What Motivated Me to Write this Market Letter?
After Wednesday’s tumultuous market, highlighted by the twenty-five percent decline in the stocks of FNMA and Freddie Mac, I thought I would compose a market letter. Several years ago, I tried to summarize my thoughts about the market, but the response was so paltry that I gave up the efforts after several weeks. Hopefully, this time, I am writing to a different audience or my message is better constructed. Truthfully, my market letter died without one whimper of complaint. However, I am obstinate and disagree with Abraham Lincoln admonition that “it is better to remain silent and be thought a fool than to open one’s mouth and remove all doubt.”
Where do I Stand?
Depending upon the day, I vacillate in confidence from either the consoling words of Franklin Roosevelt “We have nothing to fear, but fear itself” to Chicken Little “The sky is falling in.”
Ken Lay Annual Award
Before we get into discussing serious issues, I want to remind you to cast your ballots for the man most deserving of this award. One has to be a long standing shareholder of any of the following stocks to register: Enron, Citicorp, FNMA, FREDDIE MAC, MERRILL LYNCH, MBIA, COUNTRYWIDE FINANCIAL, OR TIME WARNER. Since, the later have been screwed for twenty years, they get to vote early and often.
Voters should remember that we are living in the twenty-first century, and have abrogated the normative values of our parents’ generation. Blood Sweat and Tears has been replaced by Gotcha! Jimmie Stewart has had a very bad year. Mr. Smith was ridiculed out of Washington. He has been replaced by Willie Sutton and thousands of highly paid lobbyists. George Bailey lost his job to Henry Potter. In turn Henry Potter lost his job to Chuck Prince.
What is the Silver Lining?
1) To date, the U.S. economy and the economy of other developed countries have performed well despite problems in housing and finance.
2) U.S. unemployment levels have remained level.
3) There have been significant capital inflows by “contrarian investors” in order to shore up institutions having problems.
4) Most economic forecasters still predict that the United States will experience small, positive increases in real domestic output in 2008.
5) United States exports have recently risen three times faster than imports because of the lower dollar.
6) The Federal Reserve should continue to lower interest rates.
7) No major commercial bank or investment bank is operating in a crisis mode. While Citicorp and Merrill Lynch both need capital infusions, the market place has confidence that they will resolve their outstanding problems.
How can we arrest this crisis?
Let us be guided by some of Abraham’s Lincoln’s words.
“I never had a policy; I have just tried to do my very best each and every day.”
“You cannot escape the responsibility of tomorrow by evading it today.” “You cannot help men permanently by doing for them what they could and should do for themselves.”
How Bad is the Current Financial Crisis?
The current crisis has the potential to last longer and be more punitive than the market crashes of 1998 (Long Term Capital Meltdown and Russian Financial Crises) and the 1987 market meltdown when the market declined 20% in one day for the following reasons:
The current crises involves two major industries: housing and almost every type of financial institution
The current crises is global; that is, on a worldwide basis institutions have invested promiscuously in “risky” assets and several countries have financed escalating housing prices on variable rate mortgages: United States, Great Britain, and Spain.
Globally, many institutions have incurred unreasonable levels of leverage.
The ownership of trillions of dollars of derivatives has so complicated the liability structure of institutions throughout the globe that measurement of potential damage might not be accurately calculable.
Limitations of Government Policies!
1) Since August, our government and other central banks have tried to prop up worldwide economies through the simulative actions.
2) In the United States, the Federal Reserve has cut the discount rate and the federal funds rate by 75 basis points.
3) The federal government has discussed several fiscal programs to stimulate the overall economy and has intervened on a special situation basis to rectify some specific problems such as the SIV crisis.
In a nutshell, we can expect more of the above, but in the end to quote Abraham Lincoln, “I am a firm believer in the people. If given the truth, they can be depended upon to meet any national crisis. The great point is to bring them the real facts.”
Why has the Problem Grown ?
One of the greatest problems is that the magnitude of our precarious financial situation has expanded along with the staggering write-downs by hedge funds, investment banks, commercial banks, mortgage banks, financial guarantors, pension funds, etc. We are sliding down a “slippery slope” with every new negative financial revelation. That is, highly margined institutions become geometrically more vulnerable when their capital base shrinks.
Who can we count on?
Benjamin Franklin once said, “We must all hang together, or we will surely all hang alone.”
To date, international cooperation has been muted. In some cases, some countries such as Venezuela, Iran, and Russia might wish to exacerbate our problems. Their has been some discussion that, henceforth, Opec
might choose to be compensated in a basket of currencies instead of solely in the U.S. dollar. Unless the dollar rebounds, paying for oil in non-dollar currencies could substantially raise the real cost to the United States of our oil imports.
Has American business and political leaders displayed fiduciary responsibility?
ABSOLUTELY NOT!
The Business Community
That is, many of our problems spring from horrendous business risk decisions that resulted in poor quality loans, overleveraged balance sheets, misunderstanding and over dependence upon “financially engineered risk management tools.”
The resignations of key financial leaders at major firms such as Citicorp, Merrill Lynch, H&R Block, and Home Depot reflect reckless decision-making, selfishness, and short-sidedness. Since all of these executives lost their shareholders’ billions, their huge bonuses and severance packages were clearly pouring heaps of salt into pretty big wounds. Unfortunately, the business climate in recent years has overcompensated risk takers, encouraged accounting shenanigans, and myopic focus on hyping stock prices.
Political Leaders
Several years ago, Pete Peterson, critically blamed the leaders of both political parties for fiscal irresponsibility in his book, Running on Empty. His warnings went unheeded. Peterson predicted that left unchecked our unfunded Social Security System and Medicare Program will bankrupt the nation. The Credit Agencies have warned that the credit rating of the American Government could slip below AAA without fiscal reforms.
Since writing this book, we have implemented irresponsible fiscal policies such as waging a war and increasing substantially our Medicare obligations while decreasing taxes. These irresponsible actions have undermined domestic and international confidence in the United States economy so badly that the United States dollars has fallen precipitously. The low esteem felt toward both the executive and the legislative branches reflects legitimate cynicism toward the efficacy of these public bodies to implement and execute quality foreign and domestic remedial programs.
Are our Business Leaders and Politicians Over Paid?
The Hermann Goering Consultant Firm must provide the moral basis for our outsized pay packages to executives and politicians. No reasonable yardstick applies to the contracts of executives.
In recent years we have evolved from giving retired executives gold watches to golden handcuffs to golden parachutes to the National Treasury.
There is something wrong when Al Gore, Bill Clinton, George Bush Senior, Rudolph Giuliani and Richard Cheney have net worth’s approaching one hundred to two hundred million dollars. While I do not have the ‘inside scoop” I am suspicious that $100,000 payments for “chicken dinner speeches” by major organizations, multi-million dollar advance royalty payments for auto-biographical books, and huge director fees motivate politicians to do the right thing.
Why did Colin Powell not voice his criticism of our rush to war in Iraq?
Silence is golden, particularly when you can go off to a fabulous sunset, and your son, Michael, has been appointed Chairman of the Federal Communications Committee. Michael now holds a senior position at a major hedge fund.
What are some of the Financial Bombshells that have shaken market confidence since August 2007?
Massive downgrades by the credit agencies of securitized obligations.
A need for additional capital at a variety of institutions such as Citicorp, Merrill Lynch, Freddie Mac, Countrywide Financial Services, and CFIG.
Bankruptcies of hedge funds, mortgage bankers, and commercial banks in the United States, Great Britain, and France.
30%+ stock declines in stock prices of diverse financial institutions such as Merrill Lynch, Bear Stearns, MGIC, FNMA, Freddie Mac, MBIA, Countrywide Financial Corporation, Citicorp, New York Stock Exchange, etc.
Since financial companies at the beginning of 2007 composed some 20% of the market capitalization of the S&P 500, the dramatic decline in the market value of financials has a rippling impact on the economy. That is, these institutions need to borrow substantially each day to finance their bloated balance sheets. Moreover, these institutions provide needed capital to other institutions—hedge funds, leveraged buyout funds, corporate America, mortgage brokers and individuals. Thus, a loss of confidence in the major financial houses impacts on a broad scale would-be borrowers and lenders on a global scale.
The U.S. dollar has declined almost 12% against the Eurodollar and 6% against the Japanese Yen since the beginning of the year.
The credit default market prices out the risk of FNMA and Freddie Mac at BBB, which is significantly below their current AAA rating.
What are potential problems?
$362 billion of subprime adjustable rate mortgages are scheduled to reset next year. A typical subprime loan could start at 7% and rise to 9.5% after two years.
$152 billion of other loans with adjustable rates are set to reset according to Bank of America Securities.
Many mortgage loans were acquired without provision of third-party financial verification.
1.35 million Homes will enter the foreclosure process this year and another 1.44 million next year. Foreclosed homes typically sell as a discount of 20% to 25% compared to the sale of an owner-occupied home, because these homes typically need significant repairs. Moreover, the expected further decline in housing prices could add to the default totals because home borrowers have reduced home equity cushions.
Close to 30% of mergers and acquisitions in the first half of 2007 were conducted by leveraged buyout institutions. These institutions relied heavily on leverage to consummate their buyouts and depend upon an ebullient market to maintain the confidence of their lenders and investors.
While the Federal Reserve still predicts a modest growth in the economy for 2008, thereby avoiding recession, almost all economists predict a decline in economic activity over the next twelve to eighteen months irrespective of Federal Reserve Policy.
Commodity prices—copper, oil, wheat—have risen dramatically this past year. Moreover, growth in demand from third world countries should keep commodity prices relatively high.
Outside auditors need to opine on inventory pricing, whether its securities or finished goods in order to provide a “fairness opinion for year end statement purposes.” Financial companies that are heavily leveraged run the greatest risk because significant markdowns of their Level III inventory (inventory that does not have clearly delineated priced comparables) are significantly larger than their net worth.
Personal savings rates last year were negative. Consumer consumption was maintained through increase use of credit card debt and home equity loans.
Conclusion
In conclusion, we probably have to go back to the decade of the 1970’s to find a comparable period. That is, the market setbacks of 1987 and 1998 were short-term affairs. We clearly are in much more difficult times. Unfortunately, while we can possibly be surprised on the upside as our country experienced with Franklin Roosevelt and Abraham Lincoln, none of the current presidential candidates have articulated meaningful domestic policy proposals to arrest the problem.
Originally published in the Sarasota Herald-Tribune
