Copy of letter sent to Chairman Bernanke - March 2, 2009
PETER R. MACK
March 2, 2009
Chairman Ben. S. Bernanke
Federal Reserve Board
Constitution Ave & 20th St.
Washington, DC 20551
Dear Chairman Bernanke:
SUMMARY:
The economic recovery depends on 1) stimulating the economy
and 2) repairing psychology and restoring confidence. The Fed and Treasury have
been working on stimulating the economy but restoring confidence against a barrage
of bad news is proving elusive. In order to repair psychology and restore
confidence to the markets, and to provide a better future rate-of-return to all
American citizens than an investment in Treasury Bills, I suggest that the
Federal Reserve Bank invest $1 Trillion into the domestic equity markets
through periodic purchases of large, mid and small cap index funds through the
leading fund distributors.
RATIONALE:
The markets decline almost daily, setting new multi-year
lows. Fears are being stoked by rampant rumors about troubled banks and nationalization,
putting stocks into free fall. In recent days, rumors and speculation in the
media about nationalization of Citicorp and Bank of America have driven shares
of those stocks to low single digits, putting the value of their preferred
shares and the continuance of the enterprise in great jeopardy. Managements of
both institutions have publicly tried to assure shareholders about their long
term viability but the markets are disbelieving. President Obama and Secretary
Geithner have publicly stated their opposition to nationalization but again,
the markets aren’t listening. Your own recent testimony to Congress, which I
thought was a powerful affirmation, failed to stabilize the markets.
As a small and quite recent stockholder of Citigroup, in
particular, but many otherindustrial
companies as well, and as an executive in the brokerage industry for 45 years,
I
am fearful that shareholders of common and preferred stocks
in these institutions are about to get wiped out. It is my strong belief that a
nationalization of the
two large institutions most commonly mentioned, together
with the prior catastrophic and ill conceived bankruptcy of Lehman Brothers and
collapse of AIG, Wachovia, WaMu, GM and the like of our widely held
corporations, will sound a death knell for the equity markets until long in the
future. Individuals will flee common stocks and equity mutual funds. Today, GE
broke the $8 level – a grim omen.
George Soros has long held and publicized his view that
markets drive fundamentals, rather than the other way around, producing bubbles
and crashes – a dynamic he calls reflexivity. In my view, stabilizing the
markets is the key to recovering household wealth and creation of economic
recovery. Following is my idea about how this can be accomplished while the
world waits for Government action to take effect.
THE PLAN:
The Federal Reserve must become an equity investor by
deploying $1 trillion into the equity markets through periodic purchases of
broad-based large, mid and small cap index funds through the leading fund
distributors. The Fed can operate under its normal procedures to minimize
impact on the markets. Because of the market sensitivity of prospective Fed
actions, leakers and leakees of Fed market actions under this program should be
dealt with under criminal rather than civil statutes, under Justice Department
rather than SEC jurisdiction. The public is sick of front running and other
abuses done by insiders and hearing rumors in the financial media that turn out
to be true.
These operations should be conducted on behalf of the
account of the Social Security Trust Fund. For those who believe that
privatization of Social Security into self-directed accounts was, and continues
to be, a good idea, this plan should get their support. For those who feel that
current aid to banks and financial institutions is a bailout for “fat cats” and
incompetent and spendthrift financial executives, this plan is inclusive and
benefits all citizens equally. If the US economy ever is able to emerge from its
current squalor, these investments should become quite profitable. Purchases of
equities for the Social Security account will also provide a hedge against
inflation, which many fear as inevitable following the current period of money
creation and growing deficits. There is no reason why equities should not
co-exist with low interest T Bills in the Social Security account and no more
appropriate time than now. Over the past weekend, in his letter to Berkshire
shareholders, Warren Buffett described the market in US Treasuries as an
investment bubble.
Were the Fed to conduct these open market equity operations,
the playing field would be more leveled in the equity markets. Bear markets
occur when there is an excess of fear over greed, when sellers overwhelm buyers,
in this case, because of a weak economy. Because of relaxed rules regulating
short selling and other market changes such as decimalization and the growth of leveraged short ETFs, short
sellers and hedge funds have had relative free rein, as normal buy side
investors such as mutual funds, pension plans and individual households have
had much of their ammunition taken by deflation,de-leveraging, and low confidence caused by the weak global
economy. In addition, as the markets continue to decline and further, as the
hedge fund industry is rocked by recent scandals, additional deleveraging by
hedge funds is expected as investors withdraw funds. Weakness in the markets
has driven fundamentals lower. It is not coincidence that as household wealth
and investment portfolios have declined, economic fundamentals have
deteriorated as consumers stop spending.
As you are known as a scholar of The Great Depression, you
know far better than I how, on Black
Thursday during The Crash of 1929, Richard Whitney, J.P. Morgan’s broker came
to the floor of the Exchange and placed sizable orders in blue chip stocks for Morgan’s
account. As word spread of Morgan’s intervention, prices firmed, effectively
stemming the crash. Several months ago, legendary value investor Warren Buffett
emulated Morgan by stepping in to snap up shares in Goldman Sachs and General
Electric, hoping to set a confident example as well, but he was far too early
and has lost enormous amounts of money, an experience shared by many.
Fed participation in influencing equity markets is nothing
new, having that ability through its authority in setting margin requirements.
Although I can’t recall any Fed action since at least the early 1970s, margin
requirements were a tool used to encourage or discourage equity investments.
Aside from just quaintly complaining about “irrational exuberance” a number of
years ago, Chairman Greenspan could have used the Fed’s authority to try and
curtail speculation if he thought it important enough to do something other
than to comment, but he did nothing. If this were a normal recession, now might
be an appropriate time to lower margin requirements, but with the volatility
and illiquidity in the markets, and the fact that this is more a depression
than recession, lower margin requirements would probably accomplish little at
this time.
Again, I believe it’s time for the Fed to act - to be the
Morgan of today and buy stocks on behalf of the people - to do what I and so
many others would do if we had any money left and weren’t so fearful of losing
everything. If we as a nation have any economic future at all, these purchases will
turn out to be great investments.
In
looking at the pre-market trading in Citigroup (C-NYSE) and seeing its descent
by over 60% or so from its previous close on the NYSE on high volume in
response to the Treasury department’s news, it would seem a safe assumption
that much of the pre-market trading involved high amounts of short sales done
electronically without pre-borrow or other stock loan arrangements, which, if I
understand the SEC rules correctly, would be a violation of those rules.
Extraordinarily
high short selling, whether in pre-market or during regular trading hours,
causes extremevolatility in a market
where individual investors, pension funds and mutual funds have had their
portfolios devalued and available funds depleted, The weakness in the economy
and equity markets and decline in consumer confidence, down to 25% at last
reading, has created an un-level playing field and enabled a condition of
extreme volatility, allowing the markets to be easily manipulated. In my view,
the Commission has a responsibility to ensure orderly markets.
Late
last year, I wrote to the Commission regarding re-institution of the uptick
rule and received a response explaining that, with decimalization and price
increments commonly one cent a share, the judgment was that the uptick rule
would be inconsequential and hard to implement. The solution, then, in my
opinion would be to limit decimalization to identifiable units of perhaps five
cents a share, or in any amount that would once again permit the effective
implementation of the uptick rule and permit the Commission to regulate markets.
Moreover,
although I personally have very little knowledge of how leveraged “ultra” short
index funds work, there must be some contribution to extreme downside market
volatility from these vehicles as well, perhaps involving short selling, and if
so, they should be subject to regulations and not exempted. But, again, I
really am ignorant about that product and how it works.
I
have worked in the financial markets for almost 46 years and I lament the fact
that I and my clients and the majority of the population now believe that the
equity markets are a giant casino, that they are manipulated and that they are
too risky for responsible allocation of assets. The markets need prompt and
effective regulation to insure their stability and viability in these troubled
times.
Just checking in with some comments on Secretary Geithner’s
plan.
The popular narrative is that the market was so unhappy with
the lack of specifics in the plan that it sold off 5%. I understand that the
public and the media want everything spelled out, even though reality dictates
that solutions to the economic plan have to be dynamic.
I think the major take away from the plan is that big banks
are not going to be permitted to fail, that the government will not nationalize
and will not own and operate banks. They have been saying this under Paulson,
but no one seems to believe, necessitating its constant repetition.
I think the plan is ok. First, it uses existing $350 million
left in TARP to partner with investment groups to acquire what everyone calls “toxic
assets.” There has been a deafening din about valuation under the good bank/bad
bank debate in Congress, television, on blogs, etc. Nobody wants the government
to pay too much and reward those rotten bankers. Everybody, including Nobel
Prize winning economists Krugman and Stieglitz blithely demand that the
valuation be based on market price, but it seems that only Geithner and the
bankers (and me) know that there is no market, that there is no one to trade
with, no one to put up capital. By partnering with private capital and
guaranteeing a valuation based on long-term returns rather than fire-sale
prices, the Treasury can revive a moribund market. I think this will succeed and
put a floor under these assets and trading will resume.
Secondly, under the plan, TALF sets aside $100 billion of
Treasury money which creates $1 trillion of money available to buy credit card,
auto and student loans. This is really significant and will start soon.
Thirdly, a “stress test” for banks to see if they can be
restored to health, if they are curable. Who can complain about that?
Finally, a promise to set aside $50 billion for foreclosure
relief to homeowners – ok to have no specifics – because Congress is involved
in the formulation of the plan, not Treasury alone.
There’s a tremendous amount of national anger and ignorance.
Legislators themselves are unable to process the amount of information required
to understand this very complex problem, and all are quoting constituents who are
angry but have absolutely no understanding of what’s going on. They rail about
corporate jets, and bonuses etc. – legitimate perhaps – but representative of a
greater societal problem which has gone on for a long time.
The Geithner plan is a middle-way solution that deserves
much more credit than it has received but it will require time to be implemented
and to work out. As you know, the markets generally want instant gratification
which they didn’t get yesterday, but things should stabilize as people learn
more about it and as it kicks in.
The key takeaway: The large banks will not be allowed to
fail! Taxpayers will be protected, somewhat.
NEW YORK
(MarketWatch) -- Pfizer Inc. is negotiating to acquire rival drug maker
Wyeth in a blockbuster deal potentially worth more than $60 billion
that could alter the global drug industry, the Wall Street Journal
reported Friday.
News of the possible deal sent shares of Wyeth up 13% in premarket
trading Friday, while shares of Pfizer slipped about 2.7%.
GERN5.21,
-0.08,
-1.5%)
said Friday that the U.S. Food and Drug Administration has granted
clearance for it to begin trials for what it said was the world's first
study of a human embryonic stem cell-based therapy for people. Geron
said it will begin a Phase I multicenter trial designed to establish
the safety of its treatment, currently referred to as "GRNOPC1," in
patients with complete Grade A subacute thoracic spinal cord injuries.
On October 28th, in Restoring Trust, I wrote of the need for trust to be restored in
many facets of our life and society including the economy, the markets,
financial institutions, political systems, our fiduciaries and advisors, and
lastly, our own self-confidence.
Now, less than three months later, the need to do so is even
greater. We had then just seen completed a first round of bank bailouts and
government forced corporate mergers and suddenly last week witnessed the
unraveling of the Bank of America/Merrill Lynch combination so confidently put
together in September, and now requiring another major infusion of aid from the
Treasury Department. Bank stocks which had recovered and rallied upon the
passage of the TARP (Troubled Asset Relief Program) are once again at record
lows.
In December we learned that the three domestic manufacturers
of automobiles were likely to imminently file bankruptcy if they did not
receive direct and quick aid from the government, and lest we believe that the
phenomenon was restricted to the much-reviled big three, the foreign companies
manufacturing in the US such as Toyota and Honda (known as transplants) were
also seeing sales and profits plummet.
And finally, giving authenticity to the loss of trust in financial
advisors and institutions, came the December revelation about the widespread
swindle by Bernard Madoff purportedly estimated (by him) to be around $50
billion. Since then, other Ponzi schemes have been reported, and just yesterday
came a news report of a Florida money manager disappearing and an estimated
$350 million of customer funds missing.
Economic statistics being reported for the fourth quarter
are truly dismal. Retail sales were sharply lower, housing prices continue to
sink, and foreclosures rise. On the jobs front, unemployment rose to 7.2 per
cent and is widely expected to continue for some months well into 2009. It
should be noted that corporations and organizations make budgets and plans at
the end of the prior year based on expectations for the coming year, and generally
stick to the plan. The recently-announced layoffs have been in the planning for
quite some time and are both a manifestation of the current state of business
as well aspart of strategic decisions as corporations restructure and
redirect activities. The economic climate in the fourth quarter was quite
negative and budgets going forward
were fashioned to be quite austere. Just at the end of last
week, GE Capital announced cuts of 11,000; Pfizer by 2,400, Conoco Philips
1,500 and the liquidation of Circuit City will cut another 30,000 jobs.
These numbers are almost certain to keep ratcheting upward
until the “official” unemployment rate exceeds 9 per cent or more from its
present level. To those without jobs and with dim prospects in the market, despair
will set in. To the 90 per cent of people still employed, caution and fear will
abound and for most of those people, from the self-employed to corporate
titans, salaries and compensation will be lower in 2009 than 2008. The mood of
conservatism will be entrenched. Yet, a 90 per cent employment rate is still a
powerful economic force that can keep the economy from entering a depression,
as so many doomsayers suggest.
According to recent CNN polls, only about 27% of American
people believe that President Bush did a good job in his eight years in office.
Aside from most Democrats, that polling figure suggests that more than half of
Republicans voted thumbs down. Hendrik Hertzberg writes in The New Yorker (January 19, 2009) that during the last eight years,
“the unemployment rate went from 4.2 per cent to 7.2 per cent and climbing;
consumer confidence dropped to an all-time low; a budget surplus of two hundred
billion dollars became a deficit of that plus a trillion; more than a million
families fell into poverty; the ranks of those without health insurance rose by
six million; and the fruits of the nation’s economic growth went almost
entirely to the rich, while family incomes in the middle and below declined.”
That’s the past, but there can be little question that
ultimately, the negative mood has to change and the inauguration of Barack
Obama and a new team on Tuesday, January 20th will go a long way to
starting us on the way back. The election of Obama was an affirmation of the
country’s will to restore trust and demonstrated the ability of the people to
overcome centuries of inherent racism and, to a lesser degree, partisan
politics.The nation continues to evolve.
On the positive side, many factors are in play that can turn
things around. The government, through the Federal Reserve and Treasury
Department has unleashed a torrent of funds through the $700 billion TARP
program and through Fed lending that has backstopped the banks and financial
services. Interest rates on Treasury bonds are at record lows, and have worked
through the system, bringing about the lowest mortgage rates in 30 years or
more. Rate cuts are not just in the US.
We have seen The Bank of England just reduce interest rates to the lowest
levels in 300 years, a lower rate than even George Washington might have
borrowed at when he was a farmer in Virginia and an English subject. The ECU is
lowering rates as well. Skeptics of the interest rate moves
point to Japan where low, almost negative interest rates,
failed to provide any stimulation to the economy over a decade and suggest it
could happen here – that Americans will change their habits from consumers to
savers – basically a new trick for an old dog.
It just doesn’t seem likely.
Energy costs have dropped dramatically, with gasoline, home
heating oil and natural gas prices far below (over 25 per cent) the levels of a
year ago. This drop represents the equivalent of a sizable tax cut for
consumers.
Finally, President Obama and the Democratic Congress will
pass a stimulus package probably in the area of $1 trillion to help move the
economy and advance aid to states and municipalities for infrastructure projects.
China has recently announced its own stimulus with an additional $600 billion
in infrastructure projects to augment their already significant budget.
Money will certainly begin to flow with the inauguration of
a new administration.
More than money, the change in government should bring about
effective changes in leadership. I have been a severe critic of Chairman
Christopher Cox at the SEC. I hold him personally responsible for changes in
market regulations that have harmed – maybe permanently – the workings of
markets as we have known them. The Bernard Madoff scheme appears to have been
conducted in spite of “whistle blowing” evidence provided to the agency many
years ago. As the story unfolds, more evidence of regulatory failure will be
revealed and histories will chronicle the collapse of the financial industry
under Cox’s watch.
The incoming Chair of
the SEC, Mary Schapiro, is an honest, dedicated, non-political public servant
and fiduciary. She has been the Chairman of FINRA (Financial Industry
Regulatory Authority) the agency that regulates the brokerage industry and our
firm. Under Ms. Schapiro, I expect that certain significant remedial actions
will be initiated, I hope soon after taking office. I expect her to reinstate
the uptick rule regulating short selling, to strengthen and enforce rules
prohibiting naked short selling, to revise
certain requirements of FAS 157, and, over time, to put CDSs (Credit Default
Swaps) and hedge funds under new regulatory authority.I think these actions, if taken, will go a
long way to restoring trust in the markets and reducing chaotic volatility.
With new leadership, I expect a new tone at the FDA (Food
and Drug Administration) that will revive an almost-moribund agency and place a
premium on science and health for all Americans rather than an agency that has
been transformed into one that advanced and promoted the religious ideologies
of conservatives. This will encourage the biotech and pharmaceutical industries
to rev up their search for new treatments for our major diseases.
I foresee an economic revitalization, and an expansion of
domestic manufacturing after years of disinvestment and job export to foreign
shores.
On the other hand, while I am optimistic, nonetheless we are
a country at war with an economy that is dangerously weak and depleted. The
road to recovery is bound to take a longer time than most would hope for, and
the shape of the new economy will look somewhat different from what has gone
before.
But I certainly wouldn’t sell the economy short – to bet on
failure - especially with all the positive forces arrayed against it. In short
order, someone will refinance a house and go to Home Depot and buy some paint
and a new sink. Someone else will finance a new car.
Money will begin to flow, one transaction at a time, until
the cumulative effect changes the statistics and produces better reading and better
news, thus giving others the courage to act as well. And so it goes.
Hope is on the way and no one should be so cynical as to not
share in some optimism. Maybe it will work, maybe not, but it’s what we’ll see
kick in very soon, thought out by some of the best minds that America has to
offer. One year ago today, I was in the ICU at Yale - New Haven hospital and
here I am today, still among you.
I will close by adding a poem that I particularly like by
the Welsh poet, Sheenagh Pugh, which I think sums it up better than my text.
SOMETIMES
Sometimes things don’t go, after all
from bad to worse. Some years, muscadel
faces down frost, green thrives, the crops don’t fail,
sometimes a man aims high, and all goes well.
A people sometimes will step back from war,
elect an honest man, decide they care
enough, that they can’t leave some stranger poor.
Some men become what they were born for.
Sometimes our best efforts do not go
amiss; sometimes we do as we meant to.
The sun will sometimes melt a field of sorrow
that seemed hard frozen; may it happen for you.
-Sheenagh Pugh,
“Sometimes”
Peter
R. Mack
January
18, 2009
Peter R. Mack & Co., Inc. and any of its principals including Peter R. Mack may have an investment position, either long or short, in any securities mentioned herein.Furthermore, although the information contained herein is believed to be accurate, neither the firm not its principals make any representation as to its accuracy and the reader should not rely on this information for any purpose. Opinions mentioned herein are subject to change without notification. Material contained herein is for informational and educational purposes only.
China today announced a stimulus package worth some $586 billion, equal to approximately 16.7% of the roughly $3.5 trillion economy. The US has previously announced a $700 billion rescue package which while large is equal to some 5% of the $14 trillion US economy. China's package which will concentrate on infrastructure and capital improvement is huge and is consistent with global efforts to forestall the creeping deep global recession.
BOE cuts rates aggressively to 3.0% from 4.5% signaling growing recession numbers in UK. Hopefully, we can expect the same from Federal Reserve and central bankers around the world in attempts to stimulate business activity and bring liquidity to debt markets. Somewhere, the ball has to start rolling by virtue of increased lending and availability of credit for housing, automobile sales, capital spending and even the most rudimentary functions. Troubled banks have siphoned capital and must and ought to begin their business of lending responsibility, otherwise, they have no function in society and saving them is a waste of money. Can the economy last waiting for the new team?
This
is a time when nothing is as important as restoring trust. People around the
world must restore trust in their governments and leaders; financial
institutions have to restore depositors’ trust and their own faith in competing
institutions; markets have to restore trust in liquidity and the historical
system of capital flows; and regulators and legislators need to restore trust
in their own integrity and expertise.
Most
importantly, clients have to restore trust in their own financial advisers and
money managers, and, in turn, those investment professionals have to rebuild
faith and confidence in their own abilities and judgments.
It
will be a very difficult struggle for everyone.
Personally,
I’m having a difficult time understanding how the global crisis developed into
the panic we’re currently in. I felt that I and my clients were positioned to
maintain some defense against the events. Beginning around 2004, I had become
quite wary of the financial sector after reading a number of research papers
about leverage in the financial markets and institutions from off-balance sheet
exposure to derivatives including credit default swaps (CDSs), collateralized
mortgage obligations (CMOs), etc. and coming to further understand the fixed
income markets.
In
2004, the size of the derivative market was already astonishing to me, although
it was then probably less than one fourth or so of the size it was prior to the
onset of the crisis, and 2004 was even before the explosion of mortgage debt in
housing and the emergence of the sub-prime problem.
In
July 2007, I posted a piece on my blog Notes
From The Front quoting Warren Buffet on the hazards of derivatives in the
credit markets. His concern proved to be quite prescient.
My
own concerns were sufficient to keep us out of financial stocks. We had no or
minimal exposure to the brokers, banks or the hot names such as Washington
Mutual, Fannie Mae, Freddie Mac, AIG or others that have subsequently been
taken over or closed at great loss to shareholders.
At
the height of their popularity, financial stocks represented 21% of the value
of the S&P 500, at a time, for example when energy was somewhere around 6%,
and commodity and materials were at 3%. The large financial names that
descended into dust were the core holdings, the mainstays of most of the
portfolios run by large brokers and advisers. The under-weighting of our
portfolios cost us some points in relative performance at that time, but spared
our clients the massive losses endured by others in 2008, and I am proud of
that fact.
FINANCIAL CRISIS - PART 1:
The
Global Financial Crisis has gone through two, or possibly, three stages. In my
view, stage one began in early 2007 with growing concern about housing,
mortgages and the revelation of trouble at two Bear Stearns’ hedge funds. In
theearly summer of 2007, those funds
were closedat greatloss to their investors, but the markets shrugged off
the trouble as isolated and manageable.
In
July 2007, the SEC under Chairman Cox committed the first gross blunder in the crisis
by removing the “uptick rule” regulating short sales. Under the rule, any short
sales of stock had to be executed at a price higher (or the same) as the
previous sale. The purpose of the rule was to give stocks breathing room on the
downside and prevent sellers from essentially throwing fuel on a raging fire
and driving stocks lower without interruption. The uptick rule had been in
effect for many, many years and, in my opinion, had served to soften the
downdraft of stocks subject to heavy short selling and prevent “bear raids” on
targeted stocks, by permitting buyers to buy while scaling down. Many have
defended the SEC’s action by claiming that stocks that go down would go down
whether there was an uptick rule or not, a view I totally disagree with. The
uptick rule brings order and time in place of chaos. This blunder by Cox seemed
to me to be just the start of a pattern of non-performance during his
hyper-political administration at the SEC.
For
those who may not understand selling short, the process is to sell stock(that you do not own) first, and hope to buy
the shares back later at a lower price. It is simply the reversal of the buy
low/sell high practice; it is sell high/buy low.
Additionally,
also with respect to short selling, the SEC continuously failed to enforce the
rules regarding “naked” short selling, a rule that requires short sellers to
borrow stock for delivery to the buyer before it is sold short. By its
suspension and non-enforcement of these rules, the SEC permitted chaos to enter
the markets at a very delicate and sensitive time in the global economy.
In
November of 2007, FASB (Financial Accounting Standards Board), an independent
organization that establishes accounting standards and interpretations of
accounting rules, passed Rule 157 which regulated mark-to-market valuation
methods for financial institutions. It is too complicated to fully explain it
in few words, but the rule forced financial institutions to adjust the value of
certain assets on its books – generally infrequently traded derivative
instruments - based on actual last sales in the marketplace. These assets don’t
trade on any exchange and actual market prices are not readily available. The
net result was that forced and troubled sales at fire-sale prices made by capital-impaired
institutions became the standard for all institutions and forced all those
other institutions to then mark down the value of the assets on their own
books. This constant downward revaluation created a new round of capital
shortage and book entry losses which then forced more sales to meet regulatory
capital requirements, lower values for those assets and created a vicious
downward spiral. In my opinion, the passage and implementation of 157 in
November 2007 was the second, if not one of the greatest bureaucratic blunders
of all time, and represented a major cause of Financial Crisis 1.
I
should note that the minutes of the October 2007 board meeting of FASB clearly
describe that the professional staff of FASB had recommended a one year delay
in implementation of Rule 157 but was overruled by the members of the Board in
a 4-3 split vote after a very brief debate. This was a huge mistake and in a
perfect world the four board members who forced the implementation of this rule
would answer to Robespierre, rather than be permitted to remain in the
background, preserving their relative anonymity and cupidity.
The
process of mark-to-market accounting would be similar to houses sold in
foreclosure. Hypothetically, you and your neighbor live in a gated community
and have identical houses valued at $750,000. Your neighbor has fallen on hard
times and needs to sell to raise cash by the end of the week. A buyer offers
$450,000, all cash, which is accepted. Under mark-to-market, if you were a
financial institution you would be obligated to value your house at the
$450,000 of the last sale without regard to any extenuating circumstances or
the fact that you don’t have to sell and expect to hold for years. Extending
the analogy, your lender would then call you and demand that you put up the
$300,000 marked down forcing you to sell at the discount price or even lower.
Frankly, it’s an insane process.
Once
FASB 157 went into effect, banks and investment firms started to announce and
take markdowns, yet there was still sufficient capital and liquidity to
maintain regulatory requirements. The level of concern began to rise as
institutions began to report growing losses. In January 2008, while I was a
patient in Yale New Haven Hospital, a trader at Societe Generale, a large
French bank, stunned the global markets by recording a trading loss in
derivatives of hundreds of millions, causing the market to have a then huge
selloff.
On
March 14, 2008, after Bear Stearns’ common stock had been relentlessly driven
down through rumor and intense short selling, the company was facing bankruptcy
as customers pulled funds and wouldn’t trade with them. The US Treasury was
forced to intervene and arranged a takeover of Bear Stearns by JP Morgan at $2
per share, with the Treasury positioned to guarantee all debt obligations on
Bear’s books. (Subsequently, Bear shareholders managed to increase the stock
purchase price to $10.) To everyone, this signaled a realization by the
Treasury to intervene to preserve the liquidity of the financial system in
saving those firms considered “too big to fail” and was seen by most as an
ongoing policy commitment by the government.
I
view this action and this date as the effective end of the viral portion of
Financial Crisis 1, although it was very clear that mortgage woes and housing
problems would continue to create economic problems in the future. However, the
Treasury’s actions generated a firm commitment to restore trust and liquidity
in the system and bought the time needed to work out the problems without a
global crisis. In England, the saga of Northern Rock was playing out as well,
aided by commitments and support from the Bank of England and government.
On
March 14, 2008, just prior to the rescue of Bear Stearns, the Dow Jones average
closed at 11,951. On September 8th, immediately after the rescue of
Fannie Mae and Freddie Mac but before the Lehman bankruptcy, the Dow Jones
Average closed at 11, 510, representing a decline of just 3.7% during a period
when the mortgage and housing news continued to worsen. Some people believe
that this was a case of mistaken complacency in the markets. In my view,
however, it represented the global consensus that the United States had
formulated a consistent policy of intervention which restored trust in the
stability and strength of the financial system and its institutions. I view
this as a clear demonstration of the end of Financial Crisis 1.
FINANCIAL CRISIS – PART 2:
On
Monday, September 15, 2008, Lehman Brothers filed for bankruptcy, after the US
Treasury and the Federal Reserve failed to provide or facilitate a rescue plan
in spite of having provided implicit assurances to investors that the system
would be preserved and stabilized. Within hours, the markets began to
experience devastating effects. Money market funds which had provided and held
short term loans and commercial paper in Lehman now had essentially worthless
debt and had to write down the debt, pushing net asset values below the $1.00
level, a condition known as “breaking the buck.” This caused an immediate run
on the money market funds as investors pulled trillions out of these funds as
well as from deposit accounts in banks and brokerage houses. It soon worsened
as the global panic spread around the world. Equity, bond and commodity markets
began to crash, causing margin calls and additional forced liquidation, which
in term caused more selling and another vicious circle of selling, a process
known as deleveraging.
Money
market funds are a main source of lending and liquidity in the short-term
lending market to banks and industrial corporations through commercial paper.
In general, money market funds have an average maturity life ranging from 30 –
50 days, depending on their experience and management decisions, which allows
for historically expected immediate cash needs. With the run on the funds and
need for cash, the industry was thrown into upheaval and has yet to recover.
Since
the bankruptcy of Lehman Brothers, the Dow Jones Average has dropped from
11,510 on September 8th to 8,379 on October 24th, a
decline of some 28%.
The
government’s failure to backstop Lehman, thus breaking the trust that the
markets had placed in it, in my opinion stands as the single cause (or at least
the major contributing factor) in the global financial crisis that has
devastated every single market in the world.
It
was most likely Secretary of the Treasury Paulson, or perhaps Timothy Geithner,
the President of the New York Federal Reserve bank, or the two of them who
single-handedly made the fateful and stupid decision that caused individuals,
governments and institutions trillions of dollars in losses.
Secretary
Paulson has been less than candid about why he shifted policy. At a recent
press conference, he was asked whether he would admit that it was a mistake.
Defensively, and seemingly pleading for understanding, he answered that “there
were no buyers for Lehman” as if this was sufficiently exculpatory, and
immediately changed the subject.Of
course there were no normal buyers for Lehman without the government guarantee,
just as there were no buyers for Bear Stearns other than JP Morgan back in
March without Treasury’s guarantee.
We
don’t know now and maybe we’ll never know the reason, but it seems likely that
Paulson and Geithner wanted to teach Richard Fuld, the CEO of Lehman Brothers,
a lesson he’d never forget, without understanding the consequences.
For
months prior to the bankruptcy it was reported that Paulson, Geithner and other
officials had “urged” Fuld to find a buyer and sell Lehman. For whatever
reason, he didn’t do it.These people
knew each other well, as power players in the industry. Obviously, I wasn’t in
the room and nothing has been reported, but I think what this comes down to is
simply a personality conflict, a fit of pique, a power play. “We told you to
sell and you didn’t, and we’re going to teach you a lesson you’ll never forget.
Don’t mess with us!”
Wouldn’t
it be shocking and surprising if my take on the development of Financial Crisis
Part 2 turned out to be true: a global financial catastrophe, man-made and
perhaps caused mainly by arrogance and egotistical human error!
LOOKING AHEAD:
Since
the Lehman bankruptcy, markets around the world have crashed; credit has
frozen; economic forecasts which just a month ago were cautious on the question
of recession, now question whether we can just stop at recession before moving
to depression. Our government has jumped into action, rescuing or causing to be
merged such institutions as AIG, Washington Mutual, Wachovia, Merrill Lynch,
all on the brink of failure; creating numerous plans with acronyms such as TARP
intended to shore up lending and borrowing among banks and generally making
available the resources of the US Government to keep the financial system
liquid and fluid. All the facilities are in place and hopefully the expanded
activity will be felt soon and credit restored.
Congress
has passed a broad rescue plan for mortgages and housing and another stimulus
plan for the economy is likely very soon should Obama win and the Democrats
hold or expand their control in the House and Senate.
In
Europe, the G7 and EU have met and developed concerted interventions to
backstop the European banking system, and England has done the same as
economies weaken and drop into recession. Iceland teeters on the brink of
bankruptcy. The Russian market is down 70% on the collapse of oil and
overextended lending. The Russian oligarchs, many among the richest men in the
world, have seen their industrial empires collapse amid losses in the billions
of dollars.
In
this country, some of the largest and well respected hedge funds are down by
35-40%, and investors are pulling funds, thus causing serious selling. Just
last week, SAC Capital, a hedge fund run by Stevie Cohen said that they had
sold 50% of their holdings – probably over $20 billion – to raise money, while
Calpers, the State of California Pension Plan, was actively selling at these
prices to raise money for payouts to retirees.
Today’s
news carries a convoluted tale about Volkswagen, and enormous losses being
taken by hedge funds caught in a short squeeze in a trade gone exceedingly
bad. Goldman Sachs andMorgan Stanley are off by considerable amounts as they
are rumored to be caught in the maelstrom.
The
price of oil has dropped from $145 a barrel just a few months ago down to about
$60 a barrel today, on commodity futures liquidation. Other commodities from
the metals to fertilizer plummeted with amazing speed. At the beginning of the
summer, I wrote about oil speculation and low margin requirements being the
only reason why oil had risen to excessive highs and destabilized world
economies. At the same time, George Soros and the former head of the CFTC
(Commodities Future Trading Commission) both testified before congress that
speculation by futures traders including hedge funds, had corrupted the system
and led to a catastrophic price increase. Their testimony was ridiculed by CNBC
and the free-market advocates, and ideological anti-regulation forces grabbed
the media’s attention.
Just
over a week ago, Aubrey McClendon the CEO of Chesapeake Energy (CHK), a listed
natural gas company, was forced to liquidate his entire holdings of Chesapeake,
the company he founded, selling over 31 million shares to meet a margin call.
His holdings, worth more than $2 billion at the stock’s high of $74 in July,
were worth a mere $42 million when sold.
Recently,
Warren Buffett, the legendary value investor, took significant investment
positions in General Electric and Goldman Sachs, demonstrating his willingness
to bet on the future. As of this writing, he has significant losses on those
two holdings, just like everyone else. Given his time frame, I have little
doubt that he will once again demonstrate why he is so esteemed. On the other
hand, just a few days ago, Alan Greenspan confessed that his philosophical,
ideological belief in free markets was flawed, a much belated mea culpa.
The
consolation to all of us is that governments, including our own, central banks
and legislators have given signs that they are scared, as well, and will do
anything and everything to sustain the safety and functionality of the global
economy. Initially, this means pumping money and liquidity into the respective
systems. It means lowering interest rates. It means working in cooperation and
coordination with each other. It also means balancing the needs of the people
with the needs of the institutions.
We
have endured a brutal period. We are all shocked at the destruction of our
personal wealth and many of us find the machinations of the financial system
and the markets beyond any comprehension. We are asked to have faith in our
fiduciaries – the regulators and legislators – and many of us feel that while
we don’t know much, they know even less. We can all be consoled, however, by
knowing and recognizing that every effort is being made to restore trust in the
markets, to provide liquidity and stability to the economy. I believe, or in
moments of weakness just hope, that these efforts will succeed.
I am
angry and regret very much that Secretary Paulson, or his associates, made such
a catastrophic error in judgment in spilling the Lehman Brothers poison into
our well. No matter how great their effort in trying to clean it up after the
fact, the reality is that the well has been tainted and only through time and
additional filtration can it be restored. The poison is causing a panic; the
markets are asking the question whether some chain of inexorable or
irreversible events are in place to dictate our future destiny, to bring about
a new depression. I believe not. I believe that the depth of the crisis has
passed and that the patient will soon begin to heal.
Peter
Mack, October 28, 2008
Peter R. Mack & Co., Inc .and any of its principals
including Peter R. Mack may have an investment position, either long or short,
in any securities mentioned herein. Furthermore, although the information
contained herein is believed to be accurate, neither the Firm nor its
principals make any representation as to the accuracy of any information
contained herein and the reader should not rely on the statements contained
herein for any purposes. Opinions mentioned herein are subject to change
without notification. Material contained herein is for information and
educational purposes only.
Earlier today, John McCain said that SEC Commissioner Cox
should be fired. Bravo John, you got that one right! From the suspension of the
“uptick”short selling rule in July 2007 through the failure to enforce rules regarding
naked short selling down to his present absence as an effective player while
the financial industry collapses and his charges disappear, Cox has been an
incredible failure. His firing would be but a minor sanction. For those who
don’t know him, he was a Republican Congressman from California before being
rewarded by President Bush and placed in a job heading an industry he knew
nothing about. Par for the course for the Bush administration. In response to
McCain’s firing call, earlier today Bush praised Cox, a replay of doing just a
heck of a job Brownie. Score one for McCain. Apparently, Barack is sitting this
one out, thinking up no doubt intelligent but passionless and convoluted plans.
Earlier this week, Treasury Secretary Paulson engineered a
confiscatory takeover of AIG, lending money at an interest rate of roughly 11
¾%, with mandatory principal payments and penalties and received a warrant good
for 79.9% of the company. Some might think that Vladimir Putin had a hand in
this and others looking at the interest rate and terms might think the deal was
arranged by organized crime. Both the media and politicians of both parties are
calling this a bailout. Others believe that the US has made a good and necessary
loan, and will be money good at the end of the process. Nancy Pelosi,
Democratic Speaker of the House, severely criticized the move as a bailout, not
appearing to recognize the need for the action in both US and global markets
and countries. Strike one on Nancy and the Democrats.
The end of the previous week was marked by the Treasury’s investment money in Fannie Mae
and Freddie Mac at interest levels around 10% and again seizing control in an
effort to keep the national mortgage apparatus fluid. Also this week, the
Treasury refused to help Lehman Brothers with its long-term liquidity and that
company filed bankruptcy and is now in liquidation. Most Democrats again
decried the use of government funds in the private sector.
Most people, including myself and at least 99% of our
Senators and Congresspersons, are not fully informed and just not competent to
understand the very complicated innards of “Frannie.” But I think I know enough
to believe that given the luxury of time, and no need to go to the public
market and raise capital, and no regulatory requirement to comply with FASB 157 (I’ll get to that
later), this “bailout” may ending up costing the taxpayer very little if not
nothing. Many have opined that at least 85% of the mortgages held by Frannie are
current, and will, over a time, return the principal and interest owed, and
will more than cover the 15% of the mortgages that are not current or in default.
With the luxury of time, perhaps as many as half of those 15% of problem
mortgages, will, with proper individual care be worked out, recovering all or a
large part of their principal, or, if houses are foreclosed, return a good part
of the loan In the end, the much maligned “bailout” may pay off, and may turn
out to be a good trade for America. But in any event, the loan to Frannie
should not break the American bank and Democrats would be well advised to get
with the program instead of thinking that somehow the Bush administration is
bailing out stockholders!
You can’t turn on the Republican propaganda machine known as
CNBC without repeatedly hearing the expression “moral hazard” from guests and
commentators alike, and listening to Paulson, and his stern admonitions may remind
some of Cotton Mather. Sadly, many Democrats have joined the moral hazard crowd.
The babble is indistinguishable.
And where is Barack Obama on all of this. I haven’t heard
any displaced anger, such a gentleman Barack is; no “Fire Cox” emanates from
his mouth. Sadly, and I’m a long-standing, card carrying Democrat, albeit a
past supporter of Hillary Clinton but an Obama supporter now, I just don’t know
where he is. I haven’t heard any passion from him, any criticism – no nothing –
that registered with me. I just received an e-mail of a new ad that drones on
about jobs etc., etc., etc. I imagine that he’s offsomewhere thinking about the crisis and
probably developing some complex long term strategy, but hey man, there’s a
pretty big fire raging now!
In November 2007, the Financial Accounting Standards Board
(FASB) put into effect Rule 157 that required most financial institutions to
“mark to market” their holdings of CDOs, CMOs, etc. etc. FASB is a non-profit,
advisory organization made up of business and financial leaders whose mission
is to standardize accounting rules for consistent reporting. In simple terms, the rule required those
institutions to value the assets on the last sale, rather than on a theoretical
mathematical model, as was previously allowed. As many institutions began fire
sales of assets, last sale prices went lower and lower, forcing institutions to
devalue the portfolios, and the devaluation meant that many institutions took
write-offs and had to raise capital to meet regulatory ratios. Continuing sales
by other market participants led to a vicious cycle of re-pricing, devaluation,
write offs and capital raising. In one recent one-month period, Merrill Lynch
sold assets at prices beginning at 48 cents on the dollar that went down to 22
cents on the dollar just a week or so later. Obviously, distressed asset sales
destroy orderly markets and lead to chaos.
I was wary of FASB 157 when the rule was passed and believe
that the impact of the rule has been to destabilize markets by mandating and
establishing false asset values and depriving financial institutions of the
time required to solve problems. The minutes of the FASB Board meeting on
October 17, 2007 revealed that the professional staff of FASB had recommended
at that Board meeting that the implementation of the rule be deferred by one year,
which would have brought it to November 2008 for implementation. After
discussion by Staff and the Board and deliberation of a grand total of 45
minutes, the Board in a vote of 4-3 decided not to accept the recommendation to
defer but to implement in November 2007. I believe FASB 157 to be a major
contributing factor to the financial crisis which led to the collapse of Bear
Stearns, Lehman Bros., Fannie Mae, Freddie Mac and AIG, and the shotgun merger
of Merrill Lynch, with the Bank of America, as well as the hundreds of billions
of dollars in lost wealth and market value of the so far surviving companies.
Democrats seem to be on the wrong side of this problem. Let
me just say that as a Democrat, I am totally confused about the party’s
position. There seems to be opposition to Treasury and Fed intervention in the
markets and seemingly little understanding about the complexity of the global
financial markets. They really have to change the mindset on dealing with corporate
America and the huge shift of wealth from the United States to the rest of the
world. A new approach has to be developed that goes beyond charging Exxon with
price gouging and grabbing at windfall profits. By the way, in spite of the
tremendous increase in oil prices through the first half of this year, Exxon stock
was one of the largest losers in the Standard & Poor’s 500 in that time. My
friends are Democrats and frankly I am tired of hearing stupid ideas about
corporate villains and hearing many of them sounding like conservative
Republicans.
At some point in the 1990s, the nation went through a
financial crisis involving the S&Ls, and Citicorp stock sold in single
digits. A Saudi Prince, Prince Alaweed, made a huge purchase of Citi stock at
around $9 per share. Earlier, today, Citi stock traded down to the $13 level, a
round trip for Prince Alaweed from the mid-$50s price from just a little over a
year and a half ago. Next time around, or in this current cycle, the Prince or
another sovereign investment fund may l buy the whole company at the depressed
price, rather than becoming a passive investor and allowing inept, careless
management to destroy asset values. The foreign takeover of American assets
based on our desperate need for capital is about to begin anew and it will
leave American citizens and the country’s leaders gasping for air in its wake.
Remember the Dubai ports battle which aroused Democratic bloviating about
national security? We ain’t seen nothing yet.
Although this is an election that shouldn’t even be close, Barack
Obama is in danger of losing. He’s a brilliant guy as are his advisors about
the causes and risks of the present financial crisis, but so far, what he is
saying about it and his positions are just not resonating with this Democrat
and probably many others, and independents for sure. Democrats, get with the
program and get with it soon. McCain/Palin for change, for sure, from bad to
worse!
