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When Abstract Becomes Reality Print E-mail
When Abstract Becomes Reality
I begin most every presentation I deliver to Public Funds Investors with a quote attributed to Aristotle. It goes like this, “It is the mark of an educated mind to be able to entertain a thought without accepting it.” This quote is used as a disclaimer. It frees me to voice opinions that often stray far from the accepted economic and market themes of the day. And it puts you, the reader and listener, on notice that there will be ideas expressed that do not represent the mainstream thinking as voiced by the brokers and bankers and Wall Street pundits. It has long been my belief that “groupthink” is a dangerous and stifling phenomenon that herds investors in directions that subjugate their particular best interests to those of others with very different agendas. “Groupthink” leads to excesses in the markets, often culminating in asset bubbles followed by debt deflation and ultimately insolvency. We have made no secret of our desire to “cultivate change” in the way Public Funds Investors view the relevancy of economics and the investment of public money. The concepts we explore on these pages and in many of our talks are woven in the fabric of tales of great economists and their theories. It is our goal to take these abstract theories and relate them to current real world events. The purpose in all this is to provoke an internalized paradigm of thought for each reader and listener that he or she may use in interpreting the events of the day, free of the stultifying influence of “groupthink”. In the world of economics events unfold at a snails pace. We are accustomed to connecting cause and effect in the blink of an eye. As time passes we may dismiss theory as entertaining but irrelevant- until it is. At ICM we questioned the wisdom of the “Greenspan Put” and the excessive cheap liquidity pumping up asset bubbles in 2000. We spoke about this liquidity sloshing around the globe from Asia in the ‘90’s to technology then to housing, then stocks and now to commodities. We began warning of the emergence of a housing bubble in 2004 and discussed the potential negative impact on the economy and the securities markets. In 2005 we worried about flaws in the management and business model of FNMA and the leverage magnified risks contained in its balance sheet. That same year we spoke of the “Techno-Global Revolution” and its effects on US wages and how wealth would move east on the globe. We wondered aloud about a 1970’s style stagflation two years ago. We wrote about the unfolding mechanics of the credit crunch in mid-2007 and identified commodities as the next asset bubble. Ever so slowly the wheels of eternal economic cycles grind along. The old masters that influence our thinking have been proven right. The rules that govern economic mechanics may have been manipulated but cannot be altered. We may have been tricked into believing that the Federal Government and Federal Reserve can avert the day of reckoning for fiscal and monetary irresponsibility by applying more of the same. The slow roll of time may have made the presentation of foreboding premonition appear quaint or worse yet, an exercise in fear mongering. But those who chose to form an independent paradigm and apply the ideas of learned economists  connected the dots in the financial system and saw this train wreck unfolding in slow motion. The abstract has become reality.
Today’s Reality
If there is a lesson to be learned in the current financial crisis it is that capitalism mirrors nature. Its laws are fierce and unrelenting. We defy the laws of each at our own peril. I don’t believe that Alan Greenspan has offspring. If he did I’m certain they would be spoiled and irresponsible with strong predispositions toward entitlement and privilege. I base this hollow rant on the former chairman’s conduct of monetary policy in the face of economic missteps and failures. Greenspan would have done well to follow the wisdom of Abe Lincoln when he counseled;” You can’t avoid the responsibility of tomorrow by evading it today.” It was the policy of the Greenspan Fed to forgive speculative excesses and ineptitude spawned by greed, to acknowledge said flaws with a wink and a nod and a barrel full of money. The market discipline that defines healthy capitalism was replaced with “moral hazard” that reeks and lingers these many years later. Speculators did not suffer their due when the dot com bubble burst. Instead they were soothed by rate cuts and expansion in the money supply. The natural occurrence of creative destruction and recession were deferred. The miscues of the wealthy and powerful were smoothed over with low cost cash and explained as part of the risks and costs of modern financed based capitalism To avoid a day of reckoning America’s economic prosperity was literally mortgaged when consumption was encouraged through the liquidation of home equity. That same equity was pumped into a bubble with the excess liquidity and the blessing of the Fed Chairman. The house of cards is collapsing under the weight of greed that drove speculators, bankers, undercapitalized buyers and derivatives brokers to disregard the tenets of the most powerful economic force on the planet. Regulation failed to keep pace with the financial evolution that fueled the excesses that today threaten the very solvency of America’s financial institutions. A second byproduct of this monetary policy run amuck is global inflation.  More than half of the world’s population lives under the yoke of double digit inflation. The developing world is suffering from currencies pegged to the falling dollar and low US interest rates. These exporters must print money to buy dollars in an effort to protect their economies. All the while their monetary policies fuel the very inflation that makes feeding their populations a greater burden. Those hoping that America will be spared the wage/price spiral that generated the stagflation of the 1970’s count on the false blessing that America’s workers have lost bargaining power for higher wages. These thinkers fail to connect the dots of the “Techno-Global Revolution”. America’s workers have lost their bargaining power due to the wage disparity of their global counterparts. These are the workers supplying our imports. These workers have plenty of room to demand higher wages before they bump into a competitive disadvantage. Econ 101 teaches us that labor makes up 2/3’s the cost of production. 
With food costs skyrocketing around the developing world wage demands are sure to rise as well. You see, the emerging economies still spend a significant portion of their national income on sustenance. Import inflation is running over 20% annually in the US. Don’t look for any relief before the bubble in commodities breaks. Oil is being driven by a number of powerful forces. Let’s examine the math for the suppliers particularly in the Persian Gulf. Oil in the ground is appreciating as demand soars and supply is declining. Nearly every barrel pumped is converted into US Dollars- Dollars that are falling in value. There is little reason to increase the market supply of oil. With the real estate game long over and equities plunging into bear market territory the big money of hedge funds, pension funds, endowments, mutual funds and speculators is driving prices higher through the sheer volume of dollars pointed at leveraged and largely unregulated futures markets. Since 2004 $260 Billion in new financial derivatives have targeted the energy markets.  Oil is now a financial instrument being leveraged and driven by the same investment bankers and speculators that drove housing to its most overvalued in history.  Developing nations subsidize the price of fuel pushing demand and prices artificially higher. Today, America imports inflation, exports wealth, watches its assets deflate, wages decline and its standard of living erode.
A Financial System in Crisis
The United States is suffering a near universal downgrade of credit quality. We are experiencing a deflation in the value of assets collateralizing our unsustainable mountain of debt. As a result liquidity and credit have dried up and the economy is decelerating toward a recession. The Federal Reserve has taken unprecedented steps to aid bankers, brokers and investment banks setting up lending facilities to offset the lockdown in inter-bank lending and the collapse of confidence between financial institutions behind the securitization debacle and much of the credit crisis.
Our headlines reflect the times. This one from a recent issue of the Wall Street Journal says, “Paulson (Treasury Secretary) Seeks a System to Handle Orderly Failure of Financial Firms”.  Our leaders are defining methods to liquidate financial behemoths without disrupting markets and the economy further. Irresponsibility has put the financial infrastructure of America in a precarious spot and forces us to make decisions that compromise the integrity of the system. Take Fannie Mae and Freddie Mac for example. For years the more conservative members of congress called for tighter regulation of the giant mortgage lenders. In particular they suggested smaller portfolios, greater capital reserves and less leverage. These suggestions were made when the financial system was healthier and the housing market in particular had yet to balloon with the rocket fuel of derivatives. But as is the case with most financial institutions they make hay when the sun shines and worry about the bad times another day- back to Honest Abe again. The giant mortgage lenders began to relax lending standards and take on greater risk in 2006 as competition for loans heightened. They added more ARMs and Alt-A mortgages to boost returns. Don’t forget that Fannie and Freddie are publicly traded  companies operating in the never-never land of the” for profit government sponsored entities”. Former Fed Reserve President, long a proponent of tighter regulation, referred to the GSE’s as” bastions of privilege, financed by the taxpayer”.  When the housing market collapsed with no apparent solution on the table other than free market disaster, the GSE’s became the saviors of the housing market. As we write today the news dominating the stock market is what will happen to shareholders if the companies are taken over by the Feds. The two GSE’s have enormous exposure to the housing market guaranteeing or owning outright nearly half of the $12 Trillion mortgage market. Their debt exceeds that of the US Government. Both companies sorely need to raise capital, a daunting task as shares plummet, down 91% for Freddie Mac and 85% for Fannie Mae since mid 2007.  Market discipline and a bout of panic are threatening to scuttle Mr. Paulson’s preferred solution of bailing out the faltering real estate market with the faltering GSE’s. Fannie and Freddie are truly too big to fail and will be bailed out by the Feds if necessary. Your investments in agency securities are not in danger of default. Yield spreads versus Treasuries and bid and offer spreads may widen but default is not a current risk.
Banks Are Troubled
The S&P 500 Index of Bank Shares is at 10 year lows. FDIC Chair Shelia Blair said in June “it is no longer unthinkable that a large commercial or investment bank will fail”. The FDIC is staffing up for a wave of bank failures it expects in the coming year. We have written volumes about the shenanigans of the largest institutions using off balance sheet mechanisms to take and hide huge risks and avoid the capital reserves that might have added a layer of protection in this massive derivatives meltdown. We are likely to see another Bear Stearns but public funds investors need to bring their attention to smaller banks. We rarely think of institutions with assets of between $1 and $10 Billion as small but in today’s world that’s what they are. The Financial Times reported on June 29, 2008, “Regulators are growing increasingly concerned that many small banks have high concentrations of loans to commercial and residential developers and homebuilders on their books at a time when inflated house prices are collapsing and land values are falling further.” Banks’ first quarter losses on such real estate loans were 15 times larger than the same quarter last year according to the FDIC. The Financial Times continues,” more than half of those institutions with assets worth between $1 Billion and $10 Billion have commercial real estate loan portfolios that exceed 300% of their capital”. “Similarly almost 30% of community banks have construction and development loans exceeding 100% of capital”, according to the same Financial Times article. As you might expect the culprits are largely concentrated in California, Florida, Nevada, Arizona and Michigan. Names like PFF Bancorp, Security Pacific Bancorp, Indy Mac, SunTrust, First Horizon and Washington Federal are common sightings in the news. Some like Marshall & Iisley (M&I) the Wisconsin regional are not the exception any longer. M&I strayed from its knitting and chased the Florida and Arizona markets and will book a second quarter loss of nearly $900 million citing a weak housing market. These regionals- and the list is in no way comprehensive  are increasingly left with loans valued between 5 and 70 cents on the dollar. Public Funds Investors are notoriously loyal to local banks and have been frequent buyers of large block Certificates of Deposit. While returning funds to the local economy in this manner has its merits it is important at this time to do your due diligence and protect your public funds.
Socialized Risk and Privatized Rewards
This is the characterization of the Bear Stearns bailout posited by Connecticut’s Chris Dodd, the chair of the Senate Banking Committee. One could argue that the seeds for ruin at Fannie and Freddie were planted when the private companies were granted the implied backing of the Federal Government. And the subsequent involvement of the Federal Reserve and Treasury in salvaging financial institutions and smoothing market volatility must pass this sniff test. The Fed has been generous with our tax dollars in aiding JP Morgan Chase in the take over of Bear Stearns riskiest assets. The Fed, and thus you and I are on the hook for nearly $30 Billion in black box derivatives. This portfolio of radio active waste too hot for JPM to handle was pushed off on the Fed to grease the deal. It is currently down about $1 billion in value since the deal was struck only months ago. A new set of regulations is coming to the investment banking and brokerage business. Risk management must change. Leverage must be controlled along with liquidity and transparency. It’s too late to undo this round of lunacy. Let’s hope someone is paying attention in Washington who can balance the needs of the free market with sound rules for competition. Even the arenas of the fiercest competition must have rules to assure fair play. There are winners and losers in every competition. When fair rules have been set then the outcome of the competition must not be overturned to favor the well connected or those too big to fail. If anything has become clear in this financial crisis it is that the absence of rules or skewing the rules to favor one party over another and altering the true consequences of failure only serve to short-circuit healthy capitalism and weaken our nation.
Lurching Forward
Dramatic change in the workings of financial markets is needed. The economy will be soft for moths to come. The Fed is boxed between inflation and anemic growth. It will be hard to raise rates under current circumstances. That doesn’t mean that market rates won’t rise. Safety and caution will serve public funds investors best. We will be urging cash flow analysis for all and investment strategies designed to provide targeted investment income and maturities. A steeper curve will provide great financial rewards while augmenting what may prove to be weakening revenues.