T2 Hedge Fund Report on Mortgage Market

Barrons Magazine writes on a T2 Hedge Funds report on the mortgage market: "It traces the beginnings of the mortgage mess to an almost unimaginable decline in lending standards from 2001 through 2006, which led, as night must follow day, to the extraordinary surge in subprime mortgages, which in turn touched off an astonishing and unprecedented boom in prices.

Wall Street, (T2 report) relates, was a prime agent in inflating the monster mortgage bubble, since to produce those richly profitable asset-backed securities (ABSs) and collateralized debt obligations (CDOs) it needed a vast store of loan "product," and mortgages fit the bill.

It was no sweat, as T2 points out, to generate ever-greater volumes of mortgage loans: Simply lend at higher loan-to-value ratios, with ultra-low teaser rates, to uncreditworthy borrowers and never bother to verify their income and assets (if any). A modest drawback: "Don't expect to get repaid." But, hey, so what: House prices were destined to rise eternally, if not longer.

Things didn't quite work out that way. Home prices are in free fall, the mortgage market is frozen, refinancing in many instances is a mission impossible, $440 billion worth of mortgages are slated to reset this year and defaults are rampant.

"We are seeing," warns the T2 report, "only the tip of the iceberg: An enormous wave of defaults, foreclosures and auctions is just beginning to hit the U.S. We believe it will get so bad that large-scale federal government intervention is likely."

Response to John at ArizonaRealEstate Notebook

John Wake - Real Estate // Mar 22, 2008 at 8:10 am

http://www.arizonarealestatenotebook.com

Well, I did not see prices going up they way they did in the first six months of 2005 and I didn’t see prices increasing for 12 months after the sales top in July 2005.

Inertia is the most powerful force in nature. Prices could be below their “market” value but that is more difficult than going above their market value.

I see a lot of pent up demand for homes. Once the conventional wisdom is the prices have bottomed out, sales will improve significantly. Many buyer don’t have to see good prospects for appreciation. They just need to see no prospects for depreciation.

However, as fast as prices are falling now, inertia could overshoot the market (you say $160K is the market but I think that is much too low. $180 is too low in my ballpark estimate). In the case of an overshoot, there would likely be appreciation again quickly, within a year or two.

Brian McMorris // Mar 22, 2008 at 11:23 am

John, I agree with your basic ideas about inertia. But your conclusion that $180K is an overshoot is flawed by most rational metrics.

I think Dr. Robert Shiller has shown conclusively (rationally) in studies of real estate values over 200 years of data, that real estate appreciates from 0 to 1% annually “REAL” return (that is, after inflation is netted out). This is logical. I don’t think real estate can appreciate faster than an economy in the longest run (that is productivity growth plus inflation).

If inflation is averaging around 4% the past five years and going forward a couple more years, then the appreciation rate should be around 5% from a normalized level (4+1). I think we can argue that January 2003 was a somewhat “normal” market for real estate nationally, as well as AZ.

If we look at your graph, the average home was at around $140K on Jan 1, 2003. If we compound that value at 5% over six years, we come up with a “normal” value of $187K on Jan 1, 2009. But, like you, I think inertia is powerful and trends tend to overshoot the normal. This is why I think $160K is a reasonable bottom valuation. Time will tell.

10 Brian McMorris // Mar 22, 2008 at 11:41 am

One more thought: there are some fundamental factors that can change these purely technical trends, in which case, inertia / slope of the trend could change almost instantly:

1. The Congress legislates some action to put a “floor” in on home values. This is possible in this crazy election year. There is some talk about a big tax credit (like 10% of price towards down payment) for home buyers. That would probably do it.

2. The global Central Banks and other big institutional money sources (Saudis?) drive mortgage rates down to 4% for fixed 30 year to rescue the housing market.

3. The Fed government buys up foreclosed houses and auctions them off to the lowest bidders or back to the original owners (kind of a dream scenario for the Socialists among us who want government to take care of us)

4. The last possibility is the dooms-day scenario where the Feds can’t save the big banks from failing, all mortgage lending stops, and home prices fall through to the basement becaue there are no buyers. This is the 30s Great Depression scenario, but I think the Feds and Congress have the ability to stop this from happening (at least I hope!)

Sell Commodities Now

Yesterday it became apparent that the short term play was to short commodities, the more volatile the stock the better. By the time I was home from the office and had formed a strategy to implement the idea, the Extended Market was closed. I have not yet become so sophisticated (neurotic / obsessive) as to open a 24 hour account where I can play the foreign markets late into the night. But looking at Bloomberg around 10pm my time, it was obvious the commodities were accelerating to the downside with gold off 8% in Asia. BHP, FCX, GLD, OIL were all off by a significant amount as well, so it was a general commodty selloff.

So, this morning, with strategy in hand, I got on the laptop and started trading as soon as the Extended Market opened on ETrade at 7am my time. I quickly put in short sale orders on AUY (Yamana Gold), AEM (Agnico Eagle Mining) and SKF (Proshares Ultrashort Financials). As mentioned a few days ago, the Extended Markets are very thin with just a few other nutty players like me. So, it is a bit like trading with your neighbor. I put in an order on AEM at $67.25 between the Bid and Ask price at that time, and then saw the Bid and Ask move down below my order price. I changed my order down to get between them again, and the Bid and Ask moved down once more. Obviously, there was an after hours trader on the other side who was luring me down. So, I changed direction, raised my offer to $66.90 and waited. About 15 minutes later, the transaction went through. I was short AEM.

The Yamana went more smoothly, though I had to offer $1 less than the close yesterday, which is about 7%, or most of the overnight correction in Asia. I sold 500 shares short for $15.80. It had been as high as $19 a week ago. But having followed this stock a couple years, and played its options, I know it is high beta and can easily go down to $12 from here. As soon as the order executed I put in an order to cover at $13.13 on AUY and $60.10 on AEM. No reason to get greedy. A 10% plus return on margin in less than a week will be fine.

I tried the same approach with SKF, which I just hit for a 15% return in one day on Tuesday. I put in an order at $121 which was close to the ASK price. The Bid – Ask quickly moved down to around $119 as the counterparty saw some live bait. But I didn’t bite. Instead, I raised my offer to $121.80. It never hit by the market open. (Update: SKF closed around $106 on Thursday, March 20, so if the short sale had executed at $121 in the morning, it would have meant a nice $1500 one day profit on the 100 shares I tried to sell).

Right now the market has been open for 25 minutes. I am ahead on AUY which is at $15.59 and AEM which is at $65.59. Both opened quite a bit lower on the pent up demand to sell. Once again, the Extended Market turned out to be a better way to play the short side on these fast moving stocks. I will let you know how the trades turn out.

Big Commodity Sell-Off

We just talked about the future of commodities yesterday. And just like that, they take a dive, just as we discussed. The reason is as we thought: the Fed signaled it would defend the banking system, but would not go overboard on interest rates. All this supports the dollar and reduces the anti-dollar trade. The commodities were all over bought, and have a way to go to correct. I am looking at the prices from last April-May as a reasonable level. This price level was confirmed in the August selloff for most commodities. It was after that the commodities exploded upward.

I think this will go on till oil is at $80, maybe even $70 and gold is at $800, or a little less. I would look to get in around that time, maybe 4-6 weeks out. FCX at $60 or BHP at $50 also look good. POT around $75 and MOS just under $40 look good, too. The other option is wait for these stocks to hit the sold off levels, then buy those mutual funds we discussed, like FNARX.

How to Play Commodities

Q: How far can the price of oil go? What are good ways to play the commodities markets over the next 5 years?

A: I don't have any problem with the idea of $200 oil any more than I do $2000 gold. The only question is "When"? That will depend on supply, demand and the dollar. Hard to forecast the exact direction of all the variables for any point in time. But, I think it is safe to say that supply for raw materials / commodities is hard to quickly expand, due to the infrastructure required. So, any increase in demand due to an expanding global economy, will drive prices higher.

The dollar may or may not get much weaker. At some point, the other countries will defend their own currency by either buying dollars, dropping their interest rates, or both. Emerging markets dependent on higher employment rates to keep their citizens happy, cannot allow Americans to take back jobs due to a cheap dollar. So, there is a practical limit to dollar weakness, at least in the short and mid-term (one month to five years).

But we are seeing the beginning of a correction to commodities right now, so I would wait to make a move. The Fed's defense of our banking system and economy are supportive of the dollar. This action will move money from the defensive position of precious metals and oil back to the stock market, which will deflate prices over the next couple months (or however long the rally runs). I would be prepared to move money into commodities gradually, over a long time horizon.

As for vehicles, I have always like FNARX, which is Fidelity's natural resource fund. It has done very well. I am in GGN, but it has been a bit disappointing. DBA is a good way to play the ag market. OIH and IXC are a good way to play the oil market. And, of course, I am in love with VGPMX for precious metals and have been for more than five years. But it is closed now.

Trading Off the Bottom

I made a couple of trades this morning (Tuesday, March 18) before or at the open, based on the turn around in sentiment over night. Goldman Sachs and Lehman both reported better than expected earnings and revenue for the last quarter (ended on Feb 29). GS was up almost 100% on earnings estimates. A couple of days ago, these "beats" would not have mattered to the market. The market was selling on good and bad news. But today, with the moves by the Fed yesterday (Sunday-Monday) to back up even the investment banks with the discount window, lower discount window rates (3.25%) and acceptance of collateral as low as BBB rating (basically "junk"), the market psychology towards financials has done a 180. I was just shorting financials last Thursday and Friday. But, you know the old proverb "don't fight the Fed"!

Yesterday I doubled up on some options for January 09 expiration (sold another 5 put contracts on BAC $45 for $12.10). I also pushed out my WM $17.50 put options to April expiration, from March (this week) to give the market a little more time to get its footing on financials. Both these moves are already paying off today.

This morning, I sold short 100 shares of SKF, which is the 200% inverse ETF on the XLF financials index. The SKF goes up when the financial stocks go down, and vice versa. By doing this, I am able to take advantage of the move up in financials today (and probably the rest of this week) double the market return, and do so with borrowed money on my margin account. I will take this one off within 4 days because it is so volatile. I also bought another 5 Call contracts on the BAC Jan09 $50 for only $0.95. That is a cheap bet that BAC, which has acquired the assets of CFC, will get back close to where it was in late October. All the options and short moves are in my "speculation" accounts with less than 10% of my total portfolio, or my "Mad Money" to use the overused phrase of Jim Cramer.

Bear Stearns - The Rest of the Story

As a follow on to our Bear Stearns and financial stock discussion from Friday (3/15/08), we now know the rest of the story of Bear Stearns.

Bear opened up at $2 this morning after a Sunday negotiating session with JP Morgan. As we knew / suspected, JPM had the upper hand in the negotiations since it had been annointed by the Fed to back up Bear. No other bank had that distinction of the Fed guarantees for the paper on Bear's books, so could not offer a decent negotiating alternative. JPM was really free to name its price, since the alternative for Bear was to declare bankruptcy today. Also, JPM was able to take on some of Bear's obligations. Those obligations now amount to over $6B, but are guaranteed by the Fed, so are worth close to par. But, anyone else who wanted to buy Bear, would need to pay JPM for those liabilities, but the Fed might not guarantee those obligations, so they might be much more expensive since in that case, they would trade well below par.

Kudos to JPM management (Jamie Dimon, the erstwhile student of Sandy Weill while at American Express is the CEO at JPM) for playing a great game of chess. They correctly saw the opportunity to lock up Bear for a song and played their cards correctly. They outdid the $7 bid by BAC for Countrywide back in November, in terms of shrewd negotiating for assets that will someday bolster their stock.

As for the other financial stocks, including Lehman which was the next in line to fail, they will be propped up by the notion that the Fed will do whatever it takes to stop the bleeding. The stronger of the bunch, like Citi, WFC, BAC and USB, will be the beneficiaries of any further Fed-sponsored consolidation, as we talked last Friday. Because of this move by the Fed, I concluded it was time to cover my shorts this morning. In doing so, I discovered a little anomaly that is interesting from a trading perspective.

The fear had really built up over night in the Asian and European markets. So much so, that the financials were down as much as 10% in the Extended Market (electronic markets that trade before the official open). I was able to cover some of my shorts in this extended market (at 7am my time) for that 10% decline. I held some other of my shorts till after the open, in case the market dropped from there. But the regular market is occupied by American investors, mostly the big institutions. They had yesterday and this morning to digest the implications of the Fed actions. So, at the open, the financials were quickly driven higher. I covered the rest of my financial shorts at a higher price in the regular session than in the extended session.

I also found the market much more volatile in the regular session than in the extended session. The price was really moving around and it was hard to set a price. I dared not cover with a market order because the price was bouncing so much. I would have done much better covering all my shorts in the extended session.

From here, I think the market will settle down a bit and maybe even have a rally this week after the Fed cuts rates on Tuesday. Whether today is the bottom or not, only time will tell. If the market bounces significantly, to the mid 12,000s, I will probably do a little more hedging by selling more shorts. But I will be prepared to cover those shorts at a loss if this proves to be the actual bottom.

This is a Pretty Crazy Market

This is a pretty crazy market, but then it has been since last summer. I have been working hard just to stay even with my portfolio. With your fresh funds from the sideline to bring in gradually, you should do very well over time.

Regarding the Fed / JP Morgan / Bear Stearns situation, I suspect there will be more of those down the road. Lehman may be one, Washington Mutual might be another. Even Fannie Mae and Freddie Mac may go that route. This is really the only way for the Fed to get the market restarted. It is a variation on a theme that has been recommended by many financial market experts.

The basic idea that is being implemented is that when a financial company like Carlyle Capital (failed on Wednesday) and Bear Stearns (almost failed Thursday), which are both loaded with mortgage and commercial securities that are below AAA (subprime, Alt A or other), freeze up and have their loans called back, the Fed will orchestrate an asset rescue. With Carlyle, the Fed just let that private banking company fail. Carlyle had to turn over its loan portfolio, which was collateralized by its value, to the banks to whom it owed short-term money. It had a 30:1 leverage ratio, so it was bound to fail in this environment. Carlyle, like many private banks and hedge funds, had played the "carry trade" game, which is to borrow high quality paper short term at lower rates, and then lend long term, for poorer rated debt at higher rates, and earn the spread between the two.

If the borrowing is at 4% and the lending is at 6%, then the spread is 2%. 2% does not impress wealthy clients. So, the private bank or hedge fund borrows 30 times its capital short term from bigger banks and now it can show a leveraged return of 60%, which does impress those clients. This works as long as the short term money stays cheap and the banks continue to renew the loans. But if the merry-go-round ever stops and the bigger banks refuse to renew the short term, low rate lending, then the game is over.

Bear Stearns is a much larger publicly traded banking company that the Fed did not want to see fail because of the negative psychology it would create in the Market. Apparently, the Fed approached JP Morgan Thursday night and asked it to rescue Bear. Bear had margin calls on Thursday it could not cover (just as Carlysle did on Tuesday). The Fed said it would guarantee all the loan securities that Bear sold to JPM, and it would loan JPM funds from its new TAF program to pay for those loans that were acquired. This is a way for the Fed to help Bear without a tax payer "bail-out", without violating the requirement that the Fed only accept AAA rated paper as collateral for loans under the TAF program. JP Morgan will carry the lower rated paper on its books, but it will be "insured" by the Fed. Bear will still have some equity value (it has not been wiped out but was cut in half today) and has another 28 days to try and get itself straightened out. The public is supposed to be reassu red by all of this.

But instead today, the public saw through the entire situation and showed concern that this was the first of many bank failures that must be rescued by the Fed. There are much bigger banks in trouble (Citi, BAC, WM, Wachovia, Fannie, Freddie), so the concern is "where will it all stop"? It is a legitimate concern / question. I personally feel that the Fed's moves will eventually clear the deck on the worst of the problems. Once those problems are in the open and secured by Fed guarantees to the more sound banks, it should free up the better loan securities to begin trading at something near normal prices. If the banks start trading those securities again, they will be able to gradually mark up their books and improve their capital ratios and move away from the brink of failure.

But there is a slim chance that the Fed will not be able to stop the snowball. If that happens, there will be general carnage in the banking industry and in the economy. We will have a depression (or the modern day equivalent).

Because all of this is creating so much uncertainty in the banks, I shorted several on Thursday and Friday (C, BAC and WM) to protect some of my long positions. I will take the shorts off when it looks like this gets resolved convincingly.

The high yield CEs like BDJ, VVR or DHG do have exposure to the financial stocks. Those are normally the source of higher dividends than the market average. There are also REITs in these high yield funds, along with pharma, industrial and energy stocks. As I have been suggesting, I think high yield CEs are a decent risk because of the diversity and the dividends. All the banks will not go bust with the current Fed strategy. They will be consolidated by the Fed, the weaker to the stronger. There will be winners and losers. So, the diverse CE's will have their share of each as well and will eventually prosper.

I agree that Oil and Gold must be near short term highs. They can't go to the moon, at least without a breather. What will turn them around is some success in the financial markets with clearing up the problems that are undermining the economy and the dollar. I agree that a pullback to at least $900 is likely for gold and to $90 for oil, and maybe 10-20% less for each. But we are in a long term bull for commodities, so any pullback would be a buying oppty, though it will probably not feel like it at that time.

The Canroys should be going along for the ride right now. Chesapeake is setting new highs and it is very similar in its business mix (oil and gas) to the Canroys, except it does not issue much of a dividend. If the tax situation in Canada does not get resolved, the Canroys may eventually look like Chesapeake by converting from LLCs to incorporations. They will reinvest their profits in additional production to minimize taxes. They can do so by increasing amoritization and depreciation with the new production investments.

Dick Bove Discussion on Banking Crisis

Finally we are starting to hear some rational words about this banking crisis. Dick Bove is a somber and responsible bank analyst who is respected by many. Here are his thoughts on the financial industry:

(from Seeking Alpha website):

Punk Ziegel's bank analyst Dick Bove has issued another strikingly rational report that provides tasty food for thought. This one is entitled "Wait! Stop! Think!". In it he argues that the media is fomenting hysteria about the situation in the banking industry, which in reality remains quite sound.

Bove's been around long enough to have seen this before as an analyst during the 1990 bank debacle. While the media and government figures continued to predict dire outcomes and questioned the viability of the banking industry, bank stocks actually bottomed in late 1990 and appreciated smartly thereafter.

Is today's crisis worse than 1990? Bove points out several issues that were present then that aren't now:

Developing countries were nearly bankrupt
LBO's were failing

- Commodities were deflating

- Commercial real estate was in over-supply due to a change in the tax laws

- The credit derivatives market was in dire straits mainly due to the junk bond fiasco.

THOUSANDS of banks and thrifts failed.

The only direct parallel today is the credit market implosion. The other conditions don't exist. Only 76 of 8233 banks are on the FDIC watch list. Hence, it would be up to the credit market collapse to take the system down, which Bove says requires an implosion in the single-family mortgage market.

He estimates that if 50% of the sub-prime mortgages behind the credit derivatives market fail, and the collateral value of these loans is reduced to the land only (the houses are worth zero), that the total write down might be about $500B. Although painful, this would represent only 1% of the total debt outstanding in the US economy. It would easily be absorbed by the system.

There are other issues weighing on bank stocks:

A recent accounting change requires banks to value assets based on "comparables" rather than predicted cash flows. A variety of indexes were created to support this pricing requirement, yet the indexes lack liquidity and can be (and Bove believes are being) manipulated. The index which represents Commercial Mortgage Backed Securities is reflecting a default ratio of 6%, while actual defaults are at 0.27%. Yet banks must mark some of their assets to these indexes whether they reflect reality or not, deflating their balance sheets for no good reason.

Bank cash flows and true capital (as opposed to accounting entries which reflect a variety of non-cash adjustments) are actually in good shape. The current liquidity crisis is being caused by institutions unwilling to lend to one another, not by a true lack of funds. As opposed to a crisis where funds simply don't exist, a "fear of risk" based crisis will cure itself as interest rates adjust. Bove believes this is underway and may resolve itself soon.Bove picks apart yesterday's article in the Journal entitled "New Spasm Jolts Credit Markets" which made the following statement:"Rates banks charge each other remain elevated" - false because 3-month LIBOR has dropped (from 5.34% to 3% over the past 12 months) faster than Fed Funds signaling banks' willingness to lend to each other.

"The Price of insurance against bank debt default is soaring" - The point the journal makes here is that such insurance costs 20x what it did last summer. As Bove points out, that means it was one lousy forecaster of default last summer, so why should we believe it is a good indicator now? It is in fact a lagging, not a leading, indicator.

Interest rates on a variety of instruments are being "pushed up" - Then why is it that six months ago, 30 yr mortgages were 6.46% vs. 4.88% now, and AAA bonds were at 5.73% vs 5.48% today?"Banks are constrained for capital" - actually, common equity+reserves as a percentage of assets is just below an all time high. Bove believes the Journal (much like other media outlets, as I have previously commented) wants to sell bank panic just as it did in 1990. He notes that when he is quoted by reporters lately they highlight the negatives and ignore the positives. Bove concludes: "There is a financial panic underway fed by a defin able problem; a steady flow of misinformation; bad accounting rules; manipulated indices; a lack of understanding of bank cash flows and capital; a demand for higher risk-adjusted returns; and a lack of financial leadership."

He believes that bank stocks in general should be bought. None other than Warren Buffet agrees, as he bought shares of Wells Fargo (WFC) last quarter (I own WFC in some of my managed accounts). I know that when most everyone is leaning one way and sentiment becomes extreme in one direction, my gut instinctively tells me it's overdone and that the smart thing to do is be a contrarian. At the very least, be wary of taking media reports and market zeitgeist at face value. Conversely, I pay close attention to the few rational intelligent voices willing to go against the herd.

Commodities Near a High?

Q: Did Cramer signal the end of the Gold run by shrieking its praises in his show last night? He gushed about the coming $1600 Gold price (along with $16 wheat, and $16 Nat gas, which may suggest the gold target was more about numerical alliteration than calculation).


A: Well, the commodity boom can't continue if the recession talk gets worse. Commodity demand has to decline with a globally weaker economy. All the price increase can't be explained by dollar weakness. So, I am expecting a big selloff in the commodity stocks as they have been driven up by speculation and a thin market (not so much equity chased by a lot of dollars). Gold and oil will be part of that selloff, along with the ag commodities. For this reason, I am light on all the commodities, which are the current bubble. (The fact that Cramer is pounding the table for commodities seals that prognosis for me).

But after a big blowoff, they will be strong again and continue to rise as economies recover around the world, probably late next year. The dollar should strengthen later this year when other govmts cut their own interest rates to reflect the global recession that has begun. A strengthening dollar will also help lower commodity prices in dollar terms for the next 12-18 months. By the end of 2009, there should be another gold and oil buying opportunity with gold at $700 and oil at $70. That is my take, anyway.

In the meantime, the Canroys should be fine on a cash flow basis, as they are only factoring $60 oil into their cash flow and dividend forecasts. They will probably sell down on price, though, if this all comes to pass.

Capitulation is Near?

The market has been very bad the past several months. It is hard to know when there is a bottom and it can begin going back up. But one thing is for sure, before it can, most people have to become truly discouraged. The AAII tracks investor sentiment. Sentiment is normally very bullish, since investors must normally be positive about the market (or they wouldn't invest). But right now, the sentiment is bearish, with many more investors skeptical about the market than positive. This is a good sign and points to a bottom.

In the latest poll, Bullish sentiment was 34.3% (long-term average is 39.2%). Neutral sentiment was 20.4% (31.7%) and Bearish sentiment rose to 45.3% (29.0%). Bearish sentiment exceeds bullish by more than 10 percent.

If we get a big one day capitulation in the market, shown by a spike in the VIX index, we will know we are very close to a bottom.

VIX Drops below 100 day average

The VIX went below its own 100 day moving average on February 22. Since today is February 28, we should probably wait another 4 days of below average volatility before we call a bottom, but the market is certainly looking better. The actual bear market low was probably on January 18, when we first thought it may have occurred.

There is still plenty that can go wrong in the economy. Fundamentally, the property deflation needs to stop. The Fed has temporarily stabilized the banking system, but if assets continue to deteriorate via housing deflation, the banking problems could began to grow again requiring more big writedowns. That could put the market into another leg down. There is also a commodity bubble building, which doesn’t help inflation and hurts consumers. That will be the next big bubble to pop, but it could take years for that to happen since it just got started.

So, I am cautiously optimistic. My portfolio has recovered a little bit and I am actually ahead for the year, now. The market seems to be acting better on bad news, which is a good sign.

BTE and DAYYF

Good to see the market doing better. I lightened up a little this morning since it seems the market is stuck in a trading range. Had a chance to move some sold puts at a profit, so I did (WAG and PHM). I also sold the TSO that I had put to me a week ago. I was ahead about $1 a share for a $500 gain. I could have waited, but there is a decent chance oil will spike and refiners will get hit. Everyone is talking about the technical setup for a breakout in oil to the high side. Didn't want to get caught.

The financials are still hurting. I may sell some more puts there.

After I lighten up, I would like to see the market tank again so I can get into more of the commodity and material stocks. Looks like inflation for hard goods will be with us for a while.

The Sainthood of Warren Buffett - Part 3

In response to a defense of the Municipal Insurance bailout proposal by Warren Buffett on the grounds that he would be backstopping the bond insurance industry:

Continuing with the Buffett questions: today (February 13), he is being ridiculed by professionals in the financial industry (including Wilbur Ross this morning) for exactly the same point that I made yesterday morning. His very public supposed "bail out" of the bond insurers was very self serving (and yes, he does have a fiduciary obligation to his stockholders) and would not benefit the public or the insurers in any way. In fact, if they did for some reason agree to the extorted terms (paying a premium to Buffett for bonds with virtually no risk 1.5 or 2 times what they themselves received, which would cause even more negative cash flow for the insurers), the bond insurers would be terminally injured, their reserve capital further impaired by the negative cash flow and would thus crush the bond market, thereby extending the problems of working out the financial derivative issues here and around the world.

So, Buffett, who at one time bought out-of-favor businesses with bright long term prospects, good cash flow and very good managers, is now in the business of being a vulture of the worst kind who will make deals that enrich him at the rest of the world's (literally) expense?! It is pathetic. Almost Mafia-like and beneath what I thought was his dignity and esteem. I really have lost respect for him and want nothing to do with him or BRK.

If Buffett was willing to stand behind the CDO and RMBS liabilities in return for the nice, risk-free muni bond insurance, that would be a reasonable and semi-noble position (no one expects Buffett to take a hit for the industry or the economy). But that is not what he proposed. He proposed to relieve the muni insurers (so called monoline, but not really so since they are now in multiple lines of business) of their good merchandise and leave them with the crap. The fact that vulture Wilbur Ross is looking to be a saint compared to Buffett is the whole point. Buffett has plummeted to new lows.

His supposed rescue would not restore confidence in the market in the insurers and would not elevate them back to AAA on their CDOs, etc, it would devestate their credit rating by removing the good assets on their books which at least provide relative risk free cash flow/capital, to something in the junk range and permanently impair their ability to insure muni bonds (since all that would be left against the reserve capital requirement would be wobbly commercial and mortgage derivative paper; this, of course, is Buffett's objective. He wants to eliminate all competition in the muni bond business and have it to himself).

If the insurers go, all the liabilities they insure would go back on the originators, the banks (including the big non-USA banks like UBS, Deutsche and HSBC). This hit to the banks would probably push them over the edge and cause them to default on their capital reserve requirements, putting them in technical bankruptcy. This would affect almost all the global money center banks, and potentially precipitate a global financial meltdown and depression. It probably would not go that far because the government would run to the rescue by reducing reserve requirements and possibly buying the impaired assets onto the government's accounts, or some other means; but that means the burden would be transferred to the tax payer one way or the other, all to benefit Buffett. And he talks about the need to raise taxes! That will surely be the case if he is successful, which he won't be.

Buffett's Saintly Proposal - Part 2

Answering Part 1 by my acquantiance: "If you took the stated book value of BRK and then adjusted it by adding in the value of the float from the insurance business ( which essentially was free capital for Buffett to allocate as long as the loss ratio was below 100 ) you could buy Berkshire for roughly 1X adjusted book. I thought that was a pretty good deal and the logic made sense to me [when I first looked it several years ago]. I could effectively hire Warren to manage my money on a dollar for dollar basis, no management fee!

At this point, I have a pretty substantial gain in BRK and I am concerned what Hillary/Obama and a Democrat [party] congress might do to me. They seem determined to raise taxes on capital and drive more capital and jobs overseas as a result. I love to point to Ireland as the antithesis of this warped way of thinking. Low taxes and favorable treatment of capital attracts capital and creates jobs. You know this as well as I do of course. Anyway - long winded way of saying I'm not sure what I might do with my holdings given the valuation, Warren's age, and the chance that taxes may go up. I would like to re-run the analysis on the value of the float however. It is an interesting viewpoint."

My response to the idea that BRK was still a good value:

"Your analysis / logic of BRK and mine are about the same. I read everything ever written on Warren Buffett during the mid 1990s. I became quite a student on his technique, and by extension, his mentor (Ben Graham). But, I also read the quips that he thought his own company was overvalued and wouldn't buy it himself. But you did choose the right time to buy (2002-03) his stock. That was near the end of a eight plus year plateau in BRK during the dot com bubble when insurance and consumer durables were too boring and that culminated with Katrina and concerns over his exposure through General RE. That period included a few mistakes like US Air and Solomon Bros that damaged his reputation as the untouchable / invincible investor.

But since that time, the B shares have spiked from $2000 to $5000 over a two year period as he has come back into vogue with his timely utility, CNOOC and railroad investments. At the same time, nothing special happened with BRK's fundamental value to justify that spike (the deals that went his way did not double the cash flow). This is a company that probably can't grow earnings / cash flow more than 10 to 12% annually, just based on its size, no matter how smart individual deals. So, a 150% pop in stock price has probably taken it past fair value. But I haven't done the analysis either, so can't say that for certain. I am also concerned about his age, and, irrationally, his politics.

You express concern about Hil-Obama. But Warren is a major benefactor to Hillary's campaign, and would back Obama, if not Hillary. He also came out with the ridiculous and dishonest position supporting raising income taxes on the wealthy, even though he shows very little income the way he compensates himself (minimized by paying no dividend). He is a hypocrite on this point and it was a big disappoint to me when he took this position. I wonder if he would support a wealth tax just as readily. The idea that the government can do a better job taking care of society than people of means, like himself, is against what he has always stood for. If he really believes his own hyperbole, Buffett should have just donated his wealth to the government rather than to the Gates Foundation. It would be more genuine for him to campaign for be tter treatment of charitable giving than to bash wealth. (BTW...he was notorious for being a skinflint and not giving anything to charity until the last few years when he finally realized he couldn't take it with him)."

On BRK and Buffett's Proposal to "Assist" the Mortgage Insurers

In response to a positive comment from an investor acquaintance on Berkshire Hathway, Warren Buffett's investment vehicle:

So, you have thrown in the towel and are riding Buffet's coattails? I know that is enticing. I had BRK-B until a few weeks ago when I sold it to raise cash. It was one of my few winning positions. But I thought at that time (near $5000) that it was probably a little overvalued and I had owned it since the low $3000s. People pay a big premium for BRK, more than the sum of the parts. Some of those parts won't be doing well for a while. He owns a lot of homebuilding materials companies, including furniture. His newspapers probably aren't worth too much any more, either.

The best time to buy BRK the past few years was after Katrina, when all the insurers got knocked down. That is when we got in. BRK has to have some very bad news to lose any of its market premium, there are so many people that want to own it. Maybe there will be enough bad news in consumer durables that will cause BRK to lose some premium, at least that has been my thinking. It is too big to grow much on its own, so it has become more of a valuation game to make money on BRK. (Buffett himself has said in the past at times that he would not buy BRK based on its over-valuation).

I think his proposal to reinsure the bond insurers (AMBAC, MBIA, PMI, etc), but only the municipal bond pool, is very interesting. Reinsuring something that doesn't need insurance in the first place is quite the joke. It is a typical Buffett move, intended to give him a lot of money, quickly, at very low risk. He is asking for $12B (1 1/2%) for extending 30 days of protection on a portfolio that is not at risk (the $800B of AAA municipal bonds insured by the group). But his proposal does not address the real problem with the bond insurers, the CDOs, et al.

It seems to me that if the insurers take the deal, they are admitting defeat: they are in such bad shape that only their very best, the municipal bonds, is worth anything at all, the rest is worth nothing. If the insurers tank, it will cause significant additional damage to the financial markets, and to the economy by extension. While I don't blame Buffett for trying to extort the insurers (that is exactly what this is), they should turn him down and work on deals that address their real problems.

They do need a capital infusion (Buffet's proposal does not provide them any more permanent capital, but only temporarily shifts capital coverage requirements) and a return of confidence by the market, but the best way is a gradual unwind of their positions in a rational way rather than a fire sale of their best assets as in a "going out of business" sale. They can always find a buyer for a municipal bond insurance portfolio.

Short Hedge of the Week and TSO Short Puts

Today's trading note: I have exposure to high beta Tesoro (TSO) on the Feb 45 for a $7.10 premium.  It is very volatile. I am expecting the price of oil to pull back on economic uncertainty and as predicted by T Boone Pickens.  As oil pulls back, the refiners will see their margins increase which will quickly drive the refiner stocks higher.  I think TSO at 45 by the end of February is a strong possibility.  But I will make money at any price over 38 by Feb expiration.

 

The May 30 TSO sold Put is very low risk, I agree.  If I didn't already have the Feb 45, I would consider writing the May 30 Put for $1.50 a contract.

 

I did another one of my Short Sale, Long Hedge specials this morning. This is an excellent way to hedge the downside expecting a market correction.  Because the financials have run a long way off the Jan 22 bottom and are due to pull back, I sold big bank, Washington Mutual (WM), short at 21.75 (it was already down to 20.80 this morning) and then did the collar at a 0.50 debit (1.33 on the bought Call for Mar and 0.83 on the sold Put for Mar).  The collar was for 17.50 on the put and 22.50 on the Call, so that I have almost $4 of downside oppty on the short for a cost of only 0.50.  My risk is only about 0.75, which is the difference between the call price of 22.50 and the owned price of the short at 21.75 minus the cost of the net debit (0.50).   

 

So, a 4.00 upside to a 0.75 downside is a very good upside/down ratio (anything more than a ratio of 3 is good for me).

 

Brian

 

Short Sale - Long Collar: the Perfect Hedge

This may be the perfect hedge: Short Sell a weak stock and then use a long collar to protect against it going higher.  I have been experimenting with this strategy and it is so far working very well. 

 

Here is how it has gone: on January 15 I sold short 300 shares of Radioshack (RSH) at 14.17.  RSH has shown weakness for over a year, though it did have a good spike the middle of 2007.  But lately, it has done poorly along with the rest of specialty retail.  Because the risk on a short sale is unlimited to the upside, I wanted to provide protection, so I bought (3) Feb $15 Call contracts for $0.75 each (each contract covering 100 shares).  To help pay for the Calls I sold (3) Feb $12.50 Put contracts for $0.40.  This left me some room to the downside to profit from continued weakness in RSH (14.17 - 12.50).  If the price of the stock continued to drop below the strike price of the sold put, I would realize a profit of $1.67 + 0.40 - 0.75 = $1.32 per contract (or $396 for all 3) when the put was assigned, taking out the short.  Over the one month time frame, this would provide an annualized gain of over 100% (using only margin, as shorts and sold puts require no capital).

 

But what would happen if the price of RSH rose in the meantime?  I just found out and am pleasantly surprised.  The fear of all short sellers is a rising stock price.  But using the collar, I guaranteed upside protection with the Call contracts.  I sold those contracts yesterday as the price of RSH had risen to $16.80 at the time of the sale.  Here is how the math has worked out on this transaction:  Call price on 15 Feb strike rose to $2  on Feb. 1, 2008 (it was at $2.70 earlier in the day but I have job and wasn't monitoring the contract price).  I closed out the Call contract for $2 and also closed out the short Put contract at $0.05.  My total gain on the Put and Call option contracts was (0.40 - 0.05 + 2.0 - 0.75) $1.60.  In effect, this raised the basis on my short to 14.17 + 1.60 = 15.77.  

 

I turned around and did another collar, though quite a bit higher, with a March expiry sold Put with 17.50 strike for $1.53 and a collaring $20 Call for a paid premium of 0.68.  The worse case scenario is a close below 17.50 on March 22 in which case the put option would be assigned and the Call would expire worthless.  In this case, the total possible loss is $17.50 - 1.53 + .68 = 16.65 - 15.77 (new basis) = 0.88 a share, about the same risk as for the Feb contract, so effectively rolling the strategy forward even in a market with rising prices.  But if it closes above 17.50, the sold put premium will be booked and will again increase the basis on the short position. 

 

Bottom line: this is a reasonable way to put in shorts against weak stocks while mitigating risk.  The weakness of this strategy is limited profits on a dropping stock price.  But it will do very well with flatish prices (renewing the collar will generate profits each month) and will provide protection with rising prices.  It might be possible with this short strategy even to profit with rising prices with good timing (which was not the case here as I gave up 0.70 in profit with bad execution on Friday). 

 

I will keep you posted to performance future months, and may add a couple more candidates, like Washington Mutual (WM), Garmin (GRMN) or CROX.

Market turning?

It is still too early to declare a market bottom, but maybe it is starting to turn.  The VIX is still up about 28 and needs to get down under 20 for several days before the bear is dead.  But that process may take many months with a confirming low of 1300 or so on the S&P (matching the low last week.  In the meantime, it is possible to play the rally which could go to 1425, the point where the market broke down previously (on Jan 10).  The next point of resistance on the up side would be at 1490 which was reached mid December.  So, there is some room to run, maybe 10% or so.

 

There is some danger the next couple days if the Fed does not come out with the liquidity that is expected.  The market wants the 0.50 basis point cut and more programs to support the financial industry, such as the increase on Fannie Mae / Freddie Mac loan limits to $800K from $470K.  But if that happens as expected, it will provide adequate stimulation to get the economy restarted.  That said:

 

There have been some big selloffs in good stock names on decent earnings reports that met or beat analyst expectations.  But they sold off on bearish sentiment and less than stellar guidance.  MCD, EMC and YRCW are among the candidates for a big bounce from oversold.  They can be played with options.  I sold short puts on EMC today.  Another I sold is RACK (Feb $10 for 1.40) as it is down 40% from a recent high of 15 and over 50 in 2005.  It has been pulled down by negative sentiment on the tech market, even though it continues to beat earnings and revenue expectations and has industry leading products.

 

SMH is still on the watch list since the semis have very bad sentiment right now.  But, once the market bottom is in, tech will be the first to recover as usual and will do so in multiples of the overall market.  Semi demand will increase with tech equipment demand.  Book to bill as reported on www.semi.org is already quite low at around 0.80, so there is room to run to the upside in semis. 

 

I am also buying LEAP calls on the financial names as they may go up 50% from here over the next 18 months.  I own BAC and C Jan 2010 calls and am looking at Wachovia and USB (though the latter did not go down much because of the Buffett aura).

 

There should be an opportunity for a quick short of the market around the end of February once the Q1 earnings reports and the Fed infusions are over.  If the S&P gets back to 1490, puts could be bought against SPY or a sector like XLF or XLY for the inevitable pullback to 1300.  That pullback might correspond to the typical summer doldrums and be fueld by more housing and financial industry problems. 

 

 

 

 

 

VIX: A Market Timing Tool

Jake, Here is a very simple tool for timing the market. I don’t understand the complexity of some other models that are promoted, so I don’t use them. But I could have really used a simple tool to manage this bear market.

Take a look at the attached 5 year chart for VIX. Notice how VIX provides an excellent indicator for major tops and bottoms. When the daily VIX moves below the 100 day moving average and stays there for 10 days, it is a buy signal. A major buy was given by this indicator on March 31, 2003, which if you remember, was about 10 days after the market made its major low (at the start of the Iraq war) and began a five year bull run. When the opposite happens, like on February 25, 2007, it is a sell signal. VIX went back below the MA on April 2, so a buy would have occurred 10 days later on April 12. You could have bought back in for another 2 months without much conviction from the VIX.

It skidded around along the moving average until May 23 when it broke above the line for good creating another sell signal 10 days later on June 6. The July 19 top and selloff (with the Bear Stearns sub-prime hedge fund implosion) resulted in a big spike in volatility, but vol had already moved above the average. But you wouldn’t have given up much in gains by using this timing signal (DOW moved from 13,591 to 14,000 in that time or about 3%). With a 10% selling program, 80% of the portfolio would have benefited from the rise, saving 20% of the portfolio from what was to follow. Better yet, if we require a 5% move below the VIX moving average in order to buy, or 1.0 on the VIX scale, we would have not had a buy signal on April 12 and would have just kept on selling from the start on March 5 when the DOW hit 12,050. We would have had 40% of our portfolio moved out of stocks by July 19 and been 100% out by December.

As of now, we are way above the buy signal which is at about 18 on the VIX. We will need to fall back to that level and stay under it for 10 days. Then the coast should be clear, if past teaches us anything.

You will also notice there would have been a move out and back in the market in mid 2006 when the market tanked in May and June. But if you use a gradual approach in and out of the market, maybe 10% of the portfolio a month, it would not jerk you around much. Using a 10% per month rule, you would have been completely out of the market by November after the February sell signal which triggered in March (after the 10 day waiting period). It would have been hard selling in April to June as the market kept climbing, but this is why a system is so important.

I plan to use this timing signal in the future as I did not have much discipline this last downturn. Despite a correct reading on the potential problems for the market and the magnitude (so far) of the breakdown, I kept putting my funds back into the market too soon after selling and before volatility had fully subsided, causing needless losses along the way.


CBOE VOLATILITY INDEX VIX (VIX: CBOE)
Last Price Today's Change Bid (Size) Ask (Size) Volume Trade
31.01 +3.83 (+14.09%) 0.00 x0 0.00 x0 0

CBOE Real time Quote
Last Trade as of 4:14 PM ET 1/22/08

1 Day | 3 Day | 5 Day | 1 Month | 3 Month | 6 Month | 9 Month | YTD | 1 Year | 2 Year | 3 Year | 4 Year | 5 Year | 10 Year | 20 Year
Exponential Moving Average (100)

VIX: Simple Market Timing Tool

Here is a very simple tool for timing the market. I don’t understand the complexity of some other models that are promoted, so I don’t use them. But I could have really used a simple tool to manage this bear market.

Take a look at the attached 5 year chart for VIX. Notice how VIX provides an excellent indicator for major tops and bottoms. When the daily VIX moves below the 100 day moving average and stays there for 10 days, it is a buy signal. A major buy was given by this indicator on March 31, 2003, which if you remember, was about 10 days after the market made its major low (at the start of the Iraq war) and began a five year bull run. When the opposite happens, like on February 25, 2007, it is a sell signal. VIX went back below the MA on April 2, so a buy would have occurred 10 days later on April 12. You could have bought back in for another 2 months without much conviction from the VIX.

It skidded around along the moving average until May 23 when it broke above the line for good creating another sell signal 10 days later on June 6. The July 19 top and selloff (with the Bear Stearns sub-prime hedge fund implosion) resulted in a big spike in volatility, but vol had already moved above the average. But you wouldn’t have given up much in gains by using this timing signal (DOW moved from 13,591 to 14,000 in that time or about 3%). With a 10% selling program, 80% of the portfolio would have benefited from the rise, saving 20% of the portfolio from what was to follow. Better yet, if we require a 5% move below the VIX moving average in order to buy, or 1.0 on the VIX scale, we would have not had a buy signal on April 12 and would have just kept on selling from the start on March 5 when the DOW hit 12,050. We would have had 40% of our portfolio moved out of stocks by July 19 and been 100% out by December.

As of now, we are way above the buy signal which is at about 18 on the VIX. We will need to fall back to that level and stay under it for 10 days. Then the coast should be clear, if past teaches us anything.

You will also notice there would have been a move out and back in the market in mid 2006 when the market tanked in May and June. But if you use a gradual approach in and out of the market, maybe 10% of the portfolio a month, it would not jerk you around much. Using a 10% per month rule, you would have been completely out of the market by November after the February sell signal which triggered in March (after the 10 day waiting period). It would have been hard selling in April to June as the market kept climbing, but this is why a system is so important.

I plan to use this timing signal in the future as I did not have much discipline this last downturn. Despite a correct reading on the potential problems for the market and the magnitude (so far) of the breakdown, I kept putting my funds back into the market too soon after selling and before volatility had fully subsided, causing needless losses along the way.

Gold: An Investment for Decades to Come

Jake, Thanks for the newsletter. I am pretty much in sync with this writer's perspectives.

My thoughts on gold have not changed much in several years. I think it is a store of wealth and will do better in times of inflation and dollar devaluation (which mostly run together). Even if gold stays steady and goes no where against other national currencies, as long as the dollar goes down, gold will go up by the same amount, just as other dollar denominated commodities do, like oil.

Additionally, there is the risk premium put on gold for an uncertain world and, probably most importantly, the future demand that will come from Asia. Gold is favored in Asia throughout history, so that is not likely to change soon. As Asians have more disposable income, they will buy more gold, and will increase global demand. Also, the Asian (and Middle Eastern) economies will grow rapidly over the next 20 years (10% a year on average, perhaps) and will probably need 10% more a year of gold reserves to back their currency, and maybe more as they lose confidence in the dollar and shift their reserves towards gold and sell dollar instruments like US Treasuries.

So, for many reasons, I think gold is good for many years. The only reason it did poorly the past 30 years was that the dollar took the role of global reserve currency and the global central banks, especially the US and Europe, sold off their gold reserves adding supply and dropping demand. I don't think the dollar will get that "Reserve Currency" role back anytime soon after all the losses incurred by governments and dollar investors around the world the past couple years.

As you know, I own gold through VGPMX, GGN and best of all, BEARX. Even though BEARX is a bear market fund, it held its own even in the years when stocks were in bull mode because of its gold holdings. It is half shorts and half a gold / precious metals fund, with lots of junior gold producers that will do very well if gold prices continue higher.

Hope this helps.

Asian Market Selloff - Is This the Bottom?

Brian, Any feeling for the bottom? What is interesting is as I talk to business people nationwide; not including selling or buying a house or selling a mortage.
Business is fine. No major layoffs. Are we just having a 20% correction to bring things back to reality?

Jake, I think we are pretty close to the bottom, though Tuesday could be a “limit down” day with a selloff in the Dow of over 500 points. This is what the futures say, and what is happening in Asia right now. We could be in the 11,500 range by tomorrow night, but that may be it.

Here are the indicators I will look for: a big pop in the VIX (which I think we will see tomorrow) to over 35 followed by a gradual reduction in volatility indicating the storm has passed. Looking back, I can see that most bottoms occur about the time the VIX goes below its 20 day moving average for good. You can see that average on a good charting program.

I will also look for the spread between the US Fed Funds rate and the 2 year Treasury to approach 0. Right now, it is almost 2.0, with Fed Funds at 4.25 and the 2 year around 2.50. I bet 2 year approaches 2.0 tomorrow with a panic.

The Fed will have to cut rates before the next meeting and may go 1.0 given the problems with global markets. That would bring the Fed Funds to 3.25. With another cut to 3.0 or even 2.75 in February, the 2 year might strengthen and narrow the gap towards zero. Remember back in 2003 when the bull began, the Fed Funds were at 1.0 and the 2 year was around 2.0 and went on up to 4.0 before the Fed Funds rate followed. A steep yield curve shows a strong economy and likely a bull market.

If the Fed does nothing (hard to imagine), then the bear goes on and 11,000 is not even safe. But for those who have lots of cash (you, but not me), that will just mean better deals. I have about 5% in cash on the sideline and another 10% in the BEARX funds, though that percentage increases every day as my long portfolio shrinks and my bear fund increases. I think this selloff will also show how dangerous Asia and basic materials have become, at least in the short term. Glad I am out of both.

Problems with Mortgage Bond Insurers

Jake asked me about the problems with mortgage / bond insurers. Here is a good article that briefly explains the problems with the mortgage insurers and the implications for our economy. The big dooms-dayers like David Tice (manager of my BEARX fund) and Robert Prechter have actually outlined the scenario that has begun to unfold, on their website: http://www.prudentbear.com/ in a PPT posted there (see: “The Case for a Secular Bear Market”) that I reviewed in 2003 and shared with you in my annual newsletter that year. Those two have long been leaders in campaigning against the dangers of fiat currencies and the prospect for uncontrolled inflation and dollar devaluation in the United States. The scenario began somewhat like is currently unfolding, with the inability of the insurance companies to back up the banks’ lending hedges, precipitating a financial calamity. This is the reason I own quite a bit of BEARX as a hedge. I figure that Tice will construct that fund to benefit from the disaster scenario he foretold, IF IT HAPPENS.

And that is a very big if. Even Tice has always conceded that the government had the ability, by turning up the printing presses and calling on its trading partners, to forestall or stop his worst-case scenario. But he also warned that if the Fed slipped up and miscalculated, the downward spiral could get away from them and become impossible to stop. Is Bernanke, President Bush and Congress up to the task? That is a very important question. So, just in case, I have a hedge. Ultimately, if Tice is right and as he outlines, even the dollar will become worthless (as has happened in other economies which mismanaged themselves into hyperinflation by overprinting currency, like post WW1 Germany and 70s Argentina). If the worst case occurs, the only safe haven is gold, as the historical store of value. But gold miners and ETFs are no good according to Tice as they are transacted in fiat currencies. If events get bad enough, only physical gold is really safe, as the fund companies sponsoring gold bullion ETFs (like XAU or GLD) can go broke on a cash flow basis have the physical gold reserves in bankruptcy court. My youngest brother buys gold coins because he instinctively does not trust the government. Maybe he will turn out to be right.

I am not paranoid or pessimistic enough to think the worse will happen, so my position is more moderate as mentioned. I think the government will backstop the financial system by guaranteeing the loans / insurance as they did during the S&L crisis when the formed the Resolution Trust Corp to do the same with the S&Ls (and this was a less serious problem to our national economy than the current global banking crisis). But I am monitoring the situation, and if it gets bad enough (say, DOW below 10,000), I will probably use my reserve cash to start buying enough gold bullion to survive an ultimate financial meltdown. But I won’t go all the way and build an underground bunker with food for 3 months, like my brother has.

Here is the article:

Bond-insurer woes may trigger more write-downs, turmoil By Alistair Barr Jan 18, 2008 18:08:00 (ET)

SAN FRANCISCO (MarketWatch) -- Just when you thought it was over, trouble in the $2.3 trillion bond-insurance business could trigger another wave of big write-downs from banks and brokerage firms, experts said Friday.

Leading bond insurers Ambac Financial (ABK, Trade ) and MBIA Inc. (MBI, Trade ) look increasingly likely to lose their AAA ratings. While almost unthinkable just six months ago, such concerns are also causing turmoil in the $2.5 trillion municipal-bond market.

Bond insurers agree to pay principal and interest when due in a timely manner in the event of a default -- a $2.3 trillion business that offers a credit-rating boost to municipalities and other issuers that don't have AAA ratings. Without those top ratings, their business models may be imperiled.

A more worrying consideration is that when a bond insurer is downgraded, all the securities it has guaranteed are, in theory, downgraded as well.

If Ambac and MBIA lose their top ratings, billions of dollars of muni bonds will be downgraded, and the guarantees that have been sold on mortgage-related securities such as collateralized debt obligations, or CDOs, will lose value.

Bond insurers guarantee roughly $1.4 trillion worth of muni bonds and more than $600 billion of structured finance securities, such as mortgage-backed securities and CDOs, according to Standard & Poor's. Ambac alone has guaranteed about $67 billion of CDOs.

"The destruction of the bond insurers would likely bring write-downs at major banks and financial institutions that would put current write-downs to shame," Tamara Kravec, an analyst at Banc of America Securities, wrote in a note Friday.

Kravec cut her rating on Ambac and MBIA on Friday because she thinks that ratings downgrades are "highly probable" now.

Indeed, Fitch Ratings cut Ambac's AAA rating to AA on Friday, becoming the first major agency to take that step. Fitch downgraded 137,390 muni bond issues and 114 other securities guaranteed by Ambac soon after.

Merrill Lynch & Co. (MER, Trade ) took a $3.1 billion write-down on Thursday related to the firm's CDO hedges. Merrill had bought CDO guarantees from bond insurers including ACA Capital, a smaller player that's now struggling to survive. Most of the write-downs were related to ACA.

CIBC (CM, Trade ) and French banking giant Credit Agricole unveiled similar write-downs in December, related to guarantees they bought from ACA.
But ACA is much smaller than Ambac and MBIA. If the two larger bond insurers are downgraded, banks and brokers that have bought guarantees from them may have to write-down their exposures further.

Merrill has net CDO exposure of $4.8 billion. But that includes a lot of hedging, mainly through guarantees bought from bond insurers. Excluding those hedges, the brokerage firm still has a "whopping" $30.4 billion of CDOs on its balance sheet, Brad Hintz, an analyst at Bernstein Research, noted on Friday.

"We remain very uncomfortable with Merrill's CDO balance sheet exposure," the analyst wrote in a note to investors. "If the counterparties are downgraded, and they cannot post additional collateral, we would expect that Merrill Lynch would have to take a valuation reserve against that specific exposure."

Citigroup (C, Trade ) set aside $900 million during the fourth quarter to cover heightened credit risks related to counterparties it uses to hedge CDO risks.
The impact on the muni-bond market may be just as big, experts said Friday.
There are $2.5 trillion to $3 trillion of muni bonds. Roughly half of those are insured by bond, or "monoline," insurers like Ambac and MBIA.

So more than $1 trillion of muni bonds are now in danger of being downgraded. That could trigger losses for muni-bond investors.

"Assuming the "monoline" insurers lose their triple-A ratings, underlying insured muni bonds could be susceptible to downgrades and downward repricing, leading to losses for muni-bond mutual funds," Michael Kim, an analyst at Sandler O'Neill, told investors in a note Friday.

Shares of big muni-bond fund managers, including Franklin Resources (BEN, Trade ) and Eaton Vance (EV, Trade ) have already been hit by such concerns, Kim said.

Franklin stock has slumped 22% so far this year; Eaton Vance is off 27%.
Most muni bonds insured by Ambac and MBIA are now trading as if there isn't any insurance, Richard Larkin, a municipal-trading desk analyst at JB Hanauer & Co., commented Friday.

"The market has lost all faith in bond insurance and the ratings agencies," he said. "Prices are being discounted because people wonder whether there is any value to the insurance."

That's a big problem, because there are no official ratings for many of the underlying issuers of muni bonds, such as cities, school districts and utilities, he added.

When municipalities sold debt, they asked agencies like S&P and Moody's to evaluate the securities with bond insurance attached.

If the insurance on this debt becomes less valuable, muni bond investors have few ways of checking the new creditworthiness of the issuer, Larkin said.
That's creating an "information vacuum" because the rating agencies aren't going to re-evaluate muni bond issuers unless the municipalities request and pay for new analysis, he said.

"The lack of public underlying ratings on insured debt is a big problem, and if more bond insurers are downgraded, the rating agencies are not likely to fill the vacuum and publish underlying ratings unless they are paid additional fees to do so," Larkin explained.

"Trades are being made based on people's best guesses of the creditworthiness of issuers," he added. "And if these downgrades happen, that will be the environment going forward. Not a good one."

Survival of AMBAC and the Mortgage Insurers

This gets so complicated almost on one can figure it out, which is the whole problem. Interestingly, David Tice at Bear fund actually predicted this whole scenario several years ago. But very few people saw it coming, me included. I should have believed him, and Doug Kass. I thought they were overdoing it, but I guess they were always right.

The mortgage insurers are on the hook for the “Credit Swaps” that were written to insure the companies writing the CDOs and RMBS, the securities created by packages of loans. If you were like Lehman, Citi, Merrill or JP Morgan issuing those securities, you could insure them with companies like MBIA, MGIC and Ambac. This would be similar idea to the PMI insurance that is written on individual mortgages (Private Mortgage Insurance) for loans with less than 20% equity, or the insurance on mortgages sold by Fannie Mae or Freddie Mac. In the case of FNM and FRE, the insurance policy is backed by the American government.

The problem for the commercial insurers is they don’t have enough capital to cover the insurance claims. If the government doesn’t back them up, it will be big problems for the financial system. But I think the government HAS to find some way to support them. I don’t know if $250B is the number, or not. But it would help the banks, too, if some one helped with the insurers. The banks would like to collect on their insurance policies. It would help their capital situation and would also help get the market for commercial paper moving. All this is tied together.

As for Buffett, he is creating an insurance company to insure municipal bonds, not mortgages. Most of these commercial paper insurers were doing municipal bonds till they got the mortgage bug. Now there is no healthy company to insure municipal bonds, so Buffett is stepping in.

As scary as all this sounds, it has to get resolved by the government. This is no different than the S&L crisis when the government stepped in with a $500B rescue. In fact, it is more important this time than that time, since now the money center banks are affected, not the less important S&L industry. So, I would think $250B would be a cheap bailout. Put another way, if they don’t fix this problem with the insurers and the money center banks, there won’t be much of an economy to worry about and I am not sure the dollar will be worth anything either.

The day the Feds announce a comprehensive plan to fix the problem (instead of just promises which is all we have had so far), bailout the insurance companies, the market will rebound and probably in a big way for the financials.

On Prudent Speculator and Prudent Bear

Of all the newsletter writers I read, the Prudent Speculator comes closest to matching my own personal outlook, so is the easiest one for me to follow in principle. Pru Spec also has a long term record that is very good, one of the top 10 newsletters of the past 25 years, according to reviewer Mark Hulbert. John Buckingham and his staff follow the ideas of famous value investors like David Graham. They use valuation metrics that sometimes recommend a stock too early. Still, there are almost no examples of a correction like this one (over 15% on the Dow and almost 25% on the Russell 2000 small cap), where the stocks were not higher after two years. Only during the Great Depression was this not true.

So, rather than worrying about the market valuation tomorrow, I am thinking about market valuations in 2010. I am sure they will be higher, then. But just in case this market turns out to be a rerun of the Great Depression, I am hanging on to my BEARX mutual fund holdings. If the market declines by 90% like it did in 1929 to 1932 (DOW 1400?), I expect my BEARX to do the opposite and increase by 1000%, almost offsetting all my other losses.

Comments on Foreign Investment and Steven Leeb

Jake, I read the Leeb letter you sent me. Looks like it was from year end 2006. I will be happy to share my newsletters with you if you can send me this one whenever it comes out. Even though I don't care for the style of his advertising bulletin that you sent me, I like his thinking (most of these newsletters use an over-the-top style to get people's attention). You have sent me other of his newsletters that are written more subtly and I agree with his positions. I would be very interested to receive his alerts.

Leeb does have a good track record and he did make some good observations on the direction of the global economy. The growing power of Asia (China and India) is fairly well known and I have been positioned for that for several years, though have been afraid of the big China runup recently. Looks like a stock market bubble to me. I just have a very little exposure to China with FXI and to India with IFN. Both will probably get hit hard if there is a global correction, which I think has already started. I will move more into those two funds after we go through this bear market. The place of India and China as the top two economies on the planet is just a function of their populations. India has not yet had the will to push its infrastructure along to keep pace with China, but I am sure it will do so in the next few years. Engineering companies like JEC and FLR are a good way to play infrastructure, though overpriced right now.

I see where you may be getting the signals to go all cash. It looks like Leeb has a timing service to recommend that. It will be interesting to see how that turns out. All investment books I have read say that timing doesn't work, but that modifying allocations to a more conservative posture has a good track record.

Investech is a newsletter written by Jim Stack and is more conservative than Prudent Speculator to which I also subscribe. Check out his "Housing Indicator". It is amazingly like the internet stock bubble (well not really amazing since EVERY bubble looks like that which is how it gets that name). I also subscribe to Fred Hickey's High Tech Strategist. He is also VERY bearish, especially on tech and retail stocks, and has been for several years (much too early). He and Doug Kass, another big bear, reference each other's work all the time in their letters.

Jim Stack is making the same calls as Stephen Leeb, although he is still invested in his fund, but defensively. Stack's negative calls are based on more traditional investment indicators including stock fund flows and the new "housing indicator". I have not been as aggressively bearish as Stack, but probably should have (and have changed my thinking). Now I am trying to get my portfolio in line with his allocations, which include a 10% bear fund exposure (I am only at 5% bearish right now). Prudent Bear (BEARX) is how I am doing it, since it outperforms the inverse market index funds like Proshares inverse S&P (SH). BEARX has a lot of precious metal and mineral exposure in addition to shorts on the weaker stocks. As you know, I like the protection of the precison metals, even at the already high prices.

I have more work to do to get my portfolio squared away. I will need to take some big hits on those financial stocks I picked up too early and allocate the proceeds to BEARX. I can probably keep my portfolio positive for the year if I get that done before any more damage. Too bad I didn't take the more aggressive approach along with Stack. I was up 20% for the year on my overall portfolio at the end of June.

I have also attached David Tice's most recent letter to shareholders of BEARX. It was probably written at the end of October, but is dated November 2007. Everything he warned about the financial stocks has come to pass in November (though, it had already started at the end of July). We made a double top in the broad market with the 14,000 peak in July and then again in mid-October. Double tops that break down like this one has (fast), can signal a long term (secular) high in the market. That is why I am thinking 12,000 is likely soon, if not lower. Tice is the most credible bear that I read, though Kass also has been accurate.

I don't really buy into Leeb's total gloom and doom for the American market. The inflation story at 12-15% would be no worse than the 1970s (as he himself referenced). We have had the repeat of "guns and butter" in the past 5 years and have deep financial deficits, both public (government) and private (hedge funds, banks, many underwater homeowners), which is why a period of high inflation may be on our doorstep. People did not go broke in the market during the 70s, though it was tough to break even on a "real return" basis, after inflation was netted out. The way to do well in the market in the 70s was the same as now: stay invested in hard assets. Bonds and financial stocks are deadly. We have been agreeing on this strategy, but we should not bail out on the "hard asset" investments right now.

I am staying in the Canroys because I believe as Leeb does, that oil will get more and more precious, and the US dollar will continue to weaken (it won't crash becaue our trading partners / creditors can't afford it to). The Canroys are one of the best ways to take advantage of those trends. I will take the tax uncertainties in Canada over the political uncertainties over the other big sources of global oil (Mideast, Africa) or the high cost of deep sea oil. When you buy the big oil companies like MRO, CVX, XOM or BP, you don't know how global politics might affect their ability to pump oil. They may have their assets nationalized (like in Venezuela and Russia) or the royalties jacked up (even higher than Alberta). I am staying in gold (through BEARX and other funds) because I think gold is a store of wealth while the currency situation gets sorted out. I don't trust any of the paper currencies. If there is global inflation, as Leeb su ggests, then all world currencies will devalue in relation to gold (or oil for that matter).

I don't know about this end of the American economy story-line in his 2006 letter. Like I wrote a couple days ago, China and other big American creditor nations need us as much as we need them. They can't walk away from buying Treasuries or some other American assets. They want to and need to export their consumer products to us in order to employ their huge urbanizing populations. When they export product, they get back dollars in return. They have to put those dollars to work, so they buy our Treasuries or some other financial instrument (including the CDOs and other junky stuff they now own). The other option, which I think will happen and which will eventually support our stock market, is they can recycle their dollars by buying American companies. The oil sheiks have been quietly doing this for years. The only time we hear about it is when they try to buy something that has some possible national security implications, like Dubai trying to buy our ports and China trying to buy Unocal. Then, our Congress shoots them down (unfotunately, in my opinion).

I like the idea of having every creditor country recycling dollars by buying our companies. It props up the stock market and stabilizes the global economy, and global politics by extension. For example, Germany and Japan were at war with us in the 1940s, but now are our best friends. Why? Because they own a big chunk of America (we helped make them powerhouse exporters in the 50s by rebuilding their economies with the best new manufacturing plants and then let them export their cheap products to us without tariffs or duties). When foeign companies own our companies, they send their citizens to live here and help manage their investment (I now work for a German company and just left a company that was sold to the Japanese, so have first hand experience with this).

America has the chance to be a literal United Nations (much better than the fake figurative one in New York). So, I want the Saudis, Chinese, Russians and Iranians for that matter, to take a big stake in America. That is the future I see, not America as some long-forgotten, has-been nation, as perhaps Leeb sees it.

DOW 12000 Looks Like the Target

Today brings an even worse market. But it is really thin (very low volume on all the majore index ETFs like SPY or DIA), so just means all the potential buyers are taking the day off. Market closes at 1pm EST today, I think.

Based on the big sell-off in Asia last night and the weak USA market today, I think this downward direction could continue a while, until someone announces how they plan to stablize the financial markets (the Fed? a consortium of global central banks?) The whole world's financial system is exposed to our credit markets. The European, Asian and oil exporter countries have been big buyers of the credit that is now so junky (CDOs, subprime securities, etc). China has been an especially big player. So, the whole world has a stake in how this turns out and the global markets will move accordingly.

I am thinking that 12,000 target on the DOW is looking like a pretty sure bet now. We will see if the market holds there. In the meantime, I am definitely overweight what I had planned for this occassion (too many financials...it is killing me). So, you can have the right idea, and still have poor execution. I will try to learn from this and figure out where I went wrong (mostly, I got myself exposed to high yield that I thought was safe (like Citi), but wasn't. High yield = financials).

None of this market trouble changes my thinking on the the weak dollar - strong hard asset story (oil, gold, mining, metals). That should be a theme for many years. By extension, the Asian economies and currencies will be strong for many years, since that is where the growth is. This means good things for EWY, EWT, EWH (Hong Kong), FXI (China), IFN (India) and even Japan (EWJ) which saw a big strengthening of the yen the last couple days. Japan is the financier and infrastructure engineer for China. I predict that Japan and China will eventually become very friendly to each other, like the British and Americans (they share culture, language, religion, some foods).

So, I will wait a while, but pull the trigger on these type trades once the dust settles. I will use the funds from some of my money in BEARX, which is a bear market mutual fund (wish there was a tradeable ETF for it, but there isn't). David Tice is the manager. He is a famous goldbug and long term bear. Everything he has written about the dollar and our economy over the past 10 years is coming to pass. You can see his site at: www.prudentbear.com. It can get a little scary. He is a real pessimist on the dollar.

November and the Market is Ugly

Brian, Today was wild! Do you think we test the lows on the S & P? Does someone step up and buy a Canroy? Oil to mid 80's, old to 760?. VIX to 37?, Candian dollar down 2.3%. Any thoughts on the future?

My gut is this is just a correction but all fundementals are in place for lower dollar, higher gold, higher oil and another buyout of a Canroy...

Jake, I agree this is a pretty ugly market and another leg down in what began in July. Amazing how all the gains of 3 months (since the recovery in mid-August) can be wiped out in a week. This is not a very confident market. People are looking for any reason to sell and are sure getting out now. There is a lot of fear about the housing and financial markets taking down the economy.

I think this market action is showing a rotation from real estate to consumer durables to finance to retail and now on to tech and commodities, including oil and gold, as fear of a global recession spreads (though not much evidence of that). The good news for our commodity plays is they are all high yield, which makes this whole process easier to deal with. The finance stocks bounced a little today and were up against this lousy market. The home builders are also kind of washed out, though I think there must be another leg down for them and I wouldn't get close to them until there are some bankruptcies, signalling the end of the collapse (as supply is taken off the market).

I definitely think we will test the lows of August in the Dow and S&P, which aren't that far away now. We could break through and fall back to the March lows. But I don't think the environment is nearly bad enough to fall to the 2002 lows (7500 on the Dow and 800 on S&P). The financials will establish the bottom and lead the market back, maybe within the next 3-4 months. They always lead the market back.

The big question is do we go into recession and if so, how big a recession? If the rest of the world continues to grow and doesn't collapse, it will help pull the US stock market out by continuing to purchase our goods keeping our exports strong and helping the industrial base build employment.

I think the bigger banks will end up consuming the weaker banks once most of the trouble is on the table. But we still don't know how bad the trouble is, so all the banks are getting whacked. I have picked Citibank and Bank of America to survive and eventually thrive. But they are both hurting now and I was early on them, so it has hurt me. But their 6% yields make it a little better.

The good news in all of this is that the market P/E never got that high in this cycle (20) and has come down now to around 16. If we hit 11,500 on the Dow and the earnings just stay flat (no growth), we will be back under 14 for the first time since the early 90s. That was a good time to be investing in the market since the Dow was only about 3000 then (1992) and is now 4x higher.

I don't know where all the commodities could go if we get the R word going. There is a lot of fundamental reasons for gold and oil to go higher in the long term (growth of demand in the BRIC economies and ever more expensive to produce or limited supply). But over a period of a year or two, reasons for price are more technical and speculative in nature. I think 760 is the minimum pullback, but 650 is a lot more likely. If you do a chart on gold for seven years, you see that the bottom of the uptrend channel is about 650 right now.

Same thing with Oil, you can look at the channel (http://www.chartsrus.com/chart1.php?image=http://www.sharelynx.com/chartstemp/free/chartindCRUvoi.php?ticker=FUTCL) and see the lower trend line is about 65. Oil stocks, like drillers, could go down 35-40% (I am cutting my exposure to drillers) and the Canroys could go down 15-20%, though the dividend should keep them from falling too far. I am looking at writing (selling) more puts on PWE if the price gets down to $27, which it might the next couple of days. I would try to get a $1.50 premium on the $25s (maybe on the March contract). That offers me protection down to 23.50. I think the chance of the dividend on PWE getting cut is very small, so that price would be super secure since the annual dividend is over 3.00, putting the yield when the price is at $25 a t over 12%.

When VIX hits 37-40, that is the bottom, as it was last time (in August) and almost every correction before. That shows a lot of volatility that can only happen when there is some "sell-off" panic in the market. VIX was at 31 today, so on its way.

If you really want some excitment and have your options account set up, try buying at-the-money calls on your favorite names, especially if they are high volatility. Citibank (C) and BAC would be two good ideas. Cisco is another one. You can buy the March 08 $35 C call for $3 right now. That means the break even is $38 on March 17. If the stock goes back above $41 between now and then, which it definitely could, it will be a double on your bet (and if it got back to $44, it would be a triple $9 divided by $3). But if it ends up less than $35, you lose the investment.

Why Invest in Gold and Precious Metals?

Brian, Your thoughts on Gold/Precious Metals.
I recently bought some Freeport Gold & Copper FCX and it is up 15% in one week. The price of gold is $745+-. Many analysts are saying that Gold will double in 2 years. Should I buy more? What percentage do you have in Gold/Precious Metals?

Jake, Even though I really like FCX and have owned it in the past (going back to 1999 when it was Freeport-McMoran C&G), it is not a gold pure play. It is as much copper as gold (and other minerals), but it is a very good China play since most of its mines are in Indonesia and an “anti-dollar” which is the key value of gold right now, as the dollar dives. Another good stock very similar to FCX is BHP.

I have been using funds to create a core position in precious metals and then dabbling around the edges with option contracts on the miners. My favorite gold fund is VGPMX, but it may be closed right now. It has done great the past three years I have owned it (41% annualized return over 3 years). I started buying another fund, GGN, early this year when VGPMX was closed. GGN is a “natural resource” fund and so has a lot of energy stocks as well as gold and basic materials. It also has a very good yield at 6%. There are other good precious metals funds that can be found on Morningstar or other websites.

Once I have my core position, I trade around the edges when the stocks are moving up. Precious metals and basic material stocks are very volatile, so they create good trading and option opportunities. I have been playing with AU, GG and AUY. The latter is a small cap and so very volatile. It is also a darling of the day trading crowd, so really moves fast. I just closed out my positions on AU that I have held off and on for four years. I will get back into AU when it approaches $40 again. I will probably sell put options to get in. Same is true for GG which I closed out in June when it was around $27. Now it is over $30, so probably got out too early. I just got back into AUY this week as it is well below its 52 week high. I sold (20) October 12.50 put contracts for 0.65 each on Friday (worth $1300 on Oct. 19 if AUY finishes above $12.50). That price is still good and will be on Monday (with the price of AUY at $13). I am looking for $15 or $16 in the next 6 weeks if gold stays at these levels.

Selling put options, you may end up with the stock if the price drops. That has happened to me with all the gold stocks along the way. If it happens, I just hold the stock knowing that the price is volatile and I will have a chance to get out at a profit. This is what I just did with the AU (Anglogold) and GG and AUY in the past.

Other conservative gold plays include the bullion ETF (GLD). You could also look at the silver ETF (SLV). Large cap miner possibilities are Newmont (NEM) and Barrick (ABX).

I think gold might double in 2-3 years from this level. It depends on the Fed and tax / spending policy. As long as we run fiscal deficits and also cut interest rates / create excess money, we will continue to see a devaluing dollar which encourages the price of gold to rise. If Congress and the Fed decide to protect the dollar, by raising interest rates and taxes and/or cutting Federal spending, then gold will decline in value. But I am not betting on that in the short term (during an election year).

The Trouble with Canroys

Brian, I have one question that keeps coming up on all the boards about CANROYS. The comments are that since the CANROYS pay out such a large dividend, and if they are not able to increase their production capabilites that the stocks will reduce in price over time as all the dividends are paid out. (or something close to this). Do they have a point or is this true for all oil and gas companies.

Jake, It is true that Canroys (and REITS and Master limited partnerships or MLPs in the States) are valued based on their dividend payout which is closely related to cash flow. In the States, REITs and MLPs must pay out 95% of income by law. In Canada, it is left to the royalty trust what percent to pay out.

This is an important distinction in my mind. The additional flexibility in Canada allows the Canroys to use a larger percent of income to make acquisitions to replace or expand production. You will see this is happening with the better trusts we invest in when you read the quarterly and annual reports of the trusts. PWE reinvests about 40% of its income in production, either making acquisitions (like the recent C1 Energy acquisition) or investing in additional wells on existing leases or rehabbing old wells. American trusts (MLPs and REITs) do have a problem with reinvesting in production and must issue more shares (diluting current owners) to raise money for acquisitions or expansions.

The metric that is used to measure how likely Canroys are to keep producing is Reserve Life. I look for a reserve life of at least 10 years. This doesn't mean the trust becomes worthless in 10 years, but that is how much "proven reserves" are available to last at current production rates. Each trust also has "probable reserves" which are normally many times the proven reserves. Probables are on leases that have yet to be tested, but are known to have oil and/or gas. So, as long as the trust doesn't run out of oil / gas, it will continue to produce and pay dividends.

The only other thing that can go wrong is a collapse in the price of oil and gas. Most of the trusts have a business model that generates current dividends well below current prices. (PWE's dividend model is around $40 a barrel). If the price of energy goes below that level, then profitability declines and they may start "shutting in" wells to eliminate marginally profitable pumping. But I am betting againsts that happening anytime soon. It would require a lengthy global recession to significantly reduce global energy demand.

So, in short, if we stick with the big trusts like PWE or PGH, I don't think there is much to worry about. If the trusts are acquired by a private company, then we will get a nice one time appreciation, but will lose the long term dividend. So, I am hoping the trusts remain independent and the Canadian gov't backs off on the tax change.