretty soon we would be back to business as usual.

Reaching ZIRP

Ulli Uncategorized Contact

Even though it might have been the worst kept secret of the year, The Federal Reserve, in an unprecedented move, set its key interest rates at 0% to 0.25%—the lowest level in history.

This makes the U.S. the first country to actually implement ZIRP (Zero Interest Rate Policy). Surely, others will follow as the global recession deepens. Like a drunken sailor, the stock market took ZIRP as a confirmation that this is a good thing and rallied to higher levels. Never mind, that this desperate move by the Fed signals that, economically speaking, the worst is far from being over.

Additionally, the central bank said that they would pump more cash into the economy, a process that is called quantitative easing. The money spigots are now wide open in an attempt to stimulate growth and find a floor for the housing market. Only time will tell if this approach will have the desire effects. If mortgage rates follow suit and take a steep drop as well, you might see a flood of new refinancing applications and qualified buyers taking stabs at buying real estate.

Nobody can be sure about the outcome because we are in un-chartered territory. As I said before, short-term the market trend is up; long-term we are still in bearish territory by -9.38% according to my Domestic Trend Tracking Index (TTI).

We have now been out of the market since our last sell signal was generated on 6/23/08, a date from which the S&P; 500 has now dropped over 30%. Having avoided this haircut affords us now the luxury of not having to desperately participate in bottom fishing to attempt to make up losses. We are in now in the enviable position of being able to wait until a major trend reversal has occurred before returning to equities.