Harsh Punishment and Bank Stocks KBE

Too much hard work getting this small business off the ground has kept me away from blogging, but I hope to return to a more normal schedule soon. If you really want to punish someone force them to keep a diary.

All in I think this is an interesting time for investors as recent market dislocations have created some impressive buying opportunities, especially for stocks tainted with subprime exposure. There is real difference between an operating model that is core focused on sub prime activities vs various other businesses that are weakly linked or opportunistic investors in that market. See Why Wilbur Ross Likes Subprime. I agree with everything he says, except the part about gold. Gold has negative carry while TIPS pay cash interest.

Right now is the best time in recent memory to be buying bank stocks (KBE) and other credit sensitive investments. Wider credit spreads mean more return for each unit of credit risk. Banks are very lucky (well situated) in this environment because of their access to funding via FDIC insured deposits.

The Sub-prime of Life.

The subprime meltdown has been in full swing ever since February 7th 2007, when HSBC (HBS) raised subprime loan loss reserves by 20% and New Century (NEW) announced a net loss for 4Q06 and accounting probe to determine how big that loss was.

On New Century filed a form 12b-25 with the SEC explaining why it could not file form 10-K on time. The grimmest part of this filing was:

In the event the Company is unable to obtain satisfactory amendments to and/or waivers of the covenants in its financing arrangements from a sufficient number of its lenders, or obtain alternative funding sources, KPMG has informed the Audit Committee that its report on the Company’s financial statements will include an explanatory paragraph indicating that substantial doubt exists as to the Company’s ability to continue as a going concern.

If NEW will be in technical default on its warehouse lines if they cannot get a waiver of the requirement have at least $1 of net income. Thus KPMG has feels that substantial doubt exists as to the Company’s ability to continue as a going concern.

Should New Century go bankrupt we have an untested situation.

No one with upwards of $16 billion in outstanding Asset Backed Securities has ever gone bankrupt before. In theory the ABS are all done as bankruptcy remote vehicles, and should be unaffected by the parent issuer's problems.

This is untested in practice, especially when NEW is also the servicer on those assets. Much of the investment grade (and especially AAA rated tranches) are held by investors who could be in for a nasty surprise.

NEW's bankruptcy, should it occur, will create huge chaos in the ABS markets. This would be very bad for everyone else in this business. NEW is responsible for about $22B or so debt and NFI $4B if Yahoo finance is to be trusted. This could lead to an impressive Treasury bond rally, with a parallel sell off in credit and high yield bonds.

New century has extra fun from receiving a letter on February 28, 2007, from the United States Attorney’s Office for the Central District of California, in respect to a criminal inquiry under the federal securities laws in connection with trading in the Company’s securities (i.e. insider sales) well as accounting errors regarding the Company’s allowance for repurchase losses.

Now NEW isn't only mortgage lender facing troubles (here's a list). Fremont General (FMT) has received a Proposed Cease and Desist Order from the FDIC, requiring them to end subprime and condominium construction loan activity while otherwise conducting themselves in a sober and workman like manner. It is unclear if the FDIC will start chasing after other banks with subprime operations.

The Credit Default Swap market has voted, and declares major investment banks (GS) (MER) to be nearly junk. The dirty little secret is just how much income at these firms is sourced from subprime loans. Investment banks provide warehouse lines, buy loans to be securitized for their own accounts, and underwrite public offerings of other people’s loan securitizations. Subprime business has been so profitable for the major investment banks that they have been buying up/ building up direct origination platforms (i.e. MER buys Saxon Capital and First Franklin, BSC buys ECR etc etc). Of course the value of those platforms comes into question now that the banks are tighten up lending standards and the secondary markets are less interested in subprime paper.

Value Line 100 Fund to be reorganized into ETF

First Trust has filed with the SEC a plan to reorganize the First Trust Value Line 100 Fund (FVL) into a new ETF (FTA). This is the second direct closed end to ETF conversion done by first trust. The new ETF will track an index of the 100 stocks ranked #1 by Value Line for timeliness, reconstituted monthly.

The old FVL fund tracked the VL100 stocks in real time as they were updated every week. This lead to massive turnover (roughly 400% per year) and eyewatering short term capital gains distributions. The new ETF should be much more tax efficient.

To protect value line's intellectual property, the new ETF doesn't track the VL100 index exactly, as you would get in weekly updates if you subscribed to the Value Line service. Still, the new First Trust Value Line 100 ETF (FTA) should track the famous VL100 index more closely than the current Powershares ValueLine Timeliness Select Portfolio (PIV) does. FTA is the Value Line ETF that everyone wanted in the first place.

Blumberg on REITs.

GlobeSt.com: REITs will also figure in your strategy. What structures are you looking for?

Blumberg: We're not going to buy a $10-billion REIT. We'll be looking for specialty office REITs that are regionally focused--anywhere where we have market interest. For many years, I've been talking about REITs and takeovers. REITs are sitting ducks. They can't store cash, they can't buy back their shares. From an LBO perspective, they're just an agglomeration of assets, and the purchases you're seeing now reflect what the breakup value of those assets is vs. their value in the equity markets.

From a GlobeSt.com interview with American Ventures CEO Philip Blumberg

TD Ameritrade gets in the target date lifecycle game.

Behold, TD Ameritrade's investment advisory group "Amerivest" has filed with the SEC for the introduction of a series of Target Date ETF's.

• Independence 2010 ETF


• Independence 2020 ETF


• Independence 2030 ETF


• Independence 2040 ETF


• Independence In-Target ETF

These funds will track custom indexes from Zack's, designed to outperform corresponding Lipper target benchmarks.

Once each Underlying Index is established, the Index Methodology adjusts the relative weightings of each asset class within each Index, and may adjust the relative weightings of subsectors of one or more asset classes along a "glidepath", gradually moving from a more aggressive to a more conservative allocation as the target date approaches, and then gradually back to a more moderately conservative allocation following the target date.

Each ETF will invest in portfolio of domestic, international, and fixed income assets. Each fund will share the same quantitative equity portfolio, with a different weighting given to fixed income. The contents of the fixed income portfolio will be different for each fund.

This is a big step forwards for retirement investing in the US. For the first time, with just a brokerage account, people can have a complete investment program in a single ETF share. In the past, a lifecycle strategy was only available in a mutual fund or annuity. Those vehicles often had management fee's in excess of 1% and less flexibility than ETFs.

These new TDAX Independence ETFs work nicely with TD Ameritrade's, ultra low cost iZone accounts. These accounts give qualified investors ($5000 minimum) flat rate $5 trades with no monthly fees or trading minimums.

iShares FTSE NAREIT: REIT indexes you can use

The iShares trust has filed with the SEC for the creation of ETF's that will track FTSE/NAREIT indexes

• iShares FTSE NAREIT Residential Index Fund
• iShares FTSE NAREIT Industrial/Office Index Fund
• iShares FTSE NAREIT Retail Index Fund
• iShares FTSE NAREIT Mortgage REITs Index Fund
• iShares FTSE NAREIT Real Estate 50 Index Fund

The current set of REIT ETFs (ICF), (RWR), (VNQ) all own on Real estate investment trusts that own real properties, so called equity REITs. These new ETFs chop up the REIT universe into finer sectors. To me the most interesting ETF is the iShares FTSE NAREIT Mortgage REITs Index Fund

People who own the current REIT ETFs are missing out on the lucrative world of commercial mortgage REITs such as CapitalSource (CSE), Newcastle Investment Corp (NCT) and Resource Capital Corp (RSO).

Commercial MREITs are the main sector that has not participated in REIT bubble. They are poised for growth as the interest rate environment becomes more favorable and banks dial back on commercial real estate/industrial lending. The current yields on MREITs average 8% and multiples are still attractive compared to equity REITs (pass the bubbly for (ICF) ).

Large commercial mortgage REITs like Capital Trust (CT), iStar Financial (SFI), KKR Financial (KFN) have built profitable niches taking on large loans that are too specialized and tricky for banks to handle. Other MREITs like JER Investors Trust (JRT) and Anthracite Capital (AHR) work in structured finance and mezzanine lending. The combination of a lower cost of capital, match funded leverage, and longer investment horizon gives MREITs more investment flexibility than other players. Highly recommended

(Full Disclosure: I am long JER Investors Trust (JRT) )