Archive for January, 2008

Does Soaking The Rich Actually Work?

Kurt Brouwer January 26th, 2008

This is a challenging piece from Arthur Laffer writing in the Wall Street Journal. It’s challenging in two ways. First, you have to stay awake long enough to actually read the piece and think through what the author is saying. This isn’t easy for those of us who find tax discussions less than stimulating. Second, it is challenging because this piece punctures arguments on taxes from both the left and the right. Read on [emphasis added]:

The Tax Threat To Prosperity (Wall Street Journal, January 25, 2008, Arthur B. Laffer)

‘Over the past 30 years, the U.S. has seen large changes in income tax rates as well as other tax rates. And, as would be expected, the budgetary implications of these tax changes have once again become a hotly debated partisan issue.

But missing from the discussion are the huge differences in how the top 1% of income earners respond to changes in tax rates versus, say, the bottom 75% or 80% of taxpayers — the so-called middle class and lowest income groups. The “rich” quite simply are not like the rest of us.

From the standpoint of logic, the supply of their taxable income should be far more sensitive to changes in tax rates than the supply of taxable income of the middle class and poor. In the highest tax bracket, 100% of all taxpayers have the highest tax rate as their marginal tax rate. And it’s the marginal tax rate that elicits supply-side responses…’

Before we go on with the article, I just want to help you focus on something Laffer wrote and also to get ready for an important point he is about to make. His quip that the rich are not like us is a quote from F. Scott Fitzgerald’s novel, The Great Gatsby. Cute, but also true. Laffer means that high income taxpayers have far more opportunities to avoid taxes than do lower income taxpayers. Therefore, higher or lower tax rates will affect the behavior of the rich far more than everyone else (see 1% of Taxpayers Pay Nearly 40% of All Income Taxes).

Also, I had not previously considered this next point, but it is clearly very important. He points out that lowering rates at the low end of the tax code will simply reduce overall tax revenues — from both the high income folks and the low income folks. Here’s why:

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Despite Writeoffs, Major Banks Made Money In 2007

Kurt Brouwer January 25th, 2008

This piece from Bloomberg [emphasis added below] caught me by surprise. Despite all the huge writeoffs last year, all major U.S. banks were still profitable. This does not get into how they are doing this year. Nonetheless, this piece was illuminating:

Every Major Bank U.S. Bank Was Profitable Last Year (Bloomberg, January 25, 2008, John M. Berry)

With all the large writedowns and losses announced for the fourth quarter, hardly any attention is being paid to just how profitable U.S. banks really are.

That inattention has raised unnecessary concerns that the banks may be so crippled by losses that they will cut lending to the point it might undermine the U.S. economy.

Some commentators have said the banks are in the worst shape since the Great Depression. That isn’t close to being correct.

Other analysts have raised the specter of the stagnant Japanese economy of the 1990s, when banks there were crippled by huge losses when a real estate price bubble burst at the beginning of that decade. This comparison also is off base.

Even Citigroup Inc., by far the hardest hit of the big U.S. banks by subprime-related problems, earned $3.62 billion last year. That was with a $9.83 billion fourth-quarter net loss and more than $22 billion in writedowns and additions to loan-loss reserves.

For JPMorgan Chase & Co., the third-biggest U.S. bank, the focus was on the 34 percent drop in fourth-quarter profits from a year earlier. Its full-year $15.4 billion profit, a record, was largely ignored. So were the bank’s record annual revenue of $71.4 billion and its record earnings per share of $4.38.

Bank of America Corp., the nation’s second largest, plans to report earnings today. Analysts surveyed by Bloomberg estimate that the bank was profitable in the fourth quarter, as well as the full year…

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Tax-Free Muni Bond Yields Now Above Taxable Treasury Yields

Kurt Brouwer January 25th, 2008

This is not something you see very often. Typically, municipal bonds and bond funds yield less than taxable bonds and bond funds. Why? Because most muni bonds are tax-free for Federal income tax purposes. Now, we see yields on many municipal bonds have actually crept up higher than taxable bonds yields. It is doubtful that this will last too long, but it is a good time to be a buyer of municipal bond funds in my opinion. In this piece, with its tongue-in-cheek title, John Waggoner spells it out [emphasis added]:

Municipal bonds become ‘a great value’ (USA Today, January 25, 2008, John Waggoner)

Painful as the credit crisis has been to many people, it’s become a boon to at least one group: municipal bond investors.Muni bonds - issued by states, cities and municipal authorities - offer interest that’s free from federal income tax and sometimes from state and local taxes, too. Normally, muni yields are lower than Treasury bond yields and so make a smart investment mainly for people in a high tax bracket.

But munis are now yielding more than Treasury bonds, making them attractive even if you pay no federal taxes. It’s something that’s happened just twice - and briefly - since 1990.

“Munis are a great value,” notes Dave MacEwen, chief investment officer for fixed income at American Century Investments.

And when you factor in the effect of federal taxes, the muni is even more attractive. Say you’re in the 25% tax bracket. You’d need that 2.84% five-year T-note to yield 4.21% to earn the equivalent of the muni’s 3.16% after federal taxes…

…The troubles of two municipal bond insurers — Ambac and MBIA — have also helped keep muni bond yields high. Muni bond issuers buy default insurance to try to get higher credit ratings and lower yields for their bonds. Investors demand higher yields from issuers when they detect a higher risk of default.

Muni bond insurers have also been clobbered by losses from their investments in mortgage-backed securities. Last week, Ambac fired its CEO, cut its dividend and said it expected a net loss per share of up to $32.83 for the fourth quarter of 2007. Fitch Ratings cut Ambac’s financial strength rating on Friday.

But municipal defaults are rare. Only about 0.3% of investment-grade munis default each year, compared with 2.1% of investment-grade corporate bonds, says American Century’s McEwen. Many insured munis have seen their yields rise to the levels they would be if they had no insurance at all, McEwen says.

Example: A five-year, top-rated muni bond yields 3.16%, according to Bloomberg. That compares with 2.84% for a five-year T-note.

In addition to the reasons cited above, muni bonds have been under selling pressure because many institutions such as banks, insurance companies and even hedge funds have been dumping them. With the need to raise additional cash, those holders of munis had to sell and that depressed prices. As a result, last year was the worst yield for muni bond performance since 1999 (see Bad Year For Muni Bonds).

600 Point Turnaround For Stocks — Financial Stocks Lead

Kurt Brouwer January 23rd, 2008

Another amazing day on Wall Street. The Dow Jones Industrial Average went way down by 300 points or so to start the day and then everything turned around and it finished up by nearly 300 points. The beaten-down and battered financial stocks led the turnaround. I think this came about due in part to the Federal Reserve’s surprise move on Tuesday to cut the Fed Funds rate by 3/4 of a point (see Federal Reserve Cuts Interest Rates Again). But, there was also an announcement of a meeting in New York with insurance regulators and banks designed to bolster the flagging bond insurance firms such as Ambac and MBIA. For the day, the Dow was up 2.50%, the S&P 500 gained 2.14% and NASDAQ was up by 1.05%.

Now, this does not mean that all is well and all the various issues, concerns, fears and doubts are gone (see Stocks Down Again — It’s An Official Correction). It is just a sign that positive news can get the financial markets going again. The key concerns are corporate earnings as well as the economy. Those won’t go away. However, it was a fascinating day on Wall Street and we have not had many of those lately.

Federal Reserve Cuts Interest Rates Again

Kurt Brouwer January 22nd, 2008

The Federal Reserve is scheduled to meet next week and was widely expected to cut short-term interest rates by 1/2 percent or 50 basis points. However, in a surprise move the Fed cut interest rates by 75 basis points today, shortly before the opening bell on the New York stock exchange. The Fed Funds rate is now 3.5%, down from 4.25%. The consensus view on why the Fed acted between meetings was that world stock markets took a huge tumble yesterday when our stock markets were closed due to observance of Martin Luther King, Jr. Day. This weakness combined with the poor jobs report for December seemingly led the Fed to act (see Stocks Fall On Weak Employment Growth Data).

The Fed’s move certainly surprised the financial markets and that may have been the goal. Fed Chairman Ben Bernanke has stated in the past that effective Fed policy should be surprising from time to time. Chalk up one for the surprise factor. Recently, the Fed had been criticized for inaction (see Revered Monetary Authority Slams Federal Reserve’s Inaction). Some analysts consider this a reactive move to quell weakness in global stock markets. Others, believe this was excellent and that the Fed needs to cut rates a few more time, specifically next week at the scheduled meeting.

At the opening, the Dow Industrial Average was down 460 points and it looked like a rout. However, bargain hunters began coming in and snapping up financial stocks as well as retailers. The stock market recovered a fair amount of the downturn, closing the day down almost 133 points on the Dow or 1.10%. The S&P 500 was off by 1.10% also and NASDAQ fell by just over 2%.

It was quite interesting watching the action early this morning. At the low point, the only significant buying I saw came in to battered financial and retailing stocks. Specifically, bond insurors Ambac and MBIA had a nice bounce as did many other financial stocks such as Countrywide, Washington Mutual, Morgan Stanley and Bear Stearns. Also, retailers such as Home Depot had good days as well. For both groups, it has been a long hard slog. No telling whether or not, this marks a bottom in these beleaguered stocks, but it certainly indicates that there is buying interest at the right price.

One potential signal that we are nearing the bottom is that some of our favorite mutual funds recently re-opened. They are anxious to put new money to work at these depressed valuations. Third Avenue International Value (TAVIX) and Third Avenue Real Estate (TAREX) recently reopened. And, one of our favorite value funds, Longleaf Partners (LLPFX), re-opened last Friday, January 18. In a statement, the Fund announced,

“…The Fund’s managers have identified investment opportunities totaling approximately $1.5 billion between new investments and existing holdings that are significantly discounted. Recently we have encouraged existing shareholders to join Southeastern’s employees in aggressively adding to their stakes in Longleaf Partners Fund. New inflows have totaled $730 million since mid-November. As the market has declined further, the opportunity set has become even more compelling and we are pleased to present the chance for new investors who have waited patiently to become our investment partners…”

I believe the recent market decline has already discounted an economic slowdown and in some industry groups and individual companies, it has already discounted a severe recession. While it never feels comfortable to invest in a declining stock market, opportunities are greatest when prices are most undervalued and expectations are lowest. I believe we are in such an environment now.

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