Thursday, September 25, 2008

Fixing the financial mess in four steps

The current crisis in which we currently find ourselves was 100% preventable.

During the Clinton years, it was the Internet bubble. Bill Clinton was widely credited for the economic growth and expansion that took place during his eight years in office. However, anyone who studied what was really going on also understands that this expansion was due in large part by the dot-coms that were making no money. The economy was run by venture capital. There were no products, just hope. At one point there were six Internet companies of dog food. The growth in sales was what counted, profits didn't matter. Stock market valuations reached the stratosphere. All of this occurred as a result of the infusion of massive amounts of venture capital. The adage, "Stock market valuation doesn't matter, we have reached a new paradigm" was the mantra heard. Anytime you hear this, it is time to head for the hills, because stock market valuations always matter, and bubbles will always pop. What goes up must come down. At the end of Clinton's term, the Internet bubble did burst, and in its wake, it left collateral damage of companies from every industry. These companies were affected since they no longer could do business with these failed Internet companies. This is what I call Clinton's "Fake Economy."

When Bush was elected president in 2000, he inherited a fledgling economy, and in 2001, there was another shock to the system, September 11th. This could have portended disaster to the economy. The tragedy of September 11th caused the Dow Jones to fall 681 points 7.1% to 8920, its biggest ever one day point decline. The stock market lost 1.2 trillion dollars in one week. Every industry declined especially the airline industry. Can you imagine if Bush raised taxes in this scenario? President George W Bush campaigned on lower taxes, and in 2001 he followed through on his promise. These tax cuts spurred the economy on, and avoided a recession that everyone thought was going to happen.

As the economy grew, a new bubble was forming, this was the housing bubble spurred on by low interest rates and easy credit. This was Bush's bubble. People who could not afford houses were buying houses with loans lower than the cost of money on the assumption they would make up the difference later when they sold their houses later at a higher price. Why? - Because houses would always go up. Where had we heard that before? Banks would package these loans and offload the risk to other financial institutions and investment houses making a quick buck. Investment institutions would package these loans into fancy financial instruments known as derivatives that few people could understand. Earnings on these derivatives were estimated and wildly optimistic, and their ultimate value depended on the creditworthiness of the counterparties involved, and we now know the creditworthiness of these counterparties. Warren Buffet called these derivatives in his annual letter to shareholders 2002, "Weapons of financial destruction."

If you want to understand the idiocy of bubbles, and how we will continue to follow them like a pack of rabid dogs, and how the same pattern will repeat over and over again, check out the Tulip Bubble. The tulip was introduced in Europe in the mid 17th Century from the Ottoman Empire. The tulip became so popular that buyers bid up the price to astronomical levels. In Feb 1637, Tulip bulb prices collapsed abruptly, and the trade of tulip bulbs grew to a halt. Click on Tulip Bubble to read the rest of the story. You may think that people were really gullible falling for tulips, but there is no difference in what is happening today.

Greed pure and simple drove the borrowers to take out loans they could not afford, and greed pure and simple drove the financial institutions to lend to any dead man walking.

Who is to blame? The Democrats will say it happened on Bush's watch so he is to blame, so they will point the finger and say, "This is Bush's legacy." But this started long before Bush was president. Even Bill Clinton had to concede that the Democrats were partly at fault. You can reach no other conclusion that Fannie Mae and Freddie Mac are a Democratic mess unless you are blind. The Democrats pushed for easier loans so everyone could buy a home. They don't understand that not everyone should own a home. Bush, however, is not blameless. He was responsible for many grants to left-wing organizations for the purpose of sub-prime mortgages.

So what do we do now going forward?

  1. Reinstitute the Glass-Stegall act – The Glass-Stegall act was enacted in 1933 as a result of the Great Depression. It was repealed by Bill Clinton in 1991. The intermingling of commercial banking and investing activity were thought to be the reasons for the financial crash. It was believed commercial banks took on too much risk. Banks became too greedy risking depositor's money as they tried to reap big payoffs. Many thought that the Glass-Stegall act was too harsh and adversely affected the banking industry. But with the repeal, what feared might happen after the Great Depression, happened. The Glass-Stegall act should be looked at. There needs to be a barrier between the normal financial activities of a bank and investing activities (ie: the speculation that was occurring in the subprime market between banks and the major brokerage houses.)
  2. Severely curtail the securitization of loans. Securitizing loans is the packaging of loans and selling them to a willing buyer for a profit. This allows a bank to take on more risk than they should because they offload the risk to other institutions. When did banks forget how to assess risk? That is their job. If loans are not securitized, the risk remains at the bank. The banks would not take undue risk if they knew they had to hold on to the loans.
  3. Golden parachutes and bonuses should be forfeited if companies fail.
  4. Banks and investment institutions should be transparent in the risk they are taking. I have invested in many bank stocks, and when I read the annual reports, it is almost impossible to assess the risk these institutions are taking. Loans on and off the books, performing and non-performing assets should be transparent, and the risk these financial institutions are taking should be in the annual reports. Had this been known, investors would not have been buying these companies. On April 2nd , 2008 I predicted this financial crisis in my entry The Coming Economic Tsunami. In my blog entry I quoted Whitney Tilson of Tilson Funds in which he stated,

    We've been very bearish on housing for a number of years, but after all of the recent terrible news, we had thought that we might be in the 6th or 7th inning of this unfolding debacle and perhaps it might be time to start buying some of the stocks that have been obliterated, in anticipation of a bottom and then recovery. But then we were introduced recently to the CEO of Amherst Securities Group L.P. Sean Dobson, who has collected extensive data on every mortgage that was securitized in the United States this decade. He was kind enough to share some of his data with us, which shows that we are still in the early innings of the bursting of the housing bubble. Believe it or not, as bad as things have been to date, we have only seen the tip of the iceberg: an enormous wave of defaults, foreclosures and auctions is about the hit the United States. We believe it will get so bad that large-scale federal government intervention is likely.

Why does it take a financial analyst talking to the CEO of a Securities firm to find out the gravity of this problem?  Why is this information not disclosed in the financials so investors can make informed decisions?

One final thought – The ire of voters is palpable and understandable. But, if Obama should be the next president of the United States, who thinks that Obama will not go ahead with his inane idea to raise taxes, and what do you think that will do the economy already teetering on the brink? He already suffers from abulia. One shudders to think of the possibilities.


1 comment:

IBNanouk said...

Good start, sir, but your plan does not go far enough. I concur with the first point about the GS Act, but the others are windows dressing since they would not have prevented the tsunami as you said. Point 2 would effectively end the mortgage industry (securitization just needs to be accountable back to mortgage originator), point 3 is so much to do about nothing since its the share holders' responsibility to control the Board and compensation, and point 4 is already in place simply not enforced by the SEC.

I would suggest that 2 short term changes and 2 longer term changes need to occur to solve the current financial crisis:

Short term:
1. Repeal the "mark-to-market" rule by the SEC/FASB.
2. Allow banks to write down foreclosures off over 5-10 years instead of immediately, but don't stop the foreclosures: they will quickly reduce the housing inventory.

Longer term:
1. Repeal the CRA of 1977.
2. Prevent lobbying of Congress by those impacted or affected by legislation such as GSEs and Wall Street firms.

These points I think would do more to end the current crisis sooner without government intervention.

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