United Bank & Trust Blog

After opening down yesterday more than 25 points on S&P 500 and more than 250 points on the Dow, it appears we may be moving toward correction territory (5-10% down from a cyclical peak) in the US stock market. The current Japanese situation may be the catalyst for what really is long overdue action in the stock market. Before rebounding 5% or so today, the Japanese stock market, in comparison, had been down 6% Friday and Monday, and down 10% Tuesday, reflecting the crisis and devastation they face. Today’s rebound seemed to be due to a potential pledge by the Japanese government to buy stocks, its central bank pumping liquidity into the Japanese financial system, and the simple fact that their stock market had fallen so far, so fast.

As I am sure you all have been following it, the situation in Japan is still a very fluid one. It appears that the nuclear reactor situation still is moving in the wrong direction with strong fears of radioactive contamination, as officials have yet to get them contained, cooled and under control. As fate would have it, the reactors weathered the earthquake as they are built to do; however, the tsunami that followed is what caused the real damage to them as well as the widespread area of northeast Japan.

While the situation is quite dire in Japan, there are several things to keep in mind for our clients:

• Our well-diversified portfolio strategies have very little direct exposure to Japan, typically less than 2% of the total portfolio.

In the near term, global auto manufacturers could be affected by parts shortages and certainly Japanese car manufacturing has been/will be affected negatively. Most Japanese car companies have a 2-3 month supply of inventory in the US. Please keep in mind, though, our portfolio exposure to the auto industry and suppliers is essentially none.

In time, we could actually see a ‘Hurricane Katrina’-like effect in Japan, in which the initial devastation actually transforms into a widespread reconstruction of the country – infrastructure, roads, power plants, etc. In fact, it could (eventually) actually push the Japanese economy off of its near 0% growth rate. But, remember we are still very early in the stages of this crisis and it must be stabilized before any kind of rebuilding could take place.

Could this affect the global economic recovery? In short, yes, but not in a major way and will likely not derail the recovery. Japan is the third largest economy as measured by nominal GDP. However, the area affected by the natural disasters makes up only 5-10% of Japan’s GDP. Commodity prices – specifically oil – may fall in the short term, but in the longer-term there is still solid demand especially from emerging markets.

The events in Japan [and the unrest in the Middle East] will very likely keep the Federal Reserve on hold in terms of interest rates. QE2 will be taken through its completion in June. And, it should allow the European Central Bank to back off of its hawkish inflation position and hold off on raising interest rates for now.

The fiscal year-end for the SBA was 9/30/2010 and United Bank & Trust and United Structured Finance Co. were again the number one lenders in the counties we serve.

On a combined basis, for the counties of Lenawee, Livingston, Monroe and Washtenaw, we approved 25 SBA loans resulting in over $10,000,000 in funds going into our local businesses and communities to spur economic growth and create jobs. We made more than twice the number of SBA loans than any other lender in our communities (25 compared to 11) and made almost four times the dollar amount of loans than any other lender in our communities ($10.03MM compared to $2.53MM).

In our market we made 24% of all of the SBA loans done in the fiscal year and over 30% of all of the dollars lent in fiscal 2010 were made by United Bank & Trust and United Structured Finance Co.

I am proud that this validates our commitment to our communities, local businesses and desire for job growth. So far in the fiscal year 2011 we are off to a great start in lending and are excited to see other financial institutions in our community stepping up to utilize the SBA loan programs at record levels for the benefit of all of our community clients.

It is no secret that many states are going through challenging economic times. The recession of 2007 – 2009 has put an enormous strain on the fiscal health of states and municipalities. Revenues from property taxes, sales taxes and income taxes have fallen dramatically due to the fall in home values, decrease in personal spending and growth of unemployment. Most states must have balanced budgets, so with revenues down, they must cut expenses, too. But after living through these issues for the last several years, the cuts are getting bigger, deeper and harder to make. As a result, many investors are wondering how safe their municipal bonds are today.

We have been aware of these issues for some time and have given them considerable attention. We currently manage more than $85,000,000 in municipal bonds for our clients, so these issues have relevance. The municipal bond sector has been a very safe investment option over the long-term, but with the fiscal pressures present today, there are ways to significantly reduce the risk in owning municipal bonds. It starts with credit underwriting.

• Know where and what you are buying. It’s very important to understand the community you’re investing in, what the employment picture is and the make up of the tax base.
• The structure of the bond is important too. Is it a UTGO (unlimited tax general obligation), LTGO (limited tax general obligation), revenue bond or school bond? UTGO is the best. It means that any form of revenue can be used to satisfy the obligation. LTGO is next and can be fine with a strong issuer. Essential services revenue bonds, where there is a dedicated revenue source for the debt like water or sewer payments or highway tolls, hold up well regardless of economic cycle.
• Bond Rating – Moody’s, S&P and Fitch assign credit ratings to the bonds based on the municipalities’ ability to handle their obligations. We buy only A, AA, and AAA rated bonds, and most of the portfolio is rated AA or higher. According to S&P, this means “the obligor’s capacity to meet its financial obligation is very strong.”
• School Bonds – The State of Michigan has a program known as the School Bond Qualification and Loan Fund. Bonds that qualify for this program must meet certain criteria and are then given a credit rating equal to the State (Aa2/AA-). Should the school district be unable to fulfill its obligation to bondholders, the district MUST borrow sufficient monies from the State of Michigan School Bond Loan Fund to meet principal and interest payments. This gives a second level of support.
• Cities, counties and states have many ways to offset the decline in revenue that they are experiencing today. They’re not all easy, like raising taxes, renegotiating contracts and benefits, but they do exist. Additionally, the improving economy will eventually take the pressure off, but we still have a couple years of pressure.

In a study done by the bond rating firm Moody’s over the time period of 1970 to 2009, they found default rates for high quality municipal bonds to be 0.06% compared to high quality corporate bonds of 2.50%. Buying quality is our strategy. Clearly, states and local governments will remain under budget pressures for the next several years. We won’t abandon the sector during that period, but instead maintain our high quality approach. In fact, as others are selling, it may present opportunities for our clients.