Fourth Quarter 2009
Financial Exigency: Capitalism to Fascism
ex·i·gen·cy
n. pl. ex·i·gen·cies
1. The state or quality of requiring much effort or immediate action.
2. A pressing or urgent situation. See Synonyms at crisis.
3. Urgent requirements; pressing needs. Often used in the plural.
In the world of academia there is the “rule of tenure” for those individuals who have
attained PhD’s in an area of expertise and actively teach the curricula of the
university. Theoretically, the professor who attains tenure cannot be fired by the
university system for any performance reason – something they may say in class,
behavior issues, etc. That is, they have a lifetime employment agreement. However,
there is a small clause affixed to a number of tenure agreements that allows for “financial exigency”. Financial exigency exists when the university declares it has
suffered extreme financial hardship; and once declared, the university is free to
terminate, or shall we be more politically correct and say lay off, teaching staff,
regardless of tenure.
The US federal government entered financial exigency in October of last year, post
the collapse of Lehman Brothers, when credit markets froze. Enter Treasury
Secretary Paulsen, Fed Chairman Bernanke, FDIC Chairman Bair, and our Congress,
who unanimously declared the United States in a position of emergency and called
for significant government action to rescue the country from its financial/liquidity
crisis. Although the creation of the housing bubble and the problems from
overextension of financial leverage had been “missed” by the Treasury, the Fed, and
FDIC, the country was now seemingly forced into a position of allowing these same
individuals tremendous latitude to fix the problems.
Looking back, it would appear their method of fixing the problem has been to
administer more of the same medication that made the patient sick to begin with:
expansion of credit, government guarantees and bailouts, and protecting a financial
system that capitalizes gains and socializes losses. Is anyone monitoring the
numerous actions, meetings, and legislation our Congress has enacted? Does anyone
understand the “end-run” financing schemes the Treasury and Fed have undertaken
to spend money by bypassing Congressional oversight? One man does, and his name
is Verne McKinley. Mr. McKinley worked for the Federal Reserve Dept. of Treasury
from 1985 to 1999 and has recently sued the Federal Reserve under the Freedom of
Information Act to disclose information. Why would he sue? He (a) wants to know
where has the Federal Reserve spent taxpayer money and (b) have the Federal
Reserve disclose the guidelines and reasoning by which financial institutions are
considered “systematic risks” to the country’s financial system, as opposed those
that are considered “at risk.” Mr. McKinley has been joined in his pursuit by Barron’s
and other media publications, which seek to simply “audit” the Federal Reserve, a
move which Bernanke and Company are blocking via legal proceedings.
Let’s see, the Federal Reserve spends trillions of taxpayer monies and yet the tax
payers are not allowed to know where it is spent? Our nation assumed an
unconscionable amount of deficit spending to bail out every institution save the
kitchen sink during last year’s financial crisis and continues to spend tremendous
amounts on TALF, PPIP, and other financial guarantees. How much debt, you ask?
According to the Pete Peterson Foundation website, the real national debt stands at
$56,400,000,000,000 or $483,000 per household or $184,000 for each person.
That’s a lot of money. And, this amount does not reflect the anticipated increase in
deficit spending by our government that is projected to triple over the next three
years. From the website:
The interest paid on the National
Debt is the third largest expense in
the federal budget. Only Defense
and income redistribution (The
Departments of Health and Human
Services, HUD, and Agriculture
(food stamps)) are higher. As the
debt increases, so does the interest
payment. Social spending is the
largest item in our federal budget. Do you have "Compassion" for the
lower income earners?
In Fiscal Year 2008 (FY08), the U.
S. Government spent $412 Billion of
your money on interest payments* to
the holders of the National Debt.
Compare that to NASA at $15
Billion, Education at $61 Billion,
and Department of Transportation
at $56 Billion. -- As of August 2009,
the interest expense so far this
fiscal year (FY09) is $368 Billion
Rome is still burning, Nero Obama, while you and Congress play the fiddle of healthcare
reform and cap and trade and toy with financial regulatory reform.
The Fourth Way: Capitalism to Fascism
At this time, I see no one questioning the current Keynesian thought process that
the only way out of this economic mess is for government spending to replace
private spending until “things get better.” President Obama and Fed Chairman
Bernanke’s motto is seemingly to “Walk softly and carry a big checkbook.” The
amount of capital being created from thin air is staggering: TALF at $900 billion,
TARP at $700 billion, authorizing the Fed to be buyer of last resort for commercial
paper at $1.6 trillion, buyback of mortgage securities (GNMA, FNMA, and FHLB) at
$1.5 trillion, Public-Private Investment Fund at $900 billion, bailout of Freddie Mac
and Fannie Mae at $400 billion. That’s $6 trillion of additional debt!!! Admittedly the
monies have not all been spent, but they have certainly been committed. I found it
alarming this week that the FDIC is in the red and anticipates operating in a negative
capital position until 2012. The FDIC has suffered 98 bank failures year-to-date, and
the desperation for funding is evidenced by its September 29th’ meeting, when the
FDIC called on all banks to “prepay” three years worth of premiums. What’s next?
All of these bailout policies and printing of money is causing a precipitous fall in the
dollar and the erosion of the dollar as the global currency standard. America’s future
global economic competitive position is being compromised by unprecedented deficit
spending. The perceived battle for Bernanke and Company is overcoming the forces
of over-supply, excess industry capacity, and rising unemployment that creates
deflation, versus the Federal Reserve’s intent to produce inflation, particularly real
estate inflation, at all costs. As the battle progresses I predict a continued erosion of
the dollar, and at some point the $2 billion a day consumption by foreign investors of
our US bonds/notes will experience a crash diet. The Treasury, the Fed, and
Congress have authorized and executed their version of financial exigency on the US
financial industry and will soon follow that act with an encore on health-care reform
and cap and trade legislation. Can’t you hear Bob Dylan singing “The times they are
a changing”?
In the last 25 years we have experienced 19 financial exigencies in this country,
typically caused by excessive use of leverage. Excess liquidity and financial leverage
are the two necessary ingredients to cause bubbles, bubbles, toils and troubles.
From an investor’s perspective, we note that during normal economic times the
relationship of risk versus reward in financial assets is generally sustainable, and
markets act in what one would consider an orderly fashion. However, during crisis
and popping bubbles the value-driven financial models fail and typical risk-versusreward
relationships break apart. Why? Because markets are invested in by human
beings who time and time again make irrational decisions. In Dan Ariely’s book
Predictably Irrational, he makes the case that, for most humans, the greater the
chaos the less likely we are to take any action to alter our course. In times of great
strife most of us sit like lemmings watching the carnage, unable to make decisions.
When the chaos subsides and there are fewer choices/decisions to make, then we
are more capable of action. The chaos of 2008 was enhanced because investment
professionals had begun to mistake mathematics and mathematical models as truth.
When the models broke under financial duress, investors kept banking on the
mathematics and the losses grew larger.
Where I live in Savannah, Georgia we are subject every year to “hurricane season.”
To me, market bubbles, where investors behave irrationally, are like hurricanes; they
are inevitable. The Federal Reserve, the Treasury Secretary, and our government
can no more control the inevitable cycles of investing than the weatherman can
control where a hurricane hits. We can be better prepared for the hurricanes, but
they will come and go as sure as the tides rise and fall. Our thought process
regarding governmental involvement in economics has changed dramatically from
Adam Smith’s Wealth of Nations to Keynes’ macroeconomic The Theory of
Employment, Interest and Money, to Friedman’s monetarism and the emergence of
the “Efficient Market Hypothesis.” Our government has now evolved into what I label
the “Fourth Way” – a combination of Keynesian spending and the corporate state. A
classic manifestation in today’s world of the Fourth Way is the concept of “too big to
fail,” or should I say, “too small to save.”
Too Big To Fail
In 2004, Gary Stern and Ron Feldman published their book Too Big To Fail: The
Hazards of Bank Bailouts. In it they did an excellent job of demonstrating the risks
and stupidity of a deregulated, fractional commercial banking industry, when
policymakers implicitly promise to bail out the biggest banking institutions. In 2004
this was strictly a “debatable topic,” as the thought of bank collapses and bailouts
was, at the time, unthinkable. However, a concept that was once debatable has now
become acceptable governmental policy. Not only is too big to fail accepted, it is a
policy that most feel necessary for our nation’s financial survival. Question: could the
financial markets function today without governmental support? Answer: I doubt it.
Did you know that according to Bert Dohmen’s research, “Half of the residential
mortgages are now being made by just three large banks”? The banks are Wells
Fargo, Bank of America, and JP Morgan Chase, with the Treasury guaranteeing 85%
of new mortgages, while the Federal Reserve is buying 80% of these securities that
are originated. And, by pulling strings and enacting various statutes, the government
is beginning to dictate to the financial industry who will succeed and who will fail.
The disparity between the big banks and small banks is getting greater. These large
financial institutions are ensured a quasi-government bailout, and as a result have a
superior competitive position relative to the overall banking community. The
question is, at what cost to the American people? Who foots the bill for our
government’s control of the banking industry? Not only in terms of bailouts, but at
the risk of losing community banks that to a large degree finance the small to
medium business owners (who in turn supply jobs). According to Neil Barofsky,
special inspector general for the Troubled Asset Relief Program (TARP), in a worstcase
scenario all of the federal government’s support rolled together could ultimately
cost the taxpayer $23.7 trillion. Huge government plans such as this are not meant
to help the small banks or the common man; rather they seek to concentrate power
into the hands of government. As I said in our first-quarter letter, this newfound
power of our government no longer positions them as a referee but as a player that
can decide who wins and who loses in the banking industry.
The expansion of the Fourth Way – this combination of government spending/bailout
and governance of the corporations they “invest” in – leads to an erosion of
freedoms American citizens have had, under the insidious banner of “protecting” the
common good of the nation. Consider the case of our Transportation Security
Administration (TSA) that was put in place post-9/11. In eight years TSA’s budget
has grown from $700 million to $6 billion, largely as a result of private companies
being replaced by federally mandated “union” employees. In the same eight years
TSA has yet to catch one terrorist, has abused and misspent taxpayer monies
(bought 200 “puffer machines” at $160,000 each and NONE are in use today), built a
lavish headquarters building, and now employs 50,000 security officers, inspectors,
air marshals, and managers as compared to 25,000 in 2001. I expect the next
industry for consolidation under the Fourth Way will be health care, followed by the
utility industry. If they are run as effectively as TSA, then the cost estimates being
tossed about by the President and Congress are not even close to what the final bill
will total. Control our money, our health care, and our energy supply and you pretty
well rule the nation.
As a quick aside on the stupidity of government in our country’s banking system, try
this on for size: one of the fastest-growing mortgage lenders in today’s market is
none other than the US Department of Agriculture. According to the September 28th
issue of Business Week, the Obama administration allocated $10.5 billion to the
USDA’s guaranteed loan program, which has resulted in the number of loans
generated growing from 35,000 in 2008 to 120,000 in the first nine months of 2009.
Now tell me, what does the USDA know about running a mortgage program? Oh, I
know, they are offering USDA Prime Grade A no money down, 100% financing!!! Sound familiar?
Today’s Markets: Party Like It’s 1999
From the four daily newspapers, multiple newsletters, Bloomberg wires, seven
magazines, and numerous independent research pieces that I read, the following
seems to be a consensus in the minds of the investment public:
- The US and global financial system is safe – the meltdown we flirted with last
November has been averted and capital/credit has been restored.
- “Shrinking pie” economy – although the numbers for Q3 earnings will be
favorable versus a year ago, US GDP growth will remain a fraction of its
historical average.
- ChiMerica – has become a marriage on the rocks.
- Unemployment – this will be a jobless recovery.
Financial Solvency
The financial crash of 2008 has now seemingly become a bad dream that the
markets would prefer to forget. All the toxic assets, the residential mortgages,
commercial mortgages, credit card debt, and home equity lines of credit that
plunged in value with the fall in real estate prices, magically went away with FASB’s
(Financial Accounting Standards Board) amendment in March of 2009 to “mark-tomarket”
accounting practices. As a result of rescinding mark-to-market accounting,
banks were allowed to resume the accounting practices of Christmas past and give
shareholders the present of first-quarter positive earnings. One can trace the current
stock market recovery to the week of March 16, 2009, when FASB made their
announcement to rescind FASB 159.
I cannot believe that, without a recovery in real estate prices, banks are anywhere close to being out of the woods of further defaults and foreclosures. The Case Shiller
10-City Composite Index of house prices fell by 5.5% during the first six months of
2009. From the October 5th Mortgage News Daily:
Mortgage delinquencies in the Fannie/Freddie portfolio are continuing to
increase. Loans that are 30 days delinquent increased by 11 percent during the
second quarter to 682,000 and loans in the 30-59 day bucket rose 20 basis
points to 2.2 percent of all loans. However, 27,000 more loans became 60 or
more days delinquent. This is an increase of 21percent and there are now 1.3
million 60+ day delinquent loans in the portfolios. Nearly 50 percent of
delinquent borrowers cited loss or curtailment of employment as the reason for
their problems compared to 43 percent during the first quarter.
If mortgage defaults were not troublesome enough, then consider that Moody’s
Credit Card Index rose to a default level of 11.49%, a record high, last month. This
index measures credit card loans that banks do not expect to be repaid, and it
continues to rise. Further headwind to the financial system was FASB’s
announcement in July that it will begin discussions in 2010 for increased use of
mark-to-market accounting. I quote from the press release: “All financial assets
would have to be recorded at fair value.” Currently banks classify loans in terms
such as “hold to maturity,” “hold for sale,” and “held for investment,” with each
classification accounted for differently. The new discussions are aimed at classifying
all loans and securities held by banks according to current fair market value – hmm…
this sounds familiar. Did not FASB cave to political pressure in the spring by
repealing mark-to-market accounting on mortgage portfolios? Should we expect a
different outcome when discussions begin in January 2010? I anticipate excessive
political arm bending when these discussions ensue and, given the Obama factor, I
do not expect a different outcome.
And last, I was distressed that the FDIC asked banks for a prepayment of three
years of premiums in order that it remain financially solvent. Having the banking
industry “pre-pay” simply drains another layer of capital from the banks and reduces
the capital available to lend. Until the credit cycle returns to expansion versus
contraction, one cannot expect an economic recovery of lasting proportions. The
current expectation is, let the government purchase the bad loans/mortgages, let
banks keep performing assets, and hope that the government spending programs
will replace the consumer as the economic engine. As the hippie generation said in
the sixties, “Far out, man.”
GDP
According to Bloomberg, the median projected GDP growth, year-over-year, for the
US in 2009 is -2.6%. In 2008 the actual was .40, and the consensus median for
2010 is plus 2.4%. Where do we find GDP growth with a retrenchment of the US
consumer? In my opinion, the consumer has fundamentally changed and is not going
to snap back as he/she did post-1987, -1990, and -2003. The Great Recession has
destroyed confidence as much as it has jobs and wealth. The personal savings rate
has jumped from just over 1% a year ago to over 5% today, and is still rising. The
government, via all the incentive programs, could produce 2-3% growth next year.
But, they would do so by huge deficit spending combined with incentivizing the
consumer to do exactly what got us into this mess to begin with: borrow at a higher
rate than you earn. Although I hope I am wrong, the numbers point to nominal
growth in GDP at best, but nothing on the order of 2-3%. Thus, the market is
already pricing in a goldilocks outlook for 2010.
ChiMerica
China is emerging as the financial power player in the world and poses the greatest
threat to Western democratic global leadership in the last 300 years. And how does
the global marketplace respond to the world’s biggest creditor nation? In the US, we
respond with an ill-advised trade tariff on Chinese tires! How has the EU responded?
The European Union imposed an “anti-dumping” tax of 40% on all steel pipe imports
from China. How does Australia handle China’s investing in natural resources in their
country? By enacting legislation that limits foreign ownership of their companies and
or resources to a maximum of 15%. How has China responded? They have imposed
import tariffs of their own and have decreed an unprecedented amount of
government-imposed lending to domestic industry. China’s chief bank regulator, Liu
Mingkang, announced yesterday that a 30% increase in lending is “reasonable given
the government’s push to spur the domestic economy.” China is attempting to keep
the expansion moving in hopes of maintaining employment levels. As it celebrates
the 60th birthday of the Peoples Republic, the leadership of China is well aware of the
consequences that high unemployment can bring to an emerging-market nation.
Because of its financial and productive power, China is pushing the Western world on
the economic and financial fronts. The latest push being finance minister Xie Xuren
urging the International Monetary Fund to speed up reforms and, at the G20
conference, calling on the World Bank to ensure capital adequacy of all banks in
developed countries. Both are evidence that China intends to continue its path of
replacing the West as the global market leader. China’s economic dependence on the
US is ending, for better or worse.
Unemployment
Could last Friday’s announcement and revision have been any worse? The
government announced on Friday that 842,000 more jobs were lost than it
previously had reported. That brought the losses since December, 2007 to 8 million.
The percentage exceeds every decline since the end of WWII. From the Chicago Sun
Times:
- 33: The average number of hours in a workweek -- indicates many
companies aren't operating near capacity and may boost part-time workers'
hours before adding staff.
- 103,000: The increase in people who hold a part-time job because they can't
find full-time work. Total this year: 9.1 million as of September.
- $616.11: The average weekly earnings of private-sector workers -- down 1.3
percent since January as employers are cutting hours.
- 26.2 weeks: The average duration that unemployed workers are out of a
job, a record high since the records started in 1948. The figure is up from
19.8 weeks in January.
- 5.4 million: People unemployed longer than 27 weeks.
- 17 percent: Unemployment rate when it includes frustrated workers who
have dropped out, taken part-time work or haven't looked recently.
- 10.3 percent: Unemployment rate for men over age 20, up from 10.1
percent last month. Men were hit particularly hard by job cuts at factories and
construction sites.
I think you get the picture, and it’s not pretty. The ramifications of continued job loss
will be higher credit card defaults, mortgage defaults, and diminishing consumer
spending. This recession has set records for the steepest decline since 1949 for trade
inventories, the lowest capacity utilization since 1967, and largest fall in industrial
production since 1946; add unemployment to the list. By the way, according to The
Privateer, there are 22.5 million US government employees, versus 20 million jobs in
the Manufacturing and Construction sectors. The average annual salary of the US
government worker is $75,419 per year, compared to the private sector where the
average is $39,751 per individual and $50,740 per household. And who pays these
government workers?
Market Outlook
In the face of potential legislation for health care, a carbon tax, protectionism,
reduced consumption and increased savings, bankruptcy of the auto industry, a
record number of bank foreclosures, a declining dollar, and the ongoing fight of
deflation versus inflation, the market had its best quarter of performance in the last
decade. And guess what, sports fans, I underestimated the power of the Fed and
how excessively low interest rates are distorting every business and investment
decision. The fiscal and monetary stimulus is projected to measure 10% of GDP on
the fiscal side and 9.5% on the monetary side, for a nice 19.5% pop. The record
government spending is only forestalling the bottom of this recession. Adding to my
woes, our stock portfolio is weighted with quality (low P/E’s, dividends, etc.), but
during Q3 of 2009 the junkier a company’s balance sheet the better the stock’s
performance. According to research at Baird Private Wealth Management, companies
not earning a profit had gained 92% from the March 9th lows through August,
compared to a 47% rise for companies with the highest profit margins.
David Rosenberg recently stated that forward S&P earnings are at 15.7x which
represents a valuation level higher than October of 2007, when companies were at “peak earnings.” Stocks are not cheap by any measure. The number of investment
advisors who are bullish is almost as high as at the 2007 peak, and to attain
corporate earnings projections will require substantial GDP growth. I am currently
experiencing a level of frustration similar to what we experienced in 1999, when we
shifted clients out of the dot.com/technology bubble and began being defensive to
what I viewed as a speculative market. Clients questioned our decision to shift out of
dot.com stocks then, and they will question our defensive posture today. There are a
number of investments today that can be traded on short-term speculation, but I
have no intention of risking the financial security of our clients in a game of musical
chairs.
Cliff W. Draughn, President and CIO
IMPORTANT DISCLOSURE INFORMATION
Please remember that past performance may not be indicative of future results. Different
types of investments involve varying degrees of risk, and there can be no assurance that the
future performance of any specific investment, investment strategy, or product made reference to directly or indirectly in this newsletter will be profitable, equal any corresponding
indicated historical performance level(s), or be suitable for your portfolio. Due to various
factors, including changing market conditions, the content may no longer be reflective of
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