So, Where Are We Now?

I appreciate all of the inquiries as to my disappearance lately. I'd love to report that I've been relaxing on a beach on a remote telecommunications-free island in the Caribbean, but client business, trading, earnings season, and a beautiful, laughing, 4-month old daughter have kept me very busy these past few weeks. As earnings season slows I hope to have a little more time for the Rubbernecker, sleep, and personal grooming.

I certainly haven't avoided writing due to a lack of material! Let me try and catch up with the past few weeks and recap where we stand.

• As we know, the Fed has driven interest rates to ridiculous below-market rates.
• These low rates are devastating for the savings of retirees who have no business moving out on the risk curve in search of higher yield.
  
• These low rates are also supposed to encourage more borrowing despite the fact that our economy is currently suffering from too much debt.
• Congress is angry that the banks aren't lending their bailout funds to people who already have too much debt in the middle of some type of economic "ession."
• Congress is criticizing bankers for paying themselves too much, over-levering their balance sheets, and maintaining huge off-balance sheet liabilities while Congressfolk continue to pay themselves too much, over-leverage our nation's balance sheet, and maintain huge off-balance sheet liabilities.
  
• The collective earnings of the S&P 500 companies will register its first decline ever in the fourth quarter of 2008. Ever.
  
• Congress just passed a $787 billion stimulus plan that will further increase our national debt and displace private investment. The notion that this and future stimulus is only temporary and will be withdrawn once the economy recovers is laughable.
  
• Over $8 trillion in spending/promises have been incurred in the past year.
  
• We have a Treasury Secretary in charge of both the financial industry bailout and the IRS who either isn't smart enough or honest enough to do his own taxes properly.
• This same Treasury Secretary just announced an eagerly-awaited financial bailout plan that included no details and no plan aside from somehow spending a lot more money.
  
• The Obama administration is now working on some scheme to "save" the housing market. Whatever the details of the plan, we can be sure it will entail using the tax dollars of those who were prudent to "rescue" those who made bad choices. It will also impede the housing market finding a bottom.
  
• This year's Federal budget deficit is creeping towards $1.5 trillion, and is sure to rise further as tax receipts continue to fall.
  

Debt, Debt, and More Debt
Simply put, this massive increase in debt is an inter-generational transfer of wealth. In other words, we're doing this for our own current "benefit" and will be passing the bill to our children. Where's the discussion of fairness? With every bailout of the past year, our leaders have told us that we must act immediately or the global economy will collapse. That hasn't left much time for educated discussion, nor has it prevented the global collapse that their swift undebated action was supposed to prevent. Last week, I explained to my 4-month old daughter that her share of the national debt is well over $200,000. You should have seen the diaper I had to change after that.

It amazes me how accepted it has become that the the cure for any slowdown of any magnitude is always to throw money at it. This is the policy that we've pursued consistently since the Great Depression, and look where it's gotten us. There's a popular quote that seems rather appropriate. "If you keep doing what you've been doing you'll keep getting what you've been getting."

For far too long, our policy makers have increased and encouraged borrowing at every whiff of a slowdown rather than let the market correct the excesses that have built up. Each time, they managed to forestall what would have been a healthy correction at the expense of preordaining a more severe future correction. Ironically, now that it's time to pay the piper, our authorities are laying the blame on the failings of the free market instead of their constant meddling. Unfortunately, their actions will only prolong the length of this downturn.

As I've stated before, the good news is that the market is still doing its job, and many of the excesses (excluding government credit and money supply expansion) are gradually being cleared away. The housing bubble is unwinding, consumers are beginning to save again, global equity markets are back to far more reasonable levels, excess production capacity is starting to dry up, etc. This process will take time, especially with the massive level of government meddling, but it is occurring, and it will eventually take us to a healthier level of economic activity -- one not dependent largely on household credit expansion.

Stock Market Rally?
As ugly as the situation is, there is a strong likelihood that the fiscal and monetary stimulus being dumped on the economy will appear to have a positive impact. As counterproductive and inefficient as most of this spending will eventually prove, the stimulus will at least help slow the rate of decline, probably beginning in the second half of the year. In anticipation of this or at the earliest sign of this, we may experience a fairly strong rally in the equity market as investors come to believe that the worst is behind us. The expected "Obama rally" earlier this year was doomed from the start as too many people were expecting it and were looking to sell into it. With pessimism growing again and less talk of an impending rally, the odds of a rally have actually increased.

To the extent that the credit bubble has not been allowed to correct sufficiently, it's hard to imagine that any such rally will be the real deal. As discussed in prior posts, bear rallies can be powerful. The Great Depression saw a 50% rally over a 6 month period right in the middle of the first leg down. Barring a dramatic change in policy, any rally unaccompanied by a significant correction in the credit bubble is likely to prove a dead cat bounce.

The ballooning national debt and Fed balance sheet also need to be watched. I just can't see all of this stimulus being removed without collapsing any recovery we do eventually get. Government doesn't have a terrific track record of enacting temporary stimulus. Not surprisingly, it typically manages to morph into permanent funding. New constituents will be created who will create lobbying groups, and they won't take kindly to any future talk of decreased funding. The Fed will also find it difficult to withdraw the massive monetary stimulus it has injected. Once the printing presses are humming, it's very difficult to turn them off. Although much of the talk these days is of deflation, I see significant inflation as a much more serious threat down the road.

Strategy Update
As a result, current long-term Treasury yields strike me as unsustainably low. I had shorted the long end of the curve in mid-December and sold that position near the end of January. I didn't anticipate this being a short-term position, but we were fortunate to buy the position close to its low, and it experienced a 25% gain in just over one month. Hopefully, I'll get another crack at it. The Fed has discussed buying long-dated Treasuries. Should they follow through, I would expect another decline in long yields at which time I'll take a hard look at loading up again. Longer-term, this is a position I want to own.

Gold has typically been viewed as an inflation hedge, but it's been one of the best performers in this current deflationary phase (as it was during the Great Depression) as investors flock to its safety and low interest rates minimize the opportunity cost of owning gold. We've been overweight precious metals throughout the gold bull market and have continued to add on pullbacks. In early January, I bought a few junior mining names that had been driven to ridiculously attractive prices. More recently, I eased back on our GLD/DGP position in those accounts where the position grew just a little too large following this recent rally. We still own a healthy precious metals position and would be quick to add on any significant pullback.

Most of the balance of our aggressive portfolios hasn't changed significantly. Our bias at these levels is towards select emerging markets and commodities. I take a long-term approach with these positions and am quick to point out that I have no expectation for these positions in the short-term (less than one year). The countries I'm focusing on have already declined significantly, have experienced an outflow of hot money, are marked by high savings rates, have at least reasonably solid reserves, and are trading at attractive valuation levels. Five years from now, I expect to be pleased with their performance.

We still hold a decent cash position, and we continue to have just a few short positions as the recent leg down in the market has made it more difficult to find many compelling short opportunities. As usual, at the margin I would anticipate selling some long positions and increasing short exposure if we get a strong rally without signs of a significant positive change in the underlying fundamentals.

I think that catches me up from my relative absence the past few weeks. I now have to go explain to my daughter why she'll be learning Chinese and why her savings account is short the dollar. I'll be putting a second "backup" diaper on first.

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The Market Rubbernecker is affiliated with Aspera Financial, LLC, a registered investment advisor. Please read the disclaimer on the home page of the Market Rubbernecker site.

Some Comic Relief

Hat tip to CR!

PART 1


PART 2

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The Market Rubbernecker is affiliated with Aspera Financial, LLC, a registered investment advisor. Please read the disclaimer on the home page of the Market Rubbernecker site.

Britain's Coming Real Estate Bust

The real estate troubles we've been experiencing here in the U.S. aren't at all unique to us. Many a European flat, chateau, and villa experienced a similar or greater bubble during this decade, and they're now starting to retrench as well. Home prices are falling and mortgages are more difficult to come by as many banks are (rationally) requiring higher credit standards and larger down payments, if they're willing to lend at all.

Britain seems to be just a bit behind us on this credit/housing unwind. Discretionary spending is likely to at least moderate as credit availability suffers and inflation continues to rise. We should expect to see a slowing in European real economic growth. The most interesting question just may be how our recession and a slowing in Europe would affect Asia. I'll address this in another post.

The Europeans do have one big advantage over us. If things get really bad for them they can take advantage of the weak dollar, move to the States, and buy a mansion in Cleveland for what it costs them to fill an SUV back home. Of course, they'd have have the distasteful choice of working as either as debt collector or a political strategist since these are about the only jobs available here.

From the TimesOnline:

House prices fell for the second consecutive month in March, according to official figures released today.

The Land Registry figures, which show that the average cost of a home in England and Wales dropped by 0.4 per cent in March to stand at £184,798, will add to growing fears that the UK is about to suffer a significant slump in the housing market.

The Land Registry also revealed that housing market transactions averaged 81,926 a month between October 2007 and January 2008, which was down 25.5 per cent year-on-year. Sales volumes were also weakening more markedly at the end of this period, as they were down 39.2 per cent year-on-year in January at 53,221.

Howard Archer, chief UK economist at Global Insight said: "We now expect house prices to fall by 7 per cent in 2008 and 9 per cent in 2009. Furthermore, the longer the credit crunch goes on and the deeper and longer the UK economic slowdown is, the greater the danger will be that an even sharper housing market correction will occur.

"Current rapidly deteriorating sentiment over the housing market also heightens the risk that house prices could fall more sharply over the next couple of years. Consequently, it is very possible that a drop of more than 20 per cent in house prices could occur over the next couple of years.

The official figures came as a leading estate agent suggested that house prices could fall by as much as 25 per cent if the credit crunch persists, with the market declining by 10 per cent this year and by a further 15 percentage points in 2009.

From the BBC:

The slowdown in the UK mortgage market continued in March, according to figures from the Bank of England.

It said the number of new mortgages approved for house purchases in March fell to a record low of 64,000, down from 72,000 the previous month.

This was the lowest level since the bank started collecting the data in April 2003, and was down 44% on the figure for the same month in 2007.

However, credit card and other lending increased in March from February.

A global credit crunch has caused lenders to put up prices on mortgages and withdraw mortgage deals, especially for those unable to put down a significant deposit, in recent months.

The credit crunch, when banks are less willing to lend to each other and consumers, was caused by problems in the US housing market, which saw a surge in mortgage defaults and a drop in property values.

In the UK, property prices have also started to dip during 2008, according to various housing surveys.

"The news that mortgage approvals dropped to a record low of 64,000 is hardly surprising given that lenders have been aggressively scaling back on the provision of finance to homebuyers," said Simon Rubinsohn, chief economist at the Royal Institution of Chartered Surveyors (Rics).

The Bank also reported a drop in loans approved for remortgaging, down 11,000 in March from the previous month at 98,000, and for other purposes such as buy-to-let, down 6,000 at 57,000.

The Bank of Microsoft

What do you do when your customers are stretched too thin to afford your product and can't get the money from their bank? Apparently, you lend them the money yourself. That's what Microsoft is doing.

This is one of those things that just doesn't sit right in the gut. If banks won't lend your customers money, doesn't that say something? I know liquidity is an issue, but good credits can still borrow at reasonable terms. And what skill does a software technology company have in assessing credit risk? Given these issues, it would be shocking if Microsoft didn't experience a relatively high loss rate on these loans.

I guess I'm just a little old fashioned. You know, stick to your knitting. If you're a software company, focus on making the best software possible. If you're a bank, focus on making quality loans and accurately assessing risk. Keep the chocolate out of the peanut butter.

From the Wall Street Journal:

With small-business customers finding it harder to finance high-tech purchases, Microsoft Corp. plans to increase the amount it lends them for purchases, by as much as 60%.

The move -- coming amid a historically tight credit market and at a time when other technology giants are considering selling their financing units -- raises the risk for Microsoft, which says the number of defaulting loans will likely rise and that its exposure to bad credit is "approaching materiality."

INDEPENDENT STREET BLOG

What are the pros and cons of vendor financing? Read the latest post and share your thoughts.

Microsoft said it expects to issue $1.25 billion in loans in 2008, compared with the $780 million in financing it extended in 2007. The increase may help the Redmond, Wash., software giant prop up an important sales channel for the company. "The decision to do all this was tied to the macro situation," said Brian Madison, general manager of Microsoft Financing. "Information-technology buyers keep accelerating their leasing and financing, so we see this as a time when we can make a big difference by making things easier."

Microsoft offers an array of loans between $100,000 and $500,000 -- a "sweet spot for small businesses," Mr. Madison said. Still, the financing Microsoft expects to extend in 2008 represent only about 2% of the company's expected fiscal 2008 revenue.

As credit becomes harder to come by, especially for smaller businesses, financing programs like Microsoft's are becoming a key part of the way companies buy technology products. Research firm IDC expects technology buyers to finance 38% more of their high-tech purchases by 2011, with financing reaching $111 billion, or 8% of all high-tech spending.

The strains caused by the credit-market meltdown have exposed the frailties of some tech-financing arms. Some lenders caught up in the subprime mess were also heavily involved with technology financing. Dell Inc., meanwhile, has said it is exploring strategic options for its financing arm.

IDC analyst Joe Pucciarelli expects that in three years, at least a third of the current providers of financing for technology purchases won't exist. "The broader and more important point here is that the overall IT leasing and financing market remains stressed," he said.

Time to Foreclose on Hillary's Housing Plan

Since this post is somewhat politically-related, I need to stress the following upfront:

• I have always been registered as an independent.
• I find both parties equally nauseating, ignorant, and polluted (but not in a scary Unabomber kind of way).
• I don't believe any of the three remaining Presidential candidates have a clue when it comes to economic policy.
• I tend to mumble a bit and spasm when I watch the debates.
  

With that out of the way I wanted to touch on Hillary's comment about the housing situation during last night's debate. She said,

I want to see us actually tackle the housing crisis, something I've been talking about for over a year. If I had been president a year ago, I believe we would have begun to avoid some of the worst of the mortgage and credit crisis, because we would have started much earlier than we have -- in fact, I don't think we've really done very much at all yet -- in dealing with a way of freezing home foreclosures, of freezing interest rates, getting money into communities to be able to withstand the problems that are caused by foreclosures.

To say that you would have prevented the largest housing and credit bubble we've ever seen from collapsing is the height of arrogance. She doesn't say that she would have prevented the bubble itself from happening. This thing was already uber-inflated a year ago when she claims to have started talking about it. So, though she wouldn't/couldn't have prevented the bubble she believes she could have prevented its deflation. I suppose she believes she could have prevented the tech bubble from bursting and Dutch tulips from collapsing.

Trying to prevent a bubble from popping is a terrible idea. Bubbles are not healthy for the economy in the long-term as they lead to gross mis-allocations of capital. In the case of housing, far more money was thrown at housing and mortgages than warranted by economic fundamentals. A bubble is not a state of equilibrium - that's what makes it a bubble. The quicker the bubble is popped, the quicker we return to sound economics. Trying to prop up a bubble only introduces further moral hazard and prolongs the ultimate damage.

Looking at her specific proposals, she first mentions freezing foreclosures. Keeping people in houses they can't afford serves no one. Many of these people were never qualified to be homeowners in the first place. Furthermore, the ability to foreclose is one of the reasons lenders are willing to make loans in the first place. Freezing foreclosures certainly isn't going to make more money available for mortgages. Think about what you would do if you were lending your money and all of a sudden the rules are changed so that the government, at its whim, can prevent foreclosures. Would you be as willing to lend? If you were still willing to lend, wouldn't you want to charge a higher interest rate? Wouldn't you severely tighten your lending standards so that you were only lending to those with the best credit and finances? Wouldn't you require a larger down payment? Hillary (and all politicians) love to talk about making homeownership affordable for more people, but this policy would do exactly the opposite.

How about freezing interest rates? Same thing. Imagine you're a lender and all of a sudden the government can come in and freeze the rates you charge people. You've logically been charging riskier people higher interest rates, but now the government steps in and doesn't allow those rates to adjust up (think ARMs). You might be less willing to make ARM loans. Either way, you've just had a big new risk introduced. Might you want to increase the interest rates you charge to compensate for this new risk?

Next, she mentions "getting money into communities". That's fairly vague, but it certainly entails spending tax-payer money to support a bubble. The government needs to get out of the way and let housing prices fall to market clearing levels. Housing prices in many communities never should have climbed as high as they did - virtually everyone agrees with this. So why must the politicians try so hard to keep them from falling? (that's a rhetorical question)

Sallie Mae I? No, You May Not.

I noticed SLM popped 9% this morning after their earnings release and conference call. You've got to be kidding me.

The student loan market is in disarray.

• Cuts made to the federally guaranteed loan program have hurt.
  
• The credit crisis has resulted in less funding being made available to the student loan companies.
• The lack of liquidity in the market has made it difficult for lenders to package and sell (securitize) their loans in the asset-backed market. The securitizations that they can sell are being done at very high spreads (they're very expensive to the lender). As a result, new loans are being made at a loss.
  
• Fifty-seven lenders have dropped out of the program, and 19 lenders have suspended private student loans.

With that, let's take a quick look at Sallie Mae's (SLM) press release from last night. To their credit, in the first paragraph they state that, "Under current conditions, however, loans can only be made at an economic loss. Reflecting this environment, the company is assessing how best to balance its resources and its mission to provide access for higher education."

In the next 4 paragraphs they go on to discuss "core earnings" and explain how according to "core earnings" they registered a nice $0.48 in EPS for the quarter. Finally, in the 8th paragraph, they get around to discussing GAAP earnings. Turns out they managed to LOSE $0.28 share according to GAAP.

Basically, they tell us that we should ignore the markdown they took on their derivatives position and forget about their intangible assets. Leave out the bad stuff and things don't look so bad.

Some other points. The loss provision they took didn't look overly conservative given the environment. The company admitted that they can't write new business at a profit. The company isn't sure whether any legislation coming out of Washington would help or hurt them. The company's reliance on forbearance continues to increase. Their access to reasonably priced capital continues to deteriorate. Equity is a whopping 2% (that's sarcasm) of assets. Even "core earnings" are expected to be at the low end of their range (I'd be surprised if they even hit that.).

With all that, the stock is up 9%, north of $17.50. Apparently, the market feared something worse than what the company reported, and this is some sort of relief rally.

Given the risks and uncertainties surrounding this company and its business, this would not be a good investment for your kid's education fund given what we know today.

Second Careers

I can't be sure, but I think this is the former head of risk management at Bear Stearns.

link to story

Wachovia's "Solid Underlying Performance"

From Wachovia's earnings release this morning:

"While solid underlying performance was overshadowed by market disruption- related valuation losses of $2.0 billion..."

This just isn't genuine. In just the past quarter, the company reported a 93% increase in its provision for credit losses and net charge-offs jumped 66%. The allowance for loan losses as a percent of loans has been steadily climbing the past few quarters (1.37% this quarter, .98% last quarter, and .78% in the prior quarter). However, the allowance for loan losses as a percent of nonperforming assets has actually been falling. I'd love an explanation for this. I suspect the company is still not adequately reserved.

To his credit, CEO Ken Thompson did state that he was deeply disappointed with the results, so this certainly isn't some whitewash sugar coating. But to talk about "solid underlying performance" is misleading. The charge-offs and provisioning that the company is taking now are a reflection of bad loans the company issued in prior quarters and years. Essentially, the earnings for those prior periods were overstated. You can't just talk about how strong the business is if you ignore the bad loans. This is a bank! They make loans! That's their business!

It's like a doctor touting what a terrific surgeon he is - if you ignore all the patients who died.

Stiglitz and the Charmin Prescription

Mortgage Cheats

An April 9th article by Ernest Istook of The Heritage Foundation entitled "Will Your Tax Dollars Go To Mortgage Cheats?" is worth a read.

Brief excerpts:
"By some estimates, borrower fraud accounts for most of the mortgage crisis now troubling the nation. It was certainly abetted by dishonest brokers. But just as honest taxpayers should not be expected to bail out dishonest brokers, so they shouldn't be expected to bail out dishonest borrowers."

"Greater than the financial threat to America is the moral threat of a bailout. What's next? Paying off car loans for those who were 'seduced' by a glib salesman? How about those who bought a bigger TV or a more powerful stereo system than they could afford? Where will this practice end of treating dishonest or incautious consumers as victims?"

A Fed Chairman Worth Listening To

I don't agree with all of his views, but Paul Volcker is the best Federal Reserve Chairman this country has seen. He understood the role of the Fed, the importance of its independence, and he wasn't afraid to administer some much needed but politically unpopular medicine to this country as Chairman of the Fed from 1979 to 1987. Greenspan and Bernanke look like confused, spineless, political, patsies next to this guy. He's always worth a listen. The following is his April 8th speech to the Economic Club of New York:

Bloomberg Video of Volcker speech

Chocolate and Beer - Part 2

To recap Part 1, financial regulation failed miserably to recognize or prevent the current credit crisis and actually played an integral role in creating and fostering the credit bubble. Most politicians, regulators, and pundits are using this failure as an excuse to expand that which just failed - regulation. Unfortunately, our policymakers are far too busy trying to look “responsible” and “proactive” to actually expend any effort examining the role the regulators themselves played in creating the current debacle or questioning whether less regulation may actually be the better policy. I’m accustomed to being on the unpopular side of many arguments, and this one is no different.

I’ve been reading quite a bit lately from all corners that the current credit crisis is proof of the failure of free market economics. This is laughable since we’ve hardly been operating in a free market system. When it comes to the financial markets, we have many organizations involved in the regulation and manipulation of our markets, our financial institutions, our money supply, our interest rates, etc. Despite all of this, we are facing the largest financial crisis since the Great Depression. It’s important to understand that regulation has been prevalent and growing for many decades. Yet, here we are.

Then how may things have transpired in a truly free market? Most importantly, moral hazard would not be an issue if the free market had been in operation. Basically, moral hazard means that people will be less cautious if they know they’ll be bailed out. Bailing out is exactly what the Fed under Greenspan did repeatedly, and it’s exactly what the Fed under Bernanke is doing currently. It’s also what the federal government does when it passes legislation to bail out certain constituents. Financial actors aren’t stupid. Greedy? Yes. Stupid? No. They’ve realized for some time now that the Fed and government were effectively putting a floor under the financial markets (LTCM, Asian currency crisis, tech bubble). The Fed repeatedly demonstrated that it was willing to aggressively intervene during relatively modest financial dislocations. In such a world, the obvious course of action is to lever up as much as possible and swing for the fences. Heads you win, tails you don’t lose.

In a free market, the issue of moral hazard disappears because no one gets bailed out. There is no Federal Reserve, or Treasury or Congress standing ready to lower rates, print money, and use taxpayer dollars to “rescue” the imprudent. The losers fail. They go away. Long-Term Capital Management would not have been bailed out. The Fed would not have guaranteed $30 billion of questionable Bear Stearns assets. The strong prosper. The weak fail. A strong signal is sent to all market participants that there is a significant and definable downside to taking too much risk. This signaling has unfortunately been overridden by the regulators/politicians in our increasingly quasi-capitalistic system of democratic socialism.

It’s important to recognize that government and regulatory intervention in our markets has led to ever larger bubbles, misallocations of capital, and financial dislocations. Without the Fed manipulating interest rates and the money supply, ever-larger serial bubbles would not have been blown, the money supply would not have been so grossly inflated, inflation would be less of a threat (by definition), and the dollar wouldn’t be nearly so weak. We can recognize all of this, but we can’t go back and undo what’s already occurred. Given that fact and given the crisis we’re currently in, what might we expect from a free market from this point forward if regulation were magically eliminated today? The following are just a few reasonable realistic possibilities:

• Development of better risk models and more focus on risk management
• More aversion to and higher risk premia for complicated security structures
• Increased competition in the credit-rating market resulting ultimately in better analysis and modeling
• Insolvent financial institutions would be allowed to fail
• Increased financial statement disclosure
• More accountability for evaluating risk at all levels of distribution
• Credit-rating agencies being compensated by investors rather than by the companies they rate
• A strong call for financial institutions to increase their capital position
• A continuing trend of deleveraging
• Mortgage originators retaining more security exposure to better ensure adequate underwriting standards
• Opportunists taking advantage of illiquid markets to buy securities at deep discounts to their intrinsic value
• Unwinding of and more sensitivity to counterparty arrangements
• Development of more standardized derivative contracts and clearing arrangements
• A better and more symmetrical alignment of executive compensation with longer-term shareholder goals
• More critical analysis of credit insurer strength
• Clearer and more robust mortgage terms disclosure
• Fewer no-doc or low-doc mortgages and/or higher spreads on them
• Less opaque securitizations

All of these things would be healthy for the market and would lead to a strengthening of our financial system. Some variation of many of these suggestions as well as others can be expected to occur over the next 5 years without any government intervention simply due to the demands of various financial market constituents. None of this requires government intervention.

Now let’s look at just a few examples of free market success so far in this current crisis. First is the entry of Warren Buffett into the municipal bond insurance business. This is exactly what we’d expect to see - a strong player with extensive capital and an excellent reputation entering a failed industry that didn’t adequately price its insurance or assess its risk. Other individuals and firms are also exploring entering this market. Should we use taxpayer dollars to support the incumbents (for example, MBIA, SCA, and ABK) to the detriment of the newer and stronger players? No. The free market is filling the void and will be doing so with better risk modeling and a stronger capital position.

When asset prices finally start to adequately price in risk, liquidity tends to surface. For example, on April 1 Blackstone Group LP raised a record $10.9 billion to invest in property. It was also recently reported that another opportunity fund, Dallas-based Lone Star Funds, is raising up to $10 billion to invest in real estate. Lone Star managing partner John Grayken recently told the Oregon Investment Council, ``This is as good a distressed environment as we've seen in a long time. It's a race among a number of different lenders to play this.'' This week, we also learned that Citigroup is close to unloading $12 billion of bad loans to a group of private-equity firms at 90 cents on the dollar.

There are many other examples of capital being raised. UBS recently raised another $15 billion. Lehman raised $4 billion. Washington Mutual is raising $7 billion. Sovereign Wealth Funds (SWFs) have tossed about another $70 billion into investment banks over the past year. The point is that when prices fall enough to adequately (or more than adequately) discount the risk, private funding is made available. Capitalism does work (when allowed). The quicker this process unfolds the better for the financial system and the economy. The bailout efforts by the Fed and the government are simply dragging out this price-discovery process and delaying the eventual economic recovery. Of course, others could argue that this money is only forthcoming now because of the steps that the Fed has already taken. My contention, however, is that Fed actions have been hindering and delaying the price-discovery process, keeping asset prices higher than warranted, and therefore keeping further private funding from entering the market and prolonging the correction. Granted, it's impossible to know which view is correct since we can't rewind and play it twice.

We don’t need the government to “bail out” the market, but we’re going to get it, so let’s be clear about what a government bailout means. It means the government is stealing. They’re stealing from those who were prudent – those who bought a house and selected a mortgage that they could afford, those who have been living beneath or within their means, and those who decided to save versus play. The government is using these stolen funds to support/bailout/rescue/benefit/enrich those who speculated on rising home prices, those who gambled on always being able to refinance at low rates, those who took on too much debt, those who have lived beyond their means, and the millionaires running our financial institutions. If you’re in the former group, you should be irate. The government won’t be sending you a bill directly, but they will be increasing their borrowing and increasing the money supply during this bailout. You will suffer the depreciation of your dollar assets and higher inflation as a result.

What would I like to see the Fed/government do? Put their hands back in their own pockets, get out of the way, and sit down with a nice big cup of coffee and a copy of the Constitution (to be read – not to be used as a coaster). Let the market do its job - liquidate the bad debt and the imbalances that have occurred and eliminate the ubiquity of moral hazard. It’s healthy, and it’s in the long-term best interests of our country.

If only the government could bail out common sense.

Chocolate and Beer - Part 1

I admit it. The title is a little misleading. I’m actually going to discuss financial market regulation, but I wanted you to at least get past the title. Regulation is the dentist office of the financial world – nobody really wants to go there. In the mid-90’s, I was an MBA student at the University of Chicago. They have a bidding system for classes, and I was saving a bunch of points to bid on Merton Miller’s class. He was a Nobel Prize winner, and he only taught one class each year, so I was sure the class would cost me. The topic of the class was financial regulation, but he was a Nobel Prize winner! Amazingly, the class didn’t cost me a point since the class didn’t fill up – only about 20 of us signed up. So, I know that this isn’t the most exciting topic. If a Nobel Prize winner can’t fill a small class, I realize I probably lost most of you by the second sentence. No matter. I’ll soldier on if for no other reason than to spare my wife.

The chatter about the failure of the free market and capitalism has been steadily increasing as has the call for increased financial market regulation. This is hardly surprising given the news of the past six months: credit markets seizing up, rising foreclosure rates, the failure of the rating agencies, the collapse of Bear Stearns and a number of hedge funds, mortgage origination and appraisal improprieties, tumult in the “safe” muni market, etc. Furthermore, it’s an election year and you’d better show leadership and be full of ideas if you’re running for President. Time to put the baby down and draft some legislation.

So it’s no surprise that the call for increased regulation is on the rise, but I find it a bit ironic. The current credit bubble was caused, in some part, by regulation itself. Let’s start with the Federal Reserve, arguably the most prominent regulator of the financial system. Under Greenspan, the Fed rarely hesitated to cut rates in an attempt to forestall any whiff of a slowdown or financial dislocation. This came to be known as the Greenspan Put. Greenspan repeatedly and effectively placed a floor under the markets by lowering interest rates and increasing the money supply at any hint of instability (think Long-Term Capital Management and the tech bubble collapse). This encouraged risky behavior. The thinking was straightforward. If you take a big risk and you’re right, you win. If you take a big risk and you’re wrong, the Fed bails you out. It didn’t take long for folks to figure out that it paid to take risk. The Fed was distorting the real relationship between risk and reward and causing an ever greater misallocation of resources as normal market signals were subverted. This encouraged an increasing amount of risk to be taken with each cycle of easing. The low interest rates and increased money supply ultimately found its way to the housing market, resulting in the biggest housing (and credit) bubble we’ve ever seen. I’m not saying the Fed is singularly responsible for causing the bubble, but it did play an important part.

Another example of the role that regulatory interference has played in our current crisis is the effective oligopoly that the SEC (a regulator) has given to a handful of credit-rating agencies. These credit-rating agencies essentially faced no competition, and they made their money by charging fees to the very companies they were rating – an obvious conflict of interest. It’s not exactly clear to me why the SEC should even be involved in controlling the entry of new competitors. Had a free market allowed for the entry of new competitors we would have been much more likely to have seen some evolution in the relationship and incentive structure between the credit agencies, the firms they evaluate, and the investors who ultimately purchase the securities. We would also have been more likely to have seen some evolution in the risk models that somehow managed to bestow AAA ratings upon the Frankensteinian brew of mortgage-crapped securities known as collateralized debt obligations (CDOs). Eventually, people will learn that 1+1 does not equal 3. Let’s not forget that these are the same rating agencies that also managed to miss the fact that Enron, Worldcom, and Adelphia were frauds. So our regulators protected a few credit-rating firms (which had just recently shown their tremendous failings a few years prior) from contending with new competition. We need more of that?

Don’t forget about Fannie Mae and Freddie Mac. As the nation’s primary buyers and guarantors of mortgages, they had a front row seat to the excesses in the real estate market. Importantly, these two quasi-governmental agencies are highly regulated by the Office of Federal Housing Enterprise Oversight (OFHEO). According to their website, OFHEO’s mission is to “promote housing and a strong national housing finance system by ensuring the safety and soundness of Fannie Mae and Freddie Mac. OFHEO works to ensure the capital adequacy and financial safety and soundness of two housing government-sponsored enterprises (GSEs)…” Wow. Ensuring the safety and soundness? Ensure capital adequacy? In light of Freddie and Fannie’s deteriorating balance sheet and capital position, OFHEO hasn't been terribly effective. We need more of this?

Let’s not kid ourselves. There was plenty of regulation before this latest crisis. Yes, it’s true that the financial institutions were employing strategies and creating securities to move assets off-balance sheet and out of the purview of the regulators, but everyone knew that they were doing this – including the regulators. Where were all the warnings from the regulators about this? Where were the warnings from the regulators about the markets/firms/securities they did oversee? The fact is that all parties, including the regulators, knew what was going on, but everyone chose to ignore it since it seemed to be working. When it comes to derivatives, Greenspan himself had said "these instruments enhance the ability to differentiate risk and allocate it to those investors most able and willing to take it." So, seriously, had the regulators been in charge of regulating even these non-regulated instruments would anything have played out differently? The Chief Regulator himself was a fan!

The objective of this article is simply to look at just a few examples of the role the regulators have played in the current crisis. My main point is that we had plenty of regulation already, and it failed. Depending on how you look at it, it appears the regulators were either asleep at the switch, accomplices, or negligent. They failed to forestall the current crisis, and, in fact, pursued polices that (at a minimum) exacerbated it. Despite this, we’re hearing calls for more regulation. We’re hearing that existing regulation failed because there wasn’t enough of it, and it wasn’t structured properly, and it didn’t have enough bite. Do we really think that more government bureaucrats are the answer? It might help the faltering national employment figures, but is it really the solution? Don’t these folks get something like 150 days off a year? No wonder they’ve been so ineffective.

We’re also hearing that the free market failed. The fact is that we were never operating in a free market in the first place. A truly free market isn’t encumbered by all of these regulations. A truly free market doesn’t have an elite body of 12 setting short-term interest rates. A truly free market doesn’t use taxpayer dollars to bail out banks which made bad bets or homeowners who took on more of a mortgage than they could handle. A truly free market doesn’t struggle with the issue of moral hazard because it lets the losers fail. I know this may sound crazy given the current fear and fervor in the markets and political arena, but here’s my prescription – less regulation and more accountability. I’ll follow up on this in Part 2.