GM's Wacky Sales with Partial Recourse

Over the past few weeks, government-controlled auto maker GM has been running a somewhat bizarre commercial on cable television.

A blue-collar line worker smilingly tells the viewer that GM is such a friendly, gentle industrial company that even if the purchaser of a GM vehicle loses his/her job, the firm will forgive a generous amount (I think it is up to $500) of the buyer's monthly payment for, again I believe, six months.

The GM worker extols the company's kinder, softer new image that cares so much for their customers.

To me, the commercial showcases so much of what is wrong with GM. Desperate to sell cars, they are now getting involved with dodgy buyers, assuming recourse on the loans and entangling themselves in the financial instability of others.

This is precisely the sort of nonsense that you get when the federal government meddles in the private sector. If I'm not mistaken, the feds have also become the ultimate guarantor of GM warranties.

How about GM just trying to sell cars straight up, as is, with no special financial incentives? Shouldn't we get a sense of whether anyone actually wants the firm's cars, and at what prices?

Heaven's knows how much more liability the firm is now incurring by promising payment relief to customers who may lose their jobs in the next year or so. It's hardly a model for a near-dead firm to employ in order to stagger back to life.

Welcome To The US Centrally Planned Economy

Early this month, I wrote this post concerning our government's involvement in GM's crisis, and its increasing role in planning the US economy with its selective bailouts and intrusive actions. I wrote, in part,

"It is simply wrong for our federal government to engage in such massive intervention as to be lending private-sector companies money, in hopes of avoiding their demise.

How can our government possible know, better than the natural forces of our markets, that the best use of, for example, some building in Flint, Michigan, is as a GM plant, rather than the new home of some entrepreneur's business?

Isn't this what the Soviet Union tried, and ultimately found to be inefficient, unworkable and a failure for most of the 20th century?

Who among us truly believes that our federal government is more skilled than consumers and investors in the selection of those business which ought to survive and prosper?

Government isn't the right institution to select our economy's winners and losers. For that, we have a process which we have trusted for most of our country's life- our freely-operating, private capital and consumer markets."

Then, just yesterday, I read the Wall Street Journal's article describing our president's recent economic address. The piece quoted from the speech,

"We must build our house upon a rock. We must lay a new foundation for growth and prosperity- a foundation that will move us from an era of borrow and spend to one where we save and invest; where we consume less at home and send more exports abroad."

I don't know about you, but I find it chilling that a president is decreeing what our economy's allocation will be between consumption and investment, domestic consumption and exports.

As I noted in my prior post, the Soviets tried this from the 1930s until their country failed, economically, in the 1980s. Centrally planning never worked, except in a limited sense during wartime, as was true in the US.

But that was only because government essentially prohibited consumption of capital goods and many foodstuffs, in order to use such items for war production.

It's also ironic that the largest spending bills and increases in our deficit occur under someone who claims to be returning America to a 'save and invest' ethic.

It's preposterous. And our prior president didn't do us any favors, either, both by failing to veto excessive Congressional spending and by engaging in multiple, unnecessary sector bailouts at taxpayer expense.

Among the 'five pillars' of the current president's envisioned new US economy mentioned in the article are: "renewable energy investments to create jobs and lessen the nation's dependence on imported oil."

Again, I am frightened that a government official thinks he can better judge the correct mix of US energy usage, pricing and employment than can the numerous firms which constitute that sector.

America has succeeded for centuries by employing prices as signals to either accelerate or decelerate investment in various sectors, technologies and activities. Why should we now depart from this practice and succumb to government-mandated targets other than prices?

Does any thinking person really believe that civil servants without experience better know how to run our energy sector and plan our energy usage than all of us, consumers and producers, by engaging in normal activities, in light of market price signals?

A Brainless Immelt?

GE has been running this green energy technology ad for some time.



Every time I see it, I cannot help thinking of hapless, inept GE CEO singing the lyrics,

"If I only had a brain."

Seems both ironic and fitting for the firm to use such lyrics in its commercial.

Now I'll have this image of King Jeff I as a brainless scarecrow at GE board meetings.

Anyone have a match?

Returning TARP Money: The Case of Goldman & BofA

Back in the fall of 2008, after the Bush administration urged Congress to pass the TARP legislation, then-Secretary of the Treasury Henry Paulson made clear that government investments in preferred equity of weak financial institutions was to be temporary.

Now, in the spring of 2009, we learn that Goldman Sachs and BofA, both wishing to repay the TARP money that the government requested them to take, must have permission from the feds to do so.

How did this come to pass?

Why would there need to be any permission given? If a bank can pay back its TARP funds because it has either made profits or found other investors, that's a good thing.

If, upon repaying the TARP money, a bank is essentially insolvent or has inadequate capital, then the Fed can find it so, and have the FDIC close it.

This afternoon, on Fox News, Judge Andrew Napolitano noted how curious it is that, as BofA CEO Ken Lewis wants to repay that bank's TARP funds, the SEC is suddenly investigating an allegation that Lewis and the BofA board knew of the Merrill Lynch bonus payments and failed to inform shareholders prior to their vote to approve the acquisition.

Napolitano laid out other relevant details, including the Fed's and Treasury's pressure on Lewis to make the acquisition, despite Lewis' reticence, concern over capital adequacy and due diligence.

Now it looks like there will be a full-scale fight between BofA, the SEC, Treasury and the Fed as to who knew what, when.

In the meantime, according to Napolitano, BofA's desire to get rid of the federal government as an investor is being met with the SEC investigation as a form of coercion.

Many have opined that the center of American finance has moved to Washington from New York. Given what is occurring with Goldman and BofA as they reasonably attempt to repay their TARP funds, it's troubling to see that much of what governs the US financial sector has become more political than economic or financial.

Sources of Goldman's Profit

The Wall Street Journal lead in this morning's Money & Investing section features yesterday's better-than-expected quarterly profits by Goldman Sachs.

According to the article,

"Driving the earnings was record performance in the fixed-income, currency and commodities division, where the trading of products tied to interest rates and strength in commodities helped generate $6.56 billion in net revenue, a 34% rise from the comparable period last year. Those results offset a downturn in investment banking and money management."

I don't presume to be a CFA, but I can read financial statements, and have fairly extensive experience in the financial and banking sectors.

The activities in which Goldman made most of its money last quarter are essentially trading, not lending in nature. That is, they are somewhat transitory, probably heavily proprietary, and do not reflect the bulk of what is supposed to be the 'new' commercial bank Goldman Sachs.

Yes, even old-line commercial banks make money from trading interest-rate products. But to rely on such businesses for most of their profit is to basically function as a hedge fund and/or brokerage, with some loan businesses bolted on. And it's riskier, in terms of consistent results, than most people realize.

On currently-available balance sheet data, Goldman's debt/market capitalization is roughly $323B/$57B, or 5.7x leverage. Using shares outstanding and equity share price, a rough figure of $51.2B in book equity would boost that leverage ratio to 6.3x.

Comparable ratios for Chase are debt/market cap of 5.4x, debt/equity of 4.7x, implying a market/book ratio of less than one.

So Goldman apparently is no longer leveraged much higher than one of the two remaining, large, comparatively healthy "real" commercial banks.

What puzzles me is how Goldman can be generating lower-risk profits without its prior leverage. I don't happen to know what its leverage ratios were a year ago, but one would think they must have been higher. Yet they clearly are neither taking consumer deposits, nor making garden-variety commercial loans.

Just how is this recent profit sustainable in the manner of a true commercial bank, without excessive leverage or risk?

Credit Spreads As Predictors of Economic Activity

Last Friday's Wall Street Journal contained an article discussing a predictive tool with which I had been previously unacquainted. The focus of the piece was a paper studying spreads between corporate debt and Treasuries. Essentially, higher corporate debt rates, and a widening spread over Treasuries, signals bad economic times. The key portion of the Journal piece was,

"To compensate for that, economists Simon Gilchrist and Vladimir Yankov at Boston University, and Egon Zakrajsek at the Federal Reserve constructed credit spreads over the 1990-2008 period from monthly price data on the corporate debt of about 900 U.S. nonfinancial companies. They divvied up the bonds based on both expected default rates (a more timely measure of quality than ratings) and time to maturity.

In a forthcoming paper in the Journal of Monetary Economics they show that spreads on low- to medium-risk corporate bonds, particularly those with 15 or more years until maturity, predicted changes in the economy phenomenally well, forecasting the ups and downs in both hiring and production a year before they occurred. Since writing the paper, they extended their analysis back to 1973 and found bonds' predictive ability still held.

It would be better for everyone if it doesn't hold in the future. With the massive widening in corporate-bond spreads last fall, the economists' model predicts industrial production will fall another 17% by the end of the year, and the economy will lose another 7.8 million jobs on top of the 5.1 million it has shed since the recession began."

A very revealing chart that accompanied the article was missing from the WSJ online version of the piece.

Never the less, the implications are sobering. This predictive tool, validated back more than 30 years, suggests that unemployment is not even half of the level at which it may peak, as production falls further this year.

Actually, this fits what my partner and I suspect, given the once-in-a-lifetime massive private credit deleveraging which has occurred in the past two years. While almost no government official mentions that deleveraging, or, when they do, suggest that federal replacement of that credit will "fix" everything, we think that the coming economic conditions forecast by this debt spread model seems accurate.

The "Empty Creditor"

Henry Hu, a professor at the University of Texas Law School, wrote a very interesting editorial in the Wall Street Journal on Friday concerning what he terms "empty creditors."

Such creditors, according to Mr. Hu's description,

"Thus the "empty creditor": someone (or institution) who may have the contractual control but, by simultaneously holding credit default swaps, little or no economic exposure if the debt goes bad. Indeed, if a creditor holds enough credit default swaps, he may simultaneously have control rights and incentives to cause the debtor firm's value to fall. And if bankruptcy occurs, the empty creditor may undermine proper reorganization, especially if his interests (or non-interests) are not fully disclosed to the bankruptcy court."

It's the sort of convoluted situation that the writers of our bankruptcy laws never imagined.

In the case of AIG and Goldman, which Mr. Hu uses to illustrate his point, the latter avoided a $7B loss, rather than, say, made an actual gain. But, as I observed to my business partner, on a relative basis, that's still a $7B gain over their original, unhedged position.

Imagine if a firm went further, and bought protective swaps beyond the value of their exposure, thus giving them a bona fide incentive for their counterparty's dissolution.

Mr. Hu's point is that there should be some acknowledgement of this problem, and some sort of safeguard to avoid allowing a counterparty to undermine legitimate bankruptcy proceedings.

Hu's own suggestions are rather lame- a "real-time informational clearinghouse for credit default swaps...." Highly unlikely. Those firms trading in this market are not interested in divulging their positions.

What would make more sense would be a modification of bankruptcy law such that any creditor found to be an "empty creditor," per Mr. Hu's description, would be removed from the pool of truly at-risk creditors, so that their lack of consent to a bankruptcy plan would not hinder its acceptance.

It seems to be a genuine problem, with the current concentration in commercial banking. Actions by a counterparty to a weak bank can trigger a rise in value of the credit default swaps of that bank, thus giving the counterparty a an interest in the bank's failure. This is probably not behavior which we, as a society, wish to reward.

The Pulte-Centex Merger

The big news a few days ago, before the ephemeral runup in the major equity indices due to Wells Fargo's one-quarter earnings announcement, was the combination of homebuilders Pulte and Centex.

Notionally a purchase of weaker Centex by Pulte, the Wall Street Journal article assessing the move claimed that this means Pulte thinks the bottom of the housing market has been reached.

Personally, I don't believe this is true. If anything, I think it signals that Pulte's management- and that of Centex, for that matter- are girding for a longer dry spell.

Typical of industries undergoing a decline in sales and uncertain long term prospects is consolidation. It's a Schumpeterian thing. As well as basic industrial dynamics. When heavily-leveraged balance sheets and slow sales combine, so do companies. Cost savings become paramount for survival.

As I noted in yesterday's post about the life insurers, what is happening in the homebuilding sector is normal. The life insurance bailouts are not, and actually confound and delay the reckoning of markets on poor performers.

By the way, the homebuilders' combination will most certainly result in job loss. Oh my God!

Somebody shovel some TARP money or a special program in there to preserve the two companies!

Sounds silly, doesn't it? And it is. For both the homebuilders and life insurers. And any other company, the management of which has run it up on the rocks.

Stepping back from the details, it's easy to see the sensibility in the Pulte-Centex merger. Homes were vastly overbought and overbuilt for at least the last two years. Therefore, there's less need for resources in the homebuilding sector. It's logical that it should shrink, with firms combining, employees being shed, as well as assets and expenses, where possible.

Perhaps if the national scale of homebuilding had proceeded somewhat less frenetically, both companies could have survived. But it didn't. So they didn't, either.

The same should be true of any sector. Government meddling only delays the point at which incompetent management and an oversupply of resources are finally removed by market forces.

In the meantime, we all pay, with tax dollars, for our government's wrongheaded subsidization of some companies, but not others.

All must be left to weather Schumpeter's storm of creative destruction without taxpayer "help."

Another Mistake: Bailing Out Life Insurers

I read with horror earlier this week that the federal government has decided to bail out at least three large life insurers- Hartford, Lincoln and Genworth. All three had quickly acquired small S&Ls or banks last fall, in order to get their snouts into the federal TARP trough.

Reading the Wall Street Journal piece announcing this development, I was sickened to learn,

"The news will come as a relief to a number of iconic American companies that have suffered big losses made worse by generous promises to buyers of some investment products. Shares of life insurers have fallen more than 40% this year. Their troubles led to a string of rating-agency downgrades that, in a vicious cycle, made it more difficult for some insurers to raise funds.

Life insurers had for a time seemed to be somewhat immune from the credit crisis, since they tend to invest in relatively safe assets in order to match their liabilities. These companies got into trouble for two main reasons, both tied to the weak financial markets.

First, many of the roughly two dozen insurers that dominate the variable-annuity business made aggressive promises on these popular retirement-income products, guaranteeing minimum returns, no matter what happened to the stock market. With the market's decline, the issuers are on the hook for big payouts, though most of the payments won't come due for 10 or more years. Second, the insurers also have lost money on the investments in bonds and real estate that back their policies.

Many life insurers also hold large portfolios of residential mortgage and commercial real-estate assets. While most of the assets are highly rated, further downgrades of those assets could put considerable pressure on insurers, forcing them to take additional write-downs."

So, basically, life insurers, as they seem to do once every few decades, sold products which promised returns they cannot deliver. And consumers were stupid enough to buy these.

Further, the insurance executives then invested premiums in assets of questionable value, which have now plummeted.

Such incompetence ordinarily leads to bankruptcy, sale of assets to a competitor, and the exit of the worst-managed firms.

Now, our government is rewarding these morons by bailing them out. Better-managed firms will be burdened by having to compete with insurers with access to cheap government capital.

And consumers won't learn to be more judicious in their purchase of investment products.

This bailout is troubling all the way around. Just a disastrous development.

The article further declared, as if to justify this government intervention,

"The life-insurance industry is an important piece of the U.S. financial system."

That's really rich. Does anyone think our financial system would have unimportant pieces just sitting around, operating for no good purpose? I don't think any existing financial players aren't "an important piece of the U.S. financial system," do you?

Frankly, I'm disappointed in the lack of critical reporting in the Journal on this rather important story. Why do I have to rely on my own memory to remind me that life insurers go through this cycle every 10-20 years?

Shoddy reporting of a mistaken financial rescue.

For a more uplifting story, consider the Pulte-Centex merger in the home building sector. That's an example of what should happen to struggling firms. I'll write about that tomorrow.

CNBC's Irresponsible Commentary

I've noted with some disappointment the continuing trend on CNBC of its anchors and reporters to present themselves as experts, rather than the talking heads they, in fact, are.

It's become so bad that I found myself describing it to a friend yesterday like listening to the radio. I have the channel on for news, and the occasional interesting guest. But with the menu of clunkers who are the on-air co-anchors, and too many irrelevant guests, like this morning's Howard Dean, it's getting tougher by the week.

Take morning co-anchor Mark Hanes, for example. A lawyer by training, he has recently been trumpeting his personal call of the equity market bottom. Nevermind that we have no idea if this is yet true, nor for how long.

NYSE floor reporter Bob Pisani focuses less on news, and more on cheerleading equities as if the market has a personality.

The market, she be happy.

Rather than attempt to accept and understand reality, he is prone to statements like,

'What we need is for some buyers to step up and provide broad volume.'

By far the most foolish, inane and pompous of the group, though, is senior economic idiot Steve Liesman. This irresponsible goof ball has now become a replacement for Larry Kudlow on the latter's evening program, causing me to wonder if Kudlow is back on cocaine or some other addicting, controlled substance.

Here's why.

I have an interest in science. Suppose I report on physics, and read about the subject, in order to be able to ask sensible interview questions, with the objective of providing viewers with interesting information from leading physicists.

One day, I begin to follow my interviews with my own thoughts on the views of the physicist whom I've just interviewed, criticizing his remarks, and adding my own opinions. Over time, I begin to appear personally to talk about physics theories and discoveries, their credibility, and detailed technical analyses.

That's how Liesman has morphed. Rather than have someone with credentials, like Brian Wesbury, or a Nobel Laureate like Joseph Stiglitz, remark on some piece of economic news, Liesman now personally inserts his own uncredentialed, uneducated interpretations and opinions.

It's become so prevalent and sickening that I am heading for the "mute" button on my television controller when I hear the idiot's voice.

I truly cannot understand why Kudlow, a degreed economist, would pay the slightest attention to Liesman. To make the guy Kudlow's replacement when the latter is away is just incomprehensible. Maybe CNBC forced Kudlow into that "choice."

Although a leading business cable channel, CNBC has a remarkably small audience when compared to Fox's News Channel. So I guess the silver lining is that not that many people actually listen to the CNBC anchors' and reporters' drivel. On the other hand, enough do that the occasional interview will move markets.

I can only hope that, like me, most viewers ignore the CNBC employees and focus on the news and occasional decent guests.

GM's Pathetic Latest Development- The PUMA

In one of the more comical and idiotic developments at ineptly-run, nearly-bankrupt GM, the nearby "vehicle" represents the firm's latest attempt to please its newest stakeholder, i.e., Treasury.

As a Wall Street Journal article reported,

"General Motors Corp. is teaming with Segway Inc., maker of the upright, self-balancing scooters, to build a new type of two-wheeled vehicle designed to move easily through congested urban streets.

The machine, which GM says it aims to develop by 2012, would run on batteries and use wireless technology to avoid traffic backups and navigate cities.

The struggling auto maker, surviving on a government lifeline, is looking to generate enthusiasm for its increasingly uncertain future ahead of the New York auto show this week.
GM has slashed product-development programs, advertising and spending on auto-show events. But it will take to the streets of Manhattan on Tuesday to show off a prototype of the vehicle, called PUMA, for Personal Urban Mobility and Accessibility."

Unfortunately, April Fool's day was last week. So we can't dismiss this as a joke. The Journal piece further noted,

"GM didn't say how much the machines would cost, but research chief Larry Burns said owners would spend one-third to one-fourth of the cost of a traditional vehicle.

PUMA would have a range of about 35 miles. GM said it aims to use so-called vehicle-to-vehicle technology to avoid traffic problems and potentially have it navigate itself through city streets."

What's next, bicycled from the former auto-making titan? Maybe those plastic, foot-powered toy cars for your toddler? Because that, too, would be: green, non-carbon-emitting, personal and downsized.

But let's be realistic and serious for a moment. If the PUMA is truly going to cost only a quarter of a normal car, how in the world does this address the financial problems of GM?

They don't even hold the basic patents or rights for the Segway. So their margin on this thing will probably even less than on a small car. Of course, with federal government aid, GM will be forced to assemble it with UAW labor.

Does anyone think the PUMA will be profitable? And at what volumes? Most New Yorker's don't even own cars. Commuters couldn't really drive these things into Manhattan, because they'd be out of juice by the end of the commute.

How about accidents? What happens when the PUMA runs over a pedestrian? Or is creamed by a taxi running an amber light? How would you lock this thing up, or store anything in it? It looks like thieves could just pull a pickup truck next to it, get out and lift the thing into the back of the pickup. Goodbye PUMA.

I don't even want to imagine the insurance rates for owning and driving it in a major US city.

It's a joke. Only not the funny kind. More like the continuingly pathetic sort.

Volcker's Temperance on Regulation

The Wall Street Journal ran a special section on March 30th resulting from its recent conference on financial regulation. Frankly, I found most of it to be either a rehash of ideas already put forth by others, including myself. There were a few highlights of note. One was Peter Fisher's remarks. Another were some quotes from a discussion including noted hedge fund short James Chanos.

And Paul Volcker's observations on changes in regulation. It is on this topic I wish to write today.

For me, the headline is that, despite being associated with an administration that is rushing about demanding excessive regulation, punitive actions toward private sector executives, and generally attempting to morph our capitalistic system into a fascist one, Volcker enunciates a great deal of common sense.

His remarks begin by focusing on potential changes in the regulatory approach to financial services,

"But beneath the seeming consensus on the broad elements of reform, there is a lot of disagreement. There's a lot of disagreement in principle and even more disagreement in detail. So there is a great kind of political pressure to get things done in a hurry, strike while the iron's hot.

I guess my principal feeling is: Not too fast, because any specific reform raises questions about how it fits into the whole system. And unless you have some idea of the direction in which you want the system to go, it's a little premature to be taking too much specific action.

The other way to look at it, which I favor, is no, there are distinctions that legitimately can and should be made, not only on institutional grounds but on historic grounds and given the present framework we have. And the one is a commercial bank-centered approach, accepting that commercial banks are going to be the core of any system. They've been regulated, they're going to continue to be regulated. We can improve that regulation. Those institutions have a fiduciary responsibility to serve the public, to serve their individual clients, to serve business, to serve governments. That's their job, and they also underlie the infrastructure.

The rest of the system I call a capital-market system. I would not consider them at the core of the system. They might be important, they innovate, they're flexible, but the implication is they don't need to be regulated to the extent of the banking system. Transparency is important. If one of those institutions gets so big they're in some sense systemically important, maybe we have to regulate them with capital requirements. Otherwise, I don't think there should be any presumption that the government is going to rescue them."

I find this astonishing and comforting. Volcker is essentially arguing that we retain our focus on banks, and reinforce with investors that non-bank participants in finance bear risk that will not, despite current federal government actions, be rescued. In this, I think Volcker is correct, and, if influential in the current administration, a tremendous force for slow, sensible changes, if necessary, in regulation.

Volcker then comments on this new notion of a 'systemic risk regulator.' His comments include these,

"Everybody wants a systemic-risk regulator. What is that supposed to do? And what do you mean by systemic risk? Are we talking about a regulator that's going to regulate in detail those institutions? They're going to send in examiners? If so, what do the other banking regulators do? Do they follow the same policies, different policies?

Or do we mean by systemic-risk regulator they're looking for overriding trends in the system that will over time be destructive? Should they have been sensitive to the subprime-mortgage problem and the enormous growth in mortgages, not by looking at individual institutions but by looking at what the market as a whole was producing. Should they have been concerned about an undercapitalization of the banking system generally? That's a different approach than looking at individual institutions.

And what is that systemic-risk regulator supposed to do? What is his charge? Let's not invent the role before we know what the charge should be.

Again, I think Volcker is incredibly astute in calling a spade a spade. Having been involved in my share of risk-related matters while research director at Oliver, Wyman & Co., now the financial services consulting unit of Mercer Management Consulting, I can vouch for Volcker's reticence in tackling this issue.

Whenever I hear government officials begin to babble about 'systemic risk,' I immediately want to ask him/her to define, with equations and variables, precisely what they mean.

Of course they could not. I'm quite sure that even risk management practitioners in most of today's commercial banks and asset management firms could not, either. Or at least not in anything approaching a univocal view of the subject.

Volcker correctly notes this, and even some of the potential conceptual definitions. In this, I think he helps put the brakes on any rush to invent this type of risk, and then regulate it. We are very, very far from such a point, and Volcker wisely says so.

The Journal article which contains Volcker's remarks ends with his thoughts on a few related topics,

Fair-value accounting: That's a big subject that I don't think we're going to solve in the midst of all this turmoil, but it needs careful discussion and determination.

You have this enormous issue of compensation. Well, there is a great urge politically to do something. Most of what the political system would produce is probably destructive, yet there is a real problem of how to deal with compensation policies.

So I hope we take our time to have a kind of consensus on what the general framework of the system ought to be, and what makes sense in individual instances to put into that framework."

Overall, I found Volcker's comments surprising, given his association with the current federal government administration. He seems to be the Volcker of old, who slew the inflation dragon in the late 1970s and early 1980s, speaking clearly, even against prevailing political winds.

I'm pleased to see him providing counsel to government at such a perilous time.

The Recent S&P Rally

The recent 25% upward move in the S&P500 from early March to last Friday is the subject of much debate. Unlike the similar gains in the index from mid-November to early January, this recent rally comes amid allegations that the economic news has stopped getting worse.

Using the aphorism that equity markets turn prior to the economy, many investors choose to believe that, if the pace of economic deterioration has lessened, that's good enough to justify piling into equities again.

Not so fast.

Several things about the current financial markets and economic situation cause my business partner and me to be unconvinced that there will be a sustained upsurge in the S&P that, upon being viewed in six months or so, will prove to be the beginning of a long run, healthy bull market in equities.

First, the contextual news regarding the consequences of deleveraging, as opposed to the recession, about which I wrote here in January, continues to be grim. Consumer revolving credit is becoming either more expensive, less available, or both.

Commercial real estate defaults are heralded to be worsening. Job losses continue apace.

We believe that much of this is deleveraging-related, not purely or merely caused by the recession and, thus, will not be revived anytime soon, federal leverage notwithstanding.

Second, the speed of the recent index recovery, absent strong fundamental corporate earnings data, or, for that matter, much of any other private-sector economic news of a positive nature, suggests a trading frenzy based on hope, rather than a longer term investment opportunity based upon early signs of a genuine economic revival.

Finally, the volatility of the equity markets remains distressingly high. Rather than decay in a 'normal' fashion, as equity volatility did after the crashes of 1929 and 1987, the most recent equity market crash has resulted in a uniquely sustained, high level of volatility. In fact, it has risen this year, both through the late-January decline, and the recent rally.

From our research, we believe it is very unlikely that this volatility will be associated with a healthy, sustained rise in equity market prices. Since we don't try to time the market, missing the 55% rise in the value of our March call options portfolio is acceptable.

In fact, the situation is reminiscent of a year ago. In 2008, there were three months in which call options had significantly positive returns for a long enough period to have been realized - February, March and April. May had briefer and lower levels of call returns.

Ironically, the put portfolio in May reached triple-digit returns, but much later, i.e., after the September equity market carnage. April's puts attained near-triple-digit returns near the end of their lives.

The moral of this story is that, occasionally, one side of the derivatives positions of our portfolios will peak very early, while the other achieves much higher returns much later. In a turbulent market, this is not unheard of.

We think that's what we are seeing again in the current equity markets. Near term hope driving modest equity and call returns, while longer term puts will likely have higher returns later this summer.

A Lack of Boundaries: Private Sector & Government

I recently sat with my business partner discussing the sad state of corporate management and governance that has led major US corporations to go begging to the federal government for help.

Now, we have new regulations affecting the compensation of employees at any company which accepted or requested TARP funds, completely contrary to the promises, at the time, of then-Treasury Secretary Hank Paulson that Washington would be the most passive of investors.

Further, any expenditures at companies which have accepted or requested government "help" are now scrutinized for the potential of being too "lavish" by a Congress that, itself, has overspent taxpayers' money.

How did we get to this point? Is it the fault of corporate America, or the federal government?

I believe it is the fault of both parties. Neither seems capable of respecting boundaries.

In my opinion, as well as others, such as William McGurn of the Wall Street Journal and even liberal Nobel Economics Laureate Joseph Stiglitz, the bankruptcy option has been avoided far too much in the past twelve months.

Bear Stearns, Lehman, BofA, AIG and Citigroup, upon appealing to the federal government for assistance, should all have been referred to bankruptcy court or the FDIC for closure. GM and Chrysler, too, should be in Chapter 11.

Somehow, corporate executives have come to expect their government to play favorites, pick winners, and temporarily prop up failing companies, rather than admit their own mistakes and close up shop.

By failing to observe the boundaries of responsible corporate behavior, boards of directors and CEOs unwisely opened a Pandora's Box of problems by requesting government financial aid. This left them open to having their operations and decisions overseen and scrutinized by political officials who have used the excuse of looking after taxpayer money in order to move our economy down the road of fascism.

At the same time, government officials, beginning with the Bush administration, and continuing into the current one, have unwisely consented to helping private corporations, rather than declining, and sending them to their fate in the financial markets or bankruptcy courts.

By failing to observe the clear line between private and public spheres of activity, our government officials have compromised our economic system and given into the temptation to begin manipulating companies for political purposes and pet political agendas.

Both government and corporations would have better served our society if they had just said "no."

No requests for handouts and government help. No consent by government to involve itself in any private company rescues.

It's difficult, at this point, to see how and where these mistakes will end. But it's very easy to see how and where they began. Our private and public institutions have failed the US by refusing to adhere to time-tested separations that allow the private sector to take risks and bear the consequences with limited public interference.

The Key Issue In GM's Debacle

Holman Jenkins wrote a searingly insightful, clear editorial in the Wall Street Journal yesterday.

As usual, he cut to the core of the current mess involving GM by observing,

"Keep that in mind amid reports the administration favors a "quick and surgical" bankruptcy. It's a bluff. The same administration that inserted itself into GM's corporate governance to order the resignation of a CEO is hardly likely to defer to the prescribed legal order for a failing company, namely bankruptcy. Even a "prepackaged" filing runs too much risk of a judge imposing more "sacrifice" on the UAW than the administration is prepared to tolerate.

GM bondholders understand this: They've been intransigent precisely because they calculate the UAW is too important to Democratic electoral politics for Mr. Obama to risk losing control of the reorganization process to a bankruptcy judge." (my bold)

That's the issue in a nutshell. Democrats feel a need to defend the UAW's benefits, as I noted in this post,

"The truth, of course, is that Chapter 11 is crucial to force such negotiations. Gettelfinger is scrambling to hold out for pre-bankruptcy negotiations, because, in bankruptcy, his union will have its benefits and wages slashed unilaterally.

In fact, one Democratic Senator explicitly accused, but not by name, some Republicans and pundits for using Detroit's problems to break the UAW. But the UAW is doing that all on its own. It doesn't need help."

As I wrote in another recent post, I don't like to mix politics and business on this blog. But when politics is the major force behind a business story, it's unavoidable.

Congress, as Jenkins notes in his piece, created some of the problems GM currently faces,

"The Wagner world was given a second lease on life by a peculiar feature of Congress's 1975 fuel economy law. Known as the "two fleets" rule, it effectively forces Detroit to make its cheap small cars in high-wage domestic UAW factories, even if it means losing money on every car. The rule has no fuel-economy function. Its only purpose is to shield the UAW monopoly inside each Detroit auto maker from global labor competition.

You wouldn't have noticed, but a legislative accident two years ago almost stripped away the two fleets rule. A couple of Republican senators from the South took the lead in crafting the Senate's new fuel economy bill, and built it to please Nissan, which had railed against two fleets for its own reasons.

In the final bill, to no one's surprise, two fleets was quietly restored by Rep. John Dingell and Illinois Sen. Obama (among others) as a political favor to the United Auto Workers.

The UAW's Mr. Gettelfinger had testified, coyly, during Congressional hearings that failing to renew two fleets might cost 17,000 auto workers jobs building small cars. He didn't say that two fleets is in fact the fulcrum by which, for the past 30 years, the UAW has been able to defeat globalization.

He didn't say two fleets was the sine qua non for the past generation of the UAW's power to suck the Big Three dry."

As I noted in today's prior post, undue governmental meddling in the private sector, including choosing winners and losers among companies, unions or sectors, is expensive and ultimately disastrous for taxpayers.

Government fostered the GM mess, although the company's own management stood by silently as it happened. We'd all be better off had the Bush administration simply told GM to file Chapter 11, if necessary, because our government is not in the business of picking winners and losers among sectors, companies or unions.

The Unseen Costs of Government Intervention in Businesses

Yesterday morning, I heard Alabama's Republican Senator and ranking member of the Senate Banking Committee, Richard Shelby, say on CNBC, in reference to the auto maker bailouts, to paraphrase,


'I hope GM succeeds.'


Frankly, I was horrified. It's bad enough that both the Bush and Obama administrations allowed GM and Cerebrus/Chrysler to avoid bankruptcy court via Chapter 11.


But to hear a conservative Republican express a desired outcome for a specific company was very disappointing.


In my opinion, the sentiment which Senator Shelby should have expressed was,


"As a member of Congress, I cannot, of course, express preference for one competitive US company to the detriment of another. To indicate that I, rather than the market, possess a desire for any US company to have a specific outcome is improper.


Rather, I wish that GM receive and experience what our markets, both consumer and financial, judge appropriate for the company.


If that means survival now, on its own resources, and success in the future, so be it. If, instead, it means the firm cannot continue operations, and must file for Chapter 11 bankruptcy, again, so be it."


It is simply wrong for our federal government to engage in such massive intervention as to be lending private-sector companies money, in hopes of avoiding their demise.


How can our government possible know, better than the natural forces of our markets, that the best use of, for example, some building in Flint, Michigan, is as a GM plant, rather than the new home of some entrepreneur's business?


What if the fall in rental price of that former plant is the key to allowing some new business to flourish, employing workers and having better growth prospects than GM?


In the same way as the administration's hamhanded approach to mortgage foreclosure relief is frustrating attempts by new aspirants to homeownership, about which I wrote here recently, the distressing attempts by our government to "pick winners" in the private sector is mistakenly substituting governmental preference for that of our consumer and capital markets.


Isn't this what the Soviet Union tried, and ultimately found to be inefficient, unworkable and a failure for most of the 20th century?

Who among us truly believes that our federal government is more skilled than consumers and investors in the selection of those business which ought to survive and prosper?

By propping up GM and refusing to allow it, if necessary, to enter Chapter 11 proceedings, our government- both Congress and the administration- is merely delaying the inevitable market-clearing dissolution of failing and failed companies, the recycling of their resources a la Schumpeter's observations of eighty years ago, and the freeing up of labor to be employed in new ventures.

Government isn't the right institution to select our economy's winners and losers. For that, we have a process which we have trusted for most of our country's life- our freely-operating, private capital and consumer markets.

The Troubling Loss of Fed Independence

Back in mid-March, economist Judy Shelton wrote an editorial in the Wall Street Journal entitled, "Is Inflation Baked Into the Budget Plan?"

I'll write about the main focus of her article in another post. For today, though, I'd like to quote this passage from Ms. Shelton's piece,

"The notion that monetary policy might be in cahoots with fiscal policy is sure to elicit howls of protest all the way from the Treasury to the Federal Reserve -- about a mile's distance. But no one can seriously suggest that the Fed has not been politicized beyond all pretenses toward independence. The Fed has become a key player in the government's efforts to deal with the credit crisis, purchasing hundreds of billions in mortgage-backed securities guaranteed by federal agencies and taking them onto its own balance sheet. Last month the Fed issued a joint statement with Treasury that they stood ready to inject more capital into banks "to provide a cushion against larger-than-expected future losses." And according to yesterday's surprise announcement, the Fed now plans to buy up long-term Treasury bonds -- an act of fiscal incest -- while taking another $1 trillion or so onto its balance sheet to boost consumer spending.

So the Fed is involved up to its neck in this blueprint for the future. Does anyone doubt that former Treasury Secretary Larry Summers, who heads the White House's Economic Council, is slated to be the next Fed chairman?"

The picture accompanying this post ought to give everybody pause. Surely former Fed Chairman William McChesney Martin is spinning in his grave.

I recall in my youth the general awareness that then-Fed Chairman Artie Burns was easily bullied into flooding the economy with liquidity in advance of Johnson's and Nixon's re-elections. That was a very bad time for the US dollar.

Seeing helicopter Ben at the same table with members of the current administration, especially the Treasury Secretary, gives me chills.

As Ms. Shelton wrote in the rest of her editorial, the current stimulus package and operating budget of the US government all but guarantee inflation coming soon. Rather than offset such huge doses of Treasury- and Congressionally-provided liquidity, the Fed is abetting them by purchasing US debt and other, private debt, thus adding to the flood of dollars in the global economy.

We just might come to a point where we'd fondly wish for the inflation rates of the Carter era.

Current Myths About Fund Management & Rebounds

This weekend's Wall Street Journal profiled a Texas fund manager, Donald Hodges, amidst the recent ruin of his investment strategy. It highlights a common myth that several friends have expressed to me lately. Simply stated, the belief is,

'I know the market, and my funds, fell sharply last year. But, eventually, the funds I own will come back...won't they? The market will surely regain its losses in time, so my funds will, too. Right?'

Not necessarily.

The article begins,

"For many years, Donald Hodges ran one of the top-rated stock-focused mutual funds in the country. He also has lost money for his investors over the past decade.

A $10,000 investment in Hodges Fund made 10 years ago would be worth around $9,015 today, compared with $7,720 if it was invested in the Standard & Poor's 500-stock index. Years of stellar performance were wiped out by a 49.5% plunge in 2008, a much steeper fall than the S&P, and a 11% drop so far this year."

From various pieces of information in the piece, it's clear that Hodges is a qualitative, seat-of-the-pants type manager. He doesn't seem to employ any tools to assess whether he should be long, or short in regard to equities. The article continued,

"He has become more cautious in his new stock picks, leery about buying until he is sure they are unlikely to blow up.

The "go-anywhere" Hodges Fund -- Donald Hodges invests in both value and growth issues, and ranges from small- to large-market capitalizations -- was founded in 1992 and rose to $750 million in assets by early last year. But now it is one-third that size, thanks to the brutal decline and outflows of around $31 million for the first two months of this year.

In the first half of 2008, even as the broad market fell, Hodges Fund held up relatively better because it had few financials. In the summer, Mr. Hodges took time off for an investors' cruise to Asia. He received a daily update on the fund portfolios via faxes and emails.

But after the collapse of Lehman Brothers Holdings Inc. in September, several of his fund holdings were hit hard. Mr. Hodges figured it was a buying opportunity -- a strategy that had worked well for him coming out of the 1982 and 1987 market slumps."

I found this to be just amazing. And very indicative of subjective equity managers. Without well-reasoned, defensible metrics, Hodges just felt that the fall of last year looked a lot like prior equity markets, so he started buying.

"He bought some cheap shares that he thought would hold up. One was Cal-Maine Foods Inc., a large producer and distributor of eggs. Wrong move. That stock has dropped 42% since September.

"You have to be somewhat forgiving of yourself, and realize that over a period of time you've done well," Mr. Hodges says. "And that day will return again." "

That last statement is so desperate. How can Hodges possibly know if his subjective approach will ever work again?

I have friends who, from the other side of the table, fervently want to believe the same thing. They have holdings in a disparate collection of equity mutual funds which have just been crushed in the past twelve months. They want to believe that, in concert with a hoped-for return to an S&P of 1400, their own funds will also rise.

They just don't realize how unrealistic such a hope is. Like Hodges, many of these other qualitative managers are now at sea in a very different market. We are experiencing the largest deleveraging of the past several decades, if not since the 1930s, as well as a serious recession. How anyone with a purely subjective method for selecting equities would know what to do in these conditions is beyond me.

But, as my business partner constantly reminds me, people like stories. Stories with happy endings, no matter how fictive they may be.

So investors cling to shares of mutual funds they have held for years, despite the fact that while, in an average year, 25% of mutual funds can beat the S&P, it is typically a different 25% each year. Public mutual fund managers are notoriously inconsistent in their results.

Will Hodges ever return to his prior portfolio returns? Who knows? Frankly, it's doubtful. As it is, the Journal piece notes that Hodges' fund was Lipper's best 5-year fund in that category for three years. That's a pretty narrow timeframe of outperformance, isn't it?

Multiply the Hodges story a few thousand times, and you have a pretty good picture of the equity management sector right now.

That is, failed managers, taken by surprise, desperately clinging to hope that they can reproduce whatever short period of market outperformance they once exhibited during the last few decades' largely up market on the back of expanding private leverage.

Rick Wagoner's Ouster

I've written my share, or more, of posts criticizing GM's recently-ousted CEO, Rick Wagoner.



And I don't like to mix politics with business on this blog.



But this weekend's firing of GM CEO Wagoner by the head of one of the firm's creditor's, the US federal government, breaks new ground. So I believe it needs to be addressed.



The accompanying price chart for GM and the S&P500 Index since 1962 paints a very sobering picture for the auto maker. In non-deflated dollars, the company's stock price peaked in 2000, but, in real terms, obviously much, much earlier.

Since Wagoner's assumption of the CEO title, GM's market value has headed straight downhill.

I've railed for years against GM's horrible senior management and ineffectual board of directors. I have argued for years that Wagoner should go.

But not because the president of the US, which is not even the largest creditor of the company, says so.

However, even Wagoner's dismissal by a minor creditor, is not the most troubling news related to GM today.

No, that would be the US president's contentions, as expressed in his remarks about GM this morning. It's evidently too recent to find a YouTube clip of the appearance, so my text will have to suffice.

Disturbingly, the president of our country unilaterally declared that:

-GM is too old and important to fail.
-Management is to blame, but workers are not.
-Federal money will be spent to save/create auto jobs in the communities affected by GM's troubles.
-GM will not be put through a normal Chapter 11 bankruptcy.
-After being 'fixed,' GM will rise to success once again.

No mention was made of the UAW's role in this through its exorbitant demands. Nor was Ron Gettelfinger's resignation as head of the UAW demanded by our government.

Further, our president, oddly for an attorney, provided evidence of his ignorance of what a Chapter 11 filing entails. He claimed that such a filing would result in dissolution of GM and the sale of its operations, which would also shut down.

This is simply false.

So now we have an ultimate government taking. At least with AIG, the federal government became the owner of the firm, albeit at gunpoint, and has since called the shots.

At GM, it's not an owner, but a relatively minor creditor. And should have no particular stake in the outcome of the firm. Markets are supposed to do that.

Instead, we have a near-Rooseveltian step by government into the restructuring of the auto sector. Chrysler was judged unworthy of further investment, unless it completes its pending merger with Fiat. GM has been deemed worthy of saving, but, obviously, because of the UAW jobs involved.

And those jobs, and the contracts under which they exist, will not be subject to a court-appointed bankruptcy trustee. No, the government has charged management alone with guilt in GM's failures.

The nature and extent of the federal government seizure of control of GM, using a comparatively small operating loan as the basis for its thuggery, is disturbing.

But perhaps this could have been avoided if, as I wrote half-jokingly, this post were true. Had Armando Codina been replaced by a competent board member, along with most of the rest of GM's board, perhaps this act of government seizure could have been avoided.

My business partner and I have discussed my strong belief in the necessary of death of corporations which cease to serve shareholders well. It is, admittedly, a very robust version of Schumpeterian dynamics. But this latest act in the melodrama that is GM proves my point.

Far better for the private sector to look after its own interests, shutting weak, ailing firms, than to await politically-motivated government meddling.

GM could have gone quietly, with some parts sold, others closed. Now, it's going to be forced to continue life as a money-losing "green" car maker, taking orders from Washington.

Truly, a far more ignominious end for the once-proud and profitable car maker.

The Folly Of The Mortgage "Cramdown" Plan

It's been a while since Congress' mortgage "cramdown" plan has received a lot of publicity. As I write this, I'm looking at a Wall Street Journal piece from the March 14-15 weekend edition entitled, "Mortgage 'Cramdown' Plan Hits Turbulence."

And how.

There is a high level approach to this topic that involves discussing capital markets, the rule of law, contracts, and such. I had originally intended to write that sort of piece.

But there's another level of coverage for this legislation that focuses on the local real estate markets, and that's where this post is now going.

About a week ago, I happened across a good friend and former professional international squash player who is now a local realtor. We began discussing the local market and pending governmental programs to 'help' the situation. She was not happy.

Elaine told me that the $8K credit for first-time home buyers is doing nothing around here, because the house prices are still so high that few, if any, initial buyers can afford them. She said the better solution was to have given anyone buying a home the $8K credit.

Then we turned to the subject of Congressional 'help' for delinquent or about-to-be-foreclosed mortgages.

Elaine concurred with the findings of research into delinquencies which I have read in the press within the past six months. To wit, homes that have mortgages fall into delinquency, then are given temporary relief, have a very high probability of becoming delinquent again and, eventually, entering foreclosure within six months.

Essentially, people typically become delinquent on their mortgage because there has been a job loss. They don't usually decide to take a European or Asian vacation, buy a second home, or a new car, and, thus, skip paying the mortgage on their primary residence for a month or two.

No, such drastic nonpayment events are usually the result of a job loss which exhausts the financial means of the owner of a home. If given a few months respite, the owner isn't magically given a new job, too. Just more time to resolve their delinquency.

All too often, i.e., more than half of the time, the owner re-enters a delinquent state and, then, foreclosure.

This is why cramdowns are a bad idea. It simply allows someone who can no longer afford their home to enjoy a court-ordered, unilateral rescission of the mortgage contract, effectively cutting the price of the home by forgiving some of the principal, and lowering the interest rate, too.

But, as my realtor friend noted, all this does is make taxpayers subsidize the current owner while they enjoy a price cut on their home, while anyone who was waiting to buy the home out of foreclosure at a lower price is denied that opportunity.

When normal housing markets are allowed to function, then people who can no longer afford their home due to having bought what they cannot now afford, the homes are sold out of foreclosure at lower, market-clearing prices, to new buyers who can now afford those homes.

The current foreclosure experiences across the US are not, at root, housing problems, but merely the consequences of employment problems.

You fix the latter with unemployment insurance, not mortgage relief via local court cramdowns.

Because of the looming Congressional mortgage relief, Elaine told me that delinquent homeowners and/or others wishing to sell are maintaining artificially high prices, or simply not listing yet. The result is a clogged and frozen local residential real estate market in which willing, qualified buyers are being denied the opportunity to gain access to homes that should be sold at market-clearing prices.

The mere hint of federal mortgage relief has frozen prices and is keeping the supply of homes tighter than it would be, were normal lending and market forces acting. Banks would be foreclosing, instead of halting those procedures, under TARP-related threats of Congressional penalties.

Since brokers aren't paid until homes sell, Elaine told me that she and her colleagues aren't even participating in workouts of delinquent mortgages anymore, because the owners' expectations of prices are too high to promise a sale anytime soon.

In short, the simple expression of Congressional action and interest in doing other than allowing normal market forces and the legal system operate in the instance of current residential mortgage finance, i.e., allowing lenders to handle delinquencies and foreclosures as usual, has seized up the entire residential housing market and caused existing homeowners to expect a taxpayer-financed price and interest rate reduction on their current homes, while waiting buyers are forced to subsidize this situation, while being denied their chance to finally realize their own dreams of home ownership, albeit on better-funded terms.

Things sure are upside down in the American housing market, thanks to boneheaded federal meddling.