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.

CBO Paints a Bleak Picture

The Congressional Budget Office has painted a bleak picture of the two alternative views of the nation's debt crisis. They have presented a summary that is only 4 pages and incorporates a graph of their two alternative scenarios. You can find it here:

http://www.cbo.gov/ftpdocs/122xx/doc12212/2011_06_22_summary.pdf

Neither scenario is very good. One seems not plausible and the other is kind of scary. I think the middle ground on the chart is more likely. This middle ground would be awful nevertheless. The point is that "Houston, we have a problem." Which reminds me of the kind of teamwork and leadership we need right now. The Apollo 13 crew was faced with an impossible task of returning to earth after an oxygen tank exploded causing limited power, loss of cabin heat, shortage of potable water and the danger of too much carbon monoxide taking over the spacecraft. They did not waste time blaming the engineers for the oxygen tank explosion. They all got together and worked to find a solution to the problems they faced.

Right now, all I see out of Washington is a blame game. The President continues along with the blame game. The Democrats are blaming the Tea Party. The Republicans are blaming the President and the Democratic controlled Senate. The House Republicans have tried to do something by passing legislation, but Harry Reid has blocked the Cut, Cap and Balance Plan.

Imagine if Jim Lowell, the Captain of Apollo 13 would have spent all of his precious time blaming the engineers, instead of working with them to try and solve the problem. He probably would be still floating out there in space somewhere if he played the blame game. Instead, the great American that he is, he worked with his crew and the engineers and everyone else in Houston to solve the problem. I had the pleasure of hearing Captain Lowell tell his story in person and it was truly amazing. His leadership was very evident.

There comes a time when the politics have to go. We need cooler heads to prevail along with some leadership. I have a saying that I have told my son often. "Always positive. Never negative." When you feel compelled to be negative. Look for the positive.

Right now, this is what we need from the President and Congress. Everything that comes out of their mouths needs to be positive. Nothing negative.

Twitter Followers

Either I am getting real popular or there are a lot of people using an automatic Twitter following service. Today alone, I have a half dozen new followers and the day is not yet over. Sorry, if I do not acknowledge the fact that you are following me on Twitter. If I acknowledged everyone, then I would not be able to get anything done.

I have to believe that although I have a few friends and enjoy a little popularity, I doubt that I am as popular as Twitter followers are making me out to be.

Remember When I Said...

I know that I am beginning to sound like a broken record, but I keep finding vindication for items on My Do Not Buy List. This time it relates to Structured Products. I do not like them for a lot of reasons, but the SEC Staff Report gives even more reasons not to buy them. See the SEC Staff Report via this link:

http://www.sec.gov/news/studies/2011/ssp-study.pdf

When I have more time, I am going to have to do a follow up Blog article on how many items on My Do Not Buy List have been vindicated by regulator scrutiny or financial media articles. I think it will match up pretty well. In other words, I think we will find that there are good reasons for the items on My Do Not Buy List. In case you missed it, here it is again below:

DO NOT BUY LIST

The following investments are on our Do Not Buy List. Although all of these investments are legal to be sold, it is our opinion, that these investments are not appropriate for most investors. Not all of the investments on the Do Not Buy List have all of these bad characteristics, but they have one or more of them.


The Do Not Buy List and their Bad Characteristics

(The numbers following each item refer to the Bad Characteristics listing below.)

• Private Placements – 1, 2, 3, 5, 6, 7, 8


• Structured Investments – 1, 6, 7, 8


• Non-Publicly Traded REIT’s – 1, 2, 5, 6, 7, 8


• Non-Publicly Traded Limited Partnerships – 1, 2, 5, 6, 7, 8


• Promissory Notes – 1, 2, 3, 4, 5, 6, 7, 8


• Regulation D Offerings – 1, 2, 3, 5, 6, 7, 8


• Exchange Traded Notes (ETN’s) – 1, 6, 7, 9


• Precious Metals – 1, 2, 3, 6, 7, 8


• Floating Rate Bank Loan Mutual Funds – 1, 5, 6, 7, 8


• Consumer Credit Funds – 1, 2, 3, 6, 8


• A Shares Mutual Funds (unless commission waived) – 5, 6, 7, 8


• B Shares Mutual Funds – 1, 5, 6, 7, 8


• C Shares Mutual Funds – 1, 5, 6, 7, 8


• Variable Annuities – 1, 5, 6, 7, 8, 10


Bad Characteristics


1. No liquidity, limited liquidity or penalty for early withdrawal.


2. Not publicly traded.


3. Not regulated.


4. Structured like Ponzi Schemes.


5. Excessive commission charges.


6. Higher risk of principal loss.


7. Excessive expenses and management fees.


8. Aggressively marketed.


9. Unfavorable taxation.


10. No tax deferred benefits if in IRA or Roth IRA.

If you currently own any of these investments, or have questions about them, then please feel free to contact me at 904-262-0888 or via email at rick@marianfs.com.

Keeping your informed and as always, at your service.