Tsunami!

No corner of the world seems safe at the moment. Banks failing in Hong Kong, being nationalized in Europe, Island, Moscow. This market is acting rather abnormally, because it is dealing with a lack of clarity and confidence. Each day there something unexpected arriving on the investors doorstep.

Every headline in the world screamed, Panic! Like a tsunami, there is nowhere to hide and the turbulence is extreme. As with every crisis often the first solutions offered are not solutions at all but rather lifeboats as one hopes to buy time until help arrives. The political crosswinds are dramatic as every solution looks worse than the next. The general population balks at the idea that taxpayer money should prop up the institutions that brought us to this point. Wall Street admits mistakes were made but insists a boat with a hole at one end still sinks at both ends. It needs to be plugged.

The financial rescue package is so flawed the failure to pass in the House was proper, but now we have financial brinksmanship as credit market seize up. The crisis will undoubtedly spread to the economy at large as the oil that lubricates the wheels of commerce, credit, dries up. Already anecdotal stories are coming out of businesses having credit facilities constrained. This will lead to impaired business activity, employment pressure and declining consumer spending. Buckle up for a recession of some depth and length.

I remain against the Paulsen plan but accept that intervention is required. Purchasing the toxic debt at opaque prices with taxpayer money will not solve the problems. The current state of insecurity in the banking system has created a situation of banks unwilling to lend to other banks as no one knows who is solvent and who is not.

The solution requires capital, but not to buy illiquid debts. That ship has sailed. The government (taxpayer) should step forward to buy preferred stock in the troubled banks, injecting the needed capital to assure solvency and transparency. It should not be business as usual as banks would need to match the capital call with private equity while cancelling dividend payments to common stock holders. This would provide the taxpayer with some benefit for our dollars in the form of a call on the equity of the institution. Restoring confidence in the solvency of banking partners MUST be paramount.

The underlying problem which started the house of cards, real estate, must then be addressed. Whether by cancelling debt of some homeowners through a forgiveness or other procedures needed to keep home value and debt in step. The current situation of value below debt level provides incentive to walk away, foreclose and create additional downward pressure on the housing market. The housing market needs to stablize.

It is unfortunate that the urgency and panicked solution offered is such a poor one. But clearly time is of the essence.

I am confident a solution will be found and that rush to judgement never provides good outcomes. The term that comes to mind it triage. One third cannot be helped and should not use limited resources when the negative outcome is already known. One third can walk an need no attention. It is the other third, the injured but survivable that needs focus.

Mushroom Hunting

Some years ago a friend of mine, feeling both pioneer spirit and the paternalistic imperative to teach his son went into survivor mode on a weekend camping trip. That included cooking up some delicious mushrooms to add to the ambience. A short while later, cell phone in hand (not THAT pioneerish) he called another friend who knows a good fungus from a bad. The conversation went something like this. "We're both sick. I think it might have been some mushrooms. What? Do they glow in the dark??? Hang on....uh, yeah they do. Hmmm...oh. Damn. Won't die, just feel like it? Oh. Gotta go....RIGHT NOW." Click

Congress for fear of the proverbial mushroom cloud being threatened (once again)by the administration is instead about to pick a toxic mushroom of its own. Barely an economist outside the investment banking world favors the bail out. Even Richard Fisher one of the Federal Reserve Bank governors has broken ranks with Ben Bernanke, his own chairman. In his words, "These are grand ideas that cannot be executed."
Paul O'Neill, Bush's former Treasury Secretary declared our president and nation's leaders, "in a panic." When asked the specific problems with the bill he replied, "Everything."

Last night the largest Savings and Loan in the country was taken over by federal regulators and within hours the FDIC had auctioned it off to J.P. Morgan which has sufficient capital to operate the bank, business as usual and did not run itself aground.
To put it in perspective, the previous largest bank failure in U.S. history was Continental Illinois in 1984 which had $40 billion in assets. WaMu had $310 billion.
The largest savings and loan in the country just quietly slipped beneath the waves. Its owners and bond owners have taken it on the chin. But it cost the taxpayers is close to zero and its depositors have been protected. True the FDIC may exhaust its insurance coffers as banks fail and the government will have to step in to top up the fund, and raise insurance premiums to banks, but its not a trillion dollars on a silver platter.

There is even suspicion in some serious circles that lending markets are freezing up as part of strategic behavior of large financial institutions about to benefit from the biggest gift in history. The stakes are huge. There will be winners and losers. Congress is about to choose for us.

Financial darwinism? Creative destruction? Call it what you will. There are enough managements who exercised proper risk management to survive and now are reaping the benefits. Warren Buffet, Bank of America, J.P. Morgan, PNC? or Washington Mutual, National City, AIG, Lehman? Who should get your money and your support?


John Barnyak
President

Kaopectate for Cholora

Treating symptoms does not cure illness even if it feels better. Fear. Fear and Greed. It is merely a pendulum that swings from one sentiment to another. Currently fear is in charge and those who can keep their heads will pick the pockets of those who haven't. The derivative markets had provided substantial obscurity to the value of assets and congress is being asked to provide systemic salvation with information provided by Wall St. Permitting congress or conversely the Treasury Department to determine the price of these assets is fraught with combination of temptation for abuse in the investment sector and a fear of blame in Congress. Can there be a more toxic combination? It remains to be seen what the final package will look like.

There is no shortage of capital in the world. There is a shortage of capital in the risk taking banking system. Risk was mispriced substantially because of the volume incentives in banks creating the mortgage backed securities. The request of the Treasury now,is to transfer capital from taxpayers to those banks. Those who took the most risk and made the largest mistakes are about to reap the greatest benefit. Having been for a number of years sadly sceptical of the correct functioning of a perverted capitalist model we now have an opportunity to snatch back the goodness of the free market from hands of those who abused it. What are we doing instead? Fighting back with a socialization of the losses of the profligate money changers. It is bad economics and bad public policy.

Lehman Brothers declared bankruptcy last week. There was fallout certainly. I know of an innocent investor who has seen his Lehman money market funds at his brokerage account frozen. He can't withdraw it or use it for investment. If this relatively uncommon event were to multiply across the market it would have a devastating effect. This is the type of outcome that has congress white with fear.

But the Lehman Brothers bankruptcy resulted in the company being bought as a going concern by Nomura in Japan and Barclay's in Europe and the U.S. That transaction resulted in a price whereas the bailout further obscures value and forces the taxpayer to pay more than the market and be the least senior creditor. Unless the final bill includes both protection for the taxpayer as well as participation on the upside it should not be passed.

The ensuing problems to the economy will be with us for some years but I believe the solutions should be more focused rather than random and wholesale. Let me believe in the capitalist model again, balanced to prevent abuse while allowing entrepreneurial incentives to succeed as they once did. This is the opportunity to clear out the excesses of a perverted system without the clumsy hand of government intervention. It is regulation which is needed, not distortion.

John Barnyak

And the Winner Is....?

This morning the media gushed with the news that Warren Buffet has bought a sizable portion of Goldman Sachs. The man with the golden touch sent a sigh of reassurance through some circles. In other circles it sent calculators clicking as we all tried to figure out just what the Oracle of Omaha had actually done. It's not a bad thing that a slow, patient, important investor has thrown in with GS, but rest assured that Warren struck a hard bargain with a weak negotiating partner.

In Buffet's words "Five" billion is "a bet on brains," but his boot is firmly on the throat. First Goldman will pay a 10% dividend, or $500 million per year from after tax earnings. Nice little cash flow for WB.

Next, he has "given" Goldman the right to call (buy back) the preferred stock at a premium of 10%. So, 10% yearly dividend and 10% more if they decide things are going well enough to buy back the shares.

Finally Mr. Buffett gets warrents giving him the right to buy 44 million shares of Goldman at $115. It is now trading at 128. The value in the option market of that right is $1.5 Billion. So he really is paying $3.5 Billion and has an effective dividend rate of 14%. Sweet. What an extrordinarily generous man to say he was, "betting on brains." Over the summer Goldman Sachs bought back 1.5 million shares at $180/share. He never did say whose brains he was betting on.

John Barnyak
President

Hitting the Mule

How do you get a mule to turn at the end of a row? Simple, you shout in one ear, kick it in the leg, pull on the other ear and hit it with a 2x4. Now that you've got its attention....

Now that I've had a weekend to consider the trillion dollar 2x4 I think the so called bailout may be, as the germans say, an ungeborenes kind, an unborn child.
I also think it should be.

Disrupting the credit availability of a system run amok on credit is not something to be taken lightly. But neither is the bill for the taxpayer of astronomical proportions with nothing in return.

The Fed over the past few years has micromanaged the interest rates, investment banks have borrowed with extremely high leverage and inadequate capital and the easy mark for incrementally higher returns was the mortgage market.

Investment and pension funds desperate to increase returns above the risk free treasury note bought into belief that real estate values only go one way, up. The rewards for bundling mortgages into marketable securities became so profitable, every investment bank sought to obtain more and more of this debt. Underwriting standards evaporated.Investors worldwide clamored for the mortgage debt considered safe and many cases with the implied blessing and backing of the U.S. government.


Housing prices soared above normal ratios of equity or income to debt. The end was predictable if not in the midst of the maelstrom. Income had to catch up with debt or debt with income. We are now in the midst of debt catching up with income. Debt is being destroyed at an ever accelerating pace and this bailout is seeking to transfer the debt being destroyed to the taxpayer. Not very sporting of the AIG's and Morgan Stanley's of the world.

So now we have debtors in unaffordable homes, which are still above the long term housing equilibrium price. We have investment banks with inadequate capital and non-performing assets on the books. The government solution is to murmur the recent mantra, "mistakes were made." Responsibility without consequence just doesn't cut it.

The homeowners lulled into believing that a home is a giant atm machine refilling with cash each time the value went up, and the value never falls, are not without blame. But we live in a society of relentless marketing and what investment types call "asymetrical knowledge." Knowledge is not equal. The mortgage broker lists the reasons to borrow and the homeowner shrugs and says, "sounds good, I trust you."

And how will the government price this toxic debt it is intending to buy? If it offers the bank below market rate, there is no incentive for the bank to sell it. If offered at more than market, the taxpayer eats the difference and hopes that the value will increase enough over time to dig out of the hole.

Let them fail. Let the market buy the assets at the market price and the owners of the bank absorb the loss. It is the invisible hand of creative destruction. The market cleans itself out by taking resources away from the losers, so it creatively destroys the losing companies and reallocates resources to the winning companies. How to manage the bankruptcy of an entire system is the question.

Surely a trillion dollars can be used more effectively to bridge the abyss of personal pain. If the government must be involved a more proactive fiscal approach would surely be preferable to one that rewards the profligate risk taker. We have infrastructure needs left wanting for years. Bridges, water systems, schools. Find a way to build a trillion dollar bridge connecting national need with citizen pain. If we have to give up a trillion dollars let's find a way to give it to ourselves. Privatizing profit and nationalizing losses is a perversion of capitalism.

John Barnyak
President

Big Picture Backdrop and a Surprise

With the market getting a much needed pause from despair I am concerned as to when we get the next reality check. Hopefully this bounce will provide room for portfolio adjustment as a bear market relief rally. You only find out who's been swimming naked when the tide goes out. Today the tide came in, but the analogy is apt since it will be going out again soon enough.

There is already evidence that the economy is retrenching as the credit bubble deflated. Household debt growth fell to 1.4% in August, the lowest on record. The next step will likely be a debt decline as the U.S. consumer retools to begin a rebuilding of national savings.

Federal nondefense, noninterst spending soared to a record 14.7% of the economy and the foreign holdings of U.S. debt exceeded 15% of total debt for the first time. Fundamentally sound? I bet Senator McCain would like that sound bite back.

A view I have held for a long time and over the years repeatedly been proven wrong is that the only way out of the debt will be inflationary. Perhaps this time I'll get it right with the U.S. government (taxpayer) on the hook for possibly over one trillion dollars.

The government needs to buy time to avoid a financial and credit freeze. Its move to consider establishing a fund to buy up to $800 Billion in "failed assets" on top of $400 Billion to prop up money market funds is serious stuff. Given time it is possible that a significant portion of these assets will be disposable at a level even profitable to the US taxpayer. That remains to be seen. There were rumors that Goldman Sachs tried unsuccessfully to find raise sufficient cash to buy such assets before the government moved in. Perhaps like the private purchase of Longterm Capital assets, this could actually provide some profit. More likely this will be a deal of less than the worst fears but still substantial cost to the taxpayer.

It will be necessary for the real estate market to stabilize and begin recovery to have any hope of these bail outs being less than disasterous.

Looking past the dark abyss, opportunities will likely lie in inflation sensitive asset classes and investors may want to take a deep breath and add a child's portion real estate back into the portfolio if no longer there. If it is in the governments interest to stop the collapse of real estate you can bet they will be making a mighty effort to do so. As Collin Powell once said, "you break it, you bought it."
Come January a new administration will get a chance to see if they are any better at fixing broken things.

John Barnyak
President

Economics takes a Holiday

As we approach the election for the next president of the United States I urge all readers to consider carefully the path forward as we witness, through the financial markets, something quite remarkable. The demise of conservativism. What should now be paramount to all of us is avoiding the demise of something more basic and fundamental. Exercise your right both to speak up and to vote. Never has there been in my lifetime a more crucial moment when civil discourse and dialogue is needed amongst the citizenry. Speak up, but also listen.

Some years ago I came across a quotation from a scottish academic musing on the birth of the United States as a democracy. Alexander Tyler observed in 1787 the stages of democracy and opined that it would last about two hundred years as it progressed from stage to stage.

There are eight stages of democracy he observed:

From bondage to spiritual faith;

From spiritual faith to great courage;

From courage to liberty;

From liberty to abundance;

From abundance to complacency;

From complacency to apathy;

From apathy to dependence;

From dependence back into bondage.


Tyler and others also felt that when the majority voted themselves the power of the purse, democracy was passing its potential for greatness.

The events of this past week and the political reaction to the age of conservativism by the very powers that professed it is certainly interesting. Below are the reactions of conservatives to the results of deregulation. Massive transferrance of wealth not to the society at large, but to those who enjoyed the benefit of deregulation until it turned and collapsed beneath its own weight.

- Bear Stearns
- Economic Stimulus progam
- Housing Bailout Program
- Fannie & Freddie
- AIG
- No Short selling rules
- Fed liquidity programs (Term Lending facility, Term Auction facility)
- Money Market fund insurance program
- New RTC type program

Another observer of the events of this week sees it like this;

"If you are a fan of irony, consider this: The conservative movement has utterly hated FDR, and his New Deal programs like Medicaid, Social Security, FDIC, Fannie Mae (1938), and the SEC for nearly 80 years. And for the past 8 years, a conservative was in the White House, with a very conservative agenda. For something like 16 of the past 18 years, the conservative dominated GOP has controlled Congress. Those are the facts.

We now see that the grand experiment of deregulation has ended, and ended badly. The deregulation movement is now an historical footnote, just another interest group, and once in power they turned into socialists."

This election should not be about conservatives and liberals. It should be about a nation and its electorate projecting and protecting what we believe to be good and right about this country.

John Barnyak
President