Saturday, September 20, 2008

Reflections on the Wild West


After a week as crazy as this one, I decided to unwind last night and enjoy a movie with some friends. We ended up going to see Woody Allen's Vicky Cristina Barcelona. It was the first movie I caught on the big screen in a very long time and I am glad because it was excellent.

Today I decided to reflect on what exactly happened over the past five days. How can we have come so close to the brink of collapse? We were that close to what John Mauldin calls "Financial Armageddon" (a must read article).

It's simply crazy to think that the Mother of all Ponzi schemes almost brought down the global financial system.

And now we are awaiting details on the Mother of all bailouts.

President Bush will ask Congress for $700 billion to buy bad mortgages as part of his economic bailout plan:

The plan would give the government broad power to buy the bad debt of any United States financial institutions for the next two years.

Speaking at the White House Saturday morning, the president said he decided to act boldly once he realized how bad the financial crisis was.

"It turns out there are a lot of inner links throughout the financial system," said Bush. "The system had grown to a point where a lot of people were dependent upon each other. And the collapse of one part of the system wouldn't just affect a part of the financial markets, it would affect the average citizen."

[Duh!]

It's still unclear what the government would get in return from the companies it helps.

Will this massive bailout help stabilize markets and restore investor confidence? Who knows?

On the technical side, I am paying attention to the 50 and 200 day exponential moving averages for both the Dow and S&P 500. As you can see, if you're long stocks like most people are, the trend is not your friend.

On the fundamental side, even if we wipe out all that toxic debt from banks' balance sheets, what is the next shoe to fall?

More importantly, what is the catalyst that will propel stocks to new highs? Higher unemployment? Stagflation or even worse, debt deflation? Does anyone have a clue?

Jeremy Siegel, author of Stocks for the Long Run, sees a silver lining:

"There's about a half trillion dollars' worth of write-downs already embedded in the prices of these financial stocks," which suggests that financial firms overall are finally being forced to come clean about investments. "We're seeing a changing of the players," he added. "There is still a huge demand for financial services. That demand is going to grow, and international flows of credit are going to be bigger than ever.... We are now making transparent what these instruments are worth."

Siegel's comment echoed his opinion piece in the Wall Street Journal the morning of the panel. In acknowledging the turmoil caused by the overleveraging, he noted: "There is good evidence that the worst is over, especially for the commercial banks with access to Federal Reserve credit."

Others, like Joseph Gyourko, chairman of Wharton's real estate department, are more skeptical:

"There are emerging problems on the commercial side [of the real estate market]," he said. After the session, Gyourko shook his head at what he feels is a downward spiraling securities market for commercial real estate. "There are going to be so many banks going under," he stated. "If I could re-invent myself, I'd be a distressed property fund. You simply can't get debt in this market."

According to Gyourko, stock prices for real estate investment trusts are suffering, too. But his fears for the CMBS market are well-grounded. AIG, for example, could be forced to sell off assets at a time when CMBS demand is practically non-existent. The insurer owns in excess of $21 billion of CMBS.

As for the residential side, he noted that the excess supply of new homes continued throughout 2007. "The excess supply will wear off by the end of 2009, but not before.... The end of this debacle keeps getting put off and put off."

I am not sure if "RTC-II" will absorb all the bad debt on banks' balance sheets, including commercial mortgage backed securities (CMBS).

Importantly, it's not just banks that are exposed to the CMBS market. Insurance companies and pension funds are also exposed to CMBS. If that market crumbles, watch out, it will wreak havoc on the portfolios of many public pension funds.

And what about hedge funds? While some fear the new rules will rattle their business, others are more cautious, waiting to gauge the effects of the bailout:

Hedge funds raised cash holdings during the biggest two-day global stock rally in history because they aren't sure where markets are headed after the U.S. moved to bail out banks and limit bets against financial companies.

"The rally hurt us quite a bit'' because the firm shorted some stocks in expectation they would fall, said Chris Wang, co- founder of SYW Capital Management LLC in New York, which oversees less than $100 million. "The best thing for us to do is shrink our books and hold more cash.''

The increase in cash indicates fund managers don't expect calm to return to markets in the next several weeks, said Bill Grayson, president of Falcon Point Capital LLC, a San Francisco- based investment firm. Some funds are seeking to protect the year's gains, while others are hoping to pare losses.

"The one thing I can guarantee is incredible volatility in the foreseeable future,'' he said.

I can also pretty much guarantee you more volatility and a massive shakeout of the hedge fund industry.

Longer term, the era of financial deregulation is over and no matter who the next president is, we can expect a new era of financial regulation (let's hope they get it right!).

Finally, please take the time to read two excellent articles in Counterpunch this weekend. The first one by Pam Martens, The Wall Street Model: Unintelligent Design, discusses the structural problems plaguing all Wall Street business models:

The fact that Wall Street is collapsing is a given. How it survived as long as it did under its corrupted model is the question that will be debated in history books for the next generation.

For example, imagine a business model that bases remuneration to brokers on how much money they make for their Wall Street employer and not one dime for how well their customers’ portfolios perform. A Wall Street broker receives remuneration that rises from approximately 30 to 50 per cent of the gross commission based on their cumulative trading commissions with zero regard to how well the clients’ accounts have done. There is no acknowledged internal mechanism in any of the major Wall Street firms to gauge the overall success of the accounts the broker is managing.

Ms. Marten concludes by stating an important point:

Make no mistake that what ever the dollar amount announced next week to funnel into an entity to buy bad debts from banks and Wall Street firms, it won’t be enough. It’s a Band-Aid on a malignant tumor. That tumor is Credit Default Swaps (CDS) with over $60 trillion now owed through secret contracts in an unregulated market created, financed and owned by the unintelligent design masters, Wall Street firms themselves. (See “How Wall Street Blew Itself Up,” CounterPunch, January 21, 2008.)

Ms. Marten's warnings were echoed in another excellent Counterpunch article by Michael Hudson, America's Own Kleptocracy:

Much of the blame should go to the Clinton Administration for leading the call to repeal Glass-Steagall in 1999, letting the banks merge with casinos. Or rather, the casinos have absorbed the banks. That is what has put the savings of Americans at risk.

But does this really mean that the only solution is to re-inflate the real estate market? The Paulson-Bernanke plan is to enable the banks to sell off the homes of five million home mortgage debtors faced with default or foreclosure this year! Homeowners with “exploding adjustable-rate mortgages” will lose their homes, but the Fed will pump enough credit into the mortgage-lending agencies to enable new buyers to go deeply enough into debt to take the junk mortgages off the hands of the gamblers who presently own them. Time for another financial and real estate bubble to bail out the junk mortgage lenders and packagers.

America has entered into a new war – a War to Save Computerized Derivative Traders. Like the Iraq war, it is based largely on fictions and entered into under seeming emergency conditions – to which the solution has little relation to the underlying cause of the problems. On financial security grounds the government is to make good on the collateralized debt obligations packaged (CDOs) that Warren Buffett has called “weapons of mass financial destruction.”

Hardly by surprise, this giveaway of public money is being handled by the same group that warned the country so piously about weapons of mass destruction in Iraq. Pres. Bush and Treasury Secretary Paulson have piously announced that this is no time for partisan disagreements over this shift of public policy to favor creditors rather than debtors. There is no time to make the biggest bailout in election history an election issue. Not an appropriate time to debate whether it is a good thing to re-inflate housing prices to a level that will continue to oblige new home buyers to go so deeply into debt that they must pay some 40 percent of their take-home pay on housing.

Remember when President Bush and Alan Greenspan informed the American people that there was no money left to pay Social Security (not to mention Medicare) because at some future date (a decade from now? 20 years? 40 years?) the system might run a deficit of what now seems to be merely a trivial trillion dollars spread over many, many years. The moral was that if we can’t figure out how to pay, let’s plow the program under right now.

Mr. Bush and Greenspan did have a helpful solution, of course. The Treasury could turn Social Security and medical insurance money over to Bear Stearns, Lehman Brothers and their brethren to invest at the “magic of compound interest.”

What would have happened to U.S. Social Security had this been done? Perhaps we should view the past two weeks’ events as having assigned to Wall Street gamblers all the money that has been set aside since the Greenspan Commission in 1983 shifted the tax burden onto FICA wage withholding. It is not retirees who are being rescued, but the Wall Street investors who signed papers saying that they could afford to lose their money. The Republican slogan this November should be “Gambling insurance, not health insurance.”

This is not how the much-vaunted Road to Serfdom was mapped out to be. Frederick Hayek and his Chicago Boys insisted that serfdom would come from government planning and regulation. This view turned upside down the classical and Progressive Era reformers who depicted government as acting as society’s brain, its steering mechanism to shape markets – and free them from income without playing a necessary role in production. The theory of democracy rested on the assumption that voters would act in their self-interest.

Market reformers made a kindred happy assumption that consumers, savers and investors would promote economic growth by acting with full knowledge and understanding of the dynamics at work. But the Invisible Hand turned out to be accounting fraud, junk mortgage lending, insider dealing and a failure to relate the soaring debt overhead to the ability of debtors to pay – all of this mess seemingly legitimized by computerized trading models, and now blessed by the Treasury.

This mess is far from over. Nobody knows what the future will bring but if you are concerned, do not be afraid to take money off the table (ie. sell stocks after big rallies!) and increase your cash reserves.


As always, talk to your financial adviser and ask them to take into account your present and future needs. If you're still not sure, do not be afraid to ask a second or third opinion.


***Update:


Read Paul Krugman's latest No Deal. Also, read this article by Barrie McKenna of the Globe & Mail, Wild ride, wild week, now what?

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