Charter Trust - Global Market Update

Financial (in)Security? Is securitization a boon or a bane? Securitization is one of those five-dollar words that gets leaves people scratching their heads. It’s been alternately described as the greatest financial innovation since double-entry accounting or as the worst banking product since the Bombay-based call-center. Securitization is just what it sounds like: it takes ordinary loans and bundles them up into securities. It’s been around a long time, as long as banks have been selling loans to one another. In the 1850s, during the California Gold Rush, westward expansion led to a boom in railroad construction. This required money, and by the middle of the decade there was over $400 million in outstanding railroad bonds, many of which were mortgage bonds—secured by the railroads’ land. When land values declined, the bonds defaulted, leading in part to the Financial Panic of 1857. But most bonds are quite safe: Treasuries, Municipals, Corporates. The US has a bond market worth some $15 trillion. Just about any cash stream can be securitized. Music fans may remember Bowie bonds: royalties from his albums were so stable that Prudential bought bonds based them in 1997 Only a small portion of our bond market—sub-prime mortgage loans—got into trouble in 2007-8. But the risk of that sector was concentrated in a few critical financial institutions, which fell like dominos: Bear Stearns, Fannie Mae, AIG, Lehman. The ensuing financial crisis led to a huge recession, the effects of which are still with us. This has made many investors and regulators shy of the whole securitization process. But when you fall off a horse, often the best thing to do is to get right back on again. The problems of the financial crisis weren’t the techniques, but the assets to which they were applied. At its heart, securitization moves money from where it is to where it’s needed. Until financial engineering is as trusted as civil engineering, our economy won’t grow as well as it could. Douglas R. Tengdin, CFA Chief Investment Officer Follow me on Twitter @tengdin

Getting it Right  -  Some people don’t know when to shut up. Five minutes after the Bureau of Labor Statistics released its employment report, former GE CEO and management guru Jack Welch tweeted “Unbelievable jobs numbers … these Chicago guys will do anything … can’t debate so change numbers.” The post was re-tweeted over 5,000 times in the next 10 hours. When contacted by various reporters and papers, he repeated his assertion: the unemployment statistic seemed unrealistically positive. The household survey—from which we derive the unemployment rate—showed the addition of over 800 thousand jobs in September, after six months of stagnation. “Coincidence?” he asked, “I don’t think so!”It’s certainly true that in the two employment surveys—the household survey based on 60 thousand interviews and an establishment survey based on 140 thousand businesses and government agencies—estimates are necessary and subject to interpretation. And a long time ago it was noted that people willingly see what they wish to see in all kinds of situationsBut questioning the best way to interpret a complex report with thousands of inputs and hundreds of outputs is one thing. Attributing an inconvenient statistic to “Chicago-style” boss politics is quite another. The career bureaucrats who staff the BLS and the Energy Information Agency and other government statistical bureaus don’t want to play politics. They just want to do their jobs and go home in the evening. Jack Welch was foolish to question their integrity, and stupid not to back down when he could.There are lots of problems with our government—perverse incentives, rent-seeking interest groups, system-gaming—that need informed critique. But our economic indicators aren’t one of them.

Tuning In, Turning Off?  -   Are we frying our brains?A recent study indicated that multitasking with email, SMS messaging, cell phones, and various other communication media is changing the way we think and behave. We are undermining our ability to focus, and the immediate gratification that constant messaging provides can prove to be highly addictive. Other research shows that our brains get a little dopamine jolt when we get messages. It’s pleasurable and we want to do it again.It’s becoming increasingly dangerous. Distracted driving is now the second-leading cause of accidents, after drunk driving. In some states texting while driving is considered equivalent to drinking and driving. And it’s getting worse. The new crop of smartphones with their app stores have added a level of multi-functionality that includes hundreds of thousands of possibilities.It’s no surprise that our brains change in response to new stimuli. The brain incredibly elastic, adapting its neural connections to facilitate new inputs. The connections in the brain are dynamic, with an almost infinite number of possible ways to be wired. So our brains grow new connections all the time, changing the way that we think, react, and behave.New technology has been altering the way we live for millennia. The invention of the alphabet made oral-tradition obsolete. Ever since Socrates people have fretted that new technology would erase the old ways. The key is to save the essence of what’s valuable, even if we have to embrace it in new ways. Like reading Shakespeare on an iPad. No one’s brain will get fried by that.Douglas R. Tengdin, CFA Chief Investment OfficerFollow me on Twitter @tengdin

Columbus, Columbia Why should we celebrate Columbus Day? For workaholic Americans, taking another day off seems like a waste. After all, there are reports to be run, machines to be tended, facilities to be fixed, and sales to be made. And in its initial years, Columbus Day wasn’t very popular. While President Benjamin Harrison called on people to celebrate the day on the 400th anniversary of Columbus’s landing on San Salvador in 1892, it didn’t become a state holiday until 1907, after intense lobbying by an Italian immigrant in Colorado. It wasn’t a federal holiday until 1934.Today, there is some scholarly push-back. After all, Columbus held racist views pretty typical of his era: he saw native peoples as inferior to whites. The European settlement of the Americas that followed his voyage was devastating to native cultures. South Dakota doesn’t recognize Columbus Day, but does observe, “Native American Day,” on the same day, as does Dane County, Wisconsin and the City of Berkeley, California.But there are good reasons to celebrate his landing, for all the controversy. For one thing, President Harrison particularly designated the schools as centers of the Columbus Day celebration. At that time education was increasingly viewed as essential for the preservation of a democratic republic. Immigration had been booming, and it was crucial for settling the frontier. Public schooling was seen as a way to acculturate these new arrivals.In addition, the massacre of 150-200 Lakota Sioux at Wounded Knee, South Dakota in 1890 had recently taken place, and was a national disgrace. The first Columbus Day parades saw contingents from the Carlisle Indian School in Pennsylvania march right next to students from the Dante Alighieri College of Astoria, New York. Columbus Day is a day to celebrate all the peoples who came to America—before and after 1492.There was a spirit of daring and discovery that brought Europeans here in the 15th and 16th centuries. Columbus’s landing on San Salvador changed the world. That’s not a bad reason for a day off.Douglas R. Tengdin, CFA Chief Investment OfficerFollow me on Twitter @tengdin

Too Much of a Good ThingWe often hear people say that we need to “invest in the future.” But over-investment is one of the easiest ways to destroy wealth. A few examples make this clear:In the middle of the last decade, the US overinvested in residential real estate. “Liar loans” and “NINJA mortgages” made it possible to build mansions in the middle of nowhere, and the housing  boom and bust ensued. Japan overinvested in heavy industry in the ‘80s, and its “lost decade” is still with us, 20 years later. The fearsome “Japan, Inc.” has become “Japan, the aging and stagnant society.” Russia overinvested in the ‘60s and ‘70s when it should have been satisfying consumer demandAnd overinvestment isn’t limited to governments. Kodak invested too much in its film business in the ‘90s and didn’t prepare for the digital revolution. Donald Trump has serially overinvested in casinos and hotels, and has ridden the bankruptcy process over and over again. For the life of me, I can’t understand why people see him has a business success—he’s really just managed to game the legal structure of in different states to enrich himself. The result has been a boom and bust in the gaming industry.The point is that investment isn’t an unalloyed good. If an individual, company, or government invests in an industry or technology that has a marginal or negative return, that money will be wasted. Investment is a good thing when it goes into an area with scarce resources and a bad thing when it follows the herd into a glut. A boom and a bust inevitably follow.People need to save, and that savings needs to be invested. But the object of investment is just as important as the amount. Otherwise, all that wealth is wasted.Douglas R. Tengdin, CFA Chief Investment OfficerFollow me on Twitter @tengdin

Stressing Out in St. Louis?Are you stressed?That’s what the St. Louis Fed is trying to measure. Not your personal stress level, but they have an indicator of financial stress across the country. It measures things like the difference between corporate bonds and treasury bonds, or stock market volatility, or the variability of interest rates. Eleven factors are combined into an aggregate index and is reported weekly.The stress indicator works pretty well. It shows when banks are having a hard time borrowing short-term money, or when a credit crunch might be ensuing. It ticked up back in 1998 during the Asian Contagion and then went down; it sloped higher during the bursting of the internet bubble, and popped up again after 9/11, then went back down; and it rocketed up during the mortgage crisis, as bank after bank failed. It had a mini-boomlet in the spring of 2010 and summer of 2011 with the ongoing Euro-crisis.But it’s come down pretty convincingly since then. It’s not at the low levels that might signify complacency in the markets, but it is pretty low. It means that banks, corporations, and governments can pretty much depend on the capital markets for their borrowing needs. And when institutions are able to borrow, a recession is unlikely.So whether you feel stressed or not, the market is indicating that the level of financial stress is currently pretty low. It’s not whistling “Zippidy Doo-Dah” right now, but it isn’t showing any storm clouds on the horizon, either.Douglas R. Tengdin, CFA Chief Investment OfficerFollow me on Twitter @tengdin

Losing It?  -  I lost my glasses the other day.It wasn’t remarkable; I lose them at least twice a day. I don’t need them to read, but I do use them to see at a distance. So I’m constantly taking them off to work on my computer, or putting them back on again to look out the window or to drive somewhere. So I’m always trying to remember where I set them down, or what I was doing when I last wore them.But these glasses seem to have a charmed life. They’ve gone through our dryer’s permanent press cycle, been found skulking behind the wood-bin, and even spent two hours—unscathed—in the middle of a parking lot in Richmond, Virginia. I’m tempted to think that if they fell into the ocean, a sea-bird would catch them and bring them to shore.For me, the process of losing my glasses and finding them again has become a metaphor for the global markets. Normally my day goes along, with all its tasks and projects. Then, as I need to walk somewhere, or get in my car, my stomach clenches and my mind races: “Where did I leave them THIS time?” A brief—or longer—search ensues, which up until now has always ended happily.Our financial markets do largely the same thing. Companies go along buying and selling, then a source of worry hits them: “What about inventories; are sales slipping?” The stock market pulls back, but then a solution is found and life goes on.When the market falls we need to take it seriously. The problems it faces are real. But panic is never the right response. I don’t believe that my glasses have a magic homing beacon, and I don’t believe that global markets are impervious. But somehow my glasses have always come back, and the world has a funny way of not ending. We can’t afford to be complacent; but growth—not decline—is the world’s long-term economic tendency. That’s how we need to plan.Douglas R. Tengdin, CFA Chief Investment OfficerFollow me on Twitter @tengdin

Upside-Down Tax PlanningRemember “Backwards Day?”That was that day back in high-school where if someone asked how you were, you said “bad” if you meant good, you said, “lousy” if you meant really good. People tried to walk backwards down the halls, and put as many of their clothes on backwards as they could. Up was down, low was high, and so on.Well it’s backwards day in tax-planning, now.Year-end tax planning usually consists of taking as many losses as possible this year, and deferring gains to the future. Sure, you have to take some gains—to rebalance a portfolio, or raise cash, or trim an over-weighted position. But putting off gains and realizing losses is typically good tax planning. But not this year.Capital gains rates scheduled to rise from 15% to 20% by 2013, along with the Afforable Care Act’s 3.8% Medicare surtax. Tax rates are moving higher. Yes, it’s possible that Congress will once again defer the increase, but this seems increasingly unlikely. And the surtax is almost certain to go into effect in January of next year.So when tax rates are rising, traditional tax planning gets inverted. Gains are realized, and losses should be deferred. Losses represent tax-savings—so their value goes up when tax rates rise. A $10,000 loss could save $1,500 this year, but potentially $2,380 next year. Also, converting a traditional IRA to a Roth IRA may make a lot of sense—realizing the income from the conversion at a lower rate.Personally, I found “Backward Day” annoying. It was uncomfortable and awkward, but it was one of those things the cool kids declared to show how they were really in charge. You had to go along or seem out of it. And I wondered who decided these things. But there’s no question as to who put “Tax Backwards Day” in place this time: Congress.Douglas R. Tengdin, CFA Chief Investment OfficerFollow me on Twitter @tengdin

We’re Sorry … Oops. That’s what Apple said last week about their new mapping application. In a rather embarrassing press release, CEO Tim Cook apologized to iPhone users for the buggy, fault-laden app the company put out last week. Users of the new iPhone 5 and folks who upgraded to the new operating system saw the Google Maps application replaced by Apple’s, which made a lot of mistakes: misplacing the Golden Gate Bridge, the City of Stockholm, and removing all the roads and cities from the Falklands Islands. The mislabelings and misplacements seem to be particularly pronounced in Europe. This is reminiscent of the mess Apple created when it released the iPhone 4. At that time users who held the phone a certain way had their calls dropped because of the new phone’s antenna placement. Steve Jobs initially held a press conference where he blamed users for not holding their phones correctly, but later the company offered owners $15 / each or a free iPhone case. Eventually Apple redesigned its phone and solved the problem. This time Apple put its apology onto its home page within days of the release, and suggested that users try out competitors’ products. This is like Coke telling folks that didn’t like New Coke to go ahead and buy a Pepsi. It’s pretty unusual, and shows how the company has matured under Cook’s leadership. Given how profitable mobile search ads have become, it’s not surprising that Apple would want to use its dominance in the smartphone market to capture more of that revenue stream, and it’s unlikely that the maps kerfuffle will be any worse for Apple than other gaffs--like the math errors once build in to Intel’s computer chips. Mistakes don’t sink companies; failing to correct them can. One thing’s for sure: this is one feature of the new iPhone that Apple doesn’t have to worry about Samsung or anyone else copying. Douglas R. Tengdin, CFA Chief Investment Officer Follow me on Twitter @tengdin

The Law of Unintended Consequences (Part 6) So what do we do? With interest rates at the zero-bound, and government bonds—the most stable asset class—providing yields that are below inflation, how should investors respond? How do we achieve the yields we need to live without risking the principal we need to live on? Probably the most rational response is to continue to diversify your financial holdings, and consider every asset class. That includes stocks and investment-grade bonds, but it also should include international bonds, high-yield bonds, real estate investment trusts, and master limited partnerships that have arcane tax implications. This is a time to cast as broad a net as possible to catch even a few basis points of extra yield. Be careful about extending the maturity of your portfolio, however. Interest rates are extremely low right now, but once the economy normalizes they will move back up. And it could be difficult to respond to such a move in a timely manner, as everyone who has extended their duration rushes to the exits at the same time. Interest rates can move sharply, as they did in 2005, 1994, and 1989. Don’t get freaked out when self-serving analysts trash a fundamentally sound sector, as Meredith Whitney did with municipal bonds in late 2010. That was one of the most profound misuses of notoriety I have ever seen by an investment analyst. She was rightly praised for her correct call of financial unsoundness in the largest banks in 2007, but she misused that prominence and scared millions of investors out of fundamentally sound holdings when she imprudently predicted 50-100 major municipal bankruptcies resulting in hundreds of billions in losses within a year. It didn’t happen. Keep an open mind. The forces of globalization and technology will continue to disrupt some markets and open others. New markets and asset classes can generate significant returns, but only if their growth is premised on a rational basis. A diversified approach that capitalizes on these opportunities is still the best way to generate sustainable investment income over the long haul. It’s not a free lunch. But if you do your homework, it’ll keep you fed.   Douglas R. Tengdin, CFA Chief Investment Officer Follow me on Twitter @tengdin

The Law of Unintended Consequences (Part 5)And unintended consequences are everywhere.One of the continuing consequences of the bailouts in 2008 and 2009 is a general mistrust of “bankers.” The capital issues at banks like Citi, Bank of America, and Morgan Stanley required a massive equity buy-in by the Treasury in order to maintain their solvency. But the term “banker” became a four-letter word—bankers like Dick Fuld of Lehman or Ken Lewis at Bank of America collected seven-figure bonuses even as their institutions either originated or acquired other banks that originated “ninja” mortgages: borrowers with no income, no job, and no assets.But the bankers I know are members of the Rotary, serve as volunteer firefighters, coach their kids’ soccer team, and help out the United Way. They’re engaged with their communities, taking local deposits and turning them into local commercial and residential loans. But it’s really easy to talk about tar and feathers, when what’s needed is nuance and understanding.Now Sheila Bair is weighing in with her memoir of the crisis. Not surprisingly, she tells a sordid tale of bailouts and missed opportunities, and casts herself as the tragic hero. She ticks off a list of all the things they didn’t do: help homeowners with underwater mortgages, clean up bank balance sheets, and so on. Of course, when you have a debt overhang, it’s easy to talk about debtor relief. Bair doesn’t offer any specific plan—just a vague sense that the government spent too much on bank bailouts and not enough on consumer bailouts.But that’s the rub, isn’t it? We’re still in an economy where perhaps 10% of the housing stock is still under water. Every time the economy ticks up, along comes another over-levered sector to smack it back down. That’s why it takes some time to get out of a debt overhang.Talk is cheap. It’s the only thing politicians never seem to run short on.Douglas R. Tengdin, CFA Chief Investment OfficerFollow me on Twitter @tengdin

The Law of Unintended Consequences (Part 4)So what’s going to happen to the average investor?With rates so low for so long, people have are motivated to find ways to create income from their investment principal. And there are people out there ready to exploit this situation for their personal benefit.Savers are getting flyers addressed “ATTENTION CD OWNERS” promising 5, 6, or 7% returns with principal and interest guaranteed. There’s a lot of ways for scam artists to play this. The interest might apply to just the first $500 of a $35,000 product; or it might pay a teaser rate for only the first month of a two-year period; or the guarantee might cover one tenth of the principal; and so on. The qualifications are buried in the fine print, but the liars can claim that they disclosed the limitations in writing.Structured products are another way to fleece savers. They generate big commissions for the seller, and they might have a legitimate guarantee from an insurance company, but the money is locked away for up to 20 years with huge surrender charges against early withdrawal.And then there are garden-variety Ponzi schemes: the Bernie Madoff version, where investments are never made and statements are fabricated; or the Alan Stanford approach where the CD is from a foreign bank with no deposit insurance. These are just outright theft.So a side-effect of low rates is an increased in financial fraud. Don’t be a victim! If it sounds too good to be true, it probably is.Douglas R. Tengdin, CFA Chief Investment OfficerFollow me on Twitter @tengdin

The Law of Unintended Consequences (Part 3) How should investors respond to a zero rates world? When the Fed first lowered rates to near zero in late 2008, many investors thought it would be a temporary situation; that short-term rates would rise at least to the inflation rate when the economy recovered. But rates have been here nearly four years now, and the Fed has made it clear that they will remain here for a considerable period. The extended outlook for extremely low rates has also affected yields on long-term bonds. We now live in a low rate world. For investors who depend upon their portfolios’ income, this is a trying time. They can’t just reinvest cash from maturing bonds or CDs and expect that the income will be adequate. Portfolios with such a “bond ladder” have seen their earnings decline steadily over time, and so their owners will have to find other ways replace that income. Sometimes this can be done, but the challenge is to alter your strategy without reducing your standards. Strategies can evolve; a bond portfolio that was limited to Treasury and Corporate debt might add Mortgage-backed and Asset-backed debt without adding to its risk; a total-return equity strategy could be tweaked to include more dividend-growth stocks and fewer zero-dividend companies. But lowering standards—reducing credit criteria; extending maturities; investing in illiquid instruments with lock-ups and complicated legalese—has had a long and unhappy history. Sometimes it works out and can be a temporary accommodation to an extraordinary situation. But usually it ends in tears. There are ways to maintain or even enhance income in a low-rate world. But reaching for yield by lowering the bar shouldn’t be on the list. Douglas R. Tengdin, CFA Chief Investment Officer Follow me on Twitter @tengdin

The Law of Unintended Consequences (Part 2) Are there limits to the Fed’s effectiveness? As the Fed continues to provide monetary accommodation, it’s reasonable to inquire whether it will work. After all, low interest rates aren’t a boon for everyone. When short-term rates are below the inflation rate, savers lose purchasing power as prices rise. In effect, savers are subsidizing borrowers. So how do low rates help? In the short run, low interest rates help the housing sector as they make periodic mortgage payments cheaper. They also make it easier for governments to finance deficit spending, and they reduce the cost of capital for large corporations. These short-run effects can encourage economic growth. But over time, as people come to expect ultra-low rates to last forever, they start to make decisions based on these rates that become distorted. One clear effect is with government spending. Since the marginal cost of additional spending is minimal, there is an increasing demand for government services. As a result, the size of government relative to the economy increases. At the same time, there is no incentive to increase taxes in order to reduce the deficit, as taxes will have a dampening effect on the economy. The result is an explosion in the deficit and a deterioration in our country’s long-run fiscal stability—our credit rating. Free money isn’t free. It’s partly why S&P and Egan-Jones downgraded US Government debt. So it’s important for investors to ask, “What comes next?” Douglas R. Tengdin, CFA Chief Investment Officer Follow me on Twitter @tengdin

The Law of Unintended Consequences (Part 1)Are low interest rates a free lunch?On its face, it sure looks like it. Low interest rates reduce government interest expense, make it cheaper to borrow, and stimulate the economy. They especially prop up the housing sector, which goes a long way towards recapitalizing the banks. And ultra-low short rates allow the banks to borrow short and lend long, boosting their net interest income. What’s not to like?But ultra-easy monetary policy will have unexpected second and third-order effects. For example, low rates are a real problem for savers. With inflation at 2%, zero percent short-term rates means that purchasing power is eroding year-by-year. As investors’ bond portfolios gradually mature, the interest income they can earn on new investments is significantly lower. Many people who live off their interest income are now getting squeezed. Now they are asking where they can cut back.These investors are also exploring alternative ways of generating income. Some are looking at dividend stocks: others are using real-estate investments; high-yield bonds or other alternatives are also being considered. In any case, income-sensitive investors are taking more risk in order to continue to generate the required interest.This additional risk will come back to bite the unwary. Longer-term bond portfolios are much more sensitive to interest rates; dividend-growth equity strategies make a portfolio more volatile when used as a substitute for bonds, and so on. Risk is part of investing. But if it’s not managed properly—if investors reach for yield and get burned in the process—the entire economy will suffer.There’s still no such thing as a free lunch.Douglas R. Tengdin, CFA Chief Investment OfficerFollow me on Twitter @tengdin