The Very Serious Blog

What Bernanke Doesn't Understand

2010-11-04T01:40:00.000-11:00

The United States Constitution was designed to create a government of checks and balances. Even during the Civil War, Lincoln could not ignore the powers vested on Congress and the Supreme Court. Which is why it is at least curious that we have come to vest quasi-dictatorial powers in the office of the chairman of the Federal Reserve.

Like his predecessor, Bernanke seems to be able to ad-lib extreme and profound policy initiatives with the sole backing of his "I know better" reserved for the most powerful dictators in History. Dictators, by the way, the American system has worked hard to avoid. Even Roosevelt in the midst of the Great Depression, had to deliberate, negotiate and even back down before the Supreme Court. Since the Federal Reserve was not contemplated in the Constitution, there is no mechanism to keep them in check, force them to debate, and even reconsider their actions. The confirmation process, as we have seen, is opaque enough to be out of the reach of most Americans. Yet, this individual (the other members just seem to go along for the ride) wields more economic power than the President of the United States.

As the Greeks described long ago, efficiency is the main advantage of a good dictator. The main disadvantage is that is hard to tell the dictator when he is wrong. For all the trust we seem to place in his wisdom, Bernanke has shown in the past not only a dangerous lack of understanding of the complex global financial system (see "The sub-prime crisis is small and well contained," or "American financial institutions are strong and well capitalized," among others), but also a willful disregard for the consequences of his actions. After all, is there anyone on this planet who still disputes that the Greenspan policies created the housing bubble? The most dangerous leader is the one who does not seem to acknowledge the past and learn from his mistakes.

Unfortunately, for us, Bernanke is a prisoner of his academic record. As most know, the studied the Great Depression and the Japanese debacle long ago. Back then, he decided what the problem was and what the solution should have been. As far as he is concerned, Japan could have avoided the two lost decades after their real estate bubble burst by throwing money from a helicopter. Never mind what History says about the aftermath of bubbles, or how high the relative value of Japanese land was in 1990, or the effects of an older population in a country without immigration, or any of the dozens of factors that have influenced the Japanese economy. Bernanke wrote a paper saying the monetary-hammer was the tool and, to him, every crisis looks like a monetary-nail.

Today, our esteemed professor has and OpEd in the Washington Post explaining HIS decision from yesterday. If you want to save time allow me to paraphrase, "core-inflation is too low, unemployment is too high and I do not know what else to do." That's it.

Sure, there is some academic language about lower rates encouraging consumption and investment which is dutifully parroted by our media, but who are we kidding? Does anyone really think that driving the 10 year bond from 2.80% to 2.50% will spur even one project? Would you buy your neighbor's house as an investment just because mortgage rates go from 4% to 3.5%? Would you buy it if the rate was zero?

As anyone following our economy knows, companies and individuals have been borrowing money at record low rates for a while. Those who haven't probably cannot because of lack of income, collateral or future earning streams, not because rates are too high.

What Bernanke conveniently ignores are the risks of his policies. No, I am not talking about hyperinflation, the destruction of the US dollar or other medium to long term calamities that may indeed result from his actions. My contention is that we are creating obvious problems right here and now.

Like Greenspan, Bernanke has very particular views about inflation. Not only does he choose to ignore important service components like health care which are underrepresented in the indices, but he explicitly ignores food and energy, two of the three most important items in a poor family's budget (the third being housing). Not only is much of our oil imported, but all commodities, even if locally produced are priced in dollars in the global market. In addition, for the past 10 years or so, commodities have become an active asset class for global investors/speculators. If QE results in a lower dollar, we will in all likelihood see higher commodity prices. Yet Bernanke will insist that there is no inflation, which will encourage even more speculative flows into commodities creating vicious circle that will heavily impact on the American poor. Talk about helping the little guy.

A policy of lower rates in a deleveraging economy neither spurs growth nor encourages employment. Hard as it is for Bernanke to understand, context matters and influences the economy's sensitivity to interest rates. Lower rates, instead, are nothing but a subsidy to those willing to take on leverage (banks and speculators) from those owning the capital (savers and retirees). As we know, money is fungible. Thus, the is no reason why the banks and speculators will all of a sudden rediscover productive projects at home because rates are 0.50% lower. Instead, they will continue to pump money into commodities, projects abroad and maybe stocks. Unless you own some of these, I fail to see how that benefits the average American.

I suppose it is what we can expect for forgetting the principles that made this country great and bestowing to much unchecked power in one individual, even one with a PhD.

European Stress Tests: The smoking gun

2010-07-30T07:44:00.002-11:00

What is a (banking) stress test?

In theory, is an exercise where the bank revalues its assets under one or more adverse scenarios in order to find out whether or not it is adequately capitalized.

In simple words, "if things became worse than they are now, do we have enough money (capital) to absorb the losses?"

A prudent banker prepares for the actual stress (not the test) by either reducing the price of an asset (or creating a rainy day account) once collection becomes less than certain. Again, "I think US treasuries are 100% safe so I value their chance of default as zero (no rainy day account). Greece on the other hand, I am not so sure, so I either value the bonds below par or create a rainy day account." If someone doesn't pay, the bank doesn't take the full hit on the day of default since it has provisioned against the loss. Monitoring credits and saving for a rainy day is the very essence of banking.

In Europe, bankers were happily riding the gravy train of buying Greek, Spanish, or Portuguese debt and treating it like German debt (no chance of default). Since the Greek debt paid higher coupons but required no provisioning, this was great for returns as well as bonuses.

At some point early this year, someone realized that the Greek debt was not as safe as its German brethren. Even the rating agencies, never too aggressive to downgrade anything, currently rate Greek debt as junk.

Since most European banks are loaded with Greek debt, the policy makers faced a dilemma vis-à-vis the stress tests: If they used stress prices (current market prices minus a cushion) the banks would show the potential for steep losses. If they didn't perform the tests, the market would continue to distrust the European banks.

The solution? Allow the bankers to decide which portion of their balance sheets would be tested. How? By giving them the chance to book whatever they wanted in a so-called investment account. This would be akin to grade students on just the questions they are sure they know. They can still get a few wrong so, technically, it is still a test.

According to bloomberg :

"Lenders hold about 90 percent of their Greek government bonds in their banking book and 10 percent in their trading book, according to a survey by Morgan Stanley. They have to write down the value of bonds in their banking book only if there is serious doubt about a state’s ability to repay in full or make interest payments."

Yes, you read correctly. They booked 90 percent of the Greek debt in the banking book which means they can price everything at par. One can assume that the rest of the balance sheet was treated in the same way. This, of course, includes not only Spanish, Italian, Irish, and Portuguese debt, but, we may presume, Hungarian mortgages denominated in Euros as well as all sorts of loans to Eastern European companies.

Unfortunately, the first casualty of this blatant attempt to manipulate public perception of European banks will be confidence itself. Once lost, it will not be easily restored.

Spain "Austeridad (pero no mucha)" [Austerity (but not too much)]

2010-07-30T03:06:00.000-11:00

I truly pity those who attempt to explain daily market moves. Last month, it was all about the PIIGS. This month, our manic-depressive portfolio managers, tired of waiting for another shoe to drop, have shifted their attention to the US economy.

Naturally, as they look at the US economy getting weaker, they had to do something, after all, what kind of a professional would you be if you didn't trade? So they sold the US dollar. Which of course means buying the Euro and the Yen.

So, for two weeks, we have heard that "the Euro is going up because Europe is stabilizing." Is it because of the stress tests? Well, not really, the tests had all the stress one can expect in the European continent in August. Not only did they ignore the true sovereign risk, but they made sure to render the results meaningless by allowing the banks to decide which risk would be tested while hiding the rest in investment accounts. I mean, would any buyer ignore any portion of a bank's assets on account that they promise to hold them to maturity?

In the meantime, the PIIGS are hard at work cutting their deficits for the benefit of the bondholders. Spain, for instance, has cancelled all sorts of public projects. Some of these, were only launched last year when the mantra was "Spend! Baby, spend!"

Canceling projects is relatively easy. After all, the construction workers are not the direct responsibility of the government. Public employment is another matter. As Spain announced today new record unemployment (click here if you can read numbers in Spanish) the report shows that the public sector continues to hire (click here if you can read charts in Spanish). According to this report, the "Autonomias" (regional authorities independent of the central government) have hired over 73,000 new employees in the last 12 months.

The conclusion is quite obvious. The markets focus on the big announcements by names they know like Trichet and Zapatero. If your competitors do the same, you can always say that you had all information available at the time. The reality on the ground, however, is quite different. In Catalonia, like in California, everyone the government fires/not hires is a voter. In the end, these are the people the politicians have to answer to, whether the bondholders like it or not.

Nobody has ever grown out of austerity without a devaluation. Although every situation is different, I suspect the reason is that the people on the ground, in the end, prefer bankruptcy to starvation.

I'll leave the moral judgment to the reader.

Disclosure: no stocks mentioned

An American Package for Germany

2010-05-11T08:09:00.006-11:00

In 2008 in the midst of the financial crisis. Hank Paulson gave the term bazooka financial significance. The idea was that if you announce a package large enough you will not have to deploy it because the market will step in front of you and finance whatever you want financed.

Back in those days China, the US, the UK, Brazil, among others, announced large fiscal packages to stimulate their economies. The Europeans, on the other hand, claimed they didn't need to because of the automatic stabilizing effects of their wide and generous social safety net.

Then, in the beginning of 2010, the world discovered that Greece had borrowed too much money and lied about it. Not only that, but Portugal, Ireland, Spain, Italy and others (nobody talks about Austrian banks and Eastern Europe anymore) had more or less done the same (ok, maybe except for lying).

So the Germans, stingy and hardworking as they are, complained that they shouldn't bailout the lying spendthrift Greeks who retire at 50 and do not work too hard. In addition, the law clearly states that bailouts are not allowed in Europe. True said the Greeks, but we owe 300 billion euros and, guess what, most of it to your banks and those of your new friends the French. So, you either bail us out or we blow up your financial system.

At that time, Merkel and Sarkozy went looking for the bazooka. Could it be a declaration of solidarity? the market said no and the Greek curve became inverted. Could it be 10 billion? same response. What if we call the (gulp) IMF? short lived rally. What if we promised over 100 billion which could finance Greece for several years? That should do it. Except nobody would buy the bonds from their banks and they already own a lot. What could we do?

Enter Tim Geithner, an experienced member of the Rubin/Greenspan/Bernanke team of anything for the banks. You have to make the package large enough to ignite short covering by the speculators in Chi...Frankfurt. If you set up a special purpose vehicle (we have AIG, Fannie, Freddie, etc) you do not have to show it as national debt. You can finance it over 30 years and kick the can down the road. Maybe in a couple of years they will discover spontaneous nuclear fusion in Thessaloniki and the market will rally saving the banks. In the meantime, they can put all the Greek, Spanish, Irish, AIG, Fannie, Italian, and Dubai bonds in the investment account and keep them at par.

In the Lexus and the Olive Tree, Thomas Friedman describes the world alternative models (circa 1999) as the five gas stations. In the 2010 version, everyone has become an American financial engineer. A financial alchemist can turn any solvency crisis into a liquidity crisis. Thus, no bank ever needs to write down any investment because they can always count on a government guarantee and a friendly regulator. In this context, why would Bank of America or Wells Fargo lend to anyone if they can buy Greek bonds yielding 8% with a German guarantee and finance them at 0%?

The fact is that no country has ever cut 10% of its GDP in spending without a devaluation and Greece cannot devalue without leaving the euro and, as a consequence, defaulting on its debt to the German and French banks. Nobody in their right mind would finance this with his/her own money even if it meant losing monies already sunk into such a project. Of course, other people's money gets a different treatment.

This situation is unsustainable and it may blow up with the next German election, IMF audit, or Greek strike, but it could work and, hopefully, by then I'll be gone and You'll be gone. So, party on Garth! Party on Tim, Angela, Nick, George...

Why Is The Greek Bailout Not Working?

2010-05-05T04:20:00.011-11:00

Although Greek debt problems did not appear overnight it is obvious that something has radically changed in the last 30 days. In a world used to thinking that policy makers can fix markets at will just by deploying their balance sheets it is disconcerting to see the lack of market reaction to the ongoing efforts by the IMF and the EU to avoid a Greek default. The question is why isn't anything working? Is it because the money won't come, because the Greeks won't deliver on the conditions, or are there other factors?

Although the Greek debt/deficit problems have been known for some time they did not seem to have any market impact until late last year. In fact, as late as October 2009, the Greek government didn't seem to have any trouble getting financing as Greek bond yields were around 2.3% for 2 years. During the first quarter of 2010, in the midst of shocking discoveries about off-balance sheet debt and accounting irregularities the yield on 2-year paper soared to 6.6%. By then, conversations about a European bailout began to appear on a daily basis in the financial press. After much dithering by the German government, European commitment to Greece was firmly declared and the IMF was enlisted in the rescue. The process should have climaxed last Sunday with the announcement of a gigantic package of more than 100 million euros which should be sufficient to keep Greece out of the public markets for, at least 18 months.

Under the Hank Paulson description of TARP ("If you have a bazooka in your pocket you won't need to use it") large amounts of public money commitments do their work without ever being deployed as private financing usually steps in to capture, in this case, the Greek spread for the German guarantee. After markets sold off yesterday, the consensus (if after the fact) opinion was that the markets either did not believe the monies will be forthcoming or that they process will fail over Greek intransigence. Although Ms. Merkel's speeches do not betray any conspiracy, the 48-hour Greek strike does give this theory some credence. In my opinion, however, there is something completely different and perhaps unavoidable at play.

Last Sunday, the NY Times published a useful diagram to show why Europe is so concerned about Greece ("Europe's Web of Debt"). In simple terms, the German and French banks have too much Greek debt much in the SAME way many banks own too much real estate and/or toxic assets (they still do, by the way).

Consider the case of a risk manager at a large German bank. You have been told, very recently, that owning so much Greek debt is bad banking and that you should have never accumulated so much. As luck will have it, you, your boss, and the regulator, agree that you will get a chance to get out either through bond maturities or by selling your risk as Germany will not allow Greece to go bankrupt. You are just waiting for the bonds to rally from the low 80's to something closer to par, where you have them marked as investments held to maturity often are, to cut your exposure.

Under the scenario above, every announcement meets the aggregate of all banks who have been natural buyers of Greek debt over the past n-years as better sellers and NOT as buyers as the bazooka deployers would want. In other words, the EU tried to bluff the market into financing Greece for a while longer and the market, unbeknown to its individual components, is calling the bluff.

Markets are about mass psychology. What policy makers fail to understand, is that the same participants who had no trouble accumulating Greek bonds at 150bps over German credit are unlikely to be enticed to resume financing at 14.5% over 2 years because they already own too much Greek debt. This, in my opinion, is why the Greek curve has stayed inverted in the face of positive announcements and why it is likely to stay that way. In other words, even if Germany would somehow agree to underwrite Greek risk no matter what for 3 years, which is very unlikely, the curve will stay inverted from 4 years forward (i.e. beyond the German guarantee) until all the excess Greek debt (that over what banks really think is too much) matures.

Like our sub prime borrowers, Greece borrowed too much over many years. The banks who bought this debt are now chocking on the risk and there aren't any new risk takers to take the balance. No amount of austerity from the Greeks will change the fact that 120% debt to GDP is now perceived as too high. Debt binges usually work themselves out over time or through defaults and this time is...the same.

Is TARP Greek for "Save the Bank(er)s?

2010-05-04T07:05:00.003-11:00

There was a time when we thought that the biggest problem with bailouts was moral hazard. Like with so many things in life, the only loss is to one's innocence and only the first time.

As it is well known, the Greek government is on the receiving end of an ever increasing bailout package. In exchange, for such a ridiculous amount of money and the invaluable tutelage of the IMF, which by the way will become a super-senior creditor ahead of ALL bondholders, the Greek government promises to produce what amounts to a balanced budget.

As we know, balanced budgets are as rare as honest politicians as nobody likes to pay taxes and everyone is rather attached to their salaries and/or entitlements. In my opinion, the Greeks are as likely to deliver a balanced budget in 2013 as anyone else in Europe and beyond, which means not at all. How does anyone think that raising taxes and cutting salaries will deliver short term growth in the presence of higher rates is a mystery to me. More importantly, the market for Greek bonds seems to agree with my assessment as the curve is still inverted from 2 years onward signaling concern about default.

Yet, we still get comments from various analysts and politicians to the effect that the situation is under control and it has a fair chance of getting better (if only the market would finance Greek debt at "reasonable" prices).

In this context, it is interesting to find out that the money from the package seems to be following a familiar script. In other words, just like our TARP, the Greek package is already mutating from "fund the government" (or pay the debt, which is equivalent) to "stabilize the banking system" which means the banks will get the money and decide what to do. Maybe even pay bonuses.

The problem with this (global) crisis is that it is destroying whatever credibility we may still have on the financial/political system. Enormous amounts of public money are being doled out on an attempt to keep the party going. The tragedy is not that, if History is any guide, it will not work, but that people will feel cheated out of their hard earned taxes. Money comes and goes, however, credibility is easy to lose and hard to get back.

Greece: Setting Up for the Final Act?

2010-04-30T02:13:00.002-11:00

According to our esteemed financial press it is almost a done deal. Greece has agreed to austerity measures designed to cut their deficit by 10% of GDP in three years and with this they will get an infinite amount of money from the IMF (20% courtesy of American taxpayers). With this financing, they will not have to come to market anymore (why are 2 year bonds still trading over 12%?).

"There was not much room for us to negotiate," the Greek official said. "This is the way the IMF works—if you want the money, you go by their terms. "

Makes sense. In the old days, before too big to fail, lenders used to dictate covenants for emergency financing. The IMF, as we know, thinks all the Greeks have to do is cut spending and raise taxes. Apparently, the Greeks needed the IMF to show them they didn't need to run deficits all those years because their economy would have worked the same with much less spending.

Interestingly enough, this flies in the face of the Trillions in stimuli that have been showered in the US, China, Brazil, the UK, and others, based on the theory that the worst thing you can do to a slumping economy is cut spending. I suppose Keynesianism only works in countries of certain size? I guess I missed that lecture in my macro 101.

In any case, it is clear that the overpaid geniuses at the IMF are back to their old methods. The debt must be paid at all costs because it was issued. Whether there is any chance of the Greek economy ever generating enough surpluses to pay the IMF, now first in line ahead of the bondholders, it is apparently of no interest to the politicians who just want this unforeseen crisis to away fast.

Meanwhile, in Athens, the unions are certainly going to think about what it is best for them. Can you blame them? At some point, they may realize that the problem is as much Germany's (or France's) as much as it is theirs. Why? because if Greece cannot deliver the austerity measures and the IMF does not provide the money to cover the deficit the German banks will lose (again) several billion euros. In this context, it is perfectly reasonable for the Greeks to claim shared responsibility and reject the austerity terms while accepting the money. At that point, the Greek politicians will prefer the voters to their friends in high places.

Therefore, if you think this crisis is over I suggest you consider you consider what would you do if they cut your salary because the government has issued too much debt. If you think this is a ridiculous proposition because Greek public employees are, in your view, overpaid, consider how much success you think you could have convincing them (hint: Greek unions do not like to be pushed around).

The bottom line is that, no matter what the Greek government says, a 10% deficit cut will be difficult to implement. The guys at the IMF have plenty of experience in the matter. If I have to bet, I'd guess the first audit will result in a disagreement of some kind over lack of progress. At that time, the IMF, after consultation with the G7, will issue a waiver. By then, the markets may be ready to reconsider the viability of the Greek debt (by then) junior to the IMF loans

Of course, it is possible that this time will be different and Greece will be the first country ever to emerge from a situation like this without a devaluation.

Meanwhile, the Greek bond curve is still inverted.

Greece: What to Believe?

2010-04-29T02:03:00.007-11:00

As I wake up this morning I hear my favorite news broadcaster (NPR, if you must know) proclaim something to like "markets are rallying overseas on news that the IMF has announced a $150B package for Greece." (NY Times version here

After a quick breakfast I rush to my computer to check prices. The rally still has the euro below US$1.33. My brokers, however, are all tripping over each other to bombard me with messages showing Greek CDS' at 520-620 (that is -150 from last night, dude!!). I even have one that says "...eveything back to normal !" (sic)

Wait a minute! Didn't they announce this package before? How much money has Greece actually received from the IMF or other European sources? The answer, so far, zero. In fact, the structure is exactly the same as with the "previous" package. Somebody throws a big number in order to calm the markets hoping to scare the pernicious buyers of Greek CDS's into taking profits and forcing Greek yields down. At this point, everyone in the global market is glued to their CDS screen. Except the truth is to be found elsewhere.

The columns on the right above (source: Bloomberg) show the bid-ask yield for Greek government bonds. As one can see, the curve for maturities longer than 2 years is inverted (higher yields for shorter maturities). In general, a non-risk free credit shows an inverted yield curve when the bonds trade by price and no longer by yield. In other words, unless the risk free rate is also inverted (not the case as shown by the swap curve on the left) the inverted curve signals that the market is concerned about default. In this case, apparently more concerned after 1 year.

This curve became inverted a couple of weeks ago and it is still inverted this morning as I write this. The question is: Why wouldn't European investors rush to buy 2-year paper at 12.7%? I mean, the difference between Greece and Germany can give you an extra 10% per year. Not a bad deal if you believe that Germany will bailout Greece. Same credit, much higher yield. The answer is partially explained in the NY Times today ("Already Holding Junk Germany Hesitates").

German institutions already own US$50B of Greek paper, which brings us back to the inverted curve. I do not know about you, but if I was the treasurer at a German bank sitting on a pile of Greek debt accumulated during the boom years, not only am I not buying more but I am also, quietly, looking to sell some. Maybe I am even trying to hedge my risk by hiding a few Greek CDS' in the closet.

There are more than a couple of players in this Greek Tragedy (sorry, I couldn't resist). The IMF, with Brazil becoming a financial powerhouse, has been out of a job for a while. Thus, they would love a center stage engagement monitoring Greek finances. The Germans, knowing how much Greek debt they already own, would love for the market to rally behind the Greece-IMF team one last time so that they can unload their bonds (How do you say: "never again" in German?) without having to actually lend Greece much money (Remember Hank Paulson's bazooka?).

If History is any guide, the Greeks will never deliver on the austerity packages. You can look this up, there is no precedent for an adjustment of this size (Deficit > 10% of GDP) without a devaluation.

The bottom line is that if the Greek economy could not raise the tax revenues to balance their budget and service their debt in good times with rates under 3%, I do not see why one should expect them to close the gap with higher rates and a weakening economy. The IMF and Germany may be able to refinance the Greek debt and keep creditors happy for a long time but it is unlikely that they will ever be able to make the Greeks balance their budget. Maybe Greece will show that this time is different, but in my opinion, this is all about buying time until the Germans can find a solution for their banks.

caveat emptor

How do you say Deja Vu in Greek?

2010-03-04T04:27:00.000-11:00

For those of us with a little experience in Emerging Markets, the crisis that ended in the Argentine default and devaluation in 2002 will undoubtedly stand forever in our minds as a top market event. Judging by the superficially naive analysis of the Greek situation, this memory has been lost to most Americans who hardly remember The slowest train wreck in History.

As most people know, much like Greece, Argentina is a country of contradictions. Endowed with beautiful land and sellable natural resources it was in the early 20th century one of the richest countries in the world. In addition, whether because of immigration, government policies, or other reasons, Argentina enjoyed one of the highest educational levels in Latin America, favorably comparable to many in Europe.

Somehow, they managed to screw enough things up to end up in chaos, default, and hyperinflation during the 80's (aka. The lost decade). Having lost all confidence in their currency through a recurring mix of chronic public deficits, future promises to unionized government workers and pensioners (their equivalent of Social Security went bankrupt), and quantitative easing, they resorted to an old-new idea: Convertibility, which was a US Dollar standard instead of a Gold standard. (I have attached a timeline at the end of this article).

Under convertibility Argentina thrived. The economy grew, long-term mortgage financing became available for the first time in decades, tax collections soared, etc. Debt to GDP went to a low of about 35%. There was one problem, inflation, although much lower than in pre-convertibility times, was high in dollar terms. Thus, Argentina gradually became expensive. Then, the usual happened. President Menem, trying to gain favor for a second term, opened the fiscal spigot and began to accumulate fiscal deficits which they now needed to finance in hard-currency. By the end of his second term, Debt to GDP was North of 50%, which is still low by today's standards. At the time, the argument was that Argentina's numbers were good enough to meet the Maastricht Treaty requirements to join the Eurozone, which they were.

Except Argentina is in South America. After the financial crises of 1997-1998 markets became increasingly reluctant to finance Argentine (and Brazilian) deficits.

Here is the Greek Tragedy (pun intended), even though the Argentine government tried to lower the deficit from 3-4% to zero, as opposed to from 13% to 3% as the Greeks are currently trying to do, the market never regained its appetite for, in Wall Street parlance, the story. Naturally, with every austerity package the Argentine voters rejected the situation grew worse. The economy slowed down more bringing down tax-collections and increasing the deficit.

Indeed, the IMF, which I would argue had more leeway than Germany since its directors were not subjected to the vagaries of democracy, did not want to see Argentina fail. Nor was the problem too large for the IMF which, in addition, had several allies in the Argentine government. Did I mention the Argentine debt was held by institutions and citizens in countries that controlled the IMF? (Anything rimes yet?)

Why then did they fail? Because regular people, the ones who vote and pay taxes, HATE deflation and austerity programs. Cutting some else's salary and/or pension may sound very logical in Berlin, but it is a hard sell to the average Greek just as it was to the average Argentine who, as the historical norm would have predicted, eventually accepted a biggest cut through devaluation. By the way, Germans do not vote in Greece.

Clearly, I have no idea what will happen in Greece, Spain, Portugal, or Germany. What I do know is that I have seen the cycle of promises and good intentions before. I also do not know of any country that has cut their fiscal deficit by 10% in two years without a devaluation. In any case, the similarities are worth mentioning given the level of analysis (or lack thereof) I see in the financial press. The differences I find are mostly favorable to Argentina as Greece doesn't have access to a super-abundant commodity sector or even a medium-size domestic market to fall back on.

By the way, the Argentine default took three years to develop and the market had several rallies (there were no CDS' in 1998 so I used their stock index in US$ as a proxy), so be careful what conclusions you draw from the announcements and trade carefully.

Timeline of Argentina's Crisis

1989: Carlos Menem becomes Argentina's president.
1991: Finance minister Domingo Cavallo introduces the "Convertibility Law" which pledges
to keep at least US$1 for each peso in circulation. The law is quickly approved by Congress
1993-98: Save for a brief panic during the Mexican crisis(1995), Argentina's economy soars as inflation subsides.
1995: Fiscal restraint is gradually abandoned as Carlos Menem seeks a constitutional reform and a
consecutive second term as president.
1996-98: Argentina's debt continues to grow in the midst of persistent fiscal deficits
1997-98: The Asian, Russian, and LTCM crises reduce investor appetite for EM bonds
1999: Brazil devalues its currency in January. Recession hits Argentina.
12/10/2000: F. De la Rua becomes Argentina's president. Promises to end corruption
5/29/2000: Spending cuts announced to reduce fiscal deficit. 20,000 protest.
8/24/2000: Finance minister (JL Machinea) announces more spending cuts, cites lower than expected tax-collection.
12/18/2000: Government announces IMF funded rescue package. Markets rally strongly on optimistic view that the crisis is over.
3/2/2001: Finance minister Machinea, unable to turn the situation around, resigns
3/19/2001: Government officials resign in protest at the cuts announced by new finance minister(R. Lopez Murphy)
3/20/2001: New Finance minister (R. Lopez Murphy) resigns. D. Cavallo is appointed finance minister.
6/3/2001: Argentina swaps U$40B in debt extending maturities and lowering current coupons
7/30/2001: Government approves "zero deficit" law. The package cuts state salaries and pensions by 13%
8/3/2001: IMF to accelerate $1.2B loan
8/21/2001: IMF Managing Director, Horst Koehler, agrees to recommend an $8B increase in Argentina's $20B stand-by loan agreement
11/1/2001: Mr. De La Rua and Mr. Cavallo announce a new economic plan which includes a very large debt swap to lower current payments.
12/3/2001: Government limits cash withdrawals
12/5/2001: IMF announces it will NOT disburse $1.2B loan
12/17/2001: Government presents 2002 budget which includes spending cuts of 20%
12/19/2001: Finance Minister (D. Cavallo) resigns
12/20/2001: President (F. De La Rua) resigns
12/22/2001: New president (A. Rodriguez Saa), backed by the unions, promises jobs and austerity
12/23/2001: Debt payments suspended (Total debt about US$130B, about 55% of GDP, unemployment at 18%,
Public Deficit/GDP about -3.5%)
1/2/2002: New-new president (E. Duhalde) decides to abandon the dollar peg. Intends to devalue the peso by "just" 30%
1/31/2002: Argentine peso closes at 1.40 per US$1.40
3/29/2002: Argentine peso closes at 2.935 per US$2.935
6/28/2002: Argentine peso closes at 3.81 per US$3.81
3/31/2003: Partly help by Agricultural exports, Argentine GDP grows for the first time since 1998.
Argentine peso closes at 2.9725 per US$
2003-2007: Argentina's real GDP grew by almost 9% in 2003, 2004, 2005, 2006 and 2007.
The federal government had surpluses of 1-2% of GDP. Source: CEPR).
2007: Unemployment at 9.6% first time below 10% in close to a decade.

Sources: guardian.co.uk, mapreport.com, news.bbc.co.uk, washingtonpost.com, frbsf.org

Let's hope Bernanke pulled a Casablanca moment in Congress

2010-03-04T04:24:00.000-11:00

Ben Bernanke is supposed to be a smart guy. A respected academic with enough political skill to be appointed (and reappointed) to head the Federal Reserve. In addition, he is supposed to understand basic financial products as well as banks. Having this in mind, I am still unsure of whether he was pulling a page of Casablanca ("I am shocked! shocked...") or he really didn't know that swaps are routinely used to change the look of one's balance sheet.

On the one hand he seems to be surprised that Greece would enter a transaction to get cash upfront in exchange for future cash receipts (NY Times story). After all, politicians live in the now and this is routinely done in Washington as well as in all 50 states and other public entities. In essence, you can argue that the Fed entered into such an arrangement by taking illiquid assets (Maiden Lane, for example) in exchange for cash. California is currently issuing IOUs in order to "defer cash payments into the next fiscal year" (a forced bond issuance or swap of sorts).

Then again, Bernanke was genuinely surprised by the sup-prime problem which according to him was "...small and contained..." (the quote is now too famous to require a source). So it strikes me that it is possible that the people at the Fed don't really know that convertible bonds are routinely pitched to "fixed income only" funds/entities. Maybe the also do not know that "access products" (a very lucrative area in Wall Street) involves nothing more sophisticated than packaging options, foreign currencies, and/or futures contracts into "principal protected notes" for sale to investors who are not legally allowed to buy the products directly.

In fact, CDOs were designed for investors who wanted to "own a leveraged portfolio without risking a margin call" (which of course meant the principal could go to zero). What are the odds that Greenspan, Bernanke or Chris Dodd knew this?

I'd bet if I stopped our esteemed Chairman somewhere in Washington DC and asked him what is the size of Citibank (one of our largest and most bailed out banks) he would reply: "about $2Trillion". Yet, as shown at the bottom of page 129 on their 10-Q report as of Sep2009, they held almost another Trillion in off-balance sheet liabilities.

Maybe that is why Bernanke and Geithner (and Greenspan) are so friendly with Wall Street. They know they are way over the heads when it comes to understanding the complexity of these institutions and the risks they take.

Scary.

Turning Japanese

2009-08-27T07:56:00.003-11:00

Once upon a time there was a country that was the envy of all others. Its currency was strong, its stock market was buoyant, its real estate was unstoppable, its banks were the largest in the World, its companies were imitated and their management techniques studied in business schools throughout the globe.

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.

AIG: The Lesson Not Learned

2009-08-20T02:56:00.011-11:00

Almost a year ago in the aftermath of the Lehman Brothers collapse, our government decided to change tactics and bailout AIG. We were told that failure to step in would result in a global disaster as the "insurance" company was essentially bankrupt but too interconnected to be allowed fail. AIG's problems were due to their exposure to Credit Default Swaps and other derivative products that obligated the company to make up for losses in various fixed income products. Naturally, the worst losses were related to mortgage related structures.

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).

Opinions are a dime a dozen but I would pay attention to CDS dealers since they actually put money on the line. Clearly these guys don't think the common equity is worth $4.5B as implied by an AIG-common price of $33.50.

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.

caveat emptor

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.

Say again, why did we bail out the banks?

2009-08-18T06:33:00.006-11:00

Almost a year ago, in the aftermath of the Lehman debacle, Secretary Paulson asked the American Congress for $700 million to relieve "our banks" (the meaning of the term was and is highly dependent on the user) of their "toxic assets" (his words). As Congress first said no, Paulson (aided by Bernanke) pretty much told us that failure to give him the money would mean the end of life as we knew it (another highly context dependent definition).

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.

What Happens When A Country Issues Too Much Debt?

2009-06-02T08:52:00.001-11:00

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.

On Mutual Funds and GM Stock

2009-04-30T02:56:00.006-11:00

The Mutual Fund community likes to sing their own praises when it comes to managing your money. The way the story goes, a team of professionals has a much better chance of finding good investment opportunities. After all, they have lots of advantages over the inexperienced layperson. For instance, they are trained in Accounting and Finance which allows them to navigate the increasingly complex slew of reports.

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.

caveat emptor

About those Google earnings...

2009-04-16T09:42:00.001-11:00

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.

caveat emptor.

Good unemployment numbers again!

2009-04-16T02:12:00.001-11:00

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.

Why Journalists Should Take Calculus

2009-04-10T00:50:00.003-11:00

It is hard to be an economics correspondent these days. On the one hand, you see the economy getting worse every day. Record foreclosures, record unemployment, rising bankruptcies, desperation in the minutes from the Federal Reserve from 3 weeks ago. You even see things you thought were not possible in this rich(?) country of ours, like an open squatters movement. Yet, the stock market keeps going up which makes you think the economy will recover in six months. After all, we all know that the market anticipates the recovery by six months. Furthermore, we also know that it is all a matter of psychology. If we believe things will get better, people will spend and things will get better. Where they are going to get the money? you don't really know. "Experts" say this is how it works and you are a journalist, not an economist.

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.
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

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.

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.

What Is The Stock Market Saying?

2009-04-03T06:31:00.009-11:00

The stock market has a powerful influence in the mind of the average investor. The belief that the market carries important information is deeply ingrained in our collective psyche. "Mr. Market" is supposed to have the power to predict the future, at least 6 months ahead. Allegedly it is a "giant discounting machine" that relentlessly incorporates information about the perspectives for the companies, and thus, the economy. Naturally this theory becomes more popular when the market goes up as we would like to think that things are always getting better. In my opinion, the evidence suggests that the stock market represents investor's beliefs and, thus, its predictions are often as flawed as those of its components.

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.

Caveat emptor.

Who is buying the market?

2009-04-02T04:16:00.006-11:00

Perhaps the most misunderstood phenomenon in the structure of our financial markets is the impact of trading by mutual fund managers. Paradoxically, in my opinion, it is the single most important factor to predict market moves.

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.

A Plan For The Automakers

2009-03-30T14:42:00.003-11:00

After watching President Obama's ultimatum to the automakers one couldn't help feeling bad for his cabinet. After all, with so many problems coming at them every day, it is natural that they miss a few solutions from the available set. Of course, as a taxpayer, it is in my interest to see the Obama Administration succeed in their attempt to rescue our economy even if a few trillion dollars are wasted along the way.

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...

How they use the TARP money II

2009-03-25T03:31:00.002-11:00

The TARP money, which in case anyone has forgotten is a taxpayer subsidy to the largest banks, was supposed to help recapitalize the banks so that they would lend money.

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.

http://www.nypost.com/seven/03252009/business/double_dippers_161157.htm

Questions for Mr. Geithner from a taxpayer

2009-03-23T09:00:00.003-11:00

Dear Mr. Geithner,

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.

Sincerely,

Harry Tuttle
American Taxpayer

Who works for us?

2009-03-16T04:31:00.003-11:00

Yesterday, as I was about to enjoy my copy of the NYTimes with my breakfast, I came across the news about AIG bonuses. Sure, it said that Geithner himself tried to stop the payments, that Summers was upset, that Liddy found the whole thing "distasteful" but, to no avail, the bonuses would be paid in full.

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.

In Defense of Geithner

2009-02-10T14:25:00.002-11:00

I always thought that Tim Geithner was the wrong guy to reform our financial system. Nothing personal, but I think it is hard for a guy with his resume to, all of a sudden turn against the system that made him who he is today.

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).

Who does Geithner work for?

2009-02-02T11:29:00.002-11:00

As someone who has a profound distaste for BS, I nevertheless have to admit that I admire American Bankers. For instance, take the fracas over their 2008 bonuses. While most mortals cannot believe that these guys got paid a ridiculous amount of money while racking up the largest losses in History, they actually want the rest of the World to feel sorry for them!

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.

Madoff's Mistake

2009-01-28T07:07:00.002-11:00

One of the inevitable consequences of bear markets seems to be the bust of Ponzi schemes. The explanation seems to be that Ponzi schemes are quite prevalent in our society but can remain undetected during good times. In other words, during good times people seem to have the risk appetite to believe that it is easy to make money consistently without risk of permanent loss. Under this psychological predisposition one presumably can entice his neighbors and friends (all of the caught schemers so far have been men, so women are either better at it or they do not run Ponzi schemes) into believing in unsustainable stories.

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.

Time to choose: The Country or the Stock Market

2009-01-16T02:17:00.003-11:00

Americans love the stock market. If you say "the Dow", everyone knows what you are talking about, and the index is prominently mentioned in every news broadcast in all sorts of media. You can say that the equity culture is as American as the fireworks on the 4th July, both may have been invented elsewhere, but they have never been as adored as they are here.

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.

Latest dividend information from the "big 8"

2009-01-14T09:16:00.003-11:00

---------------------------------Last---------Last--------Outstanding
---------------------------------Declared----Amount-----Shares
Bank of America (BAC).....10/16/08.....$0.32..............6.4B
Bank of NY (BK)................1/13/09......$0.24..............1.15B
Citigroup (C)....................9/29/08......$0.16..............5.5B
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.

Source: Bloomberg

How they spend the TARP Money

2009-01-14T02:30:00.003-11:00

div·i·dend (div- i-dend')
n.
1. Mathematics A quantity to be divided.
2.
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.
3.
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!

First Amendment to the United States Constitution

2009-01-13T07:20:00.000-11:00

"Congress shall make no law respecting an establishment of religion, or prohibiting the free exercise thereof; or abridging the freedom of speech, or of the press; or the right of the people peaceably to assemble, and to petition the Government for a redress of grievances."