Risk & Reactions with C & C
Insight NewsletterIssue #19
We would like to thank all for the exuberant encouragement we received from the last issue. Due to overwhelming demand, Cheech and Chong have agreed to return this week to teach us a few things about risk, getting rich, and what’s a CDO anyway.
Risk. Risk is a great English word. It can mean a lot of different things to different people. And it, like many other words in the English language, is a flexible word.
Cheech: “Hey Dude, like, what’s with the market?”
Chong: “Cheech, you already know the basics. A bunch of smart rich people, did what they always do.”
Cheech: “What’s that?”
Chong: “By taking risk with other people’s money.” The great American housing boom was exactly that. In 2005 and 2006 14 million people, many with mediocre incomes, were buying houses, using the banks money to do so. But the banks didn’t keep those loans. They sold them to structured product specialists, who then packaged them into loan portfolios that were supposed accurately rated by the ratings agencies. But then what happened, is the ratings agencies did a piss-poor job rating the holdings in these portfolios of mortgages. Them gave some of the Collateralized Debt Obligations (CDO’s) AAA-ratings when they were filled with subprime-mortgages.
Cheech: “You mean those folks making $15 bucks an hour that drive in from Modesto were classified as AAA-rated borrowers!”
Chong: “You got it Cheech”.
Cheech: “But the Fed helped out these banks didn’t they Chong, last Friday before last?”
Chong: “The Fed did step in Cheech, hit the shorts square between the eyes to inflict maximum pain. But that’s history, Cheech, yesterday’s news.”
Cheech: “So what’s today mean Chong?”
Chong: “More of the same issues Cheech, issues that won’t go away for another year or two, the real estate mess of mortgage resets on variable loans that were issued between 2003 and 2006. In the first 6 months of 2008 more than ∏ Trillion of mortgage debt will reset, and when that happens a lot of people may be giving their keys back to the mortgage servicers.”
Cheech: “Isn’t Countrywide Financial a mortgage servicer?”
Chong: “Yes they are Cheech.”
Cheech: “But Chong, is it really such a big deal, I mean, The Dow is still up 5% for the year, and it has also paid out 1.4% in dividends on top of that, year-to-date. If things are really so bad, wouldn’t the market be doing worse?
Chong: “Exactly, Cheech, you amaze me, the noise and smoke and fog and mirrors, it’s worse than T-J in ’73 and you still see the big picture…Milton should see you now!”
Cheech: “Dude, I just mean, like, my Uncle gave me some Coca-Cola stock a while back, and it’s up like $5 bucks this year, and I also have some Caterpillar stock, and it’s up over 20% this year. So I don’t get it, if the housing picture is such a mess, why doesn’t it seem worse in the market?”
Chong: “Where do I start Cheech” You’ve hit 3 nails on the head with two stocks. First, people don’t buy less Coke when their mortgage payment goes up. Also, Coke sells like a gazillion gallons a year to India, China, Brazil and Bali. What’s more, Coke sells them for other currencies. In the current falling dollar environment, that meets their profits are even larger when those currencies are repatriated into US dollars.”
Cheech: “But don’t those academic wonks always say that NO ONE is smarter than the market Chong? And the market is saying, like, “We’ll get through this.”
Chong: “One thing at a time Cheech.” “Let’s cut to the chase: As you’ve already alluded, the market is looking ahead, and it sees salvation in ’08, not despair.”
Cheech: “You mean it sees short-term rates going lower, so all those people with the adjustable rate mortgages will be able to refinance their ARMs and not lose their homes, that’s what you mean, right Chong?”
Chong: That’s exactly what I think the market is forecasting Cheech. And let’s not forget the greatest market observer of them all Cheech.”
Cheech: “Who?”
Chong: “Russell” Cheech, Richard Russell. Richard Russell has been watching every move of the market, and writing about it, since 1958. And he thinks things are looking pretty darn good.”
Cheech: “You mean, like our Grandma said, we should buy when other’s are fearful”
Chong: “Basically.” Russell believes you do better watching the market’s reaction to the news, rather than the news itself. Because the news is known, the reaction is what contains truly new information.”
Cheech: “So what’ he saying?”
Chong: “The primary trend is up, world wide growth is strong, but mostly, there has been an awful lot of dire news, and the market has just shrugged it off.” That’s bullish action “He’s saying that the market seems to believe that Fed policy will solve the liquidity crisis of 2007/2008, and that the bull market from the entrepreneurs of Asia will power things forward after this correction runs its course – unless it doesn’t of course.”
Cheech: “How will we know if it doesn’t?”Chong: “The market will close lower than it did on August 16th, which was 12,845.”
Cheech: “So shouldn’t we do something in case the worst happens.”
Chong: “Cheech, do you own any gold?”
Cheech: “Sure, I’ve got about a hundred old $20 dollar Gold coins I picked up in the 1970’s after we retired from show-biz and my uncle told me to buy them for long-term safety.”
Chong: “So what’d you pay for them back then?”
Cheech: “Dunno, maybe $40 bucks, or $50 a piece.”
Chong: “Any idea what they are worth today Cheech?”
Cheech: “None whatsoever.”
Chong: “’bout $900 smackers a piece”. Those old Liberty Gold coins have just over an ounce of Gold in them Cheech. You want some safety, own some Gold, and a bit of Silver for good measure.”
Cheech: “What about cash?
Chong: “That too.”
Cheech: “My head hurts.” So let me see if I get it. “If it sells worldwide, and pays a dividend, it’s probably going to do well. Anything more I need to know Chong, I’m wiped?”
Chong: “The beer’s cold and in the fridge. Let’s grab some and stay cool”
Cheech: “Ahh!!! (Grab’s a Corona)”
Cheech: “Chess?”
Chong: “I thought you’d never ask”
Have a terrific Holiday weekend everyone.
Blessings,
Daniel A. Barnes, CFA