Buckle Up: With transparency and truth in short supply, caution is warranted
By Tony Allison, July 21, 2008
Investor Jim Rogers minced few words, as usual, when asked about the U.S. Treasury Department's plan to shore up Fannie Mae and Freddie Mac.
“It is an unmitigated disaster”, said Rogers. “Taxpayers will be saddled with debt if Congress approves (U.S. Treasury Secretary) Henry Paulson's request for the authority to buy unlimited stakes in and lend to Fannie Mae and Freddie Mac.”
"These companies were going to go bankrupt if they hadn't stepped in to do something, and they should've gone bankrupt with all of the mistakes they've made,'' Rogers said. “What's going to happen when you put some Band-Aids on it for another year or two or three? What's going to happen three years from now when the situation's much, much, much worse?''
"They're ruining what has been one of the greatest economies in the world,'' said Rogers. “Bernanke and Paulson are bailing out their friends on Wall Street but there are 300 million Americans that are going to have to pay for this.''
It’s a pity that Rogers doesn’t speak frankly. The problem of course is that he is one of the few that will speak the truth as he sees it. He admits he is short the banks. But he has been short for years, and with good reason it turns out.
As we head toward the historically volatile fall season for the markets, and a presidential election in November, it seems a good time to take stock of the risks around us.
“Free Money” to save the day?
It’s a presidential election year and the pandering and spinning are already picking up speed. Seeking self-preservation, politicians up for election must promise special favors for their “special” donors. Modern elections are rarely about the ills of the country. They are more directly about special interest groups with deep pockets, and the results are usually more of the same; earmark politics.
But a presidential race in a year when the economy is heading south is another story. Politicians must “do something” for the little guy. And the only thing politicians are skilled at is spending money in ever greater amounts. As a result, a “stimulus package” was created in record time, and $150+ billion promptly mailed out to taxpayers. No leadership, vision or tough calls required. Just send ‘em a check. If that doesn’t work, well, send another check.
Does it matter if much of the billions end up in China and the Middle East? No, what really matters is surviving another election cycle. This strategy works until the electorate is in sufficient distress to reject it and the politicians behind it. We are moving closer to that day.
By the way, did the federal government have $150 billion sitting around in surplus? No, it is merely added to our growing federal deficit and national debt (over $9 trillion). This “stimulus package” will likely stimulate something, and that is growing inflation. Inflation is the real threat to the struggling middle class, but calls for fiscal discipline and belt-tightening do not win elections. “Free money” has always worked like a charm.
Another time-honored tradition is the election year “witch hunt”. This year’s targets are the oil-trading “speculators” and the oil company executives. Who else but they could be responsible for $5 per gallon gasoline? Certainly not the politicians, who for decades have ignored enacting any meaningful energy policies.
Credit Crisis- write-offs continue
The credit crisis effectively broke into the public consciousness last August. At the time, the total losses were estimated at $200 billion. As bank write-offs continued into the fall and winter of 2007, the estimates were revised to $400 billion. During this period Wall Street pundits repeatedly stated that “the worst was over” and the financial stocks were a significant “opportunity” at these levels. Unfortunately, the banks have continued to write-off losses well into 2008. Recently the IMF (International Monetary Fund) and others have estimated that bank write-offs will reach $1.6 trillion. Given that roughly $400 billion has been written-off worldwide, there is still a ways to go.
One of the ongoing risks is a lack of transparency and understanding of the derivative crisis. One expert that has spoken out extensively is Satyajit Das. He is beginning to sound like a modern-day Paul Revere. The following quote appeared in a column by John Markman last September on TheStreet.com.
“One of the world’s leading experts on credit derivatives (financial instruments that transfer credit risk from one party to another), Das is the author of a 4,200 page reference work on the subject, among a half-dozen other tomes. As a developer and marketer of the exotic instruments himself over the past 30 years, he seemed like the ideal industry insider to help us get to the bottom of the recent debt crunch—and I expected him to defend and explain the practice.
I started by asking the Calcutta-born Australian whether the credit crisis was in what Americans would call the “third inning”. This was pretty amusing, it seemed, judging from the laughter. So I tried again. “Second inning?” More laughter. “First?” Still too optimistic.
Das, who knows as much about global money flows as anyone in the world, stopped chuckling long enough to suggest that we’re actually still in the middle of the national anthem before a game destined to go into extra innings. And it won’t end well for the global economy.”
One would hope this derivative mess is now in the middle innings, but that may prove a tad optimistic. The problem is that bankers, economists and particularly politicians do not understand how derivatives work, and what real dangers they might present. When a true derivatives expert says we should be very afraid, perhaps it would be wise to pay attention.
Das made a return visit in Markman’s May 7th column. He doesn’t see the light at tunnel’s end just yet. “Given that the bank presidents have been consistently wrong about everything they’ve said about their losses until now, why on earth would anyone believe them now?” Das asked. He also mentioned the $1 trillion to $3 trillion that is in the process of moving onto the bank’s balance sheets from related entities where they were hidden. As to where we are in the credit crisis, Das dryly paraphrased Winston Churchill.
“This is not the end, or even the beginning of the end, though it may be the end of the beginning.”
While amusingly ironic, it does not give great comfort to a reeling global financial system. This may be one more reason to say cautious and buckled up.
End of Illusions- Fannie Mae and Freddie Mac
The Economist last week published “End of Illusions”, an article about “America’s deeply flawed system of housing finance.” The paragraphs below are excerpts from a more extensive article.
“After a headlong plunge in the two firms’ share prices, Hank Paulson, the treasury secretary, felt obliged to make an emergency announcement on July 13th. He will seek Congress’s approval for extending the Treasury’s credit lines to the pair and even buying their shares if necessary. Separately, the Federal Reserve said Fannie and Freddie could get financing at its discount window, a privilege previously available only to banks.
The absurdity of this situation was highlighted by the way the discount window works. The Fed does not just accept any old assets as collateral; it wants assets that are “safe”. As well as Treasury bonds, it is willing to accept paper issued by “government-sponsored enterprises” (GSEs). But the two most prominent GSEs are Fannie Mae and Freddie Mac. In theory, therefore, the two companies could issue their own debt and exchange it for loans from the government—the equivalent of having access to the printing press.”
“With the credit crunch, Fannie and Freddie have become more important than ever, financing some 80% of mortgages in January. So they will need to keep lending. Nor is there scope to offload their portfolios of mortgage-backed securities, given that there are scarcely any buyers of such debt. And if the Fed has to worry about safeguarding Fannie and Freddie, can it afford to raise interest rates to combat inflation? American monetary policy may be constrained.”
If the real estate market stabilizes soon, then Freddie and Fannie will greatly aid in the market’s revival. If it doesn’t, then the government (i.e. taxpayers) may have another large liability on its books. As mentioned in the article, if the Fed wants to stabilize the real estate market, Fannie and Freddie, don’t look for an increase in interest rates anytime soon. This is not good news for the dollar or the prospects for lower inflation.
As usual, the mainstream media is tripping over itself to call the latest bottom in the financial sector. The following are three headlines from this past weekend. Historically, there is rarely a bottom without some manner of capitulation and despair. The following are more along the lines of “happy days are here again”.
“Hope, and hints, that financial stocks have finally bottomed” – The New York Times
“Buy Banks- selectively”- Barron’s cover story
“Jitters ease as Citi, rivals show signs of bottoming out” The Wall Street Journal
The recent SEC proclamation forbidding short-selling financial stocks just may have been a factor in the recent financial sector rally. Caveat emptor.
Caution still warranted
Who knows where this mess will lead? Hopefully it will lead to safer ground and more stable markets sooner than later. In the meantime, it would be wise to buckle up and hunker down. Higher levels of cash and stocks of companies that own tangible assets would be one method of proceeding with caution. In March of this year, I wrote an article entitled, “The Year of Living Dangerously”. Until the financial system provides more transparency and our leadership more veracity, that title continues to sum up 2008.
U.S. stocks on Monday surrendered earlier gains as oil prices rose and investors turned cautious about the earnings outlook after two pharmaceutical giants postponed reporting their quarterly results.
The Dow Jones Industrial Average was down 29.23 to close at 11,467.34. The S&P 500 Index was nearly flat, losing .68 to close at 1,260.00. The Nasdaq was slightly lower, ending at 2,279.53, down 3.25.
Crude futures rose Monday for the first time in five sessions, rebounding from last week's biggest weekly losses, after multilateral talks over Iran's controversial nuclear program didn't yield progress and as Tropical Storm Dolly headed into the Gulf of Mexico. Crude for August delivery, which will expire Tuesday, was last up 92 cents, or 0.7%, to $129.80 a barrel on the New York Mercantile Exchange. Crude for September delivery also rose, up 78 cents to stand at $130.25 a barrel.
Gold for August delivery rose $5.70 to end at $963.70 an ounce on the New York Mercantile Exchange. Earlier, gold hit an intraday high of $966.50 an ounce.
Wishing you a good evening,
© 2008 Tony Allsion