Today vs. the Depression…a quick look (posted 3/30/09)

March 30, 2009


The Wall Street Journal took a look at how today’s economy compares with the Great Depression.  Most economists, including me, don’t think we are going there, but the chances are not trivial.  As you can see, however, current conditions, as bad as they feel, are a long way from the thirties.

Click here to link to the entire article.


The “Geithner” Plan; It’s a Good Start. (posted 3/25/09)

March 25, 2009



Source for the above: U.S. Treasury Department

I like this so-called Geithner Plan to remove toxic assets from the banks. The plan refers to “legacy assets”, which means assets acquired during “the period of foolishness” for which no true market-determined price exists because of either quality impairment or lack of a liquid market, or both.

Both loans and asset backed  securities are problems.

The overhang of troubled loans has made it very difficult for banks to raise new capital from the private market and, therefore, placed a tight limit on lending.

The asset backed seciurities are held not only by banks but also by pension funds, insurance companies, mutual funds, and funds held in IRA’s and 401K’s. They are highly illiquid and are trading at prices that are almost certainly well below where they would sell in normal markets.

I may be a bit thick, but it took me a while to fully digest the Treasury’s new plan.  After reading all the press accounts and various comments, some conflicting, I was still unsure, so I went directly to the Treasury Department’s website and found these two summaries of how the plan will work: (the bold italicized inserts are by me for clarification)

Sample Investment Under the Legacy Loans Program

Goal: To cleanse bank balance sheets of legacy loans and reduce the uncertainty associated with these assets; involve private investors to set prices; use FDIC expertise to provide oversight for the formation, funding and operation of the new funds; Treasury puts up 50% of the equity, but private managers will be the asset managers, subject to FDIC oversight

Step 1: If a bank has a pool of residential mortgages with $100 face value that it is seeking to divest, the bank would approach the FDIC.
Step 2: The FDIC would determine, according to the above process, that they would be willing to leverage the pool at a (not to exceed) 6-to-1 debt-to-equity ratio.
Step 3: The pool would then be auctioned by the FDIC, with several private sector bidders submitting bids. The highest bid from the private sector – in this example, $84 – would be the winner and would form a Public-Private Investment Fund to purchase the pool of mortgages.
Step 4: Of this $84 purchase price, the FDIC would provide guarantees for $72
(about 86%) of financing (debt issued by the buyer, collateralized by the purchased assets, and guaranteed by the FDIC), leaving $12 (about 14% of total) of equity.
Step 5: The Treasury would then provide 50% of the equity funding required on a side-by-side basis with the investor. In this example, Treasury would invest approximately $6, with the private investor contributing $6.
Step 6: The private investor would then manage the servicing of the asset pool and the timing of its disposition on an ongoing basis – using asset managers approved and subject to oversight by the FDIC.

Source for the above: U.S. Treasury Department

Presently, the market value of these loans is unknown. Presumably, involving private investors, , who will share equally with Treasury the first 14% of any loss, and whose capital input is subject to 100% loss, to set the price in an auction process, will, as Sheila Bair of the FDIC, “tease out” that part of the value discount resulting from the assets” illiquidity.

It is only after the first 14% of losses that  the principal value of the FDIC guaranteed loan will be negatively affected.

Sample Investment Under the Legacy Securities Program

Goal: to restart the market for legacy securities (asset backed securities tied to residential real estate, commercial real estate, and consumer credit) to free up capital and stimulate the extension of new credit

Step 1: Treasury will launch the application process for managers interested in the Legacy Securities Program.
Step 2: A fund manager submits a proposal
and is pre-qualified to raise private capital to participate in joint investment programs with Treasury.
Step 3: The Government agrees to provide a one-for-one match for every dollar of private capital that the fund manager raises and to provide fund-level leverage for the proposed Public-Private Investment Fund.
Step 4: The fund manager commences the sales process for the investment fund and is able to raise $100 of private capital for the fund. Treasury provides $100 equity co-investment on a side-by-side basis with private capital and will provide a $100 loan to the Public-Private Investment Fund. Treasury will also consider requests from the fund manager for an additional loan of up to $100 to the fund.
Step 5: As a result, the fund manager has $300 (or, in some cases, up to $400) in total capital and commences a purchase program for targeted securities.
Step 6: The fund manager has full discretion in investment decisions, although it will predominately follow a long-term buy-and-hold strategy. The Public-Private Investment Fund, if the fund manager so determines, would also be eligible to take advantage of the expanded TALF program for legacy securities when it is launched.

Source for the above: U.S. Treasury Department

In this case, the first two thirds of the risk are shared equally between private investors and the Treasury (taxpayers). Beyond that, losses fall entirely on the Treasury.

The key questions seem obvious? Will it work? Is it big enough to do the job? Can private investors raise the money?

Big enough?  Truthfully, nobody knows.  The estimates are sheer guesses, and vary by trillions.   However, if the plan works in providing true market-determined prices that are significantly above the wild guesses, the size of the problem will be diminished, perhaps to a confidence-inspiring degree.  But that’s a hope, not a forecast.

As to private investors putting up money, I can’t believe that’s any problem at all.  Already there are plans afoot to start new funds and mutual funds, with good quality sponsorship.

A bigger problem might be getting banks to agree to sell these assets, and take a permanent hit to capital.  There seems to be a very large difference between what the banks think they are worth and what motivated buyers might pay.  I don’t think that will happen, but that may be only a poorly informed opinion.

The Populist Storm (posted 3/24/09)

March 24, 2009

Yesterday I was watching Bill Maher on YouTube with Cory Booker (the Rhodes Scholar Mayor of Newark) and Erin Burnett (of CNBC fame) talking about the economic crisis. The general tone of the conversation was unmistakable, even though Erin Burnett tried to inject some moderation. Wall Street, the banks and bankers, AIG……… they are the villains; they are to blame for the pickle we’re in, for your son-in-law’s layoff, your neighbor’s foreclosure, the auto slump, you name it.

The audience applauded any and all insults and derogatory comments about banks, corporations, rich people, bonuses, and George Bush. Also, last week I watched Jon Stewart skewer Jim Cramer, and then endured our holier-than-thou congressmen hurl insults at the CEO of AIG. It’s become obligatory for any and all politicians to decry the AIG bonuses as virtually criminal. The House went so far as to pass a clearly unconstitutional law to tax the bonuses at 90%.

Now they are saying that the AIG bailout was a gravy train for the rest of Wall Street because it enabled that company to meet its contractual obligations with Goldman Sachs and other firms. Why, of course, you dumb politicians! Didn’t you know that was the purpose of the bailout? What did you think AIG was going to do with the money? Make campaign contributions?

Look, readers, I voted for Obama, and have high hopes for his success. Frankly, I am not an admirer of Jim Cramer, and he deserved a skewering. And I believe that the banks and bankers were incredibly greedy and stupid to lever up their balance sheets to buy assets they didn’t fully understand. And I think AIG’s management was completely asleep at the switch.  The bonuses were simply a dumb move.  They should have foreseen the reactions.

None of this changes the sad fact that the bailout of AIG was crucial in preventing an absolutely terrible systemic failure of the financial system. Yes, Goldman Sachs, other Wall Street firms, and heaven help us, even foreign banks, were counter parties on the AIG derivatives portfolio and , therefore, recipients of funds from the bailout.  I shudder to think what the world would have looked like had they not been. Oh sure, if we had the luxury of time to think more about it perhaps we could have  negotiated some “haircuts” for the counter parties, but that’s now twenty-twenty hindsight.

Poor Edward Liddy, the CEO of AIG, who was recruited from retirement to salvage what he could for AIG and taxpayers, and who is taking only a dollar a year in pay to do it was pilloried by congressmen.  He didn’t deserve it. But the fact that he got it anyway, was proof of what I’m thinking and what must be obvious to all of you readers. That there is an immense wave of populist rage sweeping America, aimed at the rich, corporate executives and directors, banks and bankers and all kinds of financial service providers, and especially at Wall Street. (see Frank Rich’s NYT column of 3/22 at )

Now we need private investors to participate in the plan to purchase toxic assets from the banks. They shouldn’t be blamed for worrying about what might happen to them if they profit handsomely from the use of government-provided leverage. The potential of populist rage is going to make them think twice about joining this effort.

People have a right to be angry.  Wall Street and the financial service industry really did mess up.  But regulations or legislation made in anger are seldom sound. So far, our new President seems to be resisting this populist storm. Good for him. But he needs to exert more influence on Nancy Pelosi, Harry Reid, and their colleagues.

Sorry for sounding off.  But it makes me feel better.

The Fed’s Big, Big, Step! (posted 3/20/09)

March 20, 2009

I could simply republish my December 2008 Musings instead of writing this. I said then that the Fed had taken a depression off the table by officially adapting quantitative easing to whatever extent necessary to prevent an economic catastrophe. (Please read my December Musings for more on this)

I thought then that investors’ depression/deflation fears were probably being reflected in stock prices, and that such Fed pronouncements would moderate the intensity of fright. That proved to be a premature conclusion as a tidal wave of bad news from the labor market and the banking system overwhelmed the prospect that quantitative monetary easing would, by later this year, give the economy some traction.

The stock market tanked. The 25% decline erased the rally from the November lows and then some. The bond market also backed up, and investor psychology, mine included, hit the skids. It didn’t seem that that the stimulus package was enough of the right medicine on a timely basis. Also, monetary easing seemed to come to a standstill, and the Treasury Department couldn’t seem to get their act together. Pessimism was extremely high.

The markets were ready for a rally and we are now in one. Investors with the guts to do so could have tripled their money in Citi and doubled it in GE. I wasn’t among them. I still felt that the market was a falling knife that I did not want to try to catch. No guts.

Had we hit bottom? Frankly, I have no idea, but until yesterday I would have said we were only in a typical bear market rally. But……..Thursday’s announcement by the Fed was truly BIG and makes me less certain of that opinion. Here is the important part of the Fed’s announcement:

“………the Committee decided today to increase the size of the Federal Reserve’s balance sheet further by purchasing up to an additional $750 billion of agency mortgage-backed securities, bringing its total purchases of these securities to up to $1.25 trillion this year, and to increase its purchases of agency debt this year by up to $100 billion to a total of up to $200 billion. Moreover, to help improve conditions in private credit markets, the Committee decided to purchase up to $300 billion of longer-term Treasury securities over the next six months. The Federal Reserve has launched the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses and anticipates that the range of eligible collateral for this facility is likely to be expanded to include other financial assets.”

This is mighty reinforcement to the Fed’s policy of quantitative easing. Fed action on this should drive long and intermediate term interest rates down, drive money supply up, and make it relatively more attractive to move money from the safest most liquid assets to less liquid and/or more risky assets. It also raises my confidence that the bottom of the economic decline will have been reached by the third quarter.

That said, it is still a very open question as to how and when a recovery will begin. There remain huge problems. The one that bothers me the most is that the quality of bank assets will continue to decline as the economy takes its toll on business loans, credit cards, leveraged buyout loans, and state and municipal credits. I still believe that we cannot build a trustworthy and lasting recovery of either sentiment and confidence until there is some better assurance that the banking system’s problems are solidly on the road to solution.

Additionally, we are not immune to the problems of Europe, where several Eastern European countries are in dire condition, affecting the European banks and Western Europe’s real economies that have benefitted from strong export demand from the eastern countries. World trade has been contracting rapidly, and its prospects for the several quarters ahead do not look good.

It seems fairly certain that the dominant downward pressures on the economy will be changing. Housing will remain depressed but not get worse. The same is true for autos. Both these areas are experiencing current demand well below their long-term demand determinants. Increasingly it is commercial construction and capital expenditures that are the negative forces.

The next worries will be about the strength of the recovery. There are really two worries. First, is about the initial bounce off the bottom, and second, will be about the following several years. I will try to address these in my next posting.

Buy Now or Wait? The Pros and Cons. (posted 3/14/09)

March 14, 2009


Today I received JP Morgan’s latest “Eye on the Market”, written by Michael Cembalest, CIO of Morgan’s Global Wealth Management. I think it is one of the better such communications from the street. The chart below was on the 3rd page, indicating that by the measure of price divided by tangible book value, the stock market has yet to return to the valuation range that prevailed for forty years, from 1950 to the early 1990’s.


The subject of the article was a discussion of the pros and cons of putting money in the market today.  It’s a good list that I found convenient to use as points of departure for my own thinking. I summarize JPM’s  letter below, along with my comments in bold italics:


Reasons to INVEST NOW

·       Global fiscal stimulus is on the way

(But the stimulus in the Eurozone is small compared to the U.S.)

·       U.S. monetary base has expanded rapidly…..central bank credit creation is roughly equal to the decline in private sector lending in U.S. and Europe

(Actually, while M1 and M2 have been expanding rapidly, M3, the broadest measure of money supply, has grown only 6.2% year-over-year, equal to only 1/10th of the growth of the monetary base. But I believe that monetary expansion is likely to be more effective in softening the decline in the months ahead than the stimulus package)

·       The Fed’s program to restart asset-backed credit markets is about to begin, with $1 trillion of capacity

(I have high hopes for this program; aggressive investors seem to be enthusiastic.  It might work to stabilize asset prices and get the securitization markets going again.  Watch it closely)

·       Loan modification programs will probably slow foreclosures

(Although the record on this is not good so far.  Many defaulted mortgages, presumably saved, have quickly slipped back into default)

·       Unemployment is a lagging indicator, so deteriorating employment conditions are less of an obstacle at the point in the cycle

(I disagree with this.  The rapid and substantial decline in jobs in this downturn may well make unemployment a leading indicator. See the article posted on this blog written by Larry Chimerine on this)

·       Short positions, while lower than last summer’s peak are still quite high

(Large short positions did not do the market any good last fall)

·       Few sectors have any optimism remaining

(This is certainly true)

·       Uptick rule is likely to be reinstated

(I don’t believe this would be any panacea.  Prices are not manipulated by short sellers the way it’s often pictured. Most value destruction would have taken place anyway)

·       There is lots of cash earning close to nothing

(absolutely……..and it can move rapidly given any incentive)

·       Mark-to-market accounting rule may be relaxed

(I’m not sure this does any good this late in the game, after most of the harm has been done. But if it were to help stabilize asset prices, it would be a big plus)

·       Assuming normalized earnings of $65 for 2010, a 13 multiple produces a price of 850, a gain of 16% from here

(I don’t think normalized earnings are as high as $65. More like $50-$55.  At 13x the market is just where it should be. But note in my February Musings, that measured by the Shiller P/E, stocks can get considerably cheaper)


Reasons TO WAIT

·       Vikram Pandit’s memo to Citi employees, which sparked the current rally, referred to earnings before provisions and writedowns.  This is important because their asset quality is deteriorating further this quarter

(I continue to maintain that the financial markets are unlikely to recover in any substantial way until investors have reliable evidence that the quality of bank assets has stopped declining.  Right now that looks to be a long shot for many months ahead)

·       Large hits to earnings are coming from unfunded pension obligations

(Agreed. Even worse are the obligations of states and municipalities, making tax cuts at the state and local levels almost impossible)

·       There is too much optimism on China. Actual 2009 stimulus is a third or a quarter of the U.S. level.  G20 stimulus is quite small

(Chinese exports, which account for about 40% of China’s GDP, fell in February by 26%, after dropping 17.5% in January.  Imports, reflecting the slowdown in domestic demand, fell 24%. Hence, questions still abound about the strength of the Chinese economy, which is the major hope for moderating the global economic decline.)

·       U.S. equity markets are effectively closed. Dividend cuts are being used as a primary way to raise capital

(GE, Dow Chemical, all the major banks so far, and many more to come will be cutting dividends.  See my posting of 3/4/09 for more on this subject)

·       Housing is a bottomless pit.  There are now 19 million homes in the “held off the market” category, that is looking like a pent-up future supply

(There are some brighter things appearing here.  Lower prices and lower interest rates have caused affordability to jump nicely.  And with starts below 500,000, and household formations running at 1.6 million, some pent-up demand is being created)

·       Treasury funding needs are staggering.  Part of the funding may have to be provided directly by the Fed

(Fed monetization of the deficit is a dangerously inflationary action; at least at some point we will have to worry about this)

·       Massive overcapacity in manufacturing…now at 71% utilization

(I’m not sure why JPM lists this as a negative. It’s a major reason why stocks are down so much. Obviously, in the short-term it means huge downward pressure on selling prices, productivity, and margins.  But when the turn comes, the upside operating leverage will be very strong)

·       Credit card delinquencies are at a “worst ever” state

(True, and it will get worse.  Also, thousands of cards are being revoked or limited more tightly. Merideth Whitney estimates that over $2 trillion of credit-card lines will be cut in 2009, and $2.7 trillion by the end of 2010. That’s out of a total of $5 trillion, $800 billion of which is now being used)

·       Questions about the productivity benefits of the stimulus spending.  Three largest 3 targets of spending: water treatment plants, community development grants and road repair

(I had not thought much about this before. But I agree it should be a concern. The stimulus package, as I have said before, is a baby aspirin for a bad migraine)

·       Valuations still not cheap enough

(I agree. See chart above, and my February Musings discussing the Shiller P/E)

·       Problems in commercial real estate, unfunded municipal pensions, intense pressures in Eurozone and Japan, Eastern European implosion

(JPM lumped these items together as a kind of after thought.  Each one is a serious problem. Can the Euro survive not having a unified fiscal policy? The recent Swiss intervention to wipe out the appreciation of their franc was dramatic news and smacks of possibilities of future competitive actions by other nations. Are the Japanese next?  And what must China think at this point about their currency?

I have nothing specific to say about commercial real estate, but the trends here are not good)


JPM’s conclusion?  Moderately underweight (by10-14%) equities.  They say they cannot identify the bottom perfectly, but expect it to occur in 2009.


On balance, as you might surmise form my comments, I am even more inclined to wait than JPM is.  I have never seen the economy fall this much this fast, and I have watched closely for over 50 years.

Needed: A Moratorium on Job Cuts (posted 3/10/09)

March 10, 2009

Larry Chimerine is a top-notch economist. I have the good fortune of working with him on the Investment Committee of Miller Investment Management, firm that carries the name of another, unrelated Miller. In the article below Larry worries that the labor market, usually a lagging indicator, has become a leading indicator and is sending ominous signs for the economy in the coming months. He tells the president what he might do about it.

The Missing Link: A Jobs Cut Moratorium
by Dr. Lawrence Chimerine

The Administration is now working feverishly to implement the stimulus package just enacted, and the mortgage modification program it recently announced. It is also trying to find the best way to utilize the remaining financial institution bailout money that Congress approved last autumn, and various other measures, to recapitalize the banking system and promote increased lending to consumers and businesses.

All of these programs are necessary to deal with the free-fall in economic activity which began last September, and as of now, shows no sign of ending. But they may not be sufficient unless some way is found to also deal with the very serious jobs crisis that has developed in recent months. Jobs are being lost at an extremely rapid rate across virtually every industry and geographic area. What is most disturbing about this trend is that, while the labor market has generally lagged business conditions in the past, it has now become a leading indicator of broad macroeconomic trends, and is therefore now sending ominous signs about the economy going forward.

This is occurring for three reasons. First, recent declines in jobs and in the average workweek have been so large that they are wiping out a significant amount of household purchasing power, exacerbating the already sharp downward trend in consumer spending. Second, as indicated by a recent Associated Press poll, about half of those still working are concerned that they may lose their jobs sometime soon – – this is double the already high level of a year earlier. This makes consumers more cautious about spending, driving the economy down even further. Finally, the huge layoffs recently announced by a large and growing number of companies not only are in response to business declines already experienced, but, in many cases, include job cuts based on the expectation of additional declines in orders, sales, etc. in the months ahead. Unfortunately, this has become a self fulfilling prophesy, virtually guaranteeing that the recession will deepen during the rest of this year.

It is thus clear that the labor market must be stabilized in order to break the downward economic spiral, and, along with the other programs the administration is putting in place, bring about a recovery. In order to accomplish this,the President should convene a meeting of the CEO’s of as many large companies as possible, perhaps through the auspices of the Business Roundtable, and ask them for a six month pause in implementing the job cuts they may have already announced, and in announcing any new ones. This will not only prevent what would otherwise be additional huge declines in employment, but will provide the time necessary for the Administration’s economic policies to begin to stimulate consumer spending.

While the President should invoke the national interest in making this request, it is probably also in the best interest of the companies themselves. Cutting jobs and other expenses to protect profits is self defeating when all companies are doing it at the same time- – the resulting drag on the economy, and therefore on corporate revenues, simply wipes out the impact of the reduction in costs on corporate earnings. For this reason, I believe most CEO’s would respond positively to such an appeal by President Obama, as long as they know that other companies are in the same boat.

The bottom line is that we are now experiencing a national economic crisis unlike anything that has occurred in this country since the 1930’s. What’s more, it is global in scope, so we can’t count on exports to the rest of the world to help turn this around. The Federal government, and the Federal Reserve, have already implemented unprecedented actions to deal with this crisis – – asking the corporate sector to assist in this process would not only be prudent, but is becoming more and more necessary as each day passes.

Larry Chimerine
Radnor Int’l Consulting

15 Worst Bear Markets Since 1896 (posted 3/8/09)

March 8, 2009