Tuesday, February 3, 2009

It Was Fannie Mae and Freddie Mac, But Now It's "Crappy Mac"

From the Desk of Joe Rollins

First, several readers from my "No One Warned Me That Old Yeller Was Going To Die!" post a few weeks ago wondered why I only discussed my Labs, Shaft and Daisy, and made no mention of my Siamese cat, Sam. All of my pets, including silly Sam, are a huge part of my family. In an effort to smooth things over with Sam, here’s a picture of him with his adopted mama, Daisy. He’s a funny little guy, and he brings all of us a lot of joy.

This week, I want to discuss how most people experience things throughout their lifetimes that force them to open their eyes to what’s going on around them. These are not always earthshaking events – sometimes things happen that simply make people view their surroundings in a different light. An instance of eye-opening experience happened to me when I was playing high school football.

In my high school, boys were required to play in every sport offered, which meant I played basketball, football, baseball, and track. In many cases, we played both offense and defense in football. In those days, it was not considered to be a disadvantage or a burden to play both directions. I wanted to play all the time, whenever I could get on the field.

I was lucky that during my entire high school and college career playing sports, I was never hurt. I never broke a bone, and as far as I can recall, I never missed a minute of playing time because of an injury. I suppose that’s why this event is etched in my mind forever…

On my high school football team, I was both a defensive end and a wide receiver. I may be slow to move now, but back in those days I could actually run faster than anyone else on the team. The fact that I was taller than most defensive backs made me a ready-target to catch passes.

I was also the “gunner” when the team was punting, which meant that I had to position myself far outside the main line and be the first to get down the field and cover the punt. Since I was generally faster than the defensive backs, that proved to be a relatively easy task, and I actually got to be good at punt coverage. I cherished the position – it was just too much fun running down the field to hit the guy who was distracted in his attempt to catch the punt.

One time, when playing our local rival high school, I was covering a long punt. Usually, when I broke through the defensive backfield, I could run unimpeded to the catcher of the ball. But that particular night, I watched the ball from behind through the bright lights to the south of me while running towards the catcher to the north. Almost instantly I ran into what felt like a brick wall – it was the most crushing blow I had ever received on the football field. One minute I was running at full speed, but the next moment I found myself laid out on the playing field with birds and stars circling my head.

As I dazedly looked over, I was certain I was hit by the biggest, meanest defensive lineman in the entire world. I had never been carried off a football field before, but as I lay in pain barely unable to move, that possibility suddenly seemed very real. I thought it was an enormous player that knocked me down so severely, and although I could hardly move my head, I was able to see the player that had hit me so hard. It was a 5’7” runt, who couldn’t have weighed more than 140 pounds dripping wet! I couldn’t believe that a kid of such small stature could inflict so much pain on me.

After I realized who had delivered the blow, I quickly jumped to my feet and ran off the field. I had no intention of giving the other team the satisfaction of knowing that such a small teammate inflicted that much pain on an opposing player. This incident was a wake-up call that impacted the rest of my football playing days. Never again did I run down the field while looking over my shoulder to cover a punt.

First, let me say that I am not a conspiracy theorist. I’ve always thought that Lee Harvey Oswald was singularly responsible for JFK’s assassination. Likewise, I am totally convinced that Elvis Presley died on August 16, 1977 (quite unceremoniously while having a private moment in his bathroom.) I also believe that the Apollo 11 mission actually happened, and that lunar-landing footage wasn’t created in Hollywood by our government. Lastly, I have never for a second believed that a UFO crashed in Roswell, New Mexico in 1947. Perhaps I’m too pragmatic to believe in conspiracy theories.

Something I do believe, based on personal experience, is that the government is often completely incompetent. As a CPA, I have had to work on IRS matters my entire professional life. Those experiences have undoubtedly shaped my opinion that the government is all too often totally inept. I’m not necessarily talking about the people working for governmental agencies as much as the system itself.

It seems that the way to get ahead when working in government is by never saying yes. If they say yes, then they’ll be held accountable. For most government workers, that means never giving a straight answer. If you think that’s cynical, then try calling your local DMV to ask a simple question. If you’re able to get through, I bet you don’t get a simple answer. The same thing applies if you call the Social Security Administration. No one in that organization ever seems to be able to concisely answer even the simplest question. The government does things the same way day-in and day-out, not because they’re right or wrong, but because that’s the way things have always been done in the past. Innovation and creativity are not sought-after qualities for governmental employees.

There is so much going on now in our government that it’s hard for me to even begin addressing the issues. However, I’m sure most of the readers of the Rollins Financial Blog are more concerned about the stock market than my thoughts on our current government, but since they are so intertwined regarding economic reality that I feel I need to address them both.

The title of today’s post refers to the “bad bank” concept currently being discussed by the new Obama financial team. Some think that the way to overcome toxic assets is by the government buying them all and selling them to the private sector systematically over time. While this isn’t a novel idea – and is actually one that was originally proposed under the original TARP plan – it is totally unnecessary in my opinion.

The banking sector is already experiencing a significant improvement and we just need to give it more time to work. My opinion is that we all need to take a deep breath and use common logic before committing to governmentally run projects that we will spend a lifetime unraveling. As I am sure all of you are aware, once a governmental project is in place it is difficult, if not impossible, to eliminate it. However, if the project is not needed anyway, it might just be better to avoid it altogether.

As for the financial markets, they were a disaster in January. However, there is no question in my mind that the market makers are attempting to hold down this market – not for economic reasons, but for selfish reasons – to generate wealth for themselves. While this isn’t illegal, I question whether the damage they are doing will not be long-term.

For the month of January, the Dow Industrial Average was down a whopping 9.6%; this represents the worst January performance ever in the Dow’s history. The Standard & Poor’s Index of 500 Stocks was down 8.4%, the NASDAQ Composite was down 6.3% and the Small Cap Russell 2000 was down an enormous 11%. While there is no question that these numbers are terrible, they are somewhat questionable. It’s unusual and depressing that for the last two trading days in January, the indices were off over 5% each. It’s no coincidence that the Dow Industrial Average ended at exactly 8,000 in January’s final trading day.

In previous posts, we discussed how the commercial credit markets are now opening up. The important three-month Libor rate is now stable and within acceptable levels to the Federal Reserve. For the first time in a several months, January showed a very positive return in many bond positions. The junk bond market showed a swift upward movement, making approximately 6% for the month. This is the first month in about eight months that investors sought higher yields in riskier investments. Correspondingly, the long-term Treasury bond returns made a significant negative return, losing over 8% for the month. The very important 10-year Treasury bond has gone from a yield close to 2% only three weeks ago to an incredible move to 2.8% on Friday. There is clearly something positive going on where investors are seeking higher returns.

In tomorrow’s post, I will discuss the new stimulus tax act and why it is misplaced and excessive, but today I want to focus on the issues regarding the movement by investors from risk-free investments like Treasury bonds and into high-yield investments like long-term bonds. There is clearly a rotation occurring, and when it’s complete it will eventually impact equity prices.

It’s also clear that the redemptions from equity mutual funds have slowed or stopped. Supposedly, the infamous hedge funds have now completed their redemption and their deleveraging clearly reflects positively on an upcoming better equity market.

The reason I feel the current stimulus bill is misplaced and exaggerated is because it hasn’t given the original TARP bill enough time to function. Below is the cover of last week’s BusinessWeek, entitled, “BROKEN BANKS: The Bailout is a Bust [and the Sooner We Realize It, the Better.] The title is certainly attention-grabbing, but its truthfulness is questionable.

So you know the exact intent of the original TARP bill, I will reflect upon its history. It was originally approved during the height of the credit squeeze to pump $700 billion into banks to stabilize them for the future. While that feels like a lifetime ago, we’ve actually not given the TARP enough time to work. Many readers of this post may be shocked to discover that as of today, only $194 billion of the original TARP funds have been deposited in the banks, and a large sum of that amount was only deposited recently. The very first payment out of the TARP occurred on October 28, 2008. Basically, the program has only been functioning for 90 days, and within those 90 days were the Christmas holidays, a time where historically very little business transacts in the U.S.

Are you as shocked as I am that BusinessWeek has proclaimed the program a failure when it has only had 90 days to work and only 27% of the money has been put into the system? It is hard for me to believe that the press is so anxious to write a story that they completely refuse to research the facts before making such aggressive allegations.

The single complaint I hear time and time again in the news and at cocktail parties is that the banks are not loaning money. That statement is just not supported by the facts. You can personally check the Federal Reserve website to see the actual lending that has occurred, and that it is ongoing and increasing. Additionally, J.P. Morgan Chase recently took out a full-page ad in the New York Times to set the record straight. This bank received $25 billion in TARP funds in late October, 2008, but made over $100 billion in new loans during the fourth quarter of 2008. That is exactly what the TARP was designed to accomplish, and it is working. To consider it a failure on 90 days worth of results is premature.

The other reason for my optimism is that we are reaching a level in the credit market where more and more banks are telling the TARP, “Thanks, but No Thanks.” The Wall Street Journal reported on January 31st that over 50 banks have rejected aid from the government. Many banks are basically saying that they do not need the money and they clearly do not want the government establishing policies that would be detrimental to their shareholders.

Aside from military defense, the government does virtually everything worse than the private sector. The last thing most independent businessmen want is the government running of their operations. The reason that I believe that the “Crappy Mac” bad bank concept will not work is based on this exact same theory. First, many of the banks will not even participate (J.P. Morgan Chase has already publicly announced that they would not). The issues regarding obtaining these assets and managing them would be a task the government is imminently unqualified to perform.

While the assets held by the bank are worth less than face value, almost no economist believes they are worth as little as they are currently recorded on the banks’ books. The best thing for all banks and for Americans in general would be to allow the banks to deal with their own issues, do the best to collect these payments and suffer the losses if losses are to occur. The banks have clearly the best people to manage these assets and the government has no one. The taxpayers should not be put in the position of having the government deal with these assets by putting politicians who are clearly incompetent in charge of evaluating them.

It is troublesome that so many people are overreacting to the current financial situation. When the GDP was announced on Friday to be down 3.8%, it was also revealed that it was better than many expected. While it will possibly be further reduced, in all honesty this is not an awful percentage. The move to completely scrap capitalism in the face of a 3.8% negative GDP is discouraging. The U.S. economy has had an extraordinary run, and to believe that we would not ever suffer a down quarter is naïve.

Focusing on the GDP from the fourth quarter of 1982 through the fourth quarter of 2008, you will see that the economy has actually been very robust. In fact, during those 26 years, there have only been five down quarters. This means that out of 106 quarters, 101 of them have been up. One of the down quarters, of course, was due to September 11, 2001, and the other down quarters were minor in nature.

The pundits that now want to abandon capitalism after one of the greatest economic runs in the history of developed countries need to rethink policies. Even with the criticisms surrounding former President George W. Bush, the economy operated in a positive GDP up until the most recent quarter. Economic activity has been extremely strong and this short bump in the road should not push us into making economic decisions that we will regret for generations to come.

If you read the fourth quarter GDP report closely, you will see that the culprit to the economy’s downfall was consumers. There was a major drop-off in consumer spending during the fourth quarter of 2008. Given that our government scared us into thinking we were looking at potential economic disaster, would anyone question why consumers failed to spend? As soon as consumer spending is stabilized, which will occur simultaneously with consumer confidence, the economy will rebound. My belief is that those days are just around the corner.

I marvel every day at the low levels of bank stocks. On a client’s behalf I recently reviewed the financial information for Bank of America. As of December 31, 2008, Bank of America had a book net worth of in excess of $200 billion. They now have a market value of $30 billion. The combined companies of Bank of America and Merrill Lynch have the potential to make $10 billion in net profits to $20 billion annually. It is clear to me that fundamental investing has lost track with reality.

My point is that market makers have forced the market down in the face of a bad economic situation. This aggressive selling and indiscriminate manipulation of the financial companies have made average investors fearful and with no desire to invest. The total S&P 500 companies that have reported for the fourth quarter of 2008 clearly reflect a case of haves and have-nots. If you exclude the financial companies from this reporting cycle, all of the other companies have reported a net increase in earnings of 4%. I know that you likely have not heard that news elsewhere, so I thought I would report it here.

Later this week I will post some other thoughts on the economy, the stimulus bill and other matters I find interesting. In the meantime, I have figured out an easy way for me to get on television: exclaim in the loudest voice possible that everything the government is doing to help is bad! It appears that we have lost our faith in the American way of life, which is sad and distressing. There is nothing wrong in the economy today that consumers going back to spending wouldn’t cure. Once people start spending money again, they will buy cars and clothing. Once that confidence level reappears, people will be reemployed and the economy will turn up.

I will also discuss later in the week the flood of money that the government is putting into the system. This increase in money supply will create many jobs and promote lending and spending by consumers. I am not sure when the economy will turn upward, but I believe we are close to that finally happening. For now, I simply wish everyone would sit back, take a deep breath and allow the programs that are already in place to work before mortgaging all of our futures on a bad program and a lack of faith in capitalism.

1 comment:

Chad said...

Great info! I'm adding your blog to the list of others I check (Carpe Diem, Good News Economist, Positive Economic News, and Calafia Beach Pundit) every morning and evening. As a financial advisor, I appreciate getting the "other side of the story" to pass along to my clients. Keep up the good work!