The Witch Hunt Continues…

This was supposed to be a financial blog.  I still have full intentions of eventually writing about the world of finance and investing.  For now though, just like everyone else, I am really caught up in the political and moral debates that have consumed the national headlines over the past few weeks.  Yes, that’s right I’m still talking about the AIG bonuses. 

I’d like to start with the Constitution of the Unites States of America.  Here is an excerpt from Article 1, section 9 of the U.S. Constitution:

Article 1 – The Legislative Branch

Section 9 – Limits on Congress

“No bill of attainder or ex post facto law shall be passed.”

Okay, what the hell does that mean?  I think some definitions are in order.  First, the term “bill of attainder” means a bill that has a negative effect on a single person or group.  Second, the term “ex post facto” means formulated, enacted, or operating retroactively. 

I’m no expert in constitutional law.  In fact, I don’t know a damn thing about constitutional law or law in general.  But it would seem this clause says that congress can not pass any bill or law that singles out a single person or group of people for the purpose of punishment and congress can not pass a law that operates retroactively.

In the spirit of Article 1, section 9, it would seem to me that the bill that was introduced and passed by the house of representatives yesterday is unconstitutional.  It should be mentioned that this is not law yet.  It must be passed by the Senate and signed by president Obama.  Maybe the Senate  won’t pass the bill and maybe, if the Senate does pass the bill, President Obama won’t sign the bill.  After all, President Obama is an expert in constitutional law, right?  I know…dream on. 

I’m sure legal experts that are much more well versed than I, will argue that the above constitutional clause refers only to criminal law and therefore does not apply to the bill that was passed by the house of representatives.  The spirit of the law seems to indicate that congress can not pass laws that are meant to hurt a single person or group of people.  That makes sense.

The one positive aspect of this bill, was that at least law makers had the common sense to not impose this new 90% tax on lower income earners.  Anyone who works for a company that received more than $5 billion in TARP money from the government and makes more than $250,000 ($125,000 for a married person filing as single) is subject to a 90% tax on any bonus payments received.  Nonetheless, the bill is still not the right way to solve the moral issues surrounding the greed and ego that got our country into this mess.  Nor will this legislation reverse excessive pay to Wall Street executives.  Trust me, they will find away around this law.

Today, the CEOs of Citigroup, Bank of America and JP Morgan all made statements denouncing the new bill.  Probably even more telling was James Lockhart (director of the Federal Housing Finance Agency), who defended the retention bonuses that were given to employees of Freddie Mac and Fannie Mae. 

I know It is a hard pill to swallow.  We the tax payers have given countless billions to financial institution to save them and to save the entire financial system.  It seems like a slap in the face that our tax dollars would go to pay bonuses to some of the same people who caused the problem.  I understand that argument.  But the simple fact is that it is much more complicated.  If these financial institutions are not afforded the leeway to compensate and incentivize employees to stay on and continue to work to strengthen their respective companies, or in the case of AIG to wind down the company, then the companies will surely fail and all of the billions of dollars that we have spent to help these financial institutions will be completely lost.  Just like most businesses in this country, the most valuable assets these financial institutions  possess come up the elevators every morning at 8AM and leave every day at 5PM.  We have to stop fighting over this issue and concentrate on the bigger picture.

My fear is that we are in the beginning stages of a class warfare in our country.  It is probably fair to say that the disparity between the have’s and have-not’s in this country is greater now than ever before.  Most middle and lower income tax payers will simply view bonus payouts to employees of TARP supported banks and financial firms as simply unfair and a fleecing of their tax dollars.  While this opinion is understandable, it is not well thought out and fails to consider the big picture.  I hope our leaders in Washington D.C.,  will begin to understand this and stop their political grandstanding.  In the meantime, let the witch hunt continue.

AIG: Lets All Take a Chill Pill

The only thing anyone wanted to talk about today how it was possible AIG was able to pay these bonuses to their employees.  The front page of the Wall Street Journal and just about every other newspaper and news show today led with this story.  Is it possible that this story, just like a lot of the headline news stories are overblown by our news media?  I think so.  Don’t misunderstand.  I certainly do not think that anyone is entitled to a $6.4 million bonus, regardless of who the employee is or how well he/she has performed.  No doubt there were people at AIG who were paid bonuses and do not deserve bonuses.  That is not right or fair.  Well, lots of things aren’t fair.

There are two reasons why we all just need to take a chill pill.  First, I suspect that there are some people in the AIG organization who have received these bonuses and have actually done a good job (i.e. they deserve the bonus).  Can you imagine, for example, a single mother of three, who works as an insurance sales agent for AIG, selling property and casualty insurance?  She busts her ass all year long to make her sales goals, earning about $60,000 throughout the year.  Because she met her sales goals, she is entitled to a $20,000 bonus.  Should she not be able to receive her bonus because of the poor decisions (which resulted in billions of dollars in losses) made by 20 reckless individuals in a derivatives products division of AIG, in the London office?  Of course not.  She is entitled to her bonus and as such should receive it and keep it.  Second, Mr. Libby in his testimony to Congress today (see video below) had some valid points.  These bonuses were contractually obligated to be paid and as such AIG is legally bound to pay those bonuses.  Second, as it turns out, the government gave the green light for these bonuses to be paid.  YES, that is right the government said “go ahead”.  So can we really blame AIG for moving forward and paying the bonuses?  No.  Not only did Mr. Libby testify that they consulted with their representatives at the Federal Reserve about the bonuses, but that the Federal Reserve knew, in advance, that AIG would making these bonus payments to their employees.  To top it all off, Senator Chris Dodd admitted today that he was pressured by representatives at the Treasury Department (i.e. Tim Geithner’s team) to put language in the federal stimulus legislation that would allow bonuses that were contractually obligated to continue to be paid out by companies such as AIG.  The same group of politicians that are screaming bloody murder about the fact that AIG paid out these bonuses are the same group of politicians that allowed the act to occur and knew about the payments in advance.  Now they want to grandstand and summons the CEO of AIG to be raked over the coals in front of Congress.  Keep in mind that Mr. Libby was just appointed (by the previous Treasury Secretary) to take over the AIG CEO position and he is paying himself $1 per year as a salary.  The guy is being paid $1 to oversee the unwinding of what may be the single worst car wreck in the economy.  The real culprits in this scandal, as with the entire economic crisis, are our politicians in Washington.

Thank You President Bush

Let me first say that 60 minutes is hands down the best show on television. It is the one show that I absolutely must watch every week. If I don’t watch it for some reason, I have to find it online and watch the show on the laptop. This week, 60 Minutes reporter, Scott Pelley, had an unprecedented interview with the sitting chairman of the Federal Reserve, Ben Bernanke (a.k.a. Big Ben).

So why should we thank President George Bush? Don’t get me wrong. I am not generally a fan of President Bush. However, I do think we should give credit, where credit is due.  We should all be grateful that President Bush chose Ben Bernanke to the Chairman of the Board of Governors of the Federal Reserve. Call it foresight, call it wisdom, call it luck, call it anything you want, Mr. Bernanke was and is the perfect person for the job.  I doubt there is any other person in the world who is better qualified to be the head of the U.S. Federal Reserve during the most difficult economic environment, since the Great Depression.

The key takeaways from this interview are; first, we have THE expert on the Great Depression overseeing the efforts to pull us out of this economic downturn.  When Mr. Bernanke speaks about our economic crisis, he leaves the impression that he knows what he is talking about and that is because he does.  Confidence in this environment is very important and  he is very confident about his role and his mission to stabilize the economy.  Another key point that Bernanke touched on was that our economy will probably pull out of this downturn sometime in the next year. That tells me that the financial markets may have bottomed or are close to bottoming (famous last words). The equity markets are a discounting mechanism. The markets always look forward. What we see in the market today reflects what the market expects in the economy six to twelve months in the future. So thank you Ben for calling the bottom of the market! Mr. Bernanke also said, even though it upsets most tax payers, it is necessary to save the financial institutions of this country. He is absolutely right. Like or not, the financial institutions are the engine of our economy. If the engine isn’t working properly, the car isn’t going to go anywhere. Finally, the most important comment that Chairman Bernanke made was that we (i.e. our representatives in Washington) need to have the “political will” to make the appropriate monetary and policy adjustments to get through this crisis. What that means to me is that if politicians in Washington D.C. continue their partisan politics (as usual), we may not be able to right the ship. We need our representatives in Washington NOT act in their own political best interests or legislate along party lines. Our representatives in Washington need to step up and simply do the right thing to stimulate the U.S. economy enough to pull out of this deep recession.

Take a look at the Bernanke interview:

 

Watch CBS Videos Online

 

Watch CBS Videos Online

Confidence…Confidence…Confidence!

We need more confidence from our representatives running the show in Washington.  Now take a look at the SNL skit from two Saturday’s ago (below).  This is how the public views the Treasury Secretary, Tim Geithner.  To be fair to Mr. Geithner, he did just start on the job.  Who knows maybe he will grow into the position and become a great Treasury Secretary.  In the meantime, Mr. Geithner leaves a lot to be desired.  The Treasury’s Secretary’s initial announcement concerning the stimulus/recovery package was a complete disaster.  Its a shame the Obama administration didn’t have the foresight to nominate a Treasury Secretary that has sales skills and a few gray hairs.  Having a Treasury Secretary that would have hit the ground running would have helped to inject confidence and optimism in the financial markets.

 

What Financial Crisis?

What Financial Crisis?

I'm not sure why I have chosen to begin my financial blog on Friday 13th. I obviously do not suffer from triskaidekaphobia. Wondering what triskaidekaphobia is? Don't feel so bad. I just learned the word today, as I sipped my coffee, waiting in traffic and listening to a story about Friday the 13th this morning on National Public Radio. Triskaidekaphobia is the fear of the number 13 and the word paraskevidekatriaphobia is a fear of Friday the 13th.

So what does Friday the 13th have to do with this blog and the financial markets? The answer is nothing. I just find it ironic that this is the day I have chosen to start writing my blog. I also find it ironic that we end this (ominous) week, of Friday the 13th, with the Dow Jones Industrial Average up 9.01%, the S&P 500 index up 10.71% and the NASDAQ 100 index up 9.75% for the week. Not too bad by most standards. Now, if we can only get the market to go up like that every week for the next few months.

I suspect that most started out this week, like I did, with the very pessimistic expectation that the equity markets would continue the seemingly never ending slide down to that next "floor" in the market indices. I am an optimist when it comes to the financial markets and the economy as a whole, but I have to admit this market has taken its toll on my optimistic outlook on the markets. This week was a breath of fresh air. I couldn't help but think that if you had taken a two year sabbatical to a remote, far-away, destination, where there were no links to the news, the economy, the markets, etc., and you came back on Sunday, March 8th (2009), you would have thought by just witnessing the moves in the equity market this week that our economy was doing very well.

Thank you Mr. Pandit

So is this jump in the market just going to be a short-lived bear market rally? Of course no one knows the answer. The market seems to be excited at the prospects of the major banks actually making money again. Citigroup's CEO, Vikram Pandit, announced that, “we are profitable through the first two months of 2009 and are having our best quarter-to-date performance since the third quarter of 2007". It is likely that this is an operational profit that Mr. Pandit is touting. It is also worth noting that there is still the month of March until the end of the first quarter. Things can change. Many banks, Citigroup included, may still have net losses for the first quarter, as a result of continued write downs on toxic assets. But if we do see operational profits, hidden inside the quarterly numbers, that is obviously a good sign. It is likely that the prices of bad assets on banks' balance sheets decreased in value so far this year, along with most other financial market asset prices. As these assets must be marked-to-market, they will likely cause more losses for financial institutions. It would be a great surprise if that is not the case.

Mark-Me-To-Market

Speaking of mark-to-market, on Thursday the House of Representatives financial services subcommittee met to discuss possible changes to the market-to-market accounting rules. In a speech on Tuesday, Federal Reserve Chairman Ben Bernanke mentioned that he did not support a suspension of market-to-market accounting rules. However, Mr. Bernanke did say that he supports "improvements" to the market-to-market accounting. Sounds to me like big Ben doesn't want to throw his political weight around too much. Come on Ben...you know we have to get rid of mark-to-market...at least temporarily.

Mark-to-market accounting was put into place with the best intentions. In normal market conditions, mark-to-market accounting provides a level of transparency that should exist. The problem is that many asset markets are completely frozen. In an environment where there are few or no buyers of the assets on banks' balance sheets, how do you appropriately value those assets?

The only reasonable way to value assets such as loans or securitized pools of loans is to use net present value of discounted cash flows. For example, if a bank has a pool of mortgages that has a total outstanding principal loan value of $100 million, that pool of mortgages should be worth whatever the net present value of the $100 million of future principal payments, plus the net present value of the interest that is being earned on those loans.

You also have to account for the fact that there are probably some delinquent loans in that pool of loans and there may even be some loans that are in default or have already defaulted. Since, you already know that these loans are delinquent or in default (i.e. non-performing), you would dramatically lower the valuation on that segment of the loan pool, using much higher discount rates and/or much lower repayment amounts of principal.

Finally, the most difficult task in accurately valuing these "bad loans" would be to account for the expectation that delinquencies and defaults are likely to increase for some time to come, given the state of the economy. There may be a lot of loans that currently are not delinquent or entering default, but may be delinquent/entering default within the next few months. Because of this, there would need to be a portion of the loan pool that uses a very high discount rate to calculate net present value. This would be necessary to compensate for the very likely event that delinquencies and defaults increase over the coming months.

All of that being said, some will still argue that if someone is only willing to pay $30 million for a pool of loans that has a principal value of $100 million, then that $30 million is the value at which the pool of loans should be listed as such for accounting purposes.

The reality is that our legislators in Washington D.C. need to make some sort of change to the accounting rules to more accurately reflect the true value of these assets. I agree that an asset is only worth what someone is willing to pay for, at any given point in time. But the true, long-term, value of an asset can be a much different value. For the purpose of listing these assets on financial institutions' balance sheets, the true, long-term values should be used.

Daily Show vs. Mad Money

If you haven't seen the head-to-head match up between John Stewart and Jim Cramer, you need to take about 15 minutes and watch the whole interview. It is entertaining to say the least. Take a look...

The Daily Show With Jon StewartM - Th 11p / 10c

Bern After Pleading

Daily Show Full Episodes
Important Things w/ Demetri Martin

Political Humor
Jim Cramer

Way to go John Stewart! Thank you for calling out Jim Cramer for what he is. The sad fact is Stewart is absolutely correct. Cramer and many others in the financial "news" business are cohorts with market manipulating institutional investors on Wall Street.

A good example of the market manipulation was the price appreciation in crude oil in the year 2008. When crude oil went to $147/barrel, the price movement had nothing to do with the supply and demand of oil. Oil went to those sky high price levels because there is a very small population of institutional investors (i.e. hedge funds) on Wall Street that have the power to manipulate financial markets. When they decide they want oil prices to go to $150/barrel, they will make it happen. In the clip that John Stewart shows, Cramer even explains how this manipulation takes place and how he manipulated asset prices, when he was in the hedge fund business.

The entire market is currently in the midst of another major market manipulation. For months, hedge fund managers and sales representatives have been running around Wall Street, pitching the case for why the market MUST continue to go down. Why do they have this negative outlook? Hedge Funds and career bears argue that, because total credit market debt/GDP ratios are at about 350% (or higher), the massive deleveraging process must continue. Therefore, they argue investors should be "short" the market, in an effort to take advantage of this imminent drop in market value. Take a look a the charge below (source: Ned Davis Research Inc.):

This is a perfect example of how the hedge fund community uses misleading information to create erroneous arguments to support their portfolio positions. Hedge funds are short the market and they are very creative and manipulative in their efforts to make "the facts" appear in their favor.

The truth is that even the Federal Reserve, who publishes the data seen in this graph, has conceded that the data is flawed. Why is this chart misleading? The securitization process in the debt markets during the past two decades has dramatically inflated this "total credit market debt" statistic. Unlike previous generations, our debt is not simply held by banks and financial institutions. Over the past 20 years, as loans have been issued by financial institutions, those loans have not been held by banks, but rather loans are packaged into securities and sold off to investors. In fact, some loans have been packaged and re-packaged through the securitization process, making the statistic even more inflated and inaccurate.

Assume a home buyer took out a mortgage for $300,000 in 2004. That $300,000 will show up in the statistic as personal debt. The bank then decides to package your mortgage loan into a collateralized mortgage obligation (CMO) and sell that CMO to investors. Your $300,000 mortgage now is counted twice (for a total of $600,000) in the total credit market/GDP statistic. In 2005, if the borrower decided to refinance from that adjustable rate mortgage (ARM) to a 30-year fixed mortgage, that mortgage refinancing will cause the original $300,000 to now be represented three times in the total credit market/GDP statistic. A $300,000 mortgage is represented in this statistic at the inflated amount of $900,000. This is not the case for all loans and debt, but it certainly is the case for much of the debt that is outstanding. The hedge funds that use this statistic to sell their funds, know this data is flawed. But they use it anyway, because it paints the picture they want the investment community to see.

This is the "back room" market that John Stewart is referring to in his interview with Cramer. To some extent, Stewart's claim that there are two markets is true. It is also important not to overdue the conspiracy theory. While market manipulation does occur and there needs to be better regulation, surveillance and enforcement of this manipulation, the fact is that the world financial markets are still the best and most efficient mechanism to price assets.

Current asset prices in the financial markets (particularly in the equity markets), by most measures, are undervalued. Rational valuations will eventually return and the financial markets and asset prices will rebound.