W.I.L. Finance Digest for Week of November 24, 2008

A VALUE INVESTOR FINDS HOPE AMID THE ANGST

An interview with Robert Fetch: Fruitful times for active managers. “I am seeing valuations I have not seen in decades ...”

Almost every class of financial asset is down 40% or more this year. There has been no place to hide, notes veteran value investor and fund manager Robert Fetch -- whose Lord Abbett Small Cap Value Fund is in the upper 2% of its class, performance-wise. He further notes that within the markets, the performance differentials among styles has also been very narrow. Growth, value, large cap and small cap alike have all been equally hit.

When the paddywagon comes the good girls go too, goes the old expression about the nature of market selloffs. But this is only true initially. As the bear market wears on the quality companies recover, while those which are deservedly down get recognized as such. Mr. Fetch offers a selection of what he believes to be the former while usefully putting the current state of the market in context.

Amid all the market carnage, Robert Fetch, a veteran value investor at Lord Abbett, senses the makings of some big investment opportunities. "I am seeing valuations I have not seen in decades, across the capitalization spectrum," says Fetch, 55, who runs $7.8 billion of assets. His responsibilities include helming the Lord Abbett Small Cap Value Fund (ticker: LRSCX), which is closed to new investors but which has bested 98% of its peers in its Morningstar category, based on 10-year returns. So we turned to him last week for his views on small-cap stocks, among many other topics.

Barron’s: It has been a brutal market this year. What are your thoughts on what has happened?

Fetch: There have been no places to hide. There has been carnage both within the market and across asset classes. The major indexes are all down about the same amount this year, roughly 40%. Bonds, commodities, timber and foreign stocks have come down as well. Within the markets, the differentiation among styles has also been very narrow. So this has been a very unique period that should prove fruitful for active managers, based on what I have found in the past.

It is only after the fact that we will find out which stocks deservedly needed to go down and ultimately will not recover and which stocks went down undeservedly and are most likely to recover -- and where you are going to see significant outperformance. The same is true in big bull markets. The tide lifts all boats in the early stages. It is only after the fact that the market begins to get more discriminating and to figure out which companies have staying power and which ones do not.

How are small-cap stocks priced, relative to bigger stocks?

Valuations of small stocks are at a slight premium to large-caps. They are at a level where they have been through much of history, with a couple of exceptions -- when they sold at major discounts in the late 1980s, and in late 1999 and the beginning of 2000, when large stocks were clearly in favor.

The prior period to that was the Nifty 50 days in the early 1970s.

The last time there was a huge premium for small-caps was in the early 1980s, on the back end of the expansion from 1976 to 1983, when there was a significant amount of initial-public-offering activity, especially in the technology area.

From 2000 through around 2006, small-caps outperformed large-caps consistently. Was that an aberration?

No, clearly not, because it was correcting an extreme that had been created. Small stocks, in particular -- but also many stocks that were not large-cap or growth or tech or Internet -- were in disfavor, and began to sell at a huge discount to the Standard & Poor's 500. When those stocks rolled over and people figured out that they were holding the bag on overvalued merchandise, investors went toward where value was the greatest, including small-caps. It took years to unwind that disparity.

It is also one of the reasons why there were such huge anomalies between large-caps and small-caps, growth and value, and tech and non-tech, among other anomalies. There was basically a zero-interest-rate policy by the Bank of Japan, so there was a huge carry trade. So hedge funds had these huge anomalies that went away over the next three to four years.

How does the overall market look in terms of finding attractive stocks?

I am seeing valuations I have not seen in decades, across the capitalization spectrum. You have the capacity right now, as a value manager, to find good, solid low-valued stocks of good companies without having to pay a premium for them for the first time, really, since the early 1980s.

So this is a historic buying opportunity?

Right. We are in the process of creating a bottom, most likely in the next 12 to 18 months. As for buying opportunities, they are not confined to small-caps. We have got the S&P at a multiple of about 11. There are some larger-cap industrials like an Eaton [ETN] and Parker Hannifin [PH] selling at 6 or 7 multiples on current earnings. You could haircut earnings next year way beyond your imagination, say 30% to 40%, and you still have a single-digit multiple on the stocks.

The percentage decline off market highs is the greatest since the Great Depression.

So the market is clearly discounting a fairly severe recession. There is a good chance that before this is done, the S&P will make a new low. When the S&P went below 804 last week, the percentage decline off the highs marked the greatest bear market in history since the Great Depression.

One thing that is still true is an old axiom: The stock market discounts. It topped out over a year ago, and it has been declining since. It is pretty much discounting much of the very ugly economic headline news that we are probably going to be facing over the next year or two.

What are some of your core beliefs about investing?

First of all -- and I include myself in this -- people tend to be impatient. Good investing, especially from an individual standpoint, is where you have the luxury of not having to participate in the market at all times. You can pick and choose the most appropriate times when the odds and probabilities of success are highly in your favor. I try to keep that in mind as a professional investor as well.

It is only through time and patience that you actually tend to build wealth through the power of compounding of returns. But doing that requires perseverance and saving, which involves sacrifice. One of the things I was most influenced by is the writings of Charles Ellis, who said you win by not losing and your primary objective in investment management is to control risk.

A successful investment requires a great deal of courage. And it requires steady nerves to invest in those areas where the greater opportunities are, even though that is not where the consensus is, and it is very lonely. The best opportunities to buy stocks occur when it has been very hard to pick up the phone -- and yet all your disciplines would suggest that is exactly the right thing to do.

What are your thoughts about the big spike in mutual-fund redemptions lately?

It reminds me of a quote I have been keeping in front of me lately. As Warren Buffett said: "Be fearful when people are greedy, and greedy when people are fearful." We have gotten to the point where it pays to be a bit greedy, because there are some unusual opportunities being created right now.

You take a more diversified -- and less concentrated -- approach to running a portfolio than some other funds do. Why do you lean in that direction?

You can be out in the middle of the ocean and not know what is ahead, so you need to be prepared for stormy seas. It just provides better ballast to a portfolio in case there are surprises. As much as you think you have got it all right at various points in time, you always want to protect yourself.

You have been underweight financials. That turned out to be a good call.

So far, knock on wood. Actually, we still are concerned with some of the fundamentals, particularly at some of the smaller regional banks, because they have not had to report some of the problems that a lot of their larger brethren have. We are just getting to the part of the recession that ought to more forcefully impact their performance. Their fortunes are tied to their local economies, and their portfolios tend to be more heavily exposed to construction lending -- not just residential, but commercial, which is under pressure. And they are exposed to consumer lending, which is going to be under pressure as unemployment levels rise.

As you are well aware, one of the biggest concerns about investing in small-caps is liquidity; many of these stocks do not trade well. How do you deal with that?

Performance is more about what stocks you own than it is about your ability to trade them.

Having said that, it is important for a small-stock investor -- and this is one factor that separates the better small-stock managers from the others -- to deal with a lack of liquidity, because by definition almost any small stock you buy is illiquid, to some degree. You have to learn to make that part of your investment process and equation.

Being value-oriented really works in our favor, compared to being more growth-oriented, because we tend to want to buy things when few others do.

If you have been successful in identifying the right company to own in the first place, and if the fundamentals play out largely as you hoped, and as the stock gets discovered, liquidity only improves with time. So when something becomes more dearly valued, very often you are generally able to sell it much more easily than when you first bought it.

Let’s hear about a few of your small-cap holdings.

The first one is Curtiss-Wright [CW]. It has been around since the early part of the 20th century. They are a diversified industrial manufacturer, and their principal products are in-motion and fluid-flow control. They make actuation systems that go into commercial and military aircraft. [An example is an actuation system used to control the flaps on an airplane.]

One of the things that we like, going forward, is that they are one of the few companies where you can play any growth in the nuclear industry. They make the pumps for nuclear-generating plants. Even though the nuclear-utility business has basically been nonexistent in terms of new builds, [CW] has been selling replacement products for many decades.

The value of the stock has been cut in half this year. Is that simply because of the faltering economy?

Yes, the market is discounting that on just about every stock that is down 40% or more. So clearly, some of that has occurred. We felt that the stock was expensive when it was up in the low-to-mid-50s, and we had actually pared back our position.

But we have seen the stock down enough, in the high 20s and low 30s, and that gave us a chance to buy more with it selling at 10 to 11 times earnings. That is unusually attractive for a company that for the past five years had grown its sales at about a 20% rate and earnings at a 16% rate. At a minimum, they ought to grow earnings and revenues [by] double-digits per annum in the next five years.

Let’s move on.

Another of our holdings is URS [URS], an engineering and construction company, with more emphasis on the engineering. They provide a lot of technical assistance.

They also have operations and maintenance services. So you can think of them providing, say, a military base with management services. These generally are long-term contracts.

They are also involved in water-infrastructure projects, as well as road-highway construction, and they bought a company called Washington Group that also expanded their services in a number of these areas as well. So they provide services to not only the federal government and private industry, but also to state and local governments.

Are there any concerns about their business holding up in this environment?

Investors will find something to have concerns about when they are fearful and when they are looking at things half-empty -- in this case because state and local governments and municipalities are clearly under revenue pressure because of the economy.

The stock came down from the low 60s late last year to the low 20s in the past month or two. But they will earn about $2.60 or $2.65 this year, so the stock is trading at about nine times.

We expect the company to grow at a minimum price of 10% next year and to earn near $3 a share. They are likely to grow faster than the market.

So you are getting a premium growth vehicle at a nice discount.

At these price levels, you have very good valuation support. That stock illustrates our investment criteria. We are not always right when we buy a stock, but we are always trying to put the probability of being right on our side. If we do that well, when we are wrong we don't get hurt badly.

One more pick, please.

Plexus [PLXS], a technology company and a contract manufacturer. They provide product engineering skills, and then will actually manufacture the product for an OEM [original-equipment manufacturer] customer.

Plexus has premium levels of profitability in an industry that has relatively narrow margins. They generate pretax margins on a consistent basis of 5% to 7%, in an industry whose average is closer to 2% or 3%. The company has minimal debt, and they have grown steadily over time.

They are diversified across a number of sectors, both in computing and networking. Medical is a big market for them in terms of customers. They also make and design products for the industrial market, defense and aerospace. We like the diversification of their portfolio.

In their most recent fiscal year, which they just completed, they earned $1.94 a share. The stock is currently around $13. This is just an unusual opportunity to buy a premium company with the financial profile they have, and the know-how that few other companies can match.

Thanks very much, Bob.

SAND CASTLES – HALF-PRICE MANSIONS

Now that the boom in luxury housing has ended, sellers will have to cut prices even further to lure buyers. New York, look out below.

The long-awaited -- by us -- real estate bust is unequivocally here. How bad has the damage been? This piece from Barron's looks at the high end side of the market. Luxury housing is not dependent to any great degree on the mortgage market as most transactions are for cash. But with financial markets way down a decided wealth effect has had its effect. Just as the dot-com paper millionaires and billionaires of a decade ago woke up one day and discovered they were not as rich as they thought, many of today's moguls are finding the same -- and pulling their housing bids accordingly.

Luxury-home shoppers have come down with a bad case of cold feet. From Malibu to Manhattan, would-be buyers of $5 million-and-up properties are pulling out of pending deals and suspending their searches out of concern over jarring drops in the stock market and dire economic news. Among the shoppers who still feel flush, many are simply waiting to see what will happen to prices. "People feel that if they buy for $5 million today, tomorrow it is going to be worth $4 million -- they do not want to commit to a price," says Saddy Delgado, owner of Miami-based Avatar Real Estate Services. The upshot: The market has slowed to a crawl.

Properties that once took a few weeks to sell are now taking months and months, even as prices continue to fall. Luxury-home prices are down an estimated 20% since peaking last year, and some savvy pros think they will drop another 10% to 15% before bottoming in 2010. That would be later than the likely bottoming of the general housing market; Barron's has maintained that a leveling-off of the broader housing market is imminent in many regions ("Bottoms Up," July 14). But the luxe downturn also began much later than the general slump. Until the second half of last year, most of the $5 million-plus market looked to be headed ever skyward.

Not anymore. Now, almost no sellers of luxury homes can escape the indignities of price-cutting -- not the Astors, not the hedge-fund titans.

The late Brooke Astor's 14-room duplex on New York's Park Avenue is now up for grabs for $34 million, down from $46 million just this summer. Though some of the rooms are smaller than today's billionaires might prefer, the apartment's charms are considerable -- six terraces, five wood-burning fireplaces and a red-lacquered library. And that is to say nothing of its location -- 16 floors up in one of the most prestigious buildings on Park Avenue, No. 778.

Out in posh Southampton, meanwhile, hedge-fund manager John Paulson, who made billions betting against housing stocks, just cut the price on his seven-bedroom "cottage," complete with an enclosed pool, to $13.9 million from $19.5 million in April.

The New York area, in fact, is at the center of luxury housing's latest problems. While so far the hardest-hit high-end markets have been Miami, Southern California, Las Vegas and Phoenix, the worst-off areas in coming months are likely to be Manhattan and surrounding suburbs, says Celia Chen, director of housing economics for Moody's Economy.com. These areas are home to many Wall Streeters and other financial types, and layoffs in finance show no signs of ending. Some 70,000 financial-services employees in the New York area are likely to lose their jobs by the second quarter of 2010, says Economy.com. For those keeping jobs, bonuses could be down 50% or more.

All told, luxury-home prices in and around Manhattan could drop by as much as 20% to 25% over the next 12 to 15 months, says Jack McCabe, CEO of McCabe Research & Consulting, a real-estate consulting firm in Deerfield Beach, Florida.

That poses a dilemma for buyers: Go for a bargain now or an even bigger one in 2009? By the end of next year, "there will be some literal steals out there," McCabe says. But holding out carries its owns risks. "Properties are not like stocks," says Leighton Candler of the New York real estate firm Corcoran, which is handling the Astor apartment. "The one you want may not be available by the time the market turns up."

Right now, with global economies teetering and the Dow off 47% from its high last year, many potential buyers are simply mulling their options. "We are in a lockdown, where there are sellers who want to sell and buyers who want to buy, but they are putting everything on hold," says David Michonski, CEO of Coldwell Banker Hunt Kennedy in Manhattan.

The fact that there are few foreclosures on luxury properties has spared the high-end market from the kind of deep rout in pricing that has crippled the mainstream market, where prices in some regions have plummeted as much 50% from their 2006 highs, according to Fiserv Lending Solutions, a home-price research firm in Cambridge, Massachusetts. While there were 886,920 foreclosures in all this year through September, only 11 were in the $5 million-and-up range, according to a database compiled by RealtyTrac, an Irvine, California, firm that tracks the foreclosure market.

The luxury market has also avoided a direct hit from the tightened mortgage market, because most ultra-high-end deals are cash transactions.

But the deluxe market has developed its own set of troubles lately. Big stock-market losses, a sagging economy and massive layoffs in financial services are sorely affecting the liquidity, wealth and confidence of potential buyers of high-end homes.

The luxury market is also suffering from dwindling interest from foreign buyers. Until lately, buyers from South America, Central America, Europe and Russia were flocking to U.S. shores to take advantage of the weak dollar.

"International activity is one of the things that kept the luxury market healthy up until now," says Laurie Moore-Moore, founder of the Institute for Luxury Home Marketing, a Dallas-based research firm. "Even if U.S. buyers had slowed down, foreign buyers were still going strong."

In fact, it was a Russian fertilizer magnate who set a record for the highest price ever paid for a U.S. residence in July, when he bought Donald Trump's Palm Beach estate for $95 million.

But deals like that may be things of the past now that the dollar has strengthened and an economic crisis is sweeping the globe. "Now foreign buyers are being devastated in their own stock markets and housing bubbles," Jack McCabe says.

A final drag on the luxury market is the inability of some folks to trade up because they cannot sell their lower-priced homes. "I have a couple looking in the up-to-$6 million range, and they are now saying, 'Well, maybe $4 million,' because their home in Florida that they are trying to sell is not even getting shown," says Jackie Garcia, a broker at Prestige Real Estate Group in Denver.

All this is causing inventories to soar to levels unheard of in recent years. Three years ago in the Los Angeles area, for example, "there was at any given time no more than a 3-month supply of [$5 million-and-up] properties," says Gary Gold of Hilton & Hyland, a real estate brokerage in Beverly Hills. In the first quarter this year, that rose to about an 8-month supply, and "now we have over a 1-year supply," he says.

Not surprisingly, home builders are not getting many orders to build new estates. "We are down 50%," says Gene Salvatore, a partner at SWS Builders, a high-end contracting firm in Stamford, Connectictu, who says that he is keeping busy with renovation projects rather than new construction. But even the nature of renovations is different these days, he says. "Before, we would be doing wine cellars, libraries, pool projects and master bathroom suites. Now we are doing more energy-related things that people feel will give them a return in a few years."

Brokers are encouraging buyers to make aggressive offers of as much as 30% below the asking price.

One thing is certain: The seller's market of just a couple of years ago has given way to a raging buyer's market. Brokers are encouraging buyers to make aggressive offers of as much as 30% below the asking price. Some brokers are even dangling gifts for buyers. "I am offering a Bentley valued at $175,000 to buyers who purchase my $65 million and $38 million listings," says Olivia Hsu Decker, owner of Decker Bullock Sotheby's International Realty in San Francisco and Marin County.

Sellers, meanwhile, continue cutting prices. The portion of $5 million-and-up listings that have had price reductions is significantly higher in many areas compared with six months ago. In Bel Air-Holmby Hills, California, 45% of listed high-end properties have slashed their prices, compared with 36% in May, according to Ziprealty.com, a national online-based brokerage. In Las Vegas, 29% of listings are marked down, compared with 17% six months ago, and in New York's Westchester County, the percentage has increased to 28% from 19%.

"We cannot ignore that there is downward pressure," says Michael Rankin, co-owner of Tutt, Taylor & Rankin in McLean, Virginia, which is offering a newly constructed house that saw a price reduction in August from $17.5 million to $15 million. The home, completed this year, has more bathrooms than bedrooms, a ballroom with seven fireplaces, and its own name, Chateau Noble De Mclean.

Some price-cutting has been much deeper. Consider the so-called Pink Palace, a 6-bedroom Baroque-style mansion on Atlanta's "billionaire row." This newly renovated home on four acres, shown on Barron's cover this week, was listed at $20 million last November, and the price was halved to $10 million this October. "Taking 50% off is unheard of -- I never thought we would have to do that," says listing agent Rosina Seydel of Smithson Seydel Real Estate.

In many markets, the biggest markdowns are in neighborhoods that have not traditionally been the core luxury hot spots but were bid up during the housing boom when demand for mansions soared.

"A dynamite house in the flats of Beverly Hills or on the Sunset Strip with a view is not going to see prices coming down," Gary Gold says. "But a house in Nicholas Canyon or other fringe areas that would have gone for $10 million before will now go for about $6 million," he states.

Those kinds of deals will only get better in the months ahead. Then, at some point, the economy will turn, unleashing pent-up demand for luxury homes of all kinds. "When there is finally some good news," says Nelson Gonzalez of Miami realty firm Esslinger Wooten Maxwell, "this market is going to come roaring back in a big way." It is just going to take some time.

FINALLY, BERKSHIRE HATHAWAY LOOKS UNDERVALUED

Ignore misplaced skepticism – Buffet’s baby is finally cheap again.

A Barron's cover story late last year basically claimed that Berkshire Hathaway was overvalued at around $145,000 per share. Now it is selling at $90,000 per share, perhaps proving their point even though that is -- amazingly -- down a bit less than the general market. At the new discount price Barron's figures it is cheap.

They make a reasonable case that it is cheap, but it does not look super-cheap by our reckoning. However; the stock never gets super-cheap. So make your own call here.

The financial crisis has gotten so bad, some investors are even questioning Berkshire Hathaway's strength. But the worries seem overblown.

Berkshire's Class A shares (ticker: BRK/A) fell 10% last week. En route to their Friday [November 21] closing price of $90,000 a share, they touched a 5-year low of $74,100 amid Thursday's market rout. The stock is off 36% for this year.

The selloff reflects concern about Berkshire's equity portfolio, valued at $76 billion on September 30, plus a sizable bet involving put options on $37 billion of equity indexes, including the Standard & Poor's 500 and foreign markets. The derivatives bet, while ultimately likely to be profitable, looks like a rare mistake by Berkshire CEO Warren Buffett, who could not be reached for comment on this story. [Ed: Not that he would have commented even if he could have been reached!]

How much Berkshire has lost on a mark-to-market basis is not clear (our estimate is $5 billion) but Wall Street seems to have overpunished the stock for the bet. As well, Berkshire stands to make record profits in 2009.

The puts give their buyers the right to make Berkshire buy the indexes at a set price, based on the indexes' level on the day the options were sold, mostly from 2005 through 2007. The puts, whose current value is difficult to determine, do not jibe with Buffett's frequent criticism of derivatives as "financial weapons of mass destruction."

Berkshire remains one of world's strongest companies, with a rare triple-A credit rating and a $140 billion stock-market value. It has loads of earnings power, due to dozens of businesses, including auto-insurer Geico, Shaw carpets and Benjamin Moore, although many are being stung by the weak economy.

Barron's took heat from Berkshire boosters with our bearish cover story on Berkshire last December, when the stock traded around $144,000. Berkshire has been hurt by declining profits in the auto-insurance and reinsurance markets, both of which might be bottoming. But now is probably a good time to buy. Looking out to 2009, Berkshire's earnings could get a lift from improving conditions in the insurance market, and from some new high-yielding investments, including $8 billion of 10% preferred stock of Goldman Sachs (GS) and General Electric (GE).

If the stock market rallies in 2009, Berkshire probably will see record profits. Its operating profits this year could be about $5,400 per Class A share, excluding losses on equity and junk-bond derivatives that may cause a 4th quarter loss. One big investor says earnings could hit $7,000 a share by 2010, a modest 13 times the current stock price.

Historically, Berkshire's stock price is linked to its book value. We estimate that Berkshire's book value now is around $66,000 a share, down $11,000, or 14%, since September 30. Our calculation factors in Berkshire's recent statement that its book value fell about $9 billion, or $6,000 a share, in October, on market declines. November has been about as bad for stocks, with the S&P off 17%.

True, Buffett does have less financial firepower to make investments because Berkshire's cash probably has been halved, to about $15 billion, since September 30 -- in part because of its investments in GE, Goldman and Wrigley. It will be interesting to see if the 78-year-old Buffett is willing to issue equity or debt for a major deal, should he want to make one in the coming months.

Berkshire now trades below 1.4 times estimated book value, versus an average of around 1.5 in the past decade -- and current book is depressed. If the stock market rallies 25% in the next year, the stock could hit $110,000, or 1.4 times potential year-end 2009 book value of $80,000 a share.

In such a recovery scenario, many stocks probably would outpace Berkshire. But if the markets do not improve, Berkshire's downside seems limited, thanks to its Fort Knox of a balance sheet. Berkshire's assets of $281 billion in September were 2.3 times its shareholders' equity, versus 20 times for many financial companies.

Buffett probably figured he was getting a great deal by pocketing $4.8 billion in premiums for writing at-the-money puts on some $37 billion of equity indexes with maturities from 2019 to 2027. The puts are only exercisable at maturity, and do not require Berkshire to post collateral whenever the markets fall and their value rises. Who knew that stocks would keep sinking?

But with the S&P 500 down 45% this year, the puts' value rose by about $1.7 billion through September, and might have increased another $3 billion since then.

The Street talk is that Berkshire's counterparties, believed to include Goldman, are worried about their Berkshire financial exposure and are trying to hedge that by buying protection in the credit-default swap market. The cost of that protection last week hit five percentage points -- up from a half-point earlier this year, and seemingly absurd for a company that still deserves a triple-A credit rating. Similar protection for Chubb, which has a lower credit rating, costs less than a percentage point.

In the current environment, fear easily can trump logic. And the overblown fear about Berkshire has created one of the better buying opportunities in years.

The Bottom Line: If the stock market rallies through 2009. Berkshire stock could rise by more than 20%. If the slump rolls on, Berkshire's solid balance sheet offers downside protection for its shares.

A CREDIT-DEFAULT SOLUTION

How to return confidence to the credit markets.

The credit default swap market is a huge, unregulated market with no central clearinghouse. In illiquid times such as today the effective bid/ask spreads on such instruments becomes so large as to preclude the CDS market from effectively functioning.

Yet many of the world's major financial institutions' assets consist of CDSs. They may have hedged their exposures by buying more CDSs, or issuing them, which in normally functioning markets would decrease the riskiness of their total package of assets and liabilities but in this case may exacerbate it instead. The point is, nobody really knows.

Most large financial institutions also have (book) asset to equity ratios on the order of 20-to-1. Their true net worth could thus be anything under the sun. Banks will not lend when they do not know how much they have to lend. Therein lies the problem. This article explains the situation in good detail.

As John Maynard Keynes taught more than 70 years ago, severe and long-lived economic downturns are caused by shortages of demand. One reason for such shortages is a shrinkage in bank credit. Add liquidity to the banking system, as the Federal Reserve has done, and the problem should disappear. But it has not worked in the current economic crisis, in large part because of the banks' pervasive use of credit default swaps.

And, contrary to myth, the Fed did try such interventions 75 years ago. The results, or lack thereof, speak for themselves. This does not detract from the article's main thesis, which is that you do not get borrowing and lending without the presence of confidence.

Banks are very weak today mostly because they cannot measure with any confidence the value of their assets and the extent of their liabilities associated with credit-default swaps, or CDSs. Earlier this year, the total notional value of such unregulated derivatives exceeded $50 trillion, far more than even the central banks could guarantee. Until clarity emerges with regard to the value of banks' CDS holdings, the Fed's fix is unlikely to work, and lending will not resume.

Banks and other investors use credit-default swaps to hedge against defaults by credit issuers. How do they work? Assume a note denoting a debt from a single debtor, or from many debtors whose paper has been bundled into a single collateralized debt obligation, or CDO. The holder of the note seeks to guarantee that he will be paid, and buys "protection" from someone who agrees to swap a package of Treasury bills with an initial value as great as that of the protected note if the debtors don't pay in full.

The contract has to specify the "acts of default" that trigger the swap, and describe the procedures for delivering both the T-bills to the purchaser of the protection and the devalued debts to the guarantor.

Anybody can issue such a guaranty; the buyer must decide whether to believe the issuer can live up to its obligations. If the credit status of the risk-accepting protector deteriorates, the purchaser of the swap has the right to demand collateral. That is what happened at American International Group (AIG), and it was just such demands that forced the Fed to give the insurance company an apparently unlimited checkbook.

The easiest way to handle the delivery problem is to forget about it and do a cash settlement. The seller of the protection pays the difference between the original value of the loans being protected and their value at the moment of the default. For ordinary CDS, that value is decided by asking four dealers for quotes on the insured CDO; the top and bottom quotes are discarded and the other two are averaged to provide a price.

When the defaulted borrower is a major player with varied swaps on its books and a zoo of counterparties -- a Fannie Mae, say, or a Lehman Brothers or Washington Mutual -- the International Swaps and Derivatives Association, or ISDA, can auction off the loans, with the bidders representing the world's big banks. ISDA auctions in September and October produced a value of 91.5 cents on the dollar for Fannie Mae debt, about eight cents for Lehman debt and 57 cents for WaMu debt.

Once an arrangement calls for a cash settlement, you no longer need the swap. At most, the parties to the contract need to reference the bond or note being insured. The seller and buyer of the protection against default can "deem" that, for the purpose of the swap contract, a debtor has issued said note or bond. Even though neither party to the new swap owns or owes or has insured the real bond, one will pay the other if that debtor defaults.

Deeming is especially useful if your purpose in acquiring a lot of swaps is to diversify your portfolio. Your friendly investment banker tells you that as a California bank or hedge fund, you have too much risk in, say, information technology and not enough in nursing homes. He can arrange swaps that will reduce your risk in Silicon Valley while enlarging your risk in Florida, all the while skimming his profit off the top. As the financial mathematician Israel Nelken noted nine years ago in his pioneering book on credit-default swaps, "Credit derivatives arose not from the needs of investors, but from the needs of investment banks."

A Pact Between Consenting Adults

Swaps are basically private contracts between consenting adults; nobody outside the transaction knows they have occurred. What is more, the CDS market is a roach motel: Both parties can enter, but except by special arrangement with each other, they cannot leave. The original seller of the protection can lay off his risk by purchasing a hedge, but if the purchaser of the original CDS claims his rights under contract, he must be paid, whether or not the hedge pays.

At the stock and commodity exchanges, by contrast, the post-trade system works through a "common counterparty." As soon as two brokers confirm a trade, the industry as a whole becomes responsible for its execution. The contract between buyer and seller disappears, replaced by two new ones -- between the clearinghouse and the seller, guaranteeing the seller will get his money; and between the clearinghouse and the buyer, guaranteeing delivery of what was bought.

The absence of a CDS clearinghouse has been disastrous.

Much ingenuity has been expended in the past 30 years to create these systems and the standardized instruments traded at exchanges, and their absence from the swap market has been disastrous. The administrators of the Lehman estate in England told the Financial Times they were able to "quite quickly" settle Lehman trades conducted via exchanges. But there are billions in over-the-counter contracts outstanding with hundreds of counterparties, and it will take years to resolve inter-company and third-party trades.

This is the fault of the regulators, who, in the name of diversification, not only permitted but encouraged bankers to replace loans with highly leveraged and immensely complicated swap contracts. Now they are sorry. The President's Working Group recently expressed the hope that someone would invent a common counterparty for CDS before the first of the year.

A common counterparty, however, requires standardized contracts that can be extinguished in the clearing process. Alas, the PWG statement begins not with a call for simplicity but with the claim that over-the-counter derivatives are "integral to the smooth functioning of today's complex financial markets ... and can enhance the ability of market participants to manage risk."

The worry is not that debtors cannot pay, but that creditors cannot afford not to be paid.

Uncertainty ruins markets not because of the worry that debtors cannot pay, but because of the fear that creditors cannot afford not to be paid. Bankers who do not know whether their hedges will protect them do not make loans. The central banks have poured limitless cash into the banks to try to convince them they really can afford not to be paid, and the sheer size of government intervention may buy time to work through the CDS disaster. Let us hope so, because lending cannot resume in a significant way until it is resolved.

The Depository Trust and Clearing Corporation has created a "warehouse" that claims to have registered up to 90% of recent CDS. The warehouse could clear these contracts so the world would know who owes how much to the system, and who has credits that might be used to clear it. Actual settlement could be delayed a few weeks, much as the settlements were delayed after the Fannie and Lehman auctions. Some banks would be unable to meet their obligations under the swap contracts and would disappear. Some would be winners. Some would be recapitalized with the Treasury's loose change, and the world could move on.

The mark-to-myth models must be exposed and destroyed for confidence to return.

In the end, an information-rich world will steeply discount a market where information is hidden. The Fed's efforts to right the ship have been hampered by its own tradition of secrecy. Indeed, some of us are old enough to remember a time when the Federal Open Market Committee did not tell anyone but its own traders that it had decided to change the federal-funds rate. The scary truth is that its leaders bought into many of the mathematical models that predicted sure things for banks.

Instead of burying these models in cash, we must expose them to the light of day and publicly destroy them. Then and only then can confidence return to our markets.

THE NEW ASSET BUBBLE IS TREASURY BONDS AND T-BILLS

People fail to realize that the housing bubble fueled by cheap credit and excess confidence is gone for this generation.

Some bubbles are obvious while they are happening, even if their top and duration are hard to predict and potentially ruinous to bet on. Others only become clear in 20-20 hindsight: An asset class tanks in price and you realize, "Yes. That was a bubble."

We posted some articles mid-year when oil was approaching $150 a barrel which cited the likes of George Soros, who noted that oil's parabolic price spike were the equivalent of bubble fingerprints. Others who noted the pattern demurred, arguing that a correction was indeed due but that oil was not necessarily in a bubble. One 2/3 price correction later it does not matter what it was -- if you were long oil last July and stayed long, you are hurting. Soros was correct. The rest is just semantics.

The current bull market in U.S. Treasuries of all durations is the latest bubble, claims veteran Barron's writer Thomas Donlan. One man's mad rush for liquidity in deflationary credit crunch times is another one's bubble, we suppose. The bottom line is that buying U.S. 30-year T-bonds yielding 4% looks like as big a sucker's bet as there is around these days. The fact that the U.S. can print money to pay its bills is paradoxically a confidence builder during a deflation. Is is a confidence destroyer come inflation's return. Caveat emptor.

For months, Americans have been made to understand that there used to be a housing bubble, fueled by easy credit and an excess of consumer confidence. But what we still do not accept is that those days are gone for this generation. We keep trying to bring them back with more cheap credit and appeals to the restoration of confidence, no matter how unwarranted.

The Treasury Department and the Federal Reserve give away money to banks, and then Congress complains that the banks do not, in turn, lend it, neither writing mortgages nor business loans.

Why should they lend? To whom would they lend? Their best customers are trying to get rid of their debt, not take on more. Their worst customers would love more credit, of course, especially if they do not have to pay it back, but who wants that kind of customer in times like these?

Clowning Around

All the world, however, is still eager to lend to one impecunious borrower: The U.S. Treasury has to beat away would-be lenders at every auction of U.S. debt.

There are so many eager investors that last week the Treasury could pay less than 1/10 of a percent per annum to borrow money for terms of one month and two months. The rate was a hair above 2% for five years' borrowing and a hair under 4% for 30 years'.

One-month money cost the Treasury an annual rate of 5% as recently as August of last year. Five-year money and 30-year money were actually a little cheaper than 5%, thanks to a yield curve inverted by fear of inflation.

Now that the fear-of-the-month is deflation, investors want to put what remains of their capital into T-bills. Now short-term money is essentially free. Traders wonder if a bull market in bills can push the return on capital into negative territory.

As the latest stock-market bubble and the latest real-estate bubble merge into the misty anguish of the technology bubble now 10 years past, should we be looking for the next one? The other bubbles, after all, were ignited by excessively cheap money.

Energy, especially oil rising to $147 a barrel, briefly looked like a promising candidate. Then the energy boom burned out, leaving a lot of bulls looking like clowns.

Where are the clowns? Don’t bother; there’re here.

"Where are the clowns? Quick, send in the clowns," as Steven Sondheim wrote in the famous song from his musical A Little Night Music. But, as the last verse ends so poignantly, "Don't bother; they're here."

Or as Pogo would have put it: We have met the clowns and they are us.

We -- the world's investors and speculators -- are the clowns who create bubbles, and we are at it again. This time, cheap money is both the cause and the effect.

If Treasury securities are assets at all, then Treasury bills and Treasury bonds are the new asset bubble. The U.S. Treasury is selling security -- return of capital -- and the world is as hungry for that product as it was hungry for energy a few months ago.

Ask the Russians and the Saudis and the Canadians how secure the Treasury's debt-issuers -- and all Americans -- should feel about the privileged status of their most important product. When world markets can drive the price of oil from $50 to $147 in three years and back below $50 in just four months, a bubble in bills should not be a lasting comfort.

Smiling Flowers

The English poet Robert Herrick issued this warning to young ladies more than 400 years ago:

“Gather ye rosebuds while ye may,
Old time is still a-flying:
And this same flower that smiles today
Tomorrow will be dying.”

Herrick's poem addresses a kind of youthful, luminous beauty that cannot last forever. But the luster of T-bills cannot forever empower the U.S. Treasury, either. Standing in for Robert Herrick in these times is a chorus of Wall Streeters called the Treasury Borrowing Advisory Committee of the Securities Industry and Financial Markets Association.

These 14 worthies met with a gaggle of civil servants on November 4 at the Hay-Adams Hotel, just across Lafayette Square from the White House and the Treasury. The formal minutes of the closed meeting betray a certain anxiety about America's fiscal rosebuds: "Acting Assistant Secretary for Financial Markets Karthik Ramanathan stated that the exceptional borrowing needs in fiscal year 2009, which according to market estimates could approach $1.4 trillion and potentially vary by $500 billion, presented a unique set of challenges for Treasury."

Some members apparently scoffed at the Treasury's estimate, and guessed that the government will need $2 trillion of new money in fiscal 2009.

Even using the Treasury's estimate, borrowing twice as much as the market absorbed in 2008 would not be a small thing. Worse, the character of U.S. debt adds to the challenges. So much of the national debt is borrowed on short maturities that borrowing activities on the Treasury's estimate could exceed $2 trillion in fiscal 2009, as short-term bills are rolled over and over.

"Despite borrowing across the curve, the average maturity has declined by three months in the last quarter," Ramanathan reported. The advisory committee urged Treasury to go longer, issuing 3-year notes, more 10-year notes and more 30-year bonds.

Mis-Leading Indicator

Is there a limit to investors' willingness to buy the security of Treasury securities?

We all are looking for it. Lengthening maturities may sharpen everyone's eyesight.

We do not know how long investors will be as willing to swallow tiny Treasury yields as they were willing to swallow high-priced oil. We do know that we will not like it when they finally stop and the bubble in bills and bonds bursts at last.

Any reasonable investor faced with the current market circumstances must cast a wistful eye at gold. The magical metal is usually the last refuge of fearful people -- not Treasury paper paying negligible interest.

But current market circumstances include a perplexing lack of faith in gold, which is off nearly a third from its record high, set in March.

The message is creepy: If gold is too expensive, what is cheap?

THIS YEAR’S FORBES INVESTMENT GUIDE IS OUT

Insight into navigating perilous economic times.

Forbes's annual Investment Guide, as with the magazine (printed or online) itself, rewards a thorough read. We will be featuring the individual articles extensively going forward. Here is the introduction/table of contents.

The lead article, below, encourages readers to engage in some fundamental thinking about their retirement planning, which in effect means thinking about their finances in general. Most of it is common sense -- spend wisely, invest wisely, etc. -- with some technical details regarding taxes, appropriate portfolio asset mix, and such. (Not discussed is the subject of legal asset protection per se.) But "knowing" what is sensible and doing what is sensible are different things. If the later flowed inevitably from the former we would live in a much different world.

It is gut-check time for savers, a time to reconsider long-term financial goals and how to achieve them. The stories offer ways to make realistic plans, protect what you have got and ensure your portfolio resumes its growth. We also offer insights on advisers, charities and complex annuities.

Retirement Rescue

Stay on the job. Defer spending. Grit your teeth and take a hard look at your portfolio.

In 2006 Michael and Lynn Neff, now 60 and 61, thought they had retirement figured out. He quit his corporate marketing job, she shut down her Washington, D.C. educational testing business and they retreated to a $1 million, 4,335-square-foot waterfront home in Irvington, Va. (pop. 650), where he would pursue a photography career and she would do a little consulting. They sank $160,000 into renovations and bought a $57,000 fishing boat.

But they found they did not enjoy small-town life as much as they expected and, after their portfolio tanked, did not want to spend so much on housing. "We swung the pendulum a little too far," Michael Neff admits. Now they plan to move to Charlotte, North Carolina, where they hope to work more and buy a house for half the price -- once they can sell their 1-acre property. They are asking $874,900 and are open to a rent-to-buy deal. "We are stuck," he says. "If we have to stay here another year, I won't be happy."

The Neffs are not your usual hard-luck story -- they have a low-6-figure income, thanks in part to her royalties from a test she created. But they are not unusual in deciding to work more, spend less and take a new look at the allocation of their investments. The Neffs had 80% of their portfolio in stocks. Market losses have reduced that to 60%, where they are sticking for now.

Folks of all ages are hurting, of course. But in theory, the market downturn could work to the advantage of those 45 and younger, with decades to go before retirement -- if they keep buying stocks now on the cheap. Kelly Blake, 30, a Fort Lauderdale, Florida insurance company data analyst, has seen the value of his 401(k) fall 40% this year. He is sticking with 100% stock and is upping his contributions from 6% to 10% of his salary. "I still have a lot of time until I need the money," reasons Blake.

At the other end of the age spectrum, only 35% of households headed by someone age 75 or older own any stock at all, compared to 63% of households headed by people between 55 and 64.

So it is not surprising that those in their 50s and 60s are the most likely to be hastily rewriting their plans. They own more equities and may also have been counting on their now shrinking home equity as a backstop in retirement. "The recently retired are the most nervous group, but the preretirees are beginning to realize that in many cases their retirement plans need to change," says Timothy Wyman, a partner with the Center for Financial Planning in Southfield, Michigan, who has been calming such investors daily. Here are some moves to consider.

Work longer

Even before the current mess, those in their 50s and early 60s planned (according to numerous surveys) to retire later and work more in retirement than the previous generation had. The top reason they gave was staying active. Working longer is now a matter of necessity, particularly for those who will be relying on investments, as opposed to a fat, fixed company or government pension, to supplement Social Security.

Alicia H. Munnell, an economist and director of the Center for Retirement Research at Boston College, says that workers, once they hit 62 and can claim reduced Social Security benefits, sometimes quit impulsively, even when they had planned to work longer. "There is a natural tendency, as we get older, to become intolerant of nonsense," says Munnell, 66. "It is important for people to recognize that in themselves and resist the temptation to say, 'I am out of here.' If you get a young boss you hate, suck it up." For each month you delay claiming Social Security, up to age 70, you earn a bigger government check. That check is adjusted each year for inflation and is key to making sure you can maintain a decent (not fancy) standard of living, no matter how old you get and no matter what your investments do.

Moreover, retiring into a bear market has drastic effects on your prospects. T. Rowe Price calculates that if a 65-year-old retires and his portfolio loses 30% in the first year, he stands a 60% chance of running out of money over the following 29 years, unless he chops planned withdrawals. Yet if that 30% drop does not hit until 15 years into the same investor's retirement, there is less than a 5% chance that with the same assets and spending plan he'll come up short.

Spend less

It will not help the overall economy, but it is crucial to conserve your cash, particularly if you are fully or partly retired and cannot ramp up earnings. "Pull in your belt. Let Nancy Pelosi and Harry Reid do the spending for you [through a federal stimulus bill]," jokes Munnell. Planner Wyman has one client putting off a $20,000 roof job and another postponing the purchase of a $35,000 Chrysler.

If you are 70 or older and have not taken your 2008 required minimum distribution from your individual retirement accounts, delay a few weeks more. There is a chance Congress could suspend the requirement that you take a payout this year. There is also a chance Congress might provide a tax break for the 2008 distributions you do take, so stay tuned.

If, however, you are young or affluent enough that you can leave your IRA to your kids, this might be the time to take money out of your traditional IRA and roll it into a Roth (see below).

Rent before you buy

Couples often buy a retirement home in some leisure spot, only to find it is not Shangri-la. That was no big deal when you could sell your mistake easily, maybe even at a profit. Now? Rent first in the new location, says James LaGrone, a cpa in Rockville, Maryland. That is what he is urging his clients the Neffs to do in Charlotte.

A couple can exclude from tax up to $500,000 in gains on the sale of a primary residence they have lived in for at least two years. Reinvesting in a new house within a certain time frame is no longer relevant to taxes. So you can take your time after selling your old house. Moody's Economy.com does not expect prices to bottom out in key Florida retirement markets until 2010 or later.

Examine your stock/bond mix

Say you started 2008 with $1 million in Vanguard's Total Stock Market Index and $1 million in its Total Bond Market Index. On November 12 your bond fund was worth $1 million and your stock fund only $590,000 -- cutting your stock allocation from 50% to 37%. Traditional investing advice would be to "rebalance" by selling bond shares and buying stock shares to get back to 50-50. In theory, rebalancing forces you to sell high and buy low. "It is the Warren Buffett point -- the best returns to stock market investing come when you invest at an attractive price," says Harvard economics professor John Y. Campbell.

But before you rebalance, ask yourself if your old allocation was well considered and, if so, whether you are still comfortable with it. According to data from Fidelity Investments, 401(k) participants aged 60 to 64 held a median of 66% of their portfolios in equities at the end of 2007, up from 60% at the end of 2002. Why more stock? "Inertia. People just were not paying attention," answers Richard Thaler, the University of Chicago behavioral economics pioneer. As their stock funds grew faster, participants never rebalanced away from them.

Is 66% stock at 60 too high? The traditional, conservative rule of thumb is to own your age in bonds, meaning a 60-year-old should be 60% in bonds, 40% in stocks. But some advisers have been advocating a higher stock allocation, based on longer life spans and the impact of inflation. T. Rowe Price, after much research, suggests 63% in stocks five years before retirement. [Interactive chart here.]

Maybe T. Rowe is right. Maybe not. But this higher stock allocation is not something you should allow yourself to drift into, particularly not until you assess your tolerance for risk. Nancy Anderson, a planner with Financial Finesse, which runs help lines as an employee benefit for big companies, says a recurring theme among older callers is that they discovered only after the bear market that they are not very risk tolerant.

So what are those worried callers doing now? Mostly nothing. "People want to panic, but they do not know how," says Thaler. "They have strong competing urges. One is to get the hell out of stocks. And then there are people telling them, 'No, you should be rebalancing [to buy more stocks].' Both of these arguments sound compelling, so they do nothing," he adds.

Ironically, doing nothing now might not be such a bad response, unless an investor is young. That saver should put more in stocks, Thaler says.

What if you decided on a high-equity allocation before stocks tanked but now are uncomfortable with it? That is not so crazy -- the world looks riskier, even to the pros, and you are poorer now. Campbell's research shows richer individual investors take on more risk. "People have a notion of a minimum amount they want to invest safely in a lockbox, for minimum subsistence. It is the surplus over that amount that you should rebalance, and the surplus is smaller now."

Says Ian Weinberg, head of Family Wealth Advocates, a Woodbury, New York planning firm: "You need to build an allocation you can ride with."

Buy TIPs (and fixed annuities)

Do not just obsess over stocks. Take a hard look at the safe portion of your portfolio. It may not be as sturdy as you thought. Investment-grade corporate bonds have sustained double-digit losses this year, with high-yield bonds doing far worse. The result is that investors seeking safety have pushed yields on Treasury bonds to absurdly low levels -- particularly considering the vast sums the U.S. is borrowing and pumping into the economy.

An exception is Treasury Inflation-Protected Securities, which provide some inflation protection, as well as protection from default risk. With TIPS, your principal is adjusted each year for inflation, and you receive a coupon consisting of a fixed percentage of that varying principal. The coupon (stated as a yield to maturity, which reflects whether the bond is trading at a premium or discount) is now 3.1% on ten-year TIPS.

If inflation stays at 4.9%, you will get an 8% nominal return. (You are taxed each year on the whole 8% as ordinary income, even though you do not receive any cash flow from the principal adjustment. So TIPS are best held in an IRA or other tax-deferred account.) Weinberg is pouring his high-tax-bracket clients into another relatively safe option paying handsome returns: municipal bonds. In early November AAA-rated 30-year municipals were paying 5.2% in federal-tax-free interest.

Mark J. Warshawsky, director of retirement research for Watson Wyatt Worldwide, suggests investors in their 70s looking for steadier cash flow also buy fixed immediate annuities. (Vanguard and other low-cost providers now sell them.) You are letting the insurance company take the market risk and hedging another risk -- namely that you will live so long you will outlast your money. What about the risk the insurer itself will go bust? Make sure your annuity is covered by a state guaranty fund.

Consider hiring a pro

Tools to help you gauge your risk and allocate assets are available on the Web. Fidelity's tools, for example, not only help you reach a target but also show you how specific sales or purchases would affect your overall allocation. If you find this too daunting, consider getting professional help. (But first read the story about when to fire a financial adviser.)

Erwin Freed, 68, and his wife, Carolyn, 64, decided to hire a pro when their 90% stock portfolio started getting slammed in the tech bust of 2000. Christopher Parr, their fee-only planner at Financial Advantage in Columbia, Maryland, says: "I told Erwin this was a high-testosterone portfolio and not suitable for someone at his stage of life."

The Freeds now have 42% of their $1.3 million portfolio in stock funds. That includes inverse funds that go up when the market is down, reducing their true equity long exposure to 30%. In the 12 months ended September 30, the Freeds were down 8.6%, while the S&P 500 declined almost three times as much. Over the last five years Parr has, net of his fees averaging 0.86% a year, produced average annual returns of 5.15% for the Freeds -- about the same as the S&P 500's return with a lot less volatility.

Not fantastic, but enough with the Freeds' $45,000 a year in pension and Social Security income to support their active, unpretentious lifestyle. Carolyn, a retired aerobics instructor, has got them both into ballroom dancing. Erwin is a bicycling buff. They rent a house in Florida each winter. Erwin Freed has no complaints. "Now I open my statements and say, 'No dog food tonight.'"

Going for the Roth Conversion

You may be able to turn today's market losses into tomorrow's tax savings through a Roth conversion. In this maneuver, you withdraw funds from a traditional individual retirement account, pay any ordinary federal and state income taxes due (preferably with non-IRA funds) and roll the proceeds into a Roth IRA, where all future growth is tax free. Only taxpayers with "modified adjusted gross income" of $100,000 or less can do a Roth conversion in 2008 or 2009. (The same $100,000 limit applies to both singles and couples and does not include the amount of the conversion or any required minimum distributions you must take from your regular IRA because you have reached 70½.)

In 2010 the $100,000 restriction is supposed to end permanently. Will Congress now close the conversion window? The progressives controlling Washington may be disinclined to give any kind of freedom to high-bracket taxpayers and will be able to argue that closing the window raises tax revenue over 10 years.

Why pay taxes before you have to? A conversion can make sense if you will not be tapping into the IRA for decades. Green Bay, Wisconsin CPA Robert Keebler is helping a 32-year-old client convert his $20,000 IRA. Since he made aftertax contributions of $8,000 to the account, only $12,000 of the total is taxable now, and he has decades to enjoy tax-free growth in a Roth. Note: You must recognize a proportionate share of your pretax contributions and earnings, as well as aftertax contributions, in any conversion.

Older folks should consider conversions, too, if they do not expect to need their IRA money. You do not have to take required distributions from a Roth, as you do from a regular IRA. Instead, you can leave the Roth to your kids, who can then stretch out tax-free growth and withdrawals over their own lives.

Another reason to do a conversion: as a risk-free bet that the market is about to surge. Risk free because, incredibly, the government gives you until the due date for your tax return -- with extensions -- to undo a conversion and pay no tax. That is until October 15 of the following year. If this December you take $100,000 from a regular IRA and put it in a Roth, and the market is flat or down on October 15, 2009, you undo the conversion and owe no tax. If the $100,000 is worth, say, $130,000, you keep the Roth and pay taxes due on the $100,000. You can do multiple conversions with separate asset classes of stocks and then keep the best-performing conversions as Roths, while reversing the rest.

If you wait until January to convert, you will have until October 2010 -- to let your market bet ride. But then you run the risk that Democrats will raise tax rates for 2009.

GLOBAL FINANCIAL SYSTEM – CALLING FOR THE PLUMBER!

Part, maybe a lot, of the difficulty of working through today's financial market problems is the sheer complexity of the contracts and arrangements involved. It will take a long time to work through the details no matter how high a priority level the task is given.

We recall a story told to us during our undergraduate days -- presented as true -- which will serve as a good metaphor: There once existed a species of deer where the males' antlers became ever bigger and fancier because that was what the females of the species were biased towards in their selection of mates. Eventually the unwieldiness of the antlers resulted in the deer becoming easy prey for their predators. Besides the weight, the antlers had a penchant for getting caught in tree branches at the wrong time. The species went extinct.

Satyajit Das, author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives, likens the system to a big fancy building that may be a wonder to behold from the outside but whose plumbing is clogged -- and there is a shortage of plumbers because the profession has been scorned as drudge-work. "Understanding of the detailed connections, whilst unglamorous, is increasingly the key to anticipating the evolution of the crisis and preventing exposure to events. It is also where long-term reform efforts of the financial system should be directed," Das concludes. Hard to argue with that.

Financial crises increasingly result from the structure of modern capital markets. External shocks -- such as declines in housing prices -- are transmitted via connections between participants who are tied together by complex chains of dealings. Concentration of trading amongst a small group of large dealers exacerbates the risk.

The decision not to support Lehman Brothers, with the benefit of hindsight, was a major miscalculation and a significant factor in the subsequent problems at AIG and other institutions as well as the complete failure of money markets.

Regulators and governments have shown limited appreciation of the detailed plumbing of the system for which they are responsible. In the present crisis, they have frequently appeared like Pritzker Prize winning architects trying to deal with blocked plumbing. Central bankers and finance ministers have found themselves in the position of Woody Allen: "Not only is there no god but try getting a plumber of weekends."

In fairness, even experienced professionals have struggled to understand the structure of modern markets. Jeremy Grantham, Chairman of GMO, recently observed:

"I want to emphasize how little I understand all of the intricate workings of the global financial system. I hope that someone else gets it, because I don't. And I have no idea, really, how this will work out. I certainly wish it had not happened. It is just so intricate that all I can conclude, by instinct and by reading the history books, is that it will be longer, harder and more complicated than we expect."

Increasingly it is difficult to analyse the solvency of financial institutions. The speed with which available liquidity and access to funding can evaporate renders financial statements out-of-date and inadequate.

Agreements such as those governing derivative contracts also increasingly affect solvency. For example, the downgrade of AIG below a "AA" rating triggered margin calls (in excess of $10 billion). The downgrade also gave counterparties to transactions with the firm the right to terminate certain contracts triggering large losses ($4-5 billion). AIG did not have adequate resources to meet these commitments ultimately requiring U.S. government support.

The exact effect of financial distress depends on the form of any restructuring. In the case of bankruptcy, Chapter 11 filing or equivalent, the crucial issue is which legal entities are placed under protection. In the case of Lehman Brothers, only selected entities (primarily the holding companies) filed while other entities continued to operate. This means that the position of each institution dealing with Lehmans may be different depending on which legal entity they contracted with.

In the case of Washington Mutual ("WaMu"), the Office of Thrift Supervision closed the bank on concerns about its ability to meet its obligations. J.P. Morgan subsequently paid $1.9 billion to the Federal Deposit Insurance Corporation ("FDIC"), in its capacity as receiver, for the assets and certain liabilities of Washington Mutual's banking operations. J.P.Morgan did not assume the senior unsecured debt, subordinated debt and preferred stock of WaMu resulting in losses for investors.

Financial distress inflicts predictable losses on creditors. In the case of Lehman, creditors included banks from every continent -- U.S., Europe, Japan, Asia and Australia. Retail investors in Asia and Europe who had purchased structured products issued by Lehmans also suffered losses.

Market estimates of recovery rates on Lehman's debt are around 10-15% of face value (a loss to investors of 85-90%). Recovery rates will be affected by the nature of assets that many financial institutions now hold -- private equity stakes, principal investments, hedge fund equity, complex slices of risk in structured finance transaction and derivatives. The difficulty in valuing these assets, their illiquidity and (currently) the absence of markets for many such assets may exacerbate losses.

If the financial institution files for Chapter 11 or bankruptcy then all derivative contracts entered into with the entity would also normally automatically terminate. This triggers a complex chain of events.

The value of the contracts must be determined by either seeking market quotations or other "commercially reasonable procedures" depending on the documentation. The values of individual contracts may be netted if the contracts specify to arrive at an overall amount that must be settled between the counterparty and the distressed entity. If the counterparty owes that amount then it must be paid immediately to the trustee in bankruptcy. This results in an immediate (possibly large) cash requirement for the non-defaulting party. If the distressed entity owes the amount then the counterparty must lodge proof of debt with the bankruptcy trustee and await payment.

If the counterparty is holding collateral securing the exposure under the contracts then the collateral must be sold to realise cash to cover the amount due.

Where the derivative contract was being used as a hedge, termination of the derivative contracts exposes the counterparty to the underlying risk. The counterparty must then enter into new contracts at current market prices to re-hedge itself to avoid additional risk. Hedging must generally be done on a contract by contract basis with limited scope for netting.

The entire process is complex and time consuming meaning that the amount of losses sustained may not be known with certainty for some time.

A bankruptcy or Chapter 11 filing may also trigger contracts referencing the financially distressed firm. For example, the bankruptcy filing would have triggered such as credit default swaps ("CDS") contracts on Lehman Brothers requiring settlement of these contracts as well.

Where CDS contracts were held as hedges they would alleviate losses that would otherwise have resulted. In all cases, settlement triggers payments creating potential losses and claims on available liquidity and funding. Settlement of credit default swaps on Lehmans totalled around $365 billion. If a party is unable to meet its obligations under a CDS on Lehmans then the process starts over again involving the new party.

Financial distress affects other parties through "contagion". Counterparties who had dealings with the distressed entity either suffer losses or suffer cash outflows as they meet termination payments. They may suffer additional losses on sales of collateral or from re-hedging positions. These losses affect their credit quality and solvency setting off falls in the price of their shares and rises in borrowing costs. If credit ratings are affected then this may trigger margin calls or other events that further threaten solvency.

Financial distress of any entity also affects the market. Volatility of asset prices increase reflecting liquidation of positions, re-hedging activity and sales of collateral. Trading liquidity is reduced as the number of counterparties falls. Credit limits become scarce limiting the ability of firms to deal with each other. Uncertainty about the impact of financial distress of one entity on all other market participants causes trading in the inter-bank market to freeze up further increasing volatility and potentially risk of failure of weaker firms. Asset price falls trigger further cash calls and distress for other market players.

The process is complicated by a variety of factors. In any bankruptcy, the sheer number of contracts that must be dealt with can be large. Lehman Brothers, it is understood, had about 2 million contracts open. There are likely to be cases of incomplete documentation and errors that will need to be resolved. Operational risks and problems of logistics abound.

The bankruptcy proceedings inevitably accelerate the need to deal with difficult to value and illiquid assets. Action taken by the trustees and administrators in the best interest of creditors can adversely affect the overall market.

Bankruptcy law is jurisdiction specific and different sets of trustees and administrators will grapple with how to best manage the assets of a specific legal entity for the advantage of its creditors. In the case of Lehman Brothers, there are already disputes about transfers (totalling $8 billion) made between the English entity and the U.S. companies. There may also be differences in approach in dealing with the assets. The U.S. trustee in bankruptcy indicated that "time was of essence" in dealing with the assets. In contrast, the UK administrator anticipated a long drawn out affair. All this creates uncertainty about the impact on creditors and the market.

Assets held in a fiduciary capacity can become entangled in the process. Where Lehman Brothers acted as prime broker, hedge funds and other asset managers now face a cumbersome process and potentially lengthy delays in recovering investments held by Lehman. This affected around $45 billion in assets and $20 billion in short positions. The legal owners now are unable to deal with their assets but may face margin calls if the value of the positions deteriorates.

The true owners of these assets also become exposed to risk of losses where their assets (pledged to cover loans) have been re-lent by Lehmans to finance itself (a process known as "re-hypothecation"). This spreads the problem to hedge funds and asset mangers with no ostensible exposure to the bankruptcy.

These complex networks and links tie to together all participants in modern financial markets. The chains of risk spread problems from distressed financial institutions to weak institutions ultimately affecting even strong entities, seemingly remote from the problem.

The risk spreads through direct losses, calls on liquidity, the ability to fund or the uncertainty created that ultimately brings the ability to deal with confidence and security in financial instruments to a halt. Contagion resembles nothing so much as a hungry wolf pack that systematically hunts down weakened prey animals within a herd one by one.

Understanding of the detailed connections, whilst unglamorous, is increasingly the key to anticipating the evolution of the crisis and preventing exposure to events. It is also where long-term reform efforts of the financial system should be directed.

John W. Gardner once observed: "The society which scorns excellence in plumbing as a humble activity and tolerates shoddiness in philosophy because it is an exalted activity will have neither good plumbing nor good philosophy: neither its pipes nor its theories will hold water." Shoddy monetary philosophies caused the financial crisis. Now inadequate plumbing of the global financial system is exacerbating its risks.

DE-LEVERAGING – FAIRY TALE ENDINGS

In an article which preceded his one covered above, Satyajit Das provides some valuable and much-needed specifics about what "the great de-leveraging" will have to look like in real life, as opposed to in the talk-o-sphere. It will be messier and more involved and take longer than everyone is expecting -- especially if the policy makers keep fighting the unwind tooth and nail.

The talk-o-sphere is the world of academia and government policy making. People and policies are abstractions and get manipulated like so many pawns on a chessboard. If the real world will not conform by doing what the central planner's figured or intended, why that is its problem. In our experience within five minutes of entering a conversation whose dominant mindset is academic/government, everything you can come up with seems oh so reasonable. It takes discipline to stay grounded in reality. And that discipline is not much in evidence right now among those most empowered to make a difference.

In The Arabian Nights, the beautiful princess Scheherazade buys one day of life at a time by recounting fantastic fables that enchant the King who has condemned her to die. Investors and traders are currently telling each other fairy tales to buy one day at a time to stave off the inevitable.

The drama and tumult of recent events are not symptoms of the disease but the cure. The "disease" is the excessive debt and leverage in the financial system, especially in the U.S., Great Britain, Spain and Australia. In the lyrics of the Bruce Springsteen song -- many have "debts that no honest man could pay."

The "cure" is the reduction of the level of debt (the great "de-leveraging"). In 1931, Treasury Secretary Andrew Mellon explained the process to President Herbert Hoover: "Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate. Purge the rottenness out of the system. High costs of living and high living will come down. And enterprising people will pick up the wrecks from less competent people."

The initial phase of the cure is the reduction in debt within the financial system. The overall losses to the financial institutions (net of re-capitalization via new equity issues) are $400 to $600 billion and may well go higher. This requires reduction in financial sector balance sheets (assuming bank system leverage of around 10 times) of around $4 to $6 trillion through reduction in lending and asset sales.

For example, the bankruptcy of Lehman Brothers resulted in $600 billion of debt being eliminated. In turn, this inflicts losses on holders of Lehman debt that in turn flows through the chain of capital. The destruction of Lehman Brothers' capital (around $20 billion) also permanently diminishes the capacity for further credit creation in the future.

The second phase of the cure is the higher cost and lower availability of debt to the real economy. This forces corporations to reduce leverage by selling assets, reducing investment and raising equity (for example, as GE has done). This also forces consumers to reduce debt by selling assets (where available) and reducing consumption.

Feedback loops mean reduction in investment and consumption lowers economic activity placing stresses on corporations and individuals setting off defaults that trigger losses for the financial system that further reduces lending capacity. De-leveraging continues through these iterations until overall levels of debt reach a sustainable level determined by lower asset prices and cash flows available to service the debt. The process of destruction echoes W.B.Yeats's words: "All changed, changed utterly: A terrible beauty is born."

Within the financial sector, de-leveraging is well advanced. In the real economy it is in the early stages.

Fairy tales in financial markets focus on the "superhuman" abilities of regulators and governments to avoid the de-leveraging under way. Central banks and governments have taken progressively more aggressive actions to try to influence events.

Central banks have supplied liquidity to the money markets accepting an increasing range of collateral. Central banks may soon accept baseball cards and Lehman, Bear Stearns and Washington Mutual ("WaMu"), Fortis and Dexia memorabilia (mugs, stress balls, desk-decoration cubes that open up to reveal Lehman Brothers' key operating principles -- "demonstrating smart risk management").

Government and central banks have also "bailed out" a number of financial institutions using a variety of strategies to limit contagion. Lower interest rates and increased government spending has been used to try to reduce the effects of the financial crisis on economic activity.

In September, the U.S. government's plan du jour was a $700 billion package that was the latest magic potion. It is puzzling why this initiative was seen as the "silver bullet" that would "fix" the problems.

A cursory analysis of TARP (Troubled Asset Relief Program) revealed considerable confusion about even what problem it is addressing. The proposal to purchase up to $700 billion in "troubled" assets was not dissimilar to the existing liquidity support provisions in place. If assets were correctly valued in the books of the selling banks, then purchase at that fair value only provided funding to the bank. The difference is the risk of the securities was transferred to the government but so was any possible recovery in the price. ...

By October 2008, TARP had receded into the background. A number of governments resorted to injecting equity into selected banks and providing extensive guarantees supporting bank borrowings. Consistent with this approach, the U.S. government made the leading banks an "offer they couldn't refuse" injecting $250 billion in equity directly into financial institutions.

The actions to stem the crisis have been increasingly directed at three areas. Banks are being forced to write-off bad loans without delay. Bank capital needs are being addressed by forced mergers and restructuring, new equity issues and (in the absence of other options) nationalisation or liquidation. Central bank guarantees of all major borrowings and other transactions to reduce solvency risk for banks are designed to enable normal transactions between parties in the financial markets to resume. The necessary coordinated global action appears at last to be under way.

The initiatives are sensible short-term measures to stablize markets. In the longer run, they transfer the problem onto the government and taxpayer balance sheet. For example, U.S. Government support for financial institutions in this financial crisis is already approaching 6% of GDP (compared to less than 4% for the Savings and Loans crisis). The bailout of Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) has almost doubled U.S. national debt. This will ultimately place increasing pressure on the U.S. sovereign debt rating and vitally the ability of U.S. to finance its requirements from foreign creditors.

Government and central bank initiatives to date have been ineffective. Money markets remain dysfunctional and inter-bank lending rates have reached record levels relative to government rates. The failures are unsurprising.

At the height of the boom, banks used a variety of techniques to increase the velocity of money. As the system de-leverages, the velocity of money has sharply decreased.

Money being supplied to the banks is not being lent through. Banks are parking the money in short dated government securities in anticipation of their own funding requirements. Around $3-4 trillion of assets are returning to bank balance sheets from the "shadow" banking system -- off-balance sheet structures -- that can no longer finance themselves. In addition, banks have large amount of maturing debt (estimates suggest $1.5 trillion by the end of 2008) that they must fund. Fear of bank failure (especially after the bankruptcy of Lehman and restructuring of WaMu) and shortages of capital also limit ability of banks to on-lend.

It remains to be seen whether the most recent global initiatives achieve the required re-capitalization of banks improves the normal supply of credit to sound borrowers and also reduces fear of default allowing normal activity between institutions to resume.

The key issues remain availability of capital and liquidity. The perceived abundance of liquidity was, in reality, merely an illusion created by high levels of debt and leverage. As the system de-leverages, it is becoming clear unsurprisingly that available capital is more limited than previously estimated.

Central bank reserves and sovereign wealth funds are often cited as evidence of the amount of available capital. These reserves are invested in U.S. dollar denominated U.S. Treasury bonds, GSE paper and highly rated securities. It will be difficult to mobilise the funds and convert them into the home currencies of the investors without large losses.

The risk of a severe dislocation in global capital flows remains a real risk in the present environment. Some have called for a global conference (along the lines of Bretton Woods) under a respected chairman (Paul Volcker is the obvious choice) bringing together all the major players to address key structural issues within the global financial system. Any such conference would focus on economic reforms (capital flows, currency policies, fiscal disciplines, trade barriers) necessary to find a resolution to the crisis.

A principal objective of this conference would be ensuring supply of funding for the U.S. in the transition period. Recent comments by China about U.S. responsibility for the crisis and its resolution miss the point. As China's Premier Wen Jiabao observed the U.S. financial crisis may "affect the whole world. ... If anything goes wrong in the U.S. financial sector, we are anxious about the safety and security of Chinese capital." All creditors have much to lose if the de-leveraging process becomes disorderly.

Ultimately, "All the king's horses and king's men" cannot prevent the de-leveraging of the financial system under way. The extent of de-leveraging is substantial and likely to take time. In recent years, money was cheap and other assets were expensive. As each of the global economy's credit creation engines breaks down and systemic leverage reduces, money becomes scarce and more expensive triggering substantial adjustments in asset prices in a reversal of the process.

David Roche of Independent Strategy, a consulting firm, estimates that $4 to $5 of debt is now required to generate $1 of economic growth. As credit creation slows and debt levels fall, the sustainable level of global economic growth may fall as well.

At best, the government and central bank actions can smooth the transition and reduce the disruption to economic activity in the transition to a lower debt world. The risk is that well-intentioned steps prevent the required adjustments from taking place, delay recognition of problems and discourage action that must be taken by financial institutions, corporations and consumers.

Like a giant forest fire the de-leveraging process cannot be extinguished. Thoughtful actions can create firebreaks that limit preventable damage to the economy and the international financial system until the fire burns itself out.

The Arabian Nights had a happy ending. The King after 1,001 night of enchantment and three sons pardons the beautiful Princess Scheherazade who becomes his queen. Despite the fairy tales that investors are putting their faith in currently, the de-leveraging that is at the heart of the current financial crisis may not have such a happy ending.

SHORT TAKES

Why banged-up Toyota is a good long-term bet.

Toyota's haven-in-a-storm status has taken a hit lately. Nevertheless, the company's stock is as cheap as it has ever been. With a yield of 4.5% you get paid something to wait, as long as the dividend is not cut. Japanese managements are far more reluctant to cut dividends than their American couterparts ... which does not mean it cannot happen. Also, see last week's coverage of Honda.

[F]or now, Toyota does not look like the big-cap growth stock hero it has been. The 9% average operating profit margin it racked up since 2004 is unlikely to be repeated in the next few years. The company projects a 2.6% margin this year. Operating profit margins limped along near 2% for several years after Japan's bubble economy collapsed in 1991, according to a Goldman Sachs note.

While the near-term outlook is bleak, the company enters one of the toughest operating environments in years with a solid balance-sheet, which should allow it to respond opportunistically, or at least flexibly.

Growth in emerging markets may cool off. But given the low car-ownership rate in the developing world -- particularly in Asia, where Toyota is strong -- the case for long-term growth is still intact.

Toyota is also the leader in high-margin hybrid-technology cars with its iconic Prius -- and has other models in the pipeline. Oil prices have dropped sharply, but the memory of $4 a gallon gas is unlikely to recede from drivers' consciousness when they return to car showrooms. ...

And while forecasting future cashflows and revenue is no easy business today, valuations for the company are also as cheap as they ever have been. Toyota stock trades at around 0.8 of book value, and company management has indicated that it is reluctant to start cutting dividends. The yield is 4.55%.

Why crude prices may stagnate, even if OPEC cuts production again.

January crude futures settled at $49.93 a barrel on Friday, November 21, a roughly $96 plunge since July and near a 3-year low. How much lower can oil go? One analyst below is predicting $40 by April. But if the major oil companies substantially cut back exploration the decline rates from currently producing fields will accelerate -- which means more dramatic price increases in the future when demand recovers.

Producers have been unable or unwilling to prevent prices from collapsing from a record $147 a barrel over the past four months. Soon, however, producers will make crucial decisions that will affect oil's availability for months or even years. OPEC has two meetings on deck before year's end: a hastily arranged gathering in Cairo on November 29, and a formal meeting in Oran, Algeria, on December 17.

A production cut would come atop a reduction by the OPEC of 1.5 million barrels a day in October, which failed to prevent oil prices from dropping further. World demand for oil is roughly 86 million barrels a day, and OPEC accounts for around 40% of that total.

To gauge the success of the cartel's likely next move, market participants recommend watching the spread between the commonly quoted front-month crude futures contract and farther out contracts. Front-month Nymex December crude futures are currently $12 cheaper than oil for delivery a year from now, a market structure known as contango -- which tends to form when traders believe the world is well-supplied with oil.

If OPEC has taken enough barrels off the market, the futures gap should narrow, says Andy Lebow, with brokerage MF Global: "We really need to see some of the contango taken out of the ... market. To look for some kind of [price] recovery, that may be the first place." But the other crucial supply decisions will emanate soon from many corporate boardrooms worldwide. Publicly traded oil producers, ranging from small firms to giants like Exxon Mobil, typically release details of the next year's exploration and production budgets in December.

While no single company has, say, Saudi Arabia's clout, widespread cutbacks would increase the rate of decline in producing fields, and delay new output. "If you cut too much now, you are going to be in trouble in a few years," says Phil Weiss, an analyst with Argus Research.

Many market watchers doubt that producers will take the drastic steps needed to align supply with weakening demand. Paul Sankey, a refining analyst at Deutsche Bank, wrote in a recent note that budget and production cuts have diminishing returns: "As oil falls, costs fall ... additionally, OPEC members are incentivized not to cut because their revenues are already falling from lower oil prices." Toss in hyperefficient refineries starting up in Asia in the next few months, and oil could dip to $40 by April, Sankey warned.

Microsoft can revel in Yahoo!’s pain.

Yahoo! fought off a bid from Microsoft of $33 a share. Now the shares trade for $9 and change. Yahoo! CEO Jerry Yang has resigned. The new CEO, whenever he/she arrives, will likely cut some kind of deal with Microsoft.

Capula Investment is gauging when to come off the sidelines.

Capula Investment Management's flagship Global Relative Value hedge fund has more than $4 billion in assets under management. The fund was up 4.45% through the end of October vs. one benchmark index's 15.5% decline. Pretty good. The performance was achieved by rigourously assessing its various risk exposures and laying off or otherwise hedging any risks it deemed questionable.

The fund is currently 83% in cash. "Capula will likely stay focused on risk-reduction into early 2009," but: "Once the credit and financial markets stabilize -- perhaps as early as next year's first three months -- Capula's managers expect much better opportunities for the hedge funds that survive."

"This is probably the worst financial crisis in many decades," says Capula co-founder Yan Huo. "By going into capital-preservation mode and not going for the double-digit returns, I think that we've made most of our investors very happy."

We will see if he can be a hero when the upside opportunities remanifest.

Previous	Back to top	Next