NOTES FROM THE FRONT

China Stimulus Package

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.

This is big news.

Bank of England cuts rates

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?

Restoring Trust

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

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MEMBER FINRA & SIPC

 

October 28, 2008

RESTORING TRUST

 

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 the early summer of 2007, those funds were closed at great loss 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 8^th, 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 8^th to 8,379 on October 24^th, 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 and Morgan 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.

 

Democrats and Financial Crisis: Out of Touch

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 off  somewhere 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!

 

PRMCO

   Long C and stocks in general.

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