Sentient Money

We get this bailout.  Luckily people are actually calling their Senators and Representatives and telling them in no uncertain terms they do not want it.  Finally!  Congress is making the correct decision by not voting for it.

Why is this a good decision? Let us take a look:

• There is no way we, or Congress, know all of the details in a $700 billion package put together over a few days. It just is not possible. Something of this size is far too complicated to rush into. If we do rush in we might create more problems than we fix over the long-term. Let us take our time and figure this out.
• The companies who made these decisions need to be punished. This should not be mistaken for revenge, as it is the idea of capitalism. People do not learn unless they feel the pain. These companies need to feel the pain and some of them need to fail. Don’t worry, there will be plenty of new banks to replace them, as there is still capital, but it doesn’t know where to go. How can it, when we won’t let the situation correct itself.
• DO NOT let Wall Street manage the $700 billion the government is giving them! The current plan calls for the same people who got us in this mess to manage the solution. Really?!! Bill Gross, the head of Pimco (huge bond/mortgage backed security investor), volunteered to have his firm manage a huge portion of this for free. Why? Because, Paulson bailed out his firm to the tune of $1.7 billion when the government decided to treat Freddie and Fannie like U.S. Treasuries, and guaranteed those agencies’ bonds.
• Prosecute those executives responsible, where appropriate, or allow the market to destroy these executives. They need to be eliminated, as they obviously do not have the skill to manage these complex financial companies.
• Compare this bailout and others to regular government expenses…it is massive. If the 2008 costs for Social Security and Medicare were added together it would only be $300 billion more than this one bailout. Essentially, this bailout almost equals the cost of 2 of the 3 most expensive government programs. If this $700 billion bailout is compared to the cost of the Iraq and Afghanistan Wars, which total $186 billion at this point, the wars are a drop in the bucket. This amount of money should not be just given away.  (Graphic below is curtesy of the NYT)

Contact your congressmen and let them know that this should not be passed because of panic.  We all need more time to think this through.

The next possible vote on this package is Thursday, but that isn’t very likely considering the Jewish holidays will allow Congress to go home for a few days. 

Note:  Commerce Bank and Fortis, both European banks, were bailed out today by their governments.

Volatility

This week is out of control.  As a result, there are fascinating new highs and lows, along with some very interesting events.

Stock market volatility is very high right now.  The VIX (see definition at the bottom) measures this volatility and highs in the VIX suggest too many that a bottom could be near.  The following information from the VIX is very interesting (all this information is from Yahoo Finance):

• At this time the VIX is at a high we have not seen for almost 3 years. 
• The VIX has only seen levels higher than the current mark (35.72) twice in the last 18 years. 
  • August 1998 the VIX hit 44.28
  • September 2002 the VIX hit 39.69
• Both, August 1998 and September 2002, signaled distinct lows. 

None of this means we are definitely at a low, as there could be, and probably will be, a little more to come.  However, this suggests we are at least at the beginning of the end if this downturn is similar to the last few.

Buffett

Every piece of business news today will probably be followed with, “Warren Buffett shows confidence in the financial sector by investing $5 billion in Goldman Sachs.”  Per Barry Ritholtz at The Big Picture this is fairly far from the truth due to the very favorable terms Mr. Buffett received:

Let’s look at the details to figure out just how much GS is paying for this capital:

• Goldman Sachs pays a fat dividend to Berkshire Hathaway of 10% on $5 Billion dollars — that’s $500 million per year. And, since this is a preferred, it gets paid out of net income in after tax dollars dollars. Ouch.
• Goldman gets the right to call the preferred at any time at a 10 percent premium. Ouch again.
• Buffett gets $5 billion worth of warrants with a strike price of $115, or about 43.47 million shares. The warrants are good for only 5 years.

If Buffett were to go to the Street earlier today to buy 44 million calls with a $115 strike price (circa 2010), they would have cost him about $1.5 billion dollars. With GS now trading at $135, Buffett’s $5 billion investment is more like $3.5B, in terms of net cost to him. Hence, the 10% interest is more like 14%. 

Doug Kass thinks its an even better deal for Berkshire –  goes further than I do, putting an intrinsic value on the warrants of about $2 billion. That makes Buffet’s net cost $3B — so the effective yield is closer to 17%.  (Ouch)

As you can see, this is a no brainer for Mr. Buffett, as it is unlikely the government will let “THE” investment bank fail during a bailout.  It should also be noted the Treasury Secretary, Hank Paulson, is a former Goldman Sachs alum.

VIX - VIX is the ticker symbol for the Chicago Board Options Exchange Volatility Index, a popular measure of the implied volatility of S&P 500 index options. Referred to by some as the fear index, it represents one measure of the market’s expectation of volatility over the next 30 day period.

Nouriel Roubini (economist at NYU) appears to be the man with his finger on the pulse of this crisis.  He has been way ahead of the curve on many issues:

• Predicting a very bad housing bubble collapse
• Predicting that subprime would not be contained and it would spread through the financial system
• Predicting Freddie and Fannie would get in serious trouble
• Predicting that total credit loses would reach $2 trillion

On most of these he has been so far ahead the curve he has been labeled Dr. Doom. 

His most recent predictions include (http://www.rgemonitor.com/blog/roubini/) :

The next stage will be a run on thousands of highly leveraged hedge funds. After a brief lock-up period, investors in such funds can redeem their investments on a quarterly basis; thus a bank-like run on hedge funds is highly possible. Hundreds of smaller, younger funds that have taken excessive risks with high leverage and are poorly managed may collapse. A massive shake-out of the bloated hedge fund industry is likely in the next two years.

And;

The real economic side of this financial crisis will be a severe US recession. Financial contagion, the strong euro, falling US imports, the bursting of European housing bubbles, high oil prices and a hawkish European Central Bank will lead to a recession in the eurozone, the UK and most advanced economies.

European financial institutions are at risk of sharp losses because of the toxic US securitised products sold to them; the massive increase in leverage following aggressive risk-taking and domestic securitisation; a severe liquidity crunch exacerbated by a dollar shortage and a credit crunch; the bursting of domestic housing bubbles; household and corporate defaults in the recession; losses hidden by regulatory forbearance; the exposure of Swedish, Austrian and Italian banks to the Baltic states, Iceland and southern Europe where housing and credit bubbles financed in foreign currency are leading to hard landings.

Thus the financial crisis of the century will also envelop European financial institutions.

It appears the run on hedge funds has started (Hedge funds suffer mass redemptions, Nick Clark):

Hedge funds could have an unprecedented level of cash pulled out by investors this quarter, according to insiders, just as they faced millions of pounds of losses from last week’s shock regulation of short selling. It has been a tough year for the industry with high-profile funds blowing up, clients increasing redemptions, as well as public fury over short selling and increased threats of regulation.

Is the severe recession far behind?  My bet is no, it is not far behind, as unemployment is rising, housing does not have a chance of coming back any time soon, and an entire sector of the world economy, the shadow finance system, is no done. 

I’m 70% cash right now and I wish I would have went 100% when I moved the money last fall.  I may pick and choose some stocks over the next few months, but I will not be getting into any mutual funds.

I mentioned Nike in my previous post, because they report earnings this week.  Today, Nike announced a share buy back program for roughly 15-20% of the outstanding shares.  The timing of this announcement is very interesting considering how close it is to their earnings announcement.  A bit of good news before a bad announcement?

This market is a mess right now.  It is entirely made up of extremes and there is no way to predict how this will fall over the next week.  Could it continue to go up?  Maybe, but probably not in massive moves like it has done over the past two days.  Could it go down?  Maybe, and the moves could range from small to massive, it is impossible to tell.  A few things to look for:

1. What are the details of the massive bailout planned by the government?  This will go a long way in determining which way the market moves.
2. When will short selling be reinstated (it is banned right now)?  What will happen when it is reinstated?  Could hedge funds and other big investors be waiting to pounce?  Also, some have suggested the recent massive shorts were financial terrorism…literally (per Jim Cramer on The Steet.com).  This is not out of the realm of possibility, as our interconnected world makes it much easier to hide who is trading and where it is coming from.  Plus, don’t be fooled by what all the vaunted leaders of the middle east say, many are terrorist sympathizers, and bankrupting us would mean they win.  It is what I would do, as a terrorist, with access to the trillions of dollars we pump into those countries for oil.  I could go off on a giant tangent here, but I will contain myself.
3. What is the level of panic?  We bottomed this week and then rocketed back up the confidence meter.  Will it stay?
4. Some companies to watch next week, as they report earnings (shame no financial companies are repoting):
   • Nike (After Market Sept. 24) - This will help determine how the consumer sector is doing.  No one buys $100 shoes when the wallet is hurting.
   • RIMM (After Market Sept. 25) - Business and consumer spending on electronics

Obviously, all of the above reasons and more make this market wildly unpredictable, but the one stock I am very interested in is Goldman Sachs.  Per Cramer:

“Goldman has no home equity loans and car loans. Goldman does not have exposure to the parts of the economy that are bad,” he said. “No one’s listening to me that I think Goldman is fine.”

Buying one of the last surviving independent investment banks, which has consistently outperformed it’s peers, on the cheap, is very enticing.

Have a good weekend and forget about all this junk for a while.  I plan on kicking back with a few Konoma Brewing Co. Wailua wheat beers and enjoying some really perfect weather…to each is own.

Every news program has some half-wit finance expert with their own theory of how this all happened (CNBC being one of the most egregious offenders). Most of these theories are only vaguely based in fact and look for someone outside of the financial industry to blame.  Well, I plan on providing a simple explanation of the major factors behind this crisis.

First, I will start with the favorite excuse of the financial pundits…short selling.  This is a very poor reason for the current financial crisis.  Short selling has been around forever and if done legally, a short seller has to find someone who already owns the shares to lend them the shares for the short sale.  The mechanics of this process makes it almost impossible for someone to sink a company with a solid balance sheet.

The one exception is naked short selling, which has been occurring.  This essentially means the short seller is shorting shares he/she has not borrowed from a current owner.  This allows a short seller to build up a short position that is much larger than normal, over a shorter period of time, which can put extra pressure on the company’s stock price.  This pressure by itself is still not enough to sink a quality company, but it might be enough to push a bad company over the edge.

The second and more important reason for this financial calamity is the quality of the financial products owned by these institutions.  This has been covered ad nauseam, so I will just say they (Wall Street) had a lot of really bad loans on their books.

Now we come to the final and most important reason by far, which is excessive leverage (poor management).  All banks/financial institutions are required to have a certain ratio of debt-to-net capital.  This keeps risk in check and prevents a major economic catastrophe, like bad mortgages, from destroying our financial institutions. 

Here is an excerpt from the Big Picture (Barry Ritholtz), who is also quoting Julie Satow from the NY Sun:

As we learn this morning from Julie Satow of the NY Sun, special exemptions from the SEC are in large part responsible for the huge build up in financial sector leverage — and the current massive unwind.

Satow interviews the above quoted former SEC director, and he spits out the blunt truth: The current excess leverage now unwinding was the result of a purposeful SEC exemption given to five firms. The SEC allowed these firms to legally violate existing net capital rules that require broker dealers limit their debt-to-net capital ratio to 12-to-1.

Instead, they levered up 30 and even 40 to 1.

Almost 3 times more leverage than what is considered safe.  This is not surprising at all given the extreme profitability of these firms over the past few years.  They used this extra leverage to make enormous sums of money, but in the end it appears to have been too risky. 

Now let’s take a look at who was given this special exemption (quoted from the Big Picture):

1. Bear Stearns (failed and bought) - Big surprise here.  Who would have thought the first major financial house to go under was doing something foolish.
2. Merrill Lynch (failed and bought) - Wow!  Another surprise.
3. Lehman Brothers (bankrupt) - This is just the most unlucky industry on the face of the planet!
4. Morgan Stanley - How shaky is Morgan?
5. Goldman Sachs - Is it possible the New England Patriots of Wall Street have a flaw?

Ignore most of the talking heads and all the fools from congress, and focus on what actually happened, which was the DESTRUCTION of REASON on Wall Street by the financial firms and the SEC/Fed/Treasury.  However, they cannot shoulder all the blame, as this DESTRUCTION of REASON was carried over from Main Street.  We have to carry some of the blame as we allowed reason to be destroyed in the public sphere way before it was destroyed on Wall Street. 

Platoon

Chris Taylor: Somebody once wrote: “Hell is the impossibility of reason.” That’s what this place feels like. Hell.

Yes, the title is a little over the top, but her recent comments on Larry King Live show how little she knows about the markets and economics

Larry King: A few months ago, you said on this very show that you would be worried if there was another big government bailout. It’s now happening. Should the government be helping AIG?

Suze Orman: Well, in this particular case, I have to tell you they should. Bear Stearns, very different. Lehman, very different. AIG is an international giant that just doesn’t have ramifications here in the United States. It is worldwide. They’re like in 130 countries. They have 100,000 employees. Everybody has an AIG insurance policy. So in this particular case, my opinion, thank God, they bailed out AIG.

Per Orman there are three main reasons why AIG should be saved, but they are less than compelling:

1. International giant/130 countries - Who cares?  If it would have just hurt the U.S. then letting AIG fail would have been fine? 
2. 100,000 employees losing their jobs - Not all of the 100,000 people would lose their jobs, as much of AIG would have been broken up and sold off.  In the worst case this would have caused 50,000 or so to lose their jobs.  People lose their jobs all the time from failed companies and the government never steps in to save them.  Sure losing your job would suck, but that is a risk we all face.  Why should we pay for these people to keep their jobs?  We should not.  We should let the system work.
3. Everyone has an AIG insurance policy - Again, who cares?  The majority of their insurance businesses would have been packaged and sold off, and maybe 20-40% of their clients would have lost real money.  Again, it sucks, but nothing is guaranteed, and it definitely should not be guaranteed with our money.

I know many respected people are saying this had to be done, even people I really respect, but this is getting ridiculous.  We are rewarding poor management and bad companies, which is perpetuating the downward economic cycle.  From the immortal Sgt. Barnes of the movie Platoon, “Shut up!  Shut up and take the pain!  Take the pain!”

Ms. Orman then follows this up with her dumbest statement yet:

King: The Federal Reserve decided to leave short-term interest rates unchanged today at 2 percent. Good or bad?

Orman: I personally think it was bad. Listen, the banks in the United States of America are in trouble. Anything we can do, in my opinion, to help the banking system so they can make a little bit more money, I think, would have been a good idea. If we had lowered interest rates, the Fed funds rate, the banks would have been making more money on the money that they lent out, which would be helping everybody in the long run. So I think they should have lowered, but they left the same.

Inflation is out of control and she wants to stoke the fires to give the banks a little more money?  How dumb is she?  This would help the banks in the short-term, but hurt the economy in long-term by increasing inflation and allowing the banks to put off tough measures longer.

It would also reduce the power of the Fed, for the immediate future, as rates this low mean they have little ammunition for future economic stimulus.

I like Ms. Orman for personal finance advice (budget, live with in your means, etc.), but she knows nothing about capitalism, the stock market or high finance.  So, take her advice, but only on the subjects were she is actually an expert.

Yes, I am happy Lehman Brothers went bankrupt.  No, it is not because I like to see failure or had a personal grudge against Lehman Brothers, but because it shows the country is waking up and noticing the extent of the economic damage. 

We, or more accurately the government, are finally allowing capitalism to work.  Our recent foray into socialism (Bear Sterns/Freddie/Fannie bailouts) has allowed the culprits to cover up their failures, save their money (ours is being spent to save their money) and prolong the economic downturn.  All of this was very reminiscent of how Japan tried to save their banks in the early 90’s.  Fifteen years later Japan is still stagnate, because they did not let the weak/poorly run businesses/banks fail.

I am not saying this is the beginning of economic recovery, in that the economy/stock market will start to rise.  In fact, I expect it to continue to decline and it may drop fairly far.  I completely expect to see further bankruptcies, or at the very least a lot of dirty laundry being aired by financial companies that pounds their stocks. 

By allowing Lehman to go bankrupt the government is signaling they will not be there to bail everyone out, and they may not be there for anyone in the future.  This will force the banks/investment firms to make the hard choices they have been putting off, and speed up the end of the down cycle. 

So, be wary, but know the blood in the street is a good thing for the economy.

####

Note:  AIG maybe next.

Finally, I have internet access again!  Just in time for this sweet story.

“Regulators and investors are bracing for a small number of banks to fail over the next 12 to 18 months. Analysts predict that 50 to 150 banks might stumble. In the first quarter this year, the F.D.I.C. listed 90 banks as troubled, which is far lower than the levels during the savings and loan crisis of the 1980s.” – NYT: Confidence Ebbs in Bank Sector and Stocks Fall

A few banks have already failed.  The most notable is IndyMac, which has caused some serious issues in California.

“Tempers flared at an IndyMac Bank branch in Encino Tuesday as customers squared off over who should be allowed into the bank first.”

“At least three police squad cars arrived at the branch on Ventura Boulevard to restore order before the bank opened its doors at 8:00am. Police urged customers to remain calm or face arrest as they tried to pull their money on the second day of the failed institution’s federal takeover.”  -  KTLA News:  Tempers Flare at IndyMac Branch, Police Called

 

Economy

What does this mean for the economy?  It does not necessarily mean the economy is getting worse.  Bank failures do not happen overnight.  This is something that has been building for quite a while.  In fact, bank failures are trailing indicators, not leading indicators of economic problems.  This means a lot of bad stuff has already happened.

The good news is the failures indicate we are at least past the beginning of the economic downturn.  The bad news is it is really hard to tell how many financial institutions will fail.  However, many of the large financial institutions report earnings (losses) this week, which might give an indication of how bad this can get. 

Your Own Accounts

If you have less than $100,000* in an FDIC insured institution you will not lose it.  The FDIC has never failed to meet their obligations.  However, sometimes it takes a week or two for the FDIC to take over the failed bank.  Thus, if you need your money quickly, you may want to make sure your bank hasn’t hit the headlines with negative news.  If your bank has a significant negative event associated with it, consider moving some or all of your money to two or more institutions.   Spread out your risk.

If you have more than $100,000* in an FDIC insured institution you need to move enough money out of the bank to ensure you only have $100,000 in the bank.  The money you take out needs to be spread among enough financial institutions to ensure you don’t have over $100,000 in any institution.

*This includes all of your accounts at that financial institution.

There has been a lot of talk recently that oil speculation is the main cause behind the huge run up in oil.  Whether this is true or not could be irrelevant based on a current Businessweek article titled In Praise of Oil Speculation.

The author states a few good reasons for why it does not matter if the increase in prices results from rogue speculators:

“If speculators and manipulators have somehow managed to get prices too high, then those prices will come back to earth as surely as apples fall from trees and meteors land in Arizona. The price decline will inflict billions of dollars of losses on those speculators and manipulators-just deserts.”

Or, if the price increases are legit:

“On the other hand, if by some chance the speculators and manipulators are correct-that oil prices could go even higher, based on supply and demand-then they will have done all of us a favor by ringing the alarm bell. High prices today are inciting suppliers to produce more oil and consumers to use less, which will ease the transition to a future of costly energy.”

“Either way, then, it’s hard to see what the big problem is. Either the traders are wrong and they are setting themselves up to lose a lot of money, or they’re right, they’ll make money, and they’re sending the proper market signals to the economy.”

Though, he is correct, this does not help anyone make money, but it does help ground our thinking in the reality of the current markets.