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.

UBS and The Market Rally

We’re off to an interesting start to the second quarter. Swiss banking giant UBS reported that it will be taking a $19 billion write-down and about a $12 billion net loss for the first quarter. This is on top of last quarter’s roughly $12.5 billion loss. $24 billionish gone in two quarters. So how far down is the stock right now? Well, it’s actually up 14%. Sounds like a bad April Fool’s joke. Too bad they didn’t write-off $40 billion – their stock might be up 30%!

So what’s going on here? First off, they’ve announced the resignation of their Chairman. You lose $20+ billion in 6 months you should probably lose your job. More importantly, the company claims to have substantially reduced its exposure to real-estate-related assets (subprime exposure fell to $15 billion from $27.6 billion last quarter) and will create a new wholly-owned unit to hold its remaining illiquid real-estate assets. UBS also said that it will be raising $15 billion of new capital, after having just raised $13 billion in February.

What does this all mean, and why is this stock and the market moving higher? Clearly, the market wants to believe that the company (as well as the financial industry) has put the worst of the credit crisis behind it and that there will be minimal future write-offs and plenty of additional capital raised. The fact that UBS is able to raise another $15 billion is also seen as a bullish sign since this would have proven difficult (at least on reasonable terms) if their balance sheet was too ugly. Finally, the bank’s Tier 1 capital will remain at a fairly healthy level for the time being following the capital raise.

As for moving the remaining exposure to a separate wholly-owned firm, UBS may be doing this to enable it to sell the entire lot at one time to a single buyer versus piece-meal in the open market. It seems that whether that happens or not, this move will allow UBS to "focus" investors on its “core” business since these poorly-performing assets will be segregated.

With the additional news that Lehman is also raising capital and that Morgan Stanley has further reduced its exposure to bad assets, it seems investors are eager to sound the all-clear and jump back into financials and equities in general. Is the worst really behind us? Was that it? From peak to trough the S&P 500 fell about 20% in 6 months - quite a bit less than the two-year 50%ish drop following the bursting of the tech bubble and relatively mild as far as bear markets go.

This credit bubble is the biggest bubble we’ve ever seen in dollar terms and in terms of breadth. Far more people are affected by falling home prices and rising mortgage payments than falling stock prices (although the combination is pretty lethal), and far more people are more dangerously over-extended when it comes to credit now than we’ve ever seen. Little of the damage we’ve seen so far has come from the obvious slowing of the economy. We still have that to look forward to.

Furthermore, although equity valuation isn’t as rich as it was at the start of the last bear market, the current P/E on the 2008 S&P 500 estimated reported earnings is still about 20x. Future returns are rarely exciting when starting from such an elevated level. It's also very likely that earnings estimates for the balance of the year are still over-stated and need to come down, particularly given the difficulties in the financial and consumer sectors. Weak personal income growth, rising foreclosures, a struggling financial industry, higher inflation, a lack of ready access to cheap capital, rising/high commodity input prices, and high equity valuation is hardly the recipe for a new and powerful bull market.

Given all of these issues, the odds that the crisis is over appears to remain low. Even if we’ve seen the lows in the market (which I doubt), it’s hard to imagine that we’re off to the races again. Bear markets are marked by intermediate and short-term rallies. These are called dead-cat bounces and sucker rallies. Look back to the 2000-2002 period. You see a number of 10-20% rallies during that bear market. I strongly suspect that what we’re seeing lately is another dead-cat bounce, just like we saw this past November and January. As the market becomes short-term oversold on strong negative sentiment almost any news short of Armageddon gets interpreted positively. That’s in part why a $19 billion write-down can result in an 14% rise in your stock.

We’ve been due for a nice rally. Markets don’t move in just one direction. Sentiment was so bad it had to improve - at least temporarily. I wouldn’t be surprised to see this rally continue a bit, but it should face a stiff headwind as companies start reporting first quarter earnings in a couple of weeks. I expect to see fairly cautious guidance from companies on the balance of the year and earnings estimates being reined in. I would be very hesitant to chase the market during this rally. However, the long-term thesis for commodities/precious metals is still attractive, and the recent pullback in this sector is healthy and is likely providing a nice opportunity to nibble.

Capital Issues: Fannie and Freddie

Two of the leading stocks in the market today are Fannie Mae (FNM) and Freddie Mac (FRE), both rallying on news that their capital requirements are being reduced to an extent that will enable them to invest another $200 billion in mortgages. The initial investor reaction as well as virtually all of the press related to this news has been overwhelmingly positive. I must admit to being a little confused and surprised by this.

First of all, as part of the press release we're being told that FNM and FRE will be required to raise additional capital. Hold on. Their capital requirements were lowered, but they need to raise more capital? The amount of the capital to be raised has yet to be disclosed, so the ultimate impact of both lowering their capital requirements and raising additional capital is a bit unclear. Regardless, lowering capital requirements during a time of distress seems quite the opposite of what common sense would dictate. Credit losses are rising and asset values are falling, so let's reduce our safety cushion! Sounds like dot-com math to me.

Why is this important? Well, their capital is essentially their cushion against a deterioration of their assets (investments and mortgage loans). Per a New York Times article, as of year-end 2007, FNM and FRE had combined capital of $82 billion. That amount supports more than $1 trillion of combined debt. If you read this past weekend's Barrons article on FNM and FRE you know that a good chunk of that $82 billion is a bit squishy and may not actually prove to be available. Also, keep in mind that combined the two lost over $5 billion last year. How big a cushion they have to weather this storm is critical. All else equal, lowering capital requirements at a time of increased default risk is dangerous.

Also, we have the issue of how these funds will be deployed. Perhaps, FNM and FRE will be able to buy mortgages at attractive prices given the lack of liquidity in the market currently. On the other hand, there is certainly a bit of political pressure for them to "help out" the subprime and distressed borrowers. If you think the credit issues we face are abating, then this is bullish as they'll be able to buy cheap assets near the bottom as well as expand their revenue and earnings. However, if you're concerned that we have a bit further to go (as I am) with this credit unwind, you have to wonder if buying additional risky assets on a potentially reduced capital base (on a percentage basis) of questionable quality is really prudent.

The other issue is government backing. Although FNM and FRE are not explicitly backed by the federal government, I don't think anyone believes they'd be allowed to fail. However, should FNM and FRE have their capital wiped out their shareholders will also be wiped out. The debt may be backed by the government, but the equity holders will get zip. Knowing this, management certainly has little incentive not to increase the balance sheet, especially given current political pressure. If they're right, they're heroes and get nice big bonuses. If they're wrong, the government bails them out (and they still probably get nice big bonuses). Not a bad risk/reward trade-off.

Bottom line: This move will clearly help provide some liquidity to the mortgage market. Will this "save" the housing market? No. But it will help at the margin. I suspect this move will also make it harder for the government to walk away from FNM and FRE should they ultimately implode. However, from an equity perspective, this latest development is unlikely to be positive if the bursting of the credit bubble has further to go. The amount and quality of their capital is critical, and there are far too many unanswered questions on this topic. Regardless of the impending capital raise, this is not the time to be lowering capital requirements. This may be marginally good for the housing market, but this is not likely to prove beneficial to shareholders.