<body><script type="text/javascript"> function setAttributeOnload(object, attribute, val) { if(window.addEventListener) { window.addEventListener('load', function(){ object[attribute] = val; }, false); } else { window.attachEvent('onload', function(){ object[attribute] = val; }); } } </script> <div id="navbar-iframe-container"></div> <script type="text/javascript" src="https://apis.google.com/js/plusone.js"></script> <script type="text/javascript"> gapi.load("gapi.iframes:gapi.iframes.style.bubble", function() { if (gapi.iframes && gapi.iframes.getContext) { gapi.iframes.getContext().openChild({ url: 'https://www.blogger.com/navbar.g?targetBlogID\x3d27708445\x26blogName\x3dWatchingTheHerd\x26publishMode\x3dPUBLISH_MODE_BLOGSPOT\x26navbarType\x3dLIGHT\x26layoutType\x3dCLASSIC\x26searchRoot\x3dhttp://watchingtheherd.blogspot.com/search\x26blogLocale\x3den\x26v\x3d2\x26homepageUrl\x3dhttp://watchingtheherd.blogspot.com/\x26vt\x3d8775860279176631146', where: document.getElementById("navbar-iframe-container"), id: "navbar-iframe" }); } }); </script>

Sunday, September 28, 2008

The Bailout: Many Devils in the Details

Momentum is building behind the weekend revisions made to the financial bailout bill which may allow it to be enacted and signed into law within days. What follows below are quick comments that come to mind from a first reading of the entire 106 page bill, now officially termed the Emergency Economic Stabilization Act of 2008. Even from a single cursory reading, it seems clear the bill lacks any material clarity required to prevent abuse of the sweeping powers it grants. It also seems clear the bill fails to include any economic and regulatory incentives to alter the market behaviors that produced the need for such a bailout in the first place.

The full text of the September 28 version of the act is available at:

http://money.cnn.com/2008/09/28/news/pdf/firstdraft.pdf

Text from the act is shown in bold letters with my commentary in normal text.


(3) Designating financial institutions as financial agents of the Federal Government, and such institutions shall perform all such reasonable duties related to this Act as financial agents of the Federal Government as may be required.

Before the earlier of the end of the 2-business-day period beginning on the date of the first purchase of troubled assets pursuant to the authority under this section or the end of the 45-day period beginning on the date of enactment of this Act, the Secretary shall publish program guidelines,


At the rate institutions are imploding, all allocated money could be committed before a single explanation of the mechanisms by which the money was committed would be communicated to the public. Even after splitting the authority of the program into phases, that's still $350 billion of unaccountable spending of public dollars.


(e) PREVENTING UNJUST ENRICHMENT.—In making purchases under the authority of this Act, the Secretary shall take such steps as may be necessary to prevent unjust enrichment of financial institutions participating in a program established under this section, including by preventing the resale of a troubled asset to the Secretary at a higher price than what the seller paid to purchase the asset.
This subsection does not apply to troubled assets acquired in a merger or acquisition, or a purchase of assets from a financial institution in conservatorship or receivership, or that has initiated bankruptcy proceedings under title 11, United States Code.


This really provides no defense at all when one of the ways the Treasury is "solving" problems is by allowing instant mergers of collapsing institutions into other banks with zero Congressional or Justice Department review.


REPORTS.—The Secretary shall report to the appropriate committees of Congress on the program established under subsection (a). Such report shall be submitted prior to any increase in the authority to purchase troubled assets in accordance with section 115.

Mechanisms for insuring assets created by the Secretary do not have to be explained until the first funding allocation is exhausted and the Secretary requests additional authorization to purchases assets. Again, that allows vast amounts of dollars to be spent and commitments made before the public has any clarity on how the mechanisms work (or don't work). In item (2) of this clause, it says the Secretary shall publish the methods used to set premiums based on risk but provides no implicitly or explicit requirement of WHEN such publication will be produced.

(3) PAYMENTS FROM FUND.—The Secretary shall make payments from amounts deposited in the Troubled Assets Insurance Fund to fulfill obligations of the guarantees provided to financial institutions under subsection (a).

Looks legal-like and official huh? This means the Secretary of the Treasury shall make payments when situations warrant paying out guarantees against defaulting instruments. Much of the document reads like this --- very obvious statements to help fill out the structure while obfuscating other content that ISN'T in the document but should be.


(5) ensuring that all financial institutions are eligible to participate in the program, without discrimination based on size, geography, form of organization, or the size, type, and number of assets eligible for purchase under this Act;

This is nonsense. The amount of funds committed by Congress is likely to be FAR less than the total value of mortgages and instruments at risk. BY DEFINITION, the effort needs to focus on institutions big enough to trigger a cascading failure if they fail. Even though a dollar is a dollar is a dollar, WHERE that dollar exists in the system (or more accurately, where it NO LONGER exists in the system) is key to the risk posed to the system. A small regional banks with $1 billion of trouble poses far less risk to the entire systemw than $1 billion of trouble at a megabank that is $1 billion away from insolvency. The Treasury's own actions to date make it clear they are willing to let small players fail while protecting the big players.


(8) that nothing in this Act prevents the Secretary from protecting the retirement security of Americans by purchasing troubled assets held by or on behalf of an eligible retirement plan other than a plan described in section 409A of the Internal Revenue Code of 1986; and

This translates to: Nothing in this act prevents the Secretary from using the funds to also attempt to backstop public and private pension plans -- other than unqualified deferred compensation plans for executives subject to 409A tax code rules. This clause essentially pulls in another class of financial institutions under the supposed protective umbrella, subjecting whatever financial limit is approved for the plan to many more competing interests.


(9) the utility of purchasing other real estate owned and instruments backed by mortgages on multifamily properties.

The secretary shall also consider the value of directly bailing out developers of overbuilt condominium and apartment complexes in the most bubble-prone areas, thus assuring Florida will remain a source of electoral shenanigans as politicians lobby to "help the most" by lobbying the Treasury to help their allies.


(c) REGULATORY MODERNIZATION REPORT.—The Secretary shall review the current state of the financial markets and the regulatory system and submit a written report to the appropriate committees of Congress not later than April 30, 2009, analyzing the current state of the regulatory system and its effectiveness at overseeing the participants in the financial markets, including the over-the-counter swaps market and government-sponsored enterprises, and providing recommendations for improvement, including—

April 30, 2009 provides roughly three months of time for players in a new Administration to take their seats and dig through the blizzard of paper left from the outgoing team. Ideally, a report from CURRENT players should be required by 12/31/2008 just to put them on the record about what happened and what they did with follow-up reports to be issued by the new Administration after they find the bathroom and nearest emergency exit by their office.


(a) STREAMLINED PROCESS.—For purposes of this Act, the Secretary may waive specific provisions of the Federal Acquisition Regulation upon a determination that urgent and compelling circumstances make compliance with such provisions contrary to the public interest. Any such determination, and the justification for such determination, shall be submitted to the Committees on Oversight and Government Reform and Financial Services of the House of Representatives and the Committees on Homeland Security and Governmental Affairs and Banking, Housing, and Urban Affairs of the Senate within 7 days.

This translates into: The Secretary doesn't have to follow existing federal laws for government contracts and purchases with regards to minority-owned or female-owned business and simply has to notify Congress it is ignoring the law when it sees fit. This is fundamentally a reflection that few of the major players benefitting from this bailout are minority- or female-owned businesses and as such, those players have no recourse with the government for the billions spent.


(c) CONSENT TO REASONABLE LOAN MODIFICATION REQUESTS.—Upon any request arising under existing investment contracts, the Secretary shall consent, where appropriate, and considering net present value to the taxpayer, to reasonable requests for loss mitigation measures, including term extensions, rate reductions, principal write downs, increases in the proportion of loans within a trust or other structure allowed to be modified, or removal of other limitation on modifications.

This provides the Secretary the ability to alter interest rates, terms or principle amounts of any mortgage assets acquired under the program. However, it doesn't explicitly tie it to any conditions applied to the entity benefiting from the change. You can bet we will be hearing stories for the next 10 years about well-connected parties having terms renegotiated while the un-connected are left with original terms that force them out of their home into bankruptcy.


(A) limits on compensation that exclude incentives for executive officers of a financial institution to take unnecessary and excessive risks that threaten the value of the financial institution during the period that the Secretary holds an equity position in the financial institution;

The section on Executive compensation for firms involved with assets acquired by the program is a key addition to the updated bailout plan. Unfortunately, the language above is so poorly worded that it might wind up being useless. It should have read:

(A) Limits specified in both percentage terms and dollar values shall be applied to all executive compensation including options, deferred compensation and performance based bonuses to prevent undue risks from being taken by firms while the Secretary owns or insures assets originated by the firms.


SEC. 112. COORDINATION WITH FOREIGN AUTHORITIES AND CENTRAL BANKS. The Secretary shall coordinate, as appropriate, with foreign financial authorities and central banks to work toward the establishment of similar programs by such authorities and central banks. To the extent that such foreign financial authorities or banks hold troubled assets as a result of extending financing to financial institutions that have failed or defaulted on such financing, such troubled assets qualify for purchase under section 101.

The Secretary will encourage the central banks of foreign countries to create similar boondoggles, but, in the event they demur, the Secretary shall have the authority to buy up their trash as well under the assumption it will aid stabilization for foreign banks doing significant business in the US.


(E) EXERCISE PRICE.—The exercise price for any warrant issued pursuant to this subsection shall be set by the Secretary, in the interest of the taxpayers.

This clause is included in the conditions on how the Secretary will act to acquire and later sell any senior debt positions or warrants in firms requiring assistance. The phrase in the interest of the taxpayers or phrases like it are scattered throughout the document. Unfortunately, most have exactly the same amount of detail to describe the "interest of the taxpayer" as that shown here. NONE. Without reference to specific formulas or existing publicly understood methods for valuation, these clauses all leave open the possibility (likelihood?) of corruption by the Secretary setting an artificially low value to be paid back, allowing troubled firms to enjoy more of the upside if they turn-around without paying back the dollars that took taxpayers to the low point of the firm's meltdown.


(b) DISCLOSURE.—For each type of financial institutions that is authorized to use the program established under this Act, the Secretary shall determine whether the public disclosure required for such financial institutions with respect to off-balance sheet transactions, derivatives instruments, contingent liabilities, and similar sources of potential exposure is adequate to provide to the public sufficient information as to the true financial position of the institutions. If such disclosure is not adequate for that purpose, the Secretary shall make recommendations for additional disclosure requirements to the relevant regulators.

If, upon reviewing the books of an institution requesting assistance under the program, the Secretary cannot make heads or tails of said books for the purposes of supporting an arm's length valuation of assets to be acquired, the Secretary shall make recommendations to appropriate regulatory agencies for additional disclosures. What this should say is that if the firm's books cannot support any reasonable determination of the value of the assets being acquired, the firm shall be required to suspend quarterly SEC filings and review / restate earnings for prior quarters appropriately before any assistance will be provided. There is no justification in allowing the firm to continue filing quarterly earnings reports pretending all is well when a floor cannot be found for assets requiring taxpayer assistance.


(c) FAST TRACK CONSIDERATION
(1) IN GENERAL --
(2) CONTENTS OF RESOLUTION --
(3) REFERRAL TO COMMITTEE --
(4) DISCHARGE OF COMMITTEE --
(5) FLOOR CONSIDERATION --


The new version of the bailout defines the requirements for the "magic resolution" which must be approved by Congress to essentially halt the program in its tracks if the Congress decides it doesn't like the results of the program after reviewing the many reports its operators are required to produce. These sections define a variety of parliamentary rules which must be satisfied in the House or Senate (whichever body initiates the resolution). It isn't clear whether these terms were added by House or Senate members. I'm sure proponents claimed these were required so that any public concern by Congress about the continuance of the program would be (relatively) quickly resolved to avoid spooking markets. However, the inclusion of such arcane parliamentary rules to control a bill's future fate within the bill itself seems very odd.

(1) ANNUAL AUDIT.—The TARP shall annually prepare and issue to the appropriate committees of Congress and the public audited financial statements prepared in accordance with generally accepted accounting principles, and the Comptroller General shall annually audit such statements in accordance with generally accepted auditing standards.

This might be the funniest clause in the entire text of the plan. Exactly HOW is the auditing of ANY of this program going to comply with Generally Accepted Accounting Principles? If GAAP had applied, these firms would have figured out five years ago that these financial instruments should have been avoided. If GAAP were applied right now, many of these assets would be marked down to zero since, by definition, we are IN this predicament because the market for these securities has completely disappeared. If no market exists to assign a value for an asset you hold, the only legitimate value to impute is ZERO.

SEC. 132. SUSPENSION OF MARK-TO-MARKET ACCOUNTING.
(a) AUTHORITY.—The Securities and Exchange Commission shall have the authority under securities laws (as such term is defined under section 3(a)(47) of the Securities Exchange Act of 1934 (15 U.S.C. 78c(a)(47)) to suspend, by rule, regulation, or order, the application of Statement Number 157 of the Financial Accounting Standards Board for any issuer (as such term is defined in section 3(a)(8) of such Act) or with respect to any class or category of transaction if the Commission determines that is necessary or appropriate in the public interest and is consistent with the protection of investors.


This will make producing those annual audits according to GAAP principles much easier -- by simply invoking superpower privileges to waive normal mark-to-market accounting rules to avoid recognizing reality and ignore the parts of GAAP that prevent the numbers from adding up.

Friday, September 26, 2008

A Guide to Financial Turmoil

DON'T PANIC.

Those were the words on the cover of The Hitch-Hiker's Guide to the Galaxy, a collection of helpful travel tips for the intrepid interstellar traveler described in the comic novels of Douglas Adams.

Maybe a copy of that book should be placed on the desk of the President and every Senator and Representative in Congress. A little panic might have actually been productive about three or four years ago and might have helped apply some brakes to the feedback cycles and fraud that have produced our current situation. As things stand now on September 25, 2008, the vast majority of the damage to be done by 30 years of flawed monetary, regulatory and political processes has already been done -- we just don't know how bad it will be.

Events are unfolding so quickly, reaction times of the Federal Government and Federal Reserve really don't matter. Here are the highlights for just one 36 hour period:

1) 2:35pm EDT 9/24 -- a presidential candidate decided to suspend his campaign to "focus" on the economic crisis (#1)
2) 1:02pm EDT 9/25 -- by a 370-58 vote, the House passed legislation granting $25 billion in relief to automakers (#2)
3) 2:05pm EDT 9/25 -- Congressional leaders announced they thought an accord on a bailout plan had been reached (#3)
4) 5:44pm EDT 9/25 -- Congressional discussions reach an impasse on the bailout plan
5) 9:39pm EDT 9/25 -- Washington Mutual is seized by the FDIC and sold to JPMorgan, a $307 billion collapse (#5)

Think about those events for a second. A seven hundred billion dollar figure has been floated in front of the public for two weeks as the cost of the all-encompassing rescue plan. Theories abound as to how this number came about and why it's being used:

* a patronizing attempt to acclimate Americans to the eventual costs to be announced in stages
* a cynical lie to the sheep who need to hear just enough to be spooked but not enough to revolt
* the players involved flat out don't have a better number

If true, the approach of the first theory makes as much sense as docking a schnauzer's tail one inch at a time -- it really doesn't make it any easier on the schnauzer. The second theory doesn't make sense either because both the Congress and President know the American public doesn't trust either of them already. Anyone paying any attention for the past three years knows the financial players involved know QUITE well that more then $700 billion is at stake -- that number may be off by an order of magnitude.

It really doesn't matter. Just focus on that $700 billion price tag and the cost of today's failure alone. The Washington Mutual collapse is forcing a takeover of a bank supposedly controlling THREE HUNDRED FIVE BILLION DOLLARS in assets by another colossal bank with absolutely ZERO anti-trust review by Congress or the Justice Department. It's worth mentioning that in the "old days", a piddly little $16 billion telecom deal like the purchase of PacTel by SBC generated ONE YEAR of state and federal hearings and haggling between the parties and the Justice department. In contrast, the failure of Washington Mutual triggered a regulatory decision that consumed 43% of the emergency funding total already communicated to the public before any final deal is even official.

The events of September 25, 2008 alone make it clear Congress, the President (ANY President) and the Federal Reserve will NEVER succeed at playing a game of catch-up to panicked world markets. The bogus price tags being thrown are a consequence of the catch-up approach.

It might be more productive for the players to take a deep breath -- quickly -- then convene ALL of the players including the Supreme Court to create a framework for creating a firewall between assets and accounts associated with the "real" economy and those tied to hedge funds, derivatives and junk mortgages. At this point, the broken financial systems in the United States bear an unfortunate resemblance to the broken health care system in the country. In healthcare, we've allowed coverage, delivery and payment systems for catastrophic care to merge with those for routine care, causing the uncontrolled costs of catastrophic care to prevent basic care from being obtained. In banking, dismantling regulations enforcing separation between investment and consumer / retail banking has allowed disasters on the investment side to contaminate the viability of systems providing basic checking and savings for consumers and simple working capital safety for small and medium business.

Why should the Supreme Court be involved? Take a look at Section 8 of the original Paulson plan. It explicitly granted $700 billion of authority under one unelected official and explicitly rejected any congressional or judicial oversight. That is flat out unconstitutional. The issues are too urgent to have incompetent Executive Branch appointees or Congressional members waste time proposing terms which would immediately fail any legal challenge. The market needs to have confidence that once new rules are promulgated, those rules will not only be fair but will stick and not be overturned. Any fixes to these problems will involve complex legal issues so those might as well be identified up front with advice from those that would field the challenges eventually.

What are the priorities this Federal triage team should establish?

1) ensuring confidence in individual checking / savings via the FDIC
2) ensuring protection for working capital accounts for small/medium business (even above $100k) to protect payrolls and routine payments to other businesses / creditors
3) recovery of bonuses / stock options / pensions from execs of bailed out firms
4) establishment of inflation-adjusted dollar limits AND calendar limits for any relief provided to ensure this bailout program cannot morph into the next Fannie / Freddie monstrosity
5) increased funding of the Congressional Budget Office to support dedicated auditing of all programs launched as part of the bailout spending
6) establishment and funding of a dedicated court system to speed prosecution of related criminal cases and resolution of civil / regulatory debates about ownership, creditor pecking orders and dozens of other issues likely to arise from untangling the blizzard of paperwork produced by securitization
7) initiating reviews of "circuit breaker" mechanisms in stock markets (domestic and foreign) to ensure they can halt panics without interfering with fluctuations crucial to establishing transparent pricing

This crisis wasn't created in a day and cannot be solved with a single Congressional all nighter. It will continue to unravel for years. World markets might gain a higher degree of confidence in the path forward and be less likely to contribute to additional collapse if the effort conveyed any sense of prioritization and strategy -- preferably strategies which interacted with each other to produce positive synergies instead of placating one constituency at the expense of another. The current panic-stricken problem solving is only magnifying the sense of favoritism and unfairness seen by individuals and increasing uncertainty in world markets by seeding doubt about American companies and assets and our underlying currency.


=======================

#1) http://www.bloomberg.com/apps/news?pid=20601087&sid=abvT79Aou2Pw

#2) http://www.thestreet.com/story/10439329/1/house-authorizes-25-billion-in-loans-to-auto-industry.html

#3)
http://www.canadianbusiness.com/markets/headline_news/article.jsp?content=b092588A

#4) http://www.latimes.com/news/nationworld/washingtondc/la-fi-bailout26-2008sep26,0,32401.story

#5) http://www.latimes.com/business/la-fi-wamu26-2008sep26,1,7648045.story

Sunday, September 21, 2008

Nobody Knows What They Own

Michael Bloomberg appeared on Meet the Press on September 21, 2008 for an interview segment after Treasury Secretary Henry Paulson. During a portion of the discussion, he summarized the key problem that will prevent this crisis from being solved overnight:

Nobody knows what they own.

The chop-shop securitization process creates such a puree of ownership and a blizzard of paperwork that it fundamentally eliminates any transparency that allows any would-be investor / rescuer from making an informed decision about the upside of any assets owned by a firm in trouble. If a firm is caught short holding $20 billion in mortage backed securities, there's no way for an outside party to take the paper for that $20 billion and trace it back to actual HOMES and actual BORROWERS. As a result, it is impossible for an outside party to make their own determination about the credit worthiness of the borrower and the residual value of the asset so they can produce their own conclusion about how much they should pay to acquire the asset.

So if it's impossible for outside parties to untangle the blizzard of paperwork and create sound valuations for these securities, how was it possible for the bankrupt institutions' auditors?

It wasn't.

Yet bond ratings were dutifully produced (all AAA of course). Yearly audits were produced by accounting firms and handsome fees collected for producing those audits. CEOs and CFOs signed off on those audits and misled their investors quarter after quarter. Where are the criminal charges?

The more important point now is that nothing being proposed with the bailout changes any of this. In the best of all scenarios, the government and taxpayers have assumed the roll of holding pen for any (ANY) suspect debt in the financial and housing sectors (autos may be yet to come...) while waiting YEARS for the economy to eventually improve to put these assets back into the black when prices stabilize then begin gaining again. The problem is any assets tied to overbuilt housing stock will be DETERIORATING assets as houses sit vacant and subject to people breaking in and removing all the copper pipe and wiring (it's already happening all over the country) or just vandalizing the house for the fun of it.

In short, we, the new "investors" in this Ponzi scheme, still have no way of knowing exactly which pigs in the poke we've "acquired" but it is very clear many of the assets dropped on our balance sheet will NEVER be worth more than they are right now, whatever that is.

The final irony of the bailout plan is that it proposes to dispense of the securities dumped on the Treasury by chopping them into small portfolios ($50 billion -- a "small portfolio") and handing those portfolios BACK to investment managers from Wall Street to manage. The official party line is that this is the GENIUS of the program because the federal government won't have to actually OWN the underlying housing assets, making the liquidation process faster. Of course, who ARE these portfolio managers? The same managers who devised the entire securitization scheme in the first place so they could make money via a computerized game of musical chairs -- pushing securities to the next sucker and collecting a fee for their effort -- instead of being real bankers and making real decisions about credit worthiness, ability to pay, and actual asset values.

Sunday, September 14, 2008

Portfolio Strategy in a Global Down Draft

The number and size of the recent failures in the financial industry (from Bear Stearns, IndyMac, Fannie and Freddie and now, apparently, Lehman Brothers and Merrill Lynch) are causing millions of investors to review their investments and try to find a way to protect their assets from future turmoil and losses. A lot of the thinking likely began during the first credit freeze-up in August of 2007 but the worldwide nature of the problem requires rethinking many truisms of portfolio management that might have been useful in the past but may have limited value in the current situation.

A Triangle Model of Investments

Traditional strategies for investing are based upon long-observed patterns of performance with assets in three key categories. Each category can exhibit movement (and hence, provide opportunity for making / losing money) independently of what happens in the others but they also frequently move in patterns related to each other which have encouraged certain strategies by investors based upon their goals (growth versus safety) and horizon (long term versus near term).

Stocks -- Investments in stocks are based upon obtaining mid- to long-term gains in the price of the stocks based upon long term growth in a company's earnings or based upon speculation of short-term mistakes in other investors' current valuation of the company. The truism with stocks is that over a long term period (NOT just one or two business cycles), a well-diversified portfolio managed to proactively cull out losers will outperform virtually any other category of investment. Another truism is that stocks should be avoided by investors with capital preservation goals over a short time horizon, especially when economic growth slows or declines outright since slow/no growth cuts earnings and drives stock prices down.

Bonds -- Investments in bonds produce profit directly for the bondholder by interest paid back to the bondholder by the issuer at maturity. Because the actual value of promises of future, fixed payments of principle and interest are DIRECTLY dependent upon changes in real (or imagined) interest rates, the price of bonds at any given moment not only reflect the credit worthiness of the borrower but reflect larger estimates of changes in interest rates over the life of the bonds. One key truism with bonds is that accurately rated bonds pose significantly less risk over short periods than stocks and are therefore a more suitable investment vehicle for investors with short term horizons whose tolerance for risk is lower than those investing with a 15-20 year horizon.

Commodities -- Commodities act as the raw materials to higher level products and services and provide two avenues by which investors can profit. By their nature, many commodities such as wheat, rice, pork bellies, oil, natural gas, etc. can have regular, seasonal fluctuations in their supply, demand or both, requiring producers and consumers to constantly make bets on those numbers and their impact on their ability to fill next week's orders of widgets. This short term speculation is virtually required in a modern economy and has profit potential for those with nerves of steel. Because of commodities' perceived role as required inputs for an economy (albeit with some seasonal fluctuation), investors often use commodity investments as a hedge against currency concerns. The idea behind this is that no matter what a government may do to devalue its currency through monetary policy, a barrel of oil or a bushel of wheat is "worth" what we get out of a barrel of oil or bushel of wheat and therefore, in theory, if a currency declines in value by half, any commodity position denominated in that currency will double, protecting the investment. The key truism for commodities is that overall demand for commodities may fluctuate week to week or month to month but is predictable and steady over many months / years. In other words, demand for commodities is nearly independent of the long term performance of one or both of the other investment categories.


Trade-offs In the Triangle

Much of the established wisdom of portfolio management for individuals and institutions revolves around correctly understanding why each of these corners of the triangle traditionally behaves the way it does and how problems with one corner affect the other two. For example,

1) fears in the stock market will lead many short-term investors to shift funds to lower-yield but higher-safety bonds, raising prices in the bond market, lowering interest rates
2) fears of weak economic growth or actual reductions in economic output often lead the Federal Reserve to lower interest rates to reduce the cost of borrowing to spur the economy, raising bond prices
3) signs of stable earnings growth increase valuations on stocks, attracting more investors into stocks and lowering demand for bonds, reducing their price and causing borrowers who DO need to borrow money to pay higher interest rates to attract lenders
4) volatility in credit markets combined with weak growth or losses in equities can trigger increases in commodities prices as investors assume steady demand for commodities will protect against currency declines resulting from inflation

The obvious assumption behind this financial triangle concept is that the primary source of uncertainty in the system is the inability of the players involved to correctly forecast performance of the system down to the nearest billion (mere rounding errors in a multi-trillion economy) in the immediate term. These short term errors cause the system to go through the normal undershoot / overshoot oscillations of the business cycle but they are systematically identified by properly functioning accounting and risk management systems and acted upon. The events since August 2007 prove this assumption is absolutely no longer holding true. Banks have been caught holding commercial paper rated AAA until the day they sold at 25 percent of face value. Banks not even on the FDIC watch list have capsized and disappeared under the water with little notice.

The larger but more subtle problem with the triangle model is the assumption that at least one investment segment -- equities, bonds or commodities --- would retain a negative correlation to the others and provide a mechanism for hedging risk due to financial / monetary problems within an economy is likely untrue. The theory doesn't account for a global economy in which systemic failures in one economy produce systemic failures in other economies at the same time. Global trade requires currencies in different economies to become a commodity for other economies to facilitate trade OR requires many economies to consciously hold a subset of currencies as a de facto world currency for transactions.

Regardless of which approach is chosen, either one immediately links the "triangles" at not only the commodity corner but the bond / credit corner as well. If a systemic problem is encountered in the bond / credit sector of one of the economies, it can immediately affect the bond / credit sector of other economies. That in turn violates the assumption of larger world markets for commodities remaining stable / predictable over the long term as economic growth in multiple economies slows due to "contagion" in the financial sector. The net result is that the interconnected financial markets create POSITIVE correlations between all three corners of a particular economy and can create POSITIVE correlations BETWEEN economies. This might be good when things are going well in the short term but poses tremendous concerns when trouble arises.

Stated in the simplest terms, the triangle concept works as long as at least ONE corner of the triangle has a strong negative correlation to the performance of the other two corners. If the stocks and bonds corners are performing poorly, an investor can still shift money to commodities and ride that up as the other two corners go down until they stabilize. If larger problems crop up in all the triangles and reduce economic growth and demand for commodities, suddenly ALL THREE corners have a positive correlation to each other, leaving investors with no where to flee to protect their investments.

The concern facing all investors now is that this is precisely the situation we face. Gross mismanagement and outright fraud in the American housing market and financial industry have propagated trillions of dollars worth of bad debt to banks throughout the world. Any economy in the global system that attempts to shun more of the bad paper at the root of the problem will trigger a collapse in its local credit markets which already carry vast amounts of that bad paper. Any such credit meltdown will likely shrink economic output, weakening its equities and reduce demand for commodities, further increasing the positive correlation in all of the economic triangles.

So what's the best strategy for protecting one's portfolio? In a global economy linked by credit systems which have poisoned the fiat money of nearly all the players at the same time, it isn't clear there IS a winning strategy. The only way to win is to not play and that option doesn't exist.

Thursday, September 11, 2008

Too Big to Succeed?

Turmoil in the financial markets has produced a great deal of conversation among politicians, financial execs and the media about causes and solutions for the current problems. Most Americans are still tuning out the discussion but for those following the discussion, one can't avoid seeing a rather disconcerting blind spot in all of the strategies formulated by the Treasury and Fed to contain the damage and in the media's explanation of events.

All of the discussions about the impact of the latest bailout (whether it's Bear Stearns in March, the GSEs in September or ________) bring up the question "too big to fail?" Of course, the answer keeps coming up "yes" which means the solution keeps coming up "bailout" or "shotgun wedding with someone still showing profits".

Of course, this shell game prevents a major corporation from reaching outright bankruptcy in public which avoids spooking the herd in the very near term. The problem is that it continues the consolidation of decision making into fewer and larger surviving firms. The group think arising from 10-20 big banks all trying to out-do each other on an unproven business model is exactly what PRODUCED this problem in the first place.

The question everyone should be asking is "are these institutions too big to succeed?" The back-office efficiencies of collapsing 10 regional banks into one megabank are far outweighed by the risk of a few really greedy / dumb strategists in that one megabank making a really bad bet and tanking a megabank. This isn't theoretical or political philosophy. It's been demonstrated repeatedly as the banks have grown larger and as regulation has been weakened for 30 years.

For the moment, some of these banks playing the "savior" role may think they're picking up assets at fire-sale prices while taking advantage of back-office deals to dump the bad loans on the Treasury. That may appear to be true but they are still growing in size and doing little to eliminate the trouble-prone lines of business.

The September 15 issue of Fortune has a cover story (#1) on Jamie Dimon and his merry band of men/women who managed to keep JP Morgan out of the sub-prime mess. The story identifies a few key factors that led Dimon to avoid the segment despite the temptation of short term profits made by rivals:

1) Dimon's management style is very critical from a logic sense -- they actively look for numbers that reflect problems across their lines of business and ACT upon them
2) unlike many big banks, JMP operated an internal mortgage payment processing unit that began noticing increases in late payments on sub-primes in late 2006
3) Dimon also noticed that despite continued AAA ratings on virtually any sub-prime paper issued (implying high quality), the cost of credit default swaps (essentially insurance against defaults on collateralized debt obligations) was skyrocketing (if the risk is so small, why is the cost of protection skyrocketing?)

At first, the overall tone of the story can leave one with the impression that the megabank model CAN work, you just need the right level-headed, brilliant guy at the top who can pay attention, read the tea leaves and avoid "obvious", colossal mistakes. However, the story is about ONE BANK which managed to avoid a disastrous strategy. Clearly, the presence of level-headed, brilliant executives at the top of American mega-banks is not the norm but the exception. So why are we encouraging continued concentration in the industry at a time when the fruits (or lack thereof) of this strategy are becoming obvious?


===========================

#1) http://money.cnn.com/2008/08/29/news/companies/tully_jpmorgan.fortune/index.htm

Sunday, September 07, 2008

McCain on the Fannie / Freddie Bailout

On the September 7, 2008 edition of Face the Nation, Senator John McCain made the following comment about the forthcoming Treasury intervention at Fannie Mae and Freddie Mac (loosely paraphrased):

I’ve talked with Treasury Secretary Paulson and the deal is structured so that when housing recovers, and it will, the American taxpayer will be the first to be paid off.

This indicates a lack of understanding of how the securitization process works. When a retail loan is sold by the originating lender, the originating lender gets their money in its entirety and they no longer have any exposure to a default from the borrower. When Fannie or Freddie buy that loan and manage to resell it to yet another party, they too no longer have any exposure to a loss if the borrower defaults. The risk lies only with those mortgages Fannie and Freddie have “in inventory” awaiting resell or those they choose to keep in their portfolio.

The impact is easier to follow with a specific example. Start with a mortgage issued for a home originally sold in 2006 in California for $500,000 with a $450,000 mortgage (10 percent down) with interest-only balloon terms increasing the payments in 2008. Assume the loan itself was resold to Fannie or Freddie between 2006 and 2008 and is still sitting in their “inventory” and now the borrower has defaulted on the loan and cannot make the higher payments. Also assume the house itself is now worth only $400,000, below the mortgage amount. In this example at the time of the default:

* the original lender is “whole” and lost no money and WILL lose no money
* the borrower cannot afford the house unless terms are renegotiated by the current note holder (Fannie or Freddie)
* the current loss on the mortgage is $50,000 (difference between the note and current home value) since the interest-only note paid down no principle
* if the house is sold to another party, THAT party cannot be forced to borrow from Fannie or Freddie to help them make up their losses on the current borrower

The key point is that once a loss on a loan is recognized, that loss hits the books of Fannie or Freddie. A future mortgage on the home involved with that loss is originated at the retail level to the new borrower – Fannie and Freddie are not retail lenders. If that mortgage isn’t resold to Fannie or Freddie, then future profits from that subsequent mortgage won’t flow to Fannie or Freddie. As a result, any restructuring plan for Fannie and Freddie cannot “guarantee” taxpayers that future profits when prices recover will make up interim losses suffered absorbing current defaults. If Fannie and Freddie cannot more accurately reflect the provenance of mortgages they are reselling to identify those in geographic markets that are underwater or at higher risk for default, investors will simply shun ALL of their MBS offerings, further tanking the market. If they adequately disclose the quality of loans within their MBS offerings, investors will simply shun those tied to the riskiest markets, sticking Fannie and Freddie with the junk, keeping the losses isolated to Fannie and Freddie and, hence, US taxpayers.

If the bailout plan for Fannie and Freddie simply involves providing Treasury backup for the solvency of the entities’ books, then there is NO WAY the plan can allow US taxpayers to be made whole in the long term as the market recovers. The losses will stick with the entities (and taxpayers) and the profits from mortgages to future borrowers will flow to the final note holders. Such a plan would only serve to hopefully keep the problem from getting worse via further liquidity problems but will do NOTHING to eliminate losses absorbed by taxpayers. If the bailout plan requires Fannie and Freddie to surrender all profits back to the government until losses are repaid, they will have a very difficult time reorganizing themselves and attracting new outside capital, further deepening their dependency on taxpayers. If the bailout for Fannie and Freddie allows the new government conservators to waive the rules of accounting and NOT mark the value of defaulted mortgages to market and defer recognition of the losses, we have a much more critical legal and financial problem.

None of the solutions for the problem are attractive and none are likely to protect us from a further meltdown without protecting many guilty parties in the financial industry and allowing them to keep the profits from this colossal fraud. However, it’s disconcerting to see a reform-minded Presidential candidate claiming the deal will (eventually) make taxpayers whole and confirming a critical lack of understanding about the basics of a trillion dollar problem he would inherit if elected.

Saturday, September 06, 2008

Hurricanes Fannie and Freddie

Rumours are leaking out now that the financial books of Freddie Mac and Fannie Mae will be completely restructured and the Treasury (that's YOU AND ME folks) will be backing their bad paper. The two entities carry a total of FIVE TRILLION DOLLARS in mortgage paper. How many bad mortgages are out there waiting to implode in that $5 trillion? A few facts:

* Freddie and Fannie traditionally resold about 50% of conforming mortgages
* in the past two years, they have absorbed nearly 70% of mortgages retailed to borrowers
* it is safe to assume EVERY home purchased in Florida and California for the past two
years is probably "under water" due to falling real-estate prices -- probably by 10-20 percent
* the total estimated exposure at Freddie and Fannie to subprime loans is $717 BILLION

The real number is probably much worse than $717 billion, though. That number doesn't count CONFORMING loans of people who legitimately COULD afford their house when they bought it but wound up getting screwed because they bought during a bubble, will lose money if they have to sell their home (if they can sell it at all in a down market glutted with inventory) and don't have the cash cushion to make payments if they lose their job. It also doesn't reflect the additional billions that will be spend by the FDIC covering failed banks as the downdraft caused by this announcement tanks other investments, exposes other frauds and renders more banks insolvent. The number is easily at least one trillion.

ONE TRILLION DOLLARS of our money bailing out Wall Street firms who profited tremendously and lavished hundreds of millions of dollars in bonuses to executives over the last six years for dumping bad loans on pseudo-independent government agencies set up to be the sucker in a vast ponzi scheme fraud.

Think of what the rest of the world holding US Treasury bills is going to think about the safety of our currency for their investment when they watch another trillion dollars instantly hit the liabilities of America, Inc. with no offsetting assets. Do we HAVE another TRILLION dollars laying around somewhere? No. Are Americans able to pay another TRILLION in taxes? Hell no.

A TRILLION dollars is another Iraq war hitting the books. Like the Iraq war, it's a giant debt load applied to a country already teetering near insolvency and like the Iraq war, it's an additional debt added with absolutely nothing to show for it. Except maybe abandoned McMansion subdivisions. Leave it to America to come up with a way to produce ghost towns equipped with Jacuzzis, "wrapping rooms" and Viking ranges.

Tuesday, September 02, 2008

Are You Experienced?

Everyone cites concerns over "experience" as a motivation for supporting their candidate and denigrating the other guy (or gal). It might be more enlightening to talk about experience in general terms and how different types of experience might or might not apply to high office. Where should the next President come from? If the Oval Office is "the show", what serves as AAA ball for up and coming political talent? What experiences SHOULD serve as qualifications for the Presidency?


State Government

Party pros and voters alike often view a governorship as an obvious launch pad for any potential Presidential bid. The thought is that state governor roles are like a "mini-Presidency", with a state House, state Senate and state Supreme Court to deal with, just like the "real thing." Even better, many states have clauses in their Constitution REQUIRING balanced budgets so many think that governors have a better grasp of what it takes to make "tough decisions" and hold down spending. The theory sounds good but reality is quite different.

In reality, the balance of power between the governor and other branches of state government varies between states. Texas is a classic example of a "weak governor" state. Most of the executives in the "Executive Branch" are elected, not appointed by the Governor. (#1) The balanced budget requirement also warrants careful review. A state constitution requiring balanced budgets just makes it easier for the governor to say "no" when spending maxes out revenues. It does NOT ensure tradeoffs made to meet a balanced budget have any sense of logic or coherence to them or that the governor can break an impasse with an intransigent legislature (This is ostensibly why California Governor Schwarzenegger won't be attending the GOP convention.) State-level balanced budget amendments certainly do not guarantee any such governor will exhibit the same budgetary willpower when placed into an environment where balanced budgets are NOT required and the government can influence monetary policy and, to some extent, cook its own books by altering economic statistics.

Another common suggestion of governorships being good training for the Presidency is the exposure to military issues via command of state National Guard troops. In a word, NO. Federal use of state Guard forces and resources has trumped local / regional use any time contention has arisen. State governors make no strategic decisions on development of new weapons systems and have little veto power over tactical questions regarding the deployment of state forces as backfill for overseas full-time forces. In essence, a governor's interaction with National Guard troops may provide "training wheels" experience in managing FEMA ($5.8 billion out of $46 billion in DHS -- see #2 and #3) but is in no way a useful introduction to global military strategy or Defense Department administration ($481 billion for the Pentagon for 2008 --- see #4).


The Boardroom

If we're looking for a "CEO" for the country, what better place to look than the boardrooms of Corporate America for a real CEO? This approach seems to arise from a relatively recent belief over the last twenty years that government doesn't work because it isn't run like a modern, efficient business. If we could only get someone who knows what it's like to make a payroll, to comply with millions of pages of government regulation and make constant make-or-break decisions, government could become much leaner and more efficient. There are NUMEROUS obvious flaws with this belief. Exhibits A and B would be the lists of American automakers and financial firms teetering on the brink of bankruptcy (and threatening to capsize the entire economy with them) because of flawed short-term thinking, gross mismanagement and outright fraud.

The more subtle problem with the boardroom as training ground is that the dynamics of power and persuasion within a private or public company are vastly different than in government. Persuasion and personality obviously play a key role in climbing the corporate ladder and operating as CEO on a daily basis. However, when key decisions come up, CEOs typically have the final say and don't have to spend much time smoothing ruffled feathers. Presidents have similar power within the Executive branch with personnel and administrative interpretation of laws and enforcement but the analogy ends there. CEOs don't have to contend with other independent branches of their firm that have subpoena power over their actions. CEOs are free to change the direction of the company (within reason) without daily consultation with stockholders. Presidents cannot change laws and change the direction of the country absent positive action from Congress.


House / Senate Experience

Veterans of the House or Senate often cite a track record of constituent friendly legislation as proof they can "get things done" and that they "understand the real problems" of voters. Given the dependency upon the Legislative branch to initiate new laws, experience in the House or Senate is arguably the single most useful experience to bring into the Presidency. Failing to understand the egos at the other end of Pennsylvania Avenue and the trade-offs and compromises Senators and Representatives must make in the course of their work is almost a certain guarantee of failure as President. However, having legislative experience alone is not sufficient background for the Presidency. (See next section.)


The Insider / Outsider Debate

Widespread corruption in Washington has led many across the political spectrum to throw up their hands and claim that the only way to clean up corruption INSIDE the beltway is to get someone from OUTSIDE the beltway inside the belly of the beast to attack corruption. Think of this as the "Mr. or Ms. Smith Goes to Washington" approach. It should only take two words to refute this theory.

Jimmy Carter.

Above all, the Carter Administration was noted for the inability of Jimmy Carter and his staff to establish any sort of working relationship with Congress. As Governor of Georgia, Carter had no long term relationships with players at the national level and everyone in his Rolodex he felt comfortable including in his Administration had equally limited contacts with the established players in the Legislative branch, including within his own party.

Obviously, long-time insiders have problems on the opposite side of the spectrum. Continued exposure to flawed or corrupt processes makes it difficult to break with contributors and do something "outside the box." Players with a long legislative background operating inside a flawed system will inevitably have dozens of votes on flawed legislation that can be pulled out the closet to combat any attempt to make positive changes.


Intelligence Versus People Skills

Is a really smart person ideally suited for the Presidency? No. Is a really good "people person" ideally suited for the Presidency? No. Effective leadership requires different skills at different times. If you're sitting in a Cabinet meeting as subordinates put secret Executive Orders legalizing waterboarding, illegal wire taps, extraordinary rendition, and the creation of a third state of existence outside US and international law, you need to be a really smart person with some formal background in the basics of the Constitution, the law, and legal precedent. You're holding the pen, you have to make the right decision. If you're huddling with leaders of the House and Senate trying to resolve a deadlock on legislation involving entitlement spending that can bankrupt the country if left unchecked, you need people skills to find areas of compromise, frame a solution as a win-win scenario and lead people to consensus. A modern term for this balance is "emotional intelligence". Either skill without the other will inevitably limit a President and harm the country.


Is Anyone Truly Ready Day One?

Stop and think back to the inauguration photo and last day photo of any President over the past 60 years. Think about the stress levels that produced those changes in appearance while in office. Now think about what happens as a new President takes office. There's the obvious handover of the codes in the nuclear "suitcase" (or whatever its current non-hot Cold War equivalent might be). What's less obvious about that Day One experience is that first REAL security briefing for the new President. Presidents-elect immediately begin receiving more detailed security briefings as they begin forming their transition team. However, it is clear there are some things you aren't told until after taking the oath. Think of it as an inventory of all the "skunk works" projects underway in the name of We The People known by only an handful of people.

Until the new President hears THAT list of items in mid-flight, no would-be President truly can say they fully grasp the responsibility they are assuming. That first post-inauguration security briefing is likely where many Presidents first realize the true constraints imposed by reality on what they will be able to accomplish and start grasping the promises they made as a candidate that will go unfulfilled as President.


What the Present Tells Us About the Future

There seem to be people in both the Republican and Democratic parties who are either unhappy about their own party's choice for President or Vice President or amused at their opposing party's choice of the same, all based upon experience. If you are concerned that a Presidential candidate or a VP candidate could seemingly come from nowhere without proving themselves on the national stage first, think about the functions the parties should be performing but are not.

In the August 2008 primaries in my state, one candidate mailed a series of post cards stating their vow to NEVER, under ANY CIRCUMSTANCE, vote to raise taxes.

REALLY?

Never? Even if an F5 tornado leveled a local high school to the foundation? Even if an earthquake struck, destroying hundreds of miles of county and state roads?

I don't think these inappropriately doctrinal stances by local politicians are uncommon. The economics of being involved at politics at the local and state level make it difficult for large numbers of "average Americans" to participate. How many people want to spend their evenings listening to arguments over zoning for a new car dealership in their city or county council for paltry pay? There are surely quite a few good citizens who are attempting to do what's best for all of the citizens of their local community. However, the local political environment also attracts extremists of both parties trying to push agendas that have nothing to do with local government. It also attracts people with major conflicts of interest in those zoning laws that bore most of us to tears but are near and dear to big box retailers looking for TIF handouts and subsidized road improvements for their investments.

If national elected positions serve as triple A ball for the White House, then local and state offices act as farm team development for those national offices. Because the issues and roles are so different between the local / state level and Federal level, there isn't a predictable, obvious "career path" for someone seeking national office or the Presidency that will reliably confirm the candidate is ready for "the show". That means We The People have to pay more attention, ignore the labels the candidates hang on themselves or their opponents, and THINK.

At this point, that seems like a mighty tall order.

==============================

#1) http://en.wikipedia.org/wiki/Government_of_Texas

#2) http://www.fema.gov/news/newsrelease.fema?id=34749

#3) http://www.dhs.gov/xabout/budget/gc_1170878892732.shtm

#4) http://www.whitehouse.gov/omb/budget/fy2008/defense.html