ProVise Management Group, LLC, an SEC Registered Investment Advisor

PROVISE BULLETS ©

(October 16, 2008)

• On Friday, October 3rd, the House finally passed the so-called “Bailout Bill” and it was immediately signed into law by the President in a very quick two hours.  No one, including Secretary of the Treasury Henry Paulson, said that this was a “cure-all to end-all”, but that whatever lies in front of us was going to be much more difficult without the passage of the Bill.  Over a month ago, Paulson began working to put together the organization needed to oversee the “bailout”, in the hopes of being able to hit the ground running.  Even if this is the case, things won’t be in place until immediately after the election.  In the meantime, additional banks and other financial institutions may need to be salvaged in other ways. 

When the House first took up the vote on the Bill on the previous Monday, only 205 votes could be found in favor of it.  The Senate, which passed an expanded version of the Bill, basically challenged the House to be defiant and in doing so attached a bunch of the “sweeteners” to the Bill.  As a result, 58 votes moved from “no” on Monday to “yes” on Friday and one vote switched from “yes” on Monday to “no” on Friday.

Underscoring the desire to use all available tools, Paulson and the Treasury Department made a significant change to corporate tax law.  Previously, the position of the IRS had been that if a profitable company acquired another company with built-in losses, the acquiring company could only write off up to $1 billion per year and could only do so over 20 years.  In other words, if the acquired company had $8 billion in losses, it would take eight years to fully convert those losses to tax advantages.  Further, if the acquired company had $28 billion in losses, $1 billion per year could be deducted for 20 years and the final $8 billion of losses would be lost.  The change in the law was that all of the losses are allowed to be absorbed and could be done immediately.  So why was this important?  You remember the deal announcement that Citigroup was acquiring Wachovia with FDIC approval?  Although the government was going to absorb all losses above $42 billion, it also received a $12 billion stake in Citigroup.  With the change in tax accounting, along came Wells Fargo, which had been in negotiations with Wachovia until the last minute but then backed away and handed it to Citigroup.  Wells Fargo then made a substantially better offer to the shareholders by raising the stock price to $7.  Wells Fargo estimates that there will be $74 billion in losses in the acquisition of Wachovia.  Thus, they will be able to deduct this amount against the first $74 billion of profits they have.  While Wells Fargo says there is not one penny of taxpayer money involved with this deal, that’s not exactly true, because even at a 30% tax rate, Wells Fargo will save around $22 billion in taxes.  Going forward, you can expect other banks will want to take advantage of this significant change in the tax regulations. 

Let’s get back to the provisions of the bailout.  We’ve all heard about the $700 billion number.  This is the amount that can be used by the government to invest directly in financial institutions or to acquire the distressed/”toxic” assets about which we have heard so much over the past several months.  Announcements have been made for some financial institutions already and others are likely to follow.  It virtually gives Paulson (or whoever might become Secretary of the Treasury), a blank check to buy whatever from whomever at whatever price deemed appropriate.  This “blank check”, however, comes with a significant amount of oversight by both the Executive and Congressional branches of government.  The money will be released in several steps, with $250 billion available immediately and another $100 billion that can be released by the President by simply certifying that the release of the money is “necessary”.  The remaining $350 billion must go back to Congress, who will be given 15 days to object.  In other words, if they can’t say “yes” or “no” it appears that the release of the money will be automatic.  It is also unknown as to whether the current President can ask for the money or whether it would be delayed until a new President and Congress are inaugurated/seated.

Although the Treasury is free to just go in and purchase the assets, they have expressed a desire to do a reverse auction.  Rather than one item being offered with many bidders, in this case there will be only one bidder, but many items to auction.  Assuming that mortgage-backed portfolios are all equal, then the government would likely buy from those asking the lowest price first.  As a result, it is entirely possible that if the Treasury “buys it right” that taxpayers could end up making money.  Having said that, the Treasury must get it right, because if it doesn’t buy these assets for a good price, the taxpayers could end up on the hook.  On the other hand, if it doesn’t pay a high enough price, it might not provide the liquidity needed for each institution.  This will be a delicate balancing act.

One provision added to the original three page Bill was to limit the salaries and bonuses for top level executives in those institutions that become a part of the bailout program.  The Treasury has the right to eliminate excessive salaries and bonuses and can significantly influence any golden parachutes that executives try to implement.  Salaries for senior executives that exceed $500,000 per year will not be deductible to the corporation, and any severance package to a senior executive that provides more than triple the annual salary will be charged an additional 20% excise tax.  As time goes by, the Treasury may develop guidelines to ensure that other firms are handled in a similar, although not identical, fashion. 

Another major change to the Bill was the temporary increase - through December of 2009 - of FDIC insurance limits.  For the next 15 months, each separate registration will now be insured for up to $250,000 as opposed to $100,000.  We believe that this provision will become so popular over the next 15 months that FDIC insurance will remain at these levels.  Already, retirement accounts like IRAs are insured at this level. 

What really “won the day” and changed the votes in the House was the addition by the Senate of significant other provisions, like the Treasury being able to modify the terms of homeowners’ mortgages, the government receiving warrants/equity in the companies it gives money to, and $149 billion in tax breaks for individuals and businesses over the next ten years.  The good news is that around one-third of this is offset by tax increases.  In fact, over the next ten years, hedge fund managers will fund around $25 billion of the total increase.  Also added to the Bill was broader mental health insurance coverage, essentially making it like any other illness.  The very popular Research Tax Credit was extended for another couple of years, which provides a tax break of about $8.3 billion.  At the individual level, the Alternative Minimum Tax was adjusted so that about 24 million households will not see an increase in this tax.  The cost for this is around $62 billion for 2008.  Alternative energy got a boost (surprise, surprise), by giving the industry $17 billion in incentives.  Not to be outdone, somehow the rum producers in the Virgin Islands and Puerto Rico were given a $192 million tax break.  Recognizing that the movie and TV industries can have big political influence, Congress built into the Bill around $478 million of tax breaks for these industries over the next ten years.  Also recognizing the rising popularity of NASCAR, they gave this organization $109 million in tax breaks for 2009 so they could build race track facilities.  The strangest pork added to the Bill was that Congress repealed the 39¢ excise tax on wooden arrows for children.  This will save someone $200,000 per year over the next ten years.  Go figure!

Although you might think that the tough work is behind the government, that’s really not the case.  Paulson has to build an entire organization to manage all of this, and unlike the Resolution Trust Company from the late ‘80s, he will have to draw talent from Wall Street.  We are likely to hear names such as PIMCO and Blackrock, among others, tapped to assist.  This makes a lot of sense, because these are the people who know the most about these mortgages.  However, they are the same people who have billions of dollars of these same securities.  Thus, there is a potential for a huge conflict of interest.  As things unfold, we will try to keep you up to date and look for the opportunities that might be presented by this turmoil.

• Volatility seems to be the watchword, and unfortunately, for the most part, this volatility has been to the downside for the past several weeks - especially last week, when the markets had their largest decline ever.  Fortunately, on Monday of this week, we saw the volatility move to the upside, as some of the overreaction of fear and emotion gave way to the reality that while things may be difficult, it is not the “end of the world”.  Most investors recognize that we have survived significant market declines in the past, including 2000 through 2002, the 1987 crash, and 1973/1974, all in the modern era.  Not only did we survive, but the economy came out stronger and as a result, and long-term investors profited even though the short term was very painful.  Investors sometimes need to be patient, even when it is most difficult. 

Markets tend to move up or down when investors least expect it.  Such is the case now, and we cannot advocate selling investments at this point, turning paper losses into real losses.  We commented throughout the spring and summer that we saw no economic justification for the rapid increase in the price of oil from $80 per barrel to $145 per barrel.  In our mind, there is no fundamental justification for a reverse bubble of the stock prices being driven down as far as they have been.  When oil was climbing, reaching $145 per barrel, many prognosticators were talking about $200 per barrel, and at one point, a price of $500 per barrel was being tossed up for discussion.  In a rising market driven by speculation, there is no “top”, or so the speculators believe.  How would you like to be the trader who entered a contract to buy oil at $145 per barrel, when oil is now selling below $80 per barrel?  Remember, many of these speculators never intended to take possession of the oil – they simply wanted to trade it.  How does this relate to the reverse bubble in the stock market?  In this case, people continued to sell, sell, sell, out of fear and emotion and out of speculation.  The short sellers are betting that they can drive the market down, down, down.  How?  Remember, when you sell the market short, you are selling stock you don’t own.  You borrow the stock from someone else, just like you borrow money from the bank.  You are going to pay the person who lends you the stock some interest, and then you are going to turn around and sell the stock to someone else, let’s say for $20 per share.  Your hope is, when you have to repay the loan, i.e., give the stock back, that you will be able to buy the stock at a lower price (say $12 per share), which means you will have made a profit of $8 per share.  At some point, however, the market finds a bottom and people start buying back in.  When these same short sellers have to buy back the stock they create demand and as this demand is created, the market climbs upward.  If short sellers don’t cover the short sale soon enough, then they face the prospect of losing money because they might have to buy the stock back at more than $20 per share.  

• How quickly things continue to change.  On Tuesday, the government announced a plan to inject capital directly into the banking system.  While the complete details of this plan remain to be seen, in essence, the government will become a preferred shareholder in some of the banks.  They will receive a 5% dividend for the next five years and then a 9% dividend after that time if the preferred shares have not been redeemed.  They also have the ability to exercise warrants to own common shares.  This will give the banks time to find private investors that can replace the government at some time in the future.  Additionally, the government is going to insure all new loans for the next three years and insure non-interest-bearing accounts.  All of these are very significant moves and yes, even we will use the word “unprecedented”.  Let us reflect for a moment on just how responsive the coordinated effort is and has been around the world.  This plan was first announced in England, then other European countries, and now the United States.  The World Bank and International Monetary Fund are behind this coordinated effort.  We can only juxtapose these measures to Japan in the late ‘80s when the government stubbornly refused to do anything and as a result Japan suffered 15 years of stagnation.  Some might argue that it continues yet to this day.

By recognizing the problem and taking bold action, the governments around the world are saying they don’t want this to happen on a worldwide basis.  As interesting and exciting as these developments are, we must keep several things in mind. First, it will take time for all of this to work its way through the U.S. economy, let alone the world.  For every dollar that the government injects into the banks, they should in turn be able to lend out $10 to businesses around the world, stimulating the global economy.  Don’t expect miracles overnight, however.  Also, don’t expect the stock market to go straight up from here.  There will undoubtedly be continued volatility in the markets, but perhaps sooner rather than later, the volatility will have an upside bias.  Finally, and perhaps most importantly, keep in mind the importance of having a diversified and a disciplined approach to investing.

• The problems we are facing are not going to be solved in the next week or two or the next month or two.  It will take time for the market to find an appropriate valuation level and then begin to build on that base as we begin to work off the excesses in the economy and the issues at hand.  Just to put all of this in perspective as to how volatile the markets can be, and to reiterate why market timing is virtually impossible, we simply need to look at Friday, October 10, 2008.  At the low point of that day, the Dow dropped to about 7700.  Of course the day finished down “only” around 140 points, and on Monday, October 13, 2008, the Dow closed at 9387.  This meant that an investor who got out at the intra-day low on Friday due to panic, missed the approximately 20% rebound that occurred in just a day and a half.  Before it’s all over, it’s possible, although we see no economic justification for it, that the recent low will be retested.  In a volatile market, the key is to remain patient and look at the underlying fundamentals of your investments, review your asset allocation, and most importantly, look at your own personal goals and objectives.  If those have changed, then perhaps your target asset allocation needs to change.  If your goals have not changed, then you will be better served if you adhere to your long-term strategy.  Two key words are “diversification” and “discipline”. 

• Over the past several weeks we have issued some Special Interim Bullets as historic events have unfolded.  We will continue to issue interim updates if conditions warrant.  In the meantime, rest assured that we are working hard, applying the collective knowledge of all of our investment team on your behalf.  Please don’t hesitate to call or e-mail us if you have any questions.

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

©10/16/08 ProVise Management Group, LLC

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