April 2004 Newsletter
Issue Four, Volume Five

THE SAME OLD STORY

By Mike Gasior

It is my habit to read an amazing number of periodicals in the course of any given month and this has been a fairly standard practice for me for the better part of the past 25 years. Whether it's newspapers, magazines, catalogs or now the near bottomless pit of information available via the Internet, it has always proven fascinating to me all the amazing things that seem to happen in the world during any given day. This is what makes it so difficult for me to decide what stories and situations I feel like expanding upon in this monthly tirade of mine. Sometimes I cannot help but discuss one of the major news stories because there is usually a reason they are considered major. More often, I enjoy focusing on stories somewhat off the beaten path that I think are important and deserving of more attention.

This will be the case this month. There are two stories I found important and not getting much mainstream media attention and wanted to focus more attention to. The third subject I decided to address is just plain interesting to me. The topic of my video commentary will be the scary situation the U.S. Treasury has put the United States in with the changes in how they've been borrowing money over the past seven years or so. With even the slightest rise in interest rates, we could see an enormous hole blown into the U.S. Federal Budget. You can view the video commentary by visiting the homepage at:

http://www.afs-seminars.com

Now onto the topics of the month.

WASN'T THE EXECUTIVE LIFE STORY LONG OVER?

For those of you who only faintly remember the name "Executive Life", they were a spectacular corporate failure long before there ever was a WorldCom and prior to you ever hearing about a company named Enron. Executive Life was a terrifically successful life insurance company headquartered out in California and rose to an amazing stature during those roaring 1980's. They offered a host of innovative insurance products as well as outstanding returns for their policyholders. Perhaps the most impressive was the fabulous ratings from Moody's and S&P (Aaa & AAA respectively) that gave Executive Life a very special aura when compared to larger, older and staid life insurance companies. Executive Life was the new breed of insurance company and viewed as the model for the future. That was the case, of course, until they came tumbling down into insolvency.

You see, the way Executive Life was able to offer these outstanding returns was in savvy investments in the Junk Bond market. The guy running things at the time was a guy by the name of Frederick Carr who had a friendly and tight relationship with none other than Michael Milken himself. The trouble began in 1991 when a crash in the Junk Bond market caused Executive Life's portfolio to tumble, and ultimately they ended up in receivership. As an interesting side note, they wore their AAA/Aaa ratings right into bankruptcy court, but that is the subject for a whole other newsletter.

Now the insurance commissioner in the State of California wanted the policy holders of the failed company to be compensated to the fullest extent possible and the insurance company and the assets they held were put up for sale to the highest bidder. There were many interested parties to this auction, but none more interested than the highest bidder, the French bank, Credit Lyonnais, which at the time was owned by the French government. Credit Lyonnais thought the bond portfolio of Executive Life might actually recover nicely and there was potentially a wonderful windfall in store for whoever ended up with the Executive Life inventory of Junk Bonds. The only problem was, there were a variety of laws that prevented Credit Lyonnais from owning a company like Executive Life.

For one, the Glass-Steagall Act was still in effect back in 1991, and it barred banks from owning certain non-bank entities like Executive Life. Plus, there were California State laws that prevent banks owned by foreign governments from owning California insurance companies. But Credit Lyonnais was not going to be deterred that easily, even though violating these laws could result in criminal prosecution, stiff fines and being thrown out of the U.S. banking market by the Federal Reserve.

To disguise who was actually purchasing Executive Life and their bond portfolio, Credit Lyonnais put together a group of French investors to be face for the purchase, particularly French billionaire Francois Pinault who owns Gucci, the Christie's auction house and the huge French retailer Printemps. Credit Lyonnais and the partners crafted a secret deal where the partners would make the purchase, but where Credit Lyonnais was the true buyer. Ultimately Credit Lyonnais would sell the insurance company and some of the bond portfolio to Mr. Pinault as his reward for being the public face of the transaction.

To make a relatively long story a lot shorter, the bond portfolio DID rebound and the purchasers enjoyed a profit of just over $2.5 billion. Unfortunately, however, for Credit Lyonnais and Mr. Pinault there was someone intimate to all the secret agreements and deals who decided to become a whistle blower to the U.S. Government and to the State of California. The identity of the whistle blower is still secret and may never be known.

Needless to say, these revelations were quite bothersome to the U.S. Attorney's office in Los Angeles, as well as the State of California Insurance Commissioner. As you might expect, indictments were prepared to bring charges against all the participants for their illegal behavior. As you might ALSO expect, the French government thought the entire matter was trivial and would ultimately be swept under the rug through diplomatic and political channels. Although there were numerous meetings and discussions between the Bush and Chirac administrations, it seems the Bush crew was not a sympathetic audience and the decision was made to let the Los Angeles prosecutors pursue their case without any interference or comments whatsoever. Even still, the French government refused to believe that any of these charges were particularly serious, nor were they concerned that this case would result in anything more than a slap on the wrist for anyone involved.

Unfortunately for everyone involved, the prosecutors thought the charges were extremely grave, and obtained secret indictments against the French government, Credit Lyonnais, Mr. Pinault, and an assortment of French bankers during July of 2003. Finally, the negotiations began in earnest to reach a plea bargain that would assure that no one would serve time in jail, and to bring these matters to a close.

This criminal case of fraud ultimately was settled recently with:

• A guilty plea to criminal fraud by the French government and others involved.
• A total of $770 million dollars in fines, which is the largest criminal settlement in U.S. history. The fine broke down as follows:

*$375 million paid by the French government.
*$200 million paid by Credit Lyonnais.
*$185 million paid by Mr. Francois Pinault.
*$10 million paid by MAAF (A French insurance company who fronted the transaction)

Suffice it to say, this was all fairly bad news for the whole sorry crew, but things might actually be getting much worse for them. It seems the California Insurance Commissioner's Office is still feeling like they've been robbed and have filed a massive civil suit seeking about $5 billion from the participants including about $2 billion from Mr. Pinault himself. Obviously, if a jury comes back with a punishing verdict, this may lead to a fire sale at Gucci, Christies and other places as Mr. Pinault is asked to produce a sizable check. One must also figure this whole situation is probably also serving to sour (even further if that's possible) the relationship between the U.S. and French governments.

As much as you might think I'm just sticking it to the French once again, you have to admit that the story is intriguing and a bit intoxicating. After all, how often is a sovereign government ever found guilty of criminal behavior of any kind. Much less, the accuser and the accused both being members of the G7. And yes..I know it's now officially the G8, but Russia has a lot of work ahead of them before they belong (economically) in the category of the other seven countries, but there is yet ANOTHER newsletter topic.

Now we can wait and see how much uglier this situation may become. One thing is always true with me; if two guys want to fight, I am ALWAYS happy to hold their jackets for them.

RISK IN THE MORTGAGE-BACKED SECURITIES MARKETS

Bringing up this subject puts me in the precarious situation of needing to explain precisely what the risks are, and why the current state of the economy might present risk. Since I have chosen to be a teacher on these subjects, I will simply don my teacher's hat and lay down some basics regarding the bond market overall.

Fact One - Bond prices will move in the opposite direction of interest rates. If interest rates are going up, bond prices are going down. This relationship is always true.

Fact Two - The longer the term of the bond, the more its price will move as interest rates change. Although I don't mind people thinking that it is the maturity of the bond that is important, the actual truth is that the duration of a bond is what truly will help you understand how sensitive the bond's price will be to changing interest rates. The most simple and economical way that I describe duration to audiences that don't understand it, is by saying; "Duration is the average time it will take you to receive the present value of all the cash flows on your investment." So a more accurate statement than the first sentence of this paragraph would be to say that the longer the DURATION of your bond, the more sensitive the bond will be to changes in interest rates.

Fact Three - Duration is not a static thing. The duration of your bond will change somewhat as interest rates change, since one of the components of calculating duration is present value. The present value of a dollar you are going to receive five years in the future depends on what current interest rates are. So as interest rates change, present values will change, and ultimately your duration of your bond changes too. The concept that measures this phenomenon is called convexity.

Fact Four - Securities that are made up of mortgages have very volatile durations, especially when compared to run of the mill bonds, since homeowners are free to prepay their mortgages literally anytime they feel like it. The trouble for investors in these mortgage-backed securities is that the homeowners always seem to do exactly the OPPOSITE of what you wish they would do. When interest rates drop, they'll prepay their mortgages like crazy when you wish they wouldn't. When interest rates rise, they'll sit tight and the stream of prepayments dries up. What this all boils down to, is that the duration of your mortgage-backed securities will get very short when you wish you had long, and extremely long, when you wish they were short.

So what is the purpose of this extremely boring lesson? Well simply to illustrate the potential risk currently in the market should interest rates begin to rise in any earnest way.

Let me clearly state that it is my belief that the Federal Reserve and Alan Greenspan had no choice but drop interest rates as aggressively as they have done since 2001 since the U.S. economy was at risk of literally falling off a cliff. If the economy is truly in a recovery stage at this point, it is completely thanks to the extraordinary stimulus provided by the Federal Reserve with their rate cuts, as well as the massive tax cuts instituted by U.S. Government. The level of stimulus pumped into the U.S. economy was without precedent, and it would have frankly been shocking if there had been no effect. The rebound currently being experienced is directly associated with these actions.

The problem, however, are some potential asset bubbles created by these moves. One is definitely the rise in U.S. housing prices, and the second is the current level of the U.S. stock market. With even the slightest increase in mortgage rates you will see an immediate and perhaps horrifying effect on the value of home prices. You will also likely witness a potentially scary decline in stock prices as well. One unfortunate side effect of historic low interest rates like the U.S. has been experiencing in recent years are people accepting higher levels of risk than they are actually willing to live with. People that might normally prefer CD's and bonds feel compelled to move to the stock market since the returns offered by such low rates seems abysmal. Also, people are willing to take on levels of mortgage debt that they would have never imagined possible because rates are so amazingly low. Somehow they rationalize that the huge principal balance is balanced by the historically low rate. They will also explain to me how real estate always goes up in value, and throw me puzzled looks when I remind them of the real estate market bubble experience in the Northeast and California during the late 1980's that took nearly 10 years to recover from. But these asset bubbles were not even the concern I was trying to address.

A third potential bubble that worries me is the large marketplace for mortgage-backed securities, and the extremely negative affect any rise in interest rates will have on their duration, and price.

The last ugly move we had in interest rates that caused billions of dollars in damage to the bond market was only ten years ago. Back in 1994, Alan Greenspan and the Federal Reserve sensed that the economy was growing a bit too fast and began raising interest rates to slow things down in bit. To give you one point of reference, the yield on the 30-year Treasury bond rose from around 5.85% up to about 8.15% over a 10-month period. What people seem to forget was the extent of the casualties that piled up including Orange County California, Kidder Peabody (the largest MBS broker in the world at the time), a variety of hedge funds including Askin Management, which went from $600 million in assets to zero over a long weekend. Investors in a variety of mortgage-backed related securities lost billions and billions of dollars, but once again the human learning curve is essentially tabletop flat since I see a similar situation in place again.

The only troubling difference I can see, however, is that the mortgage-backed securities marketplace has tripled in size since 1994. Also, with some consolidation in the brokerage community during the past few years, there are fewer brokers for you to call when your MBS portfolio starts heading south.

Remember one fundamental thing about the bond market, and that is the fact that bonds trade primarily over-the-counter. There is no "bond exchange" where the brokers connect buyers and sellers and charge a commission. When you want to buy or sell almost any fixed income product, the broker you call on the phone is either going to sell to you OUT of their own inventory, or purchase from you INTO their own inventory. Your broker is actually the other party to the transaction, and those bonds will sit in their inventory until they find another client of theirs, or another trading desk to buy that bond from them. Obviously, while that bond sits in their inventory they will be taking market risk with regard to price.

Now is the time to start adding things up.

Step One - Interest rates begin to rise.

Step Two - Mortgage-backed securities durations begin to grow longer.

Step Three - The longer the duration, the more your MBS goes down in price.

Step Four - Some investors decide they can't stand the decline and start calling their brokers.

Step Five - The brokers are already holding plenty of this stuff in their own inventories and are getting killed too.

Step Six - If enough clients keep calling, brokers have to start dropping prices they are quoting dramatically to protect themselves.

Step Seven - Other investors who weren't panicking see this drop and price and start panicking. Now they call their brokers.

Step Eight - Some brokers stop even giving prices, quote insanely low prices, or take their phone off the hook.

Step Nine - Total anarchy now kicks in.

Step Ten -You have now reached the situation that occurred 10 short years ago in 1994, and Mike Gasior says, "I told you this might happen."

So my advice is simply to understand the animal you've chosen to invest in, should it be mortgage-backed securities. And should the above scenario actually take place, try to remain calm and do not panic. Those who rode out the episode back in 1994 were nicely rewarded for their patience.

LIVING IN A WAL-MART WORLD

Let me first say, that in the past five years or so, I have grown into a total and complete fan of the Wal-Mart experience. It has now come to the point that if I know Wal-Mart sells a particular item; I won't even bother to shop around for the lowest price. I'll simply head on over to Wal-Mart and make the purchase with reasonable confidence that I'm getting the best deal.

I've grown somewhat sick of the cultural elitists who look down their noses at both Wal-Mart and the people who shop there, claiming the costs to society outweigh the benefits of cheap motor oil and dog food. Frankly, I wish these complainers would keep their whiny opinions to themselves and continue to purchase their Brie and Chardonnay wherever they do their shopping while allowing me to accumulate cheap TV's, DVD's and CD's to my hearts content. After all, cheap stuff is cheap stuff.

To understand what a monster Wal-Mart has become, consider the following facts:

• Wal-Mart produces EIGHT times more revenue every year than Microsoft.
• That amount of revenue is a teeny bit more than the Gross Domestic Product of Sweden.
• Wal-Mart now has as many supercenters (stores that combine a complete regular Wal-Mart with a complete supermarket) as it has regular retail stores and Wal-Mart is now the largest grocer in America. Wal-Mart is also the third largest pharmacy in the U.S.
• Wal-Mart intends to open another thousand of these supercenters during the next five years.
• Arkansas has a population of about 2.7 million people and has more than 85 Wal-Mart stores.
• The New York City Metropolitan area has over 8.0 million people and no Wal-Mart stores.
• Los Angeles has a population of around 9.0 million people and has one Wal-Mart.
• Wal-Mart sells more stuff every year than Kmart, Sears, Target, Walgreens, JCPenney and Kroger...COMBINED!
• 82% of everyone in the United States bought at least SOMETHING at Wal-Mart in 2002.
• One out of every three diapers sold in America is sold at Wal-Mart.
• If Sam Walton were still alive today (he died at 74 in 1992) he would easily be the richest person in the world with a fortune about double the size of Bill Gates.
• In 42 years of operation, Wal-Mart has NEVER grown less than 10% in a year and their sales are already up 11.6% in 2004.

So there may always be those people who look down on lowly Wal-Mart, but they should spend more of their apparent free time looking for a better run business than this one.

YOUR MONTHLY BRAIN TEASER

As well received as my musical Top Ten lists are (sometimes), I thought I might give the brain teaser this month a musical bent. I've worried that too many of them have leaned in the direction of mathematics, so this edition features a question open to players of all levels. So here goes...

The name of what world famous singer can be made out the letters contained in the following words:

"WORD TREATS"

After some contemplation on your part, you can view the solution at this URL:

http://www.afs-seminars.com/brainteaser_Apr2004.html

And the answer to LAST month's brainteaser is:

To express a 19/94 in the form of 1/m and 1/n, where the m and the n are positive integers, first it must be observed that since 19/94 < 1/4, then m and n must both be greater than 4.

Now 19/94 = 1/m + 1/n = (n+m)/mn, so 19mn = 94(m+n). Since 47 is a prime factor of 94, then 47 must divide by m or n. We can assume that 47 divides n. Thus, 1/n is equal to/or less than 1/47. Since 1/m = 19/94 - 1/n, the inequality means 1/m = 19/94 - i/n is equal to/or greater than 9/94 - 1/47 = 17/94 > 1/6. Thus m < 6, and since m > 4, then m must equal 5, so that 19/94 = 1/5 + 1/470.

http://www.afs-seminars.com

Copyright 2004, Michael Gasior. All Rights Reserved.

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