Friday, August 12, 2011

Is a Black Swan Event Coming?

I do not normally mean to be a doom and gloomer type, but there is something that concerns me about the Standard and Poor's downgrade of the United States Government. There are a plethora of mutual funds out there that have as their investment objective something similar to the following:

Under normal circumstances, the Fund invests at least 80% of its net assets in securities issued by the U.S. government, its agencies or instrumentalities or securities that are rated AAA by Standard and Poor's, AAA by Fitch, or Aaa by Moody's, including but not limited to mortgage securities such as agency and non-agency collateralized mortgage obligations, and other obligations that are secured by mortgages or mortgage-backed securities, including repurchase agreements. Under normal circumstances, the Fund maintains an average portfolio duration between one and 4.5 years.

Now that the U.S. is no longer rated AAA by Standard and Poor's, then this means that a fund like this one with a similar Investment Objective, would have to sell all securities that are not AAA rated by Standard and Poor's. If they are forced to sell, then this means that there could be a flood of U.S. Government securities that hit the market.

There is an out for these mutual fund managers and that would be one of two things. If they have built into their prospectus already that they can continue to buy Standard and Poor's AA rated U.S. Government securities. The other out is if the current U.S. Government securities that they own just so happen to be rated AAA by Fitch or Moody's. If this were the case, then they would not have to sell these U.S. Government securities. However, if for example, they were holding U.S. Government securities that were previously rated AAA by Standard and Poor's, but Fitch and Moody's did not have a rating on those particular securities, then the mutual fund manager would be bound by their prospectus to sell.

This could be a problem for a lot of mutual funds out there. This problem would be exacerbated if Fitch or Moody's were to also downgrade the U.S. Government. If that happened, then all of these mutual funds would have a major problem. If they all had to suddenly dump U.S. Government securities, then this would cause a shock to the market and thus my worry of a Black Swan event.

For those of you who do not know, black swans were never known to exist. Swans were always thought to be white, until some black ones were found. These black swans are rare indeed, but are an example of something that was previously thought impossible, suddenly was very real. Author Nassim Taleb wrote a book about Black Swans and thus applied the terminology to the markets. I am paraphrasing here but, he basically described sudden and swift shocks to the markets as Black Swan events.

My use of the term is related to this issue of having to sell U.S. Government securities, because of the requirements of these mutual fund charters, or prospectuses. This issue is eerily quiet to me right now and I am not sure why these mutual funds are being so quiet about a very significant issue. I suspect that they are busy preparing proxy changes to their prospectuses. This requires votes by the shareholders and this takes time. In the meantime, I am not sure how they will address this issue.

Imagine if U.S. Government securities would have to be sold which would certainly cause yields to go up. If these yields suddenly shoot up, this could cause panic selling of treasuries. The problem is that because of this week's Federal Reserve statement that they will keep rates low through mid-2013, this has caused bank CD rates to go down. Money Market Funds at brokerage firms and mutual fund families may actually have to start charging people to hold cash as evident by JP Morgan Chase's recent announcement. All of these issues lead us to a nowhere to hide our money situation. People are probably less likely to put their money in stocks if all this happens. The result of all this in my humble opinion, could be a Black Swan event, or a shock to the markets.

Add in other factors like no clear plan for job growth. Possibly no permanent reduction in tax rates for a time. Continued unemployment problems. Continued housing problems. Overall, we may be looking at an extended period of malaise.

Investing on your own may not be such a good idea right now. Tread carefully.