Thursday, August 27, 2009
Then, one day, without any warning, everything began to go wrong. Markets went down, people couldn’t pay the outrageous mortgages they had used to buy expensive real estate. The economy got progressively weaker while analysts and policymakers forecasted a near term bottom and recovery while making one policy mistake after another.
That was Japan in the late ‘80s and early ‘90s. Nobody seemed to worry about 100 year mortgages and other oddities and nobody seemed to question the model because the market kept going up. Once the correction began, policy makers exacerbated the problem by trying to help every last financial institution. Banks were not forced by regulators to recognize their losses and so the final day of reckoning was indefinitely postponed until markets recover. Except markets never recovered (the Nikkei is still almost 75% below its peak of 1989).
Analysts said the problem was eminently cultural. The Japanese value the community ahead of the individual and they prefer to endure a long deflationary period rather than embarrass their bankers and ultimately their country. Sadly, by avoiding the problem, they managed to do both. Eventually somebody had to recognize the consequences of the bad decisions that are inevitably made during long, prosperous booms.
Fortunately, this could never happen in The United States. Americans understand risk-taking. Nothing ventured, nothing gained. If you fail, get up, wash your face and try again. Markets are allowed to clear. If someone has to go bankrupt, so be it. It is not the end of the World and, eventually, under these dynamic conditions, everyone who looks for it gets a second chance. We take our losses and move on because that is good for the economy. We understand the system.
Or do we?
Most analysts and market historians think that prolonged bear markets only come from policy mistakes. Japan in the ‘90s and the World in the ‘30s are classic examples. Naturally, we try to avoid policy mistakes. Except the allure of waiting for the market to bail us out is just to hard to resist. According to several stories published since yesterday (here is one), the US Treasury and the Federal Reserve have decided that the best policy for our banks is to follow a Japanese strategy. In other words, let the banks mark their loans and toxic securities at whatever price they (the banks not the regulators) deem reasonable until the market recovers or until they earn their way out of the problem by borrowing from the government at zero percent whichever comes first.
Call me old-fashioned, but I think it is at least illogical to ask any society to subsidize the industry where the average compensation is the highest while neglecting other basic needs. In any case, since I have yet to hear of a town-hall heckler complaining about bank subsidies I suppose this topic is not a high priority for the American people. The problem with the strategy, however, is that it has very little chance of success.
Unless you think real estate prices will come back in a hurry, most of the losses Ms. Bair worries about have already occurred. In fact, much money has already been lost no matter what happens next. Thus, the choices are when and/or how fast are the losses going to be recognized. Mr. Geithner, like the Japanese, hopes that the banks will write them off as they earn money from current activities either by increasing reserves or selling assets at a loss. Except nobody forces them to do so. As you may know, the dirty secret of the financial system is that one gets away with whatever the regulator and the market allow. Since both are currently looking the other way the banks have chosen not to do anything for the time being. That way, their earnings looks good and, you guessed it, they can compensate their talent.
I suppose this state of affairs could last for a very long time (ref. Japanese model), or maybe this will all blow up soon (the Nikkei was spooked several times by this issue), or (less likely) the politicians will force the regulators to act, or (least likely) the regulators will blow-up their chances of landing a job in Wall Street and act on their own. In the meantime, the banks will continue to surprise everyone by posting good earnings while they sit on their toxic assets and postpone the day of reckoning. If that day ever comes (I was tempted to write "when" but I hate predictions) all mentioned above will excuse themselves by stating that "things were worse than expected." Bonuses securely in the their bank accounts, toxic waste the responsibility of the American taxpayer, and fairness avoided by virtue of the ignorance of the average voter.
Fortunately, both Geithner and Bernanke have studied the Japanese crisis so they have all the information they need.
Thursday, August 20, 2009
Although the complete details of their exposure remain, in my opinion intentionally, a mystery, we do know that the government contributed several billion dollars in different facilities and guarantees (I believe the analysis done by Propublica here looks reasonably accurate). We were also told that the company would sell its assets to repay the government. Since the assets, to my knowledge, look to be worth less than the government's stake, the expectation is that the equity is worth zero. Of course, nobody knows the future, and there is a lottery ticket chance that AIG makes a lot of money from asset sales, or that their obligations are worth a lot less than the market says right now, or that their accounting is wrong and they do not really owe anything, or that this has all been a nightmare and we really never had a housing collapse and prices indeed have never gone down, but I digress.
So, using the time-honored Cartesian analysis here are the facts:
- AIG still owes the government several billion dollars and they have not sold many assets.
- At least some of their senior bonds are offered at $90 for 2010 maturity. In case you care to buy some, yields are 15% and higher.
- 5Y CDS are offered at 21 points +500bps which means dealers still charge a steep price for AIG protection (as a rule the points reduce your protection making it more expensive).
So why is AIG up over 100% in less than a month?
Wouldn't you know? Because the new chairman gave a pep-talk to the troops (here). Of course there is nothing wrong with an all-American pep-talk and Benmosche, his troops, and equity holders can believe whatever they want, except for this.
In other words, we have two alternative theories:
1) Things are much better at AIG than the CDS dealers, Paulson, Bernanke, Geithner, and Liddy, among several well informed players, had anticipated and the company just needed a leader with a vision. Or,
2) Benmosche landed a prime-job in this difficult economy and sees nothing wrong with talking up his stock while offering a wildly optimistic assessment of the company.
Naturally, as was the case with Mozillo who famously announced a positive quarter for Countrywide right before selling the company to Bank of America, or Dick Fuld rebuffing a $10 offer for Lehman right before it went to zero, you never quite know what these CEO's really think. While it is clear that Mozillo knew he was lying it is possible that Fuld believed his own statements at that time.
The facts, however, seem to point to option (2) above. The fact that nobody can prove what is really in Benmosche's mind does not obscure the obvious conflict of interest or the incredible compensation package for what is in essence a government job.
I am sure that many would argue that talking up the assets will eventually benefit the taxpayer as we may get more of our money back. Notwithstanding the fact that it is unlikely that potential buyers of AIG assets will ignore the prices in the CDS market, I believe that our government is following a dangerous road if they are attempting to make money by deceiving the potential buyers. In addition, I am not sure how good people would feel if they found out that the assessment made by Bernanke et al about the seriousness of the AIG situation proved to be totally incorrect in less than a year. After all, a great deal of trust (and money) has already been invested in the judgment of these individuals.
In my opinion, the real problem we continue to have is that we, as a society, seem to want to continue to play this duplicitous game. On the one hand, we know that the crisis was really our fault because we allowed a few individuals to run amok with our financial system. On the other hand, we try to play the game one more time to see if we can avoid paying for the losses. In this instance, we have given Benmosche a big payout in the hope that he can make magic and turn around what US government had deemed a financial house of cards. Furthermore, it seems to me that Benmosche's behavior is entirely rational. It pays for him to believe. Whether it pays for us is another story.
As for the lawyers at the SEC investigating this guy for stock manipulation you can rest assured that it will not happen. The most likely scenario is that, after all is said and done, he will declare that he didn't know things at AIG were as bad as he discovered later. Or that he thought the recovery would be far stronger. By then he will probably be in agreement with Liddy, Geithner, and everyone else on the list.
Disclosure: long AIG debt, short AIG common (much smaller position). By the way, I am disclosing my positions for the sake of fairness. My purpose here is NOT to give financial advice.
Tuesday, August 18, 2009
The American Congress, after consulting their oracle (aka "The Dow Jones Industrial Average") acquiesced under proclamations of better regulations that would ensure that "this will never happen again." Even those who knew that the mess had been bipartisan (the Glass-Steagall Act was repealed during the Clinton administration) believed that some regulation would be coming. After all, that is what normally happens in politics after the horses have left the barn.
I retrospect the appointments of Tim Geithner, who was involved in all the bailouts and other interventions at the NY Fed, and Larry Summers who was the main architect of the "self-regulatory" environment that created the $60 trillion CDS market, should have been enough warning that something wasn't quite the way we had expected.
Last week, Elizabeth Warren, who was appointed by Congress to oversee the banking bailout, said on a TV program that the banks still hold most of their toxic assets. At the same time, we learned that the large banks are not lending much and that Goldman has not reduced its leverage and is trading as aggressively as ever. In addition, the same compensation schemes that had encouraged the excessive risk taking by these "regulated" institutions are back in vogue and close to their highest levels. If anything, we hear complaints from banks who cannot keep up with the competition. Furthermore, as far as I know, banks are not only still allowed to hold large off-balance sheet items but they continue to be allowed to trade CDS' and other leveraged products. Their own risk profiles are down, however, since we now KNOW that they won't be allowed to fail.
The question I would pose is why did we save these banks? It is clear that they are NOT indispensable as we were told since companies who can get credit seem to find willing substitutes either directly in the market or through smaller and healthier banks. Why should I, as an American taxpayer, have any interest in the existence of a large multinational bank prone to large risky bets that from time to time risk bringing down the whole financial system? Why does our society need to support these large institutions with their internal hedge funds and other operations that seem setup for the sole benefit of their executives?
Banks, which are regulated entities, allegedly exist to facilitate commerce by bringing together savers and borrowers for profit. Why do they need to be regulated? Because our society decided, in the 1930s that it was better to minimize systemic risk. In other words, we allow banks to exist under certain conditions because we think efficient intermediation is essential to our economy. In this model, our society as a whole benefits from having efficient banks as the cost of bringing our aggregate savings to deserving entrepreneurs is minimized. This was the argument used beginning in the Reagan administration to deregulate the banks and thrifts, "let us do business and we will bring borrowing costs down." Nothing wrong in principle as too much regulation can often get in the way of efficiency.
Unfortunately the original idea of freeing up the banks to allow them to compete at the national and global scale was stretched beyond recognition during the Clinton-Bush years. The repeal of the Glass-Steagall Act that separated investment from commercial banking, the conversion of Fannie and Freddie into aggressive for-profit institutions, and the extreme friendliness of government officials who were often regulating their future employers were all celebrated by republican and democrats alike as triumphs of deregulation. As if to add insult to injury, our system was imitated by many around the world.
This is how we ended up with our largest banks filled with toxic assets, off-balance sheet commitments, and in-house hedge funds among other "investments." I mean, who wanted to make money by intermediating savers and borrowers when you could ride the bull market with the bank's money and get paid in stock options? Unfortunately for us, they had it right because we were underwriting the risk. It wasn't the Greenspan or the Bernanke put but the USA put.
The reason this sad story is relevant today, is that this is STILL the model under which Geithner and Summers want to revive the banks. Forget about whether you believe it is possible for the banks to earn their way out of trouble "Japanese style." This is the model for when they become healthy. Lots of complex risk for large personal payout under the friendly eye of someone who will join their club in the not to distant future. If you think I exaggerate, ask yourself what has changed since the pre-Lehman days for those still employed in Wall Street? Not to mention that interest rates are zero again and the stock market is rallying (again) and they are making boat loads of money, again. How long until they decide to take another shot at sub-prime? (this time they will promise to get it right).
I personally have no problem with hedge funds and other speculative clubs, so long as they are not risking taxpayer money, whether directly (like Fannie and Freddie) or indirectly by threatening to bring down the system. On the other hand, since banks are supported by taxpayer money, I think it is fair to have their risk tightly controlled by an external regulator who should never allow them stray into areas unrelated to their core business of intermediating financial products. It is as simple as that. If they want to make money by guessing which way the December oil contract is going they can set up a hedge fund outside the bank and without implicit or explicit government guarantees.
Financial markets are perversely didactical, they will set us up to revise the lesson as often as needed, but learn it we will.
Tuesday, June 2, 2009
Unless the name of the country is Japan, this is what usually happens:
1) Long term interest rates go up and then gradually disappear. In other words, in an American context, the government "refuses" to issue 30 year bonds at a rate it considers "exorbitant," which means the next long maturity (say, 20 years) becomes the longest one. The process continues (unless the problem is brought under control) until most of the debt is between 1-day and 1-year.
2) Banks, and other private entities are first cajoled, then forced, to buy at every auction.
3) Borrowing costs go up for everyone since the government actively competes for funds ("crowding out"). For many, there are no loans at any price.
4) Inflation goes up even in the face of lower or negative growth since the higher cost of borrowing impairs production and the supply of goods.
5) All monetary policy becomes stop/go as attempts to control the problem through higher short term rates slow down the economy.
6) The exchange rate, up until now ignored by the Central Bank, becomes a critical variable. A lower currency, other things being equal, stimulates the economy but may discourage foreign inflows and drive rates higher. The result, usually, is an unstable currency with higher rates.
7) Equities go DOWN as P/Es' contract to match higher rates in competing investments and production loans.
8) Profitability suffers as resources are diverted from production to financial management.
The counter example is Japan where they have successfully managed to double the sovereign debt without, yet, paying the price of much higher interest rates. Which of the two cases is a better fit for the US is up to you. I for one am not happy to see the backup in interest rates.
Thursday, April 30, 2009
In addition, most investment houses have their own research teams. That way, they don't have to rely on "biased sell-side research geared towards investment banking" (they actually say this in their presentations). Naturally, these teams have full access to top management as the companies know who their actual and/or potential large investors are.
With these resources at their disposal, you would think professionals should have been able to avoid bad investments like GM stock. Oddly enough, a list of GM holders as of 12/31/08 (the closing price was $3.20 which was an all time low for the stock except for a few weeks last year so most of these were under water) shows that professional funds owned a big chunk of shares of an essentially bankrupt company. Many even added to their positions in 4Q08. Granted that a few of the names below, like Vanguard, manage indexed portfolios and, thus, expressed no opinion on the matter, but the point is why would an active manager own ANY shares of GM as late as December 31st?
I am sure that all of the portfolio managers responsible for investing your money (theirs is in the stream of fees you pay) in GM stock as of December 31st, 2008 will tell you that it was too late to sell. I may even be persuaded to think that they believe that. However, no matter how they try to explain it, the truth is that, for all their advantages, they acted no differently than a gambler on his last chip hoping for a recovery when the writing was already on the wall in neon lights.
As you may already know, most active managers underperform their indices over extended periods. Also, they do not see themselves as asset allocators so they never hold much cash nor will they tell you to redeem their funds so that you may hold cash when the time is right. They don't seem to catch the most egregious reporting misrepresentations (Enron, Worldcom, Bear Stearns, Lehman, and GM were all widely held names). The question is why do people still pay 1-2% for bulk institutional management? I suppose it is because that is the way we have always done it.
Thursday, April 16, 2009
Google has just reported Q1 earnings. As usual, they beat estimates handily and the stock is rallying in the after market.
The actual numbers show up on my screen as follows:
Google First-Quarter EPS Ex-Items $5.16; Analyst Est. $4.95
Wow! they really beat the estimates. Great surprise. How come Google always manages to surprise the analysts?
I keep on reading and something catches my eye:
Net Income rose 8.9 percent to $1.42 billion, or $4.49 a share, from $1.31 billion, or $4.12, a year earlier
I have just checked a few headlines from 4/17/2008 (one year ago):
Google-GOOG reports Q1 EPS $4.84 vs. consensus of $4.52
Google beats by $0.32, beats on revs
So what was the report a year ago? $4.12 or $4.84? It coudln't be $4.12 because that would have been $0.30 below consensus. So I checked. They reported $4.12. In fact, according to Bloomberg, Google has not reported above the estimates since 2Q06.
So what gives? I suppose the analysts give their estimates in US GAAP and they cannot be bothered with anticipating the "ex-items" adjustment. I suppose 3 years is not enough time to realize that, given the sizable adjustments, their headline estimate is useless. By the way, Bloomberg lists 39 analysts covering the stock. The guys from Google of course are perfectly happy with their ability to handily beat estimates every quarter.
Google is a great company and they seem to be doing well in a very difficult economy. They are entitled to report whatever they want within the law.
The analysts, however, by now have had enough time to either adjust their estimates to account for the difference or to highlight the discrepancy that took me 5 minutes to explain. If they haven't done so is probably because it is not in their best interest.
According to the WSJ headline jobless claims "fell" last week. Or did they?
An interesting new mantra has taken over the financial press in the past few weeks: "Things are getting better." For those who choose to see it, the impending improvement in the economy is supported by two undeniable facts, (1) the stock market is up, and (2) the data is "less bad" which must mean it is good (aka the positive second derivative).
Unfortunately, Calculus doesn't seem to be a required course for a career in financial journalism. If it was, maybe a few of our esteemed commentators would realize that the numbers are NOT getting better.
For instance, the Initial Jobless Claims number of 610,000 published today, means that many people filed for unemployment for the first time. Thus, saying that the number is better because in the previous week 660,000 did, or because a group of economists who could not predict the recession once it had already started expected a higher number is missing the point. The fact is that 610,000 additional people lost their jobs which means they will, in all likelihood, consume less and maybe even default on their mortgages and/or credit cards. Aside from the human tragedy, I fail to see how this is good news for the economy.
Which brings me to my second point.
Lets say you used to own a portfolio of investments which was worth $100. Lets say it went down 50% last year, so on 1/1/09 it was worth $50. Lets assume that it went down $1 in January which is either 2% ytd or 1% of your original amount. Are you happier in January than you were in December? How does the slower rate of deterioration help you predict what will happen in February and beyond? After all, your portfolio could rally in February or go down another $2. This is the nonsense that is being disseminated by the financial press. Things are supposed to be getting better because your portfolio is going down a slower pace which must mean it will turn around and go up soon. The part in italics, of course, is not true. There is no way to predict when the deterioration will stop (it could take years) or what will be the minimum for your portfolio (could be $5,$10) based on the change of rate of deterioration or second derivative.
Although I realize that unemployment is a lagging indicator, most pundits omit the obvious fact that unless you know when the economy will turn this knowledge is also useless. Also, I don't think anyone would disagree that fewer Americans losing their jobs, other things being equal, is a good thing. However, 610,000 initial claims is a terrible number because it is large and negative. The economy will not turn around until that number becomes small (even lagged by six months or even a year), and nobody can predict when that will happen based on the second derivative. No matter what they say or how loud they say it.
Friday, April 10, 2009
So, following your English Composition 201 method, you go on a quest for some evidence that you can use in your article. First you talk to a few economists. You find a few optimists who tell you that things are getting better because the rate of deterioration is slowing down. Sounds good enough. Then you pick up an article from a colleague in the NYT that says the following (my comments are in , the emphasis is also mine):
Exports, which make up about one-third of China's economy[they are close to 40%], were 17.1 percent lower in March than they were in the same month a year earlier, the government said Friday. This marked a fifth consecutive month of declines since the world economy ground to a crawl last year, sending demand for goods from China and other exporting countries sharply lower.In summary, exports, which are extremely important to the Chinese economy, continue to drop at a high rate. However, economists missed their prediction of an even higher rate, so they feel good. In addition, since the speed of the fall is lower, they expect a change in direction. Why? because once it stops falling it will either go up or stay the same. When? they are economists, not soothsayers, however, if their predictions turn to be wrong on the pessimistic side, they will feel good and tell us about it.
Imports to China fell 25.1 percent from a year ago, a slide that was steeper than that seen in February and than economists had projected.
But the fall in exports was below what economists had projected, and less severe than the 25.7 percent plunge recorded the previous month.The slowing pace of decline in exports was the latest in a string of recent statistics that, combined, have led a growing number of economists to believe that the Chinese economy may have put the worst behind it
The pace of decline is also as the second derivative of, in this case, the export numbers. In Physics, it represents the acceleration. In terms of your car, it is after all the same concept, the acceleration is the rate at which you are speeding or slowing down. It says nothing about the direction and, while it is true that in order for China's exports to grow they must stop declining, it is NOT true that declining at a slower rate means that they will start growing again. In other words, the exports may fall at 25% (faster), 17% (same), or 5%(an even slower rate) next month and then either fall, recover, or stay the same the following month. The real news would be if the grew which is NOT what is going on.
If you like analogies, imagine someone is beating you over the head with a baseball bat at a rate of 3 hits per minute. For some reason, this person decides to just hit you just once every minute (a slower pace). I suppose that we could find an economist to say that you are better off, but the fact remains that your headache will not go away until the beating stops. Whether your attacker is taking a breather or permanently slowing down makes a huge difference, but we just do not have enough information to know.
China has been exporting to the world at a ridiculous pace for years. Now, global consumption is slowing and some is unlikely to come back (think about consumption driven by home equity loans). Thus, I think it is logical that Chinese exports should not return to their 2006-2008 levels which means that they should keep contracting for the foreseeable future. At what pace? I don't know. I also could be wrong, but trying to extrapolate a recovery from a reduction in the pace of deterioration is misleading at best.
Friday, April 3, 2009
The idea of the stock market as a leading indicator does have some economic logic. As the economy begins to pick up, the first people to notice are those running actual companies in the real economy. Thus, a company sees an improvement in their business, which may result in an increase in stock buybacks and/or dividends which, other things being equal, should drive up stock prices. Similarly, as investors find out about improving earnings they are, other things being equal, willing to pay higher prices for company shares.
In the days before 24 hour dedicated financial media and internet trading there was a reasonable lag before the general public would perceive a business improvement in, say, US Steel or General Motors. In those days we had to wait for the reports to make it into the Sunday business section of the local newspaper. On the other hand, not only do we now have instant reports on every sector of the global economy, but we also have dedicated pools of capital (still) who try to exploit every piece of information (true or false) instantly. In other words, like anything else in financial markets, the financial media and the internet have significantly leveled the information advantage that a well connected investor could have enjoyed before the early 80's. In addition, the more developed the market the smaller the advantage, so there is less informational advantage in large-cap US stocks than in small-cap African stocks.
This, of course, does not mean that people won't try to anticipate earnings and that real surprises in particular companies will not occur. However, the notion that the stock market "knows" that the economy is getting better is severely challenged by the facts. For example, what was the market predicting in the Fall of 2007 when it was making new highs after the Fed began cutting interest rates? It seems to me that the answer is that it was predicting a simple liquidity problem which is what the Fed, the investor community, and most market pundits believed at the time. The same can be said for the rally from "The Bear Stearns Lows" which was hailed by most Wall St. banks as the final climax of a crisis that was barely beginning.
The stock market is nothing but the weighted sum of the beliefs of a very large group of people. Although it is based on reality as the companies do exist and represent the real economy, the fact is that its fluctuations are driven at least as much by economics as by mass psychology. The majority of the pundits, however, only emphasize the former while completely ignoring the latter. That is why, among other reasons, we have bubbles. Stocks, like paper money, are worth what people think at the time and people's thoughts can fluctuate for many reasons. That is why we had companies trading for less than their cash value in the 30's and profitless dotcom companies trading for 1000 times future earnings in the 90's.
In my opinion, this time is no different. The stock market predicted a recovery before Obama arrived because people thought he would be better than Bush. Once we saw that the problem was big enough to overwhelm even a competent administration the market predicted a worse recession. Now that it is going up we are reminded by the financial media that things must be getting better because the market is rallying.
Forgive my skepticism, but even if the monthly job losses improve to -300,000, the fact is that the economy will not really get better until that number at least gets closer to zero (i.e. we stop losing jobs at an alarming rate). It may surprise many in Wall Street, but when people are unemployed they consume less. In case you didn't know, our economy was about 70% consumption in 2008. In other words, either the jobless claims number becomes positive at some point or the economy will not improve. In fact, it may get worse. The stock market may anticipate this but the facts will not change. Putting everyone back to work may not be a necessary condition for the economy to improve but expecting a recovery because we go from losing 700,000 jobs to, say, 500,000 is a nonsensical proposition posing as analysis.
So why do people buy stocks right now? Nobody really knows. I do know, however, that most of the daily moves in the market are driven by people who manage other people's money. That is, they either get paid whether they make or lose their clients money or they have an asymmetric risk-reward payment (they get paid a lot if they win but they do not return any money if they lose). These individuals may be more prone to believe than those who have to risk their OWN kid's college fund or their OWN retirement money. In addition, they have no problem talking their book publicly on CNBC which makes them look convincing.
In summary, the economy may or may not improve in the next 6 months. The stock market, however, has a very mixed record as an accurate predictor. One thing I am sure of, the portfolio managers and other pundits parading on CNBC don't know now as they did not know in 2007 and 2008 when they predicted similar recoveries (most did not even anticipate a recession). In any case, they all have a vested interest in convincing the rest of us that the rally is "for real." As I see it, the recent rally has more to do with a change in manager's psychology than with any improvement in the real economy. As we have seen in the past, that psychology can reverse quickly and they will not even admit they were wrong.
Thursday, April 2, 2009
As recently as 1980, less than 6% of U.S. households owned mutual funds. That percentage increased steadily to its peak of almost 48% in 2001 and seems to have stabilized in the mid-low 40's (the data is not yet available for 2008). In terms of holdings, this translates to about $10 trillion as of Dec'08 of which about 1/3 are stock mutual funds. There is a wealth of data on this in www.ici.org.
The rationale behind this transformation was that the individual investor did not have the time and/or expertise to manage his or her own money and would be better-off hiring a professional money manager who could do better. Furthermore, asset-pooling would give an investor with an amount as small as $500 access to a portfolio manager with perhaps billions under management and, presumably, better expertise. In the specific case of an equity fund, the manager would presumably chose the best opportunities to "buy low and sell high" which is a sensible way to money.
Unfortunately, the mutual fund industry has metamorphosed into a perverse machine that bears little resemblance with the original design. For starters, most mutual funds are always fully invested (higher than 90%) on the theory that investors who want to hold cash would just sell the fund and, thus, hold cash. Never mind that the average investor is ill-equipped to decide when to hold cash (because most stocks are expensive, for instance) which is why he or she hires a professional in the first place. The industry blissfully ignores this paradox because "stocks always go up in the long run" which means nobody should ever sell them.
In addition, most mutual funds are measured on relative performance against some index. So, according to industry practice, if the S&P goes down 20% and your mutual fund is down 19% you should consider yourself well served. Tracking error, which is the difference between the performance of the fund and its index, is the single most important driver of most managers' decisions (as opposed to cheap vs. expensive). This is why most funds own hundreds of stocks as opposed to a handful (more stocks imply higher market correlation and lower tracking error).
Furthermore, mutual funds charge a fixed percentage of assets under management for their trouble, which means it is NEVER in their best interest to advice the client to redeem the fund and hold cash. Since they never hold much cash themselves either, it is up to the client to decide when the market (or sector) is expensive and get out.
This combination leads to a very different risk reward perspective than one would ordinarily expect. For instance, consider a situation where the portfolio manager, after careful consideration, thinks the economy will be much worse at the end of 2009 than it is today. Furthermore, lets say our manager had decided accordingly to lower the risk of his/her portfolio by raising 10% of cash at the end of February. As the S&P index went from 735 to 666 our manager did not feel too bad as the 10% decline in the index resulted in only a 9% decline in the portfolio. As the index began to recover in March our manager surely dismissed it as a bear-market rally. Unfortunately for our manager, the index decided to keep going piercing the magical round number of 800 which is 9% higher than the close of February. Gone is the outperformance as we are now underperforming.
What would a sensible investor do in this circumstance assuming that he or she thinks the economy will get worse in 2009? I think most people's answer would not be buy more stocks. However, that is exactly what many, if not most, portfolio managers do when faced with this conundrum. Think about it, if the rally continues to 900 and beyond they will be accused of underperforming the market, missing the rally, or worse. On the other hand, if the market goes back down the worst they will have to face is being down with everyone else. Investors are used to bad news when the market goes down. In fact, many don't even open their statements. However, when the market goes up, they expect to make money. The marketing director at the mutual fund company knows this fact and will make sure the portfolio manager is aware of it as well.
Where does this leave the individual investor, who is the actual owner of the stocks managed this way? Thinking that his or her money is managed professionally with incentives aligned to his or her own which is hardly what is happening in reality. As for the market, the behavior I have described is exactly the same one would observe from a short-seller with a stop loss (desperate purchase on the way up, no interest on the way down).
Naturally, while this is happening (recall the period 3/17/08, aka The Bear Stearns Lows, through 5/19/08 before we found out Fannie and Freddie were not really AAA) the pundits think things are getting better because the market goes up while the market is just recovering from and oversold condition driven by performance chasing.
I have no illusions of being able to call the bottom. However, I find hard to believe that the stock market can fully recover while the economy continues to deteriorate which still seems to be the case. While I am fully aware that the market will anticipate the recovery, I think we should be able to see more meaningful signs than "it is getting worse at a slower pace." One thing I am sure of, the current rally has a lot more to do with managers covering shorts (outright or against the index) and chasing performance than with any meaningful improvement in the fundamentals of the economy.
Monday, March 30, 2009
Thus, it is in the the best spirit of capitalist self-interest that would make Adam Smith proud that I offer the following plan to save our automakers.
The problem seems to be that GM and Chrysler have produced and keep producing more cars than people want to buy at prevailing prices. The automakers are convinced that the problem is psychological and temporary. Thus, the vehicles are really worth a lot more than the market is prepared to pay for them at this time. Our Treasury Secretary, a connoisseur of intrinsic value, agrees with this assessment.
So, for the purpose of this plan, we will designate GM and Chrysler's inventories as "toxic vehicles." Furthermore, since the new cars they produce and fail to sell increase their inventories, new unsold models will also be designated as "toxic vehicles" henceforth known by their new Washington official acronym: "TVs."
Thus, having defined "the problem" as clearing the TVs clogging our vehicle markets, we may proceed to our solution:
1) The US Treasury will pre-qualify suitable partners to buy all TVs currently in inventory including the new vehicles produced (defined as 51% finished) as of 3/31/09. The Treasury, at its sole discretion and without congressional interference may extend this date up to a decade or more if necessary.
2) Suitable partners may include large companies specialized in large purchases of US made vehicles such as the car rental companies and certain hedge funds incorporated specially for this purpose.
3) A special purpose vehicle (in the financial sense, not to be confused with the real vehicles) will be formed for the purchase of the TVs. The Treasury shall fund 50% of the special purpose vehicle (SPV) and the private partner the remainder 50%.
4) In order to encourage private participation, the SPV will be allowed to issue non-recourse debt guaranteed by the FDIC up to 85% of the final value of the leveraged entity or 11.33 times the value of the private partner's contribution.
5) The US Treasury shall make available $30 billion of the TARP still available for this plan which, by the magic of leverage, will make $400 billion available for the purchase of TVs.
6) Should the plan be successful, President Obama will invite Rick Wagoner for a nice chat in the White House such as the one he had with our most successful bankers last Friday.
Needless to say that this model maybe used for any other American industry that runs into a similar inventory indigestion.
Who knows, maybe if Larry Summers had been president of the University of Michigan...
Wednesday, March 25, 2009
For people with even a tiny knowledge of accounting, like me, this was never a credible idea. Money, after all, is fungible. In other words, if you give Citi $30B and they lend $30B there is no way to know how much they would have lent without a the subsidy. The Treasury Secretary knows this, but many members of Congress and other lay people do not which is why, on the one hand, they ask the banks to produce nonsensical reports about "how the money is spent", while on the other complain about the fact that they spend money to compensate their employees.
The problem with subsidies in general is that they are treated as "other people's money." People who spend OPM, as we know, are not subject to the same constraints as the rest of us, namely, fear and scarcity.
That is why, as we about to commit another huge amount to save these "essential" institutions in their present form, I think it is interesting to see how much they care about out money.
According to an article in today's NY Post (link below), two of the largest banks we are trying very hard to save from THEIR past risk-seeking behavior have found new interesting ideas for your money which have nothing to do with lending. Why? who knows. Perhaps is an attempt to game the up-coming auctions that are supposed to provide "transparency" to the market.
Perhaps someone should ask Mr. Geithner how come HIS banks have no trouble finding the correct prices when they want to buy these securities with OUR money. In addition, it would be nice to know whether the prices BofA and Citi use when they buy are consistent with those they show on their balance sheets.
Meanwhile, I am scared of the reaction of my fellow taxpayers when they find out as they inevitably will.
Monday, March 23, 2009
I was very pleased to hear that you were finally able to put together a plan to save the large speculative banks. I have heard that these banks are very important and staffed by the best and brightest which is why we, the taxpayers, must make sure they do not go bankrupt. So, given that my family will pay this bill for generations, I thought it would be appropriate to ask a few questions. I assure that, at this point, I am just seeking clarification and that I am not under any illusion that my opinion counts in any of this.
1) Will the pre-approved managers charge the government for the management of its position? If so, will this mean that BlackRock et al will charge 2+20% on the whole amount rather than on the amount they actually raised from their investors?
2) How will these managers get approval? Will anyone check how they have performed over the past couple of years or are we just going to round the usual suspects ala Casablanca?
3) Will there be a vetting process to make sure all of our "partners" have paid their taxes, etc, or are we going to use a lower standard than that required for other positions in your Administration?
4) Will the banks be forced to sell their securities at the auction or will they have a reserve price?
5) If the banks are allowed a reserve price, where will they mark the securities? at the bid? at the reserve price? at the old price?
6) What will you do if you discover that, at the available prices, a large bank has negative tangible equity? will you then force them to accept reality or will they be given a "gimme?"
7) What is the plan to unclog the balance sheet of the banks from the new assets which are still not considered by the bankers as "troubled," like Commercial Real Estate for instance, will there be another one of these when the time comes?
I had planned to ask you about your plan B in case the economy does not recover in 2009 as you have assumed, but I rather be a fan.
Monday, March 16, 2009
Then, I came accross the following quote:
“We cannot attract and retain the best and the brightest talent to lead and staff the A.I.G. businesses — which are now being operated principally on behalf of American taxpayers — if employees believe their compensation is subject to continued and arbitrary adjustment by the U.S. Treasury,” he[Liddy] wrote Mr. Geithner on Saturday.
They are the brightest indeed!
How else would you rate someone who manages to get paid millions of dollars after proving beyond reasonable doubt to be either unscrupulous, extremely incompetent, or both.
Wall Street seems to be the only place where bankrupt companies continue to reward their employees for past successes that have resulted in the bankruptcy of the same companies. After all, the contracts negotiated by the AIG employees a year ago assumed that they were doing great deals for AIG, didn't they? How hard would it be to prove negligence when the same deals resulted in the failure of a formerly rated AAA company?
The explanation, hard as it may be, is that these people continue to behave as if the gravy train had not stopped, because it hasn't. For all its promises of change and its protestations about the republican administration, Obama tapped a member of the Greenspan Fed to reform the system. Thus, it is no wonder that we continue to insist in the narrative of Fuld et al being "the best and the brightest."
The sad thing is that as much as we critized the Japanese for not reforming their financial institutions and prolonging the crisis, we seem to be following the same script. At least, in their case, the excuse was that their culture, which promotes communal armony above all, precluded them from nationalizing and liquidating their banks. On the other hand, adding insult to injury in our case, we are simply being taken for a ride by the same people who created the problem.
So, don't blame Wall St. bankers for trying to get paid millions. That is their nature. The fault is with the administration which was supposed to be working for the rest of us.
By the way, I have no position in any financial stock, I am, however, an American taxpayer.
Tuesday, February 10, 2009
Geithner has been part of our financial system for years. He worked at the Treasury Department early in his career, at the IMF, and more recently he was the president of the NY Fed. He worked under Rubin and Summers and was involved or close to every bailout in recent years. As part of the Fed since 2003, he was part of the Greenspan/Bernanke-Bubble machine all the way to the Bear Stearns-Lehman-AIG/now-we-do-now-we-don't policy fiasco. Not the guy I would pick for fresh out-of-the-box ideas.
Even since before he was nominated, the markets have been building up to the day when, with the magic touch of our president-wonder, he would unveil "the plan" to restore financial stability to our country. Today, he had his day under the lights, and, according to our god THE DOW, he failed. Tim Geithner, he of the many bailouts, failed to convince his former friends in Wall Street that his plan will restore our banks to health.
The problem is that NOBODY can do that. The way I see it, the financial establishment has yet to accept the fact that many of the assets clogging the banks balance sheets have been permanently lost. In other words, is not just a matter of waiting X amount of years for the securities to regain their value as the enemies of mark-to-market (which shockingly enough counts many analysts) would lead you to believe. The money is gone and it will not come back in time.
The majority of people in Wall Street are under the illusion that the whole thing can be fixed with leadership from the Obama administration. Leadership that Tim Geithner failed to exhibit today with the negative results for those counting on and Obama-rally to kick off 2009. Thus, the negative reaction by the markets and the pundits in the street. However, after carefully looking at the announcement, the real surprise is that Geithner, the Street insider, did not announce any kind of scheme that could have resulted in a purchase of bank assets at par value using taxpayer's money. This, combined with the "stress test" for the banks, leads me to believe that at least the government (if not the CNBC crow yet) is getting ready to face reality.
As many savy analysts know, the problem is not with valuing the assets, but with the reluctance to value the assets. Many firms, like Morgan Stanley and Goldman Saches, have already aggresively written down their toxic securities. Merrill Lynch had no trouble selling a portfolio of structured securities a the right price (24 cents on the dollar). Many hedge funds own and trade these securities on a daily basis. The real problem is that, at fair prices, many banks have negative equity and that is why they don't want to find the price in the hope that the government will overpay for the assets under the 2-big-2-fail theory. Geithner moved a few steps away from that possibility today and I think that is good.
According to the announcement, the government will help establish a secondary market for these assets. This means we will have a bid. With that information, the regulators will be able to perform stress tests and decide which institutions are not viable. The anwsers, no doubt, will not be pretty, but it is better than not knowing.
Acceptance is the first step to recovery (or something like that).
Monday, February 2, 2009
You see, in "the street", what counts is how much you are up or down since last year. Thus, if you made $10 million in 2007 and $5.6 million in 2008, you are actually suffering a pay cut. Furthermore, in order to compensate for this pain and to make sure that you do not take one of the many offers you may have for $10 million (remember that every bank has government money now) your manager may give you a sizable award of stock and options. Indeed, the $18 billion that caused so much distress are for bonuses paid in cash in NY and does not include any deferred compensation not taxable in 2008. In any case, since many analysts ignore the cost of options, the whole thing is essentially free.
The real reason I admire bankers is that they have managed to convince everyone that they actually have special talents who deserve to make this kind of money. It seems to me that it is far harder to perform surgery than to give a PowerPoint presentation that shows that you need to increase your company's leverage and use the money to buy your competitor or your own stock, but who am I to judge. In any case, the bankers have convinced everyone that they make a lot of money because they are smart and that the proof that they are smart is that, you guessed it, they make a lot money. Never mind that the banks, as we now know, did not really made that money since it is now all being written off.
The politicians in DC, who are not that smart to begin with, are hopelessly mismatched against these compensation geniuses. For instance, Tim Geithner, no doubt sensitized by the tough words from his boss against his old (sshhhh! its a secret) friends, is introducing tough language in his Bad Bank Plan in order to cap compensation at 60% of the World Record Year of 2007! Who is this guy kidding? Not only that, I dare Mr. Geithner to rein in the deferred compensation awards. By the time he catches on, he may already be out of Washington working for one of the large banks.
To add insult to taxpayer-injury Mr. Geithner, like his predecessor, insists on lax rules because otherwise the banks may choose not to participate. It seems to me that if they do not need the money badly enough, we could always use it for something else, but what do I understand about the world of high finance?
In any case, there is enough evidence to believe that Mr. Geithner's Bad Bank Plan will be designed to pay the maximum politically possible price for the assets these very smart people bought for the banks which in turn created the earnings that resulted in their record 2005, 2006, and 2007 bonuses. In addition, he will offer taxpayer subsidized insurance for the other assets they still have marked at par (which is another way of paying close to par) while protecting the sacrosant common equity holder. Why? because the bankers have convinced Mr. Geithner that if current sharholders lose nobody will want to buy bank stocks ever again. He either believes this or doesn't want to fight with his old and, perhaps future, friends.
Fight for the taxpayer? What a quaint idea.
Wednesday, January 28, 2009
The scariest part of the explanation I just used is that, not only applies to "12% return no volatility" (lets call it the "Madoff scheme"), but also to "we only buy growth (i.e. very high p/e) companies" (which we may call the "Internet scheme").
If you think the analogy is preposterous, consider the plight of a tech and/or internet portfolio manager in, say, 1999. His entire portfolio consisted of stocks with high p/e. Sure, many of the companies had been growing at double digit rates, but even a tech manager knows that most companies cannot maintain such growth rates indefinitely. Yet, our manager kept accepting subscriptions, and with the subscriptions bought more of the same expensive stocks, which pushed the price of his portfolio higher making his investors happy. The only difference between this scheme and Madoff's is that it had a chance of succeeding... As much of a chance as Madoff's, that is, who in the absence of a bear market could have kept the system going until his death. Also, since many tech portfolios corrected at least 90%, we can say the result was essentially the same.
In fact, if you think about it, Madoff's scheme had a better chance of outlasting and Internet fund (as it did) because it was not bound by exogenous events like company earnings. His only potential enemy was massive redemptions triggered by a generalized panic which his strategy could have never caused.
As smart as he was, or perhaps because he was never a true manager, Madoff missed one obvious recourse that could have prolonged his tenure: gating.
In case you didn't know, every hedge fund has a clause that allows the managers to reject redemption requests in order to "protect other investors." Of course, the definition of who do you think you protect and against what is in the eye of the beholder. Furthermore, I am sure that many people reading this are cringing at the comparison between a smart-money hedge fund and a run of the mill Ponzi scheme. However, consider the reasoning behind the gate clause: "If I sell to give you your money back I drive the prices down hurting people who do not redeem (including your manager)." If that is the case, then the prices depend on my actions? If they do, what is the exit strategy? Also, what was the effect of my buying on the way up and what performance fees did I pay while I pushed the prices higher?
Of course, if one wanted to speculate (a term seldom used in the Hedge Fund world), one could say that maybe the managers are concerned about losing the 2% fixed fee they continue to charge for managing the assets they cannot sell. Not to mention those managers who have invoked the gating clause because they "...refuse to be the industry's ATM" (true quote from a well know fund manager which implies that they could return your money, they just don't want to).
In summary, I consider a Ponzi scheme any investment were the return depends on successfully attracting new investors. Conversely, if the exit of investors permanently destroys the value of the investment, then it must be some kind of Ponzi scheme as well.
In the end, if Madoff had rejected the redemptions invoking some kind of obscure clause, he would probably still be in business today, even without an auditor.
Friday, January 16, 2009
An why not? The stock market is supposed to be this wonderful mechanism that allows anyone to become rich and pursue lofty goals like giving to charity and paying for our kids' education. In addition, the stock market can give us the sense of being wise investors like Warren Buffet or those guys from Yale.
Anyone who thinks a bad year can change this fails to understand the profound optimism embedded into the American psyche. "Stocks always come back," say the experts, leaving out the fact that they could take 30 years to come back and that statement would still be true.
Bonds? nobody buys bonds, unless you are some kind of insurance company. Most people who own bonds through some kind of mutual fund don't even know that they do.
The problem is that, over the past 25 years, we have taken this approach to the extreme. Employees at every level have gotten used to being compensated with stock and/or options. This in turn means that management is more concerned with "the stock" than with the long term viability of the business. In addition, "the market" gets its information about the companies from "the analysts" who mostly extrapolate management assumptions using Excel.
This fixation is now leading our government to the utterly nonsensical behavior of using your money to bail out every kind of company without first wiping-out the equity. The managers, who usually hold large amounts of equity and options are very happy with this. If the company survives, they may be able to recover their wealth. In the meantime, they can keep collecting their large salaries (and bonuses) and, maybe, issue themselves more stock and options at current prices. Meanwhile, the American public, is treated to the argument that "letting [insert bailout recipient] FAIL would be worse for all of us."
Forgive me for pointing out the obvious, but erasing GM or Citigroup's common and preferred equity in exchange for backing up all or part of their debt WOULD NOT hurt the company in any way. Not only that, but it would restore in the public mind the sense that people who made lots of money in the past by riding the credit-driven bull market can lose money by the unraveling of the same market. The latter is not a minor point if we want to entice people to invest in the future as a general sense of a rigged game does not generate confidence in the average investor.
It is time the politicians realize that our money is a scarce resource. If we need to put a safety net under a few companies to save jobs, so be it. However, insisting on saving the equity will not only discredit our financial markets, but significantly increase the size of the total bailout. They can't save everyone so it is time to choose.
Wednesday, January 14, 2009
Bank of America (BAC).....10/16/08.....$0.32..............6.4B
Bank of NY (BK)................1/13/09......$0.24..............1.15B
Goldman Sachs (GS).........12/16/08......$0.47..............442M
JPMorgan Chase (JPM)...12/09/08......$0.38.............3.7B
Morgan Stanley (MS).......12/17/08...... $0.27.............1.0B
State Street (STT)............12/18/08...... $0.24.............432M
Wells Fargo (WFC)...........10/22/08...... $0.34.............4.2B
According to my calculations, that is a total of $6.6 billion only considering the last declared dividends. Keep in mind that BAC and WFC declared theirs before receiving the money from the government.
1. Mathematics A quantity to be divided.
a. A share of profits received by a stockholder or by a policyholder in a mutual insurance society.
b. A payment pro rata to a creditor of a person adjudged bankrupt.
a. A share of a surplus; a bonus.
b. An unexpected gain, benefit, or advantage.
[The American Heritage Dictionary, 4th ed.]
If you read the financial press you may think there is something wrong with the venerable Citigroup. They seem to imply that the recent government investment in Citi is some kind of “bailout”. In addition, the press insists in propagating malicious rumors about Citi desperately needing new capital. According to these rumors, Citi would be ready to sell asset at “fire-sale” prices. In fact, they are even trying to portray Citi’s latest strategic move, the new joint venture with Morgan Stanley, as a desperate move to raise the pittance of $2.7 billion.
Fortunately for us, firm believers in the infallibility of financial markets, there is plenty of evidence that Citigroup is as strong as ever. How do we know? As any financial text will tell you, there is no stronger signal to a company’s health as its dividend to common stock. Citi, of course punctually paid a $0.16 per common share on xx/xx/08. In fact, according to their quarterly cash flow, Citigroup paid $6 billion in the three quarters to 9/30/08 ($10 billion in 2007, if you care), more than twice what they will receive in cash for 51% of Smith Barney.
Do you think that the brightest bankers in Wall St. would pay $6 billion in dividends if they needed cash? In fact who in their right mind would pay such a large dividend while raising equity? Not Citi, unless you count the $4 billion of common equity they issued in 1Q08. Wait! Issuing equity to pay dividends sounds like a Ponzi scheme. Well, only if you think money is fungible.
This begs another question, if Citi needs taxpayer money, where do they get the money to pay dividends? Better yet, why do they continue to pay dividends given that they are desperate enough to need taxpayer money? If I were Citigroup, I would stop paying dividends to conserve cash. After all, dividends are discretionary payments which means I can cut them zero. Likewise, if I was the US Treasury or the Fed, who are supposed to look after the public funds they dispense, I would ask Citigroup NOT to pay dividends while they owe me money. Otherwise, it may look to “The American People” like they are using taxpayer dollars to satisfy someone’s fetish for a predictable dividend stream.
So long as we are on the subject, have you asked yourself who gets these dividends, which lately seem to come from taxpayers dollars? Citigroup shareholders, of course, which include, as far as I know, a member of the Saudi Royal family, several institutions around the World, and Citigroup employees.
The last group deserves special attention. If I am not mistaken, Wall St. banks like to compensate their employees with restricted stock. I think restricted, in this context, means that they can not sell the stock for a period of time. However, I do think they collect the dividend. That means that the money, if fungible, goes from the taxpayer to the accounts of the holders of restricted stock some of whom are responsible for setting dividend policy. As the Church Lady would say, “isn’t that special”
In the United Kingdom, a similarly structured allegedly capitalist society, the government also had to make a “capital infusion” to shore up the banks. The first thing they did was to abolish dividend payments.
If you think Citigroup is unique, I suggest that you take a look at any American bank receiving public funds. According to the US Treasury, if forced to forego dividend payments, many banks would not “participate” (meaning they would not accept the bailout money.)
There you have it, these guys are so smart that they have convinced the US government that they need to be enticed to accept a bailout. Sweet!