NOTES FROM THE FRONT

Batten Down the Hatches

PETER R. MACK & CO., INC.

19 EAST 71^ST STREET, SUITE 3

NEW YORK, N.Y. 10021

TEL: (212) 744-3939 FAX: (212) 744-8484 EMAIL: PRMCO@AOL.COM

MEMBER FINRA & SIPC

www.prmco.com

BATTEN DOWN THE HATCHES

The Economic Outlook: Kathleen Stephansen, Credit Suisse

Last week I attended an investment conference at Credit Suisse and heard a presentation by Kathleen Stephansen, Director of Global Economic Research, which I believe was one of the most cogent and convincing discussions of the current economy that I have heard.

I thought I would pass it on to my clients and friends. I am subscribing to the conclusions and the view presented therein.

In very short summation: On the economic side, jobs and employment are headed lower; wage growth will slow down; income growth will be eroding; the surge in commodity prices will lead to higher inflation; reduced consumers’ real purchasing power will crowd out discretionary spending.

Downward pressure on house prices will erode wealth and continue to weaken demand. Inventories of new and existing homes are in a 10-12 months supply. Based on values relative to consumer disposable income, house prices could decline close to 20% from present levels. Illiquidity in the individual’s housing asset – can’t sell it, can’t borrow against it - will force homeowners to rebuild savings out of income. Consumer spending will be subdued.

Tighter credit standards on all types of mortgage loans and other consumer loans such as home equity, credit cards and autos will place additional pressure on the consumer sector, leading to a further erosion of purchasing power, income and wealth. Ms. Stephansen’s view is that the Fed signaled an end to the easing cycle through monetary policy (interest rates and money supply) which is their province, and passed the baton to fiscal policy (tax rates and legislation), which is set by Congress, and in my view, will not be determined until the next President and Congress take office in 2009.

Regarding output, the ISM (Institute of Supply Management) manufacturing report is consistent with sluggish GDP growth over time. An inventory build is developing and manufacturing activity is contracting. We have a bifurcated US economy, a weak domestic economy with weak domestic demand being buffered by a strong export performance. GDP growth is running at an approximate 1.5% growth rate currently, and is projected by Credit Suisse to drop to 0.7% in the second half of the year.

Cyclical indicators point to weak growth in both Japan and Europe with China and Asia (without Japan) expected to continue good economic growth.

Foreign capital is becoming less willing to finance our current account deficit, and a massive de-leveraging is beginning to take place. The number of financial transactions is declining rapidly which will lead to a large and bumpy contraction in that industry.

This is a pretty subdued assessment of the economy and certainly the state of the consumer in the year ahead, but I should say that a negative economic outlook does not always translate into a negative investment outlook, since, as we all know from experience, on some occasions a bad economy co-exists with a good market performance and vice versa – a condition of divergence between Main Street and Wall Street.

US/Global Equity Strategy: Jonathan Morton, Credit Suisse

Consistent with the bank’s economic outlook, Jonathan Morton of Credit Suisse presented the US/Global Equity Strategy, which I will summarize here as well. They believe that total losses related to the banking/credit crisis will total around $650 billion (the IMF is estimating losses of $1 trillion) which equates to 4.7% of GDP (compared to the S&L crisis which took 3.2% of GDP), and estimate that perhaps 56% ($365 B) of total losses have already been announced. They expect “a sluggish path to recovery”, estimating three years for bank-lending to recover in this cycle.

This equates to an L-shaped rather than V-shaped recovery, estimating annual GDP growth for the next few years beginning in 2009 at 2% annually. Recall that earlier I quoted Ms. Stephansen’s Credit Suisse GDP estimates at 0.7% in the second half of 2008.

In housing, this relates to a probable rise in delinquencies, foreclosures, and negative householder equity and a further decline in prices that Morton estimates at 10%. Morton’s conclusions on the US equity market follow:

1. It’s too early to go overweight banks

2. The risk premium on equities in general could remain high as the economy becomes more volatile

3. Focus on cheap, quality growth stocks

4. Continue to avoid expensive highly leveraged stocks in an environment of tight credit conditions

5. In particular, remain cautious of expensive small cap stocks.

Credit Suisse sees severe risks to economic growth emerging in Continental Europe with high risks relating to corporate earnings and high stock valuations, and words of caution: “be cautious of expensive US cyclical stocks that have high exposure to Continental Europe.”

The New Financial Paradigm by George Soros:

Finally, to make my week complete and to add another dimension to the big picture, I read the new book by George Soros entitled “The New Financial Paradigm.” As a matter of fact, I read it twice with my comprehension improving on each occasion. There is a third reading in my future. Dickens will have to wait. As has been widely reported in the press, Mr. Soros is extremely negative but his negativism is not devoid of hope. He recognizes the breaking of the housing bubble signaling the end of a long period of credit creation and an economic expansion of long duration fueled by that credit expansion. The end of bubbles and cycles is never smooth and will be rocky and jarring – pretty much the conclusion that Kathleen Stephansen reaches.

The new paradigm Soros speaks of is complex and refers to a change in the idea that views markets guided by the “theory of equilibrium” (the idea that markets are self-correcting and revert toward equilibrium) to be replaced by the “theory of reflexivity” (the interaction between the participants’ views and the actual state of affairs) that he has developed. The book gives no investment suggestions or “hot stocks” as would be expected. He predicts a further decline of house prices and a period of de-leveraging and credit contraction, pretty much representative of a popular view and consistent with Credit Suisse, rather than the bullishness and “everything is great” free-market pumping of  Lawrence Kudlow and the CNBC staff. So far, Soros’ book has only been released in electronic form for the Sony reader or Amazon’s Kindle reader, but will soon be in the stores and accompanied by a big publicity effort, so be prepared for televison appearances and a lot of gloom and doom.

Investment Ideas:

I have previously written of my belief that the depth of the financial crisis has passed with the well-publicized rescue of Bear, Stearns that facilitated the implicit quieter rescue of Lehman Bros. People have made self-righteous arguments and complaints about the absence of negative consequences as punishment for bad behavior and about what is perceived as weakness on the part of the Fed, but I am absolutely convinced that a Bear, Stearns’ bankruptcy on Monday, March 17^th would have resulted in a global financial catastrophe of nuclear proportions. The systemic collapse of banks and financial institutions was avoided which was a major positive outcome.

The Fed has established unique new lending facilities to the financial industry and has been aggressive with existing facilities as well as rates. It couldn’t be clearer that they have put everything on the table to avert collapse of the industry and its leading institutions. On the other hand, there has been no guarantee of any extraordinary economic stimulation to bring about a quick recovery from the anticipated slowdown. The financial stocks will struggle with an industry that has shattered and must be rebuilt anew. This would be consistent with Credit Suisse’s view of an L shaped recovery.

Run for the hills or stay in equities? Perhaps a bit of both. It is very difficult to make a case for medium to longer-term bonds except to stay very safe, which is why Treasury bonds are not even keeping pace with inflation. Recycling of our dollars now residing in the Mid-East with oil barons and Iraqi pilferers, and residing in China with party leaders are finding their way into the US Treasury market, earning a low rate of interest but keeping their best customer, the US, alive. In the meantime, those Americans who wish to save, are forced into markets where they earn a pittance, having pushed the more venturesome into higher-risk equities, real estate speculation, or high yield bonds.

In the equity market, however, I believe that there are some investment themes that are intriguing and some companies whose prosperity and growth during the difficult days ahead look promising. Fitting that criteria is the Technology/Internet sector, marked by large cap growth stocks with realistic price/earnings ratios, strong balance sheets (primarily debt-free,) serving global growth markets in Asia and elsewhere and immune from the real estate woes and financial problems in the US and Europe. Many of these high quality growth stocks are selling at prices fractional to 2000 pre-bubble levels, with much more meat on the bones. Invention has been active during these years, leading to products such as the iPhone, which has elicited “… the most important product of the still-young 21^st century” says PC Magazine in the June 2008 issue.

The Commercial Aircraft market is interesting as a long lead-time business, with two new jumbo planes being introduced (although a little delayed) and with huge backlogs stretching out for years. The industry is also witnessing major build-outs of Chinese and Mid-East airlines, and an aged and outdated American aircraft fleet. New demand for mid-size jets favor secondary manufacturers in both China and Brazil, and the wide use of lightweight carbon graphite fibers in the Boeing Dreamliner and Airbus 380, for example, benefits those specialty materials suppliers.

The Global Automobile industry looks extremely interesting with tremendous growth going on now in many emerging regions of the world, and an industry in which technology shifts are in active development in response to environmental consciousness and high energy prices. This push is here to stay and will create major opportunities in new propulsion systems - hybrids, lithium-ion battery powered vehicles, new automobile diesel engines, and hybrid diesel/electric transmissions for trucks. The near term US market outlook is uncertain for all the major domestic and foreign manufacturers as currency swings, credit tightening, labor strikes in the US, bankruptcies of parts suppliers and a consumer slowdown create an uncertain picture and it’s probably wiser to invest in this industry as the economy emerges from slowdown rather than enters it, which may occur later in the year, but I believe that the long-term opportunity will be outstanding.

The Energy industry including conventional oil and gas, drilling and services, and alternatives such as solar and wind, and the much maligned ethanol, offers selective opportunities, although a tremendous amount of investment money is already in these stocks and will come out in a giant whoosh at some point in the future. When? Don’t know but I am one of the people who feel that the supply/demand characteristics of the oil industry are not plagued by physical shortage, but rather by both financial and security premiums. I have communicated the idea to Senators and regulators, that an increase in margin requirements on futures trading would exert some limitations on speculative trading, and thus result in lower prices, but no one has heeded my message.

Global Infrastructure, i.e.roads, bridges, government buildings, schools, airports, in emerging markets and in the US (if we are able to leave Iraq and recapture some discretionary spending) will grow for years to come. Again, these are long lead-time businesses with growing backlogs. The US engineering, service and equipment companies who will continue to participate in the global spend appear to have bright futures.

Health Care and Biotechnology remains a promising investment area as the elderly population rises, and as Democratic initiatives of universal or expanded health care are likely in the near future. Hopefully, a new Democratic administration will shake up the moribund FDA and put American research and drug discovery back on a scientific course, rather than on the conservative, religiously obsessed path it has been on for the last eight years. Later this year, I expect new findings to be announced in the treatment of Alzheimer’s disease, diabetes, and cancer as well, and the widespread use of genetic identification and personalized gene treatment will lead to great advances. The companies in this industry are well capitalized which will promote consolidation.

Basic Materials and Agriculture remain somewhat puzzling at present valuations and while global demand is rising for food, the thinness of the markets has led to very high valuations. Investing abroad in India, China and Brazil through ETFs will continue as an important part of portfolio strategy. Private Equity seems to be set for a diminished role as credit availability contracts. The very recent major earthquake in China could have significant implications for the US market. Capital demands necessary for the rebuilding of the affected Chinese cities, may cause China to divert substantial funds from their US Treasury bond investments for use back home. That would cause interest rates to rise, unless our friends in the Mid-East step up to continue their life support. It was interesting that today, interest rates on the 10 and 30 year T-Bonds rose significantly as prices fell, suggesting perhaps an early validation of that idea.

Because of space limitations and my effort to avoid regulatory complications and filings, no individual securities are mentioned herein. If anyone has specific questions on individual stocks or other matters you are free to call or e-mail me.

Peter R. Mack, May 14,2008

The information, opinions, estimates, projections and other materials contained herein are provided as the date hereof and are subject to change without notice. Peter R. Mack & Co., Inc. has obtained materials from various sources and believes the information contained herein is accurate and reliable, but makes no representation as to its accuracy or reliability. No statements contained herein should be construed as a solicitation to buy or sell any security or investment product mentioned. Peter R. Mack & Co. Inc. and/or its employees may from time to time, buy, sell or hold long or short positions in any security or investment mentioned herein. Peter R. Mack & Co., Inc. does no investment banking and has received no compensation from any entity named herein.

 

Interest Rates Rising?

I see that the 10Yr Tsy Notes and 30Yr Tsy Bonds are significantly down in price today, with rising yields - the 10 yr is at 3.88%. It is possible that the large and deadly earthquake in China may necessitate huge expenditures in rebuilding which will take China out of US Treasuries and drive rates up. That's my guess!

MannKind (MNKD-NASDAQ-$2.35)

PETER R. MACK & CO., INC.

19 EAST 71^ST STREET, SUITE 3

NEW YORK, N.Y. 10021

TEL: (212) 744-3939 FAX: (212) 744-8484 EMAIL: PRMCO@AOL.COM

MEMBER FINRA & SIPC

 

April 9, 2008

 

MannKind Corporation (Nasdaq:MNKD - $2.35) is a biopharmaceutical company that focuses on the discovery, development and commercialization of therapeutic products for diseases such as diabetes and cancer. The company’s lead development product is an inhaled insulin, Technosphere, which is currently in advanced, large-enrollment Phase III trials.

 

Today, the stock declined about 60%, closing at $2.35 (NASDAQ-MNKD) on the release of adverse news from Pfizer regarding its inhaled insulin drug, Exubera, which had been approved by the FDA but abandoned in October 2007, in my opinion because of poor sales and doubtful advantage. Although the drug is not currently in development or marketing by Pfizer, the company today announced some post-trial results from a prior Phase III trial as follows: “Over the course of the clinical trial program, 6 of the 4,740 Exubera-treated patients (.0012) versus 1 of the 4,292 patients not treated with Exubera (.0002) developed lung cancer….all patients who developed lung cancer had a prior history of cigarette smoking and that there were too few cases to determine whether the development of lung cancer is related to the use of Exubera.”

 

On March 7^th of this year, Eli Lilly (LLY) abandoned its development of an inhaled insulin product citing “increased uncertainties in the regulatory environment” and uncertain commercial potential of the new drug.

In response to the abandonment of the inhaled insulin space by both Pfizer and Lilly, on March 17, 2008 MannKind released a statement, part of which is excerpted below. 

 “ MannKind is absolutely committed to the continued development of its lead development product Technosphere® Insulin….MannKind believes that the resulting efficiency and safety profile is unique and clearly differentiated from all existing diabetes treatments….MannKind recognizes that to be successful in today’s health care market a product must offer improved efficacy and safety, not just improved convenience. The decisions of Eli Lilly and Company as well as Pfizer and Novo Nordisk to discontinue the development of their inhaled insulin products reinforce this view. None of those products offer any advantages over injectable insulin analogs .”

 “By contrast, in clinical trials to date, Technosphere ®Insulin has shown important advantages over the treatment that is presently considered to be the most effective meal-time therapy for patients – rapid-acting insulin analogs….and no adverse effect on the measures of pulmonary function that have been reported to occur with other inhaled insulins.”

Today’s announcement by Pfizer of increased lung cancer risk (which seems questionable in light of the number of ex-smokers in the study and to a layman, an infinitesimal risk compared to Alzheimers, cancer, AVM, auto accidents and even equity investing) provoked a Wall Street analyst (as reported on the Street.com) to state that the data were an “absolute disaster” for MannKind and (we) “do not see a believable scenario in which the FDA would approve another inhaled insulin”

From my point of view, I am going to wait for the clinical data from the Phase III Technosphere Insulin trials currently underway to be released later in the year MannKind has repeatedly stressed the differentiation in chemistry, mechanism, delivery, safety etc. for its product compared to the others and if these claims are correct, the data will bear it out. If these claims are true, and Technosphere can get past the FDA successfully, MannKind’s Technosphere Insulin will have this entire multi-billion dollar drug category all to itself.

Full Disclosure: I and members of my family are long MNKD.

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.

 

 

 

 

 

Sunday Night Note

PETER R. MACK & CO. INC.

MEMBER FINRA/SIPC

19 EAST 71^ST STREET, SUITE 3

NEW YORK, NY 10021

TEL: (212) 744-3939 FAX (212) 744-8484

E-MAIL: PRMCO@AOL.COM

 

March 16, 2008

9:15PM

J.P. Morgan earlier this evening announced the acquisition (bailout) of Bear, Stearns (BSC) in a stock transaction valued at around $2.00 in JP Morgan (JPM) stock based on today’s prices.

Tomorrow’s market prices may be lower.

This is a dramatic reversal of fortune for Bear, whose shares traded as high as $160 per share in 2007, and just last Friday closed at $30 after trading as high as $60. This is a tragedy for all Bear employees whose net worth after long careers was tied up in shares and pension plans now rendered just about worthless. Bear was known as a very aggressive firm, and in some ways, not in the “club.” In 1998, when other firms headed by Goldman Sachs (GS) put together a consortium to advance capital and bail out the failed hedge fund Long Term Capital Management, Bear generated some enmity by declining to participate. As a leader in the underwriting, generating, and marketing of mortgage obligations of all types, Bear undoubtedly is carrying large, heavily -margined positions which have no liquidity and have lost a great deal of value, rendering them unable to raise additional cash. In addition, as word spread last week of their difficulties, other firms stopped trading with them, concerned that they would be unable to complete and honor the trades. It was almost inevitable that they would be sold or gone bankrupt, although a $2 per share price, representing a $236 million equity value seems pretty low.

It’s probably hard to generate a lot of sympathy for Bear because of the impact its behavior has had on the markets and all of our portfolios, but it is a human tragedy. There is another major investment bank – one that’s in the club - rumored to be in trouble because of an over-levered balance sheet, but that situation may be resolved in the next week.

Last week, the business media ran with the story of the failure of an investment fund called Carlyle Capital as it failed to meet margin calls. According to reports, Carlyle, with equity of around $690 million, was holding mortgage bonds bought on margin worth about $22 billion. Just for an example, a portfolio of that size that goes down about 5% loses $1.1 billion, wiping out the equity that existed. Figure out that a 10% drop loses $2.2 billion and nobody seems to have any idea what all these bonds floating around are worth.

It should be noted that equities (stocks) are purchased on 50% margin as they are perceived to be riskier than bonds. Not always the case, it seems.

Along with the merger of BSC and JPM, in which the Fed is indemnifying some (maybe all) of JPM’s assumed liabilities, the Fed also announced a cut in the Discount rate effective tomorrow, and an expansion of its lending on mortgage instruments classifying many of the issues as acceptable collateral. I anticipate a further significant reduction in the Federal Funds rate at the Fed meeting later this week. The banks are capital-short so rate reductions may not be immediately be passed on to customers, but the Fed is clearly showing a determination to flood the market with low cost paper to ease mortgages and ease the current crisis of confidence.

Should the dollar continue to weaken, I would expect a Treasury intervention to support the dollar, although it may have more of a psychological effect than an actual impact on dollar rates. Just today, Secretary of the Treasury Paulson said in a speech that the United States favors a strong dollar, even though the dollar has been plunging to record lows against the Euro without any word. Today’s words must be interpreted as a strong signal.

I believe that Congress will shortly enact legislation to expand the limits on FHA mortgages from $417,000 to significantly higher levels ($700,000 plus) and probably legislate the expansion of the lending ability of Fannie Mae and Freddy Mac mortgage lending institutions.

Add in the publicized problems involving Auction Rate Securities, rising energy and commodity prices, zooming health care costs – Oxford just raised our premium for the company’s health insurance by 17.5% - and low returns on investments and people are suffering.

 

On the other hand, stocks are relatively cheap, especially against a backdrop of declining interest rates and, believe it or not, the national foreclosure rate on housing as a percentage of mortgages outstanding is at manageable levels, with certain states holding and others in trouble. Without direct knowledge it is difficult to know what’s happening, however, it is probable that many of these mortgage bonds being marked-to-market are still collecting interest and principal payments and still represent viable investments. The main issue is determining what others will pay for them – i.e. their value as saleable assets – rather than on the long-term value as an income-producing investment.

 

We are in a crisis of confidence and there is no telling when it will be resolved. In the meantime, every media source is proclaiming the end of the financial world and people are really starting to get scared. It is very clear that the Federal Reserve and the U.S. Government seem finally ready to pull out all the stops and provide liquidity to the strapped fixed income markets.

Neither Peter R. Mack & Co., Inc nor its principals have any investment positions in any securities mentioned herein Furthemorer, the Firm makes no representations as to the accuracy of any information or statements contained herein and the reader should not rely on these statements for any purposes.

Bonds and Buying on Margin

CNBC and other media outlets are attributing the steep decline in today's equity markets on the apparent collapse of Carlyle Capital, a fund managed by the vaunted and politically well-connected Carlyle Group. Market watch reports that as of December 31, 2007 Carlyle Capital was holding bonds with a face value of $22 billion and had equity of $698 million, just about 3%. So let's see: If your portfolio declines by 5% in value - in this case amounting to $1.1 billion, the fund now has no equity left and owes an additional $400 million, etc., etc. The leverage is phenomenal on the way up in the fund's favor and on the way down, a negative. They should certainly have been more defensive starting in the middle of 2007.

In buying stocks on margin, the margin requirements are 50% so that in size like Carlyle, a $22 billion portfolio would require $11 billion in equity and if the stocks declined by 5%, the hit would be $1.1 billion and the equity would still be $9.9 billion.
Pretty big difference.

Today's market story is really the negative rumors surrounding Bear, Stearns. Maybe they're the ones to whom Carlyle owes all that money. I certainly don't know.

Health Insurance Costs

First post in quite a while.

I just received the new rates from Oxford beginning May 1, 2008 for the company's health insurance, which is not the ultra, Tiffany best, since the boss is on Medicare and this is what the users want. Rates going up 17.5% for the same coverage! The postage stamp is going up 2.4% from $0.41 to $0.42. Maybe the country should hire the USPS to handle health insurance. The rates for a family on this middling plan will be $1612 per month, $19,344 per year (based on 3.1 people - 2 adults and 1.1 child) That's really crazy!

I've had some medical issues this winter and am grateful to Medicare, which is the best. The private health insurance system is far too expensive and unmanageable. I have analyzed Hillary's approach and Obama's, and I think Hillary's is better. Obama, in my opinion, has no commitment to affordable, universal health insurance and his economic advisor, Goolsby, is basically a conservative, U. of Chicago, Milton Friedman conservative. I am afraid it will be more of the same.

No investment positions

Neurocrine Biosciences (NBIX - NASDAQ - $5.50)

Neurocrine Biosciences (NBIX) shares are sharply lower, now trading around $5.50 (10:45am) on receipt of FDA approvable letter for Indiplon insomnia medication. Approvable means do more testing, give us more data and we will approve. On this second NDA go-around, the company and investors had anticipated an approval  letter. FDA had preveiously requested data which NBIX had supplied. Now FDA seems to be taking the inquiry into brand new territory. Company had been ready to announce a new marketing partnership with major international company. Everything now on hold pending outcome of further talks with FDA.

Drug approval process has become extremely dicey over the next few years, and seems to me that the agency has become increasingly loath to approve new drugs. New drug approvals have declined over the last few years of Bush administration. Pharmaceutical and Biotechnology industry may be in danger of ceding intellectual property leadership - research and development - to distant shores.

Position: Long NBIX
Peter R. Mack is the General Securities Principal of Peter R. Mack & Co., Inc., Member FINRA/SIPC. Neither the author nor Peter R. Mack & Co., Inc. make any representations or accept any responsibility for the accuracy of the material contained herein.

A Sea Change Has Occurred

PETER R. MACK & CO. INC.
MEMBER FINRA/SIPC
19 EAST 71^ST STREET, SUITE 3
NEW YORK, NY 10021
TEL: (212) 744-3939 FAX (212) 744-8484
E-MAIL: PRMCO@AOL.COM

 September 18, 2007

 A SEA CHANGE HAS OCCURRED

 Recession has been traditionally defined as two successive quarters of negative economic growth, but in general usage, the term is used to signify a significant economic slowdown that persists for some undefined – longer rather than shorter- period of time. 

The poor employment statistics released by the government last week coupled with the mortgage fiasco and the housing collapse have now put the “Recession” word in the center of most discussions about the near-term future of the economy and investment markets. We won’t know about an official recession for many months to come, but it is strikingly clear that an economic slowdown of significant proportions is probably going to take place.

Ivy Zelman, the highly respected housing analyst formerly of Credit Suisse, was quoted thusly in the Sept. 12^th Wall Street Journal: “This recession in housing is more severe than the 1990 and 1991 downturn…It could have a much broader impact on the economy than people realize and it will be longer in duration.“ Speaking of attempts to effect some sort of bail out, she continued: “I don’t think it will do enough to forestall the inevitable, that the consumer is going to roll over.”

The Federal Reserve raised the discount rate seventeen straight times from a low of 1% percent before stopping in August 2006 at a 5.25% discount rate, leading to a mass perception that rates would then soon start reversing downwards. Monthly, the Street played “Waiting for Bernanke”, with strategists and journalists examining and parsing every bit of Fed-speak for clues to the next rate reduction.

Are rates ever low enough for the people on the Street? No matter the level, it seems that not a day has gone by without the constant drumbeat for lower interest rates as a cure-all. In the meantime, while Wall Street waited for that next rate cut, which is probably coming today, energy costs rose, consumer credit card interest rates glided higher to the 15-20% range, the economy remained strong and the markets still moved briskly forward, riding the winds of a strong global economy, and defying the many experts who had predicted a slowdown of economic growth led by weak consumer spending and interest rates that were just not low enough.

Over a year later, now, and the Fed still has not lowered rates. The federal funds and prime bank lending rates have stood at 5.25% and 8.25% respectively, and global interest rates are consistent with levels of a year ago. The 10-year Treasury note is at a level similar to last year at this time, notwithstanding a move over 5% in early June 2007. If one had not been reading the news of the last two months, from the external symptoms it would be hard to detect that a financial panic of huge proportions had taken place. Like high blood pressure, it could be called the silent killer.

But a sea change has occurred, perhaps starting with the collapse of two Bear, Stearns hedge funds that conflated the crisis and triggered events that brought about a collapse in the structure and stability of the mortgage market and spread to other sectors of the credit market. Rumors about various financial institutions and even money markets have been rife, and in the last few days there has been a run on Northern Rock, a British bank.

Credit is a business based primarily on trust, a belief by the lender that the borrower will be able to pay back the cash at a later date. No bank or financial institution can freely admit to being in trouble unless they want to be out of business in the next minute, but clearly some were and are in trouble and very few really know the truth.

But the Fed should know, and as panic developed several weeks ago, they did respond with a reduction of the discount rate, and a welcoming invitation for all banks, whether troubled or not, to come to them at the discount window and borrow what they needed. They provided liquidity, as did the European central bank and UK banking authorities to buy time and were able to keep the financial system open and substantially reduce some of the fear.

 Most importantly, the markets now believe very overwhelmingly that the Fed will cut interest rates at the next meeting later today. The consensus view is for a cut of 25 basis points on the Fed Funds rate, and a 25 basis point on the Discount rate. Whether the Fed voluntarily would have cut rates is debatable, but they have been forced to cut rates by both the market and the din from the media, including the recent rant by James Cramer, who, regardless of what one might think of his personality, is very influential. Bill Gross as well, the head of PIMCO and one of the most respected fixed income investors in the world has been a great advocate for significant rate cuts.

My own opinion is that the Fed is cutting for public perception rather than actual economic impact, so, as long as they are cutting, they might as well go 50 and 50 to show that they mean what they mean, rather than the lower consensus view which will only create immediate discussion and media speculation about the timing of their next cut.

Positions: None

Neither the author nor Peter R. Mack & Co., Inc. makes any representations  or accepts any responsibility regarding the accuracy of the material contained herein.

Credit Crunch Abating

PETER R. MACK & CO., INC.

19 EAST 71^ST STREET, SUITE 3

NEW YORK, N.Y. 10021

TEL: (212) 744-3939 FAX: (212) 744-8484 EMAIL: PRMCO@AOL.COM

WWW.PRMCO.COM

MEMBER NASD & SIPC

 

August 22, 2007

CREDIT CRUNCH ABATING: LIGHT AT THE END OF THE TUNNEL

 

Charles Gasparino of CNBC reports that banks are at the Fed Discount Window borrowing for re-lending to clients, including and mainly Wall Street, against collateral consisting of mortgage paper that was unborrowable-against for the past few weeks. On Monday,8/20, Deutsche Bank initiated the procession of borrowers at the discount window, coincidentally just one day after announcing that Alan Greenspan, former Fed Chairman, had been named as Senior Consultant.

Unwinding the mortgage problem is going to take a long time (see our earlier post with Warren Buffet’s wisdom), but the Fed is now providing that time to allow reasonable people and institutions to work things out. But I think the Fed is also signaling that this is no bail out and no silk purses will emanate from cow’s ears.

Peter Mack – Positions: Net Long Equities

Warren Buffett On Derivatives

PETER R. MACK & CO., INC.

19 EAST 71^ST STREET, SUITE 3

NEW YORK, N.Y. 10021

TEL: (212) 744-3939 FAX: (212) 744-8484 EMAIL: PRMCO@AOL.COM

MEMBER NASD & SIPC

EXCERPT FROM WARREN BUFFETT

Berkshire Hathaway 2005 Annual Report

July 30, 2007

Aside from being one of America’s most successful professional investors, Warren Buffett also has an unpretentious style and folksy quality comparable to Mark Twain, and it is Twain whom Buffett quotes in this excerpt I have taken from the 2005 Berkshire Hathaway Annual Report. The subject is derivative instruments.

It is important reading in the context of today’s problems in the fixed income and derivatives market, and the pricing and trading of illiquid, unique derivative instruments. It is important to keep in the mind the difference between benign and chaotic market conditions. Herein follows Buffett:

**********

“Long ago, Mark Twain said: “A man who tries to carry a cat home by its tail will learn a lesson

that can be learned in no other way.” If Twain were around now, he might try winding up a derivatives

business. After a few days, he would opt for cats.

“We lost $104 million pre-tax last year in our continuing attempt to exit Gen Re’s derivative

operation. Our aggregate losses since we began this endeavor total $404 million.

Originally we had 23,218 contracts outstanding. By the start of 2005 we were down to 2,890.

You might expect that our losses would have been stemmed by this point, but the blood has kept flowing. Reducing our inventory to 741 contracts last year cost us the $104 million mentioned above.

Remember that the rationale for establishing this unit in 1990 was Gen Re’s wish to meet the

needs of insurance clients. Yet one of the contracts we liquidated in 2005 had a term of 100 years! It’s

difficult to imagine what “need” such a contract could fulfill except, perhaps, the need of a compensation- conscious trader to have a long-dated contract on his books. Long contracts, or alternatively those with multiple variables, are the most difficult to mark to market (the standard procedure used in accounting for derivatives) and provide the most opportunity for “imagination” when traders are estimating their value. Small wonder that traders promote them.

“A business in which huge amounts of compensation flow from assumed numbers is obviously

fraught with danger. When two traders execute a transaction that has several, sometimes esoteric, variables and a far-off settlement date, their respective firms must subsequently value these contracts whenever they calculate their earnings. A given contract may be valued at one price by Firm A and at another by Firm B. You can bet that the valuation differences – and I’m personally familiar with several that were huge – tend to be tilted in a direction favoring higher earnings at each firm. It’s a strange world in which two parties can carry out a paper transaction that each can promptly report as profitable.

“I dwell on our experience in derivatives each year for two reasons. One is personal and

unpleasant. The hard fact is that I have cost you a lot of money by not moving immediately to close down Gen Re’s trading operation. Both Charlie and I knew at the time of the Gen Re purchase that it was a problem and told its management that we wanted to exit the business. It was my responsibility to make sure that happened. Rather than address the situation head on, however, I wasted several years while we attempted to sell the operation. That was a doomed endeavor because no realistic solution could have extricated us from the maze of liabilities that was going to exist for decades. Our obligations were particularly worrisome because their potential to explode could not be measured. Moreover, if severe trouble occurred, we knew it was likely to correlate with problems elsewhere in financial markets. So I failed in my attempt to exit painlessly, and in the meantime more trades were put on the books. Fault me for dithering. (Charlie calls it thumb-sucking.) When a problem exists, whether in personnel or in business operations, the time to act is now.

“The second reason I regularly describe our problems in this area lies in the hope that our

experiences may prove instructive for managers, auditors and regulators. In a sense, we are a canary in this business coal mine and should sing a song of warning as we expire. The number and value of derivative contracts outstanding in the world continues to mushroom and is now a multiple of what existed in 1998, the last time that financial chaos erupted.

"Our experience should be particularly sobering because we were a better-than-average candidate to exit gracefully. Gen Re was a relatively minor operator in the derivatives field. It has had the good fortune to unwind its supposedly liquid positions in a benign market, all the while free of financial or other pressures that might have forced it to conduct the liquidation in a less-than-efficient manner. Our accounting in the past was conventional and actually thought to be conservative. Additionally, we know of no bad behavior by anyone involved.

"It could be a different story for others in the future. Imagine, if you will, one or more firms

(troubles often spread) with positions that are many multiples of ours attempting to liquidate in chaotic

markets and under extreme, and well-publicized, pressures. This is a scenario to which much attention

should be given now rather than after the fact. The time to have considered – and improved – the reliability of New Orleans ’ levees was before Katrina.

"When we finally wind up Gen Re Securities, my feelings about its departure will be akin to those

expressed in a country song, “My wife ran away with my best friend, and I sure miss him a lot.”

**********