Friday, December 19, 2008

The US as The Next Argentina, Not Japan

Earlier this week, on Tuesday, I happened to catch Larry Kudlow's program on CNBC. Among his guests were: Bob McTeer, retired Dallas Fed President, Brian Wesbury, one of my favorite, and a well-regarded economist, and Rick Santelli, the Chicago-based futures and options market reporter for CNBC.

What I heard struck real fear into me.

Kudlow began a debate by relating a sort of 'thought experiment' he had done regarding the Fed's recent actions. He told a story about his days at Bear Stearns, where, every time the Fed cut rates, Larry would joke that he saw palm trees growing on the trading floor- a reference to so-called banana-republic economies. Specifically, Argentina.

McTeer chimed in to agree, as did Brian Wesbury. They all believe that Argentina, not Japan, is the potential role model for what may happen to the US economy and dollar in the years ahead.

This incited a fierce debate with other guests on the segment.

In a related argument, Wesbury noted something genuinely novel and elegant. He opined that, with the Fed pushing rates to nearly zero, there was no way bank lending could expand.

He pointed out that, at a time when risk in the economy, among borrowers, is still so high, and rates are now so low, there is absolutely no way lending can be cost-justified. The risk-adjusted returns to ultra-low interest loans are negative. Wesbury thus observed that the problem isn't a lack of borrowers, but a lack of lenders willing to effectively take a loss on new loans.

He then pointed out how ludicrous was the situation in which banks have been placed by Treasury and the Fed. They are pilloried if they don't lend out the new, unwanted TARP-based 'capital' bestowed upon them by Hank Paulson.

But, if they do make loans at market rates in this environment, those loans will surely go bad, too, resulting in even more balance sheet damage and reprimands from regulators.

Wesbury then reiterated his concern that 'mark-to-market' had not been modified or rescinded, thus causing needless damage to bank and fund balance sheets by overly-severe writedowns of still-performing instruments. McTeer agreed.

Santelli did, as well, picking a fight with a guest, who argued that mark-to-market isn't relevant to the problems at hand. Santelli challenged the guest to buy some of the toxic waste, whereupon the guest said, 'no, because they will eventually be marked down further.'

Santelli then smiled and said that this was exactly his, and Wesbury's and McTeer's point- that because everyone is worried that these structured instruments will ultimately be written down further, nobody will invest in a bank, nor a fund holding such instruments.

Thus, markets are frozen, awaiting the needless writedowns of performing, or even semi-performing assets, due to the self-fulfilling prophesy of a lack of trading markets for said assets.

It was a very informative and densely-packed 15 or so minutes of economic and financial debate. One of the best I've seen in ages.

McTeer continued to back Bernanke's flooding of markets with credit, believing that, at the first sign of inflation, Ben will withdraw said liquidity soon enough to avoid hyper-inflation down the road.

What I took away from the exchanges that evening is that we are, truly, for the first time in ages, in new economic territory. A hideously over-supplied dollar, interest rates too low to be consistent with responsible lending, collapsing asset values now, with a concern over hyper-inflation later.

All very similar to Latin American monetary and economic policies, rather than the Japanese variety. A very chilling prospect for our economic future.

Thursday, December 18, 2008

New Evidence On Consumer Choice & Cars From Bankrupt Producers

Yesterday's Wall Street Journal provided new evidence concerning whether American consumers would still buy cars from producers in Chapter 11 bankruptcy.

The answer is, 'yes,' for 90% of those surveyed. As the article notes,

"A pair of new surveys suggest buyers aren't completely unwilling to buy a car from an auto maker in bankruptcy court, as long as the federal government is willing to play a role in helping the company restructure.

This contradicts the conventional view of Detroit auto makers that suggests consumers would shun a bankrupt auto maker over fears related to the resale value of a car, the warranty and the ability to secure service and replacement parts.

Merrill Lynch & Co. recently completed a study showing 90% of car buyers would consider purchasing a vehicle from a car company in bankruptcy court.

Another survey, by CNW Marketing Research, found 48% would consider buying from a bankrupt auto maker if the company were getting help from the government, but that is up from a previous survey conducted by the Bandon, Ore., company."

Of course, this provides refutation of one of the more forceful arguments with which the UAW, GM, Ford and Chrysler have pursued Federal aid. The Journal provided more detail further on in the piece,

"The Merrill Lynch study, conducted for its clients and which included talking to 500 people, concluded that a "large majority of consumers would consider buying or leasing their next vehicle from an auto maker that is backed by U.S. government funding and may emerge as a strong company, following a restructuring through the bankruptcy process."

Merrill has had a banking relationship with domestic auto makers within the past year.

The CNW Marketing Research survey, of 9,700 domestic car owners completed Dec. 14, suggested 48% of buyers would be willing to consider a product sold by an auto maker in bankruptcy court, as long as the government was involved in the process.

CNW had been the source of an earlier study whose conclusions raised concerns about the impact of a bankruptcy filing on a car company. That survey found 80% of buyers would stay away, and the auto maker's revenue would plunge.

But CNW President Art Spinella said in an interview Tuesday that new research suggests people would feel much better about a bankrupt auto maker's chances "as long as there are loan guarantees by the government."

The results contradict much of what executives at U.S. auto makers and the United Auto Workers argue would be the impact of a bankruptcy on one or more of the companies."

Clearly, a Federal loan for debtor in possession financing would meet this criteria, as would some provision in any package for a separate warranty-funding facility.

Thus, once again, we see that the reasons for avoiding Chapter 11 filings for the US auto makers continue to fall by the wayside under closer examination.

Wednesday, December 17, 2008

Government Intervention's Effects On Risk & Private Capital

Monday's Wall Street Journal featured a very interesting piece in its 'Heard On The Street' column. Entitled "Auto Bailout's Hidden Danger," David Reilly pointed out an insidious aspect of a possible Federal pre-bankruptcy package for the Detroit-based auto makers.

Simply put, Reilly notes that, with Federal involvement causing new uncertainty in the order of creditor seniority for GM and Ford and, in some sense, Cerebrus/Chrysler, such an aid package may further chill any hope of private investment in the sector.

In a manner very similar to that now brought to light by Amity Schlaes concerning FDR's New Deal, such government intervention also brings with it the fear and risk of subsequent Federal legislation which changes the terms of seniority of creditors, or the rights of the Federal government.

For example, it is now recognized that FDR's federalization of power generation, via the TVA, drove investor capital out of that sector for decades.

When the newly-arrived rescuer of a company or sector also has the power to rewrite the laws governing recovery of investment or allocation of loss, it will come as no surprise that private capital may well steer clear of that company or sector permanently.

It's not a trivial matter. Consider what Treasury 'help' did to investors of all the major commercial banks, not to mention AIG. What investor would now be so foolish as to invest in that sector, save for short-term trading gains?

It's a very undesirable, unintended consequence of Federal 'help' for an industrial sector which would, in the end, be so much better-served by joining the rest of American business in using the available Chapter 11 bankruptcy process.

Tuesday, December 16, 2008

Paul Samuelson's Brilliant Idea

As the US finds itself firmly in a recession, with the potential for this phase of the natural economic cycle to worsen before the economy recovers, I am reminded of one standout economic insight, about which I have written before, here and here.

I am referring, of course, to MIT emeritus/retired Professor of Economics and Nobel Laureate, Paul Samuelson's 'accelerator-multiplier' theory.

Regarding the current recession, I wrote in the second linked post,

"Now, however, as Paul Samuelson's accelerator-multiplier work informs us, the same breakneck growth in housing-related spending and lending which drove prices and 'values' up in the expansion, are at work in reverse, coursing through the sector and depressing values.

The values represented by the peak prices of homes bought and constructed were contextual, and have vanished. The real dollars exchanged for those prices did, for a moment in time, also exist.

But the reverse multiplier effect on all these vendors, assets, etc., have destroyed much of the capital created and borrowed to fund these houses."

As this phenomenon from the housing sector spread through banking and into the general economy, I have ruminated recently, at length, as to what factors can turn a deepening recession into an eventual recovery.

What is it that turns a gloomy consumer outlook, vanishing banking assets, shrinking spending levels and spreading joblessness into subsequent economic growth?

The answer, quite simply, was discovered by Samuelson in the 1950s. Inducing cyclicality into a system is often simply the result of including a 'first difference' term. Samuelson's genius was understanding that businessmen and consumers view the 'first difference' between today and some past period- say, a year ago- to judge whether things have gotten better, worse, or are unchanged.

Right now, a look backward shows that volumes are shrinking, so near-term economic behavior echoes this with more belt-tightening.

But in six-twelve more months, business volumes will probably appear flat. This realization will cause businesses and consumers to conclude that the bottom has been reached in this economic cycle. Sales aren't falling anymore, joblessness isn't growing, and economic activity generally has leveled out.

Since this will be a positive change in the rate of change, planning becomes focused on maintenance or growth, rather than more cutting.

Samuelson quantified natural human behavior for economic purposes in a manner never before articulated.

Of course, there is a huge implication due to Samuelson's work on the accelerator-multiplier theory.

It demonstrates a natural cyclicality to economic conditions that cannot be 'fixed' by any sort or amount of governmental intervention. As I noted in the more recent linked post, this is why one-time fiscal 'stimuli' never work. Only permanent tax cuts can deliver a lasting change in incomes that effectively shock the perceptions of businesses and consumers into seeing the present as better than the recent past, so to trigger expansionary activity.

Further, any promises of governmental program activity, e.g., infrastructure spending, won't do much for widespread business and consumer behavior, either. It is simply impossible to arbitrarily, or determinedly lop off the 'recessionary' phase of economic cycles. The latter exist for a reason, and give society the opportunity to clean out unsustainable, unprofitable businesses, recycling their resources for use in better business opportunities.

Not only does Samuelson's work give us confidence that every recession, in effect, automatically brings about its own consequent expansion, but it confirms that this is a necessary phase in national economic cycles.

Bernie Madoff & The "Sophisticated" Investor

This week's panic over the Bernie Madoff investment fraud points out how much of a cottage industry investment management continues to be. And probably will remain.

As a veteran of the business for over a decade, I can attest to the thoroughness with which some potential investors conduct due diligence.

My initial hedge fund partners required me to replicate my strategy's results using their performance data and software system. It was a very clever approach, since I was forced to cede control over the total return data with which, had I been marketing a fraudulent system, I might have fooled them. As it was, their insistence on my reproduction of the strategy on their system resulted in the elimination of some minor errors and some improvements elsewhere in the approach.

In another case, a potential investor required exact times, dates and tickers of equities which I had bought for my personal account, in order to reconstruct my returns, to the penny.

Never did I have anyone simply accept my return series as prima facie evidence of the strategy's effectiveness. At the least, names of the equities held in each period were required, along with a monthly return series.

So it's incredible to learn that Madoff posited a steady, unchanging 1% per month return, and attracted virtually no in-depth investigation from the bulk of his investors.

However, it's not all that surprising to me that Madoff was able to run his scam for so many years.

The keys, it seems to me, were two-fold.

First, by alleging to manage individual accounts, rather than a fund, he avoided any serious SEC inspection and regulation. The allowable minima for a number of accounts managed individually prevents anyone from every really knowing whether you are in violation, or not.

Madoff's insistence on keeping the activity quiet, ostensibly because of his brokerage operation, resulted in nobody ever asking to see regulatory filings on his activities. Or, if they did, the second key to his success came into play.

By beginning with an attitude of, lets be frank, arrogance, Madoff challenged people's self-confidence. Madoff used what my business partner calls the 'club deal' approach. That is, you are favored by a personal contact with the opportunity to 'get in on' a sweet deal. But you have to just sign up and hand over your money- you can't actually delve into details.

Rather, you are supposed to be so flattered with the chance to participate. And, in fact, we have already heard stories of lucky escapes by wealthy but sceptical investors who did ask too many questions, those questions which were either ignored, or the investors were then declined the opportunity to participate.

The list of those who were bamboozled by Madoff grows daily, and even affected investor confidence yesterday, helping the S&P to drop by 1.3%.

As if the last 18 months of financial markets behavior haven't been sufficient to strike fear into equity investors, the Madoff saga seems to be a fitting bookend on which to close out 2008. If not for Madoff being affected by redemptions, like so many other investment managers, his scheme may have run for years into the future.

Apparently some $50B is gone in a classic Ponzi scheme. Some investors with realized gains may even be approached to return the gains. There's no way, at present, to know if any of the reputed performance Madoff ever had was real, or if it was a scam from the very beginning.

I guess, for me, the most amazing stories in the Madoff mess are those once-wealthy people who failed to diversify, and basically gave all of their wealth to Madoff to invest. I don't know the details of Madoff's operation, but, from my time as a registered fund manager, I know that there are safeguards required to prevent the easy looting of client assets in cases like this.

For instance, in the case of private accounts, a custodian institution is usually used. It's not clear if such an arrangement was in force for Madoff's clients. Another typical safeguard is a quarterly statement of holdings in individual accounts.

If these were not used, it shows incredible gullibility on the part of so many wealthy people. If they were, it suggests that Madoff had a lot of help, since these would have been fraudulent statements.

It's still early innings in the case, so we don't know the extent of complicity of various other people who worked in or with Madoff's investment firm.

But the scope of the fraud is staggering. As is the caliber of the people he bilked.

And, sadly, the one thing we know is that it's not the last time this will occur. Jason Zwieg's article in this weekend's Wall Street Journal pointed out how feelings of inadequacy to even ask questions, on the part of most of Madoff's clients, greatly assisted the ease with which his scheme operated. As well as Madoff's judicious use of initial clients to whom others would look up, and, feeling, again, less confident, simply invest without asking questions.

Human behavior seems to have some enduring components through time, and these certainly qualify. That's why Madoff is just the latest in this saga, not, unfortunately, the final chapter.

Monday, December 15, 2008

More Idiocy From Jim Cramer

Last week I saw yet another instance of CNBC's mad- and I mean truly mad- man Jim Cramer's inability to understand logic.

This time, Cramer was arguing with Erin Burnett's reasoned, calm presentation of evidence showing that short selling without the uptick rule has not significantly affected equity markets. And certainly has not 'caused' this fall's market collapse.

At issue was the fact that statistics show no actual, significant downward stock price pressure purely as a result of downtick selling.

Cramer was having none of it. First, he railed against the abolition of the uptick rule. When Burnett presented the data she had read, Jimbo then switched arguments.

Instead of rebutting Burnett's numbers or logic, he said something like,

'Well, there are better ways to drive a stock's price down. Like ETFs and puts. Shorting isn't actually my preferred way to manipulate a stock price.'

Okay. Makes sense.

Doesn't that, on the face of it, put Cramer on Burnett's side? Didn't he just argue that the uptick rule is irrelevant, because shorting isn't even the best way to give a big push downward to stock prices?

Apparently not, because Cramer continued his rant against the rule's removal.

Mind you, the logical next step in Cramer's position regarding options and ETFs is that there is basically no good regulatory solution for stock manipulation because, even without an uptick rule, there are 'better' ways to manipulate stock prices, such ways never having had any rules constraining their usage.

This continued about three times, before Burnett, always smiling, just stopped trying.

I don't watch Cramer at any length or with any regularity. But if this is his brand of reasoning, I wonder why anyone would watch this clown?

The Real Value of A Bankrupt Company's Cars

For the past few weeks, CNBC's mediocre auto- and airline-correspondent, Phil Lebeau, has been shouting to anyone who would listen, that the value of cars made by an auto maker which files for bankruptcy will fall precipitously.

On Friday, he was screaming about the value decline in Oldsmobiles, once GM decided to discontinue the nameplate.

I was talking with my business partner at length on Friday afternoon about the failed auto bailout bill, and brought up LeBeau's continuing assertions.

As I related his ongoing bluster, something occurred to me regarding the entire topic of used car valuations.

Perhaps LeBeau has it backwards.

Maybe the true value of all these GM cars is actually lower than their present value. The only thing propping them up is the thin reed of possibility that the company won't file Chapter 11.

With CEO Wagoner having caused GM's stock to fall from nearly $60/share five years ago to than $4 now, why wouldn't you expect the resale value of the firm's cars to plummet heavily, as well.
To worry about the loss of additional resale value of GM products is really sort of moot at this point. The company is, on a valuation basis, so near dead that everyone knows there is unlikely to be an independent GM in another twelve months.
Thus, any further drop in resale values is probably to their true value, from a current, artificially high value as the firm tries to get Congress to give it a temporary stay of execution.
All this handwringing about resale values and warranties seems to me to be beside the point. Few people buy GM products anyway, and those people must be purchasing GM cars and trucks for reasons other than resale value.
To try to turn well-functioning Schumpeterian dynamics on its head, and refuse to let a failing auto maker, or two, die, because of the likelihood of their products' values falling to their true level, seems ludicrous.

Sunday, December 14, 2008

Aftermath Of The Senate's Defeat of Auto Maker Bailout Bill

On Friday of last week, with the news of the Senate's defeat of the Detroit auto maker bailout bill, a curious thing occurred.

GM prepared to file a Chapter 11 bankruptcy, as CEO Rick Wagoner declared that the company has insufficient cash with which to operate until a more assured rescue comes, after January 20.

Now, according to Forbes, Wagoner was paid $4.82MM in 2006.

Yet, for an assumedly similar amount this year and last, what did shareholders get?

A CEO so inept that he failed to file for bankruptcy, to reorganize GM, last year. So incompetent that he forced the firm to run through nearly all its cash before seeking court protection to reorganize and renegotiate any and all contracts- union, dealership, suppliers, etc.

Instead of behaving like a real CEO, and having his staff observe, then plan for contingencies stemming from the 2007 credit market troubles, Wagoner dithered on as usual.

Having now run GM almost entirely out of liquid assets, he baldly blames Republican Senators and the President for his firm's bankruptcy.

This is rich, indeed.

A better-run firm would have headed into the safe harbor of Chapter 11 last year, when the gathering clouds of financial crisis and debt market unraveling gave warning of trouble ahead.

No, not GM. Not Wagoner.

In their playbook, all troubles which GM has recently faced are due to Washington, or the credit markets, but none of their own making.

Not even from their sins of omission- failure to notice a crisis looming, and failure to seek Chapter 11 court protection, in which to sort out their mess.