ProVise Management Group, LLC, an SEC Registered Investment Advisor

PROVISE BULLETS ©

(September 30, 2008)

• The past 12 months have taken us from what appeared to be a contained but significant issue to one that became so consequential that the Administration and Congress developed a “rescue” plan in a bi-partisan manner in less than a week.  Surprisingly, both the President and the Congressional leadership were rebuked when it failed to pass the House on Monday.  These Bullets will reflect on how we got into this mess in the first place and look at the current problem.  By no means is this intended to be an exhaustive analysis; rather it is a high level overview. 

• Many people believe that the beginning of the current crisis was June of 2007 when a couple of formerly obscure hedge funds run by Bear Stearns announced that they were going bankrupt.  The reality is that it began many years earlier, when the Federal Reserve Board, led by Alan Greenspan, reduced interest rates to where money was essentially “free” by taking interest rates down to 1% and keeping rates there for an extended period of time.  It created an “irrational exuberance” of its own.  Coming out of the internet bubble in the stock market, money shifted to other asset classes.  One such asset class dramatically affected by this “loose money” policy was real estate.  What began as a relatively benign market in real estate led to an all out bubble where many people believed they could buy real estate for any price and could make a profit by selling it to someone else at an even more ridiculously high price.  On top of this, people who would normally not have qualified for a loan suddenly found this “easy money” too hard to resist and banks and mortgage companies found the opportunity to lend money to suspect and/or unqualified borrowers just too tempting considering the money they would make for the fees involved in setting up the mortgages.  After all, who needs to worry about prices and costs when real estate is climbing at 10% or more each year?  In many cases, those who were trying to purchase a primary residence pushed their budgets to the limit.  When real estate prices collapsed, and interest rates rose, they simply couldn’t keep up with the payments.  Making matters worse, some of those borrowers lost their jobs.  Hence, the real estate bubble popped.

Worse still were the speculators who were buying multiple units, sometimes in double digits within condominium buildings, in order to “flip” the units to make a profit.  While we are definitely concerned about the people who need to keep a roof over their families’ heads, we have no sympathy for the speculators.  Like any investor, they should have understood the risks they were taking. 

Next, we had Wall Street, which for many years had packaged home mortgages in an effort to sell them to investors.  This time, however, the contracts were sliced and diced into so many pieces that it was hard to tell who owned exactly what.  For example, in selling off the sub-prime mortgages, they divided them up into several tranches.  Several investors would get a lower interest rate on these sub-prime mortgages, but would have first call on the interest.  In other words, they were taking less risk.  The tranches continued to grade down so that the most risky tranches paid the highest return.  Needless to say, Wall Street made significant fees by simply securitizing these mortgages and selling them off to investors.  Unfortunately for many people on Wall Street and many bankers, they began to believe in their own creativity and held on to a lot of these investments.

Then there were the rating agencies which participated by providing favorable ratings for the bonds.  In fact, without these AAA ratings received by many of these mortgages, none of this would likely have happened. 

Thus, there is plenty of blame to go around.  Today, it’s easy for Congress to point fingers at Wall Street or at banks or at the Federal Reserve, and even perhaps to some of their constituents who were speculating. While all of this was going on, where was the President?  Where was Congress?  Why did they wait until the last minute?  Let’s not get into the blame game that has gone on for the last week or ten days in Washington.  The point is we probably don’t have enough fingers to identify all those who are responsible, at least in part.

As a result of the Sarbanes Oxley Act (which was passed in response to the Enron debacle), the companies that owned these mortgages as an investment were forced to mark their securities to the market.  That is to say, whatever price the market was reflecting would have to be used on the books, no matter what the institution deemed to be a fair value.  While this seems logical, it presents numerous problems.  First, it takes a long-term investment (such as a 30 year mortgage) and subjects it to the short-term whims of the market.  In the beginning of this mess, as the price of these mortgages went down because other investors were less sure of their true worth, companies simply marked to the market, took the write-down and moved cash off their books into a reserve position for the write-off they might eventually have to take.  As the market deteriorated, bigger and bigger write-offs were needed and more cash was drained from the books of the companies.  When a company runs out of cash, it goes out of business.  Then, we went into the “black hole” where these securities became virtually “worthless” at least from a pricing standpoint.  That is to say, no one really wanted to buy them, or at least they were unwilling to buy them except at an extremely deep discount.  In one case, Merrill Lynch sold off a group of these securities for 22¢ on the dollar, notwithstanding the fact that these mortgages were likely to be worth significantly more than that at some time in the future.

Whenever there is a pricing discrepancy such as this, it generally leads to a bad results.  No one anticipated or expected this kind of result and thus, because of the cash taken off the books of insurance companies, large Wall Street firms, and banks, credit slowly began to evaporate.  It was determined several weeks ago that some type of further government action was needed besides simply having the Federal Reserve Board step in and take a type of action it had never taken before.

The government took small steps to get there.  First, there was the Federal Reserve’s engineering of Bear Stearns’ sale to J.P. Morgan.  Several banks failed and the FDIC insurance came into play and those depositors who had more than $100,000 in one bank ended up losing some money in some cases.  Additional “back room” maneuvering by the government pushing stronger companies to acquire weaker companies took place, and finally, when they couldn’t find anyone to take over AIG, the government stepped up with a loan of $85 billion, which in effect made the government a 79.2% owner of AIG, at a price just above $2 per share.  Even this did not stem the tide.  Lehman Brothers went bankrupt, Merrill Lynch was acquired by Bank of America, Washington Mutual Bank failed, and the Paulsen plan emerged.

The problem with Paulsen’s plan was its simplicity.  It was a three page Act of Congress which virtually gave the Administration and the Treasury Department unfettered and unsupervised ability to control $700 billion.  That never made sense, regardless of who is in the White House today or who might be there in late January.  After a week or ten days of haggling, compromising, and nudging, the House was unable to reach an agreement and failed to pass the Emergency Economic Stabilization Act of 2008.

Many of the politicians were saying that this Bill “bailed out” Wall Street.  While part of that might be true, it was not close to “management getting rich”.  Bonuses were lost, options and stock ownership became worthless.  Many lost or will lose their jobs.  Because the public has made it clear that they believe that CEOs who participated in the failure of these large institutions should not be entitled to receive Golden Parachutes, a provision concerning this was inserted into the final version of the Bill.

To say that Main Street is not touched by what is currently happening on Wall Street simply is not true.  When banks don’t have money to lend, the “average” American is deeply affected.  Let’s suppose you want to remodel your house and you go to the bank to take out a loan for the remodeling costs.  The bank can’t make that loan if it doesn’t have cash.  Let’s suppose you want to sell your house and you accept a purchase offer.  The prospective purchaser tries to get financing but the bank can’t lend them money because it doesn’t have the cash.  Let’s suppose that your employer uses a line-of-credit at the bank for working capital from time to time.  The bank, however, shuts off the line because it doesn’t have cash and thus, the employer can’t make payroll.  Obviously the “bail out” plan does affect Main Street.  Only time will tell, but we expect to have more clarity over the next couple of weeks.

• The use of the word “unprecedented” has become commonplace and in fact, it is “unprecedented” that “unprecedented” has “unprecedentedly” been used in such an “unprecedented” way (sic).  Although the legislation presented to Congress was bold action, it is not unprecedented.  We need not look back much further than the Resolution Trust Company formed by the government in the late 1980s to bail out the savings and loan industry to find another “unprecedented” government bailout.  However, this was far from the first.  Do the names Long Term Capital, Chrysler, or Penn Central ring a bell?  On numerous occasions we have made reference to the panic in the early 1900s that was brought calmly to a close by the erstwhile J.P. Morgan, who literally forced the healthy banks to pony up in order to support the unhealthy banks so that the system would remain in place.  Several years later, Congress created the Federal Reserve Board.  The real first and only “unprecedented” government intervention into the capital markets goes back to the early days of our country.  In 1792 during the term of George Washington, Secretary of the Treasury Alexander Hamilton was credited with singlehandedly stemming a panic.  There was a run on government bonds and Hamilton borrowed money from the Treasury to buy these bonds which supported and eventually increased the market.  He also told the banks that all bonds would have to be held as collateral and that the government would guarantee the collateral.  Thus, government intervention in the markets began almost 220 years ago.

• October is often thought of as being the worst month in the year for financial markets because two major prior market crashes have occurred during that month.  However, September is actually the worst performing month for the S&P 500, having declined an average of 0.63% over the past 60 years, with the average index declining 56% of the time.  These numbers compare against the other 11 months, where the average gain is 0.69% and they only decline 41% of the time.  This September we not only saw a negative return, but also significant volatility.  In fact, during the last twelve trading days of the month, there were eleven days of triple digit changes in the DJIA.  Monday saw the largest point loss for the DJIA ever.  This year during the month of September the S&P was down 8.91%, which is only going to add to the argument that September is recognized as the worst month for the market.  On a more positive note, in each of the last five years (2003 – 2007) the S&P 500 has produced a positive return for the time period of September through December.  (Source:  S&P 500)  We can only hope it happens again this year.

• There’s no way to tell when the market has hit a bottom until it has hit that bottom and time has passed and the bottom is reflected.  There are signs, however, that investors try to identify the time the market hits a bottom.  Several various astute and large investors may have signaled their belief that the economy and the market is near the bottom.  Perhaps at the top of the list (at least from a publicity standpoint) was Warren Buffet’s investment into Goldman Sachs.  He provided $5 billion for them in preferred shares where he is receiving a 10% dividend, as long as he owns the shares.  Goldman can buy them back at any time they want at a 10% premium.  Perhaps even more importantly, Buffet also extracted a warrant at $115 per share for up to $5 billion of Goldman Sachs common stock over the next five years.  He didn’t stop there.  He also acquired Constellation Energy Group, which owns Baltimore Gas and Electric for a “paltry” $4.7 billion.  One week earlier, its market cap was twice that amount.  Buffet is not the only investor looking for value and bargains, as one of Japan’s largest banks invested billions of dollars into J.P. Morgan.  Perhaps the biggest sign is an indication that private equity firms are gathering assets from everywhere they can in order to acquire some of these depressed companies, that will not only survive the current economic downturn, but will likely prosper in the inevitable upward cycle.  In times of turbulence, there is always opportunity, but patience is required.

As always, we encourage you to give us a call if you would like to discuss anything further.  We will visit again soon.

RAY, KIM, ERIC, BRUCE, and LOU

©9/30/08 ProVise Management Group, LLC

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