LRG Capital Report by Larry Goldfarb

Is It Time To Get Back Into Real Estate?

Over the past decade or so, long term investors who have followed the herd, whether it was in high flying internet stocks, or more recently buying homes as an investment in hopes of turning a quick profit have been burned.  The massive amounts of liquidity and cheap rates initiated or overseen by the Federal Reserve fueled not one, but two bubbles, the likes of which have not been seen in generations.  Prudent asset managers were forced to compete with speculators boasting of impressive, yet short term returns.  As we all know now, the dramatic rise and fall of the residential real estate market threatened to take down not only the US financial system, but the global economy as a whole.  We will leave the question of whether or not the government’s response to this crisis was appropriate for another day.  The reality is that the government chose a course of action which includes massive amounts of printing and borrowing of money in an attempt to ease the stress on banks.

In simple terms, an investor can allocate resources to five different asset classes.  These include stocks, bonds, commodities, real estate, and currencies.  As the turmoil in the residential real estate market begins to subside, and the economy as a whole begins to digest the various stimulus packages provided by the government, investors should adjust their portfolios accordingly to benefit from and guard against oncoming inflation.  Despite the negativity surrounding the real estate market in general, we believe that attractive opportunities can be found in certain regional commercial real estate markets for the medium to long term investor.

The ability of real estate to provide a hedge against inflation is one of the primary arguments for including the asset class in a diversified portfolio.  Research on the question of the inflation hedging ability of real estate generally shows that when markets are experiencing equilibrium, the lack of rental space alternatives provides negotiating power for the landlord.  By contrast, during periods of high vacancy rates, the negotiating power transfers to the tenant who will have options available to move and/or lower rental expenses.  Thus, it is important that the investor consider what kind of companies and industries inhabit a given region and will be positioned well for turnaround growth.  For example, since the current downturn has centered on the financial community, major money center metropolitan areas such as New York City will most likely not benefit greatly from inflation unless a new industry quickly emerges to fill the void left by the financial companies who are forced to cut costs and downsize.  It is our view that regions which are not heavily concentrated in finance should only see a temporary weakening of rental demand as the economy works its way through the recession and recovers more quickly.  With a long term view in mind, we believe that the 2009 inflation rate will remain moderate at best while beginning to pick up steam in the latter half of 2010 at which point the Federal Reserve will have a tough decision to make around raising interest rates.  We do not believe that the Fed will be able to raise interest rates in 2010, even with higher inflation, due to fear of damaging the recovery and causing a double dip recession or worse.  Therefore, the next 12-18 month period should provide an excellent window to find value in select commercial real estate markets.

Most analysts agree that technology companies, which spent the last 8 years cutting costs and raising cash due to the bubble burst of 2001, may be one of the strongest sectors to emerge from the current recession.  In addition to tech, well diversified regional economies with access to the global supply chain, including and especially commodity transportation and the global trade network, should stand to benefit from some of the strongest growth as the economy begins to improve.  Finally, regional economies with a high concentration of small business entrepreneurs and professional services should also perform well in a growth scenario.   We are beginning to see parallels between the commercial real estate market today and the values seen after the recession of the early 1990’s.  With interest rates at a 40-year low, massive fiscal spending by the federal government, and unemployment rates now beginning to stabilize we believe the time is right to invest in commercial real estate in well-positioned markets.  However, as value investors, we know that sometimes good prices can turn into outstanding prices with a little patience.  There is no substitute for doing the research and diligence necessary for making a good investment.  That definitely holds true in this market. 

Earlier this month, Paulson and Co., a hedge fund which made billions by correctly anticipating a crumbling housing market, said that it would buy $100 million in stock of commercial real estate services firm, CB Richard Ellis Group.  Additionally, the hedge fund company is in the early stages of raising “a couple of hundred million dollars” for a fund focused on a medium- term property recovery.  The smart money has always known to enter the marketplace when fear is at its highest.  By including commercial with residential real estate, the financial media and misinformed analysts and investors have created an artificially high risk premium for commercial properties.  The big difference that many people aren’t recognizing between commercial and residential real estate is that the hype and annual median price increases seen on the residential side were not seen in commercial real estate.  After almost two years now of monthly declines seen on the residential side, and some overheated markets such as Florida and Nevada falling as much as 40% from their peaks, we believe the downturn in housing has finally begun to stabilize.  And with major commercial operators such as General Growth Properties declaring bankruptcy, the supply of quality properties at good prices are plentiful.  Commercial property investors should not expect a straight ride up, but we do think most of the risk of investing in commercial property is already in the price.  And there are good reasons to believe that today’s opportunity to invest at decent yields won’t last forever.   

If You Think Things are Getting Better, Think Again

With the market continuing to move higher in recent weeks, the onus lies squarely on the bulls now to produce evidence of an economic rebound in the coming months.  The powerful rally in global equities has forced the staunchest bears to take notice of, at the very least, rising asset prices and a thawing out of credit conditions.  Throughout this rally, the major theme we have heard from the bulls is that “the pace of the decline is slowing”.  But does a slower rate of decline necessarily warrant a near 40% move off the bottom for the S&P 500, one of the biggest moves in the history of the index?  Are we really starting to see “green shoots” in the economy like the media says and the government would like us to believe?  Unfortunately, due to the massive government intervention in the markets, asset prices may be improving, but the global and domestic economy are still very weak, and don’t look like they can improve anytime soon.  With the astronomical amount of money the Federal Reserve has thrown at the economy, it’s no surprise that asset prices have been moving higher in recent months.  The total amount spent by the government, in addition to all of the loan guarantees, 0% interest rates, and treasury purchases is in now the range of 5 to 6 trillion dollars   To put this into perspective, less than 8 years ago our entire national debt was 3 trillion dollars.  It is my strong view now, that sooner (rather than later) the markets, most likely the currency or bond market or a combination of both, will force the Treasury and Federal Reserve back into the same precarious position of making the tough choice they should have made almost a year and trillions of dollars ago, which was to just let the market work this mess out on its own, so the country and world can truly begin the process of rebuilding.  The unintended consequences of the actions the government has chosen to embark on are just now starting to show in our economy through the troubles seen at the regional banks, or the continued funding and pension crunch in the state and local governments, and of course the daily decline in the dollar that we are all getting used to now.   Not to mention the overwhelming evidence of a credit card implosion that can further derail economic recovery.  While we applaud President Obama’s new efforts on the credit card pandemic, no one wants to really open the Pandora’s Box of the staggering amount of principal credit card debt that will never be repaid.   In my opinion, while the markets may have improved, the improvement was mainly due to the money printing by the Federal Reserve and is not reflective of the real economy which is still very weak and struggling with mountains of debt at the household level.

For those who haven’t read my previous post which refers to a potential currency crisis at home and abroad, please do so.  Already at the time of this writing, Standard and Poors is warning that the United Kingdom may lose its AAA credit rating and rumors abound that the US is next.  Immediately on these rumors, yields on US Treasury debt spiked higher to prices we haven’t seen in almost 6 months.  This is in the face of Mr. Bernanke’s continued bond purchase plan in an attempt to keep rates low.  The cat is now out of the bag.  The entire world knows now that the US and UK will do whatever it takes to save already insolvent banks, including and especially devaluing the currency.  Readers of the LRG Capital Report knew the time would come where US debt would come under pressure but that day has come quicker than anyone has expected.  We are now pushing our forecast for an outright currency crisis to sometime this fall or winter as the world begins to slow its purchases of US Dollar denominated assets that are losing money due to a declining currency.  We would caution investors who believe, like our friends at the Fed and Treasury, that a devalued currency would increase exports and stoke just the right amount of inflation.  The truth is that throughout history governments have NEVER been successful at what the Fed is attempting (reinflate a bubble without causing high inflation in other areas of the economy).  In fact, now the odds are more in favor of higher prices for food and energy and interest rates.  The cross currents the market has shown recently have been extremely negative.  The normal movements we have been used to since 2001, (or about the time the dollar began its secular decline) was on days the dollar falls, stocks would move higher due to higher commodity prices and in turn more profitable energy sector.  Over the past week or so however, we have seen the dollar decline, but at the same time commodity and US stocks falling.  This has mainly been due to the rumors that the US will lose its AAA credit rating (due to excessive debt and money printing by the government) which in turn would make it more difficult for everyone, government and private sector included, to borrow at favorable terms.  I want to personally congratulate Mr. Bernanke for potentially ruining the dollar, and now bonds, and thus the equity markets to save Wall Street. 

As far as the real economy is concerned, we must now wait and see just what kind of recovery we should expect.  We have been told by the Federal Reserve and Treasury that we should not expect to see jobs come back any time soon.  A recovery without jobs is like a birthday party with no cake.  The truth is that over the past year or so it has been the state and local governments that have done most of the new hiring.  Now, as Californians know all too well, some states are facing huge deficits and some face cash shortages.  After delaying state refund checks earlier this year, the Golden State is on the verge of running out of cash again as early as July.   With the resounding defeat of Props 1A and 1E, voters essentially told lawmakers that its time for them to finally take responsibility for their budget and stop the tax increases.  The idea of raising taxes or borrowing more money only to delay the inevitable is complete lunacy.  Three areas where the state needs to address its problems are the overpromises on pensions, union wages and a bloated budget.  The day of reckoning for decades of wasteful spending has arrived for California as well as other state and local governments across the US.  Until these structural problems are addressed by legislators, we are only delaying a worse outcome down the road.

Finally, the free markets seem to be working with respect to the Chrysler bankruptcy and inevitable General Motors bankruptcy.  Maybe the real green shoots are that the bankruptcies of Chrysler and GM (as they are bankrupt) are now showing what markets are supposed to do: stop rewarding failure so smart and productive industries, whatever they may be, can successfully compete on any level.  I applaud the Obama administration, along with the executives and counsel at Chrysler who are moving at warp speed to complete the Chrysler bankruptcy.  It’s hard to imagine that a company with the size and reach of Chrysler could complete a bankruptcy filing within 30 days, but they seem to be pulling it off.  Bankruptcy has always been the best course for both Chrysler and GM.  This will allow the companies to truly restructure labor contracts that don’t make sense and in GM’s case, may even allow it to possibly survive as a functional company.  Without bankruptcy, it will just be the same old, same old and we the taxpayers will be forced to continually fund the company’s shortfalls. 

Two Steps Forward, Three Steps Back

US stocks closed up for the sixth week in a row last week, marking the steepest six-week gain since 1938.  The S&P 500 had gained 29% since reaching a 12 year low of 666.79 on March 6th.  Washington has officially thrown the kitchen sink at the global economic crisis with measures that will have long term consequences that no one can really imagine at this point.  Various new measures aimed at “fixing” the banking system have included everything from yet another AIG bailout, to the Fed finally unleashing its plans to buy long term Treasury bonds to keep interest rates low, to a long awaited ruling and subsequent change to the way banks have to value assets on their balance sheets.  With all of the cheerleading going on in the media, it seems like happy days are here again.  And the change in character of the market can’t be ignored, with the momentum clearly now on the bull’s side.  For example, after an absolutely horrendous unemployment number was released showing that the unemployment rate rose from 8.1 % to 8.5 % in March with 663,000 jobs lost, the market opened down, only to be met with buyers who managed to push the market higher and finish the day up.  A month ago, we would have sold off on a jobs report number like that- but now the dip was bought.  So have we really bottomed?  Have the Fed and Treasury finally managed to get it right after getting it wrong for over two years?  Is the change in mark-to-market accounting really the “game changer” as our friends in the media have been proclaiming?  Probably the best answer to this question lies with the man in charge of the US economy, Ben Bernanke, who hinted that last month that nation can expect to see 10% unemployment “for a period”.  Indeed, I believe that the Fed’s reckless actions in an attempt to save the banks at any cost have not only made overall economic conditions worse, but have thrown the country into a recession not seen since the 1930’s.  I’m going to go out on a limb here and say that equity investors should expect more selloffs in the year ahead, and far lower lows in the overall market.  As evidenced by Bank of America’s earnings report, banks balance sheets are still littered with these toxic assets that have yet to be fully written down and are continuing to worsen due to the deteriorating economy.  Whether the market’s downturn will fully resume one month from now or one year from now is anyone’s guess, but the imbalances that have been created in the foreign exchange and debt markets will, at some point, spread to equities.

A closer look at the unemployment data shows that the job losses are now intensifying with almost two-thirds (3.3 million) of the total job losses  (5.1 million) since the recession began in December 2007 occurring in the last 5 months alone.  In addition, the job losses were large and widespread across the major industry sectors.  The service sector in particular, an area of the economy which held up relatively well in past recessions, lost 358,000 jobs as more and more business’ and consumers found it more difficult to refinance or get access to loans as failed banks continued to hoard cash in an attempt to repair their balance sheets.  The official unemployment rate is 8.5% and rising.  However, if you start counting all the people that want a job but gave up, all the people with part-time jobs that want a full- time job, and all the people whose unemployment benefits ran out, the more accurate number for the unemployment rate is closer to 15.6%.  These numbers do not point to a recovery in any way and if anything only should ring the alarm that a second wave of debt default, this time in consumer and credit card debt might just be under way.   With earnings season upon us, we can expect to see more and more companies miss estimates as we all know just from looking around that business activity has fallen off a cliff.  Additionally, we should begin to start hearing the results of Treasury Secretary Geithner’s stress test for the banks.  Keep in mind the rules for this stress test are that the banks that don’t need capital pass the test, whatever that means.  While the banks that do not pass the test, become eligible for MORE Federal Aid.  Thus the stress test is nothing more than a way for the Treasury to funnel more taxpayer money to failed banks.  Even worse, the public will not be allowed to know which banks passed and which banks failed the stress test.  Instead, we the taxpayers are just supposed to sit back while billions of dollars are absolutely wasted on programs that have not shown to be effective (unless you are an employee at Goldman Sachs, Morgan Stanley or any other bank that is an indirect recipient of federal funds).  For example, AIG’s bailout now totals in the $150 billion dollar range, of which a majority has gone to payoff side bets by counterparty banks, most notably Goldman Sachs.  What a nice spot for Goldman Sachs to be in to have all of its competitors ( Bear Stearns, Lehman Brothers, Merrill Lynch) disappear while having the backing of the US government and the money printing presses all working in your favor.  This is all truly illegal and a travesty to say the least. 

Going back to the subject of the economy, debt deflation is a long and painful process.  In the future we can expect more volatility as the economy tries to recover, only to see inflation move higher and weaken the economy further.  In the short term, while some areas of the economy begin to stabilize, the recoveries in those areas will be dampened by the effects of price increases in other areas of the economy, specifically in food and energy.  The result is a two steps forward, three steps back phenomena as any economic growth will be choked off by higher prices.  This will undoubtedly lengthen the downturn and spread its pain.  We expect inflation to really pick up four years from now after the full downward pressures from the recession have abated and we begin to see real economic growth (not the money printing we are seeing now).  Because of the rare nature of this recession, and Washington’s choice to continue with the failed policies of more debt and inflation to get us out of the crisis, the lack of job growth will most likely result in a second round of stimulus, much more federal capital for the banking system and stunning budget deficits.

In a 60 minutes interview, Mr. Bernanke said that many people have suggested that we should just let the banks fail.  The metaphor he used to explain how he is handling the Federal Reserve and how the Treasury is handling this crisis is that “when there is a fire in the neighborhood, you should do everything you can to put that fire out so that it doesn’t destroy the entire neighborhood”.  The Feds most recent action to inject capital into the system is through a method called quantitative easing in which the Fed will expand its own balance sheet (a balance sheet that is kept private) and go out in the open market and buy long term treasury bonds to keep rates interest rates down.  This action is essentially “printing money” or creating money out of thin air.  It has never worked in the past, (most notably it has failed in Japan, where a decade long stagflation has taken hold of the economy). Other examples of countries that have used quantitative easing are France and England in the 18th century.  This time around, instead of the banter coming out of the monetary authorities being “let them eat cake”, the line should be “let them have 5 year option ARMs with no down payment”.  Not surprisingly, the day the Fed announced that it would buy up to $300 billion of Treasuries, the dollar had its worst day since 1985, dropping an astonishing 4.8 % against the Euro alone.  Currencies, especially reserve currencies like the dollar should not move this quickly under any circumstances.  In reality, this was a de facto devaluation of the US dollar and a sign of more to come.  Over the past month and a half, during the almost 30% “rally” in stocks, the dollar fell over 12% against a basket of 6 other major currencies.  What the Fed and Treasury have done is nothing more than creating a mirage that will simply not last due to the disintegrating jobs picture.  Going back to Mr. Bernanke’s comments on using all available resources to put out the fire in the neighborhood, my interpretation of the situation is a bit different. By printing money, debasing the currency, and trying to inflate away debt, the Fed is hurting the poorest members of the society.  Inflation has always been known as the cruelest tax of all because it hurts those on a fixed budget the most because prices everywhere are rising.  Instead, the metaphor that I would use to describe the policies coming out of Washington are more like this:  “There is a fire going on in the neighborhood, and it is heading towards the most affluent portion of the neighborhood, so what we will do is burn down the poor people’s houses around the neighborhood to create a fire line that will prevent the fire from reaching the rich people's houses”.

The More Things Change, The More They Stay The Same: How to Swallow the Poison Pill and Survive

In my previous posts I have always used a lot of economic data to back up any points I’ve made, this post will be slightly different. I am so furious about what is happening that I’m going to speak honestly about what I think is going on and focus less on the details.

Our brain trusts in Washington DC just signed an additional $789 billion stimulus package into law with members of Congress having little or no time to read it.  The bill consisted of 1419 pages of creative ways to spend your money on everything from infrastructure projects to healthcare.  The media hailed the bill’s passage as a victory for the Obama administration.  The market on the other hand, seemingly has different views.  The S&P and Dow indices have been crushed ever since the Obama administration took office. The Dow is less than half its record high and the S&P is at a 12 year low.

We hope that the Obama administration is realizing that no matter how much money they say they will spend (attained through taxes or by borrowing from other countries), or how many different “plans” they come up with, they aren’t getting any closer to the solution. It seems that Washington is not yet ready come to terms with the fact that the best and inevitable course of action would be for it to just step aside and let the market quickly and efficiently (albeit painfully) find its equilibrium.  The politicians need to remember that the governments’ job when it comes to commerce and markets is to keep the playing field fair (which they seem to be incompetent at, think Madoff, Stanford, and so on).  Continually propping up failed companies, especially without understanding the business plan or valuation is simply making things worse.  With Citibank now trading at basically zero and the recent announcement that taxpayers are taking a 36% stake in the company (a deal that no prudent businessman would make), and Bank of America not much farther behind,  how do we know that Mr. Geithner and President Obama won’t do the same with the rest of the nation's banks?  As the stock market continues to plunge day after day, we hope that a light bulb is starting to go on in Washington that the current course of action will not work. As we have said in previous posts, throwing money at the problem will not make it better and it certainly hasn’t worked so far. 

It’s now obvious that we are ever so slowly nationalization our banking system.  The unfortunate thing is that most of the responsible people in Washington understand what happened in Japan, and Switzerland, and the numerous other banking crisis throughout history, yet they still pound away at the idea that “something needs to be done” in regards to our nation's banks.  No matter how big, or how much money they plan on spending, the market has more money and power than any politician, lobbying group or central bank. A few readers have asked what is wrong with propping up failed banks, or “zombies”.  Besides the moral and social aspects of playing favorites to save a certain industry group or company over another (basically the well connected or those were able to lobby the hardest), the economic consequences are far reaching. What was previously an industry that thrived on capital raising to give an entrepreneur the chance to build a business, is now a shell of itself unable to take the risks which in some cases need to be taken to expand the economy. The one good side effect that might come out of all this is the greater scrutiny of the bailed out banks and auto companies in terms of bonuses, perks, golden parachutes and parties. What makes me nauseous is that a tabloid TV show called TMZ broke the story of Northern Trust’s lavish parties including concerts by Sheryl Crow and Earth, Wind and Fire (right after they reported on Nicky Hilton eating at IHOP) before The Wall Street Journal even got wind of the story.

In a sense, by having the government take a position in the banking industry we are institutionalizing risk aversion.  It’s a vicious cycle that could lead to years of slow growth, falling capital expenditures and little or no recovery in employment.  It’s no coincidence that the second Obama announces the new budget with another $750 billion of taxpayer money slated for bank rescue the stock market takes a nose dive.  Politicians should let go of the idea that they have the power to control the markets and allow true equilibrium to be found. Not to mention, the taxpayer money and resources that have been spent in executing these plans.  By the way, has anyone figured out what happened to that first $350 billion tranche that the Bush Administration was in charge of towards the end of last year?  Or is that ancient history? 

In addition to stifling the banking sector, another problem with the stimulus package is that, in effect, it treats healthcare as a cost problem instead of a growth industry.  The healthcare and biotech industries are a group that we follow closely at LRG Capital Group.  Stifling innovation through legislation in these industries in an attempt to reduce cost is a dangerous idea that will not only hurt the industry’s profits, but also the ability for it to provide safe and reliable healthcare.  There are many ways to cut costs in the healthcare industry, with the first being the number of people the plan intends to deliver healthcare to. This is a dangerous road to go down for this Administration and the way they are addressing the inadequacies of the industry have the potential to make things worse. Maybe we must deal with the fact that life isn’t fair and even though it would be great to provide healthcare to all right now, it would bring everything down to the lowest common denominator and everyone will lose out.

In further digging our economy into a deep hole, President Obama’s nomination of Tim Geithner was by far the worst pick for his administration.  Besides the folks at the SEC, it would be tough to find another person who could receive more blame for the lack of regulation and foresight than the President of the New York Federal Reserve at the time, Mr. Geithner.  Perhaps no one had a better view of what was going on during the boom years on Wall Street than Mr. Geithner. And to make matters worse, since his plans have gone so well in “repairing” the banking industry, President Obama has added Mr. Geithner to an inter agency task force that will help determine the fate of the auto industry.  This is the same auto industry where Toyota and Honda are able to build cars profitably in the United States, while the domestic car manufacturers struggle with legacy costs and poor management decisions that they hope to dump on the taxpayer. 

With all of the rhetoric and promise of hope and change coming out of the Obama Administration, the appointment of Mr. Geithner proves that the more things change, the more they stay the same.  With the market making new lows yet again, the Treasury Department issued a statement that Secretary Geithner is planning to release yet another plan for the banking industry.  Some are now speculating that some form of nationalization would be necessary at least temporarily.  The “Swedish Model”, would call for a temporary nationalization of the weakest banks, auctioning off assets while cleaning up the failed banks’ balance sheets.  Most importantly, we hope the plan will FINALLY set out a framework that would reveal the extent of the likely credit losses facing the banks.  In a sense, the markets failure to respond in a favorable manner to all of the previous plans that were put together since the crisis began, has forced policymakers to admit total failure of those plans, and do what should have been done a long time ago, which is to have the banks completely come clean about what they are holding on their balance sheets. Hopefully we are prepared to swallow the terrible and painful pill of reality and begin the healing process. 

Since the domestic economy and the global economy, in our view, are dangerously close to implosion, I’d like to, as my last point, draw a very grave parallel between the recession and a serious illness that, in some way or another, has probably affected each one of us: cancer. A diagnosis as serious as cancer requires a quick and forceful plan of action, working to heal the patient (the economy) not just make the symptoms (the recession) go away. There is simply no way we can play Wizard of Oz and close our eyes, click our heels and wish and forecast the problem to go away, which in many ways is what we have seen the previous and current administrations attempting to do with the recession. The only cure our government has tried thus far is to feed the recession with as much money as taxpayers can handle (or not handle?) and the cancer only seems to grow. A doctor comes up with a treatment plan with varied methods of combating the illness and similarly our president needs a list of completely different treatments for our economy. Just as most doctors would quickly check off a method that wasn’t working, Obama must dismiss the idea that more and more taxpayer money will help. It’s time to move onto the next treatment option. As everyone knows treatment of such a serious problem will be difficult and extremely painful, so we are perplexed as to why people think that finding a true end to this recession will just be a mere pin pick. Once we can accept that the treatment for this recession will really hurt, we can abandon the “easy” way out and get down to really fixing our economy. Sometimes you have to stop all growth, good and bad in order to stop the cancer from growing before the healing process can begin and the same may be true of the economy. Here’s the cure to the recession we believe in (definitely a painful one): finally writing down all the assets, wiping out equity and debt in companies that owned troubled assets, treating Americans’ addiction to over-leveraging their lifestyles and start saving instead. Swallow the horrible pill and start anew.

In closing, Obama’s most recent treatment attempt, the stimulus package, we find it looks more like a disguised Federal Budget than anything else and is basically more of the same.  This package attempts to treat the symptoms of the recession not provide a cure. The moral of the story is that the administration and Congress need to realize that people are watching what they are doing now more than ever before.  People are struggling and suffering today in ways that haven’t been seen in decades.  The end of the President’s elected term of four years may seem like a long time away from now, but if the new administration and the entire Congress for that matter want to keep their jobs, the time has come for some straight talk and solutions that we all know will take some sacrifice on all our parts.  While sound bites, speeches and promises of a reduced deficit can play well with the media, they will do little good to get us through this mess if the government isn’t ready to face the reality of the pain we all are going to experience by writing down bad assets and extinguishing equity and bad debt of falling companies. It’s the only way we will truly be able to begin recovering from years and years of folly and excess.

-Larry Goldfarb

The US Banking System is Insolvent, The Fed Has Become a Conglomerate and Other Famous Sayings

As the United States celebrates the coronation, (oops, we mean inauguration), of President Obama, we remain amazed that there is a misguided view that a new Presidency and New Year are going to magically cure the severe economic crisis the world is facing today.  To be fair, President Obama has staffed his administration with some of the most brilliant economic minds of both past and present, and we applaud his choices thus far.  We are also happy to hear that President Obama has completely backtracked on his campaign promises of raising taxes, and is now solely focusing his team’s efforts on restoring confidence and growth in the economy through some form of stimulus package. It is our belief that the market was waiting for details of Obama’s stimulus package and when none were announced yesterday in his speech combined with the announcement of more dire economic data the stock market lost 330+ points closing below the 8000 mark. It is our hope that this stimulus package once detailed will create jobs, temper inevitable inflation and that the administration, unlike the failed TARP, will require banks to write down their bad loans and make banks lend again.

However, one of the myriad of major economic challenges facing the new administration is its ability, or lack thereof, to say no to companies who come to the trough asking to be bailed out.  The US financial crisis may reach $3.6 trillion in losses which is a serious problem as the US banking system only has $1.4 trillion in capital. We continue to have two of the largest financial institutions lining up for handouts. On one hand, there is Citigroup which has already received $45 billion of government capital and a US guarantee on $306 billion in troubled assets while unwinding its once famed “supermarket” financial model with the impending sale of its brokerage division to Morgan Stanley, another bailed out bank.  Bank of America, on the other hand, said that it will need more government aid to help absorb its pending purchase of Merrill Lynch blaming what they are saying are “previously undisclosed losses” from the Merrill Lynch transaction and have threatened to kill the purchase altogether.  The Treasury Department, which we have renamed “The Shoot, Fire, Aim Department” went ahead and made an emergency injection of $20 billion, on top of the $15 billion and $10 billion Bank of America and Merrill has already received respectively.  From our financial simpleton perspective, both Citibank and Bank of America have received MORE government money than the current market capitalization of each company.  Citibank’s market capitalization is approx $19 billion, yet it has received $45 billion in aid thus far; Bank of America’s market capitalization is $36 Billion, and it has received $45 billion. 

The situation with Bank of America may prove to be uglier than that of Citigroup. When the news came out in September that Bank of America had agreed to purchase Merrill Lynch, we could tell that there would be problems down the road.  A quick view of a chart of Merrill Lynch’s stock at the time showed that the company was on the verge of imploding just the way Bear Stearns and Lehman Brothers did.  Yet Ken Lewis, the CEO of Bank of America, believed there was value in Merrill Lynch and made a decision, along with his Board of Directors, to step in and purchase Merrill Lynch.  Did we all forget that back in 2006, at the very height of the housing boom, Bank of America purchased Countrywide Financial and is now stuck with its pool of highly toxic mortgage assets? Or should we say the US taxpayer is now stuck with?  Maybe Ken Lewis was purchasing Merrill Lynch with the hope that people would forget about Bank of America’s previous blunder. Now, only three months after the announcement of the Merrill Lynch deal and in the shadow of the Countrywide Financial mess, Bank of America has successfully stuck taxpayers with the bill again.

In our opinion, the charade at Bank of America has gone too far and is borderline illegal.  It was only the mammoth size of the company that gave it the leverage to put pressure and basically threaten the US government by saying that if the company did not receive aid, the risks to the economy would be unthinkable (doesn’t that sound familiar?).  It is time for Ken Lewis and the Board of Directors at Bank of America to step aside.  The ideal situation would have been an orderly liquidation of both Bank of America and Citibank letting the incompetent banks fail, rather than having the Fed prop them up, creating “zombie banks” owned by the US taxpayer.  Lets not kid ourselves, taxpayers clearly already own Citibank and at this rate will probably soon own Bank of America as well. The excessive risk-taking and greed by the banks and their executives must be accounted for.

Governmental and financial industry blunders aside, one of the most frightening things about the situation we are facing today is that there is still very little understanding of how we got into this mess.  The lack of understanding, in both the public and private sector, is hurting our chances of recovery.  We do not believe Americans know where their tax dollars are being spent.  For example, Citigroup is now using supertankers to store oil off the coast to profit from a commodity trading phenomena called “contango”, where buyers pay more for delivery of crude oil in this case, later in the year.  With this action, Citigroup is not only blatantly risking more capital, but the company is also using taxpayer capital to store oil which is taking supply off the market, which in turn raises the prices of oil causing taxpayers to pay higher gas prices.  And naturally, anything one bailed out bank can do others will follow: Morgan Stanley is now seeking a similar oil storage arrangement. 

If spending, borrowing and inflating too much money got us into this mess, it’s hard to believe that the same things can get us out.  The Federal Reserve has become too involved in central planning through, amongst other things, the manipulation of interest rates and nationalization of various US industries when what we need right now is too restore confidence that a market economy works.  The 20th century proved that central planning doesn’t work but here we are printing more money, taking on more debt and nationalizing our banking and other industries.  The Federal Reserve is trying to prop up the bad debt and dump it on the taxpayer and they don’t realize by borrowing more and more money they will be crowding out the same consumers that they are trying to induce to borrow long before they can ever repay them. The longer we delay the liquidation and write down of outstanding debt, the longer the agony will be. Had the Fed just decided to stay out of the market, and let the market find its own equilibrium, a new private sector banking system would have emerged by now that could have filled the void the Fed has decided to fill on its own.

We hope that the Obama stimulus package will create an economic environment of saving, job creation at home and outpace inevitable inflation, rather than borrowing from abroad to finance spending.  We believe that it will take two to three years of pain and depressed economic activity before we see an increased level of savings and a recovering US consumer.  We have to remember that we are working through the wreckage of what is the biggest credit bubble in history and the shock to the financial system is severe but we will be better off for it in the long run.  The less the Federal Reserve and Treasury interfere with markets and private sector, the quicker we can begin the recovery process.  We are hopeful that President Obama and his staff, unlike the previous administration, will do the right thing for the American people.  God Bless!

Beware of the Car Czar and Other Communist Terms

Last week, the National Bureau of Economic Research, a private nonprofit group of economists, proclaimed what everyone knew, except our elected officials, that the United States was now officially in a recession and has been since December 2007.  The economists continued in saying that the US economy, may be in the midst of the longest slump in the post World War II era.  The good news is that the longest economic slumps since 1945 were the 16 month downturns that ended in March 1975 and November 1982, and if the current recession began in December 2007, we are already 12 months into the downturn.  The bad news is that this current recession seems to be accelerating as evidenced by the latest unemployment figure which showed that over 500,000 Americans (and this figure is probably very understated) lost their jobs in November alone. In fact, US companies slashed payrolls in November at the fastest pace in 34 years. So far, job losses for 2008 total over 1.91 million which translates to an unemployment rate of 6.7 percent.  Most economists are now forecasting that the recent job figures suggest that the economy shrank at an annual rate of 5 percent in the final three months of the year.  To fight the downturn, President Elect Obama is promising an economic stimulus package including government spending and tax cuts that will range in the $350 billion to $500 billion range.  Included in the package would be much needed help for homeowners and the largest public works spending program in over 50 years.  Of equal importance is that Mr. Obama has backed off his campaign claim of raising taxes on the richest American households (taxing capital in the midst of the worst downturn since WWII would have made a bad situation far worse).  Mr. Obama finally admitted that the economy will get worse before it gets better.  This is not exactly surprising with the auto companies begging for money in Congress along with a real estate market where one in ten American homeowners, sub prime- or prime, have now either fallen behind on their mortgage payments or are in foreclosure.  We, of course, remain confused that despite all these factors the markets have rallied from time to time, albeit on low volume.

Over the past week we were treated to more theatrics on Capital Hill with Congressional leaders baffled and amused at the reckless mismanagement in the auto industry.  How a company like GM, for example, whose current market value is just under $3 billion, can ask for a taxpayer funded loan in the amount of at least $15 billion is a travesty in itself.  The enormous sums of money being thrown around have turned the bailout story into more of a political comedy than a business issue. It’s becoming hard to keep track of all of the different bailouts:

• TARP: Troubled Asset Relief Program. This is the Treasury's big $700 billion ($850B including pork) program that has been used to prop up financial institutions.

• TAF: Term Auction Facility (or TAFfy). Program by which the Fed auctions funds to financial institutions — allowing them to use their toxic assets for collateral.

• TALF: Term Asset-Backed Lending Facility (or "son of Taffy"). Recently announced Fed program designed to help the market for student, auto and other consumer loans.

• CPFF: Commercial Paper Funding Facility. Buys commercial paper directly from corporations.

• AMLF: Asset-Backed Money Fund Lending Facility. Fed program designed to buy short-term paper (including commercial paper) to prevent money market funds from "breaking the buck."

• TSLF: Term Securities Lending Facility. Fed program that lets banks swap bad mortgage and other debt from their books in exchange for Treasuries. 

• SLF: Special Lending Facilities. Originally designed to loan money to fund JPMorgan's purchase of Bear Stearns in March. Also used to back AIG's balance sheet to avoid total collapse.

• PDCF: Primary Dealer Credit Facility. This is the Fed program that allowed broker/dealers and other non-banks to tap the Fed's discount window (back when there were independent broker/dealers).

And with the auto bailout a forgone conclusion, we would recommend the newest program be called the Bailout Auto Relief Facility or more simply, BARF.

The failure of the auto companies should lie squarely on the executives, unions, and parts suppliers who are participating in an industry that is basically making non-cost competitive and inferior products compared to its competitors. It’s also fair to ask the question, are these really car companies, or are they finance companies that happen to make cars?  We find it laughable that the auto industry executives are calling this a global problem when we haven’t seen Toyota or Honda at the trough asking to get bailed out. It’s also disheartening to see lawmakers, such as Barney Frank, use the unemployment figure as a red herring to plead the case for bailing out the auto industry. 

Despite bailout after bailout, and failure after failure, we still haven’t heard anyone take any accountability or apologize for the mismanagement and lack of foresight at either the public or private level.  Instead, we are getting excuses as to why they should stay on as chiefs of their failed entities and even receive bonuses in some cases. Unbelievably, the CEO of Merrill Lynch, a company that is only still in existence because of a shot gun wedding to Bank of America, asked for a $10 million bonus, only to back off the request after public outcries of disgust.  And of course, the joke of the year, seeing the auto executives, hat in hand, asking for money from the taxpayers, but arriving at the hearings on company funded private jets.  The list goes on and on exemplifying just how out of touch these executives and politicians remain.  They just don’t seem to get it.

For the rest of the world, especially China, who holds the majority of US government debt, the question of who is really going to pay for all of these bailouts is being raised.  To boot, China just announced that its exports in November fell for the first time in more than 6 years, showing that China is hardly immune to the global economic crisis.  It’s mind boggling why anyone would lend money to the US government for ten years at below 3% when we are rapidly spending money we do not have (although amazingly the recent Treasury auction sold at an all in negative interest rate- probably not a good sign for equities if people are paying the US government to hold their money for them rather than invest in the equity market).  And to make matters worse, a recent Government Accounting Office report said that the TARP “is lacking on internal controls, inadequate monitoring of bailed out banks, and no real way to figure out if the TARP is working” at all.  We aren’t smart enough to know when it’s going to happen, but at some point, there will be a day of reckoning where foreigners will simply not go for this any longer and the US will really be backed into a corner.  It is becoming more evident; that a huge bout of inflation caused by a weaker dollar will be upon us over the next few years- you can only print so much money…..      

And yet, with seemingly one bad headline after another, the stock market, from time to time, is able to shrug off the bad news and muster interim rallies.  Interestingly enough, the day the horrific unemployment figure was released, the S&P 500 ended the day up 3.65 percent, with the Dow Jones Industrial Average and the Nasdaq posting similar gains.  If there ever was a silver lining to the “ Great Recession of 2008", it would be that energy prices have fallen faster and further than anyone could have predicted, just in time for the holiday shopping season which is by far the most important time of the year for retailers. Crude oil, for example, has fallen over $100 per barrel since July to close at a four year low, staying well within the $40 -$50 per barrel range. The fall in oil prices has resulted in a welcomed drop in gasoline prices which now average $1.77 a gallon nationwide, also a 4 year low. Fuel has now fallen 57 percent since a high reached in July. For the consumer, this drop in energy prices feels like a tax cut of sorts which leaves him or her more disposable income to spend or save in other places, although we believe that inflation will eventually kick in and all commodity prices, including oil will skyrocket.  Be very, very wary that this short term ease in energy prices will stay with us for long given all the monetary and fiscal easing the Fed and Treasury have pumped into the system.  As stated, we are predicting that oil is going to be higher than ever.  With the major US stock market averages down as much as 40% from their highs, a short to medium term rally can be expected as sellers begin to wane and buyers start to proclaim the markets as oversold and/or cheap. Bear market rallies are treacherous in nature since a countertrend move to the upside can be extreme, with moves of over 30 percent being common. The rally phase after a serious decline will frequently lead to a false sense of security and confidence in the investment community “that the worst is over” because stocks are rebounding sharply.  Probably the most famous bear market rally in history is the rise which took place following the October crash of 1929.  After the October 1929 crash, the market had become oversold, much like today.  The Federal Reserve cut the discount rate and government spending programs were created to help repair the economy. In the next four months, from November 1929 to April 1930, the Dow Jones Industrial Average rallied 48% from its lows. In fact, between 1929 and 1933, during the Great Depression, the Dow saw eight different bear market rallies with over double digit percentage moves higher only to finally bottom in July of 1933 at one tenth of its 1929 value.

The stock market and economy can diverge for months or even years in some cases as investor sentiment shifts from greed to fear and vice versa ( a la the recent wild up and down swings).   It is highly unlikely, however, that given the depth and breadth of the housing downturn, credit crunch, and subsequent bank failures, that we have turned any corners.  A rise in stocks, while a welcomed event, should be viewed with caution.  The buy and hold mantra works well in a bull market, but in a global slowdown and bear market such as the one we are seeing today, a more active money management approach must be taken.   

 As we close out 2008, our hearts go out to all the people who have been hurt by the negligence and greed of Wall Street and our politicians. Despite what all the talking heads and pundits say, the facts speak for themselves: we are going to have to live through the pain of spending money that we did not have for years to come. No one has even yet to fess up to the huge problem of unsecured credit card failures. Main Street USA is struggling right now in ways that haven’t been seen in generations. This holiday season, perhaps more than ever before, supporting charities of your choosing could be the best long term investment one can make.

Happy Holidays

Larry Goldfarb   

The Election is Finally Over. Now Wake Up- We Got Problems

Last week, after over a year and a half of campaigning, the United States of America elected its 44^th President, the junior Senator from Illinois, Barack Obama. Once again, the economy took center stage with most voters. In a pre-election survey by CNN/ Opinion Research Corporation Poll, 57% of the likely voters polled in the nationwide survey said that the economy was the most important issue to them in deciding on whom to vote for President. In the end, President elect Obama’s campaign theme that a vote for his opponent would be a vote for a continuation of the failed policies of the current administration was too much of a headwind for his Republican counterpart. With some of the lowest approval ratings for an outgoing President in history, President Bush didn’t leave much of a chance for whomever his party chose to run for the high office. Thankfully, the election is finally over, with a clear cut winner who will have to deal with once in a generation issues both economically and politically.

 

It’s important to understand that although a new face in the White House can certainly change the mood and social climate of the nation, it will take a long time for the economy to heal from years of financial mismanagement and readily available credit. Although some may look to the S&P 500’s 10% drop since last week as a sign that President Elect Obama is somehow doing something that the market does not like, the truth of the matter is that most market participants had factored in the Obama victory and its effects on the economy a long time ago. What is more important to look at is that the overall market, as measured by the S&P 500 is down close to 40% since it peaked out in October 2007 at a high of 1576.09, a clear trend of either a new bear market, or what many have argued as a continuation of the secular bear market that begin in the year 2000. Indeed, over a ten year span the S&P 500 is actually down by just about 10% (on October 12, 1998 the S&P 500 closed at 997.71 vs. October 12 close of 852.3).  Certainly though, the health of an economy is not measured by stock market returns, but rather it is measured by the plight of the everyday worker (we’ll call him Tim the Teacher for the purpose of this exercise) who is now struggling with debt, rising costs, and a deteriorating job outlook.

 

A simple view of this past quarter’s earnings reports shows just where Tim the Teacher is spending or not spending his money.  Last week, Seattle based Starbucks reported that profits plunged more than 96% in the last quarter as the company closed stores in the US, where same store sales were down 8%.  So certainly, Tim has replaced his morning lattes with something more cost effective. Along those lines, if Tim the Teacher could no longer afford his morning coffee, his spending habits on other items, especially his favorite electronic gadgets would also have to change. Just last week, Circuit City, the best performing stock of the 1980’s, filed for bankruptcy citing “increased competition”. And yesterday, Best Buy cut its own forecast for the year saying that this is “the most difficult climate” ever. Additionally, the auto industry has been in decline for over a year now, with even the better run companies like Toyota and Honda decreasing their forecasts. Of course, as we know, the economic pain is stemming from the deteriorating housing market which is still showing steep declines, with the S&P Case- Shiller index posting record year over year declines of 16.6%. Declines of this magnitude do not turn on a dime, or from a new President, rather they will usually take months, if not years to find, a price where the necessary buyers can meet the selling pressure. So where is Tim the Teacher spending his money these days? One needs to look no further than the golden arches.  Just last week, McDonalds reported that sales at its fast food restaurants open at least 13 months rose 8.2% in October, topping analysts’ targets and sending shares up more than 2 %.  Same- store sales, a key gauge of retail health, rose 5.3% in the US.  After years of zero savings, and spending borrowed money, frugality is now coming back into fashion. 

 

The new administration is going to have to make some extremely difficult decisions over the next few months that will impact hundreds of thousands of people. Unfortunately, the Federal Reserve and the folks in Washington have shown that their preferred option of fixing the problems is to throw money at it.  Whether it be low interest rates, increased money supply, or bailouts that reward failure, policy makers are now faced with an increasing problem of just what industry is critical enough to the nations economy that it justifies receiving taxpayers funds. This month, General Motors said that it will need some form of a bailout over the next 100 days as the company is facing a cash shortage. Already the talk out of Washington is that “allowing” a company such as GM, Ford or Chrysler to fail would be irresponsible and cause major disruptions throughout the economy. An analysis of GM, in particular, shows that the current veteran UAW member has an average base wage of $28.12 an hour, but the cost of benefits, including pension and future retiree health care costs, nearly triples the cost to GM to $78.21, according to the Center for Automotive Research. $78 an hour would be an excellent wage in high priced areas such as San Francisco or New York, but is there really a reason someone in Detroit, for example, where the cost of living is much lower than those areas should be receiving such a high hourly wage? Is it the taxpayer’s problem that GM negotiated contracts with its Unions that are unsustainable? For us, the answer is clearly that it is not, especially seeing that Toyota and Honda are now also producing cars in the US and are doing so profitably. 

           

We are going down that slippery slope that the founders of this country warned us about at its inception. In a letter to the Secretary of the Treasury Albert Gallatin (1802), Thomas Jefferson wrote,

 

“I believe that banking institutions are more dangerous to our liberties than standing armies. If the American people ever allow private banks to control the issue of their currency, first by inflation, then by deflation, the banks and corporations that will grow up around [the banks] will deprive the people of all property until their children wake-up homeless on the continent their fathers conquered. The issuing power should be taken from the banks and restored to the people, to whom it properly belongs.”   

           

Bailouts do nothing more than reward failure and cause a misallocation of capital from profitable to incompetent industries and people. We have entered a time where there is essentially no shame in failure and asking for handouts from the government. By using public funds to prop up failing companies the government is basically robbing Peter to pay Paul. Unfortunately, Congress opened the Pandora’s Box and now companies are lining up saying that their industry is critical to the health of the nation. The effect of all this bailout spending and increased money supply will eventually result in higher interest rates, a devalued currency, and higher commodity prices.  All factors which will result in more pain and hardship for the consumer. It’s simple economics that a nation cannot devalue itself into prosperity.  Unfortunately, elected officials only see the economy in 4 year terms, or their own personal re- elections. If debasing the currency, through propping up failing companies and the jobs at those companies, will allow the politician to keep their job, than that’s what he or she will do.  Hopefully, the new administration will put a stop to some or all of this madness and not give us the same kind of spin that we have become accustomed to. The Fed and banks can pump enough money into the economy to put the Dow to 100,000, but in real terms, or against gold for example, it will not feel like much of an accomplishment when it will cost $10 for a gallon of gas.

-Lawrence Goldfarb

Sources: http://money.cnn.com/2008/02/12/news/companies/gm/ 

Welcome to Socialism

For those of you who have not read my last blog, which was posted on September 11, 2008, please do so. Last Monday, September 29, 2008 a few brave congressman in the US House of Representatives voted against a $700 billion bailout package that was hastily put together by the US Treasury office and the Federal Reserve. In the days leading up to the vote, pressure was mounting on Congress from both sides of the debate. On the one hand, Congressional staffers were reporting that their phones were ringing off the hook from constituents telling them that if their elected officials voted for the bill, they would not vote for them and help mobilize a campaign against them the next time they would run for office. On the other hand, Congress had to keep in mind a rapidly declining stock market and financial executives and Wall Street telling them that if they did not vote for the bill, a financial meltdown of epic proportions would result. That morning, the market opened with a downward bias, and worsened as the day went on as the votes were starting to show that the bailout package would not be passed. The final tally against the measure was 228 to 225, with 133 Republicans turning against President Bush, the Treasury and Federal Reserve. By the end of the day, Dow Jones Industrial Average posted its largest point decline ever and the S and P 500 had its worst day since the 1987 crash. World stock markets quickly followed the US markets and by the end of the day, approximately $1.7 trillion was lost in markets around the globe. 

 

In the days following the vote, the Bush Administration vowed to put together and pass another form of a bailout package. Proponents of the bailout, including President Bush, Henry Paulson, and Ben Bernanke argued that without a bailout the US would face a “severe recession”. Leaders outside of the US were also quick to criticize Congress’ no vote on the bailout calling it “partisan and irresponsible”. The media, in usual fashion, sensationalized the volatility in the markets and instead of reporting the facts, began saying things like the US was headed for another Great Depression if a bailout wouldn’t get passed soon. Both the cable and network news channels were filled with guests proclaiming different versions of the doomsday scenario that would occur if the Congress would fail to approve the bailout. The public was lead to believe that if a bailout wasn’t passed, “farmers would not have access to capital, unemployment would immediately shoot up to 30%, and small business would not be able to make their payrolls”. The last statement in particular seemed especially puzzling to us as we began to wonder what kind of business needed to borrow money on a weekly or basis just to pay its employees?  Enter Arnold Schwarzenegger.  On Thursday, October 2^nd, the eve of the vote of the revised bailout plan, the Governator wrote in a letter that, “ California had been locked out of credit markets for the past 10 days”, and that “payments for teachers’ salaries, nursing homes, law enforcement and every other state- funded services would stop or be significantly delayed”. Certainly, with a dire warning coming from the Chief Executive of the worlds 5^th largest economy, the pressure was fully on Congress again to pass the new version of the bailout. On Friday, October 3^rd, 2008 Congress voted overwhelmingly by a 263-171 vote in favor of the bailout. 

 

When we first started this blog, we wanted to stay away from politics as much as possible and keep the focus on the markets. Obviously, with the events of last week this was not going to be possible. The ramifications of using taxpayer’s money to prop up failing companies will be felt for generations, and it is a foregone conclusion that there will more bailouts to come in the future. At last Thursday’s Vice Presidential Debate, Governor Palin was quick to deflect any remarks about her parties record over the last eight years by saying that voters are tired of looking backwards and want to start looking ahead as we tackle the challenges facing the country today. While we are in no way endorsing either candidate, because the truth is that both parties have failed the country miserably, the kind of thinking coming out from Ms. Palin is a big reason why we are in the horrible state we are in today. A quick look back at the last century of financial crisis’ shows that the path lawmakers have chosen to take to deal with this crisis is going to hurt more in the long run, with rising inflation and a debased currency, than the other alternative which would be to let the market clean the system out. $700 billion later, and in just three trading days after the revised bailout bill was passed, the S and P 500 has fallen over 10%. Although there is a possibility that the market will rally over the next weeks and months, the fundamental problem facing the markets, which is and has always been the decline in home values, has yet to be addressed by lawmakers. Like the good supply siders that they are, the Bush economic team and now Congress is putting the focus on the financial sectors ability to lend when in reality they should be focused on the consumers need to safely borrow. 

 

In a recent interview, Nouriel Roubini, an expert on financial crises suggested a few measures to restore confidence in the economy which include replacing Treasury Secretary Hank Paulson and Fed Chairman Ben Bernanke. Additionally, Mr. Roubini believes in starting a “$300 billion government works program focused on repairing and expanding our infrastructure”, or a “new, New Deal”. Lastly, Mr. Roubini thinks that the government should “provide blanket FDIC insurance on all deposits, without limitations, as there is still $2 trillion of uninsured assets in American banks and that money is moving to places like Ireland, which have granted blanket guarantees”. We are again in agreement with Mr. Roubini and are hopeful that the government begins to look at the demand side of the equation and the consumer. 

 

The ban on short selling in particular is a great example of just how government regulators and other “people in the know” are hastily trying to artificially support the market and causing more bad than good in the process. Thankfully this restriction is being lifted, but in the meantime, the move has caused hedge funds to liquidate positions, which has led to a cascade of selling and redemptions. Additionally, by banning short selling the government caused a vacuum to the downside in the equity market by not allowing profitable short positions to be bought back, which would have added liquidity and support to stocks. And in the “we’ll see how this works” category, today the Treasury announced yet another plan which would allow it to inject capital directly into banks instead of buying the banks illiquid assets. What a nice feeling it must be for a the management of a company to know that it can take as much risk as possible because if things don’t work out, the government will be there to support the company with endless taxpayer money.

 

While we are on the subject of policy, we found it very troubling that in the same week the US and most major western financial markets banned short selling for certain companies, Chinese regulators opened the door to short sellers in their own markets.  In addition, in the same week that the US passed the bailout package to prop up failing companies and assets, China put a man on the moon. It would be difficult to explain to someone just from these two examples alone which country promotes a free market economy, and which is Communist. Or which country inspires its citizens to think that anything is possible rather than one that uses excuses to help the privileged and wealthy members of its society in times of distress. 

           

In closing, we would like to put away the idea that the sky is falling and world is ending with a chart of the yield curve, (or the spread between long and short term interest rates).

 

Although we understand that the short end of the curve is being chased after at the moment by investors seeking safety, it seems that the bond market is much more optimistic about the future state of the economy than the media or bailout passing lawmakers and Wall Street would like us to believe.  Remembering that up until early 2007, the curve was inverted, which over the past 50 years has correctly forecasted 8 out of the last 10 recessions, and with this current recession should make it 9 out of the last 11. The current slope of the curve is normal, upward sloping, which most likely means that the enormous stimulus that the Fed has pumped into the system should be enough to at the very least stabilize the economy. What that translates for the stock market is anybody’s guess over the very short term, but in terms of the economy, the sky is definitely not falling. Any new attempts by bank executives (and ex bank executives who now work at Treasury) to secure new capital from taxpayer money for failed risk taking, should be viewed as self serving and untruthful. We have all had to deal with financial turmoil in our lives in some form or another. Unfortunately, most of us don’t have the direct phone numbers to the heads of Treasury and Federal Reserve and neither should bankers who should have known better than to take on the kinds of risks they did.

www.lawrencegoldfarb.com

 

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Bravo Nouriel Roubini! It’s better to be smart than popular: Is this the end of the American Empire?

As we all know, the US Treasury Department introduced a plan to nationalize Government Sponsored Entities (GSE) Fannie Mae and Freddie Mac.  After months of rumors and the back and forth of the costs and the effect of a bailout on the system, the Treasury announced its plan to bailout the companies using up to $200 billion in taxpayer money ($100 billion for each GSE).  In its current form, the bailout is already the largest in the history of the world.  In mid-August, the New York Times printed a story about Nouriel Roubini, aka “Dr. Doom”.  In the article, the New York University Professor explains why he has been so pessimistic about the US economy over the past few years in the face of many of his peers, how he predicted the housing bust and current recession, and why he is still negative about the short and medium term outlook for the economy.  The article closes with Mr. Roubini saying that the US “will likely muddle through the crisis but will emerge from it a different nation, with a different place in the world. ‘Once you run current-account deficits, you depend on the kindness of strangers,’ he said, pausing to let out a resigned sigh. ‘This might be the beginning of the end of the American empire.’” Unfortunately, with the events of the past weekend, and the inability and unwillingness of our nation’s leaders to confront a problem before it arises, it is very difficult to disagree with Mr. Roubini’s predictions. 

 

What started out as a “subprime problem” has turned into a credit crisis that has wiped out trillions of dollars in home equity and threatens to plunge the global economy into a recession or possibly worse.  The decision that the government had to make was not an easy one.  On the one hand, they could have let the market decide what would happen to the companies, which would most likely have been bankruptcy and a default of the Fannie Mae and Freddie Mac implicitly guaranteed debt, which is mostly owned by large institutions and foreigners.  The ramifications of this could have been disastrous in the sense that if foreign governments started to question the United States’ ability to repay its debts, there would be a massive sell off in US treasuries and the dollar. According to the New York Times article, “Roubini argues that the Fed’s actions averted catastrophe, though he says he believes that future bailouts should focus on mortgage owners, not investors”.  Contrary to Roubini’s view, the government decided to use taxpayer money, to inject capital into organizations that are effectively bankrupt because of years of poor management and risk controls.  In effect, 300 million Americans are being asked to pay for the financial risks that were taken on by reckless borrowers, lenders and Fannie and Freddie bond investors. 

 

Many view this unprecedented move as another example of the Federal Reserve and US Treasury coming to the aid of Wall Street and the well connected, while Main Street struggles to pay its bills.  Where we go from here is anyone’s guess.  The government is hoping that the added liquidity will spur lending and prop up the housing market.  If nothing else, the plan does give the government more control over mortgage interest rates which have been decoupled from Treasury Bond Rates for a few years now.  However, the idea that the bailout will spur demand for homes and stabilize the housing market is an entirely different story.  Going back to the New York Times article, Roubini explains, “…we have problems with credit-card debt, student-loan debt, auto loans, commercial real estate loans, home-equity loans, corporate debt and loans that financed leveraged buyouts.” All of these forms of debt, he argues, suffer from some or all of the same traits that first surfaced in the housing market: shoddy underwriting, securitization, negligence on the part of the credit-rating agencies and lax government oversight. “We have a subprime financial system,” he said, “not a subprime mortgage market.”  Add a rising unemployment rate, and rising costs pretty much everywhere else, on top of all of that debt, we believe that US consumers are most likely going to take a good hard look before they decide on a new mortgage. 

 

After the bailout of Bear Stearns in the March of this year, it became evident that the US government and the Federal Reserve were not going to allow certain banks to go bankrupt because of fears of “disruptions to the system”.  Another excuse for a bail out that Henry Paulson actually used over the weekend is that the companies “are just too big too fail”.  It is difficult to argue with the Treasury and the Federal Reserve’s views about the ramifications of banks of the size of Fannie Mae and Freddie Mac failing, but there is a fundamental and moral hazard when you subscribe to this line of thinking.  Exactly what size constitutes a bank that is “Too Big To Fail”?  Perhaps this is a good idea for a new fund category at Goldman Sachs?  You have your Small Cap Funds, Mid Cap Funds, and now the Too Big To Fail Fund.  Which would you want to invest in?  

 

On Tuesday, Lehman Brothers stock fell over 40%, the biggest one day drop in the history of the company after talks about a capital infusion from Korea Development Bank ended.   It is becoming more difficult for the banks to raise new capital now because the counterparties are watching seemingly conservative and knowledgeable investors lose a lot of money quickly.  The New Jersey Government Pension Trust Fund, for example, on June 11, 2008 made a $180 million investment in Lehman Brothers while the stock was trading at $28 per share (yesterday’s closing price was $7.25, and today it’s trading as low as $4.00).  The news out of the company yesterday wasn’t any better with an earnings report that included a $7 billion write down, and no real plan for the future, it will be interesting to see whether or not the company fits into the “Too Big Too Fail” category.  And if you are a Lehman Brothers employee, you are thinking why not at this point. What is so different from Lehman Brothers than Bear Stearns?  The irony of it all is that Alan Greenspan, Ben Bernanke, and Henry Paulson all come from a free market, Laissez Faire school of economics that preaches entirely against government intervention because it is known to be very unlikely to work.  Ben Bernanke in particular is an expert on the Great Depression and Japan in the 1990’s.  He has written articles and books that highlight the dangers of what can result when the government and central banks become too cozy with the financial sector during a financial crisis.  Now that he is at the helm of the Federal Reserve, it seems that making the correct policy decisions is taking a back seat to bureaucracy and politics.

 

Moreover, the size of the combined Fannie Mae and Freddie Mac portfolios merit a much bigger bailout than the one put together by the Treasury.  On paper, Fannie Mae and Freddie Mac have obligations estimated in the $5.5 to $6 trillion range.  A $200 billion injection is only going to keep them afloat for a limited time.  The government is betting that a) the economy will strengthen from here on out, and b) that the consumer will be willing to borrow again.  With August unemployment figures coming in at a whopping 6.1% , and an increase from the previous month that hasn’t been seen in years, the Treasury’s odds for winning this bet seem slim.  In addition, there are still billions, if not trillions of dollars in Adjustable Rate Mortgages that are due to reset beginning later this year.  Lastly, the plan over the next year or so is to wind down or reduce the size of the portfolios of Fannie and Freddie which is going to make it harder for new homebuyers to get a loan, the exact opposite of what the bailout was supposed to do.  Luckily for Mr. Paulson, he has already stated that he will not be coming back to serve at the Treasury no matter who wins in the Presidency.    

 

We agree fully with Mr. Roubini’s views, and LRG Capital Group’s various portfolio managers have been in agreement with him for years now.   We can’t keep borrowing from abroad and hope for the best.  The bailout will help to stabilize the economy for now, but it is no cure.  The tradeoff was either to take the pain right away, or have it drag on over a long period of time.  The government chose the latter.  It will cost more and will take longer to resolve.  The last country to go through a similar situation of credit unwinding was Japan in the 1990’s.  The Japanese now infamously call this period “The Lost Decade”.  We are just now seeing the result of years of financial illiteracy and recklessness.  Anyone who believes this crisis is nearing an end has their head in the sand.  It’s time to finally listen to Professor Roubini.   

www.larrygoldfarb.com or www.lawrencegoldfarb.com

History Repeating Itself: Sovereign Wealth Purchases of US Landmarks

In May of this year, the nations of Qatar and Kuwait joined a consortium of investors including Boston Properties, Morgan Stanley and Goldman Sachs, to purchase the General Motors Building (pictured below on the left) and three other skyscrapers totaling $3.95 billion. The GM building on its own was sold for $2.9 billion, making the transaction the most expensive sale of an office building in the world. Last month, the Abu Dhabi Investment Council purchased a 90 percent stake of the Chrysler Building (pictured below on the right) in New York City for an estimated $800 million dollars. The landmark building is regarded as a masterpiece of Art Deco architecture and considered by many contemporary architects to be one of the finest buildings in New York City. For a brief time, it was the world’s tallest building before it was surpassed by the Empire State Building in 1931. 

  

 

                       

As commodity prices continue to rise, countries rich in natural resources stand to gain a surplus of capital and will have to find a place to diversify their new found wealth. This is especially true for the oil rich nations of the gulf region who are raking in profits with oil hovering at levels not seen in decades. Only time will tell whether or not these investments prove to be successful, but this isn’t the first time foreign nations with a surplus of cash have started snapping up US landmarks. Unfortunately for the foreign investor, history has shown that many of these trophy purchases have turned out to be colossal mistakes.

In the 1980s, Japan was in a similar position as the oil producing nations are in today.  The combination of a thriving export market, coupled with a strong tariff policy on imports, pumped up the yen and led to a massive buildup of cash for the country. The result was an era of easy credit, which ultimately fueled a stock and real estate bubble that rivaled any other in history. At one point, the common claim was that the land beneath the Imperial Palace in Tokyo dwarfed the value of the entire state of California.  Within years, wealthy Japanese investors bought such iconic properties such as the Rockefeller Center and the Pebble Beach golf course. Other investments included Universal Studios and Columbia Records. 

 

The Mitsubishi Estate purchase of the Rockefeller Center Properties is a good example of just how quickly these high profile deals can go wrong and how staggering the losses can be. The problem with overheated economies is that they seem to lose their steam at the worst possible time. When Mitsubishi acquired its interest in 1989 for approximately $1.4 billion, the Nikkei 225 index topped out at around 39,000. By September 1990, the index was cut in half and a decade long recession was to follow. At the same time, the Manhattan commercial real estate market, which for years was viewed as a solid investment, began to falter. The original estimates that enticed Mitsubishi to the deal called for rents in the complex to reach $75 a square foot by 1994. Instead, by 1992, rents in other prime- spaces were dropping to less than $30 a square foot. With a deflationary recession at home, and decreasing commercial property prices in Manhattan, Mitsubishi was forced to push the Rockefeller Center into Chapter 11 bankruptcy protection by May 1995. 

 

Japanese investors spent $78 billion on US properties between the late 1980s and 1995. The total losses from these transactions are estimated between $38 and $62 billion. The current commodity boom is no different from what happened in the 1980s with Japan; newly minted millionaires from commodity rich countries are going to have to find a safe place like the US to invest their petrol-dollars. The biggest difference being that the current US recession is proving to be extremely tricky to navigate to the extent that the financial sector and real estate losses are anyone’s guess right now. There will, of course, be opportunities to invest safely and make good returns, but investors should be very wary and do their own due diligence before making any decisions. As with the last boom in the 1980s, there’s a new crop of bankers and lawyers that will be eagerly waiting to collect fees on trophy deals that may end up costing much more in the long run. 

 

 

 

This post was co-written by Yaron Shamash

www.lawrencegoldfarb.com

Sources:

http://www.moneymorning.com/2008/02/18/outlook-2008-three-ways-to-profit-from-sovereign-wealth-funds-the-next-wall-street/

http://money.cnn.com/news/newsfeeds/articles/apwire/1760bbaaca688542155948f589bfa338.htm 

http://www.businessweek.com/bwdaily/dnflash/content/feb2007/db20070214_271962.htm

http://online.wsj.com/article/SB121572293118743655.html?mod=googlenews_wsj

http://en.wikipedia.org/wiki/Pebble_beach

http://en.wikipedia.org/wiki/Japan-United_States_relations

http://www.nytimes.com/2008/05/25/nyregion/25gm.html?_r=1&em&ex=1211860800&en=e3c5a9497473dc1b&ei=5087%0A&oref=slogin

http://www.moneymorning.com/2008/07/17/the-lost-decade/

http://www.contrarianprofits.com/articles/the-lost-decade-how-the-us-financial-crisis-resembles-japan%E2%80%99s-ten-years-of-misery-and-how-to-play-it/3893/2