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Market Wrap

Buffet Bounce

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Warren Buffet spiced up the trading day with his offer to the troubled bond insurers to take up to $800 billion in municipal bonds off their hands. He offered to reinsure them for a fee of 1.5 times the remaining premium on the debt. On the surface this would provide greater liquidity to the insurers since they would no longer have to maintain reserves on those bonds. The market spiked over 200 points on the news but it was all a mistake.

Warren is not stupid. While it appeared on the surface as a bailout for the troubled bond insurers it was in fact a shrewd offer by Buffett. Municipal bonds rarely ever default and are considered one of the safest debt instruments you can buy. Add in the AAA insurance and it is just like cash. The hundreds of billions in municipal bonds that MBI, ABK and FGIC currently insure are not the problem. The problem is the structured finance debt or collateralized debt obligations called CDOs.

Ambac Chart - Daily

Here is where the Buffett offer breaks down. I am going to call the monocline insurers (ABK, MBI, FGIC) MONO in the rest of this commentary to simplify the sentence structure. Assume our generic company MONO has insured $500 billion in various debt. $400 billion is in muni bonds and $100 billion in CDOs. The muni bonds are equivalent to gold bars in a bank. The CDOs are equivalent to radioactive waste since they are the residue of the subprime implosion and currently worth about 15 cents on the dollar. For the sake of brevity let's assume a municipality did a $10 billion 20-year bond sale and insured it through MONO. They would have paid a small premium, say $100 million to MONO when the deal was done. MONO receives the premium fee up front. They recognize the premium as income at the rate of 1/20th per year as the bonds mature. That means all the money has been received but they have not yet counted it as income. It is in the bank and in their reserves calculation assuming they have not cheated and already used it to pay CDO claims.

Using round numbers let's assume that bond issue is 5-years old and 5-years of that 20-year premium (25%) has been counted as income and the rest is theoretically in the bank. Assume they wanted to take Buffett up on his deal. They have $75 million in unearned fees. Buffett will provide insurance for 150% of the unearned premium. That means MONO has to come up with $112.5 million to let Buffett take over the asset. Remember, they only received $100 million in premium and now they would have to cough up $112.5 million to give their most valuable asset away. This is not going to happen simply because these companies are in trouble because they don't have enough cash. Buffett said Ambac had already declined the offer. Secondly if they give away their gold bar collateral and are left with only the radioactive waste then MONO itself would turn radioactive and there would be no reason for anyone to structure a bailout of the remaining waste products.

Since MONO is reporting prorated income from the bond premiums over the length of the term they are technically going to show a profit for the next 10-15 years. It is not a cash profit but only a book profit. That means they will be bleeding cash as they pay claims on the defaulted CDOs while reporting income that was received years earlier. If they give away their gold bars of municipal bonds then they can no longer claim that yearly income, it will cost them extra cash they don't have to do the deal and profits for future years will plunge into deep losses and those losses will be actual cash losses.

The Buffett offer was nothing more than an advertising ploy for Berkshire Hathaway Assurance Corporation or BHAC. By offering to take up to $800 billion in municipal bonds or roughly half of those currently outstanding he put the regulators on notice that he had that capability and was ready to write the check within 5-days of a deal. He copied the regulators on the offer just to make sure they got a copy. The regulators are already making plans to shutdown the insurers if a broad bailout deal cannot be reached. A bailout is looking less likely every day now compared to strong hopes just a couple weeks ago. With the CDOs now valued at 14-20 cents on the dollar there is simply too much exposure and where the original talk was for a possible $15-$30 billion bailout that number has climbed to something in the $75 billion range today. If the regulators decide to let these companies go under they can reduce a significant amount of pain by accepting Buffett's offer and moving $800 billion of muni bonds out of harms way before they flush MONO. They can force MONO to pay the 150% fee out of reserves and then shut them down.

Fitch said there are approximately 137,000 Ambac insured municipal bonds of which 132,000 were downgraded to AA from AAA in late January and were placed on rating watch negative suggesting there would be further downgrades as the Ambac problem worsens. These municipalities are all being forced to pay higher payments as a result of this downgrade and are more than likely applying plenty of pressure to the Ambac bailout situation. Buffett's offer will give these municipalities something to lobby for as a takeout of their problems. Since Ambac has insufficient unallocated cash to take the offer there will need to be some regulator control exercised if it is going to happen.

All of this jockeying for position by the various companies and regulators is keeping the market off balance. The risk of an additional $75-$150 billion write-down cycle if MONO goes under is weighing on the banks. The banks no longer have enough capital to bail out MONO and the counterparty risk problem is growing. Analysts now fear that for the banks to invest $30 billion into companies that may owe them several hundred billion is a conflict of interest that could eventually force all the debt to be written off anyway. It is a lose-lose for the banks and there does not appear to be any way out short of a government funded bailout.

It was a good day for Buffett and the millions in free advertising for his new BHAC company. He will probably have more bond insurance business than he can write over the next several months. Nobody is going to be taking business to any of the MONO group but that debt still has to be sold in order to fund roads, schools, utilities, city halls, etc. This is going to be a very profitable business for Berkshire Hathaway. He is in the right place at the right time once again. His sterling credit can command a premium fee.

On the economic front the Job Openings Labor Turnover Survey (JOLTS) showed that the labor market was continuing to weaken but this was a trailing report covering the December period. The market ignored it given the Buffett announcement. Hiring declined to 3.3%, down from 3.6% in the prior period. The gross number of jobs created fell to 4.2 million for the year compared to 4.66 million in Dec 2006. Separations fell to 3.1% with 4.0 million people leaving their jobs compared to 4.25 million in Dec-2006. Available jobs declined to 2.8% at 3.6 million and down from 3.9 million in Dec-2006. It was a pretty boring report.

The weekly chain store sales continued to be volatile with a -0.7% drop after a +1.7% gain in the prior week. Cold weather in some areas depressed sales while warmer weather in others provided a lift. It is hard to get excited about this weekly report and traders completely ignore it unless there is a sharp deviation from the norm.

The ABC News/Washington Post consumer comfort index fell to -37 from -33. The drop of 17 points since early January makes it the second largest decline on record. Only the 1990-1991 recession was worse. I am not going to list all the components but one was worth a mention simply because of its disparity. Confidence among Republicans was only -8 but for Independents it dropped to -41 and for Democrats -50. I thought this election was going to be a Democrat win for sure so why are the Democrats so discouraged? Could it be they really don't like either candidate and they are faced with choosing the lesser of two evils? Is the Democratic message so negative that even their own constituency is depressed? I am not choosing sides here or trying to make a political point but this component of the survey shocked me.

Consumer Comfort Chart from Economy.com

The homebuilders took another hit today after Masco (MAS) said sales through 2008 were going to continue to decline. Masco makes cabinets, Delta and Peerless faucets and Behr paints. MAS reported a loss that was less than analysts had expected but the guidance was dreary. Masco said it sees a continued decline in housing starts of another 25-35% in 2008. Masco said 2008 was expected to be a difficult year for the U.S. economy. Masco also said it was seeing weakness in its overseas sales. Masco has cut 11,000 employees since Q4-2006. Bank America cut their estimates for 2008 earnings to 85 cents from $1.53 per share. Moody's put Masco under review for a possible downgrade on $4 billion of Masco debt.

Monsanto (MON) gained a buck after the company raised guidance for 2008. Monsanto said earnings could be in the range of $2.70-$2.80 compared to prior estimates of $2.50-$2.60 per share. The company is seeing strength in its herbicide business and rising demands for specialty seeds. In the same general sector Potash (POT) said 2008 gross margins will be 2.5 times larger than they were in 2007. The CEO said it was due to their leverage in the fertilizer sector. They have the majority of the world's excess fertilizer capacity and are bringing it to market at a premium price. They are planning on spending $5 billion over the next 4-years to bring idle production back online. One analyst said POT could also be a takeover candidate. POT gained +5.20 for the day to close at $149.

Yahoo rejected the Microsoft offer of $31 saying they had far too many projects in progress that would improve their market share and profitability. Bill Miller, the manager of the Legg Mason Value Trust, is a major stockholder of Yahoo with 6% of the outstanding stock. Miller was actively trying to talk up the Microsoft offer saying Yahoo was worth $40 a share. Yahoo shares eased slightly to $29.56 because almost everyone expects Microsoft to up their bid. Microsoft can't afford to let Yahoo get away.

After the bell today Applied Materials reported earnings of 23 cents after items compared to estimates of 20 cents. Sales were stronger than expected at 2.09 billion but still lower than the prior quarter. AMAT rose a buck in after hours trading.

The administration made another plug to ease the foreclosure process for more than a million homeowners behind on their payments. They announced a 30-day reprieve on any foreclosure with a loan at the six largest lenders to give homeowners some breathing room to solve their problem. Most analysts say this will only give them 30 days longer to pack their bags since the majority of owners are already seriously underwater. It was not seen as a major new initiative.

GM reported a loss for the full year of $38.7 billion despite a near record for global sales. GM also offered a new round of employee buyouts for all 74,000 union employees. The goal is to replace the older more experienced and highly paid employees with younger, cheaper workers. Under the offer eligible workers could get between $45,000-$62,500 as an incentive to retire early with full pension and health benefits. Other workers could get up to a $140,000 lump sum buyout with no retirement benefits. GM maintained its global manufacturing edge but only barely. They built only 3,000 more vehicles than Toyota.

Wynn Resorts posted a $65.5 million Q4 profit that was helped in part by the Macau property. Unfortunately it was not as much as the street expected and the stock was crushed for a $6 loss in after hours trading. Analysts said they were hoping Macau would generate significantly higher profits to offset weak conditions in Las Vegas.

Late in the day Venezuela said it was suspending oil sales to Exxon (XOM) because Exxon had courts seize Venezuelan assets around the world last week. Exxon quickly put out a press release saying the lack of oil from VZ would have no impact on Exxon's supplies. This was simply a political announcement by Chavez in an attempt to regain some lost face from the Exxon win last week. On Sunday Chavez said it would cut off all exports to the U.S. if the U.S. continued its economic attacks on VZ. Since the refineries in the U.S. are almost the only ones that can refine the VZ heavy crude his threat is groundless. If he had to ship his low quality oil around the world to get it refined and sold the shipping charges and the discount required to get somebody else to buy it would drastically impact his net revenue. Talk is cheap and Chavez is the king of talk. Crude rose nearly a buck on the news to $93.18.

The markets rallied on the Buffett announcement with the Dow rising over 230 points early in the day. Momentum slowed immediately after the initial bounce but the gains held until 3:PM before sellers showed up in volume. The Dow declined -158 points off its highs to a gain of only +72 points by 3:30 but there were dip buyers waiting and we closed in the middle of the range at +133. On a technical basis the morning bounce was right to the top of initial resistance and failed at that resistance. At 3:30 I was expecting the Dow to close negative given the severity of the selling. I was surprised to see the rebound so strongly and it definitely changed my bias.

Dow Chart - 120 Min

Nasdaq Chart - 120 Min

The Nasdaq rebounded less than the Dow and failed to recover from the afternoon selling. The Nasdaq ended fractionally lower with big caps weak like AAPL losing -4.58, RIMM -2.88, GOOG -3.11. The Nasdaq ended right in the middle of its 3-week congestion range and giving us no clue where it is headed. Hovering just over support at 2310 we could be ready to launch but we saw resistance at 2350 solid as a rock.

The S&P-500 had a nearly identical chart to the Dow with a dead stop at initial resistance at 1360 and a close in the middle of its range. Initial support is 1320 and should survive any further weakness without a massive news event turning sentiment sour.

S&P-500 Chart - 120 Min

Russell-2000 Chart - 120 Min

The most positive index was again the Russell 2000 with a steady uptrend still in place. A -7 point drop into the close was not enough to push it negative and a +5 point gain to 705 was above the uptrend support. I still see the Russell as our indicator that the bulls are alive and well and we could see the fund managers continue to nibble away as the Fed cuts rates.

This is an option expiration week and we saw the same week in January produce a monster drop. I do not expect that this week and I think we have established a bottom unless/until a fatal decision is reached in the bond insurer scenario. My recommendation still stands to buy dips to Russell 685 and you had two chances to buy within 5-points of that level in the last 5-days. Earnings are basically over except for a bunch of stragglers and there are no major economic reports for the rest of the week. The daily news is going to be the key and the focus will be on the bond insurers. Be patient and wait for your entries unless solid volume appears on a breakout.

Jim Brown


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