News and Information

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While we will be doing a quarterly update in a few weeks, we thought it might be helpful to address two issues that seem to be concerning to many of our clients. 1) What is the outlook for the California budget situation and 2) What is the cause and outlook for interest rates which have been rising recently.

1) California Budget Crisis - After closing a $42 budget gap for the current fiscal year and next year just a few months ago through various spending cuts and tax increases, economic conditions have deteriorated such that California needs to close an additional $24 billion projected gap for 2009/2010 (fiscal year ends in June) and a $36.5 billion projected shortfall for 2010/2011. These are daunting numbers indeed and a large percentage of the total budget (approximately $100 billion). Part of the reason for the rapid deterioration is the high beta or sensitivity to the national economy. State unemployment is running at 11% and is expected to increase to 12-15% depending on the forecasting source (vs. a 9.4% national unemployment rate). In addition to the recession, California has structural challenges as a result of enacting permanent spending measures which have been supported by temporary revenue such as capital gains. Additionally, the budgetary process requiring a 2/3 vote to pass both budgets and tax increases only makes solutions more difficult (California is the only state that requires a supermajority on both budget approval and tax increases. It is interesting to note that this is the inverse of the federal system that requires 2/3 in the Senate for most legislation but permits the budget-related legislation to pass with a simple majority. Two other legacy issues limiting financial flexibility are Proposition 13 which caps property tax increases to 2% annually until the house is sold and Proposition 98 which requires 40% of the state revenue to be spent on education. Despite all of the challenges listed, California will need to resolve its imbalance and present a viable fiscal plan quickly in order to issue short-term revenue anticipation notes (RANs) to finance operations in the near term. 

What Does This Mean for Municipal Investors?

Many states are facing financial difficulty due to the economic recession. State budgets generally lag the national economy so it is likely that things will get worse before getting better. California has sought assistance from the federal government, however, nothing is immanent at this time. One questions on investor's minds is - Will California go bankrupt? Technically, there is no chapter of the bankruptcy code that would provide protection from creditors under bankruptcy. Chapter 9 bankruptcy is reserved for municipalities and not available to states. While the state could default on its debt, we believe the ramifications of this would be so distasteful for California and many other states that the federal government would provide interim assistance if things were to deteriorate to this level. While the odds of default are not zero, we believe they are extremely low. Another concern for investors is the prospect for further downgrades of the State's credit rating by the major ratings agencies. We would point out that the yield spreads vs. treasuries are much higher now than in 2003 when the state was downgraded to BBB (Now A) so it would appear downgrades are largely "baked in" by the markets. With the "unthinkable" happening on a regular basis, the question of what happens in a default needs to be taken seriously and is one we continue to explore - even though the odds are very low. From a historical viewpoint, it is interesting that the default rate for general obligation bonds in the Great Depression was 7% (long term historical average is about .4% - yes, a decimal in front of the 4). Also, of the 7% of defaults noted, the recovery rate in the Great Depression was 90% resulting in an average loss rate of less than 1%.

Even if the gap for the upcoming fiscal year is closed, it is difficult to see how the longer-term projected deficit ($36.5 billion in 2010/2011) gets resolved without either a significant pickup in the economy or help from the federal government. In researching California Department of Finance assumptions to reach the $36.5 billion deficit, they are forecasting that unemployment improves by 1% and that taxable income increase by 4%. In the end, we believe California would be too big to fail, however, the crisis may move significantly closer to the proverbial cliff before the lifeline is thrown. In terms of the amount of any bridge loan, it would likely represent less than one quarterly payment to AIG! In analyzing how other investors are viewing the state's situation, credit default swaps (CDS) which are essentially insurance on the state of California defaulting are currently trading at 293 for a 5 year contract (can be thought of as an insurance premium for $293,000 per $10 million of coverage). This compares to over 400 at the end of last year and well below 100 prior to the financial crisis in early 2008. (Just for an additional point of reference, Bank of America is lower at 175, Russia is the same as California at 293, and Citigroup higher at 369).

One other factor that has been impacting yields in the bond market (actually holding yields on tax-exempt bonds down until two weeks ago when all yields began rising - see discussion below) is the addition of taxable Build America Bonds (BABs) a few months ago. These bonds are federally taxable but exempt from state taxes. Issuing taxable securities was done to broaden the market in order to finance infrastructure for many state projects. The entity issuing the bonds receives a 35% rebate from the federal government. What has happened is an issuer such as California that previously issued tax-exempt bonds is now better off issuing BABs (as an example, a recent BAB was issued at 7.43% which costs the state only 4.83% after the 35% federal subsidy vs. 6.10% if they had issued a tax-exempt bond). As a result, with the supply of new tax-exempt bonds constrained, yields on these securities had been pressured lower. Said differently, demand increased relative to supply pushing bond prices up and yields down. While this dynamic is still present, the dramatic increase in all interest rates as well as the increasing concerns about the state's fiscal health has recently moved taxable yields slightly higher.

2) Interest Rates and Inflation - We will go into much more detail on this in our upcoming newsletter but generally speaking there are two opposing views shaping up on the inflation/deflation debate in the marketplace. Those expecting inflation are focused on the monetary and fiscal policy measures that have tended to fuel inflation in the past. They believe that with Fed Funds rates at 0-.25% and the further injections of liquidity into the financial system through quantitative easing (1) will result in too much money chasing too few goods as well as a debasement of the US dollar through monetization (2). Those on the deflation side argue the tremendous output gap - that the difference between potential GDP and actual GDP represents such a dramatic underutilization of resources which creates downward pressure on prices. This output gap can be thought of as excess slack within the economy. This group generally cites the unemployment rate of 9.4%, capacity utilization of 65% - lowest in over 60 years, residential vacancy rates which are the highest in 50 years, etc. We'll provide our opinion and where we come down on this debate in the upcoming newsletter - stay tuned.

Interest Rates - Interest rates have been rising over the past few weeks on increasing fears of inflation as well as higher real yields due to actual and expected increases in bond issuance by the government. There are three primary components which make up a bond yield including a real return - which is determined by, among other factors, the supply and demand for a particular type of bond, an inflation component - what is the expected level of inflation over the bond's time horizon and a risk premium - what investors require to be compensated for various types of risks including but not limited to credit risk or the risk of default. Because inflation protected bonds which provide a real rate of interest, such as TIPS can be compared to regular Treasury Bonds, the expectation for future inflation can be observed. In the past couple of months, the 10-year Treasury has gone up by about 1% (from about 2.8% to 3.8%). About half of the increase is due to the rise in real yields (and change in the risk premium since this cannot be broken out) and the other half is due to an increase in inflationary expectations over that time frame (inflation expectations of approximately 1.5% a couple months ago to just under 2% today).

Source: Richard Koo. "The Age of Balance Sheet Recessions. What Post-2008 U.S., Europe and China Can Learn From Japan 1990-2005"

Equity Markets

The equity markets are up considerably off the March 9th lows (S&P 500 up 40%) as expectations have moved from Armageddon to "Less Bad" to stabilization in the second half of the year and recovery early next year. For the year, the S&P 500 is up about 5% and our portfolios (large cap portion) are doing considerably better in the 9% range. Have the markets come too far to fast? More to come on all of this in a few weeks…

(1) Quantitative easing is generally conducted when policy interest rates are extremely low and cannot be reduced further to simulate an economy. In these cases, quantitative easing refers to the process of central banks purchasing securities to reduce or hold down interest rates.

(2) Monetization refers to the conversion of an asset or liability to cash. The debt monetization term frequently discussed recently refers to the Federal Reserve purchasing the debt (bonds) issued by the Treasury. The fear of investors is that debt will be retired simply by cranking up the printing presses which will lead to a debasement of the US Dollar.

DISCLOSURE: Past performance is no guarantee of future performance. The Standard & Poor’s 500 Stock Index (S&P 500) is an unmanaged index, which includes a representative sample of 500 leading companies in leading industries of the U.S. economy. Index returns reflect the reinvestment of income dividends and capital gains, if any, but do not reflect fees, brokerage commissions or other expenses of investing. Investors may not make direct investments into any index. This report is intended for informational purposes only and does not constitute or contain an investment recommendation and is issued without regard to specific investment objectives, financial situation or particular needs of any specific recipient. The information in this analysis was obtained from sources believed to be reliable. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions, and there are no obligations to update or correct any of the information. First American Trust, FSB and its affiliates do not accept any liability for any direct, indirect or consequential damages or losses arising from any use of this report or its contents. Please consult your tax advisor for personal tax questions and concerns.

 

David K. (D.K.) Willardson, CFA
Senior Vice President &
Chief Investment Officer &
Investment Division Manager

 

3/09/2009:First American Trust Market Update

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The equity markets are now 9% below the November lows and the main question is what are the "surprises" which are taking the market lower. We believe there are two primary causes - the details of the Obama Administration budget which were far from market-friendly and a new framework for fixing the banks. The budget outlined unfavorable initiatives in certain industries such as health care and utilities as well as a less friendly stance towards capital in general (specifically capital owned by higher income earners). The general consensus on new initiatives was that given the difficult economic issues that we face, most of these initiatives would be placed on the back burner. The other primary issue, which we would ascribe even more weight is the apparent method by which the bank situation is going to be resolved - filling the holes left by diminished or worthless assets with highly dilutive common equity. Although many investors are still complaining about a lack of clarity in the government financial rescue plan, post the February 27th announcement of the conversion of Citigroup preferred stock by the government into common equity, the market has taken bank stocks down by 40% vs. the S&P 500 which is off 9%. Investor perceptions of asset quality within the financial sector over this short time period (From February 26th thru Friday) have deteriorated sharply as many firms previously believed to have better than average asset quality and capital levels have experienced significant selloffs including Wells Fargo, JP Morgan and even GE which has financial exposure through GE Capital. The method of getting capital to the banks through common equity as opposed to preferred equity is significantly more punitive to existing common shareholders and is now (unfortunately) clear. It is very possible that the government will end up being the single largest shareholder in more major U.S. financial institutions. The market does need more clarity on removing the bad assets from the banks and this plan is expected to be detailed in a few weeks. Fortunately, expectations as to how much it will help are muted due to the previous communication glitches. As we have discussed in the past, we question the degree to which banks are willing sellers at market or even slightly above market prices as large losses would have to be recognized in this process. The administration's foreclosure mitigation plan has also been announced and has a goal of helping 1 out of every 9 homeowners. There have been other plans announced in the past with high expectations - HOPE for Homeowners was announced in 2007 with similar hoopla, had a goal of 400,000 and got virtually no traction.  Other restructure plans have had re-default incidences in the range of 50%. The plan may help but is certainly not a panacea. Reducing mortgage balances are voluntary on the part of the lender or servicer and that appears to be a major sticking point.

 

The TALF (Treasury Asset Backed Lending Facility) program, on the other hand, seems to offer better prospects for repairing the financial system. Contrary to popular belief, it is not the banks causing the shortage of credit. Bank loans have actually increased during the recession and even thus far in 2009. Yes, loan underwriting is getting more stringent but this is not where the problem lies. Since the banks are not the primary problem with new credit, consider how much the "We must fix the banks to get the economy going" mantra in the media will really have an impact. A majority of financing over the past several years has occurred outside the banking system, now referred to as the "shadow banking system" where loans are securitized and sold - that is the market that is not functioning and is targeted by the TALF which should help restore the market for consumer loans, auto loans, business loans etc.

 

As we have discussed in the past, how high the consumer savings rate goes will have a significant impact on long-term economic growth. For January, this rate was approximately 5% (up from -0- a year go, although if government handouts are considered, it was about 3%). The loss of consumer wealth is likely to be approximately $20 trillion from the peak (when reported at the end of the month). For those worried that all the government actions will result in inflation, consider the loss is consumer wealth is 10x the amount the Fed has increased its balance sheet...so likely no inflation at least in the near term. In terms of GDP, estimates are in the -5% to -7% for the first quarter and -2% to -4% for the second. We are still hopeful for a positive GDP in Q3 or possibly Q4.

 

I wanted to end with a simple yet constructive economic concept developed by the late economist Hyman Minsky - That periods of stability beget periods of instability and periods of instability beget periods of stability. So....market participants making assumptions about the future will price assets which will cause those assumptions to ultimately be false. Applying to the real estate cycle - It was the mere assumption that market participants made that home prices don't fall (nationally) that was the fundamental underpinning which created the environment in which they could. As for the equity markets, it is difficult to tell what will happen in the near term, however, it certainly seems the precursor to future favorable equity returns is present......in spades.

 

David K. (D.K.) Willardson, CFA
Senior Vice President &
Chief Investment Officer &
Investment Division Manager

 

2/10/2009: First American Trust Market Update

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The Treasury’s proposal for fixing the financial system was poorly received by the markets (S&P 500 down just under 5% today). While the main reason for the sell-off is the plan’s lack of details, some provisions requiring a financial stress test for banks as well as continued anti-big-bank rhetoric notable in the delivery were likely factors as well. An additional issue we would raise is that there does not appear to be an idea of what sellers of bad assets (mostly the big banks) will likely require to enter into such transactions. There are some general objectives regarding what will be done for purchasers – i.e. government financing and potential downside insurance protection; however no detail was provided for how the sellers will be treated. The government can continue to reference poor decisions of the past, the new era of responsibility and how compensation and bonuses will be limited; however, since these banks remain open and operating in the interests of their shareholders, the process of fixing the banks remains a negotiation, not a unilateral edict from the government. Even under the rosiest scenarios, the asset values will likely be significantly less than the current value on the bank’s books, thus bank management may choose to hold the assets and realize the future appreciation themselves. At least two CEOs have indicated in the past week that they either have no interest in selling assets or do not need any more capital injections from the government. If there aren't significant sellers, it puts a major wrinkle in the plan to say the least. What is surprising is that this “Economic Dream Team” of Geithner, Summers and others did not do more homework on how the plan would be received by the market, particularly after the miscues by the previous administration.

Unfortunately, there is not an easy politically attractive solution that recapitalizes the banks while giving taxpayers an attractive return on their investment. Either the government transfers economic value from the taxpayer to the bank shareholders to plug the holes left by the bad assets, or they close the problem banks, limit losses and hope to manage through short-term dislocations. These are hard choices but the market seems to be wise to the attempts of trying to politically finesse something down the middle without really fixing the problem. In the end, someone is likely going to have to eat the losses – if it’s open bank assistance it will be the taxpayer, if it’s bank closures, it will be investors.

The financial markets and the economy continue to perform largely in line with our expectations - the markets (stocks, credit spreads, risk appetites, etc.) have stabilized and continue the bottoming process started in October / November (S&P 500 still up ~10% from November 20th lows) and the economy continues to deteriorate but at a pace that is not out of line with market expectations. GDP for the 4th Quarter of 2008 came in at a negative 3.8% which was better than the -5.5% expected; however, much of this is due to higher than expected inventory levels (GDP is based on what is produced, not what is sold) so not much to get excited about as the inventories will likely be worked through in Q1. It appears that the current quarter - Q1, will likely be the deepest decline, down in the 4-7% range. The unemployment picture continues to get worse, as expected, with the unemployment rate now 7.6% and likely to hit 9% by next year. Keep in mind, however, that this is a lagging indicator and tends to increase for 12-18 months after recessions are over.

More to follow after we get some clarity on government plans and legislative action. How much the administration learns from today’s events will be very evident in their next communication. Overall, we believe the market will continue in the bottoming process and remain at or above November 20th levels unless there is a large negative surprise as we have previously discussed. Expectations are pretty low and the only area where positive expectations had crept in was on the bank plan - and those got reset today. The markets will get better - just remember – it’s relative to expectations, not headlines that count!

David K. (D.K.) Willardson, CFA
Senior Vice President &
Chief Investment Officer &
Investment Division Manager


12/24/2008:    First American Trust Market Update

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The Holidays are in full swing and 2008 is drawing to a close. At First American Trust, we understand that this has been a hectic year with regard to the markets and the economy. Once again, we appreciate the trust you have placed and continue to place in our firm. As we head into the final lap, we wanted to provide another market update from our Chief Investment Officer, D.K. Willardson. Below please find his latest insights. Best wishes for a happy and healthy holiday season.

While economic data continues to indicate things will get worse before they get better, conditions in the financial markets are gradually improving (with the exception of the growing concern of deflation which we discussed in our last update) - volatility is down significantly, credit markets have improved as indicated by credit spreads, equities are up slightly and general signs of extreme risk aversion have eased slightly.

One constructive point of discussion is why this recession is shaping up to be the worst in decades. The primary reason is that what we are seeing is a credit driven, structural recession versus a "typical cyclical" recession. The "typical cycle" generally goes something like this - demand/consumption increase, employment increases to help meet increased demand, inventories are increased in anticipation of future demand, output and expectations get too strong and the Fed increases interest rates to slow the economy, output is reduced, inventories need to be worked down and the cycle runs in reverse, sometimes creating a recession. This typical cycle characterizes most post-war economic periods. What makes this credit driven structural recession so challenging is that overall credit and the Financial sector grew for the previous 20 years and represent such a large percentage of the economy (profits were more than 30% of the total S&P 500, market capitalization reached ~25% of the overall market). Running all that in reverse is much more challenging - not only the deleveraging which we have discussed previously, but the structural shift in the makeup of the economy and employment that needs to take place to get back to equilibrium. So we will likely see a longer duration than was originally envisioned with more potential issues coming to light in commercial real estate, retail, and other financial related businesses. Keep in mind, however, that most of the above, as bad as it sounds, is likely already discounted and that the markets can continue the bottoming process, provided we/the Fed win the war against deflation.

Interest Rates & Deflation - In the past few weeks, the 10-year Treasury has come down an additional 60 basis points or .6% to about 2.15% - primarily on the continuing fear of deflation. There is downside risk to this trend and it should not be dismissed simply because it has rarely happened - housing prices hadn't fallen nationally in over 100 years. As we discussed in our last update, it is important for the transmission mechanisms of risk and confidence to return for policy to be effective. For those interested in going back to the basics of economics - MV = PY or the change in money supply (M) * Velocity (V) = Price level (P) * Output (Y). The problem is the V (velocity of money) is not getting into the economy through typical channels via loans and investments. Yes, the Fed can print money all it wants but to get into a consumer or business bank account it has to be borrowed or earned. Fortunately, Fed Chairman Bernanke is an expert on the subject of deflation. Mortgage rates have declined in the past couple of weeks and should continue to come down. Historically, 30-year fixed rate mortgages have been 160 basis points or 1.6% above the 10-year Treasury (Applying to today's rates would be 2.15 + 1.60 = 3.75%). With 30 year rates in the high 4s, high 3s is possible and would certainly help the housing situation. Also, it appears that GDP will likely come in below the negative 3-5% put forth in the last update but that is likely no surprise from the market's viewpoint.

In closing, I wanted to touch on some of the recent press that focused on our industry. The Madoff scandal will likely have a long-lasting impact on investors and regulators. The fact that so many investors bought into a strategy that didn't have a down month for years is surprising - something that could have been caught and identified by some investors just by analyzing monthly returns. At First American Trust, our performance information is compliant with GIPS (Global Investment Performance Standards) and we have a third party firm (Ashland & Co) formally examine the Large Cap Core performance as a second point of review. We feel this is an important aspect to share as we have outperformed the S&P 500 in 9 of the last 12 years and have the audited performance numbers available for review.

In the next few weeks, we will put out our 2009 Outlook - not sure of the details yet but hopefully better than 2008!

David K. (D.K.) Willardson, CFA
Senior Vice President &
Chief Investment Officer &
Investment Division Manager

12/2/2008:    First American Trust Market Update

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Yesterday's stock market decline of approximately 9% should be viewed in the context of the 20% gains from the lows of the previous week. As we have discussed, this is very normal for a bottoming process and will likely continue for a period measured in weeks or months, not days. As economic news is released, it is important to separate the largely expected (decline in economic activity, housing, employment, etc) from the new information which looks at the increasing odds of a deflationary environment. While the initial market reaction has been lower long-term interest rates (10-year Treasury has gone from 3.8% to 2.75% in less than two weeks) which could be very constructive in softening the damage from deleveraging, a period of protracted deflation could result in a worse than expected outcome for the economy and financial markets. While deflation or a decline in the general price level may not initially sound that bad, expectations for lower prices of goods and services resulting in a deflationary environment can be troublesome for an economy. Consumers put off spending as goods & services are expected to be cheaper in the future, businesses delay investment due to lower demand as well as expected falling prices of input costs and so on. The real issue is that cash becomes more attractive and the demand for credit falls precipitously as loans must be repaid with more expensive dollars relative to the asset that is financed. As a result, sustained deflation would increase debt burdens on top of a highly levered consumer and financial system. Currently, based on yields of inflation protected bonds, inflation expectations for the next 10 years are expected to be .2% annually, down from 2.3% at the beginning of the year. On a year over year basis, the U.S. has seen only two years of deflation in the last 50 years - 1986 and 2001. In summary, this will be a key metric to watch in the coming years.

One question continues to be asked, "Why aren't all the policy actions working?" The government has taken considerable action in pumping capital & liquidity into the banking system and financial markets; however, it is not getting into the economy because of a lack of willingness to take risks on the part of lenders, investors and borrowers. The transfer of leverage/debt from the private sector to the government has certainly softened the blow, however, the flow of credit cannot get into the system without the willingness to take risk. Ultimately, the confidence necessary to provide this transmission mechanism will re-emerge, even though current sentiment is dominated by risk aversion and deleveraging. While the ultimate cure is time, the monetary and fiscal programs being utilized can certainly help ease the symptoms in the interim. With the additional deterioration in the economy recently, there does seem to be a consensus within Washington to "do whatever it takes" and that the ideological battles are over.

Additionally, with the recent bailout of Citigroup, it is clear that the government has gone to using TARP funds to support stock prices and confidence levels - A bailout vs. an "investment". In the days leading up to the Citigroup action however, there was significant investor concern that while Citi wouldn't fail because of the government "backstop", the prospect of refilling the large capital bucket one drop at a time through future earnings was going to be a very long, arduous process. What is interesting in most of these situations is that capital seems to be the weakest where the "strong capital" pronouncements are the loudest. In the case of Citi, investors essentially called the bluff on capital adequacy and Citi had no choice but to go to the government for a special deal as raising equity at a $3 stock price would have been near impossible.

While "traditional" stimulus through reduced interest rates from the Fed (1% Fed Funds rate expected to go to .5%) would appear limited, it is important to realize that the Fed still has considerable "tools" to ease monetary conditions. Quantitative Easing which the Fed has been conducting since mid September involves injecting liquidity directly into the system. Yesterday, Bernanke discussed the Fed purchasing all types of assets including Treasuries and mortgage related securities which would help bring longer-term market interest rates lower. In addition to these monetary policy actions, additional fiscal stimulus is also likely and could approach $4-500B annually for the next two years.

Just as there is a transmission mechanism for getting monetary stimulus into the economy as discussed above, there is also a transmission mechanism for fiscal stimulus - confidence on the part of consumers. This is illustrated in the recent fall of gasoline prices which provided a lift to consumers of approximately $200B (annual rate); however, due to concerns about the economy and a possible re-prioritization to pay down debt, very little of the $200B is going into the economy. Consumers appear to have changed savings habits as the savings rate increased from 1% in Sept to 2.4% in October. Whether they go back to historical norms of 8-9% will be a major determinant of the slope of the recovery.

GDP for the 4th quarter is expected to come in at -3 to -5%. This is largely expected and likely won't be a source of surprise. Eventually, risk appetites of investors, lenders and borrowers will normalize and consumer confidence will return which will repair the current broken transmission mechanisms for monetary and fiscal policy measures. Deflation is the wild card; however, just as increasing asset values didn't produce runaway inflation, declining values may not produce systemic deflation. In sum, we feel the bottoming process is in place and will continue absent a significant unexpected change.

David K. (D.K.) Willardson, CFA
Senior Vice President &
Chief Investment Officer &
Investment Division Manager