It Is Time To Get Angry...
1/22/2009 11:59:33 AM
This week's letter will focus on banks and related financial matters. Of course, this brings us squarely back to the creation of TARP. In addition to focusing on financials, I rant a bit about ethics, integrity, and honesty, as it seems, at times, these are largely missing in our leaders.
The wildcard in all of this is the use of TARP funds. Given that President Elect Barack Obama is due to be inaugurated next Tuesday, a new administration will ride herd over TARP funds. The Senate approved the remaining $350B on Friday and some of it has already begun to flow.
Let's step back to the moment in time when Treasure Secretary Henry (Hank) Paulson put forward the idea that the U.S. government needed to act swiftly to forestall a financial crisis, which was eventually dubbed the Troubled Asset Relief Program (TARP).
Paulson put forward a plan calling for $700B of relief. The plan was put forward to buy troubled assets from financial institutions that held them in order to contain the possible financial contagion that could infect the system. The idea was that the government would conduct auctions for these securities and buy them from the institutions to remove them from the companies that held them in order to turn unhealthy firms into healthy stable firms that could help the economy to grow. The bill was passed by Congress on October 3rd, 2008.
Fast forward to November 12th, 2008, Paulson gave a speech which included the following paragraph:
"During the two weeks that Congress considered the legislation, market conditions worsened considerably. It was clear to me by the time the bill was signed on October 3rd that we needed to act quickly and forcefully, and that purchasing troubled assets - our initial focus - would take time to implement and would not be sufficient given the severity of the problem. In consultation with the Federal Reserve, I determined that the most timely, effective step to improve credit market conditions was to strengthen bank balance sheets quickly through direct purchases of equity in banks." Did Paulson say that he knew he wouldn't do what he said he would before Congress even passed the legislation? Did Paulson lie?
In the blink of an eye, the focus of TARP would not be on buying up troubled assets but rather on injecting capital into our financials institutions, primarily the large banks. Nine large banks received funding of up to $25B each out of the originally $350B allocated using up about half of the then allocated funds. The government decided to specifically interfere to prop up the large financial institutions in an attempt to bring order to the financial system, which was dangerously close to imploding.
Let's wander down another path before we bring things into focus at present day.
Adam Smith started to write his "Wealth of Nations" in 1766 after touring about France from 1764-1766. He observed the effects of government interference (taxation) on the economy and looked through the prism of moral philosophy. He was educated in moral philosophy at University of Glasgow and Oxford. He is generally recognized as the father of modern economics. He advocated free markets but was clear in the free markets must function within an ethical and moral society. In fact, his "Theory of Moral Sentiments" was published in 1759 and argues that human communication relies on sympathy between agent and spectator.
In the Wealth of Nations, published in 1776, he argued that a free market would arrive at the right amount of variety of goods, guided by a so-called "invisible hand". The underlying belief is that while human motives are often driven by selfishness and greed, the competition in the free market would tend to benefit society as a whole by keeping prices low while still building an incentive for a wide variety of goods and services. He was wary of businessmen and argued against the formation of monopolies.
A popular quote from the Wealth of Nations is, "It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages."
What was important to Adam Smith was that an efficient market could be arrived at by allowing competition to occur. This required an ethical and moral backdrop in which this competition occurred. It didn't depend on individuals to act with society's interest at heart, but rather their own. It did, however, presuppose that the government would act in society's interest or rather, that the government must act in society's interest. He had observed what happened when the government upset this healthy competition by imposing taxation without representation, and denied or unbalanced competition through the creation of monopolies or significant barriers to competition.
At the time, there were no central banks. In fact, there was little regulation and the government regularly allowed and established monopolies which afforded profit opportunities to the government, and in particular, to those positioned in the government. The obvious conflict of interest wasn't the subject of public scrutiny that it would be today.
Central banks establish and modify monetary policy and the banks follow that policy. In addition, the government has regulatory bodies, such as the Securities and Exchange Commission (SEC) that is supposed to safeguard citizens and market participants from fraud and manipulation. Federal Accounting Standards Body (FASB) is the government body that sets the standards and is enforced by government regulatory agencies. Fiscal policy is a combination of what the executive branch crafts and what Congress approves.
It is obvious that the invisible hand that allows competition to foster and which, theoretically, delivers efficient markets isn't detached from manipulation in financial markets. Manipulation, in this sense, isn't necessarily sinister but it is intentional. The consequences of the manipulation aren't necessarily known, in advance and the market must react to that manipulation.
We are going to continue to explore this theme in future letters as we learn more about what is happening to banks. We'll explore how the government policies and regulation affect earnings, the adoption of risk, and whether or not we can believe what we are being told by the government finance ministers and leaders in the banking industry.
Market Outlook and Conclusion
Our outlook for equities hasn't changed. They will eventually retest the bottom. The Q408 earnings have been disappointing, as we suggested and the investors are reacting in a predictable manner to bad news. If anything, the buoyant market late in the week is ignoring the bad news and we would expect more downside ahead.
The credit markets continue to improve, which means that credit will be flowing to credit-worthy borrowers and the credit crisis will indeed pass in 2009. The TED Spread ended the week at 1.03, which shows continued improvement as it works its way down to the 0.80 level in coming weeks.
Oil continues to move lower. We are likely near a bottom for oil as the reduction in excess supply is actually occurring more rapidly than is generally obvious. Even as OPEC has move to cut approximately 5% of their production, U.S. production has actually declined 25%! Speculators are buying oil and leaving it on tankers anchored offshore, waiting for prices to lift. Once a bottom in oil is found, the bounce will help establish a trading range that will be healthy for the economy and the oil producers.
We are now waiting for the retest of the lows before committing more funds to long positions and actively looking to add to short trades where we feel the assets have moved to excess, such as in the long bond trades.
We have been lied to! (Mark's Rant)
I don't like being lied to. Most people don't like being lied to. Only the cynical expect to be lied to, and I don't consider myself a generally cynical person.
I am appalled at the state of ethical bankruptcy we find ourselves currently living in. I will share some short examples of what I mean, giving incoming President Barack Obama a pass at this time.
How many times have we heard of our elected officials committing crimes while in office? I mean, it isn't as if they are sworn in to uphold the office to which they are elected, right? (OK, I guess I am a little cynical). Blagojevich is a recent example of a politician who claims to have done nothing illegal. As the governor of Illinois, he is tasked with replacing Barack Obama's vacancy in the Senate. He marketed the Senate seat and was looking to sell it to the highest bidder! I am not certain that a law was violated, but the public trust certainly was. It is the lack of apology for unethical behavior that really galls me. It is arrogance which presumes that if it can not be proved to be illegal, it is acceptable.
Here is probably the most famous example of the same sort of behavior. Former President Bill Clinton explained, "what is is?" Mind you, this was under oath to the Grand Jury. The context was his denial to his aids that anything was going on between himself and Monica Lewinsky. This is a case where all observers knew Clinton had lied but he created a legal argument that his lie was time sensitive and therefore couldn't be proven to be a lie. He was just smarter than everyone else and was able to legally dodge the bullet.
We will mention, in passing, Richard Nixon's famous, "I am not a crook" statement. Of course, being impeached and tossed out of office suggests that he wasn't able to escape the legal consequences of being behind a break-in to the offices of the opposition party. How about even George H Bush's famous "Read My Lips, no new taxes" statement that cost him an election. We could take a shot a George W Bush but we will allow him to scurry out of office and be out of the spotlight for awhile.
Closing about elected officials, I will leave you with a thought. Do you really believe that candidates running for office will keep their campaign promises? I mean, how about the majority of them? Well, do you believe that they believed that they would keep them when they uttered them or do you think that they said what they had to in order to get elected? This is where they cynical bunch says, "so what's your point?" For those less cynical, you really need to ponder the state of affairs where the vast majority of the electorate believes that they are being lied to daily during the campaign season. Certainly, if not their own candidate lying to them, the other party's candidate is surely lying. There is something wrong that it is so clear to voters that they are being lied to.
Let's move on to corporate leaders, which is what started me into this rant in the first place. The catalyst for this was Apple's lapse into the obscurity, again.
Apple has been an innovator for decades. In 1984 they offered the Macintosh. It was David versus Goliath (The IBM PC was Goliath). The competed and won market share and forever changed personal computer landscape. It was cutting edge marketing and a focus on improving technology by designing it the way people like to work that enabled Apple to be successful. The genius behind the marketing of Apple is CEO Steve Jobs.
Jobs suffers from a rare form of cancer and Apple's past history of being up front and honest about this is checkered, at best. Then there was the options backdating scandal that cost Apple's CFO his job, while Jobs held onto his position. Most recently, Jobs health was called into question and he offered a vague explanation of a hormone imbalance that wouldn't affect his ability to do his job. A week later, Apple issued a statement that Jobs would take time off until June, but that he would be involved in all strategic decisions. I mean, does anyone believe Apple anymore? They spin everything, and they are very good at it. At this point, investors expect that their PR department will lie about anything meaningful, and then won't really admit they were lying but will give the minimum ground that they have to in order to let the issue move out of the spotlight.
Finally, Bank of America's CEO Ken Lewis told investors seven months ago that BofA's dividend was safe and there was no need to reduce it. At the time, it was paying sixty-four cents a quarter. A quarter later, BofA cut the dividend in half explaining that the acquisitions of Countrywide Financial and Merrill Lynch required that BofA needed to conserve cash. Now we find that BofA has been talking to the U.S. government since December in regards to Merrill's disastrous quarter and not going through with the acquisition without government guarantees. I mean, Lewis is either inept or he lied to investors. While nothing is certain in business, models should have been able to have given best and worst case scenarios, as well as a probable scenario. If Lewis was using the optimistic scenario in saying the dividend was safe, etc., then he was lying, because he had to choose what to represent to investors. I don't believe that he just didn't see the less than rosy models that are out there.
Summing it up, we live in a society that tolerates lying as part of normal social behavior in the form of "white lies". We expect politicians to lie to us. We accept that CEOs lie to us. I am here to say, "where does it end?" I am hopeful that the pendulum will swing so far that leaders start being convicted by their lack of ethics, rather than specifics laws that can be proven to have been broken.
I believe change comes from the top, and that we look to our leaders to set the example. That can be in a family or a group of friends. It is certainly a part of corporate culture, given the hierarchical organization structure. Our elected officials too, need to do more than avoid getting caught breaking laws. They need to make decisions to do the right thing. They need to be held to a higher standard than the rest of us.
President Barack Obama will have to have very broad shoulders in order to carry the burden of putting this country on the straight and narrow in terms of ethical behavior. He already has his hands full trying to clean up the economic mess the world is currently int. I am hopeful that he can provide the confidence and policies that allow the U.S. and the rest of the world, to overcome the current economic malaise as well as to set a new standard in ethical behavior.
Regulatory reforms that emerge on his watch have an ability to change the financial landscape in very positive and meaningful ways. I am hopeful that trickles down to less latitude on the part of CEOs in being able to meaningfully distort the truth when speaking with investors.
No one should have to tolerate being lied to.
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