My Obligation: To Mom
Mother’s Day is coming,
And a gift I’ve yet to find,
So I write this poem to you,
Though it is a waste of time
This is my obligation,
Which I do not want to do
But it is my way of saying:
Happy Mother’s Day to you
The spring’s warm air is stirring
Calm and hopeful, warm and breezy
And though one wouldn’t think to add,
It is also very cheesy
This is my obligation,
Which I do not want to do
But it’s my ONLY way of saying:
Happy Mother’s Day to you
Though you will not give me discounts,
And you get mad far too quickly,
Still you put hope in my future,
And you do not do it meekly
This is my obligation,
Which I do not want to do
But it’s an okay way of saying:
Happy Mother’s Day to you
When the happy day is over
And the last “thank you”‘s have gone,
Still you’ll always have this poem,
Which is almost like a song
This is my obligation,
Which I do not want to do,
But I guess it’s nice to say:
Happy Mother’s Day to you.
When the weather here is rainy
Or the economy is bad
You can always read this poem again
And you won’t feel quite as sad
It’s more than a little cheesy,
And perhaps not all heartfelt,
But I hope you will appreciate
These words to you I’ve dealt
This is my obligation
Which I do not want to do
Yet I hope you’ll like me saying:
Happy Mother’s Day to you
My “cuteness” years are over
And my teen has not begun
But still your task for raising me,
Is not even close to done
This is my obligation,
Which I don’t really want to do
But it’s meaningful to say:
Happy Mother’s Day to you
I know it’s really mushy,
But I’ll write it to you still
I’d like to say I love you,
Always have and always will
This is not my obligation
It’s something nice to do
And the message of this is:
Happy Mother’s Day to you
Sunday, May 3, 2009
Monday, March 30, 2009
Bottom is insight (don't like this title at all!)
BEAR MOVES IN THE stock market have anticipated nine out of the past five recessions, as an economist once famously quipped. Rebounds in stock prices are no more reliable in anticipating economic recoveries.
The only way to tell if the recent rebound in stocks is truly signaling recovery is to look at supporting data. And those data continue to suggest a bottoming in the economy by the second quarter, which would then turn out to have been duly anticipated by a bottom in the stock market in early March, the first quarter's final month.
This hardly suggests the bull is about to roar. Growth of real gross domestic product in the second half of 2009 is likely to be modest, running at an annual rate of 2% to 3%. The level of real GDP by year end will still be lower than the recent peak. There is always a danger, then, that equity prices will run ahead of this modest outlook. But at least the outlook is beginning to look positive.
Among upside surprises reported last week, one was the widespread rebound in February of durable-goods orders, tracked monthly by the Census Bureau. A durable good, as you might imagine, is technically defined as a tangible item that lasts at least three years. As such, it includes items that consumers buy, like cars and computers (although not plastics like Tupperware), but mainly covers nonconsumer goods like machinery and equipment.
The Census report on durable-goods orders is therefore a useful look into the activities of the manufacturing sector. (Yes, Virginia, there really is a domestic-manufacturing sector, even if much of it is owned by foreign companies.) The February increase in orders followed six consecutive monthly decreases and only partially reversed the decline in January. It tended to confirm the picture of a manufacturing sector that is still contracting, but at a slower rate. If final demand for goods really is beginning to stabilize, then manufacturing activity should be due for a rebound.
THE STRONGER PATTERN OF final demand got further confirmation from data for real consumer spending, released Friday. In the first two months of this year, real personal consumption ran positive, virtually guaranteeing that it will be up in the first quarter relative to the fourth.
Even if consumption flattens in the second quarter, the excessive liquidation of inventories should mean that production will still be due for a pick-up. Despite crushing job losses, it is still possible consumption will trend upward.
Job losses are not the only decisive factor in determining the trend in consumption. Otherwise, we would have to wonder how consumer spending could be higher in the first quarter than it was in the fourth, when the jobless rate was lower. One key factor that should help to buoy consumption is mortgage refinancings, fueled by a mortgage interest rate of 4.85%, the lowest on record.
The low mortgage interest rate helped bring another upside surprise reported last week, the February increase in existing home sales. With strengthening home sales, the negative wealth effect from declining home prices should diminish. One key home price tracked by the Federal Housing Finance Agency actually showed an increase in January.
Already much diminished is the negative wealth effect from the decline in stocks. That, too, should help buoy consumption.
The only way to tell if the recent rebound in stocks is truly signaling recovery is to look at supporting data. And those data continue to suggest a bottoming in the economy by the second quarter, which would then turn out to have been duly anticipated by a bottom in the stock market in early March, the first quarter's final month.
This hardly suggests the bull is about to roar. Growth of real gross domestic product in the second half of 2009 is likely to be modest, running at an annual rate of 2% to 3%. The level of real GDP by year end will still be lower than the recent peak. There is always a danger, then, that equity prices will run ahead of this modest outlook. But at least the outlook is beginning to look positive.
Among upside surprises reported last week, one was the widespread rebound in February of durable-goods orders, tracked monthly by the Census Bureau. A durable good, as you might imagine, is technically defined as a tangible item that lasts at least three years. As such, it includes items that consumers buy, like cars and computers (although not plastics like Tupperware), but mainly covers nonconsumer goods like machinery and equipment.
The Census report on durable-goods orders is therefore a useful look into the activities of the manufacturing sector. (Yes, Virginia, there really is a domestic-manufacturing sector, even if much of it is owned by foreign companies.) The February increase in orders followed six consecutive monthly decreases and only partially reversed the decline in January. It tended to confirm the picture of a manufacturing sector that is still contracting, but at a slower rate. If final demand for goods really is beginning to stabilize, then manufacturing activity should be due for a rebound.
THE STRONGER PATTERN OF final demand got further confirmation from data for real consumer spending, released Friday. In the first two months of this year, real personal consumption ran positive, virtually guaranteeing that it will be up in the first quarter relative to the fourth.
Even if consumption flattens in the second quarter, the excessive liquidation of inventories should mean that production will still be due for a pick-up. Despite crushing job losses, it is still possible consumption will trend upward.
Job losses are not the only decisive factor in determining the trend in consumption. Otherwise, we would have to wonder how consumer spending could be higher in the first quarter than it was in the fourth, when the jobless rate was lower. One key factor that should help to buoy consumption is mortgage refinancings, fueled by a mortgage interest rate of 4.85%, the lowest on record.
The low mortgage interest rate helped bring another upside surprise reported last week, the February increase in existing home sales. With strengthening home sales, the negative wealth effect from declining home prices should diminish. One key home price tracked by the Federal Housing Finance Agency actually showed an increase in January.
Already much diminished is the negative wealth effect from the decline in stocks. That, too, should help buoy consumption.
Monday, March 23, 2009
Soros: Ready for slow growth
Billionaire hedge fund manager George Soros has been warning of a global financial crisis for some time now. And when The Australian’s Peter Wilson interviewed the former partner of Jim Rogers lately, he noted how Soros has been handsomely-rewarded for such foresight. Wilson wrote yesterday:
And foreseeing the biggest economic crisis since the Great Depression has certainly paid off financially. In August 2007, with the first symptoms of the credit crunch on the horizon, Soros came out of semi-retirement to reassume control of his Quantum investment fund, astutely repositioning it for the tsunami about to hit. By year’s end Quantum was up almost 32 per cent for 2007, netting Soros profits of $US2.9 billion at a time when other financiers were struggling to break even.
His fortune was estimated at $US11 billion by Forbes in September 2008 and it has grown even larger amid the spreading financial carnage. That same year, in which Hedge Fund Research estimates the hedge fund industry lost a record 18.3 per cent, Soros was up another 9 per cent.
The chairman of Soros Fund Management, whose new book The Crash of 2008 and What it Means: The New Paradigm for Financial Markets is scheduled to be released before the end of this month, shared his latest outlook for the global economy with readers of the Australian publication. From the piece:
The entire world, but especially the West, should now brace for slower economic growth, he warns, and it will be at least a decade before the US sees robust growth. One important effect will be a new wariness in China about the US economic model, Soros says. “The Chinese used to look up to the West and try to imitate the West and they have now discovered that it may not be the right thing to imitate. They now feel suddenly impelled to develop their own system and in some ways they are actually ahead of us.
“For instance, they have been using variable capital requirements as a policy tool. They changed the minimum capital requirements for banks 17 times in the past year, first raising it rapidly and then lowering it. I think we will have to learn to do the same thing.”
In any case, the Chinese government can no longer be relied on to plough money into US government debt, he warns. “They will have less money to spend because their surplus is shrinking and their exports are falling, so they will have less to dispose of, so I think that there will be a definite shift.”
And foreseeing the biggest economic crisis since the Great Depression has certainly paid off financially. In August 2007, with the first symptoms of the credit crunch on the horizon, Soros came out of semi-retirement to reassume control of his Quantum investment fund, astutely repositioning it for the tsunami about to hit. By year’s end Quantum was up almost 32 per cent for 2007, netting Soros profits of $US2.9 billion at a time when other financiers were struggling to break even.
His fortune was estimated at $US11 billion by Forbes in September 2008 and it has grown even larger amid the spreading financial carnage. That same year, in which Hedge Fund Research estimates the hedge fund industry lost a record 18.3 per cent, Soros was up another 9 per cent.
The chairman of Soros Fund Management, whose new book The Crash of 2008 and What it Means: The New Paradigm for Financial Markets is scheduled to be released before the end of this month, shared his latest outlook for the global economy with readers of the Australian publication. From the piece:
The entire world, but especially the West, should now brace for slower economic growth, he warns, and it will be at least a decade before the US sees robust growth. One important effect will be a new wariness in China about the US economic model, Soros says. “The Chinese used to look up to the West and try to imitate the West and they have now discovered that it may not be the right thing to imitate. They now feel suddenly impelled to develop their own system and in some ways they are actually ahead of us.
“For instance, they have been using variable capital requirements as a policy tool. They changed the minimum capital requirements for banks 17 times in the past year, first raising it rapidly and then lowering it. I think we will have to learn to do the same thing.”
In any case, the Chinese government can no longer be relied on to plough money into US government debt, he warns. “They will have less money to spend because their surplus is shrinking and their exports are falling, so they will have less to dispose of, so I think that there will be a definite shift.”
Monday, March 16, 2009
A Continent Adrift
I’m concerned about Europe. Actually, I’m concerned about the whole world — there are no safe havens from the global economic storm. But the situation in Europe worries me even more than the situation in America.
Just to be clear, I’m not about to rehash the standard American complaint that Europe’s taxes are too high and its benefits too generous. Big welfare states aren’t the cause of Europe’s current crisis. In fact, as I’ll explain shortly, they’re actually a mitigating factor.
The clear and present danger to Europe right now comes from a different direction — the continent’s failure to respond effectively to the financial crisis.
Europe has fallen short in terms of both fiscal and monetary policy: it’s facing at least as severe a slump as the United States, yet it’s doing far less to combat the downturn.
On the fiscal side, the comparison with the United States is striking. Many economists, myself included, have argued that the Obama administration’s stimulus plan is too small, given the depth of the crisis. But America’s actions dwarf anything the Europeans are doing.
The difference in monetary policy is equally striking. The European Central Bank has been far less proactive than the Federal Reserve; it has been slow to cut interest rates (it actually raised rates last July), and it has shied away from any strong measures to unfreeze credit markets.
The only thing working in Europe’s favor is the very thing for which it takes the most criticism — the size and generosity of its welfare states, which are cushioning the impact of the economic slump.
This is no small matter. Guaranteed health insurance and generous unemployment benefits ensure that, at least so far, there isn’t as much sheer human suffering in Europe as there is in America. And these programs will also help sustain spending in the slump.
But such “automatic stabilizers” are no substitute for positive action.
Why is Europe falling short? Poor leadership is part of the story. European banking officials, who completely missed the depth of the crisis, still seem weirdly complacent. And to hear anything in America comparable to the know-nothing diatribes of Germany’s finance minister you have to listen to, well, Republicans.
But there’s a deeper problem: Europe’s economic and monetary integration has run too far ahead of its political institutions. The economies of Europe’s many nations are almost as tightly linked as the economies of America’s many states — and most of Europe shares a common currency. But unlike America, Europe doesn’t have the kind of continentwide institutions needed to deal with a continentwide crisis.
This is a major reason for the lack of fiscal action: there’s no government in a position to take responsibility for the European economy as a whole. What Europe has, instead, are national governments, each of which is reluctant to run up large debts to finance a stimulus that will convey many if not most of its benefits to voters in other countries.
You might expect monetary policy to be more forceful. After all, while there isn’t a European government, there is a European Central Bank. But the E.C.B. isn’t like the Fed, which can afford to be adventurous because it’s backed by a unitary national government — a government that has already moved to share the risks of the Fed’s boldness, and will surely cover the Fed’s losses if its efforts to unfreeze financial markets go bad. The E.C.B., which must answer to 16 often-quarreling governments, can’t count on the same level of support.
Europe, in other words, is turning out to be structurally weak in a time of crisis.
The biggest question is what will happen to those European economies that boomed in the easy-money environment of a few years ago, Spain in particular.
For much of the past decade Spain was Europe’s Florida, its economy buoyed by a huge speculative housing boom. As in Florida, boom has now turned to bust. Now Spain needs to find new sources of income and employment to replace the lost jobs in construction.
In the past, Spain would have sought improved competitiveness by devaluing its currency. But now it’s on the euro — and the only way forward seems to be a grinding process of wage cuts. This process would have been difficult in the best of times; it will be almost inconceivably painful if, as seems all too likely, the European economy as a whole is depressed and tending toward deflation for years to come.
Does all this mean that Europe was wrong to let itself become so tightly integrated? Does it mean, in particular, that the creation of the euro was a mistake? Maybe.
But Europe can still prove the skeptics wrong, if its politicians start showing more leadership. Will they?
Just to be clear, I’m not about to rehash the standard American complaint that Europe’s taxes are too high and its benefits too generous. Big welfare states aren’t the cause of Europe’s current crisis. In fact, as I’ll explain shortly, they’re actually a mitigating factor.
The clear and present danger to Europe right now comes from a different direction — the continent’s failure to respond effectively to the financial crisis.
Europe has fallen short in terms of both fiscal and monetary policy: it’s facing at least as severe a slump as the United States, yet it’s doing far less to combat the downturn.
On the fiscal side, the comparison with the United States is striking. Many economists, myself included, have argued that the Obama administration’s stimulus plan is too small, given the depth of the crisis. But America’s actions dwarf anything the Europeans are doing.
The difference in monetary policy is equally striking. The European Central Bank has been far less proactive than the Federal Reserve; it has been slow to cut interest rates (it actually raised rates last July), and it has shied away from any strong measures to unfreeze credit markets.
The only thing working in Europe’s favor is the very thing for which it takes the most criticism — the size and generosity of its welfare states, which are cushioning the impact of the economic slump.
This is no small matter. Guaranteed health insurance and generous unemployment benefits ensure that, at least so far, there isn’t as much sheer human suffering in Europe as there is in America. And these programs will also help sustain spending in the slump.
But such “automatic stabilizers” are no substitute for positive action.
Why is Europe falling short? Poor leadership is part of the story. European banking officials, who completely missed the depth of the crisis, still seem weirdly complacent. And to hear anything in America comparable to the know-nothing diatribes of Germany’s finance minister you have to listen to, well, Republicans.
But there’s a deeper problem: Europe’s economic and monetary integration has run too far ahead of its political institutions. The economies of Europe’s many nations are almost as tightly linked as the economies of America’s many states — and most of Europe shares a common currency. But unlike America, Europe doesn’t have the kind of continentwide institutions needed to deal with a continentwide crisis.
This is a major reason for the lack of fiscal action: there’s no government in a position to take responsibility for the European economy as a whole. What Europe has, instead, are national governments, each of which is reluctant to run up large debts to finance a stimulus that will convey many if not most of its benefits to voters in other countries.
You might expect monetary policy to be more forceful. After all, while there isn’t a European government, there is a European Central Bank. But the E.C.B. isn’t like the Fed, which can afford to be adventurous because it’s backed by a unitary national government — a government that has already moved to share the risks of the Fed’s boldness, and will surely cover the Fed’s losses if its efforts to unfreeze financial markets go bad. The E.C.B., which must answer to 16 often-quarreling governments, can’t count on the same level of support.
Europe, in other words, is turning out to be structurally weak in a time of crisis.
The biggest question is what will happen to those European economies that boomed in the easy-money environment of a few years ago, Spain in particular.
For much of the past decade Spain was Europe’s Florida, its economy buoyed by a huge speculative housing boom. As in Florida, boom has now turned to bust. Now Spain needs to find new sources of income and employment to replace the lost jobs in construction.
In the past, Spain would have sought improved competitiveness by devaluing its currency. But now it’s on the euro — and the only way forward seems to be a grinding process of wage cuts. This process would have been difficult in the best of times; it will be almost inconceivably painful if, as seems all too likely, the European economy as a whole is depressed and tending toward deflation for years to come.
Does all this mean that Europe was wrong to let itself become so tightly integrated? Does it mean, in particular, that the creation of the euro was a mistake? Maybe.
But Europe can still prove the skeptics wrong, if its politicians start showing more leadership. Will they?
Wednesday, March 11, 2009
Real S&P 500 chart - inflation adjusted:
When you have to look at the same chart over and over again it can get a bit boring so here’s the ‘real’ S&P 500 - inflation adjusted:
The chart shows monthly data from 1900 to February 2009 and is logarithmically scaled so that a percentage move in any year is comparable to other years. I’ve used the CPI (monthly) data available from official US government sources. Some say it is under-reported but what other real alternatives do we have? Removing the distorting effect of inflation is important for long term charts and also because we know that the Fed is doing all it can to create inflation. The most recent data shows the largest one year increase in money supply.
Like walking down your hometown streets, things look similar but different. For example, the chart doesn’t show the massive double top that is now recognized by everyone. Also, from 1900 to 1950, the market tread water after inflation. Then a roaring bull market followed, to then be deflated by an equally intense bear market.
Most interesting is that the bear market low is July 1982 - not 1975 as we usually see on non-inflation adjusted charts. This is where the bull market that followed next was launched. The inflation adjusted level of 238 acted as support, just as it had acted as resistance on so many occasions (temporarily pierced only by the roaring bull market of the 1920’s).
A similar situation is setting up today. We had a bull market that took us to new inflation adjusted levels and subsequently almost all the air was let out because the market is now back to where it broke out from the 1968 top. To be accurate we have a little more air to let out before the market ricochets off that level once again.
Assuming that this is the playbook the market is following; and if not, cheer up! we can only go to zero.
Friday, March 6, 2009
Unemployment Number
1974 (Half of the work force)
November - 368K
December - 602K
January -360k
February -378k
March -270k
April -186k
May +160k
June -104k
2008
November - 533K
December - 589K
January - 655K
February - 651K
Stay tuned.
November - 368K
December - 602K
January -360k
February -378k
March -270k
April -186k
May +160k
June -104k
2008
November - 533K
December - 589K
January - 655K
February - 651K
Stay tuned.
Monday, March 2, 2009
Saturday, February 28, 2009
Fix the bank
EVEN AFTER CITIGROUP'S HIGHLY DILUTIVE DEAL with the government on Friday, battered bank stocks managed to end the week up 11%, well above the lows set Feb. 20. One reason is that guidelines for the government's "stress test" for banks, unveiled Wednesday, proved less onerous than expected. A second reason is that capital levels at the nation's regional banks now look fairly sturdy.
The Citi deal has everyone on Wall Street suddenly talking about a measure of financial strength called tangible capital, which is a bank's tangible common equity divided by its tangible assets. Citi (ticker: C) ranks as one of the worst institutions by this measure, with a tangible-capital ratio of 1.5%. Now that Citi has announced that the government and private investors will have the opportunity to convert their preferred shares into common shares, Citi's tangible capital ratio looks likely to jump to 4%. Many analysts and investors think 4% will emerge as the government's targeted minimum.
Prior to the Citi deal, regulators had focused on Tier 1 capital, which includes preferred stock and has been criticized for overstating banks' financial strength.
John Kuczala for Barron's
Troweling on the dollars alone won't put a lasting patch on the broken banking system.
Citi's Tier 1 capital appears healthy at 11.9%, double the regulatory minimum despite the bank's major problems. Because all Tier 1 capital cannot be easily used to absorb losses, investors are looking beyond that measure to tangible common equity. Now it appears that regulators are doing the same.
As shown on the table below, the change shouldn't pose a problem for many of the nation's large regional banks, many of them with tangible-capital ratios exceeding 5%.
Among the largest banks, JPMorgan Chase (JPM) is nearly at the 4% threshold, with a tangible-capital ratio of 3.8%. JPMorgan could easily hit the 4% mark by building capital over time. It took a step in that direction last week, announcing plans to cut its dividend 87%. This should add $5 billion to Morgan's tangible capital this year, pushing it to the 4% mark.
The new emphasis on tangible capital is a thornier issue for Bank of America (BAC), with a 2.6% tangible-capital ratio, and Wells Fargo (WFC), with a 2.8% ratio. Like Citi, they could meet a 4% minimum by having the government or private investors convert some preferred shares to common. The problem is that such a conversion would leave current holders of common stock owning less of Bank of America and Wells Fargo.
Table: A Capital DebateFears of this dilution pushed Bank of America stock down 25% Friday to 3.95, while Wells shares fell 16% to 12.10.
Executives at both BofA and Wells have said they don't see the need to raise capital right now, and there may be merit to that view. They could argue that their assets have already been marked down in value more than the assets of other banks, in part because Bank of America recently acquired Merrill Lynch and Wells acquired Wachovia. Indeed, Merrill Lynch marked its assets down substantially before selling itself to Bank America, while Wells took large write-downs of Wachovia's assets while completing the acquisition.
What does all this mean for investors? For the brave and the bold, it could mean opportunity. Given many false dawns for bank stocks in the past year, it is hazardous to call a bottom. But there is a case to be made that last week's rally in bank stocks could continue. Most banks look inexpensive, based on the ratio of their stock prices to tangible book value, a conservative measure of shareholder equity that excludes goodwill from acquisitions. A sizable slice of the industry is trading below tangible book value for the first time since 1990, including Bank of America, Capital One (COF), KeyCorp (KEY), SunTrust Banks (STI) and Comerica (CMA).
No question, bank profits will be depressed this year, and perhaps into 2010, with many institutions showing losses in 2009, as banks set aside reserves for growing loan losses. Some investment pros are steering clear of the group in favor of other depressed financial outfits, including asset managers and insurers.
Dividends, once hefty throughout the banking sector, are likely to be trimmed, as even relatively strong institutions reduce payouts to bolster capital. Analysts say dividend cuts are possible at Wells Fargo, U.S. Bancorp (USB) and PNC Financial (PNC). Oddly enough, JPMorgan's dividend cut didn't hurt its stock. Investors have become less focused on dividends than financial strength, particularly tangible book value. Anything that enhances book, including a payout cut, has come to be seen as a plus.
Four banks -- Bank of America, Citigroup, JPMorgan and Wells Fargo -- now dominate the industry, with combined assets of $7 trillion. No. 5 PNC has less than a quarter of the assets of No. 4 Wells Fargo. Bernstein analyst John McDonald's favorite megabank is JPMorgan, because it has a very "attractive risk-reward" ratio. It is trading at 23, just above its tangible book of $22. McDonald thinks JPMorgan's profit in 2011, the year that many analysts have targeted for a full-fledged economic recovery, could top $4 a share. His one-year price target is $38.
Among JPMorgan's most valuable assets is Jamie Dimon, arguably the best chief executive at any big financial company. Such praise, however, might be going to Dimon's head. In announcing the dividend cut Monday, he lauded his bank's "fortress balance sheet." Yet JPMorgan is still leveraged more than 25-to-1, based on its tangible equity. At a true fortress like Warren Buffett's Berkshire Hathaway (BRK-A), the leverage is just 3-to-1.
McDonald's colleague at Bernstein, Kevin St. Pierre, favors Comerica and U.S. Bancorp among the regionals. Comerica is now headquartered in Dallas and has significant exposure to depressed Michigan, but it also has one of the industry's highest capital ratios, based on common equity. U.S. Bancorp historically has had some of the sector's highest returns and should be in the black this year, too.
Investors didn't react well to Citigroup's announcement Friday that the government would convert up to $25 billion of its current preferred-stock investment under the Troubled Asset Relief Program into Citi common shares, giving Uncle Sam a 36% stake in the beleaguered bank. That action, combined with Citi's offer Friday to exchange some $27.5 billion of private and publicly held preferred into common shares, sent Citi shares down 96 cents, or 39%, to $1.50 on enormous volume: nearly two billion shares.
Investors are worried about several issues, including dilution, corporate governance and future business mix. If all the preferred is converted into common, Citi's share count will balloon to 22 billion from about 5.5 billion, massively diluting the positions of existing common holders, who will own just 26% of Citi shares.
The bull case on Citi now is that it has dealt with its capital shortfall and that the stock is appealing, trading well below the likely new tangible book value of $3.70 a share. "Investors are asking: 'Is Citi investable?' " says Bernstein's McDonald.
One concern among investors is that more than half of Citi's prospective common equity of $81 billion will consist of a deferred tax asset of $44 billion, which would protect some future earnings from taxes. The worry is that a wounded Citi may not be able to earn enough to use that shield.
Citi's $15 billion of preferred shares rallied on the news, although they are trading way below their face value. The company's Series P preferred finished Friday at $8.05, up $2.57 on the session, but still a fraction of the face value of $25.
Citi's preferred exchange offer created considerable confusion among investors because important details weren't released Friday. Citi is offering to swap common shares for preferred stock held by the public, but the precise exchange ratio probably won't be known until this week. Citi's publicly held preferred could rally if the terms are as generous as those accepted by the government and private investors, who are converting into common at about 45 cents on the dollar. In contrast, the publicly held preferred, trading at $8, is now valued at just 33 cents on the dollar.
Preferred holders probably should convert because Citi will stop paying dividends on unconverted preferred. Citi will continue to pay dividends on some $23 billion of outstanding trust preferreds.
If Citi's public preferred holders fare worse than the government, expect investor complaints. Congressional critics of TARP, too, could be upset at the Treasury's initial 55% loss on the conversion.
The Citi deal has everyone on Wall Street suddenly talking about a measure of financial strength called tangible capital, which is a bank's tangible common equity divided by its tangible assets. Citi (ticker: C) ranks as one of the worst institutions by this measure, with a tangible-capital ratio of 1.5%. Now that Citi has announced that the government and private investors will have the opportunity to convert their preferred shares into common shares, Citi's tangible capital ratio looks likely to jump to 4%. Many analysts and investors think 4% will emerge as the government's targeted minimum.
Prior to the Citi deal, regulators had focused on Tier 1 capital, which includes preferred stock and has been criticized for overstating banks' financial strength.
John Kuczala for Barron's
Troweling on the dollars alone won't put a lasting patch on the broken banking system.
Citi's Tier 1 capital appears healthy at 11.9%, double the regulatory minimum despite the bank's major problems. Because all Tier 1 capital cannot be easily used to absorb losses, investors are looking beyond that measure to tangible common equity. Now it appears that regulators are doing the same.
As shown on the table below, the change shouldn't pose a problem for many of the nation's large regional banks, many of them with tangible-capital ratios exceeding 5%.
Among the largest banks, JPMorgan Chase (JPM) is nearly at the 4% threshold, with a tangible-capital ratio of 3.8%. JPMorgan could easily hit the 4% mark by building capital over time. It took a step in that direction last week, announcing plans to cut its dividend 87%. This should add $5 billion to Morgan's tangible capital this year, pushing it to the 4% mark.
The new emphasis on tangible capital is a thornier issue for Bank of America (BAC), with a 2.6% tangible-capital ratio, and Wells Fargo (WFC), with a 2.8% ratio. Like Citi, they could meet a 4% minimum by having the government or private investors convert some preferred shares to common. The problem is that such a conversion would leave current holders of common stock owning less of Bank of America and Wells Fargo.
Table: A Capital DebateFears of this dilution pushed Bank of America stock down 25% Friday to 3.95, while Wells shares fell 16% to 12.10.
Executives at both BofA and Wells have said they don't see the need to raise capital right now, and there may be merit to that view. They could argue that their assets have already been marked down in value more than the assets of other banks, in part because Bank of America recently acquired Merrill Lynch and Wells acquired Wachovia. Indeed, Merrill Lynch marked its assets down substantially before selling itself to Bank America, while Wells took large write-downs of Wachovia's assets while completing the acquisition.
What does all this mean for investors? For the brave and the bold, it could mean opportunity. Given many false dawns for bank stocks in the past year, it is hazardous to call a bottom. But there is a case to be made that last week's rally in bank stocks could continue. Most banks look inexpensive, based on the ratio of their stock prices to tangible book value, a conservative measure of shareholder equity that excludes goodwill from acquisitions. A sizable slice of the industry is trading below tangible book value for the first time since 1990, including Bank of America, Capital One (COF), KeyCorp (KEY), SunTrust Banks (STI) and Comerica (CMA).
No question, bank profits will be depressed this year, and perhaps into 2010, with many institutions showing losses in 2009, as banks set aside reserves for growing loan losses. Some investment pros are steering clear of the group in favor of other depressed financial outfits, including asset managers and insurers.
Dividends, once hefty throughout the banking sector, are likely to be trimmed, as even relatively strong institutions reduce payouts to bolster capital. Analysts say dividend cuts are possible at Wells Fargo, U.S. Bancorp (USB) and PNC Financial (PNC). Oddly enough, JPMorgan's dividend cut didn't hurt its stock. Investors have become less focused on dividends than financial strength, particularly tangible book value. Anything that enhances book, including a payout cut, has come to be seen as a plus.
Four banks -- Bank of America, Citigroup, JPMorgan and Wells Fargo -- now dominate the industry, with combined assets of $7 trillion. No. 5 PNC has less than a quarter of the assets of No. 4 Wells Fargo. Bernstein analyst John McDonald's favorite megabank is JPMorgan, because it has a very "attractive risk-reward" ratio. It is trading at 23, just above its tangible book of $22. McDonald thinks JPMorgan's profit in 2011, the year that many analysts have targeted for a full-fledged economic recovery, could top $4 a share. His one-year price target is $38.
Among JPMorgan's most valuable assets is Jamie Dimon, arguably the best chief executive at any big financial company. Such praise, however, might be going to Dimon's head. In announcing the dividend cut Monday, he lauded his bank's "fortress balance sheet." Yet JPMorgan is still leveraged more than 25-to-1, based on its tangible equity. At a true fortress like Warren Buffett's Berkshire Hathaway (BRK-A), the leverage is just 3-to-1.
McDonald's colleague at Bernstein, Kevin St. Pierre, favors Comerica and U.S. Bancorp among the regionals. Comerica is now headquartered in Dallas and has significant exposure to depressed Michigan, but it also has one of the industry's highest capital ratios, based on common equity. U.S. Bancorp historically has had some of the sector's highest returns and should be in the black this year, too.
Investors didn't react well to Citigroup's announcement Friday that the government would convert up to $25 billion of its current preferred-stock investment under the Troubled Asset Relief Program into Citi common shares, giving Uncle Sam a 36% stake in the beleaguered bank. That action, combined with Citi's offer Friday to exchange some $27.5 billion of private and publicly held preferred into common shares, sent Citi shares down 96 cents, or 39%, to $1.50 on enormous volume: nearly two billion shares.
Investors are worried about several issues, including dilution, corporate governance and future business mix. If all the preferred is converted into common, Citi's share count will balloon to 22 billion from about 5.5 billion, massively diluting the positions of existing common holders, who will own just 26% of Citi shares.
The bull case on Citi now is that it has dealt with its capital shortfall and that the stock is appealing, trading well below the likely new tangible book value of $3.70 a share. "Investors are asking: 'Is Citi investable?' " says Bernstein's McDonald.
One concern among investors is that more than half of Citi's prospective common equity of $81 billion will consist of a deferred tax asset of $44 billion, which would protect some future earnings from taxes. The worry is that a wounded Citi may not be able to earn enough to use that shield.
Citi's $15 billion of preferred shares rallied on the news, although they are trading way below their face value. The company's Series P preferred finished Friday at $8.05, up $2.57 on the session, but still a fraction of the face value of $25.
Citi's preferred exchange offer created considerable confusion among investors because important details weren't released Friday. Citi is offering to swap common shares for preferred stock held by the public, but the precise exchange ratio probably won't be known until this week. Citi's publicly held preferred could rally if the terms are as generous as those accepted by the government and private investors, who are converting into common at about 45 cents on the dollar. In contrast, the publicly held preferred, trading at $8, is now valued at just 33 cents on the dollar.
Preferred holders probably should convert because Citi will stop paying dividends on unconverted preferred. Citi will continue to pay dividends on some $23 billion of outstanding trust preferreds.
If Citi's public preferred holders fare worse than the government, expect investor complaints. Congressional critics of TARP, too, could be upset at the Treasury's initial 55% loss on the conversion.
Friday, February 27, 2009
Stanford: The First Arrest is Made
It's most frustrating being on a plane at JFK and reading the complaint against Laura Pendergest-Holt, knowing that you won't be able to blog it for another eight hours or so. It's a curious thing: basically she's been arrested on obstruction of justice charges because she wasn't completely forthright when she testified in early February, at the time that the Stanford story was breaking all over the press. But she was clearly set up as the patsy: because Allen Stanford himself, along with his CFO James Davis, refused to testify at all, they can't be arrested on similar charges.
On the other hand, there was some really big stuff that Pendergest-Holt knew and didn't say to investigators, not least that $1.6 billion of Stanford International Bank's "assets" consisted of a loan to Allen Stanford himself. And that the $541 million "capital contribution" that Sir Allen made to the bank in December was made up largely of real-estate holdings which the bank already owned, having bought them for $88 million earlier in the year.
Meanwhile, the FT has dug up an NASD arbitration proceeding from 2003 in which a former Stanford employee, Leyla Basagoitia, accused Stanford of running a Ponzi scheme. The NASD -- which later became Finra -- wasn't buying it:
Ms Basagoitia's allegations were denied by Stanford Group Company and dismissed by the dispute resolution panel. She was ordered to pay Stanford $107,782 in damages, in repayment of a loan advanced to her while an employee of the company.
Michael Falick, the lawyer who acted for Ms Basagoitia, said his client contacted the SEC about the alleged fraud in tandem with her NASD complaint. Mr Falick said: "It was really troubling, because the NASD was meant to be a regulatory body."
Note that this was an NASD proceeding, not an SEC proceeding (although Basagoitia did inform the SEC as well as the NASD of her suspicions). So Blodget's off base here:
Mary Schapiro wasn't running the SEC when it muffed this latest scam, so she can blame it on her predecessor.
Not true! The vice-chairman of the NASD at the time that Basagoitia made her allegations was one Mary Schapiro. And true to the NASD's nature, the arbitration panel reflexively sided with the company rather than the employee.
And elsewhere on the Stanford-victims front, I just got an email from a Stanford employee:
Employees in all U.S. offices were told by the Receiver that "Payroll would be met and benefits were still in effect" as part of their initial communication to employees (in person) as they closed offices. Funds for payroll are reportedly in Stanford's Treasury department, employees were called in to process payroll, but the Receiver has not approved the transfer of funds to meet this payroll obligation. Funds should have been transferred into employee bank accounts at midnight tonight, and paper checks mailed tomorrow.
Stanford employees were told they were not terminated last week, that in fact "it was business as usual" per the Receiver's email to global Stanford employees. "Consider it a paid vacation," a Stanford employee was told in Memphis, Tennessee. This means employees were not able to begin the process to file for unemployment or make other arrangements with creditors that their income had been suspended.
In fact, many employees were called in to assist the Receiver in many departments. All employees have been working under the assumption that the Receiver would honor the commitment made to meet payroll. Were these employees called back under false pretenses? Funds are in-house to pay employees per Receiver's promise - Receiver now apologizes for the hardship. Why is Receiver now denying to release the monies? Arethe lawyers and other "outside experts" hired by the Receiver being paid with funds promised to meet payroll?
While criminal charges against Allen Stanford or Jim Davis have not been filed, most employees feel that a crime has been committed against them by the Receiver.
Said employees almost certainly include former Fed governor Lyle Gramley. Has anybody got around to asking him anything about his employer yet?
On the other hand, there was some really big stuff that Pendergest-Holt knew and didn't say to investigators, not least that $1.6 billion of Stanford International Bank's "assets" consisted of a loan to Allen Stanford himself. And that the $541 million "capital contribution" that Sir Allen made to the bank in December was made up largely of real-estate holdings which the bank already owned, having bought them for $88 million earlier in the year.
Meanwhile, the FT has dug up an NASD arbitration proceeding from 2003 in which a former Stanford employee, Leyla Basagoitia, accused Stanford of running a Ponzi scheme. The NASD -- which later became Finra -- wasn't buying it:
Ms Basagoitia's allegations were denied by Stanford Group Company and dismissed by the dispute resolution panel. She was ordered to pay Stanford $107,782 in damages, in repayment of a loan advanced to her while an employee of the company.
Michael Falick, the lawyer who acted for Ms Basagoitia, said his client contacted the SEC about the alleged fraud in tandem with her NASD complaint. Mr Falick said: "It was really troubling, because the NASD was meant to be a regulatory body."
Note that this was an NASD proceeding, not an SEC proceeding (although Basagoitia did inform the SEC as well as the NASD of her suspicions). So Blodget's off base here:
Mary Schapiro wasn't running the SEC when it muffed this latest scam, so she can blame it on her predecessor.
Not true! The vice-chairman of the NASD at the time that Basagoitia made her allegations was one Mary Schapiro. And true to the NASD's nature, the arbitration panel reflexively sided with the company rather than the employee.
And elsewhere on the Stanford-victims front, I just got an email from a Stanford employee:
Employees in all U.S. offices were told by the Receiver that "Payroll would be met and benefits were still in effect" as part of their initial communication to employees (in person) as they closed offices. Funds for payroll are reportedly in Stanford's Treasury department, employees were called in to process payroll, but the Receiver has not approved the transfer of funds to meet this payroll obligation. Funds should have been transferred into employee bank accounts at midnight tonight, and paper checks mailed tomorrow.
Stanford employees were told they were not terminated last week, that in fact "it was business as usual" per the Receiver's email to global Stanford employees. "Consider it a paid vacation," a Stanford employee was told in Memphis, Tennessee. This means employees were not able to begin the process to file for unemployment or make other arrangements with creditors that their income had been suspended.
In fact, many employees were called in to assist the Receiver in many departments. All employees have been working under the assumption that the Receiver would honor the commitment made to meet payroll. Were these employees called back under false pretenses? Funds are in-house to pay employees per Receiver's promise - Receiver now apologizes for the hardship. Why is Receiver now denying to release the monies? Arethe lawyers and other "outside experts" hired by the Receiver being paid with funds promised to meet payroll?
While criminal charges against Allen Stanford or Jim Davis have not been filed, most employees feel that a crime has been committed against them by the Receiver.
Said employees almost certainly include former Fed governor Lyle Gramley. Has anybody got around to asking him anything about his employer yet?
Thursday, February 26, 2009
Jeremy Grantham Invests Cautiously These Days
Meanwhile, GMO chairman Jeremy Grantham is more upbeat — though he does expect more pain to precede any recovery.
Looking back at historic bear markets, Grantham draws comparisons to 1974 and 1982, when the S&P 500 lost roughly half its value. Since he estimates the current S&P 500 fair value at 900, Grantham puts his worst-case bottom at a hair-raising 450.
“That’s fairly scary, but on the one hand we look at the massive stimulus, and then on the other we try to work out the fact that the global economy is in worse shape than it was in ‘74 or ‘82,” says Grantham. “I’d say there are three-to-one odds that we go to a material new low. We should count on [the S&P 500] hitting 600 for a little while, and we should hope like mad it doesn’t get deep into the 500s.”
Patience rules. Another looming threat is that the market may enter an extended period of drops and rebounds that flatten long-term returns and strand buy-and-hold investors for decades.
Japan’s stalled stock market is one recent example, but the U.S. has had its shares of quagmires, too. Grantham likes to point out that investors who bought at market crests in 1929 and 1965 had to wait 19 years each time just to break even.
Still, Grantham says buy-and-hold still makes sense for long-term investors when stocks are trading below fair value. He especially favors U.S. blue chips, and his fund is on a strict, slow schedule to invest as valuations dip even lower.
“If you don’t have a schedule for investing, you will not do it,” he says. “When the market goes down, it reinforces the hoarding of cash. By the bottom, you suffer what we called in 1974 terminal paralysis — you cannot pull the trigger. Almost everyone who avoids the great pain is very slow to get back.”
Looking back at historic bear markets, Grantham draws comparisons to 1974 and 1982, when the S&P 500 lost roughly half its value. Since he estimates the current S&P 500 fair value at 900, Grantham puts his worst-case bottom at a hair-raising 450.
“That’s fairly scary, but on the one hand we look at the massive stimulus, and then on the other we try to work out the fact that the global economy is in worse shape than it was in ‘74 or ‘82,” says Grantham. “I’d say there are three-to-one odds that we go to a material new low. We should count on [the S&P 500] hitting 600 for a little while, and we should hope like mad it doesn’t get deep into the 500s.”
Patience rules. Another looming threat is that the market may enter an extended period of drops and rebounds that flatten long-term returns and strand buy-and-hold investors for decades.
Japan’s stalled stock market is one recent example, but the U.S. has had its shares of quagmires, too. Grantham likes to point out that investors who bought at market crests in 1929 and 1965 had to wait 19 years each time just to break even.
Still, Grantham says buy-and-hold still makes sense for long-term investors when stocks are trading below fair value. He especially favors U.S. blue chips, and his fund is on a strict, slow schedule to invest as valuations dip even lower.
“If you don’t have a schedule for investing, you will not do it,” he says. “When the market goes down, it reinforces the hoarding of cash. By the bottom, you suffer what we called in 1974 terminal paralysis — you cannot pull the trigger. Almost everyone who avoids the great pain is very slow to get back.”
Wednesday, February 25, 2009
Major phases of a bear market
Historically, major bear markets have also followed distinct patterns.
1. First phase
There is a sharp initial fall that removes much of the 'froth' from the market.
2. Middle phase
There is a strong rally in prices for several months, which may lull some investors into thinking that the bear market is over. The rallies can be dramatic, but have lower trading volume than the initial sell-offs. And the advances tend to be concentrated on a few selected stocks, not the whole market.
3. Third phase
There is a long slow downward grind in prices, accompanied by low volume and periodic false dawns until the bear phase ends quietly as share valuations reach rock bottom. At this point, few investors from the earlier buoyant phase in the market are interested in anything other than the most conservative investments.
1. First phase
There is a sharp initial fall that removes much of the 'froth' from the market.
2. Middle phase
There is a strong rally in prices for several months, which may lull some investors into thinking that the bear market is over. The rallies can be dramatic, but have lower trading volume than the initial sell-offs. And the advances tend to be concentrated on a few selected stocks, not the whole market.
3. Third phase
There is a long slow downward grind in prices, accompanied by low volume and periodic false dawns until the bear phase ends quietly as share valuations reach rock bottom. At this point, few investors from the earlier buoyant phase in the market are interested in anything other than the most conservative investments.
Tuesday, February 24, 2009
Worst on Records
Economists were expecting today's report on Consumer Confidence for February to come in at 35, which would have been the lowest level on record. The actual number, however, came in much lower at a level of 25. Not only is this the lowest reading on record, but it is also the fifth worst report versus expectations since at least 1999. In the chart below, we highlight the monthly readings of the Consumer Confidence report going back to 1967 (recessions highlighted in gray).
Friday, February 20, 2009
Paul Krugman
Nobel Laureate Paul Krugman made a stop at Wharton this week to give his assessment of the economy and the stimulus. He gave his standard message: Government spending is the only way out, but the current stimulus is too small.
What caught our eye was his prediction for how the economy would eventually recover:
Eventually, even with inadequate policy measures, there will likely be a spontaneous recovery. Goods "wear out, rust away," and people will someday want to buy new technologies that will be clearly superior to what they have now. "Look at auto sales," Krugman said. "At current buying rates it would take 23.9 years to replace the current stock." Obviously it's not going to take that long, he added. Buying rates will eventually pick up.
So wait, the economy will recover when our capital stock wears out and rusts away? This sounds suspiciously like our old friend the "broken-window fallacy" the silly idea that a broken store window is good for the economy because the shopkeeper has to replace it, helping everyone in the window and glass industries.
Nobody seriously believes that's true, though you sometimes hear that logic trotted out when there's a hurricane or tornado, and someone talks about all the jobs the rebuilding will create.
Under Krugman's logic, perhaps we should sabotage our equipment so that the wearing-out could happen a little faster, bringing about our recovery.
What caught our eye was his prediction for how the economy would eventually recover:
Eventually, even with inadequate policy measures, there will likely be a spontaneous recovery. Goods "wear out, rust away," and people will someday want to buy new technologies that will be clearly superior to what they have now. "Look at auto sales," Krugman said. "At current buying rates it would take 23.9 years to replace the current stock." Obviously it's not going to take that long, he added. Buying rates will eventually pick up.
So wait, the economy will recover when our capital stock wears out and rusts away? This sounds suspiciously like our old friend the "broken-window fallacy" the silly idea that a broken store window is good for the economy because the shopkeeper has to replace it, helping everyone in the window and glass industries.
Nobody seriously believes that's true, though you sometimes hear that logic trotted out when there's a hurricane or tornado, and someone talks about all the jobs the rebuilding will create.
Under Krugman's logic, perhaps we should sabotage our equipment so that the wearing-out could happen a little faster, bringing about our recovery.
Tuesday, February 17, 2009
Friday, February 13, 2009
Stimulus Package Explained
If you spend that money at Wal-Mart, all the money will go to China.
If you spend it on gasoline it will go to Hugo Chavez, the Arabs and Al Queda
If you purchase a computer it will go to Taiwan.
If you purchase fruit and vegetables it will go to Mexico, Honduras, and Guatemala (unless you buy organic).
If you buy a car it will go to Japan and Korea.
If you purchase prescription drugs it will go to India
If you purchase heroin it will go to the Taliban in Afghanistan
If you give it to a charitable cause, it will go to Nigeria
If you spend it on gasoline it will go to Hugo Chavez, the Arabs and Al Queda
If you purchase a computer it will go to Taiwan.
If you purchase fruit and vegetables it will go to Mexico, Honduras, and Guatemala (unless you buy organic).
If you buy a car it will go to Japan and Korea.
If you purchase prescription drugs it will go to India
If you purchase heroin it will go to the Taliban in Afghanistan
If you give it to a charitable cause, it will go to Nigeria
Tuesday, February 10, 2009
Marc Faber Sees High Inflation, Banana Republic In Store For U.S.
The US risks being hit by Zimbabwe-style hyperinflation and there are signs that the world’s biggest economy risks turning into a banana republic, Marc Faber, author of the Gloom, Doom & Boom report, told CNBC’s “Asia Squawk Box.”
“In the US, we have a totally new school, and it’s called the Zimbabwe school,” Faber said. “And it’s founded by one of the great leaders of this world, Mr Robert Mugabe, that has managed to totally impoverish his own country. And that is the monetary policy the US is pursuing.”
The government’s increased intervention in the economy is likely to slow down economic growth because history shows that every time the private sector shrinks to make way for the government sector, the economy suffers, he said.
Asked whether the US risked being faced with 200 percent inflation, Faber answered: “Well, not yet. Not yet. But I think eventually. If I look at government debt in the US, and debt in general, I think the only way they will not default physically on their debt is to inflate.”
Dr. Faber, who is often called “Dr. Doom” by the media, believes that the United States is on the path to becoming a “banana republic.” From the CNBC piece:
The Federal Reserve’s policy of printing money and the government’s intervention in the economy might undermine the US’s economic and political clout, Faber warned.
“Well, I wrote two years ago a report entitled ‘Is America becoming a banana republic?’ And there are some features that characterize banana republics-totalitarian states, very strong government intervention into the economy, and the polarization of wealth,” he said.
“And we have all these trends occurring in the US. We are not yet there. And in theory it could be reversed, but I doubt it will be,” Faber added.
“In the US, we have a totally new school, and it’s called the Zimbabwe school,” Faber said. “And it’s founded by one of the great leaders of this world, Mr Robert Mugabe, that has managed to totally impoverish his own country. And that is the monetary policy the US is pursuing.”
The government’s increased intervention in the economy is likely to slow down economic growth because history shows that every time the private sector shrinks to make way for the government sector, the economy suffers, he said.
Asked whether the US risked being faced with 200 percent inflation, Faber answered: “Well, not yet. Not yet. But I think eventually. If I look at government debt in the US, and debt in general, I think the only way they will not default physically on their debt is to inflate.”
Dr. Faber, who is often called “Dr. Doom” by the media, believes that the United States is on the path to becoming a “banana republic.” From the CNBC piece:
The Federal Reserve’s policy of printing money and the government’s intervention in the economy might undermine the US’s economic and political clout, Faber warned.
“Well, I wrote two years ago a report entitled ‘Is America becoming a banana republic?’ And there are some features that characterize banana republics-totalitarian states, very strong government intervention into the economy, and the polarization of wealth,” he said.
“And we have all these trends occurring in the US. We are not yet there. And in theory it could be reversed, but I doubt it will be,” Faber added.
Monday, February 9, 2009
Recover may come sooner than you want
Paul Kasriel, the great Northern Trust economist who saw much of this mess coming, uses history to explain why recovery may now come sooner than most people think.
Specifically, Paul debunks the idea that the Great Depression was a decade-long disaster: It was actually two recessions--one long bad one, and one short shallow one--separated by a robust four-year recovery. He also points out the numerous, huge mistakes made by policy-makers and observes that we aren't likely to make any of them again.
Paul concludes:
I believe that large increases in federal government spending that are monetized by the Fed and the banking system will result in a recovery in real economic activity. When that recovery sets in depends on how quickly the federal government increases its spending and by the magnitude of that increase. We can debate whether tax rates should be cut or federal spending should be increased. We can debate what kinds of spending should be increased. We can debate whether the federal government should increase any of its spending. But the facts of the 1930s appear to be pretty clear – monetized increased federal government spending does result in increased real economic activity in the short run.
The economic data are likely to be abysmal through the first half of this year. The popular
media will reinforce the gloom of the data. The same pundits who did not see this downturn
coming will not see the recovery coming either. My advice to you is to keep your eye on the
index of Leading Economic Indicators. If history is any guide, the LEI will signal a recovery
well ahead of the pundits.
Specifically, Paul debunks the idea that the Great Depression was a decade-long disaster: It was actually two recessions--one long bad one, and one short shallow one--separated by a robust four-year recovery. He also points out the numerous, huge mistakes made by policy-makers and observes that we aren't likely to make any of them again.
Paul concludes:
I believe that large increases in federal government spending that are monetized by the Fed and the banking system will result in a recovery in real economic activity. When that recovery sets in depends on how quickly the federal government increases its spending and by the magnitude of that increase. We can debate whether tax rates should be cut or federal spending should be increased. We can debate what kinds of spending should be increased. We can debate whether the federal government should increase any of its spending. But the facts of the 1930s appear to be pretty clear – monetized increased federal government spending does result in increased real economic activity in the short run.
The economic data are likely to be abysmal through the first half of this year. The popular
media will reinforce the gloom of the data. The same pundits who did not see this downturn
coming will not see the recovery coming either. My advice to you is to keep your eye on the
index of Leading Economic Indicators. If history is any guide, the LEI will signal a recovery
well ahead of the pundits.
Sunday, February 8, 2009
Recession? No, It's a D-process, and It Will Be Long
NOBODY WAS BETTER PREPARED FOR THE GLOBAL market crash than clients of Ray Dalio's Bridgewater Associates and subscribers to its Daily Observations. Dalio, the chief investment officer and all-around guiding light of the global money-management company he founded more than 30 years ago, began sounding alarms in Barron's in the spring of 2007 about the dangers of excessive financial leverage. He counts among his clients world governments and central banks, as well as pension funds and endowments.
Matthew Furman for Barron's
"The regulators have to decide how banks will operate. That means they are going to have to nationalize some in some form." -- Ray Dalio
No wonder. The Westport, Conn.-based firm, whose analyses of world markets focus on credit and currencies, has produced long-term annual returns, net of fees, averaging 15%. In the turmoil of 2008, Bridgewater's Pure Alpha 1 fund gained 8.7% net of fees and Pure Alpha 2 delivered 9.4%.
Here's what's on his mind now.
Barron's: I can't think of anyone who was earlier in describing the deleveraging and deflationary process that has been happening around the world.
Dalio: Let's call it a "D-process," which is different than a recession, and the only reason that people really don't understand this process is because it happens rarely. Everybody should, at this point, try to understand the depression process by reading about the Great Depression or the Latin American debt crisis or the Japanese experience so that it becomes part of their frame of reference. Most people didn't live through any of those experiences, and what they have gotten used to is the recession dynamic, and so they are quick to presume the recession dynamic. It is very clear to me that we are in a D-process.
Why are you hesitant to emphasize either the words depression or deflation? Why call it a D-process?
Both of those words have connotations associated with them that can confuse the fact that it is a process that people should try to understand.
You can describe a recession as an economic retraction which occurs when the Federal Reserve tightens monetary policy normally to fight inflation. The cycle continues until the economy weakens enough to bring down the inflation rate, at which time the Federal Reserve eases monetary policy and produces an expansion. We can make it more complicated, but that is a basic simple description of what recessions are and what we have experienced through the post-World War II period. What you also need is a comparable understanding of what a D-process is and why it is different.
You have made the point that only by understanding the process can you combat the problem. Are you confident that we are doing what's essential to combat deflation and a depression?
The D-process is a disease of sorts that is going to run its course.
When I first started seeing the D-process and describing it, it was before it actually started to play out this way. But now you can ask yourself, OK, when was the last time bank stocks went down so much? When was the last time the balance sheet of the Federal Reserve, or any central bank, exploded like it has? When was the last time interest rates went to zero, essentially, making monetary policy as we know it ineffective? When was the last time we had deflation?
The answers to those questions all point to times other than the U.S. post-World War II experience. This was the dynamic that occurred in Japan in the '90s, that occurred in Latin America in the '80s, and that occurred in the Great Depression in the '30s.
Basically what happens is that after a period of time, economies go through a long-term debt cycle -- a dynamic that is self-reinforcing, in which people finance their spending by borrowing and debts rise relative to incomes and, more accurately, debt-service payments rise relative to incomes. At cycle peaks, assets are bought on leverage at high-enough prices that the cash flows they produce aren't adequate to service the debt. The incomes aren't adequate to service the debt. Then begins the reversal process, and that becomes self-reinforcing, too. In the simplest sense, the country reaches the point when it needs a debt restructuring. General Motors is a metaphor for the United States.
As goes GM, so goes the nation?
The process of bankruptcy or restructuring is necessary to its viability. One way or another, General Motors has to be restructured so that it is a self-sustaining, economically viable entity that people want to lend to again.
This has happened in Latin America regularly. Emerging countries default, and then restructure. It is an essential process to get them economically healthy.
We will go through a giant debt-restructuring, because we either have to bring debt-service payments down so they are low relative to incomes -- the cash flows that are being produced to service them -- or we are going to have to raise incomes by printing a lot of money.
It isn't complicated. It is the same as all bankruptcies, but when it happens pervasively to a country, and the country has a lot of foreign debt denominated in its own currency, it is preferable to print money and devalue.
Isn't the process of restructuring under way in households and at corporations?
They are cutting costs to service the debt. But they haven't yet done much restructuring. Last year, 2008, was the year of price declines; 2009 and 2010 will be the years of bankruptcies and restructurings. Loans will be written down and assets will be sold. It will be a very difficult time. It is going to surprise a lot of people because many people figure it is bad but still expect, as in all past post-World War II periods, we will come out of it OK. A lot of difficult questions will be asked of policy makers. The government decision-making mechanism is going to be tested, because different people will have different points of view about what should be done.
What are you suggesting?
An example is the Federal Reserve, which has always been an autonomous institution with the freedom to act as it sees fit. Rep. Barney Frank [a Massachusetts Democrat and chairman of the House Financial Services Committee] is talking about examining the authority of the Federal Reserve, and that raises the specter of the government and Congress trying to run the Federal Reserve. Everybody will be second-guessing everybody else.
So where do things stand in the process of restructuring?
What the Federal Reserve has done and what the Treasury has done, by and large, is to take an existing debt and say they will own it or lend against it. But they haven't said they are going to write down the debt and cut debt payments each month. There has been little in the way of debt relief yet. Very, very few actual mortgages have been restructured. Very little corporate debt has been restructured.
The Federal Reserve, in particular, has done a number of successful things. The Federal Reserve went out and bought or lent against a lot of the debt. That has had the effect of reducing the risk of that debt defaulting, so that is good in a sense. And because the risk of default has gone down, it has forced the interest rate on the debt to go down, and that is good, too.
However, the reason it hasn't actually produced increased credit activity is because the debtors are still too indebted and not able to properly service the debt. Only when those debts are actually written down will we get to the point where we will have credit growth. There is a mortgage debt piece that will need to be restructured. There is a giant financial-sector piece -- banks and investment banks and whatever is left of the financial sector -- that will need to be restructured. There is a corporate piece that will need to be restructured, and then there is a commercial-real-estate piece that will need to be restructured.
Is a restructuring of the banks a starting point?
If you think that restructuring the banks is going to get lending going again and you don't restructure the other pieces -- the mortgage piece, the corporate piece, the real-estate piece -- you are wrong, because they need financially sound entities to lend to, and that won't happen until there are restructurings.
On the issue of the banks, ultimately we need banks because to produce credit we have to have banks. A lot of the banks aren't going to have money, and yet we can't just let them go to nothing; we have got to do something.
But the future of banking is going to be very, very different. The regulators have to decide how banks will operate. That means they will have to nationalize some in some form, but they are going to also have to decide who they protect: the bondholders or the depositors?
Nationalization is the most likely outcome?
There will be substantial nationalization of banks. It is going on now and it will continue. But the same question will be asked even after nationalization: What will happen to the pile of bad stuff?
Let's say we are going to end up with the good-bank/bad-bank concept. The government is going to put a lot of money in -- say $100 billion -- and going to get all the garbage at a leverage of, let's say, 10 to 1. They will have a trillion dollars, but a trillion dollars' worth of garbage. They still aren't marking it down. Does this give you comfort?
Then we have the remaining banks, many of which will be broke. The government will have to recapitalize them. The government will try to seek private money to go in with them, but I don't think they are going to come up with a lot of private money, not nearly the amount needed.
To the extent we are going to have nationalized banks, we will still have the question of how those banks behave. Does Congress say what they should do? Does Congress demand they lend to bad borrowers? There is a reason they aren't lending. So whose money is it, and who is protecting that money?
The biggest issue is that if you look at the borrowers, you don't want to lend to them. The basic problem is that the borrowers had too much debt when their incomes were higher and their asset values were higher. Now net worths have gone down.
Let me give you an example. Roughly speaking, most of commercial real estate and a good deal of private equity was bought on leverage of 3-to-1. Most of it is down by more than one-third, so therefore they have negative net worth. Most of them couldn't service their debt when the cash flows were up, and now the cash flows are a lot lower. If you shouldn't have lent to them before, how can you possibly lend to them now?
I guess I'm thinking of the examples of people and businesses with solid credit records who can't get banks to lend to them.
Those examples exist, but they aren't, by and large, the big picture. There are too many nonviable entities. Big pieces of the economy have to become somehow more viable. This isn't primarily about a lack of liquidity. There are certainly elements of that, but this is basically a structural issue. The '30s were very similar to this.
By the way, in the bear market from 1929 to the bottom, stocks declined 89%, with six rallies of returns of more than 20% -- and most of them produced renewed optimism. But what happened was that the economy continued to weaken with the debt problem. The Hoover administration had the equivalent of today's TARP [Troubled Asset Relief Program] in the Reconstruction Finance Corp. The stimulus program and tax cuts created more spending, and the budget deficit increased.
At the same time, countries around the world encountered a similar kind of thing. England went through then exactly what it is going through now. Just as now, countries couldn't get dollars because of the slowdown in exports, and there was a dollar shortage, as there is now. Efforts were directed at rekindling lending. But they did not rekindle lending. Eventually there were a lot of bankruptcies, which extinguished debt.
In the U.S., a Democratic administration replaced a Republican one and there was a major devaluation and reflation that marked the bottom of the Depression in March 1933.
Where is the U.S. and the rest of the world going to keep getting money to pay for these stimulus packages?
The Federal Reserve is going to have to print money. The deficits will be greater than the savings. So you will see the Federal Reserve buy long-term Treasury bonds, as it did in the Great Depression. We are in a position where that will eventually create a problem for currencies and drive assets to gold.
Are you a fan of gold?
Yes.
Have you always been?
No. Gold is horrible sometimes and great other times. But like any other asset class, everybody always should have a piece of it in their portfolio.
What about bonds? The conventional wisdom has it that bonds are the most overbought and most dangerous asset class right now.
Everything is timing. You print a lot of money, and then you have currency devaluation. The currency devaluation happens before bonds fall. Not much in the way of inflation is produced, because what you are doing actually is negating deflation. So, the first wave of currency depreciation will be very much like England in 1992, with its currency realignment, or the United States during the Great Depression, when they printed money and devalued the dollar a lot. Gold went up a whole lot and the bond market had a hiccup, and then long-term rates continued to decline because people still needed safety and liquidity. While the dollar is bad, it doesn't mean necessarily that the bond market is bad.
I can easily imagine at some point I'm going to hate bonds and want to be short bonds, but, for now, a portfolio that is a mixture of Treasury bonds and gold is going to be a very good portfolio, because I imagine gold could go up a whole lot and Treasury bonds won't go down a whole lot, at first.
Ideally, creditor countries that don't have dollar-debt problems are the place you want to be, like Japan. The Japanese economy will do horribly, too, but they don't have the problems that we have -- and they have surpluses. They can pull in their assets from abroad, which will support their currency, because they will want to become defensive. Other currencies will decline in relationship to the yen and in relationship to gold.
And China?
Now we have the delicate China question. That is a complicated, touchy question.
The reasons for China to hold dollar-denominated assets no longer exist, for the most part. However, the desire to have a weaker currency is everybody's desire in terms of stimulus. China recognizes that the exchange-rate peg is not as important as it was before, because the idea was to make its goods competitive in the world. Ultimately, they are going to have to go to a domestic-based economy. But they own too much in the way of dollar-denominated assets to get out, and it isn't clear exactly where they would go if they did get out. But they don't have to buy more. They are not going to continue to want to double down.
From the U.S. point of view, we want a devaluation. A devaluation gets your pricing in line. When there is a deflationary environment, you want your currency to go down. When you have a lot of foreign debt denominated in your currency, you want to create relief by having your currency go down. All major currency devaluations have triggered stock-market rallies throughout the world; one of the best ways to trigger a stock-market rally is to devalue your currency.
But there is a basic structural problem with China. Its per capita income is less than 10% of ours. We have to get our prices in line, and we are not going to do it by cutting our incomes to a level of Chinese incomes.
And they are not going to do it by having their per capita incomes coming in line with our per capita incomes. But they have to come closer together. The Chinese currency and assets are too cheap in dollar terms, so a devaluation of the dollar in relation to China's currency is likely, and will be an important step to our reflation and will make investments in China attractive.
You mentioned, too, that inflation is not as big a worry for you as it is for some. Could you elaborate?
A wave of currency devaluations and strong gold will serve to negate deflationary pressures, bringing inflation to a low, positive number rather than producing unacceptably high inflation -- and that will last for as far as I can see out, roughly about two years.
Given this outlook, what is your view on stocks?
Buying equities and taking on those risks in late 2009, or more likely 2010, will be a great move because equities will be much cheaper than now. It is going to be a buying opportunity of the century.
Thanks, Ray.
Matthew Furman for Barron's
"The regulators have to decide how banks will operate. That means they are going to have to nationalize some in some form." -- Ray Dalio
No wonder. The Westport, Conn.-based firm, whose analyses of world markets focus on credit and currencies, has produced long-term annual returns, net of fees, averaging 15%. In the turmoil of 2008, Bridgewater's Pure Alpha 1 fund gained 8.7% net of fees and Pure Alpha 2 delivered 9.4%.
Here's what's on his mind now.
Barron's: I can't think of anyone who was earlier in describing the deleveraging and deflationary process that has been happening around the world.
Dalio: Let's call it a "D-process," which is different than a recession, and the only reason that people really don't understand this process is because it happens rarely. Everybody should, at this point, try to understand the depression process by reading about the Great Depression or the Latin American debt crisis or the Japanese experience so that it becomes part of their frame of reference. Most people didn't live through any of those experiences, and what they have gotten used to is the recession dynamic, and so they are quick to presume the recession dynamic. It is very clear to me that we are in a D-process.
Why are you hesitant to emphasize either the words depression or deflation? Why call it a D-process?
Both of those words have connotations associated with them that can confuse the fact that it is a process that people should try to understand.
You can describe a recession as an economic retraction which occurs when the Federal Reserve tightens monetary policy normally to fight inflation. The cycle continues until the economy weakens enough to bring down the inflation rate, at which time the Federal Reserve eases monetary policy and produces an expansion. We can make it more complicated, but that is a basic simple description of what recessions are and what we have experienced through the post-World War II period. What you also need is a comparable understanding of what a D-process is and why it is different.
You have made the point that only by understanding the process can you combat the problem. Are you confident that we are doing what's essential to combat deflation and a depression?
The D-process is a disease of sorts that is going to run its course.
When I first started seeing the D-process and describing it, it was before it actually started to play out this way. But now you can ask yourself, OK, when was the last time bank stocks went down so much? When was the last time the balance sheet of the Federal Reserve, or any central bank, exploded like it has? When was the last time interest rates went to zero, essentially, making monetary policy as we know it ineffective? When was the last time we had deflation?
The answers to those questions all point to times other than the U.S. post-World War II experience. This was the dynamic that occurred in Japan in the '90s, that occurred in Latin America in the '80s, and that occurred in the Great Depression in the '30s.
Basically what happens is that after a period of time, economies go through a long-term debt cycle -- a dynamic that is self-reinforcing, in which people finance their spending by borrowing and debts rise relative to incomes and, more accurately, debt-service payments rise relative to incomes. At cycle peaks, assets are bought on leverage at high-enough prices that the cash flows they produce aren't adequate to service the debt. The incomes aren't adequate to service the debt. Then begins the reversal process, and that becomes self-reinforcing, too. In the simplest sense, the country reaches the point when it needs a debt restructuring. General Motors is a metaphor for the United States.
As goes GM, so goes the nation?
The process of bankruptcy or restructuring is necessary to its viability. One way or another, General Motors has to be restructured so that it is a self-sustaining, economically viable entity that people want to lend to again.
This has happened in Latin America regularly. Emerging countries default, and then restructure. It is an essential process to get them economically healthy.
We will go through a giant debt-restructuring, because we either have to bring debt-service payments down so they are low relative to incomes -- the cash flows that are being produced to service them -- or we are going to have to raise incomes by printing a lot of money.
It isn't complicated. It is the same as all bankruptcies, but when it happens pervasively to a country, and the country has a lot of foreign debt denominated in its own currency, it is preferable to print money and devalue.
Isn't the process of restructuring under way in households and at corporations?
They are cutting costs to service the debt. But they haven't yet done much restructuring. Last year, 2008, was the year of price declines; 2009 and 2010 will be the years of bankruptcies and restructurings. Loans will be written down and assets will be sold. It will be a very difficult time. It is going to surprise a lot of people because many people figure it is bad but still expect, as in all past post-World War II periods, we will come out of it OK. A lot of difficult questions will be asked of policy makers. The government decision-making mechanism is going to be tested, because different people will have different points of view about what should be done.
What are you suggesting?
An example is the Federal Reserve, which has always been an autonomous institution with the freedom to act as it sees fit. Rep. Barney Frank [a Massachusetts Democrat and chairman of the House Financial Services Committee] is talking about examining the authority of the Federal Reserve, and that raises the specter of the government and Congress trying to run the Federal Reserve. Everybody will be second-guessing everybody else.
So where do things stand in the process of restructuring?
What the Federal Reserve has done and what the Treasury has done, by and large, is to take an existing debt and say they will own it or lend against it. But they haven't said they are going to write down the debt and cut debt payments each month. There has been little in the way of debt relief yet. Very, very few actual mortgages have been restructured. Very little corporate debt has been restructured.
The Federal Reserve, in particular, has done a number of successful things. The Federal Reserve went out and bought or lent against a lot of the debt. That has had the effect of reducing the risk of that debt defaulting, so that is good in a sense. And because the risk of default has gone down, it has forced the interest rate on the debt to go down, and that is good, too.
However, the reason it hasn't actually produced increased credit activity is because the debtors are still too indebted and not able to properly service the debt. Only when those debts are actually written down will we get to the point where we will have credit growth. There is a mortgage debt piece that will need to be restructured. There is a giant financial-sector piece -- banks and investment banks and whatever is left of the financial sector -- that will need to be restructured. There is a corporate piece that will need to be restructured, and then there is a commercial-real-estate piece that will need to be restructured.
Is a restructuring of the banks a starting point?
If you think that restructuring the banks is going to get lending going again and you don't restructure the other pieces -- the mortgage piece, the corporate piece, the real-estate piece -- you are wrong, because they need financially sound entities to lend to, and that won't happen until there are restructurings.
On the issue of the banks, ultimately we need banks because to produce credit we have to have banks. A lot of the banks aren't going to have money, and yet we can't just let them go to nothing; we have got to do something.
But the future of banking is going to be very, very different. The regulators have to decide how banks will operate. That means they will have to nationalize some in some form, but they are going to also have to decide who they protect: the bondholders or the depositors?
Nationalization is the most likely outcome?
There will be substantial nationalization of banks. It is going on now and it will continue. But the same question will be asked even after nationalization: What will happen to the pile of bad stuff?
Let's say we are going to end up with the good-bank/bad-bank concept. The government is going to put a lot of money in -- say $100 billion -- and going to get all the garbage at a leverage of, let's say, 10 to 1. They will have a trillion dollars, but a trillion dollars' worth of garbage. They still aren't marking it down. Does this give you comfort?
Then we have the remaining banks, many of which will be broke. The government will have to recapitalize them. The government will try to seek private money to go in with them, but I don't think they are going to come up with a lot of private money, not nearly the amount needed.
To the extent we are going to have nationalized banks, we will still have the question of how those banks behave. Does Congress say what they should do? Does Congress demand they lend to bad borrowers? There is a reason they aren't lending. So whose money is it, and who is protecting that money?
The biggest issue is that if you look at the borrowers, you don't want to lend to them. The basic problem is that the borrowers had too much debt when their incomes were higher and their asset values were higher. Now net worths have gone down.
Let me give you an example. Roughly speaking, most of commercial real estate and a good deal of private equity was bought on leverage of 3-to-1. Most of it is down by more than one-third, so therefore they have negative net worth. Most of them couldn't service their debt when the cash flows were up, and now the cash flows are a lot lower. If you shouldn't have lent to them before, how can you possibly lend to them now?
I guess I'm thinking of the examples of people and businesses with solid credit records who can't get banks to lend to them.
Those examples exist, but they aren't, by and large, the big picture. There are too many nonviable entities. Big pieces of the economy have to become somehow more viable. This isn't primarily about a lack of liquidity. There are certainly elements of that, but this is basically a structural issue. The '30s were very similar to this.
By the way, in the bear market from 1929 to the bottom, stocks declined 89%, with six rallies of returns of more than 20% -- and most of them produced renewed optimism. But what happened was that the economy continued to weaken with the debt problem. The Hoover administration had the equivalent of today's TARP [Troubled Asset Relief Program] in the Reconstruction Finance Corp. The stimulus program and tax cuts created more spending, and the budget deficit increased.
At the same time, countries around the world encountered a similar kind of thing. England went through then exactly what it is going through now. Just as now, countries couldn't get dollars because of the slowdown in exports, and there was a dollar shortage, as there is now. Efforts were directed at rekindling lending. But they did not rekindle lending. Eventually there were a lot of bankruptcies, which extinguished debt.
In the U.S., a Democratic administration replaced a Republican one and there was a major devaluation and reflation that marked the bottom of the Depression in March 1933.
Where is the U.S. and the rest of the world going to keep getting money to pay for these stimulus packages?
The Federal Reserve is going to have to print money. The deficits will be greater than the savings. So you will see the Federal Reserve buy long-term Treasury bonds, as it did in the Great Depression. We are in a position where that will eventually create a problem for currencies and drive assets to gold.
Are you a fan of gold?
Yes.
Have you always been?
No. Gold is horrible sometimes and great other times. But like any other asset class, everybody always should have a piece of it in their portfolio.
What about bonds? The conventional wisdom has it that bonds are the most overbought and most dangerous asset class right now.
Everything is timing. You print a lot of money, and then you have currency devaluation. The currency devaluation happens before bonds fall. Not much in the way of inflation is produced, because what you are doing actually is negating deflation. So, the first wave of currency depreciation will be very much like England in 1992, with its currency realignment, or the United States during the Great Depression, when they printed money and devalued the dollar a lot. Gold went up a whole lot and the bond market had a hiccup, and then long-term rates continued to decline because people still needed safety and liquidity. While the dollar is bad, it doesn't mean necessarily that the bond market is bad.
I can easily imagine at some point I'm going to hate bonds and want to be short bonds, but, for now, a portfolio that is a mixture of Treasury bonds and gold is going to be a very good portfolio, because I imagine gold could go up a whole lot and Treasury bonds won't go down a whole lot, at first.
Ideally, creditor countries that don't have dollar-debt problems are the place you want to be, like Japan. The Japanese economy will do horribly, too, but they don't have the problems that we have -- and they have surpluses. They can pull in their assets from abroad, which will support their currency, because they will want to become defensive. Other currencies will decline in relationship to the yen and in relationship to gold.
And China?
Now we have the delicate China question. That is a complicated, touchy question.
The reasons for China to hold dollar-denominated assets no longer exist, for the most part. However, the desire to have a weaker currency is everybody's desire in terms of stimulus. China recognizes that the exchange-rate peg is not as important as it was before, because the idea was to make its goods competitive in the world. Ultimately, they are going to have to go to a domestic-based economy. But they own too much in the way of dollar-denominated assets to get out, and it isn't clear exactly where they would go if they did get out. But they don't have to buy more. They are not going to continue to want to double down.
From the U.S. point of view, we want a devaluation. A devaluation gets your pricing in line. When there is a deflationary environment, you want your currency to go down. When you have a lot of foreign debt denominated in your currency, you want to create relief by having your currency go down. All major currency devaluations have triggered stock-market rallies throughout the world; one of the best ways to trigger a stock-market rally is to devalue your currency.
But there is a basic structural problem with China. Its per capita income is less than 10% of ours. We have to get our prices in line, and we are not going to do it by cutting our incomes to a level of Chinese incomes.
And they are not going to do it by having their per capita incomes coming in line with our per capita incomes. But they have to come closer together. The Chinese currency and assets are too cheap in dollar terms, so a devaluation of the dollar in relation to China's currency is likely, and will be an important step to our reflation and will make investments in China attractive.
You mentioned, too, that inflation is not as big a worry for you as it is for some. Could you elaborate?
A wave of currency devaluations and strong gold will serve to negate deflationary pressures, bringing inflation to a low, positive number rather than producing unacceptably high inflation -- and that will last for as far as I can see out, roughly about two years.
Given this outlook, what is your view on stocks?
Buying equities and taking on those risks in late 2009, or more likely 2010, will be a great move because equities will be much cheaper than now. It is going to be a buying opportunity of the century.
Thanks, Ray.
Friday, February 6, 2009
Unemployment Comparison 74 vs. 08
1974 (Half of the work force)
November - 368K
December - 602K
January -360k
February -378k
March -270k
April -186k
May +160k
June -104k
2008
November - 533K
December - 589K
Stay tuned.
November - 368K
December - 602K
January -360k
February -378k
March -270k
April -186k
May +160k
June -104k
2008
November - 533K
December - 589K
Stay tuned.
Wednesday, February 4, 2009
Monday, February 2, 2009
Now Hiring, Lehman
It's bankrupt. Its reputation is in tatters. And it has been forced from its plush headquarters building. Yet working for Lehman Brothers Holdings Inc. -- what remains of it -- has become one of the hottest jobs on Wall Street.
That's because Lehman, though a shadow of its former self after selling many of its businesses to Barclays PLC and Nomura Holdings Inc., retains a broad patchwork of assets. It has some $7 billion in cash and more than 1,400 private investments valued at $12.3 billion. Then there's a thicket of about 500,000 derivative contracts with 4,000 trading partners worth some $24 billion.
Then & Now
Associated PressThen:
CEO: Richard Fuld (above)
Employees: 25,158
Cash on balance sheet: $3.3 billion
Alvarez & MarsalNow:
CEO: Bryan Marsal, (above)
Employees: 500
Cash on balance sheet: $7 billion
So for now, Lehman is seen as a relatively secure home for throngs of finance professionals thrown out of work in recent months. It's even become a place for former Lehman CEO Richard Fuld to informally hang his hat.
"We're getting swamped with résumés," says Bryan Marsal, a turnaround expert who is now Lehman's chief executive officer. The inquiries, he says, are from people affiliated with marquee names such as Bank of America, Citigroup Inc., and Morgan Stanley.
"It's just a tough, tough time, and there are a lot of good people out there looking for work."
The wages are not great by past standards. But there are hidden benefits. It could take two years or more to wind down the firm. Such a timeline promises the kind of job security that's a rarity on Wall Street today.
Charged with untangling the mess is Alvarez & Marsal, the New York-based restructuring firm where Mr. Marsal is a co-founder. With 150 full-time employees working on the case, its chief task is to sell off Lehman's remaining assets and maximize recovery for creditors, which are owed more than $150 billion.
Mr. Marsal says the goal is to dissolve the firm in 18 to 24 months from now, though several restructuring experts say that's an aggressive timetable.
Alvarez & Marsal got the gig in September after Lehman's board appointed it to administer the bankrupt company's estate. To carry out the mission, Alvarez & Marsal kept 130 Lehman employees on the firm's payroll. It has also recruited back more than 200 former Lehman employees, and is still hiring staff to handle targeted areas such derivatives and real-estate holdings.
Behind the scenes is Mr. Fuld, the firm's former chairman and chief executive, who was widely vilified when Lehman collapsed in mid-September. Though Mr. Fuld was removed from the payroll on Jan. 1 and relieved of his company-provided black Mercedes, Lehman has agreed to let him keep an office at the firm. He's just around the corner from Mr. Marsal, who says he picks Mr. Fuld's brain about Lehman's business several times a week.
"We asked him to stay if he has nowhere better to go," says Mr. Marsal. "He's been very good about making himself available for questions about Lehman assets."
Through a spokeswoman, Mr. Fuld declined to comment.
Lehman's dismantling is an expensive process. Associated costs run about $30 million a month, excluding fees to lawyers and advisers on the case. Employees are paid a salary -- with modest retention bonus added as "a kiss" says Mr. Marsal -- to entice workers to stay at a place with a limited lifespan.
Life Inside Lehman Brothers
3:25
WSJ's Dennis Berman and Peter Lattman discuss the latest at Lehman Brothers, where job stability has become surprisingly ubiquitous.
The assignment is a lucrative one for Alvarez & Marsal, which is charging Lehman hourly fees of $550 to $850 for its top executives working on the case, with rich incentive fees for the firm depending on its recovery for creditors.
Despite Lehman's assured dissolution, executive recruiters say it isn't surprising that the collapsed investment bank has become a desirable place to work.
"This is a well-paying job in one of the worst employment markets in history," says Skiddy von Stade, founder of New York-based executive placement firm F.S. von Stade & Associates. "Through the disposition of Lehman's assets, the employees will have a chance to demonstrate their strengths and skills for opportunities down the road -- possibly with the very buyers of these securities and investments."
Mr. Marsal says compensation is in line with similar jobs on Wall Street, yet far below what it was at Lehman. He and his team are "very, very careful" about the expenses of the firm, which he says are generally lean. "The excess of Lehman was the size of the salaries and the expectations of people with the bonus plan," he says.
View Full Image
Reuters
Staff members stand in a meeting room at the Lehman Brothers offices in the financial district of Canary Wharf in London Sept. 11, 2008.
Gone are the pay and perks that came with being a top executive at pre-bankruptcy Lehman. Mr. Fuld and his management team sat on the 31st floor of Lehman's former headquarters, a state-of-the-art steel-and-granite building in Times Square. Barclays bought that site and took it over, so now Lehman's command center is a run-of-the-mill office on the 45th floor of the Time-Life building, which long served as Lehman overflow space.
Mr. Marsal and his team are making due without weekly deliveries of fresh flowers and warm chocolate-chip muffins on Fridays -- perks enjoyed by the firm's former brass. Gone too is the executive dining suite where a private chef prepared lunch for Lehman's top executives. Instead, Mr. Marsal and his crew grab a bite in the cafeteria at Time Inc., which has granted access to the Lehman employees.
Henry Klein is part of Lehman's new topsy-turvy reality. A nine-year Lehman veteran, he oversaw a portfolio of investments in India from the firm's New York office. When Lehman failed, Mr. Klein was transferred to Barclays, but says he had little to do there. "I was at Barclays, but my assets were at Lehman."
Mr. Klein left Barclays in mid-November, and then approached Alvarez & Marsal. Today, he's back overseeing the very assets he says he managed at Lehman.
The 46-year-old Mr. Klein is currently focused on a small $36 million real-estate investment in Hyderabad, a large city in south central India. Lehman may continue to back the deal, but also may have to pull its funding. "It's a difficult decision," says Mr. Klein. "We don't have tons of time."
Luc Faucheux, 39, heads up the desk at the bankrupt entity that trades interest-rate swaps and other fixed-income derivatives. "I always wanted this job," laughs the former Lehman staffer who says he had a related, but less senior role. "Be careful what you wish for, because you might just get it."
"Let's face it," he adds. "Given the state of the world we're in, the things I'm learning working on the largest bankruptcy in history are a set of skills that could be marketable for the foreseeable future."
Rather than immediately sell assets into a depressed market, Alvarez & Marsal has opted to retain and manage a chunk of Lehman's holdings.
Last month, Alvarez & Marsal decided to keep a 49% interest in Lehman's money-management business, Neuberger Investment Management, selling the balance to Neuberger's management. It made a similar move with Lehman Brothers Merchant Banking, the firm's flagship private-equity business. The estate also has held on to more than 100 direct stakes in private companies. These include direct investments made alongside Lehman's private-equity clients in large boom-era buyouts such as First Data Corp. and Texas utility TXU Corp.
So far, Lehman has more than doubled its cash reserves to $7 billion from $3.3 billion, in part through the sale of its headquarters to Barclays. It is also raising money by selling off the firm's sizable art collection, whose value Lehman has pegged at roughly $30 million. Some of the photographs and paintings still grace the halls of Barclays and Lehman's Neuberger unit.
Finally, there is a cavalry of corporate jets valued at $164 million. Lehman has already sold six jets, as well as interests in fractional shares service NetJets Inc. for $53 million. Still on the block: Six more planes, including a Boeing 767, and a Sikorsky chopper.
Some of those jets Lehman owned as investments and only four were used for corporate purposes at any one time, according to a Lehman spokeswoman.
"The fleet's been grounded," Mr. Marsal reassured the bankruptcy judge overseeing the case at a hearing last month. "Nobody is flying around these planes and no one is using the helicopter.
That's because Lehman, though a shadow of its former self after selling many of its businesses to Barclays PLC and Nomura Holdings Inc., retains a broad patchwork of assets. It has some $7 billion in cash and more than 1,400 private investments valued at $12.3 billion. Then there's a thicket of about 500,000 derivative contracts with 4,000 trading partners worth some $24 billion.
Then & Now
Associated PressThen:
CEO: Richard Fuld (above)
Employees: 25,158
Cash on balance sheet: $3.3 billion
Alvarez & MarsalNow:
CEO: Bryan Marsal, (above)
Employees: 500
Cash on balance sheet: $7 billion
So for now, Lehman is seen as a relatively secure home for throngs of finance professionals thrown out of work in recent months. It's even become a place for former Lehman CEO Richard Fuld to informally hang his hat.
"We're getting swamped with résumés," says Bryan Marsal, a turnaround expert who is now Lehman's chief executive officer. The inquiries, he says, are from people affiliated with marquee names such as Bank of America, Citigroup Inc., and Morgan Stanley.
"It's just a tough, tough time, and there are a lot of good people out there looking for work."
The wages are not great by past standards. But there are hidden benefits. It could take two years or more to wind down the firm. Such a timeline promises the kind of job security that's a rarity on Wall Street today.
Charged with untangling the mess is Alvarez & Marsal, the New York-based restructuring firm where Mr. Marsal is a co-founder. With 150 full-time employees working on the case, its chief task is to sell off Lehman's remaining assets and maximize recovery for creditors, which are owed more than $150 billion.
Mr. Marsal says the goal is to dissolve the firm in 18 to 24 months from now, though several restructuring experts say that's an aggressive timetable.
Alvarez & Marsal got the gig in September after Lehman's board appointed it to administer the bankrupt company's estate. To carry out the mission, Alvarez & Marsal kept 130 Lehman employees on the firm's payroll. It has also recruited back more than 200 former Lehman employees, and is still hiring staff to handle targeted areas such derivatives and real-estate holdings.
Behind the scenes is Mr. Fuld, the firm's former chairman and chief executive, who was widely vilified when Lehman collapsed in mid-September. Though Mr. Fuld was removed from the payroll on Jan. 1 and relieved of his company-provided black Mercedes, Lehman has agreed to let him keep an office at the firm. He's just around the corner from Mr. Marsal, who says he picks Mr. Fuld's brain about Lehman's business several times a week.
"We asked him to stay if he has nowhere better to go," says Mr. Marsal. "He's been very good about making himself available for questions about Lehman assets."
Through a spokeswoman, Mr. Fuld declined to comment.
Lehman's dismantling is an expensive process. Associated costs run about $30 million a month, excluding fees to lawyers and advisers on the case. Employees are paid a salary -- with modest retention bonus added as "a kiss" says Mr. Marsal -- to entice workers to stay at a place with a limited lifespan.
Life Inside Lehman Brothers
3:25
WSJ's Dennis Berman and Peter Lattman discuss the latest at Lehman Brothers, where job stability has become surprisingly ubiquitous.
The assignment is a lucrative one for Alvarez & Marsal, which is charging Lehman hourly fees of $550 to $850 for its top executives working on the case, with rich incentive fees for the firm depending on its recovery for creditors.
Despite Lehman's assured dissolution, executive recruiters say it isn't surprising that the collapsed investment bank has become a desirable place to work.
"This is a well-paying job in one of the worst employment markets in history," says Skiddy von Stade, founder of New York-based executive placement firm F.S. von Stade & Associates. "Through the disposition of Lehman's assets, the employees will have a chance to demonstrate their strengths and skills for opportunities down the road -- possibly with the very buyers of these securities and investments."
Mr. Marsal says compensation is in line with similar jobs on Wall Street, yet far below what it was at Lehman. He and his team are "very, very careful" about the expenses of the firm, which he says are generally lean. "The excess of Lehman was the size of the salaries and the expectations of people with the bonus plan," he says.
View Full Image
Reuters
Staff members stand in a meeting room at the Lehman Brothers offices in the financial district of Canary Wharf in London Sept. 11, 2008.
Gone are the pay and perks that came with being a top executive at pre-bankruptcy Lehman. Mr. Fuld and his management team sat on the 31st floor of Lehman's former headquarters, a state-of-the-art steel-and-granite building in Times Square. Barclays bought that site and took it over, so now Lehman's command center is a run-of-the-mill office on the 45th floor of the Time-Life building, which long served as Lehman overflow space.
Mr. Marsal and his team are making due without weekly deliveries of fresh flowers and warm chocolate-chip muffins on Fridays -- perks enjoyed by the firm's former brass. Gone too is the executive dining suite where a private chef prepared lunch for Lehman's top executives. Instead, Mr. Marsal and his crew grab a bite in the cafeteria at Time Inc., which has granted access to the Lehman employees.
Henry Klein is part of Lehman's new topsy-turvy reality. A nine-year Lehman veteran, he oversaw a portfolio of investments in India from the firm's New York office. When Lehman failed, Mr. Klein was transferred to Barclays, but says he had little to do there. "I was at Barclays, but my assets were at Lehman."
Mr. Klein left Barclays in mid-November, and then approached Alvarez & Marsal. Today, he's back overseeing the very assets he says he managed at Lehman.
The 46-year-old Mr. Klein is currently focused on a small $36 million real-estate investment in Hyderabad, a large city in south central India. Lehman may continue to back the deal, but also may have to pull its funding. "It's a difficult decision," says Mr. Klein. "We don't have tons of time."
Luc Faucheux, 39, heads up the desk at the bankrupt entity that trades interest-rate swaps and other fixed-income derivatives. "I always wanted this job," laughs the former Lehman staffer who says he had a related, but less senior role. "Be careful what you wish for, because you might just get it."
"Let's face it," he adds. "Given the state of the world we're in, the things I'm learning working on the largest bankruptcy in history are a set of skills that could be marketable for the foreseeable future."
Rather than immediately sell assets into a depressed market, Alvarez & Marsal has opted to retain and manage a chunk of Lehman's holdings.
Last month, Alvarez & Marsal decided to keep a 49% interest in Lehman's money-management business, Neuberger Investment Management, selling the balance to Neuberger's management. It made a similar move with Lehman Brothers Merchant Banking, the firm's flagship private-equity business. The estate also has held on to more than 100 direct stakes in private companies. These include direct investments made alongside Lehman's private-equity clients in large boom-era buyouts such as First Data Corp. and Texas utility TXU Corp.
So far, Lehman has more than doubled its cash reserves to $7 billion from $3.3 billion, in part through the sale of its headquarters to Barclays. It is also raising money by selling off the firm's sizable art collection, whose value Lehman has pegged at roughly $30 million. Some of the photographs and paintings still grace the halls of Barclays and Lehman's Neuberger unit.
Finally, there is a cavalry of corporate jets valued at $164 million. Lehman has already sold six jets, as well as interests in fractional shares service NetJets Inc. for $53 million. Still on the block: Six more planes, including a Boeing 767, and a Sikorsky chopper.
Some of those jets Lehman owned as investments and only four were used for corporate purposes at any one time, according to a Lehman spokeswoman.
"The fleet's been grounded," Mr. Marsal reassured the bankruptcy judge overseeing the case at a hearing last month. "Nobody is flying around these planes and no one is using the helicopter.
Wednesday, January 28, 2009
Fuels on the Hill
There seems to be an amazing amount of misunderstanding of the basics of fiscal policy, even among people who should know better. Leave on one side the remarkable parade of economists who think that the savings-investment identity proves that government action can’t increase spending; PGL points us to a higher-level fallacy: the widespread belief that Ricardian equivalence doesn’t just say that tax cuts have no effect — which it does — it also says that private consumption automatically offsets any rise in government spending, which is just wrong.
Justin Wolfers suggests that this is because economists just haven’t been thinking and writing about fiscal policy. Maybe. But in my own neck of the woods, that isn’t true. In the New Open Economy Macroeconomics, which dates back to classic work by Obstfeld and Rogoff in the early 90s, both fiscal and monetary policy are usually analyzed.
And by the way: these are extremely buttoned-down models, with lots of intertemporal maximization, careful attention to budget constraints, and at most some assumption of temporary price rigidity. Nobody who was at all familiar with this literature could make the logic mistakes that are coming fast and furious from the fresh-water economists.
What this reveals, I think, is just how insular part of the macroeconomics profession has become. They just don’t read anything that doesn’t come from their cult circle; they just weren’t aware of major bodies of work that didn’t happen to be in their preferred style.
This insularity is asymmetric. Ask a PhD student at Princeton what a real business cycle theorist would say about something, and he or she can do that; ask a student at one of the freshwater schools what a new Keynesian would say, and I doubt that he or she could answer. They’ve been taught that there is one true faith, and have been carefully protected from heresy.
It’s a sad story.
Justin Wolfers suggests that this is because economists just haven’t been thinking and writing about fiscal policy. Maybe. But in my own neck of the woods, that isn’t true. In the New Open Economy Macroeconomics, which dates back to classic work by Obstfeld and Rogoff in the early 90s, both fiscal and monetary policy are usually analyzed.
And by the way: these are extremely buttoned-down models, with lots of intertemporal maximization, careful attention to budget constraints, and at most some assumption of temporary price rigidity. Nobody who was at all familiar with this literature could make the logic mistakes that are coming fast and furious from the fresh-water economists.
What this reveals, I think, is just how insular part of the macroeconomics profession has become. They just don’t read anything that doesn’t come from their cult circle; they just weren’t aware of major bodies of work that didn’t happen to be in their preferred style.
This insularity is asymmetric. Ask a PhD student at Princeton what a real business cycle theorist would say about something, and he or she can do that; ask a student at one of the freshwater schools what a new Keynesian would say, and I doubt that he or she could answer. They’ve been taught that there is one true faith, and have been carefully protected from heresy.
It’s a sad story.
Wednesday, January 21, 2009
Missing Fraudster Nadel Was 'Top US Manager' In 2003
One of the notable aspects of the Bernie Madoff case is that very few people knew who he was. Despite his stellar gains, he never got any kind of public recognition. The only articles about his performance were skeptical, like the ones in Barron's and Mar/Hedge.
Conversely, one of the newly emerge Mini-Madoffs, Art Nadel, actually was recognized as a top US money manager, in 2003. The award was given by newsletter The Wall Street Digest, according to Reuters.
Some, like 68-year-old Tony Hagar, say they were drawn to his funds by The Wall Street Digest and the upbeat report by its editor, Donald Rowe, and now question how much due diligence the investment newsletter industry conducts.
"He seemed to indicate that they were a reasonable investment. They put out a letter that says these folks have done substantially well, and that Don Rowe had looked at them closely," said Hagar.
Hagar is right to wonder how much due diligence was done here. We're guessing none to little. So far this no mention of Nadel or his award at The Wall Street Digest's "In The News" section of their website.
Conversely, one of the newly emerge Mini-Madoffs, Art Nadel, actually was recognized as a top US money manager, in 2003. The award was given by newsletter The Wall Street Digest, according to Reuters.
Some, like 68-year-old Tony Hagar, say they were drawn to his funds by The Wall Street Digest and the upbeat report by its editor, Donald Rowe, and now question how much due diligence the investment newsletter industry conducts.
"He seemed to indicate that they were a reasonable investment. They put out a letter that says these folks have done substantially well, and that Don Rowe had looked at them closely," said Hagar.
Hagar is right to wonder how much due diligence was done here. We're guessing none to little. So far this no mention of Nadel or his award at The Wall Street Digest's "In The News" section of their website.
Saturday, January 17, 2009
Markets can do anything they want
The selling over the past few days smacks of panic, yet again.
Some of this melt-down is forced selling as de-leveraging continues in the realms of the Masters of the Universe. Some of this selling is due to bear raids that are specifically designed to wreck the financial stocks and force the government to come in and wipe out the equity of bank stock holders. And some is just sheer panic.
It is incredible to me that people are willing to throw out everything and run and hide in the so-called “safety” of the Treasury market while opportunity beckons across risky assets unlike anything seen in decades. As the government gets ready to run trillion dollar deficits for as far as the eye can see, investors are so cowered that they are willing to accept 2% a year for a decade.
There is this theory in finance known as “The Efficient Market Hypothesis.” This theory postulates that the market is an efficient processor of information, whether it is all information (the strong form theory) or merely all widely known information (the semi-strong form theory), and that information is priced into stocks. Because stock prices are a reflection of all or all known information, the market is "efficient."
But consider what we have gone through over the past decade – The Asian Contagion, the collapse of Long-Term Capital Management, the Tech Bubble, the Credit Bubble, the Housing Bubble, and now the Treasury Bubble as investors were recently accepting T-bills with negative yields.
The market is not a wise, all-knowing processor of information and seer of the future.
The market is an idiot.
Everywhere I look, I read that it is the end of the world. All the news is bad. Everything is horrible. It is the Great Depression all over again. And so on.
Yes, the economy is bad. Yes, things are bleak. Yes, the world has changed. Who on God’s Green Earth does not know this already?
But is it really the end of the world?
Economic growth is driven primarily by technological progress. Advances in technology make things cheaper and lowers the cost curves of producers, freeing up resources for investment and expansion. This process is usually known as “productivity growth.” And unless the American public has become collectively lazy and stupid all of a sudden, the technological advancement and productivity growth that has made this country the richest nation the planet has ever seen will continue.
This is not to minimize the problems in the economy. We may be on the brink of a true depression, if a depression is defined as a 10% contraction in economic activity. We must continue to de-lever. We have some very serious problems we must work through.
But we are working through those problems. Many of the dominoes that had to fall have fallen. Dominoes remain standing but we are nearer the end of the decline in asset prices than the beginning.
This decade so far has been the worst decade for stocks. Ever. Valuations for stocks are attractive and the expected return from equities is at the highest level in decades. Credit markets are improving and governments are flooding the financial system with liquidity.
The most powerful force in asset markets is reversion to the mean. We have overshot the mean on the downside.
Can the market go lower? Of course. Markets can do anything they want.
But others can bet against reversion to the mean. I’m not.
Some of this melt-down is forced selling as de-leveraging continues in the realms of the Masters of the Universe. Some of this selling is due to bear raids that are specifically designed to wreck the financial stocks and force the government to come in and wipe out the equity of bank stock holders. And some is just sheer panic.
It is incredible to me that people are willing to throw out everything and run and hide in the so-called “safety” of the Treasury market while opportunity beckons across risky assets unlike anything seen in decades. As the government gets ready to run trillion dollar deficits for as far as the eye can see, investors are so cowered that they are willing to accept 2% a year for a decade.
There is this theory in finance known as “The Efficient Market Hypothesis.” This theory postulates that the market is an efficient processor of information, whether it is all information (the strong form theory) or merely all widely known information (the semi-strong form theory), and that information is priced into stocks. Because stock prices are a reflection of all or all known information, the market is "efficient."
But consider what we have gone through over the past decade – The Asian Contagion, the collapse of Long-Term Capital Management, the Tech Bubble, the Credit Bubble, the Housing Bubble, and now the Treasury Bubble as investors were recently accepting T-bills with negative yields.
The market is not a wise, all-knowing processor of information and seer of the future.
The market is an idiot.
Everywhere I look, I read that it is the end of the world. All the news is bad. Everything is horrible. It is the Great Depression all over again. And so on.
Yes, the economy is bad. Yes, things are bleak. Yes, the world has changed. Who on God’s Green Earth does not know this already?
But is it really the end of the world?
Economic growth is driven primarily by technological progress. Advances in technology make things cheaper and lowers the cost curves of producers, freeing up resources for investment and expansion. This process is usually known as “productivity growth.” And unless the American public has become collectively lazy and stupid all of a sudden, the technological advancement and productivity growth that has made this country the richest nation the planet has ever seen will continue.
This is not to minimize the problems in the economy. We may be on the brink of a true depression, if a depression is defined as a 10% contraction in economic activity. We must continue to de-lever. We have some very serious problems we must work through.
But we are working through those problems. Many of the dominoes that had to fall have fallen. Dominoes remain standing but we are nearer the end of the decline in asset prices than the beginning.
This decade so far has been the worst decade for stocks. Ever. Valuations for stocks are attractive and the expected return from equities is at the highest level in decades. Credit markets are improving and governments are flooding the financial system with liquidity.
The most powerful force in asset markets is reversion to the mean. We have overshot the mean on the downside.
Can the market go lower? Of course. Markets can do anything they want.
But others can bet against reversion to the mean. I’m not.
Wednesday, January 7, 2009
Marc Faber Jan. 07, 2009
This morning, Marc Faber, managing director of Marc Faber Ltd. and publisher of the monthly investment newsletter The Gloom Boom & Doom Report talked with Bloomberg’s Carol Massar, Erik Schatzker, and Ellen Braitman about the outlook for industrial commodities and gold prices, as well as government intervention in the economy, his outlook for the financial markets, and his investment strategy for technology stocks. Notable excerpts from the exchange included:
2009 Outlook
Well, economically it will be very bad. We have a contracting economy, globally, everywhere. And, I mean, not mildly contracting, but falling off a cliff. However, after this fall off of a cliff, the news in the next 3 months could look somewhat better than expected. In other words, there could be some rebound from the lows in economic activity.
U.S. Economic “Stimulus” Proposals
Well, it may help a little bit, temporarily. But in the long run, it’s a disaster. Any government intervention into the economy is basically bad, in particular, an intervention that is designed to support prices. The Federal Reserve, and the Treasury, both actually want to support asset prices. Most cartels that have been designed to support prices eventually broke down and prices collapsed.
Industrial Commodities
Gold is now very expensive compared to industrial commodities. Actually, it’s at the highest level in 30 years or more. And so right now, as of today, I would rather buy a basket of oversold industrial commodities.
Crude Oil
I would say, the long-term demand for oil is there. The supply won’t be there. So, long-term, I think the price will be much higher than it is today.
World War III
Everybody talks about monetary and fiscal policies, but nobody talks about the worsening geopolitical situation in the world. I think World War III has already begun.
FREE VIDEO: How to connect the market dots in 2009
Blue Chip Companies
I think in every industry, the leading companies emerging from the crisis, whenever the economy recovers, will be very strong.
Asian Stocks
If someone has no money in Asia, now you can buy top-quality companies at reasonable PE’s.
BRIC (Brazil, Russia, India, China) Stocks
Prices are now down to attractive levels as an entry-point, as a trading opportunity, like the metal stocks I mentioned. So, I think I would buy these BRIC countries for a rebound, looking for a rebound of around 30% from the present level.
Long-Term Outlook
Well, I’m very bearish long-term because I think that Treasury bond yields will go up a lot, and the trade of 2009 is to short U.S. government bonds- big time… I think it will take 5 years until the world recovers.
2009 Outlook
Well, economically it will be very bad. We have a contracting economy, globally, everywhere. And, I mean, not mildly contracting, but falling off a cliff. However, after this fall off of a cliff, the news in the next 3 months could look somewhat better than expected. In other words, there could be some rebound from the lows in economic activity.
U.S. Economic “Stimulus” Proposals
Well, it may help a little bit, temporarily. But in the long run, it’s a disaster. Any government intervention into the economy is basically bad, in particular, an intervention that is designed to support prices. The Federal Reserve, and the Treasury, both actually want to support asset prices. Most cartels that have been designed to support prices eventually broke down and prices collapsed.
Industrial Commodities
Gold is now very expensive compared to industrial commodities. Actually, it’s at the highest level in 30 years or more. And so right now, as of today, I would rather buy a basket of oversold industrial commodities.
Crude Oil
I would say, the long-term demand for oil is there. The supply won’t be there. So, long-term, I think the price will be much higher than it is today.
World War III
Everybody talks about monetary and fiscal policies, but nobody talks about the worsening geopolitical situation in the world. I think World War III has already begun.
FREE VIDEO: How to connect the market dots in 2009
Blue Chip Companies
I think in every industry, the leading companies emerging from the crisis, whenever the economy recovers, will be very strong.
Asian Stocks
If someone has no money in Asia, now you can buy top-quality companies at reasonable PE’s.
BRIC (Brazil, Russia, India, China) Stocks
Prices are now down to attractive levels as an entry-point, as a trading opportunity, like the metal stocks I mentioned. So, I think I would buy these BRIC countries for a rebound, looking for a rebound of around 30% from the present level.
Long-Term Outlook
Well, I’m very bearish long-term because I think that Treasury bond yields will go up a lot, and the trade of 2009 is to short U.S. government bonds- big time… I think it will take 5 years until the world recovers.
Tuesday, January 6, 2009
Obama's Big Tax Plan
Boy was I wrong! $300 billion in tax cuts are probably on the way -- and soon.
More Stories
Lessons From the Madoff Scandal
A Year Worth Forgetting
Fed's Balance Sheet Is Ballooning Fast
Right after the election, I was virtually certain that upper-income individuals would face higher federal income tax bills as early as this year. And I didn’t see anything very good on the business tax horizon, either. But after two more months of horrifying economic data, it’s a whole new ball game.
Now, President-elect Obama is proposing a $775 billion economic stimulus package that does not appear to impose higher taxes on anybody or anything for 2009. Instead, it looks like we will immediately see some of the “middle-class tax cuts” Obama promised, plus some unanticipated business breaks too. All in all, these tax cuts could add up to $300 billion (or more) over the next two years.
As Congress mulls over the Obama proposals, more details will emerge. Until then, here are some guesses about what might be coming.
Individual Tax Breaks
New Credit for Middle-Class Workers
We will likely see a new credit of up to $500 for working singles and up to $1,000 for working couples. The credit will probably be delivered via reduced federal payroll tax withholding, so it will take a few months for most workers to collect the full benefit in the form of bigger paychecks. When a similar-sounding credit was pitched during the campaign, it was to be phased out for singles earning over $75,000 and for couples earning over $150,000, but it appears those income limits may be moving targets now. How the credit might be extended to self-employed folks remains to be seen.
Liberalized Earned Income Credit
During the campaign, Obama pledged to increase the number of individuals who are eligible for the earned income credit and provide larger credits to noncustodial parents who fulfill their child support obligations, low-income married couples, and families with three or more children. Earned income credits are “refundable,” which means taxpayers can collect them even if they don’t owe any federal income tax (in other words, the government pays you instead of the other way around). There’s a good chance the upcoming stimulus package will include this change.
Business Tax Breaks
New Five-Year Loss Carry Back Allowance
Businesses might be allowed to "carry back" tax losses incurred in 2008 and 2009 to the previous five years. That way, taxes paid on earlier profits that were wiped out by recent losses can be reclaimed immediately as tax refunds. Under the current rules, losses can generally be carried back only two years and excess losses must be carried forward to future years -- which means those losses can’t do any tax-saving good until future profits are earned. With many companies facing uncertain prospects, extending the loss carry back period to five years would be good tax policy in my opinion.
Extended Section 179 Deduction Allowance
Thanks to the Section 179 deduction privilege, many small and medium-sized businesses can depreciate most or all of the cost of qualifying new and used assets in the first year they are put to use. Most depreciable assets (other than real estate) qualify for this deduction -- including equipment and most purchased software. For tax years beginning in 2009, the maximum Section 179 deduction was scheduled to drop from $250,000 to only $133,000. The upcoming stimulus package could extend the $250,000 allowance or perhaps make it even bigger.
Extended First-Year Bonus Depreciation
Last year, businesses were allowed to claim 50% first-year bonus depreciation for qualifying new (not used) assets that were both purchased and placed in service during calendar 2008. But this valuable break expired on Dec. 31. Unlike the Section 179 deduction, first-year bonus depreciation was available to even the largest businesses. The upcoming stimulus package could extend the first-year bonus depreciation deal through 2009.
New Jobs Credit for Employers
The stimulus package could include new tax credits for employers that hire more workers and perhaps even for those that forgo laying off workers. Details are cloudy, but a range of $40 to $50 billion worth of tax savings is being mentioned. (During the campaign, the Obama tax plan included giving businesses a $3,000 credit for each new full-time job created in the U.S.)
More Details to Come
For what it's worth, everything you’ve read here is nothing more than informed speculation. That said, there’s little doubt that we will soon see a whopping stimulus bill that includes some major tax breaks. Once the dust settles, we'll help you understand what it all means.
More Stories
Lessons From the Madoff Scandal
A Year Worth Forgetting
Fed's Balance Sheet Is Ballooning Fast
Right after the election, I was virtually certain that upper-income individuals would face higher federal income tax bills as early as this year. And I didn’t see anything very good on the business tax horizon, either. But after two more months of horrifying economic data, it’s a whole new ball game.
Now, President-elect Obama is proposing a $775 billion economic stimulus package that does not appear to impose higher taxes on anybody or anything for 2009. Instead, it looks like we will immediately see some of the “middle-class tax cuts” Obama promised, plus some unanticipated business breaks too. All in all, these tax cuts could add up to $300 billion (or more) over the next two years.
As Congress mulls over the Obama proposals, more details will emerge. Until then, here are some guesses about what might be coming.
Individual Tax Breaks
New Credit for Middle-Class Workers
We will likely see a new credit of up to $500 for working singles and up to $1,000 for working couples. The credit will probably be delivered via reduced federal payroll tax withholding, so it will take a few months for most workers to collect the full benefit in the form of bigger paychecks. When a similar-sounding credit was pitched during the campaign, it was to be phased out for singles earning over $75,000 and for couples earning over $150,000, but it appears those income limits may be moving targets now. How the credit might be extended to self-employed folks remains to be seen.
Liberalized Earned Income Credit
During the campaign, Obama pledged to increase the number of individuals who are eligible for the earned income credit and provide larger credits to noncustodial parents who fulfill their child support obligations, low-income married couples, and families with three or more children. Earned income credits are “refundable,” which means taxpayers can collect them even if they don’t owe any federal income tax (in other words, the government pays you instead of the other way around). There’s a good chance the upcoming stimulus package will include this change.
Business Tax Breaks
New Five-Year Loss Carry Back Allowance
Businesses might be allowed to "carry back" tax losses incurred in 2008 and 2009 to the previous five years. That way, taxes paid on earlier profits that were wiped out by recent losses can be reclaimed immediately as tax refunds. Under the current rules, losses can generally be carried back only two years and excess losses must be carried forward to future years -- which means those losses can’t do any tax-saving good until future profits are earned. With many companies facing uncertain prospects, extending the loss carry back period to five years would be good tax policy in my opinion.
Extended Section 179 Deduction Allowance
Thanks to the Section 179 deduction privilege, many small and medium-sized businesses can depreciate most or all of the cost of qualifying new and used assets in the first year they are put to use. Most depreciable assets (other than real estate) qualify for this deduction -- including equipment and most purchased software. For tax years beginning in 2009, the maximum Section 179 deduction was scheduled to drop from $250,000 to only $133,000. The upcoming stimulus package could extend the $250,000 allowance or perhaps make it even bigger.
Extended First-Year Bonus Depreciation
Last year, businesses were allowed to claim 50% first-year bonus depreciation for qualifying new (not used) assets that were both purchased and placed in service during calendar 2008. But this valuable break expired on Dec. 31. Unlike the Section 179 deduction, first-year bonus depreciation was available to even the largest businesses. The upcoming stimulus package could extend the first-year bonus depreciation deal through 2009.
New Jobs Credit for Employers
The stimulus package could include new tax credits for employers that hire more workers and perhaps even for those that forgo laying off workers. Details are cloudy, but a range of $40 to $50 billion worth of tax savings is being mentioned. (During the campaign, the Obama tax plan included giving businesses a $3,000 credit for each new full-time job created in the U.S.)
More Details to Come
For what it's worth, everything you’ve read here is nothing more than informed speculation. That said, there’s little doubt that we will soon see a whopping stimulus bill that includes some major tax breaks. Once the dust settles, we'll help you understand what it all means.
Monday, January 5, 2009
The End of the Financial World as We Know It
AMERICANS enter the New Year in a strange new role: financial lunatics. We’ve been viewed by the wider world with mistrust and suspicion on other matters, but on the subject of money even our harshest critics have been inclined to believe that we knew what we were doing. They watched our investment bankers and emulated them: for a long time now half the planet’s college graduates seemed to want nothing more out of life than a job on Wall Street.
Related
Op-Ed Contributors: How to Repair a Broken Financial World (January 4, 2009) This is one reason the collapse of our financial system has inspired not merely a national but a global crisis of confidence. Good God, the world seems to be saying, if they don’t know what they are doing with money, who does?
Incredibly, intelligent people the world over remain willing to lend us money and even listen to our advice; they appear not to have realized the full extent of our madness. We have at least a brief chance to cure ourselves. But first we need to ask: of what?
To that end consider the strange story of Harry Markopolos. Mr. Markopolos is the former investment officer with Rampart Investment Management in Boston who, for nine years, tried to explain to the Securities and Exchange Commission that Bernard L. Madoff couldn’t be anything other than a fraud. Mr. Madoff’s investment performance, given his stated strategy, was not merely improbable but mathematically impossible. And so, Mr. Markopolos reasoned, Bernard Madoff must be doing something other than what he said he was doing.
In his devastatingly persuasive 17-page letter to the S.E.C., Mr. Markopolos saw two possible scenarios. In the “Unlikely” scenario: Mr. Madoff, who acted as a broker as well as an investor, was “front-running” his brokerage customers. A customer might submit an order to Madoff Securities to buy shares in I.B.M. at a certain price, for example, and Madoff Securities instantly would buy I.B.M. shares for its own portfolio ahead of the customer order. If I.B.M.’s shares rose, Mr. Madoff kept them; if they fell he fobbed them off onto the poor customer.
In the “Highly Likely” scenario, wrote Mr. Markopolos, “Madoff Securities is the world’s largest Ponzi Scheme.” Which, as we now know, it was.
Harry Markopolos sent his report to the S.E.C. on Nov. 7, 2005 — more than three years before Mr. Madoff was finally exposed — but he had been trying to explain the fraud to them since 1999. He had no direct financial interest in exposing Mr. Madoff — he wasn’t an unhappy investor or a disgruntled employee. There was no way to short shares in Madoff Securities, and so Mr. Markopolos could not have made money directly from Mr. Madoff’s failure. To judge from his letter, Harry Markopolos anticipated mainly downsides for himself: he declined to put his name on it for fear of what might happen to him and his family if anyone found out he had written it. And yet the S.E.C.’s cursory investigation of Mr. Madoff pronounced him free of fraud.
What’s interesting about the Madoff scandal, in retrospect, is how little interest anyone inside the financial system had in exposing it. It wasn’t just Harry Markopolos who smelled a rat. As Mr. Markopolos explained in his letter, Goldman Sachs was refusing to do business with Mr. Madoff; many others doubted Mr. Madoff’s profits or assumed he was front-running his customers and steered clear of him. Between the lines, Mr. Markopolos hinted that even some of Mr. Madoff’s investors may have suspected that they were the beneficiaries of a scam. After all, it wasn’t all that hard to see that the profits were too good to be true. Some of Mr. Madoff’s investors may have reasoned that the worst that could happen to them, if the authorities put a stop to the front-running, was that a good thing would come to an end.
The Madoff scandal echoes a deeper absence inside our financial system, which has been undermined not merely by bad behavior but by the lack of checks and balances to discourage it. “Greed” doesn’t cut it as a satisfying explanation for the current financial crisis. Greed was necessary but insufficient; in any case, we are as likely to eliminate greed from our national character as we are lust and envy. The fixable problem isn’t the greed of the few but the misaligned interests of the many.
A lot has been said and written, for instance, about the corrupting effects on Wall Street of gigantic bonuses. What happened inside the major Wall Street firms, though, was more deeply unsettling than greedy people lusting for big checks: leaders of public corporations, especially financial corporations, are as good as required to lead for the short term.
Richard Fuld, the former chief executive of Lehman Brothers, E. Stanley O’Neal, the former chief executive of Merrill Lynch, and Charles O. Prince III, Citigroup’s chief executive, may have paid themselves humongous sums of money at the end of each year, as a result of the bond market bonanza. But if any one of them had set himself up as a whistleblower — had stood up and said “this business is irresponsible and we are not going to participate in it” — he would probably have been fired. Not immediately, perhaps. But a few quarters of earnings that lagged behind those of every other Wall Street firm would invite outrage from subordinates, who would flee for other, less responsible firms, and from shareholders, who would call for his resignation. Eventually he’d be replaced by someone willing to make money from the credit bubble.
OUR financial catastrophe, like Bernard Madoff’s pyramid scheme, required all sorts of important, plugged-in people to sacrifice our collective long-term interests for short-term gain. The pressure to do this in today’s financial markets is immense. Obviously the greater the market pressure to excel in the short term, the greater the need for pressure from outside the market to consider the longer term. But that’s the problem: there is no longer any serious pressure from outside the market. The tyranny of the short term has extended itself with frightening ease into the entities that were meant to, one way or another, discipline Wall Street, and force it to consider its enlightened self-interest.
The credit-rating agencies, for instance.
Everyone now knows that Moody’s and Standard & Poor’s botched their analyses of bonds backed by home mortgages. But their most costly mistake — one that deserves a lot more attention than it has received — lies in their area of putative expertise: measuring corporate risk.
Over the last 20 years American financial institutions have taken on more and more risk, with the blessing of regulators, with hardly a word from the rating agencies, which, incidentally, are paid by the issuers of the bonds they rate. Seldom if ever did Moody’s or Standard & Poor’s say, “If you put one more risky asset on your balance sheet, you will face a serious downgrade.”
The American International Group, Fannie Mae, Freddie Mac, General Electric and the municipal bond guarantors Ambac Financial and MBIA all had triple-A ratings. (G.E. still does!) Large investment banks like Lehman and Merrill Lynch all had solid investment grade ratings. It’s almost as if the higher the rating of a financial institution, the more likely it was to contribute to financial catastrophe. But of course all these big financial companies fueled the creation of the credit products that in turn fueled the revenues of Moody’s and Standard & Poor’s.
These oligopolies, which are actually sanctioned by the S.E.C., didn’t merely do their jobs badly. They didn’t simply miss a few calls here and there. In pursuit of their own short-term earnings, they did exactly the opposite of what they were meant to do: rather than expose financial risk they systematically disguised it.
This is a subject that might be profitably explored in Washington. There are many questions an enterprising United States senator might want to ask the credit-rating agencies. Here is one: Why did you allow MBIA to keep its triple-A rating for so long? In 1990 MBIA was in the relatively simple business of insuring municipal bonds. It had $931 million in equity and only $200 million of debt — and a plausible triple-A rating.
By 2006 MBIA had plunged into the much riskier business of guaranteeing collateralized debt obligations, or C.D.O.’s. But by then it had $7.2 billion in equity against an astounding $26.2 billion in debt. That is, even as it insured ever-greater risks in its business, it also took greater risks on its balance sheet.
Yet the rating agencies didn’t so much as blink. On Wall Street the problem was hardly a secret: many people understood that MBIA didn’t deserve to be rated triple-A. As far back as 2002, a hedge fund called Gotham Partners published a persuasive report, widely circulated, entitled: “Is MBIA Triple A?” (The answer was obviously no.)
At the same time, almost everyone believed that the rating agencies would never downgrade MBIA, because doing so was not in their short-term financial interest. A downgrade of MBIA would force the rating agencies to go through the costly and cumbersome process of re-rating tens of thousands of credits that bore triple-A ratings simply by virtue of MBIA’s guarantee. It would stick a wrench in the machine that enriched them. (In June, finally, the rating agencies downgraded MBIA, after MBIA’s failure became such an open secret that nobody any longer cared about its formal credit rating.)
The S.E.C. now promises modest new measures to contain the damage that the rating agencies can do — measures that fail to address the central problem: that the raters are paid by the issuers.
But this should come as no surprise, for the S.E.C. itself is plagued by similarly wacky incentives. Indeed, one of the great social benefits of the Madoff scandal may be to finally reveal the S.E.C. for what it has become.
Created to protect investors from financial predators, the commission has somehow evolved into a mechanism for protecting financial predators with political clout from investors. (The task it has performed most diligently during this crisis has been to question, intimidate and impose rules on short-sellers — the only market players who have a financial incentive to expose fraud and abuse.)
The instinct to avoid short-term political heat is part of the problem; anything the S.E.C. does to roil the markets, or reduce the share price of any given company, also roils the careers of the people who run the S.E.C. Thus it seldom penalizes serious corporate and management malfeasance — out of some misguided notion that to do so would cause stock prices to fall, shareholders to suffer and confidence to be undermined. Preserving confidence, even when that confidence is false, has been near the top of the S.E.C.’s agenda.
IT’S not hard to see why the S.E.C. behaves as it does. If you work for the enforcement division of the S.E.C. you probably know in the back of your mind, and in the front too, that if you maintain good relations with Wall Street you might soon be paid huge sums of money to be employed by it.
The commission’s most recent director of enforcement is the general counsel at JPMorgan Chase; the enforcement chief before him became general counsel at Deutsche Bank; and one of his predecessors became a managing director for Credit Suisse before moving on to Morgan Stanley. A casual observer could be forgiven for thinking that the whole point of landing the job as the S.E.C.’s director of enforcement is to position oneself for the better paying one on Wall Street.
At the back of the version of Harry Markopolos’s brave paper currently making the rounds is a copy of an e-mail message, dated April 2, 2008, from Mr. Markopolos to Jonathan S. Sokobin. Mr. Sokobin was then the new head of the commission’s office of risk assessment, a job that had been vacant for more than a year after its previous occupant had left to — you guessed it — take a higher-paying job on Wall Street.
At any rate, Mr. Markopolos clearly hoped that a new face might mean a new ear — one that might be receptive to the truth. He phoned Mr. Sokobin and then sent him his paper. “Attached is a submission I’ve made to the S.E.C. three times in Boston,” he wrote. “Each time Boston sent this to New York. Meagan Cheung, branch chief, in New York actually investigated this but with no result that I am aware of. In my conversations with her, I did not believe that she had the derivatives or mathematical background to understand the violations.”
How does this happen? How can the person in charge of assessing Wall Street firms not have the tools to understand them? Is the S.E.C. that inept? Perhaps, but the problem inside the commission is far worse — because inept people can be replaced. The problem is systemic. The new director of risk assessment was no more likely to grasp the risk of Bernard Madoff than the old director of risk assessment because the new guy’s thoughts and beliefs were guided by the same incentives: the need to curry favor with the politically influential and the desire to keep sweet the Wall Street elite.
And here’s the most incredible thing of all: 18 months into the most spectacular man-made financial calamity in modern experience, nothing has been done to change that, or any of the other bad incentives that led us here in the first place.
SAY what you will about our government’s approach to the financial crisis, you cannot accuse it of wasting its energy being consistent or trying to win over the masses. In the past year there have been at least seven different bailouts, and six different strategies. And none of them seem to have pleased anyone except a handful of financiers.
When Bear Stearns failed, the government induced JPMorgan Chase to buy it by offering a knockdown price and guaranteeing Bear Stearns’s shakiest assets. Bear Stearns bondholders were made whole and its stockholders lost most of their money.
Then came the collapse of the government-sponsored entities, Fannie Mae and Freddie Mac, both promptly nationalized. Management was replaced, shareholders badly diluted, creditors left intact but with some uncertainty. Next came Lehman Brothers, which was, of course, allowed to go bankrupt. At first, the Treasury and the Federal Reserve claimed they had allowed Lehman to fail in order to signal that recklessly managed Wall Street firms did not all come with government guarantees; but then, when chaos ensued, and people started saying that letting Lehman fail was a dumb thing to have done, they changed their story and claimed they lacked the legal authority to rescue the firm.
But then a few days later A.I.G. failed, or tried to, yet was given the gift of life with enormous government loans. Washington Mutual and Wachovia promptly followed: the first was unceremoniously seized by the Treasury, wiping out both its creditors and shareholders; the second was batted around for a bit. Initially, the Treasury tried to persuade Citigroup to buy it — again at a knockdown price and with a guarantee of the bad assets. (The Bear Stearns model.) Eventually, Wachovia went to Wells Fargo, after the Internal Revenue Service jumped in and sweetened the pot with a tax subsidy.
In the middle of all this, Treasury Secretary Henry M. Paulson Jr. persuaded Congress that he needed $700 billion to buy distressed assets from banks — telling the senators and representatives that if they didn’t give him the money the stock market would collapse. Once handed the money, he abandoned his promised strategy, and instead of buying assets at market prices, began to overpay for preferred stocks in the banks themselves. Which is to say that he essentially began giving away billions of dollars to Citigroup, Morgan Stanley, Goldman Sachs and a few others unnaturally selected for survival. The stock market fell anyway.
It’s hard to know what Mr. Paulson was thinking as he never really had to explain himself, at least not in public. But the general idea appears to be that if you give the banks capital they will in turn use it to make loans in order to stimulate the economy. Never mind that if you want banks to make smart, prudent loans, you probably shouldn’t give money to bankers who sunk themselves by making a lot of stupid, imprudent ones. If you want banks to re-lend the money, you need to provide them not with preferred stock, which is essentially a loan, but with tangible common equity — so that they might write off their losses, resolve their troubled assets and then begin to make new loans, something they won’t be able to do until they’re confident in their own balance sheets. But as it happened, the banks took the taxpayer money and just sat on it.
Related
Op-Ed Contributors: How to Repair a Broken Financial World (January 4, 2009) This is one reason the collapse of our financial system has inspired not merely a national but a global crisis of confidence. Good God, the world seems to be saying, if they don’t know what they are doing with money, who does?
Incredibly, intelligent people the world over remain willing to lend us money and even listen to our advice; they appear not to have realized the full extent of our madness. We have at least a brief chance to cure ourselves. But first we need to ask: of what?
To that end consider the strange story of Harry Markopolos. Mr. Markopolos is the former investment officer with Rampart Investment Management in Boston who, for nine years, tried to explain to the Securities and Exchange Commission that Bernard L. Madoff couldn’t be anything other than a fraud. Mr. Madoff’s investment performance, given his stated strategy, was not merely improbable but mathematically impossible. And so, Mr. Markopolos reasoned, Bernard Madoff must be doing something other than what he said he was doing.
In his devastatingly persuasive 17-page letter to the S.E.C., Mr. Markopolos saw two possible scenarios. In the “Unlikely” scenario: Mr. Madoff, who acted as a broker as well as an investor, was “front-running” his brokerage customers. A customer might submit an order to Madoff Securities to buy shares in I.B.M. at a certain price, for example, and Madoff Securities instantly would buy I.B.M. shares for its own portfolio ahead of the customer order. If I.B.M.’s shares rose, Mr. Madoff kept them; if they fell he fobbed them off onto the poor customer.
In the “Highly Likely” scenario, wrote Mr. Markopolos, “Madoff Securities is the world’s largest Ponzi Scheme.” Which, as we now know, it was.
Harry Markopolos sent his report to the S.E.C. on Nov. 7, 2005 — more than three years before Mr. Madoff was finally exposed — but he had been trying to explain the fraud to them since 1999. He had no direct financial interest in exposing Mr. Madoff — he wasn’t an unhappy investor or a disgruntled employee. There was no way to short shares in Madoff Securities, and so Mr. Markopolos could not have made money directly from Mr. Madoff’s failure. To judge from his letter, Harry Markopolos anticipated mainly downsides for himself: he declined to put his name on it for fear of what might happen to him and his family if anyone found out he had written it. And yet the S.E.C.’s cursory investigation of Mr. Madoff pronounced him free of fraud.
What’s interesting about the Madoff scandal, in retrospect, is how little interest anyone inside the financial system had in exposing it. It wasn’t just Harry Markopolos who smelled a rat. As Mr. Markopolos explained in his letter, Goldman Sachs was refusing to do business with Mr. Madoff; many others doubted Mr. Madoff’s profits or assumed he was front-running his customers and steered clear of him. Between the lines, Mr. Markopolos hinted that even some of Mr. Madoff’s investors may have suspected that they were the beneficiaries of a scam. After all, it wasn’t all that hard to see that the profits were too good to be true. Some of Mr. Madoff’s investors may have reasoned that the worst that could happen to them, if the authorities put a stop to the front-running, was that a good thing would come to an end.
The Madoff scandal echoes a deeper absence inside our financial system, which has been undermined not merely by bad behavior but by the lack of checks and balances to discourage it. “Greed” doesn’t cut it as a satisfying explanation for the current financial crisis. Greed was necessary but insufficient; in any case, we are as likely to eliminate greed from our national character as we are lust and envy. The fixable problem isn’t the greed of the few but the misaligned interests of the many.
A lot has been said and written, for instance, about the corrupting effects on Wall Street of gigantic bonuses. What happened inside the major Wall Street firms, though, was more deeply unsettling than greedy people lusting for big checks: leaders of public corporations, especially financial corporations, are as good as required to lead for the short term.
Richard Fuld, the former chief executive of Lehman Brothers, E. Stanley O’Neal, the former chief executive of Merrill Lynch, and Charles O. Prince III, Citigroup’s chief executive, may have paid themselves humongous sums of money at the end of each year, as a result of the bond market bonanza. But if any one of them had set himself up as a whistleblower — had stood up and said “this business is irresponsible and we are not going to participate in it” — he would probably have been fired. Not immediately, perhaps. But a few quarters of earnings that lagged behind those of every other Wall Street firm would invite outrage from subordinates, who would flee for other, less responsible firms, and from shareholders, who would call for his resignation. Eventually he’d be replaced by someone willing to make money from the credit bubble.
OUR financial catastrophe, like Bernard Madoff’s pyramid scheme, required all sorts of important, plugged-in people to sacrifice our collective long-term interests for short-term gain. The pressure to do this in today’s financial markets is immense. Obviously the greater the market pressure to excel in the short term, the greater the need for pressure from outside the market to consider the longer term. But that’s the problem: there is no longer any serious pressure from outside the market. The tyranny of the short term has extended itself with frightening ease into the entities that were meant to, one way or another, discipline Wall Street, and force it to consider its enlightened self-interest.
The credit-rating agencies, for instance.
Everyone now knows that Moody’s and Standard & Poor’s botched their analyses of bonds backed by home mortgages. But their most costly mistake — one that deserves a lot more attention than it has received — lies in their area of putative expertise: measuring corporate risk.
Over the last 20 years American financial institutions have taken on more and more risk, with the blessing of regulators, with hardly a word from the rating agencies, which, incidentally, are paid by the issuers of the bonds they rate. Seldom if ever did Moody’s or Standard & Poor’s say, “If you put one more risky asset on your balance sheet, you will face a serious downgrade.”
The American International Group, Fannie Mae, Freddie Mac, General Electric and the municipal bond guarantors Ambac Financial and MBIA all had triple-A ratings. (G.E. still does!) Large investment banks like Lehman and Merrill Lynch all had solid investment grade ratings. It’s almost as if the higher the rating of a financial institution, the more likely it was to contribute to financial catastrophe. But of course all these big financial companies fueled the creation of the credit products that in turn fueled the revenues of Moody’s and Standard & Poor’s.
These oligopolies, which are actually sanctioned by the S.E.C., didn’t merely do their jobs badly. They didn’t simply miss a few calls here and there. In pursuit of their own short-term earnings, they did exactly the opposite of what they were meant to do: rather than expose financial risk they systematically disguised it.
This is a subject that might be profitably explored in Washington. There are many questions an enterprising United States senator might want to ask the credit-rating agencies. Here is one: Why did you allow MBIA to keep its triple-A rating for so long? In 1990 MBIA was in the relatively simple business of insuring municipal bonds. It had $931 million in equity and only $200 million of debt — and a plausible triple-A rating.
By 2006 MBIA had plunged into the much riskier business of guaranteeing collateralized debt obligations, or C.D.O.’s. But by then it had $7.2 billion in equity against an astounding $26.2 billion in debt. That is, even as it insured ever-greater risks in its business, it also took greater risks on its balance sheet.
Yet the rating agencies didn’t so much as blink. On Wall Street the problem was hardly a secret: many people understood that MBIA didn’t deserve to be rated triple-A. As far back as 2002, a hedge fund called Gotham Partners published a persuasive report, widely circulated, entitled: “Is MBIA Triple A?” (The answer was obviously no.)
At the same time, almost everyone believed that the rating agencies would never downgrade MBIA, because doing so was not in their short-term financial interest. A downgrade of MBIA would force the rating agencies to go through the costly and cumbersome process of re-rating tens of thousands of credits that bore triple-A ratings simply by virtue of MBIA’s guarantee. It would stick a wrench in the machine that enriched them. (In June, finally, the rating agencies downgraded MBIA, after MBIA’s failure became such an open secret that nobody any longer cared about its formal credit rating.)
The S.E.C. now promises modest new measures to contain the damage that the rating agencies can do — measures that fail to address the central problem: that the raters are paid by the issuers.
But this should come as no surprise, for the S.E.C. itself is plagued by similarly wacky incentives. Indeed, one of the great social benefits of the Madoff scandal may be to finally reveal the S.E.C. for what it has become.
Created to protect investors from financial predators, the commission has somehow evolved into a mechanism for protecting financial predators with political clout from investors. (The task it has performed most diligently during this crisis has been to question, intimidate and impose rules on short-sellers — the only market players who have a financial incentive to expose fraud and abuse.)
The instinct to avoid short-term political heat is part of the problem; anything the S.E.C. does to roil the markets, or reduce the share price of any given company, also roils the careers of the people who run the S.E.C. Thus it seldom penalizes serious corporate and management malfeasance — out of some misguided notion that to do so would cause stock prices to fall, shareholders to suffer and confidence to be undermined. Preserving confidence, even when that confidence is false, has been near the top of the S.E.C.’s agenda.
IT’S not hard to see why the S.E.C. behaves as it does. If you work for the enforcement division of the S.E.C. you probably know in the back of your mind, and in the front too, that if you maintain good relations with Wall Street you might soon be paid huge sums of money to be employed by it.
The commission’s most recent director of enforcement is the general counsel at JPMorgan Chase; the enforcement chief before him became general counsel at Deutsche Bank; and one of his predecessors became a managing director for Credit Suisse before moving on to Morgan Stanley. A casual observer could be forgiven for thinking that the whole point of landing the job as the S.E.C.’s director of enforcement is to position oneself for the better paying one on Wall Street.
At the back of the version of Harry Markopolos’s brave paper currently making the rounds is a copy of an e-mail message, dated April 2, 2008, from Mr. Markopolos to Jonathan S. Sokobin. Mr. Sokobin was then the new head of the commission’s office of risk assessment, a job that had been vacant for more than a year after its previous occupant had left to — you guessed it — take a higher-paying job on Wall Street.
At any rate, Mr. Markopolos clearly hoped that a new face might mean a new ear — one that might be receptive to the truth. He phoned Mr. Sokobin and then sent him his paper. “Attached is a submission I’ve made to the S.E.C. three times in Boston,” he wrote. “Each time Boston sent this to New York. Meagan Cheung, branch chief, in New York actually investigated this but with no result that I am aware of. In my conversations with her, I did not believe that she had the derivatives or mathematical background to understand the violations.”
How does this happen? How can the person in charge of assessing Wall Street firms not have the tools to understand them? Is the S.E.C. that inept? Perhaps, but the problem inside the commission is far worse — because inept people can be replaced. The problem is systemic. The new director of risk assessment was no more likely to grasp the risk of Bernard Madoff than the old director of risk assessment because the new guy’s thoughts and beliefs were guided by the same incentives: the need to curry favor with the politically influential and the desire to keep sweet the Wall Street elite.
And here’s the most incredible thing of all: 18 months into the most spectacular man-made financial calamity in modern experience, nothing has been done to change that, or any of the other bad incentives that led us here in the first place.
SAY what you will about our government’s approach to the financial crisis, you cannot accuse it of wasting its energy being consistent or trying to win over the masses. In the past year there have been at least seven different bailouts, and six different strategies. And none of them seem to have pleased anyone except a handful of financiers.
When Bear Stearns failed, the government induced JPMorgan Chase to buy it by offering a knockdown price and guaranteeing Bear Stearns’s shakiest assets. Bear Stearns bondholders were made whole and its stockholders lost most of their money.
Then came the collapse of the government-sponsored entities, Fannie Mae and Freddie Mac, both promptly nationalized. Management was replaced, shareholders badly diluted, creditors left intact but with some uncertainty. Next came Lehman Brothers, which was, of course, allowed to go bankrupt. At first, the Treasury and the Federal Reserve claimed they had allowed Lehman to fail in order to signal that recklessly managed Wall Street firms did not all come with government guarantees; but then, when chaos ensued, and people started saying that letting Lehman fail was a dumb thing to have done, they changed their story and claimed they lacked the legal authority to rescue the firm.
But then a few days later A.I.G. failed, or tried to, yet was given the gift of life with enormous government loans. Washington Mutual and Wachovia promptly followed: the first was unceremoniously seized by the Treasury, wiping out both its creditors and shareholders; the second was batted around for a bit. Initially, the Treasury tried to persuade Citigroup to buy it — again at a knockdown price and with a guarantee of the bad assets. (The Bear Stearns model.) Eventually, Wachovia went to Wells Fargo, after the Internal Revenue Service jumped in and sweetened the pot with a tax subsidy.
In the middle of all this, Treasury Secretary Henry M. Paulson Jr. persuaded Congress that he needed $700 billion to buy distressed assets from banks — telling the senators and representatives that if they didn’t give him the money the stock market would collapse. Once handed the money, he abandoned his promised strategy, and instead of buying assets at market prices, began to overpay for preferred stocks in the banks themselves. Which is to say that he essentially began giving away billions of dollars to Citigroup, Morgan Stanley, Goldman Sachs and a few others unnaturally selected for survival. The stock market fell anyway.
It’s hard to know what Mr. Paulson was thinking as he never really had to explain himself, at least not in public. But the general idea appears to be that if you give the banks capital they will in turn use it to make loans in order to stimulate the economy. Never mind that if you want banks to make smart, prudent loans, you probably shouldn’t give money to bankers who sunk themselves by making a lot of stupid, imprudent ones. If you want banks to re-lend the money, you need to provide them not with preferred stock, which is essentially a loan, but with tangible common equity — so that they might write off their losses, resolve their troubled assets and then begin to make new loans, something they won’t be able to do until they’re confident in their own balance sheets. But as it happened, the banks took the taxpayer money and just sat on it.
Thursday, January 1, 2009
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