Two Plus Two Equals a Long and Painful Recession

I received a number of comments on my 2009 predictions, some agreeing, some saying I was too pessimistic and some saying I was too optimistic. For those saying I was too pessimistic, let me explain further why I believe this recession will be longer and nastier than most and when we do come out of it, things will not be the same as they were in 2007.

First, the go-go years in the decade leading up to this recession were largely fueled by massive debt. Easy credit leads to foolish levels of over-consumption. So now we are deleveraging, both at the corporate level and at the individual level, though obviously not at the government level. I tend to think times of easy credit are not returning any time soon for the masses, nor should it. As Americans learn to live within their means (by choice or otherwise) the level of consumption in this country will adjust to a new, significantly lower, level, and hopefully it will remain there. That is the good news because if we do find a way to return to our foolish spending ways - as the government seems to be trying to get us to do with "stimulus" packages - then we will simply prolong the problem and increase the eventual pain.

Second, in a normal recession, the weak fold allowing the strong to survive and perhaps become stronger. The faster this process takes place, so long as it is done orderly, the better, at least in terms of moving forward and putting the mess behind us. This will take place in various segments of the economy, but at least for the financial sector we have a very big problem. We learned from the Lehman collapse that the financial industry is way too interconnected at the moment. Some of this is due to $62 trillion in notional value in the CDS market. There were a variety of knock on effects that followed Lehman's demise that has the government spooked enough that they are not letting any of the big boys fail. But the usual money making ways for the financial goliaths are toast, the junk on their books is continuing to fester and they will continue to be a black hole for capital. We will continue to throw money at them and hope time will allow them to get back on their feet. Nonetheless, they cannot all survive. So here is the problem, we cannot let them fail and the economy cannot support their existence (at least not all of them), so here we are - stuck with a government bailout for a very long time. No easy solution here. We just need to keep them on life support long enough to figure out a way to take a few of them down in an orderly fashion. This is a situation making the cure to this recession very complicated.

Don't believe me, look at AIG. We have - so far - committed $152 billion for its bailout. Why? Was it to save the millions of policyholders from losing their coverage? NO!! The problems were at the holding company. The insurance subsidiaries are regulated on a state level by state departments of insurance. The subs are having some problems due to their association with their parent, but the books for the subs were generally strong as state insurance departments did their job and made sure the insurance subs had adequate reserves and surplus and did not invest in risky assets. So, again, why would be spend ten times as much salvaging a holding company versus the long drawn out battle we had to support the auto makers, who support millions of jobs? Why??!!

The answer is in credit default swaps. AIG Financial Services got into these big time and just happened to issue a lot of contracts to Eurpoean banks. There, these banks are allowed to use the existence of these CDSs to support their capital structure. Had AIG gone down, it would have taken a host of European banks with it, among a host of other entities. The government had no interest in saving AIG, it had to do so, however, to avoid the knock on effects. Just imagine the calls Ben, Paul, W. and others were getting when AIG was on the brink. Complications like these spell big trouble for any quick recovery.

Third,a recession is a correction; it takes things back to where they should be. Usually, we overshoot and go too far the other way, but eventually we recalibrate back to mean. If you think the last few years leading up to this recession were the mean, you are sadly mistaken. The mean is significantly lower at a level of economic activity that cannot support all the companies out there. So being at mean may in itself feel like a recession. The party is over.

Fourth, Obama's plan, though I like it, will not stop the recession. I like the plan for the following reasons:

• America insists that something be done and needs hope that it is being done. So Obama has to do something. We could waste more money giving it to financial institutions, or we could spend it in a fashion that at least gives us something we need in the long run, whether or not it ends the recession. Infrastructure spending, alternative fuel and education are worthy causes.This spending will serve us well in the future.
• Unemployment is on the rise and will continue along that path for some time. We can either spend money feeding and housing the unemployed, or we can give them jobs. The latter allows them to have money to spend, which helps the economy. Not enough, in my opinion, to stop the recession, but better than them living in homeless shelters.
• Oil will rebound massively a few years from now, if not sooner, as a significant amount of the current supply chain will shut down. Too much of the supply is in nationalized hands and being poorly managed. Spending money now on alternative energy - even though gas prices are low at the moment - is incredibly wise. If the U.S. can develop efficient and cost effective alternatives, we can become a major exporter of energy, not an importer.

Overall, Obama's plan will lessen the pain and pave the way for better times ahead, but I expect it to do little to fix the mess we are in. But I really think there are few cures to the mess other than hunkering down and waiting it out. No one likes to hear this. We all want answers. We all want quick fixes.

I promise I will return to my usual fare of summarizing articles of interest, but I needed to get this out of my system. Now I feel much better. That extra second makes a world of difference.

Disclousures: None

New Year Same Mess

Well we turned the page on the caledar and I am feeling much better. Perhaps it was that extra leap second scientists gave us to synchronize the clocks with the planet or maybe just having some time off for the holidays. Either way, I am feeling at least a second younger. Go figure. Nonetheless, the recession is still with us - get used to it.

Won the Battle, Lost theWar

Wells Fargo fought tooth-and-nail to win Wachovia from Citigroup. I have read that the FDIC arranged the Citigroup/Wachovia deal as a stealth way to prop up Citigroup (too complicated to go there now (and I do not recall all the details but it was a good read)). Wells Fargo, on the other hand, saw an oppotunity to take advantage of the Wachovia losses to gain some tax benefits (thanks to a perhaps illegal IRS statement allowing them to do so) so they were all gung-ho to take Wachovia from Citigroup's grasp. Well, Wells Fargo won that battle.

Yet the war wages on and obviously the risk takers at Wells Fargo have not been reading my blog. Wachovia was well within the top five rank for subprime and option ARMs. The latter has yet to peak in foreclosures and will spell trouble well through 2009. All one needs to do is follow Calcuated Risk to understand this. They have very nice charts there showing it all in graphic detail. I highly recommend the site (especially to the folks at Wells Fargo).

Nonetheless, Wells Fargo - a financial company that until the Wachovia deal was faring the storm fairly well - rushed in to fight for a company worth fighting to avoid, and they got what they thought they wanted. Now things do not seem to be so nice and rosy. Go figure. I intended to put a put option on Wells Fargo at the time but options, in both directions, are too over-priced right now. Still, I could have made some money on that one.

The question you have to ask yourself is how many other major purchases/mergers this past year will lead to problems beyond what was anticipated. There are at least a couple of financial behemoths that are going to face some challenges this year. Don't worry though, Paulson will save the day.

http://www.bloomberg.com/apps/news?pid=20601087&sid=aJx1Gt0NKWgo&refer=home

Goldilocks and the Four Bad Bears

I mentioned above that Calculated Risk has some nifty charts. They have a few right now comapring the current decline to other notable bear markets. Seems we may have a bit to go to keep up with bears of the past. If my predictions for 2009 are accurate, we will get there.

http://www.calculatedriskblog.com/2009/01/four-bad-bears-end-of-year-update.html

Comment Response

One of my new challenges is to review comments here and at Seeking Alpha, where some of my posts get published. One that just showed up there recommended raw materials and financial companies as an investment. Raw materials are all over the board right now so make up your own mind. Eventually they will return but you need to define for yourself "eventually."

While I try very hard not to opine on any individual stock, I am not so shy when it comes to a sector. On the financial industry, decide for yourself, but here are some considerations:

• Foreclosures will continue through 2009 and housing has not reached a bottom;
• Commercial real estate is sinking fast and is lagging the decline in non-commercial;
• The traditional way for financial companies to garner big fees are gone or at least not happening right now, so they are not making money;
• CDSs will continue to plague them throughout 2009;
• The government, hopefully, will wise up and dissolve some of these companies; and
• With so many good companies with stock prices so low right now, why would you bother.

You decide.

Disclosures: None

2009 Predictions

I have seen a lot of people posting on predictions for 2009, so what the heck, let me give it a stab. Let me warn you in advance, this is not going to be warm and fuzzy.

1. Housing will continue its decline, probably for most if not all the year. Why? Well, for one thing there are a lot of adjustable rate mortgages (ARMs) resetting in 2009. Now you might think the low rates will allow them to reset lower, and in some instances that is likely correct, but the wonderful lenders came up with a nice product called an option ARM that lets the buyer chose among various payment options, which can include paying interest only or even less than that. Moreover, while rates are low now, ARMs almost always start with artifically low teaser rates well below where the reset will go, despite low rates today. Accordingly, there will be a host of new foreclosures adding pressure to prices, along with unemployment and other factors. Some markets are near a bottom already, like parts of California, but overall, I suspect housing will continue its decline throughout 2009.
2. Credit will continue in a nearly frozen state for the year. The banks we look to for lending are simply in a horrendous situation and will not be looking to lend their money any time soon. Housing declines will continue to pressure them, as will CDSs, off-balance sheet vehicles and their debtors going belly-up. Some local and regional banks might be more willing to lend, but increasing problems in commercial real estate will impact them too. Continue to look to the government (federal government only) as the lender of only resort.
3. The stock market. I am going on the record here and predicting that the market in the U.S. will be lower at the end of next year than it is right now, and I expect a good 10-20% lower. Not many people are predicting this direction for the market, so you are asking why. After all, doesn't the market typically start to rebound six months or so before a recession ends? Well, the problems we are facing are deeply entrenched and so far we are not doing the right things to fix the problem. I have ranted here enough about the TARP and other moves being taken, so I will not repeat it again. It is possible the next administration will make smarter moves, but I fear even the right moves will not avoid a few years of pain. Yes, a few years of pain. We are in some rather severe spirals that will take a long time to escape.
4. Bankruptcies, and lots of them. And I am talking the Chapter 7 liquidation kind becasue debtor in possession (DIP) financing is very hard to come by right now, which means Chaper 11 reorg is near impossible. For the shareholders and creditors of those that go under this is bad news, but overall for the economy it is a healthy move. We no longer have the massive debt-driven consumption that enabled all the companies to exist, much less the easy credit that let them make ends meet when they probably should have folded instead. Time to thin the ranks.
5. Unemployment over 8%. Even using the government's bogus unemployment numbers I anticipate unemployment going over 8% by year-end 2009. The real unemployment rate is already above that but the government plays games with the numbers to keep them artifically low.
6. Crime will be on the increase as desperate souls seek to make ends meet. Not a surprising call, but often overlooked. Lock those doors.
7. Political instability. A number of countries will become increasingly unstable over the next year. Riots and public protests, like those taking place in Iceland and Europe, will increase. What is truly troubling is the prospect that countries will increasingly turn to military action as political frictions escalate between countries.
8. EU with no U. The strains on the EU have never been greater and Germany's reluctance to play ball with the rest of the union will, in my opinion, cause a rift that cannot be fixed. I doubt the EU will disband in 2009, but pressures will reach a critical point and it may well happen in 2010.
   

Well, there you have it, for better or worse (actually no better here). I am first in line to hope that all these predictions are dead wrong.

Disclosures: None

My Last, Final, Very Last Post for 2008

Bugger Thy Neighbor

One of the links I had yesterday noted the importance of global coordination for fixing our finacial global mess. Well, that is a nice goal but reality is likely quite different. The EU cannot even agree on a response within its ranks, so the likelihood of a coordinated global response is rather slim, to say the least.

Beyond coordination, there is the real prospect of international trade friction escalating. As Yves at Naked Capitalism points out, every country is trying to boost exports to salvage their failing economies. Only problem is there is no country anxious to be the importer. As much as the U.S. government is trying to get the U.S. consumers to return to their over-spending, debt-laden, ways, consumers (out of choice or otherwise) are not spending. They are deleveraging, which is what they need to do. Meanwhile, their deleveraging is causing some pain to countries like China, addicted to our spending ways. These countries are taking steps to alter this and expand their exports again, but this is just folly in today's economy. In any event, imbalances are developing fast. Countries are pursuing the wrong remedies and will hopefully realize this in time to avoid a prolonged global recession. I, for one, am planning on no such realization. Hunker down; this will be long and nasty.

http://www.nakedcapitalism.com/2008/12/groundwork-for-trade-conflict-being.html

Bearfund Comment

Some of my posts are occassionally posted on Seeking Alpha, where I am a contributing author. One of my more recent posts published there resulted in a rather lucid, and worth mentioning, comment from "Bearfund." I quote it here in full:

" 'A third way to benefit stockholders is for the company to do a good job, spend its capital wisely, invest in prudent growth, avoid complicated financial instruments that no one understands and make a profit. Having excess capital sitting around is not a bad thing after all...'

"Doing fine right up until the end there. In fact, having excess capital sitting around is definitely a bad thing. When I buy a business, I want the returns from that business and only from that business. I do not want exposure to arbitrary other assets. When a company builds up excess capital, it usually does so in its home currency or in one of the world's major reserve currencies (dollars, yen, euros). These assets typically earn very little yield, dragging down the company's return on equity.

Compare with dividends: the company retains enough of its earnings to pay off any debt and operate normally through a recession, and pays the remainder of its earnings to its shareholders. They can, in turn, put those earnings to use in whatever fashion they like. If you want to own, say, 3 units of exposure to AAPL's business and 1 unit of US Treasury bills, you're free to do so by taking the dividends AAPL should be paying you but isn't and buying your T-bills with them. If you would rather own 3 units of exposure to AAPL's business and 1 unit of gold, you could do that too. And, if the managers really have a great idea for growing the company, they can sell shares in the new company on the open market and use the proceeds to fund it. If the existing shareholders want to own the new venture, they can benefit from a European-style rights issue in the new shares, or they can agree to suspend the dividend to fund the new business line as an integrated unit.

AAPL is of course only one particularly egregious example, but the point is clear: give the shareholders the flexibility to decide how to save, invest, or reinvest the profits from their holdings. Don't try to turn business managers into asset managers; most of them are not very good at the latter and will consistently underperform.

In the time period of interest, you are correct that holding excess capital was profitable. But these are relatively unusual times: there has been a short squeeze in money of zero maturity; despite plentiful supply, the size of the short positions outstanding simply became too large and forced covering resulted. Under such circumstances, those T-bills did pretty well (though not, I should mention, as well as much more leveraged instruments like the Long Bond, or - curiously - the base unit of stored value, gold). If you as an investor chose to buy assets like Treasuries or gold with your earnings, good for you. If you chose to buy more shares, not so good for you. But your choice shouldn't have been made by management or the board of directors. You should have been handed a dividend check and told to fend for yourself.

Buybacks, funded by debt or not, deserve only a brief mention: most publicly traded companies provide their senior managers with most of their compensation in the form of restricted stock and/or stock options. Under such circumstances, buybacks should be strictly prohibited, especially if any senior manager also serves as a director. The main reason for buybacks is the incestuous nature of boards of directors, which usually consist of executives from other companies. Doing buybacks simply allows them to feather one anothers' nests at the expense of shareholders.

It is true that paying out substantially all earnings every year will expose marginal businesses to severe pressure during downturns, because they will mostly be forced to take on tremendous debt to provide an adequate return on equity. The solution to this is not to limit dividends but to limit debt, and encourage marginal businesses - especially mature ones in decline - to shut down. The result will be a smaller economy in notional terms, but one which is far less volatile and allows investors much greater freedom to start new enterprises (since their capital will not be tied up on the balance sheets of poor-performing companies). In short, the economy would be much more dynamic, with fewer zombie companies and more new ventures. If the money is sound as well (i.e., it is gold or silver and no central bank is on the scene) then interest rates will be low all the time (no need for an inflation premium since there's no inflation, and little demand since debt is used sparingly) and the speed of money will be high as paid-out earnings are forced to search for returns.

Who can lenders trust? A tough question to be sure. But maybe the answer, as I've outlined it here, is that it shouldn't matter so much. A more dynamic, less leveraged economy would offer all of us quite a lot - except, ironically, those who take, and introduce, only systemic risks: the large-scale leveraged borrowers operating underperforming businesses and the lenders who enable them with the help of a flood of money from the ever-devaluing central banks."

I have no qualms with Bearfund's comment. What I need to do is add a caveat to my own. When I wrote my pience I had in mind companies like Berkshire Hathaway, who do in some respects act like asset managers. They make their money investing moreso that through a typical business model. Berkshire stored away over $50 billion in capital during the bubble to take advantage of this crash. And while not all companies are oriented to investing like this, I do think most should have a CFO who is looking at the economy, determining whether a bubble might pop soon, and deciding how to perhaps build capital and take advantage of it. Even if you are of the school that this bubble was not predictable - despite dozens of very vocal voices predicting it - you might at least subscribe to the Taleb Black Swan principle and put some bucks away for the completely unpredictable. Putting something aside to take advantage of once-in-a-lifetime events can lead to once-in-a-lifetime gains. Gains that might be unthinkable otherwise. And I am not just talking gains in profit, but gains in market share, taking over competitors, and the like. Right now there are companies out there just sitting on piles of cash and they will come out of these "relatively unusual times" with opportunities unheard of in usual times. They can achieve gains on the competition that would take decades otherwise.

So Bearfund, I hear what you are saying and agree that what you have to say is sage advice, but if you have not read Taleb's book on Black Swans, I recommend it. It opens a new door to investing - the preparing for the unexpected events side - that is worthwhile exploring. Your advice is well grounded in usual times, but my comment on maintaining excess capital (which was admittedly not properly stated) is oriented to those that migh like to take advantage of less than usual times, which we can expect for some time to come.

Disclosures: None

Top 10 2008

As I suggested yesterday, here are some top 10 lists to end the year. If you find others of interest, please leave a comment and I will be happy to link them.

Top 10 Stupid Moves That Created This Mess

1. Securitized Debt. Call it mortgage backed securities, CDOs, CDOs squared, CDOs cubed, CDOs quadrillionthed or whatever, but the process of those underwriting the risk not keeping the risk led to, well, lots of risk. All was fine and well while housing continued to climb, or at least appeared to be fine and well. You know the rest of the story.
2. Rating Agencies. The rating agencies were being paid to rate the securitized debt and when you are paid handsomely to do something you do it. Seems the money making aspect of the process was perhaps the driver for some ratings that, at least in retrospect, were foolish at best. I don't care what tranch you are talking about, subprime mortgages, like liar loans and 100% LTV loans, never deserved triple A ratings or anything close.
3. Credit Default Swaps. Credit default swaps are to blame for AIG's demise. Otherwise they have not been the biggest player in creating the mess but may be the biggest player in cleaning it up. It would be nice to be able to let some of these players fold in an orderly fashion and support just those that survive. The problem is that the folding process will undoubtedly trigger some of the CDS contracts, which may result in taking down other entities in the process. With what was once estimated to be $62 trillion in CDS contracts in play, this is no small problem.
4. Commodity Futures Modernization Act. Try saying that five times real fast. While the act, which was enacted in 2000 in the final days of Clinton's presidency with no debate in either the House or the Senate, did various things, the key thing it did was legalize CDSs, which arguably were illegal before then. To the extent someone bought a CDS to protect them on a bond, for example, that was insurance and should have been regulated as such. To the extent the person buying the CDS had no interest to protect, they were simply betting that a company would default, which is gambling. The Commodity Furtures Modernization Act made sure CDSs did not get treated as insurance or gambling.
5. SEC. In 1975 a regulation was passed that limited the leverage certain financial institutions could take on, in relation to capital, to a 12-to-1 ratio. A few years ago the SEC provided an exemption to a handful of institutions, including Lehman Brothers, Bear Stearns, Merrill Lynch and Goldman Sachs, allowing them to go up to 40-to-1. Oops.
6. Liar loans, 100% LTV loans, option ARMS and the like. Closely tied to the securitization issue was the scope of mortgage products being made available. People could get mortgages with no or minimal documentation, with no money down, with payments that did not even keep up with interest accrual and with poor credit ratings. If you could fog a mirror, you could get a loan. Those taking out these foolish loans, on the expectation that prices would continue to rise, are as much to blame as anyone.
7. The Fed. The Fed, under Greenspan, kept interest rates too low for too long following the dot com bubble bursting. It also was a staunch advocate for deregulation and free market principles. Greenspan spoke openly on how CDSs for example, were good for the economy because the reduced risk. Having $62 trillion in obligations out there waiting for the shoes to drop is not my version of reducing risk, but to each his own.
8. Special Purpose Entities. These are orphan companies set up by a company, such as a bank of financial institution, that keeps certain assets and/or risks off of the sponsoring entity's balance sheet. Financial institutions have been able to hide a great deal of loss this way. Enron is a prime example of how these off-balance sheet entities can be abused.
9. Ben and Henry. They downplayed the problems for far too long and when they did react their plans were poorly conceived and executed. We seem to be following the Japanese play book and everyone can see how well that worked out. Throwing money at the institutions that created the problem is not helping anyone but those institutions. We would be better off to stand in their shoes and lend the money instead of giving it to them and hoping they will lend (which of course they are not doing).
10. The Shadow Banking System. You know who they are. Some of them are gone and some have had to merge. Some have now agreed to change their form and be regulated. These entities went unregulated and self-supervised for way too long and we are all paying the price. Some of the problem here is their compensation scheme that handsomely rewards large profits, even when they are earned at the expense of future stability. These behemoths should be dismantled, but instead we are supporting their attempts to become bigger. Iceland learned what happens when financial institutions get to big to fail and too big to save, but we never learn.

This is by no means a complete list but it is a nice start. Feel free to make suggestions.

Top 10 Records Set in 2008

Setting records can be a good thing or a bad thing, it depends on the record. As you might have guessed, this is a list of the not-so-nice records of 2008.

1. $30 trillion in market valuation losses. This is a very big and painful number. For the U.S. it comes at a time when baby boomers are getting ready to retire, so the timing is terrible (as if there ever is a good time for this to happen). While some of this will eventually reverse itself once the recession ends, it could take well over a decade for valuations to return overall, and certainly for many companies they never will. http://www.bloomberg.com/apps/news?pid=20601109&sid=ataVotdLreS0&refer=home
2. $50 billion Ponzi scheme. The biggest and perhaps longest running Ponzi scheme, engineered by Madoff, has come to an end, and the impacts are far and wide. This one does not even have three degrees of separation from Kevin Bacon. http://www.bloomberg.com/apps/news?pid=newsarchive&sid=asjgOZK87JDI
3. Highest number of foreclosures ever. I hope 2008 will be the peak, but expect foreclosure activity to be high throughout 2009 and into 2010. They will be shifting from subprime to Alt-A and prime, but they will continue as housing prices decline, jobless claims rise and credit remains tight. http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aRhcv8yIAheo
4. Record 18% decline in home prices. It is what it is, though this is through October, so it may not be a record for the calendar year once we know the year-end data. Still bad by any standard. http://www.monkeybusinessblog.com/mbb_weblog/2008/12/caseshiller-housing-index-decline-sets-another-record.html
5. $700+ billion in financial company write-downs and still counting. Most have predicted this will eventually exceed a trillion and some say two trillion. A trillion here and a trillion there and this starts to add up to some big money. http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aRhcv8yIAheo
6. Largest bankruptcy ever. Lehman Brothers bankruptcy filing, with $613 billion in debt, was the largest ever. The 158-year-old-firm had survived the Great Depression but it could not survive 40+-to-1 debt to capital ratios.
7. Record redemptions from hedge funds. Not a biggie here except that this will impact stock prices as hedge funds have to liquidate further next year. http://www.ft.com/cms/s/7b886520-d6a2-11dd-9bf7-000077b07658,Authorised=false.html?_i_location=http%3A%2F%2Fwww.ft.com%2Fcms%2Fs%2F0%2F7b886520-d6a2-11dd-9bf7-000077b07658.html&_i_referer=http%3A%2F%2Fwww.nakedcapitalism.com%2F
8. Record Oil Prices and Record Decline. Oil hit $147 a barrel earlier this year only to be followed by its biggest price drop ever. Kinda like following the bouncing ball.
9. Largest nationalization. The U.S. increased its debt load by about $5 trillion when it nationalized Fannie Mae and Freddie Mac. The irony of the bastion of capitalism doing the largest nationalization ever is not lost on the taxpayers.
10. Three-month Treasury yields below 0%. Not even during the Great Depression did rates go this low. We are effectively paying the government to keep our money. Now that spells panic.

There you have it. Not a pretty picture. For those interested, here is a nice piece by Fortune on the 21 Dumbest Moments in Business for 2008.

http://money.cnn.com/galleries/2008/fortune/0812/gallery.dumbest_moments_2009.fortune/index.html

Disclosures: None

Evening Edition

All I can say is this is bad news, as far as I am concerned. Purchasing half a billion in mortgage backed securities from those that brought us here is not inspirational, even if you have some smart people managing the process. And if you believe the line about "minimal" risk, then you have to ask yourself, if there were truly minimal risk then why? Why relieve these companies of good securities? Does that help them? Of course not. So we continue this charade. Moreover, we seem to be trying to lower interest rates. Heeelllloooo! Too much lending got us into this mess. I can see helping some people reduce their rates to make current loans affordable and reduce foreclosures, but doing anything to foster more debt at the moment is foolish. When houses get to where they can be affordable at reasonable rates or people's incomes can get to where they can afford them, then we have achieved a bottom. Until then, artificial supports are doomed to failure, in my opinion.

http://www.bloomberg.com/apps/news?pid=20601087&sid=a160y41WSJvk&refer=home

What really gets my goat about the actions to date by the Fed and Paulson are they are seeking to help the worst of the bunch. They are propping up those that foolishly created the mess in the first place. Moral hazard is totally out the window, but that aside, what about all the companies, large and small, suffering from a situation not of their own making. Where is the government support for the small businesses. It is truly lacking and that has my panties in a bunch.

This is one aspect of Obama's plan I like. Instead of throwing money at the culprits, we are spending money on things we need, like infrastructure, alternative energy and education. Perhaps this will not help the ecomony at all, or minimally, but it will have the good side-effect of a getting something done that is positive. If you can say that about the $152 billion we wasted on AIG, I am all ears. If you can say that about the tens of billions we gave away to financial companies under TARP, well the ears are still here. I think not. So doing something that solves the problem - or at least tries to - from the bottom up instead of the top down is a positive in my book.

Michael Panzner and Charles Smith do a nice couple of posts on how helping the big corporations is missing the boat as the backbone of our society is small business, not large, and they are in a whole lot of hurt at the moment. Think of how many can be helped by the money we have wasted on the financial sector alone.

http://www.financialarmageddon.com/2008/12/not-seeing-that-small-is-bigand-hurting.html

Year-End Edition

To end the year right tomorrow, I would like to do a top-ten list or two. I am open to suggestions here, so feel free to comment. Here are a few thoughts:

1. Top 10 list of stupid things done during the 2007 bubble.
2. Top 10 list of stupid things done in response to the bubble bursting.
3. Top 10 predictions of the stupid things the government will do next year in response to the bubble bursting.
4. Top 10 reasons to sell everything and move to some remote island where they cannot even spell recession.
5. Top 10 reasons to not have a top 10 reasons for anything.

Your thoughts/comments are more than welcome. I am looking for thoughts on additional categories. I am also looking for your contributions/votes on what qualifies for the top 10 lists above. Have fun!!

Who Can You Trust?

That is the question of the day when it comes to lending activity. What Buffett once referred to as financial weapons of mass destruction seem to have a very long half life. Right up there with uranium. Until the derivaties mess has played out and companies know what is on their books, credit will continue to only be available and/or affordable for the best of companies.

This is why GE and the few other remaining AAA rated financial companies are trying so desperately to maintain their rating. Once upon a time the interest rate charged a AAA company only varied a few basis points from that charged a AA- company (three steps lower), so the financial impact in terms of interest charges was relatively minimal. Well, that time is long gone and the difference now is a whopping 112 basis points (a basis point is .01 percent). For companies using massive amounts of debt, that difference can be tens of millions of dollars a year.

http://www.bloomberg.com/apps/news?pid=20601087&sid=a59gngOiy2c8&refer=home

So why such a spread today? That trust thingy explains a lot. Those still willing to lend need to be sure they will get repaid because there is virtually no secondary market for securitizing the loan. In other words, banks actually have to do some underwriting for a change because the loan will remain on their books. Accordingly, any variance from a perfect rating will cause lenders to charge a premium. There is also the supply/demand aspect to consider. Not a lot of lenders out there willing to lend at a time when there are a host of companies desperately needing to borrow. Those lenders still lending can afford to be picky and charge a premium for the privilege.

One reason banks are not lending money despite the hundreds of billions thrown to them by the U.S. is that they do not fully know how much they will need to use themselves to survive. As I have noted before, their business model is broken. All those fees they used to generate on complex financial transactions are now gone at a time when they are continuing to have building losses on loans, derivatives, credit cards and the like. If you are not making money and your losses are mounting you are not about to lend what you have to other companies that may not be able to repay you. Instead you hoard what you have until you are sure you will not need it, which could be years from now. Keep in mind that a lot of this money from the Fed is given to them as a loan that, absent them folding, will have to eventually be repaid to the Fed, so even when they do get back on their feet, they will have numerous lean years while they repay the loans. Don't look for banks to be posting good profits for some time to come.

http://www.nakedcapitalism.com/2008/12/banking-industry-sinking-faster-than.html

2009

I hope to post tomorrow some more thoughts on what 2009 holds for us. Not a pretty picture at the moment. Here are some thoughts from Wolfgang Munchau, at Financial Times, on what we should be doing in 2009. I agree with most of his thoughts (though not all of them as I do think spending on infrastructure and education makes sense). One particular point I like is that the financial industry is too large and we cannot and should not support it in its current form. Some of it needs to be broken up and wound down in an orderly fashion. I know this will have some unintended consequences, like in the CDS world, but we cannot support it all and need to use our money more wisely.

He also has a warning on things that might happen in 2009 to make matters much worse. Some of these are well within the realm of possibilities:

"It is not difficult to construct a plausible scenario of an economic catastrophe. Pick some of the following and you could end up with a depression that beats every modern record: a rise in global protectionism; competitive currency devaluations; a sterling crisis; social unrest in China, leading to political instability; a well-timed terrorist attack; continued refusal by eurozone leaders to co-ordinate; a payment default by a large sovereign in the eurozone; an acute emerging market crisis; continued lack of synchronisation of monetary policies, or a collapse of the CDS market. Obviously, the insolvency of a large global bank or the annihilation of the hedge fund industry would not go unnoticed either."

http://www.ft.com/cms/s/0/af4e7e40-d507-11dd-b967-000077b07658.html

You Can't Make This Stuff Up

Companies have variuos ways of financially benefiting their shareholders. One way is to pay dividends. The problem with dividends is that when you start paying them the expectation is that they should continue and never get reduced. Some companies this year are proving that expectation to be wrong, while others are struggling to maintain it.

Another way to benefit shareholders is through stock buybacks. Rather than just handing the money over to shareholders and building a dividend expectation in the future, some companies in good times will use some of the excess cash to rebuy shares, which should have the effect of increasing the share price for those remaining shares on the market. Note I emphasize excess cash as it makes no sense to buy back shares if you do not have the cash.

There is a good bit of controversy over share buybacks and whether they really make good sense for the company. While the logic of a buyback may be debatable generally, I think most would agree that using debt to finance a share buyback is right up there with subprime mortgages on the "ten stupidest things I did during the bubble" list. Seriously folks, how do you add value for shareholders by taking out a loan - on which you pay interest - to artificially inflate the share price with a buyback? I am sure some CFO got a nice bonus for coming up with that idea.

http://www.bloomberg.com/apps/news?pid=20601087&sid=aOW9ACek2RRg&refer=home

A third way to benefit stockholders is for the company to do a good job, spend its capital wisely, invest in prudent growth, avoid complicated financial instruments that no one understands and make a profit. Having excess capital sitting around is not a bad thing after all; just ask the companies that are now struggling to pay down debt. Indeed, those with a lot of capital now will undoubtedly get a host of investment opportunities over the coming months as competitors fail and sell assets at fire sale prices. Guess I am a bit old fashion here, but I like companies that benefit shareholders by being well run and prudent. Not all that exciting, I know, but if you want exciting you should go to an amusement park.

By the way, there is another reason why a company might do a share buyback that is worth noting. Buybacks can be done to cause a short squeeze. Just ask those that were shorting Volkswagen in late October when Porsche decided to execute on some options and increase its stake to 75%. The stock shot up 93% and the company for a while was worth more than Exxon. Talk about a squeeze.

http://benbittrolff.blogspot.com/2008/10/volkswagen-short-squeeze-hedgies.html

We Only Lost 38%!!

You know times are tough when a well run mutual fund that is closing in on the record for the most consecutive years for beating the S&P can boast that it only lost 38% this year. And, yes, that is a bit better than the S&P so far. I doubt this fact is being touted in their advertising materials but it is being touted by Bloomberg. I should note that my daughter's piggy bank is nicely beating the S&P this year, so if any Bloomberg writers are reading this, she does give interviews.

http://www.bloomberg.com/apps/news?pid=20601087&sid=aELpuqQko.Xg&refer=home

Go Figure?

Home prices in 20 major cities tracked by the S&P/Case-Shiller index dropped at a record rate, 18%, in the 12 months to October. All told, down 23% from the 2006 peak and still falling. The combination of tight credit, job losses and foreclosure sales will continue to pressure prices through 2009 and perhaps into 2010. Most predictions I have read by those that seem to be in the know are expecting the housing prices to drop 35-40% in total before all is said and done, so we still have another 12-17% or so to go. At the current pace, that is another 8-12 months before reaching bottom. We will see.

Another record also set today was in the consumer confidence index. Down to 38, which is the lowest since records began in 1967. Seems that people are realizing this recession is going to wear on for a while. There is also a lot of concern about jobs and unemployment, which is to be expected. In a word, it is dismal out there and the holiday retail numbers will reflect just how dismal.

So how does the market react to all this dismal news? Up nicely at the moment. Go figure? I guess some dismal news is already worked into the market at the moment, but we will see during the year-end reporting season coming up just how much. I still expect new market lows next year. The question is, how low?

http://www.bloomberg.com/apps/news?pid=20601087&sid=aquICb64DYOc&refer=home

http://www.bloomberg.com/apps/news?pid=20601087&sid=a1sbaSrZJxO8&refer=home

Rules To Live By

Robert Farrell, a long time analyst at Merrill Lynch (I bet they wish they had him back), developed a number of rules for guiding investment strategy. Some of these, like reversion to mean, I have discussed in some detail here. They are along the lines of my two-plus-two approach. Sooner or later we come out at four. I think these rules are all worth some consideration in these troubling times. The Big Picture recounts the 10 Rules here, with some good comments. Numbers 2, 5 and 8 are particularly worth noting at the moment.

http://bigpicture.typepad.com/comments/2008/08/bob-farrells-10.html

CRA Blame Game

Some people are seeking to blame the Community Reinvestment Act for the subprime crises. Now I know there is a logical and valid debate on whether the CRA has actually achieved its goal of ending a lending practice of redlining, i.e. not lending in poor areas, but to blame it for the current crises is ridiculous. The act itself calls for "sound" business practices and in no way, shape or form required banks to do liar loans, option ARMs, no money down or other junk loans that they were doing. Moreover, the CRA has been on the books for three decades but the current mess has largely been developing for less than a decade. Folks, there are plenty of scapegoats out there for this mess, but I hardly think the CRA qualifies. If anything the impact of the CRA has lessened under the current administration where agencies such as the OTS did little to enforce it.

http://baselinescenario.com/2008/12/16/community-reinvestment-act-housing-crisis-aei/

Here is a nice piece from the Washington Post (the first two of a three part series) on the arm of AIG that took it down, AIG Financial Services. Let me summarize what happened to AIG as best I can: GREED.

http://www.washingtonpost.com/wp-dyn/content/article/2008/12/28/AR2008122801916_pf.html

http://www.washingtonpost.com/wp-dyn/content/article/2008/12/29/AR2008122902670.html?hpid=topnews

Rick Rule Interview

Here is an interesting interview with Rick Rule (hat tip John), someone who knows commodities much better than your's truly. The part I find of interest is his discussion on oil. I noted yesterday I do not see oil prices escalating to any significant degree next year, and I am sticking with that (for now), but his point on where they might be in five years is well worth the read. He points out that a lot of the oil supply today comes from national oil companies, i.e. government owned. The governments running these operations are, generally speaking, running them into the ground. They are stripping the profits for social causes and/or their own use and not properly investing in new production or maintaining operations. This could lead to the destruction of 25% of today's supply in the years ahead. You might also have some tar-sands operations shut down, at least for now, as oil is well below where these operations are profitable. Ramping them back up could take some time. All things considered, $4 a gallon gas could sound rather cheap five years from now.

http://www.growthstockwire.com/interview/20081029_rickrule.asp

Disclosures: None

Thin Week

This is a thin week on many fronts due to the holidays and the new year, so it is wise not to read too much into any news. Stocks being down a smidge is an example. With trading volume low it does not take as much to swing things. January and February will be another tale. Despite the slim trading, the news remains dismal on the retail front, as Bloomberg reports. Not a surprise, just an affirmation.

http://www.bloomberg.com/apps/news?pid=20601087&sid=aOVg4pkw229o&refer=home

Unintended Consequences by the 800 Pound Gorilla

The 800 pound gorilla here would be the U.S. and other developed countires We are borrowing at an alarming rate. Still, people are flooding to Treasuries as a safe haven - for now, anyway. The question not asked much before is where would those dollars flow otherwise. After all, we are borrowing trillions of dollars, soaking up global capital like a desperate sponge, with little thought to the other players looking to secure some of those dollars. Well, it would seem that developing countries will once again take the brunt of our indiscretion. Their credit is drying up just as they need it most and in no small part to the larger players being on a borrowing spree. If this does not correct in time, more issues will face the global economy that will be hard to fix in short order.

http://www.nakedcapitalism.com/2008/12/emerging-economies-risk-being-crowded.html

And if you believe that, I have a bridge to sell you...

Apparently, you too can soon own a bridge, or highway, or lottery or other state assets, either full out or at least for a time. Yes, it is true, state governments are in desperate need for cash and desperate times require desperate measures. So states left and right are looking at some ways to sell, or at least lease, some of their crown jewels in terms of reveune generation in order to quickly raise some needed mula. Form your own opinion on this. To me, at least a limited term lease to make ends meet makes sense, but selling off long-term income generating assets - likely at fire sale prices - is a bit short-sighted. But then again, I am not facing a multi-billion dollar deficit, so what do I know.

http://www.financialarmageddon.com/2008/12/more-bad-choices.html

Almost Heaven

As noted yesterday, I spent the holidays with family in West Virginia. Some people have thoughts about my home state that are not too positive. Yet, I love the state and have some points to note in its defense:

1. WVU won its bowl game this year and its quarterback, Pat White, after throwing for 332 yards, won his fourth bowl game as a quarterback to set a record. This is in addition to being the NCAA all time record holder for rushing as a quarterback, not to mention having the most touchdowns of any college quarterback.
2. WVU beat the pants off Ohio State in basketball this past Saturday.
3. WV is the only state in the country that did not have an increase in unemployment between November 2007 and November 2008. And their unemployment rate, at 4.6%, is well below the national average.
4. Did I mention that it is an absolutely beautiful state?

Despite some not-so-nice comments I have heard over the years, WV is a great place and I am proud to be a mountaineer.

http://www.bls.gov/web/laumstch.htm

Not on any list!!

My first year of blogging and I have escaped all the lists of worst predictions. Now I could say this is due to making no clearly wrong predictions. Or it could be because the few dozen people who follow my blog did not write these lists. Either way, good not to be on them. Still, these list are some good reading. Some people went way off the mark and paid the price (or at least those that listened to them paid the price). One reason I give no advice. For those Hogan's Heroes fans, I am the Shultz of the blog-sphere: I hear nothing, see nothing, know nothing. Yet here you are, reading what I have to say. All I can say is thanks.

http://www.ritholtz.com/blog/2008/12/worst-predictions-for-2008/

DOW DOWN

For once I am not talking about the Dow Jones Industrial Average. This time it is about Dow Chemical. Its deal with Rohm and Haas appears over as Kuwait is drawing in the purse strings. Let's speculate that Kuwiat, like the rest of the Middle East, is feeling the pinch of low oil prices. Otherwise, they no longer saw the wisdom to the deal. Either way, Dow Chemical is being down graded and the stock is down big time today, as is Rohm and Haas. Will we need chemicals tomorrow, sure, but not as much as we needed a year ago. This demand will eventually return to some extent, but the question today is whether Dow Chemical will be here to enjoy the bounce?

http://www.bloomberg.com/apps/news?pid=20601087&sid=aEOpmCv.eKSE&refer=home

The Big Oil Rebound

I have noted here repeatedly that I despise analysts predictions as most cannot tell their predictions from a hole in the ground. In other words, they put the anal in analysts. Yet I feel compelled to report on their latest prediction. They predict $60 a barrel oil by next year. While I have little doubt it might hit that mark, I must say I disagree with any prediction that keeps oil on average that high next year. Mind you, "that high" is very low by recent standards, but I still disagree with these predictions, at least for 2009. If I am correct in my anticipation that the global economy, and especially China, will suffer big time in 2009, I think the dampered demand will, on average, keep oil in the$50 a barrel range or lower. OR - I could be wrong!!

http://www.bloomberg.com/apps/news?pid=20601087&sid=abtq_Q4RkQJQ&refer=home

Disclosures: None - other than I am from West Virginia.

I'mmmmmmmm Baaaaaack!!

Well, six houses, seven gift openings, 1300+ miles, ten dogs, dozens of relatives and a partridge in a pear tree later, I return. It is good to be home. I sit here watching the Miami/Jets game, hoping the Jets can pull it out (update, they did not do so). New England's future likely depends upon it. Oh well, like the stock market, watching it will not make a difference.

Two Months

Yesterday was the official two month anniversary of my blog. I would have liked to blog but I was on the road nearly the whole day and landed in a location where I did not have internet access. Nice break, however, after a long drive. Anyhoot, two months in and, apparently, picking up speed. Seeking Alpha posted my first contributing article today. You can either click on the Seeking Alpha certified label on this blog or go here to see it.

http://seekingalpha.com/sector/retail?source=refreshed

Quite the honor for your's truly. I will try to continue to live up to their standards. But now, on with the good stuff, what little there is:

Latvian Prostitutes

Okay, I must confess that I do not fully understand the Latvian economy or the price of hookers within it. Indeed, "not fully understand" is a vast understatement as I would be hard pressed to find Latvia on a globe, much less discuss the plight of it hookers. Thus, I refer you to Bronte Capital for more detail.

Let me be a bit clearer here, as Bronte Capital talks more about currency devaluation, monetary policy and the like moreso than the prostitution trade in Latvia, though he links an older post that I read when it came out that is more intensive on the prostitution side of things. I will not seek to fully understand or explain his musings. The only thing I can say is that the pain is obviously geographically and economically widespread. And all occupations, including the oldest, seem to be impacted. Moreover, U.S. prostitutes beware!!

http://brontecapital.blogspot.com/2008/12/hookers-that-still-cost-too-much-some.html

UPS - Social Upheaval

I will be the first to admit that I am making a mountain out of a mole hill here, but it plays well with various comments I have made here, so I am running with it. A UPS driver apparently signed in a turban wearing customer as a "terrorist." The attached article addresses the rampant racism in this act and deals well with the facts, so I will not go there.

http://consumerist.com/5119125/sikh-signs-for-package-ups-driver-enters-his-name-as-terrorist

Where I will go is the social unrest caused by economic recession or, perhaps, depression. I was thinking about this today on the long drive home so I have stretched the UPS article to fit in my thoughts. Let me begin with a quote from Time magazine when it made Hitler the Time Magazine "Man of the Year" for 1938:

"Most cruel joke of all, however, has been played by Hitler & Co. on those German capitalists and small businessmen who once backed National Socialism as a means of saving Germany's bourgeois economic structure from radicalism. The Nazi credo that the individual belongs to the state also applies to business. Some businesses have been confiscated outright, on other what amounts to a capital tax has been levied. Profits have been strictly controlled. Some idea of the increasing Governmental control and interference in business could be deduced from the fact that 80% of all building and 50% of all industrial orders in Germany originated last year with the Government. Hard-pressed for food- stuffs as well as funds, the Nazi regime has taken over large estates and in many instances collectivized agriculture, a procedure fundamentally similar to Russian Communism."

I do not pretend to understand Hitler or WWII, but as I understand it Hitler's rise to power was in part due to economic strife in Germany and a promise of economic austerity. The present times, I fear, are leading to an arena where such rhetoric can again gain a foothold. People are looking for scapegoats to execute or to explain or excuse their pain. It is this environment that on an international scale can lead to those with the wrong message being believed. Those wanting to stir the pot can stir the pot.

I hope these words ring hollow and the world comes together to fight our current economic plight. But I fear that these times will lead to enough desperartion that we will see over the next decade more political and military turmoil than we have in a long time.

I realize this is a bit off the mark from my usual fare, but the political/military/war arena impacts all others, so it needs to be considered. If I am right, I will not say I told you so. If I am wrong, I will be very happy to say so. Watch though, as things are beginning to percholate a bit around the world.

Yield Curve - No Where to Go

Those that follow the yield curve may think the worst is behind us. Well, that ignores that the Fed has taken the Treasury rate down to 0%, effectively negative, so this means nothing. Don't believe me, Krugman says it better than I can.

http://krugman.blogs.nytimes.com/2008/12/27/the-yield-curve-wonkish/

No Safe Haven (or very few)

I report here often on U.S. spending being low. Well, we are not the only ones. Britian is sucking wind as well. Not a lot to add here except to note again that the decoupling theory was just that, a theory. Sometimes theories do not hold water. And if this was your theory, well, can I hand you a sponge?

http://www.guardian.co.uk/business/2008/dec/26/creditcrunch-consumerpages

History Books

A lot will be reported about the current financial crisis as time passes. This will fill chapters in economic texts in the future. I fear it will all be reported as the dire consequences to those who could not foresee this coming, as opposed to focusing on those that anticipated it coming. I would like to be considered in the latter crowd, but I was late to the game, not joining that bandwagon until late 2007, which turned out to be in the nick of time but still a bit late. Many others saw it coming far in advance. As one comment I saw mentioned, however, some saw it coming too soon. If you predict a bubble too soon, you can miss out on massive gains. If you get out too late, you have massive losses from your earlier massive gains. If you are in the middle, Goldilocks will be happy. In the end, it is best to probably be somewhere in the middle. Early or middle, however, and the history books will forget you.

http://www.theglobeandmail.com/servlet/story/RTGAM.20081226.wmeltdown1227/BNStory/National/?page=rss&id=RTGAM.20081226.wmeltdown1227

Disclosures: I work for a subsidiary of Fairfax Financial and own stock in that company through my employee stock owernership program.